ECONOMIC DEVELOPMENT by Todaro. M and Smith.

S (13th edition)
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CHAPTER 3: CLASSIC THEORIES OF ECONOMIC Focus: Invest in industrialization and infrastructure.
GROWTH AND DEVELOPMENT Improve education and skill training. Support rural-to-
urban migration.
 “Every nation strives after development” Criticism: Assumed all countries follow a similar path
 Development is more than economic progress; and downplayed external/global influences. This results
it is a multidimensional process that expands in rural neglect and worsen income gaps between city
human freedoms and involves reorganizing and countryside.
economic, social, and institutional systems, as
well as changing attitudes, customs, and beliefs. 3. International-Dependence Revolution (1970s)
o While it often focuses on national  A more radical, political and institutional
growth, sustainable development may approach.
also require adjustments in the  Underdevelopment is a result of exploitative
international system. global relationships between rich and poor
o This chapter examines the historical and countries.
intellectual evolution of development  Viewed underdevelopment as the result of
thought through four major theories, power imbalances:
highlighting their insights, with newer o Between rich and poor countries (core–
models combining elements of the periphery relationships).
classics and further discussions on o Within developing nations (elites vs.
economic growth provided in later masses).
sections.  Highlighted structural rigidities, dual
economies, and inequality.
3.1 Classic Theories of Economic Development:
 Called for new policies to reduce poverty,
Four Approaches
diversify employment, and redistribute
1. Linear-Stages-of-Growth Model (1950s–1960s) income.
 Development seen as a series of stages every Focus: Reduce reliance on foreign imports and
country must pass through. investment. Strengthen domestic industries (“import
 Development is mainly about economic growth substitution industrialization”).
through savings, investment, and aid Criticism: Sometimes dismissed the potential benefits
o Inspired by the historical growth paths of market participation and economic growth. May
of developed nations. overblame external forces while ignoring local
o Assumed that if the right mix of capital corruption and inefficiency.
accumulation was achieved,
underdeveloped countries would follow 4. Neo-Liberalism / Neoclassical Counter-Revolution
the same trajectory. (1980s–1990s)
Focus: savings, investment, and foreign aid as the main  Reaction against dependence theory.
drivers of growth.  Stressed the role of free markets, privatization,
Criticism: Overemphasized capital formation while trade liberalization, and minimal government
ignoring structural, social, and political factors. intervention.
 Argued that underdevelopment was caused by
2. Theories and Patterns of Structural-Change excessive state regulation and inefficiency, not
Models (1970s) external exploitation.
 Focused on the internal process of Focus: open economies, deregulation, and private
transformation within economies. sector growth.
 Used economic theory and statistical analysis to Criticism: Overemphasized market efficiency, neglected
explain how a typical developing country must social equity and government’s role in correcting
shift from agriculture to industry and services. market failures. Economic success comes from free
 Emphasized the importance of sectoral markets, open trade, and minimal government
changes, technology adoption, and labor intervention.
migration.
 Saw development as more than just growth—it
required restructuring economic and social
systems.
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3.2 Development as Growth and the Linear- Capital fundamentalism (Inspired by Marshall Plan)
Stages Theories  Approach emphasized rapid physical capital
Keywords: accumulation as the key driver of growth.
STAGES-OF-GROWTH MODEL OF DEVELOPMENT - A 3.2.1 Rostow’s Stages of Growth
theory of economic development, associated with the
American economic historian Walt W. Rostow,  Walt W. Rostow, an American economic
according to which a country passes through sequential historian.
stages in achieving development.  Proposed a linear model describing
development in five stages.
HARROD-DOMAR GROWTH MODEL - A functional
Five Stages of Economic Growth
economic relationship in which the growth rate of gross
1. Traditional Society – agrarian, subsistence
domestic product (g) depends directly on the national
economy, limited technology.
net savings rate (s) and inversely on the national
2. Pre-conditions for Takeoff – initial investments,
capital-output ratio (c).
infrastructure, and external influence begin.
CAPITAL-OUTPUT RATIO - A ratio that shows the units 3. Takeoff – period of rapid growth,
of capital required to produce a unit of output over a industrialization, and self-sustaining
given period of time. momentum.
4. Drive to Maturity – diversification of economy,
NET SAVINGS RATIO - Savings expressed as a
technological progress, wider markets.
proportion of disposable income over some period of
5. Age of High Mass Consumption – advanced
time.
economy, widespread affluence, focus on
NECESSARY CONDITION - A condition that must be consumer goods and services.
present, although it need not be in itself sufficient, for Main Argument
an event to occur. For example, capital formation may  All countries must pass through these stages in
be a necessary condition for sustained economic sequence.
growth (before growth in output can occur, there must  Underdeveloped nations can achieve growth by
be tools to produce it). But for this growth to continue, following similar paths as advanced nations.
social, institutional, and attitudinal changes may have Strategy for Takeoff
to occur.  Mobilization of domestic and foreign savings to
generate investments.
SUFFICIENT CONDITION - A condition that when
 Investments are key to accelerating economic
present causes or guarantees that an event will or can
growth.
occur; in economic models, a condition that logically
Theoretical Basis
requires that a statement must be true (or a result must
 Relies on the Harrod-Domar Growth Model
hold) given other assumptions
(later known as the AK Model).
Post-World War II focus on low-income countries o Output = A × K (where A = productivity
 Interest grew as many nations gained constant, K = capital stock).
independence from colonial rule.  Applied in development planning, including
 Economists in industrialized countries lacked two-gap and three-gap models.
proper tools to analyze growth in agrarian
societies.
3.2.2 The Harrod-Domar Growth Model
Influence of the Marshall Plan  Economies must save part of their income to
 Massive U.S. financial and technical aid helped replace old capital and invest in new capital for
Europe recover quickly. growth.
 This success inspired the idea that large capital  Growth depends on the relationship between
injections could also modernize developing savings (s), investment, and capital efficiency
countries. (c).
Two main assumptions
 Economic development requires massive
capital investments.
 Historical experience of developed nations
provides a blueprint for development.
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 GDP growth rate depends:
o Directly on the national net savings rate 3.2.3 Obstacles and Constraints
(s) → higher savings = more funds for Strategy for Economic Growth
investment = higher growth.  Based on the Harrod-Domar Model, the rate of
o Inversely on the capital-output ratio (c) GDP growth (ΔY/Y) depends on:
→ the fewer units of capital needed per o Savings ratio (s): higher savings mean
more funds for investment.
unit of output, the more efficient growth
o Capital-output ratio (c): lower ratio
will be.
means capital is used more efficiently.
 Capital-output ratio (c): units of capital
 Increasing s while holding c constant will
required to produce one unit of output (lower = accelerate economic growth.
more efficient). Rostow’s “Takeoff” Stage
 Net savings ratio (s): proportion of income  Defined as the point where countries save 15–
saved and invested. 20% of GDP.
 At this level, economic growth becomes self-
The Harrod-Domar Growth Model sustaining, allowing a transition toward
maturity.
Main Obstacle to Growth
 Low capital formation in poor countries due to:
o Low domestic savings.
o Limited capacity for investment.
 ΔY/Y = growth rate of GDP Example:
 s = savings ratio  A country targets 7% growth with c = 3, needing
 c = capital-output ratio 21% savings.
o If only 15% savings is possible → savings
Right-hand side of Equation: represents the national gap of 6%.
capital-output ratio. - This gap must be filled through
Left-hand side of Equation: represents the rate of foreign aid or foreign private
change or rate of growth of GDP. investment.
Policy Consequences
Example:  This model gave rise to the idea of a “capital
 If c = 3 and s = 6%, growth = 2% per year. constraint” approach to development.
o If savings rise to 15% (via higher taxes,  Justified massive transfers of capital and
foreign aid, or reduced consumption), technical assistance from developed to
developing nations.
growth = 5% per year.
 Seen as a “Marshall Plan for the Third World,”
o Takeoff stage (Rostow): occurs when
especially during Cold War politics.
savings reach 15–20% of GDP, enabling Other Ways to Accelerate Growth (Beyond Raising
faster, self-sustaining growth. Savings)
Implications 1. Improve efficiency of capital (lower c):
 To accelerate growth:  If c decreases from 3 → 2.5:
o Raise savings and investment levels. o With s = 6%, growth rises from 2% →
o Improve efficiency of capital use 3%.
(reduced “c”). o With s = 15%, growth rises from 5% →
 Emphasizes capital accumulation as the main 7.5%.
driver of growth. 2. Reduce depreciation (δ):
Limitations
 Assumes labor is abundant (not always true).
 Ignores institutional, social, and political
factors.
 SG = often expressed in terms of gross savings
 Long-run growth also requires technological
 Δ = rate of capital depreciation
progress (reduces “c” over time).
Lowering δ by 1% directly increases GDP growth by 1%.
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portion of the rural labour force whose marginal
3.2.4 Necessary Versus Sufficient productivity is zero or negative.
Conditions: Some Criticisms of the
Stages Model PRODUCTION FUNCTION - A technological or
engineering relationship between the quantity of a
 Saving and investment are necessary for good produced and the quantity of inputs required to
growth but not sufficient by themselves. produce it.
Why the Marshall Plan Worked in Europe?
 Europe already had the right conditions to use AVERAGE PRODUCT - Total output or product divided
capital effectively: by total factor input (e.g., the average product of
o Well-functioning markets (money and labour is equal to total output divided by the total
commodities). amount of labour used to produce that output).
o Good transport and infrastructure.
o Educated and skilled workers. MARGINAL PRODUCT - The increase in total output
o Strong motivation to rebuild. resulting from the use of one additional unit of a
o Efficient government institutions. variable factor of production (such as labour or capital).
Why It Failed in Many Developing Countries? In the Lewis two-sector model, surplus labour is
 Rostow and Harrod-Domar assumed poor defined as workers whose marginal product is zero.
nations had the same readiness as Europe.
 In reality, many lacked: SELF-SUSTAINING GROWTH - Economic growth that
o Strong institutions and good continues over the long term based on saving,
governance. investment, and complementary private and public
o Skilled managers and workers. activities.
o Ability to plan and manage projects. PATTERNS-OF-DEVELOPMENT ANALYSIS - An attempt
Overlooked Factor to identify characteristic features of the internal
 Growth can also come from improving capital process of structural transformation that a “typical”
efficiency (lowering the capital-output ratio, c). developing economy undergoes as it generates and
 This means using investments more effectively, sustains modern economic growth and development.
not just increasing savings.
 Analyze how underdeveloped economies
transform their economic structure from
3.3 Structural-Change Models predominantly traditional agriculture to a more
Keywords: modern, diversified industrial and service based
economy.
STRUCTURAL-CHANGE THEORY - The hypothesis that o Purpose: To explain the mechanisms
underdevelopment is due to underutilisation of behind economic development. Guide
resources arising from structural or institutional factors policymakers in managing economic
that have their origins in both domestic and transitions for long-term development.
international dualism. Development therefore requires Approach
more than just accelerated capital formation.
 Uses neoclassical price theory (resource
STRUCTURAL TRANSFORMATION - The process of allocation through markets).
transforming an economy in such a way that the  Uses modern econometrics (statistical analysis)
contribution to national income by the manufacturing to study the transformation process.
sector eventually surpasses the contribution by the Key Models
agricultural sector. More generally, a major alteration 1. Two-Sector Surplus Labour Model (W. Arthur
in the industrial composition of any economy. Lewis)
 Focuses on moving surplus labor from
LEWIS TWO-SECTOR MODEL - A theory of
agriculture to modern industry.
development in which surplus labour from the
traditional agricultural sector is transferred to the 2. Patterns of Development (Hollis B. Chenery &
modern industrial sector, the growth of which absorbs coauthors)
the surplus labour, promotes industrialisation, and  Examines empirical evidence of structural
stimulates sustained development. changes as countries develop.

SURPLUS LABOUR - The excess supply of labour over

and above the quantity demanded at the going free-
market wage rate. In the Lewis two-sector model of
economic development, surplus labour refers to the
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Criticisms of the Lewis Model
3.3.1 The Lewis Theory of Economic 1. Labour transfer ≠ proportional to capital
Development accumulation
o Capital may be invested in labour-
 Developed by W. Arthur Lewis (1950s). saving technology (fewer jobs created).
 A two-sector surplus labour model that o Profits may also flow abroad (capital
explains development through structural flight).
transformation: 2. Surplus labour assumption flawed
o Shifting surplus labour from the o Evidence shows rural surplus labour is
traditional agricultural sector to the limited.
modern industrial sector. o Urban unemployment often increases
 Structural transformation: when the instead.
manufacturing sector’s contribution to national 3. Constant wages unrealistic
income surpasses that of agriculture. o In reality, urban wages rise due to
unions, government policies, or
The Two Sectors multinational firms.
1. Traditional (Agricultural) Sector 4. Diminishing returns in industry questionable
 Subsistence farming, low productivity.
o Modern industry often shows
 Labour-intensive techniques.
increasing returns to scale.
 Surplus labour exists: part of the rural
5. Neglect of human capital
workforce has zero or negative marginal o Ignores importance of education, skills,
productivity (MPL = 0). and health in productivity.
o Meaning: adding more workers does
not increase output.
 Wage = average product of labour (total output 3.3.2 Structural Change and Patterns of
÷ workers). Development
2. Modern (Industrial) Sector  Explains how poor economies transform over
 Manufacturing and industrial activities.
time from farming-based to modern industrial
 High productivity, capital-intensive.
economies.
 Wages set higher than rural wages (WM > WA),
 Unlike the Lewis Model (which focused only on
attracting rural workers. savings and capital investment), this approach
 Labour supply to modern sector is perfectly
says development also needs broader changes
elastic (unlimited workers at constant wage in society, economy, and institutions.
until surplus labour is absorbed). What Structural Change Means
Key Economic Concepts 1. Production changes
 Production Function: maximum output from
o From agriculture → industry →
given inputs with existing technology. services.
 Average Product (AP): output per worker →
2. Consumer demand changes
Total Output ÷ Labour. o At first: people mostly buy food and
 Marginal Product (MP): extra output from one
basics.
additional worker. o Later: demand shifts to manufactured
Growth Process (How the Model Works) goods and services.
1. Modern sector profits arise because 3. Trade changes
productivity > wages. o At first: exports are raw materials and
2. Profits are reinvested → more capital (K) → food.
higher output. o Later: exports are manufactured, high-
3. Demand for labour increases → more rural value products.
workers shift to industry. 4. Resource use
4. Cycle continues → self-sustaining growth: o Labour and capital move from farms to
continuous expansion supported by savings, factories and cities.
reinvestment, and capital accumulation. 5. Social changes
5. Lewis Turning Point: o Urbanization: people migrate from
o All surplus labour is absorbed.
villages to cities.
o Agricultural output falls if more workers
o Population:
leave → food prices rise.  Growth rises first (better health,
o Industrial wages increase.
lower death rates).
o Marks the transition to a fully
industrialized economy.
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 Then slows down (smaller Differences Exist
families, focus on education).  The pace and path of development depend on:
Constraints on Development o Natural resources and size of the
 Domestic factors: country.
o Natural resources. o Government policies and goals.
o Size of country (land + population).
o Access to foreign capital and
o Government policies and institutions.
technology.
 International factors:
o International trade environment.
o Access to foreign capital (loans,
investments). Risk of Misinterpretation
o Access to technology.  Policymakers may copy “patterns” without
o Participation in global trade. understanding cause vs. effect.
 Examples:
These international links make today’s o Seeing agriculture shrink in rich
developing countries different from how rich countries countries → some poor countries
industrialized in the past. neglect farming, even though it is still
vital for them.
Chenery’s Patterns of Development (Empirical Model)
o Seeing universities in developed
 Developed by Hollis B. Chenery (building on
countries → some poor countries invest
Simon Kuznets).
 Empirical structural change analysts emphasize
in higher education too early, before
constraints on development achieving basic literacy → results in
o Domestic: Resource endowments, size, inequality.
policies, institutions. Findings from Empirical Studies
o International: Access to trade,  Patterns of development do exist (urbanization,
technology, and external capita industrialization, population shifts).
 Based on data from many developing countries.  But the pace and outcomes vary because of
 Found “stylized facts” of development: domestic and international factors, many
o Stylized Facts - Commonly observed beyond a country’s control.
features of how economies change as Policy Implications
they develop. These are not universal,  The right mix of economic policies (domestic +
but widespread patterns seen across
international) can create self-sustaining
many countries.
growth.
1. Shift from agriculture → industry.
 Structural-change economists are optimistic
2. Steady growth of physical capital
(machines, factories) and human capital that countries can develop with proper
(education, skills). strategies.
3. Consumer demand moves from food →  This contrasts with the International-
goods and services. Dependence School, which is more pessimistic
4. Growth of cities and industries. about development prospects.
5. Population:
- First rises (high birth rates, lower 3.4 The International-Dependence Revolution
death rates).
- Then falls (lower fertility, smaller Keywords:
families).
DEPENDENCE - The reliance of developing countries on
3.3.3 Conclusions and Implications developed-country economic policies to stimulate their
own economic growth. Dependence can also mean that
 Development follows “average patterns” that the developing countries adopt developed-country
can be seen across many countries. education systems, technology, economic and political
 These patterns are similar, but not identical, systems, attitudes, consumption patterns, dress, and so
because each country has unique conditions.
on.
Development is a Process
 It is not random—countries generally go
through similar stages (agriculture → industry
→ services).
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DOMINANCE - In international affairs, a situation in Three Main Ideas
which the developed countries have much greater 1. Neocolonial Dependence Model
power than the less-developed countries in decisions o Even after colonialism ended, poor
affecting important international economic issues, such countries remain dependent on rich
as the prices of agricultural commodities and raw ones.
materials in world markets. o Rich countries exploit developing
nations through trade, investment, and
NEOCOLONIAL DEPENDENCE MODEL - A model whose
aid, keeping them weak.
main proposition is that underdevelopment exists in
2. False-Paradigm Model
developing countries because of continuing
o Developing countries often follow
exploitative economic, political, and cultural policies of
advice from foreign experts,
former colonial rulers toward less-developed countries.
international organizations, or
UNDERDEVELOPMENT - An economic situation developed nations.
characterised by persistent low levels of living in o But this advice is based on wrong
conjunction with absolute poverty, low income per models (made for rich countries, not
capita, low rates of economic growth, low consumption poor ones) → results in failure and
levels, poor health services, high death rates, high birth dependency.
rates, dependence on foreign economies, and limited 3. Dualistic-Development Thesis
freedom to choose among activities that satisfy human o Developing countries are marked by
wants. extreme inequality:
 A small modern, rich sector vs. a
CENTRE - In dependence theory, the economically
large traditional, poor sector.
developed world.
o These two sectors coexist, but the
PERIPHERY - In dependence theory, the developing modern one does not help the
countries. traditional one → inequality keeps
growing.
COMPRADOR GROUPS - In dependence theory, local
elites who act as fronts for foreign investors. 3.4.1 The Neocolonial Dependence Model
FALSE-PARADIGM MODEL - The proposition that
 A model whose main idea is that
developing countries have failed to develop because
underdevelopment in poor countries continues
their development strategies (usually given to them by
because of ongoing exploitative economic,
Western economists) have been based on an incorrect
political, and cultural policies of former colonial
model of development—one that, for example,
rulers (the “center”) toward less-developed
overstresses capital accumulation or market
countries (the “periphery”).
liberalisation without giving due consideration to
needed social and institutional change. How it Works
1. Rich Countries (the "Center")
DUALISM - The coexistence of two situations or
o Dominate world trade, finance, and
phenomena (one desirable and the other not) that are
technology.
mutually exclusive to different groups of society—for
o Set rules that favor their own growth.
example, extreme poverty and affluence, modern and
o Poor countries can only grow if rich
traditional economic sectors, growth and stagnation,
countries allow it.
and higher education for a few amid large-scale
2. Poor Countries (the "Periphery")
illiteracy
o Depend on rich countries for capital,
AUTARKY - A closed economy that attempts to be loans, and markets.
completely self-reliant. o Their growth is often limited or
controlled by these outside powers.
 View developing countries as beset by 3. Local Elites (inside poor countries)
institutional, political, and economic rigidities, o Includes politicians, landlords,
both domestic and international, and caught up businessmen, military leaders, and
in a DEPENDENCE and DOMINANCE relationship officials.
with rich countries o They benefit from working with rich
countries.
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o Instead of helping their people, they o It emphasizes that inequality is not just
protect the system that keeps a temporary stage of development, but
dependency alive. rather a long-lasting condition with a
Supporting Views tendency to worsen.
 Theotonio Dos Santos:
o Dependency means some countries 4 Main Points
(rich) can develop on their own, but
1. Coexistence of superior and inferior conditions
poor countries can only grow as a
 Within the same society or global economy,
reflection of the rich countries’ growth.
we see modern alongside traditional
o This results in backwardness and
systems, and rich alongside poor.
exploitation.
o For example, in developing countries,
 Pope John Paul II (1988):
wealthy urban elites with access to
o Global financial and economic systems
modern technology live next to large
often favor the rich and suffocate the
populations who depend on traditional
poor.
farming methods. Similarly, rich
o Even when they seem automatic, they
industrialized nations coexist with
deepen inequality.
weaker and poorer economies.
3.4.2 The False-Paradigm Model 2. Chronic and not transitional
 These inequalities are not temporary
 The proposition that developing countries have
imbalances that will automatically
failed to develop because their development
disappear over time. Instead, they persist as
strategies (usually given to them by Western
a chronic condition.
economists) have been based on an incorrect
 Unlike theories that assume poorer nations
model of development that often lead to
will eventually “catch up” as they
inappropriate or incorrect policies.
modernize, dualism suggests that poverty
o For example, poor countries may be told
and inequality are built into the system and
to focus on increasing GDP, privatizing
remain constant.
industries, or saving more money, but
3. Tendency for the gap to widen
these ignore deeper problems like land
inequality, traditional social systems,  Instead of narrowing, the difference
and the power of local elites. between rich and poor usually grows larger.
o For instance, workers in advanced
 Many local leaders are trained in rich countries
economies continue to become more
and bring back theories that look good in
productive and wealthy, while workers
textbooks but do not solve real issues at home.
in poorer countries often remain stuck
As a result, these policies often benefit the
with low productivity and limited
elites while leaving ordinary people behind.
opportunities. This results in the “rich
o In short, the False-Paradigm Model
getting richer and the poor getting
explains that bad or mismatched advice
poorer.”
leads to wrong policies, which keep poor
4. Negative interaction between superior and
countries underdeveloped.
inferior
 The existence of wealth or progress in one
3.4.3 The Dualistic-Development Thesis area does not automatically lift up the poor
or underdeveloped sectors.
 DUALISM MODEL - The coexistence of two
situations or phenomena (one desirable and the  In fact, it may do the opposite: the success
of rich countries and elites often depends on
other not) that are mutually exclusive to
exploiting the resources and labor of the
different groups of society.
poor, creating what some scholars call the
 The dualistic-development thesis explains the
“development of underdevelopment.”
persistent and widening gap between the rich
o This means the very presence of
and the poor, both among nations and within
superior conditions can deepen the
countries.
inferiority of others.
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3.4.4 Conclusions and Implications MARKET-FRIENDLY APPROACH - The notion historically
promulgated by the World Bank that successful
 Critique of old theories – Dependence, false- development policy requires governments to create an
paradigm, and dualism models reject the idea environment in which markets can operate efficiently
that simply growing GDP or following the same and to intervene only selectively in the economy in
path as rich countries will solve poverty. areas where the market is inefficient.
 Focus on inequality – They emphasize that
global power imbalances and unfair systems MARKET FAILURE - A market’s inability to deliver its
keep poor countries from developing, so theoretical benefits due to the existence of market
reforms are needed both inside countries and imperfections such as monopoly power, lack of factor
worldwide. mobility, significant externalities, or lack of knowledge.
 Limitations – These theories explain why poor Market failure often provides the justification for
countries stay poor, but not how to achieve real government intervention to alter the working of the
growth. Inward-looking or state-run policies free market.
(like China before 1978, India before 1990)
often failed, while countries that traded more CAPITAL–LABOUR RATIO - The number of units of
(like South Korea, Taiwan, later China) grew capital per unit of labour.
faster.
SOLOW NEOCLASSICAL GROWTH MODEL - Growth
o Dependence theory looks good in
model in which there are diminishing returns to each
explaining the problem but when its
factor of production but constant returns to scale.
solutions were applied, they failed.
Exogenous technological change generates long-term
 Balanced approach – The key is not choosing economic growth.
only government or only markets, but finding
the right mix of both, along with fair CLOSED ECONOMY - An economy in which there are no
international cooperation. This led to the rise of foreign trade transactions or other economic contacts
free-market ideas in the 1980s. with the rest of the world.

3.5 The Neoclassical Counter-Revolution: Market OPEN ECONOMY - An economy that practises foreign
Fundamentalism
trade and has extensive financial and nonfinancial
Keywords: contacts with the rest of the world.

NEOCLASSICAL COUNTER-REVOLUTION - The 1980s 3.5.1 Challenging the Statist Model: Free
resurgence of neoclassical free-market orientation Markets, Public Choice, and Market-
Friendly Approaches
toward development problems and policies, counter to
the interventionist dependence revolution of the
1970s.  In the 1980s, conservative governments in the
US, UK, Canada, and West Germany pushed a
FREE MARKETS - The system whereby prices of neoclassical counterrevolution against heavy
commodities or services freely rise or fall when the state control in developing countries.
buyer’s demand for them rises or falls or the seller’s Supported by the World Bank and IMF, this
supply of them decreases or increases. movement promoted free markets instead of
state planning.
FREE-MARKET ANALYSIS - Theoretical analysis of the
o Underdevelopment is not caused by rich
properties of an economic system operating with free
countries exploiting poor ones (as
markets, often under the assumption that an
dependence theory claimed), but by too
unregulated market performs better than one with
much government control, corruption,
government regulation.
and inefficiency in developing countries.
PUBLIC-CHOICE THEORY (NEW POLITICAL ECONOMY o The solution: let the “invisible hand” of
APPROACH) - The theory that self-interest guides all the market work through competition,
individual behaviour and that governments are trade, and private investment.
inefficient and corrupt because people use government
to pursue their own agendas.
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Three main strands developed/ Approach 3. Technology as key – Long-term growth mainly
depends on technological progress, which the
1. Free-Market Approach
model treats as exogenous (coming from
 Advocated minimal government, trusting the
outside the system, not explained by the model
invisible hand to guide growth
itself).
 Markets are efficient on their own.
4. Convergence idea – Poor countries can catch up
 Prices guide production and investment.
to rich ones if they:
 Government intervention only creates
o Save and invest more,
distortions.
o Control population growth, and
Example: Success of East Asian economies like
o Gain access to new technologies.
South Korea and Taiwan (though not purely laissez-
However, this “catch-up” (convergence)
faire).
is conditional—it only happens if the
2. Public-Choice Approach (New Political Economy)
right policies and conditions are in place.
 Warned that government officials often act in
5. Open vs. closed economies –
their own self-interest, leading to corruption
o Closed economies (little trade, no
and inefficiency.
foreign investment) with low savings
o Governments are often corrupt and self-
grow slowly and remain poorer.
serving.
o Open economies (with trade and
o Politicians and bureaucrats use
investment inflows) can grow faster, as
resources for personal gain (e.g., bribes,
foreign capital and ideas raise
rent-seeking).
productivity.
 Citizens use influence for special favors.
Implication
 Minimal government is best.
 According to this theory, developing countries
3. Market-Friendly Approach
should liberalize markets and attract foreign
 Accepted that the state has a role, but only in
investment to speed up growth. Government
limited areas such as infrastructure, health, and
restrictions that block investment and
education, or in correcting market failures.
technology flows will slow development.
 Recognizes that markets in developing
countries have imperfections.
3.5.3 Conclusions and Implications
 Government should play a supportive role—
investing in education, health, infrastructure, Different views of underdevelopment
and creating a good climate for business.  Dependence theorists: Poverty in poor
 Accepts that market failures (like lack of countries is caused mainly by external forces
information, environmental problems, or (exploitation by rich nations).
coordination failures) exist, so selective  Neoclassical theorists: The problem is
interventions may help. internal—too much government control,
corruption, and bad policies.
3.5.2 Traditional Neoclassical Growth
Free markets vs. reality
Theory
 In theory, free markets are more efficient than
 The neoclassical growth theory, especially the state intervention.
Solow model, explains how countries grow and  But in many developing countries, real markets
why some remain richer than others. It don’t work like in rich nations:
emphasizes savings, investment, labor, and o Information is limited.
technology as the main drivers of growth. o Markets are fragmented.
Key Points: o Many economies are still partly non-
1. Beyond Harrod-Domar – Unlike the older monetized.
Harrod-Domar model (which focused only on o Monopolies are common.
capital), the Solow model adds labor and o The “invisible hand” often benefits the
technology as growth factors. rich, leaving the poor behind.
2. Diminishing returns – Adding more labor or Usefulness of neoclassical theory
capital alone eventually produces smaller gains.  Supply-and-demand principles are still valuable
But when combined, they can still sustain for setting fair prices and improving resource
growth. allocation.
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 Governments can also use prices as tools to
encourage socially beneficial outcomes.
Main challenge
 Both markets and governments can fail in poor
countries due to inequality, rigid institutions,
and political realities.
 Development is not about choosing only free
markets or only government control. Instead,
each country needs local solutions suited to its
context.
3.6 Classic Theories of Development: Reconciling
the Differences

 No single theory fully explains development

challenges → each has strengths and
weaknesses.
Structuralist & Dependency Theories
 Emphasize history, inequality, and structural
barriers. Argue that markets alone cannot
address poverty and power imbalances.
Neoclassical Approaches
 Stress efficiency and individual incentives. Warn
against excessive state control.
Reconciliation
 Combine insights: Efficient markets + Strong
institutions + Strategic government action.
 Aim for both growth and equity, social welfare,
and sustainability.
 Development strategies must be context
specific, balancing openness, efficiency, and
fairness.