Economic Development Theories


Development economics:

• Deals with economic aspects of the development process in low-income countries.

• Focuses on methods of promoting economic growth

A. Linear-Stages-of-Growth Models (1950s):

• Share the central role of savings and capital formation as their basic theme.

i. Rostow’s Theory

• Suggests that countries pass through 5 stages of economic development:

1) Traditional Society

• Characterized by subsistence economic activity
  • Output is consumed by producers
  • Trade by barter

• Agriculture is most important industry
• Production is labor intensive

2) Transitional Stage

• Increased specialization generates surpluses for trading

• Transport infrastructure emerges

• Entrepreneurs emerge as income, savings, and investment grow

3) Take off

• Industrialization increases, with workers switching from agricultural sector to manufacturing sector

• Growth concentrated in a couple industries, and a couple regions of the country

4) Drive to Maturity

• Growth now diverse, supported by technological innovation

5) High Mass Consumption

• Economy geared towards mass consumption

Limitations:

• Many development economists argue that Rostows's model was developed with Western cultures in mind and not applicable to LDCs.

• In reality policy makers are unable to clearly identify stages as they merge together. Thus as a predictive model it is not very helpful.

• Main use is to highlight the need for investment. Essentially a growth model and does not address the issue of development in the wider context.

ii. Harrod-Domar Model:

• Suggests savings provide the funds which are borrowed for investment purposes

• Suggests that the economy’s growth rate depends on:
  • Level of saving
  • Productivity of investment (i.e. capital-output ratio)

• Developed to help analyze the business cycle. However, was later adapted to “explain” economic growth. Concluded that:
  • Economic growth depends on the amount of labor and capital.
  • Since LDCs often have an abundant supply of labor, it is a lack of physical capital that holds back economic growth and development.
  • More physical capital generates economic growth.
  • Net investment leads to more capital accumulation, which generates higher output and income.
  • Higher income allows higher levels of saving.

Implications:

• Key to economic growth is to expand the level of investment both in terms of fixed capital and human capital. To do this policies are needed that encourage saving and/or generate technological advances which enable firms to produce more output with less capital i.e. lower their capital output ratio.

Problems:

• Economic growth and economic development are not the same. Economic growth is a necessary but not sufficient condition for development

• Practically it is difficult to stimulate the level of domestic savings, particularly in the case of LDCs where incomes are low.

• Borrowing from overseas to fill the gap caused by insufficient savings causes debt repayment problems later.

• The law of diminishing returns would suggest that as investment increases the productivity of the capital will diminish and the capital to output ratio rise.

iii. Criticisms:

1. This theory has been criticized for not recognizing that capital accumulation alone is not a sufficient condition for development.
2. It doesn’t account for political, social and institutional obstacles to development.
3. Major criticism that the theory assumes conditions in developing countries are the same as those from post-WWII Europe (since the theory was developed during the Cold War and derived from the Marshall Plan)

B. Structural-Change Theory (1950s)

• Deals with policies focused on changing the economic structures of developing countries from being primarily comprised of subsistence agricultural practices to being a “more modern, more urbanized, and more industrially diverse manufacturing and service economy.”

Lewis Model

• Dual sector development model based on assumption that many LDCs had dual economies with a traditional agricultural sector and a modern industrial sector
  

• Argues that economic growth requires structural change in the economy whereby surplus labor in traditional agricultural sector with low or zero marginal product, migrate to the modern industrial sector with high rising marginal product.

• People who moved away from villages to the towns would earn increased incomes, which generates more savings. Lack of development is due to a lack of savings and investment.

• The growing industrial sector provides the incomes that could be spent and saved, which would generate demand and also provide funds for investment. Income generated by the industrial sector will trickle down throughout the economy.

Problems:

• Assumption of a constant demand for labor from the industrial sector is questionable. Increasing technology may reduce the need for labor.

• Concept of trickle-down effect has been criticized. Will higher incomes earned in the industrial sector really be saved? If the entrepreneurs and labor spend their gains rather than save it, funds for investment and growth will not be made available.

• The rural urban migration has for many LDCs been far larger that the industrial sector can provide jobs for. Urban poverty replaces rural poverty.
  
  
  
  

C. Dependence Theory (1970s)

• Unlike earlier theories, international dependence theories have their origins in developing countries and view obstacles to development as being primarily external in nature, rather than internal.

• Colonial powers and colonies
  • Views developing countries as politically and economically dependent on MDCs

• Responsibility for lack of development within LDCs rests with the MDCs

• 3 major formulations:
  • neocolonial dependence theory
  • the false-paradigm model
  • dualistic-dependence model

Problems:

• Power is not easily redistributed as countries that possess it are unlikely to surrender it

• It may be that it is not the governments of the MDCs that hold the power but large multinational enterprises that are reluctant to see the worlds resources being reallocated in favor of the LDCs

• The redistribution of assets globally will result in slower rates of growth in the MDCs and this might be politically unpopular

D. Neoclassical Theory (1980s):

• Emphasizes corruption, inefficiency, and a lack of economic incentives within developing countries as being responsible for the lack of development.

• Maintains that economic growth is caused by:
  • Increase in the labor quantity (pop. Growth)
  • Improvements in the quality of labor through training and education
  • Increase in capital (through higher savings and investment)
  • Improvements in technology

• Argues that government control inhibits growth because it encourages corruption, inefficiency and offers no profit motive for entrepreneurship.

• Argues that the root cause of underdevelopment lies with the governments of the LDCs themselves.

• Encourages these strategies:
  • Competitive free markets
  • Privatization of state owned industries
  • A move from closed (no trade) to open (trading) economies
  • Opening up the domestic economy through encouraging free trade (i.e. abolish tariffs and quotas) and foreign direct investment.

Problems:

• Makes unrealistic assumptions
  • The assumption is that the creation of a free market and a private enterprise culture is possible and desirable.
  • The existence of market failure such as externalities associated with economic growth are ignored
  • The problem of uneven distribution of income is ignored