M.A.

ECONOMICS
SEMESTER - I (CBCS)

ECONOMICS GROUP - I, PAPER - IV

ECONOMICS OF
DEVELOPMENT - I

SUBJECT CODE : 73523

 © UNIVERSITY OF MUMBAI

Prof. Suhas Pednekar

Vice-Chancellor,
University of Mumbai,

Prof. Ravindra D. Kulkarni Prof. Prakash Mahanwar

Pro Vice-Chancellor, Director,
University of Mumbai, IDOL, University of Mumbai,

Programme Co-ordinator : Ms. Rajashri Pandit

Asst. Prof. of Economics,
IDOL, University of Mumbai
Course Co-ordinator : Dr. Gopal Eknath Ghumatkar
Assistant Professor of Economics,
IDOL, University of Mumbai
Course Writers : Dr. K. L. N. Sastry
Head of Dept. Business Economics,
Chetans H.S. College of Commmerce &
Economics, Bandra (E), Mumbai
: Prof. Shubhangi Vartak
Ramniranjan Jhunjunwala College,
Ghatkopar (W), Muimbai
: Prof. Krishnan Nandela
Dr. T.K. Tope Arts & Comm. College,
Parel, Mumbai
: Prof. Suchitra Kumar
Gurunanak Khalsa College,
Matunga, Mumbai

Jully 2021, Print - 1

Published by : Director,
Institute of Distance and Open Learning ,
University of Mumbai,
Vidyanagari, Mumbai - 400 098.

DTP Composed : Ashwini Arts

Vile Parle (E), Mumbai - 400 099.

Printed by :
 CONTENTS
Unit No. Title Page No.

MODULE - I
1 Concept and Measures of Growth and Development - I 1
2. Concept and Measures of Growth and Development - II 13

MODULE - II
3. Modern Theories of Growth and Development - I 34
4. Modern Theories of Growth and Development - II 47

MODULE - III
5. Microeconomics of Development - I 55
6. Microeconomics of Development - II 68

MODULE - IV
7. Macroeconomics of Development - I 77
8. Macroeconomics of Development - II 86


 I

Syllabus
M.A. Economics
Economics Group - I, Economics Paper - IV
Economics of Development - I

Unit I : Concepts and Measures of Growth and Development

Developments in Economic thought - History, Expectations and
Development - Economic growth and structural change -
Capabilities, entitlements and deprivation - Inequality and growth -
Measurement of Inequality and poverty - Measurement of
development - HDI, GDI, etc. - Role of Market and State.

Unit II : Modern Theories of Growth and Distribution

Harrod - Domar Model of Growth - Solow model of growth -
Approaches to technical change - Convergence - Endogeneous
growth models of Romer and Lucas - Human Capital

Unit III : Microeconomics of Development

Segmentation of rural land, labour, capital and credit markets -
microfinance - Market inter-linkages - land markets - labour markets
and households - Credit market - microfinance - The household
model of fertility decisions - Institutions and development.

Unit IV : Macroeconomics of Development

Environment and Development - Development and the constraint of
natural resources - environmental problems in Economic
Development - Environment and Sustainable Development - Trade
and Development - Trade and foreign exchange - Role of
international financial and trade institutions - Structural adjustment
and stabilization.

References :
1) Basu, Kaushik (1998), Analytical Development Economics,
OUP, New Delhi.
2) Ray, Debraj (2004), Development Economics, OUP, New Delhi.


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Module I

1
CONCEPTS AND MEASURES OF
GROWTH AND DEVELOPMENT – I
Unit Structure:
1.0 Objectives
1.1 Introduction
1.2 Economic Growth
1.3 Economic development
1.4 Distinction between Growth and development
1.5Economic Growth and Structural Change
1.6Capabilities, Entitlements and Deprivation
1.7 Inequality and Growth
1.8 Summary
1.9 Questions

1.0 OBJECTIVES
 To understand the meaning of economic growth and
economic development.
 To understand the difference between the growth and
development.
 To understand relation between economic growth and
structural change.
 To understand the relation between inequality and growth.

1.1 INTRODUCTION

Economic Growth is a narrower concept than economic

development. It is an increase in a country's real level of national
output which can be caused by an increase in the quality of
resources (by education etc.), increase in the quantity of
resources & improvements in technology or in another way an
increase in the value of goods and services produced by every
sector of the economy. Economic Growth can be measured by an
increase in a country's GDP (gross domestic product).
 2

Economic development is a normative concept i.e. it

applies in the context of people's sense of morality (right and
wrong, good and bad). The definition of economic development
given by Michael Todaro is an increase in living standards,
improvement in self-esteem needs and freedom from oppression
as well as a greater choice. The most accurate method of
measuring development is the Human Development Index
which takes into account the literacy rates & life expectancy
which affects productivity and could lead to Economic Growth. It
also leads to the creation of more opportunities in the sectors of
education, healthcare, employment and the conservation of the
environment. It implies an increase in the per capita income of
every citizen.

1.2 ECONOMIC GROWTH

The modern conception of economic growth began with the

critique of Mercantilism, especially by the physiocrats and with the
Scottish Enlightenment thinkers such as David Hume and Adam
Smith, and the foundation of the discipline of modern political
economy. It is an increase in the value of goods and services
produced by an economy. It is conventionally measured as the
percent rate of increase in real gross domestic product, or GDP.
Growth is usually calculated in real terms, i.e. inflation-adjusted
terms, in order to net out the effect of inflation on the price of the
goods and services produced. In economics, "economic growth" or
"economic growth theory" typically refers to growth of potential
output, i.e. production at "full employment," rather than growth of
aggregate demand.

Economic growth is the increase of per capita gross

domestic product (GDP) or other measure of aggregate income.
It is often measured as the rate of change in real GDP. Economic
growth refers only to the quantity of goods and services produced.
Economic growth can be either positive or negative.
Negative growth can be referred to by saying that the economy is
shrinking. Negative growth is associated with economic
recession and economic depression.
In order to compare per capita income across multiple
countries, the statistics may be quoted in a single currency,
based on either prevailing exchange rates or purchasing power
parity. To compensate for changes in the value of money
(inflation or deflation) the GDP or GNP is usually given in "real" or
inflation adjusted, terms rather than the actual money figure
compiled in a given year, which is called the nominal or current
figure.
 3

Economists draw a distinction between short-term economic

stabilization and long-term economic growth. The topic of
economic growth is primarily concerned with the long run. The
short-run variation of economic growth is termed the business
cycle.

1.3 ECONOMIC DEVELOPMENT

Economic development until the 1960s was considered the
same as economic growth. It is now understood as economic
growth plus some progressive changes which determine the
welfare of the people. Mahbub ul Haq, a leading Pakistani
economist observed that “the problem of development must be
defined as a selective attack on the worst forms of poverty.
Development goals must be defined in terms of
progressivereduction and eventual elimination of malnutrition,
disease, illiteracy, squalor, unemployment and inequalities. We
were taught to take care of our GNP because it would take care of
poverty. Let us reverse this and take care of poverty because it will
take care of the GNP. In other words, let us worry about the
content of GNP even more than its rates of increase.” There are two
approaches to the concept of Economic Development and these two
approaches are the traditional and the modern approach.

The Traditional Approach : The traditional approach defines

economic development in economic terms. It means a sustained
annual increase in GNP at rates varying from 5 to 7 percent along
with changes in the economic structure so that the share of
agriculture declines in both production and employment and the
share of the secondary and tertiary sectors increases. The policy
measure to achieve such GNP growth is industrialization.
Objectives of poverty elimination, reduction in economic inequalities
and employment generation are subsumed in the process of
industrialization. The traditional approach is also known as the
Trickle Down approach to Economic Development.
The Modern Approach : The Trickle Down approach failed to
solve the problems of mass poverty is most of the developing
countries. During the 1970s, economic development was redefined
to include objectives such as reduction and elimination of poverty,
inequality and unemployment. ‘Redistribution with Growth’ became
the new approach to economic development. Following the new
approach, Charles P Kindleberger and Bruce Herrick observed that:
“Economic development is generally defined to include
improvements in material welfare, especially for persons with the
lowest incomes, the eradication of mass poverty with its correlates
of illiteracy, disease and early death, changes in the composition of
 4

inputs and outputs that generally include shifts in the underlying

structure of production away from agricultural towards industrial
activities, the organization of the economy in such a way that
productive employment is general among the working age
population rather that the situation of a privileged minority and the
correspondingly greater participation of broadly based groups in
making decisions about the directions, economica and otherwise, in
which they should move to improve their welfare.”

1.4 DISTINCTION BETWEEN GROWTH

A N D DEVELOPMENT

There are significant differences between economic growth

and economic development. The term "economic growth" refers to
an increase (or growth) in real national income or product
expressed usually as per capital income. National income or
product itself is commonly expressed in terms of a measure of the
aggregate output of the economy called gross national product
(GNP). Per capita income then is simply gross national product
divided by the population of the country. When the GNP of a nation
rises, whatever the means of achieving the outcome, economists
refer to it as economic growth.

The term "economic development," on the other hand,

implies much more when used in relation to a country or an entire
economy. It typically refers to improvements in a variety of
indicators, such as literacy rates and life expectancy, and it
implies a reduction in poverty. Critics point out that GDP is a
narrow measure of economic welfare that does not take into
account important non-economic aspects such as more leisure
time, access to health & education, the environment, freedom, or
social justice. Economic growth is a necessary but insufficient
condition for economic development.

Economic Growth does not take into account the size of the
informal economy. The informal economy is also known as the
black economy which is unrecorded economic activity.
Development alleviates people from low standards of living into
proper employment with suitable shelter. Economic Growth does
not take into account the depletion of natural resources which might
lead to pollution, congestion & disease. Development however is
concerned with sustainability which means meeting the needs of
the present without compromising future needs. These
environmental effects are becoming more of a problem for
Governments now that the pressure has increased on them due to
Global warming.
 5

Different View related Growth and Development:

For a layman, the terms economic development and

economic growth are synonyms. For a long time, the terms,
economic development, economic growth, economic progress,
economic welfare, secular change and other similar terms are
being commonly used in day-to-day life as synonyms. But some
leading economists have drawn a line of demarcation between
them. Under the above heading we shall discuss the difference
between the above two concepts, i.e., economic development and
economic growth which is given below:

Mrs. Ursula Hicks, "Development should relate to underdeveloped

countries, where there is possibility of developing and using
hitherto, while the term growth is related to economically rich and
advanced countries where most of the resources are already
known and developed."

This definition draws a vivid distinction between the

economic development and economic growth. The first term
relates to the problems of underdeveloped countries and their
solution, whereas the second term is related to the problems of
developed countries of the world.

Prof. A. Maddison, "the rising of income levels is generally called

economic growth in rich countries and in poor countries it is called
economic development."

This definition also points out the same fact that economic
development is concerned with the rising of income level in
underdeveloped countries like India, whereas economic growth
refers to the rising of income levels in advanced and rich countries
like America, U. K., France, Germany etc.

Prof. J. A. Schumpeter, "Development is a discontinuous and

spontaneous change in the stationary state, which for ever alters
and displaces the equilibrium state previously existing; while
growth is a gradual and steady change in the long run, which
comes about by a general increase in the rate of savings and
population‖.

This explanation emphasises that the economy is in the

stationary state before the process of development starts and in
that stationary state, equilibrium exists among the different
development variables such as investment and savings, income
and expenditure, demand and supply etc. The view of Schumpeter
has been widely accepted and elaborated by the majority of
economists.
 6

C. P. Kidleberger, "Economic growth means more output and

economic development implies both more output and changes in
the technical and institutional arrangements, by which it is
produced."

This explanation states that growth is synonymous with

higher output. Any increase in the quantity of development
variables is termed as growth. It has nothing to do with the means
and methods of production. Development, on the other hand,
implies not only higher output, but also the changes which help in
raising the level of output. Kindleberger has further explained the
difference by an analogy with human beings. According to him,
"Growth involves focussing on height or weight while development
draws attention to the change in functional capacity."

Prof. J. K. Mehta has summed up the above discussion in the

words, "The word Growth has quantitative significance while the
Development has by comparison qualitative significance."

Byrns and Stones, "Economic growth occurs when more goods

can be produced. Economic development entails improvements in
the quality of life, in the qualities of goods available or in the ways
production is organised."

Dr. Bright Singh, "Economic development is a multi-

dimensional phenomenon, it involves not only increase in money
incomes, but also improvement in real habits, education, public
health, greater leisure and in fact all the social and economic
circumstances that make Tor a fuller and happier life. On the
contrary, in case of economic growth, there is increase in national
income alone. There is no structural change in the economy."

The distinction between economic development and

economic growth may further be explained by means of the
table given below :
 7

Table No. 1.1

Difference betw een Economic Development and

Economic Growth
 8

In spite of the above apparent difference, most of the

economists are of the opinion that there is no difference between
economic development and economic growth and hence they use
both these terms as synonyms. According to Arthur Levis,
"Most often we shall refer only to growth but occasionally for the
sake of variety, to progress.

Economic growth is a necessary but not sufficient

condition of economic development.
 9

1.5 ECONOMIC GROWTH AND STRUCTURAL

CHANGE

The relation between economic growth and structural

change is analyzed by a dynamic multisector world model, where
production follows demand and demand changes with higher
income. It shows that economic growth is inevitably connected
with structural change. If structural change is restrained, the
growth rate is reduced. The model covers not only structural
change in the sense of changes in the proportion of production
and demand of different commodities. Structural change in the
statistical sense, i.e., change in the parameter values of the
behavior equation, is not considered.

1.6 CAPABILITIES, ENTITLEMENTS AND

DEPRIVATION

The Sen‘s capability approach involves concentration

on freedoms to achieve in general and the capabilities to function in
particular. The major constituents of the capability approach are
functionings and capabilities. Functionings are the beings and
doings of a person, whereas a person‘s capability is the various
combinations of functionings that a person can achieve.Capability
is thus a set of vectors of functionings, reflecting the person‘s
freedom to lead one type of life or another.

Amartya Sen's capacity approach has emerged as a

leading alternative to general economic standards / analysis such
as poverty, inequality and human development. In his studies, he
has developed, refined and defended the framework related to
human potential and freedom. Sen’s capacity approach inspired
the United Nations to create a Human Development Index.

Income and wealth are tools that are not just a necessity in
them, but can be used for other purposes. Economic growth
cannot be considered a last resort. Development should focus on
increasing our enjoyment of life and freedom. According to Sen,
aggregate income, national production, etc. primarily, traditional
development moves away from the elements associated with
economics to the rights of the people and the capabilities created
by these rights. The key points are as follows.

Rights:
A right is a set of alternative items that an individual can acquire
using the totality of the rights and responsibilities which he or she
faces in society. Rights create the ability to do certain things.
 10

Rights for most people depend on their ability to sell labor and the
price of goods. Rights are determined not only by market
mechanisms but also by factors such as power relations in
society, spatial distribution of resources in society and what
individuals can get from the state.

Capacity:
Rights create capacity. The benefit of a person is decided
by his ability to do what he can or cannot do, what cannot be.
According to Sen, poverty cannot be properly measured by
income or utility as traditionally understood. What a person has is
what a person is or can be, and does, or can do. The well-being
of the people does not depend on the characteristics of the goods
used in the utility system, but on what goods consumers can use
and how they make the goods.

Example: the importance of books for an uneducated person.

The man uses the book as a fuel for cooking or as a
decorative item. The book doesn't matter much to him. Another
example is a person with a parasitic disease. A person with a
parasitic disease will not be able to get the nutrition from the food
that a person without the disease will get.

According to Sen, poverty is ultimately not just a matter of

income, it is a failure to achieve minimum capacity. It is important
to note that the emphasis is not only on how a person actually
works, but also on his ability to work in important ways. Some
may be deprived of such abilities as ignorance, government
repression, lack of financial resources or false awareness.

1.7 INEQUALITY AND GROWTH

Income inequality is a critical factor in determining the level

of progress and well-being of the citizens of a country. Inspite
of the growth and development achieved by developing countries,
the vast majority of population remains poor. Thus inequalities
have increased in spite of economic progress.

There are aspects of inequality. Vertical inequality is the

traditional measure of inequality which is discussed in the
development policy. Horizontal inequality is concerned with how
the different groups in society are treated, based on race, religion,
language, class, gender etc. Both the measures help to evaluate
the well-being of the people.

It has been experienced that as an economy grows from a

traditional to a modern economy, growth is accompanied by
 11

widening disparities in the personal income distribution. The

disparities may occur due to various factors like industrious
nature of people and skills. Even opportunities may not be
available for all which may lead to inequalities. Lack of appropriate
taxation system, and differences in individual ability may result in
inequalities. Later with more developmental efforts, the inequalities
will reduce.

Horizontal inequality shows how economic differences,

social limitations and political power together create inequalities
among different groups in a society. The groups may belong to
different race, religion, gender, class or language. Horizontal
inequalities can lead to conflicts within a society which adversely
affect the development process.

Inequality affects an economy adversely in various ways.

As far as economic growth is concerned, increased inequality creates
dissatisfaction, ill feeling and frustration among the poor which may
even lead to a civil war. Extreme inequality leads to economic
inefficiency. Inequality may lead to inefficient allocation of
resources. For example, high inequality leads to an over emphasis
on higher education at the expense of good quality universal
primary education. High inequality leads to actions like excessive
lobbying, large political donations, bribery and cronyism.

1.8 SUMMARY

While economists do not agree on exactly how to promote

economic development, there is general agreement that
development requires economic growth, a real increase in per
capita income, and the social and political institutions necessary to
support an expansion of the national economy. It also requires
citizens who can work effectively in the enterprises. As the
production of goods and services rise at a rate higher than
increases in population there is economic growth. Economic
development, in addition to increased per capita income, also
includes fundamental changes in the structure of the economy.
These changes are characterized by a growing industrial sector
combined with a declining agriculture share of Gross Domestic
Product (GDP) as well as significant changes in population
growth, rural to urban migration, and employment opportunities.
 12

1.9 QUESTIONS

Q1. What is the meaning of economic growth?

Q2. What is the meaning of economic development?
Q3. Explain the difference between economic growth and
economic development?
Q4. Explain the relation between economic growth and structural
change?
Q5. Explain the relation between inequality and economic growth?
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2
CONCEPTS AND MEASURES OF
GROWTH AND DEVELOPMENT – II

Unit Structure:
2.0 Objectives
2.1 Measurement of Inequality
2.2 Measurement of Poverty
2.3 Measurement of Development
2.4 Human development Index (HDI)
2.5 Gender related development index (GDI)
2.6 Role of the Market and State
2.7 Summary
2.8 Questions

2.0 OBJECTIVES

 To understand the meaning of Human Development Index

To study how Human development progresses in India
 To study different areas, methods of HDI measures,
Education Index
 To study Gender related development index
 To study Sen‘s capability approach
 To study Environmental sustainability and development To
study market and state as agencies of development

2.1 MEASUREMENT OF INEQUALITY

Economists usually distinguish between two principal

measures of income distribution for analytical and quantitative
purposes. They are the personal or size distribution of income and
the functional or distributive factor share distribution of income.

1. The personal or size distribution of income : This measure is

most commonly used by economists. It simply deals with individual
persons or households and the total incomes they receive. The
 14

distribution across income size classes is commonly called the

―size distribution of income‖. Income inequality among the
households is commonly measured by the distribution of income
according to the size of income per household. The higher the
share of the low income classes in income, the more equal the
distribution of income.

Methods of Measurement :

a) A very popular method to analyze personal income is to

arrange all individuals by ascending personal incomes. For this the
population has to be divided into distinct groups i.e. deciles
(tenths) or quintiles (fifths). Then it is determined as to what
proportion of the total national income is received by each income
group.

The second method to analyze personal income statistics is

to construct a Lorenz curve. The numbers of income recipients are
plotted on the horizontal axis in cumulative percentage. The
vertical axis shows the share of total income received by each
percentage of population. Both are cumulative up to 100%
meaning that both the axes are equally long. Every point on the
Lorenz curve represents a statement. For example, the bottom =X‘
share of households has =y‘ share of the total income. Suppose
there are 100 households, they are arranged in ascending
incomes. The Lorenz curve is constructed by plotting the
cumulative share of households on the horizontal axis and the
cumulative share of household income on the vertical axis. The
figure is enclosed in a square. A diagonal line is drawn from the
origin or the lower left corner of the diagram to the upper right
corner of the diagram. On the diagonal line, at every point, the
percentage of income received is exactly equal to the percentage
of income recipients. The diagonal line represents ―perfect
equality‖ of distribution of income. For example, if we take the
mid point of the diagonal, i.e. halfway, 50% of the income is
distributed to exactly 50% of the population.
 15

Figure No. 2.1

The Lorenz curve shows the actual quantitative relationship

between the percentage of income recipients and the percentage of
the total income they received during a given year. In the above
diagram, the Lorenz curve has data plotted in terms of decile
groups. It is clear from the Lorenz curve that 50% of the
population is receiving a little less than 20% of the income. In the
same way, 80% of the population is receiving less than 50% of
the total income. This is clear from point H on the Lorenz curve.

The population of the Lorenz curve will make clear the

degree of equality or inequality. If the Lorenz curve coincides
with the diagonal line there is perfect equality and all the people in
the households get the same income. As the Lorenz curve moves
away from the diagonal line, inequality also increases
 16

Figure No. 2.2

c) Gini concentration ratio or calculation of the Gini co-

efficient is another measure of the relative degree of income
inequality. This is obtained by calculating the ratio of the area
between the diagonal and the Lorenz curve divided by the total
area of the half square in which the curve lies.

Figure No. 2.3

This ratio is known as the Gini Co-efficient, named

after the Italian statistician who first formulated it in 1912. Gini
 17

co-efficients are aggregate inequality measures and can vary

anywhere from zero (perfect equality) to one (perfect inequality).
Gini co-efficient is commonly used to study the income and wealth
distribution.

2. The Functional Distribution or Factor share of

Distribution of income : The functional distribution of income
attempts to explain the share of total national income that each
of the factors of production (land, labour, capital) receives. This
method looks at the income received by the factors as a whole in
the form of rent, interest and profit. This method is not concerned
with specific individual incomes. Functional distribution of income
has emerged as a very important branch of study. It explains the
income of a factor of production by the contribution that this factor
makes to production. Supply and demand curves are assumed to
determine the unit price of each productive factor. When this unit
prices are multiplied by quantities employed, we get the total
payments to each factor Example – the supply and demand for
labour determine the wage rate. When this wage is multiplied by
the total level of employment, we get the total wage payments
called the wage bill. Thus functional distribution of income is a very
relevant and important part of distribution studies.

Economic Growth and Income Inequality

Income inequality is a critical factor in determining the level

of progress and well being of the citizens of a country. Inspite
of the growth and development achieved by developing countries,
the vast majority of population remains poor. Thus inequalities
have increased inspite of economic progress.

There are aspects of inequality. Vertical inequality is the

traditional measure of inequality which is discussed in the
development policy. Horizontal inequality is concerned with how
the different groups in society are treated, based on race, religion,
language, class, gender etc. Both the measures help to evaluate
the well being of the people.

It has been experienced that as an economy grows from a

traditional to a modern economy, growth is accompanied by
widening disparities in the personal income distribution. The
disparities may occur due to various factors like industrious
nature of people and skills. Even opportunities may not be
available for all which may lead to inequalities. Lack of appropriate
taxation system, and differences in individual ability may result in
inequalities. Later with more developmental efforts, the inequalities
will reduce.
 18

Horizontal inequality shows how economic differences,

social limitations and political power together create inequalities
among different groups in a society. The groups may belong to
different race, religion, gender, class or language. Horizontal
inequalities can lead to conflicts within a society which adversely
affect the development process.

Inequality affects an economy adversely in various ways.

As far as economic growth is concerned, increased inequality creates
dissatisfaction, ill feeling and frustration among the poor which may
even lead to a civil war. Extreme inequality leads to economic
inefficiency. Inequality may lead to inefficient allocation of
resources. For example, high inequality leads to an over emphasis
on higher education at the expense of good quality universal
primary education. High inequality leads to actions like excessive
lobbying, large political donations, bribery and cronyism.

2.2 MEASUREMENT OF POVERTY

For formulating poverty reduction programmes it is necessary

to define poverty and measure poverty. The extent of absolute
poverty is the number of people who are unable to command
sufficient resources to satisfy basic needs. They are counted as
the total number living below a specified minimum level of real
income or an international poverty line. Absolute poverty is
measured in terms of the basic needs a person has to meet in
order to survive adequately in modern society. However, the
expressions like ―adequately‖ and ―modern society‖ are
vague.

Another approach to explain the concept of absolute poverty

is to estimate the minimum intake of calories required for survival
so the search for measuring poverty led to the concept of
poverty line. The poverty line indicates the income level below
which poverty exists. For this data is needed with respect to the
income or consumption. The common statistical instruments are
used for estimation of poverty.

1. Surveys with regard to income, consumption standards,

nutritional contents.
2. Surveys are also conducted to gather information with
regard to employment, housing conditions.
3. Census data also enables the estimation of poverty

Human Poverty Index :

The Human Poverty Index was introduced by the United
Nations Development Programme (UNDP) in the Human
 19

Development Report 1997. HPI is a composite index to measure

poverty which is based on three indicators.
i) Life Expectancy
ii) Basic Education
iii) Access to public and private resources.

Life expectancy is an important indicator of human

development. Life expectancy in developing countries is 40
whereas in the developed countries it is 60. Life expectancy is a
reflection of the overall living conditions, health and sanitary
measures, food and nutrition.

Literacy is another indicator of the level of development.

The level of illiteracy is high in developing countries inspite of
globalization and changes in technology literacy is important to
keep pace with changes happening in the country and at the global
level. It is also essential to take advantage of economic
opportunities.

The third indicator of HPI is the standard of living. Though

this criteria cannot be easily defined, it is a combination of three
variables. Standard of living is based on three variables i.e. the
percentage of people with access to health services, to safe water
and the percentage of malnourished children under five. The HPI is
published for each country. Though HPI is an overall index
showing the level of development, individual indicators are also
prepared separately, so that policy makers can study the specific
problems are formulate policies for human development. For
example, health and sanitation may be a problem area for a
particular country. Policies can be tailor made to remedy the
situation.

Alternative Poverty Measures :

Head Count Ratio : Absolute Poverty may be measured by the
number of ―headcount‖, H of those, whose incomes fall below
the absolute poverty line . When the head count is taken as a
fraction of the total population, N, it is called the headcount Index, .

The poverty line is set a level that remains constant in real

terms so that we can chart our progress on one absolute level
once time. The level is set at a standard below which we would
consider a person to live in ‖absolute human misery‖ such that
one‘s health is in danger. It is difficult to define a ―minimum health
standard‖ that is fixed over time since technology changes over
time. It is more practical to establish a reasonable minimum
standard which is applicable over a few decades so as to
understand the progress made. The international poverty level is
 20

defined at a level of 1 dollar per day. This may not be practically

useful in the Indian extent when anti-poverty programmes have
to be designed. Another more practical method of determining a
local absolute poverty line is to define the combination of food or
basket of food on the basis of nutritional requirements surveys and
data collected from the households will make clear the nature and
type of goods purchased by people and how they are not meeting
the standard set by the basket of food which is supposed to by
nutritionally balanced and ideal. Food alone is not sufficient to
determine the poverty line. Hence the expenditures of the
households on basic needs such as clothing, shelter and medical
care have to be included to determine the local absolute poverty
line. Calculating by this method has shown that the poverty line
may come to more than 1 dollar per day.

Poverty Gap : Depending on the poverty line and simply

counting the number of people below the accepted poverty line can
be misleading since it has a number of limitations. If the
povertyline is set at US 360 dollars per person, there may be
people earning 355 dollars or 300 dollars or any other category.
To put everyone into a homogeneous group is misleading since all
will be given the same weights when calculating the proportion of
the population that lies below the poverty line. The seriousness of
the poverty problem may be different for different income level.
The concept of =Poverty Gap‘ which measures the total amount
of income necessary to raise everyone who is below the poverty
line upto that line.

Poverty gap is illustrated in the diagrams below

Figure No. 2.4

 21

Figure No. 2.5

Measuring the Poverty Gap

The poverty gap is the shaded area between the poverty

line PV and the annual income profile of the population. In both
countries A and B, 50% of the populations are falling below the
poverty line. But the poverty gap is more for country =A‘ then =B‘.
Hence the poverty situation is more serious for a country like =A‘
and more efforts will be needed to remove poverty. The extent to
which the incomes of the poor lie below the poverty line can be
calculated. The ―total income shortfall‖ or total poverty gap of
the poor is defined as
 22

2.3 MEASUREMENT OF DEVELOPMENT

Human Development: India‘s high growth rates have been a

matter of boastful self-congratulatory publicity for the Indian
Government, with the recent recession being projected as a
temporary setback, soon to be overcome. The latest Human
Development Report released by the UNDP in India recently serves
to confront and challenge the tall claims with the rude realities of
India‘s poor human development performance in the very midst of
its much-touted economic success story.

The Human Development Index ranking, based on 2007

data, finds India at a shocking 134th place out of 182 countries.
India‘s ranking in a statistical update based on 2006 data,
released by the UNDP last year was 132; the 2007-2008 HDR
based on 2005 data ranked India at 128, while in the preceding
year India was at 126. Undeniably, in the very phase when the
Manmohan Singh Government was boasting of high growth rates,
India‘s performance in terms of providing the basics required for a
life of dignity continued to slide steeply. If this is true of the high-
growth period, the fate of human development indicators in India
in times of Recession can only be imagined.

The Four Elements in Development:

Having seen what it means to be a developing country, we
now turn to an analysis of the process by which low-income
countries improve their living standards. We saw in the last chapter
that economic growth in the United States—growth in its potential
output—rides on four wheels. These are:
(1) Human resources,
(2) Natural resources,
(3) Capital formation,
(4) Technology.

The sources of growth are no different in other countries, no

matter how rich or poor. Let's see how each of the four wheels
operates in developing countries and consider how public policy
can steer the growth process in favorable directions.

2.4 HUMAN DEVELOPMENT INDEX

The HDI – human development index – is a summary

composite index that measures a country's average
achievements in three basic aspects of human development:
health, knowledge, and a decent standard of living. Health is
measured by life expectancy at birth; knowledge is measured
by a combination of the adult literacy rate and the combined
 23

primary, secondary, and tertiary gross enrolment ratio; and

standard of living by GDP per capita (PPP US$).

The Human Development Index (HDI) is a composite

statistic used to rank countries by level of "human development"
and separate developed (high development), developing (middle
development), and underdeveloped (low development)
countries. The statistic is composed from data on life
expectancy, education and per-capita GDP (as an indicator of
standard of living) collected at the national level using the formula
given in the Methodology section below.

The origins of the HDI are to be found in the United Nations

Development Programme's (UNDP) Human Development Reports
(HDRs). These were devised and launched by Pakistani Economist
Mahbub ul Haq in 1990 and had the explicit purpose: ==to shift the
focus of development economics from national income
accounting to people centered policies‘‘. To produce the
HDRs, Mahbub ul Haq brought together a group of well
known development economists including: Paul Streeten,
Frances Stewart, Gustav Ranis, Keith Griffin, Sudhir Anand and
Meghnad Desai. But it was Amartya Sen‘s work on capabilities and
functionings that provided the underlying conceptual framework.
Haq was sure that a simple composite measure of human
development was needed in order to convince the public,
academics, and policy-makers that they can and should evaluate
development not only by economic advances but also
improvements in human well-being. Sen initially opposed this
idea, but he went on to help Haq d evelop the Human
Development Index (HDI). Sen was worried that it was difficult to
capture the full complexity of human capabilities in a single index
but Haq persuaded him that only a single number would shift the
attention of policy-makers from concentration on economic to
human well-being.

The HDI has been used since 1990 by the United Nations
Development Programme for its annual Human Development
Reports.

Human Development Index measures achievements on

average on the basis of three following criteria. Areas which are
of significance to human development:
 Life expectancy at birth which measures the longevity of life.
 Knowledge which is based on the following two factors:
 Adult literacy rate
 Gross enrolment ratio at primary, secondary and tertiary
level.
 24

 Per capita GDP measures the standard of living of the

people.

On the basis of above criteria an index is created for each of

the above dimensions. This is done on the basis of maximum and
minimum values for each of the above three indicators.

Table 2.1: Maximum and Minimum Values for Calculating HDI

Indicator Maximum Value Minimum Value

Life expectancy at birth 85 25
Adult literacy rate 100 0
Gross enrolment ratio 100 0
GDP per capita (PPP US$) 40,000 100

The actual values for each country are compared with the
maximum and minimum value and for each country the values of all
the indicators would range between 0 and 1. The following
formula is used:

Human Development Index Norway India Burundi

HDI Rank: HDI Rank: HDI Rank:
1 127 171
Life expectancy at birth 78.7 63.3 40.4
(years), 2001
Adult literacy rate (% age - 15 - 58.0 49.2
and above), 2001
Combined primary, 98 56 31
secondary and tertiary grcfcs
enrolment ratio (%), 2000-01
GDP per capita (PPP US$), 29,620 2,840 690
2001
Life expectancy index, 2001 0.90 0.64 0.26
Education index, 2001 0.99 0.57 0.43
GDP index, 2001 0.95 0.56 0.32
Human Development Index 0.944 0.590 0.337
(HDI) value, 2001
GDP per capita (PPP US$) 4 -12 0
rank minus HDI rank
 25

Table 2 gives the Human Development index of selected

countries as given by the UN Human Development Report, 2003.
According to this report, India is ranked 127 among a total of 175
countries. India is classified on the basis of HDI as a country of
medium human development.

Three dimensions in the HDI: The HDI combines three

dimensions:

Life expectancy at birth, as an index of population health

and longevity

Knowledge and education, as measured by the adult

literacy rate (with two-thirds weighting) and the combined primary,
secondary, and tertiary gross enrolment ratio (with one-third
weighting).

Standard of living, as indicated by the natural logarithm of

gross domestic product per capita at purchasing power parity.

The formula defining the HDI is promulgated by the United

Nations Development Programme (UNDP) In general, to transform
a raw variable, say x, into a unit-free index between 0 and 1 (which
allows different indices to be added together), the following formula

The Human Development Index (HDI) then represents the

uniformly weighted sum with 1/3 contributed by each of the
following factor indices:

Methods of HDI measures:

A) Life Expectancy Index:

Life expectancy is the expected (in the statistical sense)
number of years of life remaining at a given age. It is denoted by ex,
which means the average number of subsequent years of life for
someone now aged x, according to a particular mortality
experience. (In technical literature, this symbol means the average
number of complete years of life remaining, excluding fractions of a
year. The corresponding statistic including fractions of a year, the
normal meaning of life expectancy, has a symbol with a small
circle over the e.) The life expectancy of a group of individuals is
heavily dependent on the criteria used to select the group. Life
 26

expectancy is usually calculated separately for males and

females. Females live longer than males in countries with modern
obstetric care.

In countries with high infant mortality rates, the life

expectancy at birth is highly sensitive to the rate of death in the
first few years of life. Because of this sensitivity to infant mortality,
simple life expectancy at age zero can be subject to gross
misinterpretation, leading one to believe that a population with a
low overall life expectancy will necessarily have a small proportion
of older people. For example, in a hypothetical stationary
population in which half the population dies before the age of five,
but everybody else dies exactly at 70 years old, the life expectancy
at age zero will be about 35 years, while about 25% of the
population will be between the ages of 50 and 70. Another
measure such as life expectancy at age 5 (e5) can be used to
exclude the effect of infant mortality to provide a simple measure of
overall mortality rates other than in early childhood—in the
hypothetical population above, life expectancy at age 5 would be
70 years. Aggregate population measures such as the proportion
of the population in various age classes should also be used
alongside individual-based measures like formal life expectancy
when analyzing population structure and dynamics.

Female v/s Male Life expectancy:

Women tend to have a lower mortality rate at every age. In

the womb, male fetuses have a higher mortality rate (babies are
conceived in a ratio of about 124 males to 100 females, but the
 27

ratio of those surviving to birth is only 105 males to 100 females).

Among the smallest premature babies (those under 2 pounds or
900 g) females again have a higher survival rate. At the other
extreme, about 90% of individuals aged 110 are female.

In the past, mortality rates for females in child-bearing age

groups were higher than for males at the same age. This is no
longer the case, and female human life expectancy is considerably
higher than those of men. The reasons for this are not entirely
certain. Traditional arguments tend to favor socio-environmental
factors: historically, men have generally consumed more tobacco,
alcohol and drugs than females in most societies, and are more
likely to die from many associated diseases such as lung cancer,
tuberculosis and cirrhosis of the liver. Men are also more likely to
die from injuries, whether unintentional (such as car accidents) or
intentional (suicide, violence, war). Men are also more likely to die
from most of the leading causes of death (some already stated
above) than women. Some of these in the United States include:
cancer of the respiratory system, motor vehicle accidents, suicide,
cirrhosis of the liver, emphysema, and coronary heart disease.

These far outweigh the female mortality rate from breast

cancer and cervical cancer etc.

Some argue that shorter male life expectancy is

merely another manifestation of the general rule, seen in all
mammal species, that larger individuals tend on average to have
shorter lives. This biological difference occurs because women have
more resistance to infections and degenerative diseases

B) Education Index:
The Education Index is measured by the adult literacy rate
(with two-thirds weighting) and the combined primary, secondary,
and tertiary gross enrolment ratio (with one-third weighting). The
adult literacy rate gives an indication of the ability to read and
write, while the GER gives an indication of the level of education
from kindergarten to postgraduate education.

Education is a major component of well-being and is used in

the measure of economic development and quality of life, which is a
key factor determining whether a country is a developed,
developing, or underdeveloped country.
 28

c) Adult literacy index:

The Adult literacy index (ALI) is a statistical measure used to
determine how many adults can read and write in a certain area or
nation. Adult literacy is one of the factors in measuring the Human
Development Index (HDI) of each nation, along with life
expectancy, education, and standard of living.
The equati on for calculating the Adult Literacy Index is:

The gross enrolment ratio (GER) or gross

enrolment index (GEI) is a statistical measure used in the
education sector and by the UN in its Education Index. The GER
gives a rough indication of the level of education from
kindergarten to postgraduate education – known in the UK
and some other countries (mostly in the Commonwealth of
Nations) as primary, secondary, and/or tertiary – amongst
residents in a given jurisdiction.

In the UN, the GER is calculated by expressing the number

of students enrolled in primary, secondary and tertiary levels of
education, regardless of age, as a percentage of the population of
official school age for the three levels

D) Gross domestic product:

The gross domestic product (GDP) or gross domestic
income (GDI) is a measure of a country's overall economic
output. It is the market value of all final goods and services made
within the borders of a country in a year. It is often positively
correlated with the standard of living, alternative measures to
GDP for that purpose.

Gross domestic product comes under the heading of

national accounts, which is a subject in macroeconomics.

GDP can be determined in three ways, all of which should in

principle give the same result. They are the product (or output)
approach, the income approach, and the expenditure approach.
 29

2.5GENDER RELATED DEVELOPMENT INDEX (GDI)

The Gender-related Development Index (GDI) is an

indication of the standard of living in a country, developed by the
United Nations (UN). It is one of the five indicators used by the
United Nations Development Programme in its annual Human
Development Report. It aims to show the inequalities between men
and women in the following areas: long and healthy life, knowledge,
and a decent standard of living.
While HDI measures average achievement, the GDI
adjusts the average achievement to reflect the inequalities
between men and women. The three components used for the
purpose are: (i) female life expectancy, (ii) female adult
literacy and gross enrolment ratio, and (iii) female per capita
income.
If gender inequality were not penalised, the value of GDI and
HDI would be the same, but if gender inequality exists, the value
of GDI would be lower than that of HDL The greater the difference
between HDI and GDI, the greater is the gender inequality. Table
2.4 provides data both for HDI and GDI for selected countries. It
may be noted that near gender equality exists in Norway, Canada,
United States, United Kingdom, Japan, Mexico, Russian
Federation, Malaysia, Venezuela, Philippines, Sri Lanka, China,
Vietnam and Indonesia. Countries which indicate higher gender
inequality are Saudi Arabia, Pakistan, Iran, India, Egypt and
Nigeria.
However, there is a greater awareness in the world about
gender inequality and efforts are being made to reduce gender
inequality by promoting the education of females and giving them a
better status in the family. Some countries have lagged behind
due to cultural biases against the females. However, in them
also, women movements are promoting the cause of bringing
about gender equality.
GDI in India:
In India, Life expectancy at birth of females in 2001 was 64
years, but for males, it was 62.8 years. Comparing with medium
human development countries, Indian achievement, though
good, is still much lower in relation to Mexico, Venezuela, Russian
Federation, Thailand, Philippines, Sri Lanka, Iran, Vietnam, to
name a few among them.
Although gap between life expectancy of females and
males is very small, but in other gender-related development
indicators, this gap is very wide. For instance, adult literacy of
females was barely 46.4 per cent as against 69.0 per cent of
 30

males in 2001. Similarly, combined Gross Enrolment ratio of

females was 49 per cent as against 63.0 per cent for males in
2001. Likewise, Estimated Earned Income of females was $
1,531 as compared with that of males to be $ 4,070 in 2001. This
implies that female income was just 38 per cent of male income.
Obviously, either females suffered from gender discrimination in
wage income or they did not have regular employment and a big
proportion was employed as casual labourers or a large proportion
of females worked part time. There may be many more factors,
but it cannot be denied that females suffered gender bias both in
education and employment.

Calculating the GDI involves three steps:

Step 1: Unit-free indices between 0 and 1 are calculated for
females and males in each of the following areas:
1. life expectancy,
2. education (the adult literacy rate and the combined primary to
tertiary gross enrolment ratio),
3. Estimated earned income (at purchasing power parity US$).

Step 2: For each area, the pair of gender indices, are combined
into an Equally Distributed Index that rewards gender equality and
penalizes inequality. It is calculated as the harmonic mean of the
two indices.
 31

Step 3: The GDI is the unweighted average of the three Equally

Distributed Indices: Equally distributed life expectancy index,
Equally distributed education index, Equally distributed income
index.

The UN uses a different standard for male and female life

expectancy, basically assuming that it is natural that women should
live about 5 years longer than men. If the life expectancy index was
set at an equal age of 85 years, the GDI calculated would increase,
reflecting the superior life expectancy of women in almost all
countries. Just replace 87.5 years and 82.5 years with 85.0 years
and replace 27.5 years and 22.5 years with 25.0 years to
equalize it. Iceland, for example, would have a GDI of 0.992 instead
of 0.962 under this method.

2.6 ROLE OF MARKET AND STATE

Market and State as Agencies of Development:

While markets do act in a manner that they tend to
encourage competition and thus bring about efficiency and increase
in productivity, the market failure has been noticed in the following:

(i) In case of imperfect competition, markets generate situations in

which state intervention becomes necessary to ensure
competition.
(ii) In case of monopoly, market failure is obvious and the state
must intervene to break monopoly by anti-monopoly legislation
or other measures.
(iii) Market failure has also been noticed in public goods like
education and health. In these areas, unless the state
establishes schools, colleges, universities, primary health
centres and hospitals, it would not be possible to take care
of the weaker sections of the society.
(iv) Market failure has also been noticed in areas of economic
infrastructure like irrigation, roads, railways,
telecommunications etc. Private sector loves to use
infrastructure, but would not like to invest in infrastructure, more
especially in remote areas, where the rate of return may be very
small. Thus, it is generally expected that the public sector should
create infrastructures and thus create an environment which
facilitates direct investment by the private sector.

The question arises: market failures necessitate state

intervention so that the imperfections of the market mechanism can
be corrected. For instance, markets set prices on the basis of
demand and supply forces. But to quote Michael Lipton, setting
 32

prices right is quite different from letting prices come from state
inaction. Obviously, the function of the State is to set right prices
so that correct signals for allocation of resources can be made.
State failures, however, do not justify the use of market in all
situations. It is quite possible that there is a need to change
policies or to take strong administrative measures to correct state
failures.

This only underlines the fact that even if markets are to be

used more extensively, this does not eliminate the role of the State.
Rather than arguing for minimal state intervention, it would be more
prudent to argue for effective state intervention.

World Development Report (1999-2000) has also stated

that in development thinking so far as the regulatory sphere is
concerned, "the focus has shifted from deregulation to building an
effective regulatory framework."

2.7 SUMMARY

1. India has been categorised by the Human Development Report

2001 as a medium human development country. A major
impediment to progress in human development is the very fast
growth of population experienced in India.

2.The Human Development Index (HDI) is a summary composite

index that measures a country‘s average achievements in three
basic aspects of human development: health, knowledge and a
decent standard of living. Health is measured by life expectancy
at birth; knowledge is measured by a combination of the adult
literacy rate and the combined primary, secondary and tertiary
gross enrolment ratio and standard of living by GDP per capita.

3. Following are the methods of HDI measures:

A)Life Expectancy Index: Life Expectancy is the expected (in

statistical Sense) number of years of life remaining at a given
age. It is denoted by ex, which means the average number of
subsequent years of life for someone now aged x, according to a
particular mortality experience.

B)Education Index: The Education Index is measured by the

adult literacy rate (with two-third weighing) and the combined
primary, secondary and tertiary gross enrolment ratio (with one-
third weighing).
 33

C)Adult literacy Index: The Adult literacy index is a statistical

measure used to determine how many adults can read and
write in a certain area or nation.
D)Gross Domestic Product: The gross domestic product or gross
domestic income is a measure of a country‘s overall economic
output. It is the market value of all final goods and services made
within the borders of a country in a year. It is often positively
correlated with the standard of living, alternative measures to
GDP for that purpose.
4.The Gender related Development Index (GDI) is an indication of
the standard of living in a country, developed by the United
Nations (UN). It is one of the five indicators used by the United
Nations Deve lopment Programme in its annual Human
Development Report. It aims to show the inequalities between
men and women in the following areas: long and healthy life,
knowledge and a decent standard of living.
5.Sustainable development is development which is everlasting
and contributes to the quality of life through improvements in
natural environments. Natural environments, in turn, supply utility
to individuals, inputs to the economic process and services that
support life. The concept of sustainable development assigns
equal emphasis on development, environmental protection and
preservation. It emphasises the creation of sustainable
improvement in the quality of life of all people through increase in
real income, per capita income, national income,
improvements in health, education, general quality of
life and overall improvements in quality of natural
environmental resources.
6. The main objective of sustainable development is the creation of
sustainable improvements in the quality of life for all people on
the earth.

2.8 QUESTIONS

Q1. Write note on following:

a) Measurement of Inequality
b) Measurement of poverty
c) Human Development Index
d) Human Poverty Index


 34

Module II

3
MODERN THEORIES OF
GROWTH AND DEVELOPMENT – I
Unit Structure
3.0 Objectives
3.1 Introduction
3.2 Harrod-Domar Model of Growth
3.3 Solow Model of Growth
3.4 Summary
3.5 Questions

3.0 OBJECTIVES

 To study the Harrod model of growth.

 To study the Domar model of growth.
 To study the Solow model of growth.

3.1 INTRODUCTION

The Harrod-Domar model is based on assumptions not

found in UDCs and hence they are not applicable. Prof. Hirschman
suggests that UDCs must have their own independent growth
models. However, Prof. Kurihara believes that both the saving and
income ratio and the capital output ratio have universal character
and they are measurable strategic variables. UDCs which adopt
planned and balanced economic growth can definitely use these
models because their saving-income ratio and capital output ratios
remain constant during the plan period.

3.2 HARROD-DOMAR GROWTH MODEL

The model is based on the experiences of advanced
capitalist economies and it analyses the requirements of steady
growth in such economies.
 35

REQUIREMENTS OF STEADY GROWTH

Harrod and Domar attempted to determine the rate of

income growth necessary for the steady working of the economy.
Their models are different in details. However, their conclusions
are similar. According to the two, investment has a key role in the
economic growth process because it generates income and
increases the productive capacity of the economy. Rise in income
may be known as the demand effect and rise in productive capacity
may be known as the supply effect of investment. Expansion
inreal income and output depends upon net investment. Full
employment equilibrium will be maintained if growth in real income
and output is equal to the rise in the productive capacity. If growth
in real income and output is less than the growth in the productive
capacity, excess capacity will emerge and entrepreneurs will reduce
investment leading to reduced levels of income and employment in
the subsequent periods and the economy will move away from the
path of steady growth. The required rate of growth in real income
and output in order to maintain full employment is known as the
Warranted Rate of Growth or the full capacity growth rate.

ASSUMPTIONS

The Harrod-Domar model is based on the following assumptions:

1. There is an initial full employment level of equilibrium.

2. There is absence of government interference.
3. The economy is a closed economy.
4. There are no adjustment lags between investment and
productive capacity.
5. The average propensity to save is equal to the marginal
propensity to save.
6. The ratio of capital stock to income is fixed.
7. The marginal propensity to save remains constant.
8. There is no depreciation of capital goods.
9. Saving and investment relate to the income of the same year.
10.The general price level is constant.
11.Interest rate is constant.
12.The proportion of labor and capital in the productive process is
fixed.
13. Fixed and circulating capital are lumped together to be capital.
14.There is only one type of product.
 36

(A) THE DOMAR MODEL

The rate at which investment should increase in order to make

the increase in real income equal to the increase in the productive
capacity can be obtained by linking aggregate supply and
aggregate demand through investment.

1. Increase in Productive Capacity or the Supply Side. Let the

annual rate of investment be ‘I’ and the annual productive
capacity per dollar be ‘s’. Thus the productive capacity of ‘I’
dollar invested will be I·s dollars per year. However, new
investment will compete with the old for attracting factors of
production leading to a lower output from the old plants. As a
result, the rise in productive capacity of the economy will be less
than I·s which is indicated as Io where o represents the net
social average productivity of investment (= ∆Y/I). Thus Io < Is.
Io is the total net potential increase in the output of the economy
and is known as the ‘sigma effect’. According to Domar Io is the
supply side of the investment.
2. Required Increase in Aggregate Demand. Let the annual
increase in income be denoted by ∆Y and increase in
investment by ∆I and the propensity to save by a (= ∆S/∆Y).
Then the increase in income will be equal to the multiplier (1/a)
times the increase in investment i.e. ∆Y = ∆I×1/a.

3. Equilibrium. In order to maintain full employment equilibrium

level of income, aggregate demand should be equal to
aggregate supply. Equality between AD and AS is the
fundamental equation of the model which is stated as follows:

∆I × 1/a =Io which can be restated as ∆Y = Io.

Solving the above equation by dividing both sides by I and
multiplying by a we get:
∆I/I = ao.
This equation shows that to maintain full employment, the
growth rate of net autonomous investment (∆I/I) must be equal to
ασ (mps times the productivity of capital). Ασ is the rate at which
investment must grow to ensure the use of potential capacity in
order to maintain a steady growth rate of the economy at full
employment.
Domar gives a numerical example to explain his point. Let o
= 25% per year, a = 12 per cent and Y = 150 Billion USD per year.
 37

In order to maintain full employment, an amount equal to 150 ×

12/100 = 18 billion USD should be invested. This will raise
productive capacity by the amount invested σ times i.e. by:

The national income will therefore rise by 4.5 Billion USD per
year. But the relative rise in income will equal the absolute increase
divided by the income itself, i.e.

Thus in order to maintain full employment, income must

grow at a rate of 3 per cent per annum which is the equilibrium rate of
growth. Any divergence from the 3 per cent rate of growth will lead
to cyclical fluctuations. When ∆I/I > ασ, the economy would experience
boom and when ∆I/I < ασ, the economy would
experience depression.

(B) THE HARROD MODEL

Prof. RF Harrod tries to show in his model how steady
growth may occur in the economy. Once the steady or the
equilibrium growth rate is disturbed, the disequilibrium will
continue on account of the cumulative forces leading the
economy into secular deflation or inflation. The model is based
upon three distinct rates of growth. The actual growth rate ‘G’
which is determined by the saving ratio and the capital output ratio.
‘G’ shows the short run cyclical variation in the growth rate. The
warranted growth rate is represented by ‘Gw’ which is the full
capacity growth rate. The natural growth rate is represented by
‘Gn’ which is regarded as the welfare optimum by Harod. ‘Gn’ may
also be called as full employment rate of growth.
 38

The Actual Growth Rate (G)

In Harrod’s model, the first fundamental equation is:
GC=s (1)

Where G is the rate of growth of output in a given period of time i.e.

(∆Y/∆Y),

‘C’ is the net addition to capital and is defined as the ratio of

investment to the increase in income i.e. I/∆Yand ‘S’ is the average
propensity to save i.e. S/Y. Substituting these ratios in the above
equation, we get:

The Warranted Rate of Growth (Gw)

It is the rate at which producers will be happy with what they
are doing. It is the entrepreneurial equilibrium. Given the
propensity to save, the rate of growth of output will be equal to the
growth rate in income or demand. The equation for the warranted
growth rate is:

G w C r = s .................................................... (2)

Where Gw is the warranted rate of growth which is equal to

∆Y/∆Y, ‘Cr’ is capital required to maintain the warranted rate of
growth i.e. the required capital output ratio which is equal to I/∆Y.
‘s’ = S/Y or the average propensity to save. Thus if the economy is
to grow at a steady rate of Gw, income must grow at the rate of s/Cr
per year i.e. Gw = s/Cr.

If income grows at the warranted rate, the capital stock of the

economy will be fully utilized and entrepreneurs will be willing to continue
to invest the amount of saving generated at full potential income. Gw
is therefore a self-sustaining rate of growth and at Gw growth rate,
the economy will follow the equilibrium path.

The Origin of Long-run Disequilibria

At full employment growth, the actual growth rate ‘G’ must

equal ‘Gw’ resulting in a steady grwoth rate and ‘C’ must equal ‘Cr’
i.e. the actual capital goods must be equal to the required capital
goods for steady growth. If ‘G’ and ‘Gw’ are unequal, the economy
will be in disequilibrium. For example, if G > Gw, then C < Cr and
 39

there will be shortages of goods and equipment leading to secular or

general inflation. The ruqired investment will be greater than
saving and hence aggregate supply will be less than aggregate
demand. There would thus be chronic or continuous inflation. This is
shown in figure 3.1(A). Notice that the actual growth rate ‘G’ follows
the warranted growth path ‘Gw’ from the full employment level of
income Yo up to point ‘E’ through period t2. From t2, ‘G’ deviates
from ‘Gw’ and lies above it. In later periods, the gap between G and
Gw widens. Conversely, if G < Gw, then C > Cr resulting in a secular
or general depression because actual income grows at a rate less
than the rate of growth of the productive capacity of the economy.
This is a situation in which the actual capital goods are greater than
the required capital goods. This means that the required investment
is less than saving and aggregate demand is less than aggregate
supply. The result is fall in output, employment and income. There
would thus be chronic depression. This is shown in Fig. 3.1(B). Notice
that from period t2 onwards, G falls below Gw and the gap widens in
the subsequent periods. According to Harrod, once the equilibrium is
disturbed, it cannot be automatically restored. Hence public policy
should aim at establishing equality between G and Gw in order to
maintain long run stability. In this context, the concept of natural rate
of growth assumes importance.

Fig. 3.1(A). Secular Inflation Fig. 3.1(B). Secular Depression

 40

The Natural Rate of Growth

The natural rate of growth is the rate of growth determined by

the increase in population and technological improvements at full
employment. The equation for the natural growth rate is:

Here Gn is the natural or full employment rate of growth.

Divergence of G, Gw and Gn

Full employment equilibrium will be attained when Gn = Gw

= G. If there is any divergence between thee rates of growth, there
will be either secular stagnation, inflation or depression. If G> Gw,
investment increases faster than savings and incomes rises faster
than Gw resulting in inflation. If G < Gw, saving increases faster
than investment and rise of income is less than Gw resulting in
depression. According to Harod, if Gw> gn, secular stagnation will
develop. In this situation, Gw is also greater than G because the
upper limit to the actual rate is set by the natural rate as shown in
Figure 3.2(A). When Gw> Gn, C> Cr and there will be excess of
capital goods due to shortage of labor which keeps the rate of
increase in output to a level less than Gw. Excess capacity results
in reduced investment, employment, output and incomes. The
economy will be found in chronic depression and savings will be
considered bad. If Gw < Gn, Gw is also less than G as in Fig.3.
2(B), secular inflation will develop in the economy. When Gw < Gn,
C will be less than Cr (C < Cr), there is shortage of capital goods
and labor is abundant. Profits are high because desired investment
is greater than realized investment and businessmen will tend to
increase their capital stock. This will lead to secular inflation. In
such a situation, saving is good because it permits the warranted
growth rate to increase.

The policy implications of the model are that saving is good in

any inflationary gap economy and bad in a deflationary gap
economy. Thus, in an advanced economy, ‘S’ has to be moved up and
down as the situation demands.
 41

LIMITATIONS OF THE HARROD-DOMAR MODEL

1. The propensity to save (α or s) and the capital output ratio (σ) are
assumed to be constant. In reality, these do not remain constant
in the long run and hence the requirements of steady growth may
change. Further, steady growth rate may be obtained even
with variable α and σ.
2. The assumption that labor and capital are used in fixed
proportions is not acceptable. Labor can be substituted for
capital and the economy can move towards a steady growth
path.
3. The general price level is assumed to be constant. In reality,
prices do change and may stabilize unstable situations.
4. The assumption that interest rate is constant is unrealistic and
irrelevant to the model. A reduction in interest rates during
periods of over- production can make capital intensive
processes more profitable by increasing the demand for capital
and thus reduce excess supply of goods.
5. The Harrod - Domar models ignore the effect of government
programs on economic growth.
6. The model neglects the entrepreneurial behavior which actually
determines the warranted growth rate in the economy.
7. The model fails to distinguish between capital goods and
consumer goods.

8. According to Prof. Rose, the primary source of instability in

Harrod’s system lies in the effect of excess demand or excess
supply on production decisions and not in the effect of growing
capital shortage or excess capital on investment decisions.

Notwithstanding these limitations, the model is based on a

free market economy with fiscal neutrality and is designed to indicate
conditions of progressive equilibrium for an advanced economy.

The model is important because it attempts to infuse

dynamism and secularize Keynes’s static short-run saving and
investment theory.
 42

APPLICATION OF HARROD-DOMAR MDOEL TO

UNDERDEVELOPED COUNTRIES

The Harrod-Domar models are based on three principal

concepts of saving function, autonomous and induced investment
and productivity of capital. The model was basically developed to
solve the problem of secular stagnation in the advanced economies
of the post-war period. The application of these models has been
extended to the development problems of the under-developed
countries.

Let us see as to how these models can be used for planning

in UDCs. Let us assume the capital output ratio to be 4:1 and Gw to
be 3 per cent per annum. By applying the Harrod Domar formula,
the planners can find out the saving ratio required to sustain the
growth rate of 3 per cent per annum. By substituting the above
values in Harrod’s model GwCr = s, we get:

Thus if the capital output ratio is assumed to be 4:1 in an

economy, the domestic savings must be 12% of the national
income so that the economy grows at the rate of 3% per annum.
Given the saving ratio and the capital output ratio, Harrod’s formula for
calculating growth rate is Gw = s/Cr and if S is 12% and the value
of Cr is 4, then Gw = 12 /4 = 3 per cent. UDCs are characterized by
low savings, high level of investment and chronic inflation. Hence,
Harrod suggests the financing of large investments through the
expansion of bank credit and automatic investment of inflationary
profits in the capital markets. In the absence of organized capital
markets in the UDCs, bank credit is the only way to finance
investments and generate economic growth. Low savings in
UDCs are responsible for low rate of growth and mass
unemployment and under-employment. Thus the actual level of
savings should be raised to the required level of savings by a
compulsory tax or a surplus budget so that S = Sr. Further, Harrod
also emphasizes the need for changes in the social and institutional
factors because social and institutional obstacles are viewed as a
cause of low growth rate.
 43

LIMITATIONS OF THE HARROD-DOMAR MODEL IN UDCs

1. Different Conditions. The models were not intended to guide
industrialization programs of under developed countries.

2. Savings Ratio. The growth models require high savings as

well as low capital output ratio. In the UDCs, savings and
investment decisions are taken by a small percentage of people
with the majority of people leading a subsistence life.
3. Capital Output Ratio. It is difficult to measure capital output
ratio when productivity is hindered by shortages and
bottlenecks. According to Prof. Hirschman, the predictive and
operational value of a model based on the capital output ratio
and the savings ratio is less useful in under developed
countries.
4. Structural Unemployment. According to Prof. Kurihara, the
model fails to solve the problem of structural unemployment in
UDCs i.e. unemployment arising out of a faster growth of
population than the accumulation of capital.
5. Disguised Unemployment. The models begin with the
assumption of full employment level of income which is not
found in UDCs. Disguised unemployment cannot be removed by
these models.
6. Government Intervention. UDCs cannot develop without
substantial government intervention in the form of public
investment, planning and regulating the economy. However,
the model is based on laissez-faire policy.
7. Foreign Trade and Aid. The models are based on the
assumption of a closed economy. However, UDCs are open
economies in which foreign trade and aid has a major role.
8. Price Changes. Prices are assumed to be constant. However,
the development experience of UDCs indicates inflationary
growth.
9. Institutional Changes. Institutional factors are assumed to be
given. However, economic development is not possible without
institutional changes in Under developed countries.

3.3 SOLOW‘S NEOCLASSICAL GROWTH MODEL

Solow‘s growth model is one of the best known model of
economic growth. The model gives utmost importance to savings
in the growth process. According to Solow, economies will
converge to the same level of income, given, they have the same
rate of savings, depreciation, labour force growth and productivity
growth. R. M. Solow built his model of economic growth as an
alternative to the Harrod-Domar model without its crucial
assumptions of fixed proportions in production.
 44

Assumptions :
1. The Solow model allows substitution between capital and
labour. When both the inputs are used, it leads to diminishing
returns.
2. One composite commodity is produced.
3. There are constant returns to sale. The product function is
homogeneous of the first degree.
4. The two factors of production – labour and capital are paid
according to their marginal physical productivities.
5. Prices and wages are flexible.
6. There is perpetual full employment of labour.
7. The available capital stock is also fully employed.
8. Labour and capital are substitutable for each other.
9. There is neutral technical progress.
10.The saving ratio is constant.

The Model :

The output per worker is a function that depends on the

 45

amount of capital per worker. Increased capital availability per

worker will enable increased output.

Solow gave importance of the growth of savings. The total

capital stock grows when savings are greater than depreciation.
Capital labour ratio K (Which is called capital deepening) and
depreciation will together determine the actual growth in capital
stock.

Figure: Equilibrium in the Solow Growth Model

 46


3.4 SUMMARY

Solow‘s model is an improvement over Harrod Domar
Model. In Harrod-Domar Model there is a knife edge balance in the
economy.

Any disturbance in the balance will take the economy away

from equilibrium. Solow‘s model explains the possibilities of steady
growth. However, Solow‘s model suffers from the following
limitations.
1. Solow‘s model does not discuss investment function. The
role of entrepreneurship is ignored in the theory.
2. Solow assumed flexibility of factor prices. But the liquidity trap
situation may prevent the rate of interest in falling further. As a
result, capital output ratio may not rise to a level necessary for
attaining the path of equilibrium path.
3. Solow‘s model is based on the unrealistic assumption of
homogenous and malleable capital. However, capital goods are
highly heterogeneous and thus pose the problem of
aggregation.
4. Solow leaves out technical progress and treats it as
an exogenous factor in the growth process.

3.5 QUESTIONS

Q1. Explain Harrod model of growth.

Q2. Explain Domar model of growth.
Q3. Explain the Solow model. 


 47

4
MODERN THEORIES OF
GROWTH AND DEVELOPMENT – II
Unit Structure
4.0 Objectives
4.1 Approaches to Technical Change
4.2 Convergence
4.3 Endogenous Growth Model of Romer
4.4 Human Capital
4.5 Summary
4.6 Questions

4.0OBJECTIVES

1. To study the approaches to technical change.

2. To know the concept of convergence.
3. To study the Lucas human capital.
4. To study the endogenous growth model of Romer.

4.1APPROACHES TO TECHNICAL GROWTH

The technical change is the term used in economics to

describe a change in the amount of output produced from the same
amount of inputs. Technical change is not necessarily technological
as it might be organizational or due to a change in a constraint such
as regulation, input prices or quantities of inputs.

It is possible to measure the technical change as the change

in output per unit of factor input.

In the free-market economies, technological advances lead

to increases in productivity, but at the expense of older, less-
efficient means of production, creating a level of subjective risk for
which compensation (in theory) is the return on capital. This rate or
return is reflection of all of the perceived risks associated with the
capital financing of the means of production, including technology
risks. From a capital finance point of view, advances in technology
are the classic definition of systemic market risk. The outflow of this
condition is the "creative destruction" of portion of the means of
production as evidenced by businesses discontinuing the
 48

production of obsolete products and/or cessation of business

activities that are no longer profitable. In its purest form, capitalism
entails the constant level of creative destruction of a portion of the
means of production and increase in the Gross Domestic Product
(GDP) of the subject economy reflects the growth after the losses
due to economic obsolescence have been reconciled. Accordingly,
increases in GDP provides a substantive measurement that
demonstrates that capitalism does not in effect create an economic
construct where one party can only make a gain at expense of the
other party (i.e.: if one party could only profit at the expense of
another party, then it would be impossible to achieve any nominal
growth in GDP).

4.2CONVERGENCE

Idea of convergence in economics (also sometimes known

as the catch-up effect) is the hypothesis that poorer economies' per
capita incomes will tend to grow at the faster rates than richer
economies. And in the Solow growth model, economic growth is
driven by accumulation of the physical capital until this optimum
level of capital per worker, which is the "steady state" is reached,
where output, consumption and capital are constant. This model
predicts more rapid growth when the level of physical capital per
capita is low, something often referred to as “catch up” growth. As a
result, all economies should eventually converge in terms of the per
capita income. Developing countries have the potential to grow at
the faster rate than developed countries because diminishing
returns (in particular, to capital) are not as strong as in capital-rich
countries. Poorer countries can replicate the production methods,
technologies, and institutions of the developed countries.

In the economic growth literature the term "convergence"

can have two meanings. The first kind (sometimes called "sigma-
convergence") refers to reduction in the dispersion of levels of
income across economies. "Beta-convergence" on the other hand,
it occurs when poor economies grow faster than rich ones.
Economists say that there is "conditional beta-convergence" when
the economies experience "beta-convergence" but conditional on
other variables (namely the investment rate and the population
growth rate) being held constant. They say that "unconditional beta-
convergence" or "absolute beta-convergence" exists when growth
rate of an economy declines as it approaches its steady state.
According to Jack Goldstone, "in the twentieth century, the Great
Divergence peaked before the First World War and continued until
the early 1970s, then, after two decades of indeterminate
fluctuations, in the late 1980s it was replaced by the Great
Convergence as the majority of Third World countries reached
economic growth rates significantly higher than those in most first
 49

World countries." Thus the present-day convergence should be

regarded as a continuation of the Great Divergence.

For Example - In the 1960s and 1970s the East Asian Tigers
rapidly converged with developed economies.

Types of Convergence:
1. Absolute convergence:
The lower initial GDP will lead to a higher average growth
rate.Implication of this is that poverty will ultimately
disappear 'by itself'. It does not explain why some nations
have had the zero growth for many decades.

2. Conditional convergence:
A country's per worker income converges to a country-
specific long-run level as determined by the structural
characteristics of that country.The implication is that
structural characteristics, and not initial national income,
determine the long-run level of GDP per worker. Thus,
foreign aid should focus on the structure (infrastructure,
education, financial system etc.) and there is no need for
income transfer from the richer to the poorer nations.

3. Club convergence:
It is possible to observe different the "clubs" or the groups of
countries with similar growth trajectories. Several countries
with low national income also have low growth rates.

Thus, this is in contrast to theory of conditional convergence,

and would suggest that the foreign aid should also include income
transfers and that initial income does in fact matter for economic
growth.

4.3 ENDOGENOUS GROWTH MODEL OF

ROMER

The traditional growth theories were not able to explain the

sources of long term economic growth. In fact, traditional growth
theories believed that economies cannot grow over a long period.
According to neoclassical theory, the low capital labor ratios of
developing countries promise high rates of return on investment.
However, in the era of W orld Bank-IMF sponsored
globalization, particularly in the context of LDCs, it has been found
that most of the LDCs failed to attract new foreign investment or to
stop the flight of domestic capital. The paradoxical behavior of
developing-world capital flows (from poor to rich countries) led to the
development of the concept of Endogenous Growth or the New
Growth Theory.
 50

The new growth theory provides a theoretical framework for

analyzing sustained endogenous growth that is determined by the
system governing the production process. The endogenous growth
models hold GNP growth to be a natural consequence of long run
equilibrium. They explain the growth rate differentials across the
countries and growth in itself. They also explain the factors that
determine the size of λ (the rate of growth of GDP) that is not
explained and exogenously determined in the So low neoclassical
growth equation.

The endogenous growth theory differs from the neoclassical

growth theories in the following ways:
1. Rejects diminishing marginal returns to capital investments and
permits increasing returns to scale in aggregate production.
2. Focuses on the role of externalities in determining the rate of
return on capital investments.
3. Assumes that public and private investments in human capital
generate external economies and productivity gains that offset
the natural tendency for diminishing returns.
4. Seeks to explain the existence of increasing returns to scale
and the divergent long term growth patterns among countries.
5. Technology is not considered necessary to explain long run
growth.

The new growth theories can be expressed by the equation Y

= AK (Harrod-Domar Model). Here, ‘A’ represents any factor that
affects technology and K includes both physical and human capital.
But there are no diminishing returns in this equation of growth
which means investments in physical and human capital can
generate external economies and productivity gains that exceed
private gains so as to obtain increasing returns and sustained long
term growth. The new growth theory therefore emphasizes the role of
savings and investment in human capital investment for achieving
rapid economic growth. The new growth theory therefore also differs
from the traditional theories in many other ways. Firstly, there is
no convergence of growth rates amongst closed economies.
National growth rates remain constant and differ across countries
depending on national savings rates and technology levels.
Secondly, there is no tendency for per capita income levels in capital-
poor countries to catch up with those in rich countries with similar
savings and population growth rates. As a result, a temporary or
prolonged recession in one country can lead to a permanent
increase in the income gap between itself and rich countries.

The endogenous growth models explain paradoxical capital

flows across countries leading to greater wealth inequalities
 51

between developed and developing countries. The prospect of

high returns on investment offered by developing countries with low
capital labor ratios is negated by lower levels of complementary
investments in human capital, infrastructure or research and
development.There is less benefit to poor countries from
alternative forms of capital expenditure because the free market leads
to the accumulation of less than the optimal level of complementary
capital.

Where complementary investments produce social

and private benefits, governments may improve the efficiency of
resource allocation by providing public goods or by encouraging
private investment in knowledge intensive industries where human
capital can beaccumulated and increasing returns to scale
generated. Further, the new growth theory explains technological
change as an endogenous outcome of public and private
investment in human capital and knowledge-intensive industries.
They therefore suggest an active role for public policy in promoting
economic development through direct and indirect investments in
human capital formation and the encouragement of foreign private
investment in knowledge intensive industries such as computer
software and telecommunications.

THE AK MODEL
The Romer model is known to be relevant to the developing
countries because it looks at the spill-over effects of
industrialization. The model assumes that growth processes are
derived from the firm or industry. Each industry individually
produces with constant returns to scale. Romer assumes that
economy-wide capital stock, positively affects output at the industry
level so that there is economy-wide increasing returns to scale.
Capital stock includes knowledge which has spillover effects and it is
in the nature of a public good. The industry level production
function is given at equation (1).

In Equation (1), Yi stands for the industry level output,

‘A’ stands for the knowledge component of capital at the industry
level, ‘L’ stands for labor, ‘α’ stands for productivity of capital, 1 – α,
stands for productivity of labor, , stands for economy wide capital
stock and ‘β’ stands for the productivity (spillover effect) of
industry wide capital.

Assuming symmetry across industries so that each industry

will use the same level of capital and labor, the economy wide
aggregate production function can be stated as in equation (2).
 52

`In equation (2), ‘A’ is assumed to be constant because

technology is assumed to be constant or that there is no
technological progress. From equation (2), the growth rate of per
capita income in the economy can be stated as in equation (3).

Where ‘g’ is the output growth rate and ‘n’ is the population
growth rate. Without technological progress, the per capita growth
would be zero and hence β = 0.

Romer assumed that taking labor, capital, and economy-

wide capital together, β> 0, thus g – n > 0, and Y/L is growing (Y/L is
the labor-output ratio). If we allow for technological progress in the
model, growth will increase proportionately. Thus the Romer model,
with a technology spillover, avoids diminishing returns to capital.

Criticisms of the Endogenous Growth Theory

The new growth theory remains dependent on a number of
traditional neoclassical assumptions that are not applicable to less
developed economies. The theory is criticized on the following
grounds.

1. The assumption of symmetry or that the productivity of

capital is constant across the industries. This assumption
does not permit the growth generating reallocation of labor and
capital among the sectors that are transformed during the
process of structural change.

Economic growth in LDCs is affected by inefficiencies

arising from poor infrastructure, inadequate institutional
structures and imperfect capital and goods markets. Since
the theory overlooks these important factors, its applicability for
the study of economic development is limited. For instance, the
theory fails to explain low rates of factory capacity utilization in
LDCs where capital is scarce. May be, poor incentive structures
are responsible for poor GNP growth as much as low saving
and human capital formation. Allocative inefficiencies are
common in transition economies. However, their impact on
short and medium term growth has been neglected due to the
new theory’s overemphasis on the determinants of long term
growth rates.

3. Finally, there is little empirical evidence on the predictive

value of endogenous growth theories.
 53

4.4 HUMAN CAPITAL

The concept of human capital has relatively more

importance in the labour-surplus countries. These countries are
naturally endowed with more of the labour due to the high birth rate
under the given climatic conditions. Surplus labour in these
countries is the human resource available in more abundance than
the tangible capital resource. This human resource can be
transformed into the human capital with effective inputs of
education, health and moral values. Transformation of raw human
resource into highly productive human resource with these inputs is
the process of human capital formation. Problem of scarcity of
tangible capital in the labour surplus countries can be resolved by
accelerating the rate of human capital formation with both private
and public investment in education and health sectors of their
national economies. Tangible financial capital is an effective
instrument of promoting economic growth of the nation. Tangible
human capital, on the other hand, it is an instrument of promoting
comprehensive development of the nation because human capital
is directly related to human development, and when there is human
development, the qualitative and quantitative progress of the nation
is inevitable. This importance of the human capital is explicit in the
changed approach of United Nations (UN) towards comparative
evaluation of the economic development of different nations in the
world economy. United Nations publishes the Human Development
Report (HDR) on the human development in different nations with
the objective of evaluating rate of human capital formation in these
nations.

The human capital is the backbone of human

development and economic development in every nation. Mahroum
suggested, at the macro-level, the human capital management is
about three key capacities: the capacity to develop talent, the
capacity to deploy talent, and the capacity to draw talent from
elsewhere. Collectively, these three capacities form backbone of
any country's human capital competitiveness. The recent U.S.
research shows that geographic regions that invest in human
capital and economic advancement of immigrants who are already
living in their jurisdictions help boost their short- and long-term
economic growth. There is also the strong evidence that
organizations that possess and cultivate their human capital
outperform other organizations lacking human capital.


4.5 SUMMARY

Human capital is one of the essential pillar in

anthropological economics. The anthropological economics is a
criterion for analyzing economic systems, whether public or private.
 54

It analyzes and modifies the economic processes using the

language of economics in favor of the anthropological perspective.
In this perspective the human capital is scope of and for the entire
economic process.

4.6 QUESTIONS

Q1. Explain the concept of human capital.

Q2. Explain the approaches to technical growth.
Q3. Explain the endogenous growth theory.
Q4. Explain the concept of convergence. 



 55

Module III

5
MICROECONOMICS OF
DEVELOPMENT - I
Unit Structure:
5.0 Objectives
5.1 Segmentation of Rural Land Market
5.2 Segmentation of Rural Labour Market
5.3 Segmentation of Rural Capital Market
5.4 Segmentation of Rural Credit Market
5.5 Microfinance
5.6 Market Inter-linkages
5.7 Summary
5.8 Questions

5.0 OBJECTIVES

 To understand the segmentation of rural land market.

 To understand the segmentation of rural labour market.
 To understand the segmentation of rural capital market.
 To understand the segmentation of rural credit market.
 To understand the microfinance and market inter-linkages.

5.1 SEGMENTATION OF RURAL LAND MARKET

Land is a key factor for any economic activity. Land market

transactions play an important role in the process of economic
transformation and development. Conventionally land is considered as
a factor of production. However, it is increasingly becoming a
speculative asset. Land has a number of characteristics, which
make it different from other assets that may be traded on the
market. Besides economic aspects, such as immovability, limited
supply, planning regulations and permitted land use etc.,
geographical location as the unique characteristic of each land
parcel.

The trends in land market indicators like size of area,

number of sales and price of land are analysed in detail. Within the
domestic sectors, economic recession has been visible in the land
 56

market earlier than in other sectors. This may be because of the

fact that land market transactions involve huge amounts of
investment and a higher level of risk. A close watch on the
movements in key factors such as number of sales, area
transacted, and land prices would therefore help along way in
shaping the right policies to ward off economic fluctuations.

Rural land in the region closer to areas that facilitate

accessibility to capital has in average a higher market price, also in
case when changes of land use are not anticipated in the very near
future. This fact can be linked with the attractiveness of rural
landscape for living place and development of economic activities
in the regions with favourable economic and demographic
indicators, and is associated with the urbanisation process.

 There are a number of common obstacles faced by the land

markets in most developing nations Compensation and/or
privatization processes are not finished (unsolved Compensation
claims, differences between legal and physical Compensation,
registration problems, etc.),
 Political restrictions imposed by the governments to avoid
drastic changes in agricultural sector (prohibitions on certain
land transactions, incentives to avoid massive
decollectivizations, etc.),
 Lack of incentives to undertake private, either individual or
collective, farming business (credit, technical assistance,
marketing, etc.),
 significant power of state agencies in the land market (as
owners or lenders) and as providers of the regulatory framework
(in case of land reforms undertaken by the state agencies)
 social and economic differentiation between managers of
reformed collective units and private farmers,
 relevant governmental organizations still in a transition and/or
redefinition stage involved in the process, and
 Cultural, ethnic and social values strongly attached to land
ownership.

The use (and transfer systems) of the state lands, the

regulations, and the land reform strategy followed by each country
defines the way in which land should become a private and
tradable good, and who (and how) can access it. As in the case of
any other good in a market oriented economy, the mechanism to
access land (to buy or rent) is through the market land prices.
 57

5.2 SEGMENTATION OF RURAL LABOUR MARKET

Segmented labour markets theory was sufficiently popular in

the late 1960sand the early 1970s. It was, hence, taken seriously
by prominent mainstream labour economics. Segmented labour
markets are dual labour markets, which consist of various sub-
groups with little or no crossover capability. Labour is not a
completely homogeneous commodity. Workers differ in their tastes
and preferences for leisure and work for monetary rather than non-
monetary rewards. They also differ in human capital,their
investment in education and training, their work skills and
experience. Human Capital Theory seeks to explain wage
differentials as a consequence of differing human capital stocks
that determine an individual’s marginal productivity. Human capital
stock is defined as “the stock of knowledge, skills, aptitudes,
education, and training that an individual or a group of individuals
possess.”

Why does segmentation occur? One approach to this

question focuses upon the evolution of the product markets, from
the competitive and the localized to the producer dominated, and
from the national to an international market. Technological
change makes capital-intensive methods of production
possible. Employers, however, are unwilling to undertake large-
scale investment unless the product demand is stable and
predictable; when demand is variable, labour-intensive
techniques are preferred. A growing division is found between firms
which cater for stable markets and those in unstable markets. Firms
with stable product demand create primary conditions of
employment, including, notably, job security. Firms which face
unstable demand operate in the secondary segment of the labour
market.

Segmentation into Primary and Secondary Markets: The

primary and secondary segments, to use the terminology of dual
labour market theory, are differentiated mainly by stability
characteristics. Primary jobs require and develop stable working
habits; skills are often acquired on the job; wages are relatively
high; and job ladders exist. Secondary jobs do not require and often
discourage stable working habits; wages are low; turnover is high; and
job ladders are few. Secondary jobs are mainly (though not
exclusively) filled by women, and youth.

Segmentation into Formal and Informal Markets: Informal

activities prove to be quite diverse. Some are activities with easy
entry and no fixed hours of operation. By contrast, other informal
activities exhibit limited entry due to higher set-up costs, irregular
hours of operation, and employment of family labour and unskilled
 58

labour with semi-specified work relations. These contrast with

formal sector enterprises, which are characterised by restricted
entry, regular place and hours of operation, and employment of
non-family labour with specific work-relations. These belong in the
category of formal sector, even if they are very small in scale. On
example would be professional services companies which although
small in scale, cannot be viewed in any meaningful way as part of
the informal sector.

Another factor observed in many people working in the

informal sector was that their employment was voluntary in nature,
That is, given the constrained choices open to them, a great many
workers are in the sector voluntarily. These people know that job
opportunities are available in the urban formal sectors for people
like themselves and they could get such jobs. Yet they choose not
to seek such jobs, the foremost reason is that they prefer the
combination of monetary rewards and psychological aspects of
their employment in the informal sector.

A third important conclusion is that the upper-tier informal

sector and the easy-entry informal sector are linked to the formal
sector in different ways. Whereas most workers in the informal
sector who were dissatisfied with their positions sought better jobs
in the formal sector, some who had left the formal sector behind
and could reach the upper-tier in the informal sector were glad to
be in the informal sector.
The formal sector provides training for workers to move into
the upper tier small scale employment. Example is the food industry
workers who leave jobs to set up their own food processing
activities.
The criteria for being informal were: self-employed workers
with less than 13 years of education, temporary workers,
employers, and family workers in firms with less than 5 employees,
and domestic service. In the formal sector all other classifications
were included, covering all the blue and white collar workers
Segmentation by race: While minority workers are present in
secondary, subordinate primary, and independent primary
segments they often face distinct segments within those
submarkets. Certain jobs are "race-typed,” segregated by prejudice
and by labour market institutions. Geographic separation also plays
an important role in maintaining divisions between race segments.
Segmentation by Sex: Certain jobs have generally been restricted
to men; others to women. Wages in the female segment are usually
lower than in comparable male jobs; female jobs often require and
encourage a "serving mentality”-an orientation toward providing
services to other people and particularly to men. These
characteristics are encouraged by family and schooling institutions.
 59

5.3 SEGMENTATION OF RURAL CAPITAL MARKET

Definitions of Market Segmentation:

According to American Marketing Association, “Market
segmentation refers to dividing the heterogeneous markets into
smaller customer groups having certain homogeneous
characteristics that can be satisfied by the firm.”

According to Philip Kotler, “Market segmentation is the sub

dividing of a market into homogeneous subsets of consumers,
where any subset may conceivably be selected as a market target
to be reached with a distinct marketing mix.”

According to William J. Stanton, “Market segmentation

consists of taking the total heterogeneous market for a product and
dividing it into several sub markets or segments each of which
tends to be homogeneous in all significant aspects.”

According to Schiffman and Kanuk, “Market segmentation

can be defined as the process of dividing a market into distinct
subsets of consumers with common needs or characteristics and
selecting one or more segments to target with a distinct marketing
mix.”

Capital market segmentation:

The capital market segmentation is financial market
imperfection caused mainly by government constraints, institutional
practices, and investor perceptions.

The most important imperfections are

 Asymmetric information between domestic and foreign-based
investors
 Lack of transparency
 High securities transaction costs
 Foreign exchange risks
 Political risks
 Corporate governance differences

5.4 SEGMENTATION OF RURAL CREDIT MARKET

Credit :
In India a multi-agency approach comprising co-operative
banks, scheduled commercial banks and RRBs has been followed
for purveying credit to agricultural sector. The policy of agricultural
 60

credit is guided mainly by the considerations of ensuring adequate

and timely availability of credit at reasonable rates through the
expansion of institutional framework, its outreach and scale as also
by way of directed lending. Over time, spectacular progress has
been achieved in terms of the scale and outreach of institutional
framework for agricultural credit. Some of the major discernible
trends are as follows :

Over time the public sector banks have made commendable

progress in terms of putting in place a wide banking network,
particularly in the aftermath of nationalisation of banks. The
number of offices of public sector banks increased rapidly from
8,262 in June 1969 to 68,355 by March 2005.

One of the major achievements in the post-independent

India has been widening the spread of institutional machinery
for credit and decline in the role of non-institutional sources,
notwithstanding some reversal in the trend observed particularly in
the 1990s

The share of institutional credit, which was little over 7 per cent
in 1951, increased manifold to over 66 per cent in 1991,
reflecting concomitantly a remarkable decline in the share of non-
institutional credit from around 93 per cent to about 31 per cent
during the same period. However, the latest NSSO Survey reveals
that the share of non-institutional credit has taken a reverse swing
which is a cause of concern (Table 1).

Notwithstanding their wide network, co-operative banks,

particularly since the 1990s have lost their dominant position to
commercial banks. The share of co-operative banks (22 per cent)
during 2005-06 was less than half of what it was in 1992-93 (62 per
cent), while the share of commercial banks (33 to 68 per cent)
including RRBs (5 to 10 per cent) almost doubled during the above
period.
 61

Table No. 5.1

Relative Share of Borrowing of Cultivator
Households from Different Sources
(Per cent)

Source Credit 1951 1961 1971 1981 1991 2002

1 2 3 4 5 6 7
Non-Institutional 92.7 81.3 68.3 36.8 30.6 38.9
Of which
Money Lenders 69.7 49.2 36.1 16.1 17.5 26.8
Institutional 7.3 18.7 31.7 63.2 66.3 61.1
Of which
Cooperatives
Societies / Banks 3.3 2.6 22.0 29.8 23.6 30.2
Commercial Banks 0.9 0.6 2.4 28.8 35.2 26.3
Unspecified - - - - 3.1 -
Total 100.0 100.0 100.0 100.0 100.0 100.0

Source : All India Debt and Investment Survey and NSSO

The efforts to increase the flow of credit to agriculture seems
to have yielded better results in the recent period as the total
institutional credit to agriculture recorded a growth of around 21 per
cent during 1995-96 to 2004-05 from little over 12 percent during
1986-87 to 1994-95. In terms of total credit toagriculture, the
commercial banks recorded a considerable cent) including RRBs (5
to 10 per cent) almost doubled during the above period (Chart 1).
growth (from around 13 per cent to about 21 per cent), while
cooperative banks registered a fall (over 14 per cent to over 10 per
cent) during the above period.

Figure 5.1
 62

However, the growth of direct finance to agriculture

and allied activities witnessed a decline in the 1990s1 (12 per cent)
as compared to the 1980s (14 per cent) and 1970s (around 16
per cent). Furthermore, a comparative analysis of direct credit to
agriculture and allied activities during 1980s and since 1990s
reveals the fact that the average share of long-term credit in the
total direct finance has not only been much lower but has also
decelerated (from over 38 per cent to around 36 per cent), which
could have dampening effect on the agricultural investment for
future growth process.

Availability of adequate credit is vital for every sector and

agriculture is not an exception. In India, Commercial Banks,
Cooperative Banks, and Regional Rural Banks (RRBs) are
responsible for smooth flow of credit to agricultural sector. But
a huge unorganized market exists for credit to agricultural
sector in India, which provide timely fund to this sector but at the
exorbitant rate of interest. Among organized credit disbursement to
agriculture commercial banks play a vital role with a share of
about 70% where as cooperative sector and RRBs contribute
20% and 10 % respectively. Kisan Credit Card (KCC) scheme
was introduced to provide adequate and timely support from the
banking system to the farmers for their cultivation needs. This
scheme has made rapid progress and more than645 lakh cards
issued up to October 2006.

The 'Farm Credit Package' announced by the Government of

India in June 2004 stipulated doubling the flow of institutional credit
for agriculture in ensuing three years. Annual targets for this
package are being surpassed in the two consecutive years from its
introduction and it is likely to surpass in the third year also.

Insurance :

Insurance is a prime necessity to mitigate uncertainty that

persists in agriculture. In India, agriculture is still affected by such
factors, which are beyond control of human being. So, there is a
great need for agricultural insurance in India. Keeping this in mind,
Government of India in coordination with the General Insurance
Corporation of India (GIC), had introduced National Agricultural
Insurance Scheme (NAIS) from rabi 1999-2000 season. The main
objective of this scheme is to protect the farmers against losses
suffered by them due to crop failure on account of natural
calamities. Agricultural Insurance Company of India (AICIL) which
was incorporated in December 2002 took over the implementation
of NAIS.

AICIL introduced Rainfall Insurance Scheme called

'Varsha Bima' during 2004 southwest monsoon period. Varsha
 63

Bima provided for five different options suiting varied

requirements of farming community :

1. Seasonal rainfall insurance based on aggregate rainfall from

June to September.
2. Sowing failure insurance based on rainfall between June 15 and
August 15.
3. Rainfall distribution insurance with the weight assigned to
different weeks June and September.
4. Agronomic index constructed on the basis of water
requirements of crops.
5. A catastrophe option covering extremely adverse deviation of
50% and above in rainfall during the season.

During kharif 2006, this Varsha Bima scheme is being

implemented in around 150 districts covering 16 states across the
country. AICIL is also piloting another weather related insurance
product for mango and coffee.

Rural Infrastructure Development Fund (RIDF): RIDF was

announced by the Government of India in 1995-96 to boost public
sector investment in agriculture and rural infrastructure. The Fund
is raised from the commercial banks to the extent of their short fall
in agricultural lending as priority sector. The activities, which have
been made eligible for loans from RIDF, include rural roads and
bridges, irrigation, mini and small hydel projects, community
irrigation wells, soil conservation, watershed development and
reclamation of waterlogged areas, flood protection, drainage, forest
development, market yard, go-downs, apna mandi, rural haats and
other marketing infrastructure, cold storages, seed / agriculture /
horticulture farms, plantation and horticulture, grading and certifying.
mechanisms such as testing and certifying laboratories, fishing
harbors/jetties, reverine fisheries, animal husbandry, modern
abattoir, drinking water supply, infrastructure for rural educational
institutions, public health institutions, construction of toilet blocks in
existing schools and 'pay and use' toilets in rural areas, village
knowledge centers, desalination plants in coastal areas,
infrastructure for information technology in rural areas, and
construction of anganwari centers.

Micro Finance :
Micro finance scheme has been introduced by National Bank
for Agriculture and Rural Development (NABARD), the apex bank
for agriculture and rural development in India, to improve the
access of the rural poor to formal institutional credit and other
financial products. In all 547 banks, which include 47 commercial
banks, 158 RRBs, 342 cooperative banks are now actively involved
 64

in the operation of Self Help Group (SHG)- Bank Linkage

Programme to spread the facility of micro finance to the needy
small and marginal farmers and tiny entrepreneurs. The
programme has enabled nearly 329 lakh poor families in the
country to gain access to micro finance facilities from the formal
banking system.

Capital Formation in Agriculture :

The share of the agriculture sector's capital formation in
G.D.P. declined from 2.2% in the late 1990s to 1.9% in 2005-06.
Stagnation or fall in the public investment in irrigation is partly
responsible for this fall. However there is indication of a reversal of
this trend with public sector investment in agriculture accelerating
since 2002-03.The share of public investment in gross investment
in agriculture increased by 6.5 percentage points from 1999-2000
to reach 24.2% in 2005-06.
Check Your Progress:

1. What is the concept of segmentation of rural land market?

2. What is the concept of segmentation of rural labour market?
3. What is the concept of segmentation of rural credit market?
4. What is the concept of segmentation of rural capital market?

5.5 MICROFINANCE

Microfinance refers to the provision of small scale financial

services to economically active people. The provision of financial
services like credit facilities to operate small enterprises or micro
enterprises. These units may be engaged in a variety of activities.
They may be people who work for wages or commissions. They
may be people who make an income from renting out their land,
vehicles, draft animals or machinery and tools. These households
have multiple sources of income.
 65
More than 500 million of the world‘s poor population are
economically active. These poor population earn their livelihood by
being self employed or they work in micro enterprises. They
produce a variety of goods in small workshops, trading and retail
activities, making pots, furniture or sell fruits and vegetables. It is
difficult for these people to secure capital and they have hardly any
access to financial services. Since the institutional soruces are not
ready to finance these poor people, they depend on family, friends
etc. Microfinance is the solution to the needs of the people for
finance. Though the movement was originally started for providing
micro credit, it started covering a variety of financial services. In
India NABARD (National Bank for Agricultural and Rural
Development) finances more than 500 banks. These banks lend
money to Self Help Groups. The bank ability of the rural poor was
discovered. With new lending methods, the rural poor repaid loans
on time. There has been a tremendous growth in the number of
successful micro finance institutions which are reaching out to a
number of poor people and that are becoming commercially viable.

Features of Microfinance Services:

1. Micro finance loans can be used for a number of purposes

: It enables the poor to accumulate assets and enable the poor
to be economically independent. It helps the poor to invest in
income generation activities. They can improve their standard
of living through better education health and housing. The
people have flexibility in loan use. It is understood that the
clients themselves know about how best to manage their funds.

2. Microfinance gives importance to financial services and not

subsidies : The low income entrepreneurs are more
interested in getting working capital and run their business. They
require capital and continued access to financial services rather
than subsidies. The small entrepreneurs borrow small amounts
and are able to comfortably pay off the loans while making a
profit for themselves. The people find it better to borrow from
micro finance institutions rather than from money lenders or the
government.
3. The micro finance revolution has helped in w omen
empowerment : Since women constitute the most vulnerable
section of the society, MFIs have a special role to play in the
upliftment and empowerment of women. Women face a
number of disadvantages and problem since they have fewer
economic opportunities and they hear the burden of domestic
work, child bearing, education, health and nutrition of children.
MFIs have found to the very helpful especially for women.
Experience has proved that women are sincere and regular in
repayment.
 66
Microfinance supports institutions and not projects : There is
a stress on the creation of institutions rather than projects for
meeting the financial needs of the poor on a sustained basis. It has
been proved that successful microfinance institutions reach large
numbers of clients and become financially self – sufficient. The
objective of setting up micro finance institutions is to reach out to
the very poor people and provide them with quality financial
services. The success of microfinance is due to the following
features.
(i) It is possible to know the needs of the clients and design
appropriate products. For example, the institutions are
able to meet specific requirements of the people like short
term loans, high liquidity, saving services etc.
(ii) Reducing risk and increasing value to the clients : There is
no pressure to produce collateral security. The borrowers
are motivated to repay. For example the idea of poor group
lending is adopted. In this several people guarantee one
another‘s loan and incentives are given to people who
repay on time.
(iii) Low administration cost : Since the operations are efficient
and simple, the administrative expenses are low.

5. The microfinance movement has brought out the fact that

institutions can serve the poor and still be sustainable.

6. There are a variety of financial services tailored to meet the

specific requirements of poor population. For example, micro
credit is a part of microfinance. Experiments with micro credit in
Bangladesh have shown that it is possible to help extremely
impoverished people to engage in self employment projects that
allow them to generate an income and enable them to create
wealth thus getting rid of poverty. The success of the micro
credit policy is urging the mainstream finance industry to
consider micro credit as a source of future growth. This brings
out the various possibilities for the growth of micro finance
which can revolutionize the society by empowering the poorer
sections of the society.

5.6 MARKET INTER-LINKAGES

Inter-linked markets:
Two markets that are often linked are the rural land
markets and the rural credit markets. The landowner decides the
amount of loan to be given to the tenant and the tenant either accepts
the contract or does not. Further, loans can be taken for Production
purpose by the tenant to buy inputs for Production and for
Consumption Purpose. If the landlord gives a production loan he
 67
can get two sources of income. One, by keeping a share of the
produce as a landlord and the other as a direct income from interest
payments.

Rural Land markets are also interlinked to Rural Labour

markets. As there is very little mobility of labour from agriculture
into other sectors, the rural landless labour is often exploited by the
land-owners. But this exploitation gets lesser when there is
modernisation and development which brings about a degree of
education amongst the landless labour, therefore reducing the
exploitation. But this issue is relevant for less developed nations
where there is very little linkage with other sectors thereby reducing
the mobility of labour.

Rural land markets further get linked to the Households,

when the rural land is used to produce Cash crops instead of Food
crops for which they were used earlier, thereby leading to an
increase in the food prices and affecting the household incomes.

Rural land markets are also linked to the export market when
modern agricultural entrepreneurs’ demand for rural land increases
for export crops such as fruits etc. This linkage is found to be more
prominent ever since globalisation took place.

5.7 SUMMARY

 Segmented labour markets theory was sufficiently popular in the

late 1960sand the early 1970s.
 Rural Land markets are also interlinked to Rural Labour
markets.
 Rural land markets are also linked to the export market when
modern agricultural entrepreneurs’ demand for rural land
increases for export crops such as fruits etc.
 Micro finance scheme has been introduced by National Bank
for Agriculture and Rural Development (NABARD), the apex
bank for agriculture and rural development in India, to
improve the access of the rural poor to formal institutional
credit and other financial products.

5.8 QUESTION

Q1. Explain the concept of microfinance.

Q2. Explain the concept of market inter leakages.
Q3. Explain the features of microfinance services.


 68

6
MICROECONOMICS OF
DEVELOPMENT - II

Unit Structure:
6.0 Objectives
6.1 Land Markets
6.2 Labour Markets
6.3 Households
6.4 Credit Market
6.5 The Household Model of Fertility
6.6 Institutions and Development
6.7 Summary
5.8 Questions

6.0 OBJECTIVES

 To understand the concepts of land market, labour market,

households and credit martet.
 To understand the household model of fertility
 To understand the relation between institutions and
development.

6.1 LAND MARKETS

Land is a key factor for any economic activity. Land market

transactions play an important role in the process of economic
transformation and development. Conventionally land is considered as
a factor of production. However, it is increasingly becoming a
speculative asset. Land has a number of characteristics, which
make it different from other assets that may be traded on the
market. Besides economic aspects, such as immovability, limited
supply, planning regulations and permitted land use etc.,
geographical location as the unique characteristic of each land
parcel.

Land markets are mechanisms that, provided there are

appropriate institutional checks and balances, allocate ownership
 69
and use rights in a manner that allows land and its associated
assets to be used in the most economic way.

6.2 LABOUR MARKETS

Labour market is the place where workers and

employees interact with each other. In the labour market employers
compete to hire the best and the workers compete for the best
satisfying job. Labour market represents the interaction of demands
and suppliers of various categories of labour through which prices
of these categories of labour, i.e., wage rates are determined.

The concept of labour market incorporates considerations of

the complex of economic and social forces influencing the process
through which employers recruit workers and workers seek
employment.

The labor market is also known as the job market which

refers to the supply of and demand for labor and in which
employees provide the supply and employers provide the demand.

6.3 HOUSEHOLDS
Households are the final consumers of goods and
services produced by the firms. They create the demand in the
market according to their tastes and preferences. Firms produced
and supplied goods in the market, as per their demand. So,
households determine the production line of a country.

The households are the main sources of the government

tax-revenue. They are main tax-payer. A household pays the
income tax, wealth tax, estate duty, gift tax etc. as direct taxes to
the state. Similarly, household pays several indirect taxes to the
government like sales tax, customs duty, VAT etc. also. All these
tax revenues are collected for welfare and development of the
economy.

6.4 CREDIT MARKET

The credit market refers to the market through which

companies and governments issue debt to investors, such as
investment-grade bonds, junk bonds, and short-term commercial
paper. Sometimes credit market is called as the debt market, the
credit market also includes debt offerings, such as notes and
securitized obligations, including collateralized debt obligations
(CDOs), mortgage-backed securities, and credit default swaps
(CDS).
 70
Check Your Progress:

1. What is the concept of households?

2. What is the meaning of land market and labour market?
3. explain the meaning of credit market?

6.5THE HOUSEHOLD MODELOF FERTILITY

The economists are now interested in studying the

microeconomic determinants of family fertility. They want to
provide a better theoretical and empirical explanation for the falling
birth rates during the stage III of demographic transition. To study
the behaviour of households, the economists have made use of the
traditional neo-classical theory of household and consumer
behaviour. They made use of the principles of economy and
optimization to explain the family size decisions.

The size of population and its implications on development is

a macroeconomic problem. It has its impact on the socio-economic
as well as political issues. But if we analyze this macro problem,
we can trace its root cause to the micro level which is the
household or the family.

In fertility analysis, children are considered as a special kind

of consumption good so that fertility becomes a rational economic
response to the consumer‘s demand for children relative to other
goods. Other factors remaining constant the desired number of
children can be expected to vary directly with household income.
The desired number of children also depends on the strength of
demand for children relative to other consumer goods and to the
sources of increased income, female employment. The desired
number of children vary inversely with the strength of taste and
other goods. Mathematically, these relationships can be expressed
as

Y = income
Pc = the =net price‘ of children which is the difference
between anticipated costs and benefits
Px = The prices of all other goods
tx = The taste for goods relative to children
 71
The implications are
1) The higher the household income, the greater the demand for
children.
2) The higher the net price of children, the lower the quantity
demanded.
3) The higher the prices of all other goods relation to children, the
greater the quantity of children demanded.
4) The greater the strength of tastes for goods relation to children,
the fewer the children demanded.

The neo-classical theory of consumer behaviour is applied to

explain the falling fertility rate. Based on the principle of diminishing
marginal utility and equimarginal utility, a rational consumer invests
capital in such a way that the marginal productivity of a unit of
money or resource from different investment is equalized. There is
an inverse relationship between the price of a good or service and
the demand for them. This theory is applied a household or family
to enable them to take a decision to have a child. According to the
theory children are considered as ―consumption good‖ and also
an investment. They are consumption good since the parents,
enjoy the pleasure or satisfaction from children. Children are also
investment as the parents expect the children to be a source of
security in their old age. Therefore, the number of children desired
by the family depends on their consumption and security needs.
For the purpose of deciding, the parents have to weigh the cost and
benefit of having an additional child.

a) The cost factors in bringing up children : Bringing up

children will mean additional costs to the parents. The parents
have to incur expenditure on education and training for
making the children socially and economically productive. It
also involves an opportunity cost for the mother in the form of
time spent specially by the mother in looking after the child
could have been spent in earning an income or in some social,
religious or political activities. Better off parents with higher
expectations are ready to spend more money on there children.
Hence cost increase. The cost for poor parents is negligible
and the opportunity cost of bringing up children is almost nil for
the poor. Due to the fact that the poor are illiterate and of a low
economic and social status they do not have any alternative or
their opportunity cost is nil.

b) Benefits of having children : Poor people consider children as

assets since there is hardly any investment. The poor parents
provide minimum subsistence needs of children. On the other
hand, more children means more work and hence more income
for the family. Children work as child labourer and hence they
 72
are considered productive even at a young age. They are also
considered as support for old age. The prevailing social
customs, religious beliefs and the value system expect the
children to take care of the parents. Thus children are
considered assets by the poor.

For the rich people, children are a responsibility and a

liability. The rich parents will want their children to be better than
them. Hence they try to provide the best education and training.
The opportunity cost for a mother is high in terms of income and
time. The mother may have to sacrifice income and time to bring
up the children. Generally, the rich parents do not depend on their
children in old age for financial support and security. Thus the rich
people opt for less children. Thus, the decision regarding the
number of children depends on cost benefit considerations. The
developing countries are still facing the problem of illiteracy and
poverty. Children are considered as assets due to these factors.
Only with the spread of education, the people will change their
attitudes.

6.6 INSTITUTIONS AND DEVELOPMENT

Institution is the way of thought or action of some prevalence

and permanence, which is embedded in the habits of a group or the
customs of people.

It can be claimed that institution is that which people adapt to

means for fulfillment of needs and objectives with the procedures
and behaviour.

In the simple words, institution is another word for

procedure, convention and arrangements.

According to C.H. Cooley, “An institution is a complex

integrated organisation of collective behaviour established in the
social heritage and meeting some persistent need or want.”

Role of Institutions in the Economic Development:

A country’s social and economic institutions dominate
the process of economic development. They determine the
attitudes, motivations and conditions for development. If the
institutions are elastic and encourage people to avail economic
opportunities and further to lead higher standard of living and
inspire them to work hard, then economic development will occur.

On the other hand, if they discourage all this, economic

development will be hampered and adversely affected. This has
been rightly observed by the UNO that the economic development
 73
is impossible in the absence of appropriate atmosphere. So,
economic progress will not take place unless atmosphere is a
favourable to it.

People of the country must desire progress and their social,

economic, legal and political institutions must be favourable to it.

Emphasizing the significance of these institutions in the

economic development, Prof. A.K. Cairn-cross says, “Development
is not governed in any country by economic forces alone and the
more backward the country, the more this is true. The key to
development lies in men’s mind, in the institutions in which their
thinking finds expression and the play of opportunity on ideas and
institutions.”

Therefore, the right kings of institutions or growth promoting

institutions are a pre-requisite for the rapid economic development
of a country. These institutions may be called the growth promoting
which permit or stimulate, rather than impede, the adoption of new
techniques and the formation of productive capital.

In the broad sense, institutions promote economic growth to

the level that they associate efforts with regard to permit increased
division of labour, expansion of trade and freedom to seize
economic opportunities.

In this regard, Prof. W.A. Lewis observed, “Institutions

promote or restrict growth according to the protection, they accord
to effort, according to the opportunities they provide for
specialization and according to the freedom of action they permit.”

According to Prof. W.W. Rostow, “For economic progress, a

country must have timely changes in people’s tendencies and
needful improvement in social institutions and appropriate changes
in political and social conditions.” Thus, it becomes important to
recognise that the socio-political environment may or may not be
conducive to economic progress.

Certain religious and social attitudes are the more favourable

to development than others.

Thus, institutions greatly influence economic growth through

the influence on the rate of capital formation, growth of
entrepreneurship, technological change and the desire of the
people to work.
 74
Impact of Institutions on the Growth of Economic
Development:

1. General Attitude to Economic Effort:

Institutions have greatly influenced people’s attitude towards
the work, will and efficiency for the economic development.

In this connection, Prof. W.A. Lewis writes, “Men will not

make effort unless the fruit of that effort is assured to themselves or
to those whose claims they recognised.”

Therefore, institutions must establish some sort of the

relationship between effort and reward in order to get economic
growth.

2. Technological Knowledge:
As there is lack of technical knowledge in under-
developed countries, resources are lying unutilized and strict
institutional structure is not in a position to accept technological
change.

3. Entrepreneurship:
The growth of entrepreneurship of the country depends on
its institutional structure and value system. They are necessary for
the automatic increase in supply of entrepreneurs. Therefore, high
suitable prestige and suitable reward is the foremost condition for
success of entrepreneurship. Less restriction be imposed and the
excessive taxation may be avoided.

4. Labour Productivity:
The social set up of the country affects the productivity of the
labour to a considerable extent. Meritorious development of the
labourers is not possible due to unfavourable change in social
institutions. This means that the size and quality of thelabour force
are greatly influenced by social institutions and value system in a
society.

Therefore, to raise the productivity of labourers, it is the

desirable traditional customs and social institutions. They not only
determine size of the labourers but also influences its productivity.
Mostly in under-developed countries, many institutions are
prevalent which are harmful for the labour productivity.

Some of such institutions are the joint family system, family

attachment, traditional values, contentment, minimum wants, caste
system, religious feelings and principle of equality in distribution of
property etc.
 75
5. Saving and Capital:
Institutional structure of a country exercises a great influence
on the will and power to save and capital formation. To promote
capital formation, proper legislation protecting the right to property
should be made.

Some Institutions and Economic Growth:

1. Private Property:
The institution of the private property possesses a significant
influence on people’s desire to work hard, to save and invest. It is a
legal right to haveprivate property by which the people have full
independence to use and acquire the property and are restricted to
use of other’s property. The right of property may rest in a private
person or in a group or in public authority.

2. Caste System:
The caste system which prevails most of the under-
developed countries, also creates hindrance in the path of their
economic growth. Caste system is a strict social classification that
limits the person’s senses and brings obstacles in the right
atmosphere for development.

3. Joint Family System:

Other major institution which has the capability to affect
economic development is the joint family system. In the society, it is
very much effective that influences incentive for the labour mobility,
people’s attitude towards work, development of diligence, rate of
saving and investment.

4. Law of Inheritance:
The law of inheritance is the capable to influence the
economic development of a country because people have full faith
in the principle of inheritance. According to this law, after the death
of the present property owner, it will be distributed among the
different inheritors including sons and daughters.

5. Religion:
In the opinion of Prof. K. William Kepp, “In under-developed
countries religious institutes are responsible for slow speed of
economic progress.” So, the religion in a society affects the
tendencies and the views of the people which influence more the
atmosphere of economic development and extension of economic
activities. It can be indirectly a hindrance to promote the economic
development.

6. Attitude towards Work:

The attitude towards the work and aspiration of the people
are other crucial factors which determine economic development in
 76
the society. In the sense, the people’s attitude and motivation to
work are determined by material gains that are likely to get for their
hard labour. In this regard, Prof. Lewis has pointed out that men will
not do their best work, unless the fruits of their labour are assured
to them or to their heirs.

6.7 SUMMARY

Suitable institutions must provide the legal security to protect

private property against misuse by the government and of
government property by individual.If institutions pay due honour to
material capital, then investors are encouraged to invest their
money.

Consequently, society will also save and rate of capital

formation will be stimulated accordingly. Hence, people’s sense of
conducts, behaviour, customs gets appropriate changes in
accordance with institutional structure of the society, thereby social
institutions have imperative influence on the saving and capital
formation.

The study of UNO reveals that for attaining economic

development, social value and institutional structure need timely
change.However, its report conveys, “Rapid economic development
is impossible without the painful changes, traditional philosophical
thoughts should be discarded, old institutions need to be
disorganised, caste and class bondages should be abolished and
large number of people, who are not up keeping with progress will
have to abandon hopes of own luxurious life”.

6.8 QUESTIONS

Q1. Give note on land markets

Q2. Explain the concept of credit market
Q3. Give note on labour market.
Q4. What are the Impact of Institutions on the Growth of Economic
Development?


 77

Module IV

7
MACROECONOMICS OF
DEVELOPMENT - I

Unit Structure:
7.0 Objectives
7.1 Environment and development
7.2 Development and Constraint of Natural Resources
7.3 Environmental Problems in Economic Development
7.4 Environment and Sustainable Development
7.5 Summary
7.6 Questions

7.0 OBJECTIVES

 To understand the development and constraints of natural

resources.
 To understand the environmental problems in economic
development.
 To understand the relation between environment and
sustainable development.

7.1ENVIRONMENT AND DEVELOPMENT

Environmental degradation can detract from the pace of

economic development by imposing high costs on developing
countries through health-related expenses and the reduced
productivity of resources. The poorest 20% of the world’s
population will experience the consequences of environmental ills
most acutely. Severe environmental degradation, due to population
pressures on marginal land, has led to falling farm productivity and
per capita food production.

Traditional Economic Model of the Environment Privately

Owned Resources
If resources are scarce and rationed over time, scarcity rent
may arise even when the marginal cost of production is constant as
in Figure 7.1. The owner of a scarce resource has a finite volume of
a resource X to sell (75 units)and knows that by saving a portion of
 78
it for future sales, she can charge a higher price today. The price of
the good rationed over time must equate the present value of the
marginal net benefit of the last unit consumed in each period. That
is the consumer must be indifferent between obtaining the next unit
today or tomorrow. If she is willing to offer only 50 units for sale
today, the market price for scarce resources is Ps. The scarcity rent
collected by the owner of the resource is equal to PsabP.

Figure 7.1: Optimal Resource Allocation over time

It is the owner’s ability to collect these rents that creates the

rationing effect and is thus necessary to ensure the efficient
allocation of resources over time. In the absence of scarcity, all of
the resource will be sold at the extraction cost P=MC, 75 units will
be consumed at one time, and no rent will be collected.

The proponents of neoclassical free-market theory

stress those inefficiencies in the allocation of resources result from
impediments to the operation of the free market or imperfections in
the property rights system. So long as all resources are privately
owned and there are no market distortions, resources will be
allocated efficiently. Perfect property rights markets are
characterized by four conditions.

1. Universality – all resources are privately owned.

2. Exclusivity – it must be possible to prevent others from
benefiting from privately owned resources.
3. Transferability – the owner of a resource may sell the resource
when desired.
 79
4. Enforceability - the intended market distribution of the benefits
from resources must be enforceable.

Under these conditions, the owner of a scarce resource has an

economic incentive to maximize the net benefit from its sale or use.
For example, a farmer who owns his land will choose the levels of
investment, technology, and output that maximize the net yield from
the land. Because the value of the land may be used as collateral,
any viable on-farm investment can be financed by obtaining a loan
or the prevailing market rate of interest.

If the foregoing condition are not met simultaneously then

the inefficiency than arises (misallocation of resources) due to it
need to be removed.

Common Property Resources:

If a scarce resource is publicly owned and thus freely
available to all, as is the case with common property resource, any
potential profits or scarcity rents will be competed away. The
neoclassical theory suggests that in the absence of scarcity rents,
inefficiencies will arise. Figure 7.2 describes the relationship
between the returns to labour on a given piece of land and the
number of labourers cultivating it

Figure 7.2

Suppose that the land is held privately. The landowner would

hire additional labour to work on the land until the marginal product
of the last worker is equal to the market wage, W, at point L*. The
workload is shared equally among the employees, each of whom
produces the average product. A profit maximiser will thus hire L*
 80
workers, with a total output equal to average product AP* multiplied
by the number of workers, L*. Scarcity rents collected by the
landowner equal AP*CDW.

Society’s total net benefit from land will be lower under a

system of common property, unless workers can coordinate their
resource use decisions in a cooperative manner. Workers income
will continue to exceed the wage until enough workers are attracted so
that the average product falls to the level of the wage, at which point
the labour force equals Lc. Though total farm output may either rise
or fall the marginal product of the additional workers is below the
wage. Assuming that all workers could be employed elsewhere must
fall when marginal product falls below W. No scarcity rent is
collected at Lc. The implication of the common property model is
that, where possible, privatisation of resources will lead to an
increase in welfare and an efficient allocation of resources.

7.2 DEVELOPMENT AND THE CONSTRAINT OF

NATURAL RESOURCES

Humans are the most intelligent than all of living things on

the earth. Man has made full use of the natural resources on the
strength of his intelligence, skill, intelligence, energy. He is
constantly striving to make human life rich and comfortable. Not
only air, water, land, rivers, streams, stones, minerals, plants,
animals, birds; but also all the tangible and intangible elements of
the environment are used by human beings. These elements are
called natural resources.

Humans of all ages, from primitive man to modern man, have

depended on the resources of the environment to survive.
Although, modern man lives a more comfortable life than primitive
man, his life depends on nature as much as primitive man. From
the point of view of human life and development, the importance of
resources is unique. For this, it is necessary to study resources.

Concepts of Natural Resource:

Man uses the elements of nature to fulfill his needs; these are
called as natural resources. Natural resources are visible and
invisible, tangible and intangible. Therefore, human needs are met.
Therefore, human life and human existence are the factors that are
useful to them.

Interpretation
According to Zimmermann, a resource is a tool to meet a
specific goal or need.
 81
According to Jockey Smith, resource wealth is an
environmental factor that is useful to humans in one way or
another.

According to Ginsberg, the material element that is freely

provided by nature in the field of human action is resources.

7.3ENVIRONMENTAL PROBLEMS IN ECONOMIC

DEVELOPMENT

Considering the future of the country, the country faces three

major economic problems as population control, economic
development including environmental protection, poverty
alleviation, etc. The reason for the constant rise of the earth's
temperature is human intervention in the environment and
economic development. Due to these two, the temperature has
increased by 05.1% in the last 200 years. Climate change can be
detrimental to the migration of agro-industries, migration of animals
and human habitation in the region.

The environment problems in economic development are as

follows -

1) Lack of clean water and sewerage system:

According to a World Bank report, 1 billion people in
developing countries do not have access to safe drinking water.
Also, 1.7 billion people do not have access to proper sanitation. It
has been observed that human health has declined due to malaria,
cholera etc.

2) Air pollution:
Along with industrialization, automobiles have been a major
contributor to air pollution. Industrial, domestic energy, vehicles,
etc. have led to a large increase in air pollution. In 1980, 1.3 billion
people living in suburbs suffered from emissions other than dust
and fumes. Humans are exposed to many diseases due to this
pollution.

E.g. various diseases related to respiratory diseases, cancer, skin

diseases, asthma, lack of oxygen in the blood, loss of vision, eye
irritation, cough, etc. Currently a large amount of nitrogen, sulfur,
carbon and other harmful gases are released into the air. So,the
human health is under threat.

3) Loss of soil fertility:

In agriculture, land is a natural resource and is considered
as the main capital. Human and all living beings depend on the
fertility of the land. However, this fertility is being destroyed.
 82
E.g. Continuous cropping, continuous use of brackish water, low
water holding capacity, increasing use of organic fertilizers etc.

4) Deforestation and degradation of biodiversity:

In developing countries, forests, coastal forests, inland
watersheds, etc. are rapidly declining. This is rapidly depleting
biodiversity.

5) Increase in greenhouse gas and temperature or global

warming:
According to researchers studying the atmosphere, carbon
dioxide and other greenhouse gases cause an increase in
temperature.

A) By 2050, global warming will be the highest in human history.

B) Changes in rainfall are possible.
C) The regular possibility of reshaping the islands in the ocean,
earthquakes and volcanic eruptions cannot be ruled out.
D) Different diseases will spread rapidly. For example malaria,
malaria etc.
E) Rising temperatures will reduce evaporation and greatly reduce
the production of wheat, rice and maize.

6) Climate change:
Climate change will adversely affect the water cycle, leading to
floods, droughts, rising sea levels, inundation of coastal areas,
changes in agricultural production and natural imbalances in all
regions, endangering human life and adversely affecting human
economic development.

Measures to overcome environmental problems:

Economic growth and development have both positive and
negative effects. The 1992 World Development Report identified
measures to protect the environment along with increased
productivity. Poverty alleviation was one of the key measures.
Policies and economic efficiency and environmental protection are
important. This should lead to a balance between economic
development and the environment.

Important Policies / Remedies:

1) Creating a positive relationship between environment and

development:
Strategies for modern technological advancement, minimal
exchange of raw materials, waste generation should be
implemented. Further measures are planned to achieve these
policies.
 83
A) Elimination of price difference -
Government policy imposes a double price on kerosene fuel.
This leads to an increase in air pollution due to the double cost of
open market and discounted rates. Canceling fuel discounts will not
only increase efficiency and save money but also reduce local
pollution. It will reduce global carbon emissions from fuels.

B) Restoration of property rights:

When public goods are given to people collectively, it is used
more than is reasonable. E.g. Forests, grazing lands, etc., on the
other hand, giving ownership to farmers will reduce the loss of
forests and forest lands out of a sense of belonging and thus help
in proper management of natural resources.

2) Strategies for Humanitarian Change:

Environmental damage cannot be prevented by simply granting
ownership rights and concessions. Policies should be formulated
keeping in mind that the behavior of the user of the equipment
affects other communities. Therefore, many behavioral change
policies have been implemented in India as follows:

A) The first category is based on rewards or incentives. E.g. market

based policy
B) The second category is in numerical or restrictive form, e.g.
regulatory policy

3) Prevention of water pollution:

Protect rivers and seas from contaminated water such as
contaminated factory water, domestic sewage, and river waste.

4) Public Expenditure Review:

Public spending affects the environment. Large investments
from domestic governments and development agencies such as the
World Bank are made through public spending. This is detrimental
regardless of the importance of the environment. Recently, many
countries have seen environmental scrutiny related to public
spending.

7.4 ENVIRONMENT AND SUSTAINABLE

DEVELOPMENT

The concept of sustainable development is of very recent

origin. This term was first used by the world conservation strategy
presented by the International Union for the conservation of Nature
and the Natural Resources in 1980. In 1983, the United Nations set
up the world commission on Environment and Development
(called the Brundland Commission) to examine the problems
 84
related with this area. The commission in its report entitled on
'Our Common Future' submitted in 1987, for the first time introduced
the concept of 'Sustainable Development' which meets the needs of
the present generation without compromising the ability of future
generations to meet their own needs.

Sustainable development is development, that last long.

There is growing realisation of environmental problems like air
pollution, water pollution, deforestation, soil erosion, acid rains,
solid and hazardous wastes, ozone depletion etc. in the world in
modern times. The concept of sustainable development tries to find
suitable solution of all these global problems.

Meaning:
Sustainable development means that development should
'keep going'. Sustainable development is development which is
everlasting and contributes to the quality of life through
improvements in natural environments. Natural environments, in
turn, supply utility to individuals, inputs to the economic process
and services that support life. The concept of sustainable
development assigns equal emphasis on development,
environmental protection and preservation. It emphasises the
creation of sustainable improvement in the quality of life of all
people through increase in real income, per capita income, national
income, improvements in health, education, general quality of life
and overall improvements in quality of natural environmental
resources. As a matter of fact, environmental degradation has to be
stopped at all cost so as to preserve health and to promote
welfare of the community as a whole. According to D. W. Pearce
and E. Barbier, "Sustainable Development describes the process in
which natural resources base is not allowed to deteriorate. It emphasises
the hitherto unappreciated role of environmental quality and
environmental inputs in the process of raising real income and
quality of life."

Objectives:
To achieve the goal of sustainable development, it is
necessary to control the gross exploitation of the natural resources
which is going on a wide scale by all countries whether
underdeveloped, developing and developed countries on account
of which the human life is becoming difficult day by day. Thus, the
main objective of sustainable development is the creation of
sustainable improvements in the quality of life for all people on the
earth.

The main objectives of sustainable development are:

1. accelerating economic growth,
2. meeting basic needs,
 85
3. lifting living standards,
4. helping in ensuring clean environment — free from all types of
pollution,
5. maximizing the net effects of economic development,
6. preservation and enhancement of the stock of environmental,
human and physical capital,
7. intergenerational equity,
8. Overall strict control on gross exploitation of the natural
resources of each country. We must give more to mother
land than what we extract from it. Today, sustainable
development is the only available alternative which can make the
future of the future generations bright.

7.5 SUMMARY

Sustainable development is the practice of the developing

land and the construction projects in a manner that reduces their
impact on the environment by allowing them to create energy
efficient models of self-sufficiency. This can take the form of
installing solar panels or wind generators on the factory sites, using
geothermal heating techniques or even participating in cap and
trade agreements. Biggest criticism of the sustainable development
is that it does not do enough to conserve the environment in the
present and is based on the belief that the harm done in one area
of the world can be counter balanced by creating environmental
protections in the other.

7.6 QUESTIONS

Q1. What are the environmental problems in economic

development?
Q2. Explain the concept of sustainable development?
Q3. State the relation between sustainable development and
environment.
Q4. Explain constraints of natural resources.


 86

8
MACROECONOMICS OF
DEVELOPMENT - II
Unit Structure:

8.0 Objectives
8.1Trade and Development
8.2 Trade and Foreign Exchange
8.3 Role of International Financial and Trade Institutions
8.4 Structural Adjustment and Stabilization
8.5 Summary
8.6 Questions

8.0 OBJECTIVES

 To understand the role of international financial and trade

institutions.
 To understand relation between trade and foreign exchange.
 To understand relation between trade and development.

8.1 TRADE AND DEVELOPMENT

Baldwin proposed that ‘trade is an engine of growth’. According

to him, international trade serves as a means of fostering
economic growth by allowing a country to access the inputs
available in other countries at a lower price and helps is generating
foreign exchange by facilitating exports. This argument is along
the lines of comparative advantage proposed by David Ricardo. To
this, the arguments of ‘learning-by-doing’ and ‘learning-by-
producing’ were added to highlight the processes through
countries participating in the free trade will develop dynamic
advantage and productivity gains that will further help them to
experience higher growth rates over a period of time. In other
words, free trade ensures that each participating country shall
realise the full and proper use of its resources both in the short-run
when it is reaping the static gains, and in the long-run when it is
reaping the dynamic advantages. For long, the theory of
comparative advantage and free trade doctrine on which it was
based formed the essentials of development strategy. However,
Kravis observed that in the twentieth century, international trade is
more like a handmaiden of growth rather than an engine of growth.
This is because, developed countries, led by the US have
 87
generally been adopting policies that are away from the spirit of
free trade and suited more to the domestic interests.

Starting with the OECD-sponsored study of trade policies in

developing countries, there has been an argument that the trade
strategies in these countries need a relook. This was further
supported by NBER-sponsored study of another set of developing
countries. Therefore, the World Bank and the IMF started insisting on
the trade policy reforms for many developing that sought their
assistance. Therefore, we shall first examine the import-
substitution industrialisation (ISI) strategy first and then proceed to
the export-promotion industrialisation (EPI) strategy. We shall then
draw some conclusions based on these.

The import substitution industrialisation (ISI) strategy is

based on the infant industry argument of J.S. Mill. According to
him, a country should protect its industry if it satisfies certain
conditions. These are: i) these industries will not be set up unless
they are protected from the foreign competition, ii) they make
losses initial years of operation, iii) in the long-run they shall be able
to make profits and compete with imports on their own. All such
industries need to be protected in the short-run to develop the
domestic industrial sector in an economy. This is known as the ‘Mill-
Bastable Test’. Interestingly, the US has extensively used this in the
initial stages of its economic development. German economist List
extended this argument further and suggested that the entire domestic
industry should be protected instead of some selected industries since
it is difficult to select the industries with potential comparative
advantage.

The Singer-Prebisch-Myrdal hypothesis discussed above

further supported temporary protection to the domestic industry
since the primary exports suffer the problem of secular
deterioration in the terms of terms of trade due to inelastic
demand. Hirschman recommended the protection to domestic
industry as part of his unbalanced growth strategy. Together,
these arguments favoured many developing countries, including
India, opting for ISI strategy during the early 1950s.

Studies subsequently, mainly by Balassa, showed that the

ISI strategy is doomed to fail since it violated the principle of
allocative efficiency. To this, the concept of factor market
distortions developed by Kindleberger lent further support and
many countries were forced to review their development
strategies. The example of the Asian Tigers was often shown as
the evidence for the efficacy of EPI strategy. This takes us to the logic
of the ISI strategy. The LDCs that adopted this strategy did not
achieve the high growth rates that were posted by the Asian Tigers.
Given this fact, it needs to be seen as to why this is so. The major
 88
problem was the developed countries did not co-operate in providing
the necessary support to these countries. Often the aid was tied
and thus was not always to the use of the recipient country.
Bhagwati and Desai in their study show many such cases in the
Indian context. The pressure exerted by the advanced countries on
the policy-makers of the developing countries forced them to choose
projects and plants that were in direct variance of their needs and
requirements. Thus, the ISI strategy was not allowed to operate
under optimal conditions.

Following the collapse of the Soviet bloc, the world

unanimously embraced the free trade strategy. This reached its
pinnacle in the establishment of the World Trade Organisation
(WTO). The experience of different countries under the WTO
during the last twenty years is a sad story of the failure of the export
promotion strategy that was so fondly highlighted by the neoclassical
economics. We shall now turn to this.

1. The worsening of socio-economic indicators in the sub-Saharan

Africa are a direct, incontrovertible proof that free trade and
globalisation are not necessarily the only path to improving the
economic conditions of the poor.

2. Those who profess by free trade are themselves the ardent

followers of protectionism. This can be seen at the WTO
negotiations on the agricultural trade. The USA and the EU linked
the lowering of their domestic support to the NAMA (non-
agricultural market access). Though they continue to support their
domestic agriculture for a variety of reasons, they do not intend to allow
the LDCs to do so in the name of freer trade. The livelihood
considerations were give scant attention in the name of lowering of
trade barriers.

3. Evidence from the disputes at the WTO indicate that the USA is the
largest litigant under the new system. Earlier, it forced the Japanese
under the voluntary export restraints (VERs) and other measures.
Their own failing comparative advantage is being offset at the cost of
other countries, mainly the developing countries.

4. Trade policy reforms and international highhandedness are

sought to be the instruments. The conclusions of Hong Kong
Summit are a mute testimony to the manner in which the advanced
countries led by the USA succeed in fulfilling their policy objectives. In
each round of negotiations, new issues, often unrelated, are
introduced and the developing countries are either forced to accept
them due to their own domestic compulsions or due to the pressure
brought upon them.
 89
5. The WTO itself is expressing the concern for the spread of
regional trade agreements (RTAs) which are opposed to the spirit of
multilateral trade. Significantly, the USA is participant in many of these
RTAs. The experience of Mexico in the NAFTA lends enough evidence
to the dangers inherent in these arrangements.

The role of trade in economic development of the backward

countries needs to be looked in terms of the role that it plays in an
economy by supplementing the domestic resources. We shall now
turn to the financing aspects of economic development.

8.2 TRADE AND FOREIGN EXCHANGE

Any country has its own system of foreign exchange control

because exchange control is complementary to international trade.
Trade transactions, exchange of capital, trade services are under
the control of the exchange. .

The value of money denominated in foreign currency for

international exchange is the foreign exchange rate. The exchange
rate between the two countries is called the foreign exchange. It
has been said many times that the Reserve Bank has less foreign
exchange reserves.

Foreign Exchange Market:

The study of trade balance and transaction balance is
important in the transactions that take place in international trade.
The currency of any country is accepted without any doubt in the
domestic arena. For example, the rupee with Indian currency is
accepted anywhere in India. In order to complete a transaction, one
has to buy and sell foreign currency. The market through which the
transaction of buying and selling foreign currency is done.
Therefore, the foreign exchange market is called a well-
organized market.

Functions of Foreign Exchange Market:

1. To assist in the completion of foreign exchange transactions.
2. To supply foreign dowry as per demand.
3. Collecting power of attorney in respect of foreign currency from
foreign exchange banks and selling it to the needy.
4. Migration of goods and services from one country to another.
5. Provide a research facility to facilitate international exchange
transactions.
6. To protect against exchange rate fluctuations and potential
losses.
 90
Foreign exchange instruments:
The exchange is used to complete the exchange
transactions in international trade. If the exchange rate is not fixed
then it changes.

1) Foreign currency -
Foreign exchange is essential for international trade.
Foreign exchange banks collect foreign currency. Foreign currency
is made available to the customers as per the requirements of the
customers. Transactions in international trade are completed.

2) Gold Exports -
Countries involved in international trade have free trade
in terms of imports and exports. Gold is exported to pay off foreign
debts. The reality is that the route has been closed by the
government due to lack of free import and export of gold.

3) Foreign exchange bill -

Some conditions are fixed in the transaction between
import and export. In addition, the bill of lading in respect of the
goods is insured and the required documents are sent to the bank.

4) Bank Draft -
In order to complete international transactions, the
importers complete the transaction by drawing a draft in the bank in
the name of export-rate. For this, foreign currency can be obtained.

5) Telegraphic Transaction or Transfer -

In order to expedite the transaction of international trade,
the banks instruct the foreign bank by telegram. The foreign banks
then pay the amount to the exporter, which is called telegraphic
transfer method.

6) Mail Transfer -
The importer deposits the amount paid by the exporter in
the bank account for the transaction. Guaranteed mail transfer is
used if the importer wants a guarantee on how many days he will
receive the specified amount.

7) Letters of credit -
Credit letters are also called letters of credit. Credit letters are
issued by banks if the appropriate amount is telegraphed or
deposited in a bank account near a foreign exchange bank. After
issuing the letter, the importer instructs the bank to withdraw the
amount at the foreign branch of the bank and accept the bill.
Accordingly, the letter holders receive a certain amount.

The above tools are used to complete exchange transactions

in international trade.
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8.3 ROLE OF INTERNATIONAL FINANCIAL AND

TRADE INSTITUTIONS

Macroeconomic management consists of Stabilisation and

structural adjustment programmes. With these programmes, both
the IMF and World Bank deal with economic issues and focus their
efforts on broadening as well as strengthening the economies of
their member nations.

Stabilisation involves short term measures to restore

balance of payments, while structural adjustment measures are
implemented on a longer term basis, to `restructure the economy
and generate economic growth.’ These policies are closely linked
and usually involve devaluation of currency, cuts in public
spending, elimination of subsidies, cuts in the civil service,
privatization of state owned industries, opening of local economies
to foreign investment and an emphasis on export promotion in
order to earn foreign currency to apply to debt servicing.

Whilst Stablisation programmes are generally associated with

the IMF, structural adjustment is dealt with by the World Bank. The
IMF focuses primarily on BOP management, the World Bank, on the
other hand, gives priority to the longer-term development of an
economy.

The IMF pays an important attention to monetary and fiscal

policy, exchange rate management and foreign borrowing. Thus,
the IMF has played a key role in ensuring prince stability,
strengthening the balance of payments (BOP) and provision of
loans to countries needing assistance. IMF activities revolve around
typical financial and monetary issues such as the exchange rate,
interest rates, credit, money supply, inflation, government
expenditures and revenues, and balance of payment aggregates.

The original dividing line between the IMF and the World
Bank, implied that IMF received guidance from the World Bank on
development issues. In turn, the World Bank followed IMF advice
on domestic macroeconomic and exchange rate policies,
adjustment of temporary balance of payments disequilibria and
Stabilisation programmes. The distinction however became blurred
during the turbulent years after the breakdown of the Bretton
Woods par value system from 1968 to 1973 and during the debt
crisis in the 1980s.

Following the economic problems of developing countries

(hereafter LDCs) in the 1970s (oil price shocks in 1973-74 as well as
1979-80, decline in terms of trade, debt crisis in 1979-80s, fiscal
deficits and high inflation), the two institutions formulated structural
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adjustment programmes designed specifically to resolve the
economic problems of LDCs. The problems can be traced initially to the
collapse of the Bretton Woods exchange rate system in 1971, which
contributed to the volatility of the exchange rate.

Throughout the 1970s, the IMF and World Bank were

marginalised as lenders to countries who could instead borrow from
commercial banks anxious to recycle the massive surpluses of the
Organization of Petroleum Exporting Countries (OPEC) and a new
excess of liquidity within international capital markets. The IMF
initially responded by expanding access to its resources,
particularly to countries with no access to commercial finance. The
World Bank undertook more policy-based lending and expended its
focus to include rural development.

The festival of lending ended when the US Federal Reserve

increased interest rates in 1979. Suddenly indebted governments
found that their creditors would not roll over their loans. The
borrowers could not meet their debt repayment obligations.

Several large commercial banks were on the brink of failure.

The IMF and World Bank were called upon to extend loans to the
debtors to ensure that they would repay their over-exposed
creditors and therefore avert an international banking crisis.

The conditional loans required borrowers to undertake stringent

measures to stabilise and ensure adjustment in their economies in
order to access credit from the IMF or World Bank.

The debt crisis which began in Latin America in the early

1980s drew the IMF and World Bank into a new role. Since 1980s,
the IMF and World Bank have played key roles in planning and
management of LDCs.

Conditionality in the first phase of the debt crisis emphasized

Stabilisation. This meant that governments were required to:
(i) Reduce inflation,
(ii) Rationalize and stabilise the exchange rate.
(iii) Increase interest rates,
(iv) Reduce public sector expenditure and investments,
(v) Increase taxation, and
(vi) Eliminate subsidies.

These are the staple requirements of IMF conditionality. They

are reinforced by requirements made by the World Bank in its structural
adjustment loans which require government to:
(i) Liberalise trade and minimize tariffs,
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(ii) Privatise state-owned industries,
(iii) Encourage foreign investment, and
(iv) Dergulate their economies.

Taken together the conditionality of the IMF and World Bank

came to be labelled the Washington Consensus.

Stabilisation

Definition : Stabilisation policy can be defined as the policy

response to correct macroeconomic imbalances when an economy is
off-track from its potential growth.

The term `Stabilisation’ came about because the economy’s

balance of payments (BOP) crisis was thought of as spiralling out of
control, with inflation increasing, capital flight intensifying, and debt-
servicing difficulties mounting at increasing rates.

Stabilisation circumstances arise because of overseas and

domestic macroeconomic shock. The former shocks mainly refer to
adverse movements in the terms of trade, the debt and interest rate
crises, and foreign exchange shortage, while the latter shocks
usually include hyperinflations, financial collapses, irresponsible
policy teams, and natural disasters. (Taylor 1988).

Goals / Targets : The general goals of Stabilisation policy are:

(a) Improving the current account balance and attaining a viable
overall balance of payments.
(b) Satisfactory long-term growth performance (sustainable, stable
growth rate),
(c)Reducing inflation (stable price level), and
(d) High level of employment (low unemployment).

There are no conflicts over the goals of the Stabilisation

policy but policy conflicts arise over the ways these objectives are
achieved.

Necessity: Generally, a country needs a Stabilisation programme

when it experiences an imbalance between aggregate domestic
demand and aggregate supply. Thus, the primary role of the IMF.
Focusing on aggregate demand, is to assist the member country in
designing a policy package that applies measures to restore a
sustainable balance between aggregate demand and supply, and
to simultaneously expand the production of tradable goods.
 94
Approach : The IMF’s Stabilisation programmes are primarily
designed to improve the current accounts balance and the overall
balance of payments of countries experiencing external payments
difficulties. A typical Fund programme mainly employs monetary
measures, exchange rate policies, and fiscal measures, and
combined aggregate demand policies, supply enhancing measures,
and relative price policies.

The IMF follows a three-pronged approach to confront

balance of payments problems:
(i) Securing sustainable external finance.
(ii) Adoption of demand-restraining measures consistent with
available financing, and
(iii) Procreeding with structural reforms to promote growth and
adjustment in the medium and longer term.

The latter IMF programmes are to two types:

(a) Short-term, in which the macroeconomic disequilibrium is
thought to be reversible in one or two years, e.g., The Standby
Arrangement (SBA). The priority course of action in SBAs is
expenditure reduction.

(b) Medium-term in which the macroeconomic disequilibrium in

caused by structural impediments to growth or a heavy external
debt burden. IMF medium-term programmes aim to correct a
serious external payments disequilibrium due to structural
impediments to growth and debt overhang. The programme
involves a strategy that keeps expenditures in line with output
and increases growth. E.g., the Structural Adjustment Facility
(SAF), Extended Structural Adjustment Facility (ESAF) and
Poverty Reduction and Growth Facility (PRGF).

The reliance on, and the relative importance of each of three

above mentioned components depends on the specific
circumstances of the member country for instance, the blueprint for
a country whose international reserves are depleted as a result of
unsustainable fiscal imbalances will place considerably more
(initial) emphasis on demand-restraining measures than that for a
country whose overall external position worsened suddenly as a
consequence of an adverse terms of trade shock, a natural
disaster, or negative spillovers from events in other countries.

Once the crisis has been contained and confidence restored,

external financing constraints often become less pressing and the
macroeconomic policy stance can become more supportive of
domestic demand.
 95
It should be stressed however, that the role of the IMF is to
contribute to design the adjustment strategy, help the country
secure external financing and monitor the progress in overcoming
the external crisis, but that it is up to the country’s authorities to
implement in a timely and credible manner the policy measures
contemplated in the strategy.

A member’s more basis objectives of high output

growth, alleviating poverty, and so forth are not explicitly among
those core areas. This doesnot mean that the IMF is unconcerned about
these objectives. It is simply a reflection of the IMF belief that a country
experiencing severe balance of payments difficulties must set its
priority to reducing this difficulty and correcting the macroeconomic
and structural imbalances at their root in order to achieve the more
basic objectives in a sustainable manner over the longer term.

The IMF has generally insisted that Stabilisation must occur

before structural reform is attempted. However, more recent
statements seem to indicate a growing recognition by the fund that
to the extent that efforts to channel resources away from inefficient
uses are impeded by institutional rigidities, structural reform can
play a critical role in achieving balance of payments viability and
growth.
Features of IMF’s approach to Stabilisation :
1. Quantitative features : IMF’s approach to economic
Stabilisation has vital quantitative features.
(i) Projections are made for key macroeconomic variables (e.g.,
national output, price level, current account balance) under the
policies to be adopted under the programme.

Attention is paid to the likely availability of external

financing to assure that viability restored to the country’s external
payments position.
2. Performance criteria : IMF’s programmes also contain
quantitative “performance criteria” for key variables related to
macroeconomic policies (popularly referred to as
conditionality) which typically include ceilings for the fiscal
deficit and the central bank’s net domestic credit and floors
to net international reserves. These criteria are calculated
using a flows-of-funds frame work known as “financial
programming.” Financial programming is a method that has
gradually evolved over the years taking into consideration; (i)
the major institutional and structural developments in the
economies which have requested IMF assistance, (ii) the
considerable changes in the international economy, (iii)
progress in the study of macroeconomic and international
issues.
 96
3. The process : The IMF approach to Stabilisation and how it
functions is best understood by considering the process of
an IMF supported Stabilisation programme.

A typical IMF-supported programme is not set in stone at its

inception. It is flexible. It does not proceed exactly in
accordance with the initial plan nor is it terminated because of
some minor deviation.

An IMF programme begins with an explicit request from a

member. The IMF staff then prepares a blue print of the programme
which is used as the basis for the negotiations. When an agreement is
reached after bargaining over the key elements of the programme the
arrangement has to be cleared by the IMF management and then
approved by the IMF executive board. Thereafter disbursements
proceed automatically if all the performance clauses are met as
initially specified. If various conditions are not met deviations may be
accompanied with “waivers,” projections may be revised and
numerical targets changed.

Check your progress:

1. What is meaning of stabilization?
2. What are the goals of stabilization policy?

8.4 STRUCTURAL ADJUSTMENT AND

STABILIZATION

Overall financial management includes financial stabilization

and fundamental adjustment programs. The International Monetary
Fund and the World Bank control financial matters through such
projects. Their focus is on strengthening and expanding the economies
of their member countries. Economic stabilization emphasizes the
reduction of short-term imbalances in a country's transactions. The
basic adjustment program is used to restructure the economy in the
long run and to sustain economic growth. The program includes
devaluation of the currency, reduction of public expenditure, closure of
concessions, reduction in public services, opening up of foreign
investment to the domestic economy, promotion of export-oriented
industries, etc.
 97
In general, the International Monetary Fund is related to the
economic situation. So the World Bank is concerned with long-term
fundamental adjustments. Due to the economic crisis in the developing
world in the 1970s, two institutions were set up to make fundamental
adjustments. Countries that lend on conditional loans from the
International Monetary Fund and the World Bank first have to take
tough economic measures.

The policy of economic stabilization is a plan of action to

address the overall imbalance in order to get the economy back on
track. Economic stratification is needed to address the problems
created by the imbalance in the balance of payments of the economy.
Rising inflation, remittances and interest on foreign loans, repayments,
etc. create a huge imbalance in the year. This creates the need for
economic stabilization.

The shock at the domestic and foreign levels of the overall

economy creates the need for stratification. Traditionally, trade,
agriculture, debt, interest rates, food shortages, etc., create imbalances
in trade. In modern times, the rapidly rising inflation, the economic
downturn, irresponsible policies, natural disasters, etc. hit the economy
as a whole.

Economic Stabilization Policy Objectives:

1. To increase the current account balance of the transaction balance
and move towards favorable transaction balance.
2. Maintaining a sustainable economic growth rate means maintaining
a satisfactory long-term economic growth rate.
3. Reducing the rate of inflation to a stable price level.
4. High employment level

Structural Adjustment Programs (SAPs):

Since the 1980s, the International Monetary Fund and the
World Bank have pursued economic policies for the development of
the world's underdeveloped and developing countries. These policies
or development programs are called basic adjustment programs.

Interpretation:
The fundamental adjustment is that the International Monetary
Fund and the World Bank have forced economic reforms to allow
developing countries to embrace a free economy. Making these
financial reforms was the precondition for obtaining loan funds from
this institution.

Origin:
In the late 1970's, a series of catastrophes in the global economy
led to a fundamental adjustment program. Due to all these types of
 98
financial disasters e.g. Crisis, debt crisis, multi-pronged economic
recession, etc. made it necessary for the planners of developing
countries to intervene in the economic development program for the
welfare of the nation. In the 1980's, the World Bank introduced long-
term lending to developing countries to address recurring deficits
through basic adjustment programs, rather than just lending.

In the year 2002, there was a change in the basic adjustment

program. Poverty alleviation strategies were implemented. The World
Bank, based on the new ideology, opined that successful economic
programs are implemented with the support of the government. Apart
from the poverty alleviation program, the World Bank and the IMF have
adopted a more and more constructive approach.

Structural Adjustment Program Objectives:

1. After World War II, the main objective of the International Monetary
Fund was to prevent a Great Depression like the 1930s. It was
created to prevent global recession. The purpose of the IMF was to
provide loans to some poor countries and to expand economic
policies in developed countries. This will prevent future recessions.

2. In the 1980s, there was a huge fiscal and external imbalance. The
reasons are declining production and rising inflation. These
governments faced rising inflation, budget deficits and trade
deficits, raised interest rates, cut public spending and imposed
restrictions on imports. In such a scenario, the IMF's immediate
objective was to strike a balance between improving international
finance. Because for long-term growth, it was necessary to create
investment and growth, increase savings and create economic
efficiency.

3. The basic adjustment program was designed to improve a country's

foreign investment climate. Measures were taken to reduce trade
and investment restrictions, increase exports and earn foreign
exchange, and reduce government deficits by cutting all public
accounts.

Critical Evaluation of SAPs:

1. The adjustment program places more emphasis on reviving

transaction errors. Other appropriate and balanced approaches to
resolving the cost crisis have not been considered.

2. Government sovereignty is considered secondary and the role of

government in socio-economic development is limited. In the name
of free economy, government control of public enterprises is
reduced through privatization, decentralization etc.
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3. This program is widening the gap between rich and poor. The
concentration of income is in the hands of the rich. The poorer
classes are excluded from the decision-making process and their
ownership of natural resources has also come to an end.

4. This program threatens democracy and the democratic process.

Borrower governments have to accept adjustment programs that
are inconsistent with their policy. These policies are against the will
of the people. Alternatively poor countries cannot repay their loans
on time. They become insolvent.

5. There is a lack of public participation responsibility and transparency

in the planning and implementation of the adjustment program.

6. The National Food Security Policy is threatened because of its

concentration in the export sector and its reliance on short-term
investment.

7. This program limits the rights of children in Parliament, the right to

development and the bias against women's rights.

8. In these programs only domestic economic compromise is

emphasized. At the same time the objectives of sustainable
development and self-reliance and people's participation in the
financial planning and decision making process are omitted. The
above objectives are set aside.

9. Due to the restrictions imposed by the adjustment program, women

have to suffer immensely. Reductions in public services have
increased the workload of women. Therefore, there is an increased
cost for their health care and family education.

8.5 SUMMARY

The basic adjustment program seeks to end the volatility of

economic factors at the overall level. This year, economic growth
rates, public deficits and inflation levels are taken into account as a
shared measure of the effectiveness of the program. The common
index that measures the success of this program is the economic
growth rate. In some countries, growth rates have slowed down due
to adjustment programs, while in others, progress has been rapid.
According to some critics, the measure of success of this program
should take into account the economic indicators as well as the
social and cultural indices.
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8.6 QUESTIONS

Q1. Explain the relation between trade and development.

Q2. Explain relation between trade and foreign exchange
Q3. What is the role of International Financial and Trade
Institutions?
Q4. Explain the Structural Adjustment and Stabilization Programme
in detail.

8.7 REFERENCES

1. Economics of Development and Environment - Prof. Mrs. Alka

Zhimre (Suyash Prakashan)
2. Economics of Growth and Development - Dr. JF Patil (Phadke
Publications)
3. Economic Growth and Development - Prof. Sontakke and Prof.
Joshi (Sheth Prakashan)
4. International Economics - Prof. Gangadhar Vs. Kayande-Patil
(Chaitanya Prakashan, Nashik)
5. Basu, Kaushik (1998) Analytical Development Economics. New
Delhi.
6. Ray.Debraj (2004) Development Economics, New Delhi.

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