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The Neoclassical Growth Theory

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Solow, R., “A contribution to the theory of Economic Growth,” QJE, Feb, 1956, vol. 70, pp. 65-94.

“Technical change and the Aggregate Production Function,”

RES , August 1957, vol. 39, pp. 312-320.

Meade, J., “A Neo-classical Theory of Economic Growth,” Allen&Unwin, London 1961.

- Introduction
-developed by R.Solow (1956) and James Meade (1961) in order to correct the instability problem inherent in the H-D by relaxing the H-D assumptions of fixed K/Y and non-substitutability of labor and capital(by the changes in relative resource prices).

-price adjusting model rather than quantity adjusting model.

- Theme
-States that the rate of growth of an economy is influenced by the rate of growth of the factors of production (labor, capital, land , technology) weighted by the elasticity of production of each factor.

-alternatively, economic growth rate depends on the rate of growth of labor force, capital stock, technical know how over time weighted by the respective elasticity of each factor.

Y = A f(K, L) =

= rate of income growth

= rate of technological change

b= output elasticity of capital

1-b= output elasticity of labor

= rate of growth of labor force

= rate of growth of capital

- Assumptions the Neoclassical Growth Model
-Perfect substitution of factors of production (K/L)

-Perfect competition in the resources market facilitates the price adjusting mechanism

-Full employment

-Flexibility of K/Y unlike the Harrod-Domar case.

- Derivation of the Model
a. The Solow version (fixed tech.)

Given:

ln Y = ln A +b ln K + (1-b)ln L

Total differentiation with respect to time(t)

yields:

Note: b= output elasticity of capital

(1-b)= output elasticity of labor

b. The Meade version (flexible Technology)

ln Y = ln A +b ln K + (1-b)ln L

(1) Note that the rate of income growthin the Meade version depends not only onthe rate of capital formation and the rate of labor growth, but also the rate of technological change.

(2)Income per capita growth rate depends on the rate of technological progress and the growth rate of capital per capita

(3)Technological progress can rescue the economy from the trap of diminishing returns.

(4)Output-capital ratio depends on technology and labor-capital ratio

i.e.

- Some Implications of the Neoclassical Model
-Does not reflect the long-run effect of rapid labor force growth on gainful employment and growth

-The decision to save is automatically taken as the decision to invest.

i.e. S = I (classical view)

-The perfect factor substitution assumption implies that forces of competition are sufficiently strong.

-Direct application to LDCs is doubtful because peasant economies are characterized by farming rather than wage labor.

-There is a limit to income growth through K and L due to the law of diminishing returns (LDR). K and L must be accompanied by technological improvements.

- Differences between the H-D and the Neoclassical Growth
-K/L can change in the neoclassical model unlike the H-D model

-The neoclassical model assumes that population grows independently of income

-Unlike the H-D model, the neoclassical model assumes that structural flaws or constraints can be overcome by the operation of free markets

-Both capital and labor can be used to produce output unlike the H-D model which is based on the capital theory of value.

-The neoclassical growth model does not suffer from the instability problem

- Empirical Studies and Issues
A.R.Nelson,1956, attempted to explain the relation between population and income growth known as the “low level equilibrium trap”

“A Theory of Low Level Eq. Trap in UDCs” by R.Nelson, AER , vol 46 No.5 (1956) pp. 894-908.

The theory suggests that as long as per capita income remains below a critical minimum level, the population growth rate will always bring the economy back to a “low level equilibrium Trap”

dY/Y,dN/N

dN/N

K

dY/Y

Trap

L

Y/N

Y*/N

3.1=2.1 +.25(2) +.75(.7)

.5 .525

Output growth due to capital =

Output growth due to labor =

Output growth due to tech. =

progress

“A Theory of Low Level Eq. Trap in UDCs” by R.Nelson, AER , vol 46 No.5 (1956) pp. 894-908.

The theory suggests that as long as per capita income remains below a critical minimum level, the population growth rate will always bring the economy back to a “low level equilibrium Trap”

Technical progress is the best means to avoid the trap beyond which

(rate of income growth exceeds rate of population growth)

Others studies also showed similar results.

* Why does capital accumulation appear so unimportant?

The answer lies in the distinction between “disembodied” and “embodied”. In the model, technological progress is “disembodied” or taken as being independent of L and K. K and L are also assumed to be homogeneous.

In practice, technology is embodied and L , especially in capital. Moreover, K accumulation and improvement of L quality enable technological development and its installation.

Embodied technological change - tech. Change embodied in the form of the capital good itself. For instance, the diesel locomotive replaced the steam locomotive Jet airliners replaced the propeller variety. The electronic calculator has made slide rule obsolete.

Disembodied tech. Change - technological change that takes the for m of new procedures or techniques for producing goods & services. Example the use of contour-farming to prevent soil erosion on farms, the development of new management techniques in business, the pasteurization of milk.

Further Empirical Evidence on Capital Formation and Technological Progress as sources of Economic Growth

-In the 1950s, UN economists consider capital shortage as the main limit to LDC economic growth.

-Cairncross questioned whether capital role was central to economic growth although he admitted that income and capital grew at the same rate.

-Other studies showed that K/L explain 5-33% of the growth of y/L. 65-95% of the growth in output per worker was attributed to the residual, technological progress.

-Development economists used this evidence to argue that less attention was paid to technological progress (1970)

advanced the idea of appropriate tech. As a solution to the economic growth.

-Studies of non-western economics published after 1960 contradicted findings based on Western data

i.e. they argued that the contribution of K/L to growth was 50-90% and that of technology was only 10-50%

Comment

- The major source of growth per work in developing countries is capital per worker (K/L)
- The major source of growth in DCs is increased productivity due to technological progress.

- Evaluation of the Neoclassical Model
-Some of the assumptions are more realistic than others

(factor substitution, diminishing returns, out-capital ratio that depends on technology)

-Some assumptions are less realistic

(full employment, guaranteed S=I at full employment output perfect competition)

-Inclusion of more variables gives better insights into the growth process

-Importance of technological progress made clearer, but the importance of savings and investment less clear.

-Income distribution can be learned more from the model-share of labor and capital in the national income