CHAPTER 2

COMPARATIVE ECONOMIC DEVELOPMENT

WHAT TO EXPECT FROM CHAPTER 2?

 Define the developing world and describing how development is measured so

as to allow for quantitative comparisons across countries.
 The 10 important features that developing countries tend to have in common,
on average, in comparison with the developed world. These areas are the
following:
1. Lower levels of living and productivity
2. Lower levels of human capital
3. Higher levels of inequality and absolute poverty
4. Higher population growth rates
5. Greater social fractionalization
6. Larger rural populations but rapid rural-to-urban migration
7. Lower levels of industrialization
8. Adverse geography
9. Underdeveloped financial and other markets
10. Lingering colonial impacts such as poor institutions and often external
dependence.
 DEFINING THE DEVELOPING WORLD

 International Agencies that Classify Countries

 Organization for Economic Cooperation and Development (OECD)
 United Nations
 International Bank for Reconstruction and Development (IBRD),
more commonly known as the World Bank.
 World Bank - an organization known as an “international financial
institution” that provides development funds to developing
countries in the form of interest-bearing loans, grants, and
technical assistance.
 COUNTRY CLASSIFICATIONS
Per capita income - the most common way to define the developing
world

World Bank ranks countries on GNI per capita.docx

 Low Income Countries (LIC) - less than $1,025 in 2011.
 Low Middle Income Countries (LMC) - $1,025 - $4,035
 Upper Middle Income Countries (UMC) - $4,036 - $12,475
 High Income Countries (HIC) - $12,476 or more.
 Organization for Economic Cooperation and Development (OECD)
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 CLASSIFICATION OF ECONOMIES BY REGION
AND INCOME IN 2007

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CLASSIFICATION OF ECONOMIES BY REGION AND INCOME, 2007
(Latin America and the Caribbean) (Sub-Saharan
Africa)

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CLASSIFICATION OF ECONOMIES BY REGION AND INCOME, 2007

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NATIONS OF THE WORLD, CLASSIFIED BY GNI PER CAPITA

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WORLD BANK CLASSIFICATIONS FOR DEVELOPING
COUNTRIES
Low-Income Economies ($1,005 GNI per capita in U.S. dollars) – LDCs
Afghanistan Madagascar
Benin Malawi
Burkina Faso Mali
Burundi Mozambique
Central African Republic Nepal
Chad Niger
Comoros Rwanda
Congo, Dem. Rep Senegal
Eritrea Sierra Leone
Ethiopia Somalia
Gambia, The South Sudan
Guinea Tanzania
Guinea-Bisau Togo
Haiti Uganda
Korea, Dem Rep. Zimbabwe
Liberia
LOWER-MIDDLE-INCOME ECONOMIES ($1,006-$3,995
GNI PER CAPITA IN U.S. DOLLARS)

 Angola Georgia
Armenia Ghana
Bangladesh Guatemala
Bhutan Honduras
Bolivia India
Cabo Verde Indonesia
Cambodia Kenya
Cameroon Kiribati
Congo, Rep. Kosovo
Côte d'Ivoire Kyrgyz Republic
Djibouti Lao PDR
Egypt, Arab Rep. Lesotho
El Salvador Mauritania
INCOME PER CAPITA IN SELECTED COUNTRIES

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OTHER DISTINCTIONS

 Newly industrializing countries (NICs) - countries at a relatively advanced level of

economic development with a substantial and dynamic industrial sector and with
close links to the international trade, finance, and investment system.

 Least developed countries - a UN designation of countries with low income, low

human capital, and high economic vulnerability. (as of 2012 included 49 countries, 34
of them in Africa, 9 in Asia, 5 among Pacific Islands, plus Haiti).

 Human capital - productive investments in people, such as skills, values, and health
resulting from expenditures on education, on-the-job training programs, and medical
care; level of human development, including health and education attainments as
low, medium, high, and very high United Nations Development Programme (UNDP)
OTHER DISTINCTIONS
 Developing world Classification is through their degree of international
indebtedness (World Bank)
- Severely indebted, moderately indebted, and less indebted
▪ Other special UN classifications include landlocked developing countries (of
which there are 30, with 15 of them in Africa) and small island developing
states (of which there are 38).
▪ Emerging markets was introduced at the International Finance Corporation to
suggest progress (avoiding the then-standard phrase Third World that
investors seemed to associate with stagnation).
This is not used here because emerging market is widely used in the
financial press to suggest the presence of active stock and bond markets which
is only one aspect of economic development
 MEASURING DEVELOPMENT

 Gross National Income (GNI)

 Gross Domestic Product (GDP)
 Purchasing Power Parity (PPI): method instead of
exchange rates as conversion factors

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MEASURING DEVELOPMENT
 Gross national income (GNI) - The total domestic and foreign output claimed by
residents of a country, consisting of gross domestic product (GDP) plus factor
incomes earned by foreign residents, minus income earned in the domestic economy
by nonresidents.
 It is calculated as the total domestic and foreign value added claimed by a country’s
residents without making deductions for depreciation (or wearing out) of the domestic
capital stock.
 Gross domestic product (GDP) measures the total value for final use of output
produced by an economy, by both residents and nonresidents.
 Thus, GNI comprises GDP plus the difference between the income residents receive
from abroad for factor services (labor and capital) less payments made to
nonresidents who contribute to the domestic economy
 Value added - The portion of a product’s final value that is added at each stage of
production.
Difference Between GNI and GNP
 GNI measures income earned, including income from
investments, that flows back into the country.
 Gross national product includes the earnings from all assets
owned by residents. It even includes earnings that don't flow back
into the country. It then omits the earnings of all foreigners living in
the country, even if they spend it within the country. GNP only
reports how much is earned by the country's citizens and
businesses, no matter where it is spent in the world.
Comparison Chart
The chart below compares what is and isn't included in GDP, GNI, and GNP.

Income Earned by: GDP GNI GNP

Residents in Country C+I+G+X C+I+G+X C+I+G+X
Foreigners in Country Includes Includes If Spent in Excludes All
Country
Residents Out of Excludes Includes If Remitted Includes All
Country Back
Foreigners Out of Excludes Excludes Excludes
Country
Formulas
 To put things in a simpler form, here are the formulas to calculate GDP, GNI,
and GDP.
 The components of GDP are personal consumption (C) + business
investment (I) + government spending (G) + [exports - imports (X)]:
 GDP = C + I + G – X.
 GNI is calculated from GDP:
 GNI = GDP + [(income from citizens and businesses earned abroad) –
(income remitted by foreigners living in the country back to their home
countries)].
 GNP is calculated from GDP:
 GNP = GDP + [(income earned on all foreign assets – income
earned by foreigners in the country)].
 GNI is calculated from GNP:
 GNI = GNP + [(income spent by foreigners within the country) –
(foreign income not remitted by citizens)].
COMPARISON OF PER CAPITA GNI, 2005

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 PURCHASING POWER PARITY (PPP)

The PPP Hypothesis states that the exchange rate

between two countries’ currencies equals the ratio of
the currencies’ purchasing power, as measured by
national price levels.
ES = P / PF
 THE LAW OF ONE PRICE

The Law of One Price states that in competitive markets free

of transportation costs and official barriers to trade, identical
goods sold in different countries must sell for the same price
when their prices are expressed in terms of the same
currency
 THE IMPLIED PPP OF THE $

The Implied PPP of the $ is the exchange rate that would

leave a good, such as the McDonald’s Big Mac, costing
the same in the United States as in any other country
where the Big Mac is being sold.

The Implied PPP of the $ is the ratio of the price of a Big

Mac in local currency to the price of a Big Mac in the
United States.
 PURCHASING POWER PARITY

 The purchasing power parity (PPP) theory measures the

purchasing power of one currency against another after taking into
account their exchange rate.
 ‘Taking into account their exchange rate’ simply means that you
measure the strength of purchasing power on $1 with that of
PhP50 and not with PhP1 (assuming the exchange rate is $1 =
PhP50).
 Developed by Gustav Cassel in 1918, the theory states that, in
ideally efficient markets, identical goods should have only one
price.
 PURCHASING POWER PARITY

Understanding the purchasing-power parity

 i.e. PPP Theory
 • Simply put, what this means is that a bundle of goods should
ideally cost the same in Canada and the United States.
 • However, if it doesn’t happen then we say that purchasing power
parity does not exist between the two currencies.
 • Lets look at an example…
 PURCHASING POWER PARITY

 Suppose that one U.S. Dollar (USD) is currently selling for 50

Indian Rupees (INR)
 • In the United States, wooden cricket bats sell for $40 while in
India, they sell for 750 Rupees.
 • Since 1 USD = 50 INR, the bat which costs $40 USD in U.S costs
only 15 USD if we buy it in India.
 • Clearly there’s an advantage of buying the bat in India, so
consumers would be happier to buy the bat in India
 PURCHASING POWER PARITY

If consumers decide to do this, we should expect to see three things happen:

 1. American consumers’ demand for Indian Rupees would increase which will
cause the Indian Rupee to become more expensive.
 2. The demand for cricket bats sold in the United States would decrease and
hence its prices would tend to decrease.
 3. The increase in demand for cricket bats in India would make them more
expensive.
 4. Thus the prices in the US and India would start moving towards an
equilibrium.
So what happens now?
 In an ideal scenario, prices in both countries would become equal at some
price point.
1. The increased demand for INR, for instance may lead to an increase in its
value such that 1 USD = 40 INR.
2. Due to decrease in demand for the bats in the US, its price drops to USD 30.
3. The increase in demand for the bats in India takes its price up to INR 1200.
 At these levels you can see that there is ‘Purchase Price Parity’ between both
the currencies.
 This also means that whether you buy the bat in US or in India, it is one and the
same thing
 This is because a consumer can spend $30 in the
United States for a cricket bat, or he can take his
$30, exchange it for 1200 Rupees (since 1 USD =
40 INR) and buy a cricket bat in India and be no
better off.
Therefore,
 Purchasing-power parity theory tells us that price differentials between
countries are not sustainable in the long run as market forces will equalize
prices between countries and change exchange rates in doing so.
 You might think that my example of consumers crossing the border to buy
cricket bats is unrealistic as the expense of the longer trip would wipe out any
savings you get from buying the bat for a lower price.
 However it is not unrealistic to imagine an individual or company buying
hundreds or thousands of the bats in India, then shipping them to the United
States for sale.
PURCHASING POWER PARITY

Suppose that one U.S. Dollar (USD) is currently selling for 50

Philippine peso
 • In the United States, MCDo 2-piece chicken joy costs $7.79 while
in the Philippines, they sell for PhP150.
 • If 1 USD = 50 PhP, McDo chicken which costs $7.79 USD in U.S.
costs only $3 USD if we buy it in the Philippines.
 • Clearly there’s an advantage of buying McDO in the Philippines,
so consumers would be happier to buy it in the Philippines.
 It is also not unrealistic to imagine a large retail store purchasing
bats from the lower cost manufacturer in India instead of the
higher cost manufacturer in India.

 • In the long run, having different prices in the United States and
India is not sustainable because an individual or company will be
able to gain an arbitrage profit by buying the good cheaply in one
market and selling it for a higher price in the other market.
To sum up:
 What: Purchasing Power Parity Theory is a theory which
states that in ideally efficient markets, identical goods
should have only one price.
 • Why: Because of arbitrage opportunities market forces
come to play and bring about an equilibrium in prices
PURCHASING POWER PARITY

 If consumers decide to do this, we should expect to see three things

happen:
 1. American consumers’ demand for Philippine pesos would increase
which will cause the Philippine peso to become more expensive.
 2. The demand for McDo sold in the United States would decrease and
hence its prices would tend to decrease.
 3. The increase in demand for cricket bats in India would make them
more expensive.
 4. Thus the prices in the US and India would start moving towards an
equilibrium.
BASIC INDICATORS OF DEVELOPMENT

 Health Conditions
 Life Expectancy
 Education Achievements
 Human Development Index (HDI): a composite measure
of living standards
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COMMONALITY AND DIVERSITY: SOME BASIC INDICATORS

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HUMAN DEVELOPMENT DISPARITIES

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HUMAN DEVELOPMENT DISPARITIES

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HUMAN DEVELOPMENT INDEX: 23 COUNTRIES, 2004

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HUMAN DEVELOPMENT INDEX: 23 COUNTRIES, 2004

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HUMAN DEVELOPMENT INDEX VARIATIONS: SIMILAR INCOMES,
2004

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COMMON CHARACTERISTICS OF LDCS:

1. Lower levels of living and productivity

2. Lower levels of human capital investment (health-care,
education, skills)
3. Higher levels of income inequality and poverty
4. Higher population growth rates
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SHARES OF GLOBAL INCOME, 2005

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MOST AND LEAST POPULATED COUNTRIES AND THEIR PER
CAPITA INCOME, 2005

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CHILD MORTALITY RATES, 1990 AND 2005

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PRIMARY SCHOOL ENROLLMENT AND PUPIL-TEACHER RATIO

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CORRELATION BETWEEN CHILD MORTALITY AND MOTHER’S
EDUCATION

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PEOPLE LIVING IN POVERTY, 1981-2002

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COMMON CHARACTERISTICS OF LDCS:

5. Greater social fractionalization

6. Larger rural population, but rapid rural-urban migration
7. Lower levels of industrialization and manufactured exports
8. Adverse geography and resource endowment

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 URBAN POPULATION IN LDCS

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SHARE OF POPULATION EMPLOYED IN INDUSTRY 2000-2005 (%)

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COMMON CHARACTERISTICS OF LDCS:

9. Underdeveloped financial and other markets

 Imperfect markets
 Incomplete information

10. Colonial legacy and external dependence

 Institutions
 Private property
 Personal taxation
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 LDCS TODAY VS. MDCS THEN

1. Physical and human resource

endowments
2. Per capita incomes and levels of GDP
3. Climate
4. Population size, distribution, and growth
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LDCS TODAY VS. MDCS THEN

5. Historic role of international migration

6. International trade benefits
7. Scientific innovation & technological
advancement
8. Effectiveness of domestic institutions
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CONVERGENCE?

 The closing economic and technological gaps between

LDCs and MDCs?

 Evidence of unconditional convergence is hard to find

 Per capita income convergence?

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CONVERGENCE IN OECD DIVERGENCE IN THE WORLD

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PER CAPITA GDP GROWTH IN LDCS, 1995-2005

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GROWTH CONVERGENCE AND INCOME CONVERGENCE

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CHAPTER 2
COMPARATIVE ECONOMIC DEVELOPMENT