Brief answers to problems and questions for review
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Economic development is defined as a goal each country attempts to achieve. The
goal of economic development is the attainment of a standard of living roughly
equivalent to that of the average citizen in a developed country. In most of the world's
countries, low GDP per capita is associated with a host of other factors that reduce the
quality of life for most of humanity. In the poorest countries, there is pervasive
malnutrition and chronically poor housing. Past basic food and housing, the lack of
access to basic health care is also a threat to the lives of billions of people. The goal of
economic development is the alleviation of these dire conditions for billions of
people.
The low-, middle-, and high-income countries account for 3.2, 19.2, and 77.7 percent
of world economic output, respectively.
The two preconditions for economic growth are property rights and the rule of law. In
order for a market economy to work properly, it is necessary for market participants to
know who owns what. Without this knowledge, it is difficult for the usual buying and
selling that characterizes economic activity to flourish. Second, markets cannot
function properly without the rule of law. Economic activity is something like a game
with rules. Unless the government is there to enforce the rules, market participants
will be reluctant to play the game. As a result, it is necessary for the government to be
able to enforce the rules and arbitrate the disputes that are a part of economic activity.
In the social sciences it is very common to be unable to measure exactly what one
would like to measure. Property rights and the rule of law are a perfect example.
There is no easy way to create an internationally comparable measure of these factors.
In these cases, it is common to use a proxy or some other variable that is both similar
and considered to be highly correlated with what one is interested in measuring. The
economic freedom index is a reasonable proxy for property rights and the rule of law.
It is implausible that countries with a high ranking should lack these variables or that
they are strongly enforced in countries with a low ranking.
In the figure below, the size of the labor force is shown on the horizontal axis and real
GDP is shown on the vertical axis. The positive relationship indicates that as the labor
force increases, real GDP will increase.
© 2015 W. Charles Sawyer and Richard L. Sprinkle
F'
Output (GDP)
F
Y2
Y1
L1
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Labor force (L)
As seen in the graph above, along any given production function the capital stock has
been held constant. If the capital stock increases, then the entire production function
would shift upwards from F to F'. This indicates that for any given labor force such as
L1, output would increase if the capital stock increases.
In the graph above, a war would decrease the capital stock. Graphically, the
production function would shift downwards from F' to F. For any given labor force,
real GDP (Y) would fall.
FDI could increase real GDP in two ways. First, FDI would normally cause an
increase in the capital stock. This would shift the production function upwards.
Second, FDI frequently entails a transfer of technology into a developing country. An
improvement in technology would also tend to shift the production function upwards.
Changes in technology cause an improvement in an economy’s ability to mix labor
and capital, total factor productivity. This improvement in total factor productivity
allows an economy to obtain more output with the same amount of labor and capital.
A typical production function is shown below with the labor force on the horizontal
axis and real GDP on the vertical axis. This relationship indicates that real GDP
would change if the size of the labor force changed. However, any given production
function assumes that the capital stock and the level of technology is constant.
Another way of expressing technology is total factor productivity. This refers to an
economy's ability to mix capital and labor more efficiently to produce a higher level
of output with the same inputs. If total factor productivity increases, then the entire
production function would shift upward as shown. International trade tends to
increase total factor productivity. Trade tends to move resources from comparative
disadvantage industries to comparative advantage industries. This movement makes
the resources that have been moved more productive and increases the economy's
output for any given level of labor and capital.
© 2015 W. Charles Sawyer and Richard L. Sprinkle
F2
Real GDP (Y)
F1
Y2
Y1
L1
Labor force (L)
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In the context of economic development, FDI is the process of moving capital from
the capital-abundant developed countries to the capital-scarce developed countries.
However, more than just the capital is being moved. Usually, it would be true that the
level of technology in the developed countries is higher than it is in the developing
countries. The result is that FDI moves not only capital but involves a transfer of
technology. This is beneficial to the developing countries as it allows them access to
higher levels of technology. In terms of economic growth, the production function for
the developing country would shift upward not just because of an increase in the
capital stock but also as a result of an improvement in the level of technology.
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International trade in goods and services can lead to technology transfers. An example
of this is learning by doing. International trade usually involves countries becoming
more specialized in the production of certain products. Because of specialization,
countries become better at producing certain goods or services. This sort of
specialization causes an improvement in knowledge that increases total factor
productivity. The process of exporting intensifies the learning by forcing firms to
compete with other specialized firms in the world economy. The same types of effects
occur when domestic firms are forced to compete with more efficient foreign firms.
The result is that international trade leads to an increasing accumulation of knowledge
that can increase total factor productivity.
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First, the production and export of primary products may be quite profitable. This can
be a source of tax revenues for the government that can be used for economic
development. Exporting primary products may be a major source of foreign exchange
that can be used to purchase imported capital equipment necessary to enhance
economic development. Finally, primary products may be used as inputs into the
© 2015 W. Charles Sawyer and Richard L. Sprinkle
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production of higher value added products. This can make it easier for a developing
country to industrialize relative to other countries that do not have primary
commodities. However, this type of industrialization may be difficult if developed
countries have a tariff structure where the effective rate of protection escalates with
the degree of processing. Also, the prices of primary products can be quite volatile. At
a minimum, this may lead to instability in the exchange rate and make the economy
more unstable. If the product is a large percentage of GDP, then large changes in the
price of the product may tend to make the whole economy unstable. The bottom line
is that in an economy where primary products are important, it may be more difficult
to keep the economy on a stable growth path.
For the typical commodity both the demand and supply curves are relatively inelastic.
This situation can be seen in Figure 12.3. In such a case any small change in either the
demand or supply curves tends to have a major impact on price on a small impact on
quantity. Given this situation, the prices of primary commodities tends to be relatively
unstable.
An import substitution development strategy is an attempt to increase the size of the
manufacturing sector by replacing imports. This is accomplished with some
combination of high tariffs, quotas, or other forms of explicit or implicit subsidies. An
export promotion strategy is an attempt to increase the size of the manufacturing
sector by relying on the maximum growth of industries that rely on the country's
comparative advantage. In the long run, export promotion strategies seem to work
better. Import substitution may involve the transfer of resources into industries for
which that country does not have a comparative advantage. This lowers the total
output of the economy. An export promotion strategy has a better chance of
increasing economic growth as resources are encouraged to flow into industries for
which the country has a comparative advantage.
Over the last 50 years the economies of East Asia have grown faster than the
economies of Latin America. The reasons for this difference are many but a large part
of the difference has to do with development strategies. Latin American countries
tended to follow an import-substitution development strategy that emphasized
developing industries that would replace imports. This tended to cause a shift of
resources into comparative disadvantage industries that retarded growth. The
economies of East Asia tended to encourage exports which tends to put resources into
comparative advantage industries. This helps to avoid the inefficient use of resources
that import-substitution policies can cause and enhances growth.
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Official development assistance (ODA) describes the transfer of resources from
developed to developing countries to assist in the process of economic development.
ODA is a relatively unimportant factor in economic development because it is so
small. In 2005, the total global flow of ODA was less than $95 billion. This amount
represents less than one percent of the collective GDPs of the developing countries.
While ODA may be important for selected countries at particular points in time, it
does not have a substantial effect on overall economic growth in the developing
countries.
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In 2012, ODA from 22 large economies totaled $106 billion. Collectively, this is far
less than 1 percent of their GDPs. The total GDP of the developing countries is
approximately $23 trillion. Relatively speaking, ODA accounts for less than 1 percent
© 2015 W. Charles Sawyer and Richard L. Sprinkle
of the economic output of the developing countries. From almost any perspective, the
amount of ODA in the world economy is very small.
19.
The name “World Bank” is really a term used to describe the operations of five
different parts of the institution. The International Bank for Reconstruction and
Development (IBRD) borrows money in the international capital markets and loans it
to middle-income countries for specific economic development projects. The
International Development Association (IDA) gathers money donated by the
developed countries and makes concessionary loans to low-income countries. The
International Finance Corporation (IFC) makes loans to private-sector firms in
developing countries. The Multilateral Investment Guaranty Agency (MIGA) and the
International Centre for Settlement of Investment Disputes encourage FDI in
developing countries by providing insurance on these investments and providing a
mechanism for the settlement of disputes, respectively.
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There are three multilateral development banks that function much like the World
Bank. These are the African Development Bank, the Asian Development Bank, and
the Interamerican Development Bank. They operate in their respective regions and
provide loans for smaller development projects.
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The UN provides assistance to economic development primarily in the form of
technical assistance. UNCTAD provides technical assistance to developing countries
in the process of integrating into the global economy and for trade negotiations.
UNIDO provides technical assistance for countries in the process of increasing the
industrial sector of the economy. A large number of other UN agencies have at least a
tangential role in the process of economic development. The activities of these
agencies with respect to economic development are coordinated by the UN
Development Program (UNDP).
© 2015 W. Charles Sawyer and Richard L. Sprinkle