Devt II Rift Valley

DEVELOPMENT ECONOMICS II (Econ-313)
Rift Valley College Center for

Distance and Continuing Education
Adama, 2013
Copy © Rift Valley College Center for Distance and continuing Education Adama
Development economics II Page 1
Course Content
Course
introduction………………………………………………………………….….3
Course
objective…………………………………………………………………………3
Chapter One: Economic inequality, poverty and development
1.1. Measurement of income in equality and poverty……………..5
1.2. Inequality and development…………………………………14
1.3. Functional impacts of poverty………………………………17
Chapter Two: Economic Development policy issue
2.1 What do we mean by development policy?....................................24
2.2 Policies of Agricultural development & Resource use…………..32
2.3 Economic and Non-Economic factors of development…………..56
2.4 Role of the market Versus Role of the government……………...61
2.5 The Environment & Development……………………………….64
Chapter Three: Industrialization & Agriculture
3.1.1. Structural Transformation………………………..69
3.1.2. Modeling structural transformation……………...70
3.1.3. Elements of structural transformation……………72
3.1.4. Agriculture’s contribution Development………...81
3.1.5. Complementarities of Agriculture and Industry…81
3.1.6. Industrialization………………………………….81
3.1.7. External Economies & Industrialization…………81
3.1.8. Industrialization through Export Promotion……..83
3.1.9. Industrialization through Import Substitution……86
Chapter Four: Direct Foreign Investment & Foreign Aid.
4.1. The International Flow of Financial Resources…………………….96
4.2. Private DFI & the Multinational Corporations…………………….96
4.3. Foreign Aid: The Development Assistance Debate……………...101
4.3.1. Why Official Assistance?.................................................102
4.3.2. Does Aid Work?...............................................................104
Chapter Five: Experience of Some Newly Industrialized Countries……...106
References: …………………………………………………………………….109
Module Introduction
This course is a consecutive to development economics I. In this part, concepts

like inequality and its measurements, absolute poverty, growth versus income
distribution will be discussed. It is largely devoted to issues of development
policy. It begins with a review of the role and significance of policy in the context
of development. Most of the term devoted to specific policy issues in the areas of
agriculture, industrialization, international trade, domestic and external resource
mobilization, human resource development (including demography and
development) and gender issues in development. The role of foreign direct
investment and foreign aid in development is also discussed in detail in the
module.
Objective: This course is designed to equip students with

 Recent developments in the subject
 New development strategy, development policies, Industrial and
agricultural developments,
 The extent and impact of foreign aid and
 The impact of foreign direct investments and other development issues.
 Acquire a feel for the complexities of development policy as well as an
appreciation of the role that policy plays in the development process.
CHAPTER ONE
ECONOMIC INEQUALITY, POVERTY AND DEVELOPMENT
Chapter content
1.1. Measurement of income in equality and poverty

1.2. Inequality and development
1.3. Functional impacts of poverty
Objective:
After completing this chapter, students are expected to know:
 what income inequality is
 how income inequality is measured
 the relationship between income inequality and poverty
 the relationship between inequality and development
Introduction
The 1970, witnessed a remarkable change in public and private perceptions about
the ultimate nature of economic activity. In both rich and poor countries, there
was a growing disillusionment with the idea that relentless pursuit of growth was
the principal economic objective of society. In the developed countries, the major
emphasis seemed to shift toward more concern for the quality of life, a concern
manifested mainly in the environmental movement.
In the poor countries, the main concern focused on the question of growth versus
income distribution. That development required a higher GNP and faster growth
rate was obvious. The basic issue, however, was (and is) not only how to make
GNP grow but also who would make it grow, the few or the many. If it were the
rich, it would most likely be appropriated by them, and poverty and inequality
would continue to worsen. But if it were generated by the many, they would be its
principal beneficiaries, and the fruits of economic growth would be shared more
evenly.
In this chapter, we will examine the following five critical questions about the
relationship between economic growth, income distribution and poverty
1. What is the extent of relative inequality in developing countries, and how
is this related to the extent of absolute poverty
2. Who are the poor, and what are their economics characteristics?
3. What determines the nature of economics growth that is, who benefits?
4. Are rapid economic growth and more equitable distributions of income
compatible or conflicting objectives for low income countries? To put it
another way, is rapid growth achievable only at the cost of greater
inequalities in the distribution of income, or can a lessening of income
disparities contribute to higher growth rates?
5. What kinds of policies are required to reduce the magnitude and extent of
absolute poverty?
1.1. Measurement of income in equality and poverty
We can get some idea to question 1 and 2 relating to extent and character
of inequality and poverty in developing countries by pulling together same
recent evidence from a variety of sources. In this section we define the
dimensions of income distribution and poverty problems and identify some
similar elements that characterize the problem in many developing
countries. But first we should be clear about what we are measuring when
we speak about the distribution of income.
Economists usually like to distinguish between two principal measures of

income distribution for both analytic and quantitative purposes.
- The personal or size distribution of income
- The functional or distributive factor share distribution
of income.
a) Size Distributions
The personal or size distribution of income is the measure most commonly used
by economists. It simply deals with individual persons or households and the total
income they receive. The way in which that income was received is not
considered. What matters is how much each earns irrespective of whether the
income was derived solely from employment or came also from other sources
such as interest, profits, rents, gifts or inheritance. Moreover, the locational (urban
or rual) and occupational sources of the income (e.g. agriculture, manufacturing,
commerce, services) are neglected. If Ato Abebe and W/ro Mulu both receive the
same personal income, they are classified together irrespective of the fact that
W/ro Mulu may work 15 hours a day as a doctor which Ato Abebe does not work
at all but simply collects interest on his inheritance.
Economists and statisticians, therefore, like to arrange all individuals by ascending

personal incomes and than divided the total population in to distinct groups or
sizes. A common method is to divide the population in to successive quintiles
(fifths) or deciles (tenths) according to the ascending income levels and then
determine what proportion of the total national income is received by each income
group.
Table 1.1 Size distribution of personal income in a developing country by
Income shares quintiles & Deciles
Personal income Percentage share in total income
Individuals (Money Units) Quintiles Deciles
1 0.8
2 1.0 1.8
3 1.4
4 1.8 5 3.2
5 1.9
6 2.0 3.9
7 2.4
8 2.7 9 5.1
9 2.8
10 3.0 5.8
11 3.4
12 3.8 13 7.2
13 4.2
14 4.8 9.0
15 5.9
16 7.1 22 13.0
17 10.5
18 12.0 22.5
19 13.5
20 15.0 51 28.5
Total 100.0 100 100.0
Measure of inequality = total of bottom 40% to 20% = 14/51 = 0.28
The total or national income of all individuals amounts to 100 units and is the sum
of all entries in column 2. In column 3, the population is grouped in to quintiles of
four individuals each. The first quintile represents the bottom 20% of the
population on the income scale. This group receives only 5% (i.e. a total of 5
money units) of the national income. The second quintile (individuals 5 - 8)
receives 9% of the total income. Alternatively the bottom 40% of the population
(quintiles 1 plus 2 ) is receiving only 14% of the income, while the top 20% ( the
fifth quintile) of the population receives 51% of the total income.
A common measure of income inequality that can be derived from column 3 is the
ratio of the incomes received by the bottom 40% and top 20% of the population.
This ratio is often used as a measure of the degree of inequality between the too
extremes of very poor and very rich in a country. In our example, this inequality
ratio is equal to 14 divided by 51, or approximately 1 to 3.7 or 0.28.
To provide a more detailed breakdown of the size distribution of income, deciles

(10%) shares are listed in column 4. We see, for example, that the bottom 10% of
the population (the two poorest individuals) is receiving only 1.8% of the total
income, while the top 10% (the two richest individuals) receives 28.5% of the
total income.
Lorenz Curve
Another common way to a personal income statistics is to construct what is known
as a Lorenz curve. The Lorenz curve is shown below.
O’
100
90
80
Percentage of income
70
Line of Equality
60 I.
E
50
H.
40
G.
30
F.
E.
20
D.
C.
10 B.
A.
O 10 20 30 40 50 60 70 80 90 100
Percentage of income recipients
Fig. 1.1 Lorenz Curve
absolute terms but in cumulative percentages. For example, at point 20 we have
the lowest (poorest) 20% of the population at point 60 we have the bottom 60%,
and at the end of the axis all 100% of the population has been accounted for. The
vertical axis shows the share of total income received by each percentage of the
population; it also is cumulative up to 100% meaning that both axes are equally
long.
The entire figure is enclosed in a square; a diagonal line (00’) is drawn from the
lower left corner (the origin) of the square to the upper right corner. At every
point on the diagonal 00’ the percentage of income received is exactly equal to the
percentage of income recipients, for example, at point E, which is the point half
way the length of the diagonal line, represents 50% of the income being
distributed to exactly 50% of the population. Similar, at the three quarter point on
the diagram, 75% of the income would be distributed to 75% of the population. In
other words, the diagonal line 00’ is representative of "perfect equality" in size
distribution of income.
The Lorenz curve shows the actual quantitative relationship between the
percentages of income recipients and the percentage of the actual income they did
in fact receive during, say, a given year. In figure 5.1 we have plotted this Lorenz
curve using the docile data contained to each of the 10 deciles groups. Point A
shows that the bottom 10% population receives only 1.8% of the total income;
point B shows that the bottom 20% is receiving 5% of the total income, and so on
for each of the other eight cumulative deciles groups. Note that at the halfway
point, 50% of the population is in fact receiving only 19.8% of the total income.
The more the Lorenz line curves is away from the diagonal (perfect equality), the
greater the degree of inequality represented. The extreme case of perfect
inequality ( i.e. a situation in which one person receives all of the national income
while ever body else receives nothing) would be represented by the congruence of
the Lorenz curve with the bottom horizontal and right hand vertical axes. Because
no country exhibits either perfect equality or perfect inequality in its distribution
of income, the Lorenz curves for different countries will lie somewhere to the
right of the diagonal in Figure 1.1. The greater the degree of inequality, the
greater the bend and the closer to the bottom horizontal axis the Lorenz curve will
be. Two representative distributions are shown in Figure 1.2, one for a relatively
equal distribution (Figure 1.2a) and the other for a more unequal distribution
(Figure 1.2b). (Can you explain why the Lorenz curve could not lie above or to
the left of the diagonal at any point?)
above table (table 5.2) give a first approximation of the magnitude of income
inequality in these developing countries.
Gini Coefficient
A final and very convenient short hand summary measure of the relative degree of
income inequality in a country can be obtained by calculating the ratio of the area
between the diagonal and the Lorenz curve divided by the total area of the half
square in which the curve lies. This is shown below.
Gini Shaded Area A

Coefficient = Total Area BCD
ghghghg
In the above diagram (fig 1.3) the ratio of the shaded area A to the total area of the
triang le BCD is known as the Gini concentration ratio or more simply as the Gini
coefficient, named after the Italian statistician who first formulated it in 1912.
Gini coefficients are aggregate inequality measures and can vary anywhere from 0
(perfect equality) to 1 (perfect inequality). Gini coefficients for countries with
highly unequal income distributions typically lies between 0.50 and 0.70 while for
countries with relatively equitable distributions, it is on the order of 0.20 to 0.35.
b) Functional Distribution
The second common measure of income distribution used by economists, the
functional or factor share distributions of income, attempts to explain the share of
total national income that each of the factors of production (land, labour and
capital) receives. Instead of looking at individuals as separate entities, the theory
of functional income distribution inquiries into the percentage that labour receives
as a whole and compares this with the percentages of total income distributed in
the form of rent, interest, and profit (i.e. the return to land and financial and
physical capital). Although specific individuals may receive income from all
these sources, that is not a matter of concern for the functional approach.
1.2. Inequality and development
The debate about the relationship between economics distribution takes many
forms. The key arguments are the traditional argument and the counter argument.
a) The traditional Argument: Factor shares, Saving and Economic growth.

Although much of economic analysis has been strangely silent on the relationship
between economics growth and the resulting distribution of income, a large body
of theory in essence asserts that highly unequal distributions are necessary
conditions for generating rapid growth.
The basic economic argument to justify large income in equalities was that high
personal and corporate incomes were necessary conditions of saving, which made
possible investment and economic growth through a mechanism such as the
Harrod-Domar model described in chapter 3 of the first module. If the rich save
and invest significant portions of their incomes while the poor spend all their
income on consumption goods, and if GNP growth rates are directly related to the
proportion of national income saved, then apparently an economy characterized by
highly unequal distributions of income would save more and grow faster than one
with a more equitable distribution of income. Eventually, it was assumed, national
and per capita incomes would be high enough to make sizable redistributions of
income possible through tax and subsidy programs. But until such a time is
reached, any attempt to redistribute incomes significantly would serve only to
lower growth rates and delay the time when a larger income pie could be cut up
into bigger slices for all population groups.
b) Counterargument
There are five general reasons why many development economists believe the
foregoing argument to be incorrect and why greater equality in developing coun-
tries may in fact be a condition for self-sustaining economic growth.
First, sizable inequality and widespread poverty create conditions in which the
poor have no access to credit, are unable to finance their children's education, and,
in the absence physical or monetary investment opportunities, have many children
as a source of old-age financial security. Together these factors cause per capita
growth to be less than what it would be if there was greater equality.
Second, common sense, supported by a wealth of recent empirical data, bears
witness to the fact that unlike the historical experience of the now developed
countries, the rich in contemporary poor countries are not noted for their frugality
or for their desire to save and invest substantial proportions of their incomes in the
local economy. Instead, landlords, business leaders, politicians, and other rich
elites are known to spend much of their incomes on imported luxury goods, gold,
jewelry, expensive houses, and foreign travel or to seek safe havens abroad for
their savings in the form of capital flight. Such savings and investments do not add
to the nation's productive resources; in fact, they represent substantial drains on
these resources in that the income so derived is extracted from the sweat and toil
of common, uneducated, and unskilled laborers. In short, the rich do not nec-
essarily save and invest significantly larger proportions of their incomes (in the
real economic sense of productive domestic saving and investment) than the poor.
Therefore, a growth strategy based on sizable and growing income inequalities
may in reality be nothing more than an opportunistic myth designed to perpetuate
the vested interests and maintain the status quo of the economic and political elites
of Third World nations, often at the expense of the great majority of the general
population. Such strategies might better be called "anti-developmental.”
Third, the low incomes and low levels of living for the poor, which are manifested
in poor health, nutrition, and education, can lower their economic productivity and
thereby lead directly and indirectly to a slower-growing economy. Strategies to
raise the incomes and levels of living of, say, the bottom 40% would therefore
contribute not only to their material well-being but also to the productivity and
income of the economy as a whole.
Fourth, raising the income levels of the poor will stimulate an overall increase in
the demand for locally produced necessity products like food and clothing,
whereas the rich tend to spend more of their additional incomes on imported lux-
ury goods. Rising demand for local goods provides a greater stimulus to local
production, local employment, and local investment. Such demand thus creates
the conditions for rapid economic growth and a broader popular participation in
that growth.
Fifth and finally, a more equitable distribution of income achieved through the
reduction of mass poverty can stimulate healthy economic expansion by acting as
a powerful material and psychological incentive to widespread public participa-
tion in the development process. By contrast, wide income disparities and
substantial absolute poverty can act as powerful material and psychological disin-
centives to economic progress. They may even create the conditions for an
ultimate rejection of progress by the masses of frustrated and politically explosive
people, especially those with considerable education.
We can conclude, therefore, that promoting rapid economic growth and reducing
poverty and inequality are not mutually conflicting objectives. The World Bank
reached a similar conclusion in its 1990 report on poverty when it declared:
1.3. Functional impacts of poverty
The following table (table 1.3) provides data on income distribution in relation to
per capita GNP for a sample of 10 developing countries.
Table 1.3 Per Capita Income and Inequality in Developing Countries, 1990s
Country GNP per capita Income Share of Ratio of Highest Gini
1996 (US $) Lowest 40% of 20% to Lowest Coefficient
Households 20%
Bangladesh 260 22.9 4.0 0.28
Kenya 320 10.1 18.3 0.58
Sri Lanka 740 22.0 4.4 0.30
Indonesia 1080 20.4 5.1 0.34
Philippines 1160 15.5 8.4 0.43
Jamaica 1600 16.0 8.2 0.41
Paraguay 1850 8.2 27.1 0.59
Costa Rica 2640 12.8 12.9 0.47
Malaysia 4370 12.9 11.7 0.48
Brazil 4400 8.2 25.7 0.60
Income distribution in measured in three ways as the total share of income
received by the poorest 40% of the population, as the ratio of the share going to
the richest 20% divided by that of the poorest 20% and as measured by the Gini
coefficient.
What clearly emerges from table 1.3 is that per capita incomes are not highly
correlated with any of our three measures of inequality. For example, we see that
Sri Lanka has only one-sixth the per capita income of Brazil, but its three
inequality measures are much less pronounced than Brazil’s. Its Gini coefficient is
0.30 compared to Brazil's 0.60. Similarly, Paraguay, with income seven times
higher than that of Bangladesh, shows much greater inequality. Conversely,
Malaysia, with a 1996 per capita income that is 65% higher than Costa Rica, has
inequality measures that are not much different. We can conclude, therefore, that
there is no apparent relationship between levels of per capita income and the
degree of income concentration over relevant range of LDC incomes.
b) Absolute poverty: Extent and magnitude

So far, we have been looking at relative income shares. Now let's switch our
attention from relative income shares of various percentile groups within a given
population to the more significant question of the extent and magnitude of
absolute poverty in developing countries.
What is absolute poverty?
During the 1970'S as interest in problems of poverty increased, development
economists took the first step in measuring its magnitude within and across
counties by attempting to establish a common poverty line. They devised the now
widely used concept of Absolute Poverty.
Absolute poverty is meant to represent a specific minimum level of income

needed to satisfy the basic physical needs of food, clothing and shelter in order to
ensure continued survival extent of obsolete poverty is therefore the number of
people who are unable to command sufficient resources to satisfy basic needs.
A problem, however, arises when one recognizes that those minimum subsistence
levels will vary from country to country and region to region, reflecting different
physiological as well as social and economic requirements. Economists have
therefore tended to make consultative estimates of world poverty in order to avoid
unsubstantiated exaggerations of the problem. One common methodology has
been to establish an international poverty line at say, a constant $370 (based for
example, on the value of the 1985 dollar) and then attempt to estimate the
purchasing power equivalent of money in terms of developing country's own
currency.
The international poverty line knows no boundaries, is independent of the level of

national per capita income, and takes into account differing price level by
measuring poverty as any one living on less than $1 a day in PPP dollars.
In many respects simply counting the number of people below an agreed on
poverty line can have its limitations. For example, in the above exercise, both
individuals are accorded the same weight when calculating the proportion of the
population that lies below the poverty line; clearly, however, the poverty problem
is much more serious in individual B. Some economists, therefore, attempt to
calculate a poverty gap that measures the total amount of income necessary to
raise everyone who is below the poverty line up to that line. To make this clear,
let's consider the following two figures for two countries A and B, where line PV
is the poverty line.
In both country A and country B, 50% the population falls below the same poverty
line PV. However the poverty gap in country A is greater than in country B which
implies that it will take more of an effort to eliminate absolute poverty in country
A.
Inequality, Growth and the extent of poverty
Does the pursuit of economic growth along traditional GNP maximizing lines tend
to improve, worsen, or have no necessary effect on the distribution of income and
the extent of poverty in developing countries? Unfortunately, economists do not
possess any definitive knowledge of the specific factors that affect changes in the
distribution of income over time for individual countries. Simon Kuznets, to
whom we owe so much for his pioneering analysis of the historical growth pattern
of contemporary developed countries, has formulated the relationship between
distribution of income & growth, known as the inverted U hypothesis
a) The inverted U hypothesis
In his inverted U curve, Simon Kuznets has suggested that in the early stages of
economic growth, the distribution of income will tend to worsen, whereas at later
stages it will improve. This observation came to be characterized by the "inverted
U” kuzent curve because a longitudinal (time series) plot of changes in the
distribution of income - as measured, for example, by the Gini coefficient -
seemed, when per capita GNP expanded to trace out the inverted U shaped curve,
as shown in figure 5.4 below.
Gini Coefficient
0.75
0.5
0.35
0.25
0
GNP Per capital
Fig 1.4 The “Inverted U” Kuznets Curve
Explanations as to why inequality seemed first to worsen
during the early stages of economics growth before eventually improving are
numbers. They almost always relate to the nature of structural change early
growth may, in accordance with the Lewis model be concentrated in the modern
industrial sector, where employment is limited, but wages and productivity are
high. The income gap between modern and traditional sectors may widen quickly
at first before beginning to converge. Inequality in the expanding modern sector
may be much greater than inequality in the stagnant traditional sector. Income
transfers from the rich to the poor and poverty reducing public expenditures are
more difficult to undertake by governments in very low-income countries.
Chapter summary
From the discussion in this chapter, the following issues about the relationship
between economic growth, income distribution and poverty have been discussed.
1. The extent of relative inequality in developing countries, and how it is related to
the extent of absolute poverty
2. The economics characteristics of the poor
3. What determines the nature of economics growth and who benefits from it?
4. Whether rapid economic growth and more equitable distributions of income
compatible or conflicting objectives for low income countries. To put it another
way, is rapid growth achievable only at the cost of greater inequalities in the
distribution of income, or can a lessening of income disparities contribute to
higher growth rates?
5. Kinds of policies required to reduce the magnitude and extent of absolute
poverty
Review questions
1. What is absolute poverty?

2. Explain the inverted U hypothesis
Answers:
1. Absolute poverty is meant to represent a specific minimum level of income
needed to satisfy the basic physical needs of food, clothing and shelter in
order to ensure continued survival extent of obsolete poverty is therefore
the number of people who are unable to command sufficient resources to
satisfy basic needs.
2. In his inverted U curve, Simon Kuznets has suggested that in the early
stages of economic growth, the distribution of income will tend to worsen,
whereas at later stages it will improve. This observation came to be
characterized by the "inverted U” kuzent curve because a longitudinal
(time series) plot of changes in the distribution of income - as measured,
for example, by the Gini coefficient - seemed, when per capita GNP
expanded to trace out the inverted U shaped curve.
CHAPTER TWO
ECONOMIC DEVELOPMENT POLICY ISSUE
Chapter content
2.6 What do we mean by development policy?
2.7 Policies of Agricultural development & Resource use.
2.8 Economic and Non-Economic factors of development.
2.9 Role of the market Versus Role of the government.
2.10 The Environment & Development
Introduction
In the classical economy, since the invisible hand plays its role well, there is no
need for government intervention in an economy. In developing countries,
however, there are many cases where market fails appealing for government
interference to correct the market failure in different ways. To do so, there are
different policy measures available for government intervention. In this chapter,
therefore, emphasis is made on how government uses different policies to achieve
the desired outcome in an economy.
Objective: at the end of the chapter, students are expected to know:

 definition of development policy
 policies mostly suitable to agricultural development and resource use
 factors that determine development
 role of market and government in development
 the relationship between environment and development
2.1 What do we mean by development policy?
In general there are different policies available for intervention. These are:
o General economic and social policies

o Policies relating to agricultural and rural development
o Policies relating to markets and property rights
o Policies aimed at establishing democratic and participatory processes
Policies focused specifically on natural resource use and environmental
protection
Policies that affect sustainability are of five types
 General economic and social policies intended to influence overall

economic growth, trade, price levels, employment, investment and
population, attained chiefly by utilizing monetary and fiscal instruments.
 Policies relating to agricultural and rural development. Policies of this type
are usually intended to influence such factors as the agricultural resource
base, agricultural production, consumption of agricultural products,
agricultural price levels and variability, rural incomes and the quality of
food. They are usually implemented via instruments such as taxes and
subsidies, direct government production and provision of services, and
direct control through regulation.
 Policies relating to markets, including the establishment of market
institutions and rules, and circumscription of property rights.
 Policies aimed at establishing a democratic and participatory process
designed to involve all interested groups in decision making and
implementing SARD.
 Policies designed specifically to influence natural resource use and protect
the environment. These policies utilize: (i) command and control (effected,
for example, by prohibiting or limiting certain resource uses or
establishing limits on emissions, with penalties for non-compliance); (ii)
economic incentives such as taxes and subsidies; and (iii) persuasive
measures such as education and advertising.
The Range of Policy Options: Some Basic Considerations
Developing countries that aim to reduce poverty and excessive inequalities in their
distribution of income need to know how best to achieve their aim. What kinds of
economic and other policies might LDC governments adopt to reduce poverty and
inequality while maintaining or even accelerating economic growth rates? As we
are concerned here with moderating the size distribution of incomes in general and
raising the income levels of, say, the bottom 40% of the population in particular, it
is important to understand the various determinants of the distribution of income
in an economy and see in what ways government intervention can alter or modify
their effect.
a) Areas of Intervention
We can identify four broad areas of possible government policy intervention,
which correspond to the following four major elements in the determination of a
developing economy's distribution of income:
1. Functional distribution-the returns to labor, land, and capital as determined by

factor prices, utilization levels, and the consequent shares of national income
that accrue to the owners of each factor.
2. Size distribution-the functional income distribution of an economy translated
into a size distribution by knowledge of how ownership and control over
productive assets and labor skills are concentrated and distributed throughout
the population. The distribution of these asset holdings and skill endowments
ultimately determines the distribution of personal income.
3. Moderating (reducing) the size distribution at the upper levels through pro-
gressive taxation of personal income and wealth. Such taxation increases
government revenues and converts a market- and asset-determined level of
personal income into a fiscally corrected "disposable" personal income. An
individual or family's disposable income is the actual amount available for
expenditure on goods and services and for saving.
4. Moderating (increasing) the size distribution at the lower levels through public
expenditures of tax revenues to raise the incomes of the poor either directly
(e.g., by outright money transfers) or indirectly (e.g., through public employ-
ment creation or the provision of free or subsidize a primary education and
health care for both men and women. Such public policies raise the real income
levels of the poor above their market-determined personal income levels.
b) Policy Options
Third World governments have many options and alternative possible policies to
operate in the four broad areas of intervention just outlined. Let us briefly identify
the nature of some of them.
Altering the Functional Distribution of Income through Policies

Designed to Change Relative Factor Prices
Altering the functional distribution represents the traditional economic approach.
It is argued that as a result of institutional constraints and faulty government poli-
cies, the relative price of labor (basically, the wage rate) is higher than what would
be determined by the free interplay of the forces of supply and demand. For exam-
ple, the power of trade unions to raise minimum wages to artificially high levels
(higher than those that would result from supply and demand) even in the face of
widespread unemployment is often cited as an example of the "distorted" price of
labor. From this it is argued that measures designed to reduce the price of labor
relative to capital (e.g., through market-determined wages in the public sector or
public wage subsidies to employers) will cause employers to substitute labor for
capital in their production activities. Such factor substitution increases the overall
level of employment and ultimately raises the incomes of the poor, who typically
possess only their labor services.
However, it is often also correctly pointed out that the price of capital equipment
is "institutionally" set at artificially low levels (below what supply and demand
would dictate) through various public policies such as investment incentives, tax
allowances, subsidized interest rates, overvalued exchange rates, arid low tariffs
on capital goods imports such as tractors and automated equipment. If these
special privileges and capital subsidies were removed so that the price of capital
would rise to its true "scarcity" level, producers would have a further incentive to
increase their utilization of the abundant supply of labor and lower their uses of
scarce capital. Moreover, owners of capital (both physical and financial) would
not receive the artificially high economic returns they now enjoy. Their personal
incomes would thereby be reduced.
Because factor prices are assumed to function as the ultimate signals and
incentives in any economy, correcting these prices (Le., lowering the relative price
of labor and raising the relative price of capital) would not only increase produc-
tivity and efficiency but would also reduce inequality by providing more wage
paying jobs for currently unemployed or underemployed unskilled and semiskilled
workers. It would also lower the artificially high incomes of owners of capital.
Removal of such factor-price distortions would therefore go a long way toward
combining more growth, efficiently generated, with higher employment, less
poverty, and greater equality.
We deal more extensively with the important question of factor-price distortions,

employment generation, and choice of appropriate production techniques in
Chapter 7. For the present, we may conclude that there is much merit to the tra-
ditional factor-price distortion argument and that correcting prices should con-
tribute to a reduction in poverty and an improved distribution of income. How
much it actually contributes will depend on the degree to which firms and farms
switch to more labor-intensive production methods as the relative price of labor
falls and the relative price of capital rises. This-is an important empirical question,
the answer to which will vary from country to country. But some improvement
can be expected.
Modifying the Size Distribution through Progressive

Redistribution of Asset Ownership
Given correct resource prices and utilization levels for each type of productive
factor (labor, land, and capital), we can arrive at estimates for the total earnings of
each asset. But to translate this functional income into personal income, we need
to know the distribution and ownership concentration of these assets among and
within various segments of the population. Here we come to what is probably the
most important fact about the determination of income distribution within an
economy: The ultimate cause of the unequal distribution of personal incomes in
most Third World countries is the unequal and highly concentrated patterns of
asset ownership (wealth) in these countries. The principal reasons why less than
20% of their population receives over 50% of the national income is that this 20%
probably owns and controls well over 90% of the productive and financial
resources, especially physical capital and land but also financial capital (stocks
and bonds) and human capital in the form of better education. Correcting factor
prices is certainly not sufficient to reduce income inequalities substantially or to
eliminate widespread poverty where physical and financial asset ownership and
education are highly concentrated.
It follows that the second and perhaps more important line of policy to reduce
poverty and inequality is to focus directly on reducing the concentrated control of
assets, the unequal distribution of power, and the unequal access to educational
and income-earning opportunities that characterize many developing countries. A
classic case of such redistribution policies as they relate to the rural poor, who
comprise 70% to 80% of the target poverty group, is land reform. The basic pur-
pose of land reform is to transform tenant cultivators into smallholders who will
then have an incentive to raise production and improve their incomes. But as we
shall see in Chapter 10, land reform may be a weak instrument of income redistri-
bution if other institutional and price distortions in the economic system prevent
small farm holders from securing access to much needed critical inputs such as
credit, fertilizers, seeds, marketing facilities, and agricultural education. Similar
reforms in urban areas could include the provision of commercial credit at market
rates (rather than through exploitive moneylenders) to small entrepreneurs (so
called microloans-see Chapter 17) so that they can expand their 'business and
provide more jobs to local workers.
In addition to the redistribution of existing productive assets, dynamic redistri-
bution policies could be gradually pursued. For example, IDC governments could
transfer a certain proportion of annual savings and investments to low-income
groups so as to bring about a more gradual and perhaps politically more accept-
able redistribution of additional assets as they accumulate over time. This is what
is often meant by the expression "redistribution from growth." Whether such a
gradual redistribution from growth is any more possible than a redistribution of
existing assets is a moot point, especially in the context of very unequal power
structures. But some form of asset redistribution, whether static or dynamic, seems
to be a necessary condition for any significant reduction of poverty and inequality
in most Third World countries.
Human capital in the form of education and skills is another example of the
unequal distribution of productive asset ownership. Public policy should therefore
promote wider access to educational opportunities (for girls as well as boys) as a
means of increasing income-earning potential for more people. This investment in
human capital as a principal strategy for alleviating poverty has been widely
promoted (along with accelerating economic growth) by the World Bank in its
various poverty reports, especially World Development Report 1998/99:
Knowledge for Development. But as in the case of land reform, the mere pr9vision
of greater access to education is no guarantee that the poor will be any better off,
unless complementary policies-for example, the provision of more productive
unemployment opportunities for the educated-are adopted to capitalize on this
increased human capital. The relationship among education, employment, and
development is discussed further in Chapter 9.
Reducing the Size Distribution at the Upper Levels through Progressive

Income and Wealth Taxes
Any national policy attempting to improve the living standards of the bottom 40%
must secure sufficient financial resources to transform paper plans into program
realities. The major source of such development finance is the direct and progres-
sive taxation of both income and wealth. Direct progressive income taxes focus on
personal and corporate incomes, with the rich required to pay a progressively
larger percentage of their total income in taxes than the poor: Taxation on wealth
(the stock of accumulated assets and income) typically involves personal and cor-
porate property taxes but may also include progressive inheritance taxes. In either
case, the burden of the tax is designed to fall most heavily on the upper-income
groups.
Unfortunately, in many developing countries (and developed countries as well),

the gap between what is supposed to be a progressive tax structure and what
different income groups actually pay can be substantial. Progressive tax structures
on paper often turn out to be regressive taxes in practice, in that the lower-,and
middle- income groups pay a proportionately larger share of their incomes in
taxes than the upper-income groups. The reasons for this are simple. The poor are
often taxed at the source of their incomes or expenditures (by withholding taxes
from wages, general poll taxes, or indirect taxes levied on the retail purchase of
goods such as cigarettes and beer). By contrast, the rich derive by far the largest
part of their incomes from the return on physical and financial assets, which often
go unreported. They often also have the power and ability to avoid paying taxes
without fear of government reprisal. Policies to enforce progressive rates of direct
taxation on income and Wealth, especially at the highest levels, are what are most
needed in this area of redistribution activity (see Chapter 17 for a further discus-
sion of taxation for development).
Increasing the Size Distribution at the Lower Levels through Direct

Transfer Payments and the Public Provision of Goods and Services
The direct provision of tax-financed public consumption goods and services to the
very poor is another potentially important instrument of a comprehensive policy
designed to eradicate poverty. Examples include public health projects in rural
villages and urban fringe areas, school lunches and preschool nutritional
supplementation programs, and the provision of clean water and electrification to
remote rural areas. Direct money transfers and subsidized food programs for the
urban and rural poor, as well as direct government policies to keep the price of
essential foodstuffs low; represent additional forms of public consumption subsi-
dies. All these policies have the effect of raising the real personal income levels of
the very poor beyond their actual market -derived monetary incomes.
Unfortunately, in the 1980s and 1990s, with the LDC debt crisis and the imple-
mentation of World Bank- and IMF-induced structural adjustment programs, the
first victims of mandated public expenditure retrenchments were the rural and
urban poor-especially women.
2.2 Policies of Agricultural development & Resource use.
If the migration of people with and without school certificates to the cities of
Africa, Asia, and Latin America is proceeding at historically unprecedented rates,
a large part of the explanation can be found in the economic stagnation of the out-
lying rural areas. That is where the people are. Over 2.5 billion people in the Third
World grind out a meager and often inadequate existence in agricultural pursuits.
Over 3 billion people lived in rural areas in 1997. This figure will rise to almost
3.3 billion by the year 2010.
People living in the countryside comprise considerably more than half the
population of such diverse Latin American and Asian nations as Bolivia,
Guatemala, India, Indonesia, Myanmar, Ecuador, Sri Lanka, Pakistan, the
Philippines, and China. In Africa, the ratios are much higher, with almost every
country having rural dwellers in excess of three-quarters of the total population. In
spite of the massive migration to the cities, the absolute population increase in
rural areas of most Third World nations will continue to be greater than that of
urban areas for at least the next decade.
Of greater importance than sheer numbers is the fact that the vast majority (almost
70%) of the world's poorest people are also located in rural areas and engaged
primarily in subsistence agriculture. Their basic concern is survival. Many
hundreds of millions of people have been bypassed by whatever economic
progress has been attained. It is estimated that more than 800 million of these
people do not have enough food to meet their basic nutritional needs. In their daily
struggle to subsist, their behavior may have often seem irrational to many Western
economists who, until recently, had little comprehension of the precarious nature
of subsistence living and the importance of avoiding risks. If development is to
take place and become self-sustaining, it will have to start in the rural areas in
general and the agricultural sector in particular. The core problems of widespread
poverty, growing inequality, rapid population growth, and rising unemployment
all find their origins in the stagnation and often retrogression of economic life in
rural areas.
Traditionally, the role of agriculture in economic development has been viewed as

passive and supportive. Based on the historical experience of Western countries,
economic development was seen as requiring a rapid structural transformation of
the economy from one predominantly focused on agricultural activities to a more
complex modern industrial and service society. As a result, agriculture's primary
role was to provide sufficient low-priced food and manpower to the expanding
industrial economy, which was thought to be the dynamic "leading sector" in any
overall strategy of economic development. Lewis's famous two sector model
discussed in PART I of Development Economics is an outstanding example of a
theory of development that places heavy emphasis on rapid industrial growth with
an agricultural sector fueling this industrial expansion by means of its cheap food
and surplus labor.
Today, as we have seen, development economists are less sanguine about the
desirability of placing such heavy emphasis on rapid industrialization. They have
come to realize that far from playing a passive, supporting role in the process of
economic development, the agricultural sector in particular and the rural economy
in general must play an indispensable part in any overall strategy of economic
progress, especially for the 61 low income developing countries.
An agriculture- and employment-based strategy of economic development

requires at a minimum three basic complementary elements:
 accelerated output growth through technological, institutional, and price
incentive changes designed to raise the productivity of small farmers;
 rising domestic demand for agricultural output derived from an
employment-oriented urban development strategy; and
 diversified, nonagricultural, labor-intensive rural development activities
that directly and indirectly support and are supported by the farming
community.
To a large extent, therefore, the past two decades witnessed a remarkable

transition in development thinking in which agricultural and rural development
came to be seen by many as the sine qua non of national development. Without
such integrated rural development, industrial growth either would be stultified or,
if it succeeded, would create such severe internal imbalances in the economy that
the problems of widespread poverty, inequality, and unemployment would
become even more pronounced.
Five main questions, therefore, need to be asked about Third World agriculture
and rural development as these relate to overall national development:
1. How can total agricultural output and productivity per capita be substantially
increased in a manner that will directly benefit the average small farmer and
the landless rural dweller while providing a sufficient food surplus to
support a growing urban, industrial sector?
2. What is the process by which traditional low-productivity peasant farms are
transformed into high-productivity commercial enterprises?
3. When traditional family farmers and peasant cultivators resist change, is their
behavior stubborn and irrational, or are they acting rationally within the con-
text of their particular economic environment?
4. Are economic and price incentives sufficient to elicit output increases among
peasant agriculturalists, or are institutional and structural changes in rural
farming systems also required?
5. Is raising agricultural productivity sufficient to improve rural life, or must
there be concomitant off-farm employment creation along with improvements
in educational, medical, and other social services? In other words, what do
we mean by rural development, and how can it be achieved?
Learning Objectives
After studying this chapter the student is expected to be able to
 give factual account of growth and stagnation of the agricultural
sector over the past half century.
 understand the description and analysis of the basic characteristics of

agrarian systems in developing countries and identify some important
similarities and differences.
 describe the economics of peasant subsistence agriculture and discuss

the stages of transition from subsistence to commercial farming in
developing nations. Moreover, the will be able the importance of not
only economic factors but also the social, institutional, and structural
requirements of small-farm modernization.
 explore the meaning of rural development and review alternative

policies designed to raise levels of living in Third World rural areas.
Agricultural Stagnation and Growth since 1950
Many developing countries experienced respectable rates of GNP growth during

the past few decades. The greatest proportionate share of this over all-growth
occurred in the manufacturing and commerce sectors, where recorded rates of
annual output growth often exceeded 10%. In contrast, agricultural output growth
for most developing regions was much less robust during these decades, and the
share of agricultural output in total GNP declined.
In spite of the fact that the agricultural sector accounts for most of the
employment in developing countries, it accounts for a much lower share of the
output. In fact, in most developing regions, agricultural production constitutes no
more than 30% of the total national product. This is in marked contrast to the
historical experience of advanced countries, where agricultural output in their
early stages of growth always contributed at least as much too total output as the
share of the labor force engaged in these activities. The fact that contemporary
Third World agricultural employment is typically two to three times as large in
proportion to the total as is agricultural output simply reflects the relatively low
levels of labor productivity compared with those in manufacturing and commerce.
The data in Table 2.1 strongly suggest that a direct attack on rural poverty through
accelerated agricultural development is necessary to raise living standards. Mere
concern with maximizing GNP growth may not be enough. Unfortunately, the
record of the past five decades offers only limited hope, as can be seen from Table
TABLE 2.1 Outputs and Employment in Third World Agriculture, 1995
Percentage of the Output of Agriculture as a
Region Labor Force in Percentage of Gross

Agriculture Domestic Product
South Asia 64 30
East Asia (including China) 70 18
Latin America 25 10
Africa 68 20
Between 1950 and 1970, per capita food production and per capita agricultural
production (which includes not only food but also non edible agricultural products
like cotton, sisal, wool, and rubber) each increased by less than 1 % per year in the
Third World as a whole. Moreover, as Table 5.2 shows, the rates of growth of
both these measures of agricultural performance were much slower in the 1960s
than in the 1950s.
In fact, the agricultural sector in many developing countries completely stagnated

in the 1960s. People on the whole were little or no better off in terms of the per
capita availability of food at the end of the decade than they were at the beginning.
The situation improved somewhat during the 1970s as developing countries
increasingly turned their attention to raising agricultural productivity. As a result,
from 1970 to 1980, per capita food production grew at an annual rate of 0.5%.
These positive trends continued and even accelerated into the 1990s, with most of
the gains occurring toward the end of that decade.
From Table 2.2 we can also see that these same broad tendencies were at work
within each of the major regions of the developing world. In Latin America, there
was some increase in the growth of per capita food production in the 1970s
especially and in the 1980s, but agricultural production in the 1960s as a whole
showed no such increase. The picture for Africa is more dismal. Per capita food
production has declined steadily since the 1970s. Although the data reflect
changes in per capita food production, which may differ from food consumption
due to foreign trade, it is clear that the average African has suffered a fall in the
level of food consumption over the past decades. Because food consumption
constitutes by far the largest component in a typical African's standard of living,
the sharp decline in per capita food production and consumption means that the
region as a whole was becoming even more underdeveloped during the period
1970-1994.
Some reasons for the disappointing negative growth of African per capita food
production include insufficient and inappropriate innovation, cultivation of
marginal and sensitive lands, severe deforestation and erosion, sporadic civil wars,
and misguided (incentive-reducing) pricing and marketing policies-all of which
were exacerbated by the highest rate of population growth in the world. We have
examined the problems in sub-Saharan Africa in greater detail in Chapter 1.
The agricultural performance in Asia was varied. In the Near East, there was a
decline in the rate of growth compared to the pre-1960 period. During the 1960s,
both per capita food production and agricultural production tended to stagnate.
Whereas in the 1970s and especially in the late 1980s and early 1990s food pro-
duction rose sufficiently to provide growing increases in per capita output. Only in
the Far East region of Asia (and to a much lesser extent in Latin America) has per
capita production expanded steadily. Nevertheless, India's great drought of
TABLE 2.2 Annual Change in Per Capita Food and Agricultural Output in Third World Regions and Developed
Countries, 1950-1994
Change in Per Capita Change in Per Capita

Food Production (%) Agricultural Production (%)
Region 1948/195 1960- 1970- 1980- 1948/1952 1960-1970 1970-1980 1980-1994

2- 1960 1970 1980 1994 1960
0.
Latin America 0.4 0.6 0.9 0.2 0.0 0.7 0.5
8
Far East (excluding 1.
0.8 0.3 0.7 0.7 0.3 0.6 1.7
Japan) 7
Near East (excluding 1.
0.7 0.0 0.7 0.8 0.0 0.4 1.1
Israel) 3
Africa (excluding South 0.
0.0 . -0.7 -1.2 0.3 -0.5 -1.4 0.0
Africa) 0
0.
All developing countries 0.6 0.1 0.5 0.6 0.0 0.8 0.8
9
Developed countries 1.1 0.9 1.3 0.3 1.0 0.6 1.2 0.5
1987 demonstrated the still precarious nature of Third World food production in Asia.
We may conclude that in spite of some impressive rates of per capita GNP growth recorded in
LDC regions during the past few decades, per capita growth in the agricultural sector improved
substantially only in parts of Asia (notably China) while showing spotty progress in Latin
America and significant declines in Africa. Because the vast majority of people in developing
countries seek their livelihoods in this sector.
The magnitude and extent of Third World poverty has improved at best only marginally in Asia
and Latin America and has steadily worsened in Africa. This becomes especially apparent when
we realize that per capita aggregates for food production mask the inherently unequal
distribution of that production and consumption, just as per capita GNP figures often mask the
magnitude of absolute poverty.
The situation in sub-Saharan Africa is particularly acute. The United Nations Food and
Agriculture Organization (FAO) has repeatedly warned of catastrophic food shortages. In a
majority of African countries, the average per capita calorie intake has now fallen below
minimal nutritional standards. The FAO estimates that of Africa's 750 million people, more
than 270 million suffer from some form of malnutrition associated with inadequate food
supplies.
Whereas the severe famine of 1973-1974 took the lives of hundreds of thousands and left many
more with permanent damage from malnutrition, its geographic impact was limited to the
Senegal belt that stretches below the Sahara from Cape Verde, off the coast of Senegal in the
west, across the continent to Ethiopia. By contrast, in 1982-1984 and again in 1987-1988, 1991-
1992, and 1993-1994, the food crisis became much more widespread, with more than 22
nations threatened by severe famine, including, in addition to the Senegal nations, Zambia,
Tanzania, Malawi, Uganda, Botswana, Mozambique, Zimbabwe, and Angola.
A major reason for the relatively poor performance of Third World agriculture has been the
neglect of this sector in the development priorities of their governments. This neglect of
agriculture and the accompanying bias toward investment in the urban industrial economy can
in turn be traced largely to the misplaced emphasis on rapid industrialization via import
substitution and exchange-rate over valuation that permeated development thinking and strate-
gy during the postwar decades.
For example, during the 1950s and throughout most of the 1960s, the share of total national
investment allocated toward the agricultural sector in a sample of 18 LDCs was approximately
12%. This is despite to the fact that agriculture in these countries accounted for almost 30% of
GNP and more than 60% of total employment. One significant manifestation of this rural
neglect and the corresponding emphasis on urban growth has been the massive migration of
rural peasants into the teeming cities of developing nations.
As a result of this disappointing experience and the realization that the future of most
underdeveloped countries will depend to a large extent on what happens to their agriculture,
there has been a marked shift in development thinking and policymaking. This shift, which
began in the late 1970s and has continued into the 1990s, has been away from the almost
exclusive emphasis on rapid industrialization toward a more realistic appreciation of the
overwhelming importance of agricultural and rural development for national development. A
first step toward understanding what is needed for agricultural and rural development, however,
must be a comprehension of the nature of agricultural systems in diverse developing regions
and, in particular, of the economic aspects of the transition from subsistence to commercial
agriculture.
The Structure of Third World Agrarian Systems
When we look at the state of contemporary agriculture in most poor countries, we realize the
enormity of the task that lies ahead. A brief comparison between agricultural productivity in the
developed nations and the underdeveloped nations makes this clear. World agriculture, in fact,
comprises two distinct types of farming:
1. the highly efficient agriculture of the developed countries, where substantial productive
capacity and high output per worker permit a very small number of farmers to feed entire
nations, and
2. the inefficient and low-productivity agriculture of developing countries, where in many
instances the agricultural sector can barely sustain the farm population, let alone the
burgeoning urban population, even at a minimum level of subsistence
The gap between the two kinds of agriculture is immense. This is best illustrated by the
disparities in labor productivity. In 1960, the agricultural population of the developed nations
came to about 115 million people. They produced a total output amounting to $78 billion, or
about $680 per capita. In contrast, the per capita product of the agricultural population in the
underdeveloped countries in 1960 was only $52. In other words, agricultural labor productivity
in developed countries was more than 13 times that in the less developed countries.
By 1995, this productivity gap had widened to more than 50 to 1. For example, in LDCs the
value added per agricultural worker in 1995 was $459, while in countries like Norway, Sweden,
and Japan it was $34,809, $28,590, and $16,712, respectively. Another manifestation of the
productivity gap relates to land productivity. Table 5.3 shows variations in land productivity
(measured as kilograms of grain harvested per hectare of agricultural land) between Japan and
the United States on the one hand and six heavily populated countries in Asia, Africa, and Latin
America on the other.
TABLE 2.3: Land Productivity in Developed and Developing Countries, 1995

Country Average Grain Yield Population (million)
(kilograms per hectare)
Japan 6,119 125
United States 5,136 263
Bangladesh 2,602 120
Mexico 2,506 92
Brazil 2,383 159
India 2,136 929
Pakistan 1,943 130
Nigeria 1,172 111
We see that in 1995 Japanese and U.S. land productivity varied from as high as 522% and
438%, respectively, of Nigerian productivity to 235% and 244%, respectively, of productivity
in Bangladesh and Mexico.
In the developed countries, there has been a steady growth of agricultural output since the mid-
eighteenth century. This growth has been spurred by technological and biological
improvements, which have resulted in ever higher levels of labor and land productivity. The
growth rate accelerated after the First World War and particularly after the Second World War.
The end result is that fewer farmers are able to produce more food.
This is especially the case in the United States, where in 1998 only 2% of the total workforce
was agricultural, compared with more than 70% in the early nineteenth century. For example, in
1820, the American farmer could produce only four times his own consumption. A century
later, in 1920, his productivity had doubled, and he could provide enough for eight persons. It
took only another 32 years for this productivity to double again, and then only 12 more years
for it to double once more. By 1987, a single American farmer could provide enough food to
feed almost 80 people. Moreover, during the entire period, average farm incomes in North
America rose steadily.
The picture is entirely different when we turn to the agricultural production experience of
developing nations. In many poor countries, agricultural production methods have changed
relatively slowly over time. Later in this chapter we will discover that much of this
technological stagnation can be traced to the special circumstances of peasant agriculture, with
its high risks and uncertain rewards.
Rapid rural population growth has compounded the problem by causing great pressure to be
exerted on existing resources. Where fertile land is scarce, especially throughout South and
Southeast Asia but also in many parts of Latin America and Africa, rapid population growth has
led to an increase in the number of people living on each unit of land. Given the same farming
technology and the use of traditional non labor inputs (e.g., simple tools, animal power,
traditional seeds), we know from the principle of diminishing returns that as more and more
people are forced to work on a given piece of land, their marginal (and average) productivity
will decline. The net result is a continuous deterioration in real living standards for rural
peasants.
To avert massive starvation and raise levels of living for the average rural dweller, agricultural
production and the productivity of both labor and land must be rapidly increased throughout
Asia, Africa, and Latin America. Most developing nations need to become more self-sufficient
in their food production others can rely on their successful nonagricultural exports to secure the
necessary foreign exchange to import their food requirements. But for the majority of debt-
ridden, inefficient, and unsuccessful exporters, unless major economic, institutional, and
structural changes are made in their farming systems, their food dependence, especially on
North American supplies, will increase in the coming years.
Peasant Agriculture in Developing Countries
In many developing countries, various historical circumstances have led to a concentration of

large areas of land in the hands of a small class of powerful landowners. This is especially true in
Latin America and parts of the Asian subcontinent. In Africa, both historical circumstances and
the availability of relatively more unused land have resulted in a different pattern and structure of
agricultural activity. However, in terms of levels of farm productivity, there is little to distinguish
among the three regions.
A common characteristic of agriculture in all three regions, and for that matter in many
developed countries, is the position of the family farm as the basic unit of production. As Raanan
Weitz points out:
For the vast number of farm families, whose members constitute the main agricultural
work force, agriculture is not merely an occupation or a source of income; it is a way of
life. This is particularly evident in traditional societies, where farmers are closely attached
to their land and devote long, arduous days to its cultivation. Any change in farming
methods perforce brings with it changes in the farmer's way of life. The introduction of
biological and technical innovations must therefore be adapted not only to the natural and
economic conditions, but perhaps even more to the attitudes, values, and abilities of the
mass of producers, who must understand the suggested changes, must be willing to accept
them, and must be capable of carrying them out.
Thus in spite of the obvious differences between agricultural systems in Asia, Latin America,
and Africa and among individual nations within each region, certain broad similarities enables us
to make some generalizations and comparisons. In particular, agrarian systems in many parts of
Asia and Latin America show more structural and institutional similarities than differences, and
subsistence farmers in all three regions exhibit many of the same economic behavior patterns.
We examine first the major features of agricultural systems in Latin America and Asia.
Latin America and Asia: Similarities and Differences
Although Latin America and Asia have very different heritages and cultures, peasant life in these
two regions is in many ways similar. Francis Foland has succinct1y described these similar
features:
Both the Latin American and Asian peasant is a rural cultivator whose prime concern is
survival. Subsistence defines his concept of life. He may strive to obtain his and his
family's minimal needs by tilling an inadequate piece of land which is his own or, more
often, which is rented from or pawned to a landlord or moneylender, or by selling his
labour for substandard wages to a commercial agricultural enterprise. Profits which
might come to him through the fortunes of weather or market are windfalls, not
preconceived goals. Debt rather than profit is his normal fate, and therefore, his farming
techniques are rationally scaled to his level of disposable capital: human and animal
power rather than mechanized equipment; excrement rather than chemical fertilizers;
traditional crops and seeds rather than experimental cultivations.
No effective social security, unemployment insurance, or minimum wage law ease his
plight. His every decision and act impinges directly upon his struggle for physical sur-
vival. In countries with a high proportion of peasantry, traditional food crops which a
rural family can itself convert readily into the daily fare for its grain- or tuber-based
diet dominate the agriculture; corn in Mexico, rice in Indonesia, Mandioca in Brazil,
soy beans in China. India's is typical of peasant agriculture with seventy-five percent of
the cropped land devoted to food grains such as rice, wheat, millets, barley and lentils.
When these fail, as in Maharashtra in 1972, a peasant is reduced to trading his bullocks
for a few bananas.
Although the day- to-day struggle for survival permeates the lives and attitudes of peasants in
both Latin America and Asia (and also Africa, although the rural structure and institutions are
considerably different), the nature of their agrarian existence differs markedly. In Latin America,
the peasant's plight is rooted in the latifundio (large tracts of land owned by few land lords)
minifundio (very small sizes land holding) system. In Asia, it lies primarily in fragmented and
heavily congested dwarf parcels of land.
Subsistence Agriculture and Extensive Cultivation in Africa
As in Asia and Latin America, subsistence farming on small plots of land is the way of life for
the vast majority of African people. However, the organization and structure of African
agricultural systems differ markedly from those found in contemporary Asia or Latin America.
Except in former colonial settlement areas like White Highlands of Kenya and some of the large
sugar, cocoa, and coffee plantations of East and West Africa, the great majority of farm families
in tropical Africa still plan their output primarily for their own subsistence. Since the basic
variable input in African agriculture is farm family and village labor, African agriculture systems
are dominated by three major characteristics:
1. the importance of subsistence farming in the village community;

2. the existence of some (though rapidly diminishing) land in excess of immediate
requirements, which permits a general practice of shifting cultivation and reduces the
value of land ownership as an instrument of economic and political power;
3. the rights of each family (both nuclear and extended) in a village to have access to land
and water in the immediate territorial vicinity, excluding from such access use by
families that do not belong to the community even though they may be of the same tribe.
The low-productivity subsistence farming characteristic of most traditional African agriculture

results from a combination of three historical forces restricting the growth of output:
1. In spite of the existence of some unused and potentially cultivable land, only small areas
can be planted and weeded by the farm family at a time when it uses only traditional tools
such as the short-handled hoe, the ax, and the long handled knife or panga. In some
countries, use of animals is impossible because of the notorious tsetse fly or a lack of fodder
in the long dry seasons, and traditional farming practices must rely primarily on the
application of human labor to small parcels of land.
2. Given the limited amount of land that a farm family can cultivate in the context of a
traditional technology and the use of primitive tools, these small areas tend to be intensively
cultivated. As a result, they are subject to rapidly diminishing returns to increased labor
inputs. In such conditions, shifting cultivation is the most economic method of using limited
supplies of labor on extensive tracts of land. Under shifting cultivation, once the minerals
are drawn out of the soil as a result of numerous croppings, new land is cleared, and the
process of planting and weeding is repeated. In the meantime, formerly cropped land is
allowed to recover fertility until it can be used again. Under such a process, manure and
chemical fertilizers are unnecessary, although in most African villages some form of
manure (mostly animal waste) is applied to nearby plots that are intensively cultivated in
order to extend their period of fertility.
3. Labor is scarce during the busiest part of the growing season, planting and weeding times.
At other times, much of the labor is underemployed. Because the time of planting is
determined by the onset of the rains and because much of Africa experiences only one
extended rainy season, the' demand for workers during the early weeks of this rainy season
usually exceeds all available rural labor supplies.
The net result of these three forces had been a relatively constant level of agricultural total output
and labor productivity throughout much of Africa. As long as population size remained relatively
stable, this historical pattern of low productivity and shifting cultivation enabled most African
tribes to meet their subsistence food requirements. But the feasibility of shifting cultivation has
now broken down as population densities increase. It has largely been replaced by sedentary
cultivation on small owner-occupied plots. As a result, the need for other nonhuman productive
inputs and new technologies grows, especially in the more densely populated agricultural regions
of Kenya, Nigeria, Ghana, and Uganda. Moreover, with the growth of towns, the penetration of
the monetary economy, soil erosion and deforestation of marginal lands, and the introduction of
land taxes, pure subsistence-agricultural practices are no longer viable. Mixed and modern
commercial farming must appear, as indeed they have in parts of sub-Saharan Africa.
Of all the major regions of the world, Africa has suffered the most from its inability to expand
food production at a sufficient pace to keep up with its rapid population growth. As a result of
declining production, African per capita food consumption fell dramatically during the 1980s,
and early 1990s, while dependence on imports-particularly wheat and rice-increased.
Toward a Strategy of Agricultural and Rural Development: Some Main Requirements.
If the major objective of agricultural and rural development in Third World nations is the
progressive improvement in rural levels of living achieved primarily through increases in small-
farm incomes, output, and productivity, it is important to identify the principal sources of
agricultural progress and the basic conditions essential to its achievement. These are necessarily
interrelated, but for purposes of description we may separate them and further divide each into
three components:
Sources of Small-Scale Agricultural Progress
1. Technological change and innovation

2. Appropriate government economic policies
3. Supportive social institutions
Conditions for General Rural Advancement
1. Modernizing farm structures to meet rising food demands

2. Creating an effective supporting system
3. Changing the rural environment to improve levels of living
Let us look at each of these six interrelated components.
Improving Small-Scale Agriculture

Technology and Innovation
In most developing countries, new agricultural technologies and innovations in farm practices
are preconditions for sustained improvements in levels of output and productivity. In many parts
of Africa and Latin America, however, increased output in earlier years was achieved without the
need for new technology simply by extending cultivation into unused but potentially productive
lands. Almost all of these opportunities have by now been exploited, however, and there is not
much scope for further significant improvement.
Two major sources of technological innovation can increase farm yields. Unfortunately, both
have somewhat problematic implications for LDC agricultural development. The first is the
introduction of mechanized agriculture to replace human labor. The introduction of laborsaving
machinery can have a dramatic effect on the volume of output per worker, especially where land
is extensively cultivated and labor is scarce. For example, one man operating a huge combine
harvester can accomplish in a single hour what would require hundreds of workers using
traditional methods.
But in the rural areas of most developing nations where land parcels are small, capital is scarce,
and labor is abundant, the introduction of heavily mechanized techniques is not only often ill
suited to the physical environment but, more important, often has the effect of creating more
rural unemployment without necessarily lowering per-unit costs of food production. Importation
of such machinery can therefore be antidevelopment in that its efficient deployment requires
large tracts of land (and thus the expropriation of small holdings by landlords and moneylenders)
and tends to exacerbate the already serious problems of rural poverty and unemployment. And if
mechanized techniques exclude women, the male-female productivity gap could widen further,
with serious repercussions.
By contrast, biological (hybrid seeds), water control (irrigation), and chemical (fertilizer,
pesticides, insecticides, etc.) innovations-the major source are not without their own problems.
They are land-augmenting; that is, they improve the quality of existing land by raising yields per
hectare. Only indirectly do they increase output per worker. Improved seeds, advanced
techniques of irrigation and crop rotation; the increasing use of fertilizers, pesticides, and herbi-
cides; and new developments in veterinary medicine and animal nutrition represent major
scientific advances in modern agriculture. These measures are technologically scale-neutral;
theoretically, they can be applied equally effectively on large and small farms. They do not
necessarily require large capital inputs or mechanized equipment. They are therefore particularly
well suited for tropical and subtropical regions and offer enormous potential for raising
agricultural output in Third World nations.
Institutional and Pricing Policies: Providing the Necessary Economic Incentives
Unfortunately, although the new hybrid "miracle seeds" varieties of wheat, corn, and rice,
together with needed irrigation and chemicals (often collectively referred to as the green
revolution) are scale-neutral and thus offer the potential for small farm progress, the social
institutions and government economic policies that accompany their introduction into the rural
economy often are not scale-neutral. On the contrary, they often merely serve the needs and
vested interests of the wealthy landowners. Because the new hybrid seeds require access to
complementary inputs such as irrigation, fertilizer, insecticides, credit, and agricultural extension
services, if these are provided only to a small minority of large landowners' the effective impact
of the green revolution can be (and has been in parts of South Asia and Mexico) the further
impoverishment of the masses of rural peasants.
Large landowners, with their disproportionate access to these complementary inputs and support
services, are able to gain a competitive advantage over smallholders and eventually drive them
out of the market. Large-scale farmers obtain access to low-interest government credit, while
smallholders are forced to turn to moneylenders. The inevitable result is the further widening of
the gap between rich and poor and the increased consolidation of agricultural land in the hands of
a very few so-called progressive farmers. A developmental innovation with great potential for
alleviating rural poverty and raising agricultural output can thus turn out to be antidevelopment if
public policies and social institutions militate against the active participation of the small farmer
in the evolving agrarian structure.
Another critical area calling for major improvements in government policies relates to the
pricing of agricultural commodities, especially food grains and other staples produced for local
markets. Many LDC governments, in their headlong pursuit of rapid industrial and urban
development, have maintained low agricultural prices in an attempt to provide cheap food for the
urban modern sector. Farmers have been paid prices below either world competitive or free-
market internal prices. The relative internal price ratio between food and manufactured goods
(the domestic terms of trade) thus turned against farmers and in favor of urban manufacturers.
With farm prices so low-in some cases below the costs of production-there was no incentive for
farmers to expand output or invest in new productivity-raising technology. As a result, local food
supplies continually fell short of demand, and many developing nations, especially in sub-
Saharan Africa, that were once self-sufficient in food production had to import the balance of
their food needs. This caused further strains on their international balance of payments situation
and contributed to the worsening foreign-exchange and international debt crisis of the 1980s.
Economists therefore argue that if LDC governments are to promote increases in agricultural
production through new green revolution technologies, they must not only make the appropriate
institutional and credit market adjustments but must also provide incentives for small-and
medium-sized farmers by implementing pricing policies that truly reflect internal market
conditions. This often means less government intervention (especially in Africa) in the form of
public agricultural marketing boards, which monopolize the purchase and distribution of farm
output and set producer prices that are typically well below world market prices.
Conditions for Rural Development
Let us now collect what has already been said to formulate three propositions that in essence
constitute the necessary conditions for the realization of a people-oriented agricultural and rural
development strategy.
Land Reform
Proposition 1: Farm structures and land tenure patterns must be adapted to the dual
objectives of increasing food production and promoting a wider distribution of the
benefits of agrarian progress.
Agricultural and rural development that benefits the masses of people can succeed only through a
joint effort by the government and all farmers, not just the large farmers. A first step in any such
effort, especially in Latin America and Asia, is the provision of secured tenure rights to the
individual farmer. A small farmer's attachment to his land is profound. It is closely bound up
with his innermost sense of self-esteem and freedom from coercion. When he is driven off his
land or is gradually impoverished through accumulated debts, not only is his material well-being
damaged, but more important, his sense of self-worth and his desire for self- and family
improvement can be permanently destroyed.
It is for these humane reasons as well as for reasons of higher agricultural output and the
simultaneous achievement of both greater efficiency and more equity that land reform is often
proposed as a necessary first condition for agricultural development in many LDCs. In most
countries, the highly unequal structure of land ownership is probably the single most important
determinant of the existing highly inequitable distribution of rural income and wealth. It is also
the basis for the character of agricultural development. When land is very unevenly distributed,
rural peasants can have little hope for economic advancement.
Land reform usually entails a redistribution of the rights of ownership or use of land away from
large landowners in favor of cultivators with very limited or no landholdings. It can take many
forms: the transfer of ownership to tenants who already work the land to create family farms
(Japan, South Korea, Taiwan); transfer of land from large estates to small farms (Mexico), rural
cooperatives (Cuba), or state farms (Peru); or the appropriation of large estates for new
settlement (Kenya). All go under the heading of land reform and are designed to fulfill one
central function: the transfer of land ownership or control directly or indirectly to the people who
actually work the land.
There is widespread agreement among economists and other development specialists on the
need for land reform. To Myrdal, land reform holds the key to agricultural development in
Asia. The Economic Commission for Latin America (ECLA) has repeatedly identified land
reform as a necessary precondition for agricultural and rural progress. According to reports in
many Third World regions, land reform remains a prerequisite for development. The report
argued that such reform was more urgent today than ever before, primarily because
(1) income inequalities and unemployment in rural areas have worsened,

(2) rapid population growth threatens further to worsen existing inequalities, and
(3) recent and potential technological breakthroughs in agriculture (the green
revolution) can be exploited primarily by large and powerful rural landholders
and hence can result in an increase in their power, wealth, and capacity to resist
future reform.
(4) Finally, as noted earlier, from a strict view of economic efficiency and growth,
there is ample empirical evidence that land redistribution not only increases
rural employment and raises rural incomes but also leads to greater agricultural
production and more efficient resource utilization.
If programs of land reform can be legislated and effectively implemented by the government,
the basis for improved output levels and higher standards of living for rural peasants will be
established. Unfortunately, many land reform efforts have failed because LDC governments
(especially those in Latin America) bowed to political pressures from powerful landowning
groups and failed to implement the intended reforms But even an egalitarian land reform
program alone is no guarantee of successful agricultural and rural development. This leads to
our second proposition.
Supportive Policies
Proposition 2: The full benefits of small-scale agricultural development cannot be

realized unless government support systems are created that provide the necessary
incentives, economic opportunities, and access to needed credit and inputs to enable
small cultivators to expand their output and raise their productivity.
Though land reform is essential in many parts of Asia and Latin America, it is likely to be
ineffective and perhaps even counterproductive unless there are corresponding changes
1. in rural institutions that control production (e.g., banks, moneylenders, seed and fertilizer
distributors),
2. in supporting government aid services (e.g., technical and educational extension services,
public credit agencies, storage and marketing facilities, rural transport and feeder roads),
and
3. in government pricing policies with regard to both inputs (e.g., removing factor-price dis-
tortions) and outputs (paying market-value prices to farmers).
Even where land reform is not necessary but where productivity and incomes are low (as in the
whole of Africa and much of Southeast Asia), this broad network of external support services,
along with appropriate governmental pricing policies related to both farm inputs and outputs, is
an essential condition for sustained agricultural progress.
Integrated Development Objectives
Proposition 3: Rural development, though dependent primarily on small-farmer

agricultural progress, implies much more. It encompasses:
(a) efforts to raise both farm and non-farm rural real incomes through job creation,
rural industrialization, and the increased provision of education, health and nutrition,
housing, and a variety of related social and welfare services;
(b) a decreasing inequality in the distribution of rural incomes and a lessening of
urban- rural imbalances in incomes and economic opportunities; and
(c) the capacity of the rural sector to sustain and accelerate the pace of these
improvements over time.
This proposition is self-explanatory. We need only add that the achievement of its three
objectives is vital to national development. This is not only because the majority of Third World
populations are located in rural areas but also because the burgeoning problems of urban
unemployment and population congestion must find their ultimate solution in the improvement
of the rural environment. By restoring a proper balance between urban and rural economic
opportunities and by creating the conditions for broad popular participation in national develop-
ment efforts and rewards, developing nations will have taken a giant step toward the realization
of the true meaning of development.
2.3 Economic and Non-Economic factors of development.
2.3.1 Non-Economic Factors
i. Historical Factors
As mentioned in the first unit the basic reason for the backwardness of the underdeveloped
countries is that they were late comers or starters in the race. This is due to the fact that most of
them had been colonies of Western powers till recently. As explained earlier, this resulted in
their exploitation by the colonial powers. The colonies provided the raw materials as well as an
assured market for the finished products of the advanced countries. As such the latter were not
interested in developing their colonies, help them to achieve economic self-sufficiency, as that
would retard their own economic development. It was, therefore, in their interest to keep these
colonies perpetually in a state of under development. The Western countries thus developed only
those sectors, which would help in furthering their own economies and facilities exports. Thus,
railways, ports, harbors were built to open up the rich hinterland for export purposes.
After attaining independence the former colonies found themselves with practically ruined
economies, some sectors well developed while others very back ward; and they had to shoulder
the hard task of building up their economies from scratch, and to correct the many imbalances
caused by unfair economic practices of the colonists.
There are also internal factors like the class structure of the society land holding and land
distribution systems and resource ownership being very unequal and have remained an obstacle
to their development for long period of time.
The few rich and the nobility have controlled all the resources in each of these developing
countries until very recently and even use these resources for unproductive purposes (i.e., for
luxurious expenditures, real estate building etc.). These internal factors have also contributed to
their underdevelopment and resulted in that the majority or the mass rural and urban population
to live in absolute poverty.
ii. Social and Cultural Obstacles
The attitude of the masses in the underdeveloped countries is strikingly different from that of
their Western counter parts. In many underdeveloped countries, the dogmas of religion are
strictly followed, and the majority of the population believes in fate, karma, suppression of
desires and maintains philosophical attitude towards life. Greater stress is laid on spiritual
development than on material welfare.
The Western countries breaking away from the orthodox church and the narrow confines of
religion were in a better position to improve their material condition. With a more rational and
scientific outlook, they recognized the great potentiality of science and nature and worked to
harness them for economic development. But in the underdeveloped countries, where
superstition and orthodoxy prevail understanding of natural phenomena was not put to
production use.
iii. Population Pressures:

In most of the Asian countries, the high rate of population growth has had an adverse effect on
economic development. With improvements in medical and health facilities and the eradication
of many fatal diseases and epidemics the death rate has been reduced in underdeveloped
countries. With only a marginal fall in birth rate, most of the underdeveloped countries are
experiencing “population explosion. “While almost the same conditions were experienced by the
advanced countries during their development phase (in the 18 th and 19th centuries) the extra
population found an outlet in their colonies and in the New World like Canada, USA, Australia
and New Zealand. This is not possible in the present underdeveloped countries with the result
that there is over population in agriculture and other primary sectors. Population can act as an
obstacle to development in the sense that every increase in production in consumed up by the
increasing numbers. This leaves very little surplus for investment and the development effort has
to be much more than what the underdeveloped countries are capable of bearing. Increase in
demand for consumption would mean a large part of investment being diverted to the production
of goods meant for current consumption and hence a reduced investment in long term projects
which are required for reaching higher growth rates.
Increasing population leads to increasing unemployment as employment opportunities do not

keep pace with population growth. This means that the burden on the employed increases. The
unemployed, the children and the aged have to be looked after by the few employed persons.
This results in lowering the per capita income and consumption, leading to poverty, malnutrition
and frustration.
2.3.2 Economic Factors which Hinder Development
Given the non-economic factors we can now examine the fundamental economic factors which
hinder development. It has been widely accepted that it is the low level of capital accumulation
and high rate of population growth that hinder economic development. Now let us see some of
these factors:
i. Capital Deficiency
Underdevelopment is the result of lack of supply and demand for capital. Thus there are vicious
circles on both the demand and supply side of capital formation.
On the supply side, capital formation can be generated through investment of the surplus or
savings. But the savings are low due to the law level of income received. The low incomes are
due to the low level of production. Low productivity is caused by lack of capital. Lack of capital
is due to the low level of saving and investment. Hence the vicious circles of the supply side is
complete.
This can be shown in the form of a diagram:

Low
capital
formation
Low level of
investment
Lack of capital
Low income
Low productivity
On the demand side: Nurkse says that the incentive to invest in lacking. An expansion in
production is cause by increasing demand for goods and services. But in an underdeveloped
country, demand is low because of low incomes. Low incomes are caused by low productivity,
which is in turn due to lack of capital. Lack of capital is due to lack of inducement to invest. This
forms the demand side of the vicious circle. Thus:
Lack of inducement
to invest
Low levels Low demand

of capital formation
Low productivity Low incomes
It can be seen that low productivity leading to low income is a factor common to both circles.
These circles trap the underdeveloped countries in a low income, low productivity trap at a
stagnant level, and only if it can be broken at some point can development take place.
ii. Dualistic Economies

We have seen already that the underdeveloped countries are characterized by a dualistic
economic structure with great inequalities of incomes; the high-income groups are affected by
the consumption patterns of the advanced countries. A small section of the rich are able to enjoy
a very high standard of living, while others live in great poverty. The demand for luxury goods
lead to misuse of scarce capital goods, foreign exchange and trained manpower. The diversion of
these resources leads to reduction in the real resources available for legitimate economic
development. Thus a dualistic economy not only causes inequalities of income and consumption
but also sets up a terminable obstacle to economic development.
2.4 Role of the market Versus Role of the government.
Market failures and reasons for public intervention

It is a fact that free market and laissez faire types of economic policies have often led to
situations considered sub-optimal from many points of view, even from purely efficiency
considerations. Some economists then, by fundamentally accepting the theoretical argument
included in the neoclassical theory of competitive equilibrium, have tried to study in more detail,
possible reasons for why the claimed superiority of the free market may fail to manifest itself.
The reasons that have been found that prevent the economy to settle on efficient, competitive
equilibriums, have been termed as market failures, which imply the existence of something that
prevents the agents in the economy from engaging in all of the actually profitable trades. As a
result, whenever one of this failures exists, the economy will reach equilibriums which are not
competitive, and thus, not necessarily efficient. Some of the market failures recognized in the
economic literature can be listed as:
- Lack of competition
- Presence of externalities and incomplete property rights
- Presence of public goods and common property resources
- Incomplete and asymmetric information
2.4.1. Non-competitive markets
Whenever there is market power on one side of the transaction, the resulting price does not
equates the marginal cost of production, something that is needed to achieve competitive
efficiency. Part of the revenues from selling the product when in a monopoly position, will be
pure rent, rather that normal returns to the factors of production, so that one of the needed
conditions for efficiency breaks down. As a result, less of the product is sold and at a higher
price.
2.4.2. Presence of externalities and incomplete property rights

An externality is the effect of some production or consumption activity on other agents that those
directly involved in the transaction. Usually, the external benefit or costs associated with the
externality are not recognized or borne by the agents involved in the transaction, and as such,
their existence is not reflected in the equilibrium price, which fails to capture the external
benefits or the external cost, resulting in a socially inefficient allocation of the resources. Ronald
Coase has connected the problem of externalities to the problem of incomplete property rights by
suggesting that any inefficiency induced by the presence of externalities could be corrected by
the appropriate definition of property rights, which would allow the internalization of external
effects. The most common example is that of a factory whose activity releases pollution in the
air, which cause damage to the population. This is an externality if the firm owner is not held
responsible for the damages caused on the general population by the pollution. The inefficient
outcome is that too much pollution will be produced because who produced it does not pay the
relative cost for the society, and society cannot force the firm to reduce the pollution because
there is no such thing as the property right over clean air.
2.4.3. Public goods and common property resources

When a good is characterized by non-excludability, non-rivalry is defined as a public good, as
opposed to private good. For public goods it is not possible to define private property rights, and
thus the incentives to trade them are inexistent. If left to the private initiative, there will be
under-provision of public goods such as public defense, schooling and generalized health care
(such as immunization programs), natural environment protection, etc. The reason is that no
private operator will find it profitable to provide a good that other people can enjoy without
paying for it.
2.4.4. Incomplete and asymmetric information

The theorems of welfare economics are based on the assumption that individuals are aware of all
of the trade opportunities that there exist in the economy, so that they can recognize and exploit
those mutually beneficial. This is a very strong assumption that is not true in practice. For
example, the uncertainty in production we discussed yesterday may prevent producers from
making the most efficient decision regarding the use of inputs. And that is simply because of
incomplete information on the probability of occurring of the bad weather. Also, when some
goods’ benefits extend over long period of time (for example, the exploitation of forestry or other
natural resources such as oil reserves) ignorance on the potential future benefits of those
resources may lead to over exploitation in the present. These are all cases of incomplete
information, when the benefits or the costs of a given economic action are not fully known by the
agents that have to decide. Very common is also the presence of asymmetric information, namely
the fact that the two agents involved in the transaction might have different levels of knowledge
about the benefits and costs involved in the transaction. Asymmetric information leads to the
phenomena known as moral hazard and adverse selection, which are studied extensively for the
design of contracts in general and insurance and labor contracts in particular. The presence of
asymmetric information causes additional costs, related to the need for monitoring the activity of
the insured or of the worker, which would not exist if information were symmetric.
2.4.5. Government intervention in the economy

Government intervention may be justified to correct for market failures and to increase
efficiency. Levying taxes on polluting activities, for example, may be intended to correct for the
presence of externalities. Public provision of public goods may correct for the under provision of
such goods by private operators. Public contracts and subsidized insurance may correct for the
presence of asymmetric information, and so on. For any market failure, one can think of a form
of public intervention that in principle might compensate for the negative effect. Notice,
however, that correction of market failures only allows for achieving efficiency in the use of the
resources. These types of intervention do not address problems of unequal distribution of the net
benefits – i.e. the equity concern. This leads to a whole range of other possible forms of public
intervention whose objective is direct or indirect redistribution of income to achieve a higher
level of equity in the society. To summarize, it is clear that the laissez faire or non-intervention
of the government in the operation of the market is very unlikely to achieve even just the
efficient economic use of the resources, not to mention equity. For this reason, even in
capitalistic economies, the extent of state involvement in the economy can be very high, as
opposed to the traditional view that large involvement of the state in the economy is typical of
socialist economies. In short, state involvement in the economy may be needed:
- to correct for market failures;
- to achieve non efficiency objectives.
However, large involvement of the government does not necessarily implies better outcomes in
terms of efficiency and equity. The concept of state that we are assuming throughout the
discussion is a very idealistic and abstract one: we imagine the state as a benevolent, well
informed and technically equipped agent, who can correct for market failures without inducing
other forms of “failures”. In reality, the government and the state are made of people who can
suffer of the same information problems that affect common citizens. The state, in other words,
can be as inefficient as the private market because of many phenomena, which have been named
“state failures”. The most widely discussed form of state failure in the recent literature on
economic development is the so-called “rent-seeking” or directly unproductive profit-seeking
activities. In the analysis of policies, we must be aware of these problems. In other words, in
evaluating policies one should ask:
- Does the policy address equity objectives, efficiency objectives, or both?
- If it addresses efficiency, which form of market failure it tries to correct for?
- If the policy requires direct involvement of the state in the market, are there other less intrusive,
more private means of achieving the same objective?
- If not, which potential forms of “state failure” might be involved and how can they be
prevented?
2.5 The Environment & Development
a. Increase in Aggregate Output Versus increase in Per-Capita out put
Environmental regulations divert inputs from the production of output to other goals, such as,
reducing emissions. Since environmental benefits are not measured in GDP, they are not part of
measured output. Thus, resources diverted to environmental protection cannot be considered in
the equation. GDP falls, thus, economic growth, as traditionally measured, slows.
Environmental policy can affect technological change. Weather this is good or bad for growth is
a debated topic.
There are positive effects of the environment on the economy. Even though most environmental
benefits are not included in GDP, some benefits have tangible dollar values.
According to its creator’s world was built to investigate five major trends of global concern –
accelerating industrialization rapid population growth widespread malnutrition depletion of non-
renewable resources and a deteriorating environment. There trends are all interconnected in
many ways and their development is measured in decades or centuries rather than in months or
years with the model we are seeking to understand the causes of these trends their
interrelationships and their implications as much as one hundred years in future; Meadows, et al,
1972. It incorporated a limit to the:
i. amount of land available for agriculture,
ii. amount of agricultural output producible per unit of land in use
iii. amount of non-renewable resources available for extraction
iv. ability of the environment to assimilate wastes arising in production and consumption
which limit falls as the level of pollution increases
On the basis of a number of simulations using world3, the conclusions reached by the modeling
team were as follows:
a. If the present growth trends in world population industrialization, pollution food
production and resource depletion continue unchanged the limits to growth on this planet
will be reached sometime within the next 100 years the most probable result will be
sudden and uncontrollable decline in both population and industrial capacity;
b. It is possible to alter these trends and to establish a condition of ecological and economic
stability that is sustainable far into the future The state of global equilibrium could be
designed so that the basic material needs of each person on earth are satisfied and each
person has an equal opportunity to realize his or her individual human potential,
c. If the world’s population decide to strive for this second outcome rather than the first the
sooner they begin working to attain it the greater will be their chances of success.
Another argument called ‘Social limits to growth’ was developed following the “Limits to
growth’ (For instance, Hirsch, 1977). To this group the major propositions about the desirability
of growth include the:
a. desirability of growth financed by running down resources is limed by the cost imposed
on future generations,
b. extinction or reduction in the number of sentient non-human species whose habitat
disappears limits the desirability of growth financed by take over;
c. self-canceling effects on welfare limit the desirability of aggregate growth;
d. Desirability of growth is lilted by the corrosive effects on moral standards of the very
attitudes that foster growth, such as glorification of self-interest and a scientific
-technocratic world view.
The last two of these propositions are called ‘social limits to growth’ Once basic material needs
are satisfied, Further economic growth is associated with an increasing proportion of income
being spent on positional goods, As a consequence, growth is a much less socially desirable
objective than economists have usually though.
b. The Environmental Kuznets Curve
Dear learner, from the above discussion can you tell what the environment Kuznet’s curve
says?
The Kuznets Curve describes the relationship between economic growth and inequality.
According to Kuznets Curve, inequality first increases, and then decreases with economic
growth. The world development report 1992 noted that “the view that greater economic activity
inevitably hurts the environment is based or static assumptions about technology, tastes and
environmental investments.’ For example, the per capita missions of some pollutant in to the
environment (e) and per capita income (y), then the view that is being referred to can be
represented as:
e = α y ---- (1)
So that ‘e’ increases linearly with ‘y’ as shown in Figure 5.1. This is the sort of relationship that
the creators of “ Limits to growth’ claimed.
E= αy
y
e
Figure:2.1 Environmental Impact and Income: View of “Limits to Growth’ School
On the other hand, suppose that the coefficient a is itself a liner function of ‘y’:
α=β 0 −β 1 γ ----------------- (3)
For β 1 , sufficiently small in relation to 0 β
e/y relationship takes the form of an
inverted U, as shown in Figure-2.2. With this form of relationship, economic growth mean
higher emissions per capita unit per capita income reaches the truing point, and there after
actually reduce emissions per capita.
It has been hypothesized that a relationship like that shown in Figure 5.2 holds for many forms
of environmental degradation. Such a relationship is sometimes called an ‘Environmental
Kuzents Curve’ (EKC), after Kuznets (1955), who hypothesized an inverted U for the
relationship between a measure of inequality in the distribution of income and the level of
income. If the EKC hypothesis held generally, it could imply the instead of being a threat to the
environment as argued in the ‘ Limits to Growth’, economic growth is the means to
environmental improvement. That is, as countries develop economically, moving form lower to
higher levels of per capita income, over all levels of environmental degradation will eventually
fall.
y
Figure:2.2 Environmental Impact and Income: Kuznets Curve
2
E= β 0 y−β 1 y
e
c. Environmental Impact in the Long-run
The EKC implies that the magnitude of environmental impacts of economics activity will fall as
income rise above some threshold level, when both these variable are measured in per capita
terms. Some economists (For instance Common, 1995) examined the long-term implication of
EKC hypothesis. There are the following two possible outcomes of environmental impacts.
i. Environmental impacts per unit of income eventually fall to zero as the level of income
rises.
ii. Environmental impacts per unit income falling to some minimum level, say ‘k’ as in
Figure-2.3; and there after reaming constant at that level as income continue to
increase.
Figure:2.3 EKC in the long run

Environmental
Impact per unit
Income
K b
a
0 y’ y1 Y2 Income
Assume that the world consists of two categories of countries; developed and developing, which
are growing at the same constant rate of growth ‘g’. However, the growth process began at an
earlier date in the developed country and so at any point in time its per capita income level is
higher than in the developing country.
The above mentioned two cases (a) and (b) can be analyzed as follows. The highly optimistic
version of EKC, ‘a’ will be as given in the part-1 of Figure-5.4. There we can see a dip in the
central part of the curve; because for some period of time income levels in the two countries will
be such that the developed county is on the downward sloping portion of its EKC, while the
developing country is still on the upward sloping part of its EKC. However as time passes and
growth continues, both countries will be at income levels where the EKC curves have a negative
slope; together with the assumption of case ‘a’ (impacts per unit income fall to zero). This
implies that the total level of impacts will itself converge to zero as time becomes increasingly
large.
Summary
In this chapter the important points discussed are:

 the need for government intervention in an economy due to market failures
 different areas of market failure
 Different policy options available for government intervention in an economy
 Economic and non-economic factors that affect development
 Agriculture and different features of agriculture in developing countries and their
implication for government interference
Review questions
1. List some the policies available for government intervention
2. What are the conditions for general rural advancement?
Answers
1. There are different policies available for intervention. These are:

o General economic and social policies
o Policies relating to agricultural and rural development
o Policies relating to markets and property rights
o Policies aimed at establishing democratic and participatory processes
Policies focused specifically on natural resource use and environmental protection
2. Conditions for General Rural Advancement
a) Modernizing farm structures to meet rising food demands
b) Creating an effective supporting system
c) Changing the rural environment to improve levels of living
CHAPTER THREE
INDUSTRIALIZATION & AGRICULTURE
3.1.10. Structural Transformation.

3.1.11. Modeling structural transformation.
3.1.12. Elements of structural transformation.
3.1.13. Agriculture’s contribution Development.
3.1.14. Complementarities of Agriculture and Industry.
3.1.15. Industrialization.
3.1.16. External Economies & Industrialization.
3.1.17. Industrialization through Export Promotion.
3.1.18. Industrialization through Import Substitution.
Introduction
In this chapter, we will discuss structural transformation and how to model it. In addition to this,
we will consider elements of structural transformation. Moreover, the role of agriculture and in
economic development and its complementarity with industry is given emphasis.
Industrialization and its approaches like import substitution and export led are discussed.
Objectives: At the end of this chapter, students are expected to have understanding on:
 the concept of agricultural transformation and how it is modeled
 agriculture’s contribution to development and its complementarity with industry
 industrialization and external economy
 different approaches of industrialization
3.1.1. Structural Transformation.
Prof. Arthur Lewis has developed a very systematic theory of economic development with
unlimited supply of labor. This theory is one of the best-known early theoretical models of
development that focused on the structural transformation of a primary subsistence economy.
Lewis' model starts with the assumption of a dual economy with a modern industrial sector and a
traditional subsistence sector. Lewis believed that in the traditional sector of many
underdeveloped countries there is unlimited supply of labor at subsistence wage.
Surplus Labor means the existence of such a large population in the rural sector so that the
marginal productivity of labor has fallen to zero. This condition is also called disguised
unemployment. The essence of the development process in this type of an economy is the
transfer of labor resources from the agricultural sector where they add nothing to production to
the more modern industrial sector, where they create a surplus. Economic development takes
place when capital accumulates as a result of withdrawal of surplus labor from the subsistence to
the modern industrial sector. The situation of subsistence wage and surplus labor is illustrated
below.
3.1.2. Modeling structural transformation.
Fig. 3.1 shows the marginal product of successive units of labor added to the land. OW is the
subsistence wage. At this wage, there is unlimited supply of labor. The productivity of labor
increases at the beginning but after X units of labor, marginal product of labor declines. Owing
to diminishing returns, after X1 units of labor, marginal contribution of labor to output falls below
the subsistence wage. And after X 2 units of labor, the contribution of labor to output becomes
negative and total product will decline with successive additions of labor beyond X 1. All the
labor beyond X1 is considered as surplus labor and is in a completely elastic supply to the
industrial sector at whatever the industrial wage.
Fig. 3.1: Subsistence wage and surplus labour

erial Product of labour
Subsistence Wages
W
The
X1 X2 MPl
Units of
Labour added
To attract labour from agriculture to industrial sector they must be offered wages which is higher
than the wages they get in the agricultural sector. Lewis assumes that urban wages will have to
be at least 30% higher than average rural income to induce workers. As indicated on Fig. 3.2
below, industrial wage, WI, is greater than agricultural wage, WA. Employments in the industrial
sector would hire labourers to the point where it is profitable to do so. It means that they will
employ workers up to that point where the marginal productively of workers equals wage rate.
After paying the wages the remaining part of output creates profits of the employer. A part of the
profit is reinvested by the capitalist in the industrial sector. By investing more capital, he can
introduce new capital equipments, more raw materials, etc. The expansion of the industrial sector
makes it possible to employ
new employees. This for Lewis is the essence of the development process. The stimulus to
investment comes from the rate of profit, which must rise over time because all the benefits of
increased productivity accrue to capital as real wage is constant. This process continues.
Criticisms of Surplus Labor Theory

Although the Lewis two-sector development model is simple and roughly reflects the historical
experience of economic growth in the west, some of its key assumptions do not fit the
institutional and economic realities of most contemporary developing countries.
1. Lewis assumes that due to competitive labour market, the wage rate remains constant in the
urban sector for a long time. It is an unrealistic assumption.
2. If the method of production in the industrial sector is capital intensive and labour saving,
this theory will not work
3. It considers lack of skilled labourers as a temporary bottleneck in the development process
of underdeveloped countries. But it is a serious problem.
4. Lack of entrepreneurial initiative is another problem that affects the industrial expansion of
developing economies
5. It is unrealistic to assume that there is high unemployment in rural areas and full
employment in urban areas. In most developing countries the reverse is true. Schultz
argued that MP of labour in the over-crowded agricultural sector is not zero. So, when
there is shift the workers from agricultural to industry, the agricultural production decreases
6. Mobility of labour from agriculture to industrial sector is not easy. Differences in language
and customs, problem of housing, high cost of living in urban sector and the attachment of
the people to their family land are some factors that affect the labour mobility.
7. It is a one sided theory because the theory does not consider the possibilities of progress in
the agricultural sector.
3.1.3 Elements of structural transformation
For expository convenience, we can identify three broad stages in the evolution of agricultural
production:
1. The first and most primitive is the pure, low-productivity, mostly subsistence-level,
peasant farm.
2. The second stage is what might be called diversified or mixed\family agriculture, where
part of the produce is grown for consumption and part for sale to the commercial sector.
3. The third stage represents the modern farm, exclusively engaged in high-productivity
specialized agriculture geared to the commercial market.
Agricultural modernization in mixed-market developing economies may be described in terms

of the gradual but sustained transition from subsistence to diversified and specialized
production. But such a transition involves much more than reorganizing the structure of the
farm economy or applying new agricultural technologies. We have seen that in most traditional
societies, agriculture is not just an economic activity; it is a way of life. Any government
attempting to transform its traditional agriculture must recognize that in addition to adapting
the farm structure to meet the demand for increased production, profound changes affecting
the entire social, political, and institutional structure of rural societies will often be necessary.
Without such changes, agricultural development will either never get started or, more likely,
simply widen the already sizable gap between the few wealthy large landholders and the
masses of impoverished tenant farmers, smallholders, and landless laborers.
Before analyzing the economics of agricultural and rural development, therefore, we need to
understand how the agricultural system of a developing nation tends to evolve over time from
a predominately subsistence-level and small-scale peasant orientation to more diversified and
larger extended family operations and eventually to the dominance in total production of large-
scale commercial enterprises.
a. Subsistence Farming: Risk Aversion, Uncertainty, and Survival
On the classic peasant subsistence farm:

1. most output is produced for family consumption (although some may be sold or traded in
local markets), and a few staple food crops are the chief sources of food intake.
2. Output and productivity are low, and only the simplest traditional methods and tools are
used.
3. Capital investment is minimal; land and labor are the principal factors of production.
4. The law of diminishing returns is in operation as more labor is applied to shrinking (or
shifting) parcels of land.
5. The failure of the rains, the appropriation of his land, and the appearance of the
moneylender to collect outstanding debts are the banes of the peasant's existence and
cause him to fear for his survival.
Labor is underemployed for most of the year, although workers may be fully occupied at
seasonal peak periods such as planting and harvest. The peasant usually cultivates only as much
land as his family can manage without the need for hired labor, although many peasant farmers
intermittently employ one or two landless laborers. The environment is harsh and static.
Technological limitations, rigid social institutions, and fragmented markets and communication
networks between rural areas and urban centers tend to discourage higher levels of production.
Any cash income that is generated comes mostly from non-farm wage labor.
Throughout much of the developing world, agriculture is still in this subsistence stage. But in
spite of the relative backwardness of production technologies and the misguided convictions of
some foreigners who attribute the peasants' resistance to change as a sign of incompetence or
irrationality, the fact remains that given
 the static nature of the peasants' environment,
 the uncertainties that surround them, the need to meet minimum survival levels of output,
and
 the rigid social institutions into which they are locked, most peasants behave in an eco-
nomically rational manner when confronted with alternative opportunities.
As one informed observer of peasant agricultural systems has noted:
Despite the almost infinite variety of village-level institutions and processes to be found
around the world, they have three common characteristics which are pertinent to change: 1,
they have historically proven to be successful; the members have survived; 2, they are
relatively static, at least the general pace of change is below that which is considered desirable
today; and 3, attempts at change are frequently resisted, both because these institutions and
processes have proven dependable and because the various elements constitute something akin
to an ecological unity in the human realm.
The traditional two-factor neoclassical theory of production where land (and perhaps capital) is
fixed and labor is the only variable input provides some insight into the economics of subsistence
agriculture. Specifically, it provides an economic rationale for the observed low productivity of
traditional agriculture in the form of the law of diminishing marginal productivity.
Unfortunately, this theory does not satisfactorily explain why peasant agriculturalists are often
resistant to technological innovation in farming techniques or to the introduction of new seeds or
different cash crops. According to the standard theory, a rational income or profit-maximizing
farm or firm will always choose a method of production that will increase output for a given cost
(in this case, the available labor time) or lower costs for a given output level.
But the theory is based on the crucial assumption that farmers possess "perfect knowledge" of
all technological input-output relationships as well as current information about prevailing factor
and product prices. This is the point at which the theory loses a good deal of its validity when
applied to the environment of subsistence agriculture in much of Asia, Africa, and Latin
America. Furthermore, when access to information is highly imperfect, the transaction costs of
obtaining this information are usually high. As a result, peasant farmers often face price bands (a
wide range) rather than a single input price. Along with limited access to credit and insurance,
such an environment is not conducive to the type of behavior posited by neoclassical theory and
goes a long way to explain the actual day- to-day behavior of peasant farmers.
Subsistence agriculture is thus a highly risky and uncertain venture. It is made even more so by
the fact that human lives are at stake. In regions where farms are extremely small and cultivation
is dependent on the uncertainties of variable rainfall, average output will be low, and in poor
years the peasant and his family will be exposed to the very real danger of starvation. In such
circumstances, the main motivating force in the peasant's life may be the maximization not of
income but rather of his family's chances of survival.
Accordingly, when risk and uncertainty are high, a small farmer may be very reluctant to shift
from a traditional technology and crop pattern that over the years he has come to know and
understand to a new one that promises higher yields but may entail greater risks of crop failure.
When sheer survival is at stake, it is more important to avoid a bad year (total crop failure) than
to maximize the output in better years. In the jargon of economic statistics, risk-avoiding peasant
farmers are likely to prefer a technology of food production that combines a low mean per-
hectare yield with low variance (less fluctuations around the average) to alternative technologies
and crops that may promise a higher mean yield but also present the risk of a greater variance.
Figure 3.2 provides a simple illustration of how attitudes toward risk among small farmers may
militate against apparently economically justified innovations. In the figure, levels of output and
consumption are measured on the vertical axis and different points in time on the horizontal axis,
and two straight lines are drawn. The lower horizontal line measures the Minimum Consumption
Requirements (MCR) necessary for the farm family's physical survival. This may be taken as the
starvation minimum fixed by nature. Any output below this level would be catastrophic for the
peasant and his family. The upper, positively sloped straight line represents the minimum level
of food consumption that would be desirable given the prevailing cultural factors affecting
village consumption standards. It is assumed that the Minimum Desirable Consumption Level
(MDCL) rises over time to reflect rising expectations as traditional societies are opened up to
external influences. The producer's attitude toward risk will be largely conditioned by his
historical output performance relative to these two standards of reference.
Looking at Figure 3.2, we see that at time X, farmer A's output levels have been very close to
MCR. He is barely getting by and cannot take a chance of any crop failure. He will have a
greater incentive to minimize risk than farmer B, whose out put performance has been well
above the minimum subsistence level and is close to the culturally determined MDCL. Farmer B
will therefore be more likely to innovate and change than farmer A
Figure 3.2 Small-Farmer Attitudes toward Risk: Why It Is Sometimes Rational to Resist
Innovation and Change.
Minimum desirable consumption level (MDCL)
Farmer B
Output and consumption
Farmer A
Minimum consumption requirement (MCR)
0
X Time
For the more statistically minded, there is an alternative way to look at risk aversion decisions of
peasant farmers. In Figure 3.3, two graphs portraying hypothetical probabilities for crop yields
are depicted. The higher graph (technique A) shows a production technology with a lower mean
crop yield (10) than that of technique B (12), shown by the lower graph. But it also has a lower
variance around that mean yield than technique B. Clearly, the chances of starving are much
greater with technique B, so risk-averse peasant farmers would naturally choose technique A: the
one with the lower mean yield.
Many programs to raise agricultural productivity among small farmers have suffered because of
failure to provide adequate insurance (both financial credit and physical "buffer" stocks) against
the risks of crop shortfalls, whether these risks are real or imagined. An understanding of the
major role that risk and uncertainty play in the economics of subsistence agriculture would have
prevented early and unfortunate characterizations of subsistence or traditional farmers as
technologically backward, irrational producers with limited aspirations or just plain "lazy
natives" as in the colonial stereotype. Moreover, in many parts of Asia and Latin America, a
closer examination of why peasant farmers have apparently not responded to an "obvious"
economic opportunity will often reveal that:
1. the landlord secured all the gain,

2. the moneylender captured all the profits,
3. the government's "guaranteed" price was never paid, or
4. complementary inputs (fertilizers, pesticides, assured supplies of water, adequate non-
usurious credit, etc.) were never made available.
Figure 3.3 Crop Yield Probability Densities of Two Different Farming Techniques
0.5
0.4
Probability
Technique A
Technique B
We may conclude that peasant farmers do act rationally and are responsive to economic
incentives and opportunities. Where innovation and change fail to occur, we should not assume
that peasants are stupid, irrational, or conservative; instead, we should examine carefully the
environment in which the small farmer operates to search for the particular institutional or
commercial obstacles that may be blocking or frustrating constructive change. As Keith Griffin
has pointed out:
If peasants sometimes appear to be unresponsive or hostile to proposed technical

changes, it is probably because the risks are high, the returns to the cultivator are low- for
example, because of local custom or land tenure conditions, or because credit facilities
and marketing outlets are inadequate and the necessary inputs-including knowledge-are
missing.
Efforts to minimize risk and remove commercial and institutional obstacles to small-farmer
innovation are therefore essential requirements of agricultural and rural development.
b. The Transition to Mixed and Diversified Farming
It is neither realistic nor necessarily desirable to think of instantly transforming a traditional
agrarian system that has prevailed for many generations into a highly specialized commercial
farming system. Attempts to introduce cash crops indiscriminately in subsistence farms have
more often than not resulted in the peasants' loss of land to moneylenders or landlords.
Subsistence living is merely substituted for subsistence production. For small farmers, exclusive
reliance on cash crops can be even more precarious than pure subsistence agriculture because the
risks of price fluctuations are added to the uncertainty of nature.
Diversified or mixed farming therefore represents a logical intermediate step in the transition
from subsistence to specialized production. In this stage, the staple crop no longer dominates
farm output, and new cash crops such as fruits, vegetables, coffee, and tea are established,
together with simple animal husbandry. These new activities can take up the normal slack in
farm workloads during times of the year when disguised unemployment is prevalent. This is
especially desirable in many developing nations where rural labor is abundantly available for
better and more efficient use. For example,
 if the staple crop occupies the land during only parts of the year, new crops can be
introduced in the slack season to take advantage of both idle land and family labor.
 where labor is in short supply during peak planting seasons, as in many parts of Africa,
simple laborsaving devices (such as small tractors, mechanical seeders, or animal-
operated steel plows) can be introduced to free labor for other farm activities.
 Finally, the use of better seeds, fertilizer, and simple...irrigation to increase the yields of
staple crops like wheat, maize, and rice can free part of the land for cash crop cultivation
while ensuring an adequate supply of the staple food.
The farm operator can thus have a marketable surplus, which he can sell to raise his family's
consumption standards or invest in farm improvements. Diversified farming can also minimize
the impact of staple crop failure and provide a security of income previously unavailable.
The success or failure of such efforts to transform traditional agriculture will depend not only on
the farmer's ability and skill in raising his productivity but, even more important, on the social,
commercial, and institutional conditions under which he must function. Specifically, if he can
have a reasonable and reliable access to credit, fertilizer, water, crop information, and marketing
facilities; if he receives a fair market price for his output; and if he can feel secure that he and his
family will be the primary beneficiaries of any improvements, there is no reason to assume that
the traditional farmer will not respond to economic incentives and new opportunities to improve
his standard of living. Evidence from such diverse countries as Colombia, Mexico, Nigeria,
Ghana, Kenya, India, Pakistan, Thailand, and the Philippines shows that under proper conditions,
small farmers are responsive to price incentives and economic opportunities and will make rad-
ical changes in what they produce and how they produce it. Lack of innovation in agriculture, as
we have seen, is usually due not to poor motivation or fear of change per se but to inadequate or
unprofitable opportunities.
c. From Divergence to Specialization: Modern Commercial Farming
The specialized farm represents the final and most advanced stage of individual holding in a
mixed market economy. It is the most prevalent type of farming in advanced industrial nations. It
has evolved in response to and parallel with development in other areas of the national economy.
General rises in living standards, biological and technical progress, and the expansion of national
and international markets have provided the main impetus for its emergence and growth.
In specialized farming, the provision of food for the family with some marketable surplus is no
longer the basic goal. Instead, pure commercial profit becomes the criterion of success, and
maximum per-hectare yields derived from synthetic (irrigation, fertilizer, pesticides, hybrid
seeds, etc.) and natural resources become the object of farm activity. Production, in short, is
entirely for the market. Economic concepts such as fixed and variable costs, saving, investment
and rates of return, optimal factor combinations, maximum production possibilities, market
prices, and price supports take on quantitative and qualitative significance. The emphasis in
resource utilization is no longer on land, water, and labor as in subsistence and often mixed
farming. Instead, capital formation, technological progress, and scientific research and
development play major roles in stimulating higher levels of output and productivity.
Specialized farms vary in both size and function. They range from .intensively cultivated fruit
and vegetable farms to the vast wheat and corn fields of North America. In most cases,
sophisticated laborsaving mechanical equipment, ranging from huge tractors and combine
harvesters to airborne spraying techniques, permits a single family to cultivate many thousands
of hectares of land.
The common features of all specialized farms, therefore, are their emphasis on the cultivation of
one particular crop; their use of capital-intensive and, in many cases, laborsaving techniques of
production; and their reliance on economies of scale to reduce unit costs and maximize profits.
For all practical purposes, specialized farming is no different in concept or operation from large
industrial enterprises. In fact, some of the largest specialized farming operations in both the
developed and especially the less developed nations are owned and managed by large
agribusiness multinational corporate enterprises.
3.1.4 Agriculture’s contribution to Development.
The development of any country is contributed by the three sectors: agricultural sector, industrial
sector and service sector. However, the contribution of these sectors varies from countries to
countries. This contribution of the sectors depends on different variables like level of
development, comparative advantage of a country, resource endowment and others. In general
agricultural sector’s contribution is higher at lower level of development than at a higher level of
development and in developing countries than in developed countries. Therefore, the
contribution of agriculture in development varies from countries to countries.
3.1.5 Complementarities of Agriculture and Industry.
Agricultural sector and industrial sectors are not substitutable sectors. They are complementary
sectors by nature. This is to mean that the input of one sector is the output of the other sector and
vice versa. In addition to mean it implies that the development in one sector is influenced by the
development in the other sector even though the complementarity in the two sectors varies from
country to country.
3.1.6 Industrialization.
Countries follow different approaches as far as their industrialization policy is concerned.
In general countries follow either inport substitution approach or export led
industrialization or the mix of the two.
3.1.7. External Economies & Industrialization.
Trade Strategies for Development: Export Promotion versus Import Substitution
A convenient and instructive way to approach the complex issues of appropriate trade policies
for development is to set these specific policies in the context of a broader LDC strategy of
looking outward or looking inward. In the words of Paul P. Streeten, outward-looking
development policies "encourage not only free trade but also the free movement of capital,
workers, enterprises and students . . . , the multinational enterprise, and an open system of
communications.
By contrast, inward-looking development policies stress the need for LDCs to evolve their own
styles of development and to control their own destiny. This means policies to encourage
indigenous "learning by doing" in manufacturing and the development of indigenous
technologies appropriate to a country's resource endowments. According to proponents of
inward-looking trade policies, greater self-reliance can be accomplished only if you restrict trade,
the movement of people and communications, and if you keep out the multinational enterprise,
with its wrong products and wrong want -stimulation and hence its wrong technology.
Within these two broad philosophical approaches to development, a lively debate has been
carried on in the development literature since the early 1950s. This is the debate between the
free traders, who advocate outward-looking export promotion strategies of industrialization, and
the protectionists, who are proponents of inward-looking import substitution strategies. The
balance of the debate has swung back and forth, with the import substitutors predominating in
the 1950s and 1960s and the export promoters gaining the upper hand in the late 1970s and,
especially among western and World Bank economists, in the 1980s and 1990s. Among many
Third World economists and certain developed-country advocates of the "new" or "strategic"
trade theories, however, the philosophical foundations of import substitution and collective self-
reliance remained almost as strong in the 1990s as they were in prior decades.
Basically, the distinction between these two trade-related development strategies is that
advocates of import substitution (IS) believe that LDCs should initially substitute domestic
production of previously imported simple consumer goods (first -stage IS) and then substitute
through domestic production for a wider range of more sophisticated manufactured items
(second - stage IS)-all behind the protection of high tariffs and quotas on these imports. In the
long run, IS advocates cite the benefits of greater domestic industrial diversification ("balanced
growth") and the ultimate ability to export previously protected manufactured goods as
economies of scale, low labor costs, and the positive externalities of learning by doing cause
domestic prices to become more competitive with world prices.
By contrast, advocates of export promotion (EP) of both primary and manufactured goods cite
the efficiency and growth benefits of free trade and competition, the importance of substituting
large world markets for narrow domestic markets, the distorting price and cost effects of
protection, and the tremendous successes of the East Asian export-oriented economies of South
Korea, Taiwan, Singapore, and Hong Kong.
In practice, the distinction between IS and EP strategies is much less pronounced than many
advocates would imply. Most LDCs have employed both strategies with different degrees of
emphasis at one time or another.
However, since the mid-1970s, the EP strategy has been increasingly adopted by a growing
number of countries. The early EP adherents-South Korea, Taiwan, Singapore, and Hong Kong-
were thus joined by the likes of Brazil, Chile, Thailand, and Turkey, which switched from an
earlier, IS strategy. It must be stressed, however, that even the four most successful East Asian
export promoters have pursued protectionist IS strategies sequentially and simultaneously in
certain industries. So it is inaccurate to call them free traders, although they are definitely
outward-oriented. Against this background, we can now examine the issue of outward-looking
export promotion versus inward-looking import substitution in more detail by applying the
following fourfold categorization:
1. Primary outward-looking policies (encouragement of agricultural and raw material

exports)
2. Secondary outward-looking policies (promotion of manufactured exports)
3. Primary inward-looking policies (mainly agricultural self-sufficiency)

Secondary inward-looking policies (manufactured commodity self sufficiency through import
substitution)
3.1.8. Industrialization through Export Promotion.
The promotion of LDC primary or secondary exports has long been considered a major
ingredient in any viable long-run development strategy. The colonial territories of Africa and
Asia, with their foreign-owned mines and plantations, were classic examples of primary
outward-looking regions. It was partly in reaction to this enclave economic structure and partly
as a consequence of the industrialization bias of the 1950s and 1960s that newly independent
states, as well as older LDCs, put great emphasis on the production of manufactured goods
initially for the home market (secondary inward) and then for export (secondary outward). Let us
therefore look briefly at the scope and limitations of LDC export expansion, first with respect to
primary products and then with respect to manufactured exports.
Primary-Commodity Export Expansion: Limited Demand, Shrinking Markets
Many low-income LDCs still rely on primary products for most of their export earnings.
Nevertheless, with the notable exception of petroleum exports and a few needed minerals,
primary-product exports have grown more slowly than total world trade. Moreover, the LDC
share of these exports has been falling over the past few decades.
Demand Side
On the demand side, there appear to be at least five factors working against the rapid expansion
of Third World primary-product and especially agricultural exports to the developed nations
(their major markets). First, the income elasticity of demand for agricultural foodstuffs and raw
materials are relatively low compared with those for fuels, certain minerals, and manufactures.
Second, developed-country population growth rates are now at or near the replacement level. So,
little expansion can be expected from this source. Third, the price elasticity of demand for most
primary commodities is relatively low.
The fourth and fifth factors working against the long-run expansion of LDC primary-product
export earnings - the development of synthetic substitutes and the growth of agricultural
protection in the developed countries-are perhaps the most important. Synthetic substitutes for
commodities like cotton, rubber, sisal, jute, hide, skins, and recently even copper (with glass
fibers for communication networks) act both as a brake against higher commodity prices and as a
direct source of competition in world export markets. The synthetic share of world market export
earnings has steadily risen over time while the share of natural products has fallen.
In the case of agricultural protection, which usually takes the form of tariffs, quotas, and non-
tariff barriers such as sanitary laws regulating food and fiber imports, the effects can be
devastating to Third World export earnings. The common agricultural policy of the European
Union, for example, is much more discriminatory against LDC food exports than the policies that
had formerly prevailed in the individual member nations.
Supply Side
On the supply side, a number of factors also work against the rapid expansion of primary-product
export earnings. The most important is the structural rigidity of many Third World rural
production systems. These rigidities include limited resources; poor climate; antiquated rural
institutional, social, and economic structures; and nonproductive patterns of land tenure.
Whatever the international demand situation for particular commodities (and these will certainly
differ from commodity to commodity), little export expansion can be expected when rural
economic and social structures militate against positive supply responses from peasant farmers
who are averse to risk.
Furthermore, in developing nations with markedly dualistic farming structures (i.e., large
corporate capital-intensive farms existing side by side with thousands of fragmented, low-
productivity peasant holdings), any growth in export earnings is likely to be distributed very
unevenly among the rural population. Small farmers are further, disadvantaged in countries in
which agricultural marketing boards act as middlemen between the farmers and export markets.
Marketing boards often constrain export expansion by forcing cultivators to sell their goods at a
fixed price-usually well below world market prices. They thereby remove the incentive to
increase output.
Finally, we should mention here the pernicious effects of developed-country trade policies and
foreign aid policies that depress agricultural prices in LDCs and discourage production.
3.1.9. Industrialization through Import Substitution.
During the 1950s and 1960s, developing countries experienced a decline in world markets for
their primary products and growing balance of payments deficits on their current accounts. Given
a general belief in the magic of industrialization as well as the terms of trade arguments of the
Prebisch-Singer hypothesis, they turned to an import substitution strategy of urban industrial
development.
Some countries still follow this strategy for both economic and political reasons, although
pressures from the IMF and the World Bank lay heavy opportunity costs on such endeavors.
The typical strategy is first to erect tariff barriers or quotas on certain imported commodities,
then to try to set up a local industry to produce these goods. Typically, this involves joint
ventures with foreign companies, which are encouraged to set up their plants behind the wall of
tariff protection and given all kinds of tax and investment incentives.
Although initial costs of production may be higher than former import prices, the economic
rationale put forward for the establishment of import-substituting manufacturing operations is
either that the industry will eventually be able to reap the benefits of large-scale production and
lower costs (the so-called infant industry argument for tariff protection) or that the balance of
payments will be improved as fewer consumer goods are imported. Often a combination of both
arguments is advanced. Eventually, it is hoped that infant industry will grow up and be able to
compete in world markets. It will then be able to generate net foreign-exchange earnings once it
has lowered its average costs of production. Let us see how the theory of protection can be used
to demonstrate this process.
i. Tariffs, Infant Industries, and the Theory of Protection
A principal mechanism of the import substitution strategy is the erection of protective tariffs
(taxes on imports) or quotas (limits on the quantity of imports) behind which IS industries are
permitted to operate. The basic economic rationale, for such protection is the infant industry
argument mentioned earlier. Tariff protection against the imported commodity is needed so the
argument goes, in order to allow the now higher-priced domestic producers enough time to learn
the business and to achieve the economies of scale in production and the external economies of
learning by doing that are necessary to lower unit costs and prices. With enough time and
sufficient protection, the infant will eventually grow up, be directly competitive with developed
country producers, and no longer need this protection.
Ultimately, as in the case of many formerly protected IS industries in South Korea and
Taiwan, domestic LDC producers will be able to produce not only for the domestic market
without a tariff wall or government subsidies but also to export their now lower-cost
manufactured goods to the rest of the world. Thus for many Third World industries, in theory,
an IS strategy becomes the prerequisite for an EP strategy. It is for this reason, among others
(including the desire to reduce dependence and attain greater self-reliance, the need to build a
domestic industrial base, and the ease of raising substantial tax revenue from tariff
collections), that import substitution appealed to so many LDC governments.
The basic theory of protection is an old and controversial issue in the field of international
trade. It is relatively simple to demonstrate. Consider Figure 4.1 The top portion of the figure
shows standard domestic supply and demand curves for the industry in question (say, shoes) if
there were no international trade-that is, in a closed economy. The equilibrium home price and
quantity would be P1 and Q1.
If this LDC then were to open its economy to world trade, its small size in relation to the
world market would mean that it would face a horizontal, perfectly elastic demand curve. In
other words, it could sell (or buy) all it wanted at a lower world price, P 2. Domestic consumers
would benefit from the lower price of imports and the resultant greater quantity purchased,
while domestic producers and their employees would clearly suffer as they lose business to
lower-cost foreign suppliers. Thus at the lower world price, P 2, quantity demanded rises from
Q1 to Q3 whereas the quantity supplied by domestic producers falls from Q1 to Q2. The
difference between what domestic producers are willing to supply at the lower P 2 world price
(Q2) and what consumers want to buy (Q3) is the amount that will be imported-shown as line
ab in Figure 4.1
Facing the potential loss of domestic production and jobs as a result of free trade and desiring to
obtain infant industry protection, local LDC producers will seek tariff relief from the
government. The effects of a tariff (equal to t 0) are shown in the lower half of Figure 4.1. The
tariff causes the domestic price of shoes to rise from P 2 to Pt that is, Pt = P2 (1 + to). Local
consumers now have to pay the higher price and will reduce their quantity demanded from Q 3 to
Q5. Domestic producers can now expand production (and employment) up to quantity Q 4 from
Q2. The rectangular area cdef measures the amount of the tariff revenue collected by the
government on imported shoes.
Clearly, the higher the tariff, the closer to the domestic price will be the sum of the world price
plus the import tax. In the classic infant-industry IS scenario, the tariff may be so high that it
raises the price of the imported produce above P1 to, say, P3 in the upper diagram of Figure 4.1,
so that imports are effectively prohibited and the local industry is allowed to operate behind a
fully protective tariff wall, once again selling Q1 output at P1 price.
In the short run, it is clear that the impact of such a prohibitive tariff is to penalize consumers,
who are in effect subsidizing domestic producers and their employees through higher prices and
lower consumption. Alternatively, we can say that a tariff redistributes income from consumers
to producers. However, in the longer run, advocates of IS protection for LDC infant industries
argue that everyone will benefit as domestic and other shoe manufacturers reap the benefits of
economies of scale and learning by doing so that ultimately the domestic price falls below P2 (the
world price). Production will then occur for both the domestic and the world market, domestic
consumers as well as domestic producers and their employees will benefit, protective tariffs can
be removed, and the government will be able to replace any lost tariff revenue with taxes on the
now very much higher incomes of domestic manufactures. It all sounds logical and persuasive in
theory. But how has it performed in practice?
Figure 4.1 Import Substitution and the Theory of Protection
S
p3 Import price with tariff
Price
P1 Domestic price without trade
P2 a b World Price
Q2 Q1 Q3 S
P1 c d
Price
Pt = P2(1+t0)
Pt
P2 World price
e f
D
0
Q2 Q4 Q5 Q3
Quantity
ii. The IS Industrialization Strategy and Results
Most observers agree that the import-substituting strategy of industrialization has been
largely unsuccessful. Specifically, there have been five undesirable outcomes. First, secured
behind protective tariff walls and immune from competitive pressures, many IS industries
(both publicly and privately owned) remain inefficient and costly to operate.
Second, the main beneficiaries of the import substitution process have been the foreign firms
that were able to locate behind tariff walls and take advantage of liberal tax and investment
incentives. After deducting interest, profits, and royalty and management fees, most of which
are remitted abroad, the little that may be left over usually accrues to the wealthy local
industrialists with whom foreign manufacturers cooperate and who provide their political
and economic cover.
Third, most import substitution has been made possible by the heavy and often government-
subsidized importation of capital goods and intermediate products by foreign and domestic
companies. In the case of foreign companies, much of this is purchased from parent and
sister companies abroad. There are two immediate results. First, capital-intensive industries
are set up, usually catering to the consumption habits of the rich while having a minimal
employment effect. Second, far from improving the LDCs' balance of payments situation and
alleviating the debt problem, indiscriminate import substitution often worsens the situation
by increasing a need for imported capital-good inputs and intermediate products while, as we
have just seen, a good part of the profits is remitted abroad in the form of private transfer
payments.
A fourth detrimental effect of many import substitution strategies has been their impact on
traditional primary-product exports. To encourage local manufacturing through the
importation of cheap capital and intermediate goods, exchange rates (the rate at which the
central bank of a nation is prepared to purchase foreign currencies) are often artificially
overvalued. This has the effect of raising the price of exports and lowering the price of
imports in terms of the local currency.
In terms of its income distribution effects, the outcome of such government policies may be to
penalize the small farmer and the self-employed while improving the profits of the owners of
capital, both foreign and domestic. Industrial protection thus has the effect of taxing agricultural
goods in the home market as well as discouraging agricultural exports. Import substitution
policies have in practice often worsened the local distribution of income by favoring the urban
sector and higher-income groups while discriminating against the rural sector and lower-income
groups.
Fifth, and finally, import substitution, which may have been conceived with the idea of
stimulating infant industry growth and self-sustained industrialization by creating "forward" and
"backward" linkages with the rest of the economy, has often inhibited that industrialization.
Many infants never grow up content to hide behind protective tariffs, and governments loath to
force them to be more competitive by lowering tariffs. In fact, LDC governments themselves
often operate protected industries as state-owned enterprises.
iii. Tariff Structures and Effective Protection
Because import substitution programs are based on the protection of local industries against
competing imports primarily through the use of tariffs and physical quotas, we need to analyze
the role and limitations of these commercial policy instruments in developing nations. As we
have already discussed, governments impose tariffs and physical quotas on imports for a variety
of reasons. For example, tariff barriers may be erected to raise public revenue. In fact, given the
administrative and political difficulties of collecting local income taxes, fixed percentage taxes
on imports collected at a relatively few ports or border posts often constitute one of the cheapest
and most efficient ways to raise government revenue. In many LDCs, these foreign trade taxes
are thus a central feature of the overall fiscal system.
Physical quotas on imports like automobiles and other luxury consumer goods, though more
difficult to administer and more subject to delay, inefficiency, and rent-seeking corruption (e.g.,
with regard to the granting of import licenses), provide an effective means of restricting the entry
of particularly troublesome commodities. Tariffs, too, may serve to restrict the importation of
non-necessity products (usually expensive consumer goods). By restricting imports, both quotas
and tariffs can improve the balance of payments. And like overvaluing the official rate of foreign
exchange, tariffs may be used to improve a nation's terms of trade.
However, in a small country unable to influence world prices of its

t = p' - P
exports or imports (in other words, most LDCs), this argument for
p
tariffs (or devaluation) has little validity. Finally, as we have just
seen, tariffs may form an integral component of an import substitution policy of industrialization.
Whatever the means used to restrict imports, such restriction always protects domestic firms
from competition with producers from other countries. To measure the degree of protection, we
need to ask by how much these restrictions cause the domestic prices of imports to exceed what
their prices would be if there were no protection. There are two basic measures of protection: the
nominal rate and the effective rate. The nominal rate of protection shows the extent, in
percentages, to which the domestic price of imported goods exceeds what their price would be in
the absence of protection. Thus the nominal (ad valorem) tariff rate (t) refers to the final prices of
commodities and can be defined simply as where p' and p are the unit prices of industry's output
with and without tariffs, respectively.
For example, if the domestic price (p') of an imported automobile is $5,000 whereas the CIF
(cost plus insurance and freight) price (p) when the automobile arrives at the port of entry is
$4,000, the nominal rate of tariff protection (t) would be 25%.
g = v' - v
v
By contrast, the effective rate of protection shows the percentage by which the value added at a
particular stage of processing in a domestic industry can exceed what it would be without
protection. In other words, it shows by what percentage the sum of wages, interest, profits, and
depreciation allowances payable by local firms can, as a result of protection, exceed what this
sum would be if-these same firms had to face unrestricted competition (no tariff protection) from
foreign producers.
The effective rate (g) can therefore be defined as the difference between value added (percent of
output) in domestic prices and value added in world prices, expressed as a percentage of the
latter, so that where v' and v are the value added per unit of output with and without protection,
respectively. The result can be either positive or negative, depending on whether v' is greater or
less than v. For most LDCs, it is highly positive.
Most economists argue that the effective rate is more useful concept (even though the nominal or
ad valorem rate is simpler to measure) for ascertaining the degree of protection and
encouragement afforded to local manufacturers by a given country's tariff structure. This is
because effective rates of protection show the net effect on a firm or industry of restrictions on
the imports of both its outputs and its inputs.
Among the many implications of analyzing effective versus nominal tariff structures with regard
to developing countries, two stand out as particularly noteworthy. First, most developing
countries, as we have seen, have pursued import substituting programs of industrialization with
emphasis on the local production of final consumer goods for which a ready market was
presumed to exist. Moreover, final goods production is generally less technically sophisticated
than intermediate capital-goods production. The expectation was that in time, rising demand and
economies of scale in finished-goods production would create strong backward linkages leading
to the creation of domestic intermediate-goods industries.
Second, even though nominal rates of protection in developed countries on imports from the
developing countries may seem relatively low, effective protection rates can be quite substantial.
Raw materials are usually imported duty-free whereas processed products such as roasted and
powdered coffee, coconut oil, and cocoa butter appear to have low nominal tariffs.
To sum up, the standard argument for tariff protection in developing countries has four major
components:
 Duties on trade are the major source of government revenue in most LDCs because they
are a relatively easy form of taxation to impose and even easier to collect.
 Import restrictions represent an obvious response to chronic balance of payments and
debt problems.
 Protection against imports is one of the most appropriate means for fostering economies
of scale, positive externalities, and industrial self-reliance as well as overcoming the
pervasive state of economic dependence in which most Third World countries find
themselves.
 By pursuing policies of import restriction, developing countries can gain greater control
over their economic destinies while encouraging foreign business interests to invest in
local import-substituting industries, generating high profits and thus the potential for
greater saving and future growth. They can also obtain imported equipment at relatively
favorable prices and reserve an already established domestic market for local or locally
controlled producers. Eventually, they may even become competitive enough to export to
the world market.
Although these arguments can sound convincing and some protective policies have proved
highly beneficial to the developing world many have failed to bring about their desired results.
Protection can have an important role to play in the development of the Third World, for both
economic and non economic reasons, but it is a tool of economic policy that must be employed
selectively and wisely, not as a panacea to be applied indiscriminately and without reference to
both short- and long-term ramifications.
Review questions
1. list the stages in the evolution of agricultural production

2. List some of criticisms of Lewi’s Surplus Labor Theory
3. What are the two main approaches of industrialization?
Answer
1. We can identify three broad stages in the evolution of agricultural production:

a) The first and most primitive is the pure, low-productivity, mostly subsistence-level,
peasant farm.
b) The second stage is what might be called diversified or mixed\family agriculture, where
part of the produce is grown for consumption and part for sale to the commercial sector.
c) The third stage represents the modern farm, exclusively engaged in high-productivity
specialized agriculture geared to the commercial market.
2. Although the Lewis two-sector development model is simple and roughly reflects the
historical experience of economic growth in the west, some of its key assumptions do not
fit the institutional and economic realities of most contemporary developing countries.
a) Lewis assumes that due to competitive labour market, the wage rate remains
constant in the urban sector for a long time. It is an unrealistic assumption.
b) If the method of production in the industrial sector is capital intensive and labour
saving, this theory will not work
c) It considers lack of skilled labourers as a temporary bottleneck in the development
process of underdeveloped countries. But it is a serious problem.
d) Lack of entrepreneurial initiative is another problem that affects the industrial
expansion of developing economies
3. Import substitution and export led industrialization
CHAPTER FOUR
DIRECT FOREIGN INVESTMENT & FOREIGN AID
Chapter content
4.1. The International Flow of Financial Resources
4.2. Private DFI & the Multinational Corporations
4.3. Foreign Aid: The Development Assistance Debate.
4.3.1. Why Official Assistance?
4.3.2. Does Aid Work?
Introduction
Financial assets flow internationally in different forms. In this chapter, we will consider kinds of
international financial flows and the reason behind this financial flow. In addition we will give
focus on foreign aid and why this official assistance is taking place between countries or between
a country and multilateral companies. Moreover, the role of foreign direct investment on
economic growth is considered.
Objective: At the end of this chapter, students are expected to have the understanding of:
 different forms international flow of financial resources
 the role of foreign direct investment and multinational companies on development of the
host country economy
 the debate on official assistance
4.1. The International Flow of Financial Resources
The external sources of capital formation take different forms. These are:
 foreign direct investment (FDI) and multinational corporations
 Foreign aid
4.2. Private DFI & the Multinational Corporations
Portfolio investment (Foreign institutional invest): In addition to FDI, the most significant
and fastest growing component of private capital flows in the 1990s was in the area of
portfolio investment. With the increased liberalization of LDC domestic financial markets
and the opening up of these markets to foreign investors, private portfolio investment now
accounts for one-third of overall net resource flows to developing countries. Basically,
portfolio investment consists of foreign purchases of the stocks (equity), bonds, certificates
of deposit, and commercial paper for LDCs.
Limitations of Foreign Institutional Investment (FII)

1. FII are not in the development business. Most of the shares are bought and sold in the
secondary market and this does not guarantee investment.
2. Volatility
3. Fluctuations in amount
4. Fluctuations in foreign exchange rate: when a large amount of foreign capital flows in,
the exchange rate declines. But when there exists capital flight, it negatively affects the
exchange rate.
5. Fluctuations in share prices: When capital flows in, the share price goes up and vice versa
when there is capital flight.
6. Reversibility: If DCs interest rates increase and perceived LDC profit rates decline,
foreign speculators will withdraw their investment as quickly as they brought them in.
7. Inflationary: FIIs create inflation in the country, when a foreign capital flows in, it is
exchanged to new money at the central bank and this leads to inflation.
8. FIIs are guided by interest rate differentials and investor perceptions of political and
economic stability. This makes them a very tenuous foundation on which to base
medium-or long-term development strategies.
Foreign Direct Investment
Apart from official development finance, another major source of development finance is
private capital flows. These are of two types: foreign direct investment (FDI) and portfolio
investment.
There has been a vast increase in the amount of FDI going to developing countries in recent
years fuelled by three major sources.
 The rise of Multi-National Corporations (MNCs) and the search for global-profits
 The liberalization of capital markets and
 Economic liberalization within LDCs.
Companies (i.e. MNCs) wishing to invest overseas look for:

 a favorable trade & investment regime
 good infrastructure
 property rights
 political stability
 macro economic stability and
 educated and committed workforce.
FDI brings many advantages to recipient countries, but there are also many potential dangers and
disadvantages from a development points of view.
Advantages of MNCs
1. Gap filling role: This takes many aspects.
Saving’s gap: FDI raises the investment ratio above the domestic savings ratio. For example, in
the Harrod-Domar growth model
g=s/c
If the desired rate of national output growth, g, is targeted at 6% and the capital output ratio c=
4%, then the needed rate of annual saving income ratio is 24%. If the saving that can be raised
domestically is say 16%of GDP, a “saving-gap” equal to 8% is said to exist which can be filled
up by FDIs or private capital flows.
Foreign Exchange Gap: A second contribution of FDI is its contribution to filling the gap
between targeted foreign exchange requirements and those derived from net export earnings plus
net public foreign aid. This is the so-called foreign exchange gap. A great deal of FDI goes in to
the tradable goods sector of the recipient country which improves the export performance of
these countries and earns valuable foreign exchange.
In the East Asian countries, foreign corporations have been the major force in the department of
exports specially on manufactures. In the early 1990’s the share of foreign affiliates in export
was as high as 57% in Malaysia, 91% in Singapore and 25% in China.
Tax Revenue: The third gap said to be filled by foreign investment is the gap between target
Government Tax Revenues and locally raised taxes. By taxing MNC profits and participating
financially in their local operations, LDC governments are thought to be better able to mobilize
public financial resources for development projects.
Management skills, entrepreneurship, technology, innovation: Not only do Multinationals

provide financial resources and new factories to poor countries, but they also supply a package of
needed resources including management experience, entrepreneurial abilities, marketing skills
and technological skills that can then be transferred to their local counterparts by means of
training programs and the process of learning by doing.
Other arguments
Growth in GDP: In many studies on the relation between FDI and the growth of GDP have
revealed that a positive relation exists. It has been estimated by Bernstein, de Gregorio and Lee
that a one percentage point increase in the ratio of FDI to GDP in developing countries over the
period 1971-89 was associated with 0.4 - 0.7 Percentage point increase in the growth of per
capita GDP. Another study made by the World Bank found that FDI is strongly associated with
higher GDP growth in many developing countries. Total income increases in Multiplied amount
as Multiplier works in different directions.
Employment Generations: FDI also creates employment opportunities. It is estimated that

some 20 million workers are employed directly or indirectly by MNC, in LDCs.
Catalyst for Domestic Investment: Foreign investment can often be a catalyst for domestic
investment in the same or related fields it will have both backward and forward linkages which
encourages investment in different areas.
Arguments against Foreign Direct investment
The activities of MNC, come under attack on several grounds.
They spread consumerism in the country: Multinationals typically produce inappropriate

products (those demanded by a small, rich minority of the local population) and stimulate
inappropriate consumption patterns through advertising and their monopolistic market power.
These tendencies are not only wasteful but they encourage acquisitiveness, reduce domestic
saving and can worsen Balance of Payments difficulties by encouraging expensive tastes.
Inequality and Dualism: the impact of MNC, on development is very uneven and in many
situations MNC activities reinforce dualistic economic structures and exacerbate income
inequalities. They tend to worsen the imbalance between rural and urban economic opportunities
by locating primarily in urban export enclaves and contributing to the rural-urban migration.
They divert resources away from needed food production of the manufacture of sophisticated
products catering primarily to the demands of local elites and foreign consumers.
Threat to local entrepreneurs: MNCs may damage host economies by suppressing domestic
entrepreneurship and using their superior knowledge, world wide network, advertising skills and
range of essential support services to drive out local competitors & inhibit the emergence of
small scale local entrepreneurs
Inappropriate technologies: They may introduce inappropriate technologies and retard the
development of indigenous capital-goods industry. Besides, local resources tend to be allocated
for socially undesirable projects.
Adverse effects on Balance of Payment: There is caution of foreign exchange mainly in the
form of repatriation of profits. FDI has a potential disadvantages even as compared to loan
finance, that there may be outflow of profits that lasts much longer than the outflow of debt-
service payments on a loan of equivalent amount. While a loan creates obligations for a definite
number of years, FDI may involve an unending commitment.
MNCs Use their economic power to influence government policies in directions

unfavorable to development . They are able to extract sizeable of economic and political
concessions from competing LDCs governments in the form of excessive protection, tax rebates,
investment allowance and the cheap provision of factory sites and essential social service,
Low Transfer: The management entrepreneurial skills and technology provided by MNC, may
have little impact on developing local sources of these scarce skills & resources and may in fact
inhibit their development by stilling the growth of indigenous entrepreneurship as a result of the
MNC dominance of local markers.
FDI is an integral part of economic development of a country. They are an integral part of
globalization which is necessary for technological development of an economy. The question is
how to avoid the adverse effects of FDIs or MNCs.
4.3. Foreign Aid: The Development Assistance Debate.
Loans usually come in the form of official development assistance (ODA) from bilateral sources
and multilateral sources (such as the World Bank and its two affiliates, the IDA and IFC) on
concessional and non- concessional terms. Most official flows are given on concessionary terms
and are referred to as official development assistance (ODA). It is also known as foreign aid. A
loan to LDC is considered as foreign aid if it meets two criteria.
i. Its objective should be non-commercial from the point of view of donors and, It should
be characterized by concessional terms; that is, the interest rate and repayment period for
the loan should be softer (less stringent) than commercial terms.
The concept of foreign aid that is most widely used is one that encompasses all official grants
and concessional loans, in currency or in kind, that are broadly aimed at transferring
resources from the developed to less developed nations on development or income
distribution grounds.
In giving aid certain conditions are attached which is known as aid tying. Roughly one-half
of the bilateral aid is tied to the purchase of the donors’ goods. In this senses, capital inflows
are not worth as much as they might be as the recipients have to pay higher prices for goods
and services bought with aid money than the prices prevailing in the free market. Tying tends
to be of two kinds.
 Spending restrictions take the form of tying assistance to purchases in the donor
so called procurement tying.
 Use restrictions normally mean that the aid must be used to cover the foreign
exchange cost of a defined project.
Tying can be expensive. The price of tied goods can be 20% or more above the price of the
same goods in the free market.
4.3.1. Why Official Assistance?
There are several motives that inspire financial assistance from bilateral and multilateral
sources on concessionary terms. These can be grouped in to three.
1. Humanitarian (moral) motive: Aid could be given for humanitarian purposes to assist
poor countries, and particularly poor people in poor countries. The same arguments that
provide the basis for income redistribution within nations can also be applied at the
global level, namely that absolute poverty is intolerable and that if the marginal utility of
income diminishes, total welfare will be increased by a redistribution of income from rich
to poor. From a moral and welfare point of view, national boundaries are quite artificial
constructions.
2. Political motives: Political motives have been by far more important for aid granting
nations, especially for the major donor country, the United States starting from the
Marshal Plan, which aimed at reconstructing the war torn economies of Europe, the U.S.
viewed aid as a means of containing the international spread of communism. In the
1950’s & 60’s the policy of containment embodied in the U.S. aid program dictated a
shift in emphasis toward political, economic and military support for friendly less
developed nations, especially those considered geographically strategic example Israel,
Egypt, Pakistan etc.
Most aid programs to developing countries were, therefore oriented more towards purchasing
their security and propping up their sometimes-shaky regimes than promoting long term social &
economic development. British and French assistance tends to be concentrated on ex-colonial
territories, reflecting strong historical ties and perhaps some recompense for former colonial
neglect.
3. Economic motives: Within the broad context of political and strategic priorities foreign
aid programs of the DCs have had a strong economic rationale. These can be grouped in
to two aspects.
a. Economic motives from the point of view of recipients
b. Economic motives from the point of view of donors
a. Economic motives from the point of view of recipients:
o Foreign exchange constraints: External finance (both grants & loans) can play a critical
role in supplementing domestic resources in order to relieve savings or foreign exchange
bottlenecks. This is the so-called two-gap analysis of foreign assistance. Therefore, the
LDCs require foreign aid to meet the deficits in their external balance and to supplement
domestic savings.
 Technological transfer
 Provision of economic and social infrastructure e.g. health, education, railways, roads,
communication etc.
b. Motives from the point of view of donors
DCs invest in LDC, not only to raise the growth rate of the LDCs, but also to improve their own
welfare.
Rate of interest: If the rate of interest on loans is higher than the productivity of capital in
developed donor country and lower than the productivity of capital in the developing recipient
country, both parties will gain.
Tied loans: most of the bilateral loans from DCs are tied loans. The recipient country purchases
the goods from the donor country at a higher price, higher than the competitive market price.
Market: When an aid recipient country improves its economic conditions, its per capita income
improves and this creates a market for the products of DCs.
4.3.2. Does Aid Work?
The critics of official assistance oppose the alleged advantages of international assistance. These
include:
1) Assistance is mal-distributed and does not reach the poorest people in the poorest
countries. However, this is not a criticism of aid as such, but of its administration
2) Assistance has not helped economic development. Many countries are still desperately
poor after 50 years of assistance, and that many parts of the third world: South East Asia,
W. Africa & Latin America made rapid progress long before the advent of official
assistance.
3) Due to foreign aid some government may take undue advantage of it and may suppress
oppositions. Assistance breeds corruption, inefficiency & tensions in societies, which
retards development.
4) Assistance may also encourage irresponsible financial policies, and if the assistance is
free (pure aid) there may be no incentive to use resources productively.
Program aid as compared to project aid is much more open to abuse than supervised project
aid. Whatever problems are associated with foreign aid; these are the problems of faulty
implementation.
Summary
Financial assets flow internationally in different forms. In this chapter, we have considered kinds
of international financial flows and the reason behind this financial flow. In addition we have
given focus on foreign aid and why this official assistance is taking place between countries or
between a country and multilateral companies. Moreover, the role of foreign direct investment
on economic growth has been considered.
Review questions
1. What are the sources of external capital formation?

2. What are the motives of foreign aid?
Answers
1. foreign direct investment and foreign aid

2. There are different motives of foreign aid. These are:
-humanitarian motives
-political motives
-economic motives
CHAPTER FIVE
EXPERIENCE OF SOME NEWLY INDUSTRIALIZED COUNTRIES
Introduction
In this chapter, we will consider the success of the East Asian tigers. The important points to be
discussed are the secret of their success as export led economy and the lesson that other
developing countries can take from these countries.
Objective: By the end of this chapter, students are expected to have good knowledge on:
 the secret of the success of east Asian tigers
 the lesson that can be learned from them by other developing countries
Expanding Exports of Manufactured Goods: Some Successes, Many Barriers
The expansion of LDC manufactured exports has been given great stimulus by the spectacular
export performances of countries like South Korea, Singapore, Hong Kong, Taiwan, Mexico,
and Brazil over the past four decades. For example, Taiwan's total exports grew at an annual rate
of over 20%, and exports from South Korea grew even faster. In both cases, this export growth
was led by manufactured goods, which contributed over 80% of both nations' foreign exchange
earnings. For the Third World as a whole, manufactured exports grew from 6% of total
merchandise exports in 1950 to almost 45% by 1990. How-ever, in 1990 South Korea, Taiwan,
Singapore, and Hong Kong accounted for 82.8% of these exports. Despite this growth, therefore,
the LDC share of total world trade in manufactures has remained relatively small, even though it
did grow from 7% in 1965 to 18% in 1990.
The export successes of recent decades, especially among the Four Asian Tigers have provided
the primary impetus for arguments by neoclassical counterrevolutionaries -particularly those at
the World Bank and the IMF. According to them, LDC economic growth is best served by
allowing market forces, free enterprise, and open economies to prevail while minimizing
government intervention. Unfortunately, the reality of the East Asian cases does not support this
view of how their export success was achieved. In South Korea, Taiwan, and Singapore (as in
Japan earlier), the production and composition of exports was not left to the market but resulted
as much from carefully planned intervention by the government.
The demand problems for LDC export expansion of manufactured goods, though different in
basic economic content from those for primary products, are nonetheless similar. Although
income and price elasticities of international demand for manufactured goods in the aggregate
are higher than for primary commodities, they afforded little relief to many developing nations
bent on expanding their exports. For many years there was widespread protection in developed
nations against the manufactured exports of LDCs-which was in part the direct result of the
successful penetration of low-cost labor-intensive manufactures from countries like Taiwan,
Hong Kong, and South Korea during the 1960s and 1970s.
Different sources indicate that industrial-nation trade barriers have been pervasive. During the
1980s, for example, 20 of the 24 industrial countries increased their protection against LDC
manufactured or processed products. Moreover, their rates of protection were considerably
higher against LDC exports than against those of other industrial nations. Making matters worse,
MDC protection often increased with the level of processing. Example, the tariff on processed
cacao, is twice that of raw cacao, so chocolate imports are discouraged; raw sugar faces tariffs
below 2% while processed sugar products are blocked by 20% tariffs.
Then there are the non-tariff barriers, which now form the main protection against Third World
manufactured exports, affecting at least one-third of them. The most significant is the Multi-
Fiber Arrangement (MFA), a complex system of mostly bilateral quotas against LDC exports of
cotton, wool, and synthetic fiber products. The United Nation Development Program estimates
that the MFA costs the Third World $24 billion a year is lost textile and clothing export earnings.
All in all trade restrictions by developed countries cost LDCs at least $40 billion a year in
foreign exports and lowers their GNP by more than 3%. If these barriers were dropped-for
example, if the 1995 Uruguay Round of multilateral GATT negotiations can effectively be
implemented-developing-country manufactured exports could grow by $30 to $40 billion
annually.
As in the case of agricultural and other primary production, the uncertain export outlook
should be no cause for curtailing the needed expansion of manufacturing production to serve
local LDC markets. There is great scope for mutually beneficial trade in manufactures
among developing countries themselves within the context of the gradual economic
integration of their national economies. Too much emphasis has been placed on the analysis
of trade prospects of individual LDCs with the developed nations (North-South trade) and
not enough on the prospects for mutually beneficial trade with one another (South-South
trade).
Summary
In this chapter, we have considered the success of the East Asian tigers. The important points
discussed are the secret of their success as export led economy and the lesson that other
developing countries can take from these countries.
References:
 Michael Todaro, (2004). Economic Development high edition.
 Leading Issues in Economic Development ,Gerald M. Meier 6th edition
 Benjamin Higgins,(1998). Economic Development: Problems, Principles & Policies
 Shrivastavo, (2004). Economics of Growth Development & Planning

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DEVELOPMENT ECONOMICS II (Econ-313)

Rift Valley College Center for

This course is a consecutive to development economics I. In this part, concepts

Objective: This course is designed to equip students with

1.1. Measurement of income in equality and poverty

1.1. Measurement of income in equality and poverty

Economists usually like to distinguish between two principal measures of

Economists and statisticians, therefore, like to arrange all individuals by ascending

To provide a more detailed breakdown of the size distribution of income, deciles

Gini Shaded Area A

1.2. Inequality and development

a) The traditional Argument: Factor shares, Saving and Economic growth.

b) Absolute poverty: Extent and magnitude

What is absolute poverty?

Absolute poverty is meant to represent a specific minimum level of income

The international poverty line knows no boundaries, is independent of the level of

1. What is absolute poverty?

Objective: at the end of the chapter, students are expected to know:

2.1 What do we mean by development policy?

o General economic and social policies

Policies that affect sustainability are of five types

 General economic and social policies intended to influence overall

The Range of Policy Options: Some Basic Considerations

1. Functional distribution-the returns to labor, land, and capital as determined by

Altering the Functional Distribution of Income through Policies

We deal more extensively with the important question of factor-price distortions,

Modifying the Size Distribution through Progressive

In addition to the redistribution of existing productive assets, dynamic redistri-

Reducing the Size Distribution at the Upper Levels through Progressive

Unfortunately, in many developing countries (and developed countries as well),

Increasing the Size Distribution at the Lower Levels through Direct

2.2 Policies of Agricultural development & Resource use.

Traditionally, the role of agriculture in economic development has been viewed as

An agriculture- and employment-based strategy of economic development

To a large extent, therefore, the past two decades witnessed a remarkable

After studying this chapter the student is expected to be able to

 understand the description and analysis of the basic characteristics of

 describe the economics of peasant subsistence agriculture and discuss

 explore the meaning of rural development and review alternative

Agricultural Stagnation and Growth since 1950

Many developing countries experienced respectable rates of GNP growth during

TABLE 2.1 Outputs and Employment in Third World Agriculture, 1995

Percentage of the Output of Agriculture as a

Region Labor Force in Percentage of Gross

In fact, the agricultural sector in many developing countries completely stagnated

Change in Per Capita Change in Per Capita

Region 1948/195 1960- 1970- 1980- 1948/1952 1960-1970 1970-1980 1980-1994

The Structure of Third World Agrarian Systems

TABLE 2.3: Land Productivity in Developed and Developing Countries, 1995

Peasant Agriculture in Developing Countries

In many developing countries, various historical circumstances have led to a concentration of

Latin America and Asia: Similarities and Differences

Subsistence Agriculture and Extensive Cultivation in Africa

1. the importance of subsistence farming in the village community;

The low-productivity subsistence farming characteristic of most traditional African agriculture

Toward a Strategy of Agricultural and Rural Development: Some Main Requirements.

1. Technological change and innovation

Conditions for General Rural Advancement

1. Modernizing farm structures to meet rising food demands

Let us look at each of these six interrelated components.