Theories of Economic Development

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					                              Theories of Economic Development

Economic Base Theory

Dominates the thinking about local economic development in the U.S.

        The underlying premise is that the external demand for a region’s products as the primary
determinant of regional prosperity. The economic activities of a labor market are divided into those
that produce for the export market (basic industries) and those that produce for the local market
(nonbasic/service industries). The two sectors are linked in two ways. 1) The basic sector directly
purchases goods and services from the nonbasic sector. Second, workers employed in the basic sector
purchase food, clothing, shelter, public services from the nonbasic sector. Greater demand for the
region’s exports generates exports sales and income for the basic sector, which basic-sector purchases
provide income to the nonbasic sector. This is the multiplier effect.

Keynesian theory of regional income. A simple demand-driven model of regional growth. NAICS codes
determine if industry is export sector ( ag, mining and manufacturing) or nonbasic sector (everything

b+r = n

b = basic, r = nonbasic and n = total regional economic activity

r = f(n) = a*n where a is a parameter that must be estimated. The multiplier is derived by substituting
a*n for r and rearranging terms to get:

b = economic or base multiplier, a denotes the average or marginal propensity to spend locally. Given an
exogenous change in basic activity (employment, income or output), caused by an increase in demand
for regional exports, the model can be used to estimate the associated change in total regional
employment, income, or output.

Economic base theory focuses exclusively on external demand as the determinant of regional growth.
Internal demand and supply are viewed as relatively insignificant sources of income and employment
growth. Other features of the regional economy – including its endowment of natural resources, the
rate of capital investment and the quality and quantity of the labor force- are not addressed. Assumes
no significant production capacity constraints, implying that there are unemployed resources (capital
and labor) within the region that may easily be acquired.
Applications: Developers can try to expand the existing economic base in three ways: Industrial
recruitment, facilitate the expansion of export industries already part of the basic sector, indirectly
facilitate export expansion by improving the efficiency of local public infrastructure and services. \\

In the real world how do developers do this?

         Work to ensure adequate supplies of trained labor, industrial land and facilities, public
infrastructure, affordable housing.

Try to diversity exports by devising ways to stimulate the founding of new exporting enterprises.

By recognizing that due to interindustry linkages all industries give rise to multiplier effects, therefore
the most rapid rate of growth is not necessarily achieved by concentrating development efforts solely
on the basic sector.

        Criticism – As a basis for understanding the reality of local economic development, economic
base theory offers limited insights. In the form of a quantitative model, it can be applied for impact
analysis and for making predictions of economic growth only as long as the structure of the local
economy does not change. Key export sectors and local economic structure change over time.

Arbitrary division of dividing the regional economy into basic and non basic industries.

Ignores the role of the nonbasic industry in supporting and stimulating economic growth.

Staple Theory

Focus on the export staple and build on it as long as it remains competitive in the larger economic
system. In some instances strengthening the existing specialization may be more sensible than
attempting to diversify the economic base. When? Do what one knows best. This theory orients
economic developers to their local economy. Why is that useful? Local values, politics, and wealth

Sector Theory

Argues that over time the relative share of production in each major sector will change in the region.
The economy is divided into three aggregated sectors: primary (ag, forestry, fisheries), secondary (
manufacturing, mining) and tertiary (trade and services). Due to the income elasticity of demand for
primary, secondary, and tertiary products, the region becomes specialized in primary, then secondary,
then tertiary products.

In contrast to the economic base theory and staple theory, which emphasize external economic
relationships, sector theory focuses on the internal structure of the economy. Internal development
through specialization and division of labor paves the way for favorable external trading relationships.
Internal development leads to external development as opposed to economic base theory.

The income elasticity of demand for the products of different sectors drvies the sectoral shifts in
production. Increases in labor productivity support the changing sectoral allocation of the labor force.
As income per capita increases, the demand for manufactured goods will exceed the demand for ag and
other primary products. Subsequently the demand for services predominates and the service sector
becomes the largest regional sector.

Criticisms: Sector theory is too crude to be used as a strategy for encouraging economic growth. Sectors
must be examined at a finer level. To use sector theory more effectively the service sector might be
divided into 5 categories: distribution, trade, business services, education and health services, and other
public, nonprofit and consumer services.

Central Place Theory

Growth Center Theories – Regional Theories of Concentration and Diffusion

        Growth Poles

The firm attracts economic elements, supplies and demands into its space or it removes them. Poles of
growth represent individual firms, industries or economic sectors. Two phases: an initial clustering or
attraction phase, in which the dominated units lose resources to the pole, followed by an expansion
phases in which goods, investments, and information flow from the pole to the dominated units in order
to sustain growth.

        Unbalanced Growth Theory

Strategy based on the concept of geographical growth centers. In order for an economy to increase
income, it must first develop within itself one or several regional centers of economic strength. The
spread of growth from the center to peripheral areas – through increases in purchases and investments
in underdeveloped areas due to activity in the growth center – the “trickling down process”. There are
also polarization effects, such as white-collar migration out of less-developed areas and the dominance
of growth center industry. Use public investment as a policy tool for directing growth. Invest in
industries that have extensive backward and forward linkages with other industries. This leads to
unbalanced growth.

        Cumulative Causation Theories

Economic changes cause supporting social changes in a process that continues in one direction.
Exogenous change may start the process of change in a new direction. Without intervention, backward
areas can be relegated to perpetual underdevelopment, whereas a scheme of balanced locational
investment may provide the needed push toward cumulatively positive growth. Very pessimistic. The
play of market forces can increase inequalities between regions, leaving underdeveloped areas in the
backwater of growing ones. Less fortunate regions receive the backwash effects of proximity to growth
centers, such as outmigration, capital flight and unfavorable terms of trade. This will lead to “spread
effects” , growing markets for primary goods produced in the poorer area, increasing demand for raw
materials, and the absorption of the poorer regions’ excess unemployed into the growing one.
        Friedmann’s Core-Periphery Model

Based on the notion of cumulative causation. Involves a critical transition from a preindustrial phase to
a fully industrialized economy. This transition strongly affects the spatial structure of settlement which
in turn affects future economic performance. In the preindustrial phase, the economy is dominated by
relatively automnous cities and regions. As industrialization begins, and as the economy moves into its
transitional phase, investments tend to be concentrated in particular locations, establishing an unequal
relationship between theses cores and peripheral regional areas. Without government intervention to
ensure that other communities develop along with the core areas, the cores will come to dominate the
spatial economy and retard subsequent growth.

Regional Growth Theory – Two characteristics distinguish the theories below from others discussed
before. 1) These models are concerned primariliy with explaining movements in a fairly narrow set of
key macroeconomic indicators, such as output, employment, income, investment, savings, wages and
interest rates. The other regional development theories generally explore a wider range of economic
and social issues both at the macro and micro economic levels (Growth poles – interindustry linkages
and entrepreneurship – behavior of key economic agents). 2) Most relevant to understanding
interregional growth and development trends. Abandon one-region/rest of world perspective. What
determines observed disparities in regional income and income growth? Will disparities exist or will they
disappear through the natural play of market forces.

Look at Neoclassical and Post-Keynesian theories.

Neoclassical Growth Theory – focuses primarily on the supply-side issues. Early models of neoclassical
growth models de-emphasize or discourage public-sector development intervention in the market the
new neoclassical growth theory admits a more significant role for economic developers in encouraging
growth or reducing regional disparities. The supply side of much US economic development activity –
infrastructure, training programs, technical assistance, and science and technology programs may find
some justification from new growth models.

With emphasis on insufficient demand for the output of regional industries, post-Keynesian theories
have had a more limited; though still important influence on regional development thinking. Impact
stronger in Europe than US. Rely on more government policy.

Neoclassical growth within a nation leads to reduction, then elimination of productivity growth and per
capita income disparities across regions. Because the system tends to achieve and maintain this
equilibrium result on its own, there is no need for development policies to encourage growth in regions
that are underdeveloped or lagging. Government intervention is likely to do more harm than good since
the market, through the price mechanism determines the most efficient allocation of resources. There
are no supply constraints. In neoclassical regional growth theory focus exclusively on the role of supply
as the fundamental determinant of changes in the local labor market. Implicitly invokes Say’s Law:
Supply creates its own demand. Everything hinges on the capital-labor ratio. Diminishing Marginal
productivity of capital and labor. Add people with out extra capital or extra capital without people will
inhibit growth. The neoclassical model implies that when capital reaches the point where diminishing
returns set in, investment will cease and growth will come to a halt. That is why exogenous technological
progress or an increase in the size of the labor force is needed to sustain growth.

Post-Keynesian Regional Growth Theories

Emphasize the lack of equilibrium in the growth process, the dependence of local fortunes on the
strength of effective demand for regional exports, and the tendency for growth trends to become

Output growth by producers in a given location drives increase in productivity through returns to scale;
improvements in productivity make the export sector of a region more price competitive; price
competitiveness stimulates growth in exports as consumers elsewhere buy more of the region’s goods;
purchases of regional exports generate further growth in regional output through the multiplier effect.
Growth of the region’s production stimulates an influx of both workers and investment; the growth of
productive factors is not the cause, rather the result of output growth.

Trade Theory

        Ricardian Trade Theory


        Transporting goods between counties is costless

        There are no artificial barriers to trade

        Labor is homogenous

        The market is characterized by perfect competition, no increasing returns

        Production technologies are identical in each country

        That labor, the only facto of production considered, is immobile between countries.

Even if one country has an absolute cost advantage in the production of all goods, it may still engage in
trade with other nations based on differences in relative internal economic capabilities. This suggest
that a firm in a given country may still find an international market for its goods even if it produces at a
higher absolute cost than similar firms overseas. A country has a comparative advantage for the
purposes of trade in those commodities which its industry produces most cost effectively relative to
other commodities. In an economy operating at its highest potential rate of output, each good that is
produced means some other good cannot be produced.

        Factor Proportions Theory
But why would one country be able to produce a given good at lower relative cost than another
country? Factor proportions theory does a better job understanding the causes of comparative
advantage. This theory states that countries trade because they are different in terms of their
endowments of the equipment, materials, personnel, and expertise that go into producing goods.
Countries that have more land relative to workers will find their comparative advantage in land-
intensive goods such as wheat. Countries well endowed in capital and skilled workers will their
comparative advantage in such goods as electronics, computers, etc. Although factor prices in the
absence of trade first establish the basis for trade, they are not likely to remain stable once trade

Example: U.S. Comp Adv in making computers because of high skill set, demand for capital increases,
price of capital increases

        Mexico Comp adv in making apparel – demand for labor increases, wage increases

In the end, all prices should equalize.

New Trade Theory

Another explanation why countries trade: because there are economies of scale in specialization.

Product-Cycle Theory

Moves us from a world of given commodities and factors of production to a world of changing
production and trade relationships. Product development becomes the driving economic force.
Essential dynamic is innovation. Looking now at development, not so much at growth.

        Grounded in neoclassical economics and considers the interregional pattern of specialization in
trade. Unlike trade theory, product cycle theory is a partial equilibrium argument about the dynamics of
development. It suggests that interregional development patterns are modified over time by recurring
cycles of new product, maturing product and standardized product. Interregional trade does not
necessarily lead to convergence of per capita incomes. Consumption difference, production economies,
and communication advantages may continue to favor the more-developed region even with complete
factor mobility. Focuses on the micro-economic firm level decision making.

         The innovation process results in new products (as a demand from high-capital intensive
countries) which initially satisfy local demand in the more-developed country. As it matures, the product
becomes standardized and producers are able to export the product to less-developed countries. When
the production process is completely standardized, the product can be produced in both areas, and
competitive pressures drive producers to seek the lower-cost location. This diffusion process benefits
the less developed countries.

Criticism: might only be applicable for manufacturing and primary export staples, ignoring the growing
service sectors.
Entrepreneurship Theories

Puts human agency at the center of the development process. Entrepreneurs? People who carry out
venture-creation functions that in turn generate development through innovation. This is a departure
from neoclassical economics (assigns no role to the entrepreneur).

On the one hand many regard entrepreneurship in as beyond the scope of the self-contained, well-
defined problems that economics attempts to solve. It is hardly possible to study entrepreneurship
without raising issues of managerial skill, psychology, motivation. These topics are inaccessible with the
tools of the modern, mathematically oriented economist. So the role of entrep is ignored.

Could introduce the role of the entrepreneur by altering the basic assumptions of the neoclassical model
to varying degrees. But still ignores these questions… 1) what determines entrepreneurial behavior? 2)
how much economic development strategies encourage entrepreneurial activity and success?

Will discuss this in much greater detail later on in the semester

Theories of Flexible Production

“Flexible Specialization” a partial return to a less rigid and more craft-based technological model
characterized by a type of cooperative competition among smaller firms, the use of flexible
manufacturing equipment and techniques and a great reliance on social relationships (trust0 as a means
of organizing transactions.

         Industry Clusters – Cluster strategies recognize that the fortunes of individual businesses are in
many ways defined collectively, given that they depend on common factors (inputs and labor),
improvements in technology, and the general growth of the economy. Departure from traditional
theory which emphasizes the fierce competition. Clusters are geographically concentrated group of
firms interdependent along one or both of the following dimensions: presence in the same product
chain and important similarities in technology or workforce requirements.

       Interfirm Networks – a form of associative behavior among firms that helps expand their
markets, increase their value-added or productivity and stimulate learning to improve their long-term
market position. Vertical networks: firms at different stages of the production chain or in the same
markets that form an association to engage in joint marketing or share information. Horizontal network :
made up of firms that share similar technology or service needs, whether or not they are in the same
product chain.

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