ECONOMIC GROWTH AND DEVELOPMENT
(Solow, Lewis, Kuznets, Schultz, Becker, Myrdal, Angus Deaton)
The genesis of Growth theory in the last Century can be traced to. Harrod and Domar Model.s As theyare similar we discuss. Harrod- model. Explanations of Harrod model are many and the one given by A.K.Sen, in his Introduction to Growth Economics, is brief and excellent. As such, we follow Sen’s explanation of Harrod model.
It can be shown that the following relation holds between the actual and the expected growth rate.
1) gt ≥ ĝt, according as ĝt ≥ s/C
The actual growth rate gt, is equal to expected growth rate ĝt if and only if the expected growth rate, is equal to the warranted rate of growth, s/C where ‘s’ is the saving rate and ‘C’ is capital-output ratio otherwise there will be Harrod’s instability problem. If the investors expect more than the warranted rate of growth, s/C then the actual growth rate of demand will exceed expected growth rate.
Suppose, the saving rate is a 20% and the Capital-Output ratio C is 4, then the warranted growth rate is 5%. Suppose the current output level is 95, so that a 5% increase will, mean a movement to 100(approximately). If the investors in fact expect an output of 100, they will invest 20 units,(5.4) to create an additional capacity for an additional units of demand. The investment of 20 units will generate a demand level of 100,so that expectations will be realized.Suppose, the investors expect more, say 102 units of demand they have to create capacity to meet additional demand of 7 units (102-95). They invest 28 units (7.4) and through the multiplier investment of 28 units will generate a demand level of 28. 5=140 Investors will feel that they have expected too little demand. Similarly if the investors expect less, say 98, then they will invest 12units(3 . 4) and it will generate demand of only 60 units. So they feel that their expectations are very high.
Harrod employs another growth rate, the ‘Natural’ rate of growth. Harrod’s Natural rate of growth is the maximum sustainable rate of growth in the long run given by the rate of growth of the Labor force, ‘n’ and the rate of labor-saving Technical progress, ‘m’. if the warranted rate of growth given by s/c is equal to the natural rate, there is no problem. But if the warranted rate ‘Gw’ is greater than the Natural rate, Gn, then actual reaches a ceiling limit of full-employment, which may result in departures from equilibrium. On the other hand Gw<Gn then a, growing portion of un-employment will emerge.
Thus according to Harrod an economy achieves a steady growth at a constant rate only when the saving rate is equal to the product of the Capital-Output ratio and rate of growth of the (effective) Labor force.
Dissatisfied with Harrod’s crucial assumptions and its main conclusions, Solow published his classic article” A contribution to the Theory of Economic Growth” in 1956. His article marks the beginning of the Neo-Classical Model of Economic Growth”; the gist of the article is presented below.
Solow’s growth model is presented in the following fundamental Equation.
r1 + n.r = sF(r,1) or r1 = sF(r,1) – n.r
Where ‘r1’ is the rate of change in capital-labor ratio.
The function F(r,1) gives the total product as varying amounts of capital are employed with one unit of labor. Alternatively, it gives output per worker as a function of capital per worker.
Consider the right hand side of the equation. we know sF(r,1) is simply saving per worker and since in this model, saving automatically become investment, it can be interpreted as the flow of investment per worker. The second term in equation, n.r is the amount of investment that would be required to keep the capital – labor ratio ‘r’ constant, given that the labor force is growing at a constant proportional rate of n. Thus the rate of change of the capital – labor ratio, (r|) is determined by the difference between the amount of saving (and investment) per worker and the amount required to keep the capital – labor ratio constant as the labor force grows.
When the two are equal, r will be constant at the equilibrium value, re (r1= 0).
Using the above equilibrium point, there is a simple mechanism to make the equilibrium stable. Suppose for example; there is a departure from equilibrium value, re. If savings fall short of the required investment nr, then Capital labor ratio decreases toward the equilibrium value. If savings exceed the required investment, then the Capital-labor ratio will increase toward the equilibrium value.
The following conclusions are drawn from Solow’s model.
Solow and other Neo-Classical writers argued that relative shares of Labor and Capital depend on the ratio of marginal and average productivities of the Factors. The share of a Factor of Production is equal to the elasticity of production with regard to that factor. Under the assumption of constant returns to scale and competitive markets, Solow suggested that the rate of growth of output is equal to the rate of growth of labor multiplied by its share in output plus rate of growth of capital multiplied by its share in output plus the residual. This Solow’s residual is termed multifactor productivity growth. It is observed that in U.S. the output-capital ratio is relatively constant for a long period. This implies a positive Solow residual, equal roughly to the labor share times the rate of growth of labor productivity. The rate of change of multifactor productivity of Solow residual is estimated to be 1.7 in U.S. during 1950 to 1975, accounting for approximately half of the growth of the private economy of U.S. over the whole period. The source of the residual is not known.
Modern Growth theory is devoted to analyzing properties of Steady-states in industrial economies. However, Growth Theories provide useful insights to growth problems of developing Countries also. Solow’s endogenous model of growth has relevance for developing countries and it is discussed below.
Solow’s Endogenous model of Growth
In the Solow’s exogenous model discussed earlier, the relative rate of Population growth in treated as constant, n. Later, Solow relaxes this assumption and make Population an endogenous variable. This model is discussed in his book Growth Theory (2000). Suppose, for example, for very low levels of income per-capita the (real wage) Population tends to decrease; for the next stage higher levels of income, it begins to increase and that for still higher levels of income, the rate of Population growth levels off and starts to decline. The rate of growth of population depends on the level of per-capita income. Since per-Capita income is given by Y/L = F(r.1), the upshot is that the rate of growth of the labor force becomes n = n(r). The earlier Fundamental Eq. now becomes:
r1 = s F(r,1) – n(r).r
Thus, the rate of change capital/labor is constant if per capita savings are equal to the investment requirement. With Population growth nr(r), the investment requirement rises slowly, then sharply and eventually flattens out. The per-capita savings remains the same.
The investment requirement may equal the savings at low and high points r1 and r2. Point r1 is the Poverty trap point, with high Population growth and low income. The equilibrium point r1 is stable. If the initial Capital-labor ratio is less than r2 the system will move back towards r1. Point r2 is unstable. If the initial capital-labor ratio can be raised substantially by investing in a big way, so as to make it go beyond the critical level r2, then economy experiences a self-sustaining growth with increased income. The economy can avoid the Poverty trap by increasing savings and reducing the rate of Population growth.
W.A.Lewis
W.A.Lewis classic article, “Economic Development with Unlimited Supply of Labor” published in 1954, gave rise to enormous Research on the contemporary problems of large areas of the earth (of developing countries). As such the salient points in that article are presented here.
Lewis, like Classical writers, assumed the existence of disguised labor in agriculture in developing countries. In the Lewis model there are two sectors-the agricultural sector and the manufacturing sector. The two sectors may as well be described as ‘subsistence sector’ and the ‘capitalist sector’. The Capitalist sector is that part of the economy which uses reproducible capital and pays for the use thereof. The remaining part of the economy is the subsistence sector.
The Capitalist sector can expand indefinitely at a constant wage rate for un-skilled labor, drawn from the Agricultural sector. The actual wage rate will be determined by earnings in the subsistence sector, which is equal to average product and not marginal product. It is because by convention everyone in a household received an equal share of what is produced. Capitalist will have to pay some margin-perhaps 30% above average of a subsistence pay because the surplus workers in agriculture need some incentive to move to urban areas for being employed in the manufacturing sector. Supply of labor is perfectly elastic to the manufacturing sector at the current wage so determined at the institutional wage in agriculture.
In the Capitalist sector, the marginal product curve will be concave (from origin) and will be decreasing. In the Capitalistic labor will be employed up to point where its marginal product equals wage. The Capitalist will get Producer’s surplus. The surplus is reinvested by the capitalist which raises the schedule of marginal productivity of labor. And the process continues as long as there is surplus of labor. The Lewis model, in effect says that unlimited supplies of labor are available at a constant real wage and if any part of profits is reinvested in productive capacity, profits will grow continuously relative to national income and capital formation will also grow relatively to national income.
The central fact of economic development is rapid capital accumulation. Lewis model popularized the concept of Dualism in which a small industrial sector grows to absorb greater amounts of agricultural surplus labor, without adversely affecting agricultural production.
And, extending the migration mechanism suggested in Lewis model, Michael Todaro developed two-sector migration model. In the Lewis schema, people migrate from rural to urban areas in response to assured urban employment, and with out a real wage differential. In Todaro model, however, the parameters become variables. According to Todaro, an individual’s decision to migrate is a function of income gain of an urban job weighted by likelihood of finding such job. Lewis & Todaro models of Dualism are more realistic than the earlier Sociological Dualism, proposed by Dr. Boeke. According to Dr. Boeke; “Social Dualism is the clashing of an imported social system with an indigenous social system of another style”. The imported social system of high Capitalism (from the West), clashes with the existing pre-Capitalist system (in the East). According to Boeke, Dualism arises from a clash between East and West, specially between the Cultural traits of their societies.
Kuznets
Kuznets is well known for his significant contributions to Economic Growth. A Bibliography of his works is given in his latest book (published posthumously), Economic Development, the Family and Income Distribution.
As the books of Kuznets are available and accessible to Indian students and non-technical and understandable there is no point in giving all the findings of Kuznets researches. We present one important empirical finding by Kuznets.
Based on Kuznets empirical findings and conclusions a tentative hypothesis is formulated which states that income inequality first rises and then falls with development. A plot of inequality (on vertical axis) against a measure of development such as per-capita income (on horizontal axis) would then look like an inverted ‘U’ (looks like ‘∩’.
Gunnar Myrdal
Gunnar Myrdal’s methodology is characterized by an interdisciplinary approach, to social problems. In analyzing social problems he takes into consideration not only ‘pure economic factors but also the social, demographic and institutional aspects’, Further, he states his value premises explicitly.
Myrdal’s contributions to Monetary Economics are significant. But his contributions to policy issues of developing countries are widely known and appreciated. He is responsible for popularizing the concept of vicious circle. In his seminal work on U.S.Race Relations: An American Dilemma, he explained the Race relations in terms of ‘White Prejudice’ and ‘Low Negro standards’. These forces operate in a circular way in a static context, balancing each other. White Prejudice and the consequent discrimination against the Negros, block their efforts to raise their low plane of living. This on the other hand, forms part of the causation of the prejudice of the Whites.
This hypothesis of circular causation is used by Myrdal again in his works on economic development of Backward Countries. He argues that the principle of circular interdependence within a process of cumulative causation has validity over the entire field of social relations and economic development. The problem of Economic development, according to Myrdal, consists in generating cumulative movement in an upward direction. In such a case, the circular constellation of forces, instead of being vicious will become beneficient.
Myrdal wrote many books and his Magnus-opus is Asian Drama-An Enquiry into the Poverty of Nations. Many have acclaimed Myrdal as Adam Smith of Poverty.
Myrdal disagreed with the Inter-National Trade theory proposed by Heckscher-Ohlin. They argued that trade worked for equalization of Factor prices and income. Myrdal argued that Inter-National Trade (and Capital movements) will generally tend to breed inequality and will do so the more strongly when substantial inequalities are already established. Developed Countries with higher productivity and incomes will continually acquire more internal and external economics and develop, further, while under-developed countries will face back-wash effects from developed Countries and they continue to remain under developed.
Critics of Free Trade includes Paul Prebisch and others. Prebisch divides the World into Centre and Periphery; the Centre comprises of Industrial Countries and the Periphery encompasses the Underdeveloped World. Trade between the two results in adverse terms of Trade for the Periphery.
The Dependency School of writers argued that foreign Trade, foreign investments would entangle the Periphery into Capitalistic network of Centre and profits arising from these investments would be transferred as surplus from the Periphery to the Centre, aggravating the Poverty of the Periphery.
Robert E. Lucas has proposed a new theory of growth in his book Lectures on Economic Growth (2002). He developed the human capital model. It involves an external effect of human capital patterned on the external effects of knowledge capital that Romer introduced. The central idea in Lucas book is that the successful transformation from an economy of traditional agriculture to a modern growing economy depends crucially on an increase in the rate of human capital accumulation.
Economics of Education
T.W.Schultz
Economists have long known that people are an important part of the wealth of nations. Investment in human capital will further the economic growth and development of nations. Modern economists have not paid as much attention to human resources in economic growth as did some of the great Classical economists like Adam Smith and Marshall.
T.W.Schultz felt that investment in human beings has seldom been incorporated in the formal core of economics even though its relevance is recognized. In his Presidential address at the annual meeting of the American Economic Association (28, Dec.1960). Schultz has drawn attention to the need for investment in human capital.
He argues that worker need skills and knowledge which is largely a product of investment in education and improved skills of the workers, account predominantly for the productive superiority of the technically advanced nations.
When we take account of investment in education, we can find explanations for the following apparent paradoxes.:
When farm people take non-farm jobs they earn substantially less than industrial workers of the same race, age and sex, this difference in earnings correspond closely to their difference in education levels.
Schultz argues that the observed growth in productivity per worker and a large increase in real earnings of workers is partly due to improvements in investment in physical capital but largely due to steadily growing amount of human capital per worker.
Gary Becker
Becker also stressed the importance of investment in human capital. In his classic work, Human Capital: A Theoretical and Empirical Analysis, he provided a general analysis of investment inhuman capital. In his book he discusses of investment in, on the job training and also of investments in schooling, information and health. The concept of human capital embraces such activities as the purchase of health care, time spent searching for better job than accepting the first available job, migration, and acceptance of low paying jobs which have a large element of learning on the job. According to Becker, in the long-run, all such investments in human capital will be undertaken up to the point where the marginal returns to such investments are equal to the marginal cost of investment funds.
The growing realization of the need for Human development has led to the construction of Human Development Index (HDI) by World Bank. Prior to the construction of the HDI, the World Bank advocated ‘Basic needs’ approach. Human Development goes beyond ‘Basic needs’ in that it is concerned with all human beings-not limited only to the Poor Persons and Poor Countries. Of course, the main target groups are the Poor in all Countries.
Human Development Index:
Human Development Reports have been released annually under the auspicious of UNDP. The preparation of the Human Development Reports is made possible due to collective effort of many individuals and organizations. Sen served as Advisor for preparing the Human Development Reports and fruitfully interacted with many economists like Mahabub – ul-haq, Sudheer Anand, Paul Streeten & Richard Jolly. Sen, in collaboration with Sudheer Anand provides a detailed analysis of Human Development Index, Methodology and Measurement (Occasional paper12, UNDP)
HDI and India
The HDI is based on three indicators as measured by
The average of the three indices is the HDI
HDI in 1994 = .605+.528 +.206 / 3 = .1339 / 3 = 0.446
The HDI value in 1999 for India is 0.571 (HDI rank is 115) The HDI value of India in 2005 is 0.6 but India’s rank declined to 127 in 2005 and improved its rank to 126th in 2006. (The top country in HDI gets rank 1). Based on 2007 data, the HDI for India is estimated to be 0.612 and its HDI rank is 134 out of 182 countries.
The Human Poverty Index (HPI) focusing on the proportion of people below certain threshold level in each of the dimensions of the HDI is estimated at 28% for India. Using HPI, India ranks 88th out of 135 countries.
Even the HDI is viewed as inadequate measure of human well being. Recently President Sarkozy of France has set up a commission in July 2008 to suggest alternative measures of economic and social progress. The Commission has Joseph Stiglitz as Chairman, A. K. Sen as Chair advisor and an impressive list of eminent economists and social scientists. The Commission submitted its report in September, 2009, which is titled as “Report by the Commission on the Measurement of Economic Performance and Social Progress”. The report attempts to measure quality of the life of people. The report argues for concentration on Household incomes, consumption and wealth rather than total production.
Angus Deaton Daniel Kahneman (also a Nobel Economist) distinguish between Emotional well-being and life evaluation. Emotional well-being (sometimes called hedonic well-being) refers to the emotional polity of an individuals everyday experience – the frequency and intensity of experiences of joy, fascination, anxiety, sadness, anger and affection that makes one’s life pleasant and unpleasant. Life evaluation refers to a person’s thoughts about his life. It is measured using Cantril’s self-anchoring scale, which has the respondent rate his or her current life on a ladder scale in which ‘0’ is the worst possible life for you and ‘10’ is the best possible life for you. The authors conclude that when plotted against log of income, high income includes evaluation of life. High income results in an increase in emotional well-being also, but there is satiation point beyond which there is no progress in emotional well-being. Low income is associated both with low life evaluation and low emotional well-being. For that, high income buys life satisfaction but not happiness. (in an article, 10th September, 2010.)
Angus Deaton wins the Nobel Prize in Economics in 2015 “for his Analysis of Consumption poverty and welfare”. The Royal Swedish Academy of Sciences has said that “by emphasizing the links between individual consumptions decisions and outcomes for the whole economy” is work has helped transform modern Micro Economics, Macro Economics and Development Economics.
According to Deaton, we must first understand individual consumption choices to design economic policy that promotes welfare and reduces poverty. Individual consumptions levels of source can be used to get a better understanding of their leaving standards and possible paths for economic development. His research, contributions are many and varied. Look at the list of publications of Deaton, Princeton University.
A.K. Sen
Sen was born in 1933 at Shantiniketan in Bengal and spent his childhood at Dhaka. As a child he witnessed the dire effects of the Bengal Famine of 1943. Millions starved to death and this made a deep impression on young Ses’s mind. This has led him later to study the causes and effects of Famines. In his book ‘Poverty and Famines’ Sen examines the causes and effects of the Bengal Famine of 1943, the Ethiopian Famine of 1974 and the Bangladesh Famine of 1974. His analyses reveals that decline in food availability is not often the cause of Famine. It is the failure in Exchange Entitlements that have led to the Famines, Sen terms the former approach as FAD (Food Availability Decline) approach and the later as FEE (Failure of Exchange Entitlement) approach. Entitlement is a semi-legal concept focussing on the bundles of goods and services that a person or family can legitimately establish command over using the laws, regulations, conventions, opportunities and rights. In market economics entitlements reflect ownership on the one hand and opportunities of production and exchange on the other. The application of the entitlement approach helps to explain why the Malthusian focus on food availability per capita is often so badly misleading since the entitlements of specific groups could easily collapse even when average food availability per head declines very little or even rises. If one person in eight starves regularly in the World, Sen sees it as the result of his inability to establish entitlement to enough food.
Sen on Poverty
In 1971, Dandekar and Rath have studied Poverty in Indian in a comprehensive manner and since then many have made useful contributions to discussion on Poverty. Earlier studies focused attention on the Head-Count ratio and the Income-Cap ratio. Head- count ratio is obtained counting the number of poor people and expressing it as a ratio of the total population. Income gap is measured by the difference between the poverty line and the mean income of the poor. . While the head – Count ratio tells us the percentage of people below the Poverty – line, the Income –gap ratio tells us the percentage of their mean income shortfall from the Poverty Level. The Head-Count ratio ignores the extent of Poverty and the Income - gap ratio is completely insensitive to numbers involved. Sen proposed a measure of Poverty which is sensitive to income distribution. The product of the Head-Count ratio (H) and the Income-gap ratio(I), plus the product of the Head-Count ratio and the distribution of income among the poor (GP) weighted by one minus the Income gap ratio, gives Sen’s Index of Poverty (SIP). The formula suggested by Sen is:
1) SIP = H. I + H(1 – I) GP
in the above formula,
H =Head – Count ratio
The GP can be computed using the following formula:
2) GP = 1/100.100 |(n Xi Yi+1- (n Xi +1 . Yi|
In eqn. (2) Xi represents the cumulative percentage of the number of Poor people, n and Yi stands for cumulative percentage of incomes of the poor. We take the absolute value of the difference between the sums given in the brackets.
Sen on Functioning’s and Capabilities
Sen introduced the concept of Functioning’s and Capabilities and he uses this framework to examine the issues of Poverty, Standard of living and freedoms. Functioning’s tell us what a person is doing, capability to function reflects what a person can do. According to Sen the various living conditions we can or cannot achieve are functioning’s and our ability to achieve them are our Capabilities. Poverty in nothing but a failure of basic Capabilities. In the context of extreme poverty in developing Countries, we are concerned with a small number of centrally important functioning’s and the corresponding basic Capabilities, such as the ability to be well nourished and well sheltered, the capability of escaping avoidable morbidity and pre-nature mortality. Similarly, standard of living focuses attention on what life we lead and what we can or cannot do. As such, Sen argues, the standard of living is really a matter of Functioning’s and Capabilities. Likewise, Sen interprets positive Freedoms in terms of Capabilities, to function. The positive Freedoms specify what a person can or cannot do, or can or cannot be. Taking Sen’s multi dimensional view of poverty, Sabina Ali and Emma Sanosh at Oxford University have constructed in June 2010, a new multi dimensional poverty index (M.P.I). In the M.P.I. a household is considered as poor if it is deprived on over 32% of the ten indicators used. The ten indicators of poverty considered in the M.P.I. are the deprivation of basic things such as: nourishing food, proper shelter, clean drinking water, electricity, literacy and assets. Persons who are deprived along many of the dimensions of poverty are considered as poor. The extreme cut off ratio is equal to or greater than 0.32. As the research study is backed by U.N., full details of M.P.I. are published in the U.N. development Report of 2010.
Sen on Development
Sen defines Development as Freedom. Development, he says, is a process of expanding real freedoms that people enjoy. This view is different from the traditional conceptions of Development which identify development with the rate of growth of GNP or per capita GDP. Economic Growth, Sen opines, cannot be treated as an end in its self but the freedom that people value can be the end as well as the means to Development. Sen gives top priority to the promotion of substantive freedoms which include elementary Capabilities like being able to avoid such deprivations as starvation, under nourishment, escapable morbidity and premature mortality. The substantive freedoms also include such freedoms that are associated with literacy, and basic political freedoms and civil rights. Such freedoms are intrinsically important.
Sen also advocates Instrumental freedoms to people. They include Political freedoms, economic facilities, social opportunities, transparency guarantees and social safety nets.
The main aim of Development should be to enhance the opportunities the people have to improve the quality of their lives. The crucial role of economic a