Increasing Returns and Economic Development

Not so long ago, Deepak Lal claimed that the demise of development economics was likely to be conducive to the health of both the economics and economies of developing countries (Lal, 1983, p. 109). Lal attributed the analytical failures of development economics to a neglect of welfare economics and, in particular, to a misinterpretation of the theorem of the second best. Most development economists interpreted the theorem to imply that that there was a case against the introduction of piecemeal market reforms since there was no guarantee that they would lead to increased welfare. In Lal’s view, this emphasis was wrong. What the theorem really implied was that there should be a reduction in government intervention in the economy since there was no guarantee that any particular intervention would be welfare increasing. As Toye (1987) has shown, the function of the discussion of the second-best theorem in Lal’s argument seems to have been largely rhetorical. Ultimately his welfare economics argument involves little more than an assertion that the optimality results of competitive equilibrium hold, albeit approximately, in the real world. Some of the presumptions underlying this kind of argument have been addressed elsewhere, for example Toye (1987) and Killick (1989). This chapter seeks to supplement their critique by focusing on the question of the suitability of the neoclassical general equilibrium (GE) model for the analysis of developmental problems in the third world or elsewhere.