#02 • Chapter 2: Growth and the Asian Experience

FLEX Course Material

Students will be acquinted

Population
with production curves, as
this module explores the
concepts that relate to
efficiency in production.
Students will also get to
distinguish various growth
theories, and see how
these theories were Basic Concepts
successfully applied in the
development effort of
countries in the Asian
Region.

• Module Goals
 #02

At the end of this module, the

students are expected to have:
Explained through essay format
one of the three questions given
below:
✓ What are the difference
between the Solow and the
Harrod- Domar models?

✓ Other developing regions of

the world have not been as
successful in raising their
standards of living in this
period. Can you identify
several factors that might
have been responsible for
these poorer results?

✓ What measures can the

poorer countries take to Learning Goals
accelerate their growth to
bring their standards of living
more in line with the rest of
the world?
 Economic Development in Asia
Chapter 2 – Growth and the Asian Experience
 Introduction
• Why do economies grow?

• Why should they grow?

• Why do we want them to

grow faster?

• These are the types of

questions that economic
development is concerned
with.
Theory of Economic Growth
• Traditionally labor and capital
were introduced as the only
variables determining the level
and the growth of output.
Y = f (K,L).
• Land was assumed to be
included within capital.
• Other factors were not
considered until it was noted by
Solow that there was a large
residual factor that was
unexplained.
http://www.freeimages.co.uk/
Theory of Economic Growth
• Substantial time has been spent
explaining this residual.
• This residual has been called
total factor productivity (TFP) or
sometimes multifactor
productivity.
• TFP is very large in industrial
countries, explaining as much or
more than 50 percent of
economic growth in the postwar
era.
 Total Factor Productivity
Question: What factors are contained in the residual?
Y = f (K, L, A)

• Such a list might include:

– the adoption of new technology,
– better educated workers,
– better management,
– better coordination within the organization,
– more efficient production techniques,
– better inventory management,
– better and cheaper distribution and
marketing skills and organization.
Testing Different Growth Theories
• Many different approaches have
been devised to test these
alternatives. In doing this, it is
useful to distinguish between
embodied and disembodied
technical progress (TFP).
• Embodied TFP can be
measured by adjusting the factor
inputs of labor and capital.
Disembodied TFP cannot – it
has to go into the residual.
 Growth Theories
• Keynesian Theory/Harrod-Domar Model

• Solow Model

• Power Balance Theory

• Structuralist Approaches

• New Growth Theory

 The Harrod-Domar Model
• Keynesian Theory stresses the accumulation of
capital. This theory include Rostow’s stages of
growth and the Harrod-Domar growth model.
• The Harrod-Domar model is the simplest
macroeconomic model.
• This model begins from the assumption that
saving is a constant proportion of income. Thus,
s = S/Y
and Y = C + S, where C is consumption
S is saving
• S = I. , where I is investment
• Then, Y = C + I
 The Harrod-Domar Model
• Growth is dependent on the rate of capital
formation and the efficiency of the use of capital
(capital/output ratio).

• Population growth can be added and it reduces

the rate of growth ceteris paribus.
 The Solow Model
• It introduces diminishing returns to capital and
focuses on the long run.
• Convergence to a steady state level of per capita
income occurs despite differences in initial
conditions.
• Total income grows at the same rate as
population.
• The higher the rate of saving, the higher the
steady state level of per capita income.
 The Solow Model
• When we add technical progress to the Solow
model in the form of more efficient workers, then
we have growth in per capita income at the same
rate as the rate of growth in worker efficiency.

• There is still a steady state but it now relates to

efficiency units of capital.
 Power Balance Theory
• Emphasized exploitation of
poor “southern” economies
by the rich industrial
“northern” economies.
• Deterioration of terms of
trade of agricultural
products in poor economies
further aggravates the
situation.
• The theory has generally
been discredited.
A busy street in India
 Structuralist Approach
• The structural approach was developed in the 1960s
and 1970s by Hollis Chenery. Chenery was initially
trained as an engineer and this approach reflects his
training.
• Structural approaches stress the shift in output among
the sectors of the economy and the rigidities that hinder
them.
• A shifting balance between the three major sectors of
the economy – agriculture, industry and services.
 Structuralist Approach
• The structural approach was developed in the 1960s
and 1970s by Hollis Chenery. Chenery was initially
trained as an engineer and this approach reflects his
training.
• Structural approaches stress the shift in resources
among the sectors of the economy . This approach
stresses rigidities that hinder the shift in resources.

• A shifting balance between the three major sectors of

the economy – agriculture, industry and services.
 Structuralist Approach
• Agriculture diminishes over time and industry
increases. Productivity is higher in industry so higher
growth depends upon this shift.
• A stereotypical pattern of economic growth which has
been observed in many countries.
• Initially, agriculture has a large share of output when
the economy is at a low level of development. Share of
industry and services are small.
• As industrialization takes place, the share of agriculture
declines and that of industry and services grow.
 Two Sector Model
of Growth
• The Lewis-Fei-Ranis model
(LFR), named after the three
economists that developed
it, is a two sector model – a Market Place in local Thai village

modern and a traditional

sector.
• Resources move from the
traditional to the modern
sector and this spurs growth.
More on this in chapters 4
and 5.
Tokyo, Japan
Two Sector Model
of Growth
• The beauty of the LFR
model is that it describes
many of the characteristics
of the Asian economies Market Place in local Thai village

when they were just

beginning on the path to
rapid development in the
1960s and 1970s.
• That is why it has become
so popular among
development economists
studying Asia.
Tokyo, Japan
 Solow Growth Model
• (1+ ) k (t+1) = (1- ) k (t) + s y (t)
• where k and y denote the per capita units
of capital and output, respectively, i.e. k(t)=
K(t)/P(t) and y(t)=Y(t)/P(t).
• This fundamental Solow equation says
that the amount of per capita capital in the
current period depends upon the per
capita capital in the last period, the saving
rate in the previous period and the rate of
population growth.
 Solow Model
• From the foregoing, it follows that as the
economy moves to a steady state level of per
capita capital stock regardless of initial
conditions.
• In the steady state, there is no deepening of
capital and the amount of capital per capita
remains unchanged from period to period as
does the level of per capita income. That is,
there is no long run growth in per capita income.
• Total income growth rate  is thus assumed to
be the same as the rate of growth for population.
 Solow Model
• Further, in the Solow model framework,
the saving rate has no effect on the long
run growth rate of per capita output which
is zero.
• However the saving rate does affect the
equilibrium level of per capita income.
• The higher the saving rate, the higher the
steady state level of per capita income.
 New Growth Theories
• New growth theories that go beyond Solow have been
developed in the past decade.
• They stress the importance of externalities and the
possibility of increasing returns to scale rather than the
decreasing returns to scale of the Solow model.
• The key to this is human capital formation.
• Higher per capita incomes tend to slow growth because
of diminishing returns but higher endowments of human
capital tend to speed up growth.
• Returns to such investments may be increasing.
 The Asian Growth Miracle
• For the last forty years, a
group of countries in East and
Southeast Asia have grown at
remarkably high rates.
• Japan led the way, beginning
right after World War II.
• It was joined by Thailand,
Taiwan, Korea, Singapore and
Korea in the 1960s.
• Southeast Asia followed in the
1970s.
 The Asian Growth
Miracle
• Although individual
experiences vary, South
Asia did not generally
begin to grow more
rapidly until the late 1980s
and early 1990s, when
government policy shifted
toward supporting a more
open and competitive
environment.

Patiala, India
 Policy Environment Before the
Transition to Rapid Growth

• The policy environment in most developing countries

throughout the world stressed import substitution policies
for industry.
• The theory was that developing countries had a
comparative advantage in primary products and so they
should export these products.
• The import substitution theory also argued that since
incomes were low, savings rates were also low. Inflows of
investment and financial aid were needed to lift growth.
 Policy Environment Before the
Transition to Rapid Growth

• To minimize on foreign exchange outflows, industries that

substituted for some imports were promoted by
government policy.
• Such a strategy, which was followed for several decades
after World War II in many developing countries, simply
perpetuated the cycle of North-South trade and reinforced
protectionist policies that contributed to a lack of
competition and economic inefficiency.
 Policy Environment
• What Japan and later the countries of East Asia did
was to begin to develop an environment that stressed
outward looking trade policies and the acquisition of
foreign technology.
• In the case of Japan, many believe it was an attempt to
develop a mercantilist strategy to help it recover its
influence after the defeat in World War II.
 The Asian Growth Miracle
• Primary factors
- Openness
- Macroeconomic Stability
- Labor Market Flexibility
- Education Policies
• Secondary factors
- Initial Conditions
- Sector Policies
 Primary Factors-Openness
• The first factor in the primary strategy was outward
looking policies and emphasis on exports and
acquisition of foreign technology.
• First, some industrial capability was built up by
focusing on import substitution in industries with ties to
agriculture - footwear, food processing and textiles.

Silk Factory, China

Primary Factors-Openness
• Second, after some years,
industrial policy shifted to
promoting external markets.
• Initially, this focused on
extending the scope of the
industries that were producing
for the domestic markets such
as textiles and apparel, leather
products and footwear and food
processing.
Primary Factors-Openness
• In Southeast Asia, the focus
was also put on rubber, sugar,
coconut and palm oil products
as well as some specialized
textile products such as silk.
• Slowly the emphasis shifted
toward labor intensive
industries that were not
necessarily tied to the
agricultural base such as
electronics assembly and
apparel.
Primary Factors-Openness
• The shift from import
substitution to export promotion
was led by a shift in the trade
regime so that there were lower
tariff rates on exports and
imports (see Table 2.3).
• Non-tariff barriers, including
bureaucratic procedures and
graft/corruption as well as
import bans on some items,
were also reduced.
 Primary Factors-Openness
• Transformation to labor intensive export oriented
industry was supported by flow of foreign direct
investment – initially from Japan and the US, particularly
in Korea, Taiwan and the Philippines.
• Later the volume increased and more flows began
coming in from Europe.
 Primary Factors-Openness
• A virtuous cycle of growth was created by this shift in
emphasis from import substitution to export promotion
(see Tables 2.4 and 2.5).
• In South Asia, on the other hand, the shift occurred
much more slowly.
• Technological transfer served to reinforce the shift in
export emphasis.
 Primary Factors-Openness
• Foreign technology acquired by buying from foreign
companies under license.
• By copying it without license – sometimes legally and
sometimes not.
• By entering into joint ventures (FDI).
• East Asia (Korea, Japan, Taiwan) by and large followed
the first route while Southeast Asia followed the second.
 Primary Factors-Openness
• The flow of FDI increased following the Plaza accord in
1985 when the yen appreciated and Japan began to
move some of its labor intensive industries offshore.
 Primary Factors-Macroeconomic
Stability
• The second set of primary factors focused on the
importance of macroeconomic policies and the role of
the government.
• Governments generally followed polices that created
and supported a competitive environment for export
oriented industries but not necessarily for the domestic
market. Japan is a good example of the latter.
 Primary Factors-Macroeconomic
Stability
• The amount of government intervention
didn’t seem to have a direct effect on
performance.
• There was a lot of government intervention
in the industrial and financial sectors in some
countries and little in others.
• In Korea, Japan and Singapore, there was a
lot while there was less in Malaysia and
Taiwan.
• In Hong Kong and Thailand, on the other
hand, there was virtually no intervention.
• What was important was the efficiency and
incorruptibility of the bureaucracy.
 Primary Factors-Macroeconomic
Stability
• In the Philippines and Sri Lanka, policy environments
were similar to those in the successful countries but
growth was slowed by other factors such as corruption,
lack of political will, corruption and domestic unrest.
• The efficiency of government as well as policies
followed were important. Taiwan and Singapore are
good examples.
Primary Factors-Macroeconomic
Stability
• Efficient governments are
characterized by little rent seeking,
salaries are competitive and
promotions are based on
performance not on seniority,
patronage or crony connections.
• Some policies such as financial
repression and directed government
lending programs were wasteful.

• But the flow of resources for

investment were substantial and the
wastefulness and distortions created
by these policies didn’t surface until
the 1990s bubble broke.
Primary Factors-Education and
Labour Productivity
• The third set of primary factors
focused on education and labor
productivity.
• As stressed by the new growth
theories, education played a
critical role in both the transition
to an export led growth strategy
and to the ability to sustain it
(see Tables 2.8 and 2.9).
• By 2000, some of the
educational advantages of Asia
had began to erode.
 Primary Factors-Education and
Labour Productivity
• There were two reasons for this:
– diminishing returns since more resources had to
be devoted to secondary and tertiary education.
– rapid rate of income growth that tended to
outstrip the corresponding growth in human
development.

• Behrman and Schneider concludes that schooling

attainment in miracles economies was not
particularly outstanding.
Primary Factors-Education and
Labour Productivity
• The conclusion is that labor market
flexibility has to be considered
along with education.
• The miracles economies did not
have strong unions until recently
(Korea) and weak minimum wage
legislation.
• ILO rates the miracle economies
as among those with the most
flexible labor markets.
• Mobility from rural to urban is also
high.
Secondary Factors-Differences in
Initial Conditions

• Initial conditions played a part in the success of the

miracle conditions.

• Land, income and wealth distribution in the miracle

economies were generally more even than in other
countries and regions.

• Average educational attainment was high at the

beginning of the high growth period.
Secondary Factors-Sector Policy
• Sector policies were influential
to the growth of the miracle
economies.
• Agricultural sector policies
were not particularly onerous.
There were taxes on
agriculture but sector was still
viable as we will see in
Chapter 4.
• Industrial policies were benign
and competition flourished in
most countries.
 Secondary Factors-Sector Policy
• In Korea and Taiwan, “infant industry” protection
policies were strictly enforced and favored export
industries were monitored for efficiency and export
performance. Subsidies were withdrawn if performance
was below expectations.

• There is considerable debate about whether industrial

policy in these two countries was beneficial or not.

• Whatever the outcome of these discussions, it is a fact

that growth was rapid in both countries.
Aspects of Economic Performance

• High levels and growth rates of savings and investment

in miracle economies.

• Both of these variables increased dramatically as a

percent of income (see Tables 2.6 and 2.10).

• Furthermore, the saving-investment gap was small or

even negative for some countries (see Table 2.11).
Aspects of Economic Performance

• Increased productivity in miracle economies.

• Measures of TFP show a modest contribution to output

growth until the middle of the 1980 and an acceleration
afterwards.

• The latter is the combined result of previous transfer of

technology and more rapid FDI following the Plaza
accord.
 Convergence of Income
Question:

The Solow model tells us that incomes will converge to a

steady state irrespective of where they started out.

This assumes that the technical progress coefficient, ,

remains constant across all countries.

Is this a realistic inference?

 Convergence of Income
• To test this hypothesis of absolute convergence,
we can see if there is a relationship between per
capita income in an initial period and the growth in
income in successive periods.
• Using logs to denote growth we have, for the
period 1960 to 1990,

log[Y (1990) − Y (1960)] = a + b log Y (1960)

 Convergence of Income
• Tests of this model for several sets of countries
shows that it doesn’t hold for a heterogeneous
group of countries around the world.
• It does hold for OECD countries and for OECD and
Asian countries together.
• It does not hold for developing countries in general.
 Convergence of Income
• A less restrictive form of convergence is called
conditional convergence.
• In this form of the model, we allow the various
parameters of the growth equations to change
between different countries or groups of countries
• There would still be a convergence in growth rates
of income but the level of income in the steady
state would differ.
• This level would depend upon saving rates,
population growth rates and depreciation rates of
capital.
• Tests of this model show that there is still a lot of
unexplained variation in per capita income,
although variations in population growth rates and
saving rates did explain about half of the variation
in per capita income across countries.
• However these results imply that the rate of
convergence is very slow.
• What is likely is that a number of other factors are
involved aside from the saving and population
growth rates, such as the spread of technology and
the role of education.
• We return to these issues later.
 Convergence
• There is evidence that there is
convergence within groups of countries
with similar geographic and economic
similarities such as the European Union or
countries in East Asia.
• However there is less evidence that there
is convergence between rich and poor
countries
 Convergence
• For example globally there is strong
evidence for divergence.
• Rich countries get richer and poor
countries get poorer.
• This does not hold within countries
although the convergence is slow.
• German states and Japaneses prefectures
and states of the US are converging.
 Summary

• Review of the various economic growth theories.

• Application of the growth theories to the Asian growth

miracle.

• The importance of primary and secondary factors in the

success of the Asian miracle economies.