1. Chapter 3 Lecture – Classic Theories of Economic Growth and Development EC348 Development Economics Opera House, Hanoi *Dennis C. McCornac

3. Costs

4. Models of Development If we can understand how development occurs, strategies can be adopted to help countries to develop (adopted from Biz/ed http://www.bized.co.ukhttp://www.bized.co.uk 3-4

5. Rostow - Stages of Growth 3-5

6. Rostow - Stages of Growth The work of American Walt W. Rostow Rostow is an economic historian Countries can be placed in one of five categories in terms of its stage of growth: A child in Sierra Leone making breakfast. Which stage would a country like Sierra Leone fit in? Copyright: Dave Dyett, http://www.sxc.hu/http://www.sxc.hu/ 3-6

7. Rostow - Stages of Growth 1. Traditional Society Characterised by – subsistence economy – output not traded or recorded – existence of barter – high levels of agriculture and labour intensive agriculture 2. Pre-conditions: Development of mining industries Increase in capital use in agriculture Necessity of external funding Some growth in savings and investment 3-7

8. Rostow - Stages of Growth 4. Drive to Maturity: – Growth becomes self-sustaining – wealth generation enables further investment in value adding industry and development – Industry more diversified – Increase in levels of technology utilised As the economy matures, technology plays an increasing role in developing high value added 3. Take off: Increasing industrialisation Further growth in savings and investment Some regional growth Number employed in agriculture declines At this stage, industrial growth may be linked to primary industries. The level of technology required will be low 3-8

9. Rostow - Stages of Growth 5. High mass consumption – High output levels – Mass consumption of consumer durables – High proportion of employment in service sector Service industry dominates the economy – banking, insurance, finance, marketing, entertainment, leisure and so on. Copyright: Elliott Tompkins, http://www.sxc.huhttp://www.sxc.hu 3-9

10. Criticisms Too simplistic Necessity of a financial infrastructure to channel any savings that are made into investment Will such investment yield growth? Not necessarily Need for other infrastructure – human resources (education), roads, rail, communications networks Efficiency of use of investment – in palaces or productive activities? Rostow argued economies would learn from one another and reduce the time taken to develop – has this happened? 3-10

11. Market Based 3-11

12. Market Based Development is determined by the extent to which the market is able to allocate resources The price signal acts to allocate scarce resources Governments limit interference in the working of the economy Government role is to encourage enterprise and to reduce regulation and inefficiencies in free markets and establish ownership of property rights Problems Existence of market failure – externalities, monopoly power, public goods Problems of lack of infrastructure – education and health, public transport, legal structure Problems of equity in allocation – wealth and income distribution 3-12

13. International Dependence or Dependency Theory 3-13

14. International Dependence International division of labour – rich in high value activity, poor in low value, can be traced back to colonial and imperial dominance Dominance of political decision making in the hands of a few wealthy and powerful groups who aim to maintain the status quo Such interest groups also exercise power over international institutions and initiatives such as World Trade Organisation, International Monetary Fund, Kyoto talks, etc. Advice given to poorer nations has been poor – e.g. lending to less developed countries, investment advice, etc. Inability to solve the debt crisis and protectionism continues to prevent development of poorest countries 3-14

15. Criticism Offers causes but no solutions Talks to free up trade have been going on for many years, progress is slow. We know that protectionism is disadvantageous to developing countries but how do we go about putting in place solutions to help solve the problem? Copyright: Doug Wray, http://www.sxc.huhttp://www.sxc.hu 3-15

16. Structural Change 3-16

17. The Solow Model Due to Robert Solow, who won Nobel Prize for contributions to the study of economic growth A major paradigm: – widely used in policy making – benchmark against which most recent growth theories are compared Looks at the determinants of economic growth and the standard of living in the long run https://unlearningeconomics.wordpress.com/tag/the-solow-growth-model 3-17

18. Explaining the Sources of Growth Try to decompose the growth in income into growth in labor, growth in the capital stock, and growth in productivity It is a somewhat mechanical exercise, but an interesting descriptive tool Assume the following production function: Y = AF(K,L) “A” represents the technological level, usually called Total Factor Productivity We want to decompose the changes in Y into changes in A, K, and L Next 3 slides for economics majors Decomposition of the Growth in Income 3-18

19. Decomposition of the Growth in Income - Result

21. Reviewing Result 3-21

22. Expression allows one to decompose the changes in Y, and, besides, to estimate the changes in “Total Factor Productivity” We can estimate shifts in the production function due to greater efficiency in the use of inputs We only need data readily available to do that: income, capital, and labor growth rates, and wages and interest rates 3-22

23. 3-23 Imagine an economy that grew at 5% in a given year, when capital stock grew by 7%, and the labor force grew by 2%. In that same year, the share of labor income in total output was 60%, and the share of capital income was 40%. We could estimate the growth in productivity as: a = g y – ω K.g K – ω L.g L a = 0.05 – 0.4x(0.07) – 0.6x(0.02) = 0.01 = 1%  TFP accounts for 1/5 of the growth in Y Example Word of caution: “A” actually includes a span of different factors, and also measurement error in other variables. Things that will end up captured in “A” may be related to government policies, technological improvements, corruption, more intense use of existing inputs, etc. Indeed, “A” summarizes everything that we don’t know about.

24. http://www.macrometria.pt/2013/03/05/total-factor-productivity/

25. 3-25 http://www.unido.org/data1/wpd/Index.cfm https://www.conference-board.org/data/economydatabase/ Total Economy Database United Nations Industrial Development Organization World Productivity Database Total Factor Productivity http://www.bruegel.org/nc/blog/detail/article/1218- decoded-brics/

26. http://www.choicesmagazine.org/choices-magazine/submitted-articles/productivity-growth-in-global- agriculture-shifting-to-developing-countries Growth in Agriculture Productivity

27. Engel’s Law: As incomes rise, the proportion of an individual’s budget spent on food declines (Ernst Engel, 19 th century). Main function of agricultural sector is to produce food  demand for agricultural products doesn’t grow as rapidly as demand for other goods (industrial products and services) Therefore, the share of agriculture on national product declines Structural-Change Models Explanation for Increased Industry and Decline in Agriculture Share (I) 3-27

28. Productivity of the agricultural sector has risen as growth progressed That is actually the only reason why we’re able to have people employed in other (non-food producing) activities; in the beginning of human civilization, all time and labor was devoted to food production (“hunting and gathering”) Because productivity is higher, a smaller number in agriculture can feed most of the population Structural-Change Models Explanation for Increased Industry and Decline in Agriculture Share (II) 3-28

29. Figure 3.1 The Lewis Model of Modern-Sector Growth in a Two-Sector Surplus-Labor Economy 3-29

30. Criticisms of the Lewis Model Rate of labor transfer and employment creation may not be proportional to rate of modern-sector capital accumulation Surplus labor in rural areas and full employment in urban? Institutional factors? Assumption of diminishing returns in modern industrial sector 3-30

31. Why Do Industrialization and Cities Grow Together? Economies of scale for some industrial sectors  output per unit of input rises as size of the firm rises Different kinds of industries want to locate together, so that they can use same support facilities and infrastructure (power stations, transportation, wholesalers); “public good” aspect of infrastructure There’s a tendency towards agglomeration in industrial activity Also there’s a reinforcement: the larger the number of people living in cities, the higher the demand for industrial products (they do not produce their own food, clothing, etc) 3-31

32. Division of Labor and Cities More generally, since the middle ages, cities tend to be associated with the division of labor When a single person is not responsible for all production, there’s an advantage associated with being located close to other people  You can sell your chickens and by clothes, soap, corn, etc Industrialization tends to increase division of labor  increases the return to urban life This increased urbanization can become problematic. Why? 3-32

33. 3-33 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 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” The so-called experts don’t really know anything but they keep trying to help anyway, making the situation worse. They are “assisted” by the local elites who have been trained at Western educational institutions and who believe all that bunk. The main problem with the policy prescriptions is that they overlook: traditional social structures highly unequal ownership of land disproportionate control by elites of financial assets and access to credit

34. 3-34 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

35. 3-35 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 Approaches to Development

36. 3-36 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

37. Effect of Growth of Capital Stock and Land on the Production Possibility Frontier

39. Concepts for Review Autarky Average product Capital-labor ratio Capital-output ratio Center Closed economy Dependence Dominance Dualism False-paradigm model Free market Free-market analysis Harrod-Domar growth model Lewis two-sector model Marginal product Market failure 3-39

40. Concepts for Review (cont’d) Market-friendly approach Necessary condition Neoclassical counterrevolution Neocolonial dependence model Net savings ratio New political economy approach Open economy Periphery Production function Public-choice theory Self-sustaining growth Solow neoclassical growth model Stages-of-growth model of development Structural-change theory Structural transformation Sufficient condition Surplus labor 3-40