Chapter 2:Comparative Economic Development

Commonalities & Diversity

Common Characteristics of developing countries

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 population- rapid migration to cities
7. Lower levels of industrialization and manufactured exports
8. Adverse geography
9. Underdeveloped financial and other markets
10. Colonial legacies- poor institutions etc.

DefiningtheDevelopingWorld
World Bank Scheme- ranks countries on GNP/capita LIC, LMC, UMC, OECD (see
Table 2.1 and Figure 2.1) where LIC = Low-Income Countries, LMCs= Lower-MiddleIncome Countries, UMCs= UpperMiddleIncomeCountries; (LMCs + UMCs) = MiddleIncome Countries

Table2.1ClassificationofEconomiesbyRegionandIncome,2007
(LatinAmericaandtheCaribbean)

(SubSaharanAfrica)

2-2

Table 2.1 Classification of Economies by Region and

Income, 2007 (continued)

2-3

Figure 2.1: Nations of the World, Classified by GNI Per Capita

(=GNI/Population)

2-4

Measuring Development for Quantitative Comparison

across Countries
Gross National Income (GNI)
Gross Domestic Product (GDP)
PPP method instead of exchange rates as conversion factors (see Figure 2.2)

Figure2.2IncomePerCapitainSelectedCountries

2-5

GNI and PPP

GNI (Gross National Income)
The Gross national income (GNI) consists of: the personal consumption expenditures, the gross
private investment, the government consumption expenditures, the net income from assets abroad
(net income receipts), and the gross exports of goods and services, after deducting two
components: the gross imports of goods and services, and the indirect business taxes. The GNI is
similar to the gross national product (GNP), except that in measuring the GNP one does not deduct
the indirect business taxes.
PPP
Purchasing power parity (PPP) is a theory which states that exchange rates between currencies
are in equilibrium when their purchasing power is the same in each of the two countries. This
means that the exchange rate between two countries should equal the ratio of the two countries'
price level of a fixed basket of goods and services. When a country's domestic price level is
increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in
order to return to PPP. Note: PH = E*PF or E=PH/PF
Need for adjustments to GDP
1.The exchange rate reflects transaction values for traded goods between countries in contrast to
non-traded goods, that is, goods produced for home-country use. Also, currencies are traded for
purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary
more than those of physical goods. Also, different interest rates, speculation, hedging or
interventions by Central Banks can influence the foreign exchange market.

Using PPP to adjust GDP

The PPP method is used as an alternative to correct for possible statistical bias. The
Penn World table is a widely cited source of PPP adjustments, and the so-called
Penn Effect reflects such a systematic bias in using exchange rates to outputs
among countries.
2. For example, if the value of the Mexican peso falls by half compared to the US
dollar, the Mexican Gross Domestic Product measured in dollars will also halve.
However, this exchange rate results from international trade and financial markets.
It does not necessarily mean that Mexicans are poorer by a half; if incomes and
prices measured in pesos stay the same, they will be no worse off assuming that
imported goods are not essential to the quality of life of individuals. Measuring
income in different countries using PPP exchange rates helps to avoid this
problem.
3. PPP exchange rates are especially useful when official exchange rates are
artificially manipulated by governments. Countries with strong government control
of the economy sometimes enforce official exchange rates that make their own
currency artificially strong. By contrast, the currency's black market exchange rate
is artificially weak. In such cases, a PPP exchange rate is likely the most realistic
basisfor economic comparison.
7

Table 2.2 A Comparison of Per Capita GNI, 2005

2-8

Some Basic Indicators of Development

Health
Life Expectancy
Education
HDI as a holistic measure of living levels
HDI also varies for groups within countries
HDI also varies by region in a country
HDI also reflects rural-urban differences
The HDI was created to emphasize that people and their capabilities should be the ultimate
criteria for assessing the development of a country, not economic growth alone.
The HDI can also be used to question national policy choices, asking how two countries with
the same level of GNI per capita can end up with such different human development outcomes.
For example, the Bahamas and New Zealand have similar levels of income per person, but life
expectancy and expected years of schooling differ greatly between the two countries, resulting
in New Zealand having a much higher HDI value than the Bahamas. These striking contrasts
can stimulate debate about government policy priorities.

2-9

 The HDI sets a minimum and a maximum for each dimension, called goalposts, and then shows where
each country stands in relation to these goalposts, expressed as a value between 0 and 1.
The education component of the HDI is now measured by mean of years of schooling for adults aged 25
years and expected years of schooling for children of school entering age. (a).Mean years of schooling is
estimated based on educational attainment data from censuses and surveys available in the UNESCO
Institute for Statistics database and Barro and Lee (2010) methodology. (b). Expected years of schooling
estimates are based on enrolment by age at all levels of education and population of official school age for
each level of education. Expected years of schooling is capped at 18 years. The indicators are normalized
using a minimum value of zero and maximum values are set to the actual observed maximum value of
mean years of schooling from the countries in the time series.
The life expectancy at birth component of the HDI is calculated using a minimum value of 20 years and
maximum value of 83.4 years. This is the observed maximum value of the indicators from the countries in
the time series, 19802010. Thus, the longevity component for a country where life expectancy birth is 55
years would be 0.552. That is, (55 20)/(83.2 20) = 35/63.2 = 0.552
For the wealth component, the goalpost for minimum income is $100 (PPP) and the maximum is $107,721
(PPP), both estimated during the same period, 1980-2011.

10

Goalposts for the Human Development Index in this Report

Dimension

Observed Maximum

Minimum

Life Expectancy
Mean Years of Schooling
Expected Years of Schooling
Combined Education Index
Per Capita Income (PPPs)

83.2 (Japan,2010)
13.2 (US, 2000)
20.6 (Australia, 2002)
0.951 (NZ, 2010)
108,211 (UAE, 1980)

20
0
0
0
163 (Zimbabwe, 2008)

Having defined the minimum and maximum values, the sub-indices are calculated as
follows:
Dimension index

Actual Index MinimumValue

MaximumValue MinimumValue

For education, the equation is applied to each of the two subcomponents, then a
geometric mean of the resulting indices is created and finally, the equation is
reapplied to the geometric mean of the indices, using 0 as the minimum and the
highest geometric mean of the resulting indices for the time period under
consideration as the maximum.

11

Human Development Index

The HDI is the geometric mean of the three dimension indices: I

1
3

LIFE

xI

1
3

Education

xI

1
3

INCOME

The expression above embodies imperfect substitutability across all HDI dimensions. It thus addresses one of
the most serious criticisms of the linear aggregation formula, which allowed for perfect substitution across
dimensions. Some substitutability is inherent in the definition of any index that increases with the values of its
components.

Example: China
Indicator
Value
Life expectancy at birth (years) = 73.5
Mean years of schooling (years) = 7.5
Expected years of schooling (years) = 11.4
GNI per capita (PPP US$)
= 7,263
Note: Values are rounded.
Life expectancy index =(73.5 20)/(83.2 20) = 0.847
(a) Mean years of schooling index = (7.5 0)/(13.2 0) = 0.568
(b) Expected years of schooling index = (11.4 0)/(20.6 0) = 0.553
Education index = 0.568 x 0.553 0 0.589

0.951 0

Income index =

ln(7, 263) ln(163)

0.584
ln(108,211) ln(163)

Human Development Index (HDI) =

0.847 x 0.589 x 0.584 0.663

12

Table 2.3 Commonality and Diversity: Some Basic Indicators

2-13

Figure 2.3 Human Development Disparities within Selected

Countries

2-14

Table 2.4 Human Development for 23 Selected Countries

(2004 Data)

Note: (1). a positive ve number shows how much a countrys relative ranking rises when HDI is
used instead of GDP per capita.
(2). 0 implies that the use of HDI has no impact on rating by GDP per capita

2-15

Table 2.5 Human Development Index Variations for Similar

Incomes (2004 Data)

2-16

10 Characteristics of the Developing World: Diversity

within Commonality
1. Lower levels of living and productivity
2. Lower levels of human capital (health, education, skills)
3. Higher Levels of Inequality and Absolute Poverty
Absolute Poverty
World Poverty

4. Higher Population Growth Rates

Crude Birth rates

2-17

Figure 2.4: Shares of Global Income, 2005

2-18

Table 2.6: The 12 Most and Least Populated Countries and

Their Per Capita Income, 2005

1.
2.

Low incomes have nothing to do with size (measured by population), i.e. no

causality between country size and economic development
China large size but still a developing economy; St Kitts and Nevis small but
wealthy.

2-19

Figure 2.5 Under-5 Mortality Rates, 1990 and 2005

2-20

Table 2.7: Primary School

Enrollment and Pupil-Teacher
Ratios

Figure2.6:Correlationbetween
Under5MortalityandMothers
Education

2-21

Figure 2.7: People Living in Poverty, 1981-2002

2-22

Table 2.8: Crude Birth Rates Around the World, 2005

10.CharacteristicsoftheDevelopingWorld:Diversitywithin
Commonality
5.GreaterSocialFractionalization
6.largerRuralPopulationsbutRapidRuraltoUrbanMigration
7.LowerlevelsofIndustrializationandManufacturedExports
8.AdverseGeography

Resourceendowments
2-23

Table 2.9: The Urban

Population in Developed
Countries and Developing
Regions

Table2.10:Shareofthe
PopulationEmployedinthe
IndustrialSectorinSelected
Countries,20002005(%)

2-24

10 Characteristics of the Developing World: Diversity within

Commonality
9. Underdeveloped Financial and Other markets
Imperfect markets
Incomplete information

10. Colonial Legacy and external dependence

Institutions
Private property
Personal taxation
Taxes in cash rather than in kind

2-25

Low Income Countries Today And Developed Countries Then

Eight differences

Physical and human resource endowments

Per capita incomes and levels of GDP
Climate
Population size, distribution, and growth
Historic role of international migration
International trade benefits
Scientific/technological research
Efficacy of domestic institutions

2-26

Figure 2.8 Convergence among OECD Countries but

Divergence in the World as a Whole
Convergence?
Evidenceofunconditionalconvergenceishardtofind
Percapitaincomeconvergence?

2-27

Figure 2.9 Per Capita GDP

Growth in 125 Developing
Countries, 1995-2005

Figure2.10GrowthConvergence
andAbsoluteIncomeConvergence

2-28

Long-Run causes of Comparative Development

Schematic Representation

Geography
Institutional quality- colonial and post-colonial
Colonial legacy- pre colonial comparative advantage
Evolution and timing of European development
Inequality- human capital
Type of colonial regime

2-29

Figure 2.11: Schematic Representation of Leading Theories

of Comparative Development

2-30

Role of Institutions
1. Acemoglu, Johnson, and Robinsons: reversal of fortune
and extractive institutions
2. Bannerjee and Iyers:property rights institutions.
Landlords versus cultivators

Will hand out a Lecture on Institutions

2-31

Chapter 3: Classic Theories of Economic Growth and

Development
Earlier Theories

Classic Theories of Economic Development Four

Approaches
1. Linear stages of growth model
2. Theories and Patterns of structural change
3. International-dependence revolution
4. Neoclassical, free market counterrevolution
Development as Growth and Linear-Stages Theories

1. Rostows Stages of Growth

2. Harrod Domar Growth Model
3-32

Earlier Theories: Growth Theory + Development =

Growth and Development Economics
Adam Smith (as quoted in a1976 revision): Great nations are never
impoverished by private, though they sometimes are publick
prodigality and misconduct.
Thomas Malthus (1817): The practical question then for our
consideration is, what are the most immediate and effective
stimulants to the creation and progress of wealth?
W. Arthur Lewis (1955): The proximate causes of economic growth are
the effort to economize, the accumulation of knowledge, and the
accumulation of capital.
Robert Solow (1956): To change the rate of growth of real output per
head (= GDP/Population) you have to change the rate of technical
progress.
Paul Krugman (1995): Why did development economics fade away? -the leading development economists failed to turn their intuitive
insights into clear-cut models that could serve as the core of an
enduring discipline.

The First Revolution: Adam Smith;1

1.
2.

3.

4.

5.

Link between division of labor, efficiency, and the size of

the market as central in his theory of wealth creation,
public policy and economic growth.
Like Hume, he regarded saving and investment as byproducts and precursors of domestic and foreign trade; as
a means of enlarging the market and increasing the
division of labor and thus efficiency.
High saving and investment stimulate growth directly and
indirectly. Directly --- accumulation of capital on output.
Indirectly --- effects on labor productivity + interaction
with exchange and trade.
Trade (domestic and foreign) stimulates growth: smaller
countries have higher trade (Belgium and Sweden, 143%
and 77% respectively in 1995) whereas for the USA and
Japan, 24% and 17% respectively.
By Smith, anything that increases division of labor and
hence specialization increases efficiency and wealth, and
thus economic growth.

Adam Smith ;2
6. Thus, anything that increases efficiency of labor (L), capital (K) should have
the same effect on output and hence economic growth.

7. Smiths view on education, efficiency and growth follows from his distinction
between the quantity and quality of labor. Viewed inferior education as not
contributing to increased labor productivity or efficiency. Advocated
improved education for the common people. Thought education could be
improved by more private-sector involvement aided by public sector
expenditure - need for government tax revenue.

8. In sum, Adam Smith attributed economic growth to:

a. an increase in the quantity and quality of the 3 main inputs; labor (L),
capital (K), and land (N). Modern-day growth accounting attempts to
determine empirically the proportions in which economic growth can be
traced to these proximate causes. In practice, we have as determinants; the
increased quantity of capital through saving and investment AND improved
quality of labor, capital, and land as sources of economic growth.