TOPIC 2: MODELS AND

THEORIES OF ECONOMIC
GROWTH AND
DEVELOPMENT
OUTLINE
 Objectives
 Learning outcomes
 Introduction
 Development as Growth and the Linear Stages Theories
- Rostow’s stages of growth
- The Harrod-Domar Model
 Structural-Change Models
- The Lewis theory of development
- Structural change and patterns of development
 The International Dependence Revolution
-The Neo-colonial dependence model
-The False paradigm model
-The Dualistic development thesis
 Neo-classical Growth Model
- Solow Growth model
 Conclusions
Objectives
This topic aims at:
 Discussing the theories used in the study of
development issues
 Explaining how empirical studies inform our
thinking about development issues
Learning Outcomes
At the end of this topic, you should be able to
 Explain the importance of theory in
understanding development issues
 Explain and evaluate the various theories used
to study development issues
 Apply these theories in the conduct of research
in order to come up with development policies
 Introduction
 In studying development issues it is important to
start with a theory.

 Theory is not necessarily a mathematical model

but is a careful articulation of mechanisms that
link factors to outcomes.

 There are four roles that theory could play in

development:
1. It maps the relevant factors and their
interactions with each other and with
outcomes.
2. It clarifies the assumptions under which
government intervention is needed.
In other words, it helps identify the market
failures that justify policy making.
3. Theory provides quantitative implications that
could be tested using data.
4. Theory provides a framework for
understanding empirical work.
Once you have a theoretical understanding of
issues you need to test whether the predictions
are held in the data.

Furthermore, theory could outline potential

policies for improving outcomes.

In order to assess the effectiveness of such

policies you need to engage in empirical
evaluation using data.
Econometrics is a powerful tool in testing
predictions and evaluating alternative policies.

It is, however, very important to understand

the pitfalls and limitations of econometric
analysis.

Often in development economics, we are

interested in knowing the relationship between
two variables.
 For example, we want to know whether building
schools increases educational attainment or
whether getting a loan helps with entrepreneurial
activities.

 Regression analysis is the natural tool for dealing

with these questions

 About 50 years ago, the freshly decolonized,

'underdeveloped' nations began a wild process of
catching up with the West. ‘
 Development at that time meant economic growth
and industrialization as it was thought of, by the
political and economic elite, as the key to
development.

 Many of the LDCs embarked on varying projects

of national development.

 Some began to develop indigenous industries for

export, others stepped up industrial production to
substitute for imports
 In this singular conception of ‘development’ as
economic growth, industrialization became a race of
catching up with the West or with standards almost
entirely set by West-centric institutions for a country to
be deemed developed

 This activity was the project which has come to be

known as modernization also referred to in some
quarters as westernization

 Based on the concept of modernization, development

theories were developed to guide developing countries
on how they can attain development
DEVELOPMENT AS GROWTH AND THE
LINEAR-STAGES THEORIES
 These theories focus on development as a linear
stages process.

 This implies that for a country to develop, it has

to follow a linear process.

 In addition, these theories consider development

as economic growth and industrialization
Rostow’s Linear Stages of Growth Theory

 In 1960 Rostow published a book tittled “The

Stages of Economic Growth: A Non-Communist
Manifesto.”

 In this book, he proposed the Rostowian take-off

model of economic growth which is one of the
major historical models of economic growth.
 It is based on the concept of economic
modernization

 The model argues that economic modernization

occurs in five basic stages of varying length

 These stages include:

I. The traditional society
II. The pre-conditions for take off/transitional stage
III. The take-off
IV. The drive to maturity
V. The age of high mass consumption
Stage 1: Traditional Society/Stage
The first stage in Rostow’s theory is known
as the Traditional Society.

A traditional society is one whose structure

is developed within limited production
functions, based on pre-Newtonian science
and technology, and on pre-Newtonian
attitudes towards the physical world
This stage is associated with the country that
has not yet developed but the majority of the
people are engaged in subsistence agriculture

Generally speaking, the traditional societies,

because of the limitation on productivity, had
to devote a very high proportion of their
resources to agriculture
Main characteristics of the Traditional Society
Family and clan connections played a large
role in social organization.

The value system of these societies was

generally geared to what might be called a
long-run fatalism; that is, the assumption
that the range of possibilities open to one's
grandchildren would be just about what it
had been for one's grandparents
Largely agrarian

Subsistent, agricultural based economy,

Limited infrastructure

 Imperfect information

 Low degree of monopoly power

Limited market interaction

 Trade in the Traditional Society also usually done
using barter system

 There is form of technological innovations but it

only exists on ad
hoc basis (Todaro and Smith, 2003)

 The investment levels are less than 5% in

traditional society
 The society at the traditional stage has a cadre of people
that are in a condition of disparity and deny that people
could change their living
conditions because their minds are magical, mystical an
d non historical in the sense that they will not be
able to dig to find out how to change or improve their
well-being

 The manufacturing sector and industries in traditional

society have a tendency to grow but have always been
limited by the inadequate scientific knowledge and
backward frame of the minds which result into low
labour productivity (Carmody, 2004).
Stage 2: Pre-conditions For Take-Off
 The second stage of development or economic
growth is called the pre-conditions for take-off or
transitional stage

 A society at this stage undergoes a process of

change for building up of conditions for growth
and eventual take off

 The pre-condition for take-off consists of certain

dimensions that are associated with this transition
from traditional society through the conditions to
the take off phase
Main Characteristics of Pre-conditions For
Take-Off
Economic growth is seen as a necessary
condition for some other purpose, judged to be
good

There is a shift from agrarian to industrial or

manufacturing society,

Increasing access to agricultural technology

The main focus of this stage is to ensure that investment
levels are above 5% of the national income

Start of formal human capital accumulation

Trade and other commercial activities are broadened to

reach not only local markets but also international
markets

 Low levels of market specialization and diversification

 Rudimentary financial markets start emerging

 At this stage, new types of enterprising men come
forward--in the private economy, in government, or
both--willing to mobilize savings and to take risks
in pursuit of profit or modernization.

 Banks and other institutions for mobilizing capital

appear.

 Investment increases, notably in transport,

communications, and in raw materials in which
other nations may have an economic interest.
Stage 3: Take-Off
Key Characteristics of the Take-off Stage
 There is an increase in industrialization

 Further growth in savings and investments: the rate

of investment and savings may rise from 5 % of the
national income to 10% or more

 Decline in the number of employees in agriculture

 increase in entrepreneurship
 “During the take-off, new industries expand
rapidly, yielding profits a large proportion of
which are reinvested in new plant; and these new
industries, in turn, stimulate, through their rapidly
expanding requirement for factory workers, the
services to support them, and for other
manufactured goods, a further expansion in urban
areas and in other modern industrial plants”

 Once take-off has taken place a country will take

as long as fifty to one hundred years to reach
maturity as was the case with the industrial
revolution.
It was argued that the advanced nations
had all passed the stage of take-off into
self-sustaining growth and the
underdeveloped countries that were still in
either the traditional society or the “pre-
conditions” stage had only to follow a
certain set of rules of development to take
off in their turn into self-sustaining
economic growth.
Stage 4: Drive to Maturity
After take-off there follows a long
interval of sustained progress.

This is called the Drive to Maturity

This stage is attained approximately

60 years after take-off
 Formally, we can define drive to maturity as the
stage in which an economy demonstrates the
capacity to move beyond the original industries
which powered its take-off and to absorb and to
apply efficiently over a very wide range of its
resources--if not the whole range--the most
advanced fruits of (then) modern technology.

 This is the stage in which an economy

demonstrates that it has the technological and
entrepreneurial skills to produce not everything,
but anything that it chooses to produce.
Investments rise between 10-20% of the
national income is steadily invested,
permitting output regularly to outstrip the
increase in population

During this stage the economy finds its place

in the international economy and those
goods that were imported begin to be
produced locally and new requirements for
import are developed (Todaro and Smith,
2003)
Stage 5: Age of High Mass Consumption
The fifth and final stage is called the age of
high mass consumption where the leading
sectors in the society shift towards durable
consumers goods and services.

Preston (1988) asserts that this stage is

concerned with the high output levels, mass
consumption of consumer goods
and durables and increase in employment in
the service sectors.
The Role of Education in the 5 Stages
Education has an important and direct
relationship to addressing each of the five
stages of modernization theory or economic
development in any given society or country
(Carmody, 2004)

For example in the traditional society

education is vital as it helps people to acquire
better ways and methods of farming in order
to enhance agricultural activities.
 In the pre-conditions for take-off, education helps
people to be aware of the political aspects of society
and that there are other ways of investments such as
industry and manufacturing rather than farming life
which is associated with traditional society.

 Education is vital in this stage as it helps people to

acquire the knowledge about the importance of
engaging in international marketing in order to enhance
the investment levels.

 Education also inculcates new values and attitudes in

the people and also to allow them learn how to manage
their resources
 Weaknesses of the Linear Stages Growth Theory
 Focuses on industrialization as development

 Tends to treat LDCs as one homogenous group which

need similar solutions

 Too simplified: it neglects the fact that human nature

has a propensity to resist change which brings in
elements of uncertainty

 In this model, the modernization of a society requires

the destruction of the indigenous culture and its
replacement by a more Westernized one
 It is based on deterministic reason which states
that within the linear model of socio-economic
development, changes are initiated externally.

 For instance, it is associated with development aid

from the developed countries.

 The theory emphasizes supremacy of the

metropolis (developed countries) that altered
Africa’s superstructure of beliefs and value
system.
The Harrod-Domar Growth Model
 The Harrod-Domar Growth model is another linear
stages growth model which was developed in the 1950s
and 1960s based on the premise that economic growth
and/or development is a linear growth process

 It is named after the economists Roy F. Harrod and

Evsey D. Domar

 According to Rostow, for an economy to take off, it has

to mobilise domestic and foreign savings in order to
generate sufficient investment to accelerate economic
growth.
 The Harrod-Domar growth model (AK model)
describes the economic mechanism by which the
generated investments from savings can lead to
more growth

 It is a functional economic relationship in which

the growth rate of gross domestic product (g)
depends directly on the national net savings rate
(s) and inversely on the national capital-output
ratio (k), that is

𝑠
𝑔= ……………………i
𝑘
 The model is based on a linear production
function with output given by capital stock, K
times a constant, A, that is;
𝑌 = 𝐴𝐾………………..ii

 It has been applied in one form or another to

policy issues facing developing countries

 According to this model, if a nation seeks to only

replace worn out or impaired capital goods
(buildings, equipment, and raw materials), it must
save a proportion of the its national income
 But for an economy to grow, new investments
representing net additions to capital stock are
necessary

 Assuming that there is a direct relationship

between capital stock, K and total GDP, Y then
any net additions to capital stock in the form of
new investment will lead to corresponding
increases in the flow of national output

 The model also assumes full employment of

capital and labour
 Assume that the capital-output ratio (the units of
capital required to produce a unit of output over a
given period of time) is given by k. Thus
𝐾
𝑘= ………………………iii
𝑌

 Further assume that net savings, S, is a fixed

proportion of national output and that total new
investment is determined by the level of total
savings. That is

𝑆 = 𝑠𝑌…………………iv
 Net investment (I) is defined as the change in
capital stock, K and can be represented by ΔK so
that
𝐼 = ∆𝐾……………………..v

 But since K is directly related to Y, then

equation iii can be written as
∆𝐾
𝑘=
∆𝑌

OR Δ𝐾 = 𝑘Δ𝑌…………….vi
Because net savings, S, must equal net
investment, I, then

𝑆 = 𝐼………………..vii
Substituting iv, v and vi into vii yields:

𝑆 = 𝑠𝑌 = 𝑘∆𝑌 = ∆𝐾 = 𝐼 or simply

𝑠𝑌 = 𝑘∆𝑌 ……………………viii
Dividing both sides of the equation first by Y
and then by k we obtain:
∆𝑌 𝑠
= ……………………ix
𝑌 𝑘
𝑠
Or 𝑔 = ………………x
𝑘

The left hand side represents the rate of change

or the rate of growth of GDP
Equation x represents the AK model and is
sometimes called the Harrod-Domar equation

This equation states that the rate of growth of

GDP is determined jointly by net national
savings ratio, s, and the national capital-output
ratio, k

The importance of this equation is that it

shows the growth rate of output required to
maintain full employment of capital stock
More precisely, in order to have full
employment of capital stock, output must grow
𝑠
at the rate of
𝑘

𝑠
The ratio is known as the warranted rate of
𝑘
economic growth

The essence of equation x is that it tells us how

increase in GDP (Y) can be achieved overtime
and this can be achieved in two ways:
a. Lowering the capital-output ratio, k: this is
equivalent to increasing the effectiveness with
which capital is employed to produce output
b. Raising the proportion of national income that is
saved. Since in the model S = I, raising S
increases I and the productive capacity of the
economy. This in turn increases income and
output in subsequent periods
 Generally, the equation or model implies that in
the absence of government, the growth rate of
national income will be directly related to savings
ratio and inversely related to the economy’s
capital-output ratio
 The economic logic of equation x is that for economies
to grow, they must save and invest a certain proportion
of their GDP.

 The more they can save and invest, the faster they can
grow

 But the actual rate at which they can grow for any level
of investment and saving (how much additional output
can be had from an additional unit of investment) can
be measured by the inverse of capital-output ratio, k,
1
because is the output-capital or output-investment
𝑘
ratio
 𝐼
 Multiplying the rate of new investment, 𝑠 = by
𝑌
1
its productivity, will give the rate by which
𝐾
national income will increase

 In addition to investment, two other components

of economic growth are labour force growth and
technological progress

 In the context of the Harrod-Domar model, labour

force growth is not described explicitly.
This is because labour is assumed to be
abundant in a developing-country context and
can be hired as needed in a given proportion to
capital investments (this assumption is not
always valid).

In a general way, technological progress can be

expressed in the Harrod-Domar context as a
decrease in the required capital-output ratio,
giving more growth for a given level of
investment
This is obvious when we realize that in the
long run this ratio is not fixed but can change
over time in response to the functioning of
financial markets and the policy environment.

But again, the focus was on the role of capital

investment.
Obstacles and Constraints
 This theory postulates that the main constraint on
development is the relatively low levels of new
capital formation in most developing countries
 Thus the “capital constraint” and “savings gap”
stages approach to growth and development
became a rationale and (in terms of Cold War
politics) an opportunistic tool for justifying
massive transfers of capital and technical
assistance from the developed to the less
developed nations.
Capital formation, through saving and
investment, is a necessary condition for
accelerated economic growth but is not a
sufficient condition

For sustained economic growth to be achieved,

social, institutional, and attitudinal changes
may have to occur.
The economic mechanism embodied in the
linear stages growth theory did not work

This was attributed to the fact that more saving

and investment is a necessary condition for
accelerated economic growth rates but it is not
a sufficient condition.
 The Rostow and Harrod-Domar growth models
assume that developing countries possess the
necessary structural, institutional, and attitudinal
conditions to convert new capital effectively into
higher levels of output.

 For example, well-integrated commodity and

money markets, highly developed transport
facilities, a well-trained and educated workforce,
the motivation to succeed, an efficient
government bureaucracy are some of the
conditions that lack in poor countries
In addition, factors such as managerial
competence, skilled labour, and the ability to
plan and administer a wide assortment of
development projects also lack in these
countries

The Harrod-Domar model assumes fixed

levels of s and k but these can be varied
STRUCTURAL-CHANGE MODELS
The structural-change theory is the
hypothesis that un-development is due to
underutilization of resources arising from
structural or institutional factors that have their
origins in both domestic and international
dualism.

Development therefore requires more than just

accelerated capital formation.
It focuses on the mechanism by which
underdeveloped economies transform their
domestic economic structures from traditional
to an industrial economy

Tools of neo-classical price and resource

allocation theory and modern econometrics are
used to describe how transformation of a
traditional economy occurs
Two representative examples of this strand of
thought:

1. The Lewis theory of development

2. Chenery’s patterns of development

The Lewis Theory of Development
 Also known as the two-sector surplus labor model

 Basic Model Assumptions:

 The economy has only two sectors: traditional and Modern

 Marginal productivity in the traditional sector is zero

(𝑀𝑃𝑙 = 0) implying that there’s surplus labour

 All rural workers share equally in the output so that the

rural real wage is determined by the average and not the
marginal product of labour
 High productivity in the modern sector

 The model focuses on labour transfer from the

traditional sector and growth of output and
employment in the modern sector

 Transfer of labour and modern sector employment

result from output expansion given that
productivity is high in this sector.

 The speed with which output expands is

determined by the rate of industrial investment
and capital accumulation in the modern sector.
Investment occurs on the assumption that
capitalists re-invest all their profits

The level of wages in the industrial sector is

constant and above the wage in the traditional
sector

At the urban wage, the supply curve of rural

labour to the modern sector is considered to be
perfectly elastic.
Perfectly competitive labour markets and
variable capital in the modern sector such that
marginal product curve = demand curve for
labour

The process of self-sustaining growth and

employment expansion continues in the
modern sector until all of the surplus labor is
absorbed

Structural transformation of the economy has

taken place with the growth of the modern
industry
 The process of self-sustaining growth and employment
expansion continues in the modern sector until all of
the surplus labor is absorbed
 Thereafter, further transfer of labour from the
traditional sector will be done at the cost of lost food
production because the declining labour-to-land ratio
means that the marginal product of rural labour is no
longer zero
 This is known as the “Lewis turning point.” Thus the
labour supply curve becomes positively sloped as
modern sector wages and employment continue to
grow.
 Structural transformation of the economy has taken
place with the growth of the modern industry
 Criticisms of the Model
 Four of the key assumptions do not fit the realities of
contemporary developing countries

 Reality is that:
 Capitalist profits are invested in labor saving
technology
 Existence of capital flight
 Little surplus labor in rural areas
 Growing prevalence of urban surplus labor
 Tendency for industrial sector wages to rise in the
face of open unemployment
 This model thus, requires considerable modification
in assumptions and analysis to fit the reality of most
contemporary developing nations.
Taking into account laborsaving bias of most
modern technological transfer, the existence of
substantial capital flight, the widespread
nonexistence of rural surplus labor, the growing
prevalence of urban surplus labor, and the
tendency for modern-sector wages to rise
rapidly even where substantial open
unemployment exists.
 Chenery’s Structural Changes and
Patterns of Development

 Savings and investment are necessary but not

sufficient for economic growth

 Accumulation of both physical and human capital

must be accompanied by a set of interrelated
changes in the economic structure for a country to
transition from a traditional economic system to a
modern one.
Structural changes involve the transformation
of:

 production and changes in the composition of

consumer demand,
 international trade, and
 resource use
 urbanization and the growth and distribution of
a country’s population.
 Empirical studies emphasize both domestic and
international constraints to which differences in
development of developing countries ascribe.

 The domestic ones include:

 resource endowment
 population
 government policies and objectives.

 International constraints include:

 access to external capital
 technology, and
 international trade.
But, it is the international constraints that make
the transition of currently developing countries
differ from that of now industrialized
countries.

Given that developing countries have access to

sources of capital, technology, manufactured
imports and markets for exports, they can grow
at an even faster rate than that achieved by the
industrial countries during the early periods of
their economic development.
Thus, unlike the earlier stages model, the
structural-change model recognizes the fact
that developing countries are part of an
integrated international system that can
promote (as well as hinder) their development

 In conclusion, structural-change analysts

believe that the “correct” mix of economic
policies will generate beneficial patterns of
self-sustaining growth.