Chapter 3

Salale University Development Economics I
Chapter Three
3. Economic Growth Models and Theories

Model is a physical, symbolical, or verbal representation of a concept in order to make
the understanding of something clearer. Models can be developed depending on the
theoretical aspects. Theories on the other hand can be considered as answers to various
problems identified especially in the scientific world while models can be considered as a
representation created in order to explain a theory.
1. Linear stages of growth models

A) Rostow’s Stage of Economic Growth
The most influential and outspoken advocate of the stages-of-growth model of
development was the American economic historian Walt W. Rostow. According to
Rostow, the transition from underdevelopment to development can be described in terms
of a series of five steps or stages through which all countries must proceed.
1. Traditional society
2. Preconditions for take-off
3. Take-off
4. Drive to maturity
5. Age of High mass consumption
i) Traditional Society
Traditional societies are marked by their pre-Newtonian understanding and use of

technology. These are societies which have pre-scientific understandings of gadget, and
believe that gods or spirits facilitate the procurement of goods, rather than man and his
own ingenuity. The norms of economic growth are completely absent from these
societies.
The traditional society is characterized by:

– Subsistence economy – output not traded or stored;
1 Economics Department
– Existence of barter system;
– The economy largely depends on labour intensive agriculture
ii) Preconditions for take-off
The preconditions for take-off are, to Rostow, that the society begins committing itself to
secular education, that it enables a degree of capital mobilization, especially through the
establishment of banks and currency, that an entrepreneurial class forms, and that the
secular concept of manufacturing develops, with only a few sectors developing at this
point. This leads to a take-off in ten to fifty years. At this stage, there is a limited
production function, and therefore a limited output. There are limited economic
techniques available and these restrictions create a limit to what can be produced.
Preconditions for takeoff are characterized by:

– Development of mining industries
– Increase in capital use in agriculture (application of modern science to agriculture).
– Some growth in savings and investment
– Slow changes in attitude and organization
– Break from traditional rigidity to allow for occupational, geographical and social
mobility
– Emergence of banks and entrepreneurs
– Cheaper transport system and spread of commerce
iii) Take off
Takeoff is defined as ―a decisive transition in society’s history‖ – a period ―when the

scale of productive economic activity reaches a critical level and produces changes which
lead to a massive and progressive structural transformation in economies and the societies
of which they are a part, better viewed as changes in kind than merely in degree.‖
Rostow’s central historical stage is the takeoff, a decisive expansion occurring over 20 to
30 years, which radically transforms a country’s economy and society. During this stage,
barriers to steady growth are finally overcome, while forces making for widespread
economic progress dominate the society, so that growth becomes the normal condition.
The takeoff period is a dramatic moment in history, corresponding to the beginning of the
Industrial Revolution in late-18th-century Britain; pre–Civil War railroad and
manufacturing development in the United States; the period after the 1848 revolution in
Germany; the years just after the 1868 Meiji restoration in Japan; the rapid growth of the
railroad, coal, iron, and heavy engineering industries in the quarter-century before the
1917 Russian Revolution; and a period starting within a decade of India’s independence
(1947) and the communist victory in China (1949).
Rostow indicates that three conditions must be satisfied for takeoff:
1. Net investment as a percentage of net national product (NNP) increases sharply – from
5 percent or less to over 10 percent. If an investment of 3.5 percent of NNP leads to a
growth of 1 percent per year, then 10.5 percent of NNP is needed for a 3-percent growth
(or a 2-percent per-capita increase if population grows at 1 percent).
2. At least one substantial manufacturing sector grows rapidly. The growth of a leading
manufacturing sector spreads to its input suppliers expanding to meet its increased
demand and to its buyers benefiting from its larger output. In the last three decades of the
1700s, for example, the cotton textile industry in Britain expanded rapidly because of the
use of the spinning jenny, water frame, and mule in textiles and the increased demand for
cotton clothing. The development of textile manufactures, and their exports, had wide
direct and indirect effects on the demand for coal, iron, machinery, and transport. In the
United States, France, Germany, Canada, and Russia, the growth of the railroad, by
widening markets, was a powerful stimulus in the coal, iron, and engineering industries,
which in turn fueled the takeoff.
3. A political, social, and institutional framework quickly emerges to exploit expansion in

the modern sectors. This condition implies mobilizing capital through retained earnings
from rapidly expanding sectors; an improved system to tax high-income groups,

especially in agriculture; developing banks and capital markets; and, in most instances,
foreign investment. Furthermore, where state initiative is lacking, the culture must
support a new class of entrepreneurs prepared to take the risk of innovating.
iv) Drive to Maturity

The drive to maturity refers to the need for the economy itself to diversify. The sectors of
the economy which lead initially begin to level off, while other sectors begin to take off.
This diversity leads to greatly reduced rates of poverty and rising standards of living, as
the society no longer needs to sacrifice its comfort in order to strengthen certain sectors.
– Spread of technical change, and improved efficiency from the leading sectors to all the
other parts of the economy.
– Rates of growth outstrip population increase to raise diversification of production
– Growth becomes self-sustaining – wealth generation enables further investment in

value adding industry and development
– Industry more diversified
– Increase in levels of technology utilized – Sophisticated technology
v) Age of high Mass Consumption

Age of mass consumption is characterized by:
– High output levels
– Mass consumption of consumer durables
– High proportion of employment in the service sector
– increased security, welfare, and leisure to the working force
– More power for the mature nations on the world scene
Generalization:
In Rostow’s view, the advanced countries had all passed the stage of take-off and had
achieved self-sustaining growth. The developing economies were either in the
"preconditions" or "traditional" stage. Rostow defined take-off as a period when the
degree of productive economic activity reaches a critical level and produces changes
which lead to a massive and progressive structural transformation of the economy and
society. The take-off stage could only be reached if three criteria were satisfied. First, the
country had to increase its investment rate, with investment amounting to no less than 10
percent of the national income. This requirement could be satisfied either through
investment of the country’s own savings or through foreign aid or foreign investment (i.e.
mobilization of domestic and foreign saving). Second, the country had to develop one or
more substantial manufacturing sectors with a high rate of growth. Third, a political,
social and institutional framework had to exist or be created to promote the expansion of
the new modern sector.
Limitations:
 Inspired by western evolution, not applicable to LDCs
 The stages are not applicable to all countries
 It argues that agricultural expansion precedes industrial expansion. But it is

possible for both sectors to expand simultaneously
 No details of the precondition for growth
 Investment is not the only drive for high growth; total factor productivity and
incentives also matters
B) The Harrod – Domar Model (H-D-M)

Every economy must save a certain proportion of its national income, if only to replace
worn-out or impaired capital goods (buildings, equipment, and materials). However, in
order to grow, new investments representing net additions to the capital stock are
necessary. If we assume that there is some direct economic relationship between the size
of the total capital stock, K, and total GNP, Y—for example, if $3 of capital is always
necessary to produce a $1 stream of GNP—it follows that any net additions to the capital
stock in the form of new investment will bring about corresponding increases in the flow
of national output, GNP.
Commodities are categorized into consumption goods and capital goods – commodities
that are produced for the purpose of producing other commodities. Income from
production is spent on both consumer goods and capital goods. Households buy
consumer goods and firms buy capital goods to expand their production or to replace
worn-out machinery. If all income is paid to households, and if households spent their
income on consumption goods, where does the market for capital goods come from?
Households spent some fraction of their income to buy consumer goods and save the
other fraction. The saving of households will be available to firms through banks,
individual loans, governments, and stock markets. Firms will use the funds to buy capital
goods, i.e. investment. By entering a new business, by expanding a current business, or
by replacing worn-out capital, investment creates a market demand for capital goods.
These goods increase the production capacity of the economy and allow the economy to
grow. This is the starting point of all the theory of economic growth.
N.B. Economy grows when investment exceeds the amount necessary to replace
depreciated capital.
The Model
Let Y - be total output (national income), C – total consumption, and S – total savings. S
– nets out those who are borrowing for current consumption. All these variables are
aggregates over the population.
Assuming a closed economy, the following equation is true as a matter of accounting:
Y(t) = C(t) + S(t), for all dates t -------------------------------(1)

This equation indicates the use of aggregate income, i.e. national income is divided
between consumption and saving. The other equation is use of aggregate output, in
closed economy, for consumption and investment.
Y(t) = C(t) + I(t), Where I denotes Investment ----------------------------------(2)

Combining the two equations:
S(t) = I(t), savings equals investment in closed economy-------------------------------------(3)
Investment augments the national capital stock (K) and replaces the part of it which is wearing
out. Suppose that a fraction d of the capital stock depreciates. Then,
K(t+1) = (1 – d)K(t) + I(t)----------------------------------------------------------(4)

This shows how capital stock changes overtime.
Introduce two important concepts:
 Saving rate: s = S(t)/Y(t) ↔ S(t) = sY(t)

 Capital – Output ratio:– the ratio of capital required to produce a
single unit of output in the economy  = K(t)/Y(t) ↔ K(t) = Y(t) ↔
K(t+1) = Y(t+1)
Combining equation (3) and (4), using these new concepts:
Y(t+1)=(1 - d) Y(t) + sY(t) --------------------------------(4.1)
Y(t+1) - Y(t) = sY(t) - ( d) Y(t)
(Y(t+1) - Y(t))/Yt = sY(t)/Yt - ( d) Y(t)/Yt
g = s - d 
Where (Y(t+1) - Y(t))/Yt=the rate of economic growth=g
g = s/ - d ------------------------------------------------------------- (5)
OR, g + d = s/ this is the Harrod - Domar equation
Implications:
1. By pushing up the rate of savings, it would be possible to accelerate the rate of growth
2. By increasing the rate at which capital produces output (a lower ), growth would be
enhanced
Inclusion of population growth in the H-D-M
To look at per capita growth, it is important to net out the effects of population
growth. If population grows at rate n, so that P(t+1) =( 1+n)P(t). Let y(t) =
Y(t)/P(t).
Per capita growth depends on:

 The ability to save and invest (captured by s),
 The ability to convert capital into output (which depends inversely on ѳ),
 The rate at which capital depreciates (d), and
 The rate of population growth (n).
In the H-D-M the parameters are exogenous to growth. However, there are cases where
they can be determined endogenously.
1. Savings rate can be determined endogenously. It may be influenced by the overall level
of per capita income and distribution of income.
At low level of income, the rates of savings are small. As the economy grows, leaving
subsistence levels behind, there is increased room for savings. This does not necessarily
mean that savings will indeed grow. The existence of some inequality (across country and
within country) may spur savings among middle class because of the desire for prestige
and status in the global economy, i.e. there is a tendency for the savings rate to
significantly rise as we move from very poor to middle income levels, both within a
country and across countries.
2. Population is also endogenous that it varies with the level of development which is
known as demographic transition. In developing countries, especially, century ago or
half century ago, both birth rates and death rates were very high. This moderates the net
population growth rate.
But, with an increasing in living standards, death rates start to fall, while for some reason
birth rate keep at its original level or reduces by small amount. This induces the
population growth rate to be higher. With further development, as birth rates begin their
downward adjustment the population growth rate falls to a low level.
Generally, the critique of H-D-M includes:

1. Investment and savings are the necessary conditions but not sufficient conditions for
economic growth. We need the managerial capacity and skill to change saving into
investment.
2. Saving rate, population growth rate and capital-output ratio are not exogenous. They
are rather endogenous, i.e. the parameters themselves are affected by economic growth.
3. H-D-M is a neutral theory. It provides no reason why growth rates systematically differ
at different levels of income.
4. Capital – output ration is assumed to be fixed.
2. Structural Change Model

Structural-change theory focuses on the mechanism by which underdeveloped economies
transform their domestic economic structures from a heavy emphasis on traditional
subsistence agriculture to a more modern, more urbanized, and more industrially diverse
manufacturing and service economy. Representative example of this strand of thought is
the Lewis theory of development.
The Lewis Theory of Development
One of the best-known early theoretical models of development that focused on the
structural transformation of a primarily subsistence economy was that formulated by
Nobel laureate W. Arthur Lewis in the mid-1950s and later modified, formalized, and
extended by John Fei and Gustav Ranis. The Lewis two-sector model became the general
theory of the development process in surplus-labor Third World nations during most of
the 1960s and early 1970s. It still has many adherents today.
• The economy consists of two sectors

–The traditional agricultural sector is typically characterized by low wages, an abundance
of labour, and low productivity through a labour intensive production process.
– The modern manufacturing sector is defined by higher wage rates than the agricultural
sector, higher marginal productivity, and a demand for more workers initially
• Labour can be withdrawn from the traditional sector without any loss of output
(Traditional sector has surplus of labor (marginal productivity of labor is zero))
• Focus is on labour transfer and output and employment growth in the modern sector.
The rate at which this occurs is determined by the rate of industrial investment and
capital accumulation in the modern sector.
• Wages in the industrial sector are fixed at a premium above wages in the traditional
sector.
• Lewis assumed that with the urban wage above the average rural wage, that the modern-
sector employers could hire as many surplus rural workers as they wanted without fear of
rising wages
• The successive reinvestment of profits from the modern sector would increase the
production possibilities of that sector leading to successive increases in the demand for
labour. The employment expansion in the industrial sector would continue until all the
excess labour from the traditional sector is absorbed. From that point onwards, modern
sector wages would rise in order for industrial employers to attract additional workers
from the traditional sector.
• Improvement in the marginal productivity of labour in the agricultural sector is assumed

to be a low priority as the hypothetical developing nation's investment is going towards
the physical capital stock in the manufacturing sector.
• Over time as this transition continues to take place and investment results in increases in
the capital stock, the marginal productivity of workers in the manufacturing will be
driven up by capital formation and driven down by additional workers entering the
manufacturing sector. Eventually, the wage rates of the agricultural and manufacturing
sectors will equalize as workers leave the agriculture for the manufacturing, increasing
marginal productivity and wages in the agriculture while driving down productivity and
wages in manufacturing.
• The end result of this transition process is that the agricultural wage equals the
manufacturing wage, the agricultural marginal product of labour equals the
manufacturing marginal product of labour, and no further manufacturing sector
enlargement takes place as workers no longer have a monetary incentive to transition.
Illustration:
The agricultural sector is portrayed by the two right-side diagrams
 The upper part shows how subsistence food production varies with increases in
labor inputs. i.e., the productions function. Production varies as labor input
varies keeping capital in the agricultural sector constant
 The lower part shows the average and marginal product of labor
 The model makes two assumptions: MPLA (marginal product of labor in the
agricultural sector) is zero; and rural workers share equally in the output so that the
rural real wage is determined by the average and not the marginal product of labor
(but the in the modern sector wage is determined by the marginal productivity).
Since the MPLA is zero above LA, the surplus labor assumption applies to all
workers in excess of LA.
The modern industrial sector is portrayed by the two left side diagrams:
 The upper-left diagram indicates the production functions for successive amount
of capitals (KM1<KM2<KM3) gained by reinvestment.
 The lower-left diagram indicates the marginal productivity of labor in the modern
sector.
 Under the assumption of perfectly competitive labor markets in the modern sector,
the marginal productivity of labor represents the demand for labor.
WA is the average level of real subsistence income in the traditional rural sector.
WM is the real wage in the modern capitalist sector. At this wage, the supply of rural
labor is assumed to be unlimited or perfectly elastic, as shown by the horizontal labor
supply curve WMLM. In other words, Lewis assumes that at urban wage WM above
rural average income WA, modern sector employers con hire as many surplus rural
workers as they want without fear of rising wages.
At the initial fixed amount of capital KM1, total modern sector employment will be
L1 and total modern sector output will be TPM1. Total profit net of payment to workers
is WMD1F. Lewis assumes that all of these profits are reinvested and total capital stock
in the modern sector will rise from KM1 to KM2.
The increase in capital stock increases the marginal productivity of labor and the
demand for labor. A new equilibrium modern sector employment level will be
established at point G with L2 workers now employed. Total output rises to TMP2 or
OD2GL2 while total wages and profits increase to OWMGL2 and WMD2G,
respectively.
Once again, these larger (WMD2G) profits are reinvested, increasing total capital
stock to KM3, shifting the total product and labor demand curves to TPM(KM3) and to
D3(KM3), respectively, and raising the level of modern-sector employment to L3.
This process of modern-sector self-sustaining growth and employment expansion is

assumed to continue until all surplus rural labor is absorbed in the new industrial sector.
Thereafter, additional workers can be withdrawn from the agricultural sector only at a
higher cost of lost food production because the declining labor-to-land ratio means that
the marginal product of rural labor is no longer zero. Thus the labor supply curve
becomes positively sloped as modern-sector wages and employment continue to grow.
The structural transformation of the economy will have taken place, with the balance of
economic activity shifting from traditional rural agriculture to modern urban industry.
Criticisms of Lewis Theory of Development
 One of the problems with Lewis’ model is that it assumes that the rate of labor
transfer and employment creation is proportional to the rate of modern sector
capital accumulation. It does not leave room for the possibility that capitalist
profits could be reinvested in labor-saving capital equipment nor does it leave
room for the possibility of capital flight.
 The model also assumes surplus labor in rural areas and full employment in
urban areas. By and large this is not the case in most developing nations.
 The assumption of a competitive modern-sector labor market that allows
modern sector wages to remain fixed until the rural sector labor surplus is
exhausted is unrealistic. In reality there is a tendency for urban wages to rise
over time, even when there is considerable urban unemployment.
Generally: Four of the key assumptions do not fit the realities of contemporary
developing countries. The reality is that:
 Capitalist profits are invested in labor saving technology

 Existence of capital flight
 Little surplus labor in rural areas
 Growing prevalence of urban surplus labor
 Tendency for industrial sector wages to rise in the face of open
unemployment
3. The International Dependence Model (IDR)

The international-dependence models grew out of the increasing disenchantment with
both the stages-of-growth and structural-change models only for them to fall out of
favour in the 80’s and 90’s as the neoclassical models took over in importance. The IDR
models reject the exclusive emphasis on GNP growth rate as the principal index of
development. Instead they place emphasis on international power balances and on
fundamental reforms world-wide. IDR models view developing countries as beset by
institutional, political, and economic rigidities in both domestic and international setup.
The IDR models argue that developing countries are up in a dependence and dominance
relationship with rich countries. There are three streams of IDR:
 Neoclassical dependence model

 False-paradigm model
 Dualistic-development thesis
A) Neoclassical dependence model

The first major stream, which we call the neocolonial dependence model, is an indirect
outgrowth of Marxist thinking. It attributes the existence and continuance of
underdevelopment primarily to the historical evolution of a highly unequal international
capitalist system of rich country–poor country relationships. Whether because rich
nations are intentionally exploitative or unintentionally neglectful, the coexistence of rich
and poor nations in an international system dominated by such unequal power
relationships between the center (the developed countries) and the periphery (the LDCs)
renders attempts by poor nations to be self-reliant and independent difficult and
sometimes even impossible. Certain groups in the developing countries (including
landlords, entrepreneurs, military rulers, merchants, salaried public officials, and trade
union leaders) who enjoy high incomes, social status, and political power constitute a
small elite ruling class whose principal interest, knowingly or not, is in the perpetuation
of the international capitalist system of inequality and conformity by which they are
rewarded. Directly and indirectly, they serve (are dominated by) and are rewarded by (are
dependent on) international special-interest power groups including multinational

corporations, national bilateral-aid agencies, and multilateral assistance organizations like
the World Bank or the International Monetary Fund (IMF), which are tied by allegiance
or funding to the wealthy capitalist countries. The elites’ activities and viewpoints often
serve to inhibit any genuine reform efforts that might benefit the wider population and in
some cases actually lead to even lower levels of living and to the perpetuation of
underdevelopment.
In short, the neo-Marxist, neocolonial view of underdevelopment attributes a large part of

the developing world’s continuing and worsening poverty to the existence and policies of
the industrial capitalist countries of the Northern Hemisphere and their extensions in the
form of small but powerful elite or comprador groups in the less developed countries.
Underdevelopment is thus seen as an externally induced phenomenon, in contrast to the
linear- stages and structural-change theories’ stress on internal constraints such as
insufficient savings and investment or lack of education and skills.
Revolutionary struggles or at least major restructuring of the world capitalist system are
therefore required to free dependent developing nations from the direct and indirect
economic control of their developed-world and domestic oppressors.
B) The False – Paradigm Model

Less radical than international dependence models, these models attribute
underdevelopment to faulty and inappropriate advice provided by well-meaning but often
uninformed, biased and ethnocentric international advisers from developed-country
assistance agencies and multinational donor organizations. The advice given fails to
recognize resilient traditional social structures, the highly unequal ownership of land and
other property rights, the disproportionate control of elites over domestic and
international financial assets and the very unequal access to credit. The policy advice
generated from classical and neo-classical models in many cases merely serve to protect
the interests of the existing power groups, both domestic and international. Also local
university intellectuals, high-government officials and other civil servants receive

training in developed-country institutions where they learn inapplicable theoretical
models.
C) The Dualistic – Development Thesis

Implicit in structural-change theories and explicit in international-dependence theories is
the notion of a world of dual societies, of rich nations and poor nations and, in the
developing countries, pockets of wealth within broad areas of poverty. Dualism is a
concept widely discussed in development economics. It represents the existence and
persistence of increasing divergences between rich and poor nations and rich and poor
peoples on various levels. Specifically, the concept of dualism embraces four key
arguments:
1. Different sets of conditions, of which some are ―superior‖ and others ―inferior,‖ can
coexist in a given space. Examples of this element of dualism include Lewis’s notion of
the coexistence of modern and traditional methods of production in urban and rural
sectors; the coexistence of wealthy, highly educated elites with masses of illiterate poor
people; and the dependence notion of the coexistence of powerful and wealthy
industrialized nations with weak, impoverished peasant societies in the international
economy.
2. This coexistence is chronic and not merely transitional. It is not due to a temporary
phenomenon, in which case time could eliminate the discrepancy between superior and
inferior elements. In other words, the international coexistence of wealth and poverty is
not simply a historical phenomenon that will be rectified in time. Although both the
stages-of-growth theory and the structural- change models implicitly make such an
assumption, to proponents of the dualistic development thesis, the facts of growing
international inequalities seem to refute it.
3. Not only do the degrees of superiority or inferiority fail to show any signs of
diminishing, but they even have an inherent tendency to increase. For example, the
productivity gap between workers in developed countries and their counterparts in most
LDCs seems to widen with each passing year.
4. The interrelations between the superior and inferior elements are such that the
existence of the superior elements does little or nothing to pull up the inferior element, let
alone ―trickle down‖ to it. In fact, it may actually serve to push it down—to ―develop its
underdevelopment.‖
4. The Neoclassical Counterrevolution: Market Fundamentalism

The counterrevolution called for freer markets and the dismantling of public ownership,
states planning, and government regulation of economic activities. Neoclassicist also
obtained controlling power of the world’s two most influential international financial
agencies - the World Bank and the International Monetary Fund (IMF). Neoclassical
counterrevolution argues that underdevelopment is the result of poor resource allocation
due to incorrect pricing policies and too much state intervention by overly-active
developing-nation governments and that state intervention often slow the pace of
economic growth. The belief is that by allowing free markets to flourish, privatizing
state-owned enterprises, promoting free trade and export expansion, welcoming
investment from developed countries and removing the plethora of government
regulations and price distortions in factor, product and financial markets, both economic
efficiency and economic growth will be stimulated.
Contrary to the claims of the dependence theorists, the neoclassical

counterrevolutionaries argue that the Third World is under-developed not because of the
predatory activities of the First World and the international agencies that it controls but
rather because of the heavy hand of the state and the corruption, inefficiency, and lack of
economic incentives that permeate the economies of developing nations. What is needed,
therefore, is not a reform of the international economic system, a restructuring of
dualistic developing economies, an increase in foreign aid, attempts to control population
growth, or a more effective development planning system. Rather, it is simply a matter of

promoting free markets and laissez-faire economics within the context of permissive
governments that allow the ―magic of the marketplace‖ and the ―invisible hand‖ of
market prices to guide resource allocation and stimulate economic development.
The neoclassical challenge to the prevailing development orthodoxy can be divided into
three component approaches:
The Free Market Approach: markets alone are efficient – product markets provide the
best signals for investments in new activities; labor markets respond to these new
industries in appropriate ways; producers know best what to produce and how to produce
it efficiently; and product and factor prices reflect accurate scarcity values of goods and
resources now and in the future. Competition is effective if not perfect, technology is
freely available and nearly costless to absorb, information is also perfect and nearly
costless to obtain. So government intervention in this context is distortionary and
counterproductive. Ignores market imperfections in developing countries.
Public-choice theory: Government can do nothing right. Politicians, bureaucrats, citizens

and states are all self-interested and take action to achieve their own ends. Citizens use
political influence to obtain special benefits (called ―rents‖) from government policies
(e.g, import licenses or rationed foreign exchange) that restrict access to important
resources. Politicians use government resources to consolidate and maintain positions of
power and authority. Bureaucrats and public officials use their positions to extract bribes
from rent-seeking citizens and to operate protected businesses on the side. Finally, states
use their power to confiscate private property from individuals. The net result is not only
a misallocation of resources but also a general reduction in individual freedoms. The
conclusion, therefore, is that minimal government is the best government.
Market-friendly Approach: This approach recognizes that there are many imperfections
in LDC product and factor markets and that governments do have a key role to play in
facilitating the operation of markets through ―nonselective‖ (market friendly)
interventions—for example, by investing in physical and social infrastructure, health care

facilities, and educational institutions and by providing a suitable climate for private
enterprise. Also recognizes that marker-failures are more prominent in developing

countries.
The problem with the arguments of the neoclassical counterrevolution is that most LDC
economies are so different in structure and organization from the developed countries that
the behavioral assumptions and policy prescriptions are often incorrect.
– Markets are hardly competitive
– The invisible hand often acts to promote the welfare of those who are already well-off
while pushing down the vast majority.
5. Balanced versus Unbalanced Growth models

A) Theory of unbalanced Growth
The theory of unbalanced growth is generally associated with Hirschman. He contends
that deliberate unbalancing of the economy according to the strategy is the best method of
development and if the economy is to be kept moving ahead, the task of development
policy is to maintain tension, disproportions and disequilibrium. Balanced growth should
not be the goal, but rather the maintenance of existing imbalances, which can be seen
from profit and losses. Therefore, the sequence that leads away from equilibrium is
precisely an ideal pattern for development. Unequal development of various sectors often
generates conditions for rapid development. More-developed industries provide
undeveloped industries an incentive to grow. Hence, development of underdeveloped
countries should be based on this strategy.
The path of unbalanced growth is described by three phases:
1. Complementarity
2. Induced investment
3. External economies
Desirable investment programs always exist within a country that represents unbalanced
investment to complement the existing imbalance. These investments create a new
imbalance, requiring another balancing investment. One sector will always grow faster
than another, so the need for unbalanced growth will continue as investments must
complement existing imbalance. Hirschman states ―If the economy is to be kept moving
ahead, the task of development policy is to maintain tensions, disproportions and
disequilibria‖.
i) Complementarity
Complementarity is a situation where increased production of one good or service builds
up demand for the second good or service. When the second product is privately
produced, this demand will lead to imports or higher domestic production of the second
product, as it will be in the interests of the producers to do so. Otherwise, the increased
demand takes the form of political pressure. This is the case for such public services such
as law and order, education, water and electricity that cannot reasonably be imported.
ii) Induced investment

Complementarity allows investment in one industry or sector to encourage investment in
others. This concept of induced investment is like a multiplier, because each investment
triggers a series of subsequent events. Convergence occurs as the output of external
economies diminishes at each step. Growth sequences tend to move towards convergence
or divergence and the policy is usually concerned with preventing rapid convergence and
promoting the possibility of divergence.
iii) External economies

New projects often appropriate external economies created by preceding ventures and
create external economies that may be utilized by subsequent ones. Sometimes the
project undertaken creates external economies, causing private profit to fall short of what
is socially desirable. The reverse is also possible. Some ventures have a larger input of
external economies than the output. Therefore Hirschman says, "the projects that fall into
this category must be net beneficiaries of external economies.‖
The concept of Backward and forward linkages
Hirschman introduces the concept of backward and forward linkages. A forward linkage
is created when investment in a particular project encourages investment in subsequent
stages of production. A backward linkage is created when a project encourages

investment in facilities that enable the project to succeed. Normally, projects create both
forward and backward linkages. Investment should be made in those projects that have
the greatest total number of linkages. Projects with many linkages will vary from country
to country; knowledge about project linkages can be obtained through input and output
studies.
Linkages and last industries

The development of an economy using the unbalanced method depends on the linkages
between sectors. Hirschman suggests that the best strategy is induced industrialization.
This type of development will create more backward and forward linkages and should be
the first step taken.
Industries that transform semi-manufactured goods into goods needed by final demand
are called "last industries" or "enclave import industries".
In underdeveloped countries, industrialization takes place through such industries,
through plants that add final touches to unfinished imported products. Examples are
metal fabricating industries, pharmaceutical laboratories and assembly and mixing plants.
Such industries have many advantages, as they often require the smaller amounts of
capital available in such economies and without having to rely on unreliable domestic
producers. Therefore underdeveloped countries set up such "last industries" first.
The theory of unbalanced growth has generated positive and negative reactions:
 It pays insufficient attention to the question of the precise composition, direction
and timing of imbalances. What is the optimum degree to which imbalance should
be created in order to accelerate growth?
 It neglects agriculture. In heavily populated countries with agricultural

economies, neglect of agriculture could be suicidal. Shortage of agricultural goods
can emerge as a serious constraint to industrialization; unless income from
agricultural goods expands, the market for industrial products remains limited.
Unbalanced growth can also lead to emergence of inflationary pressures in the
economy, as a shortage of agricultural commodities will push up commodity

prices.
 This theory is useful in those countries where there is significant state control. For
instance, in socialist countries, this strategy is followed with some success.
B) Theory of balanced Growth

Nurkse and Paul Rosenstein-Rodan were the pioneers of balanced growth theory and
much of how it is understood today dates back to their work. The theory hypothesizes
that the government of any underdeveloped country needs to make large investments in a
number of industries simultaneously. This will enlarge the market size, increase
productivity, and provide an incentive for the private sector to invest.
Nurkse was in favour of attaining balanced growth in both the industrial and agricultural
sectors of the economy. He recognized that the expansion and inter-sectoral balance
between agriculture and manufacturing is necessary so that each of these sectors provides
a market for the products of the other and in turn, supplies the necessary raw materials for
the development and growth of the other.
Nurkse's theory discusses how the poor size of the market in underdeveloped countries
perpetuates its underdeveloped state. Nurkse has also clarified the various determinants
of the market size and puts primary focus on productivity. According to him, if the
productivity levels rise in a less developed country, its market size will expand and thus it
can eventually become a developed economy.
Size of market and inducement to invest

The size of a market assumes primary importance in the study of what induces
investment in a country. According to Nurkse, underdeveloped countries lack adequate
purchasing power. Low purchasing power means that the real income of the people is
low, although in monetary terms it may be high. If the money income were low, the
problem could easily be overcome by expanding the money supply; however, since the
meaning in this context is real income, expanding the supply of money will only generate
inflationary pressure. Neither real output nor real investment will rise. It is to be noted
that a low purchasing power means that domestic demand for commodities is low. Apart
from encompassing consumer goods and services, this includes the demand for capital as
well.
The size of the market determines the incentive to invest irrespective of the nature of the
economy. This is because entrepreneurs invariably take their production decisions by
taking into consideration the demand for the concerned product. For example, if an
automobile manufacturer is trying to decide which countries to set up plants in, he will
naturally only invest in those countries where the demand is high. He would prefer to
invest in a developed country, where though the population is lesser than in
underdeveloped countries, the people are prosperous and there is a definite demand.
Private entrepreneurs sometimes resort to heavy advertising as a means of attracting
buyers for their products. Although this may lead to a rise in demand for that
entrepreneur's good or service, it does not actually raise the aggregate demand in the
economy. The demand merely shifts from one provider to another. Clearly, this is not a
long-term solution.
Determinants of size of market

According to Nurkse, expanding the size of the market is crucial to increasing the
inducement to invest. Only then can the vicious circle of poverty be broken. He
mentioned the following pertinent points about how the size of the market is determined:
i) Money supply
Nurkse emphasised that Keynesian theory shouldn't be applied to underdeveloped
countries because they don't face a lack of effective demand in the way that developed
countries do. Their problem is to do with a lack of real purchasing power due to low
productivity levels. Thus, merely increasing the supply of money will not expand the
market but will in fact cause inflationary pressure.
ii) Population
Nurkse argued against the notion that a large population implies a large market. Though
underdeveloped countries have a large population, their levels of productivity are low.
This results in low levels of per capita real income. Thus, consumption expenditure is
low, and savings are either very low or completely absent. On the other hand, developed
countries have smaller populations than underdeveloped countries but by virtue of high
levels of productivity, their per capita real incomes are higher and thus they create a large
market for goods and services.
iii) Geographical area

Nurkse also refuted the claim that if a country's geographical area is large, the size of its
market also ought to be large. A country may be extremely small in area but still have a
large effective demand. For example, Japan. In contrast, a country may cover a huge
geographical area but its market may still be small. This may occur if a large part of the
country is uninhabitable or if the country suffers from low productivity levels and thus
has a low National Income.
iv)Transport cost and trade barriers

The notion that transport costs and trade barriers hinder the expansion of the market is
age-old. Nurkse emphasised that tariff duties, exchange controls, import quotas and other
non-tariff barriers to trade are major obstacles to promoting international cooperation in
exporting and importing. More specifically, due to high transport costs between nations,
producers do not have an incentive to export their commodities. As a result, the amount
of capital accumulation remains small. To address this problem, the United Nations
produced a report in 1951 with solutions for underdeveloped countries. They suggested
that they can expand their markets by forming customs unions with neighboring
countries. Also, they can adopt the system of preferential taxation or even abolish
customs duties altogether. The logic was that once customs duties are removed, transport
costs will fall. Consequently, prices will fall and thus the demand will rise. However,
Nurkse, as an export pessimist, did not agree with this view. Export pessimism is a trade
theory which is governed by the idea of "inward looking growth" as opposed to "outward
looking growth".
v) Sales promotion
Often, it is true that a company's private endeavour to increase the demand for its
products succeeds due to the extensive use of advertisement and other sales promotion
technique. However, Nurkse argues that such activities cannot succeed at the macro level
to increase a country's aggregate demand level.
vi) Productivity
Nurkse stressed productivity as the primary determinant of the size of the market. An
increase in productivity (defined as the output per unit input) increases the flow of goods
and services in the economy. As a response, consumption also rises. Hence,
underdeveloped economies should aim to raise their productivity levels in all sectors of
the economy, in particular agriculture and industry.
For example, in most underdeveloped economies, the technology used to carry out
agricultural activities is backward. There is a low degree of mechanization coupled with
rain dependence. So while a large proportion of the population (70-80%) may be actively
employed in the agriculture sector, the contribution to the Gross Domestic Product may
be as low as 40%. This points to the need to increase output per unit input and output per
head. This can be done if the government provides irrigation facilities, high-yielding
variety seeds, pesticides, fertilizers, tractors etc. The positive outcome of this is that
farmers earn more income and have a higher purchasing power (real income). Their
demand for other products in the economy will rise and this will provide industrialists an
incentive to invest in that country. Thus, the size of the market expands and improves the
condition of the underdeveloped country.
Reactions
Ragnar Nurkse's balanced growth theory too has been criticized on a number of grounds.
His main critic was Albert O. Hirschman, the pioneer of the strategy of unbalanced
growth. Hirschman stressed the fact that underdeveloped economies are called
underdeveloped because they face a lack of resources, maybe not natural resources, but
resources such as skilled labour and technology. Thus, to hypothesize that an
underdeveloped nation can undertake large scale investment in many industries of its
economy simultaneously is unrealistic due to the paucity of resources. To quote
Hirschman,
"If a country were ready to apply the doctrine of balanced growth, then it would not be
underdeveloped in the first place."
Simultaneous investment in a large number of sectors is a well-suited policy. The various
economic agents are temporarily unemployed and once the inducement to invest starts
operating, the slump will be overcome. However, for an underdeveloped economy, where
such resources are absent, this principle doesn't fit.
6) Theory of Circular Cumulative Causation

Circular cumulative causation is a theory developed by Swedish economist Gunnar
Myrdal in the year 1956. It is a multi-causal approach where the core variables and their
linkages are delineated. The idea behind it is that a change in one form of an institution
will lead to successive changes in other institutions. These changes are circular in that
they continue in a cycle, many times in a negative way, in which there is no end, and
cumulative in that they persist in each round. The change doesn’t occur all at once but in
small changes because that would lead to chaos.
Dynamics
Myrdal mentioned that availability of natural resources, the historical traditions of
production activity, national cohesion, religions and ideologies, economic, social and
political leadership are the characteristics that are relevant to the development process of
an economy. Myrdal stated that the immediate effect of closing down certain lines of
production in a community is the reduction of employment, income and demand.
Through the analysis of the multiplier, he pointed out that other sectors of the economy
are also affected.
Then he argued that contraction of the markets in that area tends to have a depressing
effect on new investments, which in turn causes a further reduction of income and
demand and, if nothing happens to modify the trend, there is a net movement of
enterprises and workers towards other areas. Among the further results of these events,
fewer local taxes are collected in a time when more social services is required and a
vicious downward cumulative cycle is started and a trend towards a lower level of
development will be further reinforced.
7) A model of Low level equilibrium Trap

This theory was developed by Richard R. Nelson in his article A Theory of the Low-
Level Equilibrium Trap published in 1956. According to Nelson the problem of
underdeveloped economies can be diagnosed as a stable equilibrium level of per capita
income at or close to subsistence requirements. At this low stable equilibrium level, both
the rate of investment and saving are low. If per capita income is increased above the
minimum subsistence level, it encourages growth in population. The population growth,
in turn pushes down per capita income again to subsistence level. Thus the economy is
caught in low level equilibrium trap. Getting out of the trap requires increasing the rate of
growth of income to the levels higher than the rate of increase in population.
Graphical representation of the poverty trap
The Effect of AID on poverty trap (assuming that the aid money is fully invested in new capital)
In Nelson's opinion following four conditions are conducive to trapping:
1. A high correlation between the level of per-capita income and the rate of population
growth
2. A low propensity to direct additional per-capita income to increasing per-capita

investment
3. Scarcity of uncultivated arable land

4. Inefficient production methods
Nelson uses a model with three equations. First, there is an income determination
equation. Income depends on the stock of capital, the size of the population, and the level
of technique. Second, net investment consists of saving-created capital plus additions to
the amount of land under cultivation. Third, there is the population growth equation
according to which in areas with low per-capita incomes short-run changes in the rate of
population growth are caused by changes in the death rate and changes in the death are
caused by changes in the level of per-capita income. Yet once per capita income reaches
a level well above subsistence requirements, further increases in per-capita income have a
negligible effect on death rate. With these three sets of relationships, it is easy to see that
an underdeveloped economy is caught in a low level trap.
i) Income determination equation

At the initial stage, the economy is at minimum subsistence level of per capita income.
When per capita income is less than that of the minimum subsistence level, population
decreases. After a stationary point where per capita income increases then the subsistence
level population increases until it reaches a physical limit. Population growth increases
till it reaches its upper physical limit after which it declines. The decline occurs because
at high per-capita income levels, people become conscious about their living standards
and try to adopt a small family norm.
ii) New investment is equal to capital created out of savings
In this case there is a certain level of income in the economy with no savings as all the
income is spent on consumption. Also the level of investment is zero. There is negative
investment in the economy when savings are negative implying a situation where
consumption is greater than income i.e. people live on past capital. However when per
capita income rises then savings also rises from zero level which leads to rise in the
investment level in the economy. As there is continuous increase in the per capita income
there is a rising proportion of total income saved and invested.
iii) Population growth equation

Whenever the per capita income reaches a level above the subsistence level any further
increase in it will have a negligible effect on death rates. Moreover changes in death rate
are due to changes in per capita income.
Conclusion
Starting from a low level equilibrium trap, any small increase in per capita income will
not be able to sustain itself or lead to further increase in per capita income because the
rate of growth in population is higher than the rate of growth in total income.
Consequently, per capita income will fall to previous low equilibrium level.
This happens till the time rate of growth in population is greater than the rate in growth of
total income. It is only when the level of per capita income is increased by a
discontinuous jump that the country can hope to come out of the low level equilibrium
trap, because the rate of growth exceeds the rate of growth of population. Nelson's thesis
advocates that if the country is to break the chain of low level equilibrium trap, its rate of
growth of total income must be higher than 3 percent per year. This can be done only
when, to use Leibenstein's terminology, that amount of minimum effort is undertaken
which pushes up the level of per capita income.
8. The Big Push Model

The Big – push model emphasizes that underdeveloped countries require large amounts
of investments to embark on the path of economic development from their present state
of backwardness. This theory proposes that a 'bit by bit' investment programme will not
impact the process of growth as much as is required for developing countries. In fact,
injections of small quantities of investments will merely lead to wastage of resources.

Launching a country into self-sustaining growth is a little like getting an airplane off the
ground. There is a critical ground speed which must be passed before the craft can
become airborne.
Poverty traps occur when agents fail to coordinate their actions to achieve the optimal
allocation of resources. It is argued (in the big-push model) that this phenomenon makes
economic convergence impossible and keeps agents in a poverty trap from which they
cannot escape unless a massive and coordinated industrial policy is implemented.
Paul Rosenstein-Rodan, pioneer of the Big – push model, argued that poor economies
cannot grow because of coordination failure among complementary industries. If
industrialization is simultaneously achieved in all economic sectors, industries could end
up with profit, even though no sector would be profitable if it chooses to industrialize
alone. As a result, underdevelopment equilibrium was possible. To solve this problem, a
large amount of investments are required – the so-called ―big push‖ policy.
In the 1950s, most economists thought that, if left to the impersonal forces of market,
underdeveloped economies would never turn into rich and prosperous ones. Ragnar
Nurkse (1953) argued that underdevelopment persists because of a so-called ―vicious
circle of poverty‖: on the one hand, domestic market is thin because of low incomes and,
on the other hand, the supply of goods is scarce exactly because people are too poor to
save. Thus, the level of capital accumulation, investment and productivity is low. Thus
the big push is a model of how the presence of market failures can lead to a need for a
concentrated economy-wide and probably public-policy-led effort to get the long process
of economic development.
According to the ―big push‖ theory of economic development, publicly coordinated

investment can break the underdevelopment trap by helping economies overcome
deficiencies in private incentives that prevent firms from adopting modern production
techniques and achieving scale economies. These scale economies, in turn, create demand
spillovers, increase market size, and theoretically generate a self-sustaining growth path
Main source: Michael P. Todaro Stephen C. Smith 11th Edition
that allows the economy to move to a Pareto preferred (point where all individuals in an
economy are happy) equilibrium where it is a mutual best response for economic actors
to choose large-scale industrialization over agriculture and small-scale production.
Basic points of the Big – Push model of development:
 Industrialization is "a more equal distribution of income between different areas of
the world by raising incomes in depressed area at a higher rate than in rich areas."
 Use more capital in both agricultural and non-agricultural sectors, but the stress
was on the industrial sectors.
 The "big push" was needed because industrial firms were more capital intensive.
 The big push was to develop industry and not agriculture, although agriculture
could not be ignored. This was the way to break the vicious circle of poverty!

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Salale University Development Economics I

3. Economic Growth Models and Theories

1. Linear stages of growth models

Traditional societies are marked by their pre-Newtonian understanding and use of

The traditional society is characterized by:

– Existence of barter system;

– The economy largely depends on labour intensive agriculture

ii) Preconditions for take-off

Preconditions for takeoff are characterized by:

iii) Take off

Takeoff is defined as ―a decisive transition in society’s history‖ – a period ―when the

Rostow indicates that three conditions must be satisfied for takeoff:

3. A political, social, and institutional framework quickly emerges to exploit expansion in

from rapidly expanding sectors; an improved system to tax high-income groups,

iv) Drive to Maturity

– Rates of growth outstrip population increase to raise diversification of production

– Growth becomes self-sustaining – wealth generation enables further investment in

– Industry more diversified

– Increase in levels of technology utilized – Sophisticated technology

v) Age of high Mass Consumption

– Mass consumption of consumer durables

– High proportion of employment in the service sector

– increased security, welfare, and leisure to the working force

– More power for the mature nations on the world scene

 Inspired by western evolution, not applicable to LDCs

 The stages are not applicable to all countries

 It argues that agricultural expansion precedes industrial expansion. But it is

 No details of the precondition for growth

B) The Harrod – Domar Model (H-D-M)

Y(t) = C(t) + S(t), for all dates t -------------------------------(1)

Y(t) = C(t) + I(t), Where I denotes Investment ----------------------------------(2)

K(t+1) = (1 – d)K(t) + I(t)----------------------------------------------------------(4)

 Saving rate: s = S(t)/Y(t) ↔ S(t) = sY(t)

Y(t+1) - Y(t) = sY(t) - ( d) Y(t)

(Y(t+1) - Y(t))/Yt = sY(t)/Yt - ( d) Y(t)/Yt

Where (Y(t+1) - Y(t))/Yt=the rate of economic growth=g

g = s/ - d ------------------------------------------------------------- (5)

OR, g + d = s/ this is the Harrod - Domar equation

Per capita growth depends on:

Generally, the critique of H-D-M includes:

2. Structural Change Model

• The economy consists of two sectors

• Improvement in the marginal productivity of labour in the agricultural sector is assumed

This process of modern-sector self-sustaining growth and employment expansion is

 Capitalist profits are invested in labor saving technology

3. The International Dependence Model (IDR)

 Neoclassical dependence model

A) Neoclassical dependence model

dependent on) international special-interest power groups including multinational

In short, the neo-Marxist, neocolonial view of underdevelopment attributes a large part of

B) The False – Paradigm Model

university intellectuals, high-government officials and other civil servants receive

C) The Dualistic – Development Thesis

4. The Neoclassical Counterrevolution: Market Fundamentalism

Contrary to the claims of the dependence theorists, the neoclassical

growth, or a more effective development planning system. Rather, it is simply a matter of

Public-choice theory: Government can do nothing right. Politicians, bureaucrats, citizens

interventions—for example, by investing in physical and social infrastructure, health care

enterprise. Also recognizes that marker-failures are more prominent in developing

– Markets are hardly competitive