Classical Analysis

1 Introduction- refers to a group of economists

(English) who were concerned with the conditions of economic progress during the IR in Europe (Adam Smith, David Ricardo, Thomas Malthus, John Stuart Mill)..

- sought of explain the differences in Growth rates among nations and to

isolate the requirements for continued development

2 Theme- saw the process of Economic Development as a race between population growth on the one hand and capital accumulation, technological change and expansion of markets on the other.

3 Assumptions for the realization of steady state economic growth

a. division of labor and specialization

b. capital accumulation via saving

c. free trade or market expansion

d. market allocation of resources

e. just legal system that protects property rights and freedom

of choice.

4 The Process of Economic Progress- Profit is the mainspring of growth in

creating surpluses available further investment and stimulating further expansion.

- The production function

Total output = f(factor endowments, the proportions in which they are combined, and the level of technology).

- Free market mechanism as resource allocator.

- Comparative advantage - producing goods that are least costly and exporting in exchange with goods that are not produced domestically.

5 The Classical Scenario of Economic Growth

a. Given a certain level of employment of labor (I.e. assuming labor theory of value) at certain level of Production, wages will be paid to workers according to the level of subsistence and any “surplus” will be accumulated by the capitalists.

b. Such accumulation will increase the demand for labor and with a given population (N1), wages will tend to rise (E1W1). As wages exceed the level of subsistence (N1W1), population will increase according to the Malthusian theory or paradigm.

c. With a growth of population, the supply of labor will be encouraged and wages will again fall back to the level of subsistence. This is referred to as the Iron Law of Wages.

d. As wages become equal to the subsistence level, a surplus will emerge again to encourage capital formation and the demand for labor, and the whole production value, leaving no surplus for capital accumulation, expansion and growth of population. This state is known as the stationary state.

e. The dynamic of Growth ends as the low of diminishing returns sets in and wages eat up the whole production value, leaving no surplus for capital accumulation, expansion and growth of population. This state is know as the stationary state.

6 The Limits to Economic Growth occurs due to rapid population growth resulting in diminishing returns and the decline in capitalists’ profit.

This stage of economic growth is the “stationary state” which is the stage at which economic growth ceases due to the depletion of profit (the main spring of economic progress).

Economic stagnation comes about as a result of the LDR brought about by steady population growth, the accompanying exhaustion of resources, and the “Iron Law of Wages” (ILW)

ILW (Iron Law of Wages) is the proposition that the natural wage will remain at subsistence (the cost of perpetuating the labor force or population in the LR since wages increase in proportion to the labor force).

7 An Appraisal of the Classical Theory

- Underestimated the impact of technological advance in off setting diminishing returns-paradoxical because it was formulated amidst numerous scientific discoveries and technical changes which increased output during the industrial revolution.

Examples: spinning jenny(1770) the power loom(1785), interchangeable parts(1978), the self cleaning steel plow (1837), the mechanical harvester of (1834).

- the ILW did not foresee to what extent population control could be limited at least in the west through voluntary birth control.

- Free enterprise and the role government.

- The Malthusian theory of growth has been proved to be misleading in light of the experience of economic growth of the developed countries. The Malthusian argument that people like to have more rather than bicycles, televisions, or cars when wages rise above subsistence seems to be invalid.

- The classical model is too simple.

(Attitudes, culture, and traditional institutional values exert varying degree of influence on growth.

- Distribution of income by market

The Harrod-Domar Growth Mode [H-D]

1 Introduction

- The modern generation of growth models stems from Harrod(1939, oxford) and Domar (1946, MIT). writing independently,they developed similar growth models in the late 1940s. But the essence of their models is the same. Therefore, their model is known as the H-D growth model.

- They take their point of departure from the keynesian model of short run static equilibrium [i.e. the level of investment determines incomes and those increments of investments determines increments of income] recognizing the dual character of investment i.e.

a. I spending creates income [Keynesian]

b. I spending also creates production capacity [classical].

*For instance, constructing and equipping a new factory generates a demand for steel, brick, and machinery. A factory once constructing and equipped increases the economy's productive capacity. Therefore, the economy's investment in any period has a demand and capacity increasing effect.

2 Theme of the H-D Model It is a simple mathematical relation which shows that the rate at which an economy grows is directly related to its propensity to save and its effectiveness in utilizing its capital stock to produce output.

i.e. G = s /k where G =growth rate(y/y) s = s/y; k = k/y

or k/y [ICOR]

3Some assumptions of the H-D modela. Initial full employment of resources

b. Technology is assumed fixed and thus

k/y = k/y where y = output, k = capital

c. The LR saving is a linear function of income Therefore, s/y = s/y fixed k/l i.e. no substitution of k for ld. There are no lags in adjustment and leakages (s = I ).

e. No substitution of resources.

f . The output of any economic unit [ firm, industry, or the whole economy] depends upon the amount of capital invested in that unit i.e. capital theory of value.

4 Derivation of the H-D Growth Model

a. let s = S/y represent the capital/ output ratio or incremental capital/ output ratio (ICOR) i.e. the amount of capital stock required to generate some unit of output.since investment is defined as the change is capital stock

k =k. Hence: k =K/y => K = k y or I = k y since k = I

b. let K =K/y or k/ y represent the capital output ratio or incremental capital output ratio (ICOR)

i.e. the amount of capital stock required to generate some unit of output

k = I k = K/y k =k y

or I =ky

c. In equilibrium, savings must be equal to total investment i.e.

s = I or sy = k yTherefore, G = y/y = s/k => the H-D equation

Notice: 1/k = Y/k is a measure of productivity

G = s/k says that the rate of economic growth as measured by y/y is directly related to the rate of savings and inversely with the incremental capital- output ratio [ICOR = k/y], given constant k/y, k/l, and technology.

- The H-D model implies that a low k/y in an economy will facilitate economic growth.Because of this inverse relation and the general scarcity of capital in the LDCs, the model has had a significant appeal in economic development planning.

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5 Some Interpretations of the H-D model

a. The maximum available rate of income growth without inflation.

b. The rate of income growth at which the capital stock will be fully utilized.

c. The necessary growth rate of investment to make the actual output to rise as fast as potential output so that the production capacity will be fully utilized.

d. The rate of income growth necessary to maintain full capacity utilization of a growing capital stock.

6 Implications of the H-D model

a. It implies that saving plays a significant role in economic growth because it aids the productive capacity of an economy to grow faster than the rate of growth of its population.It provides labor more capital and equipment to work with, which leads to an increase in real income.

Kuznets found that most DCs experienced net savings rate of 10-20% of GNP in periods of high growth. Net savings rates for many LDCs today average on only 5-10% if GNP. Whether this is a cause or a result of underdevelopment is subject to debate.

b. It also implies the importance of efficient capacity utilization (k/y) in slowing or speeding economic growth

7 Applications of the H-D Model to Economic planning

a.Easy to determine the target rate of y/y, given k and s[ India, Mexico, Kenya etc.]

b.It aids the determination of the required s=s/y or mps

How much by voluntary saving ?

How much by taxation ? Possibility of foreign

aid? Readjustment of the target rate.

8 Limitations of H-D Modela. It relies largely on

capital theory of value - a postulate that the worth of output depends largely on the value of capital goods used in its production.

b. The assumption of fixed technology is not realistic.

c. The model implies that AD is the main constraining factor of obtaining FE income in the same spirit of the post- Keynessian models.

d. The H-D is subject to empirical limitation in that observed growth has been faster than can be accounted for by the rate of physical capital formation and fixed k/y ratios.

[see Asian Drama vol., Appendix 3, pp. 1968-93].

e. The model is subject to instability problem.