Syllabus, Procedure and Practice Questions for Midterm Exam 1

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Wilfrid Laurier University Department of Economics Lazaridis School of Business & Economics EC 207  Section B  Economic Development Winter 2024 Date and Time: Thursday, February 15 from 11.30 am to 12.50 pm Allocated Room and Building for Midterm Exam 1: Bricker Academic Building (BA 102) Practice Questions for Midterm Exam 1 Syllabus Chapter 1: Introducing Economic Development: A Global Perspective Chapter 2: Comparative Economics Development Chapter 3: Classic Theories of Economic Growth and Development Important Concepts 1. The meaning of growth and development  The traditional measures (GNP, GNP per capita, the level of industrialization)  The new economic view of development (Sen’s capability to function approach: funtionings and capabilities) 2. The nature and scope of development economics 3. The three core values of development 4. The millennium development goals 5. The sustainable development goals 5. Which countries are regarded as developing or low-income countries?  The World bank Scheme  The HDI and NHDI measure 6. Measuring development  The exchange rate method  The PPP method 7. Characteristics of the developing world (the commonality and differences among the developing countries) 8. The issue of convergence (the empirical model- The Solow Swan growth model) 9. Classic Theories of Economic Growth and Development Students need to know the assumptions, the structure and main findings of these models. Identify the implications and limitations of each of these models. (i). The linear stages of growth model  The Harrod-Domar model  Rostow’s stages of growth model 1

(ii). The structural change model  The two-sector surplus labor model (the Lewis model)  The patterns of development model (the Chenery model) (iii). The international dependence revolution model  The neocolonial dependence model  The false paradigm model  The dualistic development thesis model (iv). The neoclassical free market counterrevolution model  The free market approach  The public choice approach  The market friendly approach  Examples  the exogenous Solow-Swan growth model and the endogenous Romer growth model Sample Questions 1. Is the concept of the developing world a useful one? Why or why not? Answer In the World Bank’s classification system, 208 economies with a population of at least 30,000 are ranked by their levels of gross national income (GNI) per capita. These economies are then classified as low-income countries (LICs), lower-middle-income countries (LMCs), upper-middle-income countries (UMCs), high-income OECD countries, and other high-income countries. Generally speaking, the developing countries are those with low-, lower middle, or upper-middle incomes. Low-income countries are defined by the World Bank as having a per capita gross national income in 2005 of $875 or less; lower-middle-income countries have incomes between $876 and $3,465; upper-middle-income countries have incomes between $3,466 and $10,725; and high-income countries have incomes of $10,726 or more. The United Nations Development Program (UNDP) classifies countries according to their level of human development, including health and education attainments. The simple division of the world into developed and developing countries is often useful for analytical and policy purposes. However, the wide income range of the latter serves as an early warning for us not to over generalize. Indeed, the economic differences between low-income countries in sub-Saharan Africa and South Asia and between upper-middle-income countries in East Asia and Latin America can be every bit as profound as those between high-income OECD and upper-middle-income developing countries. 2. In what way is development economics greater in scope than traditional economics? 2

Answer Traditional economics is concerned primarily with the efficient, least-cost allocation of scarce productive resources and with the optimal growth of these resources over time so as to produce an ever-expanding range of goods and services. By traditional economics we simply mean the neoclassical economics taught in introductory textbooks. Traditional neoclassical economics deals with  advanced capitalist world of perfect markets  consumer sovereignty  automatic price adjustments  decisions made on the basis of marginal, private-profit and utility calculations  equilibrium outcomes in all product and resource markets.  It assumes economic “rationality” and a purely materialistic, individualistic, self- interested orientation toward economic decision making. Political economy goes beyond traditional economics to study, among other things, the social and institutional processes through which certain groups of economic and political elites influence the allocation of scarce productive resources now and in the future, either for their own benefit exclusively or for that of the larger population as well. Political economy is therefore concerned with the relationship between politics and economics, with a special emphasis on the role of power in economic decision making. Development economics has an even greater scope. In addition to being concerned with the efficient allocation of existing scarce (or idle) productive resources and with their sustained growth over time; it must also deal with the economic, social, political, and institutional mechanisms, both public and private, necessary to bring about rapid (at least by historical standards) and large-scale improvements in levels of living for the peoples of Africa, Asia, Latin America, and the formerly socialist transition economies. Why Study?  The study of economic development is one of the newest, most exciting, and most challenging branches of the broader disciplines of economics and political economy.  Development economics is a distinct field, rather than an agglomeration of other economics subfields; it has own distinctive analytical and methodological identity.  Development economics must encompass the study of institutional and social, as well as economic mechanisms, for modernizing an economy while eliminating absolute poverty. 3

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3. How does the concept of “capabilities to function” help us gain insight into development goals and achievements? What is the meaning of functionings? Answer In effect, Sen argues that poverty cannot be properly measured by income or even by utility as conventionally understood; what matters is not the things a person has—or the feelings these provide—but what a person is, or can be, and does, or can do. What matters for well-being is not just the characteristics of commodities consumed, as in the utility approach, but what use the consumer can and does make of commodities. For example, a book is of little value to an illiterate person (except perhaps as cooking fuel or as a status symbol). Or as Sen noted, a person with parasitic diseases will be less able to extract nourishment from a given quantity of food than someone without parasites. To make any sense of the concept of human well-being in general, and poverty in particular, we need to think beyond the availability of commodities and consider their use: to address what Sen calls functionings, that is, what a person does (or can do) with the commodities of given characteristics that they come to possess or control. Thus, looking at real income levels or even the levels of consumption of specific commodities cannot be a good measure of well-being. Sen then defines capabilities as “the freedom that a person has in terms of the choice of functionings, given his personal features (conversion of capabilities into functionings) and his command over commodities”. Freedom of choice, or control of one’s own life, is itself a central aspect of most understandings of well-being. According to Sen (1995), “the capability to function” is what matters for a status as a poor or a non-poor person. Poverty cannot be measured properly by income or utility alone. Real income is essential, but to convert the characteristics of commodities into functionings, in most important cases, surely requires health and education as well as income. For Sen, human “well-being” means “being well” and having freedom of choices in what one can become and can do. There are five sources of disparity between real incomes and actual advantages:  personal heterogeneities (connected to age, gender, illness or disability)  environmental diversities (heating and clothing requirements, infectious diseases in tropics or the impact of pollution)  variations in social climate (prevalence of crime and violence; and social capital)  differences in relational perspectives (customs and norms)  Distribution within the family (family resource may be distributed unevenly) Some Important “Beings” and “Doings” in Capability to Function:  being able to live long  being well-nourished  being healthy  being literate 4

 being well-clothed  being mobile  being able to take part in the life of the community  being happy – as a state of being - may be valued as a functioning 4. Describe the various definitions of the term development encountered in this course. What are the strengths and weaknesses of each approach? Answer See the section in Chapter 1 entitled, “What Do WE Mean by Development,” on pages 16-22 for some ideas about how you might answer this question. Your answer should in some way say that development deals more than just growth of income per capita. Discuss the traditional measures, new economic view of development, relationship between development and happiness, three core values of development and three objectives, and finally the role of women in the development process. 5. Explain the many ways in which developing countries may differ in their economic, social, and political structures. Answer Discuss in terms of ten characteristics of the developing world (diversity within commonality) • Low levels of living and productivity • Low levels of human capital • High levels of income inequality and absolute poverty • High rates of population growth • Social fraternization • Large rural population with rapid rural–urban migration • Low levels of industrialization and manufactured exports • Adverse geography • Underdeveloped financial systems and markets • Lingering colonial impact, varying external dependence, and governance challenges See Todaro and Smith textbook, pgs. 55-73. 6. What are the main differences between the linear stages and international dependency models of development? Answer First, provide a brief overview of the two models. Linear stages of growth (1950 and 60s)  The theories of 1950s and 1960s viewed the process of economic development as a series of successive stages through which all countries must pass.  Correct mixture and quantity of saving (S), investment (I) and foreign aid are needed to follow the economic growth process. 5

 Development was synonymous with economic growth.  The development economists were mostly from developed countries and they rely on two strands of thought- Marshall Plan and the historical transformation of the developed countries. International dependence revolution theories (1970s) The principal idea behind the International-Dependence Revolution is that the third world countries are caught up in a dependence and dominance relationship with the rich countries, and the rich countries either intentionally or unintentionally contributes so that this relationship perpetuates and the status quo is maintained. Underdevelopment must be viewed in terms of international and domestic power relations; institutional and structural economic rigidities and the resulting proliferation of dual economies and dual societies both within and among the nations of the world. The model focuses on the external and internal institutional and political constraints on development. It attributes the existence and continuance of underdevelopment primarily to the historical evolution of a highly unequal international capitalist system of rich country– poor country relationships. Whether because rich nations are intentionally exploitative or unintentionally neglectful, the coexistence of rich and poor nations in an international system dominated by such unequal power relationships between the center (the developed countries) and the periphery (the LDCs) renders attempts by poor nations to be self-reliant and independent difficult and sometimes even impossible. Then discuss the major differences between the two schools of thought by discussing how these two theories identify the causes of underdevelopment. Lack of development is generated internally with the linear stages model, and is attributed to a lack of savings and investment. It is generated externally in the dependency model, and is the result of actions taken by the developed countries. 7. Why is the debate between the international dependence and the neoclassical counter-revolution schools referred to as “finger pointing?” Answer First, provide an overview of the two models and then discuss the major differences between the two schools of thought. When the existing theories of development (the linear stages and the structural change models) largely failed to bring any changes in the lives of people in the developing countries, the growing discontent among the developing country economists led to the emergence of new theories of development. These theories which became popular 6

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among the developing country economists in the 70s, came to be identified as the International-Dependence Revolution. The principal idea behind the International-Dependence Revolution is that the third world countries are caught up in a dependence and dominance relationship with the rich countries, and the rich countries either intentionally or unintentionally contributes so that this relationship perpetuates and the status quo is maintained. Essentially, international-dependence models view developing countries as beset by institutional, political, and economic rigidities, both domestic and international, and caught up in a dependence and dominance relationship with rich countries. The ideas that developed under the broad heading of International-Dependence Revolution (more commonly known as the Dependency Theories), can be further classified in to the following three sub groups. The neocolonial dependence model – Unequal power, core-periphery The false-paradigm model – Using “expert” advisors The dualistic-development thesis – Superior and inferior elements can coexist While the international-dependence revolution in development theory was capturing the imagination of many Western and LDC scholars, a reaction was emerging in the late 1970s and early 1980s in the form of a neoclassical free-market counterrevolution. This very different approach would ultimately dominate Western (and to a lesser extent LDC) development writings during the 1980s and early 1990s. In the 1980s, the political ascendancy of conservative governments in the United States, Canada, Britain, and West Germany came with a neoclassical counterrevolution in economic theory and policy. In developed nations, this counterrevolution favored supply-side macroeconomic policies, rational expectations theories, and the privatization of public corporations. In developing countries, it called for freer markets and the dismantling of public ownership, statist planning, and government regulation of economic activities. Neoclassicists obtained controlling votes on the boards of the world’s two most powerful international financial agencies—the World Bank and the International Monetary Fund. In conjunction and with the simultaneous erosion of influence of organizations such as the International Labor Organization (ILO), the United Nations Development Program (UNDP), and the United Nations Conference on Trade and Development (UNCTAD), which more fully represent the views of LDC delegates, it was inevitable that the 7

neoconservative, free-market challenge to the interventionist arguments of dependence theorists would gather momentum. The central argument of the neoclassical counterrevolution is that underdevelopment results from poor resource allocation due to incorrect pricing policies and too much state intervention by overly active developing-nation governments. Neoclassical counterrevolution in the 1980s called for freer markets, and the dismantling of public ownership, and government regulations The neoliberals argue that by permitting competitive free markets to flourish, privatizing state-owned enterprises, promoting free trade and export expansion, welcoming investors from developed countries, and eliminating the plethora of government regulations and price distortions in factor, product, and financial markets, both economic efficiency and economic growth will be stimulated. Contrary to the claims of the dependence theorists, the neoclassical counterrevolutionaries argue that the Third World is underdeveloped not because of the predatory activities of the First World and the international agencies that it controls but rather because of the heavy hand of the state and the corruption, inefficiency, and lack of economic incentives that permeate the economies of developing nations. Three variants of the model are:  Free market approach  Public choice approach  Market-friendly approach Most members of the former school tend to be developing country economists, while most members of the latter school are developed-country economists. The former blames underdevelopment on policies adopted by the developed countries, while the latter blames policies adopted by the developing countries. 8. Describe some of the advantages and disadvantages of each of the following schools: linear stages, structural change, dependence, and neoclassical. Answer Discussed in detail in chapter 3 (Todaro) and in the lecture notes. Linear stages of growth Implications  Simplistic approach  Link the growth rate of the economy to two parameters: saving rate and capital output ratio.  Industrialization stage (stage 3). 8

Limitations  Parameters for growth in the model, capital output ratio and saving rate are exogenous.  Not verified empirically.  No robust relationship between investment rate and growth rate are found.  No non –economic factors are considered. Structural change model Implications (in terms of the Lewis model)  Capital accumulation in the modern sector is the engine of growth.  Industry expansion depends on low wages.  Decrease incentives to produce in the agricultural sector. Limitations (in terms of the Lewis model)  Labor transfer is not proportional to modern sector capital accumulation.  Urban unemployment exists. Urban wage tends to rise due to union activity.  Profits are not always reinvested (capital flight).  Capital accumulation may lead to laborsaving technical progress. Expansion in total product can occur without employment rise. This phenomenon is known as “anti-developmental” economic growth. International dependence revolution model Implications  Places emphasis on power imbalances and on needed fundamental economic, political and institutional reforms, both domestic and worldwide.  Rejects the outcomes of both the linear-stages- of growth models and the structural change models.  Heavy emphasis on planning and government intervention. Limitations  No insight into how countries initiate and sustain development.  Revolutionary campaigns of industrialization and in-ward orientation. Neoclassical counter revolution model Implications  Countries with higher savings/investment grow faster in the short run and tend to converge to higher per capita income levels  absolute convergence.  In long run, without technological progress, both capital per worker and output per worker grow at a rate of zero.  How do we reconcile huge observed differences in per capita income with modest predictions of Solow (similar y*)? 9

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 Can we be satisfied to have long term growth come from exogenous parameters: population growth and TFP growth?  How do we reconcile theory (capital, labor and small exogenous TFP tell the whole story of production) with: no difference in the rate of return to capital between rich and ‐ poor countries. no massive capital flows from capital scarce to capital abundant countries. ‐ Limitations  Solow model of growth explains everything but long run growth. ‐  Including technological change in neoclassical framework is difficult. technology involves creation of non rival ideas and ‐ public goods. returns to scale tend to increase if non-rival inputs are included as factors of ‐ production.  The neoclassical approach is criticized on the grounds that markets in developing countries, when they exist, are far from perfect and cannot be made perfect by any simple formula. 9. Does it follow from the false paradigm model that World Bank economists are intentionally trying to keep developing countries from realizing genuine development? Why or why not? Answer First, explain the main idea of the false paradigm model. Then, argue that it does not exclude this possibility, but suggests that this may be done unwittingly as a result of having to work within narrow policy parameters defined by the international economic system. 10. What are the key assumptions of the Lewis model that give rise to its conclusions? How would the theory’s conclusions differ if these assumptions do not hold? Answer Assumptions of the Lewis Model (1). Dualism: coexistence of highly productive modern industrial sector with traditional overpopulated rural subsistence sector. (2). Surplus labor in traditional sector has zero marginal labor productivity. (3). Labor transfer in the modern sector is proportional to capital investment in the modern sector. (4). Neoclassical price and resource allocation theory implying diminishing returns in manufacturing. (5). Competitive labor market and no labor-saving capital accumulation. 10

6). The wages in the urban industrial sector are assumed to be constant and above the wages that prevailed in the rural subsistence agricultural sector. The Lewis dual sector model is a theory of development in which surplus labor from traditional agricultural sector is transferred to the modern industrial sector whose growth over time absorbs the surplus labor, promotes industrialization and stimulates sustained development. The answer should include the existence of surplus labor in the rural sector that guarantees an infinitely elastic labor supply in industry until the surplus is exhausted and a propensity to save by industrialists equal to one. The lack of rural surplus labor (and infinite labor supply) would imply that when industrialists reinvest their profits there is no guarantee that their surplus increases. A low marginal propensity to save by industrialists puts a break on the labor transfer process. Also, Labor transfer may not be proportional to modern sector capital accumulation. Urban unemployment may exist. Urban wage tends to rise due to union activity. Profits are not always reinvested (capital flight). Capital accumulation may lead to laborsaving technical progress. Expansion in total product can occur without employment rise. This phenomenon is known as “anti- developmental” economic growth. 11. Assume a closed economy, perfectly elastic labor supply, and linear technology. Suppose the incremental capital-output ratio (ICOR) is 3, the depreciation rate is 3%, and the gross savings rate is 10%. Use the Harrod-Domar growth equation to determine the rate of growth. What would the gross savings rate have to be to achieve 5% growth? Assuming a perfectly elastic labor supply, state one criticism of this model from an exogenous growth theory viewpoint and another criticism of this model from an endogenous growth theory viewpoint. Answer Growth rate of 0.003, that is 0.3%, and 0.24, or 24% savings rate. Exogenous: does not allow factor substitution; endogenous: does not address sources of productivity growth, or the savings decision. 12. Consider the Harro-Domar model with population growth in the dynamic version. Derive the central equation of the Harrod-Domar model: g ¿ = s ❑ - n -  Answer See the lecture note. 13. Derive the central equation of the Solow –Swan growth model: sf(k t ) = (n+  ) k t Answer 11

See Todaro and Smith, pg.155-158 and lecture note. 14. What is the difference between exogenous and endogenous growth? Answer There are increasing returns to capital investment (as opposed to decreasing), there are increasing returns to scale (as opposed to constant), and externality effects are included. 15. Describe one important criticism of Rostow’s stages of economic growth theory. Answer The stages are only necessary and not sufficient conditions, savings is too aggregate a measure, the theory does not take into account the constraints of the international economic order, and there are counter examples such as Argentina. 16. Describe the five stages of growth identified by Rostow. The developing countries can be stuck in stage 3. Why? Answer Rostow's five stages of growth 5 stages of economic development through which countries proceed. Based on European societies in 15 to 18 th century. Stage 1: The Traditional Society (the Newtonian society) Rural, subsistence and agricultural – Low productivity and rudimentary techniques – Subsistence expenditure: zero saving/investment – Mentalities do not contemplate changes – A hierarchical social structure and low social mobility Stage 2: The precondition for takeoff into self-sustained growth Transitional Stage (The Industrial Revolution) – Development of trade transactions and techniques (transport infrastructure) – Mindsets evolution, increase in saving rate –Increased specialization generates surpluses for trading – As incomes, savings and investment grow entrepreneurs emerge – External trade also occurs concentrating on primary products Stage 3: Take-off – Increase in saving and investment – The economic growth is self-sustained – Economic growth is concentrated in few regions of the country and on one or two manufacturing products – Industrialization: get over obstacles and engage in virtuous circle Stage 4: The Drive to Maturity – Economic growth and technological progress dominate this stage – New industries emerge – Diffusion of technology – Diversification of production Stage 5: The Age of High Mass Consumption 12

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– Abundance and multiplicity of choices – The economy is geared towards mass consumption – The consumer durable industries flourish  The service sector becomes increasingly dominant Development process can stall at stage 3 for lack of savings. Need to fill the financing gap through external aid and debt. 17. What is demographic transition? Why is it relevant for the Harrod-Domar model? Answer Demographic transition  The fundamental variation of population growth rates with the level of development is known to social scientists as the demographic transition.  In poor countries, both death and birth rates are high. So net growth rate of population is low.  With rise in per capita GDP, death rates start to fall. Birth rates adjust relatively slowly to this transformation of birth rates. As a result, population growth rate initially shoots up.  In the long run, with further development, birth rates begin their downward adjust and population growth rate falls to a low level once again.  In reality, saving rate is not exogenous as assumed by the Harrod-Domar model. Rate of savings may depend on the distribution and overall level of income. Saving rate rises as an economy move from low to middle income country. Population growth rate may also vary with per capita income. 18. Explain the meaning of dualism and dual societies. Do you think the concept of dualism adequately portrays the development picture in most developing countries? Explain your answer. Answer Dualism represents the existence and persistence of substantial and even increasing divergences between rich and poor nations and rich and poor people on various levels. Four key arguments of dualistic development thesis models are 1. Elements of dualism are present between modern and traditional sector, between rich and poor nations etc. 2. This existence is chronic and not transitional. 3. The degrees of superiority have an inherent tendency to increase  fail to show any signs of diminishing. 4. The existence of superior elements does little or nothing to pull up the inferior elements  no trickle-down effects. 19. Suppose that the production function takes the Cobb-Douglas form: Y= A K ❑ L 1 − ¿ ¿  Express the production function in per worker term.  The key equation in the basic Solow growth model for discrete time is: ˙ k t = s y t − 13

(n+  ) k t . In the steady state, ˙ k t , is zero. Use this condition along with the form of the production function to solve for the steady state values of capital per worker, output per worker and consumption per worker, k*, y* and c*. Answer Divide by L and simply.  y = Ak  Note: lower letter y and k are per worker terms.  the steady state value of k is derived by solving the equation sk  = (n+  ). Substituting the value of k* in y = ak  * and c= (1-s) y*, you can derive the values of y* and c*. 20. What are the limitations of Solow growth model? Answer  Solow growth model is that it does not explain the sources of growth. For example, why technological progress happens.  In reality there is very little evidence to support absolute convergence, one of the predictions of the Solow growth model 14

Syllabus, Procedure and Practice Questions for Midterm Exam 1

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