Kaldor's growth laws

Kaldor's Growth Laws

Kaldor's growth laws are a set of three propositions in economic growth theory that emphasize the crucial role of the manufacturing sector as the primary driver of a nation's overall economic expansion and productivity improvements. Formulated by Hungarian-born British economist Nicholas Kaldor in the mid-20th century, these laws challenge neoclassical views by highlighting the importance of demand-side factors, economies of scale, and structural change in economic development. Kaldor's growth laws suggest that robust growth in the manufacturing sector creates positive spillover effects across the entire economy, leading to higher aggregate demand, increased capital accumulation, and enhanced productivity growth. These principles remain influential in discussions about industrial policy and national development strategies.

History and Origin

Nicholas Kaldor, a prominent figure in the Cambridge School of economics, first articulated his growth laws in his 1966 work, "Causes of the Slow Rate of Economic Growth in the United Kingdom."⁴⁰ His observations were largely a response to the perceived sluggish performance of the British economy at the time. Kaldor's work emerged from a broader intellectual environment at Cambridge University, where economists like Joan Robinson and Richard Kahn also contributed to alternative theories of economic growth and income distribution, diverging from the prevailing neoclassical approach.³⁸, ³⁹

Kaldor's insights stemmed from empirical regularities he observed across various countries, noting a strong correlation between living standards and the proportion of resources dedicated to industrial activity. He argued that unlike agriculture or services, the manufacturing sector was uniquely positioned to generate increasing returns to scale, both static and dynamic. This concept, along with "learning by doing" effects, provided the foundation for his propositions. His lectures and subsequent publications laid the groundwork for a demand-led view of economic expansion, where manufacturing acts as the "engine of growth" through a process of cumulative causation.³⁶, ³⁷

Key Takeaways

• Manufacturing as the Engine: Kaldor's first law asserts that the growth of the manufacturing sector is the primary determinant of overall economic growth.³⁵
• Verdoorn's Law: The second law, often known as Verdoorn's Law, states that productivity growth within the manufacturing sector is positively correlated with the growth of manufacturing output due to increasing returns to scale.³³, ³⁴
• Spillover Effects: The third law suggests that productivity growth in the non-manufacturing sectors is also positively influenced by the growth of the manufacturing sector, as resources shift to more productive activities.³²
• Demand-Led Growth: The laws collectively emphasize the role of aggregate demand and structural change, particularly industrialization, in driving long-term economic expansion.³⁰, ³¹
• Policy Implications: Kaldor's growth laws provide a theoretical basis for industrial policy, advocating for government interventions that foster strong manufacturing bases.

Formula and Calculation

Kaldor's growth laws are typically expressed as empirical relationships rather than strict mathematical identities. While not a single overarching formula, each law can be represented by a linear relationship, often estimated through econometric analysis.

Kaldor's First Law (Growth Hypothesis):
This law suggests a positive relationship between the growth rate of total output (e.g., Gross Domestic Product) and the growth rate of manufacturing output.
$Q = \alpha + \beta M + \mu_1, \quad \beta > 0$
Where:

• (Q) = Growth rate of total aggregate output (e.g., Gross Domestic Product)
• (M) = Growth rate of real manufacturing sector output
• (\alpha) = Constant term
• (\beta) = Coefficient indicating the impact of manufacturing growth on total output growth
• (\mu_1) = Error term

Kaldor's Second Law (Verdoorn's Law):
This law describes the positive link between manufacturing productivity growth and manufacturing output growth.
$P_m = \beta_0 + \beta_1 M + \mu_2, \quad \beta_1 > 0$
Where:

• (P_m) = Growth rate of labor productivity growth in manufacturing
• (M) = Growth rate of manufacturing output
• (\beta_0) = Constant term
• (\beta_1) = Verdoorn coefficient, reflecting returns to scale
• (\mu_2) = Error term

Kaldor's Third Law:
This law posits a positive relationship between non-manufacturing productivity growth and manufacturing output growth.
$P_{nm} = \gamma_0 + \gamma_1 M + \mu_3, \quad \gamma_1 > 0$
Where:

• (P_{nm}) = Growth rate of labor productivity in the non-manufacturing sector
• (M) = Growth rate of manufacturing output
• (\gamma_0) = Constant term
• (\gamma_1) = Coefficient indicating the spillover effect
• (\mu_3) = Error term

These equations are typically tested empirically using time-series or panel data to validate the coefficients.²⁸, ²⁹

Interpreting the Kaldor's Growth Laws

Interpreting Kaldor's growth laws involves understanding the underlying mechanisms by which manufacturing growth influences broader economic performance. The core idea is that the manufacturing sector possesses unique characteristics, such as greater scope for returns to scale and more pronounced opportunities for technological progress, compared to agriculture or services.²⁷

When the manufacturing sector expands, it can lead to a more efficient use of resources, lower average costs of production, and the adoption of new technologies. This internal efficiency translates into higher productivity within manufacturing (Verdoorn's Law). Furthermore, as labor and other resources are reallocated from less productive sectors (like subsistence agriculture) to the more dynamic manufacturing sector, overall national productivity can rise. This shift in economic activity, known as structural change, is a key part of how Kaldor's laws suggest economic development occurs. The laws imply that policies promoting industrialization can accelerate a country's long-term economic growth by harnessing these inherent advantages of manufacturing.

Hypothetical Example

Consider a hypothetical developing country, "Agraria," heavily reliant on agricultural output. Its initial Gross Domestic Product growth is slow due to diminishing returns in agriculture. The government of Agraria decides to implement policies focused on fostering a domestic manufacturing base, such as investing in infrastructure to support factories and providing incentives for foreign direct investment in manufacturing.

In the first few years, Agraria sees its manufacturing output grow significantly at 8% annually. According to Kaldor's first law, this growth acts as an "engine." If the historical relationship for Agraria indicates a beta ((\beta)) of 0.6, then this 8% manufacturing growth contributes directly to a 4.8% increase in overall GDP growth.

Concurrently, within the new manufacturing sector, as production scales up, companies adopt more efficient processes and technologies. For example, if the Verdoorn coefficient ((\beta_1)) is 0.5, the 8% growth in manufacturing output leads to a 4% increase in productivity growth within that sector.

Finally, as the manufacturing sector expands, it draws surplus labor from less productive agricultural areas, and the demand for supporting services (like transportation and logistics) increases. This reallocation and increased activity in turn boost productivity in the non-manufacturing sectors, illustrating Kaldor's third law. This synergistic effect leads to sustained economic development for Agraria, moving it towards a more industrialized and higher-income economy.

Practical Applications

Kaldor's growth laws have significant practical implications, particularly for policymakers in countries aiming to achieve sustained economic growth and development. They provide a theoretical foundation for industrial policy, which involves government intervention to promote specific sectors, traditionally manufacturing, deemed crucial for national prosperity.²⁶

Many developing countries and even some advanced economies have historically pursued strategies aligned with Kaldor's ideas. For instance, the post-World War II economic reconstruction of Western European countries and the rapid rise of East Asian economies in the late 20th century are often cited as examples where the expansion of manufacturing sectors propelled significant increases in productivity growth and GDP.²⁵ The World Bank, for example, has emphasized the importance of "industrialized manufacturing" for job creation and sustainable growth in countries, particularly in Sub-Saharan Africa, citing its potential for capital accumulation, economies of scale, and technology acquisition.²⁴

Governments can apply these laws by focusing on policies that support innovation, skill development, and infrastructure improvements in key manufacturing industries. This includes fostering research and development, providing education and training tailored to industrial needs, and creating a conducive business environment for technological advancements.²³ The Peterson Institute for International Economics, among other institutions, frequently discusses the resurgence and nuances of industrial policy in contemporary global economic debates.²¹, ²²

Limitations and Criticisms

Despite their influence, Kaldor's growth laws face several limitations and criticisms. One primary critique is their strong emphasis on the manufacturing sector as the sole "engine of growth."²⁰ Critics argue that in modern economies, the services sector, particularly high-value-added services like information technology, finance, and specialized consulting, can also exhibit increasing returns to scale and drive productivity growth. The rise of de-industrialization in many developed countries raises questions about the continued applicability of these laws in their original form.¹⁹

Furthermore, the empirical evidence supporting Kaldor's laws has been mixed across different regions and time periods. While some studies, such as those examining the Kazakhstan economy, have found support for the laws¹⁸, others point to complexities and deviations.¹⁷ The relationships described by Kaldor, while influential, are not considered strict empirical laws that hold universally.¹⁶

Another limitation lies in the scope of Kaldorian models, which often face challenges in fully demonstrating how a cumulative causation process unfolds in an open economy.¹⁴, ¹⁵ They may also overlook the vast "unproductive expenditure" or fail to adequately account for the impact of income redistribution on human capital.¹³ Some critiques also suggest that the observed correlation between manufacturing growth and overall economic growth might not necessarily imply causation, or that the relationship could be more complex or even bidirectional.¹² Theoretical challenges, such as the aggregation problems highlighted by the Cambridge capital controversies, also raise questions about the foundations of certain macroeconomic production functions used in such analyses.¹¹

Kaldor's Growth Laws vs. Solow-Swan Model

Kaldor's growth laws and the Solow-Swan model represent distinct approaches within economic growth theory. The core difference lies in their primary drivers of long-run economic growth and their views on the role of structural change and demand.

The Solow-Swan model, an exogenous growth model, emphasizes capital accumulation, population growth, and exogenous technological progress as the key determinants of economic expansion.¹⁰ It suggests that economies converge to a steady state where output per worker grows solely at the rate of exogenous technological progress. This model largely treats technological advancement as a given external factor and focuses on supply-side dynamics.⁹

In contrast, Kaldor's growth laws adopt a more inductive, demand-led perspective. They argue that the manufacturing sector is the unique "engine of growth" due to its inherent capacity for increasing returns to scale and its ability to generate spillover effects across the economy.⁸ Unlike Solow, Kaldor viewed technological progress as largely endogenous, driven by the growth of output itself (Verdoorn's Law), especially within manufacturing.⁶, ⁷ While Solow's model often implies convergence among economies due to diminishing returns to capital, Kaldor's framework can better explain persistent differences in growth rates and the importance of industrial policy and structural transformation for developing countries.

FAQs

What are the three Kaldor's growth laws?

Kaldor's growth laws are: 1) The growth of the overall economy's output (like Gross Domestic Product) is positively related to the growth of the manufacturing sector. 2) The growth of productivity growth within the manufacturing sector is positively related to the growth of manufacturing output (known as Verdoorn's Law). 3) The growth of productivity in non-manufacturing sectors is also positively related to the growth of the manufacturing sector.⁵

Why did Nicholas Kaldor formulate these laws?

Nicholas Kaldor developed these laws in the mid-20th century, particularly in 1966, to explain observed patterns of economic growth and the perceived slow growth rate of the British economy. He sought to highlight the unique role of industrialization and demand-side factors, contrasting with prevailing economic theories that focused more on capital accumulation.³, ⁴

Are Kaldor's growth laws still relevant today given the rise of service economies?

While many developed economies have seen a shift towards service sectors, Kaldor's growth laws remain relevant in discussions about structural change and industrial policy, especially for developing countries aiming to industrialize. Even in advanced economies, the interplay between manufacturing and high-value services continues to be an area of study in macroeconomics, and some arguments suggest that certain service industries may also exhibit increasing returns.

What is the main policy implication of Kaldor's laws?

The main policy implication is that governments should consider implementing industrial policies to foster the growth of the manufacturing sector. This could involve investments in infrastructure, support for research and development, and other measures designed to enhance manufacturing output and productivity, as these are seen as key to broader economic prosperity.¹, ²