Unit 4.1 - Economic Growth, Development and Capital Formation

CONCEPT OF ECONOMIC GROWTH & DEVELOPMENT

Concept of Economic Growth

Economic growth is defined as the sustained annual increase in productive capacity of an economy over time. It is quantitative term as it represents quantitative increase in the final output (GDP, GNP, NNP, PCI) of goods and services in an economy over time. It can be measured in both nominal and real values. Traditionally, aggregate economic growth is measured in terms of gross national product (GNP) or gross domestic product (GDP). World Bank uses GNP as indicators of measuring economic growth. However, GDP is considered as one best measuring indicators of economic growth.

According to M. P. Todaro, "Economic growth is the steady process by which productive capacity of an economy increases over time to bring about rising levels of national output and income".

In the words of Edward Shapiro, "Economic growth can be defined as the increase in the economy's output over time".

According to P. A. Samuelson and W. D. Nordhaus, "Economic growth is an increase in total output of a nation over time".

It is measured in terms of increase in real GDP over time or an increase in per capita income over time. For example, let us take a hypothetical economy, which has economic growth rate is 5 percentage. It means that GDP of the economy grows by 5 percentage in a year.

Economic growth is one of the most important indicators of a healthy economy. It has long term positive impact of an economy which promotes level of employment, output, and improve the living standard of the people. Higher GDP and GDP indicates higher productivity and performance of a country as well as higher productivity of people and higher living standard of the people.

Economic growth of a country is determined by the factors like quality and quality of natural, capital and human resources, state of technology, existing socio-economic infrastructure, etc. Higher quality and quantity of human and natural resources, progress in technology, higher saving and investment, etc. cause higher economic growth in the country. The rapid economic growth rate achieved by the countries like South Korea, Vietnam, China, etc. is due to development of education, infrastructure, and industries, pollical stability, improvement in technology, etc.

Features

1. Economic growth is an increase in the production of goods and services in an economy.
2. Economic growth is contribution of capital goods, labor force, technology, and human capital in an economy.
3. It is quantitative change in economic variables such as GDP, GNP and PCI from one period to another period.
4. It is necessary condition for long run self-sustain of an economy.
5. It is change in both real and nominal values of economic variables.

Economic growth is a narrower concept than economic development because it is only an increase in real GDP of a country. But economic development is the broad concept because it is the overall development of a country, i.e., improvement in living standard of people which encompasses better food, better cloth, better health, better shelter, better education, etc. along with the rise in real GDP or higher economic growth.

Concept of Economic Development

Economic development is a broader concept. While economic growth is relevant for a developed economy; economic development is more relevant for an underdeveloped economy.

Economic Development = Economic Growth + some important dynamic changes in socio-economic, political and cultural structure of the economy

Economic development is a process whereby an economy's real national income as well as per capita income increases over a long period of time. Economic development is increase in GDP, GNP, PCI as well as reduction of poverty, inequality, positive change in attitudes  and improve in living standard of the people. It is dynamic and long-run process of an economic and non-economic activity. It contains improvement of supply chains, increase efficiency of factors of production, better health and education, improvement in mortality rate, gender equality, change in old norms, values and believes by new one, proper distribution of income and wealth to the individuals and society as well as better living standard of people. In short, economic development is both quantitative as well as qualitative change in economic and non-economic variables. There are various definitions of economic development. Some of the main definitions are as below:

According to Professor Dudley Seers, "Economic development is the reduction in unemployment, poverty and income inequality".

According to Michael P. Todaro, " Development is a multidimensional process involving major changes in social structure, popular attitudes and national institutions as well as the acceleration of economic growth, the reduction of inequality and eradication of absolute poverty".

Recently, the concept of economic development is widening. It involves not only reduction in poverty, inequality and unemployment but also improvement in quality of life, which includes cleaner environment but also improvement in quality of life, which includes cleaner environment, better education, good health and nutrition.

The World Development Report, 1991 states clearly; "The challenge of economic development is to improve the quality of life. Especially in the world's poor countries, a better quality of life generally calls for higher incomes but it involves much more. It encompasses as ends in themselves better education, higher standards of health and nutrition, less poverty, a cleaner environment, more equality of opportunity, greater individual freedom, and a richer cultural life."

From this definition, it is clear that economic development is a multidimensional process, which involves major changes in social structures, popular attitudes, national institutions, as well as the acceleration of economic growth, the reduction of inequality and eradication of poverty. Moreover, development is not an event. It is a long-run process of making better life standard through basic needs, freedom and human rights, gender equality and political empowerment to all citizens of the nation. It is also an approach of equity, sustainability, productivity and empowerment.

Difference between Economic Growth and Economic Development

Basis	Economic Growth	Economic Development
Definition	It is an increase in the real output of goods and services in the country.	It is the process of improvement in living standard of people.
Concept	It is a narrow concept.	It is broader concept.
Indicator	Increase in national income is a sufficient indicator.	Increase in real national income, i.e., level of living is the indicator.
Scope	It is concerned only with increase in output.	It is concerned with the overall changes in the economy.
Automatic/Planned	It is an automatic process.	It is the result of purposeful and planned efforts.
Time Period	This process comes within a particular time period.	It is a continuous process that applies in the long-run period.
Effect	It brings only quantitative effects in the economy.	It brings both qualitative and quantitative effects in the economy.
Measurement	It is measured by the rate of increase in GDP.	It is measured by qualitative factors like education, life expectancy, infant mortality rate, etc.
Relevance	It relevant to both developed and developing countries.	It is more relevant to the developing countries.

Video Link: Economic Growth and Economic Development

INDICATORS OF ECONOMIC DEVELOPMENT

Indicators of development are related with the measurement of economic development and growth of an economy. As economic development is a dynamic concept, its indicators also vary with passage of time. Since economic development is a long-term phenomenon, a definite criterion set up in one time may not be equally valid in the other time. However, the widely accepted popular indicators of economic development are as follows;

1. Real Gross National Product (Real GNP)

Economists like Simon Kuznets, Paul Albert etc. have considered the increase in GNP as an indicator of economic development. According to them, only increase in national income may bring increase in economic activities.

It is defined as the money value of all final goods & services produced within a nation during a year plus net factor income from abroad (NFIA). Where, NFIA is the income earned by the domestic people living in abroad minus income earned by foreigner in domestic nation. In case of Nepal, it would be the difference between the earning of Nepalese people living in abroad and the earning of foreigners living in Nepal during a year.

Symbolically,

GNP = GDP + NFIA

GNP ↑→ Good performance of the nation & Vice-versa

This index is to be regarded as suitable for developed countries but not for developing countries where the production is high with poverty and most of the people is dependent on agriculture. Similarly, this indicator of economic development has failed to take consideration of changes in growth of population, pollution, distribution of income, etc. in the economy. It does not cover all the production of developing countries which are produced and consumed at home.

2. Per Capita Income (PCI)

This indicator was used in 1950s. It is an average income of any nation or income earned by an individual during a year. It is derived by dividing the national income of a country by its total population in a given period of time.

It shows the productivity and performance of individual people. PCI represents the living standard of the people. High PCI better living standard of people and vice-versa.

It is usually measured in dollar. Symbolically,

PCI = NI (2020) / Total Population (2020)

Highest PCI in 2019 is Luxemburg with $113196 (ranked-1 IMF2020, April). Nepal ranked 159 with PCI $1085 in the world out of total countries.

The following table shows the world income distribution pattern:

Nation's Classification	PCI ($) Level
High Income	12535 or Above
Upper Middle Income	4046 to 12535
Lower Middle Income	1036 to 4045
Low Income	1035 or Below

Source: World Bank, 2020, July

It is also not satisfactory indicator of economic development because the rise in PCI may not guarantee the improvement in living standard of people. If there is high income inequality, the increased income goes to few rich instead of many poor. Until and unless, the living standard of poor or majority of people is improved, there is no economic development.

3. Basic Human Needs Index

The basic human need criterion of economic development was developed by World Bank. It is a complement to the PCI criterion. According to this criterion, the economic development is evaluated on the basis of fulfillment of basic needs in terms of wealth, education, water, food, clothing, shelter, work, etc. and non-material needs such as cultural identity and a sense of participation and purpose in life and work.

All international organization such as World Bank, ILO etc. have recognized this concept, and suggested to the least developed countries to adopt this approach in their five-year plans. The aim of this criterion is to raise productivity and alleviate poverty by providing basic human needs to poor. This is very significant criterion of economic development because it has focused attention on poor. But this criterion should be taken as the complement rather than substitute of other criteria of economic development.

4. Physical Quality of Life Index (PQLI)

This is non-income indicator of economic development which was developed by Morris D. Morris.  It is calculated from life expectancy rate, infant mortality rate and literacy of the country. These three indicators get equal weightage and average. These three indices give the composite index, which is known as PQLI.

If people live longer and are literate, PQLI value is high. PQLI value is measured in a scale of 1 to 100. The value 1 refers to very inferior level and 100 refer to very superior level. If such value crosses 50, the country is an advanced and below 50 means underdeveloped country.

This indicator is superior over PCI, even though it is also not free from defects. It does not include income indicator. Similarly, this involves subjectively while giving weights to various items as they depend on various socio-economic and political set up. In addition, it considers only current welfare but not future welfare.

5. Human Development Index (HDI)

This index was developed by Pakistani Economist Mahbub Ul Haq in 1990 and adopted by UNDP. The Human Development Index (HDI) is a composite index that measures the average achievements in a country in three basic dimensions of human development. These basic dimensions are a long and healthy life, knowledge and a decent standard of living. The above-mentioned dimensions are measured by the following indicators.

1. A long and healthy life is measured by life expectancy at birth
2. Knowledge is measured by the adult literacy rate (with two thirds weight)and the combined primary, secondary and tertiary gross enrollment ratio (with one third weight)
3. A decent standard of living is measured by GDP per capita in purchasing Power Parity (PPP) US Dollars.

For the construction of the index, fixed minimum and maximum values have been established for each of these indicators:

• Life expectancy at birth : 25 years and 85 years
• Adult literacy: 0% and 100%
• Combined Enrolment ratio: 0% and 100%
• Real GDP per capita (PPP$): PPP$ 100 and PPP$ 40,000

For any component of the HDI, individual indices can be computed according to the general formula:

Classification of Nations on the Basis of HDI

HDI	Level of Development
0 – 0.549	Low Human Development
0.550 – 0.699	Medium Human Development
0.700 – 0.799	High Human Development
0.880 or Above	Very High Human Development

HDI is regarded as the best indicator of economic development because it includes both income and non-income indicators. 

Video Link: Indicators of Economic Development

CHARACTERISTICS OF DEVELOPING COUNTRIES

The developing countries are those countries of the world, which have lower per capita income compared to developed countries like USA, UK, Japan etc. and process of economic development has started but not completed. In other words, the countries which are trying to develop faster, but are lagging far behind in the race of development are called developing countries.

In these countries, there is rapid population growth, mass poverty, dependency on agriculture, lower living standard of people, illiteracy, unemployment and under employment, underutilization of natural resources and so on. These countries are also known as the underdeveloped countries or poor countries or Third World or less developed countries or backward countries. But to avoid impoliteness of some words like backward, less or underdeveloped., the word 'developing' is used more frequently while addressing such countries.

According to G. M. Meier, "An underdeveloped country is one which is extremely poor relatively to other economies in rank with the countries of the world by real income per head; the underdeveloped countries would be at the bottom."

The main characteristics of developing countries are as follows:

A. Economic Characteristics

1. Low Per Capita Income

The first important feature of the developing countries is low per capita income. For example, PCI of Nepal is only US $1097, which is very low compared to developed countries like USA, Canada, Norway, Switzerland, Japan and others.

2. Vicious Circle of Poverty

Poverty is the grief of parents watching a 3-years-old child die of a routine childhood disease because they cannot afford any medical care.

People in these countries are not able to satisfy even the basic needs. The extent of poverty prevailing in these countries is also reflected in the low per capita income. A large proportion of population in these countries lives below the poverty line. Absolute poverty of Nepal having income less than $ 1.25 per day is 16.67% around 50 lakhs Nepalese people lies below poverty line (Economic Survey 2076/77).

3. Excessive Dependency on Agriculture

In the developing countries, majority of population lives in the rural areas. Its only one source of income and employment is agriculture. It is back bone of the economy of developing countries, it is primitive and subsistence one. For example, in the developing countries like, Nepal, India and Bangladesh approximately 66 percentage, 50 percentage and 50 percentage of population (labor force) respectively is engaged in agriculture sector. Likewise, agriculture sector has also large share to their GDP. For example, its contribution to GDP in Nepal, India and Bangladesh is 28.1 percentage, 14.4 percentage and 14.2 percentage respectively.

4. Under Utilization of Natural Resources

Most of the developing countries are rich in natural resources but they are underutilized, misutilized or unutilized due to lack of capital, lack of technical skill, lack of good governance, limited market etc.

For example, Nepal is very rich in water resources. It can produce 83,000 MW hydroelectricity if it utilizes all water resources fully but current production of hydro-electricity is around 1233 MW, which is about 1.5 percent of its total potentiality. Likewise, Africa is rich in mineral resources like copper, tin and gold and Latin America is rich in minerals like petroleum, iron and lead.

5. Low Level of Productivity

Due to the unfavorable environment, developing countries are significant by the low level of productivity. There are various factors responsible for low productivity like the dominance of small industries, primitive production technology, lack of enterprises, lack of specialization etc.

6. Lack of Infrastrucutre Facilities

Developing countries also lack infrastructure facilities such as transportation, communication, electricity, bank and financial institutions etc.

7. Dualistic Economy

Dualistic economy refers to the economy where there exists technically primitive sectors (subsistence economy) and technically advanced sectors (market economy). For example, in the developing countries like Nepal, there are technically primitive sectors in the rural areas whereas there are technically advanced sectors in the urban areas. In the rural areas, people use primitive farming technique and there are also small cottage industries. But in the urban areas, there are modern industries, which use advanced technology.

8. Lack of Capital 

Underdeveloped countries are characterized as "capital poor" countries. In these countries not only present capital stock is poor but also the current rate of capital formation is very low. People have low capacity to save due to low level of income. In most under developed countries gross investment is only 5 - 6 percent of gross national income.

9. Under Employment and Disguised Unemployment

High dependency on agriculture sector, low industrial development, lack of proper utilization of natural resources, lack of manpower planning, etc. have created unemployment and underemployment in the developing countries like Nepal. It is mainly due to lack of alternative sources of employment except agriculture.

In most of the developing countries, more than 10 percentage of population is openly unemployed and more than 30 percentage population is underemployment.

As non-agricultural employment is limited people remain unemployed during off-seasons. Even if people are working they do not get sufficient work to increase productivity. Excessive pressure of population results in disguise unemployment.

10. Dependency of Primary Exports

The developing countries are oriented towards the production and export of primary product. The development of secondary and tertiary sector is extremely lacking. That's why, these countries export primary production of lower value and import finished goods of higher value. Consequently, the developing countries face the problem of deficit in foreign trade.

B. Demographic Characteristics

Demography refers to the birth rate, death rate, marriages, illness, size of population, density of population etc. Most of the demographic indicators like Crude Birth Rate, Crude Death Rate, Infant Mortality Rate and Total Fertility Rate etc. are very high which common feature in developing countries. The conditions of children, women and elder is painful in the joint family system.

Rapid population growth is a common feature of most of the developing countries. Their population has been rising at rates varying between 1 and 3 percentage per year for the past few decades. For example, population growth rate of developing countries like Nepal is 1.35; India is 1.31; Pakistan is 1.55; and Ethiopia is 2.1.

Lack of female education, employment, easy access to family planning and traditional value of society are responsible for high natural growth of population. One of the implications of the high population growth is increase in the number of young age dependent population.  The working population is required to support the children, which decreases saving and investment for capital formation.

C. Technological Characteristics

The developing countries are also backward in state of technology. The technological backwardness is reflected firstly in high average cost of production despite low wages; secondly, in high labor-output and capital-output ratios and the fall in input productivity. The main reasons for technological backwardness are illiteracy, lack of skilled manpower, lack of scientific research and deficiency of capital required to install new technology.

D. Socio-Cultural and Institutional Characteristics

In the developing countries, social services like education, health, safe drinking water, sanitation, etc. are not adequately provided to the people.

Most of the people are illiterate, ignorant, conservative, superstitious and fatalist. They believe on god than work. There is the prevalence of child labor and inferiority of woman's status. Most of the people are guided by traditional values and institution than wisdom and reason. Prostitution, gambling, corruption and other social evils can be seen in the developing countries due to poverty. Similarly, there is lack of bank and other financial institutions. Development of money markets and capital markets are also in infant stage. Political instability, defective government policies on various sector are also the obstacles for the development of developing countries.

E. Political Characteristics

The underdeveloped countries are also trapped in party politics. The political parties instead of working for the benefit of the people may engage in misutilization of power for personal benefit. Corruption, lack of transparency in government work, lack of justice, slackness in implementation of law and order, insecurity of life and wealth, misappropriation of country's resources are responsible for despair and frustration among the people. Political instability is the major cause of economic backwardness in many underdeveloped countries.

Video Link: Characteristics of Developing Countries

PROCESS OF CAPITAL FORMATION

Capital refers to that part of man-made wealth which is used for the further generation of wealth. Money, machinery, factory buildings, plants, raw materials, means of transport, etc. are the examples of financial & physical capital and they are used in production.

Capital formation or accumulation means the addition in the stock of real capital in the country. It refers the high value in the economic development and productive activities of a nation. In another words, capital formation involves production of more capital goods like as machine, equipment, tools, factories, etc. which all are used for further production of goods.

A nation is unable to utilize its natural, human even physical resources if there is insufficient capital formation. High level of capital formation brings advancement in the productive and developmental activities. So, capital formation is regarded as a key for the economic development. The formulation of capital or the chain of capital formation is shown below.

Process of Capital Formation involves 3 steps

(1) Creation of Saving

Saving is the first stage of the process of capital formation. It is done by individuals or households. Saving is that part of income which is not consumed (Y = C+S). As the rate of income increases in an economy, the rate of saving also increases, which in turn increases the rate of capital formation and economic development. However, increase in saving depends upon many factors such as distribution of income, imposition of taxes, rate of interest, etc. The level of saving in a country depends upon the following facts:

(a) Ability of Save

It is based on level of employment in the country, per capita income of the citizens, size of average family, standard of living of the citizens, price level etc. if ceteris paribus.

(b) Willingness to Save

It is determined by culture, social status, tradition, investment opportunity, consumption habits, government stability, position of law and order, security of life and wealth, existence of BFIs paying high rate of interest, fiscal and monetary policy of government etc.

(c) Government Saving

Budget surplus, reduction in government expenditure on unnecessary headings, export promotion etc. determine the saving capacity of a society and an individual as well.

(2) Mobilization of Savings

It is the second process of capital formation. Saving capital can be mobilized through the financial institution like as banks, co-operative societies, money market and capital market, insurance companies etc. in the field of primary sector, secondary sector as well as tertiary sectors. These institutions accept the saving from the people and give loans to the investors. However, mobilization of saving in an economy depends upon many factors, such as development of BFIs, banking habit of the people, etc.

(3) Investment of Savings

The third step in the process of capital formation is the investment of savings in creating real assets. The investment of saving in productive sector depends upon availability of good entrepreneurs, rate of interest, expected rate of profit, government policy, level of economic development, etc.