Theories of Economic Growth: A Review Mathew Joseph

Economic growth refers to the expansion of a countrys potential level of output or GDP and is measured by the growth in GDP. A closely related concept is growth rate of per capita output. This represents the rate at which the countrys standards of living are rising. Indias GDP grew by 3.6 per cent per annum during first three decades of Independence, 1951-81 and a higher 6.2 per cent per annum during the next three decades, 1981-10. The GDP of United States grew by an average annual 4.2 per cent during 1950-73 and a slower rate of 2.7 per cent during 1974-10. What are the factors affecting the growth of potential output over the long run? Growth theories attempt to explain the ingredients of economic growth of nations. wealth with money and its advocacy of highly restrictive trade practices. The physiocratic thought was flawed for being pre-Industrial Revolution era economics.

2 Classical Growth Theory The classical economists belonged to the late 18th and early 19th centuries (Adam Smith, David Ricardo, Thomas Malthus and John Stuart Mill). According to these economists, the growth process is associated with distributional changes among the different economic classes. For them, capital accumulation is the vital element in economic process which enables the profit-motivated capitalists to employ workers on land for production. However, as more and more people are engaged on scarcer and scarcer land, the law of diminishing returns sets in, which will lead to distribution of a rising share of income to land-owners and a falling share going to profits and the maintenance of the mere subsistenceincome going to labourers. This will result in the whole process grinding to a halt at a stationary state which can be delayed only for some time by the onset of land-saving technical innovations. Adam Smith spoke of the possibility of a rise in labour productivity through specialisation which he called the division of labour which in turn depends on the size of the market. While Adam Smith also advocated free trade against the mercantilist notion of 1

1 Early Beginnings The mercantilists of the 16th and 17th centuries and physiocrats of the18th century can be considered as forerunners who presented a narrow sectoral view of what drives the economic growth of countries. Mercantilists considered that precious metals like gold and silver play an important role in the economic wellbeing of a nation and advocated a favourable balance of trade that facilitated inflow of bullion to the country. Physiocrats placed heavy emphasis on agriculture as the only productive sector in the economy and viewed the sectors of industry and trade as sterile. Mercantilism was soon discredited for its identification of

restricted trade, David Ricardo further advanced the argument for free trade based on the theory of comparative advantage as an essential component of growth.

3 The Marxian Model The analysis by Karl Marx (1867) mainly concentrated on the industrial sector which he believed to be characterized by increasing returns to scale. As against three-fold class groupings by classicists (capitalists, landlords and labourers), Marx compressed them into two groups: those who owned the means of production (capitalists) and those did not (workers). Here again, saving and capital accumulation by capitalists provide the locomotive for growth. Capitalists save and invest not exactly for profits but rather to avoid being driven out of business by competitors whose larger saving and investment reduces costs due to the benefits of large scale production. Even then, higher profits enable them to accumulate faster. While the objective of Marx was to lay bare the economic law of motion in capitalist society, he predicted that forces within the system will operate to bring about a downfall of the capitalist system. Firstly, there is a tendency to employ more and more machinery replacing labour which by keeping wages low lead to immiseration of workers. This, Marx believed, also leads to a falling rate of profit on the argument that labour is the only source of surplus value. Secondly, there is a tendency for concentration of capital in the hands of a few with large-scale productive units driving small units out of production which, in turn, fall into the ranks of the proletariat. Thirdly, 2

capitalist production is punctuated by periodic cycles of expansion and contraction which becomes increasingly severe leading to crises. Mechanization, immiserization, falling profit rates, business cycles, concentration of wealth all these forces operate to intensify the class struggle leading to the overthrow of the capitalist order which in turn usher in a new classless society. Marx s analysis is an extension of the classical economics and recognizes the many aspects of an industrial economy like large scale production and business cycles. However, Marxian theory is weak in its reliance on the flawed labour theory of value, inadequate appreciation of the full effects of technology particularly the benefits it brings to the working class.

4 The Harrod-Domar Model This model developed independently by R.F. Harrod (1939) and E. Domar (1946) broke fresh ground and initiated the modern growth theory. The authors addressed the growth problem in the form of three issues: 1. The possibility of steady growth and the conditions for steady growth, 2. Instability of the growth process, and 3. The occurrence of cycles in the growth process In order that the economy move on a steady growth path, investment and output should grow at a rate equal to the product of savings-output ratio (s) and the inverse of capital-output ratio (k). For example, if s = 1/10 and k = 3, then the equilibrium growth rate, g = s/k = 1/10 x 1/3 = 1/30 = 3.3%.

However, this equilibrium growth is possible only if the actual growth rate (g) is equal to the expected growth, which Harrod called the warranted growth rate (gw). And, any departure of actual growth from warranted growth will lead a further movement away from equilibrium. For example, if g > gw, then producers will feel that they expected too little and therefore will invest more and make the actual growth still higher. Similarly, if g < gw, then producers will feel that they expected too much and therefore cut down investment thereby make actual growth still lower than warranted growth. Thus, the model considers the role of expectations and possibilities of instability arising therefrom. Further more, the growth of the economy is constrained by a ceiling defined by the growth rate of labour force and technical progress and this ceiling is called the natural growth rate (gn). Once the economy reaches the ceiling, it cannot continue along that level but will be pushed down leading to a slump. This is so because, when the economy hits the ceiling, the actual growth rate is lower than the warranted growth rate and therefore producers feeling that they have expected too much will cut down investment leading to fall in growth rate. While the Harrod-Domar model highlighted the knife-edge nature of steady growth, subsequent developments in growth theory pointed out the possibility of different adjustment mechanisms to bring the warranted growth rate into equality with the natural growth rate. A higher warranted growth rate over the natural growth rate means scarcity of labour and rising real wages. Following four 3

types of mechanisms were indicated to bring about the necessary reconciliation between gw and gn.
1. The Neo-Keynesian mechanism: The

rising real wages leads to a rise in the share of income going to wages. On the assumption of higher propensity to save for profit-earners than the workers, this will reduce the saving ratio of the economy leading to a fall in s/k till it is in line with gn. (Kahn, 1959; Kaldor, 1955-6 and 1957; and Kalecki, 1954; Pasinetti , 1961-2 and 1965; Robinson, 1956 and 1962).
2. The Neo-classical mechanism:

The higher real wages mean lower rate of profit which in a perfectly competitive banking system means lower rate of interest. This will prompt profit-maximising firms to borrow more capital and shift to more capital-intensive techniques leading to a rise in capital-output ratio, k. This will result in a fall in s/k until it is equal to gn. (Solow, 1956; and Swan, 1956). The rising real wages will lead to a higher growth in labour force which will mean a higher gn. higher real wages can encourage labour saving technical progress. (Kaldor, 1954; 1955-56; 1957; 1960; 1961; 1961-62).

3. The Malthusian mechanism:

4. Induced technical progress: The

The Harrod-Domar model and its subsequent sequence of refinements provided a lot of insight into the process of the long post-World War II boom in the leading war-torn capitalist countries. The actual growth rates in these countries were kept equal to the

warranted growth rate by the investment confidence generated by the governments war-time fiscal policy which started the post-war period off on a high level of activity. And, the natural growth rate adapted to the high actual rate due to both plentiful supply of labour and induced technical progress. However, the relevance of these growth models to examine the growth process in less developed countries was limited. The Dual Sector model developed by Arthur Lewis, also called the Lewis model analyses the growth of a developing economy in terms of

the interrelationships between a traditional agricultural sector and a modern industrial sector.

5 Dualistic Growth Models Arthur Lewis (1954) showed the growth process in less developed countries in a two-sector framework in which the agriculture sector helps the industrial sector by ensuring an elastic supply of labour at a constant real wage. The process of growth in the Lewis model is illustrated with the help of Figure 13.1.

Figure 1: Economic Growth in a Dual Economy

Wage & Marginal Product

C B A

N Wi Wa

Ls
D1 O D2 D3

Quantity of Labour

The traditional agriculture sector is characterized by surplus of labour, low productivity and low wages at subsistence level (OWa) where as the capitalist industrial sector is subject to higher marginal productivity and higher wages (OWi). Ls represents the labour supply to the industrial sector which is perfectly elastic at the 4

industrial wage, OWi. The demand for labour is initially depicted by the marginal productivity schedule of labour, AD1. The initial employment of labour in the industrial sector is OL at which the current wage equals the marginal productivity for profit maximization. The total product in the industrial sector will be ANLO which

will be divided between wages of OLNWi and the capitalist profits of ANWi. The reinvestment of the capitalist surplus is the driving force in the system which creates new capital for employing more labour from the subsistence sector. This process is illustrated by the outward shift of the demand for labour from AD1 to BD2 as the marginal productivity of labour is raised through availability of larger fixed capital. This process continues with the further reinvestment of capitalist surplus and the marginal productivity of labour rising again and the demand for labour shifting further to CD3. The process continues till capital accumulation has caught up with the labour surplus in the economy and the absorption of surplus labour in the agriculture sector is complete. Then the labour supply curve becomes less than perfectly elastic and real wages rise. The weakness of the Lewis model lies in its giving a rather subordinate role to agriculture in the growth process by ignoring its role on the supply side in providing cheap food and raw materials to the industrial sector and, more importantly perhaps on the demand side, by providing an expanding market to the rising industrial production. While Ranis and Fei (1961) attempted to rectify some of the weaknesses of the Lewis model, they have not fully brought out the exact role of agriculture in the process of economic growth. Later in the early 1980s, the Kaldor-Thirwall-Vines model was put forward as a general model of growth and development in which agricultural growth is the driving force in the early stages of development and export growth in the later stages. Agriculture cannot provide 5

the necessary demand for industrial growth all along because of (i) lower income elasticity of demand for agricultural products, (ii) more than unitary elasticity of demand for imports especially by industry which creates a balance of payment constraint, and (iii) inability to push up agricultural exports.

6 The Neo-classical Growth Model The neo-classical model of economic growth was developed by Robert Solow (1956) of MIT who got the Nobel Prize in 1987 for his contributions to the theory of economic growth. The neo-classical growth model assumes an economy with a single homogeneous output, Y, which is produced by two categories of inputs, capital (K) and labour (L). This is shown as the aggregate production function: Y = F (K, L). The major factors in the growth model are capital and technological change. As the stock of capital rises in the economy through farm machines, industrial factories, equipment like computers and machine tools, etc, the quantity of capital per worker (K/L) rises and that raises the output per worker (Y/L). This in turn raises the real wages. As the capital-labour ratio rises, additional capital inputs will lead to lower returns on capital. Eventually, the economy will enter a steady state where capital deepening stops and real wages cease rising and returns on capital and real interest rate remain constant. However, improvements in technology will shift the aggregate production function upward over time. Instead of

settling into a steady state, the economy exhibits rising output per worker, rising wages and improving living standards. Also, technological progress increases productivity of capital and offsets the tendency for a fall in the rate of profit.

7 Endogenous Growth Theory The neoclassical growth theory treated technological advances as something that descends from above like manna from heaven. In the late 1980s and early 1990s research on economic growth focused on the determinants of technological progress. This is called the new growth theory or the theory of endogenous technological change. Paul Romer (1986) and Robert Lucas (1988) are the early prominent contributors to the endogenous growth theory. First of all, technological advances are not exogenous but an output of the economic system itself. This results from years of education and in particular, research involving investment in knowledge-producing human capital. This also implies the need for the right kind of institutions like institutions of science and also institutions of market like the private property rights. These institutions nurture innovation and provide incentives for individuals to be inventive. Inventions are expensive to produce but the inventors may not be able to make much profit from them as they can be easily copied by others. To provide adequate incentives to do research and development activities, governments offer protection to intellectual property rights through issue of patents and copyrights. 6

As indicated by Paul Romer (1994), the new growth theory has profound implications on public policy. It has implications on the issues of tax subsidies for private research, exemption from monopolistic regulations on public-private research ventures, activities of multinational companies, the relation between innovation and trade policy, the protection of intellectual property rights, the links between universities and private firms, public support for research, the costs and benefits of an explicit government-led technology policy, etc.

8 Indian Development Strategy and Growth Process The brief survey of growth theories makes it clear that while no single growth model is capable of fully explaining the growth process, the various models taken together can provide a satisfactory analysis of the growth phenomenon. The role of savings and capital formation has been stressed by the classical, Marxian and Harrod-Domar models. On the other hand, the number of refinements that followed the Harrod-Domar model emphasized the role of labour supply and technical progress. The dualistic models made the belated recognition of the importance of agriculture in the initial stages of economic growth and shed light on the role of exports in the subsequent stages. The neoclassical growth model has provided the most powerful tool of analysis of the modern growth process. Its flaw in considering technological advances as outside the system is rectified by the new growth theory which has uncovered the sources of technical progress which is now recognized as

the most important factor of economic growth. India launched the planning strategy as a tool for rapid economic development largely inspired by the success of the Soviet economy in building a strong industrial base from small beginnings. While the first Five Year Plan (195156) relied on the simple one-sector Harrod-Domar growth model, it was really the second Plan (1956-61) which laid the foundations of detailed planning in India. For the second Plan, India adopted the Mahalanobis growth framework with heavy emphasis on capital goods sector which had Marxian roots as developed by the Soviet economist, Feldman. It envisaged state initiative in laying the foundations of growth by investing heavily in basic and infrastructural sectors. It was a purely supply-side strategy to force the pace of the rates of saving and investment which growth theories of that time considered the single most important determinant of growth. Indian economy grew much slower than what was envisaged under the various five-year plans up to 1970s and a major setback has been the stagnation of the agriculture sector which had adverse impact on prices and living standards of large sections of society. The dual economy growth model of Lewis and others which linked industrial growth with rural sector did influence the Indian planning strategy in the 1960s and 1970s. The dualistic models indicated that the growth process involves transfer of labour from the rural agricultural sector to the urban industrial sector but this process appears to have been considerably slow in the case of India. While the 7

proportion of gross domestic output originating from agriculture sector (including forestry and fishing) has declined by half from 44 per cent in 1978 to 22 per cent in 2004, the proportion of labour force in the agriculture sector declined from 71 per cent to only 57 per cent over the same period. China also had an identical proportion of labour employment in the agriculture sector (71 per cent) in 1978 but that declined to 47 per cent in 2004. Another result under the planning has been the sluggish growth in exports. Up to 1980s, India followed an inwardlooking import-substitution industrialization strategy dictated by the objective of self-reliance emphasized in Indian planning. This involved a complex system of import controls which in effect harmed exports by making production for domestic market easier and profitable than that for the external market. The dramatic breakthrough came in the 1990s with the liberalization of the trade regime. Exports boomed and have begun to contribute to Indias economic growth as envisaged by the Kaldor-Thirwall-Vines model. Sources of Economic Growth: India Vs China Growth accounting separates out the contributions of the different ingredients of economic growth labour, capital and technology - in the neoclassical growth framework we saw earlier in this chapter. Bosworth and Collins (2006) applied the growth accounting framework recently for India and China for the period, 197804 and the results of the study are summarized in Table 13.1.

Table 1: Sources of Growth: India and China (Annual Percentage Change)

Period Country Output Employment Output per Worker 3.3 7.3 2.4 6.4 4.6 8.5 Physical Capital 1.3 3.2 1.0 2.5 1.8 4.2 Contribution of: Land Education Total Factor Productivity 1.6 3.8 1.1 3.6 2.3 4.0

197804 197893 199304

India China India China India China

5.4 9.3 4.5 8.9 6.5 9.7

2.0 2.0 2.1 2.5 1.9 1.2

0.0 0.0 -0.1 -0.1 0.0 0.0

0.4 0.2 0.3 0.2 0.4 0.2

Source: Bosworth and Collins (2006).

Taking the full period of 26 years, China grew by an extraordinary 9.3 per cent average annual rate whereas India grew by a substantially lower 5.4 per cent, which, however, is well above the countrys 3.4 per cent growth of the previous two decades. Both India and China showed almost identical rates of employment change of 2 per cent per annum which is largely determined by the growth in labour force. The growth in output per worker in both countries is equally divided between increased capital intensity and total productivity gains although the growth in labour productivity for China are twice that of India. Considering the two sub-periods, both countries registered an acceleration of the growth rate in the second period and the acceleration is most significant for India. However, since Chinese employment growth slowed considerably reflecting the sharp decline in the birth rate in the 1970s, its labour productivity growth in the second sub-period has been very rapid.

Another important finding of the study is the limited contribution to labour productivity of improvements in educational attainment in both China and India. China has largely eliminated illiteracy but in India illiteracy remains an issue. Studies show low returns to primary education in India. This is in contrast to the cases of East Asian countries (excluding China) where educational attainments have played a significant role in their superior growth performance.

Suggested Readings: 1. Economics, by P.A. Samuelson and W. D. Nordhaus, Nineteenth Edition, McGraw Hill/Irwin, 2010, New Delhi, Ch 25, pp 649675. 2. Growth Economics, Edited by Amartya Sen, Penguin Books, 1970, Introduction, pp 9-40. 3. Leading Issues in Economic Development, by G.M. Meier, Third Edition, 1976, Oxford 8

University Press, New York, pp 157-163. 4. Leading Issues in Economic Development, by G.M. Meier and J.E. Rauch, Eighth Edition, Oxford University Press, New Delhi, 2005, pp 76-80. 5. Economic Growth, by Paul Romer in The Concise Encyclopaedia of Economics, D.R. Henderson (editor), Liberty Fund, 2007. 6. Evolution of Modern Economics, by Richard T. Gill, Prentice-Hall of India Private Limited, New Delhi, 1974, Ch 2 and 3, pp 9-45

7. A History of Economic Thought, by William J. Barber, Penguin Books, 1967, Part 2: Marxian Economics, pp 117-162. 8. Accounting For Growth: Comparing China and India by Barry Bosworth and Susan M. Collins, 2007, National Bureau of Economic Research, Working Paper no. 12943, Cambridge MA, 2007

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