4 Main Features of Schumpeter’s Theory

They are: 1. Circular Flow 2. Role of Entrepreneur 3. Cyclical Process or Business Cycle and 4.
End of Capitalism.
Feature # 1. Circular Flow:
Schumpeter starts his analysis of development process with the concept of circular flow.It implies a
condition where economic activity produces itself continuously at constant rate through time.Thus, it
means a continuous activity and no destruction. It is the characteristic of an economy in stationary state.

The circular flow is similar to circulation in blood in an animal organism. Circular flow is based upon a
state of perfect competitive equilibrium in which coasts are equal to receipts and prices to average costs.
The Schumpeter, “The circular flow is a stream that is fed from the continually flowing springs of
labour power and land and flow in every economic period into the reservoir which we call income,
in order to be transformed into satisfaction of wants”.
The main features of circular flow are as under:
(a) All economic activities are essentially repetitive and follow a familiar routine course.

(b) All the producers know the aggregate demand for goods and adjust the supply of output accordingly.
This means demand and supply are in equilibrium at each point of time.

(c) The economic system has the optimum level of output and its maximum use and there is no possibility
of wastage of resources.

(d) The firms working in a system are in a state of competitive equilibrium.

(e) Under the stationary equilibrium, the prices are equal to the average cost.

Theory of Economic Development:

The above stated features imply that circular flow is used in a static setting. To make it dynamic and
consistent with development, changes must take place in flow system. These changes can be brought
through innovations.
Innovations:
Innovation may be defined as a change in existing production system to be introduced by the entrepreneur
with a view to make profits and reduce costs. The innovation is closely linked with Schumpeterian
concept of development.

He defined development as a “Spontaneous and discontinuous change in the channels of flow,

disturbance of equilibrium which forever alters and displaces the equilibrium state previously
existing”. When changes take place in the economy, circular flow is disturbed and the development
process starts. He assumed that change is the basic element of dynamic process, and those changes come
in the form of innovations.
Any innovation may consist of:
(a) The introduction of a new product

(b) The introduction of a new method of production

(c) The opening up of a new market

(d) The conquest of a new source of supply of raw materials or semi manufactured goods.

(e) The carrying out of the new organisation of any industry like the creation of a monopoly.

The new combinations of these factors are essential for the development process to start. It is to be
energised by the development agents and such agents are innovators or entrepreneurs. The entrepreneur is
considered as the hero in the Schumpeterian development.

Feature # 2. Role of the Entrepreneur:

Entrepreneur or innovator is the key figure in Schumpeter analysis of the process of development. He
occupies the central place in the development process because he initiates development in a society and
carries it forward. Entrepreneurship is different from managerial activity.

A manager simply directs production under existing techniques but entrepreneurship, requires the
introduction of something new. An entrepreneur is also different from a capitalist. The capitalist simply
furnishes the funds while the entrepreneur directs the use of these funds.

As in economic system, there is high degree of risk, thus entrepreneur is motivated:

(a) The desire to find a private commercial kingdom.

(b) The will to conquer and prove his superiority.

(c) The joy of creating, getting things done or simply of exercising one’s energy and ingenuity.

Three things are necessary for the performance of the entrepreneurial function:
(а) Technical know-how should be available to the entrepreneur for introducing new products and new
combinations of production factors.
(b) Capital resource can enable the entrepreneurs to have command over factors of production. For this,
he needs purchasing power in the form of credit and capital which he can borrow from banks and other
financial institutions.

Thus, credit and bank plays a vital role in economic development. Credit enables the entrepreneur to buy
producer’s goods which he needs for conducting new experiments and innovations. The invention in one
field of the economic activity will induce inventions in the related fields. Thus, credit creation becomes an
important part of the development model.

Role of Profits:
An entrepreneur innovates to earn profits. Profits are conceived “as a surplus over costs: a difference
between the total receipts and outlay, as a function of innovation”. Profits arise due to dynamic
changes resulting from an innovation. They continue to exist till the innovation becomes general.
Breaking the Circular Flow:
Schumpeter regards economic development as a dynamic and discontinuous process. The society
progresses through trade cycles. In order to break the circular flow, the innovating entrepreneurs are
financed by bank credit expansion. Since investment in innovation is risky, they must be paid bank
interest on it.

Once the innovations becomes successful and profitable, other entrepreneurs follow it in “swarm like
clusters”. Innovations in one field may induce other innovations in related fields. For example, the
emergence of a motor car industry, may in turn, stimulated a wave of new investments in the construction
of highways, rubber tyres and petroleum products etc. But the spread is never cent percent.

The spread of innovation can be explained with the help of a figure. 1 where percentage of firm is taken
along Y-axis and time is along X-axis. The curve OL represents that firms adopt an innovation slowly to
start but soon the adoption of innovation gains momentum but it never reaches 100 percent adoption by
firms.

Feature # 3. Business Cycle or Cyclical Process:

The next component of development according to Schumpeter is the business cycle. Schumpeter’s
approach to business cycle or crisis is historical, statistical and analytical. He believes that business cycle
or crisis is not merely the result of economic factors but also of non-economic factors. Schumpeter
concludes that crisis is the “process by which economic life adapts itself to the new economic
conditions”.

After explaining Schumpeter’s approach to business cycle or crisis, we shall now proceed to discuss the
working of business cycle. How booms and depression appear and collapse? Bank credit is an essential
element of Schumpeter’s model. According to Schumpeter, the creation of bank credit is assumed to
accelerate money incomes and prices in the economy.

It creates a cumulative expansion throughout the economy. With the increase in the purchasing power of
the consumers, the demand for the products increases in relation to supply. The rising prices and the high
rates of profits stimulate producers to raise investments by borrowing from the banks.

The credit inflation starts with the entrance of new entrepreneurs in the field of production, which
superimposes on the primary wave of innovations. This may be called boom or prosperity period. In this
stage, the economic activities reach their maximum heights and the idle or unemployed resources are
minimised.

During the boom period, the new products start appearing in the market with the entrance of new
entrepreneurs. These products displace the old ones and thus decrease their demand in the market.
Consequently, the prices of old products fall. With a view to liquidating their stocks, the old firms start
selling their goods at a low price and hence most of the firms incur losses and some firms are even forced
to run into loss.

Investment declines and unemployment starts, leading to a fall in the aggregate demand. As the
entrepreneurs start repaying bank loans, the quantity of money in circulation is reduced and prices start
falling. Profits too decline and come to zero point. Uncertainty and risk increase. A wave of pessimism
sweeps the entire economy and the boom period ends with the appearance of the phase of depression.
Schumpeter believes in the existence of the long wave of upswings (or boom) and downswings (or
depression). Once the upswing ends, the long wave of downswing begins and the painful process of
readjustment to the “point of previous neighbourhood of equilibrium” starts.

The economic forces of recovery come into operation and ultimately bring about a revival. Once again the
economy comes across the equilibrium, and the new boom period starts with a new set of innovations.
This process of capitalist development may be regarded as “creative destruction” wherein the old
economic structures of society after destruction are ultimately replaced by the new economic structures.

Schumpeter’s cyclical process of economic development has been illustrated in the above diagram where
the secondary wave is superimposed on the primary wave of innovation. In the prosperity period, as the
above figure reveals, the economic development proceeds more rapidly due to over optimism and
speculation.

The business cycle continues to fall below the level of equilibrium with the beginning of the recession
and ultimately reaches the point of depression. In the end, the retake of economic activities leads to
revival of the economy.

In the Schumpeterian analysis of development entrepreneurs have to play the central role in business
cycles. They initiate the economic development in the spontaneous and discontinuous manner. The
cyclical swings are the cost of economic development under capitalism.

Feature # 4. The Decay of Capitalism:

The continuous technical progress results in an unbounded increase in total and per capita output. As long
as technological progress takes place, the rate of profit is positive. Hence, there can be no drying up of
sources of investible funds nor any vanishing of investment opportunities.
“There is, therefore, no prior ceiling to the level of per capita income in a capitalist society. Nevertheless,
the economic success of capitalism will eventually lead to its decay”. The very success of capitalism
undermines the social institutions which protect it and inevitably creates conditions in which it will not be
able to live and which strongly point to socialism as the heir apparent.

Capitalism can maintain itself only so long as entrepreneurs behave like knights and pioneers.
Schumpeter holds a very pessimistic view about the survival of capitalism. He advocated capitalist system
of production yet he was not unaware of the weakness of this system.

Due to its drawbacks, capitalism disintegrates and yields place to socialism, Schumpeter gives the
following reasons for the disintegration of capitalism:
(a) The Obsolescence of Entrepreneurial Function:
Prof. Schumpeter observes that the success of early captains of industry have made innovation a routine
activity. It tends to degenerate into a dis-personalised, routine activity carried on in a big business through
highly trained managers.

The new lords of business are managers, depersonalised owners and private bureaucrats. This reduces the
industrial bourgeois to a class of wage earners and ‘thus’ undermines the function and the position of the
entrepreneur as the “warrior knight”.

(b) Destruction of Institutional Frame Work:

Another factor responsible for weakening the foundations of capitalism is the destruction of its
institutional frame work. The entrepreneur by his own success tends to destroy not only his economic and
social functions but also the institutional framework within which he works.

The tendency towards concentration and increase in the size of production units destroy capitalistic
institutions like private property and freedom of contract.

In case of big concerns, the proprietors are small and large shareholders who are dematerialised and de-
functionalised by professional and salaried managers and thus, the proprietary interest is replaced by large
and small stock holders. These changes tend to weaken the concept of private property and free individual
contract.

(c) Destruction of Protecting Political Strata:

The destruction of protecting political strata will administer the last blow to capitalist system. With the
progress of capitalism, not only the functions of the entrepreneur and the institutional frame work of
capitalism crumble but the group that protected early capitalism politically is also destroyed.
The very success of capitalism is destroyed by the royal power. The progress of capitalism makes
industrialists and merchants economically powerful and they begin to dominate in political field.
Rostow’s Theory of Growth | Theories | Economics

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In this article we will discuss about the Rostow’s theory of Growth.

At the end of the Second World War (1939-45) there was a renewal of interest in the subject of
development economics and the stages of growth once again preoccupied many scholars. As a non-
communist manifesto, W. W. Rostow’s stages of economic growth (1960, 1971) is a foray into
positioning the sweep of modern economic history under capitalism into neat and hopeful epochs.

Rostow’s version is an outstanding examples of continuity and evolution. Moreover, if Marx’s theory is
regarded as the banner of capitalism doomed, Rostow’s version may be referred to as a capitalism viable.

Stages of Growth:
Rostow has conceived five universal stages; viz:
(i) The traditional society,

(ii) The preparation for the take-off—a stage in which communities build up their propensities in such a
way as would be conducive to the take-off,

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(iii) The period of takeoff in which the productive capacity of the community registers a distinct upward
rise,

(iv) The stage of drive to maturity, the period of self-sustained growth in which the economy keeps on
moving, and

(v) The stage of high mass consumption.

Let us analyse each stage in detail:

(i) The Traditional Society:
A traditional society is one of the simplest and primitive forms of social organisation. It is one whose
structure is developed within limited production function, based on Pre-Newtonian science and
technology and old Pre-Newtonian attitude to the physical world.

The characteristics are:

(a) Per Capita:
Within a limited range of available technology there is a low ceiling per capita output.

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(b) Employment in Agriculture:

A high proportion of workforce (75% or more) are devoted in the production of agricultural goods. High
proportion of resources are also devoted in the agricultural section.

(c) Social Mobility:

A hierarchical, hereditary, status-oriented social structure held down the mobility of society at that time.

(d) Political Power:

The centre of gravity of political power was localistic, region-bound and primarily based on land
ownership.

(ii) Pre-Conditions for Take-Off:

It is that stage of economic growth in which the progressive elements creep into the otherwise barbaric
and primitive psyches of the members of the society. People try to break free from the rigidities of the
traditional society and a scientific attitude—a quest for knowledge in short—a questioning mid-set is very
much visible in the changing face of the society.

The features are:

(a) Economic Progress:
Economic progress became an accepted social value. At this time the change of human mind took place
and they were able to think about their respective countries.

(b) New Enterprises:

New types of enterprising people emerged on the society. Their objective was to establish a firm or
industry and produce output for a long time.

(c) Investment:
As the new enterprising persons emerged in the society, the gross investment raised from 5% to 10%, so
that the rate of growth of output outstrips the rate of population growth.

(d) Infrastructure:
As different industries were established in different parts of the country, automatically transportation,
more mobilised communication, roads, railways, ports were required. So infrastructure was built all over
the country.

(e) Credit Institutions:

At that time necessary credit institutions were developed in order to mobilise savings for investment.

(f) Mobilisation of Work Force:

Due to industrialisation a large portion of workforce was shifted from agricultural section to the
manufacturing sector. This was experienced in Great Britain in the time of “Industrialisation (1760
onwards)”.
(g) Decline of Birth rate:
At that time medical science was slowly developing. The citizens understood the essence of control of
birth rate and death rates. At first the death rate was controlled and then the birth rate was controlled. This
was the second stage of Demographic Transition experienced by the developed countries.

(h) Political Power:

Centralised political power based on nationalism replaced the land- based localistic or colonial power.

(iii) The Take-Off Stage:

The take-off stage marks the transition of the society from a backward one to one that is on the verge of
freeing itself from the elements that retard growth. In fact, it is one stage in which there is a dynamic
change in the society and there is a meteoric rise in the standards set by the members of society in all
walks of life like industry, agriculture, science and technology, medicine, etc.

There is a marked discontinuity between the first two stages as mentioned earlier and the stage of take-
off. The winds of change are triggered by some important political event that revolutionizes the political
structure or a sudden infuse of new techniques and methods of production attributed to formidable
advances in science and technology.

The former type of events took place in nations, like erstwhile USSR, East and West Germany, Japan,
China and India. The latter category may be observed in nations like UK, USA and the OPEC countries.
Events like the “Industrial Revolution” that was the brainchild of technological innovations in Britain
since 1760s or say, the“Manhattan Project (1940s)” that signaled the arrival of USA on the world
political scenario with a that are living examples of take-off stage as mentioned by Rostow.
The characteristics of this stage are:
(a) The Rate of Investment:
The first property of the stage of take-off is nothing but the rate of investment. At the time of “Industrial
Revolution” the rate of investment was from 5% or less to over 10% of the national income. At this time,
agricultural lands were acquired for industrialisation.

This led to a depression in the further period. For this purpose colonialism was required for Britain. As a
result they came to India and other colonies for business purpose at the first time and gradually took the
political power of this country.

(b) Development of One Leading Sector:

At the time of Industrial Revolution (1760 on) we saw the development of particular secondary section of
each country in Europe. In Britain we saw a large development in textile and iron and steel industry. As
iron and steel industry is essential for development of every country each country experienced growth in
iron and steel industry in Europe. Nowadays the development of a country is measured by per capita con-
sumption of iron and steel.

(c) Existence of Different Frameworks in the Society:

There was the existence of political, social and institutional framework which exploited impulses to
expansion in the modern sector and the potential external economies affected the take-off and gave the
process of growth a sustained and cumulative character.

(iv) The Drive to Maturity:

Maturity in the context of Rostow’s theory refers to that state of economy and the society as a whole,
when winning on all fronts becomes a habit or an addiction. Each and every effort to stimulate the
economy meets with success and the time period when the society tastes success is a rather long one and
the progress made on all fronts is there to stay.

It is a period when a society effectively applies the range of available modern technology to the bulk of its
resources; and growth becomes the normal mode of existence. Industries like heavy engineering, iron and
steel, chemicals, machine tools, agricultural implements, automobiles etc. take the driver’s seat.

Electric power generations as well as consumption are high due to sudden acceleration of industrial
activities. Admittedly, it is difficult to date this period precisely in view of indistinct or hazy demarcations
between the end of take-off and the beginning of maturity. Rostow would date it as about 60 years after
beginning of take-off.

The economic characters of this stage are:

(a) Shift in the Occupational Distribution:
As due to Industrial Revolution many industries were established in Britain and the countries of. Western
Europe, the work force was shifted from agricultural sector to the manufacturing sector. The proportion of
the working force engaged in the agricultural sector went down to 20% or less.

(b) Shift in the Consumption Pattern:

A new type of workforce was created which was termed white-collar workers. They were mainly officials
or managing officials of a factory’s governing body. Due to high income their preferences were shifted to
luxury goods. As a result the consumption pattern of non-agricultural goods increased. This led to
development of the existing industries and also variation in tastes and preferences took place more rapidly
in this period.

(c) Shift in the Consumption of Leading Sector:

The change in composition was observed to vary from country to country. The Swedish take-off was
initiated by timber exports, wood pulp and pasteboard products followed by the emergence of railways,
hydropower, steel, and animal husbandry and dairy products. The Russian take-off started with grain
exports, followed by railways, iron and steel, coal and engineering.

The non-economic factors of “The Drive to Maturity” are:

(a) Entrepreneurial Leadership:
In the stage of drive to maturity the change in the entrepreneurial leadership took place. Cotton-steel-
railway-oil barons gave way to the managerial bureaucracy.

(b) Boredom:
Certain boredom with industrialisation gave rise to social protest against the costs of industrialisation.

(v) The Age of High Mass Consumption:

From maturity the economy moves with growth to high mass consumption, the stage at which durable
consumer goods like radios, TV sets, automobiles, refrigerators, etc., life in the suburbs, college education
for one-third to one half the population came within reach. In addition the economy, through its political
process, expresses willingness to allocate increased resources to social welfare and security. This stage
was defined in terms of shift in emphasis from problems of production to that of consumption.
Necessarily, therefore, attention veers towards problems of allocation of resources which, according
to Rostow, came to be governed by the following considerations:
(i) Pursuit of national power and world influence,

(ii) Welfare state redistributing income to correct the aberrations of the market process,

(iii) Extension of consumer demand on durable consumer goods and high grade foods.

Comparison of Marx and Rostow:

Rostow posited the existence of five separate stages. The key among these was the take-off, which was
impelled by one or more “leading sectors”. The fast growth of the leading sectors pulled along less
dynamic parts of the economy.

According to Rostow, high price elasticities of supply and demand in the leading sectors meant that
demand pressures found supply response and that lower prices generated increases in total revenues to the
new industries.

Structurally, the leading sectors also enjoyed high income elasticities of demand and they reaped
increases in market sizes disproportionate to the size of income increases in the economy as a whole.
Finally, external economies generated by the leading sectors further stimulated demand in sectors linked
to the leading sector.

The result, at least in the countries to which the analysis applied, was an increase in the rate of growth of
output that was, in Rostow’s words, self-sustaining- a permanent transition owing to these structural
interactions between the leading sectors and the rest of the economy, from low (or no) growth to steady
growth rates. The process was “Non-Marxist” because its analysis did not depend on reference to class
struggles, growing unemployment, falling profit rates, and all the rest of the Marxian analytical tools.
Critical Review of Rostow’s Theory:
(i) Reduction of Growth:
Rostow’s theory reduces the economic growth to a single pattern. He only highlighted the growth of one
or more sectors of the economy. He did not highlight the overall condition of the economy.

(ii) Mechanism of Evolution:

Rostow’s stages of growth failed to specify the mechanism of evolution which links different stages of
growth. He explained the stages without any interrelationship.

(iii) Economic Variables:

By the stage theory Rostow described how the existing economic variables reduce the growth rate of the
country. But he did not say anything about the solution of these problems. He did not explain how the
variables interact and generate economic growth.

(iv) Lack of Symmetry:

Rostow’s stage theory was not based on a systematic scheme of causation,

(v) Predictive Value:

Paul Baran opined that Rostow’s theory had no predictive value and was without any operational
significance for underdeveloped countries attempting to break through the barriers of underdevelopment.

(vi) Hoffman Thesis:

Although Rostow seemed to have been inspired by the Hoffman thesis, his conclusions were inconsistent
with those of his mentor Rostow’s thoughts as regards the rate of investment were tied to the assumption
of a constant marginal capital-output ratio.

Hoffman’s analysis stressed on an increasing ratio of the net output of capital goods to that of consumer
goods in the manufacturing sector. This implied an increasing capital-output ratio over the various stages
of industrialisation.

(vii) Habits of Saving:

It lacked originality as a piece of academic research. It had heavily borrowed from Max Weber’s and
Tawney’s pioneering work in the field of sociology. Rostow’s reference to changing habits of saving, the
increasing pursuit of economic motives in everyday life, etc. share the same passions as those of Weber
and Tawney.

Conclusion:
Rostow had advocated his theory as an alternative to Marx’s theory. While Marx’s vision of the stages of
growth was embodied in The Communist Manifesto (1848), Rostow described his own works as the Non-
Communist Manifesto. In fact the bottom-line was that Rostow based his theory on the flows of the
Marxian theory. He criticised Marx’s theory on the ground that if suffers from “economic determinism”.

The great merit of Rostow’s doctrine was that its main facts was on continuity and evolution of society
and did not treat each stage as being mutually exclusive from the other stages. Moreover, instead of
limiting human behaviour to simple act of maximisation, Rostow interpreted human behaviour as an act
of balancing alternatives and often conflicting human objectives.
Karl Marx Theory of Economic Development
Karl Marx, the father of scientific socialism, is considered a great thinker of history.

He is held in high esteem and is respected as a real prophet by the millions of people.

Prof. Schumpeter wrote,

“Marxism is a religion. To an orthodox Marxist, an opponent is not merely in error but in sin”.

He is regarded as the father of history who prophesied the decline of capitalism and the advent of
socialism.

The Marxian analysis is the greatest and the most penetrating examination of the process of economic
development. He expected capitalistic change to break down because of sociological reasons and not due
to economic stagnation and only after a very high degree of development is attained. His famous book
‘Das Kapital’ is known as the Bible of socialism (1867). He presented the process of growth and collapse
of the capital economy.

Assumptions of the Theory:

Marxian economic theory of growth is based on certain assumptions:
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1. There are two principal classes in the society. (1) Bourgeoisie and (2) Proletatiat.

2. Wages of the workers are determined at subsistence level of living.

3. Labour theory of value holds good. Thus labour is the main source of value generation.

4. Factors of production are owned by the capitalists.

5. Capital is of two types: constant capital and variable capital.

6. Capitalists exploit the workers.

7. Labour is homogenous and perfectly mobile.

8. Perfect competition in the economy.

9. National income is distributed in terms of wages and profits.

Marxian Concept of Economic Development:
In Marxian theory, production means the generation of value. Thus economic development is the process
of more value generating, labour generates value. But high level of production is possible through more
and more capital accumulation and technological improvement.

At the start, growth under capitalism, generation of value and accumulation of capital underwent at a high
rate. After reaching its peak, there is a concentration of capital associated with falling rate of profit. In
turn, it reduces the rate of investment and as such rate of economic growth. Unemployment increases.
Class conflicts increase. Labour conflicts start and there is class revolts. Ultimately, there is a downfall of
capitalism and rise of socialism.
Marx’s Theory of Economic Development (Criticism)

Marx theory of capitalist development has been accepted by his followers as a Gospel of truth.

It has a special application to a particular society named capitalist society.

Still, it has been severely criticized on the following grounds:

(i) Materialistic Interpretation of History is Partial Truth:
The foremost point of criticism against Marx is that it is a partial concept. Marx has minimized the
significance of other non-economic factors in the history. The non-economic factors like ethical,
ideological, religious, cultural and the political conditions also greatly influence the history.

Man does not live by bread only, other things are also necessary. Bertrand Russell has rightly remarked in
this regard, “Larger events in our political life are determined by the interaction of material conditions
and human passions”. Thus, the material and non- material factors play an important part in the
development of various economic activities.
(ii) Theory of Surplus Value is Unreal:
The whole Marxian theory is based on the theory of surplus value. In real world, we are not concerned
with values but with real tangible prices. Thus, Marx has created an abstract and unreal world which has
made it difficult and cumbersome to understand proper working of capitalism.

(iii) Marx-A False Prophet:

According to some other opponents, Prof. Marx has been proved a false prophet. The countries which
have toed the Marxian line of thinking have been curiously those in which capitalist development lagged
behind. All the communist states had been poor and are even now so, as compared to capitalist countries.
On the contrary, the real wages of workers have continuously increased in their value. The workers tend
to become more prosperous with capitalist development and the middle class instead of disappearing, has
emerged as dominant class. There have been also no signs of the withering away of the state in these
countries.

(iv) Technology does not Create Unemployment:

Marx contended that with the introduction of technology, industrial reserve army expands. But, this is an
exaggerated view for the long run effect of technological progress. It creates more employment
opportunities by raising aggregate demand and income. The improved techniques of production even if
they may be labour saving can show better benefits on the labourers.

(v) Falling Tendency of Profits not Correct:

According to Joan Robinson, “Marx’s explanation of the falling tendency of profits explains nothing at
all”. Marx contends that as development proceeds, there is an increase in the organic composition of
capital which brings decline in the profit rate. But this is wrong opinion because as development
proceeds, capital output ratio falls and so the output increases and profits also increase.

(vi) Capitalist did not meet its Predicted Doomsday:

Marx also could not understand the emergence of political democracy as the protector and preserver of
capitalism. The introduction of social security measures, anti trust laws and the mixed economies have
given a lie to the Marxian prediction that capitalism contains within itself the seeds of its own destruction.

(vii) Cyclical Theory Wrong:

Marx emphasized that capital accumulation led to reduction in the demand for consumption goods and
fall in profits. But he failed to realize that with economic development, the share of wages in aggregate
income need not fall, nor the demand for consumer goods.

(viii) Static Analysis:

In the words of Schumpeter “It is unsuited for two main props being:
(a) Labour theory of value and

(b) Modified version of subsistence theory of wages.

Marx was analyzing the problem of growth with the help of tools which were essentially suited to static
economic analysis.

(ix) Analysis of Crisis is Out-dated:

Marx considered the business cycle as an integral part of capitalist development but it lacks precision.
The analysis of crisis is based on nature of capitalist production rather than on monetary and fiscal factors
and the theory which neglects the monetary and fiscal factor is considered to be incomplete and
inadequate. Marxian analysis of crisis at the most can be regarded as suggestive rather than analytical and
convincing.

(x) Unable to Solve Various Complex Problems:

Regarding consumption theory, Marx did not attempt to break sharply with classical thinking, this
analysis of the problem is inadequate. It is suggestive but vague. He fails to explain that how the rate of
profit and investment depends upon consumption.
Neoclassical Theory of Economic Growth (Explained With Diagrams)

The neoclassical growth theory was developed in the late 1950s and 1960s of the twentieth century as a

result of intensive research in the field of growth economics.

The American economist Robert Solow, who won a Noble Prize in Economics and the British economist,

J. E. Meade are the two well known contributors to the neo-classical theory of growth. This neoclassical

growth theory lays stress on capital accumulation and its related decision of saving as an important

determinant of economic growth. Neoclassical growth model considered two factor production functions

with capital and labour as determinants of output. Besides, it added exogenously determined factor,

technology, to the production function.

Thus neoclassical growth model uses the following production function:

Y = AF (K, L) … (i)

Where Y is Gross Domestic Product (GDP), K is the stock of capital, L is the amount of unskilled labour

and A is exogenously determined level of technology. Note that change in this exogenous variable,

technology, will cause a shift in the production function.

There are two ways in which technology parameter A is incorporated in the production function. One

popular way of incorporating the technology parameter in the production function is to assume that

technology is labour augmenting and accordingly the production function is written as

Y= F (K, AL) … (ii)

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Note that labour-augmenting technological change implies that it increases productivity of labour.

The second important way of incorporating the technology factor in the production function is to assume

that technological progress augments all factors (both capital and labour in our production function) and

not just augmenting labour. It is in this way that we have written the production function equation (i)

above. To repeat, in this approach production function is written as

Y-AF (K, L)

Considering in this way A represents total factor productivity (that is, productivity of both factor inputs).

When we empirically estimate production function specified in this way, then contribution of A to the

growth in total output is called Solow residual which means that total factor productivity really measures

the increase in output which is not accounted for by changes in factors, capital and labour.

Unlike the fixed proportion production function of Harrod-Domar model of economic growth,

neoclassical growth model uses variable proportion production function, that is, it considers unlimited

possibilities of substitution between capital and labour in the production process.

That is why it is called neoclassical growth model as the earlier neoclassical considered such a variable

proportion production function. The second important departure made by neoclassical growth theory from

Harrod-Domar growth model is that it assumes that planned investment and saving are always equal

because of immediate adjustments in price (including interest).

With these assumptions, neoclassical growth theory focuses its attention on supply side factors such as

capital and technology for determining rate of economic growth of a country. Therefore, unlike Harrod-
Domar growth model, it does not consider aggregate demand for goods limiting economic growth.

Therefore, it is called ‘classical’ along with ‘neo’.

The growth of output in this model is achieved at least in the short run through higher rate of saving and

therefore higher rate of capital formation. However, diminishing returns to capital limit economic growth

in this model. Though the neoclassical growth model assumes constant returns to scale which exhibits

diminishing returns to capital and labour separately.

We explain below how neoclassical growth model explains economic growth through capital

accumulation (i.e., saving and investment) and how this growth process ends in steady state equilibrium.

By steady ‘State equilibrium for the economy we mean that growth rate of output equals growth rate of

labour force and growth rate of capital (i.e., ∆Y/Y = ∆L/L = ∆K/K) so that per capita income and per

capita capital are no longer changing.

Note that for income per capita and capital per worker to remain constant in this steady state equilibrium

when labour force is growing implies that income and capital must be growing at the same rate as labour

force. Since growth in labour force (or population) is generally denoted by letter in this steady state

equilibrium, therefore, = ∆Y/Y = ∆K/K = ∆N/N = n. Neoclassic growth theory explains the process of

growth from any initial portion to this steady state equilibrium.

Neoclassical Growth Theory: Production Function and Saving:

As stated above, neoclassical growth theory uses following production function:

Y = AF (K, L)

However, the neoclassical theory explains the growth process using the above production function in its

intensive form, that is, in per capita terms. To obtain the above production function in per capita terms we

divide both sides of the given production function by L, the number of labour force. Thus
Y/L = AF ( K,L, L/L)

= AF (K/L, 1) = AF (K/L) ….(2)

To begin with we assume that there is no technological progress. With this assumption then equation (2)

is reduced to

Y/L = F (K/L) …..(3)

The equation (3) states that output per head (Y/L) is a function of capital per head K/L. Writing y for Y/L

and k for K/L, equation (3) can be written as

y = f (k) … (4)

Now, in Figure 45.1 we represent the production function (4) in per capita terms. It will be noticed from

Figure 45.1 that as capital per capita (k) increases output per head increases, that is, marginal product of

labour is positive. But, as will be seen from Figure 45.1, the slope of the production function curve

decreases as capital per head increases. This implies that marginal product of capital diminishes.

That is, the increase in capital per head

causes output per head to increase but at a diminishing rate. It will be seen from the Figure 45.1 that at
capital-labour ratio (i. e. capital per worker) equal to k1 output per head is y1. Similarly we can read from

the production function curve: y – f (k) the output per head corresponding to any other capital per head.

Neoclassical Growth Theory: Fundamental Growth Equation:

According to neoclassical theory, rate of saving plays an important role in the growth process of an

economy. Like the Harrod-Domar model, neoclassical theory considers saving as a constant fraction of

income. Thus,

S = sY …(5)

Where S = saving

Y = income

s = propensity to save

Since s is a constant fraction of income, average propensity to save is equal to marginal propensity to

save. Further, since national income equals national product, we can also write equation (5) as

sY = sF (K, L)

As in neoclassical theory planned investment is always equal to planned saving, net addition to the stock

of capital is (A K), which is the same thing as investment (I), can be obtained by deducting depreciation

of capital stock during a period from the planned saving. Thus,

∆K = I = sY-D … (6)

Where ∆K = net addition to the stock of capital, I stands for investment and D for depreciation.

Depreciation occurs at a certain percentage of the existing capital stock. The total depreciation (D) can be

written as

D = dK
Substituting dK for D in equation (6) we have

∆K= sY-dK

or sY= ∆K+ dK …(7)

Now dividing and multiplying the first term of the left hand side of equation (7) by K we have

sY = K. ∆K/K + dK…(8)

We have seen above, for the steady state equilibrium, growth of capital (∆K/K) must be equal to growth

of labour force (∆L/L), so that capital per worker and therefore income per head remains constant. If we

denote growth rate of labour force (∆L/L) by n, then is steady state ∆K/K = n.

Substituting n for ∆K/K in equation (8) we have

sY = K. n + dK

or sY=(n + d)K …(9)

The above equation (9) is a fundamental growth equation of the neoclassical growth model and states the

condition for the steady state equilibrium when capital per worker and therefore income per capita

remains constant even though population or labour force is growing.

Thus, for steady state growth equilibrium capital must be increasing equal to (n + d) K. Therefore (n + d)

K represents the required investment (or change in capital stock) which ensures steady state when capital

and income must be growing at the same rate as labour force (or population)

The Growth Process:

From the growth equation (9) it is evident that if planned saving sY is greater than the required

investment (i.e. (n + d) K) to keep per capita income constant, capital for worker will increase. This

increase in capital per worker will cause increase in productivity of worker.

As a result, the economy will grow at higher rate than the steady-state equilibrium growth rate. However,

this higher growth rate will not occur endlessly because diminishing returns to capital will bring it down

to the steady rate of growth, though at a higher levels of per capita income and capital per worker.

In order to graphically show the growth process the growth equation is conventionally used in intensive

form, that is, in per capita terms. In order to do so we divide both sides of equation (9) by L and have

sY/L = (n + d) K/L

where Y/L represents income per capita and K/L represents capital per worker (i.e. capital-labour ratio)

Writing y for Y/L and k for K/L we have

sy = (n + d)k …(10)

The equation (10) represents fundamental neoclassical growth equation in per capita terms.

Growth Process and Steady Growth Rate:

Figure 45.2 shows the growth process that moves the economy over time from an initial position to the

steady state equilibrium growth rate. In this Figure 45.2 along with per capita production function (y = f

(k)) we have also drawn per capita saving function curve sy. Besides, we have drawn (n + d) k curve

which depicts required investment per worker to keep constant the level of capital per capita when

population or labour force is growing at a given rate n.

 In Figure 45.2 y =f (k) is per capita

production function curve as in Figure 45.1. Since per capita saving is a constant fraction of per capita

output {i.e. income), the curve sy depicting per capita saving function is drawn below the per capita

output function curve (y =f (k)) with the same shape. Another straight line curve labelled as (n + d) k, is

drawn which depicts the required investment to keep capital per head (i.e., capital-labour ratio) constant at

various levels of capital per head.

Now, let us assume the current capital per head is k0 at which per capita income (or output) is sy0 and per

capita saving is It will be seen from Figure 45.2 that at capital per head k0, per capita saving sy exceeds

investment required to maintain capital per head equal to k0 (sy0 > (n + d)k).

As a result, capital per head (k) will rise (as indicated by horizontal arrows) which will lead to increase in

per capita income and the economy, moves to the right. This adjustment process will continue so long as

sy> (n + d) k. It will, seen when the economy reaches at capital per head equal to k* and per capita

income equal to y* corresponding to which saving curve sy intersects the (n + d) k curve at point T.

It will be noticed from Figure 45.2 that the adjustment process comes to rest at capital per head equal to

k* because saving and investment corresponding to this state is equal to the investment required to

maintain capital per head at k*. Thus point T and its associated capital per head equal to k* and income or

output per head equal to y* represent the steady state equilibrium.

It is worth noting that whether the economy is initially at the left or right of k*, the adjustment process

leads to the steady state at point T. It may however be noted that in steady-state equilibrium, the economy

is growing at the same rate as labour force (that is, equal to n or ∆L/L).

It will be seen from Figure 45.2 that although growth of economy comes down to the steady growth rate,

its levels of per capita capital and per capita income at point T are greater as compared to the initial state

at point B.

An important economic implication of the above growth process visualised in neoclassical growth model

is that different countries having same saving rate and population growth rate and access to the same

technology will ultimately converge to same per capita income although this convergence process may

take different time in different countries.

Impact of Increase in the Saving Rate:

As has been explained above that in steady state, both capital per head (k) and income per head (y) remain

constant when economy is growing at the rate of growth of population or labour force . In other words, in

steady state equilibrium ∆K= 0 and ∆Y= 0.

It follows from this that steady state growth rate or long-run growth rate which is equal to population or

labour force growth rate n is not affected by changes in the saving rate. Changes in the saving rate affect

only the short-run growth rate of the economy. This is an important implication of neoclassical growth
model. Now an important question is why do

we get this apparently incredible result from the neoclassical growth theory. Impact of increase in the

saving is illustrated in Figure 45.3. It will be seen from this figure that initially with the saving curve sy,

the economy is in steady state at point T0 where the saving curve sy intersects required investment curve

(n + d) k with k* as capital per head and y* as income (output) per capita.

Now suppose that saving rate increases, that is, individuals in the society decide to save a higher fraction

of their income. As a result, saving curve shifts to the new higher position s’y (dotted). This higher saving

curve s’y intersects the (n + d)k curve at point which therefore represents the new steady state.

We thus see that increase in saving rate moves the steady state equilibrium to the right and causes both

capital per head and income per head to rise to k** and y** respectively Note that in the new steady state

the economy grows at the same rate as the growth rate of labour force (or population) which is denoted by

n. It therefore follows that long-run growth rate of the economy remains unaffected by the increase in the

saving rate though the steady, state position has moved to the right.

Two points are worth noting here. First, though long-run growth rate of the economy remains the same as

a result of increase in the saving rate, capital per head (k) and income per capita (y) have risen with the
upward shift in the saving curve to s’y and consequently the change in steady state from T 0 to T1, capital

per head has increased from k* to k** and income per head has risen from y* to y**.

However, it is important to note that in the transition period or in the short run when the adjustment

process is taking place from an initial steady state, to a new steady state a higher growth rate in per capita

income is achieved. Thus, in Figure 45.3 when with the initial steady state point T0, saving rate increases

and saving curve shifts upward from sy to s’y, at the initial point T0, planned saving or investment

exceeds (n + d) k which causes capital per head to rise resulting in a higher growth in per capita income

than the growth rate in labour force (n) in the short run till the new steady state is reached.

The effect of increase in saving on growth in output

or income per head (y) and growth rate of total output (i.e., ∆Y/Y) is shown in Figure 45.4(a) and 45.4(6).

Figure 45.4(a) shows the growth in output (income) per head as a result of increase in the saving rate. To

begin with, the economy is initially in steady state equilibrium at time t0 with output per head equal to y*.
The increase in saving rate causes capital per head to rise which leads to the growth in output per head till

time t1 is reached. At time r, the economy is again in steady state equilibrium but now at a higher level

y** of output per head. Note that in the transition perused from t0to t1 output per head increases but at a

diminishing rate.

Figure 45.4 (b) illustrates the adjustment in growth rate in total output from Figure 45.4 (b) that starting

from initial steady state at time t0 the increase in saving rate and capital formation leads to growth rate in

total output higher than the steady growth rate n in the period from t0 to t1 but in period t1 it returns to the

steady growth rate path n.

It is thus evident that the higher saving rate leads to a higher growth rate in the short run only, while long-

run growth rate in output remains unaffected. The increase in the saving rate raises the growth rate of

output in the short run due to faster growth in capital and therefore in output. As more capital is

accumulated, the growth rate decreases due to the diminishing returns to capital and eventually falls back

to the population or labour force growth rate (n).

Effect of Population Growth:

For developing countries like India it is important to discuss the effect of increase in population growth

rate on steady levels of capital per head (k) and output per head (y) and also on the steady- state rate of

growth of aggregate output. Figure

45.5. Illustrates these effects of population growth. An increase in population growth rate causes an up-

ward shift in (n + d) k line. Thus in Figure 45.5, the increase in population growth rate from n to n’ causes

upward shifts of (n + d) k to (n + d) k curve dotted.

It will be seen from the Figure 45.5 that the new (n’ + d) k curve cuts the given saving curve sy at point

T’ at which capital per head has decreased from k*1 to k*2 and output per capita has fallen from y*1 to

y*2. This can be easily explained.

Due to higher growth rate of population a given stock of capital is spread thinly over labour force which

results in lower capital per head (i.e. capital-labour ratio). Decrease in capital per head causes decline in

per capita output. This is an important result of neoclassical growth theory which shows that population

growth in developing countries like India impedes growth in per capita income and therefore multiplies

our efforts to raise living standards of the people.

The Figure 45.5 also shows that higher growth rate of population raises the steady-state growth rate. It

will be seen from this figure that increase in population growth rate from n to n’ causes (n + d) k curve to

shift upward to the new position (n’ + d) k (dotted) which intersects the saving curve at new steady-state

equilibrium point T’.

The steady state growth rate has therefore risen to n’, that is, equal to the new growth rate of population.

It may however be noted that higher steady rate of growth is not a desirable thing. As a matter of fact, a

higher steady growth means that to maintain a certain given capital-labour ratio and per capita income the

economy has to save and invest more.

This implies that a higher rate of population acts as an obstacle to raise per capita income and therefore

living standards of the people. Thus, this result provides a significant lesson for the developing countries

like India, that is, if they want to achieve higher living standards for its people they should make efforts to

control population growth rate.

Long-run Growth and Technological Change:

Let us now analyse the effect of technological change on long-run growth of an economy. It is important

to note that neoclassical growth theory considers technological change as an exogenous variable. By

exogenous technological change we mean it is determined outside the model, that is, it is independent of

the values of other factors, capital and labour. That is why neoclassical production function is written as

Y = AF (K, L)

Where A represents exogenous technological change and appears outside the bracket.

In the foregoing analysis of neoclassical growth theory for the sake of simplification we have assumed

that the technological change is absent, that is, ∆A/A = 0. However, by assuming zero technological

change we ignored the important factor that determines long-term growth of the economy.

We now consider the effect of exogenous technological improvement over time, that is, when ∆A/A > O

over time. The

production function (in per capita terms), namely, y = Af (k) considered so far can be taken as a snapshot

in a year in which A is treated to be equal to 1. Viewed in this way, if technology improves at the rate of 1
per cent per year a snapshot taken in a year later will be y= 1.01 f(k), 2 years later, y = (1.01)2 f(k) and so

forth. As a result of this technological change production function will shift upward.

In general, if technological improvement ∆A/A per year is taken to be equal to g per cent per year, then

production function shifts upward at g per cent per year as shown in Figure 45.6 where to begin with

production function curve in period t0 is y0 = A0 f(k) corresponding to which saving curve is sy0.

With this, in steady state equilibrium, capital per head is equal to k*0 and output (income) per head is y1.

With g per cent rate of technological progress in period tv production function shifts to y1 =A1f(k) and

correspondingly saving curve shifts upward to sy1. As a result in period t1 in new steady state equilibrium

capital per head rises to k*l and per capita output to y1.

With a further g per cent rate of technological progress in period f2, production function curve shifts to a

higher level, y2 = A2f(k) and associated saving curve shifts to sy2.As a result, capital per head rises to

k*2 and per capita output to y2 in period t2. We thus see that progress in technology over time causes

growth of per capita output (income). With this aggregate output will also increase over time as a result of

technological progress.

The neoclassical growth theory has been successfully used to explain increase in per capita output and

standard of living in the long term as a result technological progress and capital accumulation.

Conclusion: Key Results of Solow Neoclassical Model:

Let us sum up the various key results of Solow’s neoclassical growth model:

1. Neoclassical growth theory explains that output is a function of growth in factor inputs, especially

capital and labour, and technological progress.

2. Contribution of increase in labour to the growth in output is the most important.

3. Growth rate of output in steady-state equilibrium is equal to the growth rate of population or labour

force and is exogenous of the saving rate, that is, it does not depend upon the rate of saving.
4. Although saving rate does not determine the steady-state growth rate in output, it does cause an

increase in steady-state level of per capita income (and therefore also total income) through raising capital

per head.

5. Steady state rate of growth of per capita income, that is, long-run growth rate is determined by progress

in technology.

6. If there is no technical progress, then output per capita will ultimately converge to steady state level.

7. A significant conclusion of neoclassical growth theory is that if the two countries have the same rate of

saving and same rate of population growth rate and has access to the same technology (i.e. production

function), their levels of per capita income will eventually converge that is they will ultimately become

equal.

In this context it is worthwhile to quote Dornbusch, Fischer and Startz. “The poor countries are poor

because they have a less capital but if they save at the same rate as rich countries, and have access to the

same technology, they will eventually catch up.

Sources of Economic Growth:

An important issue in growth economics is what contributions of different factors, namely, capital, labour

and technology make to economic growth. In other words, what is relative importance of these different

factors as sources of economic growth? Robert Solow and Denison have attempted to study the relative

importance of the various sources of economic growth by using the concept of production function.

The rate of economic growth in an economy and differences in income levels of different countries and

also their growth performance during a period can be explained in terms of the increase in these sources

of economic growth.
It will be recalled that the production function describes the amount of total output produced depends on

the amount of different factors used and the state of technology.

The following production function has been used to measure the various sources of economic

growth:

Y = AF(K, L) …(1)

Where Y = total national product

K = the quantity of physical capital used

L = the quantity of labour used

A = the state of technology

The production function equation (1) shows that increase in capital and labour and improvement in

technology will lead to growth in national output.

Note that improvement in technology causes output increases with the given factor supplies. In other

words, advancement in technology leads to the increase in productivity of factors used. Therefore,

improvement in technology is generally measured by growth in total factor productivity (TFP).

It will also be noticed from the production function equation (1) that technology (A) has been taken to be

a multiplicative factor. This implies that progress in technology increases the marginal productivity of

both capital and labour uniformly.

Such technological change is generally referred to as neutral technological change. Besides, we measure

the sources of economic growth with the above production function by assuming constant returns to scale.

Constant returns to scale implies that increase in inputs, that is, labour and capital, by a given percentage

will lead to the same percentage increase in output. Further, the increase in improvement in technology
(A) or what is also referred to as increase in total factor productivity causes a shift in the production

function.

With the above assumptions it can be proved that the following factors represent the sources of economic

growth.

Where Ө denotes share of capital in national product, 1- Ө denotes share of labour in national product.

The above equation, which is generally referred to as growth accounting equation shows the

various sources of growth which are summarised below:

1. The contribution of increase in capital to the growth in output (G or ∆Y/Y) is given by increase in

(∆K/K) capital multiplied by the share (Ө) of capital in national product;

2. The increase in labour force contributes to rate of economic growth equal to the labour share (1-Ө) in

national product multiplied by the growth in labour in force (∆L/L)

3. The technological improvement ∆A/A which is measured by the increase in total factor productivity

also makes an important contribution to economic growth. As mentioned above, technological progress

leads to the increase in total factor productivity (TFP) which implies that with the given resources (i.e.

capital and labour) more output can be produced.

Proof:

We can formally prove the growth accounting equation mentioned above. In the production function

equation (1) the change in output (∆Y) depends on changes in various inputs or factors — capital and

labour ∆K and ∆L and change in technology.

This can written as under:

∆Y=F (KL)∆A + MPk x ∆K + MPL x ∆L …(3)

Where MPk and MPL represent marginal products of labour and capital respectively. Dividing both sides

of equation (3) by Y we have

Now multiplying and dividing the second term of the left-hand side of equation (4) by K and also

multiplying and dividing the third term of left-hand side of the equation by L we have

Now, if rewards of factors of production are determined by marginal products of factors as actually is the

case under perfect competition in neoclassical theory, then K.MPK/Y represents the share of capital in

national product which we denote by Ө and L.MPL/Y represents the share of labour in national product

(Y) which we denote by 1 – Ө, then substituting these in equation (5) we have:

The above is the same as growth accounting equation (2) which indicates the sources of growth of output.

Table 45.1. Sources of Economic Growth:

In Table 45.1 we present the contributions made by capital, labour and total factor productivity (i.e.,

technical improvement) in growth of output in the United States, Japan and the major countries of Europe

in the two periods 1960-73 and 1973-90.

It will be seen from the table that growth of capital and improvement in total factor productivity (i.e.

technological progress) have been the important sources of economic growth, especially in case of

economic growth in Japan and European countries.

Table 45.1 further reveals that it is decline in total factor productivity (i.e. technological improvement)

and in growth of capital that is responsible for slowdown of economic growth in the USA, Japan and

European countries during the period 1973-90.

Knowledge or Education: the Missing Factor:

In the above growth accounting equation one factor, namely knowledge or education is missing which has

been stressed among others by Nobel Laureate Prof. Amartya Sen as an important factor contributing to

economic growth. It may be noted that increase in knowledge or education increases the productivity of

workers by improving their productive skills and abilities.

Besides, increased knowledge raises the productivity of capital and raises the return to investment in

capital goods. Since investment in promotion of knowledge or education makes workers and machine

more productive, the workforce equipped with knowledge and education is often called human capital

which is regarded by modern economists as an important source of economic growth.

Thus human capital or knowledge and education is the important missing factor in the growth equation of

neoclassical economists, Solow and Denison. On including human capital as a separate factor which

contributes to growth of output, the production function can be written as under.

Y = A F (K, L, H)
Where H represents human capital which was omitted by Robert Solow in his growth accounting

equation.

Economies of Scale and Economic Growth:

Robert Solow in his study of sources of growth in real income did not consider economies of scale as a

factor contributing to growth. Solow assumed constant returns to scale which implies if each factor in the

production function increases by one percent, output also increases by one per cent.

However, some economists such as Denison and those associated with World Bank emphasise economies

of scale or what is also called increasing returns to scale as a separate factor determining the rate of

economic growth. In case of the United States Denison estimated that of 2.92 per cent annual growth in

national income recorded during the period 1929-1982, 0.26 per cent was due to economies of scale.

However, whether there are increasing returns to scale or constant returns to scale is an empirical matter

for investigation.
Dualistic Theories:

There are different theories which are of the view that the poverty and underdevelopment of poor
countries is attributed to their dualistic character.

(1) Social Dualism, (2) Technological Dualism and (3) Financial Dualism.

(1) Social Dualism or Sociological Dualism:

Definition and Explanation:

J.H. Boeke is a Dutch Economist who studied Indonesian Economy and presented his theory of social
dualism.He maintains that there are three characteristics of a society in the economic sense. They are as:

(i) Social Spirit (ii) Organizational Form (iii) Techniques Dominating Them.

Their inter-relationship and interdependence is called the social system or social style. A society is
homogeneous if there is only one social system in the society. But the society which has two or more
social systems is known as dual or plural society.

Dr. Boeke says that the dual society is a society which has two full grown social styles which represent
pre-capitalism and post-capitalism. Such a dual society is furnished with the existence of an advanced
imported western system on the one side and endogenous pre capitalistic agricultural system on the other
side. The former is under the western influence which uses the advance techniques and where standard of
living is high. The later is native and it is furnished with the outdated techniques and low social and
economic life. This is called social or sociological dualism and these two systems are clashing. The
imported social system is highly capitalistic and it may be socialistic as well as communistic system.

Characteristics of Dualistic Society:

On economic basis the dualistic society is classified as by giving the names:

(i) Eastern Sector and (ii) Western Sector.

There are certain characteristics of eastern sector of a dualistic economy which distinguishes it from
western sector. They are as:

(i) The needs of eastern sector are limited. People pass a contented life.

(ii) People work for social needs rather for economic needs. For example, if a three acres are enough to
supply the needs of a household he will not cultivate six acres.

(iii) Goods are cultivated according to their prestige value rather on their use value.

(iv) As a result of all above, the eastern economies are characterized with backward bending supply
curves of effort and the risk taking.

(v) The native industries have neither organization nor capital and they are ignorant of modern technology
and market conditions.

(vi) People are indulged in speculative activities rather in business enterprises.

(vii) They do not take risk by making productive investment.

(viii) They lack the initiative and organizational skill which is a feature of western sector of dual
economy.

(ix) Labor is unorganized, passive and unskilled. They are reluctant to leave their village and community.
They are fatalist.

(x) The urban development takes place at the cost of rural life.

(xi) Exportation is the main objective of foreign trade in the eastern sector while the western sector
believes in imports.

Due to these features of eastern society the western economic theory is not applicable as far as UDCs arc
concerned.

The western economic theory is meant to explain capitalistic society whereas eastern sector is pre
capitalistic. The western sector or society is based upon unlimited wants and money economy etc.
Moreover. The MP theory cannot be applied in UDCs for resource allocation and distribution of income
because of immobility of resources. Thus Boeke says:

We should not try to transplant the delicate houseplant of western theory to tropical soils where an early
death awaits for it. If the pre-capitalistic agricultural sector of eastern sector is attempted to develop along
western lines it will create retrogression. The modern agricultural techniques can not be applied how-long
the mental attitudes of the farmers are not changed, otherwise the increase in wealth following modern
technology will result in further growth of population. Moreover, in case of failure of modern technology,
the indebtedness of the country will increase. Therefore it is better that these existing agricultural systems
should not be disturbed.

As far as industrial field is concerned the eastern producers cannot follow the western technology on the
basis of economic and social reasons. He says that the adoption of western technology to industrialize
Indonesian economy has moved the goal of self sufficiency farther and ruined its small industry.

Boeke refers to five kinds of unemployment in UDCs:

(i) Seasonal, (ii) Casual, (iii) Unemployment of regular workers, (iv) Unemployment of white collard
class, (v) Unemployment of Eurasians.

According to Boeke the govt., is unable to remove such unemployment because of the reason that it will
require the funds which the govt. cannot avail. Booke says that limited wants and limited purchasing
power in eastern sector hamper economic development. If the food supply is increased or industrial goods
are increased, it will bring a glut of commodities in the market. The prices will fall and economy will face
depression.

But this does not mean that Boeke is against industrialization, and agricultural improvement. Rather he is
in favor of slow process of industrialization and agricultural development on small scale which could
have an adaptability with the dualistic structure of eastern society. The urge for development should come
from the people themselves. New leaders must emerge who should work for the goal of development with
faith, charity and patience.

Criticism:

Professor Bengmin Higgins has criticized the social dualistic theory on the following grounds:

(i) Wants are not Limited: If we analyze "Indonesia's life" we do not find that the desires of the people
are limited because here the values of MFC and MPM are higher. This is the reason that the govt. has to
impose import restrictions. Moreover, whenever the harvest is good the farmers become prosperous and
the demand for luxurious goods rises.

(ii) Casual Labor are not Unorganized: Boeke presented the version that casual workers are
unorganized and passive. But this may be true as far as agricultural sector is concerned but they are not
unorganized in coffee, tea, rubber and plantation etc.

(iii) Eastern Labor is not Immobile: Boeke thought that eastern labor is immobile. It is not so because
of attraction of modern facilities of life in the urban areas. Moreover the high income incentives force the
labor to move from rural areas to urban areas.

(iv) Dualistic Theory is not Particular To UDCs Only: The eastern society, according to Boeke, only
exists in UDCs. It is not true. It does exist in Canada, Italy and even in the United States.

(v) Applicability to Western Society: According to Professor Higgins most of the characteristics of
eastern society given by Boeke are present even in the western societies. For example, during hyper
inflation, speculation is preferred to investment. This means, the people in the western countries also have
a strong desire to keep their capital safe and in liquid form, The western society also believes in
conspicuous consumption as discussed by Veblin and Snob effects. The backward bending supply curve
of efforts has been experienced by Australia during post war period and by US in the fifties.

(vi) Not a Theory But a Description: It is objected that the Boeke's dualistic theory is merely a
description rather than a theory. His findings are based upon neo-classical theory which has the limited
applicability in the western world.

(vii) Does not Provide Solution to the Problem of Unemployment: Boeke's dualism centers more on
socio-cultural aspects rather on economic. He only says that govt. is not in a position to remove
unemployment. Moreover, he does not mention the situation of under employment. Therefore his theory
is full of shortcomings.

Conclusion:

The main problem of dualistic economies is to provide employment opportunities and Boeke theory fails
to do it. Therefore, Prof. Higgins has developed the theory of technological dualism.

(2) Technological Dualism:

Definition and Explanation:

Professor Higgins has developed the theory of Technological Dualism. By this we mean:

"The use of different production functions in the advance sector and in the traditional sectors of UDCs".

The existence of such dualism has increased the problem of structural or technological unemployment in
the industrial sector and disguised unemployment in the rural sector. Higgins theory of technological
dualism incorporates the factor proportion problem as discussed by K.S. Eckaus, which is related to
limited productive employment opportunities found in the two sectors of a UDCs because of market
imperfections, different factor endowments and different production functions.

The UDCs are characterized with structural disequilibrium at the factor level. This arises, because a single
factor gets different returns in different uses or because price relationship among factors are out of line
with factor availabilities. Such disequilibrium leads to unemployment or underemployment in two ways.
It is as:

(i) Imperfection of price system.

(ii) Structure of demand which results in surplus labor in overpopulated backward country.

Thus the technological unemployment in UDCs is because of surplus labor which results from
misallocation of resources and structure of demand.

Higgins constructed his theory by assuming two goods; two factors and two sectors and their factor
endowments and production functions. Of these two sectors the industrial sector is engaged in plantation,
mines, oil field and large scale industry. It is capital intensive and characterized by fixed technical
coefficients that is, the factors have to be combined in a fixed proportions.

While the rural sector is engaged in producing food stuffs, handicrafts and very small industries. It has
changeable technical coefficients of production. Hence it has different alternative combinations of labor
and capital. The production functions in the industrial sector are represented as in figure:
Figure/Diagram:

Here the IQ1, represents the combination of OL1, of labor (L) and OK1, of capital (K) which produces a
certain level of output. While IQ2, IQ3 and IQ4 represent higher level of output which arc only possible if
K and L are increased in the same proportion. Thus the points; A, B, C and D show fixed combinations of
capital and labor which are used to produce different levels of output.

The line OE represents expansion path in the industrial sector and its slope represents constant factor
proportions. The line K2L2 shows that the production process is capital intensive. To produce Q1, output
OK1, of K and OL1 of L are used. If the actual factor endowment is at S rather A. It means that more
labor are available to produce same amount of output. While here units of K are OK1. Since there are
fixed technical coefficients, the excess labor supply will not affect the production techniques at all. The
L1L2 units of labor will remain unemployed. It is only when capital stock increases to SF, then it will be
possible to absorb this excess labor supply in this sector. Otherwise it has to seek employment in rural
sector.

The production functions for rural sector are shown in the figure:
The isoquants, Q1, Q2, Q3 and Q4 show variable coefficients of production. In order to produce more
output more labor is employed as compared with the capital. As a result the good land (capital) becomes
scarce and all available land is cultivated by high labor intensive techniques. At point E where maximum
output level is reached as shown by Qn.

Thus, according to Higgins, because of different production functions the unemployment and
underemployment comes into being in UDCs. According to Higgins the industrial sector uses capital
intensive techniques and fixed technical coefficients and it is not in a position to create employment
opportunities at the same rate at which population grows. Rather, the industrialization reduces the
employment in this sector. Therefore, the rural sector is an alternative for the surplus labor.

In the beginning it is possible to absorb the additional labor by bringing more lands under cultivation.
This leads to optimal combination of labor and capital. Eventually good lands become scarce. The ratio of
labor to capital in that sector rises and the techniques become increasingly variable in this sector.
Ultimately all available lands is cultivated by high labor intensive techniques and MP of labor becomes
zero and negative. Thus with the growth of population disguised unemployment begins to appear. Under
these circumstances farmers have no incentives either to invest more capital or to introduce labor saving
techniques. As a result the techniques of production, the productivity of labor and socio-economic life is
remained at low level in the rural sector.

In the long run the technological progress does not help in removing the disguised unemployment. Rather
it tends to increase the number of disguised unemployed. The situation is further aggravated by keeping
wage rates artificially high by trade unions or by govt. policies. For high industrial wages relative to the
productivity provide an incentive to the producers for introducing labor saving techniques and thereby it
diminishes the further capacity of the industrial sector to absorb surplus labor. Accordingly these factors
increase the technological dualism in UDCs.

Criticism:

Professor Higgins has attempted to present how disguised unemployment gradually rises in the rural
sector of dualistic society. But the theory has following defects:

(i) Assumption of Fixed Technical Coefficient: Higgins wrongly assumes fixed technical coefficient in
the industrial sector without any empirical verification.

(ii) Factor Prices do not Entirely Depend Upon Factor Endowment: This theory indicates how the
factor endowment and different production functions result in disguised unemployment. So disguised
unemployment is connected with the factor prices. But it has been found out that the factor endowments
do not entirely determine the factor prices.

(iii) Ignoring The Institutional Factors: There are many institutional and psychological factors which
have been ignored by Higgins in connection with their effect on factor proportion.

(iv) Ignoring the Use of Labor Absorbing Techniques: According to Higgins that industrial sector
employs highly capital intensive techniques which are imported. But practically we find that all imported
techniques are not labor saving. For example, Japan's agricultural development is not due to capital
intensive techniques.

(v) Size and Nature of Disguised Unemployment is not Assessed: Higgins does not clarify the nature
of disguised unemployment in the rural sector and excess labor supply in the industrial sector. Moreover,
he does not tell about the extent of disguised unemployed due to technological dualism.

(3) Financial Dualism:

Definition and Explanation:

Professor Hala Myint has developed the theory of financial dualism. Such dualism rises because of
division of money markets in unorganized and organized money markets in LDCs. The rate of interest in
unorganized market is higher than the rate of interest in organized money market which is concerned with
modern sector. The unorganized money market consists of village money lenders, landlords, arties. They
charge the high interest because of the following reasons.

(i) The lenders have monopoly and position of the borrowers is very weak.

(ii) There is a shortage of savings in the traditional sector because most of the savings are made in terms
of land or gold.

(iii) Due to natural calamities etc. the risk attached with such lending are very high.
Thus we find that the high interest rate which the farmers have to pay not only consists of formal interest
charges but also the concealed charges obtained through under pricing the grains purchased by the
farmers.

On the other hand, in the organized markets of LDCs the interest rates are low and credit facilities are
abundant. The loans are advanced to manufactured sector, export industry and modern commerce sector.

Professor Myint says that there was an old financial dualism which used to exist in the open economy of
colonial period and the financial dualism which now exists.

Under colonial system there was perfect convertibility at fixed exchange rate. Consequently there was no
shortage of foreign exchange and there were no BOP problems. But now a days the LDC's have to face
internal as well as external balance. Thus the poor traders and small peasants not only have to face high
interest rates, but also the shortage of foreign exchange. Then they are not in a position to get advanced
machinery etc.
Under colonial system organized money market of LDCs is consisted of the branches of western
commercial banks which were linked with international financial market. In colonial system the modern
sector consisting of mines, plantation and foreign trade borrowed at low interest rates both from western
banks and the world capital markets. But the present LDCs have attained monetary independence by
establishing their own central banks. They have introduced the exchange control.

As a result, the organized money market of the LDCs have been separated from the world capital market.
Hence, their central banks are following the cheap monetary policy even when they are having shortage
of funds. They are maintaining over-valued exchange rate on the ground that devaluation will create
inflation. On the other hand there is chronic excess demand for foreign exchange in these poor countries.
To meet this situation, these countries depend upon exchange controls, direct controls, monetary and
fiscal policies. This has led to enhance the economic dualism between the traditional sector and modern
industrial sector. The cheap monetary policy by maintaining artificial low interest rates has become
helpful for the large industrial sector. The low interest rates have discouraged the flow of funds from
abroad and savings from within the country. But it has created an excess demand for loans. Thus the
major part of domestic savings are flowing towards industrial sector. This has reduced the capital to
traditional and agriculture sector which have to get at higher interest rate.

The foreign exchange control to correct deficit in BOP has also benefited the modern industrial sector
against the traditional sector. It is because that the major share of available foreign exchange is allocated
to the industrial sector to import capital intensive goods. On the other hand, the agricultural and small
scale sector fail to get foreign exchange and import permits because of red-tapism and corruption in the
LDCs.

The most of the UDC's have established agricultural banks and cooperative societies. But these
institutions have been found providing loans to the influential people and to the model villages.

All this has led to misallocation of resources between the modern and traditional sector. So money
markets in the LDCs remain backward. Domestic inflation along with over-valued exchange rate have
encouraged flight of capital. The countries where this is checked, the capital moved in the purchase of
gold, jewellery, real estates and other speculative activities. This is because of low rate of interest against
investment. Hence the money market remains ineffective.

Govt. controls over the scarce supply of capital have also retarded the growth of financial intermediaries
in the LDCs. These controls favor the large manufacturing units and the banks. They discriminate against
the small borrowers and the money lenders who provide credit to the small borrowers. In the LDCs govts.
believe that capital funds invested in durable capital goods are productive while those invested in
financing agriculture and trading activities are unproductive.

According to Myint the cheap and easy credit to the traditional sector is not provided because of
following:

(i) The high over head costs and salaries of officials of commercial banks in the rural areas.

(ii) The red-tapism in dealing with small borrowers according to the rigid rules.

(iii) The lack of coordination between the head office and the branches.

(iv) Lack of subsidized loans supplied by the agricultural banks etc.

Professor Myint suggest two types of policies to reduce financial dualism in LDCs:

(i) The official interest rate in the organized capital market be increased. This will attract the savings both
from the country and out of the country. It will also create an equilibrium between the demand for loan
able funds and supply of loan able funds.

(ii) There should be free access on equal terms to capital funds by modern and traditional sector. This will
reduce misallocation of resources between the two sectors.

Big Push Theory of Economic Development | Economics

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The theory of ‘big push’ first put forward by P.N. Rosenstein-Rodan is actually a stringent variant of the
theory of ‘balanced growth’. The crux of this theory is that the obstacles of development are formidable
and pervasive. The development process by its very nature is not a smooth and uninterrupted process. It
involves a series of discontinuous ‘jumps’. The factors affecting economic growth, though functionally
related with each other, are marked by a number of “discontinuities” and “hump.”

Therefore, any strategy of economic development that relies basically upon the philosophy of economic
“gradualism” is bound to be frustrated. What is needed is a “big push” to undo the initial inertia of the
stagnant economy. It is only then that a smooth journey of the economy towards higher levels of
productivity and income can be ensured.

Unless big initial momentum is imparted to the economy, it would fail to achieve a self- generating and
cumulative growth. A certain minimum of initial speed is essential if at all the race is to be run. A big
thrust of a certain minimum size is needed in order to overcome the various discontinuities and
indivisibilities in the economy and offset the diseconomies of scale that may arise once development
begins.

ADVERTISEMENTS:

According to Rosenstein-Rodan, marginal increments in investment in unrelated individual spots of the

economy would be like sprinkling here and there a few drops of water in a desert. Sizable lump of
investment injected all at once can alone make a difference.

Rationale for the Big Push:

The basic rationale of the ‘Big Push’ like the ‘Balanced Growth’ theory is based upon the idea of
‘external economies’. In the theory of welfare economics, external economies are defined as those unpaid
benefits which go to third parties. The private costs and prices of products fail to reflect these. And the
market prices have to be corrected if an account of these external economies is to be taken. However, the
concept of external economies has a different connotation in growth theory. Here, they are pecuniary in
nature and get transmitted through the price system.

To explain the emergence of such external economies and their transmission, let us consider two
industries A and B. If the industry A expands in order to overcome the technical indivisibilities, it shall
derive certain internal economies. This may result in the lowering of the price for the product of the
industry A. Now if the industry B uses A’s output as an input, the benefits of A’s internal economies shall
then be passed on to the industry B in the form of pecuniary external economies. Thus, “the profits of
industry B created by the lower prices of product. A call for investment and expansion in industry B, one
result of which will be an increase in industry B’s demand for industry A’s product. This in turn will give
rise to profits and call for further investment and expansion of industry A.”

Following such a line of argument, Prof. Rosenstein-Rodan contends that the importance of external
economies is one of the chief points of difference between the static theory and a theory of growth. “In
the static allocative theory there is no such importance of the external economies. In the theory of growth
however,” remarks Prof. Rodan, “external economies abound because given the inherent imperfection of
the investment market, imperfect knowledge and risks, pecuniary and technological external economies
have a similarly disturbing effect on the path towards equilibrium.”

ADVERTISEMENTS:

Now, the basic contention of the “big push” theory is that such a mutually beneficial way of output
expansions is not likely to occur unless the initial obstacles are overcome. There are “non-
appropriabilities” or “indivisibilities” of different kinds which if not removed through a “big push” will
not permit the emergence and transmission of ‘external economies’ – which lie at the back of a self-
generating development process.

Associated with the removal of each set of indivisibilities is a stream of external economies. A ‘bit by bit’
approach to development would not enable the economy to cross over certain indivisible economic
obstacles to development. What is required is a vigorous effort to jump over these obstacles. As such, for
the economy to be successfully launched on the path of self-generating growth a “big push” in the form of
a minimum size of investment programme is necessary. In essence, therefore, an all-or-nothing approach
to development is stressed in big-push approach to development.

Requirements for Big Push:

The hallmark of the ‘big-push’ approach lies in the reaping of external economies through the
simultaneous installation of a host of technically interdependent industries. But before that could become
possible, we have to overcome the economic indivisibilities by moving forward by a certain “minimum
indivisible step”. This can be realised through the injection of an initial big dose of a certain size of
investment.

Prof. Rodan distinguishes three kinds of indivisibilities and externalities with a view to specify the areas
where big push needs to be applied.

They are:
(i) Indivisibilities in the production function, i.e., lumpiness of capital, especially in the creation of social
overhead capital.

(ii) Indivisibility of demand, i.e., complementarity of demand.

(iii) Indivisibility of savings, i.e., kink in the supply of savings.

Let us study each of these individually so as to bring out their importance in providing a self- generating
stimulus to the development process.

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(i) Indivisibilities in the Production Function:

Prof. Rodan argues that it is possible to generate enormous pecuniary external economies by overcoming
the ‘indivisibilities of inputs, processes and outputs.’ The emergence of such externalities would bring
about a wide range of increasing returns. To corroborate his contention he cites the case of United States.
He feels that the fall in the capital-output ratio in U.S.A. from 4:1 to 3:1 over the last eighty years was
chiefly due to the increasing returns made possible by the levelling down of production indivisibilities.

The most important case of indivisibilities and external economies on the supply side resides in the social
overhead capital which is now called infrastructure. The most important effect of jumping over this
indivisibility is the “investment opportunities created in other industries”. Social overhead capital consists
of all the basic industries such as transport, power, communications, and such other public utilities.

The construction of these infrastructures involves ‘lumpy’ capital investments. And the capital- output
ratio in the social overheads is considerably higher than in other industries. Moreover, these services are
only indirectly productive and involve long gestation periods. Besides, their “minimum feasible size” is
large enough. As such it is well-nigh difficult to avoid excess capacity in these, at least in the initial
periods. Above all, there is a “minimum industry mix of public utilities” that must be required to divert at
least 30 to 40 per cent of their total investment in the creation of social overhead capital.

In this view, therefore, it is possible to distinguish four types of indivisibilities of creating social overhead
capital.

They are:
(a) Indivisibility of Time:
The creation of social overhead capital must precede other directly productive industries so that it is
irreversible or indivisible in time.

(b) Indivisibility of Durability:

The infrastructures generally last long. The overhead capital with lesser durability is either technically not
feasible or is very poor in efficiency.

(c) Indivisibility of Long Gestation Periods:

The investments in social overhead capital, by all counts, involve a highly protracted period of time for
their fruition as compared with investments in other directly productive channels.

(d) Indivisibility of an Irreducible Industry Mix of Public Utilities:

Social overhead capital must grow collectively. There is an irreducibly minimum industry mix of
different public utilities that have to be created all at one stroke.
As it is impossible to import the infrastructures, they have got to be produced domestically. And because
of the existence of above explained indivisibilities, it is necessary to make ‘lumpy’ investments in them.
And their creation is a precondition to the investments in directly productive and other quick-yielding
productive activities. Only then the way for a self-generating economy can be paved. Thus the absence of
adequate social overhead capital constitutes the most important bottleneck in the development of
developing countries.

(ii) Indivisibility of Demand:

This refers to the complementarity of demand arising from the diversity of human wants. The very fact
that there is an indivisibility of complementarity of demand requires simultaneous setting up of
interrelated industries in countries to initiate and accelerate the process of development.

Indivisibility of demand generates interdependencies in investment decisions. As such, if each investment

project was undertaken independently, it is in most cases likely to flop down. This is because individual
investment projects generally have “high risks because of uncertainty as to whether their products will
find a market,” This point can be clarified with the help of the following well known example given by
Rosenstein-Rodan for a closed economy.

To start with, let us suppose that 100 disguisedly unemployed workers in an underdeveloped country
were withdrawn and employed in a shoe factory. The wages of the newly employed workers would
provide an additional income to them. Now, if they spend all their newly received purchasing power on
the shoes, an adequate market for the shoe industry would be ensured. As a result, the industry would
succeed and survive.

But the fact is that human beings having diversity of wants cannot simply afford to survive simply by the
consumption of shoes and nothing else. As such, they will not spend all their earnings on the purchase of
shoes. The market for the shoe industry will, therefore, remain limited as before. Therefore, the incentives
to invest will be adversely affected. As a result, the shoe factory investment project might end in a fiasco.

Now let us make a somewhat different assumption to see how an atmosphere congenial to the undertaking
of investments can occur. Suppose that instead of only 100 workers being engaged in the shoe factory,
10,000 workers are put to work in 100 different factories producing a variety of consumer goods. These
new factories provide larger employment and thus purchasing power to their workers. There is an increase
in the total volume of purchasing power and the total size of the market. This is because the “new
producers would be each other’s customers”.
In a way, what has happened is that due to the complementarity of demand, the risk of limitedness of
market is greatly reduced. The result is that the incentives to invest are increased. “Thus provided that the
total volume of employment and purchasing power is increased by a minimum indivisible step, each
factory Will have enough market to reach full capacity production and the point of minimum cost per
unit.”

We, therefore, find that the indivisibility of demand requires the simultaneous production of a “bundle” of
large number of wage goods on which the newly employed workers could spend their income. That alone
would ensure adequate market for the product of each producer. In terms of investment the implication is
that “unless there is assurance that the necessary complementary investments will occur, any single
investment project may be considered too risky to be undertaken at all.”

This, as Prof. Higgins remarks, results into indivisibility in the decision-making process. A large-scale
investment programme based on complementarity of demand undertaken as a unit may bring forth large
increases in national income. But each of the individual investment projects undertaken singly may not
fructify at all.

The essence of the whole analysis is that a high minimum quantum of investment in interdependent
industries is needed to overcome the indivisibility of demand and hence that of decision-making. That,
according to the big push theory, is the only reliable way of overcoming the smallness of the market size
and low inducement to invest in the developing economies.

(iii) Indivisibility in the Supply of Savings:

A high minimum package of investment cannot be undertaken without an adequate supply of savings. But
it is not possible to have such high volume of savings in underdeveloped countries due to an extremely
low price and high income elasticities of the supply of savings. The savings are low primarily because
incomes are low. This, thus, constitutes the third indivisibility. “The way out of the vicious circle,”
remarks Rosenstein-Rodan, “is to have first an increase in income and to provide mechanisms which
assure that in every second stage the marginal rate of savings will be very much higher than the average
rate of savings.” The Smithian advice that ‘frugality is a virtue and prodigality a vice’ has to be adapted to
a situation of growing income.” But in the ultimate analysis the initial big increase in income has got to
be provided through an initial big increase in investment.

The existence of the three indivisibilities outlined above make it abundantly clear that the solution to all
these lies in a high minimum quantum of investment. Thus, a big push through a minimum indivisible
step forward in the form of a high minimum quantity of investment could alone make it possible to jump
over the economic obstacles to development in the underdeveloped countries.
Lastly, Resenstein-Rodan considers the role of international trade vis-a-vis the strategy of big push in
generating a self-sustaining process of development. In this regard he is of the view that international
trade cannot be a substitute for “big push.” The provision of some of the needed wage goods through
imports can at best help in narrowing down the range of fields which call for a ‘big push’. The historical
experience provided by the nineteenth century corroborates Rosenstein- Rodan’s conclusion that
international trade cannot by itself obviate the need for ‘big push’ altogether.

Once the process of development by an initial application of ‘big push’ is underway, its sequel course
would tend to follow simultaneously three sets of balanced growth relations.

They are:
(i) A balance between the social overhead capital and the directly productive activities (in both the
consumer and capital goods sectors).

(ii) A vertical balance between capital goods and consumer goods (including the intermediate goods).

(iii) Lastly, there should be the horizontal balance between various consumer goods industries due to
complementary nature of expanding consumer demand.

The Need for Balanced Growth of Centralised Planning:

The mutual benefits arising from the external economies for industrialisation cannot be included in the
cost calculations of entrepreneurs to the fullest possible extent without recourse to some sort of
centralized ‘balanced growth’ planning. This is because of a number of reasons. First, due to the
imperfections in the market, the free market price system does not adequately give proper signal to the
private investors for the future possibilities of expansion in complementary industries.

Second, in developing countries due to the imperfections of knowledge and risks, the response of the
private entrepreneurs to any given price signal is quite imperfect and unsatisfactory. Thus, due to the
failure to take advantage of the external economies to the fullest extent, investments which may be
profitable in terms of ‘social marginal net product’ remain unprofitable in terms of ‘private marginal net
product’. In this view, therefore, there is a need for an integrated investment scheme to be carried out in
complementary industries. The best way to do that would be to carry out the investment programme under
the direction of some centralised planning authority. An individual entrepreneur in a developing country
cannot hope to have all the necessary data which the central planning authority can draw upon.

The crash programme of investment envisaged by the ‘big-push’ theory cannot by its very nature be made
just at random. It has to take into consideration the various balances – horizontal as well as vertical. Only
then could the achievement of self-generating, cumulative and harmonious growth of the economy is
possible. For this what is necessary is a unified decision-making process. “Allocation of capital,” remarks
Prof. Higgins, “on the basis of individual estimates of short-run returns on various marginal investment
projects is the very process by which the underdeveloped countries got where they are.

The basic reason for government action to promote development is that each of a set of individual private
investment decisions may seem unattractive in itself, whereas a large scale investment program
undertaken as a unit may yield substantial increase in national income.” Prof. Rosenstein-Rodan’s theory
is essentially a theory of development and thus helps us to examine the path towards development rather
than restricting itself simply to the study of conditions at the point of equilibrium. The theory highlights
the inefficiency of price system of signalling the desirable directions for investment. It is big-push
investment through a centralised planning that could put the developing countries on a self-generating
development process.

Evaluation of Rosenstein’s Big Push Strategy:

However, Prof. Rosenstein-Rodan’s all-or-nothing approach is not perfect in itself in all respects. It
suffers from a number of lacunae.

First, the main implication of the ‘big-push’ theory is State intervention and centralised planning. It is
argued that due to imperfections of market the free price system fails to register and thus communicate
properly the economic events, much less their future course. But the pertinent question involved here is –
will the prevailing circumstances of the developing countries warrant a conclusion to the contrary? The
actual fact of the matter is that the current institutional and administrative set-up of the government
machinery of the poor developing countries is too weak to cope with the dictates of the ‘big push’ theory.
It is, therefore, quite doubtful whether the government sponsored brand of communication system about
the future events would at all be more effective than the free price mechanism.

The governments of developing countries may somehow manage to draw up their initial integrated
economic plans. But they are bound to be faced with tremendous difficulties in the execution of these
plans. In any comprehensive programme comprising a complex set of related projects, delays and
continued revision of the original time-bound schedules are inevitable. “The greater the interdependence”,
remarks Prof. Myint, “between the different components of the plan, the greater the repercussions of an
unexpected or an unavoidable change in one part of the plan on the rest and the greater the need to keep
the different parts of the plans continually revised in the light of the latest information available.” These
are indeed formidable hurdles for the developing countries to cross.
Besides, on account of the poor and incompetent institutional set-ups of the developing countries, there is
bound to be insufficient knowledge about the local conditions and an “inefficient feedback of this vital
local knowledge from different parts of the country to the central planning machinery.” Mere
improvement in the standard type of statistical information would not remedy all this.

Above all, the process of unified decision-making and coordination becomes all the more difficult in
mixed economies like India. This is so because not often, the public and private sectors rather than being
complementary are in fact competitive with each other. Thus, it may so happen that the “private enterprise
is inhibited by uncertainties not only about the general economic situation but also about the future
intention of the government regulations.”

Thus, it is quite clear that the application of a ‘big push’ programme in the developing countries with their
weak and incompetent institutional and administrative machinery is likely to die its own death. In fact, as
Prof. Myint remarks, it can be compared to “an attempt to impose a complete and brand new ‘second
floor’ on the weak and imperfectly developed one floor economy of these countries.”

Secondly, the chief plank on which the ‘big push’ theory is founded is the emergence of a wide range of
external economies. Prof. Viner has shown that international trade can provide much more external
economies than does the domestic investments. However, the developing countries being primarily
primary producing countries, engage a large part of their total investment for their exports and marginal
import substitutes, the field where the external economies are found to be very- negligible.

Thirdly, the ‘big push’ theory concentrates mainly on the industrial sector – viz., capital goods, consumer
goods and social overhead capital. The manufacturing sector is considered inherently to be a better
vehicle of economic growth. But in the developing countries, the most dominant sector is composed of
agricultural and primary production. For a balanced growth of the economy, agriculture also requires a
corresponding ‘big push’. Any neglect of the agricultural sector in these countries is bound to jeopardise
the ‘big push’ effort.

Fourthly, the major part of the ‘lumpy’ investments involved in the ‘all-or-nothing’ approach is called for
by the ‘technical indivisibilities’ embodied in the creation of social overhead capital. Not only is the
quantum of investment enormously ‘lumpy’ but also the capital-output ratio high in the provision of
social overhead services than in other directions. Thus, due to the inherent capital scarcity in the
developing countries, it is really a matter of dubious wisdom to require these countries to overstrain their
meagre resources in the provision of a complete outfit of infrastructures.
The ‘big push’ theory recommends a ‘starting from scratch’ concerted action in the creation of social
overheads. This is on the implicit assumption that these services are totally non-existent in these
economies. However, for most of these countries, remarks Prof. Myint, “the practical question is not
whether to have a completely new outfit of these services starting from scratch but how to extend and
improve the existing facilities.”

Further, the ‘big push’ theory by its very nature requires the ‘lumpy’ investments in different social
overheads to be made simultaneously and once for all. With the very long gestation periods usually
associated with such investments, there are bound to be inflationary pressures in the economy due to the
shortage of consumption goods. In an inflationary atmosphere, the process of construction of the social
overheads is bound to be a protracted one. In this light it would be better to spread the infrastructure-
building activity over a period of time through phasing and changing the time dimension of the projects.
This requires selection of a suitable economic size of the social overhead investments.
Big Push Theory By Rosenstein Rodan and Economic Development:

Definition and Explanation:

The Big Push Theory has been presented by Rosenstein Rodan. The idea behind this theory is this that a
big push or a big and comprehensive investment package can be helpful to bring economic development.
In other words, a certain minimum amount of resources must be devoted for developmental programs, if
the success of programs is required.

As some ground speed is required for the aircraft to airborne. In the same way, certain critical amount of
resources be allocated for development activities. This theory is of the view that through 'Bit by Bit'
allocation no economy can move on the path of economic development, rather a specific amount of
investment is considered something necessary for economic development. Therefore, if so many mutually
supporting industries which depend upon each other are started the economies of scale will be reaped.
Such external economies which are attained through specific amount of investment will become helpful
for economic development.

Rosenstein Rodan has presented three types of indivisibilities and economies of scale. They are as:

(1) Indivisibilities in Production Function: When so many industries are established the economies
regarding factors of production, goods, and techniques of production are accrued. Rosenstein Rodan gives
more importance to economies which arise due to the establishment of social overhead capital. The infra-
structure consists of means of transportation, communication and energy resources. They all contribute to
development indirectly. They last for a longer period of time. The SOC can not be imported. To construct
it a big amount of capital is required. For some time, the excess capacity may grow in SOC, but they are
very much must. Accordingly, UDCs will have to spend 30% to 40% of investment on SOC. The SOC is
attached with the following indivisibilities:

(i) The SOC must be provided before Directly Productive Activities (DPA).

(ii) It is lumpy and it has a minimum durability.

(iii) It lasts for a longer period of time and it is irreversible.

These indivisibilities serve as big obstacle in the way of economic development of a UDC.

(2) Indivisibilities of Demand: The complementarily with respect to demand requires that UDCs should
establish such industries which could support each other. To make investment in one project may be risky
because in UDCs the demand for goods and services is limited due to lower incomes. In other words, the
indivisibilities of demand require that at least a certain amount of investment be made in so many
industries which could mutually support each other. As a result, the size of market will be extended in
UDCs; or the problem of limited market will come to an end in UDCs. It is shown with Fig.

Diagram/Figure:

Here D1 and MR1 are the average and marginal revenue curves of a firm when investment is made in this
single firm. This firm sells OQ1 quantity and charges OP1 price. Here it faces losses equal to P1cab.

But if investment is made in so many industries the market will be extended. In this way, the demand will
increase as shown by D4 and corresponding marginal revenue curve is MR4. Now the equilibrium takes
place at E where OQ4 quantity is produced and OPb price is charged. As a result, the industries are
having profits equal to P4RST.

It means that the greater investment in so many industries nay convert the losses into profits.
(3) Indivisibility in Supply of Savings: The supply of savings also serves as an indivisibility. A specific
amount of investment can be made in the presence of specific savings But in case of UDCs because of
lower incomes the savings remain low. Therefore, when incomes increase due to increase in investment
the MPS must be greater than APS.

In the presence of these indivisibilities and non-existence of external economies only a Big Push can take
the economy out of dole drums of poverty. It means a specific amount of investment is necessary to
remove the obstacles in the way of economic development.

Criticism/Demerits:

Rosenstein theory is better in the sense that it identified that market imperfections are the big obstacles in
the way of economic development. Therefore, a big amount of investment will solve the problem of
limited markets, rather depending upon market mechanism, and such heavy amounts of investment will
become helpful for economic growth. Despite this merit, followings are the demerits of this theory.

(i) Negligible Economies in Export, and Import Substitute Sectors: The 'Big Push' infrastructure may
be justified on the ground of external economies. But, according to Viner, the export sector and .import-
substitute sectors are so backward in UDCs that they hardly give rise to economies.

(ii) Negligible Economies from Cost Reducing Investment: The goods which are concerned with
public welfare hardly yield external economies. Moreover, the investment which is aimed at reducing
costs does not yield economies.

(iii) Neglecting Investment in Agri. Sector: In this theory emphasis has been laid upon making
investment in infrastructure and industries. While it neglects the investment to be made in agri. and its
allied sectors. As the agri. sector is the largest sector in UDCs and it will be a mistake to ignore it.

(iv) Inflationary Pressure: From where the funds will come in UDCs to spend them on SOC. If the
funds are raised through foreign loans and by printing new notes they will create inflation in the economy.

(v) Administrative and Institutional Difficulties: This theory stresses upon state investment to remove
deficiency of capital. But in case of UDCs the machinery is corrupt. There exist a lot of problems in state
machinery. The private and public sectors compete with each other, rather supporting each other.
Consequently, there will not be the balanced growth in the economy.

(vi) It is Not a Historical Fact: The Big Push theory is a recipe for the UDCs, but it has not been derived
on the basis of historical experience. As Prof. Hagen says, "the Big Push theory lacks the historical
evidences and facts".
Lewis Model of Economic Development

In this article we will discuss about: 1. Introduction to the Lewis Model 2. Assumptions of the Lewis
Model 3. Working 4. Role of Bank Credit 5. Critical Review.
Introduction to the Lewis Model:
Lewis published his model entitled:
“Economic Development with Unlimited Supplies of Labour”in 1954. In his model Lewis divides the
economy in an underdeveloped country in two sectors namely the Subsistence sector and the capitalist
sector. Subsistence is identified with the agricultural sector of the economy while the capitalist sector
implies mainly the manufacturing sector of the economy.
Capitalist sector also includes plantations and mining where hired labour is employed for purposes of
production. The capitalist sector can either be private or public in nature. Subsistence sector, that the
agricultural sector is considered to be labour intensive. It does not use reproducible capital. It uses poor
techniques of production and has very low productivity.

Assumptions of the Lewis Model:

(A) Surplus Labour in the Subsistence Sectors:
The basic assumption of the model is that there exists surplus labour in the subsistence sectors. It includes
labour whose marginal productivity is zero as well as that whose marginal productivity is positive but is
less than the institutional wage. This labour comprises farmers, agricultural labourers, petty traders
domestic servants and women.

The surplus labour in the agriculture sector acts as a source of unlimited supply of labour for the
manufacturing sector. By unlimited supply of labour. Lewis means that the supply of labour is perfectly
elastic at a particular wages. This particular wage is somewhat higher than the institutional wage which
each worker in the agricultural sector gets.

Lewis calls it as institutional wage because every worker gets this wage because of some institutional
arrangements. This wages is equal to an average share of each worker in the total output in the
subsistence sector. If market forces were allowed to operate in the subsistence sector labourers with zero
margin productivity or those with a very low marginal productivity would not have received this wage.

(B) Importance of Saving:

Another important assumption that Lewis makes is about the savings generated in the capitalist sector and
in the subsistence sector. The capitalist sector invests all its savings for its further expansion.

Those in the subsistence sector, on the other hand squander away their savings, if any in purchase of
jewellery & for construction of temples etc. The propensity to save of the people in subsistence sector is
also lower when compared with that of those in the capitalist sector.

Lewis in fact so much fascinated by the higher propensity to save of the capitalist sector that he even
advocates a transfer of income from the subsistence sector to the capitalist sector. He feels that steps have
to be taken to raise the rate of savings from 10% to 15% if the development of the economy has to be
smooth.
The Working of the Lewis Model:
The explanation of working of the Lewis model is quite simple. He feels that if a wage higher than the
institutional wage prevailing in the subsistence sector by a certain proportion of the institutional wage is
fixed in the capitalist sector the capitalist sector will be able to attract an unlimited quantity, the labour
from subsistence sector. This will enable the capitalist sector to expand. It will, in turn lead to the
generation of more savings in the capitalists sector.

The additional saving, will not only help the entrepreneurs to invest more but also to improve the quality
of capital invested. This will result in more employment of labour from the subsistence sector. This will
lead to generation of more savings in the Capitalist sector which can be further invested leading to
employment of more surplus labour and so on.

We is the wage rate fixed in the capitalist sector. It is higher than W which represents the institutional
wage. The wage in the capitalist sector has to be higher than the instructional wage because only such
higher wage can attract labour from the subsistence sector. At first; ON-I labour is employed. This will
lead to the generation of surplus equal to AMIS, after the wages at the rate W have been paid

According to Lewis this surplus AMIS will be reinvested either in old type of capital or may even be used
to improve the existing techniques. All this will result in marginal productivity curve of labour moving
M2 M2. Now more labour at wage. We can employee, ON2 amount of labour will now be employed.
More surplus will then be generated. It would be reinvested.

Marginal productivity of labour curve will shift to M3 M3 more labour can now be employed. Still more
surpluse will be generated and re-invested and so on. The process of transfer of labour from the
subsistence sector to the capitalist sector will continue for some time till some obstacles, hindering this
transfer appear.

Role of Bank Credit:

From the above analysis, one might get the impression that it is only through the surplus generated in the
capitalist sector that the development of the capitalist sector takes place. This however is not correct.

The process of development can also start if the capitalist sector initially does not invest its savings in the
capital but borrows from the banks. According to Lewis the basic problems is to employ the labour from
the subsistence sector and this can be initially done through investment of funds borrowed from the
banks.

Lewis is conscious of the fact that creation of bank credit will give rise to inflationary increase in prices.
However, he is not much perturbed by this prospect. He is of the view that inflationary pressures will not
continue forever.

A time will come when the additional savings generated by the investment of borrowed funds become
equal to these very funds. At that time, prices will stop rising further. As he says, an equilibrium.is
reached when savings generated through the investment of additional bank credit become equal to the
amount of bank credit itself.

He is also aware of another fact. Inflation can make the distribution of income unfair. However, he says, it
will be good for the manufacturing sector if the distribution of income moves in favour of the capitalists.
Of course, if inflation tilts the distribution of income in favour of the traders it will be bad for the
economy. It will only lead to more speculative activities.

Slowing of the Pace of expansion of the Capitalist Sector:

According to Lewis, expansion of the capitalist sector will continue unhindered so long as the supply
curve for labour from the subsistence sector is perfectly elastic i.e. so long as the labour can be transferred
to the capitalist sector at a constant wage. Lewis, of course is conscious of the fact that under certain
circumstances, the supply curve for labour can turn upwards.

These circumstances are:

(i) The pace of expansion of the capitalist sector is more rapid when compared with the rate of growth of
population in the subsistence sector. The surplus labour in that case will ultimately be fully exhausted.
(ii) Technological development in the subsistence sector raise the productivity of labour with in that case
will rise. We too will have to be raised them.

(iii) As population increase due to law of decreasing marginal return, prices of food and raw materials
will rise. This will increase both W and W.

(iv) When workers in the capitalist sector start imitating the living pattern of the capitalist themselves,
they may ask for higher wages.

If any of the above four factors start operating, then according to Lewis, the expansion of the capitalist
sector will be slow down.
Impact of the Open Economy:
The open economy can encourage the immigration of labour. If this happens, it will help in the expansion
of the capitalist sector. But immigration may not be so easy. If in that case the pace of expansion of the
capitalist sector slows down, capital may move out of the country as the economy is an open one. This
may in turn lead to balance of payments problems and the problem of stability of rate of exchange.

Critical Review of the Lewis’s Model:

Some of the objections against Lewis’s model are as follows:
(1) The assumption that disguised unemployment exists in the agriculture sector has not been accepted by
many economists. Schultz, Viner, Heberler and Hopper are a few of such economists. According to them,
the production in the subsistence sector will be affected when labour is withdrawn from it.

(2) Lewis ignored the cost involved in training the unskilled worker transferred from the subsistence
sector. Even if it is obtained at a constant wage rate, so for as its transfer from the subsistence sector is
concerned, the supply curve may slope upwards so far as the capitalist, sector is concerned if the cost of
training rises as more and more labour is transferred.

(3) When labour is transferred from the subsistence sector share of agricultural output falling to each one
left in the agricultural sector will go a rising. This means the institutional wage will go on rising with
every transfer and so will be the wages paid in the capitalist sector.

(4) The model assumes that, besides labour, there is unlimited supply of entrepreneurs in the capitalist
sector. This is not true in the case of many of the underdeveloped countries.

(5) It is wrong to assume that a capitalist will always re-invest their profits. They to can indulge in un-
productive pursuits. They can use their profits for speculative purposes.
(6) It is also wrong to assume that landlords always squander away their savings. The role of landlords of
Japan in industrialisation of the country is well known.

(7) The model assumes that there already exists a market for the industrial products in the country. This is
wrong. People of an underdeveloped country may not be able to purchase the products perturbed by the
expanding capitalist sector. Foreign markets, too, may not be available to the capitalist sector in the
beginning.

(8) Inflation is not liquidating, as has been assumed by Lewis, Experience of various, countries shows that
if once prices start rising, it, becomes difficult to control them.

(9) It is not easy to transfer labour from the subsistence Sector to the capitalist sector by offering them an
incentive of a little higher wage.

Mobility of labour is very low. Many factors like family affection, difference in language, caste, religion
etc. affect it adversely.

(10) Every underdeveloped country does not have surplus labour in the subsistence sector. As such, the
model does not apply to countries which are sparsely populated.

The only positive point in the model is its ‘general’ emphasis on the role of saving in economic
development and on the potential that overpopulated countries have in developing themselves with the
help of surplus labour.