Economic Development and the Substitution Structure of Production De-Xing Guan Department of Economics National Taipei University December 24, 2018

The Facts of Economic Development Before 1750s per capita output growth rate was near zero for almost every country in the world Since 1750s, and especially after 1870s, a few countries had escaped the Malthusian trap The first and second industrial revolutions made per capita output of industrial countries to grow at a annual rate of roughly 2%

The Stages of Economic Development There are therefore three basic stages of economic development: stagnation, transition, and growth We call stagnation the stage of Malthus, transition the stage from Malthus to Solow, and growth the stage of Solow Malthusian stage was a system of agriculture, the stage of Solow was a system of commerce, and in between was the transition from the system of agriculture to that of commerce

What Economists and Historians Said Lewis (1954) built a classical model (with production but without utility) to study economic development Murphy, Shleifer, and Vishny (1989), Lucas (2002, 2018), Galor and Weil (2000), Stokey (2001), Hansen and Prescott (2002), Parente and Prescott (2005) used two-sector models to explain development problems Deane (1965) was among the first economic historians to study industrial revolution. Following her had been North (1981), Huang (1997), Ferguson (2011), North, Wallis, and Weingast (2013), Acemoglu and Robinson (2012), McCloskey (2016), and Mokyr (2017)

Marshall’s Principle of Substitution “As far as the knowledge and business enterprise of the producers reach…the sum of the supply prices of those factors which are used is, as a rule, less than the sum of the supply prices of any other set of factors which could be substituted for them; and whenever it appears to the producers that this is not the case, they will, as a rule, set to work to substitute the less expensive method…We may call this…The principle of substitution. The applications of this principle extend over almost every field of economic inquiry.” (Alfred Marshall, Principles of Economics, 8th edition, Macmillan, 1920, p. 284)

Substitution Structure: Historical Examples England before and after the Glorious Revolution: the internal substitution structure that enemies of the enemy are friends caused the emergence of cities and the free burghers (bourgeois), and trades with America and Asia helped form the external substitution structure China before and after the 1980s: The emperor of China was not the enemy of the bureaucrats. It was not until in 1980s that the iron curtain of the communist China was opened. Since then China has grown for near forty years Japan before and after the Meiji Restoration: Similar to China, it was not until in 1868 that feudal lords of Japan decided to reallocate their rights and to open markets such that Japan began to move towards capitalism

Class Struggle: Competition or Cooperation? Marx’s two-class case: in the end of the class struggle there always remained two classes, and they could hardly cooperate with each other given the scarcity of resources Smith’s three-class case: if farmers were enemies of king’s enemy (landlords), then they could cooperate with the king to fight against landlords. This was exactly why cities and bourgeois would emerge in Western Europe Class struggle or competition might be either good or bad for a society. It depends on its internal substitution structure. Smith looked at both the bright and dark sides of class struggle. Marx looked only at the dark side of it.

What Marx Said in the Communist Manifesto “The history of all hitherto existing society is the history of class struggles. Freeman and slave, patrician and plebeian, lord and serf, guild-master and journeyman, in a word, oppressor and oppressed, stood in constant opposition to one another…Society as a whole is more and more splitting up into two great hostile camps, into two great classes directly facing each other: Bourgeoisie and Proletariat.” (Karl Marx and Friedrich Engels, Communist Manifesto, 1848, Oxford University Press, 1992, p. 3)

What Smith Said in the Wealth of Nations “The burghers naturally hated and feared the lords. The king hated and feared them too; but though perhaps he might despise, he had no reason either to hate or fear the burghers. Mutual interest, therefore, disposed them to support the king, and the king to support them against the lords. They were the enemies of his enemies, and it was his interest to render them as secure and independent of those enemies as he could. By granting them magistrates of their own, the privilege of making bye-laws for their own government, that of building walls for their own defence, and that of reducing all their inhabitants under a sort of military discipline, he gave them all the means of security and independency of the barons which it was in his power to bestow.” (Adam Smith, Wealth of Nations, 1789, 5th edition, Modern Library, 1994, p. 430)

A Classical Model of Economic Development

Balanced Growth Path

Competition, Substitution, and Transaction Cost Proposition 1: Perfect competition is a situation where there are no transaction costs. In a world with positive transaction costs, it is impossible for all markets to be perfect competition. The smaller the transactions costs, the larger the elasticity of substitution between factors of production at different margins such that markets will be more, but never be perfectly, competitive.

Morishima Elasticity of Substitution (MES) MES is a better measure of the ease of substitution when there are more than two factors of production Michio Morishima (森嶋通夫) proposed MES in 1967 in a paper written in Japanese It is more adequate than the usual Hicks-Allen elasticity of substitution especially when there are transaction costs Blackorby, Primont, and Russell (2007) generalized the original MES to the case of changing output such that it could be used to measure elasticity of substitution in an environment of economic growth and development

Proof of Proposition 1

Substitution Structure and Lewis Turning Point

Proof of Proposition 2 At the stage of Malthus: There would be no sustained per capita income growth At the stage from Malthus to Solow, there is still no sustained growth but there would be a level effect since in this case the total factor productivity A(N) is larger than that in Malthusian case: At the stage of Solow: per capita income will begin to grow. There would be both level and growth effects.