Development Economics Module Prepared by Fikadu

ODA BULTUM UNIVERSITY
COLLEGE OF AGRICULTURE
DEPARTMENT OF AGRICULTURAL ECONOMICS
DEVELOPMENT ECONOMICS (AGEC-442) MATERIAL FOR

AGRICULTURAL ECONOMICS DEPARTMENT
BY: Fekadu A. (MSc in Agricultural economics)
Email: [email protected]
APRIL 5, 2023
ODA BULTUM UNIVERSITY
Chiro, OBU, Ethiopia
Development ECONOMICS (AgEc-442) material for Agricultural Economics Department
CHAPTER 1
INTRODUCTION
1. Economics and Development Studies
1.1 Definition and Concept of Development Studies
The necessary first step in introducing the field of development economics is to define the elusive
concept of development. What does “development” mean? Most people would readily agree that
it relates to an improvement in the human condition, to better standards of living. But that merely
displaces the definitional problem. How do we know if standards of living improve?
Development is an elusive term. The concept has been understood differently in different time
periods and by different persons. Its meaning has evolved progressively to have the present
meaning. In the 1950s and 1960s, for example, development was considered as synonymous to
economic growth. Accordingly, in this period, it has been defined as the capacity of the economy
to generate and sustain the fast growth rate of GDP (per capital income).
Others tried to explain development in terms of the process of structural transformation of the
economy. In this regard, development is the planned alteration of the structure of production and
employment so that agriculture’s share of both declines and that of the manufacturing and the
service industries increases.
Later on, concerns are accorded to poverty, unemployment, inequalities of income, and other
economic, institutional, social and political factors owing to the failure of developing countries to
improve the standard of living of the poor. Many developing countries experienced relatively high
rates of growth of per capita income during the 1960s and 1970s. But the countries showed little
or no improvement or even an actual decline in employment, equality, and the real income of the
poorest part of their population. Consequently, in addition to economic growth, Dudley Seers
argues on the need of looking on what has been happening to poverty, unemployment, and
inequality as a determinant of development rather than mere growth of per capita income.
Development is further broadened still after Seers. The phenomenon of development is not merely
a question of even the quantitative measurements of income, employment, and inequality. In
addition to these issues, development has to incorporate other economic and non-economic factors.
Presently, therefore, Todaro succinctly puts the definition of development as follows:

development is “conceived as a multidimensional process involving major changes in social
structures, popular attitudes, and national institutions, as well as the acceleration of economic
growth, the reduction of inequality (and unemployment), and the eradication of absolute poverty”.
Economists most commonly used measures of output and associated income or expenditures as
metrics. These flow measures are surely related to well‐being, as virtually everyone would prefer
Compiled by Fekadu A. (MSc) Page 1

more of such things to less, all else held constant. But the inherent stochasticity and transience of
flow measures encourage other analysts to focus on stock measures – loosely speaking, assets – as
a more durable representation of human well‐being. Capital in its many guises – financial, human,
manufactured, natural, and social – thus plays a prominent role in much of development
economics. The problem with such stock or flow definitions, of course, is that incomes,
expenditures, and assets all privilege material conditions and offer a time‐bound view of the kind
of life people live.
As Sen (1981, 1985, 1995) has so eloquently argued in a series of seminal books, insofar as
development is concerned with humans experiencing a better life, the focus ought to be on the
length and quality of that life, or on the “entitlements”, “capabilities” and “functioning’s” of
persons.
A concept of development, in general, is required which embraces the major economic and social
objectives and values that societies strive for.
What Is Development Economics?
Usually, a development economics class is a potpourri of special topics. It’s hard for it not to be
because economic development involves so many different things:
 It’s income growth (how can we have development without growth in countries whose
per capita incomes now lower around $1–$2 per day?).
 It’s welfare economics, including the study of poverty and inequality.
 Its agricultural economics, How to make agriculture more productive is a big question in
countries where most of the population—particularly the poor population—is rural and
agricultural.
 It’s economic demography, the study of population growth in a world with more than 7
billion people, and population distribution in a world with more than a quarter of a billion
international migrants and many more internal ones. (China will have about that many
internal migrants in the near future if it doesn’t already.)
 Its labor economics, the study of human education, health, conditions in the workplace.
 It’s the study of markets for goods, services, inputs, outputs, credit, and insurance,
without which whole economies can grind to a standstill.
 Its public economics, including the provision of public goods from roads and
communications to utilities and waste treatment, and it’s about managing the
macroeconomic, too.
 It’s about natural resources and the environment, the study of energy, water,
deforestation, pollution, climate change, and sustainability.
Development economics is a branch of economics which deals with economic aspects of the
development process in low-income countries. Its focus is not only on methods of promoting

economic development, economic growth and structural change but also on improving the
potential for the mass of the population, for example, through health, education and workplace
conditions, whether through public or private channels. Development economics involves the
creation of theories and methods that aid in the determination of policies and practices and can be
implemented at either the domestic or international level. This may involve restructuring market
incentives or using mathematical methods such as inter-temporal optimization for project analysis,
or it may involve a mixture of quantitative and qualitative methods.
Thus development studies pay attention to involuntary deprivation of fundamental material

comforts of life, basic nutrition, rudimentary shelter, minimally competent medical attention, and
primary education. The involuntary deprivation that accompanies mass poverty has a self-fulfilling
and self-perpetuating character. It is hard to overcome because it consists of a series of vicious
circles or a set of interlocking equilibrium circumstances that reinforce one another. The poor
people consume less and fail to work hard. They earn little hence cannot save much. They think
that more children they have more their income will be. Thus it is in their interest to produce more
children, but not in the interest of society. The poverty of the poor people is transmitted to their
children. These poor persons have to live with people who are extraordinarily rich and powerful.
The rich exercise their own views mostly from Western economics, regarding the economy and
sociology. In this way, a tension is developed amongst the poor and the rich in the poor countries.
A few rich would like to get more and more wealth in these poor countries where the infant
mortality rate is high, general educational levels are low, cities are crowded, dirty, and unpleasant,
and public facilities are lacking and missing. Thus the poor countries fail to meet the common
visions of the good life.
Unlike in many other fields of economics, approaches in development economics may incorporate
social and political factors to devise particular plans. Also unlike many other fields of economics,
there is no consensus on what students should know. Different approaches may consider the factors
that contribute to economic convergence or non-convergence across households, regions, and
countries.
What is economic development not about, you might ask?
Lurking behind this question is another one, which lies at the heart of why we wrote this book:
Why is there even a field of development.
What Is Economic Development, Then?
Economic development has different meanings in different contexts. In rich countries, it is pretty
much equated with growth. Politically, development projects in high-income countries often are
motivated by some of the same goals that inspire development projects in poor countries,
particularly the creation of new jobs, incomes, and tax revenues. Their ultimate aim, however, is
likely to be growth.

Most development economists today would say that economic development is not equivalent to
growth, although it is difficult to achieve development goals without growth. Development
projects around the world focus on concrete outcomes related to poverty, malnutrition, inequality,
and health. Development is about satisfying basic physical needs like nutrition, shelter, and
clothing, and about the development of the mind (and of course people’s earnings potential)
through education. Projects also focus on the environment, conservation, and sustainable resource
use; on human rights, gender and ethnic equity, and even government corruption.
All of these questions can be vital not only to determining who reaps the benefits of economic
growth but also to understanding growth itself. Here in lays a fundamental difference in the way
we tend to look at economics and politics in rich and poor countries. In high-income countries (not
to mention our microeconomics courses), economic efficiency and equity tend to be viewed as
separate questions. The efficient allocation of resources is critical to ensure that economies
produce the biggest possible economic pie; given the constraints they face (i.e.
1.2 Current Interest in Development Economics
The focus of the world to the development problems of underdeveloped countries have started
recently. Though the study of economic development, in general, has attracted the attention of
economist’s right from the mercantilist school, the classical school down to Marx and Keynes, its
study as a separate subject is a relatively recent phenomenon. It is also after the end of the II
World War that the majority of the international bodies with the aim of promoting development
that exists today such as the World Bank and its affiliates, and agencies of the UN all have been
established.
Before the war, there was the little preoccupation with the economic and social problems of
developing countries with which we are concerned today. One of the reasons for this little
preoccupation may be that the poor countries were colonies. Moreover, the concern and attention
of most people might be focused on depression and unemployment in the developed countries.
The situation today is different. The development of underdeveloped countries and primarily the
eradication of absolute poverty are now regarded as one of the greatest social and economic
challenges facing humankind. A number of factors can be pointed out that account for this change
in attitude and upsurge of interests in the economics of development and the economies of poor
nations.
These factors can broadly be classified into three: -
i. Academic interest in development
ii. The awareness of developing countries about their backwardness and their demand for
a new international economic order
iii. The awareness of the world in general and developed countries in particular about the
mutual interdependence of the world economy
Academic Interest in Development

Academic interest in the mechanics of growth and development is a renewed interest rather than a
new preoccupation of economists. The progress and material well-being of human being and
nations have traditionally been at the center of economic writings and inquiry starting from the
classical economists. Adam Smith, David Ricardo, Thomas Malthus, John Stuart Mill, and Karl
Marx all dealt at some length with the causes and consequences of economic advances.
The New International Economic Order
There is another major factor accounting for the upsurge of interest in the growth and development
process of the developing countries. This has been the poor nations’ own increased awareness of
their inferior economic and political status in the World. For this reason, these countries desired
strongly for material improvement and greater political recognition through economic strength.
Countries are becoming more aware of their economic status. International comparisons are being
made by organizations like the World Bank and UNDP in their Annual Reports. Development is,
therefore, wanted to provide people with the basic necessities of life, for their own sake and to
provide a degree of self-esteem which is precluded by poverty.
The developing countries have also called for a fairer deal from the functioning of the world
economy. The developing countries view the present arrangement with some justifications, as
biased in favor of countries that are already rich. The official call for the establishment of a new
international economic order would be based on equity, sovereign equality, common interest and
cooperation among all states, irrespective of their economic and social system. It is aimed at
correcting inequalities and to redress existing injustices; make it possible to eliminate the widening
gap between the developed and the developing countries. It is to ensure steadily accelerating
economic and social development, peace and justice for present and future generations.
The Mutual Interdependence of the World Economy
The third major factor responsible for the growing interest and concern with the development of
the third world has been the increasing awareness particularly on the part of developed countries
that dependence is not one way.
Previously, it was believed that the relationship between developing and developed countries is
one way i.e. developing countries depend on developed countries. Today the situation is changing.
The rich countries have been compelled out of economic and political necessity to rethink their
economic relations with the poorer nations of the world. On the political front, when the world
was divided between east and west it forced the western capitalist and eastern communist
countries to compete financially and technically for getting the favor of larger part of the third
world. On the economic front, the fortunes of all countries, rich and poor are locked together by

trade and balance of payments. There exists interdependence in the world economy such that the
malfunctioning of one set of economies impairs the functioning of the others.
Therefore, it is not only a moral issue for greater efforts to raise the living standards of the third
world countries. It is also a purely practical case to be the interest of the developed countries
themselves. The ability of poor countries to sustain their growth and development means a greater
demand for the goods and services of developed countries.
Gradually, the mutual interdependence of the relationship between developed countries and
developing countries has been realized. Developed countries depend on developing countries in a
number of ways. These include: -
 Big market for the products of developed countries which generates output and
employment directly, and also help to maintain the balance of payment stability of
these countries
 Cheap source of labor and raw material
 Source of energy
1.3 Nature of development economics
Traditional Economics deals basically with the efficient, least cost allocation of scarce productive
resources and with the optimal growth of these resources over time so as to produce an ever-
expanding range of goods and services. The traditional economics consists of economic theory of
classical and neo-classical economists. It is concerned with the advanced capitalistic world of
perfect markets, consumer sovereignty; free play of forces of demand and supply; utility
calculations, and the making of economic decisions on the basis of marginal private benefit. Thus,
according to traditional economic theory, all the economic decisions are made on the basis of the
price mechanism and the goods market, resource market and financial markets are cleared on the
basis of demand and supply. Hence, the traditional economics or economic theory believes in
rationality, materialism, self-interest and individualistic approach in respect to economic
decisions. Thus this economics deals the matters subjectively.
The 'Political Economy' is also a branch of economics where a relationship is established between
politics and economics. Here the role of power in economic decision making is also evaluated.
Broadly, the political economy analyses the social and institutional processes through which
certain groups of economic and political elites like feudal, businessmen, industrialists, politicians,
trade unions and bureaucrats etc., influence the scarce productive resources either for their own
best-interests or perhaps for the interest of the whole economy. This branch of economics portrays
the process of economic and political life were from the nations of the world like US, UK, and
France etc. have passed through, and the existing nations are passing through.
Development Economics is beyond traditional economics and political economy. In addition

to efficient allocation and sustained growth of resources, it deals with economic, social, political
and institutional mechanism (both public as well as private) which could bring about rapid and

large scale improvements in levels of living for the masses who are poverty stricken, malnourished,
backward and illiterate peoples of Africa, Asia, and Latin America. Quite against the developed
countries (DCs) in the less developed countries (LDCs) the goods and the labor markets are highly
imperfect, consumers and producers have limited information regarding commodity and factor
markets, the society and economy are experiencing structural changes, and the disequilibrium is
often the destiny of the markets. In such poor economies the political decisions overweigh the
economic decisions regarding resource allocation. These economies are clutched into tribal and
ethnic conflicts, sectarianism, cultural, religious and linguistic problems. More appropriately,
development economies deals with poverty alleviation measures, standard of living improvement
methods and creating a harmony between the rich and the poor nations of the world, rather just
following the principles of profit maximization and self-interest.
Thus, the Development Economies is something more than neo-classical economics and Political
Economy because it is concerned with the economic, cultural and political requirements which
are necessary for structural and institutional transformations of entire societies in a manner that
the fruits of economic growth could be provided to the largest segment of the society the poor
class. For such all, a greater role of government and coordination amongst the decision making
unite is required, rather just depending upon the 'Invisible Hand' and 'Market Forces'. Thus, the
Development Economies in the light of traditional economic principles (as well as against them)
aims at understanding the Third World economies so that the material lives of three-quarters of
the global population could be improved.
Chapter Two
2. Economic Growth and Development
2.1. Concepts of Economic Growth and Development
A major goal of poor countries is economic development or economic growth. The two terms are
not identical. Growth may be necessary but not sufficient for development. Economic growth
refers to increases in a country’s production or income per capita (Box 2-1). Production is usually
measured by gross national product (GNP) or gross national income (GNI), used interchangeably,
an economy’s total output of goods and services. Economic development refers to economic
growth accompanied by changes in output distribution and economic structure. These changes may
include an improvement in the material well-being of the poorer half of the population; a decline
in agriculture’s share of GNP and a corresponding increase in the GNP share of industry and
services; an increase in the education and skills of the labor force; and substantial technical
advances originating within the country. With children, growth involves a stress on quantitative
measures (height or GNP), whereas development draws attention to changes in capacities (such as
physical coordination and learning ability, or the economy’s ability to adapt to shifts in tastes and
technology).
Therefore, development is hardly possible without growth, but growth is possible without
development. A country may produce more of some types of its goods and services. However, the

benefits of this growth may exclusively be appropriated by a privileged elite and small middle
class. In this case, the vast majority of the country’s people may be completely unaffected or
worsened. For instance, the growth attained in the past in countries such as South Africa, Brazil,
and the oil rich countries was large without development.
However, growth without development is not sustainable. In the oil-rich countries, for example,
their economies grow when the price of oil increases. Nevertheless, this growth is not sustainable,
as prices cannot be increased indefinitely. Development, on the other hand, is sustainable because
it is a change in the structural and institutional factors, social attitudes and customs accompanied
with a secular rise in real income through a change in output and occupational structure and
improvement in the relative contribution of inputs.
2.1.1 Economic Growth and Development in Traditional Perspective
Generally, economic growth refers to an annual increase in gross national product (GNP) of a
nation. Accordingly, from the traditional perspective, development was viewed to be highly
attached to the concept of growth. In strictly economic term, development has traditionally meant
the capacity of a national economy to generate and sustain an annual increase in its gross national
product at rates of perhaps 5% to 7% or more. A common alternative economic index of
development has been the use of rates of growth of income per capita (or per capita GNP) to take
into account the ability of a nation to expand its output at rates faster than the growth of its
population.
Economic development in the past has also been typically seen in terms of the planned alteration
of the structure of production and employment so that agriculture’s share should decline and the
share of the manufacturing and service sectors should increase. Development strategies have
therefore focused on rapid industrialization, often at the expense of agriculture and rural
development. Therefore, according to the traditional perspective of development, problems of
poverty, discrimination, unemployment, and income distribution were of secondary importance.
The primary concern of the traditional perspective of development is getting the growth job done.
2.1.2 Development Economics in Retrospect (The New View of Development)
The experience of the 1950s and 1960s, when many developing nations did realize their economic
growth-targets but the levels of living of the masses of people remained, for the most part,
unchanged, signaled that something was very wrong with the narrow (traditional) definition of
development. A number of developing countries experienced relatively high rates of growth of per
capita income during then but showed little or no improvement or even an actual decline in
employment, equality and the real incomes of the bottom 40% of their populations. An increasing
number of economists and policy makers clamored for the “dethronement of GNP” and the
elevation of direct attack on widespread absolute poverty, increasingly inequitable income
distributions and rising unemployment. In short, during the 1970s, economic development came

to be redefined in terms of the reduction or elimination of poverty, inequality, and unemployment

within the context of growing economy.
Development must, therefore, be conceived of as a multidimensional process involving major

changes in social structures, popular attitudes and national institutions, as well as the acceleration
of economic growth, the reduction of inequality, and the eradication of poverty. 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 groups within that system, moves
away from a condition of life widely perceived as unsatisfactory toward a situation or condition of
life regarded as materially and spiritually better.
2.2. Core Values of Development

Denis Goulet distinguishes three basic components or core values in this wider meaning of
development, which he calls life-sustenance, self-esteem, and freedom. All three of these core
components are interrelated and are shortly discussed below.
Life-sustenance: life-sustenance is concerned with the provision of basic needs. No country can
be regarded as fully developed if it cannot provide its entire people with such basic needs as
housing, clothing, food and minimum education. A major objective of development must be to
raise people out of primary poverty and to provide basic needs simultaneously without which there
is absolute under development. Hence, economic development is a necessary condition (but not
sufficient condition) for the improvement of the quality of life in providing these life sustenance
needs and bringing development.
Self-Esteem: self-esteem is concerned with the feeling of self-respect and independence. It means
to be a person, a sense of worth and self-respect, of not being used as a tool by others for their own
ends. Every society or individual strives towards self-esteem. Without development, the pride of
the peoples of the developing countries on their cultural identity and dignity is being eroded.
No country can be regarded as fully developed if it is exploited by others and does not have the
power and influence to conduct relations on equal terms. Nowadays, economic wealth and
technological power have become almost universal measures of worth. Developing countries seek
development for self-esteem; to eradicate the feeling of dominance and dependence which is
associated with inferior economic status.
As Denis Goulet put it, “Development is legitimized as a goal because it is an important, perhaps
even an indispensable, way of gaining esteem.
Freedom from servitude: Freedom is the ability of people to determine their destiny. It involves
an expanded range of choices for societies and their members together with a minimization of
external constraints in the pursuit of devolvement. No man is free if s/he cannot choose; if s/he is
imprisoned by living on the margin of subsistence with no education and no skills.

Economic prosperity expands the range of choices that people may have. It enables to gain greater
control over nature and physical environment. It gives the freedom to choose greater leisure, to
have more goods and services or deny material wants.
W. Arthur Lewis stressed the relationship between economic growth and freedom from servitude
when he concluded that “the advantage of economic growth is not that wealth increases happiness,
but that it increases the range of human choice.” Wealth can enable people to gain greater control
over nature and the physical environment (e.g., through the production of food, clothing, and
shelter) than they would have if they remained poor.
2.3. Meaning and Challenges of Development (self-read assignment)
2.4. Measuring Development: Key Indicators

Conventional Measures of Development: As it was explained in the preceding chapter,
development has traditionally meant the capacity of a national economy to generate and sustain an
annual increase in its gross national product at rates of perhaps 5% to 7% or more. The dominant
conventional measures of growth and development are the Gross National Product (GNP) or Gross
Domestic Product (GDP) and their corresponding per capital values. GNP is calculated as the total
domestic and foreign value added claimed by a country’s residents without making deductions for
depreciation of the domestic capital stock. The GDP measures the total value for final use of output
produced by an economy, by both residents and non-residents. Thus GNP comprises GDP plus the
difference between the income residents receive from abroad for factor services (labor and capital)
fewer payments made to nonresidents who contribute to the domestic economy.
This national income (GNP/GDP) measures are used for the measurement of economic
development in several ways. For a given country over two or more years, the absolute value of
national income or per capital income is compared for different years. The difference between the
values for various years then reflects the growth rate over the period. The level of per capita income
is taken as a measure of the average standard of living of the population, while the growth rate
measures improvements in the standard of living.
This income measure of development is also used to compare the economic performance of
different countries. Thus, the level of national income or per capita income and their growth rates
can be compared internationally. The poverty datum line, as the measure of the critical minimum
level of per capita income below which individuals are deemed to be living in absolute poverty, is
also derived from the income measure of development.
2.4.1 Per Capita Income as an Index of Development

Now let us turn to the question of the use of per capita income figures as an index of development
and its use for making a distinction between developed and underdeveloped countries, as well as
between rich and poor. While there may be an association between poverty and underdevelopment
and riches and development, there are a number of reasons why some care must be taken when

using per capita income figures alone as a criterion of development. Apart from the difficulty of
measuring income in many countries, using a single per capita income figure to separate developed
from developing countries is problematic, as it ignores such factors as the distribution of income
within countries, differences in development potential and other physical indicators of the quality
of life.
Moreover, within the countries outside the industrialized bloc, the per capita income level dividing
the low-and middle-income courtiers is arbitrary. There can be countries under this category
having a very higher level of per capita income, but none is fully industrialized. Thus, all are
‘developing’ in the sense of their level of industrialization. Because of the arbitrariness and
potential deficiencies of per capita income as a measure of development, other criteria are often
suggested. Hence, in many ways, it should be the nature and characteristics of the countries that
determine which income level should be used as the dividing line to distinguish between the
developed and under developed countries. This is important especially to categorize separately the
oil-rich countries, which have high per capita incomes but cannot be regarded as developed by the
criteria to be discussed later.
Some economists have also attempted to use a structural definition of underdevelopment that
stresses imbalances between the factors of production and factor underutilization:
underdevelopment is a state of factor imbalance reflecting a lack of adjustment between the
availability of factors and the technology of their use, as that it is impossible to achieve full
utilization of both capital and labor simultaneously. An underdeveloped structure is therefore a
situation in which there is factor imbalance. This implies full utilization of available capital is
not a sufficient condition for development since it may not be characterized by complete
absorption of the working force.
But bearing in mind per capita income is very convenient to have a readily available and easily
understandable criterion for classifying countries, it is the best single index we have. Per capita
income is not a bad proxy for comparison of the level of development across countries. If
developing countries are defined on the basis of a per capita income level so as to include most of
the countries of Asia, Africa and Latin America under the category of Least Developed Countries,
it is somehow justifiable. Because striking similarities are found between the characteristics and
development obstacles for many of the countries in these continents. These include:
 A high proportion of the labor force engaged in agriculture but low agricultural
productivity
 A high proportion of domestic expenditure on food and necessities
 An export trade dominated by primary products and an import trade dominated by
manufactured goods
 A low level of technology
 A high birth rate coupled with a falling death rate

 Savings are undertaken by a small percentage of the population

 Growing unemployment in urban areas
 Egalitarian income distributions, and
 Poor health and standards of education
There are, of course, some countries that have very higher per capita income; and on a per capita
income basis, they are classified as developed; but possess most of the above-mentioned
characteristics. These are exceptions and few. On the other hand, it is almost inconceivable to find
the reverse of this situation. That is, almost there is no country in which the above-mentioned
characteristics do not exist, having a lower level of per capita income.
In general, therefore, we conclude that per capita income may be used as a starting point for
classifying levels of development, and can certainly be used to identify the need for development.
The only major reservation that we shall have to consider is that an aggregate per capita income
figure can disguise (hide) the progress being made through time, within a country.
There is a difference, however, between using per capita incomes as a guideline for classifying
countries into developed or underdeveloped at a point in time and using the growth of per capita
income as an index of development over time. The difficulty of using per capita income for the
latter purpose is the obvious one. That is if, in a particular period, per capita income of a given
economy grows but the income distribution shows that income of most of the people is falling, one
would say that the economy has developed even though economic welfare of most of the people
has deteriorated. There can also be a situation where there is a rise in the national output but
constant in per capita income due to population growth at a rate equal to the rate of rising in the
national output, but one may end up claiming that there is no development even if there is the rise
in national output. This is an inherent weakness of linking the concept of development to a measure
of living standards.
This leads to the distinction between growth and development. Development without growth is
hardly conceivable, but growth is possible without development. On the other hand, development
is hardly possible without growth; but development is possible, as we have suggested, without a
rise in per capita income. It would be a strange, rather purposeless, type of development, however,
that left per capita income unchanged, unless the stationary per capita income was only temporary
and a strong foundation was being laid for progress in the future. For the ultimate rationale of
development must be to improve living standards and welfare, and while an increase in measured
per capita income may not be a sufficient condition for an increase in individual welfare, it is a
necessary condition in the absence of radical institutional innovations, such as the distribution of
‘free’ goods.
An increase in income is not a sufficient condition for an increase in welfare, because an increase
in income can involve costs as well as benefits. It may have been generated at the expense of
leisure or by the production of goods not immediately consumable. If development is looked upon

as a means of improving the welfare of present generations, probably the best index to take would
be consumption per man-hour worked. This index, in contrast to an index of per capita income,
focuses directly on the immediate utility derivable from consumption goods in relation to the
disutility of the work effort involved in their production.
2.4.1.1 The measurement and comparability of per capita income
When using per capita income figures to classify countries into rich and poor, the difficulties of
measuring real per capita income and real living standards between counties must be continually
borne in mind. There are two issues to discuss. The first concerns the problems associated with
national income accounting, particularly in developing countries. The second is the problem of
converting each country’s per capita income in domestic currency into a common unit of account
(that is, the US dollar) so as to be able to make meaningful international comparisons of living
standards. This leads to the topic of purchasing power parity (PPP) estimates of PCY.
1) Problems associated with national income accounting
Turning first to national income (PCY) accounting, the first point to bear in mind is that only goods
that are produced and then sold in the market are included in the value of national income,
measured by either the output or the expenditure method. Much output in developing countries
never reaches the market, particularly in the rural sector where production is for subsistence
purposes. If no allowance is made for the subsistence sector, this will bias downwards the
calculation of national income, and therefore PCY. This point also implies that any long-term
growth estimates will have an upward bias as a result of the extension of the money economy and
the shift of economic activities from the household and subsistence sector to the market place. Part
of the observed trend of faster GDP growth in developing countries over the last 50 years may be
partly as statistical illusion arising from the changing balance between the informal subsistence
sector and the modern exchange sector.
Second, growth rates may also be biased upwards by using prices as weights when compiling
national income totals from the output statistics of different sectors of the economy (unless the
weights are revised frequently), since goods with high prices, which subsequently fall, are usually
the fastest growing. This is more of a danger in developing countries than in developed countries
because of their less sophisticated accounting techniques, the greater difficulty in revising price
weights, and the more widespread introduction of new goods with high initial prices.
Third, a consideration of price is also necessary when deciding what price index to use as a deflator
of money national income in order to obtain an index of real income. The task of converting money
income statistics into real income raises all the difficulties, not peculiar to developing countries,
connected with the use of index numbers, such as which base year to take, how to take account of
changes in the quality of products, which weighting system to employ, and so on. These are
conceptual issues to be sorted out by the national income statistician rather than by the

development economist, but it is important for the economist to know how figures for real national
income, or per capita income, have been arrived at prior to analysis.
2) problem of converting each country’s per capita income in domestic currency into a common
unit of account
The other part of the story, and probably the major part, concerns the understatement of living
standards in developing countries when their national incomes measured in local currencies are
converted into US dollars (as the common unit of account) at the official rate of exchange. If the
US dollar is used as the unit of account, the national per capita income of country X in US dollars
GNPX
is given by  Exchange rate
population
For example, if the GNP of country X is 100 billion birrs, its population is 5 million, and 10 birrs
are exchanged with a dollar, then the per capita income of country X in dollars is
100 billion
 10  $2,000
5 million
But if the living standards of the two countries are to be compared by this method, it must be
assumed that 10 birrs in country X can buy the same living standard as $1 in the United States.
It is well known, however, that official exchange rates between two countries’ currencies are not
good measures of the PPP between countries, especially between countries at different levels of
development. The reason is this: exchange rates are largely determined by the supply of and
demand for currencies based on goods that are traded, the prices of which tend to be equalized
internationally.
PPP however, depends not only on the prices of traded goods, but also on the prices of non-traded
goods, which are largely determined by unit labor costs, and these tend to be lower the poorer the
country. As a general rule, it can be said that the lower the level of development and the poorer
the country, the lower the ratio of the price of non-traded goods to traded goods and the more the
use of the official exchange rate will understate the living standards of the developing country
measured in US dollars.
Let us give a simple example. The motor car is an internationally traded good. Suppose that the
dollar price of a particular model of car is $10,000 and there are 10 birrs to the dollar. Ignoring
transport costs, tariffs and so on, the price of the car in Ethiopia will be $10,000 X 10 = 100,000
birr, otherwise a profit will be made by dealers buying in the cheapest market and selling in the
most expensive. The forces of demand and supply (and arbitrage) will equalize the price of traded
goods.

But let us now consider a non-traded good such as a haircut. Suppose a haircut in the United States
costs $10 at the official exchange rate of 10 birr to the dollar, a haircut in Ethiopia should be 100
birrs. But suppose that in fact is only 25 birrs. This would mean that as far as haircuts are
concerned, the value of the birr is underestimated by a factor of four. The PPP rate of exchange
for haircuts alone is $10 ÷ 25 birrs, or $1 = 2.5 birrs. If the national income of country X measured
in birr was divided by 2.5 instead of 10, the national income of country X in dollars, and therefore
per capita income in dollars, would now be four times higher: $8,000 per head instead of $2.000
per head as in the example above.
As development proceeds, the ratio of the price of non-traded goods to traded goods tends to rise
as wage levels in the non-traded goods sector rise but productivity growth is slower than in the
traded goods sector. To make meaningful international comparisons of income and living
standards, therefore, what is required is a measure of PPP, or a real exchange rate, between
countries.
There are several methods of constructing PPP ratios in order to make binary comparisons (one
country with another) or ‘multilateral’ comparisons in which the currency of any one of a group
of countries can act as the unit of account without altering the ratios of living standards between
countries.
The most common way of constructing a PPP ratio between two countries is to revalue the national
incomes of the two countries by selecting a comparable basket of goods and services in each
country and estimating the purchasing-power equivalent of each item in country A relative to
country B. Thus if Pia is the price of item i in country A and Pib is the price of item i in country B,
the purchasing-power equivalent of item i in country A relative to country B is Pia/ Pib. By
extending this calculation to all goods and applying the price ratios to the average quantities
consumed of each item in the two countries, we obtain a formula for the overall purchasing-power
equivalent in country A relative to country B:
Q P i ia
i
 PPP
Q P
i
i ib
Where Qi is the quantities of each good consumed in the two countries. The purchasing-power-
equivalent ratio can then be used to convert one country’s national income measured in local
currency into another country’s currency.
Example, suppose that the official exchange rate between the Ethiopian (country A) birr and the
US (country B) dollar is 10:1, while the purchasing-power-equivalent ratio is calculated as follows
with some assumptions.
Assume also that:

- Only motor car and the service of haircut are produced in the two countries
- The production of motor cars in country A and country B are 10000 and 1000000 in a year,
respectively
- There are 10000000 and 1000000 haircuts in country A and country B, respectively
- The population size of country A is 80000000
- The population size of country B is 10000000
10000(100000)  10000000(25)
PPP   0.125
1000000(10000)  1000000(10)
Note that GNP of country A is 1,250,000,000 birrs while GNP of country B is 10,010,000,000
Therefore, PCY of country A is 15.63 birrs per year while PCY of country B is 1001 dollars per
year.
If we compare the per capita income of these countries in terms of the official exchange rate (10
birrs to 1 dollar), PCY of country A in terms of dollar is 15.63/10 = 1.563. But if we compare the
per capita income of these countries in terms of PPP, it will be 15.63/8 = 1.954. This shows that
the comparison of PCY of the two countries in terms of dollar underestimates the actual living
standard of the people in country A.
Irving Kravis and his associates (1975, 1978) have developed a method of making multilateral
comparisons of real per capita incomes across countries by constructing world price ratios based
on price and quantity data for over 100 commodity categories in over 100 countries. The
international prices are then used to value quantities in each of the countries. The international
prices and production values are expressed in international dollars (I$). An international dollar has
the same overall purchasing power as a US dollar for national income as a whole, but relative
prices for each country are relative to the average world prices rather than US prices. This
multilateral approach allows a direct comparison between any two countries using any country’s
currency as the unit of account.
In this method, the purchasing-power parity rate of exchange (PPPR) is equal to the official
exchange (domestic currency to dollar) rate divided by one plus the extent to which conversion of
PCY at the official exchange rate understates the true level of PCY when measured at international
prices.
𝑬𝒙𝒄𝒉𝒂𝒏𝒈𝒆 𝒓𝒂𝒕𝒆
PPPR = 𝟏+𝒓
Where: r = the extent to which conversion of PCY at the official exchange rate understates the true
level of PCY when measured at international prices.
Suppose, for example, there are 7 Kenyan shillings to 1 US dollar, and that the official exchange
rate conversion understates the Kenyan PCY by 50 per cent when Kenyan national income is
measured in international dollars. The PPPR of Kenyan shillings to US dollars is therefore PPPR

– 7/1.5 = 4.66. That is, to compare living standards between Kenya and the United States, the real
exchange rate of 4.66 ought to be used, not the official exchange rate of 7 shillings to one dollar.
However, official exchange rates between currencies of two countries are not good measures of
the purchasing power parity (PPP) between the countries, especially between countries at different
levels of development. The reason is that exchange rates are largely determined by the supply of
and the demand for currencies based on goods that are traded the prices of which tend to be
equalized internationally.
PPP, however, depends not only on the price of traded goods but also on the prices of non-traded
goods. The prices of traded goods are largely determined by unit labor cost which tends to be lower
the poorer the country. PPP is, therefore, the number of units of a foreign country’s currency
required to purchase the identical quantity of goods and services in the developing country’s local
market as $1 would buy in the United States. This point is elaborated more widely below.
We can take two commodities, TV set and a service of haircut, which are respectively one traded
and the other is non-traded. Suppose the dollar price of a particular type of TV set in USA is $500
and the exchange rate of one dollar is Birr 10. Without taking account of transport cost, tariff, etc.,
the price of the TV set in Ethiopia will be equal to Br. 5000.
If we consider the non-traded good, however, there will be a different story. Suppose in USA,
haircut costs $5. At the official exchange rate of Birr 10 to the dollar, the service in Ethiopia should
be $50. But the actual cost of this service in Ethiopia may be Birr 10. This would mean that as far
as haircut is concerned, the value of the Birr is underestimated by a value of five times. Hence,
the PPP rate of exchange for this particular service is $1 to Birr 2 while the official exchange rate
is $1 to birr 10.
Clearly, if domestic prices in markets of developing countries are lower, PPP measures of GNP
per capita will be higher than estimates using foreign exchange rates as the conversion factor. For
example, China’s 1997 GNP per capita was only 2.7% of that of the United States using the
exchange-rate conversion. But it rises to 12.5% when estimated by the PPP method of conversion.
In 1997, the ratio of the highest per capita income of Switzerland ($44,320) and Ethiopia ($110)
at foreign exchange rate was 403 to 1. But in PPP, these two countries had respectively a per capita
income of $26,320 and $510 and the ratio is decreased significantly to 51.6 to 1. Hence, the income
gaps between rich and poor nations thus tend to be less when PPPs are used. An illustration of the
significant difference of using either official exchange or PPP on the level of per capita income of
countries is indicated on table 1.
Table 2.1 per capita GNP of selected countries at official exchange rate and PPP
Country At official exchange rate At PPPs exchange rate

Switzerland 44,230 26320
Japan 37850 23400

United States 28740 28740

United kingdom 20710 20520
Canada 19290 21860
Brazil 4720 6240
Mexico 3680 8120
Colombia 2280 6720
Shicipsires 1220 3670
China 860 3570
Pakistan 490 1590
India 390 1650
Bangladesh 270 1050
Nigeria 260 880
Ethiopia 110 510
Source: World Bank, World Development Report, 1998/99 in Todaro, 2000.
Apart from the difficulty of measuring income and the difficulty of making inter-country
comparisons, using a single figure of per capita income as a means of separating the developed
from developing counties is somewhat arbitrary. This is because it ignores essential factors that
should be incorporated (these will be discussed on the topic below).
Bearing in mind this arbitrariness of per capita income, it is still convenient to have a readily
available and easily understandable criterion for classifying countries and perhaps per capita
income is the best single index we have. It also has an advantage in focusing on reason
determinants of development: raising living standard and eradicating poverty.
In the last resort, per capita income is not a bad proxy for the social and economic structure of
societies. If developing countries are defined on the basis of per capita income level, striking
similarities are found between the characteristics and development obstacles of many of the
countries. Hence, per capita income may be used as a starting point for classifying level of
development and can certainly be used to identify the need for development.
2.4.2 Alternative development Indicators
By the beginning of the 1970s a momentum started to gather around the need for an earnest search
of alternative indicators of development. Aside from the aforementioned deficiencies encountered
in measuring income itself, this search has been prompted by the following considerations:
 The failure of the GNP/GDP measures to reflect the impact of growth on the pattern of
income distribution
 The inability of the GNP/GDP measures to reflect the welfare impact of the goods and
services produced as well as the likely costs to society of certain patterns of growth.

 The invalidity of the GNP/GDP indicator as a measure of wellbeing in situations where

growth has actually deepened poverty and income inequalities, increased unemployment
and affected the environment adversely.
Therefore, the most important factor influencing the search for alternative indictors has been the
marked shift in thinking among development economists, organizations and practitioners since the
beginning of the 1970s about the meaning of development and the processes leading to it.
Attempts to construct alternative indicators have followed different routes. Some evolved around
the modification of GNP/GDP based measures to incorporate some of their glaring omissions, e.g.
environmental impact, health conditions, activities in the non-monetized sector, etc. Some others
tried to construct an explicit index of welfare to replace the use of income measures and others
gave up the idea of a single indicator or index in favor of a set of indictors that show the different
elements of welfare separately.
Among the developed alternative indicators the major are the physical quality of life index (PQLI)
developed by Morris (1979), the Human Development Index (HDI) developed by UNDP, and the
Human Poverty Index. These are to be discussed one by one below.
a. The physical Quality of Life Index (PQLI)
Quality of life refers to overall wellbeing of people of a country. It does not depend on economic
factors but on socio-political factors like: Environment Social security, National security, Political
freedom, and Overall infrastructure. One well-known endeavor in this area was Morris D. Morris's
development of the Physical Quality of Life Index (PQLI).
This composite index is based on three simple indicators: Infant mortality, life expectancy, and
literacy. This measure gives equal weight to each of the three indictors. For each indicator, the
performances of individual countries are rated on a scale of 1 to 100, where 1 represents the worst
performance and 100 the best performance. For life expectancy the upper limit of 100 was
assigned to 77 years (achieved by Sweden in 1973) and the lower limit of 1 was assigned to 28
years (the life expectancy of Guinea Bissau in 1950). Within the limits, each country’s life
expectancy figure is ranked from 0 to 100. Similarly, for infant mortality, the upper limit was set
at 9 per 1,000 (achieved by Sweden in 1973) and the lower limit at 229 per 1000 (Gabon 1950).
Literacy rates measured as percentages from 0 to 100 provide their own direct scale. The PQLI of
each country is given by the following formula.
PQLI = Life expec. Index + infant mort. Index + literacy index
The PQLI indirectly reflects the effects on human development of investment in health service,
water and sewage systems, quality of food and nutrition, education, housing, and changes in
income distribution. One positive aspect of the PQLI is, therefore, that it helped redirecting
attention away from growth, toward a broader concept of human development. P.Q.L.I helps to

government to understand the overall welfare in the economy and how well its welfare policies
are being implemented. This helps the government to take corrective action. The method followed
to measure P.Q.L.I is standard for all the countries. Therefore, it can be used to make comparison
between countries and this helps the relatively underdeveloped countries to take corrective
measure.
Example: Consider the following hypothetical assumption of scaling
PQLI Absolute figure Scale given

Infant mortality rate per thousand Less than or equal to 10 per thousand 100
Between 11 and 50 per thousand 80
Greater than or equal to 200 per 0
thousand
Life expectancy at age of one Less than or equal to 30 0
Between 31 and 40 20
Greater than or equal to 70 100
Literacy at years of 15 Less than or equal to 50 per thousand 0
Greater than or equal to 771 per 100
thousand
Consider that in a given developing country X; infant mortality rate is 130 per thousand, the
average life expectancy at age one is 40 years and the literacy rate at age 15 is 100 per thousand.
If equal weight is given for each of the following components (i.e. 33.33 is given for each), the
physical quality of life index is calculated as:
33.33(40)+33.33(20)+33.33(20)
PQLI = = 26.66
100
However, the PQLI has been criticized as an indicator of social development in relation to both
the choice of indicators as well as the weight assigned to the different indicators.

P.Q.L.I ignores many factors which influence the quality of life such as employment,
housing, justice, social security as well as human rights
 It is handicapped by the limited data availability
 It gives disproportionate weight to longevity as two of the three indicators, infant
mortality and life expectancy are related to it.
 It gives equal weight to each indicator arbitrarily without obvious rationale
 It treats economic and social indictors separately, instead of combining them in a
composite index.
 P.Q.L.I. does not explain the structural change in the economy of a country. Moreover,
it does not at all consider economic or monetary concept. Hence, it is a poor measure
of economic development as well as economic growth. In spite of these drawbacks,
P.Q.L.I. is considered as an improvement over traditional measure of economic
welfare.
b. The Human Development Index (HDI)
HDI is ranking various countries according to the relative success they have had with the human
development of their population. UNDP is offering the HDI as an alternative to the GNP for
measuring the relative socio-economic progress of nations. HDI has also attempted to take account
of some of the limitations of the PQLI. HDI is based on three variables:
 longevity:- as measured by life expectancy at birth

 educational attainment:- as measured by a condition of adult literacy (two third weight) and
a combined primary, secondary, and tertiary school enrollment ratios (one third weight)
 Standard of living measured by real per capita income at PPP. The marginal value of money
income above the world average threshold of $5120 real GDP per capita is assumed to be
rapidly diminishing
To construct the index fixed minimum and maximum values are taken for each of the variables.
For life expectancy at birth the range is 25-85 years. For adult literacy, the range is 0 – 100 percent.
For real per capita income the range is $100 – 40,000. For any component of the HDI, the
individual indices can be computed according to the general formula of:
Index = Actual value – Minimum value
Maximum value – Minimum value
 Life Expectancy Index =
 Education Index =
 Adult Literacy Index (ALI) =

 Gross Enrolment Index (GEI) =
 GDP Index =
Where: LE: Life expectancy

ALR: Adult literacy rate
CGER: Combined gross enrolment ratio
GDPpc: GDP per capita at PPP in USD
The index thus ranges from 0 to 1. If the actual value is equal to maximum the index is one. The
HDI ranks countries into three groups: low human development (0.0 to 0.49), medium human
development (0.50 to 0.79) and high human development (0.80 to 1.00). For any given year, HDI
measures relative not absolute level of human development and that its focus is on the ends of
development (longevity, educational achievement and standard of living).
Countries with an HDI value below 0.5, between 0.5 and 0.8 and above 0.8 are considered to have
a low level, a medium level and a high level, respectively. In the HDI, countries are also ranked
by their GDP per capita.
The Human Development Report, 1999 presented the HDI values, HDI rank, and real GDP per
capita ranks for the year 1997 relating to 174 developed and developing countries. Table shows
HDI values, HDI ranks and real GDP per capita ranks of some of the countries.
Table 2.3 Human Development Index for selected countries, 1997
Country HDI HDI Real GDP Real GDP Per

Value Rank Per Capita capita Rank
Rank (PPP$) minus HDI
Rank
1. High Human Development
Canada 0.932 1 13 12
USA 0.927 3 3 0
Japan 0.924 4 9 5
Australia 0.922 7 22 15
United Kingdom 0.918 10 19 9
New Zealand 0.901 18 27 9
Argentina 0.827 39 40 1
Costa Rica 0.801 45 61 16
2. Medium Human Development

Mexico 0.786 50 47 -3
Malaysia 0.768 56 49 -7
Mauritius 0.764 59 44 - 15
Sri Lanka 0.721 90 112 22
China 0.701 98 104 6
Zimbabwe 0.560 130 114 -16
3. Low Human Development
Nepal 0.463 144 133 11
Bhutan 0.459 145 142 -3
Nigeria 0.456 146 161 15
Bangladesh 0.440 150 156 6
Zambia 0.431 151 159 8
Tanzania 0.421 156 172 16
Uganda 0.404 158 153 -5
Sierra Leone 0.245 174 174 0
Source: Human Development Report, 1999
Dear learner, the interpretation of the above table is as follows. A positive figure indicates that the
HDI rank is better than the real GDP per capita rank. A negative figure indicates the opposite.
Of the 174 countries for which the HDI was calculated, 45 were in the high development category
(with an HDI value of 0.80 or more); 94 in medium category (0.5 to 0.79); and 35 in the low
category (less than 0.50). Canada, Norway and USA led the HDI rankings in the high human
development category. In the medium category, Trinidad and Tobago led with HDI ranks of 46.
Sri Lanka had a rank of 90 and India 132. In the low category, Nepal had a rank of 144 Bhutan
145, Bangladesh 150, Zambia 151, Tanzania 156 and Uganda 158. Thus the HDI reveals wide
disparities in global human development. For instance, Canada’s HDI value of 0.932 was more
than three times of Sierra Leone’s 0.254 which was at the bottom.
Thus the HDI ranking of countries differ significantly from their ranking by real GDP per capita.
Countries whose GDP ranking is higher than their HDI rank have considerable potential for
distributing the benefits of higher incomes more equitable. But they have been less successful in
channeling economic prosperity into better lives for their people. Of the 174 countries in 1997,
there were 77 such countries whose HDI rank was lower than their GDP per capita rank. Prominent
among them were Mauritius (- 15) and Zambia (- 16) (last column of Table). On the other hand,
countries whose HDI rank is higher than their GDP rank, suggest that they have effectively made
use of their income to improve the lives of their people. There were 92 such countries in 1997.
Prominent among them was Cuba (47) and Tajikistan (46). The HDI is an alternative measure of
development which supplements rather than supplants the GNP measure of economic
development.

One of the major innovations of HDI over the past few years has occurred through disaggregating
the country’s overall HDI into separate components to distinguish between Man and Women,
different social classes reflecting skewed income distributions, and different regions and ethnic
groups. Hence, the UN HDI has made a major contribution in improving our understanding of
what constitutes development, which countries are succeeding and the share of different groups
and regions within countries.
By combining social and economic data also, the HDI allows nations to take a broader measure of
their development performance, both relatively and absolutely and thus to focus their social and
economic policies more directly on those areas in need of improvement. Nevertheless, HDI has
been criticized on grounds such as:
 It does not include non-quantitative elements of human development such as human freedom,
the existence of civil liberties and the degree of political participation
 It is biased in the choice of indications
 Its assumption of the rapidly diminishing marginal value of money income above the world
average threshold of $ 5120 real GDP per capita distorts some HDI estimates and limits its
applicability.
 Its statistical methodology may also be compromised by insufficient or inaccurate data.
With all these criticisms, the fact remains that the HDI when used in conjunction with the
traditional economic measure of development greatly increases our understanding of which
countries are really experiencing development and which are not. More importantly, by examining
each of the three major components of the HDI and by disaggregating a country’s overall HDI to
reflect income distribution, gender, regional and ethnic differentials, we are now able to identify
not only whether a country is developing but also whether various groups within that country are
participating in that development.
C. Human Poverty Index (HPI)
The United Nations has constructed human poverty indices for developing countries. The
composite measure focuses on dimensions of deprivations. The HPI for developing countries is
based on three main indices:
 The percentage of the population not expected to survive to the age of 40 (P1)
 The adult illiteracy rate (P2)
 A deprivation index based on an average of three variables: the percentage of the population
without access to safe water; the percentage of population without access to health service; and
the percentage of the underweight children under five years old (P3).
 The formula is given by:
HPI = [1/3(P13 + P23 + P33)] 1/3
Review Questions on Chapter One and Two

1. Shortly show different definitions of development that have so far been used.
2. Explain the advantages of understanding the definition of development in order to formulate
helpful development strategies and policies
3. Why is a strictly economic definition of development inadequate? Use empirical evidences
as examples of countries developing economically but are underdeveloped.
4. Explain briefly why developing countries are recently pressing on their development? Why
are economists interested in having a separate subject i.e., development economics?
5. What are the major problems encountered in measuring GNP/GDP? What are the limitations
of the conventional measures of development?
6. Shortly explain the advantages of Human Development Index over the conventional
measures of development.
Chapter Three
3. Structural Feature and Common Characteristics of Third World
3.1. Structural Features of Third World
This section portrays the structural diversity of developing nations. With this intention, we will
make an examination of eight critical components. These are;
1. The size of the country (geographic area, size of population, and income levels)
2. Its historical and economical background
3. It endowments of physical and human resources
4. Its ethnic and religious composition
5. The relative importance of its public and private sector
6. The nature of its industrial structure
7. It’s degree of dependence on external economic and political forces
8. The distribution of power and the institutional and political structure within the nation.
Therefore, each of the above components is discussed in detail below. In doing this we will focus
on regional comparisons of the developing countries of Africa, Asia, and Latin America and their
sub regions.
Size and Income Level

Evidently, the economic potential of a country is significantly determined by its physical and
population size, and its level of national income per capita. These are also major factors
differentiating one developing country from another. In the world of developing countries, larger
and populated nations such as Brazil, India, Nigeria and Ethiopia exist side-by-side with small
countries like Paraguay, Nepal and Djibouti.
This size provides both advantages and disadvantages. Large size usually presents advantages of
diverse resource endowment, large potential markets, and lesser dependence on foreign sources of
materials and products. But it also creates problems of administrative control, national cohesion,
and regional imbalances.

However, it is to be born that there is no necessary relationship among a country’s size, its level
of per capita income, and the degree of equality or inequality in the distribution of that income.
For example, as compared to Ethiopia, the neighboring country, Kenya is smaller in geographic
and population size. But Kenya has about 3 times the per capita income of Ethiopia at the official
exchange rate. But Kenya has also lesser per capita income than Brazil and some other larger
developing countries.
Historical Background
The other sources of diversity among the developing countries are their traditional and colonial
heritages. Apparently, countries have their own different cultural background accumulated in their
history making them to have different social and economic institutions. Moreover, developing
nations were at one time or other colonies of Western European countries. The European colonial
powers had a dramatic and long-lasting impact on the economies, political and institutional
structures of their African and Asian colonies. The economic structures of these nations, as well
as their educational and social institutions, have typically been modeled on those of their former
economic rulers.
Hence, the diversity in colonial heritage together with the indigenous cultural differences have
resulted different structural problems in these countries. Depending on their colonial heritage
therefore the countries are required to take different measures. Countries like those in Africa that
only recently gained their independence are likely to be more concerned with consolidating and
evolving their own national economic and political structures than with simply promoting rapid
economic development. Their policies may consequently, reflect a greater interest in these
immediate political issues.
Latin American countries have a long history of political independence plus a more shared colonial
heritage. Therefore, in spite of geographic and demographic diversity, the countries possess
relatively similar economic, social, and cultural institutions and face similar problems. In Asia,
on the other hand, different colonial heritages and the diverse cultural traditions of the indigenous
peoples have combined to create different institutional and social patterns.
Physical and Human Resources
Endowments of physical and human resources are other sources of disparities in economic growth
potential of the counties. If we start with the physical resource endowments, on the one hand there
are countries which are extremely and favorably endowed in resources such as minerals, raw
materials, and fertile land. On the other hand, there are also poorly endowed nations where
endowments of raw materials and minerals and even fertile land are relatively minimal.
Moreover, geography and climate can also play an important role in the success or failure of
development efforts. Other things being equal, it is said that island economies seem to do better

than landlocked economies. With respect to climate also temperate zone countries do better than
tropical zone nations.
Developing countries are also distinguished one from the other in their human resource
endowments. The human resource endowments include not only the number of people and their
skill levels but so also their cultural outlooks, attitudes toward work, access to information,
willingness to innovate, and desire for self-improvement.
Furthermore, the level of administrative skill will often determine the ability of the public sector
to alter the structure of production and the time it takes for such structural alteration to occur. This
has to do with the whole complex of interrelationships between culture, tradition, religion, and
ethnic and tribal fragmentation or cohesion. Thus the nature and character of a country’s human
resources are important determinants of its economic structure and these clearly differ from one
region to the next.
Ethnic and Religious Composition

Ethnicity and religion often play a major role in the success or failure of development efforts.
Evidently, the greater the ethnic and religious diversity of a country the more likely it is that there
will be internal strife and political instability. There is also distinction in ethnic and religious
composition among nations. Presently more than 40% of the world’s nations have more than five
significant ethnic populations.
In most cases, one or more of these groups face serious problems of discrimination. Over half of
the worlds less developed countries have recently experienced some form of interethnic conflict.
Just in the first half of the 1990s, ethnic and religious conflicts leading to wide spread death and
distinction took place in many African countries and some countries of other regions.
But neither overt physical conflict nor widespread violence is necessary to disrupt an economy or
cause political instability. If development is about improving human lives and providing a
widening range of choice to all peoples, racial, ethnic, or religious discriminations can be equally
destructive. For example throughout Latin America, indigenous populations have significantly
lagged behind other groups on almost every measure of economic and social progress. In these
countries, being indigenous makes it much more likely that an individual will be less educated, in
poorer health, and in a lower socio economic structure than other citizens. This is particularly true
for indigenous women.
Ethnic and religious diversity need not, however, necessarily lead to inequality, turmoil, or
instability. There have been numerous instances of successful economic and social integration of
minority or indigenous ethnic populations in countries as diverse as Malaysia and Mauritius. The
point is that the ethnic and religious composition of a developing nation and whether or not that
diversity leads to conflict or cooperation can be important determinants of the success or failure
of development efforts. Too often economists neglect to recognize this fundamental fact.

Relative Importance of the Public and Private Sectors

Most developing countries have mixed economic systems, featuring both public and private
ownership and use of resources. The division between the two and their relative importance are
mostly determined by the historical and political circumstances of the countries. Thus, in general,
Latin American and South East Asian nations have larger private sectors than South Asia and
African nations.
The degree of foreign ownership on the private sector is another important variable to consider
when differentiating among less developed countries. A large foreign owned private sector usually
creates economic and political opportunities as well as problems not found in countries where
foreign investors are less prevalent.
Economic policies, such as those designed to promote more employment, will naturally be
different for countries with large public sectors and ones with sizeable private sectors. Direct
government investment projects and large rural work programs may take precedence in economies
dominated by the public sectors. In the private oriented economies, however, special tax
allowances designed to induce private businesses that can employ more workers might be more
common. Therefore, although the problem to be solved may be similar, the solution can differ in
countries with significant differences in the relative importance of the public and private sectors.
Economic Structure
Developing countries are predominantly agrarian in economic, social, and cultural outlook. Labor
force in most of these countries is overwhelmingly engaged in agriculture. The agricultural sector
contributes significantly also to the GDP of many of the poor nations. Farming is not merely an
occupation but a way of life for most people in Asia, Africa, and Latin America.
Nevertheless, there are great differences between the structure of agrarian systems and patterns of
land ownership in Latin America and Africa. Asia agrarian systems are somewhat closer to those
of Latin America in terms of patterns of land ownership. But even then the similarities are lessened
by substantial by cultural differences.
It is in the relative importance of both the manufacturing and service sectors that we find the widest
variation among developing nations. Most Latin American countries possess more advanced
industrial sectors. But in the 1970s and 1980s countries like Taiwan, South Korea, and Singapore
are rapidly becoming industrialized states.
The table below provides information on the distribution of labor force and GDP between
agriculture and industry in some developing and developed countries. The contrast among the
industrial structures of these countries is striking, especially in terms of the relative importance of
agriculture.
Table 2.1: Industrial Structure of some Countries

Percentage of labor force Percentage of GDP

Agriculture Industry Agriculture Industry
Nigeria 54 5 43 25
Tanzania 90 5 48 21
Uganda 86 4 46 16
Bangladesh 64 14 30 18
India 65 13 28 28
South Korea 21 27 6 43
Guatemala 60 12 24 20
Peru 37 19 7 37
Venezuela 16 28 4 47
All Developing
Countries 60 17 20 38
USA 2 25 2 29
UK 1 24 2 37
Source: UNDP, Human Development Report, in Todaro, 2000.

In spite of common problems, therefore, development strategies may vary from one country to the
next, depending on the nature, structure, and degree of interdependence among its primary,
secondary, and tertiary industrial sector.
External Dependence: Economic, political, and Cultural

The degree to which a country is dependent on foreign economic, social, and political forces is
related to its size, resources endowment, and political history. For most developing countries, this
dependence is substantial. In some cases, it touches almost every facet of life.
Most small nations are highly dependent on foreign trade with the developed world. Almost all
small nations are dependent on the importation of foreign and often inappropriate technologies of
production. This fact alone exerts an extraordinary influence on the character of the growth process
in these dependent nations.
But even beyond the strictly economic manifestations of dependence in the form of the
international transfer of goods and technologies is the international transmission of institutions and
values. Most notably are systems of education and governance, and attitudes toward life, work,
and self. The transmission phenomenon brings mixed blessings to most less developed countries
especially to those with the greatest potential for self-reliance. A country’s ability to chart its own
economic and social destiny is significantly affected by its degree of dependence on these and
other external forces.
Political Structure, Power, and Interest Groups

In the final analysis, it is often not the correctness of economic policies alone that determines the
outcome of national approaches to critical development problems. The political structure and the

vested interests and allegiances of ruling elites (e.g., large landowners, urban industrialists,
bankers, foreign manufacturers, the military, and trade unionists) will typically determine what
strategies are possible and where the main barriers to effective economic and social change may
lie.
The concentration of interests and power among different segments of the populations of most
developing countries is itself the result of their economic, social, and political histories and is likely
to differ from one country to the next. Nevertheless, whatever the specific distribution of power
among the military, the industrialists, and the large landowners of Latin America; the politicians
and high level civil servants in Africa; the oil Sheiks and financial moguls of the Middle East; or
the land lords, money lenders, and wealthy industrialists of Asia – most developing countries are
ruled directly or indirectly by small and powerful elites to a greater extent than the developed
nations are.
Effective social and economic changes thus require either that the support of elite groups be
enlisted or that the power of the elite be offset by more powerful democratic forces. Either way
economic and social development will often be impossible without corresponding changes in the
social, political, and economic institutions of a nation. Such institutional changes may include land
tenure systems, forms of governance, educational structures, labor market relationships, property
rights, the distribution and control of physical financial asset, laws of taxation and inheritance and
provision of credit.
2.1 Common Characteristics of Developing Countries

The foregoing discussions have demonstrated why it is sometimes risky to generalize too much
about such a diverse set of nations. Nevertheless, common economic features of developing
countries permit us to view them in a broadly similar framework.
This section portrays various dimensions of the development gap between rich and poor countries
and the similarities of poor nations. These include the level and growth rate of income,
unemployment and underemployment, population growth rate, economic structure, political and
institutional factors, and degree of dependence. We will attempt to identify these similarities and
provide illustrative data to demonstrate their importance.
For convenience, we can classify these common characteristics into seven broad categories.
I. Low levels of living, characterized by low income inequality, poor health, and inadequate
education
II. Low levels of productivity
III. High rates of population growth and dependency burden
IV. High and rising levels of unemployment and underemployment
V. Substantial dependence on agricultural production and primary product exports
VI. Prevalence of imperfect markets and limited information
VII. Dominance, dependence, and vulnerability in international relations.

I. Low levels of Living

In developing nations, general levels of living tend to be very low for the vast majority of people.
This is true not only in relation to their counterparts in rich nations but often also in relation to
small elite groups within their own societies. These low levels of living are manifested
quantitatively and qualitatively in the form of low income (poverty), inadequate housing, and poor
health, limited or no education, high infant mortality, low life and work expectancies, and in many
case a general sense of malaise and hopelessness. Let us look at some recent statistic as comprising
certain aspects of life in the underdeveloped countries and in the more economically advanced
nations.
Per Capita National Income: as you have seen it in chapter one, the GNP per capita is often used
as summary index of the relative economic well-being of people in different nations. One common
distinguishing feature of developing countries as compared to developed nations is the extremely
low level of income. In 1997, the total national product of all the nations of the world was valued
at more than $29 trillion, of which more than $22 trillion originated in the economically developed
regions and less than $7 trillion was generated in the less developed nations.
The difference in income between rich and poor nations will be apparent when one takes account
of the distribution of world population. In this term, this means that almost 80% of the world’s
income is produced in economically developed regions by 20% of the world’s people. Thus the
remaining four-fifths of the world’s population is producing only one-fifth of total world output.
In the year 1997, the collective per capita incomes of the under developed countries averaged less
than one-twentieth the per capita incomes of rich nations.
Growth Rates of Income: Many developing countries not only have much lower levels of per
capita income but also have experience slower GNP growth than the developed nations. For
example, the average growth rate slowed considerably during the 1980s. The real per capita GDP
even declined by 0.2% in 1990 and in 1991 before rising again for the next five years. Between
1985 and 1995 economic growth in Latin America and the Caribbean averaged 0.3% and in Africa
-1.1 % per capita, while growth in the developed countries was averaging 1.9% per annum.
Distribution of National Income: The growing gap in per capita incomes between rich and poor
nations is not the only manifestation of the widening economic disparity between the world's rich and
poor. To appreciate the breadth and depth of Third World poverty, it is also necessary to look at the
growing gap between rich and poor within individual LDCs.
All nations of the world show some degree of income inequality. There are large disparities
between the income of the rich and of the poor in both developed and underdeveloped countries.
Nevertheless, the gap between rich and poor is generally greater in less developed nations than in
developed nations.
Comparing the share of national income that accrues to the poorest 40% of a country's population
with that of the richest 20% can be used as an arbitrary measure of the degree of inequality. In this

case, we discover many African and Latin American countries to be with substantial income
inequality. Nevertheless, most Asian countries have either moderate inequality or lesser inequal-
ities in overall income distribution.
Moreover, there is no obvious relationship or correlation between levels of per capita income and
degree of income inequality. Kenya, with the same low per capita income as India, has a much
wider income disparity between the top 20% and bottom 40% of the population. Similarly, Kuwait,
with almost the same high per capita income as Belgium, has a much lower percentage of its
income distributed to the bottom 40% of its population.
Extent of Poverty: The magnitude and extent of poverty in any country depend on two factors:
the average level of national income and the degree of inequality in its distribution. Clearly, for
any given level of national per capita income, the more unequal the distribution, the greater the
incidence of poverty. Similarly, for any given distribution, the lower the average income level, the
greater is the incidence of poverty. But how is one to measure poverty in any meaningful
quantitative sense?
During the 1970s, as interest in problems of poverty increased, development economists took the
first step in measuring its magnitude within and across countries by attempting to establish a
common poverty line. They went even further and devised the now widely used concept of
absolute poverty. It is meant to represent a specific minimum level of income needed to satisfy
the basic physical needs of food, clothing, and shelter in order to ensure continued survival. One
common methodology has been to establish an international poverty line at, say, a constant U.S.
$370 per year (based, for example, on the value of the 1985 dollar) and then attempt to estimate
the purchasing power equivalent of that sum of money in terms of a developing country's own
currency.
We see that in the last decade of the 20th century, some 1.3 billion people, or 32% of the developing
world population, were living in absolute poverty. Looking at individual regions we find the
highest poverty rate (43%) in South Asia (Bangladesh, India, Pakistan, etc.) where the largest
numbers of poor people live (515 million). But sub-Saharan Africa with 219 million absolute poor
has by far the fastest poverty growth rate. It is estimated that during the first decade of the 21st
century, African poverty rates will approach 50 percent.
Health: In addition to struggling on low income, many people in developing nations fight a
constant battle against malnutrition, disease, and ill health. Life expectancy in 1998 still averaged
only 48 years, compared to 63 years among other Third World countries and 75 years in developed
nations. Infant mortality rates (the number of children who die before their first birthday out of
every 1,000 live births) average about 96 in the least developed countries, compared with
approximately 64 in other less developed countries and 8 in developed countries.
In the mid-1970s, more than 1 billion people, almost half the population of the developing world
(excluding China), were living on diets deficient in essential calories. One-third of them were

children under 2 years of age. These people were concentrated in the poorest countries. In the
1990s, the situation continued to deteriorate in sub-Saharan Africa, with deep declines in food
consumption and widespread famine. In both Asia and Africa, over 60% of the population barely
met minimum caloric requirements necessary to maintain adequate health.
The extent of human deprivation in terms of some key health indicators is also another indicator
of the low standard of living of these nations. For example, 766 million people in poor countries
are without access to health services, 1.2 billion do not have access to safe drinking water, 1.9
billion (almost half the population) live without sanitation facilities, and 158 million children under
age 5 are malnourished. Another often-used measure of child malnutrition is the percentage of
children who are underweight. In the early 1990s, statistics revealed that 67% of the children in
Bangladesh were underweight, 63% in India, 43% in South Africa, 42% in Vietnam, 38% in
Ethiopia, and 36% in Ghana and Nigeria.
The access to clean drinking water is one of the most important measures of sanitation.
Waterborne diseases such as typhoid fever, cholera, and a wide array of serious or fatal diarrhea
illnesses are responsible for more than 35% of the deaths of young children in developing
countries. Most of these diseases and resulting deaths would be quickly eliminated with safe
water supplies.
To make matters worse, medical care is an extremely scarce social service in many parts of the
developing world. In 1995, the number of doctors per 100,000 people averaged only 4.4 in the
least developed countries, compared with 217 in the developed countries. The ratio of hospital
beds to population is similarly divergent between these two sets of nations.
Moreover, when one realizes that most of the medical facilities in developing nations are
concentrated in urban areas where only 25% of the population resides, the woefully inadequate
provision of health care to the masses of poor people becomes strikingly clear. For example, in
India, 80% of the doctors practice in urban areas where only 20% of the population resides. In
Bolivia, only one- third of the population lives in cities, but 90% of the health facilities are found
there. In Kenya, the population-to-physician ratio is 672 to 1 for the capital city of Nairobi and
20,000 to 1 in the rural countryside where 87% of the Kenyan population lives. In terms of health
expenditures, more than 75% of LDC government outlays are devoted to urban hospitals that
provide expensive, Western-style curative care to a minority of the population.
Finally, no discussion of health problems would be complete without mentioning the terrible
human toll that AIDS is inflicting on millions of people in developing countries. After
tuberculosis, AIDS is now the second leading infectious cause of death among adult men and
women. To date, an estimated 6 million people worldwide have died of AIDS and more than 30
million have contracted the human immunodeficiency virus (HIV) that causes it. 90% of all these
people live in LDCs. At the beginning of 1998, out of the total number of these victims 66% of
them were residing in Africa while Asia and Latin America had 21% and 4.3% respectively.

Education: the spread of educational opportunities is the final indicator of the very low levels of
living that is pervasive in developing nations. The attempt to provide primary school educational
opportunities has probably been the most a significant of all LDC development efforts. In most
countries, education takes significant share of the governments’ budget.
Yet in spite of some impressive quantitative advances in school enrollments, literacy levels remain
strikingly low compared with the developed nations. For example, among the least developed
countries, literacy rates average only 45% of the population. The corresponding rates for other
Third World nations and the developed countries are approximately 64% and 99%, respectively.
There is a high level of children dropout of primary and secondary school, and out of the estimated
illiterate adults, more than 60% are women. Moreover, the education of children who do attend
school regularly is often irrelevant to the development needs of the nation in which they live.
We can summarize the major illustrations of the low standard of living of the poor nations by
listing the following points. Firstly, there is low relative levels and, in many countries, slow growth
rates of national income. Moreover, the real per capita income is either growing at a low level or
in many countries stagnating. The pattern of income distribution of the poor countries is highly
skewed with the top 20% of the population receiving 5 to 10 times as much income as the bottom
40%. Consequently, great masses of Third World populations are suffering from absolute poverty,
with up to 1.3 billion people living on subsistence incomes of less than $370 per year.
The low standard of living is also manifested in the social aspects. Large segments of the
populations are suffering from ill health, malnutrition, and debilitating diseases, with infant
mortality rates running as high as 10 times those in developed nations. In education, these countries
are characterized by low levels of literacy, significant school dropout rates, and inadequate and
often irrelevant educational curricula and facilities.
Most important is the interaction of all six characteristics, which tends to reinforce and perpetuate
the pervasive problems of "poverty, ignorance, and disease" that restrict the lives of so many
people in the developing world.
ii. Low levels of Productivity

In addition to low levels of living, developing countries are characterized by relatively low levels
of labor productivity. The concept of a production function is often used to describe the way in
which societies go about providing for their material needs. Production function is systematically
relating outputs to different combinations of factor inputs for a given technology.
But in less developed countries the concept of technical engineering concept of a production
function must be broadened by adding some important factors. Among its other inputs, this
includes managerial competence, access to information, worker motivation, and institutional
flexibility. Throughout the developing world, levels of labor productivity are extremely low
compared with those in developed countries.

This can be explained by a number of basic economic concepts. For example, the principle of
diminishing marginal productivity states that if increasing amounts of a variable factor (labor) are
applied to fixed amounts of other factors (e.g., capital, land, materials), the extra or marginal
product of the variable factor declines beyond a certain number.
Low levels of labor productivity can, therefore, be explained by the absence or severe lack of
"complementary" factor inputs such as physical capital or experienced management. To raise
productivity, according to this argument, domestic savings and foreign finance must be mobilized.
This is to generate new investment in physical capital goods and build up the stock of human
capital (e.g., managerial skills) through investment in education and training.
Institutional changes are also necessary to maximize the potential of this new physical and human
investment. These changes might include such diverse activities as;
 The reform of land tenure, corporate tax, credit, and banking structures;
 The creation or strengthening of an independent, honest, and efficient administrative
service; and
 The restructuring of educational and training programs to make them more appropriate to
the needs of the developing societies. These and other non-economic inputs into the social
production function must be taken into account if strategies to raise productivity are to
succeed.
One must also take into account the impact of worker and management attitudes toward self-
improvement; people's degree of alertness, adaptability, ambition, and general willingness to
innovate and experiment; and their attitudes toward manual work, discipline, authority, and
exploitation. Added to all these must be the physical and mental capacity of the individual to do
the job satisfactorily. The economic success stories of "The Four Asian Tigers" -South Korea,
Singapore, Hong Kong, and Taiwan-are often attributed to the quality of their human resources,
the organization of their production systems, and the institutional arrangements undertaken to
accelerate their productivity growth.
The condition of physical health most clearly reveals the close linkage that exists between low
levels of income and low levels of productivity in developing nations. It is well known, for
example, that poor nutrition in childhood can severely restrict the mental and the physical growth
of individuals. Poor dietary habits, inadequate food, and low standards of personal hygiene in later
years can cause further deterioration in a worker's health and can therefore adversely influence
attitudes toward the job and the other people at work.
The worker's low productivity may be due in large part to physical lethargy and the inability, both
physical and emotional, to withstand the daily pressures of competitive work. We may conclude,
therefore, that low levels of living and low productivity are self-reinforcing social and economic
phenomena in poor countries. It can also be said that they are the principal manifestations of and
contributors to their underdevelopment.

iii. Population Growth and Dependency Burdens

Statistics on demographic evolution by country show that the present rhythm of global population
growth is largely the result of the acceleration of growth in the developing regions. Consequently,
the population of the Third World rose from 1.7 billion in 1950, to 3.313 billion in 1980 and 4.036
billion in 1990. During the same year, the population of the developed countries stood respectively
at 832 million, 1.137 billion and 1.210 billion. The demographic load of the Third World has been
accentuated. It share from the total population has been continuously increasing to be 66.9% in
1950, 74.4% in 1980, 76.9% in 1990 and around 80% at the end of the 20th century and beginning
of the 21st century. The percentage of the population of the developed countries has fallen from
33.1% to 20% in the course of the same period.
This swift population growth in developing countries is due to their higher birth rate as compared
to death rate, though death rate also is high. Birthrates (the yearly number of live births per 1,000
population) in less developed countries are 30 to 40, whereas those in the developed countries are
less than half that figure. The crude birthrate is probably one of the most efficient ways of
distinguishing the less developed from the developed countries. There are few less developed
countries with a birthrate below 20 per 1,000 and no developed nations with a birthrate above it.
Death rates (the yearly number of deaths per 1,000 populations) in Third World countries are also
high relative to the developed nations. However, these poor nations have benefited from the
progress of medicine for the masses and the campaigns against endemic disease. This was followed
by fall in mortality. Hence, the differences in death rate between developing and developed
countries are substantially smaller than the corresponding differences in birthrates. As a result, the
average rate of population growth is now about 2.0% per year in Third World countries (2.3%
excluding China). Even there are certain African countries approaching and even exceeding 3%
per annum. This is as compared to a population growth of 0.5% per year in the industrialized
world. According to UN projections, now a day’s four out of five inhabitants of the planet are
coming from the developing countries.
These high birth rates have considerable socioeconomic implication. Children under the age of 15
make up almost 40% of the total population in these countries. This is as opposed to less than 21%
of the total population in the developed countries. Thus in most developing countries, the active
labor force has to support proportionally almost twice as many children as it does in richer
countries. By contrast, the proportion of people over the age of 65 is much greater in the developed
nations.
Both older people and children are often referred to as an economic dependency burden. This
means that they are nonproductive members of society and therefore must be supported financially
by a country's labor force (usually defined as citizens between the ages of 15 and 64). The overall
dependency burden (i.e., both young and old) represents only about one-third of the populations
of developed countries but almost 45% of the populations of the less developed nations. Moreover,
in the latter countries, almost 90% of the dependents are children, whereas only 66% are children
in the richer nations.
We may conclude, therefore, that not only are Third World countries characterized by higher rates
of population growth, but they must also contend with greater dependency burdens than rich
nations. The circumstances and conditions under which population growth becomes a deterrent to
economic development is a critical issue.
iv. High Unemployment and Underemployment
One of the principal manifestations of and contributors to the low levels of living in developing
nations is their relatively inadequate or inefficient utilization of labor in comparison with the
developed nations. In the 1980s the unemployment and underemployment problem became
increasingly pronounced and emerged as one of the most serious development problems.
Unemployment increased as a result of the fact that employment has been growing during the past
at a rate which is much slower than the rate of growth of the labor force. Stagnating economic
growth, the austerity programs implemented as a result of the Structural Adjustment Programs
(SAPs) and high levels of rural-urban migration combined to precipitate this situation. For
example, the ILO estimates that in the 1990s productive employment in sub-Saharan Africa
increased by only 2.4 per cent per annum at a time when Africa labor force has grown by a much
faster rate of 3.3 per cent a year.
Unemployment in the developing world averaged 8% to 15% of the labor force. The
unemployment rates in the 1980s for selected African countries were: Botswana, 3.2%; Cote
d’Ivoire, 20%; Ethiopia 23%; Kenya, 16.2%; Nigeria, 9.7%; Senegal, 17.3%; Somalia, 22.3%;
Tanzania, 21.6%; Zambia, 19% and Zimbabwe, 18.3% (ILO, 1991).
The unemployed exhibit two important characteristics, namely their youthfulness and their high
level of education. Youth (the age group of 15 to 24) unemployment rates are on the average twice
higher than adult unemployment rates. Unemployment is also creeping up the educational ladder.
When the underemployed are added to the openly unemployed and when "discouraged workers" -
those who have given up looking for a job-are added in, almost 35% of the combined urban and
rural labor forces in poor nations is unutilized.
Given recent and current birthrates in most LDCs, their labor supply will be expanding rapidly for
some time to come. This means that jobs will have to be created at equivalent rates simply to keep
pace. Moreover, in urban areas rural urban migration is causing the labor force to grow at explosive
annual rates of 5%, to 7% in many countries (especially in Africa). The prospects for coping effec-
tively with rising levels of unemployment and underemployment and for dealing with the
frustrations and anxieties of an increasingly vocal and educated but unemployed youth are
frighteningly poor.

v. Substantial Dependence on Agricultural Production and Primary

Product Exports
The vast majorities of people in LDCs live and work in rural areas. Over 65% are rurally based,
compared to less than 27% in economically developed countries. Similarly, 58% of the labor force
is engaged in agriculture, compared to only 5% in developed nations. Agriculture contributes about
14% of the GNP of developing nations but only 3% of the GNP of developed nations.
There is striking difference between the proportionate size of the agricultural population in Africa,
which constitutes (68%) and South Asia (64%) versus North America (3%). But the average
productivity of agricultural labor is almost 35 times greater in North America than in Asia and
Africa combined. Although international comparative figures are often of dubious quality
regarding both precision and methods of measurements, they nevertheless give us rough orders of
magnitude. Even after making necessary adjustments for Third World non-marketed agricultural
output, the differences in agricultural labor productivity would still be very sizable.
Agricultural productivity is low not only because of the large numbers of people in relation to
available land but also because LDC agriculture is often characterized by primitive technologies,
poor organization, and limited physical and human capital inputs. Technological backwardness
persists because Third World agriculture is predominantly noncommercial peasant farming.
In many parts of the world, especially in Asia and Latin America, it is characterized further by
land tenure arrangements in which peasants rent rather than own their small plots of land. Such
land tenure arrangements take away much of the economic incentive for output expansion and
productivity improvement.
Even where land is abundant, primitive techniques and the use of hand plows, drag harrows, and
animal (oxen, and donkey) or raw human power necessitate that typical family holdings be not
more than 5 to 8 hectares. In fact, in many countries, average holdings can be as low as 1 to 3
hectares. The number of people that this land must support both directly and indirectly often runs
as high as 10 to 15 people per hectare. It is no wonder that efforts to improve the efficiency of
agricultural production and increase the average yields of rice, wheat, maize, soybeans, and millet
are now and will continue to be top-priority development objectives.
Dependence on Primary Exports: Most economies of less developed countries are oriented
toward the production of primary products. These primary commodities form their main exports.
For example, for all non-Asian developing countries, these primary products account for over
70% of exports. Except in countries blessed with abundant supplies of petroleum and other
valuable mineral resources and a few leading Asian exporters of manufactured goods, most
LDC exports consist of basic foodstuffs, nonfood cash crops, and raw materials. In sub-Saharan
Africa, primary products account for over 80% of total export earnings.
Most poor countries need to obtain foreign exchange in addition to domestic savings in order to
finance priority development projects. Although private foreign investment and foreign aid are a

significant but rapidly declining source of foreign exchange, exports of primary products typically
account for 60% to 70% of the annual flow of foreign currency into the developing world.
Even though exports are so important to many developing nations, LDC export growth (excluding
oil exports) has barely kept pace with that of developed countries. Consequently, even in their best
years, most non-oil-exporting developing nations have been losing ground to the more developed
countries in terms of their share of total world trade. In 1950, for example, the LDCs' share was
nearly 33%. It has fallen in almost every year since and currently stands at around 20%.
Countries with the poorest 20% of the world's population did even worse. By 1991, their share of
world trade had fallen to 1.4%, while countries with the richest 20% had captured 85% of world
trade. Most of the success in export promotion since 1970 has been captured by a few OPEC
countries in the 1970s and the Four Asian Tigers, along with a few other NICs in the 1980s and
1990s. The majority of LDCs have experienced a continuing decline in their share of world trade.
vi. Imperfect Markets and Incomplete Information
Starting from the 1980s almost every developing country is moving toward the establishment of a
market economy for many reasons. Many countries did so at the behest of the World Bank, which
kept advocating "market-friendly" economic policies as preconditions for loans. There seemed to
be a growing consensus that there had been too much government intervention in the workings of
Third World economies. This government intervention is sighted by many as the major cause of
the problems in the poor nations. Hence, free market and unfettered competition are considered as
the key to rapid economic growth.
But the presumed benefits of market economies and market-friendly policies depend heavily on
the existence of institutional, cultural, and legal prerequisites that are taken for granted in the
industrial societies.
In many LDCs, these legal and institutional foundations are either absent or extremely weak. They
include;
 the existence of a legal system that enforces contracts and validates property rights;
 a stable and trustworthy currency;
 an infrastructure of roads and utilities that results in low transport and communication costs so
as to facilitate interregional trade
 a well-developed system of banking and insurance,
 formal credit markets that select projects and allocate loan able funds on the basis of relative
economic profitability and enforce rules of repayment, and
 Substantial market information for consumers and producers about prices, quantities, and
qualities of products and resources as well as the creditworthiness of potential borrowers.
These six factors, along with the existence of economies of scale in major sectors of the economy;
thin markets for many products due to limited demand and few sellers; widespread externalities

(costs or benefits that accrue to companies or individuals not doing the producing or consuming)
in production and consumption; and the prevalence of common property resources (e.g., grazing
lands, waterholes) mean that markets are often highly imperfect.
Moreover, information is limited and costly to obtain, thereby often causing goods, finances, and
resources to be misallocated. Therefore, the existence of imperfect markets and incomplete
information systems remains a common characteristic of developing nations and an important
contributing factor to their state of underdevelopment.
Vii. Dominance, Dependence, and Vulnerability in International Relations
For many less developed countries, a final significant factor contributing to the persistence of low
levels of living, rising unemployment, and growing income inequality is the highly unequal
distribution of economic and political power between rich and poor nations. These unequal
strengths are manifested in economic and non-economic aspects of the relationships.
Economically, the dominant powers of rich nations control the pattern of international trade. They
have also the ability to dictate the terms whereby technology, foreign aid, and private capital are
transferred to developing countries.
Other equally important aspects of the international transfer process can serve to inhibit the
development of poor nations. One subtle but nonetheless significant factor has been the transfer of
First World values, attitudes, institutions, and standards of behavior to Third World nations.
Examples include the colonial transfer of often inappropriate educational structures, curricula, and
school systems; the formation of Western-style trade unions; the organization and orientation of
health services in accordance with the curative rather than preventive model; and the importation
of inappropriate structures and procedures for public bureaucratic and administrative systems.
Of even greater potential significance may be the influence of rich-country social and economic
standards on developing country salary scales, elite lifestyles, and general attitudes toward the
private accumulation of wealth. Whether there are market-friendly policies or extensive
government intervention, such attitudes can often lead to corruption and economic plunder by a
privileged minority.
Finally, the penetration of rich-countries' attitudes, values, and standards also contributes to a
problem widely recognized and referred to as the international brain drain. Brain drain is the
migration of professional and skilled personnel, who were often educated in the developing
country at great expense, to the various developed nations. Examples include doctors, nurses, sci-
entists, engineers, computer programmers, and economists.
The net effect of all these factors is to create a situation of vulnerability among Third World nations
in which forces largely outside their control can have decisive and dominating influences on their
economic and social well-being.

Review Questions on Chapter III

1. Discuss the characteristics of Ethiopia that make it to be categorized as one of the developing
countries by taking actual figures when appropriate.
2. Define poverty, what are the methods of its measurement and explain the determinant(s) of
poverty
3. Low labour productivity is one of the features of developing countries. Using an economic
concept, explain the reasons for this condition of developing countries as distinguished from
the developed countries.
4. Provide the explanations for the dominance-dependence relationships between developing
and advanced countries.
5. Argue for and against the success of market friendly policies in developing countries.
6. Ethiopia is one of the largest nations in Africa in terms of physical and population size.
Discuss the advantages and disadvantages of this size in development.
Chapter Four
4. Theories of Economic Development
4.1 Introduction
In the previous chapter, we have discussed the dimensions of the problems of developing countries,
which may be called their diversities and common characteristics. Generally, we have tried to
make an assessment of the factors that make these countries to be categorized as poor countries.
We have also assessed the differences among them that should be observed in formulating
development policies and strategies. Now it is time to look at some of the available tools useful in
explaining development problems and formulating relevant development policies and strategies.
These helpful instruments are the growth models and development theories. There are different
theories explaining the diverse development problems of countries at different social, economic,
political, and institutional circumstances. To many people, a theory is a contention that is
impractical or has no factual support. Someone who says that free migration to the United States
may be all right in theory but not in practice implies that, despite the merit of the idea, it would be
impractical. Likewise, the statement that the idea of lower wealth taxes in India stimulating
economic growth is just a theory indicates an unverified hypothesis. For the economist, however,
a theory is a systematic explanation of interrelationships among economic variables, and its
purpose is to explain causal relationships among these variables. Usually a theory is used not only
to understand the world better but also to provide a basis for policy. In any event, theorists cannot
consider all the factors influencing economic growth in a single theory. They must determine
which variables are crucial and which are irrelevant. However, the reality is so complicated that a
simple model may omit critical variables in the real world (Kindle Berger and Herrick 1977:40).
And although complex mathematical models can handle a large number of variables, they have
not been very successful in explaining economic development, especially in the third world.
4.1 The Classical Theory of Economic Stagnation

The classical theory, based on the work of the 19th-century English economist David Ricardo,
Principles of Political Economy and Taxation (1817), was pessimistic about the possibility of
sustained economic growth. For Ricardo, who assumed little continuing technical progress, growth
was limited by land scarcity. The classical economists – Adam Smith, Thomas R. Malthus,
Ricardo, and John Stuart Mill – were influenced by Newtonian physics. Just as Newton posited
that activities in the universe were not random but subject to some grand design, these men
believed that the same natural order determined prices, rent, and economic affairs. In the late 18th
century, Smith argued that in a competitive economy, with no collusion or monopoly, each
individual, by acting in his or her own interest, promoted the public interest. A producer who
charges more than others will not find buyers, a worker who asks more than the going wage will
not find work, and an employer who pays less than competitors will not find anyone to work. It
was as if an invisible hand were behind the self-interest of capitalists, merchants, landlords, and
workers, directing their actions toward maximum economic growth (Smith 1937, first published
1776). Smith advocated a laissez-faire (governmental noninterference) and free trade policy
except where labor, capital, and product markets are monopolistic, a proviso some present-day
disciples of Smith overlook.
The classical model also took into account;
(1) The use of paper money,
(2) The development of institutions to supply it in appropriate quantities,
(3) Capital accumulation based on output in excess of wages, and
(4) Division of labor (limited primarily by the size of the market)
A major tenet of Ricardo was the law of diminishing returns, referring to successively lower
extra outputs from adding an equal extra input to fixed land. For him, diminishing returns from
population growth and a constant amount of land threatened economic growth. Because Ricardo
believed technological change or improved production techniques could only temporarily check
diminishing returns, increasing capital was seen as the only way of offsetting this long-run threat.
His reasoning took the following path. In the long run, the natural wage is at subsistence – the cost
of perpetuating the labor force (or population, which increases at the same rate). The wage may
deviate but eventually returns to a natural rate at subsistence. On the one hand, if the wage rises,
food production exceeds what is essential for maintaining the population. Extra food means fewer
deaths, and the population increases. More people need food and the average wage falls.
Population growth continues to reduce wages until they reach the subsistence level once again. On
the other hand, a wage below subsistence increases deaths and eventually contributes to a labor
shortage, which raises the wage. Population decline increases wages once again to the subsistence
level. In both instances, the tendency is for the wage to return to the natural subsistence rate. With
this iron law of wages, total wages increase in proportion to the labor force. Output increases with
population but, other things being equal, output per worker declines with diminishing returns on
fixed land. Thus, the surplus value (output minus wages) per person declines with increased
population. At the same time, land rents per acre increase with population growth, as land becomes
scarcer relative to other factors. The only way of offsetting diminishing returns is by accumulating

increased capital per person. However, capitalists require minimum profits and interest payments
to maintain or increase capital stock. Yet because profits and interest per person declines and rents
increase with population growth, there is a diminishing surplus (profits, interest, and rent)
available for the capitalists’ accumulation. Ricardo feared that this declining surplus reduces the
inducement to accumulate capital. Labor force expansion leads to a decline in capital per worker
or a decrease in worker productivity and income per capita. Thus, the Ricardian model indicates
eventual economic stagnation or decline.
Critique
Paradoxically, the stagnation theory of Ricardo was formulated amid numerous scientific
discoveries and technical changes that multiplied output. Clearly, he underestimated the impact
of technological advance in offsetting diminishing returns. According to the classical economists
the method of overcoming the problem of unemployment is the cutting down of competitive
wage rate as explained in the Marginal Productivity theory. However, such a solution is not
applicable in practice particularly in the third world countries where the supply of labor
exceeds the demand for it but labourers are already living at low subsistence level. Thus as a
result of cutting down the wage rate they would eventually be led to starvation. This would lead
to the creation of a new problem instead of solving the problem of unemployment
4.2 The Marxian Theory

Marx’s Historical Materialism
Karl Marx’s views were shaped by radical changes in Western Europe: the French Revolution;
the rise of industrial, capitalist production; political and labor revolts; and a growing secular
rationalism. Marx wanted to replace the unhistorical approach of the classicists with a historical
dialectic. History moves from one stage to another, say, from feudalism to capitalism to socialism,
on the basis of changes in ruling and oppressed classes and their relationship to each other. Conflict
between the forces of production and the existing relations of production. The interaction between
forces and relations of production shapes politics, law, morality, religion, culture, and ideas
Accordingly, feudalism is undercut by;
(1) The migration of serfs to the town;
(2) Factory competition with handicraft and manorial production;
(3) Expanded transport, trade, discovery, and new international markets on behalf of the new
business class; and
(4) The accompanying rise of nation-states.
The new class, the proletariat or working class, created by this next stage, capitalism, is the seed
for the destruction of capitalism and the transformation into the next stage, socialism. Capitalism
faces repeated crises because the market, dependent largely on worker consumption, expands more
slowly than productive capacity. Eventually the proletariat revolts, takes control of capital, and
establishes socialism. In time, socialism is succeeded by communism, and the state withers
away.
 Marx contributed to the theory of economic development in three respects:
 In providing an economic interpretation of history;

 In specifying the motivating forces of capitalist development; and

 In suggesting an alternative path of planned economic development”.
 Materialistic Interpretation of History: According to Marx, every society’s class
structure consists of the propertied and the non-propertied classes.
 This leads to the class struggle.
 Surplus Value: Marx uses his theory of surplus value as the economic basis of the ‘class
struggle’ under capitalism. Marx calls this unpaid work “surplus value.”
 The extra labor that a laborer puts in and for which he receives nothing, Marx calls “surplus
labor”.
 Capital accumulation: According to Marx, it is surplus labor that leads to capital accumulation.
The capitalist’s main motive is to increase the surplus and profit.
 Profits are determined by the amount of capital: As Marx says, “Capital kills labor by sucking
living”.
 Marx separates capital into constant capital and variable capital.
 The value of product = (c+v) + s.
 In order to analyze the nature of capitalist accumulation, Marx establishes certain relationships
between c, v, s and profit.
 The ratio of constant to variable capital (c/v) is termed as the organic composition of capital.
 The rate of surplus value is defined as s/v, the ratio of surplus value to variable capital or of
profits to wages.
 The rate of profit (r) is defined by the ratio of surplus to the sum of constant capital and
variable capital (r = s/c+v).
 Capital accumulation and concentration involve increase in constant capital and decline in
variable capital.
 Capitalists are also able to cut down wages to a semi-starvation level and appropriate more and
more surplus value.

 But when the capitalists are replacing the workers by machines, they are killing the
goose that laid the golden eggs. Hence, there is a continual reduction of the surplus
value.
 Marx believes that technological progress tends to increase the organic composition of
capital (c/v).
 Since the rate of profit is inversely related to the organic composition of capital.
s s/v
r 
c  v c / v 1
Capitalist Crisis: In order to counteract this tendency of declining rate of profit, the capitalists
increase the degree of exploitation by reducing wages, lengthening the working day, and by
“speed ups,” etc. But since every capitalist is engaged in introducing new labor-saving the ratio of
labor to total output falls still further; hence surplus value also falls. As Marx wrote, “A crisis
always forms the starting point of large new investments. In elaborating the general law of
capitalist accumulation, Marx provides the economic explanation of the necessity and inevitability
of the revolutionary transformation from capitalist to socialist society
4.2.1 A Critical Appraisal of Marxian Theory

 Unrealistic Surplus Value: However, in the real world, we are concerned not with values
but with real tangible prices. In reality, workers are usually paid beyond the value of their
surplus.
 Marx-A False Prophet: Marx has proved to be a false prophet. No doubt socialist societies
have come into existence but their evolution has not been on the lines laid down by Marx.
 Technological Progress helpful in Increasing Employment: Marx pointed out that with
increasing technological progress, the industrial reserve army expands within itself the
seeds of its own destruction.
 Falling Tendency of Profits not Correct: According to-Joan Robinson, Marx’s

explanation of the falling tendency of profits explains nothing at all.
 Marx could not Understand Flexibility in Capitalism: Marx also could not foresee the
emergence of political democracy as the protector and the preserver of capitalism.
 Wrong Cyclical Theory: Marx emphasized that capital accumulation led to a reduction
in the demand for consumption goods and fall in profits.
 The Marxian theory is not applicable directly to underdeveloped countries. Marx

did not think of the problems of such countries.

4.3. Keynesians Theory (1936 - 1970)
The great depression of 1933, (world economic crises in general and of American in particular)
initiated economists to recommend government intervention. The first economist was John
Maynard Keynes. The economists following his trend are called Keynesian economists. The
main thesis of the Keynesian paradigm is that economy is subjected to failure as markets are not
efficient and economy may not achieve full employment level
 The Keynesian thinkers believed that government intervention is inevitable.
 Following the failure of all attempts of central banks to keep the economy on the right
track, John Maynard Keynes published his book of ‘General Theory of Employment,
Interest and Money’ in year 1936.
 In his work, he suggested that quantity of money is not important especially during
depression.
 But the most important factors are investment level, fiscal factors and export level as
these are the major determinants of the position of the business cycle.
 The publication of Keynes’s book dramatically changed the economic thought.
 Generally, there have been two main intellectual traditions in macroeconomics.
 One school of thought believes that government intervention can significantly improve
the operation of the economy;
 But the other believes that markets are efficient and government intervention is not
required
 In summary, Keynesians believed that the cause of the Great Depression was due
to;
 a combination of events that led to great uncertainty,
 huge decreases in investment, and
 Economies being stuck in unemployment trap.
 The implications of the fundamental Keynesian thought are the following.
1. The economy is inherently unstable and is subject to erratic shocks.
2. The economy can take a long time to return to being close to full equilibrium after being
subjected to a shock.
Assumption of Keynes
1. Government intervention is necessary for the smooth function of the economy.

2. Aggregate demand is the predominant determinant of output and employment, and it can
be altered by the authorities.

3. Fiscal policy is preferred to monetary policy for carrying out stabilization policies.
4. The access to Information about the economic variables is the key.
 Thus, Keynesian macroeconomic theory has provided the policy makers a tool to
intervene in the economy.
 In many countries Keynesian ideas are still in use and government intervenes directly or
indirectly in the markets
Applicability of Keynes’s Theory to Underdeveloped Countries
The Keynesian theory is not applicable to every socio-economic set-up. It only applies to advanced
democratic capitalist economies. Before we study the applicability of Keynesian economics to
underdeveloped countries it is essential to analyze the assumptions of Keynesian economics vis-
à-vis the conditions prevailing in underdeveloped economies
Keynesian Assumptions and Underdeveloped Countries
Cyclical unemployment: The Keynesian theory is based on the existence of cyclical
unemployment which occurs during a depression
 Short period analysis: The Keynesian economics is a short period analysis in which Keynes takes
“as given the existing skill and quantity of available labor
 Closed economy: The Keynesian theory is based on the assumption of a closed economy. But
underdeveloped counties are not closed economies.
 Excess supply of labor and complementary of factors: The Keynesian theory assumes an excess
supply of labor and other complementary resources in the economy.
 Labor and capital are simultaneously unemployed: It can be inferred from the above
assumption that labor and capital are unemployed simultaneously
Tools of Keynesian Economics and Underdeveloped Countries
 Effective demand: Unemployment is caused by the deficiency of effective demand, and to get
over it, Keynes suggested the stepping up of consumption and non-consumption expenditures.
 Propensity to consume: One of the important tools of Keynesian economics is the propensity to
consume which highlights the relationship between consumption and income
 Propensity to save: On the saving side, Keynes regarded saving as a social vice for it is excess of
saving that leads to a decline in aggregate demand.
 Rate of interest: The rate of interest is among the determinants of investment in the Keynesian
system.
 The multiplier: Feasibility of applying the Keynesian multiplier theory and policy implications
to an underdeveloped country has analyzed.
The Keynesian concept of multiplier is based on the following four assumptions:
 Involuntary unemployment.
 An industrialized economy where the supply curve of output slopes upward toward the right but
does not become vertical till after a substantial interval.
 Excess capacity in the consumption goods industries.
 Comparatively elastic supply of the working capital required for increased output.

 Involuntary unemployment: Involuntary unemployment in the Keynesian analysis is associated

with a capitalist economy where the majority of workers work for wages
 Inelastic supply curve of output: The supply curve of output in an underdeveloped country is
inelastic which renders the working of the multiplier.
 Thus, the obvious conclusion is that the Keynesian principle of multiplier does not operate in an
underdeveloped country due to two reasons
4.4 Lewis Theory of Unlimited Supplies of Labor
Prof. Arthur Lewis has developed a very systematic theory of economic development with
unlimited supply of labor. This theory is one of the best-known early theoretical models of
development that focused on the structural transformation of a primary subsistence economy.
Lewis' model starts with the assumption of a dual economy with a modern industrial sector and a
traditional subsistence sector. Lewis believed that in the traditional sector of many underdeveloped
countries there is unlimited supply of labor at subsistence wage.
Surplus Labor means the existence of such a large population in the rural sector so that the
marginal productivity of labor has fallen to zero. This condition is also called disguised
unemployment. The essence of the development process in this type of an economy is the transfer
of labor resources from the agricultural sector where they add nothing to production to the more
modern industrial sector, where they create a surplus. Economic development takes place when
capital accumulates as a result of withdrawal of surplus labor from the subsistence to the modern
industrial sector. The situation of subsistence wage and surplus labor is illustrated below.
Fig. 3.1 shows the marginal product of successive units of labor added to the land. OW is the
subsistence wage. At this wage, there is unlimited supply of labor. The productivity of labor
increases at the beginning but after X units of labor, marginal product of labor declines. Owing to
diminishing returns, after X1 units of labor, marginal contribution of labor to output falls below the
subsistence wage. And after X2 units of labor, the contribution of labor to output becomes negative
and total product will decline with successive additions of labor beyond X1. All the labor beyond
X1 is considered as surplus labor and is in a completely elastic supply to the industrial sector at
whatever the industrial wage.
Fig. 3.1: Subsistence wage and surplus labor

To attract labor from agriculture to industrial sector they must be offered wages which is higher
than the wages they get in the agricultural sector. Lewis assumes that urban wages will have to be
at least 30% higher than average rural income to induce workers. As indicated on Fig. 3.2 below,
industrial wage, WI, is greater than agricultural wage, WA. Employments in the industrial sector
would hire laborers to the point where it is profitable to do so. It means that they will employ
workers up to that point where the marginal productively of workers equals wage rate. After paying
the wages the remaining part of output creates profits of the employer. A part of the profit is
reinvested by the capitalist in the industrial sector. By investing more capital, he can introduce
new capital equipment’s, more raw materials, etc. The expansion of the industrial sector makes it
possible to employ new employees. This for Lewis is the essence of the development process. The
stimulus to investment comes from the rate of profit, which must rise over time because all the
benefits of increased productivity accrue to capital as real wage is constant. This process continues.
Criticisms of Surplus Labor Theory
Although the Lewis two-sector development model is simple and roughly reflects the historical
experience of economic growth in the west, some of its key assumptions do not fit the institutional
and economic realities of most contemporary developing countries.
1. Lewis assumes that due to competitive labor market, the wage rate remains constant in the urban
sector for a long time. It is an unrealistic assumption.
2. If the method of production in the industrial sector is capital intensive and labor saving, this theory
will not work.
3. It considers lack of skilled laborers as a temporary bottleneck in the development process of
underdeveloped countries. But it is a serious problem.
4. Lack of entrepreneurial initiative is another problem that affects the industrial expansion of
developing economies.
5. It is unrealistic to assume that there is high unemployment in rural areas and full employment in
urban areas. In most developing countries the reverse is true. Schultz argued that MP of labor in
the over-crowded agricultural sector is not zero. So, when there is shift the workers from
agricultural to industry, the agricultural production decreases.
6. Mobility of labor from agriculture to industrial sector is not easy. Differences in language and
customs, problem of housing, high cost of living in urban sector and the attachment of the people
to their family land are some factors that affect the labor mobility.
7. It is a one sided theory because the theory does not consider the possibilities of progress in the
agricultural sector.
4.5. The Balanced Growth Theory
This theory was advocated mainly by Rosenstein-Rodan (1943), Ragnar Nurkse (1953) and
Arthur Lewis (1954). Many writers view balanced growth differently. To some writers, balanced
growth means investing in a lagging sector of the national economy or industry so as to ensure that
it catches up with others. To others, balanced growth implies that investment takes place
simultaneously in all sectors of the national economy. Still to others, it implies the balanced
development of agricultural and industrial sectors of the economy. To this extent, balanced growth

calls for maintaining the balance between the different consumer and capital goods industries. It
also calls for ensuring balance between agriculture and industry and between the domestic and
export sectors of the national economy. Additionally, it requires balance between social and
economic overheads and directly productive investment.
Moreover, the economists in favor of the balanced growth postulated the balance between supply
side and demand side. The supply side consists of simultaneous development of all interrelated
sectors, i.e., intermediate goods, raw materials, power, agriculture, transport, and consumer goods
industries. The demand side comprises provision of employment opportunities which increase
income and thus demand of the consumers.
 Rodan was the first to develop the theory of balanced growth without using these words. His main
contention was that often social marginal product (SMP) of an investment is different from its
private marginal product (PMP). When industries are planned in accordance with their SMPs, the
rate of growth of the economy is greater than it would have been otherwise. It is complimentarily
of different industries which lead to the most profitable investment from the stand point of the
society.
 It is here that he gives the famous example of a shoe factory. Suppose a large shoe factory is
started in a region where 20,000 unemployed workers earn their wages on shoes, a market for
shoes would be created. But the trouble is that the workers will not spend their entire wage on
shoes. If instead a whole series of industries were started which produce the consumption goods
on which the workers would spend their income, all industries would expand via the multiplier
process.
 This idea has been developed and elaborated by Nurkse in his thesis. According to Nurkse,
Vicious circles of poverty are at work in UDCs. To attain development, these vicious circles must
be broken. Individual decisions related to investment cannot save the problem. According to him,
“More or less synchronized application of capital to a wide range of different industries” will help
to break the vicious circles.
 To sum up in the words of Lewis, “in development programme all sectors of the economy should
grow simultaneously so as to keep a proper balance between industry and agriculture and between
production for home consumption and production for exports”.
Criticisms of Balanced Growth
1) It is argued that a simultaneous establishment of a number of industries is likely to raise money
and real cost of production. Kindle Berger observed that instead of starting with new industries
Nurkse’s model does not consider the possibility of cost reduction in the existing industries.
2) Balanced growth strategies are beyond the capability of UDCs. In these nations, the availability
of resources for simultaneous development on many fronts are generally lacking
3) The doctrine of balanced growth presupposes increasing returns. But this is a wrong assumption.
4) Dis-proportionalities in factors of production and shortage of resources make the theory unrealistic
in LDCs. This theory is applicable in a developed country.
4.6. Unbalance Growth

The theory of unbalanced growth is the opposite of the doctrine of balanced growth. The
dissatisfaction with the theoretical underpinnings of the balanced growth theory gave rise to a new
school of thought that of unbalanced growth which has an intellectual as well as a practical appeal.
Mainly Walt Rostow and more particularly Albert Hirschman were who propounded the theory
in a systematic manner. To Rostow, as noted later, for an economy to cross the stage of traditional
society and achieve take-off, it is essential for it to increase the rate of productive investment from
5% to 10% or more. This is possible only if investment is undertaken in two or more sectors
of the national economy. This will lead to the development of related industries and as a result of
increased production, profits will increase and which can in turn be reinvested. To Hirschman, the
deliberate unbalancing of the economy in accordance with a pre-designed strategy is the best way
to achieve rapid economic development in the less developed countries. Investments in
strategically selected industries or sectors of the economy, will lead to new investment
opportunities and so pave the way for further economic development. There are two types of
projects, according to Hirschman, convergent series and divergent series. The projects which
appropriate more external economies than they create are called convergent series. Some
investments on the other hand create more external economies than they appropriate. These
projects are called divergent series. While choosing the project for investment divergent series
of investment must be followed.
 Hirschman said unbalancing the economy can be made either by selecting social overhead
capital investment (SOC) or by selecting directly productive activities (DPA). If without
proper development of the social overhead facilities, investments are made on directly productive
activities, the cost of production will be high. So in an UDC, unbalancing the economy by giving
importance first to the investment on SOC is more advisable. It will create possibilities for the
development of the DPA. He is neither in favor of complete privatization nor in favor of complete
state planning. He preferred a mixed economy.
 According to this theory investment should be made in selected sectors rather than
simultaneously in all sectors of the economy. UDE does not possess sufficient capital and other
resources to invest simultaneously in all sectors. Hirschman regards economic development as a
“chain of disequilibria” that must be kept alive rather than eliminated. But this theory is also
criticized on several grounds:
Criticisms of Unbalanced Growth
1. According to Paul Streeton, Hirschman’s theory failed to say what is the optimum degree of
imbalance, where to imbalance and how much in order to accelerate economic growth
2. Streeton argued that Hirschman expected a simultaneous expansion of the economy through
balancing it. He neglected the influence of the growth retarding forces.
3. Lack of basic facilities. There may be lots of difficulties in procuring technical personnel, raw
materials and basic facilities like transport, power and even markets for the products produced.
4. Technical flexibility (factor mobility) of resources is limited in the underdeveloped countries. It
adversely affects growth process.

5. Hirschman’s development strategy is largely related to maximizing investment decisions. In an

UDC, not only investment decisions but also administrative, managerial and policy decisions are
important.
6. The investment on SOC which does not directly increase the amount of goods and services is also
inflationary.
Similarity of Balanced and Unbalanced Growth Theories
 Nurkse argued that private investment is incapable of breaking the vicious circle of poverty and
government investment is indispensable. Hirschman also called for investment in SOC which is
based on state plans. However, the unbalanced growth theory is far more applicable than the
balanced growth theory.
4.6. Dualistic Theories
 Dualism indicates a situation where types of parallel phenomena co-exist.
 It represents the existence and persistence of increasing divergences between rich and poor nations
as well as rich and poor people’s on various levels.
 Dualism has been perceived in different ways such as: social, technological, financial, and
geographic dualism.
a. Social Dualism
 The theory of social dualism was developed by a Dutch economist J.H. Bocke.
 The theory of social dualism is a general theory of economic and social development of UDCs.
 It is based on his studies of the Indonesian economy.
 Dr. Bocke maintains that there are three characteristics of a society in the economic sense.
 They are the social spirit, the organizational forms and the techniques dominating it.
 The interdependence of these characteristics is called the social system or social style.
 Some of the important characteristics of the eastern sectors of a dualistic economy which
distinguish it from a western society are the following.
 The needs of the society are limited. People are influenced more by social rather than economic
needs.
 Goods are evaluated according to their prestige value rather than value in use. Native industries
are not properly organized. It faces problems related to capital shortage, unskilled workers, poor
technology and market imperfections
 Bocke argued these distinctive factures of the eastern economy makes it impossible to apply
the western economic theory in underdeveloped countries.
Criticisms of Social Dualism
 Prof. Benjamin Higgins put forward the following arguments against this theory.
 It is argued that Bocke’s contention that people in UDCs have limited wants is unrealistic.
 According to Bocke, eastern casual worker is unorganized, passive and silent. Higgins criticized
it taking the trade union of eastern economics.
b. Technological Dualism

 As an alternative to Bocke’s social dualism, Benjamin Higgins has developed the theory of
technological dualism.
 Technological dualism implies the use of different production functions in the advanced sector
and the traditional sector of the economies of underdeveloped countries.
 Higgins builds his theory around two goods, two factors of production and two sectors with their
own factor endowments and production functions.
 The industrial sector is engaged in plantations, miners, refineries, large scale industries etc. It is
capital intensive and there is no technical substitutability of factors which are combined in different
proportions (fixed technological co-efficient).
 The rural sector is engaged in producing food stuffs, handicrafts and it consists of very small
industries. It has variable technical co-efficient of production so that it can produce the same
output with a wide range of techniques and alternative combinations of labor and capital
Criticisms of Technological Dualism
1. Technical co-efficient are not fixed in industrial sector.
2. Factor prices do not depend on factor endowments alone.
3. Higgins theory neglects institutional and psychological factors.
4. Higgins neglects the possibilities to use labor absorbing techniques in urban sector.
5. He failed to explain the nature and size of disguised unemployment.
C. Financial Dualism
Prof. Myint has developed the theory of financial dualism. Financial dualism refers to the co-
existence of different interest rates in the organized and unorganized money markets in the
LDCs. The rate of interest in the unorganized money market is higher than that in the organized
money market in the modern sectors.
The unorganized money market consists of the non-institutional lenders such as village money
lenders, land lords, shopkeepers, traders, etc. They charge very high interest rates on loans. It is
so because there is a real shortage of savings in the traditional sector. These money lenders occupy
strategic positions in the village economy and create monopoly power over the peasants.
In the organized money market of LDCs the interest rates are low and credit facilities are
abundant. The organized money market consists of the commercial banks and other financial
institutions which lend short term credit at low interest rate in the modern business sector. This
has created economic dualism between the traditional and modern sector. The fiscal and monetary
measures followed in LDCs favored the interests of the modern sector as against the traditional
sector. More investment is made in the modern sector. The agricultural and small scale sector
suffers due to these reforms.
Chapter Five
5. Economic Growth Models
5. 1 Introduction
The growth model that was particularly popular with economic planners just after World War II
came to be known as the Harrod-Domar model, since it was based on independently published
articles by Roy Harrod and Evsey Domar. The fact that the two authors independently produced

identical models was not surprising. This is because their models were simple extensions of John
Maynard Keynes’s well-known macroeconomic model, which dominated economic thinking in
the 1940s.
The Harrod-Domar model makes similar assumptions to the Keynesian macroeconomic model.
These include:
 Since there is unlimited amount of unemployed labor, output can be increased without
triggering price increases.
 As there is abundant labor to keep the capital-labor ratio constant, this leads also to the
assumption of constant marginal product of capital (capital output ratio).
 With constant capital-output ratio, therefore, output growth is directly proportional to new
investment in new capital.
 Moreover, this model assumes that productive investment is always equal to saving.
 Each model is discussed one by one below.
5.2. Harrod-Domar Growth Model
As mentioned above, Harrods original model is a dynamic extension of Keynes' static equilibrium
analysis. In this regard, there are three questions that Harrod raised and tried to answer. In keyens'
General Theory, the condition for income and output to be in equilibrium (in a closed economy)
is that plans to invest equals plans to save. Hence, Harrod asked if changes in income induce
investment, what must be the rate of growth of income for plans to invest to equal plans to save
in order to ensure a moving equilibrium in a growing economy through time. Secondly, in static
Keynesian theory, if equilibrium between saving and investment is disturbed, the economy
corrects itself and a new equilibrium is achieved via the multiplier process. Then the second
question is if growth equilibrium is disturbed, will it be self-correcting or self-aggravating? And
lastly, will this equilibrium rate be equal to the maximum rate of growth that the economy is able
to sustain given the rate of growth of productive capacity? If not what will happen?
To explain this condition, Harrod distinguished three different growth rates. These are
 Actual growth rate (g)

 Warranted growth rate (gw)
 Natural growth rate (gn)
The actual growth

The actual growth rate is defined as
g = s/c-------------------el
Where: s = the ratio of saving to incomes (S/Y)

c = the actual incremental capital output ratio, that is the ratio of extra capital
accumulation or investment to the growth of output
(K/Y=I/Y)
The expression for the actual growth is definitional true since it expresses the accounting identity
that saving equals investment. This can be shown as
g = s/c = (S/Y)/ (I/Y)
= (S/Y) (Y/I)
= Y/Y, given S=I the change over the level (Y/Y) represents the rate of growth of output.
We need more than a definitional equation, however, to know whether the actual
growth rate will provide the basis for steady advances in the future. This means
that it keeps plans to invest and plans to save in line with one another at full
employment. This is where the warranted rate & natural rate of growth become
important.
Warranted rate of growth

Warranted rate is that rate of growth which, if it occurs, will leave all parties satisfied. At this rate
producers have produced neither more nor less than the right amount. To state matters
otherwise, warranted rate of growth will put all parties into a frame of mind which will cause them
to give such orders as will maintain the same rate of growth. In other words, it is the rate that
induces just enough investment to match planned saving and therefore keeps capital fully
employed so that manufacturers are willing to carry on investment in the future at the same rate
as in the past. It is determined as:
Plans to save at any time are given by the Keynesian saving function
S = sY ------------------------------e2
The demand for investment is given by the acceleration principle. This is where cr is the
accelerator coefficient measured as the required amount of extra capital or investment to produce
a unit flow of output at a given rate of interest, determined by technological condition. Thus;
Cr = Kr/Y = I/Y
I = CrY -----------------------------------e3
For planned savings to equal planned investment therefore, we have
sY = CrY-------------------------------------------e4
And the required rate of growth for a moving equilibrium through time is

Y/Y= s/cr = gw----------------------------------e5
This is the warranted rate of growths (gw). For dynamic equilibrium, output must grow at this
rate. The condition for equilibrium is that
g=gw
From e5 and el, this means
gc == gwcr
(g/gw = cr/c)
 Suppose there is disequilibrium such that actual growth rate exceeds the warranted rate.
It is easily seen that if g>gw then c<cr, which means that actual investment falls
below the level required to meet the increase in output. There will be a shortage of
equipment, a depletion of stocks and an incentive to invest more. The actual growth rate
will then depart even further from the warranted rate.
 Conversely, if the actual growth rate is less than the warranted growth rate (g<gw) then
c>cr. In this case, there will be a surplus of goods and investment will be discouraged,
causing the actual growth rate to fall even further below the equilibrium rate.
Thus, as Harrod points out, in the dynamic field we have a condition opposite to that in static
field. A departure from equilibrium instead of being self-righting will be self-aggravating. This
is the short-term trade cycle problem in Harrod's growth model. But even if growth proceeds at
the rate required for full utilization of the capital stock and a moving equilibrium through time,
this still does not guarantee the full employment of labor, which depends on the natural rate of
growth.
The natural growth rate

The natural growth rate is derived from the identity:
Y = L (Y/L)
Where L = Labour
Y/L = Productivity of labor
Or taking the rate of growth
Y = 1 + q= gn
The natural rate of growth is therefore made up of two components: the growth of labor force (l),
and the growth of labor productivity (q) both exogenously determined.
The natural rate of growth plays two roles in Harrods model.
1. It defines the rate of growth of productive capacity or the long run full employment

equilibrium growth rate.

2. It sets the upper limit to the actual growth rate. If g>gw, g can only continue to diverge
from gw until it hits gn. When all available labor has been fully absorbed, g cannot be
greater than gn in the long-run. The long-run question for an economy then is the
relationship between gw and gn. With fixed coefficient of production, the full employment
of labor requires
g= gn
The full emp1oyment of labor and capital requires
g = gw = gn
This is a state of affairs, which Jean Robinson called it the golden age
5.2.1 Long-Run Disequilibrium of Harrod-Domar Growth Model

If gw >gn, there will be a tendency towards chronic depression. This is because the actual rate of
growth will never be sufficient to stimulate investment demand to match the amount of saving at
full employment equilibrium. There is too much capital and too much saving. This was the problem
during the 1930's. Here the economy is in a state of stagnation. Savings are not fully utilized and
the economy suffers from over accumulation of capital. This will produce excess capacity, rising
inventories and unemployment. Here Harrod suggest reduction of savings, which also reduce gw.
On the other hand, if gw < gn, there will be a tendency towards demand inflation because there will
be a tendency for the actual rate of growth to exceed that necessary to induce investment to match
saving.
5.2. 3. Relevance of the Model to Developing Countries

In most developing countries, the natural growth rate exceeds the warranted rate. If the population
growth is say 2% and labor productivity is growing at 3%, this gives a rate of growth of the labor
force in efficiency units of 5%. If the net savings ratio is, say 9% and the required incremental
capital-output ratio is 3, this gives a warranted growth rate of 3%. This has two main consequences.
1. It means that the effective labor force is growing faster than capital accumulation, which
is part of the explanation for growing unemployment in LDCs
2. It implies greater plans to invest than plans to save, and therefore resulting inflationary
pressure. If gn= 5% and cr =3, there will be profitable investment for 15% saving whereas
actual saving is only 9%.
Given the inequality gn≠gw or (l+q) ≠ (s/cr), Harrod suggested four ways in which gn and gw might
be reconciled. If the problem is gn>gw):
a) Reduce the rate of growth of the labor force. Measures to control population size can be
justified on the grounds, as a contribution to solving the problem of unemployment.
b) A reduction in the rate of growth of labor productivity would help, but this would of course
reduce the growth of living standards of those in work.

c) A rise in the saving ratio could narrow the gap. This is at the heart of monetary & fiscal
policies in UDCs.
d) Reducing the capital-output ratio through the use of more labor intensive techniques.
B. Domar’s Model
The American economist Evsey Domar, working independently of Harrod, also arrived at
Harrod's central conclusion, although by a slightly different route. A basic principle emphasized
by Domar and incorporated in all modern growth theory is the dual effect of net investment.
In other words Domar recognized that investment is a double-edged sword: net investment
constitutes a demand for output, and it also increases the capacity of the economy to produce
output. If the expanded capacity is to be fully utilized, aggregate demand in the next period will
have to exceed that of this period. Thus, in general, as long as there is net investment in one
period after another, aggregate demand must rise period after period if expanding productive
capacity resulting from net investment is to be fully utilized. Hence, the question that Domar
asked is what rate of growth of investment must prevail in order for supply to grow in line with
demand (at full employment)? In the words of Domar, if investment increases both productive
capacity and generates income, it provides us with both sides of the equation, the solution of
which may give the required rate of growth.
Increase in Capacity Output
The basic theory involves a simple production function that relates the generation of total output
to the stock of capital via the capital-output ratio. Taking the technique of production as given,
some specified amount of capital goods is necessary to produce a given amount of output. If we
let ‘K’ represent the capital stock and Y the level of output, we may define the average capital
output ratio as K/Y. In contrast, the marginal capital output ratio K/Y tells us how much
additional capital is necessary to produce a specified addition to that flow of output. To simplify
the analysis, we assume that the constant K/Y equals K/Y so that K/Y is also constant (because
technology is constant). The reciprocal of the average capital-output ratio, Y/K, represents the
average productivity of capital. Given an increase in the capital stock, K, Y/K indicates the
ratio of the increase in output to the increase in capital stock. In the simple model Y/K=Y/K.
This ratio of output to capital stock is designed by  (sigma), which Domar calls the “potential
social average productivity.”
Since K in any period equals that period’s net investment, I, Y/K=  may also be expressed
as Y/I=  or Y = I. From this it follows that the cumulative net investment of any period
increases capacity output by I. This is the most important relationship in the model. It must be
noted that Y is not necessarily the actual, or realized, increase in output but rather the potential
increase possible with full utilization of the expanded productive capacity. Since the actual
increase need not necessarily equal the potential, let us now distinguish the actual, or realized,
increase from the potential by appending subscripts: Yr and Yp.

Increase in Aggregate Demand

In a two-sector economy, aggregate demand equals the sum of consumption and investment
expenditures. With a stable consumption function, consumption expenditures will rise only as a
result of a rise in income and therefore a rise in investment expenditure is necessary to initiate a
rise in income. Consequently, we may determine the total rise in expenditures, or income that will
result from any given rise in investment by using the simple multiplier expression:
Y = (1/s) X (I), where s is marginal propensity to save
This rise in income, or expenditure, is matched by an equal rise in actual output, since, with a
stable price level, output responds in proportion to the rise in demand. With subscript ‘r’
designating realized or actual, we have
Actual output = Yr =I/s
The Equilibrium Rate of Growth

There is some rate of growth at which the increase in actual output in each period, Yr, will just
equal that period’s increase in capacity output, Yp. This rate at which Yr=Yp is called the
Equilibrium Rate of Growth. To determine equilibrium in a growing economy, Domar starts with
the assumption that the economy is at full employment equilibrium. From an original period in
which there is equilibrium as given by Yr = Yp, it follows that if the rate Yr/Yr remains equal to
the rate Yp/Yp period after period, Yr will remain equal to Yp period after period. In such situation,
aggregate realized output grows as fast as aggregate potential output, thereby producing a path of
equilibrium growth over time. Since Yr = I/s and Yp = I, the equilibrium rate is also that at
which I/s = I. The left side shows the increment to aggregate realized output for the period, since
this is equal to the increment of aggregate demand, it may be called the demand side. The right
side shows the increment to productive capacity for the period and as such may be called the
supply side. On the right side of the equation, we find not the change in net investment for the
period but the total net investment for the period. The reason of course is that total net investment
for the period times the average productivity of capital determines the change in productive
capacity.
Thus Domar's fundamental equation is
I/s = I multiplied by s yields
I = sI then, dividing by I
I /I = s
The left side of the equation now gives the required rate of growth of net investment. If actual
output is to rise as fast as potential output, the growth rate of net investment must be s, or the
propensity to save multiplied by the productivity of capital. Although I is subject to a multiplier

that makes Y greater than I, we can see that the growth rate of actual output, Yr/Yr must be
the same as the growth rate of investment, I/I. Since in equilibrium Yr = Yp and since Yp =
I, it follows that Yr = I. Furthermore, since I = sY in equilibrium, then by substitution Y=
sY and Y/Y = s. Therefore,
I /I = Y/Y = s
The rate at which actual output and investment must grow in order that actual output remains
equal to potential output is determined by the propensity to save and the productivity of capital. If
 = 1/cr (at full employment), then the Domar result for equilibrium will be
I/I = s/cr
 This is the same as Harrod’s result for equilibrium growth
Similarities and differences between Harrod and Domar Models

Similarities
 Both models have studied the requirement of steady growth with reference to developed
countries
 Assumptions of both models are similar
 Investment or capital accumulation has a central place in both models in the problem of
economic growth
 According to both approaches given the capital output ratio so long as APS = MPS the
equality of saving and investment satisfies the conditions of equilibrium rate of growth
 The Harrod model suggests that for an economy to be constantly at equilibrium, it should
grow at gw.
 In Domar’s model full employment rate of growth is s.
 Harrods gw is similar to Domar's s and Domar's  is the reciprocal of Harrods cr.
Differences
 Harrod uses incremental capital output ratio and the accelerator to build up his model.
But Domar relies on incremental output capital ratio (i.e. inverse of incremental
capital output ratio) and multiplier to formulate his model
 Harrod assumes certain behavioral pattern for entrepreneurs and deduce that it induces
investment. In Domar’s model, no such behavioral pattern has been assumed. He
thinks that proper change in investment comes exogenously.
 For Harrod, business cycle is an integral part of the growth process. Domar, however,
accommodates fluctuations by allowing  fluctuating.
 The causal relationship between investment and income is reverse in both models.
Harrod says that investment is Cr multiplied by changes in income. According to him

income first changes and investment adjusts to it. Thus, income is the active factor in
the model. Domar says that investment multiplied by accelerator is equal to increase
in income. Thus investment is the active factor in Domar's model. In his exposition,
investment first increases and income resulting from it is  times the investment.
Criticisms of Harrod-Domar (H-D) Model

 Fixed coefficient production function: The H-D model assumes that labor and capital
are used in fixed proportions. But H-D model does not allow such substitutability
 Constant assumptions
 The effect of technological progress
 Both models ignore human capital formation
 The two models also fail to consider changes in the general price level. Price changes
always occur overtime and may stabilize otherwise unstable situations.
5.3 Solow’s Model of Long-run Growth
Solow’s model was a response to the Harrod-Domar model and some of its obvious weaknesses,
especially its assumption of a constant capital-output ratio. In the introduction of his 1956 paper,
Robert Solow explained the rationale for his neoclassical growth model: “A remarkable
characteristic of the Harrod-Domar model is that it consistently studies long-run problems with
the usual short-run tools. Instead one thinks of the long run as the domain of the neoclassical
analysis, the land of the margin”.
The model is based on the following assumptions:
 One composite commodity is produced and output is regarded as net output after making
allowance for the depreciation of capital
 There are constant returns to scale. In other words, the production function is
homogeneous of degree one
 The factors of production - labor and capital - are paid according to their marginal
physical productivities
 Prices and wages are flexible
 There is perpetual full employment of labor and stock of capital
 Labour and capital are substitutable for each other and there is unitary elasticity of
substitution between the factors.
 There is neutral technical progress
 The saving ratio is constant
Given these assumptions, Solow shows in his model that with variable technical coefficient there
would be a tendency for capital-labor ratio to adjust itself through time in the direction of
equilibrium ratio. If the initial ratio of capital to labor is more, capital and output would grow more
slowly than labor force and vice versa. Therefore, combining variable proportions of the factors
and using flexible factor prices, Solow showed that the growth path of output was not inherently
unstable. If the labor force grows faster than the stock of capital, the price of labor would fall
relative to the price of capital. If capital grew faster than labor, the wage rate would rise. Solow’s

model is convergent to equilibrium path (steady state) to start with any capital labor ratio with
factor substitutability.
GW=Gn and equilibrium path is stable.
To show the model, Solow takes output as a whole, the only commodity, in the economy denoted
as Y (t). If saving is denoted by S and the rate saving is sY (t). K (t) is the stock of capital. Then
net investment is the rate of increase of this stock of capital, i.e., dk/dt or K. So the basic identity
is
K=sY…………………………………….e1
The production function which shows constant returns to scale is given by

Y=f(K,L) ……………………………….e2
Inserting e2 in e1 we get
K=sf(K,L) ………………………………e3
In e3, L represents total employment.
Since population growth is exogenously determined, the labor force increases at a constant relative
rate n. Thus
L(t)=Loe nt……………………………..e4
In the absence of technological change n is Harrod's natural rate of growth. L(t) is the available
supply of labor at a time (t). The right hand side of equation e4 shows the compound rate of the
growth of labor force from period '0' to period’t’. Alternatively equation e4 can be regarded as a
supply curve of labor. Hence, substituting e4 in e3, we get
K= sf(k,Loe nt)………………………..e5
He regards this basic equation as determining the time path of capital accumulation, k, which must
be followed if all available labor is to be fully employed. It provides the time profile of the
community’s capital stock which will fully employ the available labor. Once we determine the
time path of capital stock & labor force, we can compute the time path of the real output from
the production function. Solow concludes that when production takes place under the usual
neoclassical conditions of variable proportions and constant returns to scale, no simple opposition
between natural and warranted rates of growth is possible. There may not be any knife-edge. The
system can adjust to any given rate of growth of the labor force, and eventually approach a state
of steady proportional expansion i.e.
ΔK/K=ΔL/L =ΔY/Y

Critical Appraisal of Solow’s model
The Solow model is a major improvement over the H-D model. The H-D model is at best a knife
edge balance in a long run economic system where the saving ratio, the capital output ratio and the
rate of increase of the labor force are the key parameters. If the magnitudes of these parameters
were to slip even slightly from the dead center, the consequences would be either growing
unemployment or chronic inflation in Harrods model. This balance is poised by the equality of
GW (which depends on saving & investing habits of households and firms) and Gn (which
depends, in the absence of technical change, on the increase of labor force).
According to Solow's model, this delicate balance between Gw & Gn follows from the crucial
assumption of fixed proportions in production whereby there is no possibility of substituting labor
for capital. If this assumption is abandoned, the knife edge balance between Gw and Gn also
disappears with it. He therefore, builds a model of long run growth without the assumption of fixed
proportions in production demonstrating steady state of growth. Solow’s model is a neoclassical
model which retains the main features of the H-D model such as homogeneous capital,
proportional saving function, and a given growth in the labor force. However, unlike the H.D
model, it demonstrates steady state of growth paths. The assumption of substitutability between
labor and capital gives the growth process adjustability and makes it more realistic. In Solow’s
model, the long run rate of growth is determined by an expanding labor force and technical
progress. Thus Solow has put aside all the difficulties and rigidities of the H.D mode. Despite these
ascertains of Solow’s model, it is weak in many respects.
1. Solow’s model takes only the problem of balance between Harrod’s Gw & Gn and leaves
out the problem of balance between G & Gw.
2. In Solow’s model investment function is absent once it is introduced. The Harrodian
problem of instability quickly appears in the Solow’s model.
3. Solow’s model is based on the assumption of labor augmenting technical progress.
However, low or falling wages do not induce the capitalist to substitute the already in use
capital-intensive technique.
4. Solow’s model is based on the unrealistic assumption of homogeneous capital,
homogeneous labor etc. but capital goods are highly heterogeneous and pose problem of
aggregation.
5. Solow leaves out the causative of technical progress and treats the latter as an exogenous
factor in the growth process. He thus ignores the problems of inducing technical progress
through the process of learning, investment in research & capital accumulation.
Solow assumed flexibility of factor prices, which may bring difficulties in the path towards
steady growth. For instance the rate of interest may be prevented from falling below a certain
minimum level due to the problem of liquidity trap.
5.4 Rostow’s Stage of Economic Growth

Walt W. Rostow uses the historical approach to explain the process of economic development.
The essence of Rostow's stages of growth is that it is logically and practically possible to identify
stages of development and to classify societies according to those stages. According to him, there
are five stages of economic growth; namely, Traditional Society Pre-conditions for the Take-
off, Take-off, drive to Maturity, and Age of Mass Consumption.
The Traditional Society
The traditional society is defined as one whose structure is developed within a limited production
and backward technology. That means production function is based on pre-Newtonian science
and technology. The social structure is hierarchical in which family and class connections play a
dominant role. Political power is concentrated in the hands of the landed aristocracy. More than
75% of the population is engaged in agriculture, which is the main source of income for the state
and the peasants.
The “Pre-condition for Take-off”
Rostow calls the stage between feudalism and take-off the transition stage. During the transition
period all the pre-conditions for sustained economic development are created. It started in Western
Europe and Britain at the end of the 15th century and the beginning of the 16th century, when the
medieval age ended and modern age began. During this age reasoning and skepticism replaced
feudalism and led to the rise of nation states. Such pre-conditions require a number of radical
changes, which include: -
ii) the main economic requirement in the transition period is that

1. The level of investment should be raised to at least 10% of the national income so as
to ensure self-sustaining growth.
2. The main direction of investment must be in building of social overhead capita,
especially transportation and telecommunication to enlarge the market size.
3. A technological revolution in the agricultural sector and a transfer of surplus from
agriculture to industry.
4. an expansion of imports especially capital goods
iii) on the social front
1. a new elite (middle class) must emerge to fabricate the industrial society, and it must
supersede in authority the land-based elite of the traditional society
2. Surplus must be channeled by the new elite from agriculture to industry.
iv) Politically, the establishment of an effective modern government is vital.
Take-off
Take-off is defined by Rostow as “an industrial revolution tied directly to radical changes in
the methods of production having their impact over a short period of time which lasts for

two decades.” The take-off is the most important stage in the life of the society. Economic growth
is a normal condition of the society. Forces of modernization operate against the habits,
institutions, the values and interest of the traditional society and make a decisive break through.
The following are three necessary conditions for take-off:
i) a rise in the rate of productive investments to a level in excess of 10% of the national
income in order for per capita income to rise sufficiently to guarantee adequate
future levels of saving and investment
ii) the development of one or more substantial manufacturing sector with a high
growth rate and
iii) The existence of political, social and institutional framework which can foster
economic development.
Historically, domestic finance for take-off seems to have come from two main sources.
 From diversion of part of the product of agriculture. Example in Japan, USSR

 From enterprising landlords voluntarily ploughing back rents into commerce and industrial.
There are two approaches for take-off:
Aggregate approach-this is based on Harrod model of growth
G = s/y for growth either s/y must be high or c must be low
Leading-sector approach: Rostow emphasized on the importance of leading growth sector for
the take-off. This approach is based on the principle of unbalanced growth theory. It assumes that
simultaneous growth in all the sectors is not possible because of limitation of resources. Some
sectors of the economy will play a leading role. Example, railway transports industry, iron and
steel etc. Different industries played leading role in different countries example, textile in UK; iron
and steel, shipbuilding, and textile in Japan etc.
Rastow argues that an industry can play the role of leading sector in the take-off stage provided
that four conditions are met:
 That the market for the product is expanding rapidly to provide a firm basis for the growth
of output
 That the leading sector generates secondary expansion
 .That the sector has an adequate and continual supply of capital from ploughed back profits
.
 The new production functions can be continually introduced into the sector, meaning scope
for increased productivity

The take-off period is different for different countries. The take-off stages for some of the
developed countries are
UK 1783-1802
France 1840-60
USA 1843-60
Germany 1850-73
Japan 1878-90
Russia 1890-1914
Drive to maturity stage
This stage is defined by Rostow as a period when a society has effectively applied the range of
modern technology to develop the bulk of its resources. This calls for a period of sustained
economic growth extending over four decades. This period is required for new production
techniques to take the place of old ones and the economy being able to absorb unexpected internal
and external shocks. Rostow sees the development of the steel industry as one of the symbols of
maturity. In this stage, three significant changes take place:
a) The character of the working forces changes. They become skilled and organized.
Their real wages start increasing. People prefer to live in urban areas than in rural
areas.
b) The character of entrepreneurship changes. They become polished, polite and efficient
c) The society becomes more industrialized and it leads to more and more changes.
Age of High Mass Consumptions
During this stage, the balance of attention of society is shifted from supply to demand for goods
and services and from problems of production to consumption and welfare. There is a greater
tendency towards mass consumption of durable consumer goods, maintaining full employment
and an increasing sense of security which leads to high rates of population growth.
It should be pointed out, however, that Rostow’s last two stages – “Drive to Maturity” and “Age
of Mass consumption” describe a developed industrial economy and are the result of successful
take-off. The characteristic elements of the second and third stages- 'pre-conditions for take-off'
and 'Take-off' are also more or less similar.
Criticisms of Rostow's Model

Rostow’s model has been severely criticized and rejected as both an absurdity, and an
inappropriate basis for development. In spite of many years of striving and actually satisfying its
pre-conditions especially through the achievement of its savings investment target of 20–25%

neither take-off nor self-sustained development has occurred in most Third world Countries.
Rostow’s stages of growth have thus been rejected on several grounds.
First, it is too rigid, mechanical and deterministic with each stage rigidly leading to the next. There
is no possibility of skipping or merging stages.
Second, the universal applicability claimed for the model is false and totally absurd. Rostow’s
pure traditional society based on the ‘dual’ society thesis cannot be found in any underdeveloped
country because all of them have undergone centuries of relationships and change with
industrialized and other countries, especially through trade.
Third, the linear conception of history in the stages of growth is a-historical. History has not stood
still since the Industrial Revolution of 1750s and it is ridiculous to suggest that all underdeveloped
countries must now travel the route of the currently industrialized countries. For one thing, the
newly industrialized countries (NICs) of South-East Asia did not travel that route with enslavement
and colonization, for example.
Review Questions on Chapter III
a. In a developing country, if population grows at a rate of 2%, productivity of labour improves

at 2%, saving ratio is 10% per annum, and the capital-output ratio is 5 how do you explain
the condition of Gw and Gn? How can equilibrium growth rate be attained?
b. It is said that there is knife-age balance in the Harrod's model. Explain the meaning
c. According to Domar investment is double-aged sword. Elaborate this hypothesis.
d. Take one from the stages identified by Rostow which is relatively applicable to the present
condition of Ethiopia and compare and contrast with Ethiopia taking the social, economic,
and political characteristics of the country.
e. The unbalanced growth theory proposes certain key sector(s) should be selected to promote
development. By taking one or more industrial sectors in Ethiopia, justify how the sector will
meet the desired purpose of development.
f. In what attribute is the surplus theory applicable to Ethiopia? And in what aspects not?
CHAPTER SIX
HISTORY, EXPECTATIONS AND DEVELOPMENT
6.1 Complementarities
The Big Questions
 Are “initial conditions” important in determining final outcomes for countries?

 Does it matter where a country starts its development process from?
 Is it possible that two countries with similar potential for development end up at two
different equilibrium?
 These questions lead to a study of the relationship between history and expectations in
determining the process of economic development.

 Complementarities: is the type of externalities that create incentives (or

disincentives) for economic agents to adopt a common course of action.
 Complementarities are a special kind of externalities. They happen when the cost of an
action is lower (or the benefit is higher) if many agents are undertaking the same
action.
 Example: QWERTY vs. Dvorak keyboards for typewriters and computers
 It makes sense to adopt a technology because everyone else is using or adopting it. This
lowers the cost of adoption and learning for a new user (returns to an individual depends
on what everybody else is doing)
 Even if a new alternative technology appears on the market that is more cost-effective, it
may never get adopted because no one is expected to deviate from the older (and possibly
more inefficient) technology.
 In the figure 5.1, the incumbent technology has a market share N and costs have fallen to
A.
 For a new technology which has a lower cost curve, the cost to produce the first unit will
be B > N
 So new users are better off adopting QWERTY, which perpetuates its market size and
dominance (self-fulfilling feature)
 History plays an important role in determining the equilibrium
 Both history (the existing technology being a leader in the market) and expectations (no
one is expected to adopt the new technology) interact to prevent a new equilibrium from
being attained (even though it is perfectly feasible).
 Therefore, the economy can be stuck in a “bad” or inefficient equilibrium, even though
a “good” or more efficient equilibrium exists.
 This phenomenon is called a coordination failure:
 Individuals fail to coordinate to reach the good equilibrium, either due to history or
expectations about the future, or both.

 Another Example: Highway Congestion:

 What happens when the cost of an action increases with the number of users?
 No complementarities, but negative externalities
 Does history or expectations matter?
 Suppose there are two ways to travel between two cities. Call these Routes A and B.
 Cost to a commuter depends on congestion on the route she is using: the more the traffic,
higher is her adoption cost for a route.
Traffic Congestion
Initially, if route A existed only, cost is YN. Now, if B is set up, cost on B will be YM<YN.
Users will switch to B. This will drive up costs of using B and reduce costs of using A.
Equilibrium is at Z, where users are allocated along both routes.
History does not matter, since there are no complementarities.
 (Anti)Complementarities
 When the cost of an action increases with more adopters, the action is anti-
complementary.
 Anti-complementary actions will not encourage uniform behavior (adoption of a single
equilibrium) by all members of society?
b. Coordination Failure, Linkages and policy, and History versus Expectations
 Coordination Failure
 Coordination is required for society to switch from an inferior to a superior
complementary action, but societies often fail to accomplish this.
 So, a poor country can “lock in” a uniform low rate of investment, which could change
with proper coordination.
 Complementarities can cause an economy to be stuck in a “low-level equilibrium trap.”
 A “better” equilibrium cannot be reached because individuals cannot coordinate their
actions.
 Rosenstein-Rodan (1943): economic underdevelopment is due to a massive
coordination failure
 Critical investments do not occur because complementary investments are not
made

 One feeds on the other perpetually

 But if individuals expect others to make complementary investments, then
coordination can be achieved; otherwise, no one will want to make investments
 Multiple equilibrium (“good” and “bad”), depending on underlying expectations
about the actions of others
 This can explain why regions that have been historically poor remain poor, while others
that have been historically rich become richer, even though there are no intrinsic
differences between them!
 Linkages
Linkages can be crucial in overcoming the coordination problem:
One action or activity might create appropriate conditions for another activity.
A forward linkage lowers the cost of production for another activity
A backward linkage raises the demand for another activity or good.
 Coordination is particularly important when there are strong linkages between industries
(Albert Hirschman)
 Forward linkage—one industry provides inputs for another (steel for
railways)
 Backward linkage—one industry provides demand for another (steel for
coal)

 Linkages and Coordination
 Linkages and Policy

 The Big Push Theory
A historically “depressed” economy can be given a big push by the government:
 A simultaneous creation of coordinated investments in many different
sectors
Problems with the “big push” theory:
 The government needs to know the correct mix of investments (why?)

 Informational requirements are huge and impractical

 Balanced and Unbalanced Growth
Rosenstein-Rodan thought coordination would require the government to give a
simultaneous (balanced) “big push” of all industries at the same time.
Hirschman argued that unbalanced support of selected industries with strong linkages
(Walt Rostow’s “leading sectors”) could stimulate a coordinated expansion of all sectors
(Rostow’s “takeoff”).
Instead of all-round investments, government can create incentives selectively for certain
“leading” sectors, and let the market correct the coordination failure.
 Sectors that are “favored” or “promoted” will generate linkages and create
incentives for further investments
 Growth will be “unbalanced” in the short run, but the leading sectors will
eventually pull the economy out of its low-level equilibrium
 Examples of leading sectors: heavy industry, exports, tourism, and agriculture
 History versus Expectations
What we have learnt so far:
 History often determines equilibrium, and makes it difficult for economic agents
to coordinate to “escape” a low level “trap”
 If somehow expectations of economic agents could be changed, economy could
escape the trap to a better equilibrium
Critical question: what prevents expectations from changing?
In the following graph, if the population expected a move from old to new, that would
cause individuals to choose a move to new. But that requires expectations to adjust from
historical experience.
Problem exacerbated by delay – benefits of adjustment are not immediate, so we hope
others will begin the adjustment without us.

 In figure 5.4, though return from New is higher, since OA>OB historically, actual rate of
return in Old is higher than in New.
 People then move from New to Old: in equilibrium, no one lives in New—the lack of a
critical initial mass leads to its failure=>expectations play no role.
 On the other hand, if, for some reason, people were to believe that everyone will be in
New tomorrow=> people start moving to New and no one is left in Old=> history does
not matter.
 However, once a dynamic element is introduced, history comes back with a bang: what if
migration takes time and returns in New are realized only gradually=> this might prevent
migration from Old as everyone “waits” for a critical mass to develop in New!
 Other Roles for History
 Social Norms:
 Individual actions are often tempered by what society thinks is “acceptable”.
 Social norms are sustained over time by the immense desire for human beings to
“conform”.
 As development proceeds, certain social norms can be “sluggish” to change.
 The need for conformity can create disincentives for innovation.
 Status Quo:
 The implementation of certain policies can create winners and losers, even though
it raises total welfare of a society.
 Problems can arise due to an inability to value the gains or losses and identification
of winners and losers
 If losers cannot be compensated by winners, then implementing such policies can
be difficult (they may face political opposition) which, in turn, can slow down the
pace of development.
 Change usually creates winners and losers, even if the gains are greater than the
losses
 Compensation of losers may not be credible or implementable
c. Increasing Returns
Definition: A production activity for which an increase in the scale of operation leads
to lower unit costs.
 Transition Cost, Time, and Financial Markets
 Savings from increasing returns do not accrue immediately (partly because of consumer
inertia), so producers experience cost increases hopefully temporary) when they switch
from an old, but widely used, technology to a new one (see next slide).
 This problem would be less serious if capital markets were perfect, which is far from
true in developing countries.
 In the presence of fixed costs, a firm’s average cost of production decreases as its
production volume increases.
 This typically happens in markets that are imperfectly competitive.

 The ability to exploit increasing returns depends on:

 Size of the market
 Size of the market in turn may depend on the firm’s ability to exploit increasing
returns
 The inability to exploit increasing returns can lead to “development traps”
 Increasing Returns and History
 In figure 5.5, a new producer faces average cost b compared to the existing producers.
 If consumers do not switch to the new product instantaneously, new producer will have to
undercut its competitor’s price (say, p) until Q* is reached=> incur huge losses in the short
term.
 But if capital markets are not perfect, these losses may not be sustainable due to lack of
continued credit.
 New firm is unable to exploit increasing returns.
 Increasing Returns and Market Size: Interaction
 Limitations on market size can limit gains from external (rather than internal) economies
(inter-firm division of labor, “roundaboutness” of production, complex intermediate
goods, etc.
 Vicious or virtuous circle of demand, market size, industry-wide productivity, and income
growth.
6.2 Competition, Multiplicity and International Trade
 Competitive market: there is a price at which one can buy or sell unlimited quantities of
a commodity (take prices as given and unaffected by your actions).
 Competitive markets fully internalize the benefits and costs at the fixed price and thus will
not support coordination failure or inability to internalize backward and forward linkages.
 Competitive markets and price–taking behavior the notion that the size of the market
imposes a limit to efficient production simply does not hold.

 Back to the original discussion. See how the interaction of the production of process and
market size can product multiple equilibrium.
 Economy may be “poor” low demand for final product.
 Intermediate goods too expensive for use, so adopt a labor intensive production process.
Production low and keeps demand low.
 Virtuous circle.
 High demand for final product, intermediate goods can be produced via increasing returns,
lower cost, raises demand for final product, increased substitution from labor to capital.
Productivity of labor increases so does income as does demand for final product.
 Does it make sense to presume that the seller can sell “unlimited” quantities of a good at
any given price? Yes, if small relative to the overall size of the sector.
 Frictionless international trade competitive market assumption may be compelling.
 Yet, infrastructure is a non–traded good. Likewise, many intermediate goods are
non–traded goods.
 Hence, issues of coordination failure and limited markets apply if at all for
domestically produced and non–traded goods.
 International trade may be able to alleviate some of the difficulties we have discussed
 Success on export markets can alleviate the “market size” limitations on efficiency.
 Access to international markets for intermediate and final goods can provide “linkages”
Chapter Seven
7. Growth, Poverty and Income Distribution
7.1. Introduction
The 1970, witnessed a remarkable change in public and private perceptions about the ultimate nature
of economic activity. In both rich and poor countries, there was a growing disillusionment with the
idea that relentless pursuit of growth was the principal economic objective of society. In the
developed countries, the major emphasis seemed to shift toward more concern for the quality of
life, a concern manifested mainly in the environmental movement. In the poor countries, the main
concern focused on the question of growth versus income distribution. That development required
a higher GNP and faster growth rate was obvious. The basic issue, however, was (and is) not only
how to make GNP grow but also who would make it grow, the few or the many. If it were the rich,
it would most likely be appropriated by them, and poverty and inequality would continue to worsen.
But if it were generated by the many, they would be its principal beneficiaries, and the fruits of
economic growth would be shared more evenly. In this chapter, we will examine the following five
critical questions about the relationship between economic growth, income distribution and poverty.
1. What is the extent of relative inequality in developing countries, and how is this related to the extent
of absolute poverty?
2. Who are the poor, and what are their economics characteristics?
3. What determines the nature of economics growth that is, who benefits?
4. Are rapid economic growth and more equitable distributions of income compatible or conflicting
objectives for low income countries? To put it another way, is rapid growth achievable only at the

cost of greater inequalities in the distribution of income, or can a lessening of income disparities
contribute to higher growth rates?
5. What kinds of policies are required to reduce the magnitude and extent of absolute poverty?
7.2. Inequalities of income
Concepts and Measurement
We can get some idea to question 1 and 2 relating to extent and character of inequality and poverty
in developing countries by pulling together same recent evidence from a variety of sources. In this
section we define the dimensions of income distribution and poverty problems and identify some
similar elements that characterize the problem in many developing countries. But first we should
be clear about what we are measuring when we speak about the distribution of income. Economists
usually like to distinguish between two principal measures of income distribution for both analytic
and quantitative purposes.
 The personal or size distribution of income
 The functional or distributive factor share distribution of income
a) Size Distributions
The personal or size distribution of income is the measure most commonly used by economists. It
simply deals with individual persons or households and the total income they receive. The way in
which that income was received is not considered. What matters is how much each earns
irrespective of whether the income was derived solely from employment or came also from other
sources such as interest, profits, rents, gifts or inheritance. Moreover, the location (urban or rural)
and occupational sources of the income (e.g. agriculture, manufacturing, commerce, services) are
neglected. If Ato Abebe and W/ro Mulu both receive the same personal income, they are classified
together irrespective of the fact that W/ro Mulu may work 15 hours a day as a doctor which Ato
Abebe does not work at all but simply collects interest on his inheritance. Economists and
statisticians, therefore, like to arrange all individuals by ascending personal incomes and then
divided the total population in to distinct groups or sizes. A common method is to divide the
population in to successive quintiles (fifths) or deciles (tenths) according to the ascending income
levels and then determine what proportion of the total national income is received by each income
group.
Table 5.1 Size distribution of personal income in a developing country by
Income shares quintiles & Deciles
Personal income Percentage share in total income
Individuals (Money Units) Quintiles Deciles
1 0.8
2 1.0 1.8
3 1.4
4 1.8 5 3.2
5 1.9
6 2.0 3.9
7 2.4

8 2.7 9 5.1
9 2.8
10 3.0 5.8
11 3.4
12 3.8 13 7.2
13 4.2
14 4.8 9.0
15 5.9
16 7.1 22 13.0
17 10.5
18 12.0 22.5
19 13.5
20 15.0 51 28.5
Total 100.0 100 100.0
Measure of inequality = total of bottom 40% to 20% = 14/51 = 0.28
The total or national income of all individuals amounts to 100 units and is the sum of all entries in
column 2. In column 3, the population is grouped in to quintiles of four individuals each. The first
quintile represents the bottom 20% of the population on the income scale. This group receives only
5% (i.e. a total of 5 money units) of the national income. The second quintile (individuals 5 - 8)
receives 9% of the total income. Alternatively the bottom 40% of the population (quintiles 1 plus 2)
is receiving only 14% of the income, while the top 20% (the fifth quintile) of the population receives
51% of the total income. A common measure of income inequality that can be derived from column
3 is the ratio of the incomes received by the bottom 40% and top 20% of the population. This ratio
is often used as a measure of the degree of inequality between the two extremes of very poor and
very rich in a country. In our example, this inequality ratio is equal to 14 divided by 51, or
approximately 1 to 3.7 or 0.28. To provide a more detailed breakdown of the size distribution of
income, deciles (10%) shares are listed in column 4. We see, for example, that the bottom 10% of
the population (the two poorest individuals) is receiving only 1.8% of the total income, while the
top 10% (the two richest individuals) receives 28.5% of the total income.
Lorenz Curve

Another common way to a personal income statistics is to construct what is known as a Lorenz
curve. The Lorenz curve is shown below.
O’
100
90
Percentage of income
Line of Equality
80
I.
70
H.
G.
60 F.
E.
D.
C.
50 B.
A.
O 10 20 30 40 50 60 70 80 90 100
Percentage of income recipients
Fig. 5.1 Lorenz Curve
Dear students, as usual, we have the vertical axis and horizontal axis in the above diagram. On the
horizontal axis, the number of income recipients is plotted, not in absolute terms but in cumulative
percentages. For example, at point 20 we have the lowest (poorest) 20% of the population at point
60 we have the bottom 60%, and at the end of the axis all 100% of the population has been accounted
for. The vertical axis shows the share of total income received by each percentage of the population;
it also is cumulative up to 100% meaning that both axes are equally long.

The entire figure is enclosed in a square; a diagonal line (00’) is drawn from the lower left corner
(the origin) of the square to the upper right corner. At every point on the diagonal 00’ the percentage
of income received is exactly equal to the percentage of income recipients, for example, at point E,
which is the point half way the length of the diagonal line, represents 50% of the income being
distributed to exactly 50% of the population. Similar, at the three quarter point on the diagram, 75%
of the income would be distributed to 75% of the population. In other words, the diagonal line 00’
is representative of "perfect equality" in size distribution of income.
The Lorenz curve shows the actual quantitative relationship between the percentages of income
recipients and the percentage of the actual income they did in fact receive during, say, a given year.
In figure 5.1 we have plotted this Lorenz curve using the docile data contained to each of the 10
deciles groups. Point A shows that the bottom 10% population receives only 1.8% of the total
income; point B shows that the bottom 20% is receiving 5% of the total income, and so on for each
of the other eight cumulative deciles groups. Note that at the halfway point, 50% of the population
is in fact receiving only 19.8% of the total income. The more the Lorenz line curves is away from
the diagonal (perfect equality), the greater the degree of inequality represented. The extreme case
of perfect inequality ( i.e. a situation in which one person receives all of the national income while
ever body else receives nothing) would be represented by the congruence of the Lorenz curve with
the bottom horizontal and right hand vertical axes. Because no country exhibits either perfect
equality or perfect inequality in its distribution of income, the Lorenz curves for different countries
will lie somewhere to the right of the diagonal in Figure5.1. The greater the degree of inequality,
the greater the bend and the closer to the bottom horizontal axis the Lorenz curve will be. Two
representative distributions are shown in Figure 5.2, one for a relatively equal distribution (Figure
5.2a) and the other for a more unequal distribution (Figure 5.2b). (Can you explain why the Lorenz
curve could not lie above or to the left of the diagonal at any point?)
Exercise 5.1

Using the quintiles data on table 5.1, draw a Lorenz Curve
Gini Coefficient
A final and very convenient short hand summary measure of the relative degree of income inequality
in a country can be obtained by calculating the ratio of the area between the diagonal and the Lorenz
curve divided by the total area of the half square in which the curve lies. This is shown below.
=
Gini coff Shaded Area A
Total Area BCD
Fig. 5.3 Gini Coefficient
In the above diagram (fig 5.3) the ratio of the shaded area A to the total area of the triangle BCD is
known as the Gini concentration ratio or more simply as the Gini coefficient, named after the Italian
statistician who first formulated it in 1912. Gini coefficients are aggregate inequality measures and

can vary anywhere from 0 (perfect equality) to 1 (perfect inequality). Gini coefficients for countries
with highly unequal income distributions typically lies between 0.50 and 0.70 while for countries
with relatively equitable distributions, it is on the order of 0.20 to 0.35.
b) Functional Distribution
The second common measure of income distribution used by economists, the functional or factor
share distributions of income, attempts to explain the share of total national income that each of the
factors of production (land, labor and capital) receives. Instead of looking at individuals as separate
entities, the theory of functional income distribution inquiries into the percentage that labor receives
as a whole and compares this with the percentages of total income distributed in the form of rent,
interest, and profit (i.e. the return to land and financial and physical capital). Although specific
individuals may receive income from all these sources, that is not a matter of concern for the
functional approach.
7.2 Inequality and World Poverty

a) Inequality: Variations among Countries
As a first step in determining the significance of the income distribution and poverty problems in
developing countries, let's observe the following table. The figures in the above table (table 5.2)
give a first approximation of the magnitude of income inequality in these developing countries. For
example, we see from the last row that by averaging income shares for different percentile groups
among all 15 countries, on average the poorest 20% of the population receives only 5.2 of the income
the highest 10% and 20% receive 36.0 and 51.8% respectively. By contrast, in a developed country
like Japan, the poorest 20% receives a much higher 8.7% of the income while the richest 10% and
20% get only 22.4% and 37.5% respectively.
Exercise 5.2
What is the relationship between levels of per capita income and degree of inequality? Are higher
incomes associated with greater or lesser inequality or can no definitive statement be made? The
following table (table 5.3) provides data on income distribution in relation to per capita GNP for a
sample of 10 developing countries.
Table 5.3 Per Capita Income and Inequality in Developing Countries, 1990s
Country GNP per capita 1996 (US $) Income Share of Lowest Ratio of Highest Gini
40% of Households 20% to Lowest 20% Coefficient
Bangladesh 260 22.9 4.0 0.28
Kenya 320 10.1 18.3 0.58
Sri Lanka 740 22.0 4.4 0.30
Indonesia 1080 20.4 5.1 0.34
Philippines 1160 15.5 8.4 0.43
Jamaica 1600 16.0 8.2 0.41
Paraguay 1850 8.2 27.1 0.59

Costa Rica 2640 12.8 12.9 0.47

Malaysia 4370 12.9 11.7 0.48
Brazil 4400 8.2 25.7 0.60
Income distribution in measured in three ways as the total share of income received by the poorest
40% of the population, as the ratio of the share going to the richest 20% divided by that of the
poorest 20% and as measured by the Gini coefficient. What clearly emerges from table 5.3 is that
per capita incomes are not highly correlated with any of our three measures of inequality. For
example, we see that Sri Lanka has only one-sixth the per capita income of Brazil, but its three
inequality measures are much less pronounced than Brazil’s. Its Gini coefficient is 0.30 compared
to Brazil's 0.60. Similarly, Paraguay, with income seven times higher than that of Bangladesh,
shows much greater inequality. Conversely, Malaysia, with a 1996 per capita income that is 65%
higher than Costa Rica, has inequality measures that are not much different. We can conclude,
therefore, that there is no apparent relationship between levels of per capita income and the degree
of income concentration over relevant range of LDC incomes.
b) Absolute poverty: Extent and magnitude
So far, we have been looking at relative income shares. Now let's switch our attention from relative
income shares of various percentile groups within a given population to the more significant
question of the extent and magnitude of absolute poverty in developing countries.
What is absolute poverty?
During the 1970'S as interest in problems of poverty increased, development economists took the
first step in measuring its magnitude within and across counties by attempting to establish a
common poverty line. They devised the now widely used concept of Absolute Poverty. Absolute
poverty is meant to represent a specific minimum level of income needed to satisfy the basic physical
needs of food, clothing and shelter in order to ensure continued survival extent of obsolete poverty
is therefore the number of people who are unable to command sufficient resources to satisfy basic
needs. A problem, however, arises when one recognizes that those minimum subsistence levels will
vary from country to country and region to region, reflecting different physiological as well as social
and economic requirements. Economists have therefore tended to make consultative estimates of
world poverty in order to avoid unsubstantiated exaggerations of the problem. One common
methodology has been to establish an international poverty line at say, a constant $370 (based for
example, on the value of the 1985 dollar) and then attempt to estimate the purchasing power
equivalent of money in terms of developing country's own currency. The international poverty line
knows no boundaries, is independent of the level of national per capita income, and takes into
account differing price level by measuring poverty as anyone living on less than $1 a day in PPP
dollars.
Exercise 5.3
Let's assume that the poverty line is set at $360. If two individuals A and B earn $ 350 and $300
respectively, the two are below the poverty line Are two equally poor?
In many respects simply counting the number of people below an agreed on poverty line can have
its limitations. For example, in the above exercise, both individuals are accorded the same weight

when calculating the proportion of the population that lies below the poverty line; clearly,
however, the poverty problem is much more serious in individual B. Some economists, therefore,
attempt to calculate a poverty gap that measures the total amount of income necessary to raise
everyone who is below the poverty line up to that line. To make this clear, let's consider the
following two figures for two countries A and B, where line PV is the poverty line
in country A and country B, 50% the population falls below the same poverty line PV. However
the poverty gap in country A is greater than in country B which implies that it will take more of an
effort to eliminate absolute poverty in country A.
Exercise 5.4
"Higher per capita incomes parse do not guarantee the absence of significant numbers of absolute
poor. It is possible for a country with a higher per capita income to have a large percentage line
and a larger poverty gap than a country with a lower per capita income “Argue on this statement
by relating your answers to exercise 5.2
7.3. Inequality, Growth and the extent of poverty
Does the pursuit of economic growth along traditional GNP maximizing lines tend to improve,
worsen, or have no necessary effect on the distribution of income and the extent of poverty in
developing countries? Unfortunately, economists do not possess any definitive knowledge of the
specific factors that affect changes in the distribution of income over time for individual countries.
Simon Kuznets, to whom we owe so much for his pioneering analysis of the historical growth
pattern of contemporary developed countries, has formulated the relationship between distribution
of income & growth, known as the inverted U hypothesis.
a) The inverted U hypothesis
In his inverted U curve, Simon Kuznets has suggested that in the early stages of economic growth,
the distribution of income will tend to worsen, whereas at later stages it will improve. This
observation came to be characterized by the "inverted U” Kuznets curve because a longitudinal
(time series) plot of changes in the distribution of income - as measured, for example, by the Gini
coefficient - seemed, when per capita GNP expanded to trace out the inverted U shaped curve, as
shown in figure 5.4 below.

Explanations as to why inequality seemed first to worsen during the early stages of economics
growth before eventually improving are numbers. They almost always relate to the nature of
structural change early growth may, in accordance with the Lewis model be concentrated in the
modern industrial sector, where employment is limited, but wages and productivity are high. The
income gap between modern and traditional sectors may widen quickly at first before beginning to
converge. Inequality in the expanding modern sector may be much greater than inequality in the
stagnant traditional sector. Income transfers from the rich to the poor and poverty reducing public
expenditures are more difficult to undertake by governments in very low-income countries. Having
examined the relationship between inequality and levels of per capita income, let's look now at
the relationship, if any, between economic growth and inequality. In the figure below (Figure 5.5)
we have plotted rates of growth of GNP for 13 developing countries on the horizontal axis and the
growth rate of income of the lowest 40% of their population along the vertical axis. The data are
for the time span shown in parentheses after each country, and the scatter is intended to reveal any
obvious relationships between GNP growth rates and improvements in relative income levels for
the very poor. Each country's data, therefore, are plotted in the figure at a point reflecting its
combination of GNP growth and the income growth of the lowest 40% of its population. The 45
degree line shows a proportionate growth in percentage growth rate of gross national product and
percentage growth rates of incomes of bottom 40% of population. Countries above the 45 degree
line are those where the distribution of income has improved that is, the incomes of the bottom 40%
grew faster than the overall GNP growth whereas countries below the 45 degree line have
experienced a worsening of their income distributions over the indicated period. The scatter of points
in the above figure does not reveal any strong or obvious relationship between GNP growth and the
distribution of income. High growth rates do not necessarily worsen the distribution of income
indeed; countries like Taiwan, Iran, and South Korea experienced relatively high rates of GNP
growth and exhibited improved or at least unchanged distributions of income. Nevertheless,
countries like Mexico and panama grew just as fast but experienced a deterioration of their income
distribution. However there does not seem to be a necessary relationship between low GNP growth
and improved income distribution. In developing countries like India, Peru and the Philippines, low
rates of GNP growth appear to have been accompanied by a deterioration of the relative income

shares of the bottom 40%. And yet Sri Lanka, Colombia, Costa Rica, and El Salvador, with similarly
low GNP growth rates, managed to improve the relative wellbeing of their low-income population.
Note that in all cases the poor did share in some of the benefit of economic growth even though
there is no direct, positive relationship between rate of growth and degree of improvement.
The data from fig. 5.5 suggest that it is the character of economic growth (how it is achieved, who
participates, which sector are given priority, what institutional arrangements are designed and
emphasized etc.) that determines the degree to which that growth is or is not reflected in improved
linking standards for the very poor. It is not the more fact of rapid growth per se that determines
the nature of distributional benefits.

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ODA BULTUM UNIVERSITY

DEPARTMENT OF AGRICULTURAL ECONOMICS

DEVELOPMENT ECONOMICS (AGEC-442) MATERIAL FOR

BY: Fekadu A. (MSc in Agricultural economics)

1. Economics and Development Studies

1.1 Definition and Concept of Development Studies

Presently, therefore, Todaro succinctly puts the definition of development as follows:

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What Is Development Economics?

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Thus development studies pay attention to involuntary deprivation of fundamental material

What is economic development not about, you might ask?

What Is Economic Development, Then?

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1.2 Current Interest in Development Economics

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The New International Economic Order

The Mutual Interdependence of the World Economy

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Development Economics is beyond traditional economics and political economy. In addition

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2.1.1 Economic Growth and Development in Traditional Perspective

2.1.2 Development Economics in Retrospect (The New View of Development)

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to be redefined in terms of the reduction or elimination of poverty, inequality, and unemployment

Development must, therefore, be conceived of as a multidimensional process involving major

2.2. Core Values of Development

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2.3. Meaning and Challenges of Development (self-read assignment)

2.4. Measuring Development: Key Indicators

2.4.1 Per Capita Income as an Index of Development

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 Savings are undertaken by a small percentage of the population

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2.4.1.1 The measurement and comparability of per capita income

1) Problems associated with national income accounting

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Assume also that:

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Country At official exchange rate At PPPs exchange rate

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United States 28740 28740

2.4.2 Alternative development Indicators

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 The invalidity of the GNP/GDP indicator as a measure of wellbeing in situations where

a. The physical Quality of Life Index (PQLI)

PQLI = Life expec. Index + infant mort. Index + literacy index

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Example: Consider the following hypothetical assumption of scaling

PQLI Absolute figure Scale given

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 longevity:- as measured by life expectancy at birth

Index = Actual value – Minimum value

Maximum value – Minimum value

 Life Expectancy Index =