3.1 Defining Theory successively lower extra outputs from adding 3.

5 Vicious Circle Theory

Defining “Theory” - a systematic explanation an equal extra input to fixed land.For him, The vicious circle theory indicates that poverty
of interrelationships among economic diminishing returns from population perpetuates itself in mutually reinforcing
variables. growth and a constant amount of land vicious circles on both the supply and
- its purpose is to explain causal threatened economic growth. demand sides.
relationships among variables, to
understand the world better and provide Supply Side
basis for policy. Because incomes are low, consumption
-theorists cannot consider all the factors Also, according to the Classical Growth cannot be diverted to saving for capital
influencing economic growth in a single Theory, economic stagnation can be formation. Lack of capital results in low
theory. postponed, although ultimately not avoided. productivity per person, which perpetuates low
-reality is so complicated that a simple Limitations: levels of income. Thus, the circle is complete.
model may omit critical variables in the real 1. Ignorance with respect to technology: A country is poor because it was previously
world (Kindleberger and Herrick, 1977). The classical model of growth ignores the role too poor to save and invest.
-complex mathematical models can handle efficient technical progress could play for the 1. Traditional Society
a large number of variables, they have not smooth running of an economy. - this stage is characterized by a subsistent, As Jeffrey Sachs (2005:56) explains the
been very successful in explaining economic 2. Inaccurate determination of total wages: agricultural based economy, with intensive poverty trap: “Poverty itself [is the] cause of
development, especially in the third world The classical model of growth assumes that labor and low levels of trading, and a economic stagnation.”
(low and middle income) countries. total wages do not exceed or fall below the population that does not have a scientific
subsistence level. perspective on the world and technology. As countries grow richer, they save more,
3.2 Classical Theory of Economic 3.3 Marx’s Historical Materialism creating a virtuous circle in which high savings
Stagnation 2. Preconditions to Take-off rates lead to faster growth (Edwards 1995;
- based on the work of the 19th-century - here, a society begins to develop Economist 1995b:72; World Bank 2003i:218–
English economist David Ricardo, Principles manufacturing, and a more 220).
of Political Economy and Taxation (1817). national/international, as opposed to regional,
- was pessimistic(negative) about the outlook. Demand Side
possibility of sustained economic growth. For Because incomes are low, market size (for
Ricardo, who assumed little continuing 3. Take-off consumer goods such as shoes, electric bulbs,
technical progress, growth was limited by - Rostow describes this stage as a short period and textiles) is too small to encourage
land scarcity. of intensive growth, in which potential investors.
The classical economists – Adam Smith, industrialization begins to occur, and workers
Thomas R. Malthus, Ricardo, and John Stuart and institutions become concentrated around a Lack of investment means low productivity and
Mill – were influenced by Newtonian physics. new industry. continued low income.
-Just as Newton suggested that activities in
the universe were not random but subject 4. Drive to Maturity A country is poor because it was previously
to some grand design, these men believed Marx wanted to replace the unhistorical - this stage takes place over a long period of too poor to provide the market to
that the same natural order determined prices, approach of the classicists with a historical time, as standards of living rise, use of increase investment.
rent, and economic affairs. dialectic. technology increases, and the national
-In the late 18th century, Smith argued that in economy grows and diversifies. 3.6 The O-Ring Theory of
a competitive economy, with no competition Marxists consider classical and traditional
or monopoly, each individual will be acting economic analysis as a still photograph, which 5. Age of High Mass Consumption
according to his or her own interest. describes reality at a certain time. In contrast, At the time of writing, Rostow believed that
-It was as if an invisible hand were behind the the dialectical approach, similar to a moving Western countries, most notably the United
self-interest of capitalists, merchants, landlords, picture, looks at a social phenomenon by States, occupied this last "developed" stage.
and workers, directing their actions toward examining where it was and is going and its Here, a country's economy flourishes in a
maximum economic growth. process of change. capitalist system, characterized by mass
-Smith also advocated a laissez-faire (no production and consumerism.
government interference) and free-trade Marxists argued that history moves from one Some criticisms:
policy except where labor, capital, and stage to another, from feudalism to 1. The model assumes development in the U.S.
product markets are monopolistic. capitalism to socialism up to communism. and Europe can be copied elsewhere. In a similar fashion, Kremer proposes a
2. Ignores a lot of geography and history, such production function in which “production
A major belief of Ricardo was the law of 3.4 Rostow’s Stages of Economic Growth as the impact of colonization on economic consists of many tasks, [either
diminishing returns - referring to development. simultaneous or sequential], all of which
must be successfully completed for the The increased productivity and new migration are difficult to reconcile with
product to have full value”. consumption patterns in peripheral countries neoclassical theory.
benefited a small ruling class and its allies,
This function describes production processes who cooperated with the DCs to achieve If the same technology were available globally,
subject to mistakes in any of several tasks. modernization. skilled people embodying human capital would
You cannot substitute quantity for quality. not move from LDCs, where human capital is
The result is “peripheral capitalism”, a scarce, to DCs, where human capital is
Highly skilled workers who make few mistakes capitalism unable to generate innovations and abundant, as these people do now.
will be matched together, with wages and dependent for transformation upon decisions
output rising steeply with skill. from the outside. Nor would a given worker be able to earn a
Furthermore, he suggests that all the surplus higher wage after moving from the Philippines
Rich countries specialize in complicated is reinvested, increasing the amount of capital 3.9 Solow’s Neoclassical Growth to the United States
products, such as aircraft, whereas poor per worker and thus the marginal product of Theory
countries produce simpler goods, such as labor to MRPL2 , so that more labor QL2 can New growth theorists think their model is
textiles and coffee. be hired at wage rate wk. closer to the realities of international flows of
people and capital than the neoclassical model.
Kremer thinks the O-ring theory can explain This process enlarges the surplus, adds to
why rich countries specialize in more capital formation, raises labor’s marginal Paul Romer, a University of California-
complicated products, have larger firms, and productivity, increases the labor hired, Berkeley economist, believes that if technology
have astonishingly higher worker enlarges the surplus, and so on, through the is endogenous (explained within the model),
productivity and average incomes than cycle until all surplus labor is absorbed into the economists can explain growth where the
poor countries. industrial sector. neoclassical model fails.

3.7 The Lewis-Fie-Ranis Model Beyond the point QL3 , the labor supply curve For new growth theorists such as Romer,
This theory explains how economic growth (SLk) is upward-sloping and additional innovation or technical change, the
gets started in a less-developed country with a laborers can be attracted only with a higher embodiment in production of some new idea or
traditional agricultural sector and an industrial wage. He showed that growth need not be invention that enhances capital and labor
capitalist sector. unstable, because, as the labor force outgrew productivity, is the engine of growth.
The Fei–Ranis Modification capital, wages would fall relative to the interest
The source of capital in the industrial sector is John Fei and Gustav Ranis, in their rate, or if capital outgrew labor, wages would When the level of technology is allowed to vary,
profits from the low wages paid an unlimited modification of the Lewis model, opposed that rise. you can explain more of growth,as DCs have
supply of surplus labor from traditional the agricultural sector must grow, through higher level than LDCs. Variable technology
agriculture. technological progress, for output to grow as Solow used the following Cobb–Douglas means that the speed of convergence between
fast as population; technical change increases production function, written in the 1920s by the DCs and LDCs is determined primarily by the
Economic growth occurs because of the output per hectare to compensate for the mathematician Charles Cobb and the rate of diffusion of knowledge.
increase in the size of the industrial sector, increase in labor per land, which is a fixed economist Paul Douglas, to distinguish among
which accumulates capital, relative to the resource. the sources of growth – labor quantity and
subsistence agricultural sectors, which They recognizes the presence of a dual quality, capital, and technology.
amasses no capital at all. economy comprising both the modern
(industrial sector) and the primitive (agriculture)
The Lewis Model sector.
Urban industrialists increase their labor supply
by attracting workers from agriculture who
migrate to urban areas when wages there
exceed rural agricultural wages.

Lewis believes in zero (or negligible) marginal

productivity of labor in subsistence agriculture,
a sector virtually without capital and
technological progress.
3.10 The New Growth Theory
The New (Endogenous) Growth Theory
The University of Chicago’s Robert Lucas finds
that international wage differences and