Theories of Economic Development: Dual-Economy Models

Theories of Economic Development: Week 2 Learning Objectives

• Why history matters?
• Basic principles in analysing the history of thought in development economics
• Selected schools of thought in development
• The growth puzzle
• The Harrod-Domar model
• The Solow model
• Economic growth and structural transformation
• The dual-economy model
• Endogenous growth theory

Why History Matters?

Path dependency: History matters in understanding different patterns of economic development across countries.

• In Africa, a negative relationship between the number of slaves exported and current GDPpc.
• State antiquity: Countries with a stronger state over the long period have achieved faster growth and higher GDPpc today.

The history of economic institutions matters for economic growth.

The history of ideas also affects today's development performance.

Basic Principles in Analyzing the History of Thought in Development Economics

Development and underdevelopment are part of a single world-scale process.

Schools of thought in development economics have both positive (what the world is) and normative (what the world ought to be) intents.

Schools of thought can be placed in eight major periods, starting in 1500.

Each school differs in the relative roles of state, market and civil society in economic development.

Eight Major Periods of History Starting in 1500

1500 to 1700: the Mercantilism

1700 to 1820: the British experience

1820 to 1880: the Western experience

1880 to 1914: the Age of Empire

• 1914 to 1945: War and Depressions
• 1945 to 1982: the Asian experience
• 1982 to 1997: the Age of Globalisation (the Washington Consensus)
• 1997 to 2019: the Post-Washington Consensus

The Age of Globalization (1982-1997): Washington Consensus, Stabilization, and Adjustment

The Washington Consensus was endorsed by the IMF, the World Bank and other Washington think tanks.

It favoured a return to liberalism and a move toward renewed globalisation. Its main policy dimensions include:

• Fiscal discipline
• Financial liberalization
• Trade liberalisation
• Deregulation
• Privatisation

Post-Washington Consensus Second-Generation Reforms: Growth Diagnostics and Institution Building (1997-2019)

This is our focus and has emerged to meet the challenges of development economics beyond the Washington Consensus. Some of the main theories and approaches to development are listed below:

• Endogenous growth
• Open economy industrialization
• New institutional economics
• New political economy
• Sustainable growth
• Impact evaluation for accountability and learning
• Agriculture for development

Development Economics (1997-present)

Development Objectives

MDGs, Back to poverty

Pro-poor growth, equity for growth

Reduce vulnerability

Poor economics

Growth-poverty-inequality nexus

Business climate for private investment

Good governance and institution building

Investment in people and empowerment

State-market-civil society complementarities

Social safety nets and conditional cash transfers

Sustainable development

Impact evaluation, results-based foreign aid

Development Theories

End of big ideas, country specificity, trade-offs

Microeconomic foundations of development

Endogenous growth and multiple equilibria

New Institutional Economics

New Political Economy

Development Policies and Programs

Growth diagnostics, binding constraints

Open economy industrialization

Neo-mercantilist model

Agriculture for development

The Growth Puzzle

Growth requires (1) factor accumulation and (2) total factor productivity gains.

What drives factor accumulation and gains in factor productivity remains highly contentious.

We still can't explain economic growth satisfactorily, dubbing it as the "mystery of economic growth" and the "elusive quest for growth."

Two Families of Models

1. Classical and neoclassical growth models with exogenous technological change.
2. Endogenous growth models with technological change an outcome of economic decision-making.

Technological change plays a key role in explaining growth

Classical and neoclassical growth models predict income convergence.

Endogenous growth models predict conditional convergence or no convergence at all.

Capital Accumulation for Growth: The Harrod-Domar Model

The Harrod-Domar model was developed in the 1930s and 1940s following the Great Depression and used extensively in the 1950s.

It shows how capital accumulation sustains growth and how savings and technology determine capital accumulation.

Five Assumptions of the Harrod-Domar Model

1. The economy is closed to trade and foreign direct investment.
2. Capital and labour are used in fixed proportions in production.
3. Capital is the limiting factor to output growth, not labour. Labor is in unlimited supply
4. There are constant returns to scale for each factor.
5. Technology is such that a fixed quantity of additional capital (AK) gives us a fixed proportional increase in output (AY), where the proportionality factor is k = == = ICOR (incremental capital output ratio), which is the inverse of the marginal AY product of capital.

The Structural Form of the Harrod-Domar Model

1. An aggregate production function: AY = = AK, obtained from the definition of the ICOR. k
2. A savings function: S = sY, where S is aggregate savings, and s is the rate of savings out of national income (Y).
3. An investment function, where investment (I) is equal to available savings (S) and investment increases the stock of capital (Δ): [ = ΔK = S.

Per capita income is y = Y/P and the rate of growth of per capita income is j = Ý - P = =- (8 +n) k S

Growth According to the Harrod-Domar Model

	Gross fixed capital formation (% of GDP)	GDP growth (annual %)	ICOR
Nigeria	16.5	0.9	17.5
Mexico	23.2	2.6	8.9
China	44.6	6.7	6.7
Bangladesh	30.1	7.2	4.2

Nigeria needed about four times as much additional capital per unit of additional GDP as Bangladesh did.

Three Important Uses of the Model

1. Foreign aid and the big push

   The role of foreign aid in achieving per capita income growth and income convergence

2. Two-gap model

   Foreign aid that increases foreign savings can thus be quite effective in enhancing growth if there is a deficit of foreign exchange but enough domestic savings.

3. Two-sector Soviet model

   Under central planning, priority was given to allocating available domestic savings to heavy industry, while imposing austerity on consumers on behalf of faster future income growth. But, it increased inefficiencies in the capital goods industries.

Productivity Growth and Factor Deepening: The Solow Model

The Solow model explains growth by adding several neoclassical features to the rigid technological specification.

TFP growth can originate in technological change, in institutional change, or in improvements in the quality of factors of production and capital.

The model maintains assumes constant returns to scale for both factors combined, but with decreasing returns for each factor separately.

Sources of Growth

Y/L Y/L observed at t+1 1 Y/L = A f(K/L) (Y/L)++1 Unexplained residual due to technical change = AA Explained by factor deepening = A(K/L) (Y/L), Y/L observed at t (K/L), (K/L)(+1 K/L V =A + SK K - SLT. ΔΚ

Sources of Growth for the Asian NICs 1966-1990

	Share of labor	SI Growth labor 100*AL/L	Share of capital	Growth capital 100*AK/K	Residual 100*ΔΑ/Α	Observed GDP growth 100*ΔΥ/Υ
Hong Kong	0.63	3.2%	0.37	8.0%	2.3%	7.3%
ΔΕ Share of observed growth	28%	41%	31%	100%
Singapore	0.51	5.7%	0.49	11.5%	0.2%	8.7%
Share of observed growth	33%	65%	2%	100%
South Korea	0.70	6.4%	0.30	13.7%	1.7%	10.3%
Share of observed growth	44%	40%	16%	100%
Taiwan	0.74	4.9%	0.26	12.3%	2.1%	8.9%
Share of observed growth	40%	36%	24%	100%

SK Y =A + SK K - SLI Asian Tigers most grew from capital deepening, with only modest productivity growth.

Growth Path and the Steady-State

y y = AK (n+8)k y* SAK Ak = S 1 +n yt - n+ 8 1 +n kt Savings = Replacement investment k* k

Steady-State Solution

1. The aggregate production grows at the rate of population growth.
2. The level at which the steady state is achieved increases with the rate of savings s and total factor productivity A (that shifts up the concave function).
3. Initially poorer countries that start with a lower level of k would grow faster than richer countries with an initially higher level of k. This is how income convergence is achieved.

Limitations of the Solow Model

Exogenous technological change

Even if technology is an international public good, it may diffuse unequally across developing countries according to their own capacities to adopt and adapt.

Universal convergence

The predicted universal convergence in per capita income is not empirically supported.

International labour and capital movements

If the Solow model were right, we should see no desire for labor migration from LDCs to MDCs since the marginal product of labor should be higher in LDCs still lagging in factor deepening.

Economic Growth and Structural Transformation

The Harrod-Domar and Solow models consider the economy as producing only one good.

Structural transformation refers to the change in sectoral structure as income rises.

As GDPpc rises, the share of agriculture declines in both employment and GDP, indicating lower labour incomes in agriculture than in the rest of the economy.

The Structural Transformation in (a) SSA and (b) Asia

Structural transformation in Sub-Saharan Africa Structural transformation in Asia 1.00 0.90 Share of Agriculture in Labor Force 0.80 Cambodia Thailand · Togo Cameroon . Benin 0.50 . Côte d'ivoire South Africa Philippines South Korea 0.30 Malaysia Nigeria 0.20 0.10 0.00 4.5 5.5 6.5 7.5 8.5 4.5 5.5 6.5 7.5 8.5 Log of GDP per capita (constant 2000 US$) Log of GDP per capita (constant 2000 US$) In sub-Saharan Africa, rapidly declining shares of agriculture without an increase in GDPpc. However, in Asia, this decline is accompanied by growth in GDPpc.

0.70 India 0.60 Indonesia Pakistan 0.40