Chapter 1: Introducing economic development

1.1 How Living Levels Differ Around the World

4 Living standards strata: Introduced by Hans Rosling 

1. Lowest Stratum: Extreme Poverty

2. Second-lowest Stratum: Basic Needs met
3. Second-highest Stratum: Emerging Middle class
4. Highest Stratum: Affluent or rich and fulfilled

Poverty is more than lack of income- it is inherently multidimensional

1.2 How Countries Are Classified by Their Average Levels of Development and World income
distribution

1. Countries are often classified based on income, human development, poverty levels, and quality of
governance.
2. The World Bank classifies countries into four ranges of average national income: Low, Lower-Middle,
Upper-Middle, and High.
3. High-income countries (HICs) have a GNI per capita of at least $12,056, but it may not be considered
"upper income" in countries like Japan, the UK, and the US.
4. Middle-income countries (MICs) have experienced significant growth, with more than 60% of the
world's population living in these countries.
5. Upper-middle-income countries (UMCs) have a GNI per capita between $3,896 and $12,055, while
lower-middle-income countries (LMCs) have a GNI per capita between $996 and $3,895.
6. Low-income countries (LICs) have a GNI per capita below $1,026, and many of them are located in
sub-Saharan Africa.
7. Least-developed countries have low education and health criteria, high economic vulnerability, and low
income. Over a billion people live in these countries.
8. Developed countries with high-income levels are primarily members of the OECD.
9. China and India have experienced rapid income growth, transitioning from low-income to middle-
income countries.
10. Average levels of human development have been rising globally, as measured by the Human
Development Index (HDI) of the UNDP.
11. Inequalities in income and access to health and education exist within countries.
1.3 Economics and Development Studies:
Development Economics: The study of how economies are transformed from stagnation to growth and
from low-income to high-income status, and overcome the problems of poverty.

Development Economics holds a geographic scope considered to be most of Asia, Sub-saharan Africa,
Middle east, North Africa, Latin America and Caribbean.

The Nature of Development Economics

 Development economics has a broader scope than traditional neoclassical economics and political
economy.
 considers a wide range of factors beyond market interactions, including social, political,
historical, and institutional influences on economic development.
  recognizes the importance of institutions, governance, social norms, and cultural factors in
shaping economic outcomes.
 acknowledges the diverse realities and contexts of developing countries, including historical
legacies and unique cultural and social characteristics.
 goes beyond focusing solely on aggregate measures like GDP growth and income levels.
 emphasizes the multidimensional nature of development, including social well-being, human
capabilities, sustainability, and equity.
 Closely examines issues such as poverty, inequality, education, health, gender disparities,
environmental sustainability, and social justice.
 aims to formulate context-specific policies and interventions that are relevant and effective in
promoting development.
 seeks to promote sustainable, inclusive, and equitable development.
 embraces a multidisciplinary approach, drawing insights from various disciplines to understand
and address development challenges.

Why study Development Economics?

Studying development economics raises several critical questions that are important to understanding and
addressing the challenges faced by developing countries. Some of these questions include:
1. What causes economic disparities and poverty?
   - Understanding the root causes of poverty and inequality is crucial for designing effective strategies to
alleviate them.
2. How can economic growth be fostered and sustained?
   - Exploring the factors that contribute to economic growth and identifying sustainable strategies to
promote it is vital for long-term development.
3. What role does institutions and governance play in development?
   - Examining the impact of governance structures, legal frameworks, and institutions on development
outcomes helps in creating effective policies and institutions that support development.
4. How can social and economic inequalities be reduced?
   - Analyzing the drivers of inequality and identifying policies and interventions to reduce disparities is
important for promoting social justice and inclusive growth.
5. What is the role of international trade and globalization in development?
   - Assessing the benefits and challenges of participating in the global economy helps in formulating
trade policies that promote development and minimize negative consequences.
6. How can sustainable development be achieved?
   - Understanding the interactions between economic growth, social development, and environmental
sustainability is crucial for pursuing development paths that are environmentally responsible and socially
inclusive.
7. How do cultural, social, and political factors influence development?
   - Recognizing the influence of cultural, social, and political factors on development outcomes helps in
tailoring policies and interventions to specific contexts and addressing unique challenges.
By studying development economics and exploring these critical questions, policymakers, researchers,
and practitioners can gain insights into the complexities of development and contribute to evidence-based
decision-making and sustainable development strategies.
Economics as a social system: need to go beyond the simple economics
1. Economies are not isolated entities but are part of broader social systems.
2. Social systems consist of interconnected elements such as economic institutions, political systems,
cultural norms, social structures, and environmental factors.
3. These elements interact and influence each other, shaping the dynamics and outcomes of economic
activities.
4. Development policies should consider the broader institutional and structural variables that operate
within a society, such as governance systems, legal frameworks, social norms, educational systems,
infrastructure, and environmental sustainability.
5. Neglecting these factors can lead to incomplete or ineffective policy approaches.
6. Policymakers need to take into account institutional and structural variables alongside traditional
economic variables for a comprehensive understanding of the dynamics at play.
7. This holistic perspective enables a deeper analysis of the drivers of development and the potential
barriers or constraints that need to be addressed.
8. A development policy focused solely on increasing income levels may overlook the importance of
investing in education and healthcare systems.
9. Similarly, an exclusive emphasis on economic growth without considering social and environmental
dimensions may lead to inequalities, environmental degradation, and social unrest.
10. Therefore, a comprehensive approach to development requires recognising and analysing the
interdependencies between economic factors and the broader social systems in which they operate.
11. This approach helps identify the underlying causes of development challenges, design more effective
policy interventions, and promote sustainable and inclusive development outcomes.

Summary

Development Economics focuses beyond simple economics. Since a society is a system

consisting of different institution other than economic system like political system,
environmental factors, social norms and cultural factors, solely focusing on economic system
for making policies won’t do good. A holistic approach should be taken that considers all the
institutional and structural factors as well as traditional economic variables for proper
policies which can empower a proper economic growth. If we don’t focus on all factors, for
example, if we solely focus on raising income levels using all the resources we have, there will
be problem in education and health care system. Similarly, an exclusive emphasis on raising
economic growth by increasing GDP without considering any other variables will lead us to
income inequality, environmental degradation. Therefore, a comprehensive approach which
touches all the factors and variables should be considered.

Meaning of Development

1. Amartya Sen’s Capability approach:

 Amartya Sen argues that the "capability to function" is crucial for determining poverty and
well-being, emphasizing that income and wealth are instruments for human welfare and
freedom.
 Poverty cannot be adequately measured by income or conventional utility; what matters is
what a person can do or be.
 Real income levels or consumption alone are insufficient measures of well-being.
 Well-being should be measured by health, nutrition, personal enjoyment, social functioning,
and external capabilities.
 Utility should not be equated with happiness, as even poor individuals can have high utility
while experiencing deprivation.
 Sen introduces the concept of "functionings", which refers to what a person can do with the
commodities they possess.
 Functionings are achieved through choices based on capabilities and differ from merely
possessing goods or experiencing happiness.
  Well-being should consider the use of commodities and freedom of choice and control over
one's own life.
 Sen identifies five sources of disparity between measured real incomes and actual advantages:
personal heterogeneities, environmental diversities, variations in social climate, distribution
within the family, and differences in relational perspectives. (didn’t understand)
 Capabilities refer to the freedoms a person has to choose functionings based on personal features
and command over commodities.
 Health, education, and income are essential for converting commodities into functionings.
 Development encompasses physical well-being and providing means for a better life.
 The objectives of development include increasing the availability and distribution of life-
sustaining goods, raising living standards, and expanding economic and social choices for
individuals.

2. Three Core values of development

Three core values of development can be identified as follows:

1. Sustenance: The Ability to Meet Basic Needs

Sustenance refers to the ability to meet one's basic needs for survival and well-being. These needs
typically include access to food, water, shelter, clothing, healthcare, and other essentials. Without
the means to fulfill these basic needs, individuals may struggle to thrive and reach their full
potential. Ensuring sustenance is a crucial aspect of human rights and social justice, as it forms the
foundation for a dignified life.

2. Self-Esteem: To Be a Person

Self-esteem is the subjective evaluation and perception of one's own worth and value as a person. It
involves a sense of self-respect, self-acceptance, and belief in one's abilities and intrinsic worth.
Self-esteem plays a vital role in mental and emotional well-being, as it contributes to feelings of
confidence, resilience, and overall life satisfaction. It is nurtured through positive self-perception,
personal achievements, supportive relationships, and a sense of belonging within a community.

3. Freedom from Servitude: To Be Able to Choose

Freedom from servitude refers to the absence of oppression, exploitation, or subjugation that limits an
individual's autonomy and agency. It encompasses the ability to make choices and decisions based
on one's own values, beliefs, and preferences. This concept includes both political and economic
freedoms, such as the right to participate in decision-making processes, freedom of expression, and
the absence of forced labor or slavery. Having freedom from servitude allows individuals to live a
life of self-determination, pursuing their own goals and aspirations.

Central Role of Women in the development process:

Empowering and investing in women is essential for achieving comprehensive societal development.
Women play a pivotal role in key domains such as education, healthcare, the economy, and community
well-being. Women in developing countries have primary responsibility for child-rearing, and the
resources that they are able to bring to this task will determine how readily the cycle of transmission of
poverty from generation to generation can be broken.
Moreover, women play a significant role in transmitting values to the next generation. By ensuring
women's equitable access to education and opportunities, promoting their meaningful participation in
decision-making processes, and safeguarding their reproductive health rights, societies can unlock
their potential as catalysts for change.  Empowered women contribute significantly to economic growth,
social stability, and sustainable development.  Furthermore, investing in women yields a multiplier
effect, as they often prioritize investing in their families and communities, resulting in positive
intergenerational impacts. Recognizing and supporting the central role of women is crucial for
advancing gender equality, fostering prosperity, and forging a more inclusive future.

3. Three Objectives of Development

1. Increase availability of life-sustaining goods:
This objective focuses on ensuring access to essential goods and services necessary for sustaining life and
promoting human dignity. It includes basic needs such as food, clean water, shelter, healthcare, sanitation,
and other vital resources. By increasing the availability and affordability of these goods, societies can
improve the overall health, well-being, and survival rates of their population.
2. Raise levels of living:
Refers to improving the overall standard of living for individuals and communities. This objective aims to
improve the quality of life and enable individuals to fulfill their potential.
It encompasses various aspects such as income, education, housing, infrastructure, and access to social
services. By enhancing these factors, societies can provide better living conditions, reduce poverty, and
create opportunities for personal and collective growth.
3. Expand the range of economic and social choices:
Expanding the range of economic and social choices focuses on promoting freedom, autonomy, and
agency for individuals. It involves creating an enabling environment where people have access to diverse
economic opportunities, employment options, and the ability to pursue their desired paths. Additionally, it
entails fostering social inclusion, gender equality, and respect for human rights, allowing individuals to
make informed decisions and participate actively in social, cultural, and political spheres.

Questions and Answers: 

1.What are economic institutions, and how do they shape problems and prospects for successful
development?
Economic institutions refer to the formal and informal rules, norms, and organizations that govern
economic activities within a society. Economic institutions encompass a wide range of entities, including
legal systems, property rights regimes, financial institutions, market structures, trade policies, labor
regulations, and regulatory frameworks. They play a crucial role in shaping the problems and prospects
for successful development. Here's an explanation of economic institutions and their influence:
Economic institutions play a significant role in shaping problems and prospects for successful
development in the following ways:
1. Property Rights and Contract Enforcement: Clear and secure property rights provided by economic
institutions encourage investment, innovation, and entrepreneurship. When property rights are protected
and contracts are enforced, individuals and businesses have the confidence to engage in economic
activities, leading to economic growth and development.
2. Market Functioning and Efficiency: Economic institutions establish the rules and regulations that
govern market activities. Well-designed institutions that promote competition, prevent monopolies,
ensure fair trade practices, and protect consumers create a conducive environment for market efficiency.
This fosters healthy competition, innovation, and optimal allocation of resources, driving economic
growth.
3. Access to Finance and Credit: Sound economic institutions facilitate access to finance and credit for
businesses and individuals. Institutions such as banks, credit unions, and microfinance organizations
provide financial services, allowing entrepreneurs to invest in productive activities and individuals to
fund education, housing, and other essential needs. Access to finance is crucial for promoting investment,
job creation, and economic development.
4. Trade and Investment Policies: Economic institutions shape trade and investment policies, including
tariffs, regulations, and incentives. Favorable trade and investment policies attract foreign direct
investment, promote exports, and facilitate economic integration, enhancing growth prospects for
developing economies.
5. Governance and Corruption: Economic institutions influence governance structures and anti-
corruption measures. Transparent and accountable governance systems reduce corruption, ensure the
efficient allocation of resources, and foster investor confidence. Strong institutional frameworks that
prevent corruption contribute to sustainable development.
6. Labor Market Regulation: Economic institutions determine labor market regulations, including
minimum wage laws, employment protection, and labor standards. These regulations impact employment
dynamics, wage levels, and worker rights. Well-designed labor market institutions can promote inclusive
growth, decent work, and social well-being.
7. Social and Environmental Considerations: Economic institutions that integrate social and
environmental considerations into their policies and practices promote sustainable development.
Institutions that prioritize social equity, environmental sustainability, and community engagement
contribute to long-term prosperity and well-being.
Overall, economic institutions shape the incentives, rules, and regulations that govern economic activities.
When these institutions are well-designed, transparent, and inclusive, they create an enabling environment
for successful development by encouraging investment, fostering market efficiency, promoting fair
competition, and addressing social and environmental challenges. Conversely, weak or poorly functioning
economic institutions can impede development by creating barriers to entry, fostering corruption,
hindering market efficiency, and perpetuating inequalities. 
In addition to the aforementioned factors, colonial legacies too have had a lasting impact on economic
institutions in many developing countries. During the era of colonialism, European powers imposed
economic systems that primarily served their own interests, often resulting in extractive institutions
that perpetuated inequality and hindered local development. These institutions were designed to extract
resources, exploit labor, and control markets, rather than promote inclusive and sustainable economic
growth. The legacies of colonialism, such as unequal land distribution, limited access to education and
healthcare, and economic dependence on primary commodities, have posed significant challenges to
the prospects of successful development in many countries. Overcoming these legacies and reforming
economic institutions to be more inclusive, transparent, and responsive to the needs of the population
are critical steps in fostering sustainable development and reducing the disparities created by historical
inequalities.

2. Why do economic models fail to work in a country? ( In general )

There can be several reasons why economic models fail to work in a country, and it is important to note
that the specific factors can vary from one situation to another. Here are a few potential reasons:
1. Institutional and Governance Challenges: Economic models rely on effective governance structures
and institutions to implement and enforce policies. If a country faces corruption, weak rule of law, or
inadequate institutional capacity, it can hinder the proper functioning and effectiveness of economic
models.
2. Socio-cultural Factors: Socio-cultural factors can significantly influence the success of economic
models. Cultural norms, values, and attitudes towards work, entrepreneurship, and economic activities
can impact the adoption and implementation of economic policies.
3. Structural Limitations: Economic models often assume certain structural conditions, such as well-
developed infrastructure, competitive markets, and a skilled workforce. If a country lacks these structural
prerequisites, the economic models may not produce the desired outcomes.
4. External Factors: External factors, such as global economic conditions, international trade policies, or
geopolitical events, can significantly affect the performance of economic models. Economic models are
designed within a specific context, and changes in external factors can disrupt their efficacy.
5. Lack of Policy Consistency and Long-Term Planning: Economic models require consistent and
coherent policies over the long term to achieve desired outcomes. Inadequate policy implementation,
policy reversals, or short-term thinking can hinder the effectiveness of economic models.
6. Inequality and Distributional Issues: Economic models may fail to work if they do not adequately
address inequality and distributional issues. Neglecting inclusive growth and social development can lead
to social unrest, and political instability, and ultimately undermine the functioning of economic models.

Why do economic models fail to work in a country? ( In the context of Nepal)

In the context of Nepal, several factors can contribute to the challenges faced by economic models:
1. Political Instability: Nepal has experienced political instability and frequent changes in government
over the years. This can lead to inconsistent policies, lack of policy continuity, and delays in
implementing economic reforms, which can hinder the effectiveness of economic models.
2. Infrastructure Constraints: Nepal faces significant infrastructure constraints, including inadequate
road networks, unreliable power supply, and limited access to modern transportation and communication
systems. These infrastructure limitations can impede economic growth and hinder the smooth functioning
of economic models.
3. Geographical Challenges: Nepal's mountainous terrain and landlocked location pose unique
geographical challenges. These challenges can result in higher transportation costs, limited access to
markets, and difficulties in trade and commerce, which can affect the effectiveness of economic models.
4. Dependence on Agriculture: Nepal's economy relies heavily on agriculture, which is susceptible to
various factors such as climate change, natural disasters, and low productivity. Challenges in modernizing
and diversifying the agricultural sector can limit the effectiveness of economic models that focus on other
sectors.
5. Human Capital Constraints: Nepal faces challenges in human capital development, including low
literacy rates, limited access to quality education, and a lack of skilled labor. Insufficient investment in
education and training can hinder the implementation and success of economic models that rely on a
knowledgeable and skilled workforce. Data: Over 600 people apply for No Objection Letter Daily,
Over 1 lakh student left Nepal for abroad to study in FY 23/24.

6. Inequality and Inclusive Growth: Nepal struggles with high levels of income inequality and regional
disparities. Economic models that do not adequately address these disparities or promote inclusive growth
can face challenges in achieving their intended goals and may exacerbate social and economic divisions.
Addressing these challenges requires a comprehensive approach that encompasses political stability,
infrastructure development, human capital investment, and policies that promote inclusive and sustainable
economic growth.

3. What is the real meaning of development? Do SDGs fit with it?

The real meaning of development is a complex and contested issue. There is no single definition that is
universally accepted. The meaning can vary from individual to individual. The three core values of
development are: 
 1. Sustenance: The Ability to Meet Basic Needs

2.    Self-Esteem: To Be a Person

3.    Freedom from Servitude: To Be Able to Choose

Below are some of the key elements that are often included in definitions of development include:

 Economic growth: This refers to an increase in the overall output of goods and services in an
economy.
 Human development: This refers to the improvement in the well-being of people, as measured
by factors such as health, education, and access to basic necessities.
 Sustainability: This refers to the ability of development to meet the needs of the present without
compromising the ability of future generations to meet their own needs.

Here are some additional thoughts on the real meaning of development:

 Development is not just about economic growth. It is also about improving the quality of life for
people, both now and in the future.
 Development should be sustainable. This means that it should not damage the environment or
exhaust natural resources.
 Development should be inclusive. It should benefit everyone, not just a select few.
 Development should be equitable. It should reduce inequality and ensure that everyone has the
opportunity to reach their full potential.

The SDGs, or Sustainable Development Goals, are a set of 17 goals that were adopted by the United
Nations in 2015. The SDGs are a global agenda for sustainable development, and they aim to end
poverty, protect the planet, and ensure prosperity for all.

The SDGs fit with the real meaning of development in a number of ways. First, they focus on both
economic growth and human development. Second, they emphasize the importance of sustainability.
Third, they are global in scope, and they recognize that development is a shared responsibility. However,
there are also some ways in which the SDGs do not fully capture the real meaning of development. For
example, they do not explicitly mention issues suchas inequality, gender equality, and peace and security.
Additionally, they focus on the overall well-being of people, but they do not specifically address the
needs of marginalized groups.

Overall, the SDGs are a significant step forward in the effort to define and achieve sustainable
development. However, there is still work to be done to ensure that the SDGs are fully aligned with the
real meaning of development.

The SDGs are a step in the right direction, but they are not the end of the road. We need to continue to
work to ensure that development is truly inclusive, equitable, and sustainable.

Chapter 2: Comparative Economic Development

In this chapter, the focus is on how national levels of economic development are classified based on average income.

Background :
Characteristics of developing countries:

1. Poor Governance
2. High corruption
3. Low per capita income
4. Mass poverty
5. Rapid Population Growth
6. Poor education
7. Higher unemployment
8. Lack of infrastructures
9. Unstable Political system
10. Lack of skilled manpower 
11. Technological backwardness
12. Colonial Legacies- poor institutions etc.
13. Adverse Geography 
14. Larger rural population 
15. Low level of industrialization and manufactured

2.2.1 Conventional Comparisons of Average National Income 

 The World Bank classifies countries into income groups based on GNI per capita.
 Income is not the only factor that determines development. Other factors include education, health, and
social indicators.
 The distribution of countries across income groups is not uniform.
 Some countries classified as high-income may still face development challenges whereas the
countries classified as low-income may still be ahead in some fields of development .
 Income comparisons based on official foreign exchange rates can be exaggerated when using official
foreign exchange rates, and adjustments like purchasing power parity (PPP) are necessary for more realistic
comparisons of living standards.
 The classification of countries based on average income provides a broad framework for understanding
economic development.

2.2.2 Adjusting for Purchasing Power Parity(PPP) 

 Market exchange rates represent the value of one currency in terms of another currency. They are
determined by the foreign exchange market and reflect the current supply and demand for currencies.
 Limitations of market exchange rates: Market exchange rates do not consider the differences in the cost of
goods and services between countries. They do not account for variations in price levels, purchasing power,
or the standard of living in different countries. 

Therefore, using market exchange rates alone to compare incomes can be misleading and fail to capture the real
purchasing power of individuals.

Purchasing power parity (PPP) rates: 

-alternative exchange rates that take into account the relative prices of a basket of goods and
services in different countries. 
-They aim to equalize the purchasing power of different currencies by adjusting for the differences in price levels. 
How PPP rates work: 
-PPP rates are determined by comparing the prices of identical or similar goods and services in different countries. 
-Economists and statisticians collect data on a range of items, including food, housing, transportation, and consumer
goods, to calculate the PPP rates. These rates are then used to convert national income or GDP figures into a
common currency that reflects the purchasing power of each country.
Benefits of using PPP rates: 
-PPP rates allow for more meaningful comparisons of incomes between countries. 
-They provide a better understanding of the relative affordability and standard of living across different economies. 
-By considering PPP rates, income disparities can be assessed more accurately, taking into account the cost of living
differences and the purchasing power of individuals in each country.
-Income ( therefore development) gaps between are smaller when one converts currencies using PPP rather than
official FX rates. 
-If domestic prices are lower, PPP measures of GNI per capita will be higher than estimates using foreign exchange
rates as the conversion factor
-Eg. China’s 2008 GNI per capita was only 6% of that of the US using the exchange rate conversion
but rises to 13% when estimated by the PPP method of conversion

2.3 Comparing Countries by Health and Education, and the Human Development Index 
2.3.1 Comparing Health and Education Levels 

-By examining these indicators across different income groups and regions, it becomes evident that there are
significant variations in health and education outcomes. Low-income countries and middle-income countries display
diverse development challenges and outcomes.
-This comparison of health and education levels highlights the importance of considering multiple dimensions of
development beyond just income. 
-It emphasizes the need to evaluate a country's overall well-being and capabilities to gain a comprehensive
understanding of its economic development.

2.3.2 The Human Development Index 

Introduction

 The HDI measures a country's level of human development on a scale from 0 to 1, with 0 representing the
lowest human development and 1 representing the highest.
 The New HDI builds upon the traditional HDI, incorporating refinements to better reflect the multifaceted
nature of human development.
 In the New HDI, the countries are classified into four groups: low human development, medium human
development, high human development, and very high human development.
 HDI can also differ within the country. In nepal, Kathmandu has the highest HDI, and Humla, Bajura have
lowest HDI

It incorporates three main dimensions of development:

1. Long and healthy life, which is measured by life expectancy at birth. This indicator reflects the average
number of years a newborn is expected to live and provides insights into the overall health conditions and
healthcare access within a country.
2. Knowledge, which is measured by a combination of average schooling attained by adults and expected
years of schooling for school-age children. This indicator captures the educational attainment of the
population, reflecting the importance of education in enabling individuals to lead fulfilling lives and
contribute to society.
 3. Decent standard of living, which is measured by real per capita gross domestic income. 
 It takes into account the income level of individuals within a country, adjusted for the Purchasing
Power Parity (PPP) to account for differences in the cost of living. 
 It also considers the diminishing marginal utility of income, recognizing that the impact of
additional income decreases as a person's income level rises.

Calculation

 To calculate the New HDI, two steps are involved. First, the three "dimension indices" are created,
and then these indices are aggregated to produce the overall HDI. 

1. Creating the Dimension Indices:

   a. Health Dimension: The health dimension is measured using the life expectancy at birth index. 
Health Dimension Index = (Actual Value of Life expectancy - Min Value) / (Max value - Min Value)
   
   b. Education Dimension: The education dimension considers two indicators: average years of schooling for adults
and expected years of schooling for school-age children. 
 Minimum value for education indicators is set at 0, as societies can subsist without formal education. 
 Maximum value for average schooling is set at 15 years. 
 The indices for each indicator are calculated using the same formula as the health dimension.
   
   c. Standard of Living Dimension: 
The standard of living dimension uses the purchasing power-adjusted per capita Gross National Income (GNI). 
The upper goalpost for income is set at $75,000 per capita based on evidence suggesting that there are diminishing
gains in human development beyond this threshold. 
 Income index =[ ln(actual income) - ln(minimum value) ]  /  [ln (upper goalpost) - ln( minimum value)]

2. Aggregating the Dimension Indices:

  The UNDP uses a geometric mean, rather than an arithmetic mean, to calculate the overall HDI.
 The geometric mean ensures that poor performance in any dimension directly affects the overall
index and assumes perfect substitutability across income, health, and education.
Therefore,
HDI= ⅓ ✕ (income index) + ⅓  ✕ (life expectancy index ) + ⅓  ✕  (education index)

2.3.3 Human Development Index Ranking: How Does it Differ from Income Rankings?

 HDI is important because income alone does not accurately predict a country's performance in education
and health.
 Some countries perform better or worse on the HDI than expected based on their income levels.
 Examples include Cuba performing better and Guyana performing worse than predicted by income.
 Bangladesh outperforms Pakistan on the HDI, despite a lower income level.
 These examples highlight the limitations of using income as the sole indicator of development.

2.3.4 Drawbacks of HDI

 It is based on a limited number of indicators and does not capture other important aspects of
development, such as environmental sustainability, gender equality, and political freedom.
  The HDI gives equal weight to the three dimensions of human development. This means that a country
with a high life expectancy, but low levels of education and income, will have the same HDI as a country
with low life expectancy, but high levels of education and income.
 The indicators used in the HDI are not always comparable across countries
 It is not sensitive to changes in the distribution of income. For example, a country with a high HDI may
experience a decrease in the average level of income, but if the distribution of income remains the same,
the HDI will not change.
 The HDI is a measure of human development, but it is not a measure of well-being.

2.4  Key Similarities and Differences Among Developing Countries

Characteristics of the developing world: Diversity within commonality

1. Lower Levels of productivity and living standards:

- High income growth in East Asia (i.e China, Korea, Taiwan etc)
- Stagnant growth in Saharan Africa
Note: Productivity Vs Efficiency
Productivity: measure of how much you produce or achieve in a given period.
Efficiency: measure of how well you use your resources to achieve your desired outcome.
You can be productive by producing a lot of output, but if you are not efficient, you may be wasting
resources and time in the process. Conversely, you can be efficient by using your resources effectively, but
if you are not productive, you may not be achieving your goals.

2.  Lowers levels of human capital:

- Developing world is behind advanced nations in average levels of nutrition, health( measured by life
expectancy) and education(measured by literacy)
- Middle Income LDCs are closer to high income nations in health and education standards than they are to
low income LDCs.

Note: 
a. Human Capital is measured on the basis of skills and education.
b. Mortality rates affect the labor market by declining the number of labor forces .
c. Under-5 mortality rates are greater in the developing world. The infants die mostly due to malnutrition and
water borne diseases such as diarrhea.
d. In the case of education, least developed/ developing countries have a low pupil-teacher ratio. And region
wise, the east-pacific region has a low pupil-teacher ratio. 

3. Higher Levels of inequality and poverty:

- Global Income inequality ( Poorest 20% receives 1.5% of the world income)
- Extent of poverty in an individual LDC depends on:
i. Average level of national income.
ii. Degree of inequality in income distribution.
- Absolute poverty, representing the minimum level of income required to satisfy basic needs (i.e food,
clothing, shelter) is higher in LDCs due to low average incomes.

4. Higher population growth rates

- 2% per year in Low income countries.
- 1.1% per year in middle income countries.
 - 0.7% per year in higher income countries

5. Greater social division

Two determinants of Development success
i. Ethnic and religious composition of developing nation.
ii. Whether such diversity leads to conflict (i.e Africa) or cooperation (i.e United States)
6. Larger rural populations and rapid migration
- Rural-Urban migration is faster in developing countries. Still rural populations exceed urban populations.
*The recent urban population of Nepal is 66.08% and in 2011 it was 17.07%. This cause of
urbanization is mostly due to definition. 
7. Lower Levels of industrialization
Industrialization high productivity high incomes to be achieved through a national economic transformation
8. Low level of equilibrium trap
9. Adverse Geography:
Two aspects:
i. Unfavorable geographical locations
(i.e LDCs suffer more from tropical diseases, water resource constraints, and extremes  of heat)
ii. Scarcity of resource endowments
10. Underdeveloped financial and other markets:
- Imperfect markets( lack a legal system that enforces contracts and validates property rights, a strong
infrastructure of roads and utilities, a well developed system of banking and insurance, etc.
- Incomplete information( consumers and producers lack considerably information regarding prices,
quantities, qualities of goods, services resources)

2.5 Are Living Standards of Developing and Developed Nations Converging?

 During the industrial era, around the 18th century, the richest countries were about three times wealthier
than the poorest countries.
 Currently, the ratio between the richest and poorest countries is approximately 100 to 1, indicating a
significant increase in disparity.
 This divergence in economic growth and living standards over the past two centuries is known as the
process of divergence
 Despite the historical divergence, there is a consideration of whether developing and developed nations are
exhibiting convergence in living standards.
 Convergence refers to the idea that developing countries, through dedicated economic development
efforts, may catch up to the living standards of developed nations.

2.5.1 The Great Divergence

- The "Great Divergence" refers to the significant gap in productivity and incomes between early
industrialized countries and the rest of the world.
- The Industrial Revolution, starting in England, brought about unprecedented gains in living standards through
technological advancements.
- Colonialism and exploitation played a role in accumulating wealth during this period.
- The process of divergence was fueled by trade imbalances and hindrance of industrialization in colonies.
- Harsh working conditions and exploitation were prevalent in early factories.
- Decolonization brought significant geopolitical changes, but many developing countries struggled to achieve
economic progress.
- Historical evidence shows that there was a divergence between developing and developed countries for two
centuries after the Industrial Revolution.

2.5.2 Two Major Reasons to Expect Convergence

- Two major reasons to expect convergence between developing and developed countries are 
I. technology transfer 
II. diminishing returns to factor accumulation.

Technology transfer : 
 IT allows developing countries to adopt existing technologies and skip earlier stages of technological
development, leading to faster growth.
 The developing countries have an advantage of backwardness which refers to the shorter time needed for a
country to double its output per worker if it starts its economic growth later.
 Today’s developing countries do not have to “reinvent the wheel”; for example, they do not have to use
vacuum tubes before they can use semiconductors.

Diminishing returns to factor (or capital) accumulation: 

 It  suggests that developing countries with lower capital intensity can experience higher returns on
investment and grow their capital more quickly.
 Higher investment rates in developing countries contribute to capital accumulation until similar levels of
capital and output per worker are achieved.
 In the long run, convergence in incomes is expected as faster-growing developing countries catch up with
slower-growing developed countries.

To conclude:
- Convergence may not lead to identical incomes but tends to narrow the gap between countries.
- The concept of convergence can vary depending on the perspective, such as average country incomes or individual
incomes.
- Recent data indicates a trend towards (re-)convergence, with developing countries experiencing faster growth on
average.

How do countries converge?

Here’s a breakdown of how countries converge:

- Investment in Physical and Human Capital: Countries that invest in infrastructure, technology, education, and
healthcare tend to experience economic growth and convergence.

- Technological Progress: Adopting and developing new technologies enhances productivity, efficiency, and
competitiveness, enabling countries to catch up with more advanced economies.

- Institutional Development: Strong institutions, including governance structures, rule of law, and property rights,
create a conducive environment for investment, entrepreneurship, and economic development.

- Trade and Globalization: Engaging in international trade and embracing globalization allows countries to
specialize, expand markets, and benefit from technology transfer and knowledge sharing.

- Education and Human Capital Development: Investing in education and developing a skilled workforce boosts
productivity and innovation, contributing to economic growth and convergence.

- Infrastructure Development: Adequate infrastructure facilitates the movement of goods, services, and people,
reduces transaction costs, and attracts investment.

- Economic and Policy Reforms: Implementing sound economic policies and market-oriented reforms fosters
competition, private sector development, and investment, stimulating convergence.
- Knowledge and Technology Transfer: Collaboration, research and development, and access to international
knowledge networks and technology transfer contribute to narrowing the development gap between countries.

These factors work together to shape the convergence process, although the specific combination and impact can
vary among countries based on their unique circumstances and policy choices.

2.5.3 Perspectives on Income Convergence

Per capita income convergence

- Per capita income convergence at the country level refers to the tendency of poorer countries to grow faster than
richer countries, leading to a narrowing of the income gap between them.
- To examine per capita income convergence, growth rates are estimated as a function of initial income. If poorer
countries are growing faster, there will be a downward sloping plot, indicating convergence. If poorer countries are
growing more slowly, the plot will be upward sloping, indicating divergence.
- In the first period (1970-1994), only 63 out of 152 countries grew faster than the United States. However, in the
second period (1994-2017), 116 countries grew faster than the United States.
- It shows a significant shift from a pattern of global divergence (consistent with long-term trends) to one of
convergence.
- Previous research extending into the early 21st century suggested either no convergence or continued
divergence across countries. However, in recent years, there has been a strong change in the pattern of
growth, indicating a historic period of (re-)convergence of average incomes across countries.

This marks a significant shift in the global economic landscape, with developing countries experiencing faster
growth rates and closing the income gap with developed countries.

Conditional convergence

- Conditional convergence suggests that economies with similar characteristics tend to converge in terms of their
economic performance and income levels over time.
- Based on the idea that countries with lower initial income levels have higher investment rates and savings rates,
leading to faster economic growth.
- As the lower income  countries catch up with more developed economies, their growth rates gradually decrease,
resulting in a convergence of income levels.
- However, conditional convergence does not mean that all countries will reach the same income level; it depends
on other factors such as institutions, policies, and governance.
- Countries with favorable conditions, such as sound economic policies and institutions, are more likely to
experience conditional convergence and achieve higher income levels.

The Importance of Avoiding Selection Bias

- Early research on convergence in the mid-1980s focused on data from developed OECD countries due to their
perceived reliability and availability of comprehensive variables.
- The initial studies found strong evidence of convergence, but this conclusion was somewhat biased because it only
considered countries that were already rich.
- By only observing countries that were already wealthy, the data reflected those that had either maintained their
high income or transitioned from lower income to high income.
- When developing countries were included in the analysis, divergence rather than convergence was observed during
certain periods, such as 1965-1980 and 1980-2005
Therefore, the selection of countries at the beginning of the study period significantly influences the findings,
emphasizing the importance of a broader and more inclusive sample when examining convergence.
Absolute Income Convergence

- Absolute income convergence refers to the reduction in the absolute differences of income levels between
countries over time.
- China and India have experienced rapid economic growth since 1990, leading to relative income convergence with
high-income OECD countries.
-However, China and India started with lower incomes, so even though their growth rates were high, the actual
income gains were smaller compared to the OECD countries.
-Sub-Saharan Africa had a growth rate similar to the high-income OECD average during this period, but its absolute
income gain was much smaller in comparison.

It's important to note that even when the average income of a developing country becomes a larger fraction of
developed country incomes, the absolute income differences may continue to widen for a certain period before
eventually starting to decrease.

World-As-One-Country Convergence

- World-as-one-country convergence is an approach that considers the entire world as a single country to analyze
changes in global inequality.

- It looks at the decrease in inequality among individuals globally as convergence and the increase in inequality as
divergence..

- Unlike country-based convergence studies, world-as-one-country convergence takes into account changes in
inequality within countries as well as between them.

- In the 21st century, there has likely been world-as-one-country convergence, with faster income growth in
countries like China and India compared to wealthier nations like the United States.

- However, within-country inequality has continued to rise in countries such as China, India, and the United States.

- Most researchers and policymakers primarily focus on development at the national level and still use country-
based convergence studies as the standard approach.

The Future of convergence: opportunities and risks 

  Opportunities for convergence:

  - Technological advancements: Continued progress in technology and innovation can create new opportunities for
economic growth and convergence among countries.
  - Global cooperation: Collaborative efforts and international cooperation(including trade)  can help address
challenges and promote inclusive development, contributing to convergence.
  - Sustainable development: Emphasizing sustainable practices and addressing climate change can create a more
equitable and prosperous future for all nations.
  - Policy reforms: Implementing effective policies that prioritize inclusive growth and reduce inequality can
contribute to convergence.

  Risks to convergence:
  - Technological divides: Unequal access to technology and digital infrastructure could deepen disparities and
hinder convergence efforts.
  - Climate change impacts: Adverse effects of climate change, particularly in regions like Africa, can pose
challenges to economic development and potentially disrupt convergence.
  - Self-defeating policies: Policies driven by narrow interests or lacking a long-term vision may impede
convergence and perpetuate inequality.
  - Armed conflict: Widespread armed conflicts can disrupt economies, lead to poverty, and hinder progress towards
convergence.
  - Stagnation in least-developed countries: Some countries may face persistent challenges and remain stuck in
low-income levels, impeding overall convergence progress.
- Limitations of country averages: The convergence trend discussed focuses on average income levels among
countries, without considering inequality or extreme poverty within nations. These factors can influence the overall
picture of convergence.

 Despite the risks, there is optimism that the world may be on a sustainable path towards re-convergence after
centuries of divergence, where countries' incomes become more aligned once again. This suggests the potential for a
more equitable and balanced global economic landscape.

2.6 Long-Run Causes of Comparative Development

1. Geography: Countries with favorable geographic conditions, such as access to natural resources,
are more likely to develop.
2. Institutions: Countries with good institutions, such as a well-functioning legal system and a stable
political system, are more likely to develop.
3. Education: Countries with a well-educated workforce are more likely to develop.
4. Technology: Countries that adopt new technologies are more likely to develop.
5. Culture: The culture of a country can also affect its development. For example, cultures that value
education and innovation are more likely to develop.
6. History: The history of a country can also affect its development. For example, countries that have
been through periods of conflict or instability are more likely to lag behind in development.
7. Colonial legacies: The legacy of colonialism can have a significant impact on the development of
a country. For example, countries that were colonized by European powers often have weaker
institutions and less developed economies than countries that were not colonized. This is because
colonialism often led to the exploitation of natural resources and the suppression of indigenous
cultures. However, it is important to note that not all colonial legacies are negative. For example,
some countries that were colonized by European powers were able to benefit from the introduction
of new technologies and ideas.

How Low-Income Countries Today Differ from Developed Countries in Their Earlier
Stages
 Some of the significant differences between low-income countries today and developed countries in their earlier
stages of development can be listed below: 
1. Physical and Human Resource Endowments: Developing countries today are often less well endowed with natural
resources compared to developed countries in their earlier stages. Additionally, the difference in skilled human
resource endowments is more pronounced, affecting the ability to exploit resources and generate economic value.
2. Per Capita Incomes and GDP: People in low-income countries today have lower levels of real per capita income
compared to developed countries in the past. Developing countries began their growth process with lower per capita
income levels compared to developed countries.
3. Climate: Most developing countries are located in tropical or subtropical climates, while the economically
successful countries are mostly located in temperate zones. Extreme heat and humidity in poor countries can lead to
deteriorating soil quality, reduced crop productivity, and health issues.
4. Population Size, Distribution, and Growth: Developing countries have experienced rapid population growth, with
some still growing at high rates. The concentration of large and growing populations in certain areas presents
challenges, including higher person-to-land ratios and the potential for economic setbacks.
5. Historical Role of International Migration: In the past, international migration was a major outlet for rural
populations, with large numbers of people migrating to countries with labor shortages. However, international
migration today is more restricted due to immigration laws in developed countries, limiting the potential benefits for
reducing population pressures in developing countries.
6. International Trade Benefits: Rapidly expanding export markets and free trade played a significant role in the
development of economically advanced nations in the past. However, many developing countries in the 20th century
faced difficulties in generating rapid economic growth through world trade, with deteriorating trade positions and
declining terms of trade.
7. Basic Scientific and Technological Research and Development Capabilities: Developing countries often face
challenges in access to ideas and technology used in industrial nations, which hinders their ability to generate
economic value. The technology gap between rich and poor nations, both in physical objects and ideas, is a
significant factor in the development divide.
8. Efficacy of Domestic Institutions: The effectiveness of domestic institutions in developing countries can impact
economic growth. Institutions that are extractive or unhelpful can hinder development, while stable political
structures and flexible social institutions can provide a conducive environment for growth.

Understanding these differences is important for formulating requirements and priorities for generating and
sustaining economic growth in developing countries. Addressing these conditions can contribute to overcoming the
challenges and promoting development in low-income nations.

Chapter 3: Classic Theories of Economic Growth and Development 

In this chapter, the historical and intellectual evolution in scholarly thinking about how and why development does
or does not take place is explored.

3.1 Classical Theories of Economic Development: Four Approaches

1. The linear-stage-of-growth model (change that a typical developing countries must undergo)
2. Theories and patterns of structural change (change that a typical developing countries must undergo)
3. The international-dependence revolution (more radical and political)
4. The neoclassical counter-revolution (emphasized the beneficial role of free markets, open economies and
privatization of inefficient public enterprises)

3.2 Development as Growth and the Linear-Stages Theories 

 Interest in low-income countries grew after World War II as they gained independence from colonial rule.
 Those countries were different and mostly depended on farming. 
 They saw the success of the Marshall Plan, which helped European countries rebuild after the war.
 Emphasized the importance of accelerated physical capital accumulation.
 The term “capital fundamentalism” is used critically to highlight its focus on capital and potential
oversights in other factors.
3.2.1 Rostow’s Stages of Growth 

 Advocate: the American economic historian Walt R. Rostow.

 The transition from underdeveloped to developed countries can be described in terms of a series of steps or
stages. 
 The stages are:
1. Traditional society
2. Preconditions to take-off
3. Take-off
4. Drive to maturity
5. Age of high mass consumption

3.2.2 The Harrod-Domar Growth Model  

 A functional economic relationship in which the growth rate of gross domestic product depends directly on
the national net savings rate and inversely on the national capital-output ratio.
 The model suggests that a country’s economic growth depends on two factors: its ability to save and invest
money and how efficiently it uses its capital.
 When a country saves and invests a larger portion of its income (GDP), it has the potential to grow faster.
 The efficiency of capital utilization is important. If a country can use its capital resources more effectively,
it can generate more output (goods and services) from the same amount of investment.
 Technological progress and labor force growth also play a role in economic growth, although they are not
explicitly described in this model.
 Technological progress can make production more efficient, allowing for greater output from the same
level of investment.
 The model focuses on the significance of investment (saving and using capital) in driving economic
growth.

3.2.3 Obstacles and Constraints

 To make a country's economy grow faster, one important way is to save more money instead of spending it
all.
 Saving a higher percentage of income can lead to faster economic growth.
 Countries that can save and invest more money tend to grow faster and develop better.
 Poor countries often struggle with a lack of money for building things like infrastructure and factories.
 Getting help from other countries through foreign aid or private investment can fill the money gap and help
the economy grow.
 Using resources more efficiently and reducing the loss of value over time can also boost economic growth.

3.2.4 Necessary Versus Sufficient Conditions: Some Criticism of the Stages Model

 The theory of stages of growth, which focused on saving and investment, didn't always work to make
countries develop.
 The reason is that just saving and investing money is not enough for growth. Other things like good
markets, roads, educated workers, and efficient government are also needed.
 The models assumed that developing countries had the same conditions as Europe did after receiving help,
but often they didn't have those conditions.
 Things like skilled managers, educated workers, and good planning were often missing.
 The models didn't pay enough attention to another way to make countries grow, which is to use investments
more efficiently and get more output from them.

3.3 Structural-Change Models

Structural change theory
  Structural-change theory is about how developing economies change their economic structures from
primarily relying on traditional farming for basic survival to becoming more modern, urbanized, and
diverse in their industries and services. 
 It involves transitioning from an agrarian society to a more industrial and service-oriented economy.

Structural Transformation

 Structural transformation refers to the transition of an economy from low productivity and labor-intensive
economic activities to higher productivity and skill intensive activities
 In simpler terms, it means shifting the focus of an economy from primarily relying on farming to relying
more on manufacturing industries.

3.3.1 The Lewis Theory of Economic Development 

Introduction:

 Developed by: Sir Arthur Lewis in 1954. He graduated from London School of economics and was
awarded the Nobel Memorial Prize in Economics Sciences.
 A theory of development in which surplus labor from the traditional agricultural sector is transferred to the
modern industrial sector, the growth of which absorbs the surplus labor, promotes industrial- isation, and
stimulates sustained development

Two-Sector Model:

 Underdeveloped economy is divided into two sectors: traditional rural subsistence sector and modern
urban industrial sector.
 Rural sector has a large population and low productivity.
 Modern sector is more productive and requires labor from the rural sector.

Factors in the Model:

 Labor transfer: Workers gradually move from the rural sector to the industrial sector.
 Growth of output and employment: Expansion of production in the modern sector drives output and
employment growth.
 Investment and capital accumulation: Industrial capitalists reinvest profits, enabling expansion in the
modern sector.

Wages and Labor Supply:

- Wages in the industrial sector remain constant and are a premium above the fixed average subsistence level of
wages in the agricultural sector.
- Supply of labor from the rural sector to the industrial sector is considered to be easily available.
Assumptions:
 
1. Surplus labor in the rural sector: The model assumes that the rural subsistence sector has a surplus of labor,
meaning that additional labor can be transferred to the industrial sector without reducing agricultural output.
2. Constant wages in the industrial sector: It assumes that wages in the industrial sector remain constant over time.
These wages are determined as a premium above the fixed average subsistence level of wages in the agricultural
sector.
3. Reinvestment of profits: The model assumes that industrial capitalists reinvest all their profits into the modern
sector. This reinvestment enables the expansion of production and the growth of output and employment in the
industrial sector.
4. Elastic supply of rural labor: The model assumes that the supply of labor from the rural sector to the industrial
sector is perfectly elastic, meaning that labor is readily available for employment in the industrial sector.

Agricultural(Traditional) Sector:
-No marginal productivity
-Marginal productivity = average productivity
-Subsistent technology
-Lack of technological progress
-surplus labor which is then transferred to modern sector

Manufacturing(modern) Sector:
- Marginal Productivity = wage of worker
- The profit generated by this sector can be reused for investment which further generates demand and absorbs the
earlier sector which in overall leads to growth
-Wage rate is higher due to which labors tend to be lured towards this sector.

Diagrammatic Explanation:
Fig: Lewis two-sector model

The figure shows the labor market in a developing economy. The X axis holds the number of labors
whereas the Y axis hold the productivity
Traditional(agricultural sector)
 TPA- Total production in agriculture sector, MP/AP(Marginal productivity of labor/Average productivity
of labor), 
 As we are increasing the number of labor in the agriculture sector, TP(Total productivity)of the agricultural
sector  is increasing and after a certain point TP becomes the maximum. When TP becomes maximum, MP
will be equal to zero(represented by point L in figure b diagram(ii) ). After the point L , if we continue on
A A

hiring labor then the MP is going to be negative which creates a situation of excess(surplus) labor. 
 This surplus labor is then transferred to the modern sector.
Modern(Manufacture sector)
 TPM- Total production in manufacturing sector, W = wage rate in agriculture sector, W = wage rate in
A M

manufacturing sector
 When labor starts transferring from Primary Sector (Agricultural) to modern sector 
 Modern sector provides higher wage than the primary sector
 The wage rate of primary sector is 0W which lies lower that wage rate in manufacturing sector ‘W ‘
A M

 When excess labor is supplied to modern sector from traditional sector then TP of modern sector is
increasing
 DD curve represents marginal product of labor
 Modern sector is paying wage rate which is 0W but the marginal product of labor = OD 
M

 The gap between 0W and OD is the profit/surplus gained by modern sector.

M

 TO BE CONTINUED

Possible fall offs of Lewis two sector model:

 If the capital intensive technologies are brought up then labor forces might get replaced.(More focus should
be put on labor intensive technology).
 Possibility of capital flight 
 Rate of labor transfer and employment creation may not be proportional to rate of modern sector capital
accumulation 
 Surplus labor in rural areas and full employment in urban areas
 Assumption of diminishing returns in modern industrial sector.
  Chenery’s Model
 Talks about structural transformation 
 More focus on international trade context as well
 Revises on past records and compares to the present data empirically 
 According to this model four main strategies to achieve economic growth are:
 Transformation of production from agricultural to industrial production
 Changing composition of the consumer demand from emphasis on food commodities and other
consumable goods to desire for multiple manufactured goods and services
 International trade; creating a market for its exports 
 Using resources as well as changes in socio-economic factors as the distribution of the country’s
population

3.5 The Neoclassical Counter-Revolution: Market Fundamentalism

3.5.1 Challenging the Statist Model: Free Market, Public Choice, and Market-Friendly Approaches
 In the 1980s, conservative governments pushed for a change in economic theory and policy.
 Developed countries promoted supply-side economics, privatization, and less government regulation.
 Developing countries were encouraged to adopt freer markets and reduce government intervention.

 Supporters argued that underdevelopment was caused by incorrect pricing policies and excessive state
control.
 They believed that promoting free markets and reducing government involvement would boost economic
efficiency and growth.
 They disagreed with the idea that developed countries and international agencies were responsible for
underdevelopment.
 The neoclassical counter-revolution favored minimal government intervention and emphasized the
importance of free markets.
 Three approaches emerged: free-market approach, public-choice approach, and market-friendly approach.
 The free-market approach advocated for market efficiency and limited government involvement.
 The public-choice approach suggested that governments often make poor decisions due to self-interest.
 The market-friendly approach recognized the need for some government interventions to support markets.
 Newer schools of thought have emerged to address the limitations of the neoclassical perspective.

3.5.2 Traditional Neoclassical Growth Theory 

 Neoclassical free-market argument supports liberalization of national markets. 
 Liberalization — Domestic and Foreign Investment — Capital accumulation — GDP Growth — higher per
capita incomes — economic development.
 Solow neoclassical growth model: Growth model in which there are diminishing returns to each factor of
production but constant returns to scale. 
 The Solow neoclassical growth model uses an aggregate production function.
 GDP (Y) is determined by capital (K), labor (L), and labor productivity (A).
 Technological progress is assumed to grow at an exogenous rate (2% per year).
 The model implies diminishing returns to both capital and labor.
 Convergence to the same level of income per worker is expected, given similar conditions.
 Output growth is driven by increases in labor, capital, and technological improvements.
 Closed economies with low savings rates grow slower than those with high savings rates.
 Open economies experience income convergence as capital flows from rich to poor countries.
 Heavy government intervention impedes foreign investment and hinders economic growth.
 Openness promotes access to foreign production ideas and technological progress.
3.6 Classical Theories of Development Reconciling the Differences 
 The linear-stages model emphasizes the role of saving and investment in long-term growth.
 The Lewis two-sector model focuses on resource transfers between sectors.
 Empirical research examines structural change and key economic parameters.
 International-dependence theorists highlight the impact of decisions made in developed countries.
 Neoclassical economics recognizes the importance of efficient production and prices.

The International Dependence Revolution

 Popular in the 1970s but was replaced later by other thoughts in the 1980s and 1990s.
 Modified versions are applied in anti-globalization literature
 Main view: Developing countries are beset by institutional, political and economic rigidities and are
usually caught up in dependence and dominance relationship with rich countries.
 Unequal exchange
 Terms of Trade

Major stream of the thoughts that the model is based on: 

 Neocolonial dependence model : 
 a formerly colonized country remains economically dependent on its former colonizer or other
more developed countries. 
 can manifest in various forms, such as the exploitation of natural resources, the imposition of trade
policies that favor the developed countries, and the influence of multinational corporations in the
domestic economy of the dependent country.
 Existence and continuance of underdevelopment as historical evolution of highly unequal
international capitalist system
 Unequal power relationships between the center(developed countries) and the
periphery(developing countries)
 Comprador groups as an ally to international capitalist development and propagates unequal
exchange.
 Underdevelopment exists as an externally induced phenomenon. 

 False-paradigm model 
 Underdevelopment as an outcome of faulty and inappropriate advice from experts(developed
country)
 Offer complex but misleading models of development that leads to incorrect and inappropriate
policies
Chapter 4: Contemporary models of development and Underdevelopment

 The chapter discusses the challenges and importance of achieving economic development, as well as the
progress made in understanding the factors that hinder or promote development.
  It tells that development is difficult but possible with systematic efforts and improved understanding.
 The new models after the 1980s reveal that development faces more obstacles than previously recognized. 
 The chapter also talks about "Growth diagnostics"(Key word for the chapter) framework, which helps
identify and address the specific constraints that hinder a developing country from closing the gap with
developed nations.

4.1: Underdevelopment as a Coordination Failure

 After the 1990s, many economic theories have emphasized its focus on complementarity between several
necessary conditions.
 #complementarity: Action taken by one factor provides an incentive for the other factor to take similar
action. Complementarities often involve investments whose return depends on other investments being
made by other agents.
 Sustainable development requires multiple factors to function effectively at the same time. It's not enough
for just one aspect to work well; several things must come together for development to be successful.
 In many important situations investment needs to be made by not just one but multiple entities for any one
of them(any individual agent) to see profitable result

Coordination Failure: 

A coordination failure is a situation where everyone would be better off if they all made the same choice,
but they can't coordinate their choices, so they all end up making a different choice that is worse for
everyone.

For example, imagine that there are two roads that lead to the same destination. One road is shorter, but it
is also more crowded. The other road is longer, but it is less crowded. If everyone drove on the shorter
road, it would be faster for everyone. However, if everyone drives on the longer road, it would be slower
for everyone. 
 There are several reasons why coordination failure may occur: Some of them might be:
o people may hold different expectations about what others will do, making it challenging to align
their actions.
o individuals might hesitate to make the first move or take action because they believe it is more
advantageous to wait for someone else to initiate the coordination.
 For instance, there are firms and workers. Firms need workers with the right skills, and workers need firms
to employ them. If there are no firms, workers will not acquire the skills, and if there are no workers with
the right skills, firms will not enter the market.This can lead to a coordination failure, where the economy is
stuck in a bad equilibrium because everyone would be better off if there were firms and workers with the
right skills. In this equilibrium, there are no firms and no workers with the right skills. 

 Coordination failure can sometimes lead to underdevelopment trap, in which a region (or agent) remains
backwards

Ways to address the problem of coordination failure:

-Communication and flow of information can be one of the main ways to solve coordination failure.
-Government intervention can also help overcome coordination failures. Governments can play a role in
facilitating coordination by providing incentives, regulations, or infrastructure that encourage cooperation
and collaboration among individuals or entities.

 -Government policy is analyzed as an integral part of the development process. It acknowledges that the
government itself can be influenced by and have an impact on the underdeveloped economy. This means
that government policy is shaped by the same factors that are causing the underdevelopment.
-The most effective government policy interventions are those that can move the economy to a self-
sustaining, better equilibrium. 
-These interventions are called "deep interventions" because they require a significant amount of
government effort. However, once these interventions are successful, they can have a lasting impact on the
economy.

 In much of economics, such complementarities are not present. For example, in competitive markets, when
there is excess demand, there is counterpressure for prices to rise, restoring equilibrium. Whenever
congestion may be present, the more people there are using one road, the more commuters try to find an
alternative route.

 Coordination problems are best illustrated by the where-to-meet problem. Suppose, we four decide to meet
in Chitwan, but neglected to specify a specific location in the city. Now we all are out of communication
and can arrive at a common meeting point only by chance or by very clever guessing(The story may lose a
bit of its power in the age of texting, cell phones, social media, and e-mail). 

4.2: Multiple Equilibria

Fig: Multiple Equilibria

 The basic idea reflected in the S-shaped function of Figure is that the benefits an agent receives from taking
an action depend positively on how many other agents are expected to take the action or on the extent of
those actions.
 For example, the price a farmer can hope to receive for his produce depends on the number of middlemen
who are active in the region, which in turn depends on the number of other farmers who specialize in the
same product.

Where to find the equilibrium?

equilibrium is found where the “privately rational decision function”(Y1) crosses the 45-degree line
 The 45-degree line on the graph represents a scenario where firms' expectations match their actual
observations. 
Initially, suppose firms expected no other firms to make investments, but some firms went ahead and
invested anyway. Seeing this, it wouldn't make sense for the remaining firms to keep expecting no
investment. They would need to revise their expectations upward, aligning their expectations with the level
of investment they actually see.
 As firms adjust their expectations, they would want to invest more to match the higher expected level of
investment. This process continues until the actual level of investment matches the expected level of
investment. At this point, there is no further need for firms to adjust their expectations.
 One of the three D1, D2, D3 may be stable equilibria. They are equilibria because if expectations were
slightly changed to a little above or below these levels, firms would adjust their behavior—increase or
decrease their investment levels—in a way to bring us back to the original equilibrium. 
 At the middle equilibrium at D2, the function cuts the 45-degree line from below, and so it is unstable. This
is because in our example, if a little less investment were expected, the equilibrium would be D1, and if a
little more were expected, the equilibrium would move to D3.

4.3: Starting economic Development: The Big Push

Economic development is challenging to initiate because new technologies often go unused due to lack of
incentives. Traditional models based on perfect competition overlook the importance of economies of scale. Market
failures, such as pecuniary externalities, further complicate the process of development. 
  The most famous coordination failure model in development is “big push” developed by Paul Rosenstein-
Rodan
 The "big push" is a concept in development economics that suggests a coordinated and substantial effort is
needed to jumpstart economic development.
 The big push approach believes that small, isolated interventions may not be sufficient to initiate
sustainable development.
 It recognizes the presence of coordination failures, where individual actions alone are not enough to
achieve development.
 The concept suggests that a concentrated and synchronized effort by various agents, such as the
government, private sector, and international organizations, is necessary to overcome obstacles and propel
development.
 The big push approach  highlights the importance of investments in infrastructure, education, healthcare,
and technology and aims to create a favorable environment that encourages investment, job creation, and
productivity improvement.

4.3.1: Big Push - A graphical Model

Fig: The Big Push 

Assumptions:
 Factors: We assume that there is only one factor of production; labor, with a fixed total supply, L
 Factor payments: The labor market has two sectors. 
-Workers in the traditional sector receive a wage of 1. Workers in the modern sector receive a higher wage,
represented by W(greater than 1)
-The higher wage in the modern sector may be a compensation for the more demanding and less desirable
nature of factory work.
-In equilibrium, workers would not gain any net utility from switching sectors during industrialization.
-If economic profits are generated, it can result in an increase in average income and potential income
redistribution, making everyone better off without making anyone worse off.
-Additionally, if there is excess labor supply, the social benefits of industrialization are even greater.
 Technology: We assume that there are N types of products, where N is a large number.
 Domestic demand: We assume that each good receives a constant and equal share of consumption out of
national income
 International supply and demand: We assume that the economy is closed.
  Market structure: We assume perfect competition in the traditional (cottage industry) sector, with free
entry and no economic profits. Therefore, the price of each good will be 1, the marginal cost of labor
(which is the only input). We assume that, at most, one modern-sector firm can enter each market.

Conditions for Multiple Equilibria: 

 With a wage bill line like W1, passing below point A, it is profitable for a modern firm to enter even one
sector, with all other sectors continuing traditional “cottage” production, so industrialization is the only
equilibrium 
 With a wage bill line like W3, passing above point B, even if a modern producer entered in all product
sectors, all of these firms would still lose money, so only the traditional technique would be used.
 The steeper (the more efficient the model) the modern-sector production technique, and/or the lower the
fixed costs, the more likely it is that the wage bill will pass below the corresponding point A.
 But if the wage line passes between points A and B, it is efficient to industrialize; but in general the market
will not achieve this on its own.
 Thus, with a wage bill line like W2, passing between A and B, there are two equilibria: one in which there
is industrialization and the society is better off (point B) and one without industrialization (point A). 

Cases in which big push may be necessary

 Intertemporal effects of investment in industrial sector:
-Even if the wage rate in the industrial sector is the same as in the traditional sector, there can be multiple
equilibria (stable outcomes) based on investment decisions.
-Investment will only happen if it is expected to be profitable (that is, if demand is expected to be high
enough),  hence demand in the future period is anticipated to be high enough. Investing in the current
period can lead to a more efficient production process in the future.
-The multiple equilibria arise because a firm's profits do not fully capture its contribution to overall demand
for industrial goods, which also raises future wage income for other firms entering the market.
-A "big push" for industrialization can benefit society (Pareto-preferred) because the decrease in income in
the first period due to fixed costs is offset by increased income in the second period from both wages and
profits in other sectors.
 Urbanization effects: 
-If the traditional cottage industry is primarily located in rural areas, while the manufacturing sector with
increasing returns to scale is concentrated in urban areas, there might be a higher demand for manufactured
goods among urban dwellers.
-In such a case, achieving industrialization may require a significant push (big push) towards urbanization.
 Infrastructure effects: 
-The main point is that when one product sector industrializes, it increases the size of the market for the use
of infrastructure services that would be used by other product sectors and so makes the provision of these
services more profitable.
 Training effect: 
-Entrepreneurs are hesitant to invest in training facilities and projects because they know that trained
workers may leave for other companies offering higher wages. This leads to underinvestment in training.
-On the other hand, workers are not motivated to seek training because they are unsure about which skills
are in demand. Basic education helps workers discover their comparative advantage.
-In this case, openness to trade cannot resolve the coordination failure unless there is free mobility of labor
across borders

Why the problems cannot be solved by a Super-Entreprenuer 

 Capital market failures: How could one agent assemble all the capital needed to play the super-
entrepreneur role?
 Costs of monitoring manager:
-There are costs associated with monitoring managers and other agents within a firm and implementing
measures to ensure compliance or provide incentives. -These costs are known as agency costs.
-The entrepreneur who knows more about the firms is unlikely to sell profitable industries. This creates a
situation of asymmetric information
  Communication failures
 Limitation to knowledge: Even if we stipulate that the economy as a whole has access to modern
technological ideas, this does not mean that one individual can gain sufficient knowledge to industrialize
 Lack of any empirical evidence that would suggest this is possible.
Further Problems of Multiple Equilibria
4.4.1 Inefficient Advantages of Incumbency
 The presence of increasing returns in modern industries can lead to a situation where a firm with an
established presence has a competitive advantage over potential rivals.
 Even if a new and better technology becomes available, it may be challenging for the new technology to
replace the old one. The firm with the old technology benefits from its large output, which allows it to have
lower average costs.
 As a result, firms may need access to significant amounts of capital to cover losses while they build their
customer base.
4.4.2 Behaviour and Norms
  Moving towards a better equilibrium, (where individuals shift from corruption to honest behavior), can be
difficult.
 People's past experiences and expectations of opportunistic behavior may create a self-fulfilling cycle,
where individuals act dishonestly because they expect others to do the same.
 In some cases, individuals take it upon themselves to enforce norms of honesty and Institutions play a
fundamental role in long-term economic development. 
 Once cooperative behavior becomes the norm, more people are likely to adopt it. 
 Certain cultural values and norms that were adaptive in the past may hinder development in modern
economies, such as the belief that having a large number of children or distrusting anyone outside of one's
family.
4.4.3 Linkages
 The theory of linkages suggests that when certain industries are developed, they can have a positive impact
on other industries. This happens through two types of linkages: backward linkages and forward linkages.
 Backward linkages mean that when an industry grows, it creates more demand for goods and services from
other industries.
 Forward linkages occur when the growth of an industry leads to lower costs or improved efficiency in other
industries that use its products.
  For example, when the manufacture of power looms expands, enabling a reduction in the price of power
looms, there are forward linkage effects due to increased output of woven cloth made by the power looms.
4.4.4 Inequality, Multiple Equilibria, and Growth 
 The traditional view has been that some inequality may enhance growth because the savings of the rich are
higher than those of the poor
 Let's consider a scenario where there is significant inequality, and individuals who are poor face challenges
in obtaining loans from banks due to their lack of collateral. However, it is evident that these individuals
could improve their circumstances if they had access to loans to start their own businesses. Unfortunately,
due to their disadvantaged situation, they become trapped in subsistence or low-wage employment,
preventing them from breaking free from the poverty trap.

4.5 Michael Kremer’s O-Ring Theory of Economic Development

 The theory explains that even the smallest components (parts) of any complex process (kunai pani kaam)
must be performed properly if we desire useful value. 
 Even a slightest mistake in any small task is done the final product may have no value to the users
 The theory assumes that the productivity of the overall production process is determined by multiplying the
skill levels of each task together. For example, if there are two tasks with skill levels q1 and q2, the overall
 productivity is given by q1 * q2. This means that the productivity of the whole process depends on the
skills of individual workers and their ability to work together effectively.
 According to the theory, there is a tendency for workers with similar skill levels to work together because
their combined efforts lead to higher productivity. This is called positive assortative matching.

4.5.1 The O-Ring Model: A numeric illustration

4.5.2 Implications of the O-Ring Theory 

 Firms tend to employ workers with similar skills for their various tasks.
 Workers performing the same task earn higher wages in a high-skill firm than in a low-skill firm.
 Because wages increase at an increasing rate, wages will be higher in developed countries.
 When co-workers have higher skills, there will be greater incentive to acquire more skills
Bottleneck Effect in O-Ring theory
 The bottleneck effect suggests that even if most workers in a production process are highly skilled, the
presence of a single low-skilled worker can limit the overall productivity. 
 To overcome the bottleneck effect, efforts can be made to improve the skills or reliability of the weakest
worker or to ensure that the weakest worker is replaced by a more competent one.
4.6 Economic Development as Self-Discovery 
 According to this theory, economic development occurs as societies and individuals discover new ways of
producing goods and services more efficiently
 As more people acquire and generate new knowledge, the potential for economic growth expands
exponentially
 Information externalities is when one person or entity acquires new knowledge or information, it can
benefit others in the economy without any direct cost to them. And this sometimes creates problems. For
example if a firm keeps valuable information confidential instead of sharing it with others, it can hinder
innovation and slow down economic development.
There are three building blocks of the theory
 Uncertainty about products can be produced efficiently. 
 Need for local adaptation of foreign technology
 Reducing the profitability of pioneers

4.7 The Hausmann-Rodrik-Velasco Growth Diagnostics Framework

 It is an analytical tool used in economics to identify the binding constraints or obstacles that hinder
economic growth in a particular country or region.
 It helps policymakers and economists understand the underlying problems that need to be addressed to
promote sustainable economic development
Key Words
 Diagnostic Approach: The Growth Diagnostics Framework takes a diagnostic approach, which means it
focuses on diagnosing the specific problems that limit economic growth. Instead of applying a one-size-
fits-all solution, it recognizes that each country has unique characteristics and challenges that require
tailored interventions.
 Binding Constraints: The framework identifies the binding constraints, which are the most critical factors
holding back economic growth in a particular context.
 Fig. Growth Diagnostics decision tree
“Principles of a differential diagnosis” that growth diagnosticians should be able to point to:
 The (shadow) price of the constraint is high. A shadow price is the change in the objective function due to
an increase in the supply of a constrained input
 Movements in the constraint should produce significant movements in the objective function
 Agents in the economy should be attempting to overcome or bypass the constraint
 Agents less intensive in that constraint should be more likely to survive and thrive, and vice versa

Chapter 5: Poverty, Inequality and Development

5.1 Measuring Inequality
5.1.1 Size Distributions 
 The personal or Size distribution refers to the way income is distributed among individuals within a
population, typically categorized by size class or income brackets.
 It examines the share of total income that is received by different segments of the population, irrespective
of the sources of that income
 If Ms. X and Mr. Y both receive the same personal income, they are classified together irrespective of the
fact that Ms. X may work 15 hours a day as a doctor while Mr. Y doesn’t work at all but simply collects
interest on his inheritance.
 Table 5.1
 The table shows income distribution of 20 individuals, representing the total population of the country and
are arranged in ascending to descending order. 
 In column 3, the popn is grouped into quartiles of four and the first quartile represents the button 20% of
the population on the income scale. A common measure of income inequality that can be derived from
column 3 is the ratio of the incomes received by the top 20% and bottom 40% of the population.
 This ratio is called Kuznets ratio, and is used as a measure of the degree of inequality between high- and
low-income groups in a country
 In the above example we can see that the twentieth individual receives 15% of the income, which is higher
than the combined share of the lowest 40% 's income.

5.1.2 Lorenz Curves 

A graph depicting the variance of the size distribution of income from perfect equality.
Fig 5.1: Lorenz Curve
 At every point on that diagonal, the percentage of income received is exactly equal to the
percentage of income recipients
 The straight diagonal line in between is called the “perfect inequality” line and the
distribution of income to the population is perfect. Say, the point halfway along the
length of the diagonal represents 50% of the income being distributed to exactly 50% of
the population.
 The Lorenz curve shows the actual quantitative relationship between the percentage of
income recipients and the percentage of the total income they did in fact receive during,
say, a given year.
  Point A shows that the bottom 10% of the population receives only 1.8% of the total
income, point B shows that the bottom 20% is receiving 5%, 50% of the population is in
fact receiving only 19.8% of the total income.
 The further the Lorenz curve is from the diagonal line (perfect inequality), more that the
total income is being held by the smaller portion of the rich.
5.1.3 Gini Coefficients and Aggregate Measures of Inequality
 An aggregate numerical measure of income inequality ranging from 0 (perfect
equality) to 1 (perfect inequality).
 It is measured graphically by dividing the area between the perfect equality line
and the Lorenz curve by the total area lying to the right of the equality line in a
Lorenz diagram
  The Gini coefficient for countries with highly unequal income distributions
typically lies between 0.50 and 0.70, while for countries with relatively equal
distributions, it is on the order of 0.20 to 0.35.
Fig 5.3: Measuring the Gini Coefficient

Fig 5.4: Four possible Lorenz Curve

 Whenever one Lorenz curve lies above another Lorenz curve, the economy
corresponding to the upper Lorenz curve is more equal than that of the lower curve.
 Economy A may unambiguously be said to be more equal than economy D. Whenever
two Lorenz curves cross, such as curves B and C, the Lorenz criterion states that we
 “need more information” or additional assumptions before we can determine which of the
underlying economies is more equal.
 The anonymity principle means that inequality measurement should not depend on who
has higher income.
 The scale independence principle states that inequality measurement should not depend
on the size of the economy or the unit of income measurement because if we are
interested in inequality, we want a measure of the dispersion of income, not its
magnitude.
 The population independence principle states that inequality measurement should not be
influenced by the number of income recipients.
 The Gini coefficient can be used to measure inequality and compare different economies,
but it may not always provide a perfect solution, especially when Lorenz curves cross.
5.2 Measuring Absolute Poverty 
 Absolute poverty is a situation of being unable or only barely able to meet the subsistence
essentials of food, clothing, and shelter. 
5.2.1 Income Poverty 
 The people living under a poverty line, an international poverty line, anyone living on
less than $1.90 a day in PPP dollars. 
  One practical strategy for determining a local absolute poverty line is to start by defining
an adequate basket of food, based on nutritional requirements from medical studies of
required calories, protein, and micronutrients. Then, using local household survey data,
one can identify a typical basket of food purchased by households that just barely meet
these nutritional requirements, then add other expenditures of this household, such as
clothing, shelter, and medical care, to determine the local absolute poverty line.
Depending on how these calculations are done, the resulting poverty line may come to
more than $1.90 per day at PPP.
 Simply counting the number of people below the poverty line can have serious
limitations. Say, if the poverty line is set at Rs.90 per day, it makes a difference whether
the person earns Rs.50 or Rs.85. 
 Economists therefore calculate the total poverty gap that measures the total amount of
income necessary to raise everyone who is below the poverty line.
o Total poverty gap (TPG): The sum of the difference between the poverty line and
actual income levels of all people living below that line.
Fig 5.5: Measuring total poverty gap
How we can measure the TPG as the shaded area

 Even Though both countries; A and B have the same level of poverty, the TGP in A is
greater so it takes more effort to eliminate absolute poverty in country A.
 The TPG is found by adding up the amounts by which each poor person’s income, Yi,
falls below the absolute poverty line, Yp.

Formula: Total Poverty Gap

Average poverty gap (APG):

Formula: APG

Average Income shortfall (AIS): 

Formula: Average Income shortfall

The Foster-Greer-Thorbecke Index:
 The FGT index quantifies the extent and severity of poverty within a population.
 It is based on the concept of poverty gaps, which measures how far individuals or
households fall below the poverty line.
 The FGT index considers both the incidence (headcount ratio) and intensity (income
gaps) of poverty.

Formula: The Foster-Greer-Thorbecke Index

 When p = 0, the FGT index represents the poverty headcount ratio (proportion of the
population below the poverty line).
 As p increases, the FGT index places greater weight on the income gaps experienced by
the poor, reflecting greater intensity or severity of poverty.

5.2.2 Multidimensional Poverty Measurement 

 Multidimensional poverty index is An index that measures the percentage of households
in a country deprived along three dimensions –monetary poverty, education, and basic
infrastructure services. 
 In the multidimensional poverty approach, a poor person is identified through “dual
cutoff method”: first, the cutoff levels within each of the dimensions (falling below a
poverty line, $1.90 per day if income poverty were being addressed) and second, the
cutoff of the number of dimensions in which a person must be deprived to be deemed
multidimensionally poor.
 The multidimensional poverty index, denoted as the M index, is constructed using
calculations similar to the single-dimensional P index.
 The most basic measure is the multidimensional headcount ratio (Hm), which represents
the fraction of the population in multidimensional poverty.
 The adjusted headcount ratio (Mo) is a common measure in practice, using ordinal data
and conceptually similar to the poverty gap (P1).
 M0 is calculated as the product of the multidimensional headcount ratio (HM) and the
average fraction of dimensions in which the poor are deprived (average intensity of
poverty, denoted as A).
 The adjusted headcount ratio (M0) satisfies the desirable property of "dimensional
monotonicity," meaning that if the average fraction of deprivations increases, M0 also
increases.
 Proxy measures, known as indicators, are used for each dimension in applied studies of
multidimensional poverty measurement.
 The UNDP Multidimensional Poverty Index and the Women's Empowerment in
Agriculture Index are examples of widely used applications of multidimensional poverty
measurement.
5.3 Poverty, Inequality, and Social Welfare 
5.3.1 What is it About Extreme Inequality That’s So Harmful to Economic Development?
Our main priority is the alleviation of absolute poverty, then why should we be concerned with
relative inequality. So, there are major three reasons for this question:
 Extreme income inequality leads to economic inefficiency as it reduces access to credit
and limits opportunities for education and entrepreneurship.
High inequality results in lower overall savings rates, as the highest rate of savings is
usually found among the middle class, and the rich tend to spend a larger portion of their
incomes on luxury goods or capital flight.
Inequality can lead to an inefficient allocation of assets, such as an overemphasis on
higher education at the expense of quality universal primary education or large
plantations alongside small-scale farms.
 Income disparities undermine social stability and solidarity, strengthen the political
power of the rich, and facilitate rent-seeking behavior.
When resources are allocated to rent-seeking behaviors, power is diverted from
productive areas that could lead to faster growth. 
High inequality makes it difficult to improve poor institutions and resist socially efficient
reforms, leading to slower growth and potential social unrest.
 Extreme inequality is often seen as unfair, and the "veil of ignorance" thought experiment
suggests that people would vote for a more equal income distribution if they faced
uncertainty about their own identity.
Distribution matters in various aspects of life, including health, education, and other
capabilities to function.

5.3.2 Dualistic Development and Shifting Lorenz Curves: Some Stylised Typologies

 Traditional-Sector Enrichment Growth Typology:

All the benefits of growth are distributed among workers in the traditional sector, with
little or no growth occurring in the modern sector. This growth pattern is found in
countries that prioritize substantial reductions in absolute poverty even at low incomes
and with relatively low growth rates, such as Sri Lanka and the state of Kerala in
southwestern India.
In the traditional-sector enrichment growth typology, growth leads to higher incomes,
a more equal distribution of income, and a reduction in poverty. This is achieved by
focusing on improving the economic conditions of workers in the traditional sector. As a
result, the Lorenz curve shifts upward, indicating overall income improvement, and
moves closer to the line of equality, indicating a reduction in income inequality. The
emphasis on uplifting the traditional sector and prioritizing poverty reduction narrows the
income gap between individuals. However, it's important to note that while this approach
 can reduce poverty and promote income equality, the overall economic growth may be
limited compared to typologies that focus on expanding the modern sector. 

Fig 5.6: Improved Income Distribution under the Traditional-Sector Enrichment Growth Typology

 Modern-Sector Enrichment Growth Typology:

Economic growth is limited to a fixed number of people in the modern sector, with both
the number of workers and their wages held constant in the traditional sector. This
growth pattern is often observed in many Latin American and African economies.
In the modern-sector enrichment growth typology, economic growth leads to higher
overall incomes. However, it also results in a less equal distribution of income and does
not have a significant impact on poverty levels. This growth pattern focuses on the
modern sector, benefiting a limited number of people engaged in higher-income
activities. As a result, income disparities increase, and the income gap between
individuals widens. The Lorenz curve shifts downward, indicating improved incomes, but
moves farther from the line of equality, signifying greater income inequality. It's
important to note that while this typology boosts incomes, it does not address poverty
adequately, as the benefits may not reach the traditional sector. Overall, the modern-
sector enrichment growth typology leads to higher incomes but exacerbates income
inequality and has limited effects on poverty reduction.
 Fig 5.7: Worsened Income Distribution under the Modern-Sector Enrichment Growth Typology

 Modern-Sector Enlargement Growth Typology:

The economy develops by expanding the size of the modern sector while maintaining
constant wages in both sectors. This growth pattern is depicted by the Lewis model and
can be observed in Western developed nations and some East Asian economies like
China, South Korea, and Taiwan.
In Lewis-type, modern-sector enlargement growth, where the modern sector expands
and absolute incomes rise while reducing absolute poverty, the behavior of Lorenz curves
becomes important. The Lorenz curves always cross, making it uncertain whether relative
inequality will improve or worsen. However, Gary Fields suggests that inequality is
likely to initially worsen in the early stages of development and then improve over time.
This highlights the dynamic nature of inequality, necessitating targeted policies to
address inequality concerns and ensure more equitable distribution of income as
development progresses.

Fig 5.8: Crossing Lorenz Curves in the Modern-Sector Enlargement Growth Typology

5.3.3 Kuznets’s Inverted-U Hypothesis 

 Simon Kuznets observed that income inequality initially worsens and then improves as a
country experiences economic growth.
 The early growth is often concentrated in the modern industrial sector, where wages and
productivity are high but employment is limited.
 The Kuznets curve can be generated by a process of modern-sector enlargement growth
as a country transitions from a traditional to a modern economy.
 The "inverted-U" Kuznets curve illustrates this pattern, with changes in income
distribution showing an initial increase and later decrease as per capita GNI expands.
 Returns to education may rise initially due to demand for skilled workers in the emerging
modern sector, and then fall as the supply of educated workers increases and the supply
of unskilled workers decreases.
 The nature of the development process determines whether income inequality increases
or decreases with economic growth.
 Fig 5.9: The “Inverted-U” Kuznets Curve

 5.3.4 Growth and Inequality 

 During the 1960s and 1990s per capita growth in East Asia averaged 5.5%, while in
Africa, it declined by 0.2%. Despite the differences in growth rates, both regions saw no
significant change in their Gini coefficients, which measure income inequality.
 Hence, the rate of economic growth is not the only factor influencing changes in
inequality; the character of economic growth is equally crucial.
 How economic growth is achieved, who benefits from it, and which sectors are
prioritized play vital roles in determining the impact of growth on income inequality.
Institutional arrangements, such as policies and regulations, also influence the
distribution of growth's benefits among different segments of the population.
 It is possible to sustain higher economic growth without necessarily increasing inequality
if growth is managed in a way that ensures improved living standards for the poor.

5.4 Absolute Poverty: Extent and Magnitude

 Estimating the extent of global poverty is challenging, and different reports may provide
varying estimates due to data limitations and varying poverty lines.
 The poverty line, initially set at $1-a-day in 1987 dollars, has been adjusted over time
based on improvements in data and methods. The most recent line is $1.90 per day,
reflecting the minimum income needed for basic nutrition.
 In 2010, about 1.22 billion people lived below $1.90 per day, and 2.36 billion lived below
$3.80 per day.
 The number of people living in $3.80 per day income poverty fell by 37% from 1981 to
2010, while those living on less than $2 per day decreased by less than 8%.
 The reduction in poverty is impressive considering the significant increase in the global
population during the same period.
 The first Millennium Development Goal (MDG) of halving extreme income poverty was
met by the end of 2013.
 However, progress in poverty reduction has been uneven across regions. Sub-Saharan
Africa showed less progress, with the number of people living in poverty increasing
dramatically during the 1981–2010 period.
 In some countries, more than half the population still lives below the $1.90 per day
poverty line, and more than four-fifths live below the $3.80 line.
 While average incomes have been rising in most sub-Saharan African countries from
2010 to 2019, there are concerns about whether poverty reduction can be sustained and
extended to all countries, especially those facing economic challenges.
Fig 5.13: Global and Regional Poverty Trends

5.4.1 The Multidimensional Poverty Index (MPI) 

 Multidimensional poverty is a measure that goes beyond the concept of just income of
people and incorporates the three dimensions at the household level: health, education
and wealth.
 To measure this idea, the UNDP used the Human Poverty Index from 1997 to 2009, and
then replaced MPI with the Multidimensional Poverty Index in 2010.
  MPI takes into account that there are negative interaction effects when people have
multiple deprivations, worse poverty than can be seen by simply adding up separate
deprivations for the whole country, then taking averages, and only then combining them.
 The creators of MPI have selected the three dimensions because they reflect problems
often mentioned by the poor; they have been long considered important by the
development community particularly as reflected by the Millennium Development Goals.
 The health dimension has two parts: nutrition and child mortality. A household is
designated as deprived in nutritions if there is a child who is either stunted or
underweight. Secondly, a household is considered deprived if any child has died in the
family in a five-year period.
 The education dimension also has two parts. One being, if no member in a family at least
10 years old has completed 6 years of schooling. A household is deprived if any child is
not attending school up to the age at which students finish eighth grade.
 In terms of standard of living, one is said to be deprived if there is lack of electricity,
insufficiently safe drinking water, inadequate sanitation, inadequate housing, unimproved
cooking fuel, and doesn’t owe one of the following assets—telephone, radio, television,
refrigerator, computer, animal cart, bicycle, motorbike or similar vehicle and does not
own a car or truck.
Here’s the link to the presentation i made on multidimensional poverty:
https://docs.google.com/presentation/d/1UqDUh5y1boeb89Th9b9vVcw7c1kW6bUU/
edit#slide=id.g256ac6dfa61_0_22
5.5 Economic Characteristics of High-Poverty Groups
5.5.1 Children and Poverty:
 Poverty is more prevalent among children than among adults in most countries.
 Half of all those in multidimensional poverty are children, representing over a third of all
children globally.
 Close to 385 million children were living in extremely poor households in 2013, making
up about half of the extreme poor, despite being only a third of the population.
5.5.2 Women and Poverty
 Women make up a significant majority of the world's poor, and they experience harsher
deprivation in the poorest communities.
 Female-headed households often have lower incomes and less access to resources,
leading to higher levels of poverty among women.
 Development policies that increase productivity differentials between men and women
can exacerbate earnings disparities and economic vulnerabilities.
 Integrating women into development programs and increasing their access to education,
formal-sector employment, and resources is crucial to improving living conditions for the
poorest individuals and achieving long-term economic growth.
5.5.3 Ethnic Minorities, Indigenous Populations, and Poverty
 Poverty disproportionately affects minority ethnic groups and indigenous populations.
 Indigenous peoples, estimated at 370 million in over 5,000 groups across 70 countries,
face higher levels of extreme poverty, malnutrition, illiteracy, poor health, and
unemployment.
 In countries like Mexico, over 80% of the indigenous population is poor, compared to
18% of the nonindigenous population.

5.6 Growth and Poverty 

Some believed that rapid economic growth could marginalize the poor and hinder poverty
reduction efforts. Concerns were raised that reducing poverty would require public expenditures
that might slow down economic growth.
There are at least five reasons why policies focused on reducing poverty need not conflict with
economic growth and may even promote it:
 Poverty Hinders Productivity: Widespread poverty leads to limited access to credit and
investment opportunities, reducing economic productivity and growth potential.
 Rich Spending Habits: The wealthy in many poor countries do not necessarily invest
substantial proportions of their incomes in the local economy, limiting the impact of their
wealth on overall growth.
 Enhancing Economic Productivity: Improving the income, health, nutrition, and
education levels of the poor directly and indirectly contributes to higher economic
productivity and overall growth.
  Stimulating Local Demand: Raising the income levels of the poor increases the demand
for locally produced necessities, stimulating local production, employment, and
investment.
 Incentives for Public Participation: Reducing mass poverty acts as a powerful incentive
for widespread public participation in the development process. This active participation
fosters economic expansion and discourages rejection of progress.
Dramatic reductions in poverty are not necessarily incompatible with high economic growth.
Case studies and cross-national comparisons show that countries with sustained growth have
often experienced significant poverty reduction. China and Vietnam, for example, have achieved
substantial poverty reduction alongside rapid economic growth.
Richer countries also tend to have lower levels of absolute poverty, as they offer more
employment and entrepreneurship opportunities. While economic growth alone may not end
poverty, wise and shared stewardship of growth resources can greatly facilitate poverty
reduction.

5.7 Labour, the Functional Distribution of Income, and Inclusive

Development
5.7.1 The Functional Distribution 
 Functional income distribution focuses on the share of total income received by each
factor of production (land, labor, and capital) rather than individual income.
 The traditional neoclassical approach uses supply and demand curves to determine the
unit prices of each factor, which then multiply by the quantities employed to calculate
total payments to each factor.
 In a competitive market economy with constant-returns-to-scale production functions,
factor prices are determined by factor supply and demand curves, and factor shares
combine to exhaust the total national product.
 However, the traditional neoclassical approach doesn't account for non-market forces
such as power and influence in determining factor prices, such as employer monopsony
power and collective bargaining between employers and trade unions in wage-setting.
 The traditional neoclassical model has limitations due to its failure to consider the role of
power dynamics in determining factor prices.
 Fig 5.13: Functional Income Distribution in a Market Economy 

Figure 5.13 illustrates the traditional neoclassical theory of functional income distribution.
 The model considers two factors of production: capital (a fixed factor) and labor (the only
variable factor).
 Under competitive market assumptions, the demand for labor is determined by its
marginal product, meaning additional workers will be hired up to the point where their
marginal product equals their real wage.
 Due to the principle of diminishing marginal products, the labor demand curve is
negatively sloped (DL) and the labor supply curve (SL) is upward-sloping in the
traditional neoclassical approach.
 The equilibrium wage (WE) and employment level (LE) are determined at the
intersection of the labor supply and demand curves.
 The total national output, which equals total national income, is represented by the area
0REL.
 National income is distributed between workers and capitalists in two shares: WE LE
going to workers as wages, and WERE remaining as capitalist profits (return to owners of
capital).
 The model assumes constant-returns-to-scale production functions, where doubling all
inputs doubles the output.
 The theory suggests that each factor gets paid in accordance with its contribution to
national output.
 This model of income distribution is central to the Lewis theory of modern-sector growth,
which is based on reinvestment of rising capitalist profits.
5.7.2 Labour and Inclusive Development 
 The majority of people in developing countries receive their income from labor, but not all
labor income comes from traditional wage-based jobs.
 In low- and middle-income countries, nearly half of the workforce is engaged in self-
employment, such as farming and microenterprises, with irregular and low-productivity
incomes.
 Many people living in poverty or vulnerable to poverty are already employed but face limited
opportunities for higher income.
 Work is fundamental to economic development as it provides income and shapes future
income possibilities for individuals.
 The quality of work experiences, including skills development and job stability, can influence
individuals' capabilities and engagement in civic affairs.
 Labor market inequality can magnify other forms of inequalities in society.
 The availability of work is not guaranteed, and hundreds of millions of net new jobs will be
needed in the coming decade, especially in developing countries.
 Good government policies can facilitate the creation of quality jobs, while poorly designed or
implemented policies can hinder job creation.
 There are different perspectives on how to create quality jobs, with some advocating for job
creation diagnostics to identify constraints and address them through policy.
  Some constraints on job creation, such as infrastructure development, can be addressed with
political will, while others related to social norms and legislation require broader societal
engagement and time.

5.8 Policy Options on Income Inequality and Poverty: Some Basic

Considerations
5.8.1 Areas of Intervention 
 Governments in developing countries need to know the best strategies to reduce poverty
and excessive income inequalities.
 Four broad areas of government policy intervention are identified to modify the income
distribution:
o Altering the functional distribution: This involves influencing the returns to labor,
land, and capital, and the shares of national income received by each factor's
owners.
o Mitigating the size distribution: Understanding how ownership and control of
productive assets and labor skills are distributed, which ultimately determines the
distribution of personal income.
o Moderating the size distribution at the upper levels: Achieved through progressive
taxation of personal income and wealth, leading to inclusive growth by investing
in human capital and lagging infrastructure needs.
o Moderating the size distribution at the lower levels: Using tax revenues for public
expenditures to directly or indirectly raise the incomes of the poor, such as cash
transfers or public employment creation.
 Sustainable policies aim to build the capabilities and assets of people living in poverty.
 The goal is to create a fairer income distribution and improve the living standards of the
poor while promoting economic growth.
5.8.2 Altering the Functional Distribution of Income Through Relative Factor Prices:
Minimum Wage and Capital Subsidy Debates
 Altering the functional distribution involves modifying the relative prices of labor and
capital in an economy to affect income distribution.
 In some cases, minimum wages set above market levels can be seen as a "distorted" price
of labor, potentially leading to negative effects on employment and hurting the poor.
 However, recent research and practitioners argue that the impact of minimum wages on
poverty is nuanced, and it may have beneficial effects, especially in informal sectors with
low-skill activities.
 The price of capital equipment may also be artificially set at low levels through various
public policies, favoring capital owners with higher economic returns.
 Correcting factor prices, such as lowering the relative price of labor and raising the
relative price of capital, can lead to increased productivity, efficiency, and more wage-
paying jobs for unskilled and semiskilled workers.
 Removing factor-price distortions should contribute to reducing poverty and improving
income distribution, but the actual impact will vary based on local conditions and
production methods.
  Close study of local circumstances is crucial before concluding that minimum wages
universally hinder poverty reduction.

5.8.3 Modifying the Size Distribution Through Increasing Assets of the Poor
 Correcting resource prices and utilization levels alone is not sufficient to reduce income
inequality and poverty substantially.
 The primary cause of income inequality is the highly concentrated ownership of
productive and financial resources (physical capital, land, financial capital, and human
capital) among a small segment of the population.
 The focus should be on directly reducing the concentrated control of assets, unequal
distribution of power, and limited access to education and income-earning opportunities
in developing countries.
 Land reform is one example of a policy that can be used to transform tenant cultivators
into smallholders, but complementary measures such as access to credit, fertilizers,
marketing facilities, and agricultural education are crucial for its success.
 Dynamic redistribution policies may involve facilitating the gradual transfer of annual
savings and investments to low-income groups over time.
 Increasing access to education and skills is essential, but complementary policies to
create productive employment opportunities for the educated are equally important for
improving the income-earning potential of the poor.
 Policymakers must have a strong knowledge base and engage with people living in
poverty to better understand their specific conditions and priorities.
 Inclusive policies should consider the diversity within poor communities, including
differences between men and women, ethnic groups, and castes.
5.8.4 Progressive Income and Wealth Taxes 
 National policies aiming to uplift the living standards of the bottom 40% require adequate
financial resources to turn plans into reality.
 The main source of development finance is direct and progressive taxation on both
income and wealth.
 Progressive income taxes mean that the rich pay a larger percentage of their total income
as taxes compared to the poor.
 Wealth taxation includes personal and corporate property taxes and may also involve
progressive inheritance taxes, with the aim to burden higher-income groups more heavily.
 In many developing and some developed countries, progressive tax structures may not be
implemented effectively.
 The poor often bear a larger share of their incomes in taxes due to taxes being withheld at
the source
 The rich often derive a significant portion of their incomes from assets that may go
unreported, making it easier for them to avoid taxes.
 To achieve effective redistribution, policies are needed to enforce progressive tax rates on
income and wealth, particularly for the highest-income groups.

5.8.5 Direct Transfer Payments and the Public Provision of Goods and
Services
  Providing tax-financed public goods and services to the very poor is a crucial part of
poverty eradication policies.
 Examples include public health projects, school lunches, nutritional supplementation,
clean water, and electrification in rural and remote areas.
 Direct money transfers and subsidized food programs for the urban and rural poor are
additional forms of public consumption subsidies.
 Designing direct transfers and subsidies requires careful attention to address four
significant problems:
o Limited resources should be directed to genuinely poor individuals.
o Beneficiaries should not become overly dependent on the poverty program;
incentives for building assets like education should be maintained.
o Avoid diverting those productively engaged in other economic activities into the
poverty program.
o Consider the resentment from non-poor individuals slightly above the poverty
line.
 Subsidies should be targeted to specific geographic areas where the poor reside and
emphasize goods that non-poor people do not typically consume.
 Imposing a work requirement before food aid can be useful, as seen in programs like the
Bangladesh Food for Work Programme and the MGNREGA in India.
 Workfare programs, like the Food for Work Programme, are preferred over welfare or
direct handouts when certain criteria are met, including preserving incentives, net
benefits, and reducing stigma.
 Well-designed programs can indirectly increase the bargaining power of the poor by
providing better "outside options," such as guaranteed public employment programs.

5.8.6 Applying Insights from Behavioural Economics to Address Poverty

 The "cognitive tax of poverty" refers to the hidden cognitive burden faced by the poor,
which can impede cognitive functioning and decision-making.
 The poor may experience deficits in cognitive skills, noncognitive skills, and a higher
incidence of mental illness due to stress and environmental factors linked to poverty.
 Stressors of poverty can impair cognitive functions such as attention, inhibitory control,
flexibility, and planning, and lead to depression, anxiety, and substance abuse.
 Poverty can create a vicious circle as poor thinking and judgment may worsen poverty
and hinder actions to improve conditions.
 Cognitive challenges increase with stress, affecting the poor's ability to engage in
activities that could break the cycle of poverty.
 Undernutrition contributes to cognitive problems in the poor, leading to difficulties in
concentrating, thinking clearly, and displaying self-discipline.
 Cash transfer programs have shown to reduce stress and depression, leading to improved
psychological well-being and beneficial effects on children and youth.
 Reminders, whether through text messages or implicit cues, can help the poor overcome
cognitive limitations and improve adherence to medicine regimens or savings behavior.
 Offering self-commitment devices can help the poor manage their cognitive limitations
and achieve savings goals effectively.
 Incorporating cognitive considerations into program design, outreach, and follow-up,
following the principles of "choice architecture," can enhance the effectiveness of
poverty programs.
 Simplifying enrollment and reporting forms and considering the cognitive burden of the
poor are essential strategies in program design.