Development Theories. Sherif Khalifa. Sherif Khalifa () Development Theories 1 / 44

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1 Sherif Khalifa Sherif Khalifa () Development Theories 1 / 44

2 Definition Productivity is the quantity of goods and services produced from each unit of labor input. A nation can enjoy a high standard of living only if it can produce a large quantity of goods and services. Productivity is the key determinant of living standards, and growth in productivity is the key determinant of growth in living standards. Productivity is determined by physical capital, human capital, natural endowments, and technological knowledge. Sherif Khalifa () Development Theories 2 / 44

3 Definition Production function is a technological or engineering relationship between the quantity of a good produced and the quantity of inputs requied to produce it. Y: Output A: Technology L: Labor K: Physical capital H: Human capital N: Natural endowments Y = AF (L, K, H, N) Sherif Khalifa () Development Theories 3 / 44

4 Y cy = AF (cl, ck, ch, cn) Productivity = Y ( L = AF 1, K L, H L, N ) L L : Productivity K L : Physical capital per worker H L : Human capital per worker : Natural endowments per worker N L Sherif Khalifa () Development Theories 4 / 44

5 Definition Natural Endowments are the inputs into production that are provided by nature. Natural resources take two forms: renewable and nonrenewable. There is only a limited supply of nonrenewable resources, once depleted it is impossible to create more. Natural resources are not necessary for an economy to be highly productive in producing goods and services. Natural endowments is no guarantee of development success, and lack of it is not necessarily an impediment. Conflict over these resources leads to a focus on the distribution of wealth rather than its creation, and to social strife, undemocratic governance and inequality. This is called the curse of natural resources. Sherif Khalifa () Development Theories 5 / 44

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7 Definition Human Capital is the knowledge and skills that workers acquire through education, training and experience. Producing human capital requires inputs in the form of teachers, schools, books, libraries, and student time. Students have the job of producing the human capital that will be used in future production. Investment in human capital has a direct cost and an opportunity cost. The opportunity cost is when students forgo the wages they could have earned had they not been attending school. Sherif Khalifa () Development Theories 7 / 44

8 An educated person can generate new ideas about how best to produce goods and services. If these ideas enter society s pool of knowledge, everyone can use them. The brain drain is the emigration of many highly educated workers to developed countries. Human capital is the level of education and knowledge, in addition to health conditions as well. Healthier workers are more productive and more capable of labor. Some countries are poor because their populations are malnourished and cannot afford adequate health care. Sherif Khalifa () Development Theories 8 / 44

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15 Definition Physical Capital is the stock of equipment, tools, and structures that are used to produce goods and services. Workers are more productive if they have more tools with which to work. More tools allow workers to produce output more quickly and more accurately. Physical capital is a produced factor of production. It is an input into the production process that in the past was an output from another production process. Physical capital is used to produce all kinds of goods and services, including more capital. Sherif Khalifa () Development Theories 15 / 44

16 If the economy produces a large quantity of capital goods, then tomorrow it will have a larger capital and be able to produce more. One way to increase future productivity is to invest more current resources in the production of capital. Since resources are scarce, devoting resources to producing capital requires devoting fewer resources for current consumption. Reducing consumption means increasing saving. This extra saving funds the production of investment goods. Growth requires the society to sacrifice consumption in the present to enjoy higher consumption in the future. Sherif Khalifa () Development Theories 16 / 44

17 Harrod-Domar S: national saving Y : national income or output s: saving ratio Saving is a proportion of national income S = sy Income Y=$100 s=0.3 Consumption C=$70 Saving S=sY=$30 Sherif Khalifa () Development Theories 17 / 44

18 Harrod-Domar k: capital-output ratio K: capital I : net investment Net national saving must equal net investment S = I Investment is the change in capital stock I = K Sherif Khalifa () Development Theories 18 / 44

19 Harrod-Domar The capital output ratio is given by K Y = K Y = k K = k Y ΔY=Y 1 Y 0 =$200 Y 0 =$100 Y 1 =$300 K 0 =$300 K 1 =$900 I=ΔK=K 1 K 0 =$600 Sherif Khalifa () Development Theories 19 / 44

20 Harrod-Domar GDP growth rate is given by S = sy = I = K = k Y sy = k Y Y Y = s k The growth rate of national income is positively related to the savings ratio and negatively related to the economy s capital output ratio. In order to grow, economies must save and invest a certain proportion of their GDP. Sherif Khalifa () Development Theories 20 / 44

21 Harrod-Domar Income Y=$100 s=0.3 Consumption C=$70 Saving S=sY=$30 Deposit in a Bank $30 Loans to Investors I=S=$30 Increase in Capital ΔK=I=$30 Increase in Output ΔY=$10 Sherif Khalifa () Development Theories 21 / 44

22 Harrod-Domar Income Y=$100 s=0.6 Consumption C=$40 Saving S=sY=$60 Deposit in a Bank $60 Loans to Investors I=S=$60 Increase in Capital ΔK=I=$60 Increase in Output ΔY=$20 Sherif Khalifa () Development Theories 22 / 44

23 Harrod-Domar Income Y=$100 s=0 Consumption C=$100 Saving S=sY=$0 Deposit in a Bank $0 Borrow from developed countries Loans to Investors I=S=$60 Increase in Capital ΔK=I=$60 Increase in Output ΔY=$20 Sherif Khalifa () Development Theories 23 / 44

24 Harrod-Domar s=6% k=3 Y Y = s k 2% = 6% 3 s=15% k=3 Y = s Y k 5% = 15% 3 Sherif Khalifa () Development Theories 24 / 44

25 Harrod-Domar Low level of saving in developing countries due to low levels of income. This can not be replaced by transfers of capital and technical assistance from developed countries. The modelassumes the existence of the same circmstances in developing contries as in Europe after World war II with Marshall plan. Sherif Khalifa () Development Theories 25 / 44

26 Lewis Theory of Development Definition Structural transformation is the process of transforming an economy in such a way that the contribution to national income by the manufacturing sector eventually surpasses the contribution by the agricultural sector. Definition Lewis theory is a theory of development in which surplus labor from the traditional agricultural sector is transferred to the modern industrial sector, the growth of which absorbs the surplus labor, promotes industrialization, and stimulates sustainable development. Definition Surplus labor is the excess supply of labor over and above the quantity demanded at the going market wage rate. It refers to the portion of rural labor whose marginal productivity is zero. Sherif Khalifa () Development Theories 26 / 44

27 Lewis Theory of Development Structural change theory focuses on how underdeveloped economies transform their economic structures. The transformation is from traditional subsistence agriculture to a modern urbanized industrialized economy. A traditional, overpopulated rural subsistence sector characterized by zero marginal labor productivity. A high productivity modern urban industrial sector into which labor from the subsistence sector is gradually transferred. Sherif Khalifa () Development Theories 27 / 44

28 Lewis Theory of Development There is surplus labor in the rural sector which can be withdrawn without any loss of output. All rural workers share equally in the output so that the rural wage is determined by the average product of labor. The urban wage is above the rural average income, and modern sector can hire as many workers without fear of increasing wages. The profits of the modern sector are reinvested and the total capital stock increases inducing more labor recruitment. This process of employment expansion is assumed to continue until all surplus rural labor is absorbed in the new industrial sector. Sherif Khalifa () Development Theories 28 / 44

29 Lewis Theory of Development Labor MPL TPL APL Sherif Khalifa () Development Theories 29 / 44

30 Lewis Theory of Development TPL Labor Sherif Khalifa () Development Theories 30 / 44

31 Lewis Theory of Development APL MPL Labor Sherif Khalifa () Development Theories 31 / 44

32 Lewis Theory of Development TPL Machines Machine Labor Sherif Khalifa () Development Theories 32 / 44

33 Lewis Theory of Development 100 Wage Demand 1 Machine Demand 2 Machines 0 Labor Sherif Khalifa () Development Theories 33 / 44

34 Lewis Theory of Development 100 Wage Supply Demand 1 Machine Demand 2 Machines Labor Sherif Khalifa () Development Theories 34 / 44

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36 Lewis Theory of Development Profits can be reinvested in more sophisticated labor saving capital equipment rather than just duplicating the existing capital. Profits can be sent abroad and not reinvested in the domestic economy. The assumption that wages are fixed in the manufacturing sector is not realistic. Workers in the rural sector cannot work in the urban sector without training which is costly. Sherif Khalifa () Development Theories 36 / 44

37 Solow Growth Model Growth facts pose the question concerning the sources of economic growth over time and the cause of differences across countries. A framework is developed to think about the causes and the process of economic growth and cross country differences. This framework allows to study sources of economic growth and gain an understanding of which country characteristics are conducive to economic growth. The Solow growth model is designed to show how growth in the capital stock, growth in the labor force, and advances in technology affect a nation s total output of goods and services. Sherif Khalifa () Development Theories 37 / 44

38 Solow Growth Model ( 1 L Y = F (K, L) ) (( ) 1 Y = F K, L ( ) Y K = F L L, 1 y = f (k) ( ) ) 1 L L Sherif Khalifa () Development Theories 38 / 44

39 Solow Growth Model Y = (K ) α (AL) 1 α ( ) Y K α ( AL = L AL AL y = A (k) α ) 1 α Sherif Khalifa () Development Theories 39 / 44

40 Solow Growth Model y = c + i c = (1 s) y y = (1 s) y + i i = sy i = sf (k) Sherif Khalifa () Development Theories 40 / 44

41 Solow Growth Model Definition Investment is expenditure on new plant and equipment, and it causes the capital stock to increase. Definition Depreciation is the wearing out of old capital, and it causes the capital stock to fall. Definition The breakeven investment is the amount of investment necessary to keep the capital stock per worker constant. Sherif Khalifa () Development Theories 41 / 44

42 Solow Growth Model k = i (δ + n) k k = sf (k) (δ + n) k Definition The steady state value of capital k that maximizes consumption is called the Golden Rule level of capital. k = 0 0 = sf (k ) (δ + n) k sf (k ) = (δ + n) k Sherif Khalifa () Development Theories 42 / 44

43 Solow Growth Model Sherif Khalifa () Development Theories 43 / 44

44 Solow Growth Model Sherif Khalifa () Development Theories 44 / 44