Chapter II. Classic Theories of Economic Growth and Development

BS – ACCOUNTING INFORMATION SYSTEM – 1D|1
Chapter II. Classic Theories of Economic Growth and Development

The classic post–World War II literature on economic development has been dominated by major and
sometimes competing strands of thought: (1) the linear-stages-of-growth model, (2) theories and patterns of structural
change, (3) the international-dependence revolution, and (4) the neoclassical, (5) New growth theory
Linear stages Theory

Rostow’s Stages of Growth
The most influential and outspoken advocate of the stages-of-growth model of development was the American
economic historian Walt W. Rostow. According to Rostow, the transition from underdevelopment to development can be
described in terms of a series of steps or stages through which all countries must proceed.
Stages-of-growth model of development: A theory of economic development, associated with the American
economic historian Walt W. Rostow, according to which a country passes through sequential stages in achieving
development.
Stages
1. Traditional society, dominated by agriculture and barter exchange, and where science and technology are not
understood or exploited.
2. Pre-take-off stage, with the development of education and an understating of science, the application of science
to technology and transport, and the emergence of entrepreneurs and a simple banking system, and hence rising
savings.
3. Take-off, with positive growth rates in particular sectors and where organized systems of production and reward
replace traditional methods and norms.
4. The drive to maturity, with an ongoing movement towards a diverse economy, with growth in many sectors.
5. The stage of mass consumption, where citizens enjoy high and rising consumption per head, and where rewards
are spread more evenly.
These stages are not merely descriptive. They are not merely a way of generalizing certain factual observations
about the sequence of development of modern societies. They have an inner logic and continuity. They constitute, in
the end, both a theory about economic growth and a more general, if still highly partial, theory about modern history
as a whole. The advanced countries, it was argued, had all passed the stage of “takeoff into self-sustaining growth,”
and the underdeveloped countries that were still in either the traditional society or the “preconditions” stage had only
to follow a certain set of rules of development to take off in their turn into self-sustaining economic growth.
The Harrod-Domar Growth Model
The importance of savings and investment is also central to the work of Harrod and Domar. According to this
theory, and those derived from Harrod and Domar’s work, there are two determinants of the rate of growth of a country.
The first looks at the relationship between changes in the capital stock of a country, that is its capital investment, and its
output, called the capital-output ratio. This shows how much new capital, such as £10, is needed to create a given amount
of new national income, such as £2.
The second element of the model considers the relationship between savings and national income is called the savings
ratio, and this shows how much is saved, such as £10, from a given amount of national income, such as £100. The model
indicates how these two ratios affect the rate of growth. Essentially, the higher the savings ratio, the more an economy
will grow; and the higher the capital-output ratio, the higher the rate of growth.
Harrod-Domar growth model: A functional economic relationship in which the growth rate of gross domestic
product (g) depends directly on the national net savings rate (s) and inversely on the national capital-output ratio
(c).
Capital-output ratio: A ratio that shows the units of capital required to produce a unit of output over a given
period of time.
Net savings ratio: Savings expressed as a proportion of disposable income over some period of time.
Structural Change Model

Structural-change theory focuses on the mechanism by which underdeveloped economies transform their
domestic economic structures from a heavy emphasis on traditional subsistence agriculture to a more modern, more
urbanized, and more industrially diverse manufacturing and service economy.
Structural-change Theory: The hypothesis that underdevelopment is due to underutilization of resources arising
from structural or institutional factors that have their origins in both domestic and international dualism.
Development therefore requires more than just accelerated capital formation.
Two important example of such models are:
1. The Lewis Theory of Economic Development
2. The pattern of development empirical analysis by Chenery
The Lewis Theory of Economic Development
One of the best-known early theoretical models of development that focused on the structural transformation of a
primarily subsistence economy was that formulated by Nobel laureate W. Arthur Lewis in the mid-1950s and later
modified, formalized, and extended by John Fei and Gustav Ranis.
Nobel laureate Lewis said that underdeveloped economy consists of two sectors. A traditional, over populated rural subsistence sector with surplus
labour and a high productivity modern sector to which this surplus labour is transferred.
The focus of the model is on the process of surplus labour transfer from the traditional sector which leads to the growth of output and employment in
the modern sector. Lewis calculated that with an increase of 30% or more in the urban wages, workers will migrate from the rural areas to the urban
areas- which would lead to growth in output and employment through the modern sector.
Criticisms
It reflects the historical experience of economic growth in the West
1. Assumes that the faster the rate of capital accumulation the higher is the growth rate of the modern sector and the faster is the rate of new job creation-
but it is not necessary that the capitalist profits will be re-invested in more sophisticated labour-saving technologies or there will be no capital flight.
2. Surplus labour exists in the rural areas while there is full employment in the urban areas- this un supported by empirical literature and is generally
not valid.
3. Notion of competitive modern-sector labour market that guarantees the existence of constant real urban wages up to the point where the supply of
rural surplus labour is exhausted – however, urban wages continue to rise even in the presence of rising levels of open modern sector unemployment
and the existence of surplus labour in the rural sector due to the presence of unions, civil services wage scales and Multi National Corporations own
hiring practices that tend to negate competitive forces in the LDC modern sector.
4. Finally evidence suggests that increasing returns prevail in the modern sector instead of diminishing returns, which means that the modern sector
might continue to use more and more of capital instead of labour.
Structural Change and Patterns of Development
Like the earlier Lewis model, the patterns-of-development analysis of structural change focuses on the sequential process
through which the economic, industrial, and institutional structure of an underdeveloped economy is transformed over time
to permit new industries to replace traditional agriculture as the engine of economic growth. These structural changes involve all
economic functions – including the transformation of production and changes in the composition of consumer demand, international trade and resource
use as well as changes in socioeconomic factors such as urbanization and the growth and distribution of a country’s population.
Development shows certain patterns – for instance, a shift away from agriculture to industrial production, the steady accumulation of physical and
human capital, the change in consumer demands from emphasis on food and basic necessities to manufactured goods and services. This leads to the
growth of cities and urban industries as people migrate from the rural to the urban regions with a decline in overall family size and rate of population
growth.
Criticisms
Lack of a proper theory in explaining the pattern of development leads to the problem that we might not be sure about the causation and the effect.
International dependence revolution

Neo classical counter
New growth theory

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BS – ACCOUNTING INFORMATION SYSTEM – 1D|1

Chapter II. Classic Theories of Economic Growth and Development

Linear stages Theory

Structural Change Model

It reflects the historical experience of economic growth in the West

Structural Change and Patterns of Development

International dependence revolution

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