Development Economics Questions

Contents

TOC o “1-3” h z u Question One: What did Hollis Chenery mean when he said “factor prices don’t reflect opportunity costs with any accuracy”, and why was this so important for the development economists. PAGEREF _Toc376338408 h 1Question Two: What is the idea of low elasticity of demand among consumers (in consuming countries) and what role did it play in development economics? PAGEREF _Toc376338409 h 2Question Three: What is the idea of low supply elasticity among producers (in producer countries) and what role did it play in development economics? PAGEREF _Toc376338410 h 3Question Four: What does the term low demand elasticity among consumers (in developing countries) refer to and what role did it play in development policy? PAGEREF _Toc376338411 h 3Question Five: What was Chenery’s distinction between trade theory and growth theory and what importance did this idea have for development economics? PAGEREF _Toc376338412 h 4Question Six: What does the term “mandatory sectoral allocations” refer to and what role did this policy have in development policy? PAGEREF _Toc376338413 h 5Question Seven: What were guaranteed letters of credit and what role did they play in the economic policies of countries pursuing import-substituting industrialization? PAGEREF _Toc376338414 h 6Question Eight: What is public choice theory and what role did it play in regard to the tax policies of countries pursuing import-substituting industrialization? PAGEREF _Toc376338415 h 7Question Nine: Why did the development economists believe that the profitability of capital was greater in industry than in agriculture? PAGEREF _Toc376338416 h 8Question Ten: What are the 3 key elasticities of interest to development economics? PAGEREF _Toc376338417 h 9Question Eleven: What exactly is currency overvaluation and what role did it play in import-substituting industrialization? PAGEREF _Toc376338418 h 10Question Twelve: What is indivisibility and what importance did this idea have in the orthodox critique of development economics? PAGEREF _Toc376338419 h 11What part does exchange rate policy play in a country’s development strategy? You may wish to discuss both over and under valuation of a currency. PAGEREF _Toc376338420 h 12Why were the development economists pessimistic about the developmental prospects of the agricultural sector? Be sure to include elasticity pessimism in your answer. PAGEREF _Toc376338421 h 12What did Hollis Chenery mean when he said “factor prices do not reflect opportunity costs with any accuracy” and what is the significance of this view? PAGEREF _Toc376338422 h 14Anne O. Krueger believed that the concept of “economic indivisibility” could, by itself, explain the failure of the ISI strategy. What is that concept and what was her reasoning? PAGEREF _Toc376338423 h 15

1.0 Part One

Question One: What did Hollis Chenery mean when he said “factor prices don’t reflect opportunity costs with any accuracy”, and why was this so important for the development economists.The statement by Chenery (1961, p.21) that “factor prices do not reflect opportunity cost with any accuracy”, imply that there is no best alternative for employing the factors of production. Essentially, this statement shows that there is no state of perfect competition or full employment of factors of production among developing nations. This means that the allocation of resources is hindered by skewed balance of payments and divergent economic priorities (Rostow, 1992, p. 419). In extension, Chenery (1961) statement implies that even the determination of the cost of each factor of production does not accurately determine whether it is feasible to produce a certain product domestically and whether that product will enjoy a trade advantage at the international market. Arguably, this bold statement shows that the interaction between factors of production and the agents of production (producers, consumers, and investors) is dynamic and cannot always yield to finite observation in the long run. It distances development economics from trade theory, which according to Chenery is based on classical underpinnings of specialization and comparative costs.

The above sweeping statement has helped development economists to tailor development policies in a way that balances growth in all the sectors as opposed to specialization. This argument is in tandem with the core postulation of the growth theory that, there is an elastic supply of factors of production, and that developing countries will realize more growth if they encourage “horizontal and vertical interdependence” among related but not so similar sectors (Chenery, 1961, p. 21). Chenery’s statement has taught development economists that basing development policies on market forces alone will not result into optimized growth in developing countries. This is because the present prices of export and import commodities may not be a true reflection of the future cost and demand conditions. Such economic interdependence undermines the doctrine of comparative cost while at the same time lending credence to development economics.

Question Two: What is the idea of low elasticity of demand among consumers (in consuming countries) and what role did it play in development economics?

The idea of low elasticity of demand among consumers in consuming countries refers to an insensitive demand that does not react to changes in the price of a commodity. A low elasticity of demand is often represented by minimal percentage change in demand of a certain product over a large percentage change of another economic factor such as price, income, and government policy (Chenery, 1961). For example, there is a very low elasticity of demand in a consuming nation where a family’s annual consumption of coffee increases by only 2 lbs, from 52 lbs to 54 lbs following a large price decrease of $0.80, from $1.80 to $1.00. While the demand increase from 52 lbs to 54 lbs translates to only 4% growth and the price decrease from $1.80 to $1.00 translates to a whopping 44% decrease. This can be translated to mean that the price elasticity demand calculated by dividing the percentage demand change (4%) by percentage price change (44%), is only 0.09, an extremely low elasticity margin.

A low elasticity of demand helps in analyzing and predicting the behavior of consumers in consuming countries. For example, it guides trade and development policy formulation in countries that rely on agricultural commodities for foreign exchange. Specifically, it underscores the fact that the demand for basic commodities such as foodstuff do not change with changes in price and that, exporters of agricultural commodities cannot tap into high level demand markets (Gerschenkron, 1966). For example, a supermarket selling cornmeal will not register a demand increase even after slashing the prices of cornmeal by half. In the contrary, low elasticity of demand imply that exporters of manufactured commodities can gain access to high level demand markets with much ease. For example, an automobiles or personal computers dealer can register a higher demand following a slash of the prices of cars and trucks by half.

Question Three: What is the idea of low supply elasticity among producers (in producer countries) and what role did it play in development economics?

The idea of low supply elasticity among producers in producer countries refers to insensitive supply that does not respond to changes in the price of production. Low supply elasticity among producers implies that producers are not influenced by the changes in the price of production and will continue to produce almost to their normal capacity, nonetheless (Chenery, 1961). For example, coffee producers may not lower their production capacities even when there is a price reduction for coffee in the international market. A situation where a coffee farmer produces 250 units of coffee per year at a price of $2.00 per unit, but slashes the production by 10 units per year (4% slash) due to a price cut of $1.00 per unit (50% price cut), converts to 0.08 supply elasticity margin, an extremely low elasticity margin.

The role of a low supply elasticity among producers helps in determining supply pessimism among agricultural based economies. For instance, in the example above, it is clear that a 50% price reduction at the international coffee market will result into only 8% price reduction. When used diligently as a tool for planning and anticipating market changes, low supply elasticity can help to prioritise economic development policies regarding the allocation resources and imposition of taxes (Chenery, 1961, p.22). The justification of low supply elasticity among agricultural products has been used by many developing countries levying burdensome taxes to the agricultural sector. In addition, and as Rostow (1992) shows, the justification of low supply elasticity among farmers has been used by developed nations to siphon the little wealth generated by developing nations by offering them low prices for their agricultural prices while selling their manufactured products at high prices.

Question Four: What does the term low demand elasticity among consumers (in developing countries) refer to and what role did it play in development policy?

The term low demand elasticity among consumers in developing countries refers to the inflexibility of consumers in developed countries to price changes of primary/agricultural commodities, which mostly come from the developing world (Chenery, 1961). A typical example is the consumption of high grade coffee from developing countries, say, Kenya or Ethiopia by customers in developed nations, say, in the United States of the United Kingdom. A low demand elasticity among consumers in the developed countries manifests when the demand of a commodity, say, high grade coffee does not change substantially even when there is a huge price cut due to factors such as over supply.

A typical scenario of low demand elasticity among consumers in developed nations can manifest in the following example. Suppose a family in the United States consumes 1 unit of high grade coffee from Kenya, per week, or 52 units per year. One unit of high grade coffee costs $1.80. However, a price cut of $0.80 occasions an increase in demand of 2 units per year. The price drop, $0.80/$1.80 is equals to 44% while an increase in demand, 2/52 is equals to 4%. The demand elasticity here is therefore 0.09, a considerably low demand elasticity. In interpretation, a 44% price cut only leads to a 4% demand increase.

The low demand elasticity among consumers in developing nations effectively locks agricultural exporters from developing world from high level demand markets. Ironically, this type of demand elasticity gives undue advantage to exporters of industrial capita goods (Chenery, 1961). Moreover, this type of demand elasticity is used by the developed countries to oppress the developing countries. Since the goal of every country is to reduce deficits in its balance of payments (Krueger, 1982), developed nations emphasize on industrial sectors while convincing the developing nations that have abundance of labour and land resources to concentrate on agricultural sectors. This effectively puts the growth of the developing nations at the mercies of the developed world.

Question Five: What was Chenery’s distinction between trade theory and growth theory and what importance did this idea have for development economics?

Chenery (1961, p. 20) argued that distinctions between trade theory and growth theory border on their divergent assumptions and the use of divergent factors. The trade theory was based classical economic school of thought while growth theory is a creation of modern economic theories. The classical economic school of thought focuses on long-run economic tendencies and equilibrium conditions in the market while modern theories of growth concern their efforts on the dynamism of the interaction between and among the producers and consumers. To this end, Chenery (1961, p. 21) suggests that the classical school of thought is static while the modern growth theories are dynamic. In extension, the modern theories of growth acknowledge that the factors of production change over time, not only because of the passage of time but because of the changes in the process of production itself. For example, the classical theories are not able to properly account for things like changes in technology or reduction in cost of production that ultimately alter the course of production.

These underlying differences led development economists to develop at least four requirements that make the classical theories of trade to be applicable in developing economies. For instance, Chenery (1961, p. 22) reasons that for classical doctrine of comparative cost to work in developing economies, it must lend itself to the “possibility of structural disequilibrium in the factor market … [and it must allow for the] inclusion of indirect market and nonmarket effects” of growing a specific production area. Other requirements are the evaluation of key aspects such as products, consumption, and imports in closely related economic sectors over a period of time especially when there is a reduction in economic costs due to growth of output. Lastly, the underlying differences between trade theories and growth theories occasioned the need to allow disparity to prevail especially for the demand for exports and related data over a period of time.

Question Six: What does the term “mandatory sectoral allocations” refer to and what role did this policy have in development policy?

The term mandatory sectoral allocation is a form of banking and investment control that involves lending specific amounts of money to select sectors of the economy. This is a growth theory control strategy that economists can employ to increase productivity in certain sectors of the economy considered to be more strategic in terms of countering economic ills such as correcting negative balance of trade, increasing aggregate demand, and eliminating the low level trap among developing countries (Meier & Seers, 1984). The mandatory sectoral allocation encourages the growth of sectors considered to be risky and vulnerable to the machinations of the international market. For instance, a developing nation may channel more funds to capital intensive industries to encourage domestic investors to venture into capital goods export trade instead of relying on agriculture and tourism alone. To allow for effective competition, mandatory sectoral allocations are normally withdrawn after predetermined periods of time, once the new ventures have broken even.

Mandatory sectoral allocation encourages wealth transfer across all sectors of the economy. Channelling of differentiated interest rates and subsidies to vulnerable sectors such as capital intensive industries is crucial for the balanced growth in developing nations that solely rely on agriculture and tourism to cushion their balance of trade deficits. This also helps to stabilise local currencies, increase aggregate domestic demand, increase the opportunity cost of factors of production, and most importantly, protect developing countries against market shocks (Gerschenkron, 1966). For example, a country that relies on agriculture for survival can diversify its economy by channelling mandatory allocations to light manufacturing industries such as apparels, fertilisers, and vehicle assembly. Ultimately, this will create a multiplicity of sectors alongside the traditional sectors such as agriculture and tourism. This was a popular development policy pursued by the Breton Woods institutions in collaboration with Latin American, Asian, Middle East and African countries.

Question Seven: What were guaranteed letters of credit and what role did they play in the economic policies of countries pursuing import-substituting industrialization?

Guaranteed letters of credit were a form of formal credit promise made by a government to preferred industrial borrowers. Arguably, this is a growth oriented development policy employed by developing nations to correct negative balance of trade by reducing the amount of imports and encouraging domestic productivity. According to Meier and Seers (1984), a guaranteed letter of credit is a financial obligation taken on by a nation to supply selected industries with credit facilities whenever a need arises. For example, a government may avail unsecured loans to vehicle parts importers so as to encourage the assembly of automobiles within its boundaries. The underlying premise behind guaranteed letters of credit is the fact that developing nations are endowed with both skilled and unskilled labour, land, entrepreneurship but lack sufficient capital to put these three factors of production into optimum use.

Countries pursuing import-substituting industrialisation normally employ this form of selective financing. For example, in a bid to reduce high exchange rate taxes incurred during the importation of refined oil products, a country can provide unsecured loan facilities to investors willing to set up a local crude oil refinery plant. Since in most cases such capital intensive investment are take a long time to reach breakeven point, are prone to the changes in global fuel prices, and have low profit margin, it makes a lot of economic sense for the governments to extend guaranteed letters of credit to investors wishing to invest import-substituting industries (Gerschenkron, 1966). Local investors who have access to guaranteed letters of credit can maximise the benefits of import-substituting industries using their personal fortunes to stimulate growth in traditional industries such as agriculture and tourism.

Question Eight: What is public choice theory and what role did it play in regard to the tax policies of countries pursuing import-substituting industrialization?

Public choice theory is a school of thought that seeks to explain how public decisions touching on economic development are made. In essence, this theory demands that all economic development policies should be based on the need to ease the suffering of the masses through reducing taxes, creating more employment opportunities, increasing wages, improving workplace conditions, developing new social amenities, and creating harmony among government agencies (Meier & Seers, 1984). For instance, leaders of trade unions always yearn for more industrial benefits, reduced costs of living, and friendly workplace conditions for its members. Interestingly, all economic policies result into a win for one side and a loss for another, no matter the level of public involvements. For example, a public policy that encourages the creation of import-substituting industries may end up overburdening the agricultural sector with heavy taxes. Krueger (1982) confirms this argument by asserting that bureaucracy and rent-seeking behaviours underlie major development policies in developing nations.

Public choice theory encourages public participation in formulating tax policies among countries that pursue import-substituting industrialisation policies. Countries that pursue import-substituting industrialisation need to make responsive tax policies that do not overburden agricultural and tourism sectors in the name of encouraging growth in manufacturing sectors. Specifically, public choice theory ensures that policies does not lead to the creation of interest groups, rather, interest groups should be the ones who initiate policy formulation (Gerschenkron, 1966). To this end, the public choice theory helps to eliminate the bias between rural interests and urban interests. Since every faction of the public yearns maximise their benefits through low tax remittance, policy makers should explore the good and the bad implications of certain tax levels to the ultimate goal of subsidising the import-substitution industrialisation.

Question Nine: Why did the development economists believe that the profitability of capital was greater in industry than in agriculture?

According to development economists, the profitability of capital is greater in industry than in agriculture because of the obvious ability of the industry to optimise the factors of production more than agriculture. Though many developments have been made in mechanising agriculture, retrogressive factors such as unchecked rural urban migration and the obvious urban bias make agriculture a less profitable economic activity compared to industry. Gerschenkron (1966) reasons that the industry is able to maximise the utility of factors of production because most industries are located in urban areas where there is ample supply of skilled labour as well as the easy accessibility to credit facilities and other support infrastructures. Moreover, most developing countries are advised by their developed world partners to specialise in industries that consume high portions of the cheap, readily available factors of production. Financial difficulties also limit developing countries to producing commodities that consume less capital per unit of output.

Moreover, the low demand elasticity and supply elasticity stifles any gains that may emanate from agricultural activities. According to growth theory, low demand and supply elasticities skews opportunity cost and hence the optimum production by lowering the prices of agricultural products at the international market. Further, unlike most industry activities, agricultural activities are carried out in the rural areas where most produce is consumed locally hence diminishing the involvement of other market forces that stimulate growth. Hence the agricultural sector does not enjoy the benefits of dynamic external economy due to its homogenous nature (Chenery, 1961). On the other hand, industrial activities lend themselves to high demand and supply elasticities of capital and labour due to increased horizontal and vertical interdependence.

Question Ten: What are the 3 key elasticities of interest to development economics?

The three key elasticities of interest to development economics are low demand elasticity among consumers in consuming nations, low supply elasticity among producers in producing countries, and low demand elasticity among in developing nations. The low demand elasticity among consumers in consuming nations seeks to underscore the inflexibility among consumers in developing countries such as China to change their consumption levels even when there is price cut. This type of elasticity helps governments to make proper policy decisions regarding the allocation of resources such as credit facilities (Chenery, 1961, p.24). For example, the government can deploy marginal revenue instead of average on agricultural products because after all the change in demand will be minimal.

On the other hand, the low supply elasticity among producers in producing nations underscores the inflexibility of producers in adjusting to changes in the prices of their produce at the international market (Chenery, 1961). Development economists can rely on this type of elasticity to shift heavy taxation from industrial sectors to agricultural sectors in an effort to stimulate growth in the more profitability industrial sectors than the less profitable agricultural sectors.

The low demand elasticity of consumers in developing nations underscores the state of inflexibility among consumers of primary (agricultural) products from developing nations even when there is a price change (Chenery, 1961). For example, the amount of high grade coffee from East Africa entering the United States may not increase by a substantial margin even after fluctuation of coffee prices at the international coffee market. Arguably, Krueger (1982) shows that developed countries use this type of elasticity to exploit developing nations by convincing them to invest more in agricultural sectors at the expense of industrial sectors.

Question Eleven: What exactly is currency overvaluation and what role did it play in import-substituting industrialization?

Currency overvaluation is the deliberate increment of the conversation ratio of a local currency so that it exchanges at too few units against the base currency, the dollar. A country overvalues its currency by creating a huge, artificial tax between the actual market value of its currency and the official conversion value. For example, an overvalued shilling that converts for say, 3 units against 1 unit of the dollar, means that a rural farmer who produces $1 worth of coffee will get only 3 shillings in exchange for selling the coffee in the international market. This effectively lowers the domestic prices of traded goods hence stimulating aggregate domestic demand (Krueger, 1982). Nevertheless, overvalued exchange rate creates a parallel market that is arguably the actual reflection of the exchange rates. The difference between exchange rates at the parallel market and the official market creates huge overvaluation tax, which end up benefiting banks and importers of industrial capital goods.

Countries overvalue their currencies when they want to pursue import-substitution industrialisation strategies. Since overvalued currencies result into lowering of prices of both domestic and imported goods (Gerschenkron, 1966), the agricultural sector bears the brunt at the expense of importers of industrial capital goods such as vehicle parts. In effect, currency overvaluation is a direct transfer of wealth from the farmers to importers of industrial capital goods. The importers of industrial capital goods not only enjoy capital subsidies from the government, but also enjoy protection from both foreign and domestic competitor rivalry because of obvious price advantage. For example, when importing capital goods worth $1,000, a local importer will only need 3,000 shillings (exchange ratio of $1 = 3 shillings) at the formal market yet on the parallel market it will cost 100,000 shillings (exchange ratio of $1 – 100 shillings) converting to a 97,000 shillings subsidy.

Question Twelve: What is indivisibility and what importance did this idea have in the orthodox critique of development economics? 

The idea of indivisibility holds that there is no way an infant industry in a developing nation can match the level of efficiency demonstrated by a similar industry in developed country. For example, the capital cost of producing automobile windscreens in a developed country is $1, 000,000 units per year, where 100,000 units are produced. The same cost is incurred to produce 1,000 units of windscreens in a developing country. This comparison points to a huge difference in the cost of producing a single unit of windscreen between a developed country and a developing country. It is only $10 in the former and $1,000 in the latter. In fact, Krueger (1982) reasons that the disparity in production cost in developed and developing nations could be even huge in less protectionist developing nations that pursue orthodox economics paradigm.

The indivisibility undermines the application of the tenets of development economics in developing poor countries. Development economics target to strengthen the development credentials of developing countries by encouraging a policy shift from reliance on agricultural sector to industrial sector through import-substitution industrialisation. Even so, proponents of the orthodox economics counter this school of thought by reasoning that the differences in technology capabilities, socioeconomic and political intricacies, and of course market forces makes it very hard for developing nations to effectively compete with their developed counterparts (Gerschenkron, 1966). While using the idea of indivisibility, the orthodox critique posits that the development economics paradigm is not practically applicable because neither markets or governments is perfect, and that developing nations should embrace free trade (Chenery, 1961). A free market that is anchored on sound democratic systems will allow for a right mix between government-induced forces and the economy forces.

2.0 Part 2

What part does exchange rate policy play in a country’s development strategy? You may wish to discuss both over and under valuation of a currency.The exchange rate policy helps a country to monitor the exchange ratio of its currency in relation to the base currency, the dollar. Mostly, exchange rates are controlled by the market forces because most countries allow their currencies to float freely in the market (Gerschenkron, 1966). However, there are few cases when exchange rates are controlled by governments through legal barriers as is the case in China and South Korea. Free floating exchange rates help to keep inflation rates at watch because they encourage trade activity both at the domestic and international markets.

However, artificially controlled exchange rate may have harmful effects on the local market. Inflation targeting nations who seek to cushion themselves against volatile financial markets by fixing artificial caps for their currency end up destroying domestic production in the primary industries such as agriculture (Chenery, 1961). For example, a country that overvalues its currency against the base currency will occasion great losses to producers of export goods because it will lower the prices of both domestic goods. This will ultimately discourage mass production while encouraging imports for industrial capital goods that are used as raw materials in import-substitution industries.

Overvaluation of the currency will shift wealth from primary producers to importers of industrial capital goods. Such a scenario also opens loopholes for parallel currency markets that allow large overvaluation taxes to wealthy investors who circumvent the formal exchange system (Gerschenkron, 1966). On the contrary, countries may undervalue their currency in order to boost domestic production and make their exports very competitive at the international market. For example, China undervalues its currency against the dollar hence creating an incentive for local manufacturers and producers to venture into the international. This strategy has put China in the world’s limelight as one of the leading exporter and importer in the world.

Why were the development economists pessimistic about the developmental prospects of the agricultural sector? Be sure to include elasticity pessimism in your answer.Development economists were pessimistic about the developmental prospects of the agricultural sector because they reasoned that traditional peasants did not invest in modern production methods. Traditional peasants proved very difficult to transition into modern development policies that demanded them to diversify into other sectors such as industrial in order to enjoy the benefits of dynamic external economies (Chenery, 1961, p.24). Specifically, Chenery (1961) reasons the pessimism among development economists was partly as a result of the fact that industrial sectors are more likely to enjoy the benefits of dynamic external economies than the agricultural sectors due to factors such as internal economies of scale, high demand elasticity, efficiency in operations, ability to deploy modern technology, and training effects.

In essence, the industrial sectors are more likely to experience productivity change than the agricultural sectors because policies changes such as urban bias, import-substituting industrialization, and overvalued currency work to their favor. For example, industrial capital goods importers can streamline their production functions because they enjoy government subsidies, protection from domestic and international competition, controlled labor, and cheap credit facilities from the government.

Development economists were pessimistic about agricultural sector because of its low de