Richard Melson

August  2005




What does economic theory have to say about the growth prospects of the underdeveloped world? We start with this region first, not because we are examining the world's regions in order of demographic size, but because, there is, at this point, a greater body of theoretical and empirical research about Third World development.

To begin with, some brief comments on the various branches of economic theory. The first is classical economics. The major classical economists were Adam Smith (1723-1790), David Ricardo (1772-1823) and Karl Marx (1818-1883).

One of the problems addressed by classical economics was the question of what caused a commodity to be valuable (i.e. to command a high price). It couldn't simply be how useful the commodity is. After all, water is very useful, but has a very low price, whereas diamonds are far less useful, but have a very high price. This was the famous "diamond-water paradox" of Adam Smith. The answer given by classical economists was that the value,(cost price. essential price, or price of production) of a produced good or commodity must,in some sense, be a numerical measure of the amount of effort involved in obtaining or producing the good.

The classical economists assumed that each commodity must have a natural or essential price, which was determined by the ease or difficulty of producing it, and around which the market price would fluctuate as, supply and demand conditions changed. For example, in a hypothetical primitive economy, in which everybody obtained or produced their own goods, the value of a good should be the number of hours required to obtain or produce it. If it took one hour to hunt a deer and two hours to hunt a bear, than one bear should be worth twice as much as one deer, and two dears should exchange for one bear in the market. If the exchange, were less than that, then people who wanted bears, would find that it took less effort to hunt deer, and exchange them for bears, than to hunt bears. The supply of deer would increase and the supply of bear would drop until the two-for-one deer for bear exchange rate obtained.

Of course, the classical economists were aware that, in a more advanced economy, where the production of goods required intermediate products, hired labor, tools and instruments of production, which themselves had to be produced, different amounts of time to completion, etc., goods would not, in general, exchange with each other according to the amount of labor time embedded in each.

None the less, the classical economists felt that the essential value, if not price, of a good should, in some sense, be its labor-time equivalent. Smith maintained that the value of a good should be the number of hours somebody would be willing to work to obtain the good, (the amount of labor time commanded by the good.) Ricardo sought to measure the labor-time equivalent of a particular good by determining how much of a good, that required only labor to produce, the good in question would exchange for. Marx specified the labor time embodied in a particular good as the amount of labor required to produce that good, including the amount of labor required to produce all intermediate inputs to that good, together with the amount of labor required to produce all the inputs to the inputs, and so on, ad infinitum.

The classical economists sought to determine the laws by which the total amount of values produced per year, (the total economic output), was distributed among the three main social classes of the time, (land owners, laborers and capital-owners). They also sought to determine the laws by which the values of goods were transformed into prices of production. Marx claimed to have found a solution to these two problems, but his solutions were shown to be mathematically flawed by the Austrian economist Eugene Von Boehm-Bawerk. In short, the classical economists never really succeeded in adequately defining their concepts of value and natural price.

More recently, a group of economists known as neo-Ricardians (Piero Sraffa, Ian Steedman, Michio Morishima), using a branch of mathematics known as matrix algebra, have again returned to the problem of calculating prices of production independent of market prices and monetary measures. Also, there have been attempts to develop an energy theory of value in order to calculate, independently of the future energy prices,the rate of return on investments in alternative energy sources.(M. Slesser (1989), and N. Georgescu-Roegen (1972)).

To summarize, the classical economists, investigated the concept of natural price, divided consumers into social classes, (land-owners, capital-owners and laborers), and divided industries into branches,(i.e. agriculture and manufacturing, or capital goods and consumer goods). Natural prices were calculated by assuming that the rate of return to capital invested was equalized among the various branches of industry.

The neoclassical economists (Leon Walras (1834-1910), Stanley Jevons (1835-1882), Vilfredo Pareto (1848-1923)) took an entirely different approach to economic research. They maintained that rapid technological change made the concept of natural price or value meaningless. They also maintained that society was changing too rapidly to be divided into social classes. The method used by the neo-classical economists was to examine an economy at its maximum level of detail (maximum disaggregation). That is, they tended to view an economy as consisting of an enormous number of individual commodities, individual consumers and individual producers (firms). This is called an atomistic way of looking at an economy. The feeling was that economics can only deal scientifically with individual agents, whether consumers or producers, that it was very difficult to speak scientifically about economic aggregates.

On the face of it, it would seem that this approach converts a difficult problem into an impossible one. After all, how, can one analyze the behavior of millions of individual consumers, workers and producers? Only, it turns out, by making a number of drastic simplifying assumptions about such behavior. The most important of these assumptions, is the assumption that this behavior is describable mathematically.

To explain this, let's examine the most important doctrine of neoclassical economics, the so-called theory of general multimarket equilibrium. This theory, due to Leon Walras, was essentially an approach to determining relative prices. It maintained that if some "all knowing being" possessed enough knowledge about:

- all the types of commodities used for consumption or production (including land and labor);

- the preferences, material desires and material assets of each of the consumers;

- the methods and technologies of production of each of the producers (firms),

this knowledge would suffice to determine the relative prices of each of the commodities, assuming (among other things) that the economy was in a state of perfect competition. The relative prices so determined would be such that the market for every commodity "cleared". What do we mean by "perfect competition"? We mean that no one individual consumer or producer is large enough to have more than a vanishingly small effect on market prices. What do we mean when we say "the market for every commodity clears"? We mean that there is a set of relative prices such that:

- every consumer or producer who wants and is able to afford to buy a good can find a seller of that good;

- every consumer or producer who wants to and, has, or is able to make a particular good to sell can find a buyer for that good.

Furthermore, the theory of general equilibrium, maintains that perfect competition will bring about exactly the set of relative prices that would be calculated above by the "all knowing being". In other words, perfect competition is an "all-knowing being" who is able to perfectly allocate goods among individuals with no shortages or wastage.

To most of the economists of the time, to prove such an assertion seemed like an insanely ambitious task. Yet Leon Walras gave very convincing arguments that it could be done. A. Wald (1936) and K. Arrow and G. Debreu (1954) gave rigorous mathematical proofs of much of Walras's general equilibrium theory. Walras suggested that equilibrium prices are reached by a process known as tatonnement or "groping", suggested by his observations of the Paris stock exchange. In the process of tatonnement, there is a sort of "market machine" which coordinates all production and exchange. This "market machine" operates as follows: It begins by posting a list of prices for each commodity. It then asks each producer how much of each commodity the producer would be willing to produce at those prices, and how much of each commodity (including labor) the producer would need in order to carry out the production. It then asks each consumer how much of each commodity (including labor) the consumer would want to purchase (or sell) at those prices. If there is a shortage of any commodity, the "market machine" raises the price. If there is a surplus of any commodity, the "market machine" lowers the price. After this is done, all the producers and consumers are polled again. This process is continued until a list of prices is found, such that (1) all commodities produced at those prices will find a buyer, and (2) every consumer's and every producer's buying plans at those prices are realizable. In other words, all the bargaining takes place before any physical production or exchange takes place. While this might be a realistic description of an auction, say, it is obviously not a realistic description of most actual markets. The actual process by which "equilibrium prices" are reached in actual markets is extremely difficult to analyze mathematically, and is an object of continuing research (and acrimonious controversy). (See F. M. Fisher, 1989.)

Leaving such difficulties to one side, let's give a little more detail about Walras' general equilibrium theory as described above. How does one go about measuring a particular consumer's "preferences"? Sometimes this is done by means of a utility function which gives a numerical measure of the amount of "satisfaction" a consumer would derive from the consumption of any particular combination of commodities. Sometimes by a concept known as ranked preferences which ranks the various commodities in the order in which they are preferred, and sometimes by a more involved concept known as revealed preferences. How does one go about describing the "technologies of production" of a particular producer? This can be done by a mathematical concept known as a production function or by a mathematical concept known as a production possibility set. How does one describe the various assets owned by a particular consumer before the trading and producing takes place? This is done by describing the amount of each commodity initially possessed by the consumer, including his or her ability to provide labor services, and his or her ownership shares in each of the producers (firms). Having done this, how does one predict the behavior of each of the consumers and each of the producers? How is one able to tell what kinds of exchanges and what kinds of production will take place? This is done by assuming that each consumer will strive to maximize his or her utility and that each producer will strive to maximize its profit. The actual mathematics of Walras's general equilibrium theory is far beyond the scope of this book. It involves the solution of a very, very large number of "simultaneous equations" A description of the proof requiring college calculus can be found in Henderson and Quandt (1986) and a detailed proof can be found in Arrow and Debreu (1954).

With Keynesian economics, (John Maynard Keynes, 1883-1946) the emphasis shifts back to the study of large economic aggregates (total economic output, total consumption, etc.) Such a study was not an issue in neoclassical economics, where it was simply assumed that competitive pressures would force the economy to make the most efficient use of the resources and techniques available to it. If there was unemployment, for example, wages would drop until all labor was employed. Simultaneously, output would rise as the additional labor was put to use. The additional output, for its part, would be consumed by the larger work force, and what was not consumed would be invested.

However, in the 1930's, many of the world's economies were clearly operating below capacity amid widespread unemployment. Thus, Keynes was confronted with the problem of explaining an economic decline occurring amid gluts rather than shortages. Furthermore, the economic failure was "system-wide" rather than confined to any particular sector. Therefore, Keynes needed to study the behavior of large, economy-wide aggregates. But how are such aggregates to be measured? In classical economics, the answer was (deceptively) simple. The value of any good, or any agglomeration of goods, no matter how large, was simply the number of labor hours needed to produce it. In modern macroeconomics, however, the measurement of economic aggregates is an extremely complicated issue. In general, economic aggregates have two measures, a nominal measure (the total monetary value) and a real measure (which is actually less "real" than the monetary measure, consisting of the monetary value "adjusted for changes in the general price level"). Hence, it can be immediately seen that modern macroeconomics has a lot of complexities which weren't present in classical or neoclassical economics. In fact, modern macroeconomics is an enormous field. It addresses such areas as the collection, evaluation and aggregation of economic data (national accounts), the modeling of the economy, economic forecasting, policy advice to governments, the formulation of economic theories to explain changes in the economy, and the formulation of statistical methods to test the conclusions of these theories.

There are very few people who don't have some idea of "what Keynes said". In fact, there such a large number of popular books on this topic, that there is no need for us to dwell on it here. The question we address here is: "what theoretical techniques did Keynes use, and in what way did these theoretical techniques differ from the techniques of neoclassical economics?". For those who have a background in college calculus, A. Stevenson et. al. (1988:1-56) gives a very clear summary of this topic. The version of Keynesian theory it presents is known as the Hicks-Hansen IS-LM model. The IS-LM model is a simple general equilibrium model which is similar in, some ways, to the general equilibrium models of neoclassical economics. However, unlike neoclassical equilibrium models, it does not rely exclusively on consumer preferences and production technologies. It consists of a small group of simple equations which express the interrelationships between the following variables (known as macroeconomic variables); the money supply (M), the general price level (P), the wage rate (W), total employment (N), the real interest rate (r) and real economic output (y). For example, one such equation would be:

y = e(y,r);

where e(y,r) is real expenditure (demand) as a function of y and r.

Another equation would be:

M/P = l(y,r);

where M/P is the supply of "real purchasing power" (real balances) and l(y,r) is the demand for it.

In some cases, it can be shown that the function l(y.r) can have a shape which makes it impossible for markets to clear. In other cases, the function e(y,r) can have a shape which likewise make it impossible for markets to clear. Thus, one can use the IS-LM model to construct plausible systems of economic equations which have no realistic market clearing solutions. This gives one the "theoretical permission", as it were, to drop the assumption of market clearing for the labor market, assume unemployment, and vary the parameters e, M and P in order to observe the effect of these variations on employment (N) and real output (y). Out of this kind of analysis comes the "Keynesian multiplier", "the liquidity trap", "the Keynes effect", etc., and all of the other Keynesian terminology which you may or may not be familiar with. A more detailed explanation of the IS-LM model is given in the notes.

One of the purposes of modern Keynesian macroeconomics is to study statistical and historical economic data to search for economic structure. Economic structure consists of mathematical relationships between economic aggregates which persist over a long period of time.

An econometric forecasting model consists of a great many equations expressing structural relationships between economic aggregates. These equations are derived by means of statistical analysis of historical economic data, as well as by economic theory. Econometric models are used to predict future economic activity. They are also used to analyze and forecast the future ffects of proposed changes in government economic policies; i.e. to push economic reasoning "beyond historical experiences". (L. R. Klein and R. M. Young 1980:9) It was Professor Lawrence Klein who pioneered the construction and application of large-scale econometric forecasting models.

In the early 1970's, the economist Robert Lucas developed a very significant critique of Keynesian econometrics. This critique was called the Lucas critique.

Briefly stated, the Lucas critique maintained that there were severe limitations on the use of structural relationships between macroeconomic aggregates, either in economic policy making or economic forecasting. This is because a change in government economic policy would be observed by consumers and producers who would adjust their economic behavior in response, and structural relationships which held prior to the policy change, would no longer hold after it.

The Lucas critique means that economic theory must take into account the way in which consumers, workers and producers change their economic behavior in response to changes in government economic policies. It is now necessary to describe how consumers and producers develop forecasts of future economic conditions in response to changes in government economic policies. This study is known as the theory of rational expectations or the new classical economics. In this branch of economics, prices are not just a means of allocating resources. They are also a source of economic information about the current and future state of the economy as a whole. Consumers and producers, when confronted with a price change, face a problem of "signal extraction"; they have to decide how much of this price rise is due to inflation and how much to a change in the demand or supply of the product they are making (buying). Consumers and producers make "random errors" when doing this (according to rational expectations theory) but not systematic errors, because systematic errors would eventually be noticed and compensated for.

Rational expectations economics is a sort of "souped up" version of neoclassical general equilibrium theory. It assumes that (1) markets clear very, very rapidly at all times, (2) consumers and producers maximize their expected economic benefit, and (3) consumers and producers make decisions based on forecasts which have random errors but no systematic biases. Cycles in real wages, employment levels and real business activity are explained by means of forecast errors ("signal extraction problems"), changes in consumer preferences and changes in production technologies. Unlike Keynesian economics, rational expectations economics is pessimistic about the ability of government to manipulate the economy in a beneficial way.

In recent years, an enormous amount of empirical research has been devoted to testing the predictions of rational expectations economics. There have also been extensive searches for testable predictions of rational expectations which differ from the predictions of alternative theories. Elaborate statistical studies have been made to determine when, and to what extent, the Lucas critique of Keynesian econonometric models applies in practise.

The above summary is by no means a complete survey of the various brands of economics. Nor is the chapter to come a complete survey of development economics (which is why it's entitled "a digression on" rather than "a survey of"). For a layman's survey of the various branches of economics, we recommend Economic Theory in Retrospect by Mark Blaug (1978).

Now we are ready to address the following question: "What do the various branches of economics have to say about the prospects for Third World development?

In fact, the answer to that question is not at all obvious, since none of these branches of economics was actually formulated with Third World development in mind. Classical economics was formulated to explain the development of the first "underdeveloped" country to develop, namely England. It wasn't designed to describe development in a world market dominated by already developed countries. Keynesian economics was designed to explain the development of a mid-20th century developed country whose economic output was constrained a lack of demand, rather than by lack of supply. It wasn't designed to describe a Third World economy suffering from supply and capital shortages.

When it comes to describing Third World development, neoclassical economics certainly has the advantage. This is because the "laws" of neoclassical economics, like the laws of physics, are presumed to be the same in one area of the world as in another, and should, therefore, be able to explain economic behavior in one area of the world as well (or as badly) as in another. After all, (according to neoclassical economics) what's so special about a developing country? Isn't every country "a developing country"? Isn't every country undergoing rapid structural transformation?

And the answer, of course, is "yes, rapid structural change has been pervasive in the world economy in recent years". Indeed, this is one of the reasons why neoclassical methods have come into vogue, since the 70's, both in the developed and developing worlds. (See R. Takachi, 1993) In times of rapid and pervasive structural change, the tendency (for better or worse) is to "go back to the fundamentals", back to the "equations of motion" of individual "economic agents", where firms maximize profit and consumer maximize "utility".

As for the other branches of economics, their perspective is that a country is "developing" until it "develops", after which it is "developed". Once it "develops" then it can be described by "economics". But, until it develops (if ever), then it must be described by "development economics". "Development economics" is economics "customized", in various ways for the particular problems faced by a "developing country".

So, rather than concentrating on branches of economic theory, let's concentrate on what D. Hunt (1989) calls paradigms of Third World development. Some of these paradigms, such as structuralism and dependency theory, are rather pessimistic about the prospects for Third World development. Others, such as the neo-Marxian paradigm, are very pessimistic about the prospects for Third World development. Still others, such as the neoclassical paradigm, are optimistic. The neo-Marxian paradigm depends on the labor theory of value ala classical economics. Structuralism and dependency theory are Keynesian in orientation, and the neoclassical paradigm is obviously neoclassical in orientation.

Let's start with the most pessimistic paradigm first. We do this by using an example incorporating the labor theory of value. Now the great majority of modern day economists regard the labor theory of value as an anachronism. Expressed in its mathematically correct version, the labor theory of value is a labyrinthine tangle of matrix algebra and, in its classical form, it is mathematically incorrect! However, in its classical form, the labor theory of value does have the advantage that it yields simple examples that can be presented using arithmetic only.

To examine such an example, suppose that there is a completely self-sufficient (closed) economy that has, over its history, accumulated 140 labor units of capital stock, (where each labor unit is a very large number of labor hours). Suppose that the useful life of this capital stock is seven years. Using straight line depreciation, all firms in the economy, put together, incur a capital depreciation cost of 20 labor units yearly. Suppose, furthermore, that, in addition to the 20 labor units of capital used up annually in production, 40 units of labor must be applied to produce the economy's annual product. The total 'value' of the economy's annual output is then 40 + 20 which is 60 labor units. Suppose that total wages paid to all the laborers is the equivalent of 12 labor units of goods. Thus, the total wage cost incurred annually by all firms in the economy is 12 labor units, Hence, the total "cost of production", in labor units, is depreciation cost plus labor cost, or 20 + 12, which is 32 labor units. Since the total value of annual output is 60 labor units, the 'profit' expressed in labor units is the total value produced less the total cost of production, which is 60 less 32 which is 28 labor units.

What is the average "profit rate" of this economy expressed in labor units? It is equal to "total profits divided by total capital stock" which is 28/140 which is 20%.

Of course, in actuality, the profit rate expressed in labor unit terms is not equal to the actual profit rate, which is, of course, the profit rate in monetary terms. It is not even a close approximation. However, for the sake of argument, let's assume that the profit rate in labor unit terms is a very, very rough first approximation of the actual profit rate, and thus for the remainder of this example, we'll continue to use it as the real profit rate.



Now, let's continue with the example. What is one of the major differences between Third World countries and developed countries? Certainly, one of the major differences is that Third World countries, with very few exceptions, have a much lower standard of living and a much lower wage rate than developed countries. So let's divide our economy above into two sectors, a rich sector and a poor sector. Assume that the rich sector has accumulated 70 labor units of capital stock and that the poor sector has likewise accumulated 70 labor units of capital stock. Assume that labor in the poor sector has the same productivity as labor in the rich sector. Assume, furthermore that:

- the capital stock in both sectors has a seven year useful life;

- in each sector 20 labor units must be applied to the capital stock to produce the total annual output;

- capital and goods are completely mobile between sectors but labor is completely immobile between sectors;

- the "wage cost" in labor units is 10 for the rich sector but only 2 for the poor sector even though equal amounts of labor are performed in each sector.

Thus, each sector produces 30 labor units of output which includes, in each case, 10 units of capital stock used up in production, and 20 units of applied labor. Thus, the total value produced by both sectors taken together is again 60 labor units. The total cost of production of both sectors taken together is again 20 labor units depreciation cost plus 12 units labor cost or 32 labor units. Total profits for both sectors is again 28 labor units. In other words, the "average rate of profit" for both sectors taken together is "total profits / total capital stock" which is 28 / 140 which is again 20%. '

Since capital is completely mobile between sectors the profit rate in each sector taken individually should identical and be equal to the average rate of profit for both sectors taken together! Thus, the profit rate in each sector is 20%. Since each sector has 70 units of capital stock, the total profit in each sector is 20% times 70 units which is 14 labor units.

. This allows us to calculate the total price of produced goods in each sector individually. (Each in the table below is assumed to be in labor units).

Sector Depreciation Labor Cost Profit Price of Production

------ ------------ ---------- ------ --------------------

rich 10 + 10 + 14 = 34

poor 10 + 2 + 14 = 26

To conclude the example, the total value of goods produced in the rich sector is 30 labor units, but its total price is 34 labor units. The rich sector has gained 4 labor units of value. Conversely, the total value of goods produced in the poor sector is 30 labor units but the total price is only 26 units. The poor sector has lost 4 units of value. Because the poor sector has a lower standard of living, capital mobility and trade have worked to its disadvantage. Wealth in the form of "value" has drained out of the poor sector and into the rich sector.

And, indeed, over the past several decades, a great many poor countries, (including very poor countries such as Haiti) have been the recipients of an enormous amount of "industrial redeployment" from the rich countries without becoming wealthier and, in many cases, becoming poorer. According to the above argument, this is because capital infusions have "sucked wealth" out of those countries, rather than put wealth into them.

To take an example, S. Amin (1976) estimates the amount of "value" transferred from the undeveloped world to the developed world in 1966. He proceeds as follows. Total exports of the underdeveloped world to the developed world, in 1966, were on the order of $35 billion. Of this, the "ultra modern sector" (oil, mining, modern plantations, primary processing) contributed approximately 75% or $25 billion worth of exports. Amin calculates the total cost of these same products, if produced in the developed world, as $34 billion. He makes the following assumptions in this calculation. He assumes that, since the sectors in question are "ultramodern", the same techniques would be used in the developed world as in the developing world. He also assumes that, given the same techniques, the productivity of the workers in the developing world would be the same as that of the workers in the developed world. (Compare with R. Lucas, 1988). He assumes, furthermore, that the average rate of profit on total capital stock is 15%, and that the average useful life of ths capital is 7 years. He assumes that the average rate of surplus value (total production in labor units from which is subtracted depreciation in labor units and labor cost in labor units) is 100% Under those assumptions, Amin calculates that, in 1966, $8 billion of value was transferred from the developing world to the developed world by means of trade in the "ultramodern sector" alone.

Why are wages lower in the poor countries? Because of the growth of population and the lack of high productivity industries to employ this expanding population. This drives down wages.

In other words, underdevelopment leads to low wages, which (according to the above example) leads to economic losses through trade, which, in turn, perpetuates underdevelopment, which, in turn, leads to low wages, and so on. This, phenomenon is known as the theory of unequal exchange

Before we continue, it must be pointed out that there are a great many flaws with the above examples. First, of all, studies have shown that labor in poor countries is generally not as productive as labor in rich countries. Furthermore, the example, presented above, fails to explain why capital doesn't simply keep flowing from the rich sector to the poor sector, until wages rates equalize in both sectors. For a much more complete exposition of the theory of unequal exchange see A. Emmanuel (1972). For a critique of logical inconsistencies of this theory see P.A. Samuelson (1976).

Later on in this chapter, we will discuss several examples, neo-classical, new classical and neo-Keynesian which present "unequal exchange" in a logically and mathematically consistent form, (without recourse to "labor values").

Before doing that, however, we will discuss a more mainstream economic theory which also analyzes the obstacles to Third World development. This theory is known as the ECLA school of development economics or Latin American structuralism. This theory was developed by the Argentinean economist Raul Prebisch (1901-1986) in 1949 and is also known as the Prebisch-Singer hypothesis.

Here is a brief description of the Prebisch-Singer hypothesis. The vast majority of Third World countries began their integration into the global market economy via the export of raw materials and agricultural products, (i.e. sugar, coffee, tea, nitrates, raw silk, rubber, copper, tin, cotton, etc.) to the developed economies. In return, they imported manufactured goods from the developed economies. In some cases, these Third World export industries were developed directly by European colonizers (an example being the Dutch industrial plantations in Indonesia.) In other cases, they were the result of political and economic deals between the European colonizers and local elites such as the Zamindars in India or the Islamic Cofraternities in Nigeria. In the case of Eqypt, several thousand highly placed Egyptian government bureaucrats were converted into landowners to produce cotton for export to Britain. In the case of Latin America, the rural oligarchy, which had gained control after the liberation of Latin America from Spain, and which had acquired ownership of the bulk of the land, set up export industries to the industrial countries, primarily Britain and America.

To summarize, the underdeveloped countries exported raw material and agricultural products to the developed countries and the developed countries exported manufactured goods to the underdeveloped countries.

The economic demand for a particular commodity depends on many factors. Two of the most important factors are the price of the commodity and the income of the consumers of the commodity. The lower the price of a commodity the greater should be the economic demand for it. The higher the income of the consumers of a commodity, the greater should be the economic demand for it. As economic development takes place, the income of the consumers in the developed countries rises, and the income of the elites in the underdeveloped countries rises. Consequently, the economic demand, both for the manufactured goods of the developed countries and the raw materials of the underdeveloped countries, rises. But, according to the Prebisch-Singer hypothesis, the demand for manufactured goods rises to a much greater extent than does the demand for raw materials and agricultural goods. After all, if a consumer's income doubles that doesn't mean he or she will consume twice as much coffee or twice as much sugar. The extra income will be rather more likely to increase the person's demand for manufactured goods. Similarly, if the output of manufactured goods increases, This doesn't mean that the demand for raw material inputs to the manufactured goods will increase by the same percentage. Developed countries are always developing ways to conserve on raw material use and are always developing substitutes for raw materials (i.e. such as the substitution of fiber optics for copper cable). Thus, the price of the underdeveloped countries' exports tend to decline in relation to the prices of their imports from the developed countries; i.e. the terms of trade move against the underdeveloped countries.

Can the underdeveloped countries compensate for this disadvantage, by increasing the productivity of their raw material and agricultural export production, thereby lowering the price of and increasing the demand for their exports? No, according to the Presbisch-Singer hypothesis. If the price of coffee or sugar is halved, this doesn't mean consumption in the developed countries, will double. There is a limit to how much agricultural produce consumers, in the developed countries, will consume, no matter how low its price goes. Similarly, if the price of a raw material input to a manufactured good drops, this will generally not cause the price of the manufactured good to drop by much. The price of a raw material input is generally a very small percentage of the price of a manufactured good. Thus, the strategy of dropping the price of raw materials in order to stimulate demand for manufactured goods which use these raw materials as input is not likely to succeed. (The reader should have, by now, noticed two important exceptions to this discussion, namely oil and cocaine, but more of this later.

Actually, the Prebisch-Singer hypothesis involves more than just the type of commodity produced. It also involves the type of country which produces it (developed or underdeveloped). First of all, according to the Prebisch-Singer hypothesis, the developed countries maintain a permanent technological superiority over the developing countries; a fact which gives them a sort of "technological monopoly". This tends to put upward pressure on the prices of their exports. In addition, wage rates in the developed world tend to rise as productivity rises (a fact which is due partially to unionization and partially to custom). Therefore, technical progress and increased productivity in the developed world tends to result in higher factor incomes (higher wages for workers and higher profits for owners) rather than lower prices for consumers. In contrast, the results of increased productivity in the developing world tend to show up as lower export prices, rather than higher factor incomes. Industries in the developing world do not generally enjoy a "technological monopoly" and, secondly, wage rates in the developing world are held down by chronic labor surpluses caused by rural-urban migration. Thus, there is a "tendency for productivity improvements (to benefit) consumers in industrial countries but not in .. developing countries" and this "clearly (will) affect terms of trade and international income distribution." (H. W. Singer, 1989)

The Prebisch-Singer hypothesis was based on empirical studies by Singer of Britain's terms of trade between 1873 and 1938. The specific prediction of the Prebisch-Singer hypothesis is that the terms of trade of the underdeveloped countries with the developed countries show a long term tendency to decline. Has this, in fact, been the case? The empirical evidence is mixed. It depends on exactly how "terms of trade" are defined and on what the base year of the study is.

Both the Unequal Exchange argument of Emmanuel and the Prebisch-Singer declining terms of trade hypothesis can be presented as simple, highly aggregated, general equilibrium models called North-South models. For those who have had a course in intermediate microeconomics we recommend the formulation in E. I. Bacha 1978..

More recently, in the late 60's and early 70's, the Prebisch-Singer hypothesis has been extended to an even more pessimistic analysis of the losses to trade of the developing countries. This analysis is known as Dependency Theory. Some Dependency Theorists are Celso Furtado, Fernando Cardoso, and Theotonio Dos Santos. For a readable description of Dependency Theory (no graphs, formulas, or Greek letters) see R. A. Packenham, 1992.

Let's continue with the structuralist analysis of the barriers to Third World economic growth. Many Third World countries tried to solve their trade problems by adopting a policy of import substitution and the promotion of manufactured export goods. Import substitution is the substitution of domestically produced manufactured goods for imported manufactured goods. It usually took place behind tariff barriers, was based on the use of imported capital goods and technology, and involved the production of light manufactured goods such as textiles, certain types of machinery, leather goods, construction materials, and so on. Industrial import substitution took place in many of the large Third World countries during the breakdown of global trade during the depression and the World War II when manufactured inports became unafforable or unavailable. In fact, during the 1930's when the United States was plunged in depression, the large Latin American countries underwent an industrial expansion! At the end of World War II, Argentina was considered to be on the verge of becoming a developed country. A. Fishlow (1989) gives a readable discussion of Latin American economic performance during the 1930's and it's contrast to the Latin American debt crisis of the 1980's.

The problem with import substitution as a solution to the trade problems of Third World countries is that ,ultimately, it requires the importation of more and more capital goods, technology and intermediate goods from the developed countries. Eventually, (during the late 40's and early 50') Third World countries began to experience the same trade problems with the import of capital goods and industrial technology as they had experienced with the import of light manufactures. They were then confronted with the task of developing a domestic capital goods industry. But this involves enormous economies of scale, and very large and costly initial investments. Thus, a very large market was needed over which to amortize startup costs. The export market was not an option because it would require being internationally competitive at the outset, an impossible task.

"(In Argentina in the 50's), although substantial early success was achieved in import substitution - in terms of growth and diversification of output - the promotion of industry fell short of providing incentives to increase productivity and product specialization that would have made possible the achievment of sufficient scale of production and economies of scale. The shelter of protection prevented industry from achieving lower costs, and the high costs deterred from further expansion of production. The lag of investments in energy and transport - basic imputs to all sectors of industry - also had very adverse repercussions on the industrial cost structure. The initial phases of IS in in Argentina were also characterized by insufficient backward linkages with supply sources at the primary and intermediate input levels at a time when imports were discouraged by high tariffs----Argentina's industry was thus caught in a vicious circle, with the inefficiency in production preventing entry into international markets and the lack of competitive pressure from domestic and export markets to improve quality and lower costs contibuting to not attaining economies of scale and efficiency" (S. Teitel, F. E. Thomas, 1986).

A potential solution to this dilemma is to possess a suffiently large internal market. But very few Third World countries possessed such a market. In fact, none of them did. This is because the internal market of even populous Third World countries, such as Brazil and India, was limited by widespread inequality in wealth and land distribution, widespread poverty and landlessness, and the unproductive nature of much of the agricultural sector.

The strategy tried by many Third World countries to get around this dilemma was the institution of land reform programs. A land reform program is the redistribution of landed property titles by the government in order to make land distribution more equal.

There are several goals behind land reform programs. One is to enlarge the internal market by restributing wealth (which in many Third World countries is largely in the form of land). Another is to increase productivity and efficiency in the agricultural sector by making it less monopolistic and more competitive (See T. W. Schultz, 1964). This allows the agricultural sector to act both as a market for and a source of food for industrial expansion. It is no accident (according to structuralism) that the East Asian developing countries which have more successful economies than other underdeveloped regions, also have a more equitable distribution of land! South Korea and Taiwan had notably successful land and rural credit reform programs imposed by Japanese and then American military occupation. Other countries in East Asia, such as Malaysia and Indonesia, have created greater equality in land distribution by crop extensification, and the resettlement of landless laborers to unused land (albeit at an environmental cost),

To understand the reasoning behind land reform, imagine a situation in America in which the Confederacy had won the civil war and, with the help of a foreign power, had occupied the agriculural land of the West and Mid-West and converted it into slave plantations producing cotton and other cash crops for export to Europe. Industry in the United States would have been deprived both of its domestic market of agricultural freeholders and of a significant source of food for its laborers. The region which is now the United States might have looked very much like a Latin American country today.

Fortunately, the United States won the civil war, but, unfortunately, successful land reforms in the Third World are very much the exception rather than the rule! The obstacles to land reform in Third World countries are very formidable.

First, there is the question of "fair compensation" to the large landowners. Since, land represents much of the wealth in underdeveloped countries, very few countries can afford to pay for widespread land redistribution. In other words, without the economic growth that land reform is supposed to generate, its implementation cannot be afforded, an obvious vicious circle. (Japan financed its post-war land reform by inflation.) In many cases, large landowners can easily evade land reform legislation, especially since most of the peasants seeking to defend their claims were illiterate. In many cases, large landowners were an important part of the government that was developing and executing land reform programs. Large land owners have preferential access to subsidized irrigation, fertilizers, and mechanization programs, and often control the seed farms necessary for HYV (High Yielding Variety) crops. Even in cases where land reforms were widespread and drastic, as were the land reforms under Lazaro Cardenas in Mexico in the 1930's, they were ultimately reversed:

"... The land reforms effected by Mexican President) Cardenas were reversed because..while large land ownerers were expropriated without any compensation...a very powerful sector dominated by large farmers survived, and this sector was allowed to aggrandize itself in later years. The political conditions for systenance of land reforms were, of course, upset as soon as Cardenas (left)......" (A. K. Bagchi, 1982)

A detailed examination of almost any land reform program will reveal the many obstacles to its implementation. To take one example, R. Carpano, 1990, gives an account of the difficulties and failures encountered by Comprehensive Agrarian Reform Program (CARP) in the Philippines under Aquino. It's no accident that some of the most successful land reform programs, (Japan, South Korea, China and Taiwan) were simply imposed by military occupation or revolution.

To summarize, land distribution in most of the underdeveloped world remains very unequal. A good, short, statistical survey of land distribution in the different regions of the Third World can be found in N. Quan and A. Y. C. Koo, 1985.

Some of the results of the new growth theories (see chapter 2) could be regarded as "pessimistic" for Third World development. However, we put the word "pessimistic", here, in quotes, because the new growth theories are, after all, "new", and many of their results have to be regarded as provisional. They are not meant to be hard and fast causal explanations of development and underdevelopment, but are meant rather to be mathematical models "consistent" with the actual patterns of development and underdevelopment. Keeping this in mind, recall, that, in many of the new growth theories (as in reality) economic development tends to distribute itself unevenly across the surface of global society. Areas with a greater accumulation of human capital tend to have more opportunities for profitable investment and, thus, tend to undergo still further development. Areas of low human capital endowment on the other hand, tend to have fewer opportunities for profitable investment, and, thus, tend to remain underdeveloped, even as they continue to undergo demographic, social and economic change (The so called "development of underdevelopment"). This can be seen intuitively by examining one of the postulated mechanisms of human capital accumulation. Successful, rapidly growing, Third World countries, such as the "Asian Tigers", have tended to follow the strategy of introducing a wider and wider variety of "higher and higher quality" industrial exports. This is known as "moving up the quality ladder". (See Grossman and Helpman, 1991). In fact, the very process of continuously learning-by-doing a greater and greater variety of more and more sophisticated industrial skills itself constitutes human capital formation.

The definition of a "high quality" industrial export is technical, but, in many of the formulations of human capital growth, it is defined in relation to the tastes and preferences of consumers globally. Since the global consumer market is dominated by consumers in rich countries and by the rich and middle classs elites in Third World countries, the successful Third World countries have achieved their success by acquiring a greater and greater skill at catering to the tastes and preferences of the world's rich minority, rather than the desperate needs of the world's poor majority. As A. Mackillop (1988) puts it, "illiterate people, who desperately need basic agricultural and industrial development, are not going to generate rapidly a market for yuppie goodies."

Thus, we can see that, almost by definition, development (human capital formation) is biased against the Third World. N. Stokey (1991) incorporates these ideas in a North-South equilibirium model to show that free trade between the North and South has a retardant effect on development (human capital formation) the South. The details of her paper are way beyond the scope of this book. In her formulation, "North" means "relatively well endowed with human capital". She obtains "a unique world equilibrium" where the "north" produces "high quality goods" and the "south" produces "low quality goods". She then concludes that "with free trade ...human capital formation.. is depressed in the poor country, which now imports high-quality goods from the rich country rather than attempting to produce them at home."

Lucas (1992) also points out that any North-South equilibrium model should also encompass an explanation of the "Asian miracles", the notable economic success of the East Asian economies.

"The main engine of growth is the accumulation of human capital--of knowledge--...Learning on the job seems to be by far the most (important way of doing this).....For such learning to occur on a sustained basis, it is necessary that (the workforce continuously takes on)....tasks that are new to (it),..."

This kind of "learning experience" can take place only if the country is a large scale exporter to markets that can afford "high quality products" (products whose manufacture provides the requisite learning stimuli). This, according to Lucas, is the way that the East Asian "tigers" accomplished their "economic miracle". However, it is not an approach that could be followed by the Third World as a whole, because "there is a zero-sum aspect, with inevitable mercantilist overtones, to productivity growth fueled by learning-by-doing."

The italicized sentence above means that the entire Third World is not going to grow at East Asian rates simply by exporting to the rich countries.

Some countries have tried to get around the above dilemmas by a "brute force" approach, i.e. by having the central government take over the construction of a capital goods industry "whole cloth". An example of this strategy is the Indian heavy industry strategy developed by Mahalanobis at the Statistical Institute in Calcutta. Under this strategy, the state planned, financed and built the capital goods industry and a large part of the intermediate goods industry. The import of technological knowledge and managerial know-how was permitted only until the knowledge was absorbed by domestic industry. Import licenses and production licenses were granted on a highly selective basis, by the central government, to ensure profitability of the new industries. This strategy led to a rapidly growing and integrated industrial sector. It also led to inefficiency, bureaucratization, corruption (the "License-Raj" system), enormous import costs, foreign exchange crises, and agricultural stagnation, which , in turn,(along with droughts) led to widespread famine in the mid-60's. For a critique of the strategy of government planned and controlled development see P. T Bauer (1972).

To sum up, there are many barriers to successful Third World development. These barriers include the lack of an entrepreneurial class, the enormous inequality in land and wealth distribution, the lack of free competitive markets in land, labor and goods, the feudal, oligarchic and bureaucratic restrictions on economic development, the hypertrophy of the service sector, the leakage of investment capital into speculation, the maldistribution of population and backwardness of agriculture (particularly in Africa), the unrepresentative nature of the political processes (particularly in the Middle East), the existence of overpopulation and excessive pressure on the carrying capacity of the land (particularly in parts of Asia), old diseases such as river blindness and cholera, and new diseases such as AIDS and drug resistant Malaria. In addition, as the global economy becomes more integrated, many of the blockages to development so long characteristic of the underdeveloped countries are beginning to manifest themselves in the developed countries as well.

Indeed, current economic debate in the United States centers on precisely such factors as increasing wealth inequality, the "hollowing" of the industrial sector, the growth of the speculative service sector (what the Japanese call the "bubble sector") of the economy and so on. Emil Luttwak describes these phenomena as "The Third Worldization of America" (See E. Luttwak, 1993). As De Long (1988) states "....the ability to assimilate industrial technology appears to be surprisingly hard to acquire, and it may be distressingly easy to lose." In other words, the blockages to Third World development have now become the blockages to global development as a whole.

Not an optimistic assessment to be sure, but there is also a brighter side to the picture. First of all, not withstanding the many North-South models which give pessismistic prognoses, the fact remains that, in certain regions, certain sectors, in certain time periods, and among certain groups, extremely rapid economic growth in the Third World has, in fact, taken place.

"(Most of the developing world) envisaged as .....wretchedly poor, separated from the rich countries by a widening gap in income,...In fact, this picture bears no resemblence to reality. It does not do justice to ..the rapid growth of many formerly poor countries and the prosperity of large groups there" P. T. Bauer (1991)

"We often fail to appreciate just how spectacular the rate of accumulation has been in the Third World compared to past historical standards. It took America more than six decades to do what the Third World has done in two or three." J. Williamson (1988)

Jeffrey Williamson believes that there is a lot more dynamism in Third World societies than most people recognize. In many Third World countries agrarian reform programs have been successful up to a point. In India, for example, in the 70's large landed estates were successfully redistributed to about 10% of the rural popoulation, and agricultural productivity was dramatically increased in several of the Indian provinces including Punjab, Haryana and Andhra Pradesh using irrigation and HYV technology. In Kerala a very equitable land redistribution was carried out but without a consequent increase in industrial growth.

Secondly, mainstream free market economics is inherently optimistic that private ownership, free, competitive markets and free trade will promote economic development. It happened in the developed free market economies. Why would it not eventually happen elsewhere? Much of mainstream economic theory stresses gains through economic integration between nations and betwqeen the developed and underdeveled economies. These gains include Ricardo's well known theory of comparative advantage, the realization of economies of scale through trade (emphasized by Adam Smith) and the benefits of technology transfer through foreign investment from North to South. Much of the advice given to developing countries by the IMF and the World Bank is to follow policies that encourage integration into the world market by reversing the governmental policies that were instituted during the import substitution phases of industrialzation. Such procedures are called structural adjustments. These include currency reform such as devaluations to promote exports, monetary reforms such as the elimination of monetary creation as a form of government financing, financial reform such as interest rate deregulation, tax reform such as replacing trade taxes with consumption taxes, regulatory reform such as easing of industrial licensing, trade reform such as ending or easing import quotas, privatization of government assets to encourage capital inflow, etc. Trade agreements such as the Uruguay Round of GATT (General Agreement on Trade and Tariffs) and NAFTA (the North American Free Trade Agreement) are designed to promote Third World development through North-South trade and capital and technology transfer. In fact, during the Reagan and Bush administrations, the West's main approach to North-South economic issues has been the use and proposed use of North-South trade to promote Third World development. (See R. Reagan 1985).

Another reason for optimism about the growth prospects of the underdeveloped countries is the so-called Gerschenkron thesis updated to include the experience of the East Asian countries, The Gerschenkron thesis maintains that there are "advantages to backwardness", especially in the ability to utilize the latest developments in technology to "leapfrog" the development paths taken by the developed countries. For example, the use of cellular telephones and satellite communications can allow telephone systems to be installed in the underdeveloped countries without the enormous infrastructural and labor costs associated with the development of telephone systems in the advanced countries. Containerization and robotization allow many types of industrial plants to be built in underdeveloped countries with less need for industrial insfrastructure and industrial skill pools. Electronic communication reduces the need for literacy in skill transfer, and can potentially allow activity in any part of the world to be coordinated and managed in any other part of the world. Electronic communication can reduce the need for the "geographical clustering" that R. Lucas (1988) talks about. In fact, the economist, W. Rostow (ever the perennial optimist) projects that the above technologies ("..the fourth great technological revolution of past two centuries") will enable most of the developing world to develop rapidly.

"Despite current vissitudes, India,..China ..and (most of)..Latin America... are likely to absorb the new technologies and move rapidly forward over the next several generations". W. Rostow, 1991.

The "advantages to backwardness" become particularly strong if an environmental constraint to global growth materializes (such as the projected greenhouse effect). It is precisely the underdeveloped nature of the LDC's that could give them the potential to develop in a way that circumvents environmental constraints. In other words, the underdeveloped regions of the world, precisely because they are underdeveloped, have the potential to be more flexible in their development. It is potentially easier for them to develop along a different path, since their physical and social structures are not locked into a preexisting path. For example, compare the rapid success of the Soviet Union's free market reforms in the early 20's, when it was relatively underdeveloped, to the extreme difficulties that the present day C.I.S. is having with its privatization and marketization plans. Compare, also, China's success with free market reforms to the current difficulties of the C.I.S.

For the sake of argument, let's suppose that scientific evidence clearly shows at some point that carbon emissions into the atmoshpere have to be severely curtailed. The developed economies are now "locked into" into various physical, infrastructural and economic patterns, which are "CO2 emission intensive", centralized power grids, automobile-ization, chemical and energy intensive agriculture, fossil fuel generation of electricity. For example, the gains in CO2 emission reduction that could be realized from the use of biofuels is limited by the fact that the production of the crops to be used for biomass energy is itself energy intensive and thus creates greenhouse gas emissions. In the underdeveloped countries, on the other hand, there are large sectors of agriculture, both subsistence and commercial, which have not, as yet, modernized. The use of crops from such sectors affords a much greater reduction of greenhouse gas emissions. For example, according to the center for energy and environmental studies at Princeton University, the percentage of total electricity generated by utility companies that could have been produced from sugar cane alone using advance gas turbines is 14.9% in Asia, 19.2% in Africa, 45.1% in Latin America and 200% in Oceania. To take another example, the lack of centralized power grids in many areas of the Third World has the potential of rendering profitable many forms of energy that would not be as profitable in a developed economy, photo-voltaics, wind, geothermal and others. According to J. C. Hourcade (1981), in many parts of the developing world, the new forms of renewable energy, specifically biogas, photovoltaics, solar, ponds, and geothermy, would already be competitive, for such uses as:

- cooking, especially in rural areas;

- agricultural irrigation;

- hot water heating in temperate and cold regions;

- pumping water;

- agricultural machinery and commerical vehicles.

He maintains that, "on the whole modern sources of renewable energy have a market potential covering 40% of final demand" and, therefore, "new renewable energy energies no longer appear as the energy of the distant future, but as the more appropriate to solve the present crisis in rural areas."



This theory had been called "the Magna Carta of modern economics".

The origin of this description of tatonnement is obscure. It did not originate with Walras.

This kind of study is known as macroeconomics.

This example assumes for simplicity that only labor and goods produced by labor are used in production.

In fact, for those who have a background in college calculus, Keynes's original classic The General Theory of Employment, Interest and Money is quite readable, with the proviso that Keynesian economics is continuously being revised, amended and reinterpreted. The controversies about "what Keynes really said" are completed outside the scope of this book.

It has been maintained that the IS-LM model doesn't really describe Keynes's economic insights. For example, Keynes put great stress on expectations in analyzing economic activity, yet had no mathematical theory of expectations. Thus the IS-LM model gives a far too static view of Keynesian theory. However, since the IS-lM model is the way Keynesian theory is usually presented, we describe it here.

More precisely, in the IS-LM model, the "demand side" (in its original form) is based on "rules of thumb" rather than on reasoning about the "utility functions" of consumers and investors.

expenditure is usually divided into investment, i(y,r), and consumption, c(y,r).

For example, e can be increased by postulating an increase in government expenditure.

Later on, the IS-LM model was augmented by the inclusion of real wealth (w) as a variable in the equations. It was shown that, in this expanded model, given flexible prices, markets would clear even in the "limiting cases" discussed by Keynes. (D. Patinkin 1965). In addition, Keynes' decision to drop the assumptions of general equilibrium (such as market clearing) has remained controversial to this day, because if these assumptions are dropped then it's not clear how prices are supposed to be determined? For a survey of the economics of "sticky prices" and "disequilibrium" see D. Romer et. al (1991).

The definition of economic structure is actually more restrictive than this. See notes at the end of the chapter.

Following L. R. Klein (1980:2) we can say that the IS-LM model described above is the "mother" of Keynesian econometric models, which can be described as "extensions of the IS-LM relationship". For a (mostly) English description of a Keynesian econometric model see L. R. Klein (1980:11-45).

Economic theory, after having gone from the study of economic and social aggregates (classical economics), to the study of individual economics behavior (neoclassical economics), and from there back once again to the study of economics aggregates (Keynesian macroeconomics), has to go yet again to the study of individual economic behavior.

In many current econometric models such as, for example, the IMF/MULTIMOD model, it is assumed that the participants in the economy actually use the model itself to make their forecasts. (See S. Hall, et. al, 1994)

subject to the economic information available to them.

Rational expectations economics is sometimes called "new classical economics" (not to be confused with economic theories which still use the classical labor theory of value such as neo-Ricardian or neo-Marxist economics). "New classical economics" also includes the new growth theories.

These changes are assumed to be random and are called "demand shocks" and "technology shocks".

This is because government macroeconomic policy can often increase the problems of "signal extraction" and thus worsen business cycles rather than ameliorate them.

J. G. Williamson (1983) maintains that England's development is not a bad model for the development of contemporary developing countries, that a great many of the "pathologies" (such as income inequality and "overurbanization" ) attributed to LDC development were also true of England in the early 19th century.

In all societies, (See Chapter 3) there is often a tendency to "go back to the fundamentals" in order to find answers in the face of a confusing crisis. During the chaotic "middle periods" at the beginning of this millenium, Islamic civilization went back to "Sunni orthodoxy". During the 19th century, Chinese officials tried to "go back to Confucian fundamentals" in order to find some way of absorbing Western technology without convulsing the society.

There are actually many reasons why the neoclassical paradigm has come into vogue in the 80's and early 90's. Not least of them is the explosive advance in transportation, communication and information technology in recent years, an advance which has shaped world economic activity in ways which make it more describable by neoclassical methods. (The "transaction costs" of economic activity have been lowered. More and more economic activity is able to pass through "auction-like" markets. The globalization of production weakens the market power of monopolies and labor unions. Contracts are replaced or supplemented by spot and futures markets.) In addition, there are political reasons for the success of the neoclassical paradigm; for one thing, it's a good way of avoiding debates about global and national economic inequities. But more of this in the next chapter.

This corresponds to a capital-output ratio of 3.5.

The theory of unequal exchange is a revision of Ricardo's theory of comparative advantages to show that it doesn't hold in the LDC's.

"The market for industrial goods, apart from textiles, hardly exceeds 50 to 60 million people, or hardly 10% of the population" P.T. Patai Indian Minister of Industries, 1975

See R. Lucas, 1992.

See Chapter 2 of this book.


Notice the similarity of this assumption to the assumption of Western Christian and Islamic medieval cosmology that the motion of heavenly bodies is perfectly describable by means of mathematics. It was this assumption that ultimately gave rise to the Galilean union of mechanics, physics and astronomy. (See Chapter 3 of this book.) Neoclassical economics tries to replicate this breakthrough by assuming that the behavior of individual economic agents is describable mathematically. It's no accident that many of the neoclassical economists started out as physicists. Thus, (see Chapter 3) modern mathematical economics can be viewed as a modern variant of neoplatonism (along with popular astrology and "near death experiences").

Other requirements for the existence of an "equilibrium" are: (1) returns to scale are constant or diminishing; (2) there are no joint products or "external effects" either in production or consumption (an example of the latter is, for example, pollution, or economy-wide economies of scale); and (3) all goods are "gross substitutes" for eachother, in the sense that a rise in the price of one good will always produce positive excess demand for at least one other.

For example, suppose the three commodities are coal, wheat and coal. An iron manufacturer might say: "At those prices, I would be willing to produce 5 units of iron. I would need to purchase 3 units to grain to feed the miners (or equivalently I would need to pay the miners enough to purchase 3 units of grain), and I would need to purchase 2 units of coal to run the equipment."

Most of the proofs of the so-called "stability" of general equilibrium usually assume that the price of a commodity somehow rises in response to "excess demand" and falls in response to "excess supply" (or negative "excess demand") without specifying how this actually happens in a real market. For those who know intermediate calculus, if p = (p1(t),....,pn(t)) is the vector of prices as a function of time t, then dpi(t)/dt = Hi(Zi(p(t)),, where Zi(p) is the "excess demand" for the ith commodity and Hi(.) is a sign-preserving continuous function.

The extent to which the assumptions of "general equilibrium" (such as market clearing) are valid is central to many of the doctrinal disputes of economics. Supporters of general equilibrium maintain that one has to be very cautious about dropping its assumptions, since the mathematics of economics becomes onerously difficult without them. Opponents of general equilibrium counter that many aspects of economic reality such as unemployment and business cycles violate these assumptions. Supporters of general equilibrium (such as the "rational expectations" economists) counter that general equilibrium can be combined with probability theory to explain these phenomena (R. E. Lucas and T. J. Sargent 1978:49-72). Critics of general equilibrium counter, in turn, that "rational expectations" mathematics is hairy enough, that the mathematics needed to test its conclusions hairier still, and that there is no escaping the need for adhoc judgements when constructing economic models. (L. Taylor 1983:1-11)

To oversimplify enormously, the proof of Walras' equilibirum theory goes as follows. The "all knowing being" writes down a list of prices for each commodity. Using the producers' "production functions" and assuming that each producer would produce an amount of each commodity which would maximize its total profit, the "all knowing being" calculates, for each producer, how much of each commodity the producer would want to produce at those prices and how much of each commodity (including labor) the producer would need in order to carry out the production. Using the consumers' "utility functions" and assuming that each consumer "maximizes his or her utility", the "all knowing being" calculates, for each consumer, how much of each commodity (including labor) the consumer would want to purchase (or sell) at those prices. If there is a shortage of any commodity, the "auctioneer" raises the price. If there is a surplus of any commodity, the "auctioneer" lowers the price. After this is done, this process is continued until a list of prices is found, such that (1) all commodities produced at those prices will find a buyer, and (2) every consumer's buying plans at those prices are realizable. The proof that such a list of prices would, in fact, be found, depends on a mathematical result, which is way beyond the scope of this book, and which is known as a topological fixed point theorem. For the present purposes, we wish to make only one observation about the description of general multimarket equilibrium given in this chapter. The use of a mathematical equation such as a "utility function" to describe the behavior of an individual consumer often seems very strange to an economic novice (much stranger, say, than the use of a "production function" to describe the behavior of an individual firm). And yet, (to paraphrase the famous British neoclassical economist Francis Edgeworth), short of keeping tabs on each of the hundreds of millions of individual consumers in an economy, and short of trying to second quess the behavior of each of them, how else would one model the behavior of an economy consisting of hundreds of millions of individual agents. For a discussion of the behavioral assumptions behind "utitily maximization" see D.C. North (1990:3-26.)

For those who have a background in intermediate college calculus, here is a brief (oversimplified) summary of some of the mathematical aspects of the IS-LM model. Capital letters will represent nominal quantities and lower case letters will represent real quantities. We will assume that the labor supply (N) and the money supply (M) are fixed. We will also assume that labor is the only factor of production in the period under discussion (although investment for the next period will be included in the analysis). Furthermore, we will suppose that the economy produces only one commodity which is both an investment good and a consumption good.

Designate the general price level by P, the wage by W, the real interest rate by r and real output by y. In addition, let q(N) be the economic output as a function of N, where dq/DN >0, and d2q/D2N < 0. Let e(y,r) be total expenditure as a function of y and r. Let c(y,r) be consumption as a function of y and r. Let i(y,r) be total investment as a function or y and r. let l(y.r) be the "demand for real balances" as a function of y and r.

The equations of the IS-LM model can now be written as follows:

y = q(N) (the production function for the economy);

y = e(y,r) = c(y,r) + i(y,r) (total output = total expenditure = consumption + investment)

M/P = l(y,r) (the demand for "real balances" = the supply)

The second equation above is called the IS curve and the third equation above is called the LM curve. Now, Let y lie along the horizontal axis and r lie along the vertical axis.

Expenditure, e(y,r), will obviously increase as total output (y) increases. It will also increase as the real interest rate (r) decreases, because the lower interest cost will make more investments profitable. Thus, the IS curve is downward sloping.

Because markets clear, the economy will produce at a level (y) that uses all of the available labor (N). The real wage rate (W/P) will adjust to ensure such an outcome. What will this real wage rate be? Well, in addition to clearing the labor market, firms in the economy will also produce at a level that will maximize their profits, i.e. will maximize Pq(N) - WN. Thus, the derivative of Pq(N) - N must be zero, or, in other words, W/P = q'(N). Since we know N, this gives us the real wage rate (W/P). How does one determine the real interest rate r? One equates the demand for economic output (which is equal to e(y,r)) to the supply of economic output y and solves for r.

Now that we know y and r, we can determine l(y,r) (the demand

for "real balances"). Since this demand must be equal to the supply of real balances (M/P), we can solve for P and hence for W.

This essentially is the neoclassical view of things. Once the labor supply is determined, everything else follows.

Now, let's throw more and more labor on the market, so that N keeps increasing. This means that q(N) (or y) keeps increasing (since q' > 0). Because the IS curve is downward sloping, r will decrease. Therefore, as we keep throwing more and more labor on the market, y will keep increasing, and r will keep decreasing.

Thus, in the above system of equations, a rise in the labor supply leads to a drop in the real interest rate. Is this a realistic description of the economy?

In some circumstances, according to Keynes, yes it is. As more labor is thrown on the market, wages drop. This leads to a general price drop, which, in turn, leads to an increase in the supply of real balances (M/P). This in turn, lowers the real interest rate (r). This chain of causality is known as the "Keynes effect". So far, so good.

Suppose, however, that there is a lower bound below which the real interest rate cannot fall. Then the ability of the economy to absorb labor has to stall at a certain point.

Can such a lower bound exist. In some circumstances (according to Keynes) the answer is again yes. To show this, Keynes divides the demand for real balances (l(y,r)), into two parts: (1) a demand for transaction balances, and (2) a demand for "speculative balances". The first demand is a demand for the real balances needed to facilitate economic transactions. It will increase as y increases, and as r decreases. However, the second demand, the demand for "speculative balances" is a demand for money to be kept in reserve just in case the real interest rate has hit bottom. Investors don't want to be locked into an investment with a low rate of return, when interest rates rise, and, therefore, they will want to hold a certain amount of precautionary balances. Below a certain point, a drop in the real interest rate will increase the demand for precautionary balances. In fact, this demand for precautionary balances "may tend to increase almost without limit in response to a reduction of r below a certain figure" (J. M. Keynes 1953:203). In other words, as r approachs its minimum value from above, the function l(y,r) will "blow up". This unfortunate state of affairs is known as "the liquidity trap".

Suppose that we respond to the "liquidity trap" by simply making y large enough to clear the labor market, solving the IS curve for r, plugging r into the LM curve, and solving for P. If we do this, we end up with an absurd situation in which everybody is working for nothing and everything is free; "from each according to

his abilities, to each according to his needs"; exactly the kind of situation Keynes was trying to avoid.

Fortunately (as pointed out by A.C. Pigou in 1941), long before we reach this alarming situation, the real value of the already accumulated wealth will be so large that enough of it will be spent to clear the labor market. If prices and wages have fallen so low that a single dime will suffice to employ everybody at a living wage, then obviously the labor market will clear. However, this could take a very long time to happen.

A complete explanation of "economic structure" and "the Lucaas critique" depends on some rather arcane technical statistical concepts. For those who have some background in statistical regression analysis, structural equations are those which allow analysis of the effect of policy changes. The parameters of structural equations should be invariant to the policy changes. However, in many cases, the structural equations are not regression equations. In order to make them into regression equations, they have to be transformed into reduced form equations, which are regression equations. However, in many cases, it is impossible to go from the estimates of the parameters of the reduced form equations back to estimates of the parameters of the structural equations (a difficulty known as the identification problem). In order to do this, it is necessary, in many cases, to put simplifying restrictions on the structural equations. Lucas challenged the way in which these restrictions were introduced. Particularly suspect, according to Lucas, was the way in which expectations of future economic variables were handled. They were treated as functions of past observed values. In other words, people were assumed not to take policy changes into account in forming their expectations. But if the structural equations forecast the effect of policy changes, then why don't the people whose behavior the equations were describing also forecast the effects of policy changes? Were they stupider than the equations themselves?

Improvements in computers in recent years have had an enormous influence on economic modeling. For example, it might seem that Walras' theory of general equilibrium, while of theoretical interest, would not be of much practical use in devising models of a real economy. After all, even a small national economy consists of an enormous number of goods, consumers, and firms. And the number of equations needed to solve the general equilibrium system of such an economy would be astronomical, far beyond the power of any computer to solve. None the less, over the past 20 years, as the power of computers has grown, computer programs have been written which mimic Walras' "all knowing being". Such programs are called, Computable General Equilibrium Models, or CGE's. These CGE's obviously do not account for each individual good, consumer and firm in an economy. Instead, goods, consumers, and firms are grouped into aggregates or sectors. For example, producers might be grouped into forestry, fishing, mining, construction, export agriculture, etc. Consumers might be grouped into rural workers, landlords, capitalists, skilled urban workers, unskilled urban workers, etc.

CGE's are often used to evaluate economic policy changes by national governments, (such as, for example, a devaluation, or a tariff change). In evaluating an economic policy change, it not enough to ask whether the national economy was "better off" after the change. An economy might be impacted by an external factor, that has nothing to do with the policy change, (such as a rise in global interest rates). The relevant question is whether the economy was better off with the policy change than it would have been without it. The analysis of such a question is called a counterfactual analysis. CGE's can often be useful in performing such a counterfactual analysis.

CGEs can be very complex. For example, A. Kelly and J. Williamson (1983) used complex CGEs to investigate the reasons for Third World city growth. Their study examined several possible reasons for rural-urban migration in Third World countries, a demographic reason (population growth) and an economic reason (greater productivity growth in urban industry than in rural agriculture). In other words is rural-urban migration "driven" by "demographic push" or "economic pull"? Both factors occurred simultaneously in many Third World countries. Thus, a counterfactual or what-if analysis was necessary to assess the importance of each factor individually. The construction of CGEs made such an analysis possible.

To take another example, W. J. McKibbin and P. J. Wilcoxen (1992) developed a multi-sector computable general equilibrium model of the global economy to quantify the costs of curbing CO2 emissions.

At the other end of the scale, economic models have been developed which are purely empirical and embody as few economic

theories or assumptions as possible. These models "let the data speak for itself". They are known as Vector Autoregression (VAR) models, and are based on older method of economic forecasting known as time series analysis.

Times series analysis is basically a method of mathematically "filtering" past economic data in order to "extrapolate" future values. It cannot be used to do "policy analysis" or to answer "what if" questions. Since the Lucas critique, however, and since the failures of economic forecasting models in the 1970's, time series analysis has made a comeback. It is now used extensively in economic modeling and in economic research (See P. Kennedy 1993:249).

A time series is essentially a series of observations over time, whether on a daily, monthly, quarterly or yearly basis. Examples of times series are daily stock prices, quarterly economic growth numbers, or annual GNP figures. One of the earliest ways of analyzing a time series was to assume that it consisted of a superposition of cycles of various types, a form of analysis known as harmonic analysis. Harmonic analysis is still used extensively in economic research. For example, C. W. J. Granger (1969:424-438) used it to devise a statistically testable definition of "economic causality".

During the 1920's, the Russian economist Eugen Slutsky and the British economist G. U. Yule showed that weighted sums of "random shocks" exhibit cyclical behavior that look very much economic time series. This led to the technique of analyzing times series by treating them as weighted sums of random shocks (Autoregressive, Moving Averages).

A time series can exhibit a trend, a cyclical pattern (such a seasonal fluctuation), or a unit root (a random error which can propagate itself in an additive fashion to produce misleading trend-like behavior). Various techniques are available to remove trends, cycles and unit roots, The resulting time series can then be extrapolated mathematically into the future.

For those who've had some encounter with time series, here's a question about times series which might seem too silly to ask, or it might not. The question is: how can one analyze a time series without going back in time? Suppose, for example, that we are looking at, say, money supply figures and unemployment figures from 1970-1990. If we could keep "resetting" the economy back to 1970, and then letting it run forward to 1990, then we could say, "Yes, I see! In 95% of the run-throughs, if the money supply does such and such, then unemployment goes up!". Obviously, we can't do this. The economy is an experiment which happens only once, and in only in one direction. An economic time series, therefore, is a sample of one from a single experiment. If this is the case, then why does a time series have any significance at all?

If you've never been troubled by this kind of question about times series, then forget it.

But if you have, then the answer is as follows: A time series is an instance of a statistical phenomenon known as a dynamic random process. If a dynamic random process is sufficiently "well behaved", then one "realization" of it can tell us a great deal about its structure. This fact, which can be proved mathematically, is known as the statistical erodic theorem. Thus, we don't need a time machine to analyze a time series (according to the statistical ergodic theorem).

In most countries, the ratio of farmers to available land is much smaller than in the United States or Europe. Farms of less than a hectare characterize China, Bangladesh, and Java. In India the average farm size is approximately 1 to 2 hectares, and in Latin America farms of less than 10 to 20 hectares are the rule. In contrast, average farm size in the U.S. is well over 100 hectares and over 50 hectares in Britain. In most countries, the available farm land is not distributed equally among all potential farmers. See P. Timmer, 1988.

"A major problem (in industrialization) has been the lack of markets...The successful experience of three East Asian countries (Japan, the Republic of Korea and China) could, however, provide useful examples in this respect. The first major source of demand in these cases was a distribution of assets through land reform and a subsequent high and sustained growth of both agriculture and industry." The Impact of Development Strategies on the Rural Poor, FAO Publications, 1988.

Japan imposed land reform on its Asian colonies because it needed to increase food production for its industrial revolution. America imposed land reform in Asian countries after World War II because of fear of communism. The crucial difference between Asia and Latin America was that America occupied the Asian countries where it imposed land reform, but was dependent in Latin America on the rural oligarchies (who opposed land reform) to counter the leftists. America, not directly occupying most of Latin America, could not realize its ideal goals of a right wing land reform, and, therefore, after an abortive attempt under the Alliance for Progress in the early 60's to encourage land reform, ultimately opposed it as too destabilizing. Following Latin American structuralism, we can imagine that if Britain had fallen in World War II and if the US had decided to fight on, then the US might very well have been forced to occupy large parts of Latin America, impose land reform, encourage industrialization, and we would now be regarding Latin America as the world's "economic powerhouse" rather than East Asia. Incidently, the problems encountered by land reform efforts are nothing new. Both the Byzantine, Ottoman and Chinese empires tried unsuccessfully to prevent concentration of land holdings. Of course, the ancient, pre-capitalist "world empires" were infinitely weaker and more sluggish than a modern nation state. Even so land reform is a very difficult task at all times and in all contexts. The classic article on land reform was written in 1970 by Jacques Conchol, director of agrarian reform in Chile under Eduardo Frei. According to Conchol, a successful land reform must have the following characteristics. "(1) Agrarian reform must be a massive, rapid, and drastic process of redistribution of land and water rights. Agrarian reform and colonization must not be confused because the latter implies no change in the power structure. (2) Political forces and the entire community must be actively mobilized, so that the reform is carried out within an institutional framework and creates an awareness among the masses and political groups of ...need for substantial changes in the power structure. (3) Indemnification payments for land must be minimized since the market value of agricultural lands is often determined by the possibilities of gaining speculative rents rahter than by true productivity....(4) Agrarian reform must be part of a broad development plan for the entire agricultural sector (J. Conchol, 1970:158-172)" (Quote taken from M. Edelmen, 1993:86).

Land reforms also have risks. Both the Iranian revolution and the Afghan civil war were, in part, the precipitated by flawed land reforms. In Peru, the rural power vacuum created by the land reform aided the rise of the Shining Path querrillas.

What do economic historians have to say about the prospects for Third World development? The doyen of gloomy pessimism, in this regard, is the economic historian David. S. Landes. (See D. S. Landes, 1992:99) In a recent article, he sums up the prospects for the Third World as a whole. Many countries in the Third World, he says, "do well in some regions and languish elsewhere", a pattern that Landes calls "mottled development". Although some analysts express optimism about the recent economic performance of the Third World, Landes maintains that "we are witnessing a selection process...a window of access", in which only some of the Third World countries "will be able to develop their own capacity for innovation and thereby" and avoid the calamities of underdevelopment. Landes's rhetoric evokes images of leper colonies ("mottled development") and concentration camps ("selection process"). He concludes by saying, "If a society cannot export merchandise, it can and will export people, or, in extreme cases, get them to sell their body parts. This too is not a basis for sustainable growth." (Good God!) In contrast, other economic historians, such as Walt Rostow, are as optimistic as Landes is pessimistic. For example, W. Rostow (1991:424), projects that "..the fourth great technological revolution of the past two centuries" will enable most of the developing world to develop rapidly, since most of the Third World is "likely to absorb the new technologies and move rapidly forward over the next several generations". In fact, the entire field of development economics tends to suffer from a sort of "bipolar disorder", in which prognoses tend to range from euphoric fantasies of billions and billions of middle class customers, on the one hand, to "Bladerunner"-like images of morbid despair (ala Landes) on the other.

Obviously such an approach would seem to leave the Third World economies very vulnerable to the failure of trade negotiations and protectionist pressure in the West. (Later on, we will see that the media manipulation and public mood manipulation practised by the Reagan administration and the secrecy of the Bush administration were, in many cases, attempts to distract the American electorate from protectionist sentiment). If such protectionist policies in the West should materialize, could the South expand its trade through South-South trade aggreements? C. Van Beers and H. Linnemann (1991) argue that the potential for South-South trade in manufactures is limited. This is because there is not that much complementarity betqeen the export sectors of the various Third World economies. This would seem to imply that the potential for Third World industrialization via South-South trade is limited. `. Van Beers and H. Linnemann's paper is summarized as follows:

"Using two different measures , the degree of correspondence between a country's export vector of manufacturers and a trade partner's import vector is determined. These export-import similarity measures are shown to contibute to an explanation of bilateral trade potential in manufacturers for 34 developing countries, and an index showing the potential to replace LDC imports presently originating from developed countries. Given the existing LDC commodity composition, the possibility of subsituting imports of DC manufactures by LDC supplies is found to be limited only", C. Van Beers and H. Linnemann, 1991

Thus, not only are the industrial sectors of most Third World countries "hollow", but the industrial sector of the Third World as a whole is "hollow". And this situation is difficult even for a South-South trading bloc to ameliorate by import substitution. Nonetheless, the free market reforms in the former Soviet Union could offer some promising opportunities for East-South trade in the event of a protectionist upsurge in the West. According to Boris Yeltsin's advisor Sergei Stankevich.

"A rapid move (by Russia) into the markets and full-fledged integration into the system of economic relations of such states as the United States, Japan and the economically developed states of Europe are highly problematical. ..... At the same time, on the other hand, are far broader and qualitatively better opportunities connected with other states,... which are at a historical fronter similar to ours- ......These are the countries lying to the south of our traditional partners: in Latin America, Mexico Brazil, and Argentina, in Africa...Turkey, Asia, India, China and the Southeast Asian countries. .... Interaction with them, use of the potential available to both parties, movement into their markets, and the use of the potential of our market-these are opportunities which must not be overlooked" S. Stankevich (1992)