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									Theories

Fisher Clark's Theory of Structural Change

Next theory - The Harrod-Domar Model >>

Two economists, Fisher and Clark, put forward the idea that an economy would have three
stages of production

       Primary production is concerned with the extraction of raw materials through agriculture,
        mining, fishing, and forestry. Low-income countries are assumed to be predominantly
        dominated by primary production.
       Secondary production concerned with industrial production through manufacturing and
        construction. Middle income countries are often dominated by their secondary sector.
       Tertiary production concerned with the provision of services such as education and
        tourism. In high-income countries the tertiary sector dominates. Indeed having a large
        tertiary sector is seen as a sign of economic maturity in the development process.

Countries are assumed to first pass through the primary production stage then the secondary
stage and finally the tertiary stage. As economies develop and incomes rise then the demand for
agricultural goods will increase but due to their low income elasticity of demand at a
proportionally lower rate than income. However, the demand for manufactured goods will have a
higher income elasticity of demand. So as incomes grow further the demand for these goods will
grow at a proportionately higher rate. Hence the secondary industry will grow. As incomes
continue to grow then people will start to consume more services as these have an even higher
income elasticity of demand. Thus the tertiary sector will then grow and develop.

However, this may be misleading. Some LDCs may have a large tertiary sector due to a large
tourist industry without having developed a secondary industry. Economists argue that this could
be somewhat risky. If the economic base is dominated by an economic activity such as tourism
that has a high income elasticity of demand then a recession in the consuming nations will have
a disproportionately large impact on the export earnings. A fall income will bring about a
proportionately greater reduction in demand for the service and this will have severe impact on
the economy. If it does not have a primary or secondary production to fall back on then
borrowing and debt might be the only prospect.

Next theory - The Harrod-Domar Model >>




Related Glossary Items:
Primary Industry
Secondary Industry
Tertiary Industry
Income Elasticity of Demand

Related Theories:
The Harrod-Domar Model
The Lewis Model of Development
Rostow's Model - the Stages of Economic Development
Economic Growth and the Production Possibility Frontier


Theories

Harrod-Domar Model
Next theory - The Lewis Model of Development >>

This model, developed independently by RF Harrod and ED Domar in the l930s, suggests savings
provide the funds which are borrowed for investment purposes.

The model suggests that the economy's rate of growth depends on:

      the level of saving
      the productivity of investment i.e. the capital output ratio

For example, if $10 worth of capital equipment produces each $1 of annual output, a capital-
output ratio of 10 to 1 exists. A 3 to 1 capital-output ratio indicates that only $3 of capital is
required to produce each $1 of output annually.

The Harrod-Domar model was developed to help analyse the business cycle. However, it was
later adapted to 'explain' economic growth. It concluded that:

      Economic growth depends on the amount of labour and capital.
      As LDCs often have an abundant supply of labour it is a lack of physical capital that holds
       back economic growth and development.
      More physical capital generates economic growth.
      Net investment leads to more capital accumulation, which generates higher output and
       income.
      Higher income allows higher levels of saving.

Implications of the model
The key to economic growth is to expand the level of investment both in terms of fixed capital
and human capital. To do this policies are needed that encourage saving and/or generate
technological advances which enable firms to produce more output with less capital i.e. lower
their capital output ratio.

Problems of the model

      Economic growth and economic development are not the same. Economic growth is a
       necessary but not sufficient condition for development
      Practically it is difficult to stimulate the level of domestic savings particularly in the case
       of LDCs where incomes are low.
      Borrowing from overseas to fill the gap caused by insufficient savings causes debt
       repayment problems later.
      The law of diminishing returns would suggest that as investment increases the
       productivity of the capital will diminish and the capital to output ratio rise.

Next theory - The Lewis Model of Development >>


Theories

Lewis's Dual Sector Model of Development: The theory of trickle
down

Next theory - Rostow's Model >>

Lewis proposed his dual sector development model in 1954. It was based on the assumption that
many LDCs had dual economies with both a traditional agricultural sector and a modern
industrial sector. The traditional agricultural sector was assumed to be of a subsistence nature
characterised by low productivity, low incomes, low savings and considerable underemployment.
The industrial sector was assumed to be technologically advanced with high levels of investment
operating in an urban environment.

Lewis suggested that the modern industrial sector would attract workers from the rural areas.
Industrial firms, whether private or publicly owned could offer wages that would guarantee a
higher quality of life than remaining in the rural areas could provide. Furthermore, as the level of
labour productivity was so low in traditional agricultural areas people leaving the rural areas
would have virtually no impact on output. Indeed, the amount of food available to the remaining
villagers would increase as the same amount of food could be shared amongst fewer people. This
might generate a surplus which could them be sold generating income.

Those people that moved away from the villages to the towns would earn increased incomes and
this crucially according to Lewis generates more savings. The lack of development was due to a
lack of savings and investment. The key to development was to increase savings and
investment. Lewis saw the existence of the modern industrial sector as essential if this was to
happen. Urban migration from the poor rural areas to the relatively richer industrial urban areas
gave workers the opportunities to earn higher incomes and crucially save more providing funds
for entrepreneurs to investment.

A growing industrial sector requiring labour provided the incomes that could be spent and saved.
This would in itself generate demand and also provide funds for investment. Income generated
by the industrial sector was trickling down throughout the economy.

Problems of the Lewis Model

      The idea that the productivity of labour in rural areas is almost zero may be true for
       certain times of the year however during planting and harvesting the need for labour is
       critical to the needs of the village.
      The assumption of a constant demand for labour from the industrial sector is
       questionable. Increasing technology may be labour saving reducing the need for labour.
       In addition if the industry concerned declines again the demand for labour will fall.
      The idea of trickle down has been criticised. Will higher incomes earned in the industrial
       sector be saved? If the entrepreneurs and labour spend their new found gains rather than
       save it, funds for investment and growth will not be made available.
      The rural urban migration has for many LDCs been far larger that the industrial sector
       can provide jobs for. Urban poverty has replaced rural poverty.

Next theory - Rostow's Model >>


Theories

Rostow's Model- the Stages of Economic Development

Next theory - Models of Demographic Transition >>

In 1960, the American Economic Historian, WW Rostow suggested that countries passed through
five stages of economic development.

Stage 1 Traditional Society
The economy is dominated by subsistence activity where output is consumed by producers
rather than traded. Any trade is carried out by barter where goods are exchanged directly for
other goods. Agriculture is the most important industry and production is labour intensive using
only limited quantities of capital. Resource allocation is determined very much by traditional
methods of production.
Stage 2 Transitional Stage (the preconditions for takeoff)
Increased specialisation generates surpluses for trading. There is an emergence of a transport
infrastructure to support trade. As incomes, savings and investment grow entrepreneurs emerge.
External trade also occurs concentrating on primary products.

Stage 3 Take Off
Industrialisation increases, with workers switching from the agricultural sector to the
manufacturing sector. Growth is concentrated in a few regions of the country and in one or two
manufacturing industries. The level of investment reaches over 10% of GNP.

The economic transitions are accompanied by the evolution of new political and social institutions
that support the industrialisation. The growth is self-sustaining as investment leads to increasing
incomes in turn generating more savings to finance further investment.

Stage 4 Drive to Maturity
The economy is diversifying into new areas. Technological innovation is providing a diverse range
of investment opportunities. The economy is producing a wide range of goods and services and
there is less reliance on imports.

Stage 5 High Mass Consumption
The economy is geared towards mass consumption. The consumer durable industries flourish.
The service sector becomes increasingly dominant.

According to Rostow development requires substantial investment in capital. For the economies
of LDCs to grow the right conditions for such investment would have to be created. If aid is given
or foreign direct investment occurs at stage 3 the economy needs to have reached stage 2. If the
stage 2 has been reached then injections of investment may lead to rapid growth.

Limitations
Many development economists argue that Rostows's model was developed with Western cultures
in mind and not applicable to LDCs. It addition its generalised nature makes it somewhat limited.
It does not set down the detailed nature of the pre-conditions for growth. In reality policy
makers are unable to clearly identify stages as they merge together. Thus as a predictive model
it is not very helpful. Perhaps its main use is to highlight the need for investment. Like many of
the other models of economic developments it is essentially a growth model and does not
address the issue of development in the wider context.

Next theory - Models of Demographic Transition >>




Theories

Models of Demographic Transition

Next theory - Measuring the Circular Flow of Income >>

The Classic Model of Demographic Transition


                                                                           Reverend Thomas
                                                                           Malthus
The model of demographic transition proposed in the 1940s describes
the stages in the relationship between birth and death rates and the
overall population change. The growth in the population due to changes
in the birth and death rates is called the natural rate of population
growth. The model of demographic transition suggested that a
population's mortality and fertility would decline as a result of social and
economic development. It predicted that all countries would over time
go through four demographic transition stages. However with all models
it has its limitations and the model has been developed to consider the
demographic changes that many LDCs are experiencing.




The tables below summarise the factors affecting birth rates and death rates in each stage


Stage 1 : Pre                Stage 2: Rapid population    Stage 3: Continued and            Stage 4: Stable
industrialisation: Stable    growth                       decreasing population growth      low population
population growth                                                                           growth
High Birth rates             High Birth rates             Falling Birth rates               Low Birth rates
No or little Family Planning As stage 1                   Family Planning utilised ,
                                                          contraceptives, abortions,
Parents have many                                         sterilisation and other
children because few                                      government incentives
survive
                                                          A lower infant mortality rates
Many children are needed                                  means less pressure to have
to work the land                                          children

Children are a sign of                                    Increased mechanisation and
virility                                                  industrialisation means less
                                                          need for labour
Some religious beliefs and
cultural traditions                                       Increased desire for material
encourage large families                                  possessions and less desire for
                                                          large families

                                                          Emancipation of women
High Death Rates             Falling Death Rates          Death rates Low                   Death rates
                                                                                            Low
Disease and plague (e.g.     Improved medical care e.g.   As stage 2
bubonic, cholera,            vaccinations , hospitals,
kwashiorkor)                 doctors, new drugs and
                          scientific inventions
Famine , uncertain food
supplies and poor diet    Improved sanitation and
                          waters supply
Poor hygiene, no piped
clean water or sewage     Improvements in food
disposal                  production in terms of quality
                          and quantity

                          Improved transport to move
                          food and doctors

                          A decrease in child mortality


The model predicts that eventually industrialised countries will have low stable population
growth.

Demographic transition in LDCs
If we examine the economy of Zambia it could be argued that they have moved through stage 1
and stage 2. There is also some evidence of a decline in the birth rate, characteristic of stage
three, however there are certain fundamental differences between population growth in MDCs
and LDCs.

       The Birth and Death rates in stage 1 are higher in LDCs that in MDCs
       Stage 2 seems to have taken a much shorter time that it took with the MDCs

These two features have been included in a demographic transition model for LDCs by Berelson




Berelson suggests that

       There are 3 clear stages rather than 4.
       LDCs fall into two categories, Type A and Type B.

Type A countries are those that have experienced economic development and have seen a fall in
their birth rate together with a decline in their death rate in Stage 3. Type B countries, typical of
many low income LDCs such as Zambia have maintained a high birth rate with a death rate that
is levelling off albeit at a higher rate than Type A countries.

Observation of mortality rate statistics in Zambia suggests that the death rate is starting to
increase. The Aids epidemic and the worsening poverty are taking their toll.
Theories

The National Income Accounts: Measuring the Circular Flow of
Income:

Next theory - Neo-classical Theory >>

The circular flow of income is a simple model of the economy showing flows of goods and
services and factors of production between firms and households. In the absence of government
and international trade this simple model shows that households provide the factors of
production for firms who produce goods and services. In return the factors of production receive
factor payments, such as wages, which in turn are spent on the output of firms. This basic flow is
shown in the diagram below.




In reality the households do not spend all their current income. Some is saved. This represents a
leakage from the circular flow. In addition to the consumer spending, firms also carry out
investment spending. This is an injection to the circular flow of income, as it does not originate
from consumers' current income.

In the real world the government and international trade sectors must also be included.
Economic systems are in reality three sector open economies. Consequently there will be
additional leakages and injections. Government spending will be injected into the circular flow
and taxation will leak from it. Export flows will be injected and imports flows leaked. A full
circular flow with leakages and injections is shown below.
This model of the economy demonstrates that economic activity is a flow. In actual fact it can be
considered two flows, one of goods and services and a flow of money. The size of these flows is
an indicator of the amount of economic activity. The circular nature of the flows means that
there will be a number of different ways of measuring the size of the flow. Economists maintain
that there are three possible ways of measuring this flow with each way looking at a different
part of the circular flow of income. However all should give the same answer:

      The output method: the total amount of goods and service produced in one year
      The expenditure method: the total amount of domestic spending by consumers, firms,
       government and foreigners
      The income method: the total incomes earned by the factors of production involved in
       the production of goods and services in one year

National income accounting is the process whereby countries attempt to measure these flows.
The result of each the three methods is the gross domestic product. An examination of the
national income accounts gives an insight into the economy.

It provides data which governments and external agencies can use in a variety of different ways.
These include:

      to   determine the extent of economic growth
      to   measure changes in living standards over time
      to   make comparisons of economic performance and living standards between countries
      to   examine and judge the performance of different sectors of the economy

Next theory - Neo-classical Theory >>


Theories
Neo-Classical Theory of Growth

Next theory - Population Pyramids >>

Neo classical theory maintains that economic growth is caused by:

      increase in the labour quantity (population growth)
      improvements in the quality of labour through training and education
      increase in capital (through higher savings and investment)
      improvements in technology

Underdevelopment is seen as the result of the government's inefficient utilisation o f resources
and state intervention in markets through regulation of prices. The neo classical lobby argue that
government control inhibits growth because it encourages corruption, inefficiency and offers no
profit motive for entrepreneurship.

They argue therefore, that the root cause of underdevelopment lies with the governments of the
LDCs themselves. Only when governments adopt polices that aim to free up markets and
improve the supply side, will the economy grow and development occur. This results in a s hift of
the long-run aggregate supply as shown in the diagram below. The potential level of output of
the economy is then higher.




Neo classical economists advocate the following strategies should be encouraged:

      Competitive free markets
      Privatisation of state owned industries
      A move from closed (no trade) to open (trading) economies
      Opening up the domestic economy through encouraging free trade (i.e. abolish tariffs and
       quotas) and foreign direct investment.

These policies will stimulate investment, higher output and income and hence higher savings.

Problems of the model
This model makes a number of unrealistic assumptions and ignores a number of crucial issues

      The assumption is that the creation of a free market and a private enterprise culture is
       possible and desirable.
      The existence of market failure such as externalities associated with economic growth are
       ignored
      The problem of uneven distribution of income is ignored

Next theory - Population Pyramids >>
Theories

Population Pyramids

Next theory - Price Movements of Primary Commodities >>

How the population is structured is also of importance to economists. The structure of the
population can be considered in terms of:

      the proportion of different age groups
      the proportion of males and females

This information is often illustrated using a population pyramid.




The x-axis shows the population in millions whilst the y-axis shows different age ranges. The
higher up the y-axis the older the population. The left half of the pyramid shows age distribution
of the male population and the right half the female distribution. It is useful to examine the
changes in these pyramids over time as they give clues to how the population is changing and
how these changes may impact on the economy.

The key points to note about the population pyramid of Zambia are that the wide base of the
pyramid indicates a large proportion of the population is young. This is an indicator of a high
birth rate. The narrow top indicates a small proportion of the population is old implying a high
death rate.

Impact on the economy
Ageing or youthful populations may have implications for the following:

      labour availability and unemployment?
      economic growth?
      the size and nature of markets
      dependency ratios
      welfare services such as pensions, old peoples homes
      educational provision i.e. primary , secondary and tertiary education
      housing market

Next theory - Price Movements of Primary Commodities >>




Theories

The Dependency Ratio

Next theory - Dependency Theory >>

A rapidly growing population with a high fertility rate will mean that a relatively large proportion
of the population consists of children. An examination of the population pyramid for Zambia
shows the high proportion of under 15-year-olds making up the population - the pyramid has a
large base. The children will be dependent on the land and their families for sustenance. In
addition to children, adults who have left the labour force because of their advanced age are also
dependent.

The dependency ratio is calculated by the following formula:

population under age 15 and above age 65

working-age population (those aged 15-64)



A dependency ratio of 0.9 means there are 9 dependants for every 10 working-age people. It
indicates the economic responsibility of those economically active in providing for those that are
not.

One should bear in mind that in many LDCs that there is a large number of people who are
underemployed who would be counted amongst the working age population however have very
low levels of productivity. It should also be remembered that many children in Zambia are
economically active either working on the land or in the informal sector of the economy. The
dependency ratio is a measure of the dependence that non-working people have on working
people.
One of the results of the AIDS/HIV epidemic in Zambia is the increased mortality rate amongst
working age population. The dependency ratio would be expected to rise.

The larger the dependency ratio, the greater the responsibility the government has to provide
basic consumption needs for those people who are dependent. There is also need to invest in
social infrastructure such as schools and health care to those people who are dependent.

Next theory - Dependency Theory >>

								
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