Lecture (3)

DR. Rania Anis

Lecturer of economics
Faculty of Economic Studies and Political Science – Alexandria University
Classic Theories of Economic Development
• The classic post–World War II literature on economic development
has been dominated by four major and sometimes competing strands
of thought:
(1) the linear-stages-of-growth model,
(2) theories and patterns of structural change,
(3) the international-dependence revolution,
(4) the neoclassical, free market counterrevolution.
• In recent years, an eclectic approach has emerged that draws on all of
these classic theories.
https://prezi.com/p/19br6bxgmjd-/31-classic-theories-of-economic-development-four-approaches/
➢ The linear-stages-of-growth model
• Theorists of the 1950s and 1960s viewed the process of development as a
series of successive stages of economic growth through which all
countries must pass.
• It was primarily an economic theory of development in which the right
quantity and mixture of saving, investment, and foreign aid were all that
was necessary to enable developing nations to proceed along an
economic growth path that had historically been followed by the more
developed countries.
• Development thus became synonymous with rapid, aggregate economic
growth.
Theories and patterns of structural change
versus the international-dependence revolution
The linear-stages approach was largely replaced in the 1970s
by two competing schools of thought.

➢First, theories and patterns of structural change.

➢Second, the international-dependence revolution.

➢ Theories and patterns of structural change

Theories and patterns of structural change used modern economic theory

and statistical analysis in an attempt to portray the internal process of
structural change that a “typical” developing country must undergo if it is
to succeed in generating and sustaining rapid economic growth.
 ➢ The international-dependence revolution
• The international-dependence revolution, was more radical and more political.
• It viewed “underdevelopment” in terms of international and domestic power
relationships, institutional and structural economic rigidities, and the resulting
proliferation of dual economies both within and among the nations of the world.
Dual economies refers to the coexistence of modern and traditional economic
sectors in an economy. Dual economies are common in less developed countries,
where one sector is geared to local needs and another to the global export market.
• Dependence theories tended to emphasize external and internal institutional and
political constraints on economic development.
• Emphasis was placed on the need for new policies to eradicate poverty, to provide
more diversified employment opportunities, and to reduce income inequalities.
➢ The neoclassical, free market counterrevolution

• Throughout much of the 1980s and 1990s, a fourth approach prevailed.

• This neoclassical (sometimes called neoliberal) counterrevolution in economic
thought emphasized the beneficial role of free markets, open economies, and the
privatization of inefficient public enterprises.
• Failure to develop, according to this theory, was not due to exploitive external and
internal forces as expounded by dependence theorists. Rather, it was primarily the
result of too much government intervention and regulation of the economy.
the linear-stages-of-growth model

https://prezi.com/6kjelob55mj9/development-and-the-linear-stages-theories/
(1) The Linear-Stages Theories
1.1. Rostow’s Stages of Growth
• According to Rostow, the transition from underdevelopment to development
can be described in terms of a series of steps or stages through which all
countries must proceed.

• According to this theory, it is possible to identify all societies, in their

economic dimensions, as lying within one of five categories:
1. the traditional society,
2. the preconditions for takeoff into self-sustaining growth,
3. the take-off,
4. the drive to maturity,
5. the age of high mass consumption.
Assumptions of Rostows model,

➢The advanced countries had all passed the stage of “take-off into self-sustaining growth,”
➢The underdeveloped countries that were still in either the traditional society or the
“preconditions” stage had only to follow a certain set of rules of development to take off
in their turn into self sustaining economic growth.
• One of the principal strategies of development necessary for any takeoff was the
mobilization of domestic and foreign saving in order to generate sufficient investment to
accelerate economic growth.
• The economic mechanism by which more investment leads to more growth can be
described in terms of the Harrod-Domar growth model, today often referred to as the AK
model because it is based on a linear production function with output given by the
capital stock K times a constant, often labeled A.
1.2. The Harrod-Domar Growth Model

• Every economy must save a certain proportion of its national income, if only to replace
worn-out capital goods (buildings, equipment, and materials).
• However, in order to grow, new investments representing net additions to the capital
stock are necessary.
• There is a direct economic relationship between the size of the total capital stock, K, and
total GDP, Y.
• For example, if $3 of capital is always necessary to produce an annual $1 stream of GDP—
it follows that any net additions to the capital stock in the form of new investment will
bring about corresponding increases in the flow of national output, GDP.
• This relationship, known in economics as the capital-output ratio.
If we define the capital-output ratio as k and assume further that:
• the national net savings ratio, s, is a fixed proportion of national output
• the total new investment is determined by the level of total savings,

we can construct the following simple model of economic growth:

1. Net saving (S) is some proportion, s, of national income (Y) such that we
have the simple equation
S = sY (1)
2. Net investment (I) is defined as the change in the capital stock, K, and can be represented
by ΔK such that
I = ΔK (2)
• But because the total capital stock, K, bears a direct relationship to total national income
or output, Y, as expressed by the capital-output ratio, c, it follows that
𝐾 ∆𝐾
=c or =𝑐
𝑌 ∆𝑌
or, finally,
ΔK = cΔY (3)
1/c is a measure of the efficiency of capital utilization.
3. Finally, because net national savings, S, must equal net investment, I, we can write this
equality as
S=I (4)
• But from Equation (1) we know that S = sY, and from Equations (2) and (3) we know that
I = ΔK = cΔY
• It therefore follows that we can write the “identity” of saving equaling investment shown by
Equation (4) as
S = sY = cΔY = ΔK = I (5)
or simply as
sY = cΔY (6)
• Dividing both sides of Equation (6) first by Y and then by c, we obtain the following
expression:
∆𝑌 𝑠
= (7)
𝑌 𝑐
∆𝑌
• Note that the left-hand side of Equation (7), , represents the rate of change or rate of
𝑌
growth of GDP.
• Equation (7), which is a simplified version of the famous equation in the
Harrod-Domar theory of economic growth, states simply that “the rate of
growth of GDP (ΔY/Y) is determined jointly by the net national savings ratio, s,
and the national capital-output ratio, c”.
• More specifically, it says that in the absence of government, the growth rate
of national income will be directly or positively related to the savings ratio
(i.e., the more an economy is able to save—and invest—out of a given GDP,
the greater the growth of that GDP will be) and inversely or negatively related
to the economy’s capital-output ratio (i.e., the higher c is, the lower the rate
of GDP growth will be).
• Equation (7) is also often expressed in terms of gross savings, 𝑠 𝐺 , in which
case the growth rate is given by
∆𝑌 𝑠𝐺
= −𝛿 (7`)
𝑌 𝑐
Where, δ is the rate of capital depreciation.
• The economic logic of Equations (7) and (7’) is very simple. To grow,
economies 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 saving and
investment—how much additional output can be gained from an
additional unit of investment—can be measured by the inverse of the
capital-output ratio, c, because this inverse, 1/c, is simply the output-
capital or output-investment ratio. It follows that multiplying the rate of
new investment, s = I/Y, by its productivity, 1/c, will give the rate by which
national income or GDP will increase.
• In addition to capital accumulation (investment), two other components of economic
growth are labor force growth and technological progress.
• In the context of the Harrod-Domar growth model, labor force growth is not described
explicitly. This is because labor 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, as follows from Equation (7) or (7’). This is obvious when we realize that in the
longer run, this ratio is not fixed but can change over time in response to the functioning
of financial markets and the policy environment.
• The focus of this model was on the role of capital investment.
https://youtu.be/rol2aKFZ_IE
Some Criticisms of the Stages Model

• Unfortunately, the mechanisms of development embodied in the theory of stages of

growth did not always work. And the basic reason they didn’t work was not because more
saving and investment isn’t a necessary condition for accelerated rates of economic
growth but rather because it is not a sufficient condition.
• The Marshall Plan worked for Europe because the European countries receiving aid
possessed the necessary structural, institutional, and attitudinal conditions (e.g., well-
integrated commodity and money markets, highly developed transport facilities, a well-
trained and educated workforce, the motivation to succeed, an efficient government
bureaucracy) to convert new capital effectively into higher levels of output.
• The Rostow and Harrod- Domar models implicitly assume the existence of these same
attitudes and arrangements in underdeveloped nations. Yet, in many cases, they are
lacking, as are complementary factors such as managerial competence, skilled labor, and
the ability to plan and administer a wide assortment of development projects.
Important concepts
• Stages-of-growth model of development A theory of economic development, associated with the
American economic historian Walt W. Rostow, according to which a country passes through
sequential stages in achieving development.
• Harrod-Domar growth model 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 (c).
• Capital-output ratio A ratio that shows the units of capital required to produce a unit of output
over a given period of time.
• Net savings ratio Savings expressed as a proportion of disposable income over some period of
time.
• Necessary condition A condition that must be present, although it need not be in itself sufficient,
for an event to occur. For example, capital formation may be a necessary condition for sustained
economic growth (before growth in output can occur, there must be tools to produce it). But for
this growth to continue, social, institutional, and attitudinal changes may have to occur.
• Sufficient condition A condition that when present causes or guarantees that an event will or can
occur; in economic models, a condition that logically requires that a statement must be true (or a
result must hold) given other assumptions.