Development Economics

A question that has yet to be fully answered is how third world economies can escape famine and absolute poverty. What are the stages needed for an economy to transform?

It is commonly accepted that an economy needs to ‘grow it’s way out of poverty’. High economic growth is essential and is a symbol of a newly industrialising country.

Third World Poverty

I have mentioned the definitions of poverty being absolute and relative. The measurement of absolute poverty when talking about the third world is through the poverty line, and a countries inhabitants relation to it.

The poverty line is defined by the UN as $1.25 per day per person at purchasing power parity (PPP). Poverty is approximated in 3 ways.

  • Headcount: The percentage of the population of a country living on under $1.25 per day PPP.
  • The poverty gap: Indicates the intensity of the poverty that exists. It is the average level below the poverty line as a proportion of it, for the people below it. E.g 0.5 means the average income of those below the line is $0.625/day
  • Poverty gap squared: Each person below the line’s income as a proportion of it is squared (then the average taken). Means the very poorest are targeted if this is made a policy tool, as they exaggerate the score.

Rostows 5 Stages of Growth

Walt Rostow, an early 20th century economist, made a simplified model on the stages an economy goes through towards development.

  1. Barter Economy: Main output is agriculture and money is scarcely used as a medium of exchange.
  2. High Saving, High Investment: Over 20% of income is saved, and for reasons seen in ‘The Whole Economy on Paper’ about the same in investment.
  3. Take off and Industrialisation: The heavy investment and build up of wealth cause an industrial revolution, and transition from the primary to secondary sector output.
  4. Drive Towards Prosperity: Innovation starts to take hold, and the economy’s growth starts to slow. Transition from secondary to tertiary sector.
  5. Age of Mass Consumption: High incomes and wealth see a high propensity to consume. First World Economy, mainly in the tertiary and quaternary sector. Current account deficit as much physical produce is imported.

Arthur Lewis Model

20th Century Economist Arthur Lewis cited urbanisation as a cause, aswell as sign of economic development. When an economy grows, there is a net influx of rural citizens to major urban areas.

How much an economy has developed can be shown as the ratio of people living in towns/cities to rural areas.

How It Works: The urban people and their children learn more skills and get better education than those in rural areas, especially true when you think of China and India. A persons output is rewarded with greater income in urban areas than mere subsistnece in rural, higher incomes mean higher spending.

Faults: Some of the poorest live in inner city slums, who actually have less chance of being productive there than they would in a rural area. Moving to an urban area can result in less individual productivity and welfare, especially considering subsistence skills mean a high chance of remaining unemployed.

Harrod-Domar Model

Suggests that the key for an economy to grow out of poverty is use of existing or invented technology, high levels of saving and investment. Similar to Rostow’s 2nd stage.

What Prevents Third World Economies From Escaping Poverty?

Useful Works: The books of Partha Dasgupta ‘A Short Introduction’ and Daniel Altman’s ‘Connected’ provide various answers to this question. Despite it’s age, the great Adam Smith’s The Wealth of Nations 1776 is a great piece about the topic.

Financial Services:

The Dilemma: What arguably keeps third world subsistence farmers from enterprising is they do not have protection against the risk a leap of faith involves. If their idea fails, they have neglected sowing the seeds that have kept them alive, what are their family to live on?

Insurance, Credit and Venture Capital: Third world economies do not have adequate financial services. Without insurance markets that aspiring farmer has little to protect them if their idea does go wrong, or their factory gets destroyed by an unpredicted disaster.

For the premiums, thats where credit and venture capital comes in. With an adequate banking and VC system, entreprenuers or inventors can make their ideas happen, aswell as guard their families if it fails.

Without this, many citizens are caught in a subsistence cycle. Instead of starting up, people remain unemployed and in the same scenario.

Property Rights

Without a driving enterprise and invention of tech, such an economy relies on foreign investment. The trouble is, if an economy doesn’t have the necessary legal framework, such as enforceable property rights, then nobody will want to set up there.

Why Their Needed: Without enforeable property rights, the factory can get burnt down by a militia, or seized without any consequence. Firms see the marginal efficiency of capital as largely negative in these projects.

‘ A Deterrence of Foreign Direct Investment’


The animal spirit as noted by Akerlof. The rational economic man will, when he can, push the rules to maximise his return. Very common in third world governments(an intentional government failure).

What Types? Paying bribes to ministers to get favours. Letting someone off breaking the law due to personal relations. Laying claim to tax revenues to buy yourself a new car.

Why it Harms an Economy: Corruption creates inefficiencies, broadly, a misallocation of rescources.

Expenses and withdrawals: Indulging in expenses means instead of providing an airport which is great for enterprise and access, officials spend money on imported luxuries for themselves. Taxing the economy remains, with the payers seeing nothing in return, a net withdrawal of income.

Incompetent leaders: Also, it is not the best idea or best labour which gets hired, but a usually incompetent worker or idea gets hird and funded, so long as they know the right people. Having CEO’s and ministers who have got to where they are because of corruption only create inefficiencies on how firms and governments are run.

Lack of Trust: For contracts to be made, firms need to be confident on each others word. But if a larger supplier can get off the hook by bribery when they have breached a contract, it causes firms to become reluctant to do business, aswell as the outside world doing business with them. Activity and revenues remain low.

Little to Offer the World

Before the UAE and Kuwait discovered oil, before Spain had tourism and construction, there was little difference between them and third world economies.

Natural Rescources or Knowledge: A nation needs a comparative advantage to offer the world. Third world economies are usually those which have not stumbled upon a natural wonder to export. If an economy has little natural rescources, then it must produce knowledge workers or have enterprise to grow it’s way out of poverty.

The Dilemma: With the above problems of corruption, lack of property rights and financial sector, an economy does not have such workers. Even if the government was not corrupt, it would struggle to fund for an educated workforce with the little tax revenues a poor economy can produce.

For the talented potential knowledge workers, labour market incentives send them to the US or UK. Without a natural rescource, we end up with an economy which offers nothing to the world, remaining poor.

Why Economic Growth Does Not Always Mean Development

Economic Growth measure in GDP is not always accurate, and does not always reflect precisely how much spending power each person has. This is discussed in ‘The Circular Flow of Income’.

Assumption: Here we assume growth to be a rise in the real spending power of a household, but even with this, does it mean a rise in overall welfare?


A rise in output means a rise in production. Despite it yielding higher incomes it will not increase welfare with equal step if it involves dumping waste and pollution, for instance.

Cleaning up and correcting externalities is one of the roles of the government, which creates an opportunity cost as their time and money could be put towards productive means.

If we have high output, but also bad effects on third parties due to it, then purchasing power is an overestimate of development.

Quality of Output

How much welfare is derived from production is of course related to the what the eventual output is. If it is spending on a low cost industry with an output that can keep 500 alive, than we have a much better scenario than if it goes into productive inefficiencies, or, correction of a disaster such as an oil spill.

Consider: If the UK spends £6billion on defence, then that is registered as GDP, and goes to our factors for income, but are we better off? Surely, there is a greater level of welfare if that £6billion went into improved transport links. Something which increases incomes in making, but the output being of use too.

Government Stability

Not only does economic development depend on the state of the government, but the latter also influences the former. The effect the government approach has on it’s citizens is not revealed with rising buying power.

Think of This: One economy can have a higher GDP per capita, but its citizens may live in a dictatorship, or have anti civil laws with very strict penalities such as death.  The level of welfare may be considerably reduced due to factors such as fear and lack of free will which come about due to the approach of the controller.


A booming GDP will not add to economic development if it is enjoyed by 5 people. If they spend, however, then any inequalities will be reduced due to falling unemployment.

But If rising earnings is due to a few people exporting their product, which then hoard, the gains in welfare will not be shared. Levels of inequality define how much of the population recieve a benefit from economic growth.


Although it has a fairly inverse relationship with economic growth, increases in purchasing power do not account for this. Economic development will be much lower than another economy with the same GDP per capita, if there is a much higher level of general crime.

Rises in purchasing power do not account for fear of walking out at night, or the likelihood that you will get burgled, for instance. Peace of mind is an important part of economic development.

Malthusian Starvation

One of the first noteworthy economists, Thomas Malthus, had an idea that the growth in population and GDP cannot last forever. A boom in population in developing economies must be curtailed because the Earths natural rescources cannot keep up.

Population grows exponentially, whereas agricultural output grows only arithmetically. Where the population growth overtakes growth in primary products, there is less foodstuffs per person and food will become extremely scarce.

We get to a point where there is a large famine, as the Earths natural rescources cannot keep up with the excess population.


An evidence of this can be overcultivation of land and destruction of natural sites to make way for construction, reducing the capacity for agricultural output.

It’s not so bad: The reduction in agriculture is only really in first world economies, with less developed economies having a growing output of foodstuffs. Lower cost economies in primary products are following their comparative advantage, more than offsetting the falling output in MDC’s.

Also, as the population booms, scientists find ways to increase food output per hectare to accomodate, which Malthus leaves out. GM crops and fertilisers are more recent developments which allow agriculture to rise in step with demand.

One Response to Development Economics

  1. Pingback: Thinktank « Zahablog's Economic Page

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