Module Description

Dear distance learner Development Economics I module is prepared to provide a brief

overview of the development and underdevelopment of nations and outstanding development
theories. It explores the principles, concepts and theories of that have been developed and
applied by economists for the study of the problems of developing nations. In addition, it
examines recent developments in theories of growth and transformation in the context of
developing economies and concentrates on key areas of concern to those responsible for
development policy. Furthermore, it will address the main challenges developing world faces
and consider alternative polices and modern approaches that may contribute to stimulating
growth and speeding economic development in less developed countries. Moreover, it
introduces the student to some of the main development issues that have contributed to the
development paths pursued by developing countries like Ethiopia.

Module Objective

 To understand the nature and characteristics of the developing countries

 To acquaint learners with the understanding of how to formulate, test and measure
economic models so as to undertake /conduct economic research.
 To familiarize learners with the fundamental developmental concepts to understand
contemporary economic problems of developing countries.
 To provide learners about the different development policy mixes
 To discuss strategies for accelerating growth, attaining sustainable development,
reducing unemployment and income inequality, eradicating absolute poverty, and
decreasing external imbalances

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 Chapter 1:
Economics of Development: Concepts and Approaches

 Introduction
Dear distance student, this chapter is an introduction to the course development economics.
Development economics deals with development problems of developing countries. In other
words, it is about the causes and cures of mass poverty in the less developed nations. At the
outset, therefore, we should be aware of the relevant concepts and measuring methods of
development devised by different institutions and persons. Thus, the discussion of the
historical evolution of the concept development and the methods employed in measuring
development are vital.

Objectives
This chapter has the following major objectives:

 To help students understand the meaning of development as distinguished from

economic growth,
x To understand the current interest in development economics.
 To identify different methods of measurement of development and discuss their
advantages and disadvantages.
Contents
1.1 The nature of Development Economics
1.2 Why study Development Economics
1.3 Terminology of the developing world
1.4 Economics of Development and Economics of growth
1.5 Meaning and characteristics of modern economic growth
1.6 Measurements of Economic Growth and Development
1.7 Development gap
1.8 The Millennium Development Goals
Summary
Check list
Self evaluation test
References

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1.1 The Nature of Development Economics

The world is divided into two: the haves and the have-nots. The former are those who are rich
with bright future (they have more than enough to eat, are well clothed, healthy and have a
reasonable degree of financial security) and the latter are those who are poor (they are less
fortunate and may have in adequate food and shelter, poor health scenario and are deprived of
several wellbeing indicators).

Development economics deals with development problems of developing countries. In other

words, it is about the causes and cures of mass poverty in the less developed nations.
Development Economics is a branch of economics that studies systematically the economic
development of third world nations.

The study of economic development is one of the newest, most exciting, and most
challenging branches of the broader discipline of economics and political economy. One can
say development economics starts with Adam Smith and continued to David Ricardo, R.
Malthus, Marx K. and J. M. Keynes. But development economics as a separate field is
recognized some four/five decades ago. The awarding of the 1979 Novel prize in Economics
to the two eminent economists Arthur, Lewis and Theodor Schultz ( Chicago University) for
their pioneering studies of economic development provided a dramatic confirmation of the
status of economic development as a separate field with in the economics discipline.

So, development economics is a field of economics that is rapidly evolving its own
distinctive analytical and methodological identity. It often draws on relevant principles and
concepts from other branches of economics such as Labour Economics, Micro-Economics,
Macro-Economics, Public Finance, Monetary Economics and Political Economy in either a
standard form or modified form. Development Economics is not similar to the economics of
advanced countries (in which the economics of advanced countries is Neoclassical). Nor is it
similar to the economics of centralized socialist societies (market economics). It is the
economics of poor and underdeveloped countries or third world nations with varying
ideological orientations and diverse cultural background.

Activity

Dear learner, what do you think the peculiar features of Development Economics?

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D e a r l e a r n e r ! Have you come across with words Traditional economics and political
economy in your previous courses?- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
----------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------
- - - - - - - - - - - - - - - - - - - - - - - - - - - - Good.

If not let us see them first one by one and we will relate them with Development Economics.

Traditional Economics- is concerned with the efficient least cost combination of resources
and with the optimal growth of these resources over time so as to produce an ever expanding
range of goods and services (Classical and Neo-Classical economic thought).Traditional Neo-
classical economics deals with an advanced capitalist world of perfect markets: consumer
sovereignty, automatic price adjustment, decision making based on marginal revenue and
marginal cost ,and utility calculations: and equilibrium outcomes on all products and input
markets. It assumes economic “rationality” and a purely materialistic, individualistic and self-
interested orientation towards economic decision making.

Political Economy:- goes beyond traditional economics and studies the social and
institutional process through which certain group of economic and political elite dominate the
allocation of resources. Political economy is therefore, concerned with the relationship
between politics and economics, with a special emphasis on the role of power in economic
decision making.

Development Economics: - has an even greater scope. In addition to being involved with the
efficient allocation of the existing scarce resources and their sustained growth over time, it
also deals with economic, social, political and institutional mechanisms to bring rapid and
large scale improvement in the living standard of the mass of poverty stricken people living
in poor countries of Africa, Asia and Latin America.

Activity

D e a r d i s t a n c e l e a r n e r ! Can you guess why development Economics must be sensitive

to the uniqueness and diversity of the third world countries?- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
----------------------------------------------------------------------------------------
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Good!

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In development economics, a larger government role and some degree of co-ordinated
economic decision making are essential components. Development must be sensitive to the
uniqueness and diversity of the third world. There are only few economic principles that
work everywhere and all the time. So, we should be skeptical in using traditional neo-
classical economics. And we should be aware that there is no single development economics
in this world. However, the traditional neo-classical economics can still play a useful role in
understanding of the development problems. Before using traditional economics, we have to
see if the assumptions held in the neo-classical economics are violated. Then if the
assumptions are violated, we have to take in to consideration and perform our economic
analysis.

Because of the heterogeneity of the developing world and the complexity of the development
process, development economics must be eclectic, attempting to combine relevant concepts
and theories from traditional economic analysis along with new models and broader
multidisciplinary approaches derived from studying the historical and contemporary
development experiences of Africa, Asia and Latin America.

1.2 Why study Development Economics

The study of development economics as a recent and separate subject is because of the
increasing political and public concern of the poor nations of the world. The factors that
account for changes in attitude and upsurge of development economics are:-

1. There is a renewed interest from academician in the growth and development process
of developing countries. Adam Smith, D. Ricardo, R. Malthus, and K. Marx studied
about economic issues and their consequences. For example, classical thinkers say
that population growth with diminishing return is one of the reason for economic
stagnation. They ignore the role of technology and international trade on the
development of poor countries.
The present day development economists have already shown the role of
technological development on growth of Least Developed Countries(LDCs). But they
have still to show more on the role of trade on growth. After World War II, there is a
greater acceptance of interference in market and planning in developing countries.
This requires the input of development economists.(example ,Harrod – Domar
Model).

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 2. Poor countries themselves are aware of their backwardness which leads to a desire to
grow and strength their political power through economic growth. Example,
developing countries ask the world for a new economic order. The new economic
order was originated by special session of the United Nations (UN) assembly. The UN
General Assembly works for the establishment of the new international economics
order based on equity, sovereignty, equality and common interest among all nations.
The New International Economic Order calls for :-
a) Improve terms of trade for poor countries.
b) Greater access to markets of developed countries for manufacturing goods of
developing countries.
c) Greater financial assistance for canceling of past debts.
d) Reform of IMF and have a greater say in decision making
e) They ask international food program.
f) They ask greater assistance.
3. An increasing mutual interdependence of the world economy. During the cold war,
developed countries were rushing to divide the world to side with them.
Economically, rich and poor countries are locked up together through trade and
balance of payment. Poor countries get support of developed nations not only for
moral reason, but also from practical reasons, that is, it is from the self – interest of
the developed countries that poor nations are getting help from the rich nations.

The ability of the poor nations to sustain their growth and development means a greater
demand for the goods and services of the developed nation which generates output and
employment directly and also helps to maintain the balance of payments stability of the
developed countries.

1.3. Terminol ogy of the developing world

Activity
D e a r D i s t a n c e l e a r n e r ! Have you heard or come across about the world of the rich and
the world of the poor?--------------------------------------------------------------------------------------
--------------------------------------------------------------Good!

The most common way to define the developing world is by per capita income. Several
international agencies including the Organization for Economic Cooperation and

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Development (OECD) and the United Nations offer classifications of countries by their
economic status, but the best known system is that of the International Bank for
Reconstruction and Development (IBRD), more commonly known as the World Bank.
According to the World Bank’s classification system, the developing economies are classified
as: Low income countries (LIC), Lower middle income countries (LMIC), and Upper middle
income countries(UMIC).

Developing countries -Low – income economies (< 500$PCI,1988 price ). These

economies are known as Less Developed Countries(LDCs).

-Lower – middle – income economies ( $500-$2200 PCI)

- Upper middle income ( $2200-$6000 PCI, 1988 price)

-Some of the upper middle – income countries are known as the

newly industrialized countries ( eg. Taiwan, Hongkong…).

High – income economies (Industrial countries) :- ( > $6000, PC, in 1988 price)

There are three anomalous groups that do not fit in the World Bank classification.
These are
1. Five middle eastern petroleum exporters (Oman, Libya, Saudi Arabia, Kiwot &
United Arab Emirates) their income ranges from $ 5000 - $ 16,000 per capita in 1988
price)
2. Three other countries -Israel, Singapore & Hong-Kong their income is > $ 8000 per
capita in 1988 price.
3. Economies of Eastern Europe including Russia.
Interms of their income they are categorized into middle income countries. They can be
categorized as transitional economies.

Other types of traditional classification:

Third world countries:- The idea comes from :-
- 1st world means- North America, West Europe and Pacific Countries
- 2nd world means- East Europe socialist countries including Russia
- 3rd world means- Developing countries of Africa, Asia and Latin America.
North and South countries:- Geography based classification:
- The North:- 1st and 2nd world countries.

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 - The South: - Developing countries.

1.4 Economics of Development and Economics of growth

Activity

Dear learner can you exactly differentiate between Economic growth and Economic
development?

Many people seem to use the term economic growth and economic development
interchangeably. But the two terms are quite different in their scope and magnitude.
Therefore, it is important at the outset that we have some working definition or core
perspective on their meanings. Without such a perspective and some agreed on measurement
criteria, we would be unable to determine which country was actually developing and which
was not.

Economic Growth: - is a steady process by which the productive capacity of the economy is
increased over time to bring about rising levels of national output and
income. Whereas:

Economic Development:- is more than economic growth. Economic development include in

addition to a rise in per capita income, a fundamental change in the structure of the economy.
That is a falling share of agriculture and a rising share of industry in GDP and rising share of
population living in urban areas rather than in rural areas. Economic Development also
implies that the country must participate in the process that brought the major structural
changes.

Dear learner, from the above analysis we can conclude that Economic Growth is a necessary
but not a sufficient condition for Economic Development.

1.5 Meaning and characteristics of modern economic growth

Originally economic growth was considered similar to development. Later on economic

development was considered equal to development. Sometimes countries indicate non –
economic indicators such as gains in literacy, schooling, health condition and provision of
housing were considered as part of development. Before 1970s economic development means
development. The problem of poverty, unemployment and income distribution (equity) were

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of secondary importance in development. There was a strong assumption that a gain in the
overall real GDP will trickle down to the poor.

In 1970s economic development was redefined in terms of the reduction or elimination of

poverty, inequality and unemployment. “Redistribution from growth” becomes a common
slogan.

The World Bank in its World Development report (1991),asserted:

“The challenge of development… is to improve the quality of life in the world’s poor
countries: a better quality of life requires higher income, but it involves more than that. It
involves as ends in themselves, better education, high standard of health and nutrition less
poverty, a cleaner environment, more equality of opportunity, greater individual freedom and
a richer cultural life”[World Bank, World Development Report(1991),Oxford University
Press, New York.]

Development must therefore be conceived of as a multidimensional process involving major

changes in social structures, popular attitudes, and national institutions, as well as the
acceleration of economic growth, the reduction of inequality, and the eradication of poverty.

Amartya Sen (the 1998 Nobel laureate in Economics) argued that income and wealth are not
ends in themselves but instrument for other purpose. He postulated that the “Capability to
function1” is what really matters for status as a poor or non poor person. As Sen put it,
Economic growth cannot be sensibly treated as an end in itself. Development has to be more
concerned with enhancing the lives we lead and freedoms we enjoy. Therefore, development
cannot focus only on income, but we also need to look at other factors impacting a person’s
capability to function.

Professor Goulet ( 1971),stated that development has three core values. These are:

- Life sustenance

- Self –esteem , and

- Freedom from servitude
Life sustenance- (Ability to meet basic needs)

1
Capabilities: “freedom that a person has in terms of the choice of his functionings”
Functionings is what a person does with commodities of given characteristics that they possess/control

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It is concerned with the provision of basic human needs including food, shelter, health,
minimal education and protection. This is called the Basic Need Approach of Development
(initiated by the World Bank).When any of these is absent or in a critically short supply, we
cannot say that the country is fully developed. So, economic development is necessary to
provide people with the basic needs. Rising per capita income and the elimination of absolute
poverty, greater employment opportunities and lower income inequalities are a necessary but
not sufficient condition for development.

Self –esteem (to be a person)

This is concerned with the feeling of self-respect and independence or not being used as a
tool by others for their own need. No country can be regarded as fully development if it is
exploited by others & does not have the power & influence to conduct relations on equal
terms.

Freedom from servitude (to be able to choose)

This refers to freedom from ignorance, squalor and poverty, so that people are able to
determine their own destiny. No man is free if he can not choose, if he is imprisoned by
living in the margin of subsistence with no education and skill. The advantage of economic
growth is that it expands the range of human choice open to individual and societies at large.
Wealth also gives you more leisure as well as more goods and services. Wealth enables
people to have more control of nature, and their physical environment. Freedom also refers to
political freedom, including personal security, the rule of law, freedom of expression and
political participation on equal footing. Hence the objectives of development must include the
following:

1. Increasing the availability and widen the distribution of basic life sustaining goods such as
food, shelter, education and protection.

2. Raising the level of living including, in addition to higher incomes, the provision of more
jobs, better education, greater attention to cultural and humanistic values, all of which
will serve to generate individual and national self – esteem.

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3. Expanding the range of economic and social choices available to individuals and nations
by freeing them from servitude and dependence not only in relation to other people and
nations but also from the forces of ignorance and human misery.

The challenge of development economics lies on the formulation of economic theory and in
the application of theories in order to understand better and meet these core components of
development. Hence development economists have to adapt the Conventional economic
theory to suit the conditions prevailing in developing countries. And many of the assumptions
underlay the conventional economic model have to be abandoned or modified if they are to
yield fruitful insight in development process.

1.6 Measurements of Economic Growth and Development

Different methods of measuring development and making international comparisons have so

far been devised. Among these the Income Measures, the Physical Quality of Life Index, the
Human Development Index, and the Human Poverty Index are the widely employed
indicators. In this section we will discuss each of these measures of development and their
limitations.

1.6.1 Conventional Measures of Development

The dominant conventional measures of growth and development are the Gross National
Product (GNP) or Gross Domestic Product (GDP) and their corresponding per capital values.
GNP is calculated as the total domestic and foreign value added claimed by a country’s
residents without making deductions for depreciation of the domestic capital stock. The GDP
measures the total value for final use of output produced by an economy, by both residents
and non-residents. Thus GNP comprises GDP plus the difference between the income
residents receive from abroad for factor services (labour and capital) less payments made to
nonresidents who contribute to the domestic economy.
These national income (GNP/GDP) measures are used for the measurement of economic
development in several ways. For a given country over two or more years, the absolute value
of national income or per capital income is compared for different years. The difference
between the values for various years then reflects the growth rate over the period. The level
of per capita income is taken as a measure of the average standard of living of the population,
while the growth rate measures improvements in the standard of living.

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This income measure of development is also used to compare the economic performance of
different countries. Thus, the level of national income or per capita income and their growth
rates can be compared internationally. The poverty datum line, as the measure of the critical
minimum level of per capita income below which individuals are deemed to be living in
absolute poverty, is also derived from the income measure of development.

Limitations of conventional income measures: Development is much broader term

than economic performance, although the latter is essentially a part of it. In essence,
development ultimately refers to the quality of life and of human welfare. Thus, in essence
income indictors are incomplete and limiting measures of development.

Aside from their defects as indicators of development, the calculations of the GNP/GDP
based measures suffer from a number of shortcomings. These include the following.

x The GNP/GDP measure excludes non-market activities, transactions and subsistence

production. Since these occur to a significant degree in developing countries, this
means that a sizeable part of economic activities are left unrecorded. This leads to the
distortions of the GNP/GDP figures.

x National income accounting is also subject to a number of statistical problems. These

include the risk of double counting of intermediate inputs; the underestimation and
exclusion of unrecorded transactions, which are rampant in developing countries,
particularly across borders; the statistical problems arising from the non-
quantifiability of important economic variables and activities. The less developed an
economy, the more serious these problems are likely to be.

x The use of national income data for the purpose of international comparisons also
engenders a number of additional complications. Generally, the basis for comparison
must be identical and up to date. In spite of all efforts, statistical definitions are not
uniformly used, applied or interpreted by different countries.

x Another difficulty arises as a result of differences in the rate of inflation among

countries such that those with high rates of inflation can post very high levels of
national income. National income deflators can moderate this problem if
appropriately applied.

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 x The other problem in international comparison relates to the problem of conversion of
national incomes measured in national currencies into the US dollar at the official
exchange rate. The concern is the underestimation of the living standard of
developing countries. If the US dollar is used as a unit of account, the national per
capita income of a given country in US dollar is given by GNP/Population x exchange
rate.

However, official exchange rates between currencies of two countries are not good measures
of the purchasing power parity (PPP) between the countries, especially between countries at
different levels of development. The reason is that exchange rates are largely determined by
the supply of and the demand for currencies based on goods that are traded the prices of
which tend to be equalized internationally.

PPP, however, depends not only on the price of traded goods but also on the prices of non-
traded goods. The prices of traded goods are largely determined by unit labour cost which
tends to be lower the poorer the country. PPP is, therefore, the number of units of a foreign
country’s currency required to purchase the identical quantity of goods and services in the
developing country’s local market as $1 would buy in the United States. This point is
elaborated more widely below.

We can take two commodities, TV set and a service of haircut, which are respectively one
traded and the other is non-traded. Suppose the dollar price of a particular type of TV set in
USA is $500 and the exchange rate of one dollar is Birr 18. Without taking account of
transport cost, tariff, etc, the price of the TV set in Ethiopia will be equal to Br. 9000.

If we consider the non-traded good, however, there will be a different story. Suppose in USA,
haircut costs $5. At the official exchange rate of Birr 18 to the dollar, the service in Ethiopia
should be $90. But the actual cost of this service in Ethiopia may be Birr 10. This would
mean that as far as haircut is concerned, the value of the Birr is underestimated by a value of
nine times. Hence, the PPP rate of exchange for this particular service is $1 to Birr 2 while
the official exchange rate is $1 to birr 18.

Clearly, if domestic prices in markets of developing countries are lower, PPP measures of
GNP per capita will be higher than estimates using foreign exchange rates as the conversion
factor. For example, China’s 1997 GNP per capita was only 2.7% of that of the United States
using the exchange-rate conversion. But it rises to 12.5% when estimated by the PPP method

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of conversion. In 1997, the ratio of the highest per capita income of Switzerland ($44,320)
and Ethiopia ($110) at foreign exchange rate was 403 to 1. But in PPP, these two countries
had respectively a per capita income of $26,320 and $510 and the ratio is decreased
significantly to 51.6 to 1. Hence, the income gaps between rich and poor nations thus tend to
be less when PPPs are used.

In the last resort, per capita income is not a bad proxy for the social and economic structure
of societies. If developing countries are defined on the basis of per capita income level,
striking similarities are found between the characteristics and development obstacles of many
of the countries. Hence, per capita income may be used as a starting point for classifying
level of development and can certainly be used to identify the need for development.

1.6.2 Alternative development Indicators

By the beginning of the 1970s a momentum started to gather around the need for an earnest
search of alternative indicators of development. Aside from the aforementioned deficiencies
encountered in measuring income itself, this search has been prompted by the following
considerations:

 The failure of the GNP/GDP measures to reflect the impact of growth on the pattern
of income distribution
 The inability of the GNP/GDP measures to reflect the welfare impact of the goods and
services produced as well as the likely costs to society of certain patterns of growth.
 The invalidity of the GNP/GDP indicator as a measure of well being in situations
where growth has actually deepened poverty and income inequalities, increased
unemployment and affected the environment adversely.

Among the developed alternative indicators the major are the physical quality of life index
(PQLI) developed by Morris (1979), the Human Development Index (HDI) developed by
UNDP, and the Human Poverty Index. These are to be discussed one by one below.

a. The physical Quality of Life Index (PQLI)

This composite index is based on three simple indicators: Infant mortality, life expectancy,
and literacy. This measure gives equal weight to each of the three indictors. For each
indicator, the performances of individual countries are rated on a scale of 1 to 100, where 1

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represents the worst performance and 100 the best performance. For life expectancy the
upper limit of 100 was assigned to 77 years (achieved by Sweden in 1973) and the lower
limit of 1 was assigned to 28 years (the life expectancy of Guinea Bissau in 1950). Within
the limits, each country’s life expectancy figure is ranked from 0 to 100. Similarly, for infant
mortality, the upper limit was set at 9 per 1,000 (achieved by Sweden in 1973) and the lower
limit at 229 per 1000 (Gabon 1950). Literacy rates measured as percentages from 0 to 100
provide their own direct scale. The PQLI of each country is given by the following formula.

PQLI = Life expec. index + infant mort. index + literacy index

The PQLI indirectly reflects the effects on human development of investment in health
service, water and sewage systems, quality of food and nutrition, education, housing, and
changes in income distribution. One positive aspect of the PQLI is, therefore, that it helped
redirecting attention away from growth, toward a broader concept of human development.

However, the PQLI has been criticized as an indicator of social development in relation to
both the choice of indicators as well as the weight assigned to the different indicators.

x It is handicapped by the limited data availability

x It gives disproportionate weight to longevity as two of the three indicators, infant
mortality and life expectancy are related to it.
x It gives equal weight to each indicator arbitrarily without obvious rationale
x It treats economic and social indictors separately, instead of combining them in a
composite index.
b. The Human Development Index (HDI)

HDI is ranking various countries according to the relative success they have had with the
human development of their population. UNDP is offering the HDI as an alternative to the
GNP for measuring the relative socio-economic progress of nations. HDI has also attempted
to take account of some of the limitations of the PQLI. HDI is based on three variables:

x Longevity:- as measured by life expectancy at birth

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 x Educational attainment:- as measured by a condition of adult literacy (two third
weight) and a combined primary, secondary, and tertiary school enrollment ratios
(one third weight)
x Standard of living measured by real per capita income at PPP.

To construct the index fixed minimum and maximum values are taken for each of the
variables. For life expectancy at birth the range is 25-85 years. For adult literacy, the range
is 0 – 100 percent. For real per capita income the range is $100 – 40,000. For any component
of the HDI, the individual indices can be computed according to the general formula of:

Index = Actual value – Minimum value

Maximum value – Minimum value

x Life Expectancy Index =

x Education Index =
x Adult Literacy Index (ALI) =

x Gross Enrolment Index (GEI) =

x GDP Index =

Where: LE: Life expectancy

ALR: Adult literacy rate
CGER: Combined gross enrolment ratio
GDPpc: GDP per capita at PPP in USD

The index thus ranges from 0 to 1. If the actual value is equal to maximum the index is one.
The HDI ranks countries into three groups: low human development (0.0 to 0.49), medium
human development (0.50 to 0.79) and high human development (0.80 to 1.00). For any
given year, HDI measures relative not absolute level of human development and that its focus
is on the ends of development (longevity, educational achievement and standard of living).
Nevertheless, HDI has been criticized on grounds such as:

x It does not include non-quantitative elements of human development such as human

freedom, the existence of civil liberties and the degree of political participation

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 x It is biased in the choice of indications
x Its assumption of the rapidly diminishing marginal value of money income above the
world average threshold of $ 5120 real GDP per capita distorts some HDI estimates and
limits its applicability.
x Its statistical methodology may also be compromised by insufficient or inaccurate data.

C. Human Poverty Index (HPI)

The United Nations has constructed human poverty indices for developing countries. The
composite measure focuses on dimensions of deprivations. The HPI for developing
countries is based on three main indices:

x The percentage of the population not expected to survive to the age of 40 (P1)
x The adult illiteracy rate (P2)
x A deprivation index based on an average of three variables: the percentage of the
population without access to safe water; the percentage of population without access to
health service; and the percentage of the underweight children under five years old (P3).
The formula is given by:
HPI = [1/3(P13 + P23 + P33)] 1/3

1.7 Development gap

In this sub-topic we are going to appreciate the development gap between rich and poor
nations. Because eliminating the development gap is the prime objective of the new economic
order.

Dear Distance learner! You may question that what are the gaps? We can point out the gaps
by considering the following basic discriminatory concepts:

1. The real per capita Gross domestic product.

For example, in 2000 the real per capita GDP of

Developed Nations is $ 20,000

Developing Nations is $ 1,200

Ethiopia is $ 100

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2. Developing Countries have high Unemployment compared to developed countries that is a
gap in level of Unemployment.

3. Level of Education-that is a difference in educational attainment of nations

4. Unlike developed in developing Countries there is poor infrastructure inadequate public

service, high level of corruption, and inefficient institutions.

Activity

D e a r d i s t a n c e l e a r n e r ! Can the present developing countries can catch-up the

developed countries in per capita income? That is can the gap in percapita income be
eliminated?_________________________________________________________________
_____________________________________________Good!

To answer this we need to see the absolute gap and relative gap. For instance to eliminate the
absolute income gap between developed countries and poor countries growth rate of income
of poor countries has to be higher than that of rich countries. In actual the growth rate of rich
countries is higher than the growth rate of poor countries. Therefore it will be a real challenge
for poor countries to fill the per capita Gross domestic gap.

To have a clear idea of the percapita income (GDP) gap and challenge of poor countries Let
us answer the following four questions based on the data given following the four questions.

1. Given the recent growth rate experience of the poor countries how long it takes them to
reach the current average level of per capita income in the industrialized countries. (That
is years needed to equalize per capita income of poor countries with current average level
of per capita income of rich countries).
2. Given the recent growth rate experience of the poor countries relative to the industrialized
countries how many years it take the per-capita income gap to be eliminated? (That is
year need to eliminate the absolute income gap)
3. Given the rate of growth of the industrialized countries from now until the year (2020)
how fast the poor countries have to grow for the percapita income to be equalized by year
2020.
4. Given the rate of growth of the industrialized countries how fast would the poor countries
have to grow to prevent the absolute per capita income gap between rich and poor
countries from being any wider in the year 2020.

18 | P a g e
 Hypothetical data
Given:

- In the year 2000 the level of per capita income (PCI) of the industrialized (rich
countries) countries is $ 20,000. Represented by Y D .
i.e. YD = $ 20,000

- r D = the per capita income growth rate of the industrialized Countries is 3%

(that is the growth rate from year 2000 to 2020) i.e. r D = 3 %

- YD C – in the year 2000 the level of per capita income (PCI) of least
developed Countries (poor Countries) is $ 1 , 2 0 0 i . e . Y D C = $ 1 , 2 0 0
- r D C - the per capita growth rate of LDCs is 2% i.e. r D c = 2 %

To proceed with the calculations of the four questions we use the simple Arithmetic formula:

Compound-interest formula
S = P (1 +r)n
Where S = future sum
P = Principal
r = interest rate and
n = number of years

If we contextualize this formula in to our analysis it will be:

Y = Y0 (1 +r)n
Where Y = per capita income after n years
Yo = Current per capita income at time n
r = growth rate in percapita income
n = number of years

Now we can start to solve the questions listed above

YD*= the per capita income of industrialized Countries in 2020
Calculated as: YD*= 20,000 (1+0.03)20 = $ 36,000
Where YD = $ 20,000 = per capita income at year 2000
3
rD =3% = = 0.03 = growth rate of developed (industrialized Countries.
100
n = 20 , after 20 years i.e in 2020
rD*= represent growth rate of per capita income of the LDCs.

19 | P a g e
 Solution 1 YD = YDC (1+rDc)n equation 1
Given YD, YDC, rDC and we are asked to find n

n YD
From equation 1. 1  rDc = (Dividing Both sides of equation. 1 by YDC)
yDC

YD
Equation 3 ln 1  rDc ) n ln (Take natural logarithm of both sides)
YDC

YD
Equation 4 n1n (1+rDc) = ln (Use exponential rule of natural logarithm)
YDc

yD
ln
yDc
Equation 5 n = (Dividing both sides of equation 4 by ln (1+rDc)
ln 1  rDc

Now we can substitute given data in equation (5)

20,000
ln
1,200
n = 95
ln 1  0.02

Dear Distance learner! Therefore Given the recent growth rate experience of the poor
countries (i.e. rDc = 2%) and percapita income of $ 1,2000 of poor Countries, Poor countries
need at least 95 years to reach the current level of per capita income (i.e. YD = 20,000) of
industrialized countries.

Dear Distance learner! For the next question we need the equality equation given:
YD (1+rD)n = YDc (1+rDc)n …………. Equation (1)

The equality equation implies the elimination of the absolute income gap.

YD (1+rD)n = YDC (1+rDc )n = 0

The Given data are: YD, rD, YDc, rDc and again we are required to determine n?

Taking the natural logarithm of both sides of Equation 1

ln yD(1+rD)n = ln yDc (1+rDc)n …………. Equation 2

ln YD +ln (1+rD)n = ln yDc + ln (1 +rDc)n Equation 3 (Multiplication rule of logarithms

ln YD -1n YDc = nnln(1+rDc)- nln(1+rD)…. Equation 4 (collecting like terms)

20 | P a g e
 yD
n ln
YDc
n= ………………………………quation 5 (division rule of
ln 1  rDc  ln 1  rD
a natural logarithm and re-arraigning)

Dear Distance learner!

At this step we can substitute the hypothetical data given above in Equation 5. However, you
have to note that we must take a developing country (Poor nation), which have a current year
i.e. 2000 growth rate of greater than the current growth rate of industrialized countries or
developed national (i.e. greater than 3% in our case) unless it will be unrealistic.

For example let us take South Korea and let us further assume that the growth rate of South
Korea in 2000 is 7% and the per capita income of South Korea in 2000 is $ 5000.

§ 20,000 ·
n ln¨ ¸
© 5,000 ¹
Therefore, n= = 36 years
ln 1  0.07  ln 1  0.03

Dear Distance learner! From our calculation South Korea at least need 36 years to eliminate
the absolute income gap.

Dear Distance learner! You can exercise Question 3 and 4 by yourself. Approximately you
may get 18% and 14% respectively.

1.8 The Millennium Development Goals

Activity

Dear learner, have you heard of Millennium development Goals (MDGS)?

______________________________________________________________Very good! Can
you mention some of them?

In September 2000, the 189 member countries of the United Nations at that time adopted
eight Millennium Development Goals (MDGs), committing themselves to making

21 | P a g e
substantial progress toward the eradication of poverty and achieving other human
development goals by 2015. The MDGs are the strongest statement yet of the international
commitment to ending global poverty.

The eight goals are ambitious: to eradicate extreme poverty and hunger; achieve universal
primary education; promote gender equality and empower women; reduce child mortality;
improve maternal health; combat HIV/AIDS, malaria, and other diseases; ensure
environmental sustainability; and develop a global partnership for development. The goals
are then assigned specific targets deemed achievable by 2015 based on the pace of past
international development achievements.

Table 1: Millennium Development Goals and Targets for 2015

Goals Targets
Reduce by half the proportion of people living on less
1. Eradicate extreme poverty and hunger than $1 a day

Reduce by half the proportion of people who suffer

2. Achieve universal primary education
3. Promote gender equality and empower women
from hunger
Ensure that all boys and girls complete a full course of
primary schooling
Eliminate gender disparity in primary and secondary
education, preferably by 2005, and at all levels by
2015

4. Reduce child mortality Reduce by two-thirds the mortality rate among

children under 5.

5. Improve maternal health Reduce by three-quarters the maternal mortality ratio

6. Combat HIV/AIDS, malaria, and other diseases
7. Ensure environmental sustainability
8. Develop a global partnership for development
• Halt and begin to reverse the spread of HIV/AIDS
• Halt and begin to reverse the incidence of malaria
and other major diseases
• Integrate the principles of sustainable development
into country policies and programs; reverse loss of
environmental resources
• Reduce by half the proportion of people without
sustainable access to safe drinking water
• Achieve significant improvement in lives of at least
100 million slum dwellers by 2020
• Develop further an open, rule-based, predictable,
non-discriminatory trading and financial system;
includes a commitment to good governance,
development, and poverty reduction—both nationally
and internationally
• Address the special needs of the least developed
countries; includes tariff and quota free access for
least developed countries’ exports; enhanced program

22 | P a g e
 of debt relief for heavily indebted poor countries
(HIPCs) and cancellation of official bilateral debt; and
more generous official development assistance (ODA)
for countries committed to poverty reduction
• Address the special needs of landlocked countries
and small island developing states
• Deal comprehensively with the debt problems of
developing countries through national and
international measures in order to make debt
sustainable in the long term
• In cooperation with developing countries, develop
and implement strategies for decent and productive
work for youth
• In cooperation with pharmaceutical companies,
provide access to affordable essential drugs in
developing countries

The MDGs were developed in consultation with the developing countries, to ensure that they
addressed their most pressing problems. In addition, key international agencies, including the
United Nations, the World Bank, the International Monetary Fund (IMF), the Organization
for Economic Cooperation and Development (OECD), and the World Trade Organization
(WTO), all helped develop the Millennium Declaration and so have a collective policy
commitment to attacking poverty directly. The MDGs assign specific responsibilities to rich
countries, including increased aid, removal of trade and investment barriers, and eliminating
unsustainable debts of the poorest nations.
However, the MDGs have also come in for some criticism.29 For example, some observers
believe that the MDG targets were not ambitious enough, going little beyond projecting past
rates of improvement 15 years into the future.

Moreover, the goals were not prioritized; for example, reducing hunger may leverage the
achievement of many of the other health and education targets. At the same time, although
the interrelatedness of development objectives was implicit in the MDGs formulation, goals
are presented and treated in reports as stand-alone objectives; in reality, the goals are not
substitutes for each other but complements such as the close relationship between health and
education. Further, the setting of 2015 as an end date for the targets could discourage rather
than encourage further development assistance if it is not met. Moreover, when the MDGs
measure poverty as the fraction of the population below the $1-aday line, this is arbitrary and
fails to account for the intensity of poverty—that a given amount of extra income to a family
with a per capita income of, say, 70 cents a day makes a bigger impact on poverty than to a
family earning 90 cents per day.

23 | P a g e
Summary

x Development Economics is a branch of economics that studies systematically the

economic development of third world nations.
x The study of development economics as a recent and separate subject is because of
the increasing political and public concern of the poor nations of the world.
x The dominant conventional measures of growth and development are the Gross
National Product (GNP) or Gross Domestic Product (GDP) and their corresponding
per capital values. However these measures are incomplete and limiting measures of
development.
x The most common ways of measures of development comes out of the critics of the
conventional measures. These are the physical quality of life index (PQLI) developed
by Morris (1979), the Human Development Index (HDI) developed by UNDP, and
the Human Poverty Index
x The 8 MDGs were developed in consultation with the developing countries, to ensure
that they addressed their most pressing problems.

Checklist
Dear learner did you understand the following terms?

YES NO

Development Economics _______ ______

Traditional Economics _______ ______
Economic growth _______ ______
Economic development _______ ______
Capability approach _______ ______
Life sustenance _______ ______
Freedom from servitude _______ ______
Self esteem _______ ______
Conventional Measures of Development _______ ______
The physical Quality of Life Index (PQLI) _______ ______
The Human Development Index (HDI) _______ ______
Human Poverty Index (HPI) _______ ______
The Millennium Development Goals _______ ______

24 | P a g e
 Development Gap ________ _______

Self-evaluation test

Part I: Choose the best answer

1. All are incorrect except,
A. Development Economics is all about the efficient allocation of the existing scarce
resources
B. We need to be skeptical in employing the traditional Neoclassical Economic principles for
LDCs
C. The fall of the share of agriculture can be regarded as economic growth
D. Development is a one dimensional phenomenon.

2. Capability to function refers to:

A. Enhancing the lives we lead and freedoms we enjoy
B. Expanding enabling environment for poor.
C. Increasing political participation
D. Rising of income
E. All
F. All are correct except D
Part II: Say True if the statement is correct and False if it is incorrect
1. Economic growth is a necessary and a sufficient condition for economic development.

Part III: Write a short answer for the following questions

1. What is Development Economics all about and why is it considered as a separate field of
study?
2. What are the three core values of development and what objectives does development tries
to achieve?
3. What is the difference between economic growth and economic development?
4. Why do we say that the eve of economic growth gives a distorted picture of the level of
income in a country?
5. Mention some of the problems of using GDP/GNP as a measure of economic growth.
6. What are the eight MDGs and what factors, do you think, deter Ethiopia from achieving
them?
7. What constitutes HDI?
8. What are the limitations of the physical quality of life index?

25 | P a g e
 References
Todaro,M.,(2012)EconomicDevelopment,Fiftheditions,Longman:NewYorkand London.
Todaro,M.,(1994)EconomicDevelopment,Fiftheditions,Longman:NewYorkand London.
Gillis, DwightH. Perkins, MichaelR., Donald R. and Snodgrass, W.W. (1996) Economics of
Development, Malcolm. Norton &Company.

26 | P a g e
 Chapter Two
Structural features and common characteristics of the third
world
 Introduction
In this chapter we are going to focus on diverse structures and common characteristics of the
developing countries. The problem of the economic development of the poor countries of
today’s world is one of the most widely discussed topics of our time. Experts in various fields
such as economic, politics, sociology and engineering have held different views about the
nature of underdevelopment and poverty, its causes and its remedies. It has now been fully
recognized that the nature and causes of the “Poverty of Nations” are very complex and the
remedies are neither easy nor quick. The understanding of the problem of underdevelopment
requires a good knowledge of certain basic characteristics and Structural features of LDCs.
Because the analysis of these characteristics will shed some light on the peculiar economic
and social conditions of production, consumption and distribution of income and wealth in
the LDCs, which will help us to draw some policy implications.

Chapter Objectives: At the end of this chapter students will be able to:

 Mention the basic structural features of developing countries.

 Understand socio-economic features that are common for
developing countries.
 Describe each structural feature of their country.
Contents
2.1 An over view of the diverse structure of developing countries
2.2 Common Characteristics of Developing Countries
Summary
Check list
Self evaluation test
References

27 | P a g e
2.1 An over view of the diverse structure of developing countries

Activity
D e a r D i s t a n c e l e a r n e r ! Have you come across about structural diversity of developing
nations?.........................................................................................................................................
......................................................................very good!

This section portrays the structural diversity of developing nations. With this intention we
will make an examination of eight critical components. These are
1. The size of the country (geographic area, size of population, and income levels)
2. Its historical and economical background
3. It endowments of physical and unman resources
4. Its ethnic and religious composition
5. The relative importance of its public and private sector
6. The nature of its industrial structure
7. Its degree of dependence on external economic and political forces
8. The distribution of power and the institutional and political structure within the nation.

1. Size and Income Level

Evidently, economic potential of a country is significantly determined by its physical and
population size, and its level of national income per capita. These are also major factors
differentiating one developing country from another. In the world of developing countries,
larger and populated nations such as Brazil, India, Nigeria and Ethiopia exist side-by-side
with small countries like Paraguay, Nepal and Djibouti.

This size provides both advantages and disadvantages. Large size usually presents
advantages of diverse resource endowment, large potential markets, and lesser dependence on
foreign sources of materials and products. But it also creates problems of administrative
control, national cohesion, and regional imbalances.

However, it is to be born that there is no necessary relationship among a country’s size, its
level of per capita income, and the degree of equality or inequality in the distribution of that
income. For example, as compared to Ethiopia, the neighboring country, Kenya is smaller in
geographic and population size. But Kenya has about 3 times the per capita income of

28 | P a g e
Ethiopia at official exchange rate. But Kenya has also lesser per capita income than Brazil
and some other larger developing countries.

2. Historical Background
The other sources of diversity among the developing countries are their traditional and
colonial heritages. Apparently, countries have their own different cultural background
accumulated in their history making them to have different social and economic institutions.
Moreover, developing nations were at one time or another colonies of Western European
countries. The European colonial powers had a dramatic and long-lasting impact on the
economies, political and institutional structures of their African and Asian colonies. The
economic structures of these nations, as well as their educational and social institutions have
typically been modeled on those of their former economic rulers.

Hence, the diversity in colonial heritage together with the indigenous cultural differences
have resulted different structural problems in these countries. Depending on their colonial
heritage therefore the countries are required to take different measures. Countries like those
in Africa that only recently gained their independence are likely to be more concerned with
consolidating and evolving their own national economic and political structures than with
simply promoting rapid economic development. Their policies may consequently, reflect a
greater interest in these immediate political issues.

Latin American countries have a longer history of political independence plus a more shared
colonial heritage. Therefore, in spite of geographic and demographic diversity the countries
possess relatively similar economic, social, and cultural institutions and face similar
problems. In Asia, on the other hand, different colonial heritages and the diverse cultural
traditions of the indigenous peoples have combined to create different institutional and social
patterns.

3. Physical and Human Resources

Endowments of physical and human resources are other sources of disparities in economic
growth potential of the counties. If we start with the physical resource endowments, on the
one hand there are countries which are extremely and favorably endowed in resources such as
minerals, raw materials, and fertile land. On the other hand, there are also poorly endowed
nations where endowments of raw materials and minerals and even fertile land are relatively
minimal.

29 | P a g e
Moreover, geography and climate can also play an important role in the success or failure of
development efforts. Other things being equal, it is said that island economies seem to do
better than landlocked economies. With respect to climate also temperate zone countries do
better than tropical zone nations.

Developing countries are also distinguished one from the other in their human resource
endowments. The human resource endowments includes not only the number of people and
their skill levels but so also their cultural outlooks, attitudes toward work, access to
information, willingness to innovate, and desire for self-improvement.
Furthermore, the level of administrative skill will often determine the ability of the public
sector to alter the structure of production and the time it takes for such structural alteration to
occur. This has to do with the whole complex of interrelationships between culture, tradition,
religion, and ethnic and tribal fragmentation or cohesion. Thus the nature and character of a
country’s human resources are important determinants of its economic structure and these
clearly differ from one region to the next.

4. Ethnic and Religious Composition

Ethnicity and religion often play a major role in the success or failure of development efforts.
Evidently, the greater the ethnic and religious diversity of a country the more likely it is that
there will be internal strife and political instability. There is also distinction in ethnic and
religious composition among nations. Presently more than 40% of the world’s nations have
more than five significant ethnic populations.

In most cases, one or more of these groups face serious problems of discrimination. Over
half of the world’s less developed countries have recently experienced some form of
interethnic conflict. Just in the first half of the 1990s, ethnic and religious conflicts leading to
wide spread death and distinction took place in many African countries and some countries of
other regions.

Ethnic and religious diversity need not, however, necessarily lead to inequality, turmoil, or
instability. There have been numerous instances of successful economic and social
integration of minority or indigenous ethnic populations in countries as diverse as Malaysia
and Mauritius. The point is that the ethnic and religious composition of a developing nation
and whether or not that diversity leads to conflict or cooperation can be important

30 | P a g e
determinants of the success or failure of development efforts. Too often economists neglect to
recognize this fundamental fact.

5. Relative Importance of the Public and Private Sectors

Most developing countries have mixed economic systems, featuring both public and private
ownership and use of resources. The division between the two and their relative importance
are mostly determined by the historical and political circumstances of the countries. Thus, in
general, Latin American and South East Asian nations have larger private sectors than South
Asia and African nations.

The degree of foreign ownership on the private sector is another important variable to
consider when differentiating among less developed countries. A large foreign owned private
sector usually creates economic and political opportunities as well as problems not found in
countries where foreign investors are less prevalent.

Economic policies, such as those designed to promote more employment, will naturally be
different for countries with large public sectors and ones with sizeable private sectors. Direct
government investment projects and large rural work programs may take precedence in
economies dominated by the public sectors. In the private oriented economies, however,
special tax allowances designed to induce private businesses that can employ more workers
might be more common. Therefore, although the problem to be solved may be similar, the
solution can differ in countries with significant differences in the relative importance of the
public and private sectors.

6. Economic Structure
Developing countries are predominantly agrarian in economic, social, and cultural out look.
Labour force in most of these countries is overwhelmingly engaged in agriculture. The
agricultural sector contributes significantly also to the GDP of many of the poor nations.
Farming is not merely an occupation but a way of life for most people in Asia, Africa, and
Latin America.

Nevertheless, there are great differences between the structure of agrarian systems and
patterns of land ownership in Latin America and Africa. Asia agrarian systems are somewhat
closer to those of Latin America in terms of patterns of land ownership. But even then the
similarities are lessened by substantial by cultural differences.

31 | P a g e
It is in the relative importance of both the manufacturing and service sectors that we find the
widest variation among developing nations. Most Latin American countries possess more
advanced industrial sectors. But in the 1970s and 1980s countries like Taiwan, South Korea,
and Singapore are rapidly becoming industrialized states.

The table below provides information on the distribution of labour force and GDP between
agriculture and industry in some developing and developed countries. The contrast among
the industrial structures of these countries is striking, especially in terms of the relative
importance of agriculture.
Table 2.1: Industrial Structure of some selected Countries
Percentage of labour force Percentage of GDP
Agriculture Industry Agriculture Industry
Nigeria 54 5 43 25
Tanzania 90 5 48 21
Uganda 86 4 46 16
Bangladesh 64 14 30 18
India 65 13 28 28
South Korea 21 27 6 43
Guatemala 60 12 24 20
Peru 37 19 7 37
Venezuela 16 28 4 47
All Developing
Countries 60 17 20 38
USA 2 25 2 29
UK 1 24 2 37

Source: UNDP, Human Development Report, in Todaro, 2000.

In spite of common problems, therefore, development strategies may vary from one country
to the next, depending on the nature, structure, and degree of interdependence among its
primary, secondary, and tertiary industrial sector.

32 | P a g e
7. External Dependence: Economic, political, and Cultural

Activity
D e a r D i s t a n c e l e a r n e r ! In what way do you think that external dependence affects the
economic growth potential of the counties?..............................................................................
……………………………………………………………….Very good!

The degree to which a country is dependent on foreign economic, social, and political forces
is related to its size, resources endowment, and political history. For most developing
countries, this dependence is substantial. In some cases, it touches almost every facet of life.

Most small nations are highly dependent on foreign trade with the developed world. Almost
all small nations are dependent on the importation of foreign and often inappropriate
technologies of production. This fact alone exerts an extraordinary influence on the character
of the growth process in these dependent nations.

8. Political Structure, Power, and Interest Groups

In the final analysis, it is often not the correctness of economic polices alone that determines
the outcome of national approaches to critical development problems. The political structure
and the vested interests and allegiances of ruling elites (e.g., large landowners, urban
industrialists, bankers, foreign manufacturers, the military, trade unionists) will typically
determine what strategies are possible and where the main barriers to effective economic and
social change may lie.

The concentration of interests and power among different segments of the populations of
most developing countries is itself the result of their economic, social, and political histories
and is likely to differ from one country to the next. Nevertheless, whatever the specific
distribution of power among the military, the industrialists, and the large landowners of Latin
America; the politicians and high level civil servants in Africa; the oil Sheiks and financial
moguls of the Middle East; or the land lords, money lenders, and wealthy industrialists of
Asia – most developing countries are ruled directly or indirectly by small and powerful elites
to a greater extent than the developed nations are.

Effective social and economic changes thus require either that the support of elite groups be
enlisted or that the power of the elite be offset by more powerful democratic forces. Either

33 | P a g e
 way economic and social development will often be impossible without corresponding
changes in the social, political, and economic institutions of a nation. Such institutional
changes may include: land tenure systems, forms of governance, educational structures,
labour market relationships, property rights, the distribution and control of physical financial
asset, laws of taxation and inheritance and provision of credit.

2.2 Common Characteristics of Developing Countries

This section portrays various dimensions of the development gap between rich and poor
countries and similarities of poor nations. These include level and growth rate of income,
unemployment and underemployment, population growth rate, economic structure, political
and institutional factors, and degree of dependence. We will attempt to identify these
similarities and provide illustrative data to demonstrate their importance. For convenience,
we can classify these common characteristics into seven broad categories.

I. Low levels of living, characterized by high income inequality, poor health, and
inadequate education
II. Low levels of productivity
III. High rates of population growth and dependency burden
IV. High and rising levels of unemployment and underemployment
V. Substantial dependence on agricultural production and primary product exports
VI. Prevalence of imperfect markets and limited information
VII. Dominance, dependence, and vulnerability in international relations.

i. Low levels of Living

In developing nations, general levels of living tend to be very low for the vast majority of
people. This is true not only in relation to their counterparts in rich nations but often also in
relation to small elite groups within their own societies. These low levels of living are
manifested quantitatively and qualitatively in the form of low income (poverty), inadequate
housing, poor health, limited or no education, high infant mortality, low life and work
expectancies, and in many case a general sense of malaise and hopelessness. Let us look at
some recent statistic as comprising certain aspects of life in the underdeveloped countries and
in the more economically advanced nations.

34 | P a g e
In 1997, the total national product of all the nations of the world was valued at more than $29
trillion, of which more than $22 trillion originated in the economically developed regions and
less than $7 trillion was generated in the less developed nations.

All nations of the world show some degree of income inequality. There are large disparities
between the income of the rich and of the poor in both developed and underdeveloped
countries. Nevertheless, the gap between rich and poor is generally greater in less developed
nations than in developed nations.

Moreover, there is no obvious relationship or correlation between levels of per capita income
and degree of income inequality. Kenya, with the same low per capita income as India, has a
much wider income disparity between the top 20% and bottom 40% of the population.
Similarly, Kuwait, with almost the same high per capita income as Belgium, has a much
lower percentage of its income distributed to the bottom 40% of its population.

The magnitude and extent of poverty in any country depend on two factors: the average level
of national income and the degree of inequality in its distribution. Clearly, for any given level
of national per capita income, the more unequal the distribution, the greater the incidence of
poverty. Similarly, for any given distribution, the lower the average income level, the greater
is the incidence of poverty.

In addition to struggling on low income, many people in developing nations fight a constant
battle against malnutrition, disease, and ill health. Life expectancy in 1998 still averaged only
48 years, compared to 63 years among other Third World countries and 75 years in developed
nations. Infant mortality rates (the number of children who die before their first birthday out
of every 1,000 live births) average about 96 in the least developed countries, compared with
approximately 64 in other less developed countries and 8 in developed countries.

The access to clean drinking water is one of the most important measures of sanitation.
Waterborne diseases such as typhoid fever, cholera, and a wide array of serious or fatal
diarrhea illnesses are responsible for more than 35% of the deaths of young children in
developing countries. Most of these diseases and resulting deaths would be quickly
eliminated with safe water supplies.

After tuberculosis, AIDS is now the second leading infectious cause of death among adult
men and women. To date, an estimated 6 million people worldwide have died of AIDS and

35 | P a g e
more than 30 million have contracted the human immunodeficiency virus (HIV) that causes
it. 90% of all these people live in LDCs. At the beginning of 1998, out of the total number
of these victims 66% of them were residing in Africa while Asia and Latin America had
21% and 4.3% respectively.

The spread of educational opportunities is the final indicator of the very low levels of living
that is pervasive in developing nations. The attempt to provide primary school educational
opportunities has probably been the most significant of all LDC development efforts. In most
countries, education takes significant share of the governments’ budget.

ii. Low levels of Productivity

In addition to low levels of living, developing countries are characterized by relatively low
levels of labor productivity. The concept of a production function is often used to describe
the way in which societies go about providing for their material needs. Production function is
systematically relating outputs to different combinations of factor inputs for a given
technology.

But in less developed countries the concept of technical engineering concept of a production
function must be broadened by adding some important factors. Among its other inputs, this
includes managerial competence, access to information, worker motivation, and institutional
flexibility. Throughout the developing world, levels of labor productivity are extremely low
compared with those in developed countries.

This can be explained by a number of basic economic concepts. For example, the principle of
diminishing marginal productivity states that if increasing amounts of a variable factor (labor)
are applied to fixed amounts of other factors (e.g., capital, land, materials), the extra or
marginal product of the variable factor declines beyond a certain number.

Low levels of labor productivity can therefore be explained by the absence or severe lack of
"complementary" factor inputs such as physical capital or experienced management. To raise
productivity, according to this argument, domestic savings and foreign finance must be
mobilized. This is to generate new investment in physical capital goods and build up the
stock of human capital (e.g., managerial skills) through investment in education and training.

Institutional changes are also necessary to maximize the potential of this new physical and
human investment. These changes might include such diverse activities as

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 x the reform of land tenure, corporate tax, credit, and banking structures;
x the creation or strengthening of an independent, honest, and efficient administrative
service; and
x the restructuring of educational and training programs to make them more appropriate
to the needs of the developing societies. These and other non economic inputs into the
social production function must be taken into account if strategies to raise
productivity are to succeed.

One must also take into account the impact of worker and management attitudes toward self-
improvement; people's degree of alertness, adaptability, ambition, and general willingness to
innovate and experiment; and their attitudes toward manual work, discipline, authority, and
exploitation. Added to all these must be the physical and mental capacity of the individual to
do the job satisfactorily. The economic success stories of "The Four Asian Tigers" -South
Korea, Singapore, Hong Kong, and Taiwan-are often attributed to the quality of their human
resources, the organization of their production systems, and the institutional arrangements
undertaken to accelerate their productivity growth.

iii. Population Growth and Dependency Burdens

Statistics on demographic evolution by country show that the present rhythm of global
population growth is largely the result of the acceleration of growth in the developing
regions.

This swift population growth in developing countries is due to their higher birth rate as
compared to death rate, though death rate also is high. Birthrates (the yearly number of live
births per 1,000 population) in less developed countries are 30 to 40, whereas those in the
developed countries are less than half that figure. The crude birthrate is probably one of the
most efficient ways of distinguishing the less developed from the developed countries. There
are few less developed countries with a birthrate below 20 per 1,000 and no developed
nations with a birthrate above it.

The yearly numbers of deaths per 1,000 populations in Third World countries are also high
relative to the developed nations. However, these poor nations have benefited from the
progress of medicine for the masses and the campaigns against endemic disease. This was
followed by fall in mortality. Hence, the differences in death rate between developing and

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developed countries are substantially smaller than the corresponding differences in birthrates.
Even there are certain African countries approaching and even exceeding 3% per annum.
This is as compared to population growth of 0.5% per year in the industrialized world.
According to UN projections, now a days four out of five inhabitants of the planet are coming
from the developing countries.

These high birthrates have considerable socioeconomic implication. Children under the age
of 15 make up almost 40% of the total population in these countries. This is as opposed to
less than 21% of the total population in the developed countries. Thus in most developing
countries, the active labor force has to support proportionally almost twice as many children
as it does in richer countries. By contrast, the proportion of people over the age of 65 is much
greater in the developed nations.

Hence, not only are Third World countries characterized by higher rates of population
growth, but they must also contend with greater dependency burdens than rich nations. The
circumstances and conditions under which population growth becomes a deterrent to
economic development is a critical issue.

iv. High Unemployment and Underemployment

One of the principal manifestations of and contributors to the low levels of living in
developing nations is their relatively inadequate or inefficient utilization of labor in
comparison with the developed nations.

Unemployment increased as a result of the fact that employment has been growing during the
past at a rate which is much slower than the rate of growth of the labour force. For example,
the ILO estimates that in the 1990s productive employment in sub-Saharan Africa increased
by only 2.4 per cent per annum at a time when Africa labour force grown by a much faster
rate of 3.3 per cent a year.

Given recent and current birthrates in most LDCs, their labor supply will be expanding
rapidly for some time to come. This means that jobs will have to be created at equivalent
rates simply to keep pace. Moreover, in urban areas rural urban migration is causing the labor
force to grow at explosive annual rates of 5%, to 7% in many countries (especially in Africa).
The prospects for coping effectively with rising levels of unemployment and
underemployment and for dealing with the frustrations and anxieties of an increasingly vocal

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and educated but unemployed youth are frighteningly poor. The dimensions and implications
of the unemployment and migration problem will be discussed in detail in part two of
development economics.

v. Substantial Dependence on Agricultural Production and Primary-

Product Exports

The vast majority of people in LDCs live and work in rural areas. Over 65% are rurally
based, compared to less than 27% in economically developed countries. Similarly, 58% of the
labor force is engaged in agriculture, compared to only 5% in developed nations.

Agricultural productivity is low not only because of the large numbers of people in relation to
available land but also because LDC agriculture is often characterized by primitive
technologies, poor organization, and limited physical and human capital inputs.
Technological backwardness persists because Third World agriculture is predominantly
noncommercial peasant farming.

In many parts of the world, especially in Asia and Latin America, it is characterized further
by land tenure arrangements in which peasants rent rather than own their small plots of land.
Such land tenure arrangements take away much of the economic incentive for output
expansion and productivity improvement.

Dependence on Primary Exports: Most economies of less developed countries are oriented
toward the production of primary products. These primary commodities form their main
exports. Except in countries blessed with abundant supplies of petroleum and other valuable
mineral resources and a few leading Asian exporters of manufactured goods, most LDC
exports consist of basic foodstuffs, nonfood cash crops, and raw materials. In sub-Saharan
Africa, primary products account for over 80% of total export earnings.

vi. Imperfect Markets and Incomplete Information

Starting from the 1980s almost every developing country is moving toward the establishment
of a market economy for many reasons. Many countries did so at the behest of the World
Bank, which kept advocating "market-friendly" economic policies as preconditions for loans.
There seemed to be a growing consensus that there had been too much government
intervention in the workings of Third World economies. This government intervention is
sighted by many as the major cause of the problems in the poor nations. Hence, free market

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and unfettered competition are considered as the key to rapid economic growth.

But the presumed benefits of market economies and market-friendly policies depend heavily
on the existence of institutional, cultural, and legal prerequisites that are taken for granted in
the industrial societies. In many LDCs, these legal and institutional foundations are either
absent or extremely weak. They include

 The existence of a legal system that enforces contracts and validates property rights;
 A stable and trustworthy currency;
 An infrastructure of roads and utilities that results in low transport and communication
costs so as to facilitate interregional trade
 A well-developed system of banking and insurance,
 Formal credit markets that select projects and allocate loanable funds on the basis of
relative economic profitability and enforce rules of repayment, and
 Substantial market information for consumers and producers about prices, quantities, and
qualities of products and resources as well as the creditworthiness of potential borrowers.

These six factors, along with the existence of economies of scale in major sectors of the
economy; thin markets for many products due to limited demand and few sellers; widespread
externalities (costs or benefits that accrue to companies or individuals not doing the
producing or consuming) in production and consumption; and the prevalence of common
property resources (e.g., grazing lands, waterholes) mean that markets are often highly
imperfect.

Moreover, information is limited and costly to obtain, thereby often causing goods, finances,
and resources to be misallocated. Therefore, the existence of imperfect markets and
incomplete information systems remains a common characteristic of developing nations and
an important contributing factor to their state of underdevelopment.

vii. Dominance, Dependence, and Vulnerability in International Relations

For many less developed countries, a final significant factor contributing to the persistence of
low levels of living, rising unemployment, and growing income inequality is the highly
unequal distribution of economic and political power between rich and poor nations. These
unequal strengths are manifested in economic and non economic aspects of the relationships.
Economically, the dominant powers of rich nations control the pattern of international trade.
They have also the ability to dictate the terms whereby technology, foreign aid, and private

40 | P a g e
capital are transferred to developing countries.

Other equally important aspects of the international transfer process can serve to inhibit the
development of poor nations. One subtle but nonetheless significant factor has been the
transfer of First World values, attitudes, institutions, and standards of behavior to Third
World nations. Examples include the colonial transfer of often inappropriate educational
structures, curricula, and school systems; the formation of Western-style trade unions; the
organization and orientation of health services in accordance with the curative rather than
preventive model; and the importation of inappropriate structures and procedures for public
bureaucratic and administrative systems.

The penetration of rich-countrys' attitudes, values, and standards also contributes to a

problem widely recognized and referred to as the international brain drain. Brain drain is the
migration of professional and skilled personnel, who were often educated in the developing
country at great expense, to the various developed nations. Examples include doctors, nurses,
scientists, engineers, computer programmers, and economists.

The net effect of all these factors is to create a situation of vulnerability among Third World
nations in which forces largely outside their control can have decisive and dominating
influences on their economic and social well being.

Summary

x The understanding of the problem of underdevelopment requires a good knowledge of

certain basic characteristics and Structural features of LDCs. There are eight critical
components of the diverse structure of developing countries. These are size of the
country, historical and economical background, endowments of physical and unman
resources, ethnic and religious composition, relative importance of its public and
private sector , nature of its industrial structure, degree of dependence on external
economic and political forces, distribution of power and the institutional and political
structure within the nation.
x The dimensions of the development gap between rich and poor countries depends up
on level and growth rate of income, unemployment and underemployment, population
growth rate, economic structure, political and institutional factors, and degree of
dependence.

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Checklist
Dear learner did you understand the following terms?

Yes No

- Can you reason out why we need to study basic characteristic and  
structure features of LDCs?
- Are you able to list out the basic classification of our economic world  
based on different organizations?
- Can you list a set of common and well-defined goals shared by third  
world (LDCs) nations?
- Can you identify the structural diversity of developing countries?  

- Can you mention the advantages and disadvantages of being a large

Nation?
 

- Is there any relationship between a country’s sizes, its level of per capital
income and the degree of equality or inequality in its distribution of
 
national income?
- Can you explain how historical evolution of developing countries relates
to the developed world?
 
- Have you noted that the nature and character of a country’s population
resource are important determinants of its economic structure?
- Can you explain the rationale behind (assumption) of African countries
 
of putting greater emphasis on the public sector activities and state run
enterprises during the past times?
- Have you noted the relative difference of developing countries in the
 
nature of Industrial structure?
- Can you describe the high rate of dependence of Developing countries on  

Developed Nations?
- Can you list the social, political; and economic institution of a nation,
which are very important for effective economic and social development?  

- Is per capita income equal across countries of the world?  

- Can you explain factors that led to low productivity of Agriculture in
 
LDCs?

42 | P a g e
- Can you list the factors belind high and rising levels of unemployment  
and underemployment in LDCs?

Self-evaluation test
Direction: Discuss on the following questions.

1. Why we need to study the basic characteristics and structural features of Developing
countries?
2. What are the problems shared by developing countries at different levels of Economic
development?
3. For all of their diversity, less developed countries are linked by a range of common
problems. What are these problems? Which do you think are the most important?
Why?
4. Explain the many ways in which third world countries may differ in their economic,
social, and political structures.
5. List the seven broad categories by which we can classify the common characteristics
of developing countries.
6. Explain how low levels of living are manifested in developing countries
7. Do you think that there is a strong relationship between health, labour productivity,
and income levels? Explain.

References
Todaro,M.,(2012)EconomicDevelopment,Fiftheditions,Longman:NewYorkand London.
Todaro,M.,(1994)EconomicDevelopment,Fiftheditions,Longman:NewYorkand London.
Gillis, DwightH. Perkins, MichaelR., Donald R. and Snodgrass, W.W. (1996) Economics of
Development, Malcolm. Norton &Company.

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 Chapter three
Growth Models and Theories of development

 Introduction
Dear distance learner, in this chapter, we explore the historical and intellectual evolution in
scholarly thinking about how and why development does or does not take place. The classic
post–World War II literature on economic development has been dominated by four major
and sometimes competing strands of thought: (1) the linear-stages-of-growth model, (2)
theories and patterns of structural change, (3) the international-dependence revolution, and
(4) the neoclassical, free-market counterrevolution. In recent years, an eclectic approach has
emerged that draws on all of these classic theories. Theorists of the 1950s and 1960s viewed
the process of development as a series of successive stages of economic growth through
which all countries must pass. This linear-stages approach was largely replaced in the 1970s
by two competing schools of thought. These were patterns of structural change and the
international-dependence revolution. Throughout much of the 1980s and 1990s, a fourth
approach prevailed. This neoclassical (sometimes called neoliberal) counterrevolution in
economic thought emphasized the beneficial role of free markets, open economies, and the
privatization of inefficient public enterprises.

Chapter objectives:

At the end of this chapter students will be able to:

x Understand the different growth theories and models.

x Identify the weaknesses and strength of each growth models.
x Examine the relevance of the different growth theories and models for developing
countries.
Contents
3.1 Linear Stages of Growth
3.1.1 Rastow’s – Stages of growth model
3.1.2. Harrod – Domar Growth model
3.1.3. Solow Growth Model
3.1.4 The Endogenous (New) Growth model (early 1990s)

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3.2. Structural Change Growth model (SCM) (1970s)
3.2.1 Lewis Theory of Development
3.2.2. Structural Change and Patterns of Development Model
3.2.3. Balanced Vs Unbalanced Growth model
3.3 International Dependence Revolution Model
3.3.1 The Neo – Colonial dependence model
3.3.2 The False –Paradigm Model
3.3.3 The Dualistic Development Thesis
3.4. The Neo- classical Counterrevolution: Market fundamentalism

3.1. Linear Stages of Growth (1950s & 1960s)

Theorists of the 1950s and early 1960s viewed the process of development as a series of
successive stages of economic growth through which all countries must pass. It was primarily
an economic theory of development in which the right quantity and mixture of saving,
investment, and foreign aid were all that was necessary to enable developing nations to
proceed along an economic growth path that historically had been followed by the more
developed countries. Development thus became synonymous with rapid aggregate economic
growth.

3.1.1. Rastow’s – Stages of growth model

The most influential and outspoken advocate was the American economic historian Walt W.
Rostow. According to the Rostow doctrine, the transition from underdevelopment to
development can be described in terms of a series of steps or stages through which all
countries must proceed. Restow identified the following stages of economic growth that
societies have to pass through.
a) The traditional society
b) Pre-condition for the take-off into self sustaining growth
c) Take off
d) The derive to maturity
e) The age of high consumption.

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 Activity

Dear learner, do you agree with the proposition of Rastow’s Stages of growth model that
states development as a series of successive stages of economic growth through which all
countries must pass? …………………………………………………………….Why? or Why
not?...............................................................................................................................................
...................................................................................................Very good!

A. The traditional society.

The allocations of resources are largely determined by ancient traditions. Output per worker
is very low and does not change from time to time. In this economy there may be craft
industries with social stratification and subsistence agriculture.

B. The precondition for take-off,

The traditional economic system become largely ceremonial and has little impact on the
working of the economy. Capital is accumulated by few saving class, but there is a state of
development of roads and rail ways, growing export, new political and economic elite and
external influence.

C. The take –off stage,

Any remaining barriers to growth are overcomed and growth becomes a normal condition at
least in one sector of the economy (the leading sector). Growth begins to feed up on itself and
becomes self sustaining. Because the economy is able to generate its own new investment
from the earning of its previous investment (the main drive from growth). Investment reaches
up to 10% of GDP. Political social and institutional setup favours dynamic growth.

D. The drive to maturity,

The economy diversifies, new industries are developed, the service sector become stronger,
less reliance on import, more export are produced and sold and there arrives the age of mass
consumption where the affluent ( rich) population consumes sophisticated consumer durables
and the service sector become a major part of the economy.

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 Mass consumption

Derive to maturity

Take - off

Pre- condition for take off

Traditional society

E. Mass consumption

The age of high mass consumption refers to the period of contemporary comfort afforded
many western nations, wherein consumers concentrate on durable goods, and hardly
remember the subsistence concerns of previous stages. In the age of high mass consumption,
a society is able to choose between concentrating on military and security issues, on equality
and welfare issues, or on developing great luxuries for its upper class.

This stage is characterized by:

x The economy is geared towards high mass consumption.

 The consumer durable industries flourish.
 The service sector becomes increasingly dominant.

Dear learner! According to Rostow, the advanced countries passed the state of take-off
stage. Whereas, developing countries are still in traditional society. If Rostow's proposal is
accepted it suggests important lesson for policy makers in developed countries. For LDCs to
grow the western countries has to give foreign aid and encourage foreign investment in
developing countries.

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Criticisms of Rostow’s Model

Development economists have their critiques on Rostow’s theory mainly because his
proposal is very general.

x Rostow didn’t identify what exactly the factors are responsible for take –off.
x Following Rostow’s model, it is very difficult to identify countries at which sage
they are. But Restow’s theory has an advantage of drawing attention on long term
determinants of growth. i.e. investment.
x Rostow also reminds the importance of political and social precondition for
growth which economists easily neglect.

3.1.2. Harrod – Domar Growth model

According to Harrod and Domar, in its simplest terms, economic growth is the result of
abstention from current consumption. In other words, saving is the key factor to economic
growth. The Hrrod- Domar model can be illustrated in a simple algebra as follows.

Let t= time, 1,2,……….t

Yt = total output at time t

Ct= consumption at time t

St= saving at time t

It = investment at time t

And assume a closed economy.

Total income ( output) is divided between consumption and Saving.

Yt Ct  S t 1

The other side of the coin is that the value of produced output must be matched to goods
produced for consumption plus those needed by investors: that is,

Yt Ct  I t 2 , and the macroeconomic balance equation is

that,

St = It --------------------------------(3)

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 The accumulation of capital stock (K) is : K t 1 K t  dK t  I t , where

d= rate depreciation of capital stock.

Kt+1= (1- d ) K t  I t --------------------------------------------(4), this shows how the capital

stock built over time.

Now we introduce two important concepts: the saving rate and the capital-output ratio.
Thus, the saving rate is given by,

st
D  5
Yt

And the capital –output ratio is given by,

Kt
T Ÿ Kt TYt , this ratio shows the amount of capital required to produce a
Yt
single unit of output in the economy.

Combining equations (3) & (4) gives;

K t 1 1  d K t  S t                            (6)
K t 1 1  d K t  DYt

Yt 1 1  d TYt  DYt                              (7)

TYt 1  TYt DYt  dTYt

T Yt 1  Yt D  dT Yt

Dividing both sides by TYt: , we arrive at the rate of growth of output: g=

Yt 1  Yt D
d  8
Yt T

gd D  9
T

This last equation is the Harrod-Domar equation, named after Roy Harrod and Evsey Domar,
who wrote well known papers on the subject in 1939 and 1946, respectively. The Harrod-
Domar model firmly links the growth rate of the economy to two fundamental variables: the

49 | P a g e
ability of the economy to save and the capital-output ratio. By pushing up the rate of saving,
it would be possible to accelerate the rate of growth. Likewise, by increasing the rate at which
capital produces output (a lowerT), growth would be enhanced.

The main constraint on development according to this theory, was the relatively low level of
new capital formation in most poor LDCs ( due to low saving).

The Harrod- Domar model with population growth

A small amendment to the Harrod- Domar model allows us to incorporate the effects of
population growth on economic growth.

Let Pt population at time t.

Pt 1 Pt  nPt , Where n= rate of growth of population

Pt 1 Pt Pt
Pt 1 1  n Pt Ÿ  1 n  n              (11)
Pt Pt Pt

Let y t Percapita output.

Yt
thus, y t                                      (12)
Pt

Kt
Let also the per capita capital stock = k t
Pt

From equation (7), we have, TYt 1 1  d TYt  DYt

TYt 1
Ÿ 1  d TYt  DYt
Pt

TYt 1 Pt 1
Ÿ . 1  d TYt  Dy t
Pt Pt 1

TYt 1 Pt 1
Ÿ . 1  d Ty t  Dy t
Pt 1 Pt

Ÿ Ty t 1 (1  n) (1  d )Ty t  Dy t

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 y t 1
Dividing by Ty t :Ÿ . 1 n 1 d D
yt T

y t 1
1  g * , where g * Per capita GDP output growth rate:
yt

D
1  g * (1  n)  (1  d ) 1  g *  n  g * n  1  d
T

D g *  n  d  g *n , now both g* and n are small numbers, such as 0.05 or 0.02, so

T
their product is very small (| 0) and can be ignored. This gives us the approximate equation:

g* = D/T - n- d

Accordiing to this identity, the fundamentals to economic growth are;

1) The ability of the economy to save and invest ( captured by D)

2) The ability of the economy to convert capital into output (θ) – capital efficiency or
productivity
3) The rate at which capital depreciates(d)
4) The rate of population growth (n)

Criticisms of Harrod – Domar Model

1 Investment and saving are the necessary condition not sufficient condition for
economic growth, i.e. in addition we need managerial capacity and skill to transform
the potentials of capital investment into practice, skilled labour, the ability to plan and
administer.
2. Saving, population and capital output ratio are not exogenous. But they are
endogenous, that is, the parameters themselves are affected by economic growth.
Where saving is impossible in a subsistence economy, growth efforts must then rely
on other sources of capital accumulation, such as external credit or aid.
3. Harrod and Domar model is a neutral theory. It does not explain why growth rate at
deferent levels of per capita income differs.
4. Capital output ratio is assumed fixed in Harrod-Domar model. But what if there is a
diminishing return?

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 3.1.3. Solow Growth Model
Solow’s twist on the Harrod- Domar model is based on the law of diminishing return to
individual factors of production. Capital and abour work together to produce output. If
there is plenty of labour relative to capital, a little bit of capital will go a long way.
Conversely, if there is a shortage of labour, the incremental capital output ratio rises (or
diminishing return of capital) set in quickly.The thesis of Solow in capital output ratio (T)
is endogenous. It is not fixed. In particular, T depends on the economy wide relative
endowments of capital and labour.

The Solow equations:

To understand the implications of this modification, it will help to go through a set of

derivations very similar to those we used for the Harrod-Domar model. From equation (6)
above, we have:

K t 1 1  d K t  DYt , Dividing both sides by Pt gives:

1  n k t 1 1  d k t  Dy t                        (13)

Where the lower case kt and yt represent per capita magnitudes.

The production function Solow used is: Y= f (K, P), where, k=capital and, p= working
population. More specifically Solow used the following constant return to scale Cobb-
Douglas production function.

Y= AK E P 1 E , 0<E<1

Where, A= a measure of technological progress (or total factor productivity).

AK E P 1 E
If we divide both sides by P we have ; Y
P P

y AK E P 1 E . P 1 AK E P  E

E
y AK
P

y Ak E

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As the per capita capital stock (y) increases, output – capital ratio falls because of the relative
labour shortage and diminishing return characteristics.

Now: 1  n k (1  d )k _ Dy , translating this equation into a diagram:

The above figures shows us two initial historical levels of the per capita capital stock-one
”low” (fig “a”) and one “high” (fig “b”) starting in the year 1996. With the low stock, the
output- capital ratio is very high and so the per capita capital stock can expand quite rapidly.
How do we see this from figure “a”? The supply of per capita capital stock is read off by
traveling up to the point on the curved line corresponding to the initial stock k (1996).
However, some of this supply is eroded by population growth. To find k (1997), we simply
travel horizontally until the line (1+n)k is touched; the capital stock corresponding to this
point is 1997’s per capita capital stock. Now just repeat the process. We obtain the zigzag
path in figure ‘a’. Note that the growth of per capita capital slows down and that per capita
capital finally settles close to k*, which is a distinguished capital stock level where the curved
and straight lines meet.

Likewise, one can trace the argument for high initial capital stock as in figure ‘b’. Here there
is an erosion of per capita capital stock at time passes, with convergence occurring over time
to the same per capita capital stock (k*) . Here the output-capital ratio is low so the rate of
expansion of aggregate capital is very low. Therefore, population growth outstrips the rate of
growth of capital, thus eroding the per capita capital stock.

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We can think of k*as a steady state level of per capita capital stock to which the per capita
capital stock (starting from any level) must converge. In other words growth in the Solow
model loses its momentum if capital is growing too fast relative to labour, which is precisely
what happens to the left of k* in figure ‘a’. The reason is diminishing returns to capital,
which creates a downward movement in the capital output ratio as capital is accumulated
faster than labour. The lower output-capital ratio then brings down the growth of capital in
line with the growth of labour. This means that the long run capital labour ratio must be
constant (and this is captured by the ratio k*).

However, if the per capita capital stock settles down to some “steady- state” level, then so
must per capita income. Thus, in this version of the Solow model, there is no long-run growth
of per capita output, and total output grows precisely at the rate of growth of the population.
In particular, the saving rate has no long run effect on the rate of growth, in sharp contrast to
the prediction of the Harrod-Dosmar model.

How parameters affect the steady state?

The saving rate in Solow model does not affect the long-run growth rate of per capita income.
But, it certainly affects the level of long – run income. So does population growth rate and
the rate of depreciation. All these effects work via changes in the steady-state level of capital
per capita, which inturn affects the steady state level of per capita output, which is the same
as per capita income in the long run.

To see this a bit more formally, note from the above figure that were the economy to start
from the steady state level of k*, it would stay at k* in every period. This means that

kt k t 1 k * and if we denote y* as the steady state per capita income which comes from k*
, and move terms around in equation(13) a bit , we obtain the equation that describes the
steady state. That is:

1  n k t 1 1  d k t  Dy t

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At steady state (1+n)k*=(1- d )k *  Dy *

The effects of changes in various parameters can now be easily seen. An increase in D,the
rate of savings , raises the right hand side of the equation, necessitating an increase in the left
hand side to restore equality. This means that the new steady state capital-output ratio must
be higher. With diminishing returns, this can only happen if the new steady state level of
k*(and y*) is higher as well. We thus see that an increase in the saving rate raises the long
run level of per capita income. By exactly the same logic , we can see that an increase in the
population growth rate or the rate of depreciation will lower the long run level of per capita
income.

Level and growth effects

The population growth rate (n) is a parameter with an interesting double effect. As we have
just seen, higher population growth lowers the steady-state level of per capita income, but
note that total income must grow faster as well as a result. This must be the case because we
know that the economy converges to a steady-state level of per capita income, which is
impossible unless the long run growth of total income equals the rate of growth of the
population.

This double effect of population growth arises from a fundamental characterstic of labour that
makes it different from any other commodity. Labour is both an input in production and a
consumer of final goods. The former effect tends to raise total output; the latter effect tends to
lower per capita output because the existing capital stock must be spread more thinly over a
large population. The first effect drives the higher rate of growth of total income ; the second

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brings down the steady state level of per capita income. There fore, apart from its intrinsic
interest, population growth is noteworthy as an example of a parameter that has both a level
effect and a growth effect on income.

A growth effect is an effect that changes the rate of growth of a variable, typically income or
per capita income. A level effect, in contrast leaves the rate of growth unchanged, while
shifting up (or down) the entire path traced out by the variable overtime.

In the above figure, the log of per capita income is drawn against time. Thus, the movement
from the path of log income AB to CD shows a level effect. Parameters that cause such a
parallel shift are the saving rate (D) and rate of depreciation (d). On the other hand, a twist
from the path of log income AB to EF (change of slope), is a growth effect. Population
growth rate has both growth and level effects.

In summary

x In contrast to the Harrod-.Domar model, saving rate has level effect.

x There is a steady state level of per capita capital stock and per capita income to which
the economy converges.
x Therefore, regardless of the initial per capita capital stock and per capita income, two
countries with the same n, D and, d will converge to the same living standard.

Extensions of the Solow model: Technological progress in the Solow model

We have seen that the Solow model makes a strong claim that in the absence of technological
progress, a country can’t sustain a per capita income growth indefinitely. To have a sustained
per capita income growth, capital must grow faster than the population growth. But in this
case again because of diminishing return the managerial contribution of capital to output
must decline which eventually forces a decline in the growth rate of output and therefore
capital. But if the technology is high enough it cannot off set the tendency of the marginal
product of capital to fall in the long run and countries will exhibit per capita-out put growth at
a rate of technological progress.

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3.1.4 The Endogenous (New) Growth model (early 1990s)

These growth model theories emerge from the inabilities of the traditional growth theories
(neo classical) to explain the long-run term economic growth.

Solow model says that:

1. GDP grows at the rate of population growth rate in the long –run in the absence of
technological progress.
2. Per capita income does not grow in the long run, but it grows at the rate of
technological progress.
3. Technology is exogenous (Black –box).
4. Because of diminishing return to capital, the growth rate of countries with high and
low saving rate will converge.
5. With free international trade or capital mobility, differences in per capita income
should disappear and convergence in standards of living will occur.

However, convergence in standards of living and growth rate of countries is not occurring or
occurs only for a subset of countries. So, different approaches have been developed to
address the above problems. These approaches are collectively called New growth theories
(Endogenous growth theories).

New growth theories assume that there is a constant return to scale of production function for
each individual firm but increasing return to scale at aggregate level. These models of
endogenous growth theories discard the neoclassical assumption of diminishing return to
capital investment and permit increasing return to scale in aggregate production and focus on
the role of externalities in determining the rate of return to capital.

Capital is defined in a broader terms. It includes physical capital and human capital.
Technical improvement (growth) comes from rate of investment from the size of capital stock
and stock of human capital.

Human capital and Growth

Solow model is augmented by allowing individuals to invest in both human and physical
capital. Human capital is assumed to raise the market value of labour. Someone can directly
invest on human capital or parents invest on their children. Investment in human capital is a
deliberate action and it is not an outcome of population growth. (It is exogenous action).

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The production function in per capita terms (excluding unskilled labour) is:

yt k ta ht1 a                              (14) Ÿ , where,

h=effective labour

If we ignore depreciation for the moment:

k t 1  k t sy t (Where, s= fraction of output saved in physical capital)

ht 1  ht qy t                          (15) (Where, q=fraction of

output saved in human capital).

k t 1  k t sy t
kt kt

sk ta ht1 a
kt

sht1 a
k t1 a

1 a
§h·
s¨ ¸
©k¹

sr 1 a ( r= the ratio of human capital to physical capital)

ht 1  ht qy t
And ,
ht ht

qk ta ht1 a
ht

qht1 a h 1
k a

a
qh
k

ht 1  ht
Ÿ qr  a Ÿ the growth rate of human capital
ht

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In the long run both physical and human capital grows at the same rate:

sr 1 a qr  a Ÿ r q , this equation makes perfect sense. The larger is the ratio of saving in
s

human capital relative to that of physical capital, the larger is the long run ratio of the former
to the latter. We can now use this value of r to compute the long run growth rate. Use any of
the preceding growth rate equations to do this, because all variables must grow at the same
rate in the long run. For example, the growth rate equation for k tells us that:

K t 1  K t
sr 1 a
Kt

1 a
sq s

s a q 1a Ÿ So that the long run growth rate of all the variables, including per capita

income is given by the expression: s a q 1 a (but in Solow model it is zero)

This simple model has several implications;

1. Diminishing to physical capital, but constant return to both physical and human
capital combined.
2. The rate of saving and investment in human capital has a growth effect.
3. The introduction of human capital tells us why the return to capital in developed
countries is higher compared to LDCs.
4. Investment in human capital generates externality. Accumulation of human capital by
individuals will make workers more productive and increase productivity of physical
capital and other workers in the economy. Therefore, even if there is constant return
to scale at firm level, there could be increasing return to scale at aggregate level
because of spill over effect and learning by doing.

Deliberate Technical progress

Technical progress might come from two reasons:

1. Deliberate innovation which is fostered by allocation of resources is Research and

Development (investment in physical and human capital). Because of these factors
production function shifts up ward continuously due to a continuous change in

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 knowledge. Countries with larger capital stock (human or physical) have faster
technological progress.
2. Diffusion and spillover effect of knowhow from one firm or industry to others .

Diffusion and spillover effects

i. The accumulation of physical capital by one firm positively affects the

productivity of other firms. There will be complementarities among actions of
agents.
ii. If investment is a source of technological progress, then investing only as a
reduplication of existing capital (which is not innovation) cannot be the source of
technological progress.
iii. If however, investment may represent innovation that firms invest to solve the
problem of the firm, which is partly unique and if the investment is successful,
other firms will follow (adopt) the successful investment to their own need.
Therefore investment could be the source of technological progress. This is known
as learning by watching. Such type of investment has higher social return.

General implication of the new Growth Theories

1. Convergence in PC growth will not occur. Because the return to capital is no more
diminishing partly because of external increasing return to accumulation of capital
2. New growth theories indicate that private provision of capital & investment in
technological research will be low given the existence of external increasing return to
capital accumulation It proposes a strong government (due to externality).

3.2. Structural Change Growth model (SCM) (1970s)

This model focuses on the mechanism by which underdeveloped economies transform their
domestic economic structures from traditional subsistence agriculture to a more modern
industrially diverse manufacturing and service economy. It employs the tools of micro
economic theory econometrics to describe how this transformation process takes place. Two
well known representative examples of the structural change approach are:.

1- Surplus labour- two – sector model of A. Lewis, and

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 2- Patterns of Development of Chenery.

3.2.1 Lewis Theory of Development

One of the best known early theoretical models of development that focused on the structural
transformation of a primarily subsistence economy was that formulated by W. Arthur Lewis
in the mid -1950s and later modified ,formalized and extended by Jhon Fei and G. Ranis.

In this model, the underdeveloped economy consists of two sectors:

1) A traditional, overpopulated, rural subsistence sector characterized by zero marginal

labour productivity. This means that labour can be with draw from the agricultural sector
without affecting production.

2) The high productivity modern urban industrial sector into which labour from the
subsistence agricultural sector in gradually transferred.

The primary focus of the model is on both the process of labour transfer and the growth of
output and employment in the modern sector. Both labour transfer and modern sector
employment growth are brought about by the expansion of output and capital accumulation in
the modern sector.

Assumptions of the model

1. The industrialist profit is re-invested to expand output and employment

2. There is surplus labour in the traditional agricultural sector.
3. The rural real wage is determined by the average and not the marginal product of
labour.
4. The level of wage in the urban modern sector is constant and is determined as given
by the premium over the fixed average subsistence level of wage in the traditional
sector.

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Those workers who have zero MP is agriculture come to the urban and get wage (w). The
capitalist got S =shaded area which induces further investment to K2& so on. More labor will
be withdrawn from agriculture production will be affected

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 The process of modern sector self sustaining growth & 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 agriculture sector only at a
higher cost of lose of food production because of declining labour- to –land ratio.
Meaning that the marginal product of rural labour is no longer zero. Thus, the labour
supply curve becomes positively sloped.

The structural transformation of the economy will have taken place with the balance of
economic activity shifting from traditional rural agriculture to modern urban industry.
Then the agricultural sector enters into a commercialization stage. Wage in both sectors
become equal. Therefore, capital accumulation in the industrial sector is the engine of
growth in the Lewis model.

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 Criticims of the Lewis labour surplus model

Lewis model is consistent with the relatively of the present developed countries at their
early stages of development. But it is not consistent with today’s developing countries.
Particularly three of its assumption doesn’t fit the realities of LDCs.

1. The model assumes that the rate of labour transfer and employment creation is
proportional to the rate of modern sector capital accumulation. But actually the
capitalist can choose labour saving capital investment and no guarantee that all profit
could be re-invested.

2. The assumption that surplus labour exist in rural areas and full employment in urban
areas is questionable. There might be a huge unemployment in urban areas itself. So,
the capacity of the industrial to absorb the rural surplus labour is limited. On the other
hand, there may not be a surplus labour in rural areas, such that MPL in agriculture is
zero. Labour demand in agricultural activities is seasonal, that is, during peak
agriculture seasons; there may not be surplus labour. Hence labour can be withdrawn
from agriculture with affecting agricultural output. i.e. MPL ≠ 0 in agriculture during
peak agricultural season.

3. Lewis model assumes competitive labour market in urban area that guarantees a
constant real urban wage until the supply of surplus labour is exhausted. But in reality
real wages are rising or they do not clear the market. There are institutional factors
such as the labour union bargaining, and civil service organizations wage regulations
that prevents wage from declining. There is also labour efficiency hypothesis
suggesting that employers increase real wage to get more effort from their workers

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 and this reduces employment implying that all surplus labour from the agricultural
sector could not be absorbed.

Implicaiton of the Lewis model

In the labour- surplus model, planners have to ignore agriculture until surplus labour is
exhausted. It is after the exhaustion of the surplus labour that planners have to worry about
improving agriculture. Because the stagnation of agriculture at a later sage has a negative
consequence on industry.

3.2.2. Structural Change and Patterns of Development Model (Chenery)

This model focuses on the process through which the economic, institutional and industrial
structure of an underdeveloped economy is transformed overtime to permit new industries to
replace traditional agriculture as the engine of economic growth. However, in contrast to the
Lewis model and the Stages of development model, increased savings and investment are
perceived by patterns-of development analysts as necessary but not sufficient conditions for
economic growth. In addition to the accumulation of physical and human capital, a set of
interrelated changes in the economic structure of a country are required for the transition
from a traditional economic system to a modern one. This structural change includes the
transformation of production, a change in the composition of consumer demand, international
trade and resource use, as well as changes in socio –economic factors such a urbanization
and the growth and distribution of a country’s population.

Structural change analysts emphasize both domestic and international constraints on

development.
Domestic constraints include: - country’s resource endowment
- Physical and population size.
- Institutional constraints such as government policies and
objectives.
International constraints include: - access to external capital and technology.

- Access to international trade.

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Conclusions and implications

The major hypothesis of the structural change model is that development is an identifiable
process of growth and change whose main features are similar in all countries. However, the
model does recognize that differences can arise among countries in the pace and patterns of
development, depending on their particular set of circumstances .Factors influencing the
development process include a country’s resource endowment and size, its government’s
policies and objectives, the availability of external capital and technology, and the
international trade environment.

The pace and pattern of development can vary according to both internal and international
factors.

3.2.3. Balanced Vs Unbalanced Growth model

The advocates of balanced growth, such as Nurks or Rosenstein Rodan, argued that countries
have to develop a wide range of industries simultaneously of they have to succeed in
achieving sustain growth. They explain this by looking at what happen in the absence of
balanced growth. Example, a shoe factory in a poor country dominated by poor farmers. So,
the proposed solution to this problem is to build a number of factories simultaneously. If a
textile mill, flour will, a bicycle plant, and many other enterprises can be started at the same
time so that income of the people will rise and they can buy shoes. This kind of development
is referred as balanced growth on the demand side. Because the industry development is
determined by the demand.

Balanced growth on the supply side refers to the need to build industries simultaneously to
prevent supply bottle neck from occurring. The problem with the balanced growth argument
is that poor countries with little or no industry is told to start up a wider range of industries
simultaneously .This kind of across- the board program is referred as a Big –Push or a
Critical Minimum Effort. To do so, we need to have huge capital investment.

The proponent of unbalanced growth (Hirshman) suggests a very different pattern of

industrial development. A nation could concentrate their energy on few sectors during their
early stages of development. Certain industrial products have ready markets even among the
rural poor and in the absence of big –push towards development we can invest on these
selected sectors.

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Hirshman used the concept of back ward and forward linkages in industries. In the short term,
you can import raw materials you need & establish is factory for which you have a market.
Then others looking the existence of the market for raw materials (inputs) starts to produce
domestically, that is, import substituted is one way of beginning in industrialization on a
limited and selected basis rather than a balanced big – bush or rely on export promotion in the
short run until the domestic demand is created.

Industries with a back –ward linkage make use of inputs from other industries. On the other
hand, fore -ward linkage occurs in industries that produce goods to become inputs for other
industries.

Back ward forward

Fertilizer Agriculture agro processing (oil processing)

Both forward and backward linkages setup pressure that leads to the creation of new

industries which intern creates additional pressure and so on, this way the concept of linkage

suggests that extreme imbalance of growth will set up pressure that will force a nation a back

towards a balanced path. Thus the ultimate objective is the degree of balance in development

program. Therefore, the choice is between.

1) Attempting balanced growth from the beginning or throughout the

development process or :
2) First crate imbalance, the market through back ward & forward linkages will
eventually force towards the balances.

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In the above figure, distance between point ‘a’ and point ‘b’ is shorter if we follow the
straight line. According to unbalanced growth model, the distance between ‘a’ and ‘b’ is
shorter when one move through the curved line.

3.3 International Dependence Revolution Model (political in orientation)

During the 1970s, international dependence models gained increasing support, especially
among developing country intellectuals, as a result of growing disenchantment with both the
stages and structural change models. Essentially, international- dependence 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. Within this general approach are three major streams of thought:

1) The neo-colonial dependence model

2) The False paradigm model

3) The dualistic development thesis

3.3.1 The Neo – Colonial dependence model

This model is an outgrowth of the Marxist thinking. It attributes the existence and
continuance of under development primarily to the historical evolution of a highly unequal
international capitalist system of rich country-poor country relationships. Whether because
rich nations are internationally exploitative or unintentionally neglectful, the coexistence of

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rich and poor nations in an international system dominated by such unequal power
relationships between the centre(the developed countries) and the periphery( the LDCs)
renders attempts by poor nations to be self-reliant and independent difficult and sometimes
even impossible.

The neocolonial view of underdevelopment attributes a large part of the developing world’s
continuing and worsening poverty to the existence and policies of the industrial capitalist
countries of the Northern hemisphere and their extensions in the form of small but powerful
elite in the less developed countries. Underdevelopment is thus seen as an externally induced
phenomenon, in contrast to the linear stages and structural-change theories.

So, they proposed revolutionary struggle or a major restructuring of the world capitalist
system to free dependent developing nations from the direct (domestic minor oppressors) and
indirect (rich nation) economic control.

3.3.2 The False –Paradigm Model

It is less radical in the sense that they don’t propose revolutionary struggle. This model
attributes underdevelopment of LDCs to faulty and inappropriate advice provided by
uniformed, biased and ethnocentric international “experts” and multinational donor
organization. They suggest them to use the neoclassical model with sophisticated
econometric models of development that keeps the interest of the elites and the present power
group. In addition, according to thin arguments, leading university intellectuals, trade
unionists and high level government officials of LDCs are all trained in western countries and
they reflect the interest of the western countries. Thus they develop policies based on the
western ideas.

3.3.3 The Dualistic Development Thesis

Implicit in the structural change model and explicit in international- dependence theories is
the notion of a world of dual societies, of rich nations and poor nations, and in the developing
countries, pockets of wealth with in broad areas of poverty.

Dualism represents the existence and persistence of increasing divergences between rich and
poor nations and rich and poor peoples in various levels.

Duality has four key elements:

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 a) Different sets of conditions (may be superior and other inferior) co-exist in a given
place (example, in Lewis model, the agricultural sector and industry)
b) This co-existence is chronic and not merely transitional (coexistence continues
forever)
c) Dualism has an inherent tendency to increase (not diminishing).
d) 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.

3.4. The Neo- classical Counterrevolution: Market fundamentalism

In the 1980s, the political ascendancy of conservative governments in the Unite States,
Canada, Britain, and West Germany brought a neoclassical counterrevolution in economic
theory and policy. In developed nations, this counterrevolution favoured supply-side
macroeconomic policies, rational expectations theories and the privatization of public
corporations.

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. Rather, advocators of this
school argue that it is this very state intervention in economic activity that slows the pace of
economic growth. This school advocates a competitive free market economy.

Summary

x The Rostow’s stages of growth model states that the transition from
underdevelopment to development can be described in terms of a series of steps or
stages through which all countries must proceed.
x According to Harrod and Domar, economic growth is the result of abstention from
current consumption. In other words, saving is the key factor to economic growth.
x The primary focus of the Lewis model is on both the process of labour transfer and
the growth of output and employment in the modern sector. Both labour transfer and
modern sector employment growth are brought about by the expansion of output and
capital accumulation in the modern sector.

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 x The advocates of balanced growth argued that countries have to develop a wide range
of industries simultaneously of they have to succeed in achieving sustain growth. On
the other hand the proponents of unbalanced growth state that a nation could
concentrate their energy on few sectors during their early stages of development.
x International- dependence 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.

Checklist
Dear learner did you understand the following terms?

Yes No

Rastow’s – Stages of growth model  

Harrod – Domar Growth model  
Solow Growth Model  
The Endogenous( New) Growth model  
Lewis Theory of Development  
Lewis-Fei-Ranis Model  

Structural Change and Patterns of Development Model  

Balanced Vs Unbalanced Growth model  

International Dependence Revolution Model ( political in orientation)  

 
The Neo – Colonial dependence model
 
The False –Paradigm Model
 
The Dualistic Development Thesis
 
The Neo- classical Counterrevolution: Market fundamentalism

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Self-evaluation test
Part one: Discuss the following questions

1. Walt W. Rostow identified five linear stages of growth. Elaborate those stages and clarify
the merits and limitations of Rostow’s Stages of growth model?
2. Suppose in a Harrod-Domar equation, the saving rate is 20%, the capital-output ratio is 4,
the depreciation rate is 1%, and the rate of growth of population is 2% per year. What is
the rate of per capita income growth?
3. Discuss the Lewis two-sector theory of development?
4. Identify key difference between the Solow model and the Endogenous (new) growth
model?
5. Show mathematically that according to the endogenous growth model, even if there are
constant returns to scale at firm level, there could be increasing returns to scale at
aggregate level because of spill over effect and learning by doing?

Part Two: Attempt the following question

a. Calculate the rate of growth of output if saving ration = 6%, capital output
ration is 3% and d 0. (use Harrod-Domar model).
b. Assume saving ratio = 6%
Capital output ratio = 3% & n=2.5%, d 0

Calculate g * ?

c. Suppose Ethiopia targets to grow with a percapita growth rate of 4%, Assume
that D=7%, T= 3%, n=3% and d=0. What is the required saving rate and
financial gap?

References
Todaro,M.,(2012)EconomicDevelopment,Fiftheditions,Longman:NewYorkand London.
Todaro,M.,(1994)EconomicDevelopment,Fiftheditions,Longman:NewYorkand London.
Gillis, DwightH. Perkins, MichaelR., Donald R. and Snodgrass, W.W. (1996) Economics of
Development, Malcolm. Norton &Company.

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 Chapter Four
Historic Growth and contemporary Development: Lessons
and controversies

 Introduction
Dear distance learner! In this chapter, we start by examining some of the basic concepts of
the theory of economic growth. After looking briefly at the historical record of economic
growth in contemporary rich nations, we then isolate six economic, structural, and
institutional components that appear to have characterized all growing economies. We
conclude by asking the question, of what relevance is the historical growth experience of
contemporary developed countries to the plans and strategies of present day developing
nations?

Chapter objectives:

At the end of this chapter, you should be able to:

 Understand the growth experience of today’s developed countries.

 Understand the causes of economic growth and understand their relationship with it
(for the question how?)
 Understand the Kuznet’s six characteristics of modern economic growth.
 Identify significances differences in initial conditions between the present developed
countries at their initial stages of development and the present LDCs.
 Explain the relationship that between history, expectation and development.

4.1. The Economics of Growth, Capital, labor, and Technology.

Activity
Dear learner, what factors determine economic growth?
___________________________________________________________________________
__________________________________________________________________very Good!

Three factors or components of economic growth are of prime importance in any society.

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 1. Capital accumulation, including all new investments in land, Physical equipment, and
human resources through improvements in health, education and job skills.
2. Growth in population and hence eventual growth in the labor force
3. Technological progress.
We will see each of them in detail.

1. CAPITAL ACCUMULATION

Activity
Dear distance learner! What is capital accumulation?

___________________________________________________________________________
_____________________________________________________Did you try? Excellent!

Capital accumulation results when some proportion of present income is saved and invested
in order to augment future output and income. New factories, machinery, equipment, and
materials increase the physical capital stock of a nation and make it possible for expanded
output levels to be achieved. These directly productive investments are supplemented by
investments in what is known as social and economic infrastructure-roads, electricity, water
and sanitation, communications and the like-which facilitates and integrates economic
activities.

For example, investment by a farmer in a new tractor may increase the total output of the
vegetables he can produce, but without adequate transport facilities to get this extra product
to local commercial markets, his investment may not add anything to national food
production.

Dear learner! There are other, less direct ways to invest in a nation’s resources. The
installation of irrigation facilities may improve the quality of a nation’s agricultural land by
raising productivity per hectare if 100 hectares of irrigated land can produce the same output
as 200 hectares of non-irrigated land using the same other inputs, the installation of such
irrigation is the equivalent of doubling the quantity of non-irrigated land.

Use of chemical fertilizers and the control of insects with pesticides may have equally
beneficial effects in raising the productivity of existing farmland.

Similarly, investment in human resources can improve its quality and thereby have the same
or even a more powerful effect on production as an increase in human numbers. Formal

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Schooling, Vocational and on-job training programs, and adult and other types of informal
education may all be made more effective in augmenting human skills as a result of direct
investments in buildings, equipment, and materials (e.g. books, film projectors, computers,
etc). The concept of investment in human resources and the creation of human capital is
therefore analogous to that of improving the quality and thus the productivity of existing land
resources through strategic investments.

2. POPULATION AND LABOR FORCE GROWTH

Activity
Dear Colleague, In what way do you think that population growth affect economic
growth?____________________________________________________________________
_____________________________________________________________________good!

Population growth, and the associated eventual increase in the labor force, has traditionally
been 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. However, it is questionable whether rapidly growing supplies of workers
in surplus-labor developing countries exert a positive or a negative influence on economic
progress. Obviously, 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.

Dear student! Given your initial understanding of these first two fundamental components of
economic growth and disregarding technology (which we will discuss later). Let us see how
they interact via the production possibility curve.

Activity
Dear distance student! Can you explain the concept of production possibility frontier? --------
-------------------------------------------------------------------------------------------------------- Good!
The following graph shows two production possibility curves for rice and radios.

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Figure 1 Effect of Increases in Physical and human resources on the production possibility
Frontier.

Dear learner! Suppose now that with unchanged technology, the quantity of physical and
human resources were to double as a result of either investments that improved the quality of
the existing resources or investment in new resources land, capital, and labor. So, the figure
shows that this doubling of total resources will cause the entire production possibility curve
to shift uniformly out-ward from PP to P1P1. More radios and more rice can now be
produced.

Because these are assumed to be the only two goods produced by this economy, it follows
that the gross national product (the total value of all goods and services produced) will be
higher than before. In other words, the process of economic growth is underway.

Dear student! note that even if the country in question is operating with underutilized
physical and human resources as at point X in the figure, a growth of productive resource can
result in a higher total output combination as at point X’, even though there may still be
widespread unemployment and underutilized or idle capital and land.

Activity
Dear student, what will happen to the production possibility frontier if only capital or only
land is increased in quality and quantity instead of proportionate growth of all factors of
production?_________________________________________________________________
_____________________________________________________________________ Good.

The figures below show the effects.

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Fig 2 Effect of growth of capital stock and land on the production Possibility Frontier.

Dear learner! If radio manufacturing is a relatively large user of capital equipment and rice
production is a relatively land intensive process, the shifts in society’s production possibility
curve will be more pronounced for radios when capital grows rapidly and for rice when the
growth is in land quantity or quality.

However, because under normal conditions both products will require the use of both factors
as productive inputs, the production possibility curve still shifts slightly outward along the
rice axis when only capital is increased and along the radio axis when only the quantity or
quality of land resource is expanded.

3. TECHNOLOGICAL PROGRESS

In its simplest form, technological progress results from new and improved ways of
accomplishing traditional tasks such as growing crops, making clothing, or building a house.
There are three basic classifications of technological progress: neutral, labor saving and
capital saving.

i) Neutral Technological progress

Dear distance student! This occurs when higher output levels are achieved with the same
quantity and combinations of factor inputs simple innovations like those that arise from the
division of labor can result in higher total output levels and greater consumption for all
individuals. In terms of production possibility analysis, a neutral technological change that,
say, doubles total output is conceptually equivalent to a doubling of all productive inputs.

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By contrast, progress may either be labor saving or capital-saving technological progress.

ii) Labor saving Technological progress

Dear learner! Computers, the Internet, automated looms, high-speed electric drills these and
many other kinds of modern machinery and equipment can also be classified as product of
labor-saving technological progress.

Technological progress over the last century has consisted largely of rapid advances in labor
saving technology is for producing everything from beans to bicycles to bridges.

iii) Capital-saving Technological progress

Such progress in more efficient (lower-cost) labor-intensive methods of production- for

instance foot- operated bellows pumps, and back mounted mechanical sprayers for small-
scale agriculture. But, this is a much rarer phenomenon. This is primarily because almost all
of the world’s Scientific and technological research is conducted in developed countries,
where the mandate is to save labor, not capital. But in the labor abundant (capital- scarce).
Developing countries, such as Ethiopia, capital saving technological progress is what is
needed most.

To Summarize the discussion so far by saying that the sources of economic progress can be
traced to a variety of factors, but by and large, investments that improve the quality of
existing physical and human resources, that increase the quantity of these same productive
resources, and that raise the productivity of all or specific resources through invention,
innovation, and technological progress have been and will continue to be primary factors in
stimulating economic growth in any society.

Activity
Use the production possibility frontier to show all the three types of technological progress?

4.2 Historical growth Experience and lessons drawn

i)The Historical record: Kuznet’s six characteristic of modern economic growth.

In his exhaustive analysis, professor Kuznets has isolated six characteristic features
manifested in the growth process of almost every developed Nations.

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1. High rates of growth of percapita output and population.

In the case of both percapita output & population growth, all contemporary developed
countries have experienced large multiples of their previous historical rates during the epoch
of modern economic growth, roughly from around 1770 to the present.

2. High rates of increase in total factor productivity (output per unit of all inputs) especially
labour productivity.

The main factor behind high rates of productivity increase is technological progress
including the upgrading of existing physical and human resources.

3. High rates of structural transformation of the economy.

The historical growth record of contemporary developed nations reveals a high rate of
structural & sectoral change inherent in the growth process. The transformation includes:

 A shift from agriculture to nonagricultural sector

 A shift from industrial sector to service sector &
 A corresponding shift in the spatial location and occupational status of the
labour force away from rural, agricultural, and related non-agricultural activities toward
urban-oriented manufacturing and service pursuits.

4. High rates of social and ideological transformation for significant economic structural
change to take place in any society, concomitant transformations in attitudes, institutions,
and ideologies are often necessary. We can classify in to four categories:

a) Rationality - the substitution of modern methods of thinking acting, producing,

distributing and consuming for age old, traditional practices.

B) Economic planning - the search for a rationally coordinated system of policy

measures that can bring about and accelerate economic growth and development.

C) Social and economic equalization: the promotion of more equality in status,

opportunities, wealth, incomes & levels of living.

D) Improved institutions & attitudes. Such changes are envisaged as necessary to

increase labour efficiency and diligence; promote effective competition, social and
economic mobility, and individual enterprise; permit greater equality of opportunities;
make possible higher productivity; raise levels of living and promote development.

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Included among social institutions needing change are outmoded land tenure systems, social
and economic monopolies, educational and religious structures, and systems of
administration and planning. In the area of attitudes, the concept of " modern humanity"
embodies such ideals as efficiency, diligence, orderliness, punctuality, frugality, honesty,
rationality, Change orientation, integrity and self-reliance, cooperation, & willingness to take
the long view.

5. The propensity of economically developed countries to reach out the rest of the world for
markets and raw materials.

This relates to the historical and ongoing propensity of rich countries to reach out to the rest
of the world for primary products and raw materials, cheap labour, and lucrative markets for
their manufactured products.

6. The limited spread of this economic growth to only a third of the world's population.

In spite of the enormous increases in the world output over the past two centuries, the spread
of modern economic growth is still largely limited to less than one fourth of the world's
population.

ii)Limited values of historic growth experience:

The Historical growth experience of Developed Countries has limited value for now day’s
poor countries. The fact is that the growth position of these countries today in many in many
important ways significantly different from that of the currently developed countries as the
embarked on their era of modern economic growth.

We can identify at least eight significant differences in initial conditions-differences that

require a much-amended analysis of the growth prospects and requirements of modern
economic development:

1. Physical and human resource endowments.

In general the now least developed countries are less endowed with natural resources
than developed countries at early stages of development (Exception of OPEC LDCs).
Latin America and Africa have relatively plentiful natural resources but they have
little human resource, little capital investment for exploitation of natural resources.

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 2. Level of per capita income and GDP.

Developed countries at their beginning of their modern growth era, they were more
economically advance than the rest of the worlds hence, they took advantages of their
relative strong financial position to widen the income gap between themselves and the
less fortunate countries.

3. Climatic condition:

Hot and humid conditions in LDCs (i.e. tropical and sub-tropical location) contributes to
the determination of soil quality and rapid depreciation of many natural goods, and
favors the outbreak of malaria, Tse thes fly and others. In addition, hot weather also
reduces the desire to work or reduce the desire to engage in strenuous work. This
generates low productivity and efficiency.

4. Population size, distribution and growth:

Before and during the early growth year western nations experienced very slow rise in
population growth. But today’s LDCs population is growing at an alarming rate.

5. International migration:

During the early stage of modern growth developed countries had the opportunity for
temporary and permanent migration when they faced severe famine, pressure on land,
limited economic opportunity. This opportunity for migration is not available for
contemporary LDCs.

6. Great stimulus of international trade:

The developed countries during their early stages of economic growth they used free
trade as an engine of growth. In the 19th century and 20th century, there was relatively
free trade, free capital movement and unaffected international migration of unskilled
surplus labour. International trade was highly exploited by the today's developed
countries in their early growth process. Today's situation for many least developed
countries is different. Most of the LDCs have difficulties in using free trade to promote
economic growth.

7. Basic scientific and Technological Research & development capabilities:

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 About 98% of the world (R&D) expenditure originated from Developed counties, in
order to solve the economic & technological problem of the rich Counties in accordance
with their economic priorities and resource endowments.

Developed countries are interested in the development of sophisticated product large

markets using large inputs of capital & high level of skilled labour in order to economize
scarce labour & raw materials. The poor countries are interested in simple products;
simple design, saving of capital and use of abundant labour and the production of small
market. However, the poor countries do not have the financial resources to do their own
R & D hence they have to depend on the western R & D, which is inappropriate for
LDCs.

8. Stability and flexibility political and social institutions: Before the industrial
revolution the today's developed counties were independent nations and their state
(government) were able to pressure national policies on the basis of consensus
towards modernization and there was a stable and flexible political and social
institutions. In contrast many third world countries of today have only recently
gained their political independence and yet have to become consolidated states with
an effective ability to formulate and pursue national development strategies.

To summarize, we may conclude that due to very different initial conditions, the
historical experience of western economic growth is of only limited relevance for
contemporary technological, social, and institutional changes, which must take place of
long term economic growth is to be realized. Such transformations must occur not only
within individual developing countries but, perhaps more important, in the international
economy as well. In other words, unless there is some major structural, attitudinal and
institution reform in the world economy, one that accommodates the rising aspirations
and rewards the outstanding performances of individual developing nations, internal
economic and social transformation within the third world may be insufficient.

4.3 History, Expectations, and Development

In the previous chapters, we studied some of the classic theories of economic growth and
their implications. Some of these implications such as the predicated positive link between
investment rates and growth rates are certainly borne out by the data. Others do not appear to

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be. One of the most important implications of the solow model that is not supported by the
data is the prediction of convergence in living standards across countries.

For instance, the solow model states that if saving rates & if population growth rates are same
for two counties, and if the rate of technical progress flows in an unimpeded way across the
countries, then the two countries will come together, overtime, in terms of percapita incomes.
Such predictions are called conditional convergence.

Now, statements regarding conditional convergence are often predicated on the Similarity of
parameters (Such as saving rates) that we provisionally consider to be exogenous, and not on
some deeper underlying characteristic, which would presumably determine investment rates,
or rates of technical progress, or even population growth rates in a wider frame work. What if
such characteristics are dependent on the history of a country's development or perhaps on
what its citizens expect or their own future?

This is not to say that the earlier models are wrong, but that they explain matters at one level,
and that to understand more we must go deeper, by not necessarily regarding as exogenous
what these models regard as exogenous. What we seek, then (in the context of economic
growth) is an explanation of just why investment rates are persistently different or why a
given rate of savings translates into different growth rates under different circumstances.
More broadly, we are interested in seeing how historical forces and expectations shape the
overall economic pattern displayed by a country or region.

The fact of the matter is that people the world over are intrinsically the same: they are all
human beings, with the same borne and desires. Why do culture and economies, born from
the same intrinsic material, perform so differently? If there is a single recipe for economic
success, why do all nations not converge on that recipe? This question demands and answer.

The purpose of this sub-topic is to discuss some issues that are important in understanding
this question. We concentrate on two features that have already come up in earlier chapters:
the role of history and the role of expectations. Both our history and our expectations change
the way we behave today and in the future.

History and expectations interact and work through two main channels complementarities
and coordination failure.

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 1) Complementarities

Dear Learner! Look at the arrangement of keys on your computer or typewriter. Top left row
begins with the familiar sequence of q, w, e, r, t, y... Have you ever wondered just how this
particular sequence came in to being? Have you ever seen one of the original typewriters?
They were mechanical of course. You hit the desired key and hit the typewriter ribbon, if you
hit two keys once or twice in very speed, the two levers would jam. To avoid this jam
QWERTY key layout emerged, in part, to reduce the frequency of such jams. In no way was
the best keyboard for a more idealized object, such as an electronic typewriter or a computer
keyboard. Indeed, the Dvorak system, introduced in 1932, presented an alternative that
repeatedly won speed-typing contests. Alternative keyboards are standard on many
computers today. Why then, despite its obvious inefficiency today, does QWERTY Still rule
the roost?

To understand this it is important to realize that typing skills (until very recently) were part
of the intricate network of business and industry. Typing came from typing schools and were
almost exclusively hired by firms. Given that all firms were hiring QWERTY- trained typists,
it made little sense for any one of these firms to invest in, say, Dvorak-style keyboards, and
train their typists accordingly. The costs involved in retraining were simply too high. This
statement is perfectly compatible with the fact that if all firms and typing schools (by an
incredible act of coordination) had adopted a different system, the efficiency gains would
have been significant. We have, then, a self-fulfilling situation that is difficult for any
individual to get out of, because the return to each person depends on what everybody else is
doing. You simply cannot ask the question, "QWERTY or Dvorak for you" in a Vacuum.
Your answer depends on how others have answered the question.

Dear distance learner! This divergence between individual cost and social gain occurs
whenever a system of Production, or organizational form, exhibits externalities, so that the
cost or benefit of adopting that system by an individual depends on how many other
individuals have adopted that system. What we have here is the familiar special case of
complementarities.

Specifically, the adoption costs of a system may be reduced by the number of existing
adopters. In the case of QWERTY, the creation of typing schools and a pool of typists trained
in a particular way lowered the cost of new individuals adopting the same system. However,
it is perfectly possible that QWERTY has a higher cost curve.

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Look at fig , which plots the cost of adoption of a technology by an individual against the
number of people in the economy who have already adopted the technology. The higher,
inefficient cost curve belongs to QWERTY. True, the cost of adoption falls as the number of
people adopting QWERTY increases. That's what complementarities are all about.

Dear student! However, imagine that there is another system out there (Dvorak) with a lower
cost curve. That is, at every population size of existing users, Dvorak has a lower cost of
adoption. This Dvorak's lower cost curve represents a competing, more efficient system.

Now here comes the role of history. Dvorak may have a better-cost curve, but QWERTY is
already there by the advantage of historical precedence, and so commands a market size of N.

Fig 15 cost curves with complementarities in adoption

Dear learner! The new technology currently has no market share, so the comparison of cost
levels is really between points such as A for QWERTY and B for the competing system.
Faced with these cost levels, a new user will adopt QWERTY and not Dvorak, and this
perpetuates QWETRY's market size. Hence, the system is locked in QWERTY. We call this
QWERTY lock in effect that is difficult to get out of.

2) Coordination failure

Persuasive Complementarities might therefore lead to a situation where an economy is

stuck in a “low –level equilibrium trap,” while at the sometime there is another, better
equilibrium if only all agents could appropriately coordinate their actions to reach it. This
view of Underdevelopment has gained some popularity. According to this view, economic
Underdevelopment is the outcome of measure coordination failure, in which several

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 investments do not occur simply because other complementary investments are not made,
and these latter investments

Are not forthcoming simply because the former are missing! The argument sounds circular.

Activity
Dear learner! Can you relate the concept of coordination failure with balanced and
unbalanced growth theories?

--------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------Good!

Summary

 Capital accumulation, growth in population and technological progress are the three
important components of economic growth.
 Due to very different initial conditions, the historical experience of western economic
growth is of only limited relevance for contemporary technological, social, and
institutional changes, which must take place of long term economic growth is to be
realized.

Checklist

Did you understand the following terms? YES NO

Capital accumulation  
The historical record  
Population and labor force growth  
Technological progress  
History, expectations, and development  

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Self-evaluation test

1. How would you describe the economic growth process in terms of production
possibility analysis?

2. What are the principal sources of economic growth? Explain.

3. What does the historical record reveal about the nature of the growth process in the
now developed nations? What are its principal ingredients?

4. Of what relevance is the historical record of modern economic growth for

contemporary Third World Nations? How important are the differences in “Initial
conditions”?

5. Explain how history and Expectations affect economic Development?

6. Discuss the two main channels through which history and expectations interact and
work.

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 Chapter Five

Income Inequality, Poverty and Development

 Introduction
Dear distance learner! In this chapter we will see the extent and measurements of income
inequality and poverty in the context of LDC’s. Data reveals that an estimated 1.374 billion
people live on less than $1.25 per day at 2005 U.S. purchasing power parity, and some 2.6
billion close to 40% of the world’s population live on less than $2 a day. These impoverished
people suffer from under nutrition and poor health, have little or no literacy, live in
environmentally degraded areas, have little political voice, are socially excluded, and attempt
to earn a meager living on small and marginal farms (or as day laborers) or in dilapidated
urban slums. In this chapter, we set the stage with an in-depth examination of the problems of
poverty and of highly unequal distributions of income.

Objectives
This chapter has the following major objectives:

x To shed light on the extent of relative inequality in developing countries, and how is
this related to the extent of absolute poverty
x To identify who are poor and what are their economic characteristics
x To understand the consequence of extreme income inequality
x To understand the kinds of policies are required to reduce the magnitude and extent of
absolute poverty

Contents
5.1 Measuring inequality and poverty
5.1.1 Measuring inequality
5.1.2 Measuring absolute poverty
5.1.3 The Newly Introduced Multidimensional Poverty Index
5.2 Kuznet’s inverted –U Hypothesis
5.3 Growth versus Income distribution
5.4 The range of policy option: some basic consideration
Summary
Check list

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Self evaluation test
References

5.1 Measuring Inequality and poverty

5.1.1 Measuring Inequality

Activity

Dear learner, Can you define economic inequality in your own word?---------------------------
----------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------very good!

Economists usually distinguish between two principal measures of income distribution for
both analytical and quantitative purposes: the personal or size distribution of income and the
functional or distributive factor share distribution of income.

A. Size Distributions: The personal or size distribution of income is the measure most
commonly used by economists. It simply deals with individual persons or households and the
total incomes they receive. The way in which that income was received is not considered.
What matters is how much each earns irrespective of whether the income was derived solely
from employment or came also from other sources such as interest, profits, rents, gifts, or
inheritance. Moreover, the locational (urban or rural) and occupational sources of the income
(e.g., agriculture, manufacturing, commerce, services) are ignored. If Ms. X and Mr. Y both
receive the same personal income, they are classified together irrespective of the fact that Ms.
X may work 15 hours a day as a doctor while Mr. Y doesn’t work at all but simply collects
interest on his inheritance.

Economists and statisticians therefore like to arrange all individuals by ascending personal
incomes and then divide the total population into distinct groups, or sizes. A common method
is to divide the population into successive quintiles (fifths) or deciles (tenths) according to
ascending income levels and then determine what proportion of the total national income is
received by each income group.

For example, Table 5.1 shows a hypothetical but fairly typical distribution of income for a
developing country. In this table, 20 individuals, representing the entire population of the
country are arranged in order of ascending annual personal income, ranging from the

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individual with the lowest income (0.8 units) to the one with the highest (15.0 units). The
total or national income of all individuals amounts to 100 units and is the sum of all entries in
column 2. In column 3, the population is grouped into quintiles of four individuals each. The
first quintile represents the bottom 20% of the population on the income scale. This group
receives only 5% (i.e., a total of 5money units) of the total national income. The second
quintile (individuals 5 through 8) receives 9% of the total income. Alternatively, the bottom
40% of the population (quintiles 1 plus 2) is receiving only 14% of the income, while the top
20% (the fifth quintile) of the population receives 51% of the total income.

A common measure of income inequality that can be derived from column 3 is the ratio of
the incomes received by the top 20% and bottom 40% of the population. This ratio,
sometimes called a Kuznets ratio after Nobel laureate Simon Kuznets, has often been used
as a measure of the degree of inequality between high- and low-income groups in a country.
In our example, this inequality ratio is equal to 51 divided by 14, or approximately 3.64.

To provide a more detailed breakdown of the size distribution of income, decile (10%) shares
are listed in column 4. We see, for example, that the bottom 10% of the population (the two
poorest individuals) receives only 1.8% of the total income, while the top 10% (the two
richest individuals) receives 28.5%. Finally, if we wanted to know what the top 5% receives,
we would divide the total population into 20 equal groups of individuals (in our example, this

90 | P a g e
would simply be each of the 20 individuals) and calculate the percentage of total income
received by the top group. In Table 5.1, we see that the top 5% of the population (the
twentieth individual) receives 15% of the income, a higher share than the combined shares of
the lowest 40%.

Lorenz Curves

Another common way to analyze personal income statistics is to construct what is known as a
Lorenz curve. Figure 5.1 shows how it is done. The numbers of income recipients are plotted
on the horizontal axis, not in absolute terms but in cumulative percentages. For example, at
point 20, we have the lowest (poorest) 20% of the population; at point 60, we have the
bottom 60%; and at the end of the axis, all 100% of the population has been accounted for.
The vertical axis shows the share of total income received by each percentage of population.
It is also cumulative up to 100%, meaning that both axes are the same length. The entire
figure is enclosed in a square, and a diagonal line is drawn from the lower left corner (the
origin) of the square to the upper right corner.

At every point on that diagonal, the percentage of income received is exactly equal to the
percentage of income recipients—for example, the point halfway along the length of the
diagonal represents 50% of the income being distributed to exactly 50% of the population. At
the three-quarters point on the diagonal, 75% of the income would be distributed to 75% of

91 | P a g e
the population. In other words, the diagonal line in Figure 5.1 is representative of “perfect
equality” in size distribution of income. Each percentage group of income recipients is
receiving that same percentage of the total income; for example, the bottom 40% receives
40% of the income, while the top 5% receives only 5% of the total income.

The more the Lorenz line curves away from the diagonal (line of perfect equality), the greater
the degree of inequality represented. The extreme case of perfect inequality (i.e., a situation
in which one person receives all of the national income while everybody else receives
nothing) would be represented by the congruence of the Lorenz curve with the bottom
horizontal and right hand vertical axes. Because no country exhibits either perfect equality or
perfect inequality in its distribution of income, the Lorenz curves for different countries will
lie somewhere to the right of the diagonal in Figure 5.1. The greater the degree of inequality,
the greater the bend and the closer to the bottom horizontal axis the Lorenz curve will be.
Two representative distributions are shown in Figure 5.2, one for a relatively equal
distribution (Figure 5.2a) and the other for a more unequal distribution (Figure 5.2b).

Activity

Dear learner, Can you explain why the Lorenz curve could not lie above or to the left of the
diagonal at any point?--------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------very good.

92 | P a g e
Gini Coefficients and Aggregate Measures of Inequality
A final and very convenient shorthand summary measure of the relative degree of income
inequality in a country can be obtained by calculating the ratio of the area between the
diagonal and the Lorenz curve divided by the total area of the halfsquare in which the curve
lies. In Figure 5.3, this is the ratio of the shaded area A to the total area of the triangle BCD.
This ratio is known as the Gini concentration ratio or Gini coefficient, named after the
Italian statistician who first formulated it in 1912.

Gini coefficients are aggregate inequality measures and can vary anywhere from 0 (perfect
equality) to 1 (perfect inequality). In fact, as you will soon discover, the Gini coefficient for
countries with highly unequal income distributions typically lies between 0.50 and 0.70,
while for countries with relatively equal distributions, it is on the order of 0.20 to 0.35. The
coefficient for our hypothetical distribution of Table 5.1 and Figure 5.1 is approximately 0.44
a relatively unequal distribution.
Four possible Lorenz curves such as might be found in international data are drawn in Figure
5.4. In the “Lorenz criterion” of income distribution, whenever one Lorenz curve lies above
another Lorenz curve, the economy corresponding to the upper Lorenz curve is more equal
than that of the lower curve. Thus economy A may unambiguously be said to be more equal
than economy D. Whenever two Lorenz curves cross, such as curves B and C, the Lorenz
criterion states that we “need more information” or additional assumptions before we can

93 | P a g e
determine which of the underlying economies is more equal. For example, we might argue on
the grounds of the priority of addressing problems of poverty that curve B represents a more
equal economy, since the poorest are richer, even though the richest are also richer (and
hence the middle class is “squeezed”). But others might start with the assumption that an
economy with a stronger middle class is inherently more equal, and those observer might
select economy C.

One could also use an aggregate measure such as the Gini coefficient to decide the matter. As
it turns out, the Gini coefficient is among a class of measures that satisfy four highly
desirable properties: the anonymity, scale independence, population independence, and
transfer principles. The anonymity principle simply means that our measure of inequality
should not depend on who has the higher income; for example, it should not depend on
whether we believe the rich or the poor to be good or bad people. The scale independence
principle means that our measure of inequality should not depend on the size of the economy
or the way we measure its income; for example, our inequality measure should not depend on
whether we measure income in dollars or in cents or in rupees or rupiahs or for that matter on
whether the economy is rich on average or poor on average—because if we are interested in
inequality, we want a measure of the dispersion of income, not its magnitude (note that
magnitudes are very important in poverty measures). The population independence principle
is somewhat similar; it states that the measure of inequality should not be based on the

94 | P a g e
number of income recipients. For example, the economy of China should be considered no
more or less equal than the economy of Vietnam simply because China has a larger
population than Vietnam. Finally, we have the transfer principle (sometimes called the
Pigou-Dalton principle after its creators); it states that, holding all other incomes constant, if
we transfer some income from a richer person to a poorer person (but not so much that the
poorer person is now richer than the originally rich person), the resulting new income
distribution is more equal.

If we like these four criteria, we can measure the Gini coefficient in each case and rank the
one with the larger Gini as more unequal. However, this is not always a perfect solution. For
example, the Gini coefficient can, in theory, be identical for two Lorenz curves that cross.

Activity

Dear learner, can you see why the Gini coefficient can be identical for two Lorenz curves
that cross by looking at curves B and C in Figure 5.4? -----------------------------------------------
----------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------Very good.
Lets us assume that there are m distinct income groups and in each income class j, the
m
number of individuals in each income group is nj, so that total population= ¦ nj .
j 1

m
And each income class has an income of Yi; total income = ¦ njyi
i 1

n¦
The mean income P 1 njyj
j 1

1
Range: - is given by: R y m  y1 , where y m max .income
P
y1 min .income
Range is a very crude measure that doesn’t take the whole income distribution in
consideration.
1
Example:- In the above data Range 15  0.8 2.9 (Doesn’t satisfy Dalton’s principle).
5

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The Kuznet Ratio: is the ratio of income of the richest X% to the poorest Y%
income20%
Kr (Doesn’t satisfy Dalton’s principle).
income40%
1 m
Mean Absolute Deviation: m ¦ ni / yi  P / o It is insensitive to Dalton’s principle.
Pn i 1

Note that a measure of dispersion common in statistics, the coefficient of variation (CV),
which is simply the sample standard deviation divided by the sample mean, is another
measure of inequality that also satisfies the four criteria. Although the CV is more commonly
used in statistics, the Gini coefficient is often used in studies of income and wealth
distribution due to its convenient Lorenz curve interpretation. Note, finally, that we can also
use Lorenz curves to study inequality in the distribution of land, in education and health, and
in other assets.

§ m ·
¨ ¦n y  P
2
¸
SD 1 ¨i1 i i ¸
Coefficient of Variation: CV
mean P ¨ n ¸
¨ ¸
© ¹

This is a very good measure and satisfies Dalton’s Principle.

Where, SD= standard deviation

B. Functional Distributions
The second common measure of income distribution used by economists, the functional or
factor share distribution of income, attempts to explain the share of total national income
that each of the factors of production (land, labor, and capital) receives. Instead of looking
at individuals as separate entities, the theory of functional income distribution inquires into
the percentage that labor receives as a whole and compares this with the percentages of total
income distributed in the form of rent, interest, and profit (i.e., the returns to land and
financial and physical capital). Although specific individuals may receive income from all
these sources, that is not a matter of concern for the functional approach.

Figure 5.5 provides a simple diagrammatic illustration of the traditional theory of functional
income distribution. We assume that there are only two factors of production: capital, which
is a fixed (given) factor, and labor, which is the only variable factor. Under competitive

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market assumptions, the demand for labor will be determined by labor’s marginal product
(i.e., additional workers will be hired up to the point where the value of their marginal
product equals their real wage). But in accordance with the principle of diminishing marginal
products, this demand for labor will be a declining function of the numbers employed. Such a
negatively sloped labor demand curve is shown by line DL in Figure 5.5. With a traditional
neoclassical upward-sloping labor supply curve SL, the equilibrium wage will be equal to WE
and the equilibrium level of employment will be LE. Total national output (which equals total
national income) will be represented by the area 0RELE. This national income will be
distributed in two shares: 0WEELE going to workers in the form of wages and WERE
remaining as capitalist profits (the return to owners of capital).

Hence in a competitive market economy with constant-returns-to-scale production functions

(a doubling of all inputs doubles output), factor prices are determined by factor supply and
demand curves, and factor shares always combine to exhaust the total national product.
Income is distributed by function laborers are paid wages, owners of land receive rents, and
capitalists obtain profits. It is a neat and logical theory in that each and every factor gets paid
only in accordance with what it contributes to national output, no more and no less.

5.1.2 Measuring Absolute Poverty

Absolute poverty is the number of people who are unable to command sufficient resources to
satisfy basic needs. They are counted as the total number living below a specified minimum

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level of real income, an international poverty line. That line knows no national boundaries, is
independent of the level of national per capita income, and takes into account differing price
levels by measuring poverty as anyone living on less than $1.25 a day or $2 per day in PPP
dollars. Absolute poverty can and does exist, therefore, as readily in New York City as it does
in Kolkata, Cairo, Lagos, or Bogotá, although its magnitude is likely to be much lower in
terms of percentages of the total population.

Just like inequality, poverty is both intrinsic and functional. Most people may say removal of
poverty is fundamental way of economic development for ethical reason. Poverty is not only
intrinsic interest but it has enormous implication for the way in which the entire economy
functions. There are different conceptual approaches in measuring the wellbeing at individual
level.

1) Welfare approach.
2) Non-Welfare approach
1. The Welfare approach compares welfare and public policy decision based on the
preference of individuals. This approach avoids subjective judgment and it uses well
articulated theory of consumer behaviour. It uses utility theory to drive poverty line.
2. The non-welfare approach assesses the well being of individuals based on some
elementary achievements such as being able to be adequately nourished or clothed. It is
very subjective. Another way of assessing the well being of individuals is developed by
Sen(1987).It is a non –welfare approach. He did not rely on command commodities and
on utility theory. He defined poverty as the lack of capability. According to Sen
Capability means being able to live long, being well nourished, being healthy, literate and
so on. According to Sen, the task of poverty analysis is to determine those capabilities
achieved by a society, and who fails to reach them. He said Mortality rate is the main
indicator of under development.

According to the World Bank (2001), poverty has many dimensions. These are:

1. Lack of opportunity
2. Low capability
3. Vulnerability, and
4. Viocelessness

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 1. The first dimension is material deprivation, which is measured by appropriate
measure of income or consumption.
2. The second dimension is low achievement in education and health.
3. The third and fourth dimension of poverty are vulnerability (exposure to risk or low
level of security) and voicelesness ( empowerment).

1. Measure of Income Poverty (lack of opportunity)

We use income or consumption as a measure of poverty.In developing countries consumption

expenditure measure is preferred because:

a) People underreport income

b) Consumption is a smooth version of income and a better indication of wealth.

Poverty line: - is a level of consumption below which a person is considered to be poor.

Poverty line is the cost of bundles of goods deemed sufficient for a basic need (Able to buy
2200k cal / day/ adult and essential non- food expenditure). To estimate the poverty line, first
we have to define a representative basket of goods and then determine the amount of each
good in the basket in such a way that the total amount gives 2200k/caloric.

After determining the amount of each good in the basket, then value using appropriate price
(local price). This gives the food poverty line per day. (X. 365 = Y amount per year)

To get the total poverty line (food + non – food) divide the food poverty line by the share of
food expenditure on total expenditure.

Example; - If food poverty line = 647 Birr

Food share (percentage) = 68%

647
Poverty line = 954.5
0.68

The most commonly used poverty indices are the Foster, Greer and Thorbecke’s measure
of poverty ( 1994). That is, the PD measure of poverty.

Let’s denote poverty line =Z

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 Total exp enditure
And Consumption expenditure per adult = Yi .
adult.equivalent.HH .size

A person is considered to be poor if his consumption expenditure is less than the poverty line.

i.e. ( if
y i  Z ).We have three ways of aggregating poverty.

1) Head count Ratio(HCR).

2) Poverty gap Ratio(PGR).
3) Squared poverty gap Ratio(SPGR).
Let’s assume we have n people, and q = the number of poor people.

D
1 q Z  yi
PD ¦ Z
n i 1
;
when

D 0, P0 Head count Ratio.

D 1, P1 Poverty gap ratio
D 2, P2 Squared poverty gap

0
1 q § Z  yi · q
1- HCR P0 ¦¨
n i 1© Z ¹
¸
n
(The number of poor divided by total number of

people).

-This gives the proportion of people whose income is

below the poverty line.

e.g. if P0 0.442 Ÿ 44.2% of the population are poor.

Head count ratio is very easy to measure and to communicate.

Disadvantage- it is insensitive to the depth of poverty.

1
1 q Z  yi
2. PGR P1 ¦ Z
ni1
for y <Z:- This measures the average income gap of the poor

from the poverty line.

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Example; - If PGR( P1 ) 0.12 Ÿ the poor are far from the poverty line by 12% on the average.
Thus, this measure tells the depth of poverty. It is also an indicator of potentials for
q
eliminating poverty by targeting the transfer to the poor. Thus, the transfer = ¦ Zy
i 1
i

The draw-back of the PGR measure is that it does not capture the difference or severity of
the poverty among the poor. Meaning it doesn’t capture the transfer of income among the
poor. If income is transferred from the poor to the least poor the PGR is unaffected.

2
1 q § Z  yi ·
3. SPGR P2 ¦¨
n i 1© Z ¹
¸ ,

The drawback of this measure is that it is difficult to understand and communicate to policy
measures. It is not easy for interpretation. But it is used for comparison.

Example:

Village-A= four people with income ( 1,2,3,4,)

Village-B= four people with income ( 2,2,2,4)
Let Poverty line = 3. Then calculate P0, P1and P2.
Given: q= 3
n= 4

1. HCRA = q 3 0.75andHCRB 3 0.75

n 4 4
(3  1  3  2  3  3 3 2  3 2  3 2 1
2. PGR A andPGRB 0.25
3 3 4
4 4
3
3 1 0.25
= 4 4

1 §¨ §¨ 1 § 1 · § 1 · ·¸ ·¸
2 2
1 § 3 1  3  2  3  3 ·
2 2 2 2
3. SPG A ¨ ¸andSPGB ¨ ¸ ¨ ¸
4 ¨© 32 ¸
¹ 4 ¨© ¨© 3 © 3 ¹ © 3 ¹ ¸¹ ¸¹

= 0.14 = 0.08

Therefore, poverty is sever in village A (0.14).

2. Low Capability
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 Here the level of achievement in education and health are used as an indicator of poverty.
A. Education:
Education is an input in to the material wellbeing of a society. It helps people to earn more
income. Education is not an input only but by itself it is an achievement because it allows
individual to participate in decisions that determines the wellbeing of his society and himself.
Hence literacy enrollment rate are taken as indicator of wellbeing. Literacy is measured
above 15 years. (A person who could read and write is literate).

Net primary enrollment ratio = Total number of enrollment in primary education (7-12yrs) ×100%

Total number f children ( 7-12yrs)

Gross enrollment Ratio = The number of students in primary education

Total number of children between ( 7-12)

B. Health :– Health status of a household can be taken as an indicator of wellbeing. In

addition to struggling on improving their per capita income, many people in developing
countries fight a constant battle against malnutrition, disease and ill health. The health status
of individuals can be assessed by infant mortality rate and under 5 mortality rate (both
measured out of 1000 live births), and life expectancy.

C. Nutrition:

According to M.P.Todaro, in most Asian and African countries, over 60% of the population
barely met minimum caloric requirements necessary to maintain adequate health.

Anthropometry Measures- Anthropometry can be used to asses nutritional status at

individual and population level. A decline in an individual’s anthropometric index from one
point in time to another could indicate illness and /or nutritional deficiency. At population
level, similarly it indicates the prevalence of diseases and malnutrition. To construct an
anthropometric indices we need weigh, height and age of individuals.

There are three measures.

1) Stunting
2) Wasting Children <5
3) Body mass Index

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Stunting: is measured by dividing the height of the child by its age. Low height to age ratio
is an indication of stunting ( shortness). It is associated with poor over all economic
condition and repeated exposure to adverse condition.

heigt § height · § height ·

A child is stunted if his  mean¨¨ ¸¸  2 SD¨¨ ¸¸
age © age ¹ © age ¹

height
if  mean§¨ height ·  3SD§¨ height ·Ÿ
age © age ¸¹ © age ¸¹
 we
call it severely stunted ( showing long term malnutrition)

Where, SD = standard deviation

Wasting: - is measured by dividing the weight of the child by its height. Low weight (kg) to
height (meter) is an indication of thinness. It is a short run measure of malnutrition.

weight § weight · § weight ·

- If  mean¨¨ ¸¸  2 SD¨¨ ¸¸ , we say that the child is wasted.
height © height ¹ © height ¹

-If weight  mean§¨ weight ·¸  3SD§¨ weight · , we say that the

height © heigh t ¹ © height ¸¹
child is severely wasted.

Body Mass Index (BMI): This is a measure of adult malnutrition. This measure is obtained
by dividing the weight (kg) of an individual by the square of his/her height(meter). This
measure does not hold for pregnants and individuals with some health problems.

- If BMI > 18.4 , the individual is normal.

- If 17 < BMI < 18.4 , the individual is in Grade -I chronic energy deficient.
- If 16 < BMI < 17 , the individual is in Grade -II chronic energy deficient.
- If BMI<16 , the individual is in Grade- III chronic energy deficient.

Vulnerability:- is the probability of an individual being exposed to various shocks that

makes him to be poor. At micro level the most important risk that affects the poor are the risk
of illness, death, injury, disability, harvest failure and unemployment. At meso (community)

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level vulnerability includes deforestation, harvest failure, soil degradation, natural calamities
such as earth quick, flood and civil war. At Macro level: food, drought, inflation, balance of
payment etc could be some of the risk. These sources of vulnerability can reduce the live
hold of house hold capacity to get out of poverty. While the micro level risks can be off set
by actions at house hold level, the macro level risks require a public action.

Voicelessness:- refers to lack of voice, power and independence as well as humiliation

,shame, exploitation by institutions of the state and the society.

Example:-Gender discrimination.

The absence of rule of law, lack of protection against violence, lack of civility and
unpredictability of public officials are some of the indicators of voicelesness. Voiceless ness
in general means being prevented from involved in decision making that affects his life The
solution for voiceless ness is empowering people. Empowerment is an active process which
occurs at different levels.

At house hold level: empowerment refers to intra- house hold equality and access to and
control over resources as well as decision making.

At community, regional and national level: empowerment means equality in access to

resources and social interactions that affect gender inequality. Empowerment also includes
representativeness in decision making bodies at local, regional and national level of
governments.

5.1.3 The Newly Introduced Multidimensional Poverty Index

Poverty cannot be adequately measured with income, as Amartya Sen’s capability framework
makes apparent. Income is imperfectly measured, but even more important, the advantages
provided by a given amount of income greatly differ, depending on circumstances. To
capture this idea the United Nations Development Program used its Human Poverty Index
from 1997 to 2009. In 2010, the UNDP replaced the HPI with its new Multidimensional
Poverty Index (MPI); by building up the index from the household level, the MPI takes into
account that there are negative interaction effects when people have multiple deprivations
worse poverty than can be seen by simply adding up separate deprivations for the whole
country, taking averages, and only then combining them.

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The first step in measuring poverty is to know which people are poor. In the
multidimensional poverty approach, a poor person is identified through what is called the
“dual cutoff method”: first, the cutoff levels within each of the dimensions (analogous to
falling below a poverty line such as $1.25 per day if income poverty were being addressed),
and second, the cutoff of the number of dimensions in which a person must be deprived
(below the line) to be deemed multidimensionally poor.
The MPI has three dimensions: health, education, and standard of living. These are measured
using 10 indicators. The indicators and the criteria for someone (household/individual) to be
considered deprived in each indicator are described here below: (Alkire and Santos, 2010).

1. Education (each indicator is weighted equally at 1/6)

 Years of Schooling: deprived if no household member has completed five years of
schooling
 Child Enrolment: deprived if any school-aged child is not attending school in years 1 to
8

2. Health (each indicator is weighted equally at 1/6)

 Child Mortality: deprived if any child has died in the family
 Nutrition: deprived if any adult or child is malnourished.

3. Standard of Living (each indicator is weighted equally at 1/18)

 Electricity: deprived if the household has no electricity
 Drinking water: deprived if the household does not have access to clean drinking water
or clean water is more than 30 minutes walk from home
 Sanitation: deprived if they do not have an improved toilet or if their toilet is shared
 Flooring: deprived if the household has dirt, sand or dung floor
 Cooking Fuel: deprived if they cook with wood, charcoal or dung

 Assets: deprived if the household does not own more than one of: radio, TV, telephone,
bike, or motorbike, and do not own a car or tractor.

After counting the number of deprivation for each household the next step is deciding the
cutoff point to identify whether a household is multidimensionally poor or not.
There are three types of multidimensional poverty measurement. These are incidence of
poverty (H), Average intensity of deprivation (A) and Multidimensional poverty index (MPI).

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 i. 𝑯 � 𝒒 /𝒏
Where, H= Multidimensional headcount index.
q= total number of multidimensional poor household.
n=total number of household.
Multidimensional headcount index (H) measures the percentage of the population that is
multidimensionally poor.
n

ii. A=∑Ci(k)/dq.
i=1
Where, A= intensity of multidimensional poverty.
Ci(k)=number of deprivation for person i.
d= total number of dimension.

It calculates the deprivation share for each poor person by dividing the deprivation count by
d, and then averages across all poor persons. It indicate us the average deprivation share
among the poor.

iii. MPI= H.A

Therefore, MPI summarizes information on the incidence of poverty and its intensity and
hence it is alternatively called the Adjusted Headcount Ratio. This measure of poverty
satisfies dimensional monotonicity. It specifies that poverty should fall when the
improvement removes the deprivation entirely. This property is a very important advantage
over the multidimensional headcount index. For instance, if there are two groups of
population where both of them have 25% multidimensional poor households but one of the
groups has an average deprivation of six out of the ten indictors while the other group has an
average deprivation of four, then H does not clearly indicate such disparities. However, MPI
apparently shows this higher intensity. Another important characteristic of MPI is that it is
decomposable by population subgroups.

The UNDP reports the MPI for 104 developing countries, based on the currently available
data; some examples are given in Table 5.2.
The index can range from 0 to 1. Slovenia and Slovakia receive an MPI of 0, the lowest
possible value, indicating the least poverty, while the world’s most impoverished country for
which data were available to compute a ranking, Niger, ranks 104th, with an MPI value of
0.642. Based on the thresholds just described, the report found there were nearly 1.7 billion

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people living in what was termed “acute” poverty several hundred million more than the
estimated number living on income of less than $1.25 per day.

The results showed that knowing income poverty is not enough if our concern is with
multidimensional poverty. For example, multidimensionally, Bangladesh is substantially less
poor and Pakistan substantially poorer than would be predicted by these countries’ income
poverty. In Africa, Ethiopia is far more multidimensionally poor and Tanzania much less so
than predicted by income poverty. Most Latin American countries studied rank worse on
multidimensional poverty than on income poverty, but Colombia’s income and MPI poverty
ranks are about the same.

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5.2 Kuznets’s Inverted-U Hypothesis

Simon Kuznets suggested that in the early stages of economic growth, the distribution of
income will tend to worsen; only at later stages it will improve. This observation came to be
characterized by the “inverted-U” Kuznets curve because a longitudinal (time-series) plot of
changes in the distribution of income— as measured, for example, by the Gini coefficient—
seemed, when per capita GNI expanded, to trace out an inverted U-shaped curve in some of
the cases Kuznets studied, as illustrated in Figure 5.6
Fig. 5.6 The inverted “U” Kuznets curve

As just noted, the Kuznets curve could be generated by a steady process of modern-sector
enlargement growth as a country develops from a traditional to a modern economy.
Alternatively, returns to education may first rise as the emerging modern sector demands
skills and then fall as the supply of educated workers increases and the supply of unskilled
workers falls. So while Kuznets did not specify the mechanism by which his inverted-U
hypothesis was supposed to occur, it could in principle be consistent with a sequential
process of economic development. But as shown earlier, traditional- and modern-sector
enrichment would tend to pull inequality in opposing directions, so the net change in
inequality is ambiguous, and the validity of the Kuznets curve is an empirical question.

5.3 Growth versus Income Distribution.

The debate about the relationship between economics distribution takes many forms. The
key arguments are the traditional argument and the counter argument.

a) The traditional Argument: Factor shares, Saving and Economic growth.

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Although much of economic analysis has been strangely silent on the relationship between
economic growth and the resulting distribution of income, a large body of theory in essence
asserts that highly unequal distributions are necessary conditions for generating rapid growth.

The basic economic argument to justify large income in equalities was that high personal and
corporate incomes were necessary conditions of saving, which made possible investment and
economic growth through a mechanism such as the Harrod-Domar model. If the rich save
and invest significant portions of their incomes while the poor spend all their income on
consumption goods, and if GNP growth rates are directly related to the proportion of national
income saved, then apparently an economy characterized by highly unequal distributions of
income would save more and grow faster than one with a more equitable distribution of
income. Eventually, it was assumed, national and per capita incomes would be high enough
to make sizable redistributions of income possible through tax and subsidy programs. But
until such a time is reached, any attempt to redistribute incomes significantly would serve
only to lower growth rates and delay the time when a larger income pie could be cut up into
bigger slices for all population groups.

b) Counterargument

There are five general reasons why many development economists believe the foregoing
argument to be incorrect and why greater equality in developing countries may in fact be a
condition for self-sustaining economic growth.

First, sizable inequality and widespread poverty create conditions in which the poor have no
access to credit, are unable to finance their children's education, and, in the absence physical
or monetary investment opportunities, have many children as a source of old-age financial
security. Together these factors cause per capita growth to be less than what it would be if
there were greater equality.
Second, common sense, supported by a wealth of recent empirical data, bears witness to the
fact that unlike the historical experience of the now developed countries, the rich in
contemporary poor countries are not noted for their frugality or for their desire to save and
invest substantial proportions of their incomes in the local economy. Instead, landlords,
business leaders, politicians, and other rich elites are known to spend much of their incomes
on imported luxury goods, gold, jewelry, expensive houses, and foreign travel or to seek safe
havens abroad for their savings in the form of capital flight. Such savings and investments do

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not add to the nation's productive resources; in fact, they represent substantial drains on these
resources in that the income so derived is extracted from the sweat and toil of common,
uneducated, and unskilled laborers. In short, the rich do not necessarily save and invest
significantly larger proportions of their incomes (in the real economic sense of productive
domestic saving and investment) than the poor. Therefore, a growth strategy based on sizable
and growing income inequalities may in reality be nothing more than an opportunistic myth
designed to perpetuate the vested interests and maintain the status quo of the economic and
political elites of Third World nations, often at the expense of the great majority of the
general population. Such strategies might better be called "antidevelopmental.”

Third, the low incomes and low levels of living for the poor, which are manifested in poor
health, nutrition, and education, can lower their economic productivity and thereby lead
directly and indirectly to a slower-growing economy. Strategies to raise the incomes and
levels of living of, say, the bottom 40% would therefore contribute not only to their material
well-being but also to the productivity and income of the economy as a whole.

Fourth, raising the income levels of the poor will stimulate an overall increase in the demand
for locally produced necessity products like food and clothing, whereas the rich tend to spend
more of their additional incomes on imported luxury goods. Rising demand for local goods
provides a greater stimulus to local production, local employment, and local investment. Such
demand thus creates the conditions for rapid economic growth and a broader popular
participation in that growth.

Fifth and finally, a more equitable distribution of income achieved through the reduction of
mass poverty can stimulate healthy economic expansion by acting as a powerful material and
psychological incentive to widespread public participation in the development process. By
contrast, wide income disparities and substantial absolute poverty can act as powerful
material and psychological disincentives to economic progress. They may even create the
conditions for an ultimate rejection of progress by the masses of frustrated and politically
explosive people, especially those with considerable education.

We can conclude, therefore, that promoting rapid economic growth and reducing poverty and
inequality are not mutually conflicting objectives. The World Bank reached a similar
conclusion in its 1990 report on poverty when it declared:

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Discussions of policy toward the poor usually focus on the trade-off between growth and
poverty. But the review of country experience suggests that this is not a critical trade-off.
With appropriate policies, the poor can participate in growth and contribute to it, and when
they do, rapid declines in poverty are consistent with sustained growth.

5.4 The Range of Policy Options: Some Basic Considerations

Developing countries that aim to reduce poverty and excessive inequalities in their
distribution of income need to know how best to achieve their aim. What kinds of economic
and other policies might LDC governments adopt to reduce poverty and inequality while
maintaining or even accelerating economic growth rates? As we are concerned here with
moderating the size distribution of incomes in general and raising the income levels of, say,
the bottom 40% of the population in particular, it is important to understand the various
determinants of the distribution of income in an economy and see in what ways government
intervention can alter or modify their effect.

a) Areas of Intervention

We can identify four broad areas of possible government policy intervention, which
correspond to the following four major elements in the determination of a developing
economy's distribution of income:

1. Functional distribution-the returns to labor, land, and capital as determined by factor

prices, utilization levels, and the consequent shares of national income that accrue to the
owners of each factor.

2. Size distribution-the functional income distribution of an economy translated into a size

distribution by knowledge of how ownership and control over productive assets and labor
skills are concentrated and distributed throughout the population. The distribution of
these asset holdings and skill endowments ultimately determines the distribution of
personal income.

3. Moderating (reducing) the size distribution at the upper levels through progressive
taxation of personal income and wealth. Such taxation increases government revenues
and converts a market- and asset-determined level of personal income into a fiscally
corrected "disposable" personal income. An individual or family's disposable income is
the actual amount available for expenditure on goods and services and for saving.

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4. Moderating (increasing) the size distribution at the lower levels through public
expenditures of tax revenues to raise the incomes of the poor either directly (e.g., by
outright money transfers) or indirectly (e.g., through public employment creation or the
provision of free or subsidize a primary education and health care for both men and
women. Such public policies raise the real income levels of the poor above their market-
determined personal income levels.

b) Policy Options

Third World governments have many options and alternative possible policies to operate in
the four broad areas of intervention just outlined. Let us briefly identify the nature of some of
them.

Altering the Functional Distribution of Income through Policies Designed to

Change Relative Factor Prices

Altering the functional distribution represents the traditional economic approach. It is argued
that as a result of institutional constraints and faulty government policies, the relative price of
labor (basically, the wage rate) is higher than what would be determined by the free interplay
of the forces of supply and demand. For example, the power of trade unions to raise
minimum wages to artificially high levels (higher than those that would result from supply
and demand) even in the face of widespread unemployment is often cited as an example of
the "distorted" price of labor. From this it is argued that measures designed to reduce the
price of labor relative to capital (e.g., through market-determined wages in the public sector
or public wage subsidies to employers) will cause employers to substitute labor for capital in
their production activities. Such factor substitution increases the overall level of employment
and ultimately raises the incomes of the poor, who typically possess only their labor services.

However, it is often also correctly pointed out that the price of capital equipment is
"institutionally" set at artificially low levels (below what supply and demand would dictate)
through various public policies such as investment incentives, tax allowances, subsidized
interest rates, overvalued exchange rates, arid low tariffs on capital goods imports such as
tractors and automated equipment. If these special privileges and capital subsidies were
removed so that the price of capital would rise to its true "scarcity" level, producers would
have a further incentive to increase their utilization of the abundant supply of labor and lower
their uses of scarce capital. Moreover, owners of capital (both physical and financial) would

112 | P a g e
not receive the artificially high economic returns they now enjoy. Their personal incomes
would thereby be reduced.

Because factor prices are assumed to function as the ultimate signals and incentives in any
economy, correcting these prices (Le., lowering the relative price of labor and raising the
relative price of capital) would not only increase productivity and efficiency but would also
reduce inequality by providing more wage paying jobs for currently unemployed or
underemployed unskilled and semiskilled workers. It would also lower the artificially high
incomes of owners of capital. Removal of such factor-price distortions would therefore go a
long way toward combining more growth, efficiently generated, with higher employment,
less poverty, and greater equality.

For the present, we may conclude that there is much merit to the traditional factor-price
distortion argument and that correcting prices should contribute to a reduction in poverty and
an improved distribution of income. How much it actually contributes will depend on the
degree to which firms and farms switch to more labor-intensive production methods as the
relative price of labor falls and the relative price of capital rises. This is an important
empirical question, the answer to which will vary from country to country. But some
improvement can be expected.

Modifying the Size Distribution through Progressive Redistribution of Asset

Ownership

Given correct resource prices and utilization levels for each type of productive factor (labor,
land, and capital), we can arrive at estimates for the total earnings of each asset. But to
translate this functional income into personal income, we need to know the distribution and
ownership concentration of these assets among and within various segments of the
population. Here we come to what is probably the most important fact about the
determination of income distribution within an economy: The ultimate cause of the unequal
distribution of personal incomes in most Third World countries is the unequal and highly
concentrated patterns of asset ownership (wealth) in these countries. The principal reasons
why less than 20% of their population receives over 50% of the national income is that this
20% probably owns and controls well over 90% of the productive and financial resources,
especially physical capital and land but also financial capital (stocks and bonds) and human
capital in the form of better education. Correcting factor prices is certainly not sufficient to

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reduce income inequalities substantially or to eliminate widespread poverty where physical
and financial asset ownership and education are highly concentrated.

It follows that the second and perhaps more important line of policy to reduce poverty and
inequality is to focus directly on reducing the concentrated control of assets, the unequal
distribution of power, and the unequal access to educational and income-earning
opportunities that characterize many developing countries. A classic case of such
redistribution policies as they relate to the rural poor, who comprise 70% to 80% of the target
poverty group, is land reform. The basic purpose of land reform is to transform tenant
cultivators into smallholders who will then have an incentive to raise production and improve
their incomes. Land reform may be a weak instrument of income redistribution if other
institutional and price distortions in the economic system prevent small farm holders from
securing access to much needed critical inputs such as credit, fertilizers, seeds, marketing
facilities, and agricultural education. Similar reforms in urban areas could include the
provision of commercial credit at market rates (rather than through exploitive moneylenders)
to small entrepreneurs so that they can expand their 'business and provide more jobs to local
workers.

In addition to the redistribution of existing productive assets, dynamic redistribution policies

could be gradually pursued. For example, IDC governments could transfer a certain
proportion of annual savings and investments to low-income groups so as to bring about a
more gradual and perhaps politically more acceptable redistribution of additional assets as
they accumulate over time. This is what is often meant by the expression "redistribution from
growth." Whether such a gradual redistribution from growth is any more possible than a
redistribution of existing assets is a moot point, especially in the context of very unequal
power structures. But some form of asset redistribution, whether static or dynamic, seems to
be a necessary condition for any significant reduction of poverty and inequality in most Third
World countries.

Human capital in the form of education and skills is another example of the unequal
distribution of productive asset ownership. Public policy should therefore promote wider
access to educational opportunities (for girls as well as boys) as a means of increasing
income-earning potential for more people. This investment in human capital as a principal
strategy for alleviating poverty has been widely promoted (along with accelerating economic
growth) by the World Bank in its various poverty reports, especially World Development

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Report 1998/99: Knowledge for Development. But as in the case of land reform, the mere
provision of greater access to education is no guarantee that the poor will be any better off,
unless complementary policies-for example, the provision of more productive unemployment
opportunities for the educated-are adopted to capitalize on this increased human capital.

Reducing the Size Distribution at the Upper Levels through Progressive Income and
Wealth Taxes

Any national policy attempting to improve the living standards of the bottom 40% must
secure sufficient financial resources to transform paper plans into program realities. The
major source of such development finance is the direct and progressive taxation of both
income and wealth. Direct progressive income taxes focus on personal and corporate
incomes, with the rich required to pay a progressively larger percentage of their total income
in taxes than the poor: Taxation on wealth (the stock of accumulated assets and income)
typically involves personal and corporate property taxes but may also include progressive
inheritance taxes. In either case, the burden of the tax is designed to fall most heavily on the
upper-income groups.

Unfortunately, in many developing countries (and developed countries as well), the gap
between what is supposed to be a progressive tax structure and what different income groups
actually pay can be substantial. Progressive tax structures on paper often turn out to be
regressive taxes in practice, in that the lower-and middle- income groups pay a
proportionately larger share of their incomes in taxes than the upper-income groups. The
reasons for this are simple. The poor are often taxed at the source of their incomes or
expenditures (by withholding taxes from wages, general poll taxes, or indirect taxes levied
on the retail purchase of goods such as cigarettes and beer). By contrast, the rich derive by
far the largest part of their incomes from the return on physical and financial assets, which
often go unreported. They often also have the power and ability to avoid paying taxes with-
out fear of government reprisal. Policies to enforce progressive rates of direct taxation on
income and Wealth, especially at the highest levels, are what are most needed in this area of
redistribution activity.

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Increasing the Size Distribution at the Lower Levels through Direct Transfer
Payments and the Public Provision of Goods and Services

The direct provision of tax-financed public consumption goods and services to the very poor
is another potentially important instrument of a comprehensive policy designed to eradicate
poverty. Examples include public health projects in rural villages and urban fringe areas,
school lunches and preschool nutritional supplementation programs, and the provision of
clean water and electrification to remote rural areas. Direct money transfers and subsidized
food programs for the urban and rural poor, as well as direct government policies to keep the
price of essential foodstuffs low, represent additional forms of public consumption subsidies.
All these policies have the effect of raising the real personal income levels of the very poor
beyond their actual market -derived monetary incomes. Unfortunately, in the 1980s and
1990s, with the LDC debt crisis and the implementation of World Bank- and IMF-induced
structural adjustment programs, the first victims of mandated public expenditure
retrenchments were the rural and urban poor-especially women.

Summary
x Personal distribution of income (size distribution of income) The distribution of
income according to size class of persons for example, the share of total income
accruing to the poorest specific percentage or the richest specific percentage of a
population without regard to the sources of that income.
x Income inequality indicates the disproportionate distribution of total national income
among households.
x Lorenz curve is a graph depicting the variance of the size distribution of income from
perfect equality.
x Gini coefficient is an aggregate numerical measure of income inequality ranging from
0 (perfect equality) to 1 (perfect inequality). It is measured graphically by dividing the
area between the perfect equality line and the Lorenz curve by the total area lying to
the right of the equality line in a Lorenz diagram. The higher the value of the
coefficient, the higher the inequality of income distribution; the lower it is, the more
equal the distribution of income.
x Functional distribution of income exhibits the distribution of income to factors of
production without regard to the ownership of the factors.

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 x Absolute poverty is the situation of being unable or only barely able to meet the
subsistence essentials of food, clothing, and shelter.
x A multidimensional poverty index indicates a multiple of deprivation poor individual
experiences over a range of time.

Checklist

Did you understand the following terms? YES NO

Income inequality  
The personal or size distribution of income  
Lorenz Curves  
Gini Coefficients  
Anonymity principle  
Scale independence principle  
Population independence principle  
Transfer principles  
Functional Distributions  
Absolute Poverty  
Multidimensional Poverty Index  
Kuznets’s Inverted-U Hypothesis  

Self-evaluation test
Part one: Multiple choices

1. _______________is an indication of Low weight to height ratio

A. Wasting
B. Stunting
C. Body Mass Index
D. Anthropometry Measures
E. All

2. Which of the following statement is correct?

A. If income is transferred from someone who is better off to someone who is less well off,
the Gini coefficient always raises.

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B. The more the economy rich the more is the likely that the income inequality will be low
C. If we increase the number of population by some constant, income inequality will
increase.
D. The kuznet ratio satisfies Dalton’s principle.
E. None

3. According to the Kuznets curve, in the course of economic development,

A. Inequality first falls and then rises.

B. Inequality first rises and then falls.
C. Inequality begins low and then falls to a lower sustainable level.
D. Inequality begins low and then rises to a higher sustainable level.
E.B&C
F.B&D

Part Two: Short Answer and Workout

1. Briefly explain the following concepts.

A. Lorenz criterion
B. Poverty line
C. Kuznets’s Inverted-U Hypothesis
D. Absolute Poverty
E. Multidimensional Poverty Index

2. The following data indicates the distribution of income for a certain community. In each
situation, the first set of numbers represents the various incomes; whereas the second set of
numbers represents the number of people earning each of these incomes: (use quintiles to
depict the Lorenz curve).

(300, 100, 200, 400,); (75, 50, 25, 25)

A. Draw the Lorenze curve
B. Calculate the Gini coefficient
C. Calculate the Kuznet ratio

3. Assume that there are two villages in a certain community with the following income
distribution:

Village-A= Five people with income (100, 300, 500, 700, 900)
Village-B= Five people with income (50, 200, 300, 400, 1000)

Let Poverty line = 600.

A. Calculate the headcount ratio for each village and interpret the result.

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B. Calculate the poverty gap ratio for each village and interpret your result.
C. Calculate the squared poverty gap ratio. In which village poverty is more severe?
D. Which village needs more effort to eliminate poverty and why?

Answer to self-evaluation test

Chapter One
Part one: Multiple choices

1. B
2. E

Chapter Five
Part one: Multiple choices

1. A
2. E
3. B

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