Economic Growth and Development

Economic growth provides the foundations for economic development by increasing the wealth of a country and allowing it to provide basic needs to its citizens. Economic growth can be seen as an expansion of the curve on a production possibility frontier. On a PPF a country may be able to produce Capital Goods or Consumer Goods, the more capital goods it produces the fewer consumer goods it can make. Therefore in the short run it has to sacrifice consumption in order for economic growth to occur.

Most developing countries have a limited capacity to produce investment goods, and therefore the PPF will be much flatter and sacrifices to consumption won’t increase the amount of capital goods that significantly. This will therefore limit economic growth. The reason such countries have a limited capacity to produce investment goods is because they lack the technical knowledge and resources required to make capital goods. Many developing countries also have low standards of living and therefore much of its resources need to be allocated to consumption. If the country were to devote factors of production to the production of capital goods it would see its standard of living deteriorate further as these countries wouldn’t have as many resources to consume.

Because undeveloped countries can’t produce capital goods, they get stuck in a low-level equilibrium situation. This is demonstrated on a graph below; inability to produce capital means there is low levels of income resulting in low savings and hence low investment, low investment contributes to limited capital and the cycle is renewed.

Economic growth can also be seen as a rightward shift of the long run aggregate supply curve. For this shift to happen investment needs to be undertaken. It would only shift rightwards due to an expansion of the stock of capital or due to improvements in the effectiveness of markets.

These points lead us to conclude that the first focus for LDCs should be to encourage savings and investment in order to achieve economic growth and eventually development.

The potential productive capacity of a country depends on the quantity of factors of production and the efficiency with which they are utilised. Therefore an increase in the quantity/quality of the factors of production and their productivity would leads to a rightward shift of the LRAS curve. The quantity of labour can be increased through a baby boom, allowing more citizens to work (e.g. women, increasing the retirement age, reducing the school leaving age; although this may cause a deterioration in the quality of labour) or migration. The quality of labour can be improved through education and training, however there is an opportunity cost on this on the government’s revenues/budget. The quantity and quality of capital goods can be increased through either domestic investment or foreign direct investment.

Promotion of competition can improve the allocative efficiency of resource allocation.

Rostow Stages of Economic Growth

The economic historian Walt Rostow studied development in many different countries throughout history and as a conclusion developed the 5 stages of economic growth diagram. The first stage (traditional society) is when land is the primary of wealth and a majority of production occurs in agriculture; investment is low.

The preconditions period is the time when agricultural productivity begins to increase which enables resources to be released from the agricultural industry so that there is a surplus in workers who can provide labour for other industries. There are often social and political changes happening simultaneously during this period. In order for the manufacturing sector to increase it is vital that some basic infrastructure is also built.

During the takeoff stage the economy goes through a 2-3 decade period of expansion with high economic growth and investment rising in terms of GDP. This economic growth is usually propelled by a few sectors and entrepreneurs willing to take on risk begin to emerge in society. Investment is needed during this period, funds for this may come from domestic savings as well as external sources (such as FDI).

The drive to maturity is a stage of self sustaining growth; new sectors emerge in addition to the leading sectors pre-established during the take-off period, the economy begins to become diversified and balanced. Investment is still quite large in terms of GDP.

After the drive to the maturity the economy settles in an age of mass consumption , investment falls and consumption increases. Output per capita may continue to rise and the economy is fully diversified. Countries in this stage are considered developed.

There are many criticisms towards this models, mainly that it is based on historical evidence with no main hypothesis given for such a process. It also doesn’t explain policies which could be initiated in order to encourage growth.

Dependency Theory

Dependence theory is the belief that the developed countries became so by exploiting the resources of countries across the Globe (colonial possessions attained through imperialist oppression) and not through internal mechanisms or savings and investment.

The theory states that the world is divided into a core of countries (North America and Western Europe) and a periphery of countries in Asia, Africa and Latin America which remain reliant on primary production and were controlled by the core countries. The periphery countries were just a source of raw materials and as a market for the core countries. Thus the periphery countries would never be able to develop as they would always be repressed by the core countries.

An example of this is the triangular nature of the Slave Trade. A slave ship would leave England or colonial America with manufactured goods which would be exchanged, for a profit, in Africa for slaves. These slaves would then be transported to America and the Caribbean where they were traded with sugar and tobacco plantation owners. This was traded, again for a profit, for raw materials such as sugar and tobacco which would be sent back to the factories in England. They were then turned into manufactured goods and sold to the domestic market as well as back to Africa to continue the cycle. The result of this was that Africa could never escape (until the slave trade became illegal) the cycle and the whole process solely benefited the rich developed countries of Britain and its imperial possessions. A similar example of dependency theory is the case when Britain suppressed Indian cotton production (India was a colony at the time) in order to protect the cotton mills of Lancashire.

However, it could be argued that colonies benefited from an increase in infrastructure (railways, roads and ports) as well as educational structures which were provided by the colonising countries. It could also be argued that countries which were never colonised (Afghanistan and Ethiopia) still failed to develop; therefore suggesting that this theory alone cannot explain why some countries develop and others do not.

Industrialisation (Lewis Model)

Industrialisation is the transformation of an economy obtained through expanding industrial sectors like manufacturing. In 1954 Arthur Lewis argued that in many less developed countries there was excess labour in agriculture. He believed this was because farms were owned by families and so some members of the family may not be needed to work on the farm but would still receive an income from it. These people counted as employed but in truth they are under employed. This means there exists vast surplus labour in the agriculture industry; if this labour were to migrate to urban areas then they could work in other sectors like manufacturing.

This is what Lewis argued; he said that surplus labour could be transferred into the industrial sector without seeing a loss of agricultural output seeing as the remaining labour could take up the slack. However to make this transfer happen the industrial sector would have to set a wage slightly higher than rural wage in order to encourage workers to swap jobs. This will create profits for the industrial sector which could be reinvested to create infrastructure to help industry expand; the wage wouldn’t need to be increased – causing inflation – until there was no more excess labour. In a less developed country there may be a lot of excess labour and hence there wouldn’t be any need to increase the wages for a significant period of time.

However this model by Lewis doesn’t take into account human capital: agricultural workers don’t have the necessary skills to be easily employed in the industrial sector. Therefore it isn’t a straightforward transfer from agriculture to industry. Furthermore the industrial sector doesn’t always reinvest profits to allow expansion of the sector. Foreign firms may have sent profits home. Regardless of this modern technology and capital means that large quantities of unskilled labour are largely unnecessary. This model also encourages growth in the industrial sector but may lead governments to ignore the agriculture sector which still accounts for a large percentage of the employed labour force. A result of a change in government focus could mean that agricultural productivity remains low and that inequality grows.

Harrod-Domar Model

The Harrod-Domar model supports the view that to create economic growth an economy needs to focus on investment and savings. This model states that an economy can remain in equilibrium perpetually if it grows at a certain rate. This rate of growth depends on the savings ratio and the productivity of capital. If the economy moves away from this path then it becomes unstable.

The model is shown below; savings are needed to enable investment, some of which will be needed simply to replace existing capital that has been worn out. Further savings can be used to invest in increasing the capital stock and technology. The increased capital stock leads to an increase in output and hence incomes leading to more savings completing and accentuating the cycle.

In order to escape from the problem of the low-level equilibrium trap an LDC would have to generate savings; going by this model. This could be difficult due to low incomes. Low incomes mean that households tend to spend most of their income on consumption and have little left to save.

A result of investing is that current consumption must be foregone in order to produce capital goods to fuel future production. In order for investment to occur then there must be an intermediary to distribute savings to firms. In the developed countries this occurs through financial markets. But in LDCs the financial markets are underdeveloped making it hard for funds to be distributed in this fashion. In LDCs much saving is conducted in the form of purchasing fixed assets, or saving cash ‘under the mattress’. Such saving cannot easily be transformed into investment, making it hard for an economy to produce capital goods and hence grow.

Additionally, some governments have adopted a policy of low interest rates with the belief that this will encourage firms to borrow in order to invest. But this neglects the fact that low interest rates, whilst incentivising businesses to borrow, doesn’t provide an incentive for savers to save. The result of this may be that firms wish to invest; but don’t have the funds required to do so.

Another requirement for investment is that an entrepreneurial class must exist to identify investment opportunities and undertake such investment along with the burden of risk associated with such investments. Such a class of people may not exist in LDCs and the culture that prevails may deter such activities (some cultures perceive risk as negative and failure as derogatory). This problem could be overcome through migration. Entrepreneurs from other countries may flock to an economy in order to take advantage of a wealth of opportunities to make money; whilst taking on the associated risk.

Furthermore, for investment to be effective physical capital needs to be available. Many LDCs have limited capabilities to produce capital goods due to a lack of experience, knowledge and equipment/materials. Therefore much of a developing country’s capital goods need to be imported from developed countries.

This is beneficial, since LDCs don’t have to undertake expensive research and development to be able to advance their economy (like the pioneering developed countries) they can import the know-how from other countries. The ability to do this provides LDCs with an advantage as they can learn from earlier mistakes (made by developed countries) and grow more rapidly to reduce the gap with the more developed countries in the world.

However foreign exchange is required to pay for this. Many LDCs don’t have sufficient foreign exchange as they can’t export other goods to pay for the imports of capital goods. Hence it is difficult to get the capital goods to allow a country to be able to produce manufactured goods to export, providing another barrier to economic growth. Additionally, other imports such as food and medical supplies may be required to increase the quality of the human capital.

Another problem which may act as a barrier to development is the lack of skilled labour that can operate the complex physical capital to produce goods. To do this the labour force needs to be skilled, healthy and well educated. Therefore education is believed to be a large foundation for economic growth. To prioritise education, investment may be needed to create the necessary institutions and there may need to be a change in cultural perceptions so that a good work-ethic is instilled from adolescence.

Further refinements to the Harrod Domar model can be made. An LDC could add to its domestic savings by obtaining savings from abroad in the form of FDI. A revised Harrod-Domar model is shown below which includes possible injections and withdrawals. Savings could be supplemented by foreign aid from wealthy foreign benefactors, charities and governments/organisations; it could come from borrowing from foreign banks; or it could be increase by encouraging foreign direct investment. However there are associated withdrawals with these injections. There could be withdrawals in the form of: profits; foreign companies may repatriate profits home, therefore they won’t be reinvested to improve infrastructure and create future growth; aid may be tied and so may benefit the benefactors economy more than the developing country; and thirdly increased borrowing could lead to debt. This debt requires interest payments which obviously have an opportunity cost. This debt will also have to be repaid at a future date; if it wasn’t invested profitably (or if the investment fell through) then the country may find itself in trouble. Defaults may result in higher interest rates in the future or increased difficultly in borrowing.

Market Friendly Growth

Market friendly growth is an alternative view on how economic growth occurs, and is also known as the Washington Consensus, its most famous advocates include the World Bank and the IMF. The fundamental belief of this model is that markets should be free without government intervention. Government intervention should only occur if a market cannot operate effectively. If markets can work effectively – without intervention by governments – then resources can be allocated more efficiently. The four areas, proposed by the World Bank, for prioritising by LDCs are people, microeconomic markets, macroeconomic stability and global links. There are an additional two points which aren’t mentioned in this model but are equally as important to help developing countries grow. The first is infrastructure; transport and communications system need to be improved to encourage FDI and to allow domestic firms to expand and compete against foreign MNCs. The second is that developing countries governments need to balance their spending priorities. Some LDCs spend too much money on things like defence and military expenditure which doesn’t directly help the economy develop.

Macroeconomic Stability

Macroeconomic stability is considered important because a good environment encourages investment. An unstable environment would cause firms to lose confidence in the future and hence be unwilling to invest in the economy. For example inflation, a case of macroeconomic instability, can cause problems for inflation as firms can’t use the pricing mechanism accurately to signal what products are doing well and which are not. Furthermore inflation also makes the future more uncertain as firms aren’t sure of their future costs and they would have to have a high rate of return in nominal values to make it worth anything in real terms. Additionally, government intervention can cause problems such as crowding out, in terms of the interest rates paid by the private sector.

LDCs should prioritise making prices act as effective signals in order to ensure that they inform firms on how to allocate resources to the optimal point. A stable macroeconomic environment also means that the economy will be more able to adapt and react to any external shocks. For example, a fiscal surplus can be seen as a good macroeconomic environment; countries which operated fiscal surpluses were in a better position to react to the external shock of the Global Financial Crisis. Countries which were more unstable and run large budget deficits and had large debts may find it more difficult (and in some places currently are) to react to the crisis.

People

Human capital is necessary for development and there is a need for a skilled and well educated labour force to use the capital already accumulated and to make further capital and consumer goods. However education is a merit good and has a positive externality. Therefore the social benefits are greater than the private benefits and hence education is under consumed.

This is the case in many LDCs were there is a high drop-out rate from education as it is perceived that children would do better off to be earning and helping the family out now than gaining an education which wont – it is perceived – get them very far. Meanwhile they could be earning a trade – like how to farm – which will stand then in good stead for life. This means that there is also a high opportunity cost for children to be schooled (in the sense that they could be working and in the sense that the government has to spend scarce money and resources on the education system).

The poor state of education has been exacerbated due to a poor, or even lacking, curriculum which doesn’t provide an appropriate education necessary for LDC countries.

Global Linkages

Domestic markets in the less developed countries are often quite small and there is therefore less effective (backed up by the ability to pay) demand. This means that domestic firms are unable to benefit from economies of scale and may face increased competition from foreign producers who can exploit economies of scale (as there domestic markets are much larger and because they are used to exporting to other countries and hence have a large output enabling them to benefit from economies of scale) and hence have lower costs and can offer goods and services more cheaply creating monopolies.

For domestic firms in LDCs to be able to expand their output and benefit from lower long run average costs, they need to be able to export their produce abroad. This makes international trade important for less developed countries and gives them another market to grow and catch up with developed countries.

Better global linkages not only open up a new, incredibly large, market but they can also gain access to foreign technology which they didn’t have the ability to produce themselves. Developing global linkages allow developing countries to close their foreign exchange gap and import capital goods to expand their production possibility frontier.

A spill-over effect of good global linkages is an increase in macroeconomic stability due to increased access to physical and financial capital as well as experience and expertise from foreign countries and their economic policies. There will also be improvements in human capital from increase knowledge; this can further benefit the domestic economy and help it to play catch-up.

There may, however, be some difficulties in creating these linkages. Firstly developed countries may be unwilling to create such links if they feel they aren’t getting anything in return (and may actually be losing if there is increased competition). As a result, less developed countries may have to open up their domestic market to foreign competition as a prerequisite for global linkages. However if this isn’t controlled properly it can lead to damage to domestic firms (who face competition from the much larger foreign firms) and lead to macroeconomic instability as the economy is more prone to external shocks and doesn’t have the institutional framework to protect or react to such shocks.

Microeconomic Markets

Competitive micro-markets would increase the allocative efficiency of such markets; meaning that resources are allocated to those that demand them. This is done through the signalling mechanism of prices. Prices allow enterprise as entrepreneurs can see gaps in the market and exploit them in order to make profit; this process benefits society as a whole. Some LDC governments intervene in certain markets; for example the food market, where they keep it artificially low in urban areas to subsidise workers and encourage urbanisation. However this is a distortion and may damage farmers’ incentives; supply may fall as a result of this policy and there may be a lack of investment causing irreparable damage to the soil which will damage future production of crops.

It is also important for less developed countries’ governments to encourage a financial market to emerge; this market can then act as an intermediary between savers (who will get an interest of their savings, as oppose to when they leave it under their mattress) and investors (who will have funds to invest in the economy creating economic growth).

Better microeconomic markets which work more efficiently can ensure that people get a better return on education, thus encouraging more education and hence increasing human capital. Additionally, foreign direct investment may increase in a country which has effective microeconomic markets and the financial sector can help with macro-economic stability.

Structural Adjustment Programmes (SAPs)

The SAP is a package of economic policy measures administered by the World Bank and is based around its Market Friendly model and provided to LDCs as an ideal of how to improve and develop. 

Page last updated on 17/04/14