Theories of

Economic
Growth
What Is Economic Growth?
• Economic growth is an increase in the production of
economic goods and services, compared from one period of
time to another.
• It can be measured in nominal or real (adjusted for inflation)
terms.
• Traditionally, aggregate economic growth is measured in
terms of gross national product (GNP) or gross domestic
product (GDP), although alternative metrics are sometimes
used.
Understanding Economic
Growth
• In simplest terms, economic growth refers to an increase in
aggregate production in an economy.
• Often, but not necessarily, aggregate gains in production
correlate with increased average marginal productivity.
• That leads to an increase in incomes, inspiring consumers
to open up their wallets and buy more, which means a higher
material quality of life or standard of living.
Understanding Economic
Growth
• In economics, growth is commonly modeled as a function
of physical capital, human capital, labor force, and
technology.
• Simply put, increasing the quantity or quality of the working
age population, the tools that they have to work with, and
the recipes that they have available to
combine labor, capital, and raw materials, will lead to
increased economic output.
Understanding Economic Growth

• There are a few ways to generate economic growth.

• The first is an increase in the amount of physical capital
goods in the economy. Adding capital to the economy tends
to increase productivity of labor.
• Newer, better, and more tools mean that workers can
produce more output per time period. For a simple example,
a fisherman with a net will catch more fish per hour than a
fisherman with a pointy stick.
Understanding Economic Growth

• However two things are critical to this process. Someone in

the economy must first engage in some form of saving
(sacrificing their current consumption) in order to free up the
resources to create the new capital, and the new capital
must be the right type, in the right place, at the right time for
workers to actually use it productively.
Understanding Economic Growth

• A second method of producing economic growth is

technological improvement. An example of this is the
invention of gasoline fuel; prior to the discovery of the
energy-generating power of gasoline, the economic value
of petroleum was relatively low.
• The use of gasoline became a better and more productive
method of transporting goods in process and distributing
final goods more efficiently.
Understanding Economic Growth

• Improved technology allows workers to produce more

output with the same stock of capital goods, by combining
them in novel ways that are more productive. Like capital
growth, the rate of technical growth is highly dependent on
the rate of savings and investment, since savings and
investment are necessary to engage in research and
development.
Understanding Economic Growth

• Another way to generate economic growth is to grow the

labor force. All else equal, more workers generate more
economic goods and services. During the 19th century, a
portion of the robust U.S. economic growth was due to a
high influx of cheap, productive immigrant labor.
• Like capital driven growth however, there are some key
conditions to this process.
Understanding Economic Growth

• Increasing the labor force also necessarily increases the

amount of output that must be consumed in order to provide
for the basic subsistence of the new workers, so the new
workers need to be at least productive enough to offset this
and not be net consumers.
• Also just like additions to capital, it is important for the right
type of workers to flow to the right jobs in the right places in
combination with the right types of complementary capital
goods in order to realize their productive potential.
Understanding Economic Growth

• The last method is increases in human capital. This means

laborers become more skilled at their crafts, raising their
productivity through skills training, trial and error, or simply
more practice.
• Savings, investment, and specialization are the most
consistent and easily controlled methods.
Understanding Economic Growth

• Human capital in this context can also refer to social and

institutional capital; behavioral tendencies toward higher
social trust and reciprocity and political or economic
innovations like improved protections for property rights are
in effect types of human capital that can increase the
productivity of the economy.
The Neoclassical
Counterrevolution: Market
Fundamentalism
• The 1980s resurgence of neoclassical free-market
oricentation toward development problems and policies,
counter to the interventionist dependence revolution of the
1970s.
The Neoclassical
Counterrevolution: Market
Fundamentalism
• The neoliberals argue that by permitting competitive free
markets to flourish, privatizing state-owned enterprises,
promoting free trade and export expansion, welcoming
investors from developed countries, and eliminating the
plethora of government regulations and price distortions in
factor, product, and financial markets, both economic
efficiency and economic growth will be stimulated.
Free markets
• The system whereby prices of commodities or services freely
rise or fall when the buyer’s demand for them rises or falls or
the seller’s supply of them decreases or increases.

• The neoclassical counterrevolution can be divided into three

component approaches: the free-market approach, the public-
choice (or “new political economy”) approach, and the
“market-friendly” approach. F
Free-market analysis
• Free-market analysis argues that markets alone are efficient—
product markets provide the best signals for investments in
new activities; labor markets respond to these new industries
in appropriate ways; producers know best what to produce and
how to produce it efficiently; and product and factor prices
reflect accurate scarcity values of goods and resources now
and in the future.
Public-choice theory
• Public-choice theory, also known as the new political
economy approach, goes even further to argue that
governments can do (virtually) nothing right.
• This is because public-choice theory assumes that politicians,
bureaucrats, citizens, and states act solely from a self-
interested perspective, using their power and the authority of
government for their own selfish ends.
Market-friendly approach

• This approach recognizes that there are many imperfections

in developing-country product and factor markets and that
governments do have a key role to play in facilitating the
operation of markets through “nonselective” (market-friendly)
interventions— for example, by investing in physical and
social infrastructure, health care facilities, and educational
institutions, and by providing a suitable climate for private
enterprise. T
Market-friendly approach

• The market-friendly approach also differs from the free-market

and public-choice schools of thought by accepting the notion
that market failures are more widespread in developing
countries in areas such as investment coordination and
environmental outcomes.
• Moreover, phenomena such as missing and incomplete
information, externalities in skill creation and learning, and
economies of scale in production are also endemic to markets
in developing countries. I
Solow neoclassical growth model
• Another cornerstone of the neoclassical free-market argument
is the assertion that liberalization (opening up) of national
markets draws additional domestic and foreign investment
and thus increases the rate of capital accumulation.
• The Solow neoclassical growth model in particular
represented the seminal contribution to the neoclassical
theory of growth and later earned Robert Solow the Nobel
Prize in economics.
Solow neoclassical growth model
• The Solow neoclassical growth model implies that economies
will converge to the same level of income per worker
“conditionally”—that is, other things equal, particularly savings
rates, depreciation, labor force growth, and productivity.
• According to traditional neoclassical growth theory, output
growth results from one or more of three factors: increases in
labor quantity and quality (through population growth and
education), increases in capital (through saving and
investment), and improvements in technology
Closed economy
•

Open economy
•
Endogenous Growth Theory
• The mixed performance of neoclassical theories in
illuminating the sources of long-term economic growth has
led to dissatisfaction with traditional growth theory. In fact,
according to traditional theory, there is no intrinsic
characteristic of economies that causes them to grow over
extended periods of time.
Endogenous Growth Theory
• In the absence of external “shocks” or technological change,
which is not explained in the neoclassical model, all
economies will converge to zero growth. Hence, rising per
capita GNI is considered a temporary phenomenon resulting
from a change in technology or a short-term equilibrating
process in which an economy approaches its long-run
equilibrium.
Endogenous Growth Theory
• Any increases in GNI that cannot be attributed to short-term
adjustments in stocks of either labor or capital are ascribed
to a third category, commonly referred to as the Solow
residual. This residual is responsible for roughly 50% of
historical growth in the industrialized nations.
• Solow residual. The proportion of long-term economic
growth not explained by growth in labor or capital and
therefore assigned primarily to exogenous technological
change
Endogenous Growth Theory
• Economic growth generated by factors within the production
process (e.g., increasing returns or induced technological
change) that are studied as part of a growth model.
Criticisms of Endogenous
Growth Theory
• An important shortcoming of the new growth theory is that it
remains dependent on a number of traditional neoclassical
assumptions that are often inappropriate for developing
economies.
• For example, it assumes that there is but a single sector of
production or that all sectors are symmetrical. This does not
permit the crucial growth-generating reallocation of labor
and capital among the sectors that are transformed during
the process of structural change.