AEB 4283 International Development Policy Week 5 Theories

AEB 4283: International Development Policy Week 5: “Theories of Development” Today: • Continue and complete Chapter 3: “Theories of Development” • Start Chapter 4: “Contemporary Theories of Development” Assignment for Wednesday: • Read Todaro and Smith (Chapter 4) Next: § Discuss “Washington Consensus and Millennium Development Goals”

CLASSICAL THEORIES OF DEVELOPMENT

Chapter 3 Classic Theories of Economic Growth and Development

Classical Theories of Economic Development 1) Linear-Stages-of-Growth Model 1 -A) Rostow’s Stages of Growth 1 -B) Harrod-Domar growth model 2) Structural Change Models 2 -A) The Lewis Theory 2 -B) Patterns of Development Approach (Chenery) 3) International Dependence Revolution (Neo-Marxist Approach) 3 -A) The neocolonial dependence model 3 -B) The false-paradigm model 3 -C) The dualistic-development thesis

2) Structural-Change Models 2 -A. The Lewis Theory 2 -B. Patterns of Development Approach (Chenery)

2 -A. The Lewis Theory Background: n n n Sir W. Arthur Lewis – Nobel laureate in economics for his work in development (from St. Lucia) Developed in the mid 1950 s (later extended by Fei and Ranis) Became the general theory of the development process during the 1960 s and early 1970 s (Nobel Prize not until 1979)

2 -A. The Lewis Theory n n Primary focus of the model is on the structural transformation of a primarily subsistence economy via: • The process of labor transfer from the rural agricultural sector to the modern sector • The resultant growth of output and employment in the modern sector Characterized the economies of developing countries as consisting of two sectors: 1. A relatively high-productivity, modern, urban, industrial sector 2. A traditional, overpopulated, rural, subsistence sector characterized by zero marginal labor productivity i. e. surplus labor can be withdrawn from the agricultural

2 -A. The Lewis Theory OTHER KEY ASSUMPTIONS: • Expansion of output in the modern sector is determined by the rate of industrial investment and capital accumulation in the modern sector • Investment is made possible by profits generated in the modern sector • Capitalists re-invest all of their profits n n Very valuable as an early conceptual portrayal of the development process of sectoral interaction and structural change! However, it has limitations in terms of its relevance to fit the reality of contemporary developing nations today

2 -A. The Lewis Theory - Limitations What if capitalist profits are reinvested in labor-saving capital equipment rather than just duplicating the existing capital stock as implicitly assumed in the Lewis model? Or worse yet, what if profits are sent abroad (“capital flight”)

2 -B. Chenery Patterns of Development Approach n n A bit like Rostow’s “Stages of Growth Model” in that it identifies a sequential process through which traditional agricultural economies are transformed However, it contrasts with Rostow and Lewis Models in that in recognizes that: • Increases in savings and investment are necessary but not sufficient • Changes in the economic, industrial and institutional structures of LDCs are necessary

2 -B. Chenery Patterns of Development Approach n n Along with accumulation of human and physical capital, a set of interrelated structural changes are needed to make the transition from traditional economy to a modern one. Changes in: • Composition of consumer demand → from food and basic necessities to manufactured goods and services • International trade • Resource usage → Steady accumulation of physical & human capital • Production → Shift from agricultural to industrial production • Urbanization → Growth of cities and urban industry • The growth and distribution of the population → Decline in

2 -B. Chenery Patterns of Development Approach - Limitations Observation about decreasing share of DCs labor force in agriculture → led some LDC policymakers to neglect agricultural sector • Rate of labor transfer and employment creation may not be proportional to rate of modern-sector capital accumulation n • Observing the importance of higher education in DCs → led to emphasis in some LDCs on a university system before majority of the population has Picture source: www. thehindubusinessline

2 -B. Chenery Patterns of Development Approach – Final Points n This theoretical contribution pointed out that development can depend on domestic and international factors which are outside of the control in LDCs • DC government policies that indirectly influence them (e. g. , trade policies) • DC government and multilateral institutional influence over their domestic policies (e. g. , through foreign assistance programs)

Chenery Model Recognized that the Pace and Patterns of Development Can Vary Based On: n n n Resource endowments Country size Government policies and objectives Availability of external capital and technology The international trade environment → Highlighted the importance of the need for a correct mix of policies affecting a wide range of sectors and practices

3) The International-Dependence Revolution n Grew out of the increasing disenchantment with both the stages-of-growth and structural-change models and it gained support in the 1970 s especially among LDCs themselves. They fell out of favor in the 80’s and 90’s as the neoclassical models took over in importance. Now regaining some support among today’s antiglobalization advocates These models views • LDCs as being beset by institutional, political and economic rigidities, both domestic and international. • LDCs are caught up in dependence relationships with rich countries (Raul Prebisch)

3) The International-Dependence Revolution 3 -A) The neocolonial dependence model 3 -B) The false-paradigm model 3 -C) The dualistic-development thesis

3 -A) The Neocolonial Dependence Model n n n Outgrowth of Marxist thinking → Believes that the existence and continuance of underdevelopment is due to historical evolution of a highly unequal international capitalist system of rich/poor country relationships Unequal power relationships between the “center” (the DCs) and the “periphery” (LDCs) render attempts by LDCs to be self-reliant and economically independent difficult if not impossible These relationships are perpetuated by DCs and a small elite ruling class (landlords, military rulers, merchants, public officials, etc. ) in LDCs that is rewarded by this international capitalist system of inequality

This post-colonial theory contended that genuine economic independence could not be fully achieved, as their economies are structurally flawed by the forces of imperialism and colonialism. External-induced against internal

3 -A) The Neocolonial Dependence Model n n n Believes that underdevelopment is externally induced rather than internally induced (Linear Stages & Structural Change theories → problems are internal) Therefore revolutionary struggles, or at least major restructuring of the world capitalist system is necessary For example → The need to develop indigenous industries • The theory advocates the use of high tariffs to shelter domestic producers from international competition. • Not a good idea if tariff protection is used to support inefficient domestic producers with good political connections.

3 -A) The Neocolonial Dependence Model – Shortcomings n n Advocates argue that only substantial reform of the world capitalist system and a redistribution of assets will 'free' LDCs from poverty cycles and enable development to occur. → Power is not easily redistributed as countries that possess it are unlikely to surrender it Measures that the DCs could take would include the elimination of world debt and the introduction of global taxes such as the Tobin Tax (i. e. tax on foreign exchange transactions) → It may be that it is not the governments of the DCs that hold the power but large multinational enterprises that are reluctant to see the worlds

3 -B) The False-Paradigm Model n n n Less radical than the Neocolonial Dependence Model Underdevelopment is the result of faulty and inappropriate advice from well-meaning but poorlyinformed, biased or ethnocentric international advisors from DC assistance organizations and multilateral donor agencies Recommendations are therefore often based on an incorrect view of LDC realities → i. e. , a falseparadigm

3 -B) The False-Paradigm Model Incorrect view of LDCs → fails to recognize: • resilient traditional social structures • the highly unequal ownership of land other property rights • the disproportionate control of elites over domestic and international financial assets • the very unequal access to credit relevantdevelopment. wordpress. com

3 b) The False-Paradigm Model

3 b) The False-Paradigm Model n n n Resulting policies often tend only to serve the vested interests of existing power groups (domestic and international) due to a range of institutional factors Furthermore, many LDC politicians and high-level government officials, economists, university professors, trade unionists and other civil servants are trained at DC institutions and thus often return with irrelevant or inappropriate training and policy recommendations. . . As a result, desirable institutional and structural reforms are neglected or given insufficient attention

3 -C) The Dualistic-Development Thesis n Dualism is a concept in development economics that focuses on the existence and persistence of increasing divergences between rich and poor → “world of dual societies can co-exist”

3 -C) The Dualistic-Development Thesis Four elements of dualism: 1. Different sets of conditions, of which some are superior and others inferior, can coexist in a given space. E. g. Agriculture sector co-existing with Industrial sector 1. The coexistence is chronic and not transitional (opposite of Stages of Growth & Structural Changes models) 2. The degrees of superiority or inferiority have a tendency to increase over time. 3. The superior element does little or nothing to

3 -C) The Dualistic-Development Thesis “World of dual societies can co-exist”

3) The International-Dependence Revolution n Advocates reject the focus on traditional neoclassical economic theories designed to accelerate the growth of GNP as a principal index of development Emphasizes the need for fundamental economic, political and institutional reforms, both domestic and worldwide They call for the outright expropriation of privately owned assets in the expectation that public asset ownership and control will be a more effective means to help eradicate absolute poverty, provide expanded employment opportunities, lessen income inequalities, and raise the levels of living.

3) The International-Dependence Revolution - Limitations n n n While it does offer an explanation of why LDCs remain underdeveloped, it offers few recommendations for how they should initiate sustained development Actual experience of LDCs that have pursued revolutionary campaigns of nationalization and state-run production is mostly negative This approach suggests that all LDCs adopt a policy of autarky (national economic self-sufficiency) • But when China & India tried this approach they found growth stagnated • They achieved far more success when they opened their economies

Structural-Change vs. International Dependence 1. Structural Change Emphasis is on domestic structural changes along with government regulation to promote industrialization and generate GDP growth 2. Optimistic on Capitalism 3. Underdevelopment is a result of internal constraints such as insufficient savings and 1. International Dependence Emphasis is on international power imbalances and the need for fundamental economic, political and institutional reforms both domestic and worldwide. 2. Pessimistic on Capitalism (class struggle is a byproduct) 3. Underdevelopment is an externally induced phenomenon

Theories of Development: Reconciling the Differences n n n Development economics has no universally accepted paradigm Insights and understandings are continually evolving Each theory has some strengths and some weaknesses

Developed Countries Can. . . n n n Strongly influence patterns of trade with LDCs and terms under which they are conducted Dictate the terms under which technology, foreign aid, and private capital are transferred to LDCs Control the transfer of institutions and systems (appropriate and inappropriate) to LDCs → So forces outside of the control of LDCs have important influences on their economic and social wellbeing http: //www. gapminder. org/videos/20 0 -years-that-changed-the-world/

CONTEMPORARY THEORIES OF DEVELOPMENT

Chapter 4 Contemporary Models of Development and Underdevelopment

Contemporary Theories of Development – from the 1980 s Onward 1. The Neoclassical Revival or Counterrevolution 2. The New Growth Theory 3. Coordination Failure as an explanation for Underdevelopment a) The “Big-Push” Approach b) Kremer’s “O-Ring” Model

1. The Neoclassical Revival n n Theory argues that LDCs are underdeveloped because of heavy state involvement, corruption, inefficiency and lack of economic incentives The counterrevolution called for freer markets and the dismantling of public ownership, and government regulation of economic activities. • Argues that underdevelopment is the result of poor resource allocation due to incorrect pricing policies and too much state intervention by overly-active LDCs governments • The belief is that state intervention often slows the pace of economic growth and that by allowing free markets to flourish, both economic efficiency and economic growth will be stimulated. • Free markets → privatizing state-owned enterprises, promoting free trade and export expansion, welcoming investment from developed countries & removing the government regulations & price distortions

1. The Neoclassical Revival n n n According to traditional neoclassical growth theory, output growth results from • Increases in labor quantity and quality • Increases in capital • Improvements in technology Closed economies with lower savings rates grow more slowly in the short run than those with high savings rates and tend to converge to lower per capita GDP levels. Open economies experience income convergence at higher levels. By impeding the inflow of foreign investment, heavyhanded LDC governments retard growth.

1. The Neoclassical Revival n Economic efficiency and growth will be stimulated by: • Allowing competitive free markets • Privatizing state-owned enterprises • Promoting free trade and export expansion • Welcoming investors from DCs • Eliminating the overabundance of government regulations and price distortions in factor, product and financial markets Three approaches: 1 -a) Free-Market Analysis 1 -b) “Public-choice theory” (a. k. a. new political economy approach)

1 -a) Free-Market Analysis – Key Assumptions n n n Markets alone are efficient in providing the best signals (for investments, labor, products and inputs) Competition is effective (though admittedly not perfect) Technology is freely available and nearly costless to absorb Information is perfect and nearly costless to obtain Government intervention in this context is distortionary & counterproductive.

1 -b) Public-Choice Theory/New Political Economy Approach n n Goes beyond Free-Market approach to argue that governments can not make correct decisions Public choice theory assumes that politicians, bureaucrats, citizens and states act only in their own best interests and use their power for their own selfish ends LDCs are underdeveloped because of heavy state involvement, corruption, inefficiency and lack of economic incentives Minimal government is the best government.

1 -c) Market-Friendly Approach n n Most recent variation of neoclassical revival Recognizes that there are many imperfections in LDC product and factor/input markets and recognizes the need for government to facilitate the operation of markets through market-friendly interventions. Recognizes that governments do have an important role to play (i. e. , investing in physical social infrastructure, health care facilities, schools and in providing a suitable climate for private enterprise) Also recognizes that marker-failures are more prominent in LDCs in areas like investment coordination and environmental protection • Market failures are common in LDCs due to missing

1. The Neoclassical Revival - Criticism n 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 behavioural 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.

2. The New Growth Theory n n Historically, neoclassical theory and models only account for about half of GDP growth • New growth theory attempts to account for this “endogenous growth” New Growth Theory emphasizes the role of complementary investments in human capital, infrastructure and R&D → suggests that there is a role for public policy in promoting economic development In neo-classical models, the long-run rate of growth is exogenously determined by assuming a savings rate (Harrod–Domar model) The Solow Model expanded on the Harrod-Domar formulation by adding a second factor of production – labor

2. The New Growth Theory- Solow Model n n Exhibits diminishing returns to labor and capital separately and constant returns to both factors jointly. Technological progress became the residual factor explaining long-term growth. The level of technological progress was assumed to be exogenous. Y = GDP K = capital stock L = labour A = productivity of labor which grows at an exogenous rate α = elasticity of output with respect to capital (the percentage increase in GDP resulting from a 1% increase in

3. Coordination Failure as an Explanation for Underdevelopment n n 1. There are complementarities between a number of conditions necessary for successful development Coordination failure occurs when agents in an economy are unable to coordinate their decisions and capitalize upon the complementarities → leads to an equilibrium that leaves all agents worse off than before Coordination Failure as an Explanation for Underdevelopment a) The “Big-Push” Approach b) Kremer’s “O-Ring” Model

3. Coordination Failure – 3 -a. The “Big Push” Approach n n A “Big Push” (economy-wide and public-policy led effort) may be required to restart or accelerate development Can a “Super-entrepreneur” satisfy the need for a “Big Push”? • Capital market constraints and potential failures • High costs of monitoring managers and agents to follow the wishes of the super-entrepreneur (agency costs) • Communications failures (Many potential individuals claiming to be the Super-entrepreneur but who is really? )

3. Coordination Failure – 3 -b. Kremer’s “O-Ring” Model n n Modern production systems require that many activities be done well together to result in a highvalue product (complementarities) The O-Ring Model → Production is modeled with strong complementarities among inputs Implications of strong complementarities for economic development and the distribution of income across countries Model gets its name from the fact that a small, inexpensive “O” ring caused the 1986 Challenger Space Shuttle disaster

Theories of Development: Reconciling the Differences n n Development economics has no universally accepted paradigm Insights and understandings are continually evolving In an environment of widespread institutional rigidities and severe socioeconomic inequality, both markets and governments will typically fail. 60 Years of experience have demonstrated that. . . • Development is possible but difficult to achieve! • Yet our theories continue to advanced and our understanding of the development process

Theories of Development: Reconciling the Differences Each theory has some strengths and some weaknesses n n The linear-stages model emphasizes the crucial role of savings and investment. The Lewis two-sector model emphasizes the importance of attempting to analyze the many linkages between the traditional sector and the modern industry International dependence theories highlight the role of the structure and workings of the world economy and the impact of decisions made in the developed world on the growth prospects for LDCs. The neoclassical economic models point to the promotion of efficient production and distribution through a proper functioning price system and the damaging effect of government-induced domestic and international

The Broader Issue of “Development” n A multidimensional process involving the reorganization and reorientation of entire economic and social systems – it typically involves changes in: • Economic practices • Institutional structures • Social structures • Administrative structures • Popular attitudes • Customs and beliefs

In Summary n n “Development economists must be able to distinguish between textbook neoclassical theory and the institutional and political reality of contemporary LDCs. They can then choose the neoclassical concepts and models that can best illuminate issues and dilemmas of development and discard those that cannot. ” (Todaro) This will be our task in the second and third parts of our course