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ECONOMIC THEORIES & MODELS - Coggle Diagram
ECONOMIC THEORIES & MODELS
NEO-CLASSICAL CAPITALISM: Today's dominant model
It emphasises exchange and trade, and power of the consumer and markets.
Key concept is 'supple & demand' - According to the theory of neo-classical economics, the laws of supply and demand in the market place was the only way to organise an efficient economy. An efficient allocation of scarce resources is the key to development.
By removing government interference and other diseconomies (i.e. monopolies, cartels etc.) the market place would automatically and efficiently allocate scarce resources. An unfettered market place was best placed to achieve economic development.
Poor countries were encouraged to enter the international market with gusto; they were encouraged to scrape government spending however already meagre, they were encouraged to promote Export Orientated Industries (EOI) so they could sell products on the international market.
PRICE MECHANISM:
The interaction between supply and demand with price and quantity determines what gets produced.
The most efficient way to produce is to reward suppliers who able to accommodate the most amount of demand.
Capital will allocate itself to areas where there is under-supply and prices are high. More output will cause prices to fall allowing consumers to develop tastes for new products.
In theory there is a virtuous cycle that rewards producers and consumers and allows for ever expanding output.
MARKETS:
DO MARKETS REALLY WORK?
Sometimes it doesn't work due to 'information asymmetry' - People have to have a basic level of trust or information. If the product cannot be.
Markets only register price signals - Not all resources involved in a product are necessarily reflected in the price. For example fossil fuels may appear to be in great supply, yet they are clearly finite. They also have perverse side effects such as pollution. These are called externalities.
Markets are vulnerable to crises - Even the most efficiently functioning markets have been shown time and time again to be subject to crises.
GLOBAL FINANCIAL CRISIS (GFC): 2007-2008
There is much debate about the causes of these crises.
The problem of crises is that their management underpins the “split” between micro and macroeconomics.
Micro-economics is concerned with understanding the behaviour of individuals, households and firms.
Macro-economics is about national (and international) factors that influence how these agents operate. This includes mechanisms like monetary and fiscal policy, economic growth and currencies.
ROLE OF GOVERNMENT IN MARKETS:
Views surrounding the appropriate role of government result in ongoing debates over how much government intervention is needed to correct the problems of markets.
The
interventionists
are keen on policies like government stimulus and quantitative easing to help economic growth to recover.
The
anti-interventionists
see these measures as harmful and likely to prolong crises. They see markets as self-correcting and the main way out of crises is for price corrections to occur.
FREE MARKETS: (Washington Consensus/WC)
This consensus, encapsulated by John Williamson, entailed a renewed focus on “free markets” and efficiency.
Deeper recessions and lower economic growth in the 1970s resulted in a renewed popularity of more free market-based approaches to policy.
The Washington Consensus comprised ten policy premises under which economic development was thought to occur. They were:
Fiscal discipline
A redirection of public expenditure priorities toward health, education, and infrastructure
Tax reform (to lower marginal rates and broaden the tax base)
Interest rate liberalisation
Unified and competitive exchange rate
Trade liberalisation
Liberalisation of inflows of foreign direct investment
Privatisation
Deregulation (to abolish barriers to entry and exit)
Secure property rights.
Government controls are unnecessary:
All the ten points are premised on the general neo-classical economic theory that government was an only marginally necessary evil that should be limited in its functions and that markets would find their own ‘natural’ equilibrium in a ‘free’ or unregulated environment.
If individuals or individual enterprises prospered then the whole of society would prosper through a flow-on effect. In Australia it was called the ‘trickle down effect’.
Under the WC system enterprises prospered or failed based on their ability to meet market demand. The system decreed that the market was the greatest incentive for and determinant of efficient production. ‘Let the market decide’ they said.
If the market place was left on its own without government interference then the ‘invisible hand’ of the market would distribute goods according to supply and demand.
POST-WASHINGTON CONSENSUS:
The Post-Washington Consensus emerged as a response to the shortcomings of the Washington Consensus and the Development State paradigm.
The World Bank produced a study that attempted to reconcile the Washington Consensus with the evidence but failed, leading to a shift in focus towards national institutions and governance as part of the post-Washington Consensus.
"Good governance" was seen as a key factor for achieving development through collaboration between governments and markets.
Overall, the post-Washington Consensus represents a shift away from the idea of a one-size-fits-all approach to development towards a more nuanced understanding of the factors that contribute to development.
Governing value chains:
Refers to how revenue generated by exports is used.
This idea emerged as a way of determining whether revenue is being used for wasteful consumption by elites, repatriated as profits to developed world-owned firms, or reinvested to acquire technology and make exporting firms more competitive.
The traditional neoclassical growth theory:
Originated from the Solow model (Solow 1956), which expanded the Harrod-Domar model by adding labour, capital and technology.
Technology is assumed to explain the “residual factor”, and was assumed to be determined exogenously (outside the country).
The general model is described by the following formula:
Y = AKαL1-α
(where Y is aggregate output of the economy in a year usually measured by GDP).
The Solow neo-classical model argues that output grows as a result of three factors:
Increases in labour quantity and quality (through population growth and education)
Increases in capital (through savings and investment)
Improvements in technology
Developing countries can draw additional domestic and foreign investments by opening up national markets, thus increasing the rate of capital accumulation and returns on investments. Consequently, developing countries tend to converge to higher per-capita income levels.
However, the Solow model did not bring about the expected results, especially in several African countries. The free market in these countries failed to stimulate economic development due to weak and inadequate legal and regulatory frameworks (World Bank 2000).
DEVELOPMENT STATE PARADIGM (DSP):
A broader theory of economic development that is related to the issue of East Asian exceptionalism within the developing world. The DSP posits that the state plays a significant role in promoting economic development through its interventions in the market.
Historical investigations of the new industrialising countries (NICs), such as South Korea and Taiwan, showed that their success was not solely due to their exploitation of low-cost labor, as claimed by adherents of the Washington Consensus. Instead, the DSP argues that these economies deliberately manipulated the free market by restricting imports in favour of domestic industry and promoting industrial development through state interventions.
The DSP challenges the notion of a pure free market approach and argues that state intervention can be necessary to promote economic development. The success of the NICs led to debates about why some countries succeeded in promoting economic growth while others failed, and whether such an approach could be replicated in other parts of the world.
The developmental state paradigm (DSP) states that neither the modernisation nor the dependency approaches are perfect, rather in reality economic development tends to fall somewhere in between these approaches.
Development economics is now recognised as more complex and individual than one model can describe.
MODERNISATION THEORY: Post World War 2 economic theory
Modernisation argued that by replicating the development paths of the West, poor countries would catch up.
Modernisation saw the problem of development in a simple way - The poor were poor because of a number of reasons that when removed would allow them to catch up with the industrialised world. These bottlenecks were such things as traditional economic systems (non-cash economies, bartering), traditional relationships (kinship ties, feudal ties, extended family) traditional religious beliefs (animism, spirit worship), and traditional modes of behaviour, that is anything which was not ‘modern’.
Poverty is a result of choice
- Poverty was related to people being traditional; the answer was people becoming ‘modern’. Modern meant becoming ‘western’. This approach to modernising countries meant that many aspects of culture from the past had to be replaced by more modern practices. People did not have to be living in poverty. Poverty was not structurally caused but a result of personal choice. Poor people did not chose to be poor, but economic and other decisions they adopted made them poor. By by taking lessons from the ‘industrialised’ west the poor countries would be able to become more like them.
The policies implemented to allow poor countries to catch up were those that emphasised industrialisation. The type of industrialisation recommended was
Import Substitution Industrialisation (ISI).
By making their own goods instead of importing countries were supposed to rapidly increase their wealth. Moving directly from a peasant-based agricultural society directly to industrialisation is a rare achievement and, in two cases where it has been at least partially achieved (the former Soviet Union and China) it came with an enormously high cost in human life.
COLONIALISM:
Modernisation theory was a celebration of the success of capitalism.
In other cases, even where the goals were more modest, many newly emerging countries found that while they had achieved political independence, their economies continued to be subject to the often one-sided demands of former colonial trading partners.
Most colonial powers continued to maintain significant investments in their former colonies long after independence had been achieved. In this they were often later assisted or buttressed with investment by other industrialised (or post-colonial) states.
If the modernisation project, as a general program, was not as successful as had been hoped for, at least the elites of each country tended to benefit, or were able to preserve their privilege.
This alone ensured a resistance to change.
FIVE STAGES OF MODERNISATION: Rostow's airplane (1960)
1. The traditional stage -
whereby the poor countries were in a state of poverty going about traditional ways of living.
2. The pre take-off -
Here the poor were beginning to shed their traditional modes of living for more ‘modern’ methods. This was the plane slowly moving down the runway.
3. The ‘take-off’ -
whereby the planer or economy slowly begun to escape the situation of poverty.
4. The drive to maturity -
where the poor would really begin to look like the rich countries and would be industrialising quickly.
5. The final stage -
mass consumption. At this point the plane was flying and the poor and rich enjoying the same privileges.
According to this model, all societies should pass through a series of stages of technological advance, usually prompted by investment. At a certain point, this ‘technologisation’ would become self-fulfilling, leading to ‘take-off’.
The consequent economic growth then led to the modernisation of social, institutional and political forms, including the establishment of the primacy of the individual over the collective and the establishment of democratisation. This modernisation process would have the benefit not only of assisting the societies concerned but, according to this theory, lessening ideological tension between states (the logic being that capitalism and democracy would become the dominant forms).
REASONS THIS APPROACH DIDN'T LAST:
Most countries were unable to catch up with the West and it has been argued that many worsened their situation.
The flawed thinking was that the poor countries could do in a decade or two what had taken the rich 200 years to do.
It also pre-supposed that the West would stand still in its development and the poor would soon catch up.
Modernisation did not take into account cultural, historical, geographical, economic, political, or social differences between countries. This lack of consideration resulted in the poor getting further behind the rich between the 1950s and 1960s.
Unfortunately, it was in this period that the West enjoyed unprecedented growth and itself continued to develop. This created an increasing divide.
HARROD-DOMAR GROWTH MODEL (1946):
Suggests that economic growth could be explained by the relationship between how much savings occurs within a community and the ratio of capital (factories, machinery, etc.) and economic output.
Saving leads to investments which leads to growth.
According to this hypothesis, economic growth (EG) is determined by the savings rate (s) and the capital/output ratio (k).
EG = s/k
Todaro and Smith’s (2009, p. 114) explain the policy implications of the Harrod-Domar growth model for a developing country:
…one of the most fundamental strategies of economic growth is simply to increase the proportion of national income saved, (i.e. not consumed). If we can raise s, …we can increase…the rate of… (economic) growth. For example, if we assume that the national capital-output ratio in some less developed country is, say, 3 and the aggregate saving ratio is 6% of GDP, it follows…that this country can grow at a rate of 2% per year because
Economic growth = s/k = 6% / 3% = 2%
Now if the national net savings rate can somehow be increased from 6% to, say, 15%— through increased taxes, foreign aid, and/or general consumption sacrifices—GDP growth can be increased from 2% to 5% because now
Economic growth = s/k = 15% / 3% = 5%
In fact, Rostow and others defined the take-off stage in precisely this way. Countries that were able to save 15% to 20% of GDP could grow (“develop”) at a much faster rate than those that saved less. Moreover, this growth would then be self-sustaining. The mechanisms of economic growth and development, therefore, are simply a matter of increasing national savings and investment.
The main obstacle to or constraint on development, according to this theory, was the relatively low level of new capital formation in most poor countries. But if a country wanted to grow at, say, a rate of 7% per year and if it could not generate savings and investment at a rate of 21% of national income (assuming that k, the final aggregate capital-output ratio, is 3) but could only manage to save 15%, it could seek to fill this “savings gap” of 6% through either foreign aid or private formation investment.
Thus the “capital constraint” stage’s approach to growth and development became a rationale and (in terms of cold war politics) an opportunistic tool for justifying massive transfers of capital and technical assistance from the developed to the less developed nations. It was to be the Marshall Plan all over again, but this time for the underdeveloped nations of the developing world.
EFFECT OF THIS MODEL:
Aid = (higher) growth
The effect of the assumptions embedded in the Harrod-Domar approach is that government policies should aim to increase investment or the relationship between output and capital.
This is why aid became a main way of increasing investment for developing countries.
DEPENDENCY THEORY:
Exploitation:
Aspects of this dependency theory of development broadly focused on the idea that development could not take place while developing countries were in the process of having their economies systematically exploited by developed countries.
Indeed, based on this analysis, the ‘backward’ state of these countries was a direct result of earlier economic exploitation.
The Rich cause the Poor:
The school of Dependency believed that the poor of the world were poor because the rich of the world were rich.
Development and underdevelopment were different sides of the same coin. It was the development of the West that led to the underdevelopment of the poor. The relationship between poor and rich was causal and linear.
Each approach seeks to achieve economic development via expanding economic output (in other words—to have economic growth):
1. Modernisation:
largely by increasing savings (using foreign aid if required).
2. Dependency:
by withdrawing from international trade.
3. The Washington Consensus:
by improving labour and capital by increasing technology.
Within the first two approaches, the role of the government was central to achieving successful economic growth, whilst in the third, the market was far more important.