Community Economics: Growth Theory

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Community Economics Growth Theory

• One of the fundamental questions that economists
  struggle with deals directly with the causes of
  economic growth.
• Why does one economy grow while another struggles
  and may actually decline?
• Will economies tend to move together growing in
  such a way that poor regions will catch up to
  rich regions, or will poor regions always lag
  behind?
• What forces are behind economic growth and can
  policy be crafted in such a way as to influence
  growth patterns in a way that is more acceptable
  to the desires of society?

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Community Economics Growth Theory
While economic theory can provide insights into
these fundamental questions, more often than not
more questions are raised than answered. Ideas
and concepts that were accepted as truth thirty
years ago are now questioned. Insights into
these basic questions are fundamental to
community economic analysis because the level of
economic growth sets the tone for nearly all
discussions within the community. Equally
important is an understanding of the factors that
affect growth that are beyond the influence of
the community and those factors that local
residents can influence.
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Community Economics Growth Theory
Economic growth is associated with more jobs,
more income and more business profit.
Development captures notions of economic
opportunities, equality and quality of life in
the most extensive sense. Some would argue,
however, that economic growth is necessary for
development to occur. In one sense development
speaks to how economic growth is allocated across
economic agents. Without a dynamic growing
economy it is difficult to consider issues
related to development.
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Community Economics Growth Theory

• The growth literature can be broken into two
  general approaches
• deductive which is heavily focused on theoretical
  modeling and attempts to establish paradigms that
  predict how the economy grows and
• inductive which tends to focus on empirical
  observation from which insights on the growth
  process is explained.
• Our development of market efficiency embodied in
  Pareto optimality (or the foundations of Adam
  Smiths Invisible Hand) is a deductive approach
  to economic theory.

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Community Economics Growth Theory
Over the past 50 years economic growth theory has
moved through four periods of thinking.
Progression from one period to the next reflects
not only our ability to think about the growth
process more completely and in more realistic
ways, but also the changing economy itself.
The historical context begins with the
Rostow-Kuznets stages of growth in which capital
accumulation plays an important role of the
1950s and early 1960s. Concerns about unique
differences and the linkage between rural and
urban areas lead to the structural change models
of the 1960s.
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Community Economics Growth Theory
Extensions of these theories lead to the
Harrod-Domar model and the more fully developed
neoclassical theories which dominated much of the
thinking on economic growth during the 1960s and
1970s. Today, the focus of attention is on
lifting the assumption of perfect competition and
the ensuing theories of endogenous growth. Not
withstanding the fundamental differences between
inductive and deductive approaches, one could
argue that each of these theories is a natural
progression from the previous.
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Community Economics Growth Theory

Rostow-Kuznets stages of growth
Rostow suggested that economies progress through
five stages of growth the traditional society,
establishing the preconditions for take-off, the
take-off itself, the drive to maturity and
finally the age of high mass-consumption.
Kuznets offered his variation on Rostows stages
of growth theory as a potential explanation and
proposed that an economy moves from a primary
stage where the economy is described as
subsistence agriculture the secondary stage is
where the economy grows into a manufacturing
based economy and the tertiary stage that is a
service-based economy.
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Community Economics Growth Theory

Rostow-Kuznets stages of growth
ideas of comparative advantage specialization
need for trade demand for specialized inputs
economies of scale reinforces specialization
labor and capital productivity
higher levels of income Engles Law consumers
pattern of spending changes as income
increases markets for consumer goods begin and
expand as income increases
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Community Economics Growth Theory

Rostow-Kuznets stages of growth
Engles Law As income increases the percentage
of total income spent on food declines.
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Community Economics Growth Theory

Rostow-Kuznets stages of growth
In the short-term there are winners and losers as
the economy makes these transitions. Farmers who
were unable to take advantages of specialization,
economies of scale and new technologies lagged
behind. As new technologies make old
technologies obsolete the firms involved with the
old technologies lagged behind and in many cases
went bankrupt. This process is known as
Schumpeters creative destruction where new ideas
and technologies push out and destroy old ideas
and technologies.
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Community Economics Growth Theory

Rostow-Kuznets stages of growth
While the community economic developer is often
worried about the winners and losers of these
continuous shifts in the economy, they must keep
in mind the larger picture. In the long-term the
whole of the economy is lifted to a higher level
of wealth and social well-being. The challenge
to the community economic developer is to
position the community to minimize the hurt
associated with the losers and maximize the gain
of the winners. According to Kuznets, all
economic agents will win in the long-term.
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Community Economics Growth Theory
Notions of Income Convergence and Divergence

Gini Coefficient a/ß Gini ? 0 implied
convergence Gini ? 1 implies divergence
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Community Economics Growth Theory
Notions of Income Convergence and Divergence

Rostow-Kuznets stages of growth
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Community Economics Growth Theory
Notions of Income Convergence and Divergence

Rostow-Kuznets stages of growth
Regional Convergence Patterns
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Community Economics Growth Theory
Rostow-Kuznets stages of growth

Critique of the stages of development
theories First, the stages theory is inductive
trying to draw inferences from historical data.
A second criticism of the stages of development
theory is that many economies jump stages. A
third and perhaps more fundamental problem with
the linear stages of development approach to
growth theory relates to its prediction on income
convergence.
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Community Economics Growth Theory
Neoclassical Growth Models

Solow (1956) and Swan (1956) break from previous
discussions of growth theory and offer a
completely new approach. They hypothesize that
the economy can be represented by a traditional
production function where output (Y) is a
function of technology (A), labor (L) and capital
(K) Yf(A,L,K). Output is defined as income
in this theory of economic growth.
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Community Economics Growth Theory
Neoclassical Growth Models

Given perfectly competitive markets, constant
returns to scale and a closed economy,
specifically no international trade, a unified
and useful theory of economic growth can be laid
out. What drives growth in this simple theory is
growth in the available supply of labor and
investment in capital and technology. Because we
are concerned with growth of the economy over
time we need to think about what the economy
looks like at a given date t. So the supply of
labor at time t is expressed as L(t), real
production or income is Y(t), the index of
technology is A(t) and K(t) is the stock of
capital at time t.
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Community Economics Growth Theory
Neoclassical Growth Models

We assume that there is an exogenous and given
rate of growth of labor and can be expressed as
L(t)ent. Labor grows at an exponential rate n.
We also assume that technology growth is
exogenous and follows a similar growth pattern as
labor, or A(t)egt with growth rate g. Real
production Y(t) is given by Y(t) f(A(t)egt,
L(t)ent, K(t))
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Community Economics Growth Theory
Neoclassical Growth Models

To further simplify the model we can speak in
terms of technology-augmented labor,
specifically, effective labor AtLt. Here
technology affects labor productivity but not
capital. We can further simplify the model again
if we speak in terms of per capita, or effective
labor augmented form y is defined as Y/AL and k
is defined as K/AL. Because the supply of labor
and the level of technology is exogenous, or
determined outside the model, we want to focus
our attention on capital.
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Community Economics Growth Theory
Neoclassical Growth Models

The production function, assuming a Cobb-Douglas
form, can be expressed as Y(t)
K(t)a(A(t)L(t))1-a or y(t) k(t)a in per
capita or intensive form and a is a production
parameter ranging between zero and one. In a
simple accounting framework a is the share of
total income that accrues to capital.
Conversely, 1- a is the share of income that
accrues to labor.
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Community Economics Growth Theory
Neoclassical Growth Models

Economic growth in this stylized model reduces to
growth in capital, which can be expressed
as ?K(t) sY(t) dK(t) Or ?k(t) sy(t)
dk(t) where ?K(t) is the change in the stock
of capital over time and s and d are savings and
depreciation rates, respectively. If aggregate
savings are greater than depreciation, the stock
of capital will grow and the economy will grow.
If savings falls below depreciation the stock of
capital declines and the economy will shrink.
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Community Economics Growth Theory
Neoclassical Growth Models

Substituting equations and given our exogenous
growth of labor and technology, yields ?k(t)
s k(t)a (n g d) k(t). What we have
here is what economists call a differential
equation with five parameters (s,a,n,g,d) and is
the fundamental equation to the neoclassical
model of growth. Capital accumulation is
fundamental to the growth process since
technology and labor force growth are exogenous.
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Community Economics Growth Theory
Neoclassical Growth Models

The question that we now face is if the economy
will reach a point where growth is stable or in a
steady state in which some level of k(t) is
achieved such that ?k(t) 0. Essentially the
economy has reached a point where it is no longer
adding to its stock of capital above depreciation
replacement. The economy has matured and is no
longer growing. Whether or not the model
converges to a steady state is important in that
if it does not converge the model is explosive
and the economy spins out of control. Models
that do not converge to a steady state are
sometimes referred to as a knife-edge model in
that small deviations away from the equilibrium
(the edge of the knife) cause the economy to fall
off the edge of the knife.
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Community Economics Growth Theory
Neoclassical Growth Models

Using mathematics called first-order differential
equations one can show that a steady state can be
achieved at the level k(t) s/(n g
d)1/(1-a) where k(t) denotes the steady state
level itself.
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Community Economics Growth Theory
Neoclassical Growth Models

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Community Economics Growth Theory
Neoclassical Growth Models

Now lets introduce space. Y(t) K(t)aL(t)1-a
Change in capital is ?K(t) sY(t) dK(t)
NKM(t) Where NKM(t) is net capital movement,
or NKM(t) ?(r rA)K(t) r gt rA ?
NKM(t) gt 0 r lt rA ? NKM(t) lt 0
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Community Economics Growth Theory
Neoclassical Growth Models

The regional change in labor can be expressed
as L(t) L(t)ent M(t) where M(t) is net
migration and L(t)ent is again the natural change
in labor and can be expressed as M(t) ?(w
wA)L w lt wA ? M(t) lt 0 w gt wA ?
M(t) gt 0 .
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Community Economics Growth Theory
Neoclassical Growth Models

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Community Economics Growth Theory
Neoclassical Growth Models

• Conclusions of the neoclassical model
• Predicts CONVERGENCE
• Is based on traditionally accepted assumptions
  about the behavior of forms and individuals
• Is deductive in its approach
• Strong policy implicationsAdam Smiths Invisible
  Hand worksand it predicts equality. Hence, a
  policy of laissez faire should be followed

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Community Economics Growth Theory
Neoclassical Growth Models

Problems of the neoclassical model The one
thing that dogged the neoclassical model was its
treatment of changes in technology. Economic
historians are keen to point out that changes in
technology drive economic growth. But what causes
these jumps in technology that have significant
impacts on the growth prospects of the economy?
The neoclassical model does not help us come to
an answer to this question or provide us with any
understanding of the processes at work.
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Community Economics Growth Theory
Neoclassical Growth Models

Problems of the neoclassical model A second
problem with the neoclassical model has emerged
over the past few decades. This is, the
empirical evidence for income convergence has
weakened significantly and there is strong
evidence that incomes are diverging the rich are
getting richer and the poor are getting poorer
A third critique of the model centers on the
strong assumptions upon which the model is based
perfect competition, constant returns to scale
and no externalities. While these are common,
simplifying assumptions in our stylized models,
attempts to make the neoclassical model more
general by lifting these assumptions have proven
difficult.
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Community Economics Growth Theory
Endogenous Growth Models

Kaldor was the first to challenge the earlier
work of Solow and Swan along several fronts.
Kaldor questioned the convergence conclusion of
the neoclassical model. If convergence is the
only possible outcome of economic growth, why is
there evidence of divergence? Kaldor also
challenged the laissez faire policy implications
of the neoclassical model. Kaldor was a British
economist writing during the post-WWII period of
reconstruction. The British economy was
struggling and not experiencing the growth of
Europe or Japan and there was significant
political pressure for the government to do
something. If the neoclassical model was indeed
correct, there is no real role for government.
Not a politically acceptable answer. But
Kaldors main thrust of attack came in the role
of constant returns to scale and diminishing
marginal returns.
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Community Economics Growth Theory
Endogenous Growth Models

Kaldor maintained that the economy, primarily
manufacturing, exhibited increasing returns to
scale and once a region was able to gain a
comparative advantage and capture economies of
scale, the growth process would be cumulative, a
process that Mydral (1957) described as circular
and cumulative causation effect. Kaldor, however,
was unable to present a stylized model (i.e.
deductive) theory and his arguments were never
widely accepted. Besides, all the empirical
evidence at the time was pointing to convergence,
something the neoclassical model predicted.
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Community Economics Growth Theory
Endogenous Growth Models

The forces of economies of scale that Kaldor
advanced are what regional economists call
agglomeration economies. Internal to the
firm or internal economies External to the
market or area or external economies
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Community Economics Growth Theory
Endogenous Growth Models

In discussing the frustration of regional
economists and the followers of Kaldor Krugman
(1995) quotes a sarcastic physicist who made the
comment so what you are saying is firms
agglomerate because of agglomeration effects.
The implications of dynamic scale economies or
agglomeration economies on the economy are clear
but the forces at work that drive or cause
agglomeration economies remained bit of a black
box.
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Community Economics Growth Theory
Endogenous Growth Models

The work of Romer (1986 1987) and Lucas (1988),
however, radically changed how economist thought
about the growth process and the underlying
factors causing growth. Following a trend in
economic theory they lifted the assumption of
perfect competition which had already occurred in
the industrial organization and international
trade literatures, Romer asked what would happen
if we abandoned the neoclassical model and
started with a clean slate in which the economy
is not held to perfect competition.
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Community Economics Growth Theory
Endogenous Growth Models

Romer suggested an economy that had the following
characteristics There are many firms in a
market economy. Discoveries of new ideas
differ from other inputs in the sense that many
people can use them at the same time. In other
words, ideas are public goods (see Chapters 9 and
10 for a detailed discussion of public goods).
It is possible to replicate physical activities.
If one firm can produce a good or service in a
certain way there is nothing preventing another
firm from replicating the first firm.
Technology advances from things people do.
Technological advances do not fall from heaven as
in the neoclassical model. Many individuals and
firms have market powers and earn monopoly rents
on discoveries.
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Community Economics Growth Theory
Endogenous Growth Models

The last characteristic is the linchpin of the
Romer view of the world. Earning monopoly rents
on discoveries cannot occur in a perfectly
competitive economy, but it is the striving to
capture these rents that spur economic growth.
How does this process play out? (Technological
advances do not fall from heaven as in the
neoclassical model. Many individuals and firms
have market powers and earn monopoly rents on
discoveries.)
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Community Economics Growth Theory
Endogenous Growth Models

Grossman Helpman (1994) point to the key
idea that profit seeking investments in knowledge
play a critical role in long-term growth.
Investment in knowledge has two components. The
first is investment in human capital through
education. The second is investment in research
and development of new products and technologies
in an attempt to capture monopoly rents on those
discoveries. The latter leads us to endogenous
technological progress or endogenous growth.
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Community Economics Growth Theory
Endogenous Growth Models

Put another way, if research and development
of new products and technologies are fundamental
to the growth process, why would firms or people
invest in research and development? The key is
short-term monopoly rents that can be gained on
the new technology.
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Community Economics Growth Theory
Endogenous Growth Models

There is an important distinction here to be made
between ideas and products or technologies. An
idea or way of thinking about a problem generally
cannot be patented. If a business reorganizes
itself to gain internal synergies that firm
cannot prevent a competitor for following its
lead. Ideas and knowledge are embodied in people
who are mobile and can move from one firm to
another taking their knowledge with them. Trade
secrets or the way a particular firm goes about
its business, cannot be patented and is at times
fiercely protected by firms. Innovations, or new
ways to do old things, are almost immediately
part of the public domain. Products and
technologies, on the other hand, are tangible
things that can be patented and protected from
competitors.
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Community Economics Growth Theory
Spatial implications of endogenous growth

Krugman explicitly incorporated space into the
new endogenous growth theory by asking a basic
question what are the economic forces at play
that result in the creation of megalopolises such
as New York City and Tokyo? He suggested that
many of the notions common to regional and urban
economics could be reconsidered in the new light
of endogenous growth theory. Krugman maintains
that without the new endogenous growth theory
there is no mechanism that moves the economy
beyond a series of smaller rural hamlets. The
agglomeration forces that drive rural hamlets to
become cities are assumed in prior theories.
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Community Economics Growth Theory
Spatial implications of endogenous growth

Centrifugal and centripetal forces in a spatial
world allows for a better understanding of a
system of places. Centripetal forces create
urban centers and describe the economic forces
that pull economic activity together. Krugman
offers three broad types of centripetal forces
including market-size external economies, natural
site advantages and pure external economies.
Centrifugal forces force or spread economic
activity away from the urban center. Krugman
again offers three broad types of centrifugal
forces dispersed natural resources,
market-mediated forces and non-market forces.
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Community Economics Growth Theory
Spatial implications of endogenous growth

Drawing on the ideas of the new endogenous growth
theory Krugman is keen to make a sharp
distinction between natural advantages and
acquired advantages that are self-reinforcing
through the market processes. He also makes a
distinction between technological (non-market)
and pecuniary (market) externalities. The
behavioral forces are that we allow monopoly
profits and these are increased via agglomeration
economies. Firms locating within the same
general area create the agglomeration economies.
In the same logic as Romer, these agglomeration
economies appear as the scale of firms increase
and they become self-reinforcing as more firms
tend to locate together.
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Community Economics Growth Theory
Spatial implications of endogenous growth

The inevitable results of Krugmans stylized
model are that economic activities tend to
cluster within the same location. If the economy
begins with a random scattering of hamlets,
centripetal forces will result in economic growth
being clustered in a small number of cities.
These cities, once they gain a growth advantage
will maintain that growth advantage until
centrifugal forces begin to come into play. The
implication of the Krugman model of this system
of cities on smaller communities is not pleasant.
In essences, the forces of economies of scale
play to the favor of large places many times at
the expense of smaller places.
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Community Economics Growth Theory
Policy implications and conclusions

It is important to remember that most of this
theory has a limited direct application to
community economic development because it is
macro in scope and conceptual. This discussion
sets the context for much of what we try to do in
communities. Much of the theoretical discussions
have tended to focus on developing economies and
the process of how an economy progresses from a
simplistic to a mature advanced economy. These
theories do provide insights into the growth
process when viewed from the local perspective.
What drives overall growth sets the tone of
discussion at the local level.
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Community Economics Growth Theory
Policy implications and conclusions

What we have learned from these theories and
their implications is significant. First and
foremost are the common themes that run through
all of these theories of economic growth.
Clearly defined institutional rules, perhaps the
most important of which are property rights, are
necessary for economic growth. Comparative
advantage is a key concept and a focus of
community economic development hinges on
identifying and acting on a communitys
comparative advantage. The visions of a
community must be realistically in line with the
communitys comparative advantage. Technological
progress including human capital is an important
engine of economic growth.