Lecture 1 -- Introduction to Development Economics/ Transition from Industry to Agriculture I.

Introduction
In this course, we will apply ideas learned in other economics courses to the particular problem of development. Along the way, we will attempt to distinguish the differences between developing economies and developed economies. Today, I will begin to show you some of the differences in the economies of countries at different stages of the development process. What do we mean by development? Whereas growth of an economy is something that we can measure using a measure such as gdp/capita or income/capita, the development of an economy is a process of economic transition. Though there is not one rule about how economies must develop, there are patterns across countries and we often look at how economies developed in the past as a guide to the best paths of development in the future. All economies, including the United States, are at some stage of development. The types of transition that the more developed economies are undergoing and the problems that they face in the development process are quite different than those faced by the less-developed countries.

II. Common characteristics of least developed countries

1) Low levels of living 2) Low levels of productivity 3) High rates of population growth and dependency 4) High levels of unemployment and underemployment 5) High proportion of output and employment in agriculture 6) Dependence on a small number of primary export products 7) Incomplete Markets In general, we try to learn from the economic history of the countries that have gone through this process and then adjust our thinking to take into account that the world today may not be the same as when those countries industrialized. Some of the common features of the transition process from a traditional economy to an industrial economy are: 1) Industrialization == increasing share of industry and declining share of agriculture. Often involving increase in agricultural productivity. 2) Urbanization == increasing share of population living in urban areas 3) Changing demographics == lower birth and death rates, better health, longer life expectancy

4) Development of more complete markets -- including the markets for labor, credit, goods, and so on. 5) Development of human capital == higher literacy, more primary education, then more secondary and higher education 6) Increase in importance of non-primary export products

So the idea for the developing countries is to go from a predominantly agricultural-based traditional economy with incomplete markets to an industrial-based modern economy with complete markets. There are a lot of ways to get from one to the other and many ideas about which is the best way for the developing nations. How these processes occur and the effect that they have on the economy depends on the conditions in the country. There is a lot of diversity in the history and social conditions across countries in the process of development. Each country has a development process that corresponds to its own situation. Differences in general conditions now and then: 1) Resource endowments 2) Climactic differences 3) Population size distribution and growth, including migration 4) Role of international economic relations 5) Scientific and technological capabilities In addition, social and political conditions are extremely important. 1) Colonialism versus independence -- The timing of independence influences the history of selfgovernment, the existence of a local elite instead of a foreign elite. 2) Common national identity versus ethnic diversity -- Countries with a common national identity are more likely to invest in policies that positively affect everybody.

3) Political stability -- Does the government have credibility when it adopts a development policy?

During the 1950s and 1960s, countries tried to speed up the process of development with government intervention: 1) Import Substitution Industrialization (ISI) 2) Export-Led Growth (ELG) Both types of countries ran into some problems in the early 1980s, though they lasted longer in the ISI countries. Coming out of the 1980s, there was a consensus on several aspects of a countrys development strategy: 1) recognition of the importance of the external constraint and the government constraint 2) promotion of free markets when possible -- that is, recognize the importance of demand, supply and competition 1980s Debt Crisis Reorientation of economic development strategies 1990s Change from Planned to Market Economies, Globalization Financial Crisis 2000s Response to Terrorism

III. Some Patterns

Low Income 1,296 61 22 28 712 350 Lower Middle Income 3,437 100 31 42 2,803 1,230 Upper Middle Income 823 20 62 74 2,608 4,540 Upper Income 1,056 32 75 76 24,001 25,890 World 6,612 451 39 46 30,125 5,180

Population Density/Km2 Pct. Urban GNP GNP per Capita GNI ($b) GNI per capita

2007 2007 1980 1997 $Bill 1997

2007

748.8

6,485

5,749.6

39,682.1

52,621.4

2007

578

1,887

6,987

37,566

7,958

Percent of GDP: Agr.(VA) 1980 1997 2006 Ind.(VA) 1980 1997 2006 1980 1997 2006

36 28 25 25 28 28 39 43 48

25 15 13 41 41 41 34 44 46

10 8 5 43 34 31 47 58 64

4 2 2 37 31 26 59 63 72

7 4 3 38 32 28 56 61 69

Serv.(VA)

Low Income Male Agric. Employment: 1980 ~1997 1980 ~1997 1980 ~1997 65 61 13 15 22 25

Lower Middle Income

Upper Middle Income

Upper Income

World

59 56 21 21 20 22

34 27 32 31 33 42

8 5 34 53

50 46 22 22 25 29

Industry

Services

Female Agric.

Employment: 1980 ~1997 1980 ~1997 1980 ~1997 81 75 8 10 11 14 63 61 16 16 20 22 31 22 20 17 49 61 8 4 22 17 73 15 15 24 29 56

Industry

Services

Birth Rate Death Rate Life Expectancy Infant Mortality /1000 Births Child Mortality /1000 births Primary Education Completion

1980 1997 1980 1997 1980 1997

40 32 15 11 52 59

23 19 8 8 65 69

29 21 9 7 65 70

15 12 9 8 74 77

27 23 10 9 63 67

1980 1997

116 82

57 34

60 30

12 5

80 56

1990 2007

164 135

81 54

46 26

12 7

92 72

1991 2006

49 65

83 91

88 101

97 100

79 86

Low Incom e Exports ($b) Imports FDI ($b) External Debt

Lower Middle Income

Upper Middle Income

Upper Income

World

2007 2007 2006 2006

230.2 251.8 20.3 201.4

2,179.3 1,947.1 162.0 1,080.4

1,738.7 1,690.1 172.2 1,562.0

9,752.1 10,220.0 997.8

13,899.3 14,107.1 1,352.4

Source: World Bank, World Development Indicators Traditional View == As Development Process occurs: -- Saving and Investment up -- Difference closing -- Government Revenue up -- Education up -- Agriculture down a lot, industry up a lot, services rising, but always high -- primary exports down, other exports up. imports up. === more open economy -- increase in urbanization -- birth rate and death rates falling by a lot, birth rates by more -- inverted U-shape in income distribution.

IV. Back to Measurement

We want to summarize the complex process of development with a few basic indicators: Economic Growth (i.e. GDP, etc)-- misses social aspect Poverty and income distribution -- usually measured with income Recent attempts at other measures -- most visible is Human Development Index (HDI) from the United Nations -- Life Expectancy -- Literacy -- Per Capita Income (adjusted for purchasing level) Usefulness is in finding a way to describe differences across countries, but is not a good way to compare within countries or to design policy.

Some other definitions: Growth Rate = (Pt Pt-1) /Pt-1 = (Pt/Pt-1) 1 Inflation = Growth rate in price level Real GNP = Nominal GNP / Price Level Real Interest Rate = Nominal interest rate/Price Level

V. The Transition from Agriculture to Industry

We're going to start looking at models of how economies grow in order to explain some of the patterns we observed last time. Though the models are not completely realistic in that they are very simple, they try to isolate one or two things that are important. Some Country Examples
Population Millions 2007 21 40 1,123 1,320 7 GNP per Capita 1992 60 110 310 470 580 GNI per capita 2007 320 400 950 2,360 1,600 Percent Agricultur e 1970 41 45 32 Percent Industry 1970 17 22 22

Mozambique Tanzania India China Honduras

1992 64 61 32 27 22

2006 28 45 18 12 13

1992 15 12 27 34 29

2006 45 17 29 48 28

Philippines El Salvador Thailand

88 7 64

770 1,170 1,840

1,620 2,850 3,400

30 28 26

22 9 12

11 14 11

32 23 25

33 24 39

29 31 44

South Africa Mexico Korea

48 105 49

2,670 3,470 6,790

5,760 8,340 19,690

8 12 26

4 8 8

3 4 3

40 29 29

42 28 45

31 25 39

Hong Kong Italy U.S. Japan

7 59 302 128

15,360 17,790 23,240 28,190

31,610 33,540 37,670 46,040

2 8 3 6

0 3 2

0 2 1 2

36 41 34 47

23 32 42

9 27 23 30

Source: World Development Report

VI. Economic Models

What do we want to explain with these models? 1) Wide disparities in income per capita 2) Disparities in growth rates 3) Increasing proportion of population in non-agricultural activities 4) Increasing share of saving out of income as development goes up 5) Unemployment 6) Rural-urban migration

General ideas: 1. Savings is important as a source of investment 2. Low productivity in agriculture and low labor demand in industrial sector could be source of rural unemployment 3. Institutional rigidities that produce high urban wages could be source of urban unemployment

Summary One-Sector Model 1. Can help explain patterns in: -- differences in levels of output between countries (based on capital stock or technology) -- differences in growth in output (based on growth in capital stock or rate of technological change) 2. Policy implications: -- savings is important -- balanced growth or big push -- all sectors grow at once -- unbalanced growth -- choose a few key sectors that have backward or forward linkages to the rest of the economy

Two-Sector Model 1. Can help explain patterns: -- transition from agriculture to industry -- transition from rural to urban -- rural subsistence sector (Lewis Model) -- urban unemployment (Harris-Todaro Model) -- inverted U-shaped inequality

2. Policy implications: -- where capital is invested or technological change happens is important -- low levels of poverty in rural areas could require substantial investment -- reduction of urban unemployment is related to elimination of rigidities

VII. One-Sector Models

Basic idea == output is a function of capital stock, capital stock increases through investment, investment is foregone consumption== saving. C+S+T=C+I+G I = S + (T-G) The main question we want to ask is: How much of the good should we consume today and how much should we devote to the capital stock. Domar Model -- If we have a target GNP, we can calculate the growth in capital we need to get there, or conversely, if we see what the growth in the capital stock is, we can calculate the growth in real GNP. Solow Model -- This model gives us a desired level of output in the steady state given the technology and rate of saving. In this model, we are simplifying what is a pretty complicated decision peoples' preferences for consumption over time -- into one parameter, the saving rate.

Debate over Strategies of Development In practice, not all output is the same, so there has been a lot of debate over strategies to get from one point to another: Big Push with Balanced Growth (Rostow) == planners need to do what is necessary to increase savings. Linkages and Unbalanced Growth (Hirschman) == there are limited resources and the economy should choose those sectors that will have most effect on demand for and supply to other sectors. Where do we stand? Explain -- increase in savings; competing views about how to get there -- differences across countries; could be due to differences in capital stock -- long-run growth due to technological changes -- possible explanation for increase in inequality Do not explain: -- shift to industry (we only have one good) and rural-urban migration -- unemployment -- why countries with similar technologies and capital stocks have different growth rates -- why technological improvements continue -- lack of investment in countries with low levels of capital

VIII. Two Sector Models

Designed to explain pattern between agricultural and industrial sectors. Each sector has a value marginal product curve derived from the production function in that sector. Review: Marginal Product is the additional product from one more employed person :

Output

Slope = -MP

Production Function

Labor

Marginal Product

Labor
Value Marginal Product is value of that additional output, or Marginal Product multiplied by price of output in that sector. Competitive firms set the wage equal to the value marginal product. If they paid more, they would go out of business. If they paid less, other firms would bid away workers. A. Neo-Classical Two-Sector Model Key Assumptions 1. Competitive Market Among Firms == Implies that wage equals Value Marginal Product (W=VMP) 2. Full Employment 3. Workers Choose Sector With Highest Wage (only care about income) == Implies that wages equalize across sectors

VMP

A Agriculture VMP D Industry

C D A B C

Labor

Labor

A Little Trick-- We can show full employment by flipping over the VMP curve in industry and putting it on the diagram for agriculture starting at the full employment level. Because full employment in one sector implies no employment in the other sector, we can have one sector (industry) go from right to left starting from the point of full employment (N) in agriculture:

Value Marginal Product

Industry

Labor 0 Value Marginal Product N

Industry

Labor N
.

Basic Diagram: (N persons in Labor Force) Full employment and no rigidities force wage to be equal in both the agricultural and industrial sector

VMPA

VMPI

N 0

Employment Industry Employment Agriculture

0 N

Equilibrium occurs at point X, with La employment in agriculture and Li employment in industry. We can get the output in each sector by looking at the production function at these levels of employment. When do these curves shift? -- Marginal Product == Technology, Capital Stock, other inputs -- Price == Demand for output

Example: Increase in Technology in Industrial Sector

1. Production Function in Industry Shifts Up

Output

Production Function

Labor

2. Marginal Product in Industry Shifts Up

Marginal Product

Labor

3. Intersection of VMP in Agriculture and VMP in Industry occurs at higher employment in industry, lower employment in agriculture, and higher wage.

VMPA

VMPI

X2 X1

N 0

Employment Industry Employment Agriculture

0 N

Increase in output in industry occurs because: 1) More labor is employed in industry 2) Each unit of labor is more productive

B. Labor Surplus Two-Sector Model Key is that there is an opportunity wage in the rural sector below which workers will not work in either the sector. An intuitive way to think about this applicable to developing countries is that workers can always choose to engage in subsistence work and not offer their services to the labor market. And usually we're thinking that the production function in agriculture has a part beyond which the marginal product of labor is very low, even below the subsistence wage.

Workers in the industrial sector have to use the subsistence wage as the opportunity wage unless there are institutional rigidities to keep things higher. There is perfectly elastic supply of labor at this wage, or as Lewis put it "unlimited supplies of labor."

This will lead to a distribution of employment between the two sectors that is something like this:

VMPA

VMPI

Ws

LA

Subsistence Agriculture

LI

In book, the opportunity wage or wage in agricultural sector is the average product at the point where the marginal product becomes zero. In addition, the urban wage is above the agricultural wage by some percentage (30 %). One point of this is that the subsistence agriculture looks like unemployment in the rural sector (or, in the extreme case, a large number of workers with zero productivity). A second point is that in this model development takes place as industrialists reinvest their profits and the urban labor force demands more industrial goods and as a result the demand for industrial labor shifts out. Until the demand for urban labor curve hits the upward sloping part of the demand for agricultural labor curve, total output in the non-subsistence agricultural sector does not change.

VMPA

VMPI

Ws

LA

Subsistence Agriculture

LI

At that point, things get a little more complicated since the price of the agricultural good could change as the quantity changes and therefore the marginal value product curves shift (remember marginal value product depends on price of output and marginal product). But, increasing the demand for industrial goods should continue to pull workers out of the industrial sector and possible induce the adoption of less labor intensive technologies in the agricultural sector.

Now where do we stand? Can explain: -- shift to industry and rural-urban shift -- unemployment in rural areas -- low productivity in rural areas and subsistence agriculture -- second explanation for income inequality (shift from low wage agricultural sector to high wage industrial sector will be associated with inverse U-shaped pattern of income inequality) Cannot explain: -- urban unemployment -- changes in urban wage when opportunity wage doesn't change much These will be explained by Harris-Todaro model of migration when we talk about labor markets.

IX. New Growth Theories

Basic idea is that there can be: 1) Increasing marginal productivity of capital and increasing returns to scale in production == countries with high levels of capital have high marginal product of capital. 2) Externalities to development process. Having or not having characteristics that are attractive for development is self-reinforcing. Examples could be educational system, financial system, etc. No private investor would develop these things, but it would be profitable for the country as a whole to have them.