American Economic Association

Technical Progress, Capital Formation, and Economic Growth

Author(s): Robert M. Solow
Source: The American Economic Review, Vol. 52, No. 2, Papers and Proceedings of the
Seventy-Fourth Annual Meeting of the American Economic Association (May, 1962), pp.
76-86
Published by: American Economic Association
Stable URL: https://www.jstor.org/stable/1910871
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 TECHNICAL PROGRESS, CAPITAL FORMATION, AND
ECONOMIC GROWTH*

By ROBERT M. SOLOW
Massachusetts Institute of Technology

Introduction

The goal of this paper is an answer to the question: How much fixed
investment is necessary to support alternative rates of growth of po-
tential output in the United States in the near future? Notice that I said
"cnecessary to support" and not "sufficient to generate." I believe that a
high rate of capital formation is required if the growth of aggregate
productivity and output is to accelerate, but I do not believe that it is
all that is required. Notice also that I said "potential output" and not
"realized output." The relation between investment and output is
two sided, as I think I once heard my friend Evsey Domar say, and
I am concerned here with the supply side only. Whether any particular
required rate' of investment will be accompanied by a high enough
level of final demand to use the resulting capacity is another question.
And how a particular required rate of investment can in fact be in-
duced is yet another. Neither will be answered in this paper.
I shall try to deduce an answer to my question by estimating an
aggregate production function, because I do not know any other way
to go about it. One aggregate production function is pretty much like
another, I admit, and this one has only a few distinctive markings.
They are: (1) the data differ a little from those normally used in this
kind of enterprise; (2) it is assumed that all technological progress
needs to be "embodied" in newly produced capital goods before there
can be any effect on output; (3) a sharp distinction is drawn between
actual output and potential output, and the method includes a built-in
estimate of the gap between them.
The next section of the paper sets out the assumptions of this ap-
proach. Then I shall briefly describe the data, present some alternative
estimates of the production function, and draw the implications for
capital requirements.

Assumptions and Theory

I assume that new technology can be introduced into the production
process only through gross investment in new plant and equipment.
* All the work in this paper was done by Thomas Rothenberg and Richard Attiyeh of
M.I.T., Yale, and the staff of the Council of Economic Advisers.
76

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 THE LAGGING U.S. GROWTH RATE 77

This is certainly not literally true. No one knows whether it is more

or less true than the exactly opposite assumption that technical prog-
ress makes new and old capital goods more productive in the same
way and in the same proportion. I have worked both sides of the street
in different papers, and I will produce estimates on both assumptions
in this paper. That seems to me to be the moral equivalent of Edward
Denison's suspiciously round assumption that half of new technology
is the "embodied" kind and half the "disembodied" kind. The most
casual kind of reflection suggests to me that embodied technological
progress is by a substantial margin the more important kind.
Suppose that capital goods produced in any year are 100X per cent
more productive than those produced the year before. Suppose also
that if a gross investment of I(v) is made in year v, the amount sur-
viving in a later year t will be B (t - v). Under the further assumption
that labor and machines of various vintages are arranged in such a way
as to yield maximum output (or equivalently that all workers receive
the same wage regardless of the age of their equipment) it can be
shown that the stock of surviving capital goods of different vintage and
productivity can be summarized for production-function purposes in
an "equivalent stock of capital." The equivalent stock of capital adds
up the survivors of each vintage after weighting them by the ap-
propriate productivity improvement factor. To be precise, the equiva-
lent stock of capital in year t is

(1) J(t) = E (1 + X)VB(t - v)I(v)

V=-Qo

Potential output is a function of the available equivalent stock of

capital and the available input of labor N(t), say
(2) P(t) = F(J(t), N(t))
No explicit mention of technical progress -is needed; it is already
wrapped up in J. What we observe, however, is not P(t) but actual
output A(t). It is tempting to try to make some estimate of potential
output and then to use it in estimating the production function. But
since what one expects from the production function is a statement
about potential output, it seems a little circular to impose an inde-
pendently calculated measure of potential output to begin with. I have
tried to get around this difficulty by a device which owes a lot to some
of Arthur Okun's ideas.
Actual output falls below potential output because employment is
less than the available supply of labor and because some capital stands
idle. There is a logical pitfall here. If it is assumed-as I have tacitly
done in (2)-that labor and already existing capital are substitutable
for each other, then in principle capital should never be idle unless its

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78 AMERICAN ECONOMIC ASSOCIATION

marginal value product has fallen to zero (if depreciation occurs with
use rather than with time, I should say marginal net product). Other-
wise it would pay to use more capital with the current input of labor;
the extra product would provide at least some quasi-rent. Yet we be-
lieve there to be such a thing as idle capacity in periods of economic
slack. The paradox is easily resolved in a model which permits virtual
substitution of labor and capital before capital goods take concrete
form, but not after. I have analyzed such a model [3] but I do not at
the moment see any direct way of using it in empirical work. So I shall
simply assume, as an approximation, that the ratio of actual to poten-
tial output is a function of the unemployment rate. (The unemploy-
ment rate I shall be using is the difference between the "full employ-
ment" supply of man-hours and the number of man-hours actually
worked, expressed as a ratio of the full employment supply. It differs
from the ordinary labor-force concept in a number of ways-for ex-
ample it can become negative, and did so in 1942-44, because the num-
ber of man-hours worked exceeded the normal supply.) If I let u(t)
stand for the unemployment rate:

(3) A (t) = f(u(t))PQ(t) (u)F(J, N)

With a convenient choice of functional forms for f(u)/and F(J, N),
I can hope simultaneously to estimate the production function for
potential output, and the curve which relates the degree of slack to the
unemployment rate. The raw materials are time series of actual outpu.t,
the full employment supply of labor, and the equivalent stock of
capital, to be described in a moment.
To simplify computations, I have used the Cobb-Douglas function
with constant returns to scale for F(J, N). For f(u) I have used what
amounts to the half of a normal curve lying to the right of the peak.
This choice has the double advantage of being workable and of having
the right general shape. One would want, I think, to have a kind of
diminishing returns to the reduction of unemployment after a point,
and this occurs as the normal curve flattens out near its peak. Also,
any linear approximation near usual unemployment levels tends to
show actual output dropping to zero when the unemployment rate
reaches 30 per cent or so, and the normal curve avoids this.
With those specializations, my production function now reads:
(4) A = alOb+cu+du2'JaNl-a

though I shall fit it in the form:

(4') A/N = a1Ob+CU+dU2(J/AT)a.
or
(4") log (A/N) = log a + b + cu + dU2 + a log (J/N).

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 THE LAGGING U.S. GROWTH RATE 79

In (4") there are two constant terms, one belonging to F and one to f.
They can be separated as soon as I make a statistical definition of "full
employment." It happens that the measure of unemployment used in
this paper coincides numerically with the usual labor force measure
when they are both equal to about 4 per cent. That figure has become,
at least temporarily, the conventional description of full employment,
and I adopt it here. Now I must have actual output equal to potential
output at full employment. This implies
f(.04) = 1 or b + .04c + (.04)2d = 0
From estimates of c and d I can calculate b, and then from (4")
I can find a.
With all constants estimated it is possible to ask and answer such
questions as: given the expected increase in the supply of man-hours,
and given the already determinate mortality of existing capital, how
much gross investment is necessary to increase potential output by 3 or
4 or 5 per cent in the next year?

Data
Several time series measuring the "equivalent stock of capital" were
constructed along the lines of equation (1), with alternative trial
values of X. The case A = 0 is, of course, the plain stock of capital. All
are expressed in 1954 prices. Stock and equivalent stock figures were
computed separately for plant and equipment-sometimes using dif-
ferent values of A for each component, on the chance that equipment
improves in productivity more rapidly than plant-with mortality
calculated according to the schedules devised by George Terborgh. Be-
cause the plant and equipment series are quite highly correlated, I did
not t-ry to use them as separate inputs in the production function. In-
stead, every stock of capital or equivalent stock of capital figure in my
regressions is actually the sum of a stock of plant and a stock of equip-
ment, each generated from gross investment data with its own mortality
curve and its own value of X. The investment series used is consistent
with "producers' durable goods" plus "other construction" in the na-
tional accounts, with the exception that religious, educational, hospital
and institutional construction are excluded. (Dwellings are excluded
from the stock of capital, which is intended to be a measure of privately-
owned business plant and equipment.)
The output concept comparable to this measure of capital stock is
gross national product minus the product originating in general govern-
ment, government enterprises, households and institutions, rest of the
world, and services of houses: This defines a reasonably close approx-
imation to the output produced by the privately-owned stock of plant
and equipment. It is expressed in 1954 prices.

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80 AMERICAN ECONOMIC ASSOCIATION

The series for "full employment man-hours" is essentially due to

Knowles [2]. This is based on the age and sex distribution of the
population together with smoothed trends in participation rates and
annual hours worked. Some minor adjustments were made, particularly
to eliminate government employees since the output and capital series
are restricted to the private business economy. Analogous adjustments
were made to the BLS series on man-hours worked in the private
economy, to restrict the coverage approximately to that involved in the
other data used in the analysis.

Estimated Production Functions

Equation (1) defines the equivalent stock of capital for any con-
stant rate of increase in the productivity of capital goods. As noted
earlier, I have experimented with different improvement factors for
plant and equipment separately and then added the two series. The
regression results I shall report here use the following six combina-
tions:
Jo JL J2 J8 J4 Jo
X plant 0 .02 .02 .02 .03 .03
X equipment 0 . 02 .03 .04 .03 .04

The multiple regressions themselves are given in the following table:

The parameters are designated as in (4), with standard errors follow-
ing in parentheses, except that f(u) was actually estimated as
lob+Cu+d(u+.13O)2

Inspection of Table 1 yields some obvious generalizations.

(a) From the similarity of the estimated values of a for the equations
with J2 and J4 and for those with Li and J1, it seems clear that more
depends on the improvement factor for equipment than on that for
plant. This is associated with the fact that between 1929 and 1961 the
ordinary stock of plant increased by about 50 per cent while the stock
of equipment grew by almost 170 per cent.

(b) The estimated elasticity of output with respect to the equivalent

stock of capital declines as the improvement factor (particularly that
for equipment) increases, for obvious reasons.

(c) Very low values for the improvement factor lead to implausible
values for a. One gets nonsense results unless considerable weight is
given to technological progress.

(d) The estimated curve relating realized to potential output is not

very sensitive to alternative assumptions about the improvement
factor.

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 THE LAGGING U.S. GROWTH RATE 81

TABLE 1

Standard
log a b c d a R2 Error of
Estimate

JO -.4179 .0460 -.1244 (.2016) -1.344 (.413) 1.2377 (.0993) .9622 .0322
J1 -.3934 .0395 -.2814 (.1524) - .979 (.315) .6323 (.0364) .9789 .0241
J2 -.3328 .0382 -.3187 (.1465) - .879 (.304) .4990(.0274) .9806 .0230
J8 -.2956 .0370 -.3386 (.1398) - .813 (.291) .4026(.0221) .9825 .0220
J4 -.3888 .0387 -.3097 (.1427) - .909(.295) .5Q54(.0270) .9816 .0225
JG -.0375 .0375 - .3319 (.1381) - .838(.287) .4160(.0214) .9828 .0217

(e) The multiple correlation is a little higher and the standard error of
estimate a little smaller for the larger values of B. But because the esti-
mates of a change in an offsetting way, goodness of fit is a poor way of
distinguishing among neighboring values of X.

It will be interesting to compare the conclusions flowing from esti-

mates of (4) with those derived on the assumption that all techno-
logical progress is "disembodied," falling alike on new and old capital
goods and therefore not requiring investment to generate an increase in
productivity. For this purpose I have also estimated the production
functions

(5) A = a(1 + y) tJoaN1-alOb+cu+d(u+.130)2

with the result
(5') A 1.10(1.025)tJo11N .891O0o365-.25lu-.888(u+.13o)2
The squared correlation is .9945. The elasticity of output with respect
to Jo is about equal to its standard error. Essentially, output per man-
hour just rises at 2/2 per cent a year.

Actual and Potential Output

A useful by-product of this procedure is a built-in estimate of the
ratio of actual to potential output as a function of the unemployment
rate. It must be remembered that the measure of unemployment I am
using is not the conventional one. I define the unemployment rate in
any year as the difference between the estimated full employment
supply of man-hours and the number of man-hours actually worked,
expressed as a fraction of the full employment supply of man-hours.
This should be in principle a better measure of the excess supply of
labor, for two reasons. In the first place, when the demand for labor
is slack some people leave the measured labor force although they
would willingly take work if they thought work were available. This
kind of "unemployment'" represents excess capacity. Second, involun-
tary part-time work, thbugh it does not show up as unemployment in
the official statistics, does affect the alternative concept. On the other

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82 AMERICAN ECONOMIC ASSOCIATION

hand, the usual labor force statistics undoubtedly contain less error
than the ones used here.
A plot of the two measures of the unemployment rate against each
other shows that most points fall along a smooth nonlinear curve. It
happens by chance that the two measures coincide approximately at
an unemployment rate of 4 per cent, which is the conventional defini-
tion of "full employment" I am using. Columns 1 and 2 of Table 2
give a few selected corresponding values of u (the unemployment rate
used in this paper) and u* (the usual labor force unemployment rate).
It is also the case, mentioned earlier, that the regression equations
using different equivalent stocks give very similar curves relating the
ratio of actual to potential output to the unemployment rate. The
ratios corresponding to 14 and J5, and those corresponding to equation
(5) are given in columns 3, 4, and 5 of Table 2.

TABLE 2

,. .. A/P A/P A/P A/P

14 15 ( Okun's Law

.13 .01 1.200 1.203 1.172 1.096

.03 .02 1.094 1.094 1.084 1.064
.00 .03 1.054 1.054 1.051 1.032
.02 .035 1.028 1.025 1.027 1.016
.04 .04 1.000 1.000 1.000 1.000
.06 .05 .971 .971 .976 .968
.08 .06 .941 .942 .949 .936
.10 .07 .911 .912 .921 .904
.27 .21 .645 .652 .671 .456

The only other systematic attempt to relate the gap between actual
and potential output to the unemployment rate is Okun's Law [1]
which states that the percentage excess of potential over actual output
is 3.2 times the excess of the (conventional) unemployment rate over
4 per cent. In my notation, Okun's Law states that
P-A
= 3.2 (u*-.04).

Okun himself, it should be noted, has used this relation only for the
period since 1955. The ratio of actual to potential output read from
this equation is shown in the last column of Table 2.
It is altogether remarkable that Okun's Law and the approach used
in this paper give very similar results for conventional unemployment
rates between 3 and 7 per cent, despite the fact that they are based on
entirely different data (and the fact that u relates to private employ-
ment and u* to total). It is only natural that they should differ for
extremely high unemployment rates and extremely low ones. I intro-

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 THE LAGGING U.S. GROWTH RATE 83

duced the possibility of considerable curvature into this approach

because I wanted to allow for diminishing returns as the unemploy-
ment rate becomes very low. But as Table 2 shows, at very low levels
of unemployment, the approach in this paper indicates a greater excess
of actual over normal full employment potential than does Okun's
Law. The required curvature is actually in the equations; the apparent
paradox arises because the man-hours figures allow for the super-
normal increase in labor force and hours worked during the war years
of very low unemployment.

Investment Requirements for Economic Growth

With the unemployment rate fixed at u = .04, any one of the esti-
mated production functions states that potential output is constrained
by the currently available input of labor and by the whole history of
capital formation. If the American economy can and must move along
such a function in the next few years, the growth of productive poten-
tial is tied in a specific way to the growth of the labor supply and the
rate of investment. Movements in the supply of hours of work are
usually taken as given. That leaves the volume of investment as the
most important determinant of growth which is actually open to in-
fluence by policy. (There is also the equally important possibility of
influencing the rate of technological progress, ?; but that leads to an
entirely different set of questions.)
The movement of full employment man-hours for the entire economy
in the next few years can be estimated with reasonable accuracy from
demographic trends. It is less easy to estimate the supply of man-hours
to the private economy, because that is less purely a matter of demog-
raphy. Public employment has been gaining relative to private employ-
ment in recent years, and since there is no reason to expect a reversal
of this trend, it is safe to conclude that the supply of labor to the
private economy will rise more slowly than the total. With the labor
force expected to grow at about 1.7 per cent per year and average
annual hours worked declining at an annual rate of some 0.3-0.4 per
cent, the supply of potential man-hours is likely to increase at about
1.3-1.4 per cent a year in the near future. This is a more rapid rate
of increase than in the decade just past. But the supply of labor to the
private economy will rise more slowly than that. Between 1950 and
1960, our series for the supply of potential man-hours to the private
economy rose at an average annual rate between 0.4 and 0.5 per cent.
For looking ahead, I have made alternative calculations with an annual
increase in labor supply of 0.65 per cent and 1.0 per cent.
With this growth in labor input, a substantial amount of investment
is needed just to keep capital per man-hour constant. Suppose that

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84 AMERICAN ECONOMIC ASSOCIATION

some 212 per cent of the capital stock is retired each year. (I am
speaking now of the ordinary capital stock, with X = 0.) Then with a
capital-output ratio of about 134, 4/2 per cent of private GNP must
be invested just to replace worn-out capital, and between 5/2 and 6 per
cent of GNP must be invested (depending on the assumed rate of
growth of the labor force) to keep capital per man-hour constant. A
slightly higher rate of investment would be needed to keep capital per
worker from falling.
When we deal with an equivalent stock of capital the calculations
are a little more complicated but the results not very different. The
annual mortality of "equivalent capital" can be calculated. For I3 and
J5 it runs just over 3 per cent of the equivalent stock; for 14 it is about
2'2 per cent. The capital-output ratio is much higher because the im-
provement factor makes the equivalent stock considerably higher than
the capital stock itself. Working against this is the fact that a dollar's
worth of investment is more potent, creating more than "a dollar's
worth" of equivalent capital.
Generally speaking, the result is that the maintenance of capital
intensity-and the accompanying achievement of low rates of growth
of output-can be obtained with a somewhat slighter investment
burden than consideration of the ordinary stock of capital would
suggest.
To attain a high rate of growth of output, the equivalent stock of
capital must grow faster than the input of labor. Additional invest-
ment now performs a function beyond the widening process as the
labor force increases and the conventional deepening process as the
capital-intensity of production increases. The third function is, of
course, what one might call quickening: the carrying into production
of new technology as represented by the improvement factor. Table 3
shows-for 1960-61 values of the variables-the percentage of busi-
ness GNP which must be invested gross to permit different rates of
growth of output. The calculations are shown for J3, J4, and J5 with the
two alternative rates of growth of the labor force mentioned earlier.
In interpreting these figures it should be remembered that the out-
put concept used here covers about 80 per cent of the total gross na-
tional product. Also the omission of various kinds of institutional con-
struction reduces the gross investment total to about 93 per cent of
"producers' durable equipment" plus "other construction" in the na-
tional accounts. Thus an investment quota corresponding to the ratio
of business fixed investment to GNP would be about 86 per cent of the
number given in Table 3. With this adjustment, the estimates in the
table seem to be of the right order of magnitude. They suggest that a
necessary condition for increasing the rate of growth of output from

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 THE LAGGING U.S. GROWTH RATE 85

TABLE 3

INVESTMENT QUOTAS FOR ALTERNATIVE GROWTH RATES

Growth Rate 3% 3X% 4% 4a% 5%

Slow growth in man-hours ........ ..... 9.9 11.2 12.4 13.8 15.0
Fast growth in man-hours ....... ...... 9.2 10.4 11.7 13.1 14.3

'4

Slow growth in man-hours ............. 9.0 10.2 11.4 12.5 13.7

Fast growth in man-hours ....... ...... 8.5 9.8 10.9 12.0 13.2

Slow growth in man-hours ........ ..... 10.1 11.3 12.6 13.9 15.3
Fast growth in man-hours ............. 9.4 10.8 12.0 13.3 14.7

about 3Y2 per cent annually to 4Y2 per cent annua

per cent increase in the investment quota from the range 10-11 per
cent of business GNP to the range 12-14 per cent of business GNP. J4
gives both a lower required investment quota and a smaller relative
increase to get from 3 /2 to 4/2 per cent growth than do 13 and J5.
Alternative improvement factors have only a minor effect on the im-
plied investment requirements because the estimated elasticity changes
to make a partial compensation.
Rough calculations show that to maintain an accelerated rate of
growth throughout a decade requires a slowly rising savings-investment
quota. But the rise is slow and the average investment quota only
slightly above the initial figure shown in Table 3.
By comparison, the production function (5), which makes techno-
logical change a pure "residual," gives altogether different results. The
high time trend-a residual increase in output of 2/2 per cent annually
with labor and capital constant-and the low elasticity of output with
respect to capital imply that a fairly rapid rate of growth of output
per man-hour is achievable with very little investment but that a
visibly higher rate of growth can be supported only by an unrealisti-
cally high investment rate. For example, with the slower rate of growth
of the labor force, (5) says that a 3 per cent increase in potential out-
put is achievable with a slight decrease in the capital stock. The gross
investment implied is about 3/2 per cent of potential output; the net
investment is actually negative. But to lift the rate of growth to 4
per cent a year would require an investment quota of almost 20 per
cent of potential output. These implications seem wholly unrealistic to
me, and they suggest that the "embodied" model is a better one. But
I must admit that there is nothing in the analysis I have given which
"proves" that (4) is a better model of production than (5).
Entirely apart from all statistical difficulties, one must admit the

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86 AMERICAN ECONOMIC ASSOCIATION

possibility that our economy is not free to move back and forth along
a production function like (4) or even (5). An attempt to accelerate
movement out along the function may have the effect of shifting the
function itself. For one thing, a sharply higher rate of investment may
bring about premature scrapping of old equipment. Second, there
may be limits even in a mature economy to the speed with which the
system can adjust to large inflows of new capital. Third, a change in
the investment quota is itself a change in the composition of output;
changes in the composition of output may also have the effect of shift-
ing the function bodily, though it would be difficult to make an a priori
judgment about the nature of the shift. This reflection suggests the
wisdom of trying to make such analyses of the productivity of invest-
ment sector by sector. This would place a greater strain on the availa-
bility of data, but might in compensation yield important conclusions
about the best sectoral composition of investment.

Conclusion
Capital formation is not the only source of growth in productivity.
Investment is at best a necessary condition for growth, surely not a
sufficient condition. Recent study has indicated the importance of such
activities as research, education, and public health. But -while econo-
mists are now convinced of the significance of these factors in the
process of economic growth, we are -still a long way from having any
quantitative estimate of the pay-off to society of resources devoted to
research, education, and improvements in allocative efficiency. Since
such estimates must form the foundation for a national allocation of
resources in the interests of economic growth, their provision by hook
or by crook presents a research problem of great theoretical and prac-
tical interest. The object of this paper is to make a start in that job
for the much easier and prosaic case of tangible capital formation.

REFERENCES

1. "The American Economy in 1961: Problems and Policies," in "January 1961 Economic
Report of the President and the Economic Situation and Outlook," hearings before the
Joint Economic Committee (87th Cong., 1st sess., 1961), pp. 324, 375.
2. James W. Knowles, "Potential Economic Growth in the United States," Study Paper
No. 20, prepared for the Joint Economic Committee in connection with the Study of
Employment, Growth and Price Levels (86th Cong., 2d sess., 1960).
3. Robert M. Solow, "Substitution and Fixed Proportions in the Theory of Capital," to
appear in Rev. of Econ. Studies, 1962.

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