APEC 460/660 Spring 2006 Kilkenny

Week 8 HOMEWORK “#4”

Due Wednesday, April 3

General instructions: Read the Appendix 2.1 and chapter 3 of T&S at least once.

The following questions are intended to challenge you to analyze and critically evaluate the theories of economic development presented by Todaro & Smith. The ultimate question is: “What do T&S say are the valuable insights these models offer? Do you agree with T&S? Why do you (dis)agree? Of the three models that you analyzed in detail, which model do you think is most valuable; and why is it valuable? If you were the President of an LDC, what would you apply, thanks to what you learned from your favorite model?”

Work together or separately, whatever works best for you. Everyone must turn in their own signed assignment.

These homework problems are FOR CREDIT and will be graded.

In chapter 3, T&S discuss “classic theories” of economic development:

i. ‘Stages of Growth’ e.g., by Rostow

ii. Harrod-Domar

iii. Structural change (e.g., Lewis, Chenery)

iv. neo-colonialist dependence (e.g., Dos Santos)

v. false-paradigm

vi. dualistic development

vii. neoclassical counterrevolution (e.g. Bhagwati)

a. free-market analysis

b. public choice theory

c. market-friendly

viii. Solow neoclassical growth

We can group these theories (exclude Solow);into three sets:

Set I :‘Stages of Growth’ ; Harrod-Domar; Structural change

Set II: neo-colonialist dependence; false-paradigm; dualistic development

Set III: free-market analysis; public choice theory; market-friendly

Apply this ‘recipe’ to analyze three of the eight theories:

Step 1: in each set, pick/choose ONE

Step 2: For each of the three theories (one from each set) that you chose, apply “the Five questions” to describe the main structure of the theory:

For example: Solow neoclassical growth model (see Appendix 3.1)

Q0: What is the question? “What is the relationship between investment and growth? At what rate of saving (investment) can this economy be sustainable (achieve a steady state)?”

Q1: Who: In a country, this models focuses on people as:

1. producers

2. capital owners

3. labor owners (‘workers”)

Q2: what are the ‘who’s” objectives? Maximize output? This is NOT CLEAR.

Q3: instruments: choose a rate of saving. Note: maybe the single most relevant ‘who’ is capital owners—who save/invest? No, the model is described in terms of “savings per worker”. This model does NOT have very clear micro foundations. Hmm(!) That’s not good!

Q4 : constraints: (exogenous variables)

1. production technology: output at time t Y(t) = K(t)^α[A(t)L(t)]^1-α

is made from capital K(t) and labor L(t)

2. A(t) ~ labor productivity ~ grows over time at constant rate, γ (and let γ=1/L)

3. labor force grows at the rate n

4. capital depreciates at rate δ

5. savings per worker, at rate s, is positively related with output per worker (y=f(k)),

so s(t)/L(t) = s·f(k); but the savings rate increases at a decreasing rate as the economy grows (shown graphically in Figure A3.1)

6. in equilibrium ∆k = 0 = s·f(k) – (δ+n·)k

Q5: time horizon: very long run, because endowments of labor, levels of capital, and technology are all changing

Step 3: Discuss what the model tells us? What are its strengths and weaknesses in terms of (1) microfoundations, (2) compared to observations of the ‘real world’ over time, (3) is it practical? If you were the President of a country, what policies does the model suggest you use to encourage growth in your country?

What does the model tell us? The equilibrium condition says that if s·f(k) >(δ+n·)k, then more capital will accumulate and the economy will grow. Conversely, if s·f(k) <(δ+n·)k then there will be less saving and investment, and the economy will shrink. The modelers claim that this story identifies a k* at which, like Goldilocks and the Three Bears, “is just right.”

It does not tell us why workers or capital owners (or whoever) might decide to save more (or save less). (I wouldn’t want to save more (& invest more, which means build up productive capacity) unless I expected a higher return on my investment, which would mean, I expect everyone else to CONSUME MORE and save less. But to achieve more investment in our economy everyone has to save more. But how can everyone save more if everyone is saving less? Or, who would save more, on net, while others save less? And why might some do one thing, others do another? How do we encourage more net saving (or discourage excessive saving?) This model has weak microfoundations.

So I am not surprised that observations of the “real world” do not conform with this model’s implications. Some countries where people save a lot have high rates of GDP growth, but so do some countries where people save very little (like USA!), and v-v.

What can or should be done, realistically, to get our backwards economy out of the subsistence farming stage? It says we have to find the k*. What if we find it? How can I inspire our people to save/invest at that rate? OK, we will tell the people that at 10% savings rate is the ideal rate. Riiiiight. But plenty of places that save that much have problems. Why should they believe us? This model does not imply that the government should, for example, collect taxes and invest in education, roads, infrastructure, research, or anything like that. Indeed, if there are taxes, then there is less saving. It has nothing to say about minimum wage laws. It has nothing to say about why inequality seems to be related to growth. It has nothing to say about anti-trust regulation. It says nothing about the role of a country’s legal system….

Step 4. Repeat steps 2-3 with respect to the model of your choice from Set II.

Step 5. Repeat steps 2-3 with respect to the model of your choice from Set III.

Finally: Synthesize. What do T&S say are the valuable insights these models offer? Do you agree with T&S? Why do you (dis)agree? Of the three models that you analyzed in detail, which model do you think is most valuable; and why is it valuable? If you were the President of an LDC, what would you do, thanks to what you learned from your favorite model?