ECONOMIC DEVELOPMENT

ECONOMIC DEVELOPMENT Classic Theories of Economic Growth Professor U Kyaw Min Htun Pro-rector (Retired) Yangon Institute of Economics Economic Development: classic theories

Growth theories in the outset Newly independent governments in emerging countries and acceleration of their development at the outset in the 1950s Grand models of development strategy that involved structural transformation • breaking Nurkse's "vicious circle of poverty” • via Rosenstein-Rodan's "big push" and • through "balanced growth" that would establish complementarity in demand, • achieve Leibenstein's "critical minimum effort”, • break out of the "low-level equilibrium trap," • and fulfill the conditions of Rostow's "takeoff." Economic Development: classic theories

Four approaches • Linear-stages-of-growth models (development as a series of successive stages; 1950s + 1960s) • Structural change models(internal process of structural changes that a developing country must go through; 1970s) • International dependence models(underdevelopment in terms of -international and domestic power relationships; -institutional and structural rigidities; -the resulting proliferation of dual economies; 1970s) • Neoclassical counter-revolution (free markets, open economies and the privatization of public enterprises; also known as market fundamentalism; 1980s + 1990s) Economic Development: classic theories

1. Linear Stages of Growth • The thinking was that the developing countries could learn a lot from the historical growth experience of the now developed countries in transforming their economies from poor agrarian societies to modern industrial giants. • Emphasized the role of accelerated capital accumulation (Capital fundamentalism) and the need for the mobilization of domestic and foreign investment in order to do so. • Rostow’s Stages of Growth • Harrod-Domar’s Growth Model Economic Development: classic theories

Rostow’s stages of Growth • Walter W. Rostow, an eminent economic historian, sets forth a new historical synthesis about the beginnings of modern economic growth in 1961. • Five Stages • the traditional society • the preconditions for takeoff • the takeoff • the drive to maturity • the age of high mass consumption Criticism • insufficient empirical evidence,imprecise definitions, no theoretical ground, the mistaken assumption that economic development in LDCs will parallel the early stages DC development. Economic Development: classic theories

HarrodDomar Model (AK Model) • The AK model describes the mechanism by which more investment leads to more growth. • Pointed to the necessity of net additions to the capital stock • Used to explain an economy's growth rate in terms of the level of saving and productivity of capital. • Component Terms Capital stock (K); Output (Y)= GDP; Capital-Output ratio (k)= the dollar amount of capital needed to produce a $1 stream of GDP. K/Y or ΔK/ΔY; Savings (S) and the savings ratio (s) Economic Development: classic theories

HarrodDomar Model (AK Model) • Net savings is a fixed proportion of GDP S = sY (1) • Net investment is the change in the capital stock I = ΔK (2) • Remember that k = K/Y or ΔK/ΔY, so that ΔK = kΔY (3) • Net savings must equal to net investment so that S = I. Combining (1), (2) and (3): sY = kΔY • The model: s/k = ΔY/Y : ΔY/Y is the growth rate of GDP The more economies save and invest, the faster they can grow but the actual rate of growth is measured by the inverse of the capital-output ratio – the output-capital ratio. Economic Development: classic theories

HarrodDomar Model (AK Model) • As LDCs’ savings levels are often not enough, the “savings gaps” were filled by massive transfers of capital and technical assistance from DCs. • More savings and investment is not a sufficient condition for accelerated rates of economic growth. Many LDCs lack the necessary structural, institutional and attitudinal conditions (well-integrated commodity and money markets, highly developed transport facilities, a well-trained and educated workforce, the motivation to succeed, an efficient government) • lacked the complementary factors such as skilled labour, managerial competence, and the ability to plan and administer a wide assortment of development projects. • Also the development strategies proposed by the stages models failed to take into account the global environment in which developing countries exist – one in which development strategies can be thwarted by external forces beyond the countries control. Economic Development: classic theories

2. Structural Change Models • These models tend to emphasize the transformation of domestic economic structures - from traditional subsistence agriculture economies - to modern, urbanized and industrially diverse manufacturing and service economies. • Lewis Two-Sector Model • Patterns-of-Development Approach Economic Development: classic theories

Lewis Two Sector Model • The traditional agricultural sector: low wages, an abundance of labour, and low productivity through a labour intensive prod process. • The modern manufacturing sector: higher wage rates, higher marginal productivity, and a demand for more workers initially. • Labour can be withdrawn from the traditional sector without any loss of output (zero Marginal Productivity of Labour in the traditional sector = disguised unemployment) • Labour transfer and output & employment growth in the modern sector occur. The rate at which this occurs is determined by the rate of industrial investment and capital accumulation in the modern sector. • Modern sector wages are fixed at a premium above the traditional sector wages. Rural labour supply is perfectly elastic. • Modern sector wages would rise in order for industrial employers to attract additional workers from the traditional sector. Economic Development: classic theories

Lewis Two Sector Model • Over time as this transition continues until the wage rates of the traditional and modern sectors will equalize. -increasing marginal productivity and wages in the traditional sector -while driving down productivity and wages in the modern sector • The end result of this transition process is that - the agricultural wage equals the manufacturing wage, - the agricultural marginal product of labour equals the manufacturing marginal product of labour, - and no further manufacturing sector enlargement takes place as workers no longer have a monetary incentive to transition. Economic Development: classic theories

Problem of Lewis Model • Problems with Lewis’ model is its assumptions: • that the rate of labour transfer and employment creation is proportional to the rate of modern sector capital accumulation. • - No room for the possibility that capitalist profits could be reinvested in labour-saving capital equipment • - No room for the possibility of capital flight. • Diminishing returns in the modern sector • - much evidence that increasing returns prevail • Surplus labour in rural areas and full employment in urban areas. • - by and large this is not the case in most developing nations. • The assumption of a competitive modern-sector labour market that allows modern sector wages to remain fixed until the rural sector labour surplus is exhausted. (unrealistic) • - In reality there is a tendency for urban wages to rise over time, even when there is considerable urban unemployment. Economic Development: classic theories

Pattern of Development Approach • Hollis B. Chenery and his colleagues, using cross-sectional and time-series data, identified patterns of development. • The shift from agricultural to industrial production • The steady accumulation of physical and human capital • The shift in consumer demands from basic necessities to desires for diverse manufactured goods and services. • The decline in family size and overall population growth • The main hypothesis of these models is that development is an identifiable process of growth and main features of the change are similar in all countries. • Practitioners of this approach may lead to draw incorrect conclusions about causality since the approach is based on empirical observation and less on theory. Economic Development: classic theories

3. International Dependence Revolution These models view developing countries as beset by institutional, political, and economic rigidities both domestic and international, and caught up in a dependence and dominance relationship with rich countries. • Neocolonial Dependence Model • False-Paradigm Model • Dualistic-Development Thesis Economic Development: classic theories

Neoclassical Dependence Model • Direct outgrowth of Marxist thinking: blame for underdevelopment on historical evolution of a highly unequal capitalist system. • Unequal power relationships between the center (the rich countries) and the periphery (the developing countries). • Elite class in the developing countries have interests that help to perpetuate the international capitalist system of inequality and conformity. They serve and are rewarded by international special-interest power groups (e.g. MNCs, IMF), funded by the DCs. • Often, elite activities tend to hinder any reform efforts leading to perpetual underdevelopment. • Underdevelopment is seen as an externally-induced phenomenon. • Revolutionary struggles or at least the restructuring of the world capitalist system are therefore required. Economic Development: classic theories

False Paradigm Model • attribute underdevelopment to faulty and inappropriate advice provided by well-meaning but often uninformed, biased and ethnocentric international advisers from developed-country assistance agencies and multinational donor organizations. • The advice given fails to recognize resilient traditional social structures, the highly unequal ownership of land and other property rights, the disproportionate control of elites over domestic and international financial assets and the very unequal access to credit. • The policy advice generated from classical and neo-classical models in many cases merely serve to protect the interests of the existing power groups, both domestic and international. • Also local university intellectuals, high-government officials and other civil servants receive training in developed-country institutions where they learn inapplicable theoretical models. Economic Development: classic theories

Dualistic Development Thesis • The concept of dualism represents the existence and persistence of increasing divergences between rich and poor. • Four elements of dualism: • Different sets of conditions, of which some are superior and others inferior, can coexist in a given space. • The coexistence is chronic and not transitional. • The degrees of superiority or inferiority have a tendency to increase over time. • The superior element does little or nothing to pull up the inferior element and may in fact serve to push it down. Economic Development: classic theories

Structural Change Emphasis is on traditional neoclassical theories designed to generate GDP growth Optimistic that the right mix of economic policies will generate beneficial patterns of self-sustaining growth Underdevelopment is a result of internal constraints such as insufficient savings and investment or lack of education and skills. International Dependence Emphasis is on international power imbalances and the need for fundamental economic, political and institutional reforms both domestic and worldwide. Pessimistic in that they offer an appealing explanation of underdevelopment but they offer little formal or informal explanation of how countries can initiate and sustain development. Underdevelopment is an externally induced phenomenon Structuralism versus Dependency Economic Development: classic theories

Criticism of Dependency Theory • The actual economic performance of developing countries that have pursued revolutionary campaigns of industry nationalization and state-run production has been mostly negative. • Dependency theory suggests that countries should become more inward-looking and less entangled (delinking) with developed countries, trading only with other developing countries. • Countries like India and China that pursued inward looking policy experienced stagnant growth and eventually opened up their economies. On the other side, the Four Asian Tigers emphasized exporting to developed countries and have prospered. Economic Development: classic theories

4. Neoclassical Counterrevolution • Called for freer markets and the dismantling of public ownership, statist planning, and government regulation of economic activities. • Neoclassicist obtained controlling power of the world’s 2 most influential international financial agencies - (IBRD) and (IMF). • Argues that underdevelopment is the result of poor resource allocation due to incorrect pricing policies and too much state intervention by overly-active developing-nation governments and that state intervention often slows the pace of economic growth. • Allowing free markets to flourish, privatizing state-owned enterprises, promoting free trade and export expansion, welcoming investment from developed countries and removing the plethora of government regulations and price distortions in all markets will stimulate both economic efficiency and economic growth. Economic Development: classic theories

Approaches of Market Fundamentalism • The Free Market Approach: markets alone are efficient; competition is effective if not perfect; technology is freely available and nearly costless to absorb; information is also perfect and nearly costless to obtain. So government intervention in this context is distortionary and counterproductive. Ignores market imperfections in developing countries. • Public-choice theory: Government can do nothing right. Politicians, bureaucrats, citizens and states are all self-interested and take action to achieve their own ends. The net resultis not only a misallocation of resources but also a general reduction in individual freedoms. Minimal government is the best government. Economic Development: classic theories

Market-friendly Approach: Recognizes the imperfections in LDC product and factor markets and recognizes the need for government to facilitate the operation of markets through non-selective (market-friendly) interventions. Also recognizes that marker-failures are more prominent in developing countries. Phenomena endemic to LDC markets are - missing and incomplete information - externalities in skill creation and learning - economies of scale in production Recognition of these phenomena gives rise to the newest schools of development theory, the endogenous growth approach. Approaches of Market Fundamentalism 22 Economic Development: classic theories

Reconciling the differences • In an environment of widespread institutional rigidities and severe socioeconomic inequality, both markets and governments will fail. • The linear-stages model emphasizes the crucial role of savings and investment. • The Lewis two-sector model emphasizes the importance of attempting to analyze the many linkages between the traditional sector and the modern industry • International dependence theories highlight the role of the structure and workings of the world economy and the impact of decisions made in the developed world on the growth prospects for LDCs. • The neoclassical economic models point to the promotion of efficient production and distribution through a proper functioning price system and the damaging effect of government-induced domestic and international price distortions. Economic Development: classic theories

Neoclassical growth theory- Traditional • A direct outgrowth of the Harrod-Domar and Solow models, which both stress the importance of savings. • Liberalization (opening up) of national markets draws additional domestic and foreign investment and thus increases the rate of capital accumulation • The Solow Growth Model expanded on the Harrod-Domar formulation by adding a second factor of production – labour – and by introducing a third independent variable – technology – to the growth equation. • Technological progress became the residual factor explaining long-term growth. The level of technological progress was assumed to be exogenous. Economic Development: classic theories

sY=Saving dK=Depreciation Stationary points high saving sY low saving δK Solow Growth Model Y K K*2 K*1 Total capital stock (K) grows when savings are greater than depreciation. An increase in s will not increase growth, unlike in the HD model, it will only increase the equilibrium K* Economic Development: classic theories

Traditional growth theory • According to traditional neoclassical growth theory, output growth results from • Increases in labour quantity and quality • Increases in capital • Improvements in technology • Closed economies with lower savings rates grow more slowly in the short run than those with high savings rates and tend to converge to lower per capita GDP levels. Open economies experience income convergence at higher levels. • By impeding the inflow of FDI, heavy-handed LDC governments retard growth. Economic Development: classic theories

New (Endogenous) growth theory • Economic growth is the result of endogenous and not external forces. • Investment in human capital, innovation, and knowledge are significant contributors to economic growth having positive externalities and which offsets the diminishing return to capital accumulation. - discarding the assumption of DMR to capital investments - permitting increasing returns to scale in aggregate production • focusing on the role of externalities in determining the ROIs • Implication: an active role for public policy in promoting economic development through direct and indirect investments in human capital formation and the encouragement of foreign private investment in knowledge-intensive industries. • AK Model: y = AK ;A = a positive constant that reflects the level of the technology, K = capital (including human capital) 27 Economic Development: classic theories

The End • Todaro, Michael P. and Smith, Stephen C., 2012, “Chapter 3: Classic Theories of Economic Growth and Development” in Economic Development, 11th ed., pp. 109-154. • Rostow, W. W., 1960, The Stages of Economic Growth: A Non-Communist Manifesto, 3rd ed., Cambridge University Press. • Lewis, W. A., 1954, “Economic development with unlimited supplies of labour,” Manchester School 22 (1954): 139–191. • Chenery, Hollis B. and Syrquin, Moshe, 1975, Patterns of Development, 1950–70, London: Oxford University Press. Economic Development: classic theories

ECONOMIC DEVELOPMENT