Chapter 3

Classic Theories of Economic Development

We have Four Approaches:
1) Linear Stages of Growth Model
a) Rostow’s Stages of Growth
b) The Harrod-Domar Growth Model

2) Theories and Patterns of Structural Change

a) The Lewis Theory of Economic Development

3) International-Dependence Revolution
a) The neocolonial dependence model
b) The false-paradigm model
c) The dualistic-development thesis

4) The Neoclassical Counterrevolution

A. Market Fundamentalism

a. Free market approach

b. Public choice approach
c. Market-friendly approach

B. Traditional Neoclassical Growth Theory

a. The Solow neoclassical growth model
 Linear Stages of Growth Model

This approach underlines the crucial role of savings and investments in creating
sustainable long-term growth. It can be implemented through the following two
models:

a) Rostow’s Stages of Growth

Rostow argued that economies must go through a number of developmental

stages towards greater economic growth. He argued that these stages followed a
logical sequence; each stage could only be reached through the completion of
the previous stage.

Stages of Growth

1. Traditional society, dominated by agriculture and barter exchange, and where

science and technology are not understood or exploited.

2. Pre-take-off stage, with the development of education and an understating of

science, the application of science to technology and transport, and the emergence of
entrepreneurs and a simple banking system, and hence rising savings.

3. Take-off, with positive growth rates in particular sectors and where organized
systems of production and reward replace traditional methods and norms.

4. The drive to maturity, with an ongoing movement towards a diverse economy, with
growth in many sectors.

5. The stage of mass consumption, where citizens enjoy high and rising consumption
per head, and where rewards are spread more evenly.

Rostow’s work points to the significance of the accumulation of savings to achieve

take-off – in this case as a necessary condition for the movement from traditional to
developed societies
 b) The Harrod-Domar Growth Model
According to this theory, there are two determinants of the rate of growth of a
country. The first looks at the relationship between changes in the capital stock of a
country, that is its capital investment, and its output, called the capital-output ratio.
It indicates how much capital is needed to generate a given amount of national output.
The second element of the model considers the relationship between savings and
national income is called the saving ratio.it indicates the ratio of savings to national
income.
The model indicates how these two ratios affect the rate of growth. Essentially, the
higher the savings ratio, the more an economy will grow; and the higher the capital-
output ratio, the higher the rate of growth.

For Harrod and Domar, economies must save and invest a certain proportion of their
income to grow at a certain rate – failure to develop is caused by the failure to save,
and accumulate capital. For take-off to happen, savings must be accumulated.

Where :
s = the saving rate
Y = GDP
K = CAPITAL
C= capital output ratio = how much capital needed to increase Y by one unit.
I = INVESTMENT
 the l.h.s represents the economic growth rate and the c in the r.h.s represents
the productivity of the country. So, to increase growth saving should be
increased or decrease the capital output ratio

Evaluation of linear stage theory

The theories of Rostow, Harrod and Domar, and others consider savings to be a
sufficient condition for growth and development. In other words, if an economy
saves, it will grow, and if it grows, it must develop. Aggregate savings are largely
determined by national income, so if income is low, savings will not be
accumulated. According to Rostow’s theory, saving between 15% and 20% of
income (a savings ratio of 0.15 – 0.20) would be enough to provide the basis for
growth. If this level of saving is maintained, growth would also be sustained.

Major criticisms of this approach include:

1. It assumes that economic growth creates automatically economic development

in developing countries which is not true. That is, economic growth is necessary
but not sufficient.
2. Most analysis was based on the reconstruction of Europe after World War II, but
most developing countries do not have Europe’s institutions, attitudes, financial
markets, levels of education, and desire to succeed as found in Europe.
3. Modern theory tends to see savings as a necessary but not sufficient condition
for growth.

Structural-Change Models
This approach focuses on the structure of the economy .It underlines the importance of
analysis of numerous relationships between the traditional agriculture and modern
industry. It can be implemented through the following model:
 a) The Lewis Model
It is also known as the two sector model, and the surplus labor model. It focused on the
need for countries to transform their structures, away from agriculture, with low
productivity of labor, towards industrial activity, with a high productivity of labor.

In the Lewis model the line of argument runs:

 An economy starts with two sectors; a rural agricultural sector and an urban
industrial sector. Agriculture generally under-employs workers and the marginal
productivity of agricultural labor is virtually zero. Therefore, transferring workers
out of agriculture does not reduce productivity in the whole economy.

 Labor is then released for work in the more productive, urban, industrial sector.

 Industrialization is now possible, given the increase in the supply of workers who
have moved from the land.

 Industrial firms start to make profits, which can be re-invested into even more
industrialization, and capital starts to accumulate.

 As soon a capital accumulates, further economic development can sustain itself.

Graph

From the graph:

1- At point a , which is the maximum level of production the marginal

productivity of labor =0 , so we have labor surplus.labors are paid
according to their average productivity.

2- In the industrial sector , the marginal productivity is greater than 0 ,

so the labor wage is higher. the agric sector will supply labors only if
 the wage is above wa because Lewis assumed that the supply of
labor is perfectly elastic.
3- Labors will move from agricultural sector to manfacture sector.
4- Manfacture sector gets larger . so produce more and realize more
profit.
5- Manfacture sector invest more and attracts more labors till surplus
reaches zero which is a turning point

So Lewis sees that the benefit comes automatically through

transmission from agri to manfac.

Evaluation of the Lewis model

Though highly influential at the time, and despite the considerable logic of the
Lewis approach, the benefits of industrialization may be limited because:

 Profits may leak out of the developing economy and find their way to developed
economies through a process called capital flight.

 Capital accumulation may reduce the need for labor in the urban industrial
sector.

 The agricul sector may have shortage of labor.

 There is countries like Russia that didn’t have labor surplus

 The model assumes competitive labor and product markets, which may not exist in
reality.

 Urbanization may create problems, such as poverty, , with unemployment

replacing underemployment.

 The financial benefits from industrialization might not trickle down to the
majority of the population.

The International-Dependence Revolution

This approach argued that underdevelopment exists because of the dominance
of developed countries and multinational corporations over developing countries
and that the decisions of the developed countries, indeed, can affect the life of
millions of people in the developing world. The theory is considered an extension
of Marxist theory.

The poor countries are said to be dependent on the developed countries for
market and capital. However, developing countries received a very small portion
of the benefits that the dependent relationship brought about. The unequal
exchange, in terms of trade against poor countries, made free trade a convenient
vehicle of “exploitation” for the developed countries. Developed countries can
exploit national resources of developing countries through getting cheap supply
of food and raw materials. Meanwhile, poor countries are unable to control the
distribution of the value.

It can be implemented through the following three models:

(a) Neo-Colonial Dependence Model: It is an indirect outgrowth of Marxist

thinking. It refers to the existence and continuance of underdevelopment in a
highly unequal international capitalist system. The international system is
dominated by unequal power relationships between the centre (the developed
nations) and the periphery (the less developed countries). The poor nations
attempt to become self-reliant and independent but this system makes it difficult
and sometimes even impossible.

According to this theory, certain groups in the developing countries who enjoy
high incomes, social status, and political power constitute a small elite ruling
class whose principal interests are in perpetuation of the international capitalist
system of inequality.

Directly and indirectly, they serve (are dominated by)and are rewarded by (are
dependent on) international special-interest power groups including
multinational corporations and multilateral assistance organizations like the
World Bank or the (IMF).

Therefore, a major restructuring of the world capitalist system is required to free

dependent developing nations from the direct and indirect economic control of
their developed-world and domestic oppressors.
(b) False-Paradigm Model: This model attributes underdevelopment to faulty
and inappropriate advice provided by well-meaning but often uninformed,
biased international ‘expert’ advisers from developed-country assistance
agencies and multinational donor organizations.

These experts offer sophisticated concepts, elegant theoretical structures, and

complex econometric models of development that often lead to inappropriate or
incorrect policies.

Because of institutional factors such as the central and remarkably resilient role
of traditional social structures (i.e., tribe, caste, class, etc.), the highly unequal
ownership of land and other property rights, the disproportionate control by
local elites over domestic and international financial assets, and the very unequal
access to credit, these policies merely serve the vested interests of existing
power groups, both domestic and international.

(c) Dualistic Development Thesis: Dualism represents the existence and

persistence of increasing divergences between rich and poor nations and rich
and poor people on various levels. One of the elements of dualism is that there
is a coexistence of wealthy, highly educated elites with masses of illiterate poor
people within the same country or city.

According to this theory, there is a coexistence of powerful and wealthy

industrialized nations with weak, impoverished peasant societies in the
international economy.

This coexistence is chronic and not merely transitional. It is not due to a

temporary phenomenon, in which with the capacity of time, the discrepancy
between superior and inferior elements would be eliminated.

The Neoclassical Counterrevolution

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.so , by permitting competitive free markets to flourish, privatizing
state-owned enterprises, promoting free trade and export expansion, welcoming
 investors from developed countries, and eliminating the plethora of government
regulations and price distortions in factor, product, and financial markets, both
economic efficiency and economic growth will be stimulated. What is needed,
therefore, is not a reform to guide resource allocation and stimulate economic
development of the international economic system, Rather, it is simply a matter
of promoting free markets This approach can be implemented through the
following three models:

A. Market Fundamentalism

(a) Free-Market Analysis: Free-market analysis argues that markets alone are
efficient if:

 Product markets provide the best signals for investments in new activities,
 Labour markets respond to these new industries in appropriate ways,
 Producers know best what to produce and how to produce it efficiently, and
 Product and factor prices reflect accurate scarcity values of goods and resources.

Under free-market, competition is effective if not perfect. Technology is freely

available and nearly costless to absorb. Information is correct and nearly costless
to obtain.

Under these circumstances, any government intervention in the economy is by

definition distortionary and counterproductive.

(b) Public-Choice Theory: Public-choice theory, also known as ‘new political

economy approach’, goes even further to argue that government can do nothing
right. This is because that politicians, bureaucrats, citizens and states act solely
from a self-interested perspective, using their powers and the authority of
government for their own selfish needs. Citizens use political influence to obtain
special benefits from government policies. Politicians use government resources
to consolidate and maintain positions of power and authority. Bureaucrats use
their positions to extract bribes from citizens and to operate protected business
on the side. And finally state uses its power to confiscate private property from
individuals. The net result is not only a misallocation of resources but also a
general reduction in individual freedoms. The conclusion, therefore, is that
minimal government is the best government.
(c) Market-Friendly Approach: This approach recognizes that there are many
imperfections in LDC product and factor markets and that governments do have
a key role to play in facilitating the operation of markets through ‘non-selective’
(market-friendly) interventions — for example, by investing in physical and social
infrastructure, health care facilities, and educational institutions and by providing
a suitable climate for private enterprise.that is to intervene only selectively in the
economy in areas where the market is inefficient

B. The Solow Neoclassical Growth Model

Solow's Neoclassical Growth Model: Solow extended Harrod-Domar model in
two ways. First, he considered labor as a second factor of production. Second, he
introduced a third independent variable, technology.

According to the theory, output growth results from one or more of three
factors: increases in labor quantity and quality (through population growth and
education), increases in capital (through saving and investment), and
improvements in technology.
Increasing any one of these inputs shows the effect on GDP and, therefore, the
equilibrium of an economy. However, if the three factors of neoclassical growth
theory are not all equal, the returns of both unskilled labor and capital on an
economy diminish, which implies that increases in these two inputs have
exponentially decreasing returns (diminishing returns to labor and capital
separately and constant returns to both factors jointly) . Technology, on the
other hand, is boundless in the growth that it can add and the output it can
produce.

The Production Function of the Neoclassical Growth Theory

Y = AF (K, L).

"Y" denotes an economy's gross domestic product (GDP),

"K" represents stock of human and physical capital,

"L" describes the amount of unskilled labor in an economy

and "A" = constant , represents a determinant level of technology.

a is the elasticity of output with respect to capital and assumed to be less than one.

(the percentage increase in GDP resulting from a 1% increase in human and physical
capital).

Solow's growth model showed how the liberalization of national markets could
draw additional domestic and foreign investment and thus increase the rate of
capital accumulation which is equivalent to raising domestic savings rate.

The model explained that since in the developed countries, capital is relatively
more abundant compared to the developing countries, according to the law of
diminishing returns, capital would have a lower return in the developed countries
compared to the developing countries. As a result capital would have a natural
tendency to go towards the developing countries where the rate of return is higher.
So from the developing country's context, the best strategy would be to open up
the country to foreign capital and to remove all restrictions on inflow of foreign
capital.

The Solow neoclassical growth model implies that economies will converge to the
same level of income per worker “conditionally”—that is, other things equal,
particularly savings rates, depreciation, labor force growth, and productivity.