Development Economics (PDS3084) Lecture Notes___________________

Chapter Two: Growth Models and Theories of Development

2.1. Growth Models –Harod Domar

The Harrod–Domar model is a Keynesian model of economic growth. It is used in development

economics to explain an economy's growth rate in terms of the level of saving and of capital. It
suggests that there is no natural reason for an economy to have balanced growth. The model was
developed independently by Roy F. Harrod in 1939, and Evsey Domar in 1946, although a similar
model had been proposed by Gustav Cassel in 1924. The Harrod–Domar model was the precursor
to the exogenous growth model.

Neoclassical economists claimed shortcomings in the Harrod–Domar model—in particular

the instability of its solution and, by the late 1950s, started an academic dialogue that led to the
development of the Solow–Swan model.

According to the Harrod–Domar model there are three kinds of growth:

 Warranted growth,

 Actual growth and

 Natural rate of growth

Warranted growth rate is the rate of growth at which the economy does not expand indefinitely
or go into recession.

Actual growth is the real rate increase in a country's GDP per year. (See also: Gross domestic
product and Natural gross domestic product).

Natural growth is the growth an economy requires to maintain full employment. For example, If
the labor force grows at 3 percent per year, then to maintain full employment, the economy’s
annual growth rate must be 3 percent.

Ever since the end of Second World War, interest in the problems of economic growth has led
economists to formulate growth models of different types. These models deal with and lay
emphasis on the various aspects of growth of the developed economies. They constitute in a way
alternative stylized pictures of an expanding economy.

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A feature common to them all is that they are based on the Keynesian saving-investment analysis.
The first and the simplest model of growth—the Harrod-Domar Model—is the direct outcome of
projection of the short-run Keynesian analysis into the long-run. This model is based on the capital
factor as the crucial factor of economic growth. It concentrates on the possibility of steady growth
through adjustment of supply of demand for capital. Then there is Mrs. Joan Robinson’s model
which considers technical progress also, along with capital formation, as a source of economic
growth. The third type of growth model is that built on neoclassical lines.

It assumes substitution between capital and labour and a neutral technical progress in the sense
that technical progress is neither saving nor absorbing of labour or capital. Both the factors are
used in the same proportion even when neutral technical takes place. We deal with the prominent
growth models here. Although Harrod and Domar models differ in details, they are similar in
substance. One may call Harrod’s model as the English version of Domar’s model. Both these
models stress the essential conditions of achieving and maintaining steady growth. Harrod and
Domar assign a crucial role to capital accumulation in the process of growth. In fact, they
emphasise the dual role of capital accumulation.

On the one hand, new investment generates income (through multiplier effect); on the other hand,
it increases productive capacity (through productivity effect) of the economy by expanding its
capital stock. It is pertinent to note here that classical economists emphasised the productivity
aspect of the investment and took for granted the income aspect. Keynes had given due attention
to the problem of income generation but neglected the problem of productive capacity creation.
Harrod and Domar took special care to deal with both the problems generated by investment in
their models.

General Assumptions:
The main assumptions of the Harrod-Domar models are as follows:
i. A full-employment level of income already exists.

ii. There is no government interference in the functioning of the economy.

iii. The model is based on the assumption of “closed economy.” In other words, government
restrictions on trade and the complications caused by international trade are ruled out.

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iv. There are no lags in adjustment of variables i.e., the economic variables such as savings,
investment, income, expenditure adjust themselves completely within the same period of
time.
v. The average propensity to save (APS) and marginal propensity to save (MPS) are equal to
each other. APS = MPS or written in symbols, S/Y= ∆S/∆Y
vi. Both propensity to save and “capital coefficient” (i.e., capital-output ratio) are given
constant. This amounts to assuming that the law of constant returns operates in the
economy because of fixity of the capita-output ratio.
vii. Income, investment, savings are all defined in the net sense, i.e., they are considered over
and above the depreciation. Thus, depreciation rates are not included in these variables.
viii. Saving and investment are equal in ex-ante as well as in ex-post sense i.e., there is
accounting as well as functional equality between saving and investment.
These assumptions were meant to simplify the task of growth analysis; these could be relaxed later.
Harrod’s growth model raised three issues:
(i) How can steady growth be achieved for an economy with a fixed (capital- output ratio)
(capital-coefficient) and a fixed saving-income ratio?

(ii) How can the steady growth rate be maintained? Or what are the conditions for maintaining
steady uninterrupted growth?

(iii) How do the natural factors put a ceiling on the growth rate of the economy?

In order to discuss these issues, Harrod had adopted three different concepts of growth rates:
(i) the actual growth rate, G,
(ii) the warranted growth rate, Gw
(iii) the natural growth rate, Gn.
The Actual Growth Rate is the growth rate determined by the actual rate of savings and investment
in the country. In other words, it can be defined as the ratio of change in income (AT) to the total
income (Y) in the given period. If actual growth rate is denoted by G, then G = ∆Y/Y

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The actual growth rate (G) is determined by saving-income ratio and capital- output ratio. Both
the factors have been taken as fixed in the given period. The relationship between the actual growth
rate and its determinants was expressed as: GC = s …(1)

This relation explains that the condition for achieving the steady state growth is that ex-post
savings must be equal to ex-post investment. “Warranted growth” refers to that growth rate of
the economy when it is working at full capacity. It is also known as Full-capacity growth rate. This
growth rate denoted by Gw is interpreted as the rate of income growth required for full utilisation
of a growing stock of capital, so that entrepreneurs would be satisfied with the amount of
investment actually made.
Warranted growth rate (Gw) is determined by capital-output ratio and saving- income ratio. The
relationship between the warranted growth rate and its determinants can be expressed as Gw Cr =s
where Cr shows the needed C to maintain the warranted growth rate and s is the saving-income
ratio. Let us now discuss the issue: how to achieve steady growth? According to Harrod, the
economy can achieve steady growth when G = Gw and C = Cr
This condition states, firstly, that actual growth rate must be equal to the warranted growth rate.
Secondly, the capital-output ratio needed to achieve G must be equal to the required capital-output
ratio in order to maintain Gw, given the saving co-efficient (s). This amounts to saying that actual
investment must be equal to the expected investment at the given saving rate.
Instability of Growth:
We have stated above that the steady-state growth of the economy requires an equality between G
and Gw on the one hand and C and Cr on the other. In a free-enterprise economy, these equilibrium
conditions would be satisfied only rarely, if at all. Therefore, Harrod analysed the situations when
these conditions are not satisfied.
Comparing the second and the third relations about the warranted growth rate and the natural
growth rate which have been given above, we may conclude that Gn may or may not be equal to
Gw. In case G„ happens to be equal to Gw, the conditions of steady growth with full employment
would be satisfied. But such a possibility is remote because of the variety of hindrances are likely
to intervene and make the balance among all these factors difficult.

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Harrod-Domar Model of Growth and its Limitations

The Harrod Domar Model suggests that the rate of economic growth depends on two things:

1. Level of Savings (higher savings enable higher investment)

2. Capital-Output Ratio. A lower capital-output ratio means investment is more efficient
and the growth rate will be higher.
A simplified model of Harrod-Domar:

Harrod-Domar in more detail

 Level of savings (s) = Average propensity to save (APS) – which is the ratio of national
savings to national income.
 The capital-output ratio = 1/marginal product of capital.
 The capital-output ratio is the amount of capital needed to increase output.
 A high capital-output ratio means investment is inefficient.
 The capital-output ratio also needs to take into account the depreciation of existing
capital

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Main factors affecting economic growth

 Level of savings. Higher savings enable greater investment in capital stock

 The marginal efficiency of capital. This refers to the productivity of investment, e.g. if
machines costing £30 million increase output by £10 million. The capital-output ratio is 3
 Depreciation – old capital wearing out.
Roy Harrod introduced a concept known as the warranted growth rate.

 This is the growth rate at which all saving is absorbed into investment. (e.g. £80bn of saving
= £80bn of investment.
 Let us assume, the saving rate is 10% and the capital-output ratio is 4. In other words,
£10bn of investment increases output by £2.5bn.
 In this case, the economy’s warranted growth rate is 2.5 percent (ten divided by four).
 This is the growth rate at which the ratio of capital to output would stay constant at four.
The Natural Growth Rate

 The natural growth rate is the rate of economic growth required to maintain full
employment.
 If the labour force grows at 3 percent per year, then to maintain full employment, the
economy’s annual growth rate must be 3 percent.
 This assumes no change in labour productivity which is unrealistic.
Importance of Harrod-Domar

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It is argued that in developing countries low rates of economic growth and development are linked
to low saving rates.This creates a vicious cycle of low investment, low output and low savings. To
boost economic growth rates, it is necessary to increase savings either domestically or from abroad.
Higher savings create a virtuous circle of self-sustaining economic growth.

Impact of increasing capital

The transfer of capital to developing economies should enable higher growth, which in turn will
lead to higher savings and growth will become more self-sustaining.

Criticisms of Harrod-Domar Model

 Developing countries find it difficult to increase saving. Increasing savings ratios may be
inappropriate when you are struggling to get enough food to eat.
 Harrod based his model on looking at industrialised countries post-depression years. He
later came to repudiate his model because he felt it did not provide a model for long-term
growth rates.

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 The model ignores factors such as labour productivity, technological innovation and levels
of corruption. The Harrod-Domar is at best an oversimplification of complex factors which
go into economic growth.
 There are examples of countries who have experienced rapid growth rates despite a lack of
savings, such as Thailand.
 It assumes the existences of a reliable finance and transport system. Often the problem for
developing countries is a lack of investment in these areas.
 Increasing capital stock can lead to diminishing returns. Domar was writing during the
aftermath of the Great Depression where he could assume there would always be surplus
labour willing to use the machines, but, in practice, this is not the case.
 The Model explains boom and bust cycles through the importance of capital. However, in
practice businesses are influenced by many things other than capital such as expectations.
 Harrod assumed there was no reason for the actual growth to equal natural growth and that
an economy had no tendency to full employment. However, this was based on the
assumption of wages being fixed.
 The difficulty of influencing saving levels. In developing economies it can be difficult to
increase savings ratios – because of widespread poverty.
 The effectiveness of foreign capital flows can vary. In the 1970s and 80s many developing
economies borrowed from abroad, this led to an inflow of foreign capital however, there
was a lack of skilled labour to make effective use of capital. This led to very high capital-
output ratios (poor productivity) and growth rates didn’t increase significantly. However,
developing economies were left with high debt repayments and when interest rates rose, a
large proportion of national savings was diverted to paying debt repayments.
 Economic development implies much more than just economic growth. For example, who
benefits from growth? does higher national income filter through to improved health care
and education. It depends on how the capital is used.
2.2. Solow Theories of Development-surplus labor theory

The Solow–Swan model is an economic model of long-run economic growth set within the
framework of neoclassical economics. It attempts to explain long-run economic growth by looking
at capital accumulation, labor or population growth, and increases in productivity, commonly
referred to as technological progress. At its core is a neoclassical (aggregate) production function,

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often specified to be of Cobb–Douglas type, which enables the model "to make contact
with microeconomics". The model was developed independently by Robert Solow and Trevor
Swan in 1956, and superseded the Keynesian Harrod–Domar model.

Mathematically, the Solow–Swan model is a nonlinear system consisting of a single ordinary

differential equation that models the evolution of the per capita stock of capital. Due to its
particularly attractive mathematical characteristics, Solow–Swan proved to be a convenient
starting point for various extensions. The neo-classical model was an extension to the 1946
Harrod–Domar model that included a new term: productivity growth. Important contributions to
the model came from the work done by Solow and by Swan in 1956, who independently developed
relatively simple growth models. Solow's model fitted available data on US economic growth with
some success. In 1987 Solow was awarded the Nobel Prize in Economics for his work. Today,
economists use Solow's sources-of-growth accounting to estimate the separate effects on economic
growth of technological change, capital, and labor

Extension to the Harrod–Domar model

Solow extended the Harrod–Domar model by adding labor as a factor of production and capital-
output ratios that are not fixed as they are in the Harrod–Domar model. These refinements allow
increasing capital intensity to be distinguished from technological progress. Solow sees the fixed
proportions production function as a "crucial assumption" to the instability results in the Harrod-
Domar model. His own work expands upon this by exploring the implications of alternative
specifications, namely the Cobb–Douglas and the more general constant elasticity of substitution
(CES). Although this has become the canonical and celebrated story in the history of economics,
featured in many economic textbooks, recent reappraisal of Harrod's work has contested it. One
central criticism is that Harrod's original piecewas neither mainly concerned with economic growth
nor did he explicitly use a fixed proportions production function.

Long-run implications

A standard Solow model predicts that in the long run, economies converge to their steady
state equilibrium and that permanent growth is achievable only through technological progress.
Both shifts in saving and in populational growth cause only level effects in the long-run (i.e. in the
absolute value of real income per capita). An interesting implication of Solow's model is that poor

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countries should grow faster and eventually catch-up to richer countries. This convergence could
be explained by:

 Lags in the diffusion on knowledge. Differences in real income might shrink as poor countries
receive better technology and information;
 Efficient allocation of international capital flows, since the rate of return on capital should be
higher in poorer countries. In practice, this is seldom observed and is known as Lucas' paradox;
 A mathematical implication of the model (assuming poor countries have not yet reached their
steady state).

Baumol attempted to verify this empirically and found a very strong correlation between a
countries' output growth over a long period of time (1870 to 1979) and its initial wealth.His
findings were later contested by DeLong who claimed that both the non-randomness of the
sampled countries, and potential for significant measurement errors for estimates of real income
per capita in 1870, biased Baumol's findings. DeLong concludes that there is little evidence to
support the convergence theory.

Assumptions

The key assumption of the neoclassical growth model is that capital is subject to diminishing
returns in a closed economy.

 Given a fixed stock of labor, the impact on output of the last unit of capital accumulated will
always be less than the one before.
 Assuming for simplicity no technological progress or labor force growth, diminishing returns
implies that at some point the amount of new capital produced is only just enough to make up
for the amount of existing capital lost due to depreciation.At this point, because of the
assumptions of no technological progress or labor force growth, we can see the economy
ceases to grow.
 Assuming non-zero rates of labor growth complicate matters somewhat, but the basic logic
still applies in the short-run, the rate of growth slows as diminishing returns take effect and the
economy converges to a constant "steady-state" rate of growth (that is, no economic growth
per-capita).

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 Including non-zero technological progress is very similar to the assumption of non-zero

workforce growth, in terms of "effective labor": a new steady state is reached with constant
output per worker-hour required for a unit of output. However, in this case, per-capita output
grows at the rate of technological progress in the "steady-state"that is, the rate
of productivity growth).

Variations in the effects of productivity

In the Solow–Swan model the unexplained change in the growth of output after accounting for the
effect of capital accumulation is called the Solow residual. This residual measures the exogenous
increase in total factor productivity (TFP) during a particular time period. The increase in TFP is
often attributed entirely to technological progress, but it also includes any permanent improvement
in the efficiency with which factors of production are combined over time. Implicitly TFP growth
includes any permanent productivity improvements that result from improved management
practices in the private or public sectors of the economy. Paradoxically, even though TFP growth
is exogenous in the model, it cannot be observed, so it can only be estimated in conjunction with
the simultaneous estimate of the effect of capital accumulation on growth during a particular time
period.

The model can be reformulated in slightly different ways using different productivity assumptions,
or different measurement metrics:

 Average Labor Productivity (ALP) is economic output per labor hour.

 Multifactor productivity (MFP) is output divided by a weighted average of capital and labor
inputs. The weights used are usually based on the aggregate input shares either factor earns.
This ratio is often quoted as: 33% return to capital and 67% return to labor (in Western
nations).

In a growing economy, capital is accumulated faster than people are born, so the denominator in
the growth function under the MFP calculation is growing faster than in the ALP calculation.
Hence, MFP growth is almost always lower than ALP growth. (Therefore, measuring in ALP terms
increases the apparent capital deepening effect.) MFP is measured by the "Solow residual", not
ALP.

2.3.The Theory of Low-level Equilibrium Trap

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This theory is the brainchild of R. Nelson. This theory is also based Malthus hypothesized that the
population of a country will tend to increase when per capita income rises above the level of the
minimum subsistence costs. Robert Solow and Trevor Swan first introduced the neoclassical
growth theory in 1956. The theory states that economic growth is the result of three factors:
labor, capital, and technology. While an economy has limited resources in terms of capital
and labor, the contribution from technology to growth is bound. On initially, the population
is growing rapidly along with the increase in income per capita. However, population growth rate
will start to decline if it has reached the physical limits above as further increases in per capita
income. This theory is similar to the strategy Leibenstein thesis minimum effort critical. According
to Nelson, the disease can be diagnosed as retarded the country's economy as stable equilibrium
level of income per capita at or close to the needs cost of living. Nelson In theory, there are four
conditions that bring technological and social low-level equilibrium trap, namely:

1. The high correlation between the level of per capita income and growth rate population

2. A low tendency to use per capita income in addition to increased investment per capita

3. Lack of arable land

4. The production method is not efficient.

Moreover, inaction cultural and economic slowdown is also a factor which became the trap. Nelson
uses three types of relationship to describe the economic trap at low income levels, namely:

1. Revenue is a function of capital stock, the level of technology, and the size of the population

2. Investments net consists of capital that is created from savings in the form of additional
material on the new land area of land that is being processed

3. With low per capita income, short-term changes in the rate population growth is a result of
changes in mortality, and changes in the death rate was a result of changes the level of per
capita income.

However, while revenue per capita reached a level far above the necessities of life. The next
increment on a per capita income less effect on mortality. In theory, Nelson stressed a number of
factors needed to escape from the trap of low-level equilibrium, namely:

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a. The social and political environment that is favorable in country concerned

b. The social structure must be changed to provide greater pressure on saving and
entrepreneurship. Greater incentive to be given to produce more and to limit the amount of
family.

c. Steps should be taken to change the distribution of income, on the same time allows the
accumulation of wealth by the investor.

d. The government's overall investment program.

e. Income and capital shall be increased by funds from outside country.

f. The production technology is more adequate.

2.4. Cumulative Causation Theory

Cumulative causation refers to a self-reinforcing process during which an impulse to a system

triggers further changes in the same direction as the original impulse, thus taking the system further
away from its initial position in virtuous or vicious circles of change that may result in a continuing
increase in advantages (to some people or activities) and disadvantages (to others).The

term cumulative causation was coined by the Swedish economist Gunnar Myrdal (1898–1987),

even though the basic hypothesis first appeared in American economist Allyn Young’s (1876–

1929) analysis of economic progress (“Increasing Returns and Economic Progress,” 1928). In An
American Dilemma (1944), Myrdal used the concept of cumulative causation to explain race
relations in the United States. In a vicious circle of social determination, the prejudice of the white
populations and the low living standards of the black populations could reinforce each other in a
downward spiral: a decline in black living conditions could worsen white prejudice and trigger

institutional discriminatory processes, further deteriorating black Americans’ standards of living.

In Myrdal’s analysis, the circular interdependence between social, economic, and political forces,

by hindering identification of the “primary” factors (e.g., economic) behind social issues,

challenges traditional scholastic boundaries among the social sciences. Fundamentally, Myrdal’s

notion of cumulative causation conflicts with the concept of “stable equilibrium” (central to most

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social sciences, particularly to economics)—that is, the self-stabilization properties of the social
system, whereby a disturbance to it will trigger a reaction directed toward restoring a new state of
balance between forces. In Economic Theory and Under-Developed Regions (1957), Myrdal
addressed the failure of neoclassical economic theory to account for the persistence and widening
of spatial differences in economic development within and between countries. He ascribes these
differences to cumulative processes, whereby regions or nations that gain an initial advantage
maintain and expand it as they attract migration, capital, and trade to the detriment of development

elsewhere, an idea that permeates the voluminous “nonformal” literature on “uneven

development” of the 1960s and 1970s.

Cumulative causation is also central to the view of economic growth as a “learning

process” (resulting from virtuous circles of specialization and technical progress) that emerged in
the 1960s and 1970s . However, its assimilation into mainstream economic theory was hampered

by the difficulty of modeling “increasing returns,” on which it inherently relies. Inspired by Adam

Smith (1723–1790) and Alfred Marshall (1842–1924), Young (1928) emphasized how increasing
returns stem primarily from the process of the division of labor and specialization in production.

In Young’s virtuous circle, an expansion of the market deepens the division of labor, ensuing in
cumulative increases in production efficiency and in market size.
2.5.The big push model

The big push model is a concept in development economics or welfare economics that emphasizes
that a firm's decision whether to industrialize or not depends on its expectation of what other firms
will do. It assumes economies of scale and oligopolistic market structure and explains when
industrialization would happen.

The originator of this theory was Paul Rosenstein-Rodan in 1943. Further contributions were made
later on by Murphy, Shleifer and Robert W. Vishny in 1989. Analysis of this economic model
ordinarily involves using game theory.

The theory of the model emphasizes that underdeveloped countries require large amounts of
investments to embark on the path of economic development from their present state of

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backwardness. This theory proposes that a 'bit by bit' investment programme will not impact the
process of growth as much as is required for developing countries. In fact, injections of small
quantities of investments will merely lead to a wastage of resources. Paul Rosenstein-
Rodan approvingly quotes a Massachusetts Institute of Technology study in this regard, "There is
a minimum level of resources that must be devoted to... a development programme if it is to have
any chance of success. Launching a country into self-sustaining growth is a little like getting
an airplane off the ground. There is a critical ground speed which must be passed before the craft
can become airborne.

Rosenstein-Rodan argued that the entire industry which is intended to be created should be treated
and planned as a massive entity (a firm or trust). He supports this argument by stating that the
social marginal product of an investment is always different from its private marginal product, so
when a group of industries are planned together according to their social marginal products, the rate
of growth of the economy is greater than it would have otherwise been. According to Rosenstein-
Rodan, there exist three indivisibilities in underdeveloped countries. These indivisibilities are
responsible for external economies and thus justify the need for a big push. The indivisibilities are
as follows-

1. Indivisibility in production function

2. Indivisibility of demand
3. Indivisibility in the supply of savings

Indivisibility in production function

Indivisibilities in the production function may be with respect to any of the following:

 Inputs
 Processes
 Outputs

These lead to increasing returns (i.e., economies of scale), and may require a high optimum size
of a firm. This can be achieved even in developing countries since at least one optimum scale firm
can be established in many industries. But investment in social overhead capital comprises
investment in all basic industries (like power, transport or communications) which must
necessarily come before directly productive investment activities. Investment in social
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overhead capital is 'lumpy' in nature. Such capital requirements cannot be imported from other
nations. Therefore, heavy initial investment necessarily needs to be made in social
overhead capital (this is approximated to be about 30 to 40 percent of the total investment
undertaken by underdeveloped countries). Social overhead capital is further characterized by four
indivisibilities:

1. Irreversibility in time: It must precede other directly productive investments

2. Minimum durability of equipment:. Any lesser level of durability is either impossible due
to technical reasons or much less efficient
3. Long gestation periods: The investment in social overhead capital takes time to generate
returns and its impact in the economy is not immediately or directly visible
4. Irreducible minimum social overhead capital–industry mix: Investment needs to be of a
certain minimum magnitude and spread across a mix of industries, without which it will
not significantly impact the process of growth.

Indivisibility (or complementarity) of demand

Developing countries are characterized by low per-capita income and purchasing power. Markets
in these countries are therefore small. In a closed economy, modernization and increased efficiency
in a single industry has no impact on the economy as a whole since the output of that industry will
fail to find a market. A large number of industries need to be set up simultaneously so that people
employed in one industry consume the output of other industries and thus
create complementary demand.

To illustrate this, Rosenstein Rodan gives the example of a shoe industry. If a country makes large
investments in the shoe industry, all the disguisedly employed labor from the other industries find
work and a source of income, leading to a rise in production of shoes and their own incomes. This
increased income will not be expended only on buying shoes. It is conceivable that the increased
incomes will lead to increased spending on other products too. However, there is no corresponding
supply of these products to satisfy this increased demand for the other goods. Following the
basic market forces of demand and supply, the prices of these commodities will rise. To avoid such
a situation, investment must be spread out amongst different industries.

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The situation may be different in an open economy as the output of the new industry may replace
former imports or possibly find its market by way of exports. But even if the world market acts as
a substitute for domestic demand, a big push is still needed (though its required size may now be
reduced due to the presence of international trade).

Indivisibility in the supply of savings

High levels of investment require a corresponding high level of savings. We cannot always rely
on foreign aid as the huge levels of investments in the different sectors need to be made not only
once, but multiple times. Hence domestic savings are a must. But in an underdeveloped economy,
this is a challenge due to the low income levels. The marginal rate of savings needs to be increased
following the rise in incomes due to higher investment.

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Chapter Three: Determinants of Economic Development

3. The Traditional Approach (Economic Factors) to Development

The traditional approach to development assumes that economic development is determine d

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

A) Natural Resources

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

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

B) Capital Accumulation

Capital means the stock of physical reproducible factors of production. When capital stock
increases with the passage of time, it is called capital accumulation or capital
formation. Capital formation is investment in capital goods that leads to increase in capital
stock, national output and income. Capital formation is the key to economic development. On
the one hand, it reflects effective demand and on the other hand, it creates productive

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efficiency for production. Capital formation possesses special importance to LDCs. The
process of capital formation leads to the increase in national output in a number of
ways. Capital formation is essential to meet the requirements of an increasing population in
such economies. Investment in capital goods not only raises production but also employment
opportunities. It is capital formation that leads to technological progress. Technological
progress in turn leads to specialization and the economies of large scale production. The
provision of social and economic over heads, like transport, power education, etc. in a country
is possible through capital formation. It is also capital formation that leads to the exploitation
of natural resources, industrialization and expansion of markets which are essential for
economic progress.

C) Organization

Organization is an important part of the growth process. It relates to the optimum use of
factor of production and economic activities. Organization is complement to capital and labor
and helps in increasing their product activities. In modern economic growth, the entrepreneur
has been performing the task of an organizer and undertaking risks and uncertainties.

The underdeveloped countries lack entrepreneurial activity. Such factors as the small size of
the market, capital deficiency, absence of private property and contract, lack of skilled and
trained labor, non-availability of adequate raw materials, and infrastructural facilities like
transport, power, etc increase risk and uncertainties. That is why such countries lack
entrepreneurs.
D) Technological Progress

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

D) Division of Labor and Scale of production

Specialization and division of labor lead to increase in productivity. They lead to economies
of large scale production which further help in industrial development. Adam Smith gave

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much importance to the division of labor in economic development. Division of labor leads
to improvement in the productive capacities of labor. Every laborer becomes more efficient
than before. S/he saves time. S/he is capable of inventing new machines and process in
production. Ultimately production increases manifold. But division of labor depends upon
the size of the market. The size of the market, in turn, depends upon economic progress, i.e.
the extent to which the size of demand, the general level of production, the means of transport
etc are developed. When the scale of production is large, there is greater specialization and
division of labor. As a result, production increases and the rate of economic progress is
accelerated. Underdeveloped countries are unable to take advantage of the economics of
division of labor and large scale production due to the presence of market imperfections,
which in turn keep the size of the market small.
3.2 Institutional Approach to Development
The institutional approach to development is a recent phenomenon. It argues that
explanations of the poor economic development are found not only in economic factors but
also in non-economic factors. In fact most of these factors are explained by non-economic
factors or institutional factors. The institutional approach to development emphasizes more
on the institutional factors than the economic factors. They explain this using the case of a
metropolitan city. The central city in a metropolitan area, while gaining some high-rise
buildings, has a stagnant population and an increasing proportion of poor people. On the
other hand, suburbs are prosperous and growing rapidly.
To a certain degree, modern economics is like such a metropolitan area. The traditional
economics is at the center of the city. At the same time, the suburbs of economics are
expanding rapidly in all directions. The institution approach to development is a case in
point. For example, consider shifting the focus from capital and other resources toward the
quality of governance. In the suburbs of economics governance is a focus, but not in the city
center where capital is the focus.

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

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A) Type of Government

A country with a monarchy system is less likely to develop as compared with a coun try with
a democratic government. The nature of democracy depends on the level of education,
discipline, culture, etc. of the people. In maintaining rules, governments could be soft or
strong. To maintain rules and there by prepare the ground for development, governments need
be strong. To provide for the enforcement of contracts, the prevention of anarchy, and the
provision of other public good, the coercive power of government is necessary.
Good governance is another important factor which determines economic performance of
countries. According to Olson M, “Governance is a decisive determinant of economic
performance and that with the right economic policy and institutions, poor countries can grow
at a very rapid rate.” Good governance is reflected by long trem vision, correct policies and
effective implementation. For example, in Japan the government decided what type of
industries to develop after World War II. It gave emphasis to textile, iron and steel,
shipbuilding etc. In recent years, the government shifted towards electronics in response to a
change in world market. Another aspect of good governance is the development of
infrastructure. Countries like Hong Kong, Singapore, Malaysia, etc develop infrastructu re and
attract foreign capital.

B) Institutions

Availability of technology like the capital good, complementary factors like infrastructure,
highly skilled labor, innovation, etc. are required for an economy to grow. To have such
technological changes requires a good institution. For example, in making innovations, there
could be resistance. To calm such resistance, government effort is required. Thus, institutions
that encourage technological innovation and suitability of institution for successful adoption
of new ideas is an important question. Political and cultural dynamism help in adoption of
new technology and the negative forces such as labour union orthodoxy should be managed
properly by good governance. Spread of education and scientific culture are necessary for
adoption of new technology Reservation/Affirmative Action/. Social justice requires that if
some sections of the society are deprived, they must be given special attention i.e. reservation
is needed. The supporters of reservation justify its use in terms of social justice, equity and to
rectify historical mistakes. However, from the point of view of efficiency, it is not justified.

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C) Social Structure of Population

In some countries, we get a homogenous type of population. Homogeneity of the population

leads to the development of national feelings, which is helpful for economic development –
for example China, Japan, Korea, and Russia. On the other hand, population of a country
could also be heterogeneous _ divided on the basis of language, religion, ethnicity, caste,
etc. In such societies, some groups play entrepreneurial role.

E) Human Capital and Cultural Traits.

The difference in per capita income among countries could be explained by human capital
and cultural traits. In the DCs, human capital and cultural traits in the form of work culture,
discipline, good entrepreneurship etc have played an important role. Poor countries are poor
because they lack these traits. The cultural traits that perpetuate poverty are the result of
centuries of social accumulation and they can’t be changed quickly. Cultural advancement
according to M. Olson results in two types of human capital:

a) Marketable Italic capital; These include more skill, propensity to work harder, more
entrepreneurial personality; These qualities result in increase in the quality and quantity of
productive outputs. These results in increase in income of persons, groups as well as of
nations.

b) Civic culture. A civic culture leads to the election of good government which adopts
good policy. It also results in a disciplined society. Corruption will be less. People pay tax.

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