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Theories of
Economic Development
The three building blocks of most growth models are: (1)
the production function, (2) the saving function, and (3) the labor
supply function (related to population growth). Together with a saving
function, growth rate equals s/ß (s is the saving rate, and
ß is the capital-output ratio). Assuming that the capital-output
ratio is fixed by technology and does not change in the short run,
growth rate is solely determined by the saving rate on the basis of
whatever is saved will be invested.
The Harrod-Domar theory delineates a functional economic
relationship in which the growth rate of gross domestic product (g)
depends directly on the national saving ratio (s) and inversely on the
national capital/output ratio (k) so that it is written a g = s / k.
The equation takes its name from a synthesis of analyses of growth process
by two economists (Sir Roy Harrod of Britain and E.V. Domar of the USA).
The Harrod-Domar model in the early postwar times was commonly used
by developing countries in economic planning. With a target growth rate,
the required saving rate is known. If the country is not capable of
generating that level of saving, a justification or an excuse for borrowing
from international agencies can be established. An example in the Asian
context is to ascertain the relationship between high growth rates and
high saving rates in the cases of Japan and China. It is more difficult
to introduce the third building block of a growth model, the labor and
population element. In the long run, growth rate is constrained by population
growth and also by the rate of technological change.
The Exogenous Growth theory (or Neoclassical Growth Model)
of Robert Solow and others places emphasis on the role of technological
change. Unlike the Harrod-Domar model, the saving rate will only determine
the level of income but not the rate of growth. The sources-of-growth
measurement obtained from this model highlights the relative importance
of capital accumulation (as in the Harrod-Domar model) and technological
change (as in the Neoclassical model) in economic growth. The original
Solow (1957) study showed that technological change accounted for almost
90 percent of U.S. economic growth in the late 19th and early 20th centuries.
Empirical studies on developing countries have shown different results.
Even so, in our postindustrial economy, economic development,
including in emerging countries is now more and more based on innovation
and knowledge. Creating Porter's clusters is one of the strategies used.
One well known example is Bangalore in India.
The Lewis-Ranis-Fei (LRF) theory of Surplus Labor is an economic
development model and not an economic growth model.
Economic models such as Big Push, Unbalanced Growth, Take-off, and so
forth, are only partial theories of economic growth
that address specific issues. It is a model taking the peculiar economic
situation in developing countries into account: unemployment and underemployment
of resources (especially labor) and the dualistic economic structure
(modern vs. traditional sectors). This model is a classical model because
it uses the classical assumption of subsistence wage.
Here it is understood that the development process is triggered by
the transfer of surplus labor in the traditional sector to the modern
sector in which some significant economic activities have already
begun. The modern sector entrepreneurs can continue to pay the transferred
workers a subsistence wage because of the unlimited supply of labor
from the traditional sector. The profits and hence investment in the
modern sector will continue to rise and fuel further economic growth
in the modern sector. This process will continue until the surplus
labor in the traditional sector is used up, a situation in which the
workers in the traditional sector would also be paid in accordance
with their marginal product rather than subsistence wage.
The existence of surplus labor gives rise to continuous capital accumulation
in the modern sector because (a) investment would not be eroded by
rising wages as workers are continued to be paid subsistence wage,
and (b) the average agricultural surplus (AAS) in the traditional
sector will be channeled to the modern sector for even more supply
of capital (e.g., new taxes imposed by the government or savings placed
in banks by people in the traditional sector). In the LRF model, saving
and investment are driving forces of economic development. This is
in line with the Harrod-Domar model but in the context of less-developed
countries. The importance of technological change would be reduced
to enhancing productivity in the modern sector for even greater profitability
and to promote productivity in the traditional sector so that more
labor would be available for transfer.
The Harris-Todaro (H-T) theory of rural-urban migration is usually studied
in the context of employment and unemployment in developing countries.
In the H-T model, the purpose is to explain the serious urban unemployment
problem in developing countries. The applicability of this model depends
on the development stage and economic success in the developing country.
The distinctive concept in the H-T model is that the rate of migration
flow is determined by the difference between expected urban wages
(not actual) and rural wages. The H-T model is applicable to less
successful developing countries or to countries at the earlier stages
of development. The policy implications are different from those of
the LRF model. One implication in the H-T model is that job creation
in the urban sector worsens the situation because more rural migration
would thus be induced. In this context, China's policy of rural development
and rural industrialization to deal with urban unemployment provides
an example.
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