CHAPTER 3 CLASSIC THEORIES OF ECONOMIC GROWTH AND DEVELOPMENT

LESSON 1 Classic Theories of Economic Development

FOUR APPROACHES
1. Linear Stages of Growth Model (190s-1960s)- viewed the process of development as a series of
successive stages of economic growth through which all countries must pass.
2. Theories and Patterns of Structural Change Model (1970s)- used modern economic theory and
statistical analysis in an attempt to portray the internal process of structural change that a
“typical” developing country must undergo if it is to succeed in generating and sustaining rapid
economic growth. This theory typically change their domestic economic structures from heavy
emphasis of traditional subsistence of agriculture to more industrial.
3. International-Dependence Revolution (1970s)- It viewed underdevelopment in terms of
international and domestic power relationships, institutional and structural economic rigidities,
and the resulting proliferation of dual economies and dual societies both within and among the
nations of the world.
4. Neoclassical, Free Market Counterrevolution (1980s-1990s)- this fourth approaches in
economic thought emphasized the beneficial role of free markets, open economies, and the
privatization of inefficient public enterprises.

LESSON 2 Development as Growth and The Linear Stages Theories

Rostow’s Stages Growth Model (American Economic Historian Walt W. Rostow)

 according to Rostow, the transition from underdevelopment to development can be described in

terms of a series of steps or stages through which all countries must proceed.
 5 categories or stages
1. TRADITIONAL SOCIETY- this is an agricultural economy of mainly subsistence farming and fishing, little
of which is traded. The size of capital stock is limited. Population that does not have a scientific
perspective on the world and technology.
2. PRE-CONDITIONS FOR TAKE OFF- improved in infrastructure and commercial agriculture. Agriculture
becomes more mechanized and more out is traded, savings and investment grow although they are still
a small percentage of national income (GDP)
3. TAKE OFF- industrial revolution begin. Manufacturing industry assumes greater important than the
agriculture in relative terms although manufacturing is more important majority of people may remain
employed in the farming sector. Rostow describes this stages as a short period of intensive growth, in
which industrialization begins to occur and workers and institutions become concentrated around a new
industry.
4. DRIVE TO MATURITY- transportation and communication improved greatly. This stages takes place over
a long period of time, as standards of living rise, use technology increases and the national economy
grows and diversifies. Industry becomes more diverse. Growth should spread to different parts of the
country as the state of technology improves.
5. AGE OF MASS CONSUMPTION- output levels grow, enabling increase consumer expenditure. At the
time of writing, Rostow believed that western countries, most notably the US, occupied this last
developed stage. A country’s economy flourishes in a capitalist system, characterized by mass
production and consumerism.
  All the advanced countries argue that they all passed of the ‘take off’. In the underdeveloped countries that
were still in the traditional society or preconditions stage had only to follow certain set of rules Of development
to take off in their turn into self sustaining economic growth

Harrod-Domar Growth Model (Roy F. Harrod and Evsey Domar)

 there is some direct economic relationship between the size of the total capital stock(K), and total GDP (Y). So it
called the ‘’CAPITAL-OUTPUT RATIO’’- a ratio that shows the units of capital required to produce a unit of output
over a given period of time.
 For example if 3 dollars of capital is always necessary to produce an annual 1 dollar stream of GDP- it means that
any net additions to the capital Stock in the form of new investment will bring about corresponding increases in
flow of national output(GDP).

SIMPLIFIED VERSION OF HARROD-DOMAR GROWTH MODEL

Equation 3.1 S=sY – NET SAVINGS IS SOME PROPOTIONSOF NATIONAL INCOME

Equation 3.2 I = ΔK – NET INVESTMENT IS DEFINED AS THE CHANGE IN CAPITAL STOCK, when there is increase in
investment the capital stock will change.

But because the total capital stock bears a direct relationship to total national income or output, K/Y=c

ΔK/ΔY=c, when the capital goes up the output also goes up.

multiply both side by ΔY, you will get the Equation 3.3

Equation 3.3 ΔK = cΔY – CHANGES IN CAPITAL STOCK IS EQUAL TO CAPITAL-OUTPUT RATIO MULTIPLY BY CHANGES IN
NATIONAL INCOME

Equation 3.4 S = I – NET NATIONAL SAVINGSS IS EQUAL TO INVESTMENT

But from Equation 3.1 we know that S = sY, and from Equations 3.2 and 3.3 we know that

I = ΔK = cΔY

It therefore follows that we can write the “identity” of saving equaling investment shown by Equation 3.4 as the
Equation 3.5 below.

Equation 3.5 S = sY = cΔY = ΔK = I

Or simply as the Equation 3.6

Equation 3.6 sY = c∆Y

Dividing both sides of Equation 3.6 first by Y and then by c, we obtain the following expression:

Equation 3.7 ∆Y/Y=s/c

In left side Represents the rate of change or rate of growth of GDP.

Equation 3.7, which is a simplified version of the famous equation in the Harrod-Domar theory of economic
growth, states simply that the rate of growth of GDP (∆Y>Y) is determined jointly by the net national savings
ratio, s, and the national capital-output ratio, c.

The Equation 3.7, it says that the more an economy is able to save and invest, the greater the growth of that GDP will
be, so that the growth rate of national will be directly or positively related to savings ratio. The higher the national
capital-output ratio, the lower the rate of GDP growth will be.

The Equation 3.7 also often expressed in terms of gross savings

Equation 3.71

 Economic logic of Equation 3.7 is very simple. To grow, economies must save and invest a certain proportion of
their GDP. The more they can save and invest, the faster they can grow.

OBSTACLES AND CONSTRAINTS

For Rostow and others they defined the take off stage in a way that countries are able to save 15% to 20% so that their
GDP growth could grow/develop at a much faster rate than those that saved less.

 The main obstacles and constraints is that the relatively low level of new capital formation in most poor
countries.

3.3 STRUCTURAL-CHANGE MODELS

The model was presented in 1954. Also called as two sector model and the surplus labour model. The model
explains how the developing economy moves from a traditional agriculture base to a manufacturing led economy
developing economies had dual sector. It also shows the growth of developing countries in terms of labour transitions. It
focuses on the need for countries to transform their structures, away form agriculture, with low productivity of labour,
towards industrial activity, with a high productivity of labour. The two sectors are the agricultural sector and the
industrial sector. The agricultural sector has low marginal, average productivity, and low average wages. Industrial sector
has higher average wages, higher marginal and average productivity. And it also has higher deman for labour. There are
some criticisms on the Lewis model. First, it assumes that capital is the main factor contributing to long run growth.
Capital investment is evidently not the only factor causing growth. Improved government policies, for example, could
improve human capital leading to increased growth. Second, it assumes that all profits will be reinvested. Which is often
untrue because higher income in the industrial sectors doesn’t mean that people will save more, they may choose to
spend more on imports. Third, It assumes that there are a large number of unproductive agricultural workers. This may
be the case at certain times of the year, but the number of workers required for agriculture varies seasonally.
transferring workers to the manufacturing sector may in fact cause a reduction in agricultural output. Also, increasing in
technology would lead to a lower demand for labor in the industrial sectors. The last criticism is that it may worsen the
gap between the rich and the poor. it worsen the income distribution since the industrial workers earnings outstripping
those in the farming sector.

3.4 Necessary versus Sufficient Conditions: Some Criticisms of the Stages Model

Unfortunately, the mechanisms of development embodied in the theory of stages of growth did not always work. And
the basic reason they didn’t work was not because more saving and investment isn’t a necessary condition for
accelerated rates of economic growth but rather because it is not a sufficient condition.

International Dependency Revolution

Dependency theory

- Immerged in 1960-1970
- Research of Raul Prebisch
 - Ask a lot of question about International relationship
- Major question : “Why countries weren’t developing”

Kinds of nation (according to dependency theorist)

- Core of the Core Nations (PC)

o Developed, Powerful, and Wealthiest countries
- Periphery of the Core Nations (PC)
o Developed countries but have less power
- Core of the Periphery Nations (CP)
o Developing countries and wealthy but don’t have much power
- Periphery of the Periphery Nations (PP)
o Poor countries

International Dependence Revolution Models

- Gained increasing report especially among Developing countries

- Theory that made by Dependency theorist
- Possible answer why other countries weren’t developing
- IDR models view developing countries as beset by institutional, political, and economic rigidities.

3 Major streams of thought

Neocolonial dependence model

- Developing countries is controlled by developed countries

- Also refers to unequal economic and power relation
- Developing countries is relying to developed countries to stimulate their own economic growth
- Based on International Division of Labor
o Serves economic interest

False-paradigm Model

- Second and less radical

- Attributes underdevelopment to faulty and in appropriate advice provided by well-meaning but often
uninformed, ethnocentric international experts from developed countries or multinational donors – also suspect
are the western trained university teachers and bureaucrats and technocrats.
- This so-called experts don’t know anything, they just want to help
- Major reason why other countries weren’t developing

Dualistic-development thesis

- Existence of 2 situations or phenomena (one desirable and not)

4 key arguments
1. Different sets of conditions
- Which some are “superior” and other “inferior”, can coexist in a given space
- For example, in rich countries there are poor people and in poor countries there are rich people

2. Coexistence is chronic and merely transitional

 - Not due to temporary phenomenon, in which case , time could eliminate the discrepancy between superior and
inferior and elements.
- the international coexistence of wealth and poverty is not simply a historical phenomenon that will be rectified
in time

3. The degrees of superiority and inferiority have a tendency to increase over time
- Not only do the degrees of superiority or inferiority fail to show any signs of diminishing, but they even have an
inherent tendency to increase.
- Income inequality

4. Superior elements do nothing to help inferior elements

- The interrelations between the superior and inferior elements are such that the existence of the superior
elements does little or nothing to pull up the inferior element, let alone “trickle down” to it. In fact, it may
actually serve to push it down- to “develop its underdevelopment.

2 major weaknesses of IDR models

1. although they offer an appealing explanation of why many poor countries remain underdeveloped, they give no
insight into how countries remain initiate and sustain development.

2. the actual economic experience of developing countries that have pursued revolutionary campaigns of industrial
nationalization and state-run production has been mostly negative.

Conclusion

- The best course or option for developing countries is to pursue the policy of Autarky
(Autarky – a closed economy that attemps to be completely self-reliant)
- It’s not always the system, it’s sometimes the people.

3.5 The Neoclassical Counterrevolution: Market Fundamentalism

In the 1980s, the political ascendancy of conservative governments in the United States, Canada, Britain, and
West Germany came with a neoclassical counterrevolution in economic theory and policy.

Neoclassical counterrevolution- the 1980s resurgence of neoclassical free-market orientation toward devIn
developed nations, this counterrevolution favored supply-side macroeconomic policies, rational expectations
theories, and the privatization of public corporations.
In developed nations, this counterrevolution favored supply-side macroeconomic policies, rational
expectations theories, and the privatization of public corporations.
In developing countries, it called for freer markets and the dismantling of public ownership, statist
planning, and government regulation of economic activities

The central argument of the neoclassical counterrevolution is that underdevelopment results from poor
resource allocation due to incorrect pricing policies and too much state intervention by overly active
developing-nation governments.

Free markets - the system whereby prices of commodities or services freely rise or fall when the buyer’s
demand for them rises or falls or the seller’s supply of them decreases or increases.

The neoclassical counterrevolution can be divided into three component approaches:

Challenging the Statist Model: Free Markets, Public Choice, and Market-Friendly Approaches
1. Free-market analysis- theoretical analysis of the properties of an economic system operating with free
markets, often under the assumption that an unregulated market performs better than one with
government regulation.
2. Public-choice theory- also known as the new political economy approach, goes even further to argue
that governments can do (virtually) nothing right. This is because public-choice theory assumes that
politicians, bureaucrats, citizens, and states act solely from a self-interested perspective, using their
power and the authority of government for their own selfish ends.
3. Market-friendly approach - the notion historically promulgated by the World Bank that successful
development policy requires governments to create an environment in which markets can operate
efficiently and to intervene only selectively in the economy in areas where the market is inefficient.
-recognizes that there are many imperfections in developing-country product and factor markets and
that governments do have a key role to play in facilitating the operation of markets through
“nonselective” (market-friendly) interventions.

Market failure- a market’s inability to deliver its theoretical benefits due to the existence
of market imperfections such as monopoly power, lack of factor mobility, significant externalities, or lack
of knowledge. Market failure often provides the justification for government intervention to alter the
working of the free market.
Traditional Neoclassical Growth Theory
Another cornerstone of the neoclassical free-market argument is the assertion that liberalization (opening up)
of national markets draws additional domestic and foreign investment and thus increases the rate of capital
accumulation.
Three Driving Forces : Labor, Capital, Technology
Robert Merton Solow- was awarded the Nobel Prize in 1987,for his contributions to the theory of economic
growth.
Solow Neoclassical Growth
Model- in which there are
diminishing returns to each factor of
production but constant returns to
scale. Exogenous technological
change generates long-term
economic growth.\

the symbol k in the Solow growth

model, which stands here for the
capital-labor ratio

Capital-labor ratio-The number of

units of capital per unit of labor

( Explanation for this model: there are three driving factors which includes labor, capital and sometimes
includes the improvement of technology, in which the output result is the GDP growth)

More formally, the standard exposition of the Solow neoclassical growth model uses an aggregate
production function in which

Y is gross domestic product, which is the product or output results from one or combination of the
factors:
K is the stock of capital (which may include human capital as well as physical capital)
L is labor
A represents the productivity of labor, which grows at an exogenous rate
Closed economy- An economy in which there are no foreign trade transactions or other economic contacts
with the rest of the world.
Open economy - An economy that practices foreign trade and has extensive financial and nonfinancial
contacts with the rest of the world