Chapter Two

❑Development Theories and Models

✓ Modernization Theory
✓ Structural Change Theories
✓ Dependency Development Theories
✓ Growth models
 Neoclassical Growth Model
 Endogenous Growth Models
 Introduction
 Within the discipline of Economics, there is
a subcategory of economic development.
✓ Its major focus is to examine the
economic condition of developing
countries with regards to economic, social
and institutional issues and to devise
appropriate policies that improve a
nation’s position economically, socially
and institutionally.
 Consequently, social, economic and political
aspects are included in theories of economic
development, which apply different models
related to different key concept.
 Theories of Development were stimulated
by the situation in the mid 20th century
when decolonization occurred and the
economic disparity between European and
underdeveloped nations became obvious.
 One effective method to identify between
various theories of development is to
recognized and classify them based on the
primary concept each theory identifies as
the driver of economic development.
 Consequently, every theory, having
identified a driving concept, then proposes
specific strategies which should be applied
to achieve economic development.
1. Modernization Theory
 Modernization Theory has been defined as a theory
that uses a systematic process to move underdeveloped
countries to a more sophisticated level of development
through changing traditional views and thinking.
 It is an European-centric normative model of
development that focuses on the cultural change and
institutional reform in non-industrialized countries as
had been done in the then advanced countries.
 Emerged in the late 1950, the theory stresses the
importance of political development in the progress
and improvement of a nations’ economic standing, it
also acknowledges social and cultural reforms to
modernization.
 According to Modernization theory, the reasons
for the lack of industrialization in poor countries is
“irrational” way of resources allocation by the
traditional societies in these countries as well as
cultural, institutional and organizational barriers.
 Therefore, traditional societies became modern by
rationalization of the resource allocation, and by
eliminating cultural, institutional and
organizational barriers that did not allow
countries to develop.
 Theories of Modernization stress the shift to
modern technology and develop institutions and
labor habits which is complementary to
industrial production.
 They also consider the impact of modern beliefs
on people, families and society as a whole.
 Modernization Theory treats development as a
phased process as indicated by Rostow’s stages
of development. Rostow’s linear stages of
development – identified as five stages, gave the
shape to Modernization Theory of development.
✓ Linear Stages of development viewed the
process of development as a series of successive
stages;
✓According to Linear stages process a mix of
saving, investment, and foreign aid is necessary
for economic development and emphasized the
role of accelerated capital accumulation in
economic development following the stages.
Accordingly the five stages of development are:
▪ The traditional society;
▪ The Preconditions for take-off;
▪ The Take-off stage;
▪ The Drive to maturity
▪ The age of mass consumption
1. The traditional society (first stage ) is
characterized by:
✓ Subsistence agriculture or hunting &
gathering; almost wholly a "primary“
sector economy.
✓Limited technology;
✓A static or 'rigid' society: lack of class or
individual economic mobility, with
stability prioritized and change seen
negatively.
2. The preconditions for take-off
 At this stage the society is characterized by change
in Social attitude, expectations, structure and
value system.
 There are radical changes that must take place in
three non-industrial sectors:
✓ Transport and infrastructure expands to enlarge
market, to find out natural resources and for state
to rule effectively.
✓ Agriculture undergoes a technological revolution
and productivity increases to meet the need of the
rising population.
✓ Imports expand financed by efficient production
and market of natural resources for export.
3. The take-off Stage
 Three conditions characterize this stage:-
1. A rise in the rate of productive investment
2. Development of one or more of
substantial manufacturing sectors with a
high rate of growth
3. Existence of cultural framework that
exploits expansion
 At this stage increase in per capita output
should go ahead of the growth of population
to maintain a high level of per capita income
in the economy.
 According to Rowstow three sectors of the economy
have to develop at this stage:-
 a) Primary growth sectors- possibilities of innovation
or of exploiting new resources tend to be a higher
growth rate that in the rest of the economy.
 b) Supplementary growth sectors-due to development
in primary growth sectors, rapid growth takes place
with the development of railways, other
supplementary growth sectors grow as well e.g. iron,
coal and steel industry.
 c) Derived growth sector- production of food, houses
and other sectors grow to meet the demand of
growing population.
 Larger saving must be made to raise effective
demand for the manufactured products and
to create external economies through the
expansion of the leading sector.
 In this way, take-off is initiated by a sharp
stimulus as the development of a leading
sector or political revolution that brings an
outgoing change in the production process.
4. The Drive to Maturity
 According to Rowstow, drive to maturity is;
✓ a period when a society has effectively
applied a range of modern technologies
to the bulk of its resources.
✓Old techniques give way to new ones and
the rate of investment is higher than 10%
of the national income.
✓The economy is strong enough to cope
with unexpected events.
 When a country reaches the stage of
technology maturity the following changes
are visible:-
✓ a) Working forces have change in
character- they are skilled, city dwellers
with rising real wages and organize
themselves to gain more economic and
social security
✓ b) Enterprisership changes- refined and
polite managers in place of rugged and
hardworking masters.
 5. The age of high mass consumption
 High mass production is expressed through
migration of rural inhabitants as workers, greater
use of automobiles, durable consumer goods and
households.
 There are three forces that lead to welfare
increase:-
✓ The pursuit of national interest to increase power and
influence beyond the national frontiers
✓ A more equitable distribution of national income
through progressive taxation, increased social security
and leisure to working class.
✓ Decisions to create new commercial center and leading
sectors like cheap automobiles, houses and
innumerable electric operated household articles.
 Generally Rostow Argued that;
1. All advanced countries already passed the
stage of take-off.
2. LDCs still in the traditional or "pre-
conditions" stage.
3. LDCs only need to follow certain set of rules
to move into take-off stage.
4. Principal strategy for development: Generate
high levels of domestic and foreign saving to
generate sufficient investment to accelerate
economic growth.
Criticism of Linear stage’s theory
 Traditional society not essential for development
 Preconditions may not come before take-off. There is
no reason to trust that an agricultural revolution and
collection of social overhead capital in transport
must come before take-off.
 Overlapping of stages- for example agricultural
development could be observed in the take-off stage
as well.
 Analysis of the take-off neglects the effect of
historical heritage, time of entry into the process of
modern economic growth, degree of backwardness
and other relevant factors on the characteristics of
the early phases of modern economic development in
other countries.
 The other limitation includes:
✓ Many development economists argue that it
was developed with Western cultures in mind
and not applicable to LDCs.
✓ Policy makers are unable to clearly identify
stages as they merge together. Thus, as a
predictive model it is not very helpful.
✓ Saving and investment are NECESSARY but not
SUFFICIENT conditions for growth.
✓ The importance of external and international
influences not considered.
 2. Structural Change Theories
 Two Major Theories
1. Lewis two-sector surplus labor theory
2. Patterns of development theory (Chenery
model) Lewis
 Two-Sector Surplus Labor Theory
❑Focus on the structural transformation of a primarily
subsistence economy with two sectors:
1. Traditional sector:- Overpopulated, rural
subsistence sector with MPLA = 0
2. High-productivity, modern, urban, industrial
sector to which surplus rural labor is transferred
 Lewis Two-Sector Surplus Labor Theory
 Focus on the process of labor transfer and growth
of output and employment in the modern sector :
✓ labor transfer and employment growth from output
growth
✓ speed of output growth determined by rate of
industrial investment and capital accumulation
in urban sector
✓ investments made possible by excess of urban
sector profits over wages, assuming all such
profits are re-invested
✓ level of wage in urban sector fixed and set at
some premium over wage level in traditional
sector
 The Lewis Development Model
 Rural agricultural sector
 Low or even zero Marginal Product of Labor so
that labor is a redundant factor and wage rate is
at the subsistence level
 Urban industrial sector
 Rising demand for unskilled labor to be trained
for industrial growth results in greater
employment and more profits and higher
wages
 Rural-Urban migration
 To find jobs and earn higher wages

3-22
 Criticisms of Lewis Model
 Industrial technology is generally capital
intensive/labor-saving. Hence, the demand for
unskilled rural labor would not increase
employment
 Assumes labor is transferred and employment
created as capital accumulates in modern sector.
But what if profits NOT reinvested due to:
- capital flight
- re-investment in "labor-saving" rather than "labor-
intensive" technology ("anti developmental“
economic growth
 Industrialization must be supported by agricultural
development to supply an ever-increasing supply of
food items and raw materials
3-23
Patterns Development Theory (Chenery Model)
 Focus on the sequential process of economic,
industrial, institutional change
 Assumes that S and I necessary but not sufficient
conditions for growth
 Also necessary are changes in the economic
structure which face constraints in LDCs
 Differences in constraints (domestic and
international) account for differences in
development levels among countries
 International constraints most important since
transition can occur faster with access to
international sources of capital, technology,
manufactured imports, etc.
Patterns Development Theory (Chenery Model)
 Chenery used time series and cross country
models to identify characteristic features of the
development process.
 Identified five characteristic features (not
necessarily stages) of the development process for
countries that have developed:
1. Shift from agricultural to industrial production
2. Steady accumulation of physical and human K
3. Change in composition of consumer demand
4. Growth of cities and urban areas
5. Decline in family size and overall population
growth
3. Dependence Development Theories
Three Types of Theories in This Area
are:
1. Neoclassical dependence models
2. The false paradigm model
3. Dualistic-development thesis
Neoclassical Dependence Models
- Outgrowth of Marxist thinking
- Underdevelopment of LDCs is the result of
dominance by and dependence on industrialized
countries, international special interest groups (
foreign aid agencies, World Bank, and IMF)
- Besides small, elite ruling class in LDCs
perpetuates the dependence
- A large part of underdeveloped world’s continuing
poverty due to the existence and policies of
industrial countries
 Neoclassical Dependence Models
- LDCs can only grow and develop as large
countries grow
- Thus, underdevelopment is an EXTERNALLY
induced phenomenon
- Solution : Revolutionary struggles or major
restructuring of world capitalist system needed
to free LDCs from economic control of DCs and
elite oppressors.
False-Paradigm Model
 Underdevelopment is the result of faulty or
inappropriate advice, well-uniformed biased
recommendations by ethno-centric international
“expert” advisers from DCs
 Advisers base their models and analysis on faulty
assumptions more appropriate for DCs and thus
the problems spread by DC educational
institutions
 Domestic planners and policymakers trained in
“irrelevant” Western concepts
 What is the solution?
Dualistic-development Thesis
 Views the world as composed of divergences
between rich and poor nations
 Four Key Arguments:
1. Different sets of conditions can coexist
2. Such coexistence is chronic
3. The discrepancies in “superior” and “inferior”
conditions will increase over time
4. There is no “trickle down” from the rich to poor
Dualistic-development Thesis
 Structural transformation models create a
“dualistic” pattern of development, resulting in
an ever-increasing degree of economic inequality
both nationally and internationally:
 urban vs. rural
 industrial vs. agricultural
 modern vs. traditional
 rich vs. poor
 Weaknesses of international-dependence
theories
❑These theories call for fundamental, economic,
political, and institutional reforms but several
weaknesses:
1. They offer little explanation of how countries
initiate and sustain development
2. Actual experiences of LDCs pursuing
revolutionary change to achieve development
mostly negative (e.g., Mexico, China, India,
Cuba)
3. The logical conclusion of this theory is that
LDCs should have as little to do with DCs as
possible (self-sufficiency, import substitution)
Weaknesses of international-dependence
theories
❑What do countries experience tell us?
❑East Asian countries such as South Korea, Taiwan,
Singapore,…, pursued export led development
strategies
They interacted with industrial economies
They followed outward looking development policy
❑Latin American countries followed import
substitution (self reliance or inward looking policy)
❑Now: East Asian countries are richer that Latin
American countries
❑What can we conclude?
3. World systems theory
 World Systems Theory was proposed in
the 1970’s, by Immanuel Wallerstein as an
alternative theory to Rostow’s economic
development.
 It is a dependency theory, which emphasizes
that countries do not exist in isolation but
are part of an interconnected world system
in which all countries are dependent on
each other.
 It includes both political and economic
elements so it is sometimes classified as a
theory of political economy.
 World Systems Theory argues that international
trade specialization and transfer of resources from
less developed countries to developed countries
prevented the development in less developed
countries by making them rely on core countries
(advanced countries) and by encouraging
peripheralization.
 World Systems Theory therefore views the world
economy as an international hierarchy of unequal
relations.
 A country can change its position in the global
hierarchy with changes controlled by the “World
System”.
 According to Wallerstein, the nations within the
world system occupy three different positions of
economic and political power: core, periphery,
and semi-periphery and sometimes referred to
as the Core-Periphery model.
 The core countries consists of the strongest,
most powerful nations which monopolize world
finance and, with sophisticated technologies and
mechanized production with manufactured
products that flow mainly to other core nations
(and, to a lesser extent, the periphery and semi
periphery).
 The semi-periphery consists of industrialized
nations that export industrial goods and
commodities, but lack the power and
economic dominance of core nations.
 Finally, the periphery (least-developed
countries)consists of nations whose
economies are less mechanized than those in
the semi periphery—are focused on the
production of raw materials, agricultural
commodities, and human labor for export to
the core and semi periphery.
 The relationship between the core and the
periphery is fundamentally exploitative;
✓ as trade and other economic relations
disproportionately benefit capitalists in the
core.
• Today, immigrants from noncore nations provide
cheap labor for agriculture in core countries.
• The idea of the whole system refers to all the
human interaction networks, small and large, from
the household to global trade, constitute the
world-system.
✓ It is not just a matter of ‘‘international relations’’ or
global scale institutions such as the World Bank.
 At the present time, the world-system may
mean:
✓ all the people of the earth and all their cultural,
economic, and political institutions and
interactions and connections among them.
✓ It looks at human institutions over long periods of
time and;
✓ employs the spatial scales that are required for
comprehending these whole interaction systems.
✓ understood structurally as a stratification system
composed of economically, culturally, and
militarily dominant core societies (competition
with one another in themselves ), and dependent
peripheral and semi peripheral regions.
Classical and Neoclassical Growth Models
1. Classical Models - Harro-Domar
Model –HDM
 HDM is based on the assertion that every
economy must save a certain proportion to
its national income to:-
✓ replace worn-out or impaired capital
goods (buildings, equipment, and
materials)
✓ finance new investments representing
net additions to the capital stock that is
required to bring about growth in GDP
 --------HDM Continued
 Any net additions to the capital stock in the
form of new investment financed from
saving will bring about corresponding
increases in the flow of national output.
 This relationship between the capital stock
and total GNP is known as incremental
capital output ratio (ICOR).

41
 --------HDM Continued
 The final model is expressed as:
g (growth rate) = (s/θ) - δ OR s/ θ = g + δ
 This equation is known as Harrod-Domar growth
equation; where s is saving rate and θ is
ICOR(Incremental Capital Output Ratio) and δ = the
rate of depreciation
❑The policy implication of the model is that growth of
GDP can be raised by pushing up saving rate.
❑Note that for an open economy, policy options related
to overseas borrowing and foreign investment can be
considered in case it faces financial gap i.e. difference
between required saving and actual saving
42
 Criticisms of HDM
1. Even though necessary conditions,
investment and saving are not
sufficient conditions for economic
growth.
✓ We need some kind of skills and
managerial capacity to transform the
potentials of capital investment (saving)
into growth in GDP.
2. There is no consideration for population
growth and demographic explosion.
43
 Neoclassical (Solow growth model)
 Extended on Harrod-Domar by adding a second
factor, labor, and introducing a third independent
variable, technology, to the growth equation.
 It assumed to exhibit diminishing returns to labor
and capital separately and constant returns to both
factors jointly.
✓ This implies that θ is not fixed, rather it depends on the
economy-wide relative endowment of capital and labor
whereby it is small when labor is plenty relative to capital
and vice versa.
▪ Assumes technology as a variable whose level is
determined exogenously, that is, independently of all
other factors, and technological progress is absent
44
 Solow growth model
 The final model of Solo is given by the equation
Δkt = syt – (δ + n)k
✓where
• Δkt is the growth (change in capital per worker)
• s- is saving rate,
• δ is rate of depreciation,
• n labor force growth rate and
• k – capital per worker
 Which states that capital per worker grows when
savings are greater than what is needed to equip
new workers with the same amount of capital as
existing workers have.
45
 Solow growth model
 The situation where output and capital per
worker are not changing is known as steady
state level of k (given as k*) where k*
means the level of capital per worker when
the economy is in its steady state.
 If per capita capital stock converges to k*,
then the per capita income will be y*.
 Note that at the steady state, capital-labor
ratio (k) and thus per capita income (y) are
constant in the long run.
46
 Solow growth model
 The equilibrium (steady state) can be seen from
the following figure
f(k)=Akα

(n + δ)k

y*
sf(k)= sAkα

k* k

47
 Solow growth model
❑The capital per worker k* represents the steady
state.
✓ If k is higher or lower than k*, the economy
will return to it; thus k* is a stable
equilibrium.
❑This stability is seen in the diagram by noting
that to the left of k*, k < k*.
❑The key implication is that, unlike Harrod-
Domar analysis, in the Solow model an increase
in s will not increase output (economic growth)
in the long run; it will only increase the
equilibrium level of k and y.
48
 Solow growth model
 Implication of the model are
1) There is a steady state level of per capita capital
and per capita national income to which the
economy converges.
2) Saving rate doesn’t have a rate effect on the
growth rate; in fact, this simple Solow model
predicts that there is no per capita growth in
the long-run.
3) However, it has a level effect in that it affects
the level of k and y.
4) This is due to Solow’strong assumption of
absence of technological progress.
49
 Solow growth model
 Regardless of the initial per capita income and
capital per worker, according to Solow model,
countries with the same level of s, n, and δ will
converge to the same level of living standard
or per capita income (PCI).
 This is known as convergence hypothesis.
However, the empirical support for Solow’s
claim of convergence of PCI of countries to the
same steady state is weak.

50
 Conclusion on HDM and Solow Model
 In HDM, the ratio of capital to output is constant
and in the Solow model it increases as per capita
increases because of the diminishing marginal
returns to capital.
 Theoretical predictions of HDM and Solow
model : Parameters such s do have rate effect in
HDM but only level effect in Solow model
 Unlike HDM, Solow model predicts convergence
between per capita income of countries given that
they the same s, n, etc.

51
Problems with the neoclassical theory
of development
1. Primary problem is to consider that markets are
efficient. Practically markets are not efficient.
2. Problem of market failures ignored
✓ widespread externalities ;
✓ barriers to economies of scale
✓ market power ;
✓ multinational corporations
✓ subsistence producers (not participating in
market economy)
3. lack of information; profit maximization may
be low priority
52
3. Much of growth is not accounted for by growth
in labor or capital stock. There is what we call
Solow residual.
✓ The Solow Residual: Increases in GNP not
accounted for by adjustments in L or K stock, but
attributed to some "residual”.
✓ The residual is the result of unexplained
exogenous process of technological progress;
➢ Large % of historical growth not explained;
➢ Determinants of the technical progress undefined;
➢ Large differences in residuals across countries

53
The New (Endogenous) Growth Model
 Endogenous growth-is economic growth
process where long-run economic growth is
determined by forces that are internal to the
economic system, particularly related to the
creation and use technological knowledge.
 So when we say (endogenous) or internal to
the economic system, it refers to;
✓ the ability to use technology and thus to
develop new knowledge and new products,
and
✓ the skills of the labor force that complement
knowledge creation and its application are
formed and shaped by each particular
economy.
 In other words, growth is an endogenous process,
coming from within each particular economy, with
each having a different production function
reflecting different quantities and qualities of its
inputs and their ability to adapt, develop and use
knowledge about how to produce within that
economy.
 Therefore, in the long run the rate of economic
growth, as measured by the growth rate of GDP
per person, depends on the growth rate of total
factor productivity (TFP), which is determined in
turn by the rate of technological progress.
Different varieties of the model
 Physical Capital-Based Endogenous
Growth Models (AK Model)
✓Focus on the accumulation of physical
capital and assume that the savings (or
investment) rate has a permanent positive
contribution to the long-run growth rate.
✓AK model did not make an explicit
distinction between capital
accumulation and technological
progress.
 It argued that the aggregate production
function can exhibit an increasing marginal
product of capital
➢when firms accumulate more capital,
some of that increased capital will be the
intellectual capital that creates
technological progress, and
➢ this technological progress will offset the
tendency for the marginal product of
capital to diminish.
 According to AK theory, an economy’s long-
run growth rate depends on its saving rate
and; hence and policy action that increases
the saving rate will lead to a permanently
higher growth rates.
Human Capital-Based Endogenous Growth
Model by Lucas (1988)
 This is another variant of the endogenous
growth model that adds human capital as
factor of production.
 Lucas defined human capital as developments
in skill level where the productivity of a single
worker can be increased by increasing his/her
skill level.
 He postulates that human capital has two
effects:
✓The effect on existing factors of production
and the production function; and
✓ The time allocation that affects human
capital accumulation
 The Lucas (1988) human capital growth
model has two solutions to solve: an optimal
path and an equilibrium path.
✓ The optimal path aims to maximize
consumer utility subject to the production
function and the endogenous human
capital accumulation function.
✓The equilibrium path involves maximizing
the endogenous human capital
accumulation function (Lucas 1988).
Intellectual Capital (Knowledge) - Based
Endogenous Growth Models
 This model recognizes that intellectual
capital, the source of technological progress,
is distinct from physical and human capital.
✓ Physical and human capital are
accumulated through saving and schooling,
✓ but intellectual capital grows through
innovation.
 This model, initiated by Romer (1990),
argued that innovation causes productivity
growth by creating new varieties of products.
Schumpeterian Innovation-Based Endogenous
Growth Model
 This version of Endogenous Growth model
focused on quality-improving innovations
based on Schumpeter’s (1942)
creative-destruction theory((new innovation is
built based on the previous one)
 It postulates that aggregate output is
accumulated through continuous
improvements in intermediate products or
industrial innovations;
➢ that leads to product quality improvements
➢ which raises total factor productivity in the
manufacturing of consumer and capital
goods over time.
Policy implications of endogenous growth
 As technology advances it becomes more
complex, and hence society must make an
ever-increasing expenditure on
research and development just to keep
innovating at the same rate as before.
 Therefore, the way to grow rapidly is not
to save a large fraction of national income
but to devote a large fraction of it to
research and development.
1. In endogenous growth model physical
capital, human capital and knowledge are
not perfect substitutes for one another rather
they are complementary inputs.
2. The models suggest that government
policies can affect the rate of long-term
economic growth by impacting the
accumulation of both physical and human
capital and the effort dedicated to research
and development which creates a new
knowledge.
 Such policies are extremely important in
boosting the long-run rate of growth and the
level of income by shaping future path
dependence.
3. Finally, the endogenous growth models and
their persistence on the existence of pervasive
positive externalities and of the spread of
knowledge suggest a wider arena for public
policy action than is immediately evident from
the simple Solow model.
END OF CHAPTER TWO