James Copestake, Department of Economics and International Development, University of Bath, UK

 August 1999

 2^nd draft of an article for the UNESCO Encyclopedia of the Life Sciences.

Comments welcome
 
 

Summary

The article starts with a brief review of the history of development economics as a sub-discipline. Four sections then review theories of economic development according to whether economies are (a) relatively open or closed to international trade, (b) actively managed by the state (dirigiste) or reliant upon private activity (laissez-faire). All these theories are concerned primarily with explaining variation in long-term economic growth. Three sections then critically explore the relationship between economic growth and (a) income distribution and poverty, (b) cultural and institutional development (d) population.
 
 

Key words

Agricultural transformation, Capital, Dependency, Development, Dualism, Economic Development, Economic Growth, Economics, Human Development, Industrialization, Institutional Economics, International Trade, Labor, Planning, Population Growth, Poverty, Rational Choice, Terms of Trade, Underdevelopment.
 
 

Contents list

1. Introduction
 
 

How is it that poverty and plenty coexist? Theories of economic development have much to say on this matter. This section starts with definitions and then dips briefly into the history of the subject, introducing the three main themes of classical development economics - dualism and structuralism, industrialization and trade, and the strategic role of the state. It then contrasts such ‘grand theory’ more recent contributions to understanding the micro-level foundations of economic development. Four sections then review theories of economic development according to whether economies are relatively open or closed to international trade, and actively managed by the state (dirigiste) or reliant upon private activity (laissez-faire). All these theories are concerned primarily with explaining variation in long-term economic growth. Three sections then critically explore the relationship between economic development and (a) income distribution, poverty and well being (b) culture and institutions (c) population growth.
 
 

1.1 What is economic development?
 
 

The term ‘economic development’ refers to long-term changes in systems of production and distribution of goods and services affecting human welfare. In contrast to ‘economic growth’ it involves changes in the form as well as the scale of economic activity. In common usage, development is usually assumed to be by definition a good thing. However, students of development cannot assume this. Economies development is almost always fickle in its effects – some benefit at others’ expense, long-term gain may require short-term pain (and vice versa), and one person’s indicator of progress may be another’s indicator of regress.
 
 

The classical economists such as Smith, Ricardo, Malthus, and Marx were all directly concerned with understanding economic development (particularly early industrialization) in their own age. But as a contemporary sub-discipline of economics, development economics is often in practice defined geographically as the study of low and middle income countries, predominantly in Latin America, Africa and Asia. In 1995, the World Bank classified 49 countries (each with a population of more than one million) as low income and 58 as middle income. The basis for this classification was that their per capita Gross National Product (GNP) fell below 750 and 9,000 US dollars respectively. Together these countries contained approximately 85 per cent of the world’s population, and commanded 21 per cent of estimated global GNP. However, their economies are so heterogeneous that no satisfactory distinction can be drawn between them and the residual category of ‘rich’ countries. Neither is it possible, given the many linkages between them (in the form of trade, capital flows, migration, media and shared environmental resources) to study the economic development of the one group in isolation from the other. Third, economic development does not stop once countries industrialize. However, it is beyond the scope of one article to embrace such a wide sweep of literature. For this reasons alone, this article concentrates upon those theories that have been most influential in explaining economic development of low and middle-income countries during the second half of the twentieth century.
 
 

1.2 Classical development economics and its aftermath
 
 

A useful reference point for this discussion is the establishment of ‘classical development economics’ during the 1950s. Figure 1 illustrates its diverse intellectual origins. As the name suggests, it identified strongly with the early classical economists, particularly with the assumption of unlimited supplies of cheap labor. In attempting to build theories that incorporated institutional rigidities, and in its preoccupation with dynamic processes of change, it also had a strongly Marxian and Keynesian flavor. But while critical of the unhistorical character of much neoclassical economics at the time, classical development economics nevertheless also shared with it many underlying concepts and ideas. Equally importantly, it was also influenced by the contemporary historical context. For example, both decolonization and the emerging literature on dependency in Latin America challenged liberal economists to prescribe new and more radical development strategies.
 
 

Press here for Figure 1 – A schematic view of the history of development
 
 

Three specific sets of ideas set classical development economists apart from mainstream economics. First, they emphasized the importance of institutional constraints to the efficient functioning of domestic markets. Market infrastructure, institutions of private property, and the predominance of individualistic self-interest were all weaker in less developed countries. Input and output markets were thin and segmented, with small modern enclaves located within a sea of traditional or informal economic activity embedded in a distinct set of values and institutions. Second, they emphasized the constraints as well as the opportunities to prospective late industrializers arising from their unavoidable interaction with countries that had already industrialized. These included higher barriers to entry into markets for industrial goods and weak bargaining power in negotiating the terms of access to foreign capital and technology. Third, they argued that this combination of weak domestic market institutions and external trade possibilities reinforced the case for a more dirigiste development strategy. Optimism about the scope for state planning was also reinforced by the widely perceived success of late industrialization in the Soviet Union, as well as of Keynesian demand management, wartime planning during the Second World War, and post-war reconstruction.
 
 

Classical development economics theory had its critics from the outset, but its influence was eroded particularly by neo-liberal criticisms from the 1970s onwards. While defending informal markets and emphasizing the gains from trade, the criticism centered on the willingness and ability of politicians and civil servants to live up to the ambitious role ascribed to them. Development economists of all persuasions were also criticized by historians and other social scientists for failing to adapt their theories sufficiently to diverse local contexts, and for being over-preoccupied with industrial development, economic growth and capital constraints. These criticisms helped to stimulate a mushrooming of research in the micro foundations of economic development. This has in turn resulted in considerable theoretical reunification of classical and neoclassical development economics, as well as greater awareness of the connections between economic, political and sociological understanding of development.
 
 

The next four sections provide an overview of the main theories of economic development. Table 1 provides a summary. Section 2 (and Column 2 of Table 1) begins with theories that abstract from the role of both external trade and state intervention in order to analyze the scope for autonomous capitalist development. Section 3 (and Column 3) then relaxes the closed-economy assumption, to yield theories that are relevant to politically weak peripheral economies open to trade with countries that are already industrialized. The dirigiste closed economy theories described in Section 4 (and Column 4) reflect the reaction against this position of dependence. Finally, Section 5 (and final column of Table 1) is particularly applicable to the experience of newly industrialized countries (NICs). In all cases the main concern of theory is to explain the determinants of aggregate economic growth.

Press here for Table 1 – A typology of theories of economic development.
 
 

2. The closed economy under laissez-faire
 
 

2.1 Dual economy theory
 
 

At least three distinct models can be distinguished within Arthur Lewis’ seminal article entitled "economic development with unlimited supplies of labor". The simplest describes a single modern enclave or capitalist nucleus that expands by attracting migrants from a traditional low-productivity hinterland. Profits earned within the enclave are reinvested in new capital stock and this further raises demand for labor. However, wages do not rise because the extra demand is met through immigration. Thus profits remain high and can continue to be reinvested in new capital stock. Within this model there is no trade in goods with the hinterland, which exists only as a labor reserve.
 
 

Three assumptions underpin this simple model. The first is the classical assumption of unlimited supply of labor at a slight premium to the wage in the traditional sector. Empirical support for this assumption was provided in the form of evidence that non-capitalist agrarian institutions often encouraged populations to grow beyond the point at which the marginal product of labor was equal to the marginal return. The second assumption is of the existence of a dynamic business class (or state cadre) that reinvests the bulk of profits in new capital stock within the enclave. This assumption highlights the potential importance to development of ‘entrepreneurial culture’ and the evolution of institutions conducive to risk taking and investment (see Section 8). The third assumption is of balanced growth of supply in goods and services (hence responsive allocation of capital and skilled labor) to meet changing patterns of demand (for both wage and investment goods) as growth proceeds. This assumption highlights the possibility that growth may also be constrained by sector specific bottlenecks (see Section 4) and the terms of external trade (see Section 3).
 
 

Even without relaxing these assumptions, the model can readily be extended to accommodate more complex labor and capital allocation. With respect to labour, it explains how labor absorption into the modern enclave is governed not only by the simple wage differential, but also by the costs and probability of finding employment there. This explains why rural migration can persist even when there is widespread unemployment within the modern enclave. With respect to capital, on the other hand, the model highlights how economic growth can be expressed as a function of the rate of saving (determined within this model by the profit rate) and the marginal rate of return on capital in the modern enclave. For example, a 20 per cent saving rate combined with a marginal return on capital of 5 percent gives a growth rate (assuming zero depreciation) of 4 per cent per year. This explains the preoccupation of classical development economists with mobilising extra capital. It also provides an explanation for increasing inequality (or appropriation of the surplus over subsistence needs by the dynamic capitalist class) in the early stages of economic development. Finally, applying the concept of surplus labor to the entire world economy as a closed system highlights the importance of continued access to a pool of cheap labor (particularly in China and India) to global profit and hence growth rates.
 
 

2.2 Intersectoral terms of trade and agricultural transformation
 
 

It is a relatively simple step from the above dual economy model to a two-sector model in which the traditional sector is defined as rural and agricultural, whereas the modern sector is mainly urban and industrial. Relations between the sectors can then be extended to include product market specialization according to comparative advantage. In addition to surplus labor, the traditional sector now provides the principal wage good (food) and raw materials as well as being an additional source of demand for industrial goods and part of the arena for savings mobilization. The inter-sectoral terms of trade then acquire particular significance. If this swings in favor of industry then industrial profits and reinvestment will rise, but rural demand for industrial goods will be reduced. Conversely, high agricultural prices will reduce industrial investment but increase demand. The important implication is that expansion of the modern industrial sector may be held back by a failure to raise productivity of the generally larger population working in agriculture. Hence agricultural transformation, rather than industrial modernization may be the key constraint to economic development.
 
 

Within this framework, market structure in both sectors becomes an important determinant of economic growth. For example, mark-up pricing of industrial goods in small modern industrial enclaves is likely to undermine attempts to stimulate agriculture through price incentives alone. Meanwhile, agrarian structure will determine how any surplus income over and above subsistence requirements is distributed, and how it is allocated between investment and consumption goods. But market structure itself changes with economic development. For example, rural to urban migration (and accompanying changes in institutions and culture) may proceed to the point at which the opportunity cost of labor in the agricultural sector ceases to be zero. Further migration will then raise food prices as well as changing demand and supply of labor in each sector. At this point dualism has disappeared and the economy comes to resemble an orthodox neoclassical general equilibrium model.
 
 

2.3 Growth theory
 
 

The idea that economic development should naturally result in the erosion of dualism (in labor and other markets) establishes a link from classical development economics back to growth theory as pioneered by Abramovitz and Solow. This, in brief, seeks to break economic growth into separable components, the most important being (a) growth in the supply of labor and capital, (b) improvements in the efficiency with which they are allocated between sectors in line with their marginal productivity, and (c) sector specific improvements in technology. Within this framework, dual economy models may be viewed as a special case that highlight one historically important set of barriers to efficient resource allocation. Empirical studies confirm that growth in low income countries is attributable more to capital accumulation, whereas in high income countries it is attributable more to technological change.
 
 

More sophisticated ‘endogenous’ growth models also incorporate causal links between these sources of growth, and the effect of increasing returns to scale. For example, technological change has to be embodied in capital stock and can proceed more rapidly where this is growing. The pace of technological change in different sectors is also determined by expenditure on research and human capital accumulation. Economies of scale also result from expansion of the size of markets and opportunities for specialization. But the relationship between growth and the institutions that govern resource allocation remain important. In this sense, the dual economy model is just the leading example of a range of disaggregated models that can accommodate more complex market fragmentation, and inter-sectoral rigidities. An additional important factor is the contribution to growth of natural resources. Where abundant, these help to sustain the rate of profit. But natural resources may also be a ‘curse’ on growth, by attracting labor and capital (and the attentions of policy makers) away from sectors with higher economies of scale and therefore longer-term growth potential.
 
 

3. The open economy under laissez faire
 
 

3.1 The advantages of free trade
 
 

An obvious limitation of the theories considered so far is neglect of the links between the modernizing nucleus and other more advanced economies. External influences were important even to British industrialization. This sub-section briefly summarizes the three main explanations of why trade has a positive influence on economic development. The remaining sections then consider why trade may also be a source of underdevelopment or regress.
 
 

The most widely cited argument linking trade and economic development is Ricardo’s theory of ‘comparative advantage.’ This can most easily be illustrated with reference to two countries, each producing two goods with two factors of production, neither of which is mobile between the two countries. Ricardo demonstrated that by permitting specialization in production of the goods, trade offers a means to raise the national income of both countries - even if one country is less efficient in producing both goods. Thus, for example, a poor country can benefit from exporting agricultural commodities and importing machinery from a richer country, even if productivity of both labor and capital in the agricultural sector is lower than in the rich country). The theory provides the point of departure for international trade theory generally; extending to multiple product, factor and country cases, allowing for factor mobility, identifying how market relative market power determines the distribution of gains from trade and so on.
 
 

A second reason why trade may act as an engine of economic development, going back to Adam Smith, is that it provides a ‘vent for surplus’. Goods that in the closed economy have very low or zero marginal value (and are consequently unused) acquire value when integrated into the global economy. Natural resources (including mineral products, forest products, uncultivated land) are the leading example, although the argument can also be applied to surplus labor (in poor countries) and even capital (from rich countries). In contrast to neoclassical trade theory, the argument emphasizes the transformative nature of trade and plunder - stimulating institutional changes that increase access to untapped resources, rather than voluntary and marginal reallocations of resources within a framework of established property rights and trading rules.
 
 

A third argument for trade is the dual gap theory. While the dual economy model highlighted shortage of capital (and hence domestic resource mobilization) as the key constraint on economic growth, this theory suggests that a more important bottleneck is likely to be access to foreign exchange. More specifically, this determines the rate of import of key factors of production (such as oil, modern machinery, technical expertise) that have an almost infinite marginal value. Given a relatively constant marginal propensity to import these goods, then short-term domestic economic growth in excess of the growth of foreign exchange earnings will be inflationary. The theory goes beyond the short-term, however, in suggesting that price incentives are insufficient to stimulate domestic production of essential imports. Thus growth is constrained by the ability to export, to attract foreign investment or aid.
 
 

3.2 Adverse barter terms of trade and immiserizing growth
 
 

Perhaps the most celebrated explanation for trade pessimism, attributable to Prebisch and Seers, is that specialization according to comparative advantage may lock some countries into production of goods with low income elasticities of demand. As world income grows, so their share of it consequently declines. Producers may try to maintain demand against this trend by accepting lower prices for their goods, but if demand is price inelastic then they will end up even worse off. Conversely, if they seek to maintain income by raising output, then induced price falls may result in a net income loss - the case of immiserizing growth. Export taxes or quotas across all exporters can prevent this, but this is hard to organize given the temptation to cheat and to free ride on the agreement.
 
 

Barter terms of trade are determined not only by demand and supply for different products, but also by product-specific variation in market structure. Profit mark-ups for newer and more highly differentiated products are likely to be higher than for established and homogeneous goods. Hence gains from trade will accrue largely to the former.
 
 

These arguments explain the ‘Prebisch-Singer’ hypothesis that the terms of trade tend to move over time against primary commodities. If this was not bad enough, the prices of these products have also been found to be more volatile. Thus countries highly specialized in them have a more difficult task achieving macro-economic stability. Nevertheless, many countries, particularly in temperate parts of the world, have achieved rapid economic growth and industrialization from a position of being specialized primary commodity exporters. This suggests that specialists in primary commodity benefit in absolute (if not relative) terms from trade so long as global demand grows rapidly enough. The argument is also complicated by the acquisition of ‘primary commodity status’ by labor-intensive industrial goods, as their markets expand and become more perfectly competitive.
 
 

3.3 Coercive capitalism and the double factoral terms of trade
 
 

Neoclassical trade theory generally assumes the existence of market institutions that ensure trade only takes place with the mutual consent of buyers and sellers. It also assumes that these parties are fully informed and that the consequences of their actions on third parties are fully reflected through the price system. But even a cursory examination of the history of trade relations between the early industrializing countries and the rest of the world reveals that much of what passed as ‘trade’ (in slaves, for example) is better described as theft or (following Marx) as ‘primitive accumulation.’ Even when the rudiments of a market system were established, traders from the ‘core’ countries not only took advantage of local monopolies in the ‘periphery’, but also ruthlessly created and protected them with help from their sponsoring states.
 
 

Out of this terrible episode and the political reactions it inspired, the foundations of a more anonymous and mechanical market-based system emerged, not as an act of benevolence but because it best served the evolving interests of the rich and powerful. Marxist and post-Marxian scholarship serves as an important and continuing counterpoint to development theory that abstracts from the way political power continues to manipulate market institutions and trade. An important example of this is Emanuel’s theory of unequal exchange. This takes as its starting point Marx’s labor theory of value, and explains how the process of equalization of profits through the price system distributes the global surplus (over the cost of reproduction of labor) unequally between core and periphery within the world economy. One strand of the theory is based on how markets distribute the surplus in proportion to capital invested rather than in proportion to the rate of labor exploitation. To the extent that countries in the core are specialized in producing more capital-intensive goods they capture a share of the global surplus generated from labor exploitation in the periphery.
 
 

A second and more important argument hinges on relative wages in core and periphery and need not be rooted in a labor theory of value. The argument also helps to explain why economic development of former colonies (like Australia), that specialized in temperate agricultural goods such as meat and wool proceeded more rapidly than colonies specialized in tropical goods such as coffee, tea and rubber. The key feature of the world economy at the time was the existence of a segmented or dualistic world labor market. The pricing of temperate goods were based on the wage required to attract mostly European immigrants whose reservation wage was linked to their marginal productivity in Europe and the North American frontier. The pricing of tropical goods, in contrast, was influenced by the wage required to attract surplus labor into plantations out of traditional agricultural livelihoods, particularly in India and China. The barter terms of trade between the two types of commodity thus reflected the racially instituted segmentation of the world labor market. The double factoral terms of trade - or the number of hours of periphery labor that could be purchased per hour of core labor was thereby set heavily in favor of the core.
 
 

3.4 Cumulative causation
 
 

The historical contribution of trade to global inequality as well as to growth can be linked to the argument that peripheral countries have remained dependent on the core into the post-colonial era. The argument is primarily political rather than economic to the extent that it hinges on the ability of core countries to manipulate the institutions governing global economic activity to their advantage. However, dependency theory also has a purer economic dimension. Consider two identical and adjacent economies C & P. Assume an exogenous shock (such as industrialization) raises output in one. Neoclassical theory suggests first, that specialization according to static comparative advantage can help spread the benefits to both. Second, it suggests that free factor movements can further reduce the inequality - labor migrating from P to C until wages are again equalized, while capital flows (assuming diminishing marginal returns to capital in the C) flow in the opposite direction until rates of profit are equalized.
 
 

If these are called ‘spread’ effects (using Myrdal’s terminology), then they need to be juxtaposed with ‘backwash’ effects that arise from a failure to achieve this particular equilibrium. Migration from P to C reduces effective demand in P and hence the size of its market. This reduces opportunities for realization of economies of scale and undermines incentives to invest there. It also denudes P of entrepreneurial talent and skilled labor. Restricted in its ability to diversify into new products, the remaining capitalists in P specialize in traditional exports. Rather than reinvesting profits locally, they are more likely to invest them in C (capital flight) or use them to purchase luxury consumption goods from C - the ‘Dusenberry effect’.

In contrast, in C we have a post-Keynesian perspective on growth. Investment responds to growth according to Harrod's ‘accelerator principle’, that investment is a function of the rate of growth. Labour productivity also rises in proportion to the size of the market (Verdoorn's law). In other words, growth has external effects that stimulate further growth. Likewise C specializes in those industries that are subject to greatest economies of scale through learning by doing and investment in human capital..

Overall a process of cumulative causation (virtuous cycles in the center, vicious cycles on the periphery) magnifies the initial shock and result in a polarisation of average incomes. However, average income growth in P, while slower than in C, may nevertheless be higher than they would have done in the absence of trade.
 
 

4. Dirigisme in a closed economy
 
 

4. 1. The case for state planning
 
 

Pessimism about the effect of free-trade on national economic development, coupled with weak domestic market institutions helped to pursuade many governments of newly independent countries to play a more proactive role in relation to economic development. Eonomic historians also drew attention to the ‘Gerschenkron effect’ or growth over time in the minimum efficient scale (and hence investment cost) of industrial plant and machinery. Underdeveloped domestic capital markets seemed incapable of responding to the challenge, thus the onus was placed on the state to use a wider range of more or less coercive mechanisms (taxation, printing money, asset seizure, forced labor) to mobilize the necessary resources.
 
 

A further reason for doubting the ability of the private sector to modernize the economy was provided by the "big push" theory, of Rosenstein-Rodan. At its most general, the theory highlights a co-ordination failure among capitalists whose individual investment decisions all depend on demand and supply linkages (or pecuniary externalities) arising from each others’ investments. If they could co-ordinate these decisions then the problem could be overcome. But in practice mutual suspicion, risk and uncertainty make this difficult without the state taking a lead. The interdependence of investments also adds to the indivisibility of investment and hence the overall financing problem. In the more rigorous version of the theory the switch to more capital-intensive technology within any sector also entails having to offer labor a wage premium. But this extra cost can only be justified at a level of production (and hence demand) that can be attained only by all other firms making the switch (and paying higher wages) at the same time.
 
 

4.2. Investment planning strategies
 
 

The existence of market failures only constitutes grounds for intervention if the state can achieve the necessary resource allocation at least as efficiently. To assist in this task, input-output modeling was used to work out the intermediate inputs required at the beginning of a planning period in order to achieve a desired combination of outputs at its end. The challenge was to avoid both surplus production and bottlenecks, without being able to eliminate them through external trade or a competitive market pricing system. Power to ration consumer goods and to appropriate resources from outside the plan allowed some room for maneuver, albeit at the expense of individual rights. Planning could also be restricted to highly interdependent complexes of sectors within the economy (linked to armaments or heavy industry, for example) leaving other sectors (hopefully) to the private sector or to later generations.
 
 

A feature of this approach is the ability of the state to impose its own time horizon on the economy by surpressing private consumption. A long time-horizon also held out the alluring prospect for latecomers of being able to take short cuts. The heavy industry argument, for example, justifies surpressing current production of wage goods in order to accelerate production of capital goods. Future bottlenecks in the supply of capital goods are thereby eased, permitting the economy to acquire a larger capacity to make wage goods in the future. In a milder form, planners sought to invest strategically in goods and services (such as infrastructure) that would create investment opportunities that could then be taken up by the private sector. Taking a regional trading block as a closed economy, the core economy might similarly strategically leave some sectors for peripheral trading ‘partners’ to specialize in, so as to release domestic resources for entry into new sectors.
 
 

In its cruder and more ambitious form, central planning within a closed economy has proved unable to deliver sustained growth. The central problem was perhaps the political one of determining who should decide what to produce. Other problems included the creation of incentives to ensure compliance with the plan at all levels, while at the same time encouraging innovation. All these problems were further compounded by the growing complexity of input-output systems led by consumer demand rather than the requirements of rearmament or initial industrialization. However, disaggregated models of the economy have emerged as an important tool for analysis of policy options that are sufficiently important to have linkage effects throughout the economy. They include general equilibrium models that allow some flexibility in input-output ratios in response to price, and models based on social accounting matrices that allow analysis of the distributional impact of structural change and policy options.
 
 

5. Dirigisme in an open economy
 
 

Many of the problems of external trade under laissez faire, and of dirigisme in a closed economy can potentially be overcome through state regulation of external trade. For example, an active ‘developmental state’ may be able to renegotiate terms of trade and of inward investment to increase ‘spread’ effects and reduce ‘backwash’ effects. Meanwhile, if transaction costs are sufficiently low, then external demand can be used to drive modernization of a particular sector by itself, thereby avoiding the big-push problem. This section first reviews the policy instruments available to governments for strategic management of trade, and the infant industry argument that underpins them. It then uses the idea of the ‘Ricardian ladder’ to develop a theory of how state intervention contributed to the successful late industrialization of much of East Asia. It finishes by reviewing briefly the potential pitfalls of both the import-substitution and export-led components of this strategy.
 
 

5.1 Inward and Outward Oriented trade strategies
 
 

One policy measure open to governments is to maintain an overvalued exchange rate; that is a rate at which demand for foreign exchange (from importers and those wishing to save abroad) exceeds supply. This confers on government discretion to direct foreign exchange towards some activities and organizations, and away from others. For example, it could allow a favored company to import materials relatively cheaply, and at the same time protect it from foreign competition by restricting licenses for import of its final products. An overvalued exchange rate also often serves as a general tax on exporters. Specific import quotas and tariffs can also be used to encourage import substitution within specific sectors. To the extent that these instruments raise domestic prices and divert investment from other activities they also discourage investment in exports. These different instruments can all be used to differing degrees in pursuit of an ‘inward oriented’ industrialization strategy. In contrast, an ‘outward oriented’ strategy is based on a liberal exchange rate market, the removal of restrictions on imports and possibly use of selective subsidies to promote exports.
 
 

Economists have well worn tools for calculating the short-term budgetary and efficiency costs of using these instruments. However, they also recognize the possibility that these costs can be justified if the interventions offset market failures. For example, there may be benefits to society from the entry of a local firm into new markets - demonstration effects, for example. But if the firm itself does not reap the full reward from its investment it will hold back. A public subsidy may then encourage the firm to risk entering into the market. This then results in wider long-term benefits to the economy and these benefits more than offset the initial subsidy cost. This is an example of the ‘infant industry argument’. The important points to note about it are (a) the subsidy should only have to be temporary, (b) it is justified by benefits that cannot be captured by the investor, and (c) the resulting benefits should be more than sufficient to offset the original subsidy cost. Selective subsidies and tariffs may also help firms to overcome financial constraints to entry into new markets (by raising prospective as well as short-term profits). But such constraints are in principle better overcome by development of local capital markets, and so financial constraints do not in themselves constitute ‘infant industry’ grounds for subsidies.
 
 

5.2 The Ricardian Ladder
 
 

The infant industry argument was widely cited to justify ‘first-round’ import substitution policies to encourage domestic production of consumer goods, such as textiles. These industries generally required less advanced technology, less skilled labor and were subject to less economies of scale than more capital-intensive intermediate goods (like chemicals, machinery) and ‘knowledge-intensive’ services. For this reason, ‘second-round’ import substitution policies designed to assist local firms to penetrate these markets often proved less successful. An alternative strategy was to switch from first round import substitution to promoting exports of consumer goods. The theory of the ‘Ricardian ladder’ builds on these observations by suggesting a path for late industrialization that is based on selective application of incentives to inward and outward oriented investment. Success in export of primary products on the basis of comparative advantage can help to raise wages and hence build a market for domestic consumer goods. Success with import substitution in this market lays the foundations for export-led growth based on these same sectors. This in turn may help to increase the size of the domestic market and the skills of both labor and entrepreneurial classes to the point at which import substitution (and in time export) of more complex products becomes possible.
 
 

One precondition for successful ascent of the Ricardian ladder is the willingness and ability of policy makers to implement such a complex strategic plan through timely creation of appropriate economic incentives. If firms receive strategic subsidies for activities, but fail to become internationally competitive in them, then the whole strategy can easily degenerate into a system of political patronage that permanently sustains inefficient use of resources. Moreover, if industrial success is seen to depend mostly upon obtaining government licenses, grants and licenses for local monopolies, then this will divert entrepreneurial talent and resources away from the task of improving international competitiveness. Such behavior is called rent seeking. The efficiency cost to the economy does not equal the value of the rents themselves, such as bribes to officials for licenses. For these are pure transfers. Rather the cost arises from the directly unproductive activities (and use of resources) that they stimulate. Thus implementation of the policy depends not only on the existence of policy networks with the necessary technical ability, but also on their ability to insulate themselves from the politics of patronage. Such networks have tended to be associated within ‘developmental states’ unified by a strong national ideology or by external threats. Successful economic development can itself undermine the developmental state that delivers it. For it stimulates a proliferation of new economic interest groups (both within the business class and labor) that challenge the old networks directly, as well as the culture and ideologies that sustained them.
 
 

Another precondition for successful economic ascent of the Ricardian ladder, is access to external markets. If too many countries seek to penetrate strategic export markets simultaneously then the market may become glutted. The strategy may also provoke retaliation, particularly if it threatens local industries and if export subsidies are being used. Achieving international competitiveness may also hinge on the terms of access to foreign capital and technology, assuming these cannot be generated locally for lack of adequate financing, skills or research capability. If those

at the top of the Ricardian ladder can control access to lower rungs among satellite economies, then the theory can be transformed into a multi-sector closed economy model with a core and periphery. On the other hand, if the core needs growth in the periphery as a source of demand, then there is the potential for a global co-ordination problem – immediate fears of labor displacement blinding economic leaders from sanctioning trade liberalization to stimulate global growth from which new employment opportunities should emerge.
 
 

6. Economic development, income distribution, poverty and well being.
 
 

This review has so far concentrated on how predominantly agrarian low and middle economies can transform themselves so as to raise resource productivity and hence economic growth rates. But the latter (as measured by changes in GDP per person, for example) is widely recognized to be a deeply flawed indicator of human welfare. An important response to this problem is to broaden the definition and measurement of GDP to incorporate consumption of non-monetized goods and services. However, the more fundamental issue is how to take into account the unequal distribution of GDP on human welfare.
 
 

6.1 A utilitarian approach
 
 

A utilitarian approach to poverty definition can be easily summarized. First, overall well being or welfare is defined as a function of the welfare of individuals (or households). Second, individual income (better still consumption) is taken as a proxy indicator of individual welfare. Overall welfare can then be defined as a function of individual income. Third, all individuals are ranked according to their income, and ascribed weights according to their position. For example, a ‘progressive’ set of weights attribute a greater gain in welfare to one dollar transferred to a poorer individual than to any richer individual. In contrast, the ‘dollar democracy’ assumption (employed in most applied welfare economics) attributes the same marginal welfare gain to an extra dollar of income regardless of who receives it. This is the same as arguing that income distribution at any point in time is broadly fair. A poverty line approach, in contrast, gives zero weight to any income above that needed to secure some minimum set of basic needs. More complex measures go further by increasing welfare weights according to how far poor individuals fall below the poverty line. The consequence of defining development using any progressive welfare function (rather than aggregate national income) is that maximizing economic growth will not automatically maximize well being if it also entails a worsening in the distribution of income.
 
 

This approach provides quantitative poverty indicators, against which the performance of development policies and programs can be evaluated. For example, the World Bank estimated that the number of people living in absolute poverty (defined as the local equivalent of one US dollar a day at 1993 prices and purchasing parities) in the world in 1987 was 1,227 million (or 30.1 per cent), compared to 1,314 million (29.4 per cent) in 1993. The absolute numbers fell (from 464 to 446 million) in East Asia and the Pacific. In South Asia the numbers rose (from 480 to 515 million), but the head count ratio fell (from 45.4 to 43.1 per cent). In Sub-Saharan Africa the absolute numbers in poverty rose (from 180 to 219 million) and the head count ratio rose (from 38.5 to 39.1 per cent).
 
 

At least five criticisms of this approach to poverty definition and measurement can be distinguished. First, it assumes that all individuals have the freedom to purchase the goods and services that they most need, or that money is fully ‘fungible’. Second, it assumes that all individuals know what is best for them, or make ‘rational choices’. Third, it ignores non-market allocation of resources, particularly within households. Fourth, income measures often fail to take into account important non-tradable influences on welfare, including work, freedom, envy. Finally, it leaves undetermined the issue of which particular welfare function should be selected. For example, the legitimacy of a policy that targets people below a standard poverty line (such as a dollar a day) is limited if that line is seen as essentially arbitrary.
 
 

6.2 Alternative approaches
 
 

Problems of aggregation (and failure of the fungibility assumption) can be avoided by defining poverty in terms of the failure to satisfy a heterogeneous list of basic needs. Doyal and Gough, for example, start with just two: survival (requiring both physical and mental health) and autonomy (requiring mental health, understanding, and some freedom of choice). From this starting point they list eleven intermediate needs: food & water, shelter, non-hazardous work environment & physical environment, health care, childhood security, primary relationships, physical security, economic security, safe birth control & child bearing, basic education. These in turn can be met by a host of distinct and culturally specific institutions.
 
 

The main point of difference here from the utilitarian approach described above is the emphasis on the limited substitutability of different human needs. In place of economic growth, it suggests that human development should be measured by progress towards meeting a checklist of these needs. This also helps to avoid the problems of stigma and dependency that may arise from labeling some individuals as poor in more general terms. The weak correlation between different indicators of basic needs and average income highlights the limitations of giving too much weight to income, or indeed any one indicator. On the other hand, alternative indicators often implicitly adopt welfare weights that are inconsistent or arbitrary. For example, life expectancy and years of schooling give equal weight to extra years without any notion of diminishing marginal returns, whereas mortality and literacy rates are dichotomous like the poverty line. Composite indicators, such as the Human Development Index, are often even more inconsistent and arbitrary. Yet without them, the question of how to set priorities between different needs remains unanswered.
 
 

A second point of departure from the neoclassical approach to measurement emphasizes the relational as well as the distributional dimension of poverty. One tradition (following Durkheim) emphasizes the importance of alienation, the break down of social cohesion and solidarity. A second (particularly in the USA) highlights welfare dependency and the creation of a culture of poverty or an underclass. A third emphasizes social and political marginalization and exclusion or loss of rights. A fourth (following Townsend) emphasizes the idea of relative deprivation or lack of sufficient resources to share in living conditions (and participate in activities) that are customary to a wider society. The differences between them are important. But they all highlight the point that welfare is not separable and additive. Furthermore they all suggest that economic growth directly adversely effects some important dimensions of human well being, at the same time as increasing the resources that are potentially available to improve other aspects.
 
 

How then should the goal of economic growth through industrialization be weighed against human development, defined as fulfillment of a broad set of human needs? It is possible (following Kornai) to distinguish between three strategies: industrialize and hope that human development will follow (‘rushed growth’); go for balance (‘harmonic growth’); and go for human development first by prioritizing investment in basic services (‘social overhead capital’). The problem with rushed growth is that it may exacerbate income, wealth and power disparities in a world that has shown its capacity to confound Marxian dialectics. The problem with the second, lies in mobilizing the necessary resources - another version of the big push problem. The third option is currently fashionable among international development agencies, not least because it justifies their existence. Empirical evidence on whether investment in social overhead capital crowds industrial investment in or out is ambiguous. Much depends upon political, institutional and cultural endowments of particular states or regions.
 
 

7. Economic development, culture and institutions.
 
 

Much of the theory considered so far has implicitly assumed that there is one universal path of economic development. Consideration of the diversity of cultures and institutions within which economic activity is historically embedded leads to a different conclusion. Culture is here defined as a shared endowment of values and norms. It influences both the ends of economic activity (e.g. what is regarded as a basic need), and the means for achieving them (e.g. individual motivation). With respect to the former, "Western" economics has been criticized for being concerned too narrowly with the individual and with the material. The bias in favor of materialism can be addressed, at least in part, by incorporating other "goods" (most obviously time-use) into the utility functions of different actors. Against the charge of individualism, it can be observed that many of the theories cited so far do indeed seek to maximize collective national development. But there is a widespread tendency to neglect individual interests (particularly those of women and children) in favor of collective household interests. Addressing this problem has requires that theory is recast to reflect more complex power structures and social processes.
 
 

The direct influence of culture on the means for achieving economic development has spawned a large literature, much of it of dubious quality. The link between the two has invariably been found to depend upon on many other factors, with culture itself proving to be capable of sometimes quite dramatic adaptation to changing economic circumstances. Likewise ‘traditional’ or ‘entrepreneurial’ values (however defined and measured) are as much a consequence of economic conditions as a cause. The relationship between the two is further complicated by the influence of institutions, or rules and norms influencing how people behave. While institutions clearly reflect culture, different institutions arise within similar cultures, and similar institutions exist across different cultures. For example, not all societies that owe much to Confucianism have a strong work ethic, and this is an institution that has been linked to other cultures, most famously Protestantism.
 
 

Economists have generally sought to avoid these complexities by assuming that culture (embodied in tastes and preferences) and institutions (such as the household) are exogenous or unchanging. Alternatively, they have assumed that institutions adapt smoothly and costlessly to facilitate efficient resource allocation and can therefore be ignored. But a long line of institutional economists have dissented from this position, by seeking to make institutional change endogenous to their theories. An important conclusion arising from this work is that the best development strategy is ‘path dependent’ or depends upon its historical endowment.
 
 

7.1 Agricultural transformation and imperfect information.
 
 

The importance of the agricultural sector as a source of food and labor, and as a source of livelihoods and demand for industrial products has already been discussed. From a modernization perspective, the "moral economy" of semi-subsistence farmers or peasants was often regarded as a major obstacle to development - bound by tradition, resistant to individual advancement, suspicious of innovation and market integration. Systematic modeling of peasant household decision making, however, revealed that many seemingly irrational decisions (such as reducing marketed surplus in response to an increase in crop prices) could be explained using orthodox neoclassical models, once these were extended to accommodate income-work trade-offs and risk aversion. These laid the foundations for agricultural development policies that sought to build on peasant institutions, rather than assuming that peasants would either disappear (by separating out into capitalist farmers and landless laborers) or should be forcibly dismantled.
 
 

A famous strand of this debate concerned the institution of sharecropping, under which tenant and landlord agree to divide a crop between them. Marshall observed that this could be inefficient when compared to fixed rent or fixed wage contracts (or a mixture of the two) because it discourages labor and capital from being applied to a plot of land up to the point at which total marginal cost equals the marginal return. However, sharecropping was found to be efficient in the presence of information asymmetry (or non-trivial contracting costs) and the absence of an insurance market. Stiglitz, for example, found it to be a rational compromise between landlord responsibility (with less risk aversion but higher supervision costs) and tenant responsibility (with more risk aversion but lower supervision costs). This insight then helped economists to explain the resilience of other traditional (and seemingly inefficient) agrarian institutions, such as the common practice of ‘market interlinkage’, or contracts that combine transactions in seemingly separable goods and services.
 
 

7.2 The new institutional economics
 
 

Generalizing these insights still further, it is possible to develop a broader theory of underdevelopment that is rooted in the weakness of market institutions. In areas with a low population density, poor media for spreading information about product characteristics, and weak mechanisms for enforcing contracts then markets will be highly interlinked or missing completely. High transaction costs and strong externalities between neighbors will then encourage non-market resource allocation. Villages, for example, may be viewed as a form of social organization that internalize many functions that are performed in industrial countries by the market, firms and the state. Their identity is often framed around common pool resources and public goods, such as water, grazing, trust, peace, religious identity, and mutual knowledge. But they govern resource allocation not only through explicit forms of hierarchy, but also by accentuating the penalty to any individual of gaining a weak reputation or being deemed untrustworthy. However, critics of this strand of the new institutional economics warn that such institutions (sharecropping, market interlinkage, villages) may prove resilient over time not only because they are cost-effective responses to high transactions costs and unequal access to information. They also often help to reinforce an often highly unequal distribution of power, and are molded by social history and culture in ways that cannot be reduced to economics.
 
 

Institutional theories of economic development are not only confined to the agricultural sector and to microeconomics. The discussion of open economy dirigisme in Section 5, for example, led to recognition that a key determinant of economic growth was the willingness and ability of the ‘developmental state’ to intervene successfully in the market, and to sustain unified and effective policy coalitions. Conversely, slow growth in many other countries can be attributed to the dominance of self-serving behavior (patron-client systems, free-riding, rent-seeking) within the equivalent policy networks. Economic models based on the rational choice assumption that behavior is governed by voluntary transactions among politicians, bureaucrats, senior business people and indeed academics have advanced understanding of these problems. But this approach should not divert attention away from the importance of coercive power relations, culture and identity in explaining diverse patterns of economic development. For example, economic discourse of the kind represented by this article itself reflects a ‘Western’, technocratic assumption about the relative importance of technical and rational processes to the development process.
 
 

8. Economic development and population
 
 

No issue within the ambit of development economics is more important, or raises more controversy than that of the relationship between population growth and human welfare, particularly given the link between both and environmental change. This section starts with a review of the multiple causes of population growth, with an emphasis on the economics of children. It then explores the positive and negative effects of population growth on economic growth and human welfare, and concludes with a short discussion of population policy.
 
 

8.1 Determinants of population growth
 
 

The theory of demographic transition states that economic growth (and associated processes of modernization, such as urbanization) results in a fall in both crude death rates (CDRs) and crude birth rates (CBRs), but that the CDR falls more rapidly than the CBR. The theory can be explained in provision of death reducing institutions and services (such as clean water, sanitation, medical facilities) than of fertility reducing institutions and services (such as delayed parenthood, birth spacing and contraception). So long as a gap persists between the CBR and the CDR then natural population growth (that is growth not attributable to net migration) will be positive. Furthermore, the temporary burst of population growth thus resulting from economic development is accentuated by the phenomenon of demographic momentum. This refers to population growth arising from the increase in the proportion of women of childbearing age that itself results from population growth. The theory of demographic transition highlights the importance of understanding what determines the total fertility rate (TFR), or the number of children a woman would have if she matched current age-specific birth rates throughout her life. The TFR may be viewed as a lead indicator of the CBR, since it does not capture effects attributable to demographic momentum.
 
 

Following Becker, a useful starting point for modeling changes in the TFR is to regard children as a complex durable asset (part investment, part consumption good) subject to rational choice cost-benefit calculations of their parents. Changes in the TFR can then be linked to wider changes that have a significant positive or negative effect on the number of children that parents consider it beneficial to aim to have. Positive effects include the expected pleasure or satisfaction to be had from children and from having heirs, the net present value of income children are expected to earn for the household, and their role in providing security for parents during old age. Negative effects include physical and psychological risks and hardships of bearing and rearing children, the actual costs incurred, and the opportunity costs of labor required for childcare. Marginal opportunity costs for average parents are likely to rise as child rearing claims a larger and larger proportion of their budget, and hence there will be some optimum desired number of surviving children (DC) at which marginal costs and benefits are equal.
 
 

Models based on these assumptions permit a number of hypotheses to be advanced to explain the negative correlation between economic development and the TFR. For example, the TFR is likely (other things equal) to be higher, the greater is the present value of children’s labor, the less access parents have to formal social security, and the greater the opportunity cost of parents’ time. If the costs of rearing children assumed by women are greater than their share of the benefits, then the TFR will be lower the more say women have over fertility decisions. It is also likely to be lower where parents have the option to substitute a larger number of less educated children for a smaller number of more educated children as they become richer. However, a fully comprehensive theory of the link between fertility and economic development also needs to take into two additional considerations. First, induced changes in culture and institutions (such as marriage, pro-natalism, inter-generational relations) alter the degree of autonomy that parents have over the fertility decision. Second, nutrition, health, availability of contraception and control over intercourse may all physically prevent men and women from attaining the number of children they want.
 
 

8.2 Economic Consequences of Population Growth
 
 

Development economists were initially particularly concerned with the influence of population growth on the savings rate. There were two distinct approaches. First, changes in worker-dependency ratios (due to a rise in the proportion of both very young and very old people) might be expected to reduce savings rates (more mouths, less hands). Second, population growth would affect the functional distribution of income between workers and capitalists. If it helped to sustain the existence of surplus labor and hence restrains wages, then profit rates stay high and this may increase overall savings rates. But if real food prices rise (due to diminishing marginal returns in agriculture) then the terms of trade may go against capitalists and in favor of rich landlords and peasants whose marginal propensity to save in high productivity activities is lower. However, both these lines of reasoning are limited because they assume (a) rates of return on saving are not also being affected (b) parents are not already taking into account possible rates of return to investment in children for old age, in line with portfolio and life-cycle theories of saving.
 
 

Starting instead from a neoclassical and rational choice perspective, it can be inferred that the number of children born will be the same as the number that maximize human welfare only if three conditions are satisfied. These are that (a) parents have perfect foresight (b) they are able to achieve the number of children they want, and (c) they fully take into account externalities, or the costs and benefits of their children on other people. Economists have generally concentrated on identifying and measuring the external effects. But departures from the first two conditions are also important. In particular, overpopulation is likely to result where the infant mortality rate is high and parents are strongly averse to falling below their target number of children. This argument supports the counter-intuitive but widely accepted view that reducing infant mortality is essential to any strategy for reducing population growth. Second, reducing population growth may be desirable not because it harms economic growth, but because it indicates that more people (particularly women) are avoiding having more children than they wanted.
 
 

The most important negative externality argument is that population growth dilutes access to a fixed stock of natural capital, particularly land. Malthus’ original formulation of this argument assumed that parents could not control their own fertility (or, more precisely, that any increase in wages would be dissipated through earlier marriage leading to increased labor supply that would drive wages back again to subsistence level). But capital dilution may also result from weak property rights if parents consequently fail to take into account the marginal effect of their children on availability of capital for the children of other people. Other forms of collective capital, such as public services and aid flows, may also be diluted by population growth even where these are not fixed, but supplied with a lag.
 
 

All these arguments hinge on the existence of diminishing marginal returns to labor, and need to be weighed against empirical evidence in the opposite direction. Population growth creates opportunities for increasing specialization and realization of economies of scale. It may also increase the supply of productivity enhancing geniuses more than productivity undermining idiots, as well as inducing demand for technological change. Higher population density may also lower transactions costs, and reduce the cost per person of investment in non-rival public goods, such as defense, environmental protection, social infrastructure, public administration, research and technology generation.
 
 

In countries undergoing industrialization, population growth has almost invariably also been positive, suggesting that the positive external effects prevail. But the transitional capital dilution effects arising from population growth of more than a couple of percentage points per year may also act as a drag on the growth of average incomes, even in areas with relatively low population densities. However, the case for stronger policy intervention to reduce birth rates generally rests more convincingly on the adverse distributional effects of population growth, particularly on women. In such cases fertility can often be influenced sufficiently by measures that reduce infant mortality rates, improve women’s control over their own fertility and raise the opportunity cost of their time by strengthening their educational and employment opportunities.
 
 

Acknowledgements

 This overview of theories of economic development has evolved over seven years of teaching the subject to undergraduates and postgraduates at Bath. I am grateful to them and to colleagues for helping to clarify my thinking in innumerable ways. Thanks also to Edward Horesth, Liam Aspin and for helpful comments on an earlier draft.
 
 

Bibliography

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Table 1: A typology of theories of economic development
 
 
 

TRADE ORIENTATION	CLOSED	OPEN	CLOSED	OPEN
ROLE OF THE STATE	LAISEZ-FAIRE	LAISSEZ-FAIRE	DIRIGISTE	DIRIGISTE
MAIN ECONOMIC TASKS OF THE STATE	To maintain law & order, and protect property rights	To maintain law & order and to encourage trade	To overcome market failures through planning	To regulate markets & competing political interests
FEATURES OF LABOUR ALLOCATION	Dualism & absorption into the expanding capitalist nucleus	International division of labour; unequal exchange	Coercive mass mobilisation	Comparative advantage influenced by quality of human resources
FEATURES OF CAPITAL ALLOCATION	Financial deepening	External capital flows	Forced saving; comprehensive planning; inward orientation	Regulated competition and outward orientation
KEY MODELS & TECHNIQUES	Dual economy models; growth theory	Dual-gap model; centre-periphery models	Heavy industry & big push models. Input-output models	Swan/Salter model; cost benefit analysis
LEADING EMPIRICAL EXAMPLES	Britain during the industrial revolution	Most countries during the colonial period	Military/war economies; pre-reform Russian, China and India	The Newly Industrialized Countries (NICs)
POSITIVE ASSESSMENT	Efficient resource allocation	Benefits of a wider market, including competition, specialisation and capital inflows	Economies of scale; Reduced dependency; Faster capital accumulation	Smoother, & more equitable growth
NEGATIVE ASSESSMENT	Inequality; business cycles	Private sector monopolies and increasing inequality; immizerizing growth	Low rates of technological innovation; rent-seeking	Rent-seeking: adverse terms of trade

 
 
 

Diagram 1: A schematic view of the history of theories of economic development