Theories of Development I

1. Theories of Development I Classical and Neoclassical Theories

2. Classical Economics: Political Economy The pursuit of economic growth and development as a socially desirable goal is contemporaneous with the rise of capitalism as an economic system (and with the emergence of the industrial revolution). Two objectives of classical political economists in economic inquiry are: 1. to explain the reasons for rapid economic expansion of total economic wealth that accompanied industrialization 2. to explain the enigma of the extreme of wealth and poverty that attended this process Who are the classical (political) economists? • Adam Smith • Thomas Malthus • David Ricardo • John Stuart Mill • Karl Marx

3. The classicals assumed that capitalism represented the highest achievement of human development and it was a “natural order.” • except for Marx and Mill • Neoclassical economists (after the 1870s) • Against the radical implications of Marx • shifted the emphasis from the broader macroeconomics of growth and development to a narrower concern with the allocation of a fixed quantity of scarce resources to their best use with given institutions. • efficiency as the focus of economics • more static and marginalist perspective for economics • interest in the question of growth and development has disappeared from view for quite some time.

4. Adam SmithAn inquiry into the Nature and Causes of the Wealth of Nations, 1776 • Analyzes the newly emerging economic system: capitalism or the market economy • Likens its operation to the “invisible hand” As every individual, .., endeavors as much as he can both to employ his capital in the support of the domestic industry, and so to direct that industry that its produce may be of greatest value; every individual necessarily labors to render the annual revenue of society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it ...he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. (Smith 1973: 423; C&D: 105)

5. Smith’s Views on Economic Development Basic tenets of Capitalist production that fosters Growth and Development according to Smith: • Competition • Division of labor • Technological progress • Free trade • The law of capital accumulation

6. Thomas Malthus An Essay on the Principle of Population, 1798 • Population grows in a geometric progression, while • Agricultural output can only increase in arithmetic progression; such that • Feeding the population would become increasingly more expensive a task • This would mean misery for a majority of the population who are poor • The system (capitalism) would end up in a crisis

7. David RicardoPrinciples of Political Economy and Taxation, 1817 • the law of eventually diminishing returns (implications similar to Malthus in terms of the dilemmas of the capitalist growth proces); yet • the theory comparative advantage (implies free trade through open economies would help to escape the dilemmas posed by the law of diminishing returns.) Theory which suggests that unrestricted exchange between countries will increase total world output if each country tends to specialize in those goods that it can produce at relatively lower costs compared to its potential trading partners.

8. Ricardo’s Theory of Comparative AdvantageA numerical example to explain the virtues of free trade

9. Ricardo’s Theory of Comparative Advantage: A numerical example to explain the virtues of free tradeAssume: Both E and P have 300,000 labor hours to start with; andPre-trade both divide their time equally between cloth and wine production

11. FreeTradeaccordingtoComparativeAdvantagebenefitsall??? Critique of theComparativeAdvantageTheory of FreeTrade • Very static analysis which assumes that over time, the terms of trade between wine and cloth will remain the same. • On the contrary, historically what happened with E and P was that the terms of trade very much favored cloth; such that E had a definite trade advantage. • P stuck with wine production and importing cloth, was put in a position of ever increasing trade deficit. • dynamic or created comparative advantage as opposed to static comparative advantage • the Asian tigers.

12. A Classical Model of Economic Growth Aggregate production function: Y = f(N, L, K, T) where N = natural resources; L = labor; K = capital; T = technolog, subject to the following restrictions fN, fL, fk,>0; fNN, fLL, fkK < 0,then dY/dt = fNdN/dt + fLdL/dt + fkdK/dt + fTdT/dt assume 1. dN/dt = 0; dL/dt = q(dK/dt) where q >0 = the no of wrks required for each unit of capital; 2. fT = 0; then rewrite eq.n as dY/dt = (q fL + fk)dK/dt

13. … A Classical Model of Economic Growth • The rate of economic growth depends on the rate of physical capital accumulation. • The faster physical capital accumulates, faster is economic growth. • the limit on the rate of growth: diminishing returns. • fL decreases asL rises, until eventually the point when per capitaincome reaches a steady state level.

14. Neoclassical Growth Models: the Solow Growth Model Y(t) =A(t)K(t)1-a L(t)a where 0<a<1; A(t) = exogenous technological progress; K = capital input L = labor input in a perfectly competitive setting where each factor input is entitled to a return equal to its own marginal product, a = income share of labor 1-a = income share of capital. This production function is such that • K and L are subject to diminishing returns in the short term. • production is subject to constant returns to scale in the long term.

15. … Solow Growth Model • diminishing returns dY/dL = aLa-1AK1–a> 0 dY/dK = (1–a)K–a ALa > 0; dY2/(dL)2 = a(a–1)La–2 AK1–a < 0 dY2/(dK)2 = –a(1–a)K–(1+a)ALa < 0, (0<a<1) • constant returns to scale • ‘linearly homogeneous’ • multiplying both variable inputs by the same scalar value, v, changes production by vY: A(vL)a(vK)1-a = AvaLav1-aK1-a = v(ALaK1-a),

16. … Solow Growth Model in a perfectly competitive setting where each factor input is entitled to a return equal to its own marginal product: w=dY/dL= aLa-1 AK1–a Wage share=wL/Y= (dY/dL)*(L/Y) = the elasticity of output with respect to a change in the labor input = aLa-1 AK1–aL/ AK1-aLa =a a = income share of labor 1-a = income share of capital.

17. … the Solow Growth Model without technological change: the increased investment, K, has a limit in terms of total income: Qmax Technological change

18. … the Solow Growth Model • assume constant L, • an upper limit in terms of per capita income. • How?

19. … the Solow Growth Model • y=Y/L=AK1-aLa/L • y=AK1-a/L1-a • y=A(K/L)1-a • Let K/L=k • ΔK=Investment = Savings • capital accumulation rate will be determined by the rate of savings, s, out of income, Y. • ΔK=sY • Population (labor force) growth: constant rate=n=L/L

20. … the Solow Growth Model Steady state:

21. … the Solow Growth Model At steady state: Steady state per capita income:

22. …the Solow Growth Model • the steady state level of per capita income over the long run will converge to y = Y/L = A 1/a(s/n)(1-a)/a where s=savings rate; n=exogenous population growth rate a = incomeshare of labor 1-a = income share of capital

23. … the Solow Growth Model • If tech and the rate of increase of L are constant and assuming the LF is always fully employed, a Solow-type growth model predicts that: • for any given rate of savings (and investment), there will be a constant steady-state level of real per capita income achieved. • follows directly from the assumption of diminishing returns to capital. • Given a constant rate of saving, the return to capital falls as K rises until, ultimately, total amount of capital also reaches a steady-state level, and all new investment is just sufficient to replace old capital that has worn out and meet population growth rate. • the level of per capita income has reached its max level, given the rate of savings, pop.n growth rate and assuming no tech change which is exogenous anyway. • No further growth in per capita income

24. …the Solow Growth Model • differences in income per person across countries are explained by • different rates of savings (physical capital accumulation) • different population growth rates. • Assuming equal shares of income accruing to K and L across countries: • a higher rate of saving will raise the steady-state level of per capita income. • Countries that are poor are poor b/c they aren’t saving and investing enough. • Policy recommendation:accumulate physical K at a higher rate • Implication : conditional convergence • poorer nations will grow faster than richer nations, assuming equal rates of saving and pop.n growth rates • convergence of per capita income among different nations sharing similar fundamentals. • Two countries with the same rate of saving and population growth rate, will tend to have ultimately, the same real per capita income.

25. Criticisms • no consideration of the institutional structure which converts savings into investment • Assumption of a direct, automatic and smooth link b/t increased savings, increased investment and income growth. 2. growth is conceived of as a mechanical simple process of increasing per capita income with no consideration of processes of structural, institutional, economic, political and social transformation.

26. Karl MarxCapital, 1867, 1885, 1894 • does not assume capitalism to be immutable or natural order of society, rather one stage of a society’s historical development • capitalism will alsoultimately break down andevolve into a different system • agrees with Smith’s analysis of capitalism as an immensely dynamic system driven by the lawof capital accumulation, characterized bydivision oflabor and technological progress • yet is critical of the one sided distribution (“exploitation of labor by capital”) that results in the capitalist growth process • a relatively high-level of income per capita in a capitalist economic environment is a precondition for the evolution of a new future economic system