Study Guide

LOS 12i: Compare classical growth theory, neoclassical growth theory, and endogenous growth theory.
Vol 1, pp 659–674
LOS 12k: Describe the economic rationale for governments to provide incentives to private investment in
technology and knowledge. Vol 1, pp 671–674

3.1 Theories of Growth

3.1.1 Classical Model (Malthusian Model)

This model asserts that growth in real GDP per capita is temporary
temporary. GDP per capita only grows until it rises
above the subsistence level. Once it rises above the subsistence level, real GDP per capita falls due to a
population explosion. See Figure 3.1.

The subsistence real wage rate is the minimum real wage rate required to maintain life. If the real wage
rate is lower than the subsistence real wage rate, some people cannot survive and the population
decreases. If the real wage rate is greater, there is a population explosion.

To understand this theory, assume that technological advancement has led to investment in new capital,
which improves labor productivity. Labor demand therefore rises, and real wages increase. At this stage,
economic growth has occurred and the standard of living appears to have improved. However, once the real
wage rate exceeds the subsistence real wage rate, there is a population explosion, which eventually (due to
diminishing marginal returns to labor) reduces marginal product of labor to zero. Labor productivity and
per capita income fall back to the subsistence level.

Figure 3.1 Classical Growth Model

Basically this theory predicts that standards of living remain constant over time even with technological
progress as there is no growth in per capita output. In the long run, new technologies result in a larger
population, but not a richer population.
Empirically, this theory has not proven to be true because:

Per capita income growth has not resulted in population growth (as assumed by the theory). In fact,
population growth has historically slowed with economic growth.
The positive impact of technological progress on per capita income has outweighed the negative
impact of diminishing marginal returns.

3.1.2 Neoclassical Model (Solow's Model)

This model is based on the Cobb-Douglas production function. Both labor and capital are variable factors of
production and both suffer from diminishing marginal productivity.

The neoclassical model seeks to find the economy's equilibrium position, which it asserts occurs when the
economy grows at the steady state rate of growth (see Example 3.1). In this state:

The output-capital (Y/K) ratio is constant. This ratio is denoted by Ψ and calculated as:

= ( ) [( ) + δ + n] = Ψ
Y 1 θ
(Equation 3)
K s (1 -α)

where:
s = Fraction of income that is saved
θ = Growth rate of TFP
α = Elasticity of output with respect to capital
y = Y/L or income per worker
k = K/L or capital-labor ratio
δ = Constant rate of depreciation on physical stock
n = Labor supply growth rate
Capital per worker (k = K/L) and output per worker (y = Y/L) grow at the same rate, which is given by:
Growth rate in k and y: θ/(1 − α)
Growth in total output (Y) equals the sum of (1) the growth rate in output per worker, θ/(1 − α), and (2)
growth in labor supply, n. Notice that this assertion is in line with the labor productivity growth
accounting equation (Equation 2).
Growth rate in output (Y) = θ/(1 − α) + n
n = ΔL/L = Growth in labor supply
The marginal product of capital is also constant, and equals the real interest rate:
MPK = αY/K = r (derived earlier)
Important takeaways:

Even though the capital-labor ratio (k = K/L) is increasing [at the rate θ/(1 − α)] in the steady state,
which indicates that capital deepening is occurring in the economy, the marginal product of capital
remains constant (at MPK = αY/K = r). This can be explained by growth in TFP offsetting the impact of
diminishing marginal returns to capital.
Further, capital deepening has no effect on the growth rate of the economy in the steady state. The
economy continues to grow at a constant rate of θ/(1 − α) + n.

Example 3.1
Steady State Growth Rates
Consider the following information:
Growth Rate of Labor Cost in Total Growth Rate Growth Rate of
Country Potential GDP (%) Factor Cost (%) of TFP (%) Labor Force (%)
A 11.5 45 2.6 1.3
B 0.6 58 0.3 0.0
C 1.7 56 0.9 0.0

1. Calculate the steady state growth rates from the neoclassical model for the three countries.
2. Compare the steady state growth rates to the potential GDP growth rates and explain the results.

Solution:

1. According to the neoclassical model, the steady state growth rate of GDP is calculated as the sum
of (1) the growth rate of TFP, θ, scaled by labor factor share, (1 − α) and (2) the labor force growth
rate, n.
Growth rate in output (Y) = θ / (1 − α) + n
Using this equation, the steady state growth rates for the three countries are estimated as:
Country A: 2.6%/0.45 + 1.3 = 7.08%
Country B: 0.3%/0.58 + 0.0 = 0.52%
Country C: 0.9%/0.56 + 0.0 = 1.61%
2. For Countries B and C, their estimated steady state growth rates are very close to their growth rates
in potential GDP (B: 0.52% vs. 0.6%; C: 1.61% vs. 1.7%). Changes in growth rates of TFP (θ), labor
(n), and labor's share in GDP (1 − α), which are the three variables considered in the steady state
rate calculation, explain the growth in potential GDP (almost) in its entirety. Therefore,
improvements in the capital-labor ratio (capital deepening) will not have a significant impact on
the growth rate of potential GDP for these economies, and we can conclude that these economies
are in (or very close to) equilibrium according to the neoclassical theory.
 On the other hand, for Country A, the estimated steady-state growth rate is significantly lower than
the growth rate in potential GDP (7.08% vs. 11.5%). This implies that after accounting for changes
in growth rates of TFP and labor, and labor's share in GDP (which are the three variables
considered in the steady state rate calculation), there is still some growth in potential GDP that
remains unexplained. This growth can be harnessed by increasing the capital-labor ratio in this
economy. Therefore, we can conclude that this economy is not in equilibrium as defined by the
neoclassical model since capital deepening can play an important role in the growth rate of
potential GDP.

We can also analyze steady-state equilibrium by applying the following savings/investment equation (which
is basically a transformed version of Equation 3):

sy = [( ) + δ + n] k
θ
(1 − α)

You will not be required to transform Equation 3 into this form on the exam. However, you are required to
understand its implications and the analysis that follows.

According to this equation, steady-state equilibrium occurs at the point where savings per worker (and
actual gross investment per worker), sy, are sufficient to:

Provide capital to new workers entering the workforce at the rate, n.

Replace worn-out plant and machinery that is depreciating at the rate, δ.
Deepen the capital stock at the rate θ/(1 − α), which is the required growth rate of capital in the
steady state. When the capital-labor ratio increases at this rate, the marginal product of capital
remains constant.

Think of it this way: We know that in the steady state, capital-labor grows at θ/(1 − α) and the marginal
product of capital remains constant (equal to the real interest rate, r). We have now introduced the impact
of depreciation and labor growth into the mix. Depreciation and labor growth have a negative impact on the
capital-labor ratio. In order to keep the overall or net growth rate of the capital-labor ratio constant at θ/(1
− α), gross investment per worker (sy) must first offset the negative impact of depreciation (δ) and labor
growth (n) on the capital-labor ratio and still be sufficient to grow the capital-labor ratio at the rate of θ/(1 −
α). Therefore, overall gross investment per worker must equal the sum of θ/(1 − α), δ and n in the steady
state.

The steady state is represented graphically in Figure 3.2.

The curved line (sy0) represents the amount of actual saving/ gross investment per worker.
 The straight line [δ0 + n0 + θ0/(1 − α0)]k indicates the amount of investment per worker required to
keep the physical capital stock growing at the required rate of θ/(1−α). We shall refer to this line as the
required investment line.

The point of intersection of the investment per worker curve and the required investment line represents
the steady state (Point A) at a particular point in time. Note that at any point in time, the exogenous factors
(i.e., labor supply and TFP) are fixed.

Figure 3.2 Steady State in Neoclassical Model at a Point in Time (t=0)

Note that over time, TFP grows at θ, so output per worker, y, grows at θ/(1 − α). In turn, this growth in
output per worker results in an upward shift in the sy curve. Therefore, over time, equilibrium moves
upward and rightward along a straight line (Figure 3.3).

Figure 3.3 Steady State in Neoclassical Model over Time

Over time, TFP grows at θ, so y grows at θ/(1 − α).
Since y is increasing, the sy curve moves upwards over time (from sy0 to sy1 to sy2).
In each successive period, the point of intersection between the investment per worker curve and the
required investment line moves upward and rightward along a straight line (from Point A to Point B to
Point C).
The capital-labor ratio (k) increases from k0 to k1 to k2. It grows at the rate [θ/(1 − α)].
Output per worker (y) increases from y0 to y1 to y2. It also grows at the rate [θ/(1 − α)].
Even though there are diminishing marginal returns to capital, the marginal product of capital
remains constant over time (MPK = αY/K = r). This is because the growth in TFP (at rate θ) offsets the
impact of diminishing marginal returns.
Notes

You haven’t made any notes or highlights yet.

Flashcards

1
fc.L2R12L03.0001_1812

Explain classical growth theory (Malthusian
model).
This model asserts that growth in real GDP per
capita is temporary. GDP per capita only
grows until it rises above the subsistence
level. Once it rises above the subsistence
level, real GDP per capita falls due to a
population explosion.

2
fc.L2R12L03.0002_1812

Per capita income growth has not resulted in

Explain why, empirically, the classical model population growth (as assumed by the
has not proven to be true. theory). In fact, population growth has
historically slowed with economic growth.

The positive impact of technological progress

on per capita income has outweighed the
negative impact of diminishing marginal
returns and demands of a growing
population.

3
fc.L2R12L03.0003_1812

Explain the neoclassical growth theory This model is based on the Cobb-Douglas
(Solow's model). production function. Both labor and capital
are variable factors of production and both
suffer from diminishing marginal productivity.
The neoclassical model seeks to find the
economy's equilibrium position when the
economy grows at a steady state rate.

4
fc.L2R12L03.0004_1812
 Provide capital to new workers entering the
workforce at the rate, n.
Describe equilibrium in the Solow model.
Replace worn-out plant and machinery that is
depreciating at the rate, δ.

Deepen the capital stock at the rate θ/(1 − α),

which is the required growth rate of capital in
the steady state. When the capital-labor ratio
increases at this rate, the marginal product of
capital remains constant.