Economic Growth Theories: The Neoclassical Growth Model

Chapter 2 Theoretical framework Theories Neoclassical growth theory

The neoclassical growth theory was developed in the late 1950s and 1960s by an American economist who won a Nobel Prize in Economics named Robert Solow and a British economist, J. E. Meade. The concept of this theory is focusing on capital accumulation and its related decision of saving as an important factor of economic growth. Neoclassical growth model considered two factor production functions with capital and labor as determinants of output. Besides, it added exogenously determined factor, technology, to the production function. And we can define it as this following equation:

Y=Af(K,L) (1)

Where Y is represented to GDP, K is the stock of capital, L indicates labor

However, diminishing returns to capital limit economic growth in this model. Though the neoclassical growth model assumes constant returns to scale which exhibits diminishing returns to capital and labor separately.

We explain below how neoclassical growth model explains economic growth through capital accumulation (i.e., saving and investment) and how this growth process ends in steady state equilib­rium. By steady ‘State equilibrium for the economy we mean that growth rate of output equals growth rate of labor force and growth rate of capital (i.e., ∆Y/Y = ∆L/L = ∆K/K) so that per capita income and per capita capital are no longer changing.

Note that for income per capita and capital per worker to remain constant in this steady state equilibrium when labor force is growing implies that income and capital must be growing at the same rate as labor force. Since growth in labor force (or population) is generally denoted by letter in this steady state equilibrium, therefore, = ∆Y/Y = ∆K/K = ∆N/N = n. Neoclassic growth theory explains the process of growth from any initial portion to this steady state

It will be seen from the Figure 1 that at capital-labor ratio (i.e. capital per worker) equal to k1 output per head is y1. Similarly we can read from the production function curve: y – f (k) the output per head corresponding to any other capital per head.

In the other word, we can explain that if a country tries to increase the investment by increasing of physical capital such as industry, add more machinery or even build up more infrastructures and public utilities. Those factors would affected production process to increase more output and economic growth rate also increase. However, keep increasing investment would exceed the marginal product point, the point of the depreciation of growth. Due a country has the limit of factors such as limited land, limited resources and materials, lack of skilled labor, etc.

Saving is the main factor for the accumulation of capital and for investment as well in neoclassical production function. Its theory considers saving as a constant fraction of income:

S=sY (5)

Where S=saving; Y as income and s is saving