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Kemp, Tom. 1989. Industrialization in the Non-Western World. London: Longman.
Kohli, Atul. 1999. “Where do High-Growth Political Economies Come From? The Japanese Lineage
of Korea™s ˜Developmental State™,” pp. 93“136 in Meredith Woo-Cumings (ed.), The Developmental
State. Ithaca: Cornell University Press.
””. 2004. State Directed Development. Cambridge: Cambridge University Press.
McCullough, David. 1992. Truman. New York: Simon & Schuster.
Maddison, Angus. 1982. Phases of Capitalist Development. Oxford: Oxford University Press.
””. 1985. Two Crises: Latin America and Asia 1929“38 and 1973“83. Paris: OECD.
””. 1990. “The Colonial Burden: A Comparative Perspective,” pp. 361“76 in Maurice Scott and
Deepak Lal (eds.), Public Policy and Economic Development. Oxford: Clarendon Press.
Maizels, Alfred, Theodsios Palaskas and Trevor Crowe. 1998. “The Prebisch-Singer Hypothesis Revis-
ited,” pp. 63“85 in David Sapsford and John-ren Chen (eds.), Development Economics and Policy.
London: Macmillan.
Nehru, Jawaharal. 1960. The Discovery of India. New York: Doubleday-Anchor.
Peemans, J. P. 1975. “Capital Accumulation in the Congo under Colonialism,” in P. Duigana and L.H.
Gann (eds.), Colonialism in Africa: 1870“1960.,Cambridge: Cambridge University Press.
Reynolds, Lloyd G. 1986. Economic Growth in the Third World. New Haven, CT: Yale University
Robinson, Ronald. 1976. “Non-European Foundations of European Imperialism,” pp. 117“42 in Roger
Owen and Bob Sutcliffe (eds.), Studies in the Theory of Imperialism. London: Longman.
Rodney, Walter. 1974. How Europe Underdeveloped Africa. Washington, D.C.: Howard University
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Schumpeter, Joseph. 1951. Imperialism. Oxford: Basil Blackwell.
Singer, Hans. 1989. “Terms of Trade,” pp. 323“8 in John Eatwell et al. (eds.), The New Palgrave:
Economic Development. New York: W.W. Norton.
Spraos, J. 1983. Inequalising Trade? Oxford: Clarendon Press.
Stavrianos, L.S. 1981. Global Rift. New York: William Morrow & Co.
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Economically Underdeveloped Areas. Washington, D.C.: US Department of State.
Part 2

Theories of development
and underdevelopment
4 Classical and neoclassical theories

after reading and studying this chapter, you should better understand:
• Adam Smith™s contribution to understanding how a capitalist market economy
operates, including the importance of the invisible hand, competition, specializa-
tion, and the law of capital accumulation and how these interact to affect the rate
of economic growth;
• Thomas Malthus™s theory of population, how and why he believed rapid popula-
tion growth was so likely and the implications of rapid population growth for the
living standards of the poor;
• David Ricardo™s theories of diminishing returns, of comparative advantage, his
argument in favor of free trade and how these relate to the pace of economic
• Karl Marx™s critique of capitalism and the theory behind his belief in the ultimate
collapse of that system;
• the logic behind a Solow-type neoclassical growth model, the importance of
saving and investment in determining the level of per capita income and why the
neoclassical model predicts “conditional convergence” of income levels among
nations over time;
• the Harrod-Domar model™s importance to subsequent growth theories and strate-
• the commonality of an emphasis on physical capital as a fundamental determinant
to economic growth in all these growth models.

As we learned in the previous chapter, the pursuit of economic growth and development as
a socially desirable goal is of relatively recent origin, being more-or-less contemporaneous
with the rise of capitalism as an economic system. The Industrial Revolution in england in
the mid-eighteenth century provides a convenient date for the emergence of systematic and
intellectual interest in understanding how and why economic development occurs. It also
marks the emergence of economics “ or political economy, as it was called at that time “ as a
separate sphere of scholarly inquiry. Not at all coincidentally some of the most distinguished
and most enduring thinking about the process of economic development was produced in
110 The Process of Economic Development
Great Britain during and following the transition from feudalism to capitalism, where long-term
economic expansion and rising income per capita first materialized on an extended scale
(Maddison 1982).
Many of the great political economists whose ideas have shaped economic inquiry down
to this day lived through the early changes brought on by the Industrial Revolution. These
so-called classical political economists attempted not only to explain the reasons for the
rapid expansion of total economic wealth that accompanied industrialization. They also
tackled the enigma of the extremes of wealth and poverty that attended this process and the
lack of development affecting a large segment of the population. It was during this era that
An Inquiry into the Nature and Causes of the Wealth of Nations was composed by the Scot-
tish philosopher and political economist, Adam Smith. The Wealth of Nations, published in
1776, provided a theoretical structure and explanation for the workings of the increasingly
dominant market system at the center of the new capitalist industrial economy. It argued bril-
liantly for capitalism™s superiority as a system of production compared to feudalism and its
mercantilist tendencies. Smith™s writings continue to provide the foundation for a good part
of the optimism inherent in modern economic theory concerning the possibilities of progress
in market societies.
In the late eighteenth and early nineteenth centuries, Thomas Malthus™s pessimistic
musings on the future of capitalism, based on his famous theory of population, darkened
enthusiasm for capitalism™s future “ but only temporarily. David Ricardo helped to make
sense of the changes in economic structure and institutions that emerged as a consequence
of the spread of capitalism across Europe, and he added analytical tools to the economist™s
toolbox that remain central to economic analysis to this day.
And of course, there is Karl Marx. Though not a British subject, Marx spent many of his
most productive years in england, much of it in the Reading Room of the old British Library
in Great Russell Street, writing both a theory and a critique of capitalism which appeared
in the three volumes of Capital. Marx™s analysis of the dynamics of capitalist development
contain very important insights that have become central both to Marxist thought and, though
many do not realize it or refuse to acknowledge it, to non-Marxist enquiry into economic
growth and development.
In the first part of this chapter, the ideas and theories of these classical economists will be
briefly summarized as they relate to economic and social progress. These political economists
are called classical because they provided the framework and bedrock ideas of economics as
a separate field of enquiry. Their analysis predates neoclassical economics which emerged
after the 1870s in reaction particularly against the radical implications of Marx™s version of
classical theory.
Classical economists had an interest in the wider issues of the day, not only in how society
produced its output and wealth but also in how it was distributed among competing groups
with a claim on that income. The classicals were concerned with explaining not only how
economic growth took place but also how to reduce the numbers living in poverty. However,
except for John Stuart Mill and Marx, the classicals were similar to the neoclassicals who
followed in assuming that the capitalist order was a “natural order” that represented the
highest achievement of human development.
Neoclassical economists shifted the emphasis of economics from the broader macroeco-
nomics of growth and development to a much narrower concern with the allocation of a
fixed quantity of scarce resources to their best use with given institutions (something like
this was probably the definition of economics you learned in your first course). This turn to
efficiency as a focus led to a more static and marginalist perspective for economics. Growth
Classical and neoclassical theories 111
and development, which often require substantial qualitative change in society and not just
small quantitative change, disappeared for quite some time from the economist™s view.
Supply and demand and price determination became “economics.”
In the latter part of this chapter, the influential neoclassical-type growth theories of
Harrod and Domar and the Solow model are assessed. These theories have an affinity
in form and assumptions, if not always in their conclusions, with the classical models
discussed in the first part of the chapter. They focus on the requirements for achieving an
equilibrium level of economic growth, with a strong emphasis on the saving behavior of
society as the determinant variable. Similar to the classical view, however, is an emphasis
on the accumulation of physical capital “ machines, tools, building, etc. “ as the funda-
mental lever for economic growth. If there has been one common theme among early
economists on what generates economic progress, it has been this, the accumulation of
physical capital.
Neoclassical growth models of the Solow type have been extremely influential in concen-
trating the attention of economists and policy-makers to spotlight critical variables and tools
for accelerating economic development. These often very abstract models have shaped
public policies on how to best stimulate growth. No student can truly hope to understand
how economists think about economic development without a rudimentary understanding of
the simple foundational models reviewed in this chapter.

adam Smith: a theory of competitive capitalism and growth
Adam Smith provided one of the earliest and most enduring metaphors for the operation of
the capitalist market system: the invisible hand. What Smith called the “invisible hand” is
simply what we now refer to as the forces of supply and demand working to attain equilibrium
in a competitive economy. In such an environment, the individualistic desires of consumers
for goods and services, combined with the self-interested drive to maximize profits by the
producers of these goods and services, will tend toward deterministic levels of output and
prices. This is the equilibrium price and quantity where the supply curve crosses the demand
curve. At equilibrium, both consumers and producers gain from exchange, and there are
no shortages or surpluses. All of this happens more or less automatically in an unfettered
market system in which no one intends a result that nonetheless ends up benefiting everyone.
Smith™s words continue to be worth recalling:

As every individual, therefore, endeavours as much as he can both to employ his capital
in the support of domestic industry, and so to direct that industry that its produce may be
of the greatest value; every individual necessarily labours to render the annual revenue
of society as great as he can. He generally, indeed, neither intends to promote the public
interest, nor knows how much he is promoting it ¦ he intends only his own gain, and
he is in this, as in many other cases, led by an invisible hand to promote an end which
was no part of his intention.
(Smith 1973: 423)

Smith believed there was a harmony of interests among consumers and producers and
among workers, landlords, and capitalists and other groups in society which the competitive
market capitalist system mediates to the benefit of all. The purely self-interested, even selfish
and greedy behavior of consumers and producers of goods is not an evil to be despised or a
lamentable flaw of the capitalist, market system. Such self-interested behavior is functional
112 The Process of Economic Development
and in fact virtuous, since it leads an economy to higher levels of economic welfare. One of
Smith™s most famous quotations says it best:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect
our dinner, but from their regard to their own interest. We address ourselves, not to their
humanity, but to their self-love, and never talk to them of our own necessities but of
their advantages.
(Smith 1973: 14)

Smith™s concept of the invisible hand is well known by most first-year undergraduates.
Often neglected, forgotten, or ignored is the equal importance Smith placed on competi-
tion within his philosophy of the gains expected from the market system. Competition acts
as a counterweight to and a brake on the possible excesses that greedy and self-interested
behavior might engender in its absence. An effective competitive environment is essential
in restraining the actions of producers and owners/capitalists who constantly are tempted to
form cartels or monopolies in an effort to increase their individual profits at the expense of
both consumers and workers.
Smith™s belief in the virtues of the capitalist market economy was thus not an uncritical
view that emphasized only the market™s harmonizing effects. In the absence of competition,
Smith did not assume that “greed is good” and that individual actions automatically would
benefit everyone. Nor did Smith presume that private and societal interests were always
identical. Smith was suspicious of the intentions of naturally acquisitive capitalists. He
believed that, given the opportunity, they would eagerly monopolize markets for their own
benefit at the expense of others and might create working conditions inimical to the social
and individual development of their own workers.
For Adam Smith, the benefits to consumers of the market capitalist system thus rested on
two, non-separable constituent components: selfish behavior kept in check and regulated
by the forces of competition. When competition is threatened by the self-interested actions
of producers/capitalists, it is one of the responsibilities of government to create the legal
framework and to put in place the appropriate enforcement mechanisms to defend and main-
tain a competitive environment so that the potential benefits of the market system might
be achieved for the largest number. While Smith is often, correctly, singled out as a cham-
pion of laissez-faire, his was not a naïve or uncritical view of the workings of the capitalist
economy. He foresaw an essential role for government within this emerging and powerful
market system, a symbiotic relation between the invisible hand of the markets and the visible
hand of the state.

Smith™s views on economic development
What is the relation of Smith™s analysis of the invisible hand and the functioning of the
market system to the forces contributing to economic growth? In a broad sense, Smith
believed capitalism to be a productive system with the potential to vastly increase human
well-being. In particular, he stressed the importance of the division of labor and the law
of capital accumulation as the primary factors contributing to economic progress or, as he
termed it, to the “wealth of nations.”
The division of labor, or what also can be called “specialization,” began to evolve rapidly
with the spread of capitalism and the factory system. Prior to the Industrial Revolution, the
division of labor was relatively limited or non-existent in the production of any particular
Classical and neoclassical theories 113
product. For example, in producing a sweater, all the distinct steps were likely to be done
by one person or at most a single family. From the spinning of the yarn obtained from the
clippings of the sheep, to the weaving of the cloth from the yarn, to the cutting, sewing, and
finishing of the final garment, a single individual might have been involved in performing
many, or even all, of the tasks of production. There was little or no specialization in such non-
capitalist, non-exchange production prior to the Industrial Revolution. As might be expected,
only a small quantity of output can be produced if one person must undertake all the steps
required to make a product. Think how long it would take you to finish even a single T-shirt
if you had to gather the cotton, weave the cloth, cut, sew, and so on. And now imagine the
quality! That is a situation of no division of labor and no specialization. Both the quantity of
output and quality typically suffer.
With the Industrial Revolution in Great Britain and the emergence of the factory system,
the organization of production began to change, especially as peasants and farm laborers
were pushed from the land and into the villages and cities by the enclosure Movement. The
factory system increasingly required that workers should come to designated locations to
perform their tasks rather than producing at home.
Over time, the distinguishing characteristic of the factory system became the intensive use
of machinery powered by water and steam. The pace of work was increasingly determined by
the machinery with which employees toiled. With the expanded use of tools, the momentum
toward specialization and the dividing of tasks (hence the term, division of labor) into ever
smaller and finer components was both accelerated and made more feasible. With specializa-
tion, the process of producing clothing, for example, was changed. Some workers would be
involved only in the spinning process, others in carding the wool, others in loading the yarn
on to the machines, still others in moving the finished wool cloth to storage, in cutting cloth
to patterns, and so on. Tasks would be divided and subdivided again and again, depending
on the level of technology and the sophistication of the machinery available. Besides this
extraordinary division of labor within factories, there was an ever more refined division of
labor between industries, as specialization took place amongst those producers of consumer
goods, producer goods, services and so on.
This division of labor and specialization of work within the factory, while often boring and
repetitive for the workers involved, did unleash an extraordinary increase in the productivity
of labor. More output could be obtained from the same number of workers than if they indi-
vidually had produced a product from start to finish. Greater efficiency through specializa-
tion in factories contributed to increases in total national output and income, resulting in an
increase in the living standard for larger numbers of the population. This upward movement
of average income per capita following the Industrial Revolution was shown in Figure 3.1
of Chapter 3, and it was due to the “intensive” nature of factory production in a capitalist
market setting.
In Smith™s view, capitalism had a natural tendency toward this broadening and deepening
of the division of labor, since doing so contributed to lower costs and increased output,
thus enhancing the profit-making opportunities for producers. The naturally acquisitive
behavior of producers in search of higher profits would tend to contribute to more speciali-
zation that could increase efficiency in production economy-wide. Smith™s advocacy of
free trade among nations also was based on this logic, for the larger the market of potential
consumers “ and what market was larger than the consumers of every country? “ the greater
were the possibilities for more specialization and for ever higher levels of output.1 Owners
of firms had a definite incentive to introduce the latest and best machinery and the newest
ways of doing things since doing so would tend to increase efficiency and profits by further
114 The Process of Economic Development
extending the division of labor and by making workers even more productive. This “law of
capital accumulation” was inherent to the competitive capitalist market economy, and for
Smith it was a human characteristic that capitalism unleashed.
In Smith™s analysis, then, it is the accumulation of physical capital, technological progress,
the specialization of labor and free trade that are the intertwined sources of expanding
economic wealth. economic growth will continue as long as capital is accumulated and
new technology is introduced. Both competition and free trade contribute to making this
process cumulative, and a competitive market environment provides the framework for all
the benefits of an expanding market system to accrue to ever larger numbers of consumers,
producers, workers, and owners. Smith™s analysis of the widespread benefits of a nearly
automatically expanding world capitalist order made him one of the most optimistic of all
the classical economists. He truly thought that all the world™s peoples would be lifted up on
a wave of economic prosperity as capitalism spread.
Smith was keenly aware that the institutional structure of a society played a crucial role
in determining the likelihood of continued progress. After all, his sustained criticism in The
Wealth of Nations of England™s mercantilist policies, the fettered trade relations it fostered,
and the feudal remnants of production in the countryside had provided evidence for Smith™s
impassioned defense of capitalism, natural liberty, and a smaller state as being essential
to economic expansion. The Wealth of Nations is essentially about how a transformed
institutional environment unleashed dynamic forces of growth via a competitive capitalist
economy from which the greatest number might benefit. These constituent elements “ capi-
talism, capital accumulation, efficiency through specialization, free trade, and institutional
innovation “ continue to be essential elements in thinking about economic development
to this day. They are not all of what is important to sustained progress, but Smith definitely
provided the foundations for thinking about how economies grow.

Malthus™s theory of population and economic growth
Thomas Robert Malthus, educated at the University of Cambridge, was a parson and later
a professor of political economy. He is best known for his theory of population. Malthus
published the first edition of his major work, An Essay on the Principle of Population, in
1798, when the effects of industrialization and the path of economic progress in England and
Scotland looked quite different to him from how they had appeared to Adam Smith, the great
optimist of classical political economy.
What observers of late eighteenth-century and early nineteenth-century England witnessed
was a world not of a harmony of interests in which all gained, as Smith had postulated, but
appalling conditions of degradation for a large part of the citizenry. (Read any of Charles
Dickens™s novels of that period to get an idea of living conditions.) Only a tiny minority of
factory owners and some large rural landlords seemed to be benefiting from the spread of the
industrial factory system. What had gone wrong in the last third of the eighteenth century to
so alter the hopeful vision of the capitalist economy envisaged by Smith?
Malthus attempted to explain this disturbing state of affairs through his theory of popula-
tion, which argued that the poor were responsible for their own misery. At a time of rising
class conflict and resentment, Malthus suggested that the rich were not the enemy of the
poor, but rather the poor were the architects of their own fate. Worse, he argued there was
not much anyone, including government, could do about this state of affairs. The existing
division between the wealthy few and the impoverished many was the natural outcome of the
capitalist system. Let™s take a look at his thinking.
Classical and neoclassical theories 115
Malthus™s theory of population
Malthus assumed population would grow whenever average incomes rose above the level
necessary for subsistence. Why? Because of the “animal nature” of human beings, specifi-
cally “the labouring poor™, whom Malthus viewed as morally inferior to the land- and prop-
erty-owning rich. What was the connection between income levels and population growth in
Malthus™s view?
If average income per person were to rise as a result, say, of good weather and the higher
agricultural output that resulted, there would be more food and other necessities to go around.
As incomes and food supplies rose above what was required for mere subsistence of the
existing population, more children (and others) would be enabled to survive as the quantity
of food per person rose. As a result, the effect of rising incomes coupled with the “unquench-
able sexual desires of the poor” (these are Malthus™s words) meant population could be
expected to double about every generation, or every twenty-five years, if there was no limit
on such growth.
In Malthus™s famous formulation, population increases in a “geometric progression,” that
is, the number of people tends to grow at the rate of 2, 4, 8, 16, 32, 64, 128, 256, 512, 1,024,
2,028, and so on. For Malthus, this principle of the tendency toward the doubling of popu-
lation over every generation when wages rose above subsistence was the major factor for
understanding why the poorer classes remained poor. How, though, does population growth
per se lead to poverty?
Malthus posited that the ultimate limit on population expansion was the inability of the
land to produce sufficient food to continue to sustain the population surge. The production
of basic foods could not keep up with geometric population growth because of the natural
tendency of the fertility of the soil to be lower as additional land was brought under cultiva-
tion. Land best suited for food production already was in use. Any new land brought under
production would produce less output per unit of land than more productive lands, so the
growth in total food output would slow while population growth continued unabated.
Malthus believed that agricultural output could only increase in “arithmetic progres-
sion,” that is, at the rate of 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, and so on, certainly more slowly
than the geometric growth rate he assumed governed population growth. An increasing
population would sooner or later bump up against the obstacle of the slower-growing
production of basic foods and other goods required for subsistence. Not only could
income per person not continue to increase, it would actually begin to fall if population
growth continued. eventually incomes per person would fall below what was required
for subsistence. Of course incomes below the minimum required for survival meant
misery, starvation, death, and a declining rate of population growth, maybe even a popu-
lation decline. “Equilibrium” would be attained when population grew again at a pace
consistent with increases in food production. Malthus™s theory is one that predicts a
“vicious circle of poverty,” that is, the equilibrium level of income per person (for the
poor anyway) is one of subsistence only. Any deviations from that level of income lead
to population growth or contraction that return incomes to the poverty level (see Basu
1997: 17“23).
Malthus noted some forces that could slow the natural rate of population growth before
the ultimate barrier of incomes falling below subsistence was reached. Since the natural
population growth rate depends upon the difference between the birth rate and the death rate,
anything that tended to reduce the birth rate and/or to increase the death rate would tend to
slow the natural rate of population growth.2
116 The Process of Economic Development
Malthus identified, first, what he called preventive (or voluntary) checks. These are factors
that might be expected to reduce the number of births through human restraint, such as late
marriage and sexual abstinence.
When these preventive checks to population growth on the birth-rate side were absent
or weak, as Malthus assumed them typically to be among the poor, a second restraint on
population growth, the positive checks, came into play. These constraints affected the other
side of the population growth rate equation by increasing death rates through war, diseases,
plagues, natural catastrophes, and the ultimate check, starvation. It was this apparent inevita-
bility of poverty, squalor, disease, suffering, and death among the poorer classes that seemed
imbedded in laissez-faire capitalism that had prompted Thomas Carlyle to voice his appre-
hension about economics as “the dismal science.”
Malthus™s vision of what seemed to be an inescapable dilemma flowing from economic
growth to a population explosion to misery for the poor led him to oppose all efforts at charity
directed at the poorer classes, including better health care and hygiene, since they could only
delay the unavoidable drift of living standards toward subsistence. Indeed, acts of charity, be
they private or public, might even be expected to lead to a decrease in the willingness of the
poor to work by diminishing their fear of starvation, hence reducing total national production
and income and thus actually accelerating the pace of decline toward subsistence.3
Of course, we now know that Malthus made a critical error in his analysis. He ignored the
importance of technological progress to increasing productivity and output, even from rela-
tively fixed inputs, like land, over the long run (as discussed in Focus 4.1). Malthus assumed

Was Malthus right about the rate of growth of food production? What
factor important for increasing the level of output did Malthus overlook,
even on land that may not seem suitable for farming?
If you guessed that Malthus was neglecting or not anticipating the
advances in production that technological change in agriculture would
permit, you are correct. Since the time of the Industrial Revolution, fewer
and fewer persons working less and less land have been involved in
producing more and more agricultural output, at least in the more devel-
oped nations. The reason is quite simple. Better technology in the form
of machinery, seeds, fertilizers, irrigation, pesticides, and better-trained farmers have all
contributed to a dramatic increase in agricultural output per unit of land. Fewer farmers in
the rich countries feed ever-larger numbers of persons around the globe by being able to
produce with ever-greater efficiency on the same or even less land.
Sachs (2005: 27“8) has two very interesting graphs. In one, he shows the rapid increase
in population that begins about 1700. In a second graph, he shows the rapid increase in
per capita income that begins at precisely the same time! So, if anything, world population
growth and income per capita have been positively related to one another, not negatively,
as Malthus predicted.
What the now developed nations experienced with the rise of capitalism was not only
an industrial capitalist revolution. They also accomplished an agricultural revolution that
increased food output and permitted higher living standards with less effort. At the time
Malthus wrote, this great agricultural revolution was still somewhat in the future. But it was
coming ¦ and the Malthusian specter of starvation and unbridled population growth was
a view that could not be sustained. We will revisit this perspective in Chapter 12, as there
remain those who still stubbornly insist that “there is too much population growth” and that
it is that which causes people around the world to be poor.
Classical and neoclassical theories 117
a constant productivity of any piece of land over time. To use modern terminology, Malthus
envisaged a constant aggregate production function, TP, as shown in Figure 4.1, which never
shifted. Improvements in technology, however, are precisely what permit a shifting upward
of a nation™s production function such that more output from the same resources is possible
as shown by the higher total output curve, new TP, with technological change in Figure 4.1
(compare the level of output using L* units of labor before and after a change in technology).
It is through increases in technology and higher productivity of society™s inputs that a growing
population can be accommodated. Further, with output growing rapidly enough, there is no
necessary reason for income per capita to fall, and sufficient technological progress can
easily raise total output and income per person.4
What, then, might have accounted for the miserable living conditions among the poor that
Malthus witnessed, if they were not due to a fundamental imbalance between limited food
production and rapidly growing population as he believed? Most likely they were the result
of transitional growing pains caused by the radical structural changes taking place in Britain
as feudal society was becoming more capitalist. The benefits of the Industrial Revolution to
larger numbers of people awaited institutional changes and the further spread of technology
that were still in the future.
One thing Malthus demonstrated was that there was no automatic mechanism by which
all classes in society necessarily gained from the increased productivity of the new capitalist
structure. Fundamental institutional changes “ particularly government initiatives “ that
could contribute to the sharing of the fruits of increased productivity had yet to be devised.
The new capitalist order which Smith had so praised did have its natural tendencies “ greater
aggregate productivity, efficiency, technological change “ but the productive system existed

Total output

New TP with
Q technological change


0 Units of labour

Figure 4.1 A classical aggregate production function.
118 The Process of Economic Development
within a social, human, and institutional context which needed time and evolution to adapt to
the new productive structures. There was more to reaping the benefits of the capitalist market
system than Smith had envisaged.

ricardo™s theories of diminishing returns and comparative advantage
David Ricardo was an english contemporary of Malthus. Indeed, they were good friends and
intense intellectual rivals. While Ricardo accepted elements of Malthus™s population theory,
he parted ways with him over the dynamics of the capitalist system and, in particular, over
the relative significance of landowners and capitalists. Ricardo believed industrialists to be
at the dynamic center of the workings of the capitalist economy. With economic and popu-
lation growth, landowners would receive higher, but economically unjustifiable, incomes.
A shift of society™s income toward landowners threatened the capacity of the capitalist system
to continue to grow since this meant a reduction in profits of the industrial sector. What land-
owners gained in income with population growth, industrialists lost. Ricardo™s views on
this problem of growth in capitalist economies, or at least in england in the early nineteenth
century, were based on his famous theory of diminishing returns.

The law of eventually diminishing returns
Every economics undergraduate early on encounters Ricardo™s law of “eventually” dimin-
ishing marginal returns. In Ricardo™s (and Malthus™s) formulation, when economic growth
occurs, land of progressively lower productivity is brought into use, the reasonable assump-
tion being that farmers will make use of the best, most fertile lands first.5 As marginal land
is brought into use, the overall price of food will rise because of the rising marginal cost
of producing additional food from less productive land. For those producing on land more
productive than the marginal lands, the higher price that their output would now command
will generate for them a windfall gain. This is because the price of the output from more
productive land will be the same as that sold from less productive land, but the costs of
production will be lower on the farms with more fertile land. This results in what economists
call “economic profits” on all land more productive than the most marginal land. Economic
profits are not necessary to bring forth the existing level of output. From a social perspective,
profits above normal, i.e. economic profits, are unproductive.
In Ricardo™s language, these windfall profits to landowners were called “rents.” These
rents increase as a share of total income as population grows. As a consequence, less and
less of society™s total income is available for wages and for the profits of capitalists, who will
be unable to invest and expand industrial production. As Ricardo wrote, “the interest of the
landlord is always opposed to the interest of every other class in the community” (in Rogin
1956: 113).
It is from the law of eventually diminishing returns to agriculture that Ricardo deduced
that every economy had a maximum level of income per person that could be produced
from an optimum quantity of inputs. Any attempt to further expand production by adding
more inputs would set off a decline in per capita income as food prices rose. eventually, a
stationary equilibrium state would be reached where, as was the case in Malthus™s analysis
too, workers received only subsistence wages.
This state of affairs was not absolutely binding for Ricardo, however. economic growth
in capitalist society thrived on cheap food, since that meant industrial wages could be lower,
and lower wages meant higher profits for capitalists. Higher profits for capitalists meant
Classical and neoclassical theories 119
greater possibilities for continued capital accumulation in industry that could result in higher
levels of production and higher income levels for the economy as a whole.
Ricardo believed it was the productivity of labor in agriculture, rather than in industry, which
was the principal basis for sustaining economic growth. Only then would food, the indispen-
sable and predominant component of the consumption of workers in industry, be produced at
a lower cost. Ricardo believed greater productivity on existing land could be achieved over
the longer run from technological change. In the short term, however, it was overseas markets,
especially the colonies, which could supply food to europe to counteract rising food prices
that the law of eventually diminishing returns implied at home. It is this perspective on how
the dilemma of short-run diminishing returns might be escaped that illuminates Ricardo™s
other contribution to economics, his emphasis on the advantages of free trade.
Ricardo favored the lifting of existing restrictions on imports of grains into england
from the Continent and elsewhere. Opening the doors to free trade would flood the English
market with imported grains, particularly wheat, a basic food item for workers at the time.
This increase in supply would contribute to keeping wages lower by keeping the price of
food down, though this would come at the expense of landowners at home who would see
their economic rents dissipated by the lower prices they would now receive for their grain
production as a result of increased competition. However, for Ricardo, this was a desirable
outcome, since it meant higher profits and more capital accumulation by industrialists.
For Ricardo, free trade and an open economy contributed to offsetting the adverse effects of
the law of eventually diminishing returns from agriculture in the short term, thus permitting
industrial workers™ real wages to continue to rise even with population growth. A subsistence
income was not the necessary outcome provided that food prices could be kept sufficiently
low. At the time Ricardo was writing that meant bringing down the barriers to imported food
to england that the Corn Laws had erected.6
For countries today, achieving reasonable food prices and output in sufficient quantities
may require the equivalent of an agricultural revolution. This would mean the adaptation
of new technologies for farming, the use of new seed strains as with the Green Revolution,
better pest control, irrigation, better training of farmers, and a range of other strategies that
can increase agricultural productivity and keep food prices, and hence basic wage costs, from
increasing so rapidly that industrial production is made less profitable. As in Ricardo™s time,
food prices may be kept lower through freer trade, but greater production possibilities from
the use of new technologies and better training are also essential (these issues are discussed
in more detail in Chapter 11).

The theory of comparative advantage
If there is one economic theory that the vast majority of economists accept as universally
valid, it would be Ricardo™s theory of comparative advantage. This theory argues that unre-
stricted exchange between countries will increase total world output if each country special-
izes in those goods it can produce at a relatively lower cost compared to its potential trading
partners. each country will then trade some of its lower-cost goods for others that can be
produced elsewhere more cheaply than at home. With free trade among nations, all countries
will find that their consumption possibilities have been expanded by such specialization and
trade beyond what would have been possible from their domestic production possibilities
alone, i.e. from a situation of autarky. Because of this compelling argument, economists
tend to favor free trade, since it is presumed to be “welfare enhancing” in that the aggregate
level of world income is increased.
120 The Process of Economic Development
Using Ricardo™s own numerical example can demonstrate the logic behind the comparative
advantage argument (see Table 4.1; from Hunt 1979: 105). The first and second columns of
the table show the number of hours it takes to produce one unit of cloth or one unit of wine
in England and Portugal. Note, first, that Portugal actually is able to produce a unit of both
wine and cloth with less labor than does england. Portugal thus has an absolute advantage
over England in the production of both goods. Economists before Ricardo, including Adam
Smith, often thought that a country with lower absolute costs should produce those goods
and trade them to other countries for goods others could produce at less absolute cost.
Ricardo, by making use of the concept that we now call opportunity cost, showed that
it was not absolute costs that really mattered. Ricardo focused on the internal trade-off in
production of one good for the other, that is, on the internal opportunity cost of production
within each country for one unit of each good in terms of how much of the other must be
sacrificed. Ricardo™s approach is based on comparative (or relative) advantage.
The third and fourth columns show the opportunity costs of producing one unit of each
good in terms of the number of units of the other good that can no longer be produced once
a certain quantity of hours has been used up. For example, producing one unit of wine in
England requires 120 hours of labor. Once that one unit of wine has been produced, those
120 hours are not available for use in the production of cloth.
How much cloth is forgone in England when one unit of wine is produced? The 120 hours
expended in the production of wine would have been able to produce 1.20 units of cloth
(120 hours to produce one unit of wine/100 hours to produce one unit of cloth). For each
unit of wine produced in England, the opportunity cost is 1.20 units of cloth that cannot be
produced from the same hours once one unit of wine is produced (this value is shown in
column 4).
Likewise, the opportunity cost of producing one unit of cloth in England is 0.833 units
of wine that cannot be produced once the hours are allocated to producing cloth (100
hours expended to produce one unit of cloth/120 hours needed to produce one unit of
wine; this value is shown in column 3). The same method applies to determining the
opportunity costs of wine and cloth in terms of forgone production of the other good in
Ricardo recognized that what was important in determining what each country should
produce for trade was the relative cost of producing each good within individual coun-
tries, not the absolute cost. Looking again at Table 4.1, it is clear that it is relatively
cheaper to produce a unit of cloth in England, where the opportunity cost is 0.833 units
of forgone wine, than it is to produce cloth in Portugal, where the opportunity cost is
1.125 units of wine forgone per unit of cloth produced. England sacrifices less wine to
produce a unit of cloth than is the case in Portugal. england is the lower cost producer
of cloth.

Table 4.1 Number of hours required to produce one unit of cloth and wine in England and Portugal
Cloth Wine Opportunity cost of: 1 unit of Opportunity cost of: 1 unit of
cloth produced in terms wine produced in terms
of wine forgone of cloth forgone
(1) (2) (3) (4)

100 120 0.833 wine 1.200 cloth
90 1.125 wine
Portugal 80 0.888 cloth
Classical and neoclassical theories 121
Just the opposite is true for wine production. Portugal produces wine at relatively less cost
(0.888 units of cloth forgone for each unit of wine produced) than does England (1.2 units
of cloth forgone for one unit of wine produced).
What Ricardo™s theory of comparative advantage says is that if England specializes in the
production of cloth, the good for which it has comparative advantage, and Portugal special-
izes in wine production, the good in which it has comparative advantage, then world output
can be increased above what it was when each country did not specialize. If the two countries
now trade with one another for the good they do not produce, both countries can be better
off. How is that possible?
When countries specialize and then trade with one another, each country will be able to
consume outside its own production possibilities frontier. The benefits of specialization do
not require that each country completely forgo producing the good with the higher oppor-
tunity cost to gain from trade. It is only necessary to shift resources toward the good(s)
that can be produced at relatively lower opportunity cost, that is, toward those goods with
comparative advantage relative to potential trading partners. Let™s see how these gains from
specialization and trade can materialize.
Both countries will gain from specialization and trade in the example in Table 4.1 provided
the international trade price between England and Portugal for 1 unit of cloth is between
0.833 and 1.125 units of wine or, to say the same thing, if the price of 1 unit of wine is
between 0.8 88 and 1.20 units of cloth given up. The trade price between the countries needs
to be somewhere between the internal opportunity cost trade-offs for the individual coun-
tries shown in the last two columns of Table 4.1. To see the benefits of specialization and
trade more concretely, consider the following example.
If the trade price at which the two goods are traded is, for example, 1 cloth for 1 wine, then
England would be able to produce 1 unit of cloth “ the good in which it specializes “ and
trade it to Portugal for 1 unit of wine in exchange. How is that better for England? If England
had instead produced that 1 unit of wine itself, it would have been necessary to have sacri-
ficed the production of 1.2 units of cloth, since the production of one unit of wine in England
requires 1.2 times as much labor as one unit of cloth. Clearly England benefits by being able
to trade 1 unit of cloth and get 1 unit of wine from Portugal rather than having to “pay” 1.2
units of cloth to produce 1 unit of wine itself.
Portugal also benefits from the exchange at this trade price. In return for the 1 unit of
wine traded to England, Portugal obtains 1 unit of cloth. If Portugal produces cloth itself, it
would be necessary to give up 1.125 units of wine to release a sufficient number of workers
(= 90 hours of labor) to produce that 1 unit of cloth (column 3 of Table 4.1). Portugal also
benefits from the specialization and trade.
Ricardo™s analysis of comparative advantage strongly suggests that specialization in
production and free trade, that is, trade between countries with a minimum of tariff and
non-tariff barriers, is the best policy for countries to follow.7 Specialization and free trade
increase world production and the consumption possibilities for each country by increasing
the degree of internal efficiency in production in individual countries so that there is more
available for all to consume, as shown in Figure 4.2.
The curve labeled PPF in Figure 4.2 is Portugal™s production possibilities frontier.8 When
there is no trade between England and Portugal, the PPF is also equal to Portugal™s consump-
tion possibilities frontier since what is available for consumption depends exclusively upon
domestic production. What Portugal produces is all that Portugal has available to consume
in a world with no trade. So, for example, with no specialization and trade, i.e. in a situation
of autarky, Portugal might choose to produce at point A on its PPF. At A, there are 1,666.67
122 The Process of Economic Development
units of cloth and 1,875 units of wine produced, and the same quantity of these two goods
would be what was available for Portugal to consume without specialization and trade.
However, when Portugal specializes in the production of wine for which it has the
comparative advantage and then trades wine with England for cloth at a mutually beneficial
trade price, such as 1 cloth for 1 wine, Portugal will be able to consume more of both goods
if it chooses to do so. For example, if Portugal completely specializes, it will produce 3,750
units of wine and no cloth. At a trade price of 1 cloth:1 wine, Portugal™s consumption possi-
bilities frontier lies outside its production possibilities frontier, as shown in Figure 4.2.
(The 3,750 value on the wine axis is total production with specialization; the 3,750 value on
the cloth axis would be the maximum quantity of cloth that could be consumed assuming
all the 3,750 production of wine was traded at a 1c:1w price; of course any intermediate
combination of both goods on the consumption possibilities frontier could be consumed.)
With specialization and then trade, Portugal actually can consume more of both goods
compared to what was possible without specialization and trade. As shown in Figure 4.2,
anywhere on the line segment BC, Portugal can actually consume both more wine and more
cloth with specialization and trade. (Can you see how the values at points B and C were
determined? Use the trade price of 1 wine for 1 cloth, which is nothing but the slope of the
line, and the values at point A to calculate.) Of course, the same is true for England. Both



Consumption possibilities curve
3,333.33 with specialization and trade



1,875 2,083.33 3,750 Wine

Figure 4.2 Production and consumption possibilities with and without trade.
Classical and neoclassical theories 123
more wine and more cloth can be consumed with specialization and trade (you will be asked
to show this in a problem as the end of the chapter!).
This is a truly remarkable result, one that gives at least one of your authors goose bumps
each time he teaches comparative advantage (if you got goose bumps, too, maybe you should
be an economist!). There is no magic here, however. Specialization allows each country to
provide to the world market those goods and services that it can produce most efficiently. It
is this shift toward greater efficiency in the use of inputs that increases total world output.
Then, via mutually beneficial trade, every country can be better-off than if each had simply
produced and consumed goods in isolation. It is little wonder, then, that Ricardo™s theory of
comparative advantage has had such a profound effect on economic policy and in providing
an argument for more open trade among nations.

A brief evaluation of Ricardo™s theory of comparative advantage
There have been many criticisms of Ricardo™s analysis of comparative advantage and the
free trade conclusion to which it leads. It is important to remember some of the restric-
tions Ricardo applied to his theory. It was assumed that the factors of production “ natural
resources and land, labor and capital “ were immobile and that both (all) countries had
the capacity to produce both (or all) goods. Any imports are perfectly balanced by an
equivalently valued export flow; thus no country incurs a trade deficit which must be
Further, Ricardo assumed that perfect competition prevailed and that all resources in
each country were fully employed. In fact, with less-than-fully employed resources, tariff
or other protection to block imports and to increase domestic employment could well be the
preferred policy to free trade, since the key allocative issue would be an internal mobilization
of domestic resources to their full use rather than a reallocation of fully employed resources
among alternative uses.9
While these are important considerations to do with the validity of assumptions, there are
other concerns about a blanket endorsement of the comparative advantage argument and free
trade recommendations that go beyond assumption bashing. The late British economist Joan
Robinson™s comment on the effect of following Ricardo™s free trade advice and specializa-
tion, at least as far as Portugal was concerned, remains provocative:

the imposition of free trade on Portugal killed off a promising textile industry and
left her with a slow-growing export market for wine, while for england, exports of
cotton cloth led to accumulation, mechanisation and the whole spiralling growth of the
industrial revolution.
(Robinson 1978: 103)

Portugal™s experience highlights a potentially valuable historical lesson on the conse-
quences of simply following current comparative advantage, a conclusion supported by our
discussion of path dependence and the effects of colonialization in Chapter 3. It is not just
specialization that is important for a country, even if one grants all of Ricardo™s restrictive
assumptions. Specialization and free trade may not always result in more rapid progress over
time. Why?
Portugal specialized in a commodity that did not have the same growth potential as did
cloth for England. Portugal™s economy suffered consequently, as the productive structure
and institutions were molded in the direction of wine production. In fact, after trade was
124 The Process of Economic Development
rapidly expanded following the Methuen Treaty in 1703, Portugal was left with a sizeable
bilateral trade deficit as its exports to Britain fell short of its imports from Britain. The boom
in Portuguese“British trade fortuitously coincided with a gold rush in Brazil, Portugal™s
colony, enabling the Portuguese to cover their deficit for a time with a colonial gold flow, but
the benefits of specialization and trade over the longer term were illusive.10
It may not be specialization per se that is so important for a country™s future growth
prospects as is the choice of what to specialize in. Some commodities are more likely to
have expanding world demand over the future, as with England™s cloth production. Other
commodities may be more likely to benefit from the application of science and technology
that reduce their production costs over time, further contributing to economic expansion.
Thus the critical issue for an economy becomes what goods and services should be produced
over the future, and this requires a vision about the possibility of finding new comparative
advantage in goods and services that provide more promise for the future than the current
mix of production. It is this more dynamic way of understanding the theory of comparative
advantage and the nature of the path dependence associated with any decision to produce
particular goods which would seem to account for much of the success of the East Asian
economies in recent years, as will be discussed in later chapters.
Such a forward-looking comparative advantage perspective certainly presents the policy-
maker with more problems “ projecting demand, prices, technology, and other variables
into an uncertain future “ but also with more possibilities. Finding the right goods for
specialization can contribute to a dynamically evolving economic system with a greater
opportunity for contributing to sustained development, for overcoming the negative effects
of past path dependence, including declining terms of trade, and for shifting production
toward higher and more efficacious paths of development over the future.
As will be discussed in Chapters 5, 9 and 10, Ricardo™s theory of static comparative advan-
tage is no substitute for a more future-oriented analysis of dynamic or created comparative
advantage. The latter is a view of comparative advantage that looks to the future possibilities
associated with the production of particular goods (dynamic comparative advantage) rather
than to a consideration of what it is best to specialize in among the goods currently produced
(static comparative advantage). Nonetheless, among many economists, Ricardo™s theory of
static comparative advantage retains a particularly strong intellectual hold, one that often
uncritically informs policy recommendations. We do not feel that the success of most late-de-
veloping economies is consistent, however, with the static version of comparative advantage
theory, but rather with a more dynamic understanding of that theory as suggested here, based
on a more robust understanding of Ricardo™s theory.

A classical model of economic growth
Let us now consider a classical-type model of economic growth which builds upon Smith
and Malthus but depends especially on Ricardo™s formulation.11
The aggregate production function for an economy, which shows how inputs are turned into
outputs, has land (N), labor (L), capital (K) and technology (T) as the inputs to production.

Y = f(N, L, K, T) (4.1)

This production function is subject to the following restrictions: fN, fL, fK, fT > 0 and fNN, fLL,
fKK, fTT < 0, which simply states that the marginal product (fi) of each input, i, is positive, but
each also is subject to the law of diminishing returns (fii < 0). In other words, as additional
Classical and neoclassical theories 125
units of each input, i, are added to production, all others held constant, output rises but it rises
at a decreasing rate.12
The rate of economic growth over time (= dY/dt) depends, then, on the productivity and
the rate of expansion over time of the four inputs in the production function in equation 4.2.

dY/dt = fN dN/dt + fL dL/dt + fK dK/dt + fT dT/dt (4.2)

It seems reasonable to take dN/dt = 0, since the available quantity of land, or more gener-
ally, natural resources, can be taken as given. The growth in the labor force, dL/dt, can be
presumed in the short term to be proportional to the rate of capital accumulation, dK/dt, since
adding more physical capital requires more workers to operate these new machines and tools
of production. Thus we can write dL/dt = qdK/dt (q > 0), where q is the number of workers
required for each new unit of physical capital, K. If we also assume for simplicity that tech-
nology is given, or exogenous, in the short term, then fT = 0.
Given the above conditions, equation 4.2 can be re-written as follows:

dY/dt = (qfL + fK) dK/dt (4.3)

The rate of economic growth in the classical model thus depends essentially on the rate
of physical capital accumulation, K. The more rapid the pace of capital accumulation, K, the
faster the rate of economic growth. The rate of physical capital accumulation is determined
by the rate of profit earned by capitalist investors. For Ricardo, the ultimate limit on the
rate of capital accumulation, and hence on the rate of economic growth, was the binding
nature of the law of diminishing returns. This can be seen from equation 4.3, since fL, the
marginal product of labor, decreases as L rises until eventually the point is reached when per
capita income reaches a steady-state level (population growth performs the same function in
Malthus™s formulation of economic growth).
The important point to remember is that for the classical economists physical capital accu-
mulation is the determining factor in affecting the pace of economic progress. We shall see
below in considering the neoclassical economists that physical capital remains at the center
of their analysis of the causes of economic growth.

Marx™s analysis of capitalist development: a brief digression
Unlike Smith, Malthus, and Ricardo, and most other classical economists, Karl Marx did
not assume capitalism to be immutable or to be the natural order of society. Marx believed
capitalism to be but one stage of a society™s historical development, which began with primi-
tive communism and then evolved toward slavery, feudalism, and eventually to capitalism,
though this historical progression did not take place in all countries simultaneously nor at
the same speed.
Marx believed capitalism ultimately would break down and from it would be created a
socialist economic system and, in due course, communism. Our interest here is not in Marx™s
historical-materialist philosophy, however, but rather in his analysis of the dynamics of capi-
talism, as traditional, feudal society was transformed and ultimately left behind. Chapter 3
touched upon some of Marx™s ideas pertaining to the colonial regions, drawn largely from his
observations of the effects of British policy in India. In this section, we shall explore in more
detail Marx™s analysis of the dynamics of the capitalist economy that most other classical econo-
mists, John Stuart Mill excepted, took for granted as the ultimate stage of human development.
126 The Process of Economic Development
Marx™s great economic work was Capital, only the first volume of which was published
during his lifetime. Marx died in 1883, and the other two volumes of Capital were edited and
published in 1885 and 1894 by Marx™s close friend, collaborator, and benefactor, Frederick
Engels, from notebooks Marx left. A further volume, The Grundrisse, which some have
called the fourth volume of Capital, was not published in English until the 1970s. Marx™s
analysis of the broad dynamics of capitalism differs only slightly from the other classical
economists in many respects. For example, in his study of the relentless drive toward capital
accumulation that motivates capitalists and the resulting division of labor there is little to
distinguish Marx from Smith. It was in the implications of this process that Marx parted
ways with the classicals.
Marx greatly admired the vast productive power of capitalism, a system that had succeeded,
he noted, in creating more wealth in a hundred years than all other modes of production in
previous human history (see Focus 4.2). What appalled Marx was the human cost involved
in producing such wealth and the extremely one-sided distribution that resulted from its
production. Marx believed, and his analysis of the creation of surplus value attempted to
demonstrate this, that it was only the working class, which he called the “proletariat,” that
created wealth through their labor power. Capitalists appropriated a disproportionate share
of society™s total income solely by their “virtue” of being the owners of the means of produc-
tion, particularly the physical capital in factories and businesses, required for producing soci-
ety™s commodities.
Marx argued that the uneven distribution of the ownership of society™s means of produc-
tion was the result of a historic process in which former peasants lost access to land for their
own production and were forced into cities to become workers because of the enclosure
Movement in england and similar processes at work around the globe. He thus argued that
the ultimate distribution of income in capitalist society was unfair and a reflection of histor-
ical power relationships, not productivity. He believed that, over time, workers, as they came
to grasp the nature of their exploitation by capitalists would seize political and economic
power from the minority class of owners. Marx, however, did not think this transition toward

Marx and Engels wrote in the Communist Manifesto:

The bourgeoisie, during its rule of scarce one hundred years, has created more
massive and more colossal productive forces than have all preceding generations
together. Subjection of Nature™s forces to man, machinery, application of chemistry
to industry and agriculture, steam-navigation, railways, electric telegraphs, clearing
of whole continents for cultivation, canalisation of rivers, whole populations conjured
out of the ground “ what earlier century had even a presentiment that such productive
forces slumbered in the lap of social labour?

The “bourgeoisie” was the capitalist class, which dominated the capitalist market system.
Are you surprised Marx could heap such praise on a system he thought was immoral?
Don™t be. He admired the productive powers of the capitalist economy made possible by
its accumulation of physical capital and the continual introduction of new technologies.
What Marx objected to was the distribution of the gains of production, given that it was
workers (the proletariat) who produced the wealth of society while the bourgeoisie (the
capitalists) appropriated these gains not because of their productive contribution but by
virtue of their ownership of the productive facilities.
Classical and neoclassical theories 127
socialism would be initiated until capitalism had reached a sufficiently high degree of devel-
opment in its use of capital and technology. For Marx, a relatively high level of income per
capita within a capitalist economic environment was a precondition for the future socialist
and communist economic systems he believed would follow.
Like the other classical economists, Marx™s perspective on the dynamics of capitalist
economies rested on physical capital accumulation which spurred greater productivity, all
in the relentless pursuit of more profit. This accumulation, however, created greater wealth
and income, albeit unequally shared, which is the outcome that caused Marx such despair
and concern.

Neoclassical growth models
Interest among economists in examining the sources of economic growth and in under-
standing the trajectory of capitalist society disappeared from view for a time with the
neoclassical, marginalist revolution in economic thinking after the 1870s, perhaps in reac-
tion to the revolutionary implication of Marx™s version of classical theory which predicted
an overthrow of the capitalist order by disenfranchised workers. Neoclassical economic
analysis was resolutely micro-oriented with a focus on the utility-maximizing behavior
of individuals and the profit-maximizing actions of perfectly competitive firms. The macro-
economic perspective inherent in a concern for economic growth and in the distribution of
income among classes that had motivated the classical economists gave way to a narrower
interest in the conditions required for equilibrium prices and quantities in individual

A Solow-type neoclassical growth model
One of the most influential neoclassical growth models, and one that has shaped much
modern thinking about the process of economic growth, has been that of Nobel Prize-win-
ning American economist Robert Solow (1956). A Solow-type model can be depicted by a
simple, aggregate production function like that shown in equation 4.4.

Y(t) = A(t)K(t)aL(t)1’a, (4.4)

where 0 < a < 1. Just as in the classical models, with which it shares strong similarities, the
Solow-type growth model exhibits diminishing returns to both K and L in the short run, while
there are constant returns to scale from changing all inputs by the same percentage over the
longer term.13
A(t) is exogenous technological progress which affects the production function™s position
but not its general shape. exogenous technological change is assumed to be available to all
economies and with the same effects, regardless of the current level of development of any
specific country. Figure 4.3 shows a short-run neoclassical aggregate production function
and the impact of exogenous technological change.
Just as in the classical production function shown in Figure 4.1, a change in A(t) leads to
an upward shift of the production function, Y(t), such that more output can be produced with
the same inputs. It is this exogenous technology which is basic to higher levels of income
per capita over time. As Figure 4.3 shows, without technological change, the increased use
of inputs in production, via more investment, K, has a limit in terms of total income that can
be produced and hence (assuming L constant) in terms of per capita income, as shown by
128 The Process of Economic Development
Total output


Q max

0 K max Variable input

Figure 4.3 A Solow-type production function.

Kmax, Qmax. This is nothing more than the familiar effect of decreasing marginal returns in the
short term.
If technology and the rate of increase of L, the labor force, are constant and assuming the
labor force is always fully employed, a Solow-type growth function predicts that, for any
given rate of savings and investment, there is a constant, steady-state level of real per capita
income that can be attained.14 This result follows directly from the assumption of diminishing
returns to K in the short term. Given a constant rate of saving (= investment, by definition),
the return to capital for investors falls as the stock of capital rises15 until, ultimately, the total
amount of capital also reaches a steady-state level, and all new investment is just sufficient to
replace old capital that has worn out. When that happens, the level of per capita income of a
country will have reached its maximum level, given the rate of savings, its population growth
rate, and assuming zero technical change, which is exogenous anyway.
An even more interesting and perhaps astounding implication of the Solow-type neoclas-
sical model for economic development is that poorer nations would actually be expected to
grow faster than richer nations, assuming equal rates of saving and investment and growth
rates of population. In other words, the Solow model predicts the convergence of per capita
income amongst different nations sharing similar “fundamentals.” Two countries with the
same rate of saving and the same population growth rate will tend to have, ultimately, the
same level of real per capita income.16 Hence if one starts at a lower non-equilibrium level of
income, that economy will grow faster until it reaches the steady-state equilibrium income
level associated with the rate of savings and population growth.
However, according to the Solow formulation, and somewhat controversially, as we shall
see in Chapter 8, it is not possible for a nation to increase its rate of economic growth
by dedicating more of its income to installing more physical capital goods. Why is that?
Very simply, the law of diminishing returns means that more rapid accumulation of physical
capital will simply result in the country reaching its target level of per capita income more
Classical and neoclassical theories 129
quickly. At this point, the maximum steady-state (constant) level of income per person would
have been reached and growth stops.
Higher levels of saving and investing do contribute to a higher level of real per capita
income. Thus nations that save and invest 25 percent of their output will have a higher
steady-state level of per capita income than those which save and invest 15 percent of
their income (assuming the same rate of population growth). But a higher level of saving
and investment that adds physical capital machinery faster to the production process
does not lead to a higher rate of growth of income that can persist over time. Regard-
less of the rate of saving and investment, there is a ceiling on the level of per capita
income for that level of S and I. As an economy approaches that level of income, the
rate of growth of per capita income decreases because of diminishing returns, eventu-
ally reaching zero as the steady-state income level is attained and the optimum level of
physical capital is reached.
Without belaboring the mathematics behind this conclusion, the level of per capita income
of a country according to the Solow model will be:17

y = Y/L = (s/n)a/(1’a) (4.5)

where s is the percent of total income saved, n is the exogenous rate of growth of popu-
lation and a and 1’a are the income shares of capital and labor in total income (Solow
1956: 76“7).18
This formulation shows how differences in income per person across countries are
explained as the consequence of different rates of saving (which determine the level of phys-
ical capital accumulation) and population growth rates, assuming equal shares of income
accruing to capital and labor across countries as expressed in the value for a and 1’a. This
formulation makes clear that a higher rate of saving, s, will raise the steady-state level of per
capita income, all else being the same, since that will increase the level of physical capital
in the economy.
Countries that are poor and not growing are thus poor, according to the Solow formula-
tion, because they are not saving and investing a sufficiently high proportion of their income.
Countries that wish to increase their average standard of living can do so by increasing the
rate at which national income is saved and invested, that is, by accumulating physical capital
at a higher rate.
This recommendation to accumulate physical capital so as to reach higher levels of income
per person has been a fundamental policy insight common to virtually all the strategies
recommended by economists for developed and less-developed nations alike.19 It is impor-
tant to keep in mind the basic insights of Solow™s growth model. It continues to be a central
starting point for many economists in theorizing about the underlying forces at work which
influence the process of economic growth in real-world economies. It is a theory which has
had profound policy implications, with, again, a focus on how to speed up physical capital
accumulation being in the forefront of what is essential.

The Harrod-Domar model: a Keynesian approach
The Solow-type, neoclassical growth model was formulated not to try to explain income
levels and differences in the standard of living among real-world economies, though such
empirical work has been done and that has been the real importance of Solow™s contribu-
tion to economic growth theory and to development economics in particular (Mankiw et al.
130 The Process of Economic Development
1992). Solow actually developed his theory in response to the troubling implications about
economic stability suggested by the Harrod-Domar model. Sir Roy Harrod of the University
of Oxford in the UK and Evsey Domar of the Massachusetts Institute of Technology in the
US simultaneously developed in the late 1930s broadly similar explanations for the aggre-
gate economic growth process.
The Harrod-Domar model makes the following assumptions about how economic growth

1 The labor force, L, grows at a constant rate n = ”L/L.
2 Net saving, S, and investment, I = ”K, are fixed proportions of total output, Q, such that
S = I = sQ, where 0 < s < 1. The usual Keynesian income multiplier relation is operative,
where 1/s is the value of the income multiplier. S = I, ex post, as is typically assumed in
growth models.20
3 The two inputs to production, K and L, are used in fixed proportions. There is no substi-
tution of K and L in the production process.21 To produce any level of output, Q, there
is a minimum level of each of the inputs required, as given by the following: L = bQ
and K = vQ, where 0 < b, v < 1, and b and v are the labor“output and the capital“output
ratios, respectively.

Harrod and Domar introduced the concept of the warranted rate of growth, gw, which is
the rate of growth of output consistent with equilibrium in both the input and output markets.
This growth rate of total output turns out to be equal to the ratio, s/v, which is the fixed
savings rate, s, divided by the constant capital“output ratio, v. If output, Q, also grows over
time at the same rate, s/v, the economy will be in steady-state equilibrium, such that Q, K,
and K/L all grow at the same rate. What the growth rate of total output, s/v, shows is that
an increase in the savings rate (which allows a higher level of investment and capital goods
creation) will increase the growth rate of the economy, ceteris paribus. This is the now
familiar result of virtually all the classical and neoclassical writings on economic growth:
it is an expansion of total physical capital goods as a share of total output, i.e. higher levels
of investment, that creates higher income levels. This is accomplished via a higher rate of
savings, s, out of total income.
What was startling in the Harrod-Domar model, however, was that this equilibrium growth
rate was found to be quite unstable. If output, Q, for some reason grows at a rate faster than
s/v, then the growth rate of Q in the next period will be even larger, as investors react by
investing and producing even more output. If the rate of growth of output is less than the
warranted rate, s/v, the economy slows down even more in subsequent periods, as investors
invest and produce even less. 22
What the Harrod-Domar model suggested was that there was a knife-edge equilibrium. If
an economy was not growing at precisely the rate required by current rate of saving, s, and
given the current capital“output ratio, v, then the economy would veer further and further
away from equilibrium, either growing too quickly, and eventually igniting inflationary pres-
sures, or growing too slowly, leading to unused capacity and rising unemployment as the
economy spiralled away from equilibrium.23
It was but a small step from this startling deduction of the Harrod-Domar model “ that
equilibrium would be but a fluke “ to the implication that government action, especially to
alter the fixed rate of saving, s, could be the means, perhaps the only recourse, for averting
economic crisis. Otherwise, without the precisely right savings rate, s, the Harrod-Domar
analysis predicted the alternative abysses of either self-perpetuating inflation or spiralling
Classical and neoclassical theories 131
unemployment. This, of course, is a view squarely in the spirit of the Keynesian macroeco-
nomics revolution of the time they were writing. Keynesian economics rejected the laissez-
faire, full-employment assumption of classical theory and argued that central government
intervention was necessary to approach full-employment equilibrium. Unlike the classical
economists, Keynesians did not believe that full employment was the automatic outcome of
advanced capitalist economies. Without government oversight, inflation or unemployment
were as likely to result, perhaps more likely to result, than a fully employed economy.
While it would be perhaps an overstatement to insist that the Harrod-Domar instability
problem suggested the importance of state planning of development in the less-developed
world, it certainly is the case that the identification of key variables “ the rate of saving, the
level of physical capital accumulation, and the capital“output ratio “ that are amenable to
public policy decisions eased the way for strategies to manipulate behavior and influence
decisions to affect the pace of economic development by planners and economists, theories
which are considered in Chapters 5 and 6.

The neoclassical response to Harrod-Domar instability
Solow™s contribution to the economic growth literature was one among many in response to the
unstable disequilibrium behavior of the Harrod-Domar model (see Focus 2.3).24 Solow showed,
however, that the Harrod-Domar result was the particular consequence of assuming that produc-
tion required fixed ratios of the inputs to production (L = bQ and K = v) (see Solow 1956).
Solow made what is now the standard neoclassical assumption that the capital and labor
inputs are infinitely substitutable in production, though such substitution was subject to the law
of eventually diminishing returns. Rather than assuming that production isoquants for firms
and for society formed right angles, implying no substitution of inputs as in the Harrod-Domar
model, Solow assumed production isoquants to be smoothly convex to the origin as they typi-
cally are drawn in most economic theory texts. As a result, instead of running into the dilemma
of requiring gw = s/v for all variables if steady-state equilibrium was to be attained, an outcome
that could only be fortuitous without some sort of manipulation of the variables by govern-
ment, Solow™s equilibrium, as shown in equation 4.5 earlier, did away with the problem of the
knife- or razor-edge problem. For any rate of saving, s, there is a steady-state equilibrium level
of income per person, and the unbridled instability of the Harrod-Domar model disappeared.
Still, Solow™s model leaves the door open for public policy to impact the rate of growth and
the level of per capita income, if not the long-run rate of growth, via the saving rate, s, and the
rate of population growth, n. Policy that can increase the rate of savings, by increasing
the proportion of total output that is invested in physical capital, can increase income per
person. So can policies that reduce the population growth rate. In subsequent chapters we
will consider just how public policies might be shaped to impact the level of income in real-
world economies.

Summary and conclusions
In this chapter, we have considered the views on economic development of some key clas-
sical and neoclassical economists whose theories and writings provide the foundations of
much economic thinking. Adam Smith, Thomas Malthus, David Ricardo, Karl Marx, and
Robert Solow are pioneers in economics whose work has informed all who have followed.
What they wrote and thought, in some cases over a hundred years ago, still resonates and
affects analysis and policy down to the present.
132 The Process of Economic Development

Robert Solow (US, b. 1924) won the Nobel Memorial Prize in Economics
in 1987 for his body of work, but especially for his contributions to
economic growth theory. His influence, and sharp sense of humor,
shaped a generation or more of graduate students at the Massachu-
setts Institute of Technology (MIT), where he began teaching in 1949,
as well as researchers around the world who have been influenced and
challenged by his contributions and insights. He also has served in
the public sector, including on President John F. Kennedy™s Council of
Economic Advisors.
In his Nobel lecture in Stockholm on December 8, 1987, Solow spoke of how the impli-
cations of the Harrod-Domar model had both disturbed and stimulated his thinking:

the possibility of steady growth would be a miraculous stroke of luck [in the Harrod-
Domar model]. Most economies, most of the time, would have no equilibrium growth
path. The history of capitalist economies should be an alternation of long periods of
worsening unemployment and long periods of worsening labor shortage. ¦ An expe-
dition from Mars arriving on Earth having read this literature would have expected
to find only the wreckage of a capitalism that had shaken itself to pieces long ago.
Economic history was indeed a record of fluctuations as well as of growth, but most
business cycles seemed to be self-limiting. Sustained, though disturbed, growth was
not a rarity.

How did Solow overcome the surprising, but not very realistic, instability of the Harrod-
Domar theory? By positing a relatively smooth production function for turning inputs into
outputs, i.e. smooth isoquants with varying capital“output ratios were possible, not the
right-angled isoquants of production implied by the Harrod-Domar model:

allowing for a reasonable degree of technological flexibility accomplished two
things. In the first place, the mere existence of a feasible path of steady growth
turned out not to be a singular event. A range of steady states is possible, and
the range may even be quite wide if the range of aggregative factor-intensities is
wide. There are other ways in which an economy can adapt to the Harrod-Domar
condition, but it still seems to me that variation in capital-intensity is probably the
most important.

Since Solow, growth models have tended to be in this spirit, allowing a substantial
degree of substitutability between the inputs. As we shall see in considering some of
the “new” growth theories in Chapter 8, the growth models developed by economists
continue to generate controversy and to inform thinking and policy.
Source: http://nobelprize.org/nobel

If we had to single out one commonality of these theories, it is the centrality of physical
capital accumulation financed by saving out of an economy™s total income. Machines, tools,
buildings, and all the other produced inputs to production that make up what economists call
“capital” are a common theme “explaining” long-term growth. We shall see in subsequent
chapters that as important as physical capital is, there is more to spurring economic growth
and becoming developed than this.
Classical and neoclassical theories 133
Questions and exercises
1 For Adam Smith, the capitalist market system can yield considerable benefits to both
consumers and producers if two basic assumptions about the economic system are satisfied.
a Explain these two conditions and why both are required if a “harmony of interests”
among producers and consumers is to prevail.
b Is it reasonable to presume that both of these conditions exist in most of the less-
developed nations?
c If one or both of the stipulations upon which Smith™s conclusion of a harmony of
interests among consumers and producers in capitalist society is absent, what might
be the effects on society and different groups of the unregulated operation of the
market system? Who would be likely to gain? To lose?
2 Why are savings so important for economic growth? If there are no savings, what would
that mean for an economy? See if you can use the macroeconomics definition for a very
simple economy where Y = C + I to explain the significance of total savings to economic
growth (and also explain, then, the significance of the savings rate, s, which is simply
equal to the ratio S/Y, that is to the percent of an economy™s total GDP that is saved). Defi-
nitions: Y is total GDP; C is total consumption; I is gross investment; S is total savings.
3 Show the importance of savings to economic growth using a production possibilities
frontier (PPF) where the two goods available are consumption goods and physical
capital goods. Remember that any particular PPF represents a specific value of GDP
at one point in time, with PPFs further out measuring higher levels of total GDP. Show
how the choice of the mix of consumption and physical capital goods chosen by an
economy at any one point in time affects the level of GDP over the future. What would
happen to the PPF and total GDP in the future if all GDP produced now is consumed and
none goes to physical capital goods?
4 This problem is designed to give you practice in understanding the profound implica-
tions of Ricardo™s law of diminishing returns and its meaning for economic growth.
Pangea can produce the levels of output shown in the table near the end of the problem
by varying its labor force (the variable input) working with the following fixed inputs.
The fixed inputs are the currently available 36 square miles of arable land and Pangea™s
existing 14 factories with the machinery and technology they have installed. The actual
level of production in the country depends upon how much of the variable input labor is
combined with these fixed inputs.
a Use the data in the table to draw a graph of Pangea™s production function. If you
can use Excel, input the data beginning in cell A1. Then, highlight it and choose a
scatter diagram with lines (measure employment on the horizontal axis, total output
on the vertical). Your graph should look like that in Figure 4.1. It clearly illustrates
Ricardo™s law of eventually diminishing returns. Of course, you can draw this using
graphing paper.
b Show on a separate graph exactly at what level of employment diminishing returns
to production begin by drawing a marginal output graph (put employment on the
horizontal axis and marginal output on the vertical). You will have to calculate
these values in the marginal output column. Remember: marginal output is the
additional output produced by adding one more unit of the variable input. In this,
example, marginal output = D total output/D labor input; you should be able to write
a formula for this in excel to calculate these values or do them by hand.
134 The Process of Economic Development
c What are the implications of the law of eventually diminishing returns for the
maximum level of output? What is this maximum?
d Can total output ever be increased beyond 155? How? Show this in the graph you
drew in part a.

Employment Total output Marginal output
4 19
9 62
13 93
16 111
18 120
29 149
36 155
41 155
43 149

5 Copy the table you inputted above for problem 4a, and paste it into a new page in Excel.
Or begin anew if you are doing manual calculations.
a You now are going to invent new numbers to replace those shown in the total output
column above. Continue to use the same total employment levels shown! What
numbers should you choose? The values you invent must be such that Pangea never,
ever encounters diminishing returns to production, i.e. the value of marginal output
never decreases in the last column of your new table. Be sure to calculate and show
the marginal output column too, just to be sure you do not encounter diminishing
marginal returns.
b Draw the production function graph for your new example using the chart function
in Excel. Again, highlight the data and choose a scatter diagram with a line.
c What are the implications for total output if there are never diminishing returns
to adding more workers to production? What is happening to total output in your
example as you add more workers to the production process? Is there a maximum
level of production?
d Does it seem likely that an economy could never encounter diminishing returns to
production? Why? If there are no diminishing returns, how much land would it take
to produce the world™s supply of food?
6 The following example gives you practice in determining which country has the compar-
ative advantage in the production of two goods, jewelry and fish.

Jewelry Fish
New Zealand 500 180
India 220

These numbers represent the hours it takes to catch 1 unit of fish (in tons) and to make
1 unit of jewelry (measured in utes).
Classical and neoclassical theories 135
a Which country, if any, has the comparative advantage in producing which good?
(Hint: you must find the internal opportunity cost of producing each good in each
country and then find which country produces which good most cheaply.)
b What “price,” or better what range of prices, would be advantageous to both coun-
tries such that they would be willing to trade? This price will be in physical units
7 Refer back to Ricardo™s original example of comparative advantage in Table 4.1 to
answer this question. Let™s assume England has 500,000 total labor hours available per
day for production to produce cloth and wine and that Portugal has 400,000 labor hours
available per day to produce the two goods.
a Assume, first, that England and Portugal do not trade with each other and that
currently england devotes one-half its available labor to the production of each
good, while Portugal uses 40 percent of its labor force to produce clothing and the
remainder for wine production. How much output of each good will each country
be able to produce? What is the total “world” output of both commodities without
trade? Input these values into the following table. This is a situation of autarky,
that is , with no trade where what each country consumes is determined exclusively
by what it produces.

Cloth Wine

Total world output

A. Production without specialization or trade

b Now assume that England and Portugal both completely specialize in the commodity
in which each has comparative advantage. How much output of each good will be
produced by each country? What is the total “world” output of both commodities
with specialization but prior to trade? Show the values of production of both goods
for each country with complete specialization in the following table.

Cloth Wine

Total world output

B. Production with specialization but prior to trade

c Is it possible for both countries to benefit from trade, such that each has at least
as much of one commodity and more of the other available for consumption after
specialization and trade than was available prior to specialization and trade? How?
Can you show this result in the following table? Remember, to show this you must
choose a mutually acceptable trade price, as was done for the example used to
derive Figure 4.2.
136 The Process of Economic Development

Cloth Wine

Total world output = consumption

C. Consumption after specialization and trade at the trade price of ___________

8 The Solow equilibrium income equation 4.5 in the text says that y = Y/L = (s/n)a/1’a, that
is, that income per person, y, which is simply total GDP (Y) divided by the population
(L), is determined by the ratio of the savings rate, s, (which is the percent of GDP = Y
saved) divided by the population growth rate, n, raised to the power, a/1’a, where a is
the share of total income, Y, received (and produced) by owners of physical capital and
1’a is the share of total income received by labor.
a What is equilibrium GDP per person, y, if a country has s = 0.3 (i.e. 30 percent),
n = 0.022 (i.e. 2.2 percent) and a = 0.33 (i.e. 33 percent)? (Assume y is calculated
in $1,000 of US dollars.)
b Now, what will equilibrium income per person, y, be, in $1,000 of US dollars, if
population growth is now 0.8 percent, all the other variables the same?
c What is equilibrium y if the savings rate is 14.5 percent, labor™s share of income is
60 percent and population growth is 1.4 percent?
9 Assume two economies have exactly the same values of population growth, n, and
labor™s share of income, a, but that the savings rate in one economy is 22.2 percent
and in the other is 18 percent. What can you say about the relative equilibrium level of
income, y, in the two economies?
10 If you have access to the internet, go to http://www.j-bradford-delong.net/macro_online/
interactive/2002-11-14-Solow_growth.xls for an Excel-based interactive exercise on the
Solow growth model. You can input different values for the variables in the Solow equa-
tion, and the spreadsheet will automatically show how these values affect the steady-
state value of y and the time path followed in reaching equilibrium. There are also graphs
showing how the equilibrium values change when you vary the fundamental parameters.
(Note: the spreadsheet uses a more sophisticated form of the Solow income equation
discussed in note 18.)

1 The expansion of the market tended to decrease per unit costs of production as the benefits of
economies of scale in production could be exploited at higher levels of output.
2 A detailed discussion of population growth and of birth and death rates and their determinants can
be found in Chapter 12.
3 Implicit in Malthus™s argument that poor relief would reduce the willingness to work is the assump-
tion that the poor, unlike their more wealthy brethren, are not maximizers of their income and
consumption opportunities. Apparently the poor were presumed to have relatively low “target”
income and consumption levels which would satisfy their limited desires. In modern language, the
poor were presumed to be “satisficers” rather than maximizers; they functioned with a different set
of beliefs and motivations than capitalists and their presumed “betters.”
4 Additionally, as we shall see in Chapter 12, rising incomes lead to fewer births per woman over
time, not more, as Malthus posited. This is related to the demographic transition discussed in that
Classical and neoclassical theories 137
5 Since Ricardo, the theory of diminishing returns has focused on the eventual decrease in the
marginal product of a homogeneous variable input, as increasing quantities of that factor are added
to production, all other inputs held constant. Ricardo™s formulation had greater inputs of land
of decreasing quality being added, that is, the input being added was actually heterogeneous, as
successive units of land brought into use were of lower fertility.
6 Corn used to mean grains in general, but the Corn Laws were concerned primarily with wheat.
The Corn Laws mandated tariffs on imported grains, tariffs that helped to keep domestic prices
higher. By 1846, the last remnants of the restrictive Corn Laws had been banished from the statute
7 There is one exception that Ricardo made to his argument that free trade was the best policy: “It
is evident, then, that trade with a colony may be so regulated that it shall at the same time be less
beneficial to the colony, and more beneficial to the mother country, than a perfectly free trade”
(quoted in Hunt 1979: 109). Given this caveat, it perhaps seems reasonable to wonder why, if it is
possible for a country to improve upon the free trade outcome with a colony by regulating trade, it
would not also, under some circumstances, be reasonable to suppose that the proper policy for a
nation vis-à-vis nations other than colonies might also be other than free trade? We will consider
the possibilities of how countries might be able to improve upon the free trade outcome in later
chapters. This quotation from Ricardo reinforces, too, the discussion in Chapter 3 of the role that
colonies played in contributing to the well-being of the more advanced countries and the adverse
impact that colonial policies by the colonial powers had on the possibilities for economic progress
in the colonies.
8 Normally, a production possibilities frontier (PPF) is assumed to be concave to the origin, indi-
cating that inputs to production are specialized and that there are increasing marginal opportunity
costs of production associated with producing more of any one good. Here we make the simplifying
assumption that it is possible to produce more of one good at a constant marginal opportunity cost
of production in terms of the other good sacrificed at the constant trade-off shown in Table 4.1 and
by the straight line PPF in Figure 4.2. You will remember that a PPF summarizes all the efficient
combinations of two goods that a country can produce given existing resources and technology.
In deriving Figure 4.2, it is assumed that Portugal has 300,000 hours of labor available per day.
Using the information in Table 4.1, it is easy to calculate that if only cloth is produced and zero
wine, the maximum quantity of cloth that can be produced per day is 3,333.33 units (300,000
hours · 90 hours to produce each unit of cloth). Similarly, a maximum of 3,750 units of wine
can be produced if no cloth is produced (300,000 hours · 80 hours to produce each unit of wine).
At production Point A, to produce 1,666.67 units of cloth rather than the maximum of 3,333.33,
1,666.66 units of cloth have been given up. Given the internal trade-off in production from Table
4.1 between cloth and wine for Portugal, reducing cloth production by 1,666.66 units releases
enough labor to produce 1,875 units of wine (1,666.66 — 1.125, since for every one unit of cloth not
produced in Portugal enough labor to produce 1.125 units of wine is released).
9 Modern analyses of the advantages of specialization and free trade, like the Heckscher-Ohlin
theory, are based on Ricardo™s original analysis, extending it to take into consideration differences
in factor costs and other complications. The implications about specialization, however, remain
essentially the same, especially as they relate to recommendations for indebted less-developed
nations (Chapter 16) and as a basis for regional trade associations.
10 Between 1700 and 1770, more gold was mined in Brazil than the Spanish extracted from their colo-
nies in the entire period from 1492 to 1800! Over 25 million pounds sterling of gold was transferred
to Britain via Portugal between 1700 and 1770 (Fisher 1971: 128).
11 For a comprehensive mathematical approach to economic growth theory and economic develop-
ment in general, see Basu 1997.
12 Marginal product is simply the change in total output due to a one unit change in one of the
inputs, all other inputs being held constant. Mathematically, it is the first derivative of each of the
13 dY/dK = aKa ’ 1 > 0 and dY/dL = (1 “ a)L ’ a > 0; dY2/(dK)2 = a(a “ 1)Ka ’ 2 < 0 and dY2/(dL)2 = “ a
(1 ’ a)L’(1 + a) < 0, which demonstrates the short-run existence of diminishing returns to each factor,
holding the other constant. The aggregate production function 4.4 is also “linearly homogeneous,”
that is, multiplying both variable inputs by the same scalar value, v, changes production by vY:
A(vK)a(vL)1 ’ a = AvaKav1 ’ aL1 ’ a = v(AKaL1 ’ a), when 0 < a < 1, i.e., the production function exhibits
constant returns to scale. In this formulation of the production function, a, which is the elasticity of
138 The Process of Economic Development
output with respect to a change in the capital input, can be interpreted as the share of total output or
income received by the owners of physical capital (as profits, dividends, rents and so on) and 1 ’ a
is the share of total output or income received by labor as wages. In this form, this is an example of
the famous Cobb-Douglas production function.
14 It is important to remember that saving and investment are in an accounting, or ex post, sense
always equal. In a closed economy, and assuming no government spending, national income and
output, Y, are equal to consumption by households, C, and investment by business, I. We thus can
write total output, or GDP, as Y = C + I. Rearranging, we can write Y “ C = I. By definition, saving,
S, is any income not consumed. Thus, Y “ C = S = I, showing that saving equals investment always,
ex post. Further, I = ”K, that is, the current level of investment is equal to new physical capital
stock, I, being created, so S = ”K.
15 This is because each additional unit of capital produces less output than the previous unit due to
the law of diminishing returns. Given a constant cost per unit of capital, costs of production will
increase as more K is used, and thus the rate of return to all K will decline.
16 It is actually more accurate to state that the Solow-type neoclassical model predicts conditional
convergence of per capita income. Poorer countries with the same savings rate as an already richer
country will, all else the same, tend to have a faster growth rate than the richer country, so that
income per capita would tend to catch up with that of the richer nation. However, the poorer nation
may have a higher rate of growth of population, n, that prevents per capita income from reaching
the level of the richer nation. Convergence of per capita income levels, then, is conditional on the
identity of the so-called “fundamentals,” particularly the rate of saving and investment and, second-
arily, on the rate of population growth. Convergence of income among nations, then, depends on
the rough equality in capital/labor ratios and savings behavior among economies. See Mankiw et
al. (1992) for a recent effort that suggests that an augmented Solow model provides a reasonable
explanation for cross-country income differentials based on differences in fundamentals.
17 See Jones (1998: 20“8) for a simple derivation of this result.
18 In this simple formulation, and to facilitate our understanding of the fundamental relationships,
depreciation of physical capital is assumed to be zero. Also, exogenous technological change, A(t),
which has the same constant value for all economies, is assumed to simply be a scalar value of 1.
If depreciation of capital and the value of technological change are taken into consideration, the
equilibrium Solow equation becomes:

y =A1/(1 ’ a) [s/(n + d)]a/(1 ’ a)

where d is the rate of depreciation of physical capital. As can be seen from this statement, countries
with the same ”fundamentals,” i.e. with identical values of s, n, d, and a, will reach the same steady-
state, equilibrium level of income per person (see Jones 1998: 34“9, for an alternative derivation).
19 In order to avoid drawing any inappropriate conclusions from the Solow model or to simplify its
conclusions unduly, it is important to keep in mind the assumptions of the model, one of which is that
the society has an “efficient” institutional structure which will readily transpose increased savings
into increased capital formation. In Chapters 5 and 6, we will encounter some of the embedded


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