Theories of Economic Development
What is Economic Development?
Economic Development occurs with the reduction and elimination of poverty, inequality and unemployment within a growing economy.
Gini coefficient This is a statistical measure of income distribution. A Gini coefficient of 0 means perfect equality.
Human Development Index (HDI)
Measures a country's average achievements in three basic dimensions of
human development: life expectancy, educational attainment and adjusted
real income (PPP$ per person).
What do theories and models try to do?
Economic development theories and models seek to explain and predict how:
- Economies develop (or not) over time
- Barriers to growth can be identified and overcome
- Government can induce (start), sustain and accelerate growth with appropriate development polices
Theories are generalizations.
While Less Developed Countries (LDCs) share similarities, every
country’s unique economic, social, cultural, and historical experience
means the implications of a given theory vary widely from country to
There is no
one agreed “model of development”. Each theory gives an insight into
one or two dimensions of the complex process of development. For
example, the Rostow model helps us to think about the stages of
development LDCs might take, while the Harrod-Domar model explains the
importance of adequate savings in that process.
Economic Development Concepts:
Absolute advantage Occurs when a country or region can create more of a product with the same factor inputs.
Comparative advantage The
basis of standard free trade theory. First introduced by David Ricardo
in 1817. Ricardo predicts all countries gain if they specialize and
trade the goods in which they have a comparative advantage. Comparative
advantage exists when a country has a margin of superiority in the
production of a good or service i.e. where the opportunity cost of
production is lower. This is true even if one of the trading nations is
more productive in all traded goods (has an absolute advantage)
compared to the other country.
The Rostow Linear Stages Model
This is a
linear theory of development. It argues that to achieve ?modernity? all
countries pass through the same stages of development Economies can be
divided into primary, secondary, and tertiary sectors. The history of
developed countries suggests a common pattern of structural change:
The Harrod-Domar Savings Model
The Harrod-Domar model developed in the l930s suggests that a
population’s savings provide the funds, which are borrowed for
investment purposes. Higher rates of savings can be transferred into
higher rates of investment to generate self-sustaining economic growth.
The Lewis Dual Sector Model
The Lewis model is structural change model that explains how labor
transfers in a dual economy. For Lewis growth of the industrial sector
drives economic growth.
The Solow Growth Model Economic growth is depends on the quantity and quality of resources and technology.
Theory Dependency refers to over reliance on another nation.
Dependency theory uses political and economic theory to explain how the
process of international trade and domestic development makes some LDCs
ever more economically dependent on developed countries
Growth Theory Balanced growth (or the big push) theory argues that as
a large number of industries develop simultaneously, each generates a
market for one another.
Unbalanced Growth Theory
Unbalanced growth theorists argue that sufficient resources cannot be
mobilized by government to promote widespread, coordinated investments
in all industries. Therefore, government planning or market
intervention is required in a few strategic industries. Those with the
greatest number of backward and forward links to other industries are
The Tobin Tax on foreign exchange transactions to reduce speculation and raise revenue for development
The Trickle Down Theory
Here the initial benefits of growth go the rich, but eventually trickle
down to the poor. For example, rich families buy local produce and
employ servants, etc
The Washington Consensus A set of liberalization polices advocated by free market economists to encourage growth.
Major Economic Development Models
This is a
linear theory of development. Economies can be divided into primary
secondary and tertiary sectors. The history of developed countries
suggests a common pattern of structural change:
Stage 1 - Traditional Society:
by subsistence economic activity i.e. output is consumed by producers
rather than traded, but is consumed by those who produce it; trade by
barter where goods are exchanged they are 'swapped'; Agriculture is the
most important industry and production is labor intensive, using only
limited quantities of capital.
Stage 2 - Transitional Stage:
precondition for takeoff. Surpluses for trading emerge supported by an
emerging transport infrastructure. Savings and investment grow.
Stage 3 - Take Off:
increases, with workers switching form the land to manufacturing.
Growth is concentrated in a few regions of the country and in one or
two industries. New political and social institutions evolve to support
Stage 4 - Drive to “Maturity”
Growth is now diverse supported by technological innovation.
Stage 5 - High Mass Consumption
Implications of Rostow's model
requires substantial investment in capital equipment; to foster growth
in developing nations the right conditions for such investment would
have to be created i.e. the economy needs to have reached stage 2.
o Savings and capital formation (accumulation) are central to the process of growth hence development.
o The key to development is to mobilize savings to generate the investment to set in motion self generating economic growth.
Development can stall at stage 3 for lack of savings – 15-20% of GDP
required. If the domestic Savings rate is 5%, then international
aid/loan must total 10-15% in order to plug the ‘savings gap’.
Resultant investment means a move to stage 4 Drive to Maturity and
self-generating economic growth
Limitations of Rostow's Model
model is limited. The determinants of a country's stage of economic
development are usually seen in broader terms i.e. dependent on:
o the quality and quantity of resources
o a country's technologies
o a countries institutional structures e.g. law of contract
explains the development experience of Western countries, well.
However, Rostow does not explain the experience of countries with
different cultures and traditions e.g. Sub Sahara countries which have
experienced little economic development.
Introduction to the Harrod-Domar model
The Harrod-Domar model developed in the l930s suggests savings provide the funds, which are borrowed for investment purposes.
The economy's rate of growth depends on:
- the level of saving and the savings ratio
- the productivity of investment i.e. economy's capital-output ratio
example, if £8 worth of capital equipment produces each £1
of annual output, a capital-output ratio of 8 to 1 exists. A 3 to 1
ratio indicates that only £3 of capital is required to produce
each £1 of output annually.
The Harrod-Domar model developed in the 1930’s to analyze business cycles. it was later adapted to ‘explain’ economic growth.
- Economic growth depends on the amount of labor and capital i.e. ?NY = f(K,L)
Developing countries have an abundant supply of labor. So it is a lack
of physical capital that holds back economic growth hence economic
- More physical capital generates economic growth. (use Production Possibility Boundaries to illustrate)
Net investment (i.e. investment over and above that needed to replace
worn out capital (deprecation) leads to more producer goods (capital
appreciation) which generates higher output and income. Higher income
allows higher levels of saving
Implications of the Harrod Domar Model
growth requires policies that encourage saving and/or generate
technological advances, which lower capital-output ratio.
Criticisms of the model
Domar on Domar: My purpose was to comment on business cycles, not to derive "an empirically meaningful rate of growth."
- It is difficult to stimulate the desired level of domestic savings
- Meeting a savings gap by borrowing form overseas causes debt repayment problems later.
Diminishing marginal returns to capital equipment exist so each
successive unit of investment is less productive and the capital to
output ratio rises.
amount of investment is just one factor affecting development e.g.
supply side approach (free up markets); human resource development
(education and training)
- Economic growth is a necessary but not sufficient condition for development
- Sector structure of the economy important (i.e. agriculture v industry v services)
Lewis Model - An Overview
model is structural change model that explains how labor transfers in a
dual economy. For Lewis growth of the industrial sector drives economic
growth. The Lewis Model argues economic growth requires structural
change in the economy whereby surplus labor in traditional agricultural
sector with low or zero marginal product, migrate to the modern
industrial sector where high rising marginal product.
Transferring surplus labor from rural to urban areas has no effect on agricultural productivity as MP of rural workers = 0.
profits are reinvested. Growth means jobs for surplus rural labor.
Additional workers in urban areas increase output hence incomes and
profits. Extra incomes increase demand for domestic products while
increased profits fund increased investment. Hence rural urban
migration offers self-generating growth.
of the modern sector to absorb surplus works depends on the speed of
investment and accumulation of capital. Where firms invest in new labor
saving capital equipment, surplus workers are not taken on by the
formal sector. Recently arrived rural migrants join the informal
economy and live in shantytowns
Given urban growth drives economic growth it can lead to the neglect of agriculture by government
Neglect of Agriculture – yet most people live in rural areas where incomes are relatively low
Increased profits may be invested in labor saving capital rather than taking on newly arrived workers
LDC's, rural urban migration levels have been far greater than the
formal industrial sector’s ability to provide jobs. Urban poverty has
replaced rural poverty.
Dependency theory - An Overview
refers to over reliance on another nation. Dependency theory uses
political and economic theory to explain how the process of
international trade and domestic development makes some LDC's ever more
economically dependent on developed countries ("DC's").
Dependency theory refers to relationships and links between developed and developing economies and regions.
theory sees underdevelopment as the result of unequal power
relationships between rich developed capitalist countries and poor
developed countries dominate dependent powerless LDC's via the
capitalist system. In the Dependency model under development is
externally induced (i.e. DC not LDC’s fault) system. Growth can only be
achieved in a closed economy and pursue self-reliance through planning.
DC's have such a technological and industrial advantage that they can
ensure the ‘rules of the game’ (as set out by World Bank and IMF) works
in their own self-interest.
This partly explains the hostility shown towards the WTO in Seattle in 1999.
model under development is externally induced (i.e. DC not LDC’s fault)
and only a break up of the world capitalist system and a redistribution
of assets (e.g. elimination of world debt) will ‘free’ LDC's
Balanced Growth Theory
growth involves the simultaneous expansion of a large number of
industries in all sectors and regions of the economy. Balanced growth
(or the big push) theory argues that as a large number of industries
develop simultaneously, each generates a market for one another.
If a large
number of different manufacturing industries are created simultaneously
then markets are created for additional output. For example, firms
producing final goods can find domestic industries that can supply them
with their inputs. The benefits of growth are spread over all sectors
and, ideally, regions.
Balanced growth theory is an extension of Say’s Law the demand for one product is generated by the production of others
It is argued that free markets are unable to deliver balanced growth because entrepreneurs:
- Do not expect a market for additional output – why risk resources when sales are uncertain?
Require skilled workers but are not willing to hire and train unskilled
staff who may then leave to work for rival firms – employers cannot
‘internalize their positive externalities
- Do not anticipate the positive externalities generated by the investment of other firms engaged in expansion
- Are unable to raise finance for projects
government can co-ordinate simultaneous investment in many industries
one firm provides a market for another. This requires state planning
and intervention to:
- Train labor
- Plan and organize the large-scale investment program.
- Mobilize the necessary finance
- Nationalize strategic industries and undertake infrastructure investments e.g. build roads
- Protect infant industries through tariff (tax on imports) and quota (limit on quantity of imports) policies
strategy of balanced growth is beyond the resources of most poor
countries; Balanced growth within a closed economy rather than
specialization and trade contradicts comparative advantage
planning results in government failure i.e. government intervention in
the market fails to bring about an efficient allocation of resources
e.g. planning process creates a bureaucracy.
development policies focusing on import substitution, agricultural
self-sufficiency and state control of production yield poor growth.
Unbalanced Growth Theory
growth theorists argue that sufficient resources cannot be mobilized by
government to promote widespread, coordinated investments in all
analysis with balanced growth theorists that free markets, alone,
cannot generate development but differ in that government planning or
market intervention is required just in strategic industries.
Those with the greatest number of backward and forward links are prioritized.
A country lacks resources to finance balanced growth. Resources are therefore concentrated on strategic industries with:
- Significant forward linkages i.e. firms creating essential inputs for other key firms in the economy
- Significant backward linkages i.e. key firms buy industrial inputs from a large number of domestic firms
- Import substitution. Developing domestic industries replaces imports and so improves the balance of payments.
Government identifies strategically important areas with significant backward and forward linkages to
- Nationalize (planned economy) or
- Subsidies (market economy).
owned development banks finance priority investment projects chosen for
their contribution to growth and development goals.