Development Economics: Theories and Models

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At the beginning of the 21^st century, there is no unified theory of economic development, thus there are a lot of views and explanations of growth and economic development of different world nations. The financial stability and viability, and hence development, of an economy, depend on two fundamental factors. The first factor is the macroeconomic and structural conditions in the real economy which affect financial decisions and form the environment within which the financial system operates.

The second factor is the robustness of the financial system itself, comprising the financial markets, institutions, and arrangements through which financial transactions are carried out. By their nature, the component elements that comprise a robust financial system depend on legal structures and institutions (Mellor, 2001). Unfortunately, at the beginning of the transition process in 1989, this was little understood and therefore received very little early emphasis.

Vibrant financial markets require not only that appropriate legal rules exist, but that they operate in an environment where they are effective. While the phrase ‘rule of law’ has been repeated since the beginning of the transition process, until recently the meaning of the idea and its effective implementation received very little practical attention; for that reason, transition and financial sector development were seen as the field of economists and the role of law was viewed as largely irrelevant. Difficulties and setbacks in the transition process during the 1990s have caused the focus to shift somewhat to the ‘rule of law’ and related institution-building (Bardham, 1993).

Much has been said to qualify traditional theory when it is admitted that forces within the economic system may produce fluctuations and that “equilibrium” is not synonymous with the full employment of resources. On the other hand, equilibrium analysis seems to obscure the nature of such forces because the latter suggests relationships that lie outside the traditional equilibrium scheme. However, the purpose of the present study is not primarily one of criticism but is rather an endeavor to isolate some of the principal forces which govern business fluctuations and to inquire how they may be brought into the theoretical analysis.

The theories discussed here will be sifted for their contribution to an understanding of this problem. This brief study cannot hope to do justice to the many outstanding achievements which mark the development of dynamic theory and business cycle discussion over the past two or three decades. The theories discussed are recent contributions and are still controversial. For this reason, perhaps, they may be fairly representative of the range of contemporary dynamic theory. Above all, they represent the furthermost stage of advance in the attempt to integrate traditional theory and the problem of economic fluctuations (Todaro and Smith 2006).

This equation summarizes the main factors affecting productivity, in particular, productivity in the industry.

U+03CO + ̂ = a + bŶ + cW/Pma _-m+ dî _-n(1)

where Y is income, W/Pma is the ratio between wages and the price of machines, I is an investment, and m and n lags, and the cap over the variable represents a rate of change. From the theoretical standpoint, the rationale of the first variable can be traced back to Adam Smith, while that of the second to David Ricardo. Throughout his writings, Smith insists on the thesis that division of labor is what allows all sorts of improvements and that division of labor is in turn “limited by the extent of the market” (Mellor, 2001).

Developing Smith’s observations, economists can say that an increase in income stimulates productivity growth, both in the short run and in the long run. In the short run, productivity grows when income rises because labor can be more efficiently organized and several inputs can be saved in various ways. In the long run, a sustained economic expansion stimulates the introduction of new machines, which as a rule are more efficient than those already in operation (Nurkse, 2000).

In his structural change model, Lewis considers himself (rightly) to be in the tradition of the classical economists, in particular, Adam Smith. Lewis’s proposition that “the wage to be paid in the capitalist sector is determined by what people can earn outside this sector” is perfectly consistent with the Smithian analysis recalled previously, with the proviso that, in the latter, the existence of a subsistence sector outside the capitalist sector is not postulated. What has instead been assumed is the availability of free lands, where dependent workers can easily move if they are not treated satisfactorily in the capitalist sector (Bardham, 1993).

It is appropriate to point out that the equation aims at explaining the variations of labor productivity in industry, which is the most dynamic sector of the economy. These variations are induced by impulses generated within the economic system: income, the W/Pma ratio, and investment can be considered as such. But productivity can increase also as a result of the investment made for profit in research and development and as a consequence of discoveries made by nonprofit institutions, such as universities (Nurkse, 2000). In the latter case, the ensuing innovations cannot be directly related to economic factors and are to be considered exogenous.

Exogenous innovations can be, and often are, even more important, from the scientific viewpoint, than the endogenous ones. From the economic viewpoint, however, endogenous innovations, often consisting of adaptations and improvements, are more important for the continuity and the speed of the process of growth (Bauer and Yamey 2002).

At this point economists have to recall that Marx and Schumpeter were right: growth and cycles are to be considered not as two distinct phenomena but as the expression of the same process, that is, the process of cyclical development. In analyzing this process economists have, therefore, single out, starting from advanced countries, the industries that lead in the growth process, which as a rule are also the innovating industries. At the same time, due to the great importance that nowadays, for good or bad, the state has reached in the economy, economists have to examine the type of economic policy that is followed.

The main impulses to growth come from innovations and economic policy, and these impulses interact with one another (Bardham, 1993). When economists consider the growth process on the world scale, economists have to compare the rates of change in industrial production of each country with those of the overall index of advanced countries–the deviations deserve scrutiny. As for the underdeveloped countries, economists can assume that, as a rule, they play only a passive role in the world cycles (Lewis 1954). These countries can profit to a greater or lesser extent from the impulses coming from the advanced countries.

Therefore, the analysis of both the leading industries and the types of the economic policy followed in the major countries is also relevant to the interpretation of cyclical developments in underdeveloped countries. It should be emphasized that a macroeconomic approach for this kind of problem is justified only in the first approximation. In successive approximations, economists should work based on disaggregated multisector models, characterized by nonproportionality in the variations of output, prices, and incomes (Dorfman, 1991). Indeed, Lewis (1954) went so far as to state:

The central problem in the theory of economic development is to understand the process by which a community that was previously saving and investing 4 or 5 percent of its national income or less, converts itself to an economy where voluntary saving is running at about 12 to 15 percent of national income or more.

In isolating the variables which determine price equilibrium, traditional theory thus makes several simplifying assumptions. This is not an unusual procedure in the exact sciences. But unlike the hypotheses developed in the exact sciences, the causal explanation of price formation in traditional theory is not readily subject to empirical verification (Chenery and Syrquin, 2004). Probability theory is not entirely applicable to the type of observations that can be made in economics and the social sciences generally.

Observations occur in time series that include secular trends on which are overlaid seasonal patterns, cyclical movements, and shorter-term oscillations — a variety of intermingled changes, both uniform and irregular, for which there is no counterpart in the physical sciences. Observations are not independent of each other (i. e. are not random) and their distributions may change radically over time. Under these conditions, a series of observations may not conform to the expected distribution within a range of error given by probability theory.

Even if it were possible to postulate the stability of statistical constants derived from time series, the subjective theory of value on which the equilibrium concept rests would not be susceptible to direct measurement. The equilibrium concept may be criticized on other grounds. For example, the question of whether an equilibrium is determinate involves more than equality of equations and unknowns. There may be no determinate solution to a system of equations, a situation that frequently occurs when a system of equations is not linear (Domar, 2001).

Linear stages theory is correct if the simplifying assumptions are granted. Traditional theory has made few pretensions to empirical verification, and criticism on this score may be beside the point. The conception of traditional theory as “pure theory” has fostered a practice of generalization apart from empirical reference, with the adequacy of theory to reality being judged primarily by criteria of logical consistency based on self-evident axioms about scarcity and marginal allocation. This conception of pure theory is well set forth by a comment made by Keynes long before the appearance of the General Theory (Hirschman, 2000).

The case of Maoist China shows that China’s achievements in creating a more egalitarian income distribution under Mao also appeared to be threatened by economic reform. Maoist observers predicted that emphasis on the development of the coastal regions, expansion of the private enterprise, abolition of communes, and the introduction of bonuses and other forms of wage differentiation would increase regional and personal income inequality.

On balance, however, income distribution seems not to have been much affected by the reform. To appreciate why this is so, it is important to understand the nature of income distribution in Maoist China. Within the urban sector, abolition of property and rental income combined with an egalitarian wage policy greatly compressed urban incomes. Similarly, in rural areas, first land reform and then collectivization virtually eliminated property income and narrowed intrapersonal income differentials within each locality. But large average income differentials remained between localities and regions.

In 1979 distributed collective income per capita in Shanghai Province (which has a large rural area surrounding the city) was 4.6 times that of Guizhou Province. Leaving aside the predominantly urban provinces, the ratio of distributed collective income for Jilin Province was 2.5 times that of Guizhou (Hirschman, 2000). Differences were even greater at the county, commune, and production team levels.

China’s experience under reform has been that there is no large trade-off between growth and equity or between market-based reforms and equity and social development. China’s experience supports the conclusion that the distribution of benefits of growth depends more on the original distribution of assets than on transfers and social programs. Nevertheless, some new institutions and policy changes are needed to preserve the access to health and other services achieved under Mao and to reach remote areas almost untouched by development (Mellor, 2001).

In sum, the traditional economic theory attempts to express “laws” or persistent tendencies through the equilibrium concept. Equilibrium analysis follows the assumption that resources in the hands of individuals as well as wants and techniques are independent variables and that the data, or “other things”, are constant.

Within this scheme, individuals (firms and consumers) attempt to maximize the return from their scarce resources by equating the allocation of resources among different uses at the margin. When supply and demand are equal for each commodity in the economic system, economists have that special set of (equilibrium) prices that is compatible with the maximum positions of all individuals in the system.

References

Bardham, Pranab. (1993). “Economics of Development and the Development of Economics.” Journal of Economics Perspectives 7: 129-42.

Bauer, P. T., and Yamey, B. S. (2002). The Economics of Underdeveloped Countries. Chicago: University of Chicago Press.

Lewis, W. A. (1954). “Economic Development with Unlimited Supplies of Labor.” Manchester School Vol. 22.

Chenery, Hollis, and Syrquin, Moshe. (2004). Patterns of Development: 1950-1970. London: Oxford University Press.

Domar, E. D. (2001). Essays in the Theory of Economic Growth. New York: Oxford University Press.

Dorfman, Robert. (1991). “Review Article: Economic Development from the Beginning to Rostow.” Journal of Economic Literature 29: 573-91.

Hirschman, A. O. (2000). The Strategy of Economic Development. New Haven, Conn.: Yale University Press.

Mellor, John W. (2001). The Economics of Agricultural Development. Ithaca, N. Y.: Cornell University Press.

Nurkse, R. (2001). Problems of Capital Formation in Underdeveloped Countries. Oxford: Blackwell.

Todaro, M.P. and Smith, S.C. (2006), Economic Development, 9th edition, Pearson/Addison Wesley.

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Development Economics: Theories and Models

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