You are on page 1of 8

Introduction to Development Economics Essay. Student Name: Louis Conradie. Candidate Number: 72949. Tutor Name: Elodie Douarin.

Explain with reference to Solows growth model, what economists mean by convergence. How convincing in the empirical evidence? In traditional neoclassical growth theory, the Solow model stands prominent; providing a framework which provides insight into cross-country differences in growth and under which there is convergence in income per capita between countries. This essay will provide detailed discussion on what economists mean by convergence with reference to Solows growth model, before extending analysis into the empirical evidence and resulting conclusions on convergence. Convergence, as dened by Todaro and Smith, is the tendency for per capita income to grow faster in lower-income countries than in higher-income countries so that lowerincome countries are catching up over time (Todaro & Smith, p.78). Thus we must ask: what are the determinants of the said differences in growth? To answer this question we look to the Solow growth model for insight. Solows growth model, published in 1957 and drawn from an analysis of the industrialized economy of the U.S., related economic growth to two factors of production (capital and labour), and total factor productivity (TFP). TFP is an independent variable, represented by a residual, that captures growth not accounted for by the said inputs. Solows results indicated that technological change 1, a primary component of TFP2 , accounted for seventh-eights of the U.S. economy growth per worker in the period 1900-1950 (Easterly, p.47). The model displayed controversial ndings that challenged capital fundamentalism, the notion that investment in machinery and buildings is a fundamental determinant of growth in the long run, and argued that the only source of long-run growth is technological change (Easterly, p.47). Capital fundamentalism is sensical in theory. To achieve growth (an increment in living standards) an economy requires that each of us produces more goods on average and thus what matters is output per worker. There are two inputs in the production function: capital and workers, and therefore it would be logical to assume that to increase output per worker, one should increase capital per worker (Easterly, p.48). The Solow model indicated that this notion is problematic considering capital is subject to diminishing marginal returns if the labour supply is assumed to be xed 3. In other words, we get decreasing returns to capital whereby if one increases capital relative to workers, the

Technology can be dened a blueprint that arranges labour and capital productively. Technological progress is thus the improvement of the said blueprints. Or in other words: increased application of new scientic knowledge in the form of inventions and innovations with regard to both physical and human capital (Todaro & Smith, p.142).

While there exists much debate on the determinants of TFP growth, studies tend to nd that technological progress plays the predominant role.

If labour was not assumed constant in supply, labour and capital could in theory be increased in equal proportions and the production function would provide constant return to scales.

return to each additional unit of capital will become increasingly lower. This is denoted by the slope of the production function, f(Kt /N), in graph 1 4. Increases in output per worker would require increasing higher levels of capital per worker, having to increase faster than output per worker. At some stage the economy would be unable to save a sufcient fraction of its output and dedicate it to capital accumulation, given that the fraction of output it would need to save would exceed one5. Thus the economy will be unable to obtain the required increase in capital and as such output per worker will cease to grow (Blanchard, p.240, p.253). Therefore, capital cannot increase output indenitely (Easterly, p.49). Consequently, it can be said that in developed countries, the marginal product of capital is low relative to developing countries due to higher capital intensity (Todaro & Smith, p.78). This is illustrated by graph 1, where point K0/N represents an economy with a low level of capital per worker, with capital and output per worker increasing due to investment exceeding depreciation per worker at this point by the vertical distance CD = AC-AD. Graph 1

In the Harrod-Domar model, the production function would be a straight line, where growth in capital per worker and output per worker would continue indenitely if investment exceeding depreciation. Thus an additional implication of Solows growth model is that saving cannot procure long-run growth. Saving increases capital investment, which is subject to diminishing returns and cannot be a sustainable source of growth. As such, an economy with a higher saving rate will have a higher income relative to an economy with a lower saving rate but neither economy are able to maintain growth in the long-run through this avenue (Easterly, p.51). An increase in saving will cause a temporary increase in growth rate as the economy moves towards a higher equilibrium of capital per worker (Todaro & Smith, p.149).

Due to the decreasing returns of capital, there will be a reduction in the incentives to invest in capital until a tipping point is reached where savings, and thus investment, will be just enough to provide capital to new workers and offset depreciation6 . Thus investment will be equal to depreciation, and as graph 1 illustrates, capital per worker will reach point K*/N. This point is called the steady state or the long-run level of output. At this point, capital per worker, and output per worker, will cease to grow; remaining constant at points K*/N and Y*/N respectively. If capital cannot sustain long-run growth and labour is assumed to be constant, how can an economy continue growth once it reaches the steady state? As previously mentioned, Solows answer to the fundamental factor of sustainable long-run growth lay with technological progress. The state of technology determines how much output can be produced for given quantities of capital and labour. Thus, as Easterly states, technological change would progressively economize on the ingredient in xed supply: labour. (Easterly, p.51) and hamper the diminishing marginal returns of capital, with workers becoming more efcient, i.e. they produce more (Easterly, p.52-53). Thus, the growth of long-run output per worker has to be accrued through labour-saving technological change, or in other words: output-per-worker-increasing technology (Easterly, p.53). Technological progress will effectively cause an upward shift of the output function, increasing output per worker. The preceding discussion of the Solow model allows us to conclude that the rst factor of convergence is capital accumulation. Some countries are poorer than others because they started with relatively low levels of capital per worker. These countries will yield higher returns to capital per worker in the transition period. As such, the economies will attract higher investment, either through domestic sources or through attracting foreign investment and thus grow at a rate greater than that of the developed economies which hold higher levels of capital per worker and are closer to their steady state. Thus, Solows growth model predicts that over time, poorer countries with lower levels of capital per worker will catch up, or converge with the developed countries and ultimately grow at the rate of technological progress (Easterly, p.56). Theoretically, in the Solow model, convergence is driven by capital accumulation while technology is an exogenous factor that is uniform across countries7 . Empirically, however, in the models application to developing countries, technological progress is found to a factor of convergence and is not only applicable to growth once the steady-state has been reached. A country with primitive technology will produce less output from the same quantities of capital and labour than a country with more advanced technology (Blanchard, p.238), but over time they can become more sophisticated through importing technologies from advanced countries or developing their own. And as technology levels converge, so does output per worker (Blanchard, p.281; Todardo & Smith, p.78). Thus at this point we can conclude that the presence of technology transfer and/or quicker capital accumulation, will theoretically result in convergence of output per capital in the long run as developing countries grow at a faster rate than their developed counterparts and catch-up. Provided the countries have similar characteristics: savings rates,

In graph 1, the relation representing depreciation per worker, Kt /N, is a straight line. Depreciation per worker increases in proportion to capital per worker, so the relation is represented by a straight line with slope equal to .

All countries are assumed to have access to the same technology and thus the same rate of technological progress. The logic is that there is no reason that technology cannot be transferred, with the blueprints designed in one country being used in another country

population growth rates and depreciation rates (i.e. similar output per capita at the steady state), countries will tend to converge to the same income per capita. Empirical Evidence. The Solow models practical application8 resulted in the prediction of absolute convergence. Growth rates would decline over time as economies approached their steady states and poor countries would grow faster than rich countries, with per capita income equalizing across countries. If correct, the initial level of income and real per capita income growth should be inversely correlated. Graph 2

Graph 2 (above) examines this relationship. On the x-axis, income data are plotted from the initial year (1960); while on the y-axis, the average annual growth rate of GDP is plotted (between 1960 and 2004). The graph does not show a clear negative relationship and as such, empirical evidence does not support absolute convergence. In actuality the graph makes it evident that a selection of African countries have experienced divergence, with output per person at negative rates and declining living standards. For example: Nigers output per person in 2004 equated to 60% of its 1960 level (Blanchard, p.282) and the average income of Dem. Rep. of Congo fell from about 5% of U.S. levels in 1980, to 1% in 2007 (Todaro & Smith, p.79). Even during more recent decades (1980-2007), about 60% of countries grew more slowly than the United States (Todaro & Smith, p.79).

It is important to note that Solow never intended to provide explanation behind income differences between countries. It was a model applicable to the US and a group of advanced countries where the key fact was constant growth over a long period of time.

This basic application of the Solow models to cross-country income differences is naive and expectations of absolute convergence unwarranted. Absolute convergence is conditional on the assumption that all countries hold similar characteristics; for example: institutional quality, geography and saving rates. Naturally, countries have differing characteristics and production functions, and thus incomes should not converge to identical levels but should, as T&S state, tend to be equalized conditional on (i.e.,after also taking account of any systematic differences in) key variables such as population growth and savings rates (Todaro & Smith, p.78) 9. This is referred to as conditional or relative convergence10. Viewing data in this light provides supportive evidence in line with this altered version of the convergence hypothesis. OECD countries have similar economic attributes and have demonstrated conditional convergence. Along with OECD countries, the majority of Asian countries have experienced conditional convergence. For example: Singapore, Taiwan, Hong Kong and South Korea, four countries which are collectively termed the four tigers, experienced rapid growth - in 1960 their average output per person amounted to 12% of the US level; but by 2004 his had increased to 65% (Blanchard, p.237)11. However, overall there is no clear relation between the growth rate of output per person since 1960 and the level of output per person in 1960. Poor countries have tended to remain very poor, and rich countries have tended to remain very rich. There is evidence for upper-middle and high-income countries converging towards one another, but this is not the case for poor countries. Middle-income countries are growing faster than low-income countries, displaying a clear divergence. Developing countries remain in relative stagnation and are not catching up as a group (Colander & Gamber, p.154; Todaro & Smith, p.79). Why is there this disparity? Are cross-country income differences a result of higher capital accumulation on part of developed countries? Perhaps developing countries have not saved and invested enough. Capital accounts for approximately a third of output and thus to explain the large income gaps, an advanced country would require a lot more capital than their developing counterparts. As Robert Lucas highlighted, capital levels are evidently higher in advanced economies but not to the degree that would provide explanation to cross-country income differences (Easterly, p.57). Moreover, Easterly & Levin provide evidence of time-series data that shows that changes in factor accumulation do not match-up closely with change in economic growth (p.3). # Thus we turn to the second factor of convergence, technological progress. If technology, as the Solow model credits, is so powerful as to explain the bulk of sustained long-term economic growth in the same country, it is the logical candidate to explain big income differences between countries (Easterly, p.57).

Solow does not provide explanation into why the said characteristics differ between countries and how they are determined. Solows assumption is that they are determined by exogenous factors that exist outside the economy and the model.

The adoption of the conditional convergence concept came through the observation that convergence within countries is evident. For instance the per-capita income levels of the southern states of the United States have tended to converge to the levels in the Northern states.

In despite of higher growth in income than OECD countries, income gains were still smaller in absolute terms (Todaro & Smith, p.81).

This is indeed what multiple studies have found, including Easterly and Levine who conclude that huge differences in TFP12 account for the bulk of cross-country differences in growth rates (p.1). Evidence illustrates that growth since 1950 across countries has been largely a result of technological progress, and not unusually high capital accumulation (Blanchard, p.200)1314 . For example, Chinas rate of growth of output per worker between 1983-2003 was 8.0%, while the rate of technological progress was 8.2% (Blanchard, p.282)15. Research by Alwyn Young of Chicago Business School provided conclusions contrary to this nding, suggesting that East Asian fast growth was in most part due to capital accumulation, with technological progress contributing relatively little. For example, the results indicate that technological advancement in Singapore occurred at a rate of 0.2 percent per year. Critics of Youngs ndings provide the counterargument that capital accumulation responds to technological change. As technology progresses, capital yields a greater return and thus capital accumulates. Peter Klenow of Stanford and Andres Rodriguez-Clare of Berkeley replicated the Young calculations taking this into account and concluded that technological change in actuality comprised a larger share of output growth (Easterly, p.66-67). This proves to be a problematic part of distinguishing the relative importance of technological change versus capital accumulation. Capital investment will allow for technological change whilst technological change in itself will lead to capital yielding higher returns and involves factor upgrades. Moreover, it is improbable in practice that a country with low levels of capital per worker will be able to effectively utilize technological change to generate growth in output per worker without capital accumulation accompanying it. Determining the weight one should attribute to relative importance of each factor is a point of much discussion, but technological progress is predominately noted as the factor of greater weight. The type of technological progress and the its contribution to growth differs depending on the context. Technological progression plays a critical role for advanced countries, due to capital accumulation playing a lesser part once they are relatively close to their steady states. There is a greater need for innovation and investment in research and development in order to sustain growth. As such they are at the technological frontier and leaders in technological progression. Poorer countries, which hold a lesser need for technological change, can advance their technological state by imitating the technologies of advanced countries. The further they are behind economically, the greater the importance of imitation


As mentioned earlier, based on the general conclusions of multiple studies, we assume that the predominant TFP growth determinate is technological progress.

We are able to distinguish what proportion of growth is determined by technological change and capital accumulation. If the former is the prominent factor, output per worker should be growing at a rate equal to the rate of technological progress. If it reects the latter, the growth rate of output per worker should exceed that of technological progress.

This concurs with Solows ndings (1956) that capital accumulation explains only between one-eighth and one-fourth of income growth in developed countries, with the rest accounted for by productivity differences.

This does not deem capital accumulation irrelevant. To sustain growth, capital stock has had to increase at the same rate as output.

relative to innovation16 (Blanchard, p.283). As imitation is likely to be easier than innovation, this provides explanation to why convergence of developing countries takes the form of technological catch-up rather than innovation. The importance of technology in explaining cross-country income differences is clear. However, technological change cannot be an exogenous variable; an independent process occurring through noneconomic reasons as the Solow model suggested. This may seem plausible on an individual level that Solow initially derived the model from, i.e. the U.S. economy, but for this to be applicable to cross-country income differences is improbable. It does not seem plausible that there are no intrinsic characteristics of an economy which causes it to grow over the long-run. As Easterly remarks, it is answering the question of why growth rates differ by saying that growth rates differ (p.57). It does not explain the determinants of technological progress, thus it does not explain the causes of long-term growth. This failing has led to the development of endogenous growth theory. If technology varies across countries, and this variance leads to differing growth rates, there must be strong economic incentives to obtain better technology (Todaro & Smith, p.150). The new growth theory thus converts technological change from a residual, an exogenous parameter, into a variable that is endogenous to the model. Thus output growth becomes the outcome of forces that belong to the model. Thus discussion of endogenous growth models will perhaps provide further insight into why some poor countries, given the potential, are not on a path of convergence. As Blanchard points out, technology is more than just a set of blueprints (p.283); growth is dependent on deeper factors (geography and institutions standing as the prominent factors). Solows growth models weakness lies in that it fails to explain these fundamental determinants, with factor accumulation and TFP standing as only proximate causes of growth (Acemoglu, et al., p.388). In conclusion, under the framework and application of the Solow growth mode, economic convergence can occur through (1) technological catch-up, whereby less developed countries innovate themselves or imitate the technologies of those advanced countries at the technological frontier and (2) capital accumulation, whereby poor countries, considering their relatively low capital stock; accumulate capital faster than others. Empirical evidence suggests that absolute convergence is improbable, but supports conditional convergence and draws attention to the shared characteristics between countries which enable this convergence. Furthermore, evidence attributes technological progress as the predominant variable underpinning long run growth, cross-country income differences and convergence in output per worker (Blanchard, p.280). Not all poor countries are on a path of convergence, which puts forth the question why and warrants further discussion on the deeper determinants of cross-country differences and analysis of new growth theory to provide additional insight on convergence.


The Solow model could better t developing countries as they are importing technology, i.e. exogenous technological progress.

Bibliography. Acemoglu, D., Johnson, S and J. Robinson. (2005). Institutions as a Fundamental Cause of Long-Run Growth. Handbook of Economic Growth 1A: 386-472. Available from: http:// Blanchard, O., Amighini, A and F. Giavazzi. (2010). Macroeconomics: A European Perspective. Harlow: FT/Prentice Hall. Colander, D. and Gamberm E.N. (2006). Macroeconomics. Cape Town: Pearson Education. Easterly, W. (2001) The Elusive Quest for growth: Economists Adventures and Misadventures in the tropic. Cambridge, Mass: MIT Press. Easterly, W. and Levine, R. (2002). It's Not Factor Accumulation: Stylized Facts and G r o w t h M o d e l s . Av a i l a b l e a t : h t t p : / / w i l l i a m e a s t e r l y. l e s . w o r d p r e s s . c o m / 2010/08/33_easterly_levine_itsnotfactoraccumulation_prp.pdf Todaro, H. and Smith, S.C. (2003). Economic Development, 11/E, London: Pearson Education.