1. Introduction to Economic Development

The study of development economics is of paramount strategic importance in a world marked by profound disparities in living standards. To understand the scale of this challenge, we need only consider the conditions under which the majority of the world’s population lives. The phrase “How the Other Two-Thirds Live” encapsulates the reality for billions who exist in conditions starkly different from those in the affluent West. The case of Balayya, an Indian farm laborer, provides a vivid illustration. He and his family have a combined annual income of just $US900 to $US1,200, most of which is non-monetary. This supports a life circumscribed by a one-room mud house without electricity or clean water, limited access to healthcare, and a world defined by the distance one can walk in a day. This reality underscores the need for a specialized field of study. As the development economist Dudley Seers noted, analyzing developing economies requires us to move beyond the standard economic models of North America and Western Europe, as the problems and institutional contexts are often unique. Rigid adherence to conventional Western doctrine can be a hindrance, not a help, in understanding the complex process of development.

1.1. Differentiating Growth from Development

It is crucial to distinguish between economic growth and economic development, as the terms are not interchangeable. While growth may be a necessary condition for development, it is not sufficient.

• Economic Growth refers to a quantitative increase in a country’s production or income per capita. It is typically measured by the rise in Gross National Product (GNP) or Gross National Income (GNI).
• Economic Development is a more profound, qualitative transformation. It encompasses economic growth but also involves significant changes in the distribution of output and the structure of the economy. This includes improving the material well-being of the poorer half of the population, shifting the economic base from agriculture to industry and services, and advancing the skills and technical capabilities of the labor force.

An effective analogy is to compare a child’s growth (gaining height) with their development (improving coordination, learning new skills). The former is a simple increase in size, while the latter represents a change in capacity. Historically, the focus of policy has shifted. The disillusionment with the UN’s first development decade (1960–1970) was a turning point. Despite impressive aggregate growth in many poor countries, the benefits failed to trickle down to the poor, prompting a shift in focus from mere growth to the broader, more inclusive goal of development.

1.2. The Global Economic Landscape: Classifying Countries

To analyze the global economy, it is common to classify countries by income level. While any such categorization is a simplification, it provides a useful framework for understanding broad economic patterns.

However, this tripartite view of the world may be misleading. Research by Branko Milanovic and Shlomo Yitzhaki suggests a starker reality. They found that 78 percent of the world’s population lives in what could be called the “third world” (with incomes at or below Brazil’s level), while only 16 percent belongs to the “first world” (with incomes at or above Italy’s level). This leaves a mere 8 percent of the global population to constitute a “world middle class,” highlighting the immense scale of global inequality.

1.3. Challenges in Measurement: The Limitations of GNP

Gross National Product (GNP) is the most widely used measure of economic output, but it has significant limitations, especially when used for making comparisons over time or between countries.

1.3.1. Temporal Comparisons

Comparing a country’s GNP over time is complicated by inflation. To calculate real economic growth, economists use price deflators to adjust nominal GNP. However, constructing an accurate deflator is difficult. Two common methods, the Laspeyres index (using base-year quantities) and the Paasche index (using current-year quantities), can produce different results.

For example, consider a hypothetical case in Malaysia producing calculators and boots. If the price of calculators falls dramatically while the price of boots doubles, a Laspeyres index (which gives more weight to the previously higher-priced calculators) might show a price level increase of 50%. In contrast, a Paasche index (which gives more weight to the now higher-priced boots) might show an increase of only 12.5%. This discrepancy arises because the indices assign different weights to goods whose prices and production volumes change at different rates.

1.3.2. Cross-Country Comparisons

Comparing the GNP of developed countries (DCs) and less-developed countries (LDCs) using official exchange rates is fraught with distortions. These distortions almost universally understate the relative income of LDCs. The key reasons include:

1. Non-Market Activities: A larger share of production in LDCs occurs outside the formal marketplace (e.g., subsistence farming, household production). This output is often not captured in official GNP statistics, leading to an understatement of total production.
2. Intermediate Goods: LDCs tend to have a smaller share of their output devoted to intermediate goods (inputs used to produce other goods). This can artificially inflate the relative share of final goods in DC GNP compared to LDC GNP.
3. Comparison-Resistant Services: Services like government administration, healthcare, and education are difficult to compare across countries because there is no clear market price. Their value is often measured by the cost of inputs (e.g., salaries), which are much lower in LDCs, thus understating their real contribution.
4. The Black Market: While present in all economies, the informal or “black” market can constitute a significant share of economic activity in LDCs (e.g., an estimated 18-21% of GDP in India in the early 1980s), and this is often inadequately captured in official data.

1.4. A More Accurate Lens: Purchasing-Power Parity (PPP)

To address the distortions of exchange-rate-based comparisons, economists developed the concept of Purchasing-Power Parity (PPP). A PPP exchange rate is a conversion factor that equalizes the cost of a standardized basket of goods and services across different countries. It answers the question: how many units of a local currency are needed to buy the same quantity of goods and services that one U.S. dollar can buy in the United States?

The Economist magazine’s “Big Mac” index provides a simple, intuitive illustration. If a Big Mac costs R$4.55 in Brazil and 2.71 in the U.S., the Big Mac PPP is R1.68 per dollar. If the actual exchange rate is R$3.07 per dollar, it suggests that the Brazilian real is significantly undervalued. Conversely, a Big Mac price of Sfr5.86 in Switzerland, compared to a market rate of Sfr1.30 per dollar, suggests the Swiss franc is overvalued by 70%.

When these adjustments are applied to national income, the results are dramatic. For instance, using exchange rates, the U.S. per-capita GNP appeared to be 70 times that of India. After adjusting for PPP, the ratio shrinks to just 13 times. The general rule is that the greater the income difference between two countries, the larger the correction introduced by the PPP adjustment.

While PPP calculations are a major improvement, they are not without their own measurement errors and limitations. The process is complex and data-intensive. Nevertheless, economists Irving Kravis and Robert Lipsey concluded that the margin of error in PPP estimates is “still a small range… compared to that stemming from the use of exchange rates.”

1.5. Beyond Income: Measuring Human Well-being

Recognizing the limitations of income as a sole measure of welfare, economists and international organizations have developed broader indicators of development.

1.5.1. The Human Development Index (HDI)

The United Nations Development Programme (UNDP) created the Human Development Index (HDI) as a composite measure of well-being. It is based on the idea that development is about “enlarging people’s choices.” The HDI combines three key dimensions of human development with equal weight:

1. Longevity: Measured by life expectancy at birth.
2. Educational Attainment: A composite of the adult literacy rate (two-thirds weight) and the combined gross enrollment rate for primary, secondary, and tertiary education (one-third weight).
3. Standard of Living: Measured by the logarithm of GDP per capita in PPP dollars.

The final HDI is the simple average of these three indices. It provides a more holistic view of development, often revealing that disparities in human development are less severe than disparities in income alone.

1.5.2. The “Basic-Needs” Approach

The basic-needs approach focuses directly on the outcomes of development by measuring the attainment of essential goods and services required for a decent life. These include access to:

• Adequate food and nutrition
• Safe drinking water and sanitation
• Basic healthcare
• Housing
• Primary education

Proponents argue that while GNP remains important, basic-needs data supplement it by revealing the composition of growth and identifying who benefits from it. It shifts the focus from abstract national averages to the concrete living conditions of the population, especially the poor.

1.5.3. Development as Freedom

Nobel laureate Amartya Sen has offered an influential philosophical framework for development, arguing that freedom is both the ultimate goal and the primary means of development. From this perspective, development is the process of expanding real freedoms that people enjoy. Conversely, underdevelopment is characterized by the presence of “unfreedoms,” which include:

• Hunger and famine
• Ignorance and illiteracy
• Premature death and preventable morbidity
• Lack of political liberty and civil rights
• Barriers to economic fulfillment for women or minority groups

For Sen, freedoms like the ability to exchange goods, enter labor contracts, access social opportunities, and enjoy protective security are not just the ends of development but are also crucial instruments for achieving it.

These foundational concepts of what development is and how it is measured provide the necessary groundwork for exploring the major theories that seek to explain how this complex process of transformation occurs.