About 80% of the countries have GDP per capita below the average income per head

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1 ECON 7010: Economics of Development Introduction to Economics Development Why poor countries consume less? Because they produce less Lack of physical capital (no tools and machinery) Lack of necessary education (low productivity) Not healthy enough (low productivity) High population growth, high fertility rates, have too many children (high dependency ratio) Lack of access to credit, women who are main brokers of health and education cannot gain access to credit for income generating activities (require microfinance) Cultures, institutions and governments Poverty traps require a simultaneous and coordinated large scale investments in capital, education and technology About 80% of the countries have GDP per capita below the average income per head Poverty proxied by relative income per capita is indeed multi-dimensional. There are Proximate and Fundamental determinants of poverty. Proximate determinants of poverty are causes that directly affect the variable of interest (low income per capita) ex. Low levels of physical capital and human capital accumulation, low levels of technology, lack of access to credit high population growth and low levels of efficiency Lack of education low productivity, cannot acquire skills to participate in the industry low income Fundamental determinants of poverty are causes that indirectly affect variable of interest by systematically affecting one or more causes that in turn affect income per capita. Ex. Government, geography, climate, resources, culture, ethnic composition, rule of law. Countries near the equator have lower levels of income per capita because people in these countries have higher tendency to be malaria-striken. Poor health poor productivity low levels of income per capita Geography: Landlocked, access to markets and trade, geopolitical area, terrain and soil quality that affect agriculture Political and legal institutions, intellectual property rights that affect incentives to invest and innovate and government provision of public goods that is a prerequisite for certain investments Countries with low levels of trust such as countries with slavery history translates to low levels of investment low levels of output These causes affect income per capita by affecting the proximate causes of poverty.

2 Gross Domestic Product (GDP) = total value of all goods and services produced in a country in a year Per Capita Gross Domestic Product (GDP) = Total value of goods and services/total population Take into account inflation by using same units over time ex. In constant 1990 US$: Real per capita GDP Unadjusted figures are Nominal per capita GDP Compare prices of two different countries: Use market exchange rate Limitations Exchange rate can fluctuate significantly Exchange rate produced biased income comparisons (exchange rate adjusts to equalize price of traded goods) but in poor countries, non traded goods are relatively less expensive than traded goods Therefore x should be higher in P US = x (P IND ) where x is the market exchange rate of 1/40. If we use market exchange rate, India s GDP will be underestimated Alternative is to use Purchasing Power Parity (PPP) Purchasing power parity exchange rate is based on a basket of traded and non traded goods Best income measure: PPP adjusted real per capita GDP Richest 20% of the world population receive 62% of world income Countries are richer today because they experience faster rates of economic growth in the past therefore it is important to understand determinants of real income per capita growth Y t+n = Y t (1+g) n Asian tigers: Singapore, Taiwan, Hong Kong and South Korea experienced high rates of income growth annually with about 7% South Korea experienced rapid growth within a generation. Rise was characterized by rapidly increasing agricultural productivity, shifts of labour from agriculture to industry, steady growth of capital stock and increase in education and skills levels. Between 1965 to 1990, South Korea s income per capita grew by 7% annually. South Korea had extensive development planning, land reforms, industrial policies and government intervention that translate to high income growth. Of the world s population, 13% has not enough to eat, 16% has no access to safe drinkable water and 38% do not have access to sanitation HDI (Human Development Index) Life expectancy

3 Educational attainment (adult literacy, school enrollment) Per capita GDP Traditional Theories of Economic Development Model Key points 1. The Harrod-Domar Model Y = S + C where Y is aggregate GDP S = sy where s is savings rate All savings are invested into productive capital S = I where I is aggregate investment I = ΔK Goods are produced using capital and k is the capital-to-output ratio so $k of capital is needed to produce $1 of output Y ΔK = kδy Therefore, sy = S = I = ΔK = kδy (ΔY/Y) = (s/k) Harrod-Domar equation A country s savings rate is the primary determinant of growth and development Potential problems: a. Production is assumed to use capital only b. Production assumed to be constant returns to scale c. Production can have other inputs like labour, skills, infrastructure d. Assumes that there is a necessary government or institutional structure so that savings can be converted into investment efficiently and investment is translated into capital e. The rich has higher income so they save more and they experience more growth. Model predicts extreme divergence in income Policy implications: Financing gap All that is needed to spur economic development is sufficiently high level of savings and investment but the poor are too poor to have high level of savings.

4 Gap between needed investment and actual savings is the financing gap that can be achieved by foreign aid or soft loans. Foreign aid Investment Growth Capital-output ratio k is also known as Incremental Capital to Output ratio (ICOR) 2. Rostow s Stages of Growth 1. Traditional society (high proportion of production in agriculture, limited productivity ex. Medieval Europe) 2. Pre-conditions for take-off into self-sustaining growth (In process of transition, basic manufacture ex. Early 18 th century Western Europe) 3. The take-off -modern activity expands -more production and infrastructure -economic growth becomes persistent -savings may rise from 5% to 10% or more of national income -industry expands rapidly -this stage lasts for about 20years Ex. Britain after 1780s or US after The drive to maturity -long period of sustained growth -10% to 20% of national income saved and invested -typically after 40 years of maturity reached 5. Age of mass consumption -shift to production of consumer durables, services and other hightech and skill intensive products -development of welfare state -benefit from the investment in capital Ex. Europe and US in 1950s According to Rostow, developed countries of his time had already passed through all the stages. Developing countries are either in Stage 1 or Stage 2. Sustained growth was inevitable as long as savings rate was sufficient for the investment necessary to generate sustained

5 growth. Predicts that development is inevitable but this is not true. Some developing countries did not grow at all over the years. There are other factors affecting development such as governments, infrastructure and education. 3. Easterly s Tests Easterly s First Test shows that only 17 out of 88 countries have a positive and statistically significant relationship between aid and investment Foreign aid may not be used for investment if people do not have the incentives to invest so they will use foreign aid for consumption goods. Returns to invest are low. Giving more money does not change the incentives to invest. No relationship between investment and aid Easterly s Second Test shows there are no relationship between average investment over a 4 year period and average GDP growth over the next 4 year period so investment does not translate to growth immediately. Easterly s Third Test: Maybe investment is a necessary but not a sufficient condition for growth. BUT, in 9 out of 10 cases countries with 4 year growth episodes that are 7% per year or higher did not have necessary levels of investment Easterly s conclusion: In the short to medium run, investment is neither a sufficient nor necessary condition for increased growth. Investment is not the main constraint for growth because in countries with abundant cheap labour like China, labour can be used to substitute machinery if capital is scarce. He admits there is a positive relationship between investment and economic growth but he believes both are driven by 3 rd factor: incentives to invest in the future.

6 Incentives to invest cause investment in machines, education and efficient institutions, infrastructure, quality of public provision etc 4. Structural Change: Empiricl analysis of Hollis and Moshe 5. Lewis Two Sector Model -developed by Arthur Lewis -dominant model of Economic development in 1960s and 1970s -highlights urbanization and industrialization Stylised patterns of economic development Examined the characteristics that changed with rising income: Investment, government revenue, education, foreign trade, urbanization, agriculture, demographic transition Two sectors 1. Agricultural sector -Marginal product of labour MPL = 0 -rural workers share labour equally -there is surplus labour in this sector 2. Modern Sector -Labour is productive -MPL > 0 Sustained growth comes from two sources a. Surplus labour where labour can be drawn from agriculture to industry and modern sector expands b. Investment where capitalists profits are reinvested in capital and modern sector expands further This process continues until all surplus labour is used up. The more profits are invested, the more modern sector expands. Potential problems: a. Assume that profits are always reinvested into more capital and this results in more jobs. BUT profits may not be reinvested and they can be reinvested in new forms of labour savings capital (employment process stops) b. Assume that there is full employment in cities and unemployment in countryside. BUT there may not be surplus labour in rural areas. Surplus labour in agriculture is not a realistic assumption in vast number of low income countries (harvest season) c. Fast rate of capital accumulation fast rate of growth in

7 modern sector fast rate of job creation may not occur d. Rate of transfer of labour from agriculture to industry is proportional to rate of industrial/modern sector capital accumulation e. Modern sector wages are not set in a competitive labour market. Labour unions, multi-national companies hiring practices and institutional factors play an important role. f. Difficult to switch labour from agriculture to industry because of occupational immobility or geographical immobility Ex. In Ethiopia, with a population growth of 2.79%, labour is growing faster than what the economy can gainfully employ. Unemployment rate in urban areas is about 20.6% and agriculture is still the main economic activity for most citizens. Lewis two sector model not very applicable in Ethiopia. Harris & Todaro s rural-urban migration model -In 1960s and 1970s, there were strong labour unions and wages are institutionally set. -labour migrates on the basis of expected wages in cities -Some people ended up in informal employment in cities such as flower sellers and little food hawkers 6. The Solow Model Y = F (K, L) = AK a L 1-a -Assume production exhibits constant returns to scale -Assume diminishing marginal product of capital -2 inputs in production (capital and labour) -very optimistic model -assumes that the poor countries will grow faster and catch up with rich countries with all other things being equal -the poorer the country, the faster it should grow -predict convergence -predict that capital should flow from developed countries to developing countries since developing countries have higher MPK -BUT in reality, capital flows to most developed countries (Investment rates differ and other factors like government policy, culture, geography determines the savings rate)