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Appendix 3.

1: The Solow Neoclassical Growth Model


 Best known model of economic growth – describes developed nations somewhat better
 Implies convergence to same level of Y given same s,  , n, and A
 Unlike H-D (or AK model) Solow allows for substitution between K and L.
 Assumes diminishing returns for K and L


Y  F(K,L) aggregate production function, CRS

Y t   K (t) ( A(t)L(t))1 : Cobb-Douglas production function at any time (t)

Y=GDP; K=stock of capital (human and physical); L=labor; A(t)=exogenous prod. of L

Due to CRS: Y  F(K, L)

Y L  f (K L,1)  y  f (k)  Ak  (Cobb-Douglas last)


Set   1 L thus

y=output per worker; k=capital per worker --- capital=output (CRS)


 Note: Here k  K L  K Y like in the Ak (H-D) model; singled down to one argument!!!

- Everything in quantities per worker




n=growth of L ; nkcapital needed to provide for new workers;  =depreciation


Y grows when s>  but k grows when s>what is needed to equitably equip new workers (n+  )

k
 sf (k)  (  n)k

 
 
Note: assuming A constant thus   0 = no labor productivity growth = no tech. improvement

Steady state when k  0sf (k  )  (  n)k 



k*=level of capital per worker at steady state=stable equilibrium

Increasing s shifts sf(k) upwards increasing k* thus y – doesn’t increase growth in the LR

- only increases k*; over t K/L ratio increases as does Y/L ratio but not rate of growth

- DOES raise y* just not equilibrium rate of growth, but increases it temporarily

Chapter 4: Contemporary Models of Development and Underdevelopment


The New Growth Theory: Endogenous Growth

Motivation for the New Growth Theory


Solow residual: increases in GNI not attributed to SR adjustments in L or K (exogenous tech ∆)
Endogenous/New Growth Theories: hold GNI growth as a natural consequence of LR equilibrium
- explain determining factors of the size of 
- tech ∆ endogenous outcome of investments in human capital
Discard neoclassical assumptions:
-  marginal returns to capital investments (thus permitting  RS in aggregate production)
- focusing on role of externalities
 in determining the rate of return on capital investments
- exogenous changes in tech. no longer necessary to explain LR growth


NG theory seek to explain existence of RS and divergent LR growth patterns among countries
Y=AK (H-D but w/o diminishing returns sustained LR growth possible
Complementary Investments: I that complement/facilitate other productive factors

The Romer Endogenous Growth Model


Assumes K positively affects output at the industry level – increasing RS
- knowledge part of K = public good – like A in Solow, spilling over into greater economy
Aggregate production function= Y  AK    L1
- Assume A is constant vs. rising over t then g  n  n 1    
- g= output growth rate; n=population growth rate;   0 without spillovers


- thus g-n>0 and Y/L is growing – if  >0 growth would be  to that extent
 
Criticisms of the New Growth Theory

- Assumes that there is on sector of production, or that all are symmetrical
- Overlooks poor infrastructure, imperfect markets,
 etc.
- Very limited empirical support

Underdevelopment as a Coordination Failure


Complementarities: things that must work together well enough for sustainable dev. to occur
Coordination Failure: inability to coordinate behavior leads to an outcome/equil. of all being worse
- skill or demand first? Coordination needed in terms of investment.
O-Ring Model: production decisions by modern-sector firms are mutually reinforcing
Big Push Model: value of upgrading skills/quality depends on similar upgrading by other agents
Underdevelopment Trap: regional or national in scope where underdevelopment perpetuates itself
Deep interventions: government actions that push economy to better equilibrium
Congestions: when markets are too crowded, agents move to other options
Where-to-meet dilemma: middlemen cannot function while agents are uncoordinated

Multiple Equlibria: A Diagrammatic Approach


Pareto improvement: moving to the higher stable equilibrium
 Basic idea demonstrated by s-shape curve
 Benefits of actions taken by an agent depends on # of other agents/ expected other agents
 S-shaped curve: privately rational decision function
o Where crosses 45 degree line is equilibrium
o Firms adjust expectations to actual investment until at equilibrium
 Stable equilibria (2): where s cuts 45 degree line from above
 Unstable equilibrium (1): where s crosses 45 degree line from below
 S curve may be many shapes and may cut 45 degree line many or few times
 Market forces not strong enough sometimes to reach higher equil.
o Need for gov’t intervention
o Need for “pioneer investor” and change of expectations
 Political situation and availability of technology also affect

Starting Economic Development: The Big Push


Pecuniary externalities: spill over effects on costs or revenues
 Difficult to start modern growth
 Starting development is difficult
o Few incentives to use new technology
o Perfect competition does not have increasing returns to scale
 Big push Paul Rosenstien-Rodan
o Assumes economy cannot export
o Good has to be sold to locals- factory workers
o Not many other sources of income or other goods (small market)
o High training costs for skilled labour
o Need for public policy

The Big Push: A Graphical Model


Assumptions
1. Factors: One factor of production
- L – fixed total supply
2. Factor Payments: two sectors
- traditional wage (1)
- modern wage (>1)
3. Technology: traditional sector has CRS; modern sector IRS
4. Domestic Demand: each good consumes equal share of national income
5. International Supply and Demand: closed economy
6. Market Structure: Perfect competition in traditional sector: P of good= Marginal cost L

Conditions of Multiple Equilibria


 Modern sector more efficient than traditional
 Wages in modern sector higher
 If modern sector wages are low, there are few agents, start-up and overhead costs are low,
industrialization will not occur
 Enough agents must overcome coordination failure to provide labour and demand while
lowering costs to move towards equilibria
 Does not consider technological externalities: firms learn from other firms what works and how
to run

Other Cases in Which a Big Push May be Necessary


 Intertemporal effects: investment in the first period in many sectors is necessary without which a
big push is needed
 Urbanization effects: urbanization is needed to consume industrial goods
 Infrastructure effects: railroads and ports needed to make industrialization profitable
 Training effects: investment in training and education needed
Why the Problem Cannot Be Solve by a Super-Entrepreneur
 Capital market failure: no agent has enough money
 Agency costs: monitoring and managing of a large firm is expensive
 Asymmetric information: who controls quality? Of goods? Of labour?
 Communication failure: easy to pretend to have control
 Knowledge limitation: no one person knows enough to industrialize a whole economy
 It has never happened before

Further Problems of Multiple Equilibria


Inefficient Advantages of Incumbency
 firms may be running old technology less efficiently than market expects
 Hard for new technology to compete with firms with already large output
Behavior and Norms
 Corruption can keep a bad equilibrium
 Differences in values affect decision making
Linkages
 Linkages: possible solution to coordination failure- industries foster others and snowball effect of
urbanization and industrialization
 Pecuniary externalities are spill over effects on costs or revenues
Inequality, Multiple Equilibria, and Growth
 Poverty trap:
o Poor cannot get loans- cannot start business
o Don’t have access to school
 Not enough money to finance it
 Children supplement household income- work
o Human capital distribution

Kremer’s O-Ring Theory of Economic Development


Provides insights into low-level equilibrium traps
Many activities must be done well together in order to be successful – strong complementarities of input

The O-Ring Model


 Consumers willing to pay more for better goods
 O-Ring Production function:
BF (qiqj)=qiqj
 (NOT being tested) B is a term that depends on the characteristics of a firm
o q is level of skill required
 Positive assortative matching: workers with high skills work together
 Assumes:
o Workers imperfect substitutes for each other
o Sufficient complementarity of tasks

Implications of the O-Ring Theory


o Firms hire similar employees
o Workers with high skills will be paid more than with low skills even if producing the same
thing
 High skills= more likely to function, better quality
o Wages increase at increasing rate means wages more than proportional higher in developed
countries
o Greater incentive to acquire more skills
o Low production quality traps possible
o Local production bottlenecks become more important
 Trade important- foreign investments and inputs
 Choice of technology important- firms with higher skilled workers can use more complex technology
but getting something wrong there has bigger consequences than for low technology

Economic Development as Self- Discovery


 Individuals must discover their own comparative advantage
 Information externality (not knowing which industry to specialize in)
 Rapid diffusion of products in local markets

The Hausmann-Rodrik-Velasco Growth Diagnostics Framework


 Encouragement of efficient investment and entrepreneurship
 No one size fits all econ policy
o Each country has own restraints
 Growth Diagnostics: finding out what a country’s restraints are
 Social returns rewards for economic investments low
o Poor geography
o Low human capital
o Bad infrastructure
 Investors cannot gain adequate share of returns
o Government: property rights, taxes, corruption, fiscal instability
o Market: information externalities, coordination failure
 Too expensive to finance
o International finance: debt, inaccessibility of credit
o Local finance: domestic saving low, unavailability of credit

Conclusions: Multiple Equilibria and Coordination Failures


 It is inefficient to do inefficient things but people will do them so long as everyone around them is
doing them- no incentive to industrialize
o Leads to coordination failure
o Government policy and investment needed to overcome “vicious circle”
 Coordination failures can lead to much greater problems
 Bad gov’t policy can affect development for a long time
 Big push from gov’t- easy to corrupt
 Strategic roles of complementarities in poverty traps

Chapter 5: Poverty, Inequality, and Development

Introduction
Development requires higher GNI and faster growth rate
- also must consider inequality
Gaps between rich and poor in and within nations are increasing
Measuring Inequality and Poverty
Measuring Inequality: Size vs. Functional Distributions

Size Distributions
personal/size distribution of income: individual persons/households and total incomes they receive
regardless of where/how earned (most commonly used by economists)
- Population then divided into successive quintiles (fifths) or deciles (tenths)
- Kuznets ratio: ratio of incomes received by top 20% and bottom 40%.
- common measure of income inequality

Lorenz Curves
Lorenz Curve: Y-axis: % of income, X-axis: % of income recipients
- done in cumulative percentages up to 100% on both X and Y
- the further the Lorenz curve from the line of equality, the higher the inequality
Line of Equality: from origin to top of Lorenz Curve; represents “perfect equality”

Gini Coefficients and Aggregate Measures of Inequality


Gini Coefficient: ratio of area between Lorenz curve and equality line and the total area under the
equality line.
- 0= perfect equality, 1=perfect inequality
Lorenz Curves used to compare equality relative to different economies/nations
- Economies that seem close by Lorenz curves distinguished with Gini coefficients
Desirable properties for Inequality Measures
- anonymity principle: independent of who has the higher income
- scale independence principle: Independent of size/magnitude of the economy
- population independence principle: independent of number of income recipients
- transfer principle: transferring income from richer to poorer makes more equal

Functional Distributions
Functional/factor share distribution of income: attempts explaining distribution of income between
factors of production (labor, land, capital)
Total wage bill: market wage x total level of employment
- market wage determined by supply of and demand for labor
Traditional theory assumes only labor (variable) and capital (fixed) as factors
- X-axis=Employment, Y-axis=Wage Rate up to R
- under competitive market assumptions: DL=MPL (CRS also assumed)
- by diminishing marginal products, DL declining function of # employed
- SL upward sloping (neoclassical), equilibrium (E) = WE at LE
- Total national Income = area 0RELE where wages = 0WEELE; profits = 0WERE
- This model at the core of Lewis theory, thus similar critiques

Measuring Absolute Poverty


absolute poverty: # of people unable to command resources to satisfy basic needs
headcount index: H/N ; H = # under absolute poverty line (Yp) and N = total population
- Local Yp based on baskets of basic needs (food, clothing, shelter, medical, etc) at PPP
total poverty gap (TPG): total amount of income required to raise everyone below Yp to Yp
H

TPG =  (Y p  Yi )
i1
Simplified on a per capita basis: average poverty gap (APG) = TPG/N


normalized poverty gap (NPG) = APG/Yp falling between 0 and 1 ; unitless
- size of poverty gap in relation to Yp
average income shortfall (AIS) = TPG/H
- average amount that a poor person’s income falls short of Yp
normalized income shortfall (NIS) = AIS/Yp

The Foster-Greer-Thorbecke Measure


Gp = Gini coefficient among poor = coeff. of variation of incomes among poor (CVp)
Desirable Properties for Poverty Measures
- anonymity principle: independent of who is poor
- scale independence principle: Independent of size/magnitude of the population
- monotonicity principle: add income to under Yp poverty can be no higher than before
- distributional sensitivity principle: transferring income poor to rich = poorer economy
e.g. headcount ratio measure satisfies all but last
e.g. Sen index and forms of Foster-Greer-Thorbecke index satisfy all four
1
H Y  Y 
Foster-Greer-Thorbecke (FGT) index = Pα =
N
 p
 Y
i


i1  p 
Yi = income of the ith poor person Yp = poverty line N = population
α = 0 then numerator = H, and we get H/N
α = 1 then we get NPG 
α = 2 impact on measured poverty of an increase in income increases in proportion to distance
from poverty line

 N NIS  1 NIS CV  


2
P2 = H
2 2
p

The Human Poverty Index


Created in response to Bank’s “Income” poverty; similar to HDI
Measured and weighted equally in:
Life: Probability at birth of not surviving to age 40 (times 100)
Basic education: % of illiterate adults
Economic provisioning: % population without access to health services and safe water and
underweight children under 5 years old

Ahluwalia-Chenery Welfare Index


Assigns higher weight to income gains by lower income individuals
See Appendix 5.2

Poverty, Inequality, and Social Welfare


What’s So Bad about High Inequality?
- Social welfare depends positively on income levels, negatively on poverty & inequality levels
Why does relative inequality matter?
- Extreme income inequality = economic inefficiency; education, health = human capital
Human capital is investment in the future = economic productivity
- Extreme income disparities = undermining of social stability and solidarity = conflict
- Obviously unfair, but some inequality necessary as incentive to work (economic thought)
Welfare (W) = W(Y, I, P)
Y = income per capita I = inequality P = absolute poverty
- Both I and P enter negatively

Dualistic Development and Shifting Lorenz Curves: Some Stylized Typologies


Gary Field’s three stylized Typologies:
1. modern-sector enlargement: size growth of the modern sector while maintaining wages in both sectors
leads to economic development; Lewis model
(e.g. OECD nations and somewhat South Korea and Taiwan)
- absolute income rise and absolute poverty reduced
- effects on relative inequality vary; likely to first worsen then improve
- crossing of Lorenz curve(s)
- traditional sector incomes unchanged but smaller fraction of total
2. modern-sector enrichment: economic growth limited to fixed number of people in the modern sector
with both numbers of workers and their wages held constant in the traditional sector
(e.g. many Latin American and African economies roughly fit)
- higher incomes, no change in poverty
- a less equal relative distribution of income
- causes Lorenz curve to shift down, further from line of equality
3. traditional-sector enrichment: little or no growth in modern sector, all benefits of growth seen in
traditional sector
(e.g. countries trying to substantially reduce absolute poverty with small growth rates)
- higher income, less poverty
- a more equal distribution of income
- causes Lorenz curve to uniformly shift upward toward line of equality
Must be careful about making assumptions in the short run

Kuznets’s Inverted-U Hypothesis


Inverted-U Hypothesis: Inequality will be higher at early stages of economic growth before lowering
- Early growth may be focused in modern-sector with limited people = increased inequality
- Few argue hypothesis inevitable; dependent upon development process

Evidence on the Inverted-U Hypothesis


Income inequality ; inequality not highly correlated with per capita income
Latin American Effect: middle-income and specifically represent Kuznets’s hypothesis
Studies have shown that this hypothesis definitely isn’t universal across experiences
- Still somewhat being debated

Growth and Inequality


No strong obvious relationship between GNI growth and income distribution
High growth rates don’t always increase inequality
Character of economic growth: how, who, what, when etc. (that is the determining factor)

Absolute Poverty: Extent and Magnitude


- Population size and growth matters in terms of absolute poverty relating to economic growth
- High-quality sustainable growth and well-designed poverty programs are in need

Growth and Poverty


Reducing poverty levels need not lead to slower growth rates because….
1. Widespread poverty denies people access to credit, education, investment, thus cause per capita
growth to be less than if there were greater equality
2. The rich in current poor nations are not known for saving and investing large proportions of their
incomes back into the local economy unlike current developed countries past histories.
3. Low incomes and levels of living create lower economic productivity (less human capital)
4. Increased income levels for poor will increase demand for local inelastic goods stimulating economic
growth, whereas the rich tend to buy imported elastic goods.
5. Reducing mass poverty can start healthy economic progress creating an incentive for increased
participation in the development process.
- Close but not causual relationship between economic growth and progress exists
- Don’t need rapid growth to reduce poverty

Economic Characteristics of Poverty Groups


- Specific knowledge of poverty groups and their economic characteristics necessary for policy

Rural Poverty
Poor are disproportionately located in rural areas, involved in the agricultural sector, are women and children,
and among minority ethnic groups and indigenous peoples.
Urban-sector bias: Largest share of most LDC gov’t expenditures geared toward urban areas
- To alleviate poverty must gear more towards rural and agricultural areas

Women and Poverty


Women (and children) make up majority of world’s poor
- lower earning capacity, limited control over spouses income, less access to education
- often paid less for the same task that men do
- some places can’t own property or sign financial documents without a husband signature
- parenting, collecting firewood, cooking etc. are unremunerated or intangible
Policies geared towards reducing gender disparities may decrease absolute poverty
- some development policies are geared solely towards men, increasing inequalities
Low status of women = lower economic growth (most likely)

Ethnic Minorities, Indigenous Populations, and Poverty


Civil wars and ethnic conflict increase poverty; some conflicts related to access to resources/power
- Face more economic, political and social discrimination

The Range of Policy Options: Some Basic Considerations


- Must understand various reasons for income distribution to create effective policies

Areas of Intervention
Four elements in determining developing economy’s income distribution:
1. Altering the functional distribution: returns to labor, land, capital by factor prices, utilization levels,
profits to owners of each factor
2. Mitigating the size of distribution: changing the distribution of asset holdings and skill endowments
since these determine the distribution of income
3. Reducing the size distribution at the upper levels through progressive taxation
4. Increasing the size distribution at the lower levels through public expenditures to raise incomes of
poor directly or indirectly.
- Raises real income levels of the poor.

Policy Options
Altering the Functional Distribution of Income through Policies Designed to Change Relative Factor
Prices
- Traditional Economic Approach
- Due to inefficient institutions and government policies, price of Labor is higher
(e.g. trade unions raising minimum wages)
- Reducing relative price of labor and raising relative price of capital = more productivity
- also supposedly reduces inequality by providing more jobs and lowering profits

Modifying the Size Distribution through Progressive Redistribution of Asset Ownership


- unequal personal income distribution due to asset ownership concentration patterns
redistribution policies: reducing concentrated asset control will lower power inequalities
land reform: redistributing land (productive asset thus price setting)
- broadening educational access and increasing job opportunities

Reducing the Size Distribution at the Upper Levels through Progressive Income and Wealth Taxes
- direct, progressive taxation of income and wealth = main development finance
progressive income taxes: personal and corporate incomes where wealthy pay more
- often are regressive taxes in practice – lower/middle incomes pay more
indirect taxes (retail, alcohol, etc) tax expenses not income
- rich have resources to avoid taxes or go unreported

Direct Transfer Payments and the Public Provision of Goods and Services
Public consumption: tax financed goods and services to the very poor
- e.g. public health projects, school lunches, nutritional supplements, and clean water
- includes subsidies (e.g. lowering food product prices) and direct transfers
1. need to be directed at genuinely poor
2. need to avoid dependence on programs; build “safety nets”
3. keep incentives low enough not to recruit economically productive
4. often limited by resentment of hard working nonpoor close to poverty line
workfare programs: requiring work for assistance with public goods
- generally avoids 4 problems listed above
Targeted poverty programs such as microfinance (See Case Study)

Summary and Conclusions: The Need for a Package of Policies


Need a collection of complimentary, supportive policies including basic elements:
1. corrections for factor-price distortions improving productive efficiency reducing poverty
2. structural changes in asset and power distribution and education access and related jobs
3. modifications in size distribution in income at upper levels by progressive taxation
4. improvements in well-being of the poor and their communities and social and human capital