The Big Picture
• Many definitions & disagreements on economic development due to subjective judgments on “goals” and
because “quality of life” is a multi-dimensional concept
- different people value aspects differently
• Index: what indicators, objective or subjective, how to measure indicators, who chooses, consistency amongst
countries
• Per capita income(Lucas) is the most objective. Other side of spectrum is Happiness Index (Layard) which is
the most subjective & hard to compare countries & time
• Economic Development: expansion of people’s capabilities via increasing access to opportunities (A. Sen)
Measures
1. Per Capita Income
- 75% of the world’s population has passed the world average GDP per capita of $9909
- Strengths: easier to form a consensus on how to measure, GDP growth helps to move people out of poverty
and creates jobs so worth measuring; growth raises tax revenue for social programmes; correlates positively
with other dimensions, especially human capital (health and education) which impact quality of life
- Chen & Ravillion found fast growth went with fast poverty reduction but no change in inequality
- Limitations: only captures the value of marketed g&s; ignores other indicators of quality of life e.g. health,
educations, environment, happiness; assumes wellbeing is linked to income ignores income distribution;
ignores fluctuations in income patterns; depletion of natural resources
• It’s an average. Bermuda has high GDP per capita, only as it’s a tax haven. Citizens aren’t rich
• Growing economy is not an end, should be a way to improve lives
• Cause vs effect: does per capita income rise reduce poverty or vice versa? Or a 3rd factor e.g. gov policy
• Social conditions can determine economic status e.g. discrimination in education & work
- Issue of growth vs redistribution to help the poor
2. Percentage of the population below the poverty line
- Strengths: focusing on the poor helps us to understand economic development
• e.g. work many jobs, informal work
- Limitations: Income inequalities above and below the poverty line (be poor and fell poor relative to others);
hard to reconcile and absolute indicator (poverty) with a relative one (income inequality) i.e. not necessarily
connected
3. Inequality indices
- Strengths: sheds light on income inequality, poverty and emphasises social mobility; maybe inequality is due to
skills and education
- USA: % of kids earning more than parents fell from above 90% in 1940 to below 50% in 1990
- Limitations: No empirical support to the Kuznets inverted U hypothesis of inequality against GDP per capita
• Little empirical support for inequality negatively affecting economic growth
• Little empirical support for inequality of opportunities affecting economic efficiency
- Redistributing by income tax may reduce return to capital and incentive to save and invest so may not grow as
fast
- But may help the poor fund or borrow to support investment projects but it may be due to wealth not income
- But inequality can cause crime and other social issues that reduce investment and entrepreneurship
, The Big Picture
- Inequality of income could leave the rich in power to create weak institutions which cause unequal
opportunities and help the rich, cycle repeats
- Ignores inequality of opportunity: e.g. education, health, justice, credit i.e. equity matters more than inequality
for development.
• But promoting equality of opportunity requires a substantial redistribution of income i.e. raise funds
through tax for education.
• Negative efficiency aspects of tax are immediate but benefits from equality arise in long term
4. Human Development Indicators (e.g. HDI)
- HDI may be a good measure, averaging: per capita income, health (life expectancy), and education (adult
literacy)
- Belief that a long life is valuable and depends on many variables e.g. nutrition and health
- Other concerns such as democratic rights, free speech, crime, private property
GDP & Growth
• GDP= total value of final g&s produced in a country in a year= p1q1+p2q2+……
• Real GDP per capita accounts for inflation e.g. measure in USD 2005
• Then need to account for different currencies. But issue of using market exchange rate
- fluctuates significantly and produces biased income comparisons (different cost of living)
• Exchange rates adjust to equalise the price of traded goods only (law of one price)
• Let PUS=xPIND where x=1/40 (i.e. $1=40 rupees)
• If PUS>xPIND then cheaper to buy good in India so demand in India rises and x rises.
• But in poor countries, non-traded (Services) are relatively less expensive than traded goods
• So x should be higher (e.g. x=1/20). If we use the market exchange rate to convert rupees to dollars, India’s
GDP is underestimated
• Solution is purchasing power parity exchange rates (based of traded and non-traded goods)
• PPP is PUSALL GOODS = x PINDALL GOODS
• Means PPP adjusted real per capita GDP is the best measure of income across countries
• But can only measure every 5 years
• For some rich countries, when converting to PPP, figure is lower as they have a higher cost of living- higher
price for non traded.
• Let Y= per capita income. One year growth rate= g= (Yt+1 - Yt )/Yt
• Rearrange to get g= (Yt+1/Yt) - 1
• This implies Yt+2=Yt+1(1+g)= Yt(1+g)(1+g)= Yt(1+g)2 thus rearrange to get
• Two development indicators where China is worse than India are pollution indicators and the gender ratio. Big
focus on per capita income in China: provinces have compromised on pollution control so higher C02
• Ghatak et al. suggest that democracy has checks and balances (citizens, media and rival parties) so ruling party
can’t ignore the other development indicators.
• To take advantage of growth opportunities, poor need access to education and health.
• Focus on children- higher growth rates and reduce poverty, less need to redistribute
, Classical Theory Traditional Theories
Of Economic Growth and Development
Rostow’s Stages of Growth
1. Traditional Society
- High proportion of production in agriculture with limited productivity e.g. Medieval Europe.
- Consume what they produce: subsistence farming with no trade. Little capital stock and low labour productivity
2. Preconditions for take-off into self-sustaining growth
- In the process of transition e.g. early 18th century Western Europe. Surplus agricultural product gives scope for trade
- Start to develop manufacturing
3. The Take off: modern activity expands, economic growth becomes persistent.
- Savings may rise from 5% of national income to 10% or more. Industry rapidly expands: industrialisation
- This stage tends to last for 20 years. E.g. Britain after 1780s or US after 1860
4. The drive to maturity: long period of sustained growth. Use & state of tech rises and economy diversifies
- “10 to 20% of national income is saved and invested”. Typically after 40 years maturity is reached.
5. Age of mass consumption: shift to production of consumer durables, services & other high-tech and skill-intensive products.
- Development of a welfare state. E.g. Europe and US in the 50s
• According to Rostow, developed countries of his time had already passed through all stages
- Developing countries were still at point 1 or 2
• Sustained growth was inevitable as long as the savings rate was sufficient for the investment necessary to generate sustained
growth
• What is not consumed is saved which funds investment. Development is inevitable but not consistent with evidence
• Assumes all countries have an equal chance to develop, without regard to population size, natural resources, or location.
• Other factors important for development: gov, institutions, infrastructure, education, endowments. Growth doesn’t equal
development
Harrod – Domar growth model
1. Consumption vs savings decision. Y= total GDP, S= Aggregate savings. Y=C+S.
- s=savings rate= S/Y which rearranges to S=sY i.e. saving is a fixed share of income
2. In the closed economy, all savings are invested into productive capital. I= aggregate investment so S=I
- K= Aggregate capital stock. Kt+1= Kt + It rearrange to It= Kt+1-Kt so I= ΔK
3. Goods are produced using capital.
- k= capital to output ratio. $k of capital (K) is needed to produce $1 of output (Y). So Y=1/k or K=kY
- This implies that Kt=kYt & Kt+1= kYt+1 thus Kt+1-Kt=kYt+1-kYt or ΔK=kΔY
4. Deriving HD equation: change in capital stock= investment= saving sY=S=I= ΔK=kΔY
- So sY=kΔY, divide by kY to get equation which gives the growth rate
• Equation suggests that a country’s savings rate is the main determinant of growth and development.
- Need high savings and investment that is productive for development
• Production is assumed to use capital only and has constant returns to scale in capital so Y=(1/k)K
• k reflects the productivity of capital/investment and also how capital intensive production is
- A high k implies inefficiency e.g. idle machines as more capital for less output
• Weaknesses: model implies saving is sufficient for growth. Not all investments pay off. Value of k is assumed to be fixed but
poor countries start with a low k. Assumes a necessary government/institutions to ensure that savings can be converted into
investment efficiently and investment is always transformed into capital.
• Poor countries have a low savings rate, even if they have the same k as a rich one, and have less scope to save so slow growth
• If the rich save more, the model predicts extreme divergence in incomes
• Issue is that the poor are too poor to have high savings: financing gap between savings and needed investment
- Solution was foreign aid and low interest loans to achieve a desired level of growth by filling the gap- repayment issue
Lewis two sector model
• This is a Structural Change Model: 60s & 70s looked at cross section of comparing countries with different levels of income at
one time period. Move from subsistence agriculture to modern and industrially diverse manufacturing and service economy
• Time series: look at a country over time. See how investment, gov revenue, foreign trade, education changed with rising income.
• As GDP per capita rose, share of labour in agriculture fell and share of agriculture in GDP fell
• Dominant model in the 60s & 70s. Urbanisation and industrialisation is at the core of economic development
• 2 sectors: agricultural where MPL=0 since there’s too many workers who don’t raise output on limited land: surplus of labour
- Rural workers share labour equally and have an equal wage
• Sector 2= Modern where labour is productive so MPL>0. Wages assumed to be fixed/constant.
• Sustained growth comes from two sources
- Surplus labour: labour is moved from agriculture into industry (agricultural output is unchanged), modern sector expands
- Investment: all capitalist profits are reinvested in capital and modern sector expands further
- Process continues until all surplus labour is used (Lewis Turning Point)
• Issues: assumes profits are reinvested in more capital and this creates jobs.
- But profits may not be reinvested or may be reinvested in forms of labour saving capital
- Assumes full employment in the cites but unemployment in the countryside- not observed in reality as little surplus labour
- Assumes a competitive modern-sector labor market where wages fall to equalise to agriculture wage.
- But we see wages rising over time due to institutional factors like unions
- Not a smooth nor quick transfer of labour: different skills needed. Requires investment in education & skills which takes time
• Many definitions & disagreements on economic development due to subjective judgments on “goals” and
because “quality of life” is a multi-dimensional concept
- different people value aspects differently
• Index: what indicators, objective or subjective, how to measure indicators, who chooses, consistency amongst
countries
• Per capita income(Lucas) is the most objective. Other side of spectrum is Happiness Index (Layard) which is
the most subjective & hard to compare countries & time
• Economic Development: expansion of people’s capabilities via increasing access to opportunities (A. Sen)
Measures
1. Per Capita Income
- 75% of the world’s population has passed the world average GDP per capita of $9909
- Strengths: easier to form a consensus on how to measure, GDP growth helps to move people out of poverty
and creates jobs so worth measuring; growth raises tax revenue for social programmes; correlates positively
with other dimensions, especially human capital (health and education) which impact quality of life
- Chen & Ravillion found fast growth went with fast poverty reduction but no change in inequality
- Limitations: only captures the value of marketed g&s; ignores other indicators of quality of life e.g. health,
educations, environment, happiness; assumes wellbeing is linked to income ignores income distribution;
ignores fluctuations in income patterns; depletion of natural resources
• It’s an average. Bermuda has high GDP per capita, only as it’s a tax haven. Citizens aren’t rich
• Growing economy is not an end, should be a way to improve lives
• Cause vs effect: does per capita income rise reduce poverty or vice versa? Or a 3rd factor e.g. gov policy
• Social conditions can determine economic status e.g. discrimination in education & work
- Issue of growth vs redistribution to help the poor
2. Percentage of the population below the poverty line
- Strengths: focusing on the poor helps us to understand economic development
• e.g. work many jobs, informal work
- Limitations: Income inequalities above and below the poverty line (be poor and fell poor relative to others);
hard to reconcile and absolute indicator (poverty) with a relative one (income inequality) i.e. not necessarily
connected
3. Inequality indices
- Strengths: sheds light on income inequality, poverty and emphasises social mobility; maybe inequality is due to
skills and education
- USA: % of kids earning more than parents fell from above 90% in 1940 to below 50% in 1990
- Limitations: No empirical support to the Kuznets inverted U hypothesis of inequality against GDP per capita
• Little empirical support for inequality negatively affecting economic growth
• Little empirical support for inequality of opportunities affecting economic efficiency
- Redistributing by income tax may reduce return to capital and incentive to save and invest so may not grow as
fast
- But may help the poor fund or borrow to support investment projects but it may be due to wealth not income
- But inequality can cause crime and other social issues that reduce investment and entrepreneurship
, The Big Picture
- Inequality of income could leave the rich in power to create weak institutions which cause unequal
opportunities and help the rich, cycle repeats
- Ignores inequality of opportunity: e.g. education, health, justice, credit i.e. equity matters more than inequality
for development.
• But promoting equality of opportunity requires a substantial redistribution of income i.e. raise funds
through tax for education.
• Negative efficiency aspects of tax are immediate but benefits from equality arise in long term
4. Human Development Indicators (e.g. HDI)
- HDI may be a good measure, averaging: per capita income, health (life expectancy), and education (adult
literacy)
- Belief that a long life is valuable and depends on many variables e.g. nutrition and health
- Other concerns such as democratic rights, free speech, crime, private property
GDP & Growth
• GDP= total value of final g&s produced in a country in a year= p1q1+p2q2+……
• Real GDP per capita accounts for inflation e.g. measure in USD 2005
• Then need to account for different currencies. But issue of using market exchange rate
- fluctuates significantly and produces biased income comparisons (different cost of living)
• Exchange rates adjust to equalise the price of traded goods only (law of one price)
• Let PUS=xPIND where x=1/40 (i.e. $1=40 rupees)
• If PUS>xPIND then cheaper to buy good in India so demand in India rises and x rises.
• But in poor countries, non-traded (Services) are relatively less expensive than traded goods
• So x should be higher (e.g. x=1/20). If we use the market exchange rate to convert rupees to dollars, India’s
GDP is underestimated
• Solution is purchasing power parity exchange rates (based of traded and non-traded goods)
• PPP is PUSALL GOODS = x PINDALL GOODS
• Means PPP adjusted real per capita GDP is the best measure of income across countries
• But can only measure every 5 years
• For some rich countries, when converting to PPP, figure is lower as they have a higher cost of living- higher
price for non traded.
• Let Y= per capita income. One year growth rate= g= (Yt+1 - Yt )/Yt
• Rearrange to get g= (Yt+1/Yt) - 1
• This implies Yt+2=Yt+1(1+g)= Yt(1+g)(1+g)= Yt(1+g)2 thus rearrange to get
• Two development indicators where China is worse than India are pollution indicators and the gender ratio. Big
focus on per capita income in China: provinces have compromised on pollution control so higher C02
• Ghatak et al. suggest that democracy has checks and balances (citizens, media and rival parties) so ruling party
can’t ignore the other development indicators.
• To take advantage of growth opportunities, poor need access to education and health.
• Focus on children- higher growth rates and reduce poverty, less need to redistribute
, Classical Theory Traditional Theories
Of Economic Growth and Development
Rostow’s Stages of Growth
1. Traditional Society
- High proportion of production in agriculture with limited productivity e.g. Medieval Europe.
- Consume what they produce: subsistence farming with no trade. Little capital stock and low labour productivity
2. Preconditions for take-off into self-sustaining growth
- In the process of transition e.g. early 18th century Western Europe. Surplus agricultural product gives scope for trade
- Start to develop manufacturing
3. The Take off: modern activity expands, economic growth becomes persistent.
- Savings may rise from 5% of national income to 10% or more. Industry rapidly expands: industrialisation
- This stage tends to last for 20 years. E.g. Britain after 1780s or US after 1860
4. The drive to maturity: long period of sustained growth. Use & state of tech rises and economy diversifies
- “10 to 20% of national income is saved and invested”. Typically after 40 years maturity is reached.
5. Age of mass consumption: shift to production of consumer durables, services & other high-tech and skill-intensive products.
- Development of a welfare state. E.g. Europe and US in the 50s
• According to Rostow, developed countries of his time had already passed through all stages
- Developing countries were still at point 1 or 2
• Sustained growth was inevitable as long as the savings rate was sufficient for the investment necessary to generate sustained
growth
• What is not consumed is saved which funds investment. Development is inevitable but not consistent with evidence
• Assumes all countries have an equal chance to develop, without regard to population size, natural resources, or location.
• Other factors important for development: gov, institutions, infrastructure, education, endowments. Growth doesn’t equal
development
Harrod – Domar growth model
1. Consumption vs savings decision. Y= total GDP, S= Aggregate savings. Y=C+S.
- s=savings rate= S/Y which rearranges to S=sY i.e. saving is a fixed share of income
2. In the closed economy, all savings are invested into productive capital. I= aggregate investment so S=I
- K= Aggregate capital stock. Kt+1= Kt + It rearrange to It= Kt+1-Kt so I= ΔK
3. Goods are produced using capital.
- k= capital to output ratio. $k of capital (K) is needed to produce $1 of output (Y). So Y=1/k or K=kY
- This implies that Kt=kYt & Kt+1= kYt+1 thus Kt+1-Kt=kYt+1-kYt or ΔK=kΔY
4. Deriving HD equation: change in capital stock= investment= saving sY=S=I= ΔK=kΔY
- So sY=kΔY, divide by kY to get equation which gives the growth rate
• Equation suggests that a country’s savings rate is the main determinant of growth and development.
- Need high savings and investment that is productive for development
• Production is assumed to use capital only and has constant returns to scale in capital so Y=(1/k)K
• k reflects the productivity of capital/investment and also how capital intensive production is
- A high k implies inefficiency e.g. idle machines as more capital for less output
• Weaknesses: model implies saving is sufficient for growth. Not all investments pay off. Value of k is assumed to be fixed but
poor countries start with a low k. Assumes a necessary government/institutions to ensure that savings can be converted into
investment efficiently and investment is always transformed into capital.
• Poor countries have a low savings rate, even if they have the same k as a rich one, and have less scope to save so slow growth
• If the rich save more, the model predicts extreme divergence in incomes
• Issue is that the poor are too poor to have high savings: financing gap between savings and needed investment
- Solution was foreign aid and low interest loans to achieve a desired level of growth by filling the gap- repayment issue
Lewis two sector model
• This is a Structural Change Model: 60s & 70s looked at cross section of comparing countries with different levels of income at
one time period. Move from subsistence agriculture to modern and industrially diverse manufacturing and service economy
• Time series: look at a country over time. See how investment, gov revenue, foreign trade, education changed with rising income.
• As GDP per capita rose, share of labour in agriculture fell and share of agriculture in GDP fell
• Dominant model in the 60s & 70s. Urbanisation and industrialisation is at the core of economic development
• 2 sectors: agricultural where MPL=0 since there’s too many workers who don’t raise output on limited land: surplus of labour
- Rural workers share labour equally and have an equal wage
• Sector 2= Modern where labour is productive so MPL>0. Wages assumed to be fixed/constant.
• Sustained growth comes from two sources
- Surplus labour: labour is moved from agriculture into industry (agricultural output is unchanged), modern sector expands
- Investment: all capitalist profits are reinvested in capital and modern sector expands further
- Process continues until all surplus labour is used (Lewis Turning Point)
• Issues: assumes profits are reinvested in more capital and this creates jobs.
- But profits may not be reinvested or may be reinvested in forms of labour saving capital
- Assumes full employment in the cites but unemployment in the countryside- not observed in reality as little surplus labour
- Assumes a competitive modern-sector labor market where wages fall to equalise to agriculture wage.
- But we see wages rising over time due to institutional factors like unions
- Not a smooth nor quick transfer of labour: different skills needed. Requires investment in education & skills which takes time
