Chapter one

An introduction in to the course

The chapter deals with

 Current interest in development economics
 Definition and nature of development economics
 The meaning of economic growth and economic development
 Human development
 Development gap

“while humanity shares a single planet, it is a planet on which there

are two worlds, the world of the rich and the world of the poor’
.Ranan Weitz, 1986

1. Introduction

About 1/4th (the majority of people found in North America and

Western Europe) live in comfort table situation. For example
 Houses with many rooms
 More than enough to eat
 Well clothed
 Adequate medical treatment
 Reasonable degree of medical treatment

Abou3/4th (most people in Africa, Asia, and Latin America) live in

uncomfortable situations. For example
 No shelter
 No adequate food
 Poor health
 Can’t read and write
 Their f4euture is uncertain

Some questions follow the above seen reality

 How does traditional, subsistence low productivity
society can be transformed?
 To what extent do the economic conditions of the rich
nations help the development aspiration of the poor
countries?
The course tries to answer the above mentioned and many other
complex economic questions.

1.1The current interest in development economics

1
 The subject is of recent origin, in the post 1950s (about five
decades ago). The public and political concern for the poor
nations is only recently increasing.

 Factors which were not conducive for the development of

the subject in the pre 1950 period

 In the 1930s advanced countries were caught up in and fully

engaged in ‘the great economic depression’

 In the 1940s countries were fighting world war two

 The developing countries (Africa, Latin America and Asia) were

caught up with serfdom, stagnation and colonialism.

 The favorable factors that helped the rise of the subject

include

 The recent renewed interest from academicians in the growth

and development process of developing countries

 Recently poor countries became aware of their backwardness

and developed the desire to become strong through economic
growth. The quest for (NOE) New Economic Order by these
nations is a case in point. NEO is based on equity, sovereignty,
equality and common interest among all nations and thus calls
for

 Terms of trade improvement

 Access to markets of developed nations
 Greater financial assistance and
canceling of past depts.
 Reform on multinational financial
institutions such as IMF (International
Monetary Fund) and WB (World Bank).
 Increasing mutual interdependence of the world economy
through trade and finance

Concepts and principles in development economics

1.2definition and nature of development economics

Development economics is a branch of economics that systematically

studies the economic development of the third world nations of Africa,
Asia (except Japan) and Latin America (including Caribbean nations).

2
Development economics is one of the newest and most challenging
branches of the broadest disciplines of economics and political
economy and became a separate field of study in economics after the
pioneering studies of two economists

o Arthur Lewis and

o Theodore Schultz 1979 Nobel prize winners

Development economics draws on relevant principles and concepts

from other branches of economics such as
 Macroeconomics
 Labor economics
 Public finance
 Microeconomics .etc

The nature of development economics is different from that of

traditional economics and political economy.

 Traditional economics
It is concerned with the least cost allocation of resources and the
growth of these resources overtime. It also deals with the advanced
capitalist world of perfect market, consumer sovereignty, marginal
and individualistic based decision making, market equilibrium etc.

 Political economy
Goes beyond traditional economics and studies the social and
institutional process through which certain groups of economic and
political elites dominate the allocation of resources.

 Development economics
It Deals with economic, social, political and institutional mechanisms
necessary to bring rapid and large scale improvement in living
standards of the poverty stricken peoples of Africa, Asia and Latin
America.

Terminologies used in development economics

Various terminologies are used in development economics to identify

the rich nations from the poor nations. Some of them are;

3
  Modern Vs backward countries; this terminology is not however
commonly used because of its negative connotation
 Developed Vs underdeveloped( developing) ; this way of
classification is most popular
 Most developed Vs least developed countries; this terminology
or way of classification is also commonly used to differentiate
rich nations2 from poor nations
 High, middle and low income countries; this classification is
based on the level of income of countries. It has been later
redefined by the World Bank as follows based on specific per
capita income (PCI) ranges,
 Low income countries = are economies with PCI less than $ 755
in the year 2000’s constant prices

 Middle income economies= are countries with PCI $ 755 to

$9265 in the year 2000’s constant price

Middle-income countries may be further divided in to

 Lower middle income countries= economies

with PCI of $755 to $2995 in the year 2000’s
constant prices

 Upper middle income countries= economies

with PCI of $2995 to $9265 in the year 2000’s
constant prices

 High-income economies= are economies with PCI greater than

$ 9265 in the year 2000’s constant prices.

* Both the low and middle-income economies are categorized as

developing economies.

The meaning of economic growth and

development
The term economic development is used interchangeably with such
terms as economic growth, economic welfare, economic progress and
secular change. However, the term economic development has its own
distinctive meanings and hence differs from terms such as economic
growth. Economic development refers to the problems of
underdeveloped countries and economic growth to those of advanced
countries.

4
According to Schumpeter,” Development is a discontinuous and
spontaneous change in the stationary state, which forever alters and
displaces the equilibrium state previously existing; while growth is a
gradual and steady change in the long run which comes about by a
general increase in the rate of saving and population.”

According to Mrs. Ursula Hicks, the problem of underdeveloped

countries are concerned with the development of unused resources,
even though their uses are well known, while those advanced
countries are related to economic growth mast of their resources
being already known and developed to a considerable extent.

According to Kindle Berger, Economic development should include .

the eradication of mass poverty with its correlates of illiteracy,
disease and early death; changes in the composition of input and
output that generally include shifts in the underlying structure of
production away from agricultural towards industrial activities, the
organization of the economy in such a way that productive
employment is general among working age population rather than the
situation of the privileged minority; and the correspondingly grater
participation of the broad groups in making decisions about the
directions of economic and other activities to improve their welfare.
Economic growth is a mere expansion of the economy without
structural changes. There can be economic growth without economic
development. There are several countries that have achieved higher
rates of economic growth without improvement in the income
distribution and standards of living. For example some oil exporting
countries have achieved highest rates of national income (GDP) but
without qualitative changes in their economy.

Economic development implies growth plus structural transformation.

Economic growth can be attained in several ways but to have
development there are limited ways.

Before the 1970 economic growth was considered to be equal to

development because it was assumed that a gain in overall GDP would
trickle down to the poor.

In 1970 development was redefined in terms of

 Reduction and elimination of poverty
 Reduction and elimination of inequality and underemployment

I.e. redistribution from growth became a common slogan.

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According to world development report (1991) “ the challenges of
development is to improve the quality of life in the world’s poor
countries. A better quality of requires
 Higher income
 Better education
 Higher standards of health and nutrition
 Less poverty
 Cleaner environment
 More equality and opportunity
 Greater individual freedom
 Richer cultural life

Professor Goulet (1971) states that development has three core values
I. Life sustenance
It refers to the ability to meet the basic needs such as food, shelter,
health minimal education and protection. In a condition where the
basic needs are not met, we cannot say the country ifs fully developed
despite its high GDP or income level.

Efforts to meet these basic needs are known as the basic need
approaches to development, which was initiated by World Bank

II. Self esteem

It is concerned with the feeling of self-respect and independence or
not being used as a tool by others. No country could be regarded as
fully developed if others exploit it and does not have the power and
influence to conduct relation on equal terms.

II. Freedom from servitude (to be able to choose)

It refers to the freedom from ignorance and poverty. No body is free if
he /she cannot choose and is imprisoned by living at the margin of
subsistence with no education and skill.

Freedom also refers to political freedom including personal security,

the rule of laws, freedom of expression and political participation on
equal footing.

Hence, according to Professor Goulet, the objective if development

must be

 To increase the availability and widen the distribution of basic

life sustaining goods

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  To raise the level of living including more jobs better education,
greater attention to cultural and humanistic values all of which
serve to generate individual and national self esteem.

 To expand the range of economic and social choice available to

individuals and nations bay freeing them from servitude.
Obstacles to economic development
There are various obstacles to economic growth and development
in developing countries. Some of the basic obstacles observed in
poor nations include;

A. Vicious circle poverty

It implies a circular association of forces tending to act and
react up on one another in such a way so as to keep a poor
country in a state of poverty.
Diagrammatically
Demand side
Supply side

Low
productivity Low productivity
Capital
deficien Low
cy Capital
income
deficien
cy
Low
Low demand
investment
Low
investment
 Demand side vicious circle
Low level of income => low level of demand=> low level of
investment => back to deficiency of capital and low productivity

 Supply side vicious circle

Low level of real income=> low rate of saving => this leads to
low rate of investment. Hence, the process will lead back to
capital deficiency and low productivity.

7
 **Additionally, in developing countries, underdeveloped
natural resources are both consequences and causes of
backwardness.

Market imperfection

Underdeveloped natural
resources

Backward people

B. Low rate of capital formation

In developing nations, shortage of capital is a great obstacle to
economic development.

As the majority of the people in these nations are illiterate and

unskilled, they use age-old methods of production=> low marginal
productivity=> low real income=> low saving=> low investment
and capital formation

Further the consumption level is already low in developing nations

hence; it is very difficult to increase the level of saving (capital stock)
by reducing consumption. On the other hand, the saving of the few
rich doesn’t flow to productive channels but to durable consumer
goods and conspicuous consumption.

C. Socio cultural obstacles

LDCs (least developed countries) have social institutions and
attitudes, which are not conducive or suitable to development.

According to the UN’s report on the process’s and problems of

industrialization in LDCs, there are unfavorable factors or elements of
social resistance to economic change in LDCs, which include
institutional factors like

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  Rigid stratification of occupations reinforced by traditional
beliefs and values
 Attitudes involving inferior valuation attached to business roles
 Backward social attitudes
 Unfavorable political conditions
 Stratification and classification based on class, religious groups,
caste system, ethnic groups. Etc

D. International forces
Apart from local problems, international problems are also basic
causes of poverty. To begin with historical factors such as colonialism
and neo colonialism have played a significant role in hindering the
development of many poor African nations.

The gains from trade have also gone mainly to the developed
countries (DC s). Further the development of the export sector only
made other sectors to neglected i.e. most of the poor nations are
basically concerned towards developing exportable agricultural
commodities rather than being concerned about the overall
development of their domestic economy. Apart from this too much
dependence on exports has exposed many LDCs’ economies to
international fluctuations in the demand for and prices of their
products. Hence the development efforts of many poor nations were
negative.

Foreign investment in most African nations has been mainly directed

towards increasing exportable goods. It has, however, tended to affect
the economy adversely because the levels of productivity, incomes
living standards have not risen in the primary sector. Even in the
export sector, the level of real wages of unskilled labor has remained
low. The foreigners have been draining out large amounts of money in
the name of profit and wages of management.

Basic requirements for development

So as to be developed the poor nations must fulfill certain conditions.
Some of the basic requirements for development include
A. An indigenous base
For a poor country to be developed a strong domestic economic base
has to be created. This will happen if there is an internal motivation
for the growth process being firmly rooted within the domestic
economy.

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 B. Removing market imperfections
Market imperfections lead to factor immobility and restrict sectoral
expansion and development. To avoid the problems associated with
market imperfections the following measures have to be taken
 Improving the existing socio-economic institutions or
replacing them with new ones
 Expanding capital and money market
 Making Cheap credit facilities available to traders and
small businessmen
 Further, radical changes must be brought in the
economy so as to push the production frontier beyond
the production possibility curve.

D
C

A poor country is unable to reach at points on the production

possibility frontier such as point and C due to market imperfections
and hence, remains below the curve such as at point D. economic
development requires not only moving to a given production
possibility frontier but also to push beyond it outwards.

C. Structural changes
It implies the transformation from a traditional agricultural society to
a modern society or industrial economy involving a radical
transformation of existing institutions, social attitudes and
motivations.

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It transfers population from primary to secondary and territory
sectors. It is also the development of new social systems, which would
replace the old social systems, which are simply based on class, caste
and religious differentials.

D.Capital formation
It related to the process of developing investible funds and directing
them to investment areas. It involves three interdependent stages

i. An increase in the volume of real saving

ii. The existence of credit and financial institutions to mobilize

these savings for converting them in to investible funds.

iii. The use of these savings for the purpose of investment in

capital goods

E. Following suitable investment criterion

In the process of bringing growth and development, any developing
economy is supposed to follow suitable policies of investment but
there is no well-defined single criterion, rather a set of suitable
criterion.

i. Social and economic overheads

Investment should aim at developing the growing points in the
economy. In the beginning, particular growing points should be
developed which intern will set chain reactions and influence the
entire economy.

ii. Balanced growth

Investment should be based on the principle of balanced growth
i.e. an all round and simultaneous development of the different
sectors of the economy where there is a harmonious growth of
sectors so that no sector lags behind or moves ahead of the others.

iii. Choice of techniques

Economic planners must always make their decisions based on
broad development objectives in the process of adopting a
particular technique of production. That is a feasible production
technique needs to consider various aspects of the economy apart

11
 from achieving its direct objectives. E.g. feasible production
techniques in Ethiopia shoul make use of
 Unskilled labor (labor intensive production technique)
 Local inputs and raw materials
 Land and environmental favor abilities etc.
E.g. investments in the agricultural sector

iv. Capital output ratio (K/Y)

While making a choice among investment projects and in
determining priorities, K/Y ratio of different projects must be
compared. The lower the K/Y ratio, the higher is the growth rate of
the economy. E.g.

Project1 => K/Y = 3/1 Project1 is selected

Project2 => K/Y=4/1

F. Socio cultural requirements

To bring development it requires changing people’s attitudes from
backward and primitive thinking to modern thinking and in this
process education has to be used as a great tool of enlightenment.

G.Administrative requirements
The existence of a strong, competent and uncorrupt administration is
crucial for economic development. Government has to a strong one,
capable of maintaining law and order and defending the country
against external aggression. In the absence of stable government and
peace, public policies change very often and create problems to
ongoing investments. Further economic plans cannot be implemented
without efficient administration

** Government must offer

 Order, justice, good policy and security

 Rewards and incentives based on ability

 Assurance that business contracts would be kept

 Stability of the government itself to maintain a sense of order

and future calculability of expectations.

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 Human development
Every year, UNDP publishes HD report in which it tries to show HD
status of 175 countries using Human Development Index (HDI).

HDI attempts to rank all countries on a scale of 0 (the lowest HD) to 1

(highest HD) based on three goals or end products of development:
 Longevity as measured by life expectancy at birth
 Knowledge as measured by a weighted average of adult
literacy (2/3) and mean years of schooling (1/3).
 Standard of living as measured by real per capita income
adjusted for the differing PPP.
Using the above three measures of development and applying HDI
formula, UNDP categorizes countries into three groups:
 Low HDP (0.00 to 0.499)
 Medium HDP (0.50 to 0.799)
 High HD (0.80 to 1.0)

To calculate HDI, First, we calculate three indices, namely income

index (INI), life expectancy index (LEI), and education index (EI) and
then combine them in some way to arrive at HDI.
2. Income index:
 Calculated by dividing the logarithm of current income
minus the logarithm of the lowest per capita income as
observed over the past generations in any country by the
logarithm of maximum per capita income that a country
could reasonably aspire to over the coming generation
minus the logarithm of the lowest per capita income as
observed over the past generations in any country

Where CI = current income

LPCI = the lowest per capita income as observed
over the past generations in any country
MPCI = maximum per capita income that a country
could reasonably aspire to over the coming
generation
NB: According to UNDP, LPCI = 100 PPP and MPCI =
40000 PPP
EXERCISE: Suppose Ethiopia's 2004 PPP income per
capita was $100. Calculate the income index.
3. Life expectancy index (LEI)
 Calculated by dividing current life expectancy (CLE) in
years minus the lowest life expectancy as observed over
the past generations in any country (LLE) by the range of

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 life expectancies expected over the previous and next
generations (RLE)

where LLE and RLE are taken to be 25 years and 65 years

respectively.
EXERCISE: Suppose that in 2004 Ethiopia's population life
expectancy was 47 years. Calculate the life expectancy index.
4. Education index (EI):
 To calculate EI, we need first to calculate two indices:
adult literacy index and gross enrollment index.

 Adult literacy index (ALI):

 Calculated using the following formula

EXERCISE: suppose the 2004 adult literacy rate

in Ethiopia is 60%. Calculate adult literacy index.
 Gross enrollment index (GEI):
 Calculated using the following formula

EXERCISE: suppose, in 2004, 45 percent of

Ethiopia's primary, secondary, and tertiary age
populations are enrolled in school. Calculate
gross enrollment index.
 EI is therefore calculated by taking the weighted average
of the above two indices.

Our HDI is therefore,

Development gap
There is wide development gap between rich and poor countries in
terms of
 Level of per capita GDP
 Level of employment
 Level of education
 Level and quality of infrastructure, public service, etc
Questions:

14
 5. Can the underdeveloped countries catch up with the
developed ones? To what extent is this challenge to theses
countries?
Answers:
6. If poor countries progress at a rate faster than that of
developed countries, they can catch up; but it is not simple.
To see how daunting the challenge is, let us try to answer the
following questions.
1. given their current growth experience,
a. How long does it take developing countries to
reach the current average level of PCI in the
industrialized countries?
b. How many years does it take developing
countries to eliminate the PCI gap?
2. given the rate of growth of MDCs,
a. How fast should developing countries grow for
the next 20years (from 2006 to 2025) for their
PCI to be equal to that of MDCs by 2025?
b. How fast show developing countries grow for
the next 20 years (from 2006 to 2025) so that
the income gap between them and the MDCs
remain the same as 2006 by the year 2025?
Solution: Let:
Current (at the beginning of 2006) level of
PCI of the industrialized countries =
$20000
The PCI growth rate of industrialized
countries = 3%
Current level of PCI of LDCs = $1200
The PCI growth rate of LDCs = 2%
The PCI of industrialized countries after
certain number of years
PCI of LDCs after certain number of years
Required growth rate of PCI of the LDCs
n = number of years
1. YD =
YD =

2. =0

15
 Given that YD > YDC, the above equality holds
iff . Let us assume that 0.07 (e.g.
South Korea) and as before 0.03.

3. =

4.

16
 Measurement and comparability of PCIs
PCI is often used as a summary index of the relative economic
wellbeing of people in different nations. PCI is given by a formula

GDP is defined as the total final output of goods and services

produced by the country's economy, within the country's territory,
by residents and nonresidents, regardless of its allocation between
domestic and foreign claims.

It is inappropriate to use PCI of developing countries for comparing

them with other countries because:
7. the majority of the population in LDCs are subsistence
farmers who produce for own consumption and such outputs
are not reported correctly in calculation of GDP
8. people in LDCs underreport their income for fear of tax
9. the gradual extension of monetary economy and the shift of
economic activities from the HH to the market place in LDCs
affects GDP
10. distortion of prices is very high in LDCs than in MDCs
11. the cost of pollution and other environmental degradation
are not deducted from the GDP to get net GDP in LDCs.
These are deducted in MDCs (e.g., Sweden, Netherlands)
Even if the above problems don't exist, there is still another problem
which renders the use of PCI as economic wellbeing index
inappropriate.
 The problem arises when the national income measured in local
currencies are converted into US dollar at official exchange rate
determined by free exchange market or by the action of
governments. In this case, GDP of LDCs will tend to
underestimate the economic wellbeing of the people of LDCs.
For example, if GDP of Ethiopia is 870 birr, this can be
converted to into US dollar by using official exchange rate as
follows:
GDP in USD = 870/8.7 = $100
 Question: Is Br8.70 (=$1) in Ethiopia equivalent to $1 in USA in
terms of purchasing power? That is, can it buy the same level of
living standard in both countries, or is the official exchange rate
a good measure of purchasing power parity between countries?
 Answer: The official exchange rate, even if it is determined by a
free market, is not a good measure of purchasing power parity
(equality) between countries at different stages of development.
The reason is exchange rates are determined by the supply and

17
 demand for currencies based on traded goods only. But
domestic price is a composite of prices of
 traded commodities whose prices are equalized
internationally, and
 Non traded commodities whose prices are largely
determined by the cost of labor which tends to be
lower for poor countries.
Therefore, in LDCs where the ratio of prices of non
traded goods to traded goods is lower, GDP converted
to foreign currency using official exchange rate will
understate the living conditions of the people.
2. Therefore, to make meaningful international comparison of
economic wellbeing, we need to convert PCIs of each country
into their purchasing power equivalents (PPE) where by PPE
we mean the real buying power of a given monetary income.
But, how do we convert PCI in local currency into its PPE? In
its simplest version, PPE of PCI is calculated by multiplying
PCI in local currency by PPPs instead of official exchange
rates. As an example, suppose:
 A basket of goods costs $20 in USA and Br 36 in Ethiopia.
 Ethiopia’s PCI in 2004 is Br 870.
 Official exchange rate: $1 = Br 8.70
Given the above information, the PPE of Ethiopia’s per
capita income will be
PCIPPP = Br 870 X (20/36)
= 483.3.
where PCIPPP is PPE of per capita income. The above result
says that, in terms of purchasing power, Br 870 in Ethiopia is
equivalent to $483.3 in USA. But in terms of official exchange
rate Br 870 is equivalent to only $100.

=> Note that

 it is difficult to get representative consumption baskets

 The gap between the rich and poor nations is not as wide under
PCIPPP as compared to the gap that exists when we uses PCI
calculated using official exchange rate.

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 Chapter Two
Diverse Structure and Common Characteristics of
Developing Countries

This chapter will try to identify some of the most important

structural differences and common characteristic features
observed in developing nations.

The diverse structure of developing economies

Any portrayal of structural diversity of developing countries requires
an examination of:
1. the size of the country(geographic area, population, and
income)
2. its historical and colonial background
3. the endowment of physical and human resources
4. its ethnic ad religious composition
5. the relative importance of its public and private sectors
6. the nature of industrial structure
7. the degree of dependence on external economic and political
forces
8. the distribution of power and the institutional and political
structure within the nation
Let’s briefly consider each one of them.

1. The size of the country

The sheer physical size of a country, size of its population, and level
of its per capita income are:
9. Important determinants of its economic potential, and
10. Major factors differentiating one developing country from
another

With regard to population size, of the 160 developing countries that

are full members of UN in 2000,

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 11. 87 had fewer than 5 million people
12. 58 had fewer than 2.5 million people
13. 38 had fewer than 0.5 million people
The physical sizes of these countries also vary.

Large size (both in terms of population and physical area) usually

presents advantages of
14. diverse resource endowments
15. large potential markets, and
16. a lesser dependence on foreign resources of materials and
products
But, it also creates problems of
17. administration control
18. National cohesion, and
19. Regional imbalances
 Note that there is no necessary relationship among a country’s
size, its level of PCI and the degree of equality and inequality of
income distribution (see the table below)

Table 1: The ten most and selected least populated countries

and their per capita income, 2000
Populati Populatio
GNP per GNP per
Most on n
capita Least populous capita
populous (millions ( thousan
(US $) (US $)
) ds)
China 1261 840 Saint Kitts- 41 6600
Nevis
India 1016 460 Antigua and 68 9190
Barbuda
United 282 34260 Dominica 73 3260
states
Indonesia 210 570 Seychelles 81 7310
Brazil 170 3570 Kiribati 91 950
Russia 146 1660 Grenada 98 3520
Pakistan 138 470 Tonga 100 1660
Banglade 130 381 Saint Vincent 115 2690
sh
Nigeria 127 200 Micronesia 118 2110
Japan 127 34210 Sao Tome 149 290

2. historical and colonial background

As most LDCs were once colonies of western European countries,
their economic structure as well as their educational and social

20
institutions have typically been modeled on those of their colonial
rulers

The colonial powers of the west had a dramatic and long lasting
impact on the economies and political and institutional structures of
their colonies by their introduction of new and tradition-shattering
ideas like;
20. private property
21. personal taxation, and
22. the requirement that taxes be paid in money rather than
in kind

 Generally, different colonial heritages have

created different institutional and social patterns
in LDCs as much as similar colonial heritages have
resulted in similar institutional and social patterns.

3. Physical and human resources

A country’s potential for economic growth is greatly influenced by
its endowments of
23. physical resources (land, minerals, and other raw
materials), and
24. human resources (numbers of people and their level of
skills)

The extreme case of favorable physical resource endowments is the

Persian gulf oil states. At the other extreme are countries like Chad,
Yemen, Haiti, and Bangladesh, where endowments of raw materials
and minerals and even fertile land are relatively minimal
25. NB: high mineral wealth is no guarantee of development
success. E.g., Congo
Geography and climate can also play an important role in the
success or failure of development efforts. For example, all other
things remaining constant,
 Island economies like Taiwan seem to do better than
landlocked economies
 Temperate zone countries do better than tropical
nations

With respect to human resource endowments, the following aspects

of people of a country are important
 population size
 level and skill of the people
 people’s cultural outlooks
 attitudes towards work that people have

21
  people’s access to information
 willingness to innovate that people possess
 desire for self-improvement that people have
 level of administration skill of the people, etc

 In general, the nature and character of a

country’s human resources are important
determinants of its economic structure and these
clearly differ from one region to the next.

4. Ethnic and religious composition

Today, more than 40% of the world’s nations have more than five
significant ethnic populations and in most cases one or more of these
groups face serious problems of discrimination and thus potential
and overt conflict and violence between these ethnic groups is
becoming a common phenomenon.

Over half of the world’s LDCs have recently experience some form
interethnic conflict
e.g. Just in 1990s, ethnic and religious conflicts leading to
widespread death and destruction took place in
Afghanistan, Rwanda, Mozambique, Sri Lanka, Iraq, India,
Somalia, Ethiopia, Liberia, Angola. Myanmar, Sudan,
Yugoslavia, Haiti, Indonesia and DRC

These overt conflicts and widespread violence clearly lead to

internal strife and political instability and thus to underdevelopment.
Thus, it is not surprising that some of the most successful recent
development experiences – South Korea, Taiwan, Singapore, and
Hong Kong – have occurred in culturally homogeneous societies.

Note that
Ethnic and religious diversity need not necessarily
lead to inequality, turmoil or instability. There have
been numerous instances of successful economic and
social integration of minority or indigenous ethnic
populations in countries as diverse as Malaysia,
Mauritius, and Zimbabwe.

 To sum up, the ethnic and religious composition of

a developing nation and whether or not that
diversity leads to conflict or cooperation can be
important determinants of success or failure of
development efforts.

22
 5. Relative importance of the public and private sectors
Most developing countries have mixed economic system, featuring
both public and private ownership and use of resource. This division
between the two and their relative importance are mostly a function
of historical and political circumstances.

 In general, Latin American and south East Asian

nations have larger private sectors than south
Asian and African nations.

6. industrial structure
The majority of developing countries are agrarian in economic,
social, and cultural outlook. Agriculture, both subsistence and
commercial, is a principal economic activity in terms of the
occupational distribution of the labor force, if not in terms of
proportionate contributions to the gross national product.
Nevertheless, there are great differences between the
structure of agrarian systems and patterns of land ownership
among developing countries.

It is in the relative importance of the agricultural, manufacturing,

and service sectors that we find the widest variation among
developing nation. The following table provides information on the
distribution of labor force and gross domestic product (GDP)
between agriculture and industry in 17 developing countries, the
United States and the United Kingdom.
Table 2: industrial structure in seventeen developing countries,
United States, and the United Kingdom, 1996
Percentage of labor force Percentage of GDP
Country Agricult Industr Servic Agricultu Indust Servic
ure y e re ry e
Africa
DRC 75 12 13 64 13 23
Kenya 81 7 12 29 16 55
Nigeria 54 5 41 43 25 32
Tanzania 90 5 5 48 21 31
Uganda 86 4 10 46 16 38
Asia
Bangladesh 64 14 22 30 18 52
India 65 13 22 28 29 43
Indonesia 55 10 35 16 43 41
Philippines 46 16 38 21 32 47
South Korea 21 27 52 6 43 51
Sri Lanka 46 13 41 22 25 53
Lain America
Brazil 31 27 42 14 36 50

23
 Colombia 30 14 56 16 20 54
Guatemala 60 12 28 24 20 56
Mexico 28 19 53 5 26 69
Peru 37 19 44 7 37 56
Venezuela 16 28 56 4 47 49
All developing 60 17 23 20 38 42
countries
United states 2 25 73 2 29 69
United kingdom 1 24 75 2 37 61

7. External Dependence: Economic, Political, And Cultural

The degree to which a country is dependent on foreign economic,
social, and political forces is related to its size, resource endowment,
and political history. For most developing countries this dependence
is substantial. Most small nations are highly dependent on foreign
investment and trade with the developed world.

Even beyond economic dependence, developing countries are

dependent on developed countries through transmission of
institutions (e.g., systems of education and governance), values,
patterns of consumption, and attitudes toward life, work and self.

8. political structure, power, and interest groups

It is often not the correctness of economic policies alone that
determines the outcome of national approaches to critical
development problems. The political structure and the vested
interests and allegiances of ruling elites (e.g., large landowners,
urban industrialists, bankers, foreign manufacturers, the military,
trade unionists) will typically determine what strategies are possible
and where the main roadblocks to effective economic and social
change may lie.

 In general, most developing countries are ruled

directly or indirectly by small and powerful elites
to a greater extent than the developed nations are.
Effective social and economic change thus
requires either that the support of elite groups be
enlisted or that the power of the elites be offset by
more powerful democratic forces.

24
 Common characteristics
1. Demographic characteristics
Very poor countries are characterized by high birth rate and high
death rate. As economic development proceeds, death rate
declines because of improvement in health conditions & access to
health services. But, for birth rate to decline it requires substantial
economic development .The difference between the developed & the
LDCs is nowadays mainly in the birth rate. As a result the gap
between birth rate & death rate in LDCs is widening. As population
growth rate = Birth rate - death rate, the wide gap between the two
leads to high population growth in LDCs

 High population growth has two effects:

1. It means that overall income must grow faster than
population to keep per capita growth at reasonable
levels. Since growth in population
a. increases the number of people who divide the
national income, and
b. helps income to grow as a result of greater supply
of productive labor
Per capita income to grow 'b' should dominate 'a'. In
countries not endowed with large quantities of capital
(physical or human), 'a' is dominant.

2. The overall population will be young because high birth

rate means larger proportion of children is entering into
the population and hence population is weighted heavily
in favor of children. This leads to greater economic
dependency burden in developed countries.

Birth population dependence

rate/1000 growth burden
MDC 15-20 0.5% 1/3
s
LDC 30-40 2% 2/3
s

The consequence of high econ dependency ratio is poverty

& child labor (child poverty). Evidences show that
population growth varies with PCI. In general, the
population growth rate declines as PCI (in PPP) increases.

25
 Thus, poor countries have higher population growth than
the DCs.
2. Occupational & production structure
Substantial amount of labor is living in rural areas (72%) in LDC (in
low income countries), 60% in middle income countries and 20%
(and most of which are engaged in non- agricultural activates) in
DCs

Agriculture accounts for the significant portion of production in

LDCs the average proportion of output from agriculture is close to
30% in low income countries, 20% in middle income countries and 1-
7% in DCs..
Lab Agr
Population Urban Rural force share
(mil) (%) (%) in Agr in
(%) GDP(%)*
WORL 5420 43 57 -
D 57
DCS 1224 73 27 7 3
LDCS 4196 34 66 62 17
32
Africa
SE 21
Asia

* Greater than 60% in Ethiopia.

 There is a downward trend in the share of labor
force in agriculture as economy grows.

3. Rapid Rural- Urban Migration

The migration of rural labor force to the urban areas could be due to
push and pull reasons.
 The push from agriculture is due to the extreme poverty and
landlessness.

 The perceived pull of the urban sector is reinforced by a variety

of factors such as
1. high wage, and
2. Workers protection by labor union and their government.

Urban population growth rate varies with the level of development,

due to variation in the level of rural – urban migration, For example

 45 low income countries, the rate of growth of urban population

is 3.9% while the overall population growth rate is 2%.

26
 Therefore, the difference (3.9% - 2%) is due to rural – urban
migration.

 In the middle income countries (63 countries), urban population

growth rate is 2.8% while the overall growth rate is 1.7.
Therefore, the difference (2.8% - 1.7%) is due to rural – urban
migration.

 For the high income countries urban population growth this 0.8
while the overall population growth is 0.6%. Therefore, urban
population growth rate due to rural – urban migration is 0.2%
i.e., (0.8% - 0.6%).

 As shown above, rural urban migration is

higher in LDCs than MDCs. this is not bad, but
since it is very high (in LDCs), it imposes
enormous strain. When the migration is enormous
as the migration can not get job in urban areas
and as a result unemployment will be higher and
there will be more urban slams & shanty places.
One piece of evidence that reveals the strains from
rural – urban migration is that larger proportion of
people in LDCs is engaged in service sector
(tertiary sector). Informal sector (street vendors)
is seen as services sector. It is for this, not
because of development (healthy growth), that
large proportion of people in LDCs are said to be
engaged in the service sector

4. International Trade
Both poor & rich countries are engaged in international trade. The
intensity of trade is measured by:

There is no significant difference in this ratio between the LDCs and

MDCs. For example, in USA, Mexico & India, this ratio is 10% while
in Singapore and Hong Kong it is 100%. But there is a difference
between LDCs & DCs in the composition of export trade in that;

 LDCS are often exports of primary products such as raw

materials; cash crop (coffee, tea, cacaos) and sometimes food.

 The bulk of export from the MDCs is manufactured foods

(refrigerator, house appliances, etc).

27
Exceptions to the above broad generalizations are:
 Singapore, china, and Hong Kong (LDCs) manufactured goods
 Norway (MDC) – exports oil (primary products)

The share of primary products in total export declines with PCI. This
indicates that developing countries rely on primary products and
MDCs rely on the manufacturing product export. The traditional
explanation for the structure of international trade comes from the
theory of comparative advantage which states that countries
specialize in export of commodities in which they have a relative
cost advantage in production. This cost advantage comes from
difference in technology, domestic consumption profiles, or the
endowment of inputs that are conductive for the production of
commodities.

Because LDCs are endowed with unskilled labor & tropical climate
which is conductive for cultivation of such primary products as
crops, they have a relative cost advantage in export of such primary
products.

Some of the disadvantages of being involved in export of

primary products include

 Primary products are particularly subject to large fluctuation in

the world market price. This creates instability in export
earning.

 Over the long-run primary products become less important in

the consumption basket of people in the world. That is, their
income elasticity of demand less than 1 and thus their relative
prices will be very low (assuming that PCI increases). Therefore,
terms of trade declines for LDCs where:

Since terms of trade rises with PCI, countries with low PCI
are more likely to face a declining terms of trade compared
to the rich countries.
 Technology is often assimilated through learning by doing
(production). So if a country is producing and exporting only
primary products, then the transfer of technology from MDCs to
LDCS will be very low. E.g. Philippine currently exports

28
 manufactured goods & hence technology is being transferred
fast

 There is no difference between the MDCs and LDCs in the

composition of import.

5. High and Rising Levels of Unemployment and

Underemployment
Inefficient use of labor is one of the reasons for low level of living in
LDCs. There are two kinds of labor underutilization:
1. open unemployment
2. Underemployment

Labor underutilization occurs as an underemployment because

people both in rural & urban areas work less hour than they are
willing to work. Underemployment may also include those who are
working full time but whose productivity is very low that a reduction
in the hours of labor supply would have negligible effect on output.
This kind of under employment is known as disguised
unemployment. E.g., farming practice of Ethiopian farmers .

Open unemployment rate in the world is 10 - 15%. By open

unemployment we mean the proportion of labor willing to work but
unable to get a job. In Ethiopia:
3. open unemployment = 8%
4. Disguised unemployment = 17%
5. Total unemployment = 25%

 Open unemployment is very high in urban

areas than rural areas, but underemployment
is higher in rural areas. Open unemployment is
higher in urban areas because of rural urban
migration other features

29
 Chapter Three:
Theories of Economic Growth and Development
and the State of Development Theory

In this chapter we explore the recent historical and intellectual

evolution in scholarly thinking about how and why development does
or doesn’t take place. We do this by examining four major and often
competing classic development theories. These are:
6. the linear-stages-of-growth model
7. theories and patterns of structural change
8. the international dependence revolution, and
9. the neoclassical, free-market counterrevolution.

3.1The linear-stages-of-growth models:

Theories of the 1950s and early 1960s viewed the process of

development as a series of successive stages of economic growth
through which all countries must pass. It was primarily an economic
theory of development in which the right quantity and mixture of
saving, investment, and foreign aid were all that was necessary to
enable developing nations to proceed along an economic growth path
that historically had been followed by the more developed countries.

3.1.1 Rostow’s Stages of Growth Model

30
According to Rostow, the transition from underdevelopment to
development can be described in terms of a series of steps or stages
through which all countries must proceed. These stages are

(i) The traditional society:

10. The world was in this stage before the 19 th century
“industrial revolution”.

11. All stage of development from the stage of savagery to

horticulture, animal husbandry and pre-agricultural
development, primitive agricultural development, feudalism
etc, are covered by this stage of the Rostow’s theory.

12. It was the time in which the economy was dominated by

subsistence activities i.e. output was consumed by producers
and was not traded.

13. Agriculture was the most important industry

14. Production was labor intensive as capital was limited

15. Resource allocation was determined by traditional

methods of production

16. It was a period of stagnation and, more or less, the society

remained traditional.

17. Technical conditions and economies of scale were static.

18. Birth rates and death rates used to be high.

(ii) Precondition for take-off into self-sustaining growth

19. Specialization started to generate surplus

20. The transport infrastructure emerges to support trade

21. External trade occurs on primary products

22. As income saving and investment grow entrepreneurs

emerge

23. The entrepreneurial class mobilizes savings and

investment.

31
 24. The entrepreneurs also bring the political unification of
the country and provide it with some infrastructural facilities
i.e. transport, education and organized medical help

25. Agriculture starts developing.

26. Death rates start falling but not the birth rates.

27. A few industries develop on small scale

28. Investment ranges around 5% of the GDP

(iii) The take-off stage

29. At this stage the barriers to growth are overcome and
growth becomes a normal condition at least in one sector of
the economy (the leading sector).

30. Industrialization increases and this begins to switch

workers from the agricultural sector to the manufacturing
sector.

31. Growth is concentrated in few regions or one or two

manufacturing industries.

32. Growth begins to generate its own new investment from

the earning of its previous investment i.e. the growth in this
stage is self sustaining.

Investment => income => saving => Investment

33. Investment reaches up to a 10% of GDP.

34. Political, social, and institutional set up favors dynamic

growth.

32
 35. The economic transition will be accompanied by the
evolution of new political and social institutions that support
the industrialization.

(iv)The stage of “Drive to Maturity”

36. The conomy diversifies in to new areas (sectors), and also

it produces wide range of goods and services

37. Technological innovation provides a range of investment

opportunities

38. There will be lessreliance on imports

39. the rate of investment increases from 10% of the GDP to

higher limits up to 20 %
40. important industries come up and technical knowledge
spreads to other sectors

41. real income per head starts rising as GDP growth rate
becomes substantially higher than population growth rate

42. real Per Capita Income increasesas the growth rate of

GDP exceeds the population growth rate

43. specialization and division of labor become complex and

compound

(v) Stages of self-sustained growth of and mass consumption

44. the conomy moves to mass consumtion

45. consumer durable in dustries flourish

46. the service sector gets dominance

47. Per capita real income becomes so high that consumptions

transcends beyond food, clothes and shelter to goods of
comforts and luxuries on a mass scale.

48. Urbanization and industrialization change the values of

society and development consciousness increases

49. People don’t feel any pinch of shortages

33
Kindelberger illustrates the stages in Rostow’s model with ‘S’ curve
as shown below.

Income

1 2 3 4 5
Time

Key:
1 = traditional, 2 = precondition for take-off, 3 =
take-off, 4 = maturity, 5 = mass consumption

The advanced countries, it was argued, had all passed the stage of
“take-off into self-sustaining growth” and the underdeveloped
countries that were still in either the “traditional” society or the
“preconditions” stage had only to follow a certain set of rules of
development to take off in their turn into self-sustaining economic
growth.

One of the principal strategies of development necessary for any

takeoff was mobilization of domestic and foreign saving in order to
generate sufficient investment to accelerate growth. The economic
mechanism by which more investment leads to more growth can be
described in terms of the Harrod-Domar growth model.

3.1.2 The Harrod-Domar Growth Model

HDM of economic growth is based on the assertion that every

economy must save a certain proportion to its national income to
50. Replace worn-out or impaired capital goods (buildings,
equipments, and materials)
51. Finance new investments representing net additions to the
capital stock that is required to bring about growth in GDP

34
According to this model, if we assume that there is some direct
economic relationship between the size of total capital stock (K) and
total GNP (Y) – for example if $3 of capital is always necessary to
produce a $1 stream of GNP – it follows that any net additions to the
capital stock in the form of new investment financed from saving will
bring about corresponding increases in the flow of national output,
GNP. Note that this relationship between the size of total capital stock
and total GNP is known in economics as incremental capital output
ratio (ICOR).

The HDM of economic growth is outlined as follows. Suppose:

t = time variable
Yt = total output at time t
Ct = consumption at time t
St = saving at time t
It = investment at time t
Assuming a closed economy,
52. On the income side, total output is defined as the sum of
consumption and saving
Yt = Ct + St …………………………….(1)
53. On the output side, total output is defined as the sum of
consumption and investment
Yt = Ct + It …………………………….(2)
54. From (1) and (2) above
St = It ………………………………….. (3)
55. The accumulation of capital stock
Kt + 1 = Kt – δKt + It
Kt + 1 = (1 – δ) Kt + It ………………….. (4)
Where
δ = the rate of depreciation
Kt = capital stock at time t (current period)
Kt + 1 = capital stock at time next period
56. Let
s = St / Yt => St = sYt ………………..(5)
θ = Kt /Yt => Kt = θYt ………………..(6)
where s is saving rate and θ is ICOR
57. From (3), (4), (5), and (6) above, we get
(Yt + 1 – Yt) / Yt = (s - δ θ)/ θ
g = (s/ θ) - δ ...……………………….. (7)
s/ θ = g + δ ………………………….. (8)
Equation (8) is known as Harrod-Domar growth
equation

 The policy implication of the model is that growth of GDP can

be raised by pushing up saving rate. Note that for an open

35
 economy, policy options related to overseas borrowing and
foreign investment can be considered in case it faces financial
gap i.e. difference between required saving and actual saving.

 Criticisms of HDM
58. Though necessary conditions, investment and saving are
not sufficient conditions for economic growth. We need some
kind of skills and managerial capacity to transform the
potentials of capital investment (saving) into growth in GDP.
59. There is no consideration for population and demographic
explosion.
60. In reality, saving rate and ICOR are not as exogenous as
treated in HDM. Specifically, since in the real world we are
likely to encounter diminishing returns to scale, ICOR cannot
be a fixed parameter as assumed in the model
Exercise: 1.introduce the rate of growth of population (n) into HDM
and try to answer the following questions (see Ray, p55)
 Is g the same as (7) or different?
 Does this modified HDM predict a continual growth of
PCI?
2. Suppose Ethiopia’s target PCI growth is 4%, ICOR = 3,
population growth rate (n) = 3%, actual saving rate (s) =
7%, rate of depreciation of capital stock = 5%. Calculate
 The required saving rate
 Financial gap

3.1.3 The Robert Solow growth model

The model:
61. Expanded on Harrod-Domar formulation by adding a
second factor, labor, and introducing a third independent
variable, technology, to the growth equation.
62. Unlike the fixed-coefficient, constant-returns-to-scale
assumption of the HDM, it exhibited diminishing returns to
labor and capital separately and constant returns to both
factors jointly. This implies that in this model θ is not fixed,
rather it depends on the economy-wide relative endowment

36
 of capital and labor whereby it is small when labor is plenty
relative to capital and vice versa.
63. Assumes technology as a variable whose level is
determined exogenously, that is, independently of all other
factors, and technological progress is absent

Next, let us look at mathematical formulation of Solow model.

64. Let production function of the economy is given by

K is capital and P is working population

A is a measure of efficiency of both K and P i.e. it
shows total factor productivity. A simply
represents level of technology.
A doesn’t grow i.e., there is no technological
progress and P grows at a rate of n.
Dividing the whole by P we get

65. Recall From equation (3), (4), and (5) of HDM that
Kt + 1 = (1 – δ)Kt + sYt
Kt + 1 - Kt = sYt - δKt
ΔKt=sYt - δKt………………………………………(10)
Equation (10) states that the total capital stock grows when
savings are greater than depreciation.

As the labor force (P) grows at the rate n per year, the change
in capital per worker (k) is given by:
Δkt = syt – (δ + n)k
Δkt = sAkαt – (δ + n)kt ...(11)
Equation (11) states that capital per worker grows when
savings are greater than what is needed to equip new
workers with the same amount of capital as existing workers
have.
66. Consider a state in which output and capital per worker
are not changing. This state is known as steady state. To find
this steady state, set Δkt = 0. That is:
Δkt = syt - (δ + n)kt = 0
sAk = (δ + n)kt

37
 where k* means the level of capital per worker when the
economy is in its steady state. Here we note that k* is a constant
function. If per capita capital stock converges to k *, then the per
capita income will be y* where

Note that at the steady state, capital-labor ratio (k) and thus per
capita income (y) are constant in the long run.
67. The above equilibrium (steady state) can be seen from the
following figure.

y f(k) =Akα

(n + δ)k

y* sf(k)= sAkα

k* k

The capital per worker k* represents the steady state. If k is

higher or lower than k*, the economy will return to it; thus k* is a
stable equilibrium. This stability is seen in the diagram by
noting that to the left of k*, k < k*. Looking at the diagram, we
see that in this case, (n + δ)k < sf(k); and when this happens Δkt
> 0 and thus k in the economy is growing toward the
equilibrium point k*. Find out what happens to k if it is initially
to the right of k*.

Now, let’s see how the change in s, n, and δ affect the steady state
using simple derivatives. And then we will deal with the same issue
using graphs.

38
  If we increase the rate of savings s a temporary
increase in the rate of per capita output growth is
realized. But, change in s doesn’t affect the long run
growth rate of k* and y* because after the economy has
time to adjust, the capital-labor ratio increases, and so
does the output-labor ratio, but not their rate of
growth. Mathematically,

But, the effect of change in the rate of saving on the level of

capital per person at steady state is positive. Since capital per
person and per capita income are positively related to each
other, we conclude that change in the rate of saving on the level
of per capita income at steady state is also positive. The key
implication is that, unlike Harrod-Domar analysis, in the Solow
model an increase in s will not increase growth in the longrun; t
will only increase the equilibrium level of k and y.

 The changes in n and δ again don’t affect the growth of k* and y*

for the same reason given above. But they too affect the level of
these steady state variables as shown below.

Thus, the effect of change in the rate of growth of population and rate
of depreciation on the level of capital per person and thus on per
capita income at steady state is negative.
Next, let’s see how the change in s, n, and δ affect the steady state
using graphs.

f(k)=Akα

( n + δ)k
s'f(k)= s'Akα

sf(k)= sAkα
39
 y**
y*

k* k**
The graph shows that an increase in s to s' leads to an increase in k
and y from k* and y* to k** and y** respectively. Thus a change in s has
a positive impact on the level of k* and y*. f(k)=Akα

(n' + δ)k

(n + δ)k

y* sf(k)= sAkα
y**

k** k*

The above diagram shows that an increase/decrease in rate of

population growth to n' leads to a decline/rise in per capita capital
stock and per capita national income. A change in δ has similar effect.

As discussed above, when the economy is at its steady state per capita
capital and per capita income don’t grow or simply the rate of growth
of capital per worker and per capita income is zero. What about the
total capital stock and national income? Both grow at the rate of
population growth.

Proof:

40
 

 implication of the BSM are

1. There is a steady state level of per capita capital and per
capita national income to which the economy converges.
2. Saving rate doesn’t have a rate effect; in fact, this simple
Solow model predicts that there no per capita growth in the
long-run. However, it has a level effect in that it affects the
level of k and y. This is due to Solow’s heroic assumption of
absence of technological progress.
3. Regardless of the initial per capita income and capital per
worker, according to Solow model, countries with the same
level of s, n, and δ will converge to the same level of living
standard or PCI. This is known as convergence hypothesis.
The empirical support for Solow’s claim of convergence of
PCI of countries to the same steady state is weak.

Extension of Solow model: technological progress

Solow model makes a strong claim that a country cannot sustain a PCI
growth indefinitely. According to Solow, to have a sustained PCI
growth, capital must continuously grow faster than population. For
this to happen, capital must grow faster than population, but in such a
case, the hypothesis of diminishing returns implies that the marginal
contribution of capital to output must decline, which eventually forces
a decline in the growth rate of output and, therefore, of capital.

The foregoing argument loses its force if there is continuing technical

progress; that is, if the production function shifts upward over time as
new knowledge is gained and applied. As long as the optimistic force
of this shift outweighs the doom of diminishing returns, there is no
reason why per capita growth cannot be sustained indefinitely.

Suppose A grows at a rate of m. Given Cobb-Douglas production

function of the form , the steady state k and y,
growth of PCI can be determined as follows

41
But recall from our previous discussion that

At steady state

Then, the steady state growth rate of per capita income is

Therefore, when we incorporate exogenous technical progress,

Solow model predicts that PCI grows at the rate at which this
exogenous technology grows.
Exercise: prove that steady state per capita capital (k t) also grows
at a rate of m.

 Conclusion on HDM and Solow Model

42
In HDM the ratio of capital to output is constant and in the Solow
model it increases as per capita capital increases because of the
diminishing marginal returns to capital.

 Theoretical predictions of HDM and Solow model

 Parameters such s do have rate effect in HDM but only level
effect in Solow model
 Unlike HDM, Solow model predicts convergence between per
capita income of countries given that they the same s, n, etc.

3.2 LEWIS THEORY OF DEVELOPMENT

Using a two sector economy (agriculture and industry), professor W.

Arthur Lewis has developed a theory of economic development with
excess agricultural labor. He assumed the existence of an unlimited
supply of labor at a subsistence wage, in developing countries.

Economic development takes place when capital accumulates as a

result of the withdrawal of surplus labor from the subsistent
agricultural sector to the capitalist or industrial sector. The capitalist
or industrial sector is the sector which uses reproducible capital and
pays capitalists for the use of capital from profits earned. The
subsistence sector is the one which does not use reproducible capital.
Output per head (average product) in the subsistence sector is lower
than the capitalist sector.

LDCs are with large population as compared to capital and natural

resources so that the marginal productivity of labor is negligible, zero
or even negative. Further, as the supply of labor is unlimited, new
industries can be established or existing industries can be expanded
without limit at the current wage by shifting labor from the subsistent
sector to the capitalist sector. The main source from which workers
would be coming for employment at the subsistent wage as economic
development proceeds includes farmers, casuals, petty traders,
women in the house hold and population growth.

The problem of having skilled workers can be solved by giving

training to unskilled workers.

The subsistent wage at which the surplus labor is available for

employment in the capitalist sector depends on the minimum earnings
required for subsistence. That is the wage level cannot be less than

43
the average product of the worker in the subsistence sector. It may,
however, be higher than this, in case if the farmers are to pay higher
food costs or rents or perhaps if they feel disutilities of leaving home.
Even if the earnings in the subsistent sector provide the flour to wage
rate in the capitalist sector, practically capitalist wages are more that
30% higher than subsistent wage because of;

a) An increase in the out put of the subsistent sector will raise the
real income of farmers which will cause them to ask for a higher
capitalist wage before offering themselves for employment.
b) If with the withdrawal of labor from the subsistence sector total
product remains constant or the same, the average product and,
hence, the real income of those remaining behind in the
subsistent sector will rise and the withdrawn workers might
insist on a higher wage in the capitalist sector.
c) The higher cost of living and some humanitarian considerations
may move the employers to raise real wages. Additionally
government and trade unions may pressure for the rise in
wages.

** The supply of labor is considered to be perfectly elastic at the

existing capitalist wage.

Surplus capital and capital formation

Wage and marginal Product

p3
p2
p1
q1 q2 q3
W

S S

L1 L2 L3
O n1 n2 n3 quantity of labor

44
As the marginal productivity of labor in the capitalist sector is higher
than the capitalist wage, there will be a surplus. This surplus is
reinvested in new capital assets. Capital formation takes place and
more people are employed from the subsistent sector. This process
continues till the capital – labor ratio rises and the supply of labor
becomes inelastic and the surplus labor disappears. In the above
figure OS represents the average subsistence wage in the subsistent
(agricultural or the backward rural) sector and OW shows the
capitalist (urban) wage.

At OW wage in the capitalist sector the supply of labor is unlimited a

indicated by the horizontal labor supply curve WW.

Initially when On1 labor is employed in the capitalist sector, its

marginal productivity curve is p1L1 and the total output of this sector
is Op1q1n1.As OWq1n1 shows the cost (payment made to workers), the
area Wp1 q1 shows surplus output. This is the total profit earned by
capitalist sector. When this is reinvested, the marginal productivity
curve shifts upward to p2 L2. The employment (On2) and surplus
(Wp2q2) are larger than before. A further reinvestment raises the
marginal product curve and the level of employment to p3L3 and On3
and so on till the entire surplus labor in the subsistence (rural) sector
is totally absorbed in the capitalist (urban) sector.

After the full absorption of the surplus labor, the supply curve WW
will slope from left to right upwards like any ordinary supply curve,
wages and employment will continue to rise with development.

 Limitation of the Lewis model

The Lewis theory is applicable to over populated countries under

certain assumptions, which are the bases of its criticism.

1. wage rate is not constant in the capitalist sector

The theory assumes a constant wage rate in the capitalist sector until
the supply of labor is exhausted from the subsistent sector. However,
in reality the wage rate continues to rise overtime in the industrial
sector even when there is open unemployment in the rural sector.

2. labor saving capital accumulation

The theory assumes that the surplus is reinvested in productive
capital. However, if the productive capital is labor saving, it would not
absorb labor and, hence, the theory will fail.

45
Wage and MPL
P2
P1 q1
W W

S S

L2 L1
Quantity of labor
O n1

From the above figure we see a labor saving investment. As the MP L

shifts upward from P1L1 to P2L2, total product has increased from
Op1q1n1 to Op2q1n1. The total wage cost and quantity of labor
remaining to be OWq1n1 and On1 respectively.

3. skilled labor shortage

Skilled labor shortage isn’t a simple and temporary problem as
assumed in the theory i.e. skilled manpower formation is a serious
constraint as it takes a long time to educate and train a person.

4. capitalist class
The theory assumes that the capitalist class already exists. In
reality, however, poor countries lack capitalists with the necessary
potential and incentive to work.
5. multiplier process
The multiplier process doesn’t operate in poor nations and the theory
assumes that capital accumulation takes place when the capitalist
class continues to reinvest profits, implying investment multiplier
which won’t apply to LDCs.

6. one sided theory

The theory doesn’t consider the possibility of progress in the
agricultural sector but as the industrial sector develops, the demand
for food and raw material will rise which will inurn lead to the growth
of the agricultural sector.

7. neglect of total demand

Lewis didn’t study the problem of aggregate demand. He assumes
that whatever is produced in the capitalist sector is either consumed

46
by itself or exported. He didn’t analyze the possibility of the capitalist
sector selling its products to the subsistent sector.

8. mobility of labor is not easy

Higher capitalist wage will not necessarily lead to the movement of
surplus labor from the subsistent sector to the capitalist sector.
People are so intensely attached to their family and land that they
don’t like to leave their kin. Further differences in languages and
custom, problem of housing and high cost of living in the urban
industrial sector inhabit the mobility of labor.

9. marginal productivity of labor is not zero

MPL in the rural sector is not zero or negligible in LDCs as argued
by the theory. if it was so, the subsistent wage would also be zero.

10. with migration of labor from the subsistent sector,

production falls
Lewis assumes that the agricultural production remains the same
(unaffected) with the withdrawal of the surplus agricultural labor.
However, in reality the reduction of workers from the farm reduces
farm output.

11. low income groups also save

high income groups are not the only ones to save. People with low
incomes also save for capital accumulation while many people in the
high income group spend much for various consumer durable goods
and luxurious items i.e. they are extravagant.

3.3 BALANCED Vs UNBALANCED GROWTH THEORIES

BALANCED GROWTH

Balanced growth requires a balance between different consumer

durable goods industries and capital goods industries. It also implies a
balance between industry and agriculture, and between the domestic
and export sector. Further it refers to the balance between social and
economic overheads and directly productive investments and also
between the vertical and horizontal external economies. In short, the
theory states that there should be a simultaneous and harmonious
development of different sectors of the economy so that all sectors
grow together.

47
This doctrine requires a balance between different sectors of the
economy during the process of economic growth. There should be a
proper balance between investment in agriculture and industry, which
are complementary sectors. An increase in the industrial sector’s
output requires an expansion of agricultural output if employment
increases in the industrial sector, it will lead to an increase in the
demand for food. This necessitates the rise in food supplies. Similarly
supplies of raw materials should also rise with the expansion of the
industrial sector. In short, the agricultural sector must also develop
along with the industrial sector’s development.

There must also be a balance between the domestic and foreign

sector. Export revenue is an important source for financing
development. As production and employment increase, the domestic
sector requires increasing imports of necessary materials (raw
materials and machineries). To pay for these rising imports and to
allow exports to finance development, the country must expand its
foreign sector along with the expansion in the domestic sector.

 Criticism of the balanced growth doctrine

1. Rise in costs
Simultaneous establishment of a number of industries is likely to raise
money and real cost of production.

2. demand side problems

When the new industries are established, the demand for the products
of existing firms will decrease. The demand for factors of production,
on the other hand, rises causing a rise in price of inputs (factors). This
makes the industries unprofitable.

3. doesn’t consider the capacities of poor nations( shortage of

resources)
The doctrine doesn’t consider the capacities of poor nations. The
resources (human and physical) those are required for simultaneous
development of multiple sectors is lacking in developing countries.

When investments are undertaken in all sectors simultaneously, the

demand for factors would be competitive but the supply of factors
would be inelastic in poor nations.

4. scarcities and shortages encourage growth

Scarcities and bottle necks provide the stimulus to inventions and
inventions in turn created new scarcities and bottlenecks. Some
economists argue that had the world depended on balanced

48
development, it would have reduced or eliminated the incentives for
discoveries.

5. the concept of balanced growth is only applicable to developed

or rich nations
According to Keynes, simultaneous and multiple development during
upswing of the trade cycle can lead to balanced recovery of economic
activity as the industries , machines, managers, workers and
consumption habits are all there, only waiting to take up once again
their suspended functions. In LDCs, however, there is no temporary
suspension of economic activities. Many of the economic activities are
static or permanently missing.

UNBALANCED GROWTH

*** This theory is the direct opposite of the doctrine of the balanced
growth.

It argues investment should be made in selected sectors rather than

simultaneous investment in all sectors. No poor country owns capital
and other resources in such quantities as to enable it invest
simultaneously in all sectors. Hence, investment should be made in a
few selected sectors or industries for their rapid development, and the
economies accruing from them can be utilized for the development of
other sectors. Thus the economy moves gradually from the path of
unbalanced growth to balanced growth.

The process of unbalancing the economy to bring about development

can be undertaken through investing in social overhead capital or in
directly productive activities.

Unbalancing the economy with social overhead capital

It comprises those basic services without which primary, secondary

and tertiary productive activities cannot function.

It includes investment on education, public health, communication,

transportation and conventional public utilities like light, water,
power, irrigation, drainage schemes etc.

Large investments in social overhead capital will latter encourage

investment in directly productive activities. E.g. cheaper supply of
electric power may encourage establishment of industries. The
objective is to unbalance the economy so that subsequent investments
are stimulated.

49
Unbalancing the economy with directly productive activities

The government may invest in directly productive activities instead

of investing in social overheads. If direct productive investment is
undertaken first, the shortage of social overhead facilities is likely to
raise production costs. In course of time, political pressures might
stimulate investment in social overheads. Investment sequences are
generated by profit expectations and political pressures. Profit
expectations generate the sequence from social overheads to directly
productive activities and political pressures from directly productive
activities to social overhead capital.

** Linkage

Development should aim at discovering projects with the largest total

linkage (forward and backward linkages). Forward linkage is the case
where a given investment encourages investment in the after coming
(lateral) stages of production and backward linkage in the before
coming (initial) stages of production.

Agricultura Industrial
l sector Service
sector
sector

50
 Wheat food processing cafeteria
Factory
Backward Linkage Forward
Linkage

 Limitations (criticisms) of the unbalanced growth

doctrine

A. neglects resistance
When development is the outcome of deliberate unbalancing of the
economy, the business attitudes change due to shortages and tensions
and, hence, there will be a lot of opposition and hostility. The theory
neglects the reaction on the part of existing institutions in poor
countries.

B. inflationary pressure
When large doses of investment are being injected in to the economy
at a certain strategic points, income will rise which may tend to
increase the demand for consumer goods relative to their supply.
Shortages lead to inflationary rise in price level.

C. too much emphasis on investment decisions

Poor countries not only need investment decisions but also
administrative, managerial and policy decisions. The theory lays too
much emphasis on investment decisions as compared to other
important decisions required for development

D. lack of basic facilities

There may be difficulties in having technical personnel, raw materials,
and basic facilities like power, transport, markets for products etc.

E. lack of factor mobility

In LDCs it is difficult to shift resources from one sector to another.

3.4 THE INTERNATIONAL DEPENDENCE MODEL

51
There are three major streams of thought within this general
approach; the neo-colonial dependence model, the false
paradigm model and the dualistic development thesis.

A. THE NEO-COLONIAL DEPENDENCE MODEL

It is an indirect outgrowth of Marxist thinking. It attributes

underdevelopment primarily to the historical evolution of a highly
unequal international capitalist system of rich country- poor country
relationship, where the rich countries are playing the
central( decisive) role and the where the poor countries are playing
the peripheral role.

Certain groups in developing countries (landlords, entrepreneurs,

military rulers, merchants, salaried public officials, and trade union
leaders) enjoy high incomes, social status and political power. They
serve the perpetuation of the international capitalist system of
inequality and conformity. For doing so they are rewarded by
international special power interest groups including multinational
corporations, national bilateral aid agencies and multilateral
assistance organizations like World Bank and IMF.

Underdevelopment is seen as an externally induced phenomenon

(unlike the linear stages and structural change models which stress
internal constraints of saving, investment illiteracy).

Revolutionary struggles or at least major restructuring of the world

capitalist system are required to free developing nations from the
economic control by the developed world and domestic oppressors.

B. THE FALSE PARADIGM MODEL

It attributes underdevelopment to faulty and inappropriate advice

provided by uninformed, biased and ethnocentric international
“expert” advisers from developed country assistance agencies and
multinational donor organizations.

These experts lead to inappropriate and incorrect policies because

they fail to consider institutional factors in LDCs.

Additionally, the leading university intellectuals, trade unionists, high

level government economists etc. get their training in developed
countries where they are made to grasp alien concepts and
inapplicable theoretical models. Further, in university economics
courses many irrelevant western concepts and models are being
taught.

52
C. THE DUALISTIC DEVELOPMENT THESIS

The concept of dualism represents the existence and persistence of

increasing divergence between rich and poor nations and rich and
poor people. The concept of dualism embraces four key arguments;

1. The ‘superior’ and ‘inferior’ can coexist in a given

space.

2. This coexistence is chronic and not merely transitional.

3. The degrees of superiority and inferiority fail to show any

sign of diminishing and they are rather with a tendency to
increase, widening the gap between them.

4. The interrelationship between the superior and the

inferior is such that the superior does little or nothing to
pull up the inferior.

3.5THE NEO-CLASSICAL COUNTERREVOLUTION

(MARKET FUNDAME NTALISM)

It includes three types of approach

 FREE MARKET APPROACH

 PUBLIC CHICE APPROACH
 MARKET FRIENDLY APPROACH
A. free markets approach

The neo liberals argue that by permitting competitive free markets to

flourish, privatizing state owned enterprises, promoting free trade
and export expansion, welcoming investors from developed countries
and eliminating government regulations and price distortions in
markets, economic efficiency and growth will be stimulated.

Underdevelopment in poor countries is because of the heavy hand of

the state and the corruption, inefficiency and lack of incentives. What
is needed for growth and development of poor countries is promoting
free market and laissez faire conditions.

B. Public choice approach

The public choice theory is also known as the new political economy
approach and it argues that governments can do nothing right.

53
It assumes that politicians, bureaucrats, citizens and states act solely
from a self-interested perspective, using their power and the authority
of government for their own selfish ends. Citizens use political
influence to obtain special benefits from government policies that
restrict access to important resources. Politicians use government
resources to consolidate and maintain positions of power and
authority. Bureaucrats and public officials use their position to extract
bribes from rent seeking citizens. States use their power to confiscate
private property from individuals.

The net result is general reduction in individual freedoms in addition

to the miss allocation of resources. Therefore, the conclusion is that
“minimum government is the best government”.

C. Market friendly approach

This approach recognizes the various imperfections in developing

countries’ product and factor markets and also that governments
have a key role to play in facilitating the markets through market
friendly interventions. E.g. investment in social infrastructures, health
care facilities, education, etc

54
 Chapter 4

HISTORIC GROWTH AND LESSON LEARNED, AND THE STATE

OF DEVELOPMENT THEORY

4.1 history, growth and contemporary development lessons and

controversies

The source of economic progress can be attributed to a variety of

factors but generally investments that improve the quality, quantity
and productivity of resources through innovation and technological
progress have been the primary factors in bringing growth.

THE ECONOMICS OF GROWTH THROUGH CAPITAL, LABOR AND

TECHNOLOGY

There are three major components of economic growth;

(A) Capital accumulation

It occurs when some proportion of current income is saved and

invested. New machineries and equipments increase the physical
capital stock and help to expand output. These directly productive
investments are mostly supplemented by socio economic
infrastructures like roads, electricity, water etc.

Investment in human resources through formal schooling, vocational

training and other sorts of training increases human skills, thereby
improving the quality of the labor force.

Capital accumulation may add new resources or upgrade the quality

of existing resources.

55
(B) Population and the labor force

Theoretically, population growth and the consequential increase in

the labor force are stimulants of economic growth. In reality,
however, this depends on the ability of the economy to absorb
(employ) the additional workers.

(C) Technological progress

It results from improved ways of accomplishing a given task. There

are three basic types of technological progress;

I. neutral technological progress

It is when the technological progress results in more productive use of

both existing capital and labor.

II. Labor augmenting (capital saving) technological progress

It occurs when the quality and skills of the labor force is upgraded i.e.
the technological progress is such that it comes up with more
productive use of existing labor.

III. Capital augmenting technological progress

It is when the technological progress results in the more productive

use of existing capital goods.

THE HISTORICAL RECORD

KUZNET’S SIX CHARACTERSTICS OF MODERN ECONOMIC

GROWTH

Kuznet isolated six characteristic features manifested in the growth

process of almost every developed nation.

(1) High rate of per capita out put and population growth

For the capitalist developed countries, annual growth rates over the
past 200 years averaged 2% for per capita output, 1% for population
and 3% for total output (real GNP). These rates, which imply a
doubling time of roughly 35 years for per capita output, 70 years for
population and 24 years for real GNP, were far greater than what was
experienced in the pre – industrial revolution period.

56
* In short, these countries experienced large multiples of their
previous historical rates in recent times.

(2) High rate of productivity increase

Relatively high rate of rise in total factor productivity (output per unit
of all inputs) was observed in these countries’ growth.

The rates of productivity increase were large and were 50% to 75% of
the historical growth of per capita out put in developed countries.
Technological progress (including the upgrading of existing physical
and human resources) accounts for the historical increase in the per
capita output of these nations

(3) High rate of economic structural transformation

It refers to the gradual shift away from the agricultural to non

agricultural activities and away from small family and personal
enterprises to impersonal organizations of huge national and
multinational corporations.

In the contemporary developed nations, there was a high rate of

structural and sectoral change inherent in the growth process.

(4) High rates of social, political and ideological transformation

Transformations in attitudes, institutions, and ideologies are often

necessary to bring an ideal structural change. Examples include the
urbanization process and modernization ideals which include;

(I) Rationality

The substitution of modern methods of thinking, acting, producing,

distributing and consuming for age old traditional practices

(ii) Economic planning

The search for a rationally coordinated system of policy measures that

can bring about an accelerated economic growth and development

(iii) Social and economic equalization

57
The promotion of more equality in status, opportunities, wealth,
income and levels of living

(IV) improved institutions and attitudes

Improved institutions will be necessary to increase labor efficiency,

promote effective competition, social and economic mobility etc...

(5) International economic outreach

Rich countries reached out to the rest of the world in search of

primary products, raw materials and cheap labor and further to find
markets for their products.

Such outreach was made possible by technological advances in

transport and communication. This had the effect of unifying the globe
and bringing out the socioeconomic and political domination of the
poor nations by the rich nations. E.g. colonialism and neo- colonialism

(6) Limited international spread of economic growth

The spread of modern economic growth is limited to the less than ¼

of the world’s population found in the developed regions.

There are even widely seen tendencies where the rich grow at the expense
of the poor!!

THE LIMITED VALUE OF THE HISTORICAL GROWTH EXPERIENCE

(DIFFERING INITIAL CONDITIONS)

Economic growth theories and models were based up on the

experience of the west and, hence, they gave too little emphasis to the
very different and less favorable initial economic, social and political
conditions currently available for developing countries.

At least eight significant differences may be identified in the initial

conditions;

1. physical and human resource endowment

Developing countries, on the average, are less endowed with

natural resources than the currently developed nations at their initial

58
or early days of development. Even if natural resources are found in
some developing countries, heavy investment in capital is required to
exploit them.

The labor force of the developing countries on the whole is less

educated, less experienced and less skilled than the early period
situation of currently developed countries.

2. relative levels of per capita income and GNP

The population living in developing countries have, on the

average, a much lower level of per capita income than what the
current developed countries used to have many years ago while they
were developing.

Further, the modern developed nations were economically far

better than the rest of the world at the early days of their economic
growth. Hence, they could take advantage of their relatively strong
financial and economic position to widen the income gaps between
themselves and other less fortunate countries. However developing
countries begin their growth starting from very low per capita
income. Such a situation creates economic and psychological
frustration in growth.

3. climatic differences

The extreme heat and humidity in many developing countries

contributes to the deteriorating soil quality and the rapid depreciation
of many natural goods.

Climatic unfavorability also causes crops to have low

productivity, weakens regenerative growth of forests and leads to
poor health of animals.

It also causes discomfort to workers, weakens their health and

lowers their levels of productivity and efficiency.

4. population size, distribution and growth

During their early growth years, western nations experienced a

very slow rise in population growth. The population in most
developing countries, however, is growing and multiplying at very
high rates.

5. the historical role of international migration

59
 In the nineteenth and early twentieth century, there was a
major outlet for excess rural population in international migration.
For e.g., in countries such as Italy, Germany and Ireland, periods of
savior famine or pressure on land combined with limited opportunities
in urban areas (industrial sector) pushed rural workers to migrate to
the new world (north America, Australia ).

As to the current developing countries, there is little chance of

reducing population pressure through massive international
emigration because of factors such a great geographical distance and
very restrictive immigration laws in developed countries.

Some who manage to migrate, despite the restrictions, are

mostly the professional and technical manpower and this process of
brain drain makes developing countries loose the very valuable part
of the labor force and, hence, adversely affects their growth.

6. the growth stimulus of international trade

Free trade was the engine of growth for the currently developed
countries during the nineteenth and early twentieth century. North
American and European countries were able to participate in
international exchange mainly on the basis of free trade, free capital
movement and international migration of unskilled surplus labor.
However the today’s developing countries face many difficulties in
their trial to exploit international trade to their advantage and growth.
Developing countries face declining terms of trade and, further,
developed countries substitute the traditional commodities of the poor
nations with synthetic products using their technological advance.

7. basic scientific and technological research and

development capabilities

The contemporary developed nations utilized the outcomes of

scientific research and technology in their growth experience. These
countries also spent large sums of money to run and finance different
researches and they actively utilize their outcomes.

The current poor countries are not engaged in a production process

that invited technological advancement. They produce simple
materials by saving capital (making less use of capital) and using
more labor. Further, they neither have the financial resources nor the
know how to undertake research and development activities.

8. stability and flexibility of political and social institutions

60
The current developed countries were independent consolidate states
able to undertake national policies on the quest to modernization.
They were culturally homogeneous and politically unified. However,
most of the current poor nations have only recently got their
independence and have not yet become fully consolidated nations
states with effective ability to formulate and follow national policies.

4.3 HISTORY, EXPECTATIONS AND DEVELOPMENT

Historical experience of Economic Growth (1960-1985)

The richest 5% of the world’s nations have a PCI twenty nine times
that of the poorest 5% of the nations. Over the 25 years given above,
the gap remained constant. The income distribution also remained
constant.

Though the gap and income distribution remained constant, over the
said period countries climbed and descended the ladder of relative
economic position. For example, the entire world grew by 1.7%. But,
the seven East Asia countries: Japan Korea, Taiwan Singapore, Hong
Kong, Thailand, Malaysia & Indonesia (& recently China) have a
growth of PCI 5.5% per annum. (China 8.2%). In contrast the Latin
American & sub Saharan countries PCI growth was negative. The
Latin American growth declined by 11% except for Chile & Colombia
which showed a modest growth. SSA Economy was stagnant in 1989s.
in Nigeria, Tanzania & Ethiopia, PCI growth was negative whereas
Kenya & Uganda showed a modest growth.

In Latin America the reason for negative growth is due to

 debt-crisis
 Huge (double digit) inflation.
For SSA the reasons are due to
 war and consequence destruction of infrastructure and
 Population growth.
The reason for the success of East Asia is not fully understood. But
it may be due to:
 far sighted government policies & government interventions
 Relatively equal domestic distribution of income & access to
education & health.
 Vigorous entry in to the international market.

Despite Solow's Convergence Hypothesis (to be discussed later) that

states that poor countries grow faster than the rich & the poor
countries will catch up the rich nation, it is quite possible for the
world distribution of income to stay fairly constant in relative terms

61
while there is plenty of action within the distribution as countries
climb and descend the ladder of relative economic development.

The above observation is a cause for hope and trepidation where

 The hope is that no traps to ultimate economic success
 The trepidation is that it seems easy to slip and fall in the
process of development
But be cautious on the hope because, although there is no evidence
that very poor countries are doomed to eternal poverty, there is
some indication that low incomes are very sticky (see the following
mobility matrix)

To construct mobility matrix convert all PCI of countries to a fraction

of the worlds average PCI. The worlds average PCI is $2000. For
example if the country has PCI of $1,000, the fraction of this income
to world’s average income is ½. Then put all countries in one of the
following categories
1. Category ¼:- Countries with income as a fraction of world
average income less than or equal to ¼
2. Category ½:- Countries with income as a fraction of world
average income less than or equal to ½
3. Category 1:- Countries with income as a fraction of world
average income less than or equal to 1
4. Category 2:- Countries with income as a fraction of world
average income less than or equal to 2
5. Category ∞:- Countries with income as a fraction of world
average income greater than or equal to 2

Note that countries which fall in

 The first category are poorest ones
 The second and third category are middle income countries
 The fourth and fifth are Richest ones

1/ 1/ 1 2 ∞
4 2
1/ 76 12 1 0 0
4 2
1/ 52 31 1 7 0
2 0
1 9 20 4 2 0
6 6
2 0 0 2 5 2
4 2 4
∞ 0 0 0 5 9
5

62
The above matrix is constructed for a period between two points in
time i.e., 1962 and 1984 by Quah (1993). We can find if a country is
transferred from one category to another during the 23 years period.
Note that:
 first row and the first column of the matrix are the categories
 a cell in the mobility matrix defines pair of categories
 a number in the cell tells us the percentage of the countries that
move from its row category to its column category.
The diagonal elements of the above mobility matrix are very high. This
implies low mobility i.e., stagnation. If a country has the same number
(20%) in every entry, it shows an extra- ordinary rate of mobility.

The above mobility matrix shows.

 The middle income countries show higher mobility than the
poorest & the richest countries
 Countries in category ¼ (low income countries) in 1962 more
than half of them (76%) remained where they were and none of
them passed the world average PCI.
 95% of the world richest countries stayed right there where
they were.

Thus, as the above mobility matrix suggests, the history of

underdevelopment (or extreme poverty) puts countries at a
tremendous disadvantage, i.e. poverty feeds on itself and so
does wealth. But, on reflection, you will see that there might
be some advantages for poor countries:

 new technology are available from the more developed

countries from which they can copy & grow
 The capital stock is low relative to labor in poor countries that
the marginal product of capital could well be high and thus a
higher rate of return to capital. If there is free market, this can
attract foreign capital from MDCs to LDCs
 It is possible to study the success stories & avoid polices that
led to failure in the past.

Chapter 5
5.1 MEASUREMENT OF INCOME INEQUALITY AND POOVERTY

63
 There are two principal measures of income distribution; the
personal or size distribution of income and the function or
distributive factor share distribution of income.

I.THE PERSONAL OR SIZE DISTRIBUTION OF INCOME

It is the most commonly used measure of income distribution and
inequality. It deals with the individual persons or households and the
total income they receive. The way in which that income was received
is not considered i.e. whether from employment, interest, profit, rent,
gift or inheritance.

Economists and stasticians usually arrange all individuals by

ascending personal incomes and then divide the total population in to
successive quintiles (fifths) or deciles ( tenths) according to ascending
income levels and then determine what proportion of the total
income( national income) is received by each income group.

 Note the following table

Hypothetical but typical size distribution of personal income in
developing country by income shares quintiles and deciles
individual Personal Percentage share in total
income(money income
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

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Total (national) income 100 100
100.0
 measure of inequality ratio of bottom 40% to top 20% = 14/51
=0.28
In the above table individual (household) representing the entire
population are arranged in ascending order of annual personal
income, ranging from the individual with the lowest income (0.8) to
the one with the highest (15.0) units. 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% (a total of 5oney units out of the total 100 units)
of the national income. The second quintile (individual5-8) receives
9% of the total income.

The bottom 40% of the population (quintile 1 plus quintile 2)

receives only 14% (5% + 9%) of the national income while the top
20% (the fifth quintile) receive 51% of the total income.

A common measure of income inequality that can be derived fro

column 3 is the ratio of the income received by the bottom40% and
top 20% of the population. This ratio is often used as a measure of
the degree of inequality between the two extremes of very poor
and very rich in a country. In the above example this inequality
ratio is equal to 14 divided by 51 which is approximately equal to
0.28.

To provide a more detailed break down of the size distribution of

income, deciles (10%) share are listed in the fourth column. For
instance, the bottoms 10% of the population (the two poorest
individuals i.e. the first two) receives only 1.8% of the total income
whiles the top10% (the two richest individuals) receive 28.5%.

If we wanted to know what amount the top 5% receive, we would

divide the total population to 20 equal groups of individuals. From
the table, the top 5% of the population (the twentieth individual)
receives 15% of the national income, which is a higher share than
the combined share of lowest 40% of the population( which is 14%
of the total income).
LORENZ CURVE
It is a graphical analysis of personal income statistics where
cumulative percentage of income recipients are plotted on the
horizontal axis and cumulative percentage of income received on the
vertical axis.

100
90 J

65
% of income received

80
70
60 I
50 H
40 G
30 F
20 E
10 C D
A B
0 10 20 30 40 50 60 70 80 90 100
% of income recipients (population)

The diagonal line drawn from lower left corner to the upper
right corner is the line of equality where the percentage of income
received is exactly equal; to the percentage of income recipients. For
instance, at the half way (mid point on the line), 50% of the income is
exactly distributed to 50% of the population.

The Lorenz curve shows the actual quantitative relationship between

the percentage of income recipients and the percentage of the total
income that they did receive. Point A shows that the bottom 10% of
the population receives 1.8% of the total income. Point B shows that
the bottom 20% of the population receives 54% of the total income.

The more the Lorenz curve is away from the diagonal, the greater the
degree of inequality. The extreme case of perfect inequality i.e. a
situation in which one person receives all of the national income while
everybody else receives nothing would be represented by the
congruence (overlapping) of the Lorenz curve with the bottom
horizontal and right hand vertical axis. No country shows
either perfect equality or perfect inequality in income
distribution, hence, the Lorenz curve lies somewhere to the
% of income received

% of income received

right of the diagonal.

100
100
80
80
80
60
60 60

30
30 30
10

0
66
 10 10

O 10 30 60 80 1000 10 30 60 80 100

A. a relatively equal distribution B. a

relatively unequal
distribution

The greater the degree of inequality, the greater the bend and the
closer to the bottom horizontal axis the Lorenz curve will be.

SHIFTING LORENZ CURVE

In his book poverty, inequality and development, Gary S. Fields
demonstrates how Lorenz curves can be used to analyze three limiting
cases of dualistic development along the lines suggested by the Lewis
model. He distinguished three stylized development typologies;

(A). the modern sector growth typology, in which a two sector

economy (agriculture and industry) develops by enlarging the size of
its modern sector while maintaining constant wages in both sectors.
This is the case as shown by the Lewis model.

It roughly corresponds to the historical growth pattern of western

developed nations and, to a lesser extent, on the experience of
countries like Japan, South Korea and Taiwan.

B. the modern sector enrichment growth typology, in which the

economy grows but such growth is limited to a fixed number of people
in the modern sector, with both the number of workers and their
wages held constant in the traditional sector. This has been the
experience of many Latin American and African countries.

C. the traditional sector enrichment growth typology, in which

all of growth is equally, divided among traditional sector workers,
with little or no growth occurring in the modern sector. This was the
case in China and few other revolutionary socialist economies.

Using these three special cases and Lorenz curve, G.S. Fields was
able to demonstrate the validity of the following propositions.
Reversing the above order i.e. moving from C to B and then to A,

(C). in the traditional sector enrichment typology, growth results in

higher income, a more relative equal distribution of income and less
poverty.

67
% of income received

100

80

60

30

10

0 10 30 60 80 100

Income recipients %
Fig-improved income distribution under the traditional sector
enrichment typolog

As shown in the figure, traditional sector’s growth cause the Lorenz

curve to shift uniformly upward and closer towards the line of equality
(diagonal).

(B) In the modern sector enrichment growth typology growth results

in higher incomes, a less equal relative distribution of income and
no change in poverty. Modern sector enrichment growth causes the
% of income receied

Lorenz curve to shift down ward and further from the line of
equality as shown in the figure below.
100

80

60

30

10
O
Income recipients% 100
Fig- worsened income distribution under the modern sector
enrichment growth typology

68
 (A) Finally, in the case of Lewis type modern sector enlargement
growth absolute income rises and absolute poverty is reduced.
However, the Lorenz curves cross so that we cannot make a non
ambiguous statement about changes in relative income inequalities
i.e. the inequality may improve or may worsen. It is likely, however, to
worsen in early stages of development and then to improve.
% of income received

100
100

8080

6060

3030

1010

00
0 10 30 60 80 100

Income recepients %

Fig-crossing Lorenz curves in the modern sector enlargement growth

typology

GINI COEFFICIENT (AGGREGATE MEASURE OF INEQUALITY)

It is calculated as the ratio of the between the diagonal and the
Lorenz curve divided by the total area of the half square (triangle) in
which the curve lies.
A

69
 Fig- Gini Coefficient
In the above figure the ratio of the shaded region OBA to the triangle
OCA gives us the Gini coefficient. Gini coefficients are aggregate
inequality measures and vary from 0(perfect equality) to 1(perfect
inequality) from country to country or region to region. The gini
coefficient for countries with highly unequal income distribution
typically lies between 0.5 to 0.7 while for countries with relatively fair
distribution it lies between 0.2 to 0.35 (from empirical observation of
income distribution between countries)

II FUNCTIONAL DISTRIBUTION
The second common measure of income distribution is the functional
or factor share distribution of income which tries to explain the share
of total national income that each factor of product (land, labor and
capital) receives. Instead of looking at the individual as separate
entities, the theory of functional income distribution considers the
percentage that labor receives as a whole and compares this with the
percentage of total income distributed in the form of rent, interest
and profits i.e. the returns to land, capital and entrepreneurship.
Although a specific individual may receive income from all these
sources, it is not a matter for the functional approach.

Supply and demand curves are assumed to determine the unit price of
each productive factor. When the unit prices are multiplied by
quantities employed we get a measure of total payment to each factor.
e.g. the supply and demand for labor are assumed to determine wage.
Level of employment multiplied by wage in turn gives the total wage
payment or wage bill.

Wage
Profit SL

E
W*

DL =MPL
Wage bill

O L* labor employed

With OW* wage and OL* employment, the total national income
(national output) of OREL* will be distributed to the two factors labor

70
and entrepreneurs as wage and profit. OW*EL* goes to workers as
wage and the remaining W*RE to entrepreneurs or owners of capital
as capitalist profit.
Income is distributed by function i.e. by the function of the resources.
Laborers receive wages, owners of land receive rent and capitalists
obtain profits. Each factor gets paid only in accordance wit what it
contributes to national output. This model of income distribution (as
the Lewis’s theory of modern sector growth) based on the
reinvestment of rising capitalist profits.

The relevance of the functional theory is diminished by its failure not

to consider the influence of non-market forces such as power in
determining input prices of capital, land, and output by their own
power. Presence of strong trade union will be able to determine
wages and not just the market (productivity of inputs .MPL).

MEASURING ABSOLUTE POVERTY

Absolute poverty refers to the people who are unable to access

resources by the amount which would satisfy their basic needs. It
considers the total number of people living below a specified
minimum level of real income (an international poverty line).

Any one living on less than $1 per day in PPP (purchasing power
parity or equality) dollars is regarded to live in absolute poverty.

Absolute poverty may be measured by the number or “head count”,

H, of those whose income fall bellow the absolute poverty line, Y P.
When the head count is taken as a function of total population, N, we
will get the head count index =H/N.

In reality, however, the international poverty line of $1/day would not

tell the local absolute poverty line. The local absolute poverty line may
be determined by considering an adequate basket of food, based on
nutritional requirements from medical studies of required calories,
protein and micronutrients. Then using local household survey data
regarding expenditures for food, clothing shelter and medical care
(basic needs) one may determine the local absolute poverty line.

Poverty gap

Measures the total amount of income necessary to raise the income

of those individuals who are below the poverty line up to that line i.e.
it is the gap between the absolute poverty line and those individuals’
income who are below it.

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The total poverty gap (TPG) or the “total income short fall” of the
poor is given as
H

TPG=∑ (Yp-Yi) where, yp=poverty

i=1 Yi= an individual’s income below the
poverty line YP
H=the number of people below the
poverty line

On a per capita basis, the average income shortfall, or average

poverty gap (APG) is given as;
APG= TPG/H

INEQUALITY AND ITS VARIATIONS AMONG COUNTRIES

All countries (whether capitalist, socialist or mixed economy) show

some degree of inequality.

The former socialist countries like Czechoslovakia, Hungary, Poland

and Bulgaria had the lowest degree of equality in their distribution of
incomes i.e. they had the lowest Gini Coefficients. Developed
countries generally show a relatively more equal income distribution
than many developing countries. This is primarily because of the
reason that most economically advanced countries have been able to
develop mechanisms of transferring a portion of income from the rich
to the poor. E.g. higher taxes will be levied on the rich and this will be
transferred to the poor through government expenditures. Such basic
income transfer mechanisms are not effectively used in developing
countries. Hence, developing countries have significant variations in
their degree of inequality i.e. wide range of Gini Coefficients.

There is no direct and conclusive relationship between level of PCI

and degree of income concentration (inequality) i.e. some countries
are with better PCI than others while they show more inequality.

The magnitude of absolute poverty results from a combination of low

PCI and highly unequal distribution of income. The higher the level of
PCI, the more likely lower number of absolute poor there will be.
However, higher levels of PCI are no guarantee for lower levels of
poverty.

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ECONOMIC CHARACTERISTICS OF POVERTY GROUPS
RURAL POOVERTY
Absolute poverty is concentrated in the rural areas i.e. the poor are
located mostly in rural areas.

Most developing country governments’ expenditures flow to the

urban areas of modern manufacturing and commercial sectors.
Whether in directly productive investments or in infrastructures like
education, health, housing and other social services, the urban sector
takes the upper hand more of the favor .and, hence, develops at the
expense of the rural sector. E.g. consider the Lewis model

Policies designed to alleviate poverty must be directed to the rural

sector to a great extent as the great extent of the population (85%)
resides there.

WOMEN AND POVERTY

Poverty problems mostly attack women and children than men.

Women and children experience the harshest deprivation.

In the urban areas women are less likely to get formal formal
employment and are usually restricted to illegal or less productive
jobs. Rural women similarly suffer from many problems and have less
access to resources that would generate income.

The socio-cultural and economic setup and institution usually favors

men. Usually women are not given the chance to work and their
position would commonly pass on to men. Even if they rarely get the
chance to work, they are not paid equally to that of men.

Women control over house hold income is limited. Even if women do

much of the laborious tasks in cultivation and family businesses, it is
usually the male which controls the funds or cash from the sells of
their produce.

ETHNIC MINORITIES, INDIGENEOUS POPULATION AND POVERTY

Poverty falls on a heavy hand, especially, on minorities and indigenous

population. Some 40% of the world’s nations have more than five
significant ethnic population, one or more of which face serious
economic, political and social discrimination. This usually leads to
conflicts and civil wars.

73
In some countries such as Latin American states, both indigenous
(local) and non indigenous (external, mostly European) live together,
it is usually the indigenous people which are living in poverty. E.g.
south Africa and Zimbabwe
 minority whites are rich
 majority blacks are poor

POVERTY IN ETHIOPIA

Rural poverty in Ethiopia

An agrarian society in a land of drought

In one of the world’s poorest countries, where half of the population

lives under the poverty line, agriculture is the main source of
livelihood for more than eight out of ten Ethiopians. Yet agricultural
production is extremely vulnerable both to climatic conditions and to
the disruptive impact of war and civil conflict. Recurring droughts
leave poor farming families without food crops, causing periodic
famines. The persistent lack of rainfall is a major factor in rural
poverty. Food aid is crucial in saving the lives of millions of people
who are chronically food-insecure or affected by drought, including
more than 130,000 internally displaced people from conflict-torn
areas.

Who are Ethiopia’s rural poor people?

74
Small-scale farmers are the largest group of poor people in Ethiopia.
Their average land holdings are less than 1 ha, their productivity is
low and they are vulnerable to drought and other adverse natural
conditions. Despite efforts to reduce poverty in the country over the
past decade, farmers, herders and other rural people remain poor.

Ethiopia’s rural poor include many of the country’s 7 million people

who depend on herding for a livelihood. About 20 per cent of herders’
households are headed by women. More than 60 per cent of the
country’s land is used for grazing, and like farmers, herders are
vulnerable to the recurrent droughts that can wipe out their livestock
and assets.

Poor people in rural areas face an acute lack of basic social and
economic infrastructure – such as health and educational facilities,
veterinary services and access to safe drinking water. Households
headed by women are particularly vulnerable. Women are much less
likely than men to receive an education or health benefits, or to have a
voice in decisions affecting their lives. For them, poverty means high
numbers of infant deaths, undernourished families, lack of education
for children and other deprivations.

Where are Ethiopia’s rural poor people?

The incidence of and severity of poverty is higher in rural than urban

areas (52 per cent and 36 per cent, respectively). Poverty is uniformly
distributed throughout the country’s rural areas,with the exception of
few areas in the Inset growing areas of the SNNP and Oromia regions
where the level and intensity of poverty is lower.

Why are rural people poor?

Major historical shifts in the political climate, as well as upheavals

and migrations caused by civil conflict, have had a strong impact on
Ethiopia’s rural poor people. The onset of drought in 2001
dramatically narrowed the horizons of the country’s rural households,
and continues to do so.

The HIV/AIDS pandemic plunges rural poor people even deeper into
poverty, depriving families of the young adults who are their most
productive members. In 2003 an estimated 4.4 per cent of Ethiopia’s
adult population was HIV-positive. The pandemic is driving life
expectancy even lower than the 2003 average of 42 years.

Among the causes of rural poverty in Ethiopia are:

75
 wide fluctuations in agricultural production as a result of drought
 an ineffective and inefficient agricultural marketing system
 underdeveloped transport and communication networks
 underdeveloped production technologies
 limited access of rural households to support services
 environmental degradation
 lack of participation by rural poor people in decisions that affect
their livelihoods

Source: IFAD

To conclude;

 Poverty is deeply rooted in Ethiopia and the country is known to

be among the very poor nations on the face of the globe.

By popular measures, the percentage of poor people who could

not secure the bare minimum needs for survival is estimated to be
around 45% in 1995/96. in terms of the popular USD $1/ day per
person measure, the figure is about 89%.

 Generally poverty is a rural phenomenon in Ethiopia. A rough

estimate of poverty in rural areas indicates that 52% of the
population lives below the poverty line. The figure for urban
households was, however, 36%, according to IFAD
(International Fund for Agricultural Fund Development).

76