Transcript Theories of Development I

Theories of Development I
Classical
and
Neoclassical Theories
Classical Economics: Political Economy
The pursuit of economic growth and development as a socially
desirable goal is contemporaneous with the rise of capitalism as an
economic system (and with the emergence of the industrial
revolution).
Two objectives of classical political economists in economic inquiry are:
1. to explain the reasons for rapid economic expansion of total
economic wealth that accompanied industrialization
2. to explain the enigma of the extreme of wealth and poverty that
attended this process
Who are the classical (political) economists?
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Adam Smith
Thomas Malthus
David Ricardo
John Stuart Mill
Karl Marx
• The classicals assumed that capitalism
represented the highest achievement of human
development and it was a “natural order.”
– except for Marx and Mill
• Neoclassical economists (after the 1870s)
– Against the radical implications of Marx
– shifted the emphasis from the broader
macroeconomics of growth and development to a
narrower concern with the allocation of a fixed
quantity of scarce resources to their best use with
given institutions.
– efficiency as the focus of economics
– more static and marginalist perspective for economics
– interest in the question of growth and development
has disappeared from view for quite some time.
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Adam Smith
An inquiry into the Nature and Causes of the
Wealth of Nations, 1776
• Analyzes the newly emerging economic system: capitalism or the
market economy
• Likens its operation to the “invisible hand”
As every individual, .., endeavors as much as he can both to employ his
capital in the support of the domestic industry, and so to direct that
industry that its produce may be of greatest value; every individual
necessarily labors to render the annual revenue of society as great
as he can. He generally, indeed, neither intends to promote the
public interest, nor knows how 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 promote an end which was no part of his
intention. (Smith 1973: 423; C&D: 105)
Smith’s Views on
Economic Development
Basic tenets of Capitalist production that fosters
Growth and Development according to Smith:
• Competition
• Division of labor
• Technological progress
• Free trade
• The law of capital accumulation
Thomas Malthus
An Essay on the Principle of Population,
1798
• Population grows in a geometric progression,
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while
Agricultural output can only increase in
arithmetic progression; such that
Feeding the population would become
increasingly more expensive a task
This would mean misery for a majority of the
population who are poor
The system (capitalism) would end up in a crisis
David Ricardo
Principles of Political Economy and Taxation,
1817
• the law of eventually diminishing returns
(implications similar to Malthus in terms of the dilemmas of the
capitalist growth proces); yet
• the theory comparative advantage
(implies free trade through open economies would help to escape
the dilemmas posed by the law of diminishing returns.)
Theory which suggests that unrestricted exchange between
countries will increase total world output if each country tends
to specialize in those goods that it can produce at relatively
lower costs compared to its potential trading partners.
Ricardo’s Theory of Comparative Advantage
A numerical example to explain the virtues of free
trade
Cloth Wine
labor
hrs
per
unit
labor
hrs per
unit
90hrs
LCE
120hrs
LWE
Portugal 90hrs
LCP
80hrs
LWP
England
oppurtunity cost
opportunity
of Cloth
cost of Wine
in terms of Wine in terms of Cloth
foregone
foregone
0.750
LCE/ LWE
1.333
LWE/LCE
0.75 additional wines produced per
each unit of reduced cloth production
1.33 additional cloth produced per
each unit of reduced wine
production
1.125
LCP/ LWP
0.888
LWP /LCP
Ricardo’s Theory of Comparative Advantage: A numerical example to explain
the virtues of free trade
Assume: Both E and P have 300,000 labor hours to start with; and
Pre-trade both divide their time equally between cloth and wine production
Portugal
England
Before Trade:
Cloth
Wine
Cloth
Wine
Production &
Consumption
1666
1875
1666
1250
0
3750
3333
0
Gets 1666
Gives 1666
Gives 1666
Gets 1666
Consumption
1666
2083
1667
1666
Gains from
Trade:Country
0
+208
+1
+ 416
After Trade:
Production
Trade
Gains from
Trade:World
Pre trade wine: 3125
Post trade wine: 3750
Pre trade cloth: 3166
Post trade cloth: 3166
Free Trade according to Comparative Advantage
benefits all??? Critique of the Comparative
Advantage Theory of Free Trade
• Very static analysis which assumes that over
time, the terms of trade between wine and cloth
will remain the same.
– On the contrary, historically what happened with E
and P was that the terms of trade very much favored
cloth; such that E had a definite trade advantage.
– P stuck with wine production and importing cloth, was
put in a position of ever increasing trade deficit.
• dynamic or created comparative advantage as
opposed to static comparative advantage
– the Asian tigers.
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A Classical Model of Economic Growth
Aggregate production function:
Y = f(N, L, K, T)
where N = natural resources; L = labor; K = capital; T = technolog,
subject to the following restrictions fN, fL, fk,>0; fNN, fLL, fkK < 0,then
dY/dt = fNdN/dt + fLdL/dt + fkdK/dt + fTdT/dt
assume 1. dN/dt = 0; dL/dt = q(dK/dt)
where q >0 = the no of wrks required for each unit of capital;
2. fT = 0;
then rewrite eq.n as
dY/dt = (q fL + fk)dK/dt
… A Classical Model of Economic
Growth
• The rate of economic growth depends on
the rate of physical capital accumulation.
– The faster physical capital accumulates, faster
is economic growth.
• the limit on the rate of growth:
diminishing returns.
– fL decreases as L rises, until eventually the
point when per capita income reaches a
steady state level.
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Neoclassical Growth Models:
the Solow Growth Model
where 0<a<1;
Y(t) =A(t)K(t)1-a L(t)a
A(t) = exogenous technological progress;
K = capital input
L = labor input
in a perfectly competitive setting where each factor input is entitled to a return
equal to its own marginal product,
a = income share of labor
1-a = income share of capital.
This production function is such that
• K and L are subject to diminishing returns in the short term.
• production is subject to constant returns to scale in the long term.
…
Solow Growth Model
• diminishing returns
dY/dL = aLa-1AK1–a> 0
dY/dK = (1–a)K–a A La > 0;
dY2/(dL)2 = a(a–1)La–2 AK1–a < 0
dY2/(dK)2 = –a(1–a)K–(1+a) A La < 0,
(0<a<1)
• constant returns to scale
– ‘linearly homogeneous’
– multiplying both variable inputs by the same scalar
value, v, changes production by vY:
A(vL)a(vK)1-a = AvaLav1-aK1-a = v(ALaK1-a),
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…
Solow Growth Model
in a perfectly competitive setting where each factor input is
entitled to a return equal to its own marginal product:
w=dY/dL= aLa-1 AK1–a
Wage share=wL/Y= (dY/dL)*(L/Y)
= the elasticity of output with respect to a change in the
labor input
= aLa-1 AK1–aL/ AK1-aLa
=a
a = income share of labor
1-a = income share of capital.
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… the Solow Growth Model
without
technological
change:
the increased
investment, K, has
a limit in terms of
total income:
Qmax
Technological
change
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… the Solow Growth Model
• assume constant L,
– an upper limit in terms of per capita income.
• How?
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… the Solow Growth Model
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y=Y/L=AK1-aLa /L
y=AK1-a/L1-a
y=A(K/L)1-a
Let K/L=k
• ΔK=Investment = Savings
– capital accumulation rate will be determined by the
rate of savings, s, out of income, Y.
• ΔK=sY
• Population (labor force) growth: constant rate=n=L/L
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… the Solow Growth Model
K L
k

K
L
sY

n
K
y
 s n
k
.
Steady state:
.
k 0
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… the Solow Growth Model
sy
k
n
s 1 a
*
k  Ak
n
s 1/ a
*
 k  (A )
n
Steady state per capita income:
s 1/ a (1 a )
 y  A(( A ) )
n
1 / a s (1 a ) / a
yA ( )
n
At steady state:
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…the Solow Growth Model
• the steady state level of per capita income
over the long run will converge to
y = Y/L = A 1/a(s/n)(1-a)/a
where s=savings rate;
n=exogenous population growth rate
a = income share of labor
1-a = income share of capital
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… the Solow Growth Model
• If tech and the rate of increase of L are constant and assuming the
LF is always fully employed, a Solow-type growth model predicts
that:
• for any given rate of savings (and investment), there will be a
constant steady-state level of real per capita income achieved.
– follows directly from the assumption of diminishing returns to capital.
– Given a constant rate of saving, the return to capital falls as K rises
until, ultimately, total amount of capital also reaches a steady-state
level, and all new investment is just sufficient to replace old capital that
has worn out and meet population growth rate.
• the level of per capita income has reached its max level, given the
rate of savings, pop.n growth rate and assuming no tech change
which is exogenous anyway.
– No further growth in per capita income
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…the Solow Growth Model
• differences in income per person across countries are explained by
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– different rates of savings (physical capital accumulation)
– different population growth rates.
Assuming equal shares of income accruing to K and L across
countries:
– a higher rate of saving will raise the steady-state level of per capita
income.
Countries that are poor are poor b/c they aren’t saving and investing
enough.
Policy recommendation: accumulate physical K at a higher rate
Implication : conditional convergence
– poorer nations will grow faster than richer nations, assuming equal
rates of saving and pop.n growth rates
– convergence of per capita income among different nations sharing
similar fundamentals.
– Two countries with the same rate of saving and population growth
rate, will tend to have ultimately, the same real per capita income.
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Criticisms
1. no consideration of the institutional structure
which converts savings into investment
• Assumption of a direct, automatic and smooth
link b/t increased savings, increased investment
and income growth.
2. growth is conceived of as a mechanical simple
process of increasing per capita income with
no consideration of processes of structural,
institutional, economic, political and social
transformation.
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Karl Marx
Capital, 1867, 1885, 1894
• does not assume capitalism to be immutable or natural
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order of society, rather one stage of a society’s historical
development
capitalism will also ultimately break down and evolve
into a different system
agrees with Smith’s analysis of capitalism as an
immensely dynamic system driven by the law of capital
accumulation, characterized by division of labor and
technological progress
yet is critical of the one sided distribution (“exploitation
of labor by capital”) that results in the capitalist growth
process
a relatively high-level of income per capita in a capitalist
economic environment is a precondition for the evolution
of a new future economic system