# 04 Sep ECON F313 IED LEC NOTES

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Classic Theories of Economic Growth and Development
LINEAR GROWTH MODELS
Covered – Rostow Stages Theory
STRUCTURAL CHANGE MODELS
Lewis Model
Patterns of Development
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Linear Stages Model Harrod-Domar Growth Model.
a. The model was named after works produced by Sir Roy Harrod (in 1939) and
Evsey Domar (in 1946).
b. This model was initially developed to study business cycles and then adapted
to &quot;explain&quot; economic development/growth.
In this model, investment, saving and implicitly technological change are the
key variables that determine economic growth.
Technological change is represented by the capital-output ratio (K/Y), that is
how much physical capital is needed to produce one unit of output.
Of course, better production technology would means a smaller capital-output
ratio. .
c. Basically, this is a Keynesian model.
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d. The model suggests that to obtain growth, the economy needs to
increase investment thus pushing out the Production Possibility
Frontier (PPF) of the economy.
The model implies a higher saving rate can increase the amount of
investment.
Growth could also be achieved if the capital-output ratio is reduced, that
is less capital is required to produce a unit of output.
This can be achieved by an improvement in production technology.
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An algebraic approach to Harrod-Domar Model.
i. Savings (S) is a (s) proportion of national income (Y): S = sY.
ii. s can be seen as the Average Propensity to Save (APS) also called savings ratio
when expressed as S/Y.
iii. Investment (I) is the change in capital stocks (ΔK): I = ΔK.
iv. Let k represents capital-output ratio: k = K/Y.
v. In the original Harrod-Domar Model, both Average Propensity to Save (s) and
capital-output ratio (k) are held constant, that is they are determined by the
structural of the economy which does not change in the short run. Thus, we will
also assume that both s and k are constant.
vi. If k is constant then ΔK/ΔY is also constant, and more precisely k = ΔK/ΔY.
vii. Thus, I = ΔK becomes I = k ΔY. And for simplicity sake, let us assume that it is a
close economy and when equilibrium level of national income is achieved:
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S=I
sY = k ΔY. (by replacing I with k ΔY)
s/k = ΔY/ Y (rearranging from above) or
ΔY/Y = s/k
that is the rate of economic (national income) growth is the savings
ratio (S/Y) over capital-output ratio (K/Y).
More growth if the economy has higher saving rate or lower capitaloutput ratio, that is a unit of output can be produced with less amount of
capital.
The latter can be achieved by improvement in production technology.
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e. Implications to growth:
i. High saving rate is desirable.
ii. High rate of investment in capital goods is desirable.
iii. Improvement in production technology is desirable which leads to a lower
capital to output ratio.
iv. If the country cannot meet any of the three desirable factors above then
the country can be given a &quot;jump-start&quot; by borrowing from abroad
(commercial banks, foreign governments, or multilateral organizations
like the World Bank) or/and by receiving aid from abroad (the aid could
be monetary, machineries or technical know-how).
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f. Criticisms:
I. It is difficult to stimulate the desirable saving rate. Historical data suggests
that for an economy to take-off it need to save 15% to 20% of GDP.
II. If saving gap is to be borrowed from abroad then the economy is subjected to
the burden of loan repayments. Some developing countries that borrowed
heavily from abroad are still experiencing the effects of Debt Burden.
III. A lot of emphasis on physical capitals. In some cases, these capitals may not
be appropriate technology to the economy. The country may not have the
expertise to maintain the capital goods or their maintenance requires
expensive replacement parts from abroad. Thus, some of these imported
capitals will be out of repair in a few years.
IV. Capital goods also experience diminishing marginal returns. This rate
increases if the local workers have no expertise to maintain these capital
goods. Thus, these capital goods will give only short run returns to the
economy.
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V. Technological change in this model is implicitly assumed in the capital-output
ratio. There is no room for the economy to develop its human capital
(education, training, skills, creativity and experience) or make advances in
local technology.
VI. The &quot;jump-start&quot; approach of providing machineries and money is not
sustainable. Local workers need to be empower to shape and control their
production techniques. Without local empowerment, any imported technique
or aid cannot lead to sustainable growth.
VII. Economic growth does not necessary mean development. Economic growth
may lead to uncontrolled pollution problems, deforestation, break-down of
traditional values, and other problems associated with modernization.
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Structural Change Models
a. By the 1970s, economists used modern economic theory and statistical
analysis in an attempt to portray the internal process of structural change that
a &quot;typical&quot;developing country must undergo.
b. The focus is the mechanism of transformation from a traditional society with
subsistence agriculture to a modern industrialized economy.
c. Sir W. Arthur Lewis (Nobel Prize winner of 1979 for economic development
research) focused on the role of migration.
He argued that growth can be sustained by the gradual movement of
workers from low productivity agricultural sector in rural areas to higher
productivity industries like manufacturing and services in the urban area.
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d. The model assumes two sectors, traditional and modern sectors.
MODEL and ITS IMPLICATIONS
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Let the traditional sector be agriculture.
The agricultural sector is assumed to have marginal productivity of labor
equals to zero.
This model implicitly assumes full employment in the traditional sector and in
fact there is surplus labor in the traditional sector. That is, surplus laborers in
the rural farms are either not working or contribute nothing even though they
work in the farms.
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The modern sector (say manufacturing) has high productivity and offers a
fixed wage rate that is higher that the wage rate in the traditional sector.
The rate of transfer from agriculture to manufacturing is proportional to the
rate of capital accumulation in the modern sector.
The modern sector does not have to raise its wage rate because there are
surplus labor in the traditional sector who are always willing to work at the
prevailing fixed wage rate that is higher than that in traditional sector.
Entrepreneurs in the modern sector gain profits as prices of products are
above fixed wage rate. The model assumes that profits are reinvested to
increase capital stock and the static production technology requires a fixed
capital-labor ratio.
An increase in capital stock will require more laborers to maintain the fixed
capital-labor ratio. In another word, the modern sector does not invest in labor
saving technology as their business expands.
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In maintaining the fixed capital-labor ratio, the surplus labor in the traditional
sector is reduced and the modern sector is expanded.
The process will continue until all surplus labor in the traditional sector are
moved to the modern sector which in the end of the process is larger then the
traditional sector and the economy is now industrialized. Since the modern
sector is usually based in urban areas with better infrastructure then this
model also explains the process of urbanization as an economy develops.
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e. Implications for economic growth:
i. There is a need to invest in modern sector that has high productivity. Modern
sector is usually taken to be manufacturing industry and in turn this industry
will serve as engine for economic growth. Industrialization is taken as
synonymous to economic growth.
ii. High rate of capital investment is desirable as it speeds up the process of
industrialization and economic growth.
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f. Criticisms:
i. The model is too simplistic to assume MPL to be zero in the traditional
sector. It is more likely that workers in urban slum to have MPL=0.
Stiglitz and Charlton in Fair Trade for All point out that unemployment in
most developing countries are persistently high and models that implicitly
or otherwise assume that resources are fully employed are unrealistic for
the experience of developing countries.
ii. There is also an implicit assumption that there will be full employment in
urban area where modern sector is located. In fact, unemployment in urban
areas (slums) can be high in many developing countries.
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iii. There other assumption is that wage rate in the modern sector is fixed as
long as the MPL=0 in the traditional sector. Since MPL is assumed to 0 in
the traditional sector, wage rate in the modern sector is fixed.
This does not fit the experience of economic development. This ignores the
bargaining power of labor union, imposed wage increased by the
government, and more competitive wage rates from foreign multinationals.
iv. The model assumes that all profits are reinvested in the modern sector but
this is unrealistic. Some profits can be repatriated abroad, subject to capital
flights, consumed or reinvested in rural areas. All these reduce the need to
hire more labor in the modern sector.
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v. The assumption that the rate of labor transfer is proportional to the rate of
capital accumulation ignore the possibility that modern sector invests in
labor-saving technology.
vi. The model also implicitly assumes that all laborers are equally productive in
the use of machineries. However, this is not likely to be true. Farmers
cannot be equally skillful in using machineries that they might have never
seen before. If training is required, the model has left this out and its costs.
vii. Industrialization does not mean economic growth. What is more important
is the accumulation of appropriate technology that creates job for the
locals.
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viii. According to Alan Anderson in Economics 3rd edition, small scale
investment in rural area often yields a higher rate of return than urban
factory investment.
ix. Moreover, all regions in the developing world have very similar rate of
migration to urban area but they have different rates of growth.
x. Urbanization is not synonymous to development. Urbanization could lead
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Structural Changes and Patterns of Development: Chenery’s Model
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Thank You
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