EXPERT COMMITTEE

Prof. Atul Sarma (retd.) Prof. M S Bhat (retd.) Prof. S.K.Singh

Former Director, Indian Statistical Jamia Millia Islamia Prof of Economics(Retd)
Institute, New Delhi New Delhi IGNOU, New Delhi
Dr. Surajit Das Dr. Manjula Singh Prof. B S Prakash
CESP, Jawaharlal Nehru University St. Stephens College, University of IGNOU, New Delhi
New Delhi Delhi S.P. Sharma
Prof. Kaustuva Barik Dr. Indrani Roy Choudhary Associate Professor,
Indira Gandhi National Open Associate Professor, Economics Economics , Shyam Lal
University, New Delhi Jawaharlal Nehru University, New College, University o Delhi,
Delhi Delhi
Shri. B.S. Bagla Ms. Niti Arora Shri Saugato Sen
Associate Professor of Economics Assistant Professor Associate Professor of
PGDAV College Mata Sundri College Economics IGNOU, New
University of Delhi, Delhi University of Delhi, Delhi Delhi

COURSE PREPARATION TEAM

Block/ Unit Title Unit Wr iter
Block 1 Growth and Development
Unit 1 Concepts Indicators and
Measurement Shri Saugato Sen Associate Professor of Economics,
Unit 2 International Comparisons IGNOU, New Delhi
Block 2 Growth Models : Theory and Evidence
Unit 3 Introduction to Growth Models Dr Puja Saxena Nigam, Associate Professor, Economics,
Hindu College, University of Delhi, New Delhi
Unit 4 Harrod-Domar Model Adapted from Unit 2 of the Course MEC 004 (IGNOU)
Unit 5 The Solow Model Shri Saugato Sen Associate Professor of Economics,
IGNOU, New Delhi
Unit 6 Endogenous Growth Models Dr Puja Saxena Nigam, Associate Professor, Economics,
Hindu College, University of Delhi, New Delhi
Unit 7 Determinants of Growth Shri Saugato Sen Associate Professor of Economics,
IGNOU, New Delhi
Block 3 Inequality and Poverty
Unit 8 Inequalty Dr. Nidhi Tewathia, Assistant Professor, School of
Social Siences, IGNOU
Unit 9 Poverty
Block 4 Political Institutions and the Functioning of the State
Unit 10 Institutions and Evolution of
Democracy Shri Saugato Sen Associate Professor of Economics,
Unit 11 Theories of Regulation IGNOU, New Delhi

Unit 12 Government Failure and

Corruption

Course Coordinator: Sh. Saugato Sen Course Editor: Sh. Saugato Sen

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 CONTENTS
BLOCK 1 GROWTH AND DEVELOPMENT Page
Unit 1 Concepts indicators and Measurement 7

Unit 2 International Comparisons 24

BLOCK 2 GROWTH MODELS : THEORY AND EVIDENCE

Unit 3 Introduction to Growth Models 36

Unit 4 Harrod-Domar Model 50

Unit 5 The Solow Model 68

Unit 6 Endogenous Growth Models 88

Unit 7 Determinants of Growth 101

BLOCK 3 INEQUALITY AND POVERTY
Unit 8 Inequalty 119

Unit 9 Poverty 135

BLOCK 4 POLITICAL INSTITUTIONS AND
THE FUNCTIONING OF THE STATE

Unit 10 Institutions and Evolution of Democracy 146

Unit 11 Theories of Regulation 161

Unit 12 Government Failure and Corruption 176

Glossary 189

Some Useful Books 196

 COURSE INTRODUCTION
Welcome to this elective course titled ‘Development Economics-I. In the next
semester you will have a chance to study a companion course titled’ Development
Economics-II. Together, the 2 courses will give you a comprehensive
understanding of the economics of development. The present course is about
economic development, the economics of development, and about the role that
development economics plays in enhancing our understanding of the process of
economic development.
This course consists of four Blocks. The first Block, entitled Concepts,
Indicators and Measurement, has two units. This block sets the ball rolling by
defining concepts of growth and development, discussing the indicators of
development and also explaining how the various indicators of development are
measured. This Block also discusses presents some international comparisons.
The second Block discusses about various growth models. Since it deals with
growth models, there is of necessity certain amount of abstraction, and also, a bit
of mathematics has been used of necessity. You will learn about a few canonical
growth models, and also be presented with a discussion about the determinants of
economic growth.
Block 3 of the course is on inequality and poverty. High levels of inequality and
the prevalence of poverty are two important features that we observe in almost all
developing nations, and block 3 has a thorough discussion on these topics. You
will get an idea about measures of poverty, about poverty traps, about different
measures of inequality and the relation between economic inequality and
development.
Finally, Block 4 takes up for discussion certain topics that might appear to be non-
economic in nature. However, the block underscores the point that development is
multidimensional. It is multidimensional not only in conceptualization and
measurement; it is also multidimensional in the sense that many non-economic
factors impinge upon and influence the level and trajectory of economic
development. Keeping this in mind, the unit discusses the role of institutions in
development, and about how democracy impacts and influences economic
development. Does democracy lead to development, or vice versa, or is it a two-
way relationship? What type of configuration and arrangement of institutions is
visible in democracies. The Block also discusses important topics involving
overall governance like economic regulation and different perspectives on, and
theories regarding, regulation. The block takes up for discussion very important
topics of government failure, and corruption. The block, in discussing government
failures, also talks of types of market failure, and the role of government in
tackling the problem of market failure, and what general role the State plays in
development. Various types of corruption are listed; causes of corruption are
described, and remedies discussed.
Overall this course with 12 units spread over 4 blocks, ought to give you a wide-
ranging and deep discussion about several topics in development economics, and
also prepare you for further topics that will be presented and discussed in the
subsequent course on development economics that you will study in the next
semester.
Growth and
Development

BLOCK 1 CONCEPTS INDICATORS AND

MEASUREMENT
BLOCK 1 INTRODUCTION
The first Block of this course discusses economic growth and development. It
aims to explain the meaning of economic growth and how it is measured. The
block also discusses in detail the concept of development—both economic and
social. Furthermore, it takes up for discussion some international comparisons
across countries. The title of this Block is Growth and Development.

The Block has two units, titled Concepts, Indicators and Measurement and
International Comparisons The first Unit is about the concepts of economic
growth and development, their indicators, and the way in which economic growth
and development are usually measured. The second unit describes the story of
economic growth and economic development of certain countries. This is done
with a view to comparing the experiences of these countries so as to attempt to
search for reasons why certain countries are successful in developing more, and
usually, faster.

6
 Concept Indicators and
UNIT 1 CONCEPTS INDICATORS AND Measurement
MEASUREMENT
Structure
1.0 Objectives
1.1 Introduction
1.2 Economic Growth: Concept and Measurement
1.2.1 Concept of Economic Growth
1.2.2 Total Output and Output Per Capita
1.2.3 Comparison across Space and Time
1.3 Economic Development and its Indicators
1.4 Characteristics of Developing Nations
1.4.1 Low Per Capita Income
1.4.2 Low Manufacturing Base
1.4.3 Other Features
1.5 Development and Welfare
1.6 The Millennium Development Goals and the Sustainable Development
Goal
1.6.1 The Millennium Development Goals
1.6.2 The Sustainable Development Goals
1.7 Let Us Sum Up
1.8 Answers to Check Your Progress Exercises

1.0 OBJECTIVES
The aim of this unit is to acquaint you with the concepts, indicators and
measurement of economic growth and development. After studying this unit, you
should be able to:
 Explain what economic growth means
 Discuss how economic growth is measured
 Explain the meaning of economic development
 Discuss how development differs from economic growth; and
 Analyse the relationship among the concepts of development and wellbeing


Shri Saugato Sen, Associate Professor, IGNOU, New Delhi
7
Growth and
Development 1.1 INTRODUCTION
This first unit begins your study of the economics of development. You have
studied microeconomics and macroeconomics courses that have equipped you
with concepts and techniques that will help you to understand and gain insights
from a study of economic growth and development. Traditionally, from the time
of Adam Smith, economics was a study of economic growth and development of
nations. The title of Adam Smith’s most well-known book, published in 1776
was An Inquiry into the Nature and Causes of Wealth of Nations. Even Karl
Marx contended that his aim was to “study the laws of motion of society”. It was
with the rise of neoclassical Marginalist School that economists shifted their
attention to the study of resource allocation and production, consumption and
exchange at a point of time. Economics focussed on static analysis.
After World War II ended, and European countries had to be rebuilt and put back
on the growth path, economic growth again became a field of study in
Economics.At the same time many formerly colonised economies became
independent. There was a need to understand these economies to suggest ways
and policies for economic development. The study of economic growth also
became subsumed to a large extent within Macroeconomics, while the study of
economic development of the developing nations came to be called Development
Economics or the Economics of Development. Growth Theory also emerged as a
field of study.
This unit aims to begin your acquaintance with the concepts of Development
Economics. The unit discusses the meaning of economic development and how it
differs from growth; what the components of economic development are; what
the relation of development with welfare is; what are the indicators of
development, and so on. The unit begins by explaining the concept of growth and
how growth is measured. It explains how income levels can be compared across
time, and of different countries. Next, the unit takes up for discussion the main
topic of this unit, that is, the meaning of economic development. In doing so, it
explains the characteristics of developing countries, and what it is that makes
them known as ‘developing’ rather than ‘developed’ nation. The unit stresses that
basically, economic development is a much wider concept than economic
growth, that it is multidimensional, and that it is ultimately about the people of a
country or region. The unit finally talks about the relation between development
and wellbeing.

1.2 ECONOMIC GROWTH: CONCEPT AND

MEASUREMENT
Any discussion about economic development has to begin with economic growth.
In this section we look at the concept of economic growth and how it is
measured.

1.2.1 Concept of Economic Growth

Economic growth can be defined as “an increase in real terms of the output of
goods and services that is sustained over a long period of time, measured in
terms of value added.” The term economic growth refers to increases over time
in a country's real output of goods and services. Output is generally measured by
8
gross or net domestic product (GDP or NDP), though other measures can also be Concept Indicators and
Measurement
employed. Two points, as follows, need be noted in this definition:
Economic growth is essentially a dynamic concept and refers to a
continuous increase in output. The word ‘dynamic’ here denotes a process
taking place over time. This is contrasted with ‘static’ which does not so
much mean ‘unchanging’ as ‘at a point in time’. Forces that generate growth
generate a positive rate of change from a lower to a higher level of output
may be welcome but that is not growth.
We ought strictly to distinguish between output and output capacity. Most
theories of growth, in so far as they with increases in labour forces or the
accumulation of capital, implicitly deal with changes in output capacity,
whereas actual changes in output over time are also influenced by the ability
of an economy to utilise accumulated capacity.
Process of economic growth is essentially a dynamic concept and refers to a
continuous expansion in level of output, i.e. it refers to forces that generate a
positive rate of change over time and not the forces that lead to discrete (or
one shot) change from a lower to higher level of output which are temporary
and short lived.
The concept of the growth rate is very important and you thoroughly need to
understand it.
Let x be an economic variable. Let x0 be the initial value x1 be the subsequent
value. The proportional change in going from x0 to x1 is simply

x1 − x0 = Δx/x0 x0
The percentage change in going from x0 to x1 is simply 100 times the
proportionate change:

% Δ x = 100 ( Δ x/x0)
If we assume a constant rate of growth, the formula used for calculating the
growth rate for more than one year is as follows:

1.2.2 Total Output and Output Per Capita

The term ‘output’ is ambiguous, in that it can mean either total output or output
per capita. An increase in total output is ‘extensive growth’ (when population
and production increase at about the same pace). When one thinks of growth in
the context of an increase in standards of living or of the welfare of a population,
one naturally thinks of output per head of population. However, an increase in
total output over time may also be an extremely significant phenomenon, where,
for example, economies of scale are important. The term output expansion,
however, is subject to ambiguity in the sense that does it mean growth in total
output or growth in output per capita. An increase in the former is referred to as
‘extensive’ growth whereas an increase in the latter is called the ‘intensive’
growth. The latter one is important in the context of increase in the standards of
living of the population of the country whereas the former is extremely
significant when one wants to examine the aggregative phenomenon such as
economies of scale etc.
9
Growth and 1.2.3 Comparisons across Space and Time
Development
Another measurement issue we need to consider is how to compare levels of GDP
per capita across countries. The problem arises because each nation measures
national income in its own currency. Economic growth rates can be computed in a
nation’s own currency, but if we want to understand better what is required to
transform a nation from low to high income, it is useful to compare nations at
different income levels. To do so requires converting GDP per capita into a
common currency. The shortcut to accomplishing this goal is to use the market
exchange rate between one currency, usually U.S. dollars, and each national
currency. One problem with converting per capita income levels from one
currency to another is that exchange rates, par- ticularly those of developing
countries, can be distorted. Trade restrictions or direct government intervention
in setting the exchange rate make it possible for an official exchange rate to be
substantially different from a rate determined by a competitive market for foreign
exchange.
But even the widespread existence of competitively determined market exchange
rates would not eliminate the problem. a significant part of national income is
made up of what are called nontraded goods and services — that is, goods that
do not and often cannot enter into international trade. Generally speaking,
whereas the prices of traded goods tend to be similar across countries (because, in
the absence of tar- iffs and other trade barriers, international trade could exploit
any price differences), the prices of nontraded goods can differ widely from one
country to the next. This is because the markets for nontraded goods are spatially
separated and the underly- ing supply and demand curves can intersect in
different places, yielding different prices.
Exchange rates are determined largely by the flow of traded goods and
international capital and generally do not reflect the relative prices of nontraded
goods. As a result, GDP converted to U.S. dollars by market exchange rates gives
misleading comparisons of income levels if the ratio of prices of nontraded goods
to prices of traded goods is different in the countries being compared. The way
around this problem is to pick a set of prices for all goods and service prevailing
in one country and to use that set of prices to value the goods and services of all
countries being compared. In effect, one is calculating a purchasing power parity
(PPP) exchange rate.
To compare income across time, the choice of an appropriate price deflator has
to be thought of. There are also issues of constructing an adequate index number
to compare the current year income with the income in a suitably chosen base
year.

10
 Concept Indicators and
1.3 ECONOMIC DEVELOPMENT AND ITS Measurement
INDICATORS
Economic growth is a necessary but not sufficient condition for improving the
living standards of large numbers of people in countries with low levels of GDP
per capita. It is necessary because, if there is no growth, individuals can become
better off only through transfers of income and assets from others. In a poor
country, even if a small segment of the population is very rich, the potential for
this kind of redistribution is severely limited. Economic growth, by contrast, has
the potential for all people to become much better off without anyone becoming
worse off. Economic growth has led to widespread improvements in living
standards in Botswana, Chile, Estonia, Korea, and many other countries. The
modern economists, however, question this identity between ‘economic growth’
and ‘economic development’; development is not the same as growth. Suppose,
by analogy, we were interested in the difference between ‘growth’ and
‘development’ in human beings. Growth involves change in overall aggregates
such as height or weight, while development includes changes in functional
capacity, of ability to adapt to changing circumstances. Growth is an engine, not
an end in itself. The end is development.
The traditional concept of viewing economic development as synonymous with
economic growth was based on what came to be known as the ‘trickle-down
strategy’, which implies that the effects of rising incomes and output would
ultimately trickle down to the poor so that they would benefit poor as well as the
rich. The modern economists reject this view and stress the need for strategies
designed to meet the needs of the poor directly. Hence, economic development
has come to be redefined in terms of the reduction or elimination of poverty,
inequality, and unemployment within the context of a growing economy.
“Redistribution from growth” has become an accepted paradigm. Prof. Dudley
Seers poses the basic question about the meaning of development very clearly
when he states:
The questions to ask about a country’s development are therefore: what
has been happening to poverty? What has been happening to
unemployment? What has been happening to inequality? If all 3 of these
have declined from high levels then beyond doubt this has been a period of
development for the country. If one or two of these central problems have
been growing worse, especially if all three have, it would be strange to
call the result “development” even if per capita income doubled.

Economic development, in its essence, must represent the whole gamut of change
by which an entire social system, tuned to the diverse basic needs and desires of
individuals and social systems within that system, move away from a condition
of life widely perceived as unsatisfactory towards a situation of life regarded as
materially and spiritually “better”.

11
Growth and If economic growth does not guarantee improvement in living standards, then
Development GDP per capita may not be a meaningful measure of economic development. In
addition to problems associated with how income is spent and distributed, any
definition of eco- nomic development must include more than income levels.
Income, after all, is only a means to an end, not an end itself. If economic growth
and economic development are not the same thing, how should we define
economic development? Amartya Sen, economist, philosopher, and Nobel
laureate, argues that the goal of development is to expand the capabilities of
people to live the lives they choose to lead. Income is one factor in determining
such capabilities and outcomes, but it is not the only one. To be capable of
leading a life of one’s own choice requires what Sen calls “elementary
functionings,” such as escaping high morbidity and mortality, being adequately
nourished, and having at least a basic education. Also required are more complex
functionings, such as achieving self-respect and being able to take part in the life
of the community. Income is but one of the many factors that enhance such
individual capabilities.
In view of the above considerations economic development is now being defined
“as the process of increasing the degree of utilisation and improving the
productivity of the available resources of a country which leads to an increase in
the economic welfare of the community by stimulating the growth of national
income”.
It follows from this definition that the progress of development has to be assessed
by reference to two separate indicators, namely, (i) the indices of ‘production’ or
GDP, and (ii) the indices of ‘economic welfare’ of the community. The former
covers what may be called the ‘growth’ aspects of development.
So defined, the concept of economic development emphasises the achievement of
the following three objectives:

 To increase the availability and widen the distribution of basic life sustaining
goods such as food, shelter and protection. This, however, would be possible
with a fast increase in real per capita income.
 To raise standards of living including, in addition to higher incomes, the
provisions of more goods, better education and greater attention to cultural
and humanistic values, all of which will serve not only to enhance material
well-being but also to generate individual and national self-esteem.
 To expand the range of economic and social choice to individuals and
nations by freeing them from servitude and dependence not only in relation
to other people and nation-states, but also to the forces of ignorance and
human misery. Economic development is to be assessed ultimately by the
enhancement of the ‘positive freedom’.
12
In view of the above three objectives, the quality of life is regarded as an Concept Indicators and
Measurement
important index of development. It is contended that such quality is not
adequately reflected in the index of per capita income growth. Several factors are
involved in the measurement of such ‘quality’; some of these factors are non-
monetary, while others can be measured in money terms. There is a need to set
up a synthetic index of these different factors to measure economic development
and quality of life.
. We may note the following as important changes:
 Constituents of GDP Change: More generally, in terms of percentage
shares, saving rates increase as income grows, government revenues (and
expenditure) increase, food consumption drops and non-food consumption
increases, out of services – and, of course, also industry – increases, while
agriculture falls.
 Employment Changes: Employment changes reflect the shift in output and
changes in productivity. Labour in the primary sector of the economy does
not fall as rapidly as its share in output, the reverse is true for employment in
industry where increase in labour productivity is more easily secured.
 Shift in the Composition of Exports: As development proceeds, exports
will account for a larger proportion of income and there will have been a
marked shift in the composition of exports, so that the value of export of
manufactures rises relative to that of primary products. Imports will also
have risen and earnings and payments will be roughly balanced.
 Rate of Increase in Population: As incomes increase, the rate of increase in
population may be expected to fall, as the birth rate declines along with a fall
in the death rate. The population would still be increasing, but gradually the
rate of growth will tend to peter out.
Distribution of income: Income would at first become more unequally
distributed and then this trend would be reversed. You will read more about this
and on what is called the Kuznets ‘inverted U curve’ in Block 3 in the unit on
inequality
Economic development is a broad term that does not have a single, unique
definition.
 Life sustaining goods and services: To increase the availability and
widen the distribution of basic life-sustaining goods such as food, shelter,
health and protection.
 Higher incomes: To raise levels of living, including, in addition to higher
incomes, the provision of more jobs, better education, and greater
attention to cultural and human values, all of which will serve not only to
enhance material well-being but also to generate greater individual and
national self-esteem

13
Growth and  Freedom to make economic and social choices: To expand the range of
Development
choices available to individuals and nations by freeing them from
servitude and dependence not only in relation to other people and nation-
states but also to the forces of ignorance and human misery.
Dudley Sears has defined development as “the reduction and elimination of
poverty, inequality and unemployment within a growing economy”.
The Nobel Economist Amartya Sen in his 1998 Nobel address, identified four
broad factors, beyond mere poverty, that affect how well income can be
converted into “the capability to live a minimally acceptable life”:
• Personal heterogeneities: including age, proneness to illness, and extent of
disabilities.
• Environmental diversities: shelter, clothing, and fuel, for example, required
by climatic conditions.
• Variations in social climate: such as the impact of crime, civil unrest, and
violence.
• Differences in relative deprivation: for example, the extent to which being
impoverished reduces one’s capability to take part in the life of the greater
community.
According to Sen, economic development requires alleviating the sources of
“capability deprivation” that prevent people from having the freedom to live
the lives they desire.
In his book Development as Freedom, Sen sees development as being concerned
with improving the freedoms and capabilities of the disadvantaged, thereby
enhancing the overall quality of life. Sen pursues the idea that development
provides an opportunity to people to free themselves from the suffering caused
by
• Early mortality
• Persecution
• Starvation
• Illiteracy

Development should be about increasing political freedom, cultural and social

freedom and not just about raising incomes.
There can be several indicators to consider when taking a broad look at the
process of economic development, such as:
 Risk of extreme poverty - % of the population living on less than $1.25
per day (PPP)
 The percentage of adult male and female labour in agriculture, % of
arable land that is cultivated
 • Combined primary and secondary school enrolment figures and other Concept Indicators and
indicators of progress in building human capital. Access to clean water / Measurement
improved sanitation facilities (% of population with access)
• Energy consumption per capita
• Depth of hunger, kilocalories per day per capita
• Prevalence of HIV, average life expectancy at birth, years of healthy life
expectancy, child mortality
• Access to mobile cellular phones per thousand of the population
• Percentage of the population living in extreme poverty
• Dependence on foreign aid / levels of external debt
• Percentage of households with a bank account
• Unemployment rates and vulnerable employment rates
• High-technology exports (% of manufactured exports)
• The Human Development Index
• The multi-dimensional poverty index

In block 3 of this course, and in course BECC 114, you will be introduced to
the Human Development Index
Check Your Progress 1
1) What is the definition of Economic Growth?
2) Distinguish between economic growth and economic development.
3) What type of structural changes take place in an economy as it develops?

15
Growth and 1.4 CHARACTERISTICS OF DEVELOPING NATIONS
Development
We have seen what development means. We have also seen how it is different
from economic growth. Now, there are certain nations that are known as
developed nations, and certain nations that are called developing. What is the
difference between developed and developing nations. To say that developed
nations have a higher level of development begs the question, what does that
mean? What do we understand by a “higher level of development? Although
these questions shall be answered in greater detail in the next unit, in this unit we
look at certain characteristics that are evident in most of the developing nations.
In the next unit, we shall see there are finer sub-classifications among the
developing nations. For now, let us discuss some of the common characteristics
that most developing nations display.
1.4.1 Low Per Capita Income
Most of the developing nations have a lower per capita income than developed
nations. Some developing nations may have a high gross domestic product level
but the income per head tends to be low. one of the most commonly acceptable
criteria of underdevelopment is the low per capita real income of
underdeveloped countries as compared with the developed countries. Added to
this is low level of physical capital and low capital to worker ratio. Developing
nations also tend to low productivity and sometimes lower levels of technology.
Moreover, developing nations show high levels of poverty, low indices of human
development, very high inequality of income as well as assets, and
unemployment — structural, cyclical and disguised.
1.4.2 Low Manufacturing Base
One of the characteristics that we see about developing nations is that much of
the gross domestic product is accounted for by agriculture and sometimes,
services too, but the manufacturing sector is not so developed. Industries are not
widespread and diversified. Much of production and employment is in the
unorganized sector. Much of it stems from low capital and low investment.
Savings are often low too because of low income. Low savings lead to low
investment, which further leads to lower income. This has sometimes been called
the vicious cycle of poverty, if the income and capital accumulation range was
really low. High rates of industrial growth has been a characteristic feature of
those countries that have moved to a higher development level or even moved
from being a developing towards becoming a developed nation.
1.4.3 Other Features
Several developing nations have displayed some other features that are common
to many of these countries. Often population rates of growth and fertility levels in
these countries are high. This creates pressure on the resources and output of the
country. Secondly level of urbanization is low, and a large proportion of the
people resides in rural areas. In production, there is often an economic dualistic
structure with a low-wage low productivity rural and agricultural sector and a
smaller more productive higher-wage manufacturing sector, often located in
urban and semi-urban areas. Often there is migration from low-wage rural areas
to urban areas because of rural-urban wage gap. Often those migrants who cannot
be absorbed in the manufacturing areas end up in the urban informal sector.
16
Other features in developing countries are that exports are in many cases low, Concept Indicators and
and most of the existing exports are of primary products. Moreover some Measurement
developing nations have for a long time depended on foreign aid.. There have
also been cases of some nations getting caught in international debt trap.
Some other characteristics are that developing nations have non-diversified
financial sectors with still a large presence of informal money and capital
markets. There is financial repression and finance and credit do not flow to
requisite areas and to those who require. There are financial constraints on
growth.
Developing nations also often show low levels of attainment as far as social
sector is concerned. Education, even literacy and primary level enrollment, as
well as health levels are low, in some case basic and minimum needs are not met.
Clean drinking water and sanitation is not universal, infrastructure like good
roads electricity, good systems of telecommunication too are not widespread.
Often developing nations have governments providing poor governance, other
institutions are not well developed, and levels of social capital is low too. You
will read about all these in greater detail in later units of this course and in the
course Development Economic –II (BECC 114).

1.5 DEVELOPMENT AND WELLBEING

We have defined economic development as the sum total of economic growth (a
quantitative aspect) and economic welfare (a qualitative aspect). We have
presented above a few important indicators of economic growth. Now, let us shift
our attention to the indicators of economic welfare.
GNP as an Indicator of Economic Welfare
GNP estimates are more commonly employed as an indicator of economic
welfare. An increased output of goods and services, it is believed, implies an
increased availability of goods and services for consumption. Thus, enabling a
wider choice and a better standard of living; these are the hallmarks of economic
development.
However, this simple positive relationship between increase in GDP and increase
in economic welfare is subject to certain qualifications. Among these, the
following are noteworthy:

17
Growth and 1) Changes in the Size of GDP and Economic Welfare
Development
i) If the GDP increases but the population of the country increases in a
greater proportion, the total economic welfare will decline. As a result of
increased population, the per capita income will decline, which means
lesser purchasing power than before, lower standard of living, and
consequently, lower economic welfare.
ii) While analysing the relationship between the size of GDP and economic
welfare, the behaviour of the price movements must be thoroughly
studied. GDP calculated at current prices is always deceptive and
increase in its size will not promote economic welfare. Estimates of real
GDP (i.e., GDP calculated at fixed base prices) can provide a better
measure.
iii) GDP consists of those goods and services which are transacted in the
market and fetch money value. We know that a part of the total produce
is kept by the producers for self-consumption. Now, suppose that this
retained produce (which is not part of GDP) is offered for sale in the
market, it will definitely fetch money value and as a result GDP will also
increase. In fact, the total output is same, but since it has now come to
the monetary sector, it becomes a part of the GDP and hence increases its
value. Such an increase in GDP will not increase the economic welfare.
iv) In case increase in the size of GDP is the result of prolonged working
hours, increased employment of children in production, unhealthy and
polluted atmosphere inside the factory premises, such an increase in
GDP will not promote economic welfare.
2) Changes in the Composition of GDP and Economic Welfare Composition
of GDP refers to the kinds of goods and services produced in an economy.
Changes in the composition of GDP may sometimes increase economic
welfare and may at other times decrease it. Let us consider the following
cases:
i) If the total production has increased on account of more production of
capital goods, it will not increase economic welfare. No doubt the
money value of the total output has increased, but the volume of
consumer goods, on which depends the real economic welfare, has not
increased. It is only when the proportion of consumer goods increases in
the total output the GDP can promote economic welfare.
ii) If the GDP has increased on account of larger production of war-goods,
the resultant increase will not increase economic welfare. This may no
doubt head to increased fighting capacity of the country but it will do no
good to economic welfare.

18
3) Changes in the Distribution of GDP and Economic Welfare Concept Indicators and
Measurement
If the GDP increases and yet if it is not fairly distributed or it is concentrated
in a fewer hands, it will not promote economic welfare. It is so because as the
rich people get richer the additional money income does not provide them
the same marginal utility as the preceding unit of money income. In other
words, the law of diminishing marginal utility also applies to the additional
money income so that the economic welfare instead of increasing will
diminish.
When the distribution of GDP changes in favour of the poor, they start
getting more commodities and services than before, as a result the economic
welfare increases. Any transfer of income from the rich to the poor,
generally, promotes economic welfare. In fact, there is a unique relationship
between one’s economic welfare and that part of his income which he spends
on consumption and consequently smaller is his economic welfare compared
to this total income. The poor people who spend a major proportion of their
total income on consumption, as a matter of fact, will get more utility from
the transferred income as compared to the rich people.
Transfer of income from the rich to the poor, however, does not increase
economic welfare always, especially if additional income in the hands of the
poor gets frittered away on such things as simply reduce his welfare.

Per Capita Income as an Index of Economic Welfare

Ordinarily speaking, per capita income is considered as an indicator of the
standard of living in a country; any improvement in it is taken as a proxy for
improvement in the standard of living. That may be so, but there are certain
limitations beyond which we cannot rely on this single average.
One, per capita income is a simple average which s derived by dividing the
income of all the nationals of a country. It shows only the size of slice from the
national cake that should by going to each individual. It cannot tell us anything
about the actual distribution. In other words, per capital income estimates are
silent about the distribution of income. To that extent, per capital income
estimates may not be very useful, especially if there is a highly skewed income
distribution in an economy favouring the rich.
Two, per capita income estimates are also silent about the composition of output
– the nature of goods and services produced in the economy.
Three, standard of living is also affected by the type of expenditure incurred by
the government authorities. If the government meets the collective wants of
education, public health, public transportation, safe drinking water, etc., the
people may enjoy a higher standard of living, even with modest per capita
income.
Four, for the purpose of international comparison, per capita income estimates
are framed in a common monetary denominator, usually the American Dollar.

19
Growth and This common denominator cannot take account of purchasing power differences
Development
in different countries.
In some units in other chapters you will be acquainted with some other indicators
of welfare. In this unit we present a discussion on the Millenium Development
Goals and Sustainable Development Goals , in the following section.

1.6 THE MILLENNIUM DEVELOPMENT GOALS

AND THE SUSTAINABLE DEVELOPMENT
GOALS
1.6.1 The Millennium Development Goals
It is difficult to measure development as it is such a wide-ranging and multi-
faceted concept. There has been a lock of a commonly agreed-upon definition.
However, there have been several attempts to measure development and develop
policy measures to foster development based on the ideas about the concept of
development put forward. One such measure was the adoption of the Millenium
Development Goals. Even without a commonly agreed- on definition, policy
makers need specific targets, so as to realize policy objectives . One such set of
targets is known as the millennium development goals (MDGs). The
Millennium Declaration and Millennium Development Goals (MDGs) saw the
convergence of development agenda of United Nations Development Programme
(UNDP); United Nations Environment Programme (UNEP); World health
organization (WHO); United Nations Children's Fund (UNICEF); United Nations
Educational, Scientific and Cultural Organization (UNESCO); and other
development agencies.
In September 2000, 189 nations adopted the “United Nations Millennium Decla-
ration,” a broad-reaching document that states a commitment “to making the
right to development a reality for everyone and to freeing the entire human race
from want.” The declaration specifies a set of eight goals consistent with this
commitment:
Goal 1:Eradicate extreme poverty and hunger.
Goal 2: Achieve universal primary education.
Goal 3: Promote gender equality and empower women.
Goal 4.:Reduce child mortality.
Goal 5. Improve maternal health.
Goal 6: Combat HIV/AIDS, malaria, and other diseases.
Goal : Ensure environmental sustainability.
Goal 8. Develop a global partnership for development.
To realise these goals, there were 21 targets (that correspond to 60 indicators)
that were sought to be reached by 2015.

20
1.6.2 The Sustainable Development Goals Concept Indicators and
Measurement
The world as a whole, and India too, made considerable progress in meeting
te targets. And yet some gaps remained.
The 2030 Agenda for Sustainable Development, adopted by all United Nations
Member States in 2015, provides a shared roadmap for peace and prosperity for
people and the planet, now and into the future. At its core are the 17 Sustainable
Development Goals (SDGs), which are an urgent call for action by all countries -
developed and developing - in a global partnership. The SDGs include 17 goals
and 169 targets. The 17 goals are to be achieved by 2030. The 17 goals are:
1. End poverty in all its forms;
2. End hunger , improve nutrition and achieve food security;
3. Ensure healthy lives and well-being;
4. Ensure equitable and quality education for all and promote lifelong learning;
5. Achieve gender equality and empower women and girls;
6. Ensure availability and sustainable management of clean water and
sanitation for all ;
7. Ensure access to affordable, reliable, sustainable and clean energy for all;
8. Promote sustained , inclusive and sustainable economic growth, full and
productive employment and decent work for all;
9. Build resilient infrastructure, promote sustainable Industry, and promote
innovation,;
10. Reduce inequality within and among countries;
11. Make cities and human settlements inclusive, safe, resilient and sustainable;
12. Ensure responsible consumption and production patterns;
13. Take urgent action to combat climate change and its impacts;
14. Conserve and sustainably use seas, oceans and marine resources;
15. Promote , protect and restore sustainable use of terrestrial ecosystems,
sustainably manage forests, combat desertification, halt and reverse land
degradation and halt biodiversity loss.
16. Promote peaceful and inclusive societies for sustainable development,
provide access to justice for all, and build effective, accountable, and
inclusive institutions at all levels; and
17. Strengthen the means of implementation and revitalise global partnership for
sustainable development.
In 2000, the MDGs set the agenda for development activities and consisted of
eight targets aimed at combatting poverty. While the MDGs set the target and
there we quite a few achievements, they were faced with many criticisms. These
criticisms mainly included around their legitimacy and how the goals and targets
were chosen and set, their narrowness and under emphasis of certain aspects of
development, including human rights, gender and the environment, and how the
progress was reported and measured.

21
 When the MDGs period was reaching an end, it was agreed by all countries to
reform and propose a more widespread, inclusive and reflective set of
development goals. The SDGs emerged as an attempt to represent the challenges
that countries face in the next 15 years and beyond, and is an attempt to address
the root cause of many of them.
The 17 SDGs were identified through widespread consultation over three years
on contrast to the MDGs. This process took into account the views of all parties,
including national governments, civil society, multilateral development
institutions and individuals.
How are the SDGs different from MDGs?
While the MDGs mainly applied to developing countries, the SDGs are
universally applicable. That is they apply to all countries, no matter their current
development status.
Meeting SDGs require that they are implemented in an integrated manner and is
based on the recognition that there is no trade-off between economic, social and
environmental development. Indeed each of these aspects is mutually reinforcing
and one cannot be achieved without the other, or failure in one area could lead to
failure in others. This is in contrast to the MDGs which primarily focussed on the
social aspects of development.
By their nature, the SDGs are a set of broad goals and targets, this is so each
country can decide on the most realistic and practical way to implement policies,
programmes or projects to move towards meeting the SDGs. They build off the
MDGs, but offer more ambitious goals.
Check Your Progress 2
1. Evaluate the usefulness of (i) GDP, and (ii) per capita GDP as measures
of economic development and of welfare.
2. Discuss some characteristics of developing nations.
3. What are the Millennium Development goals? How many goals are there
in the Sustainable Development goals? List any seven

22
1.7 LET US SUM UP
This unit dealt with the basic of economics of development as well as the
concepts of economic growth and development. It began with explaining what
growth means: enlargement, expansion. Economic growth is typically seen as
growth in gross domestic product. The unit explained the measurement of growth
and also discussed the relative merits of considering growth in GDP as growth
versus growth per-capita GDP. The unit explained how growth is measured, and
how to compare income levels across countries and over time .
The unit went on to discuss in detail the concept of economic development, and
how it differs from economic growth. The unit explained that economic
development is a much broader concept than economic growth, although
economic growth is the foundation of economic development. However, though
economic growth is a fundamental concept of economic development, the latter
is characterized also by an overall structural transformation of economy.
Examples of such structural change includes decline of the share of agriculture in
GDP and the rise of that of the service sector; increasing urbanization, change in
the composition of the work-force, and so on.
Subsequently, the unit discussed in detail the characteristics and features of a
developing economy. We saw low per-capita income, a large agriculture, low
urbanization were some of the characteristics.
After this the unit discussed elaborately the concept and meaning of economic
development in all its aspects and dimensions. Finally the unit presented a
discussion the Millennium Development Goals and Sustainable Development
Goals.

1.8 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1. See section 1.2
2. See section 1.2
3. See section 1.3
Check Your Progress 2
1. See section 1.5
2. See section 1.4
3. See subsection 1.6.2

23
UNIT 2 INTERNATIONAL COMPARISONS
Structure
2.0 Objectives
2.1 Introduction
2.2 Development Gap
2.3 The Divide between Developed and Developing Nations
2.4 Historical Patterns of Development
2.5 Some Case Studies
2.6 Let Us Sum Up
2.7 Answers to Check Your Progress Exercises

2.0 OBJECTIVES
After going through this unit, you will be able to:
• Explain the nature of development gap between developed and developing
nations;
• Discuss the reasons for the emergence of the difference in the levels of
development between the developed and developing nations;
• Describe the historical patterns of development in different parts of the world;
and
• Present some case studies regarding different development experiences of
countries.

2.1 INTRODUCTION
When we study economic development we find some crucial questions confront
us regarding different countries and regions. Why are living conditions so
drastically different for people in different countries and different regions of the
world?, We find some countries poor and others rich. Why is it so? Why are
there such disparities in income and wealth? t Also there are huge difference in
the levels of health, nutrition, education, liberty, choice, women’s rights? Why
do workers in some countries have secure jobs in the formal sector, with regular
pay, while in other countries such jobs are extremely there is scarcity of such
jobs, and most workers are in informal sector with fluctuating and insecure
wages? Why are populations growing at a fast pace in certain countries, while on
the verge of being stagnant or even reducing in others? Why are public services
so inefficient, insufficient, and corrupt in some countries and so effective in
others? Why have some formerly poor countries made so much progress, and
other s so comparatively little?
This unit takes up a discussion of issues regarding the difference, the gap
between the standard of living of the developing and developed nations.
It explores the reasons for such gaps. We also have to see whether there are
historical reasons for such gaps emerging.
In the next section we see the meaning of the development gap, conceptually and International
theoretically. Subsequently we see various ways the developing nations are Comparisons
classified. After looking at World Bank’s and United Nations’ classifications, the
following unit takes a look at the basic historical patterns of development in
order to see when and how in history the gap, the divergence between developed
and developing nations emerged. Finally the unit provides some case studies in
order to illustrate the development experiences of certain countries, how certain
countries developed to a great extent over time, and how some others fell back
and sometimes had a reversal of fortune.

2.2 DEVELOPMENT GAP

In its basic sense, development gap refers to the gap in per capita income
between the richer developed countries and poorer, developing ones. Since living
standards in all countries tend to rise absolutely over time, it obviously refers to
the comparative position of poor countries, but is the comparative position being
measured taking absolute or relative differences in per capita income? How
should the 'development gap' be assessed? Unfortunately there is no easy answer
to this question , yet the answer given has a profound bearing on the growth of
per capita income that poor countries must achieve either to prevent a
deterioration of their present comparative position or for an improvement to be
registered. Relative differences will narrow as long as the per capita income
growth rate of the developing countries exceeds that of the developed countries;
and this excess of growth is a precondition for absolute differences to narrow and
disappear in the long run. In the short run, however, a narrowing of relative
differences may go hand in hand with a widening absolute difference , given a
wide absolute gap to start with, and thus the rate of growth necessary to keep the
absolute per capita income gap from widening is likely to be substantially greater
than that required to keep the relative gap the same. But suppose the relative gap
does narrow, and the absolute gap widens, are the poor countries comparatively
better or worse off? In comparing rich and poor countries it is not difficult to
argue that even if a relative per capitaincome gap is narrowed, the comparative
position of the poor may have worsened because the absolute gap has widened.
To get an idea of the gap that exists between developed nations and developing
nations, consider a hypothetical, constructed example of the gap between the
incomes of two hypothetical nations. Suppose there are two countries, A and B.
Country A is the advanced nation and country B is the backward nation (no
value-judgement attaches to the term ‘backward’; it only denotes that country B
is the poorer country). Suppose in 2021, the per capita income of country A was
$ 1000 in purchasing power-parity terms, and that of country B was $ 100 in the
same terms. So we find that the gap in per capita income of the two nations is $
1000 -$ 100 = $900. It is a big gap. Now suppose that in the year 2021-2022, the
per-capita incomes of the two nations grow at 2 %.

25
Growth and The per capita income of country A in 2022 becomes $1020 (because 2 % of $
Development 1000 is $ 20 and so its per capita income becomes $1000 + $20 = $1020). On the
other hand, the per capita income of country B in 2020 becomes $ 102 (because
2 % of $ 100 is $ 2 and so its per capita income becomes $ 100 + $2 = $102).
Let us see what happens to the gap in the per capita income of the 2 countries. In
2022 the gap is $1020 - $102 = $918. So we find that compared to 2021 the gap
has actually increased when both countries grew at the same rate. ( the gap
increased from $900 to $918). In fact, the poor country has to grow at 20 % over
2021-2022 for its per-capita income to rise to $120, so as to keep the gap in per
capita income between the rich and poor countries at $900 — the same as before
($1020 – $ 120 = $ 900. So we see that in order to merely prevent the gap in
per-capita income from increasing, the poor country in this example has to grow
10 times as fast as the developed country. As another example, Take for
illustration the case of the average person in the poor country living on the
equivalent of $200 per annum compared with the average person in the rich
country living on approximately $10 000. Suppose the income of the average
person in the poor country rises by 20 per cent and the income of the average
person in the rich country rises by 10 per cent. The average person in the poor
country is now relatively better off, but is he not comparatively worse off? The
increased command over goods and services of the average person in the rich
country (i.e. 10 per cent of $10 000) far exceeds that of the the average person in
the poor country (i.e. 20 per cent of $200)
where P is the principal sum. In our context, P can be taken as the initial per
capita income , S the final one, r the rate of growth and t the time period (number
of years )over which growth is considered

2.3 THE DIVIDE BETWEEN THE DEVELOPED

AND DEVELOPING NATIONS
A developing country is often defined by its economic output. There has been a
lot of debate as to where to draw the line between a developed country and a
developing one, which can be seen by the lack of one single meaning for the
term.
The developing countries have been labeled with many different terms. A term
much used from the mid 1940s to the 1980s, especially in international forums,
was the third world. Perhaps the best way to define it is by elimination. Remove
the industrialized economies of western Europe, North America, and the Pacific
(the First world,) and the industrialized, formerly centrally planned economies of
eastern Europe (the Second World), and the remaining countries constitute the
third world. This terminology is used much less frequently today, mainly because
almost all of the former Second World has transformed its political and
economic systems. The geographic configuration of the Third World has led to a
parallel distinction of the
North (first and second worlds) versus the South, which is still used
occasionally. The more popular classifications used today implicitly put all

26
countries on a continuum based on their degree of development. Therefore, we International
speak of the distinctions between developed and underdeveloped countries, more Comparisons
and less developed ones, or — to recognize continuing change — developed
countries and developing countries. The United Nations employs a
classification scheme that refers to the poorest nations as the least-developed
countries. Some Asian, eastern European, and Latin American economies,
whose industrial output is growing rapidly, are sometimes referred to as
emerging economies. Richer countries are frequently called industrialized
countries, because of the close association between industrialization and
development. The highest-income countries are sometimes called post-industrial
countries or service-based economies because services (finance, research and
development, medical services, etc.), not manufacturing, account for the largest
and most rapidly growing share of their economies.
The United Nations uses certain rules for distinguishing between developed and
developing countries. However, the World Bank has stopped using these terms in
favor of others, such as "low-income" or "lower-middle-income" economies,
based on gross national income (GNI) per person. The International Monetary
Fund (IMF) definition is based on per-person income, export diversification, and
the degree of union with the global financial system. (IMF) definition is based on
per-person income, export diversification, and the degree of union with the global
financial system. The IMF published a research report on the topic of
development classification in 2011. It outlined its methods for classifying a
country's level of development.
Countries that are deemed more developed are referred to as developed countries,
while those that are less developed are known as less economically developed
countries (LEDCs)
The World Bank has historically classified every economy as low, middle, or
high income. It now further specifies countries as having low-, lower-middle-,
upper-middle-, or high-income economies. The World Bank uses GNI per capita,
in current U.S. dollars converted by the Atlas method of a three-year moving
average of exchange rates, as the basis for this classification. It views GNI as a
broad measure and the single best indicator of economic capacity and progress.
The World Bank used to refer to low-income and middle-income economies as
developing economies; in 2016, it chose to drop the term from its vocabulary,
citing a lack of specificity. Instead, the World Bank now refers to countries by
their region, income, and lending status.
The World Bank assigns the world’s economies to four income groups—low,
lower-middle, upper-middle, and high-income countries. The classifications are
updated each year on July 1 and are based on GNI( Gross national Income) per
capita in current US dollars (using the exchange rates) of the previous year.
According to the World Bank, sustainable growth and development in MICs have
positive spillovers to the rest of the world. Examples are poverty reduction,
international financial stability, and global cross-border issues, including climate
change, sustainable energy development, food and water security, and
international trade.
27
Growth and MICs have a combined population of five billion, or over 70% of the world's
Development
seven billion people, hosting 73% of the world's economically disadvantaged.
Representing about one-third of global GDP, MICs are a major engine of global
economic growth.
The classifications change for two reasons:
1) In each country, factors such as economic growth, inflation, exchange rates,
and population growth influence GNI per capita. Revisions to national
accounts methods and data can also have an influence in specific cases. To
keep the income classification thresholds fixed in real terms, they are adjusted
annually for inflation. The Special Drawing Rights (SDR) deflator is used,
which is a weighted average of the GDP deflators of China, Japan, the United
Kingdom, the United States, and the Euro Area.
2) To keep the income classification thresholds fixed in real terms, they are
adjusted annually for inflation. The Special Drawing Rights (SDR) deflator is
used, which is a weighted average of the GDP deflators of China, Japan, the
United Kingdom, the United States, and the Euro Area.
3) To keep the income classification thresholds fixed in real terms, they are
adjusted annually for inflation. The Special Drawing Rights (SDR) deflator is
used, which is a weighted average of the GDP deflators of China, Japan, the
United Kingdom, the United States, and the Euro Area.
Group July 1, 2021 (new)

Low income

Lower-middle income 1,046 – 4,095

Upper-middle income 4,096 -12,695

High income > 12,695

Sometimes countries move to a different group if their Gross National Income

changes. For instance, Indonesia and Iran moved from Upper-Middle Income
Group to Lower-Middle Income Group in 2020 from 2019, and Romania had
also slipped from Higher Income to Upper-Middle Income Group in the same
period.
Sometimes the World Bank classification leads to the discovery of surprising,
even startling, facts. If we consider the situation about a decade back, in 2010,
and see the classification on the above-mentioned lines (of course, the actual
income-threshold at leach level was slightly different, due to current exchange-
rate and purchasing-power-parity requirements), we find that out of 216 countries

28
of the world considered for classification, 35 countries were low-income International
countries, 57 countries were lower-middle-income countries, 54 countries were Comparisons
in the upper-middle-income category, and 70 countries were high-income
countries. Thus the largest number of countries were in the high-income
category! However, if we consider population, the population of the low-income
countries was 12 % of world population; the population of the lower-middle-
income countries was 36 % of world population; so was the population of the
upper-middle-income countries; while the population of high-income countries
was 16 % of the world population. Thus, while most of the countries in the world
were high-income, most of the population lived in middle-income countries.
In unit 1, we brought out the difference between economic growth and economic
development. We saw development is much more than economic growth.
Development involves a structural transformation of the economy, and there are
many more indicators of development. Economic growth is a necessary condition
for development but it is certainly not a sufficient one. Here, in this unit, in the
above discussion about the difference between developed and developing nation
you may be getting the idea that a lot of emphasis is being laid on income of
nations (for instance, the World Bank classification). So what happens if the
Gross National Income (same as the Gross National Product, or GDP, as you
have read in macroeconomics courses) of a nation were to change dramatically?
Consider the case of Equatorial Guinea, a small nation on the West coast of
Africa. It has a population of less than a million people. The discovery and
development of oil deposits and reserves off its coast led to a dramatic rise in its
per-capita GDP. In 1990 its per-capita income was $330. By 2009 it had shot up
to $ 12, 420. In the decade 2000-2009 it was the fastest growing economy in the
world, reaching average growth rates of 25 per cent, exceeding growth rates of
China. With this kind of growth rates, in about a decade, Equatorial Guinea
moved from being a low-income country to a high-income one.
Notice we are talking of growth rates. Did it mean that Equatorial Guinea
became a developed nation from a developing one. The answer is no, because in
terms of other indicators this country did not progress that dramatically. It
reached the same income level as that of Hungary, but this is where the similarity
between the two nations ends. Life expectancy in Equatorial Guinea is about 50
years, while in Hungary it is 74 years. About 90% of school-aged Hungarian
children are enrolled in primary school; for Equatorial Guinea it is about 50
percent. Despite Equatorial Guinea’s sudden high level of per capita income
there has been little transformation in the low levels of education and poor health
care of most Equatorial Guineans. Nor has there been much change in their
economic activity. Rapid economic growth has not brought economic
development to most of the population of Equatorial Guinea. But again, this case
is the exception rather than the rule. In most cases, increases in per capita
incomes and economic development have moved together. Thus we see that
although levels of per-capita incomes are very important for determining whether
a country is developed or developing, we should consider many other features,

29
Growth and characteristics and indicators. What proportion of the population is rural? How
Development big is the share of agriculture in GDP? What is the composition of international
trade, particularly exports? How is the country doing in terms of social indicators
like health indicators , education, poverty, unemployment, inequality. How are
manufacturing and services placed. In all these aspects there this a big difference
and gap on the whole between developed and developing nations.
Modern economic growth, the term used by Nobel laureate Simon Kuznets,
refers to the current economic epoch as contrasted with, say, the epoch of
merchant capitalism or the epoch of feudalism. The epoch of modern economic
growth still is evolving, so all its features are not yet clear, but the key element
has been the application of science to problems of economic production, which in
turn has led to industrialization, urbanization, and even explosive growth in
population. Finally, it should always be kept in mind that, although economic
development and modern economic growth involve much more than a rise in per
capita income or product, no sustained development can occur without economic
growth.
Check Your Progress 1
1. What do you mean by development gap?
2. Describe the World Bank classification of various countries of the world
in terms of economic levels. In what way does it differ from the classification
of the United Nations?

2.4 HISTORICAL PATTERNS OF DEVELOPMENT

We study this section by considering at the findings of economic historian Angus
Maddison, who estimated income levels and corresponding rates of economic
growth for the world economy as far back as the year 1 B.c.E. Such an exercise
requires a lot of conjecture, especially the further back in time one goes. To
perform the analysis, Maddison compiled estimates of population, GDP, and a
price index for determining PPP.
According to Maddison’s calculations, average world income in 1000 was
virtually the same as it had been 1,000 years earlier. In other words, growth

30
in per capita income between 1 B.c.E. and 1000 was effectively zero. The next International
820 years (from 1000 to 1820) were barely any better, with world income per Comparisons
capita growing, on average, by just 0.05 percent per year. (Note: This is not a
growth rate of 5 percent; it is a growth rate of 0.05 percent.) During those 820
years, world GDP grew by only slightly more than the growth in world
population. After eight centuries, world per capita income had increased by only
50 percent. To place this in some perspective, China today is one of the world’s
fastest-growing economies. With more than 1 billion people (about four times the
entire world’s population in 1000), economic growth in China aver- aged about
9.5 percent over the past decade, raising Chinese per capita incomes by 50
percent, not in 820 years but in just under 5 years!
Maddison’s estimates indicate considerable uniformity in per capita incomes
throughout the first millennium. The little bit of economic growth that did take
place over the next 800 years was centered in western Europe and in what
Maddison calls the western “offshoots” (Australia, Canada, New Zealand, and
the United States). By 1820, these regions already had a decided advantage over
the rest of the world. For example, whereas China and India may have been
slightly ahead of the western European countries in 1000, average per capita
incomes in western Europe and in their offshoots were already double those of
China and India by 1820.
Maddison’s research suggests that rapid economic growth as we know it really
began around 1820. He estimates that over the subsequent 190 years, the aver-
age growth in world income increased to 1.3 percent per year. Note that the
difference between annual growth of 0.05 percent and 1.3 percent is huge. With
the world economy growing at 0.05 percent per year, it would take more than
1,400 years for aver- age income to double. With annual growth of 1.3 percent,
average income doubles in just 55 years. The world had changed from no growth
at all during the first millennium, to slow growth for most of the second
millennium, to a situation in which, in the past two centuries, average real
income began to double in less than every three generations. Several features of
these data are notable. First, economic growth rates clearly accelerated around
the world since the early 1800s and especially after 1880. Second, and perhaps
most striking, the richest countries recorded the fastest growth rates and the
poorest countries recorded the slowest growth rates, at least until 1950. Per capita
income in the Western offshoots grew by about 1.6 percent per year between
1820 and 1950, while in Asia it grew by only 0.16 percent. As a result, the ratio
of the average incomes in the richest regions to those in the poorest regions grew
from about 2:1 in 1820 to about 13:1 in 1950.
Between 1950 and 2008, the patterns of economic growth changed, at least in
several regions. The gap between the Western offshoots and western Europe,
which had been widening through 1950, narrowed significantly. The poorest
region in 1950 (Asia) recorded the fastest subsequent growth rate (3.6 percent),
thereby beginning to close the income gap with the richer regions of the world.
By contrast, Latin America’s growth stagnated during the 1980s and 1990s, and
eastern Europe’s collapsed after the fall of the Berlin Wall in 1989. Both regions
resumed economic growth during the 2000s.

31
Growth and In Africa, as elsewhere, average growth rates accelerated after 1820 and did so
Development again after 1950, in the period associated with the end of the colonial era. But as
in Latin America, economic growth in Africa faded after 1980, continued to
stagnate in the 1990s, and rebounded only recently. As a result, the income gap
between the world’s richest regions (the Western offshoots) and the poorest in
2000 (Africa) reached 19:1. According to Maddison’s work, this is the largest
gap in income between rich and poor regions the world has ever known. Because
of resurgence in economic growth in Africa during the 2000s, this gap has
narrowed but still remains huge by historical standards.
Maddison’s broad sweep of world economic history indicates how
differential rates of economic growth, especially over the past two
centuries, have produced the divergence in income levels that characterizes
the world’s economy today.

2.5 SOME CASE STUDIES

In this section we begin by looking at some countries that were at the same level
of development at one point of time, and then their levels started to diverge. We
try to arrive at some explanation for this moving apart of the countries. As we
have mentioned earlier, unit 7 in block 2 will also some determinants of growth.
After reading that unit, you should think back about applying the insights you
will get from that unit back to the content of the present unit.
A large number of less-developed countries have experienced growth in income
over the past four decades and many have enjoyed substantial growth. There are
many examples of countries that have had an income growth exceeding 2 percent
a year over the past four decades. At 2 percent annual growth, average income
doubles in 35 years; at 4 percent, it doubles in 18 years. In most of these
countries, manufacturing grew more rapidly than the gross domestic product and
thus moved these economies through the inevitable structural change that reduces
the share of income produced and labour employed in agriculture. Many other
countries experienced slower (albeit positive) growth and development, with
incomes growing 1 or 2 percent per year. In still others, incomes stagnated or
declined.
The most rapidly growing economies have been in Asia and include China, India,
Indonesia, Korea, Malaysia, and Thailand. But several non-Asian countries also
are among the fast growers, such as Botswana, Chile, Estonia, and Mauritius.
Since 1970, Botswana, a landlocked country in southern Africa, has been one of
the fastest-growing economies in the world and one that has used its increased
income to improve the lives of its citizens. Botswana’s experience challenges the
stereotype that all African countries have been stuck with little growth and
development. At the same time, several Asian countries have grown slowly or not
at all, including Myanmar (Burma), North Korea, and Papua New Guinea.
Below, we mention the facts related to some individual countries. They do not
pertain to the latest time period, or even the same period, in the case of every
country.

32
Malaysia, which previously had been known mainly for the export of rubber, tin, International
and palm oil, became one of the world’s largest exporters of electronic Comparisons
components and other labor-intensive manufactured goods. Partly because of
these exports, Malaysia emerged as one of the fastest growing economies in the
world and a leading development success story. The income of the average
Malay more than quadrupled in real terms between 1970 and 2010, infant
mortality fell from 41 to 6 infants per thousand, and life expectancy rose from 61
to 75 years. Adult literacy jumped from 58 to 92 percent and the ratio of girls to
boys enrolled in school increased from 83 to 103 percent.
Ethiopia Per capita incomes in 2004 were at about the same levels as in 1981. In
the intervening years, incomes at times increased and at other times declined, but
overall, economic stagnation characterized the nation. Since 2004, how- ever,
economic growth has been faster and more consistent, averaging 6.6 percent per
year. This is much faster than at any time over the past three decades. Despite the
global recession of 2008–09, Ethiopia’s economy continues to grow rapidly,
although it is hard to know if this will be sustained.
Looking at other indicators of living standards, infant mortality rates fell from an
estimated 136 per thousand in 1970 to 67 per thousand in 2009, reflecting the
potential for health outcomes to improve even when income does not. Life
expectancy, at 56 years, is 13 years more than in 1970 but still well below the
levels in Malaysia and other more affluent economies. Adult literacy is less than
one out of three, but this will improve in the future. Four out of every five of
Ethiopia’s children of school age are now enrolled in primary school — double
the level of a decade ago. The economy is changing too, albeit slowly. In 1970,
61% of national output was derived from agriculture; today this figure is 51%.

Bangladesh has an impressive track record of growth and poverty reduction.

It has been among the fastest growing economies in the world over the past
decade, supported by a demographic dividend, strong ready-made garment
(RMG) exports, and stable macroeconomic conditions. Continued recovery in
exports and consumption will help growth rates pick up to 6.4 percent in fiscal
year 2021-22.
Bangladesh tells the world a remarkable story of poverty reduction and
development. From being one of the poorest nations at birth in 1971 with per
capita GDP tenth lowest in the world, Bangladesh reached lower-middle-income
status in 2015. It is on track to graduate from the UN’s Least Developed
Countries (LDC) list in 2026. Poverty declined from 43.5 percent in 1991 to 14.3
percent in 2016, based on the international poverty line of $1.90 a day (using
2011 Purchasing Power Parity exchange rate). Moreover, human development
outcomes improved along many dimensions.
In 2021, Bangladesh’s Cabinet Secretary told reporters that GDP per capita had
grown by 9% over the past year, rising to $2,227. Pakistan’s per capita income,
meanwhile, is $1,543. In 1971, Pakistan was 70% richer than Bangladesh; today,
Bangladesh is 45% richer than Pakistan.
Bangladesh’s growth rests on three pillars: exports, social progress and fiscal
prudence. Between 2011 and 2019, Bangladesh’s exports grew at 8.6% every
year, compared to the world average of 0.4%.

33
Growth and The success is largely due to the country’s relentless focus on products, such as
Development garments, in which it possesses a comparative advantage. Moreover, the share of
Bangladeshi women in the labour force has consistently grown. Also, Bangladesh
has maintained a public debt-to-GDP ratio of between 30% to 40 %.
Check Your Progress 2
1) Describe the performance of the world economy between the 11th and 19th
century as elucidated by Angus Maddison. Since when did the world economy
grow?
2) Briefly bring out the contours of development of any particular developing
country of your choice, giving reasons for its success.

2.6 LET US SUM UP

In this unit we looked at the developed and developing world in a comparative
perspective. The aim was to look at the notion of economic development, and
centre the discussion around the comparison between developed and developing
countries. The central question was what are the characteristics that differentiate
developed nations from developing nations? To this end, the unit began by
explaining the concept and significance of the development gap, with the help of
a simple example. The discussion brought home the fact that the developing
nations have to grow very fast in order to not increase the gap or fall behind.
Next, the unit looked at the divide between the developed and developing
nations. The insight that we got was that the divide is not merely in terms of
income levels, but also in terms of several economic and social indicators of
development. Merely by raising rates of growth, a country can go from being in
the category of low-income nations to high-income nations, but it will not
necessarily become a developed nation. Following this, the unit took a look at
broad contours of development of the world economy, based on studies by
Angus Maddison and presented some broad historical patterns of development.
Finally, the unit mentioned the case of some developing nations that have
performed admirably in the post World War II period, and some in recent times.

2.7 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1. See section 2.2
2. See section 2.3
Check Your Progress 2
1. See section 2.4
2. See section 2.5

34
 Introduction to Growth
Models

BLOCK 2 GROWTH MODELS: THEORY AND

EVIDENCE.

BLOCK 2 INTRODUCTION
The second block of the course is titled Growth Models: Theory and Evidence.
In the first block, you had studied about the basic idea of what is meant by
economic growth and economic development and the relationship among them.
Also you were presented with some international comparisons among nations
regarding the level of development.

The present block has five units. Unit 3 is titled Introduction to Growth
Models, and the next one, unit 4 is titled Harrod-Domar Model. Unit 5 is titled
The Solow Model. Unit 6 is titled Endogenous Growth Model, and finally, unit
7 is titled Determinants of Growth.

Unit 3 provides an overview of various approaches to growth. It discusses many

different theories of growth. It begins with Classical growth theory and then
presents briefly the Marxian theory of growth. After the classical and Marxian
theory unit 3 also discusses some stages-of-growth theories like those of Rostow
and Kuznets. The unit also discusses structural change models and dependency
theories. You will also be familiarized with neoclassical theories as well as
endogenous growth theories. Finally it briefly discusses new theories called
unified growth theories.

The subsequent three units in this Block take up for discussions the various
theories one by one. Unit 4 discusses the fixed-coefficient production function
using Harrod-Domar model. Unit 5 discusses one of the central models of
economic growth in the literature on growth theory, namely, the Solow growth
model. Unit 6 discusses the endogenous growth models, that is models where
growth is determined within the system, as are the factors causing growth.

Finally, unit 7 examines the determinants of growth. It discusses the concept of

convergence, that is, whether poorer countries are catching up with the richer
countries. The unit discusses different determinants like labour, capital,
technology and total factor productivity. The unit examines the concept of path
dependence as well.

37
Growth Models:
Theory & Evidence
UNIT 3 INTRODUCTION TO GROWTH MODELS
Structure
3.0 Objectives
3.1 Introduction
3.2 Classical growth theory
3.3 Marxian Theory of growth
3.4 Stages of Growth theories: Rostow and Kuznets
3.4.1 Rostow’s Theory
3.4.2 Kuznet’s Theory
3.5 Structural Change Models
3.5.1 Lewis Model and Patterns of development analysis
3.5.2 The International Dependence Model and the Dualistic Development Thesis
3.6 The Neoclassical Counterrevolution and Traditional Neoclassical Growth
Theory
3.7 The Theory of Endogenous Growth
3.8 Unified Growth theory
3.9 Let Us Sum Up

3.0 OBJECTIVES
After going through the unit you will be able to:
● Explain the concept of economic growth ,development and growth models;
● Describe the background and evolution of growth models;
● Identify the sources of growth in various models of growth; and
● Discuss the structure of the various growth models

3.1 INTRODUCTION
Economic growth is the study of the causes and consequences of sustained
growth in real GDP per person. One can define economic growth as the increase
in the inflation-adjusted value of the goods and services produced by an economy
over time. Economists refer to an increase in economic growth caused by more
efficient use of inputs that is labour, capital, land etc. as intensive growth. GDP
growth caused only by increases in the amount of inputs available for use
(increased population, or new machinery) counts as extensive growth. The "rate
of economic growth" refers to the geometric annual rate of growth in GDP over a
period of time. This growth rate represents the trend in the average level of GDP
over the period, and ignores any fluctuations in the GDP around this trend.
Economic Development is a much wider concept in terms of scope vis-a-vis
growth and is defined as a combination of social, economic and institutional
processes that secure the means for obtaining a better life. It should be perceived
as a multidimensional process involving the reorganisation and reorientation of
economic and social systems.
38
While economists in the 20th century viewed development primarily in terms of Introduction to Growth
economic growth, sociologists instead emphasized broader processes of change Models
and modernization. Development and urban studies scholar Karl Seidman
summarizes economic development as "a process of creating and utilizing
physical, human, financial, and social assets to generate improved and broadly
shared economic well-being and quality of life for a community or region".
Daphne Greenwood and Richard Holt distinguish economic development from
economic growth on the basis that economic development is a "broadly based
and sustainable increase in the overall standard of living for individuals within a
community", and measures of growth such as per capita income do not
necessarily correlate with improvements in quality of life. Economic
development is a wider concept and has qualitative dimensions. Economic
development implies economic growth plus progressive changes in certain
important variables which determine well-being of the people, for example,
health and education.
Economic development is the primary objective of the majority of nations across
the world. The universal features of economic development-health, life
expectancy, literacy and so on-follow in some natural way the growth of per-
capita GNP. If we see it as purely economic, we can say it is synonymous to
Economic growth. But in addition to rising income it implies fundamental
changes in the structure of the economy as well. Economic growth is one of the
most important notions in the global economy. Despite the criticism that the level
and rate of growth does not always reflect the real level of a population’s living
standards, it remains the primary measure of prosperity. However, as a measure
describing the dynamics of economic processes in the country it has some
drawbacks. First, it does not record the volume of production obtained from the
informal market, known as the "black market", which means that not all
economic transactions are included in the total volume of generated output. In
addition, economic growth does not take into account changes in the amount of
time spent on work, which obviously affects the welfare of society. Also the
measure of economic growth does not include the negative processes associated
with economic activities, such as environmental pollution, its progressive
degradation, or noise pollution. However, despite all these drawbacks economic
growth remains the primary measure of the socio-economic conditions of the
citizens of a country. A model of economic growth is based on economic theory
to establish basic fundamental assumptions that allow proposing an interaction
between the factors of production in order to explain the determinants of
economic growth. The principal theories of economic growth include:
Mercantilism-At the beginning of the Industrial Revolution , wealth of a nation
was determined by the accumulation of gold and running trade surplus. It was not
a growth theory but argued that a country would be better off by accumulating
gold and by increasing exports.
Classical Theory- Adam Smith with whom the classical school started placed
emphasis on the several factors which enable increased economic growth:

39
Growth Models:
a) Role of markets in determining demand and supply.
Theory & Evidence
b) Productivity of labour that is the state of the skill, dexterity and judgement
with which labour is applied in any nation.
c) Role of Trade in enabling greater specialisation.
d) Role of increasing returns to scale.
While David Ricardo developed the classical model that assumed technological
change as constant and increasing inputs that could lead to diminishing returns,
Thomas Malthus could notthe capacity of technological improvements to
increase food yields .The theory states that food production will not be able to
keep up with growth in the human population, resulting in disease, famine, war,
and calamity .
Neo-Classical Theory- Neoclassical growth theory is an economic theory that
outlines how a steady economic growth rate results from a combination of three
driving forces—labor, capital, and technology.
Endogenous growth theories- The Endogenous Growth Theory states that
economic growth is generated internally in the economy, i.e., through
endogenous forces, and not through exogenous ones. The theory contrasts with
the neoclassical growth model, which claims that external factors such as
technological progress, etc. are the main sources of economic growth.
Keynesian Demand side Theory: Keynes criticised the Classical school of
thought and argued that Aggregate Demand could play a role in influencing
economic growth in the Short and medium, -term. Though most growth theories
ignore the role of Aggregate Demand, some economists argue recessions can
cause hysteresis effects and lower long-term growth.
Limits to growth-An environmental perspective leads some to argue that in the
very long-term economic growth will be constrained by resource degradation and
global warming.

3.2 CLASSICAL GROWTH THEORY

Analysis of the process of economic growth was the primary feature of the work
of classical economists viz. Adam Smith, Thomas Malthus and David Ricardo.
They may be regarded as the main precursors of the modern growth theory.
Specifically, they were confronted with the facts of social and economic changes
taking place in the contemporary English society living on the 18th and 19th
Centuries on the eve of or in the throes of the Industrial Revolution.
Thus, their research was against the background of the emergence of the new
economic system-the system of the Industrial Capitalism.
“Progress” was an essential component for the development of a society as it was
seen as growth of national wealth. Hence, the principal of national advantage was
regarded as an essential criterion of economic policy. Progress was also
conceived within a framework of a need to preserve private property and hence,
the interests of the property-owning class from this perspective, they
endeavoured to show that the exercise of individual initiative under freely
competitive conditions to promote individual ends would produce results
beneficial to the society as a whole.
40
Conflicting economic interests of different groups could be reconciled by the Introduction to Growth
operation of competitive market forces and by the limited activity or role of Models
Government.
They were able to provide an account of the broad force that influences economic
growth and the mechanisms underlying the growth process. They recognised that
the accumulation and productive Investment of a part of the social product is the
main driving force behind economic growth and that under capitalism this takes
place in the form of reinvestment of profits. Their critique of feudal society was
based on the observation that a large part of social product was not invested but
consumed unproductively. The explanation of the forces underlying the
accumulation process was seen as the heart of the problem of economic growth.
Associated with accumulation is technological change as expressed in the
dimension of labour and change in methods of production. To these basic forces
in economic growth they added the increase in supply of labour through growth
of population. Their analysis on the operation of these forces led them to the
common view that the process of economic growth under the conditions they
identified raises obstacles in its own path and is ultimately retarded, leading to a ”
stationery state”, which is the ultimate end of economic growth.
Adam Smith posited a supply-side driven model of growth. Population growth,
Smith proposed in the traditional manner of the time, was endogenous: it depends
on the sustenance available to accommodate the increasing workforce.
Investment was also endogenous: determined by the rate of savings (mostly by
capitalists); land growth was dependent on conquest of new lands (e.g.
colonization) or technological improvements of fertility of old lands.
Technological progress could also increase growth overall: Smith's famous thesis
that the division of labor (specialization) improves growth was a fundamental
argument. Smith also saw improvements in machinery and international trade as
engines of growth as they facilitated further specialization. Smith also believed
that "division of labor is limited by the extent of the market" - thus positing an
economies of scale argument. As division of labor increases output (increases
"the extent of the market") it then induces the possibility of further division and
labor and thus further growth. Thus, Smith argued, growth was self-reinforcing
as it exhibited increasing returns to scale. Finally, because savings of capitalists
is what creates investment and hence growth, he saw income distribution as being
one of the most important determinants of how fast (or slow) a nation would
grow. However, savings is in part determined by the profits of stock: as the
capital stock of a country increases, Smith posited, profit declines - not because
of decreasing marginal productivity, but rather because the competition of
capitalists for workers will bid wages up. So lowering the living standards of
workers was another way to maintain or improve growth (although the counter-
effect would be to reduce labor supply growth). Despite increasing returns, Smith
did not see growth as eternally rising: he posited a ceiling (and floor) in the form
of the "stationary state" where population growth and capital accumulation were
zero.

41
Growth Models: Smith's model of growth remained the predominant model of Classical Growth.
Theory & Evidence David Ricardo (1817) modified it by including diminishing returns to land.
Output growth requires growth of factor inputs, but, unlike labor, land is
"variable in quality and fixed in supply". This means that as growth proceeds,
more land must be taken into cultivation, but land cannot be "created". This has
two effects for growth: firstly, increasing landowner's rents over time (due to the
limited supply of land) cut into the profits of capitalists from above; secondly,
wage goods (from agriculture) will be rising in price over time and this then cuts
into profits from below as workers require higher wages. This, then, introduces a
quicker limit to growth than Smith allowed, but Ricardo also claimed (at first)
that this decline can be happily checked by technological improvements in
machinery (albeit, also with diminishing productivity) and the specialization
brought by trade, although he also had stationary states.
Malthusianism is the idea that population growth is potentially exponential while
the growth of the food supply or other resources is linear, which eventually
reduces living standards to subsistence levels.. Thomas Robert Malthus, in his
1798 writings, An Essay on the Principle of Population believed there were two
types of "checks" that are continuously at work, limiting population growth
based on food supply at any given time:
● preventive checks, such as moral restraints or legislative action — for example
the choice by a private citizen to engage in abstinence and delay marriage
until their finances become balanced, or restriction of legal marriage or
parenting rights for persons deemed "deficient" or "unfit" by the government.
● positive checks, such as disease, starvation, and war, which lead to high rates
of premature death — resulting in what is termed a Malthusian catastrophe.
Such a catastrophe inevitably has the effect of forcing the population (quite
rapidly, due to the potential severity and unpredictable results of the
mitigating factors involved, as compared to the relatively slow time scales and
well-understood processes governing unchecked growth or growth affected by
preventive checks) to "correct" back to a lower, more easily sustainable level.

42
 Introduction to Growth
3.3 MARXIAN THEORY OF GROWTH
Models
The Karl Marxian model of economic growth is available in his famous
book "Das-Capital". He rejects the salient features of classical model of
economic growth. He rejected the law of diminishing returns and says
that the final outcome of stationary state in classical model is not a natural
process, it is due to human arrangements. He also rejects Malthusian
theory of population.
Marx’s theory seeks to combine economics and sociology and views
economic development as a continuous change in the social, cultural and
political life of society. In this theory, economic systems reach higher
stages through strained relations between the dynamic forces of
production and slowly evolving social and political organisation which
permits production. The stages of development: a) primitive-communal
society b) feudalism c) capitalism d) socialism e) communism.

He predicted that capitalism is characterised by a class struggle. Growing

conflicts between labour and capitalists would eventually lead to a revolution in
which capitalism based on private ownership would be transformed into
socialism based on public ownership.
This theory gives an important insight to the problems faced by most developing
economies that have been relying on investment in the modern Industrial sector
to achieve development- basically the increases in employment have been much
slower due to labour-saving technologies (also in contrast to output growth as a
result of Investment).However, increase in labour force has been more due to
growing population and thus, what can be observed is growing inequality and
social instability.
Followers of Marx have highlighted how the International capitalist system has
aggravated the gap between rich and poor countries and that there is a need to
restructure the world capitalist system to help least developed countries become
less dependent and vulnerable given the subservient position this system has put
them in.

Check Your Progress 1

1. Discuss the Classical Theory of Economic growth.
Q2. How do you explain the Marxian criticism of the Classical Theory
of growth?

43
3.4 STAGES OF GROWTH THEORIES:
ROSTOW AND KUZNETS
3.4.1 Rostow’s Theory
Walt W. Rostow has explained the transition from underdevelopment to
development in terms of a series of steps or stages through which all
countries must proceed. His work”The Stages of Economic Growth”
explains in detail the growth process via these stages:
a)The traditional society b)The preconditions for take-off c)The take-off
d)The drive to maturity e)High mass consumption.
Thus, as an economy takes on the path of growth there are economic,
social and institutional changes that kick-start growth rather slowly and
then the economy grows rapidly before it saturates to a high income level.
3.4.2 Kuznet’s Theory
Simon Kuznets gave the concept of Modern Economic Growth and defined the
economic growth of a country as “a long-term rise in capacity to supply
increasingly diverse economic goods to its population, this growing capacity
based on advancing technology and the institutional and ideological adjustments
that it demands.” He defined 6 basic characteristics of Modern Economic
Growth:
1.High rates of growth of per capita output and population
2.High rates of increase in Total Factor Productivity
3.High rates of structural transformation of the economy
4.High rates of social and ideological transformation
5.The propensity of economically developed countries to reach out to the rest of
the word for markets and raw materials
6.The limited spread of economic growth to only one-third of the world’s
population

Kuznets observed these for a large number of developed countries. He said that
the 6 characteristics are mutually reinforcing and inter-related.
He developed an approach to the analysis of economic growth over long
historical periods he called as an “economic epoch”. The innovation/scientific
knowledge and its application define an epoch and thus, economic growth and
structural change.
 Introduction to Growth
Models

3.5 STRUCTURAL CHANGE MODELS

3.5.1 Lewis Model and Patterns of development analysis
Structural change models are based on the popular notion of “Dualism”,
which in Development Economics is a relevant concept to understand the
dynamics of growing economies. Dualism in Economics is the
coexistence of two contrary forces in an economic set up. It can be of
various types viz, organisational, technological or structural dualism on
the basis of classification of an economy. W Arthur Lewis in the 1950’s
is one of the most famous structural change models which focuses on the
changes in a growing economy where a traditional agricultural or rural
sector paves way for the modern industrial urban sector which then is
responsible for growth via capital accumulation. His model was based on
the unlimited supply of labour in underdeveloped economies mostly in
the traditional agriculture sector and how this surplus labour can be used
in the modern industrial sector that grows and provides employment and
higher wages to labour. Also this sector then kick starts economic growth
as it accumulates capital and as Investment happens.The process of
modern sector self-sustaining growth is assumed to continue till all
surplus labour is absorbed in the industrial sector. The balance of the
economy lies in the equilibrium of both agriculture and industrial
economic activities.
The patterns-of-development analysis of structural change focuses on the
sequential process through which the economic, industrial and
institutional structure of an underdeveloped economy is transformed to
accommodate new industries as an engine of growth. Increased savings
and Investment here are taken to be necessary but not sufficient
conditions for growth. In addition to accumulation of capital both
physical and human, there is a need for a set of interrelated changes in the
economic structure of the economy for the transition.These changes occur
both at domestic and International level. Thus, growing economies can
benefit( or lose) by being part of the integrated International system is
what this analysis recognises unlike other models that look at structural
change as a domestic process only.
3.5.2 The International Dependence Model and the Dualistic-
Development Thesis
The International Dependence Revolution models view developing
countries as engulfed in domestic and International rigidities and thus,
caught up in a dependence and dominance relationship with developed
45
Growth Models: countries. The dependence model divides the world into a “centre” and a
Theory & Evidence
“periphery” where there is an unequal set up of power dynamics. The
developed countries are the dominant Centre whereas the developing
countries are the dependent periphery governed by the dominance and
vulnerability of the Centre, thus paving way for impoverishment of the
periphery.
The Dualistic-development Thesis envisages the concept of Dualism such
that rich and poor countries and rich and poor people have inherent
differences at various levels and thus there is the existence and
persistence of divergence between these. The economic systems are
characterised by different sets of conditions which are elements of
dualism and this coexistence is chronic in nature. Also this dualism is
responsible for gaps between rich and poor that don't decrease but rather
increases with time. Hence, the increasing gaps between rich and poor.

3.6 THE NEOCLASSICAL COUNTER

REVOLUTION AND TRADITIONAL
NEOCLASSICAL GROWTH THEORY
The 1980's saw the emergence of the Neoclassical Revolution in the
developed countries where they favoured the supply-side macroeconomic
policies, rational expectations theories and privatization of public
corporations. You have read about these in your courses in
microeconomics and macroeconomics.
Free-market analysis argues that markets alone are efficient and thus, any
kind of Government intervention is distortionary and counterproductive.
Public-choice theory (new political economy approach) goes further to
argue that Government does nothing right. This is because this approach
assumes that politicians, bureaucrats, people and states all pursue their
selfish interests and hence, the overall result is misallocation of resources.
Thus, minimum Government intervention is best.
The Market-friendly approach accepts the notion of Market-failure and
unlike the Free-Market approach and Public-Choice Theory, recognises
the role of Government intervention to correct these failures. This
approach however focuses on market-friendly interventions. All these
theories are applied to all areas of economic life, including economic
growth. Hence, these are, strictly speaking, not theories exclusively of
economic growth, but rather approaches to economic policies and the role
of government in the economy.
The Neoclassical Growth Theory is an economic model of growth that
outlines how a steady economic growth rate results when three economic
forces come into play: labor, capital, and technology. Solow Model of
growth is the most popular neoclassical model of growth. It extended the

46
 Harrod-Domar model of growth, which laid the foundation of growth( Introduction to Growth
given constant returns)on the process of capital accumulation. The Models
mobilisation of savings into Investment would help a country achieve
growth via accumulation of capital in this model. Solow Model added to
this by introducing the role of labour in the given framework and
extended it further to technological advancements. Diminishing returns to
individual factors of production is Solow’s twist to the Harrod Domar
Model. The model predicts the convergence of long run growth across
countries via the Stady state.

3.7 THE THEORY OF ENDOGENOUS

GROWTH
As the predictions of the neoclassical models didn't work exactly the way
they were expected to and many developing countries could not grow
rapidly despite surge in investment and liberalization, the growth theory moved
to New Growth models that relied on explaining growth with factors that played
their role from within the system and hence the term Endogenous growth
models. These models relied on examining growth beyond the exogenous factors
as used in neoclassical models.
Endogenous growth theory holds that investment in human capital, innovation,
and knowledge are significant contributors to economic growth. The theory also
focuses on positive externalities and spillover effects of a knowledge-based
economy which will lead to economic development.
Paul Romer has made a significant contribution to Endogenous Growth theory.
In choosing Romer as one of the 2018 economics laureates, the Royal Swedish
Academy of Sciences stated that he had shown how knowledge can function as
a driver of long-term economic growth and earlier studies had not modelled how
economic decisions and market conditions determine the creation of new
technologies. Paul Romer solved this problem by demonstrating how economic
forces govern the willingness of firms to produce new ideas and innovations.
Robert Lucas along with Paul Romer heralded the birth of endogenous growth
theory and the resurgence of research on economic growth in the late 1980s and
the 1990s.
Key Policy Implications of Endogenous Growth Theory
● Government policies can raise an economy’s growth rate if the policies are
directed towards enforcing more market competition and helping stimulate
innovation in products and processes.
● There are increasing returns to scale from capital investment in the
“knowledge industries” of education, health, and telecommunications.
● Private sector investment in Research and Development is a vital source
of technological progress for the economy.
You will study more about endogenous growth theory in unit 6.
 3.8 UNIFIED GROWTH THEORY
Oded Galor founded the theory of unified growth, or unified growth theory that
explores the process of development over the entire course of human history and
identifies the historical and prehistoric forces behind the differential transition
timing from stagnation to growth. It also explores the divergence in income per
capita across countries and regions
He has made significant contributions to the understanding of the process of
development over the entire course of human history and the role of deep-rooted
factors in the transition from stagnation to growth and in the emergence of the
vast inequality across the globe. He has pioneered the exploration of the impact
of human evolution, population diversity, and inequality on the process of
development over most of human existence.
Check Your Progress 2
1. How do you explain the Neoclassical counterrevolution in explaining
growth?..
2. Examine the neoclassical growth theories and the emergence of Endogenous
growth in the light of these.

3.9 LET US SUM UP

This unit sets the ball rolling about theories of growth. The unit gave an overview
on approaches to growth, some of which you will study in detail in the next few
units, and some others in the next course on development economics that you
will meet in the next semester. The unit familiarised you about the concept of
growth and what a theory of economic growth means. You learnt the evolution of
theories of growth from the time of classical economists like Adam Smith.
The unit began with an exposition of classical theories of growth Special
emphasis was laid on Adam Smith’s theory. Then the unit briefly explained the
theories of Malthus and David Ricardo. The theory of economic growth as
expounded by Marx was discussed. We saw that Marx had talked about certain
stages through which society passes. The unit also discussed the stages of growth
theories of Rostow and Kuznets. The unit then discussed economic theories
which were about structural change. The unit mentioned the Lewis growth model
and other dualistic theories as also international dependence theories.
48 Subsequently, the unit went on to touch upon free-market espousing neoclassical
theories as well as traditional neoclassical theory. You will study about
neoclassical growth theory put forward by Robert Solow in unit 5. Finally, the
unit dwelled upon endogenous growth theory, and unified growth theory put
forward by Oded Galor.

3.10 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress 1 Check Your Progress 2
1. See section 3.2 1 See section 3.6
2. See section 3.3 2 See section 3.7
UNIT 4 HARROD DOMAR GROWTH
MODEL
Structure
4.0 Objectives
4.1 Introduction
4.2 Background to the Harrod-Domar Model
4.2.1 Essence of the model
4.2.2 Assumption of the Model
4.3 The Harrod Model (HM)
4.3.1 Statement of the Model
4.3.2 Assumption of the Model
4.3.3 Policy Implication of the Model
4.3.4 The Harrod Model and Trade Cycled
4.3.5 Critique of the Harrod Model
4.4 The Domar Model (DM)
4.4.1 Statement of the Model
4.4.2 Assumption of the Model
4.4.3 Policy Implication of the Model
4.5 Comparison of Harrod Model and Domar Model (HDM)
4.5.1 Similarities
4.5.2 Dissimilarities
4.6 Harrod-Domar Growth Model
4.6.1 Substance of the Model
4.6.2 Limitations of the Model
4.7 Let Us Sum Up
4.8 Answers to Check Your Progress Exercises

4.0 OBJECTIVES
After reading this unit you should be able to:
 Describe the context and background in which this model came to be
developed by two different economists, each working independently enters at
the others, but still reaching the same results;
 Discuss the role of savings and investment in the growth process, as
expounded by Harrod, and the implication of this relationship;
 Identity the similarities and dissimilarities between the Harrod Model and the
Domar Model;
 Develop an integrated view of the Harrod Model and the Domar Model; and
 Analyse the strengths and limitations of this integrated model.


Shri Saugato Sen, Associate Professor IGNOU, New Delhi
 Harrod-Domar Growth
4.1 INTRODUCTION Model
Economic growth, as you have seen in Unit 3, refers to a process of sustained
increase in real national income of a country. A number of theories have tried to
study the process of economic growth as it has unfolded in the past especially
within the free market framework. These theories are economic growth are also
referred to as growth models, especially when the quantitative interrelationships
among the critical variables in the process of economic growth are set out in a
rigorous form. In the remaining units of this block and the subsequent two
blocks you will study in depth about different models of economic growth as
formulated by different economists at different point of time. Each of these
models emphasises upon a different sector or a set of factors that in the opinion
of their exponents is the major factor that influenced economic growth. In this
unit, we begin with an in-depth analysis of what had come to be known as the
Harrod-Domar Model (HDM) of growth.

4.2 BACKGROUND TO THE HARROD-DOMAR

GROWTH MODEL
This model of growth was developed by two different economists, each working
independently of the other, but almost con-currently. These two economists were
R.F. Harrod and E.D. Domar. Harrod, of course, published his theory earlier
than Domar. Harrod's book Towards a Dynamic Economics was published in
1948, while Domar's book Essays in the theory of Economic Growth was
published in New York in 1957. Harrod Model and Domar Model may differ in
details, but the ideas contained in both of the models are so similar that the two
models have got integrated and more generally are presented as a single united
model, known as the Harrod-Domar Model (HDM).
HDM integrated the classical and Keynesian analysis of economic growth. In the
HDM, capital accumulation plays a crucial role in the process of economic
growth. Both the classical economists and the Keynesians had recognised the
critical role of capital accumulation in the process of economic growth. But the
classical economists considered only the capacity of the capital accumulation,
and, believing that supply created its own demand, did not pay attention to the
demand side. Keynesians, on the other hand, erred in the opposite direction.
Concerned primarily with the short-period, they considered only the adequacy of
demand and neglected the problem of increase in capacity through investment in
the long run. HDM considered both the sides of the investment process.
4.2.1 Essence of the Model
Starting from a full employment equilibrium level of income, the HDM
postulated that continuous maintenance of this equilibrium required that the
volume of spending generated by investment must be sufficient to absorb the
increased output resulting from investment. Given the marginal propensity to
save, the more the capital is accumulated and the larger the initial national

51
Growth Models: income. The larger must be the absolute volume of net investment, maintenance
Theory & Evidence
of full employment, therefore, required an ever-expanding amount of net
investment. This, in turn, required a continuous growth in real national income.
Capital accumulation and growth of income must go side by side.
An increase in capital expands the productive capacity of the economy. If it is
not accompanied by an increase in income, any of the following things may
happen:
 The new capital may remain untitled.
 The new capital may replace old capital depriving the latter of its labour
and/or markets.
 The new capital may be substituted for labour (and possibly other
factors).
Thus, increase in capital unaccompanied by an increase in income would result
into unemployment of capital and /or labour. Excessive capital accumulation
may result into overproduction and consequently into a fall in investment leading
to depression.
4.2.2 Assumption of the Model
The HDM is based on the following assumption:
1. An initial full-employment level of income exists.
2. There is no government interference in the functioning of the economy.
3. The exogenous factors do not influence the growth variables, i.e., it is a
closed economy model.
4. There are no lags in adjustment, i.e., the economic variables like savings,
investment, income, expenditure adjust themselves in the same period. Any
change in saving brings about the corresponding change in investment in the
same period.
5. The average propensity to save(S/Y) and marginal propensity to save(∆S/∆Y)
are equal to each other, i.e,. the absolute change in saving is equal to the
relative change in saving.
6. Propensity to save and "capital coefficient"(capital-output ratio) are constant.
The law of constant returns operated because of the fixity of capital-out ratio.
7. Income, investment and savings are all defined in the net sense. It implies
that these variables exclude depreciation.
8. Saving and investment are equal in ex-ante and ex-post sense, i.e., accounting
and functional equality between saving and investment the equality can be
expressed as:
S0 = I0 (accounting equality)
Se = Ie (functional equality)

52
S0 and I0 are observed saving and investment. Se and Ie are expected saving and Harrod-Domar Growth
investment. Model

All these assumptions are not necessary for the final solution of the problem;
nevertheless, they serve the purpose of simplifying the analysis.

4.3 THE HARROD MODEL (HM)

R.F. Harrod tries show in his model how steady (i.e., equilibrium) growth may
occur in an economy. Once the steady growth is interrupted and the economy
falls into disequilibrium, cumulative forces tend to perpetuate this divergence
thereby leading to either secular definition or secular inflation. In other words,
Harrod's growth model concentrated largely on the following question:
 How can steady growth-rate be achieved with fixed capital-output ratio
(capital coefficient) and fixed saving-income ratio (propensity to save)?
 How can the steady growth-rate be maintained or what are the conditions for
maintaining the stable growth?
 How do natural factors put a ceiling on the growth-rate of the economy?
The model seeks to provide answers to these questions.
4.3.1 Statement of the Model
The Harrod model is based on three growth rates. One, there is the actual
growth rate denoted by G. It is determined by the saving ratio and the capital-
output ratio. It shows short-run cyclical variation in the rate of growth. Two,
there is the warranted growth rate denoted by Gw. It is the full capacity growth
rate of income in an economy. Three, there is the natural growth rate denoted
by Gn. This is regarded as 'the welfare optimum'. It may also be called the
potential or the full employment rate of growth.
1. Actual Growth Rate (G) - The first fundamental equation in the HM is as
follows:
GC = s ........................(1)
where
G = actual rate of growth (or ∆Y/Y)
C = the marginal capital output ratio[or (I/∆Y)]
s = saving income ratio [or (S/Y)]
The eq.(1) explains the simple truth that savings and investment are equal to each
other in terms of ratio. Substituting the values of G,C and s in eq.(1) explains
this phenomenon:
GC = s
Substituting the values, we get
(∆Y/Y)  (I/∆Y) = S/Y

53
Growth Models: Y I S
Theory & Evidence  
or Y Y Y
I S
 
Y Y
or I=S
The equality between saving and inves
tment (export sense) is thus a necessary condition for achieving steady growth. It
is also called the dynamic equilibrium.
2. Warranted Growth Rate (Gw) - It is the full capacity growth rate of income
in an economy. It is also known as 'full employment growth rate' or 'potential
growth rate'. The equation for warranted growth can be stated as follows:
GwCr = s ......................(2)
where,
Gw = warranted growth rate
Cr = amount of capital required to maintain the warranted growth rate
s = saving-income ratio
Eq.(2) states that if the economy is to advance at the steady rate of Gw that will
fully utilise its capacity, income must grow at the rate of s/Cr per year, i.e.,
Gw = s/Cr. If income grows at the warranted rate, the capital stock of the
economy will be fully utilised; the entrepreneurs will be willing to continue to
invest the amount of saving generated at full potential income. Gw is therefore, a
self-sustaining rate of growth and if the economy continues to grow at this rate, it
will follow the equilibrium path shown in.

I2 I
I1

S3
SAVING & INVESTMENT

S2

S1

S1

INCOME

Fig.4.1.

54
In Fig.4.1, income is measured along the horizontal axis, and saving and Harrod-Domar Growth
investment are measured along the vertical axis. It would be seen that the change Model

in income from Y1 toY2 induced investment would be to equal savings S1 at

A(Y2). This investment, in turn, raised income to Y3 and Y3 induced I2 to equal
S2 at B(Y3). I2 in turn raised income to Y4 and Y4 induced I3 to equal S3 at C(Y4
income). In this way, the economy moves on the growth path.
The point of intersection of the investment line and the line running parallel to
the Y-axis indicated the required investment that is forthcoming.
The greater proportion of savings, the greater must be the rate of increase in
output to induce sufficient investment to maintain equilibrium if we assume no
change in the investment co-efficient.
In brief, the warranted growth rate equation in the model implies that actual
investment (ex-post investment) must be equal to expected investment (ex-ante
investment), if an economy is to achieve stable growth. In such a situation, the
following equalities will obtain:
G = Gw, and
C = Cr
The economy would be in equilibrium.
If these equalities do not obtain, the economy will be pushed into a state of
disequilibrium if either of the following situations obtain.
A. G > Gw
or
C < Cr
B. G < Gw
or
C > Cr
A. State if disequilibrium when G > Gw
Under this situation, growth rate of income is higher than the growth rate of
output. It means that the demand for output(because of higher lever of income)
would exceed the supply of output (because of lower level of output). The
economy would experience inflation.
Stated another way, if C<Cr, the actual amount of capital falls short of the
required amount of capital. This will lead to the deficiency of capital. This, in
turn, would adversely affect the goods to be produced. Fall in output would
affect the goods to be produced. Fall in output would affect the goods to be
produced. Fall in output would result in scarcity of goods, and hence inflation.
Either of the two ways lead to inflation. And growth under inflationary situation
is not stable.

55
Growth Models: B. State of disequilibrium when G < Gw
Theory & Evidence
In this situation, the growth rate of income is less than the growth rate of output.
There would be more goods for sale but the income would be insufficient to
purchase these goods. There would be deficiency of demand and the economy
would face the problem of over production.
Similarly, when C>Cr, actual amount of capital would be larger than the required
amount of capital for investment. The larger amount of capital available for
investment. The larger amount of capital available for investment would lower
the marginal efficiency of capital in the long-period. Secular decline in the
marginal efficiency of capital would lead to depression and unemployment.
Economic growth under the situation of depression cannot be stable.
Harrod stated that once g departs from Gw, it will further depart away from
equilibrium. He writed: 'Around that line of advance which it adhered to would
alone give satisfaction, centrifugal forced are at work, causing the system to
depart further and further form the required line of advance." Thus, equilibrium
between G and Gw is a knife-edge equilibrium. It follows that one of the major
tasks of public policy is to bring G and Gw together in order to mainatain long-
run stability.
For this purpose, Harrod introduces his third concept of natural rate of growth.
3. Natural Growth-rate (Gn).
It is the maximum growth rate that an economy can achieve with its available
natural resources. The equation for the natural growth rate can be state as
follows:
Gn Cr = or ≠ s ................(3)
It stated that the natural growth rate is determined by macro variables like
population, technology, natural resources and capital equipment. These factors,
place a ceiling beyond which expansion of output is not possible.
Interaction between G, Gw and Gn
Comparing Gw and Gn, it may be concluded that Gn may or may not be equal to
Gw. In case Gn happen to be equal to Gw, the condition of steady growth would
prevail. But such a possibility is remote one because a variety of factors
(influencing Gn and Gw) come into play and make balance between these two
growth-rated difficult. There exists a greater probability of inequality between
Gn and Gw. It may take two terms:
(a) Gw>Gn
(b) Gn>Gw
(a) Gw>Gn: It Gw exceeds Gn, G would lie below Gn for most of the time.

56
In this situation, there would be a tendency for cumulative recession. A Harrod-Domar Growth
downward trend would set in, resulting in unemployment and depression. Model

However, downward trend cannot continue indefinitely. The reason is that lower
limit to depression is set by the minimum consumption level. The consumption
cannot fall below a minimum level. The minimum consumption requirements
can be made possible by reducing the working capital. The entrepreneurs may
not reduce fixed capital in the hope that future might entail bright prospects for
investment. These two factors would gradually set the wheels of recovery in
motion. The economy would experience upward trend.
(b) Gn>Gw: In this situation, G would also exceed Gw for most of the time,
There would be a tendency for cumulative boom and full employment. Such a
situation will create inflationary trend. To check this trend, savings should be
encouraged, as these would ensure a high level of employment without
inflationary pressures.
4.3.2 Assumptions of the model
 The HM is based on the following assumptions:
 The level of ex-ante aggregate saving is a constant proportion of aggregate
income. It means propensity to save is assumed to be constant.
 Technical progress has been assumed to be labour argumenting or 'neutral'.
This implies that neutral technical progress is the basis of the model.
 The requirements of capital and labour per unit of output are constant, i.e.,
capital-output and labour-output ratios are assumed constant.
 Constant returned to scale operate. This implies that output increased at a
constant rate.
4.3.3 Policy Implications of the Model
The policy implications of the model are simple and straight forward. These can
be briefly summarised as follows:
Saving is a virtue in any inflationary gap economy and a vice in a deflationary
gap economy. In an advanced economy the saving coefficient, s, has to be
moved up or down as the situation demanded.
4.3.4 The Harrod Model and Trade Cycles
Harrod has used his model to explain trade cycles. In the recovery phase,
because of the existence of unemployed resources, G>Gn. When full
employment is reached G=Gn. If Gw exceeds Gn at the full employment, slump is
inevitable. Since G had to fall below Gw, it will, for the time being, be driven
progressively downwards. Further, G itself fluctuated during the course of the
business cycle. Savings as a fraction of income, though fairly steady in the long
run, fluctuate in the short run. In the short run, savings tend to be residual
between the earning and normal consumption. Companies, also, are likely to
save a large portion of their short-period increased in net receipts. Thus, even it
57
Growth Models: Gw is normally below Gn, it is likely to ride above Gn in the later stages of
Theory & Evidence advance, and, if it so happens, a vicious spiral of depression is inevitable when
full employment is reached. If Gw does not ride above Gn in the course of
advance, there would be continued pressure to advance when full employment is
reached; this would lead to inflation and consequently, sooner or later, to a rise of
Gw above Gn, resulting ultimately into a vicious spiral of depression. Actually, G
may be reduced before the employment is reached because of immobilities,
frictions, and bottlenecks and, if it so happens, depression may come before full
employment is reached. If Gw is far above Gn, G may never rise far above Gw
during the revival and the depression may result long before full employment is
reached.
4.3.5 Critique of the Harrod Model
The instability in Harrod's model is due to the rigidity of its basic assumptions,
viz. fixed production function, a fixed saving ratio, and a fixed growth rate of
labour force. Economists have attempted to relieve this rigidity by permitting
capital and labour substitution in the production function, by making the saving
ratio a function of the profit rate and the growth rate of labour force as a variable
in the growth process.
Check Your Progress 1
1. Why is the model discussed in this unit known as the Harrod-Domar
Model?
2. State in brief the basic formulations of the Harrod model of growth.
3. How does the Harrod model explain the occurrence of trade cycles?

58
 Harrod-Domar Growth
4.4 THE DOMAR MODEL (DM) Model
The fundamental question around which E.D. Domar builds his model can be
stated as follows:
Investment leading to an increase in productive capacity and income, what
should be the rate of increase in investment which would equalise the increase in
income and the increase in productive capacity, so that full employment is
maintained?
Domar answers this question by forging a link between aggregate supply and
aggregate demand through investment.
4.4.1 Statement of the Model
Domar model is based on the dual character of investment: one , investment
increases productive capacity, and two, investment generated income,. The two
sides of investment provide solution for steady growth. The following symbols
are used in DM.
Yd = Level of national income or level of effective demand at full employment
(demand side)
Ys = Level of productive capacity or supply at full employment level (supply
side)
K = real capital
I = net investment, which implies change in stock of real capital, i.e. ∆K
d = marginal propensity to save, which is the reciprocal of multiplier i.e.,
(mp  =1/multiplier)
 = productivity of capital
We can make use of these notations to frame a set of equations that help
formulate the DM.
The demand side of investment can be represented by an equation as follows:
Yd = I/d
This equation explains two things as follows:
(i) The level of effective demand (Yd) is directly related to the level of
investment(I). An increase in investment will result in an increase in effective
demand, and vice versa.
(ii) The effective demand is inversely related to the marginal propensity to save
(d). An increase in marginal propensity to save will decrease the level of
effective demand and vice-versa.
Eq.(1) represents the demand side of investment.
The supply side of investment can be represented by an equation as follows:
Y = k ....................(2)
59
Growth Models: Eq.(2) explains that supply of output(Ys) at full employment depends upon two
Theory & Evidence
factors, ie.., productive capacity of capital(  ) and the amount of real capital(K).
A change in the supply of any of these will result in a corresponding change in
the supply of output. For example, an increase in the productivity of capital will
result in an increase in output, and vice-versa. Likewise, an increase in the
amount of real capital will lead to an increase in output, and vice-versa.
Equilibrium: In equilibrium, the demand and supply should balance. Therefore,
Yd = Ys
or I/d =  K
By cross multiplication,
I = d K .............................(3)
Eq.(3) explains the condition for steady growth.
Steady growth is possible when:
Investment equals the product of saving-income ratio, capital productivity and
capital stock. From this the condition for maintaining the steady growth can be
explained. For this we have to give increment to the demand and supply
conditions presented above.
The demand equation in its incremental form can be stated as follows:
∆Yd = ∆I/d ........................(4)
Increments have been shown in the level of effective demand and investment
because they are variables, but increment has not been shown in d because it is
constant in terms of the assumptions employed.
The supply equation it its incremental form can be stated as follows:
∆Ys =  ∆K ........................(5)
Eq.(5) explains that change in the supply of output (∆Ys) would be equal to the
product of change in real capital (∆K), and the productivity of capital (  ). The
change in real capital is expressed as net investment. Therefore, ∆K represented
investment(I). Substituting I in place of ∆K in eq.(5), we get.
∆Ys =  I ........................(6)
The equilibrium between eq.(4) and eq.(6) provides us the condition for
maintaining the steady growth. In equilibrium
∆Yd = ∆Ys
or ∆I/d =  I
cross-multiplying , we get,
∆I/I =  d .......................(7)
Eq.(7) explains that the growth-rate of net investment ∆I/I should be equal to the
product if marginal propensity to save (d) and productivity of capital (  ). This
60
equality must be maintained to ensure stable and steady growth. Donar gives a Harrod-Domar Growth
numerical example to explain this condition of maintaining steady growth. Model

Let  = 25% per year

d = 12%
Y = $150billion a year
12
If full employment is to be maintained, an amount equal to 150  =$18 billion
100
should be invested. This will raise productive capacity by the amount invested
12 25
 times i.e., by 150   =$4.5 billion, and the national income will have
100 100
to rise by the same amount. But the relative rise in income will equal the
absolute increase divided by the amount itself, i.e.,
12 25

12 25
150  100 100    3%
150 100 100
Thus in order to maintain full employment, income must grow at a rate of 3% per
annum. This is the equilibrium rate of growth. Any divergence from this
"golden path" will lead to cyclical fluctuation when ∆I/I greater than  d the
economy would experience boom. The economy would suffer from depression,
it ∆I/I is less than  d.
4.4.2 Assumption of the model
The Domar model is based on the following assumption.
1. Income is determined by investment through multiplier. For the sake of
simplicity, saving-income ratio is assumed constant.
2. Productive capacity is created by investment according to the potential social
average investment productivity. For the sake of simplicity this is also assumed
to be constant.
3. Investment is induced by output growth together with entrepreneur confidence.
4. Employment depends upon the 'utilisation ratio' expressed as the ratio between
actual output and productive capacity.
5. Past and present investment can greater productive capacity at a given ratio.
4.4.3 Policy implication of the model
An economy always faced a serious dilemma if sufficient investment is not
forthcoming today, unemployment will occur today; but if enough in invested
today, still more will be needed tomorrow in order to increase demand so that the
expanded capacity can be utilised and excessive capital accumulation avoided
tomorrow; otherwise the excessive accumulation will cause a fall in investment
leading to a depression day after tomorrow. To stay at the same place, therefore,
the economy must move faster and the economy must move faster and faster,
otherwise it will slip downward.

61
Growth Models: Check Your Progress 2.
Theory & Evidence
1) Discuss the principal features of the Domar Model of growth.
2) State the conditions necessary for steady growth.
3) State the conditions necessary for maintaining for maintaining steady
growth.

4.5 COMPARISON OF HARROD MODEL AND

DOMAR MODEL
Harrod model and Domer model show both similarities and dissimilarities with
each other. Let us have a look at these.
4.5.1 Similarities
The two models are similar in substance. Harrod's is domar's d. Harrod's
warranted rate of growth (Gw) is Domar's full employment rate of growth (d  ).
Harrod's Gw=s/Cr ≡ Domar's d  ).
To prove it
S
d= or S=dY ................(1)
Y
Y
 = or  Y = I  ................(2)
I
Since S=I, and substituting S for I in eq.(2), we have
 Y = dY  [Q S=dY]
Y
or = d ................(3)
Y
Y
 Gw = d  (since Gw = )
Y

In other words, Harrod's Gw is the same as Domar's d , but in reality, Domar's

rate of growth r=ds 's Harrod's Gw, and Domar's r = d is Harrod's natural growth
rate. In Domar's model s is the annual productive capacity of newly created
capital which is greater than which is the net potential social average
productivity of investment. It is the lack of labour and other factors of
production which reduced Domar's growth rate from r=ds to r d. Since labour is
involved in therefore Domar's potential growth rate resembled Harrod's natural
rate. We may also say that the excess of s over in Domar's model expresses the
excess of Gw over Gn in Harrod's model.
4.5.2 Dissimilarities
Both the models, no doubt, are based on similar assumptions, yet there are
differences in the two models. These dissimilarities can be presented as below:
Dissimilarities between the Domar Model and Harrod Model.

62
 Parameter Domar Harrod Harrod-Domar Growth
Model
1. Long-run difficulty "Under-investment Labour shortage
sapping growth" deflecting growth
2. Position of labour Shortage of certain Determinant of natural
input labour may trigger rate of growth:
scrapping and the key element
inhibition of investment;
optional element
3. Centrifugal force Continuously undermined Unstable adjustment
from equilibrium investment incentives process
4. Reason for fixed Assumed for inconvenience Due to fixed interest
rate,
capital output ratio low substitutability,
etc.

5. State of economy Idle capacity prevalent Labour

unemployment
common place
Further differences between the two models are revealed when we discuss their
policy implications. Domar's model explains the technological relationship
between the capital accumulation and full employment growth rate of output.
Harrod model shows the behavioral or psychological relationships between the
capital accumulation and full capacity growth rate of output. Domar's analysis is
based on the principle of multiplier, whereas Harrod's analysis is based upon the
principle of acceleration. Domar's model suggests the role of planned investment
in the economic development, while Harrod's model stresses on induced
investment.

4.6 HARROD-DOMAR GROWTH MODEL

You have read about the Harrod Model (HM) and the Domar Model (DM)
separately. By now, you would have understood that the two models are similar in
substance, although they may differ in details as also in policy implications. Now
we have reached a stage in our study where we can integrate these two models in
the form of what has come to be known as the Harrod-Domar Growth Model
(HDM).
4.6.1 Substance of the Model
The main points of the HDM can be summarised as follows:
1) Investment is the central theme of the HDM. It plays a dual role. ON the one
hand it generates income and on the other it creates productive capacity.
2) The increased capacity results in greater output and greater employment,
depending on the behaviour of the income.
3) Condition regarding the behaviour of income can be expressed in terms of
growth-rates, i.e., G Gw and Gn. The equality between these growth rates
would ensure full employment of labour and full utilisation of capital stock.
63
4) These conditions, however, designate only a steady-line of growth. The actual
growth rate may differ iron the warranted growth rate. If the actual growth
rate is higher than the warranted rate of growth, the economy will experience
cumulative inflation. If the actual growth-rate is lower than the warranted
growth-rate, the economy will hurtle towards cumulative deflation.
5) The business-cycles are viewed as the deviations from the path of steady
growth. These deviations cannot go on indefinitely. There are constraints on
upper and lower limits. The "full employment ceiling" acts as an upper limit
and autonomous investment and consumption act as a lower limit. The actual
growth-rate fluctuates between these two limits.

4.6.2 Limitations of the Model

HDM throws light on the important determinants (and policy implications) of
economic development, yet they are not free from criticism. The HDM has been
criticised on the following grounds:
1) The HDM assumes key parameters, like the propensity to save and the
capital-output ratio, to be constant. In reality, these are likely to change over
the long run. Changes in these parameters would change the requirements of
steady growth.
2) The HDM includes only aggregates as variables. A model constructed on the
basis of such aggregates cannot show the inter-relations between the sectors
and as such is not meant for demonstrating the structural changes which
constitute a basic aspect of the economic development of a developing
economy. Harmonious growth of different sectors of the economy is very
important for steady grwoth. Deviations from steady growth may be caused
by a lack of harmony between the growth of different sectors even when
aggregative requirements for stability are fulfilled.
3) The HDM assumes the production function to be fixed and therefore there is
no scope for substitution between different factors. Actually different factors
of production, at least to a limited extent, can be substituted for each other.
Substitutability between different factors increases the flexibility of the
economy and thereby decreases the possibilities of cumulative deviations
from the path of steady growth.
4) The HDM pays attention only to the requirements of steady growth and
neglect the rate of growth. It is more useful for developed countries whose
main aim is stability and not the rate of growth. In contrast, developing
countries are interested more in the rate of growth. They would not mind
following policies, which create fluctuations if these considerably raise the
rate of growth.
5) The HDM is purely laizzez-faire only based on the assumption of fiscal
neutrality and designed to indicate the conditions of progressive equilibrium
for a developed economy. The policy implications, therefore, are not very
relevant to the developing economies.
Despite these limitations, the HDM is an important model because it represented a
stimulating attempt to dynamise and secularise Keynes' static short-run saving
and investment theory.
Check Your Progress 3 Harrod-Domar Growth
Model
1) State the similarities between the Harrod Model and the Domar Model.
2) State the differences between the Harrod Model and the Domar Model.
3) What are the basic features of the Harrod-Domar Model of growth? Also
state the limitations of this model.

4.7 LET US SUM UP

The Harrod-Domar growth model was developed separately, but concurrently, by
two economists. Both the Harrod Model and the Domar Model brought out the
importance of saving and investment in the process of economic growth. Both
the models sought to lay out the conditions for steady growth; the non-fulfilment
of these conditions would lead to disequilibrium, resulting in inflationary and
deflationary gap. Although both the models differed in details, they were the
same in substance. Therefore, both the models stand out integrated, and are
known as the Harrod-Domar Model of Growth. The model was developed in the
context of advanced market economies. But it has been widely used in
formulating plan models in developing economies.

4.8 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1. See Section 4.2
2. See Section 4.3.1
3. See Section 4.3.4
Check Your Progress 2
1. See Section 4.4.1
2. See Section 4.4.1
3. See Section 4.4.1

Check Your Progress 3

1. See Section 4.5.1
2. See Section 4.5.2
3. See Section 4.6.1 and 4.6.2

65
UNIT 5 THE NEOCLASSICAL GROWTH
MODEL
Structure
5.0 Objectives
5.1 Introduction
5.2 Some Basic Concepts and Tools to Study Growth Models
5.3 The Solow Model
5.3.1 Assumptions
5.3.2 The structure of the model
5.3.3 A comparison with the Harrod-Domar Model

5.4 Some Applications and Extensions of the Neo-Classical Model

5.4.1 Depreciation of Capital Stock
5.4.2 Variable Savings Rate
5.4.3 Population Growth
5.4.4 Relative Share of Factors

5.5 Money in the Neo-Classical Growth model

5.5.1 The Tobin Model
5.5.2 The Sidrauski Model

5.6 Convergence and Poverty Traps

5.7 Answer/Hints to Check your Progress Exercises

5.0 OBJECTIVES
After going through the unit, you will be able to:
 apply some essential techniques to study growth models in general;
 discuss the neo-classical growth model ;
 point out the difference between the Harrod-Domar model and neo-classical
model(s);
 apply the neo-classical growth models in the analysis of certain economic
topics like savings, fiscal policy, poverty, and so on;
 explain the comparative growth experiences of nations using the neo-
classical model; and
 examine how the concepts of money and monetary processes have been
brought into the neo-classical model.


Shri Saugato Sen Associate Professor of Economics, IGNOU, New Delhi
 The Neoclassical
5.1 INTRODUCTION
Growth Model
The previous two units of this block have introduced you to the concepts of
economic growth and development, as well as the Harrod-Domar growth model.
You saw how important economic growth is, how it differs from development,
why we should study growth models and what the limitations of economic
growth can be. The Harrod-Domar model was presented to you both as a unified
model, as well as separately the models of Harrod and Domar. You became
familiar with the model’s assumptions, its structure, limitations as well as some
applications, including application in Indian economic planning.
This unit presents for discussion a model which was put forward by Robert
Solow and Trevor Swan, independently of each other, in 1956, although brief
anticipations of the basic idea was carried out by James Tobin. However it is
commonly known as the Solow-Swan model, or even as the Solow model. Solow
has done a lot to popularise the model through subsequent papers and books. The
Solow model has proved to be one of the most used most robust, and standard
models in all of economic theory. Several economists of more than one
generation have built upon, extended and refined the Solow model. Even when
some have put forward new models, they did so referring to the Solow model as
the model that they critiqued and found limitations with. Empirical economists
spent lots of time, effort, energy to examine data sets and use statistical tools to
see if predictions which can be generated out of the Solow model, have actually
been matched by the performances of group of countries. Solow justly received a
Nobel Prize for his contribution to growth theory, and as he remarked with a
touch of pride during the address he gave at the time of receiving the prize, his
model started a “cottage industry [of model- building in growth theory]”.
In this unit we study the neoclassical growth model. We begin by acquainting
you with some tools and techniques you are going to need to study growth
models, not only in this unit, but in subsequent units as well. Once you have
familiarised yourself with these concepts, you will be introduced to the basic
neoclassical model, with the assumptions stated and the structure spelled out and
elaborated. Some applications and extensions of the model are presented ,
following which we bring in monetary factors into the basic neoclassical model.
We close the discussion with a study of the very important and relevant topics of
convergence and poverty traps.

5.2 SOME CONCEPTS AND TOOLS TO STUDY

GROWTH MODELS
If we assume a constant rate of growth, the formula used for calculating the
growth rate for more than one year is as follows:
Yt = Yo (1+r)n
=) log Yt=log Yo+n log (1+r)
log yt  log yo
=) log (1+r) =
n
log (y t /y o )
or log (1+r) =
n
69
Growth Models:
 (y / y )
Theory & Evidence =) 1+r = antilog  log t o 
 n 

  log( yt / yo )  
 r = anti log    1
  n  
This assumes constant rate of growth. r (as in a constant rate of interest in
compound interest formulations)
When the r.o.g is not constant, it is say
x1 , x2 ,........xi ............xt in t=1,2,.......i,......t
1
t
then r = (x1 , x2 ,........xt )

It is geometric mean.
Calculation of Growth Rates
Consider the following data on rice production:
Year Rice Production Year Rice Production
(in lakhs of tonnes) (in lakhs of tonnes)
1990 8 1997 18
1991 9 1998 18
1992 13 1999 18
1993 12 2000 23
1994 13 2001 23
1995 20 2002 26
1996 19 2003 28
2004 27
2005 24
(i) A crude interpretation of the growth rate is given as an average percentage
change from first year to the last year, in this example, average growth rate
would be
 24  8 
 
 8  100
16
 13.3%
This method overemphasises original and terminal values of data. Also, it does
not use all observations.
(ii) Linear growth rate : The estimated regression using the given data turn out to
be:
yt = 8.1 + 1.2.45 t
Three different growth rates may be completed by making following
manipulations:
70
  The Neoclassical
 1.245 Growth Model
(a) growth rate = y 100  8  100
0

 15.57%

 1.245
_
100  100
(b) growth rate = 18.6875
y
 6.66%


 1.245
 100   100
(c) growth rate = HM ( y ) 16.286
 7.64%


(iii) Compound growth rate: Value of  in the log-linear relation:
ln yt  ln    t

Growth
As an example, let’s model population growth
dp 1 dp / dt
. 
dt p p
dp
is called the absolute growth rate,
dt
dp
/ p is called relative growth.
dt
US population in millions 1790-1990

71
Growth Models: Example: U.S. Population in million 1790-1990
Theory & Evidence
Year Population
1790 3.9
1800 5.3
1810 7.2
1820 9.6
1830 12.9
1840 17.1
1850 23.1
1860 31.4
1870 38.6
1880 50.2
1900 76.0
1910 92.0
1920 105.7
1930 122.8
1940 131.7
dp
Suppose we went to estimate relative growth ( / p ) from 1790 to 1860 let us
dt
dp
take one particular year, say 1830. If we want to estimate / p in 1830 we take
dt
the rate of change in the population, and divide it by the population itself:
1 dp 1 popin1840  popin1830

p dt pop.in1830 10 years
1 17.1  12.9
 .  0.0326  3.26%
12.9 10
P10  P0 (1  3.47)
P10  P0 (1  0.347 10)

Similar calculations for 1790, 1800,………, 1850 give percentages as shown

below
Year Relative growth rate
1790 3.59%
1800 3.58%
1810 3.33%
1820 3.44%

72
1830 3.26% The Neoclassical
Growth Model
1840 3.57%
1850 3.53%
How do we calculate average relative growth rate for the period?
The simplest model is to answer that the relative growth rate is constant, i.le.
1 dp
k
p dt
1. Arithmetic growth (simple growth): growth by a constant amount in each
time period.
2. Geometric growth (exponential growth): growth by a constant proportion
in each time period.
3. Nominal rate of interest & effective rate of interest; compounding period.
If we have a photo & enlarge it 3 times, new are is 9  (old area).
Correct are the following
New area is 9 times the area of the original
New area is 9 times as large as the original
New area is 9 times as great as the original
Incorrect are
New area is 9 times greater than the original
New area is 9 times more than the original
New area is 9 times larger than the original
“9 times greater than” means “10 times as great as”.
B. An increase from 1 to 9 is an increase of 800%, Not 900%. If support
for a political party decreases from 60% to 30% it has dropped 30
percentage points but decreased 50%.
C. When speaking of reductions also we must be careful. A reduction
from 9 to 1 means the new amount is 1/9th as much, 8/9th less than,
11% as much as in89% less than the original.
Growth and change
Let x be an economic variable.
Let x0 be the initial value.
x1 be the subsequent value.
The proportional change in going from x0 to x1 is simply
x1  x0 x

x0 x0

73
Growth Models: The percentage change in going from x0 to x1 is simply 100 times the
Theory & Evidence
proportionate change:
%  x = 100 (  x/x0)
If x is itself in percentage it becomes tricky.
If unemployment decreases from 15% to 12% it is a reduction of 3 percentage
15  12 3
points, but a 100   100  20% fall in unemployment.
15 15
5

Time as regressor
A linear trend relationships would be depicted as:
y    T   (1)
where T indicates time. One has to appropriately define the origin
Constant growth covers
yt     T  t
yt 1     T  1  t 1
 yt  yt 1    (   t 1 )
y1    1  t .......1

Ignoring the disturbances, the series increases (decreases) by a constant amount

each period. For an increasing series (   0 ), this implies a decreasing growth
rate, and for a decreasing series (   0 ), the specification gives an increasing
decline rate.
If we wish to study a series with a constant growth rate, the formulation (1) is
inappropriate. The appropriate specifications expresses the logarithm of the
series as a linear function of time.
This can be seen as follows without disturbances, a constant growth series is
given by the equation.
yt  y0 (1  g )t (2)
( yt  yt 1 )
where g = is the constant proportionate rate of growth per period
yt 1

Taking logs of both sides of (2) given

ln y     t (3)
where   ln y0 and   ln(1  g )

If one suspects that a series has a constant growth rate, plotting the log of the
series against time provides a quick check. If the series is approximately linear,
(3) can be fitted by least squares, regressing the log of y against time. The

resultant slope coefficient then provides as estimates g of the growth rate,
namely,
74
   The Neoclassical
b= ln(1+ g ) giving g =eb-1 Growth Model
The  coefficient of (1) represents the continuous rate of change  ln yt / t ,
whereas g represents the discrete case. Formulating a constant growth series in
continuous time gives
yt  y0e  t
ln yt     t

Note that taking first difference of equation (1) given

myt    ln(1  g ) ; g

Thus, taking first difference of logs given the continuous growth rate, which in
turn is an approximation to the discrete growth rate. This approximation is only
reasonably accurate for small values of g.
Example
Bituminous coal Ot in the U8 1841-1910
Decade Av.annual Ot lny t t(my)
_______________________________________________________
1841-1850 1837 7.5159 -3 -22.5457
1851-1860 4868 8.4904 -2 -16.9809
1861-1870 12411 9.4904 -1 -9.4263
1871-1880 32617 10.3926 0 0
1881-1890 82770 11.3238 1 11.3238
1891-1900 148457 11.9081 2 23.8161
1901-1910 322958 12.6853 3 38.0558
________________________________________________________
Sum 71.7424 0 24.2408
_______________________________________________________
Plotting the log of output against time, we find a linear relationship. So we will
fit a constant growth and estimate the annual growth rate. Setting the origin for
time at the centre of the 1870s and taking a unit of time to be 10 years, we obtain
the t series shown on the table. From the data in the table
 ln y 71.7424
  10.2489
a = n 7

 t ln y 24.2408
b =   0.8657
t2 28
The r2 for this regression is 0.9945, confirming the linearity of the scatter. The
estimated growth rate per decade is obtained from

75
Growth Models: 

Theory & Evidence g  eb  1  1.3768

Thus the constant growth rate is almost 140 per cent per decade. The annual
growth rate (agr) is then found from
(1+agr)10 = 2.3768
which gives agr = 0.00904, or just over 9 per cent per annum. The equivalent
continuous rate is 0.0866 or time as regressor, see Russell Davidsos and James G.
Mackinon. Estimation and _______________ in Econometrics, OUP, 1993 pp
115-118
Growth Rates
Compound rates - geometric growth  continuous compound growth 
exponential growth
vt  vo (1  g )t
v  t
 t   (1  g )
 vo 
1
t
v 
 t   1 g
 vo 
1
v  t
 g   t  1
 vo 
Let vo equal the value of the variable in year 0 (the fast year) & vt equal the value
of the variable t years later. Further, let g equal the average compound annual
growth rate. Then
vt  vo (1  g )t
1
v  t
 g   t  1
 vo 
If the growth rate is continuously compounded, then
vo e gt  vt
vt
e gt 
vo
1 v 
g  ln  t 
t  vo 

Geometric mean growth rate is the same thing as compound growth rate.
Illustrations
Take company X’s sales for 6 years

76
Year (Net sales) Annual growth The Neoclassical
Growth Model
1979 216,283
1980 260,404 20.4%
1981 294,145 13.0%
1982 285,954 -2.8%
1983 303,498 6.2%
1984 318,842 5.1%

Annual growth rate in year t

St  St 1 St
 1
= St 1 St 1

where S is sales. (t=1,2,3,4,5,)

= 1980
The average compound (geometric mean) annual growth rate over the 5 years
from end of ’79 to end of 84’ for Co. X’s net rates is
1
S  t
g   t  1
 So 
1
S  5
  5  1
 So 
1
 318,842  5
  1
 216, 283 
1
 (1.474) 5  1
 1.081  1  .081  81%
The geometric mean growth rate is calculated as
1
n  n

 (1  gt )  1
 t 1 

In the above example,

1
g   (1.204)(1.130)(0.972)(1.062)(1.051) 5  1
1
 (1.474) 5  1
 0.81
The arithmetic mean of the five annual growth rates (arithmetic mean growth
rates)
77
 n
Growth Models:
Theory & Evidence  gt
t 1
g
n
1
 (20.4  13.0  2.8  6.2  5.1)
5
 8.4%

The arithmetic mean growth rate 8.4% is > the geometrics mean growth rate
(8.1%). In fact values all give the same, A.M.G.K. will be > G.M.G.R.
Only if gi-n are constant, will amgv=gmgr.

5.3 THE SOLOW MODEL

5.3.1 Assumptions of the Solow model
1. The economy produces one composite good which can either be
consumed or accumulated as a stock of capital. This is a simplified
picture of reality. while we do not deny that lots of goods are produced in
the economy, we consider, for purposes of building a model – a model,
after all, is a parable or a fable-- only one ‘composite’ or ‘aggregated’
good.
2. Labour supply is homogeneous. In other words, we do not distinguish
between workers with different skills or between say, blue- and white-
collared workers.
3. There is a stock of capital which has been accumulated from the past.
This capital and the labour are the factors of production, inputs to the
production process.
4. The production function exhibits constant returns to scale. This means
that if labour and capital are increased by a certain proportion, say ,
output increases by the same proportion . If labour and capital are
doubled, output is doubled. Thus there is an aggregate production
function which is continuous and which displays constant returns to scale.
5. The labour force grows at an exogenously given growth rate gL = n. Thus
labour force at time t is equal to Lt = L0ent.
6. People save a constant proportion of Income. If S denotes saving then
S = sY. This assumption is the same as in the Harrod-Domar model.
Some people feel that Solow made this deliberately to make a comparison
with Harrod-Domar model.
7. There is no foreign trade
8. The government does not intervene in the economy; there are no taxes or
government purchase

78
5.3.2 Structure of The Model The Neoclassical
Growth Model
Since we have assumed there is no depreciation, we consider the model here in
the absence of depreciation. Later on, we shall discuss the case when there is
depreciation of capital. To begin with consider the aggregate production function.
Y=F(K,L)

We have assumed that there are constant returns to scale. This means that if K &
L are increases by a proportion  , Y increases by the same proportion. The
function F is homogenous of degree one.
Y=F(λK,λL) for all λ>1

For simplicity, let λ= 1

L
Y K L
Then F , 
L  L L
Y K 
Or  F  ,1 
L L 
Let in denote quantities divided by L, by lower-case letters
So y=F(k,1)
Or y=f (k)
This gives output per person as a function of capital labour ratio.
Sometimes income is used synonymously with output. Denoting output by Q and
output-labour ratio by q, we have
q = f(k)
If we draw a picture of above the relationship we can show it as follows:

d
q,g f(k)

k
A ray od to any point d on the curve has a slobe that gives the ratio of output to
Q
Q
capital. This is because the of this ray is  L =
K K
L

79
Growth Models: This is the is verse of capital output ratio v. Each point on the production
Theory & Evidence
function is the slow model is that …………..Harrad-Domar model, l is not fixed
or exogenous different points on the production function show different, capital
output ratios.

Equilibrium Growth

We have k  K
L
Taking natural logarithms (denoted by Ln), we get
K
ln (k)=ln  
L
K
ln k=ln
L
or, ln k=ln K-ln L

Differentiating with respect to figure, gives the proportional growth ratio:

d d d
 ln k    ln k  -  ln L 
dt dt dt

dk 1 dK 1 dL 1
.  . - .
dt k dt K dt L

  
or k  K  L
dK
Now on the right hand side is equal to investment I
dt
Investment = facing in equilibrium. So
dK 
K S
dt
S  SQt (as we have assumed)
dK
So  sQt (t is the subscript denotes Q at a point of time)
dt
dL 1
The Second term on the right hand side is L  . which shows the
dt L
proportional growth rate of labour. Which we have denoted n. So our equation
  
k  K L

can be written
 sQ
k n
K
80
Dividing Q and K by L we get The Neoclassical
Growth Model
 sq sf (k )
k n   n …………………………………………..(A)
k k

This gives k , the rate of growth of k, is term of k itself.

Equation (A) is the fundamental equation of the Solow model.

dk 1 dk
The equilibrium value of k is the one for which . is  0, i.e.  0 or where
dt k dt

k, once it reaches that value, does not change. Setting k  0 in the equation
above, we get
 sf ( k * )
k 0 n
k*
sf ( k * )
or
k*  n
where an * above k denotes its equilibrium value.

The equilibrium q value is obtained as

nk
q q*  f (k *)  nk

or sf (k *)  NK *

f(k)
C/L

sf(k
q*

o k
k*
81
Growth Models: At any point to the left of k*, where k<k*,
Theory & Evidence
f ( k )  n s  k 

This implies
sf (k )
n
k

And from equation (A), we can sea that in this case k  0, which mean that when

k  k *, k increase

Similarly we can show that whenever k>k* ( to the right of k*), k is rising and

where k>k*, k is falling. Thus k* is a stable equilibrium point.
In equilibrium, when k equals k*, q reaches an equilibrium q*. As q* is a
constant,
d 1 dL 1
.  . n
dt t dt t
 
The economy thus converges to a steady state growth where   K and capital
  
output ratio v is constant. However,  and K are not greater than L but equal to
it.
The equilibrium condition in the Solow model
sf (k *)
n
k*
can be written as
Q
n f (k ) q Q 1
   L 
s k k K K V*
L
Where V is the capital output ratio.
S
So we have n  , the Harrod-Domar condition for balanced full employment
V*
growth. However the Solow model allows V to vary and explains how the
economy will turn toward a growth bath along with the Harrod-Domar condition
is and there in the Solow model, the capital output ratio V* emerges as an
equilibrium value, and not as a necessary technology assumption.
CONSUMPTION IN THE SOLOW MODEL
We know that in a closed economy with no government intervention in
equilibrium
Y CI
Where Y is aggregate output , C is aggregate consumption and I is investment.
82
Writing in per-worker ………., we have The Neoclassical
Growth Model
Y C I
 
L L L
Y
We know  y  f (k )
L
C I
So f (k )   …………………………………..(B)
L L
Now consider capital labour ratio

kK
L
dk 1 dK 1 dL 1
We have seen .  .  .
dt k dt k dt L
  
Or k  K  L

Where  denotes proportional growth rate. We had already denoted L by n

So we have
 
k  K n
 
k K  dX
or   n where X denotes Multiplying both sides by K/L we get
k k dt
 
k K K K nK
.  . 
k L K L L

K
or k   nk
L
Alternatively putting it;

K 
 k  nk …………………………………………..(C )
L
Since one of the assumptions we had made was that there is no depreciation,
hence
 dK
k I
dt
So we may write equation (C) as
I 
 k  nK
L
I
In equation (B) we can replace by the right hand side of the above equation.
L
Equation (B) then becomes
83
Growth Models: C 
Theory & Evidence f (k )   k  nK …………………………………………..(D)
L
This equation states the following: Output per worker (since we are taking  as
equal to Y and hence q=y) is put to three uses which are shown on the right hand
C
side. First, consumption per worker ; a portion of investment nk, that
L
maintains the capital labour ratio constant in the face of growing labour force;

and a portion of investment, k which increases the capital labour ratio. When
capital goods increase faster then the increase in labour, so that the capital-labour
ratio rises, it is called capital deepening, while when capital goods rise merely to
keep pace with the rise in labour force so that the capital labour ratio remains
constant, it is called capital widening. Thus output per worker, in equation D, is
divided among consumption per worker, capital deepening and capital widening.
We can arrive at equation D by a different route, from our fundamental equation
of the Solow Model.
Recall that the fundamental equation, equation (A) is
 sf (k ) sq
k n  n
k k

 k
Since k  , hence multiplying the above equation throughout by k, we get
k

k  sq  nk
Recall our assumption that q = y. We have

k  sy  nk
Y  sY
Since y  , we have k   nk
L L
We had made the assumption that S = sY
Now in equilibrium S =Y-C = I
 Y C
Hence we have k    nk
L L
Y
Now switching back in rotation f(k) for , we have
L y
 C
k  f (k )   nk
L
C 
or f (k )   k  nk
L
which is equation (D).

84
What are the basic proposition and conclusion that we get from the Solow The Neoclassical
model? Does it provide some guidelines for studying the growth trajectories of Growth Model
actual economies? We give below some theoretical conclusions that emerge from
the Solow model.
First, given the assumptions as stated earlier, there exists a steady state (balanced
growth) solution for the model. The balanced growth solution is stable. Stability
is there in that whenever the initial values of all the variables, the economy
eventually mark to the study state equilibrium value of y and k. We have already
seen this from the diagram.
The second conclusion we get that the balanced rate of growth (all ……….. grow
at the same rate) is the constant exogenous grow the of labour force, which is n.

THE SOLOW MODEL WITH DEPRECIATION

We know that in absence of depreciation

K  I Here I denote grow investment.
Let us now answer that a certain proportion  K of capital depreciates (through
wear and ………). We can now write

I  K K
Where I now is net investment and  is the constant rate of depreciation of
capital stock.
Dividing by L, we obtain

I K K
  …………………………………………..(E)
L L L
We know from equation (C ), which we …………….earlier, that

K 
 k  nk
L

K
Substituting this expression for into equation (E), we obtain
L
I 
 k  nk   k
L
I 
or  k  (n   )k
L
I S
Writing as ( in equation) and they as sy or sf(k)
L L
 
We have sf (k )  k  (n   )k or k  sf (k )  (n   )k

85
Growth Models:  sf (k )
Theory & Evidence Or k   (n   )
k
This is a modified form of the fundamental equation of the Solow model. The
fasic analysis that we studied, carrier over for the case of depreciating capital; we
merely need to replace n by (n+ ).
Poverty Traps
Empirically, the convergence by pother is has not held up very well. The neo-
clinical model has not been very successful an showing why rates of growth
differ across nations. One fact was staring everyone in the face: many rations of
the world were poor. In a sense, what was going on was the exact opposite of
what was suggested by the convergence hypothesis: Some countries were shifting
stagnant growth, while other were progressing very fact. This idea that the poorer
nations were actually caught is a traphas come to be called poverty trap. It is a
trap because inspite of efforts. These nations stay a low-level ‘equilibrium’.
There are tw o types of poverty traps: technological-Induced and population
induced. They can both be demonstrated in the Solow system.

(a) Technological trap:

If we consider the Solow production function y = f (k), or Y

L  
 F K , and
L
suppose there is a certain range where for certain values of L, K, the production
function exhibits increasing returns to scale, then there will be multiple
equilibrium. For certain values of k, say k* if the economy sports at a level
lower than k*, the economy will slump back towards a very low income and
outp0ut level because the level k* may show a unstable equilibrium.
The idea behind technological trap is that has such a hypothetical country
received an initial injection of capital so as to give a value of k larger k*, it would
have been pushed over the level. This idea is sometimes called the ‘Big push
Theory’of which you will read later in block 4. The idea of poverty trap being
caused by low savings, low technology is sometimes called the vicious circle of
poverty, about which you will read in block 4.
The second way in which poverty traps can arise is induce by population growth.
In the neo-classical model, the rate of population growth was given exogenously.
However for classical writers population growth was given endogenously.
Robertr Methus in his 1798 work, of which you will study in block 4, suggested
that the rate of growth of population depends on per capita income. As per capita
income rises, the rate of population growth rises ever faster. This has come to be
knows as the theory of demographic transition.
We can bring in the idea of demographic transition into the neo classical model.
Recall that is the neo classical model population grows exogenously at a rate n.
………….,now suppose population growth rate is dependent on y, as suggested
by the theory of demographic transition. We know that y is a function of capital

86
per person. y  f (k l ). Thus n, the population growth rate indirectly becomes a The Neoclassical
function of the capital labour ratio: Growth Model

n  g k l 

We may think of some interval k2 – k1 where for values of k below k1, n is <0,
but for values of k in the range [k2, k1] n is >0; again for values of k > k2, n may
become <0. Historically, in olden time in societies where k was below k1,
population was last theory wars, disease etc.
In our analysis, consider the range k2 – K1. Even here, n, although >0, can itself
increase or fall. In other words, although the population is increasing. The rate of
increase may itself vary. The idea is that, this leads to a situation where the
saving (or investment) curve changes shape and may turn out to be S shaped.
Then, we may have multiple equilibrium points of k most of which are unstable:
any movement from these points pushes the system far then away rather than
bringing it back into equilibrium. We have considered the interval (or range of
values between) [k2, K1] . Supposing we can two equilibrium points ka and kb.
Let ka lie between k1 and k2, i.e. k2>ka>k1. Let kb be greater than k2. Here ka is
the stable equilibrium while kb is the unstable one. n is the stable equilibrium
which creates the problem here. For any value of k leather k2, the economy is
pulled back to equilibrium level ka. Only if an injection of capital is gives which
pushed the k level above kb (where the equilibrium is unstable) will the k level
be given a “Big Push” and sent to higher and higher values and thus raising the
level of y via the f-function.
We mentioned the demographic transition which roughly says that n depends
only. But in the last century, due to advance is health care and ……….., low y
did not necessarily lead to low n. As death rates dropped, population increased.
On the other hand sub-Saharan African nation like Ethiopia did see n very low
(other nations are under populated) due to very low levels of y.

5.4 LET US SUM UP

The neoclassical growth model is the central, ‘base-line’ model which has saved
on the spring board for almost all most researches into growth theory. The no-
classical model, associated with the name of Robert Solow, presented the first
major extension to the Harrod-Domar model, by endogenusing the capital output
ratio.
In this unit, we learnt some concepts and tools useful for studying growth theory,
and then we studied the structure of the neo-classical model, along with the
assumptions. We extended the Solow model to consider depreciation and variable
savings. We their process led to apply the Solow model to look at some
applications, like convergence and poverty tragss. We also looked at some
implications of the Solow model namely technical progress is more important
than capital accumulation, and raising the savings ratio in the short run is not
going to help. In the Solow model, technological progress and consequently,
output growth is exogenous. When we get to unit 9 on endogenous growth, we
will look at models that endogenous these.

87
 UNIT 6 ENDOGENOUS GROWTH MODELS
Structure
6.0 Objectives
6.1 Introduction
6.2 Assumptions of New Growth Theory (Endogenous Growth Models)
6.3 Endogenous Growth Models
6.3.1 Arrow’s Theory of Learning-by-doing
6.3.2 TheLevhari-Sheshinski Model
6.3.3 The King-Robson Model
6.3.4 Romer Model
6.3.5 The Lucas Model
6.3.6 Romer’s Model of Technological Change
6.4 Criticism of Endogenous growth models
6.5 Policy Implications for developed and developing countries
6.6 Let Us Sum Up
6.7 Answers to Check Your Progress Exercises

6.0 OBJECTIVES
After going through the Unit, you will be able to:
 Describe the emergence of Endogenous growth models;
 List the assumptions of endogenous growth models;
 Analyse the basic ideas on which these models rest and function in the
context of real world;
 Discuss and evaluate the working of endogenous growth models;
 Identify the limitations of these models; and
 State the policy implications of these models.

6.1 INTRODUCTION
Endogenous growth theory was developed as a reaction to omissions and
deficiencies in the Solow (neoclassical) growth model. It is a new theory which
explains the long run growth rate of an economy on the basis of endogenous
factors as against exogenous factors of the neoclassical growth theory.
The new growth theory of the 1990s was labeled “endogenous growth theory”
because it attempted to explain technical change as the result of profit-motivated
research and development (R&D) expenditure by private firms. This was driven
by competition along the lines of what Schumpeter called product innovations (as
distinct from process innovations). In contrast to the Harrod-Domar model,


Dr Puja Saxena Nigam, Associate Professor, Economics, Hindu College, University of Delhi,
New Delhi
which viewed growth as exogenous, or coming from outside variables, the Endogenous Growth
endogenous theory emphasizes growth from within the system. This approach Models
enjoyed, and still enjoys, an enormous vogue, partly because it seemed to offer
governments a new means of promoting economic growth—namely, national
innovation policies designed to stimulate more private and public R&D spending.
While the neo-classical growth models explain the long run growth rate of output
based on exogenous variables namely rate of growth of population and rate of
growth of technical progress (independent of savings rate), the new growth
theory extends this by introducing endogenous technical progress in growth
models. The Endogenous growth models emphasize on technological progress
resulting from the rate of Investment, size of capital stock and stock of human
capital. The concept of economic growth here is thus, internal to the economy.
The theory is built on the idea that the improvements in innovation, knowledge
and human capital lead to increased productivity, positively affecting the
economic outlook.
The Endogenous growth theory challenges the idea of predicting growth without
incorporating technological advancements. Since economic growth is derived
from the growth rate of economic output per person, it would depend on the
productivity levels and these would in turn depend on the progress of
technological change. The endogenous growth theory considers these factors viz.
innovation and human capital as internal to the economy.
Models of Endogenous growth bear some structural resemblance to their
neoclassical counterparts but they differ considerably in their underlying
assumptions and conclusions drawn. The most significant theoretical differences
stem from discarding the neoclassical assumptions of diminishing returns to
capital investments, permitting increasing returns to scale in aggregate
production and frequently focusing on the role of externalities in determining the
rates of return on capital investments. By assuming that public and private
investments in human capital generate external economies and productivity
improvements that offset the natural tendency for diminishing returns,
endogenous growth theory seeks to explain the existence of increasing returns to
scale and the divergent long-term growth patterns among countries. While
technology still plays an important role in these models, exogenous changes in
technology are no longer necessary to explain long run growth.
The new growth theory reemphasizes the importance of savings and human
capital investments for achieving rapid growth just like Harrod-Domar model,
but it leads to several implications for growth that are in direct conflict with
traditional theory: a) there is no force leading to the equilibration of growth rates
across closed economies, it remains constant or differs according to savings rates
and technology levels and b)there is no tendency for per capita income levels in
poor countries that are capital scarce to catch up with rich countries. The best part
about this theory is that it seeks to explain the anomalous international flows of
capital that exacerbate wealth disparities between rich and poor countries.

89
Growth Models: The potentially high rates of return on investment offered by developing
Theory & Evidence economies with low capital-labour ratios are greatly eroded by lower level of
complementary investments in human capital (education and health),
infrastructure of R&D. Hence, poor countries benefit less from the social gains
associated with these. Since individuals do not internalize these gains by positive
externalities, the free market leads to sub optimal accumulation of
complementary capital in the society. The state can play a key role here by
improving the efficiency of resource allocation by provision of public goods/
infrastructure and encouraging private investments in knowledge-intensive
industries where human capital can be accumulated.

6.2 ASSUMPTIONS OF NEW GROWTH THEORIES

(ENDOGENOUS GROWTH MODELS)
In general, the new growth theories rest on the following basic assumptions
• There are many firms in the market.
• Technological advancement or knowledge is a non-rival good.
• Increasing returns to scale to all factors taken together prevails when constant
returns to a single factor exists.
• Technological advancements come from things people do. It is based on
creation of new ideas.
• Increasing returns to scale in production leads to imperfect competition and
thus, many individuals and firms have market power and earn profits from
their discoveries.
• Emphasis is on the need of the Government to provide incentives and
subsidies for businesses in the private sector.
• Investments should also be made to improve infrastructure and manufacturing
processes to achieve innovation in production.

Check Your Progress 1

1. How does endogenous growth theory explain persistent growth without
the assumption of exogenous technological progress How does this differ
from the Solow model?
2. How is endogenous growth different from exogenous growth?

90
 Endogenous Growth
6.3 ENDOGENOUS GROWTH MODELS
Models
6.3.1 Arrow’s Theory of Learning-by-doing
Learning-by-doing is a concept in economic theory by which productivity is
achieved through practice, self-perfection and minor innovations. Kenneth Arrow
used this concept in his design of Endogenous growth theory to explain the
effects of innovation and technological change. Arrow's classical paper “The
Economic Implications of Learning by doing” published in 1962 showed how
this idea fits into the modern theory of economic growth and used it as a
springboard for a critical consideration of spectacular recent developments. He
introduced the increases in per capita income that cannot be merely explained by
increases in capital-labour ratio. Identifying the role of technological change in
economic growth and providing an explanation of the concept of knowledge
which underlies a production function, he examined how knowledge has to be
acquired.
He therefore suggested an endogenous theory of the changes in knowledge which
underlie inter-temporal and international shifts in production functions. The
acquisition of knowledge called “learning” might be interpreted in different ways
yet it accepted by all schools of thought; learning is a product of experience. It
can only take place through the attempt to solve a problem and therefore, takes
place only during an activity. He generalized from many of the classical learning
experiments that learning associated with repetition of essentially the same
problem is subject to diminishing returns. There is an equilibrium response
pattern for any given stimulus, towards which the behaviour of the learner tends
with repetition. To have steadily increasing performance, then, implies that the
stimulus situations must themselves be steadily evolving rather than merely
repeating.
He emphasized the role of experience in increasing productivity that had yet to be
absorbed into the main corpus of economic theory. He thus, advanced the
hypothesis that technological change in general could be ascribed to experience
that is the very activity of production which gives rise to problems for which
favourable responses are selected over time. Hence, learning by doing is an
example of knowledge accumulation from the production process. As individuals
produce goods, ways of improving production processes happen inevitably. The
improvement in productivity occurs as a byproduct of normal production activity
and not as a result of deliberate efforts.
When learning by doing is the source of technological progress, the rate of
growth/accumulation of knowledge depends not on the proportion of GDP
devoted to R&D but from how much new knowledge is generated by traditional
productive activity. The production function can be written as

Y(t) = K(t)α [A(t) L(t)]1-α ---------------------------------(1)

Where K=Capital, L=Labour, Y=Output, A=Stock of knowledge and α = a

parameter that lies between 0 and 1

91
 The simplest case of learning by doing is found in those situations where learning
occurs as a side effect of the production of new capital. Since, the increase in
knowledge is a function of increasing capital, the stock of knowledge is a
function of the stock of capital. There is only one stock variable whose behaviour
is endogenous here
A(t)=B K(t)β B and β are both greater than 0 --------(2)
If we put this in Equation (1) we get
Y(t)=K(t)α B1-α K(t)β(1-α) L(t)1-α
In the presence of learning, the contribution of capital is larger than its
conventional contribution: increased capital raises output not only through its
direct contribution to production [term K(t)α] but also by indirectly contributing
to the development of new ideas and making all other capital more productive
[term K(t) β(1-α)].
In a simplified form, the model is represented as the following:
Yi = A(K) F(Ki, Li)
Where for a firm i
Yi is output, Ki is the aggregate stock of capital and Li is the stock of labour
A is the technical factor and K represents the aggregate stock of capital
6.3.2 The Levhari-Sheshinski Model
Levhari and Sheshinski have generalized and extended Arrow’s model. They
stress on the spillover effects of increased investment as the source of
knowledge. They assume that the source of knowledge or learning by doing is
each firm’s investment. An increase in a firm’s investment leads to a concomitant
increase in its level of knowledge. An increase in a firm’s investment leads to a
parallel increase in its level of knowledge. The model assumes that the
knowledge of a firm is a public good which other firm can have at zero cost.
Thus, knowledge has a non-rival character which spills over across all the firms
in the economy. This is when each firm operates under constant returns to scale
and the economy as a whole is operating under increasing returns to scale.
This model explains endogenous technological progress in terms of knowledge or
learning by doing that is reflected in an upward raising of production function
and economic growth in the context of aggregate increasing returns being
consistent with competitive equilibrium.
6.3.3 The King-Robson Model
King and Robson in a paper published in 1993 emphasised learning by watching
in their technological progress function. Investment by a firm represents
innovation to solve the problems it faces. If it is successful, the other firms will
adopt the innovation to their own needs. Thus, externalities resulting from
learning by watching are a key to economic growth. This study shows that

92
innovation in one sector of the economy has the contagion or demonstration Endogenous Growth
effect on the productivity of other sectors, thereby leading to economic growth. Models
Multiple steady state growth paths exist, even for economies having similar
initial endowments and policies that increase investment should be pursued.
6.3.4 Romer Model
Romer in his first paper on endogenous growth in 1986 presented a variant on
Arrow’s Model which is known as learning by investment. He assumed creation
of knowledge as a side product of investment. He took knowledge as in input in
the production function of the following form:
Y = A(R) F (Ri,Ki, Li)
Where Y = Aggregate output, A(R) = public stock of knowledge from R&D
Ri = stock of results from expenditure on R&D by firm i , Ki = capital stock of
firm i and Li = labour input of firm i
He assumed the function F is homogenous of degree1 in all its inputs Ri, Ki, Li
and treats Ri as a rival good.
Romer took three key elements in his model: externalities, increasing returns in
the production of output and diminishing returns in the production of new
knowledge. It is the spillovers from research efforts by a firm that leads to the
creation of new knowledge by other firms. New research technology by a firm
spill over instantly across the entire economy. In this model, new knowledge is
the ultimate determinant of long run growth which is determined by investment
in research technology. Research technology exhibits diminishing returns which
means that investments in research technology will not double knowledge. Also,
the firm investing in research technology will not benefit exclusively from the
increase in knowledge. Other firms also benefit from new knowledge due to
inadequacy of patent protection. Hence, the production of goods from increased
knowledge displays increasing returns and competitive equilibrium is consistent
with increasing aggregate returns owing to externalities. Romer took investment
in research technology as endogenous factor in terms of the acquisition of new
knowledge by rational profit maximizing firms.
6.3.5 The Lucas Model
Robert Lucas utilized a model of endogenous growth developed by Uzawa.
Uzawa developed an endogenous growth model based on investment in human
capital. Lucas assumed that investment on education leads to the production of
human capital which is the crucial determinant in the growth process. He
classified this as: internal effects of human capital where the individual worker
undergoing training becomes more productive and external effects which
spillover and increases the productivity of capital and of other workers in the
economy.it is the investment in human capital rather than physical capital that
have spillover effects that increase the level of technology.
Thus, the output for firm i takes the form
93
Growth Models: Yi = A(Ki). (Hi)He
Theory & Evidence
Where A is the technical coefficient
Ki and Hi are the inputs of physical and human capital used by firm i to produce
output Yi
H is the economy’s average level of human capital and e is the parameter that
represents strength of the external effects from human capital to each firm’s
productivity
In the Lucas model, each firm faces constant returns to scale, while there are
increasing returns to scale for the whole economy. Learning by doing or on the
job training and spillover effects involve human capital. Each firm benefits from
the aggregate of human capital. Thus, it is not the accumulated knowledge or
experience of other firms but the average skills and knowledge in the economy
that are crucial for economic growth.
6.3.6 Romer’s Model of Technological Change
In 1990, Romer gave the model of endogenous technological change that
identified a research sector specializing in the production of ideas. This sector
invokes human capital along with the existing stock of knowledge to produce
ideas or new knowledge. The importance of ideas over resources is the
cornerstone of his analysis where he quotes Japan as an example, a country with
few natural resources but open to new western ideas and technology.
In this model, new knowledge enters into the production process in three ways-
a) A new design is used in the intermediate goods sector for the production of a
new intermediate input
b) In the final sector; labour, human capital and available producer durables
produce the final product
c) A new design increases the total stock of knowledge which increases the
productivity of human capital employed in the research sector.
The model is based on the following assumptions:
 Economic growth comes from technological change
 Technological change is endogenous
 Market incentives play an important role in making technological changes
available in the economy
 Invention of a new design requires a specified amount of human capital
 The aggregate supply of human capital is fixed
 Knowledge or a new design is assumed to be partially excludable and
retainable by the firm who invented it (patented design that cannot be
made or sold without the agreement of the inventor) but investment in
R&D can be done by other firms and benefits can be accrued thereof.
 Technology is a non-rival input.

94
  The new design can be used by firms and in different periods without
additional costs and without reducing the value of the input.
 The low cost of using an existing design reduces the cost of creating new
designs.
 When firms make investments in R&D and invent a new design, there are
externalities that are internalized by private agreements.
Technological production function in the model is given by
ΔA=F (KA, HA, A)
Where ΔA is the technology production function for technology ( Δ stands for
change in value; thus ΔA stands for change in technology)
KA is the amount of capital invested in producing the new design or technology
HA is the amount of human capital (labour) employed in R&D of the new design
A is the existing technology of designs.
The production function shows that technology is endogenous. When more
human capital is employed for R&D of new designs, then technology increases
by a larger amount that is A is greater. Since it is assumed that technology is a
non-rival input and partially excludable, there are positive spillover effects of
technology which can be used by other firms. Thus, the production of new
technology (knowledge or ideas) can be increased through the use of physical
capital, human capital and existing technology.
Check Your Progress 2
1. Explain the learning by doing model by Kenneth Arrow?
2. Examine the relevance of Paul Romer’s model of technological change in
explaining long run growth across countries.

6.4 CRITICISM OF ENDOGENOUS GROWTH

MODELS
Many economists have criticized the new growth theory on their respective
considerations, some based on the general suggestion that endogenous growth
theory is not novel, such as
• Scott and Auerbach think that the main ideas of the new growth theory can be
traced to Adam Smith and increasing returns of Marx’s analysis.
• Srinivasan does not find anything new in the new growth theory as increasing
returns and endogeneity of variables have been taken from neoclassical and
Kaldor models of growth.
• Fisher criticizes it for depending only on the production function and steady
state.
• Olson feels that it lays too much emphasis on the role of human capital and
neglects the role of institutions.
• In various models of new growth theories, the difference between physical and
human capital is not clear.
However, a few general limitations can also be highlighted,
• Endogenous growth theory is impossible to be validated through empirical
evidence.
• It is accused of being based on assumptions that cannot be accurately
measured.
• These theories have collectively failed to explain conditional convergence
reported in empirical evidence.
• An important shortcoming of the new growth theory is that it remains
dependent on a number of assumptions of the traditional neoclassical theory
that are often inappropriate for developing and underdeveloped economies.
• In developing countries, economic growth is frequently impeded by
inefficiencies due to poor infrastructure, inadequate institutions and imperfect
capital and goods markets. The endogenous growth theory fails to incorporate
these factors.
• The theory particularly looks at long run growth and ignores short- and
medium-term growth.

6.5 POLICY IMPLICATIONS FOR DEVELOPED

AND DEVELOPING COUNTRIES
• This theory suggests the convergence of growth rates per capita of developing
and developed countries can no longer be expected to occur. The increasing
returns to both physical and human capital imply that the rate of return to
investment will not fall in developed countries relative to developing
countries. Therefore, capital need not flow from developed to developing
countries and actually the reverse may happen.
• The measured contribution of both physical and human capital to growth may
be larger than suggested by the Solow Model. Investment in education or R&D
has not only a positive effect on the firm itself but also spillover effects on the
other firms and economy as a whole. This suggests that the residual attributed
to technological change in the Solow growth accounting may be actually
smaller. Recent growth accounting exercises have suggested that the
percentage of growth accounted for by the 'unexplained residual', is much
smaller for the less advanced economy. This may of course simply reflect
capital in these countries. Alternatively, it may reflect other considerations
generally excluded from growth theory but which possess particular relevance
for the developing economies. Stern (1991) for example, has stressed the
importance of management, organization, infrastructure, and sectoral transfer
as key elements in the growth process of third world economies
• It is not necessary that economies having increasing returns to scale must reach
steady state level of income growth as suggested by Solow-Swan Model. With
positive externalities of Research and Development, growth of income does not
slow down and economy does not reach steady state. An increase in savings
rate can lead to a permanent increase in the growth rate of the economy.
• Countries having greater stocks of human capital and investing more in R&D
will enjoy a faster rate of economic growth. This may be the reason for slow
growth of many developing countries.
• Potentially, it is the less developed economy which stands to gain the most
from international trade becoming freer since by doing so it can draw upon the
stock of world knowledge. But technological flows from rich to poor
economies are by no means automatic which raises the issue of the role of
multinational corporations and how they respond to incentives for
technological transfer. This leads naturally into the question of policy. The
essence of modern statements of endogenous growth is that the technical
progress residual is accounted for by endogenous human capital formation. But
if the latter can be influenced by government policy world growth may be
changed accordingly. For example, if a country possessed of a comparative
advantage in R & D activity were to subsidize research, world growth would
increase. In the same way, a similar subsidy introduced by an economy
relatively more efficient in manufacturing as opposed to innovating may cause
world growth to decline. Trade policies which afford protection to the
manufacturing sector may promote the transfer of skilled labour from research
activity into manufacturing which will retard innovation. Ceteris paribus, trade
policy will affect a shift of resources from research to manufacturing in policy
active countries and in the opposite direction in policy inactive countries.
• Implications also emerge for the international product cycle. Traditionally,
invention and new products occur in the advanced economy where R& D
activity is well developed. Later, either by imitation or technology transfer they
will be produced in the less advanced country and ultimately production of
these goods will migrate to the low wage economy. Accordingly, trade in
manufactured products takes place on the basis of exchange between the latest
innovative goods produced only in the advanced economy and the more
traditional goods now produced predominantly by the less advanced. The
product cycle accounts for an ever-evolving pattern of international trade with
the advanced economy importing the very same goods that initially it exported.
• In the context of the product cycle model, international trade always emerges
as a contributor to faster economic growth in both advanced and less advanced
economies. In the former, the migration of production from the advanced to the
less advanced economy frees resources for use in growth enhancing product
development activity. At the same time, growth occurs faster in the less
advanced economy since the resources needed for learning and adapting the
techniques imported from the advanced economy are far fewer than those
needed for autonomous new product development. In both cases, the
subsidization of learning activities (innovation in the advanced economy,
imitation in the less advanced) may be expected to enhance long run growth
rates.
• Finally, it would appear clear that trade policy has the potential for influencing
long run growth paths for the world economy. However, numerous difficulties
present themselves. The identification of growth influencing knowledge
sectors is itself a major difficulty ex ante if not ex post. Secondly, the fact that
conclusions deriving from the model analysis can be so easily overturned by
the alteration of the conditions or assumptions underlying the analysis - which
for the most part are unlikely to be resolved empirically - weakens one's
confidence in growth prescription. Moreover, in the context of international
trade and the world economy, the outcome and effects of policy measures are
themselves interdependent with the policy actions of others. This would point
to the need for the coordination of national policies or at least the
consideration of second-best outcomes.

An endogenous growth theory implication is that policies that embrace openness,

competition, change and innovation will promote growth. Conversely, policies
that have the effect of restricting or slowing change by protecting or favouring
particular existing industries or firms are likely, over time, to slow growth to the
disadvantage of the community.
Check Your Progress 3
1. What are criticisms of endogenous growth theory?
2. Discuss the policy implications of endogenous growth for developing and
developed countries

6.6 LET US SUM UP

Endogenous growth is long-run economic growth at a rate determined by forces
that are internal to the economic system, particularly those forces governing the
opportunities and incentives to create technological knowledge. In the long run
the rate of economic growth, as measured by the growth rate of output per
person, depends on the growth rate of total factor productivity (TFP), which is
determined in turn by the rate of technological progress. The neoclassical theory
implies that economists can take the long-run growth rate as given exogenously
from outside the economic system. Endogenous growth theory challenges this
neoclassical view by proposing channels through which the rate of technological
progress, and hence the long-run rate of economic growth, can be influenced by
economic factors. It starts from the observation that technological progress takes
place through innovations, in the form of new products, processes and markets,
many of which are the result of economic activities. For example, because firms
learn from experience how to produce more efficiently, a higher pace of
economic activity can raise the pace of process innovation by giving firms more
production experience. Also, because many innovations result from R&D
expenditures undertaken by profit-seeking firms, economic policies with respect
to trade, competition, education, taxes and intellectual property can influence the
rate of innovation by affecting the private costs and benefits of doing R&D.
The central tenets of endogenous growth theory and policy implications thereof
include:
• Government policy’s ability to raise a country’s growth rate if they lead to
more internal competition in markets and help to stimulate product and
process innovation.
• There are increasing returns to scale from capital investment especially in
infrastructure and investment in education, health and communications.
• Private sector investment in R&D is a crucial source of technological
progress.
• The protection of property rights and patents is essential in providing
incentives for businesses and entrepreneurship to engage in R&D.
• Investment in Human capital is a vital component of growth.
 Government policy should encourage entrepreneurship as a means of
creating new businesses and ultimately as an important source of new
jobs, investment and further innovation.

6.7 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1.. See ection 6.1
2.. See ection 6.2
Check Your Progress 2
1. See sub-section 6.3.1
2.. Se sub-section 6.3.6
Check Your Progress 3
1. See section 6.4
2. See section 6.5
UNIT 7 DETERMINANTS OF GROWTH
Structure
7.0 Objectives
7.1 Introduction
7.2 Growth Accounting
7.3 Technology and Growth
7.4 Convergence
7.5 Other Determinants of Growth
7.5.1 Institutions
7.5.2 Geography
7.5.3 Culture
7.6 Path Dependence
7.7 Let Us Sum Up
7.8 Answers/Hints to Check Your Progress Exercises

7.0 OBJECTIVES
After going through this unit you should be able to :
 Explain the meaning of growth accounting;
 Discuss the influence of technology on growth;
 Analyse the concept of convergence and whether empirically growth rates of
developing nations and developed nations are converging;
 Examine the role of institutions, human capital, geography and culture in
determining economic growth; and
 Explain the ideas of path dependence and historical lock-ins.

7.2 GROWTH ACCOUNTING

Total Factor Productivity (TFP) or we may call it productivity is an important
concept in the context of economic Growth of a nation particularly developing
countries. Productivity contributes to industrial growth and to the
competitiveness in international markets. It refers to the rate at which
employment is generated from the employed resources. Increased productivity
result in better utilisation of resources and reduces the cost and the prices of
industrial products, which in turn, lead to a faster growth in demand in both
domestic and international markets. Ever since Robert Solow) decomposed
output growth into the contribution of input growth and a residual productivity
term; the concept has gained popularity and is used as a benchmark to rank firms
or countries. Such rankings get credibility once productivity is correlated with
other indicators of success such as employment growth, export status, or


Saugato Sen, Associate professor, IGNOU, New Delhi
Growth Models: technology adoption. Concept like low productivity is also found useful to
Theory & Evidence predict exit of the firms in an economy, the ultimate performance standard. Its
importance can also be gauged from the attention it receives as a criterion to
evaluate policy interventions or firms’ decisions. The concept has relevance and
different meaning in different branches of economics. In industrial economics,
for example, a large literature investigates the effect of R&D on productivity and
the resulting impact on industry structure. In international economics, the efforts
to evaluate the impact of trade liberalization range from estimating changes in
price-cost margins to productivity changes. Fundamentally, the objective of
productivity measurement is to identify changes in output that cannot be
explained by changes in inputs.
Behind this concept most often stands the understanding that besides the
traditional factors of production labour and capital there is something else that
leads to the increase in production. Usually this ‘thing’ is associated with
technological progress. The latter concept itself can be interpreted in various
ways, but eventually it always implies that the combination of labour force,
machines, human knowledge and skills, leads to changes in total income that are
not expected by changes in capital or labour considered separately.
Growth (increase in GDP) of an economy is generally attributed to factors that
can be clubbed under two broad headings: Capital and Labour. But you will find
when you calculate it that Capital and Labour cannot account for all the growth
and in fact there is a residual factor that comes into play and accounts for the
increase in GDP. This factor is known as Total Factor Productivity. Let us try to
understand it on the basis of an equation:
Y= A ƒ(K,L)
Where Y is the output (GDP), K is the stock of physical capital invested and
L is the labour (number of man-hours). The letter A stands for Total Factor
Productivity.
Total Factor Productivity (TFP) as a concept is also important not only in the
context of macro-economic aggregate measures of a country's performance in
terms of per capita growth and productivity, but is of equal significance in
measuring the determinants of productivity and competitiveness of firms. The
hitherto more popular measure – labour productivity or value added per unit
labour – suffers from the shortcoming that it does not reveal why the
productivity has risen or vice-versa. Is it due to increased inputs of capital, or are
there other causes? The TFP approach while analysing performance, attempts to
go into the WHY of productivity changes and thus gives deeper insights into the
underlying causes and sustainability of growth.
Productivity keeps on changing as production continues. It improves under
favourable circumstances and deteriorates when unfavourable changes occur.
The changes that lead to higher productivity of inputs are technological
improvements, improvement in efficiency, increased education of labour,
improvement in the quality of labour due to training, etc. Today, TFP is
considered an important source of output growth worldwide

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due to rapid progress in science and technology and various efficiency- Determinants of
enhancing measures. Growth

In the equation given above a higher value of A means that the same inputs lead
to more output and vice versa. It shows how efficiently that input is being used
to further the interests of the economy and it is the productivity of the capital
and labour investment. Total Factor Productivity is considered to be the actual
determining factor in the growth of an economy as both capital and labour
cannot continue to be invested indefinitely. Moreover the growth of economy, if
depended solely on capital and labour would decline as soon as these
investments in these inputs are reduced and vice-versa. Thus it is not a stable
growth. Hence increased Total Factor Productivity is the only way that an
economy can maintain a stable growth.
Also, the Law of Diminishing Marginal Returns, tells us that a sustained influx
of Labour and Capital will not achieve long term growth as the value of the
inputs get maximised; they onset to deliver lower returns over a period of time.
Thus the only way growth can be ensured and sustained is to maximise the
efficiency of these inputs and to work on improving the quality and quantity of
returns for the same amount of inputs i.e. to increase Total Factor Productivity.
Productivity is the main reason for economic growth. Some countries do better
than others primarily because they are more productive. Also, the more
productive a country is the better it is able to compete in the world markets as it
can keep cost low while still producing a superior product. A high level of
productivity also increases the standard of living of people in that country as
they would get better outputs for the same inputs i.e. have better quality products
at lower prices.
In order to conduct such an analysis, economists have built up a framework
called growth accounting to obtain a different perspective on the sources of
economic growth. Later we shall discuss that decomposing growth is essentially
a growth accounting exercise. We start with a production function that tells us
what output (Yt) will be at some particular time t is a function of the economy’s
stock of capital (Kt), its labour force (Lt), and the economy’s total factor
productivity (At). If output changes, it can only be because of the change in the
economy’s capital stock, its labour force, or its level of total factor productivity.
We are referring to the Cobb-Douglas form of the production function, which is:
Yt= At ƒ(Ktα, Lt1-α) …………………(1)
In this equation we can see that we would get higher output because of three
reasons – if more number of man hours are put in (higher L), if the people have
more equipment, etc to work with (higher K) or if capital and labour are used more
productively (higher A). The equation at (1) shows that it assumes perfect
competition and the constant returns to scale as depicted by the coefficients of K
and L. If we decompose the growth in output into each of the three elements
allotting 1/3rd of the increase in growth to capital and 2/3rd to labour (which is what
is seen in the most developed countries), the equation then becomes

Yt= At Kt 1/3 Lt 2/3 …………………(2)

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Growth Models: Taking logs the growth in output (Y) is shown by the following equation
Theory & Evidence
lnY = lnA + 0.33 lnK + 0.67 lnL …………………(3)

Where lnY is the growth in output, lnK is the increase in capital, lnL is the increase in
labour and lnA is the increase in Total Factor Productivity (all these are for a particular
time period)

We can also use this equation to calculate growth in output per worker i.e. Labour
Productivity (Y/L). This can be written as

Y/L = A (K/L)1/3 …………………(4)

When we apply the growth in output formula to this equation, it becomes

lnY/L = lnA + 0.33 lnK/L …………………(5)

Where lnY/L is the growth in output per worker, (K/L)/(K/L) is the increase
in the amount of capital per worker and A/A is the increase in Total Factor
Productivity.
Thus equation (5) shows that the output per worker can rise because of two
reasons - increase in Total Factor Productivity and increase in the amount of capital
per worker.
So if we consider a real-world situation in which all 3 — the capital stock, the
labour force, and total factor productivity are changing — then the proportional
growth rate of output is as given in equation (3), which is the key. If we know the
proportional growth rates of output, the capital stock, and the labour force, and if
we know the diminishing-returns-to-scale parameter α in the production function,
then we can use this growth-accounting equation to calculate the (not directly
observed) rate of growth of total factor productivity A, and to decompose the
growth of total output Y into (i) the contribution from the increasing capital stock
K, (ii) the contribution from the increasing labour force L, and (iii) the contribution
from higher total factor productivity A.
Since growth-accounting equation at (3) allows us to break down growth into
components that can be attributed to the observable factors of the growth of the
capital stock and of the labour force, and to a residual factor — often, in fact,
called the Solow residual or a measure of ignorance — that is the portion of growth
left unaccounted for by increases in the standard factors of production. Changes in
the Solow residual or total factor productivity can come about for many reasons
explained earlier. Economists often refer to total factor productivity as
“technology,” but if it is technology it is technology in the widest possible sense.
Not just new ways of constructing buildings, newly-invented machines, and new
sources of power affect total factor productivity, but changes in work organization,
in the efficiency of government regulation, in the degree of monopoly in the
economy, in the literacy and skills of the workforce, and in many other factors
affect total factor productivity as well.
The approach that has been used here in the measurement of total factor
productivity is the so-called growth accounting, which, although being simple with
respect to the computation technique, leads to sufficiently illuminating results.

104
 Determinants of
7.3 TECHNOLOGY AND GROWTH Growth
In the growth models that you studied, particularly Harrod-Domar and the Solow
model, the discussion was carried out in terms of how the output changed as a
result of change in the level of input use. As more of labour and capital was used
the output changed. We also discussed the important role of savings and
investment. However, the production conditions do not stay the same. As
technology improves, as technical progress takes place, inputs can be combined
more efficiently. More output can be obtained from the use of the same level of
input as before, or to produce the same amount of output as earlier, less use of
input is needed. In this section we build upon the discussion in the previous
section where we discussed growth accounting. In this section we discuss what
we mean by technical progress and analyse how technology is an important
determinant of economic growth.
You would have guessed by now that technical change has something to do with
improving the production process, and indeed so it is. We depict the change in
technical level by looking at the production function. Let us suppose for
simplicity that there is one single 'homogeneous' good in the economy. This good
gets produced by using capital and labour. The simplest way to conceptualise
technical progress is to understand that technical progress means that more output
is produced using the same amount of inputs. If you visualise a production
function, you can see that the production function shifting upward over time as
technical progress takes place. Another way to look at technical change
(improvement) is to say that the nature of the production function changed to a
superior one, or that the same amount of output can be produced by using less of
one or more factors than before.
The general way we have used to represent technical change as shifts in the
production function (it may also be depicted as shifts in the position of each
isoquant) can be expressed by bringing in time into the production function
explicitiy. The production function now becomes:
Y = F(K, L, t )
The argument t is a production function shifter.
Although the above formulation is the most geileral way of depicting technical
progress, there is another way of depicting technical change, where technical
progress takes place through shifts in the production hilction even though the
inputs used may not have increased. It is as though the factors of production were
somehow augmented and they are able to produce more output than before.
To understand technical change, we have to bear in mind that there are several
types of technical change. They have mostly to do with the capital-labour
intensity, and by implication, on the relative shares of capital and labour in tile
total product. This has repercussions on the remunerations of capital and labour,

105
Growth Models: that is, on the wage rate and rental of capital. If the capital labour ratio
Theory & Evidence capital intensity) goes up, it is called capital deepening.
Now let us begin our study of the classification of technical change, Before
doing so, let us recall our discussion of factor augmented technical progress.
We introduce a related concept here. Technical change can be embodied or
disembodied. Embodied technical change means that technical change assumes
the form in the change in the type of factor of production, usually capital. In
other words, embodied technical change is embodied in the form of new types
of machines (a new process or new technology).
Disembodied technical progress, on the other hand, means that regardless of the
type of machines, new or old, the same amount of factors can produce greater
amounts of output, or the same amount of output can be produced using lesser
quantities of inputs; in other words, the isoquant shifts inwards. The factor
augmenting technical change that we studied in the previous section is a
depiction of disembodied technical change. For most of this unit, we will have
occasion to consider disembodied technical change. Only in the final section do
we touch upon embodied technical change, and once you grasp the concept, you
will find greater use of the concept in some of the later units. In embodied
technical change, investment in new equipment or new skill is the essential
vehicle of improvements in technique.
Another concept with regard to technical change is neutrality. Neutrality
broadly means that technical change is neither labour saving nor capital saving.
Sir John Hicks looked at technical progress in terms of the effect of technical
change on the ratio of marginal product of capital to that of labour. If after the
technical change the ratio increases, in Hicks's terminology it is to be called
labour saving. If the ratio stays the same it is neutral and if the ratio falls, it is
called capital saving. We can now state the Hicksian classification of technical
progress in the following way: A technical progress will shift the per-worker
production function upward. This technical progress is said to be labour-saving
if at any given value of capital-labour ratio, the ratio of marginal product of
capital to the marginal product of labour has increased. Ifthis ratio decreases for
a given value ofcapital -labour ratio, the technical progress is said to be capital
saving, and if the ratio stays the same it is Hicks neutral.
Sir Roy Harrod put forward a classification of technical progress which was
different from Hicks's classification. He defined as neutral a technical change
one where the capital coefficient (capital-output ratio) does not change in the
presence of a constant interest rate. Broadly, he suggested that if, when the
interest rate is constant, the distribution of the total national product between
capital and labour stays constant, then it is neutral technical progress. If we
consider perfect competition and take interest rate as equal to the rental of
capital and hence equal to the marginal product of capital, then Harrod-neutral
technical progress is a statement about the relationship between capital-output
ratio and the marginal product of capital. Robert Solow's classification of
technical progress is

106
similar to Harrod's and Hicks’s classification except in one respect. Hicks's Determinants of
classification compares points on different per-worker output curves at points of Growth
constant capital-labour ratio and Harrod's scheme compares points on different
per-worker output curves at points of constant capital-output ratio. Solow's
classification compares points on old and new per-worker production at points at
which the labour-output ratio is constant. Thus Solow-neutrality is when at points
where L/Y is constant that is, the relative shares of capital and labour remain
constant. It can be shown that a Solow-neutral technical progress is capital
augmenting.

7.4 CONVERGENCE
In this section we take a look at whether the growth rates and income levels of
developing nations are converging to those of developed nations. The
convergence hypothesis claims that the poorer economies’ per capita incomes
tend to grow faster than those of richer countries. The convergence hypothesis is
also known as the ‘catching up’ hypothesis. The hypothesis is claimed on basis of
the structure and results of the Solow growth, which you studied in unit 5. In this
model, economic growth is driven by the accumulation of physical capital until
this optimum level of capital per worker, which is the "steady state", is reached,
where output, consumption and capital are constant. The model predicts more
rapid growth when the level of physical capital per capita is low; this is
sometimes referred to as “catch up” growth. As a result, all economies should
eventually converge in terms of per capita income. Let us view the facts from
history.
At the dawn of the industrial era, around the middle of the eighteenth century,
average real living standards in the richest countries were no more than about
three times as great as those of the poorest. However since the last two centuries,
a huge gap has emerged in the living standards as well as the rate of growth in
developed nations, and the developing nations. Today, the ratio of average real
living standards of the rich countries to that of the poor approaches 100 to 1.
Economist Lant Pritchett has called this phenomenon of the developed countries
as a whole enjoying a far higher rate of growth than developing nations over the
last two centuries as The Great Divergence.
The 2 centuries of exponential increase in productivity and incomes in early
industrialising countries, and comparative stagnation in most other countries, led
to the “Great Divergence.” Some countries experienced almost no gains during
this long period. Other countries were among those with the highest incomes
throughout this period. Much later, incomes in many other countries where a
majority of the world’s people live began to rise; and then to start closing the gap,
albeit often in fits and starts, and frustratingly slowly, by the turn of the twenty-
first century. Yet many people, particularly in the least-developed countries, still
have seen almost no improvements in living standards. Japan was the first non-
Western country to begin to catch up. China and India, where more than one-
third of the world’s people live, began a period of high growth rates and entered
the catch-up process by the early 1980s, (in the case of China) and early 1990s
(in the case of India).

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Growth Models: How did the enormous change happen? And why did the benefits go for so long
Theory & Evidence only to people in a small part of the world? Why are some countries still making
little progress? And how have many countries finally started to reconverge, in
some cases dramatically? Initially, some of these riches were gained through the
process of colonialism. But as time went on, an increasing majority of the gains
resulted from the productivity advances of the Industrial Revolution.
About 250 years ago, the Industrial Revolution started in England. Production
rose through the progressive application of steam power, water power, and other
technical advances. Countries that industrialised early — in West Europe and
North America — began a transformation that would lead to unprecedented gains
in living standards. There emerged a huge difference in the level of technology
available in Europe and that in other parts of the world. Europe also saw rise in
commerce and trade, other than manufacturing. The process of divergence was
underway.
There was a decolonisation wave from the years after World War II to the
mid-1970s. There was a massive historical and geopolitical change. Yet for
decades following independence of many developing, formerly colonized
countries, several observers found it puzzling that most developing countries
made rather little progress on productivity and incomes.
If the growth experience of developing and developed countries was similar, there
are (at least) two important reasons to expect that developing countries would be
“catching up” by growing faster on average than developed countries. The first
reason is due to technology transfer. Many companies and governments actively
seek to absorb new technologies; in fact, development assistance often attempts to
facilitate this goal, particularly in fields such as public health. Today’s
developing countries do not have to “reinvent the wheel”. They do not need to go
through the process of technological evolution that today’s developed nation did.
This should enable developing countries to “leapfrog” over some of the earlier
stages of technological development, moving quickly to high-productivity
techniques of production. As a result, they should be able to grow much faster
than today’s developed countries are growing now or were able to grow in the
past, when they had to invent the technology as they went along and proceed step
by step through the historical stages of innovation. Economic historian Alexander
Gerschenkron called this process the advantage of backwardness. In fact, if we
confine our attention to cases of successful development, the later a country
begins its modern economic growth, the shorter the time needed to double output
per worker. For example, Britain doubled its output per person in the first 60
years of its industrial development, and the United States did so in 45 years.
South Korea once doubled per capita output in less than 12 years, and China has
done so in 8 years. The second reason to expect convergence if conditions are
similar is based on diminishing returns to factor accumulation. Today’s developed
countries have high levels of physical and human capital; in a production function
analysis, this would explain their high levels of output per person. But in
traditional neoclassical analysis, the marginal product of capital and the
profitability of investments would be lower in developed countries where capital
intensity is higher, provided that the law of diminishing returns applied. That is,
the impact of additional capital on output would be expected to be smaller in a
developed country that already had a lot of capital in relation to the size of its
workforce than in a developing country where capital was scarce.
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As a result, we would expect higher investment rates in developing countries, Determinants of
either through domestic sources or through attracting foreign investment With Growth
higher investment rates, capital would grow more quickly in developing
countries until approximately equal levels of capital and (other things being
equal) output per worker were achieved. However, , in practice, this does not
always happen or happen quickly.
Given either or both of these conditions, technology transfer and more rapid
capital accumulation, incomes would tend toward convergence in the long run as
the faster-growing developing countries would be catching up with the slower-
growing developed countries. Although it is unlikely that incomes would
eventually turn out to be identical, they would at least tend to converge,
conditional upon that is accounting for any systematic differences in key
variables such as population growth rates and savings rates. As we have just seen,
the evidence shows that divergence occurred for two centuries from the start of
the industrial revolution. However, the most recent data demonstrate that, on
average, (re-)convergence is now underway.
The encouraging convergence trend is not inevitable. Potentially, the trend could
be reversed by new technological divides, climate change impacts in some areas,
policies that are bad or serve narrow interest groups, and disasters of widespread
armed conflict. Least-developed countries could remain stuck for other reasons.
Further, these trends in convergence reflect country averages – they do not adjust
for inequality or the presence of extreme poverty.
At the heart of the Solow model is the prediction of convergence, but
convergence is of more than one type. The strongest prediction is called
unconditional convergence. Suppose we postulate that nations, in the long run,
have no tendency to display differences in the rates of technical progress,
savings, population growth, and capital depreciation. In that case, the Solow
model predicts that in all nations, capital per unit of labour will converge to a
common value regardless of the initial state of each of these economies, as
measured by their starting levels of per capita income (or equivalently, their per
capita capital stock).
The exogenous parameters of the model are assumed to be equal, but the initial
level of the capital stock or per capita income is not. The claim of convergence is
then based on the Solow model: its content is that in the presence of similar
parameters governing the evolution of the economy, history in the sense of
different initial conditions does not matter.
Empirically, the assertion of unconditional convergence is even stronger. At the
back of our minds we base such convergence on certain assumptions regarding
the similarity of parameters across countries. However, there is no guarantee that
these assumptions hold in reality, so if we were to find convergence, it would be
a striking finding, not a trivial one.

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 Provided that all the parameters of the Solow model are constant across countries,
convergence across countries is an implication of that model. Consider the
obvious weak link in the prediction of unconditional convergence: the assumption
that across all countries, the level of technical knowledge (and its change), the rate
of savings, the rate of population growth, and the rate of depreciation are all the
same. This notion certainly flies in he face of the facts: countries differ in many,
if not all, these features. Although this has no effect on the Solow prediction that
countries must converge to their steady states, the steady states can now be
different from country to country, so that there is no need for two countries to
converge to each other. This weaker hypothesis leads to the notion of conditional
convergence.
In the literature on economic growth, the term ‘convergence” is sometimes used
in two senses. In the first sense, convergence is taken to mean a reduction in the
dispersion of levels of income among nations. This is called  (sigma )
convergence. The other sense is called  (beta) convergence. Beta convergence
means poor economies grow faster than richer countries. Conditional 
convergence takes place when economies experience  convergence, but
conditional on other variables being constant. Unconditional  convergence is
said to occur when the growth rate of an economy declines as it approaches its
steady state.
Check Your Progress 1
1. Explain the meaning of growth accounting.
2. What do you understand by total factor productivity?
3. Explain Hicks-neutral and Harrod-neutral technical progress
4. Explain the concepts of:
(1) Unconditional and conditional convergence and
(2) Sigma and beta-convergence.

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 Determinants of
7.5 OTHER DETERMINANTS OF GROWTH
In the earlier sections, we have looked at some factors that determine growth, like
accumulation, improvements in total factor productivity, technology and
technological advance. Here we would like to look at some other factors. Some
factors like human capital were considered in unit 6 on endogenous growth
theory. Some other important factors like impact of international trade and finance
on growth will be taken up for discussion in the subsequent course on
development economics.
Most of the economic determinants of growth, like factors of production,
accumulation, technology, productivity growth, and so on, have been viewed by
some economists as proximate causes. However, these economic determinants
may themselves be influenced and impacted by underlying basic causes, some of
which may be non-economic. In this section we study some of these.
7.5.1 Institutions
In recent times institutional economics has assumed considerable importance in
the analysis of developing nations.. Recently, the analysis of exchange using tools
of microeconomics has been sought to be supplemented by institutional analysis.
Even in the study of economic growth, the study of institutions has assumed
importance. . We have studied several theories of growth. We saw recently there
has emerged a group of theories that see growth as determined by processes that
are endogenous. There are differences in factors and endowments among nations,
and this is supposed to explain the differences in economic growth of nations.
Some economists have suggested that the factors which are supposed to cause
economic growth, which are endogenous, are themselves not the causes of, or
explanations of growth. They are actually the characteristics or features of
growth. The main reason for differences in growth performance is differences in
the structure of institutions in various countries. Institutions and differences in
them can account for large differences in the performance of countries.
What are institutions? Douglass North, a Nobel Prize winner in economics defines
institutions by referring to them, as “the rules of the game in a society or, more
formally, are the humanly devised constraints that shape human interaction.” He
suggests that institutions shape the constraints in interactions among people.
These interactions may be economic, social or political. Economic institutions
such as property rights and the degree of perfection of markets influence the
structure of economic incentives in society. Economic institutions also determine
how efficiently allocations will be allocated in society. Thus it is important to
realise that not only are institutions important but also that they are endogenous.
One new strand in economic thought looks at changes in property rights and
transaction costs having a great impact on economic development. This view is
exemplified by the works of Ronald Coase and Douglass North. Another strand
has sought to use the recent developments in information economics, like
asymmetric information, imperfect information, moral hazard, adverse selection,
signalling and screening, to understand how institutions affect development. They
see institutions as filling in gaps in the economy created by missing and
incomplete markets, presence of risk, and asymmetry of information. They have
used this, for instance, to model agrarian institutions, for instance on these lines.

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Growth Models: This is seen in works of economists like George Akerlof and Joseph Stiglitz.
Theory & Evidence Interestingly, all four economists have won the Nobel Prize.
The transaction costs school contends that as transaction costs change,
institutions emerge to minimise these transaction costs. This is the basis of
development. Transaction costs include costs of negotiation, monitoring,
coordination, and enforcement of contracts. When transaction costs are high,
allocation of property rights becomes crucial. Contracts come to be determined by
property relations when transaction costs are high. In the development process
there may emerge a trade-off between economies of scale and transaction costs.
In simple face to face interaction transaction costs may be low but production
costs are high because specialisation and division of labour is limited. The
transactions cost school also believes that changes in relative prices cause
institutional changes.
The information economics school cast their theories in more rigorous terms and
explicitly bring in notions of equilibrium. In addition, institutional quality affects
the amount and quality of investments in education and health, via the mediating
impact of inequality. In countries with higher levels of education, institutions
tend to be more democratic, with more constraints on elites. The causality
between education and institutions could run in either direction, or both could be
caused jointly by still other factors. It is important to understand why and how a
certain institution emerges, and what purpose it may be serving. Even an
institution that appears to be negative may be serving some purpose. It is
important to realise this to explain its persistence. The institution may not be
optimal, indeed, may be dysfunctional and may still persist. It is necessary to
observe if there are regularities in the evolution of institutions, as this gives rise to
conventions.
7.5.2 Geography
At first glance, geography seems to have had a major influence on development. It
is perhaps not a coincidence that many of the poorer nations are situated around
and near the Equator. Very hot climate saps the energy to work, so workers’
productivity is affected. Low productivity leads to low income, and many of low-
productivity workers may not be able to afford adequate amount of nutritious
food. Low nutrition levels can further diminish productivity.
Moreover, geography also influences economic development through the factor of
location. Geographical factors may lead to industries and factors to be located, or
not to be in productive regions. Similarly agriculture, urbanization and some
other aspects of the economy can also be affected by geographical condition.
Economists have started paying greater attention to geographical factors.. First,
in the very long run, very few economists doubt that physical geography,
including climate, has had an important impact on economic history. Geography
was once truly exogenous, even if human activity can now alter it, for better or
worse. But the economic role played by geography, such as tropical climate, today
is less clear. Some research suggests that when other factors, notably inequality
and institutions, are taken into account, physical geography adds little to our
understanding of current development levels. However, some evidence is mixed.

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For example, there is some evidence of an independent impact of malaria and Determinants of
indications that, in some circumstances, landlocked status may be an impediment Growth
to economic growth. Indeed, a direct link from geography to development out
comes is argued by some economists,
7.5.3 Culture
Cultural factors may also matter in influencing the degree of emphasis on
education, postcolonial institutional quality, and the effectiveness of civil society,
though the precise roles of culture are not clearly established in relation to the
economic factors
The idea that culture is a determinant of national wealth is an old one.
Sociologist Max Weber had argued that the rise of a “Protestant ethic,” which
celebrated hard work and the acquisition of wealth, led to an explosion of
economic growth in northern Europe starting in the 16th century. More recently,
economists have pondered over whether the rapid growth of such countries as
Taiwan, Singapore, and South Korea can be explained by their adherence to
“Asian values,” a term coined by The Economist magazine in 1980. Despite these
examples, however, economists have generally not seen culture as a determinant
of development, contrary to anthropologists, sociologists, and historians.
Economists do not wish to analyse culture as it is hard to quantify.
If we have to show that culture is important for economic growth, we have to
show first that culture has potentially important aspects that vary among
countries and second, that these aspects of culture significantly impactt economic
outcomes. Both these things are difficult to show as culture is hard to measure.
Not only does culture have many different dimensions, but even when we restrict
ourselves to a single aspect of culture, we often lack any objective (much less
quantitative) measure and have to rely on the observers’ subjective assessments.
Similarly, in some cases there is direct evidence of culture’s economic effects,
whereas in other cases such effects can only be inferred.
We can just touch upon a few aspects of culture and how it influences economic
growth. Some individual aspects of culture: openness to new ideas, belief in the
value of hard work, saving for the future, and the degree to which people trust
one another. Some broader characterizations of culture could be social capital,
conventions and so on. These broader characterizations will be discussed on the
subsequent course on development economics. Let us discuss some individual
characteristics:
1. Openness to new ideas: Scholars who have examined the historical process
of economic growth have often stressed the importance of a society’s openness to
importing new ideas from abroad. Many of the technologies used in any particular
country were invented in other countries, so a country that more readily adopted
technologies from abroad would be more technologically advanced.
2. Hard work: Throughout human history, in every culture, almost all adults
have had to work to survive. But cultures have differed in their view of that work:
as a necessary evil or as an activity with an intrinsic value. We would expect that
in cultures where work was viewed as good in and of itself, people would work
harder and produce more output.

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 3. Saving rate: A country’s economic growth is strongly affected by its saving
rate. We also saw that there are large differences in saving rates among countries.
If cultural differences among countries affected their saving rates, then these
differences could in turn affect the level of economic growth.
4. Trust: Economic interactions often involve reliance on a person to keep his
word. Without trust, economic activity would be reduced to a crude level, and
huge resources would have to be devoted to making sure that people came through
on their promises. Society would lose the advantages gained by creating complex
organizations — for example, allowing people to specialize in specific tasks or
exploiting gains from trade. Obviously, a society in which one could not rely on
others to hold to their commitments would be poorer.
7.6 PATH DEPENDENCE
We have studied in an earlier section that one of the issues in economics of
development is whether nations converge to a common growth rates. Statements
about convergence tend to include propositions about parameters like investment De
and saving and their relationship with growth. We saw in the previous section that
institutions too have a profound impact on the development process. We can now
ask, is history itself important? What if a country’s history itself, coupled with
people’s expectations about the future, determines not only the institutional
framework but also the parameters of the growth process like saving and
investment? We are looking at the persistence of certain patterns over long periods
and asking why is such persistence present?
People often speak of ‘historical forces’. The question is, how do we take these
into account? One view is that the course of economic development is determined
to a considerable degree on the earlier choices that were made, the basic path that
was chosen. The development process is path dependent. Path Dependence theory
postulates that when we consider the performance of an economy, its position at a
certain point of time depends on the whole sequence of events. The whole path is
important. We need to look at the entire history of the process.
Some economists have put forward the suggestion that certain inferior outcomes
may have got locked-in by historical events. You have studied in the
microeconomics course that equilibrium is usually the result of economic agents
choosing actions and making decisions while acting rationally by maximizing
some objective function. Such equilibria are optimal. However, in reality some
inferior outcomes can sometimes emerge and, moreover, may persist. It is these
situations that path dependence theory addresses. The question it asks is Why do
these situations arise, and how? Moreover, why do they sometimes tend to
continue? Why do rational decision- makers who are supposed to make optimal
choices not take corrective measures? The interesting thing is that these inferior
outcomes emerge even when superior alternatives exist and are available.
One way how this works is through complementarities and network externalities.
We shall explain these concepts with some examples from technology. The
common typing keyboard layout in typewriters and computers usually has the
letters Q, W, E. R. T. Y.... on the top row and this is called a QWERTY-type
keyboard. Now, the earliest typewriters were mechanical gadgets where, when a
key was struck, a lever with the imprint of the letter would rise and strike the
typewriter ribbon that, because it contained the fluid or the ink, the letter would
form on the page. If 2 or 3 keys were hit with quick succession the lever would
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jam. The QWERTY keyboard was designed in such a way as to minimise the
possibility of such jamming by placing the keys that were likely to be struck in
quick succession in terms of spelling of words of the English language were
placed far apart. Thus the QWERTY keyboard was designed to slow down speed.
An alternative keyboard design introduced in 1932 was realised to be better at
promoting speed when it was found that typists trained in the Dvorak system were
regularly beating typists trained in the QWERTY system at speed typing tests.
The question is, why do we then find the inefficient QWERTY-type layout in
most keyboards? The answer is that the QWERTY layout had a historical
advantage of emerging first. Given that firms and organisations hired typists
coming out of typing schools. Given that these typists were already trained in
QWERTY-type keyboard, any individual firm would have found it very costly to
invest in retraining its typists on the Dvorak system. There is now a clear
divergence between individual costs and social gains. This occurs in this case
because there are complementarities and network externalities. Externalities take
the special form of network externalities because of the complementarities. Let us
explain further what network externalities mean. You have already read in the
section of market failure what externalities are. Network externalities mean that
the cost or benefit of adopting a technology or product depends on how many
people already adopted the same technology or product. Say you plan to buy a
mobile phone, because among other uses, you think that sending and receiving
SMS messages would be very useful. But if only two or three other people whom
you know have a mobile, this feature is not going to be too useful. Surely, the
more of your friends and acquaintances already have a mobile, the more useful it
would be to you. This is an example of network externalities. This is very
important in Information and Communication Technology (ICT) like e-mail.
So, to come back to the QWERTY example, we find that complementarities and
network externalities create a situation where a suboptimal choice is made and it
tends to persist. The important thing to realise is that if we were to look at the
average cost (AC) curves (recall from your microeconomics course what these
look like) of the Dvorak system and the QWERTY system, we will find that the
Dvorak system, because it is more efficient, will have its curve downward sloping,
and everywhere below the AC curve of the QWERTY system, which would of
course be downward sloping because of scale economies. But for an individual
firm which wants to make a switch from QWERTY to Dvorak, the relevant costs
(in the two curves) to be compared are at different points corresponding to the
horizontal axis, which measures the number of units (typists trained). On the
QWERTY curve, the point is far too much to the right since QWERTY has been
around for a long time and many typists with QWERTY type training are there.
To switch to Dvorak system, we have to consider a point close to the origin on the
horizontal axis, because it will be first typist for the individual firm .so this point,
on the Dvorak curve will be too much to the left and be of higher average cost
than the QWERTY point.
Although some economists and historians of technology do not agree that the
QWERTY system is inefficient as compared to the Dvorak system, the basic idea
should be clear. There are other such examples. In the 1980s, the format for
videotapes chosen was the VHS although the Betamax system was demonstrably
superior In computer software, although other operating systems may be available,
and may even be superior or cheaper or both, because of complementarities and
network externalities, Windows operating system has become the standard.
Similarly in the case of microprocessors, although other chips like AMD and Determinants of
RISC chips are available, Intel chips have become the industry standard. The Growth
upshot of the discussion is that we find that because of complementarities and
network externalities, there may be multiple equilibria.
Which equilibrium gets chosen — and it may be the inferior one, depends on the
path chosen by history. When complementarities are present, there may occur
historical lock-ins. the same idea can be understood in terms of widespread
coordination failure where large-scale investment does not take place because
other complementary investments are not forthcoming. Because of coordination
failure, each investment is not made because other complementary investments
are not made. Investments would be made if each investor expects others to
invest. Coordination then depends on the expectations of investors. The problem
of coordination can be solved to a great extent if linkages can be created among
various sectors of such a developing economy
Check Your Progress 2
1. What are institutions? Discuss some ways in which institutions determine
economic growth.
2. How do geographical factors influence growth?
3. How do individual aspects of culture impact economic growth?
4. Explain the concepts of path dependence and historical lock-ins.

7. 6 LET US SUM UP
This unit was the last unit in this Block, which dealt with economic growth. The
first four units had focused on various theories and models of growth, while the
current one extended the discussion of the previous four units and sought to
identify the actual determinants of growth.
The unit began by discussing growth accounting. This allows us to break
economic growth down into the proportion that is caused by individual factors of
production like labour and capital, and the proportion that can be attributed to
technological growth. Proceeding ahead, you learnt about the nature of
technology. The unit explained what is meant by embodied and disembodied
technical progress. You were also acquainted with neutral and non-neutral
technical progress. The unit went on to discuss the idea of total factor
productivity, and how productivity is related to efficiency.
Following this, the unit discussed the very important concept called convergence.
In unit 2, you had learnt about development gap between rich countries and
developing nations. This unit examined whether the developing countries are
catching up with the rich ones. The unit explored the idea of whether faster rates
of growth of developing countries as compared to the developed ones will lead to
the convergence of growth rates. The unit discussed about the concept of relative
and absolute convergence..
Finally, the unit briefly discussed certain other determinants of growth. These are
largely non-economic in nature like institutions, geography, and culture,. The
unit suggested that these are often underlying factors that may influence
economic determinants of growth, and as such may be considered as indirect,
albeit underlying determinants of economic growth.
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 7.7 ANSWERS TO CHECK YOUR PROGRESS
EXERCISES
Check Your Progress 1
1. See section 7.2
2. See section 7.3
3. See section 7.3
4. See section 7.4
Check Your Progress 2
1. See sub-section 7.5.1
2. See sub-section 7.5.2
3. See sub-section 7.5.3
4. See Sub-section 7.6.4

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 BLOCK 3 INEQUALITY AND POVERTY
BLOCK 3 INTRODUCTION
The third block of the course is titled Inequality and Poverty. In the first block,
you had studied about the basic idea of what is meant by economic growth and
economic development and the relationship among them. Also you were
acquainted with comparisons among nations The second block familiarized you
with growth models and with the factors that determine growth. This third block
takes up the important issues of inequality and poverty.

The block has two units. The first unit, unit 8 is titled Inequality. The unit
discusses about the concept of inequality, various axioms related to inequality,
and various ways to measure inequality. The title of the next unit, unit 9 is
Poverty. Like the previous unit did about inequality, this unit, too deals with the
concept , measurement and some other issues, but with regard to poverty in this
case.
UNIT 8 INEQUALITY
Inequality

Structure
8.0 Objectives
8.1 Introduction
8.2 Concept of Inequality
8.2.1 Economic Inequality
8.3 Axioms of Inequality
8.4. Measures of Inequality
8.4.1 Personal Distribution
8.4.2 Functional Distribution
8.5 Inequality and Development
8.5.1 Kuznets' Inverted-U Hypothesis
8.5.2 Gary S. Fields' Prediction
8.6 Let Us Sum Up
8.7 Answers/Hints to Check Your Progress Exercises

8.0 OBJECTIVES
After going through this Unit, you should be in a position to:
 Explain the concept of inequality;
 Identify the axioms of inequality;
 Discuss the measures of inequality;
 Critically examine the measures of inequality; and
 Explain the relationship between economic growth and inequality

8.1 INTRODUCTION
Distribution of income in a country has always been an important topic of debate
in all the nations. Economic growth in a country indicates country’s development
but this is not a sufficient indicator of development. If the economic growth
distributes the income in a country more unequally, then there is a role of the
government to try and mend it in a manner that the distribution is more equal than
unequal. We begin with understanding the concept of inequality, in particular the
economic inequality. Afterwards, the axioms which need to be met by the
appropriate inequality index are discussed. There are various indexes which
measure the inequality, some of them are explained. Finally, we discussed the
relation of economic growth and inequality.

8.2 CONCEPT OF INEQUALITY

Why would one be interested in understanding the inequality in the resource
(income/wealth) distribution? There are two reasons: philosophical and ethical

Dr. Nidhi Tewathia, Assistant Professor, School of Social Siences, IGNOU
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Inequality and grounds for aversion to inequality per se and the functional reason.The
Poverty philosophical and ethical grounds meanthat the individuals having different level
of access to lifetime economic resources should not be treated differently for that
reason. Descendants have to face the consequences of the ancestors’ limited
economic resources. On the other hand, parents’ right to bequeath their wealth to
their children also leads to some individual inheriting more than sufficient
wealth. So, it is like two sides of the same coin. Bequeathing wealth seems to be
a good way as well as an unfair means to perpetuate inequality. If one does not
care about inequality at an intrinsic level and just cares about the overall
economic growth, we say that the person cares about inequality at the functional
level. It means the reason for caring about inequality is because inequality has an
impact on economic features which one cares about.
There are many economic interpretations, ideological and intellectual stances of
inequality. Its definition may depend on what stance one takes. Which way one
divides the given cake would be parallel to the way an actual income distribution
deviates from a benchmark for distributing income. Hence, there is a scope of
having different views about the degree and size of inequality, its relevance and
attached policies.
Income conditions are often used as a good proxy for understanding economic
conditions because income is positively correlated to the living standards and
other wellbeing indicators. But only the income inequality does not shape up the
economic inequality. Inequality of opportunities is as important as inequality of
outcomes; they both are related as well. Let us take an example of an individual
who is talented but cannot afford good education which means he is facing
inequalities of opportunities. As a result, he is likely to have a low-income level
which indicates inequality of outcomes.
8.2.1 Economic Inequality
Economic inequality is the fundamental cause that provides diverse choices one
individual and denies to another. It is related to the concepts like lifetime,
capabilities, political freedom, contribution to society. Let us look at few
situations which show us this: There are two individuals, one earning more than
the other but living in a country which denies him freedom like right to vote or
travel. Similarly, one individual earning more than the other till a specific age
and after that earns less than the other individual. So, economic inequality cannot
be well-defined. It depends on whether we are choosing to look at the distribution
of current income, distribution of wealth or distribution of lifetime income. The
current income shows the inequality at a point of time and such inequalities, if
are temporary, are not damaging either from the ethical point of view or the
effect on economic systems point of view. For example, there are two countries
having only two levels of incomes prevailing: in country A $2,000 per month and
$3,000 per month. In country B the income levels are $1,000 per month and
$4,000 per month. Income is more dispersed in country B as compared to country
A. If we look at the average income, it is same in both the countries. Let us say in
country A, people enter their working life at one of the 2 levels of income but
stay there forever. In country B people exchange their jobs each month between
the low-paid job and the high-paid job. If we measure inequality at any one point
in time, country A seems to be more equal but in terms of average yearly income,
each individual earns same amount in country B. It means sticky or fluid jobs
have an implication on understanding the real scenario of income distribution.
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Now let us look at inequality from another perspective. Beyond the importance Inequality
we give to how much people earn we should also try to look at not only how it is
earned. Having this perspective as a background, let us understand what is
functional and personal income distribution. Functional distribution is all about
the returns to different factors of production, such as labour with various skills,
capital equipment of different kinds, land, and so on. These factors of production
are not owned by the individuals in a society in an equal proportion. A given
household receives different categories of income. The pattern and magnitude of
the ownership of factors of production decides the flow of the various categories
of income to a household. Some households will receive only wage income as
they own only their labour. But some households will receive rent, profit and
wages as per their ownership of all three factors of production. When we
combine the functional distribution of income with the distribution of factor
ownership, we reach at the personal distribution of income which describes
income flows to individuals or households and not to the factors of production.
So, we can say that the functional distribution tells us about the relationship
between inequality and growth and for our understanding of economic
inequalities, it is imperative that we understand both how factors are paid and
how factors are owned.

8.3 AXIOMS OF INEQUALITY

We talk a lot about an egalitarian society but it is not an easy endeavour. At a
given time one is facing various alternative income distributions and which one is
relevant and appropriate is a big challenge. The measures of inequality tell us
how to measure but how to rank or order these measures is also to be understood.
Using axioms help to choose among different inequality indexes. The measures
themselves will be discussed in the next section. So, axioms are some desirable
properties or characteristics which these inequality measures/indexes should
possess. Alternate measures then will be able to be compared based on these
axioms. Let us now discuss the axioms which are desirable to be met by the
inequality measures. If the criterion is weak then many inequality measures will
be able to meet that criterion and vice versa.
Axiomatic approach to choose measurement of inequality indicates that we
choose an inequality index because it meets some desirable properties. The 4
axioms which should be possessed by a measure of inequality are: (i) the
anonymity principle; (ii) scale independence principle; (iii) population
independence principle, and (iv) transfer principle.
i) The anonymity principle: this principle states that the inequality measure
does not identify and classify the individuals in to different classes like rich,
poor, good and bad. The measure possessing this axiom will be silent about the
quality of the people.
ii) The scale independence pr inciple: this axiom indicates that size of the
economy does not dominate the measure of inequality. It means that the measure
shall not be based on the fact whether the economy is rich or poor, overall. The
dispersion in the income in the economy is of the interest and not the magnitude.
iii) The population independence principle: this axiom demands that the
measure should not be based on the number of people who receive income. It
means that the measure needs to be independent of the size of the population.
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iv) The transfer principle(the Pigou-Dalton principle): this axiom requires the
inequality measure to change when income transfers occur among individuals in
the income distribution. This means that with a progressive transfer (income
transfer from rich to poor), the inequality index should fall and vice versa in case
of regressive transfers (income transfer from poor to rich).
Check Your Progress 1
1) What do you understand by the term ‘Inequality’? Explain.
2) Discuss Economic inequality.
3) Explain any two axioms which should be possessed by the inequality
measures.
A perspective was discussed in section 8.2, i.e., looking at the concept of
inequality from the lens of personal income distribution and the functional
distribution of income. This section discusses the measures of income inequality
from that perspective.
8.4.1 Personal Distribution of Income
This approach considers the total income earned by an individual. All the
individuals earning same annual income will be considered in the same income
group even if they have invested different number of work hours to earn that
income. Location-based and occupational sources of income are not considered.
An individual earning larger personal income will be considered in higher income
group. Overtime, various measures of inequalities have been developed keeping
personal distribution of income approach in mind. Few are discussed below:
1) Lorenz Curve
Lorenz curve is the most common and widely known measure of income
inequality. An American economic statistician, Prof. Max D. Lorenz proposed this
curve. He utilised this curve to measure disparities in the distribution of income.
This curve is a cumulative frequency graph. It is applied to present data relating to
the population and the wealth distribution in a country. The population and income
components are needed to construct this curve. The figures are required in
percentage terms and then arranged in to a cumulative frequency distribution.
From the origin a straight line is drawn which ends at the coordinate of 100
percent income and 100 per cent of population. This straight line is known as the
Line of equal distribution. This line acts as a benchmark to measure how much of
inequality exists in a country. If actual distribution of income in a country is
coinciding with the line of equal distribution, then it means the country faces no
inequality of income. As the actual distribution curve keeps deviating from the
line of equal distribution, the income inequality keeps rising in a country. Farther
the actual distribution curve from the line of equal distribution, more is the income
inequality.In Figure 8.1, Y-axis represents cumulative percentage of income is
andX-axis representscumulative percentage of population.We draw the line of
equal distribution by joining the 100 per cent points on both the axes. The figure
shows two Lorenz curves for two countries i.e.,country A and country B. The
LorenzCurve relating to country B is further away from the line of equal
distribution ascompared to country A. Hence, we can infer that there are more
disparities in the distribution ofincome in country B than in country A.
 Inequality
100

Line of equal

Cumulative % of Income
distribution

Country B

Country A

0
Cumulative % of Population 100

Fig.8.1 Lorenz Curve

We can observe that the Lorenz curve possesses the principles of anonymity,
population, and relative income, because the curve does not utilise any
information on income or population magnitudes but only retains information
about income and population shares. But there are two problems with it. Mostly
the researchers of policy makers need to look at inequality in the form of a
number because that is more concrete and quantifiable as compared to a graph.
Also, any kind of inequality rankings cannot be provided by the Lorenz curves if
they cross.This means that an inequality measure that provides us with a number
for the income distribution would be perceived as a complete ranking of income
distributions. It would mean that in some situations, inequality measures tend to
disagree with one another.
2) Quintile Distribution
There is away to somewhat handle the non-numerical part of Lorenz curve. The
same underlying information on distribution can be presented in a numerical
format. World Bank favours the idea of arraying the income distribution by
population quintiles (20per cent of the population). For example, the poorest 20
per cent of India's population earns 8 per cent of the total income or the richest
quintile earns 41.4 per cent and so on. When comparing two countries, if one has
greater percentage share of income accruing in at least one quintile below the
highest and is at least equal in the other three below the highest, the country is
said to have 'Lorenz dominance', or to 'Lorenz dominate' the other country.
3) The range
It is a very simple measure to calculate. First, we find out the difference in the
incomes of the richest and the poorest individuals. This difference is then divided
by the mean to remove the dependence on the units in which income is measured.
This is a rather crude measure. It pays no attention to people between the richest
and the poorest on the income scale. From the perspective of the axiomatic
approach, it fails to satisfy the Dalton principle.
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Let us see this with the help of an example. Suppose a small transfer from the
second poorest goes to the second most rich individual. This transfer will keep
the range measure unchanged. Ideally the regressive transfer should lead to a fall
in the inequality index/measure. But we can use the range if the detailed
information on income distribution is missing. It proves to be quite useful.
4) The Kuznets ratios
In his pioneering study, Simon Kuznets introduced developed these ratios of
income distributions in developed and developing countries. These ratios are
basically one step advanced than the quintile distribution. These ratios refer to the
share of income owned by the poorest x% of the population divided by the richest
y% of the population, where x and y stand for numbers such as 10, 20, or 40. If
the ratio is high, it means society is more equal. These ratios come in handy in
situations where detailed income distribution data are missing.
5) The mean absolute deviation
This is the measure that takes advantage of the entire income distribution. It has a
simple idea behind it i.e., inequality is proportional to distance from the mean
income. Hence, we take all income distances from the average income (mean
income), and add them up. Then divide the addition by total income to present
the average deviation. This average deviation will be a fraction of total income.
It is useful to express the deviation in terms of an absolute deviation denoted by
M as the absolute value ignore sthe negative signs. It looks a promising measure
as it takes into account the overall income distribution but it has one drawback: it
is often insensitive to the Dalton principle. Let us see how. Assume there are two
people with the incomes A and B. A is below the mean income of the population
and B is above the mean income of the population which means A < B. If a
regressive transfer (a transfer from poor to rich) takes place, then the inequality
measured by M will rise because the distance of both A and B will go up. Till
now the inequality measure is faring well. Now let us take another case. We take
any two incomes A and B but this time they both are above the mean income of
the population. Again, the regressive transfer takes place from A to B. Let us say
the transfer was small enough so that after the transfer also both the income
levels A and B are above the mean income. There will be no difference in the
sum of the absolute difference from mean income. So, the mean absolute
deviation will not register any change in such a case, and hence the Dalton
principle fails. The Dalton principle is meant to apply to all regressive transfers,
not just those from incomes below the mean to incomes above the mean.
6) Coefficient of Variation
Coefficient of variation (CV) is a relative measure of dispersion of data points
around the mean. It is measured asfollows:
CV = X 100
If we want the measure in the form of decimal then we remove the multiplication
of coefficient by 100. The multiplication by 100 provides us with is the
percentage. This measure require that the income is normally distributed.
Coefficient of variation presents the extent of deviation from the normal
distribution of income. Larger the coefficient of variation, greater will be
inequality in the distribution of income and vice versa.
7) Gini Coefficient Inequality

This measure of inequality is widely used and is a measure of the relative degree
of income inequality in a country. The Gini approach starts from a fundamentally
different base. Instead of taking deviations from the mean income, it takes the
difference between all pairs of incomes and simply totals the (absolute)
differences. It is as if inequality is the sum of all pairwise comparisons of “two-
person inequalities” that can possibly be made. It can be obtained by calculating
the ratio of the area between the line of equal distribution (diagonal 45º line) and
the Lorenz curve divided by the total area of the half-square in which the curve
lies. In Figure 8.2, this is the ratio of the shaded area to the total area of the
triangle BCD, i.e.,

Gini coefficient =

A D

Line of equal
Cumulative % of Income

distribution

Lorenz Curve

B C
Cumulative % of Population
Fig. 8.2 Gini Coefficient
This ratio is known as the Gini Concentration Ratio or the Gini Coefficient, after
the Italian statistician C. Gini, who first formulated it in 1921. It very closely
related to the Lorenz curve Recall that the more “bowed out” the Lorenz curve,
the higher is our intuitive perception of inequality. It turns out that the Gini
coefficient is precisely the ratio of the area between the Lorenz curve and the 45°
line of equal distribution, to the area of the triangle below the 45° line.Gini
coefficients are aggregate inequality measures which can vary from 0 (perfect
equality) to 1 (perfect inequality). It is generally found that if the Gini coefficient
lies between 0.5 and 0.7, then the distribution is a highly unequal distribution.
And if the Gini coefficient is in the range of 0.2 to 0.5, then those countries have
relatively equitable distribution. The Gini coefficient meets all four principles
and is therefore Lorenz-consistent, just like the coefficient of variation.
8.4.2 Functional Distribution
The functional distribution or factor share distribution represents the percentage
of income received by one factor of production in comparison to the income
received by other 3 factors of production. In particular it’s the share of labour
127
in total income compared to the share of total income received in the form of Inequality
rent, interest and profits. The significance of this measure is that it attempts to
explain the income of a factor input in terms of the contribution the factor makes
to the total output. The unit prices of each factor of production are reached at
with the help of supply and demand curves. Each factor market has it own market
where its supplied and demanded. At the equilibrium in these factor markets we
receive the equilibrium prices and quantities of these factors. Factors receives
their rewards on the basis of their function. The drawback of this approach is that
it fails to consider the role and influence of non-market forces on the factors of
production. Non-market forces are those which influence the equilibrium of the
market but not directly like the bargaining power of the trade unions which affect
the wage rate, power of monopolists who manipulate the prices of capital or land.

8.5 INEQUALITY AND DEVELOPMENT

Debate on the relationship between economic development and income
inequality has always prevailed. The effect of economic growth on poverty
depends on the level of economic inequality existing in a country. Economic
growth increases the income inequality if it benefits the rich in a country which
already has high inequality. On the other hand, if the inequality reduces due to
well targeted policies, then the poverty reduction goal seems to be achievable.
Hence, it is important that we understand the link between income inequality
and economic development. The literature on the economic development-income
inequality nexus in industrial societyalso places emphasis on the causes of current
social inequality. But we will explain two main studies which describe what
happens to the distribution of income as a result of economic growth in a country.

8.5.1 Kuznets' Inverted-U Hypothesis

Simon Kuznets, an economist, proposed a particular relationship between the
income distribution and economic growth. He explains the journey of income
inequality when an economy develops from a primarily rural agricultural society
to an industrialized urban economy. He said that the relationship is of an inverted
U. This inverted U curve is known as the Kuznets' curve. The same has been
presented in Figure 8.3.We observe that at the initial levels of economic growth,
the income inequality widens. Afterwards, the inequality stabilises at a given level
of economic growth, and finally falls in the advanced stages of growth.
Y
Degree of Income Inequality

Stage of Economic Development X

Fig.8.3Kuznets’ Curve
129
Inequality and Kuznets says that the widening of income inequality in initial stages of growth is
Poverty due to the structural changes an economy goes through as the growth takes place.
The urban sector receives more weight during that time so the economic activity
takes place in favour of the urban sector characterised by higher productivity. But
in the later stages of economic growth, the relation reverses. As a country
industrialises, the center of the economy shifts from rural areas to the cities as
rural laborers, such as farmers, begin to migrate seeking better-paying jobs.Due
to the influx of rural migrants to the urban areas, the rate of growth in urban
labour becomes high. When the rate of expansion in the urban-high productivity
sector is higher than the increase in the rate of growth of the urban labour force,
the income differentials will reduce as the population in rural areas fall. But this
stage may never be achieved by the nations which experience high rate of
population growth. Early evidence suggests that developing countries appear to
have higher inequality, on average, than their developed counterparts.

But today, the world looks very different than it did in 1955 when Kuznets
proposed the inverted U relationship. In the past decades, economic inequality in
the United States and other wealthy/developed nations has risen sharply which
has induced a renewed the quest to know how the changes in income
distributions affect economic wellbeing. Over the same time period, economic
inequality has persisted and even grown in many poorer economies.
8.5.2 Gary S. Fields's Prediction
Gary S. Fields has offered predictions about how the inequality will behave as
the economic growth takes place. He found the Lorenz curves very relevant and
has used them for his predictions. He discusses three different situations:1)
traditional-sector enrichment growth typology; 2) modern-sector enrichment
growth typology, and 3)modern-sector enlargement growth.
1) Traditional-Sector Enrichment Growth Typology
As the name suggests, the traditional sector workers receive the benefits of
growth, while there is little or no growth taking place in the modern sector. This
kind of pattern will be noticed in those countries which have low incomes as well
as low growth rates and choose to work towards reduction of absolute poverty.
This kind of growth leads to higher-income and hence a more equal relative
distribution of income as well asless poverty. Diagrammatically, it means that the
Lorenz Curve shifts uniformly upward. This new shifted curve will be closerto
the line of equality as shown in Figure 8.4.
2) Modern-sector Enrichment Growth Typology
This kind of growth limits its benefits to the people who are engaged in the
modern sector. The wages and number of workers in the traditional sector
remains more or less constant.It is easy to foresee that this kind of growth results
in higher income only for those who are associated with the modern sector and
that leads to a less equal relative distribution of income andnearly no change in
poverty. Diagrammatically, this growth moves the Lorenz curve
uniformlyoutward and further from theline of equality as shown in Figure 8.5.

130
 Inequality
10 10
% of Income

% of Income
0 % of Income Recipients 0 % of Income Recipients
10 10

Fig. 8.4 Fig. 8.5

FIGURE 8.4 AND 8.5 SHIFTING LORENZ CURVES

3) Modern-sector Enlargement Growth

This is the case, the two-sector economy is developed by increasing the size of
modern sector but maintaining constant wages in both sectors. This is the case
depicted by Lewis model. You will study about Lewis model in course BECC
114. In this type of growth, absolute poverty is reduced, but the Lorenz curves
will always cross and hence we cannot say with certainty about the changes in
relative inequality. Fields believes that if this pattern of growth experience is
predominant, inequality is likely to increase in the initial stages of development
and then it may decrease. This is shown in Figure 8.6.In the figure two Lorenz
curves intersect each other. This happens because the poor who remain in the
traditional sector have their incomes unchanged, but these incomes are now a
smaller fraction of the larger total, so that the new Lorenz Curve, L2, lies below
the original Lorenz curve, L1, at the lower end of the income distribution scale.
Workers associated with the modern sector receive the same absolute income as
before, but now the share received by the richest income group is smaller, so that
the new Lorenz curve lies above the original one at the higher end of the income
distribution scale. Therefore, somewhere in the middle of the distribution, the
new and the original Lorenz curves must cross.

131
Inequality and
Poverty 100

% of Income L1
L2

0
% of Income Recipients 100

Fig. 8.6 Crossing Lorenz Curves

In a nutshell, Gary Fields says,

• with traditional-sector enrichment inequality would fall gradually;
• with modern-sector enrichment, inequality would rise gradually;
• with modern-sectorenlargement, inequality would first fall and then rise.

Check Your Progress 2

1) Explain what is Lorenz Curve with the help of a diagram.
2) Discuss the following measures of inequality: a) Range b) Coefficient of
variation.
3) What was the hypothesis presented by Simon Kuznets? Discuss his work
in relation to inequality and economic growth.
4) Mention the drawbacks of any two inequality measures.
5) Explain the functional distribution measure of inequality.

8.6 LET US SUM UP

Inequality is a concept which has to be dealt by all the countries. We began the
unit by discussing the concept of inequality with specific reference to economic
inequality. The personal income distribution and functional distribution are two
perspectives from which we can understand the concept of inequality. To
measure the inequality, one needs some kind of measures. These measures will
be able to justify their role only if they meet certain axioms. We explained four
axioms (the anonymity principle; scale independence principle; population
independence principle, and transfer principle) which are very important in order
to measure inequality in any country.
132
 Inequality
Afterwards we discussed the measures such as the Lorenz curve, Gini coefficient
at length. The relationship of economic growth and inequality was also examined
with the help of famous Kuznets curve predictions of Gary S Fields. The
economic growth increases the inequality initially and at later stages of growth,
the inequality reduces.

8.7 ANSWERS/HINTS TO CHECK YOUR

PROGRESS
Check Your Progress 1
1) Refer section 8.2
2) Refer sub-section 8.2.1
3) Refer section 8.3

Check Your Progress 2

1) Refer sub-section 8.4.1
2) Refer sub-section 8.4.1
3) Refer sub-section 8.5.1
4) Refer sub-section8.4.1
5) Refer sub-section 8.4.2

133
UNIT 9 UNDERSTANDING POVERTY
Structure
9.0 Objectives
9.1 Introduction
9.2 Concept and Meaning of Poverty
9.3 Types of Poverty
9.4 Poverty Line
9.5 India’s Poverty Line Estimation
9.6 Poverty Alleviation Programmes in India
9.7 Let Us Sum Up
9.8 Answers/Hints to Check Your Progress Exercises

9.0 OBJECTIVES
After going through this Unit, you should be in a position to:
 Explain the concept of poverty and its various dimensions;
 Identify the characteristics of poor ;
 Discuss the poverty line (national and international);
 Critically explain the recommendations made by various poverty expert
groups ;
 List a few poverty alleviation programmes in India

9.1 INTRODUCTION
In the year 2000, the General Assembly of the United Nations adopted a set of
Millennium Development Goals which contains eight such goals. The first one
itself is to eradicate extreme poverty and hunger. This indicates that poverty
reduction is the prerequisite for any country which wants to provide its citizens
with good quality of life. In this unit, we first discuss the concept of poverty. This
Unit begins with explaining the various approaches to the concept of poverty and
its types. Various correlates of poverty and characteristics that are widely shared
by poor individuals are explained. Further the concept of poverty line has been
discussed followed by the progression of India’s Poverty Line estimation. A
critical view has been taken up in order to provide you the complete picture of
the recommendations of various committees which were constituted for the task
of poverty estimation in our country. The unit concludes by discussing the main
poverty alleviation programme of India: Integrated Rural Development
Programme.


Dr. Nidhi Tewathia, Assistant Professor, School of Social Siences, IGNOU
Inequality and
Poverty
9.2 CONCEPT AND MEANING OF POVRTY
We always welcome the economic growth that spreads its benefits equitably
among the population. If the growth is distributed unequally then it needs to be
assessedin terms of equity. First, there exists an inequality of world income
distribution and then there is the inequality of income distribution within a
country. If a country is under developed then the most visible characteristic of
that country will be the existence of poverty. It is not easy to describe poverty
and its related dimensions (illiteracy, hunger, ill health, capability deprivation),
head on. Poverty is like a threat to the existence of individuals who are poor. It
destroys the aspirations, hopes and potential joy of good health and nutrition.
Poverty also indicates the absence of productive asset holdings, like possession
of land. Hence, the basic implication of poverty is that the poor will lack access
to markets, particularly the markets for credit, insurance, land, and labour. The
absence of collateral restricts their access to credit markets. This leads the
individual to the Poverty Trap. This trap makes it very difficult for a poor
individual to escape poverty as some amount of capital possession is required in
order to escape. Low wages, low work opportunities, inability to pay for
education are all causes of poverty trap. Poverty trap is a spiral which forces
people to remain poor.
Poverty as a concept is of high significance, both intrinsic and functional.
Further, it holds importance from the policy making view as well. It is a common
knowledge that a fundamental goal of economic development and of all
governments is the removal of poverty. Hence, the characteristics of the poor
need to be understood well. That helps in structuring the appropriate measure of
poverty by the policy makers. Poverty is also an outcome of economic
development which needs to be dealt with through various policies.
One view of looking at the concept of poverty is in relation to economic growth.
As a result of economic growth, the average consumption and average income
rise. It impacts poverty as the distribution of income and consumption will
change. If everyone’s income increases then we can say that the poverty reduces.
But if the economic growth only increases the incomes of the rich (still meaning
that the average income is increasing), no reduction in poverty will take place. In
fact, the distribution of income widens.
Another perspective to look at the concept of poverty is through the work of
Amartya Sen. His work is based on the relation of poverty with capability
deprivation. Individuals are deprived of capability building if they are poor. For
example, poverty denies the opportunity to gatherthe school experience which
would lead to yet another type of poverty. Such individuals will not beable to
read and write. That means they will not be able to participate in the activities
which need literacy. Only those individuals who are literate will be able to
capture the benefits of those opportunities. It is also important to look at poverty
as per the society/economy where the individual lives. Individuals are also poor if
they lack resources to participate in the society where they live, even if they have
136
enough incomes to lead their life nicely in some other society. But poverty is not Poverty
only the inadequacy of income, its domain is much wider. Poverty not only
includes not having enough income to guarantee adequate food, clothes, or
shelter, but also being unhealthy, as well as being denied access to education,
political participation in the society.International institutions like the World Bank
and the United Nations go beyond the measurement of the number of people
whose income is low. They, in addition,give importance to health, such as infant
and child mortality rates and the life expectancy, and to participation in
education. This means that the poor people in the world are poorer, and rich
people are richer because income is positively related with the above-mentioned
aspects of well-being. So, we can say that the Africans, in addition of having less
money have lower life expectancy and low level of educationas compared to
Europeans and Americans. If we look at a within country scenario, same holds.
Within acountry, poorer people are more likely to be malnourished and
unhealthy, to lose their babies and to have low life expectancy. This within
country scenario is true for both the rich countries of Europe as well as the poor
countries of Asia and Africa. Hence, to gain a wider view of poverty, a more
complete picture of deprivation and inequality should be considered.

9.3 TYPES OF POVERTY

Depending upon different viewpoints, poverty can be analysed as follows:First
classification refers to the type of base information used:Objective and
Subjective poverty; Second is depending on the scale or reference used to set the
thresholds:Absolute and Relative poverty; Third is based on the length of
duration of poverty: Transversal poverty (in a fixed year) and Persistent poverty
(Long term).
The studies which use the information directly collected by a researcher in terms
of the measurement of various variables are called Objective poverty studies. The
direct observation of a researcher provides high degree of objectivity. The
commonly used variables by researchers are household income and household
expenditure.On the other hand, the perception of the individuals or households
about their own self converts into Subjective poverty studies. Information on the
opinion of these individuals or household is used to understand poverty. Such
studies influence the subjective view on poverty as opposed to the objective
focus.
Absolute povertyindicates a situation when an individual is not able to afford
basic goods and services like food, housing and clothes. It is also linked to
destitution. It is difficult to find ways of measuring absolute poverty. Relative
poverty places the concept of poverty in relation other people around. A person is
considered poor when he/she is at a disadvantage (financially or socially) as
compared to other people in their environment. This idea of poverty is closely
linked to the notion of inequality. A person’s income level or affordability may
change over time. Hence, poverty is not a static phenomenon.Individuals move in
and move out of poverty. So, it is crucial to conductdynamic poverty studies
137
Inequality and which analyse a population considering the various changes and transitions that
Poverty
take place over a period of time. This is the context of persistent or long-term
poverty analyses.In European Union countries, a person is considered persistently
poor if they have been classified as poor in the last year and at least during two of
the three previous years.Transversal poverty studies deal with a fixed time period
for which the analysis is carried out.
Another type of poverty is from a completely different perspective. The poverty
studies based on this perspective focus on multi-dimensional deprivation i.e.,
analyses based mainly on the impossibility of access to certain basic consumption
elements. This perspective has been discussed in the previous section. Such
studies mainly stress on the social exclusion of an individual due to poverty in a
multi-dimensional manner.
Check Your Progress 1
1) Discuss the various features of poverty.
.......................................................................................................................
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.......................................................................................................................
.......................................................................................................................
2) How is poverty related to capability deprivation?
.......................................................................................................................
.......................................................................................................................
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.......................................................................................................................
3) Explain any two types of poverty.
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9.4 POVERTY LINE

At the core of the concept of poverty is a notion which is called a poverty line. It
is a critical threshold ofincome, consumption, or access to goods and services.
Individuals falling below this lineare declared poor. For example, to reach at an
estimate of the poverty line, we will need data on minimum nutrient levels which
make an adequate diet. Once that is done, we will use the prices of those food
items which provide those nutrients and the cost of clothing and shelter at a
minimum level to find out the total expenditure needed to fulfil these needs. This
total expenditure needed for fulfil the basic requirements will act as an estimate

138
of the poverty line in a given society. We can say that the poverty line is an Poverty
indicator of the minimum level of economic participation in a given society at a
particular time. The minimum wage in a given country is a legally decreed
estimate of a poverty line.
Link between hunger and poverty is strong. Many countries have nutrition-based
poverty lines. United States estimates poverty line based on food requirements. In
India, the poverty line estimate is based on the food expenditure necessary to
afford the minimum consumption of calories.It is a tradition to set the poverty
line as per the cost of a particular standard of living given a country. A major
component of poor’s income gets spent on the food requirements. So, if they do
not have enough money, it would mean like sleeping without sufficient food.The
general norm which many countries follow when they estimate the poverty line,
is by looking at a calorie norm of around 2000 calories a day. But this estimate is
gender and work sensitive. As agricultural labour works physically harder, so in
that case the calorie norm is revised upwards. Similarly, separate standards are
employed for men, women and children.The association of food and poverty
looks like an attractive one.Not only because poor people spend majority of their
budget on food, but also because this association gets more support politically for
the antipoverty programs which involve food as compared to the programs based
on goods which are seen as less admirable. The right to food is more convincing
than the right to other consumer goods.
Over the time, the basic concept of poverty line has remained the same but the
line is revised incorporating the inflation levels. Using the data for the year 2005,
the World Bank estimated the International Poverty Line (IPL), a global absolute
minimum, at the $1.25 per day figure. It was updated in the year 2008 to $1.25 a
day at 2005 purchasing-power parity (PPP). It was mainly revised due to
inflation. Further, in 2015, the World Bank updated the IPL to $1.90 per day.As
per the World Bank, in 2017, an estimated 9.2 percent of the global population
still lived below the international poverty line of $1.90 a day, which is based on
poverty lines in some of the poorest economies in the world. The COVID-19
pandemic has reversed the gains in global poverty for the first time in a
generation. About 120 million additional people are living in poverty as a result
of the pandemic (April 2021).
It is also important for us to realise that the concept of poverty line always uses
approximations and proxies. The threshold thus arrived at is fuzzy in nature. The
year after year deprivation shows its cumulative effect in later years. There are
some other issues with the concept of poverty at the fundamental level, e.g.,
should income or item-by-item expenditure be used to identify the poor, are
notions of the poverty line “absolute” or “relative,” is poverty temporary or
chronic, should we study households or individuals as the basic unit, and so on.

139
Inequality and
Poverty
9.5 INDIA’S POVERTY LINE ESTIMATION
This section provides the progression Poverty Estimation in India, post-
Independence. The Planning Commission constituted various expert groups time
to time to estimate the number of people living in poverty in India.
1. Working Group (1962): For the first time, the poverty line in India was
quantified in 1962 in terms of a minimum requirement which included
food and non-food items, for individuals in order to lead a healthy life.
This Group formulated rural and urban poverty lines at 20 and 25 per
capita per month respectively (in terms of 1960-61 prices). The Group did
not consider any regional variation while formulating these lines. This
poverty line also excluded expenditure on health and education as it was
assumed to be taken care of by the state. So, in 1960s and 1970s these
poverty lines were used to find out the state of poverty at national and
state level.

2. Study by VM Dandekar and N Rath (1971): These two economists are

responsible for laying the foundation of India’s poverty line through their
seminal work by establishing the minimum calorie requirements. This
was not a study commissioned by the Planning Commission. They
established the first consumption levels required to meet a minimum
average calorie norm of 2,250 calories per capita per day. Their study was
systematic wherein they utilized the National Sample Survey (NSS) data.
Their poverty line was based on the expenditure required to procure 2250
calories per day in both rural and urban areas. They found poverty lines to
be Rs. 15 per capita per month for rural households and Rs. 22.5 per
capita per month for urban households at 1960 61 prices.

3. Task Force on “Projections of Minimum Needs and Effective

Consumption Demand” headed by Dr. Y. K. Alagh (1979): This Task
Force was constituted in 1977 and it submitted its report in 1979. Official
poverty counts began for the first time in India based on the approach of
this Task Force. Poverty line was defined as the per capita consumption
expenditure level to meet average per capita daily calorie requirement of
2400 kcal per capita per day in rural areas and 2100 kcal per capita per
day in urban areas. Based on 1973-74 prices, the Task Force set the rural
and urban poverty lines at Rs. 49.09 and Rs. 56.64 per capita per month at
1973-74 prices.

4. Lakdawala Expert Group (1993): Until the 1990s, no attempt was made
to consider differences in prices or differences in consumption patterns
across states or over time, w.th respect to poverty lines estimation.
Poverty estimates were revised with each quinquennial NSS survey. Price
indices were used to adjust for price changes over time. This
methodology for estimating poverty was considered inappropriate by
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 some, in giving a representative picture of the incidence of poverty in the Poverty
country. So, in 1989, The Planning Commission constituted the
Lakdawala Expert Group with a particular reason of looking into the
methodology for estimation of poverty and to re-define the poverty line, if
needed. The Expert Group did not redefine the poverty line and
recommended to carry on with the separate rural and urban poverty lines
based on minimum nutritional requirements. But the Expert Group
disaggregated these poverty lines into state-specific poverty lines in order
to reflect the inter-state price differentials. It suggested that the poverty
lines should be updated using the Consumer Price Index of Industrial
Workers (CPI-IW) in urban areas and Consumer Price Index of
Agricultural Labour (CPI-AL) in rural areas rather than using National
Accounts Statistics. These recommendations were taken up by the
Planning Commission. The Commission adopted the practice of
calculating poverty levels in rural and urban areas in the states using
state-specific poverty lines together with the national estimates from 1997
to 2004-05. But over the years, this method lost the credibility. There
were many flaws in the price data. Hence, the successive poverty lines
failed to preserve the original calorie norms.
5. Tendulkar Expert Group (2009): To review the methodology used for
poverty estimation, in 2005, another expert group chaired by Suresh
Tendulkar was constituted. Mainly, it was constituted to address the three
key shortcomings of the previous methods: (i) Poverty estimates based on
the 1973-74 poverty line baskets (PLBs) of goods and services did not
reflect significant changes in consumption patterns of poor over time; (ii)
Issues with the adjustment of prices for inflation, across regions and
across time; and (iii) the assumption that only the state will provide for
health and education. The Tendulkar Committee suggested a shift from
calorie-based norms to target nutritional outcomes for poverty estimation
and poverty lines. Further, the committee recommended a uniform all-
India urban PLB across rural and urban India instead of two separate
PLBs for rural and urban poverty lines. It also recommended to
incorporate private expenditure on health and education in order to
estimate poverty. The monthly household consumption expenditure was
broken up into per person per day consumption, which resulted in the
figure of Rs 32 and Rs 26 a day for urban and rural areas. The national
poverty line for 2011-12 was estimated at Rs. 816 per capita per month
for rural areas and Rs. 1,000 per capita per month for urban areas.
6. Rangarajan Committee (2014): The Tendulkar committee made the urban
poverty line of 2004-05 the new national poverty line on the grounds that
it was “less controversial” than the current rural poverty line and it
fulfilled the requirement of statistical consistency over time. This
increased the number of rural poor.This new poverty line was also
justified on the grounds that it also provided for minimum nutritional,
141
Inequality and health and educational outcomes. These justifications were not enough to
Poverty
stand up to the scrutiny. Due to such criticism as well as due to changing
times and aspirations of people of India, Rangarajan Committee was set
up in 2012. This Committee submitted its report in June 2014. It again
started the previous practice of having separate all-India rural and urban
poverty line baskets and deriving state-level rural and urban estimates
from these. Also, it recommended separate consumption baskets for rural
and urban areas which include food items that ensure recommended
calorie, protein & fat intake and non-food items like clothing, education,
health, housing and transport. This committee raised the daily per capita
expenditure to Rs 47 for urban and Rs 32 for rural from Rs 32 and Rs 26
respectively at 2011-12 prices. Monthly per capita consumption
expenditure of Rs. 972 in rural areas and Rs. 1407 in urban areas is
recommended as the poverty line at the all-India level. The government
did not take a call on the report of the Rangarajan Committee. Rangarajan
committee missed the opportunity to go beyond the expenditure-based
poverty rates and examine the possibility of a wider multi-dimensional
view of deprivation.
Some states such as Odisha and West Bengal supported the Tendulkar Poverty
Line while others such as Delhi, Jharkhand, Mizoram etc. supported Rangarajan
report. The current official measures of poverty are based on the Tendulkar
poverty line. They are fixed at daily expenditure of 27.2 in rural areas and
33.3 in urban areas and are criticised by many for being too low.
7) Task Force by Niti Ayog (2015): The Task Force deliberated the issue of
whether a Poverty Line is required. The report of the Task Force was submitted
in July, 2016. The task force suggested four options for tracking the poor: i)
Continue with the Tendulkar poverty line; ii) Switch to the Rangarajan or other
higher rural and urban poverty lines; iii) Track progress of the bottom 30% of the
population; iv) Track progress along specific components of material poverty
such as nutrition, housing, drinking water, sanitation, electricity and connectivity.
The advantage of the level of expenditure as an indicator of poverty is that it is
directly observable and it closely correlates with poverty along different
dimensions. So, while there are additional complementary approaches to tracking
poverty, none of them can substitute the poverty line-based approach.

9.6 POVERTY ALLEVIATION PROGRAMMES IN

INDIA
There are many poverty alleviation programmes in India which target the rural
poverty mainly, as the prevalence of poverty is more in rural India. The
programmes include many wage-employment programmes, self-employment

142
programmes, food security programmes, social security programmes, skill India Poverty
programmes. A brief list of such programmes is as follows:
 Jawahar Gram Samridhi Yojana
 National Old Age Pension Scheme
 National Family Benefit Scheme
 Annapurna Scheme
 Pradhan Mantri Gramin Awaas Yojana
 Mahatma Gandhi National Rural Employment Guarantee Act
(MGNAREGA)
Apart from these, a major programme started by India to alleviate rural poverty
is Integrated Rural Development Programme (IRDP). It aims to alleviate rural
poverty by providing income-generated assets to the poorest of the poor. This
programme started in 1978-79. Its main aim is to identify the families which are
below the poverty line and raise them by creating sustainable self-employment
opportunities in the rural areas. Such families are provided with term credit by
commercial banks, cooperatives and regional rural banks. The programme
gathers 50% funds from the centre and the remaining 50% from the states. The
target group are the individuals who earn less than 11,000 (as defined by the
Eighth Five-year plan). To make the programme well targeted, it has stipulated
well defined proportions for the scheduled caste families, scheduled tribe
families, women and physically challenged persons among the total assisted
people/families. Ministry of Rural Areas and Employment is responsible for the
release of central share of funds, policy formation, overall guidance,
monitoring, and evaluation of the program.
Check Your Progress 2
1) Explain the concept of Poverty Line.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
2) Discuss the progression of the International Poverty Line.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

143
Inequality and 3) What were the recommendations of The Tendulkar Committee and how
Poverty
are they different from the recommendations made by the Rangarajan
Committee?
4) Why was the Tendulkar committee criticised for their recommendations?
5) Enlist a few Poverty alleviation programmes of India?

9.7 LET SUM UP

Poverty is not merely the lack of money. It is the absence of one or more of the
basic capabilities that are needed to achieve minimal functioning in the society in
which one lives.But largely, the measurement of poverty is based on thenotion of
a poverty line, which is constructed from monetary estimates of minimum needs.
In this Unit, we discussed the various approaches through which poverty can be
looked at (monetary, food, capability deprivation). We explained the various
types of poverty (Absolute, Relative, Objective, Subjective, Transversal and
Persistent). Afterwards, the constitution of poverty line was discussed at length.
The poverty line estimates minimum basic requirements in terms of their cost.
We critically explained the recommendations of various expert
groups/committees which were constituted for India’s poverty line estimation. In
the end, we briefly discuss the main poverty alleviation programmes in India.

9.8 ANSWERS/HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1 Check Your Progress 2
1) Refer to section 9.2 1) Refer to section 9.4
2) Refer to section 9.2 2) Refer to section 9.4
3) Refer to section 9.3 3) Refer to section 9.5
4) Refer to Section 9.5
5) Refer to Section 9.6

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BLOCK 4 POLITICAL INSTITUTIONS AND
FUNCTIONING OF THE STATE

BLOCK 4 INTRODUCTION
The final block of the course is titled Political Institutions and Functioning of
the State. In the first block, you had studied about the basic idea of what is
meant by economic growth and economic development and the relationship
among them. Also you were acquainted with comparisons among nations. The
second block familiarized you with growth models and with the factors that
determine growth. The third block discussed the important issues of inequality
and poverty.

The present block has three units. The first unit of the block, unit 10, is titled
Institutions and Evolution of Democracy. The unit discusses alternative
institutional trajectories and their relationship with economic performance. The
unit also discusses within-country differences in the functioning of the State
institutions and the relationship between democracy and development. The title
of the next unit, unit 11 is Theories of Regulation. This unit discusses the
concept of economic regulation and examines the arguments for regulation. It
also describes two broad theories that explain and discuss economic regulation.
Finally the unit shows how sometimes the economic organizations or firms that
are being regulated, themselves capture the regulatory process and get benefits
from the regulation process. The final unit of the block, which is the final unit of
this course, unit 12 is titled Government Failure and Corruption. The unit
examines the role of state in the economy, particularly the economy of a
developing nation, in response to market failure, and also to perform certain roles
that may be particularly required for developing nations. The unit also discusses
how in certain situations the government may ‘fail’ in terms of creating outcomes
where economic efficiency is reduced. Finally the unit discusses a problem that
plagues the institutional and government functioning in several developing
nations, namely, corruption.

147
 UNIT 10 INSTITUTIONS AND DEMOCRACY
Poltical Institutions
and the Functioing of
the State
Structure
10.0 Objectives
10.1 Introduction
10.2 Institutions and Evolution of Democracy
10.3 Alternative Institutional Trajectories
10.3.1 External Government Institution
10.3.2 Private Property Rights
10.3.3 Community Institution

10.4 Functions and Pre-requisites of an Institutions

10.5 Institutional Trajectories and Economic Performance
10.5.1 Institutions in India and Economic Growth

10.6 Let Us Sum Up

10.7 Answers/Hints to Check Your Progress Exercises

10.0 OBJECTIVES
After going through this Unit, you should be able to:
 Explain the evolution of institutions and democracy;
 Discuss the alternative institutional trajectories;
 Identify the pre-requisites of a sound institution;
 Discuss the functions of an institution; and
 Explain the role of institutions in economic growth of a country

10.1 INTRODUCTION
The institutional infrastructure is not constructed overnight. It is a far complex
task. It remains in formal and informal manner in a given society. The culture
and the moral fibre of the individuals influence the outcome of an institution in a
country. We begin this unit by explaining the situations which demand the
existence of an institution, the need for institutions and how individuals and an
institution are related. Afterwards, we learn about the alternative institutional
trajectories in terms of state institutions, private property rights and community-
based institutions. To understand about an institution, it is imperative to learn
about the objectives, functions or pre-requisites for a sound institution. In the


Shri Saugato Sen Associate Professor of Economics, IGNOU, New Delhi
148
latter half of the unit we discuss the relationship of institutions and economic Institution and
Democracy
development of a country with brief reference to the reforms in India.

10.2 INSTITUTIONS AND EVOLUTION OF

DEMOCRACY
The common perspective views institutions as rules. This perspective also
stresses that the new institutions represent and reflect the interests and reasoning
of economic or political agents. The perspective generally remains that one
exogenous set of institutions to explain subsequent ones. As per Douglass North
(1990, p. 3), Institutions are the rules of the game in a society or, more formally,
are the humanly devised constraints that shape human interaction. Let us look at
the evolution of institutionalism which emphasizes the importance of
environmental forces.
The popular and commonly observed phenomenon known as Tragedy of
commons was not first noticed by Hardin. Aristotle observed it a long time ago
that each individual thinks mainly of his own and not at all about the common
interest. The least care is given to the factors or resources which are common to
the greatest number of individuals. This leads to situations of conflict and men
land up fighting with each other as their primary objective remains to seek their
own good.
Another phenomenon observed is the Prisoner’s Dilemma. It challenges a
fundamental faith that rational human beings can achieve rational results. This
challenge is largely due to the paradox that in a game of prisoner’s dilemma all
the individuals choose rational strategies (individually) but those strategies are no
good for a collective outcome because the collective outcome turns out to be
irrational. In the game of Prisoner’s Dilemma, the players have complete
information and communication among the players is impossible or irrelevant as
it is not included in the model of this game. The verbal agreements, if any, are
generally non-binding.
Some believe in the logic of collective action. To govern the natural resources
which are used by many individuals, the state control is recommended. This can
be easily observed in many scholarly articles about “tragedy of commons”. These
recommendations are mainly in order to prevent destruction of the natural
resources. But there are many who suggest privatising these resources to resolve
the problem of common use of these resources.Both the regimes have their own
pros and cons. It is not easy to enable the individuals to sustain long-term,
productive use of natural resource systems. In the past, many communities of
individuals have trusted on institutions which do not resemble to the state or to
the market, in order to govern some resource systems. This regime has shown
reasonable degrees of success over long periods of time.
The goods which are commons like the natural resources allow the benefits to all
and exclusion is not possible. Further, it does not provide any incentive to the
individuals to contribute towards the provision of such goods. The logic here is
149
Poltical Institutions that the individuals are rational and display self-interested behaviour, hence the
and the Functioing of
the State
group of such individuals should also display the same but the outcome of group
behaviour is chaos or destruction.
The tragedy of the commons, the prisoner's dilemma, and the logic of collective
action are closely related concepts. A common problem which all these three
models face is the free rider problem. As mentioned earlier, the natural resources
are such in nature that individuals cannot be excluded from receiving their
benefits. This leads to an incentive for not paying for receiving such benefits and
to just free ride on the efforts/payments made by others. Eventually, we reach to
a possibility where all choose to free ride and the benefit in question cease to
exist.
There are many factors to consider while devising an institution in order to
manage the common resources. Design principles of the institutions, reasons of
continued incentive for participation in terms of effort in the governance and
management of the such resources, internal and external factors that hinder or
improve the individual capabilities. The whole exercise of organising the
collective action must address a common set of problems. This set includes
problems like coping with free-riding, solving commitment problems and
monitoring individual compliance with sets of rules. Solving such problems
contribute to an understanding of how individuals address these crucial problems
in some other settings as well. Different behaviour pattern affects the way
alternatives are perceived and weighed. Generally, those actions are not included
in the set of strategies to be considered for policy formulation or institutions
which are considered wrong among a set of individuals interacting together over
time.
These three models discussed above and their many variants are diverse
representations of a broader and still-evolving theory of collective action. Many
policies are formulated on the basis of these models but the use of the models
have been eventually only a metaphorical use. Much more work will be needed
to develop the theory of collective action into a reliable and useful foundation for
policy analysis.
The word ‘democracy’ originally comes from the Greek language. It is made of
two words: ‘demos’ meaning whole citizen living within a particular city-state
and ‘kratos’ meaning power or rule. It is generally agreed that liberal
democracies are based on four main principles:
 A belief in the individual: since the individual is believed to be both
moral and rational;
 A belief in reason and progress: based on the belief that growth and
development is the natural condition of mankind and politics the art of
compromise;
 A belief in a society that is consensual: based on a desire for order and co-
operation not disorder and conflict;
150
  A belief in shared power: based on a suspicion of concentrated power Institution and
(whether by individuals, groups or governments). Democracy

The institutions which we discuss in this unit are based on more than one
principle of democracy mentioned above.

10.3 ALTERNATIVE INSTITUTIONAL

TRAJECTORIES
The existing literature indicates there are many ways to organise such activities
with the help of institutions and policies. In Leviathan (1651), Hobbes says that
there is one alternative to solve the problem of the commons dilemma. He says
either there has to be a private enterprise system or socialism. If the ruin or chaos
is to be avoided in a crowded world then the people must be responsive to a
coercive force outside their individual psyches. Such a force is termed as a
'Leviathan’ by Hobbes.
10.3.1 External Government Institution
The presumption that external Leviathan is necessary to avoid tragedies of the
commons, leads to suggestions that central governments control most natural
resource systems. The absolute power of the sovereign was ultimately justified
by the consent of the governed, who agreed, in a hypothetical social contract, to
obey the sovereign in all matters in exchange for a guarantee of peace and
security. Some believe that "iron governments," perhaps military governments,
would be necessary to achieve control over ecological problems. In other words,
if private interests cannot be expected to protect the public domain, then external
regulation by public agencies, governments, or international authorities is
needed. In case of having an external government agency, the specific herding
strategy considered best as per the available commons, will be decided by the
central authority. This authority will also decide who uses the commons, when
they use it and how many animals can be grazed (in case of common
meadows).But this centralised government agency can only achieve optimal
efficient equilibrium if it accurately measures the capacity of a common pool
resource, assigns this capacity unambiguously, monitors actions regularly, and
takes strict actions against noncompliance. Beyond this, an important factor to
consider is the cost of creating and maintaining such an agency, which hardly is
given a thought. To achieve optimal equilibrium, the centralised agency needs to
work very hard and it is easy to not have enough information on which is based
the achievement of optimal equilibrium. Suppose the government does not have
accurate information about the availability of commons up for use. In that case
the agency will land up making errors in formulating the blueprint of the use of
that common. The implications of incomplete information can be highly
impacting. So, we can say that it is difficult for a central authority to have
sufficient time-and-place information to estimate accurately both the carrying
capacity of a common and the appropriate fines to induce cooperative behaviour.

151
Poltical Institutions 10.3.2 Private Property Rights
and the Functioing of
the State The other group of policy analysts is also influenced with the same three models
we discussed earlier but they believe in clearly defining the private property
rights over the resources owned in common by all.The group suggests that the
central authority should give out ownership rights to the resource first and then
allow individuals to pursue their own self-interests within a set of well-defined
property rights. They say that the establishment of full property rights is
necessary to avoid the inefficiency of overuse of the commons. If one has right
over the resource then the buying/selling of the resource will take place as per the
terms prevailing in the market. The prices will be reached at by the forces of
demand and supply of that resource. But it is common knowledge that the
markets for private goods also do not function efficiently at times. The
equilibrium prices at times do not signal the true scarcity of the resource. Welfare
loss may occur for some while some may benefit. Moreover, there is no one rule
in order to decide who gets the property rights.

10.3.3 Community Institution

We have noticed that some experts have oversimplified the issue at hand. They
believe that only state-established institutional arrangements could sustain the
common resources in the long run i.e., centralized government and private
property right (discussed in section 10.2). Further they believe that the
individuals who use these resources are trapped in a commons dilemma and
hence cannot provide any solutions on their own. These experts have missed
what we have mentioned in the earlier section that many communities and social
groups have been successfully able to manage the commons against the threats
like resource degradation. They are able to do so by developing and maintaining
self-governing institutions.

Human has been observed to affect natural resources of a nation and human
institutions affect the resilience of the environment. Locally evolved institutional
arrangements governed by stable communities and buffered from outside forces
have sustained resources successfully for centuries. Such community-based
institutions often fail as well when rapid change occurs. It is difficult to manage
the ideal conditions which are needed for successful governance. Significant
problems exist like trans-boundary pollution, tropical deforestation, and climate
change. These problems are at larger scale and local communities are not
successful in addressing them. A major challenge faced by the policy makers is
in terms of developing theories about human organisation which should be able
to deal with variety of situations (like tragedy of commons) and assess the human
capabilities and limitations on a realistic scale.

152
There is one similarity in the views of both centralization advocates and Institution and
Democracy
privatization advocates. They both accept that institutional change must come
from outside and be imposed on the individuals affected. Despite the common
view on the relevance of existence of the central authority, the institutional
changes they recommend could hardly be unrelated. Let us see how. If we look at
a competitive market which is made up of private institutions/players, we notice
that any individual producer can enter or exit the market at any time without
thinking about the cost of the existence of that market or of maintaining the
market, because the market simply exists for that producer. In a manner this
competitive market is like a public good. Any given market needs the support of
the public institutions in order to exist. In reality, the public and private
institutions are inter-dependent and do not exist in isolation.
Check Your Progress 1
1) List the four liberal principles of Democracy.
.......................................................................................................................
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.......................................................................................................................
.......................................................................................................................
2) Explain the concept of tragedy of commons and the Prisoners’ dilemma.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
3) List any four factors which should be considered while devising an
institution.
.......................................................................................................................
.......................................................................................................................
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.......................................................................................................................
4) Discuss any two institutional trajectories.
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.......................................................................................................................

153
Poltical Institutions 5) What alternative has been suggested by Hobbes to solve the commons
and the Functioing of
the State dilemma?
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.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

10.4 FUNCTIONS AND PRE-REQUISITES OF AN

INSTITUTION
The locally formed institutions as well as the state formed institutions have failed
in the past due to various factors. Past data testing in different models of
institution formation ideally should provide the policies and institutions which
generate far less conflict than the earlier models. Having proper information
about the human capabilities as well as the common resource is one of the factors
which helps the institution run successfully. But this is not easy. Finding ways to
measure and monitor the outcomes for such varied values is a major
informational challenge for governance. Following factors are important and to
be dealt with in order to have a successful institution formation.
One may ask how effective commons governance can be made easier to achieve.
Let us look at some factors which makes it easier to organise the collective
action;
(i) the resources and use of the resources by humans can be monitored.The
information on the use of commons can be verified and understood at relatively
low cost (e.g., trees are easier to monitor than fish).
(ii) There are moderate rates of change in resources, resource-user populations,
technology, and economic and social conditions.
(iii) dense social network in the communities (social capital), maintain frequent
face-to-face communication. This increases the potential for trust among the
communities and allow people to express and hence lowers the cost of
monitoring behaviour and prepares conducive environment for rule compliance.
(iv) Easy and low-cost exclusion of the outsiders from using the resource,
whenever necessary.
(v) intention of the users to support effective monitoring and rule enforcement.
Few settings in the world are characterized by all of these conditions. The
challenge is to devise institutional arrangements that help to establish such
conditions. In other words, the institutional modelsshould be able to meet the
main challenges of governance in the absence of ideal conditions. Some of the
challenges are:

154
 1. Dealing with conflict:It is very common to observe conflicts due to the Institution and
difference in power and values among different interested parties, in the Democracy
matters related toenvironmental choices. Dealing with such conflicts is as
important as the concern about resource itself. Conflict resolution is a
major motivation for designing resource institutions.

2. Inducing rule compliance:an institution will lead toeffective governance

only if the rules of resource use are adhered toand the violations are
modest. It is not generally recommended to penalise the first-time
offenders in a severe manner.It has been noticed that it is most effective
to impose modest sanctions on first-time offenders. The gradual increase
in the severity of sanctions shall take place for those who do not learn
from their first or second offense penalty.

3. Providing infrastructure:When we discuss about institutions, mainly our

focus is on different ways to institutionalise. But simultaneously the
physical and technological infrastructure is too important to ignore.
Infrastructure and the level of technology advancement determines the
degree to which a commons can be exploited (e.g., fishing technology).
Technology determines the extent to which waste can be reduced in
resource use, and the degree to which resource conditions and the
behaviour of users can be effectively monitored.

4. Be prepared for change:There are many features which are likely to

change in the setting of commons and their use. The institutions
formulated should be able to show some flexibility in case they need to
adapt as per changing conditions. Changes may take place inthe current
understanding, the required scale of organization, biophysical and social
systems. In such an ever-changing setting, fixed rules are likely to fail
because they place too much confidence in the current state of
knowledge. It may seem to some that allowing the room for flexibility in
the existing systems may be suboptimal. But that will only apply in short
run as allowing the institution to be adaptive will prove wiser in the long
run.
If the objectives and requirements are known to one while devising an institution,
the next step is to find some strategies through which the requirements of flexible
or adaptive governance can be met.There are some general strategies or
principles for robust governance institutions for localized resources which are
well established in the existing literature.Below are the ones which are relevant
for the problems faced at a large scale, in particular.
1. Analytic deliberation: It is crucial that the stakeholders (scientists,
resource users and public) have a well-structured dialogue based on the
analysis of key information about environmental and human-environment
systems. Such analytic deliberation provides improved information for
155
Poltical Institutions future plan of action and builds social capital. Having such deliberation
and the Functioing of
the State
allow for change and deal with inevitable conflicts as well as it helps to
produce consensus on governance rules.
2. Nesting: Institutional arrangements must not be simple and one layered.
They need to be complex and nested in many layers. The strategy should
involve market-based governancefor the world’s resources at one-level
and centralized command and control at the other level which eliminates
apparent redundancies which have proved to be inefficient over time.In
case only the central governments exert sole authority over the resources,
there can be catastrophic failures.
3. Institutional Variety: Ideally the governance should be a mix of diverse
institutional types. Governance can be effective if it includes hierarchies,
markets and community-based self-governance. This structure has a
potential of employing a variety of decision rules to change incentives,
increase information, monitor use, and induce compliance. The rule
evaders or defaulters have many ways to evade the system but the
existence of multiplicity of rules than with a single type of rule is
somewhat successful in weeding the evaders.

10.5 INSTITUTIONAL TRAJECTORIES AND

ECONOMIC PERFORMANCE
After all the discussion in earlier sections, one would want to know how the
institutions (State, private or community based) help an economy achieve its
productive potential. An important factor (in addition to the endowments of a
country) to consider while looking at the economic performance of different
countries is that these countries follow or adopt different economic policies and
institutions. This leads to the variation in the economic performance.
Let us take an example of the per capita income of a nation. We observe huge
variations in the per capita income of a rich country and a poor country. There
are two possible explanations of such differences. The first possibility is that,
national borders mark differences in the scarcity of productive resources per
capita and the aggregate production function methodology also differs. Simply
put, the poor countries are poor because they are short of resources (like land,
natural resources, human capital, latest technology). The rationality of
individuals in a country brings that country quite close to its potential, given their
different potentials. The second possibility is that due to national borders the
public policies and institutions are not only different for different nations, but in
some cases better and in other cases worse. The countries which practise better
institutions are able to reach closer to their potential and vice versa. The potential
is not reached by individual rationality but by achieving socially efficient
outcome. The earning capacity of a country can easily be increased with efficient
use of the natural and human resources. The poorer countries lack the structure of
incentives that brings out the productive cooperation. The chosen economic
policies time to time and the institutional arrangements lead to a structure of
156
incentives. That also depends on the legal systems that enforce contracts and Institution and
protect property rights and on the political structures, constitutional provisions, Democracy
and the extent of special-interest lobbies and cartels.
Now we need to know why variations in institutions and policies are the main
determinants of international differences in per capita incomes. Sometimes the
economic policies and institutions of the low-income countries keep capital in
these countries from earning rates of return appropriate to its scarcity. Similarly,
such policies make foreign investors and foreign firms unwelcome, or provoke
the flight of locally owned capital, or make lending to these countries highly
risky. So, the institutional and policy shortcomings of a country keep it from
achieving its potential. Also, the type of human capital a country possesses
matters in terms of achieving the potential. The people should have a good
amount of knowledge about how they should vote and about what public policies
will be successful. If many voters acquire more knowledge and are able to assess
about the real consequences of different proposed public policies, then those
public policies will improve and thereby increase real incomes in the society. But
this better knowledge of public policy is usually not marketable. So, this public
good human capital or civic culture is not normally marketable and only affects
incomes by influencing public policies and institutions. The existing literature
suggests that the economic performances of Hong Kong, Taiwan, West Germany
and South Korea have been much better than the performances of mainland
China, East Germany and North Korea. These are the pair of countries having
similar cultural characteristics but great differences in economic performance.
These differences cannot not be explained by differences in the marketable
human capital of the populations at issue. The hypothesis that economic
performance is determined mostly by the structure of incentives and that it is the
national borders that mark the boundaries of different structures of incentives,
has a lot of evidence in its favour. There is also direct evidence of the linkage
between better economic policies and institutions and better economic
performance.
Low-income nations may specialise in trade and experience gains from that. But
they do not have the institutions that enforce contracts impartially, they do not
have institutions that make property rights secure over the long run. Institutions
which ensure greater self-expression, allow the free flow of information and
encourage the formation of associations and clubs lead to greater economic
benefits. The democratic institutions allow greater sharing of resources and state
reduces the risks involved in the economic activity. Welfare state is an
institution which pools the resources to provide the investments in education,
health and infrastructure and constrains the effects of business cycles. Pooling
resources is a fundamental step as it complements the private investment as well
which furthers the economic interaction between various players. Institutions can
be both informal (e.g., moral codes, self-enforcing agreements) and formal (legal
rules enforced through third parties). The relative importance of formal
institutions increases as the markets widen and deepen. Informal institutions are
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Poltical Institutions like public agencies, trade unions, community structures and professional
and the Functioing of
the State
associations.
A nation follows many growth augmenting strategies. But they alone are not
sufficient for reaping the economic benefits. Without institutions, growth runs
out of steam and the economy will not remain resilient to shocks. So, we need
high-quality institutions which induce socially desirable behaviour on the part of
economic agents. Some of the institutional ingredients of a self-sustaining market
economy are public bureaucracies, independent judiciaries, stabilizing fiscal
policy, antitrust and regulation, financial supervision, social insurance, political
democracy.
10.5.1 Institutions in India and Economic Growth
A perception which is commonly voiced is that public institutions in India are on
a decline, they are weak and severely stressed. In the academic world is cautious
on the debate about condition of India’s institutions. India is densely populated
and is very heterogeneous. Some of the new institutions such as the
Telecommunications Regulatory Authority of India (TRAI), Securities and
Exchange Board of India (SEBI), and Insurance Development Regulation Act
(IDRA) have performed very respectably, given the features of the country. In
terms of employment, the Central Union Public Service Commission still
oversees a selection process that is fair and merit-based. Greater decentralization
and transparency have been introduced through the Panchayati Raj initiatives and
the Right to Information (RTI) Act. And the introduction of computer-based
technologies has improved efficiency in a number of areas, like the computerised
bookings in railways and air travel, online filing of income tax returns, virtual
payment of different taxes like property tax and online banking.

The effects of institutions in India can also be separated at the level of the states.
The formal reforms of 1991 at the centre were appreciated and received a lot of
publicity. What was less noticed was the growing decentralization of policy. For
a long time, we observed the dominancy of Congress party over the politics and
institutions of the country. But, with its dispersion came the scattering of the
political power which createdthe centrifugal forces that led to decentralization of
economic power and hence policy. Greater economic decentralization meant
states could differentiate themselves. States differ in their ability to attract private
sector investment, which is a significant factor in terms of economic performance
of the states. This decentralisation process was further strengthened by the
gradual dismantling of the industrial licensing system. When the centre was
deciding where and how much electricity capacity to install, there was little that
the states could have done to enhance their economic performance. In the pre-
1980s era centre was the deciding authority. Existing research informs that when
we relate state-level growth to state-level institutions we find that the latter have
no role in explaining growth prior to 1980 but a robust role in explaining post-
158
1980s, especially post- 1990s growth. Hence, the economic decentralization Institution and
Democracy
became important and states’ economic performance was closely tied to state-
level institutions in the post-1980s period.

The core market-creating public institutions were created during the India’s pre-
independence era. These institutions are taken as a key to India’s long-run growth
but they may not have kept pace with Indian economic veracities. India’s
institutions have shown the signs of weakness in terms of being slow to adapt or
change. This may sputter country’s growth engine. Sustaining growth is more
difficult than igniting it, and requires more extensive institutional reform. Growth
spurts are associated with just a narrow range of policy reforms.
The policy reforms which are related to growth transitions need to have elements
of both orthodoxy with unorthodox institutional practices.
Check Your Progress 2
1) Enlist any three factors which make it easier to organise the collective
action.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
2) Discuss any three main challenges of governance.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
3) Explain the relationship of institutions with the economic performance of a
nation.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
4) Discuss India’s institutional trajectory in brief.
.......................................................................................................................
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Poltical Institutions
and the Functioing of
10.6 LET US SUM UP
the State
Institutions are the rules which help us play the game of management. The
primary function of any institution is to deal with common resources in a manner
that the outcome is socially efficient. We began the unit by understanding the
need of institutions and policies. The rational individual may not lead to
optimality when it concerns the commons available for the whole population or
where the property rights are not clearly defined. Destruction of resources is a
major concern for all the nations. Three models (Tragedy of commons, Prisoners’
dilemma and the logic of collective action) provide us the base to understand the
requirement of institutions. The alternatives available are state-led institutions
(formal or informal) or the community-based local institutions which have been
mostly successful in the management of the common resources. We then moved
on to find out how the economic performance of any nation is not only dependent
on its resource endowments but also on the type of institutions and policies a
country formalizes and practises. Lastly, we discussed the Indian scenario in
relation to the reform policies and decentralization of institutions with the
background of economic development and its relation to the institutions.

10.7 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Refer section 10.2
2) Refer section 10.2
3) Refer section 10.2
4) Refer section 10.3
5) Refer section 10.3
Check Your Progress 2
1) Refer section 10.4
2) Refer section 10.4
3) Refer section 10.5
4) Refer section10.5

160
UNIT 11 THEORIES OF REGULATION
Structure
11.0 Objectives
11.1 Introduction
11.2 Economic Regulation
11.2.1 Direct Regulation
11.2.2 Price Controls
11.3 Regulation of Natural Monopolies and Public Utilities
11.4 Public Interest Theory
11.5 Public Choice Theory
11.6 Theory of Regulatory Capture
11.6 Let Us Sum Up
11.7 Answers/Hints to Check Your Progress Exercises

11.0 OBJECTIVES
After going through the unit you should be able to:
 Define economic regulation;
 Discuss the arguments in favour of economic regulation;
 Describe the various types of regulation, particularly regulation of public
utilities;
 Critically evaluate the public interest and public choice theories of economic
regulation; and
 Discuss the theory of regulatory capture.

11.1 INTRODUCTION
This unit and the subsequent one take up for discussion issues relating to
governance in developing nations. In the previous unit you studied about
institutions and democracy. You would have realized that institutions and
democracy have important bearing on economic outcomes and on the process of
economic development of developing nations. Hence it is important to
understand the role of government in economic development.
In your earlier courses on microeconomics and macroeconomics, you became
familiar with the role of government in promoting efficiency in the economy, in
establishing and maintaining property rights and rule of Law, and also
macroeconomic policies like fiscal and monetary policies as well as policies
related to international trade and finance. The previous unit (Unit 10) discussed
the role of institutions, as well as the State and democratic processes in economic


Shri Saugato Sen Associate Professor of Economics, IGNOU, New Delhi
Poltical Institutions development. Other than the legal and governance framework and various
and the Functioing of
the State
policies like monetary and fiscal policies, the state participates in the economy
through ownership, as well regulation In the last unit of this course, we will go
into greater detail about the ways government action can fail to enhance welfare,
and also about corruption. But before that, in this unit, we look at one type of
government participation in the economy, namely, economic regulation.
As you would know, regulation can be economic as well as in non-economic
spheres. As an example of non-economic regulation, government can regulate
protocols with regard to patients of some pandemic in terms of isolation or
quarantine. In this unit we shall consider economic regulation and not non-
economic regulation. Economic regulation basically suggests that there are areas
or sectors which the government may not own, or participate as producer or
provider of services, but regulates the private sector which provides the services
or products in this area.
The unit is organised as follows: the next section we discuss economic
regulation. The section explains what regulation means and who does the
regulating. It discusses the aims of regulation and what are the arguments for
regulation. It discusses in some detail the regulation tools at the disposal of the
regulating agency. The various types of regulation, like direct regulation, price
regulation, regulation of entry and exit etc , are discussed. In the next section, the
method of regulating a natural monopoly and public utility are discussed. Natural
monopoly is defined not so much in terms of number of firms present in the
market, but whether a single firm is able to cater to all of the demand in the
market. We find that often public utilities are natural monopolies in that a single
firm meets all of the demand for the utility in a given geographical area. The unit
discusses how public utilities are regulated.
The unit then goes on to discuss two important theories regarding economic
regulation. First, the public interest theory of regulation will be discussed. This
theory assumes that regulators act in the public interest and have the interest of
the consumers and the general public in mind. It also assumes that regulators
have full information and knowledge about all relevant parameters. A later
variant of the public interest theory suggests that regulation may not lead to
optimal efficiency and there may be costs to regulation, but regulation can lead to
corrections for market failures. The other theory of regulation is public choice
theory. Public choice theory suggests that government officials like regulators act
in their own interest most of the time, and their actions do not always further the
public interest. Applied to the area of economic regulation, public choice theory
Hence in most cases economic regulation does not lead to optimal outcomes in
terms of efficiency and resource allocation. Finally, the unit discusses the theory
of regulatory capture, which suggests that those firms that are being regulated
end up ‘capturing’ the regulatory process, and the regulatory authorities end up
taking actions that help the firms themselves. The theory of regulatory capture
suggests that not only does not serve the public interest, but regulation can

162
actually help the organistion or firm being regulated as the firm can manipulate Theories of
and ‘capture’ the regulatory process, and turn the regulatory process to its own Regulation

advantage.

11.2 ECONOMIC REGULATION

Regulation can be in several diverse areas and fields. There can be social
regulation as government may regulate social processes and behavior. In this unit
we are concerned with economic regulation. Economic regulation, in its essence,
seeks to modify economic behavior by certain economic agents. It works as
application of law by the government or other agencies with various objectives in
mind, such as correcting for market failure, protecting the environment,
controlling restrictive trade practices or monopoly pricing. Regulation is one of
the ways in which the government intervenes in the market. Thus, regulation is
by government agencies or autonomous bodies statutorily created. Secondly it is
private sector firms or economic agents that are regulated. Third, economic
regulation seeks to modify the behavior of private firms or economic agents or to
influence economic processes to yield outcomes that are welfare enhancing for
society as a whole. Regulation refers to actions undertaken by the central or state
governments to influence market outcomes, such as the quantity traded of some
good or service, or their price or quality. Regulation can also be in the form of
taking steps to ensure that monopolies are not formed or collusive behavior by
firms does not take place. It can take the form of enforcing property rights. The
government can also take steps to regulate activity that creates negative
externalities. Governments can take direct steps to prevent pollution by firms,
for instance by prohibiting firms from spilling sewage into rivers,, instead of
resorting to taxation. Often the government sets up special agencies which act as
regulators in various areas. In India some important regulatory authorities are
Securities and Exchange Board of India (SEBI), for capital markets, Insurance
Regulatory and Development Authority of India (IRDAI) for regulating
insurance companies, Pension Fund Regulatory and Development Authority
(PFRDA), Telecom Regulatory Authority of India (TRAI), for regulating the
entry and exit of firms, conducting auctions and also pricing in the telecom
sector, Food Safety and Standards Authority of India (FSSAI) related to food,
Bureau of Indian Standards (BIS), for ensuring a generally high standard of
quality of products Central Drugs Standard Control Organisation (CDSCO) for
drug pricing etc, National Green Tribunal for maintaining environmental
standards, and Competition Commission of India (to regulate competition).The
CCI was established in 2003 to oversee competition and enforce Competition Act
2002. The CCI became operational from 2009. It replaced the Monopolies and
Restrictive Trade Practices Commission which had been set up to oversee the
Monopolies and Restrictive Trade Practices Act, 1969. The competition
commission of India acts to prevent monopolies, to ensure competition to oversee
mergers and acquisitions. Let us now see the various instruments of regulation,
the instruments through which the government.

163
Poltical Institutions 11.2.1 Direct Regulation
and the Functioing of
the State There are several ways in which government regulates private sector provider of
goods and services. One way is what is called direct regulation. Direct regulation
is also known as command- and –control regulation. In this form of regulation,
the government takes certain actions to control the amount of a certain activity.
In this form of regulation the government aims at control of quantity.
The example about pollution is an instance of direct regulation. Ensuring safety
of food and medicines is another instance of direct regulation. Food Safety and
Standards Authority of India (FSSA) regulates levels of safety of food products
in India. Supposing it is left to the market to ensure that products meet quality. It
would be difficult as in the market system it would be costly for each individual
consumer to acquire information about quality. Consider medicines. Each
consumer would find it very difficult to ascertain that medicines meet a certain
standard. Moreover each consumer would separately have to determine and
gauge quality, and there would be massive duplication of effort. Another example
of direct regulation would be sale and purchase of alcoholic drinks. Some
governments may impose prohibition and prohibit the sale of alcohol in that state.
Residents of that state may be required to have permits to bring in alcoholic
drinks from other states. Or the government may fix a certain minimum age for a
person to be eligible to purchase or consume alcoholic drinks.
11.2.2 Price Control
Sometimes the government intervenes in the market by setting a maximum or
minimum price for some product. The regulated price may take the form of price
controls. These controlled prices may be above or in some case below the
equilibrium market price that would otherwise prevail. For example, rent may be
controlled in the sense that the government may decree that rent cannot be above
a certain level. Or in the labour market, the government may fix a minimum
wage that employers, even in the private sector, have mandatorily to pay their
workers. In India, in some cities, fares of taxis and auto-rickshaws may be
determined by the government in terms of the maximum fare at the base or
starting level, and how much additional fare the driver is allowed to charge per
kilometer. However, since monitoring costs may be high, actual auto-rickshaw
fares are sometimes determined by bargaining between the driver and passenger!
Price regulation may specify a particular price that firms must charge, or may
instead restrict firms to setting price within some range. If the concern of the
regulating agency is that a regulated monopolist will set price too high,
regulation is likely to specify a maximum price that can be charged. If the
regulated firm has some competitors that are unregulated, the regulatory agency
may also be concerned that the regulated firm will engage in predatory pricing
(that is, pricing so as to force its competitors to exit the market). In that situation,
regulation is likely to involve a minimum price as well as a maximum price.
Sometimes, regulation specifies more than a single price. The specification of a
price structure as opposed to just a single price greatly increases the complexity
164
of implementing economic regulation and can result in additional welfare losses. Theories of
In practice, price regulation may be the means by which a regulatory agency Regulation

achieves an ultimate objective of limiting industry profit. A regulatory agency

often sets price so that the regulated firm earns a normal rate of return. This is
standard practice in the regulation of public utilities, as we shall see in the next
section.
11.2.3 Control of Entry and Exit
Now we look at a way to regulate firms that does not rely on direct regulation
or price regulation. The two principal variables that regulators have controlled
are price and the number of firms, the latter through restrictions on entry and
exit. These variables are important because price and the number of firms are
the main determinants of both allocative and productive efficiency. Entry may
be regulated at several levels. First, entry by new firms may be controlled, as is
typically done in the regulation of public utilities. In addition to controlling
entry by new firms, a regulatory agency may also control entry by existing
regulated firms. These markets may already be served by other regulated firms
or may be unregulated markets. A basis for exit regulation is that regulation
strives to have services provided to a wider set of consumers than would be true
in a free market. Attaining this goal may entail regulated firms serving
unprofitable markets, which creates a need for regulations that forbid a
regulated firm from abandoning a market without regulatory approval.
11.2.4 Control of Other Variables
Sometimes regulators may try to regulate some other variables like quality of
service.The essence of economic regulation is the limitation of firm behavior
regarding price, quantity, and entry into and exit out of markets. Obviously,
firms choose many other decision variables. One of these is the quality of the
product or service that they produce. A regulatory agency may specify
minimum standards for reliability of a service. If an electric utility has regular
blackouts, the regulatory agency is likely to intervene and require an increase in
capacity in order to improve service reliability. Although product quality may
also be controlled for reasons like product safety, economic regulation does not
typically place serious restrictions on it.
One reason for the minimal use of quality regulation is the cost of implementing
it. To control any variable, the relevant economic agents have to be able to agree
on what the vari- able is and what restrictions are placed on it. In the case of price
and quantity, this is not dif- ficult. The price is the amount paid by the consumer
for the good, which is relatively easy to observe. Furthermore, restrictions take
the simple form of numbers: a maximum price and a minimum price. Similarly,
the measurability of quantity allows a regulatory agency to specify restrictions on
it. However, quality is typically neither so well defined nor so easily observed.

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Poltical Institutions
and the Functioing of
11.3 REGULATION OF NATURAL MONOPOLIES
the State AND PUBLIC UTILITIES
In the previous section, you became acquainted with the concept of regulation
and the various ways in which regulation is carried out. This section focuses on
the regulation of natural monopolies. Let us see what is a monopolist and a
natural monopolist. You may recall your study of a monopolist in your courses
on microeconomics. We know that a firm’s domination of a market is most
complete when it is the sole seller or sole buyer in a market, that is, when it is a
monopolist or a monopsonist. This section examines some of the consequences
of monopoly. What is then a natural monopolist. Let us recall the definition of
returns to scale. A production process displays increasing returns to scale if output
more than doubles when the use of every input is doubled. The cost curves of a
firm that produces under increasing returns to scale have two important
properties:
• Average cost falls as output rises.
• Marginal cost is everywhere below average cost.

A market in which production is characterized by increasing returns to scale is

said to be a natural monopoly because only one firm can survive in such a market.
Initially, a number of competing firms will “race to get big.” The larger firms will
have lower average costs than their smaller competitors and will be able to charge
lower prices. The smaller firms will be unable to earn profits and will be driven
from the market. Ultimately, only one firm will remain in the market.
Utilities are often natural monopolies because they deliver services through net-
works. An electric power company, for example, must have generating stations
to produce power and trunk lines to distribute it before it can begin operations,
but it can then deliver power to large numbers of customers by connecting them
to its power grid. The expansion of its customer base allows the power company
to spread the fixed costs (of the generating stations and trunk lines) over a greater
number of users, so that average cost falls. Similar arguments apply to water and
sewage systems, mail delivery, local telephone service, cable TV, and railways.
The monopolist maximizes its profits by expanding production until marginal
cost is equal to marginal revenue. These choices do not maximize society’s
welfare. You have read earlier that apart from producers’ surplus and
consumers’ surplus, there is deadweight loss under monopoly. This loss of
surplus (that part which belongs neither to consumers’ surplus nor to producers’
surplus) is called the, the welfare cost of monopoly A monopolist will charge
more and produce less than a perfectly competitive firm,
There are two ways of increasing the net social benefits of a monopoly. The first
is to regulate the monopoly, meaning that the government sets the monopolist’s
price and output. The second is for the government to purchase and operate the
firm. A regulator would require the monopolist to raise its output so that the
welfare cost of the monopoly is reduced. It could not, however, require the
166
monopolist to increase output to the level of competitive equilibrium output. In Theories of
the long run the firm would make losses and abandon the market, and net social Regulation

benefits would ultimately be lower than they were before the regulator’s
intervention.
What is the best outcome that the regulator can achieve? Social welfare increases as
output rises but the monopolist’s profits fall. The monopolist should be required
to raise its output until its profits are driven to zero (since these are the smallest
profits consistent with the monopolist’s
ˆ continued participation in the market).
The regulator wants profits to fall to zero at the highest possible output, so it will
allow the monopolist to charge the highest price that the market will bear. Then the
monopolist’s price is equal to the vertical distance to the demand curve and its
average cost is equal to the vertical distance to the average cost curve. Its profits
are zero when these two distances are equal.
The alternative to regulation is government ownership. A government-owned
firm does not need to earn non-negative profits, because its fixed costs can be paid
out of the government’s general revenues. A change from regulation to
government ownership would eliminate the remaining welfare cost of monopoly.
The above points may have made you think that social welfare is higher under
government ownership than under regulation, but it is somewhat misleading. The
fixed costs of a government-owned monopolist are paid out of tax revenues, so
opting for government ownership forces the government to adjust its budget. It
has two options: it can reduce spending on other programmes, or it can raise tax
revenues.
Hence, in some cases, regulation might be preferred to government ownership.
Both policies have been, and are being used to deal with natural monopoly.
Utilities like water, sewage, and mail delivery are natural monopolies, and these
services are typically provided by government-owned firms. Local telephone
service and cable TV are often provided by monopolies that are regulated.
Let us now discuss further the regulation of public utilities. Public utilities are
found both in the public as well as private sector. The first objective in
regulating a public utility is to make it charge a price that would be fair and
reasonable to consumers. Further, there are issues like marginal-cost pricing and
optimal pricing. There is also the institutional approach to rate-making, which
looks at the criteria by which the base rate is determined and a fair rate of return
to the public utility.
Public utilities as we saw above are natural monopolies which have increasing
returns to scale, and hence decreasing average costs.. When looking at the
demand for the public utility service, we find that demand is determined by the
time pattern, and the elasticity of demand.. Thus often there is price
discrimination. The crucial task of the regulator is to determine a reasonable
price. that is equitable. A theoretical first-best criterion is to choose the price such
that it equals marginal cost. In perfect competition, price would also equal
167
Poltical Institutions average cost. But in monopoly marginal cost pricing would probably lead to
and the Functioing of
the State
losses which may be subsidized, and there may be corresponding increasing in
taxation. There can be a two-part tariff to ensure that the public utility covers its
marginal as well as fixed costs. Another type of differential pricing is peak-load
pricing, often used in electricity pricing. Here prices are charged differently at
different times depending on demand. Hence marginal cost will differ and
capacity utilization would vary. Sometimes in practice, marginal cost pricing is
difficult to use, and hence a reasonable rate is determined that allows the public
utility to get a reasonable rate of return on the capital invested. It is necessary to
establish a base rate which is the property value against which the firm’s profits
are compared. Cost of services, reasonable rate of return on capital invested are
determing factors in arriving a pricing principle.
Check Your Progress 1
1. Explain the concept of direct regulation.
……………………………………………………………….................…..
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2. Discuss how price regulation is carried out.
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3. What do you understand by a natural monopoly? Why are public utilities
usually natural monopolies?
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11.4 PUBLIC INTEREST THEORY

There are two main approaches or views regarding economic regulation by the
government. The first is public interest theory and the other is called public
choice theory. Basically, these approaches differ in the way that the government
is perceived; the first approach sees the government or the State as a benevolent
agency, having the public interest in mind. The latter sees the government as just
another economic agent in the economy, or rather the individuals who form the
government –legislators, ministers, government officials, et al—as yet another set
of economic agents who optimize their chosen objective functions, which may
168
not be in consonance with social welfare or public benefit. We discuss public Theories of
choice theory in the next section. In this section, we discuss the public interest Regulation

theory of regulation.
The first group of regulation theories proceeds from the assumptions of full
information, perfect enforcement and benevolent regulators. According to these
theories, the regulation of firms or other economic actors contributes to the
promotion of the public interest. This public interest can further be described as
the best possible allocation of scarce resources for individual and collective
goods and services in society. In western economies, the allocation of scarce
resources is to a significant extent coordinated by the market mechanism. In
theory, it can even be demonstrated that, under certain circumstances, the
allocation of resources by means of the market mechanism is optimal. ). Because
these conditions do frequently not apply in practice, the allocation of resources is
not optimal from a theoretical perspective. This situation is described as a market
failure. A market failure is a situation where scarce resources are not put to their
highest valued uses. In a market setting, these values are reflected in the prices of
goods and services. A market failure thus implies a discrepancy between the
price or value of an additional unit of a particular good or service and its
marginal cost. Equalization of prices and marginal costs characterizes an
equilibrium in a competitive market. If costs are lower than the given market
price, a firm will profit from a further expansion of production. If costs are higher
than price, a firm will increase its profits by curtailing production until price
again equals marginal cost. A market equilibrium, and more generally an
equilibrium of all markets is thus a situation of an optimal allocation of scarce
resources. In this situation supply equals demand and under the given
circumstances economic agents can do no better.
One of the methods of achieving efficiency in the allocation of resources when a
market failure is identified, is government regulation. In the earlier development
of the public interest theories of regulation, it was assumed that a market failure
was a sufficient condition to explain government regulation. But soon the theory
was criticized on the grounds that it assumed that theoretically efficient
institutions could be seen to efficiently replace or correct inefficient real world
institutions. This criticism has led to the development of a more serious public
interest theory of regulation by an “Economics of Law” approach. In the
original theory, the transaction costs and information costs of regulation were
assumed to be zero. By taking account of these costs, more comprehensive
public interest theories developed. It could be argued that government
regulation is comparatively the more efficient institution to deal with a number
of market failures. Thus this approach, in contrast to the earlier approach,
suggested that in the presence of market failure, government regulation can
comparatively improve the situation, but there is no guarantee that regulation
will lead to optimal efficiency conditions. For example, with respect to the
public utilities, as we have seen, the transaction cost of government regulation in
establishing fair prices and a just rate of return are lower than the costs of
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Poltical Institutions unrestricted competition. These more serious versions of the public interest
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theories do not assume that regulation is perfect. They do assume the presence of
a market failure, and assume that regulation is comparatively the more efficient
institution and also, that for example deregulation takes place when more
efficient institutions develop. These theories also assume that politicians act in
the public interest or that the political process is efficient and that information
on the costs and benefits of regulation is widely distributed and available.
Imagine an unregulated natural monopoly firm supplying public utility services.
The firm makes supernormal profits, charges different prices to different
consumer groups and does not supply services to high-cost consumers in rural
areas. Economic theory predicts an inefficient allocation of resources. Without
regulatory intervention these costs are high. Interveningin the market results in a
decline of these welfare cost. The stronger the level of intervention, the lower
the welfare losses in the private sector will be. The naïve public interest theory
of regulation for example, would explain ‘fair rate of return’ regulation from the
presence of the natural monopoly firm. Prices must decline and production
increased until societal resources are allocated efficiently. The more complex
public interest theories of regulation take the costs of regulatory intervention
into account. The more a regulator intervenes in the private operation of the
firm, the higher the intervention costs will be. The regulator must have
information on cost and demand facing the firm before efficient prices can be
determined. There will be compliance cost for the firm in terms of time, effort
and resources. It will have to comply with procedures, adapt its administration
and incur productivity losses. Once put into practice, the cost of monitoring firm
behavior and enforcement of the regulations arises. It is to be expected that the
firm will behave strategically and conceal or disguise any relevant information
for the regulator. Furthermore, indirect costs are to be expected. The less profit
the firm makes, the lower the effort in decreasing production cost or in
developing new products and production technologies. Also less tangible effects
are predicted. Regulatory intervention makes private investments less secure.
Risks go up. Investment can decline. The public interest theories of regulation
thus basically assume a comparative analysis of institutions to have taken place
to efficiently allocate scarce resources in the economy.

11.5 PUBLIC CHOICE THEORY

In the previous section, we looked at the public interest theory of regulation. The public
interest theory posits that governments act in the public interest. It will regulate in such a
way that will benefit society. Since economic regulation is carried out by government
agencies, we need to look at the behavior of personnel and officials in various
government agencies and organs of government.
There is a school of theorists called public choice theory that says officials in
government agencies behave rationally just as economic agents like firms and consumers
do. The theory says government officials have objective functions that they optimize

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subject to constraints. Public choice theory is also known as economic approach to Theories of
political science. Regulation

Applied to regulation, public choice theory says we should look at the motivation and
incentives of the members of the regulating agency in regulating the firm. Each official
and member of the regulating agency will act in a way so as to maximize his or her own
utility. Thus the official will look at his or her own gain, rather than that of society in
implementing the regulation. If the officials find that regulating the price, for example,
do not lead to any gains for them they may be lax in implementing. On the other hand
the officials, having the power over the firm may bargain with the firm in getting a good
deal for themselves in return for arriving at a regulatory system or level that does not
hurt the firm too much.

In effect, public choice theory suggests that officials who make up government
organizations like regulating agencies, are likely to act to promote their own gain rather
than the public interest. The implicit suggestion is that the economic regulation of firms
is not likely to maximize social welfare. Hence the underlying prescription is that
government should not interfere with the market mechanism even in the presence of
market failure.

In the next section we look at a theory of economic regulation that is related to public
choice theory.. This theory also contends that economic regulation does not always lead
serving the public interest. Thus that theory is also opposed to the public interest. Let us
now study this theory, known as the theory of regulatory capture.

11.6 THEORY OF REGULATORY CAPTURE

We saw above that the approach of public choice theory to analyzing
government processes and institutions to view government officials just as
private economic agents. Just as usual economic agents like consumers or firms
optimize utility functions or profit functions, public officials are also assumed
to have their own objective functions which they optimize. This objective
function of public officials may not be in consonance with the public interest. In
the previous section we saw that theorists belong to the public choice tradition
suggest that regulators may use their regulatory power to extract benefits for
themselves. In this section we discuss a variant of the public choice approach.
This variant is called the theory of regulatory capture. Let us see what this
theory says about economic regulation.
Basically, the theory of regulatory capture says that the regulatory process is
‘captured’ by the very organizations or groups that are being captured, like
monopolies or firms in oligopolistic industries.. This means that if say a
dominant firm in an industry is being regulated in terms of price, or capacity
enhancement, this firm can take steps and manipulate the regulatory process
such that regulation is also made in terms of regulating the entry of new firms.
This ensures that firms that can be potential competitors to the existing firm in
the market are kept out and this existing firm can continue to enjoy monopoly
power. Let us learn about this theory a little more.
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Poltical Institutions To understand the process of regulatory capture, consider a monopolist
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supplying a good or service in a certain area. To make it more concrete,
suppose the firm is a natural monopolist supplying a public utility, say,
electricity in a certain geographical area. Let there be a regulatory body set up
to monitor price or tariff by the electricity utility monopoly firm. Let us denote
the firm by F and the regulatory authority or regulatory agency (set up by the
government) by RA. Let us see the likely events. The monopoly firm F would
like to charge a monopoly price Pm and supply the quantity Qm. . This would
generate monopoly profit for the firm..On the other hand, the regulatory agency
RA has the role to ensure that the firm sells at the price Pc to every customer in
the area, where Pc is the competitive price. This would result in the competitive
quantity Qm being supplied. In effect this regulatory procedure has the objective
of making the monopolist behave like a competitive firm. This would be in the
public interest. The regulator RA wants the firm F to act like a competitive
firm, though the firm has an incentive to act like a monopolist.
The situation for RA is that if it wants F to charge Pc , it must know the firm’s
cost function. But the problem that RA faces is that the firm has this
information. After all, it is the firm that is likely to have the information about
its costs. Now RA has to get this information from the firm F. There is the issue
of how costs are to be measured and which expenditure by the firm is to be
included in costs. Moreover, and this is crucial to understand, the firm has an
incentive to show its costs as high as it can. The regulated firm has a clear
informational information over the regulatory agency, because the firm controls
the information that goes to the regulatory agency.
What incentives do the various parties have? The firm has an incentive to
represent it costs as high as possible, because that will make the regulatory
agency set Pc at a very high level, thus allowing the firm to get higher profits.
The regulatory authority will then set a price which would allow the firm to get
a high return on investment, and this in turn will induce the firm to invest more.
What incentive would the regulatory authority have? We may think that the
regulatory authority would have the incentive to fix the price at Pc but in reality
it is the consumers that have to pay this price. The RA does not have to pay.
And the consumers who would like to pay an electricity tariff of Pc are not
members of RA. Consumers are another group, another party to this process,
but no individual consumer has the incentive or ability to be informed or to see
that RA looks after their interest. An individual consumer has no interest in
even participating in the whole process. For an individual consumer a low level
of Pc is some small money saved compared to if the competitive price level
tariff is set at a high level. But for the firm, a few rupees gained from each
consumer due to competitive price –level tariff being set at a higher level
transforms into a large amount in the aggregate of gain in revenue from all
consumers. Since gain from added information about costs of firms is very low
for an individual consumer, each consumer individually is rationally ignorant.

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Now, when the RA sets the rates, consumers will not be aware of what is Theories of
happening, but the firm is very aware. Here, apply public choice theory and Regulation

see what an individual member of the RA might be thinking. Many of the

members of the RA would be knowing or come to know individual members
of the firm, and may not feel like opposing members of the firm. Some may
even be given economic incentives by the firm to carry out their interests. In
some cases it has been seen that members of RA might feel that since they
have been dealing with a firm dealing with a certain product or a public utility,
and since the firm also knows it, the member of the RA has the possibility of
being given employment in the firm after the person ceases to be a member of
the RA, or after retirement. Thus an individual member may, in accordance
with what is suggested by public choice theory, act in such a way that the
interest of the firm ends up being served rather than the interest of the public.
Regulatory capture was sought to be explained through the example of
regulation of a firm supplying electricity, but such situations can happen in
other industries too, like pharmaceuticals.
After the public interest theory had come to be questioned as a result off
empirical and theoretical research, the capture theory was developed mainly
by political scientist. This theory as explained above assumes that in the
course of time, regulation will come to serve the interests of the industry
involved. Regulatory authorities subject an industry to regulation by an agency
if abuse of a dominant position is detected. In the course of time, other
political priorities arrive on the agenda and the monitoring of the regulatory
agency by authorities is relaxed. The agency will tend to avoid conflicts with
the regulated company because it is dependent on this company for its
information. It often also does not have unlimited resources which makes it
aware of the costly effects of litigation of its decisions. Furthermore, there are
career opportunities for the regulators in the regulated companies. This leads
in time to the regulatory agency coming to represent the interests of the branch
involved.
Now we turn to some criticisms directed at the theory of regulatory capture.
The capture theory is unsatisfactory in a number of respects .First of all, there
is insufficient distinction from the public interest theory, because the capture
theory also assumes that the public interest underlies the start of regulation.
Secondly, it is not clear why an industry succeeds in subjecting an agency to
its interests but cannot prevent it being created. Thirdly, regulation sometimes
may appear to serve the interests of groups of consumers rather than the
interests of the industry. Regulated companies are often obliged to extend
services beyond voluntarily chosen level of service. Examples are transport
services, the supply of gas, water and electricity and telecommunication
services to consumers living in widely scattered geographical locations.
Fourthly, much regulation, such as environmental regulation, regulation of
product safety and labor conditions are opposed by companies because of the
negative effect on profitability. Finally, the capture theory is more of a
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Poltical Institutions hypothesis that lacks theoretical foundations. It does not explain why an
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industry is able to ‘take over’ a regulatory agency and why, for example,
consumer groups fail to prevent this takeover. One reason could be that
consumers are often not organized into a pressure group. Nor does it explain
why the interaction between the firm and the agency is characterized by
capture instead of by bargaining. According to these theories, capture is the
result of the increasing power of the agency which arises because the agency
in its ongoing relationship gets to know the firm better and better. The agency
has thus more and more opportunities to pursue its own objective and display
moral hazard with regard to the political principal. The principal can only
control this by having more stringent administrative rules and fair and open
procedures.
Check your Progress 2
1. Discuss the public interest theory of economic regulation.
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2. In what way does public choice theory of economic regulation differ from
public interest theory?
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3. Explain the theory of regulatory capture.
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11.7 LET US SUM UP

This unit was the second of the three units in this block. The block deals with
the role of institutions and political processes in economic development. The
present unit discussed economic regulation and a couple of theories that have
been put forward to understand economic regulation, and how and why it
takes place. In an era when government ownership and direct control over
economic enterprise is lessening, the importance of the design of a proper
regulatory process is of prime importance. We have seen across the world in
the last few decades the process of deregulation of certain industries that used

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to be regulated earlier. Hence it is of utmost importance that whatever the Theories of
extent of regulation is there is carried out efficiently and optimally. Regulation

The unit began by explaining what is economic regulation and how economic
regulation differs from social regulation. You were also familiarized with the
types of economic regulation: direct regulation or regulation by quantity;
price regulation; regulation of entry and exit, and so on. Then the unit went
on to explain what is meant by a natural monopoly and how it is regulated.
We saw that often public utilities are natural monopolies. Regulation of
natural monopolies and public utilities was discussed in detail.
Following this, the unit discussed at length the two main theories regarding
economic regulation. First, the public interest theory of regulation was
discussed. This theory assumed that regulators act in the public interest and
have the interest of the consumers and the general public in mind. It also
assumed that regulators have full information and knowledge about all
relevant parameters. A later variant of the public interest theory suggests that
regulation may not lead to optimal efficiency and there may be costs to
regulation, but regulation can lead to corrections for market failures. The
other theory of regulation is public choice theory. Public choice theory
suggests that government officials like regulators act in their own interest
most of the time, and their actions do not always further the public interest.
Hence in most cases economic regulation does not lead to optimal outcomes
in terms of efficiency and resource allocation. Finally, the unit discussed the
theory of regulatory capture, which suggests that those firms that are being
regulated end up ‘capturing’ the regulatory process, and the regulatory
authorities end up taking actions that help the firms themselves.

11.7 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1. See subsection 11.2.1
2. See subsection 11.2.2
3. See section 11.2.3
Check Your Progress 2
1. See section 11.4
2. See section 11.5
3. See section 11.6

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UNIT 12 GOVERNMENT FAILURE AND
CORRUPTION
Structure
12.0 Objectives
12.1 Introduction
12.2 Market Failure
12.3 The Role of Government in a Developing Economy
12.4 Government Failure
12.4.1Meaning of Government Failure
12.4.2 Causes of Government Failure
12.5 Corruption
12.5.1 Concept of Corruption
12.5.2 Causes of Corruption
12.6 Let Us Sum Up
12.7 Answers/Hints to Check Your Progress Exercises

12.0 OBJECTIVES
After going through this unit, you will be able to:

 Explain the concept of market failure and describe its consequences:

 Discuss the steps and measure the government can take to correct for market
failure;
 Discuss the general role a government usually plays in a market or mixed
economy;
 Explain what government failure means and how it leads to inefficiency;
 Explain what corruption means; and
 List the types of corruption and analyse its causes.

12.1 INTRODUCTION
This unit takes the discussion about the State and its role forward, from the
previous two units. Unit 10 had discussed about democracy in general, and the
role of institutions in economic development. The previous unit talked about
economic regulation., and how economic regulation is carried out. Unit 11 had
also talked about various theories of economic regulation, like public interest
theory of regulation, public choice theory of regulation, and the theory of
regulatory capture. This unit, the last of the course, provides a broad discussion
about government and governance in the context of developing nations.

Shri Saugato Sen Associate Professor of Economics, IGNOU, New Delhi
The unit begins with a discussion of market failure. You have read about market Government Failur
and Corruption
equilibrium in your microeconomics courses. However there are situations where
market equilibrium fails to attain Pareto optimality. This type of situation is
called market failure. The unit discusses market failure in general and the
various types of market failures there are, that is, the unit explains the various
situations and conditions that lead to outcomes that are described as market
failure. It then proceeds to suggest the role of government in correcting market
failure.
The role of the government, particularly in developing nations, is not limited to
correcting market failures. The government needs to establish rule of law, create
a system of contracts and ensure that these are honoured and generally there is
faith in the government. There are many other roles that the government plays in
developing nations, and the unit discusses these.
There are situations where the government, for certain reasons is not able to
realize its objectives. The government, in trying to correct market failures, ends
up in a situation that is suboptimal. These are situations of government failure.
Government failure is taken up for discussion.
Finally the unit presents a discussion on the problem of corruption. A definition
of corruption is provided, various types of corruption are mentioned and causes
of corruption is described.

12.2 MARKET FAILURE

Adam Smith, in his classic work An Inquiry into the Nature and Causes of the Wealth of
Nations published in 1776 argued that individual pursuing their private ends would,
through competition, be led to promote the public interest as though led by an ‘invisible
hand’. Ever since then, economists have widely agreed that competitive markets do lead
to efficiency, but later on, economists realized that competitive markets promote
efficiency if certain conditions are met, and there may be situations where the
competitive market does not perform well or work perfectly.
The question is, what do we mean by efficiency, and what are these conditions that have
to be fulfilled if the market is to promote efficiency? The basic answer is provided by
what are called the two fundamental theorems of welfare economics.

The Fundamental Theorems of Welfare Economics

The first fundamental theorem says that under certain conditions, competitive markets
lead to an efficient allocation of resources. Efficiency here means the allocation is
Pareto­ efficient and the situation is one of Pareto optimality. Pareto optimality means a
situation where it is impossible to make someone better off without at the same time
making someone else worse off. It may be possible to make someone better off. But at
the same time, someone else will necessarily end up being worse off. If there is a
situation where someone can be made better off but no one else ends up being worse off,
the economy or the society in question has not yet reached a situation of Pareto
optimality. When economists speak of efficiency they usually mean Pareto­optimal

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Poltical Institutions situations. When an economy has reached a Pareto optimal state, it reaches a point on its
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utility possibility frontier and does not lie below the utility possibility frontier.

The second fundamental theorem states that given the proper initial distribution of
resources, a decentralised competitive economy will attain some point on its utility
possibility curve. Of course, any point on the utility possibility curve can be attained but
the important thing is that it will be a point on the frontier and not below it. Of course,
Pareto optimality says nothing about equity or the distribution of resources. Even under
Pareto optimality there might be gross inequality. Even if the resulting income
distribution is not acceptable, we need not abandon the competitive market mechanism.
We merely have to redistribute the initial wealth. At some specific distribution of the
initial wealth, there will be the decentralised market mechanism at work at will help to
attain the desired outcome.
The fundamental theorems of welfare economics make a powerful case for the market
mechanism. What it says is that if decision –making is decentralised, that is, individual
decision makers independently make their own decisions based on their own self interest
and there is competition at work, we do not need any centralised resource allocation
mechanism like a planning agency. The second fundamental theorem gives a modern
touch to Adam Smith’s principle of the invisible hand. The reason the second theorem
works, that is, the reason a decentralised competitive system ensures Pareto optimality is
that individuals, in making decisions to make optimum gains, equate their marginal
benefit to the marginal cost. You have come across decision­making using marginal
concepts in your microeconomics course. Of course, the fundamental theorems of
welfare economics talks about a situation where there is no change, things are static, and
firms are small and cannot influence prices. It gives quite a narrow perspective of
competition. Sometimes, people have made a case for the market mechanism with quite
a different perspective of the competitive system in mind. We have seen that the
fundamental theorems of welfare economics assert that if certain conditions are met, the
economy will be Pareto­optimal. There are circumstances or situations where the market
is not Pareto­optimal or Pareto efficient. These situations are called situations of market
failure and economists have suggested that these situations provide a justification for
government intervention and activities. What are these situations? The main ones are:

Markets that are not competitive

Pareto optimality is attained only under situations of perfect competition. In some
industries there may be a few large firms dominating the market. These situations may
not be so bad if there are many potential entrants waiting to enter the market and provide
competition. Pareto optimality will be much harder to attain if there are barriers to entry.
If entry into a market were costless and easy, even the existing firms might behave in a
competitive manner. Sometimes barriers to entry are created through government
regulation, like giving a firm or at best a few firms some contract, and sometimes firms
use the possibility of reaping scale economies, that is, increasing returns to scale to bar
entry. Increasing returns to scale increasing returns to scale implies average cost of
production declines with the scale of output. The government does sometimes regulate
monopolies. The main reason monopolies are viewed with suspicion is that a monopolist

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will generally restrict output to raise prices with a view to making profits. A monopolist, Government Failur
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just like a firm under perfect competition, produces till the point where his marginal
revenue equals his marginal cost. Under monopoly however, the prices are higher and
equilibrium output is lower than under competition. Moreover, under monopoly, the
monopolist takes off part of the consumer surplus. But there is a certain portion that
accrues neither to seller nor to the buyers. This is called the deadweight loss under
monopoly. It is for these reasons that markets with monopolies do not attain Pareto
optimality and the situation is one of market failure.

Public Goods
There are goods that have two specific characteristics: firstly it is difficult to exclude
anyone from consuming these goods. Light going out to ships from a lighthouse, or
rather, the lighthouse itself is a classic example of this kind of a good in economics. The
other characteristic is that there is no rivalry in the consumption of a good. Consumption
by one person does not diminish the amount to be consumed by any one else. The
marginal cost to the additional individual enjoying the good is zero. A classic example is
national Defence. An example of a good showing rivalry is a shirt. These types of goods
displaying rivalry and exclusion­ability are called pure public goods. The market will not
supply, or will under­supply public goods, that is, supply in insufficient quantities.

Incomplete Markets
There are situations where markets fail to provide a good or service, even though the
cost of providing it is not more than what consumers are willing to pay for it. We call
this a situation of incomplete markets. This sort of situation is often encountered in
financial markets, particularly in markets for credit and insurance. There is the related
case of absence of complementary markets missing in some cases, or coordination
failures. All these are situations of market failure. Many people advocate a strong
government intervention in such situations.

Information Failures
Sometimes there is the presence of imperfect information in markets, and this provides a
rationale for government intervention. In these situations the fear is that in the absence of
government intervention, the market will provide too little information, so that some
parties to a transaction can get too much benefit. Collection and obtaining of information
ought not to be too costly.
There are other roles that have been put forward as legitimate for the State to
intervene and act in the economy, even in a market economy. The first of these is
to combat inflation, unemployment, and situations of disequilibria in some
markets, that is, to smooth out the ill effects of business cycles. Macroeconomic
stabilisation policy has long been an activity of the state, even in developed
nations, particularly since the Great Depression of the 1930s. You can read about
these policies in your macroeconomics course.
Two other important areas for the government to intervene in market economies
have been: to improve the income distribution which might emerge as an
outcome of the working of the market economy; secondly to compel people to
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Poltical Institutions consume certain goods that the state thinks is in the best of the consumers
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themselves, or goods which consumers otherwise does not choose to consume
even though they know it is in their own best interests. These goods are called
merit goods. Private firms may provide these but also because the government
has compelled the people to consume these. Examples of such merit goods are
helmets for scooter riders or seat belts in cars. Some have viewed this action by
the government as stemming from the government purporting to decide on behalf
of consumers as a philosophy of paternalism. Critics feel a section of society is
imposing its will on others.
One basic role of the government that everybody agrees is necessary is the
government providing the legal framework and protecting property rights. This, it
is felt will provide the necessary incentives and assurance to private markets to
function smoothly and work efficiently.

12.3 THE ROLE OF GOVERNMENT IN A

DEVELOPING ECONOMY
Governments in developing nations undertake activities in all areas of the
economy, and government activities affect all the variables that influence
economic development, either directly like investment in government assets, or
indirectly, say, through fiscal and monetary policies.
Economists usually identify six major functions of governments in market
economies. Governments provide the legal and social framework, maintain
competition, provide public goods and services, redistribute income, correct for
externalities, and stabilize the economy.
The government (1) provides the legal and social framework within which the
economy operates, (2) maintains competition in the marketplace, (3) provides
public goods and services, (4) redistributes income, (5) corrects for externalities,
and (6) takes certain actions to stabilize the economy.
There are two views on what role the government should play in the economy:
the conservative view, which is slightly Right­wing, and the liberal view, which
has less than total faith in the market to be able to solve all problems of the
economy and allocate resources optimally. The Conservatives believe that the
government’s role in the economy should be severely limited. They believe that
economic and political freedom will be undermined by excessive reliance on
government. Moreover, they question the government’s ability to solve social
and economic problems. They believe that faith in the government’s power to
solve these problems is unreasonable. They point to the slowness of government
bureaucracy, the difficulty in controlling huge government organizations, the
problems political considerations can breed, and the difficulties that arise when
people try to learn whether government programs are successful or not. On the
basis of these considerations, they argue that the government’s role should be
carefully limited. They call for more and better information about what
government can reasonably be expected to do (and do well).
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What is the Liberal view? While conservatives often question the government’s Government Failur
and Corruption
ability to solve important social and economic problems, liberals often question
the market’s ability to solve such problems. They point to important limitations
within the market system, and they claim that the government can do a great deal
to overcome these limitations. Government can regulate private economic
activity—for example, through minimum­wage laws. It can also provide goods
and services that private businesses produce in insufficient quantities—for
example, health care for the poor. Liberals are concerned with certain
consequences of market activity—contending, for example, that the price system
is unfair because it awards goods and services to those who can pay the price,
that the market system is actually ‘rationing by the purse’. In their view, people
who acquire little in the way of goods and services through market activity are
forced into lives of hardship. Liberals are, therefore, more concerned than
conservatives about the unequal distribution of income produced by market
activity and are more likely to propose government policies aimed at
redistributing income in a manner that will reduce income inequality
There is a widespread view that if markets fail in an significant way, there are
pressures on the government to correct for the market failure. The other main role
of the government is the provision of public goods. Although, as we saw above, a
pervasive presence of public goods is taken to be a case of market failure, so that
public goods provision can be taken to a part of correcting for market failures,
provision of public goods is a very important role for the government to play, as
often private firms do not have the incentive to provide public goods. In the
absence of the government, there may be an undersupply of public goods.
Let us now discuss some other rolesApart from the basic functions of the
government like providing a legal framework, enforcing contracts and protecting
property rights, and also providing public goods and correcting for market
failures, the government has to perform certain important functions in developing
nations. Since the late 1940s and early 1950s, from the time that many of the
developing nations became free of colonial rule and embarked on their
independent development trajectory, the government in these developing nations
has participated actively in the economy. First, the government has owned
several of the firms, and there has been a large public sector, even in India.
Several core sectors, Defence production, railways, airlines, atomic energy, and
heavy industries have traditionally been with the public sector. There have even
been sectors or industries or individual firms and organizations that were not in
the public sector to begin with were later nationalized, like some commercial
banks in India. Even the industries or sectors that were not directly owned by the
government, governments in various nations were involved in economic
regulation of these industries. These regulations included price controls,
minimum wage laws, laws governing employment conditions and ability of the
firm to fire workers. There were regulation and elaborate licensing system to
govern setting up of industries or capacity expansion etc. Many countries went in
for central planning, with physical targets with regard to growth rates and the
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Poltical Institutions required investment rate. Several other countries that other variations of
and the Functioing of
the State
planning. Thus there was reliance on bot central planning as well as, to some
extent, on the market, for economic development.Apart from monetary and fiscal
policies governments have policies regarding international trade and finance,
foreign direct investment, foreign portfolio investment and so on.
In developing nations governments have played an active role in providing
minimum needs, in developing programmes for poverty alleviation and
employment generation and other social programmes.
Since the 1980s, and in India particularly since 1991 with liberalization, the
prevailing view appears to be that the government should be playing a far lesser
role in the economy than was considered desirable earlier. Hence the government
has been lessening its role in the economy as compared to earlier. The
government has moved away from many sectors, there has been disinvestment in
public sector enterprises and privatization. Countries have changed in many cases
from a fixed to a flexible exchange rate so that governments exercise much lesser
influence on the determination of exchange rates. Today the thinking seems to be
that the state should only focus on areas where it will be costs for the private
sector to step in. It is recognized that the government should lower the amount of
its participation in the economy and strive to improve the quality of its activities
and services. There is emphasis on good governance, rather than a large amount
of government activities.
Check Your Progress 1
1. State the First and the Second Theorems of Welfare Economics
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

2. Describe the various types of market failure.

……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

3. What are the roles of governments in developing countries?

……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

182
 Government Failur
12.4 GOVERNMENT FAILURE and Corruption
In sections 12.2 and 12.3 we saw that there are certain situations where the
government intervenes in the market to correct market failures. Also, government
might itself engage in production and supply of certain goods. Other than this, the
government provides administration. In certain societies the government
undertakes economic planning. The government undertakes monetary and fiscal
policy and incurs expenditures, generates revenues, provides subsidies and
transfers, and imposes taxes. Thus, the state performs many functions. But if we
limit ourselves to government intervention to correct the malfunctioning of the
market, we find that there are situations where the government may not in
practice be able to realise its intentions. Very often political factors come into
play and the intention of the government gets lost due to political factors.
The classic case for the government to intervene in the working of the market,
apart from its role in providing security and ensuring enforcing of contracts
between private agents, and its role in distribution, is that of market failure.
Market failure is any deviation from conditions of perfect competition, such as
externalities, information assumptions, monopolies, or the presence of public
goods. The case for government intervention in the economy in these situation as
also provision of public goods, is made by neoclassical economists on the
grounds that Pareto optimality will not obtain in these cases.

What public choice theorists and some other economists have managed to do is
forcefully argue and persuade the profession that merely the existence of
externalities does not mean that the government will do a good job, it does not
automatically make a care for the government. Governments could be inefficient
in provision, could overspend, may not pay heed to cost overturns. The situation
where government displays inefficiency in provision has been called
government failure.

12.4.1 Meaning of Government Failure

This failure of the government to realise its stated objectives is broadly known as
government failure. This concept has been put forward as a counter to those who
point out the possibility of market failure. Roughly, the idea is that merely
because there is market failure does not mean that the government can step in and
make it better. There may be government failure, which might make the situation
worse than what it was to begin with. Thus, government failure can mean either
that the government fails to realise its objectives, or makes the wrong decisions.
There are several reasons that have been suggested about why the government
fails to realise its objectives.

The outcome of government failure is suboptimal efficiency conditions and lack

of optimal allocation of resources. The social costs may also be high.
183
Poltical Institutions 12.4.2 Causes of Government Failure
and the Functioing of
the State The first reason for government failure is that the government has limited
information. One of the advantages of the market system is that it seeks and
provides information in a costless manner, unless there are market failures. No
state can match the market when it comes to processing information. Moreover,
the state sometimes cannot foresee future events and make correct expectations.
The government lacks the total information required to solve entirely the
coordination problem. The information structure is imperfect. The best solution
for this is to decentralise government as much as possible, and make the decision
­making process participative.
The second reason put forward for government failure is that the government has
limited control over the private sector, over private agents. The government may
make decisions that require the citizens to do or not do certain things but the
administrative and enforcement costs may be very high. For instance, in cities,
the government may lay down rules about the size of extension that can be made
to dwellings but these may be flouted with impunity. Also, considerations of
democratic politics constrain government actions.
The third reason why there may be government failure is that the government has
limited control over the bureaucracy. Usually the legislature creates the Act and
law, and the executive may conceive the decisions and actions, but it is the
bureaucracy that has to implement these. The executive and elected people’s
representatives may have limited control over the bureaucracy, as there may be
situations of asymmetric information here, and the issue of moral hazard comes
in with the government as the principal and the bureaucracy as the agent.
Another reason often put forward for government failure is that there are
constraints imposed by the political process. Actions and decisions of the
government affect all people but in modern democracies these decisions are made
by a small group of people. We have touched upon this point while discussing the
second type of reason above. The party or coalition that emerged victorious in the
previous election forms the government, and they have the next election to
contest.
Why do we observe government failure in developing nations? Many years ago,
the Nobel Prize winning economist Gunnar Myrdal had spoken of a ‘soft state’ to
describe the state in developing nations. According to Myrdal, the state is not
able to effectively implement its stated policy objectives. There can be several
reasons for such widespread phenomenon of this inability to met stated policy
objectives. First, government functionaries, and politicians, may in many cases
display a pursuit of self­interest. While pursuit of self­interest is much extolled in
economics as we have seen in the previous section, in this case the self­interest of
these individuals are add odds with the objectives of the organisation, or the
bureau or the executive. This pursuit of self­interest not only leads to venality
and corruption, it also leads to sub­optimal results and inefficiency from the

184
government’s as well as from society’s point of view. You will read about Government Failur
and Corruption
corruption in the next section.
Yet another reason is that, as we mentioned earlier, electoral pressures sometimes
compel governments to take populist measures and undertake policies that do not
lead to outcomes that promote efficiency. Naturally this type of situation is likely
to take place more on the eve of elections. This may be true of national
governments as well as state­level governments. Related to this is an added
reason, which is that the government often works with short­ run perspective in
mind. This is especially true about solutions that the government is trying to find
about problems. Trying to find short­term solutions does not bring about
structural changes in the economy. This leaves many problems un­addressed.
One more reason for government failure is that government actions that are
prompted by some specific policy objective or social goal sometimes lead to
disincentive effects so that again, the optimal solution or outcome does not result.
For example, the government may be driven by the desire to realise some social
objectives but adopts a taxation policy that creates distortions in the economy and
lowers revenue.
Finally, there is a reason that is very significant as it exists in democratic
societies but is constantly undermining the ideals of democracy. This is that
certain special interest groups or pressure groups mange to capture the
policymaking process and get policies made that are to their advantage. Special
interest political groups like chambers of commerce, rich farmers’ groups,
professionals always try to influence the making of policies that will suit them.
Even when there are regulatory activities of the government to regulate the prices
and activities of monopolies, some business groups often take actions that
influence the regulatory process itself so that they actually benefit from the
regulatory processes as compared to other smaller firms. This is sometimes
described in the literature as ‘regulatory capture’ as we saw in the previous unit.

12.5 CORRUPTION
12.5.1 Concept of Corruption
We have touched upon the idea of government failure leading to corruption.
Let us elaborate more on the concept of corruption. While it may be difficult to
describe, corruption is generally not difficult to recognize when
observed. In most cases, different observers would agree on whether a
particular behavior connotes corruption.
Corruption has been defined in many different ways, each lacking in some
aspect. A few years ago, the question of definition absorbed a large proportion
of the time spent on discussions of corruption. The most popular and
simplest definition of corruption is that it is the abuse of public power
for private benefit. This is the definition used by the World Bank. From
this definition it should not be concluded that corruption cannot exist within
private sector activities. Especially in large private enterprises, this
185
Poltical Institutions phenomenon clearly exists, as for ex­ ample in procurement or even in
and the Functioing of
the State
hiring. It also exists in private activities regulated by the government
Sometimes, the abuse of public power is not necessarily for one's private
benefit but for the benefit of one's party, class, tribe, friends, family, and
so on. In fact, in many countries some of the proceeds of corruption go
to finance the activities of the political parties.
Among the economic changes that have taken place in recent years,
privatization has been most closely linked with corruption. There is no
question that public or state enterprises have been a major source of
corruption and especially of political corruption because they have
occasionally been used to finance the activities of political parties and to
provide jobs to the clienteles of particular political groups.
12.5.2 Causes of Corruption
Corruption is generally connected with the activities of the state and
especially with the monopoly and discretionary power of the state.
However, some of the least corrupt countries in the world, such as
Canada, Denmark, Finland, the Netherlands, and Sweden, have some of
the largest public sectors, measured as shares of tax revenue or public
spending in gross domestic product. The way the state operates and carries
out its functions is far more important than the size of public sector activity
measured in the traditional way, to determine the extent of corruption in a
nation.
In many countries, and especially in developing countries, the role of
the state is often carried out through the use of numerous rules or reg­
ulations. In these countries licenses, permits, and authorizations of var­
ious sorts are required to engage in many activities. The existence of
these regulations and authorizations gives a kind of monopoly power to
the officials who must authorize or inspect the ac­ tivities. These
officials may refuse the authorizations or may simply sit on a decision
for months or even years. Thus, they can use their public power to
extract bribes from those who need the authorizations or per­ mits. In
India, for example, the expression "licence raj" referred to the
individual who sold permits needed to engage in many forms of eco­
nomic activities. In some countries, some individuals become middle­
men or facilitators for obtaining these permits. The fact that in some
cases the regulations are nontransparent or are not even publicly avail­
able and that an authorization can be obtained only from a specific of­
fice or individual­that is, there is no competition in the granting of
these authorizations­gives the bureaucrats a great amount of power
and a good opportunity to extract bribes. Corruption can also happen
because of nexus and networks between powerful firms and industries and
politicians or political parties. The quality of bureaucracy sometimes
affects the extent of corruption.
186
The quality of the bureaucracy varies greatly among countries. In some, Government Failur
and Corruption
public sector jobs give a lot of prestige and status; in others, much less so.
Many factors contribute to that quality.
In the real world, relatively few people are punished for acts of cor­
ruption, in spite of the extent of the phenomenon. Furthermore, with the
exception of a few countries, there seems to be a wide gap between the
penalties specified in the laws and regulations and the penalties that are
effectively imposed. Generally, effective penalties tend to be more lenient
than the statutory ones. The administrative procedures followed before a
public employee is punished for acts of corruption are slow and
cumbersome. Often legal, political, or administrative impediments prevent
the full or quick application of the penalties. All these factors limit the
role that penalties actually play in many countries, especially when
corruption is partly politically motivated. This attitude brings a toleration
for small acts of corruption that can in time encourage bigger acts.
Check Your Progress 2
1. What do you understand by government failure? How is it different from
market failure?
…………………………………………………........………………………
…………………………………………………........………………………
…………………………………………………........………………………
…………………………………………………........………………………

2. What are the main reasons for government failure?

…………………………………………………........………………….......
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
3. Explain what you understand by corruption. What are the main reasons for
corruption?
…………………………………………………........……....…………….......
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

12.6 LET US SUM UP

This unit discussed issues of great importance in the trajectory of development of
poor countries. We looked at the meaning of market failure and why markets fail.
Some of the reasons we studied were imperfections in competition, presence of
public goods, externalities and imperfections in information.
187
Poltical Institutions Before discussing market failure, the unit had acquainted you with the two
and the Functioing of
the State
fundamental theorems of welfare economics. After discussing market failure the
unit suggested that there may be situations where the government tries to correct
market failures but is unable in practice to realise its stated objectives. This type
of situation is called government failure. Among the reasons for market failure
we found were moral hazard, imperfect information, and the limited control the
government had over the bureaucracy and implementing agencies.
Before the section on government failure, the unit presented a discussion on the
role of governments in developing countries. Other than its role in providing a
legal framework and enforcing contracts, we saw that in developing nations the
government has a lager role to play, like providing basic needs, reducing poverty,
and so on. We also saw that in recent decades the idea has gained ground that
governments should play a smaller role than before, and should strive to provide
good governance. Finally, the unit discussed the concept of corruption, and tried
to provide reasons for its prevalence.

12.7 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1. See section 12.2
2. See section 12.2
3. See section 12.3
Check Your Progress 2
1. See subsection 12.4.1
2. See subsection 12.4.2
3. See section 12.5

188
GLOSSARY
Absolute poverty : The situation of being unable or only barely able to
meet the subsistence essentials of food, clothing,
shelter, and basic health care. It is the inability to
provide for one’s own biological needs of sustenance

Axioms of : axioms are some desirable properties or characteristics

Inequality which these inequality measures/indexes should
possess.

Asset : An entity possessing market or exchange value, and

forming part of the wealth or property of the owner.

Capital Augmenting : If technical change leads to a augmenting of capital

goods, it is called capital augmenting change.

Capital Deepening : It is an increase in capital intensity, measured by

something analogous to the capital stock available per
labour hour spent, or the amount of capital available
for a worker to use.

Capital good : a produced good which is used to produce other

goods, a produced means of production.

Capital - Output : The number of units of capital required to produce a

Ratio unit of output.

Closed Economy : An economy which does not engage in any foreign

trade.

Community : Locally evolved institutional arrangements governed

institution by stable communities and buffered from outside
forces have sustained resources successfully for
centuries.

Convergence : The tendency for per capita income (or output) to

grow faster in lower-income countries than in higher
income countries, so that lower-income countries are
“catching up” over time. In the situation where
countries are hypothesized to converge not in all cases
but other things being equal (particularly savings
rates, labour force growth, and production
technologies), then the term conditional convergence
is used.

189
 Corruption : The misuse and abuse of public office for private gain.
The appropriation of public resources for private
profit and other private purposes through the use and
abuse of official power or influence.

Degree of Monopoly : A measure proposed by Michal Kalecki to look at

strength of market power by a monopoly.

Depreciation : Wear and tear in the use of capital goods (machinery,

plant, equipment)

Divergence : A tendency for per capita income (or output)

togrow faster in higher-income countries than in
lower-income countries sothat the income gap
widensacross countries over time (aswas seen in
the two centuries after industrialisation began).

Economic Growth : It is an increase in the level of output of goods and

services that is sustained over a long period of time,
measured in terms of value added.

Endogenous : Something the value of which is determined within

the system. In modelling, a variable the value of
which is determined by solving the system, and is not
taken as given.

Endogenous growth : Economic growth generated by factors within the

theory production process (e.g., increasing returns or induced
technological change) that are studied as part of a
growth model.

Exogenous : Something the value of which is given from outside.

In modelling, a variable the value of which is not
determined by solving the model, but is taken as
given.

Extensive growth : This refers to growth in total output level of an

economy.

Factor analysis : refers to the analysis in which weights is given to

various variables (or indicators) according to the
importance accorded to it.

Financial repression : Constraints on investment resulting from the rationing

of credit, usually to a few large-scale borrowers, in
financial markets where interest rates and hence the
supply of savings are below market-determined levels.
190
Fixed coefficient : A production function where the inputs are
production function used in fixed proportions.

Functional : Functional distribution is about the magnitude of

Distribution of returns to different factors of production.
Income

Gini Coefficient : It is the ratio of the area between the line of equal
distribution (diagonal 45º line) and the Lorenz curve
divided by the total area of the half-square in which
the curve lies.

Golden Age : A state proposed by Joan Robinson where smooth

Equilibrium steady growth taken place and the desired and
possible rates of accumulation are equal.

Gross Domestic : Measure of the level of economic activity in an

Product economy’s boundaries in a particular time period,
normally a year or a quarter.

Growth Accounting : A method or technique to account for relative

contribution of growth of capital, that of labour and
that of technology to the overall growth in output.

Growth Accounting : It is a formula that shows through an equation that

Formula states that the growth rate of productivity equals
capital’s share of income times the growth rate of
capital per hours of work plus the growth rate of
technology.

Head Count Ratio The proportion of the number of people living below
the line of poverty in the total population.
:

Human : An index measuring national socio-economic

Development Index development, based on measures of life expectancy at
birth, educational attainment, and adjusted real per
capita income.

Income per capita : National income of a country divided by total

population.

Infant mortality : Deaths among children between birth and 1 year of

rate age per 1000 live births.

Institutions : Institutions are the rules of the game in a society or,

more formally, are the humanly devised constraints
that shape human interaction.

191
 Intensive growth : This refers to growth in per capita output level in an
economy.

Investment : That part of national income which is spent on the

acquisition of capital goods.

Kuznets curve : A graph representing the relationship between a

country’s income per capita and its inequality of
income distribution. It is an inverted U curve which
shows the relationship between the inequality and
economic growth.

Labour-augmenting : Technological progress that raises the productivity of

technological an existing quantity of labour by general education,
progress on-the-job training programmes, and so on.

Levels of living : The extent to which a person, family, or a group of

people can satisfy their material and spiritual wants. If
they are able to afford only a minimum quantity of
food, shelter and clothing, their levels of living are
said to be very low. If they enjoy a great variety of
food, shelter, clothing, and other things, such as good
health, education, and leisure, they are enjoying
relatively high levels of living.

Literacy : Ability to read and write.

Levels of living : The extent to which a person, family, or a group of

people can satisfy their material and spiritual wants. If
they are able to afford only a minimum quantity of
food, shelter and clothing, their levels of living are
said to be very low. If they enjoy a great variety of
food, shelter, clothing, and other things, such as good
health, education, and leisure, they are enjoying
relatively high levels of living.

Line of Poverty : The minimum level of income required to purchase

the basic needs of sustenance.

Literacy : Ability to read and write.

Literacy rate : The percentage of population aged 15 and above that

are able to read and write.

Lorenz curve : A graph depicting the variance of the size distribution

of income from perfect equality. It represents the
inequality in a country by using the percentage of
population and percentage of total income.

192
Malnutrition : A state of ill-health resulting from an inadequate or
improper diet, usually measured in terms of average
daily protein consumption.

Market failure : A market’s inability to deliver its theoretical benefits

due to the existence of market imperfections such as
monopoly power, lack of factor mobility, significant
externalities, or lack of knowledge. Market failure
often provides the justification for government
intervention to alter the working of the free market.

Millennium : Precursor to the SDGs adopted by the United Nations

Development Goals in 2000 to: eradicate extreme poverty and hunger;
(MDGs) achieve universal primary education; promote gender
equality and empower women; reduce child mortality;
improve maternal health; combat diseases; ensure
environmental sustainability; and develop a global
development partnership. Goals were assigned targets
to be achieved by 2015.

Multidimensional : A poverty measure that identifies the poor using dual

Poverty Index cutoffs for levels and numbers of deprivations, and
(MPI) then multiplies the percentage of people living in
poverty times the percentage of weighted indicators
for which poor households are
deprived on average.

National income : Total money value of all final goods and services
produced in an economy during a period of time,
usually a year.

Natural Growth : Refers to the maximum growth rate which an

Rate economy can achieve with its available factors of
production and resources.

Non-excludable : goods for which it is difficult to charge a price to the

goods user.

Path dependency : A condition in which the past condition of an

individual or economy, measured by the level of one
or more variables, affects future conditions.

Per Capita Income : this is calculated by total gross domestic product of a

country divided by total population. Per capita income
is often used as an indicator of level of living and
development. It can, however, be a biased index
because it takes no account of income distribution.

193
 Personal : It describes income flows to individuals or
Distribution of households.
Income

Poverty Trap The idea that low savings rate and low capital-labour
ratio lead to an equilibrium situation where poor
:
nations are trapped in poverty.

Prisoner’s Dilemma : A game where all the individuals choose rational

strategies (individually) but those strategies are no
good for a collective outcome because the collective
outcome turns out to be irrational.

Private property : Rights over the resource are clearly defined which
institution help manage the resources as it makes easier to
exercise control.

Public good : An entity that provides benefits to all individuals

simultaneously and whose enjoyment by one person
in no way diminishes that of anyone else.

Rate : Change in the value of a variable with respect to

another variable, usually time.

Relative Poverty : An extreme term of inequality.

Returns to Scale The proportion by which output changes, when all

inputs are increased by a certain equal amount.
:

Rival Goods : Goods, which, when consumed by one person,

reduces the amount left over for consumption by
other people.

Savings : That part of national income which is not spent on the

purchase of consumer goods.

Social indicators Non-economic factors of development, such as, life

expectancy at birth, literacy rate, infant mortality rate
:
and doctors per 1000 population.

Solow neoclassical : Growth model in which there are diminishing returns

growth model to each factor of production but constant returns to
scale. Exogenous technological change generates
long-term economic growth.

194
Solow Residual : Solow residual is a measure of the change in total
factor productivity in a Solow growth model. This is a
way of doing growth accounting. It represents that
part of growth in output which is not accounted for
by the growth in inputs. The Solow residual is also
known as Total Factor Productivity.

State institution : It is the institution wherein all the decisions are taken
by a central authority, generally known as
government.

Steady State : A condition in which the key variables are not

changing.

Sustainable : Successor to the earlier Millennium Development

Development Goals Goals (MDGs),a set of 17 broad goals, among them
(SDGs) to: end poverty and hunger; ensure healthy lives,
quality education, gender equality, water and
sanitation, and modern energy; promote inclusive
growth, employment, resilient infrastructure,
industrialisation, innovation, and improved cities;
educeinequality; combat climate change and
environmental damage; and promote peace, justice,
and global partnership.

Tragedy of : A phenomenon which occurs when each individual

Commons thinks mainly of his own and not at all about the
common interest.

Vicious circle : A self-reinforcing situation in which factors tend to

perpetuate a certain undesirable phenomenon.

Warranted Growth : Refers to that growth-rate of the economy when it is

Rate working at full capacity and making optimum use
of machine and manpower.

195
 SOME USEFUL BOOKS
Banerjee, Abhijit Vinayak, Benabou, Roland and Mookherjee, Dilip (eds) (2006)
Understanding Poverty, Oxford University Press, Oxford

Dasgupta, Partha (2007) Economics: A Very Short Introduction, Oxford

University Press, Oxford

De Janvry, Alain and Sadoulet, Elisabeth (2016) Development Economics:

Theory and Practice, Routledge, London

Jones, Charles,I. (2013) Economic Growth second edition (Indian reprint) Viva-
Norton, New Delhi

Meier, Gerald M. and Rauch, James E (eds.) (2000). Leading Issues in Economic
Development (7th edition) Oxford University Press, Oxford.

Ray, Debraj (1998) Development Economics, Oxford University Press, New

Delhi.

Todaro, Michael P., and Smith, Stephen C. (2017) Development, Economics, 12th
edition (Indian reprint), Pearson, New Delhi.

196
 BECC-114

DEVELOPMENT
ECONOMICS - II

EXPERT COMMITTEE
Prof. Atul Sarma (retd.) Prof. M S Bhat (retd.) Prof. S.K. Singh
Former Director, Jamia Millia Islamia Professor of Economics
Indian Statistical Institute, New Delhi (Retd)
New Delhi IGNOU, New Delhi

Dr. Surajit Das Dr. Manjula Singh Prof. B S Prakash

CESP, St. Stephens College, Indira Gandhi National
Jawaharlal Nehru University University of Delhi Open University,
New Delhi Delhi New Delhi

Prof. Kaustuva Barik Dr. Indrani Roy Choudhary Dr. S.P. Sharma
Indira Gandhi National Open University, Associate Professor, Economics Associate Professor,
New Delhi Jawaharlal Nehru University, Economics
New Delhi Shyam Lal College,
University of Delhi,
Delhi
Shri. B.S. Bagla Ms. Niti Arora
Associate Professor of Economics Assistant Professor Shri Saugato Sen
PGDAV College Mata Sundri College Associate Professor of
University of Delhi, University of Delhi, Economics
Delhi Delhi IGNOU, New Delhi

Course Coordinator: Shri Saugato Sen, Discipline of Economics,

School of Social Sciences, IGNOU, New Delhi.
Course Editors: Units 1, 2 and 6 Prof. Narayan Prasad.
Units 3, 4, 7 and 9 Prof. B. S. Prakash.
Units 5, 8 and 10 Prof. K. Barik.

School of Social Sciences

Indira Gandhi National Open University
Maidan Garhi, New Delhi-110068
COURSE PREPARATION TEAM
Unit Block/Unit Title Unit Writer
BLOCK 1 DEMOGRAPHY AND DEVELOPMENT
Unit 1 Demographic Transition and Its Dr. Varun Bhushan, Assistant Professor, PGDAV
Implications College, University of Delhi
Unit 2 Demography and the Process of Dr. Varun Bhushan, Assistant Professor, PGDAV
Development College, University of Delhi
BLOCK 2 THEORIES OF UNDERDEVELOPMENT
Unit 3 Linear Theories of Dr Puja Saxena Nigam, Associate Professor, Economics,
Underdevelopment Hindu College, University of Delhi, New Delhi
Unit 4 Structural Theories of Dr Puja Saxena Nigam, Associate Professor, Economics,
Underdevelopment Hindu College, University of Delhi, New Delhi
Unit 5 Dependency Theories of Shri Saugato Sen
Underdevelopment Associate Professor of Economics, IGNOU, New Delhi
BLOCK 3 LAND LABOUR AND CREDIT MARKETS
Unit 6 Land Markets Indrani Roy Chowdhury,
Associate Professor, CSRD, JNU, New Delhi.
Unit 7 Labour Markets Indrani Roy Chowdhury,
Associate Professor, CSRD, JNU, New Delhi.
Unit 8 Credit Market Ms. Mamta, Research Scholar, CSRD, JNU, New Delhi.
BLOCK 4 INDIVIDUALS, COMMUNITIES AND COLLECTIVE OUTCOMES
Unit 9 Individual Behaviour in Social Shri Saugato Sen
Environments Associate Professor of Economics, IGNOU, New Delhi
Unit 10 Governance in Organisations and Dr. Nidhi Tewathia, Assistant Professor,
Communities School of Social Sciences, IGNOU
BLOCK 5 ENVIRONMENT AND SUSTAINABLE DEVELOPMENT
Unit 11 Institutions and Evolution of Dr. Nidhi Tewathia, Assistant Professor,
Democracy School of Social Sciences, IGNOU
Unit 12 Theories of Regulation Dr. Nidhi Tewathia, Assistant Professor,
School of Social Sciences, IGNOU
BLOCK 6 GLOBALISATION
Unit 13 Changing Perspectives on Dr. Nidhi Tewathia, Assistant Professor,
Globalisation School of Social Sciences, IGNOU
Unit 14 Globalisation and Development Dr. Nidhi Tewathia, Assistant Professor,
School of Social Sciences, IGNOU

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 COURSE CONTENTS
INTRODUCTION 7
BLOCK 1 DEMOGRAPHY AND DEVELOPMENT 9
Unit 1 Demographic Transition and Its Implications 11
Unit 2 Demography and the Process of Development 25
BLOCK 2 THEORIES OF UNDERDEVELOPMENT 53
Unit 3 Linear Theories of Underdevelopment 55
Unit 4 Structural Theories of Underdevelopment 74
Unit 5 Dependency Theories of Underdevelopment 89
BLOCK 3 LAND LABOUR AND CREDIT MARKETS 105
Unit 6 Land Markets 107
Unit 7 Labour Markets 130
Unit 8 Credit Market 150
BLOCK 4 INDIVIDUALS, COMMUNITIES 177
AND COLLECTIVE OUTCOMES
Unit 9 Individual Behaviour in Social Environments 179
Unit 10 Governance in Organisations and Communities 194
BLOCK 5 ENVIRONMENT AND 209
SUSTAINABLE DEVELOPMENT
Unit 11 Sustainable Development 211
Unit 12 Theories of Regulation 223
BLOCK 6 GLOBALISATION 237
Unit 13 Changing Perspectives on Globalisation 239
Unit 14 Globalisation and Development 250
GLOSSARY 267
SOME USEFUL BOOKS 274

5
 COURSE INTRODUCTION
Welcome to this course on Development Economics. Your memory is fresh from
your study of the first Course on Development Economics-I in the previous semester.
The present course is on Development Economics-II. This course builds upon the
course Development Economics-I. It discusses and analyses several topics in the
economics of development. The course consists of 14 units spread over 6 blocks.
The first block is titled Demography and Development. This block has two units.
They discuss demographic transition. The block also discusses issues of the link
between demographic features and economic development.
The second block is on Theories of Underdevelopment. There are three units in
this block. Although the name suggests that these are theories of underdevelopment,
you must not take these to mean they explain the reasons for underdevelopment.
They identify the underlying factors for underdevelopment and suggest ways to come
out of the underdevelopment status so as to foster economic development.
The third block in this course is on Land, Labour and Credit Markets. This
block takes an analytical look at some of the factor markets. The focus is primarily
on the rural sector. The three units look at the markets for land, labour and capital
respectively. They mainly do so in the context of rural areas in developing countries.
The idea is to see whether these markets function like the ones you studied
theoretically in your Microeconomics courses. The units in this block also considers
if some of these factor markets are interlinked.
The next block, block four, is on Individuals, Communities and Collective
Outcomes. This block has two units. They look at situations where outcomes and
processes are deviations from usual market equilibrium. Sometimes, in developing
countries, markets for some specific products or services may be missing. In these
situations, the role of norms and customs comes to the fore. In certain situations,
multiple equilibria may exist. The block covers the role of social institutions, local
rural bodies and NGOs. It also discusses governance issues in these institutions. The
very important topic of social capital is also discussed in this block.
Block five is on Environment and Sustainable Development. This block, too,
has two units. The block discusses the crucial topic of sustainable development
along with its linkage between environment and economic development. The block
also explains the concept of externality.
The last block, Block 6, is on Globalisation. This block also has two units. They
discuss the changing perspectives on globalization, that is, the changing connotation
and conceptualization of the terms globalization, its contents, and the impact of
globalization on economic development. For this, the block discusses theories of
international trade as well as barriers to trade (tariffs and quotas). It also covers in
brief the areas of international trade, multilateral trade agreements and trade blocks.
 BLOCK 1
DEMOGRAPHY AND DEVELOPMENT
BLOCK INTRODUCTION
The first Block of this course discusses demography and development. It explains
the concepts of demography. Since population — its measurement, growth, levels etc.
are elements of demography, the block explains the impact of population growth and
levels on economic development. The block also discusses important concepts like
demographic transition, age structure of the population, etc.
The Block has two units, titled Demographic Transition and its Implications and
Demography and the Process of Development.
The first Unit is about the concepts of population and demography, age structure
of population, historical trends in developed and developing countries and the choices
involving fertility. The second unit discusses the impact of population growth on the
economy. It discusses the Solow and Harrod-Domar growth models to see how these
models can help understand the linkage between population growth and economic
growth. The unit also explains the negative impact of population growth on economic
development in terms of Malthus’s theory. The unit also covers other important topics
like human capital, rural-urban migration and gender-gap.
 Demographic
UNIT 1 DEMOGRAPHIC TRANSITION AND ITS Transition and Its

IMPLICATIONS
Implications

Structure
1.0 Objectives
1.1 Introduction
1.2 Population: Some Basic Concepts
1.3 The Importance of Age Structure of the Population
1.4 The Hidden Momentum of Population Growth
1.5 The Theory of Demographic Transition
1.6 Historical Trends in Developing and Developed countries
1.6.1 Demographic Transition in Developed Countries
1.6.2 Demographic Transition in Developing Countries
1.7 The Adjustment of Birth Rates
1.7.1 Hoarding Versus Targeting
1.7.2 Cost-Benefit Approach to Fertility Choice
1.8 Is Fertility Too High?
1.9 Let Us Sum Up
1.10 Hints to Check Your Progress Exercises

1.0 OBJECTIVES
After studying this Unit, you should be able to:
 examine the theory of demographic transition and its trends in developing and
developed countries.
 explain the role of the age structure in the study of demography.
 discuss the reasons for high population growth that creates an echo effect.
 analyse the social and economic factors that affect fertility decisions at the
level of the household.

1.1 INTRODUCTION
The relationship between population growth and the economic development is a
complex one. There is ambiguity concerning what is the cause and what is the


Dr. Varun Bhushan, Assistant Professor, PGDAV College, University of Delhi.
11
Demography and
effect. Is population growth an impediment or a stimulus to economic
Development development? This has been debated by several economists. The pessimistic
argument states that population growth cannot be good for the country as it
consumes resources. There is less per head to go around. The optimistic argument
emphasizes that necessity is the mother of invention and without pressure of
population on resources there may be no necessity and consequently no
invention. Demographic transition takes us into the discussion about the close
relationship between what the new developed countries have demographically
experienced in the past and what is currently being experienced by the
developing countries. We shall address these issues of society in this unit. There
are wide patterns in the population growth influencing the decisions made by the
individual countries regarding policies on fertility. In this unit, we shall try to
answer the questions pertaining to how economic development affects fertility.
Also, the couple’s decision regarding family size if the social impact is to be
internalized.

1.2 POPULATION: SOME BASIC CONCEPTS

Before we begin with a serious discussion on population, let us review
some basic concepts and terminology that are used by demographers.
Crude birth rate or birth rate: The number of children born alive each year
per 1000 population. For example, in each year India adds 17 new born
babies for every thousand members of the population.
Death rate: The number of deaths each year per 1000 population. For example,
a death rate of 7 per 1000 means that in each year an average of 7 people die for
every 1000 members of the population.
Population growth rate: It is computed as birth rate minus death rate and
is expressed in percentages. The natural increase in population measures the
excess of births over deaths. In technical terms, it is the difference between
fertility and mortality. The rate of population increase is the growth rate of
population after adjusting for immigration and emigration.
Net international migration: The excess of persons migrating into a country
over those who emigrate from that country. It is very limited but is growing in
its importance today. It was an extremely important source of population
increase in North America, Australia and New Zealand and corresponding
relative decrease in Western Europe.
Aggregate birth rate: It is the outcome of the age distribution in a country, the
age-specific fertility rates of women in that country and fraction of population in
different age groups.
Aggregate death rate: It is the composite (total) that comes from age-
specific death rates in a particular country and the overall age distribution in that
country.

12
 Demographic
Age specific fertility rate: It is the average number of children per year born to Transition and Its
women in a particular age group. Implications

Total fertility rate: The number of children that would be born to a women if
she were to live to the end of her childbearing years and bear children in
accordance with the prevailing age-specific fertility rates. It is calculated by
adding up all the age specific fertility rates over different age groups.
Life expectancy at birth: The number of years a new born child would live
subject to the mortality risks prevailing for the population at the time of child’s
birth.

1.3 THE IMPORTANCE OF AGE STRUCTURE OF

THE POPULATION
The age distribution of a population is given as proportions of population for
different age groups. Population can be divided into different age groups like 0-
15, 15-59, 60 and above. In developing countries, population is relatively young
and birth rate can be significantly high due to large percentage of population in
their reproductive years. Let us take an illustration.
Two countries with same population growth rates may have dramatically
different age structures. Suppose there are two countries: country A and country
B. Country A may have both significantly high birth rate and high death rate.
Country B has low birth rate and low death rate. The two effects would cancel
out and hence the net population growth rate is the same in both the countries.
But country A is adding more young people to its population than country B.
Unless the higher death rates in country A are entirely concentrated among the
young, which is unlikely, there will be more young population in country A than
in country B. Country A therefore would have a younger age distribution than
country B.
Age distribution plays a vital role in determining the pace of economic
development. In country A, the youth dependency ratio would be high. Youth
dependency ratio is the proportion of young people below 15 years to the
working age population (i.e. aged 15-59 in a country). The workforce will have
to support children in the initial phases of population growth. In country B, the
problems would differ as they would face high old age dependents (over 60) due
to population ageing.

1.4 THE HIDDEN MOMENTUM OF POPULATION

GROWTH
High population growth leads to more of younger population. This in turn leads
to high birth rates. This results in high youth dependency providing a momentum
for population growth. The phenomena of continued increase in population, even
after a fall in birth rate, is due to the large youth population. This is what is 13
Demography and called as the ‘hidden momentum of population growth’. This expands the
Development
population’s base of potential parents creating an echo effect that keeps the
population growth high.
Population growth has a built-in tendency to continue as a powerful momentum.
This is just like a speeding bicycle, which even when brakes are applied, tends to
keep moving for some time before coming to a stop. This momentum of
population growth can persist for decades after the birth rates drop. Hence,
population growth provides an enormous degree of inertia. The following are the
two main implications of this hidden momentum of population growth.
1) High birth rates cannot be altered substantially overnight. The social,
economic and institutional forces that have influenced fertility rates over the
course of centuries do not evaporate at the urge of national leaders. A
relatively large fraction of population continues to be at age where they are
just about to marry and have families. Even if the total fertility rates were
reduced, the sheer number of young people would lead to large number of
births viewed as fraction of entire population. Even the best of intentions and
implementation to halt population growth would not work in this scenario.
2) The hidden momentum of population growth relates to the age structure of
many developed and developing countries. Countries where the fraction of
prime working age citizens is rising face a potential crisis. This is because
many of them may remain unemployed with which is associated inequality
and social unrest followed by potential loss of output.

The accelerated economic growth that countries experience due to rising working
age population is also an important window of opportunity for strong income and
productivity gains. This is referred to as demographic dividend. During this
phase, working age population grows at a faster pace than the dependent
population. There are more human resources available to invest in human capital.
In contrast, there are high income countries where the proportion of working age
population decline as a result of population ageing. This requires increased
resources for old aged population support. This poses greater challenges as
higher savings rate would be required. In such situations, allowing for more
immigration can be helpful.

1.5 THE THEORY OF DEMOGRAPHIC

TRANSITION
The process by which fertility rates eventually decline to low and stable levels is
explained by a concept called demographic transition. The phasing out of
population growth rates is explained in a three stage process. The first stage is
one of stagnant growth characterized by high birth rates and high death
rates (Stage 1). The second stage is a rapid growth stage but is again a phase
of high birth rates and death rates (Stage 2). It is the third stage in which there is
stability marked by low growth with low birth and death rates (Stage 3). The
demographic

14
 Demographic
transition is jointly made up of all these three stages or phases. Together they Transition and Its
explain why all contemporary developed and developing nations have passed Implications
through these phases. Almost all the countries can be described as currently in
second or third phase of demographic transition.
First Stage of Demographic Transition: Before economic modernization, all
contemporary developed nations for centuries had stable or very slow growing
populations as a result of a combination of high birth rates and almost equally
high death rates. The phase was marked for an increase in population though the
net growth rate was still minimal. Although the birth rates were high, death rates
were also sufficiently high and persistent to keep the growth rates down.
Second Stage of Demographic Transition: This stage began when
modernization was associated with better public health facilities, healthier diets
and higher incomes. These led to a marked reduction in mortality that gradually
raised life expectancy from 40 years to 60 years. However, the decline in death
rates was not immediately accompanied by a decline in fertility. The growing
divergence between high birth rates and falling death rates led to sharp increases
in population growth.
The very forces that caused death rates to decline also caused economic
productivity to increase. For example, the rise in agricultural productivity led to
an increase in overall carrying capacity of the economy. Secondly, birth rates are
high because of the inertia that characterizes fertility choices made by the
households.
Third Stage of Demographic Transition: In this stage, the forces and
influences of modernization and development causes the beginning of a decline
Birth rate and death rate per 1,000 population

40
Birth rate

Death rate
30 Population explosion

20
Total
population

10
High birth rates falling
death rates Stable death rates, falling
birth rates
Predevelopment Developed
0
First Stage Second Stage Third Stage

Time

Fig. 1.1: Three Stages of Demographic Transition

15
Demography and in fertility. As time overcomes inertia, birth rates fall and the population growth
Development
rates decline. Falling birth rates converge with lower death rates leaving little or
no population growth. This is the third and final phase of demographic transition.

From the Fig. 1.1, we can infer that during the first stage of demographic
transition, the birth rates and the death rates are high. As the country moves high
on the trajectory of economic development, the death rates fall with birth rates
staying high. This results in population explosion. Finally, the birth rates slow
down resulting in stable population growth rate.

1.6 HISTORICAL TRENDS IN DEVELOPING AND

DEVELOPED COUNTRIES
Historical trends are different for developed and developing countries. Let us see
how this is separately.

1.6.1 Demographic Transition in Developed Countries

In the developed countries, the fall in death rate was relatively gradual, limited by
the trial and error of innovation. The (i) improved production of food, (ii)
institution of sanitation methods and (iii) greater understanding and control over
disease by medical advances were a result of new discovery or invention. In
other words, they were different from the pre-existing stock of knowledge.
The initial level of birth rates was itself generally low in Western Europe. This
was a result of either late marriage or celibacy. Overall, rates of population
growth seldom exceeded the 1% level even at their peak. Birth rates in the later
years fell slowly due to technical progress. Population growth in these countries
was more of slow spurt rather than a violent explosion i.e. birth rates fluctuated
minutely and death rates remained fairly stable or rising gradually. The pattern of
demographic transition in European countries was thus clear.
1.6.2 Demographic Transition in Developing Countries
Birth rates in many developing countries are considerably higher than developed
countries because women tend to marry at an earlier age. As a result, there are
both more couples planning their families and more years of fertility period.
The decline in death rates was widespread and sudden. However, antibiotics were
available for a variety of illness i.e. they did not have to be invented. The use of
insecticides such as DDT provided an effective way to combat malaria to
manageable proportions. Public health organisations were able to have the benefit
of application of effective modern medical and public health technologies. This
caused death rates to fall rapidly. There was widespread application of
elementary methods of sanitation and hygiene. As a result, Stage 2 of
demographic transition came to be characterized by peak population growth
rates. This was well in excess of 2% per annum in most developing countries.
16
 Demographic
Check Your Progress 1 Transition and Its
Implications
Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) State the three stages of demographic transition.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) What is meant by the notion of hidden momentum of population growth?
………………………………………………………………………………….
………………………………………………………………………………….
3) What is meant by ‘dependency burden’? Is the dependency burden high or
low in developing countries?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….

1.7 THE ADJUSTMENT OF BIRTH RATES

There are two types of inertia: macro inertia and micro inertia. The former is the
inertia at the level of the overall population i.e. inertia at the aggregate level. Age
distribution plays an important role in this. Under this, both the high birth rates
and the high death rates keeps the net population growth rate low. This is seen in
the populations of poor countries where on an average there would be more
young age population. This feature keeps the overall birth rates high even if
fertility rates are reduced at different age groups. The sheer inertia of this age
distribution guarantees that more young people of reproductive age continue to
enter the population.
Micro inertia is at household level. Societal norms change after long time.
Consider a poor society with high rates of infant mortality and intensive use of
child labour in farming as well as expected old age support. Such society
celebrates the birth of many children (especially sons). It develops certain
attitudes towards the appropriate age of marriage, the role of women, the
importance of contraception, the desirability of primary education, etc.
Even with advances in sanitation and medicine, mechanization of agriculture,
institutional forms of old age security and drop in child labour, the fertility rates
of poor countries have not declined at the same pace. Jolting such a society into a
‘new equilibrium’ requires coordinated efforts. Family planning programs play a
very important role. Apart from spreading information regarding cost, availability
and effectiveness of different methods of contraception, these programs serve as
a form of social legitimization. Media is extremely powerful in this regard and
can transmit norms from one community to another. Trends in fertility,
mortality are discernible in different countries as outlined below.
17
Demography and Fertility Choice and Missing Markets: In developing countries, children are
Development
generally a substitute for various missing institutions and markets, notably
institution of social security in old age. In a developed country, one pays a good
fraction of one’s earned income into a government fund. This is termed as social
security fund. When one retires, this fund is used to pay a retirement pension. A
second source of old age funds is an employer-subsidized retirement plan. Here,
both the employer and the employee make contributions. One’s potential to save
oneself for their retirement is also high.
On the other hand, in developing countries, such markets or mechanisms are
completely missing. The institutions of various forms of insurance are also only
available to the formal sector. It is in the informal sector where large sections of
population live or work. Employment here is largely casual and wages are
abysmally low. There is little or no incentive to set up a retirement scheme
between employer and employee. Likewise appropriate contributions to a
government-run social security system are not usually there. Due to limited
information, it is difficult for an insurance company to assess the validity of
claims such as crop failure or sudden drop in income of a street side hawker.
Agriculture is particularly hampered by income shocks. Therefore, insurance
markets in the agricultural and urban informal sectors are often missing.
Mortality and Fertility: Let us consider the probability that child will grow up
and look after his/her parents. The probability is indicated by several factors.
These are:
a) The child may die, infancy being the biggest hurdle.
b) There are diseases of childhood, which are still a significant killer in many
developing countries up to the age of five or so.
c) There is a possibility that the child may not be an adequate income earner.
d) A child may not look after his/her parents in spite of being capable of taking
care of them in their old age.
e) The parents themselves might not anticipate being around in their old age.
This is usually the case in countries with high mortality.
Let p be the probability of having a child surviving to grow up. This implies
crossing through the critical stages of (i) infant mortality and child mortality, (ii)
the eventuality that child survives but does not earn adequate income and (iii) the
possibility that the child earns adequate income but nevertheless does not look
after the parents.
Let q be the probability that the parents find a threshold probability of receiving
support from at least one child. This is a matter of attitudes towards risk and
varies greatly from couple to couple.
Suppose a parent has n children. Probability that none of the children will look
after the parents is (1- p) n. Hence the probability rule becomes 1- (1- p) n˃ q

18
Although, falling death rates are central to the fertility decline, there are other Demographic
Transition and Its
factors in the construction of p that have little to do with the fall in death rates. Implications

1) The poorer the region, the greater the anticipated probability that a single
child will not earn enough in the adulthood to support parents and hence the
greater the incentive to have more children to compensate for this possibility.
2) Falling death rates cannot in any way affect the social possibilities of
fulfilling parental obligation. These are independent phenomena that continue
even with declining death rates. It might also contribute to keeping the birth
rates high.
3) There is no guarantee that a fall in the death rate will have any impact on the
degree of gender bias. There are two types of gender bias. One is the
observable bias which is a measurable indicator of differential treatment of
boys and girls. With development, such bias would lessen as the resource
constraints loosen. A second bias has to do with the intrinsic valuation of
women in a society. It feeds into the perception of women as sources of old-
age support.

1.7.1 Hoarding Versus Targeting

Suppose an individual worries that the child may not earn enough in adulthood to
support his aging parents. This outcome does not lend itself to a wait and see
strategy. This is because, by that time, it will not be possible to have a new child.
Hoarding is a phenomenon where children are stockpiled in advance, before one
can know which among them will provide the requisite support.

In a situation where the infant mortality (death of an infant before age of one) is a
dominant form of uncertainty, wait and see strategy acquires feasibility. This is in
the sense that a couple can have a child and condition its next fertility decision,
based on the survival of this child. The desired number of children can then be
attained sequentially. This strategy is called targeting.

A change in the demographic regime from hoarding to targeting can lead to a

drastic lowering of fertility rate.

1.7.2 Cost-Benefit Approach to Fertility Choice

The costs of child rearing can take two forms. One is Direct Costs i.e. children
to be fed, clothed, kept in good health, looked after and schooled. Another is
Indirect or Opportunity Costs. These are measured by the amount of income
foregone in the process of bringing up the child. In societies where this
opportunity cost is low, fertility rates tend to be high. Gender bias also plays a
role in this. In many societies, it is presumed that women must allocate bulk of
their time to the upbringing of children. In such societies, wages for women’s
work are always low. This brings down the opportunity cost of having children
keeping the birth rates high. Similarly, if there are high rates of unemployment,
the opportunity costs of children come down. This can push the fertility upward.
19
Demography and
Development
E

Other Goods
Other Goods
C
A A

D
B B
Children Children
(a) (b)
Fig. 1.2: Income Improvements and Fertility

Becker (1960) introduced the cost-benefit approach to determine the number of

children preferred. It states that parents have children up to the point where
marginal benefit equals marginal cost. It considers the preferences of a couple
over the number of children they wish to have vis-a-vis other goods denominated
in terms of money.
Consider the total potential income of the couple if they were to have no children.
Income may be wage or other forms of income such as land rent. The amount is
represented by the height of point A in Fig. 1.2. As the number of children rises,
the income available for other goods will begin to decline. This is due to two
reasons. First, there are direct expenses of having children. Second, the income
earned also falls because one of the parents must spend some time at home to
look after the child. This introduces a trade-off traceable to the budget line AB.
With very large number of children, residual income available to the parents
would drop to zero. This is at point B. Hence, the slope of the budget line is a
measure of unit cost of having children. Thus, the the wage rate multiplied by
hours foregone per child is the opportunity cost of income.
Suppose that the income of family increases and source is not wage income.
Individual may be a landowner who receives all income from leasing land to
tenants. Rents have gone up. The budget line undergoes parallel shift to CD
[Panel (a), Fig. 1.2]. If children are normal goods, the income effect must raise
demand for children so that fertility rates go up as a result of income increases.
With change in wage income budget line will swivel and not shift outward. This
is because the opportunity cost of children has gone up. The new budget line is
EB. Potential income has gone up, but at the same time opportunity cost of
children has gone up as well. This creates a substitution effect lowers fertility and
income effect raises it. The net effect is ambiguous.
Hence, we can conclude that wage income imposes an opportunity cost of having
an extra child, whereas rental income does not. This wage income increases have
a stronger impact on fertility reductions than rental income.

20
 Demographic
1.8 IS FERTILITY TOO HIGH? Transition and Its
Implications
Suppose if the family chooses to have a large number of children, then why
should social considerations dictate anything different? What factors cause a
systematic deviation between decisions that are privately optimal (from the point
of view of family) and decisions that are optimal from the point of view of
society? There are three answers to these questions.
1) Information and Uncertainty
The first answer relies on the incompleteness of information. People simply
may not internalize the general observation that death rates have undergone a
decline. In such cases the number of children that couples have may not be
socially optimal. Faced with fresh information regarding the environment that
influences their fertility choices and decision making the couple would
typically revise their fertility decisions.
The second answer relies on the distinction between decisions that are made
ex ante and their ex-post consequences. Consider the family that wants one
child but have five in hope of increasing the chances of old-age support. Such
decisions are based both on probability of child dying and on the degree of
aversion to risk of the family. Such families will have too many children and
they will suffer because these children will have to be looked after and fed.
2) Externalities
The third answer is based on the existence of externalities. Externalities arise
because the social and private costs (or benefits) of having children. These
externalities are particularly pervasive in situations where infrastructure is
provided by the government at little or no cost to users. In such cases it is not
possible for individual families to value these resources at their true social
cost because this is not the actual cost they pay.
For instance, consider the provision of free public education in urban areas. If
a benevolent social planner could dictate the number of children that all
families should have in that area, she would take the marginal social cost of
providing educational resources into account. However, if education is
provided free of charge, the private cost to the family is lower than the social
cost, which therefore will not be properly internalized. It follows that the
number of children that people choose to have will exceed the social
optimum.
Resources that are not properly priced such as environment can be depleted
even if they are renewable, they include fisheries, ground-water, forests, soil
quality etc. The main characteristic of such resources is that they are
generally under-priced so that financial incentives bias their use in the
direction of overexploitation. Such under-pricing reduces the cost of child
rearing, fertility is biased upwards.
21
Demography and Private and Social Costs and Fertility Decisions
Development
Let us summarize the effects of costs and benefits of having children in a general
framework. For simplicity we take the cost curve to be a straight line (so that
each new child costs the same additional amount) even though there are
diminishing returns to have more children. The benefit function has a familiar
concave shape. The socially optimum number of children is found by maximising
the vertical distance between the benefit line and the social cost line. This point is
found by setting marginal benefit equal to the marginal social cost which occurs
at point A and yields a number of children n*.
In contrast the privately optimal number of children is found by maximizing the
vertical distance between the benefit line and the private cost line. This occurs at
the point B with associated number n**. (Note that n** > n*)

Benefits
B
Social Costs
Costs and Benefits

A
Private Costs

n* n** Number of Children

Fig. 1.3: Private and Social Costs and Fertility Decisions

Joint Families
Joint families naturally create an intra-family externality. Knowing that one’s
brother and sister-in-law will bear part of the costs of child rearing lowers the
private costs of having children and raises fertility. Parents are bearing part of
costs of rearing their nephews and nieces but this cost that they cannot control,
because fertility decisions are being made by someone else. Thus, these costs are
fixed costs whereas cost of their own children in turn pass on are variable costs
because they make decisions regarding their own offspring and only variable
costs count in the fertility decision. This shift of levels does nothing to affect
their fertility choice, which is n**, above the level that is optimal for the joint
family as a whole (or for the couple had they been nuclear), which is n*.

The same kind of argument holds if there are grandparents to look after children.
If the grandparents’ costs are not fully internalized by the couple, they may have
too many children relative to what is optimal for their family, leave alone society
as a whole. As the structure changes from joint or extended family to nuclear
families, the costs of children are more directly borne by the couple, which leads
to decline in fertility.

22
 Demographic
Transition and Its

Costs and Benefits

Costs to Family
Implications
B
Benefits

Total Costs to Couples

A

Variable Costs to Couples

by Other Parents
Costs Passed on

n* n** Number of Children

Fig. 1.4: Fertility Choices in Joint Family

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What do you understand by the term ‘micro inertia’?
………………………………………………………………………………….
………………………………………………………………………………….
2) Do you think that with the rise in income the demand for children also rise?
Give reasons.
………………………………………………………………………………….
………………………………………………………………………………….
3) How are private and social costs associated with fertility decisions?

1.9 LET US SUM UP

The unit begins with the terminologies of birth rates, death rates, population
growth rates, fertility rates, life expectancy etc. In the poorest of countries, both
birth rates and death rates appear to be relatively high. Then death rates fall
because of the improvements in hygiene, sanitation and medicine but birth rates
remain high. Finally, countries that have higher per-capita income or have made
systematic efforts to control population growth exhibit birth rates that are also
low. We then observed that the concept of an age distribution is important. Fast
growing societies or young societies reinforces a high birth rate and keeps death

23
Demography and rates somewhat lower than they really are in age-specific terms. Thus, a policy
Development
that brings down the total fertility rate may still cause population to overshoot a
desired target because of inertia.
The observation that birth rates remain high even as death rates fall is central to
understanding the population explosion in developing and developed countries.
Why don’t birth rates decline with death rates? It is because of macro-inertia of
birth rates in a young population and micro-inertia or inertia at micro level.
Limited information, missing market for old age security and gender bias are
factors that play an important role in slow reduction in fertility.
Finally, we shed light on the lack of information and uncertainty that play an
important role in factors that cause a systematic deviation between privately
optimal decisions and socially optimal decisions. Externalities arise because of
divergence between social and private costs (or benefits) of having children. In
this context, the role played by joint family or by externalities that are
environmental or employment related are of great importance.

1.10 HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) Stagnant growth rates characterised by high birth and high death rates. Rapid
growth stage with high birth rate and low death rates. Stability marked by
low growth with both low birth and low death rates.
2) This refers to the age-structure of population. It is a phenomena of continued
increase in population despite a decline in birth rate. This is due to a large
youth population.
3) This is a feature of high income countries where the proportion of working
age population decline as a result of ‘population ageing’. In contrast, in
developing countries, there is a phase of ‘demographic dividend’.

Check your progress 2

1) This is found at the household level. It refers to the attitudes of society
towards age of marriage, role of women, etc.
2) This depends on whether income increase is due to increase in wage or due to
a factor income like rent. The former imposes an opportunity cost to have
more children while the latter impose no such cost. Hence, the impact of
wage income increase is stronger (on the negative side) on having more
children than increase in income.
3) Information asymmetry, externalities, under-pricing of common property
resources, etc.
24
 Demography and the
UNIT 2 DEMOGRAPHY AND THE PROCESS OF Process of
Development
DEVELOPMENT
Structure
2.0 Objectives
2.1 Introduction
2.2 Population Growth and Economic Development
2.2.1 Harrod-Domar Model of Economic Growth
2.2.2 Solow Model of Economic Growth
2.3 Positive and Negative Consequences of Population Growth
2.3.1 Negative Effects of Population Growth: The Malthusian View
2.3.2 Positive Effects of Population Growth
2.4 Rural-Urban Migration
2.4.1 The Lewis Model
2.4.2 Lewis-Ranis-Fei Model of Rural-Urban Migration
2.4.3 Harris–Todaro Model
2.5 Human Capital: Role of Education and Health in Economic development
2.5.1 Linkages between Investments in Health and Education
2.5.2 Investing in Education and Health: The Human Capital Approach
2.6 The Gender Gap: Discrimination in Education and Health
2.6.1 Gender Inequality and Missing Women
2.7 Let Us Sum Up
2.8 Answers to Check Your Progress Exercises

2.0 OBJECTIVES
After studying this Unit, you should be able to:
 Examine the relationship between population growth and economic
development;
 Explain the dichotomy between the belief that world population growth is bad
and the belief that population growth would make them empowered;
 Analyse the patterns of rural-urban migration utilising Harris-Todaro model;
 Discuss how the framework of the Harris-Todaro model has been extended in
a number of different directions; and
 State the role of education and health in human capital formation.


Dr. Varun Bhushan, Assistant Professor, PGDAV College, University of Delhi.
25
Demography and
Development 2.1 INTRODUCTION
Economic development is a process that transforms all persons of different
income groups and all sectors of the economy in some harmonious and even
fashion. But there is a possibility of uneven growth which is growth that first
proceeds by benefiting some groups in a society. The economic development
entails the rapid growth of some parts of the economy, while other parts are left
behind to stagnate or even shrink. As economic development proceeds
individuals move from rural to urban areas and agriculture acts as a supplier of
labour to industry. Agriculture must be capable of producing a surplus that can be
used to feed those who are engaged in non-agricultural pursuits. Thus, agriculture
is supplier of food to industry. In this unit we shall be studying about the Lewis
model followed by the Harris-Todaro model. The main idea of Harris Todaro
model is that formal urban sector pays a high wage to workers and it is this high
wage that creates urban unemployment. Finally, we discuss about the
significance of investing in health and education to capitalize the benefits of
demography.

2.2 POPULATION GROWTH AND ECONOMIC

DEVELOPMENT
The relationship between population growth and economic development was
generally thought to be negative. Just like economic development has
implications for the pace of population growth so the latter has implications for
the rate of economic development. A large population means that there is less to
go around per person, so that the per-capita income is depressed. However more
people not only consume more, they produce more as well. The net effect must
depend on whether the gains in production is outweighed by the increase in
consumption or vice-versa.

2.2.1 Harrod-Domar Model of Economic Growth

The ingredients of standard growth model are that people make consumption and
savings decisions. Savings are translated into investment, and capital stock of the
economy grows over time. Meanwhile, the population of the economy grows too.
The rate of savings determines, via investment, the growth rate of the capital
stock. The latter determines, via the capital-output ratio, the growth rate of
national income. But all growth does not translate into an increase in income per
person. Population is growing too, and this increase surely eats away (so far as
per capita growth is concerned) at some of the increase in national output.
s/θ = (1+ g*) (1+ n) - (1- δ)
where s is the rate of savings, n is the rate of population growth, δ is the rate of
depreciation of the capital stock, and g* is the rate of growth of per capita
income. According to this model, population growth has an unambiguously
26
 Demography and the
negative effect on the rate of growth. Note that if all parameters remain constant Process of
while the rate of population growth n increases, the per capita growth rate g* Development
must fall.
The Harrod-Domar model, treats the capital–output ratio as exogenous, and
therefore makes no allowance for the fact that an increased population raises
output. There is an implicit assumption that labor and capital are not substitutable
in production (capital-output ratio is constant). Thus, added population growth
exerts a drag on the per-capita growth while contributing nothing of substance
via the production process. Since capital-output ratio is assumed constant, this
tantamounts to assuming that an increased population has no effect on output at
all.

2.2.2 Solow Model of Economic Growth

In Solow model, a production function relates capital and labor to the production
of output. There is an implicit assumption made in the Solow model that capital
and labor can be substituted for each other indefinitely although the process of
substitution may become more and more costly. The cost is expressed by
marginal rate of substitution between two inputs of production and is captured by
the degree of curvature of the production isoquants.
There is some technical change incorporated in the Solow model at some
constant rate. Once the change in the capital-output ratio is taken into account,
the steady-state rate of growth is independent of the rate of savings and the rate
of population growth. All that matters for long-run growth is the rate of
technological progress. Population growth has no effect on the long-run rate of
per capita income growth. There is a level effect, however.
Population growth means that a given level of output must be divided among an
increasing number of people, so that an increase in the population growth rates
brings down the size of the per-capita cake. An increase in population growth
rate both increases the demand on national cake and expands the ability of capital
to produce the national cake. The net effect on long run per-capita growth rates is
zero. Nevertheless, the level of per-capita income at any given point in time is
lowered. (Fig. 2.1)
This comes from the assumption in the Solow model that there are diminishing
returns to every input, so that increase in labor intensity of production
(necessitated by increased population growth) reduces the long-run per-capita
level of output relative to efficiency units of labor.

27
 B
(1+n)kTi
me

(Log)per capita income

(1-δ)k+sy D

k* k

Fig. 2.1: Growth Rates are Unaffected, but the Levels Shift Down

If n goes up, this “swivels” the line upward and brings down the steady-state
level of the capital stock, expressed as a ratio of effective labor. This means that
although the long-run rate of growth is unaffected by a change in the rate of
population growth, the entire trajectory of growth is shifted downward. Thus,
increased population growth has negative level effects in the standard growth
models. (Fig. 2.1)

Why population growth rates have no growth effect?

In the Harrod-Domar model, there is an implicit assumption that labor and capital
are not substitutable in production. Thus, added population growth exerts a drag
on per capita growth, while contributing nothing of substance via the production
process.
In the Solow model, on the other hand, population growth, while exerting a drag
on per-capita growth, contributes to productive potential as the extra labor force
is absorbed into productive activity through a change in the capital–labor ratio.
(1+n)k
(1+n)k

(1-δ)k+sy

(1-δ)k+sy

k(96) k(97) k(98) k* k k(96) k(97) k(98) k

Fig. 2.2: The Steady State in the Solow Model

28
 Demography and the
Indeed, implicit in the Solow model is the assumption that capital and labor can Process of
be substituted for each other indefinitely, although the process of substitution Development
may become more and more costly. Because of this, population growth has no
ultimate effect on the rate of growth in the Solow model. This does not mean that
an increase in the rate of population growth has no effect at all in the Solow
model. It lowers the steady-state level of the per capita capital stock, expressed in
units of capital per effective unit of labor, and in this way affects the level of per
capita income, expressed again in units of effective labor.
The left- and right-hand sides of the equation that describes the evolution of
capital stocks in the Solow model with technical progress.
(1+n) (1+ π) ǩ (t+1) = (1- δ) ǩ(t) + s ŷ(t)
where ǩ and ŷ are magnitudes per efficiency units of labor.

2.3 POSITIVE AND NEGATIVE CONSEQUENCES

OF POPULATION GROWTH
Population growth is regarded as a principal cause of poverty, low levels of
living, malnutrition, ill health, environmental degradation and other social
problems. The population-poverty cycle theory explains how poverty and high
population growth become reinforcing and intensifies and exacerbates the
economic, social and psychological problems associated with the condition of
underdevelopment. The potential negative consequences of population growth for
economic development can be divided into seven categories.
1) Economic Growth and Savings
Rapid population growth lowers the per-capita income growth in most
developing countries especially those that are already poor, dependent on
agriculture and experience pressures on land and natural resources.
Faster population growth lowers the aggregate rate of savings. This happens
because population growth eats into aggregate income. Faster population
growth shifts the age structure of the population toward the very young and in
doing so increases the dependency ratio in families. Because children
consume more than they produce this tends to lower savings rates as well.
This effect was emphasized by the demographers Coale & Hoover (1958).
2) Poverty and Inequality
The negative consequences of rapid population growth fall most heavily on
the poor because they are landless, suffer first from cuts in government health
and education programs and bear the brunt of environmental damage. Poor
need children for the old-age support. Infant mortality rates are higher for the
poor so this will translate into a higher expected number of surviving
children.
29
Demography and Poor families are likely to have a higher degree of labour force participation
Development
by females and this raises the opportunity costs of having children. However,
it is also true that growth in income creates a quantity-quality trade-off in
children. Richer households may want to invest proportionately greater sums
in the education of their children. Consequently, the costs of an additional
child are proportionately higher which brings down the total number of
children desired. Poor may have high fertility rates than the rich and hence
population growth will have a disproportionately heavy impact on the poor.
3) Education
Rapid population growth causes educational expenditures to be spread more
thinly lowering the quality for the sake of quantity. This, in turn, feeds back
on economic growth because the stock of human capital is reduced by rapid
population growth.
4) Health
High fertility increases the health risks of pregnancy and closely spaced births
have been shown to reduce the birth weight and increase infant mortality
rates and child mortality rates.
5) Food
A large fraction of developing country food requirements is the result of
population increases. New technologies of production must be introduced to
increase the productivity of land. International food relief programs become
more widespread.
6) Environment
Government provided education, health and public transportation are all
subsidized which leads to under-pricing of infrastructural resources.
a) These resources must be consumed largely by the poor.
b) Second, the inability of individuals to internalize the costs of these
resources leads to higher fertility and consequent increased pressure on
those very resources.
c) Resources such as the commons (grazing land, fish stocks, ground water)
and the environment (forest cover, pollution, the ozone layer). Population
growth rates places an additional pressure on these scarce resources.
7) International Migration
Many observers consider the increase in international migration, both legal
and illegal, to be one of the major consequences of developing countries
population growth. An excess of job seekers (caused by rapid population
growth) over job opportunities may be a factor that spurs migration. However
the economic and the social costs of migration fall on recipient countries,
30 increasingly in the developed world.
 Demography and the
2.3.1 Negative Effects of Population Growth Process of
Development
According to Malthus, whenever wages rise above subsistence level they are
eaten away in an orgy of procreation, people earlier and have more children,
which depresses the wage to its biological minimum. Thus, in long run, the
endogeneity of population keeps per-capita income at some stagnant subsistence
level.
A central ingredient of the Malthusian argument deserves critical scrutiny.
Individuals do understand that having children is costly, and it is perhaps true
that the costs increase with economic development, while the (economic) benefits
decline. Likewise, economic progress may shift societies from an extended
family system to a nuclear family system. As labor force participation increases,
it becomes progressively more unlikely that individuals in an extended family all
find jobs in the same locality. At the same time, the insurance motives probably
decline. With nuclear families, the cost of child rearing is internalized to a greater
degree which brings down fertility.
The Malthusian Population Trap
In the eighteenth-century Thomas Malthus propounded a theory of the
relationship between population growth and economic development. Malthus
postulated a universal tendency for the population of a country unless checked by
dwindling food supplies, to grow at a geometric progression doubling every 30 to
40 years. At the same time because of diminishing returns to fixed factor land,
food supplies could expand only at a roughly arithmetic rate. As each member of
population would have less land to work, his or her marginal contribution to food
production would actually start to decline. Because the growth in food supplies
could not keep pace with the burgeoning population, per-capita incomes (per-
capita food production) would have tendency to fall as low as to lead to stable
population existing barely at or slightly above the subsistence level.

2.3.2 Positive Effects of Population Growth

Demand-Driven View
The effect of population growth on technical progress can, in turn, be divided
into two parts. First, population growth may spur technical progress out of the
pressures created by high population density. This is the “demand-driven” view
explored by Boserup [1981].
Supply-Driven View
Second, population growth creates a larger pool of potential innovators and
therefore a larger stock of ideas and innovations that can be put to economic use.
This is the “supply-driven” view taken by Simon [1977] and Kuznets [I960].

31
Demography and Population, Necessity and Innovation
Development
It is true that scarcity drove man to innovate, to create or to apply methods of
production that accommodated the increased population by a quantum jump in
food output. Agriculture is a leading example of how high population densities
go hand in hand with technologically more intensive forms of farming. But
according to Boserup (1981) ‘Manufacturing industries required skilled workers
and traders as well as financial services and administrative skills which were
more concentrated in urbanised areas. The areas in Europe which first developed
manufacturing industries were those with the highest population densities.
Problems with the Demand-Driven Approach
The major problem is that what is attributed to population growth can also be
attributed to increased per-capita income. It is the combination of the two that is
likely to drive innovation or is motivated by the desire to make economic profit.
An increased population might correspond to a greater social need, but that need
must be manifested in economic demand through the marketplace for innovators
to respond. The second problem with the demand-driven approach is that it
predicts some degree of cyclicity in per capita incomes: innovations raise per
capita income as production levels kick up following the innovation, but as
population swells to bridge the newly created gap, with per capita incomes falling
once again until the pressure of resources triggers another bout of innovation.
Population, Diversity, and Innovation
The gist of the supply-driven argument is that everybody has an independent
chance of coming up with an idea that will benefit the rest of the human race. The
larger the population, the larger would be the number of people that have useful
ideas, and so the higher is the rate of technical change.
Consider an initial level of per capita income that is so low that population
growth increases with per capita income. Population is growing, and it follows
that the pace of technical progress must accelerate.
Population Growth Rates
Population Growth Rates

y* Per capita Income P* Population Size

Fig. 2.3: Population Growth, Per Capita Income and Population Levels
32
 Demography and the
As long as we are on the upward-sloping part of the curve, per capita income Process of
must rise and so must the rate of population growth. Thus, during this phase, we Development
obtain the prediction that the population growth rate is increasing with the size of
the population. This state of affairs continues until we reach the point at which
population growth rates begin to decline in income. As long as growth rates are
positive, however, the population will still grow, so that technical progress will
continue to accelerate. Coupled with a diminishing pace of population growth,
this implies an acceleration in the long-run rate of growth of per capita income.
Thus, population growth rates decline even faster. This period is therefore
associated with a leveling-off and consequent decline in the rate of growth of the
population. No longer will population growth rates increase with population, they
should decline.
If technical progress is “supply-driven” by the population, then population
growth should initially be an increasing function of population itself, but this
trend should reverse itself after some stage. P* is threshold level of population
that permits technical progress at a rate such that the threshold per-capita income
of y* is just reached after this point the population growth rates turn down as per-
capita income climbs even further. A simple extension of the model can be used
to account for this seeming discrepancy: simply allow technical progress to be a
function not just of population size, but also of the per capita income of the
society. After all, it takes brains coupled with economic resources to carry out
useful scientific research.

Check Your Progress 1

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Make a comparison about formulation of production function as envisioned
in Harrod-Domar Model of economic growth and Solow Model of economic
growth.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) How does rapid growth of population influence the poverty and inequality?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
3) What do you mean by the term ‘Malthusian population trap’?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
33
Demography and
Development 2.4 RURAL-URBAN MIGRATION
From agriculture comes the supply of labor to industry and the surplus of food
that allows a nonagricultural labor force to survive. These are the two
fundamental resource flows from agriculture, and they lie at the heart of the
structural transformation that occurs in most developing countries. Industry
supplies inputs to agriculture: tractors, pump sets, chemicals of various kinds,
and so on. With a large population in the rural sector, agriculture is often a major
source of demand for the products of industry, which include not just durables,
but final consumption goods as well. Agrarian exports can serve as the source of
vital foreign exchange, which permits the import of inputs to industrial
production. While these links are important, the flow of labor from agriculture to
industry and the parallel flow of agricultural surplus to nurture workers in
industry are often basic to the development process.

2.4.1 The Lewis Model

The dual economy
Lewis [1954] outlined a view of development that was based on the foregoing
fundamental resource flows. This approach, which views economic development
as the progressive transformation of a “traditional” sector into a “modern” sector,
goes beyond the narrower picture of agriculture-to industry transformation. The
starting point of the Lewis model is the idea of a dual economy. Dualism is the
coexistence of “traditional” and “modern,” sector.
Traditional Sector
i) It consists of agricultural sector.
ii) It means the use of older techniques of production that are labor intensive.
iii) It refers to traditional forms of economic organization based on family as
opposed to wage labor, with overall output distributed not in form of wages
and profits but in form of shares that accrue to each family member.
Modern Sector
i) It consists of industrial sector which produces manufactured commodities.
ii) It refers to use of new technology which is intensive in use of capital.
iii) It describes production organised on capitalist principles, which relies on use
of wage labour and is carried out for economic profit.
Assumptions of the Model
i) The fundamental assumption, is that labor is virtually unlimited in supply,
being drawn from a vast traditional sector.
ii) The scale of the modern sector is limited by supply of capital. Thus, capital
accumulation in modern sector becomes the engine of development.
34
 Demography and the
iii) Rate of savings and investment limits the pace of development. Process of
Development
Surplus Labour
The main idea of the Lewis model is that there is a large surplus of labor in the
traditional sector of the economy, that can be removed at little or no potential
cost. By cost, we refer to opportunity cost: the loss of traditional sector output as
labor supply is reduced.
Output

𝑤
̅

B A Labor
Fig. 2.4: Surplus Labor in the Family Farm
We take an example of the production function on a family farm where land is
fixed and hence there are diminishing returns to the labor input. The production
function is drawn so that after a certain level of labor input, there is no significant
effect on output. If the total labor input is A and total output is AQ then Average
income = AQ/A which is ϖ.
There is only so much intensity at which a given plot of land can be cultivated,
and after a point additional input of labor may have no effect at all. Thus, the
marginal product of labor at points such as A is zero or close to zero. When
reduction in the amount of labor happens from A to B, total output stays constant.
It is because the family farm has so much labor relative to land, labor is in
surplus. This situation might occur in economies where there is high population
pressure, so that there are large numbers of people per acre of arable land. This
phenomenon is not just limited to agriculture but applies to whole range of casual
jobs.
Income sharing and surplus labor
i) An entrepreneur hires labor only to the point where marginal product equals
the wage. With more labor than this, gains can be realized by cutting back on
employed labor and saving on the wage bill. Hence the wages stay positive
and marginal product is close to zero.
ii) Asymmetry between traditional sector and modern sector.
35
Demography and a) Production Methods
Development
The traditional sector involves activity intensive in labour and land but
not requiring significant quantities of capital.
b) Organization
A profit-maximizing firm regards wage payments to employees as a cost
of production, that is subtracted from revenues in order to arrive at final
profits. In contrast, a family farm might employ labor beyond the point
where the marginal product equals the “wage”, because the wage in this
case is not really a wage at all, but the average output of the farm (which
is what each member receives as compensation).
iii) Rosenstein-Rodan (1943) and Nurkse (1953) were among the writers that
realized that the presence of redundant labour in agriculture sector with no
loss in agriculture output. Surplus labour is therefore supply of labour that is
likely to be of major quantitative importance in development process of less
developed economies.
Two extensions of the surplus labor concept
Surplus labor as defined is purely a technological concept: there is simply too
much labor relative to land, or more generally, too many people relative to other
inputs of production, so that individuals are in surplus relative to production
possibilities: remove them to other activities and output will not change because
the additional labor power is of no use at all: the marginal product of labor is
literally zero.
1) Disguised unemployment
If we suppose that there is a capitalist sector elsewhere that does pay
according to marginal product, then the economy will exhibit a wage rate (for
unskilled labor) that is a true measure of the marginal product elsewhere, and
there will be efficiency gains available as long as the marginal product on the
traditional activity is less than the wage, whether it is zero or not. This
extended concept is known as disguised unemployment. The amount of
disguised unemployment may be measured roughly by the difference between
the existing labor input in the traditional activity and the labor input that sets
marginal product equal to the wage.
2) Surplus labor versus surplus laborers
We remove laborers, not labor. The remaining laborers in the traditional
activity typically adjust their labor input once some laborers are removed
(say, through rural–urban migration).If there is an increase in work effort on
the part of the remaining laborers, total output may not fall even though the
marginal product of labor is zero. This argument was originally made by Sen
[1966].
36
 Demography and the
Process of
Development

Production Function

Output
Q
Output

Production Function
Q

Marginal Cost of After Before

family Labor
Marginal Cost of
Family Labor

Total Labour Input Total Family Labour Labour Input falls Total Family Labour

Fig. 2.5: Surplus Labour

Efficient resource allocation on the family farm requires that the value of
marginal product of effort be equal to marginal cost. If the marginal cost of
family labor is constant, then the total cost is just a straight line and total family
input is determined independently of family size. The removal of some members
has no effect on total output (but note that the marginal product of labor is
positive).The second panel shows that the state of affairs is altered if marginal
cost increases with effort. Then the total cost curve of the family is shifted
upward as laborers are removed (provision of the same level of family effort as
before now involves a higher marginal cost).

2.4.2 Lewis-Ranis-Fei Model of Rural-Urban Migration

Economic development and the agricultural surplus

The interplay between rural and urban sectors as envisaged by Lewis and
extended by Ranis & Fei (1961). In the traditional agricultural sector there is
disguised unemployment, perhaps even a core of surplus labor, and the wage rate
is given by income sharing. The industrial sector is capitalistic. Economic
development proceeds by the transfer of labor from agriculture to industry and
the simultaneous transfer of surplus food-grain production, which sustains that
part of the labor force is engaged in nonagricultural activity.

37
 Industrial wage
Demand curves for Supply curve of
Industrial Labour Industrial Labour

w*

Unlimited First turning point Second turning point

supply
of Labour
A’’ B’’ C’’
x y z z'
Industrial Labour
Average Agricultural surplus

Average Surplus
𝒘
̅

Constant Surplus Declining Surplus

Declining Surplus

A’ B’ C’

Industrial Labour
Agricultural output

Output

Wage Bill

Commercialisation
Surplus Labour
Disguised Unemployment

A B C 𝒘
̅

Agricultural Labour

Fig. 2.6: The Lewis-Ranis-Fei model

Ranis and Fei [1961], provides a schematic description of how the labor force
and the corresponding agricultural surplus is transferred in the process of
development. In each panel of the diagram, the industrial labor force is read from
left to right, whereas the agricultural labor force is read from right to left.
Assume for simplicity that the total labor force is divided between agriculture
38 and industry.
 Demography and the
The production function levels off and there is a phase of surplus labor provided Process of
that the entire labor force is in agriculture. This is shown by the segment AB on Development
the diagram. Moreover, if “wages” in this sector are decided by income sharing,
then the average wage is just ῶ, which is proportional to the angle shown in this
panel. This turns out to be the wage in the nascent industrial sector. Thus, the
segment BC has no surplus labor, but does exhibit disguised unemployment,
because the marginal product of labor in agriculture is less than the wage ῶ for
labor inputs in this segment. To the right of C, the phase of disguised
unemployment ends.
We begin with the entire labor force in agriculture. Suppose we decrease this by a
small amount, so that we are still in the surplus labor phase. Then the total wage
bill in agriculture falls along the diagonal straight line in the lowest panel,
provided that the wage in agriculture does not rise. At the same time output does
not fall, because we are in the surplus labor phase. An agricultural surplus
therefore opens up; this is given by the vertical gap between the production
function and the wage bill line. If we divide this surplus by the number of
transferred workers, then we obtain the average agricultural surplus, where we
are taking the average or per capita surplus amount relative to the transferred
workers. It is easy to see that the average agricultural surplus in the surplus labor
phase must be exactly ῶ.
Because the industrial wage is described in units of industrial goods, we must
multiply ῶ by the relative price, or the terms of trade, between agriculture and
industry to arrive at the required minimum industrial wage. This is shown by the
value w* in the topmost panel. In the surplus labor phase, the minimum industrial
wage required for compensation does not change, because the average
agricultural surplus is not changing. This creates a perfectly elastic supply of
labor in the surplus labor phase, which is depicted as a horizontal line emanating
from the point w* in the topmost panel. This is the zone where it is possible to
have economic development with “unlimited supplies” of labor: an expansion in
the industrial sector does not drive up the wage rate.
As we now move into the phase of disguised unemployment, the average
agricultural surplus begins to decline. This is because total output in the
agricultural sector begins to fall, while those who are still there continue to
consume the same amount per capita. This is shown by the decreasing line in the
zone B′C′ of the middle panel.
Well, if the wage is still w* as before, transferred workers will not be able to
compensate themselves for the move, because it is physically not possible for
each of them to buy units of food. This is because the average agricultural surplus
has fallen below. The immediate effect of this is that food prices start to rise: the
terms of trade between rural and urban sectors begin to move against industry. To
compensate for this price effect the industrial wage must rise. However, rising
wages that cannot solve the problem. No matter how much the industrial wage
39
Demography and rises, it is not possible for workers to buy their old food parcel back, because
Development
there simply is not enough to go around. The only way that compensation can be
achieved, then, is for industrial workers to consume a mix of agricultural and
industrial products, the latter compensating them for the loss of the former.
The “First Turning Point”
It depends on how close the traditional wage is to minimum subsistence. The
closer is to the minimum subsistence level, the larger is the compensation
required and the steeper is the increase in the required industrial wage.
Conversely, the easier it is to substitute industrial consumption for agricultural
consumption, the softer is the necessary increase in the compensatory industrial
wage. Ranis and Fei [1961] referred to this phase, where the supply wage of
labor tilts upward, as the “first turning point.”
Commercialization of Agriculture
Continue the transfer of labor until we reach the point C, where the disguised
unemployment phase comes to an end. At this point, the marginal product of
labor begins to exceed the traditionally given wage rate. It then becomes
profitable to actively bid for labor, because the additional contribution of labor in
agricultural production exceeds the cost of hiring labor. This situation means that
the wage in agriculture rises. One implication is that the wage bill falls more
slowly than it did before along the diagonal line of the lowest panel. It now traces
the curve after C, because wages rise as the agricultural labor force decreases.
The Second Turning Point
The commercialization of agriculture, is associated with an even sharper decrease
in the average agricultural surplus. In terms of the topmost panel, this
phenomenon induces a second turning point in the industrial wage. Not only must
the wage compensate for a declining agricultural surplus and a movement of the
terms of trade against industry, it must now compensate workers for a higher
income foregone in the agricultural sector, and this creates a still sharper upward
movement in the industrial wage rate. This completes the construction of the
supply curve.
This demand for labor induces a situation where the amount of industrial labor is
x, hired at a wage of w*. With industrial production, profits are realized, parts of
which are plowed back as extra capital in the industrial sector. The expansion of
capital means that the demand for labor rises (shift to the second demand curve in
the topmost panel). Because the economy is in the surplus labor phase, this labor
is forthcoming from the traditional sector with no increase in the wage, as we
already discussed. Industrial employment is now at point y. However, with
further investment, the demand curve for labor shifts to a point where the
compensatory wage must rise. Employment rises to z. However, it would have
risen even further (to point z′) had the turning point not occurred. The fall in the
40
 Demography and the
agricultural surplus chokes off industrial employment to some extent, because it Process of
raises the costs of hiring industrial labor. Development

Capital accumulation in the industrial sector is the engine of growth. More capital
means a greater demand for labor, which, in turn, induces greater rural–urban
migration. As development proceeds, the terms of trade gradually turn against
industry: food prices rise because a smaller number of farmers must support a
greater number of nonagricultural workers. The rise in the price of food causes an
increase in the industrial wage rate. The pace of development is driven by the
accumulation of capital, but is limited by the ability of the economy to produce a
surplus of food.

2.4.3 Harris–Todaro Model

The classic theory of rural urban migration is based on Harris and Todaro (1970).
The main idea of the Harris–Todaro model is that the formal urban sector pays a
high wage to workers and it is this high wage that creates urban unemployment.
Reasons for high urban wage
a) The sector may be unionized and subject to collective bargaining over wages,
whereas other sectors of the economy are not remotely as organized, so that
wages are more flexible in those sectors.
b) In addition, the urban formal sector is often treated as the showcase of
government policy, so that minimum wage laws, pension schemes,
unemployment benefits, day care, and other facilities may be required by law.
c) Finally, it may well be the case that firms in the urban formal sector
deliberately pay wages that exceed levels found elsewhere so they can hire
workers of the best quality and fire inferior workers after their quality is
revealed.
In contrast to the high wages paid in the formal urban sector, the informal urban
sector and the rural sector have low wages that fluctuate according to supply and
demand considerations. There is no unionization here and government policy is
difficult to implement. Moreover, if the bulk of labor is family labor (as it is in
much of the urban informal businesses, as well as in rural family farms) or if the
bulk of labor effort is readily monitorable (as in harvest labor), then there will be
little incentive for employers in these sectors to pay higher wages as a potential
threat.
The Basic Model: Assumptions
1) There are only two sectors in the economy: a rural sector and a formal urban
sector.
2) Wages in both sectors are fully flexible.
The labor force is divided between the agricultural sector, which we denote by A,
and the formal urban sector, which we denote by F. The curve AB may be 41
Demography and thought of as a demand curve for labor in the urban formal sector: like most
Development
demand curves, it is downward sloping, so that more labor can be absorbed in the
sector only at a lower wage. Likewise, the curve CD captures the absorption of
labor in agriculture.

WF A D WA

W*

Agricultural Wage
W*

Formal Wage

C B

L*F L*A
Fig. 2.7: Market Equilibrium with Flexible Wages
w*: Equilibrium wage rate
LA*: Individuals in agrarian sector
L *
F : Individuals in urban sector
To alleviate persistent migration between one sector and the other, the wages in
the two sectors must be equalized. These two absorption curves combine to
analyze the equilibrium.

WF WA
A D
U
̅
𝑊 ̅
𝑊
Agricultural Wage
Formal Wage

𝑊̇

C B

𝐿̅F 𝐿̅A

Fig. 2.8: A Floor on the Formal Wage

The figure captures the situation by drawing the minimum formal wage, ѿ at a
level that lies above the intersection of the two absorption curves. It follows that
private-sector formal firms will hire no more than the amount LF of labor at this
wage. The wage in the agricultural sector must drop to 𝑊̇ . Only LA can be
soaked up in the agricultural sector. U denotes the size of unemployed pool. In
42 both sectors, we have full employment, so that no individual job seeker needs to
 Demography and the
fear unemployment if she looks for a job in either sector. Nonetheless, the wages, Process of
ѿ and 𝑊̇ are different. This cannot be an equilibrium state for the economy, Development
because with full employment in both sectors, workers will wish to migrate to the
sector with the higher wage.

Formal Urban
p

Agriculture 1− p q
Informal Urban

1− q
Unemployment

Fig. 2.9: Options Open to a Potential Migrant

The potential migrants choose between a relatively safe (though possibly
unpleasant)option, which is to stay in the agricultural sector, and the gamble of
moving to the urban sector, where a high-paying formal job may or may not be
attainable. The probability of getting such a job is determined by the ratio of
formal job seekers to available formal jobs.
In Fig. 2.9 the left set is single box agriculture with its wage w A. The right set
describes various options open in the urban sector.
1) There is the formal sector at some high wage. The probability of obtaining
such a job depends on the ratio of vacancies to job seekers. Denote this by p.
2) The wage rate in the informal sector is denoted by wI and it is assumed to be
fixed regardless of the number of people in that sector.
3) The expected value is calculated in the usual way: weigh each outcome by its
probability of occurrence and add up over all outcomes. Thus, the expected
wage in the urban sector is p ѿ + (1 − p) wI
4) It is this expected wage that is compared to the wage in the agricultural
sector.
5) The probability of getting an informal sector job, conditional on having been
turned away from the formal sector is denoted by q.
6) Thus, after being turned away from the formal sector, the migrant manages to
join the informal sector with probability q and remains openly unemployed
with probability 1 − q. The expected value of this latter set of possibilities is q
wI + (1 − q)0 = q wI. Thus, the overall expected wage is now p ѿ + (1 − p) q
wI.
Suppose that we use LI to denote informal employment. Then we can see that the
ratio LF/LF+LI captures the probability of getting a job in the formal sector. The
43
Demography and number of employed people LF tells us how many jobs there are, whereas the
Development
number LF +LI is the measure of the total number of potential job seekers. The
ratio of the two thus gives us the chances that an urban dweller will get a job in
the formal or informal sector.
Harris–Todaro equilibrium condition
Migration from the rural sector may be thought of as an irreversible decision, at
least for the proximate future. Because the fate of a potential migrant is not
known, we must consider the expected income from migration and compare it
with the actual income received in agriculture. Thus, we may conclude that if
(LF / LF +LI) ѿ+ (LI / LF +LI)wI = wA
we are at an equilibrium where no person wishes to migrate from one sector to
the other.

WF WA

̅
𝑊
WA

Agricultural Wage
Formal Wage

𝐿̅F LI LA

Fig. 2.10: Harris-Todaro Equilibrium

The equilibrium agricultural wage is given by wA. LA people are employed in
agriculture, LF people are in the urban sector and the remaining LI take refuge in
the informal sector where they obtain an income of wI.
1) First, the equilibrium condition represents a situation where ex ante people
are indifferent between migrating and not migrating; ex post, they will not be
indifferent. The lucky subgroup who land a job in the formal sector will be
very pleased that they did migrate, whereas those who seek solace in the
informal sector will regret that they made the move.
2) Observe that the equilibrium concept implies a particular allocation of labor
between the three sectors of the economy. This is because it is the allocation
of labor that affects the perceived probabilities of getting a job.
3) The fundamental requirement is that expected wages are equalized over the
two sectors for a migration equilibrium to be obtained, but these expectations
44 may be the outcome of wages in three or more urban sectors (e.g., open
 Demography and the
unemployment may be thought of simply as another sector in which wages Process of
happen to be zero) or in several sectors in agriculture. Development

Government Policy: The Paradox of Urban Job Creation

The informal sector is an outgrowth of the fact that the formal sector has wages
that are too high, so that not everyone is capable of obtaining employment in this
sector. At the same time, not everyone else can stay in agriculture as well, for
that would make the formal sector look too attractive and induce a great deal of
migration. The informal sector is a result of this migration. In the Harris–Todaro
view, the informal sector acts as a necessary counterweight to the attractiveness
of the formal sector and slows the pace of rural–urban migration.
Even though wages are fixed at ѿ, it is possible to generate additional demand for
formal labor by offering urban businesses various setup incentives (such as tax
holidays) or ongoing investment incentives (such as better treatment in the credit
market). The government might itself expand the demand for formal labor by
expanding the employment of public sector enterprises. The size of the urban
sector is endogenous, and migration will rise in response to this policy.
The Effect on the Harris–Todaro Equilibrium Condition
Imagine that the formal labor demand curve shifts out and to the right, so that, in
particular, labor demand at the wage rate rises from LF to LF′. In the short run, all
this extra labor simply comes from the informal pool. This means that relative to
the initial outcome, LF rises and LI falls. This raises the probability of getting a
formal job. Consequently, the expected urban wage must initially rise.
But the initial increase cannot be fully persistent. Rural–urban migration picks
up. More migrants enter the urban sector. Of course, they add to the informal
sector, which after its initial decline, now begins to increase once again. This
phenomenon sets in motion two related forces. First, as the labor force in
agriculture falls, the agricultural wage tends to rise (by how much it rises will
depend on the slope or elasticity of the agricultural absorption curve). Second, as
migration continues, the expected urban wage once again begins to fall (relative
to the initial sharp rise).
The fraction LF / LF +LI begins to move down as migration continues, and this
brings down the probability of getting a formal job (relative to what prevailed
just after the institution of the policy) and the expected urban wage drops with it.
With the agricultural wage climbing up and expected urban wage creeping down,
the two are bound to come into line. We have fresh allocation of labor in three
sectors (LF′,LA′LI′). The new allocation must satisfy new Harris-Todaro
equilibrium condition.
With the agricultural wage climbing up and the expected urban wage creeping
down, the two are bound to come into line once again. In the process, we have a
̅ 𝐹 . 𝐿′
fresh allocation of labor in the three sectors: (𝐿′ ̅ 𝐴 . 𝐿′
̅ 𝐼)
45
Demography and ̅𝐹
𝐿′ ̅1
𝐿′
Development ( 𝑤
̅+ 𝑤𝐼 = 𝑤′𝐴′ )
̅ 𝐹 + 𝐿′
𝐿′ ̅𝐼 ̅ 𝐹 + 𝐿′
𝐿′ ̅𝐼

where 𝑤′𝐴′ denotes the new agricultural wage after the policy.
How do we compare the magnitudes? Recall that if the agricultural wage rises (or
at least does not fall) after the introduction of the policy, it must be the case that
the new expected wage in the urban sector exceeds the old expected wage. The
only way in which this can happen is if:
̅𝐹
𝐿′ ̅𝐹
𝐿′
>
̅ 𝐹 + 𝐿′
𝐿′ ̅𝐼 ̅ 𝐹 + 𝐿′
𝐿′ ̅𝐼

In other words, if the share of the formal sector in total urban sector employment
goes up. This is a beneficial implication of the policy: the informal sector does
shrink, measured as a fraction of the total urban sector.
If the share of formal sector in total urban sector employment goes up, the
informal sector does shrink (measured as a fraction of the total urban sector).
Although it may be true that the informal sector shrinks as a fraction of the urban
labor force, it is also true that the size of the urban labor force expands. If the
latter effect dominates the former, the informal sector may well expand—an
implication of a policy that was directly aimed at reducing the size of that sector.
Attempts to increase the demand for labor in the formal sector may enlarge the
size of the informal sector, as migrants respond to the better job conditions that
are available. The migration effect may dominate the initial “soak-up effect.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) a) Graphically show the working of the Lewis-Ranis-Fei model of rural-urban
migration. Discuss the role of labour as the factor that limits the expansion
of the industrial sector in this model.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
b) Do you think that ‘the industry supply curve’ in the Lewis-Ranis-Fei
model will be upward sloping irrespective of the prevailing agricultural
wage? Explain?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….

46
 Demography and the
3) a) In the Harris-Todaro model, suppose the initial level of urban Process of
employment is EU = 2 million, the total urban labor force is LU = 3 Development

million, the urban wage is fixed by law at WU = 6 and the rural wage is
WR = 3. If the probability of finding a formal sector job is defined as
EU/LU,
i) Will a person who is currently in the rural sector find it optimal to
migrate to the urban sector?
ii) If the urban employment and urban and rural wages remain fixed,
solve for the level of the urban labor force which will result in the
post migration Harris-Todaro equilibrium.
iii) Stating with initial situation how many rural people must migrate to
the urban sector in search of jobs to achieve the equilibrium as
obtained in part ii)
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
b) Briefly explain the Harris-Todaro model of rural-urban migration and
argue that despite acceleration in the rate of absorption of labor in the
formal sector, the informal sector as a fraction of the total labor force
increases.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….

2.5 HUMAN CAPITAL: ROLE OF EDUCATION

AND HEALTH IN ECONOMIC DEVELOPMENT
Education and health are basic objectives of development. They are ends in
themselves. Both health and education are central to well-being and are
fundamental to the broader notion of expanded human capabilities. These lie at
the heart of the development. Education plays a key role in the ability of a
developing country to absorb modern technology and to develop the capacity for
self-sustaining growth and development. Health is a prerequisite for increases in
productivity. Thus, both health and education are vital components of economic
development.
Human capital can be defined as labour that is skilled, can handle sophisticated
machinery and is innovative in using machines. Productive investments
embodied in human persons, including skills, abilities, ideals, health and
locations often resulting from expenditures on education, on-the-job training
programs and medical care. Investments in human capital have to be undertaken
with both equity and efficiency for them to have their potential positive effects on
income.
47
Demography and 2.5.1 Linkages Between Investments in Health and Education
Development
Greater health capital may raise the return on investment in education for several
reasons:
1) Health is an important factor in school attendance.
2) Healthier children are more successful in school and learn more efficiently.
3) Deaths of school age children also increase the cost of education per worker.
4) Longer life-spans raise the return to investments in education.
5) Healthier individuals are more able to productively use education at any point
in life.
Greater education capital may raise the return to investment in health in the
following ways:
a) Many health programs rely on skills learned in school (including literacy and
numeracy).
b) Schools teach basic personal hygiene and sanitation.
c) Education is needed for the formation and training of health personnel.
d) Education leads to delayed childbearing, which improves health.

2.5.2 Investing in Education and Health: The Human Capital

Approach
Human capital is the term, economists often use for education, health and other
human capacities that can raise productivity. After an initial investment is made,
a stream of higher future income can be generated from both expansion of
education and improvements in health. As a result, a rate of return can be
deducted and compared with the returns to other investments. This is done by
estimating the present discounted value of the increased income stream made
possible by these investments and then comparing it with their direct and indirect
costs. The basic human capital approach focuses on the indirect ability to
increase well-being by increasing incomes.
The impact of human capital investments in developing countries can be quite
substantial. Higher levels of education start full time work at later age but their
incomes quickly outpace those who started working earlier. But such future
income gains from education must be compared with the total costs incurred to
understand the value of human capital as investment. Education costs include
direct tuition, books, uniforms and indirect costs primarily income foregone
because the student could not work while in school.

Formally the income gains can be written as summation over expected years of
working life where E is income with extra education, N is income without extra
education, t is year, i is the discount rate.
48
Ʃ (Et–Nt)/ (1+i) t Demography and the
Process of
Development
An analogous formula applies to health such as improved nutritional status with
direct and indirect cost of resources devoted to health compared with the extra
income gained in the future as a result of higher health status.

2.6 THE GENDER GAP: DISCRIMINATION IN

EDUCATION AND HEALTH
In many societies, the provision of old age support is thought to be exclusively
the task of male offspring. Although support from female children is just as
valuable, there may be a stigma associated with receiving support from daughters
as opposed to sons. This bias is source of discrimination in favour of male
children. Cain’s (1981,1983) study of Bangladesh illustrates the importance of
sons as support for widows: the ability of widows to hold on to land depends on
whether they have able-bodied sons. This is especially true when property rights
are either not well-defined or difficult to enforce by law.
Observable gender bias is a measurable indicator of differential treatment of boys
and girls. With development, such bias indeed lessens as resource constraints
loosen. A second sort of bias has to do with the intrinsic valuation of women in
society and it feeds into perception of women as sources of old-age support. This
increases with economic progress.
Young females receive less education than young males in most low-income
developing countries. The educational gender gap is especially great in the least
developed countries in Africa, where female literacy is less than half that of men.
Empirical evidence shows that educational discrimination against women hinders
economic development in addition to reinforcing social inequality. Closing the
educational gender gap by expanding educational opportunities for women is
economically desirable since it not only increases their productivity but also
results in greater labour force participation, lower fertility, later marriage and
greatly improved child health and nutrition.

2.6.1 Gender Inequality and Missing Women

Nobel laureate Amartya Sen concludes that the Sub-Saharan female male ratio of
1.022 as the benchmark yields an estimate of 44 million missing women in
China, 37 million in India and total of these countries still in excess of 100
million. The main culprit of female infanticide has been neglect of female health
and nutrition especially during childhood. In China the extent of neglect may
have increased sharply since compulsory family restrictions (one-child policy in
some parts of country) were introduced in 1979.

49
Demography and
Check Your Progress 3
Development 1) Identify the elements of the human capital approach. Why are health
and education so closely linked in the development challenge?
2) How the preference for a male child leads to an increase in the rate of
growth of population?
3) Briefly explain the concept of ‘Missing Women’? What are the
consequences of gender bias?

2.7 LET US SUM UP

Growth of population influences economic development both positively and
negatively. The simplest negative effect is that population growth eats away at a
given level of resources or income leaving less per head to go around. In Harrod-
Domar model of economic growth labour is not regarded as an essential input of
production (capital-output ratio is fixed.) This observation is naïve as increased
population means more labour input which expands production. In Solow model
these two effects cancel out and long run growth rates are unaffected by pace of
population growth. However, there is a level effect, a higher rate of population
growth pushes the economy to a lower trajectory of per-capita income. There are
positive arguments as well. The demand side view states that population growth
fosters spurt of development through innovation. The supply driven argument
states that population growth fosters development because each human being acts
as a repository of ideas and more human beings means more ideas put to use for
the economic benefit of mankind. Thus, the rate of technical progress should
increase with population size.
The most important structural transformation that a developing economy goes
through is the change from a predominantly rural economy to an industrial
economy. This inter-sectoral movement is typically accompanied by a move from
traditional forms to modern forms of organization: an economy in which such
forms coexist is often referred as dual economy. Development is characterized by
an ongoing move of labour and resources from a traditional sector to a modern
sector. Lewis argued that the traditional sector is characterized by surplus labour.
In principle this permits industrial development with unlimited supplies of labour
until the surplus-labour phase comes to an end. We integrated the traditional and
modern sectors into one interactive model. It turned out that the supply of labour
to industry was perfectly elastic in the surplus-labour phase but began to rise as
the available food surplus per-capita began to shrink and the terms of trade
between agriculture and industry turned against the industry. The model brings
50 out a fundamental tension between agriculture and industrial development:
industrialists like to keep agricultural prices low because that ensures a low wage
bill. Harris-Todaro model provides a theoretical framework in which formal
sector wages have lower bounds or floors, whereas informal and agricultural
wages are flexible. This thesis leads to a view of migration of equilibrium in
which the formal sector is characterized by an excess supply of labour with the
excess spilling over into the informal urban sector or manifesting itself in the
form of open unemployment. Thus, it is not the wages that are equalized across
the sectors but the expectation of wages in the Harris-Todaro equilibrium, the
average of various urban wages weighted by the probability of employment in
formal and informal sectors is equal to the agricultural wage. We also discussed
about the Todaro paradox where an expansion of formal employment leads to an
enlargement of the informal sector as fresh migrants from rural sector swarm into
urban sector response to the policy.
Gender bias plays an important role in understanding the connection between
Demography and the
desire for old-age security, mortality and fertility. A family desires sons and this Process of
can greatly increase the fertility rates. Finally, we have explained the concept of Development
human capital formation and linkages between investments in health and
education.

2.8 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1. See Sub-Section 2.2.1 & Section 2.2.2
2. See Section 2.3
3. See Sub-Section 2.3.2

Check Your Progress 2 Check Your Progress 3

1. See Section 2.4.2 1.. ee Section 2.4.1
2. See Section2.4.3 2.. ee Section 2.4.2
3. See Section2.4.3 3.. ee Section2.6.1

51
 BLOCK 2 Linear Theories of
Underdevelopment

THEORIES OF UNDERDEVELOPMENT

BLOCK INTRODUCTION
The present Block, the second of this course, discusses Theories of
Underdevelopment. It discusses why developing countries are poor, how they
became underdeveloped, what explains their present levels of development and
what can these countries do i.e. what policies they can follow to come out of
underdevelopment and to attain higher levels of development.
The Block has three units, titled Linear Theories of
Underdevelopment, Structural Theories of Development and
Dependency Theories of Development. The first Unit discusses theories
that see the process of development of countries as a movement from a
situation of underdevelopment to development. The second unit discusses
the impact of population growth on population. It discusses the Solow and
Harrod-Domar growth models to see how these models explains the impact of
population growth on economic development. To bring out the negative impact
of population growth on economic development the unit discusses Malthus’s
views. Some of the other important topics covered in this unit are human
capital, rural-urban migration and gender-gap. Unit 5 discusses various theories
of underdevelopment.

53
  Linear Theories of
UNIT 3 LINEAR THEORIES OF UNDERDEVELOPMENT
Underdevelopment

Structure
3.0 Objectives
3.1 Introduction
3.2 Linear Theories
3.2.1 Marx's Stages of Growth
3.2.2 Linear Stages of Growth Model – Rostow
3.2.3 Kuznets’ Theory
3.2.4 Harrod–Domar Model
3.3 Limitations of Linear Theories
3.4 State Intervention and Related Policy Implications
3.5 Let Us Sum Up
3.6 Hints to Check Your Progress Exercises

3.0 OBJECTIVES
After studying this Unit, you should be able to:
 outline the theory behind economic underdevelopment;
 discuss the evolution of classical theories of economic underdevelopment;
 analyse the implications of the Linear Theories [viz. Marx’s Stages of
Growth, Rostow’s Linear Stages of Growth, Kuznets’ Theory and Harrod-
Domar Model];
 state the limitations of the Linear Theories of underdevelopment and
 explain the policy implications of the linear theories.

3.1 INTRODUCTION
Economic progress is an essential component of every country. Development is
not purely an economic phenomenon. It encompasses more than the material and
financial side of people’s lives. It is, therefore, perceived as a multidimensional
process involving the reorganization and reorientation of entire economic and
socio-political systems. In addition to improvements in incomes and output, it
typically involves radical changes in institutional, social and administrative
structures as well as popular attitudes, customs and beliefs. The first idea that


Dr. Puja Saxena Nigam, Associate Professor, Economics, Hindu College, University of Delhi,
New Delhi.
55
Theories of emerged was that all major countries have a potential for development i.e. those
Underdevelopment
that have not developed, but can, are underdeveloped. With respect to this, two
questions came up and were answered by economists worldwide. One is how is
the level of development measured? The second is, compared to which desirable
characteristics of development, the backward countries are classified as
underdeveloped? In answers to these two questions, it was agreed that the
standard of living and per capita income are the measures of development and the
level of development of advanced or developed countries would be the
benchmark for their relative comparison. As a result, the idea of
underdevelopment equilibrium gained acceptance. This was followed by the
theories of Balanced and Unbalanced Growth.
Development theory is a collection of theories on how desirable change in
society is best achieved. If we explore the historical and intellectual evolution of
development, we come across four development theories. These offer valuable
insights and a useful perspective on the nature of development process. The
post-World War II literature on economic development dominated the four major
schools of thought. These are:
1) The Linear Stages of Growth Model
2) Theories and Patterns of Structural Change
3) The International-Dependence Revolution
4) The Neoclassical Free-Market Counter-Revolution
The 1950’s and 1960’s saw the economic theorists viewing the process of
development as a series of successive stages of economic growth through which
all countries must pass. It primarily focused on the right quantity and mixture of
‘Savings, Investment and foreign capital’. This was considered necessary to
enable the developing countries to proceed along an economic growth path that
had historically been followed by most developed countries.
This Linear-Stages approach was largely replaced in the 1970’s by two
competing schools of thought. The first of these focused on Theories and Patterns
of Structural Change. It used modern economic theory and statistical analysis to
portray the process of structural change needed by a growing country to
experience sustained rapid economic growth. The second, the International-
Dependence Revolution was more radical and political. It explained
underdevelopment in terms of: (i) international and power relationships, (ii)
institutional and structural economic rigidities, and (iii) the resulting proliferation
of dual economies. Dependence theories emphasized on the external and internal
institutional and political constraints on economic development. These, thus,
placed emphasis on the need for policies to eradicate poverty, to create
employment opportunities and to reduce inequalities.
Throughout the 1980s and 1990s, the fourth approach of neoclassical/neoliberal
56 counterview prevailed. It focused on the beneficial role of free markets, open
 Linear Theories of
economies and the privatisation of inefficient public enterprises. According to Underdevelopment
this theory, failure to develop is the result of too much government intervention
and regulation of the country instead of exploitative external and internal forces.

3.2 LINEAR THEORIES

When interest in the poor countries of the world materialized following the
Second World War, economists in the industrialized countries were caught off-
guard. They had no experience to analyze the process of economic growth for
countries which were mainly agrarian and lacked modern economic structures.
They had the recent experience of Marshall Plan, under which massive amounts
of U.S. financial and technical assistance enabled the war-torn countries of
Europe to rebuild and modernize their economies. Thus, came the Stage Theory.
This approach came to be known as ‘Capital Fundamentalism’ as it emphasized
on the role of accelerated capital accumulation.

3.2.1 Marx's Stages of Growth

Karl Marx’s theory combines economics and sociology to view economic
development as a continuous change in the social, cultural and political life of a
society. In Marx’s analysis, economic systems reach higher stages through the
strained relations that run between the dynamic forces of production and the
slowly-evolving social and political organization which permits production.
According to Marx, there are five stages of capitalist economic development viz.,
(i) primitive-communal society (ii) feudalism (iii) capitalism (iv) socialism and
(v) communism. The stages of development spans out from the beginning of the
evolution of medieval feudalism to ‘industrial capitalism’. The most advanced
stages of capitalism which features international imperialism carries the seeds of
its own destruction. Periodic crises wreck the international capitalist system to a
point of its eventual decay leading to the formation of a socialist state. The class
struggle propels this transformation. Workers and capitalists represent domestic
class struggle that spreads internationally in advanced capitalism to become
imperialism at world level. Marx predicted that growing conflicts between
workers and owners/capitalists would eventually lead to a violent revolution in
which capitalism would be transformed to socialism. This has not come true in
case of advanced industrial economies. In fact, the Marxian theory gives an
important insight into the problem faced by today’s Least Developed countries.
Many of them have attempted to achieve rapid development by concentrating
investment in the modern industrial sector. However, what could be seen is
growing inequality and social instability in these economies similar to the mid
19th century Europe.
The followers of Marx have extended the scope of Marxist theory to encompass
the international dimension on the role of capital in economic development.
According to them, the international capitalist system, which has led to great
inequalities between the rich and poor countries, has increased the dependence of 57
Theories of the least developed countries on the industrial capitalist countries for their basic
Underdevelopment
economic needs. Paradoxically, this has resulted in a lot of capital and other
resources being transferred from poor to rich countries. This is the phenomenon
of International Dependence that needs to be restructured to transform the nature
of relationship between the poor and the rich countries.

Check Your Progress 1

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Specify the evolution of classical theories of underdevelopment.

2) State the Marxian views on economic development.

3.2.2 Linear Stages of Growth Model – Rostow

American Economic Historian Walt W. Rostow (1960) came up with his Stages
of Growth model. According to him, the transition from underdevelopment to
development can be described in terms of a series of steps or stages through
which all countries must pass. They are:
i) The Traditional Society: This is the stage defined by a society that is
primitive with a large agricultural sector and hierarchical social structure. It is
characterized by the backward nature of its technology and thus possesses a
low ceiling of attainable output per head.
ii) The Pre-conditions for Take-off: This is the stage related to application of
modern science to agriculture. There must be entrepreneurs in the society and
investors who can offer financial support to new ideas. This involves slow
changes in attitudes and organization, and, sharp break from traditional
rigidity towards mobility.
iii) The Take-off: As the economy overcomes resistances to growth and change,
rate of investment jumps. This gives rise to substantial and rapid growth of
manufacturing industries. A political, social and institutional framework
emerges that is favourable to sustained growth. Rostow called this stage as
Industrial Revolution.
iv) The Drive to Maturity: This movement from take-off to maturity is the
stage of spread of technical change for improved efficiency from the leading
58 sectors of the economy to the other sectors. Rate of growth of income
 Linear Theories of
outstrips the rate of growth of population to raise the per capita income. In Underdevelopment
this stage, according to Rostow, "an economy demonstrates that it has
technological and entrepreneurial skill to produce not everything, but
anything it chooses to produce".
v) High Mass Consumption: This stage characterizes the movement of an
economy from maturity to high mass consumption such that consumer
durable goods become accessible. In addition, the economy, via its political
process, expresses willingness to allocate increased resources to social
welfare and security.

Overall, the above diagram represents the Rostow's stages of growth discussed
here. In his work, Rostow admits that his theory and the stages are not merely
descriptive or factual, but is based on logic and continuity. He suggested increase
in savings and investment for economic growth and "capital constraint" as main
obstacle to the path of development.

3.2.3 Kuznets’ Theory

Simon Kuznets developed an approach to the analysis of economic growth over
long historical periods which he called as “economic epochs”. Each economic
epoch is characterized by innovation. He elaborated the idea of Modern
Economic Growth (MEG). He defined a country’s economic growth as “a long-
term rise in capacity to supply increasingly diverse economic goods to its
population. This growing capacity is based on advancing technology and the
institutional and ideological adjustments that it demands.” The following three
components of the definition are crucial.
59
Theories of i) While the sustained rise in national output is a clear manifestation of
Underdevelopment
economic growth, the ability to provide a wide range of goods is a sign of
economic maturity.
ii) Modern technology provides the basis or preconditions for continuous
growth.
iii) To realize the potential for growth inherent in new technology, institutional,
ideological and other adjustments must be made.
MEG is characterized by a rapid growth in per capita production, higher rates of
capital formation than previous epochs and extensive use of science-based
technology. Kuznets identified the following characteristics of economic growth
of every developed nation:
1) High Rates of Growth of Per Capita Output and Slowing Down of
Population Growth: From around 1770, all contemporary developed
countries experienced high rates of growth of both per capita output and
population. Kuznets also highlighted the trend of slowing down of the rate of
population growth.
2) High Rates of Increase in Total Factor Productivity (TFP): TFP is the
output per unit of all inputs. It shows the efficiency with which all inputs are
used in the production process. High rate of rise in TFP constitutes MEG.
3) High Rates of Structural Transformation of the Economy: MEG is
characterized by a high rate of structural and sectoral change inherent in the
growth process. The changes include: (i) a gradual shift away from
agriculture to non-agricultural activities and towards services; (ii) a
significant change in the scale or average size of productive units; and (iii) a
corresponding shift in the spatial location and occupational status of the
labour force away from rural to urban sector.
4) High Rates of Social and Ideological Transformation: The major structural
changes in an economy have to be accompanied by transformation in
attitudes, institutions and ideologies. These are termed broadly as
“modernization”.
5) The Propensity of Economically Developed Countries to Reach out to the
Rest of the World for Markets and Raw Materials: Kuznets had observed
the ongoing propensity of rich countries to reach out to the rest of the world
for primary products and raw materials, cheap labour and lucrative markets
for their manufactured products. This was made feasible by the growing
power of modern technology especially in transport and communications.
6) The Limited Spread of Economic Growth to only one-third of the
World’s Population: Kuznets observed that the increase in world output was
enjoyed by only 33% of the world’s population. Two-thirds of the people in
the third world continued to live in poverty.
60
 Linear Theories of
Kuznets had expressed that the six characteristics he laid out were inter-related Underdevelopment
and mutually reinforcing. However, it all included mass application of
technological innovations. Most of the poor countries do not benefit because 90%
of research and development happens in rich countries. The poor countries lack
in resources and institutions vis-a-vis rich countries.
In his Nobel Lecture in 1971, Simon Kuznets laid out his observations as
follows: “whatever the weight of the several factors in explaining the failure of
the less developed countries (to take advantage of the potential of modern
economic growth), backwardness of the native economic and social framework
lends itself to the factual findings. At present, about two-thirds or more of world
population is in the economically less developed group. Even more significant is
the concentration of the population at the low end of the product per capita range.
In 1965, the last year for which we have worldwide comparable product
estimates, the per capita GDP (at market prices) of 1.72 billion out of a world
total of 3.27 billion, was less than $120, whereas, 0.86 billion in economically
developed countries had a per capita product of some $1900. Even with this
narrow definition of less developed countries, the intermediate group was less
than 0.7 billion, or less than 20 percent of world population. The preponderant
population was thus divided between the very low and the rather high level of per
capita economic performance. Obviously, this aspect of modern economic
growth deserves our greatest attention, and the fact that the quantitative data and
our knowledge of the institutional structures of the less developed countries are,
at the moment, far more limited than our knowledge of the developed areas, is
not reason enough for us to ignore it”.
Several preliminary findings, or rather plausible impressions, may be noted.
First, the group of less developed countries, particularly if we widen it (as we
should) to include those with a per capita product somewhat larger than $120 (in
1965 prices), covers an extremely wide range in size. This is in terms of the
relationship between population and natural resources. This is also in terms of
the past impact upon them of the developed countries (coming as it did at
different times and from different sources). There is a striking contrast in terms
of population size, between the giants like Mainland China and India, on the one
hand, and the scores of tiny states in Africa and Latin America. Furthermore, the
remarkable institutions by which the Asian civilizations produced the unified,
huge societies, that dwarfed in size any that originated in Europe until recently,
bore little resemblance to those that structured the American Indian societies or
those that fashioned the numerous tribal societies of Africa.
Generalizations about less developed countries must be carefully and critically
scrutinized in the light of this wide variety of conditions and institutions. To be
sure, their common failure to exploit the potential of modern economic growth
means several specific common features: a low per capita product, a large share
of agriculture or other extractive industries and a generally small scale of
61
Theories of production. But the specific parameters differ widely. Because the obstacles to
Underdevelopment
growth may differ critically in their substance, they may suggest different policy
directions.
Second, the growth position of the Less Developed countries today is
significantly different, in many respects, from that of the presently developed
countries on the eve of their entry into modern economic growth. This is with
the possible exception of Japan. The Less Developed areas that account for the
largest part of the world population today are at much lower per capita product
levels than were the developed countries just before their industrialization. The
latter at that time were economically in advance of the rest of the world, not at
the low end of the per capita product range. The very magnitudes, as well as
some of the basic conditions, are quite different. No country that entered modern
economic growth (except Russia) approached the size of India or China, or even
of Pakistan and Indonesia. No currently developed country had to adjust to the
very high rates of natural increase of population that have characterized many
Less Developed countries over the last two or three decades. Particularly, before
World War I, the older European countries, and to some extent even Japan, were
relieved of strains of industrialization by a substantial emigration of the displaced
population to areas with more favourable opportunities. Such an avenue was
closed to the populous Less Developed countries today. However, the stock of
material and social technology that can be tapped by Less Developed countries
today is enormously larger than that was available in the nineteenth and even
early twentieth centuries. But it is precisely this combination of greater
backwardness and seemingly greater backlog of technology that makes for the
significant differences between the growth position of the Less Developed
countries today, and that of the developed countries when they were entering the
modern economic growth process.
Despite the tremendous accumulation of material and social technology, the stock
of innovations most suitable to the needs of the less developed countries is not
too abundant. Even if one were to argue that progress in basic science may not be
closely tied to the technological needs of the country of origin, the applied
advances are a response to the specific needs of the country within which they
originate. This was certainly true of several major inventions associated with the
Industrial Revolution in England. Illustrations abound of necessity as the mother
of invention. To the extent that this is true, and that the conditions of production
in the developed countries differed greatly from those in the populous less
developed countries today, the technology that evolved in the developed
countries may not supply the needed innovations. Nor is the social technology
that evolved in the developed countries is likely to provide models of institutions
or arrangements suitable to the diverse institutional and population-size
backgrounds of many less developed countries. Thus, modern technology with its
emphasis on labour-saving inventions may not be suited to countries with a
62 plethora of labour but a scarcity of other factors. Such factors include land and
 Linear Theories of
water, modern institutions, etc. They would not be suited to the more traditional Underdevelopment
life patterns of the agricultural communities that predominate in many less
developed countries.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What is the concept of Modern Economic Growth (MEG) given by Kuznets?
How do the countries across the world differ when it comes to the
characteristics of MEG?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) State the Rostow’s Stages of growth to explain underdevelopment in poor
countries.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….

3.2.4 Harrod –Domar Model

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. A feature common to all of them 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.
The HD model is based on capital as the crucial factor of economic growth. It
concentrates on the possibility of steady growth, through an adjustment of supply
of demand for capital. It assumes substitution between capital and labour and a
neutral technical progress. This in the sense that technical progress is neither
labour saving nor results in substituting labour for capital. That is, both the
factors are used in the same proportion with the technical change taking place
playing a neutral role.
Although the Harrod and Domar models differ in details, they both 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. They both assign a crucial role to capital
accumulation in the process of growth. In fact, they emphasize the dual role of
capital accumulation in the following sense. 63
Theories of On the one hand, new investment generates income through multiplier effect.
Underdevelopment
On the other hand, it increases the productive capacity of the economy by
expanding its capital stock. You should note here that classical economists
emphasized the productivity aspect of investment, taking for granted the income
aspect. Keynes had done the opposite i.e. he 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. Let us now note down the general
assumptions of the HD model first.
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 assumption of “closed economy” holds. In other words, government
restrictions on trade and the complications caused by international trade are
ruled out.
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. That is APS = MPS. This is written in
symbols as: S/Y= ∆S/∆Y
vi) Both the propensity to save and “capital coefficient” (i.e., capital-output
ratio) are given and is constant. This amounts to assuming that the law of
constant returns to scale operates in the economy because of fixed capital-
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 which
could be relaxed later. Harrod’s growth model raised the following 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 the steady uninterrupted growth?
64 iii) How do the natural factors put a ceiling on the growth rate of the economy?
 Linear Theories of
In order to discuss these issues, Harrod adopted three different concepts of Underdevelopment
growth rates: (i) the actual growth rate, G, (ii) the warranted growth rate, Gw and
(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 economy. In other
words, it can be defined as the ratio of change in income (∆Y) to the total income
(Y) in the given period. Thus, if the actual growth rate is denoted by G, then G =
∆Y/Y. 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)
where G is the actual rate of growth, C represents the capital-output ratio ∆K/∆Y
and S refers to the saving-income ratio ∆S/∆Y. This relationship states the simple
truism that saving and investment (in the ex-post sense) are equal in equilibrium.
This is clear from the following:

The above relationship 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. According to Harrod, the economy can achieve steady
growth when G = Gw and C = Cr. This condition states two things. Firstly, that
actual growth rate must be equal to the warranted growth rate. Secondly, the 65
Theories of capital-output ratio needed to achieve G must be equal to the required capital-
Underdevelopment
output ratio in order to maintain Gw, given that the saving co-efficient is S. This
amounts to saying that actual investment must be equal to the expected
investment at the given saving rate.
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 analyzed the situations when these conditions are not
satisfied. That is:

We first analyze the situation where G is greater than Gw. Under this situation,
the growth rate of income being greater than the growth rate of output, the
demand for output (because of the higher level of income) would exceed the
supply of output (because of the lower level of output) and the economy would
experience inflation. This can be explained in another way when C < Cr. Under
this situation, the actual amount of capital falls short of the required amount of
capital. This would lead to deficiency of capital, which would in turn adversely
affect the volume of goods to be produced. Decline in the level of output would
result in scarcity of goods and hence inflation. Thus, under this situation, the
economy will find itself in the quagmire of inflation.
On the other hand, when G is less than Gw, the growth rate of income would be
less than the growth rate of output. In this situation, there would be excess goods
for sale. But the income would not be sufficient to purchase those goods. In
Keynesian terminology, there would be deficiency of demand and consequently
the economy would face the problem of deflation. This situation can also be
explained when C is greater than Cr. In this situation, the actual amount of
capital would be larger than the required amount of capital for investment. The
larger amount of capital available for investment would dampen the marginal
efficiency of capital in the long run. Secular decline in the marginal efficiency of
capital would lead to chronic depression and unemployment. This is the state of
secular stagnation.
From the above analysis, it can be concluded that steady growth implies a
balance between G and Gw. In a free-enterprise economy, it is difficult to strike a
balance between G and Gw as the two are determined by altogether different sets
of factors. Since a slight deviation of G from Gw leads the economy away from
the steady-state growth path, it is called ‘knife-edge’ equilibrium.
Gn, the natural growth rate, is determined by natural conditions such as labour
force, natural resources, capital equipment, technical knowledge, etc. These
66 factors place a limit beyond which expansion of output is not feasible. This limit
 Linear Theories of
is called Full-Employment Ceiling. This upper limit may change as the Underdevelopment
production factors grow, or as technological progress takes place. Thus, the
natural growth rate is the maximum growth rate which an economy can achieve
with its available natural resources.
The third fundamental relation in Harrod’s model showing the determinants of
natural growth rate is GnCr is either = S or ≠ S.

Fig. 3.1: Interaction of G, Gw and Gn

Comparing the second and the third relations about the warranted growth rate and
the natural growth rate given above, we can say that Gn may or may not be equal
to Gw. In case Gn 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 that are likely to intervene making the balance among
all these factors difficult. As such, there is a definite possibility of inequality
between Gn and Gw. If Gn exceeds Gw, G would also exceed Gw for most of the
time (as is shown in the Fig. 3.1 above). Thus, there would be a tendency in the
economy for cumulative boom and full employment. Such a situation will create
an inflationary trend. To check this trend, savings become desirable as it would
enable the economy to have a high level of employment without inflationary
pressures. If, on the other hand, Gw exceeds Gn, G must be below Gn for most of
the time and there would be a tendency for cumulative recession resulting in
unemployment (See Fig. 3.2 below).

Fig. 3.2: Cumulative Recession

67
Theories of The Domar Model: The Domar model bears a certain resemblance to the Harrod
Underdevelopment
model. In fact, Harrod regarded Domar’s formulation as a rediscovery of his own
version after a gap of seven years. Domar’s theory was just an extension of
Keynes’ General Theory, particularly on two counts as stated below:
1) Investment has two effects i.e. (a) an income-generating effect and (b)
productivity effect by creating capacity. The short-run analysis governed by
Keynes ignored the second effect.
2) Unemployment of labour generally attracts attention as one feels sympathy
for the jobless. But unemployment of capital attracts little attention.
However, unemployment of capital inhibits investment and hence reduces
income. Reduction of income brings about deficiency in demand and
unemployment. Thus, the Keynesian concept of unemployment misses the
root cause of the problem.
Domar wanted to analyze the genesis of unemployment in a wider sense. The
main points of the Harrod-Domar analysis are summarized below:
1) Investment is the central variable of stable growth. It plays a double role; on
the one hand, it generates income and on the other, it creates productive
capacity.
2) The increased capacity arising from investment can result in greater output or
greater unemployment depending on the behaviour of income.
3) Conditions concerning the behaviour of income can be expressed in terms of
growth rates i.e., G, Gw and Gn. Equality between the three growth rates can
ensure full employment of labour and full-utilization of capital stock.
4) These conditions, however, specify only a steady-state growth. The actual
growth rate may differ from the warranted growth rate. If the actual growth
rate is greater than the warranted rate of growth, the economy will experience
cumulative inflation. If the actual growth rate is less than the warranted
growth rate, the economy will slide towards cumulative deflation.
5) Business cycles are viewed as deviations from the path of steady growth.
These deviations cannot go on working indefinitely. These are constrained by
upper and lower limits i.e. the ‘full employment ceiling’ acts as an upper limit
and effective demand (composed of autonomous investment and
consumption) acts as the lower limit. The actual growth rate fluctuates
between these two limits.
It can be seen from the above that: (i) the three growth rates (G, Gw and Gn) vary
from country to country depending on their inherent socio-economic conditions,
and hence, (ii) HD’s results are useful for cross country comparison.

68
 Linear Theories of
3.3 LIMITATIONS OF LINEAR THEORIES Underdevelopment

The mechanisms of development embodied in the theory of Stages of Growth do

not always work. The key weakness of these models lies in their simplified
assumptions. A single production function is simply assumed for all countries.
Every economy is assumed to have the same necessary conditions and that they
would pass through the same phases, stage by stage. But such an economic
growth path, which historically had been followed by the more developed
countries, is not the only pathway. The development process is actually highly
nonlinear. Hence, countries would pursue their own distinct development paths.
Economies may miss stages, or become locked in one particular stage, or even
regress depending on many other complementary factors (such as managerial
capacities, and the availability of skilled labour for a wide range of development
projects). Overall, therefore, the criticism or the limitations of Linear Theories
highlights the following:
1) Although savings is regarded as highly significant, modern growth theory
takes into account a broad set of growth factors.
2) General weakness in terms of the unrealistic assumptions of these models,
such as perfect knowledge, stable exchange rates and constant terms of trade
do not exist.
3) Most analysis are based on the reconstruction of Europe after World War II.
But most developing countries do not have Europe’s institutions, attitudes,
financial markets, levels of education, etc.
4) Modern Theory tends to see savings as a necessary but not a sufficient
condition for growth.

3.4 STATE INTERVENTION AND RELATED

POLICY IMPLICATIONS
There are several implications for the growth problems of the less developed
countries. As Kuznets highlighted, “a substantial economic advance in the less
developed countries may require modifications in the available stock of material
technology, and probably even greater innovations in political and social
structure”. It will not be a matter of merely borrowing existing tools: material and
social. Nor is it a matter of directly applying the past patterns of growth, or
merely allowing for the differences in parameters.
The innovational requirements are likely to be particularly great in the social and
political structures. It would be an oversimplification to argue that these
innovations (in the social and political structures) were made primarily in
response to the strain between economic backwardness and the potential of
modern economic growth. For whatever reasons, the struggle for evolved
political and social organization is a response, once it has been achieved, the
results significantly shape the conditions under which economic growth can 69
Theories of occur. It seems highly probable that a long period of experimentation and
Underdevelopment
struggle (for achieving a viable political framework compatible for adequate
economic growth) lies ahead for most less developed countries of today. This
process will become more intense and acute as the perceived gap between what is
attained and what is attainable with modern economic growth widens. The most
distinctive feature of modern economic growth is the combination of a high rate
of aggregate growth with disrupting effects giving rise to new problems. The
high rate of growth is sustained by the interplay between mass applications of
technological innovations on the one hand (based on the stock of knowledge) and
further additions to that stock on the other. The disrupting effects are those that
are imposed by the rapid rate of change in economic and social structure. The
problems are the unexpected and unforeseeable results of the spread of
innovations. All these, pose a range of problems for the slow spread of economic
growth in the less developed countries. The less developed countries have a long
history of separation and relative isolation from the conditions within which
modern economic growth has originated in the developed economies. Further,
concurrent with the remarkable positive achievements of modern economic
growth, there are also unexpected negative results even within the developed
countries. The less developed countries have to therefore struggle in their
attempt to use the modern technology in order to assume their role in the
interdependent world from which they cannot withdraw even if they wished to do
so.
In general, therefore, if we look at state intervention, the following points need to
be considered:
 Common concerns include raising national savings rate; balancing growth in
different sectors of the economy; managing the demographic and economic
shifts that go along with the transition from a rural, agrarian society to an
urban, industrial one; managing monetary policy so that foreign investors will
invest in the country and trust the national currency, etc.
 Very often, the state has to raise huge amounts of capital by borrowing in the
international lending markets. The government itself need to intervene in
shaping industrialization. For example, the South Korean government acted
as an entrepreneur, a banker, and a shaper of industrial structure. It
deliberately adjusted its economy through subsidies, protection, price controls
(food, etc.), and restrictions on foreign direct investment.
There is, thus, no one formula that works equally well for all countries. Each of
the models or strategies discussed above will or won’t work depending upon
historical contingencies, government structure, geopolitical positioning,
environmental resource endowments, etc. In this, the international organizations
of the global economy (in terms of how they make rules, regulate and evolve
over time) will determine how any one strategy will fare in the global market.
70
 Linear Theories of
Nonetheless, though each country has its own set of circumstances that facilitate Underdevelopment
its economic development path, all countries and their economies are linked to
the global economy. One way to learn therefore is to investigate global
commodity chains (also known as the “global assembly line”) that produce our
everyday products.

Check Your Progress 3

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) How does the Harrod-Domar model help to explain economic growth across
countries?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) State the limitations of Linear Growth theories.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
3) Specify the areas of state intervention needed in developing countries in the
light of linear theories of growth.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….

3.5 LET US SUM UP

Development theory is a conglomeration of theories about how desirable change
in society is best achieved. One of the key development models is the ‘linear
stages of growth model’. This is heavily inspired by the Marshall Plan of the US
which was used to rehabilitate Europe’s economy after the Post-World War II
Crisis. The linear stages of growth models are the oldest and the most traditional
of all development models. It was an attempt by economists to come up with a
suitable concept as to how underdeveloped countries of Asia, Africa and Latin
America can transform their agrarian economy into an industrialized one.
In this Unit, we have introduced the schools of thought that emerged in the post-
World War II era to explain economic growth and the factors responsible for it.
The beginning of this study was the core idea of Marx and his followers. This
helped us understand the evolution of these growth theories. We studied the most
popular of the linear stage models - Rostow’s Stages of Growth Model and the
Harrod-Domar Growth Model. Also, we took an insight of Kuznets’ ideas on
71
Theories of Modern Economic Growth and the important characteristics that help us to
Underdevelopment
distinguish between developed and underdeveloped countries.
We could understand the working of these models and their broad limitations.
Overall, we could conclude that developed and underdeveloped countries behave
differently and so all models based on the experience of present-day advanced
countries (viz. The Linear Stages models of growth) do not work the same way as
they did or could then. The Marxian prediction of growing class conflicts due to
increasing inequality in capitalist systems, and an eventual violent revolution that
would end capitalism paving the way for socialism, has not come true in case of
advanced industrial economies.
The less developed countries are grappling with underdevelopment and other
correlated struggles. The basic reason is not because more Saving and Investment
is not the necessary condition for accelerated rates of growth. It rather is because
it is not a sufficient condition. The Marshall Plan worked for Europe because the
European countries receiving aid possessed the necessary structural, institutional
and attitudinal conditions to convert new capital effectively into higher levels of
output. The Rostow and Harrod-Domar Model implicitly assumed the existence
of same attitudes and arrangements in underdeveloped countries. Yet, they
actually lack in many such basic factors, and complementary factors, like
managerial competence, skilled labour, ability to plan and administer a wide
assortment of development projects, to name a few. Kuznets’ MEG approach
explained how it works for the advanced countries but such a concept is
meaningless given the state of the underdeveloped world. All the structural
characteristics explained by him show the light to the polarized world of which
we are all so much a part of.

3.6 HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) Linear Stages of Growth, Patterns of Structural Change, International
Dependence, Free Market.
2) Capitalist imperialism leading to wider inequality and socialism.

Check Your Progress 2

1) A growth characterised by rapid growth in per capita production, TFP and
capital formation.
2) Rostow specifies five stages through which a country has to transit to become
a developed country from being an underdeveloped country.

72
 Linear Theories of
Check Your Progress 3 Underdevelopment

1) By linking the behaviour of income in terms of growth rates in G, Gw and Gn

i.e. actual rate of growth, the warranted growth rate and the natural growth
rate respectively.
2) It assumes for all countries: (i) a single production function and (ii) same
necessary conditions to prevail.
3) (i) Raising national Savings rate, (ii) balancing growth in different sectors of
the economy, (iii) managing the demographic and economic shifts, (iv)
borrowing from international lending markets, etc.

73
Theories of
Underdevelopment UNIT 4 STRUCTURAL THEORIES OF UNDER
DEVELOPMENT
Structure
4.0 Objectives
4.1 Introduction
4.2 Lewis Model
4.2.1 Assumptions
4.2.2 The Model
4.2.3 Limitations
4.2.4 Policy Implications
4.3 Kaldor Model
4.4 Thirlwall Approach
4.5 Chenery’s Patterns of Development Analysis
4.6 Development of a Tertiary Sector
4.6.1 Clark –Fischer
4.6.2 Victor Fuchs
4.7 Balanced and Unbalanced Growth Approaches
4.8 Let Us Sum Up
4.9 Hints to Check Your Progress Exercises

4.0 OBJECTIVES
After studying this Unit, you should be able to:
 describe the emergence of Structural Change Models of Growth;
 analyse the assumptions, working, limitations and policy implications of
Lewis Model;
 discuss various models of structuralism viz. Kaldor, Chenery, Thirlwall;
 trace the evolution of Tertiary sector and its role in the growth of
underdeveloped countries; and
 distinguish between Balanced and Unbalanced growth theories.


Dr. Puja Saxena Nigam, Associate Professor, Economics, Hindu College, University of Delhi,
New Delhi
74
 Structural Theories of
4.1 INTRODUCTION Underdevelopment

The world today comprises the developed and underdeveloped countries. They
are in sharp contrast to each other. While developed countries are rich and
affluent, underdeveloped countries are stuck in poverty and people struggling to
afford the basic necessities. With typical dissimilarities between these two parts
of the world, and the inherent structural differences that explain this polarization,
it is important to understand how exactly can a convergence be predicted.
Various schools of thought have been focusing on the requisite path to narrow the
gap between the rich and poor nations. As theories were introduced... accepted...
rejected and modified... it was understood that no single theory could possibly
explain the growth process to suit every country of the world. It has been
acknowledged nevertheless, that there are structural differences between
developed and underdeveloped countries. Amongst the various such differences,
the prominent one recognized by the growth theorists is the sectoral division of
economies based on occupational structure. While developed countries are led by
sophisticated and well developed secondary and tertiary sectors along with a
highly commercial agricultural sector, underdeveloped countries have a typically
primitive agricultural sector and a small modern or secondary sector
accompanied by an amateur services sector. Thus, a change in the occupational
structure of underdeveloped countries can pave way for them to take steps
towards their developed counterparts.
Structuralism is a development theory which focuses on the structural aspects of
the development process. The transformation of an economy from being a
subsistence agricultural to a modern, urbanized and service economy is the heart
of this theory. It calls for major Government intervention in the economy to fuel
industrial sector particularly the Import Substitution Industrialization (ISI). It is
to be pursued to create an economy that enjoys self-sustaining growth. The only
way for underdeveloped countries to grow is via this structural transformation i.e.
push industrialization and reduce their dependency on developed countries.
Three broad schools of theory on economic development have been highlighted
in terms of how each views the sector and activity specificity. The neo-classical
and neo-Schumpeterian schools are based on the assumption that an equilibrating
process leads to an optimal allocation of factors of production at least in medium
to long run. The third school, mainly the Lewis or Kaldor school, based on
Classical roots, discusses the importance of sectors by activity specificity. Neo-
classical theory is represented by Solow’s convergence where growth is driven
by incentives to save, accumulate physical and human capital and innovate.
In this Unit, we delve deeper into the structural transformation of underdeveloped
countries in terms of structural growth models given by Lewis, Kaldor, Chenery,
and Thirlwall. This group brings together the growth dynamics that are
dependent on development of manufacturing and services. 75
Theories of
Underdevelopment 4.2 LEWIS MODEL
Arthur Lewis in 1954 came up with a model of growth based on inherent dualism
in an economy which is the co-existence of traditional and modern sectors. The
focus of the model is on the structural transformation of a predominantly agrarian
economy. It is treated as a general theory of the development process in labour
surplus developing countries. Lewis’s basic model was later extended by Ranis
and Fei in 1961within the framework provided by Lewis.

4.2.1 Assumptions
An underdeveloped economy consists of two sectors - a traditional agriculture
sector and a modern industrial sector. The former is overpopulated and is
characterized by zero marginal productivity of Labour (that is surplus labour).
The surplus labour can be removed from this sector without causing total output
to fall. The modern industrial sector is characterized by higher labour
productivity. Such an economy will grow and gain by gradually transferring
labour from the subsistence agricultural sector to the modern industrial sector.
Two primary resource flows (from traditional to modern sector) characterize the
peculiarity of the model i.e. : a) transfer of surplus labour and b) surplus of food
that allows the non-agricultural labour force to survive. This lies at the heart of
structural transformation that occurs in most of the developing countries. The
modern sector grows in output and employment. In the process, the rate of
growth of the modern sector is determined solely by the rate of industrial
investment and capital accumulation. In this sector, it is assumed that only
capitalists save and workers don't. Entire profits of capitalists are saved. The
level of wages in the modern industrial sector is assumed to be constant and
determined over a fixed average subsistence level of wages prevailing in the
traditional agricultural sector. Hence, the supply curve of the modern sector is
assumed to be perfectly elastic up to a point. Thereafter, it would allow for wages
in the industry to rise in response to changes in the agricultural sector within the
dynamics of the two-sector economy. This happens when the agricultural sector
moves from an income sharing format to a market determined set up.

4.2.2 The Model

The Lewis (Ranis and Fei) model describes economic development in terms of
the proceeds of Labour transfer from agriculture to industry. It presumes the
simultaneous transfer of surplus food grain production to sustain the part of the
labour force engaged in non-agricultural activity. The figure below (Fig. 4.1)
shows a schematic description of how the labour force and the corresponding
agricultural surplus is transferred in the process of development.
In each panel of the Fig. 4.1, the industrial labour force is read from left to right,
whereas the agricultural labour force is read from right to left. The entire labour
force is divided between agriculture and industry. Wages in the agricultural
76
 Structural Theories of
sector are initially decided on income sharing basis. Hence, the average wage is Underdevelopment
just which is proportional to the angle given in the diagram. Analysis is
undertaken from the lowest panel towards the Upper panels.
The lowest panel has a typical agricultural production function that is drawn from
right to left. It is divided into three parts. A surplus labour phase, a disguised
unemployment phase and a commercialization phase. The entire analysis is based
on the understanding that an economy transfers its labour force from agriculture
to the industrial sector.
Industrial wage

Demand
curves for Supply curve of
Industrial Labour IndustrialLabour

w*

Unlimited Second turning point

First turning point
supply
of Labour
A’’’ B’’’ C’’’
x y z z* Industrial Labour
Average Agricultural surplus

Average Surplus
𝒘
̅

Constant Surplus Declining Surplus Declining Surplus

A’’ B’’ C’’

Industrial Labour
Agricultural output

Output

Wage [w]

Commercialisation
Surplus Labour
Disguised Unemployment

A B C 𝒘
̅
Agricultural Labour

Fig. 4.1: Schematic Description of Labour Transfer 77

Theories of In the first phase (AB), that is the surplus labour phase, as labour is drawn away
Underdevelopment
from the agricultural sector, it does not affect the total output. The average
agricultural surplus remains constant. This is depicted in the second panel of the
diagram by the constant surplus phase (i.e. the average agricultural wage is
exactly ). In the uppermost panel, it gets depicted in the form of a perfectly
elastic supply curve of industrial labour, where the industrial wage is .
As labour is transferred beyond the surplus labour phase, that is the segment BC,
there is no more surplus labour. But this phase exhibits disguised
unemployment. This is because the marginal product of Labour in agriculture is
less than the wage for labour inputs in this segment. To the right of C, the phase
of disguised unemployment ends. Till this phase, the agricultural wage does not
change. Hence, in the second panel, the phase of declining surplus creeps in. It
transforms into an increasing supply curve in the first panel of the diagram.
In the Surplus labour phase, the industrial wage is higher than the agricultural
wage (in terms of attracting potential migrants) but it remains constant. In the
second phase of disguised unemployment, it starts increasing. This increase is
attributed to the shifting of terms of trade between agriculture and industry in
terms of the compensation needed by the labour that is transferred from the
agricultural to the industrial sector.
In the model, the second phase is characterized by average agricultural surplus
falling below . The immediate effect of this is on the food prices which
begins to rise. Therefore, the terms of trade between rural and urban sector begins
to move against industry. In order to compensate for this, the industrial wages
must rise. The rise in the industrial wages, however, are dependent on the extent
of compensation that is required (i.e. the traditional wage being closer or far
away from the minimum subsistence wage). This phase is known as the first
turning point. When transfer of Labour is continued beyond the point C, the
disguised unemployment phase comes to an end. Then begins the phase of
commercialization where the marginal product of Labour begins to exceed the
traditionally given wage rate. This phase is associated with an even sharper
decrease in the average agricultural surplus. This brings in the second turning
point in the uppermost panel in the industrial wage. Not only must the wage
compensate for the declining agricultural surplus, it must also compensate the
workers for a higher income foregone in the agricultural sector. Thus, it creates a
still sharper upward movement in the industrial wage rate. This completes the re-
construction of the supply curve in the first panel.
The working of the model is based on the introduction of industrial sector
demand for labour. The topmost panel of the diagram introduces the demand
curves for industrial labour and the equilibrium in the demand and supply market.
It depicts the higher industrial production phase i.e. realization of profits and
parts of profits being reinvested into the industrial sector. Capital accumulation
78
 Structural Theories of
leads to further demand for labour in the sector. Industrial employment increases, Underdevelopment
as can be seen in the diagram from x to y to z.
This version of the Lewis model typically analyzes the rise of industrial
employment further to a point ‘z’ (i.e. in case the turning point had not occurred).
The fall in the agricultural surplus chokes off industrial employment to some
extent. This is because it raises the cost of hiring industrial labour.
Overall, the Lewis-Ranis-Fei version of the model states that capital
accumulation in the industrial sector is the engine of growth. More capital means
greater demand for labour, which in turn induces greater rural-urban migration as
development proceeds. The terms of trade gradually turns against industry. Food
prices rise because a smaller number of farmers must support a greater number of
non-agricultural workers. The rise in the price of food causes an increase in the
industrial wage rate. The pace of development is driven by the accumulation of
capital, but is limited by the ability of the economy to produce a surplus food.
Lewis argued that the driver of capital accumulation was a sectoral movement of
labour, from the “traditional” sector (or the “subsistence” or “non-capitalist”
sector with low productivity and low wage, priced to average product and not the
marginal product and thus with widespread disguised unemployment) to the
“modern” or “capitalist” sector (with higher productivity where wages are set by
the productivity in the “subsistence sector”). The wages are set just above
subsistence across the whole economy. This leads to the transfer of labour over
time from the traditional or non-capitalist sector to the modern or capitalist
sectors. The resultant labour productivity gains are transferred to the capitalists as
profits which becomes the source of growth via reinvestment. The floor for
wages is institutionally set at subsistence. When the surplus labour disappears, an
integrated labour market comes to prevail and wages will begin to rise.
The Lewis model was intended as a critique of the neoclassical approach. This
was in the sense that labour is available to the modern (or capitalist) sector of an
economy but not in a perfectly elastic manner. The supply is available in an
upward sloping manner, rather than flat, with a distinction between the surplus-
producing labour and the subsistence labour. The latter was marked as a
negligible source for profits and reinvestment, which Lewis saw as the ‘driver for
growth’. Lewis also rejected the assumptions of neoclassical economists of
perfect competition, market clearing and full employment. Rather, he made the
distinction between productive labour, which produced a surplus, and
unproductive labour, which did not.

4.2.3 Limitations
The economic development under the Lewis Model, with surplus labour and
benefits of industrialization, may be limited by the following:
First, even if there is unlimited supply of labour, industrial projects may face the
shortages of skilled labour. Second, the industrial projects may find it difficult to 79
Theories of procure the initial capital equipment with which to employ the surplus workers.
Underdevelopment
Third, the migration of people from rural to urban sector makes considerable
demands on physical and social infrastructure facilities that may not be readily
available in less developed economies. These would be in terms of housing,
transport, public health services, schools and colleges. Fourth, the effective
absorption of surplus labour cannot be achieved without some fundamental
changes in the rural economic institutions as well. Fifth, profits may leak out of
the developing economies and find their way back to developed economies
through a process called capital flight. Sixth, the model assumes competitive
‘labour and product markets’, which may not exist in reality. And finally, the
economic benefits from industrialization might not trickle down to the majority
of population.

4.2.4 Policy Implications

In the course of development, economies can adopt different policies. The Lewis
Model of economic development looks at certain policies which may be
implemented like agricultural taxation and agricultural pricing policies. The
important questions with the policymakers in developing countries are about
promoting industrial sector and dealing with the agricultural sector. Should
taxation in agriculture be undertaken in order to ensure a larger food surplus in
the short to medium run, or should investments in agriculture be made to ensure
long run gains? This is a debatable issue. Alongside the question of agricultural
pricing policy via the price support programs, subsidies to inputs such as water,
electricity, fertilizers, etc. can also be studied with the evidence from various
parts of the growing world on the success and the failure of such policies
undertaken.

4.3 KALDOR MODEL

Nicholas Kaldor in 1967 postulated a growth model which follows Harrod’s and
Keynesian approach. He explained growth in terms of a framework for relating
the genesis of technological progress to capital accumulation. Kaldor posited that
economic development requires industrialization. This is because increasing
returns in the manufacturing sector means faster growth of manufacturing output
which is associated with faster economic growth. Kaldor outlined a set of
empirical regularities which came to be known as “Kaldor’s growth laws”.
They sought to explain the economic development of Western Europe through
the development of manufacturing. He argued that this was the engine of growth
for every country at every stage of economic development. Specifically, he said
that:
i) economic development requires industrialization because increasing returns
in the manufacturing sector means faster growth of manufacturing output
which is associated with faster GDP growth. This is because backward and
80 forward input–output linkages are strongest in manufacturing and the scope
 Structural Theories of
for capital accumulation, technological progress, economies of scale and Underdevelopment
knowledge spillover are strong. Further, there is a strong causal relationship
between manufacturing output growth and labour productivity because of a
deepening division of labour, specialization, and learning-by-doing. The
scope for productivity gains is also large due to economies of scale;
ii) industrialization requires a basis in agricultural modernization to ensure food
supply and labour will transfer from other sectors to manufacturing. As
manufacturing grows, productivity across the economy will rise (i.e. both in
agriculture and services). This happens through positive spillovers such as
technological knowhow and complementary markets in services. Kaldor
argued that the agriculture and industrial sectors are not only connected by
the Lewis labour transition (i.e. the elastic supply of labour due to industry
wages exceeding agriculture wages) but also because agriculture creates
autonomous demand for the manufacturing sector. Thus, land reform is
required if agriculture is not to hinder the structural transformation.
iii) aggregate demand should be managed to ensure growth (e.g. policies on
public investment, taxation, directed credit).
iv) as the economy grows, exports become increasingly important as a source of
demand for the manufacturing sector. Global competition then requires
temporary domestic industry protection accompanied by export-led growth
policies. In sum, for Kaldor, the virtuous cycle is that, demand and output
growth fuel productivity growth due to increasing returns to scale. This in
turn fuels capital accumulation.
It is Kaldor’s another law, known as Kaldor-Verdoorn law, that contains an idea
of particular importance to structural transformation and inclusive growth. It talks
of the Kaldor-Verdoorn coefficient which is the employment elasticity of growth.
The more the manufacturing sector grows, the more is the productivity growth
across the whole economy (because manufacturing provides capital goods across
the economy). This is also because increases in manufacturing employment raises
agriculture productivity (as labour migrates). The manufacturing sector is the
only sector with dynamic returns to scale due to the new processes. Kaldor’s
interpretation of Verdoorn is that output growth induces improvements in labour
productivity (assuming an elastic labour supply) and not vice versa. In contrast,
the hypothesis of neoclassical models such as Solow is that productivity growth
is due to technological progress. Verdoorn’s argument was one of cumulative
causation where demand rather than supply determines the rate of accumulation.
From this standpoint, Kaldor (and later Thirlwall) developed models where the
growth of exports leads to specialization which then leads to increases in
productivity and skill improvements. This causes resources to move to the export
sector.
Any set of contemporary challenges throws up greater levels of complexity. First,
domestic labour migration may not be permanent but circular (back-and-forth) or 81
Theories of “commuting.” Second, the contemporary scale of inter-sectoral resource flows
Underdevelopment
via the growth of remittances blurs the line between sectors. Finally, the Lewis
transition can take a variety of forms beyond the one anticipated by Lewis. It is
by no means guaranteed that the transfer will be from low- to high-productivity
activities. In fact, a transfer from low-productivity agriculture to low-productivity
services has been the experience of many developing countries. Further, a
reversing of the Lewis transition has also been a phenomenon noted in a number
of developing countries due to “premature deindustrialization.”

Check Your Progress 1

1) State the basic framework for the Structural Theories of Underdevelopment.
2) Specify the dynamics of the Lewis Model of Structural Transformation.
3) What is the thrust of Kaldor’s Model of Growth?

4.4 THIRLWALL APPROACH

Thirlwall's law states that for long run balance of payments equilibrium on
current account, so long as the real exchange rate stays relatively constant, the
long run growth of a country can be approximated by the ratio of the growth of
exports to the income elasticity of demand for imports (Thirlwall, 1979).
Suppose the real exchange rate varies considerably, but the price elasticities of
demand for imports and exports are low. Then, the long run growth of the
economy will be determined by ‘the growth of world income times the ratio of
the income elasticity of demand for exports and imports’. These are determined
by the structural characteristics of countries. One important example of this is
that if developing countries produce mainly primary products and low value
manufactured goods with a low-income elasticity of demand, while developed
countries specialize in high income elasticity manufactured goods, then the
82 developing countries will grow at a relatively slower rate.
 Structural Theories of
Thirlwall’s Balance of Payments Constrained Growth Model – or Thirlwall’s Underdevelopment
Law- is often called the dynamic Harrod trade multiplier result. This is following
the Roy Harrod’s (1933) static foreign trade multiplier result which states that Y
= X/m, where Y is national income; X is exports and m is the marginal propensity
to import. This is derived under the same assumptions as in the Thirlwall’s Law.
It is a post-Keynesian Model which provides an alternative to the supply side
models of neo-classical growth theory. The latter are the close economy models
with no demand constraints. In the Thirlwall model, the ultimate constraint on
growth is a shortage of foreign exchange, or the growth of exports, to which
factor supplies can adapt. It is changes in growth that equilibrate the balance of
payments; not the changes in relative prices in international trade.

4.5 CHENERY’S PATTERNS OF DEVELOPMENT

ANALYSIS
The patterns of development analysis of structural change focuses on the
sequential process through which the economic, industrial and institutional
structure of an underdeveloped economy is transformed overtime. Such a change
allows for new industries to replace the traditional agriculture thereby becoming
the engine of economic growth. However, in contrast to the Lewis model and the
original stages view of development, increased savings and investment are
perceived here as necessary but not sufficient conditions for economic growth. In
addition to the accumulation of capital, both physical and human, a set of
interrelated changes in the economic structure of a country are required for the
transition from a traditional economic system to a modern one. These structural
changes involve virtually all economic functions. They include the
transformation of production and changes in the composition of consumer
demand, international trade and resource use. Such a structural transformation
requires changes in many socio-economic factors like urbanization, and
distribution of a country's population. The constraints on development are both
domestic and international. The domestic ones include (i) economic constraints
like the country's resource endowment, including its physical and population
size, and (ii) its institutional constraints like government policies and objectives.
International constraints include the access to external capital technology and
trade. Differences in development level among developing countries are largely
ascribed to these domestic and international constraints. The international
constraints are responsible for making the transition of the developing countries
different from that of the present-day industrialized countries. The developing
countries have access to the opportunities presented by the advanced countries
like capital technology and manufactured imports, as well as markets for exports.
Thus, they can make the transition at an even faster rate than what was achieved
by the present-day advanced countries during their early periods of economic
development. The best-known model of structural change is the one that is
largely based on the empirical work of Harvard economist Hollis B Chenery and 83
Theories of his colleagues. They examined the patterns of development for numerous
Underdevelopment
developing countries during the post war period. Their empirical studies (both
cross-sectional among countries at a given point of time and time series over long
periods of time of countries at different levels of per capita income) led to the
identification of several characteristic features of the development process. These
included (i) the shift from agriculture to industrial production, (ii) the steady
accumulation of physical and human capital, (iii) the change in consumer
demands from food and basic necessities to diverse manufactured goods and
services, (iv) the growth of cities and urban industries as people migrate from
agriculture and (v) the decline in family size and overall population growth.
One limitation of emphasizing on observed patterns, rather than theory, is that the
approach runs the risk of drawing wrong conclusions for policy implication. For
instance, observing the decline of the share of the labour force in agriculture
overtime in the developed countries, many developing country policymakers
have been inclined to neglect the attention required for promoting a vital sector
like agriculture. Likewise, observing the important role of higher education in
developed countries, policymakers in developing countries may be inclined to
emphasize the development of an advanced university system even before the
majority of the population has gained basic literacy. Such policies have led to
gross inequalities in countries across the world.

4.6 DEVELOPMENT OF A TERTIARY SECTOR

As economies develop, it is understood that a change in the occupational
structure is inevitable. Thus, based on the hypothesis put forth by the theorists
discussed above, many economists have discussed the dominant emergence of
Tertiary Sector in course of time. This process has been called as the
tertiarisation of economies.

4.6.1 Clark –Fischer

In 1935, Alan Fisher had suggested that economic progress would lead to the
emergence of a large service sector which would follow the development of their
primary and secondary sectors. In 1940, Colin Clark developed this theme to
create the Clark Fisher development theory, also called the Fisher Clark model.
The model shares some characteristics of the early linear stages models and later
structural change models. As per this model, for economic progress to follow,
structural change must first occur in capitalist economies. This view is even
today found very relevant as explanations of development in the modern day
developing economies. The emergence of a large service sector as an indicator
of such a process of development is seen to be bearing forth in many developing
economies including India. Why does the service sector emerge after
industrialization? The answer is contained in two parts as follows: a) high income
elasticity of demand for services i.e. as income increases, demand for services
84 also increase with more employment and national output getting centred in the
 Structural Theories of
service sector and b) low productivity of labour, lower than in manufacturing Underdevelopment
because it is harder to apply new technology to many services.

4.6.2 Victor Fuchs

In the 1960s and 70s, American economist Victor Fuchs also focused on the
services sector. He attempted to develop a general theory of economic
development. In particular, he looked at the changing patterns of employment
associated with the rise of a service sector and took this to be a key indicator of
economic progress. Increasingly, growth in service sector employment could be
seen across western economies. This, he argued, also contributed to the
slowdown in economic growth rates in more developed economies as service
sector would grow slower than manufacturing.

4.7 BALANCED AND UNBALANCED GROWTH

APPROACHES
The Classical School approach to economic development is that economic
development is driven by changing structures of GDP and employment that lead
to productivity growth. As a result of the productivity growth between sectors
differing substantially, the transfer of labour and production is a major source of
productivity gains and thus economic growth.
According to MP Todero, “growth models fail to deal with many of the most
interesting problems of the development process”. A controversial issue is related
to the strategy of development of an underdeveloped country. This concerns the
balance that needs to be established between the different sectors of the
economy. The underdeveloped countries have to decide whether they should
move forward simultaneously in all sectors (The Big Push) or sequentially by
prioritizing the sectors of the economy. Hence, along with these growth theories,
two broad schools of thought on this emerged viz. the Balanced Growth approach
the Unbalanced Growth approach. Arthur Lewis, Ragnar Nurkse, Rosenstein
Rodan are the major exponents of what is called as the strategy of Balanced
Growth. Albert Hirschman, Hans Singer, Paul Streeten and Marcus Fleming, on
the contrary, argued that most of the countries have to go through stages of
imbalances in order to grow. The balanced growth theory emphasizes on the
significant interdependence between the different sectors of the economy, and
hence how a country can achieve growth simultaneously over a broad range of
activities. Balanced Growth theory may take the form of a minimum size of an
investment program required to start the process of economic development. In
the other versions of this theory, Balanced Growth may refer to the pattern of
investment necessary to keep the different sectors of an economy balanced in
relation with each other. Highlighting the various limitations of the balanced
growth approach, some economists recommended a sequential development
strategy. Albert Hirshman is the foremost proponent of the doctrine of
Unbalanced Growth. According to him, and the other economists who 85
Theories of recommend sequential investment in opposition to simultaneous investment,
Underdevelopment
underdeveloped countries are not in a position to make investment on a large
scale in a large number of different industries simultaneously. Hence, it will be
correct for such economies to identify their key or important sectors and invest in
a sequential manner in the declining order of priority. The Unbalanced Growth
approach is based on the idea of linkages, popularly known as the ‘linkage
effects’. Apart from these, various economists have used skill constraints,
technological choices and desirable technological advancements as vital
ingredients in the process of development.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) State the essence of Thirlwall Growth Model.

2) What is the crux of Chenery’s Patterns of Development Analysis?

4.8 LET US SUM UP

Underdevelopment is the concern of the economists across the world. Hence,
many theories have evolved overtime to examine the process of development.
Structural change theories have focused on the mechanism through which
underdeveloped countries can transform their domestic economic structures.
This is done by moving the focus from agriculture to a modern industrial sector,
and thereby into a service-led economy.
In this Unit, we first discussed the Lewis Model where he argued that the driver
of capital accumulation was a sectoral movement of labour. This movement is
from the “traditional” or “subsistence” or “non-capitalist” sector to the “modern”
or “capitalist” sector. Crucial for this to happen is the existence of surplus labour
in the traditional sector. Because of this, wages are set just above subsistence
level across the whole economy. This leads to the transfer of labour over time
from the traditional to the modern sectors. This accords labour productivity gains
to capitalists as profits are the source of growth via reinvestment. The floor for
wages is institutionally set at subsistence. When the surplus labour disappears, an
integrated labour market emerges. Wages will then start to rise.
86
 Structural Theories of
The Lewis model was intended as a critique of the neoclassical approach in that Underdevelopment
labour is available to the modern sector of an economy not in a perfectly elastic
supply but in an upward sloping, rather than flat, manner. We also studied the
Lewis-Ranis-Fei version of the model and understood its broad limitations and
policy implications.
According to Nicholas Kaldor, "the purpose of a theory of economic growth is to
show the nature of non-economic variables which ultimately determine the rate at
which the general level of production of economy is growing, and thereby
contribute to an understanding of the question of why some societies grow so
much faster than others.” We briefly studied the theory he gave in order to
explain the phenomenon of economic growth.
Thirlwall, in his model, provides an alternative to the supply side models of neo-
classical growth theory. The latter are close economy models with no demand
constraints. In the Thirlwall model, the ultimate constraint to growth is a shortage
of foreign exchange or the growth of exports to which factor supplies can adapt.
It is the growth in exports which equilibrates the balance of payments and not
changes in the relative prices in international trade. We studied his model briefly
before we extended our study to the patterns of development provided by
Chenery and others. Empirical studies, on the process of structural change, have
led to the conclusion that the pace and pattern of development can vary according
to both domestic and international factors. Many of these factors lie beyond the
control of an individual developing country. Despite this variation, structural
change economists argue that certain patterns can be identified in almost all
countries during their development process. And these patterns, they argue, may
be affected by the choice of the development policies pursued by underdeveloped
economies, as well as the international trade and foreign assistance policies of
developed countries. Hence, structural change analysts are optimistic that a
correct mix of economic policies will generate beneficial patterns of self-
sustaining growth.
Using the Colin-Clark hypothesis, we could study the changes in occupational
structure of economies on the path to development. The emerging Services sector
and its importance has been studied by economists like Clark-Fisher and Victor
Fuchs.

4.9 HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) The basic framework draws from the ‘sectoral division of economies based
on occupational structure’. The theory requires the transformation of an
economy from a subsistence agriculture to a modern service economy.
87
Theories of 2) The basic premise of Lewis model dwells on the assumption that the surplus
Underdevelopment
labour force from the traditional agriculture sector can be transferred to the
other sectors without causing the total output to fall.
3) Kaldor believed that economic development requires industrialisation. The
increasing returns in the manufacturing sector results in faster growth in
manufacturing output. This, in turn, results in overall faster economic
growth.

Check Your Progress 2

1) The essence of Thirlwall growth model is that the structural characteristics of
underdeveloped countries should be transformed. This transformation should
aim at developing their ability to produce high income elasticity
manufactured goods. This would ensure the ‘long run balance of payment
equilibrium on current account’.
2) The crux of this analysis is that increased Savings and Investment are
necessary but not sufficient conditions for economic growth.

88
 Dependency Theories
UNIT 5 DEPENDENCY THEORIES OF of Underdevelopment

UNDERDEVELOPMENT
Structure
5.0 Objectives
5.1 Introduction
5.2 Underdevelopment and Modernisation
5.3 Prebisch-Singer Hypothesis
5.4 Content and Structure of Dependency Theory
5.4.1 The Approach of Frank and dos Santos
5.4.2 The Approach of Sunkel and Furtado
5.4.3 The Approach of Cardoso
5.5 An Assessment of Dependency Theory
5.6 Relevance of Dependency Theory Today
5.7 Let Us Sum Up
5.8 Answer/Hints to Check Your Progress Exercises

5.0 OBJECTIVES
After studying this Unit, you should be able to:
 discuss the notion of development as viewed by dependency theorists;
 define the concepts of core and periphery in the context of the global
economy;
 describe the genesis and evolution of dependency theory;
 discuss the salient features of the Prebisch-Singer hypothesis;
 explain how dependency theory was put forward as a critique of linear
growth theories; and
 evaluate the strengths and the weaknesses of dependency theory and assess its
relevance in the present context.

5.1 INTRODUCTION
In the previous two Units, we dealt with linear theories of underdevelopment and
structural theories of unemployment. In both these units, several issues of
development and underdevelopment were discussed. As we observed, certain


Shri Saugato Sen, Associate Professor of Economics, IGNOU, New Delhi
89
Theories of features and approach were common to the models of underdevelopment (or
Underdevelopment
development). In linear theories and structural theories (when applied to
developing economies), the focus is on the trajectory of development–from being
less developed economies to becoming more developed ones. The linear theories
of economic growth (Harrod-Domar model and Rostow model in particular)
suggest that there are specific policy measures that can be taken by a developing
country to accelerate economic development. The structural theories focus on
identifying the underlying structure of the developing economies. The common
element of these development theories are that they suggest ways for the
developing economies to accelerate development, and progress from being
developing economies to developed ones.
In the present Unit, we discuss an altogether different approach to development,
that is, theories of underdevelopment. We place all these theories of
underdevelopment under a common category called Dependency Theory.
Dependency theory’s basic point is that in the global economy, the developed
(also called ‘advanced’) economies are the ‘centre’ and the developing
economies (or, underdeveloped economies as the dependency theorists insist on
calling these countries) is the ‘periphery’. It is through historical colonization that
the present day developing economies became underdeveloped. In the post
Second-World-War period when many of the developing economies attained
independence from colonial rule, there emerged certain relations of dependency.
The periphery countries become ‘dependent’ on the advanced countries of the
‘centre’.
The Unit is organized as follows: In Section 5.2 we discuss how the dependency
theorists look at the concept of underdevelopment, and what they say about the
genesis of underdevelopment and the consequences of modernization. In Section
5.3, you will be familiarized with the views of two economists, Raul Prebisch
and Hans Singer on the developing economies. According to these two
economists, the composition of the international trade and the terms of trade-of
the developing countries will turn against the developing countries. The Prebisch-
Singer hypothesis formed a precursor or a basis for the dependency theory. Thus,
in Section 5.4 we get into a discussion about the content and structure of the
dependency theory. We will look at the important features of this theory, as well
as the variants of this theory. In Section 5.5 we present an assessment of the
dependency theory, and probe whether in the present context, dependency theory
is still relevant.

5.2 UNDERDEVELOPMENT AND MODERNISATION

Before we discuss the structure and content of the dependency theory, let us
focus a bit on how dependency theorists, and also others like neo-Marxists who
are critical of mainstream economic analysis of development, or of development
economics, view underdevelopment. As you know, we classify countries into
90
 Dependency Theories
developed and developing (or less developed) countries. Some social scientists of Underdevelopment
(not only economists, but also sociologists and those in the field of ‘development
studies’) refer to developing countries as underdeveloped countries. They claim
that development is not like a spectrum or a line where a country is less or more
developed. They suggest that underdevelopment is a set of features found in
some countries. These features are such that together they set these countries
apart from the developed countries. Apart from the lower per-capita income,
there are a host of economic, social, and political characteristics that are found in
most underdeveloped countries, but not in developed countries. The dependency
theorists are part of the group of social scientists who take this view of
underdevelopment. Let us elaborate on this topic a little, and also look at the
view of the dependency theorists on modernization.
Basically, the dependency theorists look at the characteristics of developing
countries and try to come up with an explanation for the state of
underdevelopment of these countries. Underdevelopment is viewed as an
antithesis to development. As pointed out earlier, the contrast is not only in terms
of lower per capita income, low standard of living, lower levels of
industrialization, greater dependence on agriculture and greater poverty, but also
in terms of social and political characteristics. Social indicators include lower
literacy and numeracy levels, lower levels of health and nutrition, wide
prevalence of under-nutrition, and so on. Politically also, underdeveloped
countries are seen to be different from developed countries. Underdeveloped
countries often have non-democratic political regimes, greater polarization, and
sometimes less stable governments. You should note the following: dependency
theorists and others who critique the standard mainstream theories of
development posit that underdevelopment is not a less or lower form of
development; it is an antithetical state.
Let us see what dependency theorists have to say about how underdevelopment
comes about and what should underdeveloped countries do to get out of the
situation of underdevelopment. To understand this, we look at the solution to
underdevelopment provided by ‘modernization theorists’. First, Modernization
theorists contend that advanced economies are not only more developed than
underdeveloped economies, but also more modern (in terms of technology,
human capital, etc.). Second, they say that modern countries were not always
modern in the past; these countries took concrete steps and policy decisions to
become modern. Third, modernization theorists claim that different societies are
at different stages of modernity: some are very modern, some are modernizing,
and some have not yet begun the process of modernization. These theorists
suggest that all societies pass through similar stages; the developed, modern
economies of today (say in the period just after the end of World War II) were
once less developed and non-modern societies. The less-developed economies of
today are at the same stage of development where the developed economies of
today were once. It follows that, in future, the less developed economies will 91
Theories of march towards being developed and modern. An example of such modernization
Underdevelopment
theory is the linear development theory of Walt Whitman Rostow that you
studied in Unit 3 of this course. As you know, Rostow in a sweeping
generalization and a bit of simplification suggested that all countries pass through
five stages: (i) traditional society, (ii) pre-condition for take-off, (iii) take-off, (iv)
drive to maturity, and (v) the age of high mass-consumption.
Dependency theorists point out the limitations of the modernization theorists.
They argue that modernization theorists do not consider the historical specificity
and unique historical experiences of different countries. Dependency theorists
say that modernization theorists are ethnocentric and think that the experience of
the underdeveloped economies is similar to that of Western Europe.
Modernization theorists, according to the dependency theorists, ignore the impact
of colonization on the Third World countries, which were mostly former
colonies. It is due to the impact of colonization that the Third World countries
slipped into poverty. Modernization theorists are accused of ignoring the
unfavourable environment created for the underdeveloped countries.
Modernization theorists also ignore the exploitative relationship that existed
between the developed and the underdeveloped countries.

5.3 PREBISCH-SINGER HYPOTHESIS

Less developed economies specialize in production of primary goods while
developed economies specialize in the production of manufactured goods. Thus,
less developed economies export primary articles and import manufactured
goods. The classical economists believed that the terms-of-trade of primary
commodities against manufactured goods would improve over time. Due to the
operation of the law of diminishing returns for primary commodities and the
presence of increasing returns to scale in the production of manufactures, there
will be a relative increase in the prices of primary articles. The policy implication
of the above is that even if the developing countries fail to industrialise, the
forces of free international trade will distribute the gains from the industrialised
countries to the primary-producing countries. This will be through the higher
prices of exports of primary commodities and the relatively lower prices of the
imports of manufactured goods from industrialized countries. Over time, the
developing countries would even gain technical knowledge.
Around the middle of the 20th century, Charles Kindleberger, an eminent
economist working in the area of International Economics, suggested that the
classical view mentioned above will not materialise; rather the terms-of-trade
will turn against the developing countries. The reason, according to Kindleberger,
is the operation of the Engel’s law. According to the Engel’s law, as household
income increases, the percentage of income spent on food decreases, while that
on other non-essential goods increases. This appears quite logical – suppose your
monthly income is Rs. 10,000 and you spend Rs.5,000 on foods. If your income
92
 Dependency Theories
increases to Rs. 100,000per month your food expenditure does not increase of Underdevelopment
proportionately; it is much less than Rs.50,000 per month. Applying this logic on
a global scale, Kindleberger suggested that along with increase in per capita
income and living standards of a country, the demand for food and other primary
commodities will rise less than proportionately. The demand for manufactured
goods and luxury products, on the other hand, will rise more than
proportionately. It implies that the income elasticity of demand for manufactured
goods and luxury goods is greater than that of food and other primary
commodities. Hence, the terms-of-trade of primary commodities vis-à-vis
manufactured goods (i.e., the ratio of prices of primary goods to that of
manufactures) will decline. We infer that countries exporting primary
commodities will have adverse terms of trade compared to countries exporting
manufactured goods.
According to a League of Nations report (1945) over the period 1876 to 1938, the
prices of primary commodities had fallen relative to the prices of manufactures.
This was the genesis of the hypothesis of the Raul Prebisch and Hans Singer.
Prebisch gives a theoretical argument for the relative decline in the prices of
primary commodities, relative to those of manufactures. He combined this with
the independent statistical work by Singer. However, the two economists appear
to have arrived at their conclusion independently. They assumed that developing
countries (or what they called, “borrowing countries”) export primary
commodities and developed countries (they called these countries “investing
countries”) generally export manufactures. They conclude that the forces of
international trade will lead to a deterioration of the terms-of-trade of the
developing countries. The theoretical explanation, as suggested above, was on the
lines of the Engel’s law. Since the price elasticity of primary commodities is low,
if prices go down due to declining demand over time, the revenue from sales of
primary commodities will reduce.
One conclusion that some drew from the Prebisch-Singer hypothesis is that the
very structure of the global market is responsible for the persistent inequality
within the world system. The policy implications of the hypothesis was that
developing countries should not participate much in international trade, because,
given that their main items of export were primary commodities like tea, rubber,
coffee and so on, they are not likely to gain, and rather lose, from international
trade. Hence export-orientation was not suggested. Rather several developing
countries, including India, went in for import-substitution based growth strategy.
Unfortunately, due to high imports of industrial inputs to be used for
domestically produced industrial growth, some developing countries faced
balance-of-payments problems.

93
Theories of
Underdevelopment
Check Your Progress 1
Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What are the limitations of modernization theory as put forward by
dependency theorists?
………………………………………………………………………………….
………………………………………………………………………………….
2) Why, according to the Prebisch-Singer hypothesis, does the terms-of-trade of
the less developed countries decline over time?
………………………………………………………………………………….
………………………………………………………………………………….

5.4 CONTENT AND STRUCTURE OF

DEPENDENCY THEORY
Dependency theory arose in response to and as a critique of standard theories of
development. It was put forward to explain the process of economic development
in underdeveloped economies. The dependency theory was put forward first in
the 1950s. As we saw in the previous section, one of the original thinkers from
whose theories, dependency theory developed was Raul Prebisch of the United
Nations Economic Commission for Latin America (UNECLA), generally known
by the acronym ECLA. Another early thinker associated with the dependency
theory is Paul Baran, a renowned Marxist economist. In his book, ‘The Political
Economy of Growth’ (1957), Paul Baran could provide several ideas which were
incorporated and developed further by the dependency theorists.
Dependency theory arose as the result of an extensive search for a theoretical
approach to explain and analyse underdevelopment of some countries in the
global economic system. Dependency theory can be said to be in the domain of
economics, but also draws upon politics, and cultural studies.
Dependency theory has three salient features. First, international economy is seen
as composed of two types of countries: dominant (or, core) countries and
dependent (or, peripheral) countries. Second, the economies of peripheral
countries are heavily influenced by external forces. These external forces could
be multinational companies, international commodity markets, foreign aid,
communication technology, and any other means by which the dominant
countries represent their economic interests abroad. Third, the relationship
between the core and the periphery is based on historical patterns and dynamics
of international capitalism. The above relationship is a continuing process, and
the exchange relationships between the core and the peripheral economies
reinforce the patterns of inequality among countries. Dependency theory
investigates the reasons for some countries being rich and some others continuing
94
to be poor. In a nutshell, their answer is that there is dependency based Dependency Theories
of Underdevelopment
exploitative relations between the economies of the core and periphery.
Some central propositions of the dependency theory are as follows:
i) Underdeveloped economies need not imitate the economic strategy of
development followed by the developed countries. The strategy followed by
developed countries is what led to the underdevelopment of the peripheral
countries in the first place. The development strategy pursued by the
developed countries facilitated the development of the developed countries
through a core-periphery relationship of exploitation and unequal exchange.
ii) The underdeveloped countries use their resources in a manner different from
that prescribed by the dominant countries. For example, underdeveloped
countries specialize in export of food and primary commodities.
Dependency theorists argue that even though underdeveloped countries
produce a large quantity of food for export, there is widespread malnutrition
in these countries. Dependency theorists argue that underdeveloped
countries should focus on production of food grains for domestic
consumption so that incidence of malnutrition can be brought down.
iii) Dependency theorists argue that even in the case of underdeveloped
countries, the same strategy or policy-set cannot be followed by all
countries. A case can be made for the articulation of a national economic
policy for each country. For each country, its national interest would be best
served by addressing the needs of the poor and the marginalized, rather than
those of the corporate sector or dominant classes within the country.
iv) The distribution and diversion of resources over large historical periods is
maintained not only by the coercive power of the countries in the ‘core’ but
also by those of the elites in the peripheral countries. Dependency theorists
argue that the interests of the domestic elites are aligned with the interests of
the core country, and they become partners in the exploitation of domestic
resources and labour. It is in the interests of the domestic elites to maintain a
relationship of dependency with the core economies.
There are different variants, or schools of dependency theorists. As we mentioned
earlier, there was the influence of Marxists such as Paul Baran who talked of the
persistence of imperialistic relations between the developed and the developing
countries even after the latter’s independence. Such imperialistic relations are
carried out through multinational corporations and foreign aid. Another
influence, as we pointed out earlier, was the Prebisch-Singer hypothesis.
Subsequently, since the 1960s, the dependency school, particularly among the
Latin American economists came to display several variants.
There are three main versions of the dependency theory, put forward by the Latin
American economists.

95
Theories of i) The first one is the approach of Andre Gunder Frank and Theotonio dos
Underdevelopment
Santos. The main feature of their approach is that they deny the possibility
of capitalistic development in the periphery. Only the perpetuation of
underdevelopment can take place. This can be considered a neo-Marxist
approach.
ii) The second version is by O. Sunkel and Celso Furtado. This version does not
deny the possibility of capitalist development in the periphery. But for that,
internal constraints of the underdeveloped countries have to be removed
first. Market restrictions are among the most important of the constraints.
iii) The third approach is of Fernando Henrique Cardoso. This approach accepts
the possibility of capitalistic development in the periphery but claims that
capitalist development in the periphery will be subservient to the capitalist
development in the centre.
Let us elaborate on these approaches.

5.4.1 The Approach of Frank and dos Santos

Frank and dos Santos take the ideas of Paul Baran as their beginning point.
According to Baran, it is not in the interests of the advanced countries to have
economic development of developing countries. If the poorer countries develop,
the advanced countries may be cut off from important sources of raw materials
and natural resources. Further, market for foreign goods will shrink as
underdeveloped countries, after being developed, will not rely on the developed
countries for import of manufactured goods. The surplus capital of the developed
countries will not be absorbed in the underdeveloped countries.
To prevent economic development in underdeveloped countries, the developed
capitalist economies form alliances with pre-capitalist feudal, semi-feudal and
tribal groups of the developing countries. These groups (viz., feudal, semi-feudal
and tribal) are also against economic development in their own country because
they will be adversely affected. By preventing development in underdeveloped
countries, the developed countries will continue to enjoy the traditional modes of
surplus extraction. Such a strategy will reduce the possibility of economic growth
in developing countries. According to Baran, the only way out of this scenario is
for developing countries to bring about a socialist transformation of society.
Andre Gunder Frank takes up from here. He supports the view that the only
solution for developing countries is a socialist revolution; otherwise there is no
alternative to underdevelopment. Frank, however, differs from Baran in certain
aspects. He claims that large parts of the periphery have been incorporated into
the capitalist system since the early days of colonialism. Such incorporation, into
the world capitalistic system, has transformed these countries into capitalist
countries. However, the periphery countries have turned into satellites of the
developed economies. In this relationship, surplus generated in the periphery is
96 siphoned off to the core. Frank contends that as long as this ‘unequal exchange’
 Dependency Theories
continues, there is no real possibility of development of the periphery. The only of Underdevelopment
way out is a socialist transformation of the society.
Frank rejects the notion that developing economies are characterized by dualism
of the Lewis type. According to him, capitalism entered the developing countries
since the early days of colonialism. Over time, capitalist relations and capitalist
techniques of production have entered the developing countries, even in their
rural areas. So, the basic reality is the relationship of unequal exchange and the
metropolis-satellite relationship between countries of the centre and the
periphery.
Now let us discuss the views of Theotonio dos Santos. His approach is broadly
similar to that of Frank. According to dos Santos, dependence is a conditioning
situation in which the economies of a group of countries are conditioned by the
experience of others. Expansion and development of one group can condition the
development of another group. One point where dos Santos differs from Frank is
that he rejects socialism as a model of development for Latin American countries.
He rejects the capitalist model of the West. He calls the western capitalist model
as a historical (i.e., lacking perspective and context) and formal. He feels the
underdeveloped countries are in a completely different situation and need not
imitate the western developed economies, or Japan. The underdeveloped
countries do not have: (i) the sources of basic private capital formation in
international trade, (ii) the induction of vast masses of population in
manufacturing, and (iii) other underdeveloped countries to colonise and exploit.
He concludes that it is necessary to look into the specific historical situation and
the conditions of an underdeveloped country, before suggesting what course of
action it should take and which path it should follow. According to dos Santos,
the Latin American situation can only be understood using dependency theory.

5.4.2 The Approach of Sunkel and Furtado

Now let us turn to the approach of Osvaldo Sunkel and Celso Furtado. Let us
begin with the approach of Sunkel. Osvaldo Sunkel combined the ECLA point of
view and the views on internal constraints. The economists of the ECLA had
attempted to explain the phenomenon of Latin American underdevelopment in
terms of the pattern of foreign trade of Latin American countries. These countries
were exporters of primary commodities and importers of manufactured products.
The terms of trade were always unfavourable to them.
As an alternative to the above scenario, the Latin American countries made
efforts to diversify their exports. Further, they accelerated industrialisation
through import substitution policies. This model, however, failed to achieve the
desired results. It was thought that its failure and the mess created by it were due
to internal constraints to industrialisation. These internal constraints included
existing land relations and other institutional arrangements.

97
Theories of Sunkel combined the external factors with internal constraints to development in
Underdevelopment
order to present his own approach. Thus, like Frank and dos Santos, Sunkel
contends that the unit of analysis in studying underdevelopment cannot be the
national society. Domestic cultural and institutional factors of any particular
Latin American country are not the key variables responsible for its
backwardness though these have an important bearing. The phenomenon of
underdevelopment or backwardness can be understood only with reference to the
development of capitalist system on the world scale and the place of this
particular country in it. The world capitalist system is characterised by the
unequal but combined development of its different components. They interact
and condition each other. Industrial countries become central while
underdeveloped, backward countries become peripheral. The centre is the main
beneficiary of development because it alone has the dynamism while the
periphery also receives some benefits. Sunkel believes that development in Latin
America is possible provided the internal constraints are removed and
industrialisation based on import substitution and export diversification is
pursued. His approach is not pessimistic unlike that of Frank and dos Santos.
Celso Furtado also believes that underdevelopment is the consequence of the
development of capitalism as a world system. In Latin America, it created hybrid
structures; one part tending to behave as capitalist while the others perpetuating
the features of pre-capitalist system. Whether the capitalistic penetration in a
country of Latin America will induce industrialisation and development will
depend basically on the amount of income generated and available to the
community. To recall, in such a country, an export sector comes into existence in
order to cater to the demands of developed countries. Experience shows that the
economic structure of such a country does not undergo any big change as a result
of this capitalist penetration. There is hardly any appreciable increase in labour
absorption, and wages often have no relation with productivity.
In most of the countries which became export-oriented, ‘external demand’
became a crucial factor. If the external demand increases alongside the
improvement in the prices of export goods, the profits of the enterprises engaged
in the production and export would increase. In course of time, the relative
importance of the subsistence sector declines. There arises a possibility of
growth. This can be realized, provided there are reforms to remove internal
constraints and there is import substitution. A higher stage in underdevelopment
is reached when the industrial structure is diversified and is in a position to
produce capital goods needed for the expansion of productive capacity. This will
give a big boost to the process of growth. Thus, Celso Furtado holds that
underdevelopment is not a necessary stage in the process of formation of
capitalist economies. It occurs because of the penetration of modern capitalistic
enterprises into traditional or pre-capitalist structures. Furtado does not believe
that Latin American development is not possible without the defeat of world
98 capitalism. In this, his views are at variance with those of Frank and dos Santos.
5.4.3 The Approach of Cardoso Dependency Theories
of Underdevelopment
Finally, let us discuss the approach of Fernando Henrique Cardoso. Cardoso
holds a different view than Frank dos Santos as well as Sunkel-Furtado.
According to Cardoso, capitalist development is impossible in Latin America.
Also, he rejects the view of Latin America having dependent capitalism based on
the extensive exploitation of labour, and labour has to be paid only subsistence
wage. Third, he regards it erroneous to believe that the native or national
bourgeoisie in Latin American countries is no longer an active social force but a
parasitic class. He criticises the view that the penetration of multinational
corporations into Latin American countries have led to the development of "neo-
imperialism" and that states in those countries pursue policies that are
expansionist. Finally, it is not correct to say that Latin America is standing at the
cross-roads (at the period when he wrote) and there are only two options open to
it: (i) if it chooses to remain within the world capitalist system, its political
structure would become fascist, or (ii) if it opts out of the world capitalist system,
it can pursue the socialist path of development which will benefit the masses.
Cardoso thus comes to the conclusion that development is possible in Latin
American countries with the help of the capitalist class in the country which is
not totally subservient to the developed capitalist countries and their
multinational corporations. It needs to be underlined that relations of dependency
are useful to explain the historical roots of underdevelopment in Latin America,
but it does not follow from it that dependent relations by themselves perpetuate in
all cases the situation of underdevelopment. Cardoso, on the basis of his study of
contemporary Brazil, underlines the possibility of development.
We have considered above, three approaches to dependency theory. We have
seen that there are certain differences among the three approaches. Are there any
similarities in the three approaches? That is what we now briefly discuss. In spite
of differences there do appear some similarities in the three approaches. First, all
three approaches hold that dependency theory does a good job of explaining the
historical roots of backwardness or underdevelopment of Latin American
countries. Second, all three approaches claim that underdevelopment is not the
original state of existence. According to dependency theory, underdevelopment
has been caused by the development of capitalism in the West and the integration
of Latin American countries in the world capitalist system. Third, as a result of
the emergence of developed capitalist countries, some sort of dualism came into
existence in the world economy – the developed capitalist countries became the
centre of development, while the underdeveloped countries became the
periphery. Finally, all three approaches conclude that import substitution by itself
cannot generate the process of development in Latin America. In fact, it may lead
to greater dependence on the countries in the centre, and can even lead to
economic crises.

99
Theories of
Underdevelopment
Check Your Progress 2
Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) State the basic propositions of dependency theory.
………………………………………………………………………………….
………………………………………………………………………………….
2) What are the three approaches to dependency theory in the context of Latin
America?
………………………………………………………………………………….
………………………………………………………………………………….

5.5 ASSESSMENT OF DEPENDENCY THEORY

Let us look at the strengths and weaknesses of the dependency theory. We will
look at this theory by itself and see how it compares with theories that you have
studied earlier.
Let us note two features about dependency theory that sets it apart from other
theories that you have studied in this course as well as in the course,
Development Economics-I. The first feature is that dependency theory (all
variants) was developed by economists of the Third World, mostly from Latin
American countries. Thus, it was propounded by theorists who have had the
experience of being in developing countries themselves, and hence understand
the dynamics of the economies of developing countries better. Indeed, there was
a view that prevailed in the 1950s and 1960s, among a section of social scientists
from the developing countries, that economic theories that were developed by
economists from developed countries were not applicable to developing
economies. It was felt that macroeconomic theory, growth theory and also to a
large extent the economics of development were developed looking at the
experience and functioning of the institutions of developed countries. Developing
countries required a different, and preferably, indigenous theory of development.
To some of these social scientists, dependency theory seemed to fit the bill.
Dependency theory challenged the other development theories prevalent at that
time. Existing theories did not take into account the basic features and
characteristics of developing economies. Consequently, existing theories were
not relevant for the developing countries. Thus, policy prescriptions emanating
from those theories were useless at best and harmful at worst, for the developing
countries.
The second feature of dependency theory is that it is valid for open economies
only. This does not appear too much of a problem, since in the real world, most
countries are open to some extent. The openness premise is built upon statistical
observations. The reason for openness however is not grounded in too much
100 theory.
The Harrod-Domar model and the Solow model, as you know, were constructed Dependency Theories
of Underdevelopment
assuming a closed economy. The dependency theorists created this theory
without much theoretical base. There also appears be an absence of formal
modelling in building dependency theory. It is not clear which are the key
variables, what is the relationship among them, and how some variables affect
and influence others. One might observe that there is mention of some countries
as ‘dependent’ countries, but it is not explained as to which are the ‘dependent’
variables, and which are independent! Since the theoretical foundation is not
strong, it becomes difficult to go for empirical estimation.
Some economists who believe in market economies criticise the dependency
theory as being mere political propaganda rather than a coherent body of thought.
Some thinkers have argued that even if we accept the division of countries into
centre (or, core) and periphery, it is not obvious that the centre is not interested in
the growth of the periphery and want to keep them in a state of
underdevelopment. They have argued that it may be in the interest of the centre
to have the periphery experience economic growth, as that would benefit the
core, in the modern globalised world. Further, during the 20th century, there has
been uneven growth in countries in the periphery as a whole. While some
countries like the East Asian Tigers have grown very fast, some Latin American
and African countries have realised very low rates of growth.
Some thinkers had argued in the 1970s and 1980s that it is incorrect to think that
only in capitalistic economic relations, some countries are in the periphery and
are satellites of countries in the centre (the metropolis) and that the periphery is
in a dependent relation with the centre. The erstwhile USSR also acted as the
centre and communist countries in the Eastern Europe acted as its satellites.

5.6 RELEVANCE OF DEPENDENCY THEORY

TODAY
Today, due to globalization, the world is more inter-connected than ever before.
There is so much flow of capital, finance, goods & services, technology, people
and ideas. We have to view the problems of underdevelopment and development
in the current scenario, where countries are interconnected through various
economic, political and social processes. According to dependency theory there
is unequal exchange, and world system will tend to concentrate production in the
hands of relatively few transnational corporations, making the world an
oligopolistic market. From this, the theory also forecasts a tendency of slowdown
in production and income polarization. This does not seem to have happened –
many underdeveloped countries (such as Korea, Hong Kong and Malaysia) have
witnessed rapid economic growth. Globalisation, modern technology and
changing nature of production processes and international supply chains have led
us to conclude that dependency theory may not be relevant today. The emerging
market economies, the spectacular economic performance of formerly poor
countries like the Asian Tigers, and later China, suggest that thinking of countries
101
Theories of in terms of concepts like core and periphery is not very helpful in understanding
Underdevelopment
the processes of the world economy.
Another important historical development that took place in the 1990s seems to
have rendered dependency theory less relevant today. This is the collapse of
actually existing socialist countries, or what used to be known as the Second
World. Some of these countries are more developed, like Russia, while other are
less developed but have shown very high rates of growth, like China.
Why should we even study dependency theory today in courses on development
economics or international economics? Well, one reason is in terms of the history
of economic ideas. Dependency theory put forward the idea that developing
countries would not gain from joining the global economy. The reason is two-
fold: (i) developing countries would be worse off through trade as the terms-of-
trade is likely to be against them; and (ii) they will end up being in the periphery
catering to the needs of the developed countries in the core. The developed
countries would prosper while the developing economies would be trapped in
underdevelopment.
Against this backdrop, is the dependency theory still pertinent today? Is the gap
between the developed and the developing countries increasing? Are the
developing countries catching up with the developed countries? The debate on
the convergence of economic growth rates that you studied in BECC 112:
Development Economics-I is relevant even now. So, although the situation as
described by dependency theory may not obtain today, the study of the trajectory
of development of the Third World countries remains important. When analysing
the inequalities at the global level, the dependency theory comes to our mind
sometimes. When we look at the relative strengths of the developed and the
developing countries in the World Trade Organisation (WTO), we recall the
basic ideas of the dependency theory. Dependency theory has also made
economists take into account the role of historical forces in the development path
of countries.

Check Your Progress 3

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What are the main points of criticism of the dependency theory?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) State the relevance of dependency theory in the present context.
………………………………………………………………………………….
………………………………………………………………………………….

102 ………………………………………………………………………………….
 Dependency Theories
5.7 LET US SUM UP of Underdevelopment

In this Unit, we presented the Prebisch-Singer hypothesis which says that the
terms-of-trade of the developing countries turn downwards over time.
Subsequent to this, the Unit discussed various approaches to development by the
Latin American economists such as Andre Gunder Frank, Theotonio dos Santos,
Sunkel, Celso Furtado, and Cardoso.
Dependency theory considers development in the context of the global economy.
It divides countries into two groups: countries of the advanced capitalist world,
which form the ‘centre’, and countries of the developing world, the Third World,
that forms the ‘periphery’. The periphery is in a relationship of dependence on
the core or the centre.
The basic conclusion or policy prescription of dependency theory is that the
‘periphery’ countries should minimize their engagement with developed
countries. Through unequal exchange with the developed countries of the
‘centre’, the underdeveloped countries do not have any prospects of coming out
of a state of underdevelopment. In other words, underdevelopment will be
perpetuated if they trade with the developed countries. Thus, unlike the linear
theories and the structural theories, the dependency theory is more of a
‘diagnosis’ of the state of underdevelopment and a suggestion of getting out of
the current situation. Thus, unlike the linear and structural theories, dependency
theory does not predict or claim that the developing economies will pass through
certain stages and go towards a better outcome. Further, dependency theory
claims that if the developing economies continue with the current situation (when
the theory was formulated), they will stay underdeveloped and in a ‘dependency’
relationship with the advanced countries.

5.8 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
i) The dependency theorists criticize modernization theory on several grounds.
The modernization theorists do not look into the historical specificity of the
underdeveloped countries. Second, they ignore the fact that most
underdeveloped countries are former colonies of developed countries. Third,
they ignore exploitative relationship that existed between developed and
underdeveloped countries.
ii) The terms-of-trade of the developing countries decline over time because of
the operation of Engel’s law. The exports of the underdeveloped countries are
mostly primary commodities while their imports are manufactured products
produced in developed countries. The terms of trade between primary
commodities and manufactured goods have been against the primary
103
Theories of commodities, which results in adverse terms-of-trade for the underdeveloped
Underdevelopment
countries.

Check Your Progress 2

i) Dependency theory considers development in the context of the global
economy. It divides countries into two groups: countries of the advanced
capitalist world, which form the ‘centre’, and countries of the developing
world, the Third World, that forms the ‘periphery’. The periphery is in a
relationship of dependence on the core or the centre.
ii) The three main versions of the dependency theory are as follows: (i) the
approach of Frank and dos Santos. The main feature of their approach is that
they deny the possibility of capitalistic development in the periphery. Only
the perpetuation of underdevelopment can take place. (ii) The approach of
Sunkel and Furtado does not deny the possibility of capitalist development in
the periphery. But for that, internal constraints of the underdeveloped
countries have to be removed first. Market restrictions are among the most
important of the constraints. (iii) The approach of Cardoso accepts the
possibility of capitalistic development in the periphery but claims that
capitalist development in the periphery will be subservient to the capitalist
development in the centre.

Check Your Progress 3

i) Your answer should include the limitations of the dependency theory given at
Section 5.5.
ii) Go through Section 5.6 and answer.

104
 BLOCK 3
LAND LABOUR
AND
CREDIT MARKETS

BLOCK INTRODUCTION
The present Block, the third of this course, is titled Land Labour and Credit
Markets. It discusses, as the title of the block suggests, some factor markets in
developing nations. The emphasis is on factor markets in rural areas of these
nations. It discusses how rural factor markets function, whether markets are
complete and whether different factor markets are sometimes interlinked.
You will get a chance to compare how rural factor markets in developing
countries function, as depicted in the units of this block with how markets
function, as depicted in the microeconomics courses you studied earlier.
The Block has three units, titled Land Markets (unit 6), Labour markets
(unit 7) and Credit Markets (unit 8). The first Unit discusses theories
distribution of land ownership; land reforms and its effect on productivity;
contractual relationships between tenants and landlords; as well as the
important topic of land acquisition. The next unit deals with important
aspects of the characteristics, structure and functioning of labour markets.
It discusses and assesses different theories of wage determination and
employment. It also discusses the link between nutritional status and
productivity, and discusses the efficiency-wage hypothesis, and presents a
theory of nutritional status. The final unit of the block (unit 8) on credit
markets discusses several crucial topics on credit markets. It discusses
characteristics of credit markets; Demand and Supply of credit; whether the
rural poor have access to credit; size and structure of the Indian credit market;
informational problems in the rural credit markets. It also discusses topics like
informational problems in the credit contract and in this, explains the lenders’
risk hypothesis. The unit discusses the problem of the possible risk of loan
default, and also discusses credit rationing. Finally, the unit discusses credit
policy, as well as the important topic of whether rural factor markets are
interlinked.
UNIT 6 LAND MARKETS
Land Markets

Structure
6.0 Objectives
6.1 Introduction
6.2 Ownership and distribution of land
6.2.1 Land rental contracts
6.2.1.1 Contractual forms
6.2.1.2 Contracts and incentives
6.2.1.3 Incentive problem
6.2.2 Risk, tenancy and sharecropping
6.2.3 Other considerations to forms of tenancy
6.2.4 Land contracts and eviction
6.3 Land size and productivity
6.3.1 Key concepts
6.3.2 Land sales
6.3.3 Land reforms
6.4 Land Acquisition
6.4.1 Land Acquisition & compensation
6.4.2 Hold out problem
6.4.3 Land Acquisition, Rehabilitation and Resettlement (LARR) Act 2015
6.5 Let Us Sum Up
6.6 Answers to Check Your Progress Exercises

6.0 OBJECTIVES
This unit discusses about land markets and lands rental contracts that exist in the
land markets. We will also discuss about the two main forms of contracts:
sharecropping and fixed-rent tenancy. Sharecropping and fixed-rent tenancy are
the two extreme forms of land contact and can be used in different variations. We
will then look at the incentive problem and compare the two types of contracts in
different scenarios like risk, uncertainty, improper insurance markets, double-
incentive problem etc. We will also introduce some important concepts of land
markets that can help in the redistribution of land, i.e., eviction, land reforms and
land acquisition.


Dr. Indrani Roy Chowdhury, Associate Professor, CSRD, JNU, New Delhi
107
Land Labour and After going through this unit, you will be able to explain:
Credit Markets
 How do different land rental contracts address the issue of unequal
distribution of land?
 What are the main types of land rental contracts, and how do they react to the
different economic environments?
 What leads to inefficient market outcomes in a given tenancy contract?
 Are small landowners more productive than large landowners, and what are
the factors that determine the productivity of the land.
 What is the role of land reforms in determining land productivity?
 What is Land acquisition and which are the some critical issues related to
land acquisition and compensation?

6.1 INTRODUCTION
Land, along with labour and capital, is an important factor of production. Land
markets, therefore, form an integral part of an economy. However, the land is
different from other factors of production since it is finite and immovable in
nature. It is the ownership rights (property rights) of land that are bought and sold
in exchange for money in the factor market. Land markets can be both formal and
informal. Formal land markets are those where the transfer or exchange of land is
formally recognized by legal institutions and officially registered. Informal land
markets, on the other hand, constitute transactions that do not conform to the
legal procedures. They might be considered legitimate in some less developed
societies. The existence of informal markets makes it difficult to set up efficient
and effective land markets where the transfer of land follows the formal
procedures (Mahoney et al., 2007).
Like all other factor markets, which we will be studying in the subsequent units,
land markets facilitate the mismatches in the demand and supply of land. In
developing countries like India, the distribution of land is unequal, with a high
concentration of land in the hands of a few. A large number of individuals have
little or no land with them. The unequal distribution of land also depicts the
unequal distribution of wealth since land is the main form in which individuals
store their wealth (Raj, 1970). Since the rate of depreciation of land and hence
‘the cost of holding’ is low, it provides more security. Moreover, the land is also
a source of rent if leased out to somebody else. In most agrarian economies, this
type of “land rental market” is common where some or all the land is leased by
the landlord to tenants. The land is leased or rented in exchange for rent or share
of output produced by the tenant. We will learn about land ownership and its
distribution in the subsequent sections.

108
 Land Markets
6.2 OWNERSHIP AND DISTRIBUTION OF LAND
In developing countries like Asia and Latin America, the distribution of land is
highly unequal, with a large share of land in the hands of few people. In Asia, on
the whole, 84.5% of tenanted land is under share tenancy. But the percentage
range from around 30% (Thailand) through 50% (India) or 60% (Indonesia), all
the way up to 90% in Bangladesh. In Latin America, on average, 16.1% of
tenanted land is under sharecropping; the corresponding percentages are much
lower: under 10% in countries such as Costa Rica or Uruguay and negligible in
Peru, although relatively high at 50% in Colombia.
Thus, a significant proportion of the population is either landless or owns a very
small amount of landholding. Both the situations of ‘inequality in land holdings’
and ‘low per capita land holding’ lead to similar conditions where the owner
itself cultivates a significant share of his/her land. On the other hand, very large
farmers with large plots of land may use hired labour for cultivation. In the areas
where property rights are weakly defined, land may be owned and cultivated by a
group of people or communities. Some areas of Latin America have even moved
away from the tenancy system and provided ownership and land-use rights to the
tenants who have been cultivating the land for a long period. These countries
follow the principle that the tenants who cultivate the land should be granted
ownership and use rights as well. However, this type of principle may lead to the
displacement of tenancy by ‘large-scale mechanized farming.
The practice of tenancy exists in many parts of the world, but there are some
variations in the form of tenancy. The two types of tenancy are fixed-rent tenancy
and sharecropping.
 Fixed-Rent Tenancy: In this form of a tenancy, the tenant pays a fixed
amount of money to the landlord and gets the right to farm the land in return.
Rich tenants are more likely to take up this type of tenancy. In fixed-rent
tenancy, the landlord is relieved of all risk: the fixed rent is to be paid
whether the production does well or not. It is, therefore, necessary that the
tenant is willing to take the risks of bad crops or crop failures. Since rich
tenants engage in this form of tenancy, they have enough wealth to face such
risks. There is indirect evidence that Latin American tenancies are held by
large farmers. Contrast this with Asia, where the bulk of tenancy is in the
form of sharecropping.
 Sharecropping: In this form of tenancy, the tenant shares the fraction of the
crop produced as rent to the landlord. The importance of sharecropping is
particularly realized when the tenants are small and risk-averse. Since they
have to pay a fraction of produce as rent, they can deal with the fluctuations
in the output. In other words, part of the fluctuation or risk can be shared with
the landlord. The Asian tenancy probably reflects, on the whole, land leases
from relatively large landowners to relatively small landowners.
109
Land Labour and Let us now look at the land rental contracts in some more detail.
Credit Markets
6.2.1 Land Rental Contracts
6.2.1.1 Contractual Farms
There are many different types of contracts that a landlord can use to rent out
his/her land to somebody else for cultivation. The first one is a fixed-rent contract
in which the landlord rents the land in exchange for some rent. The landlord can
charge the rent monthly, yearly or seasonally. Another form of contact is
sharecropping. There can be different forms of sharecropping, but the main idea
behind this form of contract is that the tenant shares the output with the landlord
in some pre-decided proportion. Along with different variations in the proportion
in which the crop is divided, the input costs might also be shared in some cases.
For example, the landlord may give some money to the tenant for purchasing
inputs in the form of credit or in lieu of the output that the landlord purchases
from the tenant at discounted prices. This type of contract is also referred to as an
interlinked contract, which we will learn in unit 8 in detail.
We can write an equation representing different forms of rental contracts with
fixed rent and sharecropping as special cases. Equation 1 gives us the total rent
R, where Y denotes agricultural output produced o the leased land.
𝑅 = 𝛼𝑌+𝐹
 In this equation, if 𝛼 = 0 and F > 0, it represents fixed rent contact where R =
F.
 If F = 0 and 𝛼 lies between 0 and 1, then it is a sharecropping contract. Here,
𝛼 is the share given to the landlord and 1-𝛼is the share to the tenant.
 If 𝛼 = 0 and F<0, it represents a “pure wage contract”, and the wage -F is
paid to the tenant. However, the tenant, in this case, is a labourer that works
on the landlord’s land.
6.2.1.2 Contracts and Incentives
It is often argued that sharecropping is an inferior land contractual form
compared to fixed-rent tenancy. It is also referred to as Marshallian inefficiency
and is connected with the appropriate provision of incentives to the tenant. In
simple words, fixed-rent contracts ensure that the landlord gets a fixed rent
irrespective of the output produced. On the other hand, the tenant has to give a
fixed amount of money and gets to keep all the extra output produced. Contrary
to this, a tenant has only a proportion of the output in the case of sharecropping.
Only a share of extra output produced is retained by the tenant. In situations,
where the tenant cannot be monitored or controlled, he/she has an incentive to
reduce the effort they put in. It is also argued why is the tenant allowed to keep
100% output and not more, say 120%. Or why shouldn’t we charge a high fixed
rent instead of sharecropping and allow the tenant to keep the remaining output?
These cases are also inefficient and will lead to an oversupply of efforts. Let us
look at the Marshallian inefficiency argument in some detail in order to
110 understand these cases.
 Land Markets
We assume that there is only one variable input of production, i.e., the tenant’s
labour. Figure 6.1 shows the production function (OA) representing diminishing
returns to a factor (i.e., labour used on a rented plot of land). Labour is costly to a
tenant and has other uses as well. A tenant can work as a wage labourer on
somebody else’s land or simply value leisure more than work. Therefore, the cost
of labour is represented by the curve OB (cost of production). The surplus
produced in this case is given by the difference between the value of output
(production curve) and the cost of producing the output (production cost curve).
The tenant will always try to maximize his/her surplus and hence the difference
between the two curves. The maximum surplus is obtained at the point L*. At L*,
the marginal product of labour (given by the tangent of the production curve) is
equal to the marginal cost of production (constant cost in this case). CD is the
maximum surplus obtained. A

B
C
Production Function
Output Costs

Production Costs

O
L* Labour
Fig. 6.1: Production, Cost and Economic Surplus
6.2.1.3 Incentive problem
As discussed earlier, a tenant will not maximize the surplus until and unless
given an appropriate incentive to do so. The tenant will do so if the maximization
of the surplus is in his/her interest. It is also known as the incentive problem.
Fig. 6.2 illustrates the case of sharecropping. Since the tenant only gets a share of
output, the production function is given by the curve OE. Note that OE is simply
a fraction of the curve OA (the original production curve multiplied by the share
of output with the tenant). The curve not only shifts downwards but is also flatter
than the previous production function. In this scenario, the tenant will maximize
the gap OB, which is nothing but the difference between the new production
curve and the cost curve. The surplus is maximized at the point 𝐿̂ , which is
smaller than the actual marginal product L*. Hence the tenant undersupplies the
labour. 111
 A

Land Labour and

B
Credit Markets
C

Output Costs
Production Function

Production Costs

O
𝐋̅ 𝐋* Labour

Fig. 6.2: Sharecropping Contracts and Inefficiency

Fig. 6.3 shows the case of a fixed-rent contract. In this form, a fixed sum of
money is deducted from the tenant’s output. It is depicted by a downward shift in
the production curve from OA to O′E. Note that both the curves are parallel to
each other. Here, the tenant will maximize the difference between the curves O′E
and OB. The fixed-rent contract does not affect the marginal incentives of the
tenant since the slopes of both the curves are the same. The surplus is maximized
at point L*.
If the tenant gets the same output in the case of both sharecropping and fixed-rent
contact, then it is beneficial for the landlord to choose a fixed-rent contract since
the surplus is maximum in this case (Fig. 6.3).

B
Output Costs

Fixed Rent
E
C

O
O- L* Labour

Fig. 6.3: The Efficiency of Fixed-Rent Contracts

112
 Land Markets
What if the share of the tenant is more than 100%? This case is represented in
Fig. 6.4. Since a fixed rent is charged, the curve shifts downwards. However, this
time the return is more than 100%, so the new curve is obtained by multiplying
OA by 1.2 (for 120%). The new curve O′E is steeper than OA. Output is
maximized at 𝐿̂ > L*. Nevertheless, the higher output does not translate to a
higher economic surplus. The tenant’s effective return shifts down by the amount
of rent charged by the landlord and then goes up as he/she receives more than
100% of the marginal output. As a result, the tenant has to work even harder than
what was prescribed earlier. Therefore, fixed-rent contracts are the best form of
contracts and using other contracts will lead to inefficient outcomes. As seen
above, the tenant will undersupply the labour in case of sharecropping and a
rational landowner who wants maximum earnings will prefer fixed-rental
contracts.
One would then argue that if fixed-rent is the best form of contract, then why is
sharecropping even practised? One way of looking at this is that there may be
some other observations, which are, missing in this theory. More practical
reasoning for the existence of sharecropping despite the losses it generates can be
that there are other compensation factors that promote this form of contract.
Correcting these factors can reduce the inefficiencies and reduce the practice of
sharecropping. Last but not least, sharecropping may reinforce other behaviours
of tenants and landlords, like the eviction of tenants and credit to tenants.

B
Output Costs

Fixed Rent
C

O
O- 𝐋̅ Labour

Fig. 6.4: Why Marginal Returns to a Tenant Should not Exceed 100%?
113
Land Labour and
Credit Markets
Check Your Progress 1
Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What is the difference between fixed- rent tenancy and share cropping?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) What is the crux of the Marshallian inefficiency argument?
………………………………………………………………………………….
………………………………………………………………………………….
…………………………………………………………………………………

6.2.2 Risk, Tenancy and Sharecropping

Let us now look at the role of risk in land contracts. We know that a risk-averse
person is one who prefers a riskless or less risky option over an option that
involves high risk, given that the expected value of both the options is the same.
Agriculture also involves some risk, and the production is also uncertain,
especially in less developed countries where it highly depends on monsoon. Land
contracts also involve some risk. Consider two situations: good and bad. Let G
denote the value of output in a good situation and B the output in a bad situation.
Let P be the probability of producing good output. Assume that a fixed amount of
other inputs, including labour, are also used in the production process.
Furthermore, assume that the land is leased out by a rich landlord to a relatively
poor tenant. Hence the poor tenant is more risk-averse than the landlord. A
simpler version is where the landlord is risk-neutral since he/she is wealthy, and
the income from this land is not the only source of income.
In the case of a fixed-rent contract, the tenant will pay a rent of R to the landlord.
The tenant is left with G – R of the total production in case of good situations
and B – R if the situation is bad. The landlord, on the other hand, receives a fixed
amount of R in both situations. What if we use sharecropping in place of this
contract? In this case, the share of output will be chosen in a way that it provides
the same expected return to the landlord. The expected return to the landlord is
given by
𝑝𝑠𝐺 + (1 − 𝑝)𝑠𝐵
where ‘s’ is the share of the crop promised to the landlord. Equating this with the
return of the landlord in the fixed-rent contract we get,
𝑅
𝑠=
𝑝𝐺 + (1 − 𝑝)𝐵

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 Land Markets
This gives us the share of production given to the landlord in the case of
sharecropping. Since the landlord gets the same return in both the contacts, we
need to look at the returns of the tenants. In a good situation, the tenants get
𝐺 − 𝑅 in case of a fixed-rent contract and (1 − 𝑠)𝐺 in sharecropping. Hence the
difference between the returns from fixed-rent and share cropping contracts is:
(1 − 𝑠)𝐺 − (𝐺 − 𝑅)
Using the value of s derived above and the fact that G > B, we get,
𝐺𝑅
(1 − 𝑠)𝐺 − (𝐺 − 𝑅) = 𝑅 − 𝑠𝐺 = 𝑅 − <0
𝑝𝐺 + (1 − 𝑝)𝐵
This shows that in good situations, sharecropping contracts will reduce the
returns of the tenant. We can similarly derive the case for a bad state. The returns
to the tenant in sharecropping will increase in the bad situations as compared to
the returns in fixed-rent contracts. Considering the two types of contracts
(sharecropping and fixed-rent) as two different projects, we can conclude from
the above results that a risk-averse tenant will choose a sharecropping contract.
Even if the landlord increases the share taken from the tenant, the tenant will still
prefer sharecropping. Furthermore, sharecropping can allow the tenant to share
not only the output but also the risk associated with uncertain production. On the
contrary, a tenant will have to bear all the risks in the case of fixed-rent.
One might argue that if we want to reduce or eliminate tenants’ risk, why stick to
sharecropping. Fixed wage payments equal to the tenant’s share in the case of
sharecropping can be more beneficial. The tenant will be better off as compared
to the previous situation. Therefore, when there are large and risk-neutral
landowners and poor and risk-averse tenants, the tenancy will be replaced by
wage employment. Note that we have taken the landlord to be risk-neutral. If
both the landlord and the tenant are risk-averse, then neither fixed-rent contracts
nor wage contracts will help. The only option then will be sharecropping. There
is also an incentive problem in the case of fixed-wage contracts. In the absence of
supervision, the tenant will have fewer incentives to put in the required efforts.
Hence, to ensure efficiency, fixed contract is a better option. A wage contract, on
the other hand, will be beneficial for insuring the tenant from uncertainty.
Imagine a situation where we only have fixed-rental contracts and fixed-wage
contracts. Both the landlord and the tenant can decide on their exposure to
efficiency and insurance through diversification. The landlord can use hired
labour for production on the part of their land and lease out the other part for
some fixed rent. On the other hand, tenants can work for some time as wage
labour for a fixed income and take land on rent for the remaining time. However,
this kind of diversification is criticized for three reasons.
 The first reason is the monitoring problem. Fixed-rent contracts can be good
for incentives, whereas wage contracts can be bad for incentives. The

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Land Labour and superiority of the combination of these two contracts over sharecropping will
Credit Markets
highly depend on the ability of the landlord to monitor the labour.
 Combining the two contracts may be difficult in reality. The structure of the
labour market plays an essential role in it. Peak seasons may require full-time
labourers, and those employed in full time paid labour, will not be able to
cultivate the land taken on rent.
 Different forms of uncertainties that can affect the wage rate are also
neglected.

6.2.3 Other Considerations to the Forms of Tenancy

Let us now look at some other considerations, apart from risk and incentives, that
are crucial for the forms of land contracts.
Double-Incentive Problem: There can be two types of landlords. One is the
absentee landlord who is least interested in the production process and prefers
fixed-rent contracts where he earns secured income. The second type of landlord
is very much involved in the production process and keeps regular checks on the
methods and inputs used for production, maintenance of the land etc. In this
scenario, the production process depends on the efforts of the stakeholders, i.e.,
the tenant and the landlord. The “Marshallian inefficiency argument” works from
two different directions. In a fixed-rent contract, all the marginal output is kept
by the tenant, and the landlord has no incentive to put effort. On the other hand,
in the case of a wage-labour contract, landlord gets all the marginal output, but
the tenant is just an employee working for wages. The tenant will not have any
incentive to work hard. So, there is a double incentive problem. However, we can
think of sharecropping as a middle form where both the landlord and the tenant
will have some incentive to put in the effort.
Cost-Sharing of Inputs: Apart from sharing the output, the cost of inputs can
also be shared among the landlord and tenant. It is known that in sharecropping,
some fraction of the output produced is shared by the landlord. However, the cost
of labour of the tenant (which is also an input in production) is entirely borne by
the tenant. They will now equate half of the marginal product of their labour (not
shared with the landlord) with the marginal cost. Hence, the tenant will apply
labour only to a point where the marginal product still exceeds the marginal cost.
It will lead to inefficient outcomes. What if the cost of labour is observable?
Alternatively, say organic manure is the only input used in the production
process, and its use is easily observable. Now the landlord can share the cost of
using the manure. The tenant will now equate the marginal product of manure
that accrues to him/her and the marginal cost of manure paid by him/her. If both
marginal product and marginal costs are shared equally among the landlord and
the tenant, efficiency still remains. However, if the share is not equal and there
are several observable and unobservable inputs, it leads to more complications.
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 Land Markets
Limited Liability and Sharecropping: A poor tenant will not be able to pay a
fixed rent in case of uncertainty. It might lead to a limited liability problem. The
landlord will be aware of this constraint and know that the rent will have to be
forgone in case of crop failure. This further incentivizes the tenant to undertake
risky production processes since the rent will be foregone if the harvest fails, and
he gets to keep all the surplus if the harvest is good. Again, sharecropping is a
better option here as it reduces the share paid to the landlord in bad harvests and
increases the returns in good harvests.
Screening: A landlord might not always be able to screen high-quality tenants.
This can be done by offering a menu of contracts. The idea is that high-quality
tenants will prefer the contracts that can provide them with the benefit of their
marginal product. Low-quality tenants, on the other hand, will choose such
contracts that can divide their marginal product with the landlord. Furthermore,
the landlord can screen out the high-quality tenants and charge high rents from
them. But this is also possible to a limited extent since no tenant will then reveal
their true capabilities. A menu offering sharecropping and fixed-rent contracts
will be successful if two conditions are met. First, high-quality tenant prefers
fixed-rent over sharecropping as the entire marginal output stays with him/her.
Second, low ability tenants will choose a sharecropping contract since the rent
charged in a fixed rent contract is too high. This method is, however, not free
from limitations. The ability of the tenant will not be unknown forever. Once the
abilities are known, high-quality tenants will be selected, and no tenant will be
offered a sharecropping contract. Furthermore, if high-quality tenants know that
revealing their ability will result in higher rents, they will not choose fixed-rent
contracts. The benefits of screening will disappear if there is competition among
different types of tenants. If their ability is the only uncertain factor, they will
then bid for other factors of production, say e.g., land.

6.2.4 Land Contracts and Eviction

Until now, we were assuming that land contracts are renewable. In reality, the
tenancy contracts are not static. They may or may not be renewed by the
landlord. The landlord, therefore, can use eviction as a threat against the tenants
to ensure adequate efforts and better production. Furthermore, the threat of
eviction can even help deal with the “Marshallian inefficiency problem”.
Nevertheless, this also requires compensating the tenant with the risk of eviction.
For the tenant to take up the contract, the value of the contract should also be
more than the opportunity cost of the tenant. The eviction instrument is widely
used in the case of limited liability and non-verifiable information about the
tenants. A threat of non-renewal of the contract if the production is not as
expected can pressure the tenant to increase the efforts. In case of information
regarding the tenant that cannot be verified legally or included in the contract, the
threat of eviction can solve the problem. For example, a landlord is aware that the
tenant is spending extra efforts to farm his own land rather than rented land but 117
Land Labour and does not have any evidence to prove it. Such information can be used while
Credit Markets
making decisions regarding a contract renewal. The tenant is now aware that any
such behaviour can go against him, leading to his eviction. Moreover, the
landlord will also have no incentive to take undue advantage of this information.
For more understanding of the impacts of eviction, refer to Chapter 12 of Ray
(1998).

6.3 LAND SIZE AND PRODUCTIVITY

The understanding of the issue of unequal distribution of land requires
some understanding of history. In the times when the population was scattered,
and the land was abundant, labour was a more important factor compared to
land. The ownership of labour was a much more crucial issue than the ownership
of land. This, however, changed as the population density started increasing. The
issues of property rights started emerging. Property rights (rights of the land,
more specifically) were taken over by force. Those with power and wealth would
extract rent from cultivators in return for protection. As the population density
increased and the land became scarce, the battle to gain ownership of labour was
displaced by the ownership of land. There are many other reasons other than
increasing population density that led to land distribution. A large share of
unoccupied and high-quality land was given to the rich and powerful class,
reducing the land available for small scale farming. Furthermore, subsidies and
other facilities like improved infrastructure were given preferably to wealthy
farmers only. On the other hand, higher taxes were imposed on free peasants
who were involved in small-scale production. This section will provide some
idea about the effect of these inequalities on productive efficiency and the role of
land transfer from rich to the poor, and land reforms.

6.3.1 Key Concepts

Productivity: Productivity can be understood by two notions: “total factor
productivity” and “productivity in the sense of market efficiency”. Total factor
productivity measures the amount of output that can be produced given the
amount of input used. The growth in TFP, on the other hand, is the growth in
output which is not explained by the growth in inputs used for production. This
measure of productivity is tricky since the small and large farmers apply
different types of inputs. Also, measuring non-monetized inputs like family
labour is difficult. The second concept relates productivity with market
efficiency. The productivity of different types of land (small or large) can be
compared with efficient market productivity. However, market efficiency is a bit
vague concept since there are different markets in the world and efficiency in
one market may not apply to other markets.
Technology: Large plots of land are more suitable for using mechanized forms
of cultivation and capital-intensive techniques. There is also a minimum size of
land below which it will be challenging to cultivate the land. For example, when
using animal power for cultivation, economies of scale can be achieved only if a
certain

118
minimum amount of land is used. The use of machines like tractors, threshers and Land Markets
pumps for irrigation will provide economies of scale on large sizes of land
as compared to that required for animal power. Therefore, technology can
increase productivity if a certain minimum size of the land is used and favours
large land sizes in the case of highly mechanized cultivation.
Imperfect Insurance Markets: As we have seen earlier, labourers and
tenants are not risk-neutral in the real world. Neither the credit markets nor the
insurance markets are perfect. Had there been perfect credit markets (free
from limited liability) and perfect insurance markets (or risk-neutral landlords
and tenants), production efficiency could be achieved by choosing appropriate
contracts. It is not possible in the case of imperfect markets with risk-
aversion and credit-constraint tenants. These conditions, however, favour the
ownership of small lands that are farmed by family labour. They ensure
productivity advantages and efficiency gains that cannot be achieved by a
tenancy contract with fixed rent or hired labour.
Imperfect Labour Markets: Labour markets, like the land markets, are
also imperfect, more so in the case of unemployment. Let us assume that there is
full employment in the labour market. The opportunity cost to the landlord
applying a unit of labour on the land will be the wage rate of a unit of labour
prevailing in the market. The opportunity cost will be the same in case of
hired labour or family labour (his/her own labour). But the situation is
different if there is unemployment in the labour market. The opportunity cost
of hired labour is still the same (wage rate in the market). However, the
opportunity cost is lower in the case of family labour. It will depend on whether
the family knows that it can get a job or not. If they know that they can get a
job, then the opportunity cost is equal to the market wage. But if they know
that they cannot get a job, the opportunity cost will be zero. Figure 5 shows
the per-acre production function to show these cases. Small farmers who use
family labour have a low opportunity cost of labour since there is a possibility
of unemployment. He will therefore put in L** units of labour per acre (here
MP = MC of their labour). Large farmers who use hired labour on their
farms will employ less labour per acre (L*). Therefore, the output produced
per acre by small farmers will be higher than that of large farmers.
Output per Acre

Per-Acre Production Function

Opportunity Cost for Employer

(equal to the wage rate)

Opportunity Cost for Family Labor

(less than the wage rate)

L* L** Labor Input per Acre

Fig. 6.5: Imperfect Labour Markets and Small-Farm Productivity 119

Land Labour and Pooling land: So far, we have seen that imperfect insurance and labour markets
Credit Markets
favour the use of own or family labour for cultivating the land. Technology, on
the other hand, is either neutral or favours large landowners since they can take
advantage of technological returns to scale. But small farmers can also take this
advantage by pooling their land. However, pooling land is not so easy. It again
leads to the free-rider problem. If anyone farmer puts in some extra effort, the
additional output produced is divided among all the farmers. The share of extra
output enjoyed by other farmers is an externality. Unless the farmer is altruistic
enough to ignore this, he will undersupply his efforts. If this behaviour is
followed by all other farmers and all of them want to free-ride, it will reduce
productivity.
All these factors are equally important in determining the productivity of the
land. However, they run in two opposite directions. We will need some empirical
evidence to understand which factor will dominate and have a significant impact
on productivity.

6.3.2 Land Sales

More equal distribution of land can increase productivity and reap enormous
economic benefits. It is clear from the earlier section that tenancy contracts
cannot provide such gains since they have certain costs attached. One other way
to achieve equal land distribution is through land sales. If the small and poor
landowners are in a position to buy land from the rich landowners, it can help in
realizing the benefits. Nevertheless, there is sufficient empirical evidence that
land markets do not work adequately. The sale of land from rich to poor is very
minuscule. Much of the sale has happened from poor to rich in the form of
distress sales (for example, land transfer to repay the debt).
Land can be valued for two main reasons. The first component is the income that
can be earned by working on the land. Another reason is that it can be used as
collateral to take loans when the credit markets are imperfect. A seller would
want to sell the land at a price equal to the sum of these two values. The buyer
can either use his own funds or take advantage of both the values of the land.
He/she can also take a loan to buy the land. If the buyer has to keep the same
piece of land as the mortgage to take the loan, he can reap the advantage of the
collateral value of the land only in the future once the loan is repaid. Therefore,
the present value of the land for the buyer is less than that of the seller. The land
will not be sold in this case. It can be argued that if the small-scale farmers are
more productive than large scale farmers, the present value of the income stream
generated will be higher for the small farmers. The sale of land will then depend
on whether the value of land through income generated outweighs the collateral
value of the land. It is also necessary to understand the role of a credit contract
that will be used for taking the loan to buy the land.
The repayment capacity of the borrower (which in turn depends on the output
120 produced by the borrower) will also affect the credit contract. We can think of the
 Land Markets
lender as the landlord of the borrower for the period for which the loan is taken.
Fixed interest on the loan can be compared with a fixed-rent tenancy. We know
that fixed-rent tenancy is not optimal for the landlord. Similarly, fixed
repayments are not optimal for the moneylender. Therefore, the credit contract
will reduce the borrower’s productivity for similar reasons that are observed in a
tenancy contract. Using credit for purchasing the land does not seem to be the
right choice in this case.

6.3.3 Land Reform

We have briefly discussed the role of tenancy and land sales markets. You have
learnt that tenancy contracts are not the best option to realize productivity gains.
It rather reduces these gains. The land sale markets are also not the optimal
solution for equal distribution of land. The only option left is the transfer of land
from rich to poor. It can be done by framing some laws and regulations regarding
land ownership either without compensation or full or partial compensation by
the government or some foreign donors. The compensation is not given by the
beneficiaries. If the beneficiaries pay for the compensation, it will be synonym
for selling the land. Successful land reforms can be introduced only if the
government is willing to spend some money from its budget or a foreign donor;
for example, World Bank provides funds for the same.
In many cases, land reforms in Cuba, Japan and Korea were possible because of
the political upheaval where large landowners were considered enemies, and
there was immense support for the land reforms. Some other steps that can be
taken to redistribute land include providing "unlimited land use rights to the
tenants" and "land ceilings to prevent ownership of large lands". Such reforms, if
implemented successfully, can have significant effects on productivity. However,
land reforms implemented half-heartedly, without political will, and the existence
of strong landowners' lobbies can lead to opposite effects (increased land
inequality or reduction in productivity. Large-scale land reforms in South Korea
after WW II are a good example of great success. Things were not good in the
case of Mexico, where land reforms were derailed by strong lobbies of rich and
powerful landlords who were able to manipulate the government. Land
redistribution was done not on the basis of pre-defined criteria but as a political
favour. The formation of big cooperatives and ill-defined property rights further
hampered the agricultural productivity of the country.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What is the double incentive problem?
………………………………………………………………………………….
………………………………………………………………………………….
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Land Labour and 2) Why is sharecropping a better option in case of limited liability?
Credit Markets
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………………………………………………………………………………….
…………………………………………………………………………………

6.4 LAND ACQUISITION

The land is a critical bottleneck for development, and its acquisition is
problematic in many countries. In the post-liberalization period, India, along with
many emerging countries, has exhibited a voracious appetite for land in order to
meet the growing demand for industrialization, infrastructure creation, resource
extraction, urbanization etc. Protests and counter-protests, agitations and counter
agitations over the issue of land acquisition are an everyday feature in many
LDCs that are seeking to industrialize. This trend is observed in some parts of the
developed world as well.
From the developing countries’ perspective, national and regional governments
often need to acquire a chunk of land for various developmental projects like
infrastructure, industry, urbanization, mining and excavation or even for
conservation purposes. Acquiring large parcel of land already under different
land use and vested with different stakeholders is a challenging task for the
government. Due to that, many developmental projects (like building highways,
airports, metro railway lines, hospitals, educational institutions etc.) suffer huge
setbacks and often get stalled due to public opposition. Given that many such
projects have inter-temporal benefits and multiplier effects, such a situation often
creates hurdles in achieving a higher development trajectory.
If we look at the development economics literature, scarcity of capital was
consistently treated as the major constraint for development. Lewis (1954)
envisaged economic development as a process of capital accumulation. He
described the ‘development’ as a process of transferring labour from low
productive agriculture and other traditional occupations to high productive
modern industry, made possible by capital accumulation in the modern sector.
Scarcity of capital was considered a primary constraint for achieving economic
growth and development in the later decades as well (Jorgenson 1961, Dixit,
1973). The emphasis on physical capital was shifted to human capital in the mid-
’80s along with the evolution of the Endogenous Growth Theory (Romar, 1986,
1990); Lucas (1988).
However, theories are silent about the possibility that land could be a
constraining factor in the process of development. The underlying assumption
was that land requirement is negligible for industries and can be safely ignored.
At the macroeconomic level, this was justified. If one looks at the physical
requirement of land for building up industries, services and infrastructures like
roads, townships, seaports, airports or bridges, the total requirement may not be
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 Land Markets
very large compared to the total agricultural land in an agrarian economy like
India. However, this is more of a serious microeconomic problem. When land is
acquired for these purposes, it invariably entails eviction of people from their
traditional livelihood and surroundings. Since the era of independence in India,
over 21.6 million people in the period 1951-90 have been displaced for various
heavy scale projects like dams, canals, steel plants, thermal plants, sanctuaries,
industries and mining.
Land acquisition in India has been long practiced under the Land Acquisition
Act, 1894. Since 2011, the country proposed Land Acquisition and Rehabilitation
and Resettlement (LARR, 2011) Bill – which was enacted in the parliament and
has come into force from January 1, 2014. This draft (LARR, 2011) states that
around 75% of the displaced people since 1951 are still awaiting rehabilitation.
However, it should be noted that displacement is only being considered with
regard to ‘Direct Displacement’. The figures may stand even much larger if we
consider indirect displacement.
The idea is that the State can take away any private property for the public good,
that is, the Doctrine of Eminent Domain. The law permits compulsory
acquisition or what is popularly called condemnation or taking of a property by
the government if the owner voluntarily refuses to sell the property. At the same
time, this law typically entitles the owner to compensation of at least equal to the
market value of the property.
The Land Acquisition Act of 1894 laid down a principle on compensation which
should be equal to the local market price for the land. More specifically, the law
said that it should be the average price of all land transactions completed in the
area in the previous three years. Only the landowners are eligible for
compensation. Therefore, the other stakeholders like the tenants, sharecroppers,
wage labourers etc., who indirectly depend on that same piece of land, were
completely left out. The compensation package based on a three-year average
was highly regressive in nature as land prices generally increase over time both in
rural and urban areas and do not address inflation and other elements.
Land Acquisition has thus ignited mutinies in the last decade. About one-fourth
of the country’s districts across all states witness conflicts. It identifies 252 land
conflicts spread over 165 districts, spanning practically all states, in 2013-14.
This is an increase of about 42 % over 2012, when an earlier study has recorded
177 disputes and 130 districts. The data on conflict was collated by Society for
Promotion of Wasteland Development and Rights & Resources from media
reports and cases pending in high courts & Supreme courts. These data are under-
estimation as only the conflicts of certain intensity in terms of violence, injury,
death, covering more than one village etc., were recorded. It is estimated that
projects valued at Rs. 6 lakh crore are stalled due to land acquisition. This
incendiary situation is the reason behind the New Land Acquisition Law of 2015.
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Land Labour and
Credit Markets
6.4.1 Land Acquisition and Compensation
The critical question in connection to land acquisition is, therefore, what should
be the right price of land or compensation, which will make the owners
indifferent between holding the land or sharing the land. Setting the
compensation too low – i.e., providing inadequate compensation to large
numbers of poor landowners, will induce bias favouring excessive
industrialization at the expense of expropriated farmers. Setting them too high is
also not a good idea, as it will unduly lower the pace of industrialization and
overall economic growth.
So, getting it right is critical. The economic rationale says to set the
compensation high enough to satisfy farmers but not too high that it retards
industrialization excessively. Sound economic arguments for compensation of
farmers and tenants above the market price, on the grounds of efficiency, equity
and political sustainability of the industrialization programme, such that the local
community should welcome the acquisition.
What determines adequate compensation? Strong economic arguments for full
compensation of farmers and tenants. From the point of view of economic
efficiency, the industry should pay the full opportunity costs of land being
transferred. From an equity standpoint, the cost of any subsidies for industrial
development should not be borne entirely by the farmers and agricultural
workers. For the political sustainability of the growth process, it is necessary to
avoid alienating such a large number of poor and vulnerable people.
What determines adequate compensation? Is the market price of valuing land an
adequate basis for compensation?
Theoretically, ‘adequate’ compensation would be the personal valuation
(reservation price) for the owner, i.e., the price at which the owner would be
indifferent between selling and not selling.
Does a compensation set equal to market price allow the farmer to re-purchase
land in the neighbourhood (assuming that expected future prices rather than
historical prices are used for compensation purposes)?
Many farmers might have reservation prices for land that may exceed its market
value. Indeed, the fact that many owners had been holding on to these lands for
some time reveals that their reservation values exceeded the market price they
could have sold them.
Is the market price of valuing land an adequate basis for compensation?
It is argued that appropriate compensations should exceed the market value of the
land. What makes compensation tricky are: (i) poor quality of land records; (ii)
heterogeneity of plots; (iii) heterogeneity in the reservation utility or the personal
valuations placed by different owners on land as an asset.

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 Land Markets
There are two problems with this: The problems of ascertaining market values of
acquired plots (misclassification) and incorporating other relevant characteristics.
It is highly debatable how much higher should the compensation be? LARR Bill
in Parliament sets compensation at an arbitrary multiple (quadruple) of market
value in rural areas. Let us elaborate on these points.
A piece of land to its owner is not some tangible attribute and therefore has a lot
of subjective quantity. So there exists substantial heterogeneity among owners in
the valuation of land. The land value is derived not only from the flow of crop
output alone but also because farmers differ in their endowments of skill,
knowledge, capital, farming assets like bullocks or tractors, market access, and
access to alternative methods of earning a livelihood etc. Moreover, in the rural
region, land has an important role as a financial asset, often serves as collateral
for loans, offers an assured source of employment for family labour, and acts as
insurance against food price fluctuations via self-consumption. All this adds up to
the intrinsic value of the land. Besides this, another potential source of value for
land is the social prestige attached to land ownership. Thus, different owners are
likely to impute these values very differently.
The land market in rural areas in developing countries (as well as India) is very
thin and opaque due to very few transactions. Distress sales constitute a bulk of
the rural land transactions, and the full value is often concealed to escape stamp
duty. Rural areas generally have poor and very old land records, and transactions
are not well documented, leaving considerable room for officials to manipulate
the figure using selective sampling or fake transactions. Therefore, it is not easy
to get a proper estimate of the market value of land in rural areas. It is relatively
less in the urban land market, where the transactions are quite frequent. Any
industrial or development project will cause a significant appreciation in real
estate prices, making it impossible for displaced farmers to buy back land with
compensation money if they so wished.
There is also criticism against cash compensation. The land has a property of
indivisibility and is therefore relatively less prone to erosion over time (compared
with divisible financial assets such as cash or bank deposits with easy withdrawal
facilities) since there is a minimum size of a plot that can be transacted, owing to
fixed transaction costs. Moreover, cash possession is risky for a poor household.
It is subjective to temptation for them to indulge in temporary consumption needs
or difficulty of denying help to relatives or friends when asked for. Thus, the
common criticism of cash compensation is that it replaces a familiar asset (land)
with an unfamiliar one (paper assets), destroying the value of the farmer’s asset-
specific skills and leaving him vulnerable to bad investments or temptations or
self-control problems associated with liquid wealth.

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6.4.2 Holdout Problem
In India, various reports in Quartz India suggest that land acquisition issues have
delayed around 9 billion dollars worth of projects in India. Barapullah Ph III,
across the Jamuna River bridge of 3.5 km long, was delayed for 18 months to
acquire two plots of land of 8.5 acres. 20 % of the unfinished work holds up 100
% work of the flyover. The owners of the two plots were demanding very high
compensation.
A holdout is a form of monopoly power that potentially arises in the course of
land acquisition where a big chunk of land is required for a project (like
infrastructure, industry, mining extraction, urban housing etc.). Once acquisition
begins, individual owners, knowing their land is essential to the completion of
the project, can hold out for prices in excess of their opportunity costs. The result
is that such large-scale projects requiring acquisition will entail high bargaining
and transaction costs.
It is difficult to agree on a price for land that is fair to all the stakeholders, given
that land is a special asset with a fixed supply and very high attachment and
emotional value and that agricultural landowners have very few alternative
means of livelihood. Many countries, including the US and India, have therefore
promulgated ‘eminent domain’ laws that allow land acquisition for public
purposes on payment of fair compensation. Yet the problem persists, thereby
fuelling research geared towards understanding what determines a fair
compensation and redistribution package.

6.4.3 Land Acquisition, Rehabilitation and Resettlement (LARR)

In India, land acquisition is a concurrent subject and is governed by central and
state laws. The main Central Act governing land acquisition is the Right to Fair
Compensation and Transparency in Land Acquisition, Rehabilitation and
Resettlement (LARR) Act 2013. It replaced the Land Acquisition Act of 1894.
On the similar line many states have also enacted laws to regulate land
acquisition.
The LARR 2013 Act differed from the 1894 Act in several ways. It narrowed the
definition of ‘public purpose,’ i.e., the types of projects for which land could be
acquired by using the laws of eminent domain. It required the consent of
landowners if the project is for a public-private partnership (PPP) or a private
company. Compensation was set at two to four times of prevailing market rates,
and minimum norms for rehabilitation and resettlement of affected persons were
prescribed. The Act also required a Social Impact Assessment (SIA) to be
conducted to determine whether the potential benefits of the project would
outweigh the social costs.
In December 2014, an Ordinance was promulgated to amend the 2013 Act. The
Ordinance was re-promulgated in a modified form in April 2015 and again in
126 May 2015. The Right to Fair Compensation and Transparency in Land
 Land Markets
Acquisition, Rehabilitation and Resettlement (Second Amendment) Bill, 2015,
was introduced in Lok Sabha on May 11, 2015, to replace the April Ordinance
and was referred to a Joint Parliamentary Committee for detailed examination.
 The salient features of the legislation are as follows:
 It increases the minimum compensation payable but continues to use the
market price obtained from recently registered sale deeds from the region as a
yardstick.
 The minimum compensation has been fixed at four times the market price in
rural areas and twice the market price in urban areas.
 All eminent domain acquisitions, as well as private purchases of over 100
acres in rural areas and 50 acres in urban areas, are subject to a mandatory
rehabilitation and resettlement (R&R) package, with a host of benefits both
for affected landowners and livelihood losers. These benefits include
annuities, transportation allowance, land for land, a portion of capital gains
from the resale, and the construction of alternative housing and communal
amenities in the event of loss of homestead.
 Stringent restrictions on the exercise of eminent domain, placing restrictions
on the use of multi-cropped land and tightening the definition of ‘public
purpose’.
 Procedural safeguards have also been introduced, including social impact
assessment, adequate notification and consent of at least 80% of the affected
community.
 Consent: Consent of 70% of land owners is required for Public-Private
Partnership projects. Consent of 80% of landowners is required for private
projects. Irrigated multi-cropped land cannot be acquired beyond a limit
specified by the state government. The government is to ensure that the extent
of land being acquired is in keeping with the minimum land required.
 Five types of projects are exempted from consent requirements:(i) Defence,
(ii) Rural infrastructure, (iii) Affordable housing,(iv) Industrial corridors set
up by the government/government undertakings, up to one km on either side
of the road/railway of the corridor, and (v) Infrastructure including private-
public-partnership (PPP) projects where the government owns the land.
 Rehabilitation & Resettlement award clause: Clarifies that this will include
providing employment to ‘one member of such affected family of farm
labour’.
Social Impact Assessment (SIA): The government may exempt the above five
types of projects from SIA. The government is to ensure that the extent of land
being acquired is in keeping with the minimum land required.

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Land Labour and  Survey of Wasteland: The government must conduct a survey of its wasteland
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and maintain a record of the same.
 Compensation and R&R provisions of 13 types of projects (such as the
National Highways Act, 1956 and the Railways Act, 1989) are exempted
from the provisions of the Act. Compensation and R&R provisions of Acts
are in consonance with the Act.
 Return of Unutilized Land: The period after which unutilized land has to be
returned will be the latter of (i) five years or (ii) any period specified at the
time of setting up the project.
Retrospective Application: In calculating the time period for retrospective
application, any period during which the proceedings were held up: (i) due to
stay order of a court, or (ii) for a period specified in the award of a Tribunal, or
(iii) for any period where possession was taken but the compensation is lying
deposited in a court or any designated account, will not be counted.

Check Your Progress 3

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What is the holdout problem?

2) Why is the cash compensation for the land acquired criticized?

6.5 LET US SUM UP

In this unit, we have talked about the land markets. The first section looks at
ownership of land and its distribution. We studied different land rental contacts
that exist in the land markets. A landowner gives his land on lease in exchange
for some rent. This can either be a fixed-rent tenancy (where the tenant pays s
fixed sum of money to the landlord) or a share-cropping tenancy (where the
tenant has to share a part of his output/ produce with the landlord). We have also
discussed about different variations of these two contracts. Fixed rent tenancy
does not disincentivize the tenant to put in less effort. Sharecropping, on the other
hand, reduces the efforts of the tenant, leading to lower productivity. We also
came across the Marshallian inefficiency puzzle.
These different forms of rental contracts have been discussed graphically and
tried to understand the inefficiency problem in the case of sharecropping.

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 Land Markets
However, despite being inefficient, sharecropping can be an equilibrium
outcome. This is because of the existence of risk and uncertainty along with
imperfect insurance markets. Other considerations in the tenancy contract like the
double-incentive problem, limited liability, cost-sharing of inputs and screening
and the role of sharecropping in these situations have also been discussed. The
land rental contract section at the end talked about evictions that a landlord can
use as a threat at the time of contract renewal.
We also talked about land size and productivity and the impact of unequal land
distribution on land productivity. Some important concepts discussed in this
regard include productivity, technology, imperfect insurance markets, imperfect
labour markets and pooling of land. This section further discussed briefly the role
of land reforms in the distribution of land and hence.
We then moved on to a critical question of land acquisition – What should be the
correct price of land that should be paid as compensation? The holdout problem -
a form of monopoly power that potentially arises in the course of land acquisition
where a big chunk of land is required for a project was discussed. Finally, we
studied about the land acquisition acts in India, the Land Acquisition,
Rehabilitation and Resettlement Act and its salient features.

6.6 HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) See section 6.2
2) See subsection 6.2.1.2

Check Your Progress 2

1) See sub -section 6.2.3
2) See sub-section 6.2.3

Check Your Progress 3

1) See sub-section6.4.2
2) See sub section 6.4.1

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Land Labour and
Credit Markets
UNIT 7 LABOUR MARKETS
Structure
7.0 Objectives
7.1 Introduction
7.2 Characteristics and Challenges of Labour Markets
7.2.1 Characteristics of Labour Markets
7.2.2 Challenges of Labour Markets
7.3 Basic Theory of Wage Determination
7.4 Alternative Theories of Wage Determination
7.4.1 Imperfect Information Model
7.4.2 Repeated Games Model
7.5 Poverty, Nutrition and Labour Markets
7.5.1 Basic Model with Piece Rates
7.5.2 Nutrition, Time and Casual Labour Markets
7.6 A Model of Nutritional Status
7.7 Let Us Sum Up
7.8 Hints to Check Your Progress Exercises

7.0 OBJECTIVES
After going through this unit, you will be able to explain:
 describe the features of the labour market in the context of developing
countries;
 explain how wages are determined in a standard labour market;
 derive the conditions under which equilibrium between wage and output is
reached;
 discuss the explanation that is offered by the neo-classical paradigm
regarding the existence of unemployment; and
 examine the link between nutrition and work capacity and consequently the
wages received by workers.


Dr.Indrani Roy Chowdhury, Associate Professor, CSRD, JNU, New Delhi.
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 Labour Markets
7.1 INTRODUCTION
In the previous unit, we looked at the operations of the land market. Land
markets emerge because of the imbalance between the endowments of land.
Similarly, the differences in the endowments of labour give rise to the labour
market. In a perfect labour market, the supply and demand for labour interact to
determine the price of labour (wage or salary). However, in the real-world
scenario, the factor markets, including labour markets, do not work perfectly.
Developing countries are mostly endowed with a surplus labour force that does
not have gainful employment and is seeking alternative sources of employment.
Thus, from the developing countries’ perspective, labour markets play a central
role in determining economic and social progress because employment status is
one of the key determinants of poverty. However, in most developing countries, a
formal sector in the labour market is narrow. It fails to create adequate jobs that
pay well for its working population. Their labour markets tend to be
characterized by the dominance of workers in the subsistence agriculture.
Consequently, there is persistence of informality in employment contracts, with
low pay and poor working conditions. It is a matter of concern that development
and economic growth in many developing countries, especially in South Asia and
Africa, have led to highly segmented labour markets both in their rural and urban
areas. Furthermore, there are large variations in wages within a narrow
geographic region despite the presence of competition.
In low-income countries, most of the working population is either self-employed
or engaged in family work. Hence, concerns of job security, minimum wages,
and other regulations, are generally not applicable. The same applies even in
middle-income countries like Morocco where only half of the workforce are
wage employees. Even in the more structured parts of developing country’s
labour markets, compliance of labour laws is a formidable challenge. This is
because these countries are often endowed with weak institutions, which provoke
low compliance and costly processes to ensure enforcement. Hence, in most
developing countries, between a quarter and a half of wage-earners receive less
than the statutory minimum wage. Moreover, policy prescriptions for poor
countries are often self-contradictory. Given these, massive non-compliance is
the norm in many developing countries. Regulations like a national minimum
wage simply encourage the expansion of an informal market.
Further, there is a growing tendency of informalization of the formal sector. This
has resulted in newer forms of labour market duality through casual and sub-
contract labour. Another key challenge witnessed in all developing countries is
gender disparities in the labour market. Women tend to be over-represented in
informal employment. They face a range of barriers to access better jobs in the
formal economy. For this reason, when women do work, they are more likely to
be family or domestic workers and less likely to be working in the formal
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Land Labour and economy. Persistence of gender wage gaps reflect the penalty that women bear
Credit Markets
due to their compulsion to withdraw from the labour force to raise children.
Because of high population growth rates, developing countries face the challenge
of creating adequate jobs for young people who enter the labour market in large
numbers. A high rate of prevalence of youth unemployment and
underemployment are common in developing countries. This is not only because
of demand-side deficits (inadequate job opportunities) but also because they lack
skills, work experience, job search abilities and the financial resources to find
employment. As a result, youth unemployment rates tend to be two to three
times higher than for adults. Furthermore, youths have been affected by the
global financial crisis more severely than adults. This is due to the sectors they
tend to work in and their vulnerability to layoffs. Global figures show that
almost 75 million young people (between the ages of 15 and 24) are unemployed
as of 2012, reflecting an unemployment rate of 12.7 per cent (ILO, 2012).

7.2 CHARACTERISTICS AND CHALLENGES OF

LABOUR MARKETS
In this section, we discuss two important features of labour markets viz. (i)
characteristics and (ii) challenges.

7.2.1 Characteristics of Labour Markets

The following distinctive institutional characteristics of the labour market in the
informal sector of the developing countries are well documented.
 Fragmented labour markets: there are large variations in wages within a
narrow geographic region, despite the presence of competition.
 Massive involuntary unemployment: there is persistent lack of market
clearing wages despite the absence of any regulations that prevent wages
from adjusting flexibly.
 Informalisation: there is persistent subcontracting and casual employment
with a huge backlog of youth unemployment due to poor skills.
 There is pervasiveness of the absence of long-term contracts between
employers and employees.
 There is unequal treatment of observationally similar workers.
 Duality in the labour markets: Some workers have long-term contracts,
while others carry out similar tasks on a casual basis at substantially lower
wages.
 There is limited access of the poor to employment owing to malnutrition
and absence of human capital.

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 Labour Markets
Poor working conditions, wage gaps, gender discrimination, child labour, lack of
social security etc. are common i.e. while finding a job itself is a challenge,
having one does not guarantee decent living conditions.
Besides the above characteristics, a considerable share of the economic activities
is outside the ambit of the market altogether (e.g., subsistence farming, street
vending, etc.). They are indicative of an “employment-led” survivalist strategy,
rather than a “growth-led” demand for labour. The distinction here is that in
developed countries it is “growth” or “demand” which absorbs labour into jobs.
In contrast, in the developing countries, it is an abundance of underemployed
supply of labour seeking to create its own demand for its services.

7.2.2 Challenges of Labour Market

There are five primary challenges that must therefore be met to improve the
above situation in order to move towards decent employment standards.
i) Decent work: Poor working conditions are the main employment challenge.
Globally, it is estimated that 2 billion people (i.e. 61% of people with work
status) hold an informal job. Out of this, 700 million people live in extreme or
moderate poverty. Such jobs are with weak job contract and poor social
security. It results in exploitative conditions like extended hours of work,
removal from job without notice or severance pay, hazardous working
conditions, etc. There is thus a two-fold challenge: a) improving the working
conditions in the informal sector, b) increasing the formalization of work
contracts with a social protection mechanism.
ii) Youth unemployment: Globally, more than one out of five young people
(under the age of 25 years) are without any job. This means, these young
people are involuntarily unemployed, who are out of school and are without
any employable skills. At the same time, 145 million young workers live in
poverty. This is particularly alarming because youth unemployment is a
vicious cycle — those who remain excluded from the job market for a long
time fail to acquire the skills that future employers will be looking for. Youth
unemployment is thus a public policy challenge. The goal of the Global
Decent Jobs for Youth Initiative, sponsored by the UN, is to accelerate
partnerships for action in this area by disseminating the necessary
information to the stakeholders.
iii) Gender inequality in the workplace: As per the ILO, on average, a woman
with the same skills and responsibilities earn 20% less than a man. It is
compounded by another inequality — women are much more likely than men
to be involuntary part-time workers although many of them would prefer to
work more hours. In combination with persistent stereotypes, these
inequalities result in much lower labour force participation rates for women
(48%) than men (75%).
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Land Labour and iv) Environmental crisis: Climate change and the decline in biodiversity are
Credit Markets
estimated to affect millions of workers worldwide. Most of them are engaged
in agriculture with their crops vulnerable to extreme weather events (e.g.
drought). ILO estimates that the transition towards more environmentally
sustainable work culture will destroy 6 million jobs globally. Many of these
jobs would be in fossil fuels due to the transition from non-renewable to
renewable energy. There is therefore a need to anticipate green job
opportunities in sectors of the low-carbon economy via appropriate measures
for skill development and support for entrepreneurship.
v) Child labour: Child labour slows down long-run growth and social
development through reduced human capital accumulation. Children compete
with unskilled adults for the same jobs. This affects adult employment and
adult wages depending on the structure of the labour market. Child labour
discourages the adoption of skill-intensive technologies while lowering
wages in low-skill sectors. Poverty being the root cause of child labour,
policy must aim at reducing child labour by improving the economic welfare
of poor households.

7.3 BASIC THEORY OF WAGE DETERMINATION

Labour markets are not homogenous. There are two main types of hired labour:
one that is hired on a casual basis and the other employed for long-term
contracts. This distinction is important because the labour markets work
differently in the two cases. Casual labour is usually hired to carry out tasks that
are easily amenable to observation (e.g. harvesting and weeding). Long-term
labour is mixed in nature (e.g. they may serve in a supervisory capacity, or made
responsible for tasks that require special care and are relatively difficult to
monitor (e.g. application of fertilizer and pesticides). Long-term labour can be
punished by denying future employment or modifying the terms of employment.
A standard model of demand and supply (Fig. 7.1) determines the wages in a
standard labour market. The demand for labour depends, among other things, on
the “going” wage that is paid to hired employees. A fall in the going wage
reduces the demand for labour. The demand curve, therefore, is downward
sloping. On the other hand, the supply curve of labour is derived by the costs and
benefits of working. A higher going wage serves as better compensation for the
use of labour. This elicits a greater quality of work from each worker, besides
encouraging a larger number of workers to enter the labour market. Therefore,
the supply curve of labour is upward sloping. The intersection of supply and
demand curves gives us the equilibrium wage.

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 Labour Markets

Fig. 7.1: Supply of and Demand for Labour.

There are many features that cast doubt on this model.
 The first is that it does not make a distinction between the casual and long-
term labour market.
 Second, it fails to make a distinction between labour-power and manpower,
the latter being characterised by skill.
 Thirdly, the model assumes that the worker can be perfectly monitored which
is not the case in reality. A labourer in equilibrium will be indifferent
between working for his current employer and search for another employer.
When supervision is difficult, shirking is more likely which can only be
punished by the termination of employment. This means, the conditions
described in Fig.7.1 may not persist.
 Fourth, there is no provision for involuntary unemployment in the model. It
thus misses out on a crucial aspect of reality.
 Fifth, rural labour markets are characterized by substantial uncertainty and/or
seasonality in agricultural production. For instance, uncertain rainfall affects
the size of the harvest affecting the total demand for labour. Thus, the labour
demand curve is fluctuating between the highs and lows as indicated by the
dotted lines in Fig.7.2. The equilibrium wage will fluctuate between a band of
wH and wL. Though this captures some aspects of uncertainty, it does not
illustrate the possible ways in which employees and employers cope with this
uncertainty. In the same way, workers may wish to smooth out seasonal
fluctuations in their wage income. Employers who are willing to provide such
smoothing in income would be preferred by employees. Thus, some
variations in the standard demand-supply model is required to deal with the
rural labour markets in developing countries.

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Land Labour and
Credit Markets

Fig.7.2: Labour Market Equilibrium Under Uncertainty

Check Your Progress 1

1) List any three challenges faced by the labour market of poor countries.
2) How is wage determined in a simple demand-supply model?

7.3 ALTERNATIVE THEORIES OF WAGE

DETERMINATION
If wages are flexible in the downward direction, excess supply gets dealt with by
a wage cut. This is because unemployed workers undercut the existing wage by
offering to do the same work for lesser pay. This is acceptable to the employers
since they are the profit maximisers. We need to understand what prevents such
an arbitrage? The efficiency wage theory provides an answer to this. It states
that if the productive efficiency of the worker depends on the wage, a wage cut
will be accompanied by a drop in the worker’s efficiency, rendering the arbitrage
worthless to the employer.
The above also explain why a firm pays higher wages. Up to a point, raising
wages is appealing to an employer in order to raise the labour effort and
efficiency. Since the optimal wages differ in different sectors, different sectors
end up paying different wages. Thus, the main feature in efficiency wages is that
firms are deterred from cutting wages because of the detrimental effect it would

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 Labour Markets
have on the worker effort, motivation, cost of fresh recruitment, retention, etc.
All of these cumulatively affect the ultimate firm’s profits. Thus, although the
efficiency wage theory explains the existence of wage differential across sectors,
they do not explain why higher wages lead to lower labour costs. To conclude,
the following points on ‘efficiency wage’ may be underlined:
 higher wages help reduce shirking when the effort is not perfectly observed;
 higher wages improve worker morale and effort like the effect of a ‘gift
exchanged’;
 higher wages reduce worker quits and thereby the turnover costs;
 higher wages attract more applicants and increases the hiring power of firms.

7.4.1 Imperfect Information Model

In the neoclassical theory, labour is treated as a hired input like capital. However,
unlike capital, labour may decide their levels of effort. This leads to some
important effects when information is imperfect. Shapiro and Stiglitz (1984)
developed a dynamic model in which firms induce workers to work hard for
higher wages and threaten to fire workers if caught shirking. As a consequence, it
results in some workers getting employed at higher wages while others
terminated would get involuntarily unemployed. The larger the pool of
unemployed workers, the longer it would take a fired worker to find a new job.
Hence, the threat of firing becomes effective. In the competitive equilibrium, the
wage (w) and the unemployment rate (u) induce workers not to shirk. In other
words, the firms’ labour demand at w results in an unemployment rate exactly
equal to u.
In the above framework, the objective of the firm and the objective of the
employees are assumed to be not aligned. The former aims to maximize the profit
and the latter aims to maximize their labour income. Here, the labour income
represents the net return for the cost of their efforts. The employee-employer
relationship is characterized by the presence of involuntary unemployment and
imperfect information. The presence of information asymmetry leads to the moral
hazard problem making it costly for employers to monitor workers’ efforts. In
sum, the following features of the model can be underlined:
 in a situation of competitive paradigm, where all workers receive their
reservation wage (market wage), there is no unemployment. If a worker is
caught shirking, he is dismissed. Another worker is immediately rehired at
the pre-layoff wage. Therefore, even with imperfect monitoring, workers do
not have the incentive to shirk as shirking results in cost of unemployment to
the workers.
 to induce workers not to shirk, firms pay the above-market wage. In
particular, a firm willing to reduce shirking would pay more than the ongoing
137
Land Labour and wage. This would also be the optimal wage strategy of all other firms under a
Credit Markets
competitive setup.
 however, as the average wages rise above-market wages, labour demand falls,
resulting in unemployment. Then, even if all firms pay the same wage, the
incentive to shirk disappears. This is due to the disincentive that if one is
fired, he may not immediately get a new job.
 unemployment creates its own penalty for shirking acting as a worker
discipline device. It implies that unemployment and monitoring are
substitutes.
 consequently, wages serve two functions: (i) allocating labour and (ii)
offering incentive for employee effort conditional on employment. When
either of the two (wages and employment) is used as an instrument to alter
equilibrium, it leads to inefficient outcomes.

7.4.2 Repeated Games Model

Under this model, workers receive wage (w) and decide whether to spend
positive or zero effort (e) on the job. When the firm offers the worker a wage,
the worker accepts or rejects the firm’s offer. If the worker rejects w, then the
worker becomes self-employed at a wage 𝑤𝑜 . If the worker accepts w, then the
worker chooses either to supply full effort e (entailing a full disutility e) or to
shirk (entailing less disutility). The utility of the workers directly depends on
wage income and inversely on effort. Hence, the utility of the worker is a
function of income and effort i.e. U (income, effort) = Income – Effort.
The worker’s effort decision is not observed by the firm. But the worker’s output
(y) is observed by both the firm and the worker. Output can be high or low
depending on whether the worker puts full effort or shirks. For simplicity, we
take the low output to be zero (y = 0) so that we can write the high output as y >
0. If the worker supplies full effort, then the output is sure to be high. But, if the
worker shirks, then output is high with probability p and low with probability (1
– p). In this set up, low output is an incontrovertible sign of shirking. If the firm
employs the worker at wage w, and if the worker supplies full effort so that
output is high, the payoffs (return) are (y – w) for the firm and (w – e) for the
worker. Thus, in limits, if the worker shirks, then emay tend to 0. Likewise, if
the output is low, y may tend to 0.
The equilibrium is attained by a concept called Sub-game Perfect Nash
Equilibrium. Under this, equilibrium is arrived at by a strategy called ‘backward
induction’. In the infinitely repeated game, the firm can induce effort by paying a
wage w in excess of 𝑤𝑜 (self-employed wage) and by threatening to fire the
worker if the output is low. We can show that, for some parameter values, the
firm finds it worthwhile to induce effort by paying a premium wage. Note that,
𝑤𝑜 is the reservation wage which is just enough to compensate the opportunity
138 cost of alternative employment (self-employment). It is also called the
 Labour Markets
participation constraint i.e. if the employer offers a wage below the reservation
wage (𝑤𝑜 ), the workers will never accept the wage offer. We can now consider
the following strategies in the game of offering wage w* >𝑤𝑜 over an infinite
game framework by the firm. We will say that the history of strategy is high-
wage, high-output if: (i) all previous offers have been w*, (ii) all previous offers
have been accepted, and (iii) all previous outputs have been high. The firm’s
strategy is to offer (w = w*) in the first period. In each subsequent period, it
offers w = w*, provided the history of the play is high-wage, high-output; w = 0
otherwise. The worker’s strategy is to accept the firm’s offer if w >𝑤𝑜 , choose
self-employment otherwise. His strategy is to supply the effort if the history of
the play is high-wage and high-output (shirk otherwise). So, when the firm offers
w* in the first period, it is optimal for the worker to accept since w* >𝑤𝑜 . If the
worker supplies effort (e), then the worker is sure to produce a high output.
Hence, the firm will offer w* again in the next period with the worker facing the
same effort-supply decision. This cycle is repeated in an infinite time horizon
framework.
The above strategy is called the ‘trigger strategy’. Under this, the firm will
adopt a cooperative strategy i.e. to offer a wage contract of w = w*, provided that
all previous play has been cooperative i.e. firm realized an output of y (as the
workers are likely to put an effort e). But the firm will switch over to a wage
contract of w = 0, should the cooperation ever break down (i.e. y = 0 for e = 0).
The worker’s strategy is also analogous to the trigger strategy. This means the
worker too adopts a strategy of playing cooperatively provided all previous play
has been cooperative (i.e. for effort = e, the realised wage return is w = w*).
However, if w < w* but > wo, (i.e. w0<w<w*), then the worker accepts the firm’s
offer but shirks. The conditions under which these strategies results in an
equilibrium strategy can now be derived as follows.
Let 𝑉𝑒 be the present value of the worker’s payoff (when he is putting effort) and
𝛿 be the inter-temporal discount rate. Thus, if it is optimal for the worker to
supply effort, then the present value of the worker’s payoffs over the indefinite
time horizons is as follows:
𝑉𝑒 = (𝑤 ∗ − e) + 𝛿(𝑤 ∗ − e) ; t = 1
𝑉𝑒 = (𝑤 ∗ − e) + 𝛿(𝑤 ∗ − e) + 𝛿 2 (𝑤 ∗ − e)2 ; t = 2
𝑉𝑒 = (𝑤 ∗ − e) + 𝛿(𝑤 ∗ − e) + 𝛿 2 (𝑤 ∗ − e)2 + 𝛿 3 (𝑤 ∗ − e)3 ; t = 3
…………………………………………………………………
…………………………………………………………………
𝑉𝑒 = (𝑤 ∗ − e) + 𝛿(𝑤 ∗ − e) + 𝛿 2 (𝑤 ∗ − e)2 + 𝛿 3 (𝑤 ∗ − e)3 + ⋯ … … … ….; t =
∝
(𝑤 ∗ −e)
𝑉𝑒 = (𝑤 ∗ − e) + 𝛿𝑉𝑒 where𝑉𝑒 = 1−𝛿

139
Land Labour and If the worker shirks, then the worker will produce high output with probability
Credit Markets
p. In this case, the same effort-supply decision will arise in the next period. If
the worker produces low output with probability (1 – p), the firm will offer w = 0.
This means, the worker is fired and will be self-employed thereafter. Thus, if it is
optimal for a worker to shirk, then the (expected) present value of the worker’s
payoffs (𝑉𝑠 )in two periods is:
𝑤
𝑉𝑠 = 𝑤 ∗ + 𝛿 [𝑝𝑉𝑠 + (1 − 𝑝) 1−𝛿
𝑜
]
(1 − 𝛿)𝑤 ∗ + 𝛿(1 − 𝑝)𝑤𝑜
𝑉𝑠 =
(1 − 𝛿𝑝)(1 − 𝛿)
Selecting the optimal effort level for a worker, therefore, involves comparing the
lifetime utility when shirking with the lifetime utility when not shirking. Thus, it
is optimal for the worker to supply effort if the payoff from putting effort exceeds
the payoff from shirking (𝑉𝑒 > 𝑉𝑠 ). Hence:

(𝑤 ∗ − e) (1 − 𝛿)𝑤 ∗ + 𝛿(1 − 𝑝)𝑤𝑜

>
1−𝛿 (1 − 𝛿𝑝)(1 − 𝛿)
(1 − 𝛿)𝑤 ∗ 𝛿(1 − 𝑝)𝑤𝑜
(𝑤 ∗ − e) > +
(1 − 𝛿𝑝) (1 − 𝛿𝑝)
(𝑤 ∗ − e)(1 − 𝛿𝑝) − (1 − 𝛿)𝑤 ∗ >𝛿(1 − 𝑝)𝑤𝑜
𝑤 ∗ (1 − 𝛿𝑝) − 𝑒(1 − 𝛿𝑝) − (1 − 𝛿)𝑤 ∗ > 𝛿(1 − 𝑝)𝑤𝑜
𝑤 ∗ (1 − 𝛿𝑝 − 1 + 𝛿) > 𝑒(1 − 𝛿𝑝) + 𝛿(1 − 𝑝)𝑤𝑜
𝑤 ∗ 𝛿(1 − 𝑝)>𝛿(1 − 𝑝)𝑤𝑜 + (1 − 𝛿𝑝)𝑒
𝑒(1−𝛿𝑝)
𝑤 ∗ > 𝑤𝑜 + ………...(A)
𝛿(1−𝑝)

Thus, Efficiency Wage = Reservation Wage (defined by the participation

constraint) + Wage premium (defined by the incentive compatibility constraint)
Therefore, to induce effort, the firm must pay not only the reservation wage
( 𝑤𝑜 ) 𝑖. 𝑒. compensate the worker for the foregone opportunity of self-
employment and for the disutility of effort, but also pay a wage premium of
(1+𝛿)
). Naturally, if p is near one (i.e., if shirking is rarely detected), the wage
𝛿(1−𝑝)
premium must be extremely high to induce effort. On the other hand, if p = 0,
then it is optimal for the worker to supply effort if:
𝑒
𝑤 ∗ > 𝑤𝑜 + 𝛿 ………….. (B)

The RHS of (B) is lower than (A). Thus, in order to induce the worker to put his
effort, the firm has to offer higher 𝑤 ∗ in (A) i.e. when 0 < 𝑝 < 1 as compared to
(B) i.e. the case where p = 0. Thus, in equilibrium, firms have neither any
incentive to raise wages (workers provide effort e, and firms can hire all labour
they want at w∗); nor to lower wages (as lower wages imply shirking and losses).
Job seekers strictly prefer work to self-employment or unemployment. They
140
 Labour Markets
would be happy to work at w∗ or lower but cannot credibly commit not to shirk at
w <w∗ and are thus not hired.
Key Results: Key results that flow from the above analysis are: (i) presence of
involuntary unemployment, and (ii) wage rigidity (i.e. wage cuts by individual
firms will only become attractive as the unemployment pool gradually grows).
From the welfare perspective, this means: (i) equilibrium in the shirking model
is not Pareto efficient, (ii) sources of inefficiency i.e. each firm employs too few
workers because it faces the private cost of hiring with w∗level of wages rather
than the social cost level i.e. e < w∗,(iii) there are negative externalities i.e. each
hiring firm raises Vu (voluntary unemployment) for all other firms and
consequently (iv) unemployment is inefficiently high. With a simple and
sensible set of assumptions (workers choose effort, firms cannot monitor them
costlessly), this theory can potentially explain a key set of stylized facts that the
competitive paradigm could not address. Hence:
 it became very influential generating a huge amount of literature;
 it introduced into labour economics a set of tools that feature prominently in
job search models; and
 has the limitation that individuals being ‘rational cheaters’ can only be
motivated by carrot (wages) and stick (firing).
Alternative efficiency wage models offer similar predictions but with different
assumptions on human behaviour.

Check Your Progress 2

1) State the crux of the Efficiency Wage Theory.
2) What is a limitation of the Efficiency Wage Model?

7.5 POVERTY, NUTRITION AND LABOUR

MARKETS
Labour markets generate income and create the principal potential source of
nutrition and good health. The relationship between nutrition and the capacity to
perform productive work is indicated by the capacity curve. Fig.7.3 shows the
capacity curve where the X-axis represents income and the Y-axis plots the work
capacity. Here, we assume that all the income is spent on nutrition. It shows work
capacity as a measure of the number of tasks an individual can perform during

141
Land Labour and the period under review. The curve, therefore, links different nutrition levels to
Credit Markets
the corresponding levels of work capacity generated by the individual.

Fig. 7.3 The Capacity Curve

Most nutrition initially goes into maintaining the body’s resting metabolism
leaving little energy for productive work. So, work capacity in this region is close
to zero and does not increase quickly as nutrition levels change. Once resting
metabolism is taken care of, there is a marked increase in work capacity. With
nutrition as an additional input, it triggers productivity. Finally, there is a phase
of diminishing returns, as natural bodily limits restrict the conversion of
increasing nutrition into ever-increasing work capacity. Hence, the curve is a
right inclined S shaped.

7.5.1 Basic Model with Piece Rates

We first consider a labour market where piece rates are paid. Here, there is a
two-way relationship between income and work capacity i.e. it a relationship
between the number of tasks performed and total income (Fig.7.4). Let us now
superimpose Fig.7.3 on Fig. 7.4 to get Fig.7.5. Four different piece rates, v1, v2,
v3 and v4, are shown in Fig. 7.5. The curve v1 shows that a person gets paid v1
rupees for every bushel of crop harvested. Therefore, v1 is larger than v2,v2 is
larger than v3, which in turn exceed v4. Now suppose that a labourer tries to
obtain the highest possible level of income that he can possibly earn, given the
constraints imposed by his capacity curve. Suppose, the going piece rate is v1.
He will clearly choose point A, which yields the largest possible feasible income.
As the piece rate drops to v2, his maximum income falls. On the graph, it now
slides down to point B, which involves less total work and lower income. At v3
(just tangent to the capacity curve along with its hump), he can just choose point
C. If the piece rate drops a little more, then the amount of work that he can
supply drops dramatically, jumping, as it were, from a point like C to a point like
D (which is the intersection of the lowest piece rate with the capacity curve). It
means that low levels of nutrition permit only very low levels of work, and
moderate to high levels creates a

142
 Labour Markets

Fig. 7.4: Piece Rate Payment

Fig. 7.5: Piece Rates and Work Effort

rapid increase in work capacity. We can use all this information to generate a
supply curve of labour by multiplying the individual labour supply by the number
of labourers like him in the economy. It shows different levels of labour-power
supplied at different piece rates. Fig. 7.6 shows the transition from individual
labour supply to aggregate labour supply. Its left-hand panel shows the labour
supply by simply transplanting the information gleaned from Fig. 7.5. The gap in
labour supply at the piece rate v3 captures our previous discussion that after a
certain threshold wage, the labour supply of a worker must jump discontinuously.
The right-hand panel effectively multiplies this individual supply curve by the
number of labourers. Two things happen. First, the horizontal axis gets blown up
by the number of labourers. Second, the meaning of dots used to fill the gaps will
become clear in the discussion ahead on equilibrium.

143
Land Labour and
Credit Markets

Fig.7.6: Individual and Aggregate Labour Supply

Equilibrium: Let us now introduce a demand curve for labour which is
downward sloping. Fig. 7.7 shows the demand and supply curves on the same
diagram. Two cases are of interest. In the first case, represented by the left-hand
panel of the figure, the demand curve for labour cuts the supply curve at a point
that is beyond the gap in the supply curve. This case is perfectly normal since the
market determines an equilibrium piece-rate v*. Everybody gets to supply a
“high” level of work effort i.e. a level of work effort that is somewhere on the
hump of the capacity curve for each labourer. The market clears in a standard
fashion.
The case represented by the right-hand panel is different. Here, supply is large
relative to demand so that the demand curve passes through the dotted gap in the
aggregate supply curve. Here, we have a problem with determining the
equilibrium piece rate. If the rate is larger than v*, we have excess supply which
brings the piece rate down. On the other hand, for piece rates below this critical
level, there is excess demand. So, wages are bid up. However, note that a piece
rate of exactly v* can be thought of as an equilibrium, provided we admit the idea
of unemployment.

Fig.7.7: Equilibrium in the Labour Market

144
 Labour Markets
Just as in Figure 7.6, we can “fill in” the gap in the aggregate supply curve by
having some people work and restricting labour market access to others. This
unemployment is involuntary in the sense that unemployed people are strictly
worse off than those who are lucky to find employment. However, the piece rate
cannot be bid down because no one can “credibly” supply the same amount of
labour at any lower piece rate. We thus see that the vicious cycle is complete in
this model. Lack of labour market opportunities makes for low wages. However,
it is not only the wages which determine the work capacity: a low capacity to
work feeds back on the situation by lowering access to labour markets.

7.5.2 Nutrition, Time and Casual Labour Markets

Paul Rosenstein-Rodan observed that one of the fundamental features of labour
markets that lack contractual structure is its neglect of beneficial externalities.
The example that he cites is on-the-job training. Firms that impart on-the-job
training to their workers not only contribute to their own profits but raise the
level of skills and proficiency throughout the economy. However, firms fail to
capture the entire benefit of their training activities since workers might change
jobs leading to an externality. If the firm incurs such training expenses, it would
also like to reap some gains. Although Rosenstein-Rodan focused on training,
their perspective apply equally to the nutritional status of workers who supply
labour in the casual market with no regulations or safeguards. Well-nourished
workers are of long-term advantage to their employers, provided there is some
way to guarantee that such workers remain with the employer. In the absence of
such guarantees, the collapse of nutritional status in a poor rural labour market
can be comprehensive. The curse of a casual labour market is especially harsh in
developing countries. In order to make sure that firms recoup their investments,
there must be restrictions on labour movements. Such restrictions have their own
costs.

7.6 A MODEL OF NUTRITIONAL STATUS

Partha Dasgupta and Debraj Ray, two economists who have worked on the
economics of nutrition, offer a theory regarding the relationship between
nutritional intake and work effort. At low levels of nutritional-intake, there is a
positive relationship between a person’s nutrition status and his ability to
function. Thus, a person’s consumption-intake affects his productivity. The
central idea is that unless an economy in the aggregate is richly endowed with
physical assets, those without assets are vulnerable in the labour market. Potential
employers find the latter attractive because, in effect, they are cheaper workers. If
the distribution of assets is highly unequal, even competitive markets are
incapable of absorbing the entire labour force. The assets are too expensive to
employ in their entirety. The theory provides a link between persistent
involuntary unemployment and the incidence of undernourishment. It does this
145
Land Labour and by relating the production and distribution of income to the distribution of assets.
Credit Markets
Its basic framework is as follows.
Work capacity or labour-power 𝜆 is nil until a threshold level of consumption, 𝐼 ∗ ,
the resting metabolic rate (RMR). 𝜆(I) is an increasing function beyond 𝐼 ∗ . But it
increases at a diminishing rate, indicating a concave function (Fig. 7.8).

Fig.7.8: Work Capacity and Consumption

A worker’s current nutritional status, and therefore his ability to carry out
sustained work, depends not only on his current consumption of nutrients but also
on the history of that consumption (Fig. 7.9). The curves marked A and B are
capacity curves corresponding to distinct nutritional histories. Observe that work
capacity varies with current nutrition (shown by the upward slope of the curve for
any given history). However, it is also affected by past nutrition (leading to
distinct curves of the form A and B). The nutritional intake is assumed to be a
scalar variable such as calories consumed by an individual. This is divided
between maintenance of the body and physical activity of various types.

Fig. 7.9: Nutritional History and the Capacity Curve

Let xt denote the energy intake of the individual at time t, rt the resting metabolic
rate, qt the energy expended on physical activity and bt the energy released from
(or stored in) the body. Neglecting losses due to the inefficiency of energy
metabolism, we can write the fundamental energy balance equation as:
xt = rt + qt + bt
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 Labour Markets
There are interconnections between these variables. Nutritional status is the state
of an individual’s physical health at any time. It varies from time to time
depending on the stresses he is subjected to and his access to nutritional inputs.
We can equate it to body mass m. The value of m decreases when energy is
borrowed from the body; its storage increases it. We can represent this
schematically as
Given mt → higher bt → lower m t+1.
The two equations above represents the trade-off to an employer who hires this
individual. The employer pays a wage which the individual uses to buy nutrition
x. The employer also dictates the pace of work, which affects m. For a fixed
wage, the higher he pushes the requirements of work, the greater will be the
amount of borrowing from the body, and the lower will be the next period’s
nutritional status. For a given genotype, resting metabolism is related positively
to body mass. Therefore, a lowering of body mass brings down resting
metabolism r. A lowering of r creates extra elbow space in the energy-balance
equation (equation 1) i.e. the body eats up less for resting metabolism. It can use
this extra energy more “efficiently” for work. This is therefore the resting
metabolism effect. Lower nutritional status (in terms of increased susceptibility
to illness, physical breakdown, disease, and death) cannot be ignored from a
social point of view. This is despite how efficient the adaptation appears from an
economic point of view. Greater physical health and strength, on the other hand,
enables the individual to carry out tasks that an undernourished person finds it
difficult or impossible to do. In other words, better nutritional status increases
work capacity. This therefore is the capacity effect. Putting together the two
effects we get the net outcome. For a given amount of borrowing, the capacity
curve of a person with lower nutritional status has a tendency to shift upward.
Because of the resting metabolism effect, more energy can be channelled into
work. At the same time, the increased energy available for work can be used
better by a better-nourished person, especially at high ranges of work output (due
to the capacity effect). Thus, it is reasonable to postulate that at low work levels,
the former effect dominates so that the capacity curve shifts down with better
nutritional status. In contrast, at higher work levels, the opposite occurs.
We therefore can interpret curve B as corresponding to a better nutritional status.
If an employer can choose between creating the nutritional status of A and B, he
would choose the one with low levels of nutrition. It is because the resting
metabolism effect dominates and the employer actually benefits from hiring
undernourished people. This is especially so if the tasks involve severe manual
labour with a dominance of the capacity effect. It is more likely that the
employer would prefer to sacrifice some current output from his employee and/or
pay a higher wage (thus increasing xt). This however requires that the employee
will be around tomorrow to allow the employer to reap the benefits of this
investment.
147
Land Labour and There are two problems that arise in casual labour markets. First, because
Credit Markets
employment is casual, the employee may not physically be present for the next
period. He may work for a different employer or might migrate. Under these
circumstances, the employer would be reluctant to do the investment. Second, if a
person in good health can be identified by other employers, the market will bid
up the wage rate for such an employee. This essentially means that the employer
must reap the entire benefit of the employer-financed investment in the form of a
higher wage. If this is the case, then why undertake the investment in the first
place? Note that this problem can be overcome if the employer and employee
were to sign a contract that requires the employee to work for the current
employer in the future as in the case of permanent employment.
The implication is that the casual labour market generally fails to improve the
nutritional status of workers. This process makes the employers worse off
because they have to hire workers of inferior nutritional status. This raises their
labour costs even in the short run since the capacity effect dominates the resting
metabolism effect. This is a classic case of a prisoner’s dilemma i.e. casual
markets create nutritional externalities that everybody ends up paying for
(employees through their bad nutritional status and employers through the hiring
of inefficient labour). The observation that nutritional status is degraded in the
presence of casual labour markets is strengthened if the ability to adapt (by a
decrease in resting metabolism) is heightened. The greater the resting metabolism
effect, less is the need for employers to raise wages.

7.7 LET US SUM UP

In this unit, we studied the labour markets specifically in the context of
developing countries. We saw that labour markets also act as a device to manage
the mismatch between demand and supply of labour. In the casual labour market,
labour is hired for small tasks that do not require much observation. The
efficiency wage theory explains why firms prefer to pay higher wages when they
can hire employees at a lower wage. This is because wage cuts are often
accompanied by a reduction of efforts by the employees reducing efficiency. The
neoclassical model of wage determination is the shirking model of wage
efficiency. This model uses Sub-game Perfect Nash equilibrium to determine
efficient wages. An efficient wage being the sum of reservation wage and wage
premium, in equilibrium, the firms do not increase or decrease wages. The job
seekers too strictly prefer work over unemployment or self-employment. The two
outcomes of this theory are involuntary unemployment and wage rigidity. There
is a close relationship between poverty, nutrition and labour markets. The main
premises of this discussion are: (i) the work capacity of labour affects the income
they receive and (ii) their income, in turn, affects their work capacity.

148
 Labour Markets
7.8 HINTS TO CHECK YOUR PROGRESS
EXERCISES
Check Your Progress 1
1) Decent work, youth unemployment, environment.
2) At the point where the supply and the demand curves intersect.

Check Your Progress 2

1) It states that if productive efficiency of workers depends on wages, a wage
cut will result in a drop in worker’s efficiency.
2) It does not explain why higher wages lead to lower labour costs.

149
Land Labour and
Credit Markets
UNIT 8 CREDIT MARKET
Structure
8.0 Objectives
8.1 Introduction
8.2 Characteristics of Credit Markets
8.3 Demand for and Supply of Credit
8.3.1 Demand for Credit
8.3.2 Supply of Credit
8.4 Size and Structure of Indian Credit Market
8.5 Imperfect Information and Formal Credit Market
8.5.1 Adverse Selection
8.5.2 Ex Ante Moral Hazard
8.5.3 Ex Post Moral Hazard
8.6 Imperfect Information and Informal Credit Market
8.6.1 Lender’s Risk Hypothesis
8.6.2 Default and Fixed Capital Loans
8.6.3 Default and Collateral
8.6.4 Default and Credit Rationing
8.6.5 Default and Enforcement
8.7 Policies on Credit
8.7.1 Vertical Formal-Informal Links
8.7.2 Microfinance
8.7.3 Grameen Bank
8.8 Inter-linkages among Rural Factor Markets
8.9 Let Us Sum Up
8.10 Hints to Check Your Progress Exercises

8.0 OBJECTIVES
In this Unit, we highlight the characteristics, size and structure of the credit
market. We will then look at the profile and properties of buyers and sellers,
especially in the case of rural credit markets. The Unit also provides some
insights into different sources of credit. It further provides a deeper
understanding of the informational problems and credit contracts followed by
policies related to credit markets. The last section tries to link the credit market
with other rural factor markets, i.e., land and labour.


Contributed by Ms. Mamta, Research Scholar, CSRD, JNU, New Delhi
150
After going through this unit, you will be able to: Credit Market

 appreciate the significance of credit for resource constraint developing

economies;
 identify the reasons for the non-availability of formal credit to the poor
despite high demand;
 explain why the poor end up paying high interest on their loans;
 describe credit rationing and the role of imperfect information in the rural
credit market (adverse selection, moral hazard);
 describe the role of joint liability lending, positive assortative matching, and
other features of microcredit contract; and
 explain the Inter-linkages between rural factor markets and the supply of
credit.

8.1 INTRODUCTION
Economic theories have emphasized the positive association between access to
financial services and economic growth and development. Access to financial
services is intermediated by financial institutions such as banks. Development of
financial instruments, markets and institutions ameliorate the problems of
information, enforcement and transaction costs. In an economy, how effectively
the financial system reduces the information, enforcement, and transaction costs
will influence the (i) savings rate, (ii) investment decisions, (iii) technological
innovations, and (iv) growth rate.
In a credit-starved developing economy, financial intermediaries actually bridge
the gap between supply and demand, thereby boosting economic activity,
productivity, and growth. However, the performance of formal sector lending to
the poor is rather depressing in terms of penetration, outreach, targeting, and
repayment rates.
Poor economies are characterized mainly by seasonal fluctuations of income,
poor asset base, and savings base. Credit is critically essential in such resource
constrained rural economy because the accessibility of credit from the formal
sectors is highly skewed in the absence of collateral.
We describe below the importance of credit in an under-developed economy.
 Credit market serves as intermediation between the lenders and the
borrowers. Credit market thus affects output, investment, technology choices
and inequality. It is critically important for capacity expansion (by means of
financing working capital and investment in fixed capital), particularly
among poor farmers.
 The importance of credit lies in the fact that many economic activities
(production) are spread over time. For example, when a farmer invests today, 151
Land Labour and (s)he realises returns during harvest. Moreover, people’s income is subject to
Credit Markets
large seasonal fluctuations (e.g., farmer’s income due to uncertain monsoon;
or probability of losing job due to informal job contracts; etc.). The credit
market plays a great role in smoothening consumption. Moreover,
unwarranted events such as illness or wedding in the family often create a
pressing need for credit. Apart from the intrinsic benefit of being able to
withstand such shocks, the availability of credit largely reduces the inertia to
adopt better technologies and help individuals raise mean levels of income
and undertake moderate risk.
 One of the stylized facts about a poor rural economy is credit rationing. It is a
situation when borrowers are unable to borrow an adequate amount (or some
borrowers are unable to borrow at all) due to lenders’ inhibition to supply
credit at the ongoing interest rate. It is particularly the case where formal
sector credit is rationed because poorer households lack sufficient assets to
put up as collateral for borrowing – a usual prerequisite for bank lending. A
significant fraction of credit transactions in underdeveloped countries occurs
in the informal sector (local moneylenders), despite serious government
efforts to channel credit directly via its own banks or by regulating
commercial banks. On an average, interest rate in the informal sector is much
higher than the interest rate in the formal sector; also it shows significant
dispersion. Siamwalla et al. (World Bank Economic Review, 1990), in a
study of rural credit markets in Thailand, found that the informal sector
interest rate could be up to 60 per cent. In contrast, the formal sector rate
ranged from 12 per cent to 14 per cent. The credit market is usually highly
segmented, marked by long-term exclusive relationships and repeat lending.
There is frequent inter-linkage with other markets, such as land, labour or
production.
 Numerous case studies and empirical analyses in a variety of countries have
revealed that informal credit markets often display patterns and features not
commonly found in institutional lending: Credit markets are often subject to
market imperfections, where loans are often advanced on the basis of oral
agreements rather than written contracts, with little or no collateral. The two
crucial features that can disrupt its functioning are involuntary default and
voluntary default. The lender (who supplies credit) hands over an amount L
now, and the borrower (who demands credit) is supposed to repay an amount
L(1 + i) at a later stage, where ‘i’ is the interest rate. The borrower may be
unable to repay the loan resulting in involuntary default. There may be a
situation where the borrower strategically decides not to repay the loan. It is
known as voluntary default and often occurs when the legal system of the
credit market is weak. In developing countries, formal financial institutions
face ‘information asymmetry’ in the case of collateral-free loans. The loan
may be used for activities that involve high risk; it may also be invested in
152 activities involving zero or negative payoffs making strategic default an
 attractive option for a borrower. Because of the above problems, informal Credit Market

financial institutions are better equipped with information tracking and better
enforcement than the formal sector because of their local network.
The stylized features of the credit market of a rural economy will be discussed in
detail in the subsequent sections.

8.2 CHARACTERISTICS OF CREDIT MARKET

 We find that rural credit markets are not perfectly competitive and do not
function smoothly. Interest rate is not determined by the simple
interaction of demand for and supply of credit. This section highlights the
characteristics of the credit market.
 Informational Constraints: This is the fundamental feature that creates
imperfections in credit markets. Information asymmetry is rooted in the fact
that the lender is unaware of the intrinsic characteristics of the borrower – the
lender does not know whether the borrower will use the loan optimally and
repay it at the end of the loan cycle or default at the end of loan cycle. Such
problems in information economics are called the adverse selection problem.
There is another problem in information asymmetry called the moral hazard
problem due to the hidden action of the borrower. The lender has limited
knowledge about the incentives that motivate the borrower to default.
Lenders face two forms of informational gaps: lack of information regarding
(i) how the loan will be utilised by the borrower, and (ii) repayment decision
of the borrower.
 Segmentation of Markets: One of the characteristics of the rural credit
market is its tendency toward segmentation. In many cases, credit
relationships (informal in nature) are personalised. A moneylender in a rural
area does not serve all; he usually serves a limited number of clients and lend
them on a regular basis. These relationships build up over time. The clients
usually belong to the lender’s village or areas close to his village. The
moneylender, therefore, has information about the borrowers and their
activities. Repeat lending is a common practice, i.e., moneylender lends to
borrowers who have been taking loans from him/her in the past.
 Inter-linkage of Markets: Inter-linkage (interlinked credit transactions) is
related to segmentation of markets. When you approach a formal financial
institution (a commercial bank, for example), it scrutinises your request
independent of other issues such as personal acquaintance, social hierarchy,
etc. A majority of moneylenders in rural areas constitute wealthy landlords,
traders dealing in crops, shopkeepers, etc. Thus, segmentation often takes
place along occupational lines and promotes the complementarity of some
production relationship (tenant and landlord or shopkeeper and customer) and
credit relationship. This inter-linkage of different markets makes rural credit
markets very different from the impersonal, independent market structure. 153
Land Labour and  Interest Rate Variation: Informal credit markets are characterised by great
Credit Markets
variations in interest rates. The interest rates may vary by geographical
location, sources of funds, and even the characteristics of the borrowers. The
absence or extremely low levels of interest rate could be misleading.
Sometimes the interest rate may be hidden in other features of the overall
deal. It happens because of the interlinked nature of markets. For example, a
trader may provide a loan to a farmer at a lower interest rate but buys the
farmer’s output at a lower price. Another example is the implicit lower wage
at which a labourer is expected to work in exchange for an interest-free loan.
The lender takes into account different types of information about the
borrower before deciding to lend. Thus, the rate at which a landlord lends to
client A from village X may not be the same rate at which he is willing to
lend to client B from village Y.
 Rationing: In informal credit markets, there is a system of rationing which
limits the amount of money that a borrower can borrow from a moneylender.
It is quite apparent that a moneylender will not lend an infinite amount of
money. However, in this case, rationing means that at a given interest rate,
the borrower would like to borrow more but cannot. Another form of
rationing is when a lender does not lend money to certain borrowers even if
they want to borrow. In other words, some borrowers are excluded from
credit transactions. It is connected with the ‘segmentation of credit market’.
 Exclusivity: The borrowers might use different sources for lending money
that the moneylenders do not like. Therefore, one of the crucial characteristics
of the credit market is exclusivity. A moneylender would want the borrowers
to deal with him only and nobody else for supplementary loans. Because of
segmentation and inter-linkage, it is difficult to get an idea of overall
competition in an informal credit market by simply looking at the number of
active borrowers and lenders. “Despite the overall background of the
competition, particular dealings are often (though not always) bilateral,
informational and locational. Historical advantages often lead to the creation
of a “local monopoly” of the money lenders”.

8.3 DEMAND FOR AND SUPPLY OF CREDIT

Demand for credit comes from those who need more liquid money than what is
available to them. Supply of Credit (either directly to borrowers or offered
through banks) comes from those who have more liquid money than they need.

8.3.1 Demand for Credit

Credit is demanded for different types of activities. The demand for credit can
broadly be put under three categories.

154
a) Fixed Capital – Credit is demanded for starting new businesses or expanding Credit Market

the existing production lines. Fixed capital is required for purchase and repair
of durable inputs like machines, factories and warehouses.
b) Working Capital – Credit is demanded for supporting the ongoing
production activity. The need for credit can arise because of substantial time
lag between the investment required for production and sales receipts. For
example, a trader who buys crops from farmers might give some money (in
the form of credit) to purchase inputs like seeds, fertilisers, pesticides, etc.
Credit advances are deducted from the price that the trader will pay while
purchasing the crops produced.
Consumption Credit – This type of credit is usually demanded by poor
individuals mainly for consumption smoothing. Individuals may need money
either because of sudden downturns in their production or a sudden decrease in
the prices they get for their produce. Individuals engaged in seasonal work may
need credit to meet consumption during out of work season. They might also
need credit for catastrophic expenditure due to illness, death or festivities like
wedding. The demand for consumption credit forms the basis for the demand for
insurance. A group of individuals who face sudden loss (due to, for example,
crop failure, theft, fire or illness) can create demand for insurance.
Market for fixed capital is crucial for the overall growth of an economy, but
markets for working capital and consumption expenditure are equally important
for a poor agrarian economy. These are important for the agriculture sector
mainly because of the seasonality factor and the low incomes of the stakeholders.
For instance, a farmer may need working capital at the beginning of the crop
cycle for purchasing various inputs. It is difficult for small and marginal farmers
to bear the combined cost of all the inputs, and hence they need credit. The loan
is repaid after the crop is harvested and sold. This process usually happens
repetitively with every crop cycle. Agriculture also has uncertainty attached to
the production process. A crop failure or drop in prices of crops in the market due
to over-underproduction can create temporary hardships. Moreover, the peasants
or landless labourers might face fluctuations in their earnings over the year. They
attempt to smoothen such fluctuations in income by resorting to credit.

8.3.2 Supply of Credit

Credit is primarily supplied from two sources: (i) formal or institutional source,
and (ii) informal source. The informal source caters to the credit needs of a large
segment of the population that remains outside the ambit of the formal lending
institutions. We discuss below the features of formal and informal suppliers of
credit.
a) Institutional/Formal Lenders: This category includes formal lenders such
as government and commercial banks, credit bureaus, or co-op society banks.
Some other sources of formal credit include insurance and provident fund 155
Land Labour and agencies, financial co-operatives, and financial companies. Apart from these,
Credit Markets
special banks are also set up in developing countries like Thailand,
Bangladesh, India and the Philippines to cater to the needs of the rural
population. Formal credit agencies, however, have certain limitations. They
often lack ground-level information about the characteristics and activities of
their customers. They cannot monitor how the loans granted by them are
being used. The borrower might not use the money for the purpose for which
the loan was taken or may invest the money into more risky production
processes. Furthermore, the borrower in the absence of collateral has limited
liability. Limited liability means that the borrower cannot be held responsible
for the repayment of the debts if their project fails or the borrower declares
bankruptcy. It incentivises the borrower to take too much risk since he/she
does not have any legal obligation to repay the loans if the project fails. This
is one important reason why institutional lenders discriminate against poor
borrowers and prefer rich borrowers, who can always support their credit
demand by providing collateral. In case of default, the creditor has the option
to confiscate the collateral to make up for the losses. Further, taking a loan
from a formal institution requires a lot of paperwork, which an illiterate or
semi-literate landless labourer may not be able to fulfil. These procedures
lead to high transaction costs in the case of formal credit.
b) Informal Lenders: Poor borrowers do not have the type of collateral
required by formal lending agencies for providing a loan. For instance, a
labourer might have his labour as the only option to provide as collateral.
Informal lenders may be willing to provide the credit by accepting a non-
standard form of collateral. An employer who needs labour for his farm will
accept the labour of an individual as collateral. This is why formal lenders
fail to reach the poor borrowers, whereas informal moneylenders do a much
better job. Given their local proximity, informal money lenders have better
access to information about the borrowers, the activities they are involved in,
and their credit history.
‘Credit rationing’ and high transaction cost by the formal institutions to obtain
credit push the borrowers towards informal sources. The informal sector includes
a wide range of lenders like relatives, friends, landlords, credit co-operatives,
traders, and other agents who have lending as their side business. Different
characteristics of informal lenders such as proximity and accessibility, their
relationship with the borrowers, and the limited access to formal credit markets,
along with complicated procedures of getting formal sector credit, explain the
significance of informal credit markets, especially in rural areas.
According to the All India Debt and Investment Survey (AIDIS), 2019 by the
National Statistical Office (NSO), there is a rise in the incidence of indebtedness
of rural households. About 35 per cent rural households are indebted with an
average outstanding debt of Rs. 59,748. Informal sources of credit accounted for
156 34 per cent of rural and 13 per cent of urban credit in 2018.
Check Your Progress 1 Credit Market

Note: i) Use the space given below for your answers.

ii) Check your progress with those answers given at the end of the unit.
1) Differentiate between voluntary and involuntary default in repayment of debt.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) What are the different types of demand for credit?
………………………………………………………………………………….
…………………………………………………………………………………

3) What is meant by rationing in the credit market?

………………………………………………………………………………….
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…………………………………………………………………………………

8.4 SIZE AND STRUCTURE OF INDIAN CREDIT

MARKET
The credit market has undoubtedly played a significant role in addressing the
financial needs of various sectors in the Indian economy. There have been major
structural changes in the credit markets in India, especially in the rural credit
markets. This section briefly explains the size and structure of the Indian credit
market and its evolution over the years. The current structure of the credit market
consists of different financial institutions like commercial banks, regional rural
banks (RRBs), urban, state and district cooperative banks, primary agriculture
credit societies (PACS), state co-operative and agricultural rural development
banks (SCARDBs) primary co-operative and agricultural rural development
banks (PCARDBs), financial institutions (FI), and non-banking financial
companies (NBFCs). Among these, the scheduled commercial banks are an
important segment of the Indian credit market. The urban co-operative banks are
crucial in meeting the requirements of urban and semi-urban regions of the
country, whereas rural co-operatives cater to the needs of the rural and
agriculture sector. Apart from banks, financial institutions also play an important
role in addressing the long-term capital needs in the Indian economy. Other non-
banking financial companies include asset finance companies, loan companies,
and investment companies.
Before the introduction of the large scale financial reforms in the 1990s, the
Indian credit market was highly regulated with various credit controls. The
market was characterized by high segmentation and limited competition,
resulting in various inefficiencies. Despite the existence of a formal credit market
in India, rural credit requirements were met largely by the informal credit market. 157
Land Labour and There have been various initiatives like the introduction of cooperative credit
Credit Markets
societies and state partnerships in these societies during the period 1955-1969.
These co-operatives, however, failed to expand their reach in the rural credit
markets, further impacting the quality of lending. This directed the policymakers
to consider the role of commercial banks in the rural credit market. The next
major change, therefore, was the nationalisation of private banks in 1969 and
further setting up rural branches of commercial banks in rural areas. A large
number of Regional Rural Banks were also set up in the 1970s. During 1960s and
1970s (which was also the period of green-revolution), a ‘multi-agency approach’
was adopted in order to ensure the increasing requirements of credit in the
agricultural sector (rural areas) and create competition for informal moneylenders
(Ray 2019). This was also accompanied by the establishment of the National
Bank for Agriculture and Rural Development (NBARD) in 1982. The main
objective was to expand the flow of credit and maintain efficiency in rural areas.
The policies introduced in rural credit markets since 1980s were more focused on
targeting the marginalised sections of society who are left out of the formal credit
system, giving a greater emphasis on ‘priority lending’. One such example is the
introduction of a pilot programme – Self Help Group-Bank Linkage program
(1992), to ensure credit availability to the low-income female members of the
rural Self Help Groups. The programme has expanded since then to include other
target groups such as small farmers, landless labourers, artisans, craftsmen and
small businesses. Self-help Groups (SHGs) and Micro-Finance Institutions
(MFIs) are two major components of the microcredit model in India. Apart from
this, the Kisan Credit Card (KCC) scheme was introduced in 1998 to address the
day-to-day liquidity requirements of the farmers.
The Indian credit market has evolved over time to provide adequate credit
facilities to the rural sector (especially the agricultural sector). There has also
been a rise in the availability of credit in these sectors. Inadequate access to
formal credit still remains a major concern in many rural regions. Furthermore,
an increase in formal credit facilities could not keep pace with the increasing
demands of credit in rural areas. According some researchers, issues like credit
rationing and high transaction costs associated with the formal lending
institutions led to a shift towards informal sources of credit. Other issues
responsible for increasing informal credit markets include inadequate and
untimely credit, lack of motivation among the staff in rural banks and procedural
delays.

8.5 IMPERFECT INFORMATION AND FORMAL

CREDIT MARKET
In the classical models, we assume that markets are perfect. An implication of the
above is that there is perfect information about a transaction in the market. In the
rural credit market, we find that there is asymmetry in information. The borrower
knows everything about the lenders, particularly formal lending institutions such
158 as banks. The lender, on the other hand, does not have complete information
about the borrower. For example, bank is not fully aware of the risk involved in Credit Market

the project chosen by the borrower and the level of effort the borrower will put
into the project. This sort of scenario is called information asymmetry.
Let us try to formalise this issue in a credit transaction. We consider two agents:
a borrower and a lender. The borrower has a project, but no money to finance it;
and she has to depend on the lender. Information related problems arise due to
the lender’s inability to verify either the borrower’s characteristics (e.g., nature of
the project and the risk involved) or the borrower’s effort in utilizing the loans on
the project for which the loan has been procured. Further, with infrequent
transactions, credit history and reputation are weak for the rural poor. The
absence of collateral and weak legal enforcement mechanism, coupled with
limited liability, often accentuates the problem. This information asymmetry can
be classified into three groups:
1) Adverse Selection: This is a problem due to the hidden characteristics of
borrowers. The lender may not have reliable information about the ‘quality of
the borrowers’ and their risk-taking behaviour (i.e., whether the borrower is a
good/safe or a bad/risky borrower). This issue was first highlighted by
George Akerlof in 1970 as the famous “market for lemons problem” (lemon
in this context means goods of poor quality). The information asymmetry is
due to the fact that transaction costs of monitoring the borrowers and
enforcement of legal actions may be costly.
2) Ex Ante Moral Hazard: This problem is due to the hidden actions of the
borrowers after the disbursal of credit and before the return of the project is
realized. This problem arises as a result of limited information and
uncertainties about the usage of borrowed money.
3) Ex Post Moral Hazard: This sort of problem arises due to the hidden actions
of the borrowers after the project starts giving returns. The lender may have
limited information about the size of the returns realized by the borrower. In
such a scenario, it is tempting for the borrower to under-report (i.e., report a
lower figure) the profitability of the project and announce a loss in order to
escape the repayment of a loan. The strategic default is an outcome in the
face of limited liability on the part of the borrower.

8.5.1 Adverse Selection

Banks face borrowers with potentially viable projects but are unable to
discriminate between good (i.e., safe) and bad (i.e., risky) borrowers. If borrower
types were known, the bank could charge different rates of interest from different
types of borrowers (relatively higher interest rate from risky borrowers for their
added risk of default). In the absence of such information, however, the bank has
to charge uniformly high-interest rate to everyone to compensate for the
possibility of having risky borrowers in the client pool. At this high interest rate,
however, good borrowers may not find it worthwhile to borrow, despite having 159
Land Labour and profitable projects. Thus, mostly risky borrowers approach the bank for a loan.
Credit Markets
This is the problem of adverse selection, which is essentially the lemons problem
in another guise. Hence, the credit market intervention by merely raising the
interest rate may not ensure efficiency. Stiglitz and Weiss (1983) highlight this
issue in details.
Example 8.1: Let us use a simple example to illustrate the idea. Consider a poor
economy consisting of 200 rational profit-maximising individuals, 100 good
(safe) and 100 bad (risky) borrowers. Each individual can invest Re 1 by
borrowing in a one-period project. A safe borrower has projects that yield a
return (𝑌1 ) of Rs 2 with certainty on investment of Re 1. Bad borrowers have
risky projects – an investment of Re 1 yielding a return ( 𝑌2 ) of Rs 4 with
1 1
probability 𝑝 = 2 and 0 with a probability (1 − 𝑝) = 2 . Hence, if the venture
succeeds, risky borrowers can earn a higher profit than safe borrowers (𝑌2 >𝑌1 ).
However, if the venture fails, risky borrowers earn zero and cannot repay the
loan. For simplicity, we have assumed that both types have identical expected
returns; i.e., the two types do equally well when returns are adjusted for risk
1
(2 𝑌2 = 𝑌1 ). Suppose for the banks an investment of Re 1 has an opportunity cost
of Rs = 1.8 (under competition, the return of Rs 1.8 is the break-even point of the
bank). This is equal to the full cost of raising money from depositors. Thus, a
bank would agree to give a loan of Re 1 to the poor, provided the expected return
is at least 1.8. Note that for any factor of interest, say 𝑥 < 2, the bank’s expected
1 1 1 3
return is ( 𝑥 + 2 . 2 𝑥 = 4 𝑥). From the break-even condition, this implies that 𝑥
2
3
must be at least 2.4 (that is, 4 𝑥 = 1.8, or𝑥 = 2.4). Since the bank cannot practise
price discrimination, the presence of risky borrowers in the mix causes the bank
to raise the interest rate. At such high-interest rate, however, the safe borrower
will not be interested in taking the loan. In fact, it is easy to show that the only
equilibrium involves the risky borrowers getting a loan. Thus, raising the rate of
interest may not bring efficiency. Hence, the lender’s lack of information on the
type of the borrowers (who can be good or bad) leads to a situation where the
lender may not find an interest rate that appeals to all creditworthy customers and
allows the bank to break even. This accentuates the problem of credit rationing
in a poor rural economy.

8.5.2 Ex Ante Moral Hazard

In a perfectly competitive market, a project is worthy of getting a loan if gross
project returns (net of all costs) exceeds the marginal cost of capital. Suppose,
however, that project success depends on the effort level of the borrower. In an
ideal situation, the borrower will provide the effort necessary to make it a
success. However, that is not the complete story since ex-ante and ex-post moral
hazard is missing from the framework. Ex-ante moral hazard refers to the idea
that borrowers take non-verifiable actions after the loan has been disbursed but
before the project returns are realised. This hidden action affects project returns,
160
 Credit Market
which in turn may generate inefficiencies since optimally, the borrower may not
want to lend at all, or more generally, reduce the scale of the loan. We illustrate
this idea with a very simple model.
Example 8.2: Consider a poor borrower who has a potentially profitable project
that requires an investment of Rs 2. Project returns, however, depend on the
effort put in by the borrower. It is Rs 5 if the borrower works hard and zero if she
shirks. Shirking, however, provides a private benefit of, say, Rs 3.5 (working as a
labourer in somebody’s field). The moral hazard problem arises because the
lender cannot verify whether the borrower is shirking or not. Given this, the
borrower is necessarily going to shirk when the loan is made. This is because her
payoff from working is at most Rs. 3 (that is, Rs 5–Rs 2) (since she has to return
the bank at least Rs 2).
Note that the above analysis relies on two implicit assumptions: first, the
borrower has no collateral, and second, even if the borrower has some assets,
there is a limited liability so that these assets cannot act as collateral. How would
the analysis change if the bank keeps collateral of Rs 2 from the borrower? Note
that in the case of shirking, the borrower would lose her asset and obtain a net
payoff of Rs 1.5 only (that is, Rs 3.5–Rs 2). The optimal condition in this case is
that the borrower would not shirk, because she has a ‘pay off’ of Rs 3 for putting
effort into the project, and a payoff of Rs 1.5 when she shirks.

8.5.3 Ex Post Moral Hazard

Ex post moral hazard, or the enforcement problem, refers to difficulties that
emerge after the loan is made and the borrower has invested. Even if all the steps
proceed well, the borrower may decide to take the money and run away once
project returns are realised. This situation arises because the lender does not fully
monitor the borrower’s profits (so that the borrower can falsely claim an
exogenous shock). The same scenario will come up when the return is observable
but not verifiable. We again use a very simple model to illustrate the idea.
Example 8.3: Consider a borrower who needs Re 1 to start a project that yields
Rs. Y with certainty. Let the rate of interest be R (this is either exogenously given
or comes from the break-even condition of the lender). Let the borrower have a
pledgeable asset of w being used as collateral to get the loan. The borrower
repays if and only if (Y–R) <w. Thus, from the lender’s point of view, it is risky
to provide a loan to a borrower without collateral. Her payoff from shirking is
Rs 3.5 in Example 8.2 as we have seen. Thus, optimally the lender will not give a
loan at all, since in the case of shirking, the lender cannot recover the loan.

161
Land Labour and
Credit Markets 8.6 IMPERFECT INFORMATION AND INFORMAL
CREDIT MARKET
Interest rate can sometimes be exorbitantly high in the informal credit market.
One of the reasons for this could be the exclusive monopoly enjoyed by the
informal money lender. The interest rate charged could be higher than the
opportunity cost, i.e., the interest rate charged by the formal credit market.
However, there are two problems worth mentioning. First, the informal lender
can have only a ‘local monopoly’ with certain limitations. Secondly, the lender
would choose profits in different forms while keeping the interest rate
comparatively low. Let us discuss the informational problems associated with
different forms of credit contracts.

8.6.1 Lender’s Risk Hypothesis

There is always a risk of default by the borrower (either on interest payments or
principal amount), especially in the rural credit markets. The reason for such
behaviour could be (i) involuntary default (due to misfortune, for example), or
(ii) strategic default. Let us consider a simple theoretical model.
Example 8.4: Let L be the amount of loan, i be the interest rate in the
competitive equilibrium in the informal sector, and r be the opportunity cost for
the lender. The opportunity cost of the lender can be assumed to be equal to the
ruling interest rate (𝑟) in the formal sector. Further, let 𝑝 be the probability that
the borrower repays the loan at the end of the cycle and (1 − 𝑝) be the
probability that a borrower may default. Because of the competition between the
moneylenders, the interest rate comes down to a level at which the expected
profit of the lenders is zero, i.e., all they get is the opportunity cost of the funds
(1 + 𝑟)𝐿. Thus, the expected profit will be 𝑝(1 + 𝑖)𝐿 + (1 − 𝑝)0 = (1 + 𝑟)𝐿
and the zero-profit condition implies:
(1+𝑟)
𝑝(1 + 𝑖)𝐿 − (1 + 𝑟)𝐿 = 0 ⟹ 𝑖 = { − 1}. ... (8.1)
𝑝

Suppose the probability of repayment is one (it implies, 𝑝 = 1), i.e., there are no
chances of default. From equation (8.1) we find that 𝑖 = 𝑟 (the rate of interest in
the formal sector (𝑖) is equal to the interest rate in the informal credit market (𝑟)).
However, if 𝑝 < 1, the repayment of the loan by the borrower is not so certain.
An implication of the above is that, 𝑖 > 𝑟 , which means the interest in the
informal credit market is higher than the interest rate in the formal sector.
The implication of the above indicates an essential aspect of the rural credit
market. In well-developed credit markets (markets in developed countries) with
strong legal institutions, there is a lower risk of default. In the case of weak legal
machinery, the chances of default are higher, as in the case of informal credit
markets. We now discuss various methods that can be used to manipulate and
reduce the risk of default.
162
8.6.2 Default and Fixed Capital Loans Credit Market

The larger the size of the loan and longer the period of the loan cycle before
repayment the greater is the risk of default. It implies that some loans will not be
repaid, no matter how large the interest rate premium is. The premium also
affects the chances of repaying a loan. Here large size loans also depend on many
factors related to society, for example, per capita wealth. The kind of use to
which a loan will be put also determines the repayment of the loan. If a borrower
uses the loan in a way where he will never have to borrow again, the informal
moneylender will not provide the loan. In the case of the informal market with no
legal enforcement mechanism, the threat to not advance any loan in the future is
the only tool used by the moneylender. But if there is no need for future loans,
the threat will have no value. Therefore, in order to resist a strategic default, the
lender will provide loans only for working capital or consumption purposes and
not for any permanent or fixed investments.

8.6.3 Default and Collateral

The informal lender may strictly insist on collateral when the perceived risks of
default are high. Collateral is an asset that a borrower is asked to give to the
moneylender as a security against the money borrowed. It can be of different
forms. Two main types of collateral are: (i) asset that is highly valued by the
borrower but not by the lender, and (ii) asset that is highly valued by both lender
and borrower. The second type of collateral has an added advantage since it
covers the lender against involuntary default. Interestingly, in some cases, credit
can also be a veil for acquiring collateral. Let us look at this scenario in the
following example.
Example 8.5: Let us assume that a small farmer needs a loan of L. He goes to the
moneylender, who is also a large landowner of his area. The moneylender asks
the small farmer (borrower) to pledge his land as collateral, and that land could
be just next to the large landowner’s land. Let i be the interest rate charged, 𝑉𝑆 be
the value that the small farmer (borrower) assigns on his land and 𝑉𝐵 be the value
that the big landowner (lender) assigns to the same plot of land. Given that the
moneylender has capital, he can reap higher productivity by investing optimally
in the plot and therefore let us assume that 𝑉𝐵 is greater than 𝑉𝑆 . Suppose F is the
value that the borrower will lose in case of default over and above the collateral.
Also, F can include the fear of not receiving any future loans or the threat of
physical retribution. While deciding to default or not, the borrower will compare
his gains𝐿(1 + 𝑖) to his losses (𝑉𝑆 + F).
The borrower will repay the loan if: 𝐿(1 + 𝑖)<(𝑉𝑆 + F)
The lender will prefer to get his money back if: 𝐿(1 + 𝑖) > 𝑉𝐵 ⟹ 𝑉𝐵 <
𝐿(1 + 𝑖)
Therefore, the repayment is preferred by both when: (𝑉𝑆 + F) >𝑉𝐵
163
Land Labour and This means that the value attached by the lender should not be more than the
Credit Markets
value that the borrower attaches to his collateral. If the collateral is of high value
to both the borrower and the lender, the lender would want the borrower to
strategically default. The lender would actually like the credit transaction as an
excuse to acquire the collateral. He can ensure that the borrower will default by
charging a high interest rate. This can be one of the reasons why land inequalities
rise in poor rural societies where there exist inter-linkages in different markets.
The land passes from the poor farmers to the rich landowners in lieu of unpaid
debt. Bonded labour is another example where labour-power acts as collateral.

8.6.4 Default and Credit Rationing

Credit rationing is a situation in which, at the prevailing interest rate, the lenders
are unwilling to advance additional funds to the borrowers. Consider a demand
curve of loans in Fig. 8.1. Credit rationing refers to all the loan-interest
combinations to the left of the demand curve. Let us discuss how the possibility
of default is associated with the extent of the credit rationing.
Suppose a moneylender has capital that he wishes to allocate in a way that will
maximize his return from it. There are a large number of borrowers (small
farmers) who want to borrow the loan as working capital to buy inputs for
production. Fig. 8.1 shows the total product curve of a borrower who uses the
loan as a working capital L and converts it into output. The production function
depicts diminishing returns to working capital (because of the fixed input of
available land). Lest us assume that L(1+i) is the total cost of borrowing an
amount L (where i is the interest rate on loan). The moneylender will try to
maximize his returns by choosing i as large as possible (i.e., the cost line to be
steeper). But there is a limit to this since the borrower always has a choice to
borrow from someone else after a certain point. Let us assume that the borrower
can earn a maximum amount of A from his next best source. The moneylender
cannot choose i so high that he pushes the borrower to profit less than A. So the
vertical gap between the production function and the cost line (output minus loan
cost) is the return of the farmer from the productive activity. This difference
needs to be kept at least at A in order to secure the farmer’s participation in
seeking credit from the moneylender. The largest interest rate that the lender can
charge is found by setting marginal product equal to the marginal cost 1+i. This
is nothing but the interest rate at which the tangent to the production function is
parallel to the cost line. So, i* is the interest rate where the borrower receives his
desired loan size (𝐿∗ ), and there is no credit rationing.

164
 Credit Market

Fig. 8.1: Maximising the Rate of Interest i on Loan

What if there is a possibility of strategic default? If the borrower defaults, the
possibility of getting a future loan from the moneylender will be closed, although
the farmer can avail next best alternative to secure a return A. Whether the
borrower defaults or not depends on the discount rate s(he) assumes, i.e., how
(s)he foresees her/his future gains and losses. Assume that t is the number of
periods in the future which the borrower is concerned about, which will affect the
current decisions of the borrower. The participation constraint of the borrower is
given by:
𝑓(𝐿) − 𝐿(1 + 𝑖) ≥ 𝐴 ... (8.2)
Here 𝑓(𝐿) is the production function of the borrower. The above equation means
that total gains from participation should give him/her at least as much as the
next best alternative A. In case of default, he/she also compares his short-term
gains from default to long-term losses.
In case of no default, he gets: 𝑡[𝑓(𝐿) − 𝐿(1 + 𝑖)]
In case of default (or non-payment of the loan), he/she gets entire 𝑓(𝐿) today and
A for the entire (𝑡 − 1)period: 𝑓(𝐿) + (𝑡 − 1)𝐴
Thus, for default not to occur, the following constraint needs to be satisfied.
𝑡[𝑓(𝐿) − 𝐿(1 + 𝑖)] ≥ 𝑓(𝐿) + (𝑡 − 1)𝐴
𝑡
⟹ 𝑓(𝐿) − (𝑡−1)
𝐿(1 + 𝑖) ≥ 𝐴 ... (8.3)

The above equation (8.3) is the no-default constraint. It is similar to the

𝑡
participation constraint (8.2) except for the term (𝑡−1) (which is always greater
than 1). This condition is tighter than the participation constraint. . If the no-
default constraint is satisfied, the participation constraint is automatically
165
Land Labour and satisfied. Note that the shorter the time horizon, the more difficult it is to meet the
Credit Markets
no-default constraint. For instance, if 𝑡 = 1, the borrower never contemplates the
future consequences of his current actions and will always default. So, no loans
will be advanced. On the other hand, if the borrower is very farsighted, then𝑡 is
𝑡
very large and the fraction ( (𝑡−1) ≃ 1)has a value close to 1. In that case, the no-
default constraint is approximately equal to the participation constraint.
The no-default constraint is shown in Fig. 8.2, which is simply a modified cost
𝑡
line weighted by a factor (𝑡−1). For each interest rate i, we need the no-default
constraint to be satisfied, i.e., to maximize the vertical difference between the
production function and the modified cost line and then ensure that the difference
is no less than A. This is to set the marginal product of the production function
𝑡
equal to the slope of the modified cost line (𝑡−1) (1+i). Thus, for maximization of
the gains, the tangent to the production function is equal to the slope of the
modified cost line. At an interest rate, i** the maximization process will give a
loan size L**. The new loan size L** is less than the amount the borrower would
like to have at i**. This gives rise to credit rationing.
A question may be arising in your mind: Why is credit rationed when a
moneylender can provide more loans by simply increasing the interest rate? The
answer is that a higher amount of loan increases the borrower’s returns to default.
A higher interest rate further increases the returns from defaulting as the
borrower would want to save on the repayment of more interest. Therefore,
credit-rationing is preferred in such cases.

Fig. 8.2: Loan Contracts when Default is Possible

166
8.6.5 Default and Enforcement Credit Market

Suppose a borrower defaults on repayment of a loan. Can he go to another lender

and ask for new loans afterwards? How is this prevented?
An important implication of no-default constraint is that the borrower’s deal with
the moneylender must yield a greater profit than he/she could get from someone
else by defaulting. The borrower’s profits are 𝑓(𝐿∗∗ ) –(1 + 𝑖 ∗∗ )𝐿∗∗ . Using the no-
default constraint, we can derive that:
𝑡
𝑓(𝐿∗∗ ) –(1 + 𝑖 ∗∗ )𝐿∗∗ > [𝑓(𝐿∗∗ ) – ((𝑡−1)) (1 + 𝑖 ∗∗ )𝐿∗∗ ] = 𝐴 ... (8.4)

Equation (8.4) tells us that if the borrower is patient (have a longer mental
horizon t), he/she can be given a relatively worse deal without any fear of default.
Since the borrower is very patient, the threat of termination of future credit is
costly for the borrower, and the lender can charge higher rates without fear of
default.
If the borrower has access to more than one moneylender, then he/she might have
an incentive to default and switch to some other lender if the current lender
refuses to give a loan in the future. However, in reality, reputations play a crucial
role, and the rural economy is more insular. If a borrower defaults with one
lender, his reputation may be damaged, making it difficult to access a loan as
other lenders will be reluctant to lend him in the future. This can happen only
when the information about the borrower’s default action spreads throughout the
lending community. In credit markets of industrialized countries, credit histories
are tracked using a network of computers which acts as a device to discipline the
borrowers. On the other hand, traditional village societies with limited mobility
have very strong community networks. These networks act as a credible source
of information in the absence of a computerized credit agency. However, as
societies develop, mobility increases and traditional networks fall apart. The
computerized system of information networks may take a long time to come.
There is a large intermediate range of cases where the flow of information slows
down. This stage is a transition stage witnessed by many developing countries. It
can be said that information dissemination follows a U-shaped pattern, i.e., both
the traditional and the modern societies have good network of information
dissemination, but the transitional societies do not.
In the absence of information, credit market can break down. Therefore, it is
crucial for the moneylenders to screen the borrowers properly. Screening also has
positive externalities in the sense that they prevent default on the loans of other
lenders. Another way is to give testing loans – a small amount of loans to check
the credibility of the borrowers. These small loans act as indirect tests of the
borrower’s intrinsic honesty.

167
Land Labour and
Credit Markets
Check Your Progress 2
Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What are the issues that arise due to imperfect information in the formal
credit market?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) Explain the Lender’s Risk Hypothesis.
………………………………………………………………………………….
………………………………………………………………………………….
…………………………………………………………………………………

3) Indicate (with the help of appropriate diagram) why the private money
lenders resort to credit rationing in rural areas.
………………………………………………………………………………….
………………………………………………………………………………….
…………………………………………………………………………………

8.7 POLICIES ON CREDIT

We have understood why large formal sector financial institutions such as
commercial banks fail to serve the needs of rural credit markets. The micro-level
information that is required for these operations precludes efficient market
coverage on the part of these large organizations. There is a need for different
kinds of policies to increase the outreach and penetration into the rural markets.
One of the policies is to recognize explicitly that informal lenders can grant and
recover loans from small borrowers more effectively as compared to formal
institutions. Therefore, instead of replacing informal lending, it can be
encouraged by providing formal credit to economic agents who will further use
the funds in informal markets. Another way out is to design micro level credit
organisations that can benefit from the local information.

8.7.1 Vertical Formal-Informal Links

One of the solutions to address the imperfect information problems faced by
formal credit markets is to develop a linkage between the formal and the informal
market. The formal sector can increase its penetration in rural areas by lending
money via informal lenders and benefit from extracting the local information
they have. This type of vertical linkage is better than the horizontal displacement
of one lender by another. It will also help in generating competition among the
informal moneylenders and benefit the borrowers who fall outside the reach of
168
the formal credit system. Similarly, loans might be extended to co-operative Credit Market

groups having social or religious links with other members. The implications of
this approach are discussed below.
a) Cost of Monitoring: When the formal sector provides funds to the informal
sector, one of the outcomes could be the reduction in the interest rate due to
increased competition among the moneylenders. It also increases the number
of moneylenders in the informal credit market, increasing the options
available to the borrowers. The chances of default will also increase as a
result. This further adds an additional fixed cost to the lending process, i.e.,
the cost of monitoring the loans. Lenders will now have to spend additional
resources as well as time for tracking loans and checking the borrower’s
credit history. The equilibrium rate of interest will also increase as a result of
these increased costs. Therefore, increased competition can have the opposite
effect on the borrowers.
b) Collusion: In informal credit markets, the moneylenders may collude and
decide not to encroach upon each other’s territories. In other words, the
moneylenders decide an arrangement, and if the arrangement is not followed,
there is a punishment for it. Since these interactions are repeated, people
generally comply with the arrangements. However, the probability of
sustained cooperation depends on various factors. For instance, it will depend
on the additional profits that a moneylender can gain from breaking the
arrangement, the loss that other moneylenders face by the counter-invasion of
a rival, or the lag between invasion and counter-invasion. The vertical
expansion of formal credit market, therefore, leads to the following two
effects: (i) increasing competition and hence providing incentives to an
outsider to invade, and (ii) decrease the collusive practices by increasing the
punishments if someone deviates from the pact.
c) Differential Information: The third possible effect of this policy was
explored by Bose (1997). Different lenders may have different information
about the borrowers. Let us suppose that there are two lenders, A and B.
Lender A has more information as compared to B. Lender A can easily
identify bad and good borrowers and obviously will try to pick good
borrowers and leave the bad ones for lender B. The extension of formal
support will allow lender A to pick some more good borrowers. Lender B
will, however, find it unprofitable to operate. The expansion of the formal
sector will lead to a decline in informal-sector lending. The vertical linkage of
the formal sector with the informal sector will expand the activities of the
moneylenders to some extent. But due to the presence of differential
information, some of the moneylenders might face losses and choose to shut
down their lending activities, leading to a decline in informal-sector lending.

169
Land Labour and 8.7.2 Microfinance
Credit Markets
The term microfinance refers to a small loan especially meant for working capital
and designed for poor people. It is treated as one of the cost-effective and
sustainable ways to reach those who are out of the formal banking system. It is
suitable to provide credit facilities to poor individuals in rural areas. There is a
growing consensus that microfinance programs can help in identifying people at
the bottom of the pyramid and bring them into the formal credit system.
Moreover, microfinance loans do not require collateral, making it easier to reach
the poor. In this respect, let us discuss the main features of Grameen Bank, a
leading microcredit institution in Bangladesh.

8.7.3 Grameen Bank

Institutional lending can mimic and exploit some of the features of informal
lending. One example is Grameen Bank in Bangladesh, started in the mid-1989s
by Mohammed Yunus. The Grameen Bank extends loans to poor households and
to groups of borrowers rather than individuals. A group consists of five
borrowers, and the loan is provided to individuals in the group on a sequential
basis. For example, the loan is initially given to the first two members, and once
they repay some of the initial instalments, another two borrowers get the loan.
The central feature of the Grameen Bank’s lending policy is that in case of
default of any member of the group, no further loan is granted to the group
members. The principle is based on the joint liability contract. This helps in the
careful selection of group members and prevents the risky borrowers who can
disturb the creditworthiness of the group. It is interesting to observe that the
banks benefit from the information without having any access to it. The
borrowers themselves use the information and form groups such that no risky
borrower is included in the group.
Another feature of group lending is progressive loans, i.e., increasing the loan
size in the case of repayment of the loan. Borrowers with good credit records
may also receive loans that can be used in activities other than production. This
type of money lending design also draws some features of rotating savings and
credit associations (ROSCAs) as well as local moneylenders. The feature of
compulsory savings acts as a substitute for collateral, whereas flexibility in
repayment addresses the demand and supply-side problems. This also reduces the
transaction costs that include monitoring, screening and enforcing costs of
lending. There have been some other innovations like lending money to women
groups. The Grameen Bank scheme also provides women-centric loans aimed at
empowering women and increasing their intra-households bargaining. Some
other features of group lending or Grameen Bank specifically include regular
group meetings for discussion on repayments, sharing information, creating
social capital and enhancing productivity. Let us also look at some of the
implications of this type of credit system.
170
● Joint Liability: The contract design in the presence of joint liability ensures Credit Market

that in the case of default in repayment, the group would be responsible. Joint
liability can help resolve the adverse selection problem through peer
monitoring. Moreover, joint liability loan (JLL) provides an incentive for
“endogenous group formation”, leading to “positive assortative matching”
and “social capital formation”. Consider a situation with one single lender
and two borrowers. Of these two borrowers, one has only a good project, and
the other one has both a good and a bad project. Both good and bad projects
require an initial investment of Re 1, which must be borrowed from the
lender. The good project returns Rs 2 to the borrower, but the bad project
returns only Rs 1.5, which the borrower can pocket. The imperfect
information problem (discussed earlier) arises because the bank does not
know about the borrower’s type. Consequently, if the loan goes to the risky
borrower, he will necessarily select the bad project where the bank faces a
loss due to no repayment. Thus, to break even in an expected sense, the bank
must charge at least Rs 2 from both borrowers. But in that case, the good
borrower may decide to opt-out of the market, which is the lemons problem.
While this problem will not arise if the lender could monitor the borrowers,
monitoring is very costly given that typically the bank officials are outsiders
who have little information regarding the characteristics of the borrowers.
However, the borrowers themselves are likely to have more inside
information about each other. The question is to devise mechanisms that
would allow the lender to tap into this information. The policy of JLL
provides a tool for doing precisely this.
Suppose that the lender makes a joint liability loan (JLL) to groups consisting of,
say, two borrowers. In that case, several effects are going to come into play. One
effect is that of peer monitoring, whereby borrowers monitor one another.
 Positive Assortative Matching: Joint liability via an endogenous group
formation can help in resolving the asymmetric information problem in the
rural credit market. Consider a scenario with two groups of borrowers, safe
and risky. Further, suppose that the lender opts for group lending. The fact
that borrowers endogenously decide on choosing their own group is the key
to the solution. Faced with joint liability, safe borrowers form a group with
safe types rather than with risky types, so that safe type sticks together. The
risky borrowers have no alternative, but to form groups with risky types,
leading to segregated group formation, referred to in the literature as
“positive assortative matching” (PAM). Interestingly, this helps the bank to
keep safe types of borrowers in the market and ensure efficiency. Self-
selection, therefore, helps in keeping the risky borrowers away from the
credit market. Because the investment projects undertaken by risky borrowers
fail more often, they have to repay their defaulting peers more often under
group lending with joint liability; otherwise, they will be denied future access
to credit. Safe borrowers no longer have to cross-subsidise the default of the 171
Land Labour and risky borrowers. Consequently, there is a risk transfer from the bank to the
Credit Markets
risky borrowers themselves. This also implies that the safe types pay lower
interest rates than the risky types. Such a policy allows the bank to be better
insured against defaults and thereby charge a lower interest rate for safe and
risky types. The lower interest rates, in turn, encourage the safe borrowers to
re-enter the market, thus correcting the market failure.
● Peer Monitoring: The members of a particular group can at best predict
what a fellow member does with the loan but cannot completely control
his/her decisions. They might also be able to ‘monitor and influence’ the
choice of investments a borrower makes with the borrowed money. The
members might want the project to be relatively safe as compared to what an
individual might choose as an independent borrower. An individual with
limited liability would invest in a risky activity. However, in the case of
group lending with joint liability, all the members will put pressure on each
other to take up less risky projects. It is important to note that group lending
results in peer monitoring where other group members influence the borrower
to reduce the level of risk.
● Sequential Lending and Sequential Repayment: The flip side of joint
liability loan (JLL) is that it creates “strategic complementarities” in the
monitoring levels of the borrowers in a group. A decrease in the level of
monitoring by others in the group reduces the individual incentive to monitor.
The implication is that in equilibrium, there may be under-monitoring. The
intuition for strategic complementarity is simple to understand. A borrower
has an incentive to monitor if other borrowers monitor since if she does not,
she would be in trouble under JLL. This works both ways. If she is a risky
borrower and is being monitored by her peers, she would lose all private
benefits from a bad project. If she were a safe borrower with a good project,
she would have to part with her project return if she does not monitor.
Consequently, there may be virtually no peer monitoring in equilibrium. The
above argument identifies one possible reason why some group-lending
schemes fail. Moreover, group-lending schemes also involve other subtle
features that differentiate microfinance from traditional banking. These
include dynamic elements like “sequential repayment”, “sequential
lending”, and “contingent renewal”.
● Sequential Repayment: Sequential repayment refers to the feature that while
repayment starts within a month or so of the loans, these come in small and
easy but regular instalments. This is surprising since it is possible that the
project may not have started yielding any returns so soon. However, asking
for early repayments forces the borrowers to look for subsidiary loans from
family and even moneylenders. It is then argued that such bridge loans will
be forthcoming, provided the borrower is efficient and uses the initial loan
amount wisely. This information is likely to be available with friends and
172
 family, and perhaps even the local moneylender, but is unlikely to be Credit Market

available with the microfinance organisation that is an outsider. The argument

again relies on the basic idea that sequential repayment allows the lender to
tap into information that is available at the local level. Hence, it screens out
undisciplined borrowers, gives an early signal to the loan officers and peer
group members and allows the bank to get hold of cash flows before they are
totally misused.
● Sequential Lending: One major incentive of sequential lending is that it
minimises the contagion effect of involuntary default. Because of the
sequential nature, later recipients of loan have an incentive to monitor the
early recipients. This reduces the possibility of default. Moreover, these
dynamic incentives with a small loan can be used for the initial screening of
borrowers and help sort out the worst prospects before expanding the loan
scale. In the Grameen Bank, for example, the groups have five members
each. Loans are sequential in the sense that these are initially given to only
two of the members (to be repaid over a period of one year). If they manage
to pay the initial instalments, then, after a month or so, another two borrowers
receive loans and so on. Sequential lending allows one to circumvent
collusion possibilities among the borrowers. The borrowers may otherwise
collude and select risky projects. If the case of simultaneous lending, the
Pareto dominant outcome for both the borrowers will be to collude among
themselves and not monitor each other at all. Under sequential lending,
however, the borrower who is supposed to get the loan later on will not
receive the loan unless she ensures that the other borrower repays faithfully.
Even in the absence of JLL, sequential lending may solve the under-
monitoring problem.
Contingent Renewal: Contingent renewal refers to the fact that in the case of
default by a member of a group, no member of the group receives further loans.
On the other hand, in case the group repays, future loan is ensured. In the
presence of contingent renewal, sequential lending performs an interesting role in
that it allows the bank to test for agent types. Suppose there are two groups of
agents, one good (with social capital) and the other bad (i.e., has no social
capital). In the presence of contingent renewal, there would be an assortative
matching, with the good borrowers clubbing together. The cost of being clubbed
with a bad borrower is very high in the presence of contingent renewal. A good
borrower loses all future borrowing possibilities. Thus, in the presence of
sequential lending, the bank can ascertain group types easily, at the cost of
lending to a subset of the borrowers, so that the cost of a bank making a bad loan
is minimised. Interestingly, Grameen Bank has schemes where the magnitude of
future loans depends on current loan history. In the case of default, the borrowers
are not completely cut off from access to future loans, but their credit history is
wiped out so that they have to restart from a basic loan.
173
Land Labour and
Credit Markets 8.6 INTERLINKAGES AMONG RURAL FACTOR
MARKETS
One of the features of the credit market in developing countries is that it is linked
with other factor markets like land and labour market. As mentioned earlier, it is
common in rural credit markets that a money lender is also a landlord who
provides credit to tenants in exchange for their labour as collateral. Similarly, a
trader may provide loans to the farmers in exchange for the output they will sell
after harvest. Therefore, the moneylenders benefit from the assets owned by the
borrowers. However, the benefit can be realised only when the borrower and the
lender are engaged in similar kinds of occupations. If both of them have
occupations that go well with each other, it is easier to conduct credit transactions
under one contract. For example, a trader who deals in wheat may provide credit
to the farmers who cultivate wheat and also trade in the wheat produced by them.
The trader money lender, in this case, has an added advantage compared to other
moneylenders. We explain the important reasons for the interlinkage of credit
markets.
● Hidden Interest: Some societies have banned the practice of explicitly
charging interest. For example, usury (lending money at an unreasonably
high interest rate) is banned in Islamic societies under the Shariat Law. In
such cases, some other forms of interest might be charged. Interlinked
transactions provide a way to earn in the form of hidden interest. A wheat
trader may give an interest-free loan to a farmer and keep a condition that the
farmer would sell his output to the trader at discounted prices. This is how the
trader earns profit in the name of an interest-free loan.
● Inter-linkages and Information: Interlinked credit contracts can also reduce
the chances of default by a borrower without any extra cost of monitoring.
Suppose a trader gives a loan to a wheat farmer in exchange for a contract to
sell the output for repaying the loan. At the time of harvest, the trader might
go to pick up the output. The trader gets the first claim on the crop produced.
Therefore, interlinkage can benefit the moneylender as it reduces the chance
of default.
● Inter-linkages and Enforcement: Interlinked transactions can also help in
reducing strategic default. When a landlord provides a loan to the tenant, it
has an “interlinked threat” attached to it. If the tenant defaults, his tenancy is
at stake. It, therefore, incentivizes the tenant to repay the loan. Furthermore,
the threat also ensures that the tenant puts sufficient effort required in the job
assigned. The interlinked contract serves two different roles in this case.
Inter-linkages and Creation of Efficient Surplus: Inter-linkages also play an
important role in preventing distortions that might reduce the total surplus to be
divided between the lender and the borrower. A high-interest rate may discourage
borrowers to take a loan for production whereas a subsidized or low interest rate
174
along with a low buying price of output produced by the borrower maintains the Credit Market

incentive to take loans. The moneylender (who is also a trader) can acquire the
surplus by paying lower prices for buying the output.

8.9 LET US SUM UP

In this unit, we looked at some important characteristics of credit markets. The
main features of the credit market are incomplete information, segmentation,
interlinkage, interest-rate variation, credit rationing and exclusivity.
Subsequently, we discussed the sources of demand and supply of credit. We also
distinguished between the formal lenders (government and commercial banks)
and informal lenders (moneylenders, landlords, traders etc.) of credit. The formal
lenders face various problems such as lack of information, unacceptable forms of
collateral and limited liability that act as an advantage for the informal lenders.
We discussed various problems of the credit markets arising due to incomplete
information. The different types of information asymmetry are adverse selection,
ex-ante moral hazard and ex-post moral hazard. We looked at Lender’s risk
hypothesis and various credit contracts that can help in addressing the issue of
default. Different features of credit contracts such as fixed capital loans,
collateral, credit rationing and enforcement can be used by the informal lenders
to overcome the problems of information asymmetry.
In addition to the above, we discussed different policies that can help in reaching
the small borrowers who are out of the reach of formal credit markets. One such
policy is to create vertical linkages between informal and formal credit markets
and take advantage of the information network of informal lenders. This policy,
however, has certain disadvantages such as cost of monitoring, collusion and
differential information. Another policy that has gained immense importance is
providing small-scale loans to a group of people, also known as microfinance.
Under this type of lending, loans are given to a group of people rather than
individual borrowers. We look at various features of this policy such as joint
liability, peer monitoring, positive assortative matching, sequential lending,
sequential repayments, contingent renewal and lender monitoring. We concluded
this Unit with a discussion on the Inter-linkages between rural credit markets and
the reasons for these Inter-linkages.

8.10 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) In voluntary default the borrower is in a position to repay the loan but takes a
strategic decision to fail on repayment. In involuntary default he is not in a
position to repay due to natural calamities or family problems. Voluntary
default could be due to weak legal system in the country. 175
Land Labour and 2) Demand for credit could arise to fund additional requirement of fixed capital,
Credit Markets
working capital or consumption expenditure.
3) Credit rationing is a situation when borrowers are unable to borrow an
adequate amount (or some borrowers are unable to borrow at all) due to
lenders’ inhibition to supply credit at the ongoing interest rate.

Check Your Progress 2

1) The problems could be adverse selection and moral hazard. See Section 8.5
for details.
2) The borrower may not repay the loan. In order to reduce voluntary default,
the lender may ask for collateral. Go through Sub-Section 8.7.1 and answer.
3) Go through Sub-Section 8.7.4. Explain Fig. 8.2.

Check Your Progress 3

1) Vertical formal-informal links do not displace private money lenders. It
increases competition among private money lenders and reduces interest rate.
Go through Section 8.7.1 and answer.
2) Assortative matching is a positive feature of joint liability loans. The
borrowers decide on choosing their own group. Faced with joint liability, safe
borrowers form a group with other safe borrowers. Thus, safe type borrowers
stick together. Go through Sub-Section 8.7.3 and answer.

176
 BLOCK 4
INDIVIDUALS, COMMUNITIES
AND
COLLECTIVE OUTCOMES

BLOCK INTRODUCTION
The fourth block of the course, titled Individuals, Communities and Collective
Outcomes, has two units. The basic objective of the block is to discuss the
role of the community in economic development. By community we mean that
part of society and exchange relations that do not involve the government and
the market mechanism. The two units in the block explore the role of social
norms, of personal relations among members of the community as also of
voluntary organizations and non-government organizations (NGOs), and
of panchayati raj institutions in India.
Unit 9 is on Individual Behaviour in Social Environments. It discusses
civil society organizations and institutions, and explores the role of social
norms and institutions. It discusses social institutions and social
equilibrium. The unit explains the emergence of multiple social equilibria
and deviations from usual market equilibrium.
Unit 10 is on Governance in Organisations and Communities. It deals with
various topics like the role and functioning of NGOs. The unit discusses, with
special reference to India, how rural local bodies like panchayati raj
institutions work. The unit also presents a theoretical discussion of the
important concept of ‘social capital’.
 Individual Behaviour
UNIT 9 INDIVIDUAL BEHAVIOUR IN SOCIAL in Social Environments

ENVIRONMENTS
Structure
9.0 Objectives
9.1 Introduction
9.2 Private Goods, Public Goods and Common Property Resources
9.3 Markets, Norms and Communities
9.4 Trust, Social Capital and Cooperation
9.5 Social Institutions and Social Equilibrium
9.6 Network Externalities and Multiple Social Equilibria
9.7 Let Us Sum Up
9.8 Hints to Check Your Progress Exercises

9.0 OBJECTIVES
After going through this unit, you will be able to explain:
 explain the impact of social norms in the realization of economic outcomes;
 discuss the role of social institutions and their relationships with economic
institutions;
 describe how members of communities do social interactions among each
other based on trust;
 define the concept of social capital;
 describe the use and role of common property resources in developing
countries; and
 discuss the possible reasons for social equilibrium being suboptimal (or
outcomes deviating from optimal ones) in developing countries.

9.1 INTRODUCTION
This unit discusses some topics that are of importance in understanding the
working of developing economies. We know that markets can play an important
role in allocating resources efficiently and also in providing incentives for
growth. But do they always work? We know that there can be market failure and
in trying to mitigate market failures, government action can make the situation
worse creating other problems. This needs us to investigate the working of the


Shri Saugato Sen, Associate Professor of Economics, IGNOU, New Delhi
179
Individuals, non-market, non-state part of the society. How does it work? What role does it
Communities and
Collective Outcomes play in influencing economic outcomes? Do economic agents make economic
decisions and take actions based on norms, customs and trust in the fellow-
members of the society? How do norms emerge? How are they sustained? This
unit discusses all these.
In this unit, therefore, we look at what are called civil society institutions or the
voluntary sector. We look at the social scaffolding of the economy. We look at
the role of norms and conventions. We look at the impact and influence of
institutions on the process of development. Traditionally, in microeconomics and
macroeconomics, we sometimes make analysis as if we are in an institutions-free
environment. But institutions matter. Therefore, firstly, the variables that have
to be taken into account when analysing economic processes must include non-
economic factors i.e. political, social and cultural factors. Secondly, institutions
vary across space and over time i.e. institutions are neither static nor uniform. In
developing countries, social institutions and communities impinge on the
economic processes a good deal. Hence, any study of developing countries need
to take this into account. Quite often, we observe that outcomes which are
inefficient and sub-optimal not only emerge but also tend to persist. It is as
though the society has chosen inefficiently an entire path of development that has
got itself historically locked–in. The unit therefore also discusses the importance
of governance, in terms of its impact on policy-making, and thereby on
development.

9.2 PRIVATE GOODS, PUBLIC GOODS AND

COMMON PROPERTY RESOURCES
Let us begin by taking a look at the classification of goods in terms of whether
they are private or public goods or a combination of both. You have studied
these in your courses on microeconomics. Private goods are rival and excludable.
In contrast to private goods, public goods are non-excludable (i.e. it is impossible
to prevent individuals from consuming them) and non-rival (consumption by
individuals does not reduce the amount of the good available for consumption by
others). Goods in the social sector or civil society institutions are not fully
private or public goods. For example, Non-Government Organisations (NGOs)
have comparative advantage in activities that typically lie between conventional
private and public goods. They are usually partially rival and partially
excludable. For instance, common property resources – CPR (or common-pool
resources as they are also sometimes called), are characterised by low
excludability but high rivalry. Examples are fisheries, pastures, and forests, with
open access. Economic theory of common-property resources suggest that unless
society manages them well, these resources tend to be overused (and
underinvested). We can think of many similar hybrid contexts with
characteristics of both private and public goods. They could be non-rival but
180 excludable. This means consumption by one individual does not reduce the
 Individual Behaviour
amount left for consumption by others, but it is possible to exclude some from in Social Environments
consuming. One example is transfer of technology. A special form of public good
that operates at the local level or in a specialised subgroup of a society is known
as local public good. Local public goods are excludable from those outside the
area but generally not for those in the local area. Local public goods such as local
amenities are provided by government, firms and also by civil-society
organizations. Under some conditions, a decentralised solution to the allocation
of such goods can be found. Broadly, the private sector provides private goods,
the public sector provides public goods and the civil-society organizations
provide the hybrid type of goods. Hence, successful economic development
requires improved functioning of the public, private, and civil-society sectors.
Each have their own weaknesses. This means that each leg of this “three-legged
stool” needs strengthening. This is because, each plays an important and
complementary role in fostering balanced, shared, and sustainable development.
Let us now know a little more about CPR.
CPR can be compared to private and open-access resources in that they are rival.
They can also be compared to club goods in that they are excludable. Examples
include community grazing lands (for cattle communities), community forestry
(village forests in India), community-run irrigation systems, and fishing grounds.
Elinor Ostrom defined a CPR as a resource possessing the following four
characteristics.
1) They have well delineated boundaries and well-defined group of users.These
two conditions are necessary to be able to exclude non-members from the use
of the resource.
2) Users cannot choose others and cannot exclude others. All community
members have an inherent right to use the resource provided (i) they follow
the rules for extraction from the resource and (ii) contribute to the
maintenance of the resource.
3) CPR is rival i.e. each user appropriates the full benefit from his extraction
from the resource. This means, if there are Nusers, each user is prepared to
bear only 1/Nth of the cost he imposes on others while extracting. This is
even while his/her maximum extraction depletes the availability of the
resource to others. As a result, individual users tend to impose negative
externalities on each other by their overuse. Unless the community is able to
impose rules to limit the individual levels of extraction, there is a tendency to
over-extract compared to the socially optimum level. This is called the
‘tragedy of the commons’
4) Let us consider maintenance of the resource. If each member bears only 1/Nth
share of the cost but draws the benefits from the resource freely, there is over
extraction and faster depletion. Therefore, unless the community is able to
impose rules on individual contributions to maintenance, there is a tendency
for under-provision of maintenance services compared to the socially 181
Individuals, optimum level of provision. In other words, free-riding works counter
Communities and
Collective Outcomes productively.
Property rights over an asset such as land have different degrees of completeness.
They include the following five aspects: (i) right to access, (ii) right to extract,
(iii) right to manage, (iv) right to exclude others and (v) right to sell or transfer
the asset to another person (called right to alienate). For these rights to matter,
they have to be enforced. Open-access resources offer users only two rights:
access and extraction. Common property resources (CPR) also give community
members the rights of access, extraction, management, and exclusion. Under
CPR, the services of a resource [such as fishing, grazing of animals, and the
extraction of firewood or timber from a forest] are: (i) collectively excludable
(non-members are excluded, while members cannot be excluded), and (ii) rival in
use (the fish, forage, or timber depletes faster with appropriation by members).
Having all five dimensions makes property rights complete.
Private ownership including the right to alienate, well enforced, is thus the most
complete form of property right in an economy. Incomplete property rights may
lead to mismanagement of the resource. This shows that the allocation of
property rights and the nature of these rights is a fundamental determinant of how
resources are used. This is the reason why economists usually consider property
rights enforced by the rule of law as the most important institution. But it does
not mean that property rights have to be in the form of individual ownership, nor
that they need to be complete to be efficient. Community ownership (that does
not include the right to buy and sell, but does include the other four rights)
backed by strong ability to cooperate can also result in optimum resource use.

Check Your Progress 1

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Define the concepts of rival and excludable goods.
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2) Distinguish between private goods and CPR.
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3) Why is a CPR an ‘incomplete property right’?
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182 ………………………………………………………………………………….
 Individual Behaviour
9.3 MARKETS, NORMS AND COMMUNITIES in Social Environments

In your microeconomics course, you have studied about markets that are perfect
and some that are imperfect. Even when markets are imperfect, they exist so that
transactions take place. However, there are situations where markets are not only
imperfect, they are incomplete and even missing in some cases. There may be
coordination failure to such an extent that even when sellers are willing to sell
and buyers are present, the required transactions may not take place. This means,
the transaction costs and the costs of searching are too high.
Market imperfectness arise when there are a few sellers in the market and the
conditions of perfect competition are not met. We know that the latter are like:
(i) no seller is able to influence market price, (ii) there is free entry, (iii)
information flows are perfect and (iv) the product is homogeneous. Market
incompleteness, on the other hand, means that, some markets may not exist at all
i.e. markets may be missing. This situation quite often exists in rural markets,
particularly markets for credit. Likewise, in inter-temporal trade, incompleteness
of markets often comes into the picture. This is especially true for some financial
markets like futures markets, where delivery is to be made in the future
contingent on some event. For instance, if you are to receive an umbrella if it
rains (i.e. state-contingent), then an umbrella in sunshine can be considered a
‘different’ commodity from an umbrella if it rains. In the presence of risk and
uncertainty, and absence of information, it is difficult to transact for each state-
contingent commodity. In this sense, there may be incompleteness of markets. In
other words, in state contingent situations, if transactions are to be made ahead of
the events of delivery of goods, it may not be possible to specify each such
situation. An example of market that displays incompleteness is insurance
markets. In such cases, when we study developing economies, we find that
institutions, social norms and customs play a role. Hence norms and customs can
create additional constraints because norms may either promote development or
hinder it. Norms may remain static and unchanging or may evolve over time.
Every society has its own norms, some of which are also upheld by law. At the
same time, it is not that only the ‘best’ norms survive. Norms that are best in one
setting, may be inimical to development in another setting. This does not mean
that norms will be eroded overnight. The desire for human beings to conform is
immense. As long as conformity is fundamental, norms will take their own time
to change. It may appear that norms are always a hindrance and that conformity
can only slow down the pace of development. But this is not true because
without norms of decency and appropriate social conduct, economic life would
simply fall apart. History too plays a role because it establishes social equilibrium
that persists. This type of equilibrium often determines whether a new policy can
be undertaken.

183
Individuals, What kind of role does the community play in economic development? As
Communities and
Collective Outcomes people specialize in various activities, a system is required to coordinate them.
The 'economic system' is a combination of the economic organizations that
coordinate various economic activities so as to achieve a socially optimum
output. In this, market is an organization that coordinates profit-seeking
individuals through competition using prices as signal. Likewise, state is an
organization that influences people to adjust their resource allocations which it
does by government fiat (or a decree or law). On the other hand, community is an
organization that guides its members to voluntary cooperation based on personal
ties and mutual trust. Communities, therefore, provide a principle for
organisation. They have the potential to correct market and government failures
providing thereby an impetus to development. In other words, (i) market by
means of the price mechanism, (ii) state by means of command, and (iii)
community by means of cooperation and norms (based on a combination of
mutual trust and gain), coordinates the division of labour and allocation of
resources for a socially optimal outcome. In reality, the community and the state
often overlap. For instance, a village is a community where villagers cooperate
voluntarily. However, if villagers authorize a particular individual like the
village elder or panchayat to exercise coercive power in the administration of
village affairs, then the village functions like a small state.

9.4 TRUST, SOCIAL CAPITAL AND COOPERATION

It is not always easy to correct market or government failure. It might seem that
these failures can be corrected through legal procedures. But they are usually
very costly both for the individual and the society. Moreover, when there is moral
hazard in the judicial and administrative system itself, then government failure
only goes to exacerbate market failure. The incidence of moral hazard would be
smaller among economic agents who interact with each other in a personal
manner and interact repeatedly. By interacting repeatedly they come to predict
each other’s behaviour, and know that others can also predict their behaviour.
This creates the basis for developing mutual trust. The community does not
always solve problems about the division of labour. But it guides members to
cooperate voluntarily based on close personal ties and mutual trust. Thus, the
market is based on competition, the state on coercion and command, while
community relations are based on cooperation. When organisations are created
based on community relationships, they are called ‘civil society organisations’.
Inability to form long term cooperative relationships based on mutual trust can
lead to considerable loss. If trust is absent, it may lead to a decline or breakdown
in communication. Building trust, and developing network relationships, leads to
lowering of transaction costs. The sum total of network relationships that a
person has, in relation to other members of the community, is called (by writers
like James Coleman and Robert Putnam) as ‘social capital’. This is like human
184 capital but is not based individually in terms of endowment of health and
 Individual Behaviour
education. Rather, it is situated in the network and interaction among in Social Environments
individuals. It is common to say that an individual with contacts with a wide
range of people, has a large social capital. However, the endowment of social
capital is often discussed at the level of a community or society. This social
capital acts as a ‘local public good’ whose benefits are limited to a particular
group of individuals interacting with each other. Supply of local public good is
the comparative advantage that the community has over the state and the market.
Mutual trust created by long-term repeated interactions could be strengthened by
forming inter-linked transactions. Once mutual trust–based interactions become
widespread in the community, they become positive norms leading to lowering of
transaction costs. Where transaction costs through interlinked transaction are not
lowered, organisations with hierarchically structured relations, such as a firm, is
formed. In some cases, governments step in to correct for the undersupply of
social capital. Hence, where common property resources are involved,
community based relationships assume importance. It helps avoid a situation of
‘tragedy of the commons’.
Even where relationships are based on contracts, how far can we put faith in the
legal system or the formal authorities to ensure the honouring of contracts? In
some cases, like employment relations, or certain commercial contracts, it is
possible. But in practice, in developing countries, particularly in rural societies,
these are very difficult. Third-party mediation, especially formal court
procedure, entails significant costs. Hence, it does not pay to apply it to conflicts
involving small sums of money. Since scales of both production and transaction
are typically small in developing economies, legal means have very limited
power to solve problems of enforcing contracts and exchanges.
Lack of communication and mutual trust between transacting parties is the main
reason for suboptimal outcomes to arise. These should be prevented by the
formation of trust through the development of a community relationship. One
way to achieve this relationship is to shift from spot transactions between
anonymous agents solely based on the price parameter to long-term continuous
transactions (called ‘clientelisation’). For instance, a shopkeeper may be
tempted to cheat an unknown new customer. But for a regular customer coming
to his shop he would be less willing to risk losing a long-lasting business
opportunity for a one-shot moral hazard. Thus, repeated transactions that are
expected to continue over a long time have the power to protect the transacting
parties from inferior social outcomes. Mutual trust created by long-term
continuous transactions can be further reinforced by multiple interlinked
transactions. You have studied about interlinked transactions in the previous
block. Thus, trust developed through personal interactions in the community
increases efficiency and reduces costs. Thus, trust emerges as a kind of 'social
capital’. However, such social capital is useful for community members alone.
In this sense, social capital is a kind of 'local public good' whose benefit is
limited to a particular group. Generally speaking, the comparative advantage of 185
Individuals, community over the market and the state lies in the supply of local public goods.
Communities and
Collective Outcomes This is in contrast to the market's supply of private goods and the state's supply of
'global public goods'. Community relationship is effective in preventing free
riders.
Local public goods can be supplied by the command of government also.
However, in the process of raising necessary tax revenue and allocating it among
alternative uses and areas, significant administrative as well as political lobbying
costs are inevitably entailed. Also, governments are usually short of the capacity
to accurately grasp the structure of demand for public goods at the grassroots.
Therefore, local communities (including local governments supported by
community relationships) should be assisted to develop the capacity to obtain
local consensus and prevent free-riding among community members. Then,
governments can concentrate on the supply of ‘global public goods’ leaving the
supply of ‘local public goods’ to beneficiary communities. However,
communities with meagre accumulation of trust capital have no comparative
advantage in the supply of local public goods. Hence, they have to depend on
government for its supply even at a high cost. Gross undersupply of local public
goods would be inevitable in such a society.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) State the role of norms and the social community in economic development.
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2) What is meant by social capital?
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3) How does trust among members of a community act as a ‘local public good’?
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9.5 SOCIAL INSTITUTIONS AND SOCIAL

EQUILIBRIUM
In earlier courses, you have been familiarised with how the markets sometimes
fail to function efficiently, and how, as the government tries to correct these
market failures, the possibility exists that government actually makes things
worse. These situations of government and market failure suggest that it is
important to consider the institutional framework under which the markets
186
 Individual Behaviour
function as also the structure of governance. The decisions and actions by the in Social Environments
government sector should be such as to provide correct information and
incentives to private agents in the economy.
We can therefore broadly define an institution as any set of formal rules, informal
norms, and related enforcement mechanisms that constrain people’s choices
regarding a particular set of actions. Some institutions are informal, involving
only unwritten and shared understandings among members of neighbourhoods or
communities. Other institutions are more formal, involving codified rules as well
as informal norms. Formal rules at the local level may be related to local
governments or to membership-based organisations such as agricultural
cooperatives. Formal rules at the national level include laws and rules involving
government programs and rules governing legal systems.
In recent times, institutional economics has assumed considerable importance in
the analysis of developing nations. Institutions were important topics of analysis
earlier as well, as exemplified by the works of economists like Thorstein Veblen.
But, by and large neo-classical economics was conducted assuming an
institution- free environment. Recently, the analysis of exchanges, using tools of
microeconomics, has sought to be supplemented by institutional analysis.
Another reason for institutions assuming importance is the interest in work on
economic growth. We have studied several theories of growth. We saw recently
there has emerged a group of theories that see growth as determined by processes
that are endogenous. There are differences in factors and endowments among
countries and this is supposed to explain the differences in economic growth of
different countries. Some economists have suggested that the factors which are
supposed to cause economic growth, and which are supposedly endogenous, are
themselves not the causes of, or explanations of, growth. They are actually the
characteristics or features of growth. The main reason for differences in growth
performance is differences in the structure of institutions in different countries.
Institutions, and differences in them, can therefore account for large differences
in the performance of countries.
About traditional private goods that are excludable and rival, what is the best
institutional arrangement happens to be well known: there should be the presence
of strong property rights and anonymous markets. However, non-rival goods can
create a problem because it is not clearly known what are the right institutions for
them. Hence, there is a lot of scope for innovation in institutional set-up. We
need to know in a more detailed form, and in greater nuances, what should be the
correct institutional set-up for a particular type of non-rival good. The optimal
design of institutions is thus as yet an unresolved problem.
Douglass North, a Nobel Prize winner in economics, defined institutions as: ‘the
rules of the game in a society, or the humanly devised constraints, that shape
human interaction’. He suggested that institutions shape the constraints in
interactions among people. These interactions may be economic, social or 187
Individuals, political. Economic institutions such as property rights, and the degree of
Communities and
Collective Outcomes perfection of markets, influences the structure of economic incentives in society.
Economic institutions also determine how efficiently allocations will be made in
the society. Thus, it is important to realise that not only are institutions important
but also that they are endogenous.
In the early history of economic thought, there have been theories of
development that have sought to analyse institutions by considering them
endogenously. In the next block, you will study about the theories of
development of the classical economists. Among them Marx, for instance, gave a
broad ranging theory of development where institutions affect each other. Forces
of production, that is, technology, are the driving force behind institutions. They
affect the production relations constituting the mode of production. As the mode
of production (i.e. the economic system) changes, it affects the entire
superstructure of political, legal and social relations.
In the microeconomics tradition of Walrasian economics, analysis was often
conducted as though in an institution-free environment. Recently, there have
been two strands of economic analysis that have sought to extend the Walrasian
paradigm to incorporate institutions. One strand looks at changes in ‘property
rights and transaction costs’ as having a great impact on economic development.
This view is exemplified by the works of Ronald Coase and Douglass North. The
other strand has used the recent developments in information economics (like
asymmetric information, imperfect information, moral hazard, adverse selection,
signalling and screening), to understand how institutions affect development.
They see institutions as filling-in gaps in the economy created by missing and
incomplete markets in the presence of risk and asymmetric information. They
have used this, for instance, to model agrarian institutions on these lines. This is
seen in the works of economists like George Akerlof and Joseph Stiglitz.
Interestingly, all four economists have won the Nobel Prize.
The transaction costs school contends that as transaction costs change,
institutions emerge to minimise these transaction costs. This is the basis of their
theory development. Transaction costs include costs of negotiation, monitoring,
coordination, and enforcement of contracts. When transaction costs are high,
allocation of property rights become crucial. When transaction costs are high,
contracts are determined by property relations. In the development process, there
would emerge a trade-off between economies of scale and transaction costs. In
simple face to face interactions, transaction costs may be low. But production
costs are high because specialisation and division of labour is limited. The
transaction cost school also believes that changes in relative prices cause
institutional changes. The information economics school, on the other hand, cast
their theories in more rigorous terms, explicitly bringing in the notions of
equilibrium.

188
 Individual Behaviour
It is important to understand why and how a certain institution emerges, and what in Social Environments
purpose it serves. Even an institution that appears to be negative may be serving
some purpose. It is important to realise this to explain its persistence. The
institution may not only be not optimal; indeed, they may be dysfunctional but
may still persist. It is necessary to observe if there are regularities in the
evolution of institutions, as this gives rise to conventions.

9.6 NETWORK EXTERNALITIES AND MULTIPLE

SOCIAL EQUILIBRIA
We have studied in the course on development economics-I that one of the issues
in economics of development is whether countries converge in their growth rates.
Statements about convergence tend to include propositions about parameters like
investment and savings and their relationship with growth. We saw in an earlier
section of this unit that institutions make a profound impact on the development
process. We can now ask, is history itself important? What, if a country’s history
itself, coupled with people’s expectations about the future, determines not only
the institutional framework but also the parameters of the growth process like
savings and investment? We are looking at the persistence of certain patterns
over long periods and asking why does such persistence exist? People often
speak of ‘historical forces’. The question is, how do we take these into account?
One view is that the course of economic development is determined to a
considerable degree on the earlier choices that were made i.e. the basic path that
was chosen. In other words, the development process is ‘path dependent’. Path
Dependence Theory postulates that ‘when we consider the performance of an
economy, its position at a certain point of time depends on the whole sequence of
events’. That is, the whole path is important. We need to look at the entire
history of the process.
Brian Arthur is an economist who put forward the suggestion that certain inferior
outcomes may have got locked-in by historical events. You have studied in the
microeconomics course that equilibrium is usually the result of economic agents
choosing actions and making decisions while acting rationally by maximizing
some objective function. Such equilibria are optimal. However, in reality some
inferior outcomes can sometimes emerge and, having set in, may persist. It is
these situations that path dependence theory addresses. The question it asks is:
why do these situations arise, and how? Why do they sometimes tend to
continue? Why do rational decision- makers, who are supposed to make optimal
choices, not take corrective measures? The interesting thing is that these inferior
outcomes emerge even when superior alternatives exist and are available.
One way of how this works is through ‘complementarities and network
externalities’. We shall explain these concepts with some examples from
technology. The common typing keyboard layout in typewriters and computers
usually have the letters Q, W, E. R. T. Y.... on the top row and this is called a
189
Individuals, QWERTY-type keyboard. Now, the earliest typewriters were mechanical
Communities and
Collective Outcomes gadgets where, when a key was struck, a lever with the imprint of the letter
would rise and strike the typewriter ribbon so that, because it contained the fluid
or the ink, the letter would print or type on the page. If two or three keys were hit
with quick succession the lever would jam. The QWERTY keyboard was
designed in such a way as to minimise the possibility of such jamming. This was
done by placing the keys that were likely to be struck in quick succession i.e. in
terms of spelling of words of the English language, they were placed far apart.
Thus the QWERTY keyboard was designed to slow down speed of typing
thereby minimising the jamming. An alternative keyboard design introduced in
1932 was realised to be better at promoting speed. It was found that typists
trained in the Dvorak system were regularly beating typists trained in the
QWERTY system in speed typing tests. The question is, why do we then find the
inefficient QWERTY-type layout in most keyboards even today? The answer is
that the QWERTY layout had a historical advantage of emerging first. Given that
firms and organisations hired typists coming out of typing schools, given that
these typists were already trained in QWERTY-type keyboard, any individual
firm would found it very costly to invest in retraining its typists on the Dvorak
system. There is now a clear divergence between individual costs and social
gains. This occurs in this case because there are complementarities and network
externalities. Externalities take the special form of network externalities because
of the complementarities. Let us explain further what network externalities mean.
You have already read in the section on market failure what externalities are.
Network externalities mean that the cost or benefit of adopting a technology or
product depends on how many people have already adopted a particular
technology or product. Say, you plan to buy a mobile phone, because among
other uses, you think that sending and receiving SMS messages would be very
useful. But if only two or three other people whom you know have a mobile, this
feature is not going to be too useful. Surely, the more of your friends and
acquaintances already have a mobile, the more useful it would be to you. This is
an example of network externalities. This is very important in Information and
Communication Technology (ICT) like e-mail.
So, to come back to the QWERTY example, we find that complementarities and
network externalities create a situation where a suboptimal choice is made and it
tends to persist. The important thing is to realise that if we were to look at the
average cost (AC) curves of the Dvorak system, and the QWERTY system, we
will find that the Dvorak system, because it is more efficient, will have its curve
downward sloping. This downward sloping would be because of scale
economies. But for an individual firm which wants to make a switch from
QWERTY to Dvorak, the relevant costs (in the two curves) to be compared are at
different points. They are at the point corresponding to the horizontal axis, which
measures the number of units (i.e. typists trained). On the QWERTY curve, the
190 point is far too much to the right since QWERTY has been around for a long time
 Individual Behaviour
and many typists with QWERTY type training are already there. To switch to in Social Environments
Dvorak system, we have to consider a point close to the origin on the horizontal
axis because it will be the first typist with the Dvorak system. Hence, this point,
on the Dvorak curve will be too much to the left and be of higher average cost
than the QWERTY point.
There are other such examples. In the 1980s, the format for videotapes chosen
was the VHS although the Betamax system was demonstrably superior.
Likewise, in computer software, although other operating systems may be
available, and may even be superior or cheaper or both, because of
complementarities and network externalities, Windows operating system has
become the standard. Similarly in the case of microprocessors, although other
chips like AMD and RISC chips are available, Intel chips have become the
industry standard. The upshot of this discussion is that we quite often find that,
because of complementarities and network externalities, there may be multiple
social equilibria. Which equilibrium gets chosen, and it may be the inferior one,
depends on the path chosen by history. This is what is meant by saying, when
complementarities are present, there may occur historical lock-ins.
Recall the idea of the ‘low level equilibrium trap’. The same idea can be
understood in terms of widespread coordination failure where large-scale
investment does not take place because other complementary investments are not
forthcoming. Investments would be made if each investor expects others to
invest. Coordination then depends on the expectations of investors. The problem
of coordination can be solved to a great extent if linkages can be created among
various sectors of such a developing economy. Rosenstein-Rodan used this kind
of an idea to formulate his theory of the Big Push.

Check Your Progress 3

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What is the concept of path dependence and historical lock-ins?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) What is meant by network externalities?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
…………………………………………………………………………………
191
Individuals,
Communities and 9.7 LET US SUM UP
Collective Outcomes
The thrust of this unit was two-fold. First, the concept of private goods, public
goods and common property resources was discussed. It explained the basic
characteristics of common property resources. The unit then looked at how
social and non-economic factors and processes influence economic outcomes.
The unit then introduced you to the non-market and non-state sector of society,
called the social community or civil society or civic sector. The unit looked at the
working of local communities. It then discussed the meaning and emergence of
norms, and why they persist.

Other important topics like the impact and influence of institutions on the
development process in developing countries was also discussed in the unit.
How institutions like property rights and the structure of markets determine
social outcomes were explained. The unit then analysed the role of social norms
and the community in economic development. Of late, it is being realised that
patterns of social interaction, social customs and norms and the community, exert
significant influence on the course of development of developing countries.
Finally, the unit discussed how widespread coordination failures can take place.
The puzzle of how suboptimal equilibria emerge and persist, and how the path
chosen initially determines the subsequent growth path, and how societies can get
locked in into inferior outcomes, were all explained in the unit..

9.8 HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) Rival goods are those where, though no one is prohibited, consumption by
one depletes the availability to others. Excludable goods are those where by
a means like an entry fee, some members are prohibited from its use.
2) Private goods are both rival and excludable. CPR are rival but access is open
to all in the region/community.
3) CPR does not include right to sell or alienate.

Check Your Progress 2

1) Norms help in economic transaction when markets are absent or incomplete.
Communities provide a principle for organised transactions. They sometimes
correct market and government failures. They thereby aid development.
2) It refers to the ‘sum total of network relationships’ that a person is able to
establish with the other members of the community.
3) When mutual trust based transactions become widespread in a community, it
192 acts as a ‘social capital endowment’ and a ‘local public good’.
 Individual Behaviour
Check Your Progress 3 in Social Environments

1) It refers to a particular method or technology which appears first in the

market and continues to remain the leader, even when superior methods have
come up later.
2) It means that the cost or benefit of adopting a technology or product depends
on how many people have already adopted the particular technology or
product.

193
Individuals,
Communities and
Collective Outcomes
UNIT 10 GOVERNANCE IN ORGANISATIONS
AND COMMUNITIES
Structure
10.0 Objectives
10.1 Introduction
10.2 Non-Government Organisations (NGOs)
10.2.1 Importance of an NGO
10.2.2 Functions of an NGO
10.3 Rural Local Bodies
10.3.1 Panchayati Raj Institutions
10.3.1.1 Recommendations of the Balwant Rai Mehta Committee
and The Ashok Mehta Committee
10.3.1.2 73rd Constitutional Amendment
10.3.2 Functions of Panchayati Raj Institutions
10.3.3 Sources of Income of Panchayats
10.3.4 Ministry of Panchayati Raj
10.4 Social Capital
10.4.1 Dimensions of Social Capital
10.4.2 Social Capital and Economic Growth
10.4.3 Social Capital and Poverty
10.4.4 Limitations of Social Capital
10.5 Let Us Sum Up
10.6 Hints to Check Your Progress Exercises

10.0 OBJECTIVES
After going through this unit, you will be able to explain:
 discuss the importance of NGOs in economic development;
 enumerate the functions of NGOs;
 state the recommendations of the Balwant Rai Mehta Committee;
 explain the working of Panchayati Raj Institutions;
 describe the three facets of social capital; and
 elucidate the relation of social capital with economic growth and poverty.


Contributed by Dr. Nidhi Tewathia, Assistant Professor, School of Social Sciences, IGNOU
194
 Governance in
10.1 INTRODUCTION Organisations and
Communities
Effective governance takes place with the help of proper devolution of functions
and power. India being such a diverse nation in terms of religion, communities
and culture that the organisation of roles and power is a challenging task. Having
only the central and state government is not enough and hence the organisation at
the local level is necessary. We will learn about the rural local bodies like the
Panchayati raj institutions which are working at the grassroot level to enhance the
process of democratisation. Further, there are certain occasions when the
government finds it difficult to work successfully for the social justice and
promotion of development of the society. Certain sections become marginalised
and are not able to take benefit of many available resources. To bridge this gap,
we need non-governmental organisations (NGOs). We discuss the importance
and the functions of NGOs in India. In the last section, we discuss the concept of
‘social capital’, its various dimensions and its relation with economic growth and
poverty reduction. Social capital is the backbone of any country as it is the
relations and the bonds various groups and communities hold in a given nation.
The efficiency of various ways and types of governance depends on the social
capital of a country.

10.2 NON-GOVERNMENT ORGANISATIONS

In the Charter of the United Nations in 1945, the term Non-Governmental
Organisations (NGO) was used for the first time. There is no fixed definition for
an NGO but they are generally taken as the non-profit organisations on which
governmental control does not apply. In India, NGOs are registered under a
Central Act called the Societies Registration Act. The main source of finances for
an NGO is donations. But NGOs may receive some funding from the government
under certain laws. A group of individuals who intend to do good for the society
and have enough funds also can start an NGO and work in accordance with their
own terms and principles. The membership is open to anyone. Individual
members can work in any NGO for any duration they wish to and can quit
whenever they want to. At times, if situation demands, some NGOs ask some
individuals to help them out by coming forward and becoming a member of their
NGO. The volunteers, i.e., the members who wish to work with an NGO for a
short duration on some specific project need to express their suitability and
intention of working with that NGO. Overall, we can say that an NGO is a
voluntary body.

10.2.1 Importance of an NGO

NGOs work for the welfare of the society at a broad scale or at the local level.
One can say they are the link between government and the society. When we
observe that the government bodies are not able to function effectively in terms
of welfare augmentation and redistribution, NGOs play a significant role. Over
195
Individuals, the years, we have seen that people help each other in difficult times. In ancient
Communities and
Collective Outcomes India, religion was also a factor for such helpful conduct. Religiously active
people believed that helping others will wash away their own sins. Many felt that
they will die peacefully as they have helped others in their life. Rulers started
charity work and serving human lives in order to receive blessings from the
almighty. Some helped from the view of good deeds. Community life was active.
Many people were supportive to each other and did not care much for wealth or
God. They dedicated their finances and physical strength for helping the needy.
Beyond the individual level, many organisations were formed comprising
individuals who wished to provide their services to the community in a structured
manner. These organisations were far from the social evils such as the caste
system and other kinds of discrimination based on religion or gender. Mahatma
Gandhi is a famous example of the fight against social evils which marginalise
some sections of the society. Feeling encouraged by the philosophy and actions
of Mahatma Gandhi, many NGOs came into existence in Gujarat and many other
states. Eklavya, Disha and SEWA are a few examples. Since Independence,
people have more awareness about their basic rights; even the government has
launched many community development schemes which target upliftment of
certain sections and welfare maximisation in general. The process of
development has also increased inequalities such as gender inequality, economic
inequality, and social inequality. Urbanisation and migration to cities has led to
issues such as unemployment, over-utilisation of natural resources and pollution.
It is required that people help themselves by contributing to the society’s welfare.
To make society a better place, many NGOs have been established. There are
some NGOs which are formed for a particular group of the society, for example,
women, children, widows, acid victims, victims of domestic violence, etc. All
over the world, NGOs have gained importance over the years.

10.2.2 Functions of an NGO

When some issues are not solved by the government, the functions of NGOs play
a crucial role in assigning such issues to the government. Some issues are looked
into by the NGOs with a strong intention. NGOs help the uneducated section
receive education. The individuals who benefit from the services of such NGOs
are able to enjoy the fruits of education which other educated people do.
Similarly, NGOs are giving their best in eliminating the gender inequality and
spread gender awareness. Girls face discriminatory behaviour in their families,
e.g., no education or less education, early marriage, not allowing them to work
outside the houses, etc. Such ideology is very difficult to be eliminated. NGOs
are putting efforts to bring in gender equality in the society. Women have greater
employment opportunities due to the efforts of NGOs like SEWA. Overall, we
can say that NGOs are helping many to restore their dignity.
Following are some of the functions of NGOs: Augmenting social justice, saving
196 animals and work for their rights, conservation of environment, human rights,
rights of children, removing poverty, senior citizens care, controlling diseases, Governance in
Organisations and
enhancing nutrition and health, empowerment of women, Hygiene and Communities
sanitisation, relief during natural calamity. Activities taken up by NGOs are: (i)
Advocacy and Raising Awareness, (ii) Intermediation, (iii) Conflict Resolution,
(iv) Capacity Building, (v) Service Delivery, and (vi) Programme Monitoring and
Evaluation. To be an effective functionary the members of an NGO should be
educated, inspired and enthusiastic.
These functions of NGOs have led to an improvement in areas such as social
justice, literacy, sustainable development, and socio-economic conditions.

10.3 RURAL LOCAL BODIES

There are many basic facilities which we need in our everyday life. The activities
like water supply, drainage system, garbage disposal, street lights, public health
and sanitation are a few examples of many such activities. Let us think of a day
when the street light repairing is taking place in your locality. Which government
is getting it done – Central government or State government? Many of you will
say none of them. That is right because it is the local government which deals
with such activities. The local government has an important role to play in both
urban and rural areas.
Local bodies are duly elected as per rules. The elections are conducted by the
State Election Commission. The finances of these bodies are regulated by the
State Finance Commission.

10.3.1 Panchayati Raj Institutions

In ancient times, a village was the basic unit of social and economic life for any
Indian. Mahatma Gandhi believed that all sections of the society have certain
power and that democracy lives in the grassroots. This is manifested by the
village panchayats. Prior to the British period, village panchayats played an
important role in the social life of the villagers, particularly in terms of dispute
settlement among the villagers. New laws, judiciary and revenue collection
system was put in place by the Britishers. Due to the change in the social
structure during the British period, village panchayats lost their importance. The
features of the traditional Indian economy vanished wherein the village was
organised in a self-sufficient manner.
In the post-independence period, the union and the state governments were given
a directive to take steps and organise village panchayats. This was not taken up
very seriously until Panchayati Raj institutions received the Constitutional status.
The main aim of the Panchayati Raj is to involve millions of people in the
functioning of democracy. This system enables each and every family even in the
remotest village to be part of the democratic process. For a country like India,
which is committed to the democratic form of government, Panchayati Raj helps
197
Individuals, to build democratic traditions. Such traditions can only be built by involving all
Communities and
Collective Outcomes the people directly or indirectly.
10.3.1.1 Recommendations of the Balwant Rai Mehta Committee and
The Ashok Mehta Committee
The Balwant Rai Mehta Committee (constituted in 1957) recommended that the
Panchayati Raj institutions should be granted enough resources and power and
should be structured in a three tier level. These three tiers are: a) Zila Parishad at
district level, b) Panchayat Samiti at the block level, and c) Village or gram
panchayat at the village level. The lower body chairperson represents the body in
the higher body (for example, chairperson of the gram panchayat is a member in
the next level, i.e., Panchayat Samiti). That is how all three are inter linked. This
model first was implemented in Rajasthan. Initially, there was enthusiasm among
various agencies involved but due to political interference and government
indifference the Panchayati Raj institutions started declining soon. The Ashok
Mehta Committee (constituted in 1977) was asked to review these institutions
and their working. The committee submitted its report in 1978. The report
mentioned that these institutions are not very successful in terms of carrying out
economic development. A two-tier structure was suggested by this committee,
i.e., Zila Parishad at district level and Mandal Panchayat. More weightage was
given to Zila Parishad. Unfortunately, these recommendations could not be
implemented as the union government collapsed in 1980. Since then, there have
been many reasons for the Panchayati Raj institutions to be not working the way
they were expected to.
10.3.1.2 73rd Constitutional Amendment
In 1992, the 73rd amendment to the Constitution was enacted. The amendment
made some statutory provisions in order to establish and empower the
functioning of the Panchayati Raj institutions. Its salient features are:
a) organisation of Gram Sabha
b) creation of a three-tier Panchayati Raj structure
c) most of the posts to be filled by direct elections
d) minimum age of 21 years for contesting the elections
e) reservation for Scheduled Castes, Scheduled Tribes and women
f) setting up of the State Election Commission which will conduct the elections
for Panchayati Raj institutions.

10.3.2 Functions of Panchayati Raj Institutions

The three-tier structure of Panchayati Raj involves Gram Panchayat, Panchayat
Samiti and Zila Parishad. Gram Panchayat further has three components i.e., (a)
Gram Sabha (b) Gram Panchayat (c) Nyaya Panchayat. The functions of
198 Panchayati Raj institutions can be divided into three categories: a) General
Administrative Functions, b) Developmental and Social Functions, and c) Governance in
Organisations and
Maintenance Functions. Mainly, the Panchayati Raj institutions perform the Communities
functions which are mentioned in the state laws in relation to Panchayati Raj.
There are certain obligatory functions related to sanitation, public toilets, and
primary health care. In addition, Panchayati Raj institutions have some optional
functions such as roadside plantation, child and maternity welfare, and promotion
of agriculture. These will be taken up only if there are enough resources with the
Gram Panchayat. The functions of Gram Panchayats have been widened after the
73rd Amendment. Now, functions like preparation of Annual Development Plan
of panchayat area, annual budget, tackling the public land encroachment issue,
implementation and monitoring of the poverty alleviation programmes are
performed by the Gram Panchayats. In some states, the Gram Panchayats also
look after the public distribution system, chulhas and biogas plants, etc.
Block Development Officer is the head of the Panchayat Samiti. Some
development functions are assigned to Panchayat Samiti such as agriculture, land
improvement, watershed development, technical and vocational education.
Additional functions relate to the government schemes for which the Panchayat
Samiti has been given a particular sum of money.
Zila Parishad coordinates and supervises the functioning of the Panchayat
Samitis. It also looks after the development of the district by undertaking some
yojanas related to the improvement of agricultural output, rural electrification,
employment generation, construction of roads, etc. Zila Parishad also looks after
the welfare of people in the district, particularly women and children. They create
orphanages, night shelter and support the relief operations during any natural
calamity. Zila Parishad is responsible for the overall coordination and
implementation of employment generation programmes in the district such as
MGNREGA.
Apart from the above, Panchayati Raj institutions train individuals for leadership
by providing training to the elected ones for moving to higher representative
institutions. It also helps citizens to gain knowledge and experience of the
operations of the political machinery and role of elected representatives in that
machinery. Understanding the local issues widens the horizon of the individuals
and helps them to understand the national issues.

10.3.3 Sources of Income of Panchayati Raj Institutions

Panchayats have mainly three sources of income. The main source of income for
the panchayats is the grants from the State Government. Secondly, panchayats
have some taxation powers. They can levy taxes such as house tax, cattle tax,
immovable property tax, sanitation fee, etc. Thirdly, they receive certain share
from the land revenue collected by the State.

199
Individuals, Panchayat Samitis receive grants from the State Government. Apart from these
Communities and
Collective Outcomes grants, they can impose user charges on the facilities they provide such as
drinking water and irrigation, tolls for the bridges they maintain, etc.
Zila Parishads have five sources of income: (i) collection of license fees on
individuals (such as businessmen, brokers, commission agents, etc.) and taxes on
the sale of goods in the markets established by the Zila Parishad; (ii) share in the
land revenue collected by the State; (iii) income from various properties of the
Zila Parishad; (iv) grants from central and state governments; and (v) funds
received under developmental activities in the state.
During the Covid-19 pandemic, the Panchayati Raj institutions had an important
role to play. These institutions took initiatives in creation of isolation centres,
organisation of medical camps, carrying out awareness campaign, contact
tracing, provision of food to the poor, etc. Availability of funds is a major
problem of the Panchayati Raj institutions. According to the Economic Survey
2017-18, about 95 per cent of the resources of the Panchayats is received as
grants from the State and the Centre. Panchayats have a very low tax base
because of which they are not able to generate internal resources. Further, there is
some reluctance on the part of the local governments to impose taxes.

10.3.4 Ministry of Panchayati Raj

In May 2004, a new ministry, by the name of Ministry of Panchayati Raj, was
created to look after the process of decentralisation and local governance in the
states. All the matters related to the Panchayati Raj and the institutions are looked
into by this Ministry. The mission of the Ministry is “empowerment, enablement
and accountability of Panchayati Raj Institutions to ensure inclusive development
with social justice, and efficient delivery of services.”
The Ministry ensures that the elections are held timely, sets up the State Finance
Commissions, implements the recommendations of these commissions,
constitutes and empowers the District Planning Committees so that the State and
Central planning gets effective feed from the grass root planning mechanism. A
significant role of this Ministry is to ensure that the State Governments devolve
funds for carrying out the functions of the Panchayati Raj Institutions as per the
constitutional provisions. It also takes the responsibility of formulating and
implementing an action plan in order to help Panchayati Raj Institutions emerge
as the Institutions of Local-Self Government. This will help these institutions
achieve economic development with social justice.
The ministry of Panchayati Raj also works for capacity building of Panchayati
Raj Institutions, through many training programmes. To encourage development
of Panchayats, the Ministry also encourages research work through funding
projects, workshops and seminars. In addition to that, the Ministry has instituted
several awards such as e-Panchayat Puraskar, Child-friendly Gram Panchayat
Award, and National Panchayat Award to encourage efficient functioning of the
200 Panchayats.
Check Your Progress 1 Governance in
Organisations and
Communities
Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What is meant by the term NGO? Why do the NGOs exist.
………………………………………………………………………………….
………………………………………………………………………………….
2) List a few functions of an NGO.
………………………………………………………………………………….
…………………………………………………………………………………
3) Name the three tiers of Panchayati Raj Institutions?
………………………………………………………………………………….
………………………………………………………………………………….
4) Discuss the functions of Zila Parishad and Gram Panchayat.
………………………………………………………………………………….
………………………………………………………………………………….

10.4 SOCIAL CAPITAL

We come across the term ‘Social Capital’ very often. It is used in academic
literature, government policy documents, economic and social initiatives and
non-government organisations. This term however does not have a standard
definition. There are multiple interpretations of this term. The OECD defines
social capital as “networks together with shared norms, values and
understandings that facilitate cooperation within or among groups”. Pierre
Bourdieu, a French Sociologist, views social capital as a property of an
individual, derived from his/her social position and status. According to him,
social capital is the resources that provide access to group goods in order to
secure economic capital. According to Robert Putnam, social capital is the norms
and networks that facilitate cooperation for mutual benefit in order to secure
effective democracy and economy. Mainly, the social capital helps shape the
quality and quantity of society’s social interactions. Social networks can be
formal or informal, as we discuss later in this Unit.
Social capital comprises all the mutual relations and the level of trust within a
group or a community. Thus, it is associated with trust, credibility, norms,
membership of various groups, and voluntary activities. Let us consider a few
examples. One fine morning you find that you do not have sugar in your kitchen.
Instead of going to the shop to buy sugar, you borrow a cup of sugar from your
neighbour. You can approach your neighbour if you are in good terms with them
and you expect that they will take your request positively. Another example:
Suppose you plan to migrate to Canada and find a job there. If you know
someone who has a similar experience, and willing to help you, your migration 201
Individuals, and search for jobs will be somewhat easier. You can think of many other
Communities and
Collective Outcomes examples from your daily life – someone returning your lost wallet, opening the
door for you, lending you money without a contract, etc. You tend to benefit
from such activities of others, which implies that social capital contributes to
economic development.

10.4.1 Dimensions of Social Capital

The World Bank has prepared a conceptual framework which distinguishes
various dimensions of social capital. As per this framework, there are three
aspects of social capital: (i) bonding social capital, (ii) bridging social capital,
and (iii) linking social capital. Bonding social capital mainly indicates the strong
and close connections between groups of individuals who are most likely
homogeneous. For small groups of individuals such as immigrants, clubs,
criminal gang, and business acquaintances these ties are very relevant. Social
capital for such groups facilitates bonding, which helps them to unite and
strengthen the community. These ties are mostly between similar people and
refer to horizontal ties.
Bridging social capital indicates weak ties between heterogeneous groups of
individuals. These ties are weaker than the bonding ties. The function of this
facet of social capital is to connect and bridge differences between different
groups which is very significant for the society. It helps the functioning of the
government, communities and the society as a whole, through dialogue and
communication between different groups. In fact, this dimension of the social
capital acts as a glue for bridging different communities together.
Linking social capital refers to the vertical ties between the poor and the rich. We
can also say that these ties are across groups which are from different strata of
society or culture. This dimension of social capital was ignored in the past but is
being recognised in recent years. This is linked with the issue of exclusion of
certain groups from development process.
In addition to the above three aspects of social capital, we can classify it under
the following two categories: (i) formal social capital, and (ii) informal social
capital. In order to increase and build up social capital we need formal
organisations and institutions. For example, when you become a member of
certain club or association you can interact with other members and gain
knowledge. But formal social capital is not sufficient. The potential and the effect
of informal social capital is generally underestimated. The informal relationships
hold a great weight of facilitating the process of social capital building. Social
relationships we establish with family, friends, colleagues and neighbours are
examples of informal social capital. It facilitates the operating of individuals and
the society, which eventually leads to growth of social capital.

202
10.4.2 Social Capital and Economic Growth Governance in
Organisations and
Communities
We find that many countries having similar or identical production technology
and capital, have economic disparities across them. We expect that if two
countries have similar natural resources and production technology, then their per
capita gross domestic product should be similar. But this is not so. Many social
scientists and economists find themselves in a kind of puzzle as they find it
difficult to explain why the economic growth in two countries differ which
otherwise have equal access to technology, resource endowment, and market
access.
In order to analyse economic growth in an economy, we use standard economic
theories such as the Solow model or the Walrasian equilibrium model. They
assume that economic variables are the reasons of fluctuations in output level.
The problem with these two and other similar models is that they do not give
required weightage to the role of social and cultural factors which actually affect
the economic outcomes. So, a major criticism of economic theories is that they
are not able to explain economic growth completely. Social factors such as
norms, beliefs and institutions provide the missing part of the explanation. These
factors play a significant role in furthering the economic performance of a
country. Hence, these factors need to be considered in growth theories. Another
criticism is that the standard theories are unable to explain the factors behind
unsustainable unprecedented growth levels. Such high growth levels are also
accompanied by some undesirable externalities such as income inequality, social
injustice, environmental degradation, sluggish improvement in quality of life, and
social conflicts. Standard economic theories fail to explain why unprecedented
growth levels are also accompanied by these negative externalities. Further, the
whole economic development measurement model does not take into account the
prevailing social value systems.
At present, it is well established that there is a strong link between culture and
development. Social scientists are giving a good consideration to the process of
development informed by the social values and system. The preceding sub
section makes it clear that the social capital plays a very significant role in a
country’s development process.

10.4.3 Social Capital and Poverty

Social conditions in a community help shape up the employment opportunities
which leads to improvement in quality of life. These social conditions in a
community are believed to be influenced by investment in human capital.
According to Amartya Sen, if individuals are deprived of social arrangements
and community relations (social capital) such as public healthcare, basic
education, and law and order, then individuals may face poverty and deprivation.
In order to improve economic opportunities, private enterprise has also taken up
many initiatives. Such private foundations believe that poverty is not just about 203
Individuals, the lack of financial capital. They believe that the state of poverty is an indicator
Communities and
Collective Outcomes of the lack of social relationships. Social relationships require building up of
social capital through comprehensive community initiatives. The NGOs
contribute significantly to this process of creation of social capital. They are
engaged in improving the level of various communities at the grassroots level.
The NGOs work from the foundation level, i.e., establishing social services to the
funding and implementation of these social services.
Among organisations, social capital gets reflected in partnerships and
collaborations. There are visible factors like norms of behaviour, trust and
reciprocity in such partnerships. They also work in the direction of exploiting
scale economies. This encourages them to scale up their operations related to
social capital initiatives. Therefore, it needs underlined that all three types of
organisations, viz., social, political and economic are all equally important in
enhancing economic development through community involvement.

10.4.4 Limitations of Social Capital

From the discussion in the previous sub-section, it follows that social capital is an
important factor missing from the neoclassical scheme of economic analysis.
However, there are some risks attached to the inclusion of social capital in
economic analysis. We should understand that social capital is not uniformly
distributed among individuals and communities. This is because of different
social, educational and cultural contexts or due to geographical differences in
terms of connectedness or isolation. The differences can also be witnessed due to
variations in endowments available to individuals or groups. The ability of
sharing such resources, and willingness to cooperate, differs. Hence, there
remains a big question about the access and mobilisation of social capital.
Various groups indicating bonding, bridging or linking social capital may lack
transparency. They may restrict participation in a collaboration, have unrealistic
expectations from communities, or manifest dominance by political elite.
Social capital is not always beneficial; they can be used to harm the society. Drug
cartels and criminal gangs are also a form of social capital; they are based on the
links and trust. Various companies and brands can face difficulties if they possess
the wrong kind of social capital, e.g., connection between the employees who are
too inward-looking and distanced from the affairs of the wider world.
Social capital is also criticised in terms of its ownership. It is different from other
types of capital. It is not tangible as it exists in terms of relationships. If we look
at human capital, we say it is in the heads of individuals. Similarly, the money as
economic capital is also with individuals in their houses, wallets or banks. But
social capital resides in the structure of the relationships between different
individuals. Further, if you wish to sell or buy physical capital such as land,
vehicles, etc. you can do so easily by following the set procedure. But social
capital cannot be bought or sold as it is owned collectively by more than one
204
individual in terms of a relation. The individuals who own that social capital are Governance in
Organisations and
all the owners of that social relation and no one of them has complete right over Communities
that relation. In order to sustain the social capital, all the individuals in that social
relation have to work and anyone’s action or effort will not be sufficient. The
difference between social capital and other forms of capital indicate that the
characteristics of social capital do not fit under the conventional category of
capital.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Name the three facets of Social Capital. Define the term ‘bridging social
capital’.
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2) How is social capital related to economic growth of a country?
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3) Does social capital have any disadvantage?
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10.5 LET US SUM UP

We began this unit by describing the importance and the functions of NGOs. The
NGOs have been successful to a certain extent in terms of poverty reduction,
increasing the literacy rate and working for various marginalized sections of our
society. We moved further to the concept of local governance in rural areas in
terms of Panchayati Raj Institutions. They work in a three-tier system, i.e., Zila
Parishad at the district level, Panchayat Samiti at the block level, and Gram
Panchayat at the village level. These institutions have their own sources of
income and have very specific functions to perform. In the last section we learnt
about the importance of social capital in economic development. As per the
World Bank’s conceptual framework, there are three facets of Social Capital, i.e.,
bonding social capital, bridging social capital, and linking social capital. Social
capital also has a flip side when we look at it in the context of groups such as
drug cartels and criminal gangs.
205
Individuals,
Communities and
10.6 ANSWERS/HINTS TO CHECK YOUR
Collective Outcomes PROGRESS EXERCISES
Check Your Progress 1
1) NGO stands for Non-Governmental Organisation. The NGOs are needed to
bridge the gap in the areas where the government is unable or fails in
operations like social justice, discrimination, education, etc.
2) Important functions of an NGO are: saving animals and work for their rights,
conservation of environment, human rights, rights of children, enhancing
nutrition and health, empowerment of women, hygiene and sanitisation, relief
during natural calamity, etc.
3) Three tiers of Panchayati Raj are Zila Parishad, Panchayat Samiti and Gram
Panchayat.
4) Zila Parishad coordinates and supervises the functioning of Panchayat
Samitis. It also looks after the development of the district by undertaking
some plans related to the improvement of agricultural output, rural
electrification, employment generation, construction of roads, etc. Gram
Panchayat prepares the Annual Development Plan of the panchayat area,
annual budget, tackles the public land encroachment issue, and implements
and monitors the poverty alleviation programmes.
5) Ministry of Panchayati Raj was established in May 2004. The objective of
this ministry is the empowerment, enablement and accountability of
Panchayati Raj Institutions to ensure inclusive development with social
justice, and efficient delivery of services. The ministry also provides
incentives in terms of awards for well-functioning panchayats.

Check Your Progress 2

1) Three facets of social capital are bonding social capital, bridging social
capital, and linking social capital. Bridging social capital indicates weak ties
between heterogeneous groups of individuals. The individuals within a a
group are more or less homogenous. Bridging social capital tries to reduce the
differences between different groups of individuals. It helps the functioning
of government, communities and the society as a whole, through dialogue and
communication between different groups.
2) Social factors such as norms, beliefs and institutions are missing from the
standard growth theories. Social capital helps facilitate access to more
information, increases social cohesion, boosts political participation,
improves government responsiveness and efficiency, solves collective
problems, and enhances civic engagement. These factors play a significant
role in furthering the economic performance of a country.
206
3) Groups like criminal gangs or drug cartels can do harm to the society and Governance in
Organisations and
hence social capital may not always be beneficial for a country. Social capital Communities
resides in the structure of the relationships between different individuals. It
cannot be bought or sold since it is owned by more than one individual in
terms of a relation. In order to sustain the social capital, all the individuals in
that social relation have to work and any one’s actions or efforts will not be
sufficient.

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 BLOCK 5
ENVIRONMENT
AND
SUSTAINABLE DEVELOPMENT

BLOCK INTRODUCTION
Now we arrive at the penultimate block—the fifth—of the course.
This block is titled Environment and Sustainable Development This
block, too, has two units. The block discusses the crucial topic of
sustainable development. The concept is discussed and the link between
environment and economic development is explained. The block also
describes the concept of externality.

The first unit of this block, unit 11, titled Sustainable Development
discusses how economic development impacts the environment. The
unit defines and discusses sustainability and also explains and discusses
the role of renewable resources in development. The unit provides a brief
history of environmental change. The unit also explains and discusses
common-pool resources.

The final unit of the present block, unit 12, is titled Theories of
Regulation. This unit combines elements of public economics,
environmental economics and development economics. The unit explores
the relation between economic activity and climate. The concept of
externalities, is explained and discussed in the unit. The unit also
discusses very important topics in economics, like the Coase Theorem,
correcting for externalities, Pigovian taxes and the pros and cons of
emission taxes.

209
UNIT 11 SUSTAINABLE DEVELOPMENT
Sustainable
Development

Structure
11.0 Objectives
11.1 Introduction
11.2 Sustainable Development
11.3 Renewable Resources
11.3.1 Types of Renewable Resources
11.4 A Brief History of Environmental Change
11.4.1 India’s Environmental Problems
11.4.2 Globalisation and Environmental change
11.5 Common Pool Resources
11.5.1 Tragedy of Commons
11.6 Let Us Sum Up
11.7 Hints to Check Your Progress Exercises

11.0 OBJECTIVES
After going through this unit, you will be able to:
 Explain the concept of Sustainable Development
 Define the renewable resources and explain its types
 Discuss the environmental changes over time
 Describe the common pool resources
 Present the issues related to common pool resources.

11.1 INTRODUCTION
Environment is of a great importance for the mankind. There are different types
of resources which humans use in day-to-day life. The way we use them impacts
the environment. The wastage of resources leads to depletion of such resources.
We begin this unit by understanding the concept of Sustainable development and
renewable resources. The changes in global environment and climate change is
something we all keep hearing in the news now and then. So, in one of the
sections, we will learn about the environment and the changes in environment
over the years. Environmental degradation also takes place due to the property of


Dr. Nidhi Tewathia, Assistant Professor, School of Social Sciences, IGNOU
211
Environment and common ownership of certain resources. Such resources fall in the category of
Sustainable
Development common pool resources and we humans take advantage of the existence of such
resources. The last section of this unit is dedicated to such resources.

11.2 SUSTAINABLE DEVELOPMENT

Natural resources are considered as basic requirements for development of an
economy. But they are limited and available on specific location only. The limit
leads to the scarcity and the basic three central problems of an economy. The
extraction of resources and moving them at the required location involves cost
which gets added to the cost of production. Hence, it becomes necessary to
allocate these resources in a judicious manner. This helps us achieve the most
efficient cost combination. So, we can say that resource allocation is an important
area of study for efficient allocation of factors of production including natural
resources.
Many countries have achieved rapid growth due to the existence of natural
reserves like minerals, oil and other metals. But, the social cost of this type of
growth is environmental degradation. Degradation of natural resources leads to
loss of livelihood as many people are dependent on these resources on everyday
basis. This degradation is also a threat to the health and wellbeing of people. It is
of common knowledge that the air and water pollution have become a major
health hazard over the decades. This also indicates that the resources are not used
at their efficient level. Realisation of such effects led to the concept of
sustainable development. Sustainable development is the idea that human
societies must live and meet their needs without compromising the ability of
future generations to meet their own needs. The “official” definition of
sustainable development was developed for the first time in the Brundtland
Report in 19871. In other words, sustainable development is a way to organize the
society so that it can exist in the long term. This means we take into account the
present and the future requirement of resources with a clear objective of efficient
use of those resources, social and economic equality.
In its report, the World Commission on Environment and Development, 1987,
puts stress on achieving international as well as inter-generational equity for
achieving a level of growth which can be sustained over time. This way the
available resource base would help to improve the average quality of life of
present and future generations. To create the non-declining consumption of
resources in the context of inter-generational efficiency, economists suggested
that we need to reinvest. The reinvestment should be into the creation,

1
In 1987, the World Commission on Environment and Development (WCED), which had been set
up in 1983, published a report entitled ‘Our common future’. The document came to be known
as the Brundtland Report after the Commission's chairwoman, Gro Harlem Brundtland. It
developed guiding principles for sustainable development as it is generally understood today.
212
 Sustainable
exploration and search of the renewable and non-renewable resources. The Development
problem with this approach is that all the resources are not substitutable. Also,
they cannot be created at the same speed at which they are being consumed.
There is a lot of discussion based on the concept of ecological sustainability. To
keep the welfare of the future generations in mind, the resources should be
allocated in a stable manner which can help us to sustain the levels of
development over time. That means we need to question the levels of
consumerism that the developed world and the rich class of the developing
countries are manifesting. This was the context of The Earth Summit, Rio de
Janeiro, 1992. The Agenda 21 of the Earth Summit accepted that human beings
are entitled to a healthy and productive life in harmony with nature. The
Sustainable Development Goals (SDGs), also known as the Global Goals, were
adopted by all United Nations Member States in 2015 as a universal call to action
to end poverty, protect the planet and ensure that all people enjoy peace and
prosperity by 2030. The 17 SDGs are integrated—that is, they recognize that
action in one area will affect outcomes in others, and that development must
balance social, economic and environmental sustainability.
But we must admit that uncertainty is a vital consideration in the economics of
sustainability. Over time it is expected that changes will occur in technology,
income and people’s preferences. Technology may change enormously as an
answer to changing relative scarcities and knowledge. Income will also not be
constant and preferences will differ across generations. The problem is not the
changes but we do not know for sure how and when these changes will occur and
we do not know what the implications of these changes will be for future
resource availability.

11.3 RENEWABLE RESOURCES

Renewable energy is often referred to as clean energy. The natural resources
which are classified as renewable are capable of self-production. Anything that is
a part of the atmosphere comes under the category of renewable natural
resources. For example, sunlight or wind keep shining and blowing, even if their
availability depends on time and weather. While renewable energy is often
thought of as a new technology, harnessing nature’s power has long been
used for heating, transportation, lighting, and more. Wind has powered boats to
sail the seas and windmills to grind grain. The sun has provided warmth during
the day and helped kindle fires to last into the evening. Resources like fish and
forest are renewable resources and can also be replaced.
Over the past 500 years or so, humans increasingly turned to cheaper, dirtier
energy sources such as coal and fracked gas. Searching for the right method of
using renewable resources is a task that is growing ever more important as the
Earth’s supply of non-renewable resources continues to dwindle. But, in recent
years, renewable power has become more popular as innovation is bringing down 213
Environment and costs. It seems that the promise of a clean energy future can become a reality.
Sustainable
Development The renewables are increasingly displacing “dirty” fossil fuels in the power
sector which offers the benefit of lower emissions of carbon and other types of
pollution.
But the use of natural resources is becoming increasingly intense, several
varieties of renewable resources cannot be replaced at the speed they are being
consumed, hence the fear of destruction/extinction of these resources. In recent
years, depletion of several species of fish and extinction of several flora and
fauna thus reducing biodiversity has become a major concern. Several action
plans with a global reach have been devised to protect the endangered species. In
this context, forestry and wildlife protection have assumed significance to retain
diversity in nature and to stabilize the survival of various species of plants and
animals. Further, not all sources of energy marketed as “renewable” are
beneficial to the environment. Biomass and large hydroelectric dams create
difficult trade-offs when considering the impact on wildlife, climate change, and
other issues. Another challenge associated with using renewable resources is that
the renewable energy can be less reliable than non-renewable energy. There are
seasonal and even daily changes in the amount of such energy produced.
However, scientists are continually working to improve feasibility and reliability
of renewable resources. Converting to renewable energy will not only better
sustain the world’s rapidly growing population, but it will also provide a cleaner,
healthier environment for the generations to come.

11.3.1 Types of Renewable Resources

Biomass refers to organic material from plants or animals. This includes wood,
sewage, and ethanol (which comes from corn or other plants). Biomass can be
used as a source of energy because this organic material has absorbed energy
from the Sun. This energy is, in turn, released as heat energy when burned.
Excluding residential use, Brazil, the U.S. and India are the top countries
utilizing all sources of biomass for energy.
Hydropower is one of the oldest renewable resources and has been used for
thousands of years. Today, every U.S. state uses some amount of
hydroelectricity. With hydropower, the mechanical energy from flowing water is
used to generate electricity. Hydroelectric power plants use the flow of rivers and
streams to turn a turbine to power a generator, releasing electricity. China
produces the most electricity from hydropower.
Geothermal energy comes from the heat generated deep within the Earth’s core.
Geothermal reservoirs can be found at tectonic plate boundaries near volcanic
activity or deep underground. Geothermal energy can be harnessed by drilling
wells to pump hot water or steam to a power plant. This energy is then used for
heating and electricity. Iceland has many such reservoirs.

214
 Sustainable
Wind energy generates electricity by turning wind turbines. The wind pushes the Development
turbine’s blades, and a generator converts this mechanical energy into electricity.
This electricity can supply power to homes and other buildings, and it can even
be stored in the power grid. China has the world's largest onshore wind farm in
Gansu Province.
Radiation from the Sun can be used as a power source as well. Photovoltaic cells
can be used to convert this solar energy into electricity. Individually, these cells
only generate enough energy to power a calculator, but when combined to create
solar panels or even larger arrays, they provide much more electricity. China,
U.S, Germany, Japan and India are top 5 countries producing solar energy.

Check Your Progress 1

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Why the concept of sustainability important?
………………………………………………………………………………….
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2) Explain the challenges which are thrown in by uncertainty to maintain
sustainability.
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3) List few renewable resources.
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4) Explain how the renewable energy works. Are there any challenges in order
to use renewable energy?
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11.4 A BRIEF HISTORY OF ENVIRONMENTAL

CHANGE
Broadly speaking environment is essential for continuation of life on earth. It
performs several functions which can be divided into four categories. These are,
i) production functions, ii) regulation functions, iii) habitat functions, and iv)
information functions. As you are aware, environmental degradation restricts the
flow of environmental services. Dumping of pollutants in excess of its
assimilative capacity into air, water and soil results in deterioration of the quality
of these crucial resources.
215
Environment and 11.4.1 India’s Environmental Problems
Sustainable
Development
The nature of environmental problem depends upon the level of economic
development and the geographical condition of the area under consideration.
India being a developing economy with a low per capita income, high population
density, agriculture-dependent labour force, and high percentage of rural areas,
the problems here are different from those in developed countries. The tropical
climate with scanty rainfall in many areas also brings in a specific set of
environmental problems. Poverty, illiteracy and lack of awareness have
aggravated environmental problems in many cases. Poverty in rural areas, largely
due to unavailability of gainful employment, compels people to go to the nearby
forests to collect fuelwood and minor forest products to supplement their
household income. Agriculture being the backbone of the country and draught
animal being the major source of power, animals are reared in large numbers and
sent to forests for grazing. Cooking by using fuelwood not only aggravates
destruction of forest but also releases harmful gases into the air. Lack of proper
sanitation both in rural areas and urban slums vitiates the local environment.
High population density in urban areas without adequate infrastructure such as
water and electricity supply, public transport and waste disposal has brought in
many environmental problems. For example, lack of public transport and rise in
per capita income have led urban households to go for private vehicles which has
increased fuel consumption, traffic congestion, and increased emission from
vehicles. Technological progress has also contributed to environmental problems
in India. Disposal of effluents without treatment have increased pollution of air,
water and soil. Technological progress in agriculture has led to increased use of
fertilizer on land which has increased pollution of land. The cultivation of water-
intensive crops by using ground water has depleted ground water table. In order
to attract investment several governments offer concessions to industries
overlooking environmental concerns. In the process industries come up in the
area but convert the state into a pollution haven. A particular problem of North
India around the months of October and November is stubble burning. With the
onset of winter, farm fires become rampant in northern India, particularly in the
states of Punjab, Haryana and western Uttar Pradesh. Stubble burning is
intentionally setting fire to the straw stubble that remains after grains, like paddy,
wheat, etc., have been harvested. This activity emits fine particulate matter
(PM 2.5), an air pollutant that is a concern for people's health. The environmental
management will have to be more serious and of growing dimensions in the
coming years.

11.4.2 Globalisation and Environmental Change

In a globalised world, the boundaries between states are less visible and political,
economic, cultural and social events are more interconnected with far- reaching
impact. We all experience diverse effects of globalisation. The damage caused to
216 ecosystem from the oil that spilled from one of the leaking containers of British
 Sustainable
Petroleum in 2010 is just one of the examples of the threat globalization poses to Development
the environment. Climate change, deforestation, pollution are now, few of the
many, widely used expressions in international relations as we have achieved the
era of the resource wars.
The process of globalization has further intensified the use of untapped natural
resources of the poor countries with minor benefits for the traditional users of
these resources. The multinational companies - particularly those engaged in
trading agricultural products or processed agricultural produce - have destroyed
the sustainable agriculture of several poor nations through exports of their cheap
and subsidised food products. The control over the production and distribution of
seeds by multinationals has led to destruction of biodiversity. In other words,
while the United Nations and other agencies talk about achieving the goal of
sustainable development, the process of globalization and increasing
concentration of wealth has negated these measures. 'The lop-sided distribution
of wealth has led to manifold increase in consumption levels of the rich few
while the poor are displaced from their traditional habitat.
The literature on environmental effects of globalisation mainly talks about two
types of effects i.e., direct and indirect effects. The direct effects include
emissions and environmental damage which is related to the physical movement
of goods from exporters to importers. This largely includes emissions from fossil
fuel use. Simultaneously there are numerous indirect effects that are caused due
to the growth in trade and foreign direct investment. These indirect effects are
classified in three categories: composition, scale and technique effects. The scale
effect indicates that the global production possibilities frontier shifts due to the
more efficient allocation of resources within countries. This increases the size of
the industrial pollution base which means there will be greater global emissions
other things being equal. The composition effect measures changes in emissions
which arise as a result of trade liberalisation as the country’s industrial
composition changes. For example, if liberalization expands the service sector of
a country while the heavy industry contracts, then the country’s total emissions
will most probably fall as the sector which is expanding is less emission
intensive. Finally, the technique effect refers to the glut of channels through
which globalisation impacts the rate at which the pollution increases by the
industry and the households. These channels include changes in the
environmental regulations and their stringency. Such changes are in response to
income growth or the political climate surrounding such regulations. The
technique effect also includes the technology transfer which is facilitated by trade
or we can say by globalisation.
The international agencies which have been created for protecting the
environment shall once revisit their concerns and are required to show a strong
will to implement the decisions in this direction.

217
11.5 COMMON POOL RESOURCES
Common Pool Resources (CPRs) are the resources which may be owned by
national, regional, or local governments, by communal groups, by private
individuals or corporations. They may be used as open access resources by
anyone who can access it. CPRs share two attributes of importance for economic
activities: (1) it is costly to exclude individuals from using the resource either
through physical barriers or legal instruments, and (2) the benefits derived by one
individual reduce the benefits available to others.
These resources may not have a formal owner but some kind of ownership
control is exercised collectively and the resources are often managed as common
property. The goods produced from these resources are consumed
individually (as private goods). For example, forests and grazing lands are
CPRs and they provide goods such as firewood and fodder.
CPRs play an important role in the users’ life. They supplement rural livelihood
and act as the safety nets for the poor in some seasons or at the time of bad
harvest or any other kind of crisis. CPRs are public goods with limited/
subtractive benefits; if individual A uses more, less will be left for others. Many a
times, CPR users resort to the practices which reflect their selfishness and short
sightedness. To avoid such deliberate acts, some sanction rules also are applied to
people or to whole communities in order to make them do what they may not
want to do. CPRs are therefore likely to face problems related to congestion,
depletion or degradation.
CPRs exhibit free or restricted access. Situations where there are no restrictions
on the access to a resource or its use, are called free or open access CPR. When a
resource is in abundant supply, it does not make sense to restrict its access or
limit its use. However, if the demand for the resource increases due to factors like
population pressure, industrialization, economic growth, etc. and the resource
becomes scarce, a common property free access regime is no longer appropriate.
Different models of CPRs’ governance are suggested by different people. There
are two dominant conceptual models of common property resource management:
a capitalist model and a socialist model. The capitalist model argues that
resources that are held commonly are subject to degradation. Hence, privatization
of public resources is the only viable solution to the problem. The socialist model
explains that economic poverty caused by inequitable distribution of resources
among rural agrarian population is the delivering force of resource destruction.
Therefore, collectivization or nationalization of public resources serves as an
equitable strategy of resource management.

11.5.1 Tragedy of Commons

Due to open access and lack of proper management, CPRs are being
degraded overtime due to overuse. To see this, consider an agricultural village in
which the villagers graze their cows on a common field. An individual villager
would use the grazing land to the point where his private marginal cost equals his
private marginal revenue. But in doing so, each villager generates an external
cost borne by all other villagers in terms of reduced fodder available for their
cows that would reduce the productivity of cows. Since each villager ignores the
social cost of grazing an additional cow, too many cows will be grazed on the
common land.
 Sustainable
Thus, the social cost of exploiting the resource exceeds the individual private Development
cost. In this sense, open-access common property resources are closely linked to
congestible public goods. This is explained by Garret Hardin in an essay of 1968,
entitled the tragedy of the commons. He argued that if individuals
act independently, rationally and focused on pursuing their individual interests,
they would end up going against the common interests of their
communities and exhaust the planet’s natural resources. This overuse of public
resources is termed as the "Tragedy of the Commons". Overfishing in
international waters, deforestation, and several species of animals being on the
verge of extinction due to overhunting, are some of the examples of this
phenomenon. Of course, assigning private rights to the resource can ensure its
efficient use. In situations where there is some difficulty in assigning such
rights, the overuse can be prevented by social institutions that are strong
enough to limit the use of the resource by individuals. These are called
restricted access CPRs.
Though we have discussed about few CPRs already but we can list a
large number of CPRs, which can be brought under the broad headings
like land resources, forest resources, water resources, and fishery resources.
Land Resources
Common property land resource refers to lands identified with a specific type of
property rights. The common lands covered in the National Sample Survey
(NSS) enquiry are panchayat lands, government revenue lands, village
common lands, village thrashing lands, unclassified forest lands,
woodlands and wastelands, river banks, and lands belonging to other
households used as commons.
Forest Resources
Another category of land for which common property rights may exist is land
under forests. Unclassified forests, with very low productivity, are always
open to use by local communities. Accordingly, both protected and unclassified
forests are treated as forming a part of common property forest resources. It is,
therefore, the subset of total forest area minus reserve forests to which
common property rights are assumed to exist.
Water Resources
There are a variety of resources of water, which are in the public domain, and
a significant part of these are included in the category of commons. Examples
are flows of rivers, tanks and natural lakes, groundwater, wetland and
mangrove areas, and such other water bodies. Man-made water resources such as
dams and

219
Environment and canals, tube wells, other wells, and supply of all types of potable water also fall
Sustainable
Development in the category of CPRs depending upon their property rights. Unfortunately,
even after many debates about property rights (such as traditional rights,
community rights, and basic need human rights), water has not yet been declared
as CPR in India, though references are made in the water policy document
indirectly. By and large, water resources in India are in common property
regimes only. Irrigation canals are managed jointly by the government and
communities. Traditionally, tanks, village ponds, and lakes - all of which are
treated as CPRs - are sources of water for drinking, livestock rearing, washing,
fishing and bathing, and several sanitary-related activities.
Overall, we can say that human free access and unlimited consumption of finite
resource would extinguish such common resources. Hardin believed that since
man is compelled to procreated unlimitedly the Earth resources would eventually
get overexploited. To his eyes, mankind needed to radically change its way of
using common resources to avoid a disaster in the future. And this would also be
the way to keep on a sustainable development track.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) How are India’s environmental problems different than developed world.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….

2) How is globalisation adding up to the environmental problems?

………………………………………………………………………………….
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3) What are the characteristics of common pool resources? Explain?

………………………………………………………………………………….
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4) Define Tragedy of Commons.

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220
 Sustainable
11.6 LET US SUM UP Development

In this unit we began by the understanding of concept of sustainability. The

future generations need the resources which we are over using today and the
orientation of many countries towards conserving the natural resources further
needs to be serious. The capacity of earth to assimilate waste is limited and the
present consumption patterns indicate that we are moving in a direction which
holds danger for the future. There are many resources which are renewable in
nature which are gaining popularity but still need to be cost-effective. The
environmental problems discussed in this Unit are of diverse and grave nature.
The efforts towards pollution abatement and cleaner environment need to be
more targeted and effective at both national and international level. A key reason
for many kinds of environmental problems is common pool resources. These
resources do not have clearly defined property rights due to which the people
around such resources usually land up over using them. We discussed how
dangerous this over-use can be. Overall, we learnt about the environmental issues
we presently face and which the future generations will also face if we do not
give the required importance to the concept of sustainable development.

11.7 HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) (Refer section 11.2) Natural resources are considered as basic requirements
for development of an economy. But they are limited and available on
specific location only.
2) (Refer section 11.2) Over time it is expected that changes will occur in
technology, income and people’s preferences. Technology may change
enormously as an answer to changing relative scarcities and knowledge.
Income will also not be constant and preferences will differ across
generations
3) (Refer section 11.3) Hydropower, geothermal, wind energy, solar energy etc
4) (Refer section 11.3) But the use of natural resources is becoming increasingly
intense, several varieties of renewable resources cannot be replaced at the
speed they are being consumed, hence the fear of destruction/extinction of
these resources.

Check Your Progress 2

1) (Refer sub-section 11.4.1) India being a developing economy with a low per
capita income, high population density, agriculture-dependent labour force,
and high percentage of rural areas

221
Environment and 2) (Refer sub-section 11.4.2) The damage caused to ecosystem from the oil that
Sustainable
Development spilled from one of the leaking containers of British Petroleum in 2010 is just
one of the examples of the threat globalization poses to the environment.
3) (Refer section 11.5) Common Pool Resources share two attributes of
importance for economic activities: (1) it is costly to exclude individuals from
using the resource either through physical barriers or legal instruments, and
(2) the benefits derived by one individual reduce the benefits available to
others.
4) (Refer sub section 11.5.1) Garret Hardin argued that if individuals act
independently, rationally and focused on pursuing their individual interests,
they would end up going against the common interests of their communities
and exhaust the planet’s natural resources. This overuse of public resources is
termed as the "Tragedy of the Commons".

222
 Theories of
 Regulation
UNIT 12 THEORIES OF REGULATION
Structure
12.0 Objectives
12.1 Introduction
12.2 Externalities and its Types
12.2.1 Positive Externality
12.2.2 Negative Externality
12.3 Coase Theorem
12.4 Economic Activity and Climate
12.5 State Regulation of the Environment
12.5.1 Pigouvian taxes
12.5.2 Emission taxes
12.6 Let Us Sum Up
12.7 Hints to Check Your Progress Exercises

12.0 OBJECTIVES
After going through this unit, you will be able to:

 Define the negative and positive externality with the help of an example

 Discuss the economic consequences of externalities

 Describe the Relationship between the economic activity and climate change

 Explain the role of state as the regulator of environment

 Discuss the pigouvian taxes and their rationale.

12.1 INTRODUCTION
In this unit, we will start with understanding the concept of Externality and its
types. The economic consequences of externalities will also be discussed in order
to understand how the basic activity of production and consumption impacts the
climate. The role of state is very important in order to mitigate the environmental
damage due to economic activity. Hence the unit also covers the role of state in
this regard. The specific mechanisms like Pigouvian tax or emission tax are also
explained in detail.


Dr. Nidhi Tewathia, Assistant Professor, School of Social Sciences, IGNOU
223
Environment and
Sustainable 12.2 EXTERNALITIES AND ITS TYPES
Development
We noted in the previous unit that market mechanism will not be successful if the
resource ownership is not clearly defined. The property being the common
resource, individuals could neither take account of the full benefits nor they could
completely understand the costs of their actions. This happens because the costs
and benefits are treated as incidental or external by such individuals. Similarly,
there is another situation wherein the individuals do not take a complete account
of their transaction/activity. A technical term used to describe this situation is
externality. Externalities are the conditions which arise when the actions of some
individuals have direct effects on the welfare or utility of other individuals. The
effects mentioned can be positive or negative. Also, an externality is a spillover
effect associated with production or consumption that extends to a third party
outside the market. Externalities can also be distinguished as depletable and non-
depletable. The flowers falling from a tree are depletable externality because if
one person takes it another cannot. The fragrance of flowers, however, is a non-
depletable externality because one person's enjoying it does not reduce the
fragrance for others. In many instances, the problem of externality creeps into
many government policies having spill over effects. For example, free electricity
offered to farmers for irrigation purposes results in over-extraction of ground
water, which depletes the water table that reduces the availability of water to
others.

12.2.1 Positive Externality

When the effect of the actions of an individual on another individual is positive,
we call it a positive externality. For example, I may get pleasure from observing
my neighbour’s flower garden—this is an example of a positive consumption
externality. The activity of gardening in my neighbour’s house has provided a
benefit to me. I have not spent any amount of money of time in maintaining that
flower garden but yet I am drawing a positive utility out of it. Similarly, when a
firm’s production positively affects the production possibilities of the other firm,
a positive production externality is generated. A simple example is that if an
apple orchard is located next to a beekeeper (Many varieties of fruit and nut trees
need bees to pollinate their blossoms, thereby allowing the trees to produce
crops). The bees will help the apple orchard to produce large number of apples.
In a situation where a positive externality is present:
Social benefits = Private benefits + External benefits
And External benefits > 0
Therefore, Social benefits > Private benefits
In the Fig. 12.1, the curve D shows private benefits or the demand for the product
which involves positive externality. MSB curve represents marginal social
benefit, which is derived after adding the external benefits to the private benefits.
224
 Theories of
This means that the difference between the D curve and MSB curve is external Regulation
benefits.
Given a constant marginal cost (MC), the private equilibrium leads to the
quantity Q1 but the social optimum will be achieved with the intersection of MC
and MSB. This intersection gives us the quantity Q*. So, we can say that if the
positive externality is not considered, less quantity of the product is produced and
exchanged in the market as Q1< Q*. We now understand that in the presence of a
positive externality, we expect to observe a clear divergence between social and
private benefits which leads to less than social optimal level of production.

Fig. 12.1: Positive Externality

12.2.2 Negative Externality

Negative externality is an external effect that imposes costs on a third party. For
example, I don’t drive but the pollution produced by local automobiles affects my
health or my neighbour loves to play loud music in the early morning hours when
I prefer to sleep. These are all examples of negative consumption externalities.
Similarly, a negative production externality arises when the production
possibilities of one firm impacts the choices of another firm in a harmful manner.
For example, a fishery downstream cares about the amount of pollutants dumped
into the river upstream by a steel manufacturer. This will be harmful for the fish
and will affect the revenue of the fishery. In a case where negative externality
prevails:
Social costs = Private costs + External costs
And External costs > 0
Therefore, Social costs > Private costs.

225
Environment and In the Fig. 12.2, the curve MC shows private costs of the product which involves
Sustainable
Development negative externality. MSC curve represents marginal social cost, which is derived
after adding the external costs to the private costs. This means that the difference
between the MC curve and MSC curve is external costs. Given a horizontal
demand curve (P1), the private equilibrium leads to the quantity Q1 but the social
optimum will be achieved with the intersection of MSC and demand curve. This
intersection gives us the quantity Q*. So, we can say that if the negative
externality is not considered, more quantity of the product is produced and
exchanged in the market as Q1> Q*.

Fig. 12.2: Negative Externality

We now understand that in the presence of a negative externality, we expect to
observe a clear divergence between social and private costs which leads to more
than social optimal level of production.

12.3 COASE THEOREM

Externalities generally arise due to two reasons. First, the resource or product in
question by its very nature may be nonrival in consumption. Such a product will
be subject to joint consumption. Second, for either natural or technical reasons,
the transaction cost of internalizing the externality may be excessively high. In
the example of steel manufacturer and fishery, the river is viewed as a common
pool resource and hence, no one can be excluded from using it. Thus, the
nonexclusive use of the river is what causes an externality to persist. The non-
exclusiveness resulted from the fact that the resource under consideration is non-
rival, and thus is subject to joint consumption. Further, the non-exclusiveness
resulted from the fact that the ownership of the resource (the river) was not
clearly defined – that is why it is treated as a common property. Hence, we can
generalize that lack of excludability (non-exclusiveness) is the root cause of
externality.
If the garden of a neighbour generates positive consumption externality for you,
it makes no economic sense to exclude you from the use (consumption) of such
an activity. Of course, it is possible to exclude the you and other neighbours by
226 building a tall concrete wall around the house. However, this will involve an
 Theories of
additional cost. The most commonly used economic jargon to describe the costs Regulation
associated with internalizing (remedying) externalities is transaction costs. In
broad terms, transaction costs include any outlay expended for the purpose of
specifying property ownership, excluding nonusers and enforcing property rights.
This would be the intended effect if, in fact, the neighbour in our example
decided to erect a concrete wall around her or his clearly identified property line.
By now we know that the problem arises if the property rights over the
product/service, which generates externality, are not well defined. If A believes
that he has the right to smoke and B believes that he has the right to clean air, we
will have issues. So, we can say that the practical problems with externalities
generally arise because of poorly defined property rights. My neighbour feels he
has the right to play loud music in the early hours of the morning while I prefer to
think that I have the right to sleep undisturbed at that time. The steel factory feels
it has the right to dump all its pollutants in the river whereas the fishery believes
they have the right to breed fish in the same river.
Ronald Coase developed the property rights approach in 1960. The approach
suggests that an efficient solution to the problem of externality may be arrived at
if property rights are well-defined and this solution is known as Coase theorem.
The theorem states that efficient allocation of resources and solution to Pareto
relevant externality is possible but with the following assumptions:
i) Zero transaction costs – the cost involved in the bargaining process between
the two parties does not exist,
ii) Well-defined property rights - either of the party or both the parties possess
well-defined property rights,
iii) Perfect competition prevails in the market,
iv) No income or wealth effects are imposed with the Coasean solution,
v) No free rider effects -- since the parties have well-defined property rights.
If property rights are well defined (regardless of which party has the right over
the property), and mechanisms are in place to allow for negotiation between
people, then people can trade their rights to produce externalities in the same way
that they trade rights to produce and consume ordinary goods. Let us understand
with the help of an example. Suppose the steel factory’s effluents dumped in the
river upstream reduce the profit of the fishery which is located downstream. The
problem between the steel factory and the fishery arises because their economic
activities involve the joint use of a river.
To demonstrate how this problem can be solved using a property rights approach
(Coase Theorem), let us start by assuming that the legal rights to the use of the
river belong to the fishery. So, if the fishery wants, it could completely deny the
river access to the steel factory. Then the steel factory would not be permitted to
use the river to discharge its waste.
227
Environment and In Fig. 12.3, this situation is represented by the origin O, where the amount of
Sustainable
Development waste emitted into the river from the steel factory is zero. This means that the
steel factory has to find an alternative way of disposing the waste (a total of 200
units) from its current operation. But, will that be a stable solution? Given the
MDC (Marginal damage cost) and MCC (Marginal control cost) curves presented
in Fig. 12.3, the answer to the question would be a no.
Let us look at the reason. When the waste discharged by the steel factory is less
than EO (110 units), we observe that the MCC is greater than the MDC. For
example, for the 70th unit of the waste that is emitted into the river, the MDC to
the fishery is Rs. 20. However, to achieve this same result, the cost to the steel
factory is Rs. 50. Note that this Rs. 50 is the MCC of treating (cleaning) the 130 th
unit of waste (200 - 70). Thus, given this situation, the steel factory will clearly
have an incentive to offer a financial bribe to the fishery for the right to use the
river for discharging its industrial waste. For example, to discharge the 70th unit
of waste the steel factory will be willing to pay the fishery a fee of between
Rs. 20 and Rs. 50. This should be acceptable to both parties.
For the fishery, a payment exceeding Rs. 20 more than compensates for the
damage caused to its fish operation from the dumping of the 70th unit of waste
into the river. Similarly, this situation should also be advantageous to the steel
factory because the cost of using an alternative technology to dispose of the 70th
unit (i.e. to clean up the 130th unit) of waste to this firm is at least Rs. 50.
In general, then, these two firms will be in a position to engage in a mutually
beneficial transaction provided that, at the point where the negotiation is taking
place, MCC > MDC. Furthermore, the negotiation between these two parties
ceases when, for the last unit of waste discharged by the steel factory,
MCC = MDC. This takes place at EO, or 110 units of emission. We can call
MCC = MDC the condition for the optimal level of pollution.

Fig. 12.3: Coase Theorem

228
 Theories of
The Coase theorem goes beyond the recognition of optimality. It also states that Regulation
this optimal outcome is completely independent of the two parties who have
rights to the river. So, let us now consider the case where the steel factory has
exclusive legal rights to the use of the river. The steel factory, if wishes, can
dispose of all its waste into the river. If this strategy is followed, then as shown in
Fig. 12.3, the steel factory will discharge a total of 200 units of waste into the
river. However, this is not the only option for the steel factory. For each unit
between 110 and 200 units of waste discharged, the MDC is greater than the
MCC. This situation will allow the fishery and the steel factory to engage in a
mutually beneficial transaction.
Let us see what happens when the emission is at 140 units. When this unit of
waste is discharged, the MDC to the fishery is Rs. 45, but the cost to the steel
factory of treating this same unit is Rs. 15. Note that the Rs. 15 is the marginal
cost to the steel factory for controlling the 60th unit of emission (200 - 140).
Thus, when the emission level is at 140 units the MDC is greater than the MCC.
Given this, the fishery will have an incentive to offer a financial bribe to the steel
factory of anywhere between Rs. 15 and Rs. 45 to withhold this unit of waste.
It is easy to see that the steel factory will most likely take this offer seriously
since the cost of controlling the 60th unit of waste (200 - 140) is only Rs. 15.
Thus, to the extent that the offer of the fishery exceeds Rs. 15, the steel factory
will abide by the wishes of the fishery.
A similar situation prevails for all the units where the MDC exceeds the MCC,
i.e., between 200 and 110 units. Thus, the optimal level of pollution is again
reached at EO or 110 units, where MDC = MCC. This result verifies the validity
of the Coase theorem.
In general, the amount of the externality that will be generated in the efficient
solution will depend on the assignment of property rights. The reflective
implication of this theorem has been that pollution problems can be resolved by
an arbitrary assignment of property rights. The optimal level of pollution is
attained through voluntary negotiation of private parties – just like it happens in a
private market.
The Coasian approach has certain weaknesses. However, in many real-world
situations, the sources of the pollution are likely to be multifaceted and their
impacts quite diffuse. In addition, environmental disputes normally involve
several parties. In a typical real-world situation, then, the cost of negotiation and
enforcement – the transaction cost (the monetary outlays for specifying, defining
and enforcing property rights) – could be quite high. A high transaction cost
could distort the final outcome of an environmental dispute in a rather significant
manner. In such a situation, a resolution reached using the property rights
approach might be far removed from what is considered to be socially optimal.

229
Environment and
Sustainable
Check Your Progress 1
Development
Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Define Positive externality and Negative externality.
………………………………………………………………………………….
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2) Why does the social optimal level of production is higher in case of positive
externality? Explain with the help of a diagram.
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3) Why do the externalities arise?
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4) Define Coase Theorem. Under which assumptions the theorem works?
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12.4 ECONOMIC ACTIVITY AND CLIMATE

Resource allocation through market mechanism – i.e., one that is based solely on
consideration of private costs and benefits – would be inefficient when viewed
from the perspective of society at large (refer to sub-section 12.2.1 & 12.2.2).
This constitutes a clear case of market failure because the market, if left alone,
lacks any mechanism by which to account for external costs and/or benefits. So
we can say that the high consumption levels have led the Earth to struggle in
order to keep up with the regeneration of resources which is required for us to
maintain those high consumption levels.
Our lifestyles have been altered over the years. We are globally consuming more
products, discarding more clothes and piling more electronic waste. This all has
impacted the ecological cycle as increased consumerism leads to high levels of
production which requires more transportation of raw materials and that in turn
leads to high carbon footprints. Stress on transportation has led to the added
strain on the non-renewable sources of energy. The waste generated from
production gets dumped in the oceans which adversely affects the sea life. The
incidents where sea animals are found dead on the shores are not rare now.
230 Foreign foods are preferred more than the locally- grown food. The genetic
 Theories of
makeup of the plants is also getting affected due to toxic waste disposal. Plastic is Regulation
very useful for packaging and preserving the products. While many studies have
found that plastic is non-biodegradable and one of the major toxic pollutants, we
still continue to use it in various ways. There are innumerable examples and
incidents which clearly suggest that the consumption patterns have made
irreversible changes to our lives and has also led to some major concerns,
environment in particular.
Climate change is a cause of concern for the mankind as it has serious and
various catastrophic economic, ecological and environmental implications. It is a
common knowledge that due to climate change we experience many disasters.
The frequency and the severity of climate related disasters is on an increase.
Hurricanes like Katrina in USA, Tsunamis in South Asia, Earthquakes in
Afghanistan and India, and Tokage Typhoon in Japan are a few examples of the
disasters from the recent past. India is also one of the highly vulnerable countries
to global warming because the Indian economy highly depends on climate
sensitive sectors like agriculture, water, forest and hydro-power. Further addition
to the magnitude of vulnerability is provided by India’s densely populated low-
lying coastline. The coastline remains under constant threat from climate related
disasters including rise in level of sea water.
Environmental economists are interested in externalities that damage the
atmosphere, water supply, natural resources, and overall quality of life. To model
these environmental externalities, the relevant market must be defined as the
good whose production or consumption generates environmental damage outside
the market transaction.

12.5 STATE REGULATION OF THE ENVIRONMENT

The classic examples of externalities (like the garden of the neighbour or
beekeeper near apple orchard) suggest as if they are a trivial concept without any
grave consequences. Externalities, however, have serious consequences in the
context of environment. Contaminated drinking water, smog in cities,
deforestation, threat to coastal areas, depletion of ozone layer, acid rain, global
warming, etc. are important examples of externality that pose a threat to
sustainability of mankind. There is a clear urgency to tackle them.
Government regulation in an economy has been quite varied depending upon the
nature of commodity or activity in question and prevailing business environment.
Basically, there are two types of policies that the government follows: i)
command and control measures (CAC), and ii) market-based incentives (MBI).
In order to control production of goods with negative externalities the
government in traditional approach imposes restrictions of firms. On the other
hand, government tries to enter into production of goods which generate positive
externalities. Pollution abatement is usually by means of regulatory approach also
231
Environment and known as CAC measures, which are in the form of imposing bans, specifying
Sustainable
Development quotas or emission standards. Under the CAC approach certain economic
activities, considered to be polluting, are prohibited as well. In other cases, a
quota for many polluting activities are determined and allocated among firms
through licensing.
According to the CAC approach, either the government or its designated body
fixes the standards for various pollutants (liquid, gas and noise) emerging out of
various pollution sources. The emission standards are fixed by keeping in view
the assimilative capacity of the ambient environment as well as the health
impacts on human beings living in the area, and existing natural resources. In
order to regulate the environmental pollution, there could be two types of
standards:
a) ambient environment standards,
b) industry specific standards.
Ambient environment standards refer to the limits set for various pollutants that
is considered to be safe for living beings and property. These standards have been
prescribed for ingredients of the environment such as air, water and noise. The
National Ambient Air Quality Standards are prescribed by the Central Pollution
Control Board (CPCB). These standards have been determined keeping in view
the air quality necessary to protect public health, vegetation and property.
Different standards are laid down for industrial, residential and sensitive areas.
The CAC measures are found to be inefficient as it imposes higher cost on
society for realizing a target. As the CAC approach does not distinguish between
polluting agents and puts a universal ban on certain activities, it does not leave
any scope for innovation in clean technology. Studies have shown that similar
objectives can be achieved at a much lower cost through MBIs.
The main aim of the MBIs is creation of a market mechanism where the social
cost of pollution will be borne by the polluters. Thus, the divergence between
private cost and social cost will be avoided and polluting goods will be produced
at their socially optimum level. The MBIs are developed on the basis of the
principles of the market structure, and attempt to remove the distortions emerging
out of inefficient use of resources by removal of subsidies and introduction of
environmental charges on emission, input and output.
Let us consider the case of environmental pollution. Producers of a polluting
good would dump the effluents to the river or the sea. As a result, the water
downstream or on the seacoast would get polluted. The adverse effect of the
polluting activities often prompted the government to impose restriction on
production of polluting goods or shifting of polluting activities away from
residential areas. Dumping the effluents anywhere free of cost reduces the cost of
production for the producer. This encourages the producer to produce at a level
232
 Theories of
higher than the social optimum. In recent years, there is a shift in policy from Regulation
CAC measures to MBIs. Thus, instead of imposing a blanket ban on polluting
activities, the government collects certain amount of pollution charge (Emission
tax) from the polluting units. The objective is to increase the cost of production
so that polluting goods are produced at socially optimum level. In the process,
however, the government generates revenue which can be used for pollution
abatement or for other productive activities.

12.5.1 Pigouvian Taxes

An economic solution to the problem of externalities was evolved in the 1920s by
the well-known British economist Arthur Pigou in the form of pollution tax. This
tax is popularly known as Pigouvian tax. According to Pigou, the social damage
or the social cost imposed by a firm by its pollution activity on society may be
neutralised by imposing a pollution tax on the firm. According to Pigou, the rate
of the tax is equal to the marginal environmental cost or marginal social damage
by the polluting firm on society. This is the same external cost which we
discussed in the sub-section 12.2.2.
Let us take the example of the steel firm located on the upstream river and the
fishery located at the downstream river. In the absence of any fine or tax, the
steel firm faces the wrong price for pollution. As far as the steel firm is
concerned, its production of pollution costs it nothing. But that neglects the costs
that the pollution imposes on the fishery. According to this view, the situation
can be rectified by making sure that the polluter faces the correct social cost of its
actions. One way to do this is to place a tax on the pollution generated by the
steel firm.
We explain the situation in Fig. 12.4 where MCS is the social marginal cost while
MCP is the private marginal cost of production of a good. As more output is
produced, MC, increases with the level of pollution. The demand for the
pollution good is given by the demand curve D' (representing marginal revenue
curve, MR). As per market mechanism, the equilibrium is at point b indicating
the equilibrium output to be q1, and equilibrium price to be P1. Here, MCP = MR
or D'. Socially optimum level of output, however, is Q* and price P*, where
MCS = MR or D'. If the producer were made to pay for the social costs also,
equilibrium output would have been at the level Q1.
We observe from Fig. 12.4 that the difference between MCS and MCP, at the
socially optimum level output is 'ac'. In order to internalize the externalities
Pigou suggests imposition of a tax t per unit of output where t = ac. It is
necessary to note the assumption that pollution emitted per unit of output remains
unchanged as level of output changes.

233
Environment and
Sustainable
Development

Fig. 12.4: Pigouvian Tax

12.5.2 Emission Taxes

With respect to environmental regulations, we shall examine cases where the
legal system is used only indirectly, and primarily to correct price distortions.
One major approach which is used to address these issues is effluent charges or
emission tax. An emission tax is a tax or financial penalty imposed on polluters
by government authorities. The charge is specified on the basis of rupees per unit
of emission into the ambient environment. For example, a firm may be required
to pay an emission tax of Rs. 100 per unit of waste material it discharges into a
lake.
Figure 12.5 shows a Marginal cost of abatement (MCA) curve and the specific
emission tax (T1) by a horizontal curve. MCA is low at high emissions level and
vice-versa. The emission tax equals the MCA at L1 levels of emissions. If the
firm wants to reduce the emissions and wish to be on the left side of L1 level then
the MCA is greater than the emission tax T1 so the firm will not bear the higher
cost of abatement and would like to pay the emission tax and stay at the L1 level
of emissions.
Similarly, if the firm wants to be at the emission level which is on the right side
of L1 then the MCA is smaller than the emission tax T1. The firm would like to
bear the MCA instead of paying the emission tax for all the levels of emissions
till L1 level of emissions.

234 Fig. 12.5: Emission Tax

 Theories of
As public policy instruments, effluent charges have a long history and have been Regulation
used to resolve a wide variety of environmental problems. There are three major
attractions of an emission tax. First, it is less interventionist than emission
standards and operates purely on the premise of financial incentive or
disincentive, not on a CAC principle. Second, it can be relatively easy to
administer. Third, it provides firms with incentives to reduce their pollution
through improved technological means.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) How does the rising consumption levels affect the climate?
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2) How does state regulate the environmental issues related to externalities?
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3) Explain the Pigouvian Tax with the help of a diagram.
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4) What is Emission Tax? What are its advantages?
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12.6 LET US SUM UP

In this unit we began by the understanding of concept of externality and its types.
There are two - positive and negative - externalities. It was necessary to
understand how the over production or under production takes place in case of a
product generating externality. The environmental negative externalities affect
the environment drastically and hence the government needs to look in to the
matter of externalities generating activities and firms. Globally the issue of
environmental externalities has taken an important place and so in India. There
are ways to curb the over production of such products by the way of regulation:
Control and Command Approach and the Market Based Incentives. We also
discussed the Pigouvian tax and the emission tax as two major ways to regulate
the environmental pollution. 235
 12.7 HINTS TO CHECK YOUR PROGRESS
EXERCISES
Check Your Progress 1
1) (Refer sub section 12.2.1. and 12.2.2) When the effect of the actions of an
individual on another individual is positive, we call it a positive externality.
Negative externality is an external effect that imposes costs on a third party.
2) (Refer sub section 12.2.1) In the presence of a positive externality, we expect
to observe a clear divergence between social and private benefits which leads
to less than social optimal level of production.
3) (Refer Section 12.3) Externalities generally arise due to two reasons. First,
the resource or product in question by its very nature may be non-rival in
consumption. Such a product will be subject to joint consumption. Second,
for either natural or technical reasons, the transaction cost of internalizing the
externality may be excessively high.
4) (Refer Section 12.3) The approach suggests that an efficient solution to the
problem of externality may be arrived at if property rights are well-defined
and this solution is known as Coase theorem. It works under these
assumptions: Zero transaction costs, Well-defined property rights, Perfect
competition prevails in the market, No income or wealth effects are imposed
with the Coasean solution, No free rider effects -- since the parties have well-
defined property rights.

Check Your Progress 2

1) (Refer Section 12.4) We are globally consuming more products, discarding
more clothes and piling more electronic waste. This all has impacted the
ecological cycle as increased consumerism leads to high levels of production
which requires more transportation of raw materials and that in turn leads to
high carbon footprints.
2) (Refer Section 12.5) Basically, there are two types of policies that the
government follows: i) command and control measures (CAC), and ii)
market-based incentives (MBI).
3) (Refer sub section 12.5.1) The social damage or the social cost imposed by a
firm by its pollution activity on society may be neutralised by imposing a
pollution tax on the firm called Pigouvian tax.
4) (Refer sub section 12.5.2) An emission tax is a tax or financial penalty
imposed on polluters by government authorities. The charge is specified on
the basis of rupees per unit of emission into the ambient environment. There
are three major advantages of this tax. First, it is less interventionist than
emission standards and operates purely on the premise of financial incentive
or disincentive, not on a CAC principle. Second, it can be relatively easy to
administer. Third, it provides firms with incentives to reduce their pollution
through improved technological means.

236
 BLOCK 6
GLOBALISATION
BLOCK INTRODUCTION
The present Block, the sixth and final one of this course, is titled, and discusses,
globalization. Since the late 1980s, and particularly since the early 1990s,
globalisation has received a spurt in many countries. India, too embarked on a
course of globalization in 1991 with much vigour and vim. The units of this
block present a theoretical discussion of glaobalisation and its impact on
development.

The Block has two units, titled Changing Perspectives on Globalisation

(unit 13)and Globalisation and Development (unit 14). Unit 13 discusses
concepts of globalization and its constituent elements. It discusses the
meaning of globalization and various arguments in favour of, and against,
globalization. The unit also presents various approaches to globalization. Unit
14 presents topics that are usually discussed in courses on international
economics. The unit takes up for discussion theories of international trade and
development; tariff and non-tariff barriers; international finance; multilateral
trade agreements; and trading blocks.

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 Changing Perspectives
UNIT 13 CHANGING PERSPECTIVES ON on Globalisation

GLOBALISATION
Structure
13.0 Objectives
13.1 Introduction
13.2 Concept and Meaning of Globalisation
13.3 Perspectives on Globalisation
13.3.1 The Economistic Perspective
13.3.2 The Multidimensional Perspective
13.3.3 The Cosmopolitan Perspective
13.4 Approaches to Globalisation
13.5 Impact of Globalisation
13.5.1 Globalisation and Labour
13.5.2 Globalisation and Environment
13.5.3 Globalisation and Poverty
13.6 Let Us Sum Up
13.7 Hints to Check Your Progress Exercises

13.0 OBJECTIVES
After going through this unit, you will be able to:
 Discuss various perspectives on globalization
 Explain the three approaches to globalization
 Identify the impact of globalization.

13.1 INTRODUCTION
Globalisation is a multi-dimensional concept. Due to the complexity involved in
this term, it is difficult to give it one definition. It can be understood as a term
indicating that all political, economic, cultural and social activities operate at one
level i.e., the international level. We all have observed an unexpected and fast
growth in people and communities connecting globally. The physical distance
between different people, communities and cultures has become less due to
available platform of communication using new technology via various
applications. This Unit provides the understanding of the concept of
globalization, the various perspectives on globalization, approaches of
globalization and a general discussion on the impact of globalization.


Dr. Nidhi Tewathia, Assistant Professor, School of Social Sciences, IGNOU
239
Globalisation
13.2 CONCEPT AND MEANING OF
GLOBALISTAION
The term globalisation is widely used. For example, it is used in various branches
of social sciences, in the profession like journalism and in popular discourse. But
its wide usage has still not led to one globally accepted definition of
globalisation. It seems every one agrees that it is a process of social change
which affects various dimensions of an individual’s life or of a country. But the
nature of the process and the effects of globalization have always been debated
and contested.
Different interpretations of the nature of global change which come to surface as
a result of these debates, reflect different perspectives on globalization, from the
viewpoint of various disciplines of social science. The views of economists,
sociologists and the political scientists on globalization emphasize various
dimensions of globalization. Due to such views about globalization, the term is
evaluated and assessed differently. Let us discuss the emergence of the concept
of globalization and its social science usage.
Presently the term globalization is used in everyday discourse. It was popularized
only in the 1990s. But, in social sciences it has been used for many more years
prior to the 1990s. As per Jan Scholte (2000) the term was first employed in the
social sciences during the Second World War. Mainly, the term was used to focus
on global economic exchanges. Innovations in the communications technology
started creating a ‘global village’ as such innovations exponentially amplified the
stream of information around the world with reflective consequences for
economic, political and cultural interactions. The meaning of global village was
taken in the sense that people living in global village will have a common global
view which will act as identity changer. In such a situation, it was common to
assume that a global citizen will emerge with a global consciousness of the unity
of all humankind. All of this affected the international economic scenario as it
stressed the increasing interdependence of different countries and the emergence
of a global market. Such changes affect the areas like communications,
international migration, governance and political arrangements.
Roland Robertson, a professor of sociology at the University of Aberden, was the
first person who defined globalization as ‘the understanding of the world and the
increased perception of the world as a whole’ 1. Martin Albrow and Elizabeth
King, sociologists, define globalization as ‘all those processes by which the

1
Robertson, Roland (1992). Globalization : social theory and global culture (Reprint. ed.).
London: Sage. ISBN 0803981872
240
 Changing Perspectives
peoples of the world are incorporated into a single world society’2. Thus, we can on Globalisation
say that globalisation is about communication between the nations, cultures,
different social, economic and political structures. It requires reshaping and
reorganizing of the roles and responsibilities of market, governments and the
society.

13.3 PERSPECTIVES ON GLOBALISATION

Renewable Globalisation is multifaceted and that is why there have been attempts
to study and differentiate between its different dimensions, by social scientists of
various disciplines. Different dimensions of globalization are separated into
economic and non-economic dimensions. As mentioned earlier globalization is
about international economic changes but globalization is also about the impact
on communications, culture, migration, politics and many other aspects of
contemporary life. Apart from these, globalization also affects international
power relations that shape the international economy and affect social and
cultural circumstances around the world. Globalisation has hegemonic features of
global capitalism. The proponents of uni-polarism insist that globalization can
benefit the human kind as it diffuses their values, institutions and world-view.
The analytical and normative aspects globalization are explained by different
perspectives. The difference in these perspectives lead to difference in the policy
interventions which in turn affect the welfare and justice consequences of the
globalization process.

13.3.1 The Economistic Perspective

The economistic perspective emphasises on increased frequency of international
economic exchanges, greater interdependence between different countries and
rise in the facilitation of their integration. It is said that the world is moving
towards the ubiquitous endogenous economic policy approach which has its base
in the outward looking growth model. Such a model is dependent on international
investments and the flow of capital and trade. This would lead to the demise of
Keynesian economics and the centralized economic planning model.
The signatories to the agreement in 1944 Bretton Woods conference hoped to
avoid fiscal instability like the Great Depression of the 1930s by reaffirming the
gold standard. The objective was smooth functioning of the international
capitalist system. However, the impact was faced by the growth model which
soon was abandoned, the endogenous economic development model. It was only
in 1995 that an international organization WTO came into being. Before that, any
efforts to have an international organization, in particular, for trade were

2
Albrow, Martin and Elizabeth King (eds.) (1990). Globalization, Knowledge and Society
London: Sage. ISBN 978-0803983243.

241
Globalisation postponed. But by 1995 the endogenous model became less relevant because of
increased economic exchanges and interdependence. The gold standard was
repealed in 1971 which made the international flow of financial capital easy. This
had an impact on East Asian countries which experienced a boost in their exports
due to the availability of low cost labour.
There have been many developments historically which manifest the process of
globalization.
 The consolidated hold of the United States over the International Monetary
Fund and World Bank.
 The deregulation of international economic exchanges
 Increased volume of global trade
 New opportunities for multinational corporations
 More frequent outsourcing and relocation of production
 Disintegration of the Soviet Union
 Adoption of market liberalism in the former communist countries
 China’s expansion of the global economic market
The economists believe that the global market has done the following:
 created mass employment in many low-income developing economies
 the production of goods for export to the high-income countries has brought
about increases in standards of living
 created new opportunities for entrepreneurs
 stimulated employment in the Western countries
The overall result seems to be a win-win situation in which standards of living
for those who participate in the global economy rise dramatically. But these
assertions have been widely challenged by many groups like academicians,
policymakers, union leaders. Many people also lost their jobs due to outsourcing
and the relocation of industrial production. So, we can say that globalization will
not ultimately benefit all of humankind. It is believed that the economistic
perspective is narrow and it does not consider and capture the complex
multidimensional features of the globalization process.

13.3.2 The Multidimensional Perspective

The process of globalization is not simply economic. Sociologists point out that
the globalization is technological, cultural, political as well as economic. The
ones who criticize the economic perspective still agree that primarily the driving
force of globalization is economic. But they also propose that to foster
international exchanges, interdependence and integration, developments in
communication technology, immigration patterns and political relations play an
242
important role. Role of technology has been a major contributor to the process of Changing Perspectives
on Globalisation
globalization. Millions of people around the world have received the exposure to
world events due to technology led innovations in mass media. The outcome of
such an exposure is that people are now more aware about diverse cultures and
lifestyles. There is an increase in the interpersonal contacts between people from
many countries. Travelling has increased and the internet has allowed people to
interact with others instantaneously, who are distant locations in other regions.
Globalisation has also facilitated the consumption of cultural artifacts
internationally. It has become easier for an ordinary person to consume the
cuisine, art, music and apparel of another country. It is nothing but diffusion of
cultures. But this diffusion is a matter of debate for many globalization scholars
as they are not sure is the diffusion is really taking place.
Migration is not a new concept but the magnitude of migration in recent decades
from low to high income countries suggests it is an important dimension of
globalization. Western countries attract many people from the Global South.
Well educated people with technical skills are a major chunk of new migrants.
The homogenous cultures are becoming very complex and diverse. The
multilateral organisations are fostering the increased political cooperation and the
growth of civil society activities at the international scale. This too is the facet of
globalization process as it contributes to international cooperation and
reciprocity. There is an advent of global civil society through which the ordinary
people are able to exercise influence. Various digital media platforms are
available to an individual to utilize and become part of global civil society. The
concept of nation state is still relevant as the nation states are likely to serve as
fundamental social and political formations for many decades to come. The
globalization has brought critical changes in the way people of these nation states
relate and interact with each other. People now have a shared global
consciousness of their common humanity.

13.3.3 The Cosmopolitan Perspective

The cosmopolitan view asserts the principle that all human beings are members
of one global community. Cosmopolitans believe that focused efforts should be
made to promote the integration of different societies and remove the cultural,
religious and national differences. Globalisation serves as an agent of universality
by enabling the realization of these ideals. The term cosmopolitan is roughly used
to refer to a form of political organization which surpasses the nation state. The
term is also used to manifest the outlook that does not accept confined national
loyalties and prejudices and encourages identifying the commonalities among
people of different nations. This cosmopolitan vision encourages the
establishment of multilateral, institutional arrangements that facilitate
cooperation between the world's nation states. In order to encourage human well-
being and social justice, the cosmopolitan view provides the idea that world's
nation states can cooperate through multilateral institutions, international law and
human rights conventions. 243
Globalisation The roots of this type of cosmopolitanism is usually accredited to the Kantian
idea that the social agreement can be applied internationally in order to create a
coalition of sovereign, nation states dedicated to the preservation of peace. The
massacre of the First World War influenced many that better efforts to protect
peace through international cooperation were essential. Despite the failure of the
League of Nations, its revival in the form of the United Nations in 1945
energized liberal cosmopolitanism. Further, the adoption of the Universal
Declaration of Human Rights, regular recourse by national judiciaries to the
principles of international law and the creation of international juridical
institutions such as the World Court and the International Criminal Court
reinforced liberal cosmopolitanism. The formation of the European Economic
Community and its following reconstruction as a quasi-political union further
refreshed cosmopolitan ideals.
Proponents of liberal cosmopolitanism view globalization as vehicle for
achieving the goals of global peace, integration and interdependence. With
globalization taking place, people and their governments increasingly identify
that they are members of the similar human community. The countries have
much to gain from cooperation and hence they will work together to regulate the
forces of globalization to endorse social well-being and social justice for all. The
key element of this perspective is the belief that the forces of globalization can be
tamed to serve human interests. This perspective expresses various proposals for
consolidation existing multilateral arrangements or creating new arrangements
that can efficiently manage global economic as well as political courses for the
nations. Revitalising the international unions and organisations and creating new
ones will help tackling the challenges of globalization by promoting international
cooperation. These proposals are packed within a social democratic framework
that is reflective of liberal cosmopolitan ideals.
The objective of fostering global cooperation can be achieved with the growing
faith in the role of the emerging civil society institutions. Direct democratic
representation has also been suggested in the recent times for the new and
reformed multilateral institutions. These proposals are known to be criticized in
the light of existing inequalities in global power and hegemonic exercise of uni-
polarist beliefs.

13.4 APPROACHES TO GLOBALISATION

From the discussion in previous section, we see that three senses have gradually
emerged within the discourses on globalisation: transference, transformation and
transcendence. A basic claim of contemporary globalisation is that the concept of
nation state (A nation state is an independent country which has a large amount
of people that share the same language, traditions and history) has become
obsolete. A nation’s boundaries are not as important as they used to be due to
globalization.
244
 Changing Perspectives
But it depends on which view you look at, as there are following three different on Globalisation
approaches to globalization.
 Internationalist
 Transformationalist
 Globalist
As per internationalists view, globalization is a myth. They believe that most
economic and social activity is carried on regionally rather that globally. At the
front of worldwide trade, they assert that most of exchange takes place at a
regional level rather than global. The European Union, the Pacific Rim and other
trading blocs serve as examples. They believe that the logic of global capitalism
has led to greater polarization between the developed and developing countries.
They believe that globalisation extends the role of the state to confront modern
dilemmas.
As per transformanationalists view the nation state remains powerful and
whatever challenges exist, they can be reversed by restructuring, reforming and
by accommodating the new forms of global governance. The governments can
adjust their roles instead of losing power altogether. As new global political
scenario is emerging, we cannot assume that all governments will have an equal
say in global decision making. The poorest governments across the world have a
little say in global decision making. USA and the European Union and Japan may
work together and some other countries will be ignored, mainly the poorer ones.
This is mainly because the most powerful economies have more political power
than the poor countries.
In case of the UK, the nation state is still very important. The UK government
might have to adjust to consider other countries but a majority of these countries
are within the European Union, it looks like the UK government is becoming
more regionalised than globalized. The UK government had to change its roles
on a local level more than global level. The claim that globalization has made the
nation state obsolete does not seem to be true as it is more likely that the nation
state is being reshaped within the Unions like the European Union, but not at the
global level.
There has been a rapid increase in the co-operation and mutual understanding
between countries. This has led to a dramatic increase in the number of
intergovernmental organisations across the world. In each of these organisations,
the representatives for each country are present who are actually representing the
nation state they come from. The growth of communication and organisations
that link human kind across the globe is encouraged by the globalisation. Because
the communication and interaction between people are not constrained by their
national boundaries, hence globalisation does not mean that a nation state loses
its sovereignty. The transformationalist stance shows a realistic approach to
245
Globalisation globalisation. It does not try to oppose the existence of global trends, but rather
tries to face the dilemmas it poses.
The globalists view globalisation as an inevitable process and claims that the
world has entered a truly global age legalising the dominance of ‘global
capitalism’. The logic of globalist attitude is supported by neo-liberal agenda
which views globalisation in terms of open market. A global market and free
trade present a threat to the national economy which puts an end to the nation
state as the primary unit of political organisation. Liberal progressives also
support the idea of economic liberalization, but they also admit the fact that it can
act as a double-edged sword if no special attention is paid to equality issues. The
globalists clearly believe that the globalization creates a more diverse society, but
it also presents the dangers of global environmental pollution. The positive
globalizers argue that the pollution can be reduced if we all take some
responsibility for reducing our unsustainable levels of consumption. They find an
important role of the development of new technologies in order to reduce levels
of pollution. Overall, the globalists believe that any attempts to resist
globalisation are doomed to failure.
Globalization in one way or another is creating a more uncertain and diverse
world. Each approach has its flaws and has valid points to each of its arguments.
Each argument could be seen valid depending on how its seen and what you
believe in, but every individual will have their own opinion on each outcome.

13.5 IMPACT OF GLOBALISATION

Not only individuals but institutions have also felt the impact of delocalization.
An important reason has been the declining power of national governments to
direct and influence their economies. The changes in economic activities, for
instance in U.S. and Japan, are felt across the globe. The impact of globalization
is felt the extent to which policies everywhere are now essentially market driven.
It means if the governments want to survive in their office, they have to increase
their capability to manage their national policies adapting to the pressures of
transnational market forces.
The scale and scope of the action of multinational corporation is increasing in the
presence of globalisation but their degree of control over the subtleties of
globalization remains limited. The global market makes it impossible for the
corporations to assume the past functions of the sovereign states. Multinationals
have played a substantial role in the growth of globalization but it is important to
note that the degree of control they have on the dynamics of globalization is not
substantial.

13.5.1 Globalisation and Labour

A poor nation like Bangladesh which has a low GDP relies on the exports of
246 manufactured goods as compared to the exports of traditional agricultural or
 Changing Perspectives
mineral products. Workers who work tirelessly for manufacturing such export on Globalisation
goods in a developing country are paid very little, in particular, by advanced-
country standards. These workers have few good alternatives in such poor
economies. Even the conditions of work are also very bad in many cases.
The activists argue that the low wages and the poor working conditions showed
that globalization was not helping workers in developing countries. For example,
Japan is the leading country in foreign direct investments in Vietnam and
Indonesia. Countries like Vietnam have young population, low GDP and cheap
labour which makes these countries a very attractive option for the developed
nations to utilise. It is easier for employers to replace high-wage workers in Japan
with lower-paid workers in Vietnam, the globalization had hurt employees from
both countries. But some argue that while wages and working conditions in
countries like Vietnam may appear appalling, they represent an improvement
over the alternatives available in such countries. The rise of employment in
foreign factories indicated that workers preferred the jobs they could find there to
the other alternatives present in front of them. The standard argument in favour
of globalisation is that despite the low wages earned by workers in developing
countries, those workers are better off than they would have been if globalization
had not taken place. The reason is that capital is mobile internationally, while
labour is not; and that this mobility gives capitalists a bargaining advantage.

13.5.2 Globalisation and Environment

Complaints against globalization go beyond labour issues. Many critics argue
that globalization is bad for the environment. It is true that environmental
standards in the export industry of developing-country are much lower than in the
industries of advanced countries. Substantial environmental damage has been
done in order to provide goods to advanced-country markets. For example, the
heavy logging of Southeast Asian forests is carried out to produce forest products
for sale to Japanese and Western markets. But on the other hand, there are also
examples of environmental damage that has occurred in the name of “inward-
looking” policies of countries unwilling to participate with the global economy.
There has been the destruction of many square miles of rain forest in Brazil, due
to a domestic policy that subsidizes development in the interior. This policy has
nothing to do with globalisation and in fact began during the years that Brazil
was attempting to pursue inward-looking development.
There is debate over whether trade agreements should include environmental
standards. The two sides of such agreements are that such agreements can lead to
some improvements in the environment which will benefit everyone and that
attaching environmental standards to trade agreements will shut down potential
export industries in poor countries, for which to maintain Western standards will
be a costly affair.

247
Globalisation The intersection of trade and the environment does raise a number of important
issues. Environmental issues are playing a growing role in disputes about
international trade. Some anti-globalization activists claim that growing
international trade continually harms the environment. Some also claim that
international trade agreements and the role of the World Trade Organization,
have the effect of hindering environmental action. Most international economists
do not believe that trade agreements prevent countries from having enlightened
environmental policies.

13.5.3 Globalisation and Poverty

Globalization did not benefit all nations and hence globalization is often accused
of increasing world poverty. The other view is that the world poverty would
probably be even more widespread without globalization. Some of the poorest
nations in the world, like the ones in the sub-Saharan Africa, seem to have been
left behind. The cause of poverty in such regions is not globalization but drought,
famine, internal strife, war, and AIDS. But globalization did not spread the
benefits of increased efficiency and openness, that come with globalization, more
evenly and equitably to all nations. Without globalization the number of world
poor would have been higher. But there still are many people living mostly in
non-globalizing nations facing acute poverty.

Check Your Progress 1

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What does economistic perspective to globalisation signify? Discuss.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) How is transformationalist approach to globalisation different than the
globalist approach?
………………………………………………………………………………….
………………………………………………………………………………….
…………………………………………………………………………………
3) Explain the impact of globalisation on environment.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
4) Discuss the concept of globalisation.
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248 ………………………………………………………………………………….
 Changing Perspectives
13.6 LET US SUM UP on Globalisation

The discussion in the unit showed that globalisation is a difficult concept to

perceive. There is a variety of attitudes and each of them is an attempt to define
the phenomenon within its own framework. An even trickier issue involves the
effect of globalization on local and national cultures. It is unmistakably true that
the growing integration of markets has led to a homogenization of cultures
around the world. People worldwide increasingly tend to wear the same clothing,
eat the same food, listen to the same music, and watch the same films and TV
shows but overall, the process of globalisation impacts environment. Various
perspectives and approaches were discussed at length which indicate the wide
line of thought behind the concept of globalisation. These perspectives and
approaches influence the policy formulation and the results of globalisation
process. We can say that a positive and balanced approach to react to global
changes means consolidating local and global as they are indispensable elements
of globalisation.

13.7 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) (Refer sub-section 13.3.1) The economistic perspective emphasises on
increased frequency of international economic exchanges, greater
interdependence between different countries and rise in the facilitation of
their integration.
2) (Refer section 13.4) As per transformanationalists view the nation state
remains powerful and whatever challenges exist, they can be reversed by
restructuring, reforming and by accommodating the new forms of global
governance. The logic of globalist attitude is supported by neo-liberal agenda
which views globalisation in terms of open market. A global market and free
trade present a threat to the national economy which puts an end to the nation
state as the primary unit of political organisation
3) (Refer sub-section 13.5.2) It is true that environmental standards in the export
industry of developing-country are much lower than in the industries of
advanced countries. Substantial environmental damage has been done in
order to provide goods to advanced-country markets.
4) (Refer section 13.2) Different interpretations of the nature of global change
which come to surface as a result of these debates, reflect different
perspectives on globalization, from the viewpoint of various disciplines of
social science. The views of economists, sociologists and the political
scientists on globalization emphasise various dimensions of globalization.
Due to such views about globalization, the term is evaluated and assessed
differently. Let us discuss the emergence of the concept of globalization and
its social science usage. 249
Globalisation
UNIT 14 GLOBALISATION AND DEVELOPMENT
Structure
14.0 Objectives
14.1 Introduction
14.2 Theories of International Trade and Development
14.2.1 Theory of Absolute Advantage
14.2.2 Theory of Comparative Advantage
14.2.3 Heckscher-Ohlin Theory
14.3 Tariff and Non-Tariff Barriers
14.3.1 Tariff
14.3.2 Non-Tariff Barriers
14.4 Multilateral Trade Agreements
14.5 Trading Blocs
14.5.1 Asian Pacific Economic Cooperation (APEC)
14.5.2 European Union
14.5.3 North American Free Trade Agreement
14.5.4 ASEAN
14.5.5 SAARC
14.6 International Finance
14.6.1 Importance of International Finance
14.6.2 Financial Globalisation
14.7 Let Us Sum Up
14.8 Hints to Check Your Progress Exercises

14.0 OBJECTIVES
After going through this unit, you will be able to explain:
 understand the different theories of free trade
 appreciate the advantages of or gains from international trade
 situate the theories explained in the present context of globalisation
 differentiate between tariff and non-tariff barriers
 explain the formation and progression of GATT and WTO
 discuss various trade agreements and trade blocs
 justify the existence of international finance mechanism.


Dr. Nidhi Tewathia, Assistant Professor, School of Social Sciences, IGNOU
250
 Globalisation and
14.1 INTRODUCTION Development

The unit begins with explaining various theories of free trade like theory of
absolute advantage, theory of comparative advantage and Heckscher-Ohlin
theorem. The theories also indicate the scope of exploitation of smaller countries
by the big countries. To protect the trade, countries impose tariff and non-tariff
barriers which allow the countries to escape the exploitation. Such barriers are
explained at length. After that, the unit progresses to describe various trade
agreements like bilateral agreements, multilateral agreements and the trading
blocs. The objectives and the progression of trade agreements like GATT and the
formation of WTO are also explained. With globalization and increasing
importance of international trade comes the requirement of international financial
structure. The need and benefits of such a structure is explained in detail towards
the end of this unit.

14.2 THEORIES OF INTERNATIONAL TRADE AND

DEVELOPMENT
A sound understanding of trade theories holds a greater importance in the domain
of trade policy-making, specifically in the context of recent trends and debates on
globalisation and trade liberalisation. It becomes imperative for us to understand
the basic working of these theories. Different trade theorists have highlighted and
emphasised different determinants of the potential gains from international trade.
Some of the major limitations of these theories are also important to understand
which help us to compare and contrast different strands of thoughts.

14.2.1 Theory of Absolute Advantage

Adam Smith started with the simple truth that for two nations to trade with each
other voluntarily, both nations must gain. If one nation gained nothing or lost, it
would simply refuse to trade. According to him, trade between two nations is
based on absolute advantage. The theory of absolute advantage can be explained
through a simple example. Let us take an example of two goods A and B and two
nations X and Y. Let us assume that goods A and B can be produced by labour
alone. It takes 10 units of labour to manufacture one unit of good A in nation X
but 20 labour units in case of nation Y. Conversely, it takes 20 units of labour to
manufacture one unit of good B in nation X but only 10 labour units in case of
nation Y. In other words, nation X is more efficient in producing good A,
because it uses less labour per unit of output than nation Y. Similarly, nation Y is
more efficient in producing good B. So, we can say that nation X has the
absolute advantage over nation Y in producing good A and nation Y has an
absolute advantage over nation X in producing good B.
In such a situation, both nations would benefit if each specialized in the
production of the commodity of its absolute advantage and then traded with the
other nation. Let us see how. Nation Y may gain by producing one unit of B, 251
Globalisation using 10 labour units, and exporting it to nation X in exchange for one unit of A.
In effect, nation Y has used 10 labour units to obtain one unit of A indirectly,
rather than using the same labour to produce 0.5 unit of A directly.
Correspondingly, nation X must have used 10 units of labour to produce the unit
of A for export, in exchange for which it received one unit of B. But if it had
tried to produce one unit of B itself, it would have required 20 units of labour.
Thus, it may be concluded that by trading, both nations will gain by having more
of both goods.
Nations do gain in case they observe theory of absolute advantage however, gains
from international trade of goods need not be limited to the situations of absolute
advantage. David Ricardo shows how the benefits from trade can be reaped also
in situations of comparative advantage. This theory is known as the theory of
comparative advantage.

14.2.2 Theory of Comparative Advantage

In 1817, Ricardo published his Principles of Political Economy and Taxation, in
which he presented the law of comparative advantage. According to this law,
even if one nation is less efficient than (has an absolute disadvantage with respect
to) the other nation in the production of both commodities, there is still a basis
for mutually beneficial trade. Let us look at an example to understand this.
Suppose in an economy, there are only two individuals Brad and Claire and they
produce food and wood. The daily production of each individual is given in
Table 14.1. It is clear that Claire has an absolute advantage in the production of
both food and wood as she produces more of both the goods in the same time as
compared to Brad. Now the question is what should brad produce then and
whether the two individuals would gain from trade? In fact, both Claire and Brad
would gain from trade if the concepts of opportunity costs manifested in
comparative advantages are understood at this stage. In simple words, the
opportunity cost of a good A is defined as the amount of another good, i.e., B,
that has to be given up in order to produce an additional unit of A.
Table 14.1: Daily production of Food and Wood
Food (in bushels) Wood (in logs)
Brad 16 8
Claire 20 20
Brad produces 8 logs of wood or 16 bushels of food in a day’s work. To produce
16 bushels of food, Brad must give up 8 logs of wood. That means the economy
loses 1 log of wood and gains 2 bushels of food. Opportunity cost of 1 log of
wood is 2 bushels of food. On the other hand, the opportunity cost of 1 bushel of
food is ½ log of wood. Claire produces 20 logs of wood or 20 bushels of food in
the same one day. In her case, she must give up 20 logs of wood to produce 20
bushels of food. So, the economy will lose 1 log of wood and gain 1 bushel of
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food. That means the opportunity cost of 1 log of wood is 1 bushel of food and Development
vice versa.
So, if we keep the same loss in case of both individuals i.e., if both are asked to
give up 1 log of wood, then Claire produces 1 bushel of food while Brad
produces 2 bushels of food. The gain is more in case of Brad producing food. The
opportunity cost is less in this case which also means that Brad is relatively more
efficient in the production of food. So, Brad shall produce food. As per Ricardo,
Brad has a comparative advantage in the production of food. Similarly, if we ask
both of them to give up 1 bushel of food and start producing logs of wood, then
Brad produces ½ log of wood and Claire produces 1 log of wood. This indicates
that Claire has a comparative advantage in the production of wood. So, Claire
should produce wood and Brad should produce food. both the individuals should
sell the good of comparative advantage to the other one.
The same thing applies to the countries and trade. A country has a comparative
advantage in producing a good if the opportunity cost of producing that good is
lower at home than in the other country.

14.2.3 Heckscher-Ohlin Theorem

Different countries have different factor endowments and technology at hand, to
produce various goods and services. Heckscher-Ohlin (H-O) theorem shows that
comparative advantage is influenced by the interaction between nations’
resources and the technology of production. Some factors of production are
scarce and some are in abundance with a given nation. Similarly, the technology
decides at what level of factor intensity a nation has to operate while deciding
various production processes.
The H-O model was first conceived by two Swedish economists, Eli Heckscher
and Bertil Ohlin. In this model, trade between different countries is caused due to
differences in relative factor endowments of those countries. It is a theory of
long-term general equilibrium in which the two factors are mobile between
sectors. Thus, the H-O framework sheds new light on the determinants of trade in
terms of 'factor proportions' and is also known as factor-proportions theory. It is
the ratio (or proportion) of one factor to another that gives the model its generic
name: the factor-proportions model
As per this theory, the determinants of trade are factor endowments of countries
and factor intensities of goods. A country specialises in and exports that good,
which intensively uses its most abundant factor. For example, if a country like
India is abundant in labour then India would mainly specialise in labour-intensive
goods that would form a large share of its export basket. On the other hand, India
would import capital intensive goods from countries that are capital-abundant.
In the H-O model the ratio of the quantity of capital to the quantity of labour used
in a production process is the capital-labour (K/L) ratio. And it is assumed that
different industries producing different goods have different capital-labour ratios. 253
Globalisation An industry which has a higher K/L ratio than the other one, is a capital-intensive
industry as compared to the other one. This also implies that the other industry is
labour-intensive relative to the first one.
Some countries like the US are well-endowed with physical capital relative to its
labour force. In contrast, many less developed countries have very little physical
capital but are well-endowed with large labour forces. The ratio of the aggregate
endowment of capital to the aggregate endowment of labour is used to define
relative factor abundance between countries. Thus if, for example, the has a
larger ratio of aggregate capital per unit of labour than India's ratio, we would say
that the U.S. is capital-abundant relative to India. By implication, India would
have a larger ratio of aggregate labour per unit of capital and thus India would be
labour-abundant relative to the U.S.
As mentioned earlier, the H-O theorem says that a capital-abundant country will
export the capital-intensive good while the labour-abundant country will export
the labour-intensive good. A capital-abundant country is the one that is well-
endowed with capital relative to the other country. This gives the country a
propensity for producing the good which uses relatively more capital in the
production process, i.e., the capital-intensive good. As a result, if these two
countries were not trading initially, i.e., they were in autarky, the price of the
capital-intensive good in the capital-abundant country would go down (due to its
extra supply) relative to the price of the good in the other country. Similarly, in
the labour-abundant country the price of the labour-intensive good would be
going down relative to the price of that good in the capital-abundant country. By
the same token, labour-intensive goods would be costly in the capital-abundant
country and capital-intensive goods would be available at a high price in the
labour abundant country. Once trade is allowed, profit-seeking firms will move
their products to the markets that temporarily have the higher price. Thus, the
capital-abundant country will export the capital-intensive good since the price
will be temporarily higher in the other country. Like-wise the labour-abundant
country will export the labour-intensive good. The trade flows will rise until the
price of both goods are equalised in the two markets.

14.3 TARIFF AND NON-TARIFF BARRIERS

There are many tools or instruments of trade protection. The tools of trade
protection that countries typically use to restrict imports can be broadly classified
into price related measures such as tariffs and non-price measures or non-tariff
barriers (NTBs).
14.3.1 Tariff
A tariff is a tax levied when a good is imported. Tariffs may be applied to
imports of both final and intermediate goods. Tariffs may be specific or ad
valorem. Specific tariffs are levied as a fixed amount per unit of the good (e.g.,
254 Rs.400 per box of imported dates). While, ad valorem duties are levied as a fixed
 Globalisation and
percentage of the total value of the goods (e.g., 30% duty on imported computer Development
parts). Tariffs are the oldest form of trade policy and have traditionally been used
as a source of government income.
The effect of the tariff is to raise the cost of shipping goods to a country, whether
the tariff has been imposed on the final goods or the intermediate goods. From
the point of view of someone shipping goods, a tariff is just like a cost of
transportation. If country A imposes a tax of Rs. 100 on every bushel of wheat
imported, shippers will be unwilling to move the wheat unless the price
difference between the two markets is at least Rs.100.
A tariff on an imported good, raises the price received by domestic producers of
that good. This effect is often the tariff’s principal objective—to protect domestic
producers from the low prices that would result from import competition. As a
result of these price changes, consumers lose in the importing country and gain in
the exporting country. Producers gain in the importing country and lose in the
exporting country. Also, a tariff or import duty essentially alters the relative
prices of traded goods vis a vis non-traded goods in the domestic market.
In analyzing trade policy in practice, it is important to ask how much protection a
tariff or other trade policy actually provides. the 'effective rate of protection',
which is used to measure the extent of actual protection granted to value added in
a particular industry by the entire tariff structure (covering final and intermediate
goods). The answer is usually expressed as a percentage of the price that would
prevail under free trade. An import quota on sugar could, for example, raise the
price received by U.S. sugar producers by 35 percent. Measuring protection
would seem to be straightforward in the case of a tariff: If the tariff is an ad
valorem tax proportional to the value of the imports, the tariff rate itself should
measure the amount of protection; if the tariff is specific, dividing the tariff by
the price net of the tariff gives us the ad valorem equivalent. However, there are
two problems with trying to calculate the rate of protection this simply. First, if
the small-country assumption is not a good approximation, part of the effect of a
tariff will be to lower foreign export prices rather than to raise domestic prices.
This effect of trade policies on foreign export prices is sometimes significant.
The second problem is that tariffs may have very different effects on different
stages of production of a good.
The importance of tariffs has declined in modern times because modern
governments usually prefer to protect domestic industries through a variety of
nontariff barriers (discussed in the next section). Nonetheless, an understanding
of the effects of a tariff remains vital for understanding other trade policies.
14.3.2 Non-Tariff Barriers
Tariffs are the simplest trade policies, but in the modern world, most government
intervention in international trade takes other forms which are categorised as
Non-tariff barriers (NTBs). NTBs are applied to quantities and other attributes of
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Globalisation traded goods and services. Non-Tariff Barriers (NTBs), unlike tariffs, may
impose direct restrictions on the inflow of imported goods. For instance,
conventional NTBs like import quotas directly restrict the quantum of imports
into the domestic country. While other NTBs restrict the flow of traded goods in
a more indirect manner.
Import Quotas: Import quotas impose direct restrictions on the quantum of
imports into a country. In practice quotas are administered through a system of
import licenses. Only license holders are given permission to import specified
quantities of the imported good into the domestic market. It is important to avoid
having the misconception that import quotas somehow limit imports without
raising domestic prices. The truth is that an import quota always raises the
domestic price of the imported good. When imports are limited, the immediate
result is that at the initial price, the demand for the good exceeds domestic supply
plus imports. This causes the price to be bid up until the market clears. In the end,
an import quota will raise domestic prices by the same amount as a tariff that
limits imports to the same level. The difference between a quota and a tariff is
that with a quota, the government receives no revenue. When a quota instead of a
tariff is used to restrict imports, the sum of money that would have appeared with
a tariff as government revenue is collected by whoever receives the import
licenses. License holders are thus able to buy imports and resell them at a higher
price in the domestic market. The profits received by the holders of import
licenses are known as quota rents.
Export Subsidies: An export subsidy is a payment to a firm or individual that
ships a good abroad. Like a tariff, an export subsidy can be either specific (a
fixed sum per unit) or ad valorem (a proportion of the value exported). When the
government offers an export subsidy, shippers will export the good up to the
point at which the domestic price exceeds the foreign price by the amount of the
subsidy.
Voluntary Export Restraints: A variant on the import quota is the voluntary
export restraint (VER), also known as a voluntary restraint agreement (VRA). A
VER is a quota on trade imposed from the exporting country’s side instead of the
importer country’s side. The most famous example is the limitation on auto
exports to the United States enforced by Japan after 1981. From an economic
point of view, however, a voluntary export restraint is exactly like an import
quota where the licenses are assigned to foreign governments and is therefore
very costly to the importing country. A VER is always more costly to the
importing country than a tariff that limits imports by the same amount. The
difference is that what would have been revenue under a tariff becomes rents
earned by foreigners under the VER, so that the VER clearly produces a loss for
the importing country. That means, voluntary export restraints can be beneficial
for the exporting country and damaging to the importing country.

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Local Content Requirement (LCR): LCR is a regulation that requires some Development
specified fraction of a final good to be produced domestically. In some cases, this
fraction is specified in physical units. In other cases, the requirement is stated in
value terms by requiring that some minimum share of the price of a good
represent domestic value added. Local content laws have been widely used by
developing countries trying to shift their manufacturing base from assembly back
into intermediate goods. From the point of view of the domestic producers of
parts, a local content regulation provides protection in the same way an import
quota does. From the point of view of the firms that must buy locally, however,
the effects are somewhat different. Local content does not place a strict limit on
imports. Instead, it allows firms to import more, provided that they also buy more
domestically. This means that the effective price of inputs to the firm is an
average of the price of imported and domestically produced inputs.
Exchange Controls: Exchange controls are restrictions imposed by countries'
Central Banks that directly limit domestic residents' ability to acquire foreign
currency in exchange for domestic currency. For instance, one method of
imposing exchange controls, involved acquiring the Central Bank's permission to
hold foreign currency bank accounts.
Import Deposit Schemes: These are rules imposed by countries' Central Banks,
which tend to restrict imports by making them more expensive. For instance,
under the rules importers are required to deposit a certain amount (usually in
proportion to the value of the imported good) with the Central Bank, which
effectively raises the cost of importing.

Check Your Progress 1

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) State the theory of absolute advantage with the help of an example.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) How is comparative advantage to a country helps it in trade? Use an example.
………………………………………………………………………………….
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3) Which theory explains the basis of trade as factor endowment and factor
intensity? Explain the theory.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
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Globalisation 4) How can tariff serve as a trade barrier? What are its benefits to the country
which imposes a tariff?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….

14.4 MULTILATERAL TRADE AGREEMENTS

Internationally coordinated tariff reduction as a trade policy dates back to the
1930s when the U.S. passed the Smoot-Hawley Act. Since then, a lot of progress
has taken place in the area of trade agreements.
Bilateral negotiations, however, do not take full advantage of international
coordination. Benefits from a bilateral negotiation may “spill over” to parties that
have not made any concessions. For example, if the U.S. reduces tariffs on coffee
as a result of a deal with Brazil, Colombia will also gain from a higher world
coffee price. Furthermore, some advantageous deals may inherently involve more
than two partners: The United States sells more to Europe, Europe sells more to
Saudi Arabia, Saudi Arabia sells more to Japan, and Japan sells more to the
United States. Thus, after bilateral negotiations, the next step in international
trade liberalization was to proceed to multilateral negotiations involving a
number of countries.
Multilateral negotiations began soon after the end of World War II. A group of
23 countries began trade negotiations under a provisional set of rules that became
known as the General Agreement on Tariffs and Trade, or GATT. This
provisional agreement ended up governing world trade for the next 48 years. The
countries participating in the GATT were officially designated as contracting
parties. In 1995, the World Trade Organization, or WTO, was established, finally
creating the formal organization. However, the GATT rules remain in force, and
the basic logic of the system remains the same. The process of binding exists to
prevent backsliding. Bound tariff rate means, the country imposing the tariff
agrees not to raise the rate in the future. In addition to binding tariffs, the GATT-
WTO system generally tries to prevent nontariff interventions in trade. To move
forward, a stylized process known as a trade round, in which a large group of
countries get together to negotiate a set of tariff reductions and other measures to
liberalize trade. Eight trade rounds have been completed since 1947. The first
five trade rounds under the GATT took the form of parallel bilateral negotiations,
where each country negotiates pair-wise with a number of countries at once.
Multilateral agreements make all signatories treat each other equally. No country
can give better trade deals to one country than it does to another. That levels the
playing field. It's especially critical for emerging market countries. Many of them
are smaller in size, making them less competitive. It increases trade for every
participant. Their companies enjoy low tariffs. That makes their exports cheaper.
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It standardizes commerce regulations for all the trade partners. Companies save Development
legal costs since they follow the same rules for each country. Further, countries
can negotiate trade deals with more than one country at a time.

14.5 TRADING BLOCS

Jacob Viner introduced the key concepts of trade creation and trade diversion in
his pioneering study of the theory of customs unions. Through a simple model,
Viner showed that forming a customs union could have welfare increasing effects
whereas it could have welfare-reducing effects in other circumstances.
Trade creation means that a free trade area (FTA), through preferential tariff
concessions, creates trade that would not have existed otherwise. As a result,
supply occurs from a more efficient producer of the product within an FTA. In all
cases trade creation will raise a country's national welfare, as imports replace
high-cost domestic production. Trade diversion means that a free trade area
diverts trade, away from a more efficient supplier outside the FTA, towards a less
efficient supplier within the FTA. In some cases, trade diversion will reduce a
country's national welfare but, in some cases, national welfare could improve
despite the trade diversion.
If the positive effects from trade creation are larger than the negative effects from
trade diversion, the FTA will improve national welfare. It is for this reason that
even the multilateral regime of the erstwhile GATT and the present WTO allows
for derogation from the principle of non- discrimination enshrined in Most-
favoured Nation (MFN).
Considering this, the vast majority of WTO members are party to one or more
regional trade agreements. As a result, a huge majority of global trade is
conducted under RTAs and not under the MFN principle. It is this sense that
regional trading blocs have emerged as promoters of global trade. But if an RTA
causes more negative effects of trade diversion than positive effects of trade
creation then the RTA may, be welfare reducing for a country.

14.5.1 Asia Pacific Economic Cooperation (APEC)

APEC began as an informal Ministerial-level dialogue group with 12 members
in1989 in Canberra, Australia. APEC Economic Leaders met for the first time to
outline APEC's vision, "stability, security and prosperity for our peoples" in 1993
in the U.S. In 2000 in Brunei, APEC established an electronic Individual Action
Plan (e-IAP) system, providing IAPs online and committed to the Action Plan for
the New Economy, which, amongst other objectives, aimed to triple Internet
access throughout APEC region by 2005. It agreed to re-energise the WTO Doha
Development Agenda negotiations and stressed the complementary aims of
bilateral and regional trade agreements. APEC dedicated itself not only to
promoting the prosperity of member economies, but also to improving the
security of the peoples of the Asia- Pacific region. APEC pledged to take specific 259
Globalisation actions to dismantle terrorist groups, eliminate the danger of weapons of mass
destruction and confront other security threats. APEC also strengthened its efforts
to build knowledge-based economies, promote sound and efficient financial
systems and accelerate regional structural reform. Leaders issued a stand-alone
statement in support of a successful conclusion to the WTO's 6th Ministerial
Meeting in Hong Kong, China and agree to confront pandemic health threats and
continue to fight against terrorism, which could cause deep economic insecurity
for the region.

14.5.2 European Union

The European Union grew out of the European Coal and Steel Community
(ECSC), which was founded in 1951, by the six founding members: Belgium,
Netherlands, Luxembourg (the Benelux countries), West Germany, France and
Italy. Its purpose was to pool the steel and coal resources of the member states,
thus preventing another European war.
The ECSC was followed by attempts to found a European Defence Community
(EDC) and a European Political Community (EPC). Following the failure of the
EDC and EPC, the six founding members tried again at furthering their
integration, and founded the European Economic Community (EEC). The
purpose of the EEC was to establish a customs union among the six founding
members, based on the "four freedoms": freedom of movement of goods,
services, capital and people. The growth of these European Communities into
what is currently the European Union can be said to consist of two parallel
processes - first their structural evolution and institutional change into a tighter
bloc with more competences given to the supranational level, which can be called
the process of European integration or the deepening of the Union. The European
Communities enlarged (and later European Union) from 6 to 25 member states,
which is also called the widening of the Union. On January 1, 2002, Euro notes
and coins entered circulation. The EU is considered to be the most telling
example of a customs union and a monetary and economic union. However, due
to differences among its members problems lie ahead such as in the case of the
Euro, which does not have full membership.

14.5.3 North American Free Trade Agreement

In January 1994, Canada, the United States and Mexico launched the North
American Free Trade Agreement (NAFTA) and formed the world's largest free
trade area. NAFTA is considered to have brought economic growth and rising
standards of living for the people of all three member countries since 1994. This
has been achieved by strengthening the rules and procedures governing trade and
investment throughout the continent. This has been brought about by formulating
and implementing the free trade agreement, which covers dimensions such as the
Trade in Goods, Rules of Origin, Technical Barriers to Trade; Government
260 Procurement, Investment, Services and Related Matters, Intellectual Property,
 Globalisation and
and Administrative and Institutional Provisions. NAFTA has enabled both Development
Canada and Mexico to increase their exports to the United States. Manufacturers
in all three countries are better able to realise their full potential by operating in a
larger, more integrated and efficient North American economy.
Under NAFTA, countries have been able also to introduce the highly successful
approach of parallel environmental and labour cooperation agreements. The
economic integration promoted by NAFTA has spurred better environmental
performance across the region. Through the North American Agreement on
Environmental Cooperation, the three partners are promoting the effective
enforcement of environmental laws. Through the North American Agreement on
Labour Cooperation, Mexico and the United States are working together to
protect, enhance and enforce basic workers' rights. NAFTA is often cited as a
successful example of a regional trading bloc, which has through the effects of
trade creation brought welfare gains to the participating countries.

14.5.4 ASEAN
The Association of Southeast Asian Nations (ASEAN) was established in 1967
by the five original member Countries, namely, Indonesia, Malaysia, Philippines,
Singapore, and Thailand. Brunei Darussalam joined in 1984, Vietnam in 1995,
Laos and Myanmar in 1997 and Cambodia in 1999, making it ASEAN-10.
ASEAN began with emphasis on political issues but in recent times economic
integration has become priority, especially since the Asian crisis of the 1997. The
Framework Agreement on Enhancing Economic Cooperation was adopted at the
Fourth ASEAN Summit in Singapore in 1992, which included the launching of a
scheme toward an ASEAN Free Trade Area or AFTA. The strategic objective of
AFTA is to increase the ASEAN region's competitive advantage as a single
production unit. The elimination of tariff and non-tariff barriers among the
member countries is expected to promote greater economic efficiency,
productivity and competitiveness. The Fifth ASEAN Summit held in Bangkok in
1995 adopted the Agenda for Greater Economic Integration.
In 1997, the ASEAN leaders adopted the ASEAN Vision 2020, which called for
ASEAN Partnership in Dynamic Development aimed at forging closer economic
integration within the region. The vision statement also resolved to create a
stable, prosperous and highly competitive ASEAN Economic Region, in which
there is a free flow of goods, services, investments, capital, and equitable
economic development and reduced poverty and socio-economic disparities.
ASEAN cooperation has resulted in greater regional integration. Tourists from
ASEAN countries themselves have been representing an increasingly important
share of tourism in the region. ASEAN economic cooperation is comprehensive,
which covers the following areas: trade, investment, industry, services, finance,
agriculture, forestry, energy, transportation and communication, intellectual
property, small and medium enterprises, and tourism.
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Globalisation 14.5.5 SAARC
The South Asian Association for Regional Cooperation (SAARC) was
established when its Charter was formally adopted on 8 December 1985 by the
Heads of State or Government of Bangladesh, Bhutan, India, Maldives, Nepal,
Pakistan and Sri Lanka. The Association provides a platform for the peoples of
South Asia to work together in a spirit of friendship, trust and understanding. It
aims to promote the welfare of the peoples of South Asia and to improve their
quality of life through accelerated economic growth, social progress and cultural
development in the region. The areas of cooperation under the reconstituted
Regional Integrated Programme of Action which is pursued through the
Technical Committees now cover: Agriculture and Rural Development; Health
and Population Activities; Women, Youth and Children; Environment and
Forestry, Science and Technology and Meteorology; Transport; and Human
Resource Development. Working Groups have also been established in the areas
of: Information and Communications Technology (ICT); Biotechnology;
Intellectual Property Rights (IPR); Tourism; and Energy.
Summits are the highest authority in SAARC and are to be held annually. The
Agreement on SAARC Preferential Trading Arrangement (SAPTA) was signed
in 1993 and four rounds of trade negotiations have been concluded. With the
objective of moving towards a South Asian Economic Union (SAEU), the
Agreement on South Asian Free Trade Area (SAFTA) was signed during the
Twelfth Summit in Islamabad in January 2004. SAFTA entered into force since
July 2006. During the Twelfth Summit in Islamabad, the SAARC Social Charter
was signed in order to address social issues such as population stabilisation,
empowerment of women, youth mobilisation, human resource development,
promotion of health and nutrition, and protection of children, which are keys to
the welfare and well-being of all South Asians.

14.6 INTERNATIONAL FINANCE

International Finance discusses the global issues related with monetary
interactions. These issues are of at least two or more countries. Exchange rates of
currencies, monetary systems of the world, foreign direct investment (FDI), and
other important issues associated with international financial management come
under the umbrella of international finance.
The existence of International finance is rooted in the fact that economic
activities of businesses, governments, and organizations get affected by the
existence of different nations. Countries often borrow and lend from each other.
In doing so, many countries utilise their own currencies. One currency is
different in terms of its value as compared to another currency. International
finance provides a way to compare various currencies and to understand how the
imports are paid for and what is the determining factor of the prices that the
currencies trade at. The World Bank, the International Finance Corporation (IFC)
and the International Monetary Fund (IMF) are some of the notable international
finance organizations.
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As we discussed in previous sections that trade is an engine of growth for a Development
country and the importance of trade has increased manifolds due to globalization.
The resurgence of the US from being the biggest international creditor to become
the largest international debtor is an important global issue. It has implications on
the international finance and how the international organizations work.

14.6.1 Importance of International Finance

International finance plays a significant role in international trade. The reasons
behind its importance are listed below:
 International finance is an important tool to find the exchange rates, compare
inflation rates, get an idea about investing in international debt securities,
ascertain the economic status of other countries and judge the foreign
markets.
 Exchange rates are very important in international finance and international
trade, as they enable us to determine the relative values of currencies.
International finance helps in calculating these rates.
 International investment decisions are based on many economic factors.
Economic factors of economies help in determining whether or not investors’
money is safe with foreign debt securities.
 Utilizing International Financial Reporting Standards (IFRS) is an important
factor for many stages of international finance. Financial statements made by
the countries that have adopted IFRS are similar and provide uniformity to
the system. It helps many countries to follow similar reporting systems.
 IFRS system, which is a part of international finance, also helps in saving
money by following the rules of reporting on a single accounting standard.
 International finance has grown in stature due to globalization. It helps
understand the basics of all international organizations and keeps the balance
intact among them.
 An international finance system maintains peace among the nations. Without
a solid and robust finance measure, all nations would work for their self-
interest which would lead to many issues. International finance helps in
keeping that issue at bay.
 International finance organizations, such as IMF, the World Bank, etc.,
provide a mediators’ role in managing international finance disputes.
The very existence of an international financial system means that there are
possibilities of international financial crises. This is where the study of
international finance becomes very important. Without international finance,
chances of conflicts and thereby, a resultant mess, is apparent. International
finance helps keep international issues in a disciplined state.
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Globalisation In the recent decades, the financial economies have increasingly got
interconnected around the world. The impact of globalization has been felt in
every aspect of economy. Financial globalization has offered substantial benefits
to the national economies and to both investors and wealth creators. However, it
has a wreaking effect on financial markets as well.
14.6.2 Financial Globalisation
When we talk about financial globalization, there are four major factors which
act as its driving force. They are:
 Advancement in information and communication technologies −
Technological advancements have made market players and governments far
more efficient in collecting the information needed to manage financial risks.
 Globalization of national economies − Economic globalization has made
production, consumption, and investments dispersed over various geographic
locations. As barriers to international trade have been lowered, international
flows of goods and services have significantly increased.
 Liberalization of national financial and capital markets − Liberalization and
fast improvements in international trade and the globalization of national
economies have resulted in highly spread financial innovations. It has
increased the growth of international capital movements.
 Competition among intermediary services providers − Competition has
increased manifold due to technological advancements and financial
liberalization. A new class of nonbank financial entities, including
institutional investors, have also emerged.
There are many benefits and risks of financial globalisation. They are:
 One of the major benefits of Financial Globalization is that the risk of a
"credit crunch" has been reduced to extremely low levels. When banks are
under strain, they can now raise funds from international capital markets.
 With more choices, borrowers and investors get a better pricing on their
financing. Corporations can finance the investments more cheaply.
 The disadvantage is that the markets are now extremely volatile, and this can
be a threat to financial stability. Financial globalization has altered the
balance of risks in international capital markets.
 With financial globalization, creditworthy banks and businesses in emerging
markets can now reduce their borrowing costs. However, emerging markets
with weak or poorly managed banks are at risk.
The crises of the 1990s have shown the importance for a prudent sovereign debt
management, effective capital account liberalization, and management of
domestic financial systems. The system of international finance acts as a
safeguarded in the following ways:
 Private financial institutions and market players can now contribute to
financial stability by managing their businesses well and avoiding
264 unnecessary risk-taking.
  As financial stability is a global public good, governments and regulators Globalisation and
Development
also play a key role in it. The scope of this role is increasingly getting
international.
The IMF is a key role-player as well. Its global surveillance initiatives to enhance
its ability to manage international financial stability also act as a safeguard.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What is GATT and how does it work with respect to gainful trade?
………………………………………………………………………………….
………………………………………………………………………………….
2) Name few trading blocs. Outline any two of them.
………………………………………………………………………………….
…………………………………………………………………………………
3) Why is there a need of international finance system?.
………………………………………………………………………………….
………………………………………………………………………………….
4) State the benefits and risk of financial globalisation.
………………………………………………………………………………….
………………………………………………………………………………….

14.7 LET US SUM UP

In this unit we began by the understanding various trade theories which indicated
the existence of different basis on which two countries can engage in gainful
trade. The absolute advantage basis paved way for comparative advantage theory.
Later Heckscher-Ohlin theory was formulated which emphasised the factor
endowment and factor intensity of a country and its production processes.
Countries generally follow some trade barriers for trade protection. These
barriers fall in the category of tariff and non-tariff barriers. The trade theories
also lead the countries on the path of trade agreements. Such agreements are part
of a country’s trade policy measures. The agreements existed in the form of
bilateral and multilateral trade agreements between various nations in order to
benefit from trade. Different trading agreements were discussed e.g., European
Union, APEC and NAFTA to throw some light on the relevance of such
agreements. With international trade barriers lowering, the importance of an
international financial system has also grown. The driving forces of financial
globalisation and the risks and benefits of financial globalisation are discussed.
Such a financial system safeguards different nations and has significant role in
international trade and reducing the financial disputes.
265
14.8 HINTS TO CHECK YOUR PROGRESS
EXERCISES
Check Your Progress 1
1) (Refer sub-section 14.2.1) It takes 10 units of labour to manufacture one unit
of good A in nation X but 20 labour units in case of nation Y Then nation X
has absolute advantage in the production of good A.
2) (Refer sub-section 14.2.2) A country has a comparative advantage in
producing a good if the opportunity cost of producing that good is lower at
home than in the other country.
3) (Refer sub-section 14.2.3) Heckscher-Ohlin (H-O) theorem shows that
comparative advantage is influenced by the interaction between nations’
resources and the technology of production. As per this theory, the
determinants of trade are factor endowments of countries and factor
intensities of goods. A country specialises in and exports that good, which
intensively uses its most abundant factor.
4) (Refer sub-section 14.3.1) A tariff is a tax levied when a good is imported.
Tariffs may be applied to imports of both final and intermediate goods.
Tariffs may be specific or ad valorem. A tariff on an imported good, raises
the price received by domestic producers of that good. This effect is often the
tariff’s principal objective—to protect domestic producers from the low
prices that would result from import competition. As a result of these price
changes, consumers lose in the importing country and gain in the exporting
country. Producers gain in the importing country and lose in the exporting
country.
Check Your Progress 2
1) (Refer section 14.4) A group of 23 countries began trade negotiations under a
provisional set of rules that became known as the General Agreement on
Tariffs and Trade, or GATT. The process of binding exists to prevent
backsliding. Bound tariff rate means, the country imposing the tariff agrees
not to raise the rate in the future. In addition to binding tariffs, the GATT-
WTO system generally tries to prevent nontariff interventions in trade.
2) (Refer section 14.5) APEC, ASEAN, NAFTA, EU etc
3) (Refer sub-section 14.6.1) International finance provides a way to compare
various currencies and to understand how the imports are paid for and what is
the determining factor of the prices that the currencies trade at.
4) (Refer sub-section 14.6.2) Credit crunch, emerging markets with weak or
poorly managed banks are at risk, more choice for borrowers and investors.
 GLOSSARY
Adverse selection : This is a problem of the hidden types of borrowers.
The lender may not have reliable information about
the ‘quality of the borrowers’ and their risk-taking
behaviour (i.e., whether the borrower is a
good/safe or a bad/risky borrower).
Age specific fertility rate : It is the average number of children per year born
to women in a particular age group.
Aggregate birth rate : It is the outcome of the age distribution in a
country, the age-specific fertility rates of women in
that country and fraction of population in different
age groups.
Bonding Social Capital : It indicates the strong and close connections
between groups of individuals who are most likely
homogeneous.
Capacity effect : Greater physical health and strength of an
individual allows him to carry out tasks that an
undernourished person might find difficult to do. A
person with better nutrition status has more
working capacity compared to the one with low
nutrition status.
Coase Theorem : Coase Theorem is a legal and economic theory
developed by economist Ronald Coase that affirms
that where there are complete competitive markets
with no transactions costs, an efficient set of inputs
and outputs to and from production-optimal
distribution will be selected, regardless of how
property rights are divided.
Common Pool Resource : Common pool resources are generally open access
resources and used by many to support their
livelihood.
Comparative Advantage : A country has a comparative advantage
inproducing a good 'A' if the opportunity cost of
producing good 'A' is lower at home than in the
other country.
Contingent renewal : Contingent renewal in case of joint liability means
that if any member(s)of the group defaults, no
group member receives any further loans. Whereas
in case the group repays, it ensures future loan
openings.
Cosmopolitan Perspective : The cosmopolitan view asserts the principle that all
human beings are members of one global
community.
Credit rationing : Credit rationing refers to a situation in which, at the
going interest rate (or the rate of interest prevailing in
the market), the borrower wants to borrow more
money, but the lender does not allow to do so.
 to do so. It can be understood as an upper limit on
the amount a person can borrow.
Decent work : Decent work is work that pays a fair income to
men and women, guarantees job security, safe
working conditions and respects the fundamental
rights of the workers.
Derived demand : The derived demand is the demand for a factor of
production (in this case, labour) that occurs due to
the demand for some other final good.
Discount rate : In present value calculations, the annual rate at
which future values are decreased to make them
comparable to values in the present.
Disguised : If we suppose that there is a capitalist sector
unemployment elsewhere that does pay according to marginal
product, then the economy will exhibit a wage rate
(for unskilled labor) that is a true measure of the
marginal product elsewhere, and there will be
efficiency gains available as long as the marginal
product on the traditional activity is less than the
wage, whether it is zero or not. This extended
concept is known as disguised unemployment. The
amount of disguised unemployment may be
measured roughly by the difference between the
existing labor input in the traditional activity and
the labor input that sets marginal product equal to
the wage.
Economic Perspective : The economistic perspective emphasises on
increased frequency of international economic
exchanges, greater interdependence between
different countries and rise in the facilitation of
their integration.
Economic Perspective : The economistic perspective emphasises on
increased frequency of international economic
exchanges, greater interdependence between
different countries and rise in the facilitation of
their integration.
Emission Tax : An emission tax is a tax or financial penalty
imposed on polluters by government authorities.
The charge is specified on the basis of rupees per
unit of emission into the ambient environment.
Eviction : It is when the tenant of the land is asked to leave
the owner's property in case rent is not paid on
time or the required efforts are not applied. The
landlord often uses it as a threat to keep the tenant
motivated.
Factor Endowment : A country's endowment with resources such as
land, labour, and capital.
Factor intensity : Factor intensity is the relative importance of one
factor (i.e., land or labour or capital) versus others
 in production process in a given industry usually
compared across ' industries. Factor Intensities are
mostly defined by ratios of factor quantities
employed at common factor prices. These are also
defined sometimes by factor shares or by marginal
rates of substitution between factors.
Globalisation : All those processes by which the peoples of the
world are incorporated into a single world society.
Holdout problem : A holdout is a form of monopoly power that
potentially arises in the course of land acquisition
where a big chunk of land is required for a project
(like infrastructure, industry, mining extraction,
urban housing etc.). Once acquisition begins,
individual owners, knowing their land is essential to
the completion of the project, can hold out for
prices in excess of their opportunity costs.
Human capital : It can be defined as labour that is skilled, can
handle sophisticated machinery and is innovative in
using machines. Productive investments embodied
in human persons, including skills, abilities, ideals,
health and locations often resulting from
expenditures on education, on-the-job training
programs and medical care.
Information : It is a condition where the lender is unaware of the
asymmetry intrinsic characteristics of the borrower. The two
types of problems associated with information
asymmetry are adverse selection (problem of
hidden types) and moral hazard (problem of hidden
actions).
Internationalist view : Internationalists believe that most economic and
social activity is carried on regionally rather that
globally.
Involuntary : It occurs when w person is willing and able to
unemployment work at the prevailing wage rate but are not getting
the job.
Involuntary : It occurs when w person is willing and able to
unemployment work at the prevailing wage rate but are not getting
the job.
Joint liability loan : JLL is a loan given by banks to a group of people
on a sequential basis. The joint liability feature
ensures that in case of default by a group member,
the whole group is responsible for the repayment.
Land Acquisition : It means acquiring a large part of the land already
under different uses. It is usually done by acquiring
that large parcel of land already under different land
use and vested with different stakeholders

Land reforms : Land reforms refer to the process of transfer of

land ownership from wealthy landowners (more
 powerful people) to poor or relatively less
powerful people. This is usually done by changing
the laws and regulations that govern land
ownership.
Lender monitoring : Lender monitoring is associated with group
lending where the bank also monitors the group
resulting in a double safety net, also reducing the
strategic complementarity problem.
Limited liability : It means that the borrower cannot be held
responsible for the repayment of the debts if their
project fails or the borrower declares bankruptcy.
Linking Social : It indicates the vertical ties between the poor
Capital individuals and influential people.
Market failure : It refers to the inefficient distribution of goods and
services (credit, in this case) in the free market. It
occurs when the demand for goods/services is not
equal to the supply of goods/services. The main
types of market failure discussed in this chapter are
asymmetric information and concentrated market
power.
Microfinance : It refers to small loans provided to unemployed or
low-income individuals or groups who are left out
of the formal credit market. The loan is primarily
meant for working capital needs.
Moral Hazard : It refers to the problem of hidden action (lack of
problem information about how the loan will be used or
lack of information about the repayment decision).
Moral Hazard : It refers to the problem of hidden action (lack of
information about how the loan will be used or
lack of information about the repayment decision).
Negative Externality : When the effect of the actions of an individual on
another individual is negative, we call it a positive
externality.
NGOs : Non- Governmental Organisations which are
beyond the governmental influence and work for
the well-being of the society.
Panchayati Raj : The three tier institutions of rural local governance
Institutions comprising of Zila Parishad, Panchayat Samiti and
Gram Panchayat.
Participation : The participation constraint is used to define the
constraint reservation wage. According to this, if the firm
offers a wage lower than the reservation wage, the
worker will not accept the job.
Peer monitoring : It is a phenomenon of group lending where group
members monitor the members who have
borrowed money and influence the borrower to
reduce the level of riskiness.
Piece rate : Piece rate means that the payment given to a
worker is based on the tasks completed by them.
Pigouvian Tax : A pollution tax that neutralises the social damage
or the social cost imposed on the society by a
polluting the firm.
Population growth : It is computed as birth rate minus death rate and is
rate expressed in percentages. The natural increase in
population measures the excess of births over
deaths or in technical terms, the difference between
fertility and mortality.
Positive assortative : It is associated with JLL where safe borrowers
matching decide to come together to form a group, and the
risky borrowers have no alternative but to group
with the remaining risky types.
Positive Externality : When the effect of the actions of an individual on
another individual is positive, we call it a positive
externality.
Pump-priming : In the case of joint liability where the borrowers
monitor other members of the group, the additional
and relatively costly monitoring by the bank
induces more efficient monitoring by the
borrowers themselves. This is called the pump-
priming effect.
Regional Trading : A group of countries those are geographically
Bloc closely associated in international trade, usually
some sort of Preferential Trading Arrangement
(PTA).
Rehabilitation : It refers to the process of restoration of land to its
former/ original state.
Renewable Resources : Renewable resources are considered to be infinite
and substitutable between varieties.
Reservation wage : It is the minimum wage at which a person is
willing to work or accept a job.
Resettlement : It is a process of settling again the people whose
land has been acquired in a new area.
Resting metabolism : According to this effect, the body eats up less for
effect resting metabolism and can use the extra energy
more efficiently for work.
Sequential : It refers to the feature that while repayment starts
repayment within a month or so of the loans, it comes in small
and easy but regular instalments.
Sharecropping : It is a type of tenancy contract where the tenant is
allowed to cultivate the land in exchange for a
share of the crop produced in the form of rent.
Surplus Labor : Labour that can be removed at little or no potential
cost. It is a situation in the physical marginal
product of labor is equal to zero.
Sustainable : The concept of sustainable development lays more
Development emphasis on equity rather than on efficiency in the
use of resources. This implies that resources should
be used in an egalitarian manner which would
improve the quality of life of the majority of
people.
Tariff : A tariff is a tax levied when a good is imported.
Tenancy : It is a temporary possession of somebody else’s
land or property by a tenant.
The doctrine of : It generally means that the ruling government has
Eminent Domain the right to take over any property in the general
public interest. It even allows the government to
take over the land forcefully if a person is not
willing to sell.
The Malthusian : A universal tendency for the population of a
Population Trap country unless checked by dwindling food
supplies, to grow at a geometric progression
doubling every 30 to 40 years. At the same time
because of diminishing returns to fixed factor land,
food supplies could expand only at a roughly
arithmetic rate. Because the growth in food
supplies could not keep pace with the burgeoning
population, per-capita incomes (per-capita food
production) would have tendency to fall as low as
to lead to stable population existing barely at or
slightly above the subsistence level.
The population- : It explains how poverty and high population
poverty cycle theory growth become reinforcing and intensifies and
exacerbates the economic, social and psychological
problems associated with the condition of
underdevelopment.
Total fertility rate : The number of children that would be born to a
women if she were to live to the end of her
childbearing years and bear children in accordance
with the prevailing age-specific fertility rates. It is
calculated by adding up all the age specific fertility
rates over different age groups.
Trade Creation : Viner gave the concept of trade creation in 1950. It
is that trade, which occurs between members of a
preferential trading arrangement and that replaces
what would have been produced in the importing
country in the absence of PTA. Trade creation is
associated with welfare improvement for the
importing country since it reduces the cost of the
imported good.
Trade diversion : Viner gave the concept of trade diversion in 1950.
It is that trade, which occurs between members of a
preferential trading arrangement that replaces what
would have been imports from a country outside in
 the PTA. It is associated with welfare reduction for
the importing country since it increases the cost of
the imported good.
Tragedy of : If individuals act independently, rationally and
Commons focused on pursuing their individual interests, they
would end up going against the common interests
of their communities and exhaust the planet’s
natural resources. This overuse of public resources
is termed as the "Tragedy of the Commons".
Transformationalists : The nation state remains powerful and whatever
view challenges exist, they can be reversed by
restructuring, reforming and by accommodating
the new forms of global governance.
Youth dependency : It is the proportion of young people under 15 to the
ratio working age population aged 15-59 in a country.
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