EXPERT COMMITTEE

Prof. Atul Sarma (retd.) Prof. M S Bhat (retd.) Prof. S.K.Singh

Former Director, Indian Statistical Jamia Millia Islamia Prof of Economics(Retd)
Institute, New Delhi New Delhi IGNOU, New Delhi
Dr. Surajit Das Dr. Manjula Singh Prof. B S Prakash
CESP, Jawaharlal Nehru University St. Stephens College, University of IGNOU, New Delhi
New Delhi Delhi S.P. Sharma
Prof. Kaustuva Barik Dr. Indrani Roy Choudhary Associate Professor,
Indira Gandhi National Open Associate Professor, Economics Economics , Shyam Lal
University, New Delhi Jawaharlal Nehru University, New College, University o Delhi,
Delhi Delhi
Shri. B.S. Bagla Ms. Niti Arora Shri Saugato Sen
Associate Professor of Economics Assistant Professor Associate Professor of
PGDAV College Mata Sundri College Economics IGNOU, New
University of Delhi, Delhi University of Delhi, Delhi Delhi

COURSE PREPARATION TEAM

Block/ Unit Title Unit Wr iter
Block 1 Growth and Development
Unit 1 Concepts Indicators and
Measurement Shri Saugato Sen Associate Professor of Economics,
Unit 2 International Comparisons IGNOU, New Delhi
Block 2 Growth Models : Theory and Evidence
Unit 3 Introduction to Growth Models Dr Puja Saxena Nigam, Associate Professor, Economics,
Hindu College, University of Delhi, New Delhi
Unit 4 Harrod-Domar Model Adapted from Unit 2 of the Course MEC 004 (IGNOU)
Unit 5 The Solow Model Shri Saugato Sen Associate Professor of Economics,
IGNOU, New Delhi
Unit 6 Endogenous Growth Models Dr Puja Saxena Nigam, Associate Professor, Economics,
Hindu College, University of Delhi, New Delhi
Unit 7 Determinants of Growth Shri Saugato Sen Associate Professor of Economics,
IGNOU, New Delhi
Block 3 Inequality and Poverty
Unit 8 Inequalty Dr. Nidhi Tewathia, Assistant Professor, School of
Social Siences, IGNOU
Unit 9 Poverty
Block 4 Political Institutions and the Functioning of the State
Unit 10 Institutions and Evolution of
Democracy Shri Saugato Sen Associate Professor of Economics,
Unit 11 Theories of Regulation IGNOU, New Delhi

Unit 12 Government Failure and

Corruption

Course Coordinator: Sh. Saugato Sen Course Editor: Sh. Saugato Sen

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 CONTENTS
BLOCK 1 GROWTH AND DEVELOPMENT Page
Unit 1 Concepts indicators and Measurement 7

Unit 2 International Comparisons 24

BLOCK 2 GROWTH MODELS : THEORY AND EVIDENCE

Unit 3 Introduction to Growth Models 36

Unit 4 Harrod-Domar Model 50

Unit 5 The Solow Model 68

Unit 6 Endogenous Growth Models 88

Unit 7 Determinants of Growth 101

BLOCK 3 INEQUALITY AND POVERTY
Unit 8 Inequalty 119

Unit 9 Poverty 135

BLOCK 4 POLITICAL INSTITUTIONS AND
THE FUNCTIONING OF THE STATE

Unit 10 Institutions and Evolution of Democracy 146

Unit 11 Theories of Regulation 161

Unit 12 Government Failure and Corruption 176

Glossary 189

Some Useful Books 196

 COURSE INTRODUCTION
Welcome to this elective course titled ‘Development Economics-I. In the next
semester you will have a chance to study a companion course titled’ Development
Economics-II. Together, the 2 courses will give you a comprehensive
understanding of the economics of development. The present course is about
economic development, the economics of development, and about the role that
development economics plays in enhancing our understanding of the process of
economic development.
This course consists of four Blocks. The first Block, entitled Concepts,
Indicators and Measurement, has two units. This block sets the ball rolling by
defining concepts of growth and development, discussing the indicators of
development and also explaining how the various indicators of development are
measured. This Block also discusses presents some international comparisons.
The second Block discusses about various growth models. Since it deals with
growth models, there is of necessity certain amount of abstraction, and also, a bit
of mathematics has been used of necessity. You will learn about a few canonical
growth models, and also be presented with a discussion about the determinants of
economic growth.
Block 3 of the course is on inequality and poverty. High levels of inequality and
the prevalence of poverty are two important features that we observe in almost all
developing nations, and block 3 has a thorough discussion on these topics. You
will get an idea about measures of poverty, about poverty traps, about different
measures of inequality and the relation between economic inequality and
development.
Finally, Block 4 takes up for discussion certain topics that might appear to be non-
economic in nature. However, the block underscores the point that development is
multidimensional. It is multidimensional not only in conceptualization and
measurement; it is also multidimensional in the sense that many non-economic
factors impinge upon and influence the level and trajectory of economic
development. Keeping this in mind, the unit discusses the role of institutions in
development, and about how democracy impacts and influences economic
development. Does democracy lead to development, or vice versa, or is it a two-
way relationship? What type of configuration and arrangement of institutions is
visible in democracies. The Block also discusses important topics involving
overall governance like economic regulation and different perspectives on, and
theories regarding, regulation. The block takes up for discussion very important
topics of government failure, and corruption. The block, in discussing government
failures, also talks of types of market failure, and the role of government in
tackling the problem of market failure, and what general role the State plays in
development. Various types of corruption are listed; causes of corruption are
described, and remedies discussed.
Overall this course with 12 units spread over 4 blocks, ought to give you a wide-
ranging and deep discussion about several topics in development economics, and
also prepare you for further topics that will be presented and discussed in the
subsequent course on development economics that you will study in the next
semester.
Growth and
Development

BLOCK 1 CONCEPTS INDICATORS AND

MEASUREMENT
BLOCK 1 INTRODUCTION
The first Block of this course discusses economic growth and development. It
aims to explain the meaning of economic growth and how it is measured. The
block also discusses in detail the concept of development—both economic and
social. Furthermore, it takes up for discussion some international comparisons
across countries. The title of this Block is Growth and Development.

The Block has two units, titled Concepts, Indicators and Measurement and
International Comparisons The first Unit is about the concepts of economic
growth and development, their indicators, and the way in which economic growth
and development are usually measured. The second unit describes the story of
economic growth and economic development of certain countries. This is done
with a view to comparing the experiences of these countries so as to attempt to
search for reasons why certain countries are successful in developing more, and
usually, faster.

6
 Concept Indicators and
UNIT 1 CONCEPTS INDICATORS AND Measurement
MEASUREMENT
Structure
1.0 Objectives
1.1 Introduction
1.2 Economic Growth: Concept and Measurement
1.2.1 Concept of Economic Growth
1.2.2 Total Output and Output Per Capita
1.2.3 Comparison across Space and Time
1.3 Economic Development and its Indicators
1.4 Characteristics of Developing Nations
1.4.1 Low Per Capita Income
1.4.2 Low Manufacturing Base
1.4.3 Other Features
1.5 Development and Welfare
1.6 The Millennium Development Goals and the Sustainable Development
Goal
1.6.1 The Millennium Development Goals
1.6.2 The Sustainable Development Goals
1.7 Let Us Sum Up
1.8 Answers to Check Your Progress Exercises

1.0 OBJECTIVES
The aim of this unit is to acquaint you with the concepts, indicators and
measurement of economic growth and development. After studying this unit, you
should be able to:
 Explain what economic growth means
 Discuss how economic growth is measured
 Explain the meaning of economic development
 Discuss how development differs from economic growth; and
 Analyse the relationship among the concepts of development and wellbeing


Shri Saugato Sen, Associate Professor, IGNOU, New Delhi
7
Growth and
Development 1.1 INTRODUCTION
This first unit begins your study of the economics of development. You have
studied microeconomics and macroeconomics courses that have equipped you
with concepts and techniques that will help you to understand and gain insights
from a study of economic growth and development. Traditionally, from the time
of Adam Smith, economics was a study of economic growth and development of
nations. The title of Adam Smith’s most well-known book, published in 1776
was An Inquiry into the Nature and Causes of Wealth of Nations. Even Karl
Marx contended that his aim was to “study the laws of motion of society”. It was
with the rise of neoclassical Marginalist School that economists shifted their
attention to the study of resource allocation and production, consumption and
exchange at a point of time. Economics focussed on static analysis.
After World War II ended, and European countries had to be rebuilt and put back
on the growth path, economic growth again became a field of study in
Economics.At the same time many formerly colonised economies became
independent. There was a need to understand these economies to suggest ways
and policies for economic development. The study of economic growth also
became subsumed to a large extent within Macroeconomics, while the study of
economic development of the developing nations came to be called Development
Economics or the Economics of Development. Growth Theory also emerged as a
field of study.
This unit aims to begin your acquaintance with the concepts of Development
Economics. The unit discusses the meaning of economic development and how it
differs from growth; what the components of economic development are; what
the relation of development with welfare is; what are the indicators of
development, and so on. The unit begins by explaining the concept of growth and
how growth is measured. It explains how income levels can be compared across
time, and of different countries. Next, the unit takes up for discussion the main
topic of this unit, that is, the meaning of economic development. In doing so, it
explains the characteristics of developing countries, and what it is that makes
them known as ‘developing’ rather than ‘developed’ nation. The unit stresses that
basically, economic development is a much wider concept than economic
growth, that it is multidimensional, and that it is ultimately about the people of a
country or region. The unit finally talks about the relation between development
and wellbeing.

1.2 ECONOMIC GROWTH: CONCEPT AND

MEASUREMENT
Any discussion about economic development has to begin with economic growth.
In this section we look at the concept of economic growth and how it is
measured.

1.2.1 Concept of Economic Growth

Economic growth can be defined as “an increase in real terms of the output of
goods and services that is sustained over a long period of time, measured in
terms of value added.” The term economic growth refers to increases over time
in a country's real output of goods and services. Output is generally measured by
8
gross or net domestic product (GDP or NDP), though other measures can also be Concept Indicators and
Measurement
employed. Two points, as follows, need be noted in this definition:
Economic growth is essentially a dynamic concept and refers to a
continuous increase in output. The word ‘dynamic’ here denotes a process
taking place over time. This is contrasted with ‘static’ which does not so
much mean ‘unchanging’ as ‘at a point in time’. Forces that generate growth
generate a positive rate of change from a lower to a higher level of output
may be welcome but that is not growth.
We ought strictly to distinguish between output and output capacity. Most
theories of growth, in so far as they with increases in labour forces or the
accumulation of capital, implicitly deal with changes in output capacity,
whereas actual changes in output over time are also influenced by the ability
of an economy to utilise accumulated capacity.
Process of economic growth is essentially a dynamic concept and refers to a
continuous expansion in level of output, i.e. it refers to forces that generate a
positive rate of change over time and not the forces that lead to discrete (or
one shot) change from a lower to higher level of output which are temporary
and short lived.
The concept of the growth rate is very important and you thoroughly need to
understand it.
Let x be an economic variable. Let x0 be the initial value x1 be the subsequent
value. The proportional change in going from x0 to x1 is simply

x1 − x0 = Δx/x0 x0
The percentage change in going from x0 to x1 is simply 100 times the
proportionate change:

% Δ x = 100 ( Δ x/x0)
If we assume a constant rate of growth, the formula used for calculating the
growth rate for more than one year is as follows:

1.2.2 Total Output and Output Per Capita

The term ‘output’ is ambiguous, in that it can mean either total output or output
per capita. An increase in total output is ‘extensive growth’ (when population
and production increase at about the same pace). When one thinks of growth in
the context of an increase in standards of living or of the welfare of a population,
one naturally thinks of output per head of population. However, an increase in
total output over time may also be an extremely significant phenomenon, where,
for example, economies of scale are important. The term output expansion,
however, is subject to ambiguity in the sense that does it mean growth in total
output or growth in output per capita. An increase in the former is referred to as
‘extensive’ growth whereas an increase in the latter is called the ‘intensive’
growth. The latter one is important in the context of increase in the standards of
living of the population of the country whereas the former is extremely
significant when one wants to examine the aggregative phenomenon such as
economies of scale etc.
9
Growth and 1.2.3 Comparisons across Space and Time
Development
Another measurement issue we need to consider is how to compare levels of GDP
per capita across countries. The problem arises because each nation measures
national income in its own currency. Economic growth rates can be computed in a
nation’s own currency, but if we want to understand better what is required to
transform a nation from low to high income, it is useful to compare nations at
different income levels. To do so requires converting GDP per capita into a
common currency. The shortcut to accomplishing this goal is to use the market
exchange rate between one currency, usually U.S. dollars, and each national
currency. One problem with converting per capita income levels from one
currency to another is that exchange rates, par- ticularly those of developing
countries, can be distorted. Trade restrictions or direct government intervention
in setting the exchange rate make it possible for an official exchange rate to be
substantially different from a rate determined by a competitive market for foreign
exchange.
But even the widespread existence of competitively determined market exchange
rates would not eliminate the problem. a significant part of national income is
made up of what are called nontraded goods and services — that is, goods that
do not and often cannot enter into international trade. Generally speaking,
whereas the prices of traded goods tend to be similar across countries (because, in
the absence of tar- iffs and other trade barriers, international trade could exploit
any price differences), the prices of nontraded goods can differ widely from one
country to the next. This is because the markets for nontraded goods are spatially
separated and the underly- ing supply and demand curves can intersect in
different places, yielding different prices.
Exchange rates are determined largely by the flow of traded goods and
international capital and generally do not reflect the relative prices of nontraded
goods. As a result, GDP converted to U.S. dollars by market exchange rates gives
misleading comparisons of income levels if the ratio of prices of nontraded goods
to prices of traded goods is different in the countries being compared. The way
around this problem is to pick a set of prices for all goods and service prevailing
in one country and to use that set of prices to value the goods and services of all
countries being compared. In effect, one is calculating a purchasing power parity
(PPP) exchange rate.
To compare income across time, the choice of an appropriate price deflator has
to be thought of. There are also issues of constructing an adequate index number
to compare the current year income with the income in a suitably chosen base
year.

10
 Concept Indicators and
1.3 ECONOMIC DEVELOPMENT AND ITS Measurement
INDICATORS
Economic growth is a necessary but not sufficient condition for improving the
living standards of large numbers of people in countries with low levels of GDP
per capita. It is necessary because, if there is no growth, individuals can become
better off only through transfers of income and assets from others. In a poor
country, even if a small segment of the population is very rich, the potential for
this kind of redistribution is severely limited. Economic growth, by contrast, has
the potential for all people to become much better off without anyone becoming
worse off. Economic growth has led to widespread improvements in living
standards in Botswana, Chile, Estonia, Korea, and many other countries. The
modern economists, however, question this identity between ‘economic growth’
and ‘economic development’; development is not the same as growth. Suppose,
by analogy, we were interested in the difference between ‘growth’ and
‘development’ in human beings. Growth involves change in overall aggregates
such as height or weight, while development includes changes in functional
capacity, of ability to adapt to changing circumstances. Growth is an engine, not
an end in itself. The end is development.
The traditional concept of viewing economic development as synonymous with
economic growth was based on what came to be known as the ‘trickle-down
strategy’, which implies that the effects of rising incomes and output would
ultimately trickle down to the poor so that they would benefit poor as well as the
rich. The modern economists reject this view and stress the need for strategies
designed to meet the needs of the poor directly. Hence, economic development
has come to be redefined in terms of the reduction or elimination of poverty,
inequality, and unemployment within the context of a growing economy.
“Redistribution from growth” has become an accepted paradigm. Prof. Dudley
Seers poses the basic question about the meaning of development very clearly
when he states:
The questions to ask about a country’s development are therefore: what
has been happening to poverty? What has been happening to
unemployment? What has been happening to inequality? If all 3 of these
have declined from high levels then beyond doubt this has been a period of
development for the country. If one or two of these central problems have
been growing worse, especially if all three have, it would be strange to
call the result “development” even if per capita income doubled.

Economic development, in its essence, must represent the whole gamut of change
by which an entire social system, tuned to the diverse basic needs and desires of
individuals and social systems within that system, move away from a condition
of life widely perceived as unsatisfactory towards a situation of life regarded as
materially and spiritually “better”.

11
Growth and If economic growth does not guarantee improvement in living standards, then
Development GDP per capita may not be a meaningful measure of economic development. In
addition to problems associated with how income is spent and distributed, any
definition of eco- nomic development must include more than income levels.
Income, after all, is only a means to an end, not an end itself. If economic growth
and economic development are not the same thing, how should we define
economic development? Amartya Sen, economist, philosopher, and Nobel
laureate, argues that the goal of development is to expand the capabilities of
people to live the lives they choose to lead. Income is one factor in determining
such capabilities and outcomes, but it is not the only one. To be capable of
leading a life of one’s own choice requires what Sen calls “elementary
functionings,” such as escaping high morbidity and mortality, being adequately
nourished, and having at least a basic education. Also required are more complex
functionings, such as achieving self-respect and being able to take part in the life
of the community. Income is but one of the many factors that enhance such
individual capabilities.
In view of the above considerations economic development is now being defined
“as the process of increasing the degree of utilisation and improving the
productivity of the available resources of a country which leads to an increase in
the economic welfare of the community by stimulating the growth of national
income”.
It follows from this definition that the progress of development has to be assessed
by reference to two separate indicators, namely, (i) the indices of ‘production’ or
GDP, and (ii) the indices of ‘economic welfare’ of the community. The former
covers what may be called the ‘growth’ aspects of development.
So defined, the concept of economic development emphasises the achievement of
the following three objectives:

 To increase the availability and widen the distribution of basic life sustaining
goods such as food, shelter and protection. This, however, would be possible
with a fast increase in real per capita income.
 To raise standards of living including, in addition to higher incomes, the
provisions of more goods, better education and greater attention to cultural
and humanistic values, all of which will serve not only to enhance material
well-being but also to generate individual and national self-esteem.
 To expand the range of economic and social choice to individuals and
nations by freeing them from servitude and dependence not only in relation
to other people and nation-states, but also to the forces of ignorance and
human misery. Economic development is to be assessed ultimately by the
enhancement of the ‘positive freedom’.
12
In view of the above three objectives, the quality of life is regarded as an Concept Indicators and
Measurement
important index of development. It is contended that such quality is not
adequately reflected in the index of per capita income growth. Several factors are
involved in the measurement of such ‘quality’; some of these factors are non-
monetary, while others can be measured in money terms. There is a need to set
up a synthetic index of these different factors to measure economic development
and quality of life.
. We may note the following as important changes:
 Constituents of GDP Change: More generally, in terms of percentage
shares, saving rates increase as income grows, government revenues (and
expenditure) increase, food consumption drops and non-food consumption
increases, out of services – and, of course, also industry – increases, while
agriculture falls.
 Employment Changes: Employment changes reflect the shift in output and
changes in productivity. Labour in the primary sector of the economy does
not fall as rapidly as its share in output, the reverse is true for employment in
industry where increase in labour productivity is more easily secured.
 Shift in the Composition of Exports: As development proceeds, exports
will account for a larger proportion of income and there will have been a
marked shift in the composition of exports, so that the value of export of
manufactures rises relative to that of primary products. Imports will also
have risen and earnings and payments will be roughly balanced.
 Rate of Increase in Population: As incomes increase, the rate of increase in
population may be expected to fall, as the birth rate declines along with a fall
in the death rate. The population would still be increasing, but gradually the
rate of growth will tend to peter out.
Distribution of income: Income would at first become more unequally
distributed and then this trend would be reversed. You will read more about this
and on what is called the Kuznets ‘inverted U curve’ in Block 3 in the unit on
inequality
Economic development is a broad term that does not have a single, unique
definition.
 Life sustaining goods and services: To increase the availability and
widen the distribution of basic life-sustaining goods such as food, shelter,
health and protection.
 Higher incomes: To raise levels of living, including, in addition to higher
incomes, the provision of more jobs, better education, and greater
attention to cultural and human values, all of which will serve not only to
enhance material well-being but also to generate greater individual and
national self-esteem

13
Growth and  Freedom to make economic and social choices: To expand the range of
Development
choices available to individuals and nations by freeing them from
servitude and dependence not only in relation to other people and nation-
states but also to the forces of ignorance and human misery.
Dudley Sears has defined development as “the reduction and elimination of
poverty, inequality and unemployment within a growing economy”.
The Nobel Economist Amartya Sen in his 1998 Nobel address, identified four
broad factors, beyond mere poverty, that affect how well income can be
converted into “the capability to live a minimally acceptable life”:
• Personal heterogeneities: including age, proneness to illness, and extent of
disabilities.
• Environmental diversities: shelter, clothing, and fuel, for example, required
by climatic conditions.
• Variations in social climate: such as the impact of crime, civil unrest, and
violence.
• Differences in relative deprivation: for example, the extent to which being
impoverished reduces one’s capability to take part in the life of the greater
community.
According to Sen, economic development requires alleviating the sources of
“capability deprivation” that prevent people from having the freedom to live
the lives they desire.
In his book Development as Freedom, Sen sees development as being concerned
with improving the freedoms and capabilities of the disadvantaged, thereby
enhancing the overall quality of life. Sen pursues the idea that development
provides an opportunity to people to free themselves from the suffering caused
by
• Early mortality
• Persecution
• Starvation
• Illiteracy

Development should be about increasing political freedom, cultural and social

freedom and not just about raising incomes.
There can be several indicators to consider when taking a broad look at the
process of economic development, such as:
 Risk of extreme poverty - % of the population living on less than $1.25
per day (PPP)
 The percentage of adult male and female labour in agriculture, % of
arable land that is cultivated
 • Combined primary and secondary school enrolment figures and other Concept Indicators and
indicators of progress in building human capital. Access to clean water / Measurement
improved sanitation facilities (% of population with access)
• Energy consumption per capita
• Depth of hunger, kilocalories per day per capita
• Prevalence of HIV, average life expectancy at birth, years of healthy life
expectancy, child mortality
• Access to mobile cellular phones per thousand of the population
• Percentage of the population living in extreme poverty
• Dependence on foreign aid / levels of external debt
• Percentage of households with a bank account
• Unemployment rates and vulnerable employment rates
• High-technology exports (% of manufactured exports)
• The Human Development Index
• The multi-dimensional poverty index

In block 3 of this course, and in course BECC 114, you will be introduced to
the Human Development Index
Check Your Progress 1
1) What is the definition of Economic Growth?
2) Distinguish between economic growth and economic development.
3) What type of structural changes take place in an economy as it develops?

15
Growth and 1.4 CHARACTERISTICS OF DEVELOPING NATIONS
Development
We have seen what development means. We have also seen how it is different
from economic growth. Now, there are certain nations that are known as
developed nations, and certain nations that are called developing. What is the
difference between developed and developing nations. To say that developed
nations have a higher level of development begs the question, what does that
mean? What do we understand by a “higher level of development? Although
these questions shall be answered in greater detail in the next unit, in this unit we
look at certain characteristics that are evident in most of the developing nations.
In the next unit, we shall see there are finer sub-classifications among the
developing nations. For now, let us discuss some of the common characteristics
that most developing nations display.
1.4.1 Low Per Capita Income
Most of the developing nations have a lower per capita income than developed
nations. Some developing nations may have a high gross domestic product level
but the income per head tends to be low. one of the most commonly acceptable
criteria of underdevelopment is the low per capita real income of
underdeveloped countries as compared with the developed countries. Added to
this is low level of physical capital and low capital to worker ratio. Developing
nations also tend to low productivity and sometimes lower levels of technology.
Moreover, developing nations show high levels of poverty, low indices of human
development, very high inequality of income as well as assets, and
unemployment — structural, cyclical and disguised.
1.4.2 Low Manufacturing Base
One of the characteristics that we see about developing nations is that much of
the gross domestic product is accounted for by agriculture and sometimes,
services too, but the manufacturing sector is not so developed. Industries are not
widespread and diversified. Much of production and employment is in the
unorganized sector. Much of it stems from low capital and low investment.
Savings are often low too because of low income. Low savings lead to low
investment, which further leads to lower income. This has sometimes been called
the vicious cycle of poverty, if the income and capital accumulation range was
really low. High rates of industrial growth has been a characteristic feature of
those countries that have moved to a higher development level or even moved
from being a developing towards becoming a developed nation.
1.4.3 Other Features
Several developing nations have displayed some other features that are common
to many of these countries. Often population rates of growth and fertility levels in
these countries are high. This creates pressure on the resources and output of the
country. Secondly level of urbanization is low, and a large proportion of the
people resides in rural areas. In production, there is often an economic dualistic
structure with a low-wage low productivity rural and agricultural sector and a
smaller more productive higher-wage manufacturing sector, often located in
urban and semi-urban areas. Often there is migration from low-wage rural areas
to urban areas because of rural-urban wage gap. Often those migrants who cannot
be absorbed in the manufacturing areas end up in the urban informal sector.
16
Other features in developing countries are that exports are in many cases low, Concept Indicators and
and most of the existing exports are of primary products. Moreover some Measurement
developing nations have for a long time depended on foreign aid.. There have
also been cases of some nations getting caught in international debt trap.
Some other characteristics are that developing nations have non-diversified
financial sectors with still a large presence of informal money and capital
markets. There is financial repression and finance and credit do not flow to
requisite areas and to those who require. There are financial constraints on
growth.
Developing nations also often show low levels of attainment as far as social
sector is concerned. Education, even literacy and primary level enrollment, as
well as health levels are low, in some case basic and minimum needs are not met.
Clean drinking water and sanitation is not universal, infrastructure like good
roads electricity, good systems of telecommunication too are not widespread.
Often developing nations have governments providing poor governance, other
institutions are not well developed, and levels of social capital is low too. You
will read about all these in greater detail in later units of this course and in the
course Development Economic –II (BECC 114).

1.5 DEVELOPMENT AND WELLBEING

We have defined economic development as the sum total of economic growth (a
quantitative aspect) and economic welfare (a qualitative aspect). We have
presented above a few important indicators of economic growth. Now, let us shift
our attention to the indicators of economic welfare.
GNP as an Indicator of Economic Welfare
GNP estimates are more commonly employed as an indicator of economic
welfare. An increased output of goods and services, it is believed, implies an
increased availability of goods and services for consumption. Thus, enabling a
wider choice and a better standard of living; these are the hallmarks of economic
development.
However, this simple positive relationship between increase in GDP and increase
in economic welfare is subject to certain qualifications. Among these, the
following are noteworthy:

17
Growth and 1) Changes in the Size of GDP and Economic Welfare
Development
i) If the GDP increases but the population of the country increases in a
greater proportion, the total economic welfare will decline. As a result of
increased population, the per capita income will decline, which means
lesser purchasing power than before, lower standard of living, and
consequently, lower economic welfare.
ii) While analysing the relationship between the size of GDP and economic
welfare, the behaviour of the price movements must be thoroughly
studied. GDP calculated at current prices is always deceptive and
increase in its size will not promote economic welfare. Estimates of real
GDP (i.e., GDP calculated at fixed base prices) can provide a better
measure.
iii) GDP consists of those goods and services which are transacted in the
market and fetch money value. We know that a part of the total produce
is kept by the producers for self-consumption. Now, suppose that this
retained produce (which is not part of GDP) is offered for sale in the
market, it will definitely fetch money value and as a result GDP will also
increase. In fact, the total output is same, but since it has now come to
the monetary sector, it becomes a part of the GDP and hence increases its
value. Such an increase in GDP will not increase the economic welfare.
iv) In case increase in the size of GDP is the result of prolonged working
hours, increased employment of children in production, unhealthy and
polluted atmosphere inside the factory premises, such an increase in
GDP will not promote economic welfare.
2) Changes in the Composition of GDP and Economic Welfare Composition
of GDP refers to the kinds of goods and services produced in an economy.
Changes in the composition of GDP may sometimes increase economic
welfare and may at other times decrease it. Let us consider the following
cases:
i) If the total production has increased on account of more production of
capital goods, it will not increase economic welfare. No doubt the
money value of the total output has increased, but the volume of
consumer goods, on which depends the real economic welfare, has not
increased. It is only when the proportion of consumer goods increases in
the total output the GDP can promote economic welfare.
ii) If the GDP has increased on account of larger production of war-goods,
the resultant increase will not increase economic welfare. This may no
doubt head to increased fighting capacity of the country but it will do no
good to economic welfare.

18
3) Changes in the Distribution of GDP and Economic Welfare Concept Indicators and
Measurement
If the GDP increases and yet if it is not fairly distributed or it is concentrated
in a fewer hands, it will not promote economic welfare. It is so because as the
rich people get richer the additional money income does not provide them
the same marginal utility as the preceding unit of money income. In other
words, the law of diminishing marginal utility also applies to the additional
money income so that the economic welfare instead of increasing will
diminish.
When the distribution of GDP changes in favour of the poor, they start
getting more commodities and services than before, as a result the economic
welfare increases. Any transfer of income from the rich to the poor,
generally, promotes economic welfare. In fact, there is a unique relationship
between one’s economic welfare and that part of his income which he spends
on consumption and consequently smaller is his economic welfare compared
to this total income. The poor people who spend a major proportion of their
total income on consumption, as a matter of fact, will get more utility from
the transferred income as compared to the rich people.
Transfer of income from the rich to the poor, however, does not increase
economic welfare always, especially if additional income in the hands of the
poor gets frittered away on such things as simply reduce his welfare.

Per Capita Income as an Index of Economic Welfare

Ordinarily speaking, per capita income is considered as an indicator of the
standard of living in a country; any improvement in it is taken as a proxy for
improvement in the standard of living. That may be so, but there are certain
limitations beyond which we cannot rely on this single average.
One, per capita income is a simple average which s derived by dividing the
income of all the nationals of a country. It shows only the size of slice from the
national cake that should by going to each individual. It cannot tell us anything
about the actual distribution. In other words, per capital income estimates are
silent about the distribution of income. To that extent, per capital income
estimates may not be very useful, especially if there is a highly skewed income
distribution in an economy favouring the rich.
Two, per capita income estimates are also silent about the composition of output
– the nature of goods and services produced in the economy.
Three, standard of living is also affected by the type of expenditure incurred by
the government authorities. If the government meets the collective wants of
education, public health, public transportation, safe drinking water, etc., the
people may enjoy a higher standard of living, even with modest per capita
income.
Four, for the purpose of international comparison, per capita income estimates
are framed in a common monetary denominator, usually the American Dollar.

19
Growth and This common denominator cannot take account of purchasing power differences
Development
in different countries.
In some units in other chapters you will be acquainted with some other indicators
of welfare. In this unit we present a discussion on the Millenium Development
Goals and Sustainable Development Goals , in the following section.

1.6 THE MILLENNIUM DEVELOPMENT GOALS

AND THE SUSTAINABLE DEVELOPMENT
GOALS
1.6.1 The Millennium Development Goals
It is difficult to measure development as it is such a wide-ranging and multi-
faceted concept. There has been a lock of a commonly agreed-upon definition.
However, there have been several attempts to measure development and develop
policy measures to foster development based on the ideas about the concept of
development put forward. One such measure was the adoption of the Millenium
Development Goals. Even without a commonly agreed- on definition, policy
makers need specific targets, so as to realize policy objectives . One such set of
targets is known as the millennium development goals (MDGs). The
Millennium Declaration and Millennium Development Goals (MDGs) saw the
convergence of development agenda of United Nations Development Programme
(UNDP); United Nations Environment Programme (UNEP); World health
organization (WHO); United Nations Children's Fund (UNICEF); United Nations
Educational, Scientific and Cultural Organization (UNESCO); and other
development agencies.
In September 2000, 189 nations adopted the “United Nations Millennium Decla-
ration,” a broad-reaching document that states a commitment “to making the
right to development a reality for everyone and to freeing the entire human race
from want.” The declaration specifies a set of eight goals consistent with this
commitment:
Goal 1:Eradicate extreme poverty and hunger.
Goal 2: Achieve universal primary education.
Goal 3: Promote gender equality and empower women.
Goal 4.:Reduce child mortality.
Goal 5. Improve maternal health.
Goal 6: Combat HIV/AIDS, malaria, and other diseases.
Goal : Ensure environmental sustainability.
Goal 8. Develop a global partnership for development.
To realise these goals, there were 21 targets (that correspond to 60 indicators)
that were sought to be reached by 2015.

20
1.6.2 The Sustainable Development Goals Concept Indicators and
Measurement
The world as a whole, and India too, made considerable progress in meeting
te targets. And yet some gaps remained.
The 2030 Agenda for Sustainable Development, adopted by all United Nations
Member States in 2015, provides a shared roadmap for peace and prosperity for
people and the planet, now and into the future. At its core are the 17 Sustainable
Development Goals (SDGs), which are an urgent call for action by all countries -
developed and developing - in a global partnership. The SDGs include 17 goals
and 169 targets. The 17 goals are to be achieved by 2030. The 17 goals are:
1. End poverty in all its forms;
2. End hunger , improve nutrition and achieve food security;
3. Ensure healthy lives and well-being;
4. Ensure equitable and quality education for all and promote lifelong learning;
5. Achieve gender equality and empower women and girls;
6. Ensure availability and sustainable management of clean water and
sanitation for all ;
7. Ensure access to affordable, reliable, sustainable and clean energy for all;
8. Promote sustained , inclusive and sustainable economic growth, full and
productive employment and decent work for all;
9. Build resilient infrastructure, promote sustainable Industry, and promote
innovation,;
10. Reduce inequality within and among countries;
11. Make cities and human settlements inclusive, safe, resilient and sustainable;
12. Ensure responsible consumption and production patterns;
13. Take urgent action to combat climate change and its impacts;
14. Conserve and sustainably use seas, oceans and marine resources;
15. Promote , protect and restore sustainable use of terrestrial ecosystems,
sustainably manage forests, combat desertification, halt and reverse land
degradation and halt biodiversity loss.
16. Promote peaceful and inclusive societies for sustainable development,
provide access to justice for all, and build effective, accountable, and
inclusive institutions at all levels; and
17. Strengthen the means of implementation and revitalise global partnership for
sustainable development.
In 2000, the MDGs set the agenda for development activities and consisted of
eight targets aimed at combatting poverty. While the MDGs set the target and
there we quite a few achievements, they were faced with many criticisms. These
criticisms mainly included around their legitimacy and how the goals and targets
were chosen and set, their narrowness and under emphasis of certain aspects of
development, including human rights, gender and the environment, and how the
progress was reported and measured.

21
 When the MDGs period was reaching an end, it was agreed by all countries to
reform and propose a more widespread, inclusive and reflective set of
development goals. The SDGs emerged as an attempt to represent the challenges
that countries face in the next 15 years and beyond, and is an attempt to address
the root cause of many of them.
The 17 SDGs were identified through widespread consultation over three years
on contrast to the MDGs. This process took into account the views of all parties,
including national governments, civil society, multilateral development
institutions and individuals.
How are the SDGs different from MDGs?
While the MDGs mainly applied to developing countries, the SDGs are
universally applicable. That is they apply to all countries, no matter their current
development status.
Meeting SDGs require that they are implemented in an integrated manner and is
based on the recognition that there is no trade-off between economic, social and
environmental development. Indeed each of these aspects is mutually reinforcing
and one cannot be achieved without the other, or failure in one area could lead to
failure in others. This is in contrast to the MDGs which primarily focussed on the
social aspects of development.
By their nature, the SDGs are a set of broad goals and targets, this is so each
country can decide on the most realistic and practical way to implement policies,
programmes or projects to move towards meeting the SDGs. They build off the
MDGs, but offer more ambitious goals.
Check Your Progress 2
1. Evaluate the usefulness of (i) GDP, and (ii) per capita GDP as measures
of economic development and of welfare.
2. Discuss some characteristics of developing nations.
3. What are the Millennium Development goals? How many goals are there
in the Sustainable Development goals? List any seven

22
1.7 LET US SUM UP
This unit dealt with the basic of economics of development as well as the
concepts of economic growth and development. It began with explaining what
growth means: enlargement, expansion. Economic growth is typically seen as
growth in gross domestic product. The unit explained the measurement of growth
and also discussed the relative merits of considering growth in GDP as growth
versus growth per-capita GDP. The unit explained how growth is measured, and
how to compare income levels across countries and over time .
The unit went on to discuss in detail the concept of economic development, and
how it differs from economic growth. The unit explained that economic
development is a much broader concept than economic growth, although
economic growth is the foundation of economic development. However, though
economic growth is a fundamental concept of economic development, the latter
is characterized also by an overall structural transformation of economy.
Examples of such structural change includes decline of the share of agriculture in
GDP and the rise of that of the service sector; increasing urbanization, change in
the composition of the work-force, and so on.
Subsequently, the unit discussed in detail the characteristics and features of a
developing economy. We saw low per-capita income, a large agriculture, low
urbanization were some of the characteristics.
After this the unit discussed elaborately the concept and meaning of economic
development in all its aspects and dimensions. Finally the unit presented a
discussion the Millennium Development Goals and Sustainable Development
Goals.

1.8 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1. See section 1.2
2. See section 1.2
3. See section 1.3
Check Your Progress 2
1. See section 1.5
2. See section 1.4
3. See subsection 1.6.2

23
UNIT 2 INTERNATIONAL COMPARISONS
Structure
2.0 Objectives
2.1 Introduction
2.2 Development Gap
2.3 The Divide between Developed and Developing Nations
2.4 Historical Patterns of Development
2.5 Some Case Studies
2.6 Let Us Sum Up
2.7 Answers to Check Your Progress Exercises

2.0 OBJECTIVES
After going through this unit, you will be able to:
• Explain the nature of development gap between developed and developing
nations;
• Discuss the reasons for the emergence of the difference in the levels of
development between the developed and developing nations;
• Describe the historical patterns of development in different parts of the world;
and
• Present some case studies regarding different development experiences of
countries.

2.1 INTRODUCTION
When we study economic development we find some crucial questions confront
us regarding different countries and regions. Why are living conditions so
drastically different for people in different countries and different regions of the
world?, We find some countries poor and others rich. Why is it so? Why are
there such disparities in income and wealth? t Also there are huge difference in
the levels of health, nutrition, education, liberty, choice, women’s rights? Why
do workers in some countries have secure jobs in the formal sector, with regular
pay, while in other countries such jobs are extremely there is scarcity of such
jobs, and most workers are in informal sector with fluctuating and insecure
wages? Why are populations growing at a fast pace in certain countries, while on
the verge of being stagnant or even reducing in others? Why are public services
so inefficient, insufficient, and corrupt in some countries and so effective in
others? Why have some formerly poor countries made so much progress, and
other s so comparatively little?
This unit takes up a discussion of issues regarding the difference, the gap
between the standard of living of the developing and developed nations.
It explores the reasons for such gaps. We also have to see whether there are
historical reasons for such gaps emerging.
In the next section we see the meaning of the development gap, conceptually and International
theoretically. Subsequently we see various ways the developing nations are Comparisons
classified. After looking at World Bank’s and United Nations’ classifications, the
following unit takes a look at the basic historical patterns of development in
order to see when and how in history the gap, the divergence between developed
and developing nations emerged. Finally the unit provides some case studies in
order to illustrate the development experiences of certain countries, how certain
countries developed to a great extent over time, and how some others fell back
and sometimes had a reversal of fortune.

2.2 DEVELOPMENT GAP

In its basic sense, development gap refers to the gap in per capita income
between the richer developed countries and poorer, developing ones. Since living
standards in all countries tend to rise absolutely over time, it obviously refers to
the comparative position of poor countries, but is the comparative position being
measured taking absolute or relative differences in per capita income? How
should the 'development gap' be assessed? Unfortunately there is no easy answer
to this question , yet the answer given has a profound bearing on the growth of
per capita income that poor countries must achieve either to prevent a
deterioration of their present comparative position or for an improvement to be
registered. Relative differences will narrow as long as the per capita income
growth rate of the developing countries exceeds that of the developed countries;
and this excess of growth is a precondition for absolute differences to narrow and
disappear in the long run. In the short run, however, a narrowing of relative
differences may go hand in hand with a widening absolute difference , given a
wide absolute gap to start with, and thus the rate of growth necessary to keep the
absolute per capita income gap from widening is likely to be substantially greater
than that required to keep the relative gap the same. But suppose the relative gap
does narrow, and the absolute gap widens, are the poor countries comparatively
better or worse off? In comparing rich and poor countries it is not difficult to
argue that even if a relative per capitaincome gap is narrowed, the comparative
position of the poor may have worsened because the absolute gap has widened.
To get an idea of the gap that exists between developed nations and developing
nations, consider a hypothetical, constructed example of the gap between the
incomes of two hypothetical nations. Suppose there are two countries, A and B.
Country A is the advanced nation and country B is the backward nation (no
value-judgement attaches to the term ‘backward’; it only denotes that country B
is the poorer country). Suppose in 2021, the per capita income of country A was
$ 1000 in purchasing power-parity terms, and that of country B was $ 100 in the
same terms. So we find that the gap in per capita income of the two nations is $
1000 -$ 100 = $900. It is a big gap. Now suppose that in the year 2021-2022, the
per-capita incomes of the two nations grow at 2 %.

25
Growth and The per capita income of country A in 2022 becomes $1020 (because 2 % of $
Development 1000 is $ 20 and so its per capita income becomes $1000 + $20 = $1020). On the
other hand, the per capita income of country B in 2020 becomes $ 102 (because
2 % of $ 100 is $ 2 and so its per capita income becomes $ 100 + $2 = $102).
Let us see what happens to the gap in the per capita income of the 2 countries. In
2022 the gap is $1020 - $102 = $918. So we find that compared to 2021 the gap
has actually increased when both countries grew at the same rate. ( the gap
increased from $900 to $918). In fact, the poor country has to grow at 20 % over
2021-2022 for its per-capita income to rise to $120, so as to keep the gap in per
capita income between the rich and poor countries at $900 — the same as before
($1020 – $ 120 = $ 900. So we see that in order to merely prevent the gap in
per-capita income from increasing, the poor country in this example has to grow
10 times as fast as the developed country. As another example, Take for
illustration the case of the average person in the poor country living on the
equivalent of $200 per annum compared with the average person in the rich
country living on approximately $10 000. Suppose the income of the average
person in the poor country rises by 20 per cent and the income of the average
person in the rich country rises by 10 per cent. The average person in the poor
country is now relatively better off, but is he not comparatively worse off? The
increased command over goods and services of the average person in the rich
country (i.e. 10 per cent of $10 000) far exceeds that of the the average person in
the poor country (i.e. 20 per cent of $200)
where P is the principal sum. In our context, P can be taken as the initial per
capita income , S the final one, r the rate of growth and t the time period (number
of years )over which growth is considered

2.3 THE DIVIDE BETWEEN THE DEVELOPED

AND DEVELOPING NATIONS
A developing country is often defined by its economic output. There has been a
lot of debate as to where to draw the line between a developed country and a
developing one, which can be seen by the lack of one single meaning for the
term.
The developing countries have been labeled with many different terms. A term
much used from the mid 1940s to the 1980s, especially in international forums,
was the third world. Perhaps the best way to define it is by elimination. Remove
the industrialized economies of western Europe, North America, and the Pacific
(the First world,) and the industrialized, formerly centrally planned economies of
eastern Europe (the Second World), and the remaining countries constitute the
third world. This terminology is used much less frequently today, mainly because
almost all of the former Second World has transformed its political and
economic systems. The geographic configuration of the Third World has led to a
parallel distinction of the
North (first and second worlds) versus the South, which is still used
occasionally. The more popular classifications used today implicitly put all

26
countries on a continuum based on their degree of development. Therefore, we International
speak of the distinctions between developed and underdeveloped countries, more Comparisons
and less developed ones, or — to recognize continuing change — developed
countries and developing countries. The United Nations employs a
classification scheme that refers to the poorest nations as the least-developed
countries. Some Asian, eastern European, and Latin American economies,
whose industrial output is growing rapidly, are sometimes referred to as
emerging economies. Richer countries are frequently called industrialized
countries, because of the close association between industrialization and
development. The highest-income countries are sometimes called post-industrial
countries or service-based economies because services (finance, research and
development, medical services, etc.), not manufacturing, account for the largest
and most rapidly growing share of their economies.
The United Nations uses certain rules for distinguishing between developed and
developing countries. However, the World Bank has stopped using these terms in
favor of others, such as "low-income" or "lower-middle-income" economies,
based on gross national income (GNI) per person. The International Monetary
Fund (IMF) definition is based on per-person income, export diversification, and
the degree of union with the global financial system. (IMF) definition is based on
per-person income, export diversification, and the degree of union with the global
financial system. The IMF published a research report on the topic of
development classification in 2011. It outlined its methods for classifying a
country's level of development.
Countries that are deemed more developed are referred to as developed countries,
while those that are less developed are known as less economically developed
countries (LEDCs)
The World Bank has historically classified every economy as low, middle, or
high income. It now further specifies countries as having low-, lower-middle-,
upper-middle-, or high-income economies. The World Bank uses GNI per capita,
in current U.S. dollars converted by the Atlas method of a three-year moving
average of exchange rates, as the basis for this classification. It views GNI as a
broad measure and the single best indicator of economic capacity and progress.
The World Bank used to refer to low-income and middle-income economies as
developing economies; in 2016, it chose to drop the term from its vocabulary,
citing a lack of specificity. Instead, the World Bank now refers to countries by
their region, income, and lending status.
The World Bank assigns the world’s economies to four income groups—low,
lower-middle, upper-middle, and high-income countries. The classifications are
updated each year on July 1 and are based on GNI( Gross national Income) per
capita in current US dollars (using the exchange rates) of the previous year.
According to the World Bank, sustainable growth and development in MICs have
positive spillovers to the rest of the world. Examples are poverty reduction,
international financial stability, and global cross-border issues, including climate
change, sustainable energy development, food and water security, and
international trade.
27
Growth and MICs have a combined population of five billion, or over 70% of the world's
Development
seven billion people, hosting 73% of the world's economically disadvantaged.
Representing about one-third of global GDP, MICs are a major engine of global
economic growth.
The classifications change for two reasons:
1) In each country, factors such as economic growth, inflation, exchange rates,
and population growth influence GNI per capita. Revisions to national
accounts methods and data can also have an influence in specific cases. To
keep the income classification thresholds fixed in real terms, they are adjusted
annually for inflation. The Special Drawing Rights (SDR) deflator is used,
which is a weighted average of the GDP deflators of China, Japan, the United
Kingdom, the United States, and the Euro Area.
2) To keep the income classification thresholds fixed in real terms, they are
adjusted annually for inflation. The Special Drawing Rights (SDR) deflator is
used, which is a weighted average of the GDP deflators of China, Japan, the
United Kingdom, the United States, and the Euro Area.
3) To keep the income classification thresholds fixed in real terms, they are
adjusted annually for inflation. The Special Drawing Rights (SDR) deflator is
used, which is a weighted average of the GDP deflators of China, Japan, the
United Kingdom, the United States, and the Euro Area.
Group July 1, 2021 (new)

Low income

Lower-middle income 1,046 – 4,095

Upper-middle income 4,096 -12,695

High income > 12,695

Sometimes countries move to a different group if their Gross National Income

changes. For instance, Indonesia and Iran moved from Upper-Middle Income
Group to Lower-Middle Income Group in 2020 from 2019, and Romania had
also slipped from Higher Income to Upper-Middle Income Group in the same
period.
Sometimes the World Bank classification leads to the discovery of surprising,
even startling, facts. If we consider the situation about a decade back, in 2010,
and see the classification on the above-mentioned lines (of course, the actual
income-threshold at leach level was slightly different, due to current exchange-
rate and purchasing-power-parity requirements), we find that out of 216 countries

28
of the world considered for classification, 35 countries were low-income International
countries, 57 countries were lower-middle-income countries, 54 countries were Comparisons
in the upper-middle-income category, and 70 countries were high-income
countries. Thus the largest number of countries were in the high-income
category! However, if we consider population, the population of the low-income
countries was 12 % of world population; the population of the lower-middle-
income countries was 36 % of world population; so was the population of the
upper-middle-income countries; while the population of high-income countries
was 16 % of the world population. Thus, while most of the countries in the world
were high-income, most of the population lived in middle-income countries.
In unit 1, we brought out the difference between economic growth and economic
development. We saw development is much more than economic growth.
Development involves a structural transformation of the economy, and there are
many more indicators of development. Economic growth is a necessary condition
for development but it is certainly not a sufficient one. Here, in this unit, in the
above discussion about the difference between developed and developing nation
you may be getting the idea that a lot of emphasis is being laid on income of
nations (for instance, the World Bank classification). So what happens if the
Gross National Income (same as the Gross National Product, or GDP, as you
have read in macroeconomics courses) of a nation were to change dramatically?
Consider the case of Equatorial Guinea, a small nation on the West coast of
Africa. It has a population of less than a million people. The discovery and
development of oil deposits and reserves off its coast led to a dramatic rise in its
per-capita GDP. In 1990 its per-capita income was $330. By 2009 it had shot up
to $ 12, 420. In the decade 2000-2009 it was the fastest growing economy in the
world, reaching average growth rates of 25 per cent, exceeding growth rates of
China. With this kind of growth rates, in about a decade, Equatorial Guinea
moved from being a low-income country to a high-income one.
Notice we are talking of growth rates. Did it mean that Equatorial Guinea
became a developed nation from a developing one. The answer is no, because in
terms of other indicators this country did not progress that dramatically. It
reached the same income level as that of Hungary, but this is where the similarity
between the two nations ends. Life expectancy in Equatorial Guinea is about 50
years, while in Hungary it is 74 years. About 90% of school-aged Hungarian
children are enrolled in primary school; for Equatorial Guinea it is about 50
percent. Despite Equatorial Guinea’s sudden high level of per capita income
there has been little transformation in the low levels of education and poor health
care of most Equatorial Guineans. Nor has there been much change in their
economic activity. Rapid economic growth has not brought economic
development to most of the population of Equatorial Guinea. But again, this case
is the exception rather than the rule. In most cases, increases in per capita
incomes and economic development have moved together. Thus we see that
although levels of per-capita incomes are very important for determining whether
a country is developed or developing, we should consider many other features,

29
Growth and characteristics and indicators. What proportion of the population is rural? How
Development big is the share of agriculture in GDP? What is the composition of international
trade, particularly exports? How is the country doing in terms of social indicators
like health indicators , education, poverty, unemployment, inequality. How are
manufacturing and services placed. In all these aspects there this a big difference
and gap on the whole between developed and developing nations.
Modern economic growth, the term used by Nobel laureate Simon Kuznets,
refers to the current economic epoch as contrasted with, say, the epoch of
merchant capitalism or the epoch of feudalism. The epoch of modern economic
growth still is evolving, so all its features are not yet clear, but the key element
has been the application of science to problems of economic production, which in
turn has led to industrialization, urbanization, and even explosive growth in
population. Finally, it should always be kept in mind that, although economic
development and modern economic growth involve much more than a rise in per
capita income or product, no sustained development can occur without economic
growth.
Check Your Progress 1
1. What do you mean by development gap?
2. Describe the World Bank classification of various countries of the world
in terms of economic levels. In what way does it differ from the classification
of the United Nations?

2.4 HISTORICAL PATTERNS OF DEVELOPMENT

We study this section by considering at the findings of economic historian Angus
Maddison, who estimated income levels and corresponding rates of economic
growth for the world economy as far back as the year 1 B.c.E. Such an exercise
requires a lot of conjecture, especially the further back in time one goes. To
perform the analysis, Maddison compiled estimates of population, GDP, and a
price index for determining PPP.
According to Maddison’s calculations, average world income in 1000 was
virtually the same as it had been 1,000 years earlier. In other words, growth

30
in per capita income between 1 B.c.E. and 1000 was effectively zero. The next International
820 years (from 1000 to 1820) were barely any better, with world income per Comparisons
capita growing, on average, by just 0.05 percent per year. (Note: This is not a
growth rate of 5 percent; it is a growth rate of 0.05 percent.) During those 820
years, world GDP grew by only slightly more than the growth in world
population. After eight centuries, world per capita income had increased by only
50 percent. To place this in some perspective, China today is one of the world’s
fastest-growing economies. With more than 1 billion people (about four times the
entire world’s population in 1000), economic growth in China aver- aged about
9.5 percent over the past decade, raising Chinese per capita incomes by 50
percent, not in 820 years but in just under 5 years!
Maddison’s estimates indicate considerable uniformity in per capita incomes
throughout the first millennium. The little bit of economic growth that did take
place over the next 800 years was centered in western Europe and in what
Maddison calls the western “offshoots” (Australia, Canada, New Zealand, and
the United States). By 1820, these regions already had a decided advantage over
the rest of the world. For example, whereas China and India may have been
slightly ahead of the western European countries in 1000, average per capita
incomes in western Europe and in their offshoots were already double those of
China and India by 1820.
Maddison’s research suggests that rapid economic growth as we know it really
began around 1820. He estimates that over the subsequent 190 years, the aver-
age growth in world income increased to 1.3 percent per year. Note that the
difference between annual growth of 0.05 percent and 1.3 percent is huge. With
the world economy growing at 0.05 percent per year, it would take more than
1,400 years for aver- age income to double. With annual growth of 1.3 percent,
average income doubles in just 55 years. The world had changed from no growth
at all during the first millennium, to slow growth for most of the second
millennium, to a situation in which, in the past two centuries, average real
income began to double in less than every three generations. Several features of
these data are notable. First, economic growth rates clearly accelerated around
the world since the early 1800s and especially after 1880. Second, and perhaps
most striking, the richest countries recorded the fastest growth rates and the
poorest countries recorded the slowest growth rates, at least until 1950. Per capita
income in the Western offshoots grew by about 1.6 percent per year between
1820 and 1950, while in Asia it grew by only 0.16 percent. As a result, the ratio
of the average incomes in the richest regions to those in the poorest regions grew
from about 2:1 in 1820 to about 13:1 in 1950.
Between 1950 and 2008, the patterns of economic growth changed, at least in
several regions. The gap between the Western offshoots and western Europe,
which had been widening through 1950, narrowed significantly. The poorest
region in 1950 (Asia) recorded the fastest subsequent growth rate (3.6 percent),
thereby beginning to close the income gap with the richer regions of the world.
By contrast, Latin America’s growth stagnated during the 1980s and 1990s, and
eastern Europe’s collapsed after the fall of the Berlin Wall in 1989. Both regions
resumed economic growth during the 2000s.

31
Growth and In Africa, as elsewhere, average growth rates accelerated after 1820 and did so
Development again after 1950, in the period associated with the end of the colonial era. But as
in Latin America, economic growth in Africa faded after 1980, continued to
stagnate in the 1990s, and rebounded only recently. As a result, the income gap
between the world’s richest regions (the Western offshoots) and the poorest in
2000 (Africa) reached 19:1. According to Maddison’s work, this is the largest
gap in income between rich and poor regions the world has ever known. Because
of resurgence in economic growth in Africa during the 2000s, this gap has
narrowed but still remains huge by historical standards.
Maddison’s broad sweep of world economic history indicates how
differential rates of economic growth, especially over the past two
centuries, have produced the divergence in income levels that characterizes
the world’s economy today.

2.5 SOME CASE STUDIES

In this section we begin by looking at some countries that were at the same level
of development at one point of time, and then their levels started to diverge. We
try to arrive at some explanation for this moving apart of the countries. As we
have mentioned earlier, unit 7 in block 2 will also some determinants of growth.
After reading that unit, you should think back about applying the insights you
will get from that unit back to the content of the present unit.
A large number of less-developed countries have experienced growth in income
over the past four decades and many have enjoyed substantial growth. There are
many examples of countries that have had an income growth exceeding 2 percent
a year over the past four decades. At 2 percent annual growth, average income
doubles in 35 years; at 4 percent, it doubles in 18 years. In most of these
countries, manufacturing grew more rapidly than the gross domestic product and
thus moved these economies through the inevitable structural change that reduces
the share of income produced and labour employed in agriculture. Many other
countries experienced slower (albeit positive) growth and development, with
incomes growing 1 or 2 percent per year. In still others, incomes stagnated or
declined.
The most rapidly growing economies have been in Asia and include China, India,
Indonesia, Korea, Malaysia, and Thailand. But several non-Asian countries also
are among the fast growers, such as Botswana, Chile, Estonia, and Mauritius.
Since 1970, Botswana, a landlocked country in southern Africa, has been one of
the fastest-growing economies in the world and one that has used its increased
income to improve the lives of its citizens. Botswana’s experience challenges the
stereotype that all African countries have been stuck with little growth and
development. At the same time, several Asian countries have grown slowly or not
at all, including Myanmar (Burma), North Korea, and Papua New Guinea.
Below, we mention the facts related to some individual countries. They do not
pertain to the latest time period, or even the same period, in the case of every
country.

32
Malaysia, which previously had been known mainly for the export of rubber, tin, International
and palm oil, became one of the world’s largest exporters of electronic Comparisons
components and other labor-intensive manufactured goods. Partly because of
these exports, Malaysia emerged as one of the fastest growing economies in the
world and a leading development success story. The income of the average
Malay more than quadrupled in real terms between 1970 and 2010, infant
mortality fell from 41 to 6 infants per thousand, and life expectancy rose from 61
to 75 years. Adult literacy jumped from 58 to 92 percent and the ratio of girls to
boys enrolled in school increased from 83 to 103 percent.
Ethiopia Per capita incomes in 2004 were at about the same levels as in 1981. In
the intervening years, incomes at times increased and at other times declined, but
overall, economic stagnation characterized the nation. Since 2004, how- ever,
economic growth has been faster and more consistent, averaging 6.6 percent per
year. This is much faster than at any time over the past three decades. Despite the
global recession of 2008–09, Ethiopia’s economy continues to grow rapidly,
although it is hard to know if this will be sustained.
Looking at other indicators of living standards, infant mortality rates fell from an
estimated 136 per thousand in 1970 to 67 per thousand in 2009, reflecting the
potential for health outcomes to improve even when income does not. Life
expectancy, at 56 years, is 13 years more than in 1970 but still well below the
levels in Malaysia and other more affluent economies. Adult literacy is less than
one out of three, but this will improve in the future. Four out of every five of
Ethiopia’s children of school age are now enrolled in primary school — double
the level of a decade ago. The economy is changing too, albeit slowly. In 1970,
61% of national output was derived from agriculture; today this figure is 51%.

Bangladesh has an impressive track record of growth and poverty reduction.

It has been among the fastest growing economies in the world over the past
decade, supported by a demographic dividend, strong ready-made garment
(RMG) exports, and stable macroeconomic conditions. Continued recovery in
exports and consumption will help growth rates pick up to 6.4 percent in fiscal
year 2021-22.
Bangladesh tells the world a remarkable story of poverty reduction and
development. From being one of the poorest nations at birth in 1971 with per
capita GDP tenth lowest in the world, Bangladesh reached lower-middle-income
status in 2015. It is on track to graduate from the UN’s Least Developed
Countries (LDC) list in 2026. Poverty declined from 43.5 percent in 1991 to 14.3
percent in 2016, based on the international poverty line of $1.90 a day (using
2011 Purchasing Power Parity exchange rate). Moreover, human development
outcomes improved along many dimensions.
In 2021, Bangladesh’s Cabinet Secretary told reporters that GDP per capita had
grown by 9% over the past year, rising to $2,227. Pakistan’s per capita income,
meanwhile, is $1,543. In 1971, Pakistan was 70% richer than Bangladesh; today,
Bangladesh is 45% richer than Pakistan.
Bangladesh’s growth rests on three pillars: exports, social progress and fiscal
prudence. Between 2011 and 2019, Bangladesh’s exports grew at 8.6% every
year, compared to the world average of 0.4%.

33
Growth and The success is largely due to the country’s relentless focus on products, such as
Development garments, in which it possesses a comparative advantage. Moreover, the share of
Bangladeshi women in the labour force has consistently grown. Also, Bangladesh
has maintained a public debt-to-GDP ratio of between 30% to 40 %.
Check Your Progress 2
1) Describe the performance of the world economy between the 11th and 19th
century as elucidated by Angus Maddison. Since when did the world economy
grow?
2) Briefly bring out the contours of development of any particular developing
country of your choice, giving reasons for its success.

2.6 LET US SUM UP

In this unit we looked at the developed and developing world in a comparative
perspective. The aim was to look at the notion of economic development, and
centre the discussion around the comparison between developed and developing
countries. The central question was what are the characteristics that differentiate
developed nations from developing nations? To this end, the unit began by
explaining the concept and significance of the development gap, with the help of
a simple example. The discussion brought home the fact that the developing
nations have to grow very fast in order to not increase the gap or fall behind.
Next, the unit looked at the divide between the developed and developing
nations. The insight that we got was that the divide is not merely in terms of
income levels, but also in terms of several economic and social indicators of
development. Merely by raising rates of growth, a country can go from being in
the category of low-income nations to high-income nations, but it will not
necessarily become a developed nation. Following this, the unit took a look at
broad contours of development of the world economy, based on studies by
Angus Maddison and presented some broad historical patterns of development.
Finally, the unit mentioned the case of some developing nations that have
performed admirably in the post World War II period, and some in recent times.

2.7 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1. See section 2.2
2. See section 2.3
Check Your Progress 2
1. See section 2.4
2. See section 2.5

34
 Introduction to Growth
Models

BLOCK 2 GROWTH MODELS: THEORY AND

EVIDENCE.

BLOCK 2 INTRODUCTION
The second block of the course is titled Growth Models: Theory and Evidence.
In the first block, you had studied about the basic idea of what is meant by
economic growth and economic development and the relationship among them.
Also you were presented with some international comparisons among nations
regarding the level of development.

The present block has five units. Unit 3 is titled Introduction to Growth
Models, and the next one, unit 4 is titled Harrod-Domar Model. Unit 5 is titled
The Solow Model. Unit 6 is titled Endogenous Growth Model, and finally, unit
7 is titled Determinants of Growth.

Unit 3 provides an overview of various approaches to growth. It discusses many

different theories of growth. It begins with Classical growth theory and then
presents briefly the Marxian theory of growth. After the classical and Marxian
theory unit 3 also discusses some stages-of-growth theories like those of Rostow
and Kuznets. The unit also discusses structural change models and dependency
theories. You will also be familiarized with neoclassical theories as well as
endogenous growth theories. Finally it briefly discusses new theories called
unified growth theories.

The subsequent three units in this Block take up for discussions the various
theories one by one. Unit 4 discusses the fixed-coefficient production function
using Harrod-Domar model. Unit 5 discusses one of the central models of
economic growth in the literature on growth theory, namely, the Solow growth
model. Unit 6 discusses the endogenous growth models, that is models where
growth is determined within the system, as are the factors causing growth.

Finally, unit 7 examines the determinants of growth. It discusses the concept of

convergence, that is, whether poorer countries are catching up with the richer
countries. The unit discusses different determinants like labour, capital,
technology and total factor productivity. The unit examines the concept of path
dependence as well.

37
Growth Models:
Theory & Evidence
UNIT 3 INTRODUCTION TO GROWTH MODELS
Structure
3.0 Objectives
3.1 Introduction
3.2 Classical growth theory
3.3 Marxian Theory of growth
3.4 Stages of Growth theories: Rostow and Kuznets
3.4.1 Rostow’s Theory
3.4.2 Kuznet’s Theory
3.5 Structural Change Models
3.5.1 Lewis Model and Patterns of development analysis
3.5.2 The International Dependence Model and the Dualistic Development Thesis
3.6 The Neoclassical Counterrevolution and Traditional Neoclassical Growth
Theory
3.7 The Theory of Endogenous Growth
3.8 Unified Growth theory
3.9 Let Us Sum Up

3.0 OBJECTIVES
After going through the unit you will be able to:
● Explain the concept of economic growth ,development and growth models;
● Describe the background and evolution of growth models;
● Identify the sources of growth in various models of growth; and
● Discuss the structure of the various growth models

3.1 INTRODUCTION
Economic growth is the study of the causes and consequences of sustained
growth in real GDP per person. One can define economic growth as the increase
in the inflation-adjusted value of the goods and services produced by an economy
over time. Economists refer to an increase in economic growth caused by more
efficient use of inputs that is labour, capital, land etc. as intensive growth. GDP
growth caused only by increases in the amount of inputs available for use
(increased population, or new machinery) counts as extensive growth. The "rate
of economic growth" refers to the geometric annual rate of growth in GDP over a
period of time. This growth rate represents the trend in the average level of GDP
over the period, and ignores any fluctuations in the GDP around this trend.
Economic Development is a much wider concept in terms of scope vis-a-vis
growth and is defined as a combination of social, economic and institutional
processes that secure the means for obtaining a better life. It should be perceived
as a multidimensional process involving the reorganisation and reorientation of
economic and social systems.
38
While economists in the 20th century viewed development primarily in terms of Introduction to Growth
economic growth, sociologists instead emphasized broader processes of change Models
and modernization. Development and urban studies scholar Karl Seidman
summarizes economic development as "a process of creating and utilizing
physical, human, financial, and social assets to generate improved and broadly
shared economic well-being and quality of life for a community or region".
Daphne Greenwood and Richard Holt distinguish economic development from
economic growth on the basis that economic development is a "broadly based
and sustainable increase in the overall standard of living for individuals within a
community", and measures of growth such as per capita income do not
necessarily correlate with improvements in quality of life. Economic
development is a wider concept and has qualitative dimensions. Economic
development implies economic growth plus progressive changes in certain
important variables which determine well-being of the people, for example,
health and education.
Economic development is the primary objective of the majority of nations across
the world. The universal features of economic development-health, life
expectancy, literacy and so on-follow in some natural way the growth of per-
capita GNP. If we see it as purely economic, we can say it is synonymous to
Economic growth. But in addition to rising income it implies fundamental
changes in the structure of the economy as well. Economic growth is one of the
most important notions in the global economy. Despite the criticism that the level
and rate of growth does not always reflect the real level of a population’s living
standards, it remains the primary measure of prosperity. However, as a measure
describing the dynamics of economic processes in the country it has some
drawbacks. First, it does not record the volume of production obtained from the
informal market, known as the "black market", which means that not all
economic transactions are included in the total volume of generated output. In
addition, economic growth does not take into account changes in the amount of
time spent on work, which obviously affects the welfare of society. Also the
measure of economic growth does not include the negative processes associated
with economic activities, such as environmental pollution, its progressive
degradation, or noise pollution. However, despite all these drawbacks economic
growth remains the primary measure of the socio-economic conditions of the
citizens of a country. A model of economic growth is based on economic theory
to establish basic fundamental assumptions that allow proposing an interaction
between the factors of production in order to explain the determinants of
economic growth. The principal theories of economic growth include:
Mercantilism-At the beginning of the Industrial Revolution , wealth of a nation
was determined by the accumulation of gold and running trade surplus. It was not
a growth theory but argued that a country would be better off by accumulating
gold and by increasing exports.
Classical Theory- Adam Smith with whom the classical school started placed
emphasis on the several factors which enable increased economic growth:

39
Growth Models:
a) Role of markets in determining demand and supply.
Theory & Evidence
b) Productivity of labour that is the state of the skill, dexterity and judgement
with which labour is applied in any nation.
c) Role of Trade in enabling greater specialisation.
d) Role of increasing returns to scale.
While David Ricardo developed the classical model that assumed technological
change as constant and increasing inputs that could lead to diminishing returns,
Thomas Malthus could notthe capacity of technological improvements to
increase food yields .The theory states that food production will not be able to
keep up with growth in the human population, resulting in disease, famine, war,
and calamity .
Neo-Classical Theory- Neoclassical growth theory is an economic theory that
outlines how a steady economic growth rate results from a combination of three
driving forces—labor, capital, and technology.
Endogenous growth theories- The Endogenous Growth Theory states that
economic growth is generated internally in the economy, i.e., through
endogenous forces, and not through exogenous ones. The theory contrasts with
the neoclassical growth model, which claims that external factors such as
technological progress, etc. are the main sources of economic growth.
Keynesian Demand side Theory: Keynes criticised the Classical school of
thought and argued that Aggregate Demand could play a role in influencing
economic growth in the Short and medium, -term. Though most growth theories
ignore the role of Aggregate Demand, some economists argue recessions can
cause hysteresis effects and lower long-term growth.
Limits to growth-An environmental perspective leads some to argue that in the
very long-term economic growth will be constrained by resource degradation and
global warming.

3.2 CLASSICAL GROWTH THEORY

Analysis of the process of economic growth was the primary feature of the work
of classical economists viz. Adam Smith, Thomas Malthus and David Ricardo.
They may be regarded as the main precursors of the modern growth theory.
Specifically, they were confronted with the facts of social and economic changes
taking place in the contemporary English society living on the 18th and 19th
Centuries on the eve of or in the throes of the Industrial Revolution.
Thus, their research was against the background of the emergence of the new
economic system-the system of the Industrial Capitalism.
“Progress” was an essential component for the development of a society as it was
seen as growth of national wealth. Hence, the principal of national advantage was
regarded as an essential criterion of economic policy. Progress was also
conceived within a framework of a need to preserve private property and hence,
the interests of the property-owning class from this perspective, they
endeavoured to show that the exercise of individual initiative under freely
competitive conditions to promote individual ends would produce results
beneficial to the society as a whole.
40
Conflicting economic interests of different groups could be reconciled by the Introduction to Growth
operation of competitive market forces and by the limited activity or role of Models
Government.
They were able to provide an account of the broad force that influences economic
growth and the mechanisms underlying the growth process. They recognised that
the accumulation and productive Investment of a part of the social product is the
main driving force behind economic growth and that under capitalism this takes
place in the form of reinvestment of profits. Their critique of feudal society was
based on the observation that a large part of social product was not invested but
consumed unproductively. The explanation of the forces underlying the
accumulation process was seen as the heart of the problem of economic growth.
Associated with accumulation is technological change as expressed in the
dimension of labour and change in methods of production. To these basic forces
in economic growth they added the increase in supply of labour through growth
of population. Their analysis on the operation of these forces led them to the
common view that the process of economic growth under the conditions they
identified raises obstacles in its own path and is ultimately retarded, leading to a ”
stationery state”, which is the ultimate end of economic growth.
Adam Smith posited a supply-side driven model of growth. Population growth,
Smith proposed in the traditional manner of the time, was endogenous: it depends
on the sustenance available to accommodate the increasing workforce.
Investment was also endogenous: determined by the rate of savings (mostly by
capitalists); land growth was dependent on conquest of new lands (e.g.
colonization) or technological improvements of fertility of old lands.
Technological progress could also increase growth overall: Smith's famous thesis
that the division of labor (specialization) improves growth was a fundamental
argument. Smith also saw improvements in machinery and international trade as
engines of growth as they facilitated further specialization. Smith also believed
that "division of labor is limited by the extent of the market" - thus positing an
economies of scale argument. As division of labor increases output (increases
"the extent of the market") it then induces the possibility of further division and
labor and thus further growth. Thus, Smith argued, growth was self-reinforcing
as it exhibited increasing returns to scale. Finally, because savings of capitalists
is what creates investment and hence growth, he saw income distribution as being
one of the most important determinants of how fast (or slow) a nation would
grow. However, savings is in part determined by the profits of stock: as the
capital stock of a country increases, Smith posited, profit declines - not because
of decreasing marginal productivity, but rather because the competition of
capitalists for workers will bid wages up. So lowering the living standards of
workers was another way to maintain or improve growth (although the counter-
effect would be to reduce labor supply growth). Despite increasing returns, Smith
did not see growth as eternally rising: he posited a ceiling (and floor) in the form
of the "stationary state" where population growth and capital accumulation were
zero.

41
Growth Models: Smith's model of growth remained the predominant model of Classical Growth.
Theory & Evidence David Ricardo (1817) modified it by including diminishing returns to land.
Output growth requires growth of factor inputs, but, unlike labor, land is
"variable in quality and fixed in supply". This means that as growth proceeds,
more land must be taken into cultivation, but land cannot be "created". This has
two effects for growth: firstly, increasing landowner's rents over time (due to the
limited supply of land) cut into the profits of capitalists from above; secondly,
wage goods (from agriculture) will be rising in price over time and this then cuts
into profits from below as workers require higher wages. This, then, introduces a
quicker limit to growth than Smith allowed, but Ricardo also claimed (at first)
that this decline can be happily checked by technological improvements in
machinery (albeit, also with diminishing productivity) and the specialization
brought by trade, although he also had stationary states.
Malthusianism is the idea that population growth is potentially exponential while
the growth of the food supply or other resources is linear, which eventually
reduces living standards to subsistence levels.. Thomas Robert Malthus, in his
1798 writings, An Essay on the Principle of Population believed there were two
types of "checks" that are continuously at work, limiting population growth
based on food supply at any given time:
● preventive checks, such as moral restraints or legislative action — for example
the choice by a private citizen to engage in abstinence and delay marriage
until their finances become balanced, or restriction of legal marriage or
parenting rights for persons deemed "deficient" or "unfit" by the government.
● positive checks, such as disease, starvation, and war, which lead to high rates
of premature death — resulting in what is termed a Malthusian catastrophe.
Such a catastrophe inevitably has the effect of forcing the population (quite
rapidly, due to the potential severity and unpredictable results of the
mitigating factors involved, as compared to the relatively slow time scales and
well-understood processes governing unchecked growth or growth affected by
preventive checks) to "correct" back to a lower, more easily sustainable level.

42
 Introduction to Growth
3.3 MARXIAN THEORY OF GROWTH
Models
The Karl Marxian model of economic growth is available in his famous
book "Das-Capital". He rejects the salient features of classical model of
economic growth. He rejected the law of diminishing returns and says
that the final outcome of stationary state in classical model is not a natural
process, it is due to human arrangements. He also rejects Malthusian
theory of population.
Marx’s theory seeks to combine economics and sociology and views
economic development as a continuous change in the social, cultural and
political life of society. In this theory, economic systems reach higher
stages through strained relations between the dynamic forces of
production and slowly evolving social and political organisation which
permits production. The stages of development: a) primitive-communal
society b) feudalism c) capitalism d) socialism e) communism.

He predicted that capitalism is characterised by a class struggle. Growing

conflicts between labour and capitalists would eventually lead to a revolution in
which capitalism based on private ownership would be transformed into
socialism based on public ownership.
This theory gives an important insight to the problems faced by most developing
economies that have been relying on investment in the modern Industrial sector
to achieve development- basically the increases in employment have been much
slower due to labour-saving technologies (also in contrast to output growth as a
result of Investment).However, increase in labour force has been more due to
growing population and thus, what can be observed is growing inequality and
social instability.
Followers of Marx have highlighted how the International capitalist system has
aggravated the gap between rich and poor countries and that there is a need to
restructure the world capitalist system to help least developed countries become
less dependent and vulnerable given the subservient position this system has put
them in.

Check Your Progress 1

1. Discuss the Classical Theory of Economic growth.
Q2. How do you explain the Marxian criticism of the Classical Theory
of growth?

43
3.4 STAGES OF GROWTH THEORIES:
ROSTOW AND KUZNETS
3.4.1 Rostow’s Theory
Walt W. Rostow has explained the transition from underdevelopment to
development in terms of a series of steps or stages through which all
countries must proceed. His work”The Stages of Economic Growth”
explains in detail the growth process via these stages:
a)The traditional society b)The preconditions for take-off c)The take-off
d)The drive to maturity e)High mass consumption.
Thus, as an economy takes on the path of growth there are economic,
social and institutional changes that kick-start growth rather slowly and
then the economy grows rapidly before it saturates to a high income level.
3.4.2 Kuznet’s Theory
Simon Kuznets gave the concept of Modern Economic Growth and defined the
economic growth of a country as “a long-term rise in capacity to supply
increasingly diverse economic goods to its population, this growing capacity
based on advancing technology and the institutional and ideological adjustments
that it demands.” He defined 6 basic characteristics of Modern Economic
Growth:
1.High rates of growth of per capita output and population
2.High rates of increase in Total Factor Productivity
3.High rates of structural transformation of the economy
4.High rates of social and ideological transformation
5.The propensity of economically developed countries to reach out to the rest of
the word for markets and raw materials
6.The limited spread of economic growth to only one-third of the world’s
population

Kuznets observed these for a large number of developed countries. He said that
the 6 characteristics are mutually reinforcing and inter-related.
He developed an approach to the analysis of economic growth over long
historical periods he called as an “economic epoch”. The innovation/scientific
knowledge and its application define an epoch and thus, economic growth and
structural change.
 Introduction to Growth
Models

3.5 STRUCTURAL CHANGE MODELS

3.5.1 Lewis Model and Patterns of development analysis
Structural change models are based on the popular notion of “Dualism”,
which in Development Economics is a relevant concept to understand the
dynamics of growing economies. Dualism in Economics is the
coexistence of two contrary forces in an economic set up. It can be of
various types viz, organisational, technological or structural dualism on
the basis of classification of an economy. W Arthur Lewis in the 1950’s
is one of the most famous structural change models which focuses on the
changes in a growing economy where a traditional agricultural or rural
sector paves way for the modern industrial urban sector which then is
responsible for growth via capital accumulation. His model was based on
the unlimited supply of labour in underdeveloped economies mostly in
the traditional agriculture sector and how this surplus labour can be used
in the modern industrial sector that grows and provides employment and
higher wages to labour. Also this sector then kick starts economic growth
as it accumulates capital and as Investment happens.The process of
modern sector self-sustaining growth is assumed to continue till all
surplus labour is absorbed in the industrial sector. The balance of the
economy lies in the equilibrium of both agriculture and industrial
economic activities.
The patterns-of-development analysis of structural change focuses on the
sequential process through which the economic, industrial and
institutional structure of an underdeveloped economy is transformed to
accommodate new industries as an engine of growth. Increased savings
and Investment here are taken to be necessary but not sufficient
conditions for growth. In addition to accumulation of capital both
physical and human, there is a need for a set of interrelated changes in the
economic structure of the economy for the transition.These changes occur
both at domestic and International level. Thus, growing economies can
benefit( or lose) by being part of the integrated International system is
what this analysis recognises unlike other models that look at structural
change as a domestic process only.
3.5.2 The International Dependence Model and the Dualistic-
Development Thesis
The International Dependence Revolution models view developing
countries as engulfed in domestic and International rigidities and thus,
caught up in a dependence and dominance relationship with developed
45
Growth Models: countries. The dependence model divides the world into a “centre” and a
Theory & Evidence
“periphery” where there is an unequal set up of power dynamics. The
developed countries are the dominant Centre whereas the developing
countries are the dependent periphery governed by the dominance and
vulnerability of the Centre, thus paving way for impoverishment of the
periphery.
The Dualistic-development Thesis envisages the concept of Dualism such
that rich and poor countries and rich and poor people have inherent
differences at various levels and thus there is the existence and
persistence of divergence between these. The economic systems are
characterised by different sets of conditions which are elements of
dualism and this coexistence is chronic in nature. Also this dualism is
responsible for gaps between rich and poor that don't decrease but rather
increases with time. Hence, the increasing gaps between rich and poor.

3.6 THE NEOCLASSICAL COUNTER

REVOLUTION AND TRADITIONAL
NEOCLASSICAL GROWTH THEORY
The 1980's saw the emergence of the Neoclassical Revolution in the
developed countries where they favoured the supply-side macroeconomic
policies, rational expectations theories and privatization of public
corporations. You have read about these in your courses in
microeconomics and macroeconomics.
Free-market analysis argues that markets alone are efficient and thus, any
kind of Government intervention is distortionary and counterproductive.
Public-choice theory (new political economy approach) goes further to
argue that Government does nothing right. This is because this approach
assumes that politicians, bureaucrats, people and states all pursue their
selfish interests and hence, the overall result is misallocation of resources.
Thus, minimum Government intervention is best.
The Market-friendly approach accepts the notion of Market-failure and
unlike the Free-Market approach and Public-Choice Theory, recognises
the role of Government intervention to correct these failures. This
approach however focuses on market-friendly interventions. All these
theories are applied to all areas of economic life, including economic
growth. Hence, these are, strictly speaking, not theories exclusively of
economic growth, but rather approaches to economic policies and the role
of government in the economy.
The Neoclassical Growth Theory is an economic model of growth that
outlines how a steady economic growth rate results when three economic
forces come into play: labor, capital, and technology. Solow Model of
growth is the most popular neoclassical model of growth. It extended the

46
 Harrod-Domar model of growth, which laid the foundation of growth( Introduction to Growth
given constant returns)on the process of capital accumulation. The Models
mobilisation of savings into Investment would help a country achieve
growth via accumulation of capital in this model. Solow Model added to
this by introducing the role of labour in the given framework and
extended it further to technological advancements. Diminishing returns to
individual factors of production is Solow’s twist to the Harrod Domar
Model. The model predicts the convergence of long run growth across
countries via the Stady state.

3.7 THE THEORY OF ENDOGENOUS

GROWTH
As the predictions of the neoclassical models didn't work exactly the way
they were expected to and many developing countries could not grow
rapidly despite surge in investment and liberalization, the growth theory moved
to New Growth models that relied on explaining growth with factors that played
their role from within the system and hence the term Endogenous growth
models. These models relied on examining growth beyond the exogenous factors
as used in neoclassical models.
Endogenous growth theory holds that investment in human capital, innovation,
and knowledge are significant contributors to economic growth. The theory also
focuses on positive externalities and spillover effects of a knowledge-based
economy which will lead to economic development.
Paul Romer has made a significant contribution to Endogenous Growth theory.
In choosing Romer as one of the 2018 economics laureates, the Royal Swedish
Academy of Sciences stated that he had shown how knowledge can function as
a driver of long-term economic growth and earlier studies had not modelled how
economic decisions and market conditions determine the creation of new
technologies. Paul Romer solved this problem by demonstrating how economic
forces govern the willingness of firms to produce new ideas and innovations.
Robert Lucas along with Paul Romer heralded the birth of endogenous growth
theory and the resurgence of research on economic growth in the late 1980s and
the 1990s.
Key Policy Implications of Endogenous Growth Theory
● Government policies can raise an economy’s growth rate if the policies are
directed towards enforcing more market competition and helping stimulate
innovation in products and processes.
● There are increasing returns to scale from capital investment in the
“knowledge industries” of education, health, and telecommunications.
● Private sector investment in Research and Development is a vital source
of technological progress for the economy.
You will study more about endogenous growth theory in unit 6.
 3.8 UNIFIED GROWTH THEORY
Oded Galor founded the theory of unified growth, or unified growth theory that
explores the process of development over the entire course of human history and
identifies the historical and prehistoric forces behind the differential transition
timing from stagnation to growth. It also explores the divergence in income per
capita across countries and regions
He has made significant contributions to the understanding of the process of
development over the entire course of human history and the role of deep-rooted
factors in the transition from stagnation to growth and in the emergence of the
vast inequality across the globe. He has pioneered the exploration of the impact
of human evolution, population diversity, and inequality on the process of
development over most of human existence.
Check Your Progress 2
1. How do you explain the Neoclassical counterrevolution in explaining
growth?..
2. Examine the neoclassical growth theories and the emergence of Endogenous
growth in the light of these.

3.9 LET US SUM UP

This unit sets the ball rolling about theories of growth. The unit gave an overview
on approaches to growth, some of which you will study in detail in the next few
units, and some others in the next course on development economics that you
will meet in the next semester. The unit familiarised you about the concept of
growth and what a theory of economic growth means. You learnt the evolution of
theories of growth from the time of classical economists like Adam Smith.
The unit began with an exposition of classical theories of growth Special
emphasis was laid on Adam Smith’s theory. Then the unit briefly explained the
theories of Malthus and David Ricardo. The theory of economic growth as
expounded by Marx was discussed. We saw that Marx had talked about certain
stages through which society passes. The unit also discussed the stages of growth
theories of Rostow and Kuznets. The unit then discussed economic theories
which were about structural change. The unit mentioned the Lewis growth model
and other dualistic theories as also international dependence theories.
48 Subsequently, the unit went on to touch upon free-market espousing neoclassical
theories as well as traditional neoclassical theory. You will study about
neoclassical growth theory put forward by Robert Solow in unit 5. Finally, the
unit dwelled upon endogenous growth theory, and unified growth theory put
forward by Oded Galor.

3.10 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress 1 Check Your Progress 2
1. See section 3.2 1 See section 3.6
2. See section 3.3 2 See section 3.7
UNIT 4 HARROD DOMAR GROWTH
MODEL
Structure
4.0 Objectives
4.1 Introduction
4.2 Background to the Harrod-Domar Model
4.2.1 Essence of the model
4.2.2 Assumption of the Model
4.3 The Harrod Model (HM)
4.3.1 Statement of the Model
4.3.2 Assumption of the Model
4.3.3 Policy Implication of the Model
4.3.4 The Harrod Model and Trade Cycled
4.3.5 Critique of the Harrod Model
4.4 The Domar Model (DM)
4.4.1 Statement of the Model
4.4.2 Assumption of the Model
4.4.3 Policy Implication of the Model
4.5 Comparison of Harrod Model and Domar Model (HDM)
4.5.1 Similarities
4.5.2 Dissimilarities
4.6 Harrod-Domar Growth Model
4.6.1 Substance of the Model
4.6.2 Limitations of the Model
4.7 Let Us Sum Up
4.8 Answers to Check Your Progress Exercises

4.0 OBJECTIVES
After reading this unit you should be able to:
 Describe the context and background in which this model came to be
developed by two different economists, each working independently enters at
the others, but still reaching the same results;
 Discuss the role of savings and investment in the growth process, as
expounded by Harrod, and the implication of this relationship;
 Identity the similarities and dissimilarities between the Harrod Model and the
Domar Model;
 Develop an integrated view of the Harrod Model and the Domar Model; and
 Analyse the strengths and limitations of this integrated model.


Shri Saugato Sen, Associate Professor IGNOU, New Delhi
 Harrod-Domar Growth
4.1 INTRODUCTION Model
Economic growth, as you have seen in Unit 3, refers to a process of sustained
increase in real national income of a country. A number of theories have tried to
study the process of economic growth as it has unfolded in the past especially
within the free market framework. These theories are economic growth are also
referred to as growth models, especially when the quantitative interrelationships
among the critical variables in the process of economic growth are set out in a
rigorous form. In the remaining units of this block and the subsequent two
blocks you will study in depth about different models of economic growth as
formulated by different economists at different point of time. Each of these
models emphasises upon a different sector or a set of factors that in the opinion
of their exponents is the major factor that influenced economic growth. In this
unit, we begin with an in-depth analysis of what had come to be known as the
Harrod-Domar Model (HDM) of growth.

4.2 BACKGROUND TO THE HARROD-DOMAR

GROWTH MODEL
This model of growth was developed by two different economists, each working
independently of the other, but almost con-currently. These two economists were
R.F. Harrod and E.D. Domar. Harrod, of course, published his theory earlier
than Domar. Harrod's book Towards a Dynamic Economics was published in
1948, while Domar's book Essays in the theory of Economic Growth was
published in New York in 1957. Harrod Model and Domar Model may differ in
details, but the ideas contained in both of the models are so similar that the two
models have got integrated and more generally are presented as a single united
model, known as the Harrod-Domar Model (HDM).
HDM integrated the classical and Keynesian analysis of economic growth. In the
HDM, capital accumulation plays a crucial role in the process of economic
growth. Both the classical economists and the Keynesians had recognised the
critical role of capital accumulation in the process of economic growth. But the
classical economists considered only the capacity of the capital accumulation,
and, believing that supply created its own demand, did not pay attention to the
demand side. Keynesians, on the other hand, erred in the opposite direction.
Concerned primarily with the short-period, they considered only the adequacy of
demand and neglected the problem of increase in capacity through investment in
the long run. HDM considered both the sides of the investment process.
4.2.1 Essence of the Model
Starting from a full employment equilibrium level of income, the HDM
postulated that continuous maintenance of this equilibrium required that the
volume of spending generated by investment must be sufficient to absorb the
increased output resulting from investment. Given the marginal propensity to
save, the more the capital is accumulated and the larger the initial national

51
Growth Models: income. The larger must be the absolute volume of net investment, maintenance
Theory & Evidence
of full employment, therefore, required an ever-expanding amount of net
investment. This, in turn, required a continuous growth in real national income.
Capital accumulation and growth of income must go side by side.
An increase in capital expands the productive capacity of the economy. If it is
not accompanied by an increase in income, any of the following things may
happen:
 The new capital may remain untitled.
 The new capital may replace old capital depriving the latter of its labour
and/or markets.
 The new capital may be substituted for labour (and possibly other
factors).
Thus, increase in capital unaccompanied by an increase in income would result
into unemployment of capital and /or labour. Excessive capital accumulation
may result into overproduction and consequently into a fall in investment leading
to depression.
4.2.2 Assumption of the Model
The HDM is based on the following assumption:
1. An initial full-employment level of income exists.
2. There is no government interference in the functioning of the economy.
3. The exogenous factors do not influence the growth variables, i.e., it is a
closed economy model.
4. There are no lags in adjustment, i.e., the economic variables like savings,
investment, income, expenditure adjust themselves in the same period. Any
change in saving brings about the corresponding change in investment in the
same period.
5. The average propensity to save(S/Y) and marginal propensity to save(∆S/∆Y)
are equal to each other, i.e,. the absolute change in saving is equal to the
relative change in saving.
6. Propensity to save and "capital coefficient"(capital-output ratio) are constant.
The law of constant returns operated because of the fixity of capital-out ratio.
7. Income, investment and savings are all defined in the net sense. It implies
that these variables exclude depreciation.
8. Saving and investment are equal in ex-ante and ex-post sense, i.e., accounting
and functional equality between saving and investment the equality can be
expressed as:
S0 = I0 (accounting equality)
Se = Ie (functional equality)

52
S0 and I0 are observed saving and investment. Se and Ie are expected saving and Harrod-Domar Growth
investment. Model

All these assumptions are not necessary for the final solution of the problem;
nevertheless, they serve the purpose of simplifying the analysis.

4.3 THE HARROD MODEL (HM)

R.F. Harrod tries show in his model how steady (i.e., equilibrium) growth may
occur in an economy. Once the steady growth is interrupted and the economy
falls into disequilibrium, cumulative forces tend to perpetuate this divergence
thereby leading to either secular definition or secular inflation. In other words,
Harrod's growth model concentrated largely on the following question:
 How can steady growth-rate be achieved with fixed capital-output ratio
(capital coefficient) and fixed saving-income ratio (propensity to save)?
 How can the steady growth-rate be maintained or what are the conditions for
maintaining the stable growth?
 How do natural factors put a ceiling on the growth-rate of the economy?
The model seeks to provide answers to these questions.
4.3.1 Statement of the Model
The Harrod model is based on three growth rates. One, there is the actual
growth rate denoted by G. It is determined by the saving ratio and the capital-
output ratio. It shows short-run cyclical variation in the rate of growth. Two,
there is the warranted growth rate denoted by Gw. It is the full capacity growth
rate of income in an economy. Three, there is the natural growth rate denoted
by Gn. This is regarded as 'the welfare optimum'. It may also be called the
potential or the full employment rate of growth.
1. Actual Growth Rate (G) - The first fundamental equation in the HM is as
follows:
GC = s ........................(1)
where
G = actual rate of growth (or ∆Y/Y)
C = the marginal capital output ratio[or (I/∆Y)]
s = saving income ratio [or (S/Y)]
The eq.(1) explains the simple truth that savings and investment are equal to each
other in terms of ratio. Substituting the values of G,C and s in eq.(1) explains
this phenomenon:
GC = s
Substituting the values, we get
(∆Y/Y)  (I/∆Y) = S/Y

53
Growth Models: Y I S
Theory & Evidence  
or Y Y Y
I S
 
Y Y
or I=S
The equality between saving and inves
tment (export sense) is thus a necessary condition for achieving steady growth. It
is also called the dynamic equilibrium.
2. Warranted Growth Rate (Gw) - It is the full capacity growth rate of income
in an economy. It is also known as 'full employment growth rate' or 'potential
growth rate'. The equation for warranted growth can be stated as follows:
GwCr = s ......................(2)
where,
Gw = warranted growth rate
Cr = amount of capital required to maintain the warranted growth rate
s = saving-income ratio
Eq.(2) states that if the economy is to advance at the steady rate of Gw that will
fully utilise its capacity, income must grow at the rate of s/Cr per year, i.e.,
Gw = s/Cr. If income grows at the warranted rate, the capital stock of the
economy will be fully utilised; the entrepreneurs will be willing to continue to
invest the amount of saving generated at full potential income. Gw is therefore, a
self-sustaining rate of growth and if the economy continues to grow at this rate, it
will follow the equilibrium path shown in.

I2 I
I1

S3
SAVING & INVESTMENT

S2

S1

S1

INCOME

Fig.4.1.

54
In Fig.4.1, income is measured along the horizontal axis, and saving and Harrod-Domar Growth
investment are measured along the vertical axis. It would be seen that the change Model

in income from Y1 toY2 induced investment would be to equal savings S1 at

A(Y2). This investment, in turn, raised income to Y3 and Y3 induced I2 to equal
S2 at B(Y3). I2 in turn raised income to Y4 and Y4 induced I3 to equal S3 at C(Y4
income). In this way, the economy moves on the growth path.
The point of intersection of the investment line and the line running parallel to
the Y-axis indicated the required investment that is forthcoming.
The greater proportion of savings, the greater must be the rate of increase in
output to induce sufficient investment to maintain equilibrium if we assume no
change in the investment co-efficient.
In brief, the warranted growth rate equation in the model implies that actual
investment (ex-post investment) must be equal to expected investment (ex-ante
investment), if an economy is to achieve stable growth. In such a situation, the
following equalities will obtain:
G = Gw, and
C = Cr
The economy would be in equilibrium.
If these equalities do not obtain, the economy will be pushed into a state of
disequilibrium if either of the following situations obtain.
A. G > Gw
or
C < Cr
B. G < Gw
or
C > Cr
A. State if disequilibrium when G > Gw
Under this situation, growth rate of income is higher than the growth rate of
output. It means that the demand for output(because of higher lever of income)
would exceed the supply of output (because of lower level of output). The
economy would experience inflation.
Stated another way, if C<Cr, the actual amount of capital falls short of the
required amount of capital. This will lead to the deficiency of capital. This, in
turn, would adversely affect the goods to be produced. Fall in output would
affect the goods to be produced. Fall in output would affect the goods to be
produced. Fall in output would result in scarcity of goods, and hence inflation.
Either of the two ways lead to inflation. And growth under inflationary situation
is not stable.

55
Growth Models: B. State of disequilibrium when G < Gw
Theory & Evidence
In this situation, the growth rate of income is less than the growth rate of output.
There would be more goods for sale but the income would be insufficient to
purchase these goods. There would be deficiency of demand and the economy
would face the problem of over production.
Similarly, when C>Cr, actual amount of capital would be larger than the required
amount of capital for investment. The larger amount of capital available for
investment. The larger amount of capital available for investment would lower
the marginal efficiency of capital in the long-period. Secular decline in the
marginal efficiency of capital would lead to depression and unemployment.
Economic growth under the situation of depression cannot be stable.
Harrod stated that once g departs from Gw, it will further depart away from
equilibrium. He writed: 'Around that line of advance which it adhered to would
alone give satisfaction, centrifugal forced are at work, causing the system to
depart further and further form the required line of advance." Thus, equilibrium
between G and Gw is a knife-edge equilibrium. It follows that one of the major
tasks of public policy is to bring G and Gw together in order to mainatain long-
run stability.
For this purpose, Harrod introduces his third concept of natural rate of growth.
3. Natural Growth-rate (Gn).
It is the maximum growth rate that an economy can achieve with its available
natural resources. The equation for the natural growth rate can be state as
follows:
Gn Cr = or ≠ s ................(3)
It stated that the natural growth rate is determined by macro variables like
population, technology, natural resources and capital equipment. These factors,
place a ceiling beyond which expansion of output is not possible.
Interaction between G, Gw and Gn
Comparing Gw and Gn, it may be concluded that Gn may or may not be equal to
Gw. In case Gn happen to be equal to Gw, the condition of steady growth would
prevail. But such a possibility is remote one because a variety of factors
(influencing Gn and Gw) come into play and make balance between these two
growth-rated difficult. There exists a greater probability of inequality between
Gn and Gw. It may take two terms:
(a) Gw>Gn
(b) Gn>Gw
(a) Gw>Gn: It Gw exceeds Gn, G would lie below Gn for most of the time.

56
In this situation, there would be a tendency for cumulative recession. A Harrod-Domar Growth
downward trend would set in, resulting in unemployment and depression. Model

However, downward trend cannot continue indefinitely. The reason is that lower
limit to depression is set by the minimum consumption level. The consumption
cannot fall below a minimum level. The minimum consumption requirements
can be made possible by reducing the working capital. The entrepreneurs may
not reduce fixed capital in the hope that future might entail bright prospects for
investment. These two factors would gradually set the wheels of recovery in
motion. The economy would experience upward trend.
(b) Gn>Gw: In this situation, G would also exceed Gw for most of the time,
There would be a tendency for cumulative boom and full employment. Such a
situation will create inflationary trend. To check this trend, savings should be
encouraged, as these would ensure a high level of employment without
inflationary pressures.
4.3.2 Assumptions of the model
 The HM is based on the following assumptions:
 The level of ex-ante aggregate saving is a constant proportion of aggregate
income. It means propensity to save is assumed to be constant.
 Technical progress has been assumed to be labour argumenting or 'neutral'.
This implies that neutral technical progress is the basis of the model.
 The requirements of capital and labour per unit of output are constant, i.e.,
capital-output and labour-output ratios are assumed constant.
 Constant returned to scale operate. This implies that output increased at a
constant rate.
4.3.3 Policy Implications of the Model
The policy implications of the model are simple and straight forward. These can
be briefly summarised as follows:
Saving is a virtue in any inflationary gap economy and a vice in a deflationary
gap economy. In an advanced economy the saving coefficient, s, has to be
moved up or down as the situation demanded.
4.3.4 The Harrod Model and Trade Cycles
Harrod has used his model to explain trade cycles. In the recovery phase,
because of the existence of unemployed resources, G>Gn. When full
employment is reached G=Gn. If Gw exceeds Gn at the full employment, slump is
inevitable. Since G had to fall below Gw, it will, for the time being, be driven
progressively downwards. Further, G itself fluctuated during the course of the
business cycle. Savings as a fraction of income, though fairly steady in the long
run, fluctuate in the short run. In the short run, savings tend to be residual
between the earning and normal consumption. Companies, also, are likely to
save a large portion of their short-period increased in net receipts. Thus, even it
57
Growth Models: Gw is normally below Gn, it is likely to ride above Gn in the later stages of
Theory & Evidence advance, and, if it so happens, a vicious spiral of depression is inevitable when
full employment is reached. If Gw does not ride above Gn in the course of
advance, there would be continued pressure to advance when full employment is
reached; this would lead to inflation and consequently, sooner or later, to a rise of
Gw above Gn, resulting ultimately into a vicious spiral of depression. Actually, G
may be reduced before the employment is reached because of immobilities,
frictions, and bottlenecks and, if it so happens, depression may come before full
employment is reached. If Gw is far above Gn, G may never rise far above Gw
during the revival and the depression may result long before full employment is
reached.
4.3.5 Critique of the Harrod Model
The instability in Harrod's model is due to the rigidity of its basic assumptions,
viz. fixed production function, a fixed saving ratio, and a fixed growth rate of
labour force. Economists have attempted to relieve this rigidity by permitting
capital and labour substitution in the production function, by making the saving
ratio a function of the profit rate and the growth rate of labour force as a variable
in the growth process.
Check Your Progress 1
1. Why is the model discussed in this unit known as the Harrod-Domar
Model?
2. State in brief the basic formulations of the Harrod model of growth.
3. How does the Harrod model explain the occurrence of trade cycles?

58
 Harrod-Domar Growth
4.4 THE DOMAR MODEL (DM) Model
The fundamental question around which E.D. Domar builds his model can be
stated as follows:
Investment leading to an increase in productive capacity and income, what
should be the rate of increase in investment which would equalise the increase in
income and the increase in productive capacity, so that full employment is
maintained?
Domar answers this question by forging a link between aggregate supply and
aggregate demand through investment.
4.4.1 Statement of the Model
Domar model is based on the dual character of investment: one , investment
increases productive capacity, and two, investment generated income,. The two
sides of investment provide solution for steady growth. The following symbols
are used in DM.
Yd = Level of national income or level of effective demand at full employment
(demand side)
Ys = Level of productive capacity or supply at full employment level (supply
side)
K = real capital
I = net investment, which implies change in stock of real capital, i.e. ∆K
d = marginal propensity to save, which is the reciprocal of multiplier i.e.,
(mp  =1/multiplier)
 = productivity of capital
We can make use of these notations to frame a set of equations that help
formulate the DM.
The demand side of investment can be represented by an equation as follows:
Yd = I/d
This equation explains two things as follows:
(i) The level of effective demand (Yd) is directly related to the level of
investment(I). An increase in investment will result in an increase in effective
demand, and vice versa.
(ii) The effective demand is inversely related to the marginal propensity to save
(d). An increase in marginal propensity to save will decrease the level of
effective demand and vice-versa.
Eq.(1) represents the demand side of investment.
The supply side of investment can be represented by an equation as follows:
Y = k ....................(2)
59
Growth Models: Eq.(2) explains that supply of output(Ys) at full employment depends upon two
Theory & Evidence
factors, ie.., productive capacity of capital(  ) and the amount of real capital(K).
A change in the supply of any of these will result in a corresponding change in
the supply of output. For example, an increase in the productivity of capital will
result in an increase in output, and vice-versa. Likewise, an increase in the
amount of real capital will lead to an increase in output, and vice-versa.
Equilibrium: In equilibrium, the demand and supply should balance. Therefore,
Yd = Ys
or I/d =  K
By cross multiplication,
I = d K .............................(3)
Eq.(3) explains the condition for steady growth.
Steady growth is possible when:
Investment equals the product of saving-income ratio, capital productivity and
capital stock. From this the condition for maintaining the steady growth can be
explained. For this we have to give increment to the demand and supply
conditions presented above.
The demand equation in its incremental form can be stated as follows:
∆Yd = ∆I/d ........................(4)
Increments have been shown in the level of effective demand and investment
because they are variables, but increment has not been shown in d because it is
constant in terms of the assumptions employed.
The supply equation it its incremental form can be stated as follows:
∆Ys =  ∆K ........................(5)
Eq.(5) explains that change in the supply of output (∆Ys) would be equal to the
product of change in real capital (∆K), and the productivity of capital (  ). The
change in real capital is expressed as net investment. Therefore, ∆K represented
investment(I). Substituting I in place of ∆K in eq.(5), we get.
∆Ys =  I ........................(6)
The equilibrium between eq.(4) and eq.(6) provides us the condition for
maintaining the steady growth. In equilibrium
∆Yd = ∆Ys
or ∆I/d =  I
cross-multiplying , we get,
∆I/I =  d .......................(7)
Eq.(7) explains that the growth-rate of net investment ∆I/I should be equal to the
product if marginal propensity to save (d) and productivity of capital (  ). This
60
equality must be maintained to ensure stable and steady growth. Donar gives a Harrod-Domar Growth
numerical example to explain this condition of maintaining steady growth. Model

Let  = 25% per year

d = 12%
Y = $150billion a year
12
If full employment is to be maintained, an amount equal to 150  =$18 billion
100
should be invested. This will raise productive capacity by the amount invested
12 25
 times i.e., by 150   =$4.5 billion, and the national income will have
100 100
to rise by the same amount. But the relative rise in income will equal the
absolute increase divided by the amount itself, i.e.,
12 25

12 25
150  100 100    3%
150 100 100
Thus in order to maintain full employment, income must grow at a rate of 3% per
annum. This is the equilibrium rate of growth. Any divergence from this
"golden path" will lead to cyclical fluctuation when ∆I/I greater than  d the
economy would experience boom. The economy would suffer from depression,
it ∆I/I is less than  d.
4.4.2 Assumption of the model
The Domar model is based on the following assumption.
1. Income is determined by investment through multiplier. For the sake of
simplicity, saving-income ratio is assumed constant.
2. Productive capacity is created by investment according to the potential social
average investment productivity. For the sake of simplicity this is also assumed
to be constant.
3. Investment is induced by output growth together with entrepreneur confidence.
4. Employment depends upon the 'utilisation ratio' expressed as the ratio between
actual output and productive capacity.
5. Past and present investment can greater productive capacity at a given ratio.
4.4.3 Policy implication of the model
An economy always faced a serious dilemma if sufficient investment is not
forthcoming today, unemployment will occur today; but if enough in invested
today, still more will be needed tomorrow in order to increase demand so that the
expanded capacity can be utilised and excessive capital accumulation avoided
tomorrow; otherwise the excessive accumulation will cause a fall in investment
leading to a depression day after tomorrow. To stay at the same place, therefore,
the economy must move faster and the economy must move faster and faster,
otherwise it will slip downward.

61
Growth Models: Check Your Progress 2.
Theory & Evidence
1) Discuss the principal features of the Domar Model of growth.
2) State the conditions necessary for steady growth.
3) State the conditions necessary for maintaining for maintaining steady
growth.

4.5 COMPARISON OF HARROD MODEL AND

DOMAR MODEL
Harrod model and Domer model show both similarities and dissimilarities with
each other. Let us have a look at these.
4.5.1 Similarities
The two models are similar in substance. Harrod's is domar's d. Harrod's
warranted rate of growth (Gw) is Domar's full employment rate of growth (d  ).
Harrod's Gw=s/Cr ≡ Domar's d  ).
To prove it
S
d= or S=dY ................(1)
Y
Y
 = or  Y = I  ................(2)
I
Since S=I, and substituting S for I in eq.(2), we have
 Y = dY  [Q S=dY]
Y
or = d ................(3)
Y
Y
 Gw = d  (since Gw = )
Y

In other words, Harrod's Gw is the same as Domar's d , but in reality, Domar's

rate of growth r=ds 's Harrod's Gw, and Domar's r = d is Harrod's natural growth
rate. In Domar's model s is the annual productive capacity of newly created
capital which is greater than which is the net potential social average
productivity of investment. It is the lack of labour and other factors of
production which reduced Domar's growth rate from r=ds to r d. Since labour is
involved in therefore Domar's potential growth rate resembled Harrod's natural
rate. We may also say that the excess of s over in Domar's model expresses the
excess of Gw over Gn in Harrod's model.
4.5.2 Dissimilarities
Both the models, no doubt, are based on similar assumptions, yet there are
differences in the two models. These dissimilarities can be presented as below:
Dissimilarities between the Domar Model and Harrod Model.

62
 Parameter Domar Harrod Harrod-Domar Growth
Model
1. Long-run difficulty "Under-investment Labour shortage
sapping growth" deflecting growth
2. Position of labour Shortage of certain Determinant of natural
input labour may trigger rate of growth:
scrapping and the key element
inhibition of investment;
optional element
3. Centrifugal force Continuously undermined Unstable adjustment
from equilibrium investment incentives process
4. Reason for fixed Assumed for inconvenience Due to fixed interest
rate,
capital output ratio low substitutability,
etc.

5. State of economy Idle capacity prevalent Labour

unemployment
common place
Further differences between the two models are revealed when we discuss their
policy implications. Domar's model explains the technological relationship
between the capital accumulation and full employment growth rate of output.
Harrod model shows the behavioral or psychological relationships between the
capital accumulation and full capacity growth rate of output. Domar's analysis is
based on the principle of multiplier, whereas Harrod's analysis is based upon the
principle of acceleration. Domar's model suggests the role of planned investment
in the economic development, while Harrod's model stresses on induced
investment.

4.6 HARROD-DOMAR GROWTH MODEL

You have read about the Harrod Model (HM) and the Domar Model (DM)
separately. By now, you would have understood that the two models are similar in
substance, although they may differ in details as also in policy implications. Now
we have reached a stage in our study where we can integrate these two models in
the form of what has come to be known as the Harrod-Domar Growth Model
(HDM).
4.6.1 Substance of the Model
The main points of the HDM can be summarised as follows:
1) Investment is the central theme of the HDM. It plays a dual role. ON the one
hand it generates income and on the other it creates productive capacity.
2) The increased capacity results in greater output and greater employment,
depending on the behaviour of the income.
3) Condition regarding the behaviour of income can be expressed in terms of
growth-rates, i.e., G Gw and Gn. The equality between these growth rates
would ensure full employment of labour and full utilisation of capital stock.
63
4) These conditions, however, designate only a steady-line of growth. The actual
growth rate may differ iron the warranted growth rate. If the actual growth
rate is higher than the warranted rate of growth, the economy will experience
cumulative inflation. If the actual growth-rate is lower than the warranted
growth-rate, the economy will hurtle towards cumulative deflation.
5) The business-cycles are viewed as the deviations from the path of steady
growth. These deviations cannot go on indefinitely. There are constraints on
upper and lower limits. The "full employment ceiling" acts as an upper limit
and autonomous investment and consumption act as a lower limit. The actual
growth-rate fluctuates between these two limits.

4.6.2 Limitations of the Model

HDM throws light on the important determinants (and policy implications) of
economic development, yet they are not free from criticism. The HDM has been
criticised on the following grounds:
1) The HDM assumes key parameters, like the propensity to save and the
capital-output ratio, to be constant. In reality, these are likely to change over
the long run. Changes in these parameters would change the requirements of
steady growth.
2) The HDM includes only aggregates as variables. A model constructed on the
basis of such aggregates cannot show the inter-relations between the sectors
and as such is not meant for demonstrating the structural changes which
constitute a basic aspect of the economic development of a developing
economy. Harmonious growth of different sectors of the economy is very
important for steady grwoth. Deviations from steady growth may be caused
by a lack of harmony between the growth of different sectors even when
aggregative requirements for stability are fulfilled.
3) The HDM assumes the production function to be fixed and therefore there is
no scope for substitution between different factors. Actually different factors
of production, at least to a limited extent, can be substituted for each other.
Substitutability between different factors increases the flexibility of the
economy and thereby decreases the possibilities of cumulative deviations
from the path of steady growth.
4) The HDM pays attention only to the requirements of steady growth and
neglect the rate of growth. It is more useful for developed countries whose
main aim is stability and not the rate of growth. In contrast, developing
countries are interested more in the rate of growth. They would not mind
following policies, which create fluctuations if these considerably raise the
rate of growth.
5) The HDM is purely laizzez-faire only based on the assumption of fiscal
neutrality and designed to indicate the conditions of progressive equilibrium
for a developed economy. The policy implications, therefore, are not very
relevant to the developing economies.
Despite these limitations, the HDM is an important model because it represented a
stimulating attempt to dynamise and secularise Keynes' static short-run saving
and investment theory.
Check Your Progress 3 Harrod-Domar Growth
Model
1) State the similarities between the Harrod Model and the Domar Model.
2) State the differences between the Harrod Model and the Domar Model.
3) What are the basic features of the Harrod-Domar Model of growth? Also
state the limitations of this model.

4.7 LET US SUM UP

The Harrod-Domar growth model was developed separately, but concurrently, by
two economists. Both the Harrod Model and the Domar Model brought out the
importance of saving and investment in the process of economic growth. Both
the models sought to lay out the conditions for steady growth; the non-fulfilment
of these conditions would lead to disequilibrium, resulting in inflationary and
deflationary gap. Although both the models differed in details, they were the
same in substance. Therefore, both the models stand out integrated, and are
known as the Harrod-Domar Model of Growth. The model was developed in the
context of advanced market economies. But it has been widely used in
formulating plan models in developing economies.

4.8 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1. See Section 4.2
2. See Section 4.3.1
3. See Section 4.3.4
Check Your Progress 2
1. See Section 4.4.1
2. See Section 4.4.1
3. See Section 4.4.1

Check Your Progress 3

1. See Section 4.5.1
2. See Section 4.5.2
3. See Section 4.6.1 and 4.6.2

65
UNIT 5 THE NEOCLASSICAL GROWTH
MODEL
Structure
5.0 Objectives
5.1 Introduction
5.2 Some Basic Concepts and Tools to Study Growth Models
5.3 The Solow Model
5.3.1 Assumptions
5.3.2 The structure of the model
5.3.3 A comparison with the Harrod-Domar Model

5.4 Some Applications and Extensions of the Neo-Classical Model

5.4.1 Depreciation of Capital Stock
5.4.2 Variable Savings Rate
5.4.3 Population Growth
5.4.4 Relative Share of Factors

5.5 Money in the Neo-Classical Growth model

5.5.1 The Tobin Model
5.5.2 The Sidrauski Model

5.6 Convergence and Poverty Traps

5.7 Answer/Hints to Check your Progress Exercises

5.0 OBJECTIVES
After going through the unit, you will be able to:
 apply some essential techniques to study growth models in general;
 discuss the neo-classical growth model ;
 point out the difference between the Harrod-Domar model and neo-classical
model(s);
 apply the neo-classical growth models in the analysis of certain economic
topics like savings, fiscal policy, poverty, and so on;
 explain the comparative growth experiences of nations using the neo-
classical model; and
 examine how the concepts of money and monetary processes have been
brought into the neo-classical model.


Shri Saugato Sen Associate Professor of Economics, IGNOU, New Delhi
 The Neoclassical
5.1 INTRODUCTION
Growth Model
The previous two units of this block have introduced you to the concepts of
economic growth and development, as well as the Harrod-Domar growth model.
You saw how important economic growth is, how it differs from development,
why we should study growth models and what the limitations of economic
growth can be. The Harrod-Domar model was presented to you both as a unified
model, as well as separately the models of Harrod and Domar. You became
familiar with the model’s assumptions, its structure, limitations as well as some
applications, including application in Indian economic planning.
This unit presents for discussion a model which was put forward by Robert
Solow and Trevor Swan, independently of each other, in 1956, although brief
anticipations of the basic idea was carried out by James Tobin. However it is
commonly known as the Solow-Swan model, or even as the Solow model. Solow
has done a lot to popularise the model through subsequent papers and books. The
Solow model has proved to be one of the most used most robust, and standard
models in all of economic theory. Several economists of more than one
generation have built upon, extended and refined the Solow model. Even when
some have put forward new models, they did so referring to the Solow model as
the model that they critiqued and found limitations with. Empirical economists
spent lots of time, effort, energy to examine data sets and use statistical tools to
see if predictions which can be generated out of the Solow model, have actually
been matched by the performances of group of countries. Solow justly received a
Nobel Prize for his contribution to growth theory, and as he remarked with a
touch of pride during the address he gave at the time of receiving the prize, his
model started a “cottage industry [of model- building in growth theory]”.
In this unit we study the neoclassical growth model. We begin by acquainting
you with some tools and techniques you are going to need to study growth
models, not only in this unit, but in subsequent units as well. Once you have
familiarised yourself with these concepts, you will be introduced to the basic
neoclassical model, with the assumptions stated and the structure spelled out and
elaborated. Some applications and extensions of the model are presented ,
following which we bring in monetary factors into the basic neoclassical model.
We close the discussion with a study of the very important and relevant topics of
convergence and poverty traps.

5.2 SOME CONCEPTS AND TOOLS TO STUDY

GROWTH MODELS
If we assume a constant rate of growth, the formula used for calculating the
growth rate for more than one year is as follows:
Yt = Yo (1+r)n
=) log Yt=log Yo+n log (1+r)
log yt  log yo
=) log (1+r) =
n
log (y t /y o )
or log (1+r) =
n
69
Growth Models:
 (y / y )
Theory & Evidence =) 1+r = antilog  log t o 
 n 

  log( yt / yo )  
 r = anti log    1
  n  
This assumes constant rate of growth. r (as in a constant rate of interest in
compound interest formulations)
When the r.o.g is not constant, it is say
x1 , x2 ,........xi ............xt in t=1,2,.......i,......t
1
t
then r = (x1 , x2 ,........xt )

It is geometric mean.
Calculation of Growth Rates
Consider the following data on rice production:
Year Rice Production Year Rice Production
(in lakhs of tonnes) (in lakhs of tonnes)
1990 8 1997 18
1991 9 1998 18
1992 13 1999 18
1993 12 2000 23
1994 13 2001 23
1995 20 2002 26
1996 19 2003 28
2004 27
2005 24
(i) A crude interpretation of the growth rate is given as an average percentage
change from first year to the last year, in this example, average growth rate
would be
 24  8 
 
 8  100
16
 13.3%
This method overemphasises original and terminal values of data. Also, it does
not use all observations.
(ii) Linear growth rate : The estimated regression using the given data turn out to
be:
yt = 8.1 + 1.2.45 t
Three different growth rates may be completed by making following
manipulations:
70
  The Neoclassical
 1.245 Growth Model
(a) growth rate = y 100  8  100
0

 15.57%

 1.245
_
100  100
(b) growth rate = 18.6875
y
 6.66%


 1.245
 100   100
(c) growth rate = HM ( y ) 16.286
 7.64%


(iii) Compound growth rate: Value of  in the log-linear relation:
ln yt  ln    t

Growth
As an example, let’s model population growth
dp 1 dp / dt
. 
dt p p
dp
is called the absolute growth rate,
dt
dp
/ p is called relative growth.
dt
US population in millions 1790-1990

71
Growth Models: Example: U.S. Population in million 1790-1990
Theory & Evidence
Year Population
1790 3.9
1800 5.3
1810 7.2
1820 9.6
1830 12.9
1840 17.1
1850 23.1
1860 31.4
1870 38.6
1880 50.2
1900 76.0
1910 92.0
1920 105.7
1930 122.8
1940 131.7
dp
Suppose we went to estimate relative growth ( / p ) from 1790 to 1860 let us
dt
dp
take one particular year, say 1830. If we want to estimate / p in 1830 we take
dt
the rate of change in the population, and divide it by the population itself:
1 dp 1 popin1840  popin1830

p dt pop.in1830 10 years
1 17.1  12.9
 .  0.0326  3.26%
12.9 10
P10  P0 (1  3.47)
P10  P0 (1  0.347 10)

Similar calculations for 1790, 1800,………, 1850 give percentages as shown

below
Year Relative growth rate
1790 3.59%
1800 3.58%
1810 3.33%
1820 3.44%

72
1830 3.26% The Neoclassical
Growth Model
1840 3.57%
1850 3.53%
How do we calculate average relative growth rate for the period?
The simplest model is to answer that the relative growth rate is constant, i.le.
1 dp
k
p dt
1. Arithmetic growth (simple growth): growth by a constant amount in each
time period.
2. Geometric growth (exponential growth): growth by a constant proportion
in each time period.
3. Nominal rate of interest & effective rate of interest; compounding period.
If we have a photo & enlarge it 3 times, new are is 9  (old area).
Correct are the following
New area is 9 times the area of the original
New area is 9 times as large as the original
New area is 9 times as great as the original
Incorrect are
New area is 9 times greater than the original
New area is 9 times more than the original
New area is 9 times larger than the original
“9 times greater than” means “10 times as great as”.
B. An increase from 1 to 9 is an increase of 800%, Not 900%. If support
for a political party decreases from 60% to 30% it has dropped 30
percentage points but decreased 50%.
C. When speaking of reductions also we must be careful. A reduction
from 9 to 1 means the new amount is 1/9th as much, 8/9th less than,
11% as much as in89% less than the original.
Growth and change
Let x be an economic variable.
Let x0 be the initial value.
x1 be the subsequent value.
The proportional change in going from x0 to x1 is simply
x1  x0 x

x0 x0

73
Growth Models: The percentage change in going from x0 to x1 is simply 100 times the
Theory & Evidence
proportionate change:
%  x = 100 (  x/x0)
If x is itself in percentage it becomes tricky.
If unemployment decreases from 15% to 12% it is a reduction of 3 percentage
15  12 3
points, but a 100   100  20% fall in unemployment.
15 15
5

Time as regressor
A linear trend relationships would be depicted as:
y    T   (1)
where T indicates time. One has to appropriately define the origin
Constant growth covers
yt     T  t
yt 1     T  1  t 1
 yt  yt 1    (   t 1 )
y1    1  t .......1

Ignoring the disturbances, the series increases (decreases) by a constant amount

each period. For an increasing series (   0 ), this implies a decreasing growth
rate, and for a decreasing series (   0 ), the specification gives an increasing
decline rate.
If we wish to study a series with a constant growth rate, the formulation (1) is
inappropriate. The appropriate specifications expresses the logarithm of the
series as a linear function of time.
This can be seen as follows without disturbances, a constant growth series is
given by the equation.
yt  y0 (1  g )t (2)
( yt  yt 1 )
where g = is the constant proportionate rate of growth per period
yt 1

Taking logs of both sides of (2) given

ln y     t (3)
where   ln y0 and   ln(1  g )

If one suspects that a series has a constant growth rate, plotting the log of the
series against time provides a quick check. If the series is approximately linear,
(3) can be fitted by least squares, regressing the log of y against time. The

resultant slope coefficient then provides as estimates g of the growth rate,
namely,
74
   The Neoclassical
b= ln(1+ g ) giving g =eb-1 Growth Model
The  coefficient of (1) represents the continuous rate of change  ln yt / t ,
whereas g represents the discrete case. Formulating a constant growth series in
continuous time gives
yt  y0e  t
ln yt     t

Note that taking first difference of equation (1) given

myt    ln(1  g ) ; g

Thus, taking first difference of logs given the continuous growth rate, which in
turn is an approximation to the discrete growth rate. This approximation is only
reasonably accurate for small values of g.
Example
Bituminous coal Ot in the U8 1841-1910
Decade Av.annual Ot lny t t(my)
_______________________________________________________
1841-1850 1837 7.5159 -3 -22.5457
1851-1860 4868 8.4904 -2 -16.9809
1861-1870 12411 9.4904 -1 -9.4263
1871-1880 32617 10.3926 0 0
1881-1890 82770 11.3238 1 11.3238
1891-1900 148457 11.9081 2 23.8161
1901-1910 322958 12.6853 3 38.0558
________________________________________________________
Sum 71.7424 0 24.2408
_______________________________________________________
Plotting the log of output against time, we find a linear relationship. So we will
fit a constant growth and estimate the annual growth rate. Setting the origin for
time at the centre of the 1870s and taking a unit of time to be 10 years, we obtain
the t series shown on the table. From the data in the table
 ln y 71.7424
  10.2489
a = n 7

 t ln y 24.2408
b =   0.8657
t2 28
The r2 for this regression is 0.9945, confirming the linearity of the scatter. The
estimated growth rate per decade is obtained from

75
Growth Models: 

Theory & Evidence g  eb  1  1.3768

Thus the constant growth rate is almost 140 per cent per decade. The annual
growth rate (agr) is then found from
(1+agr)10 = 2.3768
which gives agr = 0.00904, or just over 9 per cent per annum. The equivalent
continuous rate is 0.0866 or time as regressor, see Russell Davidsos and James G.
Mackinon. Estimation and _______________ in Econometrics, OUP, 1993 pp
115-118
Growth Rates
Compound rates - geometric growth  continuous compound growth 
exponential growth
vt  vo (1  g )t
v  t
 t   (1  g )
 vo 
1
t
v 
 t   1 g
 vo 
1
v  t
 g   t  1
 vo 
Let vo equal the value of the variable in year 0 (the fast year) & vt equal the value
of the variable t years later. Further, let g equal the average compound annual
growth rate. Then
vt  vo (1  g )t
1
v  t
 g   t  1
 vo 
If the growth rate is continuously compounded, then
vo e gt  vt
vt
e gt 
vo
1 v 
g  ln  t 
t  vo 

Geometric mean growth rate is the same thing as compound growth rate.
Illustrations
Take company X’s sales for 6 years

76
Year (Net sales) Annual growth The Neoclassical
Growth Model
1979 216,283
1980 260,404 20.4%
1981 294,145 13.0%
1982 285,954 -2.8%
1983 303,498 6.2%
1984 318,842 5.1%

Annual growth rate in year t

St  St 1 St
 1
= St 1 St 1

where S is sales. (t=1,2,3,4,5,)

= 1980
The average compound (geometric mean) annual growth rate over the 5 years
from end of ’79 to end of 84’ for Co. X’s net rates is
1
S  t
g   t  1
 So 
1
S  5
  5  1
 So 
1
 318,842  5
  1
 216, 283 
1
 (1.474) 5  1
 1.081  1  .081  81%
The geometric mean growth rate is calculated as
1
n  n

 (1  gt )  1
 t 1 

In the above example,

1
g   (1.204)(1.130)(0.972)(1.062)(1.051) 5  1
1
 (1.474) 5  1
 0.81
The arithmetic mean of the five annual growth rates (arithmetic mean growth
rates)
77
 n
Growth Models:
Theory & Evidence  gt
t 1
g
n
1
 (20.4  13.0  2.8  6.2  5.1)
5
 8.4%

The arithmetic mean growth rate 8.4% is > the geometrics mean growth rate
(8.1%). In fact values all give the same, A.M.G.K. will be > G.M.G.R.
Only if gi-n are constant, will amgv=gmgr.

5.3 THE SOLOW MODEL

5.3.1 Assumptions of the Solow model
1. The economy produces one composite good which can either be
consumed or accumulated as a stock of capital. This is a simplified
picture of reality. while we do not deny that lots of goods are produced in
the economy, we consider, for purposes of building a model – a model,
after all, is a parable or a fable-- only one ‘composite’ or ‘aggregated’
good.
2. Labour supply is homogeneous. In other words, we do not distinguish
between workers with different skills or between say, blue- and white-
collared workers.
3. There is a stock of capital which has been accumulated from the past.
This capital and the labour are the factors of production, inputs to the
production process.
4. The production function exhibits constant returns to scale. This means
that if labour and capital are increased by a certain proportion, say ,
output increases by the same proportion . If labour and capital are
doubled, output is doubled. Thus there is an aggregate production
function which is continuous and which displays constant returns to scale.
5. The labour force grows at an exogenously given growth rate gL = n. Thus
labour force at time t is equal to Lt = L0ent.
6. People save a constant proportion of Income. If S denotes saving then
S = sY. This assumption is the same as in the Harrod-Domar model.
Some people feel that Solow made this deliberately to make a comparison
with Harrod-Domar model.
7. There is no foreign trade
8. The government does not intervene in the economy; there are no taxes or
government purchase

78
5.3.2 Structure of The Model The Neoclassical
Growth Model
Since we have assumed there is no depreciation, we consider the model here in
the absence of depreciation. Later on, we shall discuss the case when there is
depreciation of capital. To begin with consider the aggregate production function.
Y=F(K,L)

We have assumed that there are constant returns to scale. This means that if K &
L are increases by a proportion  , Y increases by the same proportion. The
function F is homogenous of degree one.
Y=F(λK,λL) for all λ>1

For simplicity, let λ= 1

L
Y K L
Then F , 
L  L L
Y K 
Or  F  ,1 
L L 
Let in denote quantities divided by L, by lower-case letters
So y=F(k,1)
Or y=f (k)
This gives output per person as a function of capital labour ratio.
Sometimes income is used synonymously with output. Denoting output by Q and
output-labour ratio by q, we have
q = f(k)
If we draw a picture of above the relationship we can show it as follows:

d
q,g f(k)

k
A ray od to any point d on the curve has a slobe that gives the ratio of output to
Q
Q
capital. This is because the of this ray is  L =
K K
L

79
Growth Models: This is the is verse of capital output ratio v. Each point on the production
Theory & Evidence
function is the slow model is that …………..Harrad-Domar model, l is not fixed
or exogenous different points on the production function show different, capital
output ratios.

Equilibrium Growth

We have k  K
L
Taking natural logarithms (denoted by Ln), we get
K
ln (k)=ln  
L
K
ln k=ln
L
or, ln k=ln K-ln L

Differentiating with respect to figure, gives the proportional growth ratio:

d d d
 ln k    ln k  -  ln L 
dt dt dt

dk 1 dK 1 dL 1
.  . - .
dt k dt K dt L

  
or k  K  L
dK
Now on the right hand side is equal to investment I
dt
Investment = facing in equilibrium. So
dK 
K S
dt
S  SQt (as we have assumed)
dK
So  sQt (t is the subscript denotes Q at a point of time)
dt
dL 1
The Second term on the right hand side is L  . which shows the
dt L
proportional growth rate of labour. Which we have denoted n. So our equation
  
k  K L

can be written
 sQ
k n
K
80
Dividing Q and K by L we get The Neoclassical
Growth Model
 sq sf (k )
k n   n …………………………………………..(A)
k k

This gives k , the rate of growth of k, is term of k itself.

Equation (A) is the fundamental equation of the Solow model.

dk 1 dk
The equilibrium value of k is the one for which . is  0, i.e.  0 or where
dt k dt

k, once it reaches that value, does not change. Setting k  0 in the equation
above, we get
 sf ( k * )
k 0 n
k*
sf ( k * )
or
k*  n
where an * above k denotes its equilibrium value.

The equilibrium q value is obtained as

nk
q q*  f (k *)  nk

or sf (k *)  NK *

f(k)
C/L

sf(k
q*

o k
k*
81
Growth Models: At any point to the left of k*, where k<k*,
Theory & Evidence
f ( k )  n s  k 

This implies
sf (k )
n
k

And from equation (A), we can sea that in this case k  0, which mean that when

k  k *, k increase

Similarly we can show that whenever k>k* ( to the right of k*), k is rising and

where k>k*, k is falling. Thus k* is a stable equilibrium point.
In equilibrium, when k equals k*, q reaches an equilibrium q*. As q* is a
constant,
d 1 dL 1
.  . n
dt t dt t
 
The economy thus converges to a steady state growth where   K and capital
  
output ratio v is constant. However,  and K are not greater than L but equal to
it.
The equilibrium condition in the Solow model
sf (k *)
n
k*
can be written as
Q
n f (k ) q Q 1
   L 
s k k K K V*
L
Where V is the capital output ratio.
S
So we have n  , the Harrod-Domar condition for balanced full employment
V*
growth. However the Solow model allows V to vary and explains how the
economy will turn toward a growth bath along with the Harrod-Domar condition
is and there in the Solow model, the capital output ratio V* emerges as an
equilibrium value, and not as a necessary technology assumption.
CONSUMPTION IN THE SOLOW MODEL
We know that in a closed economy with no government intervention in
equilibrium
Y CI
Where Y is aggregate output , C is aggregate consumption and I is investment.
82
Writing in per-worker ………., we have The Neoclassical
Growth Model
Y C I
 
L L L
Y
We know  y  f (k )
L
C I
So f (k )   …………………………………..(B)
L L
Now consider capital labour ratio

kK
L
dk 1 dK 1 dL 1
We have seen .  .  .
dt k dt k dt L
  
Or k  K  L

Where  denotes proportional growth rate. We had already denoted L by n

So we have
 
k  K n
 
k K  dX
or   n where X denotes Multiplying both sides by K/L we get
k k dt
 
k K K K nK
.  . 
k L K L L

K
or k   nk
L
Alternatively putting it;

K 
 k  nk …………………………………………..(C )
L
Since one of the assumptions we had made was that there is no depreciation,
hence
 dK
k I
dt
So we may write equation (C) as
I 
 k  nK
L
I
In equation (B) we can replace by the right hand side of the above equation.
L
Equation (B) then becomes
83
Growth Models: C 
Theory & Evidence f (k )   k  nK …………………………………………..(D)
L
This equation states the following: Output per worker (since we are taking  as
equal to Y and hence q=y) is put to three uses which are shown on the right hand
C
side. First, consumption per worker ; a portion of investment nk, that
L
maintains the capital labour ratio constant in the face of growing labour force;

and a portion of investment, k which increases the capital labour ratio. When
capital goods increase faster then the increase in labour, so that the capital-labour
ratio rises, it is called capital deepening, while when capital goods rise merely to
keep pace with the rise in labour force so that the capital labour ratio remains
constant, it is called capital widening. Thus output per worker, in equation D, is
divided among consumption per worker, capital deepening and capital widening.
We can arrive at equation D by a different route, from our fundamental equation
of the Solow Model.
Recall that the fundamental equation, equation (A) is
 sf (k ) sq
k n  n
k k

 k
Since k  , hence multiplying the above equation throughout by k, we get
k

k  sq  nk
Recall our assumption that q = y. We have

k  sy  nk
Y  sY
Since y  , we have k   nk
L L
We had made the assumption that S = sY
Now in equilibrium S =Y-C = I
 Y C
Hence we have k    nk
L L
Y
Now switching back in rotation f(k) for , we have
L y
 C
k  f (k )   nk
L
C 
or f (k )   k  nk
L
which is equation (D).

84
What are the basic proposition and conclusion that we get from the Solow The Neoclassical
model? Does it provide some guidelines for studying the growth trajectories of Growth Model
actual economies? We give below some theoretical conclusions that emerge from
the Solow model.
First, given the assumptions as stated earlier, there exists a steady state (balanced
growth) solution for the model. The balanced growth solution is stable. Stability
is there in that whenever the initial values of all the variables, the economy
eventually mark to the study state equilibrium value of y and k. We have already
seen this from the diagram.
The second conclusion we get that the balanced rate of growth (all ……….. grow
at the same rate) is the constant exogenous grow the of labour force, which is n.

THE SOLOW MODEL WITH DEPRECIATION

We know that in absence of depreciation

K  I Here I denote grow investment.
Let us now answer that a certain proportion  K of capital depreciates (through
wear and ………). We can now write

I  K K
Where I now is net investment and  is the constant rate of depreciation of
capital stock.
Dividing by L, we obtain

I K K
  …………………………………………..(E)
L L L
We know from equation (C ), which we …………….earlier, that

K 
 k  nk
L

K
Substituting this expression for into equation (E), we obtain
L
I 
 k  nk   k
L
I 
or  k  (n   )k
L
I S
Writing as ( in equation) and they as sy or sf(k)
L L
 
We have sf (k )  k  (n   )k or k  sf (k )  (n   )k

85
Growth Models:  sf (k )
Theory & Evidence Or k   (n   )
k
This is a modified form of the fundamental equation of the Solow model. The
fasic analysis that we studied, carrier over for the case of depreciating capital; we
merely need to replace n by (n+ ).
Poverty Traps
Empirically, the convergence by pother is has not held up very well. The neo-
clinical model has not been very successful an showing why rates of growth
differ across nations. One fact was staring everyone in the face: many rations of
the world were poor. In a sense, what was going on was the exact opposite of
what was suggested by the convergence hypothesis: Some countries were shifting
stagnant growth, while other were progressing very fact. This idea that the poorer
nations were actually caught is a traphas come to be called poverty trap. It is a
trap because inspite of efforts. These nations stay a low-level ‘equilibrium’.
There are tw o types of poverty traps: technological-Induced and population
induced. They can both be demonstrated in the Solow system.

(a) Technological trap:

If we consider the Solow production function y = f (k), or Y

L  
 F K , and
L
suppose there is a certain range where for certain values of L, K, the production
function exhibits increasing returns to scale, then there will be multiple
equilibrium. For certain values of k, say k* if the economy sports at a level
lower than k*, the economy will slump back towards a very low income and
outp0ut level because the level k* may show a unstable equilibrium.
The idea behind technological trap is that has such a hypothetical country
received an initial injection of capital so as to give a value of k larger k*, it would
have been pushed over the level. This idea is sometimes called the ‘Big push
Theory’of which you will read later in block 4. The idea of poverty trap being
caused by low savings, low technology is sometimes called the vicious circle of
poverty, about which you will read in block 4.
The second way in which poverty traps can arise is induce by population growth.
In the neo-classical model, the rate of population growth was given exogenously.
However for classical writers population growth was given endogenously.
Robertr Methus in his 1798 work, of which you will study in block 4, suggested
that the rate of growth of population depends on per capita income. As per capita
income rises, the rate of population growth rises ever faster. This has come to be
knows as the theory of demographic transition.
We can bring in the idea of demographic transition into the neo classical model.
Recall that is the neo classical model population grows exogenously at a rate n.
………….,now suppose population growth rate is dependent on y, as suggested
by the theory of demographic transition. We know that y is a function of capital

86
per person. y  f (k l ). Thus n, the population growth rate indirectly becomes a The Neoclassical
function of the capital labour ratio: Growth Model

n  g k l 

We may think of some interval k2 – k1 where for values of k below k1, n is <0,
but for values of k in the range [k2, k1] n is >0; again for values of k > k2, n may
become <0. Historically, in olden time in societies where k was below k1,
population was last theory wars, disease etc.
In our analysis, consider the range k2 – K1. Even here, n, although >0, can itself
increase or fall. In other words, although the population is increasing. The rate of
increase may itself vary. The idea is that, this leads to a situation where the
saving (or investment) curve changes shape and may turn out to be S shaped.
Then, we may have multiple equilibrium points of k most of which are unstable:
any movement from these points pushes the system far then away rather than
bringing it back into equilibrium. We have considered the interval (or range of
values between) [k2, K1] . Supposing we can two equilibrium points ka and kb.
Let ka lie between k1 and k2, i.e. k2>ka>k1. Let kb be greater than k2. Here ka is
the stable equilibrium while kb is the unstable one. n is the stable equilibrium
which creates the problem here. For any value of k leather k2, the economy is
pulled back to equilibrium level ka. Only if an injection of capital is gives which
pushed the k level above kb (where the equilibrium is unstable) will the k level
be given a “Big Push” and sent to higher and higher values and thus raising the
level of y via the f-function.
We mentioned the demographic transition which roughly says that n depends
only. But in the last century, due to advance is health care and ……….., low y
did not necessarily lead to low n. As death rates dropped, population increased.
On the other hand sub-Saharan African nation like Ethiopia did see n very low
(other nations are under populated) due to very low levels of y.

5.4 LET US SUM UP

The neoclassical growth model is the central, ‘base-line’ model which has saved
on the spring board for almost all most researches into growth theory. The no-
classical model, associated with the name of Robert Solow, presented the first
major extension to the Harrod-Domar model, by endogenusing the capital output
ratio.
In this unit, we learnt some concepts and tools useful for studying growth theory,
and then we studied the structure of the neo-classical model, along with the
assumptions. We extended the Solow model to consider depreciation and variable
savings. We their process led to apply the Solow model to look at some
applications, like convergence and poverty tragss. We also looked at some
implications of the Solow model namely technical progress is more important
than capital accumulation, and raising the savings ratio in the short run is not
going to help. In the Solow model, technological progress and consequently,
output growth is exogenous. When we get to unit 9 on endogenous growth, we
will look at models that endogenous these.

87
 UNIT 6 ENDOGENOUS GROWTH MODELS
Structure
6.0 Objectives
6.1 Introduction
6.2 Assumptions of New Growth Theory (Endogenous Growth Models)
6.3 Endogenous Growth Models
6.3.1 Arrow’s Theory of Learning-by-doing
6.3.2 TheLevhari-Sheshinski Model
6.3.3 The King-Robson Model
6.3.4 Romer Model
6.3.5 The Lucas Model
6.3.6 Romer’s Model of Technological Change
6.4 Criticism of Endogenous growth models
6.5 Policy Implications for developed and developing countries
6.6 Let Us Sum Up
6.7 Answers to Check Your Progress Exercises

6.0 OBJECTIVES
After going through the Unit, you will be able to:
 Describe the emergence of Endogenous growth models;
 List the assumptions of endogenous growth models;
 Analyse the basic ideas on which these models rest and function in the
context of real world;
 Discuss and evaluate the working of endogenous growth models;
 Identify the limitations of these models; and
 State the policy implications of these models.

6.1 INTRODUCTION
Endogenous growth theory was developed as a reaction to omissions and
deficiencies in the Solow (neoclassical) growth model. It is a new theory which
explains the long run growth rate of an economy on the basis of endogenous
factors as against exogenous factors of the neoclassical growth theory.
The new growth theory of the 1990s was labeled “endogenous growth theory”
because it attempted to explain technical change as the result of profit-motivated
research and development (R&D) expenditure by private firms. This was driven
by competition along the lines of what Schumpeter called product innovations (as
distinct from process innovations). In contrast to the Harrod-Domar model,


Dr Puja Saxena Nigam, Associate Professor, Economics, Hindu College, University of Delhi,
New Delhi
which viewed growth as exogenous, or coming from outside variables, the Endogenous Growth
endogenous theory emphasizes growth from within the system. This approach Models
enjoyed, and still enjoys, an enormous vogue, partly because it seemed to offer
governments a new means of promoting economic growth—namely, national
innovation policies designed to stimulate more private and public R&D spending.
While the neo-classical growth models explain the long run growth rate of output
based on exogenous variables namely rate of growth of population and rate of
growth of technical progress (independent of savings rate), the new growth
theory extends this by introducing endogenous technical progress in growth
models. The Endogenous growth models emphasize on technological progress
resulting from the rate of Investment, size of capital stock and stock of human
capital. The concept of economic growth here is thus, internal to the economy.
The theory is built on the idea that the improvements in innovation, knowledge
and human capital lead to increased productivity, positively affecting the
economic outlook.
The Endogenous growth theory challenges the idea of predicting growth without
incorporating technological advancements. Since economic growth is derived
from the growth rate of economic output per person, it would depend on the
productivity levels and these would in turn depend on the progress of
technological change. The endogenous growth theory considers these factors viz.
innovation and human capital as internal to the economy.
Models of Endogenous growth bear some structural resemblance to their
neoclassical counterparts but they differ considerably in their underlying
assumptions and conclusions drawn. The most significant theoretical differences
stem from discarding the neoclassical assumptions of diminishing returns to
capital investments, permitting increasing returns to scale in aggregate
production and frequently focusing on the role of externalities in determining the
rates of return on capital investments. By assuming that public and private
investments in human capital generate external economies and productivity
improvements that offset the natural tendency for diminishing returns,
endogenous growth theory seeks to explain the existence of increasing returns to
scale and the divergent long-term growth patterns among countries. While
technology still plays an important role in these models, exogenous changes in
technology are no longer necessary to explain long run growth.
The new growth theory reemphasizes the importance of savings and human
capital investments for achieving rapid growth just like Harrod-Domar model,
but it leads to several implications for growth that are in direct conflict with
traditional theory: a) there is no force leading to the equilibration of growth rates
across closed economies, it remains constant or differs according to savings rates
and technology levels and b)there is no tendency for per capita income levels in
poor countries that are capital scarce to catch up with rich countries. The best part
about this theory is that it seeks to explain the anomalous international flows of
capital that exacerbate wealth disparities between rich and poor countries.

89
Growth Models: The potentially high rates of return on investment offered by developing
Theory & Evidence economies with low capital-labour ratios are greatly eroded by lower level of
complementary investments in human capital (education and health),
infrastructure of R&D. Hence, poor countries benefit less from the social gains
associated with these. Since individuals do not internalize these gains by positive
externalities, the free market leads to sub optimal accumulation of
complementary capital in the society. The state can play a key role here by
improving the efficiency of resource allocation by provision of public goods/
infrastructure and encouraging private investments in knowledge-intensive
industries where human capital can be accumulated.

6.2 ASSUMPTIONS OF NEW GROWTH THEORIES

(ENDOGENOUS GROWTH MODELS)
In general, the new growth theories rest on the following basic assumptions
• There are many firms in the market.
• Technological advancement or knowledge is a non-rival good.
• Increasing returns to scale to all factors taken together prevails when constant
returns to a single factor exists.
• Technological advancements come from things people do. It is based on
creation of new ideas.
• Increasing returns to scale in production leads to imperfect competition and
thus, many individuals and firms have market power and earn profits from
their discoveries.
• Emphasis is on the need of the Government to provide incentives and
subsidies for businesses in the private sector.
• Investments should also be made to improve infrastructure and manufacturing
processes to achieve innovation in production.

Check Your Progress 1

1. How does endogenous growth theory explain persistent growth without
the assumption of exogenous technological progress How does this differ
from the Solow model?
2. How is endogenous growth different from exogenous growth?

90
 Endogenous Growth
6.3 ENDOGENOUS GROWTH MODELS
Models
6.3.1 Arrow’s Theory of Learning-by-doing
Learning-by-doing is a concept in economic theory by which productivity is
achieved through practice, self-perfection and minor innovations. Kenneth Arrow
used this concept in his design of Endogenous growth theory to explain the
effects of innovation and technological change. Arrow's classical paper “The
Economic Implications of Learning by doing” published in 1962 showed how
this idea fits into the modern theory of economic growth and used it as a
springboard for a critical consideration of spectacular recent developments. He
introduced the increases in per capita income that cannot be merely explained by
increases in capital-labour ratio. Identifying the role of technological change in
economic growth and providing an explanation of the concept of knowledge
which underlies a production function, he examined how knowledge has to be
acquired.
He therefore suggested an endogenous theory of the changes in knowledge which
underlie inter-temporal and international shifts in production functions. The
acquisition of knowledge called “learning” might be interpreted in different ways
yet it accepted by all schools of thought; learning is a product of experience. It
can only take place through the attempt to solve a problem and therefore, takes
place only during an activity. He generalized from many of the classical learning
experiments that learning associated with repetition of essentially the same
problem is subject to diminishing returns. There is an equilibrium response
pattern for any given stimulus, towards which the behaviour of the learner tends
with repetition. To have steadily increasing performance, then, implies that the
stimulus situations must themselves be steadily evolving rather than merely
repeating.
He emphasized the role of experience in increasing productivity that had yet to be
absorbed into the main corpus of economic theory. He thus, advanced the
hypothesis that technological change in general could be ascribed to experience
that is the very activity of production which gives rise to problems for which
favourable responses are selected over time. Hence, learning by doing is an
example of knowledge accumulation from the production process. As individuals
produce goods, ways of improving production processes happen inevitably. The
improvement in productivity occurs as a byproduct of normal production activity
and not as a result of deliberate efforts.
When learning by doing is the source of technological progress, the rate of
growth/accumulation of knowledge depends not on the proportion of GDP
devoted to R&D but from how much new knowledge is generated by traditional
productive activity. The production function can be written as

Y(t) = K(t)α [A(t) L(t)]1-α ---------------------------------(1)

Where K=Capital, L=Labour, Y=Output, A=Stock of knowledge and α = a

parameter that lies between 0 and 1

91
 The simplest case of learning by doing is found in those situations where learning
occurs as a side effect of the production of new capital. Since, the increase in
knowledge is a function of increasing capital, the stock of knowledge is a
function of the stock of capital. There is only one stock variable whose behaviour
is endogenous here
A(t)=B K(t)β B and β are both greater than 0 --------(2)
If we put this in Equation (1) we get
Y(t)=K(t)α B1-α K(t)β(1-α) L(t)1-α
In the presence of learning, the contribution of capital is larger than its
conventional contribution: increased capital raises output not only through its
direct contribution to production [term K(t)α] but also by indirectly contributing
to the development of new ideas and making all other capital more productive
[term K(t) β(1-α)].
In a simplified form, the model is represented as the following:
Yi = A(K) F(Ki, Li)
Where for a firm i
Yi is output, Ki is the aggregate stock of capital and Li is the stock of labour
A is the technical factor and K represents the aggregate stock of capital
6.3.2 The Levhari-Sheshinski Model
Levhari and Sheshinski have generalized and extended Arrow’s model. They
stress on the spillover effects of increased investment as the source of
knowledge. They assume that the source of knowledge or learning by doing is
each firm’s investment. An increase in a firm’s investment leads to a concomitant
increase in its level of knowledge. An increase in a firm’s investment leads to a
parallel increase in its level of knowledge. The model assumes that the
knowledge of a firm is a public good which other firm can have at zero cost.
Thus, knowledge has a non-rival character which spills over across all the firms
in the economy. This is when each firm operates under constant returns to scale
and the economy as a whole is operating under increasing returns to scale.
This model explains endogenous technological progress in terms of knowledge or
learning by doing that is reflected in an upward raising of production function
and economic growth in the context of aggregate increasing returns being
consistent with competitive equilibrium.
6.3.3 The King-Robson Model
King and Robson in a paper published in 1993 emphasised learning by watching
in their technological progress function. Investment by a firm represents
innovation to solve the problems it faces. If it is successful, the other firms will
adopt the innovation to their own needs. Thus, externalities resulting from
learning by watching are a key to economic growth. This study shows that

92
innovation in one sector of the economy has the contagion or demonstration Endogenous Growth
effect on the productivity of other sectors, thereby leading to economic growth. Models
Multiple steady state growth paths exist, even for economies having similar
initial endowments and policies that increase investment should be pursued.
6.3.4 Romer Model
Romer in his first paper on endogenous growth in 1986 presented a variant on
Arrow’s Model which is known as learning by investment. He assumed creation
of knowledge as a side product of investment. He took knowledge as in input in
the production function of the following form:
Y = A(R) F (Ri,Ki, Li)
Where Y = Aggregate output, A(R) = public stock of knowledge from R&D
Ri = stock of results from expenditure on R&D by firm i , Ki = capital stock of
firm i and Li = labour input of firm i
He assumed the function F is homogenous of degree1 in all its inputs Ri, Ki, Li
and treats Ri as a rival good.
Romer took three key elements in his model: externalities, increasing returns in
the production of output and diminishing returns in the production of new
knowledge. It is the spillovers from research efforts by a firm that leads to the
creation of new knowledge by other firms. New research technology by a firm
spill over instantly across the entire economy. In this model, new knowledge is
the ultimate determinant of long run growth which is determined by investment
in research technology. Research technology exhibits diminishing returns which
means that investments in research technology will not double knowledge. Also,
the firm investing in research technology will not benefit exclusively from the
increase in knowledge. Other firms also benefit from new knowledge due to
inadequacy of patent protection. Hence, the production of goods from increased
knowledge displays increasing returns and competitive equilibrium is consistent
with increasing aggregate returns owing to externalities. Romer took investment
in research technology as endogenous factor in terms of the acquisition of new
knowledge by rational profit maximizing firms.
6.3.5 The Lucas Model
Robert Lucas utilized a model of endogenous growth developed by Uzawa.
Uzawa developed an endogenous growth model based on investment in human
capital. Lucas assumed that investment on education leads to the production of
human capital which is the crucial determinant in the growth process. He
classified this as: internal effects of human capital where the individual worker
undergoing training becomes more productive and external effects which
spillover and increases the productivity of capital and of other workers in the
economy.it is the investment in human capital rather than physical capital that
have spillover effects that increase the level of technology.
Thus, the output for firm i takes the form
93
Growth Models: Yi = A(Ki). (Hi)He
Theory & Evidence
Where A is the technical coefficient
Ki and Hi are the inputs of physical and human capital used by firm i to produce
output Yi
H is the economy’s average level of human capital and e is the parameter that
represents strength of the external effects from human capital to each firm’s
productivity
In the Lucas model, each firm faces constant returns to scale, while there are
increasing returns to scale for the whole economy. Learning by doing or on the
job training and spillover effects involve human capital. Each firm benefits from
the aggregate of human capital. Thus, it is not the accumulated knowledge or
experience of other firms but the average skills and knowledge in the economy
that are crucial for economic growth.
6.3.6 Romer’s Model of Technological Change
In 1990, Romer gave the model of endogenous technological change that
identified a research sector specializing in the production of ideas. This sector
invokes human capital along with the existing stock of knowledge to produce
ideas or new knowledge. The importance of ideas over resources is the
cornerstone of his analysis where he quotes Japan as an example, a country with
few natural resources but open to new western ideas and technology.
In this model, new knowledge enters into the production process in three ways-
a) A new design is used in the intermediate goods sector for the production of a
new intermediate input
b) In the final sector; labour, human capital and available producer durables
produce the final product
c) A new design increases the total stock of knowledge which increases the
productivity of human capital employed in the research sector.
The model is based on the following assumptions:
 Economic growth comes from technological change
 Technological change is endogenous
 Market incentives play an important role in making technological changes
available in the economy
 Invention of a new design requires a specified amount of human capital
 The aggregate supply of human capital is fixed
 Knowledge or a new design is assumed to be partially excludable and
retainable by the firm who invented it (patented design that cannot be
made or sold without the agreement of the inventor) but investment in
R&D can be done by other firms and benefits can be accrued thereof.
 Technology is a non-rival input.

94
  The new design can be used by firms and in different periods without
additional costs and without reducing the value of the input.
 The low cost of using an existing design reduces the cost of creating new
designs.
 When firms make investments in R&D and invent a new design, there are
externalities that are internalized by private agreements.
Technological production function in the model is given by
ΔA=F (KA, HA, A)
Where ΔA is the technology production function for technology ( Δ stands for
change in value; thus ΔA stands for change in technology)
KA is the amount of capital invested in producing the new design or technology
HA is the amount of human capital (labour) employed in R&D of the new design
A is the existing technology of designs.
The production function shows that technology is endogenous. When more
human capital is employed for R&D of new designs, then technology increases
by a larger amount that is A is greater. Since it is assumed that technology is a
non-rival input and partially excludable, there are positive spillover effects of
technology which can be used by other firms. Thus, the production of new
technology (knowledge or ideas) can be increased through the use of physical
capital, human capital and existing technology.
Check Your Progress 2
1. Explain the learning by doing model by Kenneth Arrow?
2. Examine the relevance of Paul Romer’s model of technological change in
explaining long run growth across countries.

6.4 CRITICISM OF ENDOGENOUS GROWTH

MODELS
Many economists have criticized the new growth theory on their respective
considerations, some based on the general suggestion that endogenous growth
theory is not novel, such as
• Scott and Auerbach think that the main ideas of the new growth theory can be
traced to Adam Smith and increasing returns of Marx’s analysis.
• Srinivasan does not find anything new in the new growth theory as increasing
returns and endogeneity of variables have been taken from neoclassical and
Kaldor models of growth.
• Fisher criticizes it for depending only on the production function and steady
state.
• Olson feels that it lays too much emphasis on the role of human capital and
neglects the role of institutions.
• In various models of new growth theories, the difference between physical and
human capital is not clear.
However, a few general limitations can also be highlighted,
• Endogenous growth theory is impossible to be validated through empirical
evidence.
• It is accused of being based on assumptions that cannot be accurately
measured.
• These theories have collectively failed to explain conditional convergence
reported in empirical evidence.
• An important shortcoming of the new growth theory is that it remains
dependent on a number of assumptions of the traditional neoclassical theory
that are often inappropriate for developing and underdeveloped economies.
• In developing countries, economic growth is frequently impeded by
inefficiencies due to poor infrastructure, inadequate institutions and imperfect
capital and goods markets. The endogenous growth theory fails to incorporate
these factors.
• The theory particularly looks at long run growth and ignores short- and
medium-term growth.

6.5 POLICY IMPLICATIONS FOR DEVELOPED

AND DEVELOPING COUNTRIES
• This theory suggests the convergence of growth rates per capita of developing
and developed countries can no longer be expected to occur. The increasing
returns to both physical and human capital imply that the rate of return to
investment will not fall in developed countries relative to developing
countries. Therefore, capital need not flow from developed to developing
countries and actually the reverse may happen.
• The measured contribution of both physical and human capital to growth may
be larger than suggested by the Solow Model. Investment in education or R&D
has not only a positive effect on the firm itself but also spillover effects on the
other firms and economy as a whole. This suggests that the residual attributed
to technological change in the Solow growth accounting may be actually
smaller. Recent growth accounting exercises have suggested that the
percentage of growth accounted for by the 'unexplained residual', is much
smaller for the less advanced economy. This may of course simply reflect
capital in these countries. Alternatively, it may reflect other considerations
generally excluded from growth theory but which possess particular relevance
for the developing economies. Stern (1991) for example, has stressed the
importance of management, organization, infrastructure, and sectoral transfer
as key elements in the growth process of third world economies
• It is not necessary that economies having increasing returns to scale must reach
steady state level of income growth as suggested by Solow-Swan Model. With
positive externalities of Research and Development, growth of income does not
slow down and economy does not reach steady state. An increase in savings
rate can lead to a permanent increase in the growth rate of the economy.
• Countries having greater stocks of human capital and investing more in R&D
will enjoy a faster rate of economic growth. This may be the reason for slow
growth of many developing countries.
• Potentially, it is the less developed economy which stands to gain the most
from international trade becoming freer since by doing so it can draw upon the
stock of world knowledge. But technological flows from rich to poor
economies are by no means automatic which raises the issue of the role of
multinational corporations and how they respond to incentives for
technological transfer. This leads naturally into the question of policy. The
essence of modern statements of endogenous growth is that the technical
progress residual is accounted for by endogenous human capital formation. But
if the latter can be influenced by government policy world growth may be
changed accordingly. For example, if a country possessed of a comparative
advantage in R & D activity were to subsidize research, world growth would
increase. In the same way, a similar subsidy introduced by an economy
relatively more efficient in manufacturing as opposed to innovating may cause
world growth to decline. Trade policies which afford protection to the
manufacturing sector may promote the transfer of skilled labour from research
activity into manufacturing which will retard innovation. Ceteris paribus, trade
policy will affect a shift of resources from research to manufacturing in policy
active countries and in the opposite direction in policy inactive countries.
• Implications also emerge for the international product cycle. Traditionally,
invention and new products occur in the advanced economy where R& D
activity is well developed. Later, either by imitation or technology transfer they
will be produced in the less advanced country and ultimately production of
these goods will migrate to the low wage economy. Accordingly, trade in
manufactured products takes place on the basis of exchange between the latest
innovative goods produced only in the advanced economy and the more
traditional goods now produced predominantly by the less advanced. The
product cycle accounts for an ever-evolving pattern of international trade with
the advanced economy importing the very same goods that initially it exported.
• In the context of the product cycle model, international trade always emerges
as a contributor to faster economic growth in both advanced and less advanced
economies. In the former, the migration of production from the advanced to the
less advanced economy frees resources for use in growth enhancing product
development activity. At the same time, growth occurs faster in the less
advanced economy since the resources needed for learning and adapting the
techniques imported from the advanced economy are far fewer than those
needed for autonomous new product development. In both cases, the
subsidization of learning activities (innovation in the advanced economy,
imitation in the less advanced) may be expected to enhance long run growth
rates.
• Finally, it would appear clear that trade policy has the potential for influencing
long run growth paths for the world economy. However, numerous difficulties
present themselves. The identification of growth influencing knowledge
sectors is itself a major difficulty ex ante if not ex post. Secondly, the fact that
conclusions deriving from the model analysis can be so easily overturned by
the alteration of the conditions or assumptions underlying the analysis - which
for the most part are unlikely to be resolved empirically - weakens one's
confidence in growth prescription. Moreover, in the context of international
trade and the world economy, the outcome and effects of policy measures are
themselves interdependent with the policy actions of others. This would point
to the need for the coordination of national policies or at least the
consideration of second-best outcomes.

An endogenous growth theory implication is that policies that embrace openness,

competition, change and innovation will promote growth. Conversely, policies
that have the effect of restricting or slowing change by protecting or favouring
particular existing industries or firms are likely, over time, to slow growth to the
disadvantage of the community.
Check Your Progress 3
1. What are criticisms of endogenous growth theory?
2. Discuss the policy implications of endogenous growth for developing and
developed countries

6.6 LET US SUM UP

Endogenous growth is long-run economic growth at a rate determined by forces
that are internal to the economic system, particularly those forces governing the
opportunities and incentives to create technological knowledge. In the long run
the rate of economic growth, as measured by the growth rate of output per
person, depends on the growth rate of total factor productivity (TFP), which is
determined in turn by the rate of technological progress. The neoclassical theory
implies that economists can take the long-run growth rate as given exogenously
from outside the economic system. Endogenous growth theory challenges this
neoclassical view by proposing channels through which the rate of technological
progress, and hence the long-run rate of economic growth, can be influenced by
economic factors. It starts from the observation that technological progress takes
place through innovations, in the form of new products, processes and markets,
many of which are the result of economic activities. For example, because firms
learn from experience how to produce more efficiently, a higher pace of
economic activity can raise the pace of process innovation by giving firms more
production experience. Also, because many innovations result from R&D
expenditures undertaken by profit-seeking firms, economic policies with respect
to trade, competition, education, taxes and intellectual property can influence the
rate of innovation by affecting the private costs and benefits of doing R&D.
The central tenets of endogenous growth theory and policy implications thereof
include:
• Government policy’s ability to raise a country’s growth rate if they lead to
more internal competition in markets and help to stimulate product and
process innovation.
• There are increasing returns to scale from capital investment especially in
infrastructure and investment in education, health and communications.
• Private sector investment in R&D is a crucial source of technological
progress.
• The protection of property rights and patents is essential in providing
incentives for businesses and entrepreneurship to engage in R&D.
• Investment in Human capital is a vital component of growth.
 Government policy should encourage entrepreneurship as a means of
creating new businesses and ultimately as an important source of new
jobs, investment and further innovation.

6.7 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1.. See ection 6.1
2.. See ection 6.2
Check Your Progress 2
1. See sub-section 6.3.1
2.. Se sub-section 6.3.6
Check Your Progress 3
1. See section 6.4
2. See section 6.5
UNIT 7 DETERMINANTS OF GROWTH
Structure
7.0 Objectives
7.1 Introduction
7.2 Growth Accounting
7.3 Technology and Growth
7.4 Convergence
7.5 Other Determinants of Growth
7.5.1 Institutions
7.5.2 Geography
7.5.3 Culture
7.6 Path Dependence
7.7 Let Us Sum Up
7.8 Answers/Hints to Check Your Progress Exercises

7.0 OBJECTIVES
After going through this unit you should be able to :
 Explain the meaning of growth accounting;
 Discuss the influence of technology on growth;
 Analyse the concept of convergence and whether empirically growth rates of
developing nations and developed nations are converging;
 Examine the role of institutions, human capital, geography and culture in
determining economic growth; and
 Explain the ideas of path dependence and historical lock-ins.

7.2 GROWTH ACCOUNTING

Total Factor Productivity (TFP) or we may call it productivity is an important
concept in the context of economic Growth of a nation particularly developing
countries. Productivity contributes to industrial growth and to the
competitiveness in international markets. It refers to the rate at which
employment is generated from the employed resources. Increased productivity
result in better utilisation of resources and reduces the cost and the prices of
industrial products, which in turn, lead to a faster growth in demand in both
domestic and international markets. Ever since Robert Solow) decomposed
output growth into the contribution of input growth and a residual productivity
term; the concept has gained popularity and is used as a benchmark to rank firms
or countries. Such rankings get credibility once productivity is correlated with
other indicators of success such as employment growth, export status, or


Saugato Sen, Associate professor, IGNOU, New Delhi
Growth Models: technology adoption. Concept like low productivity is also found useful to
Theory & Evidence predict exit of the firms in an economy, the ultimate performance standard. Its
importance can also be gauged from the attention it receives as a criterion to
evaluate policy interventions or firms’ decisions. The concept has relevance and
different meaning in different branches of economics. In industrial economics,
for example, a large literature investigates the effect of R&D on productivity and
the resulting impact on industry structure. In international economics, the efforts
to evaluate the impact of trade liberalization range from estimating changes in
price-cost margins to productivity changes. Fundamentally, the objective of
productivity measurement is to identify changes in output that cannot be
explained by changes in inputs.
Behind this concept most often stands the understanding that besides the
traditional factors of production labour and capital there is something else that
leads to the increase in production. Usually this ‘thing’ is associated with
technological progress. The latter concept itself can be interpreted in various
ways, but eventually it always implies that the combination of labour force,
machines, human knowledge and skills, leads to changes in total income that are
not expected by changes in capital or labour considered separately.
Growth (increase in GDP) of an economy is generally attributed to factors that
can be clubbed under two broad headings: Capital and Labour. But you will find
when you calculate it that Capital and Labour cannot account for all the growth
and in fact there is a residual factor that comes into play and accounts for the
increase in GDP. This factor is known as Total Factor Productivity. Let us try to
understand it on the basis of an equation:
Y= A ƒ(K,L)
Where Y is the output (GDP), K is the stock of physical capital invested and
L is the labour (number of man-hours). The letter A stands for Total Factor
Productivity.
Total Factor Productivity (TFP) as a concept is also important not only in the
context of macro-economic aggregate measures of a country's performance in
terms of per capita growth and productivity, but is of equal significance in
measuring the determinants of productivity and competitiveness of firms. The
hitherto more popular measure – labour productivity or value added per unit
labour – suffers from the shortcoming that it does not reveal why the
productivity has risen or vice-versa. Is it due to increased inputs of capital, or are
there other causes? The TFP approach while analysing performance, attempts to
go into the WHY of productivity changes and thus gives deeper insights into the
underlying causes and sustainability of growth.
Productivity keeps on changing as production continues. It improves under
favourable circumstances and deteriorates when unfavourable changes occur.
The changes that lead to higher productivity of inputs are technological
improvements, improvement in efficiency, increased education of labour,
improvement in the quality of labour due to training, etc. Today, TFP is
considered an important source of output growth worldwide

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due to rapid progress in science and technology and various efficiency- Determinants of
enhancing measures. Growth

In the equation given above a higher value of A means that the same inputs lead
to more output and vice versa. It shows how efficiently that input is being used
to further the interests of the economy and it is the productivity of the capital
and labour investment. Total Factor Productivity is considered to be the actual
determining factor in the growth of an economy as both capital and labour
cannot continue to be invested indefinitely. Moreover the growth of economy, if
depended solely on capital and labour would decline as soon as these
investments in these inputs are reduced and vice-versa. Thus it is not a stable
growth. Hence increased Total Factor Productivity is the only way that an
economy can maintain a stable growth.
Also, the Law of Diminishing Marginal Returns, tells us that a sustained influx
of Labour and Capital will not achieve long term growth as the value of the
inputs get maximised; they onset to deliver lower returns over a period of time.
Thus the only way growth can be ensured and sustained is to maximise the
efficiency of these inputs and to work on improving the quality and quantity of
returns for the same amount of inputs i.e. to increase Total Factor Productivity.
Productivity is the main reason for economic growth. Some countries do better
than others primarily because they are more productive. Also, the more
productive a country is the better it is able to compete in the world markets as it
can keep cost low while still producing a superior product. A high level of
productivity also increases the standard of living of people in that country as
they would get better outputs for the same inputs i.e. have better quality products
at lower prices.
In order to conduct such an analysis, economists have built up a framework
called growth accounting to obtain a different perspective on the sources of
economic growth. Later we shall discuss that decomposing growth is essentially
a growth accounting exercise. We start with a production function that tells us
what output (Yt) will be at some particular time t is a function of the economy’s
stock of capital (Kt), its labour force (Lt), and the economy’s total factor
productivity (At). If output changes, it can only be because of the change in the
economy’s capital stock, its labour force, or its level of total factor productivity.
We are referring to the Cobb-Douglas form of the production function, which is:
Yt= At ƒ(Ktα, Lt1-α) …………………(1)
In this equation we can see that we would get higher output because of three
reasons – if more number of man hours are put in (higher L), if the people have
more equipment, etc to work with (higher K) or if capital and labour are used more
productively (higher A). The equation at (1) shows that it assumes perfect
competition and the constant returns to scale as depicted by the coefficients of K
and L. If we decompose the growth in output into each of the three elements
allotting 1/3rd of the increase in growth to capital and 2/3rd to labour (which is what
is seen in the most developed countries), the equation then becomes

Yt= At Kt 1/3 Lt 2/3 …………………(2)

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Growth Models: Taking logs the growth in output (Y) is shown by the following equation
Theory & Evidence
lnY = lnA + 0.33 lnK + 0.67 lnL …………………(3)

Where lnY is the growth in output, lnK is the increase in capital, lnL is the increase in
labour and lnA is the increase in Total Factor Productivity (all these are for a particular
time period)

We can also use this equation to calculate growth in output per worker i.e. Labour
Productivity (Y/L). This can be written as

Y/L = A (K/L)1/3 …………………(4)

When we apply the growth in output formula to this equation, it becomes

lnY/L = lnA + 0.33 lnK/L …………………(5)

Where lnY/L is the growth in output per worker, (K/L)/(K/L) is the increase
in the amount of capital per worker and A/A is the increase in Total Factor
Productivity.
Thus equation (5) shows that the output per worker can rise because of two
reasons - increase in Total Factor Productivity and increase in the amount of capital
per worker.
So if we consider a real-world situation in which all 3 — the capital stock, the
labour force, and total factor productivity are changing — then the proportional
growth rate of output is as given in equation (3), which is the key. If we know the
proportional growth rates of output, the capital stock, and the labour force, and if
we know the diminishing-returns-to-scale parameter α in the production function,
then we can use this growth-accounting equation to calculate the (not directly
observed) rate of growth of total factor productivity A, and to decompose the
growth of total output Y into (i) the contribution from the increasing capital stock
K, (ii) the contribution from the increasing labour force L, and (iii) the contribution
from higher total factor productivity A.
Since growth-accounting equation at (3) allows us to break down growth into
components that can be attributed to the observable factors of the growth of the
capital stock and of the labour force, and to a residual factor — often, in fact,
called the Solow residual or a measure of ignorance — that is the portion of growth
left unaccounted for by increases in the standard factors of production. Changes in
the Solow residual or total factor productivity can come about for many reasons
explained earlier. Economists often refer to total factor productivity as
“technology,” but if it is technology it is technology in the widest possible sense.
Not just new ways of constructing buildings, newly-invented machines, and new
sources of power affect total factor productivity, but changes in work organization,
in the efficiency of government regulation, in the degree of monopoly in the
economy, in the literacy and skills of the workforce, and in many other factors
affect total factor productivity as well.
The approach that has been used here in the measurement of total factor
productivity is the so-called growth accounting, which, although being simple with
respect to the computation technique, leads to sufficiently illuminating results.

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 Determinants of
7.3 TECHNOLOGY AND GROWTH Growth
In the growth models that you studied, particularly Harrod-Domar and the Solow
model, the discussion was carried out in terms of how the output changed as a
result of change in the level of input use. As more of labour and capital was used
the output changed. We also discussed the important role of savings and
investment. However, the production conditions do not stay the same. As
technology improves, as technical progress takes place, inputs can be combined
more efficiently. More output can be obtained from the use of the same level of
input as before, or to produce the same amount of output as earlier, less use of
input is needed. In this section we build upon the discussion in the previous
section where we discussed growth accounting. In this section we discuss what
we mean by technical progress and analyse how technology is an important
determinant of economic growth.
You would have guessed by now that technical change has something to do with
improving the production process, and indeed so it is. We depict the change in
technical level by looking at the production function. Let us suppose for
simplicity that there is one single 'homogeneous' good in the economy. This good
gets produced by using capital and labour. The simplest way to conceptualise
technical progress is to understand that technical progress means that more output
is produced using the same amount of inputs. If you visualise a production
function, you can see that the production function shifting upward over time as
technical progress takes place. Another way to look at technical change
(improvement) is to say that the nature of the production function changed to a
superior one, or that the same amount of output can be produced by using less of
one or more factors than before.
The general way we have used to represent technical change as shifts in the
production function (it may also be depicted as shifts in the position of each
isoquant) can be expressed by bringing in time into the production function
explicitiy. The production function now becomes:
Y = F(K, L, t )
The argument t is a production function shifter.
Although the above formulation is the most geileral way of depicting technical
progress, there is another way of depicting technical change, where technical
progress takes place through shifts in the production hilction even though the
inputs used may not have increased. It is as though the factors of production were
somehow augmented and they are able to produce more output than before.
To understand technical change, we have to bear in mind that there are several
types of technical change. They have mostly to do with the capital-labour
intensity, and by implication, on the relative shares of capital and labour in tile
total product. This has repercussions on the remunerations of capital and labour,

105
Growth Models: that is, on the wage rate and rental of capital. If the capital labour ratio
Theory & Evidence capital intensity) goes up, it is called capital deepening.
Now let us begin our study of the classification of technical change, Before
doing so, let us recall our discussion of factor augmented technical progress.
We introduce a related concept here. Technical change can be embodied or
disembodied. Embodied technical change means that technical change assumes
the form in the change in the type of factor of production, usually capital. In
other words, embodied technical change is embodied in the form of new types
of machines (a new process or new technology).
Disembodied technical progress, on the other hand, means that regardless of the
type of machines, new or old, the same amount of factors can produce greater
amounts of output, or the same amount of output can be produced using lesser
quantities of inputs; in other words, the isoquant shifts inwards. The factor
augmenting technical change that we studied in the previous section is a
depiction of disembodied technical change. For most of this unit, we will have
occasion to consider disembodied technical change. Only in the final section do
we touch upon embodied technical change, and once you grasp the concept, you
will find greater use of the concept in some of the later units. In embodied
technical change, investment in new equipment or new skill is the essential
vehicle of improvements in technique.
Another concept with regard to technical change is neutrality. Neutrality
broadly means that technical change is neither labour saving nor capital saving.
Sir John Hicks looked at technical progress in terms of the effect of technical
change on the ratio of marginal product of capital to that of labour. If after the
technical change the ratio increases, in Hicks's terminology it is to be called
labour saving. If the ratio stays the same it is neutral and if the ratio falls, it is
called capital saving. We can now state the Hicksian classification of technical
progress in the following way: A technical progress will shift the per-worker
production function upward. This technical progress is said to be labour-saving
if at any given value of capital-labour ratio, the ratio of marginal product of
capital to the marginal product of labour has increased. Ifthis ratio decreases for
a given value ofcapital -labour ratio, the technical progress is said to be capital
saving, and if the ratio stays the same it is Hicks neutral.
Sir Roy Harrod put forward a classification of technical progress which was
different from Hicks's classification. He defined as neutral a technical change
one where the capital coefficient (capital-output ratio) does not change in the
presence of a constant interest rate. Broadly, he suggested that if, when the
interest rate is constant, the distribution of the total national product between
capital and labour stays constant, then it is neutral technical progress. If we
consider perfect competition and take interest rate as equal to the rental of
capital and hence equal to the marginal product of capital, then Harrod-neutral
technical progress is a statement about the relationship between capital-output
ratio and the marginal product of capital. Robert Solow's classification of
technical progress is

106
similar to Harrod's and Hicks’s classification except in one respect. Hicks's Determinants of
classification compares points on different per-worker output curves at points of Growth
constant capital-labour ratio and Harrod's scheme compares points on different
per-worker output curves at points of constant capital-output ratio. Solow's
classification compares points on old and new per-worker production at points at
which the labour-output ratio is constant. Thus Solow-neutrality is when at points
where L/Y is constant that is, the relative shares of capital and labour remain
constant. It can be shown that a Solow-neutral technical progress is capital
augmenting.

7.4 CONVERGENCE
In this section we take a look at whether the growth rates and income levels of
developing nations are converging to those of developed nations. The
convergence hypothesis claims that the poorer economies’ per capita incomes
tend to grow faster than those of richer countries. The convergence hypothesis is
also known as the ‘catching up’ hypothesis. The hypothesis is claimed on basis of
the structure and results of the Solow growth, which you studied in unit 5. In this
model, economic growth is driven by the accumulation of physical capital until
this optimum level of capital per worker, which is the "steady state", is reached,
where output, consumption and capital are constant. The model predicts more
rapid growth when the level of physical capital per capita is low; this is
sometimes referred to as “catch up” growth. As a result, all economies should
eventually converge in terms of per capita income. Let us view the facts from
history.
At the dawn of the industrial era, around the middle of the eighteenth century,
average real living standards in the richest countries were no more than about
three times as great as those of the poorest. However since the last two centuries,
a huge gap has emerged in the living standards as well as the rate of growth in
developed nations, and the developing nations. Today, the ratio of average real
living standards of the rich countries to that of the poor approaches 100 to 1.
Economist Lant Pritchett has called this phenomenon of the developed countries
as a whole enjoying a far higher rate of growth than developing nations over the
last two centuries as The Great Divergence.
The 2 centuries of exponential increase in productivity and incomes in early
industrialising countries, and comparative stagnation in most other countries, led
to the “Great Divergence.” Some countries experienced almost no gains during
this long period. Other countries were among those with the highest incomes
throughout this period. Much later, incomes in many other countries where a
majority of the world’s people live began to rise; and then to start closing the gap,
albeit often in fits and starts, and frustratingly slowly, by the turn of the twenty-
first century. Yet many people, particularly in the least-developed countries, still
have seen almost no improvements in living standards. Japan was the first non-
Western country to begin to catch up. China and India, where more than one-
third of the world’s people live, began a period of high growth rates and entered
the catch-up process by the early 1980s, (in the case of China) and early 1990s
(in the case of India).

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Growth Models: How did the enormous change happen? And why did the benefits go for so long
Theory & Evidence only to people in a small part of the world? Why are some countries still making
little progress? And how have many countries finally started to reconverge, in
some cases dramatically? Initially, some of these riches were gained through the
process of colonialism. But as time went on, an increasing majority of the gains
resulted from the productivity advances of the Industrial Revolution.
About 250 years ago, the Industrial Revolution started in England. Production
rose through the progressive application of steam power, water power, and other
technical advances. Countries that industrialised early — in West Europe and
North America — began a transformation that would lead to unprecedented gains
in living standards. There emerged a huge difference in the level of technology
available in Europe and that in other parts of the world. Europe also saw rise in
commerce and trade, other than manufacturing. The process of divergence was
underway.
There was a decolonisation wave from the years after World War II to the
mid-1970s. There was a massive historical and geopolitical change. Yet for
decades following independence of many developing, formerly colonized
countries, several observers found it puzzling that most developing countries
made rather little progress on productivity and incomes.
If the growth experience of developing and developed countries was similar, there
are (at least) two important reasons to expect that developing countries would be
“catching up” by growing faster on average than developed countries. The first
reason is due to technology transfer. Many companies and governments actively
seek to absorb new technologies; in fact, development assistance often attempts to
facilitate this goal, particularly in fields such as public health. Today’s
developing countries do not have to “reinvent the wheel”. They do not need to go
through the process of technological evolution that today’s developed nation did.
This should enable developing countries to “leapfrog” over some of the earlier
stages of technological development, moving quickly to high-productivity
techniques of production. As a result, they should be able to grow much faster
than today’s developed countries are growing now or were able to grow in the
past, when they had to invent the technology as they went along and proceed step
by step through the historical stages of innovation. Economic historian Alexander
Gerschenkron called this process the advantage of backwardness. In fact, if we
confine our attention to cases of successful development, the later a country
begins its modern economic growth, the shorter the time needed to double output
per worker. For example, Britain doubled its output per person in the first 60
years of its industrial development, and the United States did so in 45 years.
South Korea once doubled per capita output in less than 12 years, and China has
done so in 8 years. The second reason to expect convergence if conditions are
similar is based on diminishing returns to factor accumulation. Today’s developed
countries have high levels of physical and human capital; in a production function
analysis, this would explain their high levels of output per person. But in
traditional neoclassical analysis, the marginal product of capital and the
profitability of investments would be lower in developed countries where capital
intensity is higher, provided that the law of diminishing returns applied. That is,
the impact of additional capital on output would be expected to be smaller in a
developed country that already had a lot of capital in relation to the size of its
workforce than in a developing country where capital was scarce.
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As a result, we would expect higher investment rates in developing countries, Determinants of
either through domestic sources or through attracting foreign investment With Growth
higher investment rates, capital would grow more quickly in developing
countries until approximately equal levels of capital and (other things being
equal) output per worker were achieved. However, , in practice, this does not
always happen or happen quickly.
Given either or both of these conditions, technology transfer and more rapid
capital accumulation, incomes would tend toward convergence in the long run as
the faster-growing developing countries would be catching up with the slower-
growing developed countries. Although it is unlikely that incomes would
eventually turn out to be identical, they would at least tend to converge,
conditional upon that is accounting for any systematic differences in key
variables such as population growth rates and savings rates. As we have just seen,
the evidence shows that divergence occurred for two centuries from the start of
the industrial revolution. However, the most recent data demonstrate that, on
average, (re-)convergence is now underway.
The encouraging convergence trend is not inevitable. Potentially, the trend could
be reversed by new technological divides, climate change impacts in some areas,
policies that are bad or serve narrow interest groups, and disasters of widespread
armed conflict. Least-developed countries could remain stuck for other reasons.
Further, these trends in convergence reflect country averages – they do not adjust
for inequality or the presence of extreme poverty.
At the heart of the Solow model is the prediction of convergence, but
convergence is of more than one type. The strongest prediction is called
unconditional convergence. Suppose we postulate that nations, in the long run,
have no tendency to display differences in the rates of technical progress,
savings, population growth, and capital depreciation. In that case, the Solow
model predicts that in all nations, capital per unit of labour will converge to a
common value regardless of the initial state of each of these economies, as
measured by their starting levels of per capita income (or equivalently, their per
capita capital stock).
The exogenous parameters of the model are assumed to be equal, but the initial
level of the capital stock or per capita income is not. The claim of convergence is
then based on the Solow model: its content is that in the presence of similar
parameters governing the evolution of the economy, history in the sense of
different initial conditions does not matter.
Empirically, the assertion of unconditional convergence is even stronger. At the
back of our minds we base such convergence on certain assumptions regarding
the similarity of parameters across countries. However, there is no guarantee that
these assumptions hold in reality, so if we were to find convergence, it would be
a striking finding, not a trivial one.

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 Provided that all the parameters of the Solow model are constant across countries,
convergence across countries is an implication of that model. Consider the
obvious weak link in the prediction of unconditional convergence: the assumption
that across all countries, the level of technical knowledge (and its change), the rate
of savings, the rate of population growth, and the rate of depreciation are all the
same. This notion certainly flies in he face of the facts: countries differ in many,
if not all, these features. Although this has no effect on the Solow prediction that
countries must converge to their steady states, the steady states can now be
different from country to country, so that there is no need for two countries to
converge to each other. This weaker hypothesis leads to the notion of conditional
convergence.
In the literature on economic growth, the term ‘convergence” is sometimes used
in two senses. In the first sense, convergence is taken to mean a reduction in the
dispersion of levels of income among nations. This is called  (sigma )
convergence. The other sense is called  (beta) convergence. Beta convergence
means poor economies grow faster than richer countries. Conditional 
convergence takes place when economies experience  convergence, but
conditional on other variables being constant. Unconditional  convergence is
said to occur when the growth rate of an economy declines as it approaches its
steady state.
Check Your Progress 1
1. Explain the meaning of growth accounting.
2. What do you understand by total factor productivity?
3. Explain Hicks-neutral and Harrod-neutral technical progress
4. Explain the concepts of:
(1) Unconditional and conditional convergence and
(2) Sigma and beta-convergence.

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 Determinants of
7.5 OTHER DETERMINANTS OF GROWTH
In the earlier sections, we have looked at some factors that determine growth, like
accumulation, improvements in total factor productivity, technology and
technological advance. Here we would like to look at some other factors. Some
factors like human capital were considered in unit 6 on endogenous growth
theory. Some other important factors like impact of international trade and finance
on growth will be taken up for discussion in the subsequent course on
development economics.
Most of the economic determinants of growth, like factors of production,
accumulation, technology, productivity growth, and so on, have been viewed by
some economists as proximate causes. However, these economic determinants
may themselves be influenced and impacted by underlying basic causes, some of
which may be non-economic. In this section we study some of these.
7.5.1 Institutions
In recent times institutional economics has assumed considerable importance in
the analysis of developing nations.. Recently, the analysis of exchange using tools
of microeconomics has been sought to be supplemented by institutional analysis.
Even in the study of economic growth, the study of institutions has assumed
importance. . We have studied several theories of growth. We saw recently there
has emerged a group of theories that see growth as determined by processes that
are endogenous. There are differences in factors and endowments among nations,
and this is supposed to explain the differences in economic growth of nations.
Some economists have suggested that the factors which are supposed to cause
economic growth, which are endogenous, are themselves not the causes of, or
explanations of growth. They are actually the characteristics or features of
growth. The main reason for differences in growth performance is differences in
the structure of institutions in various countries. Institutions and differences in
them can account for large differences in the performance of countries.
What are institutions? Douglass North, a Nobel Prize winner in economics defines
institutions by referring to them, as “the rules of the game in a society or, more
formally, are the humanly devised constraints that shape human interaction.” He
suggests that institutions shape the constraints in interactions among people.
These interactions may be economic, social or political. Economic institutions
such as property rights and the degree of perfection of markets influence the
structure of economic incentives in society. Economic institutions also determine
how efficiently allocations will be allocated in society. Thus it is important to
realise that not only are institutions important but also that they are endogenous.
One new strand in economic thought looks at changes in property rights and
transaction costs having a great impact on economic development. This view is
exemplified by the works of Ronald Coase and Douglass North. Another strand
has sought to use the recent developments in information economics, like
asymmetric information, imperfect information, moral hazard, adverse selection,
signalling and screening, to understand how institutions affect development. They
see institutions as filling in gaps in the economy created by missing and
incomplete markets, presence of risk, and asymmetry of information. They have
used this, for instance, to model agrarian institutions, for instance on these lines.

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Growth Models: This is seen in works of economists like George Akerlof and Joseph Stiglitz.
Theory & Evidence Interestingly, all four economists have won the Nobel Prize.
The transaction costs school contends that as transaction costs change,
institutions emerge to minimise these transaction costs. This is the basis of
development. Transaction costs include costs of negotiation, monitoring,
coordination, and enforcement of contracts. When transaction costs are high,
allocation of property rights becomes crucial. Contracts come to be determined by
property relations when transaction costs are high. In the development process
there may emerge a trade-off between economies of scale and transaction costs.
In simple face to face interaction transaction costs may be low but production
costs are high because specialisation and division of labour is limited. The
transactions cost school also believes that changes in relative prices cause
institutional changes.
The information economics school cast their theories in more rigorous terms and
explicitly bring in notions of equilibrium. In addition, institutional quality affects
the amount and quality of investments in education and health, via the mediating
impact of inequality. In countries with higher levels of education, institutions
tend to be more democratic, with more constraints on elites. The causality
between education and institutions could run in either direction, or both could be
caused jointly by still other factors. It is important to understand why and how a
certain institution emerges, and what purpose it may be serving. Even an
institution that appears to be negative may be serving some purpose. It is
important to realise this to explain its persistence. The institution may not be
optimal, indeed, may be dysfunctional and may still persist. It is necessary to
observe if there are regularities in the evolution of institutions, as this gives rise to
conventions.
7.5.2 Geography
At first glance, geography seems to have had a major influence on development. It
is perhaps not a coincidence that many of the poorer nations are situated around
and near the Equator. Very hot climate saps the energy to work, so workers’
productivity is affected. Low productivity leads to low income, and many of low-
productivity workers may not be able to afford adequate amount of nutritious
food. Low nutrition levels can further diminish productivity.
Moreover, geography also influences economic development through the factor of
location. Geographical factors may lead to industries and factors to be located, or
not to be in productive regions. Similarly agriculture, urbanization and some
other aspects of the economy can also be affected by geographical condition.
Economists have started paying greater attention to geographical factors.. First,
in the very long run, very few economists doubt that physical geography,
including climate, has had an important impact on economic history. Geography
was once truly exogenous, even if human activity can now alter it, for better or
worse. But the economic role played by geography, such as tropical climate, today
is less clear. Some research suggests that when other factors, notably inequality
and institutions, are taken into account, physical geography adds little to our
understanding of current development levels. However, some evidence is mixed.

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For example, there is some evidence of an independent impact of malaria and Determinants of
indications that, in some circumstances, landlocked status may be an impediment Growth
to economic growth. Indeed, a direct link from geography to development out
comes is argued by some economists,
7.5.3 Culture
Cultural factors may also matter in influencing the degree of emphasis on
education, postcolonial institutional quality, and the effectiveness of civil society,
though the precise roles of culture are not clearly established in relation to the
economic factors
The idea that culture is a determinant of national wealth is an old one.
Sociologist Max Weber had argued that the rise of a “Protestant ethic,” which
celebrated hard work and the acquisition of wealth, led to an explosion of
economic growth in northern Europe starting in the 16th century. More recently,
economists have pondered over whether the rapid growth of such countries as
Taiwan, Singapore, and South Korea can be explained by their adherence to
“Asian values,” a term coined by The Economist magazine in 1980. Despite these
examples, however, economists have generally not seen culture as a determinant
of development, contrary to anthropologists, sociologists, and historians.
Economists do not wish to analyse culture as it is hard to quantify.
If we have to show that culture is important for economic growth, we have to
show first that culture has potentially important aspects that vary among
countries and second, that these aspects of culture significantly impactt economic
outcomes. Both these things are difficult to show as culture is hard to measure.
Not only does culture have many different dimensions, but even when we restrict
ourselves to a single aspect of culture, we often lack any objective (much less
quantitative) measure and have to rely on the observers’ subjective assessments.
Similarly, in some cases there is direct evidence of culture’s economic effects,
whereas in other cases such effects can only be inferred.
We can just touch upon a few aspects of culture and how it influences economic
growth. Some individual aspects of culture: openness to new ideas, belief in the
value of hard work, saving for the future, and the degree to which people trust
one another. Some broader characterizations of culture could be social capital,
conventions and so on. These broader characterizations will be discussed on the
subsequent course on development economics. Let us discuss some individual
characteristics:
1. Openness to new ideas: Scholars who have examined the historical process
of economic growth have often stressed the importance of a society’s openness to
importing new ideas from abroad. Many of the technologies used in any particular
country were invented in other countries, so a country that more readily adopted
technologies from abroad would be more technologically advanced.
2. Hard work: Throughout human history, in every culture, almost all adults
have had to work to survive. But cultures have differed in their view of that work:
as a necessary evil or as an activity with an intrinsic value. We would expect that
in cultures where work was viewed as good in and of itself, people would work
harder and produce more output.

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 3. Saving rate: A country’s economic growth is strongly affected by its saving
rate. We also saw that there are large differences in saving rates among countries.
If cultural differences among countries affected their saving rates, then these
differences could in turn affect the level of economic growth.
4. Trust: Economic interactions often involve reliance on a person to keep his
word. Without trust, economic activity would be reduced to a crude level, and
huge resources would have to be devoted to making sure that people came through
on their promises. Society would lose the advantages gained by creating complex
organizations — for example, allowing people to specialize in specific tasks or
exploiting gains from trade. Obviously, a society in which one could not rely on
others to hold to their commitments would be poorer.
7.6 PATH DEPENDENCE
We have studied in an earlier section that one of the issues in economics of
development is whether nations converge to a common growth rates. Statements
about convergence tend to include propositions about parameters like investment De
and saving and their relationship with growth. We saw in the previous section that
institutions too have a profound impact on the development process. We can now
ask, is history itself important? What if a country’s history itself, coupled with
people’s expectations about the future, determines not only the institutional
framework but also the parameters of the growth process like saving and
investment? We are looking at the persistence of certain patterns over long periods
and asking why is such persistence present?
People often speak of ‘historical forces’. The question is, how do we take these
into account? One view is that the course of economic development is determined
to a considerable degree on the earlier choices that were made, the basic path that
was chosen. The development process is path dependent. Path Dependence theory
postulates that when we consider the performance of an economy, its position at a
certain point of time depends on the whole sequence of events. The whole path is
important. We need to look at the entire history of the process.
Some economists have put forward the suggestion that certain inferior outcomes
may have got locked-in by historical events. You have studied in the
microeconomics course that equilibrium is usually the result of economic agents
choosing actions and making decisions while acting rationally by maximizing
some objective function. Such equilibria are optimal. However, in reality some
inferior outcomes can sometimes emerge and, moreover, may persist. It is these
situations that path dependence theory addresses. The question it asks is Why do
these situations arise, and how? Moreover, why do they sometimes tend to
continue? Why do rational decision- makers who are supposed to make optimal
choices not take corrective measures? The interesting thing is that these inferior
outcomes emerge even when superior alternatives exist and are available.
One way how this works is through complementarities and network externalities.
We shall explain these concepts with some examples from technology. The
common typing keyboard layout in typewriters and computers usually has the
letters Q, W, E. R. T. Y.... on the top row and this is called a QWERTY-type
keyboard. Now, the earliest typewriters were mechanical gadgets where, when a
key was struck, a lever with the imprint of the letter would rise and strike the
typewriter ribbon that, because it contained the fluid or the ink, the letter would
form on the page. If 2 or 3 keys were hit with quick succession the lever would
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jam. The QWERTY keyboard was designed in such a way as to minimise the
possibility of such jamming by placing the keys that were likely to be struck in
quick succession in terms of spelling of words of the English language were
placed far apart. Thus the QWERTY keyboard was designed to slow down speed.
An alternative keyboard design introduced in 1932 was realised to be better at
promoting speed when it was found that typists trained in the Dvorak system were
regularly beating typists trained in the QWERTY system at speed typing tests.
The question is, why do we then find the inefficient QWERTY-type layout in
most keyboards? The answer is that the QWERTY layout had a historical
advantage of emerging first. Given that firms and organisations hired typists
coming out of typing schools. Given that these typists were already trained in
QWERTY-type keyboard, any individual firm would have found it very costly to
invest in retraining its typists on the Dvorak system. There is now a clear
divergence between individual costs and social gains. This occurs in this case
because there are complementarities and network externalities. Externalities take
the special form of network externalities because of the complementarities. Let us
explain further what network externalities mean. You have already read in the
section of market failure what externalities are. Network externalities mean that
the cost or benefit of adopting a technology or product depends on how many
people already adopted the same technology or product. Say you plan to buy a
mobile phone, because among other uses, you think that sending and receiving
SMS messages would be very useful. But if only two or three other people whom
you know have a mobile, this feature is not going to be too useful. Surely, the
more of your friends and acquaintances already have a mobile, the more useful it
would be to you. This is an example of network externalities. This is very
important in Information and Communication Technology (ICT) like e-mail.
So, to come back to the QWERTY example, we find that complementarities and
network externalities create a situation where a suboptimal choice is made and it
tends to persist. The important thing to realise is that if we were to look at the
average cost (AC) curves (recall from your microeconomics course what these
look like) of the Dvorak system and the QWERTY system, we will find that the
Dvorak system, because it is more efficient, will have its curve downward sloping,
and everywhere below the AC curve of the QWERTY system, which would of
course be downward sloping because of scale economies. But for an individual
firm which wants to make a switch from QWERTY to Dvorak, the relevant costs
(in the two curves) to be compared are at different points corresponding to the
horizontal axis, which measures the number of units (typists trained). On the
QWERTY curve, the point is far too much to the right since QWERTY has been
around for a long time and many typists with QWERTY type training are there.
To switch to Dvorak system, we have to consider a point close to the origin on the
horizontal axis, because it will be first typist for the individual firm .so this point,
on the Dvorak curve will be too much to the left and be of higher average cost
than the QWERTY point.
Although some economists and historians of technology do not agree that the
QWERTY system is inefficient as compared to the Dvorak system, the basic idea
should be clear. There are other such examples. In the 1980s, the format for
videotapes chosen was the VHS although the Betamax system was demonstrably
superior In computer software, although other operating systems may be available,
and may even be superior or cheaper or both, because of complementarities and
network externalities, Windows operating system has become the standard.
Similarly in the case of microprocessors, although other chips like AMD and Determinants of
RISC chips are available, Intel chips have become the industry standard. The Growth
upshot of the discussion is that we find that because of complementarities and
network externalities, there may be multiple equilibria.
Which equilibrium gets chosen — and it may be the inferior one, depends on the
path chosen by history. When complementarities are present, there may occur
historical lock-ins. the same idea can be understood in terms of widespread
coordination failure where large-scale investment does not take place because
other complementary investments are not forthcoming. Because of coordination
failure, each investment is not made because other complementary investments
are not made. Investments would be made if each investor expects others to
invest. Coordination then depends on the expectations of investors. The problem
of coordination can be solved to a great extent if linkages can be created among
various sectors of such a developing economy
Check Your Progress 2
1. What are institutions? Discuss some ways in which institutions determine
economic growth.
2. How do geographical factors influence growth?
3. How do individual aspects of culture impact economic growth?
4. Explain the concepts of path dependence and historical lock-ins.

7. 6 LET US SUM UP
This unit was the last unit in this Block, which dealt with economic growth. The
first four units had focused on various theories and models of growth, while the
current one extended the discussion of the previous four units and sought to
identify the actual determinants of growth.
The unit began by discussing growth accounting. This allows us to break
economic growth down into the proportion that is caused by individual factors of
production like labour and capital, and the proportion that can be attributed to
technological growth. Proceeding ahead, you learnt about the nature of
technology. The unit explained what is meant by embodied and disembodied
technical progress. You were also acquainted with neutral and non-neutral
technical progress. The unit went on to discuss the idea of total factor
productivity, and how productivity is related to efficiency.
Following this, the unit discussed the very important concept called convergence.
In unit 2, you had learnt about development gap between rich countries and
developing nations. This unit examined whether the developing countries are
catching up with the rich ones. The unit explored the idea of whether faster rates
of growth of developing countries as compared to the developed ones will lead to
the convergence of growth rates. The unit discussed about the concept of relative
and absolute convergence..
Finally, the unit briefly discussed certain other determinants of growth. These are
largely non-economic in nature like institutions, geography, and culture,. The
unit suggested that these are often underlying factors that may influence
economic determinants of growth, and as such may be considered as indirect,
albeit underlying determinants of economic growth.
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 7.7 ANSWERS TO CHECK YOUR PROGRESS
EXERCISES
Check Your Progress 1
1. See section 7.2
2. See section 7.3
3. See section 7.3
4. See section 7.4
Check Your Progress 2
1. See sub-section 7.5.1
2. See sub-section 7.5.2
3. See sub-section 7.5.3
4. See Sub-section 7.6.4

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 BLOCK 3 INEQUALITY AND POVERTY
BLOCK 3 INTRODUCTION
The third block of the course is titled Inequality and Poverty. In the first block,
you had studied about the basic idea of what is meant by economic growth and
economic development and the relationship among them. Also you were
acquainted with comparisons among nations The second block familiarized you
with growth models and with the factors that determine growth. This third block
takes up the important issues of inequality and poverty.

The block has two units. The first unit, unit 8 is titled Inequality. The unit
discusses about the concept of inequality, various axioms related to inequality,
and various ways to measure inequality. The title of the next unit, unit 9 is
Poverty. Like the previous unit did about inequality, this unit, too deals with the
concept , measurement and some other issues, but with regard to poverty in this
case.
UNIT 8 INEQUALITY
Inequality

Structure
8.0 Objectives
8.1 Introduction
8.2 Concept of Inequality
8.2.1 Economic Inequality
8.3 Axioms of Inequality
8.4. Measures of Inequality
8.4.1 Personal Distribution
8.4.2 Functional Distribution
8.5 Inequality and Development
8.5.1 Kuznets' Inverted-U Hypothesis
8.5.2 Gary S. Fields' Prediction
8.6 Let Us Sum Up
8.7 Answers/Hints to Check Your Progress Exercises

8.0 OBJECTIVES
After going through this Unit, you should be in a position to:
 Explain the concept of inequality;
 Identify the axioms of inequality;
 Discuss the measures of inequality;
 Critically examine the measures of inequality; and
 Explain the relationship between economic growth and inequality

8.1 INTRODUCTION
Distribution of income in a country has always been an important topic of debate
in all the nations. Economic growth in a country indicates country’s development
but this is not a sufficient indicator of development. If the economic growth
distributes the income in a country more unequally, then there is a role of the
government to try and mend it in a manner that the distribution is more equal than
unequal. We begin with understanding the concept of inequality, in particular the
economic inequality. Afterwards, the axioms which need to be met by the
appropriate inequality index are discussed. There are various indexes which
measure the inequality, some of them are explained. Finally, we discussed the
relation of economic growth and inequality.

8.2 CONCEPT OF INEQUALITY

Why would one be interested in understanding the inequality in the resource
(income/wealth) distribution? There are two reasons: philosophical and ethical

Dr. Nidhi Tewathia, Assistant Professor, School of Social Siences, IGNOU
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Inequality and grounds for aversion to inequality per se and the functional reason.The
Poverty philosophical and ethical grounds meanthat the individuals having different level
of access to lifetime economic resources should not be treated differently for that
reason. Descendants have to face the consequences of the ancestors’ limited
economic resources. On the other hand, parents’ right to bequeath their wealth to
their children also leads to some individual inheriting more than sufficient
wealth. So, it is like two sides of the same coin. Bequeathing wealth seems to be
a good way as well as an unfair means to perpetuate inequality. If one does not
care about inequality at an intrinsic level and just cares about the overall
economic growth, we say that the person cares about inequality at the functional
level. It means the reason for caring about inequality is because inequality has an
impact on economic features which one cares about.
There are many economic interpretations, ideological and intellectual stances of
inequality. Its definition may depend on what stance one takes. Which way one
divides the given cake would be parallel to the way an actual income distribution
deviates from a benchmark for distributing income. Hence, there is a scope of
having different views about the degree and size of inequality, its relevance and
attached policies.
Income conditions are often used as a good proxy for understanding economic
conditions because income is positively correlated to the living standards and
other wellbeing indicators. But only the income inequality does not shape up the
economic inequality. Inequality of opportunities is as important as inequality of
outcomes; they both are related as well. Let us take an example of an individual
who is talented but cannot afford good education which means he is facing
inequalities of opportunities. As a result, he is likely to have a low-income level
which indicates inequality of outcomes.
8.2.1 Economic Inequality
Economic inequality is the fundamental cause that provides diverse choices one
individual and denies to another. It is related to the concepts like lifetime,
capabilities, political freedom, contribution to society. Let us look at few
situations which show us this: There are two individuals, one earning more than
the other but living in a country which denies him freedom like right to vote or
travel. Similarly, one individual earning more than the other till a specific age
and after that earns less than the other individual. So, economic inequality cannot
be well-defined. It depends on whether we are choosing to look at the distribution
of current income, distribution of wealth or distribution of lifetime income. The
current income shows the inequality at a point of time and such inequalities, if
are temporary, are not damaging either from the ethical point of view or the
effect on economic systems point of view. For example, there are two countries
having only two levels of incomes prevailing: in country A $2,000 per month and
$3,000 per month. In country B the income levels are $1,000 per month and
$4,000 per month. Income is more dispersed in country B as compared to country
A. If we look at the average income, it is same in both the countries. Let us say in
country A, people enter their working life at one of the 2 levels of income but
stay there forever. In country B people exchange their jobs each month between
the low-paid job and the high-paid job. If we measure inequality at any one point
in time, country A seems to be more equal but in terms of average yearly income,
each individual earns same amount in country B. It means sticky or fluid jobs
have an implication on understanding the real scenario of income distribution.
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Now let us look at inequality from another perspective. Beyond the importance Inequality
we give to how much people earn we should also try to look at not only how it is
earned. Having this perspective as a background, let us understand what is
functional and personal income distribution. Functional distribution is all about
the returns to different factors of production, such as labour with various skills,
capital equipment of different kinds, land, and so on. These factors of production
are not owned by the individuals in a society in an equal proportion. A given
household receives different categories of income. The pattern and magnitude of
the ownership of factors of production decides the flow of the various categories
of income to a household. Some households will receive only wage income as
they own only their labour. But some households will receive rent, profit and
wages as per their ownership of all three factors of production. When we
combine the functional distribution of income with the distribution of factor
ownership, we reach at the personal distribution of income which describes
income flows to individuals or households and not to the factors of production.
So, we can say that the functional distribution tells us about the relationship
between inequality and growth and for our understanding of economic
inequalities, it is imperative that we understand both how factors are paid and
how factors are owned.

8.3 AXIOMS OF INEQUALITY

We talk a lot about an egalitarian society but it is not an easy endeavour. At a
given time one is facing various alternative income distributions and which one is
relevant and appropriate is a big challenge. The measures of inequality tell us
how to measure but how to rank or order these measures is also to be understood.
Using axioms help to choose among different inequality indexes. The measures
themselves will be discussed in the next section. So, axioms are some desirable
properties or characteristics which these inequality measures/indexes should
possess. Alternate measures then will be able to be compared based on these
axioms. Let us now discuss the axioms which are desirable to be met by the
inequality measures. If the criterion is weak then many inequality measures will
be able to meet that criterion and vice versa.
Axiomatic approach to choose measurement of inequality indicates that we
choose an inequality index because it meets some desirable properties. The 4
axioms which should be possessed by a measure of inequality are: (i) the
anonymity principle; (ii) scale independence principle; (iii) population
independence principle, and (iv) transfer principle.
i) The anonymity principle: this principle states that the inequality measure
does not identify and classify the individuals in to different classes like rich,
poor, good and bad. The measure possessing this axiom will be silent about the
quality of the people.
ii) The scale independence pr inciple: this axiom indicates that size of the
economy does not dominate the measure of inequality. It means that the measure
shall not be based on the fact whether the economy is rich or poor, overall. The
dispersion in the income in the economy is of the interest and not the magnitude.
iii) The population independence principle: this axiom demands that the
measure should not be based on the number of people who receive income. It
means that the measure needs to be independent of the size of the population.
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iv) The transfer principle(the Pigou-Dalton principle): this axiom requires the
inequality measure to change when income transfers occur among individuals in
the income distribution. This means that with a progressive transfer (income
transfer from rich to poor), the inequality index should fall and vice versa in case
of regressive transfers (income transfer from poor to rich).
Check Your Progress 1
1) What do you understand by the term ‘Inequality’? Explain.
2) Discuss Economic inequality.
3) Explain any two axioms which should be possessed by the inequality
measures.
A perspective was discussed in section 8.2, i.e., looking at the concept of
inequality from the lens of personal income distribution and the functional
distribution of income. This section discusses the measures of income inequality
from that perspective.
8.4.1 Personal Distribution of Income
This approach considers the total income earned by an individual. All the
individuals earning same annual income will be considered in the same income
group even if they have invested different number of work hours to earn that
income. Location-based and occupational sources of income are not considered.
An individual earning larger personal income will be considered in higher income
group. Overtime, various measures of inequalities have been developed keeping
personal distribution of income approach in mind. Few are discussed below:
1) Lorenz Curve
Lorenz curve is the most common and widely known measure of income
inequality. An American economic statistician, Prof. Max D. Lorenz proposed this
curve. He utilised this curve to measure disparities in the distribution of income.
This curve is a cumulative frequency graph. It is applied to present data relating to
the population and the wealth distribution in a country. The population and income
components are needed to construct this curve. The figures are required in
percentage terms and then arranged in to a cumulative frequency distribution.
From the origin a straight line is drawn which ends at the coordinate of 100
percent income and 100 per cent of population. This straight line is known as the
Line of equal distribution. This line acts as a benchmark to measure how much of
inequality exists in a country. If actual distribution of income in a country is
coinciding with the line of equal distribution, then it means the country faces no
inequality of income. As the actual distribution curve keeps deviating from the
line of equal distribution, the income inequality keeps rising in a country. Farther
the actual distribution curve from the line of equal distribution, more is the income
inequality.In Figure 8.1, Y-axis represents cumulative percentage of income is
andX-axis representscumulative percentage of population.We draw the line of
equal distribution by joining the 100 per cent points on both the axes. The figure
shows two Lorenz curves for two countries i.e.,country A and country B. The
LorenzCurve relating to country B is further away from the line of equal
distribution ascompared to country A. Hence, we can infer that there are more
disparities in the distribution ofincome in country B than in country A.
 Inequality
100

Line of equal

Cumulative % of Income
distribution

Country B

Country A

0
Cumulative % of Population 100

Fig.8.1 Lorenz Curve

We can observe that the Lorenz curve possesses the principles of anonymity,
population, and relative income, because the curve does not utilise any
information on income or population magnitudes but only retains information
about income and population shares. But there are two problems with it. Mostly
the researchers of policy makers need to look at inequality in the form of a
number because that is more concrete and quantifiable as compared to a graph.
Also, any kind of inequality rankings cannot be provided by the Lorenz curves if
they cross.This means that an inequality measure that provides us with a number
for the income distribution would be perceived as a complete ranking of income
distributions. It would mean that in some situations, inequality measures tend to
disagree with one another.
2) Quintile Distribution
There is away to somewhat handle the non-numerical part of Lorenz curve. The
same underlying information on distribution can be presented in a numerical
format. World Bank favours the idea of arraying the income distribution by
population quintiles (20per cent of the population). For example, the poorest 20
per cent of India's population earns 8 per cent of the total income or the richest
quintile earns 41.4 per cent and so on. When comparing two countries, if one has
greater percentage share of income accruing in at least one quintile below the
highest and is at least equal in the other three below the highest, the country is
said to have 'Lorenz dominance', or to 'Lorenz dominate' the other country.
3) The range
It is a very simple measure to calculate. First, we find out the difference in the
incomes of the richest and the poorest individuals. This difference is then divided
by the mean to remove the dependence on the units in which income is measured.
This is a rather crude measure. It pays no attention to people between the richest
and the poorest on the income scale. From the perspective of the axiomatic
approach, it fails to satisfy the Dalton principle.
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Let us see this with the help of an example. Suppose a small transfer from the
second poorest goes to the second most rich individual. This transfer will keep
the range measure unchanged. Ideally the regressive transfer should lead to a fall
in the inequality index/measure. But we can use the range if the detailed
information on income distribution is missing. It proves to be quite useful.
4) The Kuznets ratios
In his pioneering study, Simon Kuznets introduced developed these ratios of
income distributions in developed and developing countries. These ratios are
basically one step advanced than the quintile distribution. These ratios refer to the
share of income owned by the poorest x% of the population divided by the richest
y% of the population, where x and y stand for numbers such as 10, 20, or 40. If
the ratio is high, it means society is more equal. These ratios come in handy in
situations where detailed income distribution data are missing.
5) The mean absolute deviation
This is the measure that takes advantage of the entire income distribution. It has a
simple idea behind it i.e., inequality is proportional to distance from the mean
income. Hence, we take all income distances from the average income (mean
income), and add them up. Then divide the addition by total income to present
the average deviation. This average deviation will be a fraction of total income.
It is useful to express the deviation in terms of an absolute deviation denoted by
M as the absolute value ignore sthe negative signs. It looks a promising measure
as it takes into account the overall income distribution but it has one drawback: it
is often insensitive to the Dalton principle. Let us see how. Assume there are two
people with the incomes A and B. A is below the mean income of the population
and B is above the mean income of the population which means A < B. If a
regressive transfer (a transfer from poor to rich) takes place, then the inequality
measured by M will rise because the distance of both A and B will go up. Till
now the inequality measure is faring well. Now let us take another case. We take
any two incomes A and B but this time they both are above the mean income of
the population. Again, the regressive transfer takes place from A to B. Let us say
the transfer was small enough so that after the transfer also both the income
levels A and B are above the mean income. There will be no difference in the
sum of the absolute difference from mean income. So, the mean absolute
deviation will not register any change in such a case, and hence the Dalton
principle fails. The Dalton principle is meant to apply to all regressive transfers,
not just those from incomes below the mean to incomes above the mean.
6) Coefficient of Variation
Coefficient of variation (CV) is a relative measure of dispersion of data points
around the mean. It is measured asfollows:
CV = X 100
If we want the measure in the form of decimal then we remove the multiplication
of coefficient by 100. The multiplication by 100 provides us with is the
percentage. This measure require that the income is normally distributed.
Coefficient of variation presents the extent of deviation from the normal
distribution of income. Larger the coefficient of variation, greater will be
inequality in the distribution of income and vice versa.
7) Gini Coefficient Inequality

This measure of inequality is widely used and is a measure of the relative degree
of income inequality in a country. The Gini approach starts from a fundamentally
different base. Instead of taking deviations from the mean income, it takes the
difference between all pairs of incomes and simply totals the (absolute)
differences. It is as if inequality is the sum of all pairwise comparisons of “two-
person inequalities” that can possibly be made. It can be obtained by calculating
the ratio of the area between the line of equal distribution (diagonal 45º line) and
the Lorenz curve divided by the total area of the half-square in which the curve
lies. In Figure 8.2, this is the ratio of the shaded area to the total area of the
triangle BCD, i.e.,

Gini coefficient =

A D

Line of equal
Cumulative % of Income

distribution

Lorenz Curve

B C
Cumulative % of Population
Fig. 8.2 Gini Coefficient
This ratio is known as the Gini Concentration Ratio or the Gini Coefficient, after
the Italian statistician C. Gini, who first formulated it in 1921. It very closely
related to the Lorenz curve Recall that the more “bowed out” the Lorenz curve,
the higher is our intuitive perception of inequality. It turns out that the Gini
coefficient is precisely the ratio of the area between the Lorenz curve and the 45°
line of equal distribution, to the area of the triangle below the 45° line.Gini
coefficients are aggregate inequality measures which can vary from 0 (perfect
equality) to 1 (perfect inequality). It is generally found that if the Gini coefficient
lies between 0.5 and 0.7, then the distribution is a highly unequal distribution.
And if the Gini coefficient is in the range of 0.2 to 0.5, then those countries have
relatively equitable distribution. The Gini coefficient meets all four principles
and is therefore Lorenz-consistent, just like the coefficient of variation.
8.4.2 Functional Distribution
The functional distribution or factor share distribution represents the percentage
of income received by one factor of production in comparison to the income
received by other 3 factors of production. In particular it’s the share of labour
127
in total income compared to the share of total income received in the form of Inequality
rent, interest and profits. The significance of this measure is that it attempts to
explain the income of a factor input in terms of the contribution the factor makes
to the total output. The unit prices of each factor of production are reached at
with the help of supply and demand curves. Each factor market has it own market
where its supplied and demanded. At the equilibrium in these factor markets we
receive the equilibrium prices and quantities of these factors. Factors receives
their rewards on the basis of their function. The drawback of this approach is that
it fails to consider the role and influence of non-market forces on the factors of
production. Non-market forces are those which influence the equilibrium of the
market but not directly like the bargaining power of the trade unions which affect
the wage rate, power of monopolists who manipulate the prices of capital or land.

8.5 INEQUALITY AND DEVELOPMENT

Debate on the relationship between economic development and income
inequality has always prevailed. The effect of economic growth on poverty
depends on the level of economic inequality existing in a country. Economic
growth increases the income inequality if it benefits the rich in a country which
already has high inequality. On the other hand, if the inequality reduces due to
well targeted policies, then the poverty reduction goal seems to be achievable.
Hence, it is important that we understand the link between income inequality
and economic development. The literature on the economic development-income
inequality nexus in industrial societyalso places emphasis on the causes of current
social inequality. But we will explain two main studies which describe what
happens to the distribution of income as a result of economic growth in a country.

8.5.1 Kuznets' Inverted-U Hypothesis

Simon Kuznets, an economist, proposed a particular relationship between the
income distribution and economic growth. He explains the journey of income
inequality when an economy develops from a primarily rural agricultural society
to an industrialized urban economy. He said that the relationship is of an inverted
U. This inverted U curve is known as the Kuznets' curve. The same has been
presented in Figure 8.3.We observe that at the initial levels of economic growth,
the income inequality widens. Afterwards, the inequality stabilises at a given level
of economic growth, and finally falls in the advanced stages of growth.
Y
Degree of Income Inequality

Stage of Economic Development X

Fig.8.3Kuznets’ Curve
129
Inequality and Kuznets says that the widening of income inequality in initial stages of growth is
Poverty due to the structural changes an economy goes through as the growth takes place.
The urban sector receives more weight during that time so the economic activity
takes place in favour of the urban sector characterised by higher productivity. But
in the later stages of economic growth, the relation reverses. As a country
industrialises, the center of the economy shifts from rural areas to the cities as
rural laborers, such as farmers, begin to migrate seeking better-paying jobs.Due
to the influx of rural migrants to the urban areas, the rate of growth in urban
labour becomes high. When the rate of expansion in the urban-high productivity
sector is higher than the increase in the rate of growth of the urban labour force,
the income differentials will reduce as the population in rural areas fall. But this
stage may never be achieved by the nations which experience high rate of
population growth. Early evidence suggests that developing countries appear to
have higher inequality, on average, than their developed counterparts.

But today, the world looks very different than it did in 1955 when Kuznets
proposed the inverted U relationship. In the past decades, economic inequality in
the United States and other wealthy/developed nations has risen sharply which
has induced a renewed the quest to know how the changes in income
distributions affect economic wellbeing. Over the same time period, economic
inequality has persisted and even grown in many poorer economies.
8.5.2 Gary S. Fields's Prediction
Gary S. Fields has offered predictions about how the inequality will behave as
the economic growth takes place. He found the Lorenz curves very relevant and
has used them for his predictions. He discusses three different situations:1)
traditional-sector enrichment growth typology; 2) modern-sector enrichment
growth typology, and 3)modern-sector enlargement growth.
1) Traditional-Sector Enrichment Growth Typology
As the name suggests, the traditional sector workers receive the benefits of
growth, while there is little or no growth taking place in the modern sector. This
kind of pattern will be noticed in those countries which have low incomes as well
as low growth rates and choose to work towards reduction of absolute poverty.
This kind of growth leads to higher-income and hence a more equal relative
distribution of income as well asless poverty. Diagrammatically, it means that the
Lorenz Curve shifts uniformly upward. This new shifted curve will be closerto
the line of equality as shown in Figure 8.4.
2) Modern-sector Enrichment Growth Typology
This kind of growth limits its benefits to the people who are engaged in the
modern sector. The wages and number of workers in the traditional sector
remains more or less constant.It is easy to foresee that this kind of growth results
in higher income only for those who are associated with the modern sector and
that leads to a less equal relative distribution of income andnearly no change in
poverty. Diagrammatically, this growth moves the Lorenz curve
uniformlyoutward and further from theline of equality as shown in Figure 8.5.

130
 Inequality
10 10
% of Income

% of Income
0 % of Income Recipients 0 % of Income Recipients
10 10

Fig. 8.4 Fig. 8.5

FIGURE 8.4 AND 8.5 SHIFTING LORENZ CURVES

3) Modern-sector Enlargement Growth

This is the case, the two-sector economy is developed by increasing the size of
modern sector but maintaining constant wages in both sectors. This is the case
depicted by Lewis model. You will study about Lewis model in course BECC
114. In this type of growth, absolute poverty is reduced, but the Lorenz curves
will always cross and hence we cannot say with certainty about the changes in
relative inequality. Fields believes that if this pattern of growth experience is
predominant, inequality is likely to increase in the initial stages of development
and then it may decrease. This is shown in Figure 8.6.In the figure two Lorenz
curves intersect each other. This happens because the poor who remain in the
traditional sector have their incomes unchanged, but these incomes are now a
smaller fraction of the larger total, so that the new Lorenz Curve, L2, lies below
the original Lorenz curve, L1, at the lower end of the income distribution scale.
Workers associated with the modern sector receive the same absolute income as
before, but now the share received by the richest income group is smaller, so that
the new Lorenz curve lies above the original one at the higher end of the income
distribution scale. Therefore, somewhere in the middle of the distribution, the
new and the original Lorenz curves must cross.

131
Inequality and
Poverty 100

% of Income L1
L2

0
% of Income Recipients 100

Fig. 8.6 Crossing Lorenz Curves

In a nutshell, Gary Fields says,

• with traditional-sector enrichment inequality would fall gradually;
• with modern-sector enrichment, inequality would rise gradually;
• with modern-sectorenlargement, inequality would first fall and then rise.

Check Your Progress 2

1) Explain what is Lorenz Curve with the help of a diagram.
2) Discuss the following measures of inequality: a) Range b) Coefficient of
variation.
3) What was the hypothesis presented by Simon Kuznets? Discuss his work
in relation to inequality and economic growth.
4) Mention the drawbacks of any two inequality measures.
5) Explain the functional distribution measure of inequality.

8.6 LET US SUM UP

Inequality is a concept which has to be dealt by all the countries. We began the
unit by discussing the concept of inequality with specific reference to economic
inequality. The personal income distribution and functional distribution are two
perspectives from which we can understand the concept of inequality. To
measure the inequality, one needs some kind of measures. These measures will
be able to justify their role only if they meet certain axioms. We explained four
axioms (the anonymity principle; scale independence principle; population
independence principle, and transfer principle) which are very important in order
to measure inequality in any country.
132
 Inequality
Afterwards we discussed the measures such as the Lorenz curve, Gini coefficient
at length. The relationship of economic growth and inequality was also examined
with the help of famous Kuznets curve predictions of Gary S Fields. The
economic growth increases the inequality initially and at later stages of growth,
the inequality reduces.

8.7 ANSWERS/HINTS TO CHECK YOUR

PROGRESS
Check Your Progress 1
1) Refer section 8.2
2) Refer sub-section 8.2.1
3) Refer section 8.3

Check Your Progress 2

1) Refer sub-section 8.4.1
2) Refer sub-section 8.4.1
3) Refer sub-section 8.5.1
4) Refer sub-section8.4.1
5) Refer sub-section 8.4.2

133
UNIT 9 UNDERSTANDING POVERTY
Structure
9.0 Objectives
9.1 Introduction
9.2 Concept and Meaning of Poverty
9.3 Types of Poverty
9.4 Poverty Line
9.5 India’s Poverty Line Estimation
9.6 Poverty Alleviation Programmes in India
9.7 Let Us Sum Up
9.8 Answers/Hints to Check Your Progress Exercises

9.0 OBJECTIVES
After going through this Unit, you should be in a position to:
 Explain the concept of poverty and its various dimensions;
 Identify the characteristics of poor ;
 Discuss the poverty line (national and international);
 Critically explain the recommendations made by various poverty expert
groups ;
 List a few poverty alleviation programmes in India

9.1 INTRODUCTION
In the year 2000, the General Assembly of the United Nations adopted a set of
Millennium Development Goals which contains eight such goals. The first one
itself is to eradicate extreme poverty and hunger. This indicates that poverty
reduction is the prerequisite for any country which wants to provide its citizens
with good quality of life. In this unit, we first discuss the concept of poverty. This
Unit begins with explaining the various approaches to the concept of poverty and
its types. Various correlates of poverty and characteristics that are widely shared
by poor individuals are explained. Further the concept of poverty line has been
discussed followed by the progression of India’s Poverty Line estimation. A
critical view has been taken up in order to provide you the complete picture of
the recommendations of various committees which were constituted for the task
of poverty estimation in our country. The unit concludes by discussing the main
poverty alleviation programme of India: Integrated Rural Development
Programme.


Dr. Nidhi Tewathia, Assistant Professor, School of Social Siences, IGNOU
Inequality and
Poverty
9.2 CONCEPT AND MEANING OF POVRTY
We always welcome the economic growth that spreads its benefits equitably
among the population. If the growth is distributed unequally then it needs to be
assessedin terms of equity. First, there exists an inequality of world income
distribution and then there is the inequality of income distribution within a
country. If a country is under developed then the most visible characteristic of
that country will be the existence of poverty. It is not easy to describe poverty
and its related dimensions (illiteracy, hunger, ill health, capability deprivation),
head on. Poverty is like a threat to the existence of individuals who are poor. It
destroys the aspirations, hopes and potential joy of good health and nutrition.
Poverty also indicates the absence of productive asset holdings, like possession
of land. Hence, the basic implication of poverty is that the poor will lack access
to markets, particularly the markets for credit, insurance, land, and labour. The
absence of collateral restricts their access to credit markets. This leads the
individual to the Poverty Trap. This trap makes it very difficult for a poor
individual to escape poverty as some amount of capital possession is required in
order to escape. Low wages, low work opportunities, inability to pay for
education are all causes of poverty trap. Poverty trap is a spiral which forces
people to remain poor.
Poverty as a concept is of high significance, both intrinsic and functional.
Further, it holds importance from the policy making view as well. It is a common
knowledge that a fundamental goal of economic development and of all
governments is the removal of poverty. Hence, the characteristics of the poor
need to be understood well. That helps in structuring the appropriate measure of
poverty by the policy makers. Poverty is also an outcome of economic
development which needs to be dealt with through various policies.
One view of looking at the concept of poverty is in relation to economic growth.
As a result of economic growth, the average consumption and average income
rise. It impacts poverty as the distribution of income and consumption will
change. If everyone’s income increases then we can say that the poverty reduces.
But if the economic growth only increases the incomes of the rich (still meaning
that the average income is increasing), no reduction in poverty will take place. In
fact, the distribution of income widens.
Another perspective to look at the concept of poverty is through the work of
Amartya Sen. His work is based on the relation of poverty with capability
deprivation. Individuals are deprived of capability building if they are poor. For
example, poverty denies the opportunity to gatherthe school experience which
would lead to yet another type of poverty. Such individuals will not beable to
read and write. That means they will not be able to participate in the activities
which need literacy. Only those individuals who are literate will be able to
capture the benefits of those opportunities. It is also important to look at poverty
as per the society/economy where the individual lives. Individuals are also poor if
they lack resources to participate in the society where they live, even if they have
136
enough incomes to lead their life nicely in some other society. But poverty is not Poverty
only the inadequacy of income, its domain is much wider. Poverty not only
includes not having enough income to guarantee adequate food, clothes, or
shelter, but also being unhealthy, as well as being denied access to education,
political participation in the society.International institutions like the World Bank
and the United Nations go beyond the measurement of the number of people
whose income is low. They, in addition,give importance to health, such as infant
and child mortality rates and the life expectancy, and to participation in
education. This means that the poor people in the world are poorer, and rich
people are richer because income is positively related with the above-mentioned
aspects of well-being. So, we can say that the Africans, in addition of having less
money have lower life expectancy and low level of educationas compared to
Europeans and Americans. If we look at a within country scenario, same holds.
Within acountry, poorer people are more likely to be malnourished and
unhealthy, to lose their babies and to have low life expectancy. This within
country scenario is true for both the rich countries of Europe as well as the poor
countries of Asia and Africa. Hence, to gain a wider view of poverty, a more
complete picture of deprivation and inequality should be considered.

9.3 TYPES OF POVERTY

Depending upon different viewpoints, poverty can be analysed as follows:First
classification refers to the type of base information used:Objective and
Subjective poverty; Second is depending on the scale or reference used to set the
thresholds:Absolute and Relative poverty; Third is based on the length of
duration of poverty: Transversal poverty (in a fixed year) and Persistent poverty
(Long term).
The studies which use the information directly collected by a researcher in terms
of the measurement of various variables are called Objective poverty studies. The
direct observation of a researcher provides high degree of objectivity. The
commonly used variables by researchers are household income and household
expenditure.On the other hand, the perception of the individuals or households
about their own self converts into Subjective poverty studies. Information on the
opinion of these individuals or household is used to understand poverty. Such
studies influence the subjective view on poverty as opposed to the objective
focus.
Absolute povertyindicates a situation when an individual is not able to afford
basic goods and services like food, housing and clothes. It is also linked to
destitution. It is difficult to find ways of measuring absolute poverty. Relative
poverty places the concept of poverty in relation other people around. A person is
considered poor when he/she is at a disadvantage (financially or socially) as
compared to other people in their environment. This idea of poverty is closely
linked to the notion of inequality. A person’s income level or affordability may
change over time. Hence, poverty is not a static phenomenon.Individuals move in
and move out of poverty. So, it is crucial to conductdynamic poverty studies
137
Inequality and which analyse a population considering the various changes and transitions that
Poverty
take place over a period of time. This is the context of persistent or long-term
poverty analyses.In European Union countries, a person is considered persistently
poor if they have been classified as poor in the last year and at least during two of
the three previous years.Transversal poverty studies deal with a fixed time period
for which the analysis is carried out.
Another type of poverty is from a completely different perspective. The poverty
studies based on this perspective focus on multi-dimensional deprivation i.e.,
analyses based mainly on the impossibility of access to certain basic consumption
elements. This perspective has been discussed in the previous section. Such
studies mainly stress on the social exclusion of an individual due to poverty in a
multi-dimensional manner.
Check Your Progress 1
1) Discuss the various features of poverty.
.......................................................................................................................
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.......................................................................................................................
.......................................................................................................................
2) How is poverty related to capability deprivation?
.......................................................................................................................
.......................................................................................................................
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.......................................................................................................................
3) Explain any two types of poverty.
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9.4 POVERTY LINE

At the core of the concept of poverty is a notion which is called a poverty line. It
is a critical threshold ofincome, consumption, or access to goods and services.
Individuals falling below this lineare declared poor. For example, to reach at an
estimate of the poverty line, we will need data on minimum nutrient levels which
make an adequate diet. Once that is done, we will use the prices of those food
items which provide those nutrients and the cost of clothing and shelter at a
minimum level to find out the total expenditure needed to fulfil these needs. This
total expenditure needed for fulfil the basic requirements will act as an estimate

138
of the poverty line in a given society. We can say that the poverty line is an Poverty
indicator of the minimum level of economic participation in a given society at a
particular time. The minimum wage in a given country is a legally decreed
estimate of a poverty line.
Link between hunger and poverty is strong. Many countries have nutrition-based
poverty lines. United States estimates poverty line based on food requirements. In
India, the poverty line estimate is based on the food expenditure necessary to
afford the minimum consumption of calories.It is a tradition to set the poverty
line as per the cost of a particular standard of living given a country. A major
component of poor’s income gets spent on the food requirements. So, if they do
not have enough money, it would mean like sleeping without sufficient food.The
general norm which many countries follow when they estimate the poverty line,
is by looking at a calorie norm of around 2000 calories a day. But this estimate is
gender and work sensitive. As agricultural labour works physically harder, so in
that case the calorie norm is revised upwards. Similarly, separate standards are
employed for men, women and children.The association of food and poverty
looks like an attractive one.Not only because poor people spend majority of their
budget on food, but also because this association gets more support politically for
the antipoverty programs which involve food as compared to the programs based
on goods which are seen as less admirable. The right to food is more convincing
than the right to other consumer goods.
Over the time, the basic concept of poverty line has remained the same but the
line is revised incorporating the inflation levels. Using the data for the year 2005,
the World Bank estimated the International Poverty Line (IPL), a global absolute
minimum, at the $1.25 per day figure. It was updated in the year 2008 to $1.25 a
day at 2005 purchasing-power parity (PPP). It was mainly revised due to
inflation. Further, in 2015, the World Bank updated the IPL to $1.90 per day.As
per the World Bank, in 2017, an estimated 9.2 percent of the global population
still lived below the international poverty line of $1.90 a day, which is based on
poverty lines in some of the poorest economies in the world. The COVID-19
pandemic has reversed the gains in global poverty for the first time in a
generation. About 120 million additional people are living in poverty as a result
of the pandemic (April 2021).
It is also important for us to realise that the concept of poverty line always uses
approximations and proxies. The threshold thus arrived at is fuzzy in nature. The
year after year deprivation shows its cumulative effect in later years. There are
some other issues with the concept of poverty at the fundamental level, e.g.,
should income or item-by-item expenditure be used to identify the poor, are
notions of the poverty line “absolute” or “relative,” is poverty temporary or
chronic, should we study households or individuals as the basic unit, and so on.

139
Inequality and
Poverty
9.5 INDIA’S POVERTY LINE ESTIMATION
This section provides the progression Poverty Estimation in India, post-
Independence. The Planning Commission constituted various expert groups time
to time to estimate the number of people living in poverty in India.
1. Working Group (1962): For the first time, the poverty line in India was
quantified in 1962 in terms of a minimum requirement which included
food and non-food items, for individuals in order to lead a healthy life.
This Group formulated rural and urban poverty lines at 20 and 25 per
capita per month respectively (in terms of 1960-61 prices). The Group did
not consider any regional variation while formulating these lines. This
poverty line also excluded expenditure on health and education as it was
assumed to be taken care of by the state. So, in 1960s and 1970s these
poverty lines were used to find out the state of poverty at national and
state level.

2. Study by VM Dandekar and N Rath (1971): These two economists are

responsible for laying the foundation of India’s poverty line through their
seminal work by establishing the minimum calorie requirements. This
was not a study commissioned by the Planning Commission. They
established the first consumption levels required to meet a minimum
average calorie norm of 2,250 calories per capita per day. Their study was
systematic wherein they utilized the National Sample Survey (NSS) data.
Their poverty line was based on the expenditure required to procure 2250
calories per day in both rural and urban areas. They found poverty lines to
be Rs. 15 per capita per month for rural households and Rs. 22.5 per
capita per month for urban households at 1960 61 prices.

3. Task Force on “Projections of Minimum Needs and Effective

Consumption Demand” headed by Dr. Y. K. Alagh (1979): This Task
Force was constituted in 1977 and it submitted its report in 1979. Official
poverty counts began for the first time in India based on the approach of
this Task Force. Poverty line was defined as the per capita consumption
expenditure level to meet average per capita daily calorie requirement of
2400 kcal per capita per day in rural areas and 2100 kcal per capita per
day in urban areas. Based on 1973-74 prices, the Task Force set the rural
and urban poverty lines at Rs. 49.09 and Rs. 56.64 per capita per month at
1973-74 prices.

4. Lakdawala Expert Group (1993): Until the 1990s, no attempt was made
to consider differences in prices or differences in consumption patterns
across states or over time, w.th respect to poverty lines estimation.
Poverty estimates were revised with each quinquennial NSS survey. Price
indices were used to adjust for price changes over time. This
methodology for estimating poverty was considered inappropriate by
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 some, in giving a representative picture of the incidence of poverty in the Poverty
country. So, in 1989, The Planning Commission constituted the
Lakdawala Expert Group with a particular reason of looking into the
methodology for estimation of poverty and to re-define the poverty line, if
needed. The Expert Group did not redefine the poverty line and
recommended to carry on with the separate rural and urban poverty lines
based on minimum nutritional requirements. But the Expert Group
disaggregated these poverty lines into state-specific poverty lines in order
to reflect the inter-state price differentials. It suggested that the poverty
lines should be updated using the Consumer Price Index of Industrial
Workers (CPI-IW) in urban areas and Consumer Price Index of
Agricultural Labour (CPI-AL) in rural areas rather than using National
Accounts Statistics. These recommendations were taken up by the
Planning Commission. The Commission adopted the practice of
calculating poverty levels in rural and urban areas in the states using
state-specific poverty lines together with the national estimates from 1997
to 2004-05. But over the years, this method lost the credibility. There
were many flaws in the price data. Hence, the successive poverty lines
failed to preserve the original calorie norms.
5. Tendulkar Expert Group (2009): To review the methodology used for
poverty estimation, in 2005, another expert group chaired by Suresh
Tendulkar was constituted. Mainly, it was constituted to address the three
key shortcomings of the previous methods: (i) Poverty estimates based on
the 1973-74 poverty line baskets (PLBs) of goods and services did not
reflect significant changes in consumption patterns of poor over time; (ii)
Issues with the adjustment of prices for inflation, across regions and
across time; and (iii) the assumption that only the state will provide for
health and education. The Tendulkar Committee suggested a shift from
calorie-based norms to target nutritional outcomes for poverty estimation
and poverty lines. Further, the committee recommended a uniform all-
India urban PLB across rural and urban India instead of two separate
PLBs for rural and urban poverty lines. It also recommended to
incorporate private expenditure on health and education in order to
estimate poverty. The monthly household consumption expenditure was
broken up into per person per day consumption, which resulted in the
figure of Rs 32 and Rs 26 a day for urban and rural areas. The national
poverty line for 2011-12 was estimated at Rs. 816 per capita per month
for rural areas and Rs. 1,000 per capita per month for urban areas.
6. Rangarajan Committee (2014): The Tendulkar committee made the urban
poverty line of 2004-05 the new national poverty line on the grounds that
it was “less controversial” than the current rural poverty line and it
fulfilled the requirement of statistical consistency over time. This
increased the number of rural poor.This new poverty line was also
justified on the grounds that it also provided for minimum nutritional,
141
Inequality and health and educational outcomes. These justifications were not enough to
Poverty
stand up to the scrutiny. Due to such criticism as well as due to changing
times and aspirations of people of India, Rangarajan Committee was set
up in 2012. This Committee submitted its report in June 2014. It again
started the previous practice of having separate all-India rural and urban
poverty line baskets and deriving state-level rural and urban estimates
from these. Also, it recommended separate consumption baskets for rural
and urban areas which include food items that ensure recommended
calorie, protein & fat intake and non-food items like clothing, education,
health, housing and transport. This committee raised the daily per capita
expenditure to Rs 47 for urban and Rs 32 for rural from Rs 32 and Rs 26
respectively at 2011-12 prices. Monthly per capita consumption
expenditure of Rs. 972 in rural areas and Rs. 1407 in urban areas is
recommended as the poverty line at the all-India level. The government
did not take a call on the report of the Rangarajan Committee. Rangarajan
committee missed the opportunity to go beyond the expenditure-based
poverty rates and examine the possibility of a wider multi-dimensional
view of deprivation.
Some states such as Odisha and West Bengal supported the Tendulkar Poverty
Line while others such as Delhi, Jharkhand, Mizoram etc. supported Rangarajan
report. The current official measures of poverty are based on the Tendulkar
poverty line. They are fixed at daily expenditure of 27.2 in rural areas and
33.3 in urban areas and are criticised by many for being too low.
7) Task Force by Niti Ayog (2015): The Task Force deliberated the issue of
whether a Poverty Line is required. The report of the Task Force was submitted
in July, 2016. The task force suggested four options for tracking the poor: i)
Continue with the Tendulkar poverty line; ii) Switch to the Rangarajan or other
higher rural and urban poverty lines; iii) Track progress of the bottom 30% of the
population; iv) Track progress along specific components of material poverty
such as nutrition, housing, drinking water, sanitation, electricity and connectivity.
The advantage of the level of expenditure as an indicator of poverty is that it is
directly observable and it closely correlates with poverty along different
dimensions. So, while there are additional complementary approaches to tracking
poverty, none of them can substitute the poverty line-based approach.

9.6 POVERTY ALLEVIATION PROGRAMMES IN

INDIA
There are many poverty alleviation programmes in India which target the rural
poverty mainly, as the prevalence of poverty is more in rural India. The
programmes include many wage-employment programmes, self-employment

142
programmes, food security programmes, social security programmes, skill India Poverty
programmes. A brief list of such programmes is as follows:
 Jawahar Gram Samridhi Yojana
 National Old Age Pension Scheme
 National Family Benefit Scheme
 Annapurna Scheme
 Pradhan Mantri Gramin Awaas Yojana
 Mahatma Gandhi National Rural Employment Guarantee Act
(MGNAREGA)
Apart from these, a major programme started by India to alleviate rural poverty
is Integrated Rural Development Programme (IRDP). It aims to alleviate rural
poverty by providing income-generated assets to the poorest of the poor. This
programme started in 1978-79. Its main aim is to identify the families which are
below the poverty line and raise them by creating sustainable self-employment
opportunities in the rural areas. Such families are provided with term credit by
commercial banks, cooperatives and regional rural banks. The programme
gathers 50% funds from the centre and the remaining 50% from the states. The
target group are the individuals who earn less than 11,000 (as defined by the
Eighth Five-year plan). To make the programme well targeted, it has stipulated
well defined proportions for the scheduled caste families, scheduled tribe
families, women and physically challenged persons among the total assisted
people/families. Ministry of Rural Areas and Employment is responsible for the
release of central share of funds, policy formation, overall guidance,
monitoring, and evaluation of the program.
Check Your Progress 2
1) Explain the concept of Poverty Line.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
2) Discuss the progression of the International Poverty Line.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

143
Inequality and 3) What were the recommendations of The Tendulkar Committee and how
Poverty
are they different from the recommendations made by the Rangarajan
Committee?
4) Why was the Tendulkar committee criticised for their recommendations?
5) Enlist a few Poverty alleviation programmes of India?

9.7 LET SUM UP

Poverty is not merely the lack of money. It is the absence of one or more of the
basic capabilities that are needed to achieve minimal functioning in the society in
which one lives.But largely, the measurement of poverty is based on thenotion of
a poverty line, which is constructed from monetary estimates of minimum needs.
In this Unit, we discussed the various approaches through which poverty can be
looked at (monetary, food, capability deprivation). We explained the various
types of poverty (Absolute, Relative, Objective, Subjective, Transversal and
Persistent). Afterwards, the constitution of poverty line was discussed at length.
The poverty line estimates minimum basic requirements in terms of their cost.
We critically explained the recommendations of various expert
groups/committees which were constituted for India’s poverty line estimation. In
the end, we briefly discuss the main poverty alleviation programmes in India.

9.8 ANSWERS/HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1 Check Your Progress 2
1) Refer to section 9.2 1) Refer to section 9.4
2) Refer to section 9.2 2) Refer to section 9.4
3) Refer to section 9.3 3) Refer to section 9.5
4) Refer to Section 9.5
5) Refer to Section 9.6

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BLOCK 4 POLITICAL INSTITUTIONS AND
FUNCTIONING OF THE STATE

BLOCK 4 INTRODUCTION
The final block of the course is titled Political Institutions and Functioning of
the State. In the first block, you had studied about the basic idea of what is
meant by economic growth and economic development and the relationship
among them. Also you were acquainted with comparisons among nations. The
second block familiarized you with growth models and with the factors that
determine growth. The third block discussed the important issues of inequality
and poverty.

The present block has three units. The first unit of the block, unit 10, is titled
Institutions and Evolution of Democracy. The unit discusses alternative
institutional trajectories and their relationship with economic performance. The
unit also discusses within-country differences in the functioning of the State
institutions and the relationship between democracy and development. The title
of the next unit, unit 11 is Theories of Regulation. This unit discusses the
concept of economic regulation and examines the arguments for regulation. It
also describes two broad theories that explain and discuss economic regulation.
Finally the unit shows how sometimes the economic organizations or firms that
are being regulated, themselves capture the regulatory process and get benefits
from the regulation process. The final unit of the block, which is the final unit of
this course, unit 12 is titled Government Failure and Corruption. The unit
examines the role of state in the economy, particularly the economy of a
developing nation, in response to market failure, and also to perform certain roles
that may be particularly required for developing nations. The unit also discusses
how in certain situations the government may ‘fail’ in terms of creating outcomes
where economic efficiency is reduced. Finally the unit discusses a problem that
plagues the institutional and government functioning in several developing
nations, namely, corruption.

147
 UNIT 10 INSTITUTIONS AND DEMOCRACY
Poltical Institutions
and the Functioing of
the State
Structure
10.0 Objectives
10.1 Introduction
10.2 Institutions and Evolution of Democracy
10.3 Alternative Institutional Trajectories
10.3.1 External Government Institution
10.3.2 Private Property Rights
10.3.3 Community Institution

10.4 Functions and Pre-requisites of an Institutions

10.5 Institutional Trajectories and Economic Performance
10.5.1 Institutions in India and Economic Growth

10.6 Let Us Sum Up

10.7 Answers/Hints to Check Your Progress Exercises

10.0 OBJECTIVES
After going through this Unit, you should be able to:
 Explain the evolution of institutions and democracy;
 Discuss the alternative institutional trajectories;
 Identify the pre-requisites of a sound institution;
 Discuss the functions of an institution; and
 Explain the role of institutions in economic growth of a country

10.1 INTRODUCTION
The institutional infrastructure is not constructed overnight. It is a far complex
task. It remains in formal and informal manner in a given society. The culture
and the moral fibre of the individuals influence the outcome of an institution in a
country. We begin this unit by explaining the situations which demand the
existence of an institution, the need for institutions and how individuals and an
institution are related. Afterwards, we learn about the alternative institutional
trajectories in terms of state institutions, private property rights and community-
based institutions. To understand about an institution, it is imperative to learn
about the objectives, functions or pre-requisites for a sound institution. In the


Shri Saugato Sen Associate Professor of Economics, IGNOU, New Delhi
148
latter half of the unit we discuss the relationship of institutions and economic Institution and
Democracy
development of a country with brief reference to the reforms in India.

10.2 INSTITUTIONS AND EVOLUTION OF

DEMOCRACY
The common perspective views institutions as rules. This perspective also
stresses that the new institutions represent and reflect the interests and reasoning
of economic or political agents. The perspective generally remains that one
exogenous set of institutions to explain subsequent ones. As per Douglass North
(1990, p. 3), Institutions are the rules of the game in a society or, more formally,
are the humanly devised constraints that shape human interaction. Let us look at
the evolution of institutionalism which emphasizes the importance of
environmental forces.
The popular and commonly observed phenomenon known as Tragedy of
commons was not first noticed by Hardin. Aristotle observed it a long time ago
that each individual thinks mainly of his own and not at all about the common
interest. The least care is given to the factors or resources which are common to
the greatest number of individuals. This leads to situations of conflict and men
land up fighting with each other as their primary objective remains to seek their
own good.
Another phenomenon observed is the Prisoner’s Dilemma. It challenges a
fundamental faith that rational human beings can achieve rational results. This
challenge is largely due to the paradox that in a game of prisoner’s dilemma all
the individuals choose rational strategies (individually) but those strategies are no
good for a collective outcome because the collective outcome turns out to be
irrational. In the game of Prisoner’s Dilemma, the players have complete
information and communication among the players is impossible or irrelevant as
it is not included in the model of this game. The verbal agreements, if any, are
generally non-binding.
Some believe in the logic of collective action. To govern the natural resources
which are used by many individuals, the state control is recommended. This can
be easily observed in many scholarly articles about “tragedy of commons”. These
recommendations are mainly in order to prevent destruction of the natural
resources. But there are many who suggest privatising these resources to resolve
the problem of common use of these resources.Both the regimes have their own
pros and cons. It is not easy to enable the individuals to sustain long-term,
productive use of natural resource systems. In the past, many communities of
individuals have trusted on institutions which do not resemble to the state or to
the market, in order to govern some resource systems. This regime has shown
reasonable degrees of success over long periods of time.
The goods which are commons like the natural resources allow the benefits to all
and exclusion is not possible. Further, it does not provide any incentive to the
individuals to contribute towards the provision of such goods. The logic here is
149
Poltical Institutions that the individuals are rational and display self-interested behaviour, hence the
and the Functioing of
the State
group of such individuals should also display the same but the outcome of group
behaviour is chaos or destruction.
The tragedy of the commons, the prisoner's dilemma, and the logic of collective
action are closely related concepts. A common problem which all these three
models face is the free rider problem. As mentioned earlier, the natural resources
are such in nature that individuals cannot be excluded from receiving their
benefits. This leads to an incentive for not paying for receiving such benefits and
to just free ride on the efforts/payments made by others. Eventually, we reach to
a possibility where all choose to free ride and the benefit in question cease to
exist.
There are many factors to consider while devising an institution in order to
manage the common resources. Design principles of the institutions, reasons of
continued incentive for participation in terms of effort in the governance and
management of the such resources, internal and external factors that hinder or
improve the individual capabilities. The whole exercise of organising the
collective action must address a common set of problems. This set includes
problems like coping with free-riding, solving commitment problems and
monitoring individual compliance with sets of rules. Solving such problems
contribute to an understanding of how individuals address these crucial problems
in some other settings as well. Different behaviour pattern affects the way
alternatives are perceived and weighed. Generally, those actions are not included
in the set of strategies to be considered for policy formulation or institutions
which are considered wrong among a set of individuals interacting together over
time.
These three models discussed above and their many variants are diverse
representations of a broader and still-evolving theory of collective action. Many
policies are formulated on the basis of these models but the use of the models
have been eventually only a metaphorical use. Much more work will be needed
to develop the theory of collective action into a reliable and useful foundation for
policy analysis.
The word ‘democracy’ originally comes from the Greek language. It is made of
two words: ‘demos’ meaning whole citizen living within a particular city-state
and ‘kratos’ meaning power or rule. It is generally agreed that liberal
democracies are based on four main principles:
 A belief in the individual: since the individual is believed to be both
moral and rational;
 A belief in reason and progress: based on the belief that growth and
development is the natural condition of mankind and politics the art of
compromise;
 A belief in a society that is consensual: based on a desire for order and co-
operation not disorder and conflict;
150
  A belief in shared power: based on a suspicion of concentrated power Institution and
(whether by individuals, groups or governments). Democracy

The institutions which we discuss in this unit are based on more than one
principle of democracy mentioned above.

10.3 ALTERNATIVE INSTITUTIONAL

TRAJECTORIES
The existing literature indicates there are many ways to organise such activities
with the help of institutions and policies. In Leviathan (1651), Hobbes says that
there is one alternative to solve the problem of the commons dilemma. He says
either there has to be a private enterprise system or socialism. If the ruin or chaos
is to be avoided in a crowded world then the people must be responsive to a
coercive force outside their individual psyches. Such a force is termed as a
'Leviathan’ by Hobbes.
10.3.1 External Government Institution
The presumption that external Leviathan is necessary to avoid tragedies of the
commons, leads to suggestions that central governments control most natural
resource systems. The absolute power of the sovereign was ultimately justified
by the consent of the governed, who agreed, in a hypothetical social contract, to
obey the sovereign in all matters in exchange for a guarantee of peace and
security. Some believe that "iron governments," perhaps military governments,
would be necessary to achieve control over ecological problems. In other words,
if private interests cannot be expected to protect the public domain, then external
regulation by public agencies, governments, or international authorities is
needed. In case of having an external government agency, the specific herding
strategy considered best as per the available commons, will be decided by the
central authority. This authority will also decide who uses the commons, when
they use it and how many animals can be grazed (in case of common
meadows).But this centralised government agency can only achieve optimal
efficient equilibrium if it accurately measures the capacity of a common pool
resource, assigns this capacity unambiguously, monitors actions regularly, and
takes strict actions against noncompliance. Beyond this, an important factor to
consider is the cost of creating and maintaining such an agency, which hardly is
given a thought. To achieve optimal equilibrium, the centralised agency needs to
work very hard and it is easy to not have enough information on which is based
the achievement of optimal equilibrium. Suppose the government does not have
accurate information about the availability of commons up for use. In that case
the agency will land up making errors in formulating the blueprint of the use of
that common. The implications of incomplete information can be highly
impacting. So, we can say that it is difficult for a central authority to have
sufficient time-and-place information to estimate accurately both the carrying
capacity of a common and the appropriate fines to induce cooperative behaviour.

151
Poltical Institutions 10.3.2 Private Property Rights
and the Functioing of
the State The other group of policy analysts is also influenced with the same three models
we discussed earlier but they believe in clearly defining the private property
rights over the resources owned in common by all.The group suggests that the
central authority should give out ownership rights to the resource first and then
allow individuals to pursue their own self-interests within a set of well-defined
property rights. They say that the establishment of full property rights is
necessary to avoid the inefficiency of overuse of the commons. If one has right
over the resource then the buying/selling of the resource will take place as per the
terms prevailing in the market. The prices will be reached at by the forces of
demand and supply of that resource. But it is common knowledge that the
markets for private goods also do not function efficiently at times. The
equilibrium prices at times do not signal the true scarcity of the resource. Welfare
loss may occur for some while some may benefit. Moreover, there is no one rule
in order to decide who gets the property rights.

10.3.3 Community Institution

We have noticed that some experts have oversimplified the issue at hand. They
believe that only state-established institutional arrangements could sustain the
common resources in the long run i.e., centralized government and private
property right (discussed in section 10.2). Further they believe that the
individuals who use these resources are trapped in a commons dilemma and
hence cannot provide any solutions on their own. These experts have missed
what we have mentioned in the earlier section that many communities and social
groups have been successfully able to manage the commons against the threats
like resource degradation. They are able to do so by developing and maintaining
self-governing institutions.

Human has been observed to affect natural resources of a nation and human
institutions affect the resilience of the environment. Locally evolved institutional
arrangements governed by stable communities and buffered from outside forces
have sustained resources successfully for centuries. Such community-based
institutions often fail as well when rapid change occurs. It is difficult to manage
the ideal conditions which are needed for successful governance. Significant
problems exist like trans-boundary pollution, tropical deforestation, and climate
change. These problems are at larger scale and local communities are not
successful in addressing them. A major challenge faced by the policy makers is
in terms of developing theories about human organisation which should be able
to deal with variety of situations (like tragedy of commons) and assess the human
capabilities and limitations on a realistic scale.

152
There is one similarity in the views of both centralization advocates and Institution and
Democracy
privatization advocates. They both accept that institutional change must come
from outside and be imposed on the individuals affected. Despite the common
view on the relevance of existence of the central authority, the institutional
changes they recommend could hardly be unrelated. Let us see how. If we look at
a competitive market which is made up of private institutions/players, we notice
that any individual producer can enter or exit the market at any time without
thinking about the cost of the existence of that market or of maintaining the
market, because the market simply exists for that producer. In a manner this
competitive market is like a public good. Any given market needs the support of
the public institutions in order to exist. In reality, the public and private
institutions are inter-dependent and do not exist in isolation.
Check Your Progress 1
1) List the four liberal principles of Democracy.
.......................................................................................................................
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.......................................................................................................................
.......................................................................................................................
2) Explain the concept of tragedy of commons and the Prisoners’ dilemma.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
3) List any four factors which should be considered while devising an
institution.
.......................................................................................................................
.......................................................................................................................
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.......................................................................................................................
4) Discuss any two institutional trajectories.
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.......................................................................................................................

153
Poltical Institutions 5) What alternative has been suggested by Hobbes to solve the commons
and the Functioing of
the State dilemma?
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.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

10.4 FUNCTIONS AND PRE-REQUISITES OF AN

INSTITUTION
The locally formed institutions as well as the state formed institutions have failed
in the past due to various factors. Past data testing in different models of
institution formation ideally should provide the policies and institutions which
generate far less conflict than the earlier models. Having proper information
about the human capabilities as well as the common resource is one of the factors
which helps the institution run successfully. But this is not easy. Finding ways to
measure and monitor the outcomes for such varied values is a major
informational challenge for governance. Following factors are important and to
be dealt with in order to have a successful institution formation.
One may ask how effective commons governance can be made easier to achieve.
Let us look at some factors which makes it easier to organise the collective
action;
(i) the resources and use of the resources by humans can be monitored.The
information on the use of commons can be verified and understood at relatively
low cost (e.g., trees are easier to monitor than fish).
(ii) There are moderate rates of change in resources, resource-user populations,
technology, and economic and social conditions.
(iii) dense social network in the communities (social capital), maintain frequent
face-to-face communication. This increases the potential for trust among the
communities and allow people to express and hence lowers the cost of
monitoring behaviour and prepares conducive environment for rule compliance.
(iv) Easy and low-cost exclusion of the outsiders from using the resource,
whenever necessary.
(v) intention of the users to support effective monitoring and rule enforcement.
Few settings in the world are characterized by all of these conditions. The
challenge is to devise institutional arrangements that help to establish such
conditions. In other words, the institutional modelsshould be able to meet the
main challenges of governance in the absence of ideal conditions. Some of the
challenges are:

154
 1. Dealing with conflict:It is very common to observe conflicts due to the Institution and
difference in power and values among different interested parties, in the Democracy
matters related toenvironmental choices. Dealing with such conflicts is as
important as the concern about resource itself. Conflict resolution is a
major motivation for designing resource institutions.

2. Inducing rule compliance:an institution will lead toeffective governance

only if the rules of resource use are adhered toand the violations are
modest. It is not generally recommended to penalise the first-time
offenders in a severe manner.It has been noticed that it is most effective
to impose modest sanctions on first-time offenders. The gradual increase
in the severity of sanctions shall take place for those who do not learn
from their first or second offense penalty.

3. Providing infrastructure:When we discuss about institutions, mainly our

focus is on different ways to institutionalise. But simultaneously the
physical and technological infrastructure is too important to ignore.
Infrastructure and the level of technology advancement determines the
degree to which a commons can be exploited (e.g., fishing technology).
Technology determines the extent to which waste can be reduced in
resource use, and the degree to which resource conditions and the
behaviour of users can be effectively monitored.

4. Be prepared for change:There are many features which are likely to

change in the setting of commons and their use. The institutions
formulated should be able to show some flexibility in case they need to
adapt as per changing conditions. Changes may take place inthe current
understanding, the required scale of organization, biophysical and social
systems. In such an ever-changing setting, fixed rules are likely to fail
because they place too much confidence in the current state of
knowledge. It may seem to some that allowing the room for flexibility in
the existing systems may be suboptimal. But that will only apply in short
run as allowing the institution to be adaptive will prove wiser in the long
run.
If the objectives and requirements are known to one while devising an institution,
the next step is to find some strategies through which the requirements of flexible
or adaptive governance can be met.There are some general strategies or
principles for robust governance institutions for localized resources which are
well established in the existing literature.Below are the ones which are relevant
for the problems faced at a large scale, in particular.
1. Analytic deliberation: It is crucial that the stakeholders (scientists,
resource users and public) have a well-structured dialogue based on the
analysis of key information about environmental and human-environment
systems. Such analytic deliberation provides improved information for
155
Poltical Institutions future plan of action and builds social capital. Having such deliberation
and the Functioing of
the State
allow for change and deal with inevitable conflicts as well as it helps to
produce consensus on governance rules.
2. Nesting: Institutional arrangements must not be simple and one layered.
They need to be complex and nested in many layers. The strategy should
involve market-based governancefor the world’s resources at one-level
and centralized command and control at the other level which eliminates
apparent redundancies which have proved to be inefficient over time.In
case only the central governments exert sole authority over the resources,
there can be catastrophic failures.
3. Institutional Variety: Ideally the governance should be a mix of diverse
institutional types. Governance can be effective if it includes hierarchies,
markets and community-based self-governance. This structure has a
potential of employing a variety of decision rules to change incentives,
increase information, monitor use, and induce compliance. The rule
evaders or defaulters have many ways to evade the system but the
existence of multiplicity of rules than with a single type of rule is
somewhat successful in weeding the evaders.

10.5 INSTITUTIONAL TRAJECTORIES AND

ECONOMIC PERFORMANCE
After all the discussion in earlier sections, one would want to know how the
institutions (State, private or community based) help an economy achieve its
productive potential. An important factor (in addition to the endowments of a
country) to consider while looking at the economic performance of different
countries is that these countries follow or adopt different economic policies and
institutions. This leads to the variation in the economic performance.
Let us take an example of the per capita income of a nation. We observe huge
variations in the per capita income of a rich country and a poor country. There
are two possible explanations of such differences. The first possibility is that,
national borders mark differences in the scarcity of productive resources per
capita and the aggregate production function methodology also differs. Simply
put, the poor countries are poor because they are short of resources (like land,
natural resources, human capital, latest technology). The rationality of
individuals in a country brings that country quite close to its potential, given their
different potentials. The second possibility is that due to national borders the
public policies and institutions are not only different for different nations, but in
some cases better and in other cases worse. The countries which practise better
institutions are able to reach closer to their potential and vice versa. The potential
is not reached by individual rationality but by achieving socially efficient
outcome. The earning capacity of a country can easily be increased with efficient
use of the natural and human resources. The poorer countries lack the structure of
incentives that brings out the productive cooperation. The chosen economic
policies time to time and the institutional arrangements lead to a structure of
156
incentives. That also depends on the legal systems that enforce contracts and Institution and
protect property rights and on the political structures, constitutional provisions, Democracy
and the extent of special-interest lobbies and cartels.
Now we need to know why variations in institutions and policies are the main
determinants of international differences in per capita incomes. Sometimes the
economic policies and institutions of the low-income countries keep capital in
these countries from earning rates of return appropriate to its scarcity. Similarly,
such policies make foreign investors and foreign firms unwelcome, or provoke
the flight of locally owned capital, or make lending to these countries highly
risky. So, the institutional and policy shortcomings of a country keep it from
achieving its potential. Also, the type of human capital a country possesses
matters in terms of achieving the potential. The people should have a good
amount of knowledge about how they should vote and about what public policies
will be successful. If many voters acquire more knowledge and are able to assess
about the real consequences of different proposed public policies, then those
public policies will improve and thereby increase real incomes in the society. But
this better knowledge of public policy is usually not marketable. So, this public
good human capital or civic culture is not normally marketable and only affects
incomes by influencing public policies and institutions. The existing literature
suggests that the economic performances of Hong Kong, Taiwan, West Germany
and South Korea have been much better than the performances of mainland
China, East Germany and North Korea. These are the pair of countries having
similar cultural characteristics but great differences in economic performance.
These differences cannot not be explained by differences in the marketable
human capital of the populations at issue. The hypothesis that economic
performance is determined mostly by the structure of incentives and that it is the
national borders that mark the boundaries of different structures of incentives,
has a lot of evidence in its favour. There is also direct evidence of the linkage
between better economic policies and institutions and better economic
performance.
Low-income nations may specialise in trade and experience gains from that. But
they do not have the institutions that enforce contracts impartially, they do not
have institutions that make property rights secure over the long run. Institutions
which ensure greater self-expression, allow the free flow of information and
encourage the formation of associations and clubs lead to greater economic
benefits. The democratic institutions allow greater sharing of resources and state
reduces the risks involved in the economic activity. Welfare state is an
institution which pools the resources to provide the investments in education,
health and infrastructure and constrains the effects of business cycles. Pooling
resources is a fundamental step as it complements the private investment as well
which furthers the economic interaction between various players. Institutions can
be both informal (e.g., moral codes, self-enforcing agreements) and formal (legal
rules enforced through third parties). The relative importance of formal
institutions increases as the markets widen and deepen. Informal institutions are
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Poltical Institutions like public agencies, trade unions, community structures and professional
and the Functioing of
the State
associations.
A nation follows many growth augmenting strategies. But they alone are not
sufficient for reaping the economic benefits. Without institutions, growth runs
out of steam and the economy will not remain resilient to shocks. So, we need
high-quality institutions which induce socially desirable behaviour on the part of
economic agents. Some of the institutional ingredients of a self-sustaining market
economy are public bureaucracies, independent judiciaries, stabilizing fiscal
policy, antitrust and regulation, financial supervision, social insurance, political
democracy.
10.5.1 Institutions in India and Economic Growth
A perception which is commonly voiced is that public institutions in India are on
a decline, they are weak and severely stressed. In the academic world is cautious
on the debate about condition of India’s institutions. India is densely populated
and is very heterogeneous. Some of the new institutions such as the
Telecommunications Regulatory Authority of India (TRAI), Securities and
Exchange Board of India (SEBI), and Insurance Development Regulation Act
(IDRA) have performed very respectably, given the features of the country. In
terms of employment, the Central Union Public Service Commission still
oversees a selection process that is fair and merit-based. Greater decentralization
and transparency have been introduced through the Panchayati Raj initiatives and
the Right to Information (RTI) Act. And the introduction of computer-based
technologies has improved efficiency in a number of areas, like the computerised
bookings in railways and air travel, online filing of income tax returns, virtual
payment of different taxes like property tax and online banking.

The effects of institutions in India can also be separated at the level of the states.
The formal reforms of 1991 at the centre were appreciated and received a lot of
publicity. What was less noticed was the growing decentralization of policy. For
a long time, we observed the dominancy of Congress party over the politics and
institutions of the country. But, with its dispersion came the scattering of the
political power which createdthe centrifugal forces that led to decentralization of
economic power and hence policy. Greater economic decentralization meant
states could differentiate themselves. States differ in their ability to attract private
sector investment, which is a significant factor in terms of economic performance
of the states. This decentralisation process was further strengthened by the
gradual dismantling of the industrial licensing system. When the centre was
deciding where and how much electricity capacity to install, there was little that
the states could have done to enhance their economic performance. In the pre-
1980s era centre was the deciding authority. Existing research informs that when
we relate state-level growth to state-level institutions we find that the latter have
no role in explaining growth prior to 1980 but a robust role in explaining post-
158
1980s, especially post- 1990s growth. Hence, the economic decentralization Institution and
Democracy
became important and states’ economic performance was closely tied to state-
level institutions in the post-1980s period.

The core market-creating public institutions were created during the India’s pre-
independence era. These institutions are taken as a key to India’s long-run growth
but they may not have kept pace with Indian economic veracities. India’s
institutions have shown the signs of weakness in terms of being slow to adapt or
change. This may sputter country’s growth engine. Sustaining growth is more
difficult than igniting it, and requires more extensive institutional reform. Growth
spurts are associated with just a narrow range of policy reforms.
The policy reforms which are related to growth transitions need to have elements
of both orthodoxy with unorthodox institutional practices.
Check Your Progress 2
1) Enlist any three factors which make it easier to organise the collective
action.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
2) Discuss any three main challenges of governance.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
3) Explain the relationship of institutions with the economic performance of a
nation.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
4) Discuss India’s institutional trajectory in brief.
.......................................................................................................................
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Poltical Institutions
and the Functioing of
10.6 LET US SUM UP
the State
Institutions are the rules which help us play the game of management. The
primary function of any institution is to deal with common resources in a manner
that the outcome is socially efficient. We began the unit by understanding the
need of institutions and policies. The rational individual may not lead to
optimality when it concerns the commons available for the whole population or
where the property rights are not clearly defined. Destruction of resources is a
major concern for all the nations. Three models (Tragedy of commons, Prisoners’
dilemma and the logic of collective action) provide us the base to understand the
requirement of institutions. The alternatives available are state-led institutions
(formal or informal) or the community-based local institutions which have been
mostly successful in the management of the common resources. We then moved
on to find out how the economic performance of any nation is not only dependent
on its resource endowments but also on the type of institutions and policies a
country formalizes and practises. Lastly, we discussed the Indian scenario in
relation to the reform policies and decentralization of institutions with the
background of economic development and its relation to the institutions.

10.7 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Refer section 10.2
2) Refer section 10.2
3) Refer section 10.2
4) Refer section 10.3
5) Refer section 10.3
Check Your Progress 2
1) Refer section 10.4
2) Refer section 10.4
3) Refer section 10.5
4) Refer section10.5

160
UNIT 11 THEORIES OF REGULATION
Structure
11.0 Objectives
11.1 Introduction
11.2 Economic Regulation
11.2.1 Direct Regulation
11.2.2 Price Controls
11.3 Regulation of Natural Monopolies and Public Utilities
11.4 Public Interest Theory
11.5 Public Choice Theory
11.6 Theory of Regulatory Capture
11.6 Let Us Sum Up
11.7 Answers/Hints to Check Your Progress Exercises

11.0 OBJECTIVES
After going through the unit you should be able to:
 Define economic regulation;
 Discuss the arguments in favour of economic regulation;
 Describe the various types of regulation, particularly regulation of public
utilities;
 Critically evaluate the public interest and public choice theories of economic
regulation; and
 Discuss the theory of regulatory capture.

11.1 INTRODUCTION
This unit and the subsequent one take up for discussion issues relating to
governance in developing nations. In the previous unit you studied about
institutions and democracy. You would have realized that institutions and
democracy have important bearing on economic outcomes and on the process of
economic development of developing nations. Hence it is important to
understand the role of government in economic development.
In your earlier courses on microeconomics and macroeconomics, you became
familiar with the role of government in promoting efficiency in the economy, in
establishing and maintaining property rights and rule of Law, and also
macroeconomic policies like fiscal and monetary policies as well as policies
related to international trade and finance. The previous unit (Unit 10) discussed
the role of institutions, as well as the State and democratic processes in economic


Shri Saugato Sen Associate Professor of Economics, IGNOU, New Delhi
Poltical Institutions development. Other than the legal and governance framework and various
and the Functioing of
the State
policies like monetary and fiscal policies, the state participates in the economy
through ownership, as well regulation In the last unit of this course, we will go
into greater detail about the ways government action can fail to enhance welfare,
and also about corruption. But before that, in this unit, we look at one type of
government participation in the economy, namely, economic regulation.
As you would know, regulation can be economic as well as in non-economic
spheres. As an example of non-economic regulation, government can regulate
protocols with regard to patients of some pandemic in terms of isolation or
quarantine. In this unit we shall consider economic regulation and not non-
economic regulation. Economic regulation basically suggests that there are areas
or sectors which the government may not own, or participate as producer or
provider of services, but regulates the private sector which provides the services
or products in this area.
The unit is organised as follows: the next section we discuss economic
regulation. The section explains what regulation means and who does the
regulating. It discusses the aims of regulation and what are the arguments for
regulation. It discusses in some detail the regulation tools at the disposal of the
regulating agency. The various types of regulation, like direct regulation, price
regulation, regulation of entry and exit etc , are discussed. In the next section, the
method of regulating a natural monopoly and public utility are discussed. Natural
monopoly is defined not so much in terms of number of firms present in the
market, but whether a single firm is able to cater to all of the demand in the
market. We find that often public utilities are natural monopolies in that a single
firm meets all of the demand for the utility in a given geographical area. The unit
discusses how public utilities are regulated.
The unit then goes on to discuss two important theories regarding economic
regulation. First, the public interest theory of regulation will be discussed. This
theory assumes that regulators act in the public interest and have the interest of
the consumers and the general public in mind. It also assumes that regulators
have full information and knowledge about all relevant parameters. A later
variant of the public interest theory suggests that regulation may not lead to
optimal efficiency and there may be costs to regulation, but regulation can lead to
corrections for market failures. The other theory of regulation is public choice
theory. Public choice theory suggests that government officials like regulators act
in their own interest most of the time, and their actions do not always further the
public interest. Applied to the area of economic regulation, public choice theory
Hence in most cases economic regulation does not lead to optimal outcomes in
terms of efficiency and resource allocation. Finally, the unit discusses the theory
of regulatory capture, which suggests that those firms that are being regulated
end up ‘capturing’ the regulatory process, and the regulatory authorities end up
taking actions that help the firms themselves. The theory of regulatory capture
suggests that not only does not serve the public interest, but regulation can

162
actually help the organistion or firm being regulated as the firm can manipulate Theories of
and ‘capture’ the regulatory process, and turn the regulatory process to its own Regulation

advantage.

11.2 ECONOMIC REGULATION

Regulation can be in several diverse areas and fields. There can be social
regulation as government may regulate social processes and behavior. In this unit
we are concerned with economic regulation. Economic regulation, in its essence,
seeks to modify economic behavior by certain economic agents. It works as
application of law by the government or other agencies with various objectives in
mind, such as correcting for market failure, protecting the environment,
controlling restrictive trade practices or monopoly pricing. Regulation is one of
the ways in which the government intervenes in the market. Thus, regulation is
by government agencies or autonomous bodies statutorily created. Secondly it is
private sector firms or economic agents that are regulated. Third, economic
regulation seeks to modify the behavior of private firms or economic agents or to
influence economic processes to yield outcomes that are welfare enhancing for
society as a whole. Regulation refers to actions undertaken by the central or state
governments to influence market outcomes, such as the quantity traded of some
good or service, or their price or quality. Regulation can also be in the form of
taking steps to ensure that monopolies are not formed or collusive behavior by
firms does not take place. It can take the form of enforcing property rights. The
government can also take steps to regulate activity that creates negative
externalities. Governments can take direct steps to prevent pollution by firms,
for instance by prohibiting firms from spilling sewage into rivers,, instead of
resorting to taxation. Often the government sets up special agencies which act as
regulators in various areas. In India some important regulatory authorities are
Securities and Exchange Board of India (SEBI), for capital markets, Insurance
Regulatory and Development Authority of India (IRDAI) for regulating
insurance companies, Pension Fund Regulatory and Development Authority
(PFRDA), Telecom Regulatory Authority of India (TRAI), for regulating the
entry and exit of firms, conducting auctions and also pricing in the telecom
sector, Food Safety and Standards Authority of India (FSSAI) related to food,
Bureau of Indian Standards (BIS), for ensuring a generally high standard of
quality of products Central Drugs Standard Control Organisation (CDSCO) for
drug pricing etc, National Green Tribunal for maintaining environmental
standards, and Competition Commission of India (to regulate competition).The
CCI was established in 2003 to oversee competition and enforce Competition Act
2002. The CCI became operational from 2009. It replaced the Monopolies and
Restrictive Trade Practices Commission which had been set up to oversee the
Monopolies and Restrictive Trade Practices Act, 1969. The competition
commission of India acts to prevent monopolies, to ensure competition to oversee
mergers and acquisitions. Let us now see the various instruments of regulation,
the instruments through which the government.

163
Poltical Institutions 11.2.1 Direct Regulation
and the Functioing of
the State There are several ways in which government regulates private sector provider of
goods and services. One way is what is called direct regulation. Direct regulation
is also known as command- and –control regulation. In this form of regulation,
the government takes certain actions to control the amount of a certain activity.
In this form of regulation the government aims at control of quantity.
The example about pollution is an instance of direct regulation. Ensuring safety
of food and medicines is another instance of direct regulation. Food Safety and
Standards Authority of India (FSSA) regulates levels of safety of food products
in India. Supposing it is left to the market to ensure that products meet quality. It
would be difficult as in the market system it would be costly for each individual
consumer to acquire information about quality. Consider medicines. Each
consumer would find it very difficult to ascertain that medicines meet a certain
standard. Moreover each consumer would separately have to determine and
gauge quality, and there would be massive duplication of effort. Another example
of direct regulation would be sale and purchase of alcoholic drinks. Some
governments may impose prohibition and prohibit the sale of alcohol in that state.
Residents of that state may be required to have permits to bring in alcoholic
drinks from other states. Or the government may fix a certain minimum age for a
person to be eligible to purchase or consume alcoholic drinks.
11.2.2 Price Control
Sometimes the government intervenes in the market by setting a maximum or
minimum price for some product. The regulated price may take the form of price
controls. These controlled prices may be above or in some case below the
equilibrium market price that would otherwise prevail. For example, rent may be
controlled in the sense that the government may decree that rent cannot be above
a certain level. Or in the labour market, the government may fix a minimum
wage that employers, even in the private sector, have mandatorily to pay their
workers. In India, in some cities, fares of taxis and auto-rickshaws may be
determined by the government in terms of the maximum fare at the base or
starting level, and how much additional fare the driver is allowed to charge per
kilometer. However, since monitoring costs may be high, actual auto-rickshaw
fares are sometimes determined by bargaining between the driver and passenger!
Price regulation may specify a particular price that firms must charge, or may
instead restrict firms to setting price within some range. If the concern of the
regulating agency is that a regulated monopolist will set price too high,
regulation is likely to specify a maximum price that can be charged. If the
regulated firm has some competitors that are unregulated, the regulatory agency
may also be concerned that the regulated firm will engage in predatory pricing
(that is, pricing so as to force its competitors to exit the market). In that situation,
regulation is likely to involve a minimum price as well as a maximum price.
Sometimes, regulation specifies more than a single price. The specification of a
price structure as opposed to just a single price greatly increases the complexity
164
of implementing economic regulation and can result in additional welfare losses. Theories of
In practice, price regulation may be the means by which a regulatory agency Regulation

achieves an ultimate objective of limiting industry profit. A regulatory agency

often sets price so that the regulated firm earns a normal rate of return. This is
standard practice in the regulation of public utilities, as we shall see in the next
section.
11.2.3 Control of Entry and Exit
Now we look at a way to regulate firms that does not rely on direct regulation
or price regulation. The two principal variables that regulators have controlled
are price and the number of firms, the latter through restrictions on entry and
exit. These variables are important because price and the number of firms are
the main determinants of both allocative and productive efficiency. Entry may
be regulated at several levels. First, entry by new firms may be controlled, as is
typically done in the regulation of public utilities. In addition to controlling
entry by new firms, a regulatory agency may also control entry by existing
regulated firms. These markets may already be served by other regulated firms
or may be unregulated markets. A basis for exit regulation is that regulation
strives to have services provided to a wider set of consumers than would be true
in a free market. Attaining this goal may entail regulated firms serving
unprofitable markets, which creates a need for regulations that forbid a
regulated firm from abandoning a market without regulatory approval.
11.2.4 Control of Other Variables
Sometimes regulators may try to regulate some other variables like quality of
service.The essence of economic regulation is the limitation of firm behavior
regarding price, quantity, and entry into and exit out of markets. Obviously,
firms choose many other decision variables. One of these is the quality of the
product or service that they produce. A regulatory agency may specify
minimum standards for reliability of a service. If an electric utility has regular
blackouts, the regulatory agency is likely to intervene and require an increase in
capacity in order to improve service reliability. Although product quality may
also be controlled for reasons like product safety, economic regulation does not
typically place serious restrictions on it.
One reason for the minimal use of quality regulation is the cost of implementing
it. To control any variable, the relevant economic agents have to be able to agree
on what the vari- able is and what restrictions are placed on it. In the case of price
and quantity, this is not dif- ficult. The price is the amount paid by the consumer
for the good, which is relatively easy to observe. Furthermore, restrictions take
the simple form of numbers: a maximum price and a minimum price. Similarly,
the measurability of quantity allows a regulatory agency to specify restrictions on
it. However, quality is typically neither so well defined nor so easily observed.

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Poltical Institutions
and the Functioing of
11.3 REGULATION OF NATURAL MONOPOLIES
the State AND PUBLIC UTILITIES
In the previous section, you became acquainted with the concept of regulation
and the various ways in which regulation is carried out. This section focuses on
the regulation of natural monopolies. Let us see what is a monopolist and a
natural monopolist. You may recall your study of a monopolist in your courses
on microeconomics. We know that a firm’s domination of a market is most
complete when it is the sole seller or sole buyer in a market, that is, when it is a
monopolist or a monopsonist. This section examines some of the consequences
of monopoly. What is then a natural monopolist. Let us recall the definition of
returns to scale. A production process displays increasing returns to scale if output
more than doubles when the use of every input is doubled. The cost curves of a
firm that produces under increasing returns to scale have two important
properties:
• Average cost falls as output rises.
• Marginal cost is everywhere below average cost.

A market in which production is characterized by increasing returns to scale is

said to be a natural monopoly because only one firm can survive in such a market.
Initially, a number of competing firms will “race to get big.” The larger firms will
have lower average costs than their smaller competitors and will be able to charge
lower prices. The smaller firms will be unable to earn profits and will be driven
from the market. Ultimately, only one firm will remain in the market.
Utilities are often natural monopolies because they deliver services through net-
works. An electric power company, for example, must have generating stations
to produce power and trunk lines to distribute it before it can begin operations,
but it can then deliver power to large numbers of customers by connecting them
to its power grid. The expansion of its customer base allows the power company
to spread the fixed costs (of the generating stations and trunk lines) over a greater
number of users, so that average cost falls. Similar arguments apply to water and
sewage systems, mail delivery, local telephone service, cable TV, and railways.
The monopolist maximizes its profits by expanding production until marginal
cost is equal to marginal revenue. These choices do not maximize society’s
welfare. You have read earlier that apart from producers’ surplus and
consumers’ surplus, there is deadweight loss under monopoly. This loss of
surplus (that part which belongs neither to consumers’ surplus nor to producers’
surplus) is called the, the welfare cost of monopoly A monopolist will charge
more and produce less than a perfectly competitive firm,
There are two ways of increasing the net social benefits of a monopoly. The first
is to regulate the monopoly, meaning that the government sets the monopolist’s
price and output. The second is for the government to purchase and operate the
firm. A regulator would require the monopolist to raise its output so that the
welfare cost of the monopoly is reduced. It could not, however, require the
166
monopolist to increase output to the level of competitive equilibrium output. In Theories of
the long run the firm would make losses and abandon the market, and net social Regulation

benefits would ultimately be lower than they were before the regulator’s
intervention.
What is the best outcome that the regulator can achieve? Social welfare increases as
output rises but the monopolist’s profits fall. The monopolist should be required
to raise its output until its profits are driven to zero (since these are the smallest
profits consistent with the monopolist’s
ˆ continued participation in the market).
The regulator wants profits to fall to zero at the highest possible output, so it will
allow the monopolist to charge the highest price that the market will bear. Then the
monopolist’s price is equal to the vertical distance to the demand curve and its
average cost is equal to the vertical distance to the average cost curve. Its profits
are zero when these two distances are equal.
The alternative to regulation is government ownership. A government-owned
firm does not need to earn non-negative profits, because its fixed costs can be paid
out of the government’s general revenues. A change from regulation to
government ownership would eliminate the remaining welfare cost of monopoly.
The above points may have made you think that social welfare is higher under
government ownership than under regulation, but it is somewhat misleading. The
fixed costs of a government-owned monopolist are paid out of tax revenues, so
opting for government ownership forces the government to adjust its budget. It
has two options: it can reduce spending on other programmes, or it can raise tax
revenues.
Hence, in some cases, regulation might be preferred to government ownership.
Both policies have been, and are being used to deal with natural monopoly.
Utilities like water, sewage, and mail delivery are natural monopolies, and these
services are typically provided by government-owned firms. Local telephone
service and cable TV are often provided by monopolies that are regulated.
Let us now discuss further the regulation of public utilities. Public utilities are
found both in the public as well as private sector. The first objective in
regulating a public utility is to make it charge a price that would be fair and
reasonable to consumers. Further, there are issues like marginal-cost pricing and
optimal pricing. There is also the institutional approach to rate-making, which
looks at the criteria by which the base rate is determined and a fair rate of return
to the public utility.
Public utilities as we saw above are natural monopolies which have increasing
returns to scale, and hence decreasing average costs.. When looking at the
demand for the public utility service, we find that demand is determined by the
time pattern, and the elasticity of demand.. Thus often there is price
discrimination. The crucial task of the regulator is to determine a reasonable
price. that is equitable. A theoretical first-best criterion is to choose the price such
that it equals marginal cost. In perfect competition, price would also equal
167
Poltical Institutions average cost. But in monopoly marginal cost pricing would probably lead to
and the Functioing of
the State
losses which may be subsidized, and there may be corresponding increasing in
taxation. There can be a two-part tariff to ensure that the public utility covers its
marginal as well as fixed costs. Another type of differential pricing is peak-load
pricing, often used in electricity pricing. Here prices are charged differently at
different times depending on demand. Hence marginal cost will differ and
capacity utilization would vary. Sometimes in practice, marginal cost pricing is
difficult to use, and hence a reasonable rate is determined that allows the public
utility to get a reasonable rate of return on the capital invested. It is necessary to
establish a base rate which is the property value against which the firm’s profits
are compared. Cost of services, reasonable rate of return on capital invested are
determing factors in arriving a pricing principle.
Check Your Progress 1
1. Explain the concept of direct regulation.
……………………………………………………………….................…..
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2. Discuss how price regulation is carried out.
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3. What do you understand by a natural monopoly? Why are public utilities
usually natural monopolies?
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11.4 PUBLIC INTEREST THEORY

There are two main approaches or views regarding economic regulation by the
government. The first is public interest theory and the other is called public
choice theory. Basically, these approaches differ in the way that the government
is perceived; the first approach sees the government or the State as a benevolent
agency, having the public interest in mind. The latter sees the government as just
another economic agent in the economy, or rather the individuals who form the
government –legislators, ministers, government officials, et al—as yet another set
of economic agents who optimize their chosen objective functions, which may
168
not be in consonance with social welfare or public benefit. We discuss public Theories of
choice theory in the next section. In this section, we discuss the public interest Regulation

theory of regulation.
The first group of regulation theories proceeds from the assumptions of full
information, perfect enforcement and benevolent regulators. According to these
theories, the regulation of firms or other economic actors contributes to the
promotion of the public interest. This public interest can further be described as
the best possible allocation of scarce resources for individual and collective
goods and services in society. In western economies, the allocation of scarce
resources is to a significant extent coordinated by the market mechanism. In
theory, it can even be demonstrated that, under certain circumstances, the
allocation of resources by means of the market mechanism is optimal. ). Because
these conditions do frequently not apply in practice, the allocation of resources is
not optimal from a theoretical perspective. This situation is described as a market
failure. A market failure is a situation where scarce resources are not put to their
highest valued uses. In a market setting, these values are reflected in the prices of
goods and services. A market failure thus implies a discrepancy between the
price or value of an additional unit of a particular good or service and its
marginal cost. Equalization of prices and marginal costs characterizes an
equilibrium in a competitive market. If costs are lower than the given market
price, a firm will profit from a further expansion of production. If costs are higher
than price, a firm will increase its profits by curtailing production until price
again equals marginal cost. A market equilibrium, and more generally an
equilibrium of all markets is thus a situation of an optimal allocation of scarce
resources. In this situation supply equals demand and under the given
circumstances economic agents can do no better.
One of the methods of achieving efficiency in the allocation of resources when a
market failure is identified, is government regulation. In the earlier development
of the public interest theories of regulation, it was assumed that a market failure
was a sufficient condition to explain government regulation. But soon the theory
was criticized on the grounds that it assumed that theoretically efficient
institutions could be seen to efficiently replace or correct inefficient real world
institutions. This criticism has led to the development of a more serious public
interest theory of regulation by an “Economics of Law” approach. In the
original theory, the transaction costs and information costs of regulation were
assumed to be zero. By taking account of these costs, more comprehensive
public interest theories developed. It could be argued that government
regulation is comparatively the more efficient institution to deal with a number
of market failures. Thus this approach, in contrast to the earlier approach,
suggested that in the presence of market failure, government regulation can
comparatively improve the situation, but there is no guarantee that regulation
will lead to optimal efficiency conditions. For example, with respect to the
public utilities, as we have seen, the transaction cost of government regulation in
establishing fair prices and a just rate of return are lower than the costs of
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Poltical Institutions unrestricted competition. These more serious versions of the public interest
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theories do not assume that regulation is perfect. They do assume the presence of
a market failure, and assume that regulation is comparatively the more efficient
institution and also, that for example deregulation takes place when more
efficient institutions develop. These theories also assume that politicians act in
the public interest or that the political process is efficient and that information
on the costs and benefits of regulation is widely distributed and available.
Imagine an unregulated natural monopoly firm supplying public utility services.
The firm makes supernormal profits, charges different prices to different
consumer groups and does not supply services to high-cost consumers in rural
areas. Economic theory predicts an inefficient allocation of resources. Without
regulatory intervention these costs are high. Interveningin the market results in a
decline of these welfare cost. The stronger the level of intervention, the lower
the welfare losses in the private sector will be. The naïve public interest theory
of regulation for example, would explain ‘fair rate of return’ regulation from the
presence of the natural monopoly firm. Prices must decline and production
increased until societal resources are allocated efficiently. The more complex
public interest theories of regulation take the costs of regulatory intervention
into account. The more a regulator intervenes in the private operation of the
firm, the higher the intervention costs will be. The regulator must have
information on cost and demand facing the firm before efficient prices can be
determined. There will be compliance cost for the firm in terms of time, effort
and resources. It will have to comply with procedures, adapt its administration
and incur productivity losses. Once put into practice, the cost of monitoring firm
behavior and enforcement of the regulations arises. It is to be expected that the
firm will behave strategically and conceal or disguise any relevant information
for the regulator. Furthermore, indirect costs are to be expected. The less profit
the firm makes, the lower the effort in decreasing production cost or in
developing new products and production technologies. Also less tangible effects
are predicted. Regulatory intervention makes private investments less secure.
Risks go up. Investment can decline. The public interest theories of regulation
thus basically assume a comparative analysis of institutions to have taken place
to efficiently allocate scarce resources in the economy.

11.5 PUBLIC CHOICE THEORY

In the previous section, we looked at the public interest theory of regulation. The public
interest theory posits that governments act in the public interest. It will regulate in such a
way that will benefit society. Since economic regulation is carried out by government
agencies, we need to look at the behavior of personnel and officials in various
government agencies and organs of government.
There is a school of theorists called public choice theory that says officials in
government agencies behave rationally just as economic agents like firms and consumers
do. The theory says government officials have objective functions that they optimize

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subject to constraints. Public choice theory is also known as economic approach to Theories of
political science. Regulation

Applied to regulation, public choice theory says we should look at the motivation and
incentives of the members of the regulating agency in regulating the firm. Each official
and member of the regulating agency will act in a way so as to maximize his or her own
utility. Thus the official will look at his or her own gain, rather than that of society in
implementing the regulation. If the officials find that regulating the price, for example,
do not lead to any gains for them they may be lax in implementing. On the other hand
the officials, having the power over the firm may bargain with the firm in getting a good
deal for themselves in return for arriving at a regulatory system or level that does not
hurt the firm too much.

In effect, public choice theory suggests that officials who make up government
organizations like regulating agencies, are likely to act to promote their own gain rather
than the public interest. The implicit suggestion is that the economic regulation of firms
is not likely to maximize social welfare. Hence the underlying prescription is that
government should not interfere with the market mechanism even in the presence of
market failure.

In the next section we look at a theory of economic regulation that is related to public
choice theory.. This theory also contends that economic regulation does not always lead
serving the public interest. Thus that theory is also opposed to the public interest. Let us
now study this theory, known as the theory of regulatory capture.

11.6 THEORY OF REGULATORY CAPTURE

We saw above that the approach of public choice theory to analyzing
government processes and institutions to view government officials just as
private economic agents. Just as usual economic agents like consumers or firms
optimize utility functions or profit functions, public officials are also assumed
to have their own objective functions which they optimize. This objective
function of public officials may not be in consonance with the public interest. In
the previous section we saw that theorists belong to the public choice tradition
suggest that regulators may use their regulatory power to extract benefits for
themselves. In this section we discuss a variant of the public choice approach.
This variant is called the theory of regulatory capture. Let us see what this
theory says about economic regulation.
Basically, the theory of regulatory capture says that the regulatory process is
‘captured’ by the very organizations or groups that are being captured, like
monopolies or firms in oligopolistic industries.. This means that if say a
dominant firm in an industry is being regulated in terms of price, or capacity
enhancement, this firm can take steps and manipulate the regulatory process
such that regulation is also made in terms of regulating the entry of new firms.
This ensures that firms that can be potential competitors to the existing firm in
the market are kept out and this existing firm can continue to enjoy monopoly
power. Let us learn about this theory a little more.
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Poltical Institutions To understand the process of regulatory capture, consider a monopolist
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supplying a good or service in a certain area. To make it more concrete,
suppose the firm is a natural monopolist supplying a public utility, say,
electricity in a certain geographical area. Let there be a regulatory body set up
to monitor price or tariff by the electricity utility monopoly firm. Let us denote
the firm by F and the regulatory authority or regulatory agency (set up by the
government) by RA. Let us see the likely events. The monopoly firm F would
like to charge a monopoly price Pm and supply the quantity Qm. . This would
generate monopoly profit for the firm..On the other hand, the regulatory agency
RA has the role to ensure that the firm sells at the price Pc to every customer in
the area, where Pc is the competitive price. This would result in the competitive
quantity Qm being supplied. In effect this regulatory procedure has the objective
of making the monopolist behave like a competitive firm. This would be in the
public interest. The regulator RA wants the firm F to act like a competitive
firm, though the firm has an incentive to act like a monopolist.
The situation for RA is that if it wants F to charge Pc , it must know the firm’s
cost function. But the problem that RA faces is that the firm has this
information. After all, it is the firm that is likely to have the information about
its costs. Now RA has to get this information from the firm F. There is the issue
of how costs are to be measured and which expenditure by the firm is to be
included in costs. Moreover, and this is crucial to understand, the firm has an
incentive to show its costs as high as it can. The regulated firm has a clear
informational information over the regulatory agency, because the firm controls
the information that goes to the regulatory agency.
What incentives do the various parties have? The firm has an incentive to
represent it costs as high as possible, because that will make the regulatory
agency set Pc at a very high level, thus allowing the firm to get higher profits.
The regulatory authority will then set a price which would allow the firm to get
a high return on investment, and this in turn will induce the firm to invest more.
What incentive would the regulatory authority have? We may think that the
regulatory authority would have the incentive to fix the price at Pc but in reality
it is the consumers that have to pay this price. The RA does not have to pay.
And the consumers who would like to pay an electricity tariff of Pc are not
members of RA. Consumers are another group, another party to this process,
but no individual consumer has the incentive or ability to be informed or to see
that RA looks after their interest. An individual consumer has no interest in
even participating in the whole process. For an individual consumer a low level
of Pc is some small money saved compared to if the competitive price level
tariff is set at a high level. But for the firm, a few rupees gained from each
consumer due to competitive price –level tariff being set at a higher level
transforms into a large amount in the aggregate of gain in revenue from all
consumers. Since gain from added information about costs of firms is very low
for an individual consumer, each consumer individually is rationally ignorant.

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Now, when the RA sets the rates, consumers will not be aware of what is Theories of
happening, but the firm is very aware. Here, apply public choice theory and Regulation

see what an individual member of the RA might be thinking. Many of the

members of the RA would be knowing or come to know individual members
of the firm, and may not feel like opposing members of the firm. Some may
even be given economic incentives by the firm to carry out their interests. In
some cases it has been seen that members of RA might feel that since they
have been dealing with a firm dealing with a certain product or a public utility,
and since the firm also knows it, the member of the RA has the possibility of
being given employment in the firm after the person ceases to be a member of
the RA, or after retirement. Thus an individual member may, in accordance
with what is suggested by public choice theory, act in such a way that the
interest of the firm ends up being served rather than the interest of the public.
Regulatory capture was sought to be explained through the example of
regulation of a firm supplying electricity, but such situations can happen in
other industries too, like pharmaceuticals.
After the public interest theory had come to be questioned as a result off
empirical and theoretical research, the capture theory was developed mainly
by political scientist. This theory as explained above assumes that in the
course of time, regulation will come to serve the interests of the industry
involved. Regulatory authorities subject an industry to regulation by an agency
if abuse of a dominant position is detected. In the course of time, other
political priorities arrive on the agenda and the monitoring of the regulatory
agency by authorities is relaxed. The agency will tend to avoid conflicts with
the regulated company because it is dependent on this company for its
information. It often also does not have unlimited resources which makes it
aware of the costly effects of litigation of its decisions. Furthermore, there are
career opportunities for the regulators in the regulated companies. This leads
in time to the regulatory agency coming to represent the interests of the branch
involved.
Now we turn to some criticisms directed at the theory of regulatory capture.
The capture theory is unsatisfactory in a number of respects .First of all, there
is insufficient distinction from the public interest theory, because the capture
theory also assumes that the public interest underlies the start of regulation.
Secondly, it is not clear why an industry succeeds in subjecting an agency to
its interests but cannot prevent it being created. Thirdly, regulation sometimes
may appear to serve the interests of groups of consumers rather than the
interests of the industry. Regulated companies are often obliged to extend
services beyond voluntarily chosen level of service. Examples are transport
services, the supply of gas, water and electricity and telecommunication
services to consumers living in widely scattered geographical locations.
Fourthly, much regulation, such as environmental regulation, regulation of
product safety and labor conditions are opposed by companies because of the
negative effect on profitability. Finally, the capture theory is more of a
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Poltical Institutions hypothesis that lacks theoretical foundations. It does not explain why an
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industry is able to ‘take over’ a regulatory agency and why, for example,
consumer groups fail to prevent this takeover. One reason could be that
consumers are often not organized into a pressure group. Nor does it explain
why the interaction between the firm and the agency is characterized by
capture instead of by bargaining. According to these theories, capture is the
result of the increasing power of the agency which arises because the agency
in its ongoing relationship gets to know the firm better and better. The agency
has thus more and more opportunities to pursue its own objective and display
moral hazard with regard to the political principal. The principal can only
control this by having more stringent administrative rules and fair and open
procedures.
Check your Progress 2
1. Discuss the public interest theory of economic regulation.
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2. In what way does public choice theory of economic regulation differ from
public interest theory?
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3. Explain the theory of regulatory capture.
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11.7 LET US SUM UP

This unit was the second of the three units in this block. The block deals with
the role of institutions and political processes in economic development. The
present unit discussed economic regulation and a couple of theories that have
been put forward to understand economic regulation, and how and why it
takes place. In an era when government ownership and direct control over
economic enterprise is lessening, the importance of the design of a proper
regulatory process is of prime importance. We have seen across the world in
the last few decades the process of deregulation of certain industries that used

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to be regulated earlier. Hence it is of utmost importance that whatever the Theories of
extent of regulation is there is carried out efficiently and optimally. Regulation

The unit began by explaining what is economic regulation and how economic
regulation differs from social regulation. You were also familiarized with the
types of economic regulation: direct regulation or regulation by quantity;
price regulation; regulation of entry and exit, and so on. Then the unit went
on to explain what is meant by a natural monopoly and how it is regulated.
We saw that often public utilities are natural monopolies. Regulation of
natural monopolies and public utilities was discussed in detail.
Following this, the unit discussed at length the two main theories regarding
economic regulation. First, the public interest theory of regulation was
discussed. This theory assumed that regulators act in the public interest and
have the interest of the consumers and the general public in mind. It also
assumed that regulators have full information and knowledge about all
relevant parameters. A later variant of the public interest theory suggests that
regulation may not lead to optimal efficiency and there may be costs to
regulation, but regulation can lead to corrections for market failures. The
other theory of regulation is public choice theory. Public choice theory
suggests that government officials like regulators act in their own interest
most of the time, and their actions do not always further the public interest.
Hence in most cases economic regulation does not lead to optimal outcomes
in terms of efficiency and resource allocation. Finally, the unit discussed the
theory of regulatory capture, which suggests that those firms that are being
regulated end up ‘capturing’ the regulatory process, and the regulatory
authorities end up taking actions that help the firms themselves.

11.7 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1. See subsection 11.2.1
2. See subsection 11.2.2
3. See section 11.2.3
Check Your Progress 2
1. See section 11.4
2. See section 11.5
3. See section 11.6

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UNIT 12 GOVERNMENT FAILURE AND
CORRUPTION
Structure
12.0 Objectives
12.1 Introduction
12.2 Market Failure
12.3 The Role of Government in a Developing Economy
12.4 Government Failure
12.4.1Meaning of Government Failure
12.4.2 Causes of Government Failure
12.5 Corruption
12.5.1 Concept of Corruption
12.5.2 Causes of Corruption
12.6 Let Us Sum Up
12.7 Answers/Hints to Check Your Progress Exercises

12.0 OBJECTIVES
After going through this unit, you will be able to:

 Explain the concept of market failure and describe its consequences:

 Discuss the steps and measure the government can take to correct for market
failure;
 Discuss the general role a government usually plays in a market or mixed
economy;
 Explain what government failure means and how it leads to inefficiency;
 Explain what corruption means; and
 List the types of corruption and analyse its causes.

12.1 INTRODUCTION
This unit takes the discussion about the State and its role forward, from the
previous two units. Unit 10 had discussed about democracy in general, and the
role of institutions in economic development. The previous unit talked about
economic regulation., and how economic regulation is carried out. Unit 11 had
also talked about various theories of economic regulation, like public interest
theory of regulation, public choice theory of regulation, and the theory of
regulatory capture. This unit, the last of the course, provides a broad discussion
about government and governance in the context of developing nations.

Shri Saugato Sen Associate Professor of Economics, IGNOU, New Delhi
The unit begins with a discussion of market failure. You have read about market Government Failur
and Corruption
equilibrium in your microeconomics courses. However there are situations where
market equilibrium fails to attain Pareto optimality. This type of situation is
called market failure. The unit discusses market failure in general and the
various types of market failures there are, that is, the unit explains the various
situations and conditions that lead to outcomes that are described as market
failure. It then proceeds to suggest the role of government in correcting market
failure.
The role of the government, particularly in developing nations, is not limited to
correcting market failures. The government needs to establish rule of law, create
a system of contracts and ensure that these are honoured and generally there is
faith in the government. There are many other roles that the government plays in
developing nations, and the unit discusses these.
There are situations where the government, for certain reasons is not able to
realize its objectives. The government, in trying to correct market failures, ends
up in a situation that is suboptimal. These are situations of government failure.
Government failure is taken up for discussion.
Finally the unit presents a discussion on the problem of corruption. A definition
of corruption is provided, various types of corruption are mentioned and causes
of corruption is described.

12.2 MARKET FAILURE

Adam Smith, in his classic work An Inquiry into the Nature and Causes of the Wealth of
Nations published in 1776 argued that individual pursuing their private ends would,
through competition, be led to promote the public interest as though led by an ‘invisible
hand’. Ever since then, economists have widely agreed that competitive markets do lead
to efficiency, but later on, economists realized that competitive markets promote
efficiency if certain conditions are met, and there may be situations where the
competitive market does not perform well or work perfectly.
The question is, what do we mean by efficiency, and what are these conditions that have
to be fulfilled if the market is to promote efficiency? The basic answer is provided by
what are called the two fundamental theorems of welfare economics.

The Fundamental Theorems of Welfare Economics

The first fundamental theorem says that under certain conditions, competitive markets
lead to an efficient allocation of resources. Efficiency here means the allocation is
Pareto­ efficient and the situation is one of Pareto optimality. Pareto optimality means a
situation where it is impossible to make someone better off without at the same time
making someone else worse off. It may be possible to make someone better off. But at
the same time, someone else will necessarily end up being worse off. If there is a
situation where someone can be made better off but no one else ends up being worse off,
the economy or the society in question has not yet reached a situation of Pareto
optimality. When economists speak of efficiency they usually mean Pareto­optimal

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Poltical Institutions situations. When an economy has reached a Pareto optimal state, it reaches a point on its
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utility possibility frontier and does not lie below the utility possibility frontier.

The second fundamental theorem states that given the proper initial distribution of
resources, a decentralised competitive economy will attain some point on its utility
possibility curve. Of course, any point on the utility possibility curve can be attained but
the important thing is that it will be a point on the frontier and not below it. Of course,
Pareto optimality says nothing about equity or the distribution of resources. Even under
Pareto optimality there might be gross inequality. Even if the resulting income
distribution is not acceptable, we need not abandon the competitive market mechanism.
We merely have to redistribute the initial wealth. At some specific distribution of the
initial wealth, there will be the decentralised market mechanism at work at will help to
attain the desired outcome.
The fundamental theorems of welfare economics make a powerful case for the market
mechanism. What it says is that if decision –making is decentralised, that is, individual
decision makers independently make their own decisions based on their own self interest
and there is competition at work, we do not need any centralised resource allocation
mechanism like a planning agency. The second fundamental theorem gives a modern
touch to Adam Smith’s principle of the invisible hand. The reason the second theorem
works, that is, the reason a decentralised competitive system ensures Pareto optimality is
that individuals, in making decisions to make optimum gains, equate their marginal
benefit to the marginal cost. You have come across decision­making using marginal
concepts in your microeconomics course. Of course, the fundamental theorems of
welfare economics talks about a situation where there is no change, things are static, and
firms are small and cannot influence prices. It gives quite a narrow perspective of
competition. Sometimes, people have made a case for the market mechanism with quite
a different perspective of the competitive system in mind. We have seen that the
fundamental theorems of welfare economics assert that if certain conditions are met, the
economy will be Pareto­optimal. There are circumstances or situations where the market
is not Pareto­optimal or Pareto efficient. These situations are called situations of market
failure and economists have suggested that these situations provide a justification for
government intervention and activities. What are these situations? The main ones are:

Markets that are not competitive

Pareto optimality is attained only under situations of perfect competition. In some
industries there may be a few large firms dominating the market. These situations may
not be so bad if there are many potential entrants waiting to enter the market and provide
competition. Pareto optimality will be much harder to attain if there are barriers to entry.
If entry into a market were costless and easy, even the existing firms might behave in a
competitive manner. Sometimes barriers to entry are created through government
regulation, like giving a firm or at best a few firms some contract, and sometimes firms
use the possibility of reaping scale economies, that is, increasing returns to scale to bar
entry. Increasing returns to scale increasing returns to scale implies average cost of
production declines with the scale of output. The government does sometimes regulate
monopolies. The main reason monopolies are viewed with suspicion is that a monopolist

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will generally restrict output to raise prices with a view to making profits. A monopolist, Government Failur
and Corruption
just like a firm under perfect competition, produces till the point where his marginal
revenue equals his marginal cost. Under monopoly however, the prices are higher and
equilibrium output is lower than under competition. Moreover, under monopoly, the
monopolist takes off part of the consumer surplus. But there is a certain portion that
accrues neither to seller nor to the buyers. This is called the deadweight loss under
monopoly. It is for these reasons that markets with monopolies do not attain Pareto
optimality and the situation is one of market failure.

Public Goods
There are goods that have two specific characteristics: firstly it is difficult to exclude
anyone from consuming these goods. Light going out to ships from a lighthouse, or
rather, the lighthouse itself is a classic example of this kind of a good in economics. The
other characteristic is that there is no rivalry in the consumption of a good. Consumption
by one person does not diminish the amount to be consumed by any one else. The
marginal cost to the additional individual enjoying the good is zero. A classic example is
national Defence. An example of a good showing rivalry is a shirt. These types of goods
displaying rivalry and exclusion­ability are called pure public goods. The market will not
supply, or will under­supply public goods, that is, supply in insufficient quantities.

Incomplete Markets
There are situations where markets fail to provide a good or service, even though the
cost of providing it is not more than what consumers are willing to pay for it. We call
this a situation of incomplete markets. This sort of situation is often encountered in
financial markets, particularly in markets for credit and insurance. There is the related
case of absence of complementary markets missing in some cases, or coordination
failures. All these are situations of market failure. Many people advocate a strong
government intervention in such situations.

Information Failures
Sometimes there is the presence of imperfect information in markets, and this provides a
rationale for government intervention. In these situations the fear is that in the absence of
government intervention, the market will provide too little information, so that some
parties to a transaction can get too much benefit. Collection and obtaining of information
ought not to be too costly.
There are other roles that have been put forward as legitimate for the State to
intervene and act in the economy, even in a market economy. The first of these is
to combat inflation, unemployment, and situations of disequilibria in some
markets, that is, to smooth out the ill effects of business cycles. Macroeconomic
stabilisation policy has long been an activity of the state, even in developed
nations, particularly since the Great Depression of the 1930s. You can read about
these policies in your macroeconomics course.
Two other important areas for the government to intervene in market economies
have been: to improve the income distribution which might emerge as an
outcome of the working of the market economy; secondly to compel people to
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Poltical Institutions consume certain goods that the state thinks is in the best of the consumers
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themselves, or goods which consumers otherwise does not choose to consume
even though they know it is in their own best interests. These goods are called
merit goods. Private firms may provide these but also because the government
has compelled the people to consume these. Examples of such merit goods are
helmets for scooter riders or seat belts in cars. Some have viewed this action by
the government as stemming from the government purporting to decide on behalf
of consumers as a philosophy of paternalism. Critics feel a section of society is
imposing its will on others.
One basic role of the government that everybody agrees is necessary is the
government providing the legal framework and protecting property rights. This, it
is felt will provide the necessary incentives and assurance to private markets to
function smoothly and work efficiently.

12.3 THE ROLE OF GOVERNMENT IN A

DEVELOPING ECONOMY
Governments in developing nations undertake activities in all areas of the
economy, and government activities affect all the variables that influence
economic development, either directly like investment in government assets, or
indirectly, say, through fiscal and monetary policies.
Economists usually identify six major functions of governments in market
economies. Governments provide the legal and social framework, maintain
competition, provide public goods and services, redistribute income, correct for
externalities, and stabilize the economy.
The government (1) provides the legal and social framework within which the
economy operates, (2) maintains competition in the marketplace, (3) provides
public goods and services, (4) redistributes income, (5) corrects for externalities,
and (6) takes certain actions to stabilize the economy.
There are two views on what role the government should play in the economy:
the conservative view, which is slightly Right­wing, and the liberal view, which
has less than total faith in the market to be able to solve all problems of the
economy and allocate resources optimally. The Conservatives believe that the
government’s role in the economy should be severely limited. They believe that
economic and political freedom