Lecture 4

Economic Development Theories in Review

Harrod-Domar Model

This model, developed independently by RF Harrod and ED Domar in the l930s, suggests savings provide the funds which are borrowed for investment purposes.

The model suggests that the economy's rate of growth depends on:

• the level of saving: measured by the Average Propensity to Save = APS

-APC = savings/income

example: total income $1000, and savings $200. APS = 200/1000 = 0.2

• the inverse of the productivity of capital: Measured by the Incremental Capital Output Ratio (ICOR)

- ICOR = a required increase in capital / income increase

For example, if $10 worth of capital equipment is needed to produce $1 more of output, the ICOR = 10/1 = 10. The efficiency of the capital is the inverse of 10 = 1/10.

If $5 worth of capital equipment is required to produce one more dollar worth of output, then the ICOR is 5/1=5. The efficiency of capital is 1/5. Compared to the previous example, now the capital is twice as efficient.

Mathematical-Formal Harrod-Domar Model: Calculating the Growth Rate of GDP

The growth rate of GDP can be calculated very simply.

The ICOR is defined as the growth in the capital stock divided by the growth in GDP. Since Investment (I) is defined as the growth in the capital stock, the ICOR is equal to Investment divided by the growth of GDP.

Investment will be equal to savings and Savings is equal to the APS times GDP. If we divide both sides by the ICOR and we divide both sides of the equation by GDP we have the result that the growth rate of GDP will equal the Average Propensity to Save (APS) by the Incremental Capital -Output Ratio (ICOR).

Thus if the APS is 12% and the ICOR is 3 the growth rate of GDP, G(Y), would be 4%.

Thus, Growth Rate = Saving Rate x Efficiency of Capital

What is taken for granted:

The Harrod-Domar model was developed to help analyse the business cycle. However, it was later adapted to 'explain' economic growth. It concluded that:

• In general, economic growth depends on the growth of labour L, capital K, and technology T.

Y = f (K, L; T) production function

dY = f (dK, dL; dT)

However, the Harrod Domar model has only one factor of production, that is, capital K. Why?

• As developing countries often have an abundant supply of labour, it is a lack of physical capital that holds back economic growth and development. In other words, the bottleneck for the economic growth is dK or an increase in capital.
• An increase in capital comes from investment.
• Investment = savings.

Implications of the model

q The key to economic growth is to expand the level of investment: capital accumulation or ‘Mobilization of capital’ is important.

q Equally important is the productivity of capital: the lower the capital output ratio, the better.

In general, eventually, the more amount of capital, the productivity of capital decreases:

The marginal product of capital decreases as the amount of capital increases.

Recall: The S curve of the total output. In the latter part of the S curve, the MP of capital is a decreasing function of capital –“Decreasing Marginal Returns” or “Law of Diminishing Marginal Return”

This happens as the size of capital grows in the natural course of economic growth.

It is a formidable task to keep the marginal product of capital constant or even increasing.

This can be achieved by generating technological advances or technical innovations which enable firms to produce more output with less capital i.e. lower ICOR (incremental capital output ratio).

- Some countries have succeeded in mobilization of capital, but failed in the efficient use of capital. Eg) North Korea, East Germany

- Kozo Yamamura’s paper reports that during the take-off stage of economic growth of Japan, the capital output ratio fell significantly. Subsequently, during the period of growth rates decelerating, the capital output ratio rose steadily.

q Policies are needed to encourage savings; and/or to enhance efficiency of capital.

Problems of the model

• Practically it is difficult to stimulate the level of domestic savings particularly in the case of developing countries where incomes are low.
• One way of supplementing the low domestic savings would be foreign savings:

However, borrowing from overseas to fill the gap caused causes debt repayment problems later.

• The law of diminishing returns would suggest that as investment increases the productivity of the capital will diminish and the capital to output ratio rise. Fighting this natural law is a formidable task.

In a word, the model does not give any recipe for a success of economic development while it explains the surface of the given economic growth.

Lewis's Dual Sector Model of Development: The theory of ‘trickle down’

Lewis proposed his dual sector development model in 1954. It was based on the assumption that many LDCs had dual economies with both a traditional agricultural sector and a modern industrial sector.

The traditional agricultural sector was assumed to be of a subsistence nature characterized by low productivity, low incomes, low savings and considerable underemployment: the marginal labor productivity is nearly zero.

The industrial sector was assumed to be technologically advanced with high levels of investment operating in an urban environment.

Lewis suggested that the modern industrial sector would attract workers from the rural areas. Industrial firms, whether private or publicly owned, could offer wages that would guarantee a higher quality of life than remaining in the rural areas could provide. As the level of labour productivity was so low in traditional agricultural areas people leaving the rural areas would have virtually no impact on output. Indeed, the amount of food available to the remaining villagers would increase as the same amount of food could be shared amongst fewer people. This might generate a surplus which could them be sold generating income.

Those people that moved away from the villages to the towns would earn increased incomes and this crucially according to Lewis generates more savings.

The lack of development was due to a lack of savings and investment. The key to development was to increase savings and investment.

Lewis saw the existence of the modern industrial sector as essential if this was to happen. Urban migration from the poor rural areas to the relatively richer industrial urban areas gave workers the opportunities to earn higher incomes and crucially save more providing funds for entrepreneurs to investment.

A growing industrial sector requiring labour provided the incomes that could be spent and saved. This would in itself generate demand and also provide funds for investment. Income generated by the industrial sector was trickling down throughout the economy.

Problems of the Lewis Model

• Sustainable growth or steady job creation in the urban sector is not automatic.

-The assumption of a constant demand for labour from the industrial sector is questionable.

-Increasing technology may be labour saving, and reducing the need for labour.

-How much can the urban sector absorb the migrants from the rural areas?

• Stability of economy might be adversely affected by this kind of economic development. As the industry concerned decline, the demand for labour will fall. The industrial production may be more subject to business cycles while there might be no business cycles in the subsistence economy.

• Will higher incomes earned in the industrial sector be saved? If the entrepreneurs and labour spend their newly found gains (Consumerism) rather than save it, funds for investment and growth will not be made available.

• The rural urban migration has for many LDCs been far larger that the industrial sector can provide jobs for. Urban poverty has replaced rural poverty.

Rostow's Model- the Stages of Economic Development

In 1960, the American Economic Historian, WW Rostow suggested that countries passed through five stages of economic development.

Stage 1 Traditional Society
The economy is dominated by subsistence activity where output is consumed by producers rather than traded. Any trade is carried out by barter where goods are exchanged directly for other goods. Agriculture is the most important industry and production is labour intensive using only limited quantities of capital. Resource allocation is determined very much by traditional methods of production.

Stage 2 Transitional Stage (the preconditions for takeoff)
Increased specialisation generates surpluses for trading. There is an emergence of a transport infrastructure to support trade. As incomes, savings and investment grow entrepreneurs emerge. External trade also occurs concentrating on primary products.

Stage 3 Take Off
Industrialisation increases, with workers switching from the agricultural sector to the manufacturing sector. Growth is concentrated in a few regions of the country and in one or two manufacturing industries. The level of investment reaches over 10% of GNP.

The economic transitions are accompanied by the evolution of new political and social institutions that support the industrialisation. The growth is self-sustaining as investment leads to increasing incomes in turn generating more savings to finance further investment.

Stage 4 Drive to Maturity
The economy is diversifying into new areas. Technological innovation is providing a diverse range of investment opportunities. The economy is producing a wide range of goods and services and there is less reliance on imports.

Stage 5 High Mass Consumption
The economy is geared towards mass consumption. The consumer durable industries flourish. The service sector becomes increasingly dominant.

According to Rostow development requires substantial investment in capital. For the economies of LDCs to grow the right conditions for such investment would have to be created. If aid is given or foreign direct investment occurs at stage 3 the economy needs to have reached stage 2. If the stage 2 has been reached then injections of investment may lead to rapid growth.

Limitations

q Many development economists argue that Rostows's model was developed with Western cultures in mind and not applicable to LDCs. It addition its generalised nature makes it somewhat limited.

q It does not set down the detailed nature of the pre-conditions for growth: what brings about the take-off?. In reality policy makers are unable to clearly identify stages as they merge together.

q Rostow does predict that every economy is going through the same stage. However, some economies are stuck in the first stage forever while other economies “take off”. The development pattern or growth path is not deterministic at all. Rostow model does not tell these differences.

q Thus as a predictive model it is not very helpful. Perhaps its main use is to highlight the need for investment. Like many of the other models of economic developments it is essentially a growth model and does not address the issue of development in the wider context.

Neo-Classical Theory of Growth

Neo classical theory maintains that economic growth is caused by:

• increase in the labour quantity (population growth)
• improvements in the quality of labour through training and education
• increase in capital (through higher savings and investment)
• improvements in technology

You may recall the two building blocks for this theory from macroeconomic theories:

(1) In the long-run, the equilibrium national income is determined by the long-run aggregate supply curve.

(2) Neo-classical Production function or Long-run Aggregate Supply curve.

Y = f(K, L : Technology) for LRAS

(3) As K, L or T rises, the LRAS curve shifts to the right and the Yf , which shows the maximum potential level of income, moves to the right.

Underdevelopment is seen as the result of some bottlenecks that hinders the full utilization or accumulation of production factors, such as K, L, or technical innovations.

For instance, first and foremost, the state intervention in markets through regulation of prices may hinder the full utilization of production factors. It inhibits growth because it encourages corruption, inefficiency and offers no profit motive for entrepreneurship.

The neo classical economists argue that for economic growth, the bottlenecks should be removed. For instance, government control should be removed.

They argue therefore, that very often, the root cause of underdevelopment lies with the governments of the LDCs themselves. Only when governments adopt polices that aim to free up markets and improve the supply side, will the economy grow and development occur. This results in a shift of the long-run aggregate supply as shown in the diagram. The potential level of output of the economy is then higher.

Neo classical economists advocate the following strategies should be encouraged:

• Competitive free markets
• Privatisation of state owned industries
• A move from closed (no trade) to open (trading) economies
• Opening up the domestic economy through encouraging free trade (i.e. abolish tariffs and quotas) and foreign direct investment.

These policies will stimulate investment, higher output and income and hence higher savings.

Problems of the model
This model makes a number of unrealistic assumptions and ignores a number of crucial issues

• The assumption is that the creation of a free market and a private enterprise culture is possible and desirable.
• The existence of market failure such as externalities associated with economic growth are ignored
• The problem of uneven distribution of income is ignored.

Empirical Extension of Neoclassical Model: ‘Growth Accounting’

This theory identifies the attribution of each factors, K, L (=N at macro level), and T to economic growth.

The Solow model( a more sophisticated version of Neo-Classical Model)

The Solow model (for which the American economist Robert Solow was awarded the Nobel prize in economics in 1987) ignores the temporary ups and downs of the business cycle and explains potential income (output) as it obtains in the long run.
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The main building block is the aggregate production function. While the 3D production function shows output to depend on the capital stock K and the labour force or total number of workers N, the basic version of the Solow model keeps the labour force fixed at its normal level:

Y/N is per-person national income, or GDP/workers. This per-capita income is a better measurement of economic growth and development than just GDP: the standard living depends on Y/N , not Y.

The per-capita version of the Aggregate Production Function is equal to

Y/N = F (K/N: Technology), and assume that Technology is constant.

We may then operate with the partial production function that keeps L fixed, and for now assume that technology is fixed as well.

Now Y/N is an increasing function of K/N for a fixed level of technology (for now).

The curve of per-capita Aggregate Production Function is concave. Why?

The answer is that there is a diminishing marginal return to any additional production factor while all other factors are fixed.

Y/N

K/N

K/L

To identify the level of (potential) income (or output) this economy generates in long-run equilibrium, we need to find out when the capital stock for each worker or K/N is maintained at the constant or steady level in long-run equilibrium:

Over time, if no investment is done, in general K/N falls due to two natural forces. First, N rises due to population growth. In other words, as new workers are added, they should be given a certain amount of capital, such as equipment and facilities. Otherwise, their K/N or per capita capital stock falls.

Second, over time, capital depreciates.

So only when investment exceeds depreciation and population growth rate, the capital stock grows; when investment falls short of depreciation and the population growth rate, the capital stock per capita or K/N shrinks. Thus, the standard of living or Y/N would fall, too.

The capital stock remains unchanged, or steady, if investment equals (offsets) depreciation and population growth rates. This situation is called a steady state.
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When does investment exceed depreciation, and when does it fall short of it? This can only be answered if we know what determines investment and depreciation:
As regards depreciation, we may safely assume that a constant fraction of the capital stock, say 5 percent, is lost every year because it is used up or became obsolete. Then depreciation equals 5 percent of the current capital stock. The population growth rate is assumed to be, say, 3%. In the diagram, the requirement investment line is a straight line with slope 0.08.
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To determine investment, suppose there is no government and no trade with other countries. Then according to the circular flow diagram investment equals saving. Saving is a fixed share of income. Then the amount people save and invest at different capital stocks may be read off the red savings curve in the accompanying diagram.
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Whether the capital stock grows or shrinks depends on where it currently is. If it is at K₀(/N), the level of capital stock is so low and thus the required level of savings is low, too. As the level of required savings is so low, actual savings can easily lead to investment that exceeds the depreciation requirement. There will be a net positive increase in the capital stock per worker. The capital stock per capita K/N will be higher next year.

If the capital stock is at K₁/(N), investment fails to replace all capital that wears out, capital stock per capita would decrease. Net investment is negative. The capital stock will be lower next year.
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The crux of this is that if current per capita capital is smaller than K*(/N), the capital stock grows; if it exceeds K*(/N), the per capital capital stock falls. So the per capita capital stock always moves towards K*/(N), where it will stay, since only there depreciation is exactly replaced by new investment. K*/N is the steady-state per capita(per worker) capital stock, and Y*/N is steady-state income per capita.

Implications

q The higher the K/N, the higher per capita income or output Y/N, and thus the standard of living.

q Is that the higher K/N (without the backing of a higher rate of savings), the better? Yes, as we have seen, for one point of time. But, not for a sustainable period of time.

Example) foreign aids of capital goods(externally increased K/N); a one-time increase in capital(exogenously increased K/N)

-Note that there is such a thing as “Optimal Level of Capital Per worker or per capita, here given as K*/(N): recall the picture is for one person, and thus K* should be read in fact as K*/N. if actual K/N is above K*/N, there is an excessive amount of capital(too much of investment), and if the actual K/N of the economy is below K*/N, there is insufficient amount of capital.

-We note that this has some elements of convergence theory: economic growth rates would be higher when K/N is low, and the rates will fall as K/N rises.

q We can get a steady state per-capita income rising by having a permanent and sustained shift up of “savings curve”. The curve rises up as the domestic savings ratio (S/Y) rises. Note that an increase in the total amount of Savings is not sufficient, but the savings ratio itself should rise. In other words, a larger share of income should be saved. How does it show on the graph?

q An easy way of increasing K/N is controlling the population through birth control. How does it show on the graph?

q A once-and-for all increase in capital or scattered investment does not lead to an increase in per-capita income at all. For instance, “Great Leap Movement’ would not help bring an increase in the national income forever. Why? How does it show on the graph?

q You can add the foreign savings, through capital inflows or foreign borrowings, to the curve. This will lead to a higher equilibrium for the steady state national income per person. However, this injection of foreign investment should be continuous, not just one shot, in order to raise the equilibrium level of per-capita income. For instance, foreign aids do not help raise the standard of living of a country permanently. Why?

q So far we have assumed that Technology is fixed. However, you can shift up the equilibrium per-capita income by having Technical Innovations. How does this show in the graph?