DEVELOPMENT ECONOMICS I

MODULE II

Prepared by: Fredu Nega

MEKELLE UNIVERSITY
FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS

December 5, 2005
 Table of Contents Page
4. Determinants of Economic Development 4
Introduction 4
4.1 Traditional Approach (Economic Factors) to Development 4
a) Natural Resource 4
b) Capital Accumulation 5
c) Organization 5
d) Technological Progress 6
e) Division of Labour and Scale of Production 6
4.2 Institutional Approach to Development 7
a) Type of Government 7
b) Institutions 8
c) Social Structure of Population 9
d) Social Capital and Cultural Traits 9

5. Inequality, Poverty and Development 10

Introduction
5.1 Inequalities of Income: Concepts and Measurement 11
a) Size Distribution 11
b) Functional Distribution 17
5.2 Inequalities and Absolute Poverty 18
a) Inequality: Variation Among Countries 18
b) Absolute Poverty: Extent and Magnitude 20
5.3 Inequality, Growth and Extent of Poverty 22
a) The Inverted U - Hypothesis 23
5.4 Growth Versus Income Distribution 25
a) The traditional Argument: Factor shares, Saving and Economic growth 26
b) Counterargument 26
5.5 The Range of Policy Options: Some Basic Considerations 29
a) Areas of Intervention 29
b) Policy Options 30
6. International Trade and Economic Development 36
Introduction
6.1 Trade Theory and Development: the Traditional Argument 37
6.2 Arguments Against Free Trade within the Context of Developing Countries 38
a) Fixed Resources, Full Employment, and the International Immobility of
Capital and Skilled Labor 39
b) International factor mobility and multinational corporations 44
c) Fixed, Freely Available Technology and consumer Sovereignty 44
d) Internal factor Mobility and Perfect Competition: 46
e) The Absence of National Governments in Trading Relations 47
f) Balanced Trade and International Price Adjustments 48
g) Trade Gains Accruing to Nationals 49
6.3 Some Conclusions on Trade and Economic Development: The limits
of Theory 50
6.4 The Terms of Trade and the Prebisch-Singer Thesis 51

2
 INTRODUCTION

This is the second module of Development Economics I. In the first module you have
seen general concepts about Development including its historical background,
different models of growth and development.

Module II of Development Economics I basically has three parts. In part I, we will

look at the determinants of Economic Development. Two approaches to the
determinants of economic development will be discussed. Part II is devoted to
inequality, poverty and development. In this part, concepts like inequality and its
measurements, absolute poverty, growth versus income distribution will be discussed.
The last part deals with the relationship between International Trade and
Development. Here the two approach – the traditional argument and the counter
argument will be discussed in the context of Less Developed Countries.

3
Chapter IV
DETERMINANTS OF ECONOMIC DEVELOPMENT
Introduction

Today, countries of the world are divided into rich (developed) countries and
poor (developing) countries. There is a wide gap between the rich and the poor
countries. The statement that “the rich nations get richer and the poor countries
get poorer” has become popular in the literature in world poverty. But what are
the explanations for the poor performance of the developing countries? There
are two approaches to explain the determinants of economic development the
traditional approach and the institutional approach.

4.1 Traditional Approach (Economic Factors) to Development

The traditional approach to development assumes that economic development

is determined by economic factors, like natural resources, capital, technology,
etc. Let’s see each of the major economic factors

a) Natural Resources.
The principals factor affecting the development of an economy is the natural
resources or land. “Land” as used in economic includes natural resources such
as fertility of land, its situation and composition, forest wealth, minerals,
climate, water resources, sea resources, geographical proximity with rich
countries etc. For growth, the existence of natural resources in abundance is
essential. A country which is deficient in natural resources will not be in a
position to develop rapidly. As pointed out by Lewis, “Other things being
equal, men can make better use of rich resources than they can of poor.”
In LDCs natural resources are either unutilized, underutilized or misutilized.
These is one of the reasons for their backwardness. The presence of natural
resources is not sufficient for economic growth. What is required is their
proper exploitation.

4
It is often said that economic growth is possible even when an economic is
deficient in natural resources. As pointed out by Lewis, “A country which is
considered to be poor in resources today may be considered very rich in
resources at some later time, not merely because unknown resources are
discovered, but equally because new uses are discovered for the known
resources.” Japan is one such country which is deficient in natural resources
but it is one of the advanced countries of the world because it has been able to
discover new uses for limited resources.

b) Capital Accumulation
Capital means the stock of physical reproducible factors of production. When
capital stock increases with the passage of time, it is called capital
accumulation or capital formation. Capital formation is investment in capital
goods that leads to increase in capital stock, national output and income.
Capital formation is the key to economic development. On the one hand it
reflects effective demand and on the other hand, it creates productive efficiency
for production. Capital formation possesses special importance to LDCs. The
process of capital formation leads to the increase in national output in a number
of ways. Capital formation is essential to meet the requirements of an
increasing population in such economies. Investment in capital goods not only
raises production but also employment opportunities. It is capital formation
that leads to technological progress. Technological in turn leads to
specialization and the economies of large scale production. The provision of
social and economic over heads, like transport, power education etc in a
country is possible through capital formation. It is also capital formation that
leads to the exploitation of natural resources, industrialization and expansion of
markets which are essential for economic progress.

c) Organization
Organization is an important part of the growth process. It relates to the
optimum use of factor of production economic activities. Organization is

5
complement to capital and labour and helps in increasing their product
activities. In modern economic growth, the entrepreneur has been performing
the task of an organizer and undertaking risks and uncertainties.

The underdeveloped countries lack entrepreneurial activity. Such factors as the

small size of the market, capital deficiency, absence of private property and
contract, lack of skilled and trained labour, non-availability of adequate raw
materials and infrastructural facilities like transport, power, etc increase risk
and uncertainties. That is why such countries lack entrepreneurs.

d) Technological Progress
Technological charges are regarded as the most important factor in the process
of economic growth. They are related to changes in the methods of production
which are the result of some new techniques of research or innovation.
Changes in Technology lead to increase in productivity of labour, capital and
other factors of production.

e) Division of labour and scale of production

Specialization and division of labour lead to increase in productivity. They
lead to economies of large scale production which further help in industrial
development. Adam Smith gave much importance to the division of labour in
economic development. Division of labour leads to improvement in the
productive capacities of labour. Every laborer becomes more efficient than
before. S/he saves time. S/he is capable of inventing new machines and
process in production. Ultimately production increases manifold. But division
of labour depends upon the size of the market. The size of the market, in turn,
depends upon economic progress, i.e. the extent to which the size of demand,
the general level of production, the means of transport etc are developed. When
the scale of production is large there is greater specialization and division of
labour. As a result production increases and the rate of economic progress is
accelerated.

6
Underdeveloped countries are unable to take advantage of the economics of
division of labour and large scale production due to the presence of market
imperfections, which in turn keep the size of the market small.

4.2 Institutional Approach to Development

The institutional approach to development is a recent phenomenon. It argues
that explanations of the poor economic development are found not only in
economic factors but also non-economic factors. In fact most of these factors
are explained by non-economic factors or institutional factors.

The institutional approach to development emphasizes importance of the

institutional factors more than the economic factors using the case of a
metropolitan city. The central city in a metropolitan area, while gaining some
high-rise buildings, has a stagnant population and an increasing proportion of
poor people. On the other hand suburbs are prosperous and growing rapidly.

To a certain degree, modern economics is like such a metropolitan area. The

traditional economics is at the center of the city. At the same time, the suburbs
of economics are expanding rapidly in all directions. The institution approach
to development is a case in point. For example, consider shifting the focus
from capital and other resources toward the quality of governance. In the
suburbs of economics, governance is a focus, but not in the city center where
capital is the focus.

The institutional factor further argues that most of the economic factors can be
obtained in the globalize market. For example, many MNCs are ready to invest
a significant amount of capital if conditions are favorable. Besides LDCs can
also borrow technologies from DCS.

7
The institutional factors that determine economic performance include.
a) Type of Government
A country with a monarchy system is less likely to develop as compared with a
country with a democratic government. The nature of democracy depends on
the level of education, discipline, culture etc of the people. In maintaining
rules, governments could be soft or strong. To maintain rules and there by
prepare the ground for development, governments need be strong. To provide
for the enforcement of contracts, the prevention of anarchy, and the provision
of other public good, the coercive power of government is necessary.

Good governance is another important factor which determinants economic

performance of countries. According to Olson M. “Governance is a decisive
determinant of economic performance and that with the right economic policy
and institutions, poor countries can grow at a very rapid rate.” Good
governance is reflected by long tem vision, correct policies and effective
implementation. For example, in Japan the government decided what type of
industries to develop after World War II. It gave emphasis to textile, iron and
steel, shipbuilding etc. In recent years, the government shifted towards
electronics in response to a change in world market.
Another aspect of good governance is the development of infrastructure.
Countries like Hong Kong, Singapore, Malaysia, etc develop infrastructure and
attract foreign capital.

b) Institutions
Availability of technology like the capital good, complementary factors like
infrastructure, highly skilled labor, innovation etc are required for an economy
to grow. To have such technological changes requires a good institution. For
example, in making innovations, there could be resistance. To calm such
resistance, government effort is required. Thus, institutions that encourage
technological innovation and suitability of institution for successful adoption of
new ideas is an important question. Political and cultural dynamism help in

8
adoption of new technology and the negative forces such as labour union
orthodoxy should be managed properly by good governance. Spread of
education, scientific culture are necessary for adoption of new technology
Reservation/Affirmative Action/. Social justice requires that if some sections
of the society are deprived, they must be given special attention i.e. reservation
is needed. The supporters of reservation justify its use in terms of social justice,
equity and to rectify historical mistakes. However, from the point of view of
efficiency, it is not justified.

c) Social Structure of Population.

In some countries, we get a homogenous type of population. Homogeneity of
the population leads to the development of national feelings, which is helpful
for economic development – for example China, Japan, Korea, Russia. On the
other hand, population of a country could also be heterogeneous - divided on
the basis of language, religion, ethnicity, caste etc. In such societies, some
groups play entrepreneurial role. For example, the Jews in USA.

d) Human Capital and Cultural Traits.

The difference in per capita income among countries could be explained by
human capital and cultural traits. In the DCs, human capital and cultural traits
in the form of work culture, discipline, good entrepreneurship etc have played
an important role. Poor countries are poor because they lack these traits. The
cultural traits that perpetuate poverty are the result of centuries of social
accumulation and they can’t be changed quickly. Cultural advancement
according to M. Olson results in two types of human capital:
a) Marketable human capital - these include more skill, propensity to
work harder, more entrepreneurial personality - these qualities result
in increase in the quality and quantity of productive outputs. These
results in increase in income of persons, groups as well as of nations.
b) Civic culture. A civic culture leads to the election of good
government which adopts good policy. It also results in a disciplined
society. Corruption will be less. People pay tax.

9
CHAPTER V
INEQUALITY, POVERTY AND DEVELOPMENT
Introduction
The 1970, witnessed a remarkable change in public and private perceptions
about the ultimate nature of economic activity. In both rich and poor countries,
there was a growing disillusionment with the idea that relentless pursuit of
growth was the principal economic objective of society. In the developed
countries, the major emphasis seemed to shift toward more concern for the
quality of life, a concern manifested mainly in the environmental movement.

In the poor countries, the main concern focused on the question of growth
versus income distribution. That development required a higher GNP and
faster growth rate was obvious. The basic issue, however, was (and is) not
only how to make GNP grow but also who would make it grow, the few or the
many. If it were the rich, it would most likely be appropriated by them, and
poverty and inequality would continue to worsen. But if it were generated by
the many, they would be its principal beneficiaries, and the fruits of economic
growth would be shared more evenly.

In this chapter, we will examine the following five critical questions about the
relationship between economic growth, income distribution and poverty
1. What is the extent of relative inequality in developing countries, and
how is this related to the extent of absolute poverty
2. Who are the poor, and what are their economics characteristics?
3. What determines the nature of economics growth that is, who benefits?
4. Are rapid economic growth and more equitable distributions of income
compatible or conflicting objectives for low income countries? To put it
another way, is rapid growth achievable only at the cost of greater
inequalities in the distribution of income, or can a lessening of income
disparities contribute to higher growth rates?
5. What kinds of policies are required to reduce the magnitude and extent
of absolute poverty?

10
 5.1 Inequalities of income: Concepts and Measurement
We can get some idea to question 1 and 2 relating to extent and
character of inequality and poverty in developing countries by pulling
together same recent evidence from a variety of sources. In this section
we define the dimensions of income distribution and poverty problems
and identify some similar elements that characterize the problem in
many developing countries. But first we should be clear about what we
are measuring when we speak about the distribution of income.

Economists usually like to distinguish between two principal measures

of income distribution for both analytic and quantitative purposes.
- The personal or size distribution of income
- 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 income 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 rual) and occupational sources of the income (e.g.
agriculture, manufacturing, commerce, services) are neglected. If Ato Abebe
and W/ro Mulu both receive the same personal income, they are classified
together irrespective of the fact that W/ro Mulu may work 15 hours a day as a
doctor which Ato Abebe does not work at all but simply collects interest on his
inheritance.

Economists and statisticians, therefore, like to arrange all individuals by

ascending personal incomes and than divided the total population in to distinct

11
groups or sizes. A common method is to divide the population in to successive
quintiles (fifths) or deciles (tenths) according to the ascending income levels
and then determine what proportion of the total national income is received by
each income group.
Table 5.1 Size distribution of personal income in a developing country by
Income shares quintiles & Deciles
Personal income Percentage share in total income
Individuals (Money Units) Quintiles Deciles
1 0.8
2 1.0 1.8
3 1.4
4 1.8 5 3.2
5 1.9
6 2.0 3.9
7 2.4
8 2.7 9 5.1
9 2.8
10 3.0 5.8
11 3.4
12 3.8 13 7.2
13 4.2
14 4.8 9.0
15 5.9
16 7.1 22 13.0
17 10.5
18 12.0 22.5
19 13.5
20 15.0 51 28.5
Total 100.0 100 100.0
Measure of inequality = total of bottom 40% to 20% = 14/51 = 0.28

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 in to
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 5 money units) of the national income. The second quintile (individuals 5 -
8) receives 9% of the total income. Alternatively the bottom 40% of the

12
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 bottom 40% and top 20% of the
population. This ratio is often used as a measure of the degree of inequality
between the too extremes of very poor and very rich in a country. In our
example, this inequality ratio is equal to 14 divided by 51, or approximately 1
to 3.7 or 0.28.

To provide a more detailed breakdown of the size distribution of income,

deciles (10%) shares are listed in column 4. We see, for example, that the
bottom 10% of the population (the two poorest individuals) is receiving only
1.8% of the total income, while the top 10% (the two richest individuals)
receives 28.5% of the total income.

Lorenz Curve

13
 Another common way to a personal income statistics is to construct what is
known as a Lorenz curve. The Lorenz curve is shown below.
O’
100

90

80

70
Percentage of income

Line of Equality
60
I.

50 E

40 H.

30 G.

F.
20
E
D.
10
C.
B.
A.
O 10 20 30 40 50 60 70 80 90 100
Percentage of income recipients
Fig. 5.1 Lorenz Curve

Dear students, as usual, we have the vertical axis and horizontal axis in the
above diagram. On the horizontal axis, the number of income recipients is
plotted, 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

14
by each percentage of the population; it also is cumulative up to 100% meaning
that both axes are equally long.

The entire figure is enclosed in a square; a diagonal line (00’) is drawn from
the lower left corner (the origin) of the square to the upper right corner. At
every point on the diagonal 00’ the percentage of income received is exactly
equal to the percentage of income recipients, for example, at point E, which is
the point half way the length of the diagonal line, represents 50% of the income
being distributed to exactly 50% of the population. Similar, at the three quarter
point on the diagram, 75% of the income would be distributed to 75% of the
population. In other words, the diagonal line 00’ is representative of "perfect
equality" in size distribution of income.

The Lorenz curve shows the actual quantitative relationship between the
percentages of income recipients and the percentage of the actual income they
did in fact receive during, say, a given year. In figure 5.1 we have plotted this
Lorenz curve using the docile data contained to each of the 10 deciles groups.
Point A shows that the bottom 10% population receives only 1.8% of the total
income; point B shows that the bottom 20% is receiving 5% of the total
income, and so on for each of the other eight cumulative deciles groups. Note
that at the halfway point, 50% of the population is in fact receiving only 19.8%
of the total income.

The more the Lorenz line curves is away from the diagonal (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 ever body 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 Figure5.1. The

15
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). (Can
you explain why the Lorenz curve could not lie above or to the left of the
diagonal at any point?)

Exercise 5.1
Using the quintiles data on table 5.1, draw a Lorenz Curve

Gini Coefficient
A final and very convenient short hand 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
half square in which the curve lies. This is shown below.

Gini Shaded Area A

Coefficient = Total Area BCD

16
In the above diagram (fig 5.3) the ratio of the shaded area A to the total area of
the triangle BCD is known as the Gini concentration ratio or more simply as
the Gini coefficient, named after the Italian statistician who first formulated it
in 1912.

Gini coefficients are aggregate inequality measures and can vary any where
from 0 (perfect equality) to 1 (perfect inequality). Gini coefficients for
countries with highly unequal income distributions typically lies between 0.50
and 0.70 while for countries with relatively equitable distributions, it is on the
order of 0.20 to 0.35.

b) Functional Distribution
The second common measure of income distribution used by economists, the
functional or factor share distributions of income, attempts to explain the share
of total national income that each of the factors of production (land, labour and
capital) receives. Instead of looking at individuals as separate entities, the

17
 theory of functional income distribution inquires into the percentage that labour
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 return 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.

5.2 Inequality and Absolute Poverty

a) Inequality: Variations among Countries

TABLE 5.2 Some Income Distribution Estimates, 1990s

Quintile
Country 1st 2nd 3rd 4th 5th Highest 10% Year
9.4 13.5 17.2 22.0 37.9 23.7 1992
Bangladesh

Botswana 3.6 6.9 11.4 19.2 58.9 42.9 1986

Brazil 2.5 5.7 9.9 17.7 64.2 47.9 1995
Colombia 3.1 6.8 10.9 17.6 61.5 46.9 1995
Costa Rica 4.0 8.8 13.7 21.7 51.8 34.7 1996
Ghana 7.9 12.0 16.1 21.8 42.2 27.3 1992
Guatemala 2.1 5.8 10.5 18.6 63.0 46.6 1989
Honduras 3.4 7.1 11.7 19.7 58.0 42.1 1996
India 9.2 13.0 16.8 21.7 39.3 25.0 1994
Jamaica 5.8 10.2 14.9 21.6 47.5 31.9 1991
Pakistan 8.4 12.9 16.9 22.2 39.7 25.2 1991
Peru 4.9 9.2 14.1 21.4 50.4 34.3 1994
Philippines 5.9 9.6 13.9 21.1 49.6 33.5 1994
South Africa 3.3 5.8 9.8 17.7 63.3 47..3 1993
Zambia 3.9 .8.0 13.8 23.8 50.4 31.3 1993
Averages 5.2 8.5 13.7 20.8 51.8 36.0

As a first step in determining the significance of the income distribution and

poverty problems in developing countries, let's observe the following table

18
 The figures in the above table (table 5.2) give a first approximation of the
magnitude of income inequality in these developing countries. For example,
we see from the last row that by averaging income shares for different
percentile groups among all 15 countries, on average the poorest 20% of the
population receives only 5.2 of the income the highest 10% and 20% receive
36.0 and 51.8% respectively. By contrast, in a developed country like Japan,
the poorest 20% receives a much higher 8.7% of the income while the richest
10% and 20% get only 22.4% and 37.5% respectively.

Exercise 5.2
What is the relationship between levels of per capita income and degree of inequality? Are
higher incomes associated with greater or lesser inequality or can no definitive statement be
made?

The following table (table 5.3) provides data on income distribution in relation
to per capita GNP for a sample of 10 developing countries.
Table 5.3 Per Capita Income and Inequality in Developing Countries, 1990s
Country GNP per capita Income Share of Ratio of Highest Gini
1996 (US $) Lowest 40% of 20% to Lowest Coefficient
Households 20%
Bangladesh 260 22.9 4.0 0.28
Kenya 320 10.1 18.3 0.58
Sri Lanka 740 22.0 4.4 0.30
Indonesia 1080 20.4 5.1 0.34
Philippines 1160 15.5 8.4 0.43
Jamaica 1600 16.0 8.2 0.41
Paraguay 1850 8.2 27.1 0.59
Costa Rica 2640 12.8 12.9 0.47
Malaysia 4370 12.9 11.7 0.48
Brazil 4400 8.2 25.7 0.60

19
Income distribution in measured in three ways as the total share of income
received by the poorest 40% of the population, as the ratio of the share going to
the richest 20% divided by that of the poorest 20% and as measured by the Gini
coefficient.

What clearly emerges from table 5.3 is that per capita incomes are not highly
correlated with any of our three measures of inequality. For example, we see
that Sri Lanka has only one-sixth the per capita income of Brazil, but its three
inequality measures are much less pronounced than Brazil’s. Its Gini
coefficient is 0.30 compared to Brazil's 0.60. Similarly, Paraguay, with income
seven times higher than that of Bangladesh, shows much greater inequality.
Conversely, Malaysia, with a 1996 per capita income that is 65% higher than
Costa Rica, has inequality measures that are not much different. We can
conclude, therefore, that there is no apparent relationship between levels of per
capita income and the degree of income concentration over relevant range of
LDC incomes.

b) Absolute poverty: Extent and magnitude

So far, we have been looking at relative income shares. Now let's switch our
attention from relative income shares of various percentile groups with in a
given population to the more significant question of the extent and magnitude
of absolute poverty in developing countries.

What is absolute poverty?

During the 1970'S as interest in problems of poverty increased, development
economists took the first step in measuring its magnitude within and across
counties by attempting to establish a common poverty line. They devised the
now widely used concept of Absolute Poverty.

Absolute poverty is meant to represent a specific minimum level of income

needed to satisfy the basic physical needs of food, clothing and shelter in order

20
to ensure continued survival extent of obsolete poverty is therefore the
number of people who are unable to command sufficient resources to satisfy
basic needs.

A problem, however, arises when one recognizes that those minimum

subsistence levels will vary from country to country and region to region,
reflecting different physiological as well as social and economic requirements.
Economists have therefore tended to make consultative estimates of world
poverty in order to avoid unsubstantiated exaggerations of the problem. One
common methodology has been to establish an international poverty line at say,
a constant $370 (based for example, on the value of the 1985 dollar) and then
attempt to estimate the purchasing power equivalent of money in terms of
developing country's own currency.

The international poverty line knows no boundaries, is independent of the level

of national per capita income, and takes into account differing price level by
measuring poverty as any one living on less than $1 a day in PPP dollars.

Exercise 5.3
Let's assume that the poverty line is set at $360. If two individuals A and B earn $ 350 and
$300 respectively, the two are below the poverty line Are two equally poor?

In many respects simply counting the number of people below an agreed on

poverty line can have its limitations. For example, in the above exercise, both
individuals are accorded the same weight when calculating the proportion of
the population that lies below the poverty line; clearly, however, the poverty
problem is much more serious in individual B. Some economists, therefore,
attempt to calculate a poverty gap that measures the total amount of income
necessary to raise everyone who is below the poverty line up to that line. To

21
make this clear, let's consider the following two figures for two countries A and
B, where line PV is the poverty line.

In both country A and country B, 50% the population falls below the same
poverty line PV. However the poverty gap in country A is greater than in
country B which implies that it will take more of an effort to eliminate absolute
poverty in country A.

Exercise 5.4
"Higher per capita incomes per se do not guarantee the absence of significant numbers of
absolute poor. It is possible for a country with a higher per capita income to have a large
percentage line and a larger poverty gap than a country with a lower per capita income "
Argue on this statement by relating your answers to exercise 5.2

5.3) Inequality, Growth and the extent of poverty

Does the pursuit of economic growth along traditional GNP maximizing lines
tend to improve, worsen, or have no necessary effect on the distribution of
income and the extent of poverty in developing countries? Unfortunately,
economists do not possess any definitive knowledge of the specific factors that
affect changes in the distribution of income over time for individual countries.
Simon Kuznets, to whom we owe so much for his pioneering analysis of the
historical growth pattern of contemporary developed countries, has formulated

22
the relationship between distribution of income & growth, known as the
inverted U hypothesis

a) The inverted U hypothesis

In his inverted U curve, Simon Kuznets has suggested that in the early stages of
economic growth, the distribution of income will tend to worsen, where as at
later stages it will improve. This observation came to be characterized by the
"inverted U” kuzent 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 GNP expanded to trace out the inverted
U shaped curve, as shown in figure 5.4 below.

0.75
Gini Coefficient

0.5

0.35

0.25

0
GNP Per capital
Fig 5.4 The “Inverted U” Kuznets Curve

Explanations as to why inequality seemed first to worsen during the early

stages of economics growth before eventually improving are numbers. They
almost always relate to the nature of structural change early growth may, in
accordance with the Lewis model be concentrated in the modern industrial
sector, where employment is limited, but wages and productivity are high. The
income gap between modern and traditional sectors may widen quickly at first
before beginning to converge. Inequality in the expanding modern sector may
be much greater than inequality in the stagnant traditional sector. Income

23
transfers from the rich to the poor and poverty reducing public expenditures are
more difficult to undertake by governments in very low-income countries.

Having examined the relationship between inequality and levels of per capita
income, let's look now at the relationship, if any, between economic growth
and inequality. In the figure below (Figure 5.5) we have plotted rates of
growth of GNP for 13 developing countries on the horizontal axis and the
growth rate of income of the lowest 40% of their population along the vertical
axis. The data are for the time span shown in parentheses after each country,
and the scatter is intended to reveal any obvious relationships between GNP
growth rates and improvements in relative income levels for the very poor.
Each country's data, therefore, are plotted in the figure at a point reflecting its
combination of GNP growth and the income growth of the lowest 40% of its
population

24
The 45 degree line shows a proportionate growth in percentage growth rate of
gross national product and percentage growth rates of incomes of bottom 40%
of population. Countries above the 45 degree line are those where the
distribution of income has improved that is, the incomes of the bottom 40%
grew faster than the over all GNP growth whereas countries below the 45
degree line have experienced a worsening of their income distributions over the
indicated period.

The scatter of points in the above figure does not reveal any strong or obvious
relationship between GNP growth and the distribution of income. High growth
rates do not necessarily worsen the distribution of income indeed, countries like
Taiwan, Iran, and South Korea experienced relatively high rates of GNP
growth and exhibited improved or at least unchanged distributions of income.
Nevertheless, countries like Mexico and panama grew just as fast but
experienced a deterioration of their income distribution. However there does
not seem to be a necessary relationship between low GNP growth and
improved income distribution. In developing countries like India, Peru and the
Philippines, low rates of GNP growth appear to have been accompanied by a
deterioration of the relative income shares of the bottom 40%. And yet Sri
Lanka, Colombia, Costa Rica, and El Salvador, with similarly low GNP growth
rates, managed to improve the relative well being of their low-income
population. Note that in all cases the poor did share in some of the benefit of
economic growth even though there is no direct, positive relationship between
rate of growth and degree of improvement.

The data from fig. 5.5 suggest that it is the character of economic growth (how
it is achieved, who participates, which sector are given priority, what
institutional arrangements are designed and emphasized etc.) that determines
the degree to which that growth is or is not reflected in improved linking
standards for the very poor. It is not the more fact of rapid growth per se that
determines the nature of distributional benefits

25
5.4 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.

Although much of economic analysis has been strangely silent on the
relationship between economics 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 described in chapter 3 of the first module. 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.

26
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 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.

27
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 reduc-
ing poverty and inequality are not mutually conflicting objectives. The World
Bank reached a similar conclusion in its 1990 report on poverty when it
declared:

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.

28
5.5 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 translat-
ed 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 pro-
gressive 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.
4. Moderating (increasing) the size distribution at the lower levels through
public expenditures of tax revenues to raise the incomes of the poor either

29
 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 equip-
ment is "institutionally" set at artificially low levels (below what supply and
demand would dictate) through various public policies such as investment

30
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 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
wagepaying 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.

We deal more extensively with the important question of factor-price distor-

tions, employment generation, and choice of appropriate production techniques
in Chapter 7. 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.

31
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 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. But as we shall see in Chapter 10, 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,

32
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 called microloans-
see Chapter 17) so that they can expand their 'business and provide more jobs
to local workers.

In addition to the redistribution of existing productive assets, dynamic redistri-

bution 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 there-
fore 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 Report
1998/99: Knowledge for Development. But as in the case of land reform, the
mere pr9vision 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. The relationship among education,
employment, and development is discussed further in Chapter 9.

33
Reducing the Size Distribution at the Upper Levels through Progressive
Income and Wealth Taxes
Any national policy attempting to improve the living standards oi 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 without 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 (see Chapter 17 for a further discussion of taxation for
development).

34
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.

35
CHAPTER VI
INTERNATIONAL TRADE AND ECONOMIC DEVELOPMENT

Introduction
International trade has often played a crucial though not necessarily benign role
in the historical development of the third world. In this chapter, we focus on
traditional and more contemporary theories of international trade in the context
of five basic themes or questions of particular importance to developing
nations.
1. How does international trade affect the rate, structure, and character of
LDC economic growth? This is the traditional “trade as an engine of
growth” controversy, set in terms of contemporary development
aspirations.
2. How does trade alter the distribution of income and wealth within a
country and among different countries? Is trade a force for international
and domestic equality or inequality? In other words, how are the gains
and losses distributed, and who benefits at whose expense (for every
winner must there be at least one or, more likely, many losers)?
3. Under what conditions can trade help LDCs achieve their development
objectives?
4. Can LDCs by their own actions determine how much they trade?
5. In the light of past experience and prospective judgment, should LDCs
adopt an outward-looking policy (free trade, expanded flows of capital
and human resources, ideas and technology, etc) or an inward-looking
one (protectionism in the interest of self-reliance), or should they pursue
some combination of both, for example, in the form of regional
economic cooperation? What are the arguments for and against these
alternative trade strategies for development?

36
6.1. Trade Theory and Development: the Traditional Arguments
The neoclassical free trade model, which you will see in another course
“International economics” gives answers to the questions raised above. Here is
a summary of the theoretical answers to the five basic questions about trade
and development derived from the neoclassical free trade model.
1. Trade is an important stimulator of economic growth. It enlarges a
country's consumption capacities, increases world output, and 'provides
access to scarce resources and worldwide markets for products without
which poor countries would be unable to grow
2. Trade tends to promote greater international and domestic equality by
equalizing factor prices, raising real incomes of trading countries, and
making efficient use of each nation's and the world’s resource
endowments (e.g., raising relative wages in labor abundant countries and
lowering them in labor-scarce countries).
3. Trade helps countries achieve development by promoting and rewarding
the sectors of the economy where individual countries possess a
comparative advantage, whether in terms of labor efficiency or factor
endowments.
4. In a world of free trade, h1te~national prices arid costs of production
determine how much a country should trade in order to maximize its
national welfare. Countries should follow the dictates of the principle of
comparative advantage and not try to interfere with the free workings of
the market.
5. Finally, to promote growth and development an outward looking
international policy is required. In all cases self- reliance based on
partial or complete, isolation is asserted to be economically inferior to
participation, in. a world of unlimited free trade

37
6.2. Arguments against free trade within the context of developing
countries.
The conclusions of traditional international trade theory are derived from a
number of explicit and implicit assumptions that in many ways are often
contrary to the reality of contemporary international economic relations. The
theory therefore often leads to conclusions foreign to both the historical and the
contemporary trade experience of many developing nations.

What are the major and crucial assumptions of the traditional factor endow-
ment theory of trade, and how are these assumptions violated in the real world?
What are the implications for the trade and financial prospects of developing
nations when a more realistic assessment of the actual mechanism of interna-
tional economic and political relations is made?

Six basic assumptions of the neoclassical trade model must be scrutinized:

1. All productive resources are fixed in quantity across nations. They are
fully employed, and there is no international mobility of productive
factors.

2. The technology of production is fixed (classical model) or semilar and

freely available to all nations (factor endowment model). Moreover, the
spread of such technology works to the benefit of all. Consumer tastes
are also fixed and independent of the influence of producers
(international consumers sovereignty prevails.)

3. Within nations, factors of production are perfectly mobile between

different activities, and the economy as a whole is characterized by the
existence of perfect competition. There are no risks or uncertainties.

4. The national government plays no role in international economic

relations; trade is carried out among many atomistic and anonymous
producers seeking to minimize costs and maximize profits. International
prices are therefore set by the forces of supply and demand.

38
 5. Trade is balanced for each country at all point in time, and all economies
are readily able to adjust to changes in the international prices with a
minimum of dislocation

6. The gains from trade that accrue to any country benefit the nationals of
that country.

We can now take a critical look at each of these assumptions in the context of
the contemporary of position of developing countries in the international
economic system. Some of these criticisms form the basis of other, non-
neoclassical theories of trade and development, including vent-for-surplus,
structuralist, and North South models. .. ..

a) Fixed Resources, Full Employment, and the International Immobility of

Capital and Skilled Labor
This initial assumption about the static nature of international exchange that
resources are fixed, fully utilized; and internationally immobile with same
product production functions everywhere identical - is central to the whole
traditional theory of trade and finance. In reality, the world economy is
characterized by rapid change, and factors of production are fixed neither in
quantity nor in quality. Not only do capital accumulation and human resource
development take place all the time, but trade has always been and will
continue to be one of the main determinants of the unequal growth of
productive resources in different nations. This is especially true with respect to
resources most crucial to growth and development, such as physical capital,
entrepreneurial abilities, scientific capacities the ability to carry out
technological research and development, and the upgrading of technical skills
in the labor force

It follows, therefore, that relative factor endowments and comparative costs are
not given but are in a state of constant change. Moreover they are often deter-
mined by, rather than themselves determining, the nature and character of inter-

39
national specialization. In the context of unequal trade between rich and poor
nations, this means that any initial state of unequal resource endowments will
tend to be reinforced and exacerbated by the very trade that these differing
resource endowments were supposed to justify. Specifically, if rich nations (the
North) as a result of historical forces are relatively well endowed with the vital
resources of capital, entrepreneurial ability, and skilled labor, their continued
specialization in products and processes that use these resources intensively
will create the necessary conditions and economic incentives for their further
growth. By contrast, Third World countries (the South), endowed with
abundant supplies of unskilled labor, by specializing in products that
intensively use unskilled labor and for which world demand prospect and terms
of trade may be very unfavorable, often find themselves locked into a stagnant
situation that perpetuates their comparative advantage in unskilled
unproductive activities. This will in turn inhibit the domestic growth of needed
capital, entrepreneurship, and technical skills. Static efficiency become
dynamic inefficiency, and a cumulative process is set in motion in which trade
exacerbates already unequal trading relationships, distributes the benefits
largely to the people who already "have," and perpetuates the physical and
human resource underdeveloped merit that characterizes most poor nations.

In recent years, some economists have therefore challenged the static neoclas-
sical model with alternative dynamic models of trade and growth that
emphasize the process of factor accumulation and uneven development along
the lines suggested in the, preceding paragraphs. These so-called North-South
trade models focus specifically on trade relations between rich and poor
countries, here as the traditional model was assumed to apply to all nations.
The typical North-South model argues, for example, that initial higher
endowments of capital in the industrialized North generate external economies
in manufacturing output and higher profit rates. This in combination with the
rise in monopoly power stimulates higher Northern growth rates (in accordance
with Harrod-Domar model discussed earlier) through further capital

40
accumulation. As a result, the rapidly growing North develops a cumulative
competitive advantage over the slower-growing South.

No country likes to think of itself as specializing in unskilled labor activities

while letting foreigners reap the rewards, of higher skills, technology and
capital. By pursuing the theoretical dictates of their endowments, however, less
developed countries may lock themselves into a domestic economic structure
that reinforces such relatively poor endowments and is inimical to their long-
run. development aspirations. Some countries, like the Four Asian. Tigers
(Taiwan, South Korea, Singapore, and Hong Kong), may succeed in
transforming their economies through purposeful effort from unskilled-labor to
skilled-labor to capital-intensive production. However, for the vast majority of
poor nations, the possibilities of trade itself stimulating similar structural
economic changes are much more remote.

Unemployment, Resource Underutilization, and the Vent-far-

Surplus Theory of Trade
The assumption of full employment in traditional trade models, like that of the
standard perfectly competitive equilibrium model of microeconomic theory,
violates the reality of unemployment and underemployment in developing
nations. Two conclusions could be drawn from the recognition of widespread
unemployment in the Third World. The first is that underutilized human
resources create the opportunity to expand productive capacity and GNP at
little or no real cost by producing for export markets products that are not
demanded locally. This is known as the vent-for-surplus theory international
trade. First formulated by Adam Smith, it has been expounded more recently in
the context of developing nations by the Burmese economist Hla Myint.

According to this theory, the opening of world markets to remote agrarian soci-
eties creates opportunities not to reallocate fully employed resources as in the
traditional models but -rather to make use of formerly underemployed land and

41
labor resources to produce greater output for export to foreign markets. The
colonial system of plantation agriculture as well as the commercialization of
small scale subsistence agriculture were made possible, according to this view,
by the availability of unemployed and underemployed human resources. In
terms of our production possibility analyses, the vent-for-surplus argument can
be represented by a shift in production from point V to point B in Figure 6.1
below.

C
Y’ International price ratio, Pa / Pm
Importables Imports
(manufacres)
Y B
V
Exports

O X X’
Exportables (Primary Products)

We see that before trade, the resources of this closed Third World economy
were grossly underutilized. Production was occurring at point V; well within
the confines of the production possibility frontier, and OX primary products
and OY manufactures were being produced and consumed. The opening up of
the nation to foreign markets provides the economic impetus to utilize these
idle resources. (mostly excess land and labor) and expand primary product
exportable production from OX to OX’ at point B on the production frontier.
Given the international price ratio Pa / Pm , X’ – X (equal to VB) primary
product can now be exported in exchange for Y' - Y. (equal to VC) manufac-
tures, with the result that the final consumption point, C, is attained with the
same primary products (X) being consumed as before but with Y'- Y more
imported manufactures now available.
The vent-for-surplus argument does provide a more realistic analytical scenario

42
of the historical trading experience of many LDCs than either the classical or
neoclassical model. However, in the short-run, the beneficiaries of this process
were often colonial and expatriate entrepreneurs rather than LDC nationals.
And in the long run, the heavy structural orientation of the LDC economy
toward primary-product exports in many cases created an export "enclave"
situation and thus inhibited needed structural transformation in the direction of
a more diversified and self-reliant economy.

The second conclusion that we may draw from the recognition of widespread
unemployment in the Third World is that a major .way to create substantial
local job opportunities is to protect domestic-, industries (both manufacturing
and agriculture) against low-cost foreign competition. This protection is
accomplished through the erection of various trade barriers such as tariffs or
quotas. We will discuss the pros and cons of commercial policy in part II of
development economics is that LDCs that place priority on employment
creation may wish to pursue a short - run protectionist policy in order to build
up local rural and urban industries to absorb their surplus labor. This is what
South Korea and Taiwan did in the

A third and most interesting theoretical implication of the violation of the

full employment and immobile-capital assumptions of classical trade
theory occurs when (It capital is, completely mobile, (2) one nation (the
MDC) in a two-country, two-commodity model has an absolute advantage
in unit labor costs in both commodities and (3) the other nation (the WC)
has unemployed labor. In such a situation, which require frequently in the
real world, the more developed country with the absolute advantage in both
goods can attract enough foreign capital to meet global demand each
commodity. The less developed country will in the way then see its
production and employment decline to zero!

43
b) International factor mobility and multinational corporations

The third component of the crucial first assumption of traditional trade

theory the international immobility of productive factors is, after the
assumption of perfect competition, the most unrealistic of all premises of
classical and neoclassical trade theory. Capital and skilled labor have
always moved between nations. The nineteenth-century growth experience
of Western nations can largely be explained in terms of the impact of
international capital movements. Perhaps the most significant development
in international economic relations during the past two decades has been
the spectacular rise in power and influence of the giant multinational
corporations. These international carries of capital, technology, and skilled
labor, with their diverse productive operations throughout the Third World,
greatly complicate the simple theory of international trade, especially as
regards the distribution of its benefits. To assume away their existence and
their impact on the economies and economic structures of developing
nations, as in the classical and factor endowment theories of trade, is to
blind ourselves realities of contemporary world economy.

c) Fixed, Freely Available Technology and consumer Sovereignty

Just as capital resources are rapidly growing and being dispersed to maximize
the returns of their owners throughout the world, so too is rapid technological
change (mostly in the West) profoundly affecting world trading relationships.
One of the most obvious examples of the impact of developed country
technological change on Third World export earnings is the development of
synthetic substitutes for many traditional primary products. Over the past four
decades, synthetic substitutes for such diverse commodities as rubber, wool,
cotton, sisal, jute, hides, and skins have been manufactured in increasing
quantities. The third World's market shares of these natural products in all
cases has fallen steadily. For example, between 1950 and 1980, the share of the
natural rubber in total world rubber consumption fell from 62% to 28%, and
cotton's share of total fiber consumption dropped from 41% to 29%.

44
Technological substitution, together With the low income and price elasticities
of demand for primary products and the rise of agricultural protection in the
markets of developed nations; goes a long way toward explaining why
uncritical, adherence to the theoretical dictates of comparative advantage can
be a risky and often unrewarding venture for many LDCs.

On the other side of the ledger, however, is the argument that the worldwide
availability of "new technologies developed in the West has provided many
newly industrializing countries the-opportunity to capitalize on Western
research and development expenditures. By, first imitating-products
developed abroad but not on the frontiers of technological research, certain
LDCs- With sufficient human capital (e.g., the Asian NICs) can follow the
product cycle of international trade. Using their relatively lower Wages,
they move from low-tech to high-tech production, filling-manufacturing
gaps left, vacant by the more industrialized nations.

The assumption of fixed world Wide consumer tastes and preferences

dictating production patterns to market-responsive atomistic producers is
another fiction, of trade theory. Not only are capital and production
'technologies disseminated throughout the world by means of the
multinational corporations often aided and abetted by their home
governments, but consumption technologies (consumer preferences and
tastes) are often 'treated and .reinforced by the advertising campaign§ of the
powerful financial giants who dominate local markets. By creating demands
for imported goods, market -dominating international enterprises can create
the conditions for their own further aggrandizement. This is particularly
significant in LDCs, where limited and imperfect information in both
production and consumption creates a situation of highly incomplete mar-
kets. For example, it has been estimated that in many developing nations,
more than 90% of all advertising is financed by foreign firms, selling in the
local market. As pointed out earlier, contemporary consumers are rarely

45
sovereign about anything, let alone about what and how many major
corporations are going to produce.

d) Internal factor Mobility and Perfect Competition:

The Structuralist Critique and the Phenomenon of Increasing Returns,
Imperfect Competition, and Controlled Markets
The traditional theory of trade assumes that nations are readily able to adjust
their economic structures to the changing dictates of world prices and markets.
Movements along production possibility frontiers involving the reallocation of
resources from one industry to another may be easy to make on paper, but
according to structuralist arguments, such reallocations are extremely difficult to
achieve in practice. This is especially true in developing nations, where
production structures are often very rigid and factor movements are largely
restricted. The most obvious example o this is plantation and sII1all-farm
commercial agriculture. In economies that have gradually become heavily
dependent on a few primary- product exports, the whole economic and social
infrastructure (roads, railways, communications power locations, credit and
marketing arrangements, etc.) may be geared to facilitate the movement of
goods from production 10catiQnsJo shipping and storage depots for transfer to
foreign markets. Over time, cumulative investments of capital may have been
sunk into these economic and infrastructure facilities and they cannot easily be
transferred to, Third World manufacturing activities located elsewhere. Thus the
more dependent nations become on a few primary, product exports, the more
inflexible their economic structures become, and the c, more vulnerable they are
to the unpredictability’s of international markets. It may, take many years to
transform an underdeveloped economy from an almost exclusively primary-
product export oriented reliance to a more diversified, multisector structure.

More generally, structuralists argue that all kinds of politically and

institutionally generated structural rigidities, including product supply
inelasticites, lack of .intermediate products, fragmented money markets, limited
foreign exchange, government licensing, import controls, poor transport and

46
distribution facilities, and scarcities of managerial and skilled labor, often
inhibit an IDC's ability to respond in the smooth and frictionless way of the
neoclassical-trade model to changing international price signals.

e) The Absence of National Governments in Trading Relations

In domestic economies, the coexistence of Ij.ch and poor regions, of rapidly
growing and stagnating industries, and of the persistent disproportionate
regional distribution of the benefits of economic growth can all, at least theory,
be counteracted and ameliorated by the intervention of the state. Cumulative
processes for inequality within nation-states by which growth poles may enrich
themselves at the expense of the regions left behind can be modified by
government legislation taxes, transfer payment subsidies, social services
regional development, programs and so forth: But since there is no effective
international government to modify and counter the natural tendency of the rich
nations to grow, often at the trading expense of the poor the highly uneven
gains from trade can easily become self-sustaining.

This result is than reinforced by the uneven power of national governments to

promote and protect the interests of their own countries. The spectacular
export successes of Japan and, more recently, South Korea & Taiwan were in
no small way aided and abetted by government planning and promotion of
favored export industries.

By focusing on the atomistic behavior of competitive firms in the context of

different commodities being produced in anonymous countries, standard trade
theory has ignored the crucial role governments play in international economic
affairs. They are not impartial bystanders. Rather, governments are often
partisan players whose activist interventions in this area of industrial policy
(guiding the market through strategic coordination of business investments to
increase export market shares) are specifically designed to create a comparative
advantage where none existed before but where world demand is likely to rise
in the future.

47
Our point, therefore, is quite simple. Traditional trade theories neglect the
crucial role that national governments can and do play in the international
economic arena. Governments often serve to reinforce the unequal distribution
of resources and gains from trade resulting from differences in size and
economic power. Rich-country governments can influence world economic
affairs by their domestic and international policies. They can resist
countervailing economic pressures from weaker nations and can act in
collusion and often in conjunction with their powerful multinational
corporations to manipulate the terms and conditions of international trade to
their own national interests. There is no super agency or world government to
protect and promote the interests of the weaker parties (the LDCs) in such
international affaires. Trade theory makes no mention of these powerful
governmental forces. Its prescriptions are therefore greatly weakened by this
neglect.

f) Balanced Trade and International Price Adjustments

The theory of international trade, like other perfectly competitive general-
equilibrium models in economics, is not only a full-employment model but also
one in which flexible domestic and international product and resource prices
always adjust instantaneously to conditions of supply and demand. In
particular, the terms of trade (international commodity price ratios) adjust to
equate supply and demand for a country's exportable and importable products
so that trade is always balanced; that is, the value of exports (quantity times
price) is always equal to the value of imports. With balanced trade and no
international capital movements, balance of payments problems never arise in
the pure theory of trade. But the realities of the world economy in the 1980s
and 1990s, especially in the period following the rapid increase in international
oil prices in the 1970s, were such that balance of payments deficits and the
consequent depletion of foreign reserves (or the need to borrow foreign funds
to cover commodity deficits) were a major cause of concern for all nations, rich
and poor. .

48
For the non-oil-producing poor nations in particular, a combination of declin-
ing terms of trade and sluggish international demands for their export products
has meant chronic merchandise trade deficits. The gradual drying up of
bilateral and multilateral foreign assistance and the growing concern of LDCs
with the social costs of private foreign investment have meant that severe
balance of Payments problems necessitate further departures from relatively
free trade.

g) Trade Gains Accruing to Nationals

The sixth and final major assumption of traditional trade theory, that trade
gains accrue to nationals in the trading countries, is more implicit than the other
five. It is rarely spelled out, nor need it be if we accept the assumption that
factors are internationally immobile. But given the gross unreality of that
assumption, we need to examine the implicit notion, rarely challenged, that if
developing countries do benefit from trade, it is the people of these countries
who reap the benefits. The issue thus revolves around the question of who
owns the land, capital, and skills that are rewarded as a result of trade. Are they
nationals or foreigners? If both, in what proportions are the gains distributed?

We know, for example, that in the enclave economies in the Third World, such
as those with substantial foreign-owned mining and plantation operations, for-
eigners pay very low rents for the rights to use land, bring in their own foreign
capital an skilled labor, hire local unskilled workers at subsistence wages, and
have a minimal effect on the rest of the economy even though they may
generate significant export revenue although mining and plantation enclaves
are gradually disappearing, they are often being replaced by "manufacturing
export enclaves personal computer assembly, running shoe and toy
manufacture, etc.) as a result of the economic penetrations of multinational
corporations

Our point here is an important one. With the proliferation of multinational

corporations and the increasing foreign ownership of the means of

49
production in a wide range of countries, aggregate statistics for LDC export
earnings (and, indeed, GDP) may mask the fact that LDC nationals,
especially those in lower income brackets, may not benefit at all from these
exports. The major gains from trade may instead accrue to non-nationals,
who often repatriate large proportions of these earnings. The inter-and
intraindustry trade that is being carried out may do ok like trade between
rich and poor nations. But in reality such trade is being conducted between
rich nations and other nationals of rich nations operating in Third World
countries! Until recently, the activities of most mining and plantation
operations had this characteristic. More important, much of the recent
export enclave manufacturing activities in poor countries may merely be
masking the fact that a large proportion of the benefits are still being
reaped by foreign enterprises. In short, LDC export performances can be
deceptive unless we analyze the character and structure of export earnings
by ascertaining who owns or controls the factors of production that are
rewarded as a result of export expansion.

6.3) Some Conclusions on Trade and Economic Development: The limits of

Theory
We can, now attempt to provide some preliminary general answers to the five
questions posed at the beginning of the chapter. Again, we must stress that our
conclusions are general and set in the context of the diversity of developing
nations. Many will not be valid for specific nations at any given point in time.
But on the whole these conclusions do appear to represent the consensus of
current economic thinking, especially among Third World economists, on the
relationship between trade and development, as the latter term has been
defined in module one.

First, with regard to the rate, structure, and character of economic growth, our
conclusion is that trade can be an important stimulus to rapid economic
growth. This has been amply demonstrated by the successful experiences of
countries like 'Malaysia, Thailand, Brazil, Chile, Taiwan, Singapore, and

50
South Korea. Access to the markets of developed nations (an important factor
for developing nations bent on export promotion) can provide an important
stimulus for the greater utilization of idle human and capital resources.
Expanded foreign exchange earnings through improved export performance
also provide the wherewithal by which LDC can augment their scarce physical
and financial resources. In short where opportunities for profitable exchange
arise, foreign trade can provide an important aggregate economic growth
along the lines suggested by the traditional theory.

6.4) The Terms of Trade and the Prebisch-Singer Thesis

The question of changing relative price levels for different commodities
brings us to another important quantitative dimension of the trade problems
historically faced by developing nations. The total value of export earnings
depends not only on the volume of these exports sold abroad but also on the
price paid for them. If export prices decline, a greater volume of exports will
have to be sold merely to keep total earnings constant. Similarly, on the
import side, the total foreign exchange expended depends on both the quantity
and the price of imports.

Clearly, if the price of a county’s exports is falling relative to the prices of the
products it imports, it will have to sell that much more of its export product and
enlist more of its scarce productive resources merely to secure the same level
of imported goods that it purchased in previous years. In other words, the real
or social opportunity costs of a unit of imports will rise for a country when its
export prices decline relative to its import prices.

Economists have a special name 'for the relationship or ratio between the price
of a typical unit of exports and the price of a typical unit of imports. This
relation ship is called the commodity terms of trade, and it is expressed as
Px/Pm, where Px and Pm represent the export and import price indexes,
respectively, calculated on the same base period (e.g., 1985 = 100). The
commodity terms of trade are said to deteriorate for a country if Px/ Pm falls,

51
that is, if export prices decline relative to 'import prices, even though both may
rise. Historically, the prices of primary commodities have declined relative to
manufactured goods. As a result, the terms of trade have on the average tended
to worsen over time for the non-oil exporting developing countries while
showing a relative improvement for the developed countries. For example,
recent empirical studies suggest that real primary product prices have declined
at 'an average annual rate of 0.6%, since 1900. In the 17 years between 1977
and 1994, the prices of non-oil commodities relative to those of exported
manufactures declined by almost 60% so that 1994 they had reached their
lowest point in 90 years.

A good deal of the argument against primary-product export expansions and in

favor of diversification into manufactured exports for developing countries
during the 1960s was based on the presumed secular deterioration of the non-
oil commodity terms of trade. These terms of trade pessimism has come to be
known as the Prebisch-Singer thesis, after two famous development economists
who explored its implications in the 1950s. They argued that there was and
would continue to be a secular decline in the terms of trade of primary-
commodity exporters due to a combination of law income and price elasticities
of demand. This decline resulted in a long-term transfer of income from poor
to rich countries that could be combated only by efforts to protect domestic
manufacturing industries through a process that has come to be known as
import substitution.

After Prebish and Singer have put their analysis, a number of other economists
have worked on the historical trend analysis of the terms of trade. Some have
shown the existence of trend determination in the terms of trade of LDC and
others have shown a trendless movement. A major study of the recent behavior
of non-oil commodity price by the IMF reaches the following conclusions:
• The recent weakness of real commodity prices (the terms of trade) appears
to be primarily of a secular, persistent nature, and not the product of a large
temporary deviation from the trend.

52
 • The declining trend is partly the result of a slowing up in the growth of
demand, but much more important has been the growth of commodity
supply.
• The volatility of commodity prices has increased steadily and considerably
since the early 1970s, particularly in the once relatively stable food
grouping.

Questions for Discussion

1. Why is the traditional Economics viewed like a Metropolitan city? What is the
main emphasis in the traditional economics? Is it the same as the emphasis in
institutional economics?
2. Distinguish between size and functional distributions of income in a nation.
Which do you feel is the more appropriate concept? Explain your answers.
3. What is meant by absolute poverty? What is poverty gap? How do these
measures differ from the UNDP’s Human Poverty Index (HPI)?
4. What is the relationship between a Lorenze curve and a Gini coefficient? Give
some examples of how Lorenz curves and Gini coefficients can be used as
summery measures of equality and inequality in a nation’s distribution of
income.
5. Are rapid economic growth (as measured by either GNP or per capita GNP) and
a more equitable distribution of personal income necessarily conflicting
objectives? Summarize the arguments both for and against the presumed
conflict of objectives, and state and explain your own view.
6. Economic growth is said to be a necessary but not sufficient condition to
eradicate absolute poverty and reduce inequality. What is the reasoning behind
this argument?
7. Proponents of free trade, primarily developed-country economists, argue that
the liberalization of trading relationships between rich and poor nations (the
removal of tariff and non-tariff barriers) would work toward the long-run
benefit of all countries. Under what conditions might the removal of all tariffs
and other impediments to trade work to the best advantage of developing
countries? Explain.
8. Third world critics of international trade sometimes claim that present trading
relationships between developed and underdeveloped countries can be a source
of “antidevelopment” for the latter and merely serve to perpetuate their weak
and dependent status. Explain their argument. Do you tend to agree or
disagree? Explain why?

53