The Neoclassical Growth Theory

The neoclassical growth theory of Solow (1956) and Swan (1956) is founded on a neoclassical production function; a Cobb-Douglas production function which satisfies the assumptions of constant returns to scale, diminishing returns to each input (i.e. capital and labour), and positive and smooth elasticity of substitution between the inputs. This production function is combined with exogenous savings and population growth rates to generate a simple general-equilibrium model in a closed economy (Barro & Sala-i-Martin, 2004).

The model predicts that savings rate, physical capital accumulation, and growth rate of population are the key determinants of economic growth. While physical capital accumulation and savings rates have positive impact on

Romer (1986) adopted the notion of learning-by-doing introduced by Arrow (1962) to model a production function in which physical capital accumulation leads to the creation of new knowledge. In this model, the author showed that investment in physical capital by one producer improves the efficiency of the investing company. Subsequently, this new knowledge spills over to other producers in the industry thus, improving overall industry efficiency. Consequently, there is an upward shift in the industry technology. This process continuous infinitely ruling out any possibility of diminishing returns to physical capital and even creating room for increasing returns (Barro & Sala-i-Martin,

Romer (1990) was the first to introduce the role of Research and Development (R&D) by firms as one of the key drivers of long-run economic growth. In this model, technological change arises from a conscious investment decision by firms with a view to maximising profits. In addition, the new technology is non-rival and partially excludable good. The new technology is partially excludable because even though a single firm may be the first to invest into R&D that leads to the discovery of the new technology, other firms in the industry can use the new technology albeit after the expiry of any patent rights. As a consequent, production process improves leading to growth in aggregate output in the long run. He argues that the new technology can lead to increasing returns to all the input variables. Subsequently, Grossman and Helpman (1991) make important contributions to the work by Romer (1990). In their new model, R&D results in product innovation (i.e. invention of new goods) and consumers tend to consume more of a new product because they derive greater utility from them. The increase in demand of new products therefore leads to increase