Chapter 3: Classic Theories of Economic Growth and Development

Introduction

• Every nation strives for development, which is more than just economic progress; it
encompasses a holistic transformation of the economy, society, and institutions.
• Economic progress is essential, but development goes beyond that and involves radical
changes in institutional, social, and administrative structures, as well as popular attitudes
and even customs and beliefs.
• Development is multidimensional. Although development is usually defined in a national
context, its more sustainable and widespread realization often requires modifying the
international economic and social systems.
• This chapter delves into historical and intellectual approaches to understanding
development: why it happens and why it doesn’t.
• Development theories are tools for examining how economic progress occurs in different
countries. These theories are further amplified in the next chapters and appendices.

3.1 Classic Theories of Economic Development: Four Approaches

Development economics literature, primarily from the second half of the twentieth century, can
be classified into four major approaches:

1. The Linear-Stages-of-Growth Model

a. Focused on economic growth as a process of successive stages that all countries
must go through.
b. Savings, investment, and aid are necessary for developing countries to proceed
along an economic growth path.
2. Theories and Patterns of Structural Change
a. Emphasizes the shift from traditional agricultural economies to more
industrialized economies.
3. The International-Dependence Revolution
a. These theories argue that developing countries remain underdeveloped due to
external constraints imposed by international relationships, such as unequal trade,
exploitation, and dependence on rich nations.
4. The Neoclassical, Free-Market Counter-Revolution
 a. Advocates for minimal government intervention, free markets, and open
economies.

These theories were developed against the backdrop of different historical, political, and economic
contexts. The 1950s and 1960s were formative decades for these theories, which reflect different
perspectives on the dynamics of economic development.

3.2 Development as Growth and the Linear-Stages Theories

3.2.1 Rostow’s Stages of Growth

• Rostow is one of the most influential theorists in the linear-stages-of-growth model.

• He posited that economic development could be understood as a series of stages that all
countries must pass through:
o Traditional Society: Economy is dominated by subsistence agriculture, and
technology is limited.
o Preconditions for Take-Off: New techniques in agriculture and industry create
opportunities for investment and growth. Capital accumulation increases.
o Take-Off: Rapid industrialization and sustained growth begin in specific sectors.
The economy starts to expand.
o Drive to Maturity: The economy diversifies beyond its initial focus sectors.
Technological and innovative practices spread throughout the economy.
o Age of High Mass Consumption: The economy becomes mature, and citizens
have disposable income, which leads to a focus on mass consumption and welfare
state provisions.
Key Concept: Rostow’s theory emphasizes the necessity for capital accumulation and productive
investments to fuel growth.

3.2.2 The Harrod-Domar Growth Model

• Another important linear-stage theory, the Harrod-Domar model, focuses on the

relationship between savings, investment, and economic growth.
o The model assumes that savings and investment are critical drivers of growth.
o The rate of growth in an economy is determined by the level of investment and the
productivity of that investment.

Key Equations:
3.2.3 Obstacles and Constraints

• One of the biggest obstacles in the Harrod-Domar model is the lack of sufficient capital
investment.
o Developing countries often have low savings rates, which limits their ability to
invest in growth.
o Example: If a country has a capital-output ratio of 3 and saves 6% of its GDP, the
growth rate is only 2%. However, if the savings rate increases to 15%, the growth
rate rises to 5%.

Key Concept: The idea of the “savings gap” — if a developing country cannot generate sufficient
savings, it may struggle to invest enough to grow at a fast rate. Foreign aid or investment is
sometimes necessary to fill this gap.

• Capital Constraints: Developing countries often face a “capital constraint,” meaning they
have difficulty raising enough capital to spur growth.
• Structural Rigidities: These economies may also face rigidities that prevent labor and
capital from moving freely to more productive sectors.

3.2.4 Necessary versus Sufficient Conditions: Some Criticisms of the Stages Model

• Necessary vs. Sufficient Conditions:

 o A necessary condition for development refers to factors that must be present for
development to occur, but may not be enough by themselves to ensure development.
o A sufficient condition is one that, if present, guarantees development.
• Criticisms of the Stages Model:
o The Rostow’s stages model and the Harrod-Domar model focus heavily on
capital accumulation and savings as essential to triggering development.
o However, capital formation alone is not sufficient for sustained economic growth.
Other factors, such as institutional, social, and political conditions, play
significant roles in economic development.
o In the case of the Marshall Plan, capital assistance helped Europe recover after
World War II, but this success was largely due to the strong institutional and
administrative structures that already existed in Europe.
o In developing countries, simply increasing savings and investment without
addressing institutional and social rigidities (e.g., structural obstacles) will not
necessarily lead to economic growth.
o The assumption in the linear-stages model is that all countries follow the same
path to development. This overlooks the complexities of developing economies,
where factors like cultural attitudes, political systems, and external constraints
(e.g., foreign debt, international trade dynamics) play critical roles.
o Dual economies: Many developing countries have dual economies where
traditional, agricultural sectors coexist with modern industrial sectors. The stages
model oversimplifies this reality by assuming uniform development across all
sectors.
• Complementary Factors: For development to occur, complementary factors such as
human capital, skilled labor, education, healthcare, and institutional development are
essential. Without these, capital investment alone will not be sufficient to produce
sustainable economic growth.
• Conclusion: The stages model provides a useful framework but fails to capture the
complexity of the development process, especially in terms of institutional development,
human capital, and structural obstacles.

3.3 Structural-Change Models

3.3.1 The Lewis Theory of Economic Development

The Lewis model, developed by W. Arthur Lewis in the 1950s, is one of the most well-known
early models of structural change in development economics. It is particularly significant because
it explains how surplus labor from the traditional agricultural sector is gradually absorbed into the
modern industrial sector.

• Basic Structure:
o The economy is divided into two sectors:
▪ Traditional Agricultural Sector: Characterized by surplus labor. This
means that labor can be transferred to other sectors without reducing output
in agriculture. The marginal productivity of labor in this sector is close to
zero.
▪ Modern Industrial Sector: Characterized by high productivity and the
capacity to absorb surplus labor from agriculture. This sector offers higher
wages, which motivates workers to move from agriculture to industry.
• Mechanism of Growth:
o Labor Transfer: As the modern industrial sector grows, it attracts surplus labor
from the agricultural sector. This leads to an expansion of output in the industrial
sector.
o Capital Accumulation: Profits from the industrial sector are reinvested, leading to
more capital formation. This results in further expansion of the industrial sector,
creating more demand for labor.
o As more labor is transferred from the agricultural sector, the wages in the modern
sector initially remain constant because of the unlimited supply of labor in the
agricultural sector. However, once the surplus labor in agriculture is exhausted,
wages in the industrial sector begin to rise. This is known as the “Lewis turning
point.”
• Key Assumptions:
o The model assumes that the traditional agricultural sector has surplus labor,
meaning that workers can move to the industrial sector without reducing
agricultural output.
o The real wages in the modern industrial sector are fixed at a level higher than the
average wage in the traditional agricultural sector. This wage differential motivates
workers to move to the industrial sector.
o The modern sector is capitalist, meaning that profits are reinvested in the sector,
leading to further capital accumulation and economic growth.
• Growth Dynamics:
o In the early stages of development, the marginal productivity of labor in
agriculture is zero or near zero, meaning that moving workers from agriculture to
industry does not reduce agricultural output.
o As more labor is transferred to the industrial sector, the marginal product of labor
in the traditional sector rises, and wages in the modern sector increase once the
surplus labor is fully absorbed.
 o Capital formation in the modern sector accelerates this process, as more capital
allows the modern sector to produce more output and employ more labor.
• Diagrammatic Representation (refer to Figure 3.1 in the text):
o TPA Curve: Total product of labor in the agricultural sector.
o TPLM Curve: Total product of labor in the modern industrial sector.
o As labor moves from the agricultural sector (with low productivity) to the industrial
sector (with higher productivity), the economy experiences structural
transformation.

The growth process is illustrated by the shifting of labor from the agricultural sector to the modern
sector. At the same time, the modern sector’s profits are reinvested, further increasing the demand
for labor.

• Figure 3.1a and 3.1b:

o The figure shows the two-sector model of the Lewis theory. On the left side (3.1a),
we see the modern sector’s labor demand and supply curves. As the modern sector
expands, the demand for labor increases, but real wages stay constant due to the
surplus labor.
o On the right side (3.1b), the agricultural sector’s total product curve remains
constant even as labor is transferred out, which illustrates the concept of surplus
labor.

• Criticisms of the Lewis Model:

o Surplus Labor Assumption: In reality, many developing countries may not have
such large amounts of surplus labor. This assumption may not hold, especially in
urban economies, where unemployment is prevalent.
o Fixed Wage Assumption: The assumption that wages remain constant in the
industrial sector until the surplus labor is exhausted is often not realistic. In many
developing countries, wages tend to rise even when there is surplus labor, due to
factors like labor unions, government policies, or social pressures.
o Institutional Factors: The model does not take into account the role of institutions
in facilitating labor transfer and capital accumulation. Factors like education,
healthcare, and infrastructure are critical in supporting the transition from
agriculture to industry.
• Lewis Turning Point:
o Once the surplus labor in agriculture is absorbed by the modern sector, wages in
the industrial sector begin to rise. This is known as the “Lewis turning point.”
Beyond this point, economic growth requires improvements in productivity, as
simply transferring labor from agriculture to industry will no longer suffice.
 • Key Concept: The Lewis model shows how economies transition from being agrarian-
based to industrial economies. The movement of surplus labor from agriculture to industry
is key to this transformation.

3.3.2 Structural Change and Patterns of Development

The patterns-of-development analysis of structural change focuses on how developing

economies transform their structures from traditional subsistence agriculture to more diversified
manufacturing and service economies. This theory emphasizes that economic development
involves the progressive shift in the economic structure of a country, and it is closely linked to the
Lewis model but goes further in identifying more comprehensive patterns of transformation.

• Main Features of Structural Change:

o Shift from agriculture to industry: Developing countries typically experience a
reduction in the importance of agriculture and a corresponding increase in the share
of industry and services.
o Urbanization: Economic growth is often accompanied by a migration of labor
from rural to urban areas, where industrial and service sectors are located.
o Accumulation of human and physical capital: Development requires investment
in education, health, and infrastructure, which increases labor productivity.
o Changes in consumption patterns: As per capita income rises, consumers tend to
spend less on food (a basic necessity) and more on manufactured goods and services.
• Empirical Evidence and Trends:
o Studies by Hollis Chenery and colleagues provided empirical evidence that certain
“average patterns” of development can be observed across countries. These
patterns reflect the economic transformation and changes in sectoral composition
as countries develop.
o Stages of Development:
▪ In the early stages of development, agriculture dominates, but as
industrialization begins, the importance of agriculture declines, and
manufacturing and services become the main sectors.
▪ International Trade: Trade plays a critical role in this process. Exporting
agricultural products, and later industrial goods, helps developing countries
generate the capital needed for industrialization.
• Policy Implications:
o Governments must adopt policies that encourage industrialization, infrastructure
development, and investments in human capital.
 o Export-led growth: Many successful developing countries have adopted export-
led growth strategies, integrating into the global economy by focusing on producing
and exporting manufactured goods.
o Human capital development: Education, healthcare, and skills development are
crucial for improving labor productivity and transitioning to higher-value industries.
• Structural Constraints:
o Institutional rigidities, such as inadequate education systems, poor infrastructure,
and corruption, can hinder structural change and limit growth.
o Population growth: Rapid population growth can create challenges by increasing
the labor supply faster than the economy can absorb it into productive jobs.
o Technology: Adoption and diffusion of new technologies are critical to improving
productivity and sustaining growth.
• Conclusion:
o The patterns-of-development approach highlights that economic development
involves fundamental changes in the structure of an economy, with the gradual shift
from agriculture to industry and services. It emphasizes that capital accumulation,
technological progress, and human capital development are essential for sustained
growth.

3.3.3 Conclusions and Implications

The patterns-of-development model provides important insights into how economies develop
over time. Some key conclusions include:

• Economic Diversification: Development involves a shift from primary production

(agriculture) to more diversified economic activities, such as manufacturing and services.
• Urbanization and Industrialization: As countries develop, urbanization accelerates, and
industrialization becomes the driving force behind economic growth.
• Investment in Human Capital: Education, healthcare, and infrastructure development are
essential to increasing labor productivity and supporting economic transformation.
• Role of International Trade: Trade is crucial in driving structural change, especially when
countries adopt export-led growth strategies.
• Government Policy: Effective government policies that support industrialization,
investment in infrastructure, and human capital development can help overcome structural
constraints and foster economic development.
3.4 The International-Dependence Revolution

The international-dependence models emerged in the 1970s as a response to the perceived

failures of the linear-stages and structural-change models. These models emphasize that
underdevelopment in the developing world is the result of external forces, particularly the
dominance of developed countries over developing countries.

• Key Ideas:
o Dependency Theory: Developed countries (the “center”) exploit and control
developing countries (the “periphery”) through mechanisms such as international
trade, investment, and multinational corporations. This exploitation keeps
developing countries underdeveloped and dependent on the developed world.
o Neo-colonialism: After gaining political independence, many developing countries
continued to be economically dependent on their former colonial powers. The
legacy of colonialism, combined with the influence of multinational corporations,
perpetuates this dependence.
o Dualism: The dualism thesis highlights the coexistence of two sectors within
developing countries: a modern, urban industrial sector and a traditional, rural
agricultural sector. This dualism reflects not only economic disparities but also
social and political inequalities.

3.4.1 The Neocolonial Dependence Model

This model emphasizes the exploitative relationship between developed and developing
countries, where the former control and exploit the latter’s resources, labor, and markets. This
relationship leads to a cycle of dependency and underdevelopment in the periphery.

• Key Concepts:
o Elites in developing countries: Local elites, who often collaborate with
multinational corporations and foreign governments, reinforce the dependency of
their countries by benefiting from the existing system.
o International Power Structures: The global economic system is structured in a
way that benefits the developed countries and hinders the economic progress of
developing nations.
o Inequitable Trade Relations: Developing countries often export raw materials at
low prices and import manufactured goods at high prices, reinforcing their
subordinate position in the global economy.
• Key Figures: Prominent thinkers in this field include Andre Gunder Frank, who argued
that underdevelopment is not an original state but a condition imposed on developing
countries through their integration into the global capitalist system.
3.4.2 The False-Paradigm Model

This model criticizes the policy prescriptions given to developing countries by international
organizations like the World Bank and International Monetary Fund (IMF). It argues that these
organizations promote policies based on Western economic models, which may not be suitable
for developing countries.

• Misguided Advice: The false-paradigm model claims that the advice provided by Western-
trained economists and institutions is often inappropriate for the conditions in developing
countries. As a result, these policies may lead to greater inequality and inefficiency rather
than development.
• Examples: Policies such as trade liberalization, privatization, and fiscal austerity have
often been implemented in developing countries with negative consequences, including
rising poverty and unemployment.

3.4.3 The Dualistic-Development Thesis

This thesis emphasizes the coexistence of two sectors in developing economies: a modern,
dynamic sector and a traditional, stagnant sector. This dualism is not just an economic
phenomenon but also a social and political one.

• Key Features of Dualism:

o Different conditions: Dualism reflects a situation where advanced and
underdeveloped sectors coexist in the same economy, with the advanced sector
growing rapidly while the traditional sector remains stagnant.
o Superior and inferior elements: The modern sector benefits from investment,
technology, and productivity, while the traditional sector remains trapped in
poverty, low productivity, and subsistence agriculture.
o Interconnectedness: Despite their differences, the two sectors are often
interconnected. The modern sector may exploit the traditional sector by using its
resources (e.g., labor, land) without fostering its development.
o Persistence: Dualism tends to persist over time, even as the modern sector grows,
because the traditional sector does not benefit from the same investment and growth.
3.4.4 Conclusions and Implications

• External Control: The international-dependence models highlight the role of external

forces, particularly the dominance of developed countries, in shaping the economic
destinies of developing nations.
• Inequality and Exploitation: Developing countries are often trapped in a cycle of
dependency, where they are forced to rely on developed countries for capital, technology,
and markets, which in turn exacerbates their underdevelopment.
• Policy Implications: These models suggest that developing countries should pursue
policies of self-reliance, reduce their dependence on foreign capital and multinational
corporations, and focus on domestic development strategies.