Econ 112 Lecture 3a Sept 6

Economic development as a subject did not exist prior to World War II.

However, there was an important book,

The Theory of Economic Development,

by Joseph Schumpeter.

Schumpeter coined the term “creative destruction,”

which is better phrased as “creative reconstruction”.

1. Circular Flow 2. Role of Entrepreneur

an economy in stationary state

a) All economic activities are essentially repetitive and follow a familiar routine course.

(b) All the producers know the aggregate demand for goods and adjust the supply of output accordingly. This means demand and supply are in equilibrium at each point of time.

(c) The economic system has the optimum level of output and its maximum use and there is no possibility of wastage of resources.

(d) The firms working in a system are in a state of competitive equilibrium.

(e) Under the stationary equilibrium, the prices are equal to the average cost.

To make it dynamic and consistent with development, changes must take place in flow system. These changes can be brought through innovations.

Innovation may be defined as a change in existing production system to be introduced by the entrepreneur with a view to make profits and reduce costs.

He defined development as a “Spontaneous and discontinuous change in the channels of flow, disturbance of equilibrium which forever alters and displaces the equilibrium state previously existing”.

When changes take place in the economy, circular flow is disturbed and the development process starts.

He assumed that change is the basic element of dynamic process, and those changes come in the form of innovations.

Any innovation may consist of:

(a) The introduction of a new product

(b) The introduction of a new method of production

(c) The opening up of a new market

(d) The conquest of a new source of supply of raw materials or semi manufactured goods.

(e) The carrying out of the new organization of any industry like the creation of a monopoly.

The new combinations of these factors are essential for the development process to start.

It is to be energised by the development agents and such agents are innovators or entrepreneurs. The entrepreneur is considered as the hero in the Schumpeterian development.

Feature # 2. Role of the Entrepreneur:

The entrepreneur is the key figure in Schumpeter analysis of the process of development.

He occupies the central place in the development process because he initiates development in a society and carries it forward.

Entrepreneurship is different from managerial activity.

A manager simply directs production under existing techniques but entrepreneurship, requires the introduction of something new.

An entrepreneur is also different from a capitalist.

The capitalist simply furnishes the funds while the entrepreneur directs the use of these funds.

Three things are necessary for the performance of the entrepreneurial function:

Technical know-how should be available to the entrepreneur for introducing new products and new combinations of production factors.

Capital resources enable the entrepreneurs to have command over factors of production.

For this, he needs purchasing power in the form either savings or else credit from which he can borrow from banks and other financial institutions.

Thus, credit and banks play a vital role in economic development.

Credit enables the entrepreneur to buy producer’s goods which he needs for conducting new experiments and innovations.

The invention in one field of the economic activity will induce inventions in the related fields. Thus, credit creation becomes an important part of the development model.

The Role of Profits

An entrepreneur innovates to earn profits.

Economic profit is “as a surplus over costs: a difference between the total receipts and outlay, as a function of innovation”.

Profits arise due to dynamic changes resulting from an innovation.

They continue to exist till the innovation becomes general.

Classical economic theory emphasized the wealth and growth of economies,

and so theories of economic development go back to the French Physiocrat economists of the 1700s.

Economic development as a branch of applied economics was a response to historical elements.

The European colonial empires were mostly dismantled from 1945 to 1965.

India and Pakistan become independent, and then the contries of Indochina, Africa, and elsewhere.

There was also the economic policies of the command economies, the USSR and China,

which raised the economic question of whether state planning or free markets promoted economic development the most.

Economic growth was emphasized by classsical economics.

This emphasis diminished with the rise of neoclassical theory in the late 1800s.

Poor and less developed economies are in a world where other countries have more advanced technology, more capital goods, and higher incomes.

An advantage today when economies can import technology such as cell phones.

Developing countries send students to schools in the more developed economies.

Developed economies send teachers to the developing countries.

Some people in less developed economies don’t want to develop,

especially primal peoples such as the Indians in the Amazon.

Ec Dvm, ch2 comparative ec dvm

Share of population living on less than $1.25 per day is

9% East Asia and Latin America, 32% South Asia, 41% Sub-Saharan Africa.

But numbers are misleading. The rental value of housing is not included.

97% of net population growth in 2012 took place in developing countries.

Children and the elderly create a dependency burden, but some of these are productive.

Indigenous populations usually lag behind, due to discrimination and traditionalism.

Rural to urban migration.

Not always voluntary.

50% of world population urban,

75% in more developed.

31% in South-central Asia (p. 65.)

Colonial legacy

Europeans got forced labor from head taxes paid in money.

P. 77: The evidence is that legalizing immigration provides a net positive economic effect.

Many immigrants are skilled, educated, and entrepreneurial.

Brain drain would be less if home country had entrepreneurial opportunity.

Remitances from migrants $200 billion globally.

Free trade the engine of growth.

Terms of trade: ratio of average export prices to import prices.

Change in terms of trade matters.

Convergence: per-capita income grows faster in low-income countries.

Marginal product of capital goods is lower in developed economies.

Long-Run Causes of Comparative Development p.85


US North vs. South.

Geography is not destiny.

Technology overcomes geographic limits,

e.g. air conditioning, heating; elevators.

Institutions are the most important cause.

An established law, practice, or custom.

Private property in land versus communal property.

England evolved mass democracy, now world-wide.

Contrast small-group voting.

Economic development requires institutional change.

E.g. a better rule of law, property rights, stable money, a better tax system.

No country today has an optimal economic policy.

Colonial powers established some bad institutions,

such as the latifundia in Latin America.


In some of the states of India,

land revenue collection was taken over by the British

between 1820 and 1856.

There, landlords did not receive the land rent.

Some rent was kept locally,

and there was more spending for health and education.

Land taxation was a major source of revenue for the monarchs of India from ancient times.

Slave labor.

Economic classes.


States arose from conquest.