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Lecture 3 Classical theories of economic development

Issues in Global Economics (The University of Edinburgh)

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IGD Lecture 3: Classical theories of Economic Development

Classical theory of economic development: 4 approaches

1. Linear stages of growth model

- series of successive stages of economic growth through which all countries pass
- savings, investment, foreign aid necessary
- development associated with rapid aggregate economic growth
- Rostow’s stages of growth, Harrod-Domar (AK) Growth Model

2. Theories and patterns of structural change

- mechanisms by which underdeveloped countries transform their domestic economic

structures from a heavy emphasis on traditional subsistence agriculture to a more modern,
urbanised, more industrially diverse manufacturing and service economy
- employs tools of neoclassical price and resource allocation theory and modern econometrics
to describe how this transformation takes place
- Lewis two-sector growth model

3. International dependence revolution

- developing countries beset by institutional, political and economic rigidities, both domestic
and international
- also caught up in a dependence and dominance relationship with rich countries
- Neocolonial dependence model; False-paradigm model; Dualistic-development thesis

4. Neoclassical, free market counterrevolution

- In developed countries, favouring supply-side macroeconomic policies (argues

that economic growth can be most effectively created by lowering barriers for people to
produce (supply) goods and services as well as invest in capital), rational expectations
theories, privatisation etc.
- in developing countries, calls for freer markets and dismantling of public ownership, statist
planning and government regulation of economic activities
- Solow growth model, Romer growth model

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Development as Growth and Linear-stages theories:

A classic statement: Rostow’s Stages of Growth

- opening chapter of The Stages of Economic Growth

- can identify all societies, in their economic dimensions, as lying within one of five categories

1. traditional society
2. preconditions for take-off into self-sustaining growth
3. take-off
4. drive to maturity
5. age of high mass consumption

Inner logic and continuity constitute both a theory about economic growth and a more general, if
still highly partial, theory about modern history as a whole

- developed countries have passed take-off into self-sustaining growth and developing world
stuck at 1) or 2)
- key element is domestic and foreign savings needed to generate sufficient investment to
accelerate economic growth

The Harrod-Domar Model – a simplified version:

Allows for endogenous growth – policies can influence the long run growth rate

- consider no exogenous technological progress (in Solow model gA = 0)

- Modify production function such that α = 1 (alpha is the elasticity of output with respect to
capital 0 < α < 1). Functional form (with positive constant A) – no diminishing returns to
capital

Y = AK

Let A = 1/c, where c is defined as the capital-output ratio (units of capital required to produce a unit
of output over a given period of time)

- net saving (S) is some proportion, s, of national income, (Y) such that we have the simple
equation:

S = sY

- net investment (I) is defined as the change in the capital stock, (K) and can be represented as
such that:

I = ΔK

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Total capital stock (K), bears a direct relationship to total national income (Y) as expressed by capital-
output ratio (c):

K/Y = c; ΔK/ΔY = c, ΔK = cΔY

We know that in a closed economy national savings equals national investment:

S=I

We also know that:

I = ΔK = cΔY

It therefore follows that:

S = sY = cΔY = ΔK = I

Or simply that:

sY = cΔY

Dividing both sides by (Y) and then by (c) we obtain:

ΔY / Y = s / c

The above equation is also often expressed in terms of gross savings, in which case the growth rate
is given by:

ΔY / Y = ( sG / c )– δ

Where δ is the rate of capital depreciation

 Key result: growth rate of an economy is an increasing function of the investment rate
 Therefore government policies that increase the investment rate of the economy
permanently will increase the growth rate of the economy permanently
 The parameter α measures the “curvature” of the sY curve
 If α = 1 which is the limiting case – transition dynamics never end – Harrod-Domar (AK)
model generates growth endogenously
 No need to assume anything in the model grows exogenously in order to generate per
capita growth – technology, population (all growth can be generated from within a country)

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Harrod-Domar Model:

Policy implications:

 GDP growth is proportional to the share of investment spending in GDP – a wonderfully

simple prediction

Remember Y = AK, therefore gY = gA + gK ; gA = 0  gY = gK

- where g = growth rates

Where does capital come from?

- if savings are available, savings  (capital) investment

- if without savings (incomplete/missing markets), foreign aid  capital (investment)
- remember we assume c and d are constant, s can change

Conclusion: higher the savings rate, the faster the rate of economic growth

Aid to investment and growth –evidence: Theory and evidence

Aid to investment  various factors may break this link

- corruption, embezzlement
- incentives to spend money right away
- no good investment opportunities

Research shows only 17 out of 88 countries show a positive statistical association between aid and
investment

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- among those 17 countries, only 6 passed the test that aims to establish a 1-1 relationship
between investment with aid (Easterly)

Investment to growth

- even weaker link

- only 1 out of 138 countries passed the test (Easterly)
- investment is necessary but not sufficient for growth and growth necessary but not
sufficient for development

Criticisms of the Stages models:

 Savings and investment necessary but not sufficient conditions for economic growth
 Marshall Plan worked for Europe after WW2 because countries receiving aid possessed
necessary structural, institutional and attitudinal conditions necessary to convert new capital
into higher levels of output

- well integrated commodity and money markets

- highly developed transport facilities
- well-trained and educated workforce
- motivation to succeed
- efficient government bureaucracy

Rostow and Harrod-Domar models explicitly assume these

 insufficient focus on strategies to reduce capital-output ratio c and increase efficiency with
which investments generate extra output

Domar himself admitted:

“My model was intended to comment on an esoteric (niche/understood by few) debate on business
cycles, not to derive an empirically meaningful rate of growth. It is not a growth model”

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Structural-change models:

The Lewis two-sector model:

- general theory of development process in surplus labour countries during 60s/70s – still
sometimes applied to study recent growth experience in China and labour markets in other
developing countries

Underdeveloped economy consists of 2 sectors:

 traditional, overpopulated rural subsistence sector characterised by zero marginal labour

productivity (saturated labour markets for these industries)
 surplus labour can be withdrawn from traditional agricultural sector without any loss of
output
 high productivity, modern industrial sector into which labour from subsistence sectors is
gradually transferred (marginal productivity of labour > 0 for these industries)
 focus of model is both process of labour transfer and the growth of output and
employment in modern sector - both brought about by expansion of modern sector
 speed of expansion determined by rate of industrial investment and capital accumulation in
modern sector

Agricultural sector:

Total Product:TP A =f ( LA , Ḱ A , t́ A )

Marginal product of labour (due to surplus) MPL A = 0

All rural workers share equally in output with real wage equal to the average product w A=TP A / L A

Modern industrial sector:

Total Product:TP M =f (LM , Ḱ M , t́ M )

Under assumption of perfectly competitive markets, labour markets in modern sector, marginal
product curves are actual demand curves for labour MPLM = D (KM)

Demand for labour = added benefit one can get from employing extra labour (intuitive)

Assuming at an urban real wage wM above the rural real wage wA, modern sector employees can hire
as many workers as they want without rising wages (incentive to transfer always there): SL perfectly
elastic, wM = MPLM

Reinvestment of profits will increase the capital stock (from K M 1 → K M 2 → K M 3 ¿ which in turn
causes the total product curve to shift (from TP M ( K M 1 ) → TP M ( K M 2 ) → TP M ( K M 3 ) and labour
demand curves to rise (from D 1 ( K M 1 ) → D 2 ( K M 2 ) → D 3 ( K M 3 )

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Level of modern-sector employment thus raised (from L1 → L2 → L3)

The Lewis model of Modern-sector growth in two-sector surplus-labour economy

Structural-change models:

The Lewis two-sector model:

 the process of modern-sector self-sustaining growth and employment expansion is assumed

to continue until all surplus rural labour is absorbed in the new industrial sector
 thereafter, additional workers can be withdrawn from the agricultural sector only at a
higher cost of lost food production because the declining labour-to-land ratio means that
the marginal product of rural labour is no longer zero
 this is known as the “Lewis turning point”

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 The labour supply curve becomes positively sloped as modern-sector wages and
employment continue to grow. The structural transformation of the economy will have
taken place with the balance of economic activity shifting from traditional agriculture to
more urban industry

People are employed more productively from agriculture (lower productivity) to industrial and
service sectors (higher productivity)

Criticisms of the Lewis Model:

Rate of labour transfer and employment creation may not be proportional to rate of modern-sector
capital accumulation (this could be either a) more and more capital replacing potential labour-
operated jobs, or b) too little capital to allow for employment of more workers to operate said
capital)

- capitalist profits may be reinvested in more sophisticated labour saving capital equipment
- capitalist profits may even be reinvested abroad in the form of capital flight (model assumes
full capitalist reinvestment in country of revenue generation)

Is there surplus labour in rural areas and full employment in urban?

Competitive modern-sector labour market that guarantees continued existence of constant real
urban wages up to the point where supply of rural surplus labour is exhausted

- institutional factors – union labour bargaining – civil service wage scales – multinational
corporations hiring practises tend to negate competitive forces in modern-sector labour
markets in developing countries

Assumption of diminishing returns in modern industrial sector – evidence of increasing returns to

this sector

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Structural change – conclusions and implications:

 Main hypothesis is that development is identifiable process of growth and change whose
main features are similar in all countries
 Model does recognise that differences can arise among countries in pace and pattern of
development
- resource endowment and size
- government policies and objectives
- availability of external capital and technology
- international trade

 Patterns of development can vary according to both domestic and international factors –
many of which lie beyond control of developing nation
 However, certain patterns may be affected by developing country policy choices of
governments as well as international trade and foreign-assistance policies of developed
countries
 Optimistic about development process

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The international-dependence revolution:

 The neo-colonial dependence model

Legacy of colonialism, unequal power, core-periphery

 The false-paradigm model

Pitfalls of using “expert” foreign advisors who misapply developed-country models

 The dualistic-development thesis

Superior and inferior elements can coexist; Prebisch-Singer hypothesis

In economics, the Prebisch–Singer hypothesis (also called the Prebisch–Singer thesis) argues 

that the price of primary commodities declines relative to the price of manufactured goods over the 
long term, which causes the terms of trade of primary-product-based economies to deteriorate.

 Criticisms and limitations

Does little to show how to achieve development in a positive sense; accumulating

counterexamples

The neoclassical counterrevolution: Market Fundamentalism

 Challenging the Statist model: Free markets, public choice, and market-friendly approaches

Free market approach – approach emphasises that markets are efficient and any government
intervention is counterproductive

Public choice approach – or new political economy, the approach emphasises inherent government
failure and the self-interested behaviour of public officials

Market-friendly approach – recognises market imperfections, and hence a limited but important
role for government through nonselective interventions such as infrastructure, education, and
providing a climate for private enterprise

Main arguments:

- denies efficiency of intervention

- points up state owned enterprise failures
- stresses government failures
- traditional neoclassical growth theory – with diminishing returns, cannot sustain growth
by capital accumulation alone
- However, the neoclassical approach is criticised on the grounds that markets in developing
countries, when they exist, are far from perfect and cannot be made perfect by any simple
formula

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Classical theories of development: Reconciling the differences (Possible conclusion for answer
regarding models for economic growth and development?)

 governments do fail, but so do markets; a balance is needed

 must attend to institutional and political realities in developing world
 development economics has no universally accepted paradigm
 insights and understandings are continually evolving
 each theory has some strengths and some weaknesses

Appendix 3.1: Components of economic growth

 Capital accumulation, investments in physical and human capital

- increase capital stock

 growth in population and labour force

 technological progress
- neutral, labour/capital-saving, labour/capital augmenting

Effect of increases in physical and

human resources on the production
possibility frontier

Effect of growth of capital stock and

land on the production possibility frontier

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Effect of technological change in the

agricultural sector on the production
possibility frontier (no change in
manufacturing sector = no change in radio
production)

Effect of technological change in the industrial

sector on the production possibility frontier (no
change in agricultural sector (e.g. land resources) =
no change in rice production

The Solow neoclassical growth model:

Equilibrium in the Solow growth model:

sf (k *) (  n)k * (A3.2.5)

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Endogenous/new growth theory:

Motivation for the new growth theory:

- no intrinsic (belonging naturally, essential) characteristic of economies that cause them to

grow over extended periods of time
- absent exogenous shocks in Solow mode, economy converges to zero growth
- new growth theory postulates that economic growth is generated by factors within the
production process that are studied as part of the growth model

Increasing returns or induced technological change

- most interesting (perhaps?) is that they help explain anomalous international flows of capital
that exacerbate wealth disparities between developed and developing countries

Potential for high rates of return on investment in developing countries greatly eroded by lower
levels of complimentary investments in human capital, infrastructure of R&D

The Romer model (very briefly):

- endogenous model in which technical spillovers are present

- economy wide capital stock positively affects output at the industry level
- hence, increasing returns to scale at the economy wide level
- learning by investing
- assume positive capital externality β > 0

α 1−α β
Y i= AK i Li K̄
α +β 1−α
Y = AK L
N
g n
1    
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