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Publisher Notice Development Economics Revision Toolkit 2005 Published by: Tutor2u Limited. 19 Westwood Way Boston Spa Wetherby West Yorkshire LS23 6DX www.tutor2u.net Online Learning Resource of the Year 2003 (BETT Awards) 1st Edition First published 15 September 2004 © Tutor2u Limited 2004. All rights reserved. ISBN 1-84582-005-3

TABLE OF CONTENTS

DEVELOPMENT CONCEPTS ................................................................................................4 What is development? ........................................................................................................4 Growth and development....................................................................................................5 Measuring development .....................................................................................................6 Classification of Development..............................................................................................8

STAGES OF DEVELOPMENT ................................................................................................9 Sectors of an Economy .......................................................................................................9 Similarities and Differences............................................................................................... 11 Economic, Social and Political Influences............................................................................. 13

MODELS OF DEVELOPMENT............................................................................................. 15 Absolute and comparative advantage .................................................................................. 15 Rostow’s Theory of Development ........................................................................................ 18 Lewis Two-Sector Model.................................................................................................... 20 Harrod-Domar model ....................................................................................................... 22 Dependency theory.......................................................................................................... 23 Balanced and Unbalanced Growth Theory............................................................................. 25

DEVELOPMENT POLICY.................................................................................................. 27 Domestic policies to promote development - overview............................................................ 27 Import substitution and export promotion ........................................................................... 29 Import substitution and export promotion ........................................................................... 29 Structural Adjustment...................................................................................................... 30 Macroeconomic stabilisation ............................................................................................. 31 International Policies to Promote Development - Overview ...................................................... 32 Aid ............................................................................................................................... 35 Foreign Direct Investment – pros and cons ........................................................................... 37 International Institutions................................................................................................. 38

PROBLEMS OF DEVELOPMENT .......................................................................................... 41 Internal problems of developing economies ......................................................................... 41 Rural-urban migration ..................................................................................................... 45 Environment and sustainability.......................................................................................... 46 External problems of developing economies ......................................................................... 48 Globalisation.................................................................................................................. 50 Price instability .............................................................................................................. 52

DEVELOPMENT ECONOMICS GLOSSARY ................................................................................ 54

tutor2u™ Development Economics Revision Toolkit ( 4 )

© tutor2u Limited and Deborah Smithies 2004 http://www.tutor2u.net

Development Concepts

What is development?

Introduction

The dictionary definition of ‘development’ is to improve, to progress, or to grow – but economic development is not just about economic growth (see our revision note on economic growth to better understand the difference between the two).

Different definitions

Dudley Sears defined development as “the reduction and elimination of poverty, inequality and unemployment within a growing economy”. Under this definition, development is essentially about improving the incomes of those living in poverty.

Some economists have taken a wider view of development. Amartya Sen, in his Nobel prize-winning book “Development as Freedom”, sees development as being concerned with improving the freedoms and capabilities of the disadvantaged, thereby enhancing the overall quality of life. Development should be about increasing political freedom, economic freedom, and social freedom (welfare provisions etc) – not just about raising incomes.

In essence: development economics is concerned with the study of the causes of problems facing those economies where the majority of the population are in absolute poverty, and with finding solutions to those problems in order to raise the quality of life.

The objectives of development

Michael Todaro specified three objectives of development (quoted in full, with his italics):

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

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

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

Note the emphasis on ‘cultural and human values’, ‘self-esteem’ and freedom from ignorance; it is important to remember that economic development is about much more than simply achieving economic growth. See the revision note on ‘growth and development’ for more on this.

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Growth and development

Introduction

Economic development is about raising standard of living – but we must beware of confusing standards of living with levels of economic growth. Raising a country’s GNP will not necessarily improve the lives of those who live there.

The difference

Economic growth is a sustained increase in national income. This is often brought about by an increase in the productive capacity of the economy.

Growth is usually measured using Gross National Product per capita – the aggregate monetary output of the economy divided by the population.

Economic development is much more complicated. It is concerned with the improvement of human welfare within an economy, and so it encompasses such concepts as standard of living, cultural identity and political freedom.

The most common measurement of development is the Human Development Index (see revision note on measuring development).

Clearly, an increasing GNP will often indicate that people’s lives are getting better – but there are several reasons why this might not always be the case.

Examples

1. An economy in which wealth is distributed very unequally. If most of a country’s wealth is in the hands of a small elite, they are likely to be the only ones who gain from an increase in GNP. No real development can occur if the general population are prevented from benefiting from the economy’s growth. An example might be the oil-rich economies, where most wealth lies with rich oil sheiks.

2. An economy in which income is spent irresponsibly. If a large percentage of GNP is frittered away on tanks and nuclear warheads, the general public are unlikely to benefit from increases in GNP. If the government spends lots of money on health, education and social welfare, then the people are far more likely to see rising standards of living when national income rises.

3. An economy in which subsistence farming is widespread. If a significant proportion of output is consumed rather than sold, then national income figures will understate human welfare levels. If one year a farmer decides to sell part of his crop, then national income figures will show that economic growth has occurred – but we cannot really say that the economy has developed.

4. Finally, many economists have argued that economic development should include a move towards political freedom. A rising GNP is unlikely to really raise standards of living if the people are politically oppressed; giving the general public the right to choose who governs them is usually seen as an important part of the process of development.

Key terms Standard of living




Measuring development

Introduction

The revision note on the meaning of development showed that development is about quality of life rather than just being about incomes. How can economists measure such qualitative factors?

The Human Development Index

The most common measurement of development is the Human Development Index (HDI). This is the average of three indices based on three different variables:

- Life expectancy at birth

- Education – a weighted average of adult literacy (two-thirds) and average years of schooling (one third)

- Real GNP per capita – measured in US dollars, at purchasing power parity exchange rates.

Clearly, this index gives us a better way of estimating standards of living than just GNP taken on its own. However, it is still far from perfect. Economists have recently been looking at ways to include other factors in the measurement, such as income distribution (perhaps using the Gini coefficient), gender inequalities, and inequalities by region or by ethnic group.

What exactly are we trying to measure?

How we go about measuring development will clearly depend on how exactly we define development. If we use Michael Todaro’s definition, then HDI notably fails to take account of more qualitative factors, such as cultural identity and political freedom.

There are plenty of other factors which might also help us judge a country’s level of development – such as access to clean water, the percentage of buildings with electricity, or access to good roads and rail links.

It would be incredibly difficult to find a measurement which would give us a complete picture of a country’s development; there are simply too many factors that could be taken into account.

The difficulties in measuring development

- Developing countries often have high levels of subsistence agriculture. Since no market transaction occurs where this takes place, any produce used for subsistence is not included in the measure of GNP. This will distort the final HDI figure. In recent years, economists have made allowance for this non-market component – but it is still thought to be hugely underestimated.

- The GNP per capita figure – and consequently the HDI figure – takes no account of income distribution. If income is very unevenly distributed, then the GNP per capita will actually be a very inaccurate measure of the monetary wellbeing of the people.

- Inflation must be taken into account. Fluctuating rates of inflation will mean that similar goods have different values over time. Countries with high rates of inflation will appear wealthier. Thus, the effects of inflation must be removed from the national income figures – which is why it is real GNP per capita, rather than nominal, that is used in the HDI calculation.




- GNP figures can also be distorted by movements in exchange rates. GNP figures must be expressed in a common currency in order to be compared; but exchange rates are not always in line with the actual purchasing power of the currency. Thus under- or over-valuation of currencies will distort the comparison of different countries’ GNP per capita figures.

Still worth something, despite its flaws

Having noted all these difficulties, we must also bear in mind that the main practical purpose of the HDI index is to provide a means of ascertaining how living standards in any given country compare with other countries. Taken on its own, one country’s HDI figure is unlikely to tell us very much – but that is not its purpose. HDI is intended to allow economists to draw broad conclusions about which countries enjoy relatively high standards of living, and which are, by comparison, under-developed.

Key terms

Gini coefficient




Classification of Development

Introduction

Economists need some broad standard by which to determine which economies are developed, which are transitional, and which are developing.

The IMF model

The IMF identifies 24 developed economies – these are the major industrialised nations. The group is made up of the G8 (US, UK, Canada, Germany, Japan, France, Spain & Russia); 14 other European countries; and Australia and New Zealand.

The transitional economies are the 28 countries which emerged from the former USSR (such as Kazakhstan, Uzbekistan, the Ukraine), plus Central and Eastern Europe.

The rest of the world makes up the developing economies: all of the Western hemisphere (except North America); Asia (except Japan); the Middle East; and Africa. These amount to over 130 countries.

The newly industrialised economies are those countries of South-East Asia, such as Taiwan, Singapore and South Korea, which have recently enjoyed large increases in national income through rapid expansion of industrial exports.

The World Bank model

Clearly, this classification of developing economies is too wide to be useful. Thus, the World Bank uses national income figures to identify three broad groups.

High-income countries are those with an annual GNP per capita of $9,656 or higher (using 1997 values). High-income countries cover 17% of the world’s population – but they earn 49% of the world’s income.

Middle-income countries have a GNP per capita between $786 and $9655.

Upper middle-income: $3,125 - $9,655 (e.g. Uruguay)

Lower middle-income: $786 - $3,125 (e.g. the Philippines)

Low-income countries have a GNP per capita of $785 or less. They make up 44% of the world’s population, but only earn 17% of the world’s income.

A note on differentiated development

The Examiner requires you to be aware that specific areas and regions within a developed economy can display characteristics of a developing economy, such as poverty, high unemployment, and social deprivation.




Stages of Development

Sectors of an Economy

Introduction

We can look at economies in the light of several different distinctions, in order to gain an insight into where and how economic activity is taking place.

Industrial activity

There is a correlation between the structure of a country’s production and its national income. Poorer countries tend to have a much larger proportion of their resources devoted to the primary sector; as incomes increase, the balance shifts more towards industry and services.

The primary sector is the basis for exports in most developing countries. In sub-Saharan Africa, 95% of all exports are primary products. However, the sector suffers from price instability and a general downward drift in prices (see separate revision note). The sector is also beset by low productivity.

The secondary sector involves processing primary products, and tends to be urban based. It is generally much more productive – although we must note that the opportunity cost associated with expanding industry is usually a smaller primary sector.

The tertiary sector is made up of services, such as banking, lawyers, insurance, and retailers.

Some economists believe that countries must pass through the primary and secondary sectors before reaching the tertiary sector; but the expansion of tourism has allowed some countries to skip industrialisation and start concentrating on services rather than manufacturing.

The quarternary sector consists of those services which are solely aimed at the needs of businesses. Amongst these are commercial law, management consultancy, marketing, and e-commerce.

Rural and urban

One characteristic of development is the rural-urban drift. As urban incomes improve, rural workers are motivated to migrate to the cities. This can have detrimental effects on urban standards of living – see separate revision note for more detail.

Formal and informal

The formal sector essentially consists of all economic activity that the government knows about. Goods and services are produces by legally formed companies and registered traders; activity is controlled by legislation, such as health and safety guidelines; and companies keep records of their accounts and pay tax on their profits.

The informal sector involves economic activity which doesn’t officially take place. It is unregistered, unregulated, and often illegal. Transactions are unrecorded.

The informal economy consists of barter, mutual self-help, odd jobs, allotment farming, street trading, and other similar activities. Most of the world's population participate in their local informal economies.




It should be noted, though, that the informal economy can be much more efficient than the formal sector: it uses very little capital to provide exactly what consumers want, and it provides income and employment that wouldn’t be there if the industries were formalised.

Modern and traditional

The modern sector is the sector we would refer to as ‘industrialised’. It generally involves capital intensive, mechanised production techniques, high productivity, and low unit costs. Usually associated with the urban sector, modern production plants are often set up by foreign investors.

The traditional sector is much more labour intensive, making more use of human and animal power. The sector tends to be beset by low productivity, using basic tools and low technology. It is this low productivity that developing countries are trying to move away from.




Similarities and Differences

Introduction

With nearly 130 countries classified as ‘developing economies’ by the IMF, it is not surprising that there are many ways in which these countries differ; but we must first identify the characteristics that they tend to have in common.

Many of these factors are briefly mentioned here, but discussed in more detail in the other revision notes in this guide.

Similarities

- Low living standards. Almost by definition, low-income countries are very likely to have low standards of living.

- High population growth. In most developing countries, birth rates remain high (due to a lack of widespread use of contraception or family planning, amongst other things), whilst death rates have been falling slightly in most parts of the world, due to better diets, better healthcare, and higher standards of living.

- High levels of unemployment and underemployment. Most low-income countries fail to make full use of their available labour.

- Low productivity. The primary sectors of the developing world are often beset by low levels of productivity – due to the use of basic tools and technology and traditional methods.

- A narrowly focused economy. Low-income countries tend to concentrate on just one or two industries, and have failed to diversify.

- A dualistic economy. We usually find two distinct sectors: an industrialised urban sector, and an agricultural rural sector. The population is thus divided; the urban population has a higher standard of living and range of opportunities than the rural population. This causes rural-urban migration, which can have a very detrimental effect on urban quality of life.

- Lack of physical capital. Most have inadequate physical infrastructure, such as transport links, electricity, schools and hospitals.

Differences

- Size. Some are geographically huge, whilst others are really very small; some, such as India, have large GNPs, whilst others have tiny national incomes.

- Population. 83 developing countries have populations smaller than 5 million; but China and India together have 2 billion inhabitants.

- Resources. Different countries have different endowments of physical resources (e.g. the Middle East has lots of oil, whilst Zambia isn’t short of copper); moreover, we also find different levels of human resources – that is, different numbers of workers, educational levels, attitudes to work, and attitudes to change.

- Location. Most, but not all, are situated in the tropics, making them vulnerable to drought etc. Many are land-locked, which makes trade with other continents more difficult; some are in




close proximity to the developed world, which is an advantage in terms of trading with rich countries, whereas others are a very long way away.

- Ownership of the factors of production. In some countries, such as Cuba and North Korea, the state owns most of the factors of production. In others, such as the Latin American countries, private enterprise is more favoured.

- History. Some developing countries have, in the past, been colonised by Western countries such as Britain and Portugal; others were occupied by the Soviet Union during the Cold War, whilst others still have a much stronger tradition of independence.




Economic, Social and Political Influences

Introduction

There are very many factors which affect the level of development of an economy, some of which are economic, and some of which are more to do with culture and society. These non-economic factors do not receive much attention in the Development Economics module – unsurprising, since you’re doing an Economics A-level – but the Examiner requires candidates to be aware of these important influences on development.

History – colonial legacy

Much of today’s developing world – Africa, South America and Asia - was at some point colonised by powerful Europeans. The colonial powers exploited their colonies as rich sources of raw materials, and so industry in poor countries tended to be almost entirely based in the primary sector. That historical legacy is still causing difficulties today, as developing countries try to shift the balance of their industry into the secondary sector.

Systems of government

Different types of government will encourage or discourage free enterprise. The Soviet command economy, the largely authoritarian regimes of the Middle East, and the Communist system in China all worked to suppress free trade. Free markets, and the efficient allocation of resources which usually arises from them, can also be hindered by such factors as:

- Political instability

- Corruption in government

- The lack of an independent judiciary

- The lack of freedom of speech

- A biased police force and army

Culture

A country’s culture affects the attitudes of its citizens to all sorts of aspects of development. For example, rapid development requires an appetite for change, and so some commentators have pointed to China’s conservative attitudes to help explain their slow development. Development also requires a culture of self-interest, which is often not found in countries previously used to very communal lifestyles. Finally, the legal system has to protect private property rights, to guarantee the ownership of land, resources, and even of ideas.

Economic system

Most countries have some free enterprise and some government control, but the balance between the two is vitally important in trying to achieve development. The degree of government interference in the economy is often indicative of the level of development.

In terms of an economic infrastructure, any economy needs:

- A good financial network – that is, a central bank, and commercial banks to channel savings into investment.




- A good communications network – transport infrastructure, telephone lines, postal service etc

- An efficient civil service – to regulate economic activity and promote business.




Models of Development

Absolute and comparative advantage

Introduction

The principle of division of labour, or specialisation, states that it is more productive to assign production tasks so that each worker specialises in one or a few operations. This principle can also be applied to the international economy: countries can concentrate production on what they do best, and any surplus can be exchanged on the international market for the other goods that they require – thus increasing consumer choice and welfare.

Absolute advantage

If one country can produce more of a good than another country with the same amount of resources, then that country has an absolute advantage in producing that good. This occurs mainly because different countries have different factor endowments (for example, of natural resources, climate, or skilled labour forces).

Example

Say two countries, with the same amount of resources, produce different goods, dividing the resources they have equally between the two:

Country Guns Butter

A 1000 500

B 750 1500

World Output 1750 2000

Country A has an absolute advantage in producing guns, whilst Country B has one in producing butter. Both countries decide to specialise:

Country Guns Butter

A 2000 -

B - 3000


World output of both goods has increased. Now the countries trade their surpluses of 900 units each:

Country Guns Butter

A 1100 900

B 900 2100


The standard of living in both countries has improved:

- consumers have more choice as to which products they can buy




- The example above shows a world increase of 250 units of guns and 1,000 unit of butter. Country A benefits by 100 guns and 400 butter whereas Country B benefits by 150 guns and 600 butter.

Comparative advantage occurs where one country can produce a good for a lower opportunity cost than another country. An absolute advantage need not necessarily exist.

Example

Two countries, again with the same amount of resources, devote equal amounts of resources to the production of bread and wine:

Country Bread Wine

A 3000 1500

B 500 1000


Country A is better at producing wine and bread than country B, but B can produce wine for a lower opportunity cost – it has to give up less bread to produce 1000 units of wine than A would have to.

B decides to concentrate its efforts entirely on wine, whilst A switches half its resources engaged in wine production to bread production instead:

Country Bread Wine

A 4500 750

B - 2000


Again, the countries trade their surpluses, this time 800 units of each:

Country Bread Wine

A 3700 1550

B 800 1200


Both countries have more of both goods than they had to start with, so the consumers in both countries are better off. Country B can still gain from specialisation and trade, even though it does not have an absolute advantage in the production of either good.

The theory depends on the existence of a free market, mobility of factors of production (including zero transport costs), and a willingness to specialise. It also assumes appropriate exchange rates that reflect the opportunity costs of production for each country.

The importance of international trade

- Where international trade occurs, domestic producers have access to much larger markets, giving them the opportunity to expand production. They may achieve economies of scale, eventually reaching the lowest point on their long-run average cost curves and becoming more productively efficient.




- The access to larger markets may increase employment levels in the domestic economy.

- Increased exports will increase domestic income and foreign exchange reserves.

- As firms experience increased revenue and profits, they have more money to plug back into expansion and investment in the latest technology, research and development.

Possible drawbacks of specialisation

- Developing economies are in danger of overspecialising in the labour-intensive primary sector, since they have more cheap labour available than developed economies. This leaves them exposed to the problems associated with exporting primary products - namely price instability, barriers to trade such as the Common Agricultural policy, and diminishing terms of trade.

- More general problems arising from overspecialisation are the possibility of diseconomies of scale, and vulnerability to sudden changes in demand for the product. A sudden and drastic reduction in demand is likely to cause structural unemployment.

- Countries become dependent on imports of essential goods, and so shocks affecting trading partners, such as war or economic disaster, may prove dangerous for the domestic economy.

- Infant industries may find it impossible to gain a foothold in the international market, since they cannot be expected to compete with long-established foreign industries which already enjoy significant economies of scale.

- Foreign producers may engage in dumping, whereby they sell their output below what it cost to produce in order to gain a foothold in foreign markets.

Related glossary terms:

Specialisation

Absolute advantage

Balance of payments

Economies of scale

Opportunity cost

Efficiency

CAP

Terms of trade




Rostow’s Theory of Development

Introduction

Walt Rostow, writing as an economic historian, proposed a linear model of development, under which economies pass through five distinct stages before achieving developed economy status.

Stage 1 – Traditional society

Producers tend to use primitive technology, and produce largely for subsistence; whatever is left over is bartered. The economy is dominated by the primary sector, and production is labour-intensive. Social structures tend to be hierarchical.

Stage 2 – Preconditions for take-off

Technology and transport improve, and the gradual emergence of surpluses for trade over and above what producers need for their own subsistence allows trade, investment and savings to increase. The growth of education and entrepreneurship assist economic progress.

Stage 3 – Take-off

The last obstacles to economic growth are removed. During take-off, we see rapid economic growth and increasingly sophisticated technology. The savings rate (savings as a percentage of GNP) rises from 5% to at least 10%, facilitating significant levels of investment, primarily in the secondary sector. As a result, resources – particularly workers – are transferred from employment in the primary sector to employment in manufacturing industries. Growth tends to be concentrated in a few areas of the country and in one or two specific industries; the growth in these areas drives growth in the economy as a whole. New political and social institutions emerge to support the industrialisation process.

Stage 4 – Drive to maturity

We now start to find self-sustaining growth; investment increases to between 10% and 20% of GNP, and technology advances even further. Greater diversification occurs in both the primary and secondary sectors, and imports start to fall.

Stage 5 – High mass consumption

Consumer goods and services become increasingly important as the tertiary sector expands. The welfare state comes into being.

The implications of Rostow’s theory

- Savings and capital accumulation are the most important engines of growth; the key to development is to reach a high enough savings rate to generate the investment required to build up the economy’s capital stock.

- Therefore, development could stall at stage 3 if the savings rate is not high enough. Aid or loans may be needed to plug the ‘savings gap’.

The limitations of Rostow’s theory

- Rostow’s linear approach to growth theory has been seen as too simplistic. For example, high savings will not necessarily translate into high investment if there are no institutions in place




to channel savings into investment. Social and political conditions may make investment infeasible, for example if there is political instability, a lack of skilled workers, of a lack of infrastructure.

- More fundamentally, Rostow’s model implies that a country’s economic conditions will invariably improve over time, which has clearly not been the case in most of the developing world.

- The model suggests that all countries will imitate the economic experiences of Europe and America, but in reality, the economies of the developing world are far too diverse to make such an assumption.

- The stages Rostow describes may not be as distinct as he implies. They may well overlap; in any case, it is often difficult to see which point an economy is at, since the characteristics of each stage often prove too vague to measure.

- Rostow’s model is essentially a model for economic growth rather than development; he was more concerned with increases in GNP than with the performance of other indicators of human welfare, such as the Human Development Index. There are circumstances under which an economy can grow without achieving any increase in standards of living.


Subsistence

Savings rate

Gross National Product

Infrastructure

Human Development Index

Economic growth

Savings gap




Lewis Two-Sector Model

Introduction

The central idea of the Lewis model is that the backward agricultural sector has low productivity, whilst the modern industrialised urban sector has the potential to be far more productive.

The development trap: low productivity in the agricultural sector leads to low incomes, low savings, and therefore low investment. If investment is low, then it becomes very difficult to improve productivity.

The development path: high productivity in the industrial sector leads to higher incomes, higher saving, and therefore higher levels of investment. Significant investment will help to increase productivity in the sector, thus further increasing incomes and savings.

The model

- Lewis assumes that there are workers in the rural sector which have zero marginal productivity, and so can be transferred to the far more productive urban sector with no loss of agricultural output.

- Workers are attracted to the urban sector by higher wages:

- L is the total availability of labour in the economy




- Wr is the initial wage offered to workers in agricultural industry

- W1 is offered as a wage in industry; L1 labour is attracted to industry, leaving (L-L1) of the workforce to work in agriculture.

- The surplus is then reinvested in new equipment, workforce training, and production techniques. MRP1 shifts to MRP2, and more rural workers transfer to urban employment.

- More workers in industry means higher output, driving economic growth. The workers’ higher incomes increase domestic aggregate demand, whilst the extra profits earned can be re-invested, expanding the industrial sector in the same way again.

In essence, rural-urban migration will set off a virtuous circle of self-generating growth.

Criticisms of the model

- The model fails to take account of the cost of educating and training rural workers for urban employment.

- It assumes that the profits from industrial expansion are re-invested locally; in reality, these profits may well be handed over to foreign shareholders and investors.

- It is also possible that profits will be invested in labour-saving capital, reducing the amount of labour needed and causing urban unemployment.

- There are several serious problems associated with large amounts of rural-urban migration. Amongst these are:

o a lack of sufficient housing, leading to the development of squatter townships

o pressure on social infrastructure such as schools and hospitals

o increases in disease, due to a lack of clean water and sanitation.

These problems are exacerbated if the industrial sector cannot absorb all the workers arriving in the cities in search of employment, which has often been the case in developing economies. Recent migrants from rural areas who cannot find work form the new urban poor, widening income inequality in the cities and often expanding the informal economy.

Related glossary terms

Productivity

Marginal product

Marginal revenue product

Rural-urban migration/urban drift

Informal economy




Harrod-Domar model

Introduction

This model was developed in the 1930s by Roy Harrod and Evsey Domar. It emphasises the roles of investment, savings and technological change as the major determinants of growth.

The model

- Savings provide the funds which banks can lend for investment purposes

- Economies need to make new investments which add to the capital stock (rather than just replacing worn-out capital)

- Therefore, economic growth depends on the level of saving and on the productivity of the investment that takes place (i.e. the capital-output ratio)

- Consequently, growth also depends on the amount of labour and capital available. Developing economies have plenty of cheap labour, so it must be a lack of physical capital (such as machinery) that prevents economic growth. Increasing capital will generate growth.

- Net investment will lead to more producer goods, generating higher output and GNP. This higher income will allow higher levels of saving, thus allowing higher levels of investment. A virtuous circle comes into being.

The implication is that growth will accelerate if the capital-output ratio can be lowered. This can be achieved by encouraging saving and investment, and by technological advances which may make production more efficient.

Criticisms of the model

- The Harrod-Domar model assumes that savings and investment are all that is needed to generate growth. In reality, several complementary factors are required – for example, a healthy and educated workforce, growth in infrastructure (roads, water, electricity etc) to support growth in production, political stability, and the existence of financial institutions such as banks to channel savings into investment.

- As investment increases, we would expect the law of diminishing returns to apply. The capital-output ratio may well be reduced with each successive unit of new capital, as investment becomes less productive.

- Plugging the savings gap by borrowing from foreign or international lenders could cause debt repayment problems in the future.


Capital-output ratio

Depreciation

Diminishing returns




Dependency theory

Introduction

Dependency theorists argue that developing economies are prevented from achieving significant growth by the dominance of the wealthier (and therefore far more powerful) nations. It is external rather than internal factors that result in under-development; LDC’s are dependent on the actions and economies of the richer nations.

1. Neo-colonial dependency model

- Under colonial rule, colonies in the developing world were made to concentrate excessively on the primary sector in order to satisfy the needs of their Western colonial rulers.

- Since all the former colonies gained independence, they have been stuck with this emphasis on agriculture. The real value of the primary products they look to export has declined, resulting in a significant deterioration in the terms of trade.

Criticism: some former colonies, particularly those of South-East Asia, have successfully industrialised.

2. Marxist model

- Interest groups, both within and outside of developing economies, conspire to keep poor countries poor and rich countries rich.

- Inside: it is in the interest of landowners, government officials, and other powerful groups to keep wages low and profits high; these groups prevent development because they take the lion’s share of any economic growth.

- Outside: multinational companies, the IMF, the World Bank, and other international institutions conspire to keep developing economies poor so that they can continue to provide cheap raw materials, land and labour to the rich world.

Criticism: the model states that change will only occur through Marxist revolutions led by communist governments. In reality, Marxist states such as Cuba and Mozambique have failed to develop, whilst other, non-Marxist states, such as the Asian tiger economies, have flourished.

3. False paradigm model

- Under-development has been attributed to inappropriate economic advice given by misguided Western economists.

- Example: foreign economists advised developing economies to borrow in order to plug the savings gap. Most of the investments made with the borrowed capital were not productive enough to repay the interest and the capital borrowed, and so countries were saddled with massive debts which they were unable to repay. The advisors were either ill-informed, biased, incompetent, or insensitive to the particular economic and social characteristics of the countries they were advising.

General criticism




These theories all aim to explain how the developing world came to be so poor; none really details how they can begin – and sustain – the process of development.

Dependency theorists tend to argue that LDCs need to operate in closed economies, in order to escape the domination of the rich world, and that governments should actively manage their economies. Experience has shown that both these policies usually result in disaster.




Balanced and Unbalanced Growth Theory

Introduction

These theories reflect the debate about government-controlled economies versus free market economies.

Balanced Growth

- Investment must be coordinated in order for real economic growth to occur; that way, simultaneous expansion in a wide range of industries can be achieved.

- This can only be done through extensive government intervention:

o Planning all economic activity from the centre (a command economy)

OR

o High taxation, reducing consumption and providing funds for investment, either directly (nationalising industries) or indirectly (providing large state subsidies).

- The benefits of economic growth are then spread across all regions and industries.

- The theory is, in essence, an extension of Say’s law: supply creates its own demand. More generally, the demand for one product is generated by the supply of others; expanding supply in all industries will increase demand in all industries, resulting in real growth in all sectors.

- Balanced growth theorists reject the idea that a free market might help development. Development cannot be initiated by one or a few industries - so balanced growth theorists may have difficulty explaining the rapid development of the Asian tiger economies.

- Foreign trade should be controlled, to avoid dependency; note that this contradicts comparative advantage.

Criticisms

The theory has been proved empirically wrong. Soviet state planning was a bureaucratic, inefficient disaster, whilst South East Asia achieved impressive development by concentrating on exporting hi-tech goods. Widespread government planning will inevitably lead to government failure.

Unbalanced Growth

- Developing economies do not have sufficient funds to pursue simultaneous expansion. It is far better to prioritise investment, and to concentrate on a few growth centres.

- A few rapidly growing industries will stimulate backward linkages, whereby suppliers to the industries have increased demand, increased prices and therefore increased profits, and forward linkages, whereby demand is increased for such services as transport, warehousing and retailing.

- Economies can then pursue import substitution. Key growth centres may replace imports of certain goods, which will improve the balance of payments.




- Unbalanced growth theorists agree that significant development cannot be achieved within free, unregulated markets by a small number of industries. Some government intervention will still be necessary – protectionism, subsidies, or fixed exchange rates, for example - but only in those industries designated as the engines of growth.

- Governments should pick industries in which a comparative advantage exists (usually labour intensive industries such as agriculture or textiles), which have significant forward and backward linkages and the potential for import substitution.

Criticisms

Governments may select inappropriate sectors for support – for example, capital-intensive sectors in which no comparative advantage exists.

Subsidies create market distortions and allocative inefficiency.

There are several potential problems with attempts at import substitution.

o It decreases demand for foreign currency, thereby raising the exchange rate and making it more difficult to market exports

o It reduces the benefits of comparative advantage, since countries are trying to make what they import most of rather than what they are best at producing.

o It distorts the allocation of resources, since resources are not being used in industries where they can be used most effectively


Command economy

Subsidy

Asian tiger economies

Allocative inefficiency

Protectionism

Fixed exchange rate

Labour-intensive

Capital-intensive




Development policy

Domestic policies to promote development - overview

1) Resource improvement and management

Improve the productivity of the agricultural sector, by using modern products and techniques. Fertilisers, pesticides, GM crops, irrigation and crop rotation schemes will all make the primary sector more efficient.

But this is easier said than done

- Agricultural prices should be allowed to rise, to act as an incentive for farmers to be more efficient. This means withdrawing subsidies – which is politically unpopular.

- Increased food prices will lead workers to demand higher wages. This will increase firm’s costs, reduce competitiveness and perhaps also contribute to inflation.

- Pursuing exports might cause domestic food shortages

- Taxing farmers as agricultural incomes increase may provide a wider tax base for the government, but it will also be a disincentive for farmers.

2) Sectoral Change

As GNP rises, resources can be diverted from agriculture to industry and services. See models of development – especially Lewis and Rostow.

3) Industrialisation

Either by import substitution or export promotion – see our more detailed revision note on industrialisation

4) Population Control

Governments can attempt to slow down population growth to match economic growth – thus raising standard of living. Possible policies include:

- Education programmes

- Family planning clinics offering contraception and advice

- Disincentives to have lots of children. China has legislated against having too many children – fines are equal to ten times the average per capita income – whilst Singapore only offers free education and healthcare to the first two children.

- Introduce state pensions, so people don’t feel they need to have lots of children to support them in their retirement. But this requires taxation – a dilemma facing developed and developing economies alike.

- Change the status of women. Improving women’s education and job prospects will mean that they assign a higher opportunity cost to having children.

5) Structural Adjustment




This involves a wide range of measures to increase efficiency in the economy. See our separate revision note on structural adjustment.

6) Macroeconomic stabilisation

Reduce inflation, balance the government budget, and achieve balance of payments equilibrium. See the separate revision note on macroeconomic stabilisation.




Import substitution and export promotion

Introduction

One of the main aims of developing countries is to pursue industrialisation by expanding the secondary sector. All well and good; but producers need to make decisions as to what to produce. There are two broad strategies that countries can follow with regards this problem.

Import substitution

In order for an economy to established and develop infant industries, it is generally accepted that these industries initially need to be protected by import tariffs. Infant industries provide the capability for a developing economy to adopt a policy of import substitution.

The idea is to domestically produce what was previously imported from elsewhere. There are some economically sound reasons for doing this; producing rather than importing will save valuable foreign exchange and ease the balance of payments deficit that most poor countries have. Moreover, there is obviously a ready-made market for the product, because people are already buying it from abroad.

In theory, new firms would start by importing ‘investment goods’ [machinery], ‘intermediate goods’ [raw materials], and expertise. Once off the ground, the industry would be able to import capital goods to make all the necessary machinery themselves. The government would remove the tariffs once the industry was ready to compete with producers from around the world.

In reality, firms have rarely got beyond the first stage. Import tariffs have remained in place, since producers were unprepared to face global competition – and so they had no incentive to become efficient and competitive.

Import substitution has usually failed because:

- Governments have interfered too much

- Firms have suffered from a shortage of foreign exchange (needed to buy raw materials)

- Firms have tried to use inappropriate technology that needed foreign expertise; remember that developing countries often have a comparative advantage in labour-intensive production.

- Tariffs have allowed the industries to carry on producing at high costs, with no incentive to strive for greater efficiency and productivity.

Export Promotion

This was the approach adopted by the ‘Asian Tiger’ economies in their expansion of hi-tech manufacturing industries. Countries try to find markets in which they can make use of their comparative advantages and sell their products to buyers elsewhere in the world.

- Production centred on labour-intensive technologies (for the comparative advantage!)

- Industry made up of private-sector firms driven by the profit motive

- Government provides incentives for firms to export




Structural Adjustment

Introduction

The aim of structural adjustment programs – most notably those enforced by the IMF – is to adopt a range of measures to increase the general level of efficiency in the economy.

IMF loans are often conditional on acceptance of a programme of structural adjustment policies.

The policies

1. Currency devaluation: either adopt a lower fixed rate, or allow the rate to float freely. As a result, exports will appear cheaper and imports more expensive. There will be an incentive to produce for export, since export prices have been made more competitive.

2. Privatisation: allow nationalised industries to be run by the private sector instead. Businessmen are better at running industries than politicians in centralised government are! The profit motive should be an incentive to increase efficiency and productivity in privatised industries.

3. Remove import controls: allow market demand and supply to determine what is imported and what is not. Competition from foreign companies should also be encouraged.

4. Market deregulation: get rid of all legislation that restricts free market competition. These hinder the pursuit of efficiency and the natural allocation of resources.

5. Reduce government spending in order to balance the government budget. Food subsidies in particular should be reduced (since they reduce prices for local farmers).

6. Encourage foreign direct investment through tax incentives, foreign exchange control etc.

These policies may well be painful in the short term. Economic growth might slow initially; inflation and unemployment may also rise, and this is likely to hit the poorest members of society hardest.

In the long run, though, these policies should stimulate sustainable growth, and thereby eventually increase standards of living.




Macroeconomic stabilisation

Introduction

If significant economic growth is to be achieved, it is important to work towards a stable macroeconomic environment. Thus, governments should look at ways of reducing inflation to a manageable level if necessary, balancing their budgets over the economic cycle, and avoiding surplus or deficit on the balance of payments.

Reducing inflation

In countries where inflation is a serious problem, governments must attempt to reduce the general price level. This is best done by reducing aggregate demand, and so governments have two weapons with which to fight inflation:

- Fiscal policy: reduce government spending, by cutting down on investment projects and public sector employment; and increase tax revenue, by raising taxes, leaving tax bands unchanged (‘fiscal drag’), and widening the tax base – for example, by charging VAT on more items.

- Monetary policy: raise interest rates, to dampen borrowing and therefore spending.

Balance the government budget

Most developing countries find themselves running a budget deficit year after year, with government spending always exceeding tax receipts. This worsens the debt repayment problems they already face. Thus, they should aim to balance budgets over the economic cycle – that is, compensate for deficits in times of recession with surpluses in boom periods.

In practical terms, the strategies involved are the same – reducing government spending and increasing tax revenue. In the short term, these policies are likely to hit the poorest people the hardest – but it is hoped that stabilising the economy will put the country in a better position to achieve strong growth in the long run.

Balance of Payments equilibrium

Most developing countries have balance of payments deficits – that is, imports tend to exceed exports.

Imports can be reduced by rationing foreign exchange; by implementing a licence system to limit the number of importers; and by allowing the exchange rate to float, since rates invariably float downwards.

Exports can be increased by offering tax incentives to producers to export; by encouraging FDI, since foreign firms will produce for export; and again by allowing the exchange rate to float.




International Policies to Promote Development - Overview

1) Balance of trade improvement

Increase exports by focussing on areas in which the country has a comparative advantage; developing tourism; providing tax incentives to export; reducing the bureaucracy involved in selling abroad; and offering preferential access to foreign exchange to exporting firms.

Reduce imports by pursuing import substitution: encourage domestic industries, and look for industries where ‘added value’ can be achieved.

2) Foreign debt management

Causes of debt problems:

- Over-reliance on primary sector exports. Primary product prices are volatile, and drift downwards over time.

- Over-reliance on manufactured imports, whose prices tend to float upwards

- Oil prices have risen significantly. Developing countries have borrowed large amounts of OPEC ‘petrodollars’, which has landed them in large amounts of debt.

- The Western recession saw interest rates go up, and demand for the primary exports of the developing world go down.

- The composition of the current account deficit. Deficits can only be justified if the money is being spent on capital goods which increase productive capacity; in the past, money has instead been frittered away on consumer goods.

Policies:

- Default!

- Re-schedule loans (that is, renegotiate the length of the loan, the interest rate, and even the amount).

- Pursue a tight domestic policy. Take anti-inflationary measures, such as increasing interest rates, increasing taxes, and decreasing government spending; this should reduce aggregate demand, reduce imports, and encourage domestic producers to export instead.

- Seek IMF assistance – but this is always conditional on structural adjustment

- Get the debt written off – for example, the Jubilee 2000 campaign

- Restrict forex availability

3) Foreign aid – for detailed notes, see revision note on aid

Possible problems:

- Tied aid prevents importers from making their own decisions and determining their own priorities about what foreign products to buy




- Tied aid often provides labour-saving capital, which is inappropriate – it reduces employment and prevents developing economies using their greatest asset, which is their abundance of cheap labour.

- Untied aid can be abused. It can be misspent, or intercepted by corrupt officials.

Benefits:

- Grants are preferable, as they impose no financial burden

- Untied aid is far more useful. Domestic producers and consumers can choose their own goods and technology, and can decide their own priorities.

- Aid – especially aid provided by Non-Governmental Organisations, who often have strong links with local communities – can be targeted to the most vulnerable groups in society.

4) Foreign Direct Investment

Multi-National Companies can provide a much-needed injection of resources – but there are several potential, and serious, drawbacks to FDI. See separate revision note on the pros and cons of foreign direct investment.

5) Trade agreements and trade liberalisation

Domestic markets tend to be very small-scale – so producers have little chance of achieving economies of scale. This, added to the fact that foreign markets are often protected by high tariffs, means that industries and firms based in developing economies will find it very difficult to become competitive in the international market.

Trade agreements can involve two countries reducing tariffs on each other’s goods, or perhaps reducing bureaucracy by simplifying import/export procedures.

Trade liberalisation might involve creating free-trade areas. This creates larger markets, greater access to raw materials, and more competition. The happy ending should be lower unit costs, since firms are able to gain economies of scale. From the consumers’ point of view, lower prices and greater choice should make them happy too.

6) Currency stabilisation

High and fluctuating inflation is a problem in many poor countries, since demand outstrips supply, and supply is vulnerable to sudden shocks such as drought, war, and increased oil prices. Thus, the value of the domestic currency tends to fall.

Combined with a fluctuating exchange rate which tends to float downwards, this makes life very difficult for exporters. The domestic currency becomes less and less valuable relative to other currencies, and so exporters earn less forex for their goods.

The solution is essentially to reduce the government deficit. By reducing aggregate demand and increasing aggregate supply, the domestic economy can be stabilised, which should help the currency stabilise.

Aggregate demand can be reduced by putting up interest rates, increasing taxes, and reducing government spending; whilst aggregate supply can be increased by encouraging enterprise and




FDI, providing tax incentives and export grants, privatising industries, and reducing bureaucracy.

See revision note on macroeconomic stabilisation for more detail.




Aid

Introduction

Aid essentially involves international financial institutions or rich countries giving or loaning resources to developing countries. It sounds like a good idea on the face of it – but there are some important drawbacks to take into consideration in an exam answer.

Types of aid:

Bilateral: an agreement between 2 countries

Multi-lateral: joint assistance, for example from the EU or the United Nations

Tied aid: specific conditions attached, such as an obligation for the recipient to buy goods from the donor

Untied aid: no strings attached! Unfortunately, this doesn’t happen often.

Loans: must be repaid

Grants: no repayment necessary

Should rich countries give aid to poorer ones?

Yes if:

- It’s used to increase the country’s productive capacity (e.g. buying capital); the benefits of extra production are likely to be widely spread, thus decreasing poverty, inequality and unemployment

- It represents an injection of resources, which can facilitate investment and therefore growth [see the Harrod-Domar model]

- It helps the transmission of new ideas

No if:

- It’s frittered away on current consumption

- It’s spent on inappropriate, labour-saving capital which does not create employment or increase wages

- It is spent on ‘showcase’ infrastructure projects for which there is no real demand, such as international airports

- It leads to dependency

- It is in the form of free or cheap food, which lowers prices for local farmers

- The right social, political, institutional and cultural conditions are not in place

- The funds are intercepted by corrupt politicians

- The aid flows are unsustainable




Debt cancellation

Most developing countries are saddled with large amounts of debt which they have huge difficulty repaying. There are some very strong moral arguments for cancelling such debts; but again, there is another side to the argument.

- Debt cancellation diverts funds from future investment in less developed countries

- Decreasing debt does not necessarily decrease poverty. The extra funds may well be misused by government, and the benefits may not be evenly distributed amongst the population

- Loans impose discipline on developing countries; cancellation could encourage reckless borrowing




Foreign Direct Investment – pros and cons

Introduction

Foreign Direct Investment involves a multi-national corporation building a manufacturing plant, or other physical investment, in the economy in question. Such investment will undoubtedly bring benefits for the selected country; but there are also some serious drawbacks which must be taken into account in evaluating the desirability of FDI.

Benefits

- FDI can help to plug the savings gap – the difference between the level of savings and the amount of investment needed.

- The MNC will import valuable foreign exchange into the country

- A large amount of jobs will be created directly – i.e. employed in the new factory

- But employment will also be created indirectly, through the multiplier effect.

- MNCs can introduce new technology into the country – and educate their workers as to its use

- If profitable, they generate valuable tax revenue for the government [see revision note on macroeconomic stabilisation].

Drawbacks

- MNCs tend to invest in urban areas. This widens the gap between urban and rural incomes – and aggravates the problem of rural-urban migration [see revision note].

- Many MNCs have been accused of exploiting their workforces. For example, they may force workers to work in unsafe, or simply miserable, conditions; they may employ children, and pay shockingly low wages (by Western standards). For an alternative view on this, see Paul Krugman’s article, ‘In Praise of Cheap Labour: bad jobs at bad wages are better than no jobs at all’ – but this isn’t essential for the exam.

- MNCs are also accused of exploiting local environments, by polluting air and rivers, cutting down rainforests, or by reducing biodiversity. See revision note on ‘environment and sustainability’.

- Any dividends and profits are likely to be shipped back to the international headquarters somewhere in the developed world.

- Finally, MNCs often use inappropriate, capital-intensive production methods, thus preventing countries from exercising their comparative advantages in labour-intensive industries.




International Institutions

1. Non-Governmental Organisations such as Oxfam, Christian Aid, Save the Children, Amnesty International, and the World Wildlife Fund

Advantages:

- Can hold developed countries accountable for ‘exploitation’

- Can often work effectively with local communities. This is especially because they are “less constrained by political imperatives and motivated largely by humanitarian ideals” (Todaro 2003)

- This close engagement with local communities means that the people they are trying to help are likely to be much less cynical about their good intentions

- They often campaign to increase aid and decrease debt

Disadvantages:

- They are self-appointed, self-serving and unaccountable

- They have been accused of imposing foreign values on the developing world – perhaps there is evidence of neo-colonialism

- Providing free or cheap food in fact reduces agricultural prices for local farmers

- Communities and countries may become dependent on help from NGOs

2. Trans-National Corporations such as Nike, Gap, Levi

• Foreign direct investment is ‘footloose’ – it is sensitive to: tax policies, subsidies offered by government, local economic conditions, and the human capital of the labour force.

• TNCs often make use of transfer pricing. Transfer prices are the internal prices used for transactions between semi-autonomous divisions of the company – such as one branch of Levis selling cotton to another branch.

These prices can be set above or below the market price, in order to minimise the payment of tariffs. Profits can thus be moved from a high-tax country to a low-tax to country.

Advantages:

- Can introduce new resources (without incurring an opportunity cost)

- The multiplier effect – money from foreign investors will circulate and multiply in the economy

- Increased employment, and training in modern management and production techniques

- Forward and backward linkages [see unbalanced growth theory]

- Positive externalities – improvements in infrastructure




Disadvantages:

- Inappropriate, labour-saving technology may be used

- Possible exploitation of labour and environment [see sustainable development]

- Transfer pricing

- Any profits will go to the company’s headquarters, for example New York or London

3. The International Monetary Fund (http://www.imf.org) promotes international financial stability.

• Lends to countries with balance of payments problems

• Aims to promote development by restoring short run stability and by supporting long term adjustment and reform

• Conditionality: the IMF generally sets preconditions for its loans, i.e. that countries follow its Structural Adjustment Program, under which countries should:

- decrease government spending and run a balanced budget

- pursue privatisation (e.g. Ghana’s water industry was privatised in 2002)

- get prices right – set by market forces rather than government

- get interest rates right

- liberalise trade by removing barriers (such as tariffs and legislation)

- consult with civic society

Advantages:

- structural adjustment programs discourage competitive currency devaluations

- the policies generally move in the right direction for development

Disadvantages:

- mission creep – the IMF sets out to do more than it was originally intended to do

- it has been accused of blindly imposing one-size-fits-all policies [for more on this, have a look at Joseph Stiglitz’s book ‘Globalisation and its Discontents’]

- its stringent conditions are often politically unpopular, since they tend to disproportionately affect the poorest members of society

4. The World Bank (http://www.worldbank.org) promotes institutional, structural and social development by providing low interest loans and technical assistance for domestic investment projects.

It aims to help countries meet the UN Millennium Development Goals. It is, though, constrained by a lack of resources.

http://www.imf.org/

http://www.worldbank.org/

http://www.imf.org

http://www.worldbank.org




The World Bank generally imposes similar constraints to those of the IMF.

Advantages:

- The short-term reforms demanded by the World Bank will lead to long-term prosperity

Disadvantages

- One-size-fits-all policies?

- The burdens of the structural adjustment programs can fall disproportionately on the most vulnerable members of society

- Some argue that providing aid would be a more efficient use of World Bank resources

5. The World Trade Organisation (http://www.wto.org) deals with the global rules of trade.

• It aims to promote international trade in goods and services [see comparative advantage etc] by liberalising trade: i.e., reducing tariffs and quotas and opening domestic markets to foreign competition.

• It also adjudicates in trade disputes – such as the US vs. EU spat over bananas.

Advantages:

- Trade enables specialisation by comparative advantage, which is generally a very good idea. The resultant increase in output and trade will increase economic welfare for everyone – given the right terms of trade.

- Developed countries have followed protectionist trade policies in the past – it’s good that we have an organisation that can reprimand them

Disadvantages

- Does free trade benefit rich countries more than poor ones?

- Can free trade cause poor countries to be dependent on the rich world?

http://www.wto.org/




Problems of Development

Internal problems of developing economies

1) Limited resources

- some countries have very few resources

- some have resources that have yet to be exploited at all

- some have lots of resources that are being used wrongly

- some have few physical resources, but have been able to use their human resources effectively

2) Savings rates and capital accumulation

- savings are needed for investment (in order to raise productivity)

- but savings are deferred consumption – and some countries are simply too poor to save

- countries have a ‘savings gap’ – savings rates are not high enough to meet the investment requirement

Possible solutions:

o foreign loans

o foreign direct investment

o foreign aid

(note: each of these three is flawed)

3) Structural change

- developing countries have inefficient, low productivity primary sectors

- they are largely unable to free up resources

- low productivity is caused by:

o basic tools

Low savings

Low investment

Low productivity

Low incomes




o traditional methods

o small areas of cultivation

o an emphasis on animal and human power rather than machinery

- The problem can be eased with the introduction of appropriate technology, planting newly developed crops (perhaps genetically modified), and reforming the laws that govern land ownership.

4) Population growth

- we are in the midst of a population explosion:

- the birth rate now exceeds the death rate (which falls because of improved diets, health services, standards of living and hygiene)

- this creates problems for developing economies:

o increased dependency ratio

o more babies and children to feed, house, clothe, educate etc

o increased pressure on social infrastructure (schools, hospitals, homes)

- in many countries, AIDS is wiping out a whole generation of adults – worsening the problem of the dependency ratio

5) Rural-urban migration

Excessive migration to the cities brings with it all the problems of overcrowding and squalor. The problem can be eased by trying to develop rural areas, and by making rural people aware of the problems in the cities. See our more detailed note on rural-urban migration.




6) Environment and sustainability

Definition of sustainable development: development that meets the needs of the present generation without compromising the ability of future generations to meet their own needs.

Developing economies must take care to ensure that economic growth does not come at the expense of the environment and irreplaceable natural resources.

See our more detailed note on environment and sustainability.

7) Unemployment and underemployment

high levels of unemployment result in:

o migration in search of jobs (along with all the problems of rural-urban migration – see above)

o waste of resources, in that people are educated but unemployed

o negative impact on savings, and therefore on investment

Underemployment refers to partially used resources. MRP is low or zero.

Solutions:

o increase investment in labour-intensive industries

o boost tourism – although this is often seasonal and foreign-owned

8) Poverty and inequality

(9) Weak financial institutions

- if a country lacks a good financial infrastructure (i.e. banks, savings organisations, a stock exchange and the like), it is difficult to channel savings into investment




- Informal financial markets may appear. Informal money lenders can charge extortionate interest rates to vulnerable borrowers.

- There are often no credit facilities available in rural areas.

(10) Price instability

- Traditionally, developing countries export primary goods and import manufactured goods

- But there are declining terms of trade [export prices ÷ import prices]

- Countries are often dependent on one or two products.

- Prices fall over time, due both to increased supply (better productivity, technology etc) and decreasing demand (as synthetic materials replace natural ones in secondary production):

Solutions:

o International commodity agreements. Buffer stocks can be used to influence prices. Examples are the 1981 International Cocoa Agreement and the 1985 International Tin Agreement.

o Quota agreement: limit the supply of primary goods to the international market. OPEC’s oil quotas are a good example.




Rural-urban migration

Introduction

Rural-urban migration was originally viewed as beneficial, since it aided structural change (as argued in the Lewis model). The process has accelerated in the second half of the twentieth century.

Rural people migrate into the cities in search of better wages, the chance of a better education and healthcare, and because of other social attractions. The results, though, are often far from beneficial; cities simply cannot absorb floods of rural migrants without a substantial reduction in standard of living.

Problems:

o overcrowding and homelessness in the cities

o the emergence of ‘shanty towns’

o increased crime

o increased pollution

o increased congestion

o qualification inflation – with such a large pool of unemployed workers to choose from, employers often set absurdly high requirements for menial jobs in order to reduce the number of applications.

o significant expansion of the informal economy

Essentially, the main cities in developing economies have simply not been prepared for the huge influx of rural migrants over the past decade or so. Governments were unprepared for the huge strain on urban water supplies and sanitation. Existing property laws in some countries mean that much urban housing is illegal, rendering occupants ineligible for government services.

Pollution, overcrowding, dirty water and inadequate sanitation facilities are serious health hazards for the millions of people exposed to them. Conditions in large cities throughout the developing world are often ripe for disease, epidemics and health crises.

Congestion and pollution emissions are also very bad news for the environment.

Solutions:

The most effective way to combat excessive migration is to pursue policies aimed at developing the rural areas. Making life better in rural areas should help to remove the incentive to migrate to the cities.

o Encourage the use of labour-intensive production methods in rural areas – using appropriate intermediate technology. This should increase both employment and output in rural areas.

o Improve the social and physical infrastructure in rural areas – schools, hospitals, roads, electricity. Such provisions go a long way to making people’s lives easier.

o Make rural people aware of the problems associated with living in the cities. People are less likely to move if they recognise that life in the city may in fact be worse than rural life.




Environment and sustainability

Definition of sustainable development: development that meets the needs of the present generation without compromising the ability of future generations to meet their own needs.

Introduction

In trying to achieve significant economic growth in the world’s poorest countries, it would be easy to overlook environmental concerns and judge that alleviating poverty as quickly as possible is more important. However, in doing so we run the risk of making it very much more difficult for future generations to be prosperous. Our efforts to eradicate poverty and economic stagnation can bring about all sorts of serious environmental problems.

Problems:

a) Air pollution: due to increased traffic, poor vehicle regulation and inspection, and the burning of biomass fuels such as straw and wood

b) Water: urban areas lack clean water and sanitation, making the people vulnerable to diseases such as cholera; whilst in rural areas, the lack of irrigation systems hinders the productivity of the agricultural sector.

c) Deforestation: the eradication of tropical rainforests (e.g. in Asia and South America), the erosion of topsoil, and global warming

d) Soil degradation: due to deforestation, overgrazing, and overintensive farming (e.g. in South Africa)

e) Reduction in biodiversity.

Our oceans and the ozone layer are public goods; everyone suffers if they are damaged. Environmental damage is therefore a negative externality, since the social costs exceed the private costs. Countries and firms who damage them are acting as free riders.

The only way to ensure sustainable development is through international cooperation – but the political will has to be there (e.g. the Kyoto agreement, in which such will was noticeably lacking in certain quarters).

Solutions:

o Legislation with regards pollution emissions – make it illegal for firms to produce more than a certain amount of pollution.

o International agreements, under which each country agrees to reduce the amount of pollution it produces. Kyoto is a good example.

o Reform property rights. In many developing economies, property is owned by the community as a whole. Private ownership of land is a much better incentive to invest in that land and make sure it is in good condition.

o Government intervention to ensure clean water supplies. In this case, the government would be intervening to correct for a negative externality.




o Tax firms on the pollution they produce – a clear monetary incentive to produce as little pollution as possible

o Tradable pollution permits are a more complicated version of the legislation idea above. Each firm has a certain amount of pollution it is allowed to produce, but if it produces less than that, it can trade the right to produce that extra pollution with a firm which is finding it more difficult to reduce pollution.




External problems of developing economies

1) Pattern of trade

- Developing economies are usually reliant on exporting primary goods, such as raw materials and agricultural produce. The very poorest countries of the world are those that rely most on such exports.

- Therefore, the price obtained for the exports has a direct effect on GDP and standard of living

- Since 1900, the price of primary goods has halved, and the terms of trade have deteriorated significantly.

Solutions:

o In the long term, these countries should aim to diversify into manufacturing and services

o In the short and medium term, they should try and diversify into primary products that can attract a premium price – such as organic foods.

o Primary production should take advantage of modern mechanical techniques in order to increase productivity

o Some organisations aim to educate the Western consumer – inducing them to buy third world produce using ethical arguments

o Countries might also consider expanding tourism. The industry is very labour intensive, low-skilled, low-tech, and earns valuable foreign exchange.

2) Balance of payments

Most developing countries run balance of payments deficits – that is, they import much more than they export. They cannot earn enough foreign exchange from their exports to pay for all their imports, and so debt problems are exacerbated.

To ease this problem, governments can encourage exports and discourage imports. One effective way to do this is to allow the exchange rate to float – since most developing countries’ currencies float downwards.

For more on this, see the revision note on macroeconomic stabilisation.

3) Dependency

The world economy is very dualistic in character; on the one had we have the rich, developed world, and on the other, the poor, developing world. The gap between the two is large – and getting bigger.

For theories about how the developing world has come to be so dependent on the developed world, see revision note on dependency theory.

4) Foreign debt




Borrowing is fine, so long as the rate of return of the investment is greater than the interest payable on the loan. This has not always been the case. Many poor countries are burdened by huge amounts of debt, and have very little to show for it.

5) Terms of trade = price of exports 100price of imports

×

The Prebisch-Singer hypothesis: developing countries increase their production of primary products

But demand for them is price inelastic, and the income elasticity is low – so in the long term, prices drift downwards.

Result: any given quantity of exports will, over time, buy a smaller and smaller amount of imports.

6) International capital flows

- The constraints on domestic savings constitute a significant barrier to growth. Therefore, an influx of foreign capital is needed

- Foreign capital is attracted by higher rates of return on investments – that is, faster growing economies.

- Foreign investment can be either portfolio investment (buying local shares and government/corporate bonds) or foreign direct investment (establishing companies in developing countries).

- But, foreign investors will leave quickly if any problems arise – such as political instability, security issues, or falling rates of return on their investments. Their exit is likely to cause instability in the country, and as capital leaves, the balance of payments capital account will deteriorate, and the exchange rate will suffer.

- Net transfer – developing countries pay more to the developed world than they receive.

7) Exchange rate fluctuations

a) Fixed rate. If overvalued, imports are cheap and exports are expensive, hence a balance of payments deficit. The country cannot earn enough foreign exchange, and so it has to be rationed. This will lead to regular devaluations.

b) Floating rate – determined by supply and demand. Local currency tends to float downwards – so there’s still a balance of payments deficit.

8) Globalisation has brought its own problems, relating to exposure to the international economy and the whims of multi-national corporations. See the note on globalisation for more detail.




Globalisation

Introduction

Globalisation is the process by which the world’s economies become more integrated and interdependent. The process has very important implications for politics, economics, and culture – but it’s the economics bit that’s important for the exam.

The most significant economic symptoms of this process are a greater amount of trade; more international portfolio investments by private investors; and, or course, much larger flows of foreign direct investment. As the economic borders between countries are broken down, and physical distances cease to matter very much, it becomes much easier for foreign companies to build production plants in other countries, or simply to outsource their production to other companies based in other countries.

The increasing power of multi-national corporations in the new globalised economy is the most relevant aspect of globalisation for the Development Economics exam – but you should be aware that globalisation involves much more than just foreign direct investment.

Multi-national corporations are hugely important, because of their size, influence, and potential to provide investment. In the 1990s, the 500 largest MNCs controlled 70% of world trade, 80% of world investment, and 30% of world GDP. That makes them pretty powerful.

They are attracted to developing economies by a variety of factors. Poor countries usually have an abundance of cheap labour available; governments often provide incentives for them to invest in the country; and they may be able to avoid inconvenient regulations in place in rich countries, such as tariff barriers, high tax rates, health and safety regulations and environmental controls.

Advantages:

- MNCs can provide FDI (foreign direct investment), which can help to bridge the savings gap. In Rostow’s theory, this makes it possible for the country to progress to the next stage of development.

- They generate income and employment in the region they invest in. Note that the multiplier effect will make the injection of resources even more effective.

- Source of valuable foreign exchange, which is often scarce in countries with large balance of payments deficits.

- They transfer expertise (through training their staff) and technology. This increases both the human capital of the workforce and the productive capacity of the economy.

- Finally, they provide lots of tax revenue for the domestic government.

Disadvantages:

- MNCs can create a new local elite, consisting of those lucky enough to work for the big company. This can widen the income gap in the local community, perhaps also creating social rifts between those with relatively well-paid manufacturing jobs and those still struggling to earn a subsistence wage.

- They are often accused of exploiting of local labour, through making workers work in an unsafe working environment, and through employing child labour




- Possible damage to the environment [see environment and sustainability]. MNCs have in the past had few reservations about damaging an environment that doesn’t belong to them in the pursuit of profit.

- Currency outflows – the firm’s profits will most likely go back to its international headquarters, rather than staying in the domestic economy.

- Stifles local enterprise

- MNCs can avoiding tax payments through clever transfer pricing, whereby they transfer profits to the country that has the lowest taxes of all the countries they operate in.

- Corruption – both in the MNCs themselves, and in government officials.

- They often employ inappropriate, capital-intensive technology, which does nothing to increase overall employment, and prevents the country using its comparative advantage in labour-intensive production.




Price instability

Introduction

Most of the world’s developing economies concentrate their production in the primary sector – in agriculture, forestry, or mining, for example. In sub-Saharan Africa, 95% of all exports are primary products.

The Problems

Problems of price instability arise because demand for these primary products is fairly price inelastic. Thus, even a small increase or decrease in world production, which is assumed to be perfectly inelastic in any given year, will have a large impact on the world price.

Price

Quantity

S1 S2 S3

Demand

P1

P2

P3

Looking at the diagram above, a slight increase in world supply from S1 to S3 produces a significant fall in price from P1 to P3.

We can see that this puts the world’s primary producers in a tricky situation. The more productive they become, and the more output they produce, the more the price falls and the less revenue they are able to earn. A year in which harvests are poor around the world will earn the farmers more money, but in a bumper harvest year, farmers find themselves worse off.

Even worse, it appears that the price of primary goods falls over time anyway:

- Supply will continue to increase, due to increased productivity and technological advance; but demand will fail to rise as quickly, as synthetic materials start to replace natural ones.

- Technological change reduces demand for certain minerals, such as metals that can be replaced by plastics.

- Moreover, primary goods are income inelastic; as world incomes rise, demand for primary goods rises by a less than proportionate amount.




PriceS1

D1

S2

D2

S3

D3

Quantity

Long-term trend in prices

Individual farmers have no influence over any of this. All they can do is produce as much as they can and hope for the best; the price they receive will be determined by global factors beyond their control.

These large, unpredictable swings in price can be devastating for communities which rely on primary production for their livelihood. A sudden drop in the price of cotton, coffee, sugar, or any other primary product will hit the world’s poorest people the hardest. This is a real obstacle to attempts to achieve significant economic growth in the developing world.

Possible Solutions

There isn’t much that can be done about declining prices in primary markets, but there are two possible ways of dampening the effects:

- International commodity agreements, such as the 1981 International Cocoa Agreement and the 1985 International Tin Agreement. A group of countries can agree to use buffer stocks to influence the world price of a commodity. These have been largely ineffective.

- Quota agreements: to restrict the supply of a good onto the market, thus pushing up its price. OPEC (the Organisation of Petroleum Exporting Countries) is a good example.




Development Economics Glossary

Term Definition

Absolute advantage When one country can produce more of a given good or service than another country with the same factor inputs, that country is said to have an absolute advantage in the production of the good.

Allocative efficiency Measures the best way to share out resources and satisfy the maximum number of customers. Where allocative efficiency is achieved, resources are being allocated to the production of those goods most valued by society. Customers place value on goods by their willingness to pay different amounts for those goods; we can therefore argue that, in terms of allocative efficiency, price must equal marginal cost.

Asian tiger economies The economies of South-East Asia, such as Taiwan, South Korea and Hong Kong, which managed to achieve very rapid development through fierce pursuit of export promotion, which successfully capitalised on a comparative advantage in hi-tech manufacturing.

Balance of payments A record of country’s economic transactions with the rest of the world over a certain period. There are two main parts to the balance of payments: the current account, which records exports and imports in goods and services, and the capital account, which records inward and outward foreign direct investment.

Capital-output ratio The ratio between the amount of capital employed and the level of output. Put another way, this expresses how many units of capital are required to produce one more unit of output.

Command economy An economy in which all economic activity – production, consumption and pricing – is determined and co-ordinated by the government. Private enterprise is illegal

Common Agricultural Policy

The European Union policy on agriculture, involving a price support scheme which has led to overproduction.

Comparative advantage Comparative advantage occurs where one country can produce a particular good for a lower opportunity cost than another country. A country which enjoys a comparative advantage in something will have to sacrifice less of other goods in order to produce a given extra quantity of the good in question.

Complementary development

Development strategies that aim to strengthen both the primary and secondary sectors simultaneously, rather than strengthening one at




Term Definition

the expense of the other.

Dependency ratio The ratio of people of working age to pensioners. The dependency ratio essentially expresses the number of working people who are supporting each pensioner.

Depreciation The reduction of the value of existing capital as it becomes worn out or outdated, and needs to be replaced with new capital.

Diminishing returns Occur when a proportionate increase in inputs results in a less than proportionate increase in outputs.

Economic growth A sustained increase in Gross National Product

Economies of scale A reduction in unit costs brought about by an increase in output.

Efficiency Obtaining the maximum possible output from and given amount of inputs, or achieving a given level of output with the minimum possible inputs.

Fixed exchange rate The government sets the rate at which units of domestic currency can be traded for units of other currencies. The market is prevented from influencing the official rate, usually expressed in US dollars.

Foreign direct investment Investment in a country by a foreign company. This investment is usually in the form of the purchase of real assets, such as land, factories, or mines. An example of FDI might be the setting up of a factory on domestic soil by a foreign company (usually an MNC).

Gini coefficient An index which expresses the degree of income inequality within an economy. A higher figure signifies an more unequal income distribution.

Gross Domestic Product Another measure of national income. GDP differs from GNP in that it does not include money earned by citizens abroad, but it does include money earned by foreigners working in the country.

Gross National Product The main measure of national income. GNP includes all incomes earned by citizens of that country living or working abroad, but does not include money earned by foreigners on domestic soil.

Human capital The overall level of education and expertise of the labour force

Human Development The measure of development used by most institutions, including the




Term Definition

Index World Bank and the IMF. HDI is an average of three different indices: life expectancy at birth; education (adult literacy and years of schooling); and real GNP per capita. This index makes it easier to compare different countries and determine which is more developed.

Informal economy Consists of unrecorded, unregistered, unregulated, and often illegal economic transactions. As such, these transactions cannot be included in official calculations of GNP.

Infrastructure The physical network that is essential to economic development. Includes roads, airports, railways, water and sewage systems, electricity, and other public utilities.

Marginal product The output created by the employment of one extra unit of a factor of production (holding all other inputs fixed).

Marginal revenue product The change in total revenue resulting from the employment of one more unit of a variable factor. MRP is calculated by multiplying the marginal product by the marginal revenue (i.e. the price). Therefore, it is affected by changes in price and by changes in marginal product (technology, specialisation, or perhaps the number of hours worked).

Multiplier effect An injection of a given amount of resources into an economy will have a total effect greater than the initial injection because of the multiplier effect. Money is spent more than once in an economic cycle; if, say, £100,000 is initially put into the economy, that money will change hands perhaps 3 or 4 times in a given period. At each stage, some of the money will be saved rather than spent. The total increase in GDP, then, will depend on the marginal propensity to consume in the economy, but will certainly be some amount greater than the original £100,000.

Opportunity cost The amount of other goods and services which could have been bought or produced instead of any good or service.

Privatisation The handing over of control of government-run firms and industries to the private sector.

Productivity A measure of the efficiency with which goods are produced. More specifically, the more productive a factor of production (such as labour or capital) is, the more output can be produced with any given quantity of inputs.




Term Definition

Protectionism Occurs where governments follow policies especially designed to discourage free trade and protect domestic industries from competition. Such policies may include hefty import tariffs, or unduly large amounts of bureaucracy involved in granting foreign firms permission to sell in the domestic economy.

Purchasing power parity (“PPP”)

A method of measuring the relative purchasing power of different countries’ currencies over the same types of goods and services. Because goods and services may cost more in one country than in another, PPP enables more accurate comparisons of standards of living across countries. PPP estimates use price comparisons of comparable items but since not all items can be matched exactly across countries and time, the estimates are not always reliable.

Qualification inflation The devaluation of qualifications in the labour market. This only really happens if there are a large number of applicants chasing every job on offer – for example, where significant rural-urban migration has taken place, and jobs are very scarce. With so many applicants to choose from, employers must somehow cut down the number eligible to apply for the job. Thus, we may find employers requiring A-level qualifications for a street cleaning job – if only to make the number of applicants more manageable.

Returns to scale The proportionate increase in output resulting from a proportionate increase in all inputs

Rural-urban migration The movement of workers from rural areas into the cities, usually in search of employment. Wages and opportunities are generally better in urban than in rural areas, although these benefits can be eroded by the problems arising from excessive migration. (sometimes termed ‘urban drift’)

Savings gap The gap between the actual savings rate (usually expressed as a percentage of GNP) and the savings needed to fund the required level of investment. It has been suggested that this gap can be filled with aid or loans, but this may cause debt repayment problems in the future.

Savings rate The level of savings in an economy expressed as a percentage of Gross Domestic Product

Specialisation In microeconomics, the allocation of labour such that each worker performs one (or a few) tasks in the production process. Applied to the international economy, specialisation occurs where individual




Term Definition

countries concentrate on producing something in which they enjoy an absolute or comparative advantage and trade the surplus, rather than trying to be self-sufficient by producing everything they need for themselves.

Structural adjustment The process of fundamental change in the makeup of an economy. Structural adjustment usually refers to changes in the balance of sectors in an economy – for example, shifting resources from the primary to the secondary sector – but it can also refer to changes in the economic organisation of a country. The transition from command economy to free-market economy would constitute major structural adjustment. The IMF and the World Bank often loan to developing economies only on the condition that they follow their ‘Structural Adjustment Programs’, which recommend a range of free-market measures to achieve greater efficiency.

Subsidy A direct payment made by the government, either to the producer or to the consumer, to encourage the production or consumption of a particular good. A producer subsidy will mean that total revenue for the firm exceeds the market price multiplied by the quantity sold, whilst a consumer subsidy will mean that the price paid by the consumer is less than the amount it cost to produce the good.

Subsistence A producer, usually in the primary sector, produces solely to satisfy his own immediate needs rather than for trade with other producers.

Sustainable development Development that meets the needs of the present generation without compromising the ability of future generations to meet their own needs.

Terms of trade The ratio of a country’s export prices to its import prices.

Transfer pricing The price one branch of a multi-national corporation charges another branch of the same corporation for its produce. For example, the price that a Levi’s production plant buys cotton at from its own cotton farm is the transfer price. Transfer pricing strategies can be used to move profits from one country to another in order to avoid taxes.


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