Module 5

Economic Growth and Human

Capital
 Productivity Growth and Factor Deepening:
Growth Accounting in the Solow Model

• The Solow (1957) model builds on the Harrod–Domar model in seeking to

explain growth, but adds several neoclassical features to the rigid
technological specification.
• It recognizes that there is a decreasing marginal product to each factor of
production and possible substitutions between labor and capital in production.
• Some countries will choose a more labor-intensive growth path with a low
capital/labor ratio because labor is cheap relative to capital, while others will
choose a more capital-intensive growth path with a high capital/labor ratio
because labor is expensive relative to capital.
• The model also captures a major lesson learned from data analysis after World
War Two: namely, that TFP gains played a very important role in contributing to
observed output growth.
• This means that output growth can come from two sources:
• factor deepening (more labor and/or more capital used in production according to factor
proportions) and
• TFP growth.
• TFP is thus the part of output Y that cannot be explained by factors of production
such as labor and capital.
• TFP growth can originate in technological change (more productive techniques), in
institutional change (better ways of organizing production), or in improvements in
the quality of factors of production such as labor (education, health, skills) and
capital (more productive machines, new seeds in agriculture).
• The model maintains the Harrod–Domar assumption of constant returns to scale
for both factors combined, but with decreasing returns for each factor separately.
• When the TFP growth shifts the production function upward, the aggregate
production function for the economy can be written as
• Y = Af ( K, L),
• where Y is national income, A is the TFP, K is capital, and L is labor
• Because f is assumed to have constant returns to scale, the production
function can also be written as:
•Y/ L = Af( K/ L) or y = Af( k)
• where y = Y/ L is the productivity of labor (or income per capita since L is also
population) and
• k = K/ L is capital intensity, or the stock of capital per worker.
• The aggregate production function, Y = F(K, L) is assumed characterised by
constant returns to scale
•
Factor deepening and productivity growth in the Solow model
• Encouraging technological progress
• Solow model - sustained growth in income per worker must come from
technological progress.
• Technological progress as exogenous; it does not explain it.
• Public Policies
• policies encourage the private sector to devote resources to technological innovation.
• For example, the patent system gives a temporary monopoly to inventors of new
products;
• the tax code offers tax breaks for firms engaging in research and development; and
• government agencies can directly subsidize basic research in universities.
• Establishing the right institutions
• Legal tradition
• English-style countries have better-developed capital markets. Nations with
better-developed capital markets, in turn, experience more rapid growth
because it is easier for small and start-up companies to finance investment
projects, leading to a more efficient allocation of the nation’s capital
• Quality of government
• Ideally, governments should provide a “helping hand” to the market system
by protecting property rights, enforcing contracts, promoting competition,
prosecuting fraud, and so on.
• Yet governments sometimes diverge from this ideal and act more like a
“grabbing hand” by using the authority of the state to enrich a few powerful
individuals at the expense of the broader community.
• Colonial Origins of Modern Institutions
• International data show a remarkable correlation between latitude
and economic prosperity: nations closer to the equator typically have
lower levels of income per person than nations farther from the
equator.
• Both northern and southern hemispheres

• What explains the correlation?

• Tropical climates near the equator have a direct negative impact on
productivity.

• An indirect mechanism of the impact of geography on institutions

(Daron Acemoglu, Simon Johnson, and James Robinson)

• Extractive institutions
• 2024 Nobel Memorial Prize in Economic Sciences
• Daron Acemoglu, Simon Johnson, and James Robinson “for studies of
how institutions are formed and affect prosperity.”
• How do political institutions fundamentally shape the wealth of nations?
This immediately raises a crucial follow-up question—what shapes these
institutions?

Not for the questions asked

or for the answers given,
but for the empirical and
theoretical tools used to
answer those questions
• Used the colonial experience as a natural experiment to study how
institutions affect long-term prosperity.
• Their key argument was that colonial strategies had lasting impacts on
institutional quality, which drove economic outcomes.

• In places where Europeans faced high mortality (like tropical areas with
malaria), they set up extractive institutions designed to transfer resources
back to Europe.
• But in places like Canada and the United States? colonisers formed
inclusive political and economic systems for the long-term benefit of
European migrants.
• The poorest 50 percent of the global population earns less than a tenth of
total income and owns just 2 percent of total net wealth. This inequality is
primarily driven by disparities between countries, which contribute to
approximately two-thirds of global income inequality.
• Such large and sustained cross-country income differences are
inconsistent with the basic growth model, which predicts that, all else
being equal, poor countries should catch up to rich countries over time.
• In reality, all else is not equal.
• Poor countries differ from rich countries when it comes to the proximate drivers
of income and growth, such as investment, population growth, human capital
accumulation, and productivity.
• Moreover, they differ in the nature of institutions – the humanly devised
constraints, both formal and informal, that shape interactions in economic and
political spheres – that have been highlighted as fundamental drivers of prosperity
• So why don’t poor countries simply copy what rich countries have
done and catch up over time?
• According the 2024 Nobel laureats, the wealth of nations is
fundamentally shaped by political institutions. That is, there is a
hierarchy of institutions, with political institutions influencing
economic institutions, and economic institutions then affecting
economic outcomes.
• They explain why some countries, but not others, adopt institutions
favourable for economic growth
• Institutions and prosperity
• Establishing a causal relationship between economic institutions and
prosperity is fraught with challenges.
• structure of institutions at any given time and place is shaped by complex
historical developments, ie., institutions are endogenous.
• no commonly accepted view of how economic institutions should be
conceptualized and, therefore, of how they should be measured.
• Systematically measuring their historical evolution is even harder, given the
limitations in the data.
• Acemoglu, Johnson, and Robinson empirically traced the importance and
persistence of colonial strategies for subsequent economic development.
• They hypothesised that the institutions set up or maintained by colonial
powers have had persistent effects on political and economic institutions
until today.
• ie., the type of institutions – inclusive or extractive – observed in many
low-income countries today can be traced to colonialism.
• The type of institutions that the colonizers created in different colonies
depended on the initial conditions in the colonized areas.
• They created institutions that were beneficial to them. What was beneficial
to the colonizers, in turn, depended on initial conditions in the colonized
areas.
• This also explains the differences in economic prosperity, even among
countries under the same colonizer.
• Their evidence also suggests that the type of institutions implemented by
the colonizers is they key mechanism, although the exact impact of
institutional quality on income is difficult to quantify.
• Institutional persistence and institutional change
• Institutions are almost by definition persistent.
• Yet institutions within a country do sometimes change and institutions
differ across countries.
• For example, private property rights – an economic institution – are well
defined and enforced for all in some countries but not others.
• The constraints on politicians – a political institution – differ widely over
time and countries, with some societies having their leaders constrained
by free and representative elections, while others are ruled by
unconstrained and repressive authoritarian regimes.
• Acemoglu, Johnson and Robinson (2005) defined good economic institutions
as those that enforce property rights for broad segments of the population.
• Such institutions provide incentives for investment and allow the
participation in economic relations for wide cross-sections of society. Good
political institutions allow the majority of the population to have a say in
governance such that the interests of the majority of the population are
taken into consideration (example, democracy vs dictatorship)
• Acemoglu and Robinson (2012) subsequently defined the combination of
economic and political institutions having these features as “inclusive
institutions.” To designate bad institutions, Acemoglu, Johnson and Robinson
(2001) used the term “extractive institutions,” where the rule of law and
property rights are absent for the large majority of the population. Extractive
institutions are more likely to occur when political power resides in the hands
of a narrowly defined elite.
• In places where Europeans faced high mortality (like tropical areas
with malaria), they set up extractive institutions designed to transfer
resources back to Europe.
• But in places like Canada and the United States? colonisers formed
inclusive political and economic systems for the long-term benefit of
European migrants.
• The European colonization led to significant transformations in the
institutions of many regions and countries under their control.
• Across their global empires, European countries implemented different
institutions depending partly on how attractive it was for their citizens to
settle in the colonies in large numbers.
• When the conditions deterred European settlements, the colonial
powers instead maintained or introduced institutions that protected the
interests of a small European elite and allowed Europeans to extract as
much resources as possible.

• What were these initial conditions?

• What were these initial conditions?
• Disease environment.
• In tropical areas, mortality among the settlers due to diseases such as
malaria and yellow fever was high. Therefore, Europeans did not enter in
large numbers, and, consequently, they had strong incentives to embark
on an extractive colonization strategy.
• By contrast, in temperate areas – such as Canada and the United States –
these diseases were not prevalent. Mortality was thus lower among the
settlers, Europeans entered the colonies in larger numbers, and inclusive
institutions, favoring the interests of the majority of the population,
were more likely to be implemented.
• Size of the local population. It had two implications.
• First, in places with larger local populations, colonizers faced greater
opposition; because of conflict, mortality among the settlers was high, and
and Europeans entered to a lesser extent.
• Second, where the local populations were large, the areas were prosperous.
This meant there were plenty of resources for the colonizers to extract, and
they designed institutions allowing them to exploit the indigenous population
and capture as much of the resources – e.g., gold, silver, and sugar – as
possible.
• This reasoning has a striking implication: if institutions are important,
colonized countries that were prosperous pre-colonization should be poorer
today because they were more likely to be subject to bad institutions,
featuring, e.g., little protection of property rights.
• Reversal of fortune
• In regions that were prosperous before colonization, i.e., regions that
were densely populated and advanced, it was in the interest of
Europeans to establish extractive economic institutions, with
declining relative prosperity as a result.
• In comparatively poor and less densely populated regions, where
Europeans could easily settle, it was in the colonizers’ interest to
introduce inclusive economic institutions that helped to boost
prosperity for the majority in the long run.
Reversal of Fortune
Settler mortality, institutions, and prosperity
To establish causality, they used early European settler-mortality rates as an
instrument for institutional quality.
 Module 6
Agriculture, Labour,
Migration and Population
• 1. Developing countries’ labor markets are typically highly dualistic,
with a formal sector offering wages above the full-employment
equilibrium, and surplus labor accumulating in the informal sector
with low wages and harsh work conditions.

• 2. Rural–urban migration is an integral component of the structural

transformation of an economy that accompanies GDPpc growth.
• Structural transformation
• Process of shifting an economy's production and activities to higher
value-added and higher productivity activities. It can also involve an increase
in the share of higher skilled work.
• Long-term shift in an economy's fundamental institutions, characterized by:
• A change in productivity in the modern sector
• A movement of the workforce from labor-intensive activities to skill-intensive ones
• The reallocation of economic activity across the three broad sectors of agriculture,
manufacturing, and services
• A declining share of agriculture in GDP and employment
• Rural-to-urban migration
• A demographic transition from high to low rates of births and deaths
Labour and Employment
• The employment problem in developing and
industrialized countries

• The employment problem takes different forms in

different countries.

• Developing countries vs Developed countries

 Labour and Employment
• In developing countries, few people can afford to be openly unemployed.
• Since there is typically no formal social assistance provided to the unemployed,
everyone able to work has to generate a living in some way, with different degrees of
success.
• Informal sector - entry is easy, labor productivity is low, labor regulations such as
paying the legal minimum wage and respecting work-safety codes are absent or not
respected, taxes are not paid, social benefits are absent, and value-added is generally
not counted in GDP (though it is often guesstimated).
• Informal-sector employment - working conditions are harsh, pay is low, there are no
social benefits, and workers’ rights are not recognized.
• Because entry to the informal sector is easy, it provides a survival strategy for
unskilled workers and new urban migrants.
• A large informal sector, sprawling urban slums, lack of public services for slum
dwellers, and high congestion externalities are symptomatic of a developing country’s
urban environment.
• It is important to induce more firms to enter into the formal sector, allowing them
access to formal financial institutions and public support and their workers better
conditions.
• The labor problem in industrialized countries is different.
• In continental Europe, employment conditions tend to be rigid, union power
is high, and social benefits comfortable.
• Relatively high rate of unemployment as employers are careful about hiring
new workers that are expensive and that they will have a hard time
dismissing should they want to.
• In the US, by contrast, employment is more flexible, union power generally
weak, and social benefits limited.
• Jobs are often available on a part-time basis, with few if any social benefits.
• As a consequence, the labor problem has historically been of remunerative
wages and social protection for unskilled labor.
• Real wages for unskilled labor falling steadily - disparities between skilled and
unskilled workers rises, contributing to the rise in inequality.
• The labor problem in continental Europe has been one of creating more jobs,
while in the US it has been one of creating better jobs.
 Indicators of unemployment
• Developing countries
• Little open unemployment (due to lack of unemployment insurance and other formal
social-safety nets)
• But, there is a bigger underemployment than unemployment problem.
• Characterizing employment requires indicators that include but go beyond open
unemployment.
• International Labor Office (ILO):
• 1. Open unemployment: includes only people “actively seeking work,”.
• Unemployed - people above a specified age (usually 15), not being in
paid employment or self-employment but currently available for work during the reference
period. (Reference period – 1 week; 1 day; or 1 year)
• 2. Hidden unemployment: defined as “discouraged workers.” They are typically not counted
when characterizing unemployment, leading to an underestimation of the true level of lack of
access to jobs.
• 3. Underemployment :
• when people do not work full time due to seasonal unemployment or to part-time work.
• when people are working in low-productivity jobs relative to their skills and effort level.
Employment in the formal and informal sectors
• The formal and informal sectors are interrelated.
• Excessive regulation in the formal sector can push economic activity into
the informal sector; and
• High wages paid in the formal sector, above the full-employment
equilibrium, can push employment into the informal economy.
• High wages can be due to minimum-wage legislation, labor unions effectively
lobbying for higher wages for their members, and “efficiency wages,” whereby
employers pay wages above the full-employment equilibrium wage as a way of
increasing worker productivity or efficiency.
•
• Informal employment is defined as not receiving social-security
benefits through employment.

• Distribution of total employment (%), India

• Informal economy is highly heterogeneous.
• Part of it is disguised unemployment - a large refuge sector for workers
unable to find employment in the formal sector.
• This segment of the informal sector tends to be counter-cyclical to
formal-sector employment: when formal-sector employment contracts
due to a recession or to rising formal-sector wages, employment in the
informal sector expands.
• But part of the informal economy is complementary to the formal
sector, in particular subcontracting with formal-sector firms. This
segment of the informal economy is pro-cyclical to formal-sector
employment

• Counter-cyclical effect is supported empirically

• An influx of rural migrants, pushed into urban labor markets by
adversity (ex. bad-weather shocks), can crowd out local residents in
the formal-sector labor market and push them into informal
employment.
• Rural migrants pushed by adversity are detrimental to labor-market
outcomes for local residents:
• For local residents, employment declines, especially in the formal
sector, and income falls, especially in the informal sector.
• The impact is largest on low-skill resident workers (and also on
women and young workers): their formal sector employment
declines, they switch to informal-sector employment, and there is a
decline in informal-sector income.
Rural–Urban Migration
• Migration is a huge phenomenon, both domestically and
internationally.
• Domestic migration:
• Mostly rural–rural and rural–urban,
• Urban–rural – not so common; mostly when unemployment or adversity
strikes in the urban environment.
• Domestic migration:
• seasonal, short-term, long-term, or permanent.
• It can be pushed by adversity, or driven by opportunity.
• It can be at the initiative of the migrant, or part of a household strategy
focused on the role of remittances for household welfare.
• Structural transformation and urbanization
• Migration from rural to urban is part of the normal process of structural
transformation of an economy
• As GDPpc rises, the labor force increasingly leaves agriculture and rural areas
to move to urban environments and employment in industry and services.
• The shares of agriculture in total employment and GDP fall, while the shares
of industry and services rise.
• At high levels of GDPpc, the service sector - largest employer in the economy
and the largest contributor to GDP.
• Industry is losing its capacity to generate employment with rising income,
while services are gaining employment capacity, with the same pattern
observed for the share of GDP. This declining role of industry, which has been
called premature deindustrialization (Dani Rodrik, 2015) (Refer Notes)
• worrisome for countries that count on industrialization to help absorb rural–urban
migrants in productive employment.
• Sectoral shares of employment
• Sectoral shares of GDP
• The decision to migrate from the rural to the urban sector responds to expected
income differentials between rural and urban locations in excess of migration costs.
• Importantly, the comparison is not only about private income but also about the
consumption of public goods and services. Public goods are more accessible in the
urban environment, and contribute to attracting migrants.
• Migration helps equilibrate the labor market, shifting labor toward higher
productivity urban employment. In this sense, migration is a “normal” and desirable
phenomenon, contributing to both efficiency gains and poverty reduction.
• However, migration may be excessive if it adds to urban unemployment, contributes
to the sprawl of urban slums, and creates congestion externalities in urban areas.
Eg., the share of the urban population that lives in slums is high in Indian
subcontinent.
• Migration may then displace poverty from the rural to the urban sector instead of
contributing to rising levels of labor productivity and wellbeing. In this case, socially
optimal migration may be less than privately optimal migration.
• The reverse can also hold. Migration may be detained by lack of information,
liquidity constraints, and excessive risk of migration failure given current poverty
levels.
• What induces people to migrate? There are two complementary
theories.
• 1. One is when migration is an individual decision, driven by
self-interest. In this case, it is the expected gain for the migrant that
makes him decide.
• 2. The other is when migration is a household decision, where a
household member migrates to improve conditions for the household
as a whole. In this case, the key motivation in migration is the
remittances that the migrant will send back home, driven by the
household’s collective interest.
Individual decision to migrate: The Harris–Todaro
model
•
• Todaro’s theory - answer to a big puzzle he saw: why is there continuing,
rapid rural–urban migration in spite of the fact that there is high urban
unemployment?
• With a perfect labor market, economic theory predicts that, if there is
unemployment, wages will fall until unemployment is eliminated. At this
equilibrium, both wages will be equal, up to migration costs, and it will no
longer be beneficial to migrate.
• In contrast, the Harris–Todaro model helps explain why migration continues
even with high unemployment, but not forever.
• It does this by looking at how a formal-sector urban wage held above the
full-employment equilibrium induces migrants to take a chance in the hope
of getting the high wage, in spite of high unemployment.
• The Harris–Todaro model is formulated as follows:
•
•
•
• The important message here is that migration is economically rational
for rural migrants in spite of eventually extensive urban
unemployment.
• Unemployment is provoked by a large urban labor-market failure,
whereby the urban wage fails to adjust to unemployment.
• With a large rural–urban wage gap, it is no wonder that we find large
and expanding urban informal sectors and slums.