Theories of Development ITheories of Development I

Classical Classical

andand

Neoclassical Neoclassical TheoriesTheories

Classical EconomicsClassical Economics: P: Political Economyolitical EconomyThe pThe pursuit of economic growth and development as a socially ursuit of economic growth and development as a socially

desirable goal desirable goal is is contemporaneous with the rise of contemporaneous with the rise of capitalism as an economic system (and with the emergence capitalism as an economic system (and with the emergence

of the industrial revolution)of the industrial revolution)..Two objectives of Two objectives of classical political economistsclassical political economists in economic in economic

inquiryinquiry are: are:1. to explain the reasons for rapid economic expansion of 1. to explain the reasons for rapid economic expansion of total economic wealth that accompanied industrializationtotal economic wealth that accompanied industrialization2. to explain the enigma of the ext2. to explain the enigma of the extreremmee of wea of weallth and th and poverty that attended this processpoverty that attended this process

Who are the Who are the classical classical ((politicalpolitical)) economists economists??• Adam SmithAdam Smith • Thomas MalthusThomas Malthus • David RicardoDavid Ricardo• John Stuart MillJohn Stuart Mill• Karl MarxKarl Marx

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• The classicals assumed that capitalism The classicals assumed that capitalism represented the highest achievement of represented the highest achievement of human development and it was a “natural human development and it was a “natural order.”order.”– except for Marx and Millexcept for Marx and Mill

• NNeoclassical economists (after the 1870s)eoclassical economists (after the 1870s) – Against the radical implications of MarxAgainst the radical implications of Marx– shifted the emphasis from the broader shifted the emphasis from the broader

macroeconomics of growth and development to a macroeconomics of growth and development to a narrower concern with the allocation of a fixed narrower concern with the allocation of a fixed quantity of scarce resources to their best use with quantity of scarce resources to their best use with given institutions. given institutions.

– efficiency as the focus of economics efficiency as the focus of economics – more static and marginalist perspective for more static and marginalist perspective for

economics economics – interest in the question of growth and interest in the question of growth and

development has disappeared from view for quite development has disappeared from view for quite some time.some time.

Adam SmithAdam SmithAn inquiry into the Nature and Causes An inquiry into the Nature and Causes of the Wealth of Nations, 1776of the Wealth of Nations, 1776

• Analyzes the newly emerging economic system: capitalism or Analyzes the newly emerging economic system: capitalism or the market economythe market economy

• Likens its operation to the “invisible hand”Likens its operation to the “invisible hand”

As every individual, .., endeAs every individual, .., endeaavors as much as he can both to vors as much as he can both to employ his capital in the support of the domestic industry, and employ his capital in the support of the domestic industry, and so to direct that industry that its produce may be of greatest so to direct that industry that its produce may be of greatest value; every indivivalue; every individdual necessarily labors to render the annual ual necessarily labors to render the annual revenue of society as great as he can. He generally, indeed, revenue of society as great as he can. He generally, indeed, neither intends to promote the public interest, noneither intends to promote the public interest, norr knows how knows how much he is promoting it ...he intends only his own gain, and he is much he is promoting it ...he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intenpromote an end which was no part of his intenttion.ion. (Smith 1973: (Smith 1973: 423; C&D: 105)423; C&D: 105)

Smith’s Views on Smith’s Views on Economic DevelopmentEconomic Development

Basic tenets of Capitalist production that Basic tenets of Capitalist production that fosters Growth and Development fosters Growth and Development according to Smith:according to Smith:

• CompetitionCompetition

• Division of laborDivision of labor

• Technological progressTechnological progress

• Free tradeFree trade

• The law of capital accumulationThe law of capital accumulation

Thomas Malthus Thomas Malthus An Essay on the Principle of Population, An Essay on the Principle of Population, 17981798

• Population grows in a geometric Population grows in a geometric progression, whileprogression, while

• Agricultural output can only increase in Agricultural output can only increase in arithmetic progression; such thatarithmetic progression; such that

• Feeding the population would become Feeding the population would become increasingly more expensive a taskincreasingly more expensive a task

• This would mean misery for a majority of This would mean misery for a majority of the population who are poorthe population who are poor

• The system (capitalism) would end up in a The system (capitalism) would end up in a crisiscrisis

David RicardoDavid RicardoPPrinciples of rinciples of PPolitical Economy and olitical Economy and TaxationTaxation,, 1817 1817

• the law of eventually diminishing returnsthe law of eventually diminishing returns(implications similar to Malthus in terms of the dilemmas (implications similar to Malthus in terms of the dilemmas

of the capitalist growth proces); yetof the capitalist growth proces); yet• the theory comparthe theory comparaative advantagetive advantage(implies free trade through open economies would help to (implies free trade through open economies would help to

escape the dilemmas posed by the law of diminishing escape the dilemmas posed by the law of diminishing returns.)returns.)

Theory which suggests that unrestricted exchange Theory which suggests that unrestricted exchange between countries will increase total world output if between countries will increase total world output if each country tends to specialize in those goods that it each country tends to specialize in those goods that it can produce at relatively lower costs compared to its can produce at relatively lower costs compared to its potential trading partners.potential trading partners.

Ricardo’s Theory Ricardo’s Theory oof Comparative Advantagef Comparative AdvantageA numerical example to explain the virtues of A numerical example to explain the virtues of free tradefree trade

ClotClothh

labor labor hrs hrs per per unitunit

WineWine

labor labor hrs per hrs per unitunit

oppoppurtuniurtunity ty cost ofcost of ClothCloth

in terms of Wine in terms of Wine foregoneforegone

oppopportuniortunity ty cost ofcost of WineWine

in terms of in terms of Cloth foregoneCloth foregone

EnglanEnglandd

9090hrhrss

LLCECE

120hrs120hrs

LLWEWE

0.0.750750

LLCECE/ L/ LWEWE0.75 additional wines produced 0.75 additional wines produced per each unit of reduced cloth per each unit of reduced cloth

productionproduction

1.1.333333

LLWEWE/L/LCECE1.33 additional cloth produced 1.33 additional cloth produced per each unit of reduced wine per each unit of reduced wine

productionproduction

PortugPortugalal

90hr90hrs Ls LCPCP

80hrs 80hrs LLWPWP

1.1251.125

LLCPCP/ L/ LWPWP

0.8880.888

LLWPWP /L /LCPCP

Ricardo’s Theory Ricardo’s Theory oof Comparative Advantagef Comparative Advantage: A numerical example : A numerical example to explain the virtues of free tradeto explain the virtues of free trade

Assume: Both E and P have 300,000 labor hours to start with; andAssume: Both E and P have 300,000 labor hours to start with; andPre-trade both divide their time equally between cloth and wine Pre-trade both divide their time equally between cloth and wine

productionproductionPortugalPortugal EnglandEngland

Before Trade:Before Trade: ClothCloth WineWine ClothCloth WineWine

Production & Production & ConsumptionConsumption

16661666 18751875 16661666 12501250

After Trade:After Trade:

ProductionProduction 00 37503750 33333333 00

TradeTrade Gets Gets 16661666

Gives 1666Gives 1666 Gives 1666Gives 1666 Gets 1666Gets 1666

ConsumptionConsumption 16661666 20832083 16671667 16661666

Gains from Gains from Trade:CountryTrade:Country

00 +208+208 +1+1 + 416+ 416

Gains from Gains from Trade:WorldTrade:World

Pre trade wine: 3125Pre trade wine: 3125

Post trade wine: 3750Post trade wine: 3750Pre trade cloth: 3166Pre trade cloth: 3166

Post trade cloth: 3166Post trade cloth: 3166

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Free Trade Free Trade according to Comparative according to Comparative Advantage benefits all??? Advantage benefits all??? CritiqueCritique of the of the

Comparative Comparative AdvantageAdvantage Theory of Free TradeTheory of Free Trade

• Very static analysis which assumes that over Very static analysis which assumes that over time, the terms of trade between wine and time, the terms of trade between wine and cloth will remain the same. cloth will remain the same. – On the contrary, historically what happened with E On the contrary, historically what happened with E

and P was that the terms of trade very much and P was that the terms of trade very much favored cloth; such that E had a definite trade favored cloth; such that E had a definite trade advantage. advantage.

– P stuck with wine production and importing cloth, P stuck with wine production and importing cloth, was put in a position of ever increasing trade deficit.was put in a position of ever increasing trade deficit.

• dynamic or created comparative advantage as dynamic or created comparative advantage as opposed to static comparative advantage opposed to static comparative advantage – the Asian tigers.the Asian tigers.

A Classical Model of Economic A Classical Model of Economic GrowthGrowth

Aggregate production function:Aggregate production function:

Y = f(N, L, K, T)Y = f(N, L, K, T)

where N = natural resources; L = labor; K = capital; T = technolog,where N = natural resources; L = labor; K = capital; T = technolog,

subject to the following restrictions subject to the following restrictions ffNN, f, fLL, f, fkk,,>0; >0; ffNNNN, f, fLLLL, f, fkKkK < < 0,then 0,then

dY/dt = fdY/dt = fNNdN/dt + fdN/dt + fLLdL/dt + fdL/dt + fkkdK/dt + fdK/dt + fTTdT/dt dT/dt

assume assume 1. 1. dN/dt = 0; dL/dt = q(dK/dt) dN/dt = 0; dL/dt = q(dK/dt)

where q where q >0 = the no of wrks required for each unit of capital>0 = the no of wrks required for each unit of capital ;;

2. 2. ffT T = 0= 0;;

then rewrite eq.n asthen rewrite eq.n as

dY/dt = (q fdY/dt = (q fL L + f+ fkk)dK/dt)dK/dt

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… … A Classical Model of Economic A Classical Model of Economic GrowthGrowth

• The rate of economic growth depends on The rate of economic growth depends on the rate of physical capital accumulation. the rate of physical capital accumulation. – The faster physical capital accumulates, The faster physical capital accumulates,

faster is economic growth.faster is economic growth.

• the limit on the rate of growth: the limit on the rate of growth: diminishing returns. diminishing returns. – ffL L decreases asdecreases as L rises, until L rises, until eeventually the ventually the

point when per capitapoint when per capita income reaches a income reaches a steady state level.steady state level.

Neoclassical Growth Models:Neoclassical Growth Models: the Solow Growth Model the Solow Growth Model

Y(t) =A(t)K(t)Y(t) =A(t)K(t)1-a1-a L(t) L(t)a a where 0where 0<<aa<<1; 1;

A(t) = exogenous technological progress;A(t) = exogenous technological progress;K = capital inputK = capital inputL = labor inputL = labor input

in a perfectly competitive setting where each factor input is entitled to a in a perfectly competitive setting where each factor input is entitled to a return equal to its own marginal product,return equal to its own marginal product,

a = income share of labora = income share of labor1-a = income share of capital.1-a = income share of capital.

This production function is such thatThis production function is such that• K and L are subject to diminishing returns in the short term.K and L are subject to diminishing returns in the short term.• production is subject to constant returns to scale in the long term.production is subject to constant returns to scale in the long term.

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… … Solow Growth Model Solow Growth Model

• diminishing returnsdiminishing returnsddYY/dL = aL/dL = aLa-1a-1AAKK1–a1–a> 0 > 0 ddYY/d/dKK = (1–a)K = (1–a)K–a –a AA LLaa > 0; > 0; dYdY22/(d/(dLL))22 = a(a–1) = a(a–1)LLa–2 a–2 AAKK1–a1–a < 0 < 0 dYdY22/(d/(dKK))22 = –a(1–a)K = –a(1–a)K–(1+a)–(1+a) AA LLaa < 0, < 0, ((00<<aa<<1)1)

• constant returns to scaleconstant returns to scale– ‘‘linearly homogeneous’linearly homogeneous’– multiplying both variable inputs by the same scalar multiplying both variable inputs by the same scalar

value, value, vv, changes production by , changes production by vYvY: : AA((vLvL))aa((vKvK))1-a1-a = = AvAvaaLLaavv1-a1-aKK1-a1-a = = vv((ALALaaKK1-a1-a), ),

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… … Solow Growth ModelSolow Growth Modelin a perfectly competitive setting where each factor in a perfectly competitive setting where each factor

input is entitled to a return equal to its own input is entitled to a return equal to its own marginal product:marginal product:

w=dY/dL= aLw=dY/dL= aLa-1 a-1 AAKK1–a1–a

Wage share=wL/Y= (dY/dL)*(L/Y)Wage share=wL/Y= (dY/dL)*(L/Y)= the elasticity of output with respect to a change = the elasticity of output with respect to a change

in the labor inputin the labor input= = aLaLa-1 a-1 AAKK1–a1–aL/ L/ AKAK1-a1-aLLaa

=a=a

a = income share of labora = income share of labor1-a = income share of capital.1-a = income share of capital.

1717

… … the Solow Growth Modelthe Solow Growth Model

Technological change

without technological change:

the increased investment, K, has a limit in terms of total income: Qmax

1818

… … the Solow Growth Modelthe Solow Growth Model

• assume constant L, assume constant L, – an upper limit in terms of per capita an upper limit in terms of per capita

income. income.

• How?How?

1919

… … the Solow Growth Modelthe Solow Growth Model

• y=Y/L=y=Y/L=AKAK1-a1-aLLaa /L/L

• y=y=AKAK1-a1-a/L/L1-1-aa

• y=y=AA((KK/L)/L)1-1-aa

• Let K/L=kLet K/L=k

• ΔΔK=K=Investment = Savings Investment = Savings – capital accumulation rate will be determined by capital accumulation rate will be determined by

the rate of savings, s, out of income, Y.the rate of savings, s, out of income, Y.

• ΔΔK=sYK=sY

• Population (labor force) growth: constant Population (labor force) growth: constant rate=n=rate=n=LL//LL

2020

… … the Solow Growth Modelthe Solow Growth Model

nk

ys

nK

sYL

L

K

Kk

.

Steady state:

0.

k

2121

… … the Solow Growth Modelthe Solow Growth Model

aaa

aa

a

a

n

sAy

n

sAAy

n

sAk

Akn

sk

n

syk

/)1(/1

)1(/1

/1*

1*

)(

))((

)(

Steady state per capita income:

At steady state:

2222

……the Solow Growth Modelthe Solow Growth Model

• the steady state level of per capita the steady state level of per capita income over the long run will converge income over the long run will converge to to

y = Y/L = y = Y/L = A A 11/a/a(s/n)(s/n)(1(1-a-a)/a)/a

where s=savings rate; where s=savings rate; n=exogenous population growth raten=exogenous population growth ratea = incomea = income share of laborshare of labor1-a = income share of capital1-a = income share of capital

2323

… … the Solow Growth Modelthe Solow Growth Model

• If tech and the rate of increase of L are constant and assuming If tech and the rate of increase of L are constant and assuming the LF is always fully employed, a Solow-type growth model the LF is always fully employed, a Solow-type growth model predicts that:predicts that:

• for any given rate of savings (and investment), there will be a for any given rate of savings (and investment), there will be a constant steady-state level of real per capita income achieved. constant steady-state level of real per capita income achieved. – follows directly from the assumption of diminishing returns to follows directly from the assumption of diminishing returns to

capital.capital.– Given a constant rate of saving, the return to capital falls as K rises Given a constant rate of saving, the return to capital falls as K rises

until, ultimately, total amount of capital also reaches a steady-until, ultimately, total amount of capital also reaches a steady-state level, and all new investment is just sufficient to replace old state level, and all new investment is just sufficient to replace old capital that has worn out and meet population growth rate.capital that has worn out and meet population growth rate.

• the level of per capita income has reached its max level, given the level of per capita income has reached its max level, given the rate of savings, pop.n growth rate and assuming no tech the rate of savings, pop.n growth rate and assuming no tech change which is exogenous anyway.change which is exogenous anyway.– No further growth in per capita incomeNo further growth in per capita income

2424

……the Solow Growth Modelthe Solow Growth Model• differences in income per person across countries are explained bydifferences in income per person across countries are explained by

– different rates of savings (physical capital accumulation) different rates of savings (physical capital accumulation) – different population growth ratesdifferent population growth rates..

• AAssuming equal shares of income accruing to K and L across ssuming equal shares of income accruing to K and L across countries:countries:– aa higher rate of saving will raise the steady-state level of per capita higher rate of saving will raise the steady-state level of per capita

income.income.• Countries that are poor are poor b/c they aren’t saving and investing Countries that are poor are poor b/c they aren’t saving and investing

enough. enough. • Policy Policy recommendationrecommendation:: accumulate physical K at a higher rateaccumulate physical K at a higher rate• Implication : conditional convergenceImplication : conditional convergence

– poorer nations will grow faster than richer nations, assuming equal poorer nations will grow faster than richer nations, assuming equal rates of saving and pop.n growth rates rates of saving and pop.n growth rates

– convergence of per capita income among different nations sharing convergence of per capita income among different nations sharing similar fundamentals. similar fundamentals.

– Two countries with the same rate of saving and population growth Two countries with the same rate of saving and population growth rate, will tend to have ultimately, the same real per capita income.rate, will tend to have ultimately, the same real per capita income.

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CriticismsCriticisms

1.1. no consideration of no consideration of the institutional structure the institutional structure which converts savings into investment which converts savings into investment

• AssumptionAssumption of a direct, automatic and smooth link b/t of a direct, automatic and smooth link b/t increased savings, increased investment and income increased savings, increased investment and income growth. growth.

2.2. growth is conceived of as a mechanical simple growth is conceived of as a mechanical simple process of increasing per capita income with no process of increasing per capita income with no consideration of processes of structural, consideration of processes of structural, institutional, economic, political and social institutional, economic, political and social transformation.transformation.

Karl MarxKarl Marx Capital, 1867, 1885, 1894Capital, 1867, 1885, 1894

• does not assume capitalism to be immutable or does not assume capitalism to be immutable or natural order of society, rather one stage of a natural order of society, rather one stage of a society’s historical developmentsociety’s historical development

• ccapitalism will alsoapitalism will also ultimately break ultimately break ddown andown and evolve into a different systemevolve into a different system

• aagrees with Smith’s analysis of capitalism as an grees with Smith’s analysis of capitalism as an immensely dynamic system driven by the lawimmensely dynamic system driven by the law of of capital accumulation, characterized bycapital accumulation, characterized by division ofdivision of labor and technological progresslabor and technological progress

• yyet is critical of the one sided distribution et is critical of the one sided distribution (“exploitation of labor by capital”) that results in (“exploitation of labor by capital”) that results in the capitalist growth processthe capitalist growth process

• aa relatively h relatively hiigh-level of income per capita in a gh-level of income per capita in a capitalist economic environment is a precondition capitalist economic environment is a precondition for the evolution of a new future economic for the evolution of a new future economic systemsystem