Unit

3 Growth Models and Theories

of Development
This unit covers:
n Development as Growth and the Linear-Stages
Theories
n The Neoclassical Model
n Endogenous Growth Theory
n Structural-Change Model – The Lewis Model
n The Dependency Theory
n The Big-Push Theory
n The O-Ring Model
Development as Growth and the Linear-
Stages Theories
n Theorists of the 1950s and 1960s viewed the
process of development as a series of successive
stages of economic growth through which all
countries must pass.
n The linear stages of growth models share the
central role of savings and capital formation as
their basic theme.
n The two examples of these models are:
ü Walt W. Rostow’s stages of growth theory, and
ü the Harrod-Domar growth model
Rostow’s Stages of Growth

n The most influential advocate of the stages-of-

growth model of development was the American
economic historian Walt W. Rostow.
n According to the theory, the transition from
underdevelopment to development can be
described in terms of a series of steps or stages
through which all countries must proceed.
n Rostow’s five stages are:
ü the traditional society
ü the preconditions for take-off
Rostow’s Stages of Growth

ü the take-off
ü the drive to maturity, and
ü the age of high mass consumption
n One of the principal strategies of development
necessary for any takeoff was the mobilisation of
domestic and foreign saving in order to generate
sufficient investment.
Rostow’s Stages of Economic Growth
The Harrod-Domar Growth Model

n What is the economic mechanism by which more

investment leads to more growth?
n The model was developed independently by Roy
Harrod and Evsey Domar.
n The model is a dynamic extension of Keynes’ static
equilibrium analysis.
n In Keynes’ theory, the condition for a static
equilibrium of income is that plans to invest must
equal plans to save.
n The basic equation of the Harrod-Domar growth
model is as follows:
The Harrod-Domar Growth Model
The Harrod-Domar Growth Model

n The above equation states that in the absence of

government, the rate of growth of GDP (ΔY /Y) will
be directly or positively related to the savings ratio, s,
and inversely or negatively related to the economy’s
capital-output ratio, c.
n That is, the more an economy is able to save—and
invest—out of a given GDP, the greater the growth of
that GDP will be.
n On the other hand, 1/c expresses the efficiency with
which capital is utilized (i.e. the lower the value of c
that an economy can attain, the greater the output
that can be gained from additional investment).
The Harrod-Domar Growth Model

n Thus, it follows that multiplying the rate of new

investment, s = I/Y, by its productivity, 1/c, will give
the rate by which GDP will increase.
n In the aforementioned equation, s is expressed in
terms of gross savings ratio.
n If we want to express it in terms of net savings ratio,
then the growth rate is given by:

where δ is the rate of capital depreciation

The Harrod-Domar Growth Model

n Illustrative Example
n Suppose a country has a gross savings rate of 20%,
a depreciation rate of 3%, and an lCOR of 2.5.
Using the Harrod-Domar growth model, find the
implied rate of growth of total GDP in the country
n How much would the rate of savings have to
increase to raise the growth rate of total GDP to
9%?
n Answer: Growth = s/2.5 – 3 = 9 , so s/2.5 = 12 or s =
30% (that is, up 10 percentage points from 20% to
30%)
 Gross capital formation as percentage of GDP in selected
regions, 1970-2005

40
SSA excluding
35 South Africa

30
South and Central
25 America
20
Eastern and South-
15
Eastern Asia
10 excluding China

5 South Asia

0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
Data source: World Development Indicators
 Investment Ratio in Ethiopia
(percentage of GDP)
SDPRP PASDEP GTP-I GTP-II
45

40

35

30

25

20

15

10

0
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Data source: World Development Indicators & UNSD
Criticisms of the Stages Model

n Necessary versus sufficient conditions

n The Rostow and Harrod-Domar models
implicitly assume the existence of same attitudes
and arrangements in underdeveloped nations
compared to European nations
n There was also insufficient focus on another
strategy for raising growth, i.e. reducing the
capital-output ratio, c , which entails increasing
the efficiency with which investments generate
extra output (i.e. technological progress).
The Neoclassical Growth Model

n The Solow neoclassical growth model

represented the seminal contribution to the
neoclassical theory of growth.
n The model is originated with the work of Robert
Solow in 1956.
n The theory states that economic growth is the
result of three factors – labor, capital, and
technology.
n It differed from the Harrod-Domar formulation
by adding labor and introducing technology to
the growth equation.
The Neoclassical Growth Model

n Unlike the constant-returns-to-scale assumption

of the Harrod-Domar model, Solow’s model
exhibited diminishing returns to labor and
capital separately and constant returns to both
factors jointly.
n Technological progress is the residual factor
explaining long-term growth, and it is
determined exogenously, i.e., independently of
all other factors in the model.
n Hence, the Solow neoclassical model is
sometimes called an exogenous growth model.
The Neoclassical Growth Model

n The standard exposition of the Solow growth model

uses an aggregate production function in which

where Y is gross domestic product, K is the stock of

capital L is labor, and A represents the productivity of
labor (i.e. technology), which grows at an exogenous rate.
⍺ represents the elasticity of output with respect to
capital (i.e. the percentage increase in GDP resulting from
a 1% increase in capital) such that ⍺ < 1 and ⍺ + (1 – ⍺ ) = 1
The Neoclassical Growth Model

n Since ⍺ is assumed to be less than 1, this formulation

yields diminishing returns both to capital and to
labour.

where lowercase variables are expressed in per-worker

terms.
n The above equation states that output per worker is a
function that depends on the amount of capital per
worker.
A Cobb-Douglas Production Function
The Neoclassical Growth Model

n The second key equation of the Solow model is an

equation that describes how capital accumulates.

where 𝛿 is the depreciation rate and n is the rate of

growth of the labour force
The Neoclassical Growth Model

n This equation shows that the growth of k depends on

savings sf(k) or sy, after allowing for the amount of
capital (per worker) required to replace depreciating
capital, 𝛿k, plus nk, the amount of capital (per
worker) that needs to be added due to population
(labour force) growth.
The Solow Diagram
The Neoclassical Growth Model

n The difference between the curve sy and (n+ 𝛿)k

is the change in the amount of capital per
worker.
n For simplicity, let’s assume that A remains
constant.
n In that case, there will be a state in which output
and capital per worker are no longer changing,
known as the steady state.
n Therefore, a steady state is a point at which sy =
(n + 𝛿)k.
The Neoclassical Growth Model

n To find this steady state, set Δk = 0, thus:

where k* is the level of capital per worker when the

economy is in its steady state.
n This equilibrium is a stable equilibrium, i.e. if k is
higher or lower than k*, the economy will return
to it.
n Thus the Solow model has a single equilibrium
income per worker.
Equilibrium in the Solow Model
The Neoclassical Growth Model

n In contrast, in the Harrod-Domar model, there is

no equilibrium income per worker, i.e., the
model exhibits a constant, balanced growth.
n This is because f(k)—and hence sf(k)—does not
exhibit diminishing returns; rather, it is a straight
line.
n Provided that the line sf(k) is above the (n+ 𝛿)k
line, growth in capital per worker—and output
per worker—would continue indefinitely.
The Neoclassical Growth Model

n What happens in the Solow growth model if we

increase the rate of savings, s?
n Unlike in the Harrod-Domar model, in the Solow
model an increase in s will not increase growth in the
long run – but only temporarily as the economy
moves toward the higher equilibrium capital per
worker.
n That is, after the economy has time to adjust, the
capital-labour ratio increases, and so does the output-
labour ratio, but not the rate of growth.
n Thus, unlike the Harrod-Domar model, s is necessary
but not sufficient condition for growth.
The Long-Run Effect of Changing the Saving Rate in the
Solow Model
The Neoclassical Growth Model

n So far we have set A to 1; but it can grow over time,

representing productivity growth.
n According to Solow, long run growth is only possible
through technological progress.
n Technology is the way inputs to the production
process are transformed into output.
n If there is technological progress, income per worker
can increase proportionately.
n Thus, in a steady state with technological change,
output and capital grow at a constant rate
determined by the rate of technological change.
Endogenous Growth Theory

n Neoclassical theory credits the bulk of economic

growth to an exogenous or completely
independent process of technological progress,
commonly referred to as the Solow residual.
n Thus, in the absence of external “shocks” or
technological change, which is not explained in
the neoclassical model, all economies will
converge to zero growth.
Endogenous Growth Theory

n The neoclassical approach has at least two

drawbacks:
ü it is impossible to analyze the determinants of
technological advance because it is completely
independent of the decisions of economic agents.
ü the theory fails to explain large differences in residuals
across countries with similar technologies
n According to endogenous growth theory, GDP
growth is determined by the system governing the
production process rather than by forces outside that
system.
n Hence the name endogenous growth theory or, more
simply, the new growth theory.
Endogenous Growth Theory

n The most significant theoretical differences with

the traditional neoclassical theory stem from:
ü discarding the neoclassical assumption of
diminishing marginal returns to capital
investments
ü permitting increasing returns to scale in aggregate
production
ü focusing on the role of externalities by assuming
complementary investments in human capital
(education), infrastructure, or R&D that offset the
natural tendency for diminishing returns
Endogenous Growth Theory

n Many endogenous growth theories can be expressed

by the simple equation
Y = AK
where A represents any factor that affects technology,
and K includes both physical and human capital
n Unlike the Solow model, new growth theory models
explain technological change as an endogenous
outcome of public and private investments in human
capital and knowledge-intensive industries.
n In contrast to the neoclassical theory, endogenous
growth models suggest an active role for public
policy in promoting economic development.
Endogenous Growth Theory

n The Romer Model

n We use a simplified version of Romer’s model to
illustrate the endogenous growth approach.
n This model addresses technological spillovers (in
which one firm or industry’s productivity gains
lead to productivity gains in other firms or
industries).
n The model begins by assuming that growth
processes derive from the firm or industry level.
n Each industry individually produces with
constant returns to scale.
Endogenous Growth Theory

n The Romer Model

n Formally,

n Romer departs from Solow by assuming that the

economy wide capital stock, , positively affects
output at the industry level, so that there may be
increasing returns to scale at the economy wide
level.
n Each firm’s capital stock includes its knowledge.
Endogenous Growth Theory

n The Romer Model

n The knowledge part of the firm’s capital stock is
essentially a public good that is spilling over
instantly to the other firms in the economy.
n We can think of this model as endogenizing the
reason why growth might depend on the rate of
investment.
n That is the rate of investment is positively related
to the rate of technological progress itself.
Endogenous Growth Theory

n The Romer Model

n If we assume symmetry across industries, so each
industry will use the same level of capital and
labor, then we have the aggregate production
function:

n This exhibits increasing returns to scale.

Criticisms of Endogenous Growth Theory

n The new growth theory remains dependent on a

number of traditional neoclassical assumptions
that are often inappropriate for developing
economies. For example,
ü It assumes that all sectors are symmetrical. So it
does not take into account the structural change
aspect.
ü It overlooks the impediment to economic growth
in developing countries arising from poor
infrastructure, inadequate institutional structures,
and imperfect capital and goods markets.
Structural-Change Theory

n According to structural-change theory

development requires more than just accelerated
capital formation – it requires structural
transformation or change.
n Structural change refers to long-term and
persistent shifts in the sectoral composition of
economic systems.
n And industrialisation is the central process of
structural change.
n One of the best-known approach that focused on
structural transformation is the Lewis two-sector
model.
The Lewis Two-Sector Model

n The model was formulated by

Nobel laureate W. Arthur Lewis
in the mid-1950s.
n The Lewis model became the
general theory of the
development process in surplus
labour developing nations.
n In this model surplus labour
refers to the portion of the rural
labour force whose marginal
productivity is zero or near to
zero.
The Lewis Two-Sector Model

n Thus such surplus-labour can be withdrawn

from the traditional agricultural sector without
any loss of output.
n In the Lewis model, the underdeveloped
economy consists of two sectors:
ü a traditional overpopulated subsistence sector
characterized by zero or near to zero marginal
labor productivity, thus resulting in surplus
labour, and
ü a high-productivity modern urban industrial
sector into which labour from the subsistence
sector is gradually transferred.
The Lewis Two-Sector Model

n The primary focus of the model is on both the

process of labor transfer and the growth of output
and employment in the modern sector.
n The speed with which output expansion in the
modern sector occurs is determined by the rate of
industrial investment and capital accumulation in the
modern sector.
n Such investment is made possible by the excess of
modern-sector profits over wages on the assumption
that capitalists reinvest all their profits.
n Lewis also assumed that the level of wages in the
urban industrial sector was constant and above that
of the subsistence sector.
The Lewis Model of Modern-Sector Growth in a Two-Sector
Surplus-Labour Economy
The Lewis Two-Sector Model

n Lewis makes two assumptions about the

traditional sector:
ü first, there is surplus labour in the sense that MPLA
is zero, and
ü second, all rural workers share equally in the
output so that the rural real wage is determined
by the average and not the marginal product of
labour.
n Lewis also assumed that the level of wages in the
urban industrial sector was constant and above
that of the subsistence sector.
The Lewis Two-Sector Model

n This process of modern-sector growth and

employment expansion is assumed to continue
until all surplus rural labour is absorbed in the
new industrial sector.
n Thereafter, additional workers can be withdrawn
from the agricultural sector only at a higher cost
of lost food production.
n Thus, the labour supply curve becomes
positively sloped as modern-sector wages and
employment continue to grow.
n This is known as the Lewis turning point.
Criticisms of the Lewis Model

n The following key assumptions of the model do

not fit the institutional and economic realities of
most contemporary developing countries.
ü Rate of labor transfer and employment creation
may not be proportional to rate of modern-sector
capital accumulation
The Lewis Model Modified by Laborsaving
Capital Accumulation
Criticisms of the Lewis Model

ü Questionable assumption of surplus labor in rural

areas and full employment in urban (there is
growing prevalence of urban surplus labor as
well)
ü Questionable assumption of a competitive modern
sector labor market that guarantees the continued
existence of constant real urban wages.
ü Institutional factors have a small (if any) role in
this approach
ü Debatable assumption that capitalist profits are, in
fact, reinvested in the local economy and not sent
abroad as a form of “capital flight”
Criticisms of the Lewis Model

n Thus the model – though valuable as an early

conceptual portrayal of the development process
– requires modification in assumptions and
analysis to fit the reality of most contemporary
developing nations.