Growth Theories “Frame of Reference” Lecture 1 of Eco 3317 J.D. Han at King’s

Conventional Growth General Neo-Classcial Model Harrod-Domar Model Solow Model (Representative Neo-Classical Model) Endogenous Growth Model -Human Capital -Others Lewis Model Rostow Model

Solow Model is ‘the’ representative Neo-Cl assical Growth Model: focusing on saving s and investment. It explains the long-run evolution of economy quite well with all being held Constant – Dynamic Model The problem is that it really does not Explain the Asian Economic Growth -Simplistic

Neo-classical Model focuses too much on Capital (“Material Things”), and focuses too little on Human Elements All matters depend on Human Act(s) ( 事在人爲 )

Harrod-Domar model is older and cruder,but opens up the room for other factors (for economic development), It may be better for explaining Asian Economic Development.

Neo-Classical Economics Microeconomics that you have learned Aggregate Demand does not matter for long-run growth of income Macroeconomic Policies of Government (controlling Money Supply, Government Expenditures )do not matter for Y in the long-run – “You cannot pull yourself up by your own bootstrap”

1. Neo-classical Mode = Supply Side Economics Economic growth = Growth of Income = Growth of aggregate output comes from an increase in labour L; an increas in capital K; and/or improvement of technology T

In General ‘production function’ Y = f (K, L; T) Growth function dY = f (dK, dL; dT)

Specific Formula of Production Function Most Widely Used Production Fn is “Cobb-Douglas Production Function”: Y = A K a L 1-a, and a<1 *Realistic and Convenient Features of C-D function: Diminishing Marginal Return Constant Return to Scale

*Why are the two features realistic in Economics? Diminishing Marginal Returns(DMR) eg) Y = F(K,L ) 10 = F(5, 5) 13 = F(10, 5) Decreasing Marginal Productivity of Capital or Labor dY/dK = MPk, d MPk/ dk <0 or dY 2 /d 2 K <0 dY/dL = MPL, d MPL / dL <0 Constant Return to Scale (CRS) If Y = F (K, L) is true, Y = F (2K, 2L) = 2 F (K, L) is attainable. You do not have to take DRS 1.5 Y = F (2K, 2L)

**Diminishing Marginal Returns as a Fact of Life Biological growth- “S curve”(upper part) Stages of Acceleration (Youth) and Deceleration (Maturity) Convergence Production Function Stages of Increasing Marginal Return and Decreasing Marginal Return inflection point between IMR and DMR Why is IMR no substantive issue?

2. Harrod-Domar Model Income Growth Rate = Saving Rate x Efficiency of Capital dY/Y = dY/dK x dK/Y ( as S = I = dK ) = dY/dK x S/Y = Marginal Product(ivity) of Capital x Savings Ratio

= S/Y dK/dY Average Propensity to Save = Average Propensity to Save Incremetal Capital Output Requirement

Note: MPK = 1/ ICOR Relationship between MPK(dY/dK) and AP K(Y/K) -When Y/K falls, MPK < APK -When Y/K rises, MPK > APK

In general, eventually, the more amount of capital, the Marginal Productivity of capital decreases – “Convergence” Recall: 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 weighted average Marginal Product of Capital constant or even Increasing for the entire economy.

Implications of the H-D model The key to economic growth is to expand the lev el of investment: capital accumulation or ‘Mobilization of capital’ Equally important is the productivity of capital: the higher the marginal product(ivity) of capital, the better, or the lower the required incremental capital-output ratio, the better.

Application and Modification of Harrod-Domar Model

How to enhance Efficiency of Capital?: Higher MP of Capital, or lower ICOR 1) Through Technological advances or Technical innovations – This can happen to any economic system: Market(economy) can take care of this while government may promote it too. 2) Though resource allocation by ‘visible hands’, government, channeling capital into ‘efficient areas’ – - A specific Economic System/Institution key words) Centrally planned economy; Economic Planning; Resource Allocation Planning; Industrial Policy; Promotion of National Strategic Industries; Key Industry

For “starter countries, Institutional Rearrangements are easier than technical Innovation. -> “Economics Reform” -> “Restructuring”

*To spark Growth, we may need Institutions ‘Institutions’ (as opposed to Market Economy) covers Government; Economic System; Value System(ethics,religion) - Mechanism to ‘Mobilize Capital’? How to increase Saving Rate? - Mechanism to raise the Efficiency of Capital?

*East Asian Government’s Role for Promotion of Economic Growth Government Policies are needed to 1) encourage/force savings; 2)and/or to enhance efficiency of capital by allocating scarce capital primarily to strategic area of industry.

* Case Studies of Government’s Forced Savings and Resource Allocation 1)Successes -Japan by Kozo Yamamura or Kazuo Sato’s paper reports that during the take-off stage of economic growth of Japan, the average capital-output ratio fell significantly due to Innovations(?) and Government’s Industrial Policy. -Korea Promotion of chae-bol(s) Strategic industries of Ship-building, Cars, Semi- conductors, IT Industries, etc.

2) Debacles Some countries have succeeded in mobilization of capital, but failed in the efficient use of capital. Stalinist Economy North Korea Great Leap Movement in China

Still, Modification of the Harrod-Domar Model is needed to explain growth spurts difficult to stimulate the level of domestic savings particularly in the case of developing countries One way of supplementing the low domestic savings would be foreign savings/investment: However, borrowing from overseas causes debt repayment problems later. The law of diminishing returns would suggest that as investment increases the marginal 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 easy recipe for a success of economic development while it can explain the surface of the given economic growth.

3. Solow Model Focusing on capacity of Savings to meet the demand for Investment as Capital Requirements and, beyond, as Capital Accumulation for expansion of Production capacity Refer to the Separate PPP

4. Lewis Model: Dual Sector Model of Economic Growth many LDCs had dual economies with a traditional agricultural sector and a modern industrial sector Traditional Sector has too much labor at subsistence level. It has to release excessive labor. MP labour = 0; Y = C + S + T = C + I + G Modern Sector absorbs labor and becomes the source of economic surplus or 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. 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. 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. How does the Mechanism work?

Policy Implications of Lewis model Induced Displacement of Population from Rural to Urban Sector Government may use push and pull factors using Institutions or System -‘Vanity Effect’ as a magnet: Glamorous/modernized Urban Sector versus Backward/‘Suppressed’ Rural Area -Income Inequality is as a ‘magnet’

Lewis Model is Unbalanced Economic Growth Strategy ( 不均衡的经济发展战略） This is a practical strategy. Let’s reflect on side-effect/problems -Sustainability in the long-run: Ravaging impacts of labor saving technology; How much and how long is the modern sector absorb the surplus labor? What will happen to no-longer-needed surplus labor? -Inequality between agricultural – industrial sectors Income Inequality; Urbanization issues -Urban/Modern Sector may not Save but Spend: Urban ‘Consumerism’ -Rural-Urban Migration is larger than what the urban sector can absorb: Rural Poverty simply becomes Urban Poverty

Case Studies: Casual Analysis England in 18 th Century Enclosure Movement U.S. in 19 th century Slave-Emancipation Japan Korea in the 1970s and the 1980s *New Village Movement (Sae-Ma-Eul-Un-Dong) Taiwan (part of China) China

*Quantitative Analysis: Income (Distribution) Inequality and Economic Growth Income Inequality is measured by Gini-Coefficient Some international comparisons argue as economy grows, Gini Coefficient generally rises first and then fall It is in line with Lewis’ theory: Income inequality is not only inevitable, but also necessary for economic growth - Case studies of Korea, Japan, and China (presentation)

5. 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 -dominated by subsistence (defined as no economic surplus, meaning output being consumed by producers rather than traded); -trade being carried out by barter, meaning goods being exchanged directly for other goods; -Agriculture being the most important industry;Production being labor intensive using only limited quantities of capital. Stage 2 Transitional Stage (the preconditions for takeoff) -Increased specialization starting to generate surpluses for trading. -an emergence of a transport infrastructure to support trade; External trade also occurs concentrating on primary products; Entrepreneurs emerge -savings and investment grow. Stage 3 Take Off -Rapid Industrialization or Industrial Revolution - Growth 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 industrialization. - The growth is self-sustaining: investment leads to increasing incomes in turn generating more savings to finance further investment. Stage 4 Drive to Maturity -Industrial Diversification; producing a wide range of goods and services; reliance on exports and imports may start decreasing Stage 5 High Mass Consumption - Mass Consumption （大众消费） ; Domestic Aggregate Demand is the major determinant of Business (Cycles) - Consumer durable industries; Service sector

Limitations Deterministic Path for All? Rostow 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”. -leaving a room for ‘cultural explanation’ It does not set down the detailed nature of the pre-conditions for growth; What sparks the take-off? -Exogenous Shocks as a Catalyst for Great Transformation? It is not very helpful as a policy prescription. Perhaps its main use is to highlight the need for investment. * Explaining the fast is always easier than Predicting the future

Major Contribution of Rostow’ Model Emphasis of ‘Take-Off’ -Economic Development is not a continuous process; -There should be some Event for Great Transformation.

* Case Studies: Catalyst for Take off Catalysis for Take Off= Exogenous Shocks Japan Meiji Revolution; Korean War Korea President Park, Jeong Hee; Vietnam War China Deng Xiao Ping’s Reform Jiang Ze Min’s “Southern Journey(Nan Xun)” Iraq War?

Neo-classical Model focuses too much on Capital (“Material Things”), and focuses too little on Human Eelement All matters depend on Human Act(s) ( 事在人爲 )

We need a new Frame of Reference which puts more emphasis on Human Factors

6. Endogenous Growth Theory Y = F(K,L:T) does not fully explain divergent growth experiences acrss countries. There has to be an additional factor endogenous to countries. Excellent Summary of Endogenous Growth Models

*Value System as a ‘Foundation’ Institution for Economic Growth: Max Weber arguned that “Protestant Work Ethic” sanctioned hard work, frugality and wise investment. Rodney Stark is one of the most highly regarded sociology of religion scholars alive today. He recently published The Victory of Reason: How Christianity Led to Freedom, Capitalism, and Western Success.The Victory of Reason: How Christianity Led to Freedom, Capitalism, and Western Success Professor Tu Wei-Ming at Harvard University said that Neo- Confucianism of the Far East is similar to protestant ethic. - refer to the essence of his idea