Finance:Low-level equilibrium trap

The low-level equilibrium trap is a concept in economics developed by Richard R. Nelson, in which at low levels of per capita income people are too poor to save and invest much, and this low level of investment results in low rate of growth in national income. As per capita income rises above a certain minimum level at which there is zero saving, a rising proportion of income will be saved and invested and this will lead to higher rate of growth in income.

Theory

The theory developed by Richard R. Nelson in his article A Theory of the Low-Level Equilibrium Trap published in 1956. According to Nelson the malady of underdeveloped economies can be diagnosed as a stable equilibrium level of per capita income at or close to subsistence requirements. At this low stable equilibrium level, both the rate of investment and saving are low. If per capita income is increased above the minimum subsistence level, it encourages growth in population. The population growth, in turn pushes down per capita income again to subsistence level. Thus the economy is caught in low level equilibrium trap. Getting out of the trap requires increasing the rate of growth of income to the levels higher than the rate of increase in population. In Nelson's opinion following four conditions are conducive to trapping:

1. A high correlation between the level of per-capita income and the rate of population growth
2. A low propensity to direct additional per-capita income to increasing per-capita investment
3. Scarcity of uncultivated arable land
4. Inefficient production methods

Model

Nelson uses a model with three equations. First, there is an income determination equation. Income depends on the stock of capital, the size of the population, and the level of technique. Second, net investment consists of saving-created capital plus additions to the amount of land under cultivation. Third, there is the population growth equation according to which in areas with low per-capita incomes short-run changes in the rate of population growth are caused by changes in the death rate, and changes in the death are caused by changes in the level of per-capita income. Yet once per capita income reaches a level well above subsistence requirements, further increases in per-capita income have a negligible effect on death rate. With these three sets of relationships, it is easy to see that an underdeveloped economy is caught in a low level trap.

Income determination equation

In first case the economy is at minimum subsistence level of per capita income. When per capita is less than that of the minimum subsistence level the population decreases. After a stationary point when per capita income increases then the subsistence level population increases until it reaches a physical limit. Population growth increases till it reaches its upper physical limit after which it declines. The declines occurs because at high per-capita income levels, people become conscious about their living standards and try to adopt a small family norm.

New investment is equal to capital created out of savings

In this case there is a certain level of income in the economy with no savings as all the income is spent on consumption. Also the level of investment is zero. There is negative investment in the economy when savings are negative implying a situation where consumption is greater than income i.e. people live on past capital. However, when per capita income rises then savings also rises from zero level which leads to rise in the investment level in the economy. As there is continuous increase in the per capita income there is a rising proportion of total income saved and invested.

Population growth equation

Whenever the per capita income reaches a level above the subsistence level any further increase in it will have a negligible effect on death rates. Moreover, changes in death rate are due to changes in per capita income.

Conclusion

Starting from this low-level equilibrium trap, any small increase in per capita income will not be able to sustain itself or lead to further increase in per capita income because the rate of growth in population is higher than the rate of growth in total income. Consequently, per capita income will fall to previous low equilibrium level.

This happens till the time rate of growth in population is greater than the rate in growth of total income. It is only when the level of per capita income is increased by a discontinuous jump that the country can hope to come out of the low level equilibrium trap, because the rate of growth exceeds the rate of growth of population. Nelson's thesis advocates that if the country is to break the shackles of low level equilibrium trap, its rate of growth of total income must be higher than 3 percent per year. This can be done only when, to use Leibenstein's terminology, that amount of minimum effort is undertaken which pushes up the level of per capita income.

Critical appraisal

The phrases 'low level equilibrium trap' and 'vicious circle of poverty' have become popular in economic literature and so have the perceptions of getting out of these states like Big Push, Critical Minimum effort etc.. Most of the economists agree with Leibenstein that if the underdeveloped countries have to get out of low level equilibrium trap they must undertake investment programmes of such magnitude that the growth of per capita income breaks the population barrier. However, H. Myint points out two sets of difficulties in applying this theory to underdeveloped countries:

First, it is not always possible to draw a rigid functional relation between the level of per capita and the rate of growth of population and rate of growth in total income. Main causes of growth in population in most of the underdeveloped countries in recent decades have been reduction in death rates due to improvements in public health and the control of epidemics and endemics, which were not closely related to prior rise in per capita income level. The functional level of per capita income and the level of growth in total income is still more complex and, according to Myint takes place in two steps. The relation between the level of per capita income and the rate of saving and investment is modified by number of factors such as pattern of distribution of income and effectiveness of financial institution in mobilizing savings. The relation between investment and the resultant output is also not given by stable capital-output ratio, but depends on how far the productive organization of the country can be improved and how far land- savings innovations can be adopted to overcome the tendency to diminishing returns on additional investment which will continue even after the population growth has levelled off at 3 percent per annum.

Second introduction of the time element creates some complications. Myint argues that it illustrates a set of timeless functional relationship rather than the time series of growth and population and income. The stable and the unstable equilibrium has been taken from the Trade Cycle Theory which deals with turning points in the level of short run economic activities in the developed countries. We therefore may question how far this type of analysis originally designed to illustrate the gear shifts in short run economic activity of a fully developed countries is useful for the study of the problem of long term economic development of the underdeveloped countries which is concerned with the construction of the engine of growth itself.

See also

• Big Push Model
• Development economics
• Race to the bottom
• Virtuous circle and vicious circle

External links

• Strategic Product Choice and Equilibrium Traps for Less Developed Countries

Further reading

• Herrick; Kindleberger. Economic Development ISBN:0-07-034584-8.
• Nelson, Richard R. (1956) “A Theory of the Low Level Equilibrium Trap”, American Economic Review, Vol. 46, p. 894–908.
• Todaro, M. P. Economic Development ISBN:978-0-201-77051-3