UNIT ONE

DEVELOPMENT ECONOMICS: PRINCIPLES AND CONCEPTS

Introduction

Dear Students! What is the study of development economics? Development economics a

branch of economics refers to ‘’the systematic study of the problems and processes of the
economic development of underdeveloped countries.’’ Why? This is because, in the 1950s
and 1970s, strictly economic terms, development has traditionally meant achieving sustained
rates of growth of income per capita to enable a nation to expand its output at a rate faster
than the growth rate of its population. Levels and rates of growth of “real” gross national
income (GNI) and GNI per capita are then used to measure the overall economic well-being
of a population. Economic development in the past has also been typically focused on rapid
industrialization, often at the expense of agriculture and rural development. Problems of
poverty, discrimination, unemployment, and income distribution were of secondary
importance to “getting the growth job done.”

However, in the 20th century and especially after the Second World War, economists started
devoting their attention towards analyzing the problems of underdeveloped countries and
formulating theories and models of development and growth for underdeveloped countries.
Interest in the economics of development has been further stimulated by the wave of political
resurgence that swept the Asian and African nations as they threw off the colonial yoke after
the Second World War. The desire on the part of new leaders in these countries to promote
rapid economic development coupled with the realization on the part of the developed nations
that ‘poverty anywhere is a threat to prosperity everywhere,’ has aroused further interest in
the subject. However, a study of the poverty of nations and the methods of removing poverty
cannot be based on the experience of the rich nations, for in the advanced countries there has
been a tendency to take economic development for granted-as something that takes care of
itself and to concentrate on the short-term oscillations of the economy. Therefore, Myrdal
says that the underdeveloped countries should not accept our inherited economic theory
uncritically but remold it to fit their own problems and interests.

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Objectives of the unit

After reading this Unite, students will be able to understand and explain:

 the study of economic development;

 the complexity of the concept of development;
 the imperative to study economic development;
 the meaning of economic growth and economic development; and
 the institutional and economic structural changes in the process of development

Section 1: Economics and Development Study

Introduction

Dear Students! What is the study of economic development? What is economic development?
What are its basic comments? Is economic development study normative or positive
premises? These are the important questions we shall discuss in this particular section. First,
the nature of economic development as a new branch of economics, its distinctive features
and relations with other branches of economics will be discussed. This will be followed by the
discussion of the concept of development and its basic components. Finally, the normative
value premises feature of economic development will be examined.

Objectives of the section

After reading this section, students will be able to understand and explain:

 the study of economic development;

 the complexity of the concept of development;
 the basic components or constituents of development, and
 the normative value premise of economic development.

1.1.1 The Nature of Development Economics

The study of economic development is one of the newest, most exciting, and most challenging
branches of the broader disciplines of economics and political economy. Although one could
claim that Adam Smith was the first “development economist” and that his Wealth of Nations,
published in 1776, was the first treatise on economic development, the systematic study of the
problems and processes of economic development in Africa, Asia, and Latin America has
emerged only over the past five decades. Although development economics often draws on
relevant principles and concepts from other branches of economics in either a standard or
modified form, for the most part it is a field of study that is rapidly evolving its own
distinctive analytical and methodological identity. Traditional economics is concerned
primarily with the efficient, least-cost allocation of scarce productive resources and with the
optimal growth of these resources over time so as to produce an ever-expanding range of
goods and services.

Traditional neoclassical economics deals with an advanced capitalist world of perfect

markets; consumer sovereignty; automatic price adjustments; decisions made on the basis of
marginal, private-profit, and utility calculations; and equilibrium outcomes in all product and
resource markets. It assumes economic “rationality” and a purely materialistic, individualistic,
self-interested orientation toward economic decision making. Traditional economics is an
approach to economics that emphasizes utility, profit maximization, market efficiency, and
determination of equilibrium. Development economics has an even greater scope. In addition
to being concerned with the efficient allocation of existing scarce (or idle) productive
resources and with their sustained growth over time, it must also deal with the economic,
social, political, and institutional mechanisms, both public and private, necessary to bring
about rapid (at least by historical standards) and large-scale improvements in levels of living
for the peoples of Africa, Asia and Latin American countries.

Thus development economics, to a greater extent than traditional neoclassical economics or

even political economy, must be concerned with the economic, cultural, and political
requirements for effecting rapid structural and institutional transformations of entire societies
in a manner that will most efficiently bring the fruits of economic progress to the broadest
segments of their populations. All in all, development economics is the study of how
economies are transformed from stagnation to growth and from low-income to high-income
status, and overcome problems of absolute poverty. Therefore, Economics and economic
systems, especially in the developing world, must be viewed in a broader perspective than that
postulated by traditional economics. They must be analyzed within the context of the overall
social system of a country and, indeed, within an international, global context as well.

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Is it possible, then, to define or broadly conceptualize what we mean when we talk about
development as the sustained elevation of an entire society and social system towards a
“better” or “more humane” life? This is question of our next discussion.

1.1.2 What is Development?

In the 1960s the identification of development with economic growth came under increasing
criticism. Authors such as Myrdal (1971), Seers (1979) and Sen (1985) pointed out that
developing countries did not experience much change in the living conditions of the masses of
the poor in spite of the impressive growth figures in the post-World War II period. They
came to the conclusion that development involves more than economic growth and changes in
economic structures. Seers formulated three additional requirements for the use of the term
development, namely that there should be a decrease in poverty and malnutrition, that income
inequality should decline, and that the employment situation should improve (Seers, 1979).

Other critics went even further and challenged the too narrow focus on the economic
dimensions of development alone. A country can grow rapidly, but still do badly in terms of
literacy, health, life expectancy and nutrition (Sen, 1999). The environmental costs of growth
are insufficiently recognized Economic growth does not necessarily make people more happy
or satisfied. Criticism of growth fetishism led to the emergence of so-called ‘social
indicators’: life expectancy, literacy, levels of education, infant mortality, etc. Some authors
even went so far as to posit an opposition between growth and development. Social scientists
have stated that development should not be viewed in terms of economics only. One should
also pay attention to changes in family structures, attitudes and mentalities, cultural changes,
demographic developments, political changes and nation building, the transformation of rural
societies and processes of urbanization.

The Swedish Nobel prize-winner Gunnar Myrdal has argued that discussions of development
have implicitly been based on a series of modernization ideals or values. Opinions may differ
on the way in which these ideals should be pursued. Nevertheless, according to Myrdal, there
was a widespread consensus on the ultimate objectives of development among the members
of political elites in developing countries involved in developmental policy (Myrdal, 1968).
The broad concept of development therefore involves a change of the entire society in the
direction of the modernization ideals. Recently, Sen (1985) has argued for an even broader
concept of development focusing on the concept of freedom. He sees development as an
integrated process of expansion of substantive freedoms. Economic growth, technological
advance and political change are all to be judged in the light of their contributions to the
expansion of human freedoms. Among the most important of these freedoms are freedom
from famine and malnutrition, freedom from poverty, access to health care and freedom from
premature mortality. In his perspective, economic growth remains important, but not as a goal
in itself. Economic growth always remains one of the necessary conditions for ‘long-term
development’ and tremendous advances have been made in measuring it in a standardized
fashion.

Dear Students! Insofar as development is concerned with the achievement of a better life, the
focus of development analysis has to include the nature of the life that people succeed in
living. People value their ability to do certain things and to achieve certain types of beings
(such as being well nourished, being free from avoidable morbidity, being able to move about
as desired, and so on. Let us therefore examine each in turn.

1.1.3 Basic Components of Development

What constitutes the good life is a question that one must periodically reevaluated and
answered afresh in the changing environment of world society. The appropriate answer for
developing nations today is not necessarily the same as it would have been in previous
decades. But at least three basic components or core values serve as a conceptual basis and
practical guideline for understanding the inner meaning of development. Goulet (1997)
distinguished three basic components or core values in this wider meaning of development,
which he calls life sustenance, self-esteem the feeling of self respect and independence and
freedom from the three evils of want, ignorance and squalor so as to be able to determine their
own destiny. They relate to fundamental human needs that find their expression in almost all
societies and cultures at all times. Let us therefore examine each in turn.

1.1.3.1 Sustenance: The Ability to Meet Basic Needs.

Sustenance means the basic goods and services, such as food, clothing, and shelter that are
necessary to sustain an average human being at the bare minimum level of living. A basic

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function of all economic activity is to provide as many people as possible with the means of
overcoming the helplessness and misery arising from a lack of food, shelter, health, and
protection. When any of these is absent or in critically short supply, a condition of “absolute
underdevelopment” exists. To this extent, we may claim that economic development is a
necessary condition for the improvement in the quality of life that is development. Without
sustained and continuous economic progress at the individual as well as the societal level, the
realization of the human potential would not be possible. One clearly has to “have enough in
order to be more.” Rising per capita incomes, the elimination of absolute poverty, greater
employment opportunities, and lessening income inequalities therefore constitute the
necessary but not the sufficient conditions for development.

1.1.3.2 Self-Esteem: To Be a Person

A second universal component of the good life is self-esteem, sense of worth and self-respect,
of not being used as a tool by others for their own ends. Self-esteem is the feeling of
worthiness that a society enjoys when it’s social, political, and economic systems and
institutions promote human values such as respect, dignity, integrity, and self-determination.
All peoples and societies seek some basic form of self-esteem, although they may call it
authenticity, identity, dignity, respect, honor, or recognition. The nature and form of this self-
esteem may vary from society to society and from culture to culture.

However, with the proliferation of the “modernizing values” of developed nations, many
societies in developing countries that have had a profound sense of their own worth suffer
from serious cultural confusion when they come in contact with economically and
technologically advanced societies. This is because national prosperity has become an almost
universal measure of worth. Due to the significance attached to material values in developed
nations, worthiness and esteem are nowadays increasingly conferred only on countries that
possess economic wealth and technological power, those that have “developed.” As Denis
Goulet (1971) put it, “Development is legitimized as a goal because it is an important, perhaps
even an indispensable, way of gaining esteem.”
1.1.3.3 Freedom from Servitude: To Be Able to Choose

A third and final universal value that we suggest should constitute the meaning of
development is the concept of human freedom. Freedom is a situation in which a society has
at its disposal a variety of alternatives from which to satisfy its wants and individuals enjoy
real choices according to their preferences. Freedom here is to be understood in the sense of
emancipation from alienating material conditions of life and from social servitude to nature,
other people, misery, oppressive institutions, and dogmatic beliefs, especially that poverty is
predestination. Freedom involves an expanded range of choices for societies and their
members together with a minimization of external constraints in the pursuit of some social
goal we call development. Sen (1985) who won the Nobel Prize in economics in 1998 for his
work on the interface between welfare and development economics, says that freedom is the
primary objective of development as well as the principal means of achieving development.
For Sen, development consists of the removal of various types of ‘un freedoms’ that leave
people with little choice and opportunity. Major categories of ‘un freedoms’ include famine
and undernourishment; poor health and lack of basic needs; lack of political and civil rights,
and economic insecurity.

Lewis (1955) stressed the relationship between economic growth and freedom from servitude
when he concluded that “the advantage of economic growth is not that wealth increases
happiness, but that it increases the range of human choice.” Wealth can enable people to gain
greater control over nature and the physical environment for instance, through the production
of food, clothing, and shelter than they would have if they remained poor. It also gives them
the freedom to choose greater leisure, to have more goods and services, or to deny the
importance of these material wants and choose to live a life of spiritual contemplation. We
may conclude that development is both a physical reality and a state of mind in which society
has, through some combination of social, economic, and institutional processes, secured the
means for obtaining a better life. Whatever the specific components of this better life,
development in all societies must have at least the following three objectives:

1. To increase the availability and widen the distribution of basic life-sustaining goods such
as food, shelter, health, and protection;

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2. To raise levels of living, including in addition to higher incomes, the provision of more
jobs, better education, and greater attention to cultural and human values, all of which will
serve not only to enhance material wellbeing but also to generate greater individual and
national self-esteem; and

3. To expand the range of economic and social choices available to individuals and nations
by freeing them from servitude and dependence not only in relation to other people and
nation-states but also to the forces of ignorance and human misery.

1.1.4 Development Economics a Normative Value Premises

Is Development Economics normative or positive value premises? It is necessary to

recognize from the outset that ethical or normative value premises about what is or is not
desirable are central features of the economic discipline in general and of development
economics in particular. The very concepts of economic development and modernization
represent implicit as well as explicit value premises about desirable goals for achieving or
realization of the human potential. Concepts or goals such as economic and social equality,
the elimination of poverty, universal education, rising levels of living, national independence,
modernization of institutions, rule of law, access to opportunity, political and economic
participation, grassroots democracy, self-reliance, and personal fulfillment all derive from
subjective value judgments about what is good and desirable and what is not.

The major issues of development as poverty and inequality, population growth, rural
development, environmental sustainability, etc, are the mere identification of these topics as
problems conveys the value judgment that their improvement or elimination is desirable and
therefore good. That there is widespread agreement among many different groups of people
that these are desirable goals does not alter the fact that they arise not only out of a reaction
to an objective empirical or positive analysis of what is but also ultimately from a subjective
or normative judgment about what should be. It follows that value premises, however
carefully disguised, are an inherent component of both economic analysis and economic
policy. Economics cannot be value-free in the same sense as, say, physics or chemistry.
Thus, the validity of economic analysis and the correctness of economic prescriptions should
always be evaluated in light of the underlying assumptions or value premises.
Once these subjective values have been agreed on by a nation or, more specifically, by those
who are responsible for national decision making, specific development goals and public
policies based on “objective” theoretical and quantitative analyses can be pursued.

Section 2: The Development Imperative

Introduction

In the preceding section, we have discussed the nature and basic concepts of economic
development. However, does that mean the level of development is the same everywhere
across countries in the world and with in areas in a nation? The answer is definitely ‘No!’’
The disparity is so high than one can expect. This is prominently obvious between the
developing and developed countries in general and even within the developing countries
themselves. That is why, the study of economic development is still an important issue in the
developing countries. Therefore, an overview of this disparity will be discussed using recent
economic growth and poverty reduction achievements of some countries from global
perspective. The intension is not to cover such a wider concept of development but to give
you some insight as to why we need to study economic development as a new branch of
economics.

Objectives of the section

After reading this section, students will be able to understand and explain:

 the imperative to study economic development;

 the differences in income levels amongst regions; and
 the differences in poverty rates amongst regions.

1.2.1 Why study economic development?

The discussion of development is always tied up with basic questions like: why are poor
countries poor and rich countries rich? Why do poor countries lag behind rich countries in the
development of their standards of living? How can poor countries become more prosperous?
How can poor countries catch up with the rich countries? These are the important questions
why development economics is an imperative for the economic development of developing
countries and we will discuss them in different Unites of this Module.

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Economic development is about realizing very fundamental human values and finding the
means to extend the fruits of these values to the greatest majority of the world’s population.
Economic development is of the utmost interest and of the gravest consequence. It touches
our shared humanity. The great economists of the eighteenth, nineteenth, and early twentieth
centuries Adam Smith, David Ricardo, John Stuart Mill, Karl Marx, Alfred Marshall, were
inspired by a profound concern for understanding the roots of economic wealth and the
reasons for poverty, as well as for discovering the mechanisms through which economic and
social gains might best be increased and shared amongst the members of society.

These matters have captured the attention and hearts as well as the minds of many brilliant
thinkers. They are noble questions that often lead students to wish to study economics in the
first instance. However, it was the disturbing reality of world poverty, of a sharp division
between rich nations and poor nations and within nations, and of so much human suffering in
far too many countries that first brought, in the late 1960s and early 1970s, to be keenly
interested in development economics and the problems of what was then called the “Third
World.. For more understanding, see Table 1 and 2 which highlight the enormous divergence
in income and poverty between the developing and developed countries. Trying to formulate
reasonable explanations for such observed disparities, and, by extension, suggesting what
might be done to overcome the barriers that retard economic, social, and human development
is what development economics is all about.

Many abstract theories about how to develop have been advanced by economists. Such
theories are an integral part of development economics and provide an important historical
window on how economists have thought and continue to think about development. It is on
this adventure into theory and reality that we are about to embark. There are no easy answers
that apply always and everywhere. There is no magic, one-stop, cure-all solution that can be
offered that applies to every country in all parts of the world. Becoming more developed is a
challenge that requires vision and hard work from both the leaders of nations and their
citizens. Nonetheless, there are patterns and lessons to be learned from successful as well as
unsuccessful development experiences that can help those with the power and the will to
move their economies and nations forward.
It is to these patterns and regularities based upon the concrete historical experiences of
successful and failed development episodes that we shall turn repeatedly. We are looking for
the critical signposts that mark the “process” of development, such that it will be possible to
determine what, broadly speaking, needs to be done and what should be avoided if progress is
to be made. Development economic is an inquiry into what those in the less-developed
nations must do if they are to improve their economic and social lot.

1.2.2 Recent Trends in Economic Growth

Table 1 highlights the enormous divergence in incomes separating the less-developed nations
from the developed, and among the less-developed regions of the world themselves even that
data fails to fully convey the magnitude of this disparity. The less-developed world, with
more than four-fifths of the world’s population, received slightly more than one-fifth of total
world income in 2005. In a cruel symmetry, the developed world nations, with well less than
one-fifth of the world’s population, received nearly four-fifths of total world income in 2005,
precisely the same share as in 1985, though with a smaller proportion of total world
population in 2005. Looked at slightly differently, the developed world received about five
times its “equality share” of total world income (78.1 percent of world income divided by
15.9 percent of world population). The less-developed world received 26 percent of what its
equality share of world income would have been.

Examining particular regions within the less-developed world, inequality was even more
extreme and income more meagre. South Asia, with nearly 23 percent of total world
population, received but slightly more than 2 percent of world income in 2005. This meant
that South Asia received only 10.1 percent of its equality share of income (2.3 percent of total
income/22.8 percent of total population). The relatively better-off Latin America and the
Caribbean region, by comparison, received about 65 percent of what its hypothetical equality
share of world income would have provided in 2005 (5.5 percent of total income/8.5 percent
of total population). Sub-Saharan African countries with nearly 12 percent of total world
population, received but slightly more than 1 percent of world income in 2005. This meant
that Sub-Saharan African countries received only 0.1 percent of its equality share of income
(1.3 percent of total income/11.7 percent of total population).

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The disparities between the less-developed nations vis-à-vis the developed nations are not of
recent origin. Worse, differences within the less-developed world itself have been growing,
both between regions and within countries themselves. Many of the poorest countries for
instance, Sub-Saharan African countries, have suffered a relative decline, and in some
instances, an absolute deterioration in their position on many significant measures of
productivity and in their contribution to world output.

Table 1: World income, world population, and their distribution in 2005

Share of world’s Share of world’s

Regions Income (%) population (%)

Developed economies 78.1 15.9

Less-developed economies 22.0 84.1
East Asia and Pacific 6.8 29.2
Latin America and Caribbean 5.5 8.5
Middle East and North Africa 1.6 4.7
South Asia 2.3 22.8
Sub-Saharan Africa 1.3 11.7

1.2.3 Poverty in the Less-Developed World

Table 2 provides an overview of the incidence of poverty facing the less-developed nations by
the World Bank’s classification of having less than the equivalent of about $1 a day per
person to meet their needs. Overall, the incidence of extreme poverty by 2004 had fallen by
more than half compared to 1981. That is good news. Of course, world population has grown
too, so the number of persons in extreme poverty had declined by less than 50 percent, from
1.5 billion in 1981 to about 968 million in 2004. What is disheartening is the relatively small
decrease in poverty in some of the regions not to mention the increase in the incidence of
poverty in Africa in the early 1990s. The decline in the share of the population in poverty in
East Asia from 20 percent of the region’s population in 1985 to 9.0 percent in 2004 (and even
lower when China is excluded) is one of the success stories of the past two decades.
Still, poverty levels remain agonizingly high, reducing opportunities for the poor and their
children over the future in a vicious circle. Table 2 provides what is called a “headcount” of
the numbers of poor falling below the poverty line. Such a measure does not distinguish
between those whose incomes are far below the poverty line and who hence need more
assistance to reach the poverty threshold and those whose incomes already have brought them
closer to the income level needed to escape. More than 1 billion people, one-fifth of the
world’s population, live on less than one dollar a day a standard that Western Europe and the
United States attained two hundred years ago” (World Bank 1991: 1). This is still true today.

Table 2: The Percentage of poor population in the less-developed nations

Regions 1981 1985 1990 2004

East Asia and Pacific 57.7 20 29.6 9.0

China 63.8 20 33.0 12.5
Latin America and Caribbean 9.7 19 11.3 8.6
Middle East and North Africa 5.1 31 2.3 1.5
South Asia 51.5 51 41.3 30.8
Sub-Saharan Africa 41.6 47 44.6 41.1
All less-developed countries 40.4 33 27.9 18.1

Activity 1.1

Since the last two decades, Ethiopia has documented impressive economic growth as well as
poverty reduction achievements. However, still in Ethiopia, addressing extreme poverty and
reducing the disparity among and with in rural and urban areas and across regions are
important issues. Explain why economic development sill imperative in Ethiopia from this
perspective.
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Section 3: Economic Growth, Development and Structural Changes

Introduction

Dear student! Can you distinguish the difference between the terms ‘development’ and
‘growth?’’ These two terms are different but have close relationship. That is why, the close
link between economic development and economic growth is simultaneously a matter of
importance as well as a source of considerable confusion. These terms do not have any
relationship with the type of economic system that the nation follows. That means, economic
growth and economic development are essential for a better human life where ever peoples
are living around the world. Economic growth is a narrow concept and related to a
quantitative sustained increase in the country’s per capita output while economic development
is a wider concept than economic growth. It is taken to mean growth plus change. Economic
growth is a very limited measure of development and concerns only on the quantitative or
material prosperity. While economic development means more than quantitative prosperity
including improvement in the quality of life and change in the institutional and organizational
structures required towards this end. Therefore, in this particular section, the concept of these
two terms will be discussed along with the structural changes in the process of economic
development.

Objectives of the section

After reading this section, students will be able to understand and explain:

 the meaning of economic growth and development;

 the links and differences between economic growth and development; and
 the institutional and economic structural changes in the process of development.

1.3.1 Economic Growth and Development

The close link between economic development and economic growth is simultaneously a
matter of importance as well as a source of considerable confusion. Economic growth can be
defined as the increase in the economy’s output over time. In other words, one can say that the
economy has increased its physical ability to produce more goods and services. According to
Kindleberger, “Economic growth means more output, while economic development implies
both more output and changes in the technical and institutional arrangement by which it is
produced and distributed. Growth may well involve not only more output derived from
greater amount of inputs but also greater efficiency, i.e., an increase in output per unit of
input. Development goes beyond this to imply changes in the composition of output and in the
allocation of inputs by sectors. Friedman defines growth as an expansion of the system in one
or more dimensions without a change in its structure, and development as an innovative
process leading to the structural transformation of social system. Schumpeter makes the
distinction clearer when he defined development as a continuous and spontaneous change in
the stationary state which forever alters and displaces the equilibrium state previously
existing; while growth is a gradual and steady change in the long run which comes about by a
gradual increase in the rate of saving and population.

This view of Schumpeter has been widely accepted and elaborated by the majority of
economists. There can scarcely be any doubt that, given other things, an expansion of
opulence must make a contribution to the living conditions of the people in question. It was,
therefore, entirely natural that the early writings in development economics, when it emerged
as a subject on its own after the Second World War, concentrated to a great extent on ways of
achieving economic growth, and in particular increasing the gross national product (GNP) and
total employment. The process of economic development cannot abstract from expanding the
supply of food, clothing, housing, medical services, educational facilities, etc. and from
transforming the productive structure of the economy, and these important and crucial
changes are undoubtedly matters of economic growth.

Activity 1.2

The identification of development with economic growth came under increasing criticism.
Developing countries did not experience much change in the living conditions of the masses
of the poor in spite of the impressive growth. Explain your understanding from the global or
your local area context. .
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Dear Students! The importance of "growth" must depend on the nature of the variable the
expansion of which is considered and seen as "growth". The crucial issue, therefore, is not the
time-dimensional focus of growth, but the salience and reach of GNP and related variables on
which usual measures of growth concentrate. To illustrate the problem, GNP per capita and
life expectancy at birth in 1984 are given in Table 3 for five different countries, namely,
China, Sri Lanka, Brazil, Mexico, and South Africa. South Africa, with about seven times the
GNP per capita of China and Sri Lanka, has a substantially lower expectation of life than the
latter countries. Similarly, Brazil and Mexico also with many times the income of China and
Sri Lanka have achieved considerably less in longevity than these two much poorer countries.

Table 3: GNP per capita and life expectancy in 1984

GNP per capita Life expectancy

Countries ( Dollars) at Birth (years)

China 310 69
Sri Lanka 360 70
Brazil 1,720 64
Mexico 2,040 66
South Africa 2,340 54

To point to this contrast is not, of course, the same thing as drawing an immediate policy
conclusion as to exactly what should be done, but the nature of the contrast has to be borne in
mind in refusing to identify economic development with mere economic growth. Even though
an expansion of GNP, given other things, should enhance the living conditions of people, and
will typically expand the life expectancy figures of that country, there are many other
variables that also influence the living conditions, and the concept of development cannot
ignore the role of these other variables. Life expectancy is, of course, a very limited measure
of what has been called "the quality of life". Indeed, in terms of what it directly measures, life
expectancy is more an index of the "quantity" of life rather than of its quality. But the forces
that lead to mortality, such as morbidity, ill health, hunger, etc. also tend to make the living
conditions of the people more painful, precarious, and unfulfilling, so that life expectancy
may, to some extent, serve as a proxy for other variables of importance as well.
Therefore, Economic development relates to qualitative changes in economic wants, goods,
incentives, institutions, productivity and knowledge or the upward movement of the entire
social system. It describes the underlying determinants of growth such as technological and
structural changes. In fact, economic development embraces both growth and change. The
concept of development should embrace the major economic and social objectives and values
that society strives for.

1.3.2 Structural Change

You might remember from your introductory economic course that economics is the study of
“how societies can best allocate scarce resources among alternative uses” so as to maximize
something usually the level of each individual’s or household’s satisfaction or utility. The
allocation of society’s resources is assumed to take place within a given institutional and
organizational setting that is taken to be exogenous to the analysis done by the economist.
However, economic development is not simply about the efficient allocation of existing
resources within a given institutional regime. It is not simply about maximizing utility or
profits within the constraints of what is currently available to that society and inherited from
the past. Rather, development is fundamentally about regime change and about the search for
an optimal growth path, or at least one that is superior to the existing allocation of resources
and current efficiency levels.

Further, fomenting development typically requires substantially new institutional patterns and
organizational structures necessary to support such a dynamic process of change. To get a
country on the road to development very often requires a “leap” – often a quite substantial one
– away from the past structures. Marginal modifications of the economy and society simply
may be insufficient to initiate the forward momentum needed to propel the system in the
requisite new direction and on to a higher path of progress for the future. For the less-
developed nations, development compels them to undertake substantial qualitative structural
change. The future cannot be just an extension of the past, of doing more of what is now
being done. Change must be dramatic. The past and its weight on the present are precisely
what have made these nations poor and are what need to be transcended. Here these structural
changes are briefly introduced to suggest the nature of qualitative change required and to
point out the direction we shall be taking in the process of economic development.

17
1.3.2.1 Increase in industrialization

Economic growth and development are strongly associated with an increasing share of a
nation’s output and labor force involved in industrial. Over time, services become
increasingly important too as an economy matures even further. Wages tend to be higher in
the industrial sector than in agriculture, because the level and use of technology is greater.
This leads to both higher levels of production and worker productivity, and the resulting
higher income that is created is shared by workers and owners of enterprises. Production
methods also become relatively intensive in the use of knowledge – human capital – and of
physical capital. As part of this unfolding process, the urban population tends to grow both
relatively and absolutely compared to the rural population, as rural workers migrate to the
cities in search of the higher income promised by urban and industrial pursuits.

1.3.2.2 Decrease in agriculture

Economic development is a process of moving from a set of assets based on primary products,
exploited by unskilled labor, to a set of assets based on knowledge, exploited by skilled labor”
This description captures the nature of these first two fundamental structural changes required
for long-term development progress. Parallel to the expansion of the industrial sector of the
economy is a decline in the share of agricultural output in total output. This also means a
reduction in the share of the total labor force employed in agriculture and a decrease in the
share of the rural population within the total population. The increase in industrialization and
the decrease in agriculture are intimately related. “Surplus labor” (i.e. low-productivity labor)
in agriculture migrates to urban areas in search of the promise of better-paid and higher
productivity industrial employment.

It is this shift of workers from low-productivity agricultural employment to higher-

productivity industrial employment that contributes to a sharp increase in total national output
when this process of internal labor migration is initiated. In this process, the following points
should be worth mentioning. Industrialization is often essential for economic growth, and for
long-run poverty reduction. The pattern of industrialization, however, impacts remarkably on
how the poor benefit from growth. Pro-poor economic and industrial policies focus on
increasing the economic returns to the productive factors that the poor possess, for instance
raising returns to unskilled labour, whereas policies promoting higher returns to capital and
land tend to increase inequality, unless they also include changes in existing patterns of
concentration of physical and human capital and of land ownership. Use of capital-intensive
methods instead of labour-intensive ones tends to increase income disparities, as does the
employment of skill-biased technologies, especially where the level of education is low and
human capital concentrated. Also, the location of industrial facilities has an impact on overall
poverty reduction and inequality. As enterprises are often concentrated in urban areas –
because of ready access to skilled labour force, better infrastructure, larger markets and
technological spillovers (Lanjouw, 2001), industrialization may increase inequality between
urban and rural areas. Promoting development of rural non-agricultural activities, like
production in small and medium-sized enterprises (SMEs), may decrease this disparity.

1.3.2.3 Increased application of human capital and knowledge

Economic growth and development require increases in the productivity of labor in all sectors
of the economy if incomes and the standard of living of the population are to rise. This is
achieved partly, but quite importantly, through improvements in the training and education of
the existing and future labor force by means of increases in what economists call human
capital accumulation. This takes place not only through the formal schooling process but also
via “learning-by-doing” at the workplace. Increased productivity of labor is also a
consequence of an expansion in the use of more physical capital, that is, more machines and
tools which typically embody more advanced technology and knowledge that can help to
make a properly trained labor force even more efficient.

Human capital accumulation, physical capital accumulation, and technology thus all
contribute in a synergistic process to increase the productivity of the labor force. Greater
productivity means the possibility of higher wages for labor and an easier workplace
environment, both of which contribute to the potential well-being of the population. We shall
stress again and again the essential complementarily of human and physical capital
accumulation and the urgency for less-developed nations not only to tap into the existing pool
of knowledge available at the world level but also developed over time an autonomous
technological capacity based on indigenous labor skills.

19
1.3.2.4 Undertaking essential institutional change

Economic growth and development require fundamental institutional change. New

organizations such as banks, stock and bond exchanges, and insurance companies gain added
importance as an economy modernizes. The role of the central government – the state – must
change to facilitate and not thwart private initiatives. Physical infrastructure such as roads,
ports, communications, the provision of electricity, water, and other essential services must be
improved, and the state typically must play a central role in these areas, particularly during
early stages of structural transformation. The specific nature of the legal system and of
property rights; the rules and regulations governing the emerging financial system of banks,
stock and bond markets and other financial intermediaries; the creation and operation of a
civil service system; determining what will be taught in the schools and how success will be
measured and so on all must be worked out and codified by government.

Without fundamental changes in the rules of the game, without the specifics defining how
new institutions will work and provide improved outcomes compared to existing institutions,
many of the “big-picture” structural changes will not have their full desired effects. It is thus
not only physical infrastructure that must be built, maintained, and improved, but also these
“soft” infrastructural institutions of the state, like the law and property rights, that must be
created and put into place if a more modern, productive, and equitable outcome is to be
attained. Indeed institutional change runs deep into basic values and motivations too.
Businesses must increasingly be operated with more attention to efficiency and profitability in
a more competitive and open environment. Old ways of thinking and doing will undoubtedly
be threatened by what often will appear to be unsettling attention paid to profit maximization
by “new” entrepreneurs in industry, agriculture, and services, like retail sales.

Some of the most cherished institutions of many societies today, such as close family
structures and interpersonal relations, religious traditions and the general pace of life, will be
altered over time, becoming more and more like those institutions and patterns of behavior in
other societies on the path to development and more like those institutions and values already
in place in developed nations. There is no doubt that these changes can be conflictual and
often wrenching. Economic growth and development, however, definitely require a break
with the past.
1.3.2.5 Changing trade patterns

Successful development is almost always marked by a maturation in the structure of trade.

Successful developers shift from a dependence on the traditional, primary export products
greater diversity of export products and by an evolving export mix toward manufactured
goods and services and other types of high value-added production. As a result of this
evolutionary transformation, manufacturing exports typically come to dominate the export
profile of more developed nations as the share of primary exports in total exports shrinks
within the export profile.

Activity 1.3

Discuss the major institutional patterns and organizational structural changes and their roles
that have been undertaken in the past years in supporting the implementation of the
sustainable economic growth and poverty reduction policy in Ethiopia.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

SUMMARY

 The study of economic development is one of the newest branches of the broader
disciplines of economics for the systematic study of the problems and processes of
economic development of the developing countries.

 Although development economics often draws on relevant principles and concepts from
other branches of economics in either a standard or modified form, for the most part it is a
field of study that is rapidly evolving its own distinctive analytical and methodological
identity.

 Development economics in addition to being concerned with the efficient allocation of

existing scarce productive resources and with their sustained growth over time, it must
also deal with the economic, social, political, and institutional mechanisms to bring rapid
and large-scale improvements in the life of the masses of the poor peoples.

21
 Development involves more than economic growth and changes in economic structures.
The term development should include a decrease in poverty and malnutrition, decline in
income iniquity, employment opportunity, literacy, health, life expectancy and nutrition
improvement and sustainable environmental growth.

 Development also pay attention to changes in family structures, attitudes and mentalities,
cultural changes, demographic developments, political changes and nation building, the
transformation of rural societies and processes of urbanization.

 Amartya Sen (1999) has argued for an even broader concept of development focusing on
the concept of freedom. He sees development as an integrated process of expansion of
substantive freedoms.

 Three basic components or core values in this wider meaning of development are life
sustenance for the basic goods and services, self-esteem the feeling of worthiness and
respect and freedom enjoying real choice.

 Normative value premises about what is or is not desirable are central features of the
economic discipline in general and of development economics in particular.

 The close link between economic development and economic growth is simultaneously a
matter of importance as well as a source of considerable confusion. Economic growth a
quantitative sustained increase in the per capita output while economic development is a
wider concept than economic growth. It is taken to mean growth plus change.

 Development typically requires substantially new institutional patterns and organizational

structures necessary to support such a dynamic process of change. Therefore, for the
developing nations, development compels them to undertake substantial qualitative
structural change.
REFERENCES

Cypher J. M. and J. L. Dietz, 2009. The Process of Economic Development. Third edition
Routledge, 2 Park Square, Milton Park, Abingdon,

Denis Goulet, 1971. The Cruel Choice: A New Concept in the Theory of Development, New
York: Atheneum.

Lanjouw, P., 2001. The Rural Non-Farm Sector: Issues and Evidence from Developing
Countries. Agricultural Economics, Vol. 26.

Lewis W.A., 1955. The Theory of Economic Growth. Homewood, IL: Irwin.

Sen, A.K., 1985. 'Well-being, agency and freedom: The Dewey lectures 1984', Journal of
Philosophy,

Todaro M.P and S.C. Smith, 2012. .Economic Development, 11th edition, Pearson Education,
Inc, USA

23
UNIT TWO

MEASURING ECONOM DE GROWTH AND DEVELOPMENT

Introduction

Dear Students! How one can measure development? Historically, development was mostly
perceived in terms of economic performance. We have too long been preoccupied with
material production and there has been a search for a good measure of it. Surely, per capita
income has been proved to be a good candidate and has dominated the scene ever since. One
can ask - why per capita income? First it is an attractive single indicator for assessing
economic performance. Second, it is also useful to for dividing the world into groups, rich and
poor or developed and developing. Third per capita income estimates are good criteria for
allocating official development assistance at the international level. Fourth, good reliable and
solid data on national income accounts were available to calculate per capita income at a point
of time and over time.

But over years development perspective, its rationale and measures have changed. What are
these changes? With the introduction of the concept of human development in 1990 and the
publication of the first Human Development Report (HDR), the development perspective
underwent a fundamental change. Today, development is not about economic performance
alone, but most importantly about people and their well-being. Why should we shift from
economic performance to people, what is the rationale? This is because people are the
ultimate objective of development. Economic growth is not an end by itself, it is a means to
enhancing people’s lives. The benefits of growth must be translated into lives of people. With
that context in mind, there were naturally new searches for measures for human well-being
and various human development indices and indicators evolved. There are two broad
methodologies, the income per person or economic growth criterion and the social indicators
criteria. We will discuss these criteria in the first and second sections of this unit. The third
and fourth sections of the Unit will discuss the economic and income distribution, and the
development economics retrospective view
Objectives of the unit

After reading this Unite, students will be able to understand and explain:

 how GNI/GNI per capita can be used as a measures of economic development;

 the necessary adjustments to GNI measures as measure of economic development;
 how the purchasing power parity (PPP) definition of income differs from the usual GNI;
 the Physical Quality of Index and how it is used as an measure of development;
 the Human Development Index and how it is used as measure of development;
 the importance of knowing income distribution, the Lorenz curve and the Gini coefficient;
 the significance of the Kuznets inverted-U hypothesis;

Section 1: Traditional Economic Measures

Introduction

Economists often use the level of a nation’s per capita income as a proxy measure for
evaluating the overall level of national development and welfare. You might remember our
discussion in Unite One. Development, being broader than income alone, it encompasses a
wide range of social and human goals that, while including the level of income and economic
growth, go well beyond these as well. Therefore, in this particular section, we shall discuss
how economists typically measure the level of development of a nation. There are two broad
methodologies. First, the income per person, or economic growth criterion, suggests that
income levels are reasonably good approximate measures for comparing economies. In this
view, income per person can serve as a surrogate for gauging overall progress. Second, the
competing perspective argues that development is such a complex, multi-faceted notion that it
should be conceived from the outset as considerably broader than income and hence can only
be measured by entirely different standards. Let us turn to a discussion of these two
viewpoints and methodologies in the first and sections.

Objectives of the section

After reading this Unite, students will be able to understand and explain:
 how GNI/ GNI per capita can be used as a measures of development;
 the necessary adjustments to GNI measures as measure of economic development; and
 how the purchasing power parity (PPP) definition of income differs from the usual GNI.

29
2.1.1 GNI/GNI Per Capita

Economists often use the level of a nation’s per capita income as a proxy measure for
evaluating the overall level of national development and welfare. The level of economic
development and economic growth can be measured either by the growth of total output or of
total income. The two most common measures used for international income and output
comparisons, and hence for measuring economic growth, are gross national income (GNI) and
GNI per capita. GNI is the total value of all income accruing to residents of a country,
regardless of the source of that income, that is, irrespective of whether such income is derived
from sources within or outside the country. GNI is one of the methods to measure economic
development in terms of an increase in the economy’s real national income over a long period
of time. The second is GNI Per Capita measure relates to an increase in the per capita real
income of the economy over the long period. Economists have similar grounds in defining
economic development in terms of an increase in per capita real income or output. But these
are not satisfactory definitions and require adjustments. Let me give you an activity and we
shall discuss the adjustments later.

Activity 2.1

Explain the problem associated with national income accounting in computing the GNI and
GNI per capita particularly in developing countries and the necessary adjustments.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

Dear Students! I hope you remember that you have learned these concepts in your
Macroeconomic Course Module. Please referee back and read your Macroeconomic Course
Module or contact the course module Instructor if this part of the discussion is not well
addressed. There are four issues to discuss.

1. The first concerns the problem associated with national income accounting, particularly in
developing countries. Price changes will have to be ruled out while calculating real
national income because variations in price are inevitable. Changes in the growth of
 population must be taking into consideration. If a rise in real national income is
accompanied by a faster growth in population, there will be no economic growth but
retardation.

2. The second is the problem of converting each country’s per capita income in domestic
currency into a common unit of account that is, the US dollar so as to be able to make
meaningful international comparisons of living standards. International comparisons of the
real GNI per capita are inaccurate due to exchange rate conversion of different currencies
into a common currency. These normal exchange rates do not reflect the relative
purchasing power of different currencies. Thus, the comparisons of GNI per capita of
different countries are erroneous. This leads to the topic of Purchasing Power Parity (PPP)
estimates of per capita income.

3. The third problem relates to the question of externality and non-marketability. The GNI
captures only those means of well-being that happen to be transacted in the market, and
this leaves out benefits and costs that do not have a price-tag attached to them. Even when
non-marketed goods are included for instance, peasant outputs consumed at home, the
evaluation is usually restricted to those goods which have a market and for which market
prices can be easily traced. as economic growth is concerned only with GNI per head,

4. The fourth, GNI leaves out the question of the distribution of that GNI among the
population. It is, of course, possible for a country to have an expansion of GNI per head,
while its distribution becomes more unequal, possibly even the poorest groups going down
absolutely in terms of their own real incomes. Therefore, now let me give you a brief look
at on the necessary adjustments on these issues.

2.1.2 Necessary adjustments to GNI measures

The values for total GNI are total nominal figures, that is, they are the total current US dollar
value of measures of total income. There are a number of adjustments to these total nominal
values that are desirable if income is to be used in a reliable manner as a surrogate measure
suitable for ranking economies as to their level of development.

31
i) Adjusting for population size

A first necessary correction to the total GNI is to adjust for population size. Dividing GNI by
the total population provides a measure of per person income, or, simply, average income.
This population adjustment or using per capita income is essential for two reasons. These are
to determine if, over time, changes in the level of aggregate income of any particular economy
first, just sufficient to keep up with population growth, so that per capita GNI remains
constant over time and Second, more than sufficient to keep up with population growth, so
that per capita GNI is rising over time.

ii) Adjusting nominal income for price changes over time

The total and per capita GNI are what are called nominal values. To judge how any economy
is performing over time, that is, to really be able to compare per capita income figures over
years, it is necessary to convert nominal or current price to real or constant price. The problem
of using current prices is that when comparing different years, unless prices have remained
constant, the current price measure of each year’s GNI will be a mix not only of changes in
physical production but also of the variations in the prices of the goods and services produced.
In comparing GNI in different years, then, what we want to measure is how much real
physical output have changed independent of price changes that may have taken place
between years.

iii) Accounting for income distribution

Income per capita values are at best an imprecise measure of the actual income received by
any particular person. The per capita income measure does not provide any information about
the dispersion of actual incomes around this mean. It is thus helpful to also know something
about the distribution of income in an economy if one is to make reasonable sense of the
average income figures which we shall discus later in this Unite in Section 2 while we discuss
measuring income distribution.

iv) Considering home production

One of the most significant omissions from the GNI measure is an estimate for the value of
home production. In particular, the value of the output derived from the labor of women and
children, who cook and clean and tend children, who make and mend clothing, who toil in
home gardens and subsistence farms and who perform a variety of other unpaid tasks in the
production of non-traded goods and services for their families’ own consumption, are not
included in the traditional GNI estimates. to the extent that men and boys do work on
subsistence farms, in gardens, and in workshops at home resulting in the production of goods
or services consumed solely by the family, the value of their production to an economy’s total
production also is underestimated and ignored. The value of these home productions are
excluded because such goods and services are not valued by or exchanged in the market.

v) Accounting environmental costs

Environmental destruction of forests, and production processes that spew toxic wastes into the
air and water and then force society to pay for their clean-up or which create health problems
requiring remediation via higher health costs are counted as positive contributions to the
measured level of GNI. Such activities do not add to the level of development or to society’s
welfare to the degree that their market-valued contributions would suggest, since social costs
and private costs of such goods diverge, often dramatically, as a result of the negative
externalities created by their production. Economists have devised alternative methods to
measure an economy’s “true” output and income that go beyond the traditional GNI values.
This will be discussed later in this Unite in Section 3 while we discuss sustainable
development.

2.1.3 International Comparisons of Income

The other part of the story, and probably the major part, concerns the understatement of living
standards in developing countries when their national incomes measured in local currencies
are converted into US dollars (as the common unit of account) at the Official Rate Of
Exchange. The Official Exchange Rates between two countries’ currencies are not good
measures of the PPP between countries, especially between countries at different levels of
development. The reason is this: exchange rates are largely determined by the supply of and
demand for currencies based on goods that are traded, the prices of which tend to be equalized
internationally. However, for non-traded goods and non-traded services, which by definition
do not enter into international trade between nations, prices between countries can vary quite
substantially.

33
Therefore, PPPr, depends not only on the prices of traded goods, but also on the prices of non-
traded goods, which are largely determined by unit labour costs, and these tend to be lower
the poorer the country is. As a general rule, it can be said that the lower the level of
development and the poorer the country is, the lower the ratio of the price of non-traded goods
to traded goods and the more the use of the official exchange rate will understate the living
standards of the developing country measured in US dollars. Let’s illustrate this concept using
examples. If the US dollar is used as the unit of account, the national per capita income of
country X in US dollars is given by:

GNP X
 Exchange Rate
Population

For instance, if the GNP of country X is 100 billion birr, its population is 5 million, and there
are 10 birr to the dollar, then the per capita income of country X in dollars is computed as:

100 billion
 10  $2,000
5 million

If the living standards of the two counties are to be compared by this method, it must be
assumed that 10 birr in country X can buy the same living standard as $1 in the United States.
But this is not the case. Let me give a simple example. Suppose consider a non-traded good, a
haircut in Ethiopia and in USA. Given the Official Exchange Rates is 10 birr to the dollar, a
haircut which costs $10 in the USA will cost in Ethiopia 100 birr if a haircut would have
traded good. But actually a haircut is a non-traded good and in Ethiopia costs 25 birr which is
much lower than in USA.

That means the value of a haircut cut is underestimated by a factor of four. The PPP rate of
exchange for haircuts alone is $10 ÷ 25 birr, or $1 = 2.5 birr. If the national income of country
X measured in birr was divided by 2.5 instead of 10, the national income of country X in
dollars, and therefore per capita income in dollars, would now be four times higher: $8,000
per head instead of $2.000 per head as in the example above. To make meaningful
international comparisons of income and living standards, therefore, what is required is a
measure of PPP, or a real exchange rate, between countries. This is usually covered by a
separate area of economics called Comparative economics.
Section 2: The New Economic Measures

Introduction

Now let us discuss the second competing perspective argues that development is such a
complex, multi-faceted notion that it should be conceived from broader than income Those
who use income per person to evaluate progress are quite aware that the development of a
nation encompasses much more than the level of average income and the growth rate of that
income. Development incorporates the diverse and broad aspirations of what might be called
the “good life” in all its economic, social, and political dimensions that each society. Societies
may value, each perhaps differently, goals as diverse as equality of opportunity; rising income
and standard of living, equity in the distributions of income and wealth; the expanding the
availability and opportunity of education and health; clean and healthy environment; etc.

Hence, economists have tried to measure social indicators of basic needs by taking one, two
or more indicators for constructing composite indices of human development. In this part of
this section, we shall discuss about the different social indices and their respective limitations.
We will study below the Physical Quality of Life Index (PQLI) of Morris and the Human
Development Index (HDI) as developed by the United Nations Development Program
(UNDP).

Objectives of the Section

After reading this Unite, students will be able to understand and explain:

 the social indicators as the basic needs indicators for development;

 the Physical Quality of Index and how it is used as an measure of development;
 the relationship of Physical Quality of Index and GNP per capita;
 the Human Development Index and how used as an measure of development; and
 the relationship of Human Development Index and GNP per capita

2.2.1 Social indicators

Dissatisfied with GNI and GNI per capita as the measure of economic development, certain
economists have tried to measure it in terms of social indicators. Social indicators are often
referred to as the basic needs for development. Basic needs focus on alleviation of poverty by

35
providing basic human needs to the poor. The direct provision of such basic needs as health,
education, food, water, sanitation and housing affects poverty in a shorter period and with
fewer monetary resources than GNP/GNP per capita strategy which aims at increasing
productivity and incomes of the poor automatically over the long run. It should be known that
the merit of social indicators is that they are concerned with ends, the ends being human
development. Economic development is a means to these ends. Social indicators tell us how
different countries prefer to allocate the GNP among alternative uses. Some may prefer to
spend more on education and less on hospitals. Moreover, they give an idea about the
presence, absence or deficiency of certain basic needs.

Activity 2.2

Identify and list down the possible types of basic needs or social indicators important for
sustaining human life.
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

Dear Students! I expected you have tried to list down some of these indicators. Basically,
such indicators fall into two groups, those that seek to measure development in terms of a
“normal” or “optimal” pattern of interaction among social, economic, and political factors
and those that measure development in terms of the quality of life. Economists include a wide
variety of items in social indicators. However, there is no unanimity among economists as to
the number and type of items to be included in such an index. For instance, Hicks and
Streeten consider six social indicators for basic needs that is Health, education, food, water
supply, sanitation and housing. Except for calorie supply per head, all other indicators are
output indicators. Of these, infant mortality is both the indicator of sanitation and clean
drinking water facilities because children are prone to water-borne diseases. It is also related
to life expectancy at birth and nutritional deficiencies among infants. Thus, the infant
mortality rate measures four of the six basic needs.
Morris D .however, constructed a composite Physical Quality Life Index (PQLI) by
combining three component indicators of infant mortality, life expectancy at age one and
basic literacy at age 15 to measure performance in meeting the most basic needs of the
people. Similarly, the most widely used measure of the comparative status of socioeconomic
development is presented by the United Nations Development Program (UNDP) in 1990.
Human Development Index (HDI) based on three goals or end products of development:
longevity as measured by life expectancy at birth, knowledge as measured by educational
attainment, and standard of living as measured by real per capita gross domestic product
adjusted for PPP.

On the other hand, one of the early major studies on the first group of composite indicators
was carried out by the United Nations Research Institute on Social Development (UNRISD)
in 1970. The study was concerned with the selection of the most appropriate indicators of
development and an analysis of the relationship between these indicators at different levels of
development. The result was the construction of a composite social development index.
Originally, 73 indicators were examined. However, only 16 core indicators (9 social
indicators and 7 economic indicators) were ultimately chosen (See Table 4).

Generally, it is so difficult to have a comprehensive list of social indicators. You might

remember our discussion in Unit One. Development means not only increasing the
availability of material needs but also means widen their distribution, improving the quality of
life, self-respect and dignity of peoples, enhancing peoples freedom of choice and
participation, etc. At the same, the nature and composition of the social indicators to be taken
are dynamic overtime and vary cross individuals and countries depending on the social,
economic, cultural, religious and political setting. Therefore, an attempt to catch up and
measure such a complex concept of development is difficult. In so far, however, there are
some attempts. Of which, The Physical Quality Life Index and Human Development Index
will be discussed under this section.

37
Table 4: List of Core indicators of socioeconomic development

No Socioeconomic Indicators

1 Expectation of life at birth

2 Combined primary and secondary enrollment
3 Vocational enrollment ratio
4 Consumption of animal protein per capita per day
5 Energy consumption, kg of coal equivalent per capita
6 Electricity consumption, kw per capita
7 Percentage of economically active population
8 Agricultural production per male agricultural worker
9 Percentage of adult male labor in agriculture
10 Percentage of population in localities of 20,000 and over
11 Average number of persons per [residential] room
12 Steel consumption, kg per capita
13 Newspaper circulation per 1,000 population
14 Percentage GDP derived from manufacturing
15 Foreign trade per capita
16 Percentage of salaried and wage earners to total economically active population

Limitations of social indicators

However, social indicators as a measure of economic development have their own limitations.
First, there is no unanimity among economists as to the number and type of items to be
included in such an index. For instance, Goldstein takes only infant mortality as an indicator
of basic needs to construct an index. Hagen uses eleven to eighteen items with hardly a few
common. On the other hand, Morris uses only three items, i.e., life expectancy at birth, infant
mortality and literacy rate in constructing a “Physical Quality of Life Index.” Second, there is
a problem of assigning weights to the various items which may depend upon the social,
economic and political set-up of the country. This involves subjectivity. Morris assigns equal
weights to the three indicators which undermine the value of the index in a comparative
analysis of different countries.
Third, social indicators are concerned with current welfare and are not related to the future.
Fourth, the majority of indicators are inputs and not outputs, such as education, health, etc.
Fourth, they involve value judgments. Therefore, in order to avoid value judgments and for
the sake of simplicity, economists and UN organizations use GNP per capita as the measure
of economic development.

2.2.2 Physical Quality of Life Index (PQLI)

Morris D. Morris constructed a composite Physical Quality Life Index (PQLI) in 1979
relating to 23 developing countries for a comparative study. He combines three component
indicators of infant mortality, life expectancy at age 1 and basic literacy at age 15 to measure
performance in meeting the most basic needs of the people. For each indicator, the
performance of individual countries is rated on a scale of 1 to 100, where 1 represents the
worst performance by any country and 100 the best performance. For life expectancy, the
upper limit of 100 was assigned to 77 years (achieved by Sweden in 1973) and the lower limit
of 1 was assigned to 28 years (the life expectancy of Guinea-Bissau in 1950).Within these
limits, each country’s life expectancy figure is ranked from 1 to 100. For example, a life
expectancy of 52, midway between the upper and lower limits of 77 and 28, would be
assigned a rating of 50. Similarly, for infant mortality, the upper limit was set at 9 per 1,000
(achieved by Sweden in 1973) and the lower limit at 229 per 1,000 (Gabon, 1950).

Literacy rates, measured as percentages from 1 to 100, provide their own direct scale. Once a
country’s performance in life expectancy, infant mortality, and literacy has been rated on the
scale of 1 to 100, the composite index for the country is calculated by averaging the three
ratings, giving equal weight to each. These indexes represent a wide range of indicators such
as health, education, drinking water, nutrition and sanitation. According to Morris, each of
the three indicators measures results and not inputs such as income. Each is sensitive to
distribution effects. It means that an improvement in these indicators signifies an increase in
the proportion of people benefiting from them. But none of the indicators depends on any
particular level of development. Each indicator lends itself to international comparison.
Factor analysis was used to examine the interdependence between social and political
variables and the level of economic development.

39
The researchers found numerous correlations between certain key variables and economic
development. For instance, Morris presents the following correlation among infant mortality,
life expectancy and basic literacy (See Table 5). The coefficient of correlation between life
expectancy at age one and infant mortality is of a high degree and negative. Similar is the
correlation between literacy and infant morality rate i.e., with literacy the infant morality rate
declines. The coefficient between literacy and life expectancy show a high degree of positive
correlation i.e., with literacy the life expectancy also increases. Morris regards life expectancy
at age one and infant mortality as very good indicators of the physical quality of life. So are
literacy and life expectancy. In fact, the literacy indicator reflects the potential for
development.

Table 5: Correlation among literacy, infant mortality and life expectancy

(N = 150) Infant Mortality Life Expectancy

Life expectancy at age one - 0.919 -+

Literacy - 0.919 0.897

2.2.2.1 Comparing the income per capita and PQLI measures

Morris observes that there is no automatic link between GNP per capita and PQLI. In fact, the
presence or absence of social relations, nutritional status, public health, education and family
environment determine a society’s PQLI. Further, it takes considerable time to build
institutional arrangements that can generate and sustain a high PQLI. For instance, consider
Table 6 which provides a sample of developing countries ranked both by per capita income
and by PQLI in the early 1980s. Although the study found that countries with low per capita
GNP tended to have low PQLI and countries with high per capita GNP tended to have high
PQLI, the correlations between GNP and PQLI were not substantially close. Some countries
with high per capita GNP had very low PQLI even below the average of the poorest countries.
Other countries with very low per capita GNP had PQLI that were higher than the average for
the upper-middle- income countries. The result seem to indicate that significant improvements
in the basic quality of life can be achieved before there is any great rise in per capita GNP or,
conversely, that a higher level of per capita GNP is not a guarantee of a better quality of life.
Note in particular the wide PQLI variations for countries with similar levels of per capita
income such as Angola and Zimbabwe, China and India, Tanzania and Gambia, Taiwan and
Iraq, and Costa Rica and Brazil. A particularly striking contrast is that between Saudi Arabia
and Sri Lanka.

Table 6: GNP per capita and PQLI for selected less developed countries

Country GNP per capita (U.S. $) PQLI

Gambia 348 20
Angola 790 21
Sudan 380 34
Pakistan 349 40
Saudi Arabia 12,720 40
India 253 42
Iraq 3,020 48
Qatar 27,790 56
Tanzania 299 58
Zimbabwe 815 63
Brazil 2,214 72
China 304 75
Sri Lanka 302 82
Singapore 5,220 86
Taiwan 2,503 87
Costa Rica 1,476 89

Source: Lewis J.P and V. Kallab (1983)

2.2.2.2 Limitations of the PQLI

Morris admits that PQLI is a limited measure of basic needs. It supplements but does not
supplant the GNP. It does not measure economic growth. Further, it does not explain the
changing structure of economic and social organization. It, therefore, does not measure
economic development. Similarly, it does not measure total welfare. However, it measures the
qualities of life which are essential for the poor. Morris has been criticized for using arbitrary

41
weights for the three variables of his PQLI. According to Meier, “Non-income factors
captured by the PQLI are important but so are income and consumption statistics and
distribution-sensitive methods of aggregation by which to obtain an overall poverty index.
Conclusion: Despite these limitations, the PQLI can be used to identify particular regions of
under-development and groups of society suffering from the neglect or failure of social
policy. It points towards that indicator where immediate action is required so that the state can
take up such policies which increase the PQLI rapidly along with economic growth.

2.2.3 Human Development Index (HDI)

Since 1990, the UNDP has been presenting the measurement of human development in terms
of a Human Development Index (HDI) in its annual Human Development Report. Since then,
fundamental difference was made in the way development is perceived. This changed
perspective led to a fundamental difference in the way development is to be measured and
monitored. Since economic performance by itself cannot be the objective of development,
neither can per capita income be a measure of it. The concept of human development
emphasized that:

i) Development is about enlarging people’s choices by enhancing their functionings and

capabilities;

ii) Development is of the people, for the people and by the people. The first refers to human
capital formation and human resources development through nutrition, health and
education. Development for the people stresses that the benefits of economic growth
must be translated into lives of people. Development by the people means that people
must be able to influence the process, which affects their lives; and

iii) Development must be woven around people, and not people around development.

2.2.3.1 What is the Human Development Index (HDI)?

The HDI serves as a frame of reference for both social and economic development. It is a
summary measure for monitoring long-term progress in a country’s average level of human
development in three basic dimensions: a long and healthy life, access to knowledge and a
decent standard of living. Therefore, HDI is a composite index of three social indicators: life
expectancy, adult literacy and years of schooling and real GDP per capita. Thus, the HDI is a
composite index of achievements in three fundamental dimensions: a long and healthy life,
knowledge and a decent standard of living. The HDI value of a country is calculated by taking
three indicators:

 Longevity: as measured by life expectancy at birth: the range is 25 to 85 years.

 Educational attainment: as measured by a combination of adult literacy (two-thirds

weight) and combined primary, secondary and tertiary enrolment ratios (one-third
weight). The range for adult literacy is 0% to 100% and combined enrolment ratio: 0% to
100%.

 Standard of living, as measured by real GDP per capita based on purchasing power parity
in terms of dollar (PPP$) : $ 100 and $ 40,000. For any component of the HDI, the
individual indices can be according to the general formula:

Actual Value - Minimum Value

Index 
Maximum Value - Minimum Value

The index takes ranges from 0 to 1. If the actual value is the minimum value, the index is
zero. If the actual value is equal to the maximum value, the index is one. The HDI is a simple
average of life expectancy index, educational attainment index, and the adjusted real GDP per
capita (PPP$) index. It is calculated by dividing the sum of these three indices by 3. The
maximum and minimum value for each variable which are fixed, are reduced to a scale
between 0 and 1, with each country at some point of the scale. The HDI value for each
country indicates the distance it has traveled towards the maximum possible value of 1 and
how far it has to go to attain certain defined goals: an average life span of 85 years, access to
education for all and a decent standard of living. The HDI ranks countries in relation to each
other. A country’s HDI rank is within the world distribution i.e., it is based on its HDI value
in relation to each developed and developing country for which the particular country has
traveled from the minimum HDI value of 0 towards the maximum HDI value of 1. Using
these three measures of development and applying a formula the HDI ranks countries into
four groups: low human development (0.0 to 0.499), medium human development (0.50 to
0.799), high human development (0.80 to 0.90), and very high human development (0.90 to
1.0).

43
For Instance, the life expectancy at birth rate for Bangladesh in 2007 was found to be 65.7
years. In the same yea, the adult literacy rate at age 15 and the enrollment rates were given as
53.5%, 52.1% respectively. In addition, the PPP GDP per capita was $1,241. The steps in the
calculation of the HDI are illustrated as follows.

1. To find the life expectancy index, starts with a country’s current life expectancy at birth
and the maximum and minimum values of 25 and 85 years respectively given earlier.

65.7 years  25 years

 0 .678
85 years  25 years

2. The educational attainment index is made up of two parts, with two-thirds weight on adult
literacy and one-third weight on school enrollment. Note that the maximum and minimum
values are 100% and 0% respectively for the adult literacy as well as the enrollment rate.
To determine the education attainment index, again tree steps procedure is necessary.

53.5 % - 0
i) Adult literacy index =  0 . 535
100 % - 0%

52.1 % - 0
ii) The enrollment index =  0 . 521
100 % - 0 %

2 l
iii) The Education index = ( Adult Literacy Index  )  ( Enrollment Index  )
3 3

2 l
= (0.535  )  (0.521  )  0. 530
3 3

3. To find the income index, one subtracts the log of 100 from the log of current income, on
the assumption that real per capita income can not possibly be less than $100 PPP. Note
also that 40, 000 is the maximum GDP per capita given earlier. The GDP per capita index
calculated as:

Log (1,241)  Log (100)

GDP per capita index =  0 . 420
Log (40, 000)  Log (100)
4. Finally, Human Development Index is a simple average of the three indices. Calculated by
dividing the sum of the three indices by 3, i.e.,

Life Expectancy Index  Enrollment Index  GDP Per Capita Index

3

0.678  0.530  0.420

 0 . 543
3

This result can be interpreted as the value of Human Development Index 0.543 indicates that
by the year 2002 Bangladesh had a medium level of human development.

2.2.3.2 Advantages of the HDI

1. It does reveal that a country can do much better than might be expected at a low level of
income and that substantial income gains can still accomplish relatively little in human
development.

2. Furthermore, HDI reminds us that by development we clearly mean broad human

development, not just higher income. Many countries, such as some of the higher-income
oil producers, have been said to have experienced “growth without development.

3. Moreover, better indicator of development disparities and rankings might be found by

including health and education variables in a weighted welfare measure rather than by
simply looking at income levels, and the HDI offers one very useful way to do this. Health
and education are inputs into the national production function in their role as components
of human capital, meaning productive investments embodied in persons.

4. 2.2.3.3 Limitations of the HDI

Although, it is reality about human development and deprivation, the HDI is not free from
certain limitations:

1. The three indicators are not the only indicators of human development. There can be
others like infant mortality, nutrition, etc.

2. Gross enrollment in many cases overstates the amount of schooling because in many
countries a student who begins primary school is counted as enrolled without considering
whether the student drops out at some stage.

45
3. The HDI measures relative rather than absolute human development so that if all countries
improve their HDI value at the same weighted rate, the low human development index
countries will not get recognition for their improvement.

4. The attachment of weights to each of these items is arbitrary.

5. HDI of a country may shift the focus away from the high inequality found within it.

6. Last, the alternative approach of taking the GNP per capita ranking and supplementing it
with other social indicators is still a better one.

Activity 2.3

Explain your understanding about the relationship between economic growth and the Human
Development Index. To put is differently, does the correlation between HDI and GNP per
capita substantially close?
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

Dear Students! I think you remember our discussion in the preceding section about the
relationship between the PQLI and the GNP per capita growth. Similarly, although some
studies found that countries with low per capita GNP tended to have low HDI and countries
with high per capita GNP tended to have high HDI, the correlations between GNP and HDI
were not substantially close. Let us turn to a discussion of this issue taking a sample of
developed and developing nations below.

2.2.3.4 Comparing the income per capita and HDI measures

Table 7 shows the 2009 Human Development Index using 2007 data for a sample of
developed and developing nations ranked from low to very high human development (column
3) along with their respective real GDP per capita (column 4) and a measure of the differential
between the GDP per capita rank and the HDI rank (column 5). A positive number shows by
how much a country’s relative ranking rises when HDI is used instead of GDP per capita, and
a negative number shows the opposite.
Table 7: The 2009 Human Development Index Report for a Sample of Countries

GDP Rank
Relative GDP minus HDI
Country Ranking HDI Per Capita Rank

Low Human Development

Niger 182 0.340 627 -6

Rwanda 167 0.460 866 1
Senegal 166 0.464 1,666 -
Malawi 160 0.493 761 12

Medium Human Development

Bangladesh 146 0.543 1,241 9

Pakistan 141 0.572 2,496 -9
India 134 0.612 2,753 -6
South Africa 129 0.683 9,757 - 51
Nicaragua 124 0.699 2,570 6
Gabon 103 0.755 15,167 - 49

High Human Development

Saudi Arabia 59 0.843 22,935 - 19

Costa Rica 54 0.854 10,842 19
Cuba 51 0.863 6,876 44
Chile 44 0.878 13,880 15

Very High Human Development

United Kingdom 21 0.947 35,130 -1

United States 13 0.956 45,592 -4
Canada 4 0.966 35,812 14
Norway 1 0.971 53,433 4

47
Clearly, this is one of the critical issues for the HDI. If country rankings did not vary much
when the HDI is used instead of GDP per capita, the latter would serve as a reliable proxy for
socioeconomic development, and there would be no need to worry about such things as health
and education indicators. You can see from Table 2.4 that the country with the lowest HDI
(0.340) in 2007 was Niger, and the one with the highest (0.971) was Norway.

It should be stressed that the HDI has a strong tendency to rise with per capita income, as
wealthier countries can invest more in health and education, and this added human capital
raises productivity. But what is so striking is that despite this expected pattern, there is still
such great variation between income and broader measures of well-being For example,
Senegal and Rwanda have essentially the same average HDI despite the fact that real income
is 92% higher in Senegal. And Costa Rica has a higher HDI than Saudi Arabia, despite the
fact that Saudi Arabia has more than double the real per capita income of Costa Rica. Many
countries have an HDI significantly different from that predicted by their income. South
Africa has an HDI of 0.683, but it ranks just 129th, 51 places lower than to be expected from
its middle-income ranking.

Section 3: Economic Growth and Income Distribution

Introduction

Dear Students! In Unite One, you have been introduced the problem that despite significant
improvements over the past half century, extreme poverty remains widespread in the
developing world. Moreover, in the previous section we have seen that development requires
a higher GNI, and hence sustained growth, is clear. The basic issue, however, is not only how
to make GNI grow but also who would make it grow, the few or the many. If it were the rich,
it would most likely be appropriated by them, and progress against poverty would be slow,
and inequality would worsen. But if it were generated by the many, they would be its
principal beneficiaries, and the fruits of economic growth would be shared more evenly. The
elimination of widespread poverty and high and even growing income inequality are at the
core of all development problems. In this section, therefore, we shall examine the recent and
historical arguments along with the Lorenze and Gini Coefficient for analyzing income
distribution
Objectives of the Section

After reading this Unite, students will be able to understand and explain:

 the traditional and new perspective of economic growth and income distribution;
 the techniques of the Lorene and Gini Coefficient for analyzing income distribution; and
 the Kuznets findings and critical appraisal.

2.3.1 Traditional Economic Development Perspective

The traditional economic development literature considered highly unequal income and
wealth distribution as a necessary condition for continued and rapid economic growth. The
basic economic argument to justify large income inequalities was that high incomes (personal
and corporate) were a necessary condition for higher savings, which in turn were needed for
investment and economic growth A view widely held in the domain of development
economics is that the benefits of economic growth diffuse automatically across all segments
of society. This is indeed the well-known trickle down hypothesis, which was a dominant
thinking in the 50s and 60s. An influential study published in 1955 by the late Nobel Prize-
winning economist Simon Kuznets examined the historical relationship between income per
capita and income distribution, one broad indicator of equity.

Kuzentes suggested on the experience of the developed countries that historically there was a
tendency for income inequality to increase first, and then to be reduced as countries developed
from a low level. Accordingly, it was believed that a high degree of inequality in the
distribution of income had a favorable effect on economic growth in the early stage of
development and as development gained momentum its benefits would automatically ‘trickle
down’ to the lower income groups over the long run. So this development approach
emphasized the maximization of the growth rate of the economy by building up capital,
infrastructure and productive capacity of the economy and leaving the distribution of income
untouched. We will have a detail examination of Kuznets hypothesis later in this section.
Arthur Lewis was the principal supporter of this strategy. He outlined the process through
which income inequalities led to the economic growth of the 19th century England, 19th
century Western Europe and the early 20th century Japan. He advocated the same for the
LDCs.

49
He contended that the voluntary savings formed a significantly large share of the national
income where the inequality of income distribution was such that profits were relatively large
share of the national sector and the relative share of profits in national income also increased.
This tended to perpetuate income inequalities. In the long run, when employment
opportunities increased all-round and the traditional sector also developed, the distribution of
income would stabilize. This was an automatic process and was only a side effect of the
growth of the economy.

2.3.2 The New Political Economy Perspectives

The new political economy literature, on the other hand, links greater inequality to lower
future growth paths, and considers it an impediment to poverty-reducing growth, as the
elasticity of poverty with respect to growth is found to decline when inequality increase.
High inequality, manifested in a large proportion of population having poor health, nutrition,
and education, is also likely to impact on overall labour productivity and to cause slower
economic growth Raising income levels of the poor, on the other hand, stimulates demand for
domestic products and increases employment and production. More equitable distribution of
income may also act as a material and psychological incentive to widespread public
participation in the development process whereas inequality may cause political and economic
instability.

Therefore, the most important goal for the developmental effort has become poverty
reduction, which can be achieved by economic growth and/or by the distribution of income.
Issues related to the benefits of growth accrued to the poor have also been a priority of
development policy in the 1990s. An emerging consensus is that growth alone is a rather blunt
tool for poverty reduction. In addition to the emphasis on poverty reduction, policies of
redistribution of income and assets have become increasingly important. A policy agenda that
addresses both distributional concerns and poverty reduction could lead to the enhancement of
both economic growth and equity. Indeed, the relation among growth, inequality and poverty
is complex and interdependent one.
Activity 2.4

What kind of relationship do you expect between economic growth and income inequality?
Does income inequality increases, decreases or remain unchanged especially from developing
countries context?
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________.

Dear Students! There has been much controversy among economists over the issue whether
economic growth, increases or decreases income distribution especially from developing
countries context. It is difficult to generalize this relationship. A number of studies have found
different results. The nature of the relationship depends on the structure of the economic
growth. For instance, economic policies focusing on increasing the economic returns to the
productive factors that the poor possess raising returns to unskilled labour, whereas policies
promoting higher returns to capital and land tend to increase inequality, unless they also
include changes in existing patterns of concentration of physical and human capital and of
land ownership.. Use of capital-intensive methods instead of labour-intensive ones tends to
increase income disparities, as does the employment of skill-biased technologies, especially
where the level of education is low and human capital concentrated.

Also, the location of industrial facilities has an impact on overall poverty reduction and
inequality. As enterprises are often concentrated in urban areas because of ready access to
skilled labour force, better infrastructure, larger markets and technological spillovers,
industrialization may increase inequality between urban and rural areas. Promoting
development of rural non-agricultural activities, like production in small and medium-sized
enterprises (SMEs), may decrease this disparity. Generally, there are two groups of arguments
or perspectives, the traditional economic development and the new political economic
development perspectives.

51
 2.3.3 Analyzing Income Distribution

Economists usually distinguish between two principal measures of income distribution for
both analytical and quantitative purposes: the personal or size distribution of income and the
functional distribution of income. We shall see here the Lorenze Curve and the Gini
Coefficient, the two most commonly used measures of size or personal distribution of income

2.3.3.1 Lorenz Curve

Lorenz Curve is a common way of analyzing personal income statistics. It is constructed by

plotting number of income recipients on the horizontal axis (in cumulative percentage) and
total income percentage (cumulative) shared by each percentage of the population on the
vertical axis. The entire figure is enclosed in a square and a diagonal line is drawn from the
lower left corner (origin) to the upper right corner. At every point on the diagonal, the
percentage of income received is exactly equal to the percentage of income recipients. For
example, the point half way along the length of the diagonal represents 50% of the income
being distributed to exactly 50% of the population. In other words, the diagonal line is
representative of perfect equality in size distribution of income (See Figure 1).

Line of Complete
Percentage of income

Equality
A

450

O Percentage of population growth C

Figure 1: Lorenz curves for DCs and LDCs

The more the Lorenz curve is away from the diagonal, the greater the degree of inequality
represented. The extreme case of perfect inequality is a situation in which one person receives
all of the national income while everybody else receives nothing.
This would be represented by the congruence of the Lorenz curve with the bottom horizontal
and right hand vertical axis. Because no country exhibits either perfect equality or perfect
inequality in its distribution of income, the Lorenz curve for different countries will lie
somewhere to the right of the diagonal. The greater the degree of inequality, the grater the
bend of Lorenz curve away from the diagonal line.

2.3.3.2 Gini Coefficient

Gini coefficient (also Gini concentration ratio) is named after the Italian statistician who first
formulated it in 1912. It is obtained by calculating the ratio of the area between the diagonal
and the Lorenz curve divided by the total area of the half square in which the curve lies. Gini
coefficients are aggregate inequality measures and vary from 0 (perfect equality) to 1 (perfect
inequality). Gini coefficients for countries with highly unequal income distribution typically
lies between 0.5 and 0.7, while for countries with relatively equal distribution, it is on the
order of 0.2 to 0.35. It was in his 1963 study that Kuznets developed his inverted U-shaped
hypothesis by taking the data of 18 countries by size distribution of income. On this basis, he
constructed different Lorenz curves for DCs and LDCs and derived their Gini coefficients.

It was 0.37 for DCs and 0.44 for LDCs. It showed that income inequalities were higher in
LDCs than in DCs. This is explained in Figure 1 where the 45o straight line OD is of equal
income distribution. The thick curve to the right and nearer to this line is the Lorenz curve of
DCs. The dotted curve further to the right represents the Lorenz curve of LDCs. The Gini
coefficient of distribution is a better measure of the degree of income inequality. It varies
from 0 (complete equality) to 1 (complete inequality). The larger the coefficient, the greater
will be the inequality. The Gini coefficient is measured in Figure 1 as the ratio of area A/A +
B or A/ OCD. The greater is this ratio, the more unequal is the distribution of income i.e.,
the more the Lorenz curve falls below the 45o line. In Figure 1, the area covered by the thick
Lorenz curve roughly represents 37% of the triangle OCD for DCs and the area covered by
the dotted Lorenz curve represents roughly 44% of the area of the triangle OCD for LDCs.

2.3.4 Kuznet’s Hypothesis

In the 1950s and 1960s, the thinking in income inequality and development was influenced by
Kuznets’ Inverted U-Shaped Curve. Kuzentes suggested on the experience of the developed

53
countries that historically there was a tendency for income inequality to increase first, and
then to be reduced as countries developed from a low level. Accordingly, it was believed that
a high degree of inequality in the distribution of income had a favorable effect on economic
growth in the early stage of development and as development gained momentum its benefits
would automatically ‘trickle down’ to the lower income groups over the long run. So this
development approach emphasized the maximization of the growth rate of the economy by
building up capital, infrastructure and productive capacity of the economy and leaving the
distribution of income untouched. It was like riding the horse of economic development and
leaving the horse of economic equality to feed for itself. In his 1955 Study, Kuznets takes
the following data relating to three LDCs (Less Developed Countries) -India, Ceylon and
Puerto-Rico and two DCs (Developed Countries)-The U.K. and U.S. Table 8 shows that in
LDCs the poorest 60% received 30% and less of national income, where as in DCs they
received more than 30% of national income. As far as the richest 20% in LDCs are concerned,
they received 50% and more of national income. In DCs, they received 45% and less. Kuznets
comes to the conclusion that the size distribution of income was more unequal in LDCs than
in DCs. It was high (1.67 to 2.33) in LDCs and low (1.25 to 1.29) in DCs.

Table 8: Relative income inequality in various countries in about 1950

Income Share % Richest 20%

Ratio 
Country Poorest 60%
Poorest (60%) Riches (20%)

India (1949-50) 28 55 1.96 

Ceylon (1950) 30 50 1.67  LDCs
Puerto-Rico (1948) 24 56 2.33

United Kingdom (1950) 34 44 1.29

DCs
United States (1947) 36 45 1.25

The change in the distribution of income as measured by the Gini coefficient in relation to
increase in per capita income trace out the Kuznets inverted U-shaped curve K, as shown in
Figure 2. Note that the more robust portion of the Kuznets curve lies to the right: income
inequality falls with an increase in per capita income at higher levels of development.
The variance around the estimated Kuznets curve is greatest, however, from low to middle
levels of development. The inverted U-shaped curve hypothesis applies to the present
developed and developing countries but the degree of inequality in the latter is greater than in
the former.

0.70
0.60
0.50
0.50
Gini Coefficient

0.40
0.30
0.10 K
0.10
O Per Capita Income

Figure 2: Change in distribution of income with an increase in per capita income

2.3.4.1 Causes of Increase in Inequality with Development

There are many factors which tend to increase relative income inequality in the early stages of
development in LDCs. LDCs are characterized by geographic, social, financial and
technological dualism. When the process of transition from a traditional agricultural society to
modern industrial economy begins, it increases inequalities in income distribution. There are
structural changes which lead to increasing employment opportunities, exploitation on new
resources, and improvements in technology. All these led to increase in per capita income in
the industrial sector. The incomes of workers, managers, entrepreneurs, etc. in urban areas
increase more rapidly. But income per capita of workers engaged in agricultural and non-
agricultural occupations in rural areas does not rise due to subsistence agriculture, defective
land tenure system and rural backwardness. The industrial sector uses capital-intensive
techniques which absorbs only educated, skilled and trained workers. Workers in this sector
have high incomes and employers earn large profits. Thus the modern industrial sector grows
faster than the rural subsistence sector. As a result, the relative share of income and profit in
national income of this sector rises, more than in the rural sector.

55
The migration of rural population to urban areas does not provide gainful employment
opportunities to the uneducated and unskilled people in towns and cities. The majority of
them become vendors of fruits, vegetables, newspapers, car washers, waiters, porters, shop
assistants, domestic servants, etc. All such persons are underemployed and have low
incomes. When migration to urban areas starts in the early stages of development, some
landlords also move to the urban sectors who invest in urban property, stocks, bonds, etc.
Such investments bring them higher incomes than from landownership in rural areas. On the
other hand, with technological advance and increase in financial facilities in urban areas, a
new class of entrepreneurs emerges which leads to diversification in manufacturing, trade and
business. Consequently, incomes and profits of persons engaged in them increase. There is
urban bias in the allocation of financial resources for development on the part of governments
with the result that the rural economy remains backward with disguised unemployment and
low per capita income. Above all, higher growth rate of population among the masses in
LDCs increases the absolute number of people and hence relative inequality.

2.3.4.2 Causes of Reduction in Inequality with Development

Kuznets gives two reasons for the decrease in inequality of income distribution when the
country reaches high income levels in the later stages of development. First, the per capita
income of the highest income groups falls because their share of income from property
decreases. Second, the per capita income of the lowest income groups rises when the
government takes legislative decisions with respect to education and health services,
inheritance and income taxation, social security, full employment and economic relief either
to whole groups or individuals. As development proceeds, it sets in motion a chain of
cumulative expansion in the industrial sector, thereby leading to higher per capita income.
This, in turn, increases the demand for farm products and other products of rural and
backward areas which raise the per capita income of the people of these areas. This is what
Hirchman calls “trickling down effects” and Myrdal calls “spread effects” of development.
Besides, the incomes of rural areas also increase from urban remittances and/or foreign
remittances.

People belonging to rural areas but working in urban areas and/or living in foreign countries
remit large sums to their dependents. Above all, as development gains momentum the growth
rate of population declines which increases per capita income. Montek S.Ahluwalia has also
pointed out the improvement in income distribution observed in the later stages of
development. It has been due to inter-sectoral shifts in the structure of production, expansion
in educational attainment and skill of the labor force, and reduction in the rate of growth of
population.

2.3.4.3 Critical Appraisal

Kuznet’s inverted U-hypothesis has been empirically tested and confirmed by some
economists while other find it the other way. Kravis in his study of eleven developing and
developed countries confirms the Kuznets hypothesis that the degree of inequality first
increases at lower levels of development and the declines at higher levels of development.
Adelman and Morris in their study of 43 developing and 13 developed countries work out
their average Gini coefficients as 0.47 and 0.29 respectively. They come to the conclusion that
income inequality increase up to a certain level of development and then declines, thereby
conforming the Kuznets inverted U-hypothesis.

Similarly, Montek S. Ahluwalia in his analysis of the data for 60 countries finds that relative
income inequality increases substantially in the early stages of development with reversal of
this tendency in the later stages. Despite these, the validity of the Kuznets inverted U-
hypothesis has been questioned on the basis of the data taken by Kuznets and others for their
studies. Kuznets takes a very small sample of developing and developed countries. Critics
argue however that his analysis is based on 5 per cent empirical information and 95 per cent
speculation.

According to Todaro the long-run data for developed countries do seem to support the
Kuznets hypothesis but the studies of the phenomenon in LDCs have produced conflicting
results. His study in 13 LDCs shows that “higher income levels can be accompanied by
falling and not rising inequality”. Todaro also finds fault with the methodology used by
economists to test the Kuznets hypothesis. The time-series data being not available for most
LDCs, economists use cross-sectional data.

57
Using cross-sectional data for a time-series phenomenon for drawing conclusion is basically
wrong. In a recent study, Anand and Kanbur have shown that the choice of data as the
measure of inequality may lead to U-relationship between income inequality and
development, inverted-U relationship or no relationship at all.

Section 4: Development Economics Retrospect

Introduction

Dear Students! Over the past fifty years, development economics has undergone many
changes. The emphasis has shifted from growth in GNP per capita to the creation of
employment, to redistribution of income, to basic human needs, to structural adjustment and
sustainable development. These isuues will be discussed in this section.

Objectives of the Section

After reading this Unite, students will be able to understand and explain:

 the merits and consequences of the GNP growth strategies;

 the implications of the stabilization and structural policies; and
 the importance of sustainable development.

2.4.1 GNP Per capita

In the 1950s and 1970s, strictly economic terms, development has traditionally meant
achieving sustained rates of growth of income per capita to enable a nation to expand its
output at a rate faster than the growth rate of its population. Levels and rates of growth of
“real” per capita gross national income (GNI) (monetary growth of GNI per capita minus the
rate of inflation) are then used to measure the overall economic well-being of a population,
how much of real goods and services is available to the average citizen for consumption and
investment. Economic development in the past has also been typically seen in terms of the
planned alteration of the structure of production and employment so that agriculture’s share of
both declines and that of the manufacturing and service industries increases. Development
strategies have therefore usually focused on rapid industrialization, often at the expense of
agriculture and rural development. With few exceptions, such as in development policy
circles in the 1970s, development was until recently nearly always seen as an economic
phenomenon in which rapid gains in overall and per capita GNI growth would either “trickle
down” to the masses in the form of jobs and other economic opportunities or create the
necessary conditions for the wider distribution of the economic and social benefits of growth.
Problems of poverty, discrimination, unemployment, and income distribution were of
secondary importance to “getting the growth job done.” Indeed, the emphasis is often on
increased output, measured by gross domestic product (GDP).

2.4.2 Basic Human Needs

Dissatisfied with growth, employment and income distribution approaches of development,

economic thinkers turned towards the “basic human needs” strategy for promoting human
well-being, especially that of the poor. The World Bank’s first mission to an LDC, Columbia,
in 1950 had stated its objectives in terms of meeting “basic human needs”. But this objective
was not taken due account of the multiplicity of planning objective in the LDCs in those early
years. It was, however, at the World Employment Conference of 1976 that the ILO espoused
the concept of a “basic needs strategy”. India was the first among the LDCs to adopt this in its
Fifth-Year Plan in 1974, two years ahead of the ILO declaration.

The basic human needs strategy laid emphasis on providing basic material needs in terms of
health, education, water, food, clothing and shelter. The productivity and income of the rural
and urban poor in labor surplus LDCs can be improved through labor-intensive production
techniques by providing them basic needs. It also emphasized the removal of poverty by
providing such public services as education, drinking water and health. Such public services
were financed by the government. Criticism: This approach was criticized as a prescription to
“count, cost and deliver”, i.e., count the poor, cost the number of public services and deliver
them to the poor. It was thus regarded as state action from top to bottom. It was also criticized
for not providing the poor with productive assets and capital.

2.4.3 Stabilization and Structural Adjustment

In the early 1980s, the decline in the growth rate of developed countries, the rise in oil prices,
the debt crisis in developing countries and the worsening of their terms of trade, pushed the
basic needs strategy in the background. Many countries embarked on programs of
stabilization and structural adjustments. Initially, stabilization measures, supported by the
IMF and World Bank, aimed at reducing inflation, both budget and trade deficits, cutting

59
public spending, reducing wages and raising interest rates. But these measures often led to
recession in some countries. Moreover, these were short-term measures. Guided by the World
Bank and IMF, many developing countries switched to long-term structural adjustment
programs. It is a domestically designed program of reforms by following the policies of
liberalization, adjustment and privatization. These involve reducing the role of the state,
removing subsidies, liberalizing prices and opening economies to flows of international trade
and finance. These often include measures to reduce the fiscal deficit. The majority of LDCs
are still pursuing structural adjustment programs. But these have led to reduction in
government spending on social services like health and education. Poverty and unemployment
have increased and the concern for the poor has been pushed into the background.

Activity 2.5

List down and discuss the structural adjustment measures taken in Ethiopia and their
relevance from the point of view of bringing economic growth, equitable income distribution
and poverty reduction.
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

2.4.4 Human Development Approach

The UNDP incorporated Sen’s view in its first Human Development Report in 1990.
According to it, human development goes far beyond income and growth to cover all human
capabilities – the needs, aspirations and choice of the people. It defined human development
as “a process of enlarging people’s choices” that is created by expanding human capabilities.
Income is one of the choices but it is not the only choice. Rise in income is not the same thing
as the increase in human capabilities. Besides higher income, poor people put a high value on
adequate nutrition, access to safe drinking water, better medical facilities, and better school
for their children, affordable transport, adequate shelter, secure livelihood and productive and
satisfying jobs. Human development is a broad and comprehensive concept. It is as much
concerned with economic growth as with its distribution, as with basic human needs as with
variety of human aspirations, as with the distress of the rich countries, and as with the human
deprivation of the poor. The UNDP report explained the relationship between economic
growth and human development. It emphasized that there is no automatic link between the
two. Economic growth is important because no society has been able to sustain the well-being
of its people without continuous growth. So economic growth is essential for human
development. But human development is equally important because it is healthy and educated
people who contribute more to economic growth through productive employment and
increase in income. Thus, human development and economic growth are closely connected. In
reality, economic growth is a means to end, and the end is human development.

Policy makers should, therefore, pay more attention to the quality of growth so as to support
all-round human development. Prof. Amartya Sen emphasized on the concept of promoting
‘human capabilities’. According to him, at the core of human well-being is freedom of choice
by enhancing people’s capabilities for attaining higher standards of health, knowledge, self-
respect and the ability to participate activity in community life. The standard of living of a
society should not be judged by GNP per capita and the supply of particular goods but by
people’s capabilities, i.e., what a person can or cannot do, can or cannot be. It is entitlement,
the set of alternative commodity bundles that a person can command in society, that generate
these capabilities. The relevant capabilities are: being free from starvation, from hunger, from
under-nourishment; participation in communal life; being adequately sheltered and so on.

The expansion of these capabilities implies freedom of choices- political, social, economic
and cultural freedom. Sen’s human capabilities concept has been criticized on the following
grounds: first, freedom of choices goes beyond economic development when freedom from
servitude, freedom from religion and political freedom are included; and second, the problem
is of measuring each of these items. How to measure the achievement of social and political
objectives when data for measuring economic indicators are not available in LDCs. It is,
therefore, advisable to confine the concept of human capabilities to only freedom from
starvation, hunger, etc. which relate to economic capabilities.

61
2.4.5 Sustainable Development

Since the 1970s, there has been a growing concern about the impact of economic growth on
the natural environment. In 1971, a United Nations conference on the Environment and
Development was held in Switzerland followed in 1972 by the UN conference on the Human
Environment in Sweden. These and other gatherings of academics, politicians, activists, and
NGOs (non-governmental organizations) culminated in the UN conference on Environment
and Development – the so-called “Earth Summit” – held in Rio de Janeiro, Brazil, in 1992.
And, of course, concern over global warming and its relationship to how and what economies
produce has become front-page news since the late 1990s. The outcome of these various
forums and of a growing body of scientific research has been an increasing awareness of and
interest in the issue of the sustainability of economic growth.

Sustainable development was defined by the Brundtland Commission as “development that

meets the needs of the present without compromising the ability of future generations to meet
their own needs.’’ While there is still debate over precisely what this definition means, efforts
to operationalize it to account for the impact of current economic activities on natural
resource use and the carrying capacity of the environment to absorb changes are evident in the
creation of the Genuine Progress Indicator (GPI) and in other measures, such as the
Environmentally adjusted net Domestic Product (EDP), as well as other efforts to “green” the
national accounts countries traditionally use to measure their economic progress. The
motivating conviction of sustainable development is that economic growth need not be in
conflict with the natural environment if attention is paid in economic and public policy
decisions to the goal of conserving and enhancing the natural resource base and in using
technology in ways that value not only higher levels of output but also consider the impact of
such economic expansion on the environment.

Activity 2.6

Explain the new way of looking economic growth and sustainable development.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
Dear Students! This is part of the new way of looking at sustainability rests on the critical
observation that there is pollution due to poverty, as well as the perhaps more familiar
pollution arising from affluence. Some researchers have suggested there may be an
environmental Kuznets curve, similar to Figure 2. Lets us return to discuss it.

An Environmental Kuznets curve

At relatively low income levels, increases in economic growth result in increased pollution
and environmental destruction. However, after a threshold level of income per person is
reached, pollution and adverse environmental effects will be reduced. Why might such a
relationship be expected? Why might such a relationship be expected? Pollution due to
poverty exists in less-developed nations as a result of the degradation of marginal farm lands
by landless farmers, leading to the erosion of top-soil and desertification, and from the clear-
cutting of forests, both of which lead to poorer water quality after rains and run-off
exacerbated by the lack of sanitation facilities. Toxic fumes enter the atmosphere, generated
by using wood as a cooking fuel and the burning of trash by many small farms. Pollution due
to poverty extends to the cities of less-developed countries, in the slums and shanty towns
where unclean water and a lack of sanitation create environmental hazards for the poor urban
dwellers who crowd into areas that are too small and lacking in necessary services.

Pollution arising from affluence is the environmental damage due to increased industrial
production and from higher-income consumption patterns, such as the proliferation of private
motor vehicles and of non-recyclable waste and refuse that contribute to air, land, and water
degradation. This type of pollution tends to increase with economic growth, while pollution
from poverty tends to decrease, and it is not clear that they cancel out over time with world-
wide economic expansion. Both pollution arising from poverty and pollution due to affluence
can have local and global effects. Pollution has been blamed for global warming, the
depletion of the ozone layer, desertification, and species extinction. The danger is that
degradation of the water, air, and land has set in motion potentially irreversible processes, the
effects of which, if unchecked, could have devastating consequences for future generations.
There thus is a compelling need to find the means and the will to balance the pressing need
for continued economic growth and a better distribution of income and wealth in the poorest
nations against the effects this can have on the natural environment.

63
SUMMARY

 Historically, development was mostly perceived in terms of economic performance.

However, today, development is not about economic performance alone, but most
importantly about people and their well-being.

 There are two broad methodologies in measuring economic development the income per
person or economic growth criterion and the social indicators criteria.

 Social indicators are often referred to as the basic needs for development. Basic needs
focus on alleviation of poverty by providing basic human needs to the poor.

 Morris combines three component indicators of infant mortality, life expectancy at age 1
and basic literacy at age 15 to measure performance in meeting the most basic needs of
the people.

 Since 1990, the UNDP has been presenting the measurement of human development in
terms of a Human Development Index (HDI) HDI is a composite index of three social
indicators: life expectancy, educational attainment and real GDP per capita.

 The traditional economic development literature considered highly unequal income and
wealth distribution as a necessary condition for continued and rapid economic growth.

 The new political economy literature, on the other hand, links greater inequality to lower
future growth paths, and considers it an impediment to poverty-reducing growth.

 Lorenz Curve is a common way of analyzing personal income statistics. It is constructed

by plotting number of income recipients on the horizontal axis (in cumulative percentage)
and total income percentage (cumulative) shared by each percentage of the population on
the vertical axis.

 Gini coefficients are aggregate inequality measures. It is obtained by calculating the ratio
of the area between the diagonal and the Lorenz curve divided by the total area of the half
square in which the curve lies.

 The thinking in income inequality and development was influenced by Kuznets’ inverted
U-Shaped Curve. Kuzentes suggested on the experience of the developed countries that
 historically there was a tendency for income inequality to increase first, and then to be
reduced as countries developed from a low level.

 Over the past fifty years, development economics has undergone many changes. The
emphasis has shifted from growth in GNP per capita to the creation of employment, to
redistribution of income, to basic human needs, to structural adjustment and sustainable
development.
 Sustainable development was defined by the Brundtland Commission as “development
that meets the needs of the present without compromising the ability of future generations
to meet their own needs.’’

 Some researchers have suggested there may be an environmental Kuznets curve. At

relatively low income levels, increases in economic growth result in increased pollution
and environmental destruction. However, after a threshold level of income per person is
reached, pollution and adverse environmental effects will be reduced.

REFERENCES

Cypher J. M. and J. L. Dietz, 2009. The Process of Economic Development. Third edition
Routledge, 2 Park Square, Milton Park, Abingdon

Kuznets, Simon. 1971. Economic Growth of Nations. Cambridge, MA: Harvard University
Press.

Lewis J/P. and V/ Kallab, 1983. Foreign Policy and the Third World, Agenda, New York,
USA, Greenwood Publishing Group, Inc.

Morris, Morris D. 1979. Measuring the Condition of the World’s Poor: The Physical Quality
of Life Index. New York: Pergamon Press.

Todaro M.P and S.C. Smith, 2012. .Economic Development, 11th edition, Pearson Education,
Inc, USA

United Nations Development Programme (UNDP), 1993. Human Development Report 1993.
Oxford: Oxford University Press.

United Nations Research Institute on Social Development (UNRISD), 1970. Contents and
Measurements of Socioeconomic Development United Nations, Geneva.

65
UNIT THREE

CHARACTERISTICS OF AN UDERDEVELOPED COUNTRY

Introduction

Dear Students! In the previous two Units of this module we have dealt with the basic concepts
of economic development, meaning economic growth and development and related topics. In
this Unite we shall discuss about the different areas of similarities among underdeveloped
countries. But before we study the characteristics of an underdeveloped country, it is essential
to understand the meaning of the term ‘underdeveloped.’ The term ‘underdeveloped’ has been
used in a variety of ways. ‘Underdeveloped’ and ‘undeveloped’ countries are often used as
synonyms. But these two terms are easily distinguishable. An undeveloped country is one
which has no prospects of development. An underdeveloped country, on the other hand, is one
which has no potentialities of development. The Antarctic, the Arctic and parts of the Sahara
may be termed as undeveloped, while India, Pakistan, Uganda, Columbia, Panama, etc. may
be called underdeveloped.

A “Poor” and “backward” are also used as synonyms for “underdeveloped”. A poor country
does not mean a young country. Poverty simply refers to the low level of per capita income of
a country. It has nothing to do with the country’s culture. Backward countries’ is a static term
like the term ‘underdeveloped’. So the terms ‘poor’ and ‘underdeveloped’ are
interchangeable. A more respectable term “developing countries” has also come to be used in
economic literature. Underdeveloped, because it so clearly suggests that the condition it
describes is abnormal, reprehensible and also perhaps readily rectifiable. Poor or materially
backward are the most appropriate expression. The World Bank uses the term developing
countries and divides them into low income and middle income countries. Middle income
countries are further divided into lower-middle-income and upper-middle income countries.
Of late, a new term Third World is being used. We shall be using all these terms
interchangeably throughout this module.
Objectives of the Unit

After reading this Unite, students will be able to understand and explain:

 the meaning of the term’’ underdevelopment;

 the characteristics of underdevelopment;
 obstacles to economic development in under developed countries; and
 factors of economic growth

Section 1: The Characteristics of Underdevelopment

Introduction

Dear Students! In order to examine the problems of an underdeveloped country, it is useful to

have in mind a general sketch of the economy of such a country. Though it is difficult to
locate a representative underdeveloped country on the world map, yet it is possible to focus
attention on some of its characteristics. These characteristics will be discussed in this section.

Objectives of the section

After reading this section, students will be able to understand and explain:

 the general poverty gap between the developed and developing nations;
 the agricultural sector as the main occupation of underdeveloped countries;
 the dualistic economic characteristics of underdeveloped countries;
 the underdeveloped natural resources and demographic features;
 the dimensions of unemployment;
 the Economic and technological backwardness; and
 Foreign trade orientation

3.1.1 General Poverty

An underdeveloped country is poverty-ridden. Poverty is reflected in low GNP per capita.

According to the World Development Report, 1999-2000, 59.6 per cent of the world
population in 1998 living in low-income economies has GNP per capita of $760 or less; 25.4

73
per cent in middle income economies had $761 to $9,360; and 15.0 per cent in high-income
economies had $9,361 or more. The extremely low GNP per capita of low-income economies
reflects the extent of poverty in them. Further, the World Bank Report pointed out vast
income disparities among nations. It should be known, however, that it is not relative poverty
but absolute poverty that is more important in assessing such economies. Absolute poverty is
measured not only by low income but also by malnutrition, poor health, clothing, shelter and
lack of education. Thus absolute poverty is reflected in low living standards of the people. In
such countries, food is the major item of consumption and about 80 per cent of the income is
spent on it as compared with 20 per cent in advanced countries. The vast majority of the
people in LDCs are ill-fed, ill-clothed, ill-housed and ill-educated. The number of people in
absolute poverty in LDCs, excluding China, is estimated at about 1,000 million. Half of them
live in South Asia, mainly in India and Bangladesh; a sixth live in East and Southeast Asia,
mainly in Indonesia; another sixth is Sub-Saharan Africa; and the rest in Latin America, North
Africa and the Middle East. Poverty is, therefore, the basic malady of an underdeveloped
country which is involved in ‘misery-go-round.

3.1.2 Agriculture, the Main Occupation

In underdeveloped countries two-thirds or more of the people live in rural areas and their
main occupation is agriculture. There are large times as many people occupied in agriculture
in some underdeveloped countries as there are in advanced countries. In low-income countries
like China, Kenya, Ethiopia and Vietnam, more than 71 per cent of the population is engaged
in agriculture while the percentages for the United States, Canada and West Germany are 3, 3
and 4 respectively. This heavy concentration in agriculture is a symptom of poverty.
Agriculture, as the main occupation, is mostly unproductive. It is carried on in an old fashion
with obsolete and outdated methods of production.

The average land holdings are as low as 1 to 3 hectares which usually support 10 to 15 people
per hectare. As a result, the yield from land is precariously low and the peasants continue to
live at a bare subsistence level. We can, therefore, say that an underdeveloped country is a
primary sector economy. Besides the primary sector there is the underdeveloped secondary
sector with a few simple, light and small consumer goods industries and an equally
underdeveloped tertiary sector; i.e., transport, commerce, banking and insurance services. In
some of the low-income countries such as Bangladesh, Ethiopia, Nepal, Uganda, Ghana and
Tanzania the share of agriculture in GDP continues to be more than 40 per cent and the share
of industry and manufacturing stands at less than 20 per cent.

3.1.3 A Dualistic Economy

Almost all underdeveloped countries have a dualistic economy. One is the market economy;
the other is the subsistence economy. One is in and near the towns; the other is in the rural
areas. One is developed, the other is less developed. Centered in the towns, the market
economy, ultra-modern with all amenities of life. The subsistence economy is backward and
is mainly agriculture-oriented. Dualism is also characterized by the existence of an advanced
industrial system and an indigenous backward agricultural system. The industrial sector uses
capital-intensive techniques and produces variety of capital goods and durable consumer
goods. The rural sector is engaged in producing agricultural commodities with traditional
techniques. Both perpetuate unemployment and disguised unemployment. There is also
financial dualism consisting of the unorganized money market charging very high interest
rates on loans and the organized money market with low interest rates and abundant credit
facilities. This aggravates economic dualism between the traditional sector and the modern
industrial sector

3.1.4 Underdeveloped Natural Resources

The natural resources of an underdeveloped country are underdeveloped in the sense that they
are either unutilized or underutilized. A country may be deficient in natural resource, but it
cannot be so in the absolute sense. Although a country may be poor in resources, it is just
possible that in the future it may become rich in resources as a result of the discovery of
presently unknown resources or because new uses may be found for the known resources.
Thus instead of saying that underdeveloped countries are absolutely deficient in natural
resources, it is more appropriate to say that they have not been successful in overcoming the
scarcity of natural resources by appropriate changes in technology and social and economic
organization. Generally speaking, they are not deficient in land, mineral, water, forest or
power resources.

75
3.1.5 Demographic Features

Underdeveloped countries differ greatly in demographic position and trends. Diversity exists
in the size, density, age-structure and the rate of growth of population. But there appears to be
one common feature, a rapidly increasing population which adds a substantial number to the
total population every year. With their low per capita incomes and low rates of capital
formation, it becomes difficult for such countries to support this additional number. And when
output increases due to improved technology and capital formation, it is swallowed up by
increased population. As a result, there is no marked improvement in the living standards of
the masses. Warning about the increase in numbers, Keen Layside writes “The womb is
slower than the bomb but it may prove just as deadly. Suffocation rather than incineration
may mark the end of the human story”.

Almost all the underdeveloped countries possess high population growth potential
characterized by high birth-rate and high but declining death-rate. The advancement made by
medical science has resulted in the discovery of marvelous drugs and the introduction of
better methods of public health and save reduced mortality and increased fertility. Declining
death-rates and increasing birth-rates give a very high natural growth rate of population. The
average annual growth rate of population in developing countries is 2 per cent as compared
with about 0.7 per cent in developed countries. This rapid increase in numbers aggravates the
shortage of capital in such economies because large investments are required to be made to
equip the growing labor force even with obsolete equipment.

An important consequence of high birth-rate is that a larger proportion of the total population
is in young age groups. The percentage of population under 15 years of age is about 40 per
cent in developing countries, compared with only 20 to 25 per cent in developed countries.
Moreover, 90 per cent of the dependents are children in LDCs whereas their percentage is
only 66 in developed countries. A large percentage of children in the population entail a
heavy burden on the economy which implies a large number of dependents who do not
produce at all but do consume. With many dependents to support, it becomes difficult for the
workers to save for purposes of investment in capital equipment. It is also a problem for them
to provide their children with the education and bare necessities of life that are essential for
the country’s economic and social progress in the long run. Underdeveloped countries have
also a shorter life expectancy. Average life expectancy at birth is roughly 51 years in low
income countries whereas in the developed countries it is 75 years. Low life expectancy
means that there are more children to support and few adults to provide for them which inhibit
the rate of economic growth.

3.1.6 Unemployment and Disguised Unemployment

In underdeveloped countries there is vast open unemployment and disguised unemployment.

The unemployment is spreading with urbanization and the spread of education. But the
industrial sector has failed to expand along with the growth of labor force thereby increasing
urban unemployment. Then there are the educated unemployed who fail to get jobs due to
structural rigidities and the lack of manpower planning. But underemployment or disguised or
concealed unemployment is a notable feature of underdeveloped countries. Such
unemployment is not voluntary but involuntary. People are prepared to work but they are
unable to find work throughout the year due to the lack of complementary factors. Such
unemployment is found among rural landless and small farmers due to the seasonal nature of
farm operations and inefficient land and equipment to keep them fully employed.

A person is said to be disguised unemployed if his contribution to output is less than what he
can produce by working for normal hours per day. His marginal productivity is nil or
negligible, and by withdrawing such laborers, farm output can be increased. There are also
other types of underemployed persons in such countries. A person is considered to be
underemployed if he is forced by unemployment to take a job that he thinks is not adequate
for his purpose, or not commensurate with his training.

3.1.7 Economic Backwardness

In underdeveloped countries particular manifestations of economic backwardness are low

labor efficiency, factor immobility, limited specialization in occupation and in trade,
economic ignorance, values and social structure that minimize the incentive for economic
change. The low labor efficiency results from general poverty which is reflected in low
nutritional standards, ill health, illiteracy and lack of training and occupational mobility, etc.
There is also occupational immobility of labor due to the joint family system and the caste
system. Certain cultural and psychological factors are more dominant than wage rates in

77
determining the supply of labor. The joint family system makes people lethargic and stay-at-
home. In many underdeveloped countries, certain occupations are reserved for members of
some particular castes, religion, race, tribe or sex. Underdeveloped countries have what might
be termed “an uneconomic culture.” Primarily, this means that traditional attitudes discourage
the full utilization of human resources.
There is lack of entrepreneurial ability. Entrepreneurship is inhibited by the social system
which denies opportunities for creative faculties. The force of custom, the rigidity of status
and the distrust of new ideas and of the exercise of intellectual curiosity, combine to create an
atmosphere inimical to experiment and innovation. The small size of the market, lack of
capital, absence of private property, absence of freedom of contract and of law and order
hamper enterprise and initiative.

3.1.8 Technological Backwardness

Yet another characteristics of underdeveloped countries is the backward state of technology.

Their technological backwardness is reflected in Firstly, in high average cost of production
despite low money wages; secondly, in high labor-output and capital-output ratios as a rule,
and on the average, given constant factor prices thus reflecting a generally low productivity of
labour and capital; thirdly, in the predominance of unskilled and untrained workers; and
Lastly, in the large amount of capital equipment required to produce a national output.
Deficiency of capital hinders the process of scrapping off the old techniques and the
installation of modern techniques. Illiteracy and absence of a skilled labor are the other major
hurdles in the spread of techniques in the backward economy. Thus it may be pointed out that
technological backwardness is not only the cause of economic backwardness, but it is also the
result of it.” This technological backwardness is leads to technological dualism which implies
the use of different production functions in the advanced sector and the traditional sector of
the economy. The existence of such dualism has accelerated the problem of structural or
technological unemployment in the industrial sector and disguised unemployment in the rural
sector.

3.1.9 Foreign Trade Orientation

Underdeveloped economies are generally foreign trade-oriented. This orientation is reflected

in exports of primary products and imports of consumer goods and machinery. The
percentage share of fuels, minerals, metals, and other primary products in the merchandise
exports of the majority of LDCs, as revealed by the recent World Bank data is on the average
about 80 per cent. For instance, the share of Ethiopia is 99 per cent, of Burma 97 per cent, of
Uganda 99 per cent, of Indonesia 96 per cent, of Malaysia 80 per cent, Algeria 100 per cent,
and of Kenya 86 per cent. This, too much, dependence on exports of primary products leads to
serious repercussions on their economies. Firstly, the economy concentrates mainly on the
production of primary exports to the comparative neglect of the other sectors of the economy.
Secondly, the economy becomes particularly susceptible to fluctuations in the international
price of the export commodities. A depression abroad brings down their demand and prices.
As a result, the entire economy is adversely affected. Lastly, too much dependence on a few
export commodities to the utter neglect of the other consumption goods has made these
economies highly dependent on imports.

Imports generally consist of fuel, manufactured articles, primary commodities, machinery and
transport equipment, and even food. Coupled with these is the operation of the demonstration
effect which tends to raise the propensity to import still further. Of late, there has been a
secular decline in the income terms of trade (capacity to import) of the underdeveloped
countries so that they are faced with the balance of payments difficulties. An underdeveloped
country’s weak export capacity relatively to its strong import needs is reflected in its
persistent external indebtedness. The foreign trade orientation also manifests itself through the
flow of foreign capital to underdeveloped countries. Foreign capital has tended to monopolize
its position in certain selected fields like minerals, plantations, and petroleum in
underdeveloped countries. The multi-national corporations (MNCs) from the developed
countries have spread themselves in developing countries in manufacturing, export-oriented
plantations, petroleum and mining. Such a widespread hold of foreign capital drains their
resources. The foreigners are interested only in maximizing their gains at the expense of the
developing counties.

Section 2: Obstacles to Economic Development in the Under Developed Countries

Introduction

Dear Students! The basic characteristics of underdeveloped countries discussed in the

preceding section might as well be regarded as the obstacles to economic development. Even

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though the general characteristics of underdevelopment are not common to all the
underdeveloped countries, yet a broad answer to the question ‘why a poor country is poor?’ is
implicit in these characteristics. A number of these characteristics are both the cause and
consequence of poverty. In this section we discuss factors and analyze the mutual causative
relationships that inhibit development.

Objectives of the section

After reading this section, students will be able to understand and explain:
 the vicious circles of poverty;
 the capital formation constrains and is causes;
 the socio-cultural constraints to economic change;
 the agricultural constraint and the environment in which farmers operate; and
 the foreign exchange constraint and disequalizing forces in the international market
3.2.1 Vicious Circles of Poverty

The vicious circles of poverty are the circular relationships that tend to perpetuate the low
level of development in LDCs. It implies a circular constellation of forces tending to act and
react upon one another in such a way as to keep a poor country in a state of poverty. For
example, a poor man may not have enough to eat; being underfed, his health may be weak;
being physically weak, his working capacity is low, which means that he is poor, which in
turn means that he will not have enough to eat; and so on. A situation of this sort relating to a
country as a whole can be summed up in the trite proposition: “A country is poor because it is
poor.” The basic vicious circle stems from the fact that in LDCs total productivity is low due
to deficiency of capital, market imperfections, economic backwardness and
underdevelopment. However, the vicious circles operate both on the demand side and the
supply side.

The demand side of the vicious circle is that the low level of real income leads to a low level
of demand which, in turn, leads to a low rate of investment and hence back to deficiency of
capital, low productivity and low income. This is shown in Figure 3. Vicious circle of
underdevelopment is a self-feeding mechanism which can be explained using demand side or
supply side of the economy. The demand side basically tries to show how the economy fails
to improve demand condition in the economy. Underdeveloped country suffers from lack of
industrialization and at the same time increasing population puts pressure on agriculture.
Excessive labor employed in agriculture reduces the productivity to a very low level. Low
productivity means subsistence level of output with very less surplus. With very little surplus
from agriculture, demand for industrial products will be low leading to lack of
industrialization and underemployment.

Low productivity Low agricultural surplus

Over population in Low demand for

agriculture industrial product

Lack of Industrialization

Underdevelopment

Figure 3: Vicious Circle: demand side

On the supply side, in an underdeveloped economy, per capita income is low leading to low
level of savings in the economy. Low level of saving leads to low level of investment and
hence low level of capital formation. With low level of capital formation, capital per worker is
low resulting low productivity. Low productivity means low per capita income and
underdevelopment. Hence the circle is complete. The supply side circle can be seen from
Figure 4. Low productivity is reflected in low real income. The low level of real income
means low saving. The low level of saving leads to a low investment and to deficiency of
capital. The deficiency of capital, in turn, leads to a low level of productivity and back to low
income. Thus the vicious circle is complete from the supply side. The low level of real
income, reflecting low investment and capital deficiency is a common feature of both vicious
circles.

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 Economic
underdevelopment

Low per capita income

Low Productivity Low savings

Low capital per worker Low capital formation

Figure 4: Vicious Circle- supply side

A third vicious circle envelops underdeveloped human and natural resources. Development of
natural resources is dependent upon the productive capacity of the people in the country. If
the people are backward and illiterate, lack in technical skill, knowledge and entrepreneurial
activity, the natural resources will tend to remain unutilized, underutilized or even mis-
utilized. On the other hand, people are economically backward in a country due to
underdeveloped natural resources. Underdeveloped natural resources are, therefore, both a
consequence and cause of the backward people as explained in Figure 5.

Market imperfection

Underdeveloped Natural Resource

Backward People

Figure 5: Vicious circle of underdeveloped human and natural resources

Poverty and underdevelopment of the economy are thus synonymous. A country is poor
because it is underdeveloped. A country is underdeveloped because it is poor and remains
underdeveloped as it has no the necessary resources for promoting development. Poverty is a
curse, but a greater curse is that it is self-perpetuating.
3.2.2 Low Rate of Capital Formation

The most pertinent obstacle to economic development is the shortage of capital. This stems
from the vicious circles of poverty analyzed above. Poverty is both a cause and a consequence
of a country’s low rate of capital formation. In an underdeveloped country, the masses are
poverty-ridden. They are mostly illiterate and unskilled, use outmoded capital equipment and
methods of production. They practice subsistence farming, lack mobility and have little
connection with the market sector of the economy. Their marginal productivity is extremely
low. Low productivity leads to low real income, low saving, low investment and to a low rate
of capital formation. The consumption level is already so low that it is difficult to restrict it
further to increase the capital stock. That is why millions of farmers in such countries use
outmoded and obsolete capital equipment.

It is the high income group that does most of the saving in underdeveloped countries. But
these savings do not flow into productive channels. On the other hand, they are dissipated
into real estate, gold, jewellery, commodity hoards and hoards of foreign or domestic
currency, money lending and speculation. Thus ‘Value-retaining’ objects and durable
consumer goods dominate their expenditure pattern. In addition, conspicuous consumption
plays an important part in their consumption pattern. Consequently, they prefer an imported
article for its prestige value to an equally good domestic article. In addition to these imperfect
maintenance of law and order, political instability, unsettled monetary conditions, lack of
continuity in economic life, the extended family system with its drain on resources, and its
stifling of personal initiative and certain system of land tenure also contribute to low level of
saving and investment in LDCs.

3.2.3 Socio-Cultural Constraints

Economic development has much to do with human endowments, social attitudes, political
conditions and historical accidents. Capital is a necessary but not a sufficient condition of
progress. There are elements of social resistance to economic change in underdeveloped
countries which include institutional factors characterized by ‘rigid’ stratification of
occupations reinforced by traditional beliefs and values; attitudes involving inferior valuation
attached to business roles and their incompatibility with the patterns of living and concepts of
social dignity upheld by the high status groups and ‘factionalism’ which has been defined as

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‘the tendency of the society to be divided by caste and class cleavages, ethnic or religious
distinctions, differences in cultural tradition and social pattern, kinship loyalties and regional
identification. Such factors tend to inhibit social and geographical mobility and constitute a
drag on progress. The people of such countries are averse to accept new values created by the
impact of innovations.

In such a society efficiency suffers because special abilities go unused. Moreover, social
attitude towards education is further inimical to economic progress. Purely academic
education which trains people for government and other clerical jobs is preferred to technical
and professional education in such countries. There is prejudice against manual work which is
despised and ill-rewarded. Oriental religions place high values on leisure, contentment and
participation in festivals and religious ceremonies. People in such countries consider work as
a necessary evil-rather than a virtue. People do not believe that progress is possible through
human efforts and man is not helpless before the blind forces of fate. Religious dogmas
inhibit progress, for they prevent social, economic and political institutions to change in a way
that is conducive to economic development.

3.2.4 Agricultural Constraint

The majority of LDCs are predominantly agricultural production, which is controlled by

custom and tradition. It is, in fact, not the behavior of farmers that acts as a constraint on
agricultural growth. Instead, the constraints are to be found in the environment in which
farmers operate: the technology available to them, the incentives for production and
investment, the availability and price of inputs, the provision of irrigation, and the climate.
The LDCs situated in tropical and sub-tropical zones are at a disadvantage in terms of climate.
Due to heat and torrential rains, their soils are poor as they contain little organic matter. As a
result of the environmental factors, agricultural output fails to increase to meet the rising
demand of the developing economy. Further, when the growth rate of population is also high,
per capita agricultural and food output may actually decline instead of increasing. Thus the
poor performance of the agricultural sector is a major constraint on the sluggish economic
growth of LDCs.
3.2.5 Foreign Exchange Constraint

Economists like Myint, Prebisch, Singer, Lewis and Myrdal maintain that certain dis-
equalizing forces have been operating in the world economy as a result of which the gains
from trade have gone mainly to the developed countries leading to foreign exchange
constraint. After the opening up of underdeveloped countries to world markets, there has been
a phenomenal rise in their exports. But this has not contributed much to the development of
the rest of the economy of these countries, as the export sector has developed to the utter
neglect of the other sectors of the economy. On the other hand, too much dependence on
exports had exposed these economies to international fluctuations in the demand for and
prices of their products. They have become unstable due to cyclical instability and balance of
payments difficulties. During a depression, the terms of trade become adverse and foreign
exchange earnings fall steeply. As a result, they suffer from unfavorable balance of payments.

They are unable to take advantage of a fall in the prices of their products by increasing their
exports due to the inelastic nature of supply (because of structural rigidity of their production
system) of their export goods which are mainly agricultural and mineral products. On the
contrary, increased export earnings lead to inflationary pressure, misallocation of investment
expenditure and to balance of payments difficulties. As a result, there has been a secular
deterioration in the income terms of trade (or the capacity to import) of LDCs so that they are
faced with the foreign exchange constraint. This has led to the need for larger inflow of aid
and foreign investment. Consequently, debt servicing of amortization and interest have risen,
income payments of dividends and profits on private direct foreign investment have grown
and the net inflow of foreign capital has declined. All these have led to further shortage of
foreign exchange reserves which acts as a severe limitation on the development program of
LDCs.

Section 3: Factors of Economic Growth

Introduction
Dear student! The process of economic growth is determined by two types of factors,
economic and non-economic. Economic growth is dependent upon its natural resources,
human resources, capital, enterprise, technology, etc. These are economic factors. But
economic growth is not possible so long as social institutions, political conditions and moral

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values in a nation do not encourage development. These are non-economic factors. In this
section we study these economic and non-economic determinants of economic growth
separately.

Objectives of the section

After reading this section, students will be able to understand and explain:

 the economic factors of economic growth; and

 the non-economic factors of economic growth

3.3.1 Economic Factors of Economic Growth

Economists regard factors of production as the main economic forces that determine growth.
The growth rate of the economy rises or falls as a consequence of changes in them. Some of
the economic factors are discussed below

3.3.1.1 Natural resources

The principal factor affecting the development of an economy is the natural resources or land.
Land as used in economics includes natural resources such as the fertility of land, its situation
and composition, forest wealth, minerals, climate, water resources, sea resources etc. For
economic growth, the existence of natural resources in abundance is essential. A country
which is deficient in natural resources will not be in a position to develop rapidly. As pointed
out by Lewis, other things being equal, men can make better use of rich resources than they
can make of poor resources.

In LDCs, natural resources are unutilized, underutilized or misutilized. This is one of the
reasons for their backwardness. The presence of abundant resources is not sufficient for
economic growth. What is required is their proper exploitation. This is due to economic
backwardness and lack of technological factors. Therefore, natural resources can be
developed through improved technology and increase in knowledge. For example, Britain
underwent agricultural revolution by adopting the method of rotation of crops. Similarly,
France was able to revolutionize its agriculture on the British pattern despite shortage of land.
On the other hand, the countries of Asia and Africa have not been able to develop their
agriculture because they have been using old methods of production. It is often said that
economic growth is possible even when an economy is deficient in natural resources. As
pointed out by Lewis, a country which is considered to be poor in resources today may be
considered very rich in resources at some later time, not merely because unknown resources
are discovered, but equally because new uses are discovered for the known resources. Japan is
one such country which is deficient in natural resources but it is one of the advanced countries
of the world because it has been able to discover new uses for limited resources. Thus for
economic growth the existence of abundant natural resources is not enough. What is essential
is their proper exploitation through improved techniques so that there is little wastage and
they could be utilized for a longer time.

3.3.1.2 Capital accumulation

Capital means the stock of physical reproducible factors of production. When the capital stock
increases with the passage of time, this is called capital accumulation (or capital formation).
The process of capital formation is cumulative and self-feeding and includes three inter-
related stages: the existence of real savings and rise in them; the existence of credit and
financial institutions to mobilize savings and to divert them in desired channels; and to use
these savings for investment in capital goods. There are various possibilities of increasing the
rate of capital accumulation. Since the propensity to save is low in an LDC, voluntary savings
will not be forthcoming in sufficient quantities. Therefore, the obvious way is to resort to
forced savings. Forced savings reduce consumption and thereby release resources for capital
formation.

The various methods of forced savings are taxation, deficit financing and borrowing. Nurkse
also suggests mobilization of the disguised unemployed in rural areas for construction works
as an important means for capital formation in LDCs. Besides, there are external resources in
the form of loans, grants and larger exports that can help in capital formation. Capital
formation is the main key to economic growth. On the one hand, it reflects effective demand
and, on the other hand, it creates productive efficiency for future production. Investment in
capital goods not only raises production but also employment opportunities. It is capital
formation that leads to technological progress. Technological progress in turn leads to
specialization and the economies of large-scale production.

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Capital formation helps in providing machines, tools and equipment for the rising labour
force. The provision for social and economic overheads like transport, power, education, etc.,
in the country is possible through capital formation. It is also capital formation that leads to
the exploitation of natural resources, industrialization and expansion of markets which are
essential for economic progress. According to Lewis, the rate of capital formation in LDCs is
5 per cent or less which should be raised to the level of 12 to 15 per cent. The estimates of
Kuznets reveal that during modern economic growth gross capital formation in developed
countries was from 11-13 per cent and rose to 20 per cent and above while net capital
formation was form 6 per cent to 12-14 per cent.

3.3.1.3 Organization

It is an important part of the growth process. It relates to the optimum use of factors of
production in economic activities. Organization is complement to capital and labor and helps
in increasing their productivities. In modern economic growth, the entrepreneur has been
performing the task of an organizer and undertaking risks and uncertainties. But LDCs lack in
entrepreneurial activity. LDCs should create a climate for encouraging entrepreneurship.
Besides, it requires the establishment of financial institutions which collect savings and
channelize them for entrepreneurial activities. The government should also adopt such
monetary and fiscal policies which encourage the growth of entrepreneurship.

3.3.1.4 Technological progress

The changes in technology lead to increase in the productivity of labor, capital and other
factors of production. Kuznets traces five distinct patterns in the growth of technology in
modern economic growth. They are a scientific discovery or an addition to technical
knowledge; an invention; an innovation; an improvement; and the spread of invention usually
accompanied by improvements. In modern economic growth the five factors, mentioned by
Kuznets, have helped in the development of technology. He points out that LDCs must import
modern technology to accelerate their productive capacity in the short run because they
cannot wait until they themselves invent or modify the technology of advanced countries. But
as they adopt imported technology, they must develop their indigenous technical kills.
3.3.1.5 Division of labor and scale of production

The specialization and division of labor lead to increase in productivity. They lead to
economies of large-scale production which further help in industrial development. Adam
Smith gave much importance to the division of labor in economic development that it
increases productive capacities of labor. Every laborer becomes more efficient than before
and saves time. He is also capable of inventing new machines and processes in production.
Ultimately, production increases manifold. But division of labor depends upon size of the
market. The size of the market, in turn, depends upon economic progress, that is, the size of
demand, the general level of production, the means of transport, etc., and when the scale of
production is large there is greater specialization and division of labor.

3.3.1.6 Structural changes

Structural changes imply the transition from a traditional agricultural society to a modern
industrial economy involving a radical transformation of existing institutions, social attitudes,
and motivations. Such structural changes lead to increasing employment opportunities, higher
labor productivity and the stock of capital, exploitation of new resources and improvements in
technology. In short we can say that an LDC is characterized by a large primary sector and a
very small secondary sector along with an equally small tertiary sector. Structural changes
may begin with the transfer of labor from the primary to secondary and then to tertiary
employment.

In an over populated agriculture-oriented economy, 70-80 per cent of the population is

engaged in the agricultural sector. Structural changes involve the expansion of the non-
agricultural sector so that the proportion of population in the agricultural sector is
progressively reduced. It implies reduction in the size of contribution to net national output by
the agricultural sector. But a decline in the share of the agricultural sector in the net national
product does not mean a fall in the output of agricultural sector. When agricultural production
increases, it increases money income in the agricultural sector. This, in turn, expands rural
demand for consumer goods and agricultural inputs which act as stimulants to the expansion
of the industrial sector.

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3.3.2 Non-economic Factors of Economic Growth

I hope you have a good idea of the economic factors of growth. Now let’s turn to the other
factors namely the non-economic factors.

3.3.2.1 Social factors

The social attitudes, values and institutions also influence economic growth. The term
“attitude” means the totality of beliefs and values that cause human behavior to be what it is.
The term “values” refers to motivations of human behavior towards particular ends. Modern
economic growth has been influenced by social and psychological factors. Western culture
and education led to reasoning and skepticism. It inculcated the spirit of adventure which led
to new discoveries and inventions and consequently to the rise of the new mercantile classes.
These forces brought about changes in social attitudes, expectations, and values. People
cultivated the habits of saving and investment, and assumed risks to earn profits. They
developed what Lewis calls, ‘the will to economize,” to maximize output for a given input. As
a result, the European countries experienced the Industrial Revolution in the 18th and 19th
centuries. Economic and religious freedom brought about further changes in social attitudes
and values. Single family unit took the place of joint family system which further helped in
modern economic growth.

In LDCs there are such social attitudes, values and institutions which are not conducive to
economic development. Religion gives less inducements to the virtues of thrift and hard work.
People are fatalists and therefore are not hard working. They are influenced more by
traditional customs and place high values on leisure, contentment and participation in festivals
and ceremonies. Thus social attitudes stand in the way of development when money is wasted
on non-economic ventures. Moreover, the joint family is the primary social and economic
unit. It prevents people from taking independent economic decisions, breeds lethargy, and
encourages growth in numbers. In such societies relations are personal or patriarchal. People
are influenced by caste, clan or creed at the social level. These social attitudes, values and
institutions should be changed or modified for economic development to take place. Social
organizations like the joint family, caste system, kinship, and religious dogmas should be
modified so that they may be more favorable to development. But it is not an easy task. Any
social change will bring discontentment and resistance in its wake.
3.3.2.2 Human factor

Human resources have been an important factor in modern economic growth. Economic
growth is attributed to the development of the human factor which is reflected in the increased
efficiency or productivity of labor force. This is called human capital formation. This “is the
process of increasing knowledge, the skills, and the capacities of all people of the country.” It
includes expenditure on health, education and generally on social services. For example
estimates reveal that the expenditure incurred on education in the United States from 1929-57
contributed 23 percent to its gross national output. But rapidly increasing population is a great
hindrance to the economic development of LDCs. With their low per capita incomes and low
rates of capital formation, it becomes difficult for them to support the increase in population.
And when output increases due to improved technology and capital formation, it is swallowed
up by the increase in numbers. As a result, there is no improvement in the real growth rate of
the economy.

A proper use of human resources can be made for economic development in the following
ways. First, there should be control over population. Human resources can be utilized best if
the size of population is controlled and reduced. This requires family planning and research
on population control so as to bring down the birth-rate. Second, there should be change in the
outlook of the labor force. The social behavior of the labor force is important in the process of
economic development. To increase labor productivity and the mobility of labor there should
be change in the outlook of the people so that they should imbibe the importance of dignity of
labor. This requires changes in institutional and social factors. Such changes depend upon the
spread of education. It is the educated and trained labor force with high productive efficiency
that leads to rapid economic development. Thus “the most important requirement of rapid
industrial growth is people. People ready to welcome the challenge of economic change and
the opportunities in it.

3.3.2.3 Political and administrative factors

Political and administrative factors also helped in modern economic growth. The economic
growth of Britain, Germany, the United States, Japan and France has been due to their
political stability and strong administration since the 19th century. With the exception of the
United States, they were directly involved in the two World Wars and were devastated. Still

91
they have continued to progress on the strength of their political and administrative traditions.
On the other hand, Italy has not been able to grow up to their level due to political instability
and corrupt and weak administration. Peace, protection and stability have encouraged the
development of entrepreneurship in developed countries, along with the adoption of
appropriate fiscal and monetary policies by the governments from time to time.

The weak administrative and political structure is a big hindrance to the economic
development of LDCs. A strong, efficient and non-corrupt administration is, therefore,
essential for economic development. Professor Lewis rightly observes: “The behavior of
government plays an important role in stimulating or discouraging economic activity.” Peace,
stability and legal protection encourages entrepreneurship. The greater the freedom, the more
the entrepreneurship will prosper. Technical progress, factor mobility and large size of market
help stimulate enterprise and initiative. But the former can only take place under clean
administration and stable political conditions. Similarly, a good government can help in
capital formation by adopting the right monetary and fiscal policies, and by providing timely
overhead capital facilities.

All LDCs have emerged as independent nations from the colonial rule. But independence has
not necessarily led to national consolidation. Myrdal regards national consolidation as “a pre-
condition both for the preservation of the states as a growing concern and for its efficient
functioning as a matrix for the effective formation an execution of national policies, that is,
for planning.” By national consolidation he means “a national system of government, courts
and administration that is effective, cohesive, and internally united in purpose and action, with
unchallenged authority over all regions and groups within the boundaries of the state.”
National consolidation, in turn, requires “emotional integration” which coincides with the
modernization ideas of changes in values, attitudes and institutions.
SUMMARY

 An underdeveloped country is one which has no potentialities of development.

Underdeveloped, because it so clearly suggests that the condition it describes is abnormal,
reprehensible and also perhaps readily rectifiable. A poor, backward, developing and third
world countries are also used as synonyms for underdeveloped countries.

 An underdeveloped country is poverty-ridden. It is not relative poverty but absolute

poverty that is more important in assessing such economies. In underdeveloped countries
two-thirds or more of the people live in rural areas and their main occupation is
agriculture. Agriculture, as the main occupation, is mostly unproductive.

 Almost all underdeveloped countries have a dualistic economy. One is the advanced
industrial system and the other is an indigenous backward agricultural system. The natural
resources of an underdeveloped country are underdeveloped in the sense that they are
either unutilized or underutilized.

 Underdeveloped countries differ greatly in demographic position and trends. Diversity

exists in the size, density, age-structure and the rate of growth of population. In
underdeveloped countries there is vast open unemployment and disguised unemployment.

 In underdeveloped countries particular manifestations of economic backwardness are low

labor efficiency, factor immobility, limited specialization Yet another characteristics of
underdeveloped countries is the backward state of technology reflected in high average
cost of production, high labor-output and capital-output ratios.

 Underdeveloped economies foreign trade orientation is reflected in exports of primary

products and imports of consumer goods and machinery.

 The vicious circles of poverty are the circular relationships that tend to perpetuate the low
level of development in LDCs. The vicious circles operate both on the demand side and
the supply side.

 The most pertinent obstacle to economic development is the shortage of capital, social
attitudes, political conditions and historical accidents.

93
 The constraint on agricultural grow are the technology available to them, the incentives
for production and investment, the availability and price of inputs, the provision of
irrigation, and the climate.

 The process of economic growth is determined by two types of factors, economic and
non-economic factors. Economic growth is dependent upon its natural resources, human
resources, capital, enterprise, technology, etc. The non-economic factors are the social
institutions, political conditions and moral values in a nation.

REFERENCES

Cypher J. M. and J. L. Dietz, 2009. The Process of Economic Development. Third edition
Routledge, 2 Park Square, Milton Park, Abingdon

Sachs Jeffrey. 2005. The End of Poverty: Economic Possibilities for Our Time, New York:
Penguin Books.

Todaro M.P and S.C. Smith, 2012. .Economic Development, 11th edition, Pearson Education,
Inc, USA

World Bank. 1990. World Development Report 1990. Oxford, Oxford University Press.
UNIT FOUR

THEORIES OF ECONOMIC GROWTH AND DEVELOPMENT

Introduction

Dear Students As we learned in the previous Units, the pursuit of economic growth and
development as a socially desirable goal is of relatively recent origin, being more-or-less
contemporaneous with the rise of capitalism as an economic system. The Industrial
Revolution in England in the mid-eighteenth century provides a convenient date for the
emergence of systematic and intellectual interest in understanding how and why economic
development occurs. It also marks the emergence of economics or political economy, as it
was called at that time as a separate sphere of scholarly inquiry. It was during this era that An
Inquiry into the Nature and Causes of the Wealth of Nations was composed by the Scottish
philosopher and political economist, Adam Smith. The Wealth of Nations, published in 1776,
provided a theoretical structure and explanation for the workings of the increasingly dominant
market system at the center of the new capitalist industrial economy. These political
economists are called classical because they provided the framework and bedrock ideas of
economics as a separate field of enquiry. In the first section of this Unit, the ideas and theories
of these classical economists will be discussed as they relate to economic and social progress.

After the Second World War and particularly after the quick success of the United States
financed Marshall Plan in helping to rebuild the European economies turned their attention to
the question of the economic development of less-developed regions. Among these early
pioneers of development thinking were the Nobel Laureate economist Sir Arthur Lewis and
the American economic historian Walt Whitman Rostow. In a broad sense, the ideas of these
early development economists was the 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
industrial economy. In the second section of this Unit, the ideas and theories of these
economists will be discussed.

100
Objectives of the Unit

After reading this Unit, students will be able to understand and explain:

 Adam Smith’s contribution to understanding how a capitalist market economy operates;

 David Ricardo’s theories of diminishing returns and his argument in favor of free trade;
 Schumpeterian theories of the forces of spontaneous change in a circular flow;
 Rostow’s stages of growth theory;
 Lewis’s theories of the potential role of surplus labor as a stimulant to growth; and
 The Limits to Growth Model and the harmful effects of economic growth on environment.

Section1: Classical Theories of Economic Development

Introduction

Many of the great political economists whose ideas have shaped economic inquiry down to
this day lived through the early changes brought on by the Industrial Revolution. These so-
called classical political economists attempted not only to explain the reasons for the rapid
expansion of total economic wealth that accompanied industrialization. They also tackled the
enigma of the extremes of wealth and poverty that attended this process and the lack of
development affecting a large segment of the population. Classical economists had an interest
in the wider issues of the day, not only in how society produced its output and wealth but also
in how it was distributed among competing groups with a claim on that income. However, the
classical were assuming that the capitalist order was a “natural order” that represented the
highest achievement of human development. Let us turn to discuss these classical theories.

Objectives of the section

After reading this section, students will be able to understand and explain:

 Adam Smith’s contribution to understanding how a capitalist market economy operates;

 David Ricardo’s theories of diminishing returns and his argument in favor of free trade;
 Schumpeterian Theory of the forces of spontaneous change in a circular flow.

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4.1.1 Adam Smith’s Theories

Basically, Adam Smith contributes how a capitalist market economy operates, including the
importance of the invisible hand, competition, specialization, and the law of capital
accumulation and how these interact to affect the rate of economic growth. Let us discuss
these concepts.

4.1.1.1 Natural Law/Invisible Hand

Adam Smith believes in the doctrine of ‘natural law’ or ‘invisible hand’ in economic affairs.
He regarded every person as the best judge of his self interest who should be left to pursue it
to his own advantage. In furthering his own self interest he would also further the common
good. In pursuance of this, each individual was led by an “invisible hand” which guided
market mechanism. Since every individual, if left free, will seek to maximize his own wealth,
therefore all individual, if left free, will maximize aggregate wealth. Smith was naturally
opposed to government intervention in industry and commerce and advocated the policy of
laissez-faire in economic affairs. The “invisible hand”, the automatic equilibrating mechanism
of the perfectly competitive market tended to maximize national wealth.

4.1.1.2 Competition

Smith’s concept of the invisible hand is well known by most first-year undergraduates. Often
neglected, forgotten, or ignored is the equal importance Smith placed on competition within
his philosophy of the gains expected from the market system. Competition acts as a
counterweight to and a brake on the possible excesses that greedy and self-interested behavior
might engender in its absence. An effective competitive environment is essential in restraining
the actions of producers and owners/capitalists who constantly are tempted to form cartels or
monopolies in an effort to increase their individual profits at the expense of both consumers
and workers.

Smith’s belief in the virtues of the capitalist market economy was thus not an uncritical view
that emphasized only the market’s harmonizing effects. In the absence of competition, Smith
did not assume that “greed is good” and that individual actions automatically would benefit
everyone. Nor did Smith presume that private and societal interests were always identical.
Smith was suspicious of the intentions of naturally acquisitive capitalists.

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He believed that, given the opportunity, they would eagerly monopolize markets for their own
benefit at the expense of others and might create working conditions inimical to the social and
individual development of their own workers.

4.1.1.3 Smith’s views on economic development

What is the relation of Smith’s analysis of the invisible hand and the functioning of the
market system to the forces contributing to economic growth? In a broad sense, Smith
believed capitalism to be a productive system with the potential to vastly increase human
well-being. In particular, he stressed the importance of the division of labor and the law of
capital accumulation as the primary factors contributing to economic progress or, as he
termed it, to the “wealth of nations.”

i) Division of labor

The division of labor is the starting point of Smith’s theory of economic growth. The division
of labor, or what also can be called “specialization” began to evolve rapidly with the spread of
capitalism and the factory system. Smith's most important contributions was to introduce into
economics the notion of increasing returns, based on the division of labour. It is division of
labor that results in the greatest improvement in the productive powers of labor. He attributed
this increase in productivity to the increase in the dexterity of every worker, the saving in time
to produce goods and the invention of large number of labor-saving machines. It is this
notion of increasing returns, based on the division of labor, that lay at the heart of his
optimistic vision of economic progress as a self-generating process, in contrast to later
classical economists who believed that economies would end up in a stationary state owing to
diminishing returns in agriculture, and capitalism would collapse through its own 'inner
contradictions', by which he meant competition between capitalists reducing the rate of profit,
and the alienation of workers.

The growth of output and living standards depends first and foremost on investment and
capital accumulation. Investment in turn depends on savings out of profits generated by
industry and agriculture and the degree of labor specialization (or division of labor). The
division of labor determines the level of labor productivity, but the division of labor is limited
by the extent of the market.

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The extent of the market, however, partly depends on the division of labor as the determinant
of per capita income. Increasing returns is meant rising labor productivity and per capita
income as output and employment expands, while diminishing returns means falling labor
productivity and per capita income and a limit to the employment of labor at the point where
the marginal product of labor falls to the level of the subsistence wage. Beyond that point
there will be no more employment opportunities and disguised unemployment prevails.
Increasing returns are prevalent in most industrial activities, while diminishing returns
characterize land-based activities such as agriculture and mining, because land is a fixed
factor of production and one of the incontrovertible laws of economics is that if a variable
factor is added to a fixed factor its marginal product will eventually fall (the law of
diminishing returns). Poor developing countries tend to specialize in diminishing returns
activities, while the rich developed countries tend to specialize in increasing returns activities,
and this is one of the basic explanations of the rich country-poor country divide in the world
economy.

ii) Specialization

Specialization provides greater scope for capital accumulation by enabling complex processes
to be broken up into simpler processes permitting the use of machinery. But the ability to
specialize, or the division of labor, depends on the extent of the market. Smith uses the
example of the production of pins. There is no point in installing sophisticated machinery to
deal with the different processes of pin production if the market for pins is very small. It is
only economical to use cost-saving machinery if the market is large. If the market is small,
there would be surplus production. Smith recognized, however, that increasing returns based
on the division of labor was much more a feature of industry than agriculture. The nature of
agriculture, indeed, does not admit of so many subdivisions of labor for there is no complete
separation of one business from another. This does not mean, of course, that agriculture is
unimportant in the development process. On the contrary, even though industry offers more
scope for the division of labor, it would be difficult for industry to develop at all without an
agricultural surplus, at least in the absence of imports. Smith recognized that an agricultural
surplus is necessary to support an industrial population, and labor released by improved
productivity in agriculture can be used for the production of non-agricultural goods. So
agriculture is certainly important for industrialization from the supply side.

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On the demand side, it is the agricultural surplus that gives rise to the demand for other goods,
which can be purchased with the excess supply of agricultural goods. We have here a model
of reciprocal demand between agriculture and industry, with industry demanding food from
agriculture to feed workers, and agriculture exchanging its surplus for industrial goods.
Balanced growth between agriculture and industry is essential for the growth and
development process to proceed without impediment, as also reflected by many later models
of economic development.

iii) Process of capital accumulation

Besides division of labor, Smith emphasized that capital accumulation must precede the
introduction of division of labor. Like the modern economists, Smith regarded capital
accumulation as a necessary condition for economic development. So the problem of
economic development was largely the ability of the people to save more and invest more in a
country. The rate of investment was determined by the rate of saving and savings were
invested in full. But almost all savings resulted from capital investments or the renting of
land. So only capitalists and landlords were found to be capable of saving. The labor classes
were considered to be incapable of saving. This belief was based on the “Iron Law of Wages’.
The classical economists also believed in the existence of a wages fund. The idea is that
wages tend to equal the amount necessary for the subsistence of the laborers. If the total
wages fund at any time becomes higher than the subsistence level, the labor force will
increase competition for employment and wages will come down to the subsistence level. In
such a situation, some of the workers will find it difficult to pull on below an accustomed
normal living standard.

They will, therefore, be unable to marry or bring up children. The working force will be
reduced and competition among the capitalists for employing workers would tend to raise
wages. Thus, Smith believed that “under stationary conditions, wage rates fall to the
subsistence level, whereas in periods of rapid capital accumulation, they rise above this level.
The extent to which they rise depends both upon the rate of accumulation and upon the rate of
population growth. He believed that savings found their way into investment more or less
automatically. Thus the wages fund could be increased by increasing the rate of net
investment.

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According to Smith investments were made because the capitalists expected to earn profits on
them; and the future expectations with regard to profits depended on the present climate for
investment as well as actual profits. Smith believed that profits tended to fall with economic
progress. When the rate of capital accumulation increases, increasing competition among
capitalists raises wages and tends to lower profits. In fact, it is the increasing difficulty of
finding new profitable investment outlets that leads to falling profits.

iv) Role of interest rate in economic development

Smith wrote that with the increase in prosperity, progress, and population, the rate of interest
falls, and as a result the supply of capital is augmented. The reason being that with the fall in
interest rate the moneylenders will lend more to earn more interest for the purpose of
maintaining their standard of living at the previous level. Thus the quantity of capital for
lending will increase with the fall in the rate of interest. But when the rate of interest falls
considerably the moneylenders are unable to lend more in order to earn more to maintain their
standard of living. Under these circumstances they will themselves start investing and become
entrepreneurs. Thus, even with the fall in the rate of interest there is increase in capital
accumulation and economic progress.

v) Agents of growth

According to Smith, farmers, producers and businessmen are the agents of economic progress.
The functions of these three are interrelated. To Smith, development of agriculture leads to
increase in construction works, and commerce. When agricultural surplus arises as a result of
economic development, the demand for commercial services and manufactured articles rises.
This leads to commercial progress and the establishment of manufacturing industries. On the
other hand, their development leads to increase in agricultural production when farmers use
advanced production techniques. Thus capital accumulation and economic development take
place due to the emergence of the former, the producer and the businessman.

vi) Process of growth

Taking institutional, political and natural factors for granted, Smith starts from the assumption
that a social group-we may call it a “nation” will experience a certain rate of economic growth
that is accounted for by increase in numbers and by saving.

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This induces a widening of market which in turn increases division of labor and thus increases
productivity. This process is no doubt exposed to disturbances by external factors, that are not
economic but in itself it proceeds steadily, continuously. According to Smith, this process of
growth is cumulative. When there is prosperity as a result of progress in agriculture,
manufacturing industries and commerce, it leads to capital accumulation, technical progress,
increase in population, and expansion of markets, division of labor and rise in profits
continuously. All this happens in Smith’s progressive state which is in reality the cheerful and
the hearty state to all the different orders of the society.

vii) Stationary state

The progressive state of Smith is not endless. It ultimately leads to a stationary state. It is the
scarcity of natural resources that finally stops growth. In such an opulent state, the
competition for employment would reduce wages to the subsistence level and competition
among businessmen would bring profits as low as possible. Once profits fall, they continue to
fall. Investment also starts declining and in this way the end result of capitalism is the
stationary state. Smith’s theory is explained graphically where time is taken on the horizontal
axis and rate of accumulation, on the vertical axis. The economy grows from K to S during
the time path T. After T, the economy reaches the stationary state linked to S where further
growth does not take place because wages rise so high that profits become zero and capital
accumulation stops (Figure 6).

dk
S
dt

0 T

Figure 6: Smith’s growth process and stationary state

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When this happens, capital accumulation stops; population becomes stationary; profits are the
minimum; wages are at the subsistence level; there is no change in per capita income and
production, and the economy reaches the state of stagnation. According to Smith, the
stationary state is dull, the declining melancholy. Life is hard in the stationary state for the
different sections of the society and miserable in the declining state. All this happens in a free
market economy.

4.1.1.4 Critical Appraisal of Smith’s Theory

Smith’s theory has the great merit of pointing out how economic growth came about and what
factors and policies impede it. In particular, he pointed out the importance of parsimony in
saving and capital accumulation; of improved technology, division of labor and expansion of
market in production; and of the process of balanced growth in the interdependence of
farmers, traders and producers. Despite these merits, it has certain weaknesses.

i) Rigid division of society

Smith’s theory is based on the socio-economic environment prevailing in Great Britain and
certain part of Europe. It assumes the existence of a rigid division of society between
capitalists (including landlords) and laborers. But the middle class occupies an important
place in modern society. Thus, this theory neglects the role of the middle class which provides
the necessary impetus to economic development.

ii) One-sided saving base

According to Smith, capitalists, landlords and moneylenders save. This is, however, a one
sided base of savings because it did not occur to him that the major source of savings in an
advanced society was the income-receivers and not the capitalists and landlords.

iii) Unrealistic assumption of perfect competition

Smith’s whole theory is based upon the unrealistic assumption of perfect competition. This
laissez-faire policy of perfect competition is not to be found in any economy. Rather, a
number of restrictions are imposed on the private sector, and on internal and international
trade in every country of the world.

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iv) Neglect of entrepreneur

Smith neglects the role of the entrepreneur in development. This is a serious defect in his
theory. The entrepreneur is the focal point of development. It is the entrepreneur who
organizes and brings about innovations thereby leading to capital formation.

v) Unrealistic assumption of stationary state

Smith is of the view that the end result of a capitalist economy is the stationary state. It
implies that there is change in such an economy but around a point of equilibrium. There is
progress but it is steady, uniform and regular like a tree. But this explanation of the process of
development is not satisfactory because development takes place by ‘fits and starts’ and is not
uniform and steady. Thus the assumption of the stationary state is unrealistic.

vi) Static model

According to Hicks Smith’s model, though it looks like a growth model, is not a growth
model in the modern sense. It does not exhibit a sequence. Thus it is a static model.

4.1.1.5 Applicability of Smith’s theory to underdeveloped countries

In development economics we take interest in understanding the problems of underdeveloped

countries and solving these problems. The theories formulated, hence, should apply to the
present situations in which these countries are found in. Accordingly we will analyze their
applicability one by one. The smith theory of economic development has limited validity for
underdeveloped countries. In such economies the size of the market is small. As a result, the
capacity to save and inducement to invest are low. Since the size of the market is small,
productivity is low, and low productivity implies low level of income.

The low level of income results in small capacity to save and inducement to invest and they
keep the size of the market small. To use the Keynesian terminology, the level of real income
is low in underdeveloped countries but the propensity to consume is very high and every
increase in income is spent on food products. Little is saved and invested. The volume of
production remains at a low level. Consequently, the size of the market remains small.
Moreover, the political, social and institutional assumptions underlying Smith’s theory are not
applicable to the conditions prevailing in underdeveloped countries. Laissez-faire has lost its
significance in such economies.
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Competition has been gradually replaced by monopoly which has tended to perpetuate and
strengthen the vicious circles of poverty. Therefore, development is possible through
government intervention rather than through a policy of laissez-faire. Despite this, Smith’s
theory of economic development points toward certain factors that are helpful in the process
of developing underdeveloped countries. Farmers, traders and producers, the three agents of
growth mentioned by Smith, can help in developing the economy by raising productivity in
their respective spheres. Their interdependence also points toward the importance of balanced
growth for such economies. Further, his emphasis on importance of saving, improved
technology, division of labor and expansion of market in the process of development has
become the corner stone of policy in such countries. As remarked by Rostow, indeed looked
at from the present day, the Wealth of Nations is a dynamic analysis and program of policy
for an underdeveloped country’

Activity 4.1

How do you evaluate the contribution of Adam Smith to the development of economics of
development in relation with solving the present problems and challenges of underdeveloped
countries like our economy?
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4.1.2 The Ricardian Theory

David Ricardo was another of the great classical pessimists. In 1817 he published his
Principles of Political Economy and Taxation, in which he predicted that capitalist economies
would end up in a stationary state, with no growth, also owing to diminishing returns in
agriculture. In Ricardo's model, like Smith's, growth and development is a function of capital
accumulation, and capital accumulation depends on reinvested profits. However, profits are
squeezed between subsistence wages and the payment of rent to landlords, which increases as
the price of food rises owing to diminishing returns to land and rising marginal costs. Ricardo
thought of the economy as 'one big farm’ in which food (or corn) and manufactures are
consumed in fixed proportions, so that corn can be used as the unit of account. Let us discuss
these concepts.

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4.1.2.1 The theory of distribution

We should pint out at the outset that Ricardo never propounded any theory of development.
He simply discussed the theory of distribution. Therefore, Ricardo’s analysis is a detour. The
Ricardian theory is based on the marginal and the surplus principles. The marginal principle
explains the share of rent in the national output, and the surplus principle explains the share of
rent in the national output, and the surplus principle explains the division of the remaining
share between wages and profits. Ricardo saw the fall as the result of diminishing returns to
land, and profits being squeezed between rent and wages, leading to a stationary state. In the
Ricardian system, the whole economy consists of one huge farm fixed in supply which is
engaged in producing only corn by applying homogeneous units of labor and capital.

It grows on the basis of interrelations of three groups in the economy. They are landlords,
capitalists and laborers, among whom the entire produce of land is distributed. The total
national output is distributed among the three groups as rent, profits, and wages respectively.
Division of rent, profits and wage given the total output of corn, the share of each group can
be determined. Rent per unit of labor is the difference between the average and marginal
product of labor X (multiplied by) the quantity of labor and capital applied on land. The wage
rate is determined by wage fund divided by the number of workers employed at the
subsistence level. Thus, out of total corn produced and sold, rent has the first share and the
residual (produce minus rent) is distributed between wages and profits, while interest is
included in profits.

4.1.2.2 Process of capital accumulation

According to Ricardo, capital accumulation is the outcome of profits because profits lead to
saving of wealth which is used for capital formation. Capital accumulation depends on two
factors: first, the capacity to save; and second, the will to save. The capacity to save is more
important in capital accumulation. This depends upon the net income of society which is a
surplus out of total output after meeting the cost of workers’ subsistence. The larger is the
surplus, the larger will be the capacity to save. The size of this surplus of net income depends
on the rate of profit. The rate of profit = profits/wages i.e., the rate of profit is equal to the
ratio of profits to capital employed. But since capital consists only of working capital, it is
equal to the wage bill.

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When there are improvements in agriculture, the productive power of land increases, or by
applying better machines less workers produce more output. This results in fall in the price of
corn. As a result, the subsistence wage also falls, but profits increase and there is more capital
accumulation. This will increase the demand for labor and the wage rate will rise. This, in
turn, will increase population and the demand for corn and its price. Thus wages will rise and
profits decline. In the Ricaridian system wages play an active role in determining income
between capital and labor. The wage rate increases when the prices of commodities forming
the subsistence of the workers increase.

The commodities consumed by workers are primarily agricultural products. As the demand
for food increases, less fertile land is brought under cultivation. For this purpose, to produce a
unit of the product more laborers are required. The demand for labor starts rising which raises
wages. Moreover, to match the increasing cost of subsistence, money wages will also
continue to rise. Thus wages rise with the increase in the price of corn and then profits
decline. In such a situation, rent also increases which absorbs the rise in the price of corn.
Since wages also increase, profits decline. These tendencies ultimately retard capital
accumulation.

4.1.2.3 Declining profits in other industries

According to Ricardo, the profits of the farmer regulate the profits of all other trades. In
manufacturing industry, corn is used as an input and the equality in the rate of profit comes
through a definite relationship between the prices of industrial goods and the price of corn.
Thus, when the profit rate declines in the agricultural sector, it also declines in the
manufacturing industry. For with the rise in the price of corn, the industry will have to raise
the wages of laborers, thereby reducing profits. Thus the price of corn determines the rate of
profit in industry. When profits decline in the agricultural sector, profits of all trades also
decline. According to Ricardo, taxes are to be levied only to reduce conspicuous
consumption. Otherwise, the imposition of taxes on capitalists, landlords, and laborers will
transfer resources from these groups to the government. But taxes adversely affect
investment. Therefore, Ricardo does not favor the imposition of taxes because taxes reduce
income, profits and capital accumulation.

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4.1.2.4 Free trade

Ricardo is in favor of free trade and consider it as an important factor for the economic
development of the country. The profit rate can be saved from declining by importing corn.
The capital accumulation will, therefore, continue to be high. In this way, the resources of the
world can be used more efficiently through foreign trade. But the import of corn leads to fall
in the demand for labor which deteriorates the economic condition of laborers.

Qof cor
Q R
A B
P T AP

W L S
MP
0 M N Labor

Figure 7: Illustration of Recardian theory

In Figure 7 quantities of corn are measured on the vertical axis and the amount of labor
employed in agriculture on the horizontal axis. The Figure is discussed as: the curve AP
represents the average product of labor and MP the marginal product of labor. With OM
amount of labor, OQRM total corn is produced. Rent is shown by the rectangle PQRT, as the
difference between AP and MP. At the subsistence wage rate OW, the supply curve of labor
WL is infinitely elastic, and the total wage bill is OWLM. Total Profits, WPTL, are the
residue after deducting rent and wages from the total output:

WPTL = OQRM – (PQRT-OWLM)

4.1.2.5 Stationary state

According to Ricardo, there is a natural tendency for the profit rate to fall in the economy so
that the country ultimately reaches the stationary state. When capital accumulation rises with
increase in profits; total output increases which raises the wages fund. With the increase in the

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 wages fund, population increases which raises the demand for corn and its price. As
population increases, inferior grade lands are cultivated to meet the increasing demand for
corn. Rents on the superior grades of land rise and absorb a greater share of the output
produced on these lands. This reduces the share of capitalists and laborers. Profits decline and
wages tend to fall to the subsistence level. This process of rising rents and declining profits
continues till the output from the marginal land just covers the subsistence wage of the labor
employed.

Then profits are zero. This situation is explained in Figure 7. During the course of capital
accumulation, the amount of labor increases from OM to ON and the total output from
OQRM to OABN. Of this, OWSN is the total wage bill (fund) and WABS is the rent. There
are no profits at all. The stationary state arrises. In this state, capital accumulation stops,
population does not grow, the wage rate is at the subsistence level and technical progress
ceases. The basic causal force in this scheme is the fact of diminishing returns in agriculture, a
grim tendency which can only be postponed temporarily by technical progress. But technical
progress cannot prevent the ultimate disappearance of profit and the onset of the stationary
state.
W
P3 S
P
TOTAL PRODUCT --RENT

P2 W3

P1
W2

W1
O
N1 N2 N3 N
Population

Figure 8: Movement towards stationary state in Ricardian theory

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The above Figure 8 explains movement towards stationary state in Ricardian theory.
Population is measured along the horizontal axis and the total product minus rent on the
vertical axis. The curve OP is the production function which shows total production minus
rent as the function of population. As population increases, the OP curve flattens out due to
the operation of the law of diminishing returns. The ray through the origin OW measures the
constant real wage rate. The vertical distance between the horizontal axis and the wage rate
line OW measures the total wage bill at different levels of population. Thus W1N1, W2N2,
and W3N3 are the total wage bills at ON1, ON2, and ON3 levels of population. When the
wage bill is W1N1, the profits are P1W1 i.e total product minus rent the (total wage bil) l, i.e.,
P1N1 W1N1= P1W1. When profits are P1W1, investment is encouraged. The demand for labour
increases to ON2, which pushes up the wage bill to W2N2. But profits decline to P2W2. This
profit will encourage further investment (although small) and technical progress and raise the
demand for labor to ON3 and the wage bill will also increase to W3N3. But the profits will
decline to P3W3. This process of capital accumulation, increase in population and the wage
bill will continue till profits disappear altogether at point S from where the stationary state
sets in.
4.1.2.6 Critical appraisal of Ricardian Theory
Ricardo was the forerunner of modern economists and his ideas on economic development
have been adopted by them. He emphasized the importance of raising savings and profit rate
for capital accumulation. But it has certain flaws which are discussed below:

i) Neglects the impact of technology

Ricardo pointed out that improved technology in the industrial field leads to the displacement
of labor and other adverse consequences. In the beginning, technological progress might
counteract the action of diminishing returns. But ultimately when the impact of technological
progress is exhausted, diminishing returns set in and the economy moves towards the
stationary state. Thus, the Ricardian theory is primarily based on the law of diminishing
returns. Rapid increase of farm produce in the advanced nations has proved that Ricardo
underestimated the potentialities of technological progress in counteracting diminishing
returns to land. Ricardo gave unnecessary importance to the law of diminishing returns and
failed to visualize the important impact that science and technology had on the rapid
economic development of the now developed nations.
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ii) Wrong notion of the stationary state

The Ricardian view that the state reaches the stationary state automatically is baseless,
because no economy attains the stationary state in which profits are increasing, production is
rising and capital accumulation is taking place.

iii) Baseless notion regarding population

The Ricardian view that the wage rate does not increase with the rise in population has been
disproved. First, the Malthusian theory of population has been proved wrong by population
trends prevailing in the Western World. Second, wages have not tended to be at the
subsistence level. Rather, there has been a continuous increase in money wages, and
population has tended to decline.

iv) Impracticable laissez-faire policy

The Ricardian theory is based on the impracticable notion of laissez-faire. According to this
policy, there is no government interference and the economy operates automatically through
perfect competition. In reality, there is no economy which is free from government
interference and in which perfect competition prevails.

v) Neglects institutional factors

One of the principal defects of the Ricardian theory is that it neglects the role of institutional
factors. They have been assumed as given. But they are crucial in economic development and
cannot be overlooked.

vi) Distribution rather than growth theory

According to Schumpeter, the Ricardian theory is not a growth theory but it is a theory of
distribution which determines the shares of workers, landlords and capitalists. Even in this, he
regards the share of land as primary, and the residual as the share of labor and capital. Ricardo
failed to present a functional theory of distribution because he did not determine the share of
each factor separately.

vii) Land also produces goods other than corn

Ricardo believed that only one product corn is produced on land. But this is an old notion
because land produces a variety of products other than corn.

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This view appears to be still obsolete when Ricardo opined that the other factors of production
are supported only by the produce of land.

viii) Neglects the interest rate

The most serious defect of the Ricardian theory is the neglect of the rate of interest in
economic growth. He does not regard the interest rate as an independent reward of capital but
includes it in profits. This wrong notion stems from his inability to distinguish between the
capitalist and the entrepreneur.

ix) Static model

According to Hicks, Ricardo uses the static method for the analysis of a regularly progressive
economy. It is confined to the comparison of static equilibrium of even stationary states, and
therefore cannot be extended to the analysis of a dynamic process.

4.1.2.7 Underdeveloped countries and Ricardo’s theory

Despite the weaknesses, the Ricardian theory points toward the importance of capital
accumulation through agricultural development, and increase in the various sources of savings
and the profit rate. The theory may not be fully applicable to underdeveloped countries but it
does point out the factors that retard their rate of economic growth. The two basic
assumptions of the Ricardian theory, diminishing returns to land and the Malthusian principle
of population, are of particular significance for understanding the problems of over-populated
underdeveloped economies.

Activity 4.2

Explain the difference in the theories of Adam Smith and David Ricardo in their approach to
development. Elaborate also how Ricardo’s theory is better in its application to
underdeveloped countries than Adam Smith’s theory.
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4.1.3 Schumpeterian Theory

Dear Students! Joseph Alois Schumpeter first presented his theory of economic growth in the
Theory of Economic Development published in German in 1911 (its English edition appeared
in 1934) which was elaborated and refined but in no way altered in any essential respect in his
Business Cycles (1939) and capitalism, Socialism and Democracy (1942).

4.1.3.1 Circular flow equilibrium theory

Schumpeter assumes a perfectly competitive economy which is in stationary equilibrium. In

such a stationary state, there is perfect competitive equilibrium: no profits, no interest rates,
no savings, no investments and no involuntary unemployment. This equilibrium is
characterized by what Schumpeter terms the “circular flow” which continues to repeat itself in
the same manner year after year, similar to the circulation of the blood in an animal organism.
In the circular flow, the same products are produced every year in the same manner. For
every supply there awaits somewhere in the economic system a corresponding demand, and
for every demand there is corresponding supply.” In other words, all economic activities are
repetitive in a time-less economy. To Schumpeter, “The circular flow is a stream that is fed
from the continually flowing springs of labor-power and land, and flows in very economic
period into the reservoir which we call income, in order to be transformed into the satisfaction
of wants.”

According to him, “is spontaneous and discontinuous change in the channels of the circular
flow, disturbance of equilibrium, which for ever alters and displaces the equilibrium state
previously existing.” These spontaneous and discontinuous changes in economic life are not
forced upon it from without but arise by its own initiative from within the economy and
appear in the sphere of industrial and commercial life. Development consists in the carrying
out of new combinations for which possibilities exist in the stationary state. New
combinations come about in the form of innovation. An innovation may consist of the
introduction of a new product; the introduction of a new method of production; the opening
up of a new market; the conquest of a new source of supply of raw materials or semi-
manufactured goods; and the carrying out of the new organization of any industry like the
creation of a monopoly. According to Schumpeter, it is the introduction of a new product and
the continual improvements in the existing ones that lead to development.

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4.1.3.2 Role of innovator

Schumpeter assigns the role of an innovator not to the capitalist but to the entrepreneur. The
entrepreneur is not a man of ordinary managerial ability, but one who introduces something
entirely new. He does not provide funds but directs their use. The entrepreneur is motivated
by the desire to found a private commercial kingdom, the will to conquer and prove his
superiority, and the joy of creating, of getting things done, or simply of exercising one’s
energy and ingenuity. Entrepreneur’s nature and activities depend on his social-cultural
environment. To perform his economic function, the entrepreneur requires two things. First,
the existence of technical knowledge in order to produce new products; and second, the power
of disposal over the factors of production in the form of credit. According to Schumpeter, a
reservoir of untapped technical knowledge exists which he can make use of. Therefore, credit
is essential for development to start.

4.1.3.3 Role of profits

An entrepreneur innovates to earn profits. Profits are conceived “as a surplus over costs; a
difference between the total receipts and outlay as a function of innovation”. According to
Schumpeter, under competitive equilibrium the price of each product just equals its cost of
production, and there are no profits. Profits arise due to dynamic changes resulting from an
innovation. They continue to exist till the innovation becomes general.

4.1.3.4 Breaking the circular flow

Schumpeter’s model starts with the breaking up of the circular flow with an innovation in the
form of a new product by an entrepreneur for the purpose of earning profits. In order to break
the circular flow, the innovating entrepreneurs are financed by bank-credit expansion. Since
investment in innovations is risky, they must pay interest on it. Once the new innovation
becomes successful and profitable, other entrepreneurs follow it in “swarm-like clusters.” An
innovation in one field may induce other innovations in related fields. For example, the
emergence of a motor car industry may, in turn, stimulate a wave of new investments in the
construction of highways, rubber tires and petroleum products, etc. The spread of innovation
is shown in Figure 9 where the percentage of firms adopting a particular innovation is shown
on the vertical axis and time taken on the horizontal axis.

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The curve OI shows that firms adopt an innovation slowly to start with but soon the adoption
of innovation gains momentum. But it never reaches 100 per cent adoption by firms.
Adoption rate

O TIME

Figure 9: Spread of innovation according to Schumpeter

4.1.3.5 Cyclical Process

Since investment is assumed to be financed by creation of bank – credit, it increases money

incomes and prices and helps to create a cumulative expansion throughout the economy. With
the increase in the purchasing power of the consumers, the demand for the products of the old
industries increases in relation to supply. Prices rise, profits increase and old industries
expand by borrowing from the banks. It induces a secondary wave of credit inflation which is
superimposed on the primary wave of innovation. Over – optimism and speculation add
further to the boom. After a period of gestation the new products start appearing in the market
displacing the old products and enforcing a process of liquidation, re-adjustment and
absorption.

The demand for the old products is decreased. Their prices fall. The old firms contract output
and some are even forced to run into liquidation. As the innovators start repaying bank loans
out of profits, the quantity of money is decreased and prices tend to fall. Profits decline.
Uncertainty and risks increase the impulse for innovation is reduced and eventually comes to
an end. Depression ensues. Schumpeter believes in the existence of the long-wave of
upswings and downswings in economic activity. Each long-wave upswing is brought about by
an innovation in the form of a new product which leads to further innovations in the methods
of production, new forms of business organization, new sources of supply of raw materials
and intermediate products, and new markets.

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Thus there is abundance of goods available for the masses. In the words of Schumpeter, “mass
production means production for the masses.” Once the upswing ends, the long-wave
downswing begins and the painful process of readjustment to the “point of previous
neighborhood of equilibrium” starts. Ultimately the natural forces of recovery bring about a
revival.

Secondary wave
Equilibrium path

Recession
Income

Primary wave Revival

Depression

O
Time

Figure 10: Schumpeter’s cyclical process of economic development

Schumpeter’s cyclical process of economic development is illustrated in Figure 3.6 where the
secondary wave is superimposed on the primary wave of innovation. With over-optimism and
speculation, development proceeds more rapidly in the prosperity phase. When recession
starts, the cycle continues downward below the equilibrium level to the depression phase.
Ultimately, another innovation brings about revival. Firstly, entrepreneurs are the key figures
in the Schumpeterian analysis. They bring about economic development in spontaneous and
discontinuous manner. And “cyclical swings are the cost of economic development under
capitalism,” a permanent feature of its dynamic time-path. Secondly, continued technological
progress will result in an unbounded increase in total and per capita output, since historically
there are no diminishing returns to technological progress. As long as technological progress
takes place, the rate of the profit will be positive. Hence there can be no drying up of sources
of ingestible funds nor any vanishing of investment opportunities.

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Can capitalism survive? No, I do not think it can,” wrote Schumpeter, as his final appraisal of
the future of capitalism. To him, the very success of capitalism “undermines the social
institutions which protect it, and “inevitably” creates conditions in which it will not be able to
live and which strongly point to socialism as the heir-apparent.

4.1.3.6 Process of the end of capitalism

According to Schumpeter, capitalism can maintain itself only so long as entrepreneurs behave
like knights and pioneers. But such daring innovators are being destroyed by the capitalist
system itself which rests on a rational attitude. This enquiring, skeptical and rational attitude
permeates the entire capitalist society. In the early stages of capitalism, the driving force came
from entrepreneurs who dared to innovate, to experiment, and to expand. But now innovation
is reduced to a routine. Technological progress has become the business of teams of trained
specialists. The new ‘lords’ of business are the managers, depersonalized owners and private
bureaucrats. This reduces the industrial bourgeoisie to a class of wage-earners and thus
undermines the function and the position of the entrepreneur as the “warrior knight.” There is
also the destruction of the bourgeoisie family. Parents adopt a rationalistic attitude in their
behavior towards children. The traditional family idea is weakened. The desire to found a
“private kingdom”, a “dynasty” is no longer there. The will to accumulate wealth gradually
disappears, and along with it another important aspect of the capitalist society.

4.1.3.7 Criticisms of the Schumpeterian theory

Schumpeter’s theory must be ranked as a major performance, one worthy of such great
economists as Smith, Mill, Marx, Marshall and Keynes. No doubt, it is replete with brilliant
reasoning and insight of a great theorist, yet it is not free from criticisms.

 The entire process of Schumpeter’s theory is based on the innovator whom he regards as an
ideal person. Such persons were to be found in the 18th and 19th centuries. At that time
innovations were made by entrepreneurs or inventors. But now all innovations form part of
the functions of a joint stock company. Innovations are regarded as the routine of industrial
concerns and do not require an innovator as such.
 According to Schumpeter, economic development is the result of the cyclical process. The
downswings and the upswings are not essential for economic development. As Nurkse has
pointed out, economic development is related to continuous changes.

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 Schumpeter’s contention that cyclical changes are due to innovations is also not correct. As
a matter of fact, cyclical fluctuations may be due to psychological, natural, and financial
causes.
 Again, Schumpeter regards innovations as the main cause of economic development. But
this is far from reality because economic development not only depends on innovations but
also on many economic and social changes.
 Schumpeter gives too much importance to bank credit in his theory. Bank credit may be
important in the short run when industrial concerns get credit facilities from the banks. But
in the long run when the need for capital funds is much greater, bank credit is insufficient.
For this, business houses have to float fresh shares and debentures in the capital market.
 Schumpeter’s analysis of the process of transition from capitalism to socialism is not
correct. He does not analyze how a capitalist society is transformed into socialism. He
simply tells that the institutional framework of a capitalist society is transformed with
changes in the functions of the entrepreneur. His analysis of the end of capitalism is
emotional rather than real.

4.1.3.8 Schumpeter’s Analysis and underdeveloped countries

The applicability of Schumpeter’s theory to underdeveloped countries is limited for the

following reasons.

i) Different Socio-Economic Order

Schumpeter’s theory corresponds to a particular socio-economic order that existed in Western

Europe and America of the 18th and 19th centuries. In that period some of the prerequisites of
growth already existed. In underdeveloped countries the socio-economic conditions are
altogether different and the prerequisites for development in the form of economic and social
overheads are non-existent.

ii) Lack of Entrepreneurship

The Schumpeterian analysis depends upon the existence of an entrepreneurial class. However,
in underdeveloped countries adequate entrepreneurship is lacking. In such economies there
are low state of technologies which do not encourage innovational investments in new plant
and equipment. Moreover, the lack of adequate power, transport, skilled personnel, etc. act as
disincentives to entrepreneurial activity.
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iii) Not Applicable to Socialist Countries:

Schumpeter’s analysis is not applicable to the majority of underdeveloped countries which

have socialist leanings. For example, the introduction of social security measures and high
progressive income taxes are inimical to the development of an entrepreneurial class because
they tend to reduce profits.

iv) Not Applicable to Mixed Economies

Schumpeter’s innovator is a private entrepreneur who does not fit in the present day mixed
economies. In an underdeveloped country, government is the biggest entrepreneur. The main
impetus for development comes from the public and the semi-public sectors. Thus,
Schumpeter’s innovator has a limited role to play in an underdeveloped country.

v) Institutional Changes and not Innovations needed

To start the development process and to make it self-sustaining it is not innovation alone but a
combination of several factors like organizational structures, business practices, skilled labor
and appropriate values, attitudes and motivations which are required.

vi) Assimilation of Innovations

According to Henry Wallich, the development process in underdeveloped countries is based,

not on innovation, but on the assimilation of existing innovations for, entrepreneurs in
underdeveloped countries are not in a position to innovate. Rather, they adopt innovations
taking place in advanced countries.

vii) Neglects Consumption

The Schumpeterian process is ‘production oriented’ while the development process is

‘consumption-oriented’. This appraisal is applied in the current trend towards the welfare state
in which demand and consumption play a leading role.

viii) Neglects Savings

Schumpeter’s exclusive emphasis on bank credit obscures the role of real savings in
investment. It also undermines the importance of deficit financing, budgetary savings, public
credit and other fiscal measures in economic development.

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Section 2: Structural Change Theories of Economic Development

Introduction

In a broad sense, the ideas of these early development economists were mutually supportive.
They formed a loose school of thought on the issue of economic development, emphasizing a
less theoretical and more historical and practical approach to the question of how to develop
particularly in relation to those who stressed the applicability of classical models. Like any
such school of analysis, there were differences of emphasis and interpretation between these
theorists. These differences are particularly striking in the work of W.W. Rostow, who
stressed a descriptive approach while emphasizing the near inevitability and predictability of
economic development, based on the premise that the industrial past of Europe presents a
rough picture of the approaching future of the developing nations.

The others emphasized analytical constructs and were not striving to construct a mega-theory
of economic history. Yet they coincided in believing, in Rostow’s words, that “the tricks of
growth are not that difficult” in the less-developed world. Therefore, the 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. It employs the tools of neoclassical price and resource allocation theory and
modern econometrics to describe how this transformation process takes place. Let us proceed
to discuss these theories.

Objectives of the section

After reading this section, students will be able to understand and explain:
 Rostow’s stages of growth theory;
 Lewis’s theories of the potential role of surplus labor as a stimulant to growth; and
 The Limits to Growth Model and the harmful effects of economic growth on environment.

4.2.1 Rostow’s Stages of Economic Growth

Now let us introduce one of the most outstanding economists who forwarded what is called
the stages of economic growth. Professor W.W Rostow has sought an historical approach to
the process of economic development. He distinguishes five stages of economic growth, viz.,

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(1) the traditional society; (2) the pre-conditions for take-off; (3) the take-off; (4) the drive to
maturity; and (5) the age of high mass-consumption. Let us now see each of these stages one
by one.

4.2.1.1 The traditional society

When we say a traditional society it should be understood that we mean a society “as one
whose structure is developed within limited production functions based on pre-Newtonian
science and technology and as pre-Newtonian attitudes towards the physical world.” This
does not mean that there was little economic change in such societies. In fact, more land could
be brought under cultivation, the scale and pattern of trade could be expanded, manufactures
could be developed and agricultural productivity could be raised along with increase in
population and real income. But the undeniable fact remains that for want of a regular and
systematic use of modern science and technology ‘a ceiling existed on the level of attainable
output per head’. It did not lack inventiveness and innovations, but lacked the tools and the
outlook toward the physical world of the post- Newtonian era.

The social structure of such societies was hierarchical in which family and clan connections
played a dominant role. Political power was concentrated in the regions, in the hands of the
landed aristocracy supported by a large retinue of soldiers and civil servants. More than 75
per cent of the working population was engaged in agriculture. Naturally, agriculture
happened to be the main source of income of the state and the nobles, which was dissipated
on the construction of temples and other monuments, on expensive funerals and weddings and
on the prosecution of wars.

4.2.1.2 The pre-conditions for take – off

The second stage is a transitional era in which the pre-conditions for sustained growth are
created. The pre-conditions for sustained growth were created slowly in Britain and Western
Europe, from the end of the 15th and the beginning of the 16th centuries, when the mediaeval
Age ended and the modern Age began. The pre-conditions for take-off were encouraged or
initiated by four forces: The New Learning or Renaissance, the New Monarchy, the New
World and the New Religion or the Reformation. These forces led to ‘Reasoning’ and
‘Skepticism’ in place of ‘Faith’ and ‘Authority’, brought an end to feudalism and led to the

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rise of national states; inculcated the spirit of adventure which led to new discoveries and
inventions and consequently the rise of the bourgeoisie – the elite- in the new mercantile
cities. Thus, these forces were instrumental in bringing about changes in social attitudes,
expectations, structure and values. Generally speaking, the preconditions arise not
endogenously but from some external invasion. For example, the pre-conditions ended in
Europe (excluding Britain) with the domination of Napoleon Bonaparte whose victorious
armies set in motion new ideas and attitudes which brought about changes in the structure of
traditional societies and paved the way for the unification of Germany and Italy.

In any case, the process of creating pre-conditions for take-off from traditional society
follows along these lines: “The idea spreads that economic progress is possible and is a
necessary condition for some other purpose, judged to be good; be it national dignity, private
profit, the general welfare, or better life for the needs of modern activity. New types of
enterprising men come forward in the private economy, in government, or both, willing to
mobilize savings and to take risks in pursuit of profit to modernization. Banks and other
institutions for mobilizing capital appear. Investments increase, notably in transport,
communications and in raw materials in which other nations may have an economic interest.
The scope of commerce, internal and external, widens. And here and there, modern
manufacturing enterprise appears, using the new methods.”

According to Rostow, this development has usually required radical changes in three no-
industrial sectors: First, a build-up of social overhead capital, especially in transport, in order
to enlarge the extent of the market, to exploit natural resources productivity and to allow the
state to rule effectively. Second, a technological revolution in agriculture so that agricultural
productivity increases to meet the requirements of a rising general and urban population.
Third, an expansion of imports, including capital imports, financed by efficient production
and marketing of natural resources for exports. The continuous development and expansion of
modern industry was mainly possible by the ploughing back of profits into fruitful investment
channels. As Rostow says: “The essence of the transition can be described legitimately as a
rise in the rate of investment to a level which regularly, substantially and perceptibly outstrips
population growth.”The role of social and political factors in creating the pre-conditions has
already been explained in the beginning of this ‘stage’. But the political forces deserve further

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explanations with reference to underdeveloped countries and colonial territories. It was
“reactive nationalism” – reaction against the fear of foreign domination which acted as a
potent force in bringing about the transition. In Japan it was the demonstration effect, not of
high profits or new manufactured consumers’ goods, but of the Opium War in China in the
early 1840’s and Commodore Perry’s seven black ships, a decade later, that cast the die for
modernization. But in the colonies, the policy followed by the colonial power to build up
social overhead capital, apparently to meet its own requirements, helped in moving the
traditional society along the transitional path. The spread of modern education brought about
a gradual transformation in thought, knowledge and attitude of the people, and a growing
spirit of nationalism started resenting the colonial rule. Lastly, under the influence of a
powerful international demonstration effect, people wanted the products of modern industry
and modern technology itself.

Activity 4.3

Explain the pre requisites for bringing about a sustained industrialization and list some more
social overhead capitals.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

4.2.1.3 The take-off

This stage called the take-off is the ‘great watershed’ in the life of a society “when growth
becomes its normal condition…, forces of modernization contend against the habits and
institutions. The value and interests of the traditional society make a decisive breakthrough;
and compound interest Rostow implies ‘that growth normally proceeds by geometric
progression, such as a saving account if interest is left to compound with principal.’ At
another place, Rostow defines the take – off ‘as an industrial revolution, tied directly to
radical changes in the methods of production, having their decisive consequence over a
relatively short period of time.” This stage is supposed to be a short period, lasting for about
two decades. Rostow has given the following tentative take-off dates for those countries
which are considered to be airborne.

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 Table 9: Rostow’s tentative take-off dates

Country Take-off Country Take – off

Great Britain 1783-1802 Japan 1878-1900

France 1830-1860 Russia 1890-1914
Belgium 1833-1860 Canada 1896-1914
United States 1843-1860 Argentina 1935
Germany 1850-1873 Turkey 1937
Sweden 1868-1890 India & China 1952

Let us now discuss about the conditions for Take-off. The requirements of take-off are the
following three related but necessary conditions: First, a rise in The requirements of take-off
from, say, 5 per cent or less to over 10 per cent of national income or net national product;
second, the development of one or more substantial manufacturing sectors with a high rate of
growth; and third, the existence or quick emergence of a political, social and institutional
framework which exploits the impulses to expansion in the modern sector and gives to growth
an outgoing character.” Let us examine these conditions in detail.

(1) Rate of net investment over 10 per cent of national income

One of the essential conditions for take – off is that the increase in per capita output should
outstrip the growth of population to maintain a higher level of per capita income in the
economy. As Rostow explains: “If we take the marginal capital/output ratio for economy in its
early stages of economic development at 3.5:1 and if we assume, as is not abnormal, a
population rise 1-1.5 per cent annum it is clear that something between 3.5 and 5.25 per cent
of NNP must be regularly invested if NNP per capita is to be sustained. An increase of 2 per
cent per annum in NNP per capita requires, under these assumptions that something between
10.5 and 12.5 per cent of NNP be regularly invested. By definition and assumption, then, a
transition from relatively stagnant to substantial regular rise in NNP per capita under typical
population conditions, requires that the proportion of national product productively invested
should move from somewhere in the vicinity of 5 per cent to something in the vicinity of 10
per cent.”The typical case explained by Rostow is based on the supposition that the
incremental capital-output ratio and the rate of population growth remain constant.

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It thus precludes the effects of increase labour force and improved technology on national
income. However, during the take-off capital-output ratio tends to decline with the change in
investment pattern and a rise in the proportion of net investment to national income takes
place from 5-10 per cent, thus definitely outstripping the growth of population.

(2) Development of leading sectors

Another condition for take – off is the development of one or more leading sectors in the
economy. Rostow regards the development of leading sectors as the ‘analytical bone
structure’ of the stages of economic growth. There are generally there sectors of an economy:
Primary growth sectors, where possibilities of innovation or of exploiting new or unexplored
resources lead to a higher growth rate than in the rest of the economy. The cotton textiles of
Britain and New England in the early stages of growth fall into this category. Supplementary
growth sectors, where rapid growth takes place as a consequence of development in the
primary growth sectors. For example, the development of railways is a primary growth sector
and the expansion of iron, coal and steel industries may be regarded as a supplementary
growth sector. derived growth sectors, where growth takes place “in some fairly steady
relation to the growth of total income, population, industrial production or some overall
modestly increasing variable. “For example, the production of food and the construction of
houses in relation to population. Historically, these sectors have ranged from textiles in
Britain and New England to railways in the United States, the USSR, Germany and France: to
modern timber cutting in Sweden. In addition, modern agriculture also forms part of the
leading sectors.

For example, the rapid growth of Denmark and New Zealand has been due to the scientific
production of bacon, eggs and butter, and mutton and butte respectively. Thus, ‘there is
clearly, no one sectoral sequence to take-off, no single sector which constitutes the magic
key”. According to Rostow, the rapid growth of the leading sectors depends upon the
presence of four basic factors: First, there must be an increase in the effective demand of their
products generally brought about by discharging, reducing consumption, importing capital or
by a sharp increase in real incomes. Second, a new production function along with an
expansion of capacity must be introduced into these sectors.

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 Third, there must be sufficient initial capital and investment profits for the take-off in there
leading sectors. Lastly, these leading sectors must introduce expansion of output in other
sectors through technical transformations.

Activity 4.4

Discuss the leading sector that plays this role in the Ethiopian economy and the role of other
sectors in the economy.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

(3) Cultural framework that exploits expansion

The last requirement for take-off is the existence or emergence of cultural framework that
exploits the impulses to expansion in the modern sector. A necessary condition for this is the
ability of the economy to mobilize larger savings out of an expanding income to raise
effective demand for the manufactured products, and to create external economies through the
expansion of leading sectors.
SAVING,NET INVESTMENT, CAPITAL

K1
K0 T2 S

I2
I1 T1

I0 T

O YO Y1 Y2 NNP

Figure 11: The take – off stage

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As Rostow says, “Take-off requires the massive set of pre-conditions, going to the heart of a
society’s economic organization, its politics and its effective scale of values…. It usually
witnesses a definitive social, political and cultural victory of those who would modernize the
economy over those who would either cling to the traditional society or seek other goals… By
and large, it persuades the society to persist and to concentrate its efforts on extending the
tricks of modern technology beyond the sectors modernized during the take off.” The take –
off stage is explained in Figure 11 .Let us now discuss about the details of this graph. The
horizontal axis represents NNP and the vertical axis the amount of saving, net investment and
capital. S is the saving schedule. K0 Y0 and K1 Y1 are the curves of capital-output ratio drawn
as downward sloping to simplify the figure. They are drawn parallel to each other to indicate a
constant capital-output ratio, i.e., OKo/OYo = OK1/OY1. TYo/YoY1 is the marginal capital-
output ratio.

To start with, the society has a very flat saving curve and a very steep capital – output ratio
curve in the pre-take-off stage. It implies that people save little out of their income and the
capital-output ratio is very high. In the time period 0, as OIo net investment is made it tends to
increase the capital stock which becomes productive in time period 1 and raises NNP to OY1.
Then in the take off stage when OI1 (=T1Y1) investment takes place, some major stimulus
leads to the growth of the productive capital more quickly leading to a fall in the capital-
output ratio to T1Y1/Y1Y2. As a result, the investment pattern changes and the capital-output
ratio curve becomes flatter. It is T1Y2. NNP increases to OY2 which further raises net
investment to OI2 (=T2Y2). The economy has taken off, and if this pattern of growth is
continued it will become Thus, the take-off is initiated by a sharp stimulus, such as the
development of a leading sector or a political revolution which brings an outgoing change in
the production processes, a rise in proportion o net investment to over 10 per cent of national
income outstripping the growth of population.

4.2.1.4 The drive to maturity

Rostow defines this stage as “the period when a society has effectively applied the range of
(then) modern technology to the bulk of its resources.” It is a period of long sustained
economic growth extending well over four decades. New production techniques take the place
of the old ones. New leading sectors are created.

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Rate of net investment is well high over 10 per cent of national income. And the economy is
able to withstand unexpected shocks. When a country is in the stage of technological
maturity, three significant changes take place. First, the character of working force changes. It
primarily becomes skilled. People prefer to live in urban areas rather than in rural. Real wages
start rising and the workers organize themselves in order to have greater economic and social
security. Second, the character of entrepreneurship changes. Rugged and hardworking masters
give way to polished and polite efficient managers. Third, the society feels bored of the
miracles of industrialization and wants something new leading to a further change.

4.2.1.5 The age of high mass-consumption

The age of high mass-consumption has been characterized by the migration to suburbia, the
extensive use of the automobile, the durable consumers’ goods and household gadgets. In this
stage, “the balance of attention of the society is shifted from supply to demand, from
problems of production to problems of consumption and of welfare in the widest sense.”
However, three forces are discernible that tend to increase welfare in this post-maturity stage.
First, the pursuit of national policy to enhance power and influence beyond national frontiers.
Second, to have a welfare state by a more equitable distribution of national income through
force taxation, increased social security and leisure to the working force. Last, decisions to
create new commercial centers and leading sectors like cheap automobiles, houses, and
innumerable electrically operated household devices, etc.

The tendency towards mass consumption of useable consumer goods, continued full
employment and the increasing sense of security has led to a higher rate of population growth
in such societies. Historically, the United States was the first to reach the age of high mass
consumption in the 1920’S, Japan and Western Europe in the 1950’S, and the Soviet Union
after the death of Stalin.

4.2.1.6 Criticism of the stages of economic growth

Rostow’s The Stages of Economists Growth is the most widely circulated and highly
commented piece of economic literature in recent years. Economists are one five ‘stages of
growth’ as presented by Rostow. Are these ‘stages’ inevitable like birth and death or do they
follow a set ‘sequence’ like childhood, adolescence, maturity and old age? Can we tell with

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sufficient precision that one stage is complete and the other has begun? To maintain that
every economy follows the same course of development with a common past and the same
future is to over schematize the complex forces of development and to give the sequence of
stages a generality that is unwarranted.” Let us comment on these ‘stages’ in detail.

i) Traditional society not essential for development

A number of nations such as the United States, Canada, New Zeland and Australia were born
free of traditional societies and they derived the preconditions from Britain, a country already
advanced. So it is not essential for growth that a country must pass through the first stage.

ii) Preconditions may not precede the take- off

In the case of preconditions’, it is not necessary that they must precede the take- off. For
example, there is no reason to believe that and agricultural revolution and accumulation of
social overhead capital in transport must take place before the take-off. G.meier, Leading
Issues in Development Economics. Prof. Habakkuk in his review of Rostow’s ‘Stages wrote
that “ the work is essentially an essay in classification which contains some ideas on how one
stage proceeds to the next, but they do not cohere into anything which could reasonably be
signified as a theory of production. ”

iii) Overlapping in the stages

In fact, the experience of most countries tells us that development in agriculture continued
even in the take-off stage. The take-off in the case of New Zeland and Denmark is attributed
to agricultural development. Similarly, social overhead capital in transport, especially in
railways, has been one of the leading sectors in the take-off, as Rostow himself tells us. It
shows that there is considerable overlapping in the different stages.

iv) The take-off

The most widely discussed and controversial stage is the take-off. As Cairn Cross has stated:
“The stage that has struck the public mind most forcibly is undoubtedly that of the take-off.
Largely, no doubt, because the aeronautical metaphor prolonged in the phrase into self-
sustained growth” suggests at once an effortlessness and finality congenial to modern thought.
The reactions of historians and economists have been less favorable. They have grown
accustomed to emphasizing the continuity of historical explosions and to explaining away the

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apparent leaps in economic development. They are inclined, therefore, to regard Rostow as a
latter day Toynbee, stressing a discontinuity that is no more than symptomatic of the
underlying forces at work and making the symptoms more decisive than they really were?
Possibilities of failure are not considered. According to Habakkuk, “In his aeronautical
concept of growth he (Rostow) ignored the bump downs and crash landings.” Further, ‘the
analysis of the take-off neglects the effect of historical heritage, time of entry into the process
of modern economic growth degree of backwardness, and other relevant factors on the
characteristics of the early phases of modern economic growth in the different countries.

v) The Stage of drive to maturity puzzling and misleading

It contains all the features of the take-off rate of net investment over 10 per cent of national
income, development of new production techniques, leading sectors and institutions. Then
where lies the need for a separate stage where the growth process becomes self sustained. It
can be self-sustentative evidence and analysis not provided by Rostow.”

vi) The Stage of high mass consumption not chronological

The age of high mass consumption is so defined that certain countries like Australia and
Canada have entered this stage before even reaching maturity. According to one, “the period
of mass-consumption is nothing else but minus its ideological overtone.”

4.2.1.7 Importance of take-off for underdeveloped countries

The concept of take- off is ideally suited for the industrialization of underdeveloped countries.
As Dasgupta has written, “The term lacks precision and yet it is suggestive and can be given
interpretation which is useful for an understanding of the process of economic development of
an underdeveloped country. It is indeed the vagueness of the term that gives it strength for one
can put an interpretation upon it to suit the conditions of the economy in which one is
interested.” Of the three necessary conditions for take-off, the first two, namely, capital
formation of one or more leading sectors, are helpful in the process of industrialization of
underdeveloped countries. So far as the first condition is concerned, there can be little doubt
about achieving that percentage. But the second condition can be mounded to suit a country’s
environments. For instance, the leading sectors can be in agriculture or in the production of
primary products for exports.

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The last condition is more important in the context of underdeveloped countries where
monetary and political institution, and skills and technology are at a low level whereby they
retard the expansion of the modern sector.

4.2.2 Lewis Theory of Unlimited Supplies of Labour

Dear Students! Professor W. Arthur Lewis has developed a very systematic theory of
economic development with unlimited supplies of labour. The Lewis Theory also known as
the Two sector Economy Theory. Let us discus it.

4.2.2.1 The Lewis Theory: Two Sector Economy

Like the classical economists, he believes that in many underdeveloped counties an unlimited
supply of labour is available at a subsistence wage Economic development takes place when
capital accumulates as a result of the withdrawal of surplus labour from the “subsistence”
sector to the “capitalist” sector is undertaken. The capitalist sector is that part of the economy
which uses reproducible capital and pays capitalists for the use thereof’. It employs labour for
wages in mines, factories, and plantations for earning profits. The subsistence sector is that
part of the economy which does not use reproducible capital. In this sector, output per head is
lower than in the capitalist sector. Lewis starts his theory with the assertion that the classical
theory of perfectly elastic supply of labour at a subsistence wage holds true in the case of a
number of underdeveloped countries.

Such economies are over-populated relatively to capital and natural resources so that the
marginal productivity of labour is negligible, zero or even negative. Since the supply of
labour is unlimited, new industries can be established or existing industries expanded without
limit at the current wage by drawing upon labour from the subsistence sector. The current
wage is what labour earns in the subsistence sector, i.e., the subsistence wage. The main
sources from which workers would be coming for employment at the subsistence wage as
economic development proceeds are “the farmers, the casuals, the petty traders, the retainers
(domestic and commercial), women in the household and population growth. “But the
capitalist sector also needs skilled workers. Lewis argues that skilled labour is only a “quasi
bottleneck,” a temporary bottleneck which can be removed by providing training facilities to
unskilled workers.

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Activity 4.5

Explain concept of perfectly elastic supply of labour at a subsistence wage and the relation
between this perfect elasticity with the current employment structure in the Ethiopian context.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

4.2.2.2 Capitalist surplus

Now the question is what determines the subsistence wage at which the surplus labour is
available for employment in the capitalist sector? It depends upon the minimum earnings
required for subsistence. To be precise, the wage level cannot be less than the average product
of the worker in the subsistence sector. It may, however, be higher than this, if the farmers
are to pay rent or food costs more or if they feel that psychic disutilities of leaving home are
large. Though “earnings in the subsistence sector set a floor to wage in the capitalists sector”,
yet in practice capitalst wages are more than 30 percent higher than subsistence wages due to:

1. A substantial increase in the output of the subsistence sector which by raising real income
might induce workers to ask for a higher capitalist wage before offering themselves for
employment;
2. If with the withdrawal of labour from the subsistence sector total product remains the
same, the average product and hence the real income of those remaining behind will rise
and the withdrawn workers might insist on a higher wage in the capitalist sector;
3. The high cost of living and some humanitarian consideration may move the employers to
raise the real wage, or governments may encourage trade unions and support their wage-
bargaining efforts. The supply of labour is, however, considered to be perfectly elastic at
the existing capitalist wage.

4.2.2.3 Capital formation depends on capitalist surplus

You should know by now that capitalist aim at profit maximization. It is they who save and
automatically invest what they save. Since the marginal productivity of labour in the capitalist
sector is higher than the capitalist wage, this results in capitalist surplus.

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This surplus is reinvested in new capital assets. Capital formation takes place and more people
are employed from the subsistence sector. This process continues till the capital-labour ratio
rises and the supply of labour becomes inelastic and the surplus labour disappears. Thus
capital formation depends on the capitalist surplus. The Lewis theory can be explained with
the help of the Figure 12. Let us now try to analyze the graph one by one.

The horizontal axis measures the quantity of labour employed and the vertical axis, its wage
and marginal product. OS represents average subsistence wage in the subsistence sector, and
OW the capitalist wage. At OW wage in the capitalist sector, the supply of labour is
unlimited, as shown by the horizontal supply curve of labour WW. In the beginning, when
ON1 labour is employed in the capitalist sector, its marginal productivity curve is P1L1 and the
total output of this sector is OP1Q1N1. Out of this, workers are paid wages equal to the area
OWQ1N1. The remaining area WP1Q1 shows surplus output. This is the capitalist surplus or
total profit earned by the capitalist sector. When his surplus is reinvested, the curve of
marginal productivity shifts upwards to P2L2. The capitalist surplus and employment are now
larger than before being WP2Q2 and ON2 respectively.

P3
P2
P1

Q1 Q2 Q3
W W
L1 L2 L3
S S

O N1 N2 N3
Quantity of Labour

Figure 12: The Lewis model of a two-sector surplus-labor economy

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Further reinvestments raise the marginal productivity curve and the level of employment to
P3L3 and ON3 and so on, till the entire surplus labour is absorbed in the capitalist sector.
After this, the supply curve WW will slope from left to right upwards like an ordinary supply
curve, and wages and employment will continue to rise with development. Capital is, thus,
formed out of profits earned by the capitalists. According to Lewis, if technical progress is
capital-saving, it may be considered as an increment in capital, and if it is labour-saving, it
may be considered as an increment in the marginal productivity of labour. As such, he does
not make any distinction between the growth of technical knowledge and the growth of
productive capital and treats them as a “single phenomenon” with the result that technical
progress tends to raise profits and increase employment in the capitalist sector.

4.2.2.4 Role of the state and private capitalists

The central problem in the theory of economic development,” according to Lewis, “is to
understand the process by which a community which was previously saving and investing 4
or 5 percent of its national income or less converts itself into an economy where voluntary
saving is running at about 12 to 15 per cent of national income. or more. This is the central
problem because the central fact of economic development is rapid capital accumulation
including knowledge and skills with capital).” In underdeveloped countries with surplus
labour, only 10 percent of the people with the largest income save who receive about 40
percent of the national income. The wage and salary classes hardly save 3 per cent of the
national income. But the dominant classes consisting of landlords, traders, moneylenders,
priests, soldiers, princes are engaged in prodigal consumption rather than in productive
investments. It is, therefore, the state capitalist and indigenous private capitalists who create
capital out of profits earned.

The indigenous private capitalist is bound up with the emergence of new opportunities,
especially something that widens the market, associated with some new technique which
greatly increases the productivity of labour, and hence the capitalist surplus. The state
capitalist, on the other hand, can accumulate capital even faster than the private capitalist, on
the other hand, can accumulate capital even faster than the private capitalist, since he can use
for this purpose not only the profits of the capitalist sector, but also what he an force or tax
out of the subsistence sector.” Thus, once a capitalist sector has emerged it is only a matter of

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time before it becomes sizable. If the opportunities for using capital productivity increase
rapidly, the surplus will also grow rapidly, and the capitalist class with it.

4.2.2.5 Capital formation through bank credit

Capital is created not only out of profits, but it is also created out of bank credit. In an
underdeveloped economy which has abundant idle resources and shortage of capital, credit
creation has the same effect on capital formation as profits. It will raise output and
employment. Credit financed capital formation, however, leads to inflationary rise in prices
for some time. When the surplus labour is engaged in the capitalist sector and paid out of
created money, prices rise because income increases while consumer-goods output remains
constant. This is only a temporary phenomenon, for as soon as capital goods start producing
consumption goods, prices start falling. In the words of Lewis, “Inflation for the purpose of
capital formation is a very different kettle of fish. It is self-destructive. Prices begin to rise but
are sooner or later overtaken by rising output, and may, in the last stage, end up lower than
they were at the beginning.

The inflationary process also comes to an end “when voluntary savings increase to a level
where they are equal to the inflated level of investment.” As capital formation is taking place
all the time, output and employment rise continuously and so do profits. Since higher profits
lead to higher savings, a time will come when savings increase so much that new investments
can be financed without recourse to bank credit. This analysis also applies to the government
which receives back the inflation financed money in the form of taxes. Secondly, when
national income increases with rising output, it is not required to resort to deficit financing.
Given abundant labour and scarce physical resources, the effect of capital formation either
through taxation or credit creation is the same on output. Since backward economies are faced
with unlimited supplies of labour, the Lewis theory is primarily concerned with this problem.

4.2.2.6 End of the growth process

The theory shows that “if unlimited supplies of labour are available at a constant real wage,
and if any part of profits is reinvested in productive capacity, profits will grow continuously
relatively to the national income and capital formation will also grow relatively to national
income.” But the process of growth cannot go on indefinitely, i.e. it can be brought to a halt if

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as a result of capital accumulation no surplus labour is left. It may also stop if, despite the
existence of surplus labour, real wages rise so high as to reduce the capitalist profits to the
level where they are all consumed and nothing is left for net investment. This may happen in
any one of the four ways:

1. If the capitalist sector expands so rapidly that is reduces absolutely the population in the
subsistence sector, the average productivity of labour rises in the latter sector because there
are very few people to share the product and so the capitalist wage rises in the former
sector (in the diagram SS and WW will shift upwards and reduce profits);

2. If as a result of the expansion of the capitalist sector relatively to the subsistence sector, the
terms of trade turn against the former with rising prices of raw materials and food, the
capitalists will have to pay higher wages to the workers:

3. If the subsistence sector adopts new techniques of production, real wages would rise in the
capitalist sector and so reduce the capitalist surplus; and lastly, if the workers in the
capitalist sector imitate the capitalist way of life; an agitate for higher wages; and

4. If successful in raising their wages, the capitalist surplus and the rate of capital formation
will be reduced.

In Open Economy when capital accumulation is adversely affected by any of these factors, it
can continue by encouraging mass immigration or by exporting capital to such countries as
possess abundant labour at subsistence wage. Both these possibilities are, however, ruled out
by Lewis himself. First, mass immigration of unskilled labour is not possible because trade
unions in the high-wage countries oppose it. They fear that labour imports would bring down
wages to the subsistence level of the poorest country. Second, the effect of capital exports is
to reduce the creation of fixed capital at home and hence to reduce the demand for labour and
wages in the capital exporting country. But the reduction in wages is offset if capital exports
cheapen the things which workers import because their real wages will rise. On the other
hand, the reduction in wages is further encouraged if capital exports raise the cost of imported
things as the real wages of workers will fall. So the effect of capital exports cannot be
assessed with definiteness.

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 4.2.2.7 A critical appraisal

The Lewis theory is applicable to overpopulated underdeveloped countries under certain set
conditions. Its applicability is, therefore, circumscribed by its assumptions which are the bases
of criticisms discussed below.

i) Wage Rate not Constant in the Capitalist Sector

The theory assumes a constant wage rate in the capitalist sector until the supply of labour is
exhausted from the subsistence sector. This is unrealistic because the wage rate continues to
rise over time in the industrial sector of an under developed economy even when there is open
unemployment in its rural
ii) Not Applicable if Capital Accumulation is Labour Saving
Lewis assumes that the capitalist surplus is reinvested in productive capital. But according to
Reynolds, if the productive capital happens to be labour saving, it would not absorb labour
and the theory breaks down. This is shown in Figure 13 where the curve P2L2 has a greater
negative slope than the curve P1L1, thereby showing labour – saving technique. With the
shifting of the marginal productivity curve upwards from P1L1 to P2L2, the total output has
risen substantially from OP1 Q1 N1 to OP2Q1N1. But the total wage bill OWQ1N1 and the
labour employed ON1 remain unchanged.

P2

P1
Wage/Marginal Product

W Q1 W

S L2 L1 S

O N1
Quantity of Labour

Figure 13: The inapplicability of the Lewis Theory in labour saving techniques

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iii) Skilled Labour not a Temporary Bottleneck

Given an unlimited supply of labour, Lewis assumes the existence of unskilled labour for his
theory. Skilled labour is regarded as a temporary bottleneck which can be removed by
providing training facilities to unskilled labour. No doubt skilled labour is in short supply in
underdeveloped countries but skill-formation poses a serious problem, as it takes a very long
time to educate and train the multitudes in such countries.

iv) Lack of Enterprise and Initiative

The Lewis theory is based on the assumption that a capitalist class exists in underdeveloped
countries. In fact, the entire process of growth depends in the existence of such a class which
has the necessary skill to accumulate capital. In reality, such counties lack capitalists with
necessary enterprise and initiative.

v) Multiplier Process does not operate in LDC

Again, the theory assumes that capital accumulation takes place when the capitalist class
continues to reinvest profits. It, therefore, presupposes the operation of the “investment
multiplier” which is not applicable to underdeveloped countries. For if profits are reduced
somehow or the prices of wage goods rise, the process of capital formation will stop before all
the surplus labour is absorbed.

vi) One sided Theory

This is a one-sided theory because Lewis does not consider the possibility of progress in the
agricultural sector. As the industrial sector develops with the transfer of surplus labour, th
demand for food and raw materials will rise which will, in turn, lead to the growth of the
agricultural sector.

4.2.3 The Limits to Growth Model

Dear learner, since the times of Malthus, Ricardo and Mill, economists like Galbraith Mishan,
Carson, Boulding, Commoner, etc. have voiced their concern about the harmful effects of
economic growth on environment. They are of the view that growth has produced pollution
and wasteful consumption of trivia that contribute nothing to human happiness. According to
them, the objectives of economic growth are to be reviewed because, it has negatively
affected the quality of life, pollution of the environment, waste of natural resources and its
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failure to solve socio-economic problems. In 1968, a group of about seventy five persons
belonging to different strata of society from around the world founded the Club of Rome. It
believed that the possibilities of continuous growth have been exhausted and timely action is
essential in order to avert a planetary collapse. It chose its initial theme “The predicament of
Mankind” in June 1970. It commissioned the research by four MIT scientists led by Donald
Meadows which was published by the Club of Rome as The Limits to Growth in 1972. The
second report entitled Beyond the Limits was published in 1992 which gave fresh evidences as
to how mankind has crossed beyond the limits.

4.2.3.1 The model

It was jay Forrester of MIT who in his book World Dynamics published in 1971 devised a
model that investigates the interplay of such highly aggregated variables as world population,
industrial world production, food supply, pollution and natural resources still remaining in the
world. Using the “system dynamics” methodology of Forrester, the authors of the Limits to
Growth constructed an elaborate computer model of the world. They presented a large and
new type of model designed to predict the future development of five global inter- related
variables population, food production, industrial production, non-renewable resources and
pollution. The model is based on the thesis that “the continued growth leads to infinite
quantities that just do not fit into a finite world”. This basic idea has been elaborated in a
highly complicated model which cannot be easily described in equation form. This is be easily
described in equation form. This is because the many relations between the five variables are
not rectilinear. The multipliers in question depend on the level of the variables.

Among the various relationships, there are “feedback loops” that register the effects of
changes in one variable such as food production on another variable like population growth.
For example, population growth is positively related to food production. But food production
is negatively related to pollution, and pollution, in turn, is positively related to industrial
output. The model also uses past data on such factors as growth rates of population, industrial
output and agricultural production, and the estimates of rates of technological progress. These
factors would lead to the use of new resources, raise agricultural productivity and control
pollution.

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4.2.3.2 Predictions of the Model

The predications (or conclusions) of the Limits to Growth (LTG) model are based on its basic
thesis that” the continued growth leads to infinite quantities that just do not fit into a finite
world”. This basic thesis can be analyzed as under:

1. The future world population level, food production and industrial production will first
grow exponentially, become increasingly unmanageable and then collapse during the 21th
century.
2. The collapse follows because the world economy will reach its physical limits in terms of
non-renewable resources, agricultural land and the earth’s capacity to absorb excessive
pollution which are finite.
3. Eleven vital minerals such as copper, gold, lead, mercury, natural gas, oil silver, tin and
zinc are being exhausted. If, in addition, industrial production continues to increase, that
too will give rise to catastrophic results.
4. If the present growth trends in world population, industrialization, pollution levels, food
problem and resource depletion continue unchanged, the limits to growth on this planet
will be reached within the next one hundred years. The most probable results will be a
rather sudden and incontrollable decline in both population and industrial capacity
sometime before the year 2010.
5. Since technological progress cannot expand physical resources infinitely, it would be
prudent to put limits on out future growth rather than await the doomsday within the
coming 50 or 1000 years.
6. This catastrophe can be averted by controlling the growth rate of output and population,
reducing the pollution levels, and thus achieving a global equilibrium with zero growth.

The Limits to Growth report developed an interactive simulation mode that produced a variety
of scenarios which were especially useful for defining what was to prevented. It stressed that
pollution, high population growth rate, and shortages of food and resources make the future
prospects of the world bleak which will lead to catastrophic results. Since the resources are
finite and are likely to be depleted within 50 or 100 years, people should change their attitude
towards the use of resources, their reproduction and pollution levels so as to save the world
from collapse

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4.2.3.3 Its Graphic Explanation

The Limits to Growth model is explained in Figure 14. Time in years is taken on the
horizontal axis beginning from the year 1900 to 2100. In Panel (A), resources are measured
along the vertical axis and are represented by the downward sloping R curve. Since such
resources as oil, natural gas, copper, lead, etc. are fixed, they are being continuously depleted
over time from the year 1900 and beyond 2100. In Panel (B), the growth of population and
food supply are measured on the vertical axis and are represented by the P and F curves
respectively.

(C) PN
Pollution Level

(B) P
Population and Food

E F
Production

(A)
Resources

1900 2000 Time 2100

Figure 14: The limits to growth model

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They are shown to increase up to point E at the same rate from 1900 to 2000 year. But beyond
the year 2000, the population curve P continues to rise, while the food production curve F
rises at a diminishing rate and then starts declining by 2100. In Panel (C) the curve PN show
the pollution level which continues to rise beyond the year 2010 and if not checked in time,
will lead to catastrophic results in the world.

4.2.3.4 Criticisms

The Limits to Growth was an alarming report predicting the collapse of the world economy in
the 21st century. It sold ten million copies in over thirty languages and had considerable
impact on economic and political thinking and provided an impetus to antigrowth sentiment.
In fact, the world community was divided into two groups: the resource pessimists and the
resource optimists. The former accepted the predictions of the report and the latter criticized
them on the following grounds:

i) Static reserve index

The model has been criticized for assuming that the non-renewable resources are scarce and
are likely to the exhausted by the year 2100. This perspective is based on the use of the static
reserve index (ie. Reserve to use ratio) which is the ratio of current reserves to current
consumption. The current reserves represent known resources that are economically
extractable. The index expresses the number of years until the resources are depleted, given
that there will be no additions to the known resources and also the future annual use of the
reserves remain at the current level. But the static reserve index is flawed because it neglects
technological development in recycling and reuse of resources and the possibility of
substituting scarce materials for abundant resources. Further, with the discoveries of new
deposits of oil, gas, etc., the size of reserves may increase overtime despite their continuing
extraction.

ii) Technological development

This model neglects technological development in resource extraction, use and substitution. In
fact, the size of reserves of non-renewable resources has been increasing due to rapid
technological development which makes the extraction of sub economic stocks of resources
less expensive.

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Moreover, scarcity of resources has led to technological developments in new resources such
as atomic energy, bio-gas, etc. For industrial and human use. According to Giddens, it is the
world of endless change and endless expansion which the LTG report overlooks.

iii) Food production

The model assumes the availability of limited land and consequent decline in food production.
According to H. Kahn, whenever certain limits are reached, new technologies effectively
either remove the limit or as time passes a subsequent technology can remove the kahn. Kahn
sees production rising with the invention of new technologies as in the case of the Green
Revolution in developing countries which has increased food production and solved their food
problem.

iv) Population growth

The model predicted that the world population growing at an exponential rate would be 7
billion in 2000. If the morality rate continues to decline without lowering the fertility rate, it
will be 14.4 billion in 2030. But the world population has not grown exponentially. It was 6
billion in 2000, as against 7 billion predicted in the model. Highly populated countries like
China and India have slowed down their population growth rates by adopting birth control
measures. Moreover, empirical studies have shown that economic growth accompanied by
rising incomes lowers the fertility rate.

v) Pollution

The model assumes that the level of pollution is increasing exponentially in the world due to
growth in agricultural and industrial activities. Consequently, the degradation of environment
will adversely affect the quality and existence of human life, and flora and fauna. No doubt,
pollution of the environment is a serious problem. Yet both developed and developing
countries are trying to bring down pollution levels by using cleaner technologies. So there is
no need for pessimism that pollution will the doomsday nearer. However, pollution can be
reduced by a judicious choice of economic and environmental policies and environmental
investments. This is only possible through economic growth, at the model emphasizes.

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vi) Price system

The LTG model neglects the price system and the dynamics of the market system. The model
predicts that unlimited economic growth will lead to the depletion of non-renewable
resources. But resource optimist economists do not agree with this view. According to them,
as the scarcity of resources increases, their prices will rise which will, in turn, affect non-
renewable resources in different ways (i) with the rise in their prices, their direct
consumption may be reduced; (ii) the use of high-priced resources in production will fall by
substituting techniques that are less intensive in their use;(iii) high prices of non-renewable
resources will encourage the search for new sources such as atomic energy for power
generation;(iv) their high prices will provide incentives for the development of substitutes for
these resources through new technologies such as bio-gas for power. Thus the efficiency of
the market mechanism seems to be one reason why the most gloomy predictions for the
depletion of non-renewable resources have failed.

vii) Zero economic growth

The LTG report suggests a zero rate of economic growth in order to stop the rise in the
pollution level. Critics point out that if a positive rate of growth will lead to doom, a zero
growth rate will do the same but on a smaller time table. Instead, they argue that economic
growth, especially in developing countries, will provide more resources that can be used to
reduce pollution by supplying potable water, sanitation facilities, providing better housing
facilities and reducing congestion in urban areas. Moreover, economic growth is the only
hope for developing countries to bring people out of the vicious circle of poverty and raise
their standard of living. Thus the very idea of a zero rate of economic growth is fanciful.

Activity 4.6

Explain the measures to be taken to reduce the impact of development on the ecological
integrity of your region
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

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4.2.3.5 Its Implications

The Limits to Growth report highlights the dangers posed by the relentless pursuit of material
wealth by the developed countries. It warns readers about the consequences of unconstrained
growth by the industrialized countries, depletion of non- renewable resources, deterioration of
environment and of population explosions. The report calls forth policy makers, NGOS and
the people in general to protect environment, save non-renewal resources and control
population. Another important policy prescription of the LTG model is that the governments
should voluntarily adopt a zero growth policy. Such a policy would require world
redistribution of income and wealth. For zero economic growth, the redistribution of income
and wealth both within and between countries would be on a very large scale. It can only be
possible by force which would lead to upheavals between the rich and the poor. Moreover, the
model fails for explain how redistribution of income and wealth can be effected with zero
growth rate.

SUMMARY

 We have discussed the views on economic development of some key classical and
structural change theories that provide foundations of much economic thinking of the day.
 Classical economists had an interest in the wider issues of the day, not only in how society
produced its output and wealth but also in how it was distributed among competing groups
with a claim on that income.
 However, the classical theories were believe the existence of an automatic free market and
perfect competition free from any government interferences and capita accumulations a
key to economic growth.
 The structural change theories emphasizing a less theoretical, more historical and
practical approach to the question of how to develop particularly in relation to those who
stressed the applicability of classical models.
 The structural change theories, therefore, focus on the mechanism by which
underdeveloped economies transform their domestic economic structures from traditional
subsistence agriculture to a more modern industrial economy.

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 Adam Smith, the great classical economist, contributes to the theory of how a capitalist
market economy operates, including the importance of the invisible hand, competition,
specialization, and the law of capital accumulation and how these interact to affect the rate
of economic growth.
 David Ricardo, another great classical economist, contributes to the theories of
diminishing returns, comparative advantage, arguments in favor of free trade and how
these relate to the pace of economic expansion.
 Schumpeter’s theory is the one worthy of such great economists as Smith, The entire
process of Schumpeter’s theory regards innovator, innovations and bank credit as the main
cause of economic development.
 Rostow has distinguished five stages of economic growth. His theories of the take-off,
capital formation and development of one or more of the leading sectors are helpful in the
process of industrialization of underdeveloped countries.
 Arthur Lewis has developed a very systematic theory of economic development with
unlimited supplies of labour. Economic development takes place when capital
accumulates as a result of the withdrawal of surplus labour from the “subsistence” sector
to the “capitalist” sector is undertaken.
 The limits to growth model concern about the harmful effects of economic growth on
environment. It believed that the possibilities of continuous growth have been exhausted
and timely action is essential in order to avert a planetary collapse.

REFERENCES

Cypher J. M. and J. L. Dietz, 2009. The Process of Economic Development. Third edition
Routledge, 2 Park Square, Milton Park, Abingdon

Lewis, W.A. 1954. “Economic Development with Unlimited Supplies of Labour, Manchester
School of Economic and Social Studies.

Meier, Gerald. 1976. “Future Development in Historical Perspective,” Leading Issues in

Economic Development, 3rd edn., Oxford University Press.

Nurkse, Ragnar. 1953. Problems of Capital Formation in Underdeveloped Countries. New

York, Oxford University Press.

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Rostow, Walt. 1960. The Stages of Economic Growth: A Non-Communist Manifesto,
Cambridge University Press.

Smith, Adam. 1973. An Inquiry into the Nature and Causes of the Wealth of Nations, New
York, the Modern Library.

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