Economic theory of development

September 5, 2016
8 28.8.2015 Economic theory of
"The real differences are not quantitative, but qualitative. Egypt's inability to raise its standard of living has more to do with its social, political, and economic institutions and with its perceptions of past, present, and future than with any lack of effort or personal talents" Fred Gottheil, Principles of Macroeconomics 3e, p. 426.

the stages of economic growth

The Stages of Growth: A Non-Communist Manifesto, Walt Whitman Rostow, 1960.

The theory is intended as a direct counter to the Marxist stage theory of capitalist development. The basic proposition is that all countries are located in one of a hierarchy of developmental stages:

  1. traditional society
  2. transitional stage: the preconditions for take-off
  3. take-off
  4. drive to maturity
  5. high mass consumption
In stages four and five nations achieve stable conditions for self-sustaining growth and wealth creation. This notion presents a direct challenge to the Marxist argument of a violent end to the capitalist system.

The launching platform for development is in the preconditions stage.

  • Agriculture moves more toward market orientation in which food and raw materials become available to other sectors of the economy. The agricultural sector develops beyond subsistence with production for the market.
  • Transportation and other social infrastructure develop.
  • Export expansion is necessary in order to finance the increased capital imports needed for a strong foundation for economic growth.
The critical stage is the take-off stage. At this time the rate of investment increases sharply. Leading economic sectors emerge and create investment opportunities in other parts of the economy. This ensures the self-sustained growth of the drive to maturity and high mass consumption stages.

Study Questions:
Profile less developed countries (LDCs) using as many of the 10 criteria given in the lecture as you feel are necessary to provide an adequate picture of life in a LDC.

Harrod-Domar Growth model

Harrod, R. F. (1939), "An Essay in Dynamic Theory, " Economic Journal, Vol. 49, No. 1.

Domar, D. (1946), "Capital Expansion, Rate of Growth and Employment, " Econometrica, Vol. 14.

Neither of the articles was concerned with developing countries. Each dealt with conditions for stable growth in more developed countries. Nevertheless the articles have had a great impact on economic development theory.


  1. Aggregate demand and supply would be in balance when investment (It) in any period equaled the change in national income (Yt -Yt-1) times the capital to output ratio (k). The capital to output ratio indicates the value of capital required to produce one unit of output in a single time period.
  2. At equilibrium in a closed economy intended investment would equal intended savings (St), which gives the initial equilibrium condition.

The rate of growth is determined jointly by the national savings ratio and national capital to output ratio. The more a nation can save and invest the quicker it can grow!

e.g. assume k = 3, s = 6%
but, if one can increase national savings from 6% to 15%
This helped Rostow to define the "take-off" stage. If a country could just save 15% to 20% it could develop and grow at a much faster rate than those who saved less. This growth would be self-sustaining.

The primary policy implication is that the needed investment resources could be met through foreign aid.

Study Question:
Describe the Harrod-Domar Growth Model including equations and policy implications.

two-gap model

The two-gap model is an extension of the Harrod-Domar growth model. The second "gap" (in addition to the savings gap) is found by introducing foreign trade and rephrasing the model such that:
savings gap - domestic savings are inadequate to support the level of growth which could be permitted given the import purchasing power of the economy and the level of other resources

foreign exchange gap - import purchasing power conferred by the value of exports plus capital transfers may be inadequate to support the level of growth permitted by the level of domestic saving

The two-gap theory purports that investment and development are restricted by level of either domestic saving or import purchase capacity.

the vicious circle of poverty

The vicious circle of poverty is perpetuated by the lack of capital.
The way to break the cycle is to increase savings and therefore increase capital stock which will lead to increased productivity and higher income. With higher income the vicious cycle is broken.

Study Question:
Describe W. W. Rostow's Stages of Growth model for LDC development.

the big push/balanced growth

Rosenstien-Rodan, Paul N., "Problems of Industrialization of Eastern and Southeastern Europe, " Economic Journal (June - Sept. 1943), p. 202-211.

  • Industrialization is "the way of achieving a more equal distribution of income between different areas of the world by raising incomes in depressed area at a higher rate than in rich areas."
  • Use more capital in both agricultural and non-agricultural sectors, but the stress was on the industrial sectors.
  • Rejects the Rostowian view that development proceeds from more to less developed areas.
  • The "big push" was needed because industrial firms were more capital intensive.
  • The big push was to develop industry and not agriculture, although agriculture could not be ignored. This was the way to break the vicious circle of poverty!
  • Establish large number of factories, each producing a different product. This would include all factory workers as well as initial buyers because supply would not create its own demand.
  • Firms would be profitable. One big push would assure there would be a sufficient market for incentive to invest.
  • The big push would create external economies (services such as warehousing, deliveries, cleaning, and security) which would provide cost reductions to an individual firm that was made possible by the proximity of a large number of firms.
  • The big push - sudden sharp increase in the rate of investment (capital formation) required large scale government planning. this notion took for granted the appropriateness of capital intensive techniques.
unbalanced growth

The Strategy of Economic Development, A. O. Hirschman, Yale University Press, 1958.

Unbalanced growth recognized both backward (inputs create demand for other products) and forward (inputs to other industries).

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