POLITICAL ECONOMY OF DEVELOPMENT

Unit 1 Lesson
1. DEFINING POLITICAL ECONOMY

Economics—the social science that deals with the production, distribution, and consumption of
material wealth and with the theory and management of economic systems or economies — was
once called political economy. Anchored in moral philosophy, thence the art and science of
government, this articulated the belief in the 18 th–19th centuries that political considerations—and
the interest groups that drive them— have primacy in determining influence and thus economic
outcomes at (almost) any level of investigation. However, with the division of economics and
political science into distinct disciplines from the 1890s, neoclassical economists turned from
analyses of power and authority to models that, inherently, remove much complexity from the
issues they look into.

Today, political economists study interrelationships between political and economic institutions
(or forces) and processes, which do not necessarily lead to optimal use of scarce resources.
Refusing to eschew complexity, they appreciate politics as the sum of activities—involving
cooperation, conflict, and negotiation—that shape decisions touching the production,
consumption, and transfer of scarce resources, irrespective of whether the activities are formal or
informal, public or private, or a combination thereof. (Lest this compass be thought beyond
reach, it should be pointed out that politics are not normally random and therefore
unpredictable.) In summary, they analyze and explain the ways in which governments affect the
allocation of scarce resources in society through laws and policies and, by the same token, the
ways in which the nature of economic systems and the behavior of people acting on their
economic interests impact governments and the laws and policies they formulate. Depending on
the outlook, they can thereby, for example, bring a focus to bear on outcomes—practices might
be a better term— such as inequality or exclusion.
2. MODELS IN POLITICAL ECONOMY

The concept of a model takes on many different meanings in everyday and scientific parlance.
Thus we may encounter miniature models of buildings and vessels, mathematical models of
natural or social processes, role models and model theory, to name just a few prominent usages.
Achinstein (1968: 209–225) suggests a threefold classification: (i) representational models, (ii)
theoretical models, and (iii) imaginary models. In the first class we find true, distorted and
analog models. The unifying characteristic is that the models represent an object.
A representational model is a man-made construct that represents something which is not
necessarily man-made. It is primarily a tool enabling the analysis or experimentation of the entity
of which it is a model. The use of these types of models in political economy is very restricted.
Perhaps the best examples are gaming models of, say, international trade, where persons
represent countries and the idea is to learn something about the interaction between countries
with varying natural resources, etc. These models are primarily teaching tools.

Theoretical models in Achinstein’s terminology refer to constructs that characterize the object
of study in theoretical terms. Examples from physics include the corpuscular model of light
which states that light is basically a set of moving particles, and Bohr’s model of atom which
makes specific assumptions regarding the position and movements of nucleus and electrons
(Achinstein 1968: 212). The defining features of this model concept is that rather than
representing its object it states some assumptions regarding the object. Thus, the above two
examples claim something about the research object, namely that light is basically particle
movement and that electrons relate to nuclei in a specific manner. The property that distinguishes
theoretical models from theories proper is that they do not purport to describe all aspects of the
research object but are intended as convenient simplifications useful for explaining or predicting
certain phenomena or structures. When a person says she has a theory about something, that
usually means that she is convinced that the theory is true. In contrast, if a person has a model of
something, that does not make the same truth claim. Indeed, one could argue that by speaking of
a model rather than a theory, the person ipso facto believes that the description given in the
model is not literally true, but a useful approximation.
Theoretical models include mathematical, statistical and computational ones. These abstract
certain features of the research object and express their relationships in formal expressions. The
usefulness of these models stems from their amenability to formal manipulations. The models
encountered in modern political economy are predominantly of this type, i.e. theoretical,
simplified descriptions of objects of study. However, there are also models of Achinstein’s third
type, namely imaginary models. These are distinguished from theoretical and representational
ones by not involving any commitment to the truth of the description. Indeed, to the contrary,
imaginary models make assumptions regarding the study objects that are known to be false.
The assumptions and, consequently, the models themselves are tools of thought
experiments. These models are also common tools of political economy.

Models are basic tools of political economy and, indeed, of many other fields of inquiry.
Amenability to analysis and experimentation is their fundamental property. In fact, much
work in political economy is focused on the study of models rather than the part of the
world they are models of. Models are refined, elaborated, extended and solved. In these
works the borderline between theory and model is often blurred. Sometimes the concept of
theory is used in a wide, overarching sense as, for example, in the concept of game theory
which basically covers the theoretical study of game models. In other contexts the model
concept is wider than that of a theory. For example, one can speak of solution theory of
two-person game models meaning the derivation of predictions from models describing
interaction between two persons. The wide variation in the usage of the terms theory and
model should be kept in mind when studying the texts of political economy. In the following
we use these terms in loose conformity with the existing literature. Proposing some kind of
terminological orthodoxy would not be helpful in outlining the basic ideas.

2.1. Normative and factual models

The models we shall mainly be dealing with are built on behavior principles. These are to
economic and social theory what natural laws are to theories in physics or chemistry. In
contradistinction to the laws of natural sciences, the principles can often be given two types of
interpretations, factual and normative. By factual principle of behavior we mean regularity of
observed behavior, e.g. that people tend to raise their hand in an auditorium to attract the
attention of the speaker. The normative principle, in contrast, pertains to behavior one thinks
ought to guide behavior, e.g. that in a bus full of people young persons ought to relinquish their
seats to old ones.

Systems of factual and normative principles can be – and often are – called theories or models.
Often the principles themselves or the intended field of their application reveals whether one is
dealing with factual or normative system of principles. But there are systems in which the
dividing line is particularly thin. Many models of political economy are in this category. There
are certainly models that are easily classifiable as factual ones, e.g. many macro-economic
models linking employment, interest rates, exchange balance, etc. But the models based on
individual behavior are sometimes difficult to classify.

The reason for this is the notion of rationality that forms the basis of the behavior principles in
these models. Rationality is certainly a desirable property of a pattern of behavior in many – if
not all – circumstances. But it is also natural to think that individuals act in a rational manner in
matters related to political economy. After all, as was pointed out above one of the definitions of
political economy is to see it as an economic approach to political choices. This, in turn, amounts
to postulating rational behavior on the part of the individuals. Thus, it would seem that to the
extent that events in political economy do not coincide with those predicted by our theories, the
discrepancies can be explained by the failure of the actors to behave according to the dictates of
normative rationality.

This is, however, too simplified a view. The concept of rationality, normative or factual, is
open to a wide variety of different interpretations. In other words, even though one may envision
simple settings where nearly all reasonable people might agree on what is the rational way to
proceed, there are circumstances of just a modicum of complexity where the dictates of
rationality imply several non-equivalent ways of behavior.

Another central concept of political economy, namely optimality, lends itself to normative and
factual interpretations as well. Of course, achieving optimal outcomes is by definition the best
one can do, but optimal behavior by each member of a group of individuals may lead to
outcomes that are worse than other outcomes for all group members. Thus, optimality on one
(individual) level may contradict optimality on another (group) level.

The third central concept is justice. It is at first sight a purely normative concept, something
inherently desirable. As John Rawls (1971) puts it: justice is a fundamental value of all well-
organized societies. This means that shortcomings in justice cannot be compensated with other
aspects of the society, such as an increase in the standard of living, defence capability or
excellence of educational institutions. But along with normative content, justice also has a
factual content which refers to people’s perception of justice in the prevailing institutions.

Normative political economy deals with concepts such as rationality, justice and optimality,
specifies their exact meaning and studies the compatibility or incompatibility of various
meanings as well as the relationships between these and various other normative concepts.
Factual political economy builds models that attempt to describe the real world in a simplified
manner that allows for detailed analysis of some aspects of real economies and polities. One
typically looks for solutions of models, i.e. some kind of stable outcomes or equilibria which
constitute the theoretical predictions of models. These then operate as tests of the validity of
models. However, more typical are uses of models in the evaluation of politico-economic
institutions. By building models out of planned institutions, one may conduct experiments on
them and estimate the effects of various outer impulses or shocks on the behavior of the
institutions. One may also vary the structure of the model to see the effects of the variation on
various aspects of the institution.
UNIT 3: THE POLITICAL ECONOMY OF THE POST – INDUSTRIAL PERIOD

THE SPREAD OF INDUSTRIALIZATION: TECHNOLOGY CLUSTERS, SOURCES

OF GROWTH, AND SPATIAL HETEROGENEITY

At any time most industrial and economic growth is, however, driven by the dominant
technology cluster, frequently associated with the most visible technological artifact or
infrastructural system (or "leading sector") of the time (e.g., the "railways era'· [Schumpeter,
1939] or the "age of steel and electricity" [Freeman, 1989]). We emphasize the concept of
technology clusters because studies under the leading sector hypothesis (e.g., Fishlow, 1965;
O'Brien, 1983; Tunzelmann, 1982) have shown that these can explain only a fraction of
economic and industrial growth. Only the combination of a whole host of innovations in many
sectors and technological fields can account for sustained industrial and economic growth.

Four historical and a prospective fifth future cluster are identified, named after their most
important carrier branches or functioning principles. These are: the textile industrialization
cluster, extending to the 1820s; the steam cluster until about the 1870s; heavy engineering,
lasting until the eve of World War II; and mass production/consumption until the 1970s and
1980s. Currently we appear in the transition to a new age of industrialization. Both its
characterization as a "total quality" cluster (i.e., with control of both the internal and external, or
environmental, quality of industrial production) and the technological examples given are
necessarily speculative.

1.1. 1750-1820: Textiles

Industrialization as a process of structural change began in I 8th-century England. Technological

innovations transformed the manufacture of textiles and gave rise to what later became a new mode
of production: the factory system. Important bottlenecks for industrialization and its concomitant
spatial concentration of population and economic activities began to be overcome. Coal and Darby's
coke combined with the stationary steam engine (particularly important for coal mine dewatering)
put an end to fuelwood and charcoal shortages and provided for spatial power densities previously
found only in exceptional locations of abundant hydropower. The improvements in parish roads and
turnpikes and especially the "canal mania" around the tum of the 19th century enabled the supply of
rapidly rising urban and industrial centers with food, energy, and raw materials. Charcoal and the
puddling furnace produced the first industrial commodity and structural material: wrought iron.
Innovations in spinning (and after the 1820s also in weaving) enabled falling costs and rising output,
particularly in the manufacture of cotton textiles. The introduction of fine porcelain from China gave
rise to an expanding chinaware industry.

The nexus of innovations involving cotton textiles, the coal and iron industries, and the introduction
of steam power constitute the heart of England's Industrial Revolution. However, in order for these
developments to take place, important preconditions must be mentioned. More complex crop rotation
patterns, abandonment of fallow lands, field enclosures, new crops, and improved animal husbandry
allowed fewer people to grow more food (cf. Grigg, 1987; Grtibler, 1992). Freed from agriculture,
people sought urban residence and industrial employment. In the institutional sphere, the separation
of political and economic power, new institutions for scientific research and dissemination of its
results, organization of market relations, etc., all mark the breakdown of feudal and medieval
economic structures with their associated monopolies, guilds, tolls, and restrictions on trade. Perhaps
the intellectual and institutional/organizational changes were indeed the most fundamental
(Rosenberg and Birdzell, 1986) as enabling and encouraging changes in the fields of industrial
technology, products, markets, infrastructures, etc. Under a general laissez faire attitude, no provision
was made to socially smooth the disruptive process of structural change in employment, rural-urban
residence, value generation, and distribution of income, leading to violent manifestations of social
and class conflict (e.g., Luddists, or the Captain Swing movement; cf. Hobsbawn and Rude, 1968).

1.2. 1820-1870: Steam

In this period, lasting to the recession in the 1870s, industrialization emerges from a spatially and
sectorally confined phenomenon to a pervasive principle of economic organization. Industrialization
continues to be dominated by England, which reaches its apogee as the world's leading industrial
power by the 1870s, accounting for nearly one-quarter of the global industrial output.
Industrialization spreads to the continent (Belgium, and the Lorraine and the Ruhr in France and
Germany, respectively) and to the eastern United States much along the lines of the successful
English model (textiles, coal and iron industry).

Coal (fuelwood in the United States) provides the principal energy form for industry, whereas
transportation and household energy needs continue to be supplied mostly by renewable energy
sources (animal feed and wood). The steam period is characterized by the emergence of mobile
steam power (locomotives and boats), but transport infrastructures are still dominated by inland
navigation and canals, reaching their maximum network size by the 1870s (in England, France and
the United States). Important innovations emerge in the fields of materials (Bessemer steel
production), transport and communications (railways and telegraphs), energy (city gas), and the
(coal-based) chemical industry. These were to become the dominant technological cluster of the
second half of the 19th century until the Great Depression of the 1930s.

1.3. 1870-1930: Heavy Engineering

Fueled by coal, this industrialization phase is dominated by railways, steam, and steel: it is the most
smokestack-intensive period of industrialization. Dominated by the output of primary commodities
and capital equipment, the industrial infrastructure spreads on a global scale. Enlarging the industrial
and infrastructural base becomes almost a self-fulfilling purpose, driven by economies of scale at all
levels of industrial production and organization. Standardization of mass-produced components and
structural materials, perhaps best symbolized by the Eiffel Tower, is another characteristic of heavy
engineering.

England loses its position as industrial leader (in terms of production and innovations) to Germany
and the United States. The latter emerges as the world's largest industrial power by the 1920s,
accounting for 40% of global manufacturing output (Bairoch, 1982), 60% of world steel production
(Grtibler, 1987), and 80% of cars registered worldwide (MVMA, 1991 ).

Railway networks and ocean steamships draw distant continents into the vortex of international trade,
dominated by the industrialized core countries. Free world trade, greatly facilitated by the universal
adoption of the Gold Standard, grows exponentially, but its political counterparts are imperialism and
colonialism. Trade flows are dominated by trade between the industrialized core countries and the
rapidly industrializing rim (Russia and Japan). The industrial periphery (regions with the weakest
industrial base) provides ever-enlarging markets for the products of the industrialized core and
supplies raw materials and food (long-distance trade being made possible after the invention of
canned food and refrigeration).

The pace of technological change accelerates with the emergence of oil, petrochemicals, synthetics,
radio, telephone, and, above all, electricity, but the institutional and regulative picture is less
progressive. Emerging industrial giants, monopolies, and oligopolies, perhaps best symbolized by
Rockefeller's Standard Oil Company, are at the focus of government regulatory efforts, while social
issues are only beginning to be tackled. Legislation to limit child labor, provide for elementary health
care, and reduce long working days (up to 16 hours per day) is introduced at a slow pace and
implemented at an even slower one. Dissatisfaction with the prevailing capitalistic accumulation
regime stimulates the development of alternative theoretical expositions (Marxism) and the
emergence of new social movements (the labor movement, trade unionization), aiming at a more
equitable distribution of productivity gains. Workers reap some of the benefits in the form of
increasing employment, falling real-term prices of food and manufactured products, and (to a smaller
extent) rising wages. But the inability of the social/institutional framework to provide for a more
equitable distribution of productivity gains causes increased social conflicts. These begin to be
resolved only by progressively internalizing labor costs into the economics of industrial growth, as
symbolized by the social welfare state emerging in the 1920s.

1.4. 1930-1980: Mass Production/Consumption

The post-World War II economic boom was based on a cluster of interrelated technical and
managerial innovations, leading to productivity levels clearly superior to those of the heavy
engineering paradigm. The extension of the continuous flow concept of the chemical industry to the
mass production of identical units enabled unprecedented real-term cost and price decreases and thus
mass consumption. Typical products include the internal combustion engine and the automobile,
petrochemicals and plastics, farm machinery and fertilizers, consumer durables, etc. The prototype of
the associated production organization was the Fordist assembly line, complemented on the
organizational level by a separation of management and administration from production along the
ideas of Taylor's scientific management. Additional economies of scale were realized by the
increasing vertical integration of industrial activities and the emergence of enterprises operating on a
global scale (multinationals).
Although industrialization has become a global phenomenon, an analysis reveals only a few
examples of successful catching up (notably Japan). Instead, catching up happens more within given
geographical regions or between regions with not too different degrees of industrial development. In
terms of the spatial taxonomy adopted here, this implies that some former members of the industrial
rim (Canada, Japan, Scandinavia, Austria, Switzerland, Italy) have joined the core, but the
dominance of the core is as great as ever. The members of the Organization for Economic
Cooperation and Development (OECD) countries account for 70% of the world's industrial output
and for 75% of the world merchandise trade (World Bank, 1992). Over 80% of OECD' s imports of
manufactured goods is imported from other OECD members, another 9% from the industrial rim
(Eastern Europe and 4-Tigers ), and only about I 0% from the rest of the world (World Bank, 1992).

2. CONDITIONS FOR INDUSTRIAL DEVELOPMENT

The urgency of problems faced by the developing countries stems, in large part, from the fact that,
due to unusual demographic pressures, they need to industrialize at a much quicker pace than that
achieved in the past by more advanced countries. The developing countries are confronted with
additional difficulties, among which are the considerably higher capital-labour ratios now prevailing
in most industries, the growing complexity of modern techniques, and the unfavourable impact on
them of the international division of labour. These disadvantages more than offset the possible
benefits reserved to latecomers who supposedly can omit some stages of technological development.
As matters now stand, even after a considerable leap forward in industrialization, a developing
country can hardly expect to enter world markets for industrial goods, although the lack of access to
these markets does not solely come from a lack of competitiveness. If this were the only obstacle, it
could probably be overcome by a policy of subsidies for exports. In the long run, however, there is
no reason to believe that developing countries will suffer from a comparative disadvantage in
industrial production as long as such activity is well planned, i.e. adapted to the local conditions and
availability of resources. The more a particular type of production depends on human skills, the less
reason there is to believe that people living in one particular country are more fit for it than those in
another; they may be better trained or better equipped, but such differences can be overcome. The
last century provides many historical examples in support of this proposition.

This optimism about the long run (which boils down to a reaffirmation of the basic equality of all
groups of human beings with respect to their potentialities) should not be understood, however, as an
invitation to indulge in adventurous planning that is out of touch with the hard realities of the present
day. The quest for industrial development strategy should start with a sober assessment of the
available resources and their limitations.

2.1. Natural resources

As manufacturing consists of making articles from raw materials extracted from nature or grown by
man, the possession of plentiful supplies of such materials constitutes an invitation to enter the field
of processing industries, particularly where these raw materials are bulky as well as cheap, thus
making transport costs high in relation to their value. In practice, however, we see many exceptions
to this rule of thumb. Oil producers export the bulk of their output in the form of raw petroleum,
while Japan manages to produce steel at competitive prices, even though it is compelled to import the
necessary raw materials over great distances. If the case of the oil-producing countries can be
explained by the pressure of vested foreign interests, solidly entrenched and backed by big powers,
no such reason can be invoked to explain why Sweden, for example, finds it profitable to export iron
ore.

These examples are used to emphasize the need to undertake a careful economic analysis whenever
the apparently obvious case for exploiting a country's natural resources arises. Mineral riches do not
necessarily make a country rich; access to them may require costly investment, characterized by a
"lumpiness" of the capital expenditure involved and long gestation periods. As for processing
industries based on locally produced raw materials, they may not enjoy an internal market of
reasonable size. Furthermore, access to foreign markets often depends not so much on the
competitiveness of the articles produced as on the policies followed by the major industrial countries
and powerful oligopolies. Briefly, no easy optimism can be derived from the mere identification of
large mineral deposits, forestry resources, or similar natural resources.

In spite of the need to guard against early over optimism, there will normally be plenty of
opportunities to start or expand industries based on locally produced raw materials and to specialize
eventually in some of them. This calls for a careful surveying of domestic resources and a
concentration of scientific and technological research on the best way to utilize them. Whenever
possible, the strategy for industrial development should specify one or more industries that are
expected to become leaders in the economy. All forward and backward linkages of such industries
should be carefully investigated, as it may prove rewarding to pursue the idea of an industrial
complex organized around each of them.

As for export-oriented industries based on exportable raw material, their development should
normally be rewarding; it should pay a country to increase the value-added incorporated in its
exports. But two qualifications must be noted. One is the problem of access to foreign markets. This
problem can often be solved by developing an appropriate foreign trade strategy, consisting of long-
term export agreements. It may be possible to negotiate such agreements in return for granting
similar import contracts. The developing countries have hardly started to explore such fields of
mutual co-operation. The second problem is that of vertical integration. An investigation should
always be made whether it is more profitable to enter all stages of production, from extraction to the
distribution of the final product, or to enter only certain areas. The time scheduling of the whole
operation is an important matter.

2.2. Human resources

Only the broad outlines of an inquiry into this complex subject can be indicated here. A full
treatment comprises an assessment of the impact of the sociopolitical organization on the working of
the economy and studies of the social stratification, the demography, and some more specific
questions dealing with the labour force and manpower availability. In other words, it calls for a
global institutional approach.

Perhaps the most delicate task in framing development strategy is dealing with wholesale changes in
the economic behaviour of the various strata of the population. How can social change, commonly
called modernization, be brought about? To what extent does it constitute a prerequisite to, or an
outcome of, industrialization? Under what circumstances is the implementation of industrial
development programmes most likely to catch the popular imagination and so gain active support?
What place should be assigned to the national government? What institutions should be created, or
supported, or discriminated against? The strategist must have an intimate knowledge, based on
extensive interdisciplinary research, of what goes on at the grass roots. It is permissible to doubt
whether he is always aware of this important dimension of his task.

The labour force and manpower situation are more commonly reviewed. Broadly speaking, an
investigation is likely to highlight the following aspects:
(a) An overabundance of unskilled labour, coupled with acute shortages of qualified manpower,
aggravated by a wasteful distribution of skills (too many lawyers and holders of diplomas in the
humanities, but very few scientists, engineers, or technicians and hardly any intermediate-level
skilled manpower).

(b) Urbanization without sufficient accompanying industrialization, owing to the migration from
outlying villages, where living conditions are miserable, of people attracted by the mirage of job
opportunities in towns.

(c) Social stratification very different from past experience in Europe and the United States, with
relatively few industrial workers enjoying a privileged position compared to the large but poor rural
population and those urban wage earners who have not managed to get stable employment in the
modern sector of the economy.

Taken as a whole, the human resources situation imposes severe constraints on the strategy of
development. Some economists and politicians tend to argue that an overabundant supply of
unskilled labour is a boon, as it can be used for labour-intensive investment projects. Unfortunately,
there are limitations to such operations; even workers who perform the very simplest of tasks must be
fed, clothed, and housed, and therefore the ability to satisfy these essential needs sets an upper limit
on mass mobilization of labour. One should also be aware of the very difficult organizational
problems involved, as well as of the relatively restricted scope of investment activity of the pick-and-
shovel type. Thus, investment schemes based on labour-intensive methods will continue to find a
place in industrial development strategy, but they will seldom, by themselves, provide the possibility
for a big leap forward.

2.3. Supply of technology

The supply of technology is a severely limiting factor. As a rule, developing countries live by direct
transfers of techniques used in more advanced countries, and often they are not equipped even to
adapt such techniques. Original local research is scarce and its results are seldom developed into
workable production techniques. This dependent condition makes the developing countries
vulnerable to all sorts of pressures. They must buy on a seller's market, mitigated to some extent by
international competition. Many transfers of technology are ill-conceived or simply redundant, not
necessarily through the action of a vested interest; often it is due to lack of imagination on the part of
foreign technicians from developed countries who are used to completely different environmental
conditions and factor ratios and so are naturally inclined simply to duplicate solutions already
existing in their own countries. Thus, mimicry of modern techniques takes the place of invention. On
the other hand, developing countries must rely for years on a dual industrial structure, owing to the
employment implications if their cottage industries were destroyed. For this reason, the traditional
techniques should definitely be improved wherever it is even marginally feasible to do so, i.e.
whenever they do not result in a level of productivity below the acceptable minimum having regard
to the postulated level of real wages.

2.4. Markets

The size of the market is of paramount importance in making decisions about the introduction of new
industries. The indivisibilities and economies of scale affect especially the modern steel,
petrochemical, and automobile industries. However, for many industries the minimum viable size of
plant continues to be relatively small and, in those countries where transport costs are high, local
industries enjoy a kind of protection on this, account.

The size of the market depends roughly on the country's total population and its per capita income.
This approach can be misleading, however, to the extent that it does not take into account the
distribution of income by social or economic classes. If, in a country of 100 million people, i per cent
of the population enjoys an average annual income of about $6,500, 9 per cent about $800, 40 per
cent about $300, and 50 per cent about $125, the average per capita income of more than $300
indicates little about the demand for different kinds of commodities.

In fact, the top 1 per cent can afford many luxuries, the next 9 per cent have already crossed the
income threshold which permits them to purchase durables, but the poorer half of the population can
hardly spend more than a few dollars a year on very simple manufactured goods. Thus, there is a
very differentiated picture of the demand for various types of goods. There is a relatively small
market of relatively well-to-do people for luxuries, a larger market for less-expensive durables (easy
to overestimate, owing to the existence of deferred demand arising from import difficulties), and a
deceptively small market for mass-consumption industrial goods, including those produced by
traditional techniques. Expansion of this last market depends on bold policies of support for peasant
agriculture which, at the same time, would increase the food supply for additional industrial workers.
An industrial development strategy should not be based wholly on market considerations. In the
interests of long-term social and economic development, the rate of expansion of industries turning
out luxuries has to be restricted in order to permit the allocation of scarce resources, such as capital
goods, foreign exchange, and skills, to other projects with higher social priority. The application of
this social policy on the supply side needs to be co-ordinated with an income and fiscal policy
directed towards a corresponding restraint of the growth of demand for luxuries.

The opposite approach is required for essentials. The income policy should aim at increasing the
demand for them, and the income elasticities of demand should be carefully respected.

Thus far, only the domestic market has been considered. But whenever the minimum viable size of
production exceeds the domestic demand, the question of access to foreign markets arises. Here the
basic problem is not usually competitive prices, for it is often possible to subsidize exports if this is
the only obstacle; rather, it is a problem of organizational and political obstacles. Whenever the
world market has an oligopolistic structure and big vested interests are involved, a newcomer has
little chance to break through. This problem can be dealt with only through imaginative trade policies
and active entry into markets that are not entirely dominated by such interests.

When comparing the prospective demand with the production possibilities, it may be useful to divide
all industries into two groups:

(a) So-called supply-determined industries, where rates of growth are limited by the availability of
natural resources or by technical or organizational ceilings.

(b) Demand-determined industries, where it should be possible to expand output as the markets grow.
When rates of growth become sufficiently high, all industries are supply-determined, and therefore
the concept has only a relative meaning in the context of a given rate of growth. It does help to
clarify, however, the importance of the market size for each industry considered and to identify

potential export surpluses and supply shortages to be covered by imports.

2.5. Capacity to import and foreign aid

All deficits in supply—whether of raw materials, intermediate goods, capital equipment, consumer
goods, management know-how, or skilled manpower—can be made up by imports, as long as the
country has sufficient import capacity. Thus, there is a fundamental need for the strategist to make a
sober and realistic assessment of the country's present and future position in the international division
of labour, as well as of the foreign resources available on conditions considered acceptable in the
country's long-term interest. His conclusions drawn from such an assessment may weigh heavily on
the rate of industrial development he proposes, depending on whether or not the country can expect a
sizable yearly expansion of its traditional exports at reasonable prices.

It may be desirable to resort to foreign resources when an irreducible trade gap appears likely. On the
other hand, a savings gap may be taken care of by proper fiscal and income policies.8 But the
strategist should make sure that the growing indebtedness and the non-economic obligations which
often accompany foreign aid do not restrict still more his freedom of choosing a development
strategy. The policies regarding the inflow of foreign resources should be geared to the
implementation of the chosen strategy, but in practice the strategy quite often is made to conform
with projects that are offered as a package within the framework of foreign assistance.

When considering resort to foreign resources, it is necessary to take into account all inflows and
outflows of resources. The inflow of foreign capital must be weighed against payments to be made
abroad in order to service foreign debt and foreign direct investment. Technical assistance received
from outside should be weighed against the brain drain of young talents to other countries.

3. INDUSTRIALIZATION AND ENVIRONMENT

The environmental implications of industrialization can perhaps best be described by Gray's (1989)
paradox of technological development. Industrialization has brought unprecedented levels of
environmental impacts stemming from effluents whose impacts are fairly well understood. It has also
introduced new materials and substances (e.g., chlorofluorocarbons) with hitherto unknown impacts
on the environment. But at the same time, the technological change that goes along with
industrialization and the growing incomes generated by rising productivity have also enhanced our
technological and economic capacities for remedies.

Industry has built in an inherent incentive structure to minimize factor inputs. This is primarily
driven by economics and by continuous technological change. Therefore, industry moves in the right
direction, and the real issue is how to accelerate this desirable trend. "The right direction" means, in
principle, two things: (1) minimizing resource inputs per unit of economic activity, i.e., demate· r-
ialization, and (2) improving the environmental compatibility of the materials Jsed, processed, and
delivered by industry, i.e., with respect to industrial !nergy use, decarbonization.

4. IMPACTS OF INDUSTRIALIZATION ON CONSUMPTION

AND LEISURE

Industrialization had and continues to have far-reaching social impacts. Changes in employment
structure, urbanization, increased life expectancy, rising incomes, and reductions in working time are
examples of social changes directly and indirectly resulting from industrial output and productivity
growth. Contingent on a social consensus, productivity gains have been distributed among rising
wages and incomes (cf. Phelps Brown, 1973) and reductions of working time.

Perhaps the changes in time allocation patterns are among the least known of the social impacts of
industrialization. Some 100 years ago, a U.K. laborer had an average life expectancy at the age of 10
of about 48 years and at age 20 of about 40 years, i.e., a total life span of less than 60 years. Before
education became mandatory, labor began young, and essentially men who were healthy enough
worked until they died (average length of a work career: about 47 years). Over his lifetime a male
worker worked about 150,000 hours, or 60% of his available lifetime after subtracting necessary
"physiological" time (i.e., the time required to eat and sleep). Today a typical male worker in the
U.K. works some 88,000 hours during his lifetime. Due to reduced working time and increased life
expectancy he spends only about 25% of his available lifetime at the work place. Trends in working
timE reductions (at paid work) for women have been less pronounced, but nevertheles~ noteworthy
(cf. Ausubel and GrUbler, 1990). International and intertemporal timebudget studies report on a
broadly converging change in the structure of time allocation of the population.

More free time, coupled with higher incomes, has led to the development of lifestyles centered
around private consumption and demand for services (cf. Gershuny, 1983). The structure of
employment, industry, and production has followed suit. It is important to note to what extent
resource consumption in postindustrial societies has become dominated by private consumption and
leisure activities. Schipper et al. (1989) present data on final energy consumption for the FRG,
indicating a dramatic shift in the relative share of energy consumption between productive (i.e.,
industrial) and consumptive (i.e., services and private households) uses of energy. Industry accounted
in 1950 for two-thirds of final energy consumption, whereas today it accounts for only one-third. In
future, it will become increasingly important for industry to take up the challenge to assist consumers
in more environmentally compatible lifestyle choices-in providing not only new ("green") products,
but also ways to ensure that environmentally friendly products are adopted, used and dispensed
appropriately. All this implies redefining traditional markets for industrial products and services in
the direction of integrated packages, focusing on the delivery of end-use services rather than on
artifacts.

UNIT 6: CORPORATE AND THE GLOBAL ECONOMY

1. OPEN ECONOMIC SYSTEM

The modern economy of most nations is no longer a closed-localized system. Virtually every
nation on earth has some sort of relations with other nations. The extent to which an economic
system is involved in economic relations with other countries is the degree to which that
economy is open. Foreign economic relations involves the importation and exportation of goods
and services. When you buy a Toyota you are having economic relations with Japan. When you
work for Philips (Aero-Quip etc.) you are having economic relations with Holland (Philips is a
Dutch company). Over the past three decades our reliance on foreign produced goods has
become increasingly important to our standard of living. On the other hand, foreigners have
become increasingly reliant on American goods. Without trade among nations then everyone
would suffer the loss of goods they desire that must be imported.
Controversy abounds concerning international economic relations. The outsourcing of jobs
abroad has real costs for the affected households and is a source of discontent among workers
who have lost their jobs to foreign competition. In many cases these job loses are simply
employers taking advantage of very low income populations in poor countries – with all of the
social and political ills associated with economic exploitation. Over the next several decades
these issues will take a more central place in political debate, and concerns over the social
responsibility of business.

Technology transfers are also controversial. There are currently bands on the transfer of certain
technologies that have implications for national defense. However, in general, technology
transfers is the exportation of ideas, knowledge and equipment that may permit less fortunate
nations to more adequately participate in the global economic system.

3. MARKET SYSTEM CHARACTERISTICS

The characteristics of the market system is both practically and intellectually different than
capitalist ideology. The characteristics of the market system are those things upon which the
operationalization of markets depend to decide what is produced and how it will be allocated.
The characteristics of a typical of market system are: (1) the division of labor & specialization,
(2) significant reliance on capital goods, and (3) reliance on comparative advantage. These
characteristics have significant interactions and together are responsible for the competitive well-
being of most market system economies.

In market economies the competition among producers requires high levels of technical
efficiency, which, in turn, requires labor to become specialized and focused on narrow aspects of
a particular production process. By dividing tasks into small components people become better at
repetitive movements and therefore their efficiency increases. As efficiency increases, cost per
unit declines.

Because of the need to compete, capital is typical used where it is less costly. Capital can be
substituted for labor in many production processes and significantly reduce per unit costs of
production.
4. COMPARATIVE ADVANTAGE AND TRADE

However, comparative advantage is somewhat more complicated. Comparative advantage is the

motivation for trade among people (and nations). Terms of trade are those upon which the parties
may agree and depends on the relative cost advantages of trading partners and their respective
bargaining power.

Trade between industries and individuals also arises from comparative advantage. However,
barter (direct trading of commodities) becomes increasingly difficult as an economic system
becomes more complex. Barter requires a coincidence of wants, it does no good to have apples if
you want oranges and the only people who have oranges hate apples. No transaction will occur
under this scenario unless a third-party can be found that has a commodity that both original
trading parties value and who accept both apples and oranges. Therefore, as complexity rises, so
does the need for the ability to conduct business without reliance on barter, therefore the need for
money.

5. MONEY IN AN ECONOMIC SYSTEM

Money facilitates market activities and is necessary in complex market systems. With money
people can avoid the problems associated with coincidence of wants. Among, these problems is
the pricing of commodities. Prices stated in the terms of all possible trading goods makes it
difficult to determine what anything costs. In barter economies hours are spent in negotiating for
even simple transactions, these hours are resources that could have been spent on other activities
(therefore the hours of negotiations are the opportunity cost of a money economy).

The functions of money include; (1) medium of exchange, (2) store of value, and (3) a
measure of worth. Because money is acceptable as a form of payment for all commodities,
barter is no longer needed. Money can be easily stored in a tin can or bank account, so
commodities need not be stored and can be purchased when needed. Because money is
acceptable in virtually all transactions, prices can be stated in terms of dollars or yen thereby
simplifying transactions substantially. In other words, money is the grease that lubricates any
complex economic system.
Fiat money is what is common in modern economic systems. Fiat money is money that is
defined as legal tender by either a government or some organization with the authority to
define legal tender. In the United States the Federal Reserve System issues Federal Reserve
Notes, which serve as the legal tender for the United States. The currency used here is backed by
nothing except the faith of the general public that this money will be acceptable by everyone else
with whom you could have an economic transaction.

Fiat money is not a new idea. Some European historians identify the first use of fiat money in
Europe resulting from gold and silver smiths issuing their customers receipts for gold or silver
left in their care. The receipts were commands over that gold and silver, and began to trade as
easily as the commodity itself, to the extent that the parties to the transaction knew of the smith
and the note bearer. This trade in receipts dates back to the mid-fifteenth century. Hence, in this
case the value of money is based on some mutual trust between the principles to these
transactions.

The first recorded use of fiat money, however, dates to three hundred years earlier in Asia.
Because of the shortage of gold and silver to run the Mongol Empire, Genghis Kahn began to
issue orders, in writing, that the written order was to be given deference as a specific amount of
gold or silver. Genghis was known to a be nononsense sort of guy, and the violation of his
decrees were clearly unhealthy acts, therefore these orders were the first fiat money recorded in
history, and not backed by anything save the martial might of the Mongol Army. Perhaps, in
retrospect, it is better that currency be acceptable on economic grounds, than under threat of
violence from a government.

6. FOREIGN EXCHANGE

International economic relations also depend, in large measure, on monetary issues. You are
unlikely to accept the Turkish Lire in payment for your wages in this country, simply because
you can’t easily use that money to buy anything. You want U.S. dollars in payment for your
services, because you can easily spend the dollar. Countries act the same way you do. There are
currencies that virtually everyone accepts as payment, and those widely accepted currencies are
called hard currency.
The currency of the big, developed, high income economies are the hard currencies – U.S. dollar,
Japanese Yen, Canadian dollar, British pound and the E.E.U.s’ Euro.

Prior to the Euro, there were seven countries whose currencies were considered hard currencies.
In addition to the U.S., Japan, Canada, and the United Kingdom, the French Franc, German
Mark, and Italian Lire were also considered hard currencies. These seven nations are called the
G-7 countries because the size and strength of their economies made them the leading economic
forces on the planet, and their currencies the most accepted.

The relative value of currency is called the exchange rate. For example, one U.S. dollar may
buy 109 Japanese Yen but only .85 Euros. It is these currency exchange rates that, in large
measure, determine net exports and foreign investment in the U.S.

As the dollar gains strength, i.e., goes from 109 Yen to the dollar to 120 Yen to the dollar, then
imports are cheaper. If at 110 Yen to the dollar a particular Japanese car costs $20,000 that is
also 2.2 million Yen. If the dollar gains strength, and it can now purchase 125 Yen per dollar,
then that 2.2 million Yen car is only $17,600. As can be readily seen the strong dollar give the
American consumer an advantage in buying imports. If the dollar becomes weak then that
advantage turns to disadvantage. Going back to the example above, if the 2.2 million Yen vehicle
was available at $17,600 at 125 Yen per dollar, the additional cost of $2400 would be observed if
the dollar could only purchase 110 Yen.

The same sort of analysis applies to American exports. With an expensive dollar it is hard to sell
American goods abroad. If the Mexican Peso will buy 10 cents we may be able to sell some
goods in Mexico, however if the dollar becomes stronger and Mexicans can only get 5 cents per
peso, we will observe a marked decline in exports to Mexico.

Currency also impacts foreign investment. If our Mexican friends invest 2 million pesos in the
U.S. when the peso buys 10 cents ($200,000), and then suddenly the peso becomes worth 25
cents ($500,000) the foreign investor just made 250% on his investment simply because the U.S.
dollar weakened with respect to the Mexican peso. On the other hand, if the Mexican investor
bought dollars at 25 cents per peso and over a year the dollar fell to 10 cents per peso, his
investment went from $500,000 to only 40% of his original investment. In other words, foreign
investment becomes more attractive with strength in the host countries’ currency.

A strong dollar policy means that the government will undertake policies that will increase the
value of the dollar with respect to other currencies. Contractionary fiscal and monetary policies
are typically associated with strong dollar policy and is properly the subject of the next course
(macroeconomics). Strength a nation’s currency is typically a reflection of its strong economy
and institutions. The relative supply and demand for a currency will also impact the currency
exchange rates.

Strong dollar policies promote the importation of goods and services from abroad, and foreign
investment in our domestic enterprises. On the other hand, a weak dollar policy promotes the
exportation of goods and services abroad, and U.S. investment overseas. Often, the international
aspects of domestic monetary and fiscal policies are less important than political consideration in
the U.S. or policy consideration concerning unemployment or inflation. However, one must
always remember that lobbyists and special interest groups are quick to point-out to policy
makers the advantages and disadvantage of either policy for their constituents back home.

7. THE CIRCULAR FLOW DIAGRAM

The circular flow diagram is used to show the interdependence that exists among sectors of the
economy. The diagram illustrates that there are several collections of similar economic agents,
called sectors. Households provide resources to government and business and consume the
outputs of these other sectors. The markets in which land, labor, capital, and entrepreneurial
talent are sold are called resource markets. The markets in which the output of business and in
some cases government is sold are called product markets.

To this point, the circular flow diagram is relatively simple. However, when a foreign sector or
substantial governmental sector is added it becomes more complicated. It is not unusual for a
modern economy to have substantial participation in both the product and resource markets from
both foreigners and governments (sometimes even foreign governments).
Consider a relatively simple open-economy, trade and foreign investment occurs. The following
diagram illustrates this relatively simple economic system. The interdependence in the sectors is
represented by the flows in both the resource and factor markets. Resources flow from household
to both the government and businesses. Private goods and services flow from the businesses to
households and government, and public goods and services flow from the government to both
households and businesses. The triangle representing these domestic sectors rests on a
foundation called the foreign sector. Foreign households, business, and even governments (in
limited ways) participate in the flows that would otherwise have been purely domestic if the
economy was a closed economy.