Determinants of Economic Development
Factors that Determine Economic Growth and Development of a Country!
The process of economic growth is a highly complex phenomenon and is influenced by numerous and varied factors such as economic, political, social and cultural factors. It is believed by some economists that the capital is the only requirement for growth and therefore the greatest emphasis is laid on capital formation to bring about economic development. But this is wrong. As Professor Nurkse rightly remarks, “Economic development has much to do with human endowments, social attitudes, political conditions and historical accidents. Capital is a necessary but not a sufficient condition of progress.”
The following are various factors which determine economic growth and development:
(i) Supply of Natural Resources;
(ii) Capital form action which depends upon the rate of domestic saving and investment and inflow of foreign capital;
(iii) Growth of population;
(iv) Technological Progress; and We examine below each of these factors in turn.
(i) Supply of Natural Resources
The quantity and quality of natural resources play a vital role in the economic development of a country. Important natural resources are land, minerals and oil resources, water, forests, climate, etc. The quality of natural resources available in a country puts a limit on the level of output of goods which can be attained.
Without a minimum of natural resources there is not much hope for economic development. It should, however, be noted that resource availability is not a necessary condition for economic growth. For instance, India, though rich in natural resources, has remained poor and under-developed.
This is because resources have not been fully utilised for productive purposes. Thus it is not only the availability of natural resources but also the ability to bring them into use which determines the growth of an economy. On the other hand, Japan has a relatively few natural resources but has shown a very high rate of economic growth and as a result has become one of the richest countries in the world.
How has Japan done this miracle? It is international trade that has made possible for Japan to achieve higher growth rate. Japan imports many of natural resources such as mineral oil it requires for production of manufactured goods. It then exports manufactured goods to the countries that are rich in natural resources. Thus experience of Japan shows that abundant natural resources are not a necessary condition for economic growth.
Supplies of natural resources can be increased as a result of new discoveries of resources within a country or technological changes which facilitate discoveries or transform certain previously useless materials into highly useful ones. It should also be noted that the scarcity of certain natural resources can be overcome by synthetic substitutes.
For example, the synthetic rubber is being increasingly used in the place of natural rubber in advanced countries. Further, nylon which is a synthetic substance is being largely used in place of silk which is a natural substance. The use of natural resources and the role they play in the economic growth depend, among other things, on the type of technology. The relationship of resources to the kind and level of technology is very intimate.
One does not have to go back very far in history to find when an item currently as valuable as petroleum was of little or no significance. It is only recently that the various radioactive elements have come to be regarded as valuable. In many developing economies there are, no doubt, deposits of many minerals that are not being used because of technological deficiencies.
(ii) Capital Formation
Labour is combined with capital to produce goods and services. Workers need machines, tools and factories to work. In fact the use of capital makes workers more productive. Setting up of more factories equipped with machines and tools which raise the productive capacity of the economy.
Therefore, in the opinion of many economists, capital formation is the very core of economic development. Whatever the type of economic system, without capital accumulation the process of economic growth cannot be accelerated.
Levels of productivity in the United States of America are very high mainly because American people work with more and better type of capital goods built up over the last several years. Low productivity and poverty of developing countries is largely due to the scarcity or shortage of real physical capital in these countries.
Economic growth cannot be speeded up without accumulating various types of capital goods, that is, without building factories, machines, tools, dams, bridges, roads, railways, ports, ships, irrigation works, fertilizers, etc., much economic development is not possible.
But capital formation requires saving, that is, the sacrifice of some current consumption. An increase in supplies of capital goods can only result from investment, and investment in turn is only possible if a portion of current income is saved. Thus saving is essential to economic growth.
According to Professor Arthur Lewis, “The central problem in the theory of economic growth is to understand the process by which a community is converted from being a 5 per cent saver to a 12 per cent saver with all the changes in attitudes, in institutions and in techniques which accompany this conversion Underdeveloped economies generally save very little; not more than 5 per cent of their national income.
For instance, saving in India on the eve of independence was about 6 per cent of the national income. On the other hand, rich countries save from 15 to 30 per cent of their national income. In order to bring about economic growth, rate of savings must be stepped up to over 15 per cent of national income.
But in developing countries, the rate of saving is low because income of the people is low and that they are living at the level of subsistence. Thus, the lower the per capita income, the more difficult it is to forgo current consumption. It is difficult for people living at or near subsistence level to curtail current consumption. This in large part explains the low level of saving in the poor, underdeveloped countries.
It may be noted that gross saving rate in India has now risen to 24 per cent of national income in 2001-02. However, for achieving 8 per cent rate of growth in GNP in the 10th plan period, it is estimated that 32 per cent rate of saving is needed if capital-output ratio remains constant at 4 which was actually obtained in the 9th plan period.
It must be emphasized, however, that savings in itself do not contribute to economic growth. It is only when savings are invested and used productively that they contribute to economic growth. If savings are hoarded in the form of gold or precious jewels, or if they are used for buying land, they do not result in an increase in supplies of capital goods and thus make no contribution to economic growth.
Studies conducted to examine the relationship between investment and growth in terms of increase in GDP has found that there exists a strong correlation between the two though it is not perfect. Countries that allocate a larger fraction of their GDP to investment such as Japan and Singapore achieved high growth rates, and countries that allocate a small share of GDP to investment such as Bangladesh and Nepal have low growth rates.
Foreign Capital: Foreign Aid and Foreign Investment:
As domestic savings are not sufficient to make possible the necessary or desired accumulation of capital goods, borrowing from abroad may play an important role. Professor A.J. Brown rightly says that “Development demands that people somewhere should refrain from spending part of their incomes, thus allowing part of the world’s productive resources to be used for accumulation of capital goods. The people who can best afford to do this are generally those who live in countries of high average income. On the other hand, the countries where development is likely to alleviate suffering and promote welfare to the greatest extent are those where average incomes are low. There is a strong general case for the rich countries lending to the poor ones.”
Nearly every developed state obtained the foreign assistance to supplement its own small saving during the early stages of its development. England borrowed from Holland in the seventeenth and eighteenth centuries, and in turn came to lend to almost every other country in the world in the nineteenth and twentieth century’s.
The United States of America, now the richest country in the world, borrowed heavily in the nineteenth century, and has now emerged as the major lender country of the twentieth century which is assisting the poor countries in their attempts to bring about economic growth.
It should be noted that foreign capital does not flow into the developing countries in the form of aid alone (that is, loans at concessional rates of interest) but also through direct investment by foreign companies. Foreign direct investment (FDI) is an important way for a country to accelerate its economic growth.
Though the foreign companies send back profits earned, their investments in factories increase the rate of capital accumulation in the developing countries leading to a higher rate of economic growth and higher productivity of labour. Besides, foreign direct investment enables the developing countries to learn the new advanced technologies developed and used in the rich developed countries.
The importance of foreign capital is reinforced by the need of a developing country for foreign exchange to buy imports. A developing country has to import huge quantities of capital goods, technical know-how and essential raw-materials which are required for industrial growth and building up of infrastructure such as power projects, roads, irrigation facilities, ports and telecommunication.
For all these, foreign exchange is needed which can be obtained if foreign rich countries lend it to developing economies or if foreign companies make direct investment in the developing countries. If foreign assistance is not forthcoming in adequate quantity, then the developing countries will experience serious difficulties of balance of payments. In the absence of sufficient borrowing from abroad, or direct foreign investment, rapid economic development of the developing countries will turn their balance of payments seriously adverse.
Furthermore, developing countries suffer not only from a shortage of savings but also from a lack of technical know-how, managerial ability, etc. Foreign capital when it comes in the form of private investment in developing countries by foreign companies, especially the multinational corporations (MNCs) bring with it these complementary factors which are very essential for development.
Due to bad experience of the colonial rule in the past, the developing countries were generally against the foreign capital, especially against private foreign investment. However the fears of foreign investment and aid are now no longer there.
Further, now multilateral foreign aid is available through World Bank and International Monetary Fund (IMF) which provide loans at concessional rates to the developing countries for accelerating growth. As far as private foreign investment is concerned, the developing countries (including China and India) are competing with each other to attract private foreign investors.
In India, the Government has set the target of achieving annual inflow of $10 billion of foreign direct investment. It has now been realised that foreign investment will not only supplement domestic saving and thereby raise the rate of investment, bring better technology and managerial know-how but will also ease the problem of foreign exchange.
Through raising the rate of investment and providing foreign exchange resources, it will not only increase output but will also generate employment opportunities. Besides, like the domestic investment, foreign investment also produces a multiplier effect on output, income and employment in the developing countries.
In the last fifteen years, China’s very high rate of economic growth which is generally described as “Chinese growth miracle” is due to higher inflow of foreign direct investment (FDI) as compared to India. Foreign direct investment flows to China grew from $3.5 billion from 1990 to $53 billion in 2002.
On the other hand, FDI flow to India was a low $0.4 billion in 1990 and rose to $5.5 billion in 2002. Further, FDI has contributed significantly to the rapid growth of China’s manufacturing exports. In India by contrast FDI has been much less important in driving India’s export growth, except in information technology.
For higher foreign direct investment flows to China World Investment Report 2003 mentions among other things that China has more business-oriented and FDI-friendly attitudes, its FDI procedures are easier and decisions are taken rapidly.
Besides, China has more flexible labour laws, a better labour climate and better entry and exit procedures for business. It is therefore not unexpected that China has emerged at the top in attracting FDI flows. Against this, at present (i.e. in 2002) India is 15th in the World’s FDI destination.
Human Capital: Education and Health
Till recently economists have been considering physical capital as the most important factor determining economic growth and have been recommending that rate of physical capital formation in developing countries must be increased to accelerate the process of economic growth and raise the living standards of the people.
But in the last three decades of economic research has revealed the importance of education as a crucial factor in economic development, Education refers to the development of human skills and knowledge of the labour force.
It is not only the quantitative expansion of educational opportunities but also the qualitative improvement of the education which is imparted to the labour force that holds the key to economic development. Because of its significant contribution to economic development, education has been called as human capital and expenditure on education of the people as investment in man or human capital.
Speaking of the importance of education or human capital. Prof. Harbison writes: “human resources constitute the ultimate basis of production human beings are the active agents who accumulate capital, exploit natural resources, build social, economic and political organisations; and carry forward national development. Clearly, a country which is unable to develop the skills and knowledge of its people and to utilise them effectively in the national economy will be unable to develop anything else.”
(iii) Technological Progress and Economic Growth
Another important factor in economic growth is progress in technology, Use of advanced techniques in production or progress in technology brings about a significant increase in per capita output. Technological advance refers to the discovery of new and better ways of doing things or an improvement in the old ways.
Sometimes technological advances result in an increase in available supplies of natural resources. But more generally technological advance results in increasing the productivity or effectiveness with which natural resources, capital and labour are used and worked to produce goods. As a result of technological advance it becomes possible to produce more output with same resources or the same amount of product with less resource.
But the question arises as to how the technological progress takes place. The technological progress takes place through inventions and innovations. The word invention is used for the new scientific discoveries, whereas the innovations are said to take place only when the new scientific discoveries are used for actual production processes or commercial purposes. Some inventions may not be economically profitable to be used for actual production.
It is quite well known that improvements in technology greatly increase the effectiveness with which natural resources are used. In United States, for instance, increased used of mechanized power-driven farm equipment on land has greatly raised the agricultural productivity of land per hectare.
It may also be noted that some technological improvements have resulted in the increased effectiveness with which capital goods are used. But, as stated above, technological change more generally results in higher productivity of resources.
Technological change raises the productivity of workers through the provision of better machines, better methods and superior skills. By bringing about increase in productivity of resources the progress in technology makes it possible to produce more output with the same resources or the same amount of output with less resource.
Technical progress manifests itself in the change in production function. So a simple measure of the technical progress would be the comparison of the position of production function at two points of time. The technological change may operate upon the production function through improvements of various sorts such as superior equipment, an improved material, and superior organisational efficiency.
Also, the technological progress may express itself in making available new products. It is now widely accepted that technological change raises productivity and that a continuous technological change will enable the economy to escape from being driven to the stationary state or economic stagnation.
Classical economists like Ricardo and J.S. Mill expressed fear that the increase in the stock of capital will sooner or later, because of the operation of diminishing returns, land the economy into stationary state beyond which economic growth will come to an end.
Classical economists remained occupied with the idea of a stationary state because they did not take into account technological progress that could postpone the occurrence of a stationary state and ensure continued economic growth. Indeed, if technological progress continuously takes place, demon of stationary state can be put off indefinitely.
It may be noted that Adam Smith viewed technological progress as a rise in productivity of workers as a result of increase in division of labour and specialisation. The rise in productivity leads to the growth in national income. But it was J.A. Schumpeter who laid great stress on the role of technological innovations in bringing about economic growth. He laid stress on the introduction of technical innovations in bringing about economic progress.
It is the entrepreneur who carries out the innovations and organises the production structure more efficiently. As, according to Schumpeter, innovations occur in spurts rather than in a smooth flow, economic progress is not a smooth and an uninterrupted process. The pace of economic progress is punctuated by the pace of innovations. Prof. Rostow proposed five stages in the development of an economy.
These stages are:
(i) Traditional society;
(ii) Preconditions for takeoff;
(iii) Take-off into self-sustaining growth;
(iv) Drive to maturity and
(iv) Stage of high mass consumption.
It may be noted that the economic transformation of the society from one stage to another involves, along with other things, a change in the level and character of technology. In the present age of greater specialisation it is the technology factor that underlies all major aspects of the modern productive apparatus such as decision making, production programming, skill requirements and market strategy.
Productivity of worker depends upon the quantity and quality of capital tools with which the labourers work. For higher productivity the instruments of production have to be technologically more efficient and superior. The technological options open to an economy determine the input-mix of production. A commodity can be produced by various technologies.
The quantity and quality of capital, skills and other factors required for production is directly dependent on the efficiency of the technique of production being used. Also, the managerial and organisational expertise has to be in tune with the technological requirements of production. Viewed thus, technology in the present stage of economic development is an indispensable factor of production.
This is the age of technology. The developing countries are obsessed by the desire to make rapid progress in technology so as to catch up with the present-day developed countries. Strenuous efforts are being made to use improved technology in agriculture, industries, health, sanitation, education and, in fact, in all walks of human life. Indeed, the newly emerging nations have come to regard technology as a bastion of national autonomy and as a status symbol in the international community.
The process of technological progress is inseparably linked with the process of capital formation. In fact, both go hand in hand. Technological progress is virtually impossible without capital formation. It is because the introduction of superior or more efficient techniques require building up of new capital equipment which incorporates new technology.
In other words, new and superior technology can contribute to national product and its growth if it is first embodied in the new capital equipment. The new capital investment has, therefore, been called the vehicle for the steady introduction of new technology into the economy.
The new inventions and innovations lead to new and more efficient techniques of production and new and better products. As is well known, it is the inventions and innovations in cotton textile industry that led to the industrial revolution in England. In the olden times inventions were the work of some individuals and innovations were introduced into the production process by the private entrepreneurs.
Keeping in view the importance of technological progress in the economic growth of a country, the governments of various countries are spending a lot of money on “research and development” (R & D), which is carried on in various laboratories and institutes to promote technological progress.
Developing countries are using the technology imported from the developed countries because they have not yet made sufficient progress in technology, nor have they developed to adequate extent capital goods industries which produce capital goods, embodying advanced technology.
But imitation and use of the technology of the advanced countries by these under-developed countries has produced one unfavourable result. It is that the technology of the advanced countries is not in accordance with the factor endowments of these developing countries, since they have abundance of capital while the developing countries have surplus labour.
As a result of the use of the capital-intensive technology, enough employment opportunities have not been created by the large-scale industries using imported technology. As a result, unemployment in developing countries like India has been increasing despite the progress in industrialisation of the economy.
In view of this not so happy experience in regard to the creation of employment opportunities by industrial growth, an eminent English economist, Prof. Schumacher has recommended the use of intermediate technology or what is also known as appropriate technology by the developing countries like India.
By Intermediate or appropriate technology is meant the technology which is labour-intensive and yet highly productive so that with its use enough employment opportunities are created along with more production. But in order to find out this appropriate technology for several industries, a good deal of research and development (R & D) activity is required to be carried out.
(iv) The Growth of Population:
The growth of population is another factor which determines the rate of economic growth. The growing population increases the level of output by increasing the number of working population or labour force provided all are absorbed in productive employment.
We saw above that according to estimates of Denison, increase in the quantity of labour contributed to the extent of 32 per cent to economic growth of output in the USA during 1929-1982. Moreover, the increase in population leads to the increase in demand for goods.
Thus, growing population means growing market for goods which facilitates the process of growth. When market for goods is enlarged, they can be produced on a large scale and thus economies of large-scale production can be reaped. The economic history of U.S.A. and European countries shows that population growth contributed greatly to the increase in their national output.
But what has been true of U.S.A. and European countries may not be true in case of the present-day developing countries. Whether or not the growth of population contributes to economic growth depends on the existing size of population; the available supplies of natural and capital resources, and the prevailing technology.
In the United States, where supplies of natural and capital resources are comparatively abundant, the growth in population raises national output by increasing the quantity of labour. In India where supplies of other economic resources especially capital equipment, are relatively scarce, increase in population hinders economic growth instead of promoting it.
Labour is combined with capital to produce goods and services. Therefore, increase in the quantity of labour force will contribute to economic growth when the cooperating factor capital is also increasing. In the modern times workers need machines, tools and factories to work. Since a developing country such as India has a lot of surplus labour but a small stock of capital, the workers cannot be productive if they are employed in some activities.
We thus see that a rapidly growing labour force by itself is no guarantee of economic growth. Increase in national output, that is, economic growth is possible only when the supplies of capital and other resources are increasing adequately along with the growth of labour force. If, on the other hand, when the supplies of capital and the other resources are meagre, the increase in the labour force (or population) will merely add to unemployment and will not bring about increase in national output.
As stated above, economic growth requires increasing supplies of capital goods. Increasing supplies of capital goods become possible only with higher rate of investment. And a higher rate of investment, in turn, is possible if rate of saving is high.
Now, increase in population by adding to number of mouths to be fed tends to raise consumption and, therefore, lowers both saving and investment. Thus rapid growth of population by causing lower rate of saving and investment tends to hold down the rate of economic growth in developing countries. Thus, under conditions like those in India population growth actually impedes economic development rather than facilitates it.
It is worth noting here that changes in total GDP which are used to measure rate of economic growth are not a good measure of economic well-being. For the purpose of evaluating changes in economic well being or living standards of the people of a country GDP per capita is more important for it tells us the amount of goods and services that is available for an individual in the economy.
But how does growth in population or labour force affect GDP per capita? The reason is that rapidly increasing labour forces the economy to spread more thinly the other cooperating factors, especially capital and land. As a result, capital or land per work declines causing decline in productivity of GDP per worker.
Further, rapid population growth nullifies out efforts to raise the living standards of our people. In other words, a high rate of increase in population swallows up a large part of the increase in national income so that per capita income or living standard of the people does not rise much.
This is precisely what has happened during the planning era in India. This while the aggregate national income of India went up by 17.5 per cent in the first plan period and 20 per cent in the second plan period, per capita income rose by only 8 per cent and 9 per cent respectively.
Over the period of the third plan, as against an increase of 11.5 per cent in national income, per capita income improved by only 0.5 per cent. The relatively slow rate of rise in per capita income has been due to rapid population growth. The annual rate of population growth which was no more than 1.86 per cent in the First Plan period went up to 2.15 per cent in the second plan period and further to 2.25 per cent in the third and fourth plans.
Harrod-Domar Growth Equation: Rate of Investment and Capital-Output Ratio as Determinants of Growth:
We have analysed above the various factors such as availability of natural resources, rate of saving and capital formation, foreign capital, technological progress, increase in population which determine economic growth in a country.
These determinants of economic growth affect (1) the rate of investment and (2) captia-output ratio. Therefore, the rate of economic growth, that is, increase in GNP depends upon the rate of investment and capital-output ratio. This fact is brought out by the growth models of Harrod and Domar.
According to Harrod-Domar growth models rate of economic growth is given by the following formula:
Where g stands for rate of growth (i.e., rate of increase in GNP)
I stands for rate of investment, and
v for capital-output ratio
The above equation can also be expressed in the following form
Rate of Growth = Rate of Investment/Capital – output Ratio
If in an economy rate of investment is 30% of national income and capital-output ratio is equal to 4, then from the above formula, we can find out the rate of economic growth.
Rate of Growth = 30/4 = 7.5
Therefore, the rate of increase in GNP of national income will be 7.5 per cent per annum.
In the Tenth Five Year Plan (2002-07) it has been planned that the rate of investment will rise to 28 per cent of national income. Besides, through increase in efficiency capital-output ratio has been estimated to decline to 3.5.
With 28 per cent of national income as rate of investment and 3.5 as capital- output ratio, target rate of growth during the Tenth Plan period has therefore been fixed at 8 per cent per annum (Applying Harrod-Domar growth equation, namely, (g = 1/v = 28/3.5 = 8% ). The experience of the last four years shows that both these targets of average rate of investment of 28 per cent per annum during the 10th plan period and 3.5 as capital-output ratio will be achieved.
As a matter of fact, on the basis of this Harrod-Domar growth model, it was suggested by several economists that in order to achieve a higher rate of growth, the developing countries should get foreign aid and foreign direct Investment to supplement their domestic savings to raise the rate of investment to the desired level.
In follows from above that in addition to rate of investment capital-output ratio is an important factor that determines rate of economic growth in the country. Give the rate of investment, the lower the capital-output ratio the higher the rate of economic growth. Therefore, the study of capital-output ratio at some length is called for.