Important note - · PDF file · 2015-12-07Important note amner commentare ... equal...

Impo

rtan

t no

te

Examiners’ commentaries

EC3044 Economics of Development

Important note

This commentary reflects the syllabus and assessment arrangements for this course in the academic year 2013–14. From September 2014 the syllabus and examination will change. The commentary refers throughout to the 2011 edition of the subject guide and the recommended readings that were current in the academic year 2013–14. The 2011 edition of the subject guide is included in the commentary for reference only, and does not reflect the current syllabus or assessment arrangements.

This commentary is therefore provided to give general guidance, and should not be used as a guide to the syllabus for 2014–15 or future years.

When studying this course, please ensure that you are using the current (2014) edition of the subject guide.

Examiners’ commentaries 2014


EC3044 Economics of development

Comments on specific questions – Zone A

Candidates should answer EIGHT of the following FOURTEEN questions: FIVE from Section A(5 marks each) and any THREE from Section B (25 marks each). Candidates are stronglyadvised to divide their time accordingly.

If more questions are answered than requested, only the first answers attempted will be counted.

Section A

Answer FIVE questions from this section.

Question 1

Assume that country Pindya has a target growth rate. In Pindya savings is 897,investment requirement is 1,234, import requirement is 978 and export revenue is550. Based on the dual-gap framework, how much aid will the country require toachieve its target?

Reading for this question

Chapter 5 of the subject guide.

Thirlwall (2011), Chapter 14.

Todaro and Smith (2011), Chapter 14.

Approaching the question

This question is about the two gap model. The amount of aid required is determined by thelarger of the two gaps. The two gaps are calculated as follows: I − S = 337 and M −X = 428.Therefore, the amount of aid required will be $428 million.

Question 2

Griffin (1970) argues that foreign aid would ‘displace’ domestic savings. Brieflyexplain how.





1



The question here is: does aid promote growth? The simple answer would be yes, since it raisesthe quantity of resources in the economy. The displacement argument states that aid will be seenas a permanent transfer, thus encouraging the recipient government to use it for the purpose ofconsumption. Moreover, aid will discourage revenue collection efforts by government, thusreducing public savings – which in turn will affect total savings.

Question 3

In the Lewis dual-sector model are workers in the traditional (agricultural) sectorpaid their marginal product? Explain.



Basu (1997), Chapter 7.




Since there is surplus labour, which is the main assumption of the Lewis model, in this modelworkers in the traditional (mostly agricultural) sector income-share so they are paid their averageproduct and not their marginal product, as in the neoclassical model. Therefore workers sharethe output equally.

Question 4

Consider the following diagram that shows an economy with a small amount of oilconsisting of two industries only: oil and agriculture. The diagram shows marginalproduct of labour in these two industries; WA and WO are wages in agriculture andoil respectively. W (= WA = WO) is the equilibrium wage. Labour is freely mobilebetween these two industries but capital is industry specific. Oil explorations reveala very large amount of oil in this country (Somalia is an example). What would youexpect to be the impact of this find on the agricultural sector?

2



This is a question of the resource curse, or the Dutch Disease. We expect labour demand toincrease in the oil sector, thereby generating mobility from agriculture to oil, and raising theequilibrium wage.

Question 5

Assume the pay-off to have an extra child to both father and mother is 10N , whereN is the number of children. The cost of a child to the father is N2 but for themother it is 5N2 because of higher childcare responsibilities. What is the optimalnumber of children if the mother and the father have equal bargaining power(50–50)? (Hint – You can either do this algebraically, or write down the pay-off foreach child).


Chapter 7 if the subject guide.

Ray (1998), Chapter 9, also the mathematical appendix at the end.

Approaching this question

Pay-off for the father is maximum when N = 5 (pay off is 10N −N2 – differentiate and set itequal to zero to find max N), for the mother when N = 1, but for the family, assuming 0.5weight, it is 0 when N = 0, 7 when N = 1, 8 when N = 2 and then declines. So the answer is 2children.

Question 6

Assume the European Union (EU) imports shoes from the rest of the world at AC20and it takes AC12 worth of leather, at the free world price, to make a pair of shoes.Now assume the EU imposes a nominal rate of tariff of 30% on shoes but allowsleather to be imported at the free trade price. What is the effective rate ofprotection in the EU?



3





In this case the value added in the EU is initially 8 (20 − 12). The tariff raises the domestic priceto 20 + 0.3(20) = 26, but does not raise the leather costs, so the value added is now 26 − 12 =AC14. Hence the effective rate of protection is (14 − 8)/8 = 0.75 or 75% while the nominal tariffrate is only 30%. The general formula for ERP is:

ej =tj −

∑i aij · ti

1 −∑

i aij

where tj is the nominal tariff rate for industry j, ti is the nominal tariff rate in the inputindustry, and aij is the share of inputs in the value of output of industry j. So:

e =30% − 0.6(0%)

1 − 0.6= 75%.

Section B

Answer THREE questions from this section.

Question 7

(a) Explain the Kuznets inverted-U hypothesis.

(b) Outline its strengths and limitations.

(c) Discuss whether it is supported by empirical evidence in the context ofdeveloping countries.



Ray (1998), Chapter 4.


Ghatak (2003), Chapter 10.

Nafziger (2006), Chapter 6.


(a) A good answer should note that the theoretical base of Kuznets’ model is the Lewis dualsector model, where labour supply is unlimited. Given this unlimited supply of labour, asthe economy grows, profits rise more than the wage bill – hence inequality rises. Once theunlimited supply of labour is exhausted, as the economy grows and therefore labour demandrises, the wage bill rises more than profit and so inequality falls.

(b) There are other explanations as to why inequality might worsen during early stages ofdevelopment and then improve, although they all go back to the issue of structural change.Kuznets’ contribution can be differentiated from the prevailing wisdom of the time in atleast two important aspects. First, he focused on the household distribution of income andnot on the class distribution of income. Second, for Kuznets the developing world is anon-homogeneous, two-sector system.

4


(c) At the empirical level, it should be noted that, while some cross-country studies appear tosupport the Kuznets hypothesis, time series studies find little support for it. In other words,once we single out the experience of individual countries, Kuznets’ hypothesis does not hold.Another criticism of Kuznets’ conclusion is that, in his sample, many of the middle incomecountries were in Latin America, a region with historically high levels of inequality. Crosscountry studies show that when some countries (usually Taiwan, China and Sri Lanka) areexcluded, the inverted U is supported, but not otherwise. The best type of studies arecountry-specific studies. These show that, for some countries, inequality falls asdevelopment occurs; for others it rises and for some there is hardly any change. Thisindicates that pooling countries in a cross section analysis may give misleading results.

Question 8

‘In countries where tax revenue as a share of gross national income is low, it makessense to resort to inflation to finance public expenditure.’

Do you agree? (Explain your answer.)



Basu (1997), Chapter 4.




Indeed, some governments in developing countries resort to inflation as a major ‘tax’ to financepublic spending. Inflation can raise revenues for the government. It can also help increase privateinvestment due to the increased profitability it brings to firms. It can also reduce governmentdependence on external financing and thus help reduce its debt burden. Another argument putforward is that inflation could help promote the growth of banks and other financial institutions.However, inflation can have detrimental effects on the economy. For example, it could distort theefficient allocation of resources. It could also reduce the country’s competitiveness and worsenincome inequality. On the empirical front the relationship between inflation and growth remainsinconclusive.

Question 9

Explain what is meant by ‘financial liberalisation’ and discuss the arguments againstit.






The answer should start by discussing what is meant by financial repression. Indeed, financialrepression refers to the view that a bundle of government policies, regulations, laws, and other

5


restrictions stop the financial intermediaries of an economy from functioning at their full capacity.These policies generally include capital controls, interest rate and credit ceilings, high bankreserve requirements, liquidity ratio requirements, restrictions on market entry into the financialsector or restrictions on directions of credit allocation, and government ownership of banks.

The main argument for financial restriction is that it allows a government to channel funds toitself more cheaply than it could in a typical financial market. However, McKinnon and Shaw(1973) argue that such repressive policies would impede financial deepening and hinder efficiencyof the financial system, and thus would impact negatively economic growth. Indeed, McKinnon(1973) argues that money holdings and capital accumulation are complementary in thedevelopment process and therefore low interest rates would discourage agents from pursuing theaccumulation of money balances and investment. Shaw (1973), on the other hand, highlights theimportance of financial liberalisation and the beneficial effect of high interest rates onencouragement to save and discouragement to invest in low-yielding projects. High interest ratesallow the banking system to increase its liability and, therefore, to lend more resources toproductive investment efficiently.

Empirically, however, the case against financial repression is not as strong or unambiguous.Along the same line, Stiglitz (2000), for instance, argues that the recently increased frequency offinancial crises was closely associated with financial market liberalisation in developing countries.Good answers should refer to the empirical literature related to financial liberalisation andgrowth. For example, it should be noted that on empirical grounds, the financialliberalisation–growth relationship is not strong. Excellent answers might also discuss howfinancial liberalisation might also lead to financial crises.

Question 10

‘Ensuring environmental sustainability’ is at the heart of the MillenniumDevelopment Goals. Explain why this is important in the context of developingcountries. Discuss some ‘effective’ policies that could help in tackling the issue ofenvironmental degradation.








The question refers to the environmental challenges faced by developing countries and the linkbetween the environment and development. A good answer will note that in order to reduceenvironmental degradation, solutions to the problem will often involve the reversal ofinappropriate public policies (for example, subsidised credit or tax concessions for resource use orextraction). These policies can, generally, take two forms. The first form could be characterisedas domestic environmental policies, which could be direct (provision of financial aid to helpreforestation or to fund soil stabilisation programmes, anti-salination measures, etc.) or indirect(increasing spending in education, encouraging grants of legal title to property, etc.). The secondis in the form of global environmental policies (reduction in the emission of greenhouse gases,improvement of emitting technologies, etc.). Excellent answers will also touch on the issue of theenvironment and social cost-benefit analysis.

6


Question 11

Assume three agriculturalists live in a village. One produces only coffee, the secondproduces only wheat and the third produces both coffee and wheat. The villagesuffers from floods and half of each producer’s output is destroyed. Assuming thestarvation set is the same for all three, show how each can starve suffering from (a)direct entitlement failure (b) trade entitlement failure. Is it true that those whoproduce food are less vulnerable under these conditions?



Sen (1981).

Ghatak (2003), pp.314–19.


This question requires three diagrams, one for each farmer.

Diagram (1) is the food producer. They can only starve if their food output is below the levelindicated by the arrow. That will put this farmer in the starvation set, which is the area belowthe dotted line (production possibility frontier).

Diagram (2) is the farmer producing a combined level of food and non-food. They initiallyproduce at x. They can starve by either falling within the starvation set (x moving to xx) or by arise of the relative price of food (the steeper price line).

Diagram (3) is the coffee producer. Initially this farmer is at point A and exchanging coffee forfood. This farmer also may starve through a fall in their output or a rise in the relative price offood.

Sen argues that those who produce food only suffer from direct entitlement failure, whereas thosewho produce non-food may also suffer from trade entitlement failure, hence the latter group aremore vulnerable. These concepts should be clearly defined and explained in your answer.

Question 12

(a) Assume all potential candidates for the three types of agricultural contract,wage labour, sharecropping, and fixed rent, have the same entrepreneurial

7


ability. Show that these three contracts are identical if the landlord chooses hisshare in the sharecropping contract such that his income is maximised.

(b) Now assume potential candidates for these three contracts have different levelsof ability. Show that, depending on the range of ability, individuals willself-select into different contracts.



Ray (1998), pp.420–441.

Basu, Chapter 12.


(a) This question can be answered either mathematically or diagrammatically. It can be shownthat the landlord will aim to maximise his share, aQ(L) subject to (1− a)Q(L) = wL, wherea is the share of the landlord, Q is output, w is wage and L is labour supply (hours). Theconstraint is that the sharecropper must at least earn the same amount in the sharecroppingcontract as in a wage contract. Otherwise they will not enter the sharecropping contract.Deriving first order conditions, one can show that the outcomes of the three contracts arethe same.

(b) However, Hallagan has shown that if the potential candidates have different levels of ability,then the most able will take the fixed rent contract, the middle group will take thesharecropping contract and the low ability group will take the wage contract. This tends toexplain what are usually called ‘agricultural ladders’.

Question 13

Assume a developing country, Protectoria, imports 100,000 cars under free trade.To reduce imports to 50,000 the authorities impose a tariff.

(a) Analyse the static welfare effects of this tariff.

(b) Now assume that the authorities decide to replace this tariff with a quota of50,000. Show that this policy has the same effect as the above tariff.

(c) Give at least one example where such protectionism can lead to a higher welfarein Protectoria. Support your answer with economic analysis.





(a) & (b) Assume that a tariff at a specific level, ‘t’, achieves this objective. The answer to this isthe two areas given by b and d in the diagram below. This is the standard static deadweightloss of a tariff and is the difference between consumer surplus loss (a+b+c+d), producersurplus gain (a) and government tax revenue (d). The case of a quota is similar. At theworld price, if we restrict imports we will have excess demand. Price will rise until excessdemand disappears. This will be the same price as the tariff price. Note that AB = 50,000.

8


(c) There are at least three cases that students can discuss to support their answer to thisquestion. The infant industry argument is probably the most important one and should bepresented here. An excellent answer would also include discussion of distortions in thecommodity markets, and/or distortions in the factor markets.

Question 14

(a) Discuss the impact of population growth on developing countries.

(b) Assume the population growth rate is non-linear, as shown in the followingdiagram, where n is the population growth rate, d is the depreciation rate, s isthe savings rate, and y is income per worker. Can this be the cause of a povertytrap? (Explain what the poverty trap is and refer to the diagram to give youranswer).

9






There are many positive and negative arguments around population growth. A few points that a‘population pessimist’ may make are as follows:

• Malthusian doomsday – starvation occurs as diminishing returns to land set in

• capital widening occurs, rather than capital deepening

• there is a higher dependency rate, leading to ‘tragedy of the commons’ (negativeexternalities, etc).

On the other hand there are positive points, promoted by ‘population optimists’ such as J.Simon’s argument that:

• humans are the ultimate resource

• demand drives supply response

• economies of scale should be taken into account

• technical change is induced by population growth.

For any k below that of point A (see diagram above), savings is greater than the investmentrequired to keep k constant, so k will rise. Between A and B it is lower so k will fall. Thereforefor any k between those values there is a poverty trap. After point B, savings is greater again,hence k will rise and this takes us to the next stable equilibrium.

10




Comments on specific questions – Zone B

Candidates should answer EIGHT of the following FOURTEEN questions: FIVE from Section A(5 marks each) and any THREE from Section B (25 marks each). Candidates are stronglyadvised to divide their time accordingly.

If more questions are answered than requested, only the first answers attempted will be counted.

Section A

Answer FIVE questions from this section.

Question 1

Assume that country Pindya has a target growth rate. In Pindya savings is 897,investment requirement is 1,234, import requirement is 978 and export revenue is550. Based on the dual-gap framework, how much aid will the country require toachieve its target?






This question is about the two gap model. The amount of aid required is determined by thelarger of the two gaps. The two gaps are calculated as follows: I − S = 337 and M −X = 428.Therefore, the amount of aid required will be $428 million.

Question 2

Briefly outline the main limitations of the Human Development Index (HDI) as ameasure of economic development.



Thirlwall (2011), Chapters 1 and 2.



11



Although the HDI has many advantages over income per capita as a measure of economicdevelopment, it does present some weaknesses. For example, it does not take into account genderdisparities across countries: it assigns equal weight to both men and women in the calculation ofthe various indices included in its calculation. Moreover, it does not take inequality into account.It focuses on three specific elements: health, education and income. However, the MillenniumDevelopment Goals and their associated international development targets demonstrate that aset of other factors are equally important.

Question 3

Briefly discuss the arguments against economic planning in developing countries.







Generally, planning is thought to be useful when markets fail. It is argued, however, thatplanning is not necessarily effective in addressing markets’ imperfections. A second argumentagainst it is that many developing countries do not have the skilled manpower required toprepare and execute an efficient planning mechanism. These problems become acute when thebureaucracy in the country is corrupt. A further argument against planning is that the costassociated with plans is very large for many developing countries.

Question 4

Consider the following diagram that shows an economy with a small amount of oilconsisting of two industries only: oil and agriculture. The diagram shows marginalproduct of labour in these two industries; WA and WO are wages in agriculture andoil respectively. W (= WA = WO) is the equilibrium wage. Labour is freely mobilebetween these two industries but capital is industry specific. Oil explorations reveala very large amount of oil in this country (Somalia is an example). What would youexpect to be the impact of this find on the agricultural sector?

12



This is a question of the resource curse, or the Dutch Disease. We expect labour demand toincrease in the oil sector, thereby generating mobility from agriculture to oil, and raising theequilibrium wage.

Question 5

Assume the pay-off to have an extra child to both father and mother is 10N , whereN is the number of children. The cost of a child to the father is N2 but for themother it is 5N2 because of higher childcare responsibilities. What is the optimalnumber of children if the mother and the father have equal bargaining power(50–50)? (Hint – You can either do this algebraically, or write down the pay-off foreach child).


Chapter 7 if the subject guide.

Ray (1998), Chapter 9, also the mathematical appendix at the end.

Approaching this question

Pay-off for the father is maximum when N = 5 (pay off is 10N −N2 – differentiate and set itequal to zero to find max N), for the mother when N = 1, but for the family, assuming 0.5weight, it is 0 when N = 0, 7 when N = 1, 8 when N = 2 and then declines. So the answer is 2children.

Question 6

Because of high humidity in tropical areas, tropical countries have a higherdepreciation rate of their capital stock. Hence, all other things being equal, percapita income in these countries will be lower than non-tropical countries. True orfalse? Explain using the Solow diagram.



13




As the depreciation rate is greater in tropical areas, dt > dnt, then the steady state income perworker, yt, will be lower than that of the non-tropical areas, Ynt. The diagram should look likethis:

Section B

Answer THREE questions from this section.

Question 7

Briefly outline the motives for giving foreign aid to developing countries and discusswhether it [aid] has been effective in promoting economic growth.






Motives for giving aid to developing countries generally include humanitarian, strategic andpolitical reasons, donor interest and recipient interest (the dual-gap model). Candidates areexpected to discuss each of the above briefly.

The second part of the question should discuss aid effectiveness. It should be noted that whileearly studies, following the work of Chenery and Strout (1966), reported a positive impact of aidon growth, later studies failed to find a robust relationship between the two variables. Excellentanswers should discuss the contribution of Burnside and Dollar (1997, 2000) who argued that aidis effective in spurring growth within a good policy environment, although this finding has beenrefuted by subsequent studies.

14


Question 8

Explain what is meant by ‘financial liberalisation’ and discuss the arguments againstit.






Your answer should start by discussing what is meant by financial repression. Indeed, financialrepression refers to the view that a bundle of government policies, regulations, laws, and otherrestrictions stop the financial intermediaries of an economy from functioning at their full capacity.These policies generally include capital controls, interest rate and credit ceilings, high bankreserve requirements, liquidity ratio requirements, restrictions on market entry into the financialsector or restrictions on directions of credit allocation, and government ownership of banks.

The main argument for financial repression is that it allows a government to channel funds toitself more cheaply than it could do in a typical financial market. However, McKinnon and Shaw(1973) argue that such repressive policies would impede financial deepening and hinder theefficiency of the financial system, thus impacting economic growth negatively. Indeed, McKinnon(1973) argues that money holdings and capital accumulation are complementary in thedevelopment process and therefore low interest rates would discourage agents in theaccumulation of money balances and investment.

Shaw (1973), on the other hand, highlights the importance of financial liberalisation and thebeneficial effect of high interest rates on encouragement to save and discouragement to invest inlow-yielding projects. High interest rates allow the banking system to increase its liability and,therefore, to lend more resources to productive investment.

Empirically, however, the case against financial repression is not as strong or unambiguous asthis would suggest. Along the same line, for instance, Stiglitz (2000) argues that the recentlyincreased frequency of financial crises was closely associated with financial market liberalisationin developing countries. Good answers should also refer to the empirical literature related tofinancial liberalisation and growth. For example, it should be noted that on empirical groundsthe financial liberalisation–growth relationship is not strong. Excellent answers might alsodiscuss how financial liberalisation might also lead to financial crises.

Question 9

(a) Show that a positive level of unemployment is a feature of the Harris–Todaromigration model, indicating that migration is simply a disequilibriumphenomenon.

(b) Harris and Todaro argue that the only way to overcome this problem is asubsidy to the modern sector firms, and restriction on migration from rural tourban areas (coercion). Show that there is a unique solution to this problemthat does not involve coercion.



15




Basu, Chapter 8.


Candidates should use the Harris–Todaro diagram to show that if the urban wage is fixed and apositive urban rural wage differential exits, then the model effectively becomes a model ofequilibrium unemployment. This implies that when urban unemployment is less than theequilibrium, migrations flows occur, raising the unemployment level to equilibrium. Migrationwill cease when the level of unemployment reaches the equilibrium level. Under these arguments,some have proposed that the urban firms should be subsidised. Harris and Todaro have shownthat we cannot get a rise of the equilibrium unemployment even if we subsidise urban firms,because this shifts the demand for labour out, leading to more migration, a phenomenon knownas the Todaro paradox. Hence, subsidy should be complemented with restrictions on migration(coercion). There is, however, a unique level of subsidy that can eliminate this unemployment, ifit is given to employers in urban and rural areas (this analysis is presented in Basu). This shouldbe shown in the Harris–Todaro diagram.

Question 10

Assume three agriculturalists live in a village. One produces only coffee, the secondproduces only wheat and the third produces both coffee and wheat. The villagesuffers from floods and half of each producer’s output is destroyed. Assuming thestarvation set is the same for all three, show how each can starve suffering from (a)direct entitlement failure (b) trade entitlement failure. Is it true that those whoproduce food are less vulnerable under these conditions?



Sen (1981).

Ghatak (2003), pp.314–19.


This question requires three diagrams, one for each farmer.

16


Diagram (1) is the food producer. They can only starve if their food output is below the levelindicated by the arrow. That will put this farmer in the starvation set, which is the area belowthe dotted line (production possibility frontier).

Diagram (2) is the farmer producing a combined level of food and non-food. They initiallyproduce at x. They can starve by either falling within the starvation set (x moving to xx) or by arise of the relative price of food (the steeper price line).

Diagram (3) is the coffee producer. Initially this farmer is at point A and exchanging coffee forfood. This farmer also may starve through a fall in their output or a rise in the relative price offood.

Sen argues that those who produce food only suffer from direct entitlement failure, whereas thosewho produce non-food may also suffer from trade entitlement failure, hence the latter group aremore vulnerable. These concepts should be clearly defined and explained in your answer.

Question 11

(a) Assume all potential candidates for the three types of agricultural contract,wage labour, sharecropping, and fixed rent, have the same entrepreneurialability. Show that these three contracts are identical if the landlord chooses hisshare in the sharecropping contract such that his income is maximised.

(b) Now assume potential candidates for these three contracts have different levelsof ability. Show that, depending on the range of ability, individuals willself-select into different contracts.



Ray (1998), pp.420–441.

Basu, Chapter 12.


(a) This question can be answered either mathematically or diagrammatically. It can be shownthat the landlord will aim to maximise his share, aQ(L) subject to (1− a)Q(L) = wL, wherea is the share of the landlord, Q is output, w is wage and L is labour supply (hours). Theconstraint is that the sharecropper must at least earn the same amount in the sharecroppingcontract as in a wage contract. Otherwise they will not enter the sharecropping contract.Deriving first order conditions, one can show that the outcomes of the three contracts arethe same.

(b) However, Hallagan has shown that if the potential candidates have different levels of ability,then the most able will take the fixed rent contract, the middle group will take thesharecropping contract and the low ability group will take the wage contract. This tends toexplain what are usually called ‘agricultural ladders’.

Question 12

Assume a developing country, Protectoria, imports 100,000 cars under free trade.To reduce imports to 50,000 the authorities impose a tariff.

(a) Analyse the static welfare effects of this tariff.

17


(b) Now assume that the authorities decide to replace this tariff with a quota of50,000. Show that this policy has the same effect as the above tariff.

(c) Give at least one example where such protectionism can lead to a higher welfarein Protectoria. Support your answer with economic analysis.





(a) & (b) Assume that a tariff at a specific level, ‘t’, achieves this objective. The answer to this isthe two areas given by b and d in the diagram below. This is the standard static deadweightloss of a tariff and is the difference between consumer surplus loss (a+b+c+d), producersurplus gain (a) and government tax revenue (d). The case of a quota is similar. At theworld price, if we restrict imports we will have excess demand. Price will rise until excessdemand disappears. This will be the same price as the tariff price. Note that AB = 50,000.

(c) There are at least three cases that students can discuss to support their answer to thisquestion. The infant industry argument is probably the most important one and should bepresented here. An excellent answer would also include discussion of distortions in thecommodity markets, and/or distortions in the factor markets.

Question 13

(a) Discuss the impact of population growth on developing countries.

(b) Assume the population growth rate is non-linear, as shown in the followingdiagram, where n is the population growth rate, d is the depreciation rate, s isthe savings rate, and y is income per worker. Can this be the cause of a povertytrap? (Explain what the poverty trap is and refer to the diagram to give youranswer).

18






There are many positive and negative arguments around population growth. A few points that a‘population pessimist’ may make are as follows:

• Malthusian doomsday – starvation occurs as diminishing returns to land set in

• capital widening occurs, rather than capital deepening

• there is a higher dependency rate, leading to ‘tragedy of the commons’ (negativeexternalities, etc).

On the other hand there are positive points, promoted by ‘population optimists’ such as J.Simon’s argument that:

• humans are the ultimate resource

• demand drives supply response

• economies of scale should be taken into account

• technical change is induced by population growth.

For any k below that of point A (see diagram above), savings is greater than the investmentrequired to keep k constant, so k will rise. Between A and B it is lower so k will fall. Thereforefor any k between those values there is a poverty trap. After point B, savings is greater again,hence k will rise and this takes us to the next stable equilibrium.

19


Question 14

Table 1 shows income distribution, based on 20 households, for two countriesKermany and Tanzia.

(a) Using the information provided in the table compute the Kuznets ratio(Kuznets measure of income inequality) for both countries. (For this purpose,you could group the population into quintiles.)

(b) Construct the Lorenz curve for both countries (in the same graph). Withoutcalculating, show how you can obtain the Gini coefficient from the Lorenz curve.

(c) Which country shows the most unequal distribution of income? Outline thetype of policies that can be used to improve inequality in that country.

Table 1 – Income distribution: personal income (money units)Households Tanzia Kermany

Income arranged in Income arranged inascending order ascending order

1 0.8 0.12 1 0.33 1.4 0.64 1.8 0.75 1.9 1.16 2 1.37 2.4 1.58 2.7 2.29 2.8 2.310 3 2.411 3.4 2.412 3.8 2.613 4.2 3.114 4.8 3.215 5.9 3.816 7.1 3.917 10.5 11.218 12 13.119 13.5 1420 15 30.2

Total: 100.0 Total: 100.0








(a) The answer should recognise the need to arrange income in each country in ascending ordescending order (ascending in the table below). Secondly, quintiles should be calculated.

20


Households Tanzia KermanyIncome arranged in Quintiles Income arranged in Quintiles

ascending order ascending order1 0.8 0.12 1 0.33 1.4 0.64 1.8 5 0.7 1.75 1.9 1.16 2 1.37 2.4 1.58 2.7 9 2.2 6.19 2.8 2.310 3 2.411 3.4 2.412 3.8 13 2.6 9.713 4.2 3.114 4.8 3.215 5.9 3.816 7.1 22 3.9 1417 10.5 11.218 12 13.119 13.5 1420 15 51 30.2 68.5

Total: 100.0 100 Total: 100.0 100

The Kuznet inequality ratio = income received by the top quintile/income received by thebottom two quintiles.

KuznetTanzia = 51/(5 + 9) = 3.64.

KuznetKermany = 68/(1.7 + 6.1) = 8.78.

The larger the ratio, the greater inequality is. From these calculations it is clear that incomeinequality is more pronounced in Kermany than in Tanzia.

(b) To construct the Lorenz curve one must have the percentage of income on the y-axis againstthe percentage of population on the x-axis. The Lorenz curve is obtained by joining thedifferent points. The further the Lorenz curve is situated from the 45-degree line (whichdepicts perfect equality) the worse inequality is. Thus one would expect the Lorenz curvefor Kermany to be to the right of the Lorenz curve for Tanzia. This confirms our findingobtained by using the Kuznet income inequality ratio. The Gini coefficient = Area A/Area(A+ B), as shown in Figure 1 (below). The Gini takes a value of 0 (perfect equality) to 1(perfect inequality). In practice, however, these values lie respectively between 0.2 and 0.35(relatively equal distribution) and 0.50 and 0.70 (unequal distribution).

(c) Having established which country shows the most unequal distribution of income (Kermany)the four main types of policies that can be used to improve inequality there are:

• altering the functional distribution of income

• modifying the size distribution

• reducing the size distribution at the upper levels

• direct transfer payments and the provision of public goods and services.

21


22

The following subject guide does

not reflect the syllabus or

examination arrangements for 2014-15 onwards, and should only be used for reference.

Undergraduate study in Economics, Management, Finance and the Social Sciences

This subject guide is for a Level 3 course (also known as a ‘300 course’) offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. This is equivalent to Level 6 within the Framework for Higher Education Qualifi cations in England, Wales and Northern Ireland (FHEQ).

For more information about the University of London International Programmes undergraduate study in Economics, Management, Finance and the Social Sciences, see: www.londoninternational.ac.uk

Economics of developmentG.R. ArabsheibaniDV3044, 2790044

2011

Old ed

ition.

For ref

erenc

e only

.

This guide was prepared for the University of London International Programmes by:

G.R.Arabsheibani, PhD (LSE), Reader in Economics at Swansea University.

This is one of a series of subject guides published by the University. We regret that due to pressure of work the author is unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

University of London International Programmes

Publications OfficeStewart House32 Russell SquareLondon WC1B 5DNUnited Kingdom

Website: www.londoninternational.ac.uk

Published by: University of London

© University of London 2009

Reprinted with minor revisions 2007

The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher.

We make every effort to contact copyright holders. If you think we have inadvertently used your copyright material, please let us know.

Old ed

ition.

For ref

erenc

e only

.

Contents

i

Contents

Chapter 1: Introduction .......................................................................................... 1

Introduction .................................................................................................................. 1Aims and objectives ....................................................................................................... 1Learning outcomes ........................................................................................................ 2How to use the subject guide ......................................................................................... 2Reading advice .............................................................................................................. 3Essential reading ........................................................................................................... 3Further reading .............................................................................................................. 3Online study resources ................................................................................................... 6Examination advice........................................................................................................ 8Syllabus ......................................................................................................................... 9Glossary of abbreviations ............................................................................................. 10

Chapter 2: Economic development ...................................................................... 11

Aims of the chapter ..................................................................................................... 11Learning outcomes ...................................................................................................... 11Essential reading ......................................................................................................... 11Further reading ............................................................................................................ 11Introduction ................................................................................................................ 11The concept of development ........................................................................................ 12Some terminology........................................................................................................ 13Measuring economic development ............................................................................... 14Characteristics of developing countries ......................................................................... 15A reminder of your learning outcomes .......................................................................... 15Sample examination questions ..................................................................................... 15

Chapter 3: Models of growth and development .................................................. 17

Aims of the chapter ..................................................................................................... 17Learning outcomes ...................................................................................................... 17Essential reading ......................................................................................................... 17Further reading ............................................................................................................ 17Introduction ................................................................................................................ 17Harrod –Domar growth model ...................................................................................... 19Neoclassical growth theory .......................................................................................... 20Growth accounting ...................................................................................................... 23The Lewis model – growth with unlimited supplies of labour ........................................ 24Endogenous growth theory .......................................................................................... 25Underdevelopment as coordination failure ................................................................... 27A reminder of your learning outcomes .......................................................................... 28Sample examination questions ..................................................................................... 28

Chapter 4: Domestic resources and inflation ....................................................... 29

Aims of the chapter ..................................................................................................... 29Learning outcomes ...................................................................................................... 29Essential reading ......................................................................................................... 29Further reading ............................................................................................................ 29Introduction ................................................................................................................ 29Domestic saving and the role of financial capital .......................................................... 30

Old ed

ition.

For ref

erenc

e only

.

44 Economics of development

ii

Private capital markets, financial intermediation and financial policy ............................. 31Taxation ...................................................................................................................... 33Inflation ...................................................................................................................... 34A reminder of your learning outcomes .......................................................................... 36Sample examination questions ..................................................................................... 36

Chapter 5: Foreign resources ................................................................................ 37

Aims of the chapter ..................................................................................................... 37Learning outcomes ...................................................................................................... 37Essential reading ......................................................................................................... 37Further reading ............................................................................................................ 37Introduction ................................................................................................................ 38Foreign capital requirements and types of capital inflow ............................................... 38Foreign aid .................................................................................................................. 39External debt ............................................................................................................... 40Foreign direct investment and multinational corporations ............................................. 42A reminder of your learning outcomes .......................................................................... 43Sample examination questions ..................................................................................... 43

Chapter 6: The state, planning and resource allocation ....................................... 45

Aims of the chapter ..................................................................................................... 45Learning outcomes ...................................................................................................... 45Essential reading ......................................................................................................... 45Introduction ................................................................................................................ 45The need for planning .................................................................................................. 46Planning models .......................................................................................................... 46Project appraisal .......................................................................................................... 47Planning failure and the Washington Consensus........................................................... 49A reminder of your learning outcomes .......................................................................... 49Sample examination questions ..................................................................................... 49

Chapter 7: Population, employment, income distribution and poverty ............... 51

Aims of the chapter ..................................................................................................... 51Learning outcomes ...................................................................................................... 51Essential reading ......................................................................................................... 51Further reading ............................................................................................................ 51Introduction ................................................................................................................ 52Theories of population growth ..................................................................................... 52The consequences of population growth ...................................................................... 53Employment and migration .......................................................................................... 54Human capital: education and health ........................................................................... 56Poverty and inequality ................................................................................................. 58Child labour ................................................................................................................ 59Malnutrition and famine .............................................................................................. 60Growth and inequality ................................................................................................. 62A reminder of your learning outcomes .......................................................................... 63Sample examination questions ..................................................................................... 63

Chapter 8: Agricultural development ................................................................... 65

Aims of the chapter ..................................................................................................... 65Learning outcomes ...................................................................................................... 65Essential reading ......................................................................................................... 65Further reading ............................................................................................................ 65Introduction ................................................................................................................ 66

Old ed

ition.

For ref

erenc

e only

.

Contents

iii

Are peasant farmers efficient? ..................................................................................... 66Are peasant farmers rational? ...................................................................................... 68How do peasant farmers respond to price changes for their output? ............................. 70Sharecropping and other agricultural contracts ............................................................. 71Land reform................................................................................................................. 74Technical change in agriculture .................................................................................... 76Insurance .................................................................................................................... 78A reminder of your learning outcomes .......................................................................... 78Sample examination questions ..................................................................................... 78

Chapter 9: International trade ............................................................................. 79

Aims of the chapter ..................................................................................................... 79Learning outcomes ...................................................................................................... 79Essential reading ......................................................................................................... 79Further reading ............................................................................................................ 79Introduction ................................................................................................................ 80The case for free trade ................................................................................................. 80The arguments against free trade (or in favour of protectionism) ................................... 81Developing countries’ specific trading problems ........................................................... 82A reminder of your learning outcomes .......................................................................... 84Sample examination questions ..................................................................................... 84

Chapter 10: Industrial development and related trade policy ............................. 85

Aims of the chapter ..................................................................................................... 85Learning outcomes ...................................................................................................... 85Essential reading ......................................................................................................... 85Further reading ............................................................................................................ 85Introduction ................................................................................................................ 85Industrialisation strategies 1: import substitution .......................................................... 86Industrialisation strategies 2: export promotion ............................................................ 87Export promotion: transferability, market access and the move away from import substitution ............................................................................................. 88A reminder of your learning outcomes .......................................................................... 89Sample examination questions ..................................................................................... 89

Chapter 11: Economic development and the environment .................................. 91

Aims of the chapter ..................................................................................................... 91Learning outcomes ...................................................................................................... 91Essential reading ......................................................................................................... 91Further reading ............................................................................................................ 91Introduction ................................................................................................................ 91Economic activity–environment interactions ................................................................. 92Natural resources ........................................................................................................ 93Environmental degradation .......................................................................................... 93Coasian bargains ......................................................................................................... 95The environment and social cost–benefit analysis ......................................................... 95The concept of sustainable development ...................................................................... 96International dimensions ............................................................................................. 97A reminder of your learning outcomes .......................................................................... 97Sample examination questions ..................................................................................... 98

Old ed

ition.

For ref

erenc

e only

.


iv

Chapter 12: Gender and development ................................................................. 99

Aims of the chapter ..................................................................................................... 99Learning outcomes ...................................................................................................... 99Essential reading ......................................................................................................... 99Further reading ............................................................................................................ 99Introduction ................................................................................................................ 99What can be done to improve women’s role in development? .................................... 100A reminder of your learning outcomes ........................................................................ 101

Appendix 1: The Solow model ............................................................................ 103

A. With no technical progress ..................................................................................... 103B. Incorporating technical progress ............................................................................. 104

Appendix 2: Sample examination paper ............................................................ 105

Old ed

ition.

For ref

erenc

e only

.

Chapter 1: Introduction

1


IntroductionThis subject guide is a signpost to the subject matter of Economics of development. Its aim is to enable you to interpret fully the published syllabus. It does so by identifying what you are expected to know within each area of the syllabus, mainly by stating where in specific textbooks that material can be found and, if necessary, elaborating and clarifying the textbooks’ treatment. This guide is not a substitute for textbooks.

For each main subject area listed in the syllabus, the topics which should be studied and the appropriate level of analysis have been determined by their treatment in a limited number of textbooks which are widely used for courses similar in content and level to this one.

The syllabus and guide assume that you are competent in microeconomic and macroeconomic analysis. The syllabus for 44 Economics of development, building on these foundations, aims to extend and deepen your understanding of economic principles and their application. 44 Economics of development is designed to equip you with the theories and principles which are necessary to analyse problems of economic development, to introduce you to relevant empirical work and to analyse policy issues in the light of both economic theory and empirical evidence. It thus enables you to understand the main controversies concerning the process of economic development.

If taken as part of a BSc degree you must have passed 65 Macroeconomics and 28 Managerial economics or 66 Microeconomics before this course may be attempted. You are expected to use your knowledge of economic principles and statistical and econometric techniques, developed in other subjects, to the utmost in order to increase your understanding of issues, empirical studies and policy analysis relating to economic development.

Aims and objectivesThe aims of this course are to:

• provide you with a basic knowledge of the key structural features of developing countries

• enhance your understanding of the contribution which economic analysis can make in examining the key problems of developing countries

• enhance your understanding of the main economic models and key indicators from which development policies are derived, and offer a critique of underlying theories

• develop understanding of policy issues faced by developing economies

• equip you with the analytical tools needed to meet these aims.

Old ed

ition.

For ref

erenc

e only

.


2

Learning outcomesAt the end of this course, and having completed the Essential readings, you should be able to:

• outline the main theories and concepts in development economics

• recall the relevant empirical evidence on the important economic issues related to economics of development

• discuss the major policy issues and problems in developing countries

• apply economic theory to the analysis of theoretical, policy and empirical issues important in the economics of development.

How to use the subject guideEach subject chapter of the guide has the following format:

• The chapter begins by describing the aims and the learning outcomes of the chapter.

• It then lists the Essential and Further reading in the textbooks. Although some sections of these chapters may not be specifically recommended in the guide, you are advised to read every part of all the chapters listed so that the specific syllabus topics are studied in context. This will aid your understanding of the relationships between topics.

• The rest of the chapter works through the topic and specifies what you are expected to know. Where necessary, we refer you to the relevant sections or page numbers of the recommended textbooks. Key terms and concepts are in bold. Where there may be some doubt, that section also states what topics are not included in the syllabus. Finally, it draws attention to material which may be more difficult and, if necessary, it elaborates on the textbook.

• The more extensive coverage in the longer chapters reflects the fact that the textbook treatment of certain subjects requires more elaboration.

• The final section gives you examples of typical examination questions.

For each syllabus topic, you should consult the relevant chapter in the guide and thoroughly read the Essential reading and as much Further reading as you can. Careful note-taking is essential. Unless otherwise stated in the guide, a thorough understanding of the material covered in the essential passages in the textbooks is necessary if you are to maximise the benefits you derive from studying this subject. If you do not understand some of the treatment of a topic in one book, you should refer to other textbooks. You are strongly advised to attempt the questions or problems both in the textbooks and at the end of the chapters in the guide in order to test whether you have understood the material.

44 Economics of development is a paper in economic principles and their application and therefore the following general guidance is offered. First, you are not expected to learn and reproduce vast quantities of statistical data. Textbook authors include statistics to introduce, illustrate or highlight particular issues, often prior to presenting possible analytical explanations of the data. To the extent that you wish to refer to statistics in your examination answers, broad orders of magnitude will suffice. Second, some of the textbooks present case studies (in the form of sections either in the main body of chapters or at the end of chapters) to illustrate the main analysis of an issue. This is how you should use case studies: you should be able to refer to this type of material in your examination

Old ed

ition.

For ref

erenc

e only

.


3

answers but you are not expected to reproduce details. Similarly, you should feel free, in the examination, to refer to trends or events in particular countries or in the international trading system, for example, which illustrate your main argument. You are encouraged to read current publications which are known to cover issues that have a bearing on economic development. Finally, you should be familiar with the results or conclusions of empirical studies referred to in the textbooks but you will not be expected to have a detailed knowledge of the techniques used in the original research.

Reading adviceNo single book is adequate for this course as a whole because books vary in their coverage and treatment of topics. However, this subject guide is specifically designed to be used in conjunction with the textbooks listed below. You will obtain more benefit from this subject guide by having access to these books rather than others because, by referring to particular pages, it specifies what you are expected to know. You are advised to have access to at least two or three of these books. These are the Essential readings. However, you will benefit from additional reading and from sampling a variety of textbooks in order to find which style and presentation suits you best. I have mentioned a number of books as Further reading. Occasionally it is necessary to refer to a journal article in order to understand a topic better, and in particular to become familiar with the most recent empirical materials. Of course, the list is not exhaustive and you are encouraged to read other relevant material.

Essential readingBasu, K. Analytical Development Economics: The Less Developed Economy

Revisited. (Cambridge: MIT Press, 1997) [ISBN 9780262024235].Murphy, K.M., A. Scheifer and R. Vishny, ‘Income Distribution, Market Size and

Industrialization’, Quarterly Journal of Economics, 104(3) 1989, pp.537–64. [Available in the Online Library].

Ray, D. Development Economics. (Princeton NJ: Princeton University Press, 1998) [ISBN 9780691017068].

Thirlwall, A.P. Growth, and Development with Special Reference to Developing Economies. (Basingstoke: Palgrave Macmillan, 2006) eighth edition [ISBN 9781403996015].

Todaro, M.P. and S.C. Smith, Economic Development. (London: Pearson, 2006) ninth edition [ISBN 9780321311955].

Detailed reading references in this subject guide refer to the editions of the set textbooks listed above. New editions of one or more of these textbooks may have been published by the time you study this course. You can use a more recent edition of any of the books; use the detailed chapter and section headings and the index to identify relevant readings. Also check the virtual learning environment (VLE) regularly for updated guidance on readings.

Further readingPlease note that as long as you read the Essential reading you are then free to read around the subject area in any text, paper or online resource. You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world. To help you read extensively, you have free access to the VLE and University of London Online Library (see below).

Old ed

ition.

For ref

erenc

e only

.


4

The following four books are particularly useful further reading for the course.

Ghatak, S. Introduction to Development Economics. (London and New York: Routledge, 2003) fourth edition [ISBN 9780415280761].

Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development. (New York and Oxford: Oxford University Press, 2005) eighth edition [ISBN 9780195179606]. This is not a textbook in the strict sense. It is a collection of some of the most important literature in development economics with extremely useful notes contributed by the editors.

Nafziger, E.W. Economic Development. (Cambridge: Cambridge University Press, 2006) fourth edition [ISBN 9780521829663].

Siggel, E. Development Economics: A Policy Analysis Approach. (Aldershot: Ashgate, 2005) [ISBN 9780754642930].

The two books by Basu and Ray set the standard of the course. However, overall they have a microeconomics approach, and where there is macroeconomic analysis other references should be consulted. Therefore, in particular for the macroeconomics part of the course, you need to look at alternatives. Todaro and Smith’s book is very basic. Thirlwall’s book is at a higher level. In cases where Basu and Ray cover the material, Thirlwall or Todaro and Smith should be read to lay the foundation.

All of these books use theoretical analysis as well as verbal reasoning, supplemented by tables and diagrammatic analysis, as the main method of presentation. Basu and Ray use more advanced algebra whilst Ghatak and Thirlwall use relatively simple algebra.

Most of the above books have an extensive bibliography (Basu, Ray, Ghatak) and some refer to Further reading (Todaro and Smith). The books have end-of-chapter sections as follows:

• summary or key terms and concepts – Nafziger, Todaro and Smith

• problems (exercises) or questions – Nafziger, Ray, Thirlwall, Todaro and Smith.

Some key terms or concepts are highlighted by bold or italic print in the main text in Nafziger and Thirlwall. Todaro and Smith has a glossary of terms and concepts and there is a companion website at www.aw-bc/todaro_smith which offers a student study guide.

For ease of reference we provide below a full list of all the Further reading listed in the guide.

BooksBliss, C.J. and N.H. Stern Palanpur: The Economy of an Indian Village. (Oxford:

Clarendon Press, 1982) [ISBN 9780195614565], Chapter 5.Boserup, E. Women’s Role in Economic Development. (London: Earthscan

Publications, 1995), [ISBN 9781853830402].Devereux, S. Theories of Famines. (New York and London: Harvester

Wheatsheaf, 1993) [ISBN 9780133022179], Chapter 2.Ellis, F. Peasant Economics (Cambridge: Cambridge University Press, 1993),

[ISBN 0521457114].Elson, D. Male-Bias in the Development Process. (Manchester: Manchester

University Press, 1995), [ISBN 9780719042300].Fry, J.M. Money, Interest, and Banking in Economic Development. (Baltimore:

Johns Hopkins Press, 1995) second edition [ISBN 9780801850271]. Griffin, K. Alternative Strategies for Economic Development. (Macmillan, 1999)

[ISBN 9780312223403]. Chapter 6.Jones, C.I. Introduction to Economic Growth. (New York: W.W. Norton, 2002)

second edition, [ISBN 9780393977455]. Chapter 8.

Old ed

ition.

For ref

erenc

e only

.


5

Psacharopoulos, G. and M. Woodhall Education for Development: An Analysis of Investment Choices. (New York: Oxford University Press, 1985), [ISBN 9780195204780].

Schultz, T.W. Transforming Traditional Agriculture. (New Haven: Yale University Press, 1964), [ISBN 9780226740751].

Sen, A.K., Poverty and Famines: An Essay on Entitlement and Deprivation, (Oxford: Clarendon Press, 1981), [ISBN 9780198284635].

Thomas, J.J. Informal Sector Activity. (Hemel Hempstead: Harvester–Wheatsheaf, 1992), [ISBN 9780472104208].

Van Den Berg, H. Economic Growth and Development. (New York: McGraw Hill, 2001), [ISBN 9780072397970].

JournalsArabsheibani, G. ‘The Wiles Test Revisited’, Economics Letters, 29(4) 1989,

pp.361–64. Arabsheibani, G.R. ‘Male –Female Earnings Differentials in an Islamic Country:

The Case of Highly Educated Egyptians’, Education Economics, 8(2) 2000, pp.129–38.

Arabsheibani, G.R. and L. Manfor, ‘From Farashia to Military Uniform’, Economic Development and Cultural Change, 50(4) 2002, pp.1007–21.

Arabsheibani, G.R. and L. Manfor, ‘Non-Linearities in Returns to Education in Libya’, Education Economics, 9(2) 2001, pp.139–44.

Arabsheibani, G.R., F.G. Carneiro and A. Henley, ‘Gender Wage Differentials in Brazil: Trends over a Turbulent Era’. The World Bank Research Policy Paper 3148 (2003).

Arabsheibani, G.R., F.G. Carneiro and A. Henley, ‘Human Capital and Earnings Inequality in Brazil 1988–1998: Quantile Regression Evidence’, The World Bank Research Policy Paper 3147 (2003).

Athukorala, P. ‘Manufactured Exports from Developing Countries and Their Terms of Trade: A Re-examination of the Sarkar–Singer Results’, World Development, 21(10) 1993, pp.1607–13.

Basu, K. ‘Child Labor: Causes, Consequences and Cure, with Remarks on International Labor Standards’, Journal of Economic Literature, 37 1999, pp.1083–120.

Benjamin, D. ‘Can Unobserved Land Quality Explain the Inverse Productivity Relationship?’, Journal of Development Economics, 46 1995, pp.51–84.

Bhaduri, A. ‘On the Formation on Usurious Interest Rates in Backward Agriculture’, Cambridge Journal of Economics, 1 1977, pp.341–52.

Bhalla, J. and P. Roy ‘Mis-specification in Farm Size Productivity Analysis: The Role of Land Quality’, Oxford Economic Papers, 40 1988, pp.55–73.

Bleaney, M.F. ‘Manufactured Exports of Developing Countries and Their Terms of Trade since 1965: A Comment’ World Development, 21(10) 1993, pp.1615–16.

Bliss, C. and N. Stern, ‘Productivity, Wages and Nutrition: Part I: Theory, Journal of Development Economics, 1978, pp.331–62.

Bliss, C. and N. Stern, ‘Productivity, Wages and Nutrition: Part II: Some Observations’, Journal of Development Economics, 1978, pp.363–98.

Burgess, R. and J. Zhuang, ‘Modernisation and son preference’. Discussion Paper dedps29 (London School of Economics and Political Science 2000), http://sticerd.lse.ac.uk/dps/de/dedps29.pdf

Dorward, A. ‘Farm Size and Productivity in Malawian Smallholder Agriculture’, Journal of Development Studies, 35(5) 1999, pp.141–61.

Grilli, E.R. and M.C. Yang, ‘Primary Commodity Prices, Manufactured Goods Prices and the Terms of Trade in Developing Countries: What the Long Run Shows’, World Bank Review, 2(1) 1988, pp.1–48.

Hallaghan, W. ‘Self–selection by Contractual Choice and the Theory of Sharecropping’, Bell Journal of Economics, 9 1978, pp.344–54.

Old ed

ition.

For ref

erenc

e only

.


6

Hopper, D.W,. ‘Allocation Efficiency in Traditional Indian Agriculture’, Journal of Farm Economics, August 1965.

Immink, M.D.C. and F.E. Viteri, ‘Energy Intake and Productivity of Guatemalan Sugarcane Cutters: Part I’, Journal of Development Economics, 1981, pp.251–72.

Immink, M.D.C. and F.E. Viteri, ‘Energy Intake and Productivity of Guatemalan Sugarcane Cutters: Part II’, Journal of Development Economics, 1981, pp.272–87.

Kavoussi, R.M. ‘International Trade and Economic Development: The Recent Experience of Developing Countries’, The Journal of Developing Areas, (19) 1985, pp.379–92.

Kravis, I.B. ‘Trade as a Handmaiden of Growth: Similarities Between the Nineteenth and Twentieth Centuries’, The Economic Journal.

Levine, R. and D. Renelt, ‘A Sensitivity Analysis of Cross-Country Growth Regressions’, American Economic Review, 82(4) 1992, pp.942–63.

Lipton, M, ‘The Theory of Optimizing Peasant’, Journal of Development Studies, 3, 1968, pp.327–51.

Mankiw, N.G., D. Romer and D. Weil, ‘A Contribution to Empirics of Economic Growth’, Quarterly Journal of Economics, 107(2) 1992, pp.407–37.

Oster, E. ‘Hepatitis B and the Case of Missing Women’, Journal of Political Economy, 116(5) 2005, pp.1163–216.

Powell, A. ‘Commodity and Developing Country Terms of Trade: What Does the Long Run Show?’, The Economic Journal 101, 1991, pp.1485–96.

Sarkar, P. and H.W. Singer, ‘Manufactured Terms of Trade Deterioration: A Reply’, World Development, 21(10) 1993, pp.1617–20.

Sen, A.K. ‘Development: Which Way Now?’, Economic Journal, 93(372) 1983, pp.745–62.

Singer, H.W. and P. Gray, ‘Trade Policy and Growth of Developing Countries: Some New Data’, World Development, 16, 1988, pp.395–403.

Stark, O., M.R. Gupta and D. Lehvari, ‘Equilibrium Urban Unemployment in Developing Countries: Is Migration the Culprit?’, Economics Letters, 37, 1991, pp.477–82.

Stern, N. ‘The Economics of Development: A Survey’, Economic Journal, 99(397) 1989, pp.597–685.

Temple, J. ‘The New Growth Evidence’, Journal of Economic Literature, 37(1) 1999, pp.112–56.

Additional resourcesIn addition to the above books, you will benefit from having access to recent editions of the World Bank’s World Development Report, and the United Nations Development Programme (UNDP) Human Development Report (both published annually by Oxford University Press) which, apart from chapters on their main theme development, contain a wealth of statistical information. You can obtain them from the websites of the World Bank and the UNDP respectively:

www.worldbank.org

www.undp.org

Online study resourcesIn addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library.

You can access the VLE, the Online Library and your University of London email account via the Student Portal at:

http://my.londoninternational.ac.uk

Old ed

ition.

For ref

erenc

e only

.


7

You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on your application form. You have probably already logged in to the Student Portal in order to register! As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account.

If you forget your login details at any point, please email [email protected] quoting your student number.

The VLEThe VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community. It forms an important part of your study experience with the University of London and you should access it regularly.

The VLE provides a range of resources for EMFSS courses:

• Self-testing activities: Doing these allows you to test your own understanding of subject material.

• Electronic study materials: The printed materials that you receive from the University of London are available to download, including updated reading lists and references.

• Past examination papers and Examiners’ commentaries: These provide advice on how each examination question might best be answered.

• A student discussion forum: This is an open space for you to discuss interests and experiences, seek support from your peers, work collaboratively to solve problems and discuss subject material.

• Videos: There are recorded academic introductions to the subject, interviews and debates and, for some courses, audio-visual tutorials and conclusions.

• Recorded lectures: For some courses, where appropriate, the sessions from previous years’ Study Weekends have been recorded and made available.

• Study skills: Expert advice on preparing for examinations and developing your digital literacy skills.

• Feedback forms.

Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates.

Making use of the Online LibraryThe Online Library contains a huge array of journal articles and other resources to help you read widely and extensively.

To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you will be required to register and use an Athens login:

http://tinyurl.com/ollathens

The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine.

If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons.

Old ed

ition.

For ref

erenc

e only

.


8

For further advice, please see the online help pages: www.external.shl.lon.ac.uk/summon/about.php

Examination adviceImportant: the information and advice given here are based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to always check both the current Regulations for relevant information about the examination, and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions.

StructureIn the three-hour examination paper for 44 Economics of development, you will have to answer four questions from a choice of 12. There are no compulsory sections or questions in the examination.

Types of questionsExamples of the type of questions that appear in the examination are given at the ends of Chapters 2 to 11. However, those questions are specifically designed to test your understanding of the subject matter in the respective chapters. It is possible that, in the examination, questions may be set which require you to think across subject areas. Question 9 in the Sample examination paper in Appendix 2 is an example of such a question.

AdviceYou should follow all the excellent advice to candidates which is published annually as an introduction to the Examiners’ commentaries.

In addition, the following advice is valuable.

1. Prepare thoroughly for the examination by attempting the problems/questions in the textbooks and in this subject guide.

2. If you are a little unsure of what a question is asking, for example because of doubt about its interpretation, state at the beginning of your answer how you interpret the question. Do not answer a question if you are very uncertain of what is required.

3. Even though a question may not specifically ask for it, it is preferable to define, at the appropriate place(s) in your answer, key terms or concepts given in the question. Where you need to use a word or term the meaning of which is ambiguous – ‘the exchange rate’ for example – define the term when you first use it.

4. The introduction to the Examiners’ commentaries mentions the importance of key words. Be prepared for words which will tell you what to do – for example, analyse, describe, discuss, outline, examine, assess, suggest, propose – and make sure you follow the instruction. Do not deviate by writing down all you know about a subject or topic in the hope that some of it is relevant.

5. In many cases, good answers will require diagrammatic (or simple algebraic) analysis to complement verbal reasoning. The complementary dimension is important: good diagrams can often save much verbal explanation but free-standing diagrams, however well-drawn and labelled, do not communicate sufficient information to the examiners. Diagrams and algebraic presentations need to be explained

Old ed

ition.

For ref

erenc

e only

.


9

in the text of the answer. Symbols and abbreviations, other than those which are widely known and used (for example, ‘Y’ for output; ‘S’ for saving; ‘FDI’ for private foreign investment; ‘IMF’ for International Monetary Fund), should be defined/spelled out when you first use them in the examination.

6. 44 Economics of development is a paper involving economic analysis. The examiners are primarily looking for analytical explanations and/or suggestions for policy based on economic theory and empirical evidence and will very rarely be expecting purely descriptive answers. Thus, even if they do not specifically mention them, underlying the questions will be one or more hypotheses, theories, concepts or models; demonstrable knowledge of these, together with relevant empirical evidence, will constitute the basis of a good answer.

Remember, it is important to check the VLE for:

• up-to-date information on examination and assessment arrangements for this course

• where available, past examination papers and Examiners’ commentaries for the course which give advice on how each question might best be answered.

Syllabus• Concepts and measurements of economic development and the

characteristics of developing countries; models of growth and development (Harrod–Domar, Neoclassical model and growth accounting, Lewis dual sector, endogenous growth and their variants); gender and development.

• Mobilising domestic resources; domestic savings, private capital markets and financial intermediation; rural informal capital markets; insurance; tax policy; monetary policy; inflation.

• Mobilising foreign resources; foreign capital requirements; multinational corporations; foreign aid and private foreign investment; external debt.

• Planning: planning models, project appraisal and social cost –benefit analysis.

• Human dimensions of development: population growth, determinants of fertility; son preference; employment and unemployment; rural–urban migration and the informal sector; child labour; nutrition and efficiency wages; education and human capital; poverty; inequality and famines.

• Agriculture: role in development; resource allocation and producer rationality; price responsiveness; land reform and tenural relationships; technical change and Green Revolution.

• International Trade: role in development; infant industry protection; the terms of trade; export earnings instability.

• Balance of payment and development: balance of payment and exchange rates; international financial crises; industrialisation by import substitution and export promotion.

• The environment and development: sustainable development; market failure; common properties.

Old ed

ition.

For ref

erenc

e only

.


10

Glossary of abbreviationsCBR Crude birth rate

CDR Crude death rate

DC Developed country

FAD Food availability decline

FDI Foreign direct investment

FED Food entitlement decline

GATT General Agreement on Tariffs and Trade

GDP Gross domestic product

GNP Gross national product

GSP Generalised System of Preferences

HDI Human Development Index

ICOR Incremental capital –output ratio

LDC Less developed country

MEC Marginal external cost

MFC Marginal fertiliser cost

MNC Multinational corporation

MP Marginal product

MPP Marginal physical product

NIC Newly industrialising country

OECD Organisation for Economic Cooperation and Development

PQLI Physical Quality of Life Index

SAM Social accounting matrix

TNC Transnational corporation

TVP Total value product

UNCTAD United Nations Conference on Trade and Development

UNIDO United Nations Industrial Development Organisation

WTO World Trade Organization

Old ed

ition.

For ref

erenc

e only

.

Chapter 2: Economic development

11


Aims of the chapterMany economics concepts are widely used but usually imprecisely defined. Economic development is one of these. This chapter will:

• cover the concept of development and how it has evolved over time

• discuss different measurements of economic development and some general characteristics of developing countries

• consider some important objectives of development and the Millennium Development Goals.

Learning outcomesBy the end of this chapter, and having completed the Essential reading, you should be able to:

• recall examples of concepts, dimensions, and definitions of economic development

• explain what indicators of economic growth and development are and their problems and limitations

• list general economic characteristics of developing countries.

Essential readingRay, D. Development Economics, Chapter 2.Thirlwall, A.P. Growth and Development with Special Reference to Developing

Economies, Chapters 1–3.Todaro, M.P. and S.C. Smith, Economic Development, Chapters 1 and 2.

Further readingGhatak, S. Introduction to Development Economics, Chapter 1.Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

Selections IA and IB.Nafziger, E.W. Economic Development, Chapters 1–4.Sen, A.K. ‘Development: Which Way Now?’, Economic Journal, 93(372) 1983,

pp.745–62.Siggel, E. Development Economics: A Policy Analysis Approach, Chapter 1. Stern, N. ‘The Economics of Development: A Survey’, Economic Journal,

99(397) 1989, pp.597–685.

IntroductionAlthough the central theme of this chapter is the concept of development, you should begin your study of the economics of development by reading the introductory chapters in all the textbooks in order to place the entire subject in context. For example, you will benefit from a brief excursion into the historical context of current development. Nafziger and Ray provide such a review,1 whereas Meier and Todaro and Smith present a more formal discussion of the differences in the initial conditions between those which face today’s developing countries and those which faced today’s developed countries in the past, especially in the nineteenth century.2

1 See Nafziger, Chapter 3; Ray, pp.16–25.2 See Meier and Rauch, pp.73–78, and pp.81–100; Todaro and Smith, pp.71–83.

Old ed

ition.

For ref

erenc

e only

.


12

‘Development’ and the narrower concept of ‘economic development’ are difficult to define precisely. After exploring what is meant by these concepts, you should be able to offer a working definition of development.3 There follows a note on the terminology used to describe different groups or categories of countries.4 In order to understand many development issues, and hence parts of this syllabus, it is essential to be able to measure development. Problems of quantifying or measuring development are referred to in ‘Measuring economic development’ below. You should also be familiar with the main economic and related characteristics of developing countries.5

You are advised to return to this chapter after completing this subject guide and the Essential reading. Having studied this course, you will be better equipped to understand the subject matter, especially the concept of development and the problems of measuring economic development.

The concept of developmentWhat is development? Can economic development be separately distinguished? To the extent that it can be, this paper is concerned with economic development. The essential tasks for you in this area are to:

1. be as clear as possible as to what economic development is and what it is not

2. understand that economic development has a number of dimensions

3. know and to be able to justify a definition of economic development which incorporates those dimensions on which there is a broad consensus.

Development certainly implies change or transformation but, when referring to a country, its society or its economy, the concept of development can be interpreted very broadly. It would include, in addition to certain economic changes and processes, other transformations which would usually be regarded as political and/or social. For the purpose of this course, you must confine your attention to the economics of development or to economic development issues. However, you will know that a country’s economy does not exist in a vacuum, devoid of any institutional, political and social contexts.

You are not expected to analyse development from non-economic perspectives but you should appreciate that what are often considered to be non-economic factors are economic factors if they affect economic behaviour and hence development. For example, you are not expected to know the reasons why different systems of agricultural land ownership exist, but you will be expected to know the economic significance of different systems including the effects of a change from one system to another.

So, what is meant by economic development? What are its dimensions? Economic development certainly involves economic growth measured by an increase in gross domestic product/gross national product (GDP/GNP) per capita. Economic growth cannot be continuous unless the economy adjusts to factors which affect the supply of and demand for goods and services; thus, there must be changes in the structure of production. There is also general agreement that development has a distributional dimension. Even if a country’s economy is growing rapidly and its production structure is changing significantly, it would not be considered to be developing unless the benefits of that growth were widely shared across the population. Though some economists would not

3 See ‘The concept of development’ below.4 See ‘Some terminology’ section of this chapter.

5 Most books have a section or a chapter on this topic.

Old ed

ition.

For ref

erenc

e only

.


13

define development so widely as Goulet (1971), discussed in Thirlwall and Todaro and Smith,6 the vast majority of development economists would consider that some dimensions of reducing poverty, improving the provision of basic needs goods and services and, at least to some extent, reducing inequalities in income distribution should be incorporated in the definition of development. These issues are at the heart of A.K. Sen’s ‘Capabilities Approach’ to development.7 Typically, income transfers through the government sector are insignificant in developing countries. Therefore, the only way that poverty can be reduced and basic needs met is by increasing the availability of productive employment. Thus growth of employment opportunities or a reduction in the under-utilisation of labour is another dimension.

Economists have long since recognised that it would be possible for a country to be viewed satisfactorily on all the above dimensions or criteria while concurrently reducing its capital stock. Such development would not be sustainable. More recently, concern with the quality of the physical environment has extended this idea to encompass the concept of environmentally-sustainable development.8

On account of its complexity, few textbooks present a formal definition of economic development. Having studied the relevant concepts and issues, you should attempt your own definition of economic development – it would be useful to undertake this task both at the beginning and end of your study plan. However, one definition that encapsulates the discussion in the recommended references might be:

Economic development is a sustainable process of structural change in which real per capita output increases and in which there is a wider participation in the production and consumption of output, such that an increasing proportion of the population experiences an improvement in its level of economic welfare.

You should be able, from your understanding of the concept of development, to appreciate why no country can be considered to be fully developed.

Some terminologyFor the purpose of this course the following sets of terms, used to describe a country or groups of countries, are sometimes used synonymously:

• less developed (LDCs), developing, underdeveloped, poor, backward, ‘Third World’, ‘South’

• developed (DCs), more developed, industrial, industrialised, rich, advanced, ‘First World’, ‘North’.

Some of these terminologies are incorrect when applied to some countries. It is, for example, possible that a country is not developing, in a general sense. Others terminologies were more relevant at some point in the past, but are no longer. For example, North –South is an incorrect division since some of the major LDCs are in the North and Australia and New Zealand are in the South. Similarly First World –Third World has a cold war background and is no longer relevant. In this subject guide we use the distinction DCs and LDCs.

6 See Thirlwall, pp.17–19; Todaro and Smith, pp.20–22.

7 See Todaro and Smith, pp.17–20.

8 See Chapter 11.

Old ed

ition.

For ref

erenc

e only

.


14

Measuring economic developmentIt will become clear in many parts of this course that a measure of economic development is highly desirable, if not essential. You must understand a number of basic problems involved in the measurement of economic development. They can be divided into:

a. problems of devising a quantifiable measure or indicator for each of the dimensions of economic development

b. problems of combining appropriate indicators for each dimension into a single indicator of economic development.

These problems are conceptual and practical. With regard to (a) above:

• You will be expected – as indicated in the specified tasks in Chapter 7 – to understand the difficulties of measuring poverty, income distribution and employment and unemployment. Here, attention is concentrated on per capita GDP/GNP/income.

• You should know some of the problems of national income accounting in developing countries and why they tend to underestimate real domestic or national output expressed in terms of national currency.

• More attention, however, should be paid to understanding the problems of making international comparisons: you must know what factors cause the use of international comparisons based on conversions (from national currency to US dollars) using current exchange rates to tend to overstate and understate the real average per capita income difference, or gap, between developed and developing countries.

• You should also know why the average per capita income is not a perfect indicator of the income of the typical member of the population.

• You should be familiar with the rationale for and use of purchasing-power parity conversions and why such conversions result in a more accurate indication of the gap in real average incomes between rich and poor countries.

The problems associated with exchange rate conversions has led to a search for non-monetary indicators which, it is thought, would provide a more accurate representation of the real difference in levels of living between countries and which could be used in the construction of composite indicators of economic development.

• You are expected to know the problems of devising composite indicators (the choice of component indicators, how they should be scaled and how they should be weighted in the composite indicator) and hence their limitations.

• You should be familiar with these issues especially in the context of the Physical Quality of Life Index (PQLI) and the United Nations’ Human Development Index (HDI), the two most well-known composite indicators which are discussed in the textbooks.9 The Human Poverty Index, which attempts to measure deprivation, is another index that you should be familiar with.10

Using a large sample of countries, developed and developing, there are high (rank) correlations between per capita income based on current exchange rate conversions on the one hand, and purchasing-power parity adjusted per capita income and composite indicators such as the PQLI and the HDI on the other. This is one reason why, despite its limitations, current exchange rate-based per capita income continues to be the most

9 HDI calculations are shown in: Siggel, pp.15–17; Todaro and Smith, pp.59–64; Thirlwall, pp.47–53; Nafziger, pp.35–39.

10 For illustrative calculations, see Thirlwall, p.54 and Table 2.5, pp.55–58.

Old ed

ition.

For ref

erenc

e only

.


15

widely accepted single indicator of the level of economic development. Additional reasons are its familiarity and, the index number problem11 notwithstanding, it is fairly unambiguous what an increase in real per capita income means which cannot be claimed of the composite indicators.

Finally you should understand the concepts of the relative income gap and the absolute income gap between rich and poor countries, and the relationship between income growth rates and the size of the absolute gap. Whether the latter will widen or narrow depends on the relative growth rates of the rich and poor countries and the ratio of the initial per capita incomes of the two country groups.

Characteristics of developing countriesAll countries differ in economic and in non-economic characteristics. Even within the developing countries as a group, there is a great deal of heterogeneity. Nevertheless, there are a number of features which are common to most, although not necessarily to all, developing countries. Ghatak, Thirlwall and Todaro and Smith provide the most comprehensive lists and discussion.12 Although questions on the characteristics of developing countries specifically will not appear on the examination paper, greater knowledge in this area will significantly enhance your understanding of the more substantive issues tackled in this course, which are the subject matter of all the following chapters of this guide.

A reminder of your learning outcomesHaving completed this chapter, and the Essential reading, you should be able to:

• recall examples of concepts, dimensions, and definitions of economic development

• explain what indicators of economic growth and development are and their problems and limitations

• list general economic characteristics of developing countries.

Sample examination questions1. Define economic development and justify your definition.

2. ‘The problems associated with composite indicators of development are as numerous and as difficult as those associated with any other single measure of economic development.’ Discuss.

3. Why, despite their limitations, are figures for per capita income or output based on current exchange rates used to measure levels and growth rates of economic development?

11 See, for example, Siggel, pp.23–24.

12 See Ghatak, Chapter 1; Thirlwall, Chapter 3; Todaro and Smith, Chapter 2; Nafziger Chapter 4.

Old ed

ition.

For ref

erenc

e only

.

Notes


16

Old ed

ition.

For ref

erenc

e only

.

Chapter 3: Models of growth and development

17


Aims of the chapterThis chapter covers economic models that explain growth and development. It starts with the popular Harrod –Domar growth model, discusses the Neoclassical growth theory, the Production Function Approach and growth accounting, the Lewis model and the new (or endogenous) growth theory.


• explain the Harrod –Domar model, its applications and limitations

• describe neoclassical growth theory

• define growth accounting and list the sources of growth

• describe the Lewis model and its criticisms

• explain endogenous growth theory and other contemporary models of growth and development

• explain the meaning of coordination failure and how it might cause underdevelopment.


Revisited, Chapter 3.Ray, D. Development Economics, Chapter 3.Thirlwall, A.P. Growth and Development with Special Reference to Developing

Economies, Chapter 4. Todaro, M.P. and S.C. Smith, Economic Development, Chapter 3.


Selection IC2.Nafziger, E.W. Economic Development, Chapter 5.Siggel, E. Development Economics: A Policy Analysis Approach, Chapter 2.Van Den Berg, H. Economic Growth and Development, Chapters 2–5.

IntroductionThe last 50 years have witnessed a remarkable increase in the development of theories of economic growth which attempt to show how the structure of a country’s economy is expected to change when factors determining the rate of growth change.

Proliferation of these theories coincided with the end of the second world war which, together with the Great Depression, had a devastating effect on developing countries. Furthermore, this period coincided with the

Old ed

ition.

For ref

erenc

e only

.


18

beginning of the end of the colonial era when many LDCs started to get their independence, developed a sense of national identity and recognised the ‘need to develop’.

Theories of growth and development generally receive very good textbook coverage. Although each writer has a different style and preferences, there seems to be a consensus that the era of a ‘grand’ theory of development is over and, hence, only the relatively modern views get thoroughly covered. For those interested in the historical background of the subject, Van Den Berg presents a brief review of ‘economic growth through history’ (Chapter 2).

Nafziger (Chapter 5) presents these theories in approximately the order they appeared historically starting with:

• the classical theory (pp.124–26)

• Marx’s views (pp.129–28)

• Rostow’s stages model (pp.128–31).

He then pays attention to one of the most important questions of the 1950s and 1960s – should LDCs follow a gradualist policy or a big push? Balanced versus unbalanced growth (pp.132–36). This section includes a description of the modern version of the big push theory, or the Murphy –Shleifer –Vishny model (for explicit analysis of this model see Todaro and Smith). This is then followed by the dual sector model (pp.138–42), Neo-Marxist (pp.142–44) and dependency theories (pp.144–48), and Neoclassical and New Growth theories (pp.153–59). In each case a critique is also offered.

Van Den Berg (Chapters 3–5) analyses the major theories only, starting with the Harrod –Domar, proceeding to the Solow model, the AK model and then considers the empirical aspects of growth.

Todaro and Smith (Chapters 3 and 4) proposes that theories of development can be divided into five competing strands of thought:

• linear stages (e.g. Rostow) (pp.103–08)

• theories and patterns of structural change (e.g. the Lewis model)(pp.108–15)

• the international dependence revolution (pp.115–19)

• the neoclassical counter-revolution (pp.119–24)

• the New Growth Theory and contemporary models of growth and development (Chapter 4).

Thirlwall presents:

• Rostow’s stages model (pp.107–14)

• Kaldor’s growth laws (pp.117–20)

• the classical, Harrod –Domar and Neoclassical Theories (pp.123–40)

• balanced versus unbalanced growth (pp.307–13)

• the production function approach (pp.140–53)

• the Lewis model (pp.188–92)

• the New Growth Theory (pp.153–60).

Meier and Rauch’s treatment covers a number of issues including the new endogenous growth theory (note I.C.2, pp.79–80), and the dual sector model (selection VI.B.1, pp.355–57).

Old ed

ition.

For ref

erenc

e only

.


19

Ghatak offers possibly the best treatment of the subject. In Chapter 2 he presents a range of theories starting with:

• the classical model (pp.49–51)

• the implications of Keynesian theory for LDCs (pp.51–54).

There is then a clear treatment of:

• the Harrod –Domar model (pp.54–56)

• the neoclassical theory (pp.56–60 and Appendix 2: pp.75–78, where the neoclassical model is derived)

• Marxian and neo-Marxian approaches (pp.61–67)

• the Kaldor –Mirlees model in which the capital –output ratio is fixed but the savings ratio can be flexible (pp.67–69)

• endogenous growth theories (pp.70–75).

In Chapter 3 he presents dual economy models and their extensions.

Basu, in Chapters 2 and 3, looks at the vicious circle theory (pp.19–32), the O-ring theory (pp.33–39), the Harrod –Domar model (pp.43–46), the neoclassical model (pp.46–50) and the endogenous growth model (pp.50–55). The treatment of endogenous growth in this book is complicated and you are not required to know this version of the model.

Ray discusses growth in Chapters 3 and 4. The Harrod –Domar model is covered first (pp.51–64 and Appendix 3.A.1) followed by the Solow model (pp.64–90 and Appendix 3.A.2). Different versions of the endogenous growth model are discussed in Chapter 3 as well as a case study of total factor productivity (pp.119–23).

This guide will concentrate only on post-second world war theories starting with the Harrod –Domar model (an example of a one-sector model). This is followed by neoclassical growth accounting and by the Lewis model (an example of a two-sector model). Finally, we look briefly at endogenous growth (the ‘new’ growth theory).

You are expected to know these theories as well as the dependency theories referred to above.

Other theories are usually variants of the four main theories and arise out of relaxing or adding assumptions (e.g. Kaldor–Mirlees). Knowledge of the other theories is not essential but useful, particularly as an example of the application of one of the four major theories (e.g. Mahalanobis) or a critique of some of their assumptions.

You should note that the mathematical notation in the remaining sections of this chapter varies in order to be consistent with the notations used by the authors referred to; for example, rK is the same as K. K

Harrod –Domar growth modelNow read:


Revisited, pp.43–46.Ray, D. Development Economics, pp.51–64.Thirlwall, A.P. Growth and Development with Special Reference to Developing

Economies, pp.130–136. Todaro, M.P. and S.C. Smith, Economic Development, pp.105–07.

Old ed

ition.

For ref

erenc

e only

.


20

Further readingGhatak, S. Introduction to Development Economics, pp.54–56.Nafziger, E.W. Economic Development, pp.162–63.Van Den Berg, H. Economic Growth and Development, pp.105–11.

The Harrod –Domar model was developed to answer a key question: ‘what

determines the rate of growth of output?’ The Harrod equation g =

∇

YY

= svprovides a very simple answer: g, the rate of growth of output, depends on s, the savings ratio and v the incremental capital –output ratio (ICOR). For a given v, it provides a very strong tool for policy analysis: hence its popularity. If a stable g is required then a particular level of savings will enable it to be achieved. The major question for LDCs,

however, is how to raise g? Again, for a target rate of growth g* = s*v

there is a unique savings rate s* leading to g*. The ways in which domestic resources can be generated to achieve the target rate of growth g* are discussed in Chapter 4. The model also provides a strong case for foreign aid1 if domestic resources are insufficent to yield the target rate of growth. In this case we can write where a is the ratio of foreign aid to GNP and s < s*. As long as a > 0 the rate of growth achieved will be greater than that yielded just by domestic resources. The target rate g* can be achieved if s*– s = a.

You are expected to know the assumptions behind the model, its derivations2 and its shortcomings.

The limitations of the model can be divided into less important issues (e.g. it does not include lags, and it does not take account of depreciation) and more significant ones. The latter includes two important issues:

1. the instability or the knife-edge problem discussed by Ghatak and Nafziger3

2. the problems associated with the calculation and stability of the ICOR.4

Ghatak and Van Den Berg discuss general problems associated with the application of the Harrod –Domar model to LDCs.5

An important point, not covered by the textbooks, is that the justification provided by the Harrod –Domar model for foreign aid has come under attack from those who believe that a high proportion of foreign aid is likely to be project aid, usually in large, prestigious and highly capital-intensive projects, which will raise the ICOR. In this case the effect on growth is not always positive. To demonstrate this issue, assume the country receives aid, so where v´ > v. Hence g´ can only be greater than g if aid raises the numerator more proportionally than the ICOR rises.

Ray presents the Harrod –Domar model and analyses and two important extentions, where the savings rate and the population growth rate are endogenous.

Neoclassical growth theoryNow read:


Revisited, pp.46–50.Ray, D. Development Economics, pp.64–84Thirlwall, A.P. Growth and Development with Special Reference to Developing

Economies, pp.136–40.Todaro, M.P. and S.C. Smith Economic Development, pp.136–39.

1 See Chapter 5 of this guide.

2 See for example Ghatak, pp.54–55; Todaro and Smith, pp.105–06.

3 See Ghatak, p.55.

4 See Nafziger at www.ksu.edu/economics/nafwayne, supplement to the fourth edition of Economic Development.

5 See Ghatak, p.56; Van Den Berg, pp.108–109.

Old ed

ition.

For ref

erenc

e only

.


21

Further readingGhatak, S. Introduction to Development Economics, pp.75–78.Nafziger, E.W. Economic Development, pp.153–55.Van Den Berg, H. Economic Growth and Development, pp.115–45.

The major shortcoming of the Harrod –Domar model, which caused the knife-edge problem, was the assumption that capital and labour had to be combined in technologically fixed proportions. The neoclassical (Solow) growth model overcomes this problem by allowing capital and labour to be used in variable proportions. This then allows the capital –output ratio to be a policy variable, to be used to the best advantage of any country given its unique characteristics. The neoclassical growth model is discussed in the above readings. It can easily be shown that from a production function of the form Y = f(K, L) = AKL the following expression can be derived:

rY = rA + rK + rL (3.1)

where rY, rK and rL are, respectively, the annual rates of growth of output, capital and the labour force. This type of expression for the rate of growth in continuous time involves taking logarithims of the variables in the production function and differentiating with respect to time. The constants and are output elasticities with respect to capital and labour respectively. Under the assumption of constant returns to scale and competitive factor markets they add up to one and are equal to the shares of capital and labour respectively in national income. The term rA

represents growth in output which is not attributable to the growth of the factor inputs, capital and labour; it is also known as total factor productivity growth and, in growth accounting,6 as the residual. You should know how to derive equation (3.1) and the assumptions on which it is based.

Recalling the discussion of the concept of development and the definition of economic development,7 an expression for the growth of output per head is arguably more relevant than that for the growth of output. Assuming the population growth rate and the labour force growth rate are equal (reasonable for long run analysis), equation (3.1) can be manipulated as follows:

rY = rA + rK + rL

rY – rL = rA + rK + rL – rL

= rA + rK – rL) (3.2)

assuming there are constant returns to scale (that is + = 1).

This equation (or its variants) states that the growth of output per head (or per worker) equals the growth rate of total factor productivity (or technical progress) plus some factor () of the growth rate of the capital –labour ratio or capital per head. Technical progress (rA) is exogenous in the Solow neoclassical growth model but you should know what factors explain it8 both in the context of growth accounting and endogenous growth theory.

9

Most textbooks derive what Solow called the fundamental equation of his model,

10 which in the absence of technical progress and depreciation is:

k = sf(k) – nk (3.3)

where k is the change in the capital–labour ratio, sf(k) is saving (= investment) per worker and nk is investment required to keep the capital–labour ratio constant. You are not expected to derive Equation 3.3

6 See ‘Growth accounting’ later in this chapter.

7 See ‘The concept of development’ in Chapter 2.

8 See Ghatak, pp.71–73; Thirlwall, pp.165–72.

9 See ‘Endogenous growth theory’ later in this chapter.10 See for example Ghatak, pp.75–78.

Old ed

ition.

For ref

erenc

e only

.


22

(the derivation is presented in Appendix Ia.) but you should understand its implications. Essentially the change in the capital –labour ratio (k) will be positive, negative or zero if sf(k) > nk, sf(k) < nk, and sf(k) = nk respectively. The model predicts that, with given values of s and n, the economy will achieve a steady state in which the capital stock and output both grow at the exogenously-determined labour force growth rate. To demonstrate this, consider Figure 3.1, in which the per capita (or per worker) production function [f(k)], which exhibits diminishing returns to capital, the per capita saving function [sf(k)] and the capital requirements line (nk) are plotted against the capital –labour ratio (k).

Figure 3.1 The Solow model of economic growth

Initially sf(k) > nk, then k will rise because saving (= investment) per worker is greater than that required to keep the capital –labour ratio constant. Conversely if sf(k < nk, then k will fall because investment per worker is less than that required to keep the capital –labour ratio constant.

When sf(k)= nk , that is when k= k* (at ‘a’ in Figure 3.1), there is no inducement for k and hence y (output per worker) to change: this is the steady state. Now consider the identity:YL

YK

= · KL

(3.4)

At k = k* the capital –labour ratio (K L ) is constant and so is output per worker (Y L ) but because the labour force is growing at rate n both the capital stock and output are growing at rate n.

What is the relevance of this model to economic development? It puts a different perspective on the roles of saving and capital accumulation from that of the Harrod –Domar model. A once-and-for-all rise in the saving rate will, other things being equal, cause only a temporary rise in the growth rate of output and output per head. An increase in the saving rate to s´ will shift the saving function to s´ f(k) intersecting nk at b and cause k to rise to k1, and output per head to rise from y* to y1 . Thereafter, however, identity 3.4 holds and the capital stock and output again grow at rate n.

Thus, for a given n and in the absence of technical progress, continuous rises in output per head require continuous increases in the saving rate. There will be an upper limit to a country’s saving rate. A similar manipulation can be done for the growth of the labour force. A once-off fall in n, represented in the diagram by a downward rotation of nk, will cause only a once-off increase in the growth of output and in output per head. Although lowering the population growth rate might be desirable for other reasons,11 the Solow model demonstrates that such a demographic

11 See ‘The consequences of population growth’ in Chapter 7.

Old ed

ition.

For ref

erenc

e only

.


23

change will not result in a permanently higher growth of per capita income. A once-off technological improvement will shift the production and savings functions upwards: the saving function will intersect the capital requirements line at a higher capital –labour ratio, the capital –labour ratio rises and this results in a higher output per worker as given by the new production function. Thus, according to the model, continuous technical progress is required for continuous increases in output per worker or per head to be achieved.12

The Solow model has been criticised for a number of reasons. First, it relies on efficient markets but developing countries may exhibit dualistic features and changes (migration for example) may come about only slowly. Adjusting the factor intensity of production in response to price changes may require a long time and hence developing countries may be, in effect, operating with fixed capital –labour ratios. Doubts about the relevance of applying the neoclassical model to developing countries are raised in Ghatak, and Thirlwall discusses the limitations of the Cobb –Douglas production function approach.

The second major criticism is that the model predicts convergence,13 that is, the per capita outputs of countries converge over time. Assume there are two countries, one with high and one with low per capita income. Assume, further, that both have the same exogenous saving rate and the same exogenous growth rate of technical progress. The country with the low per capita income will have a low capital –labour ratio and a high marginal productivity of capital. Thus, since the saving rate is identical in the two countries and capital will flow from the high income country where the marginal productivity of capital is lower, the low per capita income country will experience faster capital accumulation and faster growth of output. Hence the per capita income in the two countries will converge. In other words, there will be a negative relationship between per capita income (or GDP) and growth of per capita income (or GDP). This result is not observed and empirical evidence shows that while there has been convergence between OECD countries and some of the newly industrialising countries (NICs), there still exist very wide per capita income differentials between the developed and most of the developing countries.

Growth accountingNow read:

Essential readingRay, D. Development Economics, pp.74–84.Thirlwall, A.P. Growth and Development with Special Reference to Developing

Economies, pp.147–53.

Further readingLevine, R. and D. Renelt, ‘A Sensitivity Analysis of Cross-Country Growth

Regressions’, American Economic Review 82(4) 1992, pp.942–63.Mankiw, N.G., D. Romer and D. Weil, ‘A Contribution to Empirics of Economic

Growth’, Quarterly Journal of Economics, 107(2) 1992, pp.407–37.Nafziger, E.W., Economic Development, Chapter 11.Temple, J. ‘The New Growth Evidence’, Journal of Economic Literature, 37(1)

1999, pp.112–56.Van Den Berg, H. Economic Growth and Development, Chapter 5.

12 See Appendix 1B.

13See Ghatak, pp.71–72; Van Den Berg, pp.136–40; Ray, pp.74–84; Siggel, pp.54–62.

Old ed

ition.

For ref

erenc

e only

.


24

Equation 3.1 is used as the foundation for estimating the sources of economic growth. You should know the factors which explain the residual (rA) and the results of attempts to disaggregate it, in addition to knowing which of the variables, rK, rL and rA is more important for developing countries as a group compared to developed countries and the reasons for this.14 Van Den Berg, in Chapter 5 of his book, thoroughly analyses the empirical aspects of the Solow model. Other useful discussions and empirical results can be found in papers by Mankiw et al., Levine and Renalt, and Temple.

The Lewis model – growth with unlimited supplies of labour

Now read:


Revisited, pp.153–61.Ray, D. Development Economics, pp.353–72.Thirlwall, A.P. Growth and Development with Special Reference to Developing



Selection VI.B.2.Nafziger, E.W. Economic Development, pp.138–42.

The Lewis model (1954) was the first model which specifically addressed growth in LDCs. In his model Lewis assumed that developing countries are dualistic in nature: that is, they have a modern sector and a traditional sector. The two sectors differ with respect to their production function. The textbook treatments of the model are adequate, the best being those of Todaro and Smith, and Ray.

You are required to know:

a. the assumptions behind the model

b. the way it explains growth in a dualistic economy

c. criticisms of the model.

One of the major shortcomings of the model is that it assumes the growth of the economy is only dependent upon the growth of the capitalist sector and therefore ignores the growth of the agricultural sector. Fei and Ranis’s model, presented in Ghatak, considers the implications of agricultural and population growth in a dualistic context. Ghatak discusses other criticisms of the Lewis model and offers some empirical results.15

Other extensions of the Lewis model are discussed by Ghatak. Jorgenson’s model is a dual economy model within the neoclassical framework, the Dixit –Marglin model introduces dynamic behaviour in the dual economy models, and Kelly et al.’s model is a general theory of growth in a dual economy. Ghatak16 presents an excellent criticism of all dual economy models.

You are not expected to know the details of the three models mentioned in the previous paragraph but may find it useful to refer to them when criticising Lewis’s model.

14 See Ghatak, pp.71–73; Nafziger pp.138–42; Ray, pp.84–88, Thirlwall, pp.149–53, and ‘Endogenous growth theory’ later in this chapter.

15 See Ghatak, pp.82–84.


Old ed

ition.

For ref

erenc

e only

.


25

You must be aware that terminology used by various books on this section might be confusing. Lewis called his two sectors ‘capitalist’ and ‘traditional’. Other common terms used to describe the capitalist sector are ‘modern’, ‘industrial’ or ‘urban’, whereas the traditional sector is sometimes described as ‘backward’, ‘agricultural’ or ‘rural’. Although these terms are not identical in meaning (for example, plantations and mines may be rurally located but in the capitalist sector), they are close enough to be used interchangeably.

Endogenous growth theoryNow read:


Revisited, pp.50–55.Ray, D. Development Economics, Chapter 4.Thirlwall, A.P. Growth and Development with Special Reference to Developing


Further readingGhatak, S. Introduction to Development Economics, pp.71–75.Nafziger, E.W. Economic Development, pp.155–57.Jones, C. I. Introduction to Economic Growth, Chapter 8.

Since the early 1980s, there has been a disenchantment with the neoclassical theory’s inability to explain long-term growth. Many LDCs experienced little or no growth despite the free market reforms imposed on them by the International Monetary Fund (IMF) and the World Bank. Furthermore, the size of the residual is typically quite large in those growth accounting studies which assume constant returns to scale. In the late 1980s, the concept of endogenous growth, or the new growth theory, was introduced.

Endogenous growth models attempt to explain a greater proportion of observed growth as well as why different countries experience different growth rates. They generally use the neoclassical model but allow the production function to exhibit increasing returns to scale, focus on externalities and assume that technological change, although important, is not necessary to explain long-run growth. One version of this model, presented in Ghatak, intoduces the role of human capital. Although this new approach is obviously significant it falls into some of the traps of its neoclassical counterpart.17 Just how significant it is remains to be seen. The subject requires both further theoretical developments and many more empirical studies.

Because of a lack of textbook coverage it is useful to examine at least one form of these models. The models are similar in nature. Romer, for example, argues that production of physical capital leads to technical progress because of the accumulation of experience through learning by doing.

In his 1986 paper Romer ignores physical capital and only considers ‘knowledge’ but a general form of his model can be written as:

Y = A(R) F (Rj, Kj, Lj)

where Rj, Kj and Lj are, respectively, stock results from research and development expenditure by firm j, physical capital of firm j and labour of

17 See Todaro and Smith, pp.144–45

Old ed

ition.

For ref

erenc

e only

.


26

firm j; R is the aggregate stock of knowledge. Any private research effort will have a spillover effect for the public stock of knowledge A(R). This type of model can explain why countries experience different growth rates. A country with an initial higher level of K experiences a higher rate of growth of K leading to a higher rate of growth of per capita income because such a country is more ‘experienced’ through ‘learning by doing’. This is an external effect that prevents diminishing returns.

Another popular model is that of Lucas (1988) which although similar to that of Romer includes human capital which is taken as the general level of skill embodied in workers in the form of formal education or on-the-job training. Lucas assumes that each worker allocates u fraction of his time to producing goods and 1-u fraction to producing human capital and he writes the production function in per capita form as:

y = K (uh)1– ha

or in growth rate terms as:

where:

= growth of per capita income

= growth of physical capital

= rate of growth of human capital

= rate of growth of average human capital

and b, 1-b and are the shares of each factor in output. In the steady state,

so

Thus in the steady state the rate of growth of per capita income is:

KK

•yy

•= β +(1 β)( + ) + γ( )u

u

•hu

•hu

•a

a

yy

•

KK

•

h•

h

a

h•

a

u

yy

•KK

uu

•h

a= h and h

•

h= δ(1 u)=0,

•= ,

h•

a

ha

=h•

h= δ(1 u)

=1 - β + γy

y• [ 1 - α

[

(1 u )δ

Old ed

ition.

For ref

erenc

e only

.


27

Hence the fraction of time spent on production of human capital directly affects the increase in human capital production (h) and indirectly affects the increase in average human capital production (ha). The rate of growth of per capita income in all countries can be specified as:

but if a country has a higher initial level of human capital, per capita income will always be higher. Assume two countries, one rich (subscriptR)

with higher level of human capital and another poor (subscriptR) with lower level of human capital, then

and

if

Underdevelopment as coordination failureNow read:

Essential readingMurphy, K.M., A. Scheifer and R. Vishny, ‘Income Distribution, Market Size and

Industrialization’, Quarterly Journal of Economics, 104(3) 1989, pp.537–64.Todaro, M.P. and S.C. Smith, Economic Development, pp.145–73.

Further readingNafziger, E.W. Economic Development. pp.132–38.

There are a number of models of coordination failure. Kremer proposes the O-Ring Theory, based on the space shuttle Challenger, which exploded. The argument is that Challenger has thousands of parts, which worked, but exploded because one part, the O-Rings, malfunctioned. Kremer argues that the production process consists of many tasks, all of which must function for the product to have a full value. Kremer proposes that this model can explain why rich countries specialise in complicated products such as aircraft and poorer countries specialise in simpler production, such as tea. For a description of the O-Ring model see Nafziger (pp.137–38) and Todaro and Smith (pp.166–71).

Another version of coordination failure is when agents’ inability to coordinate their behaviour leads to an outcome that leaves all agents worse off. This model is presented in Todaro and Smith (pp.144–53).

The big push theory can be viewed as another coordination failure. A simple version of this model is presented in Todaro and Smith (pp.153–62). The full model can be found in Murphy, K.M., A. Scheifer and R. Vishny (see ‘Essential reading’ above). This model is based on Rosenstein -Rodan’s original ideas. For simplicity assume there are no exports. If a firm industrialises who will buy the goods produced by that firm since in the subsistance sector nobody has enough income to buy this good? Obviously some of output is sold to its own workers, but workers do not spend all their income on one good and wish to spend some of their budget on other goods. This implies that the profitability of the first industrialising factory depend on whether other factories open, which in turn depend on its own profitability, which depends on other factories’ profitability. This circular

=1 - β + γy

y• [ 1 - α

[

(1 u )δE

KP=y β(uh)

P

1−βh γ

aP

KR=y β(uh)

R

1−βh γ

aR

h >hR P

y>yR Ph >haR aPand then

Old ed

ition.

For ref

erenc

e only

.


28

causation is the typical coordination problem. Furthermore to industrialise we require trained workers – but who pays for training costs when as soon as the workers are trained they might get poached by other potential entrants? The implication is obvious: no firm wants to be the first to industrialise. Todaro and Smith discuss the implications of this model and why a super-entrepreneur cannot solve the problem.


• explain the Harrod –Domar model, its applications and limitations

• describe neoclassical growth theory

• define growth accounting and list the sources of growth

• describe the Lewis model and its criticisms

• explain endogenous growth theory and other contemporary models of growth and development

• explain the meaning of coordination failure and how it might cause underdevelopment

Sample examination questions1. Outline the Harrod –Domar model. Discuss the possible uses and

limitations of the model for developing countries.

2. Outline the neoclassical model of economic growth and discuss the differences in sources of growth between developed and developing countries.

3. Present a two-sector model of economic development. How have such models improved our understanding of the development process?

Old ed

ition.

For ref

erenc

e only

.

Chapter 4: Domestic resources and inflation

29


Aims of the chapterFinancing development requires resources. These resources can be accumulated or acquired from abroad. This chapter addresses the role of finance in economic development and how domestic resources can be generated to finance developmental activities. As we learned in the previous chapter, domestic savings are one of the most important factors affecting capital accumulation. However, equally important are the existence and efficiency of capital markets and financial intermediation, the country’s financial policy, taxation and tax policy and finally inflation and its impact.


• explain the role of finance in development

• list the sources of savings in developing countries

• describe the role and nature of financial intermediation

• describe the role, instruments and limitations of monetary policy

• discuss the following aspects of taxation: tax ratio and tax capacity; the structure of taxation; tax criteria applied to major types of tax; tax reform

• discuss the following aspects of inflation: the role of inflation in mobilising financial resources; the causes and effects of inflation; policies designed to reduce inflation.

Essential readingThirlwall, A.P. Growth and Development with Special Reference to Developing

Economies, Chapter 14.Todaro, M.P. and S.C. Smith, Economic Development, Chapter 16.

Further readingFry, J.M. Money, Interest, and Banking in Economic Development, Chapters 5 and 8.Ghatak, S. Introduction to Development Economics, Chapter 5.Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

Selection V.Nafziger, E.W. Economic Development, Chapter 14.Siggel, E. Development Economics: A Policy Analysis Approach, Chapter 3.Van Den Berg, H. Economic Growth and Development, Chapter 8.

IntroductionIn all the models of economic growth discussed in Chapter 3, capital accumulation – net investment – plays a major role. Compared to the developed countries, growth in the quantity of employed resources is a relatively more important source of growth in developing economies than increases in factor productivity.

Old ed

ition.

For ref

erenc

e only

.


30

Investment can be financed from domestic and foreign sources and the central theme, but certainly not the only theme, of this chapter and Chapter 5 is the mobilisation of financial resources. The current chapter commences by reviewing the role of domestic savings and finance. Essentially there are three ways in which domestic finance can be mobilised. The first is through the private capital market and, in ‘Private capital markets, financial intermediation and financial policy’, below, the characteristics of this market and financial intermediation are outlined and the scope for financial policy in raising private savings is discussed. The second method is by taxation and, in ‘Taxation’, p.33, we present a number of tax issues. The recommended textbooks pay little attention to government expenditure and so you are not expected to know this side of the government budget. However, in Chapter 6, you will be informed of the factors which the government should take into account in making expenditure decisions, especially those relating to investment. Finally, although inflation may be a source of public finance, the main focus in the section on ‘Inflation’, p.34, is on other aspects of inflation in developing countries.

Domestic saving and the role of financial capitalNow read:



Further readingFry, J.M. Money, Interest, and Banking in Economic Development, Selections 5.3

and 8.2.Van Den Berg, H. Economic Growth and Development, pp.274–90.

Most models of economic growth, the exception being endogenous growth theories, and empirical studies of sources of growth (growth ‘accounting’) in both developed and developing countries indicate that net investment is a necessary, if not sufficient, condition for increasing output. How much investment is required to achieve a particular growth of output? As shown in the Harrod –Domar growth model in Chapter 3, a simplistic approach to this question can be provided by rearranging the Harrod –Domar growth equation to yield an expression for the saving or investment to GDP ratio which is required for a particular output growth rate (per cent per annum) on the assumption of a known economy-wide ICOR.

Manipulation of the national income identity yields the following expression: I = S + F where I is domestic investment, S is domestic saving and F is foreign saving or capital import. The above equation (strictly speaking an identity when the economy is in equilibrium) states that domestic investment can be financed from domestic saving and/or foreign saving.

Whereas the focus of Chapter 5 is foreign saving, the remainder of this chapter is concerned with domestic financial saving, of which there are three main sources.

In accounting terms, these sources are:

a. the household sector including unincorporated businesses

b. the corporate business sector

c. the government sector including the net saving of state-owned enterprises.

Old ed

ition.

For ref

erenc

e only

.


31

Private sources comprise (a) and (b). Notwithstanding the lack of accurate data on household saving (it usually being estimated as a residual from income and expenditure data), there is evidence that in many developing countries, households are the largest single source of saving. The government sector is usually, in conventional accounting terms, a net disssaver although the extent of dis-saving would be lower if certain expenditures (for example, under health and education headings) were reclassified from the current to the capital side of the budget.

Van Den Berg presents a formal two period (inter-temporal) model of savings behaviour and analyses its relevance and its relationship with the Life Cycle model.1

Private capital markets, financial intermediation and financial policy

Now read:


Revisited, Chapter 13Ray, D. Development Economics, Chapter 14.Thirlwall, A.P. Growth and Development with Special Reference to Developing


Further readingBhaduri, A. ‘On the Formation on Usurious Interest Rates in Backward

Agriculture’, Cambridge Journal of Economics, 1, 1977, pp.341–52.Fry, J.M. Money, Interest, and Banking in Economic Development, Chapters 1–3, 5–6.Ghatak, S. Introduction to Development Economics, Chapter 5.Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

Selection V.2.Van Den Berg, H. Economic Growth and Development, Chapter 8.

The financial sector is regarded as playing a crucial role in economic development.2 However, there are different dimensions of this sector that you need to know about. First, you should understand that the major role of the private capital market is financial intermediation: a mechanism for transferring command over resources from those economic agents (typically individuals and some enterprises) who have an excess of current income over planned expenditure to those whose planned expenditure is in excess of their current income. In ‘dualistic’ economies there exists an unregulated, informal or ‘curb’ (= kerb in standard English) credit/money market alongside the formal or modern financial institutions. This dualism has implications for financial policy3 and for rural development policy. A straightforward implication is that the interest rate in the informal sector tends to be higher that that in the formal sector. There are two general theories that candidates should know, and these are are best represented in Basu and in Ray’s books. The first is the Lender’s Risk Hypothesis,4 which proposes that the lender needs to earn a given return and has to charge a higher interest to recoup the defaulted part of the loans. Basu presents the model that assumes the default probability is independent of the amount to be repaid. Ray relaxes this assumption and presents the model where the default probability is not independent and then goes on to look at the effect of credit rationing. The second approach proposes that high interest rates are the result of monopoly power of the lender, however defined.5

1 See Van Den Berg, pp.279–84.

2 See the paper by Levine printed in section V.2 in Meier and Rauch.

3 See later in this chapter.

4 See Basu, pp.267–69 and Ray, pp.543–53.

5 Basu, pp.269–74 and Bhaduri (see reference p.31).

Old ed

ition.

For ref

erenc

e only

.


32

Financial intermediation can only flourish if the economy is highly monetised (the monetisation ratio being the proportion of total output which is purchased with money) and if there are financial institutions which offer potential savers a range of financial assets on which a positive return (capital gains or interest or dividends) is expected. The financial ratio (the ratio of net financial assets to GDP or GNP) provides an indication of the extent of financial intermediation or financial depth6 in an economy.

You are expected to understand the intermediation process and the basic roles of financial institutions, but you are not expected to know the details of the nature of operations of particular types of institutions which vary between countries.

While there is some debate on the demand-following and supply-leading role of the financial sector, the mobilisation and allocation of finance is likely to be hindered if the financial sector is repressed.

You should know:

1. what is meant by

2. the features of and

3. the effects of

a. shallow finance and financial repression, and

b. deep finance and financial liberalisation

especially in the context of the loanable funds market.7 Thus you should understand why financial liberalisation, involving moves to positive real interest rates by means of reducing inflationary expectations8 and/or decontrolling nominal interest rates, is expected to raise levels of saving and actual, as opposed to planned, investment.

However, there are some weaknesses in this approach:

• mixed evidence on the assumed positive relationship between real interest rates and total rather than financial saving9

• the implicit assumption that the supply of (bank) credit is only dependent upon the volume of (bank) deposits.10

In this section, you should also know of the differences between developed and developing countries in terms of the role and effectiveness of financial policy. Monetary policy for example can be seen as a part of a wider financial policy. In developing countries the monetary authorities have a wider role but the instruments of monetary policy are likely to be less effective because the financial system, through which they work, is not so well-developed. As part of studying this area, you will be expected to understand the role and nature of the informal credit market. You should also appreciate why the limited role of open market operations (because of the characteristics of the securities market) has implications for control of the foreign component of the domestic money supply under a fixed exchange rate regime.

6 See later in this chapter.

7 For a diagramatic presentation and analysis see Todaro and Smith, pp.754–56; Fry; Van Den Berg, pp.305–07; and Thirlwall’s presentation of the McKinnon–Shaw arguments, pp.424–30.

8 See also ‘Infl ation’ later in this chapter.

9 See Thirlwall, pp.414.

10 See Thirlwall, pp.426–30.

Old ed

ition.

For ref

erenc

e only

.


33

TaxationNow read:


Economies, pp.431–37.Todaro, M.P. and S.C. Smith, Economic Development, pp.760–65.

Further readingGhatak, S. Introduction to Development Economics, pp.134–44.Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

Selection V.

Taxation is the principal means used by governments to finance their expenditure. Public enterprises rarely make a profit and borrowing from the domestic non-bank sector is handicapped by the narrow securities market.11 Nevertheless, the tax ratio (the ratio of total tax revenue to GDP or GNP) is typically much lower in developing than in developed countries.

This is the first feature of taxation you should know. Many economists consider that developing countries’ tax ratios are below their taxable capacity or taxation potential but, when judged against various tax criteria, raising the tax ratio may not be desirable. You should understand these concepts and issues.

You should also know the approximate percentage shares of total tax revenue accounted for by various broad categories of tax. These are:

• direct (personal income, corporate income, wealth and property) and

• indirect (international trade – imports and exports; domestic commodity taxes – sales and excise) as shown in tables in most books.

Although the main theme of this chapter is the mobilisation of domestic resources, taxes are levied for various purposes12 and have a variety of effects. The remainder of this paragraph presents your main task in the area of taxation. You should be able to analyse each of the main types of taxes listed above with respect to the following four tax criteria or principles:

1. revenue raising

2. efficiency and resource allocation effects

3. equity considerations

4. administrative considerations.

You will need to be familiar with the following concepts:

• ability to pay

• progressive/regressive taxes

• incidence of taxation

• incentive effects (with respect to work effort and saving)

• excess burden of taxation

• tax evasion

• tax avoidance

• capital flight

• costs of collection.

11 See the previous section: ‘Private capital markets, fi nancial intermediation and fi nancial policy

12 See Ghatak, p.128, for fi scal policy objectives.

Old ed

ition.

For ref

erenc

e only

.


34

For this area there is no real substitute for Gillis, although Ghatak presents useful discussions of land taxes and indirect taxes (especially value-added tax). In your reading for this topic, you will meet concepts which are highly relevant to other parts of the course – examples include:

• fiscal incentives designed to attract private foreign direct investment

• transfer pricing13 by multinational companies14

• import taxes and import substitution.15

You should be able to propose changes designed to increase the total revenue of the tax system. These might include:

• raising tax rates

• new taxes (that is, designating new tax bases)

• improvements in tax administration

• major reform of the system involving all the above elements.

You should be able to discuss the scope and limitations of these methods, using your knowledge of the tax system in developing countries and of the taxation principles referred to in the preceding paragraph.

InflationNow read:

Essential readingBasu, Analytical Development Economics: The Less Developed Economy Revisited,

Chapter 4.Thirlwall, A.P. Growth and Development with Special Reference to Developing


Further readingGhatak, S. Introduction to Development Economics, pp.122–28.Nafziger, E.W. Economic Development, pp.478–89.Siggel, E. Development Economics: A Policy Analysis Approach, pp.209–16.

Given the main theme of this chapter it would be appropriate first to explain how inflation can mobilise domestic resources (the inflation tax), a small task but one which students often find difficult. Inflation, being a persistent rise in the price level, continuously erodes the real value of nominal money holdings. Therefore, in the presence of inflation, if the private sector wishes to hold a particular real value or quantity of money balances, it must hold more nominal money balances. Holding more nominal money balances at any given level of income means that real expenditure must be reduced. It is the reduction in expenditure (consumption or investment) by holders of nominal money balances which is equivalent to a tax: inflation is a tax on nominal money holdings. The higher the rate of inflation, the greater the reduction in expenditure for any given desired real money balances. As the government is the issuer of currency it gains the revenue from the inflation tax which it can then spend.16 If the government uses the revenue to finance a programme, the overall net investment increase in investment (public + private) will be less than the increase in public investment if some of the reduced private planned expenditure, induced by inflation was invested.17

13 See Todaro and Smith, p.713.

14 See Chapter 5 of this guide.


16 See Ghatak, pp.123–26; Thirlwall, pp.444–45, for formal models.

17 See Ghatak, p.126.

Old ed

ition.

For ref

erenc

e only

.


35

The government is not the only beneficiary from inflation. In the case of demand-induced inflation, output prices rise faster, at least initially, than input prices. Therefore there will be a redistribution of income from wage earners to firms. If the marginal propensity to save out of business income is greater than out of wages, total saving will rise, enabling greater capital formation.

By following the analysis outlined so far, you will have been introduced to the potential benefits and costs of inflation in the context of economic development. The effects of inflation are spelt out by Ghatak, Nafziger and Thirlwall. For developing countries the overall effect of inflation has typically been studied by investigating the relationship between inflation and economic growth. The evidence on this relationship is mixed – a result which is not surprising given the various impacts of inflation.

Understanding inflationary finance and the effects of inflation are your first and second tasks. The third is to understand the causes of inflation; this would usefully be preceded by obtaining an awareness of inflation rates in developed and developing countries. All the books present tables of relevant data.18 Not all developing countries experience inflation higher than the developed countries as a group but Latin America does have a significantly higher rate than other regions. Not surprisingly, therefore, much of the theoretical and empirical debate on the causes of inflation in developing countries has centred on that continent.

The relatively simple macroeconomic aggregate demand–aggregate supply model points to two clear primary causes of inflation – demand-induced and supply (or cost)-induced. Even Nafziger’s extensive list of causes19 fits such a classification. Thus the structuralist side of the ‘monetarist–structuralist’ debate can be viewed in terms of the inadequacy of supply (of exportables and hence of foreign exchange, and food) in the context of increasing demand in individual markets or in the economy as a whole. Note, however, that the structuralists would regard some inflation as the inevitable concomitant of economic growth. Basu presents a simple structuralist model of inflation.

On the demand side, growth of the money supply is regarded as the main cause. On account of the difficulty of raising tax revenue and of borrowing from the non-bank private sector, governments are tempted to finance expenditure by borrowing from the banking sector or from abroad: such borrowing increases the money supply. Indeed, any net receipt of foreign exchange, from whatever source, will increase the domestic money supply. (Note that the scope for offsetting open market sales of government securities – sterilisation – is limited.20) However, you must know that not all increases in the domestic money supply contribute to an increase in aggregate demand and hence to inflation. But equally you must realise that an increase in the money supply is a necessary condition for inflation to be maintained, irrespective of its causes.

Finally, on the basis of your knowledge of the causes of inflation in developing countries, you should be able to discuss policies designed to reduce inflation. Such policies are invariably a feature of the International Monetary Fund’s stabilisation programs.21

18 In Ghatak consult Chapter 1, Table 1.1. In Thirlwall see Table 14.5 p.451.

19 See Nafziger, pp.480–85.

20 See ‘Private capital markets, fi nancial intermediation and fi nancial policy’ earlier in this chapter.

21 See Siggel, pp.209–16; Nafziger, Chapter 19.

Old ed

ition.

For ref

erenc

e only

.


36


• explain the role of finance in development

• list the sources of savings in developing countries

• describe the role and nature of financial intermediation

• describe the role, instruments and limitations of monetary policy

• discuss the following aspects of taxation: tax ratio and tax capacity; the structure of taxation; tax criteria applied to major types of tax; tax reform

• discuss the following aspects of inflation: the role of inflation in mobilising financial resources; the causes and effects of inflation; policies designed to reduce inflation.

Sample examination questions1. Explain and discuss the role of financial intermediation in the saving–

investment process. Why might attempts to increase investment by lowering the cost of credit be unsuccessful?

2. Why are the tasks of the monetary authorities in developing countries considered to be more difficult than those of their counterparts in developed countries? What factors influence the effectiveness of monetary policy in developing countries?

3. ‘In many developing countries, the tax system is neither efficient nor equitable.’ Elaborate and explain.

Old ed

ition.

For ref

erenc

e only

.

Chapter 5: Foreign Resources

37

Chapter 5: Foreign resources

Aims of the chapterThis chapter looks at financing development through foreign resources. In other words it looks at different sources of foreign inflow of capital (e.g. foreign direct investment (FDI) or foreign aid), their determinants, and their impact on LDCs. We also look at accumulation of deficit financing from abroad, generally leading to external debt.


• list the main types of capital inflow

• describe and explain the two-gap model and its use and limitations

• explain donor and recipient motives for aid

• explain and discuss the possible effects of aid on economic development

• propose donor and recipient policies to improve the quality of aid

• describe international lending and the concept of debt

• explain the origins of LDCs’ indebtedness and their recent debt experience

• describe measures by debtors and creditors to reduce international debt and debt

• discuss servicing problems and the effects of such measures on debtors

• state the characteristics of MNCs and their role in international production and trade

• explain the potential effects on LDCs of direct foreign investment

• propose host government policies to increase the net social benefits of inward direct foreign investment.


Revisited, Chapter 6.Thirlwall, A.P. Growth and Development with Special Reference to Developing

Economies, Chapter 15.Todaro, M.P. and S.C. Smith, Economic Development, Chapters 14 and 15.

Further readingGhatak, S. Introduction to Development Economics, Chapters 6 and 13.Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

Selection III.B.2.Nafziger, E.W. Economic Development, Chapter 15.Siggel, E. Development Economics: A Policy Analysis Approach, Chapter 8.

Old ed

ition.

For ref

erenc

e only

.


38

IntroductionThe topics discussed in this chapter are among the most controversial in development economics and it is tempting to allow emotions and anecdotes to overrule sound economic analysis. For example, large multinational corporations (MNCs) are seen as wielding extensive economic power and it is easy to jump to the conclusion that, when they operate in a small developing country, they cannot be enhancing its development. With respect to foreign aid, any observer of development can point to cases of the failure or inappropriateness of a foreign aid-financed project. Furthermore, although this course is named Economics of development, you should realise that governments – whether they be donors or recipients (actual or potential) – do have to take non-economic factors into account in making decisions. We, however, devote our attention to the economics of foreign aid, private direct investment and external debt.

Foreign capital requirements and types of capital inflowNow read:


Revisited, pp.88–93.Thirlwall, A.P. Growth and Development with Special Reference to Developing


Further readingGhatak, S. Introduction to Development Economics, pp.145–50.Nafziger, E.W. Economic Development, pp.504–08.Siggel, E. Development Economics: A Policy Analysis Approach, pp.93–102.

One way of estimating a country’s foreign capital requirements is the use of two-gap or dual-gap analysis. The essentials of this approach are as follows. Recall the identity I = S + F (in Chapter 4) which shows that domestic investment can be financed by either domestic saving or foreign saving. A similar manipulation of the national income identity yields the expression I – S = M – X. This accounting identity, which holds when the economy is in equilibrium, can be variously interpreted: for example, a country which invests more than its domestic saving can only do so by having a trade deficit, or an excess of imports over exports means that the country is investing more than it is saving. This identity necessarily holds ex post but it need not do so ex ante. There is no reason why the excess of planned investment (required to achieve a target output growth rate) over expected saving, the ‘saving gap’ (Ip > Se) (subscript p stands for planned and e stands for expected) should equal the excess of planned imports (those required to achieve the target output growth rate) over expected exports, the ‘trade gap’ or the ‘foreign exchange gap’ (Mp > Xe).

You should understand the implications of each gap being larger than the other – that is whether growth is saving-constrained or foreign exchange-constrained. You should appreciate the fact that, in the case of a saving constraint, capital imports will only fall if the marginal propensity to save exceeds the desired investment rate and that, in the case of a foreign exchange constraint, capital imports will only fall if exports grow faster than output. These conclusions are pertinent to the discussion of external debt later in this chapter. You should also realise that the resources gap

Old ed

ition.

For ref

erenc

e only

.


39

(the difference between gross domestic investment and gross domestic saving, usually expressed as percentages of GDP) is not negative for all developing countries. Those of you with access to a recent issue of the World Development Report or Ghatak will find statistics on the resource balance (the difference between exports and imports): this, too, is not negative for all developing countries. The resource balance–gross domestic investment ratio measures the proportion of domestic investment which is financed from abroad.

You should be aware of the various types of capital inflow which can be used to finance a current account deficit. Apart from Todaro and Smith (who present hypothetical values), all the books present tables of actual flows. The terminology concerning resource flows and resource transfers (and the difference between gross and net flows) can be confusing especially when consulting different textbooks or official publications. The following definitions of resource flow aggregates should be useful:

• net disbursements (or net resource flow) = gross disbursement – amortisation

• net transfer = net resource flow – (interest payments and profits on private investment remitted + profits on private investment reinvested).

It is the net transfer which therefore represents the transfer of real resources. You should also know the flows can be classified as follows:

• public: official development assistance/foreign aid: bilateral; multilateral

• private: direct investment; bank lending; export credits.

You are not expected to know the size of these flows but should appreciate that, in a typical year, official development assistance is the largest single flow, followed by private direct investment, and that these two account for 55 to 70 per cent of the total flow.

Foreign aidNow read:


Revisited, pp.93–98.Thirlwall, A.P. Growth and Development with Special Reference to Developing


Further readingGhatak, S. Introduction to Development Economics, Chapter 6, pp.146–58 and

pp.180–84.Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

pp.315–19.Nafziger, E.W. Economic Development, pp.508–22.Siggel, E. Development Economics: A Policy Analysis Approach, pp.102–05.

You are not expected to know vast quantities of statistics on foreign aid. Rather your task is:

• to understand the motives for giving and receiving aid

• to understand the main elements in the controversy concerning the effects of aid on economic growth, especially in the context of the two-

Old ed

ition.

For ref

erenc

e only

.


40

gap model, and on other dimensions of development, in particular the effect of aid on domestic savings and on the growth rate of output.

• to be able to comment on ways in which both donors and recipients could improve the qualitative effectiveness (not the quantity) of aid.

You should face no major conceptual problems in these areas apart from understanding the likely effects of aid when one or other of the two ‘gaps’ is binding. If the foreign exchange gap is binding the country has underused domestic resources (labour, for example) and all available foreign exchange is used for imports. Foreign capital is likely to have beneficial effects on growth because additional foreign exchange can be used to purchase imported inputs (for example, capital goods) which would be combined with the surplus domestic resources: that is, additional foreign resources result in the employment of previously unused domestic resources. An increase in domestic saving alone would not increase capital formation. On the other hand, if the saving constraint is binding, the country is not using all its available foreign exchange and there is no surplus of domestic resources which could be used to complement additional foreign resources. Increased imports of aid-financed imports of capital goods, for example, would result in the reallocation of domestic resources and not an increase in their availablity. The expected output gain from additional foreign resources would be small with the strong possibility that the foreign resources would be used to finance increased consumption.

External debtNow read:


Revisited, Chapter 6.Thirlwall, A.P. Growth and Development with Special Reference to Developing




One of the features of foreign aid is that it is not all in the form of outright grants; there are loans which have to be repaid and interest charges which have to be paid. Developing countries have borrowed at commercial terms from private foreign financial institutions and the foreign shareholders of MNCs with operations in developing countries expect a return on their investment. The repayment of capital and the payment of interest, profits and dividends has to be in a currency acceptable to the creditor: almost invariably this is not the debtor’s own currency – it is either the domestic currency of the creditor or the US dollar. Thus, typically, developing countries have a stock of external debt and are having to service that debt, debt service being a prior claim on the countries’ foreign currency earnings or reserves. Debt statistics can be confusing and you should at least appreciate that total debt is essentially the sum of public (or sovereign), publicly-guaranteed (payments

Old ed

ition.

For ref

erenc

e only

.


41

are ultimately the responsibility of developing countries’ governments), private non-guaranteed, and short-term debt.

There are five main issues concerning external debt which you are expected to cover:

1. The causes of developing countries’ debt and their debt experience since the early 1970s. Todaro and Smith provides the relevant formal theory of the determinants of the basic transfer the net foreign exchange inflow/outflow associated with international borrowing.

2. How, in theory, can a country reduce or eliminate its debt? Thirlwall use the two-gap model in a formal way to explore this issue whereas Ghatak does so less formally.

You need to understand the conditions that allow reduction or elimination of debt. Essentially, the two gaps must be closed with the excess of saving over investment being converted into foreign exchange (sometimes referred to as the external transfer problem) which, in the case of public debt, must be available to the government. Note that debt is an economy-wide phenomenon in the sense that it is the economy as a whole which must be able to generate sufficient foreign exchange for debt servicing; it is not necessary for a specific loan financed-project to yield a foreign exchange surplus.

3. Knowledge, not detailed, of the plans and schemes which have been proposed and/or implemented to tackle debt problems. These problems and macroeconomic conditions and prospects vary between debtor countries. Therefore the optimum solution to a particular country’s debt problems should be unique to that country. However, you will not be expected to address this topic at such a disaggregated level. One way of classifying these plans and schemes is as follows:

i. IMF and World Bank programmes directed, wholly or in part, to improving debtors’ budgetary positions and trade balances, thereby raising their debt servicing capabilities

ii. reduction of debt or reduction of debt service through i. debt foregiveness (writing off debt) or rescheduling of the principalor ii. debt conversion or exchange of claims.

You should know:

• the main elements of IMF and World Bank stabilisation and structural adjustment programmes and

• the essential features and effects of the Baker and Brady plans and of debt alleviation techniques such as swaps (e.g. debt–equity swaps).

4. Reasons why it may be in the interests of creditors to forgive or reschedule debt. The idea here is the Debt Laffer curve. Ghatak and Basu formally analyse this.1

5. Some of the effects within debtor countries of conforming to the conditions of international agencies’ stabilisation and structural adjustment programs.

1 See Basu, pp.138–42; Ghatak, pp.443–49.Old

editio

n. For

refere

nce o

nly.


42

Foreign direct investment and multinational corporations

Now read:



Further readingGhatak, S. Introduction to Development Economics. 158–73.Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,


Multinational corporations (MNCs) or transnational corporations (TNCs) are highly significant actors in global production and trade and the possible impact of their operations on the economic development process is critical. By their very nature, many aspects of MNC operations impinge on development but, for present purposes, we are only concerned with the effects of MNCs’ direct investment – foreign direct investment (FDI), the establishment of subsidiaries – on economic development. Each act of FDI (and the subsequent operation of the subsidiary) is unique in terms of a multitude of dimensions of which the type of product, technology employed, size and location are only some. Not surprisingly, the effects of such investment vary from case to case and empirical studies on specific and overall effects have not yielded universally-accepted conclusions. Ideally, host governments would assess each potential act of FDI using social cost – benefit analysis.2

However, you should be able to:

• list the main characteristics of MNCs

• describe the main issues in the debate on their role in development – that is, you should be able to identify and discuss the potential benefits and costs of FDI

• use this knowledge to address the question of how a host government might be able to maximise the net social benefits of FDI.3

In connection with the third point above, you will appreciate that host governments have to strike a balance between those policies which might increase the net benefits and those which might discourage net FDI. Apart from a brief treatment in Thirlwall, these issues are covered in all the textbooks with Colman and Nixson providing the best overall treatment. In studying this topic you should clearly identify and concentrate on those effects of FDI arising from the foreign-ness and the other specific characteristics of MNCs which result or may result in MNCs’ behaviour being different from that of indigenous enterprises. To illustrate, indigenous firms, when faced with distorted factor prices, will also tend to use production techniques which are considered to be too capital-intensive; if the distribution of income is highly unequal, indigenous firms, too, may well tend to produce products which are considered ‘inappropriate’. Thus, in connection with task 3 above, you should realise that some of the most appropriate policies are not necessarily MNC-specific: for example, removing factor price distortions will enhance employment creation.4

2 See Chapter 6: ‘Project appraisal’ in this subject guide.

3 See Ghatak (1995) pp.171–73.

4 See Chapter 6 of this subject guide.

Old ed

ition.

For ref

erenc

e only

.


43


• list the main types of capital inflow

• describe and explain the two-gap model and its use and limitations

• explain donor and recipient motives for aid

• explain and discuss the possible effects of aid on economic development

• propose donor and recipient policies to improve the quality of aid

• describe international lending and the concept of debt

• explain the origins of LDCs’ indebtedness and their recent debt experience

• describe measures by debtors and creditors to reduce international debt and debt

• discuss servicing problems and the effects of such measures on debtors

• state the characteristics of MNCs and their role in international production and trade

• explain the potential effects on LDCs of direct foreign investment

• propose host government policies to increase the net social benefits of inward direct foreign investment.

Sample examination questions1. What is the potential role of foreign aid in the development process?

Why is it unlikely that foreign aid given for investment will be used exclusively for that purpose?

2. What have been the main causes of developing countries’ external debt? Comment briefly on either international measures or policies which debtors could adopt to reduce the debt burden.

3. Discuss the potential costs and benefits to a host country of private direct investment. Why might host government policies designed to increase the net social benefits of such investment result in a fall in inward investment?

Old ed

ition.

For ref

erenc

e only

.

Notes


44

Old ed

ition.

For ref

erenc

e only

.

Chapter 6: The state, planning and resource allocation

45


Aims of the chapterThis chapter looks at the rationale for development planning. The basic premise is that there must be some reason why the market cannot allocate resources efficiently, and hence there is a need for the state to intervene. We will investigate different aggregate planning models and methods of project appraisal.


• discuss the arguments for and against planning in developing countries

• explain the use and limitations of aggregate growth models and input–output models in the planning process

• explain and discuss examples of project appraisal techniques: rationale, methodology and problems

• discuss the Washington Consensus and the New (Santiago) Consensus.

Essential readingGhatak, S. Introduction to Development Economics, Chapter 11.Nafziger, E.W. Economic Development, Chapter 18.Thirlwall, A. P. Growth and Development with Special Reference to Developing

Economies, pp.297–99. Todaro, M.P. and S.C. Smith, Economic Development, Chapter 11.

IntroductionChapters 4 and 5 of this guide looked at the role and importance of domestic and foreign resources in the process of development. The role of the government in the distribution of those resources has, however, been hotly debated. While few doubt that a certain degree of government involvement (e.g. providing the legal framework for markets to work, setting standards, regulating some sectors such as banking, etc.) is necessary, there are many who advocate that markets should be allowed to operate with minimal government intervention. In practice, however, many LDC governments have taken a very active role in planning.

Planning can be described as the deliberate and coordinated attempt by the government to alter the outcome resulting from unimpeded market mechanisms. These actions could be included in anti-poverty programmes, family planning, investment projects, education or health programmes, or fiscal and monetary policy. The list of possible programmes shows clearly that planning is neither the same as socialism, although socialist countries used planning extensively, nor is it only used in developing countries. The major questions in this subject area which you must consider are:

a. why do we need to plan?

b. how do we plan?

Old ed

ition.

For ref

erenc

e only

.


46

The need for planningNow read:



Further readingGhatak, S. Introduction to Development Economics, pp.363–64.Nafziger, E.W. Economic Development, pp.655–58.

The major reason for planning is market failure. This occurs where markets do not exist (e.g. in the provision of public goods) or where markets exist but result in an incorrect allocation of resources (e.g. externalities) or where they do not function properly (e.g. market imperfection) or where they yield results which may be efficient as far as resource allocation is concerned but do not satisfy other objectives (e.g. regarding income distribution).

These arguments are covered by all the authors mentioned in this section. You must clearly understand why different types of market failure require government intervention. Another important point is that market failure exists in all economies. Why, then, is it argued that LDCs need more government intervention? Here opinion is divided between the dirigistes

who believe that standard economic theory does not apply to LDCs, and those who believe that LDCs suffer from a greater degree of market failure and hence recommend more government intervention. Nafziger gives examples of different type of planning and further readings for this debate.1

Nafziger discusses different types of planning horizon (short-term, medium-term, medium-term rolling and long-term);2 Thirlwall discusses different development strategies and considers:

• the choice between industry and agriculture (p.303)

• the desirability of the comparative cost doctrine (pp.303–04)

• present versus future consumption (pp.304–06)

• choice of techniques (pp.306–07)

• balanced versus unbalanced growth (pp.307–13)

• investment criteria (pp.313–14).

Planning modelsNow read:






Old ed

ition.

For ref

erenc

e only

.


47

Planning, in general, is done at three different levels or stages:

a. aggregate growth models

b. multi-sector input–output models

c. social cost–benefit analysis.

Aggregate growth models deal with the entire economy with the objective of identifying the most important determinants of the level and growth of income. A simple but typical question would be how to manipulate instruments to achieve a particular target rate of growth. Most of these models are some variant of the Harrod –Domar model discussed in Chapter 3.

Ghatak:

• presents a simple Harrod –Domar model (pp.365–66)

• discusses its application in the case of India’s First Five Year Plan (p.367)

• and then extends the analysis to a two-sector Harrod –Domar model in the case of Kenya (p.368).

Ghatak then:

• looks at the Feldman–Mahalanobis sectoral planning model as applied to India’s Second Five Year Plan (pp.368–71)

• covers a complicated macroeconometric model of a type which is becoming very popular (pp.371–74).

You must be aware of the problems and weaknesses of aggregate growth models as well as additional problems arising from their use in forecasting output and growth. You are not required to reproduce complicated models such as that of Feldman–Mahalanobis.

Such models are too aggregated and do not recognise the importance of interaction between different production sectors or industries. The linkages or inter-relationships between different industries are extremely important for planners if they are to formulate a consistent plan. For example, expansion of the industrial sector without proper expansion of agriculture to provide inputs might lead to bottlenecks, particularly when there is a foreign exchange shortage. Input–output models, which capture linkages, are briefly mentioned in Todaro and Smith and are extensively covered by Thirlwall and Ghatak.3

You are not required to know the theory of input–output analysis developed by Leontief. However, you must know how and under what assumptions a typical country’s input–output table is constructed, and the general strengths and weaknesses of using input–output tables for planning purposes.

It is not necessary for you to be able to reproduce the theoretical foundations of these type of models.

Project appraisalNow read:


Economies, Chapter 10. Todaro, M.P. and S.C. Smith, Economic Development, pp.525–29.

3 See Ghatak (1995) pp.374–78 and Thirlwall, Chapter 13.

Old ed

ition.

For ref

erenc

e only

.


48


Project appraisal is the most microeconomic and the most commonly employed tool of planning. It is usually used in addition to macro and sectoral (input–output) models. Project appraisal is based on the theory of social cost–benefit analysis. It involves three initial basic steps:

1. The objective function that is to be maximised must be set.

2. Net social benefit, (i.e. benefits minus costs) must be calculated. This requires:

3. Discounting (or finding present values) and the use of appropriate prices. You must be familiar with the discounting technique and its limitations.4

A major problem in cost–benefit analysis is that, if markets do not exist or if market prices do not reflect the ‘true costs of resources’, then shadow prices must be calculated and used. The reasons behind calculations of shadow or social accounting prices are discussed in Thirlwall, using the shadow wage as an example.5

There are two widely used methods in project appraisal. The first is the United Nations Industrial Development Organisation (UNIDO) approach which uses domestic prices; the second is the Little–Mirlees approach, which uses world prices, conveying the idea that the alternative to a project making a tradable good is to buy the good from abroad. The best reference for this section is Ghatak.6 Thirlwall also discusses the two approaches, how traded and non–traded goods are dealt with, and what determines the appropriate social discount rate. He then introduces the concepts of shadow wage rate and shadow exchange rate7 and gives a numerical example of the application of the two approaches to a case study.

Ghatak discusses:

• the Little–Mirlees approach (pp.389–93)

• criticisms of this approach (pp.393–94)

• the UNIDO approach (pp.394–95)

• and goes onto compare the two approaches (pp.395–97).

You are required to know why shadow prices are used and the factors which should be taken into account in calculating the shadow wage rate and the shadow exchange rate.

Once costs and benefits have been ‘correctly’ estimated and net present value calculated, the fourth step of project appraisal can be performed. This requires choosing a decision criterion to decide whether or not to undertake a particular project or to choose between a number of projects. Cost–benefit analysts usually use either the net present value method or the internal rate of return criterion.

4 Discounting is described in Ghatak, pp.386–87.



7 See Thirlwall, pp.326–35

Old ed

ition.

For ref

erenc

e only

.


49

Planning failure and the Washington ConsensusNow read:

Essential readingTodaro, M.P. and S.C. Smith, Economic Development, pp.529–33

and pp.537–41.

Todaro and Smith give five reasons for plan failure: deficiencies in plans and their implementation; insufficient and unreliable data; unanticipated external or internal economic disturbances; institutional weaknesses, and lack of political will. They then take a look at government failure and problems with government intervention in LDCs. These problems gave strength to the free market supporters. A 10-point agenda, proposed by John Williamson and usually referred to as the Washington Consensus, became popular in 1980s and 1990s. The 10 points are presented by Todaro and Smith.8 Recently, a new consensus has emerged, usually referred to as the New or Santiago Consensus, where the 1998 summit was held. This consensus is described in Todaro and Smith. Its main point of diversion is the reliance on the role of the state in poverty reduction.


• discuss the arguments for and against planning in developing countries

• explain the use and limitations of aggregate growth models and input–output models in the planning process

• explain and discuss examples of project appraisal techniques: rationale, methodology and problems

• discuss the Washington Consensus and the New (Santiago) Consensus.

Sample examination questions1. ‘Since market failure is more prevalent in developing than in developed

countries there is a greater need for planning in less developed countries.’ Discuss.

2. Outline the rationale, methodology and problems of using cost–benefit analysis in developing countries.

3. Why should shadow prices rather than market prices be used in appraising projects in less developed countries?

8 See Todaro and Smith, Table 11.1, p.538.

Old ed

ition.

For ref

erenc

e only

.

Notes


50

Old ed

ition.

For ref

erenc

e only

.

Chapter 7: Population, employment, income distribution and poverty

51


Aims of the chapterThis chapter will cover theories of population growth; consequences of population growth; employment; unemployment and migration; human capital; poverty and inequality; malnutrition and famine; growth; inequality and equity.


• explain the demographic transition and Malthusian theories of population growth, and the micro-theoretic model of fertility

• analyse the possible effects of population growth and the arguments for government intervention to influence fertility

• discuss concepts relating to employment and underutilisation of labour, and policies designed to reduce unemployment

• assess models of rural–urban migration and their limitations especially in the context of the informal sector

• describe the importance in economic development of investment in human capital, education and health

• discuss concepts of income distribution, inequality and poverty, and their measurement

• explain the causes and consequences of malnutrition and famine and their policy implications

• explain the relationship between nutrition and wages

• explain the relationships between economic growth and inequality

• discuss the implications of child labour and whether banning it is desirable.


Revisited, Chapters 7–10.Ray, D. Development Economics, Chapters 6–10.Thirlwall, A.P. Growth and Development with Special Reference to Developing

Economies, Chapter 8 and pp.188–209.Todaro, M.P. and S.C. Smith, Economic Development, Chapters 6–7.

Further readingArabsheibani, G. ‘The Wiles Test Revisited’, Economics Letters, 29(4) 1989,

pp.361–64. Arabsheibani, G.R., F.G. Carneiro and A. Henley, ‘Human Capital and Earnings

Inequality in Brazil 1988–1998: Quantile Regression Evidence’, The World Bank Research Policy Paper 3147 (2003).

Old ed

ition.

For ref

erenc

e only

.


52

Arabsheibani, G.R. and L. Manfor, ‘Non-Linearities in Returns to Education in Libya’, Education Economics, 9(2) 2001, pp.139–44.

Basu, K. ‘Child Labor: Causes, Consequences and Cure, with Remarks on International Labor Standards’, Journal of Economic Literature, 37, 1999, pp.1083–120.

Bliss, C. and N. Stern, ‘Productivity, Wages and Nutrition: Part I: Theory’, Journal of Development Economics, 1978, pp.331–62.

Bliss, C. and N. Stern, ‘Productivity, Wages and Nutrition: Part II: Some Observations’, Journal of Development Economics, 1978, pp.363–98.

Burgess, R. and J. Zhuang, ‘Modernisation and son preference’. Discussion Paper dedps29, (London School of Economics and Political Science, 2000), http://sticerd.lse.ac.uk/dps/de/dedps29.pdf

Devereux, S. Theories of Famines. (New York and London: Harvester Wheatsheaf, 1993) [ISBN 07450141787], Chapter 2

Ghatak, S. Introduction to Development Economics, Chapter 7.Immink, M.D.C. and F.E. Viteri, ‘Energy intake and Productivity of Guatemalan

Sugarcane Cutters: Part I’, Journal of Development Economics, 1981, pp.251–72.

Immink, M.D.C. and F.E. Viteri, ‘Energy Intake and Productivity of Guatemalan Sugarcane Cutters: Part II’, Journal of Development Economics, 1981, pp.272–87.

Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development, Selections IV.A and IV.B.

Nafziger, E.W. Economic Development, Chapters 8–10. Psacharopoulos, G. and M. Woodhall Education for Development: An Analysis of

Investment Choices. (New York: Oxford University Press, 1985) [ISBN 0195204786].

Sen, A. K. Poverty and Famines: An Essay on Entitlement and Deprivation. (Oxford: Clarendon Press, 1981) [ISBN 0198284632].

Stark, O., M.R. Gupta and D. Lehvari, ‘Equilibrium Urban Unemployment in Developing Countries: Is Migration the Culprit?’, Economics Letters, 37, 1991, pp.477–82.

Thomas, J.J. Informal Sector Activity. (Hemel Hempstead: Harvester–Wheatsheaf, 1992) [ISBN 9780472104208].

IntroductionIn 2000 the world population was over six billion, more than four-fifths of whom were living in LDCs. This has become a matter of much concern and debate. This chapter looks at theories of population growth and the impact of population growth on development, emphasising the debate between ‘population optimists’ and ‘population pessimists’. It then considers certain aspects associated with population, namely employment and migration, human capital, poverty and inequality, malnutrition and famine, and growth and equality. For this part of the syllabus, you are not expected to reproduce facts and figures about different aspects of population.

Theories of population growthNow read:


Revisited, Chapters 7–10.Ray, D. Development Economics, Chapter 9.Thirlwall, A.P. Growth and Development with Special Reference to Developing


Old ed

ition.

For ref

erenc

e only

.


53

Further readingBurgess, R. and J. Zhuang, ‘Modernisation and son preference’. Discussion

Paper dedps29, (London School of Economics and Political Science, 2000), http://sticerd.lse.ac.uk/dps/de/dedps29.pdf

Ghatak, S. Introduction to Development Economics, pp.133–34.Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

Selection IV.Nafziger, E.W. Economic Development, Chapter 8.

Theories of population growth are covered very well by the textbooks. They generally include:

• The demographic transition theory.1 This is not really a theory but a pictoral representation of crude birth rate (CBR) and crude death rate (CDR). You should be familiar with the meaning of CBR, CDR, the natural and actual increases in population and population momentum. Moreover you should be able to explain why CBR and CDR diverge or converge in different stages and, in particular, at what stage population explosion occurs.

• The Malthusian theory of population. This attempts to explain why population tends to rise and then become stable at around the subsistence level of income.2

• Modern theory. This, which is best discussed by Todaro and Smith (pp.282–87) takes a microeconomic approach to the determinants of fertility. Todaro presents the theory, discusses the demand for children in LDCs, and offers some empirical results. A major concern here is that if fertility is a consequence of rational choice, why do governments need to intervene (for example, in family planning)? Reasons can range from custom and tradition, asymmetric information, difficulty of properly calculating the costs and benefits of children, and the divergence between the social costs and private costs of children (for example, regarding expenditure on education by government).

• An implication of the application of choice theoretic models to fertility decisions is the issue of son preference. This is related to the issue of missing women, discussed in Chapter 11. The argument is that a utility maximising household would have preference for sons. There are many reasons for this, including work on family farms, the fact that if sons inherit, wealth does not go out of the family, as well as the negative impact of dowries on the desirability of having daughters (in societies that practice a dowry system). Burguess and Zhuang (see reference above) discuss son preference in China.

The consequences of population growthNow read:

Essential readingRay, D. Development Economics, Selection 9.4.Thirlwall, A.P. Growth and Development with Special Reference to Developing

Economies, Chapter 8 and pp.188–209.Todaro, M.P. and S.C. Smith, Economic Development, pp.287–301.


1 See for example Ghatak, pp.233–34, Todaro and Smith, pp.275–77, among others..

2 The theory and its criticisms are discussed by Todaro and Smith, pp.277–82.

Old ed

ition.

For ref

erenc

e only

.


54

The consequences of rapid population growth have been debated since the seventeenth century, when most writers saw population as the main source of national wealth. Malthus expressed the opposite view but his position has not been confirmed by events. The debate has, however, continued.

You must be familiar with the following arguments:

• the dependency burden

• employment requirement

• urbanisation

• poverty and its associated consequences.

Todaro and Smith consider the low level equilibrium trap, and criticisms of it as a concept, also mentioning the poverty consequences.

Thirlwall argues that population growth might be an obstacle to capital accumulation (it causes capital shallowing rather than capital deepening) through its effect on savings. He then uses the Cobb–Douglas production function to derive the conditions under which a reduction in population growth does not raise per capita income growth. This is followed by a brief review of empirical work by Enke, a population pessimist.

Nafziger looks at population and food supply, urbanisation and congestion, dependency ration and the employment problem.

On the positive side, the chief advocate of a positive impact of population on development is J. Simon, whose views are considered by Thirlwall (pp.272–74). Most of the books discuss why population may not be a problem (see for example Ray, section 9.4).

If population growth is a problem, due to reasons discussed under the microeconomic approach (see ‘’Modern theory’, page 53) and in this section, then there is a need for a population policy. Different policies have been adopted in different countries and with varying degrees of success. In general two main strategies are suggested. The first is birth control (family planning) and the second is development in a general sense. The latter includes creating incentives to have fewer children as well as changes in attitudes and customs, and improvement in income and income distribution. Todaro also considers what LDCs should do as well as how developed countries can help.3

Employment and migrationNow read:


Revisited, Chapter 8.Ray, D. Development Economics, Chapter 10.Todaro, M.P. and S.C. Smith, Economic Development, Chapter 7.

Further readingGhatak, S. Introduction to Development Economics, pp.252–65.Nafziger, E.W. Economic Development, Chapter 9. Stark, O., M.R. Gupta and D. Lehvari, ‘Equilibrium Urban Unemployment in

Developing Countries: Is Migration the Culprit?’, Economics Letters, 37, 1991, pp.477–82.

Thomas, J.J. Informal Sector Activity.


Old ed

ition.

For ref

erenc

e only

.


55

The Lewis dual sector model assumes that surplus labour is absorbed by the modern sector smoothly and that no unemployment occurs in the modern (urban) sector. This does not correspond with the real world. Open unemployment exists in cities and there is the more important concept of underemployment. The textbooks cover these issues very well. You must be familiar with various definitions such as employment, unemployment, underemployment and disguised unemployment. These issues are discussed in most textbooks. Causes of unemployment (or models of employment determination) and policies to reduce unemployment are for example discussed by Ghatak4 among others.

One of the most commonly used theories is the Harris–Todaro model of migration. You must understand the determinants of the individual propensity to migrate in the Todaro model and the assumptions, structure and implications of the Harris–Todaro model; he is a two-sector type. Ghatak formally presents both the Todaro model5 and the Harris–Todaro model.6 Todaro discusses migration in Chapter 8 of his book and addresses the implications of the Harris–Todaro model which includes an important diagram which you must be able to reproduce. He also covers the policy implications of migration. Ray covers the migration models and government policy in Section 10.3. Hgowever, the best treatment is presented in Basu (Chapter 8).

The implication of the Harris–Todaro model is that, in equilibrium, the rate of urban unemployment is given by:

Substituting actual average rural (WR) and urban (WU) wages, this predicts a much higher unemployment figure for urban areas in LDCs than is observed. This has led to a number of extensions to the model. One is the informal sector model of Fields, which argues that the urban informal sector absorbs many migrants temporarily until they find jobs in the formal (modern) sector. Fields’ model is presented in the book by Thomas (Chapter 4).

The informal sector is also discussed by Ghatak (p.259) – who also briefly covers Stark’s model (pp.262–63). There is a considerable amount of recent empirical work on migration and the informal sector. Some studies (e.g. Banerjee looked at a sample of migrants in New Delhi; see Banerjee, B., Oxford Economic Papers, 1983) show that the informal sector offers certain advantages and many migrants view it as a ‘destination’ rather than a temporary ‘stepping stone’.

You are advised to study, where possible, evidence on migration and the informal sector in your own country; this is not a requirement, but would make a useful contribution in answering a potential question.

Knowledge of Stark’s model is not essential. However, it is an example of how the Harris–Todaro model has been refined.

There are two additional points of which you must be aware:

• The Harris–Todaro model is a fixed price–quantity adjustment model (at least urban wages are fixed). It is in fact a theory of unemployment. When, given a fixed urban wage, urban unemployment is below equilibrium, migration occurs. Hence migration is a disequilibrium phenomenon.




WR

WU

1 .

Old ed

ition.

For ref

erenc

e only

.


56

• Urban job creation policies will, other things being equal, raise the probability of finding a job and hence induce more migration. This is called the Todaro paradox. The implication is that appropriate policies must be aimed at reducing the effect of factors that ‘push’ individuals out of the rural areas and those that ‘pull’ individuals towards the urban areas. A drastic action is total prohibition. However, Stark, Gupta and Lehvari (see the above reference) have shown that the elasticity of demand for labour is an essential factor in determining whether or not we have a paradox. They show that for the range of elasticities relevant to LDCs we are not likely to have a paradox. This model is slightly different to the Harris–Todaro model in the sense that it is the rural wage that is fixed here, not the urban wage. In addition, Basu shows that it is possible to subsidise both the rural and the urban sectors in such a way to eliminate urban unemployment. This policy, although theoretically possible, is impractical because the size of the subsidy is likely to be greater than some LDCs, GNP.

Human capital: education and healthNow read:

Essential readingTodaro, M.P. and S.C. Smith, Economic Development, Chapter 8.

Further readingArabsheibani, G. ‘The Wiles Test Revisited’, Economics Letters, 29(4), 1989,

pp.361–64. Arabsheibani, G.R., F.G. Carneiro and A. Henley, ‘Human Capital and Earnings

Inequality in Brazil 1988–1998: Quantile Regression Evidence’, The World Bank Research Policy Paper 3147 (2003).

Arabsheibani, G.R. and L Manfor ‘Non-Linearities in Returns to Education in Libya’, Education Economics, 9(2) 2001, pp.139–44.

Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development. Selections IV.A and IV.B.

Nafziger, E.W. Economic Development, Chapter 10. Psacharopoulos, G. and M. Woodhall, Education for Development: An Analysis

of Investment Choices. (New York: Oxford University Press, 1985) [ISBN 0195204786].

EducationIn the section on endogenous growth theory7 we argued that human capital differences between countries can explain differences in growth rates between countries. But what exactly is human capital? The simplest definition is the investment (or the use of scarce resources) that individuals (or their parents) make in order to increase their own productivities (or those of their children). The main forms of such investment are formal education, and both formal and on-the-job training, although individuals also learn informally, for example through learning by doing.

The concept of investment in education is consistent with empirical observation of age/experience earnings profiles shown in Todaro and Smith.8 Profiles of earnings over time by education level show that the higher the level of education the higher the profile. Since, in a competitive labour market, pay is related to productivity, education is regarded as a productivity-augmenting factor: that is, an investment. Psacharopoulos9 observes that the rate of return to educational investment is very close to that of physical capital investment in DCs. However, in LDCs this rate

7 In Chapter 3.

8 See Todaro and Smith, p.370.

9 See Meier and Rauch, p.189.

Old ed

ition.

For ref

erenc

e only

.


57

is much higher than in DCs. The reason, Psacharopoulos argues, is the relative scarcity of human capital in LDCs and the barrier to the allocation of funds to human capital investment, so that returns to both human and physical capital investment equalise at the margin.

A second important difference is between social and private rates of return to education. Social rates are generally lower because of state subsidisation of education. The calculation of private and social rates of return to education is an exercise in cost–benefit analysis which is discussed in Todaro and Smith.10 The non-monetary (or externality) effects of education are discussed in Nafziger.11

A positive return to educational investment is only one of the factors affecting the demand for education. Other factors include the probability of finding a modern sector job (positive impact on demand) and direct and indirect costs of acquiring education (negative impact on demand).

By looking at the educational characteristics of LDCs a number of observations may be made.

1. The rate of return to primary education is highest followed by secondary and higher education, indicating that expenditure should be directed to the primary sector first. However, expenditure on higher education is much greater than on primary education.12

2. Enrolment in education has grown rapidly but has often resulted in teacher shortages.

3. Educational expenditure in LDCs may be inefficient because of a high drop-out rate and repeats. It is therefore possible to increase the efficiency of such expenditure by reducing the ‘wastage’ in the system.

4. Certain countries have experienced unemployment among the educated, either because of an excess supply of graduates or a mismatch between education and job requirements. Faced with this problem, Egypt introduced a guaranteed employment policy for graduates with the government employing those graduates who did not find a job in the private sector. The result was underemployment in an excessively large public sector.

So, what is the role of education in economic development? The textbook coverage of this question is adequate, so this guide only highlights the key issues you must know, which are as follows:

• Education (human capital) increases growth. This was discussed in the endogenous growth section but more general details are provided by Todaro.

• Expansion of education at lower levels improves equality of opportunity, primarily for females as discussed by Nafziger (Chapter 10), but education may increase inequality in income. You must be aware of the reasons given in Todaro for this perverse effect.13

• Education, particularly female education, tends to reduce fertility.

• Education may reduce income inequality, although this is not necessarily so, particularly if the recipients of education are mostly male. However, Arabsheibani, Carneiro and Henley (2003) (see reference p. 56) have shown that increase in human capital reduced income inequality in Brazil.

• Education may increase migration because the educated have a better chance of finding jobs in urban areas. This may increase urban unemployment in a Harris–Todaro world. Moreover, educated individuals (particularly highly educated ones) tend to migrate abroad.

10 See Todaro and Smith pp.383–86.

11 See Nafziger, p.337.


13 Todaro and Smith, pp.388–90.Old

editio

n. For

refere

nce o

nly.


58

This phenomenon is called brain drain and results in a loss of human capital. Consequently it requires policies to reduce the propensity to migrate abroad. These issues are discussed in Nafziger and Todaro and Smith.14

On account of the important role of education, LDCs must develop appropriate policies towards education. These are discussed in Nafziger.15

No model is without its critics. The human capital model has been attacked by those who believe in the screening hypothesis discussed in and Nafziger.16 For empirical evidence on screening for LDCs see Arabsheibani (references above). This view proposes that education does not increase productivity; rather it signals ability – that is it serves as a screen to identify the more able from the less able.

HealthHealth is another form of human capital. Healthy workers are more productive than sick workers, therefore investment in health is investment in human capital. These general issues are discussed in Todaro and Smith (pp.399–402), who also look at the Disease Burden (pp.394–96), with examples of malaria and parasitic worms (pp.396–98), and more importantly, HIV and AIDS (pp.398–99 and pp.407–12). They conclude by considering the health system in general and appropriate health policies.

Maier and Rauch (Selection IV.B.3), as well as Nafziger (pp.355–57) looks at AIDS and its impact.

Poverty and inequalityNow read:

Essential readingRay, D. Development Economics, Chapters 6–8. Thirlwall, A.P. Growth and Development with Special Reference to Developing

Economies, Chapter 2, pp.40–68.Todaro, M.P. and S.C. Smith, Economic Development, Chapter 7.

Further readingGhatak, S. Introduction to Development Economics, pp.252–65.Nafziger, E.W. Economic Development, Chapters 6–7.

This section is concerned with the material well-being of people in LDCs. Economic growth is a necessary condition to improve well-being but not a sufficient condition since it may increase the incomes of a few already rich. Hence a general increase in income may not reduce poverty, and may increase inequality, if only the rich get richer. For this section you should be familiar with how income distribution is measured or graphically presented (functional versus size distribution, and the Lorenz curve), and the meaning and measurement of inequality and poverty, relative and absolute poverty, the Gini coefficient, and the poverty line. In addition you should be familiar with the desirable characteristics of measures of poverty and inequality, and be able to discuss if the common measures satisfy those characteristics.

• Nafziger (Chapter 6) has an excellent descriptive coverage of these poverty, issues in addition to offering evidence on global versus regional poverty, different measurements of poverty and inequality, and also identifying poverty groups and policies to reduce poverty and inequality. He also covers a number of case studies (pp.196–202).

14 See Nafziger, pp.348–50 and Todaro and Smith, pp.390–92.


16 Nafziger, pp.338–9.

Old ed

ition.

For ref

erenc

e only

.


59

He then concentrates on aspects of rural poverty and looks at factors contributing to it (Chapter 7).

• Ray deals with inequality in Chapters 6 and 7 and poverty in Chapter 8. In the case of inequality he defines the concept, sets out the measurements and desirable criteria for those in Chapter 6 and then looks at the relationship between inequality and growth, inequality and savings, inequality and demand composition and inequality and capital markets in Chapter 7. In Chapter 8 he discusses the concept and definition of poverty and looks at poverty measures and the relationship between poverty and credit, nutrition, and the intra-household distribution of poverty.

• Todaro and Smith (Chapter 5) look a measurements of poverty and inequality, inequality and growth, poverty and growth, the poverty and minority groups, and policies to deal with poverty and inequality.

• Ghatak briefly discusses inequality and absolute poverty (pp.242–50). He also discusses different measurements of poverty (pp.265–67).

Child labourNow read:

Essential readingsTodaro, M.P. and S.C. Smith, Economic Development, pp.372–76.

Further readingBasu, K. ‘Child Labor: Causes, Consequences and Cure, with Remarks on

International Labor Standards’, Journal of Economic Literature, 37, 1999, pp.1083–120.

When families are poor they tend to send their children to work. This is a rising phenomenon in most parts of the developing world (Asia is an exception). This is regarded by many as immoral. Note that working children may not be able to go to school, but they earn income, and hence raise the GDP. Educated children are expected to be more productive. Hence, effectively child labour results in ‘bad growth’ rather than ‘good growth’. The model of child labour is presented, in a non-mathematical way, in Todaro and Smith. The model is a multiple equilibria model, with two stable equilibria, one with child labour and one without. It therefore tends to show that banning child labour may not be desirable in all cases. Furthermore, there are many empirical studies now that argue that child labour and child schooling are not substitutes. Rather, given poverty, children can only afford to go to school if they work.

Old ed

ition.

For ref

erenc

e only

.


60

Malnutrition and famineNow read:


Revisited, Chapter 10.Ray, D. Development Economics, Chapter 8.

Further readingBliss, C. and N. Stern, ‘Productivity, Wages and Nutrition: Part I: Theory’,

Journal of Development Economics, 1978, pp.331–62.Bliss, C. and N. Stern, ‘Productivity, Wages and Nutrition: Part II: Some

Observations’, Journal of Development Economics, 1978, pp.363–98.Devereux, S. Theories of Famines, Chapter 2Ghatak, S. Introduction to Development Economics, pp.314–19.Immink, M.D.C. and F.E. Viteri, ‘Energy Intake and Productivity of Guatemalan

Sugarcane Cutters: Part I’, Journal of Development Economics, 1981, pp.251–72.

Immink, M.D.C. and F.E. Viteri, ‘Energy intake and Productivity of Guatemalan Sugarcane Cutters: Part II’, Journal of Development Economics, 1981, pp.272–87.

Sen, A. K., Poverty and Famines: An Essay on Entitlement and Deprivation.

A common consequence of poverty is malnutrition, which is caused by insufficient calorie intake (consumption). Ray provides the best treatment covering the relationship between poverty and malnutrition (pp.261–67) and poverty, nutrition, and work (pp.272–79). This relationship, which is often referred to as the nutritional version of the efficiency wage hypothesis, is covered theoretically by Basu and theoretically and empirically by Bliss and Stern, and Imminek and Vitteri. The important implication of the model here is the fact that employers voluntarily, that is for profit maximising reasons, pay workers a higher wage than the equilibrium wage in the competitive market, and hence unemployment under these conditions is involuntary. This implies that wage differentials may be endogenous, rather than exogenous, as in the Lewis and Harris–Todaro models. Under these conditions it is also possible for the employer to pay different workers different wages if the employer knows the workers’ non-wage incomes. Given the existence of personal relationships between employers and workers in rural areas, this is very likely.

Starvation is the extreme form of malnutrition, often leading to death. The incidence of starvation increases during famines with consequent deaths in excess of a million. The conventional view on the causes of famine was food availability decline (FAD). Sen (1981) argues that starvation is the characteristic of some people not having enough food to eat.17 It is not necessarily a characteristic of there being not enough food. The latter is a supply-side problem and is one of the causes of starvation. Another is insufficient entitlement or command on food which is a demand side explanation. Sen argues that in a private ownership market, economic entitlement can be generated through trade, own production, labour power, inheritance and transfers. General failure of entitlement can lead to famines which we define here as mass starvation leading to death.18 Sen refers to this as food entitlement decline (FED).

Sen’s model can be described briefly as follows. Assume that we can define a minimum food requirement for each individual and that there exists a set of commodity bundles that satisfy the minimum requirement. For

17 See Ghatak (1995) 314–19 for discussion of Sen’s model, but also see his book (see the above reference) for the model and a number of very interesting case studies. Devereux (1993), also discusses the model (Chapter 6).

18 There are many different defi nitions of famine as described in Devereux (1993) Chapter 2.

Old ed

ition.

For ref

erenc

e only

.


61

simplicity assume that the bundle contains C (coffee beans = non-food) and W (wheat = food). Point M in Figure 7.1 defines the minimum food requirement – that is 0M kilograms (kg) of wheat. Alternatively, the individual can produce 0M´ kg of C and exchange 0M kg of W at given

market prices, pw and pc, here p = is the slope of MM´. 0MM´ is

defined as the starvation set. Assume an individual has an entitlement E which is outside the set. The individual can starve:

1. if there is a collapse in his or her entitlement, E E´ or

2. if p rises such that E is now in the new starvation set OMM´.

Such collapse can occur as a result of direct entitlement failure (the individual produces less food for her or his own consumption) or trade entitlement failure (the individual can exchange her or his output or labour power for less food).

Figure 7.1 The Sen entitlement model of famine C

To illustrate these points assume that maximum W entitlement is W_. For a

coffee producer:

where:

qc = output of coffee

pc = price of coffee

pw = price of wheat.

The individual can starve if qc falls or if falls. This is a case of trade entitlement failure.

For a wheat producer

Hence this producer can only suffer from direct entitlement failure: that is, qw falling.

pW

pC

W=pC.qC

pW

= qC

pC

pW

pC

pW

W =pw.qw

pW

= qw .Old

editio

n. For

refere

nce o

nly.


62

For this reason, Sen argues that those who are further away from food production are more likely to suffer since they are affected by a reduction in their output as well as adverse price effects. An important issue here is that anyone in the starvation set should not be considered as ‘dead’. Rather, if someone’s endowment is in the starvation set, the probability of starvation rises. Individuals can cope with the situation by rationing, hunting, gathering food, etc.

In his book Sen considers a number of famines and shows that famines have occurred during both boom (Bengal) and slump (Bangladesh) times, as a result of floods or drought. In each case he does not dispute the fact that some output is lost but he shows that output during the famine years was higher than in some other years during which no famine occured. He thus concludes that during famines certain groups lose entitlements and suffer the consequences. These groups include, for example, landless peasants, fishermen and transport workers in the Bengal famine, and nomads, water carriers, prostitutes and women in services in the Ethiopian famine.

Growth and inequalityNow read:

Essential readingRay, D. Development Economics, Chapter 7.Todaro, M.P. and S.C. Smith, Economic Development, pp.212–18.

Further readingGhatak, S. Introduction to Development Economics, pp.246–50.Nafziger, E.W. Economic Development, Chapter 6.

Finally in this chapter you need to know the relationship between growth and inequality, better known as the inverted-U hypothesis. This was first proposed by Simon Kuznets. The theoretical base for this model is the dual sector model. Given the unlimited supply of labour, as the economy grows profits rise more than the wage bill, and hence inequality rises. Once the unlimited supply of labour is exhausted, then as the economy grows, and hence labour demand rises, wages will rise, so the wage bill rises more proportionally than profits, and hence inequality falls. Todaro and Smith also discuss a very interesting model by Fields in which the objective is to maximise a social welfare function, which depends on GDP, poverty and inequality within a dual sector model. Todaro and Smith’s approach excludes the mathematical part, but includes the diagrammatic representation of Field’s model, distinguishing between enrichment and enlargement of the modern sector, and enrichment of the traditional sector (those interested in the mathematical derivation can refer to the book by Fields, see the above reference). The implication of this model is that the inverted U is not necessarily the outcome of the growth process.

The concept of growth with equity and policies that achieve it are discussed in Ray (Chapter 7), Todaro and Smith (Chapter 5), Nafziger (pp.210–212) and Ghatak (pp.250–52).

Old ed

ition.

For ref

erenc

e only

.


63


• explain the demographic transition and Malthusian theories of population growth, and the micro-theoretic model of fertility

• analyse the possible effects of population growth and the arguments for government intervention to influence fertility

• discuss concepts relating to employment and underutilisation of labour; policies designed to reduce unemployment

• assess models of rural–urban migration and their limitations especially in the context of the informal sector

• describe the importance in economic development of investment in human capital, education and health

• discuss concepts of income distribution, inequality and poverty, and their measurement

• explain the causes and consequences of malnutrition and famine and their policy implications

• explain the relationship between nutrition and wages

• explain the relationships between economic growth and inequality

• discuss the implications of child labour and whether banning it is desirable.

Sample examination questions1. Explain how the microeconomic theory of fertility might explain some

features of the demographic transition.

2. ‘The Harris–Todaro model is of limited use in explaining rural–urban migration because it takes no account of the urban informal sector.’ Discuss.

3. Outline some of the problems of measuring the extent of poverty and inequality in developing countries.

Old ed

ition.

For ref

erenc

e only

.

Notes


64

Old ed

ition.

For ref

erenc

e only

.

Chapter 8: Agricultural development

65


Aims of the chapterThis chapter analyses a number of important issues related to agricultural development. We start by looking at the efficiency and rationality of peasant farmers and ask the questions: Are they maximisers? What exactly do they maximise? We then proceed to look at farmers’ responses to output price changes. An important aspect of agricultural development is type of tenure. We will present the analysis of sharecropping and compare it to two other common contracts, wage labour and rent. We also look at the effect of farm size on output, the major reason, on efficiency grounds that land redistribution is generally advocated. Finally we consider the effect of technical change on agricultural development.


• explain the role of the agricultural sector in economic development

• describe the efficiency of peasant farmers and their rationality in input and output decisions

• give examples of typical land ownership structures in developing countries

• explain the equity and efficiency issues concerning land reform

• discuss the typical components, effects and rate of adoption of ‘Green Revolution’ technical change

• explain and discuss the nature of sharecropping and other agricultural contracts

• propose policies that would contribute to the development of the agricultural sector

• discuss the reasons why insurance is desirable and the problems associated with mutual insurance.


Revisited, Chapter 12.Ray, D. Development Economics, Chapters 12 and 14.Thirlwall, A.P. Growth and Development with Special Reference to Developing


Further readingBenjamin, D. ‘Can Unobserved Land Quality Explain the Inverse Productivity

Relationship?’, Journal of Development Economics, 46, 1995, pp.51–84. Bhalla, J and P. Roy, ‘Mis-specification in Farm Size Productivity Analysis: The

Role of Land Quality’, Oxford Economic Papers, 40, 1988, pp.55–73. Bliss, C.J. and N.H. Stern, Palanpur: The Economy of an Indian Village. (Oxford:

Clarendon Press, 1982), Chapter 5

Old ed

ition.

For ref

erenc

e only

.


66

Dorward, A. ‘Farm Size and Productivity in Malawian Smallholder Agriculture’, Journal of Development Studies, 35(5) 1999, pp.141–61.

Ellis, F. Peasant Economics. (Cambridge: Cambridge University Press, 1993) [ISBN 0521457114].

Hallaghan, W. ‘Self–selection by Contractual Choice and the Theory of Sharecropping’, Bell Journal of Economics, 9,1978, pp.344–54.

Hopper, D.W. ‘Allocation Efficiancy in Traditional Indian Agriculture’, Journal of Farm Economics, August 1965.

Ghatak, S. Introduction to Development Economics, Chapters 8–9.Griffin, K. Alternative Strategies for Economic Development. (Macmillan, 1999),

Chapter 6.Lipton, M, ‘The Theory of Optimizing Peasants’, Journal of Development Studies,

3,1968, pp.327–51. Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

Selection VII.Schultz, T.W. Transforming Traditional Agriculture. (New Haven: Yale University

Press, 1964).

IntroductionFei and Ranis’s extension of the dual economy model of Lewis1 demonstrated the contribution of agriculture to economic development. The agricultural sector provides food and other raw materials (inputs), and can be an important source of savings or foreign exchange earnings (both essential to growth), as well as being the source of livelihood for the majority of LDCs’ populations. Most textbooks provide useful coverage of the contribution of the agricultural sector to economic development, which you need to know.2

However, most textbooks do not go into detailed analysis of a number of important issues in agriculture in LDCs. These issues are presented below as a set of questions. Where answers are adequately provided in textbooks, page references are given; otherwise, simple analysis is provided. You are, however, strongly encouraged to consult Further readings for this section of the syllabus. You are also encouraged to use material which is specifically relevant to your own country. A good example is land reform where you are encouraged to use evidence on land reform in your own country (if it was ever implemented) in your examination answers.

The six concepts considered in this chapter are:

• efficiency

• rationality of peasant farmers

• their response to price changes

• sharecropping

• land reform

• technical change in agriculture (Green Revolution).

Are peasant farmers efficient?Now read:

Further readingEllis, F. Peasant Economics, Chapter 4. Hopper, D.W. ‘Allocation Efficiency in Traditional Indian Agriculture’, Journal of

Farm Economics, August 1965.Schultz, T.W. Transforming Traditional Agriculture. (New Haven: Yale University

Press, 1964).

1 See `The Lewis model – growth with unlimited supplies of labour’ in Chapter 3

2 See Ghatak (1995) pp.271–73.

Old ed

ition.

For ref

erenc

e only

.


67

This is a controversial subject that was first advocated by T.W. Schultz (1964) in the form of the efficient but poor hypothesis. Schultz argued that farmers are efficient but are caught in a low-level equilibrium trap. It is important for you to be able to distinguish between different types of efficiency. Technical efficiency is achieving the maximum output for a given level of input(s), given the range of alternative technologies available to peasant farmers. Allocative efficiency is achieved when the marginal value product of an input (or factor) is equal to the marginal factor cost of the input and when the principle of equi-marginal returns holds: that is, the marginal value product of an input is equal across different outputs (i.e. uses of that input). This is illustrated in Figure 8.1.

Figure 8.1 Concepts of efficiency

The production function is Q = f(I1, I2) where I1 and I2 are inputs. Assume Q1Q1 and Q2Q2 both represent the same number of units produced. Clearly Q1Q1 is technically efficient and Q2Q2 technically inefficient (Q1Q1 minimises the level of inputs required to produce the same level of output). Both points A and C are allocatively efficient (that is, given by the tangency of the iso-quant and iso-cost line) but only point A is economically efficient: that is, both allocatively and technically efficient.

Estimating farm production functions has been the main method of testing efficiency of peasant agriculture. A production function is estimated for, say, a crop yield as one input varies and the marginal physical product (MPP) of each input is then calculated (the MPP being the slope of the production function). The level of MPP in which we are interested is the average level at which farms are operating. To consider whether we have allocative efficiency we need the price of the product and that of the input. The condition to satisfy allocative efficiency is MVP1 = P1 where MVP1 = MPP1. PX

MPP1 = Marginal physical product of input I

PX = Price of product X (the farm product under consideration).

For example, in the case of labour input (L, with wage rate w), allocative efficiency is satisfied when:

MVPL = w or w = 1MVPL

Old ed

ition.

For ref

erenc

e only

.


68

Empirical studies on peasant efficiency focus on the above ratio, often called the ‘allocative efficiency rate’ (K), where EQ and test for K=1.

There are many empirical studies on India and other Asian countries that tend to support the hypothesis that peasant farmers are efficient.

One major criticism is that peasant farmers might not be profit maximisers, an assumption underlying the above analysis, but rather survival maximisers. This leads us to the second question concerning peasant rationality.

Are peasant farmers rational?Now read:

Essential readingTodaro, M.P. and S.C. Smith, Economic Development, pp.442–46.

Further readingEllis, F. Peasant Economics, Chapter 5. Lipton, M. ‘The Theory of Optimizing Peasants’, Journal of Development Studies,

3,1968, pp.327–51.

This question raises the issue of what, if anything, peasant farmers maximise. But why is this important? The reason is that peasant farmers consume what they produce and so they are both households and firms. So do they maximise utility or farm profits? A major contribution to the literature is by Griffin who proposes the ‘safety-first principle’. This approach is based on peasant farmers being risk-averse. Let us formally address this issue. Assume that farmers, due to variability of weather, are faced with variable income. Risk is the income variance as a result of uncertain events (changes in weather). Consider a case, illustrated in Figure 8.2, when we calculate the total value product (TVP) of different levels of fertiliser applied. Assume for simplicity that there are two states of the world, a ‘good’ and a ‘bad’ year.

TVP1 = total value product response to fertiliser in a ‘good’ year.

TVP2 = total value product response to fertiliser in a ‘bad’ year.

E(TVP) = the expected total value product

= P1 . TVP1 + P2 .TVP2 where P1and P2 are probabilities of ‘good’ and ‘bad’ year occurring.

TFC = Total fertiliser cost.

Fertiliser input X1 is consistent with allocative efficiency on TVP1. It yields the largest profit ab if a good year occurs but a large loss of bj if a bad year occurs. A farmer choosing this level is a risk-taker.

Fertiliser input X2 is consistent with allocative efficiency on TVP2. If a good year occurs, the farmer makes ce profit; in a bad year, the farmer still makes de profit which is, however, small. This farmer is risk-averse because safety is chosen in the expectation that the worse outcome will occur.

Fertiliser level XE is consistent with allocative efficiency of a balanced assessment of a good and a bad year. If a good year occurs a profit of fh is made; in a bad year a loss of hi is made. The profit in this state is not the highest; neither is the loss the highest. A farmer choosing this level of input is a risk-neutral farmer.

Old ed

ition.

For ref

erenc

e only

.


69

Figure 8.2 Attitudes to risk and optimal factor use

It could be argued that out of necessity peasant farmers must choose X2 because they have to guarantee that they produce what is required for their household’s survival. This implies that this type of farmer would not use the optimum level of fertiliser. This can be shown in Figure 8.3.

Figure 8.3 Risk and efficiency

E(MVP) and MVP2 (drawn linearly for simplicity) are the slopes of E(TVP) and TVP2 respectively. Marginal Fertiliser Cost (MFC) is the slope of TFC. The optimum quantity of fertiliser use in a neoclassical sense is XE since if X2 is used then, on average, E(MVP) > MFC (shown by a>b) implying that a suboptimal level of fertiliser (or, in general, all inputs) is used. This has a number of implications.

1. If farmers are risk-averse, they tend to trade off economic efficiency with security and adopt farming practices such as mixed cropping (cultivating more than one crop).

2. Risk-aversion reduces farmers’ willingness to adopt new technology.3

3. Risk-aversion declines as wealth or income increases.

Most of the empirical studies tend to confirm these implications. For example, a study by Norman (1974) of farmers in Northern Nigeria found that they cultivate up to eight crops at a time. He argues that there are certain advantages in mixed cropping. These are:

a. superior use of light, water and nutrients because crops differ in spacing, height and nutrient requirement

3 See ‘Technical change in agriculture’ later in this chapter.

Old ed

ition.

For ref

erenc

e only

.


70

b. some plants are nitrogen fixing and therefore benefit other plants

c. protection of soil due to the overlapping periods during which leaf cover and root systems are in place

d. labour required for weeding and harvesting is evened out over the year

e. variety and nutritional balance in food supply

f. security of food supply.

Of these only (f) relates to risk-averse behaviour, (e) refers to utility maximisation in consumption and the remainder are generally related to production efficiency. Hence, according to Norman, risk-avoidance is not necessarily in conflict with other criteria.

How do peasant farmers respond to price changes for their output?

Now read:

Essential readingGhatak, S. Introduction to Development Economics, pp.273–90.

Further readingMeier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development, pp.428–30.

The question of whether agricultural output is very responsive to price increase is very important to the design of agricultural policy. Furthermore if, due to a shortage, the ultimate size of the price increase is smaller, the output will be more price-responsive. Within a dual economy context, this implies a smaller increase in the subsistence wage.

The response to price changes has been studied within agricultural household models.

A simple version of this model is discussed by Meier.4 Assume the household produces good ‘x’ (for example, tobacco) which is not consumed by the household itself and that the price of x rises. The standard consumer theory of household choice between work and leisure can be applied. The increase in price of x results in an income effect which, if leisure is a normal good, leads to more leisure and less work and hence less output is produced. There is also a substitution effect because every hour of work now leads to a higher income and hence more work is done and more output is produced. The final effect on output is ambiguous and depends on the relative size of the income and substitution effects. On the other hand, if the household produces good ‘y’ (wheat, for example) which the household consumes, the model becomes more complicated. The reason is that now the household will have to decide not only how much to produce but also how much to consume. This determines the size of the marketable surplus. Under these circumstances, if the price of y rises, there is a profit effect which will dampen and may outweigh the negative income and substitution effects. The argument is that the income effect tends to increase the household’s own consumption of y and reduce marketed surplus. The substitution effect reduces the household’s own consumption of y and increases marketed surplus because of the increased cost of consumption. The final result may be any combination of output rising/remaining constant/falling with marketed surplus rising/remaining constant/falling. Empirical studies of the impact of price changes on agricultural output come to a wide variety of conclusions, which is not surprising given the theoretical unpredictability of the outcome.

4 See Meier (1995) pp.424–28.

Old ed

ition.

For ref

erenc

e only

.


71

Ghatak defines marketed surplus (p.273) and then relates it to capital formation (pp.273–74) and the terms of trade (pp.274–78). He also presents a theoretical model of a utility–maximising farmer (pp.278–81). Empirical studies of this type of model give inconclusive results. A number of studies find negative price elasticities while others find positive price elasticities. Finally, Ghatak (pp.288–89) considers the limitations of pricing policy in mobilising marketed surplus.

Sharecropping and other agricultural contractsNow read:


Revisited, Chapter 12.Ray, D. Development Economics, pp.420–41.Todaro, M.P. and S.C. Smith, Economic Development, pp.446–51.

Further readingBliss, C.J. and N.H. Stern, Palanpur: The Economy of an Indian Village. (Oxford:

Clarendon Press, 1982), Chapter 5. Ellis, F. Peasant Economics, Chapter 8. Hallaghan, W. ‘Self–selection by Contractual Choice and the Theory of

Sharecropping’, Bell Journal of Economics, 9, 1978, pp.344–54.Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

pp.416–24.

Agricultural contracts between landlords and peasants generally come in one of three forms: wage labour, fixed rent or sharecropping. Of these, sharecropping is by far the most common in LDCs. The economic analysis of sharecropping (or metayage) goes back to Marshall who showed that it is an inefficient contract. The obvious implication of his argument is that there is a need for land reform or at least tenancy reform. However, it is possible to show that under certain conditions all three types of contract mentioned above are equivalent.

Sharecropping exists where the landlord and the tenant have a contract of the following form: the landlord gives the tenant a plot of land and the tenant gives the landlord a fixed proportion of output, say ‘a’, at the end of the season. Assuming that the tenant cannot lease more land and labour is the only input, MP is the marginal product of labour and (1-a)MP is the share of marginal product going to the tenant: see Figure 8.4.

Figure 8.4 Sharecropping I

Old ed

ition.

For ref

erenc

e only

.


72

Assuming that the wage is fixed at W, then the tenant devotes OL2 units of labour and earns OM´AL2. The landlord receives a proportion of total output which, given L=L2 is OMBL2-OM´AL2 = MBAM´. The sale of OL2 units of labour by the tenant on the open market at a wage W would give the tenant an income of OWAL2. Hence the tenant makes an extra WAM´ if he sharecrops compared to offering his labour in the open market at wage W. On the other hand, if the landlord decides to opt for a wage contract he will hire labour up to the point C – that is, OL1 units – and earn WCM profit (total output MCL1O less the wage bill WCL1O). In this case both output and employment are higher and therefore labour, under a sharecropping arrangement, is suboptimally used.

Cheung has argued that, if tenants’ income is higher under a sharecropping contract than a wage contract, there must be an excess supply of people who want to sharecrop. The implication is that the Marshallian analysis cannot be modelling an equilibrium. Assuming competitive markets, no administration costs and that the landlord can choose ‘a’, we can show that fixed rent, sharecropping and wage contracts are all equivalent. The proof is shown here to satisfy your curiosity but is not required.

The diagrammatic presentation of the model (Figure 8.5), however, is required and will follow the proof.

Assume that the landlord’s objective is to maximise profit and that he is faced with a production function Q = Q(L) where L = labour

and eq = marginal product of labour

and EQ

that is, the marginal product of labour declines as more labour is used.

The landlord chooses a to maximise his profit aQ(L) subject to a constraint that his tenant must do as well in sharecropping as under a wage contract. So maximise aQ(L) subject to (1a)Q(L)WL

The Lagrangian5 is ZaQ(L)[WL(1a)Q(L)]

dZ Q(L)QL0da

dZ a dQ WadQ 0dL dL dL

since 11 then dQw which suggests an optimal use of labour.

dL

dZ WL1aQL0d

so

a QL WL QL

5 This technique is covered in two books recommended for Mathematics for Economists paper: Black, J. and Bradley, J.F. Essential Mathematics for Economists (J. Wiley and Sons, 1980) 2nd edition [ISBN 0471276596] Chapter 8 and Timbrell, M. Mathematics for Economists. (Basil Blackwell, 1985) [ISBN 0631140867] Chapter 15.Old

editio

n. For

refere

nce o

nly.


73

Figure 8.5 Sharecropping II

Refer to Figure 8.5. From the above discussion we know that the sharecropper’s income must be the same under both contracts and that optimal use of labour is made so OL* labour is used and M*DL*0 =WCL*O. Hence WA*M*=A*CD. So the landlord’s income under sharecropping, MCDM*, is equal to WCM. Hence sharecropping and wage contracts are equivalent.

But if the landlord wants to opt for a fixed rent contract, what would be the fixed rent? Consider that a fixed rent contract does not affect the marginal product of labour, so a tenant applies OL* units of labour under a fixed rent and his income will be Q(L) – fixed rent, given L=L*: that is, OMCL* – fixed rent. Since the tenant has the option of choosing a wage contract at wage W, the minimum income he must make under a fixed rent contract is OWCL*. Hence a profit – maximising landlord would charge the maximum possible rent, WCM. The implication of the above is that all three contracts are equivalent.

There are a number of problems with this analysis. First, ‘a’ is assumed to be determined by landlords. However, ‘a’ is generally very close to one-half and this raises the question of whether or not it is determined institutionally (customs, tradition etc.). Moreover, if fixed rent and sharecropping are the same, why do landlords choose such a complex contract in preference to a simple fixed rent contract? One explanation is risk aversion. Under a fixed rent contract, tenants bear the risk whereas under a wage contract landlords bear all the risk. Sharecropping therefore allows risk-sharing and may be optimal. Another explanation, suggested by Hallagan, is entrepreneurial ability (E). He argues that:

Q = Q(E), > 0 and 0 E 1 but E cannot be measured.

So landlords do not know the amount of E possessed by potential tenants. He shows that under these circumstances there is a range of E, OE1 in Figure 8.6, that it is better for the worker to go for a wage contract. If ability is between El and E2 he would choose a sharecropping contract and, for ability higher than E2, a fixed rent contract.

dQdE

Old ed

ition.

For ref

erenc

e only

.


74

Figure 8.6 Sharecropping III

WW = wage contract

RR = rent contract

SS = sharecropping contract.

Basu criticises this view. His arguments are as follows.

Assume Q= f(E) but Q > 0 if E=0: that is, f(0) > 0.

Consider only a wage contract where workers would not use their E.

Therefore landlord’s income per unit of land = f(0) – W and worker’s income = W.

Basu argues that not only is this not an equilibrium but that there is no equilibrium wage contract – the reason being that at least one agent can improve their condition. For example, the landlord can offer a fixed rent contract R.

Since f(l) > f(0) it follows that there must be a real number R to satisfy

R f(0) – W

f(1) – R W.

For a worker with E = 1 it pays to take the rent contract and earn f(1) – R rather than the wage contract. The landlord also benefits because R >f(0) – W.

Basu argues that if in the real world we observe both wage and rent contracts then R =f(0) – W; that is it must be an equality rather than an inequality.

But this implies that f(E) – R > W if E > 0. Hence, all workers except those with E = 0 would want a rent contract and those with E = 0 would be indifferent between the two. Hence the rent contract must emerge as the dominating contract; but this result is not empirically supported in most LDCs.

Land reformNow read:

Essential readingRay, D. Development Economics, pp.445–62.

Further readingBenjamin, D. ‘Can Unobserved Land Quality Explain the Inverse Productivity

Relationship?’, Journal of Development Economics, 46, 1995, pp.51–84.

Old ed

ition.

For ref

erenc

e only

.


75

Bhalla, J and P. Roy, ‘Mis-specification in Farm Size Productivity Analysis: The Role of Land Quality’, Oxford Economic Papers, 40, 1988, pp.55–73.

Dorward, A. ‘Farm Size and Productivity in Malawian Smallholder Agriculture’, Journal of Development Studies 35(5) 1999, pp.141–61.

Ellis, F. Peasant Economics, Chapter 10. Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

pp.407–15.

The structure of land ownership in many developing countries is severely concentrated, mainly for historical reasons. In Latin America, for example, land ownership is in the form of latifundios (large estates) owned by a few very rich landowners and minifundios (small farmers) which may be so small that they cannot support the owner’s needs. It is argued that a redistribution of land under these circumstances is desirable on equity as well as efficiency grounds. While there is no doubt that land reform, or simply a redistribution involving a subdivision of land, improves equity, it is not clear if it improves efficiency. Although some authors categorically claim that land reform may be a necessary condition for increased productivity in agriculture, they realise that it is not sufficient in the sense that a general agricultural reform is necessary, complementing land redistribution with provision of credit, crop-insurance, inputs, know-how, transport facilities, etc. Many countries have adopted land reform: some have successfully increased output; others have not. Agricultural output, on the other hand, has been successfully increased through technical change without land reform, which tends to suggest that land reform is not even necessary.

The issue of the relationship between productivity and farm size is crucial to the argument that land redistribution increases agricultural output. A negative relationship between yield per acre and farm size is one of the most striking empirical findings. When a regression of the type log (yield per acre) = a+b.log (farm size) + u (where u is the error term) is run, b is negative and significant. This negative coefficient is generally, but sometimes incorrectly, interpreted as evidence for decreasing returns to scale and therefore for the superiority of small farms, hence justifying land reform on economic grounds. Although decreasing returns to scale could explain b < 0, evidence of a negative b has been found when output exhibits constant returns to scale. The main explanation is that smaller farmers use factors more intensively. Reasons include:

• There is evidence that smaller farms make use of a higher proportion of available lands so declining land productivity as farm size increases is due to under-utilisation of total available land.

• Large farms may be used to produce more land-intensive output such as livestock.

• Smaller farms use more irrigation. There are two simple explanations for this – distress sales and land sub-division due to inheritance. In the first case, hard-up farmers sell land which has less access to irrigation, keeping land with better irrigation for themselves. Hence smaller farms tend to have better access to irrigation. The inheritance case is a similar phenomenon. Irrigated land has a higher value. So when land is being divided for inheritance purposes, the share with the better irrigation will tend to be smaller.

• Imperfections in factor markets. Relatively cheaper labour for small family farms and relatively cheaper capital for larger farms implies that smaller farms use labour more intensively and hence produce a higher yield per acre.

Old ed

ition.

For ref

erenc

e only

.


76

• It can be argued that large landowners hold land for other reasons (e.g. prestige or as a hedge against inflation, etc.). Hence they are unwilling to reduce its value by working it intensively.

• It can be argued that smaller farms have better quality land. This point is related to the irrigation explanation mentioned above. A recent empirical study of 21,500 farm households by Bhalla and Roy in India confirms this (and Benjamin and Dorward further extend this analysis). They ran the conventional regression, ln (output per acre) = a+b.ln (farm size) + u , and b was found to be negative. They then ran another regression: ln (output per acre) = a’ + b’. In (farm size) + c’(land quality) + u’ and used various measures of quality such as soil texture, soil colour, and depth of soil. Their results show that, before inclusion of quality variables, b < 0 for all districts in India. With inclusion of quality variables, b’< 0 for only 30 per cent of districts and the effect is much weaker. Hence, it seems that land quality has a significant role in the farm size–productivity relationship. If this is true, then it is not clear that a simple subdivision of large farms is the answer to increasing agricultural output.

Technical change in agricultureNow read:



Further readingBliss, C.J. and N.H. Stern Palanpur: The Economy of an Indian Village. (Oxford:

Clarendon Press, 1982), Chapter 7. Ghatak, S. Introduction to Development Economics, Chapter 9.Griffin, K. Alternative Strategies for Economic Development, (Macmillan, 1999),

Chapter 6.Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

pp.397–99 (Gives further readings).

Although the farm size–productivity argument lends support to the case for small farms, it is neither necessary nor sufficient that a policy of land redistribution will increase agricultural productivity. It is not sufficient because countries such as Iraq have used this policy but experienced a fall in agricultural output. It is not necessary because technical change in agriculture can bring about an increase in the output of farm products.

Historically, rapid population growth and increased demand for food has led to an increase in food supply. This, which is sometimes referred to as ‘induced innovation’, was achieved in the West, especially the USA, through the use of large machines. This type of capital-intensive innovation is not, however, very useful for LDCs. Increased yield without necessarily increasing capital intensity is more appropriate for poor countries. The best treatments of technical change are by Ghatak discusses the mechanical package (pp.504–07) and the biological package (pp.507–10). The latter, usually referred to as the Green Revolution, consists of the use of modern (or high yield) varieties of crops and dates back to research in Mexico and the Philippines on wheat and rice respectively. The causes of the Green Revolution are discussed in Ghatak (pp.297–302). The intention is to increase, at any given levels of other inputs, yields per acre by the introduction of modern varieties. The

Old ed

ition.

For ref

erenc

e only

.


77

Green Revolution is essentially a package of technologically-improved seeds, irrigation, and fertilisers. It has, in certain parts of the world, resulted in a remarkable increase in output. It is important for you to understand the nature of the technology (for example, why is a dwarf variety of wheat more appropriate?), its impact on food production and the reason why modern varieties have not been widely adopted. Some of the suggested readings deal with these issues in depth. The three main reasons for non-adoption are higher risk, changes in farming practices due to the ‘package’ nature of Green Revolution and the cost of adopting modern varieties.

Changing farming practices requires abandoning some of the traditional ways of production and adopting new methods, and requires a limited provision of know-how on the part of government – for the simple reason that usually a specific seed requires a specific fertiliser in a given proportion. The timing of fertiliser application is also crucial and often farmers with low levels of education cannot apply the ‘package’. The riskiness of adopting modern varieties, Griffin argues, leads to large farmers adopting them first and hence, in general, benefiting more from this technology, which he claims worsens income distribution in rural areas.6 There are many other reasons put forward for the earlier adoption by larger farmers, including the fact that larger farmers have better access to credit (superior collateral, city connections, etc.). Griffin’s arguments have been criticised on the grounds that:

a. large holdings are usually farmed as a number of small plots

b. empirical evidence from India and the Philippines shows that diffusion of modern varieties was fastest in farms of five to 20 acres.

A number of additional points are worth noting. First, the environmental impact of the Green Revolution is an important concern due to the increased use of fertilisers. Secondly, it is argued that land prices go up in areas where adoption is widespread; this has led to the eviction of tenants so that landowners can themselves reap the benefits. This leads to landlessness and an increase in poverty. Thirdly, it is argued that the Green Revolution increases demands for labour due to additional needs for weeding and harvesting.

There seems to be a case for public policy aimed at the following:

• provision of farmer education to help farmers use inputs correctly and efficiently

• provision of complementary inputs – for example, pesticides

• subsidisation of poor farmers’ purchases of inputs

• provision of credit, credit subsidies and, where appropriate, crop insurance

• correction of the very common ‘cheap food policy’ – often designed to subsidise urban consumers – which reduces production incentives

• use of progressive income taxes to finance some of the above expenditures.

Other implications of the Green Revolution are presented by Ghatak (pp.293–97) who then discusses the role of public policy (pp.306–08).

6 See Ghatak (1995) pp.295–97.

Old ed

ition.

For ref

erenc

e only

.


78

InsuranceNow read:

Essential readingRay, D. Development Economics, Chapter 15.

Insurance is desirable in a risky world assuming that individuals wish to smooth consumption. One way of smoothing consumption, according to Ray, is self-insurance. This is, for example, the use of accumulated cash or savings, or other assets such as livestock, jewellery, etc. Ray gives an interesting study of self-insurance, using bullocks as assets, in India. A second method to smooth consumption is access to credit. A third way is mutual insurance. For mutual insurance to work there must be a negative correlation between the fortunes of the participating agents. Ray gives an example of this (pp.594–96). He then sets up the ‘perfect insurance model’ (pp.596–97) and tests it (pp.597–600). Finally he considers cases when the model fails: informational problems (pp.600–05), and enforcement problems (pp.605–15).


• explain the role of the agricultural sector in economic development

• describe the efficiency of peasant farmers and their rationality in input and output decisions

• give examples of typical land ownership structures in developing countries

• explain the equity and efficiency issues concerning land reform

• discuss the typical components, effects and rate of adoption of ‘Green Revolution’ technical change

• explain and discuss the nature of sharecropping and other agricultural contracts

• propose policies that contribute to the development of the agricultural sector

• discuss the reasons why insurance is desirable and the problems associated with mutual insurance.

Sample examination questions1. ‘Land reform is necessary for agricultural development.’ Discuss.

2. ‘A development strategy which ignores the agricultural sector will fail.’ Discuss.

3. Consider the reasons for the introduction of new technology in the agricultural sector in LDCs and examine the outcome of that strategy.

Old ed

ition.

For ref

erenc

e only

.

Chapter 9: International trade

79


Aims of the chapterThis chapter will consider arguments for and against free trade. Free trade should be based on comparative advantage. There are, however, different theories of comparative advantage. After considering these theories we proceed to look at the meaning and instruments and reasons behind protectionism and discuss the infant industry argument. We then consider other important LDC trade problems such as ‘the declining net barter terms of trade’ and ‘instability in export earnings’ and discuss policies to reduce the impact of these problems on LDCs.


• discuss the benefits of international trade

• state the case for and against tariff protection

• define terms of trade concepts and explain the causes and implications of developing countries’ terms of trade experience

• explain the causes and consequences of export earnings instability

• describe international arrangements for primary commodities and LDCs’ export earnings

• explain how to promote trade between developing countries.

Essential readingRay, D. Development Economics, Chapters 16 and 17.Thirlwall, A.P. Growth and Development with Special Reference to Developing


Further readingAthukorala, P. ‘Manufactured Exports from Developing Countries and Their

Terms of Trade: A Re-examination of the Sarkar-Singer Results’, World Development, 21(10) 1993, pp.1607–13.

Bleaney, M.F. ‘Manufactured Exports of Developing Countries and Their Terms of Trade since 1965: A Comment’, World Development, 21(10) 1993, pp.1615–16.

Ghatak, S. Introduction to Development Economics, Chapter 10.Grilli, E.R. and M.C. Yang, ‘Primary Commodity Prices, Manufactured Goods

Prices and the Terms of Trade in Developing Countries: What the Long Run Shows’, World Bank Review, 2(1) 1988, pp.1–48.

Kavoussi, R.M. ‘International Trade and Economic Development: The Recent Experience of Developing Countries’, The Journal of Developing Areas, 19, 1985, pp.379–92.

Kravis, I.B. ‘Trade as a Handmaiden of Growth: Similarities Between the Nineteenth and Twentieth Centuries’, The Economic Journal, 80, 1970, pp.850–72.

Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development, Selections III.A and III.B.

Old ed

ition.

For ref

erenc

e only

.


80

Nafziger, E.W. Economic Development, Chapter 17.Powell, A. ‘Commodity and Developing Country Terms of Trade: What Does the

Long Run Show?’, The Economic Journal, 101,1991, pp.1485–96.Sarkar, P. and H. W. Singer, ‘Manufactured Terms of Trade Deterioration: A

Reply’, World Development, 21(10) 1993, pp.1617–20.Siggel, E. Development Economics: A Policy Analysis Approach, Chapter 5. Singer, H. W. and P. Gray, ‘Trade Policy and Growth of Developing Countries:

Some New Data’, World Development, 16,1988, pp.395–403.

IntroductionMost of the preceding chapters of the guide assume, implicitly or explicitly, a closed economy. In this chapter, we consider open economies. The conventional view, based on the theory of comparative advantage, is that trade leads to growth and hence to improvements in the standard of living. However, there has been considerable disagreement about this and concerns regarding the possible outcome of free trade was one of the reasons for the adoption of the import substitution industrialisation strategy.1

What you are required to know in this subject area is posed in the form of three important questions:

a. in general, is free trade better than autarky (no trade)?

b. are there circumstances in which protection (but not prohibition) of trade might be preferred?

c. do developing countries suffer from additional problems that might lead us to believe that free trade is not appropriate?

The case for free tradeNow read:

Essential readingRay, D. Development Economics, Chapters 16. Thirlwall, A.P. Growth and Development with Special Reference to Developing


Further readingSiggel, E. Development Economics: A Policy Analysis Approach, pp.124–27

The basic argument in favour of free trade is the resulting gains in output. Until recently, models of trade were based on the concept of comparative advantage which arises either from productivity differences or factor endowment differences between countries. Both of the above predict that countries specialise in the production of the good in which they have a comparative advantage and export it in exchange for the good in which they have a comparative disadvantage – their importable. These models are presented in Thirlwall which considers the Ricardian model and Todaro and Smith which discusses the factor endowment model.

You should understand the meaning of absolute and relative/comparative advantage and how they lead to increased output. You must also know criticisms of the traditional models. Todaro and Smith discuss these criticisms and their implications for the traditional model and also considers the vent for surplus model (pp.597–98).

1 See Chapter 10.

Old ed

ition.

For ref

erenc

e only

.


81

The arguments against free trade (or in favour of protectionism)

Now read:



Further readingGhatak, S. Introduction to Development Economics, pp.321–29.Nafziger, E.W. Economic Developments, pp.596–603.Siggel, E. Development Economics: A Policy Analysis Approach, pp.128–30.

Theories of comparative advantage are based on the assumption of perfect domestic markets for goods and factors of production. The most basic argument against free trade is the existence of imperfect domestic markets. Imperfections in the domestic market can arise either if the goods market is distorted (e.g. monopoly or external costs) or if factor markets are distorted (dual sector model where the opportunity cost of labour is below the modern sector wage). Some of these issues are relevant to the import substitution strategy discussed in ‘Industrialisation strategies i: import substitution’ in Chapter 10. Suffice it to say in this chapter that, in the above cases, a tariff may improve welfare but there is always a better policy to achieve the same objective. Thirlwall shows the case where a production subsidy leads to a higher level of welfare than a tariff. Ghatak shows that a tax-cum-subsidy is better than a tariff when there is a domestic distortion.2

In the absence of market imperfections, two arguments are used in favour of tariffs. The first is the optimum tariff argument3 which states that a large country (a country that has monopoly or monopsony power with respect to the good in question) can impose a tariff and (in the absence of retaliation) improve its welfare. It is not likely that a single LDC can behave in this way but a number of them together, e.g. OPEC in the case of oil, can do so.

The second, and most popular, rationale is the infant industry argument. Infant industries are newly established industries that are not yet internationally competitive but may potentially become competitive. You must be able to explain why these industries initially have disadvantages and how, over time, they may improve their competitiveness. In particular the scale economies argument and the learning argument are crucial.

The approach taken here is a simple partial equilibrium model. Ghatak uses a more complicated general equilibrium approach. Apart from the fact that the position of his final indifference curve (unlabelled in diagram 10.4)4 and hence his final consumption point C is not correct under normal assumptions, he makes an unusual assumption of applying a ‘prohibitive tariff’, which is a tariff that takes us from a free trade position (P = production, C = consumption) to a no-trade position (P´= consumption = production).

Assume the government of a developing country believes that production of good x is an essential part of its development strategy. Initially the country is not competitive in production of x and imports all its requirements (Figure 9.1). The country faces a perfectly elastic world supply of x, Sw.


3 Discussed in Ghatak, pp.321–32.

4 See Ghatak, p.325.Old ed

ition.

For ref

erenc

e only

.


82

Figure 9.1 Infant industry tariff protection

S1 and Dx are the domestic supply and demand curves respectively. At the world market price (Pw) domestic consumption is OK, all imported. Now assume that a tariff is imposed which raises the domestic price to Pt, inducing domestic production of OL. Domestic consumption at the new price is OM, Pt – Pw being the tariff, and imports fall to LM (the rectangle c is tariff revenue). The deadweight loss of this tariff is area (b + d). Now assume that, after a time, through scale economies and learning, the supply curve of the domestic industry shifts to S2 and the government removes the tariff. Domestic production, at price Pw, is now ON, imports are NK and producers earn an additional surplus equal to the triangle e. This is now a classic case of cost–benefit analysis. Assume for simplicity that the life of this industrial project is 25 years, all costs occur in the first five years and benefits from years six to 25. If D(b + d) is the discounted value of costs for the first five years and D(e) is the discounted value of benefits from years six to 25, then if D(e) D(d + b) tariff protection is justified and otherwise it is not.

However, you must be aware that in this case a subsidy is better than a tariff: the analysis is identical to Thirlwall. There is an important additional point, mentioned in Ghatak,5 imperfections in the capital market. These occur when either the borrowing rate is too high or sufficient funds are not available, possibly due to the high risk of the project. Even in this case it is more appropriate for the government to subsidise interest rates, provide funds or underwrite loans rather than to change relative prices by introducing tariffs (or import quotas). It should be noted that, if there are no capital market imperfections and if the project is socially worthwhile, the project would always be privately profitable since the private sector only compares area b with area e.

Developing countries’ specific trading problemsNow read:


Economies, Chapter 16.

Further readingAthukorala, P. ‘Manufactured Exports from Developing Countries and Their

Terms of Trade: A Re-examination of the Sarkar-Singer Results’, World Development, 21(10) 1993, pp.1607–13.

5 See Ghatak, p.325

Old ed

ition.

For ref

erenc

e only

.


83

Bleaney, M.F. ‘Manufactured Exports of Developing Countries and Their Terms of Trade Since 1965: A Comment’, World Development, 21(10) 1993, pp.1615–16.

Ghatak, S. Introduction to Development Economics, Chapter 10.Grilli, E.R. and M.C. Yang, ‘Primary Commodity Prices, Manufactured Goods

Prices and the Terms of Trade in Developing Countries: What the Long Run Shows’, World Bank Review, 2(1) 1988, pp.1–48.

Kravis, I.B. ‘Trade as a Handmaiden of Growth: Similarities Between the Nineteenth and Twentieth Centuries’, The Economic Journal, 80, 1970, pp.850–72.

Powell, A. ‘Commodity and Developing Country Terms of Trade: What Does the Long Run Show?’, The Economic Journal (101)1991, pp.1485–96.

Sarkar, P. and H. W. Singer, ‘Manufactured Terms of Trade Deterioration: A Reply’, World Development, 21(10) 1993, pp.1617–20.

Before the 1950s, advocates of free trade hailed primary product exports, goods in which the LDCs had a comparative advantage, as the engine of growth. This improved the utilisation of existing factors, expanded factor endowments and created linkage effects. The basis for these arguments was the successful experience of countries such as the United States of America, Canada and Australia. Since the late 1950s a number of economists have raised doubts about the engine of growth argument. Kravis, for example, agrues that trade is a handmaiden of growth. However, arguments have been put forward that trade may not be so beneficial for LDCs. The most damaging argument is the Prebisch–Singer thesis.6 This thesis proposes that the net barter terms of trade (NBTT) between primary exports and manufactured exports tends to decline over time. An obvious implication, which was adopted by some Latin American countries, was import substitution industrialisation.

You must be aware of the decline’s possible causes, both on the demand side (sluggish demand in developed countries and the oligopolistic nature of their markets) and on the supply side (the competitive nature of most non-oil primary exports). You must also be familiar with the results of empirical studies on this issue which are discussed in Ghatak and Thirlwall. It is also important to question whether the net barter terms of trade are the relevant measure. Other measures of the terms of trade and their relevance are discussed in Nafziger.

Most of the empirical analysis of the Prebisch–Singer hypothesis show that there is a decline, but the size of the decline is much smaller than early studies, and in some cases (tropical beverages) there is a rise over the studies period (see Grilli and Yang). However, what about the fact that many LDCs are now exporting manufactures? Sarkar and Singer argue that the NBTT of LDCs is still declining. This is come to be known as the Sarkar–Singer Hypothesis. However, Bleaney and Athukorala criticise this view, but Sarkar and Singer, through a short reply, defend their hypothesis.

The instability of export earnings is a related problem the argument being that primary commodities’ export earnings tend to be unstable, particularly in the short run, and that this is damaging to LDCs because it hinders their ability to import.

6 See Ghatak, pp.340–42; Thirlwall, pp.550–55.

Old ed

ition.

For ref

erenc

e only

.


84

You should be familiar with the meaning of export earnings instability (not to be confused with the trend in export earnings), how it affects LDCs’ economies and empirical findings on this topic. These issues are discussed in Ghatak7 who also discusses indices of export instability used in different studies.8

How should LDCs react in the face of such adverse conditions?

• Thirlwall discusses international commodity agreements, buffer stocks, restriction schemes and price and income compensation agreements – pp.559–67.

• Ghatak discusses the role of the United Nations Conference on Trade and Development (UNCTAD)9 and the formation of trading blocks – pp.347–49.

The success of newly industrialising countries (NICs) and BRICs (Brazil, Russia, India and China) has raised the possibility of other countries, such as Malaysia, South Africa etc., successfully emulating this group. This in turn has led to a new wave of protectionism, mainly in the form of non-tariff barriers (e.g. voluntary export restraints, standards, etc.) – since using tariffs would be contrary to World Trade Organization (WTO) rules unless they are used as an anti-dumping duty. One suggested response is that LDCs should trade more with each other and become more economically integrated. The issue of South–South trade and economic integration is discussed in Todaro and Smith.10

You need only be familiar with the basic concepts of the economics of integration, in particular trade creation and trade diversion.

Todaro proposes a number of reforms in DC–LDC trade relationships.11


• discuss the benefits of international trade

• state the case for and against tariff protection

• define terms of trade concepts and explain the causes and implications of developing countries’ terms of trade experience

• explain the causes and consequences of export earnings instability

• describe international arrangements for primary commodities and LDCs’ export earnings

• explain how to promote trade between developing countries.

Sample examination questions1. ‘There is no justification for tariffs except that they are a very important

source of revenue for developing countries.’ Discuss.

2. Does the finding that the net barter terms of trade for developing countries fall over time justify a protectionist policy?

3. Why do export revenues of LDCs fluctuate more than those of developed countries? Outline some of the effects of export instability.


8 See Ghatak, pp.358–60

9 See Ghatak,pp.344–47.



Old ed

ition.

For ref

erenc

e only

.

Chapter 10: Industrial development and related trade policy

85


Aims of the chapterThis chapter will consider industrial development of open economies. We start with import substitution, a phase that India and many Latin American countries went through, and export promotion strategies.


• discuss import substitution as a development strategy: rationale, policy characteristics and effects

• explain export promotion as a development strategy: rationale, policy characteristics and effects

• discuss the transferability of the strategy across developing countries

• discuss protectionism in developed countries and market access

• compare the views of export pessimists and export optimists and be able to use recent evidence to back one or the other argument.

Essential readingRay, D. Development Economics, Chapter 17.Thirlwall, A.P. Growth and Development with Special Reference to Developing


Further readingGhatak, S. Introduction to Development Economics. Chapter 10.Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development,

Selections III.A and III.B.Nafziger, E.W. Economic Development, Chapter 17.

IntroductionIn Chapter 8, we addressed some of the problems of agricultural and rural development. In Chapter 9 we covered some of the problems (the terms of trade, export instability) resulting, at least in part, from a concentration of developing countries’ exports in agricultural and other primary products. These issues, together with the observation that most developed countries are more industrialised than developing countries, contributed in the past to a widely-held belief that industrial development is essential for economic growth and development. It is one thing for industrialisation to be a legitimate policy objective and another to design an appropriate industrialisation strategy. Industrialisation strategies and their associated trade policies are the subject matter of this chapter.

At the outset it is worth noting that the terms ‘industry’ and ‘industrialisation’ usually refer to the manufacturing sector. Although

Old ed

ition.

For ref

erenc

e only

.


86

one can quite legitimately refer to the agricultural industry, ‘industry’ or the ‘industrial sector’ is usually defined to include sectors other than manufacturing such as power generation, transport and communications, and water supply. Development of these sectors, often collectively referred to as physical infrastructure, is essential for the growth of all other production sectors – agriculture, manufacturing and services. In common with the terminology adopted in the textbooks, manufacturing and industry will be considered as synonyms in what follows.

Industrialisation strategies 1: import substitutionNow read:


Economies, pp.542–47.Todaro, M.P. and S.C. Smith, Economic Development, pp.621–22 and pp.626–34.

There are no universally-accepted definitions of import substitution and export promotion as strategies or exactly what constitutes an inward-oriented strategy as opposed to an outward-oriented strategy. However, a key element in definitions in this area is the degree to which domestic production is biased in favour of the domestic market relative to the export market.

You will recall that developing countries are less industrialised than their developed counterparts.1 You should also know that the demand for manufactures is more income – elastic than for primary products. As developing countries grow, a question arises: should they produce manufactures or import them from abroad? In the early stages of their economic development – and if international trade were perfectly free – developing countries would not be significant producers of manufactures because their comparative and absolute advantages dictate otherwise. If policy-makers in developing countries want to increase domestic industrial output, they must raise the returns to factors of production engaged in industry relative to those engaged in other sectors.

One way of doing this is by protecting domestic producers of manufactures from imports (foreign competition); typically tariffs and import quotas have been the most commonly used measures. You were directed to the infant industry argument for protection and its analysis in Chapter 9: ‘The arguments against free trade’. The case for policy intervention (irrespective of what that policy is) is only valid if the present value of the discounted social benefits of the policy at least equals the present value of the discounted social costs of the policy. It is the extensive and potentially large costs arising from direct protection from imports – referred to in the following paragraphs – which have severely damaged import substitution as an industrial development strategy. Also, to the extent that the current cost disadvantage of a domestic industry is solely the result of a market distortion, economic theory says that the best policy is to remove that distortion by, for example, subsidising the use of a specific input, rather than providing blanket protection to all factors of production employed in the industry: that is, tariff or quota protection can rarely be justified on the grounds of economic efficiency.

1 Chapter 2: ‘Characteristics of developing countries’.

Old ed

ition.

For ref

erenc

e only

.


87

You must, therefore, be able to present a formal analysis of the static effects of tariff protection and to understand the concept of effective protection and formulae used for its calculation. In this context you should be aware of the rather ad hoc way in which tariffs and other protective devices have actually been introduced by many developing countries, with the result that the degree of effective protection varies considerably between and within both consumer goods and producer (capital) goods industries. Effective protection measures the extent to which nominal protection of an activity effectively taxes activities which use the output of the protected activity as an input: that is, industries/sectors which are forward-linked to the protected industries/sectors are discriminated against.

You also need to know why protection results in exchange rate distortion: the rate is moved away from its free trade value. Irrespective of how the exchange rate is defined (units of foreign currency per unit of domestic currency, or units of domestic currency per unit of foreign currency), the domestic currency appreciates. The actual official exchange rate may be overvalued relative to the competitive equilibrium rate.2

Using your knowledge of tariffs, the concepts of effective protection and exchange rate overvaluation, you should be able to identify and discuss the effects of an import substitution strategy especially with respect to domestic prices, consumers, exports, the agricultural sector, the choice of technique in manufacturing, rent-seeking and income distribution. Adverse impacts in these areas – the costs of the strategy – together with the observably superior performance of some countries which adopted a different approach to industrial development led to dissatisfaction with the strategy and, in some countries, to its abandonment in favour of what is referred to as a more outward-oriented strategy.

Industrialisation strategies 2: export promotionNow read:

Essential readingRay, D. Development Economics, pp.676–84.

Thirlwall, A.P. Growth and Development with Special Reference to Developing Economies, pp.533–37 and pp.547–48.

Todaro, M.P. and S.C. Smith, Economic Development, pp.622–26.

Further readingGhatak, S. Introduction to Development Economics, pp.349–56.

Recalling the first paragraph of ‘Industrialisation strategies 1: import substitution’ earlier in this chapter, a feature of export promotion is that there is no policy bias against exports relative to domestic sales: in this sense ‘export promotion’ should more correctly be regarded as a neutral trade policy regime. Thus a neutral regime can consist of a combination of measures which protect some activities while increasing the profitability of exporting the output of other activities. A genuine export promotion strategy requires the effective rate of subsidy to be higher for exports than for domestic sales.

All the books list and discuss the advantages of exports and/or neutral or export promotion policies. References to empirical work in this area and on the related question of the relative performance of countries following different trade strategies are also given in most textbooks.

2 See Ghatak, pp.335.

Old ed

ition.

For ref

erenc

e only

.


88

Although the bulk of the evidence weighs heavily against the import substitution strategy, you should be aware that several of the countries which are usually thought to have experienced rapid economic growth as a consequence of their outward-oriented strategy did in fact follow an import substitution strategy either for certain industries or in an earlier period. For the purposes of clarity in this subject guide, import substitution and ‘export promotion’ have been presented as alternatives, but you should realise that many countries have used both approaches, and the distinction between them in practice is not so stark as is implied in this and the preceding section.

Export promotion: transferability, market access and the move away from import substitution

Now read:

Essential readingRay, D. Development Economics, pp.684–90.Todaro, M.P. and S.C. Smith, Economic Development, pp.639–45.

Further readingGhatak, S. Introduction to Development Economics, pp.347.Kavoussi, R.M., ‘International Trade and Economic Development: The Recent

Experience of Developing Countries’, The Journal of Developing Areas, 19,1985, pp.379–92.

Singer, H. W. and P. Gray, ‘Trade Policy and Growth of Developing Countries: Some New Data’, World Development, 16, 1988, pp.395–403.

There has been a debate on whether the experience of the NICs – countries which have achieved rapid export growth rates (especially of manufactures) – can be replicated by other or all developing countries. There is no reason why all countries should be expected to have the same potential export performance. Resource endowments differ across countries and, although resources can be created (for example, labour with particular skills) and international trade, migration and investment enable all countries to use the world’s resources, we are a long way from a situation in which absolute advantages are similar across countries. In such circumstances, countries with a comparative advantage in the production of goods and services for which demand is expanding rapidly will, other things being equal, experience more rapid export growth. Thus a country’s export performance is and will be dependent upon both supply factors (whether the country can respond to changes in patterns of demand) and demand factors.

An important factor on the demand side is market access for manufactures in developed countries. The latter do use tariff and non-tariff barriers (for example, voluntary export restraints and anti-dumping duties) to limit developing countries’ access to their markets for manufactures. These impose costs on developed countries’ consumers in exactly the same way as protection in developing countries does.

You should be able to discuss market access in these general terms, noting that effective rates of protection tend to increase with the degree of processing and that some trade preferences, including the Generalised System of Preferences (GSP), are extended to developing countries.

Old ed

ition.

For ref

erenc

e only

.


89

Recently, the success of countries such as India and China, and before that the NICs, which is/was based on exports, has given the upper hand to trade optimists (those who promote export led/outward orientated development strategy) over trade pessimists. These arguments are presented in Todaro and Smith (pp.639–43), and some examples are given in Ray (pp.684–90). However, Kavoussi has argued that neither the optimists not the pessimists are correct at all times. When the world economy expands, as it did between, say, 1960–73, the more export – orientated countries outperformed others. When the world economy slowed down, as for example during 1973–77, the more open economies had more problems. Singer and Gray confirm this hypothesis.


• discuss import substitution as a development strategy: rationale, policy characteristics and effects

• explain export promotion as a development strategy: rationale, policy characteristics and effects

• discuss the transferability of the strategy across developing countries

• discuss protectionism in developed countries and market access

• compare the views of export pessimists and export optimists and be able to use recent evidence to back one or other argument.

Sample examination questions1. What are the main features and effects of an industrialisation strategy

based on protection from imports?

2. Analyse the static effects of a tariff. Discuss the limitations of nominal tariff rates as indicators of the degree of protection.

3. ‘Theory suggests that export promotion is a preferable strategy to import substitution and evidence supports this view.’ Discuss.

Old ed

ition.

For ref

erenc

e only

.

Notes


90

Old ed

ition.

For ref

erenc

e only

.

Chapter 11: Economic development and the environment

91


Aims of the chapterIn all the definitions of development, there is some notion of growth. However, growth is not costless. We are all aware of the problems with the ozone layer, the greenhouse effect and global warming, and flash floods. This chapter will consider the environmental impacts of economic activity, including its effect on natural resources and environmental degradation. We argue that social cost–benefit analysis can be used as a tool to assess the environmental impact of growth. The concept of sustainable development is defined and studied. Finally it is argued that the environment has an international dimension: it is a global public good.


• explain and discuss the nature of the inter-relationships between economic activity, poverty and the environment

• explain the conditions for the efficient use of renewable and non-renewable resources

• define the concept of economic rent and the significance of rent capture

• explain the nature and causes of environmental degradation, and solutions to environmental degradation

• demonstrate the application of social cost–benefit analysis to environmental matters

• define the concept of sustainable development and discuss its operational implications

• explain developed countries’ involvement in developing countries’ environmental problems.




Selection X.Nafziger, E.W. Economic Development, Chapter 13.

IntroductionThe subject matter of this chapter is relatively new. Thorough and rigorous analysis of environmental issues, many of which were unknown 30 or so years ago, is a relatively recent phenomenon. Formerly, the flow of

Old ed

ition.

For ref

erenc

e only

.


92

resources from the natural environments of developing countries was more or less simply regarded as a factor of production in their production function, usually represented by the term land. This is certainly not meant to imply that the inhabitants of LDCs, especially farmers and hunter-gatherers, did not appreciate the value of the environment. Indeed, they were, and still are, very conscious of the role of the environment and practised some forms of environmental management. Land-based societies are highly dependent upon natural resources and environmental processes for their survival. As we shall see, there is a complex set of interactions between economic activity and the environment, and the adverse environmental effects of certain types of economic activity have only recently been observed and understood. One reason for this is that knowledge and understanding of these sets of interactions (physical, chemical and biological) is incomplete. Issues concerning the environment in developing countries have become the focus of attention because the catalogue of known instances of environmental degradation in those countries has grown and because the international dimension of certain environmental problems (for example the climatic effects of tropical deforestation) has now been recognised. This chapter addresses those issues concerning natural resources and the environment which are central to the study of economic development. Throughout your study of this subject area you should pay particular attention to policy issues. These feature highly because many of the problems of environmental degradation in developing countries are either caused by policy failure and/or can be rectified, at least to some extent, by appropriate public policies.

Four of the recommended textbooks devote a chapter to the environment – Ghatak, Gillis, Thirlwall, and Todaro and Smith. Although there are a number of common themes, the authors approach them in different ways. Thus the order of topics covered in this chapter does not correspond with that of any of the books. Thirlwall is the most comprehensive in terms of formal economic analysis; references to the relevant issues are rather scattered in Meier. You are advised, first, to read the chapter references listed above in order to obtain an overview of the issues and then to use this chapter as a guide to more detailed study.

Economic activity–environment interactions1

Your first task is to appreciate the nature of some of the inter-relationships between economic activity and the environment. Although this, of itself, is rather descriptive, it not only puts the topics which follow into perspective but more importantly demonstrates how use of the environment contributes to economic development (and why environmental degradation might contribute to poverty) and how development affects the environment (why poverty might lead to environmental degradation). In Todaro and Smith, apart from Table 10.1, references to the relevant relationships are combined with his discussion of causes of environmental degradation; this treatment highlights poverty as both a cause and a consequence of environmental degradation. In Table 10.1 Todaro and Smith detail the productivity and health effects of several environmental problems; Ghatak illustrates (in his Figure 14.1) the diverse and widespread impacts of an external shock which initially reduces tree cover, and Nafziger (pp.425–26) lists economic manifestations of environmental degradation, and solutions.

1 Ghatak (1995) p.453; Todaro, pp.470–80.

Old ed

ition.

For ref

erenc

e only

.


93

Natural resourcesNatural resources are either renewable or non-renewable. You do not need to know details of the natural resource endowments of developing countries nor of their production and exports of fuels and non-fuel minerals. However, you should be aware of the important contributions the mining sector makes to output and exports for some LDCs, because the extraction of minerals provides scope for the government to capture some of the associated rents.

The next task in this area is to know the conditions for the efficient harvesting of a renewable resource and the conditions for the optimal depletion of a non-renewable resource.2 Note that two variables are common to both conditions as expressed in Thirlwall’s equations 11.2 and 11.3 – the proportionate gain in the value of the stock and the discount rate, the former being related to the total economic value of the stock are more fully discussed in a later section.3 At this stage it is important to note that the marginal social value of a resource will typically not be equal to its current price. As Thirlwall points out in the derivation of his equation 11.3 and discussion of his Figure 11.6, this discrepancy is crucial in the matter of maximising the economic rent from a non–renewable resource.

Different concepts of rent are analysed by Ghatak (in the case of fuelwood harvesting) and by Todaro and Smith.4 You should understand the concept of rent and why, if the market price is not equal to the marginal social value, government policy has a role, if the social value of the stock of the non-renewable resource is to be maximised.

Here we introduce the concept of natural capital: non-renewable resources are a part of a country’s natural capital.5 Extraction of a non-renewable resource is nothing less than the depletion of the stock of natural capital. If a country is going to deplete its natural capital it should maximise the social return from such depletion.

Environmental degradationA useful introduction to this part of the subject would be to familiarise yourself with the diverse types of environmental problems found in LDCs; examples of these, which typically pose fundamental dilemmas for policy-makers, are presented in Todaro (see Table 10.1). However, you may be better acquainted with other instances in your own country. Whichever examples you know, bear them in mind as you study the economics of environmental degradation to which we now turn.

The main issues are:

• what are the causes of environmental degradation?

• what are the solutions and their associated problems?

One method of categorisation is to claim that, in general, environmental degradation is caused variously by poverty, ignorance, or institutional failure, including:

a. market failure: rules governing economic decision-makers (for example, property rights) in addition to externalities, public goods and non-competitive markets; and

b. organisational failure, including public organisations, which affect the functioning of markets (includes policy failure).

2 Thirlwall, pp.347–49.

3 See ‘The environment and social cost–benefi t analysis’ – in this chapter.

4 Ghatak, p.465; Todaro and Smith, pp.480–82.

5 Thirlwall (1994) p.227.

Old ed

ition.

For ref

erenc

e only

.


94

In many instances environmental degradation is caused by a combination of factors. For example, the tragedy of the commons6 typically results from market failure (the system of property rights gives rise to an externality) together with poverty as each ‘commoner’ seeks to derive the maximum private benefit from the open access or common property resource. Todaro uses a neoclassical model of resource use to explain the ‘tragedy’ and points out that private property rights might have adverse equity effects.

For each cause of environmental degradation you should be able to propose an appropriate solution.7 Solutions will often involve the reversal of inappropriate public policies (for example, subsidised credit or tax concessions for resource use or extraction). You should also be able to identify any problems associated with a particular solution. For example, changes in the law or more effective enforcement of the law may be necessary in order to achieve secure and transferable property rights, and Ghatak points out that devaluation, a frequently advocated policy designed to improve developing countries’ trade balances, encourages the use of forest resources.

The remainder of this section deals with more formal analysis of negative externalities, a major cause of environmental degradation. Here you are expected to know possible market and non-market solutions, applicable to LDCs, and their respective implementation problems. Ghatak (whose treatment might be confusing), Todaro and Thirlwall present these solutions.8

Thirlwall illustrates the externality problem with the example of overgrazing of land by ‘farmers’ upstream imposing costs (flooding) on ‘inhabitants’ downstream. His Figure 11.3 is reproduced as part (b) of Figure 11.1 below. Part (a), which may help you to interpret part (b), represents the market for good x, the output of the farmers upstream. If there are no positive consumption externalities, Dx equals the social marginal benefit of x. Farmers produce output Z where Dx = PMCx, the private marginal cost of x. Assuming a proportional relationship between the output of x and environmental degradation downstream, SMCx is the social marginal cost of producing x. Therefore the social optimum level of output is X. In part (b), MB is the farmers’ (net) marginal private benefit schedule: it is the difference between the price farmers receive and their marginal cost – that is, MB = (P – PMCx). It represents the net marginal benefit to farmers of increasing environmental degradation.

Figure 11.1 Solutions for a negative externality

6 Ghatak, pp.452–55; Todaro and Smith, pp.480–86.

7 Ghatak (1995) pp.464–65; see also the importance of correctly pricing environmental resources and the use of discount rates in the next section ‘The environment and cost–benefi t analysis’.

8 Ghatak (1995) pp.455–58 Thirlwall, pp.342–46.

Old ed

ition.

For ref

erenc

e only

.


95

The schedule is also known as the marginal abatement cost. This is minimised at the level of environmental degradation 0Z which corresponds to the profit maximising level of output 0Z’. The MC schedule is the marginal cost to the inhabitants downstream; it is the marginal external cost (MEC) of environmental degradation and is the difference between the social and private marginal costs of producing x – that is MC = (SMCx – PMCx). Thus the social optimal level of environmental degradation is 0X, corresponding to output level 0X’.

How can these levels be achieved? Thirlwall analyses three possibilities, the first two involving public policy:

• a Pigovian tax, imposed on farmers, equal to the marginal cost of environmental degradation at the optimum level of environmental degradation (also analysed by Todaro and Smith, p.490)

• administrative or legal action: for example, imposing a maximum permitted amount of environmental degradation or standard.

Coasian bargainsA third possibility is that when the property rights are well defined and transaction costs are zero (or low) the competitive market can reach the optimal amount of externality. This is called Coase’s theorem. Understanding Thirlwall’s analysis of the application of Coase’s theorem may be aided by the following. If, initially, the farmers have the legal right to the environment and thus to cause degradation, then the inhabitants are prepared to pay them up to XACZ to reduce degradation from Z to X while the minimum compensation farmers will accept to reduce degradation by this amount is XAZ. Similarly, if initially the inhabitants have the legal right to a non-degraded environment, farmers will be prepared to compensate the inhabitants up to a maximum of OBAX and the inhabitants will be prepared to accept a minimum compensation of OAX for farmers to cause OX degradation.

Thirlwall identifies the problems associated with each of these possible solutions, for example determining the MC function in Figure 11.1 and hence the Pigovian tax rate or the maximum permitted amount of degradation. To his list of assumptions for Coasian bargains, one should add that bargaining is assumed to be costless. This is unlikely if there are many farmers and many inhabitants. Note, too, that these solutions do not address considerations of equity: the ‘inhabitants’ might have a much higher average income than the ‘farmers’.

You will appreciate that these approaches to the externality problem would, in practice, require knowledge of the physical nature of the externality and of the total economic value of the resource or environment in question. The latter concept is treated in the next section.

The environment and social cost–benefit analysisCost–benefit analysis is usually used by policy-makers in their decisions concerning investment in physical assets. A reafforestation project can be similarly regarded – but the technique can be usefully applied to other environmental questions such as what are the social costs and benefits of alternative uses for a particular tract of land including leaving it intact? By viewing environmental issues in this way, you will enhance your understanding of the role of the environment in economic development and it will enable you to see how public policy can affect the use of the environment. As in the case of investment

Old ed

ition.

For ref

erenc

e only

.


96

projects, the application of cost–benefit analysis requires, among other things, prices which correspond to the true opportunity costs of resources and the use of an appropriate social discount rate. This section addresses these two issues.

It will be apparent from your study of the causes of environmental degradation that prices, of environmental resources whether market- or government-determined, typically do not correspond to the marginal economic value of those resources or, in other words, they do not equal marginal social cost. Thus your first task in this area is to understand the concept of total economic value and to appreciate the problems of identifying and then valuing the various benefits of an intact resource. Ghatak covers this in the context of tropical forests.9

In Ghatak’s terminology, prices typically cover only the actual use value; in Thirlwall’s terminology, prices typically cover only the private marginal cost of production. Thus the option value and existence value of a resource are often ignored. Estimating the latter is especially difficult. One reason for this is that all the effects of, for example, the total destruction of a tropical rainforest are not known with certainty. Notwithstanding the conceptual and practical difficulties of putting into effect the concept of total economic value, there is a consensus that the prices charged for the use of an environmental resource must be raised closer to opportunity cost.

You will already be familiar with the social discount rate.10 Policy-makers face a dilemma when choosing a discount rate for projects which affect the environment: a high rate penalises those projects which only generate significant benefits in the long run (a reafforestation scheme, for example); on the other hand, a low rate would increase the attractiveness of projects which deplete the environment (a logging operation, for example).

The concept of sustainable development11

The term sustainable development has become popular, but since there is no consensus as to its definition, it gives rise to much confusion and it is far from obvious how to use it in practice. The recommended books offer the following definitions, at least one of which you should know:

• the development path that maximises the long-term net benefits to humankind

• development that meets the needs of the present generation without compromising the ability of future generations to meet their own needs.

The concept raises a number of issues.

The first concerns the question of the treatment of inter-generational equity. How can this, implicit in the concept, be achieved when it is not clear that the welfare of individuals can be compared? The concept is devoid of any consideration of the ability of future generations to deal with environmental problems; indeed, it is silent on the productivity of those generations. If total economic values are correctly determined there is no need to change the social discount rate in order to ensure that sufficient natural capital is passed on to future generations.

The second issue concerns natural capital – its role, its comparability with other forms of capital and its transformation into those other

9 Ghatak, pp.464–65.

10 See Chapter 6: ‘Project appraisal’.

11 Thirlwall, pp.357–58; Todaro and Smith, pp.471–72 and pp.503–10.

Old ed

ition.

For ref

erenc

e only

.


97

forms. Sustainable development may well require that an item of natural capital be converted into other forms of capital including other types of natural capital. On the other hand, there is a strong case that certain ‘environments’ which provide unique or rare plant or animal habitats should be left intact.

The third issue is the accounting treatment of capital and certain types of expenditure. As you will know, national income accounts permit the calculation of net domestic product by taking into account the depreciation of physical capital. It is argued that natural capital should be similarly treated; otherwise, observed economic growth may not be all that it seems. Full incorporation of natural capital’s depreciation requires accurate estimation of the stocks of the very diverse types of natural capital and the flow of services from these . The resources which would be necessary to undertake a natural capital or environmental audit would probably be very large, especially if the different types of capital were to be valued using a common numeraire (we are back to estimating total economic values). The inclusion of certain types of expenditures relevant to environmental matters in GNP or GDP calculations affect the indicators of economic welfare. For example expenditure in cleaning up an oil-spill raises GDP but the negative environmental impact of that oil-spill is not included in GDP calculations.

International dimensions12

The issues discussed in this chapter are not confined to developing countries. Developed countries, too, face problems of environmental degradation. Certain dimensions of ‘the environment’ are international, indeed global, as some externalities transcend national borders. Action on the environment which recognised this international dimension culminated in the United Nations Conference on Environment and Development (the Earth Summit, Rio de Janeiro) in June 1992. You do not need to know details of the main forms of ‘global pollution’ for which the developed countries are primarily responsible. However, you should know know why, on account of the positive externalities involved, it is in the economic interests of developed countries to assist LDCs to prevent certain types of environmental degradation. Ghatak provides the relevant analysis, conceptually similar to the discussion of Figure 11.1(b) in this chapter, of the conservation of tropical forests. You should also know how various measures that could be undertaken by developed countries (trade liberalisation, debt relief, etc.) would help developing countries tackle their environmental problems.


• explain and discuss the inter-relationships between economic activity, poverty and the environment

• explain the conditions for the efficient use of renewable and non-renewable resources

• define the concept of economic rent and the significance of rent capture

• explain the nature and causes of environmental degradation, and solutions to environmental degradation

12 Ghatak, pp.467–68.

Old ed

ition.

For ref

erenc

e only

.


98

• demonstrate the application of social cost–benefit analysis to environmental matters

• define the concept of sustainable development and discuss its operational implications

• explain developed countries’ involvement in developing countries’ environmental problems.

Sample examination questions1. What are the economic causes of environmental degradation in

developing countries? Outline appropriate government policies to tackle these causes.

2. ‘The argument that a moral obligation to future generations demands special treatment of environmental investments is fatuous’. Discuss.

3. Explain the conditions for the efficient use of renewable and non-renewable resources. What actions should a government take if the price of a non-renewable resource does not fully reflect its social value?

Old ed

ition.

For ref

erenc

e only

.

Chapter 12: Gender and development

99


Aims of the chapterThis chapter covers gender issues in economic development. It is generally argued that women are treated as the less equal partners. This chapter argues that women receive less education, fewer health services, lower wages for the same jobs, etc., than men. Moreover, development programmes and policies are generally male – biased.

Learning objectivesBy the end of this chapter, and having completed the Essential reading, you should be able to:

• explain the role of women in economic development

• discuss the differential treatment faced by women in many LDCs

• outline and discuss the meaning and the implication of female marginalisation theorem

• discuss which policies would promote the status of women in underdevelopment.

Essential readingTodaro, M.P. and S.C. Smith, Economic Development, pp.227–31, 241–47,

333–34, 376–79.

Further readingArabsheibani, G. R., ‘Male–Female Earnings Differentials in an Islamic Country:

The Case of Highly Educated Egyptians’, Education Economics, 8(2) 2000, pp.129–38.

Arabsheibani, G. R., F. G. Carneiro and A. Henley, ‘Gender Wage Differentials in Brazil: Trends over a Turbulent Era’, 2003. The World Bank Research Policy Paper 3148.

Arabsheibani, G. R. and L. Manfor, ‘From Farashia to Military Uniform’, Economic Development and Cultural Change, 50(4) 2002, pp.1007–21.

Boserup, E. Women’s Role in Economic Development. (London: Earthscan Publications, 1989) [ISBN 1853830402].

Elson, D. Male-Bias in the Development Process. (Manchester: Manchester University Press, 1995) [ISBN 9780719042300].

Meier, G.M. and J.E. Rauch (eds) Leading Issues in Economic Development, Selection IV.D.1., IV.D.2. and IV.D.3.

Nafziger, E.W. Economic Development, Chapter 5.Oster, E. ‘Hepatitis B and the case of Missing Women’, Journal of Political

Economy, 116(5) 2005, pp.1163–16.

IntroductionAlthough many books have been written on women and development or gender issues in development, not many textbooks cover such material, and when they do it is in a patchy way. For example, none of the recommended textbooks allocate a chapter to this topic. Sometimes, sub-sections of chapters are dedicated to the subject. This makes referencing in this chapter quite difficult, and different compared to other chapters

Old ed

ition.

For ref

erenc

e only

.


100

in this subject guide. If you are particularly interested in this topic we encourage you to read the sub-sections and then try to place the material in an overall framework. In doing so, keep the following important issues in mind:

• what is the role of women in economic development?

• do women realise their potential role? If not, why not? Obviously, here the role of gender bias and discrimination against women becomes very important.

What can be done to improve women’s role in development?

To make referencing effective, this guide will go through the three main books and discuss what is covered.

Meier and Rauch is the most straightforward as it deals with three distinct selections. Selection IV.D.1. discusses gender inequalities in labour supply, employment and earnings and proceeds to look at the control of resources and within household bargaining. Whilst women fare worse than men in LDCs, it is important to note that this also applies in developed countries. There are many published papers on discrimination against women. I have cited a number above but I would encourage you to find similar examples for your own country.

Selection IV.D.2. debates the issue of missing women. Sen raised this, by arguing that there are more than 100 million missing women in Asia alone, if we compare the actual sex ratios with the expected sex ratios. Many have argued that this is to do with population control policies in countries such India and China (one child policy). If there are strict controls on the number of children, then because of son-preference, female babies will be aborted. Recently, Oster has argued that women suffering from Hepatitis B Virus are 1.5 times more likely to bear male offsprings, and that a significant proportion of women in Asia suffer from this virus, hence it is natural to have high male–female ratio.

Selection IV.D.3 deals with women as policy makers and argues that a number of countries have introduced reservation policies (for example, in Morocco 30 per cent of seats in the parliamentary elections are reserved for women) and this has very important implications for public policy. The findings are that, under these circumstances, women elected as leaders tend to invest more in public goods more closely linked to women’s concerns (like drinking water) and less closely linked to men’s concerns (education or roads). At least this seems to be the evidence in West Bengal and in Rajistan (in India). Hence reservation policies seem to promote more female – orientated public policy.

Todaro and Smith discuss women and poverty (pp.227–31). The empowerment of women is an important part of the Millennium Development Goals. However, females form the majority of the world’s poor and female – headed households are the poorest of the poor. This is related to the fact that males earn more than females, either because they are endowed with more productivity augmenting characteristics, such as human capital (for example the Taliban banned education for females in Afghanistan) or because of discrimination. Furthermore, development policies/programmes aimed at raising productivity (e.g. training) seem to increase the male–female differential because more males participate in these programmes. This makes targeting education/health policies towards women very important. Todaro and Smith present the case study

Old ed

ition.

For ref

erenc

e only

.


101

of the Grameen Bank, a very successful experiment in Bangladesh (pp.241–47).

Todaro and Smith then consider women in the informal sector (pp.333–34), look at the gender gap in education and the consequences of gender bias in education and health (pp.376–79), and the role of women in agriculture (pp.440–42).

Nafziger discusses women, poverty, inequality and male dominance (pp.191–93), women and strategies to reduce fertility (pp.297–304), and entrepreneuship and gender (pp.407).

The two books mentioned on the role of women and gender and development should be read as a whole. Whilst they are useful reading, you must choose to allocate your study time efficiently to make sure you cover everything you need. The book by Boserup puts forward a very interesting proposition: that women get treated worse in societies assiciated with plough agriculture, where land is generally scarce, and men devise methods to marginalise women. In rotating agriculture, where land is not scarce, women’s position is higher. Elson discusses the female marginalisation theorem as well as the impact of development on women, and in particular the notion that the structural adjustment policies were male – biased.


• explain the role of women in economic development

• discuss the differential treatment faced by women in many LDCs

• outline and discuss the meaning and the implication of female marginalisation theorem

• discuss which policies would promote the status of women in underdevelopment.

Old ed

ition.

For ref

erenc

e only

.

Notes


102

Old ed

ition.

For ref

erenc

e only

.

Appendix 1: The Solow model

103

Appendix 1: The Solow model

A. With no technical progressThe assumptions are:

• In the absence of technical progress, the aggregate (one-good) production function exhibits constant returns to scale and positive but diminishing returns to capital.

• The labour force grows at an exogenously determined rate, n; saving is proportional to income (the average propensity to save equals the marginal propensity to save s).

• For simplicity, we also assume no depreciation.

Y = f (K, L) the production function

Define y = YL

(output per worker) and k = KL

(the capital–labour ratio)

y = f(k) output per worker is a function of the capital–labour ratio

y = f(k) change in output per worker is a function of the change in the capital–labour ratio.

Now the rate of change in the capital–labour ratio = rate of change in K – rate of change in L

∴ Δ (K/L)K/L = ΔK

KΔLL = Δk

k (A3.1)

With no depreciation, K = I = S = sY in macroeconomic equilibrium.

Substituting K = sY and n = LL (the rate of growth of the labour force)

into A3.1 gives:

k = sY – n k K

k = sY . K – nk K L

k = s.Y – nk L

Substituting f(k) = Y gives L

k = sf(k) – nk Solow’s fundamental equation

= fYL [ [

∴KL

LL

,

= fYL [ [

∴KL

recall that k = K L

Old ed

ition.

For ref

erenc

e only

.


104

B. Incorporating technical progressThe production function used above can be manipulated as follows:

Y = (K, L)

Y = KL1– assuming constant returns to scale

and KLy = Y

L = KL

αL1-α KL

α

= α =α

= θα

Therefore the rate of growth of output per capita is:

= αyy

•( ) f

f

•( )

In the steady state because the growth of output, g = n, the exogenous rate of growth of the population, then income per capita growth is zero.

This is not supported by facts and hence raises the possibility that, if there is technical progress, it should be incorporated into the model.

This can be done as follows. The production function is modified to include technical progress:

Y = eatKL1–

so that per capita income is:

Y = eat KL

= eat

and per capita income growth is:

= a + αyy

•( ) θ

θ

•( )

In the steady state the rate of growth of KL

is zero so:

= ayy

•( )

that is, per capita income grows at an exogenous rate a.

However, the rate of growth of per capita income is the rate of growth of output minus the rate of growth of the population so:

= g–nyy

•( )

g – n = a that is, output or income grows at the rate a + n.

Old ed

ition.

For ref

erenc

e only

.

Appendix 2: Sample examination paper

105

Appendix 2: Sample examination paper

Important note: This Sample examination paper reflects the examination and assessment arrangements for this course in the academic year 2009−2010. The format and structure of the examination may have changed since the publication of this subject guide. You can find the most recent examination papers on the VLE where all changes to the format of the examination are posted.

Time allowed: three hours

Candidates should answer FOUR of the following TWELVE questions. All questions carry equal marks.

1. To what extent are theories used to explain the growth of advanced countries relevant to developing countries?

2. Examine the possible effects of rapid population growth.

3. What are the dimensions of economic development? How can they be measured?

4. What are the causes of inflation in developing countries? Use your analysis to outline an anti-inflationary strategy for a typical developing country.

5. Identify and discuss measures which donors and recipients could adopt to improve the effectiveness of aid in promoting economic development.

6. How can aggregate growth models and input–output models assist in the planning process?

7. Discuss what is meant by malnutrition and propose policies to reduce it.

8. To what extent can the export success of some newly-industrialising countries be copied by all developing economies?

9. Outline the reasons why factor prices in developing countries are distorted. What problems are caused by such distortions?

10. What is the impact of the Green Revolution on income distribution in rural areas of LDCs?

11. Discuss how peasant households may react to a rise in the price of their output.

12. Explain some of the arguments in favour of protectionism in developing countries.

END OF PAPEROld ed

ition.

For ref

erenc

e only

.

Notes

106


Old ed

ition.

For ref

erenc

e only

.

Important note - · PDF file · 2015-12-07Important note amner commentare ... equal...

Documents

Transcript of Important note - · PDF file · 2015-12-07Important note amner commentare ... equal...