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Chapter 2:Comparative Economic DevelopmentCommonalities & Diversity

Common Characteristics of developing countries

1. Lower levels of living and productivity2. Lower levels of human capital3. Higher levels of inequality and absolute poverty4. Higher population growth rates5. Greater social fractionalization6. Larger rural population- rapid migration to cities7. Lower levels of industrialization and manufactured exports8. Adverse geography9. Underdeveloped financial and other markets10. Colonial legacies- poor institutions etc.

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Table 2.1 Classification of Economies by Region and Income, 2007

Defining the Developing World

World Bank Scheme- ranks countries on GNP/capita LIC, LMC, UMC, OECD (see Table 2.1 and Figure 2.1) where LIC = Low-Income Countries, LMCs= Lower-Middle-Income Countries, UMCs= Upper-Middle-Income Countries; (LMCs + UMCs) = Middle-Income Countries

(Latin America and the Caribbean) (Sub-Saharan Africa)

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Table 2.1 Classification of Economies by Region and Income, 2007 (continued)

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Figure 2.1: Nations of the World, Classified by GNI Per Capita (=GNI/Population)

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Figure 2.2 Income Per Capita in Selected Countries

Measuring Development for Quantitative Comparison across Countries

Gross National Income (GNI) Gross Domestic Product (GDP) PPP method instead of exchange rates as conversion factors (see Figure 2.2)

GNI and PPP

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GNI (Gross National Income)

The Gross national income (GNI) consists of: the personal consumption expenditures, the gross private investment, the government consumption expenditures, the net income from assets abroad (net income receipts), and the gross exports of goods and services, after deducting two components: the gross imports of goods and services, and the indirect business taxes. The GNI is similar to the gross national product (GNP), except that in measuring the GNP one does not deduct the indirect business taxes.

PPPPurchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP. Note: PH = E*PF or E=PH/PF

Need for adjustments to GDP1.The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods, that is, goods produced for home-country use. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by Central Banks can influence the foreign exchange market.

Using PPP to adjust GDP

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The PPP method is used as an alternative to correct for possible statistical bias. The Penn World table is a widely cited source of PPP adjustments, and the so-called Penn Effect reflects such a systematic bias in using exchange rates to outputs among countries.

2. For example, if the value of the Mexican peso falls by half compared to the US dollar, the Mexican Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem.

3. PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases, a PPP exchange rate is likely the most realistic basis for economic comparison.

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Table 2.2 A Comparison of Per Capita GNI, 2005

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Some Basic Indicators of Development Health

Life Expectancy

Education

HDI as a holistic measure of living levels– HDI also varies for groups within countries

– HDI also varies by region in a country

– HDI also reflects rural-urban differences

The HDI was created to emphasize that people and their capabilities should be the ultimate criteria for assessing the development of a country, not economic growth alone.

The HDI can also be used to question national policy choices, asking how two countries with the same level of GNI per capita can end up with such different human development outcomes. For example, the Bahamas and New Zealand have similar levels of income per person, but life expectancy and expected years of schooling differ greatly between the two countries, resulting in New Zealand having a much higher HDI value than the Bahamas. These striking contrasts can stimulate debate about government policy priorities.

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The HDI sets a minimum and a maximum for each dimension, called goalposts, and then shows where each country stands in relation to these goalposts, expressed as a value between 0 and 1.

The education component of the HDI is now measured by mean of years of schooling for adults aged 25 years and expected years of schooling for children of school entering age. (a).Mean years of schooling is estimated based on educational attainment data from censuses and surveys available in the UNESCO Institute for Statistics database and Barro and Lee (2010) methodology. (b). Expected years of schooling estimates are based on enrolment by age at all levels of education and population of official school age for each level of education. Expected years of schooling is capped at 18 years. The indicators are normalized using a minimum value of zero and maximum values are set to the actual observed maximum value of mean years of schooling from the countries in the time series.

The life expectancy at birth component of the HDI is calculated using a minimum value of 20 years and maximum value of 83.4 years. This is the observed maximum value of the indicators from the countries in the time series, 1980–2010. Thus, the longevity component for a country where life expectancy birth is 55 years would be 0.552. That is, (55 – 20)/(83.2 – 20) = 35/63.2 = 0.552

For the wealth component, the goalpost for minimum income is $100 (PPP) and the maximum is $107,721 (PPP), both estimated during the same period, 1980-2011.

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Goalposts for the Human Development Index in this Report

Dimension Observed Maximum Minimum

Life ExpectancyMean Years of SchoolingExpected Years of Schooling Combined Education IndexPer Capita Income (PPPs)

83.2 (Japan,2010)13.2 (US, 2000)20.6 (Australia, 2002)0.951 (NZ, 2010)108,211 (UAE, 1980)

20000163 (Zimbabwe, 2008)

Having defined the minimum and maximum values, the sub-indices are calculated as follows:

Dimension index

For education, the equation is applied to each of the two subcomponents, then a geometric mean of the resulting indices is created and finally, the equation is reapplied to the geometric mean of the indices, using 0 as the minimum and the highest geometric mean of the resulting indices for the time period under consideration as the maximum.

Actual Index MinimumValue

MaximumValue MinimumValue

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Human Development IndexThe HDI is the geometric mean of the three dimension indices:

The expression above embodies imperfect substitutability across all HDI dimensions. It thus addresses one of the most serious criticisms of the linear aggregation formula, which allowed for perfect substitution across dimensions. Some substitutability is inherent in the definition of any index that increases with the values of its components.Example: ChinaIndicator ValueLife expectancy at birth (years) = 73.5Mean years of schooling (years) = 7.5Expected years of schooling (years) = 11.4GNI per capita (PPP US$) = 7,263Note: Values are rounded.

Life expectancy index =(73.5 – 20)/(83.2 – 20) = 0.847

(a) Mean years of schooling index = (7.5 – 0)/(13.2 – 0) = 0.568

(b) Expected years of schooling index = (11.4 – 0)/(20.6 – 0) = 0.553

Education index =

Income index =

Human Development Index (HDI) =

ln(7,263) ln(163)0.584

ln(108,211) ln(163)

3 0.847 0.589 0.584 0.663x x

0.568 0.553 00.589

0.951 0

x

1 1 1

3 3 3LIFE Education INCOMEI x I x I

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Table 2.3 Commonality and Diversity: Some Basic Indicators

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Figure 2.3 Human Development Disparities within Selected Countries

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Table 2.4 Human Development for 23 Selected Countries (2004 Data)

Note: (1). a positive ve number shows how much a country’s relative ranking rises when HDI is used instead of GDP per capita.

(2). 0 implies that the use of HDI has no impact on rating by GDP per capita.

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Table 2.5 Human Development Index Variations for Similar Incomes (2004 Data)

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10 Characteristics of the Developing World: Diversity within Commonality

1. Lower levels of living and productivity

2. Lower levels of human capital (health, education, skills)

3. Higher Levels of Inequality and Absolute Poverty– Absolute Poverty

– World Poverty

4. Higher Population Growth Rates– Crude Birth rates

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Figure 2.4: Shares of Global Income, 2005

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Table 2.6: The 12 Most and Least Populated Countries and Their Per Capita Income, 2005

1. Low incomes have nothing to do with size (measured by population), i.e. no causality between country size and economic development

2. China – large size but still a developing economy; St Kitts and Nevis – small but wealthy.

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Figure 2.5 Under-5 Mortality Rates, 1990 and 2005

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Table 2.7: Primary School Enrollment and Pupil-Teacher Ratios

Figure 2.6: Correlation between Under-5 Mortality and Mother’s Education

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Figure 2.7: People Living in Poverty, 1981-2002

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Table 2.8: Crude Birth Rates Around the World, 2005

5. Greater Social Fractionalization6. larger Rural Populations but Rapid Rural-to-Urban Migration7. Lower levels of Industrialization and Manufactured Exports8. Adverse Geography

-Resource endowments

10. Characteristics of the Developing World: Diversity within Commonality

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Table 2.9: The Urban Population in Developed Countries and Developing Regions

Table 2.10: Share of the Population Employed in the Industrial Sector in Selected Countries, 2000-2005 (%)

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10 Characteristics of the Developing World: Diversity within Commonality

9. Underdeveloped Financial and Other markets– Imperfect markets

– Incomplete information

10. Colonial Legacy and external dependence– Institutions

– Private property

– Personal taxation

– Taxes in cash rather than in kind

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Low Income Countries Today And Developed Countries Then

Eight differences – Physical and human resource endowments

– Per capita incomes and levels of GDP

– Climate

– Population size, distribution, and growth

– Historic role of international migration

– International trade benefits

– Scientific/technological research

– Efficacy of domestic institutions

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Figure 2.8 Convergence among OECD Countries but Divergence in the World as a Whole

Convergence? -Evidence of unconditional convergence is hard to find-Per capita income convergence?

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Figure 2.9 Per Capita GDP Growth in 125 Developing Countries, 1995-2005 Figure 2.10 Growth Convergence

and Absolute Income Convergence

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Long-Run causes of Comparative Development

Schematic Representation– Geography

– Institutional quality- colonial and post-colonial

– Colonial legacy- pre colonial comparative advantage

– Evolution and timing of European development

– Inequality- human capital

– Type of colonial regime

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Figure 2.11: Schematic Representation of Leading Theories of Comparative Development

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Role of Institutions

1. Acemoglu, Johnson, and Robinson’s: “reversal of fortune” and extractive institutions

2. Bannerjee and Iyer’s:“property rights institutions”. Landlords versus cultivators

Will hand out a Lecture on Institutions

Chapter 3: Classic Theories of Economic Growth and Development

Earlier Theories

Classic Theories of Economic Development – Four Approaches

1. Linear stages of growth model

2. Theories and Patterns of structural change

3. International-dependence revolution

4. Neoclassical, free market counterrevolution

Development as Growth and Linear-Stages Theories

1. Rostow’s Stages of Growth

2. Harrod Domar Growth Model

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Earlier Theories: Growth Theory + Development = Growth and Development Economics

Adam Smith (as quoted in a1976 revision): “Great nations are never impoverished by private, though they sometimes are publick prodigality and misconduct.”

Thomas Malthus (1817): “The practical question then for our consideration is, what are the most immediate and effective stimulants to the creation and progress of wealth?

W. Arthur Lewis (1955): “The proximate causes of economic growth are the effort to economize, the accumulation of knowledge, and the accumulation of capital.”

Robert Solow (1956): To change the rate of growth of real output per head (= GDP/Population) you have to change the rate of technical progress.

Paul Krugman (1995): Why did development economics fade away? -- the leading development economists failed to turn their intuitive insights into clear-cut models that could serve as the core of an enduring discipline.

The First Revolution: Adam Smith;1

1. Link between division of labor, efficiency, and the size of the market as central in his theory of wealth creation, public policy and economic growth.

2. Like Hume, he regarded saving and investment as by-products and precursors of domestic and foreign trade; as a means of enlarging the market and increasing the division of labor and thus efficiency.

3. High saving and investment stimulate growth directly and indirectly. Directly --- accumulation of capital on output. Indirectly --- effects on labor productivity + interaction with exchange and trade.

4. Trade (domestic and foreign) stimulates growth: smaller countries have higher trade (Belgium and Sweden, 143% and 77% respectively in 1995) whereas for the USA and Japan, 24% and 17% respectively.

5. By Smith, anything that increases division of labor and hence specialization increases efficiency and wealth, and thus economic growth.

Adam Smith ;26. Thus, anything that increases efficiency of labor (L), capital (K) should have the same effect

on output and hence economic growth.

7. Smith’s view on education, efficiency and growth follows from his distinction between the

quantity and quality of labor. Viewed inferior education as not contributing to increased

labor productivity or efficiency. Advocated improved education for the ‘common people.’

Thought education could be improved by more private-sector involvement aided by

public sector expenditure - need for government tax revenue.

8. In sum, Adam Smith attributed economic growth to:

a. an increase in the quantity and quality of the 3 main inputs; labor (L), capital (K), and

land (N). Modern-day growth accounting attempts to determine empirically the

proportions in which economic growth can be traced to these proximate causes. In

practice, we have as determinants; the increased quantity of capital through saving and

investment AND improved quality of labor, capital, and land as sources of economic

growth.