Classic Theories of Economic

Growth and Development

GROUP 5
RANJO, KYLE DOMINIC
REYES, JANNZ TRISHA
RODRIGUEZ, MARIA CRISTINA
ROMANO, PATRICIA MARIEL
SILVANO, CARL RYAN
3.1. Classic Theories of Economic Development:
Four Approaches

 The Linear-stage-of-growth model

 Theories and patterns of Structural
Change
 The International-Dependence
Revolution
 The Neoclassical, free market
counterrevolution
 3.2. DEVELOPMENT AS GROWTH AND
THE LINEAR-STAGES THEORY
Rostow’s Stages of Growth
1. Traditional Society-This is an agricultural economy of mainly
subsistence farming, little of which is traded.

2. Pre-conditions for take-off-Agriculture become more mechanized

and more output is traded.

3. Take-off-Manufacturing industry assumes greater importance,

although the number of industries remains small.

4. Drive to maturity-Industry becomes more diverse.

5. Age of mass consumption- Output levels grow, enabling increased

consumer expenditure.
The Harrod-Domar Growth Model

- This model is based on the capital

factor as the crucial factor of
economic growth. It concentrates on
the possibility of steady growth
through adjustment of supply of
demand for capital.

• The Harrod-Domar Model suggests that

economic growth rates depend on two
things:

a. Level of Savings (higher savings enable

higher investment)
b. Capital-Output Ratio. A lower capital-
output ratio means investment is more
efficient and the growth rate will be
higher.
 A Simplified model of Harrod-Domar:

 Main factors affecting Economic Growth:

 Necessary versus Sufficient Conditions:
Some Criticisms of the Stages Model

• Unfortunately, the mechanisms of development embodied in the theory of stages

of growth did not always work. And the basic reason they didn’t work was not
because more saving and investment isn’t a necessary condition for accelerated
rates of economic growth but rather because it is not a sufficient condition.

 Necessary Conditions
If we say that "x is a necessary condition for y," we mean that if we don't
have x, then we won't have y. Or put differently, without x, you won't have
y. To say that x is a necessary condition for y does not mean that x
guarantees y.

 Sufficient Conditions
If we say that "x is a sufficient condition for y," then we mean that if we have x, we
know that y must follow. In other words, x guarantees y.
 3.3 The Structural-Change Models

-focuses on the mechanism by which underdeveloped economies transform their

domestic economic structures to a more modern, more urbanized, and more
industrially diverse economy
-it is the hypothesis that underdevelopment is due to underutilization of resources

 Two important example of such models are:

1. Lewis’s Model

2. The Pattern of Development Empirical Analysis by Chenery

 Lewis’s Structural Change Model

-Nobel laureate Lewis said that underdeveloped economy consists of two sectors. A
traditional, over populated rural subsistence sector with surplus labour and a high
productivity modern sector to which this surplus labour is transferred.

-The focus of the model is on the process of surplus labour transfer from the
traditional sector which leads to the growth of output and employment in the
modern sector. Lewis calculated that with an increase of 30% or more in the urban
wages, workers will migrate from the rural areas to the urban areas- which would
lead to growth in output and employment through the modern sector.
Criticisms
-It reflects the historical experience of economic growth in the West

1. Assumes that the faster the rate of capital accumulation the higher is the growth
rate of the modern sector and the faster is the rate of new job creation- but it is not
necessary that the capitalist profits will be re-invested in more sophisticated
labour-saving technologies or there will be no capital flight.

2. Surplus labour exists in the rural areas while there is full employment in the urban
areas- this un supported by empirical literature and is generally not valid.

3. Notion of competitive modern-sector labour market that guarantees the existence

of constant real urban wages up to the point where the supply of rural surplus
labour is exhausted – however, urban wages continue to rise even in the presence
of rising levels of open modern sector unemployment and the existence of surplus
labour in the rural sector due to the presence of unions, civil services wage scales
and Multi National Corporations own hiring practices that tend to negate
competitive forces in the LDC modern sector.

4. Finally evidence suggests that increasing returns prevail in the modern sector
instead of diminishing returns, which means that the modern sector might
continue to use more and more of capital instead of labour.
 Patterns of Development Analysis

-Economic, industrial, and institutional structure of an economy transformed to permit

new industries as engine of growth
-Capital accumulation + changes in economic structure needed
-Constraints (affect level of development)
 Internal (resources, population size, government policies)

 External (access to capital, technology, trade

-Empirical work of Harvard economist Chenery and his colleagues, cross-sectional and
time series studies of countries different levels of per capital income, identifies
characteristic features of the development process:
 Shift from agriculture to industrial production

 Steady accumulation of physical and human capital

 Change in consumer demand from basic necessities to diverse manufactured goods

 Growth of cities and urban industries

 Decline in family size and overall population

-Proponents of structural change model prefer “facts to speak for themselves” unlike
theories such as stages of growth
 Conclusion

-Major hypothesis: development in an identifiable

process of growth and change with features similar in
all countries
-Problem: The model does not recognize differences,
factors influencing development process
-Limitations emphasizing patterns over theory that
may draw wrong conclusions about causality
-Optimistic that “correct” mix of policies will generate
beneficial patterns
 3.4. The International-Dependence
Revolution
-During the 1970s, international-dependence models gained
increasing support, especially among developing-country
intellectuals, as a result of growing disenchantment with both
the stages and structural-change models.

The Neocolonial Dependence Model

•Underdevelopment results from a historical evolution of an unequal
international capitalist system consisting of the centre and the
periphery.
•Groups including landlords, merchants, trade union leaders etc. with high
incomes political power and social status have their interests in link with
the international capitalist system of inequality.
•Underdevelopment is seen as an externally induced phenomenon.
 The False-Paradigm Model
•Underdevelopment is a result of inappropriate advice provided by well-
meaning but uninformed, biased experts from assistance agencies of
developed countries and multinational donor organizations.
•Too much emphasis is placed on attempts to measure capital-output
ratios, to increase savings and investment ratios or maximize GDPs divert
attention from institutional and structural reforms.

 The Dualistic-Development Thesis

•This thesis recognizes the existence and persistence of increasing
divergences between rich and poor nations, and between rich and poor
people at various levels. The urban elites in developing countries will
remain rich and become richer. The wealth of these elite will not trickle
down to the rest of the society.
•Basically, dependency theories highlight the need for major new policies to
eradicate poverty, to provide more diversified employment opportunities,
and to reduce income inequalities.
•Four elements of dualism:
1. Different sets of conditions, of which some are superior and
others inferior, can coexist in a given space.
2. The coexistence id chronic and not transitional.
3. The degrees of superiority or inferiority have a tendency to
increase over time.
4. The superior element does little or nothing to pull up the
inferior element and may in fact serve to push it down.
 3.5
The Neoclassical Counterrevolution: Market Fundamentalism

 Neoclassical Counterrevolution

1. Developed Nations
-This counterrevolution favored supply-side
macroeconomic policies, rational expectation theories, and
the privatization of public corporations.
2. Developing Countries
- It called for freer markets and the dismantling of public
ownership, statist planning, and government regulation of
economic activities.
 The neoclassical counterrevolution can be divided
into three component approaches:

1. Free-market analysis argues that markets alone are efficient—product

markets provide the best signals for investments in new activities; labor
markets respond to these new industries in appropriate ways; producers know
best what to produce and how to produce it efficiently; and product and factor
prices reflect accurate scarcity values of goods and resources now and in the
future.
2. Public-choice theory, also known as the new political economy approach,
goes even further to argue that governments can do (virtually) nothing right.
This is because public-choice theory assumes that politicians, bureaucrats,
citizens, and states act solely from a self-interested perspective, using their
power and the authority of government for their own selfish ends.
3. The market-friendly approach is a variant on the neoclassical
counterrevolution associated principally with the 1990s writings of the World
Bank and its economists, many of whom were more in the free-market and
public-choice camps during the 1980s.15 This approach recognizes that there
are many imperfections in developing-country product and factor markets and
that governments do have a key role to play in facilitating the operation of
markets through “nonselective” (market-friendly) interventions.

Traditional Neoclassical Growth Theory

In terms of GDP growth, this is equivalent to raising domestic savings rates, which enhances
capital-labor ratios and per capita incomes in capital-poor developing countries.

Capital-labor ratio - the number of units of capital per unit of labor.

 Solow Neoclassical Growth Model
-represented the seminal contribution to the neoclassical theory of
growth and later earned Robert Solow the Nobel Prize in economics.1
-More formally, the standard exposition of the Solow neoclassical growth
model uses an aggregate production function in which

where Y is gross domestic product, K is the stock of capital (which

may include human capital as well as physical capital), L is labor, and A
represents the productivity of labor, which grows at an exogenous rate.
-The Solow neoclassical growth model implies that economies will
converge to the same level of income per worker “conditionally”—that is,
other things equal, particularly savings rates, depreciation, labor force
growth, and productivity.
 3.6. Classic Theories of Development :
Reconciling the Difference
 Linear Stages Model
-emphasize the crucial role that savings and investment play in promoting
sustainable long run growth.

 Lewis two sector model of structural change

-importance of transfers of resources frow low to high productivity

 International Dependence Theory

-importance of the structure and workings of the world economy.

 Conventional Neoclassic Economic Theory

-needs to be modified to fit the unique social, institutional and
structural circumstances of developing nations.
 Appendix 3.1 Components of Economic
Growth
1 .Capital accumulation
-some proportion of present income is saved and invested in order to
augment future output and income
*Capital stock - assets that help with the production
*Economic infrastructure-refers to the facilities, activities and services
which support operation and development of other sectors of the economy.
2.Population and Labor Force Growth
-Population growth, and the associated eventual increase in the labor
force, have traditionally been considered a positive factor in stimulating
economic growth.
3. Technological Progress
-Increased application of new scientific knowledge in the form of
inventions and innovations with regard to both physical and human
capital.
 Neutral technological progress -Higher output levels achieved with
the same quantity or combination of all factor inputs.

 Labor-saving technological progress -The achievement of higher

output using an unchanged quantity of labor inputs as a result of some
invention or innovation

 Capital-saving technological progress -Technological progress that

results from some invention or innovation that facilitates the achievement
of higher output levels using the same quantity of inputs of capital

 Labor-augmenting technological progress -raises the productivity

of an existing quantity of labor

 Capital-augmenting technological progress -raises the productivity

of capital by innovation and inventions
 APPENDIX 3.2
SOLOW NEOCLASSICAL GROWTH MODEL

 Robert Solow of the Massachusetts Institute of

Technology, received the Nobel Prize
 Best known model of economic growth
 It implies that economies will conditionally
converge to the same level of income if they
have the same rates of savings, depreciation,
labor force growth, and productivity growth.
 Solow model is the basic framework for the
study of convergence across countries
 The aggregate production function, Y = F(K, L) is assumed
characterized by constant returns to scale.

Cobb-Douglas production function, at any time t we have

where Y is gross domestic product, K is the stock of capital (which may

include human capital as well as physical capital), L is labor, and A(t)
represents the productivity of labor, which grows over time at an
exogenous rate.
 More generally,

 where γ is some positive amount (1.1 in the case of a 10% increase).

Because γ can be any positive real number, a mathematical trick useful in
analyzing the implications of the model is to set γ = 1>L so that

 In the Harrod-Domar model, this would instead be a straight, upward-

sloping line. This simplification allows us to deal with just one argument
in the production function. For example, in the Cobb-Douglas case
introduced in Equation
 Appendix 3.3 Endogenous Growth Theory

 Motivation for the new growth (endogenous) theory

 Mixed performance of neoclassical theories

 External shocks or technical change necessary (FDI, human

investment, etc.)
 Rising output always temporary; convergence to zero
growth
 Cannot analyze causes of technological advance

 Cannot explain large residual differences across countries

 Market reforms of LDCS and no convergence

 Solow (exogenous, neoclassical) vs. Romer
(endogenous)
 Structural similarities
 DMR (Solow) vs. IR (endogenous)

 Spillovers impact rate of return (endogenous)

 (Y=AK)

 No force leading to equilibrium of growth rates

 No income catch-up based on savings rates (prolonged

income gap)