Chapter three: Governance and

development
At the end of this unit, you should be able to
•Discuss the definitions and meaning of
development.
•Discuss the definitions and meaning of
development studies
•Explain the characteristics and nature of
development.

1
 Meaning of Development
• For almost every writer a different definition of development exists.

 Development is not purely only an economic phenomenon but rather a

multi-dimensional process involving reorganization and reorientation of
entire economic and social system.

 Development is a process of improving the quality of all human lives

with three equally important aspects. These are sustenance, self-
esteem, and freedom from servitude.
 Literarily, development is an off-shoot of growth which implies a sustained
increase in the size of any organism and enriched wellbeing.

 In economics development means improvement in country’s economic (an

increase in National output, identifiable with a sustainable increase in average
income of citizenry of that economy) and social conditions.
2
 Identities (or Core Values) of
Development
 There are three basic components or core
values that serve as a conceptual basis and
practical guidelines for understanding the
inner meaning of development.
 These core values are;
Sustenance,
Self-esteem, and
Freedom. These core values relate to the
fundamental human needs and also represents
common goals sort by all individuals and societies.
3
 Process of Development
 Development as Modernization emphasizes
process of social change which is required to
produce economic advancement; examines
changes in social, psychological and political
processes.
 Development process can also be seen as stepwise
procedures that combine social, cultural, and
technological transformation to create growth,
progress, positive change or the addition of
physical, economic, environmental, social and
demographic components.
4
 Other
• Trends in Gross Domestic Product (GDP): Contribution
of Agriculture, Industry and Services
• Purchasing Power Parity (PPP) Index
• Fiscal Deficit
• Trends in Inflation Rate
• Interest Rates
• Balance of Payment
• Foreign Exchange Reserves
• Crude Oil Rates
• Foreign Direct Investment (FDI) Trends
• Exchange Rate
• Savings/GDP Ratio
• Human Development Index
5
 a) GNP and its growth rate
• Economic development is measured in terms of
an increase in the economy’s real national
income over a long period of time
• Critics
– Fails to take care of population growth
– It does not say any thing about distribution of income
– GNP figures does not reflect social cost of production
such as pollution
– Conceptual difficulties in the measurement of GNP
(under ground economy, public goods, double
counting)
6
 b) GNP per capita
• GNP as a measure of economic development
failed in reducing poverty, unemployment,
inequalities
• GNP per capita is an increase in the per capita
real income over a long period of time
• Increase in real income should be greater
than the growth rate of population

7
 Problems with GNP per capita
• Reliability of data
• An increase in per capita income may not raise
the real standard of living of the masses
• Distribution issue
• Quality of life
• It does not show the level of provision of basic
need such as nutrition, health sanitation, housing
• GNP per capita is not an accurate measure of
development for comparison among countries….
Impact of exchange rate… PPP
8
 The Purchasing Power Parity (PPP)
• Converting GNP of one country measure in
local currency in to an international
currency (common unit of account) using
official exchange rate has a problem
• The conventional approach understates the
living standards in developing countries
• Per capita income of a country equals to:
( GNP )/ ExchangeRate
Population

9
 PPP
• PPP is defined as the number of units of
a foreign country’s currency required to
purchase the identical quantity of
goods and services in the local LDCs
market as a $1 would buy in US
• Generally, prices of non traded services
are much lower in LDCs because wages
are lower
10
 Example
• If GNP of Ethiopia is 300 billion Birr where
total population is 80 million, and the
official exchange rate is 15 birr per USD
• The per capita income of Ethiopia in USD
is : (
300billion
)  15  250USD
80million

 If living standards are to be compared by

this method, it must be assumed that 15
Birr in Ethiopia can buy the same living
standard as a 1 USD in the US.
11
 PPP
• Official exchange rate is not a good measure
of PPP between two countries
• Official exchange rate depends on demand for
currencies traded in international mkts
• PPP depends not only on the prices of traded
goods but also on prices of non traded goods
• The prices of such goods are largely
determined by labor costs and prices of other
inputs
• The implication is that price of non traded
goods would be lower in poor countries
12
 PPP
• Cost of living is cheap in developing
countries for non traded goods
• E.g.1: Price of a hamburger in US could be
5USD and using official exchange rate one
may estimate the corresponding price in
Ethiopia as Birr 45(5*15) which is not
correct
• If cost of a hamburger in Ethiopia is Birr
15, The PPP rate of exchange for
hamburger alone is 5USD/15 Birr=0.33 or
1USD= Birr 3.
13
 PPP
• PP is underestimated for hamburger
• Per capita National Income should be
evaluated in similar fashion using the
new approach
• Divide Per capita income by 3 not 15
• Per capita income increases in
Ethiopia
14
 PPP
• Is a real exchange rate between countries
• Several ways of constructing PPP
• Could be bilateral or multilateral
• Common way is to revalue the national
incomes of two countries by selecting
comparable basket of goods and services
and estimating the PP equivalent of each
item in both countries

15
 E.G for PPP construction
• If P1E is the price of first item in Ethiopia &

• If P1K is the price of second item in Kenya

• The purchasing power equivalent of item 1 in

Ethiopia relative to Kenya is P1E/P1K.

• For N number of commodities, the formula for

purchasing power equivalent in ETH relative to
Kenya is
16
• Is given as: , Q
 1 P1E

Q 1 P1K

• where Q1 is average of the quantities consumed in the two

countries
• The purchasing power equivalent ratio can be then used to convert
once country’s national income (measured in local currency) in to
another country’s currency

 Q1 P1E  4 :1
 Q1PUS
1

• If ,then converting the GDP of Ethiopia to

USD based on official exchange rate requires dividing GDP of Eth by
16 than by 4.
• Irving Kravis and his associates( 1975 and 1978) developed a
method of multilateral comparisons
17
c) Welfare
• Economic development is a sustained increase or
improvement in material wellbeing
• Can be shown by increased flow of goods and
services
• Problems
– GDP may be composed of capital goods
– How a good is produced is also important
(physical pain and sacrifice)
– The equity issue again

18
d) Social Indicators
• Dissatisfaction with GNP/GDP as a measure of
development
• Social indicators are basic needs for
development
• Includes
– Health -----Life expectancy at birth
– Education ------Literacy rate
– Food -----Calorie intake per head
– Water Supply -----Infant mortality %
percentage of population
with access to potable water
– Sanitation ----Infant mortality % percentage of
population with access to potable water
– Housing -----None

19
• Problems with social indicators

– How much items to include in social

indicators
– How to assign weights

– Focus on current welfare

20
 e) The Physical Quality of Life Index
• Developed by Morris in 1979
• Used data of 23 developing countries to measure
the performance of an economy in meeting the
basic needs
• PQLI has three elements
– Infant mortality
– Life expectancy at age one
– Basic literacy at age 15
• Captures health, nutrition ,sanitation drinking
water
21
• Scale for each from 0(worst)-100 (best)
• The index is an average of the three with equal
weights
• PQLI varies from 0-100
• Values
• Infant mortality
– 0 = Gabon’s case of 229/1000 in 1950
– 100=7/1000 in 2000 year
• Life expectancy
– 0= 38 years from Vietnam in 1950
– 100=77 for men and women combined in the
year 2000
22
• Literacy rate at age of 15:
– 0 lower limit
– 100 upper limit
PQLI  Actualvalue  MinimumValue
MaximumValue  MinimumValue
– Limitations
• Can not replace GNP and income
measure
• It does not measure total welfare
• Does not explain the changing structure
of economic and social organization
23
 F) The HDI
• Started in 1990 by UNDP in HDR
• HDI is composed of three index
– Life expectancy
– Adult literacy and Years of schooling
– Real GDP per capita
• Longevity:
Longevity life expectancy at birth
– Ranges from 25 to 85 years
• Educational attainment:
• Adult literacy(2/3 weight) and combined primary,
secondary and tertiary enrolment ratios(1/3
weight)
– Ranges from 0% to 100%
24
• Standard of living: measured by real
GDP per capita based on PPP in USD
(Adjusted real GDP per capita)
– Ranges from 100 to 40,000 USD
• Individually each index can be calculated
as
Actualvalue  MinimumVal ue
Index 
MaximumVal ue  MinimumVal ue
• The HDI is simple average of the three
• The HDI takes ranges from 0 to 1
25
Human Development Index (HDI)

26
 Cut-off points for HDI
• The cut-off points for each category are:
– Low HDI (0.000 to 0.499),
– Medium HDI (0.500 to 0.799),
– High HDI (0.800 to 0.899),
– Very High HDI (0.900 to 1.000).
• Limitations
– The three indicators are not the only variables
– HDI is a relative measure of human development
– Arbitrary weight assignment

27
Table 2.5 Human development index (HDI) and GDI, selected countries, 1990 & 2004
HDI value HDI ranka PPPGDP ranking-HDI Rankingb GDId
1990 2004 2004 2004
High Human Development (HDI > 0.800 in 2004)
Australia 0.893 0.957 3 11 0.956 High Income Economies 0.942
Japan 0.914 0.949 7 11 0.942
United States 0.917 0.948 8 -6 0.946
Middle Income Economies 0.768
United Kingdom 0.889 0.940 18 -5 0.938 Low Income Economies 0.556
Singapore 0.823 0.916 25 -4 --
Korea 0.823 0.912 26 5 0.905
Argentina 0.813 0.863 36 10 0.859
Source:  UNDP (2006: Tables 1 and 2,
Chile 0.787 0.859 38 18 0.850 pp. 283-91; Table 21, 210-13).
Costa Rica 0.793 0.841 48 13 0.831 a The highest, or best, ranking was 1
United Arab Emirates 0.810 0.839 49 -25 0.829
Mexico 0.766 0.821 53 7 0.812
(Norway) in 2004; the lowest, or
Malaysia 0.723 0.805 61 -44 0.795 worst, ranking, was 177 (Niger).
b If positive, the ranking for the
Medium Human Development (0.500<HDI<0.799 in 2004)
Brazil 0.720 0.792 69 -5 0.789 country on the HDI is better than the
Venezuela 0.760 0.784 72 17 0.780 country’s ranking on per capita PPP
Thailand 0.717 0.784 74 -9 0.781 GDP (PPP GDP rank – HDI rank > 0);
Saudi Arabia 0.708 0.774 76 -31 0.744
China 0.628 0.768 81 9 0.765 if negative, the HDI ranking for the
Philippines 0.722 0.763 84 19 0.761 country is worse than the per capita
Turkey 0.682 0.757 92 -22 0.745 PPP GDP ranking (PPP GDP rank –
Sri Lanka 0.706 0.755 93 13 0.749
Jamaica 0.719 0.724 104 6 0.721 HDI rank < 0).
Indonesia 0.626 0.711 108 8 0.704 d Gender-related Development Index;
Vietnam 0.618 0.709 109 12 0.708
South Africa 0.735 0.653 121 -66 0.646
adjusts HDI for differences in
Morocco 0.549 0.640 123 -15 0.615 achievement on the HDI variables
India 0.515 0.611 126 -9 0.591 between males and females.
Botswana 0.680 0.570 131 -73 0.555
Pakistan 0.463 0.539 134 -6 0.513
Bangladesh 0.422 0.530 137 7 0.524
Congo 0.528 0.520 140 25 0.519

Low Human Development (HDI < 0.500 in 2004)

Zimbabwe 0.639 0.491 151 -18 0.483
Kenya 0.548 0.491 152 7 0.487
Rwanda 0.339 0.450 158 -5 0.449
Nigeria 0.407 0.448 159 -1 0.443
Côte d'Ivoire 0.443 0.421 164 -15 0.401
M o za mb i q u e 0.316 0.390 168 -14 0.387
Ethiopia 0.314 0.371 170 1 --
Niger 0.246 0.311 177 -7 0.292 28
 Discussion
Explain how and why economists are
attempting to find ways of measuring
economic ‘development’ as distinct
from ‘growth’.

29
•
Possible answer
Economic growth is most often measured by changes in real Gross Domestic Product
(GDP) over a period of time. On the other hand, Economic development occurs when
there has been an increase in the standard of living across a broad section of the
population. As GDP represents the total value of goods and services produced in an
economy, and not the actual standard of living, a very large GDP does not necessarily
mean that the standard of living will also be high. For example, India is considered to
be a less developed country when it's GDP is 4 times larger than Norway, the country
considered to have the highest standard of living.As a result, economists have
developed different factors to measure economic development. The most widely
accepted measure today is the Human Development Index (HDI). The HDI consists of
three primary factors: Literacy rate (education), GDP per capita (GDP divided by
population) and Life expectancy. It combines all three factors and allocates a number
between 0 and 1 for each country - the closer to 1, the higher the standard of living.
Using GDP per capita is particularly more beneficial than just GDP as it gives an
average estimate of how much income each person in a country receives. As is the
case with India, a country might have a very large GDP, but if it has to be divided by an
extremely large population the average person will not have a high income. However,
it is not a completely accurate measure either as GDP per capita does not account for
income distribution (how evenly income is spread throughout a population) within a
country. Hence, there could be a high GDP per capita but still a considerably large
number of poor people in a country. 30
 Historical Overview of Development Indicators
• A) 1950s and 1960s
• Growth rate in GNP and GNP per capita
• 5-7% growth rate in GNP and GNP per capita
was taken as an indicator of development
• The “Trickle down” effect
• Failed as a measure of development
• Prevalence of malnutrition, high infant
mortality, low life expectancy, wide spread
illiteracy in developing countries despite
achievement of 5% growth rate in GDP
31
 B) 1970s
• Emphasis shifted from the growth rate in
GNP to the quality of development
process
• Progressive reduction in poverty,
unemployment inequalities were given
priorities
• Emphasis shifted from output or growth
approach to income or poverty

32
 c) The 1980s…..”the lost decade”
• Early 1908s there was:
– a decrease in growth rate of developed countries
– Rise in oil price
– Debt crisis in developing countries
– Worsening of terms of trade
• Many countries embarked on Stabilization and Structural
Adjustment
• Stabilization measures were initially supported by WB and IMF
• The programs aim at:
– Reduction in inflation
– Reduction of budget and trade deficits
– Reduced public spending
– Reducing wages and
– Rise in interest rates
33
• Effect: recession in some countries
• Later, guided by WB and IMF, many
developing counties switched to long
term Structural Adjustment Programs
(SAP)
(SAP
• Involves :
– Liberalization,
– Adjustment and
– Privatization
• In effect reducing the role of the state
and opening economies to international
trade and finance
34
• Most LDCs are still pursuing these
programs
• Effect:
Effect
• Reduction in government spending
on social services ( health and
education)
• Poverty and unemployment have
increased
35
 After 1980s
• Sustainability issue was introduced in
1987
• Meeting the needs of the present
generation without compromising the
needs of the future generation
• Human capabilities by Amartya Sen
• Human Development by UNDP….HDI, HPI

36
1Sources of Economic Growth and Development
• The process of economic growth is affected by
two types of factors
1. Economic or real factors
– Are basically natural and human resources,
capital, entrepreneurship and technological
know how
2.Non-economic or socio-cultural factors
– Social institutions, political conditions,
ethical and moral values, historical factors
etc
37
Economic Factors
a) Natural Resources or Land
• Are principal factors of economic growth
• It includes land fertility, forest wealth,
minerals, water, climate condition
• Note that the presence of natural
resources could be a blessing or a curse
• Proper exploitation of natural resources
is a key issue
38
 What are the possible advantages and
disadvantages of LDCs finding deposits of
diamonds?

39
 b) Capital Accumulation
• refers to the stock of physical reproducible factors
of production
• Capital formation or accumulation is when there is
an increase in physical capital
• Is possible through:
• Rise in real saving rates
• The existence of credit and financial institutions

• The use of savings for investment in capital

goods
• Loans and grants
40
Physical Capital: Accumulation of
factors of production especially
infrastructure

41
• Note that saving rates is generally low in LDCs and
governments should go for forced savings
• Forced savings could be done through:
• Taxation
• Deficit financing: spending to boost economy
• the practice of deliberately allowing
government spending to exceed its revenues in
order to try to boost economic activity and
lower unemployment
• Borrowing

42
c) Human Capital
• Refers to the process of increasing
knowledge, skill and the capabilities of
people in a country
• Could be done through expenditure on
education and health services and other
social services
• Uncontrolled population growth is a threat
to economic growth and development
• Need for family planning

43
d) Entrepreneurship
• Implies optimum use or combination of
economic resources
• Very scare resource in developing
countries

44
e) Technological Progress
• Leads to increased productivity of labor, capital
and other resources
• Could be through:
– Invention
– Innovation
– Improvement
• LDCs should adopt modern technology and work
on indigenous skill development since it takes
time to invent or innovate their own

45
F ) Division of labor and scale of production

• Economies of scale and division of labor

reduces cost of production
• Adam Smith gave emphasis on division of
labor
• Division of labor increases labor
efficiency

46
G ) Structural changes and institutional
formations
• Is the transition from a traditional agricultural
society to a modern industrial economy
• it involves a radical transformation of existing
institutions, social attitudes and motivations
• Type of institutions:
– participatory, centralized or democratic
• Sound economic policies
• Property rights and ownership

47
Non economic factors
1) Social factors:
– Includes social attitudes, values and
institutions
• Religion gives less values for the virtues of thrift
and hard work in this world
• Production and consumption decisions are
influenced by customs and traditions
• Social gatherings and ceremonies are also
common in LDCs
• Go for modernization
48
 2. Political and Administrative factors
• Political stability and strong
administration are essential elements of
development of an economy
• It is good for
– Technical progress
– For entrepreneurship development
– Increased capital formation

49
 Political and Administrative factors ……Cont’d
In LDCs and developing countries in general there is:
•Poor administration (no accountability and
transparency)
•Corruption
•Lack of freedom and choice
•Conflicts (clan, ethnic and religious)
•Lack of peaceful transfer of power
– Power from ballot not bullet
•Governance and leadership should be
considered like a relay in athletics
50
Obstacles to Economic Growth and Development
• Are answers for the question why a poor country is
poor?
• They are both causes and consequences of poverty
• The major bottlenecks are:
– The vicious circles of poverty
– Low rate of capital formation
– Agricultural constraint
– Human resource constraint
– Foreign exchange constraint
– Socio-cultural constraint
51
 Definition and Explanation
According to Prof. Nurkse: 

"It is the vicious circle of poverty (VCP) which is

responsible for backwardness of UDCs".

Vicious circle of poverty:

"Implies a circular constellation of forces tending to

act and react in such a way as to keep a country in
the state of poverty".
52
 Obstacle#1: the vicious circle of poverty
-the demand side
• Vicious circle shows circular relationships between
variables that hinder development in LDCs
• A country is poor because it is poor
• Basic problem is that there is low demand and
income as a result of low productivity in LDCs
which is caused by :
– to capital deficiency
– market imperfections
– economic backwardness and
– underdevelopment.
• Poor demand condition in the economy
53
 The Vicious circle… the demand side

Underdevelopment

Lack of
Industrialization

Low Demand for Over Population

in Agriculture
Industrial Products

Low
Low
Agricultural Surplus Productivity

54
55
 The Vicious Circle: the demand Side
• Low agricultural productivity
• Implies low income/surplus
• Leads to low demand for industrial products
• Leads to low rate of investment
• Implies lack of industrialization
(Underdevelopment)
• Implies overpopulation in agriculture
• Finally leads back to low agricultural
productivity
56
The Vicious circle… the supply side
Economic
Underdevelopment
Low Per
capita Income

Low
Productivity Low Savings

Low Capital Low

Per Worker Capital Formation

57
 The Vicious Circle: The Supply Side
• Low per capita income
• Implies low savings
• Leads to low level of investment
• Implies low level of capital formation
• Leads to low level of productivity
• Finally leads back to low level of per
capita income

58
 The Vicious circle: the resource and market side

Underdeveloped
Market Natural Backward
Imperfections Resources People

59
The Vicious circle: the resource and market side
• Underdevelopment is due to
underdeveloped human and natural
resources.
• Development of natural resources depend
on productive capacity of people
• Backward and illiterate people with lack of
technical skill, knowledge and
entrepreneurial ability
• Leads to unutilized, underutilized or ill-
utilized natural resources
• On the other hand, people are economically
backward due to underdeveloped natural
resources

60
• Underdeveloped natural resources are causes and
consequences of backwardness
• Conclusion:
– A country is poor because it is underdeveloped
– A country is underdeveloped because it is poor
– Poverty is a curse and the greater curse is that it
is self-perpetuating
• From Vicious to virtuous circle
• virtuous circle is an increasingly beneficial chain of
events: a chain or cycle of events in which one event
with a beneficial outcome brings about further
events with increasingly beneficial.
61
Obstacle#2: Low Rate of Capital Formation
• Shortage of capital can be taken as the most
pertinent obstacle to economic growth
• Low income and low savings rate in
underdeveloped countries
• Subsistence farming
• Low marginal productivity
• Low income
• Low savings
• Low capital formation
62
• High income groups make some savings
in developing countries
• But their savings generally do not flow in
to productive channels
– They are used for purchase of gold,
jewelry, real state, money lending,
speculation etc
• High income group prefer conspicuous
consumption

63
Reasons for Low level of Capital Formation and
investment in Developing countries
• Lack of law and order
• Political instability
• Small domestic market
• Lack of alternative sources of funds
• Lack of skilled labor and factor mobility
• Inadequacy of basic services such as:
• Transportation services
• Power supply
• Water supply
• Entrepreneurial ability

64
 Obstacle#3: Socio-Cultural Constraints
• Capital is a necessary but not sufficient condition
for development
• There are social resistance to change and
classification of some business roles as inferior.
• Social beliefs, norms, values and religious
considerations are important
– Artisans ,Shoe polishing, farming in Ethiopia
– The Ethiopian names given to a farmer and a
pastoralist in the past indicates the negative
attitude of the ruling parties

65
 Obstacle#4: Agricultural Constraint
• Agriculture, which is dominated by tradition and
custom is the major production in LDCs
• Problems are not the farmers but
– The technology available to farmers
– The incentives for production and investment
– Availability and price of inputs and output
– The provision of irrigation
– Access to markets
– Imperfect markets and information asymmetry

66
Obstacle#5: Human Resource Constraint
• In developing countries, the composition
and skill of the human resource is also a
bottleneck to development
• HR
• Low skill
• Poorly educated
• Work ethics
• Time management
67
 Obstacle#6: Foreign Exchange Constraint
• The gains from trade is favors developed countries
at the expense of developing countries
• Price of their imports and exports exhibit quite
different characteristics
• In relation to export earnings, there are:
– Major exports are agricultural and primary goods and
minerals
– Instability in export prices
– Inelastic supply at least in the short run
– Low income elasticity of demand in foreign markets
– Export items are vulnerable to various shocks such as
bad weather condition
68
 Foreign exchange…… cont’d
• Import items on the other hand are
– Manufactured outputs
– Their prices are generally stable in
international markets
– Most of them are important items that could
not be produced domestically in LDCs (SR)

69
Obstacle#6: Governance and Institutional Constraint
• Lack of good governance
– Corruption
– Limited capacity
– Accountability
– Transparency
– Honesty
• Lack of appropriate institutional arrangements
– Property rights and ownership
– “the tragedy of the commons”

70
 Factors Contributing to Poverty in Ethiopia
1. Work culture and Mental attitude
2. Education, Skill and Experience
3. Socio-political stability
– Internal and external
4. Poor savings culture
5. Low consumption
6. Low level of technological advancement
7. Backward production methods
8. Lack of peaceful power transmission
9. Population growth
10. Lack of good governance, transparency and
accountability
71
 Reasons for Under-development of
Developing Countries
The circumstances or situation whereby economic
growth will fail to promote economic development
can be stated and explained below:
•Inadequate Growth in comparison with Population.
•Widening Inequality in the Distribution of Income.
•Imbalance in Inter-sectoral Development.
•Environmental Degradation and Ecological
Disturbances,
•Moral, intellectual, spiritual and social decadence.
•Economic dependence.
72
 A Way Forward for Developing Countries

 Correction those problems associiated

underdevelopment through policies and strategy
programmes such as;
 Birth control,
 Provision of basic infrastructure facilities to boost
national output,
 Balance development strategy,
 Taken care of ecology and environment,
 Income redistribution,
 Stabilising the polity security wise, and
 Provide social safety net. Also,
73
 Development Theories
It should be noted that development
theories came-up as result of global
yearnings for development of developing
and underdeveloped countries, then,
some developed nations became a
template or caveat upon which the
development models were built for other
to learn.

74
 Development theories seek to
explain development processes
and development inequalities based on
particular characterisations of development.
 Development theory could also be seen as a
collection of models about how desirable
change in society is best achieved.

75
4.1 The Classical Theories of Growth and
Development
• Adam Smith’s Theory
• David Ricardo’s Theory
• The Malthusian Theory
• John B. Say
• John Stuart Mill

76
Adam Smith

(1723-1790)

77
1. Adam Smith
• From June 1723 -July 1790, (aged 67) from Scotland
• Is thought of as the father of modern economics
• Major publications:
– “An Inquiry in to the Nature and Causes of the Wealth of
Nations”…… 1776
– The Theory of Moral sentiments……1759
– The Theory of Moral Sentiments focuses on situations
where man's morality is likely to play a dominant role
among more personal exchanges
• Primarily concerned with the problem of economic
development

78
 Adama Smith
• Basic tenets of Capitalist production that fosters Growth and
Development according to Smith:
• Competition and Modern Free Market
• Division of Labor
• The “invisible hand“
• Technological progress
• Free trade as opposed to mercantilism and
state intervention …..Absolute Advantage
• Economic growth depends on capital accumulation, which in
turn depends on savings from the revenues derived from
working hard
• Specialization, the division of labor, markets, and trade
were, for Smith, the bases of modern economic growth

79
 Elements of Smith’s theory
1. Natural Law
• He believed in the doctrine of natural law
in economic affairs
– Every person is a best judge of his self
interest
– Individuals should be free in making
decisions
– opposed any government intervention in
industry and commerce.

80
• The theory of invisible hand
– The invisible hand refers to the self-
regulating nature of the marketplace in
determining how resources are
allocated based on individuals acting in
their own self-interest.
• He advocated the laissez-faire economy
– is an economic system in which transactions
between private parties are free from
government intervention such as regulation,
privileges, tariffs, and subsidies.
81
 Elements ……Cont’d
• humans are inherently “self-interested”
• one should not expect people to be good or kind
• “It is not from the benevolence of the butcher, brewer or
baker that we expect our dinner, but from regard to their
own interest.”
• Smith preferred “self-interest”—self love mitigated
(controlled) by “virtue”
• “self-love” should be self regulated by the disciplined,
and should that prove insufficient, selfishness (in the
form of greed) should be limited by laws made by the
state.
82
 Elements ……Cont’d
• Justice rather than pure
selfishness should be the basis of
society—with “justice” basically
meaning regulated, principled
self-interestedness

83
 Smith …………..Cont’d
2. Division of Labor
• Breaking the total labor effort of society into
specialized components.
• He believed that specialization and division of labor
improves factor productivity
• Adam Smith introduced the notion of increasing
returns to scale based on division of labor
• According to Smith division of labor increases
productivity through:
– Increase in dexterity or skillfulness of every worker
– Saved time to produce a good
– Invention of alternative methods
• labor-saving machinery invented by persons familiar with
the minute tasks they performed over and over again every
day
84
• the cost of something was made up from the labor that
went into making it…the labor theory of value…..
• “labour . . is the real measure of the exchangeable value
of all commodities”
• The products made by specialized producers in
specialized industrial districts can be exchanged, through
trade and markets, for agricultural products made
elsewhere
• Regulation was to be provided not by the state, which in
Smith’s day was still committed to the interests of the
noble landowners.
• Rather, regulation came from competition among free
individuals acting as buyers and sellers in the
marketplace.
• Over the long run, markets and free competition within
them would force prices toward their natural, or “socially
just,” levels
85
 Elements ……Cont’d
3. Capital Formation
• Capital is a necessary condition for economic
growth
• Depends on the ability of people to save
• According to Smith, source of capital
formation are landlords and capitalists
• The labor class were assumed to be
incapable of saving due to the “Iron Law of
Wages”

86
 Elements ……Cont’d
• The Iron Law of Wages, is a proposed law of
economics that asserts that real wages always
tend, in the long run, toward the minimum
wage necessary to sustain the life of the
worker.
• The theory was first named by
Ferdinand Lassalle in the mid-nineteenth
century.
• "Every tax, however, is, to the person who
pays it, a badge, not of slavery, but of liberty."
87
 Elements ……Cont’d
4. Agents for Growth
•According to Smith the agents of economic
growth are farmers, producers and
businessmen
•Agricultural surplus is a demand for
industrial products
•Industrial advancement promotes
agricultural productivity
88
 Adam smith’s Absolute advantage model
• Adam smith was a leading advocate of
free trade (open markets) on the grounds
that it promotes international division of
labor.
• With free trade nations could
concentrate their production on those
goods they can produce most cheaply,
and import the remaining goods from
other countries at relatively lower price.
89
 Elements ……Cont’d
5. Stationary State
•Growth of the economy is not endless
•It is the scarcity of natural resources that finally
limits growth
•Competition among businessmen would reduce
profits
•Competition for employment would reduce
wages to subsistence level
•Finally investment falls and capital
accumulation stops, profits are minimum,
•The economy will achieve stationary state and
the state of stagnation
90
 Elements ……Cont’d
• Graphically,
Dk/dt
S

0 t

• dk/dt measures the rate of capital accumulation

• The economy achieves stationary state at time t
91
 Application of Smith’s theory to developing countries
• Has limited validity in developing countries
• Reason:
– Small market size which leads to low productivity and
low income
– Low real income but high MPC
– little is saved and invested
– Political, social and institutional assumptions
underlying Smith’s theory are not applicable to the
conditions prevailing in underdeveloped countries
• Development is possible through government
intervention rather than through a laissez-faire
economy
92
 Critics of Smith’s Theory
• Source of savings are only capitalists, landlords
and moneylenders
• The assumption of perfect competition
• Unrealistic assumption of stationary state
• Rigid division of the society in to two
groups….landlords and laborers
– There is middle class today

93
David Ricardo

1772– 1823

94
 David Ricardo
• Was one member of the “philosophical radicals”
• David Ricardo (1772– 1823).
• A British millionaire, trader in securities during the
day
• He devoted his spare time to intellectual pursuits,
eventually writing a rigorous theoretical treatise
on political economics under the title:
• Principles of Political Economy and Taxation, first
published in 1817.

95
 The theories
• In his book he predicted that capitalist economy
would end up in stationary state with no growth
• The law of eventually diminishing returns
• The theory of value
• The theory comparative advantage
– Was his most important contribution
– Is a fundamental argument in favor of free
trade among countries and of specialization
among individuals.

96
The Law of Eventually Diminishing Returns
• With an expanding population and increased
demand for food;
– the margins of agricultural production would
expand,
– cultivation of land of lesser fertility
• increases the cost of grain
• The capitalist would be faced by the higher wage
costs necessary for buying more expensive grain to
sustain workers
• There is also a need to engage in international trade
• There is a natural tendency of the profit to fall in the
economy so that the country ultimately reaches
stationary state
97
• On the other hand, there will be increasing
returns to landlords owning the better lands
• landlords got more revenues even though
they themselves contributed little to the
wealth-creating process (because they
owned land and yet did not work).

98
 Theory of Value
• Ricardo accepted Smith’s labor theory of commodity
value with some modifications (a commodity’s value
was also determined by scarcity)
• The labor theory of value states that the relative
price of two goods is determined by the ratio of the
quantities of labor required in their production
• Similar to Smith, Ricardo was against the land-
owning class.
• Economic world tends to expand, with capitalists
accumulating capital from profits, building factories,
and employing more workers while increasing
wages.

99
• There are three groups of producers
• Landlords
• Capitalists and
• Laborers
• The entire income is distributed among these three
groups as rents, profits and wages respectively
• Ricardo is responsible for developing theories of
rent, wages, and profits
• Rent has the first share out of the total corn
produced and the residual (produce minus rent) is
distributed between wages and profits

100
 The Process of Capital Accumulation
• Capital accumulation is the outcome of profits
• It depends on:
– The capacity to save which depends on net
income of the society
– The will to save
• Wage plays an important role in determining the
rate of capital accumulation
• An increase in prices of commodities (corn) that
form the subsistence of workers leads to an upward
pressure on wage rates

101
• When demand for food items increase;
Less fertile land would be cultivated
More laborers are required
Demand for labor increases
Wage rates tend to increase
 profits tend to fall
Capital accumulation declines

102
 Taxes as sources of capital formation
• Taxes should be levied to reduce conspicuous
consumption
• Taxes adversely affect investment because it implies
transfer of resources from capitalists and laborers to the
government
• Taxes reduce income, profits and capital accumulation
• Tax on land value or land rent was the only form
of taxation that would not lead to price increases;
– it is paid by the landlord, who is not able to pass it on
to a tenant.
– Implication is to tax landlords
103
 The Theory Comparative Advantage
• Like Adam Smith, Ricardo was also an opponent of
Protectionism for national economies, especially for
agriculture
• He argued in favor of free trade
• Ricardo argued that there is mutual benefit from trade (or
exchange) even if one party is more productive in every
possible area than its trading counterpart
• He believed that the British “Corn Laws"—tariffs on
agriculture products---- kept grain (and bread) prices high
– landowners benefited from the industrial revolution
with its increased demand for food and raw materials
– ensured that less-productive domestic land would be
harvested and rents would be driven up
104
• He argued for freeing trade of all state restrictions
—“free trade” would result in lower grain costs that
benefited industrial capitalists through lower wages
– Less money could be paid to workers to buy bread and
other food staples.
• Ricardo believed that the Corn Laws were leading to
the stagnation of the British economy
• Landlords tended to squander their wealth on luxuries,
rather than investments
• Parliament repealed the Corn Laws in 1846.

105
• Ricardo’s main contribution to classical economics,
was a theory of free trade based on the principle of
comparative advantage
• Ricardo used trade between England and Portugal as
a model case.
• The theory suggests that unrestricted exchange
between countries will increase total world output if
each country tends to specialize in those goods that it
can produce at relatively lower costs compared to its
potential trading partners.
106
 Criticism of the Ricardian theory

• Laissez faire policy

• Neglects institutional factors

• Is a distributional theory than a

growth theory

107
Thomas Robert Malthus

1766-1834

108
Malthusian Theory
• Developed by Thomas Malthus
• Thomas Malthus (1766-1834) was a British
economist
• Malthus is known for his two contributions:
– Essay on the Principle of Population (1798)
– Principles of Political Economy
• Malthus's main contribution to economics
was his theory of population, published in
Essay on the Principle of Population (1798).
• Considered as the father of demography
• He devoted his book II of the Principles of
Political Economy to the problems of growth
under the title “the progress of wealth.”
109
• Unfortunately regarded as a pessimist

• His essay was considered to be a “negative”

contribution to the economics of
development
• The poor are themselves responsible for
their poverty because they multiply
irrationally
110
 His Population Theory
• According to Malthus, population tends to
increase faster than the supply of food available
for its needs.
• Population grows in a geometric progression
and tended to double in each generation (2-4-8-
16-32
• Agricultural output can only increase in
arithmetic progression (2-4-6-8-10)
(
• Feeding the population would become
increasingly more expensive task
• This would mean misery for a majority of the
population who are poor
• The system (capitalism) would end up in a crisis

111
• The doubling should be checked either by
nature or human prudence.
• There are two types checks for uncontrolled
population growth: Positive and preventive
checks
• Positive checks are nature’s check or miseries
and
• preventive checks are human carefulness or
“moral restraint”
112
 The eleven positive checks by Malthus
• In order of severity, the eleven positive checks are:
1. Unwholesome occupations
2. Severe labor
3. Exposure
4. Bad and insufficient food and clothing
5. Bad nursing of children
6. Unhealthy living of great towns and manufacturing
factories
7. Common diseases and epidemics
8. Wars
9. Infanticide
10. Plague
11. Famine
113
 Preventive Checks
• Voluntary limitation of population should not be by
contraception, but by :
• late marriage and
• sexual abstinence or chastity before marriage
• Restrain and monogamous life after marriage
• All artificial methods of conception control reduce
the affection of soul and make women “special
prostitutes.”
• These methods encourage promiscuous intercourse
and degrade the female character
114
 The development Model of Malthus
1. Economic development is the function of optimizing
savings and consumption
• Increased savings come from increased productivity
and increased revenue and not from reduction of
consumption
– Too rapid savings destroy the motive and power of
future accumulation
2. Economic Development is the function of increasing
effective demand
• Malthus was the first to write about the consumption
and saving propensities of Keynesian model
• Both consumption and savings are important
115
• Consumption expenditure encourages
investment and future production
• Parsimony or unwillingness to spend money
limits economic growth
3. The tendency towards subsistence wage
• The level of real wages tend toward subsistence
unless the rate of population growth is
sufficiently checked by moral restraints
• Continued population growth of the labor force
will depress the wage rate to the lowest level
compatible with subsistence

116
4. Rent as an inherent appearance in a society
• Rent payment on land is due to three reasons:
1. Land produces more than enough to maintain the life of
its cultivators
2. With increase in population, price of agricultural output
or food supply rises above its cost of production
– Rent is a surplus
3. Difference in land fertility
– Fertile lands are scarce and with population growth
marginal lands should come under cultivation
– High cost of production on the inferior land
– Superior land should pay rent since cost of production
is low
– Rent as a differential surplus

117
 5. The Problem of Commodity Gluts
• There is ever-increasing productive power of the capitalistic
system
– There is overproduction
• Workers have purchasing power of subsistence wage
• Technological advancement worsen things
• The principles of effective demand
• Economic crises through over production
• He supported “unproductive consumption”
– Consumption of luxuries and non-material or services
– It is absolutely essential for an economy with great powers
of production to have a body of unproductive consumers
• Examples of people with “unproductive consumption” are
– Landlords, statesmen, physicians, judges, lawyers, etc.
• “Unproductive consumption” is the “safety valve” which
diminishes the undesirable effects of too rapid accumulation
118
6. The Protectionist View
• He favored restricting free trade in corn
– It encourages domestic production of corn or
grain
– helps to maintain effective demand
– It helps to protect the working mass from severe
business fluctuations (increase in price)
– It would minimize the evil effects of
unemployment during rapid industrialization

119
 The Demographic Transition Model
• The model of demographic transition suggested that a population's mortality
and fertility would decline as a result of social and economic development. It
predicted that all countries would over time go through four demographic
transition stages.

120
 Growth Retarding Factors
• Three factors were mentioned by Malthus
1. Backward sloping supply curve for efforts
both for workers and managers
• No incentive to work hard due to Small domestic
market
• Solution is to broaden market through
international trade and improvement in
transport and communication facilitates

121
2. Lack of structural transformation
– Lack of progressive transformation from
agriculture to industrial economy
3. Lack of technological advancement
– There should be rapid technological
advancement in the industrial sector
– There is diminishing returns for increased
employment on agriculture
– Technological advancement can be used to
neutralize this diminishing returns in agriculture
• In general the interaction between these two
sectors leads to stationary state

122
John B. Say

(1767-1832)

123
 John B. Say
• Was a French economist and businessman
• He had Liberal views and argued in favor of
competition, free trade, and lifting restraints on
business.
• Say’s law of “Supply creates its own demand”
• "Aggregate supply creates its own
aggregate demand"

124
• The exact phrase "supply creates its own demand"
was coined by J.M. Keynes
• Goods are intended to be exchanged for other
goods
• Every act of production simultaneously creates a
market for the product produced
– Workers earn income because of their contribution in the
production of a good
• Aggregate effective demand is equivalent to
aggregate supply
• There will be no over production or glut

125
 John Stuart Mill
• John Stuart Mill (1806-1873), British philosopher-
economist.
• He had a great impact on 19th-century British
thought, not only in philosophy and economics but
also in the areas of political science, logic, and
ethics.
• He studied pre-Marxian socialist doctrine, and,
although he did not become a socialist, he worked
actively for improvement of the conditions of the
working people.

126
 J.S. Mill….Cont’d
• Major writings include:
– Principles of Political Economy (1848),
– The Subjection of Women (1869),
– his Autobiography (1873), and
– Three Essays on Religion (1874).

127
 Main Arguments
• Liberal economy where there is no government
intervention
• The only purpose for which power can be rightfully
exercised over any member of a civilized community
against his will is to prevent harm to others.
• No society was truly free unless its individual citizens
were permitted to take care of themselves
• Human action should arise freely from the character of
individual human beings, not from the despotic
influence of public opinion, customs, or expectations.

128
 J.S. Mill….Cont’d
• The government was never justified in trying to
control, limit, or restrain:
1. private thoughts and feelings, along with their public
expression;
2. individual tastes and pursuits, as expressed through
efforts to live happily;
3. the association of like-minded individuals with one
another.

129
 J.S. Mill….Cont’d
• Mill was in favor of liberty:
• governmental action was legitimate only
when it was demonstrably necessary for
the protection of other citizens from direct
harm caused by any human conduct
• The principles of competition were the
bases of economic laws that could be
outlined with precision and given universal
validity by an abstract science of
economics.
130
 J.S. Mill….Cont’d
• Diminishing marginal productivity in agriculture
productivity could be exceeded by increased
productivity in industrial sector almost without limit
• Hence, economic growth was naturally led by
industry rather than agriculture
• Mills believed that Malthus’s contradiction could be
avoided by workers voluntarily restricting their
numbers
• capitalism and growth were viewed as proceeding
together in relative harmony.

131
 J.S. Mill….Cont’d
• Mill’s most significant contribution to classical
political economy, and to growth theory, lay in
his ideas about values
• Societies could decide to redistribute wealth
through state intervention (beyond labour
theory of values)
• He found notions of competition and the
“struggle for existence” as ideals for economic
life to be merely symptoms of an early, crude
phase of industrial progress.

132
 J.S. Mill….Cont’d
• The existing antagonism between workers and
capitalists could be relieved by:
– profit sharing
– eventually avoided through worker–capitalist
partnerships and
– even workers’ ownership of factories
• Mill thought that laissez faire should be the general
rule, but he found room for many exceptions, as
with poor relief (welfare) or factory legislation
(state regulations on child labor, hours, and
conditions of work, etc.)

133
 J.S. Mill….Cont’d ….Conclusion
• Mill was a radical liberal who believed that
capitalism would eventually give way to
cooperativism
• More extreme socialist versions of these ideas
were worked out by Karl Marx and Frederich
Engels

134
 Summary of the classical issues
• They have similarities and differences in explaining
what determines economic growth
• Possible to present one synthesized model since
basic approach& framework is same for all
– Advocated laissez-faire policy
– Growth and distribution of income and output
between wages and profits are their major
concerns
– Some people feel that it may not proper to mix
them and present one model as a representative
of the classical models
135
 Summary……..Cont’d
1. Growth process is explained by rate of
technological progress and population
growth
• The faster physical capital accumulates,
the faster is economic growth.
2. Production is a function of four factors:
• Stock of capital, labour force, land, and
the level of technology

136
 Summary……..Cont’d
3. Technological progress is constrained by capital
accumulation (by savings and investment)
4. Investment depends on profits
• All productive activities are motivated by profits
5. Labour supply and technological progress determine
the level of profits
• increase in population leads to diminishing productivities
in agricultural sector
• Technological improvement leads to increasing returns in
industries
– The trend of profit depends on the relative strength of
these two tendencies
– Circular reasoning of the classicists
• (Profit I T Profit.)

137
 Summary……..Cont’d
6. The size of labour force is constrained by the
size of the wages fund
• They believe in the “iron-law of wages”
• It is the size of the wages fund or the amount of
money available to pay wages that determines the
rate of population growth
• A rise in wage fund temporarily increases wage
rates which induces workers to have more children

138
 Summary……..Cont’d
7. The wage fund is determined by the
level of investment not by savings
• For Malthus, savings are different form investment due
to the concept of effective demand
8. Profits from business tend to decrease as
business firms continue production
9. The end result of capital accumulation and
economic growth is a stationary state

139
Karl Marx

1818-1883

140
• Was a German philosopher, political economist,
historian, political theorist, sociologist, and
communist revolutionary
• Born in 1818 in Purssia—colony of French
• His ideas played a significant role in the
development of modern communism and socialism
• He worked against capitalist
• His theory of economic development and
transformation has three parts
• Bottom-line of his analysis was his believe that
capitalism will ultimately break down and evolve
into a different system

141
• Marx's major work on political economy was
published in his book:
– A Critique of Political Economy (better known by
its German title Das Kapital)
• It has a three-volumes but only the first
volume was published in his lifetime (the
others were published by Friedrich Engels
from Marx's notes)
• Marx's notes made in preparation for writing
Capital were published years later under the
title Grundrisse.
142
• Marx theory can be called theory of the“ stages of
economic development”
• There are three stages of economic development
– Pre-capitalist (Before capitalism) Development
• Primitive Communism
• Slavery
• Feudalism
– Capitalism and Imperialism
– Socialism and Communism ( the most developed
communism)

143
1. Pre-capitalist development
• Pre capitalist stages of economic development is
characterized by the three stages of:
1. Primitive Communism
– Uncivilized people
– People lived on what they find than what they can grow
– Domestication of animals and primitive agriculture started at
this period
2. Slavery
– Landlords own and exploit slaves
– Workers could be bought , exchanged or even killed at will
– Labor division got extended
3. Feudalism
– Workers were no longer bought and sold like animals
– The guild and the wage system of economic
development developed

144
 2. Capitalism and Imperialism
• Capitalism is an economic system in which private
individuals and business firms carry on the production
and exchange of goods and services through a complex
network of prices and markets.
• Capitalism is primarily European in its origins
• The term capitalism was first introduced in the
mid-19th century by Karl Marx, the founder of
communism
• Imperialism, practice by which powerful nations or
peoples seek to extend and maintain control or influence
over weaker nations or peoples.

145
 Fundamentals of capitalism by Marx
1. The Production function
• Similar to the classical arguments in most cases
• Economic development is a function of material output
which in turn depends on natural resources( land),
labor capital and organization
• Capital accumulation and technology depends on the
rate of savings in the society
– Classicals…..savings depend on abstinence or parsimony
– Marx ….savings depend on the degree of exploitation or “stolen labor”
– Rate of capital accumulation and savings depends on low subsistence
real wages and high rates of profit

146
2. Commodity relations determine human relations
• Economic relationships determine social status
3. Money becomes an asset rather than a medium of
exchange
• Pre Capitalist System: C M C
– Money is a medium of exchange
• Capitalist System: M C M
– Some people get money through devious means of
paying less to workers which they use it buy
commodities produced by others to earn more money

147
4. Workers are not paid according to the “labor
theory of value”
• According to the labor theory of value, the value of
the commodity is equal to the amount of labor hours
used in the production of a good.
• Note:
– Socially necessary labor should be used to measure the
value of a product
– The labor hour of skilled workers can be taken as a certain
multiple of the unskilled workers

148
• Karl Marx pointed out that employers do not pay
the workers the full value of the output produced
by them
• Surplus value of labor hour are retained by firms
• Two types of surplus values might be identified:
– Absolute surplus value and
– Relative surplus value
• Absolute surplus value could be generated by making
workers work for longer hours for the same old wage
• Relative surplus value can be generated by increasing
the productivity per worker by using money and paying
less to workers relative to payment for capital

149
5. Capitalism gets atrophied to Imperialism
• Capitalism is all about exploitation
• Capitalists first exploit their workers people of
their country
• When limits of exploitation are reached, they
try to exploit the workers and people of other
countries
• Capitalism leads to imperialism
• In imperialism, the big capitalists become
“fat” as they are “vampires who thrive on the
blood of the people”
• Capitalists were compared with leeches and
parasites
150
6. “Industrial reserve army” emerges
• Capitalists employ machines to increase labor
productivity and increase surplus value
• They fire workers at a higher rate than they hire
them
• Capitalism creates “relative surplus” labor
• Industrial reserve army of unemployed people
increases

151
7. Down fall of capitalism
• Due to :
– Materialistic contradiction
• Struggle between classes (oppressed against
oppressors)
– Economic contradiction
• Capitalists had a blind race for profits
• Over investment in machinery
• Over investment in production
• Low income paid to workers
• Lack of demand
– Marx rejects Say’s low of Supply creates its own
demand”
• Crisis becomes endogenous problem of capitalism
• Mass misery, oppression, slavery, degradation,
exploitation all increase
152
8. Revolutionary overthrow of capitalism
• Marx wanted the workers to unite and
overthrow the capitalist order by revolt,
revolution and force.
• “force is the midwife of every old society
pregnant of new one”

153
9. Socialism and Communism
• Socialism is a transitory stage from capitalism and
imperialism to communism
• The fundamental principle of Socialism: “from each
according to the ability and to each according to
work”
– He who shall not work shall not eat, except sick, retired,
under-age and house wives.
– Work shall be a matter of right, honour, and glory

154
• Communism was the last stage of
development for max
– “Equality in prosperity”
• The guiding principle could be “from each
according to the ability to each according to
needs.”

155
 Critics of Marxian Theory
• Socialism should not be considered as a transition state
• Whether the rate of profit in capitalism tended to fall is
a subject of debate
• Marx's economic system was based on based on the
classical labour theory of value
– According to Marshall, price, or value, is determined not just
by supply but by the demand of the consumer
– Capital is also an important input
• Keynes argues that Marxist theory is not applicable to
modern world though Joan Robinson argued that
Keynes had never read Marx seriously, if at all.

156
 Marxian Model of Development and Transformation
• Does not assume capitalism to be immutable or
natural order of society, rather one stage of a
society’s historical development
• Agrees with Smith’s analysis of capitalism as an
immensely dynamic system driven by the law of
capital accumulation, characterized by division of
labor and technological progress

157
• Marx criticizes the one sided distribution
(“exploitation of labor by capital”) that results
in the capitalist growth process
• A relatively high-level of income per capita in
a capitalist economic environment is a
precondition for the evolution of a new future
economic system

158
Joseph Schumpeter

(1883-1950)

159
 Schumpeter’s Model: Innovation and Credit Model
I. Background
• An Austrian-born economist sociologist who
spent most of his career at Harvard University
• He was born in the year which Marx died
• Schumpeter died while he was participating in
International Economic Conference
• Schumpeter remained at Harvard for the rest of
his career (starting from1932) after visiting the
United States as an exchange professor at
Columbia University in 1913 and at Harvard
University in 1927 and 1931.

160
Summary of Major Issues and Arguments

161
• Predicted the downfall of capitalism
just like Marx.
– Marx did it with joy while Schumpeter
with regrets
– His position is the same as a physician
who sees the end of his patient but is
always sorry to say so.

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II. Major Arguments
1. Economic development is a function of dynamism
introduced in the economy by the entrepreneur and
innovations
• He theorized that capitalist economic systems depend
on the creativity of entrepreneurs
• He emphasized the entrepreneur's role in stimulating
investment and innovation, thereby causing “creative
destruction.”
• Creative destruction occurs when innovation makes
old ideas and technologies obsolete

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• Land, labour, capital and organization are
important but more important is the
entrepreneur
• They introduce new combinations of production
and this introduces dynamism in the economy
• An entrepreneur creates a new climate by
breaking the old set-up

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 The Five Types of Innovations
1. Introduction of new good in the market
2. Introduction of new method of production
which could reduce cost or lead to increased
output
3. Opening of new market
4. Discovering a new source of supply of raw
materials
5. New reorganization of industry (e.g. making
it monopoly)
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2. Credit capital availability determines the role of
innovations for development
• Economic development is a function of credit
availability
• Without capital and capital market there can
be no development and
• Without development there can be no capital
and capital markets
• Capital market is “the headquarter of
capitalism”
• Development without credit is not possible
and credit creation without development is
equally impossible according to Schumpeter
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3. Profits are the driving forces of development
while interest rates act as a “brake” on
development
• Without profits there can be no economic
development and vice versa
• High wages and interest rates act as a break
on development and
• Can not be abolished just as brakes can not
be taken out from an automobile

167
4. Economic development is the result of
clustering of the innovations
• In Schumpeter's model innovations should
occur in groups
• Development can not take place unless there
are clustering of innovations
• When there is an important innovation, others
start imitating the original autonomous
investment
• Old firms try to defend their old position and
goods and can do that by defensive investment
or new investment
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5. Economic development experiences the four phases
of a business cycle
• Economic development is not a steady process
• There are ups and downs in economic development
• The four phases:
– Prosperity or boom……due to innovation
– Recession….due to death of some firms
(accidental, illness and natural death-inability to keep
pace with innovation)
– Depression
– Recovery
• Each successive cycle raises the national and per
capita income and takes the economy to a
higher plane
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6.Capitalist system will collapse due to
inherent weaknesses
• Capitalism would collapse due to internal
contradictions
• The major causes of failure of capitalism:
– Unemployment
– Excess reserves
– Gluts in money and product markets
– Falling profits and
– Vanishing investment opportunities

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 Criticisms of Schumpeter’s model
1. Too much emphasis on innovation
• Innovations are not the only causes of fluctuations
• Real factors, external shocks, financial factors &
natural causes
2. The assumption of laissez-faire economy
3. Development is not a matter of credit and finance alone
•Other infrastructural factors are also important
•Need of sponsored growth
4. Entrepreneurs may not really help development
5. Developing countries may not afford the cost of
“creative destruction”
171
 The Neoclassical Theories
• During the last half of the 19th century economics
changed from being “political economy,” to being
“economic science
• Economics became a specialized scientific discipline
fascinated by calculus, algebra, and plane geometry and
increasingly removed from social concerns.
• The central theme of economics changed from the
growth of national wealth to the role of margins in the
efficient allocation of resources.
• The marginalist movement in economics began in earnest
when three theorists—W. S. Jevons (1835– 1882), Carl
Menger (1840–1921), and Léon Walras (1837–1910)
• Alfred Marshall is also an important member
• Harrod-Domar and Solow Model
172
 Applicability of these Theories to
Ethiopian Economy
• The most applicable theory to the Ethiopian
situation is the endogenous growth theory
which borrow it’s mechanism from the
weaknesses of previous growth model. Such
weaknesses which includes the unrealistic
assumptions of constant income-saving
proportion, constant output ratio, constant
level of technology, saving-capital ratio also
assumed to be constant.
173
 CORRUPTION AND DEVELOPMENT

• Corruption is the use of public resources for private

gain.
• Corruption is an opportunist behavior aimed at
producing benefits for individual or group at the
expense of society
• Corruption can be measured by corruption
Index(CPI), which ranks countries based on how
investors, political and risk analysts, and the public
perceive levels of corruption.
• The Index ranges from zero (high corruption), to 10
( highly clean-minimum corruption)
• The CPI is based on 1999 data is shown in table 14.1
174
3. Increases the burden of the public sector on citizens.
4. It demoralizes, and leads to political opportunism such as
‘rent seeking” that contribute to inefficiency.
5. Leads to inability of a government to sustain professionals and
administrators,
6. Encourages the underutilization of skilled and educated labor
cost or the ‘brain drain’..,
7. Distorts international trade and investment,
8. discourages investment and leads to capital flight,
9. May stunt innovation and introduction of new technologies.

175