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Week Two Notes: Development Theories
Reading Notes
Reading 1: Classic Theories of Economic Growth and Development
SOURCE: M. Todaro and S. Smith, ch. 3 “Classic Theories of Economic Growth and Development” in
Economic Development, Pearson Ltd. (2020) pp. 116-139
SUMMARY: 23 pages to 12 pages ISH
Classic Theories of Economic Growth and Development
● Development is a multidimensional process involving the reorganization and reorientation of
entire economic and social systems.
● Involved radical changes in institutional, social, and administrative structures as well as in
popular attitudes and customs, and beliefs
● Not only national, but a widespread and sustainable realization may also require modification
of the international economic and social system as well.
Classic Theories of Economic Development: Four Approaches
1. The linear-stages-of-growth model:
Originally ‘development’ was an economic theory in which which the right quantity and mixture
of saving, investment, and foreign aid were all that was necessary to enable developing nations to
proceed along an economic growth path that had historically been followed by the more
developed countries.
2. Theories and patterns of structural change:
Which focused on theories and patterns of structural change, used modern economic theory
and statistical analysis in an attempt to portray the internal process of structural change that a
“typical” developing country must undergo if it is to succeed in generating and sustaining rapid
economic growth.
3. The international-dependence revolution:
was more radical and more political. It viewed underdevelopment in terms of international and
domestic power relationships, institutional and structural economic rigidities, and the resulting
proliferation of dual economies and dual societies both within and among the nations of the
world.
4. The neoclassical, free-market counter-revolution:
emphasized the beneficial role of free markets, open economies, and the privatization of
inefficient public enterprises. It was primarily the result of too much government intervention and
regulation of the economy.
Development as Growth and the Linear-Stages Theories
Interest in the low-income countries of the world really began to materialize following World War II,
increasingly so as more countries succeeded in achieving independence from colonial rule.
● Industrialized countries had no readily available conceptual apparatus with which to analyze the
process of economic growth in largely agrarian societies that lacked modern economic structures
● But they had the Marshall Plan → massive amounts of US financial and technical assistance
enabled the war-torn countries of Europe to rebuild and modernize their economies in a matter of
years
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● All modern industrial nations were once undeveloped agrarian societies, their experience
transforming their economies from poor agricultural subsistence societies to modern industrial
giants had important lessons for the “backward” countries.
○ Because of its emphasis on the central role of accelerated physical capital accumulation,
this approach is often dubbed “capital fundamentalism.”
Rostow’s Stages of Growth
● The stages-of-growth model of development was created by the American economic historian
Walt W. Rostow.
● The advanced countries, it was argued, had all passed the stage of “takeoff into self-sustaining
growth,” and the underdeveloped countries that were still in either the traditional society or the
“pre-conditions” stage had only to follow a certain set of rules of development to take off in
their turn into self-sustaining economic growth.
● One of the principal strategies of development necessary for any takeoff was the mobilization of
domestic and foreign savings in order to generate sufficient investment to accelerate economic
growth.
● The economic mechanism by which more investment leads to more growth can be described in
terms of the Harrod-Domar growth model, today often referred to as the AK model
The Harrod-Domar Growth Model
● Harrod-Domar growth model: A functional economic
relationship in which the growth rate of gross domestic
product (g) depends directly on the national net savings
rate (s) and inversely on the national capital-output ratio
(c).
● Every economy must save a certain proportion of its
national income, if only to replace worn-out or impaired
capital goods.
● However, in order to grow, new investments representing
net additions to the capital stock are necessary
● Capital-output ratio (c): a ratio that shows the units of
capital required to produce a unit of output over a given
period of time.
○ For example, if $3 of capital is always necessary to produce an annual $1 stream of
GDP—it follows that any net additions to the capital stock in the form of new
investment will bring about corresponding increases in the flow of national output,
GDP.
● Net savings ratio (s): Savings expressed as a proportion of disposable income over some
period of time.
If we define the capital-output ratio as c and assume further that the national net savings ratio, s, is a
fixed proportion of national output (e.g., 6%) and that total new investment is determined by the level
of total savings, we can construct the following simple model of economic growth:
1. Net saving (S) is some proportion, (s), of national income (Y) such that we have the simple
equation:
S = sY
Net savings is equal to national net savings ratio, s, multiplied by national income (Y)
2. Net investment (I) is defined as the change in the capital stock, K, and can be represented by
ΔK such that:
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I = ΔK
But because the total capital stock, K, bears a direct relationship to total national income or output, Y,
as expressed by the capital-output ratio, c3 it follows that:
𝐾 Δ𝐾
𝑌
=c or, Δ𝑌
=c or, finally, ΔK = cΔY
Change in total capital stock is equal to capital output ratio multiplied by change in total national income
3. Finally, because net national savings, S, must equal net investment, I, we can write this equality
as
S=I
But from Equation S = sY, and from I = ΔK and ΔK = cΔY we know that:
I = ΔK = cΔY
Net investment = to change in total capital stock = to capital output ratio multiplied by change in total national
income
It therefore follows that we can write the “identity” of saving equalling investment shown by Equation
S = I as,
S = sY = cΔY = ΔK = I
Or, simply as
sY = cΔY
national net savings ratio multiplied by total national income = capital output ratio X by change in total national
income
Dividing both sides of equation first by Y and then by c, we obtain the following expression:
Δ𝑌 𝑠
𝑌
= 𝑐
Change in total national income over national income = national net savings ratio over capital output ratio
● The simplified equation of the famous, Harrod-Domar theory of economic growth, states simply
that the rate of growth of GDP (ΔY/Y) is determined jointly by the net national savings ratio,
s, and the national capital-output ratio, c.
● More specifically, it says that in the absence of government, The growth rate of national income
will be:
○ directly or positively related to the savings ratio
■ i.e. the more an economy is able to save—and invest—out of a given GDP, the
greater the growth of that GDP will be.
○ And inversely or negatively related to the economy’s capital-output ratio
■ i.e., the higher c is, the lower the rate of GDP growth will be.
● To grow, economies must save and invest a certain proportion of their GDP. The more they can
save and invest, the faster they can grow.
● The rate of growth depends as much upon the efficiency with which investment is used as the
amount of capital invested.
○ In addition to investment, two other components of economic growth are labor force
growth and technological progress
● Labor force growth is not described explicitly because labor is assumed to be abundant in a
developing-country context and can be hired as needed in a given proportion to capital
investments (this assumption is not always valid)
