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3/4th Of the World Lives In The Third World – Economics Essay

3/4th Of the World Lives In The Third World – Economics Essay
“More than three fourths of the world’s population live in developing countries but they only enjoy 16% of the world’s income while the richest 20% have 85% of global income.”

Despite these startling statistics, concern for the developing countries of the world is a recent phenomenon. The Second World War seems to have been a major turning point in the fight against poverty, with many soldiers returning from the “backward” countries of the world realising the types of awful living conditions that many people in the developing world still endure today. Indeed the bulk of international bodies encouraging development, such as the World Bank and the United Nations’ development agencies, were only established after World War Two. Furthermore, the successful implementation of the Marshall Plan, a program during which huge quantities of physical capital and technical assistance were donated by the US to the war-stricken countries of Europe, sparked new academic interest in development economics as professional economists studied their own development processes. Economists were to a certain degree ignorant to the economic growth processes in largely agrarian developing countries with little modern economic structures. Initial policies to combat underdevelopment focused on rapid capital accumulation, like those put forward in the Marshall Plan, to increase worker productivity and thus increase GNP/Capita (Capital fundamentalism). During the 1950s and 60s many developing countries did achieve what economists at the time believed to be development; this being sustained growth rates of 5-7%. However standards of living in many countries did not change, as growth was unequally distributed. This was largely due to the economic, social, and institutional differences between developed and developing countries. More recently empirical studies by American economist Hollis B Chenery have tried to provide more mathematical and objective tools to combat underdevelopment. Development is not just a measure of the average citizen’s ability to buy goods and services but rather a complex process involving major structural changes in the economy, “redistribution from growth”, higher rates of total factor productivity and the annihilation of poverty, as well as accelerating economic growth. One developing economy that exemplifies many of the experiences, past and present, of many less developed countries today is that of Kenya. The structural changes observed as economies move across the development trajectory, as well as why Kenya’s sectoral shares of GNP accounted for by agriculture, manufacturing and services differ from Chenery’s estimates that will be the focus of this essay.

As a developing economy moves along the development trajectory, one of the most important structural changes is the replacement of agriculture as the main component of production by the more profitable manufacturing and service sectors. This change is inherent in the growth process given the differing characteristics between agricultural and manufacturing commodities. Firstly, the majority of agricultural products are inferior goods; they have inelastic income elasticity, whereas some manufacturing goods have income elasticity greater than unity. Therefore as people’s incomes rise there will be a less than proportionate increase in the demand for agricultural products. On the other hand their demand for manufactured goods will increase. This explains a further structural change in the economy. The proportion of consumer demand accounted for by food (and other basic necessities) falls whilst the proportion spent on diverse manufactured goods and on service increases.

Secondly, on the production side, agricultural production often exhibits deceasing returns to scale. Increases in productivity due to technological progress, allow greater income, and are regularly insufficient to provide for a rapidly increasing population, as the value of total product is shared between the workers. These Malthusian pressures encourage workers to seek work in the modern sector in the beginning of the development process. Towards the end of the development trajectory, capital intensive methods may well serve to increase this surplus labour. In contrast the manufacturing sector, where all factors of production are variable, benefits from increasing returns to scale. Therefore firms wish to expand output in order to further cut log run average cost. In the Lewis theory of development this expansion is facilitated by the movement of labour from rural communities to a more urban way of life. The Lewis Model of Modern-Sector Growth in a Two-Sector Surplus-Labour Economy

The Lewis model looks at the transfer of this surplus labour. He theorises that a wage differential of 30% between subsistence farm work and work in the modern sector will be enough compensate for the economic and social cost of changing to an urban way of life. To a certain degree the cost will be balanced by the attraction of what we would classify as basic amenities such as sanitation, electricity, education and health services. This mass rural-urban migration is another key structural change as an economy develops. With greater access to health facilities and educational structures the quality of human capital will increase. An able and educated labour force will find it easier to adapt to new technology in the modern sector thus increasing labour productivity. Indeed, along with greater awareness and accessibility to birth control family size and population growth rates will decrease. A key factor contributing to a smaller family size is the quality of human capital that the family produces as parents rely on their children for economic security in the future. An educated child will hopefully be more employable and earn a higher income in the modern sector either in the developing country or abroad. The trade off between current and future benefits and costs of children can be seen in the diagram below:

One constraint on the structural transformation of a developing country is the leaching of its highly skilled and professional classes to developed countries. This can be seen as an indirect opportunity cost for the developing economy as government expenditure on anything other than creating high income job opportunities may have contributed to a loss in human capital.

Another key focal point in the Lewis model is the growth of output and employment in the modern industrial sector. This is achieved by another structural change in the developing economy, the proportions of GNP Saved and invested increasing. This allows a steady accumulation of both human and physical capital. Lewis assumes that all the profits are reinvested into the production process, buying more capital to duplicate the process and thus creating more employment. This assumption seems unrealistic as firms may wish to cut the costs of production, in the interests of competition, by investing in labour saving technologies. An international constraint on this structural transformation is the occurrence of capital flight, where companies invest their profits overseas usually in Western banks instead of reinvesting it in the developing economy. DIAGRAM ON LEWIS MODEL AND MINOR ANNOTATIONS!

The composition of exports also shows evidence of the structural change in the proportions of GNP with the share of manufactured exports in GNP as well as in total exports increasing and the share of primary exports in total exports decreasing. These figures may be interrelated in the sense that a larger manufacturing sector will require an increased volume of raw materials that may be efficiently produced domestically. Other contributing factors to the decrease of primary exports include; the price volatility of primary goods in global markets, the relative higher profit margins on finished goods and also the encouragement of private foreign investment through the use of tax incentives etc.

The government’s revenue as a proportion of GNP also increases as an economy develops. This hopefully allows the government to formulate more effective policies in the fight against underdevelopment. Expenditure on education increases total factor productivity, with primary giving the highest social return on investment. Similarly expenditure on the physical infrastructure of a country, such as transportation and communication links, also assists in trade opening up new markets and lowering haulage costs. The government’s tax policy also plays an active role in the income distribution within the economy. The composition of income distribution also changes as an economy develops with the proportion of GNP received by the highest 20% of income earners rising at the beginning of the development then falling. Furthermore the proportion of national income earned by the lowest 40% falls then rises. A harsh regressive tax policy may counterbalance this new-found income for the poorest people in society.

The structural changes presented thus far can be found in American economist Hollis Chenery’s empirical studies into development patterns. Chenery’s research looks at the necessary but not sufficient changes in economic, social, and institutional variables over time that allow a traditional peasant agricultural economy to metamorphose into an economy that relies on more stable manufacturing and service sectors as both the main component and stimulant of GNP. In his research paper “Development Patterns: Among Countries and Over Time” Chenery splits the countries into smaller subgroups to make the results more credible and useful. This allows policy makers to review the results and hopefully formulate effective development policies. By applying cross sectional and time series data into multiple regression analysis Chenery calculated accurate estimates (given the repeated sampling) of relationships between economic variables. For example the relationship between the proportions of GNP accounted for by agriculture, manufacturing, and services with the level of GNP/Capita (PPP) and population would be calculated as follows:

When the actual values for the Kenyan sectoral shares of GNP are compared to the Chenery estimates, they show deviations. For instance Chenery’s normal level of manufacturing’s share of output overestimates the actual value for manufacturing’s share of output in Kenya by %. In fact, Chenery’s estimate would have been much more accurate in the first decade after Kenya’s independence from the United Kingdom when state owned manufacturing enterprises were the main engine behind growth rates of 7%. However the oil price shocks during1973-74 coupled with severe drought in 1984 played leading roles in the reduction of growth figures to negative values throughout the 1990’s. Coupled with a declining total GNP is the relative increase in agricultures share of output. Indeed this partly explains Chenery’s underestimation of % in agriculture’s share of output.

The following features specific to Kenya inhibit domestic savings and investment that are seen as necessary but not sufficient to development in Chenery’s “Patterns of Development”. For instance, heavy rainfalls frequently endured by the Kenyan people often destroy vital infrastructure such as roads, bridges and telephone lines. Entrepreneurial activity and foreign direct investment are discouraged as a result due to the increased uncertainty over transportation and communication links. Crops may also be ravaged by extremes of rainfall. For example in 1984 severe drought compromised many manufacturing enterprises involving the processing of crops such as maize, tobacco, and cotton. Kenya’s shortages in basic infrastructure such as hydroelectric power also contribute to the lack of industry. Infrastructure built to facilitate during the colonial period may also not be applicable for internal use.

In addition, Kenya suffers from a relatively low endowment of natural resources when compared to other countries of its size. With three fifths of the country being semiarid desert making the land infertile, economic activity is limited. Agricultural production in these areas is mainly nomadic farming, where a person’s wealth is measured in terms of ownership of animals. This is largely X-inefficient as people do not seek to profit-maximise as they are happy with their current standards of living. Domestic savings are largely impossible to many nomadic farmers and thus decrease investment. This pastoral way of life also makes the provision of healthcare and education more difficult. Kenya’s climate also increases the disease burden on the economy with malaria, Cholera and Tuberculosis decreasing worker productivity and increasing healthcare costs. Climatic conditions are more favourable in coastal areas and around Lake Victoria where the greatest concentration of fertile land and population lies. In fact Agriculture is the backbone of the country’s economy employing 85% of the population with tea and coffee being the main cash crops. Unfortunately for Kenya current world demand for these products is lower than supply causing export earnings, helping in the payment of internal loans, to plummet. With lowering incomes for many farmers, tax revenues will fall, thus the acquisition of physical capital by both public and private sectors will decrease. Agricultural production is highly labour intensive as the tools used by workers are very basic and the tstste fly hampers the use of animals in many areas thus lowering productivity.

Furthermore institutional constraints exacerbate the insufficient funds needed for the manufacturing sector to increase. Frequently in the past the government would give farmers a set price, often below the world market value, for their cash crops. Thus profits from production would not be invested in domestic banks or back into the production process. With extreme climatic conditions desecrating crop yields and farmers living on subsistence levels of income this has caused rapid rural-urban migration.

With a population growth rate of 2.3% and unemployment at 30% this has induced many workers into the informal petty services sector of the economy. This greatly contrasts service sectors in the developed world where the provision of finance, leisure and commerce take precedence. The relative accuracy of the Chenery estimate here with only a overestimation/underestimation can be partly explained by this occurrence. Similarly Kenya’s tourism industry bulks up this figure. However the recent bombing of the United States of America’s embassy building in Nairobi and the increased terror threat have decreased must needed foreign exchange earnings by 40%.

Kenya currently has a Transparency Internal Corruption perceptions Index score of 2.1, significantly higher than other large countries used in the calculations. Given the countries heterogeneous ethnicity and religious background, corruption and political upheaval have plagued the Kenyan economy for many years and may be the main reason behind the inaccuracy of Chenery’s estimate of manufacturing’s share of output. Corruption has served to pull the plug on investment with public confidence in financial institutions faltering thus resulting in a Gross National Savings figure of 11% , 2% lower than the Sub-Saharan average. Government intervention in markets and the distribution of import licences along with other regulatory measures have caused allocative and productive inefficiency within the Kenyan economy. Corruption serves the comprador groups that have only self interests in the current share of output; not on the long term growth of the economy.

Furthermore, corruption has also become an international constraint on structural change. For example during the summer of 1997 the International Monetary Fund and the World Bank ceased nearly three hundred million dollars of vital investment. Political instability has also served to deter foreign multinational companies locating in Kenya with its neighbours Tanzania and Uganda now receiving greater levels of foreign direct investment. Technological progress suffers as a result as many foreign companies are the providers of new technology. This has perpetuated Kenya’s vicious cycle of poverty:

Kenya’s macro economy has suffered major setbacks in the past thirty years. The failure expansionary policies during the 1980’s have left Kenya with a current level of external indebtedness in the region of $5.7billion. This serves to worsen the already troubling budget deficit as an increasing percentage of export earnings outflow to international banks. Expenditure on improving human capital such as education and the provision of healthcare has been cut thus lowering the potential for workers to absorb foreign technology. Kenya’s current Human development index figure of 0.489 indicates this to foreign investors. Kenya’s current indebtedness also restricts access to future external capital funds as many banks see them as too much of a risk. The disbarment of the East African trade agreement also aggravates declining export earnings

The correlation between Kenya’s rapid population growth of 2.3% and dismal performance in manufacturing can be seen through Solow’s growth model: diagram on pg 202 Mankiw.Therefore with a population growth rate of 2.3 % the Kenyan economy must grow by %. This enables the structural change within the economy towards Chenery’s estimates.

In conclusion, structural changes observed as economies move across the development trajectory are not identical in every country. Deviations originate from different domestic and international constraints facing any economy. Therefore policymakers can hopefully encourage development using a combination of Chenery’s “Patterns of Analysis” approach and well-informed local information into the constraints faced by the developing country. The deviations may also be partly explained on the empirical methods used by Chenery as much of the data relies on national income accounts which inherently contain imperfections due to factors such as double counting and the shadow economy.