Economic Growth & Development - Classic Theories

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Chapter 3
Classic Theories
of Economic
Growth and
Development

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-2
Class Theories of Economic
Development – Four Approaches
• Structural change model
– Linear stages of growth
– Saving-investment
– Rural-urban migration
• Neocolonial dependence theory
– Dependence: Center vs. Periphery
– False Paradigm
• Neoclassical theory
– Market friendly approach
– Dualistic approach
– Public choice approach

Rostow’s Linear-Stages Model
1. Traditional society
2. Pre-condition to take-off
3. Take-off
4. Drive to maturity
5. Age of high mass consumption

1. Traditional society: slow economic and
population growth
2. Pre-condition to take-off: development of
institutions, organizations, and
infrastructure
3. Take-off: large investment in selected
industry (10 to 15% of GDP)

4. Drive to maturity: sustained growth of the
industry and economy
5. Age of high mass consumption:
production of consumer goods and
services to serve an affluent society

t1 t2
Take-off
Time
GDP Growth
Pre Take-off
Post Take-off
Economic Growth

Harrod-Domar Growth Model
S = sY S=Saving; Y=Real GDP; s=Saving Ratio
I = ΔK I=Investment; ΔK=Capital Accumulation
S = I Saving-Investment identity
Define the Marginal Capital-Output Ratio as k = ΔK/ΔY
Write ΔK = kΔY or I = kΔY
From S = I, write sY = kΔY or ΔY/Y = s/k

Harrod-Domar Growth Model
The source of growth is saving and investment in
production of goods and services. Accordingly,
s = national saving ratio; k = marginal capital-output ratio
If s=6% and k=3, then GDP growth rate=2%. Given k=3,
to raise growth rate to 4%, we need to increase the saving
ratio from 6% to 12% with 6% of foreign saving
GDP growth rate = s/k

Criticism of Investment Models
• Many LDCs have not been able to take-off
or achieve maturity despite massive
foreign investment
• Many nations have neglected the
development of institutions, organizations,
and infrastructure required for
industrialization

The Lewis Development Model
• Rural agricultural sector
– Low or even zero Marginal Product of Labor so that
labor is a redundant factor and wage rate is at the
subsistence level
• Urban industrial sector
– Rising demand for unskilled labor to be trained for
industrial growth results in greater employment and
more profits and higher wages
• Rural-Urban migration
– To find jobs and earn higher wages

Demand for Labor
Employment
Wage
WR
WU SR
DU1
DU2
E1 E2
Wage
Profit
R: Rural U: Urban
W: Wage E: Employment
D: Labor Demand S: Labor Supply
Investment in urban areas
increases the demand and
employment for rural labor.

Criticisms of Lewis Model
• Industrial technology is generally capital
intensive/labor-saving. Hence, the demand
for unskilled rural labor would not increase
employment
• Industrialization must be supported by
agricultural development to supply an
ever-increasing supply of food items and
raw materials

Demand for Labor
Employment
Wage
WR
WU
SR
DU2
DU1
E1 = E2
Wage
Profit
No increase in employment when
technology is labor saving

Neocolonial Dependence Model
• MDCs form the “center” of global economic
relations and technological advancement
• LDCs serving as the “periphery” are dominated by:
– unequal trade and finance relations
– domestic politico-economic elite
– multinational corporations
Under these conditions economic development is
impossible

Neocolonial Dependence Model
American
MDCs
African LDCS
Latin American LDCS
Asian LDCS
European
MDCs
Other
MDCs

False-Paradigm Model
• Economic development relies heavily on funds
from international donor agencies such as the
World Bank and IMF
• The policy of these agencies is to support urban
industrial growth and impose capitalistic
austerity measures
• They reinforce the pattern of “dependent
development”

Dualistic Development Model
• Structural transformation models create a
“dualistic” pattern of development, resulting in an
ever-increasing degree of economic inequality
both nationally and internationally:
– urban vs. rural
– industrial vs. agricultural
– modern vs. traditional
– rich vs. poor

Approaches to Development
• Free-market approach: rely of the allocation role
of markets and limited government involvement in
economics. But, there are several areas in which
markets fail to achieve efficient outcomes:
– income distribution
– public goods
– externalities
– market power

• Market-friendly approach: improve market
operation through “nonselective”
interventions such as
– income redistribution system
– investment in social and human capital
– environmental protection policy
– anti-trust laws

• Public-choice approach: public officials and
bureaucrats in the position of authority are
“rent-seeking” citizens acting on self-interest
rather than public-interest
• Need a system of checks and balances to monitor
the behavior of public officials and bureaucrats
• Need a democratic system to let people choose
public officials and bureaucrats for limited duration
of authority

• Capital Formation
– Physical capital formation: investment in tools,
equipment, machinery, buildings
– Social capital formation: investment in roads, dams,
airports, railroads, bridges
– Human capital formation: investment in education,
training, health, nutrition
– Political capital formation: investment is creating a
secular and democratic government and free mass
media
Appendix 3.1: Components of
Economic Growth

Determinants of Economic
Growth
• Physical Capital Formation
– Increase in the amount of physical
capital per unit of labor

Determinants of Economic
Growth
• Technological Advancement
– Increase factor productivity (labor,
land, capital)

Production Possibilities Curve
• Maximum quantities of two good and
services the economy can produce,
assuming:
– full employment / efficiency
– fixed resources
– constant technology

PPC Schedule
Combination
Radios
Rice
A B C E
100 90 50 0
0 40 80 100

Rice
100
100
90
50
80
40
A
B
C
E
D
PPC Graph
F
Radios
Combinations A, B, C, and E are attainable
Combination D is unattainable given resources
and technology
Combination F is attainable, but inefficient

Economic Growth
Rice
100
100
90
50
80
40
A
B
C
E
D
Radios
Combination D becomes available with
more resources and better technology

Rice
100
100
90
50
80
40
A
B
C
E
Economic Improvement
F
Radios Combinations G (or B or C) becomes
efficient with more employment
and/or improved efficiency
G

Technological Advancement
Rice
Radios
Neutral: proportional increase in the supply of Rice and Radios

Rice
Radios
Capital augmenting: greater increase in the supply of Radios

Rice
Radios
Labor augmenting: greater increase in the supply of Rice

Rice
Radios
Advancement only in agricultural production
Advancement only in agricultural production

Rice
Radios Advancement only in industrial production
Advancement only in industrial production

Factor Accumulation Accounts for
Only a Fraction of Growth

Economic Growth & Development - Classic Theories

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