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ECON 45- ECONOMIC DEVELOPMENT

UNIT 2: Theories of Development

Classic Theories of Economic Development Four Approaches:

1. The Linear-Stages of growth model

2.Structural change pattern Theories
3.International-Independence
4. Neo-Classical (counter-revolution) Theory

1. The Linear-Stages of Growth Model

1.1. Rostow’s Stages of Growth

One of the key thinkers in 20th-century Development Studies was W.W. Rostow, an American
economist and government official. Prior to Rostow, approaches to development had been based on the
assumption that "modernization" was characterized by the Western world (wealthier, more powerful
countries at the time), which were able to advance from the initial stages of underdevelopment. Accordingly,
other countries should model themselves after the West, aspiring to a "modern" state of capitalism and
liberal democracy. Using these ideas, Rostow penned his classic "Stages of Economic Growth" in 1960,
which presented five steps through which all countries must pass to become developed:

1. Traditional Society: This stage is characterized by a subsistent, agricultural-based economy with

intensive labor and low levels of trading, and a population that does not have a scientific perspective
on the world and technology.
2. Preconditions to Take-off: Here, a society begins to develop manufacturing and a more
national/international—as opposed to regional—outlook.
3. Take-off: Rostow describes this stage as a short period of intensive growth, in which
industrialization begins to occur, and workers and institutions become concentrated around a new
industry.
4. Drive to Maturity: This stage takes place over a long period of time, as standards of living rise, the
use of technology increases, and the national economy grows and diversifies.
5. Age of High Mass Consumption: At the time of writing, Rostow believed that Western countries,
most notably the United States, occupied this last "developed" stage. Here, a country's economy
flourishes in a capitalist system, characterized by mass production and consumerism.

Note: Singapore follows the development outline by Rostow

Criticisms
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1. bias towards a western model as the only path towards development

2. all countries do not develop in such a linear fashion; some skip steps or take different paths.

1.2. The Harrod-Domar growth model

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:

▪ 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

Importance of the Harrod-Domar

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.

Historical Example: “The Marshall Plan” in Europe/Germany succeeded due to the existence of
these other factors such as educated labor and knowledge even though the physical
infrastructure was destroyed by the War.

Criticisms of Harrod-Domar Model

1. Developing countries find it difficult to increase saving. Increasing savings ratios may be
inappropriate when you are struggling to get enough food to eat.
2. Harrod based his model on looking at industrialized 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.
3. 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.
4. There are examples of countries who have experienced rapid growth rates despite a lack of
savings, such as Thailand.
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2. Structural Change Pattern Theories

The focus of these theories is on the way economies are transformed over time, from traditional to
modern/industrial economies.

2.1. The Lewis Model of Development

Lewis theory of economic development is a structural-change theory. This theory explains the
mechanism of changing structure of underdeveloped economies from subsistence agriculture t modern and
more urbanized. This model became the general theory of the development process for surplus labor nation
during 1960’s and early 1970’s.

The Lewis Model consists of two sectors in the economy. They are:

i) Traditional Sector. This sector is overpopulated subsistence sector where marginal productivity
of labor is zero. Due to zero marginal productivity of labor it is possible to withdraw labor from this sector
without affecting the level of output. This is why Lewis classified this sector as surplus labor sector.

ii) Modern Sector: This sector is urban industrial sector. Productivity is high in this sector. Labor
is gradually transferred into this sector from traditional sector. Movement of labor from traditional to modern
sector brings the expansion in both output and employment. The speed of this expansion depends on:

a) Rate of industrial investment and capital accumulation which ultimately depends on the level of
profit. Lewis assumes that all profits are reinvested.

b) Wage of difference between rural and urban sector. According to Lewis there should be at least
30% higher wages rates in urban sector than rural sector in order to transfer labor automatically from rural
to urban.

Evaluation

1. China provides a good example: official Chinese statistics place the number of internal migrants
over the past 20 years at over 10% of the 1.3bn population. 45% were aged 16-25 and two-thirds were
male. Urban incomes are around 3.5 times those of rural workers.

2. A Marxist criticism states that profits will be retained by the capitalist entrepreneur, at the expense
of workers. In addition, urban expansion might be driven by increases in capital rather than labour.

3. Evidence suggests that surplus labour is as likely in the urban sector as in the agricultural sector.
Migrating workers may possess insufficient information about job vacancies, pay and working conditions.
This results in high unemployment levels in towns and cities.

4. Towns and cities may also be fixed in size and unable to accommodate large numbers of
immigrants. This gives rise to slums and shanty towns, which are often illegal, built on flood planes or areas
vulnerable to landslides and without sanitation or clean water. Cape Town provides a good example.
Globally 1bn people live in slums.

Criticisms

1. The model implicitly assumes that the rate of transfer & employment creation in modern sector
is proportional to the rate of modern sector capital accumulation. And what if capitalists do not re-invest
profits in the local economy but are actually invested in other countries (i.e, capital flight)?

2. Model roughly explains the historical growth experience of today’s industrial nations. But, its key
assumptions do not reflect the realities of today’s LDCs. Why? Profits may not be re-invested domestically
in Less Developing Countries especially in African economies i.e. there may be “capital flight”

3. Surplus labor may not exist in rural economy.

2.2. Structural Change & Patterns of Development by Hollis Chenery

Like the Lewis model, the patterns-of-development analysis of structural change focuses on the
sequential process through which the economic, industrial, and institutional structure of a developing
economy is transformed over time to permit new industries (replacing traditional agriculture) as the engine
of economic growth.

The best-known model of structural change is the one based on the empirical work of Harvard
economist Hollis Chenery. Chenery examined patterns of devt for numerous 3rd world countries during the
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post-war period. Chenery examined patterns of devt for numerous 3rd world countries during the post-war
period. His empirical studies (both cross-sectional & time series) of countries at different levels of per
capital income led to the identification of several characteristic features of the development process.

These include the following:

1. a shift from agricultural to individual production;

2. the steady accumulation of physical & human capital;
3. The change in consumer demand from emphasis on food & basic necessities TO
the desires for diverse manufactured goods;
4. The growth of cities & urban industries as people migrate from farms and small towns;
5. The decline in family size & overall population growth as children lose their econ value as parents
substitute quality (education) for quantity.

Conclusions and Implications of Structural Change

Structural change economists argue that despite variations, one can identify certain patterns
occurring in almost all countries during the development process. Further, they argue that these patterns
may be affected by the choice of development policies as well as the international trade & foreign assistance
policies of developed nations. The structural change analysts are basically optimistic that the “correct” mix
of econ policies will generate beneficial patterns of self-sustaining growth. In contrast, the international
dependence analysts are PESSIMISTIC.

3. International-Dependence
During the 70s, international dependence models gained increasing support, especially among the
3rd world intellectuals. This resulted from the disenchantment with both the stages and structural change
models. These models view developing countries as beset by institutional, political, & econ rigidities both
domestic & int’l and caught up in a “dependence and dominance’ relationship with the rich countries.

3.1. The Neocolonial Dependence Model

This is an indirect outgrowth of Marxist thinking which is a subgroup of development economics.

According to this doctrine, third world underdevelopment is viewed as the result of highly unequal
international capitalist system or rich country-poor country relationships. It is viewed that the rich countries
through their intentionally exploitative or unintentionally neglectful policies hurt the developing countries.
The rich countries and a small elite ruling class in the developing countries, who serve as the agent of the
rich countries, are responsible for the perpetuation of underdevelopment in the developing countries.

Unlike the Stage Theories or the Structural Change Models, which considered underdevelopment
as a result of internal constraints such as insufficient savings, investment or lack of infrastructure, skill or
education, the proponents of the Neocolonial Dependence model saw underdevelopment as an
externally induced phenomenon. The remedy, according to those who preached these ideas, was to
initiate revolutionary struggles to topple the existing elite of the developing countries and the restructuring
of the world capitalist system to free the third world nations from the direct and indirect control of their first
world and domestic oppressors.

Dependency theory, an approach to understanding economic underdevelopment that

emphasizes the putative constraints imposed by the global political and economic order. First proposed in
the late 1950s by the Argentine economist and statesman Raúl Prebisch, dependency theory gained
prominence in the 1960s and ’70s.

According to dependency theory, underdevelopment is mainly caused by the peripheral position of

affected countries in the world economy. Typically, underdeveloped countries offer cheap labour and raw
materials on the world market. These resources are sold to advanced economies, which have the means
to transform them into finished goods. Underdeveloped countries end up purchasing the finished products
at high prices, depleting the capital they might otherwise devote to upgrading their own productive capacity.
The result is a vicious cycle that perpetuates the division of the world economy between a rich core and a
poor periphery. While moderate dependency theorists, such as the Brazilian sociologist Fernando
Henrique Cardoso (who served as the president of Brazil in 1995–2003), considered some level of
development to be possible within this system, more-radical scholars, such as the German American
economic historian Andre Gunder Frank, argued that the only way out of dependency was the creation
of a non-capitalist (socialist) national economy.

Note: watch video on dependency theory

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3.2. The False-Paradigm Model

A less radical international-dependence approach to development, False-Paradigm model

attributes underdevelopment to faulty and inappropriate advice provided by well-meaning but often
uninformed, biased international expert advisers from developed countries and multilateral donor such as;
World Bank, IMF, UNDP, ILO, UNCIEF and FAO etc. These experts offer sophisticated concepts, elegant
models and complex technical methods of Economics and other social sciences which can lead to
inappropriate policies. Because of institutional and structural factors such as the highly unequal ownership
of land, disproportionate control over domestic and international financial assets and very unequal access
to credit etc., these policies often serve the vested interests of existing power structures, both domestic and
global.

Moreover, according to this argument, leading university intellectuals, trade unionists, future high-
level government, economists and other civil servants all get their training in developed-country institutions
where they are injected with the foreign ideas, concepts and models which have least relevance for their
own countries.

Source: Economics.Concepts.Com

3.3. The dualistic-development thesis

Dual societies mean that there exist rich nations and poor nations at world level; and a few rich
accompanied with a majority of poor people in the developing countries. Thus, dualism is a concept which
represents the existence and persistence of increasing divergences between rich and poor both at world
level and at country levels.

Prof. Hans Singer presents the four components of dualisms:

1. The different sots of conditions amongst which some are superiors while others are inferior,
and they coexist in a given space at a same time. For example, the co-existence of modern
and traditional methods of production in urban and rural sectors; the co existence of wealthy,
highly educated elites with the masses of illiterate poor people; and the coexistence of powerful
and industrialized wealthy nations with the weak, impoverished peasant societies in the
international economy etc.
2. The co-existences which we mentioned above are chronic, not just the transitional. Thus it is
not a temporary phenomenon which in time will eliminate the discrepancy between the superior
and inferior elements.
3. The degrees of superiority or inferiority have an inherent tendency to increase, rather
diminishing As the productivity gap between a DC industry and its counter-part in LDCs goes
on to widen day by day.
4. The inter relations between superior and inferior elements are of such nature that superior
element does little or nothing to pull up the inferior.

International Dualism

There are four components of international dualism:

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1. There exist greater differences in between different countries and geographical regions
regarding per capita incomes.
2. These differences are not temporary and short termed, rather they are chronic. As the standard
of living enjoyed by an average Pakistani and that of an American is different for centuries, not
for decades.
3. These differences go on increasing, rather decreasing. As the growth rates of GNP and that of
GNP per capita have really been widened between developed countries and under-developed
countries.
4. The inter-relationships between rich and poor countries in international economy are of such a
nature that they have promoted the growth of the rich countries at the cost of poor countries.

Factors of International Dualism

The following factors have been found responsible for international dualism:

1. The DCs have a power to control and manipulate world resources and commodity markets to
their advantage.
2. The foreign investment activities by MNCs.
3. The privileged access of rich nations to scarce raw material.
4. The export of unsuitable and inappropriate science and technology.
5. The transfer of out-dated and irrelevant systems of education to societies where education is
considered as a key component in the process of development.
6. Dumping policies pursued by the rich countries which discourage industrialization efforts of
UDCs.
7. The harmful international trade theories and policies which have confined the UDCs to export
just primary products.
8. The harmful aid policies pursued by donors which help in perpetuating the international dualistic
economic structures.
9. The creation of elites in poor countries who are influenced by the external ideas.

Domestic/Local Dualism:

1. The standards of living vary greatly between the top 20% and the bottom 40% of the
population. The majority of the rich reside in big cities like Lahore, Karachi and Islamabad in
Pakistan, while the great cluster of mass poverty are generally found in the rural regions.
2. The coexistences of a few rich accompanied by mass poverty, and the craze to use capital
intensive technologies by a few producers accompanied by labor intensive technologies by
majority of the producers go on increasing, rather disappearing.
3. The gap between the rich and the poor, and between modern and traditional methods of
production shows signs of growing even wider, not only within individual UDCs, but also among
the 3rd world countries as a group. Countries like South Korea, Singapore, Taiwan and
Malaysia etc. have experienced higher growth rates of per capita. While Pakistan India,
Bangladesh and Ghana etc., have shown a little growth in per capita income. Again, the gap
between the rich and the poor within the dualistic economies is also widening.
4. In case of UDCs one does not find any relationship between the rising wealth of modern
enclaves and improvement in the living standards of traditional society. In other words, in case
of dual societies one does not find the existence of "Spread Effects". It means that the growth
of the superior is keeping inferior weaker and inferior.

4. Neo-Classical or Neoliberalism (counter-revolution) Theory

New-classical theorists rejected the Keynesian view which dominated the 1970s. Despite
differences of emphasis, they have tended to agree that development is best left to markets. In
particular, New-classical economists believe that, to develop, countries must liberate their markets,
encourage entrepreneurship (risk taking), privatize state owned industries, and reform labour markets,
such as by reducing the powers of trade unions.

Criticisms

The one size fits all “more markets, less government,” formula for economic policy can in many
cases be overly simplistic and will not produce the best outcomes in every socioeconomic context, but
that could be said for nearly any economic philosophy and really isn’t incredibly innovative as an
argument.

4.1. Market Fundamentalism

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Market Fundamentalism conceals a profound contradiction. Free trade, technological

progress, and other forces that promote economic “efficiency” are presented as beneficial to
society, even if they harm individual workers or businesses, because growing national incomes
allow winners to compensate losers, ensuring that nobody is left worse off.

4.1.1. Free Markets

Argues that markets alone are efficient- product markets provide the best signals for
investments in new activities; labor markets respond to these new industries in appropriate ways,
producers know best what to produce, & product as well as factor prices reflect the scarcity value
of goods and services.

Countries that engage in free trade reforms see considerable accelerations in economic
development. Estevadeordal and Taylor (2008) find that, on average, countries that engage in free
trade reforms see considerable accelerations in economic development relative to the control
group, such that the income per capita of the liberalizers is 25% higher after a quarter-century.

Drawback: However, when a country is in free markets, the wealthy individuals and
corporations tends to dominate the market; individual agents without social conscience and with
nothing more than their short-term profits in mind which creates imbalance in the economy thus,
creating unequal distribution in income.

4.1.2. Public-Choice or New Political Economy

Public choice theory argues that governments cannot solve economic problems, since the
state itself is dominated by politicians, bureaucrats, that use power for selfish ends. State officials
extract “rents”, taking bribes, and confiscate or nationalize property, and reduce freedom of citizens.
Therefore, it is best to minimize the role of governments. Big corporations also suffer from similar
problems but market and public policy disciplines them.
Governments select policies to appeal to a winning coalition of voters, public choice
theory considers the ways in which interest groups’ policy preferences and relative bargaining
power will affect government policies. The theory assumes a logic in which the government
awards policy goods to those groups best able to lobby for their interests.

Criticism:

1. Public choice theory may give short shrift to the key role that domestic institutions play
in determining policy outcomes, because the groups of interest are often modeled as
if they were operating in an institutionally unconstrained policy market.
2. Critics allege that public choice theory, which was developed primarily within the
American political context, is unsuited to nondemocratic countries in which the capacity
of opposition groups to lobby for their policy preferences is repressed.

4.1.3. Market-friendly Approach

It is an approach used by World Bank & IMF economists. This approach recognizes market
imperfections, missing markets, and externalities (a side effect or consequence of an industrial or
commercial activity that affects other parties without this being reflected in the cost of the goods or
services involved).

Therefore, there is a need for government role in areas such as providing public goods,
developing market supporting institutions or rules, and defining and protecting property rights. The
state or the government has a necessary role of being an “impartial” referee in the economic game.

4.2. The Neoclassical Growth Theory – The Solow Growth Model

The Solow model expanded the Harrod-Domar Model, that stressed the critical role of
savings, Investment & capital accumulation. It formalized & expanded the Harrod Model by adding
labor, capital, and technology. Technology is assumed to explain the “residual” factor, and was
assumed to be determined exogenously.
Solow’s model is a synthesis of the classical and modern views. This model retains the
basic assumptions of the classical model i.e., existence of full employment and perfect competition
etc. and removes the difficulties and rigidities associated with the post- Keynesian growth analysis.
Thus, it is a full-employment model which at the same time attempts to maintain the conditions of
steady growth.
The model has its practical importance. It seeks to maintain full-employment through
choice of the appropriate technique. The various routes to full-employment via fiscal, monetary and
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population policies, leaves the nation some leeway to choose whether it wants high employment
with high capital investment (rapid growth and low consumption) or the reverse or some mixture of
both. An important advantage of this model of growth is that it provides a theoretical apparatus of
exploring these practical possibilities.

Criticisms
1. There is no investment function which depends upon profit rate.
2. The theory does not explain the pace and direction of technical progress.
3. Robert Eisner criticised the Solow’ analysis. In his view, Solow did not pay adequate attention to
the Keynesian difficulties, e.g., liquidity traps, downward inflexibility of wage rate, etc. Moreover,
marginal product of capital may become zero at some finite capital-labour ratio. Therefore, Solow’s
analysis too has limited empirical validity.
Though this model suffers from some weaknesses, yet its importance cannot be minimised.
The major contribution of this model is to establish the automatic stability of neo-classical growth
path through the market adjustment mechanism. The major attraction of this model lies in its sweep
and simplicity. Solow’s model has been a major landmark in the history of growth economics in that
it opened up the discussion of technical progress into growth models of the neo-classical variety.

5. Schumpeter’s Theory
5.1 Schumpeter’s Theory of Innovation

Schumpeter’s Theory of Innovation is in line with the other investment theories of the business
cycle, which asserts that the change in investment accompanied by monetary expansion are the major
factors behind the business fluctuations, but however, Schumpeter’s Theory posits that innovation in
business is the major reason for increased investments and business fluctuations.

▪ Economic growth is a dynamic process and not continuous – national income does not always
increase.
▪ National income exhibit cyclical pattern -increases and decreases.
▪ National income increases when innovations takes place.
▪ Innovation means the discovery of a new product, a new process or a new market.
▪ Entrepreneurs introduce innovations through new profit opportunities
▪ Therefore, entrepreneurs are central to the development process
▪ As long as innovations proceeds, the economy continues to grow
▪ Leading entrepreneurs are imitated by others, thus prosperity continues.
▪ After some time, when banks loans are paid off, depression comes because old firms disappear
due to innovations.

Criticisms

1. It is not only difficult but also unavailing to perform the objective evaluation of Schumpeter’s
theory of the business cycle because its arguments are more based on the sociological factors
rather than the economic factors.
2. Schumpeter’s theory is not basically different from the over-investment theory; it differs only in
the respect of the cause of variation in investment when the economy is in stable equilibrium.
3. Like other theories of the business cycle, this theory also leaves out other factors that cause
fluctuations in the economic activities. Innovation is not the sole factor, rather is only one of the
factors that cause fluctuations in the economy.

5.2 Schumpeter’s Theory of Creative Destruction

Schumpeter describes creative destruction as the "process of industrial mutation that incessantly
revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating
a new one." The theory assumes that long-standing arrangements and assumptions must be destroyed to
free up resources and energy to be deployed for innovation.

Creative destruction theory treats economics as an organic and dynamic process. This stands in
stark contrast with the static mathematical models of traditional Cambridge-tradition economics. Equilibrium
is no longer the end goal of market processes. Instead, many fluctuating dynamics are constantly reshaped
or replaced by innovation and competition.

As is implied by the word destruction, the process inevitably results in losers and winners.
Entrepreneurs and workers in new technologies will inevitably create disequilibrium and highlight new profit
opportunities. Producers and workers committed to the older technology will be left stranded.
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To Schumpeter, economic development is the natural result of forces internal to the market and is
created by the opportunity to seek profit.

Example of Creative Destruction

1. Netflix is one of the modern examples of creative destruction, having overthrown disc rental
and traditional media industries—now being known as the “Netflix effect” and being “Netflixed.”
2. Henry Ford's assembly line and how it revolutionized the automobile manufacturing industry.
However, it also displaced older markets and forced many laborers out of work.
3. The Internet is perhaps the most all-encompassing example of creative destruction, where the
losers were not only retail clerks and their employers but bank tellers, secretaries, and travel
agents. The mobile Internet added many more losers, from taxi cab drivers to mapmakers.

The point, as Schumpeter noted, is that an evolutionary process rewards improvements and
innovations and punishes less efficient ways of organizing resources. The trend line is toward progress,
growth, and higher standards of living overall.

Conclusion: Theories of Development: Reconciling the Differences

1. Development economics has no simplistic and universally accepted paradigm: But it is also not the
case that any policy or strategy will work! History & Evidence shows this.
2. Insights and understandings are continually evolving.
3. Each theory has some strengths and some weaknesses. Incites can be gained from a combination
of alternative theories and experiences of successful countries to guide development policy.