The Birth of Modern Economy: Stages of Economic Development (Part 2)

In the previous article (part 1), we dived head first into the our discussion regarding the stages of economic development by first listing 3 main sectors, namely, primary sector, secondary sector, and tertiary sector, out of which the last sector is further sub-divided into 2 other distinct sectors: quaternary sector and quinary sector. These are the 5 components that constitute our modern economy. Long story short:

  • Primary sector makes direct employment of natural resources,

  • Secondary sector produces manufactured goods,

  • Tertiary sector produces service,

  • As for the 2 other sub-sectors, Quarternary sector produces knowledge (branch of the tertiary/service sector),

  • and Quinary sector dedicates itself to high-level decision making.

At different stages of growth, as already mentioned in part 1, the proportion of the national GDP accounted by each one of these components varies. In almost all known cases though, a nation usually ignites its economic engine by producing and thus serving what it has most abundant. That sector might or might not end up as the cornerstone for the economy in the long run, but regardless, it will ultimately support the growth of its backward or forward linked industries, sometimes also the so-called “Nascent Industries” or “Strategic Industries“, high-growth industries that contributes greatly to the economic improvement and stability. These industries also, in many instances, generate substantial economic spillovers. For example, re-newable wind and solar energies are currently a part of the strategic industries in China, and they are basically what China thinks will promote its economic growth in the modern age. If succeeded in reducing the cost and increasing the efficiency of these re-newable sources of energy, it will have profound impacts (positive externalities) on almost every other industry in China, further lowering the cost of manufacturing (increasing international competitiveness) while promoting greener Chinese earth (laugh now), a healthier workforce and a more vibrant economic environment with greater resiliency and resistance to shocks.

But, before even reaching and claiming this pinnacle of development, a nation has to go through many steps and stages that can take decades of painstaking processes with daunting obstacles along the way. In this article, I will walk you through, hopefully, each and every such stage, and one by one, discuss thoroughly the various challenges and opportunities a nation might face. Hopefully, at the end, we will have some space left for a solid conclusion, and relate the improvement made through achieving higher economic welfare to the changes in social and political landscapes of a nation.

Discussing this subject in detail can be tedious, so wanting to cover lots of details does not seem to help. So, in this second part of our discussion, I will only talk about the first stage of development, known as the “Traditional Economy”, because at this very early stage, there usually are lots going on and here too lies the crossroad of economic development where a nation either flourishes or stagnates. This is where nations are most vulnerable to economic phenomena like “Poverty Trap” and “Resource Curse”. Does it not sound exciting? Well, without further ado, let us begin.

1. Stages of Economic Development

+ Stage 1: Traditional Economy

De Kaap Gold Fields, South Africa

Direct extraction of natural endowment

Traditional economy relies heavily on primary sector and sometimes also light industries of the secondary sector. It marks the inception of an economy.

At first, each country might have started at different point in time, but what we have observed is that initially, just as how an ant colony begins with the gathering of the first grain of rice, a nation starts off by first generating food on which its people subsist. At this stage, the economy is in its earliest form, sometimes known as “Subsistence Economy“. In essence, subsistence economy is a term that marks an economy in which most people can only support themselves (provide for their own basic needs) at a bare minimum level. The most common way a nation acquires provisions is through the consumption and direct employment of its natural endowment, and by that, I am referring to the raw materials obtained from earth: fish, animal products, timber, stone, etc. Livelihood mostly depends on hunting and gathering, and humans, just like animals, have to frequently move from place to place to seek new sources of resources after the old one had been depleted. Causes of disease usually unknown, weather conditions and natural disasters unpredictable, and protection against predators minimal. Unlike the nature-loving beings we now are, humans living in traditional economy might think of nature more as an unfriendly hostile force because they are subject to constant harassment by our mother earth which helps explain the small population size in the olden days.

The development of Agriculture

Later, our ingenuity brought about new modes of survival and many ground-breaking inventions leading to the prosperity and inception of human civilization. The greatest invention of all is probably none other than agriculture. At this stage, the economy can support a larger settlement, and this aids the emergence of great cities and powerful nations.

Agriculture revolutionized our way of life. If you really want to be amazed, just read about “Corn”. Corn alone can explain almost the entire human history (I’m exaggerating a bit). Corn is probably one of the strategic crops that made possible enormous empires of the ancient time and the modern world of today. Fun fact: the corn we know so well today was actually domesticated. Originally, corn had very low yield as the plant itself was quite small in size. However, through the progression of human knowledge in agriculture, corn went through several stages of artificial selection, leading to the present day’s corn that have kept us fed for centuries (and making possible the popcorn we love!). This is just one example of many that exhibits the importance of agriculture to the human race.

To put simply, agriculture is one of the prime reasons that allows us to flourish by settling near any great source of water, and it is one of the reasons why geographic conditions matter so much (of course, other reasons being: transportation, commerce, defense, fresh water, fish, etc). This is exaclty why the Nile is so important to the Egyptian, the Yangtze to the Chinese, and the Mekong to the Indochine people.

However, even with agriculture, people can sometimes only produce enough for our own consumption. This is because agriculture depends heavily on exogenous factors like weather conditions, fertility of the land, favorable supply of water from the river/lake or rainfall, and the presence or absence of pests. As a consequence, the annual yields fluctuate from year to year, meaning there are years of great abundance and years of tragic loss and poverty. Therefore, people in such stage of development have to be frugal in terms of their consumption and save any surplus to prepare themselves for the time of shortage; thus, little left for expansion and commerce.

The 1st Development Crossroads:

The Malthusian Trap, the Catch 22, and the Pradox of Plenty

And, this is an appropriate spot for us to take a break from mere description and engage in some critical thinking because from here onwards (i.e. from the point of the practice of traditional agriculture), observation shows that economies of different nations begin to diverge in terms of their evolution. Starting here is when understanding and practicing economics will make significant differences in economic growth.

Note that agriculture is ubiquitous, and this is a true statement. Even in the most impoverished region on Earth, some sort of ploughing, sowing, planting, or harvesting activity is taking place. As long as people are at liberty to practice agriculture, they have the incentive to roll up their sleeves and do it because farming, animal husbandry, etc., are, to many, their livelihood. This is a common achievement shared by virtually every nation on our planet; we basically know how to cultivate the land and produce agricultural yields.

What is to be emphasized is, however, not the commonly shared features, but what usually differs from one nation to the next, what in the practice of agriculture that distinguishes the least-developed from advanced countries.

They are no other than the methods employed, the technical knowhows of the agricultural practitioners, which usually account for the huge difference in outputs obtainable from the same amount of inputs. The superiority as well mostly extends beyond the quantity and quality of the final products to the safety, convenience, speed, and efficiency of the effort and process from sowing to reaping the harvest to getting it into the market and onto your dinner plate. However, to even get to this point of growth, nations normally confront with many obstacles, and 3 of the greatest of those will be discussed in details below to give you, my reader, the big picture of economic development.

The Malthusian Trap

Malthusian Trap: the more, the less

The Malthusian trap was named after Thomas Rober Malthus, a very influential scholar in the field of political economics and demography, whose published work in 1798, “An Essay on the Principle of Population” pretty much implied the extinction of the human race. His writing was probably one of the reasons why economics was later dubbed “Dismal Science”.

Malthusian trap is one of the classical economic theories, a mirror into the mind of scholars molded by the era he lived within. “Malthusian trap” is the idea that population growth would outstrip the growth of food supply eventually leading to the age of great famine as food supply became too small to sustain the population.

Now, this was a very logical thinking of that time. While the population size increased exponentially, food supply did not. Plus, knowing the limited arable land we have, Malthus must have thought that sooner or later the increasing population would be accompanied by diminishing production of labour. Why could that have been the case? Because as more people work on the same plot of land, there will be fewer tasks for everyone to perform and thus lower per capita yield. Simply put, doubling the labour will not double the output.

Think about it. Even if you can increase output by 5%, but if you have 20% more people to feed, then your per capita growth would be -15%. The same principle applies to the calculation of GDP per capita. If GDP grows at, say, 7% per year, but population grows at 5%, then you will end up with only 2% per capita GDP growth. Hence, the formula:

[GDP per capita growth rate = Real GDP growth rate – Population Growth rate]

This makes perfect sense. The higher the popopulation growth, the more people we have, but if without a proportional rise in the level of output, then we would have fewer outputs for everyone.

Malthus, however, did not foresee the drastic increase in productivity and efficiency of production brought about by the great industrial revolution. Of course, the human race continues to thrive due to new agricultural techniques, modern physical capital and food processing, which expands annual output of each unit of labour to unprecented rate.

Nonetheless, Malthusian Trap remains a strong influence to many subsequent economic thoughts. In the context of contemporary development, we see that many poor nations have high population growth, and this does eats away the growth of GDP they have. Since there is no force that acts as the “Big Push” to get them to a certain threshold that allows them to escape poverty like what the industrial revolution did to many countries of the west, many least-developed nations are facing stagnant economic growth (we will talk about this soon).

What to do then?

Addressing this problem requires, among others: reproductive health education (educating people on the use of birth control methods, etc) to reduce population growth to a manageable rate and gender empowerment to assist women in traditional society in getting education and transiting into the labour force. Moreover, a substantial amount of initial investment is often required to get people’s income above a certain cutoff; otherwise, economics explains, they would not be able to generate the amount of wealth required to get to the next income status, and their next generations would still be trapped in the low-income bracket. For this reason, economists often are worried that external aids, even if placed on the right target, can be too little to create impact. The existence of this income threshold, below which poverty awaits, is related to what we are about to discuss next.

The Catch-22

During the first stage of growth (traditional economy), besides malthusian trap, another concern is the Catch 22 situation. What is a catch 22 you ask? For example, you need experience to get a job, but you need a job first to get experience. This contradictory rule is what make catch 22 situation hard to exit. In terms of economic development, all else constant, least-developed nations usually take decades to get out of catch 22. Consider it for a bit; like in one instance, you need strong educational instutions to get capable workforce, but you also need a good proportion of capable workforce to constitute good institutions and transfer knowledge.

Likewise, it happens in agriculture. In this sector of the economy, there exist several important inputs: labour, human capital, physical capital (machinery), land, technology. Just to clarify, in economics, labour refers, for the most part, to raw labour, to quantity, to the amount of available and accessible workforce, whereas human capital refers to the stock of knowledge, innovation, creativity and the like that the workforce is capable of generating. Physical capital and technology can sometimes get mixed up, but just bear in mind that, at least for the purpose of our discussion, physical capital is referred to the tangible instruments/equipments that aids labour during production. Technology, on the other hand, is the system, the mechanism, the technique, how all other inputs are assembled and employed together or synergized for the production of goods and services.

We can easily observe that labour and land are usually not a concern for most least-developed nations. What really sets the north and the south (rich and poor, respectively) apart and thus render poor countries less productive is the lack of human capital, physical capital, and technology.

This becomes immediately apparent when we gaze at the gap between, say, the US and Myanmar. While the US employs less than 2% of its population in agricultural sector, it is able to feed its entire population and is still a net exporter of agriculture products. Myanmar, on the other hand, where agriculture accounts for 60% of its GDP, has about 65% of its labour force working in this sector, but its population is still under-nourished. This is indeed caused partly by the low purchasing power (price of provisions is high in relative to income), but that is to be expected considering the low yield per capita. This smaller output per capita is the result of the strong dependence on weather conditions, the lack of irrigation system, the lack of agricultural machinery and techniques necessary for intensive farming. Also, though the practical agricultural knowhows related to techniques like crop rotation, natural pest predator, rice-fish farming, and soil enrichment would be able to greatly increase output-input ratio (at low cost), the lack of human capital in such sector renders agricultural training as such scarce.

So, where is this catch 22 situation I mentioned earlier? It is probably obvious to you, but for the sake of clarification, I am going to say it out loud. You see, one of the goals to economic growth (I said “one of”) is increasing GDP or the total annual outputs produced by the economy. However, due to insufficient human capital, technology and physical capital (like modern machinery/equipment) conducive to economic growth, traditional economy usually seeks to achieve this by first engaging most of its population in agriculture, mining, logging, fishing, etc., as discussed. There is though a limit to the amount of possible outputs by mere labour, and that is why things like machinery and new farming techniques are needed. But, these all require initial investment, and for that to happen, capital (in money usually) is needed. Capital is generated by either saving or borrowing. However, with no technology and physical capital to amplify the output-labour and output-land ratios to begin with, raw labour can only produce enough output to sustain consumption and not enough leftover for saving. With little income, it also makes borrowing less likely and micro-financing scarce. This is thus a vicious cycle (poverty trap), especially for those dwelling in unfavorable geographic locations or unfavorable climatic conditions. For instance, the climate in Africa render agricultural practice less effective (as an instance, both human and livestock over there are more prone to disease, and disease outbreaks are more frequent), leaving little to consume and none to saving/capital for further growth. In such region, people rarely generate enough output for the creation of new capital that induces further accumulation of wealth (Hence, the famous “Income Threshold” regarded as a requisite for exiting poverty by economists). That is why in economics, affluence is not simply the result of hardwork, but also various other exogenous factors beyond human control.

What can one do in such a situation?

First, more state investments should be channeled towards the training of farmers and agricultural subsidies and the backward and forward links of agriculture like transportation, energy and food processing. Economists often argue, however, that subsidies are bad because it leads to inefficiency. For instance, water subsidy can lead to waste of water as water becomes cheaper, and the loss in tax revenue to sustain this waste is a loss to the whole society. In agriculture, however, subsidy in the right place and time (especially, subsidizing strategic crops like rice and corn) is worth the cost. It allows for greater abundance of food and the development of new agricultural techniques to further expand production. And, when the majority of population is working in this occupation, the higher and more profitable yield will allow higher income and saving, or at least, enough income per capita to allow for safe borrowing (i.e. enable the functioning of micro-finance sector). Saving and borrowing will prove themselves useful in the accumulation of more advanced physical capital that propels the economy both at micro and macro levels by inducing the creation of commercial agriculture and food processing. A step forward is to see the emergence of more and more SMEs (Small and Medium Enterprises). With financial security, it will also enable sufficient bequest and spare time for the younger portion of the population to get education that can prepare labour force for higher-level employment in other sectors, a true positive externality. This is basically the “Big Push” that we need to propel the population out of poverty trap. Of course, subsidiy will lead to short-term government revenue loss and probably food market shock, but there are times when policy makers need to push the power boost button knowing its long-term positive impacts.

Also, at this phase of development, mobilization and effective coordination and employment of external aids, especially in terms of human resource, will also be crucial in lifting the population out of absolute poverty and creating knowledge spillovers that help expand labour productivity, increase labour/input efficiency in agriculture to make more labour available for the development of other vital sectors.

The most important thing to never overlook is ensuring that any financial packages dedicatd to development projects are large enough to create impacts. Economic research should be conducted on the level of income required (Income Threshold) to lift the majority of people out of absolute poverty. Policies should be aimed towards the job market and information should be made available, accessible, attractive and visible to the young generation, especially concerning the general direction of development (like investment targets, etc).

As a matter of fact, there are other economic routes to be incorporated to get the majority out of poverty. With much raw labour but little human capital at hands, we can start moving to low-skilled labour-intensive industry like garment, but this introduces a new set of challenges that I am going to talk about in the second stage of economic development. Be patient!

There are, though, other challenges to consider during the phase of traditional economy to ensure sustainable and equitable growth. One of the most interesting cases is related to how we decide to use resources. There are indeed countries with abundant natural endowments but remain poor for decades. This introduces a new problem that might baffle many, but I hope that what we discuss next will make it crystal clear to you why natural resource is not always a bless.

The Paradox of Plenty (a.k.a Resource Curse)

We have covered a great deal on the topic of agriculture, but traditional economy also relies heavily on natural resources because afterwards, society will demand more of raw materials like iron, coal, oil, whale oil, and more that can be used as inputs to produce energy and more sophisticated tools. Activities like mining and logging, at this early phase, will sooner or later turn into thriving industries that create revenue stream for the economy through exports of such resources to more advanced countries in high need of raw materials. However, depend on how those resources are managed, these industries can either promote further growth and keep the whole nation fed or lead to economic stagnancy, regression and internal strife.

This economic phenomenon, that causes the possession of resources to adversely affect a nation, is known as “the paradox of plenty” or “resource curse”. This is the direct result of mismanagement of one’s fortune. Definitely your everyday news.

So, how exactly can having more lead to having less? Let us use PoorLand as our example.

First, it is due to the influx of foreign capital from other countries who invest in the extraction projects and those who purchase (import) the raw materials extracted from PoorLand. Both lead to a huge demand for the local currency, and as a result, PoorLand’s currency appreciates. Consequently, for PoorLand, it makes imported foreign goods even cheaper because now a unit of PoorLand Dollar can purchase more of other currency. Simultaneously, the export of domestic products becomes more and more difficult as they are now more expensive when sold in other countries (due to the rise in real exchange rate as mentioned). All of these render many other industries in PoorLand less competitive. The development of local companies are harder, and this causes wages to be pushed down as people also find it challenging to get a job in other industries. This makes Economic Diversification much more difficult to achieve.

Second, by having one’s economy relying on the export of raw materials, the economic development in such a country is also subject to the global economic shocks. When the world is doing great and thus is in high demand of raw materials, PoorLand might thrive, but the reverse also applies. In case of global economic downturn, it can spell disaster for the nation since a considerable proportion of its population is sustained through employment in industries like mining and logging. Once affected by the adverse shocks, they can easily get laid off.

Third, prolonged exploitation of natural resources can give rise to the inevitable resource depletion and environmental damages. These negative externalities will result in losses for many other economic sectors like, but not limited to, agriculture, construction, and tourism.

Fourth, The mismanagement of natural resources easily leads to various other social and political problems. The easy-money nature of the revenue flow from a single source (resource extraction activities) is, in a sense an incentive to bribe and be bribed, a tempting offer to high-ranking officials who crave power and luxurious lifestyle to corrupt. This perverse incentive that leads to individual corruption might eventually lead to a deep-seated systematic corruption where everyone is involved, where everyone can be implicated, and thus, there will then be less incentive to report and take action to combat corruptions. This diverts substantial amount of national revenue from its citizens, resulting in greater and greater income inequality, and eventually, loss of confidence and resentment by the people towards their own government. Once this happens, it is not hard to foresee political turmoil, social insecurity and instability, and ultimately, violent contest over power involving armed conflict which in extreme case will turn into civil war altogether. This in reality is not as gloomy as how I make it sounds, but do keep in mind that such scenario can play out in one way or another with varying degree of extremity. Should it happen, the collapse of the free economy is undoubtedly inevitable and decades would be needed for restoration.

Of course, I should have added “If and only if the resource is mis-managed“. Plus, in the real world, though we do see institutional inefficacy and corruption, most of the time, it is not as severe as the case above. Nevertheless, to a certain extent, you can easily observe events happening similar to what I have described so far in many developing nations of the global south. In overall, regardless of individual peculiarity, We do tend to see nations with great natural endowments grow slower than those without. Is mismanagement of resources the only cause of this slower economic growth? No. But, it can contribute significantly to the economic setback.

Then, what should we do?

It is advised that in the period of strong reliance on natural resources, a nation should start devising economic development strategies to diversify its major economic components and to prepare itself and its labour force for transition from the produce of raw materials to the building of processing facilities that can convert its resources in intermediate or final products. Lower taxes should thus be imposed on businesses that consume as inputs the raw materials the nation has. While closely linked sectors are encouraged, it should simultaneously look into the next potential source of income that can help diversify risks and safeguard against the market volatility of any one commodity.

All these (following all recommendations and warnings stated above) should be done and precautions taken prior to the arrival of the next stage of economic development, where nations usually begin to rely more on Secondary Sector, on its ability to turn raw materials into finished products. Most of the nations at this second stage are usually at lower-middle income or upper-middle income level. When it happens, we usually see the betterment in well-being as well as rising income inequality. We will study the causes and effects, the advantages and disadvantages, the challenges and opportunities that the next stage of development presents. Until then!