2.2 The Development Approach to Regional Integration

The core idea of the development approach to regional integration stems from neoclassical growth theory and is formally captured in the Solow-Swan Model (cf. e.g. Burda & Wyplosz 2002: 44ff. for an introduction).

Growth Theory – The Solow Model

Output in terms of GDP per capita (y) is believed to be di­rectly dependent on the capital-labor ratio k, i.e. the amount of capital per worker or inhabitant. The productivity of the capital stock and the labor included depend on the technology, which is expressed by the production function ).

Image 2.1:The Solow Model – A basic Version
Growth and Development Approach to Regional Integration – The Solow Model

Source: own image, standard model

Growth in terms of increased GDP per capita occurs when the capital stock k is augmented. As capital (just like labor) fea­tures only a diminishing marginal product, growth rates will be higher when the capital stock is lower and decrease with the augmentation of the capital stock. The capital stock grows with investment – captured here as the saving rate  – but (real) depreciation δ (i.e. capital wore-out) will set an upper bound to capital accumulation. This is because depreciation is linear while the marginal product of capital is a degressive function, thus, gains grow only in a de­creasing manner while maintenance costs grow linear with the capital stock. Ac­cordingly, GDP per capita will grow with capital accumulation until the saving rate (i.e. the investment and reinvestment possibilities) just can replace the losses from capital depreciation.

This situation is termed steady state (k*,y*). After an economy reached its steady state no more growth can occur but via two mechanisms. First, an in­creased saving rate could shift the steady state upwards by making a fur­ther augmentation of the capital stock permanently feasible; obviously, only at the price of lower consumption. Second, technolo­gical progress can shift the production function upwards, hence, the steady state. Output y is thereby augmented and hence, savings. This is of course just a very basic version of the Solow-model but sufficient for our needs here.

Implications for the Growth and Development Approach

The Solow-model has at least two important implications for regional integration. First,  more developed economies, which feature already a bigger capital stock grow slower than developing economies (with the same steady state), where MPK is still higher. Second, the steady state of an economy depends on the technologies deployed and its investment opportunities (here captured as the saving rate).

This means that regional integration ought to have two effects. First, liberalization of capital markets, technological diffusion and the alignment of the business environment (institutions) should homogenize the production functions and investment possibilities among the markets to be merged, hence their steady states. This process is a convergence to the upper level as less developed economies adopt the technologies and institutions of the better developed economies, not vice-versa. Second, the economies with a lower capital stock, hence income, will grow faster than the developed economies. This catch-up is facilitated by their higher MPK, which ought to attract more investments than the developed economies as a higher MPK means higher returns on capital. The reasoning is just the same as the in the preceding chapter 2.1.4 about factor movements and allocational optimization. The welfare assessment remains likewise the same. If capital and technology diffusion is mainly driven by the reloca­tion of factors, capital-owners in the richer regions and workers in the poorer regions are bet­ter off, while capital owners in the poorer regions lose together with workers from the richer regions. If capital and technology diffusion is mainly driven by additional investments, capital owners in general are better off as they face more investment opportunities (maybe with the exception of those from the poorest region). Furthermore profit workers in the poorer regions as they can expect an augmentation of the capital stock and an increasing MPL.

Growth and Development through Regional Integration?

Academic Research paper and Study of the Economy of Romania and Romanian Business

To sum it up, regional integration should yield a convergence of income levels and living standards among the participating economies by a catch-up of the less developed economies towards the higher level. This is reached by institutional alignment, technology diffusion and the liberalization of capital markets. Empirical literature tries to track convergence as either β-convergence or σ-convergence. The first refers to the observation of higher growth rates among poorer economies, the latter tracks the “decrease in the dispersion of income levels” (Vass 2005: 6).

Next, we will turn to the SEM and the related EU policies and have short insight into the em­pirical assessment of the effects of regional integration in the case of the European Union.