solow model and the case of south korea in 1960 1979

CHAPTER 1: THEORETICAL CONCEPT1 Neoclassical Growth Theory This model assumes that economic agents are free capitalists, make independent decisions, and act based on personal interests,

HO CHI MINH CITY CAMPUS

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-ECONOMIC DEVELOPMENT

MID-TERM REPORT

Major: INTERNATIONAL BUSINESS ECONOMICS

SOLOW MODEL

1960-1979

Ho Chi Minh City, August 2023

TABLE OF CONT ENT

CHAPTER 1: THEORETICAL CONCEPT 1

1) N EOCLASSICAL G ROWTH T HEORY 1

2) S OLOW M ODEL 1

3) C OMPARISON BETWEEN C LASSICAL AND N EOCLASSICAL : 2

a Time Period and Context: 2

b Marginal Analysis: 3

c Utility and Demand: 3

d Labor Theory of Value: 3

e Distribution of Income: 3

f Government Intervention: 4

g Methodology: 4

CHAPTER 2: SWOT ANALYSIS 4

CHAPTER 3: APPLICATION IN REALITY 6

1) 1950 1960 - 6

2) 1960 1979 - 7

3) C ONCLUSION 11

CHAPTER 4: LESSONS LEARNED FOR VIETNAM 12

1 I NCREASING THE S AVING R ATE 12

2 L OWERING P OPULATION G ROWTH 13

3 E NHANCING T ECHNOLOGICAL P ROGRESS 13

4 I NFRASTRUCTURE NVESTMENT I 13

5 L ONG -T ERM P LANNING AND S TABILITY 13

CHAP TER 1: THEORETICAL CONCEPT

1) Neoclassical Growth Theory

This model assumes that economic agents are free capitalists, make independent decisions, and act based on personal interests, interacting with each other through fully informed markets It suggests that a market economy is capable of automatic equilibrium through competition and makes optimal decisions for the entire society

This model also makes other assumptions such as maximum investment in production, exclusive information, and complete financial assets Economists use this model to analyze the effects of economic policies and predict market behavior in different situations However, this model also faces criticism as it cannot fully describe the reality of a market economy

2) Solow Model

Model grew out of work by Robert Solow (and, independently, Trevor Swan)

in 1956 Describes how “natural output” (Y , assuming full efficiency) evolves in an

economy with a constant saving rate Key question: Can an economy sustain

perpetual growth in per-capita income through ongoing increases in capital?

Unlike the fixed-coefficient, constant- returns- -to scale assumption of the Harrod-Domar model, Solow’s neoclassical growth model exhibited diminishing returns to labor and capital separately and constant returns to both factors jointly It differed from the Harrod-Domar formulation by adding a second factor, labor, and introducing a third independent variable, technology, to the growth equation The standard exposition of the Solow neoclassical growth model uses an aggregate production function in which

𝑌" = 𝐾!

(𝐴𝐿)"#$#!

"

where Y: gross domestic product, K: stock of capital (which will include human capital as well as physical capital, L: labor, A: productivity of labor, 𝛼: the elasticity

of output with respect to capital Since 𝛼 is assumed to be less than 1 and private capital is assumed to be paid its marginal product so that there are no external

economies, this formulation of neoclassical growth theory yields diminishing returns both to capital and to labor → output growth results from one or more of three factors: increases in labor quantity and quality (through population growth and education), increases in the capital (through saving and investment), and improvements in technology (i.e new and improved ways of accomplishing traditional tasks such as growing crops, making clothing, or building, a house)

In developed countries, this rate has been estimated at about 2% per year It may be smaller or larger for developing countries, depending on whether they are stagnating or catching up with the developed countries

Closed economies (those with no external activities) with lower savings rates (other things being equal) grow more slowly in the short run than those with high savings rates and tend to converge to lower per capita income levels Open economies (those with trade, foreign investment, etc.), however, experience income convergence

at higher levels as capital flows from rich countries to poor countries where capital-labor ratios are lower and thus returns on investments are higher

⇒ By impeding the inflow of foreign investment, the heavy-handedness of many developing countries’ governments, according to neoclassical growth theory, will retard growth in the economies of the developing world

3) Comparison between Classical and Neoclassic al:

a Time Period and Context:

Classical Economics: The classical school emerged in the late 18th and early

19th centuries, with prominent economists like Adam Smith, David Ricardo, and John Stuart Mill Classical economists focused on understanding the dynamics of a largely agrarian and early industrial economy

Neoclassical Economics: Neoclassical economics emerged in the late 19th and

early 20th centuries as a response to perceived shortcomings in classical theory It became more dominant in the 20th century and is the foundation of modern mainstream economics

b Marginal Analysis:

Classical Economics: Classical economists often did not explicitly employ

marginal analysis (examining the effects of small changes) in their theories They relied more on broad general principles and were concerned with issues like value, distribution, and economic growth

Neoclassical Economics: Neoclassical economics introduced the concept of

marginal analysis as a central tool Marginal utility theory (in consumer behavior) and marginal productivity theory (in factor markets) became core components of neoclassical economics

c Utility and Demand:

Classical Economics: Classical economists had a more limited view of

consumer behavior and did not explicitly develop the concept of utility maximization Their focus was on supply-side factors like production and distribution

Neoclassical Economics: Neoclassical economics emphasized the role of

utility in consumer decision-making The theory of consumer behavior is based on the idea that individuals maximize their utility subject to their budget constraints

d Labor Theory of Value:

Classical Economics: Classical economists, such as David Ricardo, often

adhered to the labor theory of value, which posited that the value of a commodity is determined by the amount of labor required to produce it

Neoclassical Economics: Neoclassical economists shifted away from the labor

theory of value and introduced subjective value theory They argued that a good's value is determined by its marginal utility, or the additional satisfaction gained from consuming one more unit

e Distribution of Income:

Classical Economics: Classical economists were concerned with the

distribution of income between the three main classes: landlords, capitalists, and workers They often discussed the role of rent, wages, and profits in determining income distribution

Neoclassical Economics: Neoclassical economics focused more on analyzing

individual and firm behavior within markets The neoclassical approach to income distribution is often seen through the lens of factor markets, where wages and returns

on capital are determined by supply and demand

f Government Intervention:

Classical Economics: Classical economists generally favored laissez-faire

policies and believed that markets would naturally self-regulate and lead to optimal outcomes

Neoclassical Economics: Neoclassical economists also emphasize the

efficiency of markets but recognize that market failures can occur They suggest that

in cases of market failure, limited government intervention may be necessary to correct inefficiencies

g Methodology:

Classical Economics: Classical economists relied more on deductive

reasoning and abstract principles to develop economic theories They often used simple models to illustrate their ideas

Neoclassical Economics: Neoclassical economics brought a more formal

mathematical and analytical approach to economic analysis Models became more complex and mathematical rigor became more important

CHAPTER 2 : SWOT Analysis

The SWOT analysis of the Traditional Neoclassical Growth Theory highlights its strengths, weaknesses, opportunities, and threats within the realm of economic

development

Firstly, in terms of its strengths, the Traditional Neoclassical Growth Theory offers valuable insights into the fundamental drivers of economic development Its strengths lie in its focus on key factors such as capital accumulation, labor force expansion, and technological progress as essential determinants of long-term economic growth By emphasizing the role of investment in physical and $, the theory provides a framework to understand how these inputs contribute to increasing

production capacities Additionally, the theory's consideration of diminishing returns

to both labor and capital ensures a realistic portrayal of the limits of growth This model has been influential in shaping discussions about the core elements that underpin economic advancement, making it a foundational tool in the study of economic growth and development

Besides, while influential in its approach to explaining long-term economic growth, this theory is not without its weaknesses One notable weakness lies in its oversimplification of real-world complexities The model assumes constant returns

to scale, disregarding the potential for economies to experience increasing returns due to factors such as technological advancements or positive externalities Additionally, the theory often neglects the role of institutions, social factors, and distributional issues, which can significantly impact economic development Moreover, the focus on aggregate measures like capital and labor fails to account for the heterogeneity within these factors across industries and regions Furthermore, the theory's inability to explain disparities between countries with similar levels of physical capital and technology highlights its limitations in capturing the nuanced dynamics of global economic growth As a result, critics argue that the Traditional Neoclassical Growth Theory falls short in providing a comprehensive and accurate

The Solow Model can also be an opportunity to develop in order to fix the modern economy in recent decades Firstly, The Solow Model can be integrated with newer growth theories that address its limitations, such as endogenous growth theory,

to create more comprehensive and realistic models The second change is the empirical Testing and Validation In particular, the model's predictions can be tested against real-world data to validate its accuracy and identify areas where it might fall short And last is the policy implications By understanding the strengths and weaknesses of the model, policymakers can make informed decisions about strategies for fostering sustainable economic growth

Finally, there are some threats that exist in this theory The Solow Model faces criticisms from other growth theories that offer alternative explanations and insights, which may challenge its dominance in the field of economic growth theory Secondly,

the model's assumptions might not hold true in rapidly changing economic environments, such as those driven by rapid technological advancements or significant shifts in global trade dynamics Last is the complexity of Real-world Dynamics: The model's simplifications may limit its applicability when dealing with more complex economic situations, such as those involving structural changes, economic shocks, or nonlinear relationships

CHAPTER 3: Application in reality

previously underdeveloped country that, after the 1960s, embarked on a process to achieve development before other underdeveloped countries Korea's journey from underdeveloped to developed is measured on the basis of the Solow theory of development, considering the productive factors (Physical, Human, Social, and Financial Capital, Labor, resources, environment), economic agents (State, Firms, Banks) on its growth process

The case of Korea can be divided into 2 phases:

1) 1950 - 1960

South Korea’s GDP in 1950 -1960 was equivalent to that of Sudan and the Republic of Congo (Heng, 2010) For an even more graphic comparison, prior to

1963, South Korea’s GDP was lower than that of Bolivia and Mozambique (Noland, 2011) In 1960 South Korea’s real GDP per worker was only 584 dollars The

production was below post-war levels, and they had almost 3-digit inflation

Figure 1: Log GDP per capita for South Korea from 1953 – 2017

Source: World Bank

2) 1960 - 1979

When Park Chung-Hee came to power in 1963, he created the conditions that allowed the development of the “3 lows”: low grain price, low exchange rate, and low interest- rate This authoritarian government oversaw a distributive income policy and broad participation of the industrial sector in the economy.The whole country from the ashes of the Korean War began a process of strong and continuous growth thanks to policies to boost exports, restructure the economy, develop heavy industry, and modernize Between 1954-86, the share of industry in the GDP went from 12.2%

to 30.2% and the agricultural sector saw its share decrease from 44.6% to 13.5% (Kim, 1991) Savings went from a negative rate ( 3.8%) to 23.1% in 1973 (Frank and -Kim, ob cit.) The Korean development strategy was based on 3 stages:

- Import Substitution Industrialization (ISI): The infrastructure for industrial development was built between 1954 and 1960

- Export-Oriented Industrialization (EOI): Between 1961 and 1979 an export-oriented industrialization phase took place This phase was implemented by General Park in conjunction with his development plan

- Restructuring: Implemented after the debt crisis in 1980 to end stagflation This period began the liberalization of the economy

The Solow model allows us to see how Korea moved towards a Balanced Growth Path (BGP) based on the behavior of Capital and effective Labor (K and L, respectively) The BGP is a steady state in which “level variables” such as Capital (K) and Production (Y) grow at constant rates and the ratios among key variables are

stable A country is said to have a BGP if the following four conditions hold:

- The growth rate of GDP per capita is stable

- The ratio of gross capital formation to GDP (I/Y) is stable

- Labor’s share of costs (ϕL) is stable

- The capital/output ratio (K/Y) is stable

We assume that the growth rates of Labor, Technological development, and Capital

as constant