Chapter 6: Growth

and Development
Introduction
 Economists are increasingly concerned with
explanations of per capita GDP levels and their rates of
growth
 For such explanations, economists turn to what is known
as growth theory
 Here we consider two variants of growth theory
 “old” growth theory or the Solow model
 “new” or “endogenous” growth theory
 We also consider the inter-relationships among human
capital, trade, institutions and growth
Robert Solow: Originator of
Modern Growth Theory
Growth
 Outcome assessment: The process of embracing some
metric(s) to judge the progress of countries over time
and to compare the progress of one country with others.
 An early and persistent conception of economic
development is in terms of the sustained increase in
either per capita production or per capita income 
growth
 GDP per capita is an important measure of the level of
economic development, and the growth rate of GDP per
capita is an important measure of the pace of economic
development over time.
Growth
 The growth perspective based on GDP per capita has many
limitations:
 Per capita GDP is not a measure of welfare
 Per capita GDP does not account for factor income flows between the
countries of the world
 Per capita GDP includes only market activities, and many activities in
low- and middle-income countries take place outside the market
 Per capita GDP does not account for certain costs associated with
development (the use of non-renewable resources, the loss of
biodiversity, and pollution)
 Per capita GDP is an average measure that hides the distortion of
income between households of a country
 Per capital GDP is not always an accurate predictor of human
development, such as in the form of education and health.
 The nominal or currency exchange rates used to convert GDP into US
dollars for comparison between countries are misleading.
Growth
 There is another way to consider GDP and GNI in
terms of deprivations.
 Income deprivations are central measure of
poverty.
 income poverty is measured by the World Bank in
three forms:
 Living on US$1.90 per day or less
 Living on US$3.20 per day or less
 Living on US$5.50 per day or less
Recent evolution of world poverty (millions of
persons)
Growth
 Analyzing the relationship between growth and poverty
takes note of the fact that poverty reduction depends on
initial inequality levels and changes in inequality as well
as growth itself. It also gives rise to what has come to be
known as pro-poor growth.
 This line of thinking considers what is known as the
growth elasticity of poverty, namely the ratio of the
percentage change in a poverty rate to the percentage
change in growth measure such as GDP per capita.
Real GDP per capita for Ghana, South
Korea, Malaysia, and Thailand (2010 US$)
Old Growth Theory: Production
Function
 Growth theory began with Nobel Laureate
Robert Solow (1956) in what is now known as
“old” growth theory
 Growth theory uses what economists call a
production function, in particular, the intensive
production function.
Intensive Production Function and
Capital Deepening
 The intensive
production function
relates two economic
variables
 Per capita GDP denoted
by where is GDP and
is the labor
force/population
 The capital-labor ratio
denoted by where is
the total amount of
physical capital
Old Growth Theory: Production
Function
 there is a positive relationship between the capital-labor
ratio and per capita GDP
 As the capital-labor ratio increases and each worker has more
physical capital to work with, per capita GDP increases
 This is a process known as capital deepening
 also indicates that the relationship between the capital-
labor ratio and per capita GDP is decreasingly positive
(the slope of the graph becomes flatter as increases)
 This is the result of diminishing returns to labor and capital
Old Growth Theory: Technological
Change
 There is a set of other possible source of increases in
per capita income
 This we will refer to as shift factors because they shift the
intensive production function.
 Solow had referred to this as technological change,
but this turns out to be only one possible shift factor
 As a result of these shift factors, at a given capital-labor ratio, ,
per capita income increases from to
 Increases in per capita incomes can come about through
increases in the capital-labor ratio (capital deepening) or
through other shift factors such as improvements in
technological efficiency
Technological Change in the Intensive
Production Function
Old Growth Theory
 Some additional requirements for economic
growth based on capital deepening:
 Increases in capital-labor ratio, k, require increases in
the capital stock that more than offset any increases in
population.
 Increases in capital stock, in turn, require investment.
 Investment requires saving.
 Domestic investment = Domestic savings + Foreign
savings
Old Growth Theory
 In the absence of shift factors such as technological improvements,
increases in domestic and foreign savings are the only sources of
growth in per capita incomes.
 If the increase in the capital stock is not large enough, k and y will fall because of
population growth, known as capital shallowing.
 Increasing household savings is often a matter of making institutions
available to the households of the economy to facilitate savings.
 Increasing government savings is a matter of decreasing
government expenditures and increasing government tax revenues,
moving the government budget towards surplus.
 Some types of government expenditures (e.g. education) can positively affect the
level of technology.
 Some government investments (e.g. infrastructure) are complementary to private
investments.
 Increasing foreign savings is a matter of increasing the
capital/financial account surplus on the balance of payments.
Old Growth Theory
 “Old” growth theory draws our
attention to savings and shift factors
such as technology as central
variables that can be affected by
various institutional and policy
regimes.
 However, this theory leaves a lot to
be explained, as represented
 The vertical, double-headed arrow in
this diagram indicates the amount of
the unexplained growth in per capita
incomes, which is known as the
Solow residual.
Unexplained growth in per capita
 In practice, Solow residuals can be incomes
large
New Growth Theory and Human
Capital
 New growth theory attempts to explain some of these
Solow residuals
 The models of the new growth theory are varied
 A number of new growth theory models emphasize the
role of a third factor of production in addition to labor and
physical capital, namely human capital
 Because productive knowledge can be embodied in
workers, there appears to be a positive link between
human capital and technological efficiency
 This leads to a modification of the intensive production
function so that increases in human capital shift it
upward through a positive impact on technological
efficiency
Human Capital
 In this intensive production function
of new growth theory, technology is
an endogenous variable that can
be influenced by levels of human
capital, measured perhaps as
literacy rates or years of education.
 The implication of this can be see:
an increase in human capital from
period 1 to period 2 shifts the
intensive production function
upwards.
 The amount of unexplained growth
(the Solow residual) declines, and
changes in human capital are an
Human capital and unexplained growth in per
important component in this
capita incomes
decline.
Empirical Evidence
 Early attempts to address this possibility indicated the human capital
was empirically important
 However, subsequent work questioned the empirical importance of
human capital as education in explaining development as growth
 One suggestion was that it is difficult to establish the role of
education in growth due to measurement errors
 This can relate to an important distinction to be made between
educational attainment and educational achievement.
 Educational attainment refers to the number of years of education an
individual has completed.
 Recent studies seem to have resolved the measurement error
difficulties by establishing a non-linear relationship between
education and human capital
 Once this is done, it appears that education does indeed contribute to
development as growth
Rate of Return to Education
 Further evidence on the importance of human capital in
the form of education comes from research on the rate
of return to education (RORE). Standard results from
this body of research suggest that:
 The private/market RORE is generally higher than the rate of
return on physical capital investments
 The private/market RORE is generally higher at lower levels of
education
 The private/market RORE is generally higher at lower levels of
GDP per capita
 There is also a growing body of research looking at
female education that suggests that the human capital of
girls and women is particularly important
Human Development and
Growth
 It is important to recognize that human capital includes
health and well as education
 It is Important to include a broader definition of human
capital (encompassing health and nutrition as well as
education)
Trade and Growth
 Many development and trade economists have
suggested that countries’ openness to international trade
has a positive impact on growth in per capita GDP and,
therefore, on poverty alleviation and human development
 This argument actually has a number of components
 Increased exports can support increased employment and wage
incomes, with the latter being reinvested in increases in human
capital
 Increased trade (both imports and exports) can in some
circumstances improve competitive conditions in domestic
markets
 Exports can contribute to improved technological efficiency as a
shift factor in the intensive production function diagram
Trade and Growth: Technological
Efficiency
 Technological efficiency responds to two impulses
 The first impulse is domestic innovation, which is positively
affected by human capital accumulation in some new growth
theory models
 The second impulse is the absorption of new technology from the
rest of the world
 Therefore, exports are sometimes seen as having a
positive externality for the exporting country
 Exports generate additional technology gains on the
supply side of the economy
Evidence of Export Externalities
 Export externalities are often justified with the historical experience
of East Asia
 More formally, early studies in the 1990s deployed statistical
techniques to show that the more open countries are to international
trade, the faster their growth in per capita GDP
 these externalities are notably absent in the case of primary product
exports, which characterize many developing countries
 More recent studies based on extended and improved indicators do
seem to support the trade and growth link
 There are other caveats to the role of exports in economic growth
 There is some agreement that the accumulation of human capital is an important
prerequisite to the absorption of technology from abroad.
 human capital and manufactured exports interact positively in supporting the
growth of per capita incomes
Institutions and Growth

 Increasing recognition has gone to the role of institutions

in growth as an additional shift factor in the intensive
production function diagram
 There are some relevant institutional categories and their
potential contributions to growth: These include
 Rule of law
 Property rights
 Contract enforcement
 Regulation
 Social insurance
Institutions and Growth
 What is the evidence on the role of institutions in
economic growth?
 The entire classical literature on economics from Adam Smith on,
as well as the entire early development economics literature,
both addressed precisely this question
 A set of new quantitative studies of the role of institutions in
growth, and, taken as a whole, they indicate that institutions (in
multiple dimensions) do matter.
 The task of actually constructing effective institutions is
difficult given the “overwhelmingly incremental” nature of
institutional change.
Review questions

 Why do countries establish limits on trade?

 If home industries are unable to compete with
foreign industries, the government will
impose trade restrictions to aid the
development of indigenous industries.
Governments may also impose trade
restrictions in order to encourage domestic
business rather than encouraging businesses
to relocate outside of the nation.
Review questions
 What Are The Factors Determine Size Of
Gain Of International Trade?
Answer :
 Nature of Terms of Trade

 Difference in Cost Ratios

 Productive Efficiency of the Country

 Relative Elasticity of Demand

 Factor Endowments and Technological

Conditions
 Review questions
 What Are The Objectives Of WTO? among all trading partners so as to
Answer : benefit consumers and help in
Important objectives of WTO are global integration;
mentioned below:  To increase the level of production
 To implement the new world trade and productivity with a view to
system as visualized in the ensuring level of employment in the
Agreement; world;
 To promote World Trade in a To expand and utilize world
manner that benefits every country; resources to the best;
 To ensure that developing countries To improve the level of living for the
secure a better balance in the global population and speed up
sharing of the advantages resulting economic development of the
from the expansion of international member nations.
trade corresponding to their
developmental needs;
 To enhance competitiveness
 Review questions
 What Are The Factors That Nature of Goods:
Influence The Terms Of Economic Development:
Trade?  Rate of Exchange:
 Answer :  Tariff Policy:

 Terms of trade are Size of Population:

influenced by a number Size of Country:
 Degree of Competition:
of factors. Important
among them are given
below:
 Elasticity of Demand:
 Elasticity of Supply: