Theories of Economic Development: Adam Smith, Ricardo, Marx, Schumpeter, Rostow, Balanced & Unbalanced Growth, Big Push Approach – Notes

Introduction

• Economic Development is not a new concept. It has its roots in the past; it has attracted the attention of economists, sociologists and politicians from the ancient times. They propounded various theories of development so as to analyse and explain the mechanism of economic development.

• Economic growth is to be equated here with the growth of an economy as measured through its aggregate output adjusted for input-use, which is to say value added over a year. The simplest aggregate measure of value added through economic activities in the economy is its gross domestic product (GDP) at constant prices. What makes this flow to grow over time is the theme in this Unit. Various economists have articulated as to how GDP grows and can be made to grow on a regular basis.

• Economists have known that economies do not grow in a linear fashion but they have noticed that they grow along a trend with fluctuations around it. There are theories for both the phenomena – long-term economic growth and short-terms fluctuations, but we shall concentrate here on theories dealing with the former. Theories for the latter are often known as business cycle theories, where business means level of economic activity in an economy. We also do not consider a view that changes cannot be separated into growth trends and fluctuations and constitute one single movement. We are also not considering the factors like trade and finance across economies, which do impact growth in one way or another.

• Despite the fact that economic growth is a long-term phenomenon, we have to measure growth in terms of two consecutive periods, normally years. Growth simply means more output in period (t) than that in period (t – 1). Period is usually reckoned with a year, that too an accounting year. However, growth in this context has to be in terms of growth rate, to be precise, in terms of proportional growth rate. So even though economic growth is a long term phenomena its measurement in is terms of ‘so much percent per annum during the period from such and such year to such and such year’.

• The way discussion of growth theory has been conducted, it proceeds as if the economy produces only one good, say corn, which is consumed, saved, invested, inventoried or hoarded. Often, the writings have used only two factors of production viz., capital and labour, which may grow over time, apart from technology. It is partly for the ease of analysis and partly legacy of classical rigorous economic writings that much of macroeconomics has been conducted this way except for money. However, there is no simpler way to do macroeconomics than use aggregates. Most of the modern analyses are carried out in terms of per capita income/product rather than in terms of total product and changes in population-size are considered exogenous.

Classical Theory of Economic Development

• The classical economists were the earliest of those who propounded theory of economic development which is popularly known as classical theory of development. The views of classical economists differ on a number of developmental issues but the essence of their approach was the same.

• The different classical economists, viz. Adam Smith (1776), Malthus (1798), David Ricardo (1823) and Mill (1848) focused their attention on the factors affecting economic development such as land, population, labour, production, markets and capital accumulation. Their approach to economic development was macro in character.

• The essential aspects of the approach of classical theorists are presented below.

Assumptions of Classical Theory

• The main classical assumptions of this theory included the following:

  1. The natural laws are superior to the laws of States. Statutory law or man-made law can never be perfect or absolutely beneficial for the society. It has its favorable effects on the economic progress of a country.

  2. The classical theory of economic development is based on the principle of laissez-faire, which requires that the State should not impose any restrictions on the freedom of action of an individual.

  3. There is perfect competition.

  4. Supply of land is fixed which is used for the production of corn.

  5. The production function is subject to the law of diminishing returns.

  6. The state of technical knowledge is given.

  7. Full employment will exist in the economy.

  8. The supply price of labour is given and constant.

Features of Classical Theory

i) Division of Labour:

• Division of labour is the starting point of Adam Smith’s (1776) theory of economic development. Division of labour increases productivity of labour through specialization of tasks. When a particular work is divided into several parts and the worker is asked to choose and work on small parts of whole job, his/her efficiency increases as he/she can focus his/her full attention on that particular part only.

• According to Smith, division of work is an important technique to increase both production and productivity, as it increases the skill of every worker, saves the time and promotes largely inventions of labour-saving machines. In his opinion, the size of the market is an important limitation of the division of labour. Adam Smith (1777) in his book ‘Wealth of Nations’ points out the following three main benefits of division of labour:

  • (a) Increase in the dexterity of every worker.

  • (b) Reduction in the time required to produce commodities.

  • (c) Inventions of better machines and equipments.

• By division of labour the worker acquires more skills and efficiency which are needed for raising the level of output. Division of labour necessarily leads to exchange of goods, which is in the larger interest of the society and highlights the importance of the individual both at national and international level.

• In short, division of labour leads to the exchange of goods which, in turn, promotes trade and widens the extent of market. Wide extent of market is an essential pre-requisite for economic development. Wide market leads to increased sales, and increased sales tend to increase the amount of profits which, in turn, promotes more capital formation.

ii) Capital Accumulation:

• According to David Ricardo (1823) capital accumulation is the main source of economic development. It acts as an engine of growth. The role of capitalist is very important from the economic development point of view, because this class does most of the savings in the country. According to David Ricardo (op. cit): “capital is saved from profits, and high profits are favourable to the accumulation of capital”. For Ricardo profit is the primary source of capital accumulation, although among secondary sources he includes wages and rent as well.

• Now, the question arises as to what is the source of profit? Profit or economic surplus is the difference between the market value of a finished product and its cost at a subsistence wage level. Since the labourers and land lords could not save much, so the capitalists had to contribute the major share to the economic surplus of the economy.

• Capital accumulation depends on two factors:

  • Firstly, the capacity to save; and

  • Secondly, the will to save.

• However, the capacity to save is more important in capital accumulation as compared to will to save. This depends on the net income of the society i.e. surplus out of total output after deducting the cost of workers subsistence. The larger is the surplus, the larger will be the capacity to save. According to Ricardo (op. cit.): “out of two loaves, I may save one, out of four I may save three”. The accumulation of this surplus depends on the rate of profit.

iii) Production Function:

• Adam Smith (1776) recognized the existence of three factors of production, namely, labor, capital and land. His production function may be expressed as:

$$Y = f(K, L, N)$$

Where:

• \(K\) denotes stock of capital,

• \(L\) represents labour force, and

• \(N\) stands for land.

• Adam Smith (op. cit.) gave topmost importance to labour as a factor of production as it is the only active factor of production and rest are the passive factors of production. Adam Smith regarded labour as father and land as mother; land is the only instrument which enables the farmer to earn the wages of his labour and to make profits of this stock.

• Adam Smith (op. cit.) has not assumed the concept of diminishing marginal productivity. The production function is subject to increasing returns to scale. In his opinion, with the passage of time the size of market expands in both internal and external economies which in turn will eventually lower down the real cost of production. He asserted that division of labour does not depend merely on technological feasibility; it greatly depends on the extent of the market.

• As far as the size of market is concerned, it depends on the available capital stock and the institutional restrictions placed upon national and international trade. Thus, accumulation of capital is a pre-condition to increasing division of labour. The regulatory measures against trade have a tendency to restrict the size of the market which obviously limits the division of labour.

• Adam Smith (op. cit.) recognizes the importance of technological development for improvement in productivity. However, it is possible only when sufficient stock of capital is available. In other words, he assumed the improvement in productivity would never suffer for want of technical know-how if there is regular flow of requisite capital stock. The person who employs his stock in maintaining labor, endeavors both to make, among his work-men, the most proper distribution of employment and furnish them with the best machines which he can either invent or afford to purchase. His ambition in both these respects is generally in proportion to the extent of his stock of capital or to the number of people which it can employ.

iv) Stationary State:

• Almost all classical economists visualize the stationary state at the end of the process of capital accumulation. When once profits start declining, this process continues till profits become zero; population and capital accumulation stop increasing, and the wage rate reaches subsistence level. The economic development too receives a set back and at this stage there is no further increase in capital and, thus, the economy enters a stationary state.

• However, Mill (1848) has welcomed the stationery state because according to him it leads to improvement in income and large remuneration for labour. But, this is possible only through control on increase in numbers.

v) Distribution of National Product:

• The national income is the result of joint efforts made by land lords, capitalists and labourers, who share it in the form of rent, profits and wages. Rent for unit of labour is the difference between average and marginal product or total rent equates the difference between average product and marginal product multiplied by the quantity of labor and capital on land. The wage is determined by wage fund divided by the number of workers employed at subsistence wage level. Thus, out of total corn produced and sold rent has first right and residual is distributed among wages, while interest is included in profits. However, their shares vary as a result of complicated process of economic growth.

• The capitalist, being induced by the desire of earning more and more profits, invests more and more in productive undertakings. Consequently, the increasing demand for both land and labor results in higher rents and higher wages and in gradually reducing profits.

• According to David Ricardo, if we take into account the entire economy:

  • the higher wages will lead to competition in the labour market and will ultimately depress wages of workers at nearly subsistence level;

  • the growth rate of capital stocks and population leads to enhancement of aggregate wages, but not essentially aggregate profits;

  • there will be a downward trend in the rate of profits with the technological improvements; and

  • as regards rent, with the rise of population and stock of capital, the demand for agricultural products as well as for land accelerates causing higher agricultural prices and higher rents in a forward economy.

vi) Supply of labour and technological progress determine the level of profits:

• In the classical system, it is possible to identity two main factors which determine the level of profits. These factors are:

  • (a) Supply of labour force depending upon population growth, and

  • (b) Technological progress.

• The classical economists thought that the population would grow over time and the supply of land is taken as fixed, and thereby an increase in supply of labour would result in diminishing returns in agriculture. On the other hand, this would raise labour costs and thus it would reduce profits. The classists did not expect increasing returns in agriculture despite improvements in farm technology.

vii) The wage is determined by the level of investment:

• The wage fund defined as the amount of money available for paying wages to the hired labourers constitutes the working capital. It is created out of savings.

• However, both Adam Smith and David Ricardo believed that savings automatically get converted into investment. Malthus (1798), however, differed from them and asserted that, in the absence of effective demand savings of the capitalists do not find investment opportunities.

• Keeping these differences in view, the classical position can be correctly stated by saying that wage fund depends on the level of investment rather than savings.

viii) Population growth and economic development:

• In his Principles of Political Economy, Malthus was more realistic in his analysis of population growth in the context of economic development. He believed that population growth was not enough to stimulate economic development in a country, but it was itself the result of the development process.

• In other words, population growth increases wealth only if it increases effective demand and it is the increase in effective demand which leads to increase in wealth of a country.

ix) Deficiency of effective demand:

• Malthus was against Say’s (1855) law of markets which states that ‘supply creates its own demand’. He did not accept his view that there could not be a general over production or glut in the market.

• As against his views, Malthus believed that the general over production in the economy was possible, because workers get their wages much less than the values they produce and, thus they, as the consumers, cannot purchase all the commodities available in the market.

• This gap between supply and demand cannot be bridged even by capitalists because of their own desire to save more for more investment for more profits. The deficiency of effective demand leads to fall in prices, saving, investment, employment, output, and capital accumulation.

Adam Smith’s Theory of Economic Development

• Adam Smith is regarded as the foremost classical economist. His monumental work, An Enquiry into the Nature and Cause of Wealth of Nations published in 1776, was primarily concerned with the problem of Economics of Development. Though he did not expound and systematic growth theory, yet a coherent theory has been constructed by later day economists.

• Smith posited a supply-side driven model of growth. Succinctly we can set out the story via the simplest of production functions:

$$Y = f(L, K, T)$$

where:

• \(Y\) is output,

• \(L\) is labour,

• \(K\) is capital, and

• \(T\) is land,

• Thus, output is related to labour and capital and land inputs. Consequently output growth \((g_Y)\) was driven by population growth \((g_L)\), investment \((g_K)\), land growth \((g_T)\) and increases in overall productivity \((g_f)\). Succinctly:

$$g_Y = \phi(g_f,\; g_K,\; g_L,\; g_T)$$

Assumptions:

• Smith proposed that:

  1. Population growth, in the traditional manner of the time, was endogenous. It depended on the sustenance available to accommodate the increasing workforce.

  2. Investment was also endogenous; determined by the rate of savings (mostly by capitalists).

  3. Land growth was dependent on conquest of new lands (e.g. colonisation) or technological improvements of fertility of old lands.

  4. Technological progress could also increase growth overall; Smith’s famous thesis that the division of labour or specialisation improves growth was a fundamental argument.

  5. Smith also saw improvements in machinery and international trade as engines of growth as they facilitated further specialisation.

  6. He also assumed the existence of perfect competition.

Main Features:

• Natural law – laissez-faire and self interest leads to Development: Adam Smith believed in the doctrine of ‘Natural law’ in economics affairs. He regarded every person as the best judge of his own interest who should be left to pursue it to her own advantage. In furthering her own self interest she/he would also further the common good. In pursuance of this, each individual was led by an ‘invisible hand’. “It is not to the benevolence of the baker but to his self-interest that we owe our bread”, said Smith. Since every individual if left free will seek to maximise his own wealth, therefore all individuals, if left free, will maximise aggregate wealth. Smith was naturally opposed to any government interventions in industry and commerce. He was a staunch supporter of free trade and advocated the policy of laissez-faire in economics affairs. The “invisible hand” – the automatic equilibrating mechanism of the perfectly competitive market tended to maximise national wealth.

• Division of Labour – Division of labour increases productivity which depends upon the size of the market: Division of labour is the starting point of Smith’s theory of economic growth. It is division of labour that results in the greatest improvement in the productive powers of labour. The attributes of this increase in productivity are:

  • (i) the increase in the dexterity of every worker;

  • (ii) the saving in time to produce goods; and

  • (iii) to the inventions of large number of labour saving machines.

  The last cause to increase in productivity stems not from labour but from capital. Therefore in Smith’s scheme; it is improved technology that leads to division of labour which, however, depends on the size of the market.

• Process of Capital Accumulation – Division of labour leads to capital accumulation and capital accumulation leads to economics of development: Smith, however, emphasised that capital accumulation must precede the introduction of division of labour. He wrote “As the accumulation of stock must, in the nature of things, be previous to the division of labour, so that labour can be more and more sub-divided in proportion only as stock is previously more and more accumulated”. Like the modern economists, the classical economists regarded capital accumulation as a necessary condition for economics of development. Hence the problem of economics of development was largely the ability of the people to save more and invest more in a country. As Smith said, “that portion which a person annually saves is immediately employed as a capital.”

• But since almost all saving resulted from capital investments or the renting of land; only capitalists and landlords were held to be capable of saving. The labouring classes were considered to be incapable of saving. This belief was based on the ‘Iron Law of Wages’. The classical economists also believed in the existence of ‘wages fund’. The idea was that ‘wages’ tend to equal the amount necessary for the subsistence of the labourers. If the total wages fund at any time becomes higher than the subsistence level, the labour force will increase, competitions for employment will become keener and wages will come down to the subsistence level.

• Why do capitalists make investment? – Investment is made to earn profits: According to classical economists, investments were made because the capitalists expected to earn profits on them; and future expectations with regard to profits depended on the present climate for investment as well as actual profit. But what is the behaviour of profits during the development process? Smith believed that profits tend to fall with economic progress when the rate of capital accumulation increases. Increasing competitions among capitalists tends to lower profits. Thus with the growth of economy’s capital stock, competition among entrepreneurs for scarce labour tends to bid up wages and thereby lowers profits.

• Interest: Regarding the role of interest in economics of development, Smith wrote that with the increase in prosperity, progress and populations the rate of interest falls and as a result the supply of capital is augmented. The reason being that with the fall in interest rate the moneylenders will lend more to earn more interest. Thus the quantity of capital for lending will increase with the fall in the rate of interest. But when the rate of interest falls considerably the moneylenders are unable to lend more in order to earn more to maintain their standard of living. Under the circumstances they will themselves start investing and become entrepreneurs. Thus even with the fall in the rate of interest there is increase in capital accumulation and economic progress.

• Agents of Growth: According to Smith, farmers, producers and businessman are the agents of progress and economic growth. The functions of these three are, however, interrelated. To Smith, development of agriculture leads to increase in construction works, and commerce. When agricultural surplus arises as a result of economics of development, the demand for commercial services and manufactured articles rises. This leads to commercial progress and the establishment of manufactured industries. On the other hand, their development leads to increase in agricultural productions when farmers use advanced production techniques.

• Shortage of natural resources stops growth: According to Smith, the process of growth is cumulative. When there is prosperity as a result of progress in agriculture, manufacturing industries and commerce, it leads to capital accumulations, technical progress, increase in population, expansions of markets, division of labour and rise in profits continuously. But this process is not endless. It is the scarcity of natural resources that finally stops growth. Competition among businessmen would bring profits as low as possible. Once profits fall, they continue to fall. Investment also starts declining and the end result of capitalism is the stationary state. When this happens capital accumulation stops; populations becomes stationery, profits are the minimum; wages are at the subsistence level; there is no change in per capita income and production, and the economy reaches the state of stagnation.

A Critical Appraisal:

• Smith’s model has the great merit of pointing out ‘how economic growth came about and what factors and policies impede it’. In particular, he pointed out the importance of parsimony in saving and capital accumulation; of improved technology, division of labour and expansion of market in production; and of the process of balanced growth in the interdependence of farmers, traders and producers. Despite these merits, it has certain weaknesses.

  1. Rigid division of Society: Smith’s theory is based on the socio-economic environment prevailing in Great Britain and certain parts of Europe. It assumes the existence of a rigid division of society between capitalists (including landlords) and labourers. But the middle class occupies an important place in modern society. Thus, this theory neglects the role of middle class.

  2. One sided saving base: According to Smith, Capitalists, landlords and money lenders save. This is, however, a one-sided base of saving because it did not occur to him that the major source of savings in our advance society was the income receivers and not the capitalists and landlords.

  3. Unrealistic assumption of perfect competition: Smith’s whole model is based upon the unrealistic assumption of perfect competition. The laissez-faire policy of perfect competition is not to be found in any economy. Rather, a number of restrictions are imposed on the private sector, and on internal and international trade in every country of the world.

  4. Neglect of Entrepreneur: Smith neglects the role of entrepreneur in development. This is a serious defect in his theory. The entrepreneur is the focal point of development, as pointed out by Schumpeter. It is the entrepreneur who organizes and brings about innovations thereby leading to capital formation.

  5. Unrealistic Assumption of Stationery State: Smith is of the view that the end result of a capitalist economy is the stationery state. It implies that there is change in such an economy but around a point of equilibrium. There is progress but it is steady, uniform and regular like a tree. But this explanation of the process of development is not satisfactory because development takes place by ‘fits and starts’ and is not uniform and steady. Thus the assumption of stationary state is unrealistic.