Economic Development

Thirteenth Edition

Chapter 3
Classic Theories of
Economic Growth and
Development

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

3.1 Classic Theories of Economic Development:
Four Approaches
• Linear stages of growth model
• Theories and patterns of structural change
• International-dependence “revolution”
• Neoclassical, free market “counterrevolution”

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 3.2 Development as Growth and Linear-
Stages Theories
• An influential approach following WWII, often
dubbed “capital fundamentalism.”
• A Classic Statement: Rostow’s Stages of Growth
• Harrod-Domar Growth Model
• (Also referred to as the AK model, because the
capital stock is multiplied by a constant factor,
sometimes called “A”)

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 3.2 Development as Growth and Linear-
Stages Theories
• “This book presents an economic historian’s way of generalizing the
sweep of modern history. . . . It is possible to identify all societies, in their
economic dimensions, as lying within one of five categories: the
traditional society, the pre-conditions for takeoff into self-sustaining
growth, the take-off, the drive to maturity, and the age of high mass
consumption. . . . These stages are not merely descriptive. They are not
merely a way of generalizing certain factual observations about the
sequence of development of modern societies. They have an inner logic
and continuity. . . . They constitute, in the end, both a theory about
economic growth and a more general, if still highly partial, theory about
modern history as a whole.”

---- The Stages of Economic Growth (1960) by Walt W. Rostow

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Simplified Harrod-Domar Growth Model
• Sometimes called the “AK model”
• Harrod-Domar Growth Model Derivation
• Y = (1/c)*K
• Linear relationship assumed, so,
• ΔY = (1/c)*ΔK; or,
• ΔY = SNet/c
• Dividing by Y: ΔY/Y = (SNet/Y)/c; so,
• Growth = (sNet)/c; that is,
• Growth = Net savings rate/ICOR

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The Harrod-Domar Model – Simplified
Version, Alternate Derivation

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The Harrod-Domar Model – Simplified Version

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 The Harrod-Domar Model – Incorporating
Capital Depreciation
• Equation 3.7 is also often expressed in terms of gross savings, in
which case the growth rate is given by

(3.7’)

where δ is the rate of capital depreciation

The derivation follows in the next two slides:

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

Harrod-Domar (or “AK”) Model: Derivation of
disaggregated treatment of depreciation
ΔK
ICOR ≡ c ≡
ΔY
1
ΔY = ΔK
€
c
G
And, ΔK = I − δK
€ 1 G
ΔY = [ I − δK ]
c

€ 1 G 1
ΔY = I − δK
c c
€
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Harrod-Domar (or “AK”) Model: Derivation of
disaggregated treatment of depreciation
(Continued)
1 G 1
ΔY = I − δK
c c

(I G
≡S G
)
€ % SG (
' *
ΔY S G δY & Y )
= − = −δ
Y Yc Y c
€
ΔY sG
€ So, = −δ
Y c
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
 The Harrod-Domar Model – Economic Logic

• The more countries save and invest, the faster they can grow.
• 1/𝑐 expresses the efficiency with which capital is utilized: the
lower (more efficient) the value of 𝑐, the greater the output
that can be gained from additional investment.
• Two other components of economic growth are labour force
growth and technological progress.
– Labour is assumed to be abundant and can be hired as needed in a given
proportion to capital investments (not always valid).
– Technological progress can be expressed as a decrease in the required
capital-output ratio 𝑐, giving more growth for a given level of
investment.

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

The Harrod-Domar Model – Economic Logic

https://www.tutor2u.net/economics/reference/economic-growth-harrod-domar-model

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

Illustrative Exercise on Growth Potential

‘Back-of-the-envelope’ calculations with the H-D

(or AK) growth model.

Suppose sG = .125, d=.04, c =2.5

.125
Then, gTOT = − .04 = .01
2.5

But if sG = .175, d =.03, c =2.5

€
.175
Then, g TOT
= − .03 = .04
2.5

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Illustrative Exercise: Growth Targets
• Suppose a country has a gross savings rate of 20%, a depreciation
rate of 3%, and an lCOR of 2.5
• Using the Harrod-Domar growth model, find the implied rate of
growth of total GDP in the country
• Answer: Growth = .2/2.5 - .03 = .05 (i.e., 5%)
• How much would the rate of savings have to increase to raise the
growth rate of total GDP to 9% (a target discussed in India)?
• Answer: Now the savings rate is your unknown.
• Growth = s/2.5 - .03 = .09 , so s/2.5 = .12 or s = .3 (that is, up 10
percentage points from 20% to 30%)
• Targeted growth rates and required savings are considered further
in Chapter 11
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
 Obstacles and Constraints
• According to the AK model, one of the most fundamental strategies of
economic growth is simply to increase the proportion of national income
saved.
• Rostow and others defined the takeoff stage in precisely this way: countries
that were able to save 15 to 20% of GDP could grow (“develop”) at a much
faster rate than those that saved less.
• The main obstacle to or constraint on development, according to this theory, is
the relatively low level of new capital formation in most poor countries, who
can fill this “savings gap” through either foreign aid or private foreign
investment.
• Thus, the “capital constraint” stages approach to growth and development
became a rationale and (in terms of Cold War politics) an opportunistic tool for
justifying massive transfers of capital and technical assistance from the
developed to the less-developed nations - the Marshall Plan all over again.

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Criticisms of the Stages Model
• Necessary versus sufficient conditions.
• Insufficient focus on another strategy for
raising growth: reducing the capital-output
ratio, 𝑐.

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 3.3 Structural-Change Models
• Structural-change theory focuses on the mechanism by which
underdeveloped economies transform their domestic
economic structures from a heavy emphasis on traditional
subsistence agriculture to a more modern, more urbanised,
and more industrially diverse manufacturing and service
economy.
• The Lewis two-sector model, formulated by Nobel laureate
W. Arthur Lewis in the mid-1950s, became the general theory
of the development process in surplus-labour developing
nations during most of the 1960s and early 1970s.
• The “patterns of development” empirical analysis.

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 The Lewis Theory of Economic Development
• The underdeveloped economy consists of two sectors:
– A traditional, overpopulated, rural subsistence sector characterised by zero
marginal labour productivity (surplus labour).
– A high-productivity modern, urban industrial sector into which labour from
the subsistence sector is gradually transferred.
• The primary focus of the model is on both the process of labour transfer
and the growth of output and employment in the modern sector.
• The speed with which this expansion occurs is determined by the rate of
industrial investment and capital accumulation in the modern sector,
made possible by the excess of modern-sector profits over wages on the
assumption that capitalists reinvest all their profits.
• The level of wages in the urban industrial sector was constant, determined
as a given premium over a fixed average subsistence level of wages in the
traditional agricultural sector.

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Figure 3.1
The Lewis Model of Modern-Sector Growth in a
Two-Sector Surplus-Labour Economy

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 The Lewis Turning Point
• This process of modern-sector self-sustaining growth and
employment expansion is assumed to continue until all
surplus rural labour is absorbed in the new industrial sector.
• Thereafter, additional workers can be withdrawn from the
agricultural sector only at a higher cost of lost food production
because the declining labour-to-land ratio means that the
marginal product of rural labour is no longer zero.
• This is known as the “Lewis turning point.”
• The labour supply curve becomes positively sloped as
modern-sector wages and employment continue to grow.

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Criticisms of the Lewis Model
• Rate of labor transfer and employment creation may not be
proportional to rate of modern-sector capital accumulation.
• What if capitalist profits are reinvested in more sophisticated
labour-saving capital equipment rather than just duplicating
the existing capital?
• As is shown in Figure 3.2, all of the extra output accrues to
capitalists in the form of profits, leading to what some might
call “antidevelopmental” economic growth.
• Capitalist profits could also be sent abroad as a form of
“capital flight”.

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

Figure 3.2
The Lewis Model Modified by Laborsaving
Capital Accumulation: Employment Implications

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Criticisms of the Lewis Model
• Questionable assumption of surplus labor in rural areas and full
employment in urban.
– Development economists today agree that Lewis’s assumption of rural surplus
labour is generally not valid.
• Questionable assumption of a competitive modern-sector labour market
that guarantees the continued existence of constant real urban wages.
– Prior to the 1980s, a striking feature of urban labour markets and wage
determination in almost all developing countries was the tendency for these
wages to rise substantially over time, both in absolute terms and relative to
average rural incomes.
– Institutional factors tend to negate competitive forces in modern-sector
labour markets in developing countries, but have a small (if any) role in this
approach.
• Questionable assumption of diminishing returns in modern industrial
sector, at least in some cases.

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Empirical Patterns of Development -
Examples
• Some processes are very typical but not universal; so these
are often referred to as “stylized facts”:
‒ Switch from agriculture to industry (and services).
‒ Rural-urban migration and urbanization.
‒ Steady accumulation of physical and human capital.
‒ Population growth first increasing and then decreasing
with decline in family size.
• See Kuznets, S. (1973). Modern Economic Growth: Findings
and Reflections. The American Economic Review, 63(3), 247–
258.

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 3.4 The International-Dependence “Revolution”
• The neocolonial dependence model
– Legacy of colonialism, Unequal power, Core-periphery
• The false-paradigm model
– Pitfalls of using “expert” foreign advisors who misapply
developed-country models
• The dualistic-development thesis
– Superior and inferior elements can coexist; Prebisch-Singer
Hypothesis
• Criticisms and limitations
– Accumulating counterexamples; the framework does little
to show how to achieve development in a positive sense

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 3.5 The Neoclassical Counterrevolution, or
“Market Fundamentalism”
• Challenging the Statist Model: Free Markets, Public Choice, and
Market-Friendly Approaches
– Free market approach
– Public choice approach
– Market-friendly approach
• Main Arguments
– Denies efficiency of intervention
– Points up state owned enterprise failures
– Stresses government failures
– Urges reliance upon the “magic of the marketplace”
– Associated with a different (Solow) formal model of growth:

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 3.5 The Neoclassical Counterrevolution, or
“Market Fundamentalism”
• Associated with a different (Solow) formal model of
growth
‒ Traditional neoclassical growth theory (Solow model)
‒ Includes labor as a separate input
‒ Shows that with diminishing returns, growth cannot be
sustained by capital accumulation alone
‒ Adds separate, explicit accounting of the role of
technological change
‒ The model details are presented in Appendix 3.2

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Appendix 3.2: The Solow Neoclassical
Growth Model
• Compared with the the Harrod-Domar (or AK) growth model,
the Solow model allows for substitution between capital and
labour.
• The aggregate production function, ϒ = F(K, L) is assumed
characterised by constant returns to scale.
• For example, in the special case known as the Cobb-Douglas
production function, at any time t we have

• Here ϒ is gross domestic product, K is the stock of capital, L is

labour, and A(t) represents the productivity of labour.

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Appendix 3.2: The Solow Neoclassical
Growth Model
• Because of constant returns to scale, we have 𝛾𝑌 =
𝐹(𝛾𝐾, 𝛾𝐿) for any positive value 𝛾.
!
• Set 𝛾 = " , we have

• The concave shape of f(k) reflects diminishing returns to

capital per worker.
• In our Cobb-Douglas case, the per-worker output is given by

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Figure A3.2.1
Equilibrium in the Solow Growth Model

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 Appendix 3.2 The Solow Neoclassical
Growth Model: The Solow Equation

Δk = sf (k) − (δ + n)k (A3.2.4)

Equilibrium is found where Δk = 0, as in equation A3.2.5 on the next slide.

Note: We can also use equation A3.2.4 above to provide a “heuristic” proof
by contradiction – making use of Figure A3.2.1 – to see that the equilibrium
must be where Δk = 0: otherwise k is growing to the left of k* and shrinking
if to the right of k*.

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Equilibrium Condition in the Solow
Neoclassical Growth Model

sf (k *) = ( + n)k * (A3.2.5)
Again:
s is the savings rate;
f(k*) is the production function relating capital per worker to output; the
function has diminishing returns; So,
sf(k*) is savings per worker
δ is the rate of capital depreciation; n is the rate of growth of the labor force;
Savings per worker sf(k*) is just equal to the sum of:
δk*: the amount of capital (per worker) needed to replace depreciating
capital, and,
nk*: the amount of capital (per worker) that needs to be added - due labor
force growth – to keep capital per worker from falling

Details of the model are examined in Appendix 3.2

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Figure A3.2.2
The Long-Run Effect of Changing the Saving
Rate in the Solow Model

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 The Solow Equation:
A Heuristic Numerical Example
• Note: This heuristic example addresses the capital per worker component,
not production (output per worker)
• Income depends upon capital (K) per worker (L): i.e., K/L
• Before K/L can grow we must invest to make allowance for a) depreciation;
and b) growth of the labor force L
• To illustrate, consider a 10-worker economy growing to 12 workers;
initially K/L = 2; and depreciation = .05
• To increase K/L to 2.5 we must invest:
‒ 1 unit of K for depreciation allowance: (20)*(.05) = 1
‒ 4 units of K for “capital widening” (equipping the new workers with the
same capital as the existing workers)
‒ 6 units of K for “capital deepening,” to finally increase the K/L ratio, up
to where each worker has 2.5 units of capital to work with
‒ Overall, the K stock grows from 20 to 30, i.e., 30/12 = 2.5

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 Supplementary Note: The Role of
Technology*
• If there is technological progress, income per worker can
increase proportionately
• Think of K in the Solow production function as multiplied by a
constant, A, “AK”:
• So far we have implicitly set A to 1; but it can grow over time,
representing productivity growth
• In equilibrium, if the “effective workforce” increases at rate l,
then the Solow equilibrium is:
• sf(k*) = (d + n + l)k*
• The “effective workforce” then grows faster than the (actual)
workforce, corresponding to an increase in output per worker
*This slide addresses a topic not explicitly explained or currently formalized in the text

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Contributions and Limitations of the
Four Schools
• Capital Fundamentalism
– Points up importance of investment, and of efficiency of capital allocation
– Investment may be necessary but is not sufficient. Broader context matters
• Structural/Empirical Patterns of Development
– Careful empirical evidence can remove theories from contention
– But, still need theory to interpret data, avoid cart-before-horse policies
• Dependency
– Existing international relations/ trade/ investment can place constraints on pattern
of development
– But, growing number of counter-examples of stronger versions of dependency
theory; good performance of “globally” integrated countries
• Market Fundamentalism
– Governments fail (e.g. in SOEs, planning) and we must account for this
– But, markets also fail in developing countries; the East Asia experience shows that
government role can be constructive

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 3.6 Classic Theories of Development:
Reconciling the Differences
• Governments do fail, but so do markets; a balance is
needed
• Must attend to institutional and political realities in
developing world
• Development economics has no universally accepted
paradigm
• Insights and understandings are continually evolving
• Each theory has some strengths and some
weaknesses

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Appendix 3.1: Components of Economic
Growth
• Capital Accumulation, investments in physical and
human capital
– Increase capital stock
• Growth in population and labor force
• Technological progress
– Neutral, labor/capital-saving, labor/capital augmenting

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Figure A3.1.1
Effect of Increases in Physical and Human
Resources on the Production Possibility Frontier

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Figure A3.1.2
Effect of Growth of Capital Stock and Land on
the Production Possibility Frontier

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Figure A3.1.3
Effect of Technological Change in the Agricultural
Sector on the Production Possibility Frontier

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Figure A3.1.4
Effect of Technological Change in the Industrial
Sector on the Production Possibility Frontier

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 Concepts for Review

• Autarky • Dualism
• Average product • False-paradigm model
• Capital-labor ratio • Free market
• Capital-output ratio • Free-market analysis
• Center • Harrod-Domar growth
• Closed economy model
• Comprador groups • Lewis two-sector model
• Dependence • Marginal product
• Dominance • Market failure

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 Concepts for Review (Continued)

• Market-friendly approach • Production function

• Necessary condition • Public-choice theory
• Neoclassical counterrevolution • Self-sustaining growth
• Neocolonial dependence • Solow neoclassical growth model
model • Stages-of-growth model of
• Net savings ratio development
• New political economy • Structural-change theory
approach • Structural transformation
• Open economy • Sufficient condition
• Patterns-of-development • Surplus labor
analysis • Underdevelopment
• Periphery

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