3.

2 Structural – Change Models

(W.A Lewis and H.B. Chenery)

 These models deal with the mechanism by which

underdeveloped economies transform their
domestic economic structures from a heavy
emphasis on traditional subsistence agriculture to
a more modern, more urbanized and more
industrially diverse manufacturing and service
economy.
 It employs the tools of neo – classical price and
resource allocation theory and modern
econometrics to describe how this transformation
process takes place.
 The Lewis Theory of Development.
 Structural Transformation of a primarily
subsistence economy by Lewis – later
formalized and extended by Fei and Ranis.
 The Lewis two sector model became the
general theory of the development process in
surplus – Labor Third World Nations
during most of the 1960’s and early 1970’s.
 In the Lewis model, the under developed
economy consists of two sectors:
 A traditional, over populated rural subsistence
sector. Over populated rural sub sector
characterized by zero marginal labor productivity.

 A high productivity modern urban industrial

sector in to which labor from the subsistence
sector is gradually transferred.

 The model focuses on both the process of Labor

transfer and growth of output and employment in
the modern sector.
 The speed with which this expansion occurs is determined
by the rate of industrial investment and capital
accumulation in the modern sector. Such investment is
made possible by the excess of modern sector profits over
wages on the assumption that capitalists reinvest all their
profits.
 The level of wages in the urban industrial sector is
assumed to be constant and determined as a given premium
over a fixed average subsistence level of wages in the
traditional agricultural sector.
 At the constant urban wage, the supply curve of rural labor
to the modern sector is considered to be perfectly elastic.
 We can illustrate the Lewis model of modern sector growth
in a two- sector economy by using graphs. Fig.3.1. below:
 Consider first the traditional agricultural sector
portrayed in the two right side diagrams of fig 3.1b.
 The upper diagram shows how subsistence food
production varies with increases in Labor inputs
(Agricultural production function).
 TPA is determined by changes in the amount of L A;
given a fixed quantity of capital k A; and unchanging
traditional technology tA.
 In the lower right diagram, we have the average and
marginal product of labor curves; APL A and MPLA
which are derived from the Total Product Curve
shown immediately above.
 The quantity of agricultural labor Q LA available is
the same on both horizontal axes.

Two assumptions about the traditional sector

 Surplus labor; MPLA is zero

 All rural workers share equally in the output so that
rural wage is determined by the average and not the
MPLA.
Surplus labor assumption applies to all workers in
excess of LA
 The upper left diagram of (Fig 3.1a) portrays the total
product curve for the modern, industrial sector. Output of
manufactured goods (TPM) is a function a variable labor
input, LM, for a given capital stock Km and technology, tM.
 On the horizontal axes, the quantity of labor employed to
produce an output of, say, TPM, with capital stock KM1, is
expressed in thousands of urban workers, L.
 In the Lewis model, the modern – sector capital stock is
allowed to increase from KM1 to KM2 to KM3 as a result of
reinvestment in profits by industrial capitalists. This will
shift the total product curve in fig.3.1a to shift upwards
from TPM (KM1) to TPM (KM2) to TPM (KM3).
 The process that will generate these capitalist
profits for reinvestment and growth illustrated
in the lower – left of fig 3.1a. Here we have
Modern sector Marginal Labor Product curves
derived from the TPM. Under the assumption of
perfectly competitive Labor markets in the
modern sector MPL curves are in fact the actual
demand curves for labor.
The system works as follows:
 W
A - in the lower diagrams represents the
average Level of Real Subsistence Income in
the Traditional Rural Sector.
 WM – Real wage in Modem Capitalist sector. In this
wage, the supply of labor is assumed to be unlimited or
perfectly elastic as shown by horizontal labor supply curve
WM SL.
 Lewis assumes that at urban wage WM above rural average
income WA, modern sector employers can hire as many
surplus rural workers as they want without fear of rising
wages.

 Given a fixed supply of capital KM1 in the initial stage of

modern – sector growth, the demand curve for labor is
determined by labor’s declining MP and is shown by the
negatively sloped curve D1 (KM1) in the lower left diagram.
 Because, profit maximizing modern sector employers are
assumed to hire laborers to the point where their MPP is
equal to the real wage (Point F), total modern sector
employment will be equal to L1. Total output TPM would be
given by area bounded by points OD1 FL1.
 The share of this total output paid to workers in the form of
wage would be equal to the area of the rectangle OWM FL1.
 Area of the output shown by WM D1F would be the total
profit that accrues to the capitalists. Because all of these
profits are reinvested, the total capital stock in the modern
sector will rise from KM1 to KM2. This causes the total product
curve of modem sector to shift to TPM (KM2). This outward
shift in the labor demand curve is shown by line (D2 Km2).
New equilibrium is at G with L2 workers and output TPM2.
 This process of modern- sector self – sustaining
growth and employment expansion is assumed to
continue until all surplus labor is absorbed in the
new industrial sector.
 Thereafter, additional workers can be withdrawn
from the agricultural sector only at a higher cost of
lost food production (MPL is no longer zero).

 The whole process would lead to structural

transformation of the economy (Traditional rural
agriculture to modem urban industry)
 Criticism on the Lewis Model
 What if capitalist profits are reinvested in more
sophisticated labor saving capital equipment?

 There is little general surplus labor in rural locations

(geographic and seasonal exceptions).

 Tendency of urban wages to rise substantially over time

both is absolute terms and relative to average rural
incomes, even in the presence of rising levels of open
modern sector unemployment or zero MP L in Agri.
(Unions bargain).
 Growing prevalence of urban surplus labor and
there no tendency of diminishing returns in
modern sector.
 Model roughly explains the historical growth
experience of today’s Industrial Nations. But, its
key assumptions do not reflect the realities of
today’s LDCs.
 Lewis two sector models require considerable
modification in assumptions and analysis to fit
the realities of contemporary developing nations.
 3.3 Structural Change and Patterns of
Development (B. Chenery)

 The patterns of development analysis of

structural change focuses on the sequential
process through which the economic, industrial,
and institutional structure of an under developed
economy is transformed over time to permit new
industries to replace traditional agriculture as the
engine of economic growth.
 Increased saving and investment are necessary
but not sufficient conditions for economic growth
 The structural change involves:
 The transformation of production and changes in the
composition of consumer demand
 International trade
 Resource use
 Socio economic changes such as urbanization, growth
and distribution of population
 Both domestic and international constraints on
development.
Domestic constraints such as resource endowments,
physical and population size, institutional constraints.
International constraints include access to external
capital, technology, and international trade
 Shift from agriculture to industrial
production.
 The steady accumulation of physical and
human capital
 The decline in family size.
3.4 THE INTERNATIONAL – DEPENDENCE REVOLUTION

This view emphasizes that developing countries are

beset by institutional, political, economic rigidities, both
domestic and international and are caught up in a
dependence and dominance relationship with rich
countries.
With in this general approach are three major streams of
thought:
 The Neo Classical Dependence Model,
 The False Paradigm Model,
 The Dualistic Development Thesis
The Neo Classical Dependence Model:
 Unequal power relationship b/n the center and
periphery
 Attempts by poor nations to be self reliant and
independent are difficult.
 Underdevelopment as an externally induced
phenomenon
 Dominant countries are endowed with
technological, commercial, capital and socio-
political predominance over dependent countries.
 The False- Paradigm Model
 This attributes underdevelopment to faulty and in
appropriate advice provided by well-meaning but often
uninformed, biased, and ethnocentric international
expert’ advisers from developed country assistance
agencies and multinational donor organizations.
 Leading university intellectuals, trade unions, high
level gov’t economists and other civil servants all get
their training in developed country institutions where
they are un wittingly served an unhealthy dose of alien
concepts and elegant but in applicable theoretical
models.
 The Dualistic Development Thesis.

 Dualism represents the existence and persistence

of increasing divergence between poor and rich
nations and rich and poor people. Wealthy, highly
educated elites with masses of illiterate poor
people;
 Superiority and inferiority, inherent tendency to
increase in this gap. Chronic co-existence.
 The three models reject the exclusive emphasis on
acceleration of GNP growth as the principal index
of development.
 3.5 The Neoclassical Counter Revolution: Market
fundamentalism
 Supply side macroeconomic policies; rational
expectations theories, and privatization of public
corporations were favored in this version (1980’s)
 In developing countries it called for freer markets and
the dismantling of public ownership, statist planning,
and government regulation of economic activities.
 The central argument of the neo- classical counter
revolution is that under development results from poor
resource allocation due to in correct pricing policies and
too much state intervention by overly-active developing
nation’s governments.
 The neo liberals argue that by permitting competitive
free markets to flourish, privatizing state-owned
enterprises, promoting free trade and expansion of
exports, welcoming FDI, eliminating the plethora of
government regulations and price distortions, in factor,
product and financial markets, both economic
efficiency and economic growth will be stimulated.
 Heavy hand of the state inefficiency, lack of economic
incentives… and corruption is the cause for
underdevelopment.
 Hence restructuring of dualistic developing economies,
increase in foreign aid, attempts to control population
growth and a more effective development planning
system is a requirement.
 3.6 The Big Push Theory
 It is a model of how the presence of
market failures can lead to a need for a
concerted economy wide and public policy
led effort to get the long process of
economic development underway or
accelerate it.
 Coordination failure works against
successful industrialization, a
counterweight to the push for
development.
 The development process is a series of discontinuous
jumps. The functional relationships among the causal
factors in economic growth are full of ‘lumps’ and
discontinuities, hence a minimum effort or ‘big push’
is needed to overcome the original inertia of a stagnant
economy and start it moving towards higher levels of
productivity and income.

 The big push is related to the idea of external

economics: benefits which accrue to the society as a
whole but may not bring direct return to the investor
concerned.
 Rosenstein – Rodan and Three
Indivisibilities:
Three kinds of indivisibilities and external
economics maybe distinguished:

 Indivisibilities in the production function

(social overhead capital)
 Indivisibility of demand
 Indivisibility in supply of savings.
 Because of these indivisibilities proceeding bit by
bit will not add up in its effects to the sum total of
the single bits. A minimum quantum of
investment is a necessary condition for success.
 Development theory maintains that nature does
make jumps. Development theory is more
realistic in taking account of indivisibilities and
non – appropriateness in the production function.
 It examines the path to equilibrium and not just
the equilibrium conditions.
 Indivisibilities in the production Function:

Social over head capital (power, transport,

communications, housing etc) is the most instances
of indivisibility and external economics on the
supply side. They usually require a great minimum
size, so that excess capacity will be unavoidable
over the initial period in under developed countries.
Investments in the ‘infrastructure’ have a high
minimum durability, a long gestation period, and a
minimal industry mix of several different kinds of
public utilities.
 Indivisibility of Demand:

 Investment decisions are interdependent and

individual investment projects have high risk because
of uncertainty as to whether their product will find a
market.

 The basic reason for government action to promote

development is that each of a set of individual
investment decisions may be unattractive in itself,
where as a large- scale investment program
undertaken as a unit may yield substantial increases in
national income.
 The needed investment is unlikely to take place
without government intervention in the decision-
making process.

 Isolated and small efforts may not add up to a

sufficient impact on growth, and an atmosphere of
development effectiveness may also arise only with
a minimum speed or size of investment.

 International trade is not always a means of

avoiding the necessity of a big push.
 3.7 Balanced and Unbalanced Growth:

Balanced Growth
 In presenting his version of the minimum effort

thesis, Ragnar Nurkse advocates “a frontal attack, a

wave of capital investments in a number of different
industries” which he calls “Balanced Growth”.

 Hans Singer and Albert Hirschman have criticized

Nurkse’s Formulation, they insist that what is
needed is not balanced growth but a strategy for
judiciously unbalanced growth.
 The Nurkse Thesis
 Nurkse’s basic argument resembles Rosenstein-
Rodan’s ideas. Nurkse says, “Low real income is a
reflection of low productivity, which in turn is due
largely to lack of capital.” The lack of capital is a
result of the small capacity to save and so the circle is
complete.
 The inducement to invest, in turn, is limited by the
size of the market. But a crucial determinant of the
size of the market is productivity; capacity to buy
means capacity to produce. Any productivity depends
largely on the degree to which capital is used in the
production
 A synchronized application of capital to a wide range
of different industries is a requirement. Balanced
growth is an overall enlargement of the market.
 Most industries are complementary in the sense that
they provide market for, and support each other. The
case for balanced growth rests on the need for a
balanced diet.
 He makes a case for building up import replacing
industries behind a tariff wall. To push primary
commodities in the face of an inelastic and more or
less stationary demand would not be a promising line
of long – run development
 The Singer Critique:
 Underdeveloped countries employ 70 – 90% population in
agriculture. This reflects low productivity. The low level of
productivity in the farming decrees that the bulk of the
people must be in farming in order to feed and clothe
themselves, and they have little to spare over and above their
own needs.
 High percentage of low incomes is spent on food and
essential clothing and the demand for other things is limited
and investment in producing them is not attractive.
 When we talk about varied investment packages for industry
and major additional blocks in investment in agriculture, at
the same time, we ran in to serious doubts about the capacity
of underdeveloped countries to follow the balanced growth
path.
 Unbalanced Growth
Hirschman’s Strategy of Unbalance
 Deliberate unbalancing of the economy, in accordance
with a predesigned strategy, is the best way to achieve
economic growth.
 Ability to invest is the one serious bottleneck in
developing countries. Ability to invest depends mainly
on how much investment has already been made. The
ability to invest is acquired and increased primarily by
practice: The supply of capital is fixed and
industrialization should take the form of small
industries in small towns in order to economize on
overhead capital out lays.
 Hirschman argues: undertake a big push in
strategically selected industries. Development has
proceeded with growth being communicated from
the leading sectors of the economy to the followers.
Market will not guarantee in the now under
developed countries.
 The rate of growth is likely to be faster with chronic
imbalance precisely because of “incentives and
pressures” it sets up.
 Any particular investment project may have both
forward linkage and back ward linkage. The task is
to find the project with the greatest total linkage.
 3.8 The New Growth Theory: Endogenous
Growth.
 The poor performance of Neo-Classical Theories in
illuminating the source of long term economic
growth has led to a widespread dissatisfaction with
traditional growth theories.
 Under such theories there is no intrinsic
characteristic of economies that causes them to
grow over extended periods of time. It is concerned
with the dynamic process through which capital-
labor ratios approach long-run equilibrium levels.
 In the absence of external shocks or technological
change, which is not explained in the Neo-classical
model, all economies will converse to zero growth.
Hence rising PC GNP is considered a temporary
phenomenon resulting from a short term equilibrating
process or a change in technology.
 Any increase in GNP that cannot be attributable to short
run adjustments in stocks of either labor or capital are
ascribed to a third category, commonly referred to as the
Solow Residual.
 Solow residual is the proportion of long term economic
growth not explained by growth in labor or capital and
therefore assigned primarily to exogenous technological
change.
 This residual is responsible for 50% of historical growth in the
industrialized nations. In a rather ad hoc manner neoclassical
theory credits the bulk of economic growth to an exogenous
(independent) process of technological progress.
 The theory failed to explain large difference in residuals across
countries with similar technologies.
 It is possible to analyze the determinants of technological
advance.
 The anomalous behavior of developing world capital flow (from
poor to rich nations) helped provide the impetus for the
development concept of endogenous growth or New Growth
Theory.
 The New Growth Theory provides a theoretical frame work for
analyzing endogenous growth, persistent GNP growth that is
determined by the production process rather than by forces
outside the system.
 Endogenous growth theories seek to explain the factors that
determine the rate of growth of GDP that is left
unexplained and exogenously determined in the Solow
equation.
 This theory discards the neo classical assumption of
diminishing marginal returns to capital investment,
permitting increasing returns to scale in aggregate
production, and frequently focusing on the role of
externalities in determining the rate of return on capital
investments.
 Many endogenous growth theories can be expressed by the
simple equation Y=Ak, as in the Harrod- Domar Model.
A= any factor that affects technology,
K= Physical and human capital.
 No diminishing returns to capital. Investment
in physical and human capital can generate
external economies and productivity
improvements that exceed private gains by an
amount sufficient to offset diminishing returns.
The result is sustained long term growth.
 Potentially high returns of investment offered
by developing economies with low capital
labor ratios are greatly eroded by lower levels
of complementary investment in human capital
infrastructure and research and development.
 Unlike the Solow model, New Growth Theory
models explain technological change as an
endogenous outcome of public and private
investments in human capital and knowledge-
intensive industries.

 These models suggest an active role for public

policy in promoting economic development
through investment in human capital formation
and FDI in knowledge intensive industries &
telecom computer soft ware.
 The Romer Model
 The Romar endogenous model – addresses technological
spillovers that may be present in the process of
industrialization.
 The model assumes that growth processes are derived
from the firm/industry level. Each industry produces
individually with constant returns to scale so the model
is consistent with perfect competition, matches the
solow growth model .
 What makes it different for the solow model is: The
economy wide capital stock, K, positively affects output
at an industry level, so that that there may be increasing
returns to scale (IRS) at the economy wide level.
 The knowledge part of the firm’s capital stock is
essentially a public good, like A in the Solow
model that is spilling over instantly to the other
firms in the economy.
 It is just learning by investing. Romer’s model is
spelling out (Endogenizing) the reason why growth
might depend on the rate of investment.
 We abstract from the house hold sector, an
important feature of the original model, in order to
concentrate on issues concerning industrialization.
Formally
 Yi= AKi α Li1- α Kβ …………………………..(3-
1)
 We assume symmetry across industries for simplicity, so
each industry will use the same level of capital and labor.
Then we have the aggregate production function.
Y= AK α+β L1-α………………………………….(3-2)
 To make endogenous growth stand out clearly, we assume
that A is constant, i.e., we assume that there is no
technological progress. With a little calculus, it may be
shown that the resulting growth rate for PC income in the
economy would be
g-n= β/[1 – α+β] ...........(3.3)
 Where g is the output growth rate and n is the population
growth rate. Without spillovers, as in the Solow model
with constant returns to scale β=0 and so per capita growth
would be zero. (Without technological progress).
 Romer assumes, however, that taking the
three factors together, including the capital
externality, β>o, thus g-n >0 and Y/L is
growing.
 Now we have endogenous growth, depending
on the level of savings, and investment
undertaken in the model, not driven
exogenously by increases in productivity.
 With an investment (technology) spill over,
the model avoids diminishing returns to
capital
 Criticism:
 Remains dependent on a no of traditional
neo classical assumptions that are in
appropriate for LDC, (e.g. Single sector of
production, all sectors are symmetrical)
 Poor infrastructure, inadequate institutional
structures, imperfect capital at goods market,
poor incentive structures, allocative
inefficiencies impede economic development
in poor countries.
Kremer’s O – Ring Theory of Economic Development.
 Modern production requires that many activities be done

well together in order for any of them to amount to high

value. This is a strong form of complementarities and is a
natural way of thinking about specialization and division
of labor.
 The name for kremer’s Model is taken from the 1986

Challenger disaster, in which the failure of one small,

inexpensive part caused the space shuttle to explode.
 The key feature of the 0-ring model is the way it models

production with strong complementarities among inputs.

 The O-ring effects magnify the impact of local production

bottlenecks because such bottle necks have a

multiplicative effect on other productions.