NS4053 Winter Term 2014

Theories of Economic Development

Stage Theories

Economic Development Theories I

• A number of theories or approaches to economic development

• Theories attempt to capture key interrelationships among economic variables

• Purpose is to explain the causal relationships among these variables

• Intent is not only to understand the world better but also provide a basis for policy

• Impossible to consider all the factors influencing economic development is a single theory

• Must determine which variables are crucial and which are irrelevant

• Still reality is so complicated that a simple model may omit critical variables in the real world

• Each theory may be best for a specific setting but not all situations. 2

Economic Development Theories II

• Broad Classes of Theories• Stage Theories

• Rostow – 5 stages

• Bremer and Kasarda – failed take-off – New Second World

• Porter – modern upgrading

• Sachs – environmental settings

• World Economic Forum competitiveness stages (empirical section)

• Trap Theories

• Vicious Circles

• Balanced vs. Unbalanced Growth

• Big Push Theories

• Middle Income Trap• Sector/Dualism Models

• Lewis – classical model

• Fei-Ranis – two sector3

Rostow Stage Theory I

• Rostow Stage Theory• Basic idea that when economic change occurs, it

occurs quickly• growth not a continuum, but rather goes

through a particular sequencing• Main stages of growth in Rostow:

• Traditional society

• The preconditions for takeoff

• The takeoff

• The drive to maturity and

• The age of high mass consumption

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Rostow Stage Theory II• Stage 1: Traditional Society• Rostow does not have much to say about this state• Presumably based on attitudes and technology before

turn of eighteenth century• After Newton widespread belief that external world

• subject to a few knowable laws

• systematically capable of productive manipulation

• Stage 2: Precondition Stage• Stage includes radical non-industrial changes through

• Increased transport investment to enlarge market and production specialization

• Revolution in agricultural to feed a growing urban population

• Expansion of imports including capital financed by exporting natural resources

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Rostow Stage Theory III

• Changes in the preconditions stage including including increased capital formation require a political elite interested in economic development

• This interest may be stimulated by:

• Nationalist reaction against foreign domination

• Or simply desire to have a higher standard of living

• Stage 3: Take-off• Central stage in Rostow framework• Entails a decisive expansion occurring over

twenty to thirty years – during which time

• There is a radical transformation of a country’s society

• Barriers to growth finally overcome

• Forces making for widespread progress dominate society so that growth becomes normal 6

Rostow Stage Theory IV

• Takeoff is a dramatic movement in history

• Major take-offs cited by Rostow

• Beginning of the industrial revolution in late eighteenth-century Britain

• Pre-Civil War railroad and manufacturing development in the U.S.

• The period after the 1848 revolution in Germany

• The years after the 1868 Meiji restoration in Japan;

• Rapid growth of the railroad, coal, iron and heavy engineering industries in the quarter century before 1917 Russian Revolution

• Periods starting within a decade of India’s independence (1947) and

• Communist victory in China (1949)

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Rostow Stage Theory V

• Three conditions must be satisfied for the take-off:

• 1. Net investment as a percentage of Net National Product (NNP) increases sharply:

• from 5% or less to greater than 10%

• If an investment of 3.5 % of NNP leads to growth of 1% yearly then 10.5% of NNP is needed for a 3% growth

• 2. At lease one substantial manufacturing sector growth rapidly

• Growth of a leading manufacturing sector spreads to its input suppliers

• Ideal industry – spectrum of backward linkages

• Indirect linkages also important

• Historically textiles: wide indirect effects on demand for coal, iron, machinery and transport

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Rostow Stage Theory VI

• 3. Political, social and institutional framework• Quickly emerges to exploit modern expansion implies:

• Mobilizing capital through retained earnings from rapidly expanding sectors

• An improved system to tax high income growts, especially in agriculture

• Developing banks and capital markets• Where state initiative is lacking the culture must

support a new class of entrepreneurs prepared to risk innovation

• Stage 4: Drive to maturity• A period of growth that is regular, expected, and self-

sustained• Labor force that is predominantly urban, increasingly

skilled, less individualist, and more bureaucratic• Workers look increasingly to the state to provide

economic security9

Rostow Stage Theory VII

• Stage 5: Age of high mass consumptions

• Reached in the U.S. in 1920s

• Western Europe in 1950s

• Characterized by automobile, suburbanization and a wide spectrum of consumer goods

• Rostow: other societies may choose a welfare state or international military and political power

• Critique of Rostow

• Rostow in vogue with U.S. government officials in the 1960s especially in international aid agencies

• Held out hope for sustain growth in developing countries after substantial initial infusions of foreign assistance

• The main criticisms center around historical fact and conceptual vagueness in the Rostow model

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Rostow Stage Theory VIII• Historical facts

• Many historians see that the advanced countries experienced gradual growth occurring over long periods of time rather than a rapid takeoff

• Historians do not find rapid accelerations in investment and growth in the now advance countries

• Rostow’s conditions defined so vaguely that they stretch to cover any case

• Conceptual problems

• Rostow’s stages imprecisely defined are difficult to test scientifically

• If stages are to explain how development is caused – must be defined in terms other than economic development – the variable the theory is trying to explain

• Traditional society and high mass consumption define rather than explain reasons for development

• Past economies – primitive, ancient, medieval and those of the presently developed countries of a century or tow are all placed in a single category, traditional society.

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Rostow Stage Theory IX

Various criticisms of Rostow:•Theory does not take into account dualism – countries where a modern sector coexists with more backward activities – theory implies homogenous economies•Frequently characteristics of one of Rostow’s stages are not unique to it•Why would the agricultural revolution, capital imports and social overhead investment of preconditions stage not be consistent with the abrupt increase in investment rates during take-off stage•Why would the development of leading sectors or emergence of an institutional framework exploiting growth not take place in preconditions stages as well as during take-off?•Why would the abrupt increase in growth and investment rates during takeoff not continue through drive to maturity?

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Rostow Stage Theory X• Unlike Marx, Rostow’s approach does not show how

the characteristics and processes of one stage move society to the next stage

• How do we explain the reactively effortless self sustained growth after take-off?

• Presumably some obstacles to growth have been removed

• What are they and how does his theory explain their removal

• Rostow’s premise is that economic modernization implies a change from an underdeveloped economy to one similar to those in North America and Western Europe -- many variants of development

• Rostow assumes one path to development – as has turned out may variations with somewhat different sequencing

• In retrospect neglected institutional/governance change that sets stage for further growth and development

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Brenner/Kasarda Stages I• One of the major flaws of the Rostow theory was that

it did not anticipate failed-takeoffs.• According to Rostow once a country took off,

continued growth was assured• Brenner and Kasarda’s stage model provides an

explanation for failed takeoffs• Their model, “New Second World” has three phases.• The first or early phase begins when a low income

country starts to industrialize rapidly• An agrarian transition is often launched and • the complex transformations – urbanization, income

growth and economic diversification accompany• Process similar, but not identical to Rostow’s take

off if countries growth for a decade or more.• In this case, country reaches the middle New Second

World phase14

Brenner/Kasarda Stages II

• In the second phase, industrial production per capita may now be around three times what it was whan the transition started

• Growth in low-value-added manufacturing is rapid and sustained.

• Incomes rise and a middle class emerges• If this middle phase continues for 10-20 years, the

country would likely reach the advanced phase – often a time of recurring economic crisis and political turmoil

• Many countries in the first stage have failed to move forward to the middle stage largely because of growth-limiting policies and institutional rigidities

• Failure to make progress through the early stage as it did in post World War I Russia and now much of the Middle East can lead to violence

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Brenner/Kasarda Stages III

• Those who don’t make it out of the first stage have comment elements:

• Slowness in adopting choice-based systems: systems encompassing both market-based economies and

• democratic political institutions and organization

• No indexes of choice-based systems exist• Closest proxy is Frasier Institute’s Economic Freedom

Index – basically property rights and free choice• If reforms not undertaken – take-off fails and

individual dashed hopes, frustration/resentment increases – may be a cause of terrorism in some countries

• Transition from second to third stage often derailed by lack of financial reform – Asia Crisis, Argentina

• Can derail countries, resulting in long periods of sup-par growth and internal instability

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Bremer/Kasarda Stage Theory

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Porter’s Stage Theory I• Porter’s model centers around competitiveness and

the ways countries can increase their competitive position

• Main proposition:

• Developing countries are often tripped up by microeconomic failures

• Unless firms are fundamentally improving their operations and strategies and competition is moving to a higher level

• Growth snuffed out as jobs fail to materialize

• Wages stagnate

• Returns to investment prove disappointing

• Successful economic development requires progress on multiple fronts simultaneously

• Reform efforts need to be tightly connected to the current stage of each country’s development

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Porter’s Stage Theory II

• As an economy progresses, the constraints to continued advancement shift

• At strategic points in the development process, the whole basis of national competitiveness must be transformed

• This requires a change in many aspects of company strategy as well as new requirements for the national business environment

• Central challenge in economic development is how to create conditions for rapid and sustained productivity growth

• Stable political/legal institution and sound macroeconomic policies create the potential for improving national prosperity

• But wealth is actually created at the micro-economic level –in the ability of firms to create goods and services using productive methods

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Porter’s Stage Theory III• The microeconomic foundations of productivity rest on:

• The sophistication with which companies in the country compete, and

• The quality of the micro-economic business environment• The sophistication of companies is intertwined with the

quality of the business environment• More sophisticated strategies by companies require

• More highly skilled people, better information,

• Improving infrastructure, more advanced institutions and

• Stronger competitive pressures• Private sector not only a consumer of the business

environment but also plays a role in shaping it

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Porter’s Stage Theory IV• Moving to more sophisticated ways of competing depends

on parallel changes in the business environment• The business environment consists of fur interrelated

influences:

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Porter’s Stage Theory V• Government can play a significant role in development

because it affects many aspects of the business environment:

• Quality of factor conditions through its training and infrastructure polices

• Sophistication of home demand derives in part from regulatory standards and processes, consumer protection laws government purchasing and openness to imports

• Successful economic development is a process of successive upgrading in which the business environment evolves to support and encourage increasingly sophisticated and productive ways of competing

• Nations at different levels of development face distinctly different challenges

• Explains why so many disagreements in international organizations such as WTO – countries positions on key issues often conflict with best interests of other countries. 22

Porter’s Stage Theory VI

• Economic development is therefore a sequential process

• The influence of one part of the microeconomic business environment depends on others with certain elements more critical at different stages of development

• Three main stages defined in terms of their characteristic competitive advantages and modes of production

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Porter’s Stage Theory VII

Factor Driven Stage: •Basic factors conditions such as low-cost labor and access to natural resources are dominant sources of competitive advantage and international products•Firms produce commodities or relatively simple products designed in other more advanced countries•Technology assimilated through imports, foreign direct investment and imitation•Companies compete on price and lack direct access to consumers•They have limited roles in value chain and are focused on assembly, labor intensive manufacturing and resource extraction•Environment highly sensitive to world economic cycles, commodity price trends and exchange rate fluctuations

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Porter’s Stage Theory VIII

Investment Driven Stage•Efficiency in producing standard products and services becomes dominant source of competitive advantage•Products and services produced become more sophisticated, but technology and designs largely from abroad•Countries not only assimilate technology but also develop the capacity to improve on it•National business environment supports heavy investment in efficient infrastructure and modern production methods•Economy concentrated on manufacturing and on outsourced service exports•It is susceptible to financial crisis and external, sector-specific demand shocks 25

Porter’s Stage Theory IX

Innovation-Driven Stage•Ability to produce innovative products and services at the global technology frontier, using the most advanced methods becomes the dominant source of competitive advantage•National business environment is characterized by strengths in all areas, together with presence of deep clusters•Institutions and incentives supporting innovation are well developed•Companies compete with unique strategies tha are often global in scope•An innovation-driven economy has a high service share and is resilient to external shocks

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Porter’s Stage Theory X

• Empirical Testing: Business Environment and Productivity (per capita income)

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Porter’s Stage Theory XI

• Current Competitiveness Index: Country Ranking

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Porter’s Stage Theory XII• Porter’s framework shows why countries find transition to

a new stage development difficult• Such inflection points require wholesale transformation of

many interdependent dimensions of competition• Many countries find that their reliance on sustained

infrastructure investments, original equipment manufacturing for multinationals and government guidance of the economy to boost efficiency are insufficient to support higher levels of prosperity

• Yet current level of wages and domestic costs makes them vulnerable to competition from lower wage countries

• Need to move to innovation driven economy

• To do this companies need to • move to new types of strategies, • Change investment priorities

• Government’s role in the economy needs to shift

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Defining Iraq's Post-war Economy

Iraq's post-war economy was a complicated mix of different models, each of which required a different policy remedy

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Model RemedyTransition Economy Creation of a market system, with openness to

trade and integration into global economy.Failed State Restoration of law and order, government

services and an open trade regime to resolve group grievances and halt economic decline

Rentier Economy Diversification away from oil and curbing the government’s authoritarian tendencies

Post-conflict Economy Restoration of social and physical capital, as well as stability, before initiating economic reforms.

Failed Take-off EconomyIncreased economic freedom, improved regulatory institutions and anti-corruption measures.

Post-War Economic Strategy I

• US post-war economic strategy in Iraq was initially based largely on only the Transition Economy/Shock Therapy model:

• This model is an extreme version of shock therapy focus on long-term efficiency

• Its goal was to wipe the slate clean and start the economy anew

• The strategy aimed to create an open economy with low taxes to promote foreign private investment

• Its emphasis was on creating macroeconomic stability and an independent central bank, with government remaining largely passive in dealing with economy

• It aimed for high job creation through rapid private sector investment and expanded output, with foreign direct investment (FDI) and profitable imbalances from massive reconstruction projects as its key ingredients--an unbalanced development strategy 31

• The post-war economic strategy assumed that the government must reduce its role in the economy, expand the play of market forces, and undertake key reforms:

• Liberalizing economic activity, prices and market operations

• Establishing political accountability for economic performance, as well as public responsiveness to private sector economic needs

• Developing indirect, market-oriented Instruments for macroeconomic stabilization

• Using these instruments to increase market-based employment opportunities for Iraqis

• Achieving effective enterprise management and economic efficiency, usually through privatization

• Second-stage -- establishing an institutional framework to secure property rights, rule of law, and transparent market-entry regulations.

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Post-war Economic Strategy II

Post-War Strategy Dynamics

• Iraq’s post-war strategy was intended to create Porter-type mechanisms of private-sector-induced reforms

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Flaws in Initial Economic Strategy

• With time, it became apparent that initial economic strategy was unsuited to Iraqi reality. It created an environment more favorable to criminals and extremists than to private investors intent on rebuilding the economy

• The economic plan shut large numbers of Iraqis with no skills or capital out of the economic process and fueled widespread anger

• It was impossible to attract the private investment on which the strategy depended in the face of political and economic uncertainty

• The inability to produce sustainable short-run economic gains made economic reforms an easy target for extremist groups

• US-led initial reforms did not lead to second stage of Iraqi-led institutional reforms but, instead, created a vacuum that was filled by existing organized religious and criminal groups

• The incomplete reforms and inadequate price controls created profitable Black Market opportunities

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Sachs: Patterns of Development I

• Sachs approach not a stage theory like Porter• Rather wants to tailor make analysis to groups

of countries that share unique environments• Identifies five different patterns of development

– each related to

• underlying geography,

• economic policies and

• resource endowments

• Group 1: Endogenous growth – (similar to Porter’s final stage)

• Countries have self sustaining increases in income generated by technological innovation

• Innovation raises national income, which in turn stimulates further innovation in a positive feed-back process 35

Sachs: Patterns of Development II

• Group 2: Catching up Growth (similar to Porter’s intermediate stage)

• Countries with low-level technology and incomes narrows the income gap with the higher technology and richer countries through a process of technological diffusion and capital inflows

• Group 3: Resource Based Growth

• Economies experience cycles of per capita income mainly as the result of resource booms and busts

• Group 4: Malthusian Decline

• Countries in this group often have falling per capita income caused by population pressures outstripping the carrying capacity of the local economy

• Country neither innovating nor successfully adopting technologies from abroad

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Sachs: Patterns of Development III

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Sachs: Patterns of Development IV

• Group 5: Economic Isolation

• Economic disadvantage that results from an economy’s physical or policy-induced isolation from world markets

• Policy Implications for Each Group

• Group 1: Endogenous growth countries

• Innovation rather than capital accumulation the main factor in growth and income increases

• In theory

• These countries might not hit diminishing returns but

• Could accelerate growth over time through investments in R&D, knowledge bases and education

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Sachs: Patterns of Development V

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Sachs Patterns of Development VI

• Group 2: Catching up Countries• Growth greatly influenced by technological diffusion

from abroad• Problem: countries that rely wholly on imported

technologies will lag behind technological innovators even if they are able to absorb new technologies of the leading countries at a high rate

• Therefore should strive to support home-grown innovation to eventually become endogenous growth economies in their own right

• Typically requires

• substantial public investment in education and government scientific laboratories

• carefully designed laws governing intellectual property rights

• increased interaction of government laboratories, universities and private business

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Sachs: Patterns of Development VII

• Group 3: Resource based growth• In the past half century natural-resource-rich countries have

faired poorly -- generally growing less rapidly than resource scarce economies

• Several theories offered:

• Prebisch theory –

• natural resource economies vulnerable to a secular loss in the terms of trade

• caused by technological innovations in leading countries leading to substitutes for natural resources

• Dutch Disease effects

• Strengthening of exchange rates in boom years leads to loss of competitive exporting countries, overdependence on resource rents

• Failure of Governance

• Much time and effort spent rent-seeking

• Institutions to sustain non-resource development not developed

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Sachs: Patterns of Development VIII

• Resource Economies - best strategies• Diversify – lay foundation for non-resource development• Entails investing in human capital• Strong exchange rate will not block new sectors if skills

of labor force are also increasing• Group 4: Malthusian Decline Countries• Many experiencing long-term decline in living standards

that transcends terms-of-trade shocks of cyclical phenomena

• Often severe demographic pressures due to high birth rates

• Many African countries facing infectious diseases and low levels of food production

• Vicious cycle of undernourishment and vulnerability to diseases

• Need to break cycle before development can proceed

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Sachs: Patterns of Development IX

• Group 5: Economically Isolated Countries• Problem: sea based freight still the cheapest form

of international transportation• Countries far from coastal ports face tremendous

burden in shipping bulky products• 28 landlocked countries with a population of at

least one million• None are rich or growing rapidly on a consistent

basis• Hindered by geographical location• Foreign investors do not view these countries as

effective platforms for export oriented investment• Hard to attract kind of assembly operations which

have been important stepping stones in countries with more favorable location

• New information technologies may be best strategy – requires large investments in education.