What is economic development?

‘What is economic development and how would you measure it? Does an increase in per capita national income always constitute an increase in the standard of living?’

Economic development is hard to define, but is an improvement in the living conditions of the population as a whole. Whilst closely linked with economic growth – high growth could result in high development – they are not the same thing and economic growth, as we shall discover, does not necessarily equate to economic development. It can be measured in a variety of different ways and Streeten believes it is necessary for its own sake, to improve the condition of people, because it results in higher productivity and lower fertility (which is generally seen as a good thing), can lead to a better environment and a healthier civil society, democracy and social stability.

Gross National Product per capita is the most common measure of an economy’s development and is used to compare between countries internationally and to compare a country’s progress over time. As a measure it is basically the sum of all goods and services produced multiplied by their market value. This presents the first flaw of this measure: it only takes into account goods/services which are produced in the market and is immediately biased towards richer, more developed economies which have a greater share of transactions conducted on the market compared to less developed countries (LDCs). In LDCs a lot of production is for consumption, for example a subsistence farmer who produces to feed himself and his family; this production wouldn’t count towards GNP and would therefore under-represent the amount of production which goes on in LDCs. In a similar vein, things like childcare, healthcare, and many other services are transacted through goodwill (perhaps through the family structure) or are traded with something which isn’t money and is therefore not accounted for. Moreover, due to the tax structure in many LDCs there is an incentive to report less than one earns to minimise one’s tax bill which presents further complications in the size of the economy.

The second flaw in GNP as a measure is that the comparisons are sometimes made after a figure is transferred in to US dollars (the currency of comparison) based on the exchange rate. However, the Penn effect tells us that real GDP is understated for LDCs because of the Balassa-Samuelson effect, whereby rich countries have higher productivity in trade-able products, which leads to higher wages and eventually a higher aggregate price level overall, thus strengthening their currency. To overcome this we need to use a PPP exchange measure which uses the theory of one price and takes a basket of goods/services in each country, calculates the price of this basket and then creates a PPP exchange rate on this comparison assuming that the price of each basket should be the same with another country.

The two flaws in GNP we have examined so far are more in its methodology which results in an incomplete comparison between nations, of which there are many more flaws, however, more fundamentally GNP is arguably the wrong measure for development because it doesn’t capture what economic development is. In 1984 South Africa had a GNP per head of $2,340 with a life expectancy at birth of 54 years, compared to the much poorer China, with an income of $310 but which had a life expectancy of 69 (World Bank 1986), hence showing that economic growth doesn’t necessarily lead to economic development. GNP could rise for a number of reasons without leading to a rise in living standards. For example, there could be an earthquake which causes mass devastation – deaths, loss of homes, the destruction of human and physical capital – but GNP could rise due to the rebuilding effort. In this case GNP has risen whilst living standards have actually fallen, showing that a rise in GNP doesn’t always mean a rise in standards of living.

It could be argued that GNP doesn’t include externalities like environmental damage (global warming, deforestation, the pollution of water supply and the air to name a few such damages) which is at the detriment of living standards if people are morbid and/or die because of this. Whilst this is the case, and high economic growth does usually come at the expense of the environment, Barro highlights that rich countries tend to have better environmental policies than poor countries, due to better education and greater ability to afford renewable policies.

We could also have a case where GNP goes up but only for a minority of people (i.e. the richest) and thus doesn’t benefit the majority of the population, instead resulting in higher inequality. As Ray says “the poor are twice cursed: once for living in countries that are poor on average, and then again for being on the receiving end of the high levels of inequality in those countries”. Basu proposes on this basis that we should therefore look at income changes of the bottom quartile, rather than the country as a whole. He believes there is a moral argument for helping out those in the bottom quartile along with the fact that market failure may mean there are talented resources in this group which aren’t recognised by the market. Using this measure we are at least able to say whether the poor are benefitting from any economic growth, although having more money/goods doesn’t equate to seeing a rise in living standards. As Sen points out, there is a difference between having a physical good (as a result of having a higher income) and having a capability or function. As a result of a higher income a person in the bottom quartile of a country’s population could purchase a bike, but they do so not to have the bike as a physical good, but to have the function of being able to move cheaply between two locations. This would suggest that we need to think about development more in terms of enabling people to lead a fruitful life and less in terms of possessing physical goods.

To see development with a greater emphasis on functioning’s and not materials, economists have come up with other ways to measure economic development, such as HDI and composite indices which include political and social cohesion. HDI is perhaps the most famous such index, which is a measure of life expectancy, education and per capita income (with a lower weighting for an income beyond $5000 to account for diminishing marginal utility) and is useful in capturing the public’s attention and encouraging policymakers to think of progress in terms of not just income. HDI isn’t a perfect measure: like all composite indices it is arbitrary in what it does and doesn’t include, and is still an average of its components which means it doesn’t completely reflect inequalities within a society. Despite this there is less scope for its components to be skewed because, unlike income, there is an upper bound – education is fixed at 100% (in terms of literacy and enrolment rates) and there is a physical limit to the maximum age a person can live, therefore meaning that HDI isn’t as affected by inequality as GNP is. The most fundamental issue with composite indices, as already mentioned, is the arbitrary nature of its components – ultimately, different people will value certain components differently, some will prefer to live a long rich life, whilst others would prefer political and social freedom to express themselves, therefore we cannot conclusively say that one particular index completely captures development, as this will vary for different societies and even within societies.

Despite our criticism of these various different measures, they are still important and relevant in highlighting the need for improvement, and giving policymakers (as well as the public who hold such people accountable) a target for improvement. Moreover there is evidence by Dasgupta and Weale which show that the correlation between income per capita and development measures as a whole is high – 0.84, as we can see from the matrix, which although is not as high as life expectancy (0.91) is still quite a good measure. Hence, we can conclude that whilst GNP has many flaws and isn’t a perfect representation of economic development, it is still quite a good conduit for evaluating the progress of economic development. We have seen though that it is not the only measure, it could usefully be coupled with such other measures to get a more rounded measure of development, and caution needs to be taken with using it.


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