IB Economics/Development Economics/Sources of Economic Growth and/or Development

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5.1 Sources of Economic Growth and/or Development[edit | edit source]

Development (Todaro): multidimensional process (ideally each outcome will have its own indicator) involving the reorganization and reorientation of entire economic and social systems:

  • Producing more necessities/needs (i.e., food, shelter and health care) and broadening the distribution.
  • Increasing standard of living and self-esteem.
  • Expanding economic and social choices.
  • Reducing fear of the future.

Development (Rubenstein): improvement of material conditions in economic, social and demographic characteristics through diffusion of knowledge and technology.

Development (Seers): concerned with outcomes, as development happens with reduction/elimination of poverty, unemployment and inequality within a growing economy.

Development (Green): dynamic process of increasing choices available to people.

Increasing Standard of Living: prosperity of a country/individual (measured by GDP/capita, quality of housing and food, medical care, educational opportunities, transportation, communications, and others); more of an entire country/region relative measurement.

Increasing Quality of Life: includes housing, food, education, clothing, transportation, and employment opportunities, environmental and recreational benefits, as well as social infrastructure (e.g., availability of child care, in attracting/retaining businesses in a community); more an individual relative measurement.

Economic development: occurs if there is a reduction in poverty, inequality, and unemployment - having more choices for the population is essential - this will include increasing the access to and the means to obtain improved food, shelter, health and protection under law (rule of law).

  • If growth occurs with no improvement in living standard for most of the population, then economic development has not taken place
    • Trickle down theory (market economy): an early theory which assumed that economic growth, leading to greater prosperity, would diff.use from the rich to the poor raising overall living standards.
    • Development plan (central planning): must include targets and policies for reducing poverty, inequality and unemployment.

There are about 144 developing economies (LEDCs) in the world, of which 83 have fewer than 5 million people.

  • LEDCs tend to have low standards of living, and low GNP per capita.
    • Low income countries receive $700 per capita, middle income countries receive from $700 to $8,000 per capita.
    • They tend to have a high population growth rate
  • More than 50% of the population is involved in primary production:
  • Primary goods are the most prominent exports.
  • Mining tends to be dominated by MNCs (multinational corporations)/TNCs (transnational corporations).
  • Infrastructure, often built by colonial powers, is designed to move primary goods to the coast for shipment overseas.
  • All sectors are characterised by low productivity and high unemployment:
  • Capital equipment and technology is likely to have been imported.
  • Processing and manufacturing for export is discouraged because MEDCs tend to raise trade barriers against higher value added goods.
  • Economic power is unequally distributed both internally and externally.
  • Latin American and Asian countries tend to have more private enterprise, African countries tend to have greater state ownership of enterprises.

Measuring Development

Measuring Growth

Economic growth is an increase in the real level of national output of a country, as measured by GDP

  • The share of a sector or component of GDP such as manufacturing or agriculture is measured by the value added contributed by that sector.
  • Value added: the addition to value of a product during a stage of production.
  • Value added in the cotton textile industry: the value of the textiles when they leave the factory minus the value of raw cotton used in their manufacture.
  • This is equal to payments to the factors of production: wages paid to labour plus profits, interest, depreciation of capital, and rents for buildings and land.
  • If economic growth is 1%, it will take approximately 72 years for the value of the economy to double.
  • If the growth rate is 10% it will only take 7.2 years for the economy to double.

Growth Theories.

  • The trickle down theory has failed to happen in most LEDCs - while the emphasis on growth has switched more toward development, growth is still of great concern as it is a necessary foundation for economic development (makes development much more likely).
  • Growth occurs:
  • Through increases in the factors natural resources and capital.
  • It also occurs by increasing the productivity of existing factors through investment in education (labour) and technology (capital).

Stages of Growth.

  • Countries appear to go through distinct stages of growth, and are arrayed along the following spectrum:
  • Low income LEDCs (HIPCs=Highly Indebted Poor Countries) are characterized by subsistence agriculture with a manufacturing and service sector producing goods and services using simple technologies to service the rural sector (food processing, textiles), perhaps exporting basic commodities.
  • Middle income LEDCs are further up the escalator and are involved in processing raw materials for export and producing basic chemicals, steels, some farm machinery, clothes for export, and perhaps some tourism.
  • The NICs, newly industrialized countries are involved in manufacturing clothes, cars, some simple electronics for export
  • MEDCs are heavily involved in manufacturing higher value added products, e.g., luxury cars, sophisticated electronics and simple services such as tourism
  • High income MEDCs are at the top of the escalator such as the US and Switzerland which put greater emphasis on the production of highly sophisticated services such as research, development, design, marketing, financing, computer software, and management consulting
Transitioning economies (from command to market) have similar characteristics: inflation rate, unemployment rate, difficulty attracting FDI, nonconvertible currency
  • The position of each country on the spectrum is determined by the endowment of natural resources, the historical heritage of experience with commerce, finance, and trade, the size of the country which can lead to economies of scale, and the level of investment in human capital both in terms of education and training and in terms of learning by doing

Factors Contributing to Development/Growth[edit | edit source]

Natural factors: the quantity and/or quality of land or raw materials

  • Many LEDCs have abundant natural resources
  • Agriculture is especially important as an export sector, and is an area for initial mechanisation, productivity gains and growth
  • Agricultural (arable) land is finite and therefore the law of diminishing returns applies as more labour is added to the land - many LEDCs have had problems with severe weather, low agricultural productivity, worsening terms of trade and rising prices for crucial pesticides and fertilisers
  • It is estimated that more than half the renewable natural resources are being utilized in the world - this includes arable land, fisheries, forests, and water
  • There are still significant amounts of non-utilized arable land in some African and Latin American countries

Human factors (labour): the quantity and/or quality of human resources - relatively high population growth rates in LEDCs reduce growth in per capita GDP

Physical capital and technological factors: the quantity and/or quality of physical capital

  • Investment in machinery and equipment add directly to productivity
  • Investment in infrastructure such as roads, bridges, dams, sanitation and electricity are indirectly productive, but equally as essential
  • The opportunity cost of capital investment is the lower levels of current consumption which result from saving
  • Savings present a great hardship for people who may already be living below the poverty line
  • Technology developed in MEDCs is appropriate for labour scarce, rich countries - because it is labour saving, it is inappropriate in labour abundant countries where it is more efficient to use more labour and less capital
  • Capital intensive development often displaces workers and does little to reduce unemployment
  • Factor rewards go to capitalists or investors from foreign countries - it does little to relieve poverty

Institutional Structures that contribute to development:

  • Banking system
  • Education system
  • Health care
  • Infrastructure
  • Political stability
  • Key institutions: property ownership or land tenure, domestic markets (free or controlled), labour markets, education, financial sector (savings and investment, capital markets), international trade (import substitution or export oriented), government (structures and experience), and the colonial creation of artificial countries
  • Countries with a history of stable government and a developed commercial sector including merchants, financiers and businesses familiar with international trade tend to have fewer problems with development
  • Countries with governments previously dominated by colonial powers and with commerce controlled by minorities, find it difficult to compete in international trade and finance

Substituting for Missing Institutions

Is it necessary to substitute for missing institutions in order to enhance the development process in LEDCs?

  • Many countries have managed to develop without the need for accumulated wealth or developed financial sectors (Germany, Russia, Japan)
  • Importing foreign experts with knowledge and experience is not as effective as training and utilizing local talent
  • There is a need to transfer power from old ruling classes with no interest in promoting development for poorer people:
  • Landowners block small farm development to prevent competition, and block growth of industrialists to prevent loss of influence and power
  • Rich industrialists try to block small businesses to prevent competition
  • 'Corporate' unions lobby the govt. for high minimum wages and labour protection laws (making it difficult for business to be competitive), in order to stop erosion of artificially high wages
  • Problem: downtrodden peasants of one generation become materialistic consumers of the next generation who prefer imported goods

The Need for Stable Government

  • Stable government reduces risks for local investors, encourages investment, and reduces capital flight
  • Stable government is more willing to make tough decisions such as devaluation, reducing urban subsidies, reducing overstaffed bureaucracies, reducing tariffs to promote competition and perhaps redistributing income to poorer people
  • Stable government is more able to encourage small scale entrepreneurs to:
  • Take initiative, develop managerial ability and undertake risks
  • Train to overcome weaknesses in marketing, finance and managerial ability

Analysing Economic Growth

  • If we call real output Y, and the stock of capital K, then output can be related to the capital stock:Y=K/k, where k=the capital output ratio (the amount of capital required to produce a unit of output), and is simply a measure of the productivity of capital
  • Growth, g, is simply the rate of change in Y and is related to the investment in the capital stock K, where investment measures the rate of change in K
  • If we designate S/Y as the percent saving rate in the nation and call it s, then: g=s/k
  • Capital created by investment is one of the main determinants of growth and it is savings by people and corporations that pays for that investment


  • Given the formula, planners can decide on the rate of growth, g, and the equation tells them the savings and investment necessary to achieve that growth level
  • Alternatively, planners can decide on the rate of savings and investment that is feasible, and the equation tells them the rate of growth that can be achieved - often referred to as the savings gap, the ‘s’ tells planners how much they need to borrow internationally after deducting what the nation saves domestically
  • Poor countries with low savings rates and unemployed labour can achieve higher growth rates by economizing on capital and utilizing as much labour as possible
  • As economies grow and per capita income rises:
  • Savings rates tend to increase and the labour surplus diminishes
  • Savings become relatively more abundant and hence the price of capital falls while employment and wages rise
  • Producers increasingly economize on labour and use more capital
  • Technological change and learning by doing can play important roles; both can contribute to increased productivity of all factors of production
  • Richer nations like the US, Japan and Norway tend to have higher capital output ratios because capital is less expensive relative to labour than in LEDCs
  • Studies indicate that increases in productivity or efficiency account for a much higher proportion of growth than was believed to be the case
  • Between 50% and 70% of growth can be attributed to increases in factor productivity, including mobilization and improvement in the quality of labour
  • Increases in the capital stock frequently account for much less than half of the increase in output, particularly in rapidly growing countries; however, capital tends to play a larger role in growth in today's developing countries, and some of the increases in efficiency or productivity involve advances in technology that is embodied in capital equipment

Productivity and Growth

Policies to Stimulate Growth

According to the World Bank, rapid growth in Asia is a direct result of policy guidance rather than just a free market - these policies include:

  • Making income distribution more equitable: measured by Lorenz Curve and Gini coefficient
  • Encouraging savings and making banks more reliable
  • Improving primary and secondary education
  • Improving agricultural productivity
  • Facilitating technology transfer and encouraging FDI
  • Streamlining legal and regulatory structures to create a positive business environment
  • Setting industry wide standards and monitoring quality facilitates marketing
  • Targeting key industries for development:
  • Protecting infant industries in the early stages
  • Managing resource allocation
  • Facilitating exports through government-assisted marketing

Low Productivity Leads to Slow Growth

Diminishing returns is the major cause of low productivity in LEDCs

  • There is a scarcity of capital and trained management, ever increasing supplies of labour combine with relatively fixed supplies of land, capital and management
  • Also people need to be healthy and educated in order to be productive; some studies have shown that a third of the working population in very poor countries are afflicted with internal parasites which drain energy rapidly
  • Savings are needed for investment in both physical and human capital, but savings requires a higher income, and higher income requires greater productivity - often referred to as the 'poverty trap'
  • Higher productivity does not require high tech solutions:
  • Billions of dollars in aid for large scale, high tech projects has only increased dependency for the poor rather than increasing productivity
  • What is needed is technology appropriate for the poor which will allow them to help themselves
  • Appropriate technology uses local materials, and local labour skills, and capital that can easily be repaired locally:
  • Simple clay stoves, pipe wells, pipe latrines, micro hydro power transformers, better harnesses for oxen, etc

Growth Through Enhancing Factor Productivity

Natural resources

  • While there is still land to be developed, the bulk of land available to most populations is limited in size
  • Irrigation, drainage, the use of chemicals for fertilizing, pest and weed control, and the use of machinery can increase productivity dramatically
  • The green revolution is an example of this
  • The problem is that the damage to the soil can be so extensive, that the increase in productivity may only last 70 years before the soil is destroyed
  • Already India is starting to seriously question the use of irrigation, machinery and chemicals as soil degradation is very serious


  • If 50% to 70% of economic growth arises from improvements in the productivity of factors, there is a need for better education, greater efficiency in management, and better training in technology
  • LEDCs have made large investments in primary and secondary education
  • Increase in worker skills is essential in order to make use of capital equipment and new technology, and to provide the services needed for growth in the future


  • 85% of the scientists working in research and development live in the US, Japan, and Germany. The new ideas and inventions which are applied through the new technology and capital are dominated by MEDC thinking
  • Only modest amounts are invested in research and development in LEDCs

Growth & Multinational/Transnational Corporations

  • 50 of the top 100 ‘national incomes’ in the world are earned by MNCs/TNCs
  • MNCs/TNCs have no loyalty and are happy to produce and sell anywhere, they are economically powerful and often more influential than the governments they deal with
  • Industrial orientation: 40% of FDI by MNCs/TNCs is for manufacturing, and 60% is for extraction and processing of natural resources:
  • 500 MNCs control 80% of the FDI, 40% of them are US based, and 30% are based in the UK, Germany and Japan
  • Most European and US based MNC/TNCs tend to invest in other MEDCs
  • US owned: US MNCs/TNCs still account for 50% of total FDI in LEDCs - much of the FDI from US based MNCs/TNCs is directed toward the oil industry
  • Japanese owned: 60% of Japanese MNCs/TNCs investment has been in LEDCs
  • LEDC owned: MNCs/TNCs which are LEDC based and invest exclusively in other LEDCs have the fastest growth rate

Growth Through Industrialization

  • Manufacturing has been growing faster than GDP in most LEDCs, but can only absorb 30% of the growing workforce
  • In the early stages of development, manufacturing growth often occurs through backward integration from consumer to producer goods
  • Primary sector growth usually occurs through forward linkages rather than backward linkages
  • Cities have grown rapidly because:
  • There are agglomeration economies (face-to-face contact with bankers, government decision makers, lawyers, marketing, and suppliers)
  • There are external economies (railroads, ports, airports, communications utilities, roads, water and sewage)
  • Businesses prefer large cities, infrastructure costs can be 15% higher in smaller cities

Benefits of Industrialization

  • Industrialization allows economies of scale to be reached in production:
  • Exports: access to larger markets allows minimum efficient scale to be reached more rapidly
  • Research and development: costs are more spread out
  • Heavy industries: economies of scale are important for steels and chemicals
  • Cost savings: size confers concessions and discounts through bulk buying, and lower interest rates when borrowing money
  • Industrialization leads to better firm management:
  • In many industries this is more important than economies of scale
  • Firms become more efficient through the introduction of: subcontracting systems, re sequencing of production systems, and just in time delivery; while the product life cycle can confer temporary monopoly profits
  • The introduction of flexible computer integrated manufacturing has made low cost labour less important for assembly operations
  • Increased productivity enhances the possibilities for import substitution as well as for export promotion
  • Industrialization can ensure that inputs needed to enhance productivity in the primary sector are available
  • Industrialization can enhance job creation:
  • K/L ratios can be as low as 4 to 1 in textiles in LEDCs which contrasts with 80 to 1 in MEDCs, thus providing 20 times as much employment

Balanced Industrial Growth

  • Balanced growth requires countries to develop a wide range of industries simultaneously to achieve sustained growth: on the demand side to absorb the output, on the supply side to prevent bottlenecks
  • Balanced growth is very important for centrally planned economies, without price adjustment, all sectors must be developed simultaneously:
  • Information about shortages in one sector cannot be transmitted properly as prices are not permitted to rise
  • Even if prices were permitted to rise and rates of return were to rise in those industries in response, there are no entrepreneurs to respond to the profit opportunities by investing to reduce the shortages
  • Unbalanced growth typically occurs for a developing country which cannot start up a wide range of industries simultaneously:
  • Import substitution can be followed as a way to ensure a ready market for the output of a domestic industry
  • Alternatively export promotion can be pursued: access to larger markets, economies of scale are quickly reached, and workers learn by doing

Backward and Forward Linkages

  • With unbalanced growth, imports provide what cannot be produced locally
  • Backward linkages can be created as follows:
  • Fabrication: as the imported goods are repaired, domestic industries are set up to supply the parts required rather than importing parts
  • Forward linkages are also created as follows:
  • Adding value: rather than exporting raw materials, processing industries are created to add value to the output, for example iron ore is smelted into steel
  • Once processing is viable, there are opportunities to invest in machinery, metal processing and eventually car part fabrication and assembly plants
  • Both forward and backward linkages set up pressures that lead to the creation of new industries, all operating through the profit driven investment process
  • Governments build the infrastructure necessary to service the expanding industry: roads, railways, harbours, airports, electricity, water and sewage
  • Linkage pressures will eventually lead to balanced growth, provided:
  • Free market pricing is permitted to allow the proper signalling to occur to reflect enhanced profit opportunities
  • A stable banking system is instituted to allow the process of saving and investing to proceed with low risk
  • An entrepreneurial sector is fostered through training to allow individuals to respond to the profit signals by investing in areas of the economy where shortages and profit opportunities are the greatest
  • Super-normal profits can be earned


  • Unemployment is not a result of demand deficient cyclical unemployment:
  • In most LEDCs it is supply bottlenecks that create constraints on employment creation
  • There are insufficient savings and investment to create the expensive workplaces needed to create urban jobs
  • Where there has been technology transfer from MEDCs, investment is labour saving and does not create jobs
  • Capital is often subsidized by a government intent on accelerating growth - firms use the cheap capital as a substitute for labour
  • Wages may be too high due to minimum wage laws or MNCs/TNCs permitting unions to bid up wages and forcing firms to replace labour with capital

Small Scale Industry (small and medium enterprises/SMEs)

  • There needs to be investment in small scale, labour intense industries in both urban and rural areas to provide alternatives to low paid farm jobs, and the competition for scarce industrial jobs in cities
  • Small scale businesses in both urban and rural areas have certain characteristics
  • People perform all sorts of services and fashion all sorts of products from recycled materials
  • Capital and materials are scarce but human labour is abundant, production is labour intensive
  • Usually employs 5 workers or less, and yet can account for 30% of the work force
  • Are a wonderful way to flush out entrepreneurial talent
  • Governments favour large firms through price distortions, output controls, regulations, export licenses, and credit rationing
  • To foster small scale businesses, government needs to:
  • Remove controls and regulations to reduce the bias against small firms
  • Provide a technology extension system to assist in the process of technology transfer to small entrepreneurs
  • Small, modern factories grow out of small scale businesses:
  • They generally employ 50 or less, and yet can account for 50% of the industrial labour force
  • If they stay in the rural economy, they can provide technology transfer
  • However, they are often forced to move to cities to gain: agglomeration and external economies, access to pools of skilled workers, cheap transport and marketing; and access to subcontract work for large firms

Growth & Financial Institutions

  • A good banking system is essential for economic growth:
  • Savers: deposit money in the bank and expect to receive a steady interest rate (e.g., 5%); savers know that there is no risk attached and do not mind earning such a low rate of return
  • Lenders: banks then take the money and lend it out to entrepreneurs; they charge 10% on the loans for several reasons:
  • The bank assesses the investment proposals of various businesses looking for those which are feasible (can be done) and viable (can support themselves and repay the loan), and rates them according to risk and return
  • Low risk investors pay 10% and higher risk investors pay up to 18%
  • The rate differential between savers and borrowers covers the paperwork, earns a return on invested capital, and covers the loans which may fail
  • By diversifying across various sectors in the economy and geographic regions in the country, banks are able to reduce risk
  • They can also reduce risk through securitization:
  • Banks grade loans by risk (grade A, B etc.), and group the loans into standard sized packages/tranches, such as $5 million)
  • The packages of loans are sold to domestic and foreign investors
  • Before investing, entrepreneurs analyse the various opportunities available and rank projects according to the expected rates of return
  • They borrow at the bank as long as the project rate of return at least covers the bank charges
  • They can often earn considerably more, but need it to cover the risks of failure which can be very high for certain projects:
  • Primary sector projects may find no oil or minerals, manufacturing projects may face competition from new products or lower cost imports
  • The product life cycle may be near exhaustion, or new technology may render a project obsolete
  • Entrepreneurs earn more because they are prepared to accept the risk of failure and the consequences of going bankrupt
  • They are willing to take new technology and apply it to a new product, or to invest in innovative locations or new product areas - their reward is a relatively high rate of return