Theories of Growth and Development

Theories of Growth and Development
Theories of Growth
- Harrod-Domar Model
- Solow Growth Model
- Two-Sector Models
- New Growth Theory
- Coordination Failures
- Big Push
- Kremers O-Ring Theory

Development Theories
- Structuralist School of Thought
- Rostows Linear Stages of Growth
- Neo-Marxist Approach
- Neoclassical Counterrevolution

Harrod-Domar Model
- fixed coefficient production function (L)
- constant returns to scale
- equation: g=(s/v) d
where g = growth rate
s = savings rate
v = capital productivity (ICOR)
d = depreciation rate
Harrod-Domar Growth Model

A Flow chart model
Depreciation
Rate
Saving Rate
Ig
s
C
GDP
v= K/Y or Capital/Output
a=Y/K Ratio or Productivity
In
Capital
Production function
Factors Explaining the growth rate

According to Harrod-Domar model
+
Rate of
Economic
Growth
g
_
Explained variable
Saving rate
Capital productivity
Capital depreciation
Explanatory Variables

Harrod-Domar Model
- message: you save more, and make
productive investments, then economy would grow
- economic analysts use this framework to
predict growth or calculate the amount of saving
required to achieve target growth rate
- eg. What is g? if s=.24, v=.03, d=.05?
- then from g= (s/v) d
- g = (.24/.03) - .05 = .03 (3 percent growth)

Harrod-Domar Model
- Strengths: (1) small data
requirements, (2) easy to use/estimate, and
(3) accuracy for short period, in absence of
shocks in the economy
- Weaknesses: (1) not true: savingsinvestment is sufficient for growth, (2) no
substitution effect in capital-labor, (3) role of
technology in growth process

Solow Growth Model
- neoclassical production function with
diminishing marginal returns to capital (curve)
- constant returns to scale, but with focus on
intensification of factor inputs (K and L)
- equation 1: y = f(k)
where y = output per worker
k = capital per worker
- message: capital per worker is fundamental
to the growth process

Solow Growth Model
- equation 2: k = sy (n+d)k
where sy = saving per worker (+)
k = capital per worker
n = population (-)
d = depreciation (-)
- messages: (1) change in k is positively
related to saving (investment) per worker, (2)
change in k is negatively related to population
growth, and (3) depreciation erodes capital stock

Solow Growth Model

Solow Growth Model

Solow Growth Model
- solow residual: Y= A f(K, L)
- A as residual refers to technological
change
- Technological change is either labor
augmenting (human capital from
health/education) or capital augmenting
(new innovations and processes)

Solow Growth Model
- strengths: (1) flexibility on K-L mix, (2)
diminishing marginal returns on capital, (3) impact
of growth on savings, population, depreciation and
technology
- weaknesses: (1) not provide full explanation
for growth, (2) one-sector does not imply resource
allocation, and (3) does not explain factor
accumulation and productivity growth explicitly

Two-Sector Models
- Started by David Ricardos basic
assumptions: (1) agricultural production is subject
to diminishing returns, and (2) labor surplus
similar to rural unemployment, underemployment
or disguised unemployment
- Two-sector labor surplus model by Fei and
Ranis (1964) and Lewis (1955) assumes that (1)
marginal product of labor in agriculture is zero, and
(2) institutionally fixed minimum wage
- Neoclassical two-sector model emphasized
the balance between growth in agriculture and
industry

New Growth Theory
- Endogenous growth, the importance of
knowledge, research and development
- Romer (1986) Y= A(R) f(R,K,L)
where A(R) = public knowledge stock
R = private research
K = physical capital
L = labor
- message: countries are more experienced
in research through learning by doing (knowledge)

Coordination Failures (Underdevelopment)
- Big Push: to create markets for
industrial output, all industries have to grow
together, each employing workers who would
demand the output of other industries
- message: no firm wants to
industrialize first

Coordination Failures (Underdevelopment)
- Kremer O-Ring Model: linked to
explosion of Challenger (which exploded
because of the O-ring malfunctioning), thus
production must function as a whole to work
- message: advanced countries
build/specializes on spaceships, poorer
countries build/specialize on tea products

Structuralist School of Thought
- State-led development as main driver
- Import substitution and tariff
- State-owned enterprises
- Public Goods
- BUT, the rich became richer, poor
became poorer

Rostows Stages of Growth
- (1) traditional society, (2) preconditions to take-off, (3) take-off, (4) drive to
maturity, (5) age of high mass consumption
- Applied in Europes Marshall Plan
- BUT, failed on account of structural
causes of low savings and investment in
developing countries

Neo-Marxist Approach
- Dependency approach
- Developing nations cannot pass the
Advanced stage of development without
moving to socialism
- Advanced economies exploit
developing economies unless they resort to
social revolution or unrest
- Provocative BUT, flawed and too
formalistic

Neoclassical Counterrevolution
- Private Markets are Key to
Development
- Privatization, Decentralization, Free
Trade Advocacy, Deregulation
- Lead to the formulation of the
Washington Consensus

Neoclassical Counterrevolution
1. Fiscal discipline
2. A redirection of public expenditure priorities toward fields offering both
high economic returns and the potential to improve income distribution,
such as primary health care, primary education, and infrastructure
3. Tax reform (to lower marginal rates and broaden the tax base)
4. Interest rate liberalization
5. A competitive exchange rate
6. Trade liberalization
7. Liberalization of inflows of foreign direct investment
8. Privatization
9. Deregulation (to abolish barriers to entry and exit)
10. Secure property rights

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