Macro and Micro Development Economics

MODULE ON

MACRO AND MICRO DEVELOPMENT ECONOMICS

Training Needs of Reference

The module presents a simple analytical treatment of some fundamental issues in the field of Development Economics. This module aims at providing a general but rigorous knowledge of the main theories explaining economic growth and the structural change of an economy throughout its development process. The target of the module, therefore, is whoever wants to have a basic knowledge of some macroeconomic and microeconomic aspects of the development process.

The module count for 2 ECTS: the effort required for a comprehensive and active understanding is around 50 hours of wok; of which one third will be devoted to lectures.

TABLE OF CONTENTS

Introduction...... pag.5

Part 1 – A quantitative perspective on development: A review of growth models………………………………...... …..pag.6

1.1 The neoclassical perspective on economic growth………………………………pag.6

1.1.2 The Solow model…………………………………………………………………….pag.7

1.2 Some notes on the “endogenous growth” models……………………………….pag.9

1.2.1 The AK model………………………………………………………………………..pag.9

1.2.2 Spill over effects in the endogenous growth models……………………………….pag.10

Part 2 - Some critical assessments of the standard neoclassical approach: possible refinements and alternative growth models…………pag.11

2.1 Economicdecline in poor economies. The case of the poverty traps…………..pag.11

2.2 Alternative approaches to growth: the case of the Keynesian growth models....pag.13

2.3 Policy implications of the heterodox perspective on growth: the case of a growth-enhancing trade tariff……………………………………………………………...pag.14

Part 3 – Microeconomic aspects of development: the structural change of the productive pattern and the migration from the countryside……………………………………………………...pag.16

3.1 The structural change of the productive system from agriculture to industry: The Lewis model (1954)……………………………………………………………….pag.16

3.1.1 Technical progress in agriculture………………………………………….pag.20

3.2 Migrations: The Harris-Todaro Model (1970)…………………………………..pag.22

INTRODUCTORY NOTES

Introduction

In This module we present a simple analytical treatment of some fundamental issues in the field of Development Economics. In particular, we will analyse both the “macroeconomic” issue of economic growth and the “microeconomic” aspects of development, mainly the process of industrialization and the migration from countryside to cities. We will raise some empirical controversies to stimulate debate among the readers. In this light, the formal analysis we carry out simply aims at providing readers with the necessary tools to consciously participate in current debate on development strategies.

The Solow model will constitute the basic theoretical scheme for analysing the specific issue of economic growth. The role of capital accumulation and of technological progress for the long run improvement of living standards will be thus observed from the standpoint of neoclassical theory. A further in depth analysis of the mechanisms feeding economic growth will lead us to consider also some features of the more recent “endogenous growth” models. Particular attention will be focus on the role of human capital at R&D efforts as additional factors affecting economic dynamic.

The discrepancies between the current evidence on worldwide growth performances and the implications of the Solow model seem to demand for some departures from the standard neoclassical approach. In this regard, the module takes into account two kinds of departures. First of all, it considers the case of poverty traps explaining the economic decline of the African continent. Then, it briefly sketches out the post-Keynesian/Structuralist view on the income disparities between developed countries and developing countries. Some considerations on the role of trade policies for igniting economic growth in backward economies are proposed as well.

The Lewis model will constitute the conceptual framework for examining the microeconomic aspects of economic development. In particular, the Lewis model will help us to describe the structural change of an economy from a prevalently agrarian economy to a modern industrial economy. The issues of the role of labour supply, agricultural surplus and rural productivity in feeding industrialization are therefore observed from the Lewis standpoint. Some brief considerations on the role of technological progress in agriculture are provided as well.

The Harris-Todaro model will be the benchmark for the analysis of the other side of structural changes: urbanisation and the birth of the informal sector in highly densely populated urban area. This model mainly focuses on the arbitrage between urban expected wage and rural wage as the main factor explaining mass immigration towards city. This approach also considers the technical-institutional factors, such as wage rigidities and rural productivity, which influence equilibrium condition and policy measures’ effectiveness.

Part 1 - A quantitative perspective on development. A review of growth models

Economic development is a very complex multi-faceted process. It takes into account, or it should take into account, multiple aspects of human living, education and health standards for instance, but more in general all the progresses against the various uncertainties of life. In a way, economic development may be defined as the pattern of opportunities and capabilities a person has or can concretely acquire to satisfy its human wants.

Economic growth, therefore, is not the unique dimension of economic development. Nevertheless, it is probably the leading one. Actually, day-by-day experience seems to suggest that almost all the multiple aspects of human development depend heavily on rising labour productivity and growing income per capita (Ray, 1999). Indeed, it is quite difficult to imagine backward economies improving their lacking educational and health standards without a sustained growth of their material wealth. At the same time, it seems equally challenging that people may pursue their own human aspirations without the disposal of sufficient economic resources (at least higher than mere subsistence!). If we may therefore conceive economic growth without development, otherwise we find rather difficult to imagine human/economic development without growth.

According to such a growth-centred perspective of development, the first section of this module aims at enquiring into the issue of economic growth. In particular, it provides a simple analytical treatment of some fundamental contributions in the theory of growth. The first model that will be analysed is the very traditional neoclassical model by Solow (1956). Some basic notes on the more recent “endogenous growth models” will then conclude our brief review of the theory of growth.

1.1 The neoclassical perspective on economic growth

The neoclassical perspective on economic growth represents an important piece of economic growth theory. Surely, it is a completely disputable perspective, and later we will criticise it. Nevertheless, it allows us to examine the role of capital accumulation in the development process.

In figure 1 we provide a simple schematisation of the neoclassical approach to growth.

Figure 1 - The neoclassical flows between production, consumption, saving/investment, growth

The economic mechanisms feeding growth are very simple. First of all, firms distribute wages and profits (i.e. income Y) among households to repay them of their contributions in the production process (i.e. the supply of labour and the supply of capital). Households, in turn, distribute income between consumption and saving. On the one hand, they spend part of their income for current consumption purposes, so generating demand for the consumption goods (C). On the other hand, they save part of their current income (S) so as to finance smooth consumption throughout their life. The households savings are channelled to firms (i.e. the traditional net debtors of the economy) through the banking and financial system. Firms, in turn, use the borrowed funds for investing, so increasing the aggregate per worker capital stock. At the end of the circle, it is exactly such an increase of per worker capital stock (i.e. increasing K/L) that ultimately feeds expanding production and rising income per head (i.e. increasing Y/L), i.e. economic growth. Indeed, the higher per workers capital stock gives rise to an enlarged circle among production, income, saving and accumulation.

1.1.1 The Solow model

The role of capital deepening on economic growth is even clearer by considering the very traditional Solow model (1956). Let us provide a brief analytical overview of the Solow model.

Assume an aggregate production function in capital and labour showing constant returns to scales (CRS) in both inputs but decreasing marginal returns in each of them. Analytically, we have:

Y = AF(K, L) => Y/L=with (1.1)

Where Y is aggregate output (aggregate income); K and L are the aggregate capital stock and the aggregate labour force/population (we assume all population works and there is not unemployment), respectively; k, finally, is per head capital stock.

By equation (1.1), income per capita is a positive and increasing function of capital per head. Indeed, just like in the previous scheme, higher values of capital per head induces allow the productive process to expand and income per head to increase. Nevertheless, income per capita shows decreasing marginal returns in capital per head. Therefore, any additional unit if capital per head, although increasing (Y/L), will produce constantly smaller variations of income per capita.

In the Solow model, the dynamic of income per capital depends on capital deepening. Let us describe the motion rule of per head capital stock through the following equations:

(1.2) (1.3) (1.4)

Where “hat” variables identify percentage variations (i.e. growth rates).

Equation (1.2) describes the growth rate of per head capital stock as the difference between the growth rate of aggregate capital stock K (in upper case) and the growth rate of population L. Equation (1.3) defines the growth rate of aggregate capital stock as the difference between the gross investments (i.e. sF(K,L)/K) and the depreciation rate (d). Equation (1.4), finally, gives the growth rate of population, here assumed as exogenous and equal to n.

Substituting equations (1.3) and (1.4) in equation (1.2), we obtain:

Knowing that, where is the variation of per head capital stock, we obtain the following expression for the k dynamic:

(1.5)

Figure 2 describes both the dynamics of capital per head (equation (1.5)) and of income per capita. Three particular cases stand out.

a) If k<kE then and >0. At very low levels of per head capital stock, any additional unit of capital has great impact on aggregate production. As a consequence, the net growth of the capital stock is higher than population growth. Clearly, per head capital stock rises, so that income per capita rises as well towards the long run equilibrium (Y/L)E.

Figure 2 – Capital per head accumulation and rising income per capita in the Solow model

b) If k=kE then and =0. We are in the stable equilibrium point. At this level of per head capital stock, the net percentage increase of capital stock is just equal to the population growth. Per head capital stock, therefore, is constant with income per capita.

c) If k>kE then and 0. In this case, per head capital stock is very high. Due to the decreasing marginal returns of capital, any additional unit of capital has really small effects on aggregate production. Net capital accumulation, therefore, is lower than the population growth, so that per head capital stock shrinks towards the equilibrium kE. Clearly, also income per capital decreases towards the long run equilibrium level (Y/L)E.

The Solow model bears relevant implications for long run growth and for the economic performances of different economies at different stages of development. We want to stress the following two points.

a) In the long run (i.e. when k = kE), income per capital will keep on growing only in presence of exogenous technological progress. Indeed, with (Y/L) = Af(k) and k = kE, the effects of increasing capital per head will vanish in the long run. Income per capita, therefore, will increase only assuming technological improvements raising A values (or labour saving technological improvements). Assuming “x” as the instantaneous rate of technological progress, in the long run income per capital will grow exactly at the same pace.

b) Neglecting the issue of long run growth, the Solow model implies that poor countrieswill necessary grow. At the very beginning of capital accumulation (when k is low), the returns of capital accumulation are particularly high (tending to ∞ when k tends to 0). Net investments (sAf(k) - dk), therefore, will be positive and higher than population growth, so that per head capital stock will inevitably rise. Consequently, income per capital will also grow, tending toward the long run equilibrium. More importantly, the Solow model seems to implyeconomic convergence amongdifferent economies. On the one hand, economic systems having the same parametrical settings (i.e. equal saving rate “s”, depreciation rate “d” and population growth “n”) will reach exactly the same long run level of income per capita. On the other hand, transitional growth (i.e. the growth path leading to the long run equilibrium) is proportional to the distance from the long run steady state. The further away an economy is from the long run equilibrium, the higher its growth rate will be. If we reasonably assume poorer countries to be further away than richer economies from the long run equilibrium, then worldwide convergence would occur. According to the Solow framework, soon or later poorer economies should catch up to developed economies, reaching similar degrees of development.

1.2 Some notes on the endogenous growth models

The “Growth accounting” tries to estimate the contributions to the economic growth of the productive factors’ accumulation and of technological progress. Since the early works in this field of investigation (Abramovitz (1956) and Solow (1957)), the technological progress has turned out to be the leading force of economic growth. The improvements in Total Factor productivity (TFP henceforth), in fact, have seemed to count for almost the seven-eighth of the overall economic growth.

Such a result sounds a bit disappointing for the neoclassical theory of growth, which traditionally assumes as exogenous, and thus substantially unexplained, what seems to be the main fuel of economic growth.During the most recent years, at least since the mid 80s on, the economic research has thus tried to squeeze down the degree of “our ignorance about growth (Abramovitz (1956))” and to reduce the importance of exogenous technological progress. In doing that, the economic research has followed two main strategies. On the one hand, the empirical works have tried to capture and include as much “residuals” as possible in the accumulation of the productive factors. Indeed, it has been reasonably argued, technological progress is not divided from capital accumulation, but it is more likely embedded in the adoption of new machine tools. On the other hand, the theoretical works have tried to endogenise the technological progress by conceiving it as planned outcome of voluntary decisions of the economic agents, mainly firms.

In the following pages we briefly analyse some theoretical contributions of the so-called “new growth theory”. In particular we will focus on the very simple AK model by Rebelo (1991) and on the “spill over effects” models a la Romer (1986).

1.2.1 The AK model

The dynamic behaviour of the Solow model relies heavily on the assumption of decreasing returns to capital. This sounds like a completely reasonable assumption. It is quite reasonable to conceive that rising capital stock will have constantly smaller effects on output when it combines with other fixed productive inputs (lands or unskilled labour, for instance).

The assumption of decreasing returns to capital, however, may be convincingly dropped whenever we adopted a broader perspective on capital, considering also the human capital. Indeed, the quality and the ability of workers likely influence the productivity of physical capital. More skilled workers, for example, can master more quickly how to use new machines. Otherwise, high skilled workers can move down faster on their own experience curve. In analytical terms, a broader perspective on capital that takes into account also for the human capital, may reasonably allow us to assume constant return to capital accumulation. This is exactly the main economic implication of the following production function:

Y =F(K) =AK So that (Y/L)=Ak (1.6) (the AK production function)

The following figure 3 depicts the behaviour of the AK model. The differences with respect to the Solow model stand out clearly.

Figure 3 – The behaviour of the AK model

In particular, we want to stress here three important features of the AK model.

a) The long run autonomous growth of capital per head and income per capita. In the AK model, any increase in capital per head always leads to a direct and proportional increase of output per head. Therefore, capital per head and the income per capita will keep on growing also in the long run, without the need of any exogenous technological progress. Both capital per head and income per capita will keep on growing at the constant rate. In the AK model, therefore, there is not any steady state equilibrium.

b) The relevance of the parametrical setting for the long run growth. In the AK model, the parameter setting, mainly the saving rate “s” and the population growth “n” affect also the long run growth rate of income per capita. In particular, a higher saving rate will permanently increase both the long run capital accumulation rate as well as the income per capita growth rate. Vice versa, a higher growth rate of population (n) will tend to depress the long run growth rate of income per capita.