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Module 4 in AE 12 (Economic
Development)
Theories of Economic Development
At the end of Module 4, students are expected to answer:
- Is Ricardian classical economic theory applicable to LDCs?
- How valid is the assumption that the development of LDCs will parallel the earlier stages of today’s DCs?
- How well does Rostow’s stage theory explain that country’s economic growth?
- How might Marxian economic analysis (like Mao’s or Bettelheim’s) threaten political elites in socialist countries?
Module Overview
This module discusses a few of the major theories of economic development, reserving for subsequent modules lesser comprehensive theories dealing with specific economic questions. As they did in the 1950s and 1960s, economists recently have stressed all-encompassing theories of development, including neoclassicism and rival theories.
The Classical Theory of Economic Stagnation
MODEL
The classical theory, based on the work of the 19th-century English economist David Ricardo, Principles of Political Economy and Taxation (1817), was pessimistic about the possibility of sustained economic growth. For Ricardo, who assumed little continuing technical progress, growth was limited by land scarcity The classical economists – Adam Smith, Thomas R. Malthus, Ricardo, and John Stuart Mill – were influenced by Newtonian physics. Just as Newton posited that activities in the universe were not random but subject to some grand design, these men believed that the same natural order determined prices, rent, and economic affairs. In the late 18th century, Smith argued that in a competitive economy, with no collusion or monopoly, each individual, by acting in his or her own interest, promoted the public interest. A producer who charges more than others will not find buyers, a worker who asks more than the going wage will not find work, and an employer who pays less than competitors will not find anyone to work. It was as if an i nvisible hand were behind the self-interest of capitalists,
merchants, landlords, and workers, directing their actions toward maximum economic growth. Smith advocated a laissez-faire (governmental noninterference) and free-trade policy except where labor, capital, and product markets are monopolistic, a proviso some present-day disciples of Smith overlook. The classical model also took into account (1) the use of paper money, (2) the development of institutions to supply it in appropriate quantities, (3) capital accumulation based on output in excess of wages, and (4) division of labor (limited primarily by the size of the market). A major tenet of Ricardo was the law of diminishing returns , referring to successively lower extra outputs from adding an equal extra input to fixed land. For him, diminishing returns from population growth and a constant amount of and threatened economic growth. Because Ricardo believed technological change or improved production techniques could only temporarily check diminishing returns, increasing capital was seen as the only way of offsetting this long-run threat. His reasoning took the following path. In the long run, the natural wage is at subsistence – the cost of perpetuating the labor force (or population, which increases at the same rate). The wage may deviate but eventually returns to a natural rate at subsistence. On the one hand, if the wage rises, food production exceeds what is essential for maintaining the population. Extra food means fewer deaths, and the population increases. More people need food and the average wage falls. Population growth continues to reduce wages until they reach the subsistence level once again. On the other hand, a wage below subsistence increases deaths and eventually contributes to a labor shortage, which raises the wage. Population decline increases wages once again to the subsistence level. In both instances, the tendency is for the wage to return to the natural subsistence rate. With this iron law of wages , total wages increase in proportion to the labor force. Output increases with population but, other things being equal, output per worker declines with diminishing returns on fixed land. Thus, the surplus value (output minus wages) per person declines with increased population. At the same time, land rents per acre increase with population growth, as land becomes scarcer relative to other factors. The only way of offsetting diminishing returns is by accumulating increased capital per person. However, capitalists require minimum profits and interest payments to maintain or increase capital stock. Yet because profits and interest per person declines and rents increase with population growth, there is a diminishing surplus (profits, interest, and rent) available for the capitalists’ accumulation. Ricardo feared that this declining surplus reduces the inducement to accumulate capital. Labor force expansion leads to a decline in capital per worker or a decrease in worker productivity and income per capita. Thus, the Ricardian model indicates eventual economic stagnation or decline. Marx’s Historical Materialism Karl Marx’s views were shaped by radical changes in Western Europe: the French Revolution; the rise of industrial, capitalist production; political and labor revolts; and a growing secular rationalism. Marx (1818–83) opposed the prevailing philosophy and political economy, especially the views of utopian socialists and classical economists, in favor of a worldview called historical materialism.
FIVE STAGES
Rostow’s economic stages are (1) the traditional society, (2) the preconditions for
takeoff, (3) the takeoff, (4) the drive to maturity, and (5) the age of high mass consumption.
Rostow has little to say about the concept of traditional society except to indicate that it
is based on attitudes and technology prominent before the turn of the 18th century. The work
of Isaac Newton ushered in change. He formulated the law of gravity and the elements of
differential calculus. After Newton, people widely believed “that the external world was subject
to a few knowable laws, and was systematically capable of productive manipulation.”
PRECONDITIONS STAGE
Rostow’s preconditions stage for sustained industrialization includes radical changes in
three nonindustrial sectors: (1) increased transport investment to enlarge the market and
production specialization; (2) a revolution in agriculture, so that a growing urban population can
be fed; and (3) an expansion of imports, including capital, financed perhaps by exporting some
natural resources. These changes, including increased capital formation, require a political elite
interested in economic development. This interest may be instigated by a nationalist reaction
against foreign domination or the desire to have a higher standard of living.
TAKEOFF
Rostow’s central historical stage is the takeoff, a decisive expansion occurring over 20 to 30 years, which radically transforms a country’s economy and society. During this stage, barriers to steady growth are finally overcome, while forces making for widespread economic progress dominate the society, so that growth becomes the normal condition. The takeoff period is a dramatic moment in history, corresponding to the beginning of the Industrial Revolution in late-18th-century Britain; pre– Civil War railroad and manufacturing development in the United States; the period after the 1848 revolution in Germany; the years just after the 1868 Meiji restoration in Japan; the rapid growth of the railroad, coal, iron, and heavy engineering industries in the quarter-century before the 1917 Russian Revolution; and a period starting within a decade of India’s independence (1947) and the communist victory in China (1949). Rostow indicates that three conditions must be satisfied for takeoff.
- Net investment as a percentage of net national product (NNP) increases sharply – from 5 percent or less to over 10 percent. If an investment of 3.5 percent of NNP leads to a growth of 1 percent per year, then 10.5 percent of NNP is needed for a 3-percent growth (or a 2-percent per-capita increase if population grows at 1 percent).
- At least one substantial manufacturing sector grows rapidly. The growth of a leading manufacturing sector spreads to its input suppliers expanding to meet its increased demand and to its buyers benefiting from its larger output. In the last three decades of the 1700s, for example, the cotton textile industry in Britain expanded rapidly because of the use of the spinning jenny, water frame, and mule in textiles and the increased demand for cotton clothing. The development of textile manufactures, and their exports, had wide direct and
indirect effects on the demand for coal, iron, machinery, and transport. In the United States, France, Germany, Canada, and Russia, the growth of the railroad, by widening markets, was a powerful stimulus in the coal, iron, and engineering industries, which in turn fueled the takeoff.
- A political, social, and institutional framework quickly emerges to exploit expansion in the modern sectors. This condition implies mobilizing capital through retained earnings from rapidly expanding sectors; an improved system to tax high-income groups, especially in agriculture; developing banks and capital markets; and, in most instances, foreign investment. Furthermore, where state initiative is lacking, the culture must support a new class of entrepreneurs prepared to take the risk of innovating.
DRIVE TO MATURITY
The drive to maturity, a period of growth that is regular, expected, and self-sustained, follows takeoff. A labor force that is predominantly urban, increasingly skilled, less individualistic, and more bureaucratic and looks increasingly to the state to provide economic security characterizes this stage.
AGE OF HIGH MASS CONSUMPTION
The symbols of this last stage, reached in the United States in the 1920s and in Western Europe in the 1950s, are the automobile, suburbanization, and innumerable durable consumer goods and gadgets. In Rostow’s view, other societies may choose a welfare state or international military and political power. Vicious Circle Theory
The vicious circle theory indicates that poverty perpetuates itself in mutually reinforcing
vicious circles on both the supply and demand sides.
SUPPLY SIDE
Because incomes are low, consumption cannot be diverted to saving for capital
formation. Lack of capital results in low productivity per person, which perpetuates low levels
of income. Thus, the circle is complete. A country is poor because it was previously too poor to
save and invest. Or as Jeffrey Sachs (2005:56) explains the poverty trap: “Poverty itself [is the]
cause of economic stagnation.”
Japan’s high savings rates during periods of rapid economic growth during the 1950s,
1960s, and 1970s, and the high savings rates of the Asian tigers, Malaysia, and Thailand imply
the other side of the coin of the vicious circle. As countries grow richer, they save more,
creating a virtuous circle in which high savings rates lead to faster growth (Edwards 1995;
Economist 1995b:72; World Bank 2003i:218–220).
For Rosenstein-Rodan, a major indivisibility is in infrastructure, such as power, transport, and communications. This basic social capital reduces costs to other industries. To illustrate, the railroad from Kanpur to the Calcutta docks increases the competitiveness of India’s wool textiles domestically and abroad. However, the investment for the 950-kilometer, Kanpur–Calcutta rail line is virtually indivisible, in that a line a fraction as long is of little value. Building the Aswan Dam or the Monterrey–Mexico City telegraph line is subject to similar discontinuities.
Indivisibility in demand.
This indivisibility arises from the interdependence of investment decisions; that is, a prospective investor is uncertain whether the output from his or her investment project will find a market. Rosenstein-Rodan uses the example of an economy closed to international trade to illustrate this indivisibility. He assumes that there are numerous subsistence agricultural laborers whose work adds nothing to total output (that is, the marginal productivity of their labor equals zero). If 100 of these farm workers were hired in a shoe factory, their wages would increase income.
THE MURPHY–SHLEIFER–VISHNY MODEL
Kevin Murphy, Andrei Shleifer, and Robert Vishny analyze an economy in which world trade is costly – perhaps today, Bolivia, where a majority of the population live on a high plateau between two north–south Andes mountain chains; landlocked east-central African states Rwanda, Burundi, Uganda, or Malawi; or isolated islands Papua New Guinea; or, in the 19th century, the United States, Australia, or Japan. Domestic agriculture or exports may not be sufficient for industrialization, so these economies need large domestic markets, a la Rosenstein-Rodan. For increas- ` ing returns from sliding down the initial part of a U-shaped long-run average cost curve (representing successive plants with more specialized labor and equipment), sales must be high enough to cover fixed setup costs.
HIRSCHMAN’S STRATEGY OF UNBALANCE
Albert O. Hirschman (1958) develops the idea of unbalanced investment to complement existing imbalances. He contends that deliberately unbalancing the economy, in line with a predesigned strategy, is the best path for economic growth. He argues that the big push thesis may make interesting reading for economists, but it is gloomy news for the LDCs: They do not have the skills needed to launch such a massive effort. The major shortage in LDCs is not the supply of savings, but the decision to invest by entrepreneurs, the risk takers and decision makers. The ability to invest is dependent on the amount and nature of existing investments. Hirschman believes poor countries need a development strategy that spurs investment decisions. He suggests that since resources and abilities are limited, a big push is sensible only in strategically selected industries within the economy. Growth then spreads from one sector to another (similar to Rostow’s concept of leading and following sectors). However, investment should not be left solely to individual entrepreneurs in the market, as the profitability of different investment projects may depend on the order in which they are undertaken. For example, assume investment in a truck factory yields a return of 10 percent per year; in a steel factory, 8
percent, with the interest rate 9 percent. If left to the market, a private investor will invest in the truck factory. Later on, as a result of this initial investment, returns on a steel investment increase to 10 percent, so then the investor invests in steel. Assume, however, that establishing a steel factory would increase the returns in the truck factory in the next period from 10 to 16 percent. Society would be better off investing in the steel factory first, and the truck enterprise second, rather than making independent decisions based on the market. Planners need to consider the interdependence of one investment project with another so that they maximize overall social profitability. They need to make the investment that spurs the greatest amount of new investment decisions. Investments should occur in industries that have the greatest linkages, including backward linkages to enterprises that sell inputs to the industry, and forward linkages to units that buy output from the industry. The steel industry, with backward linkages to coal and iron production, and forward linkages to the construction and truck industries, has good investment potential, according to Hirschman. Even a government that limits its major role to providing infrastructure can time its investment projects to spur private investments. Government investment in transport and power will increase productivity and thus encourage investment in other activities. Initially, planners trying to maximize linkages will not want to hamper imports too much, because doing so will deprive the country of forward linkages to domestic industries using imports. In fact, officials may encourage imports until they reach a threshold in order to create these forward linkages. Once these linkages have been developed, protective tariffs will provide a strong inducement for domestic entrepreneurs to replace imports with domestically produced goods.
Coordination Failure: The O-Ring Theory of Economic Development
Balanced and unbalanced growth advocates focus on preventing or overcoming coordination failure. Michael Kremer uses the 1986 space shuttle Challenger as a metaphor for coordinating production in “The O-Ring Theory of Economic Development.” The Challenger had thousands of components, but it exploded because the temperature at which it was launched was so low that one component, the O-rings, malfunctioned. In a similar fashion, Kremer proposes a production function in which “production consists of many tasks, [either simultaneous or sequential], all of which must be successfully completed for the product to have full value.” To illustrate, a violinist who plays off key or misses the beat can ruin a whole symphony orchestra. This function describes production processes subject to mistakes in any of several tasks. You cannot substitute quantity for quality; indeed, “quality is job one.” This production function does not allow the substitution of quantity (two mediocre violinists, copyeditors, chefs, or goalkeepers) for quality (one good one). Highly skilled workers who make few mistakes will be matched together, with wages and output rising steeply with skill. Rich countries specialize in complicated products, such as aircraft, whereas poor countries produce simpler goods, such as textiles and coffee. Kremer thinks the O-ring theory can explain why rich countries specialize in more complicated products, have larger firms, and have astonishingly higher worker productivity and average incomes than poor countries. Taiwan and South Korea, otherwise ready for takeoff in the mid-1960s, relied on government action to override coordination failure. Both countries have a reasonably skilled labor force but a low
For the more capital-intensive urban industrial sector to attract labor from the rural area, it is essential to pay ws plus a 30-percent inducement, or wk (the capitalist wage). This higher wage compensates for the higher cost of living as well as the psychological cost of moving to a more regimented environment. At wk the urban employer can attract an unlimited supply of unskilled rural labor. The employer will hire this labor up to the point QL1 , where the value of its extra product (or the left marginal revenue product curve MRPL1 ) equals the wage wk. The total wages of the workers are equal to OQL1 , the quantity of labor, multiplied by wk, the wage (that is, rectangle OQL1BA). The capitalist earns the surplus (ABC in Figure 5-1), the amount between the wage and that part of the marginal product curve above the wage. Lewis assumes that the capitalist saves the entire surplus (profits, interest, and rent) and the worker saves nothing. Furthermore, he suggests that all the surplus is reinvested, increasing the amount of capital per worker and thus the marginal product of labor to MRPL2 , so that more labor QL2 can be hired at wage rate wk. This process enlarges the surplus, adds to capital formation, raises labor’s marginal productivity, increases the labor hired, enlarges the surplus, and so on, through the cycle until all surplus labor is absorbed into the industrial sector. Beyond this point QL3 , the labor supply curve (SLk) is upward-sloping and additional laborers can be attracted only with a higher wage. As productivity increases beyond MRPL3 to MRPL4 , the MRPL (or demand for labor) curve intersects the labor supply curve at a wage wT and at a quantity of labor QL4 in excess of surplus rural labor. In the Lewis model, capital is created by using surplus labor (with little social cost). Capital goods are created without giving up the production of consumer goods. However, to finance surplus labor, additional credit may sometimes be needed. The significance of Lewis’s model is that growth takes place as a result of structural change. An economy consisting primarily of a subsistence agricultural sector (which does not save) is transformed into one predominantly in the modern capitalist sector (which does save). As the relative size of the capitalist sector grows, the ratio of profits and other surplus to national income grows.
Dependency Theory
Celso Furtado, a Brazilian economist with the U.N. Economic Committee for Latin America, was an early contributor to the Spanish and Portuguese literature in dependency theory in the 1950s and 1960s. According to him, since the 18th century, global changes in demand resulted in a new international division of labor in which the peripheral countries of Asia, Africa, and Latin America specialized in primary products in an enclave controlled by foreigners while importing consumer goods that were the fruits of technical progress in the central countries of the West. The increased productivity and new consumption patterns in peripheral countries benefited a small ruling class and its allies (less than a tenth of the population), who cooperated with the DCs to achieve modernization (economic development among a modernizing minority). The result is “peripheral capitalism, a capitalism unable to generate innovations and dependent for transformation upon decisions from the outside.” A major dependency theorist, Andre Gunder Frank, was a U.S. expatriate recently affiliated with England’s University of East Anglia. Frank, writing in the mid-1960s, criticized the view held by many development scholars that contemporary underdeveloped countries resemble the earlier stages of now- developed countries. Many of these scholars viewed modernization in LDCs as simply the adoption of economic and political systems developed in Western Europe and North America. For Frank, the presently developed countries were never underdeveloped, although they may have been undeveloped. His basic thesis is that underdevelopment does not mean traditional (that is, nonmodern) economic, political, and social institutions but LDC subjection to the colonial rule and
Development (UNCTAD) and International Labor Organization (ILO), which, like the 1960s and 1970s, are still dominated by third-world ideologies demanding a more just world economic order.
The Neoclassical Growth Theory
The MIT economist Robert Solow won a Nobel Prize for his formulation of the neoclassical theory of growth, which stressed the importance of savings and capital formation for economic development, and for empirical measures of sources of growth. Unlike the Harrod–Domar model of growth, discussed in the appendix to this chapter, which focused on capital formation, Solow allowed changes in wage and interest rates, substitutions of labor and capital for each other, variable factor proportions, and flexible factor prices. He showed that growth need not be unstable, because, as the labor force outgrew capital, wages would fall relative to the interest rate, or if capital outgrew labor, wages would rise. Factor price changes and factor substitution mitigated the departure from the razor’s edge of the Harrod–Domar growth path. Because aggregate growth refers to increases in total production, we can visualize growth factors if we examine the factors contributing to production. We do this in a production function stating the relationship between capacity output and the volume of various inputs. Y = TKαLβ where Y is output or income, T the level of technology, K capital, and L labor. T is neutral in that it raises output from a given combination of capital and labor without affecting their relative marginal products. The parameter and exponent α is (_x0005_Y/Y)/(_x0005_K/K), the elasticity (responsiveness) of output with respect to capital (holding labor constant). (The symbol x0005 means increment in, so that, for example, _x0005_Y/Y is the rate of growth of output and _x0005_K/K the rate of growth of capital.) The parameter β is (_x0005_Y/Y)/(_x0005_L/L), the elasticity of output with respect to labor (holding capital constant). If we assume α + β = 1, which represents constant returns to scale (that is, a 1 percent increase in both capital and labor increases output by 1 percent, no matter what present output is), and perfect competition, so that production factors are paid their marginal products, then α also equals capital’s share and β labor’s share of total income. (Constant returns to scale, where output and all factors of production vary by the same proportion, still entail diminishing returns, where increments in output fall with each successive change in one variable factor.) The Cobb–Douglas production function allows capital and labor to grow at different rates.
The New (Endogenous) Growth Theory
The University of Chicago’s Robert Lucas finds that international wage differences and migration are difficult to reconcile with neoclassical theory. If the same technology were available globally, skilled people embodying human capital would not move from LDCs, where human capital is scarce, to DCs, where human capital is abundant, as these people do now. Nor would a given worker be able to earn a higher wage after moving from the Philippines to the United States. Moreover, Harvard’s Robert Barro and Xavier Sala-i-Martin observe that diminishing returns to capital in the neoclassical model should mean substantial international capital movements from DCs, with high capital–labor ratios, to LDCs, with low capital–labor ratios. These capital movements should enhance the convergence found in Solow’s model, in contrast to the lack of convergence found in the real world.7 Additionally, most LDCs attract no net capital inflows, and many LDCs even experience domestic capital flight. New growth theorists
think their model is closer to the realities of international flows of people and capital than the neoclassical model. Paul Romer, a University of California-Berkeley economist, believes that if technology is endogenous, explained within the model, economists can elucidate growth where the neoclassical model fails. When the level of technology is allowed to vary, you can explain more of growth, as DCs have higher level than LDCs. Variable technology means that the speed of convergence between DCs and LDCs is determined primarily by the rate of diffusion of knowledge. For new growth theorists such as Romer, innovation or technical change, the embodiment in production of some new idea or invention that enhances capital and labor productivity, is the engine of growth. Neoclassical theorists assume that technological discoveries are global public goods, so that all people can use new technology at the same time. Indeed, it is technologically possible (but not historically accurate) for every person and firm to use the internal-combustion engine, the transistor, the microcomputer, and other innovations. For new growth economists, however, technological discovery results from an LDC’s government policies (the neoclassical growth theorists have no role for the state) and industrial research. Neoclassical economists assume that the innovator receives no monopoly profits from their discoveries. However, because individuals and firms control information flows, petition for patents to restrict use by rivals, and charge prices for others to use the technology, new growth economists assume a temporary monopoly associated with innovation. Note the concentration of high-technology industries in particular locations such as the Silicon Valley, in Santa Clara County, California, and Route 128, which runs around Greater Boston. Private and government support for technological concentration and control breaks down the assumption of perfect competition, as well as the ability to compute factor shares. References Anderson, Anthony B. “Smokestacks in the rainforest: Industrial development and deforestation in the Amazon basin.” World Development 18 (2019) Anderson, Anthony B., ed. Alternatives to Deforestation. New York: Columbia University Press, 2019. Assunção, Juliano, “Land Reform and Landholdings in Brazil,” UNU-WIDER Research Paper No. 2006/137, November 2017. Baer, Werner. The Brazilian Economy: Growth and Development. Boulder, Colo.: Rienner, 2018. Bank Information Center. Funding Ecological and Social Destruction: The World Bank and the IMF. Washington, D.C.: Bank Information Center, 2020. Bauman, Renato, and Helson C. Braga. “Export financing in the LDCs: The role of subsidies for export performance in Brazil.” World Development 16 (2018)
