Economics of Least Developed Countries

Week 2: Theory of Economic Growth and Convergence

Economics of LDCs 1
Lecture 2: Economic Growth and Convergence
Introduction

„The consequences for human welfare involved in questions like these

(economic growth) are simply staggering: Once one starts to think about
them, it is hard to think about anything else.“ Lucas

Small percentage change in rate of growth => huge difference for standard of
living
– Example: country growing 1% double income in 70 years vs 3% doubles in 23
years
– Rule of thumb for period necessary for doubling income (70/g)
– Great appeal to find determinants of economic growth

Growth as very recent phenomena

Economics of LDCs 2
Lecture 2: Economic Growth and Convergence
 Neoclassical models

Harrod-Domar model

Sollow model

Convergence?

Unconditional

Conditional

Why catching-up may not take place?

Endogeneity of variables

Human capital

Complementarities

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Lecture 2: Economic Growth and Convergence
Harrod-Domar model (I): Capital fundamentalism

Economic growth results from abstention from current consumption in the

form of savings

Macroeconomic balance (savings = investments)

All that is needed for production is physical capital => constant capital-output
ratio
Y (t ) = K (t ) / θ

Saving rate: proportion of income saved s = S (t ) / Y (t )

Economic growth is positive when investments (I) exceed depreciation (delta)
– Total: K (t + 1) = (1 − δ ) K (t ) + I (t )

– Per capita: k (t + 1) = (1 − δ − n) k (t ) + s / θ * k (t )

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Lecture 2: Economic Growth and Convergence
Harrod-Domar model (II): Results

Influential Harrod-Domar equation: g ≅ s /θ − δ − n

Determinants of growth: ability to save and invest (s), ability to convert
capital into output (teta), depreciation rate and population growth (n)

y= k / θ
s*y=s* k / θ

(n+d)k

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Lecture 2: Economic Growth and Convergence
Harrod-Domar model (III): Implications and Beyond

Policy implications
– To ensure growth stimulate savings and reduce population growth
– Foreign capital can substitute domestic
– Case: India and Soviet Union: pushing up savings in CP, not very successful

Beyond Harrod-Domar model

– How are savings and population growth determined?
– Constant returns to physical capital is not very plausible assumption => Solow
model
– Is physical capital the only important factor of growth? Labor? Technology? Other?

Economics of LDCs 6
Lecture 2: Economic Growth and Convergence
Solow model (I): Diminishing returns

Adds to H-D model law of diminishing returns to individual factors of

production (capital and labor)
– In very poor countries returns to capital are very high due to abundance of labor
and available technology
– In richer countries the capital has lower returns (marginal product)

Model
– Production function with diminishing returns: y = f (k )

– Per capita capital accumulation k (t + 1) = (1 − δ − n) k (t ) + sy (t )

• Figure fresh investment sf(k) are eaten by depreciation and population growth

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Lecture 2: Economic Growth and Convergence
Solow model (II): Results

f(k)

(n+d)k

sf(k)

k* k

Results
– If k is low => returns are high (abundance of labor) => capital accumulation
– If k is high => returns are low (lack of labor) => capital decreases
– k* is staedy state: from any initial level of income the economies should converge

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Lecture 2: Economic Growth and Convergence
Solow model (III): Implications

Savings and capital accumulation are not capable to ensure long-term growth
of per capita income, their effect eventually dies out
– Level effect (savings, population, depreciation) vs. growth effect (outside of this
model)
– Need to study technological progress (not specifically part of this course)

Hypothesis of international convergence irrespective of its historic starting

point
– very important feature!
– Poor countries should grow faster than rich countries and eventually catch up

Economics of LDCs 9
Lecture 2: Economic Growth and Convergence
 Neoclassical models

Harrod-Domar model

Sollow model

Convergence?

Unconditional

Conditional

Why catching-up may not take place?

Endogeneity of variables

Human capital

Complementarities

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Lecture 2: Economic Growth and Convergence
Convergence? Intuition

Technology is a global public good – can spread among countries and can be
easily adopted once invented

Falling marginal returns to capital (Solow model)

Change from agriculture to industry has a higher pace in poor countries

Learning from mistakes of more developed countries

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Lecture 2: Economic Growth and Convergence
 Unconditional Convergence

Unconditional convergence
– In long-run technical progress, saving rate, population growth and capital
depreciation are the same in all countries => the countries will converge to
the same staedy state
– Predicts strong negative relationship between growth rates and initial
value of per capita income

(log) per
capita F B
income
D
E

time

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Lecture 2: Economic Growth and Convergence
Unconditional Convergence? Evidence (I)

Methodology
– Regress: g = a + b log yt0 + e
– Interpretation:
• If b < 0 poor countries grow faster => indicating unconditional converge
• If b > 0 rich countries grow faster => divergence

Baumol (1986)
– Examined 16 richest countries at that time and plotted their 1870 per capita
income and average growth rate in in period 1870-1979
– Finds unconditional convergence
– BUT: selection bias: these countries are not selected randomly, only success
stories included into the sample (Japan vs. Argentina)

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Lecture 2: Economic Growth and Convergence
Unconditional Convergence? Evidence (II)

De Long (1988)
– adds 8 countries that (seen with the eyes of 1870) should have caught up (e.g.
Argentina, Ireland, Spain)
– unconditional converge does not hold

Cross-country comparison over short time

– 102 countries included into the sample over period 1960-85
– In scatterplots of average growth versus initial income we do not see convergence
– again poorer do not grow faster

Conclusion:
– Unconditional convergence does not hold!
– Forces that go against convergence may be powerful

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Lecture 2: Economic Growth and Convergence
Conditional Convergence?

Saving rate and population growth may differ among countries in long run =>
Each country converges towards its own steady state = conditional
convergence

Difficult to test empirically, but there is some empirical support for conditional
convergence

B’
(log) per F
capita
income A’ D

E B

time

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Lecture 2: Economic Growth and Convergence
Critical questions

Why saving rate and population growth remain systematically different

different across countries?
– Endogeneity of critical parameters (so far treated as exogenous)
– Persisting cultural and social norms („The proper woman has a lot of children.“)

Are physical capital, labor and technology the only major factors of growth?
– Human capital: education and health
– Institutions and Politics

Does technollogical progress costlessly diffuses?

– Complementarities
– Ability to absorb: human capital

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Lecture 2: Economic Growth and Convergence
 Neoclassical models

Harrod-Domar model

Sollow model

Convergence?

Unconditional

Conditional

Why catching-up may not take place?

Endogeneity of variables

Human capital

Complementarities

Economics of LDCs 17
Lecture 2: Economic Growth and Convergence
 Endogeneity of Savings and Income

Mutual relationship between savings and income

– Imagine someone close to subsistance level of income => saving rate is very low
– As an economy gets richer people save more => saving rate increases

Poverty trap may appear: poor people cannot save, and therefore remain poor

f(k)
(n+d)k
sf(k)

k
k*poor country kthreshold k*rich country

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Lecture 2: Economic Growth and Convergence
Human capital and Convergence (I)

Human capital (~quality of labor)

– Represents education, health, nutrition, knowledge, experience, etc
– Can be accumulated through investments e.g. in education
– Additional factor of production besides technology, labor and physical capital,

Human capital, returns to physical capital and convergence

– In poor country is high return to physical capital due to abundance of unskilled
labor and available technology => convergence (argument from Sollow)
– But: In poor country labor is unskilled which decreases the return to physical
capital => lack of human capital hinders convergence
– Total: competing effects on marginal product => due to lack of human capital not
necessarily higher investments in poorer countries => convergence weakened

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Lecture 2: Economic Growth and Convergence
Human Capital and Convergence (II)

Human capital as new factor of production => flatter production function (in
extreme can be even constant) because returns to physical capital diminish
less rapidly

f(k)
(n+d)k
sf(k)

k* k

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Lecture 2: Economic Growth and Convergence
Human Capital and Convergence: Implications and Evidence

Poor countries will convergence to rich countries only if they will invest
enough into the human capital (!)

Examples:
– Germany after WWII, Japan in 1960, Korea and Taiwan later: low stock of physical
capital and relatively high stock of human capital → phenomenal growth,
– Sub-Saharan Africa in 1960: school enrolments were relatively low relative to their
per capita GDP → slow growth

Barro (1991): Evidence for convergence conditional on level of human capital

– by conditioning on the level of human capital, poor countries tend to grow faster
than rich countries

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Lecture 2: Economic Growth and Convergence
Technological progress and Complementarities (I)

Technological progress
– A) Deliberate diversion of resources from current productive activity into R&D
– B) Diffusion of technology (transfer of technical knowledge)

Many investments complementary with the decisions of other firms

Example of complementarity
– Two possible states: Only agriculture vs. Railways, coal, steel
– Consider undertaking separate investments:
• Railway alone – who will use it?
• Coal alone: who will buy it? How to transport it?
• Steel alone: no coal, no freight, no engineers
– These investments are complementary: All of them are needed and at once and
depend on the believes of the investments in the other ”complementary” sectors

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Lecture 2: Economic Growth and Convergence
 Technological progress and Complementarities (II)

Model: Individual investment rates (s) as a function of projected average economy-wide

rates (sa)

If the firm believes the investments in the economy sa will be high → it will invest big
proportion s

Individual
investment
rate

45
s1 s2
Anticipated investment
rates in an economy (sa)

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Lecture 2: Economic Growth and Convergence
Technological Progress and Complementarities: Implications

Possibility of two investment equilibriums

– s1: individual firms have pessimistic expectations about investments of the others
in an economy => low investments
– s2: positive forecasts, stable climate (important in poorest countries), optimistic
expectations => high investments

Two identical copies of the same economy may grow at different rates
depending on expectations and history

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Lecture 2: Economic Growth and Convergence
Summary

Sollow model:
– Difference from Harrod-Domar model
– logic and its implications for growth and convergence of countries

Unconditional and conditional convergence: intuition and evidence

Why countries may not catch-up?

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Lecture 2: Economic Growth and Convergence
Readings for Week 2

Primer readings

Debray Ray (1998): Development Economics, ch.3 and 4

Barro and Sala-i-Martin (2004): Economic Growth, Introduction

Recommended readings

Todaro and Smith (2003): Economic Development, ch. 4 and 5

Barro and Sala-i-Martin (2004): Economic Growth, Selected parts of ch.1

(Solow model) and 5 (Human capital)

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Lecture 2: Economic Growth and Convergence