Chapter 3

Classic Theories of Economic

Growth and Development
Chapter Goals

 To
explore the historical and intellectual
evolution in scholarly thinking about how and
why development does or does not take place.

 Examine four major development theories and

the nature of their development process.
Classic Theories of Economic
Development – Four Approaches
1. Linear stages of growth models
2. Theories and patterns of structural change
3. International-dependence revolution
4. Neoclassical, free market counterrevolution

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 From Adam Smith
to modern times ...
Adam Smith, 1776
John Maynard Keynes, 1936

Paul N. Rosenstein-Rodan, 1943

Gunnar Myrdal, Nobel Prize 1974 (not for D.E.)
A. William Lewis & Theodore Schultz, Nobel Prize 1979
Amartya K. Sen, Nobel Prize 1998
Joseph Stiglitz, Nobel Prize 2001
Muhammad Yunus, Nobel Peace Price 2006

4
 Development as Freedom /
Capabilities

„The process of economic development has

to be concerned with what people can or
cannot do, e.g. whether they can live long,
escape avoidable morbidity, be well
nourished, be able to read and write and
communicate, take part in literary and
scientific pursuits ...“

Sustenance, self-esteem, freedom

(A. K. Sen 1983)

5
 Theories of economic development

 Theory – systematic explanation of

interrelationships among economic
variables.
 Purpose – to explain causal relationships
among these variables, to understand
world better and provide basis for policy.

6
Observations:
 LDCs have much less capital per worker than rich
countries.
 “Capital” = machinery and equipment
 Result: Lower productivity of labor
 And thus Lower wages/incomes.
 LDCs are poor because they lack
capital
Development as Growth and Linear-
Stages Theories
 A theoryof economic development, associated
with the American economic historian Walt W.
Rostow, according to which a country passes
through sequential stages in achieving
development.
 Rostow’s Stages of Growth
Traditional, Preconditons, Take-off, Drive to
Maturity, High Mass Consumption

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 Rostow’s Stages of Economic Growth

 Traditionalsociety.
 Preconditions for takeoff.
 Takeoff.
 Drive to maturity.
 Age of high-mass consumption.

18
Rostow’s Traditional Society
 Dual economies are common in less developed countries, where one
sector is geared to local needs and another to the global export
market. Dual economies may exist within the same sector, for
example a modern plantation or other commercial agricultural entity
operating in the midst of traditional cropping systems.

 Sir Arthur Lewis used the concept of a dualistic economy as the basis
of his labor supply theory of rural-urban migration. Lewis
distinguished between a rural low-income subsistence sector with
surplus population, and an expanding urban capitalist sector (Dual-
sector model). The urban economy absorbed labor from rural areas
(holding down urban wages) until the rural surplus was exhausted.
Rostow’s traditional society
 characterized by subsistence agriculture or hunting and gathering;
almost wholly a "primary" sector economy
 limited technology
 Some advancements and improvements to processes, but limited ability
for economic growth because of the absence of modern technologies,
lack of class or individual economic mobility, with stability prioritized
and change seen negatively
 This is where society generally begins before progressing towards the
next stages of growth
 No centralized nations or political systems.
Farming Prior to the Industrial Revolution
• Villages feed themselves
• Subsistence farming
• 1 of 3 fields left fallow (empty)
• Farmed in long strips
Farming Prior to Industrial Revolution
Farming Prior to Industrial Revolution
Farming Prior to the Industrial Revolution
 Rostow’s Preconditions Stage and
Radical Change Outside Industry

 Increasedtransport investment – enlarge

market and specialization.
 Agricultural revolution to feed urban population.
 Expansion of imports (especially capital),
perhaps financed by exporting natural
resources.

25
Rostow’s Preconditions for Take-off

 External demand for raw materials initiates economic change.

 Development of more productive, commercial agriculture and cash
crops not consumed by producers and/or largely exported.
 Widespread and enhanced investment in changes to the physical
environment to expand production (i.e. irrigation, canals, ports)
 Increasing spread of technology and advances in existing technologies
 Changing social structure, with previous social equilibrium now in flux
 Individual social mobility begins
 Development of national identity and shared economic interests.
Take-off
 Urbanization increases, industrialization proceeds, technological
breakthroughs occur.

 "Secondary" (goods-producing) sector expands and ratio of

secondary vs. primary sectors in the economy shifts quickly
towards secondary.

 Textiles and apparel are usually the first "take-off" industry, as

happened in Great Britain's classic "Industrial Revolution“

 An Example of the Take-off phase is the Agriculture (Green)

Revolution in the 1960s.
Take-off

 One of the principal strategies of development necessary

for any takeoff was the mobilization of domestic and
foreign saving in order to generate sufficient investment
to accelerate economic growth.
 The economic mechanism by which more investment
leads to more growth can be described in terms of the
Harrod-Domar growth model (AK Model)
What was the Industrial Revolution?

 The Industrial Revolution was a fundamental

change in the way goods were produced,
from human labor to machines

 The more efficient means of production and

subsequent higher levels of production
triggered far-reaching changes to
industrialized societies
  Industrialization - the process of developing
 Industrial machine production of goods
Revolution  Industrial Revolution - Refers to the greatly
output of machine-made goods in the middle
1700s
 Began in England because of:
1. Large population of workers
2. Extensive natural resources like:
A. waterpower + coal – to fuel machines
B. iron ore - construct machines, tools
C. Rivers for transportation
 3. Expanding economy
 Industrial
Revolution 4. Highly developed banking system
(loans)
5. Trade was growing quickly
6. Political stability
 Britain
had all the resources needed to
produce goods + services
Land, labor, + capital (wealth) +
entrepreneurship
 Textile Industry is  Clothing industry
1st to be
 Why?
transformed
 population - people need clothes
 Inventions are improved over + over
Become too big + expensive to use at
home
 of clothing factories
 need of cotton from USA
EliWhitney invents cotton gin
(removes seeds from cotton –
makes slavery extremely
profitable)
 Transportation
Improvements  Entrepreneur – person who
organizes, manages, + takes on the
risks of a business
 Steamboat (in USA)
 Canals – human made waterways
 Better transportation of goods
and people
 Better roads
 Agricultural
Revolution  Period of dramatically improved farming methods in the 1700
 Began in England
 Wealthy landowners bought out local farmers’ small plot
of land and enclosed them to cultivate larger fields
 Experimented w/ more productive seeding and harvestin
methods
 crop yields
Two important results:
1. New agricultural methods
2. Many small farmers forced to become tenant farmer
or to give up farming + move to cities
 Process of crop rotation improved
 Improvements in livestock breeding
 This all leads to a population
 Railroads

 1821 – beginning of 1st railroad line

Effects:
1. Spurred Industrial Revolution
because of a cheap way to transport
materials and goods
2. Created MANY jobs
3. increased England’s agricultural
and fishing industries (could now
transport goods)
4. People travelled more
During the Industrial Revolution
Farming After the Industrial Revolution
Farming After the Industrial Revolution
Take-off

Harrod–Domar Model
 a classical Keynesian model of economic growth
 The model was developed independently by Roy F. Harrod in
1939, and Evsey Domar in 1946, although a similar model had
been proposed by Gustav Cassel in 1924. The Harrod–Domar
model was the precursor to the exogenous growth model.
 It is used in development economics to explain an economy's
growth rate in terms of the level of saving and productivity of
capital suggesting that there is no natural reason for an
economy to have balanced growth.
 Harrod–Domar Model

 Implications -- growth depends on the quantity of labour and

capital; more investment leads to capital accumulation, which
generates economic growth.

 The model carries implications for LDCs, where labour is in

plentiful supply but physical capital is not, slowing down
economic progress. LDCs do not have sufficiently high incomes
to enable sufficient rates of saving; therefore, accumulation of
physical-capital stock through investment is low.

 The model implies that economic growth depends on policies to

increase investment, by increasing saving, and using that
investment more efficiently through technological advances.
Development as Growth and Linear-
Stages Theories
 Harrod - Domar Growth Model
Mobilizationof savings to generate sufficient
investment to accelerate growth.
A functional economic relationship in which the
growth rate of GDP (g) depends directly on the
national net savings rate (s) and inversely on the
national capital-output ratio (c).

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The Harrod-Domar Model

S = sY Net Saving is some proportion of national income (3.1) Savings rate s

I = K Net investment (I) is defined as the change (3.2) Invest = ΔCapital

in the capital stock, ΔK

Since total capital stock, K, bears a direct

relationship to total national income or output, Y, as (3.3) Capital/Output = c
expressed by the capital-output ratio, c, then
K/Y = c or ΔK /ΔY = c or, finally, ΔK = cΔY

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 Netsavings ratio - Savings expressed as a
proportion of disposable income over
some period of time.

 Capital-output ratio - A ratio that shows

the units of capital required to produce a
unit of output over a given period of time.
 The Harrod-Domar Model

S=I (3.4) Closed Economy

 From 3.1, S = sY, and from 3.2 and 3.3,
I = ΔK = cΔY
 Therefore, we can write the “identity” of S = I as
S = sY = cΔY = ΔK = I (3.5)
 or simply as
sY = c∆Y (3.6)
The Harrod-Domar Model

both sides of Equation 3.6 (sY = c∆Y) first by Y

 Dividing
and then by c, we get:
 ∆Y/ Y = s/c (3.7)

where ∆Y/Y, represents the rate of change or rate of

growth of GDP determined jointly by the net national
savings ratio, s, and the national capital-output ratio, c.
The Harrod-Domar Model

 Therefore, it implies that in the absence of government, the

growth rate of national income will be directly or positively
related to the savings ratio (i.e., the more an economy is
able to save—and invest—out of a given GDP, the greater
the growth of that GDP will be) and inversely or negatively
related to the economy’s capital-output ratio (i.e., the higher
c is, the lower the rate of GDP growth will be).
Criticisms of the Harrod-Domar Model
 Necessary versus sufficient conditions
 Is Saving necessary for growth?
 Not if foreign investment or foreign aid (World Bank
Loans, etc.)
 Is Saving (Investment) sufficient for growth?
 Are there institutions to channel savings to
productive uses: a well-functioning financial system
or government plan?

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Criticisms of the Harrod-Domar Model
 Necessary condition - a condition that must be present, although it
need not be in itself sufficient, for an event to occur (eg. capital
formation may be a necessary condition for sustained economic
growth i.e., before growth in output can occur, there must be tools
to produce it). But for this growth to continue, social, institutional,
and attitudinal changes may have to occur.

 Sufficient condition - a condition that when present causes or

guarantees that an event will or can occur; in economic models, a
condition that logically requires that a statement must be true (or a
result must hold) given other assumptions.
 The Rostow and Harrod-Domar models implicitly assume the
existence of well-integrated commodity and money
markets, highly developed transport facilities, a well-
trained and educated workforce, the motivation to
succeed, an efficient government bureaucracy to convert
new capital effectively into higher levels of output in
underdeveloped nations.

 In many cases, complementary factors such as managerial

competence, skilled labor, and the ability to plan and
administer a wide assortment of development projects are
lacking.
Drive to Maturity
 Diversification of the industrial base; multiple industries expand
and new ones take root quickly

 Manufacturing shifts from investment-driven (capital goods)

towards consumer durables and domestic consumption

 Rapid development of transportation infrastructure.

 Large-scale investment in social infrastructure (schools,

universities, hospitals, etc.)
Age of High Mass Consumption

 The industrial base dominates the economy; the primary sector is of

greatly diminished weight in economy and society

 Widespread and normative consumption of high-value consumer goods

(e.g. automobiles)

 Consumers typically (if not universally), have disposable income, beyond

all basic needs, for additional goods

 Urban society (a movement away from rural countrysides to the cities)

Observations:

LDCs often have two quite different sectors:

▪ Traditional (subsistence) agriculture

Low K/L, low Land/L, “old” technology
(NOT: tractors or combines, hybrid seeds,
chemical fertilizer, pesticides, herbicides)

Result: VERY low productivity and incomes

“Modern” Industrial Sector

 Higher K/L, more modern technology than traditional

sector (though often low by rich country standards)

 Result: Higher productivity and incomes

 Also: Large Urban-Rural gaps in income result in

migration to the cities
  By the 1800s, people could earn
Short-Term
wages in factories than on farms
Effects of
1. Plentiful jobs
Industrial
Revolution 2. of cities
3. Unhealthy working conditions
4. Water and air pollution
5. child labor abuses
6. Wealth for middle class
Child Labor During the Industrial Revolution
Working Conditions
 ChildLabor
was very
common
 Urbanization

 Factorieswere built
near energy
sources
Water
Coal
 Citiesgrew rapidly
near these factories
Urbanization

 Rapid growth of cities created

problems
 workingclass lived in
crowded buildings
 High crime rates
 Lack of sanitation or sewage
systems
Garbage piled in streets
Open sewers
 Spread of disease
 Urbanization
 Europeans leave farms to look for jobs
and higher wages
 For the first time, more Europeans live
in cities than in rural areas
(urbanization is city-building and the
movement of people to cities)
 Factories were built in clusters because
entrepreneurs built them near sources
of energy like water and coal
 Some cities became centers for a
particular industry
Manchester and Leeds – textiles
Birmingham – iron smelting
Working Conditions
 Workers had to work long hours
 12-16 hours a day
 Boring work; repetitive
 Unsafe/dangerous working
conditions
 Mine work most dangerous
 No government assistance to
workers injured on the job
 Enclosure
Movement

Agrarian
Revolution
Population
Growth
People
move to
cities
Rapid
looking for urbanization
Need for work
workers
Factory
System
Better pay
than farming
 Health and Living Conditions

 Lower-class workers lived in

Tenement homes near the
factory; many families lived
on one floor or
same apartment
 Areas around tenements
were known as slums
because of high crime, dirty
streets, poor workers
Living  Because cities rapidly, there was no
Conditions in development plans, sanitary codes, or
Cities building codes
 No adequate housing, education, or police
protection
 Many slums developed
 Illnesses spread rapidly
 Many wealthy merchants and factory owners
move outside the city to suburbs and live in
luxurious homes
Long-term  Created jobs and wealth
Effects of  Encouraged technological progress and invention
Industrial  Production of goods and standard of living
Revolution  Better housing and cheaper, mass-produced clothing
 Demand for educated professionals (ex. Engineers)
 Eventually, workers received wages, hours, and
better working conditions after they formed unions
 Most people would eventually be able to afford goods
that decades before would have been luxuries
 Profits produced tax revenues, which allowed
governments to invest in developments to improve
standard of living
Results of Agricultural Revolution

• Small farmers move to cities

• Food production increased
• In 1700—10 farmers = make
enough food for 17 people
• In 1800—10 farmers = make
enough food for 25 people
• Population increased =
urbanization or moved to cities
The Agricultural Revolution
• Conditions in Cities:
• Unsafe buildings
• Little light or ventilation
• Open sewers (waste, dead
animals, etc.)
• Diseases ran rampant
 Social Consequences
• Work
• People (men, women
and children)
• Hours (14 hours a day
6 days a week)
• Not on seasons but the
almighty clock
Workers’ Issues

• Dirty and poorly lit

environments
• Dangerous working
conditions
• Laid off (fired) with little
warning
 Urban-Rural Income Ratio: China

3.0

2.8

2.6

2.4

2.2

2.0

1.8
1978 1983 1988 1993 1998
Chen (2002)
Constant (2004-05) Rupees
Rural vs. Urban Consumption
1,200
Rural Urban 1,052
per Person per Month

1,000
779
800
559
600
405
400
200
0
NSSO 1972-73 2004-05
Structural-Change Models
 The Lewis two-sector model

 The dual-sector model is commonly known as the Lewis model after

Economist W. Arthur Lewis.
 It explains the growth of a developing economy in terms of a labor
transition between two sectors, the capitalist sector and the
subsistence sector.
 Explains how economic growth gets started through structural change
– increase in size of the industrial sector relative to subsistence
agricultural sector.
 Lewis concerned about labor shortages in expanding industrial sector.

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

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Criticisms - 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 (no) and full employment in urban (no)?

 Institutional factors (unions, minimum wage)?

 Assumption of diminishing returns in modern sector (agglomeration

economies)

 BUT: Captures some elements of urban-rural divide. Chapter 7: Todaro

Model
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The International-Dependence Revolution
 The neoclassical dependence model
 Unequal power, core-periphery (exploitation)
 The false-paradigm model
 Using “expert” advisors who give wrong advice (true!)
 The dualistic-development thesis
 Superior and inferior elements can coexist (true)
 Implications
 Autarky (end exploitation by “neocolonialists”)
 State led development: SOEs, central planning, regulation

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The International-Dependence
Revolution
 1970s – International-dependence models gained support
because of disenchantment w/ stages and structural-change
models • Resurgence in various forms in the 21st century
 Developing countries caught in a dependence and dominance
relationship with rich countries because of institutional, political
and economic rigidities = difficulty for poor nations to be self-
reliant and independent
The International-Dependence Revolution

 1. NEOCOLONIAL DEPENDENCE MODEL - Indirect outgrowth

of Marxist thinking - Underdevelopment as result of
historical evolution of highly unequal international
capitalist system of rich country-poor country relationships
- Regardless if intentional, nations are under unequal
power relations between the center and the periphery
The Neoclassical Counterrevolution
 The 1980s resurgence of neoclassical free-market orientation toward
development problems and policies, counter to the interventionist
dependence revolution of the 1970s.

 Challenging the statist model of government led development

 Central planning, SOEs, etc., not usually successful
 Free market approach
 Public choice approach (not: government is “bad;” rather, what
incentives for politicians/bureaucrats)

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The Neoclassical Counterrevolution

 Criticism of Neoclassical Counterrevolution:

 Institutional
and political realities in developing world differ
from Western world
assume property rights and functioning court systems
ignorepower relationships of traditional social systems
based on caste, gender, elites
Theories of Development: Reconciling
the Differences
 Development economics has no universally accepted
paradigm

 Insights and understandings are continually evolving

 Each theory has some strengths and some weaknesses

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Appendix 3.1: Components of Economic Growth

 Capital Accumulation, investments in physical and human

capital
 Increase capital stock
 Growth in population and labor force
 Technological progress
 Neutral, labor/capital-saving, labor/capital augmenting

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Components of Economic Growth
Capital Accumulation, investments in physical and human capital

 Capital Accumulation - increasing a country’s stock of

real capital (net investment in fixed assets). To increase
the production of capital goods necessitates a reduction
in the production of consumer goods.

 Capital stock - The total amount of physical goods

existing at a particular time that have been produced
for use in the production of other goods and services.
Components of Economic Growth

 Economic infrastructure - The amount of physical and

financial capital embodied in roads, railways, waterways,
airways, and other transportation and communications,
plus other facilities such as water supplies, financial
institutions, electricity, and public services such as health
and education.

 Human capital creation – improvement in the quality of

labor force through education and improved health.
 Components of Economic Growth
Population and Labor Force Growth

 considered a positive factor in stimulating economic growth; a larger

labor force means more productive workers, and a large overall
population increases the potential size of domestic markets.
 Is rapidly growing supplies of workers in developing countries with a
surplus of labor exert a positive or a negative influence on economic
progress? (Chapter 6).
 It will depend on the ability of the economic system to absorb and
productively employ these added workers—an ability largely associated
with the rate and kind of capital accumulation and the availability of
related factors, such as managerial and administrative skills.
Figure A3.1.1 Effect of Increases in Physical and Human
Resources on the Production Possibility Frontier

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Figure A3.1.2 Effect of Growth of Capital Stock
and Land on the Production Possibility Frontier

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Components of Economic Growth
Technological Progress

 Technological progress - Increased application of new scientific knowledge in

the form of inventions and innovations with regard to both physical and human
capital.
 Neutral Technological progress - Higher output levels achieved with the
same quantity or combination of all factor inputs.
 Labor-saving technological progress - The achievement of higher output
using an unchanged quantity of labor inputs as a result of some invention (e.g.,
the computer) or innovation (such as assembly-line production).
 Capital-saving technological progress Technological progress that results
from some invention or innovation that facilitates the achievement of higher
output levels using the same quantity of inputs of capital.
Figure A3.1.3 Effect of Technological Change in the Agricultural Sector on
the Production Possibility Frontier

Labor-Augmenting Technological Progress

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Figure A3.1.4 Effect of Technological Change in the Industrial Sector on
the Production Possibility Frontier

Capital-Augmenting Technological Progress

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Appendix 3.2: The Solow Neoclassical Growth Model
Y(t) = K(t)α [A(t) L(t)] 1- α
 Y = F ( K ,  L )
Because γ can be any positive real number, a mathematical trick useful in
analyzing the implications of the model is to set γ= 1/L so that
Y L = f ( K L ,1) or y = f (k )

y = Ak
k = sf (k ) − ( + n)k
sf (k ) = ( + n)k
 

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 Because γ can be any positive real number, a
mathematical trick useful in analyzing the
implications of the model is to set γ= 1>L so that
Y(t) = K(t)α [A(t) L(t)] 1- α
Appendix- Solow Growth Model

k = sf (k ) − ( + n)k (A3.2.4)

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Appendix- Solow Growth Model

sf (k *) = ( + n)k * (A3.2.5)

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Figure A3.2.1 Equilibrium in the Solow Growth Model

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Figure A3.2.2 The Long-Run Effect of Changing the
Saving Rate in the Solow Model

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Appendix 3.3: Endogenous Growth Theory

 Motivation for the new growth theory

 The Romer model
 1− 
Yi = AKi L i K
 +  1−
Y = AK L
N
g−n=
1 −  −  
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