The Classical Growth Theory postulates that a country’s economic growth will decrease with an increasing population and limited resources. Such a postulation is an implication of the belief of classical growth theory economists who think that a temporary increase in real GDP per person inevitably leads to a population explosion, which would limit a nation’s resources, consequently lowering real GDP. As a result, the country’s economic growth will start to slow.

Structural Model

In the chart above, the y-axis represents total production, and the x-axis represents labor. Curve OW outlines the total subsistence wages. If the level of population (labor) is ON, and the level of output is OP, the per capita wage is represented by NR. Consequently, the surplus or profit is RG.

Because of the surplus, the capital formation process comes into effect. Consequently, the demand for labor increases, leading to a rise in total wages, as the curve moves to GH. If the total population remains constant at ON, and wages exceed subsistence wages, i.e., NG > NR, then total population or total manpower will increase as the curve moves toward OM. Because of the increase in population, surplus can be generated.

In such a manner, the process will continue until the economy reaches point E, as depicted by the arrow. Point E represents a stationary situation wherein wages and total output equalize, and no surplus can be generated. However, according to classical economists, with technological progress the production function will shift upward, as depicted by the curve TP2. Also, according to the Classical Growth Theory, economic stagnation can be postponed, although ultimately not avoided.

Limitations of the Classical Growth Model

Ignorance with respect to technology: The classical model of growth ignores the role efficient technical progress could play for the smooth running of an economy. Advancements in technology can minimize diminishing returns.

Inaccurate determination of total wages: The classical model of growth assumes that total wages do not exceed or fall below the subsistence level. However, this is not entirely true. Changes in the industrial structure and substantial economic development can result in total wages exceeding or falling below the subsistence level. Moreover, the classical theory of growth does not consider the role played by trade unions in the process of wage determination.

2. Neoclassical Growth Model

The Neoclassical Growth Theory is an economic model of growth that outlines how a steady economic growth rate results when three economic forces come into play: labor, capital, and technology. The simplest and most popular version of the Neoclassical Growth Model is the Solow-Swan Growth Model.

The theory postulates that short-term economic equilibrium is a result of varying amounts of labor and capital that play a vital role in the production process. The theory argues that technological change significantly influences the overall functioning of an economy. Neoclassical growth theory outlines the three factors necessary for a growing economy. However, the theory puts emphasis on its claim that temporary, or short-term equilibrium, is different from long-term equilibrium and does not require any of the three factors.

Production Function in the Neoclassical Growth Model

The Neoclassical Growth Model claims that capital accumulation in an economy, and how people make use of it, is important for determining economic growth.

It further claims that the relationship between capital and labor in an economy determines its total output. Finally, the theory states that technology augments labor productivity, increasing the total output through increased efficiency of labor. Therefore, the production function of the neoclassical growth model is used to measure the economic growth and equilibrium of an economy. The general production function in the neoclassical growth model takes the following form:

Also, because of the dynamic relationship between labor and technology, an economy’s production function is often re-stated as Y = F (K, AL). This states that technology is labor augmenting and that workers’ productivity depends on the level of technology.

Assumptions of the Neoclassical Growth Model

Capital subject to diminishing returns: An important assumption of the neoclassical growth model is that capital (K) is subject to diminishing returns provided the economy is a closed economy.

Impact on total output: Provided that labor is fixed or constant, the impact on the total output of the last unit of the capital accumulated will always be less than the one before.

Steady state of the economy: In the short term, the rate of growth slows down as diminishing returns take effect, and the economy converts into a “steady-state” economy, where the economy is steady, or in other words, in a relatively constant state.

Key Conclusions of the Neoclassical Model of Growth

Output as a function of growth: The neoclassical growth model explicates that total output is a function of economic growth in factor inputs, capital, labor, and technological progress.

Growth rate of output in a steady-state equilibrium: The growth rate of total output in a steady-state equilibrium is equal to the growth rate of the population or labor force and is never influenced by the rate of savings.

Increased steady-state per capita income level: While the rate of savings does not influence the steady-state economy growth rate of total output, it does result in an increase in the steady-state level of per capita income and, therefore, total income as well, as it raises the total capital per head.

Long-term growth rate: The long-term growth rate of an economy is solely determined by technological progress or regress.

3. Endogenous Growth Theory

The Endogenous Growth Theory states that economic growth is generated internally in the economy, i.e., through endogenous forces, and not through exogenous ones. The theory contrasts with the neoclassical growth model, which claims that external factors such as technological progress, etc. are the main sources of economic growth.

Key Policy Implications of Endogenous Growth Theory

Governmental policies can raise an economy’s growth rate if the policies are directed toward enforcing more market competition and helping stimulate innovation in products and processes.

There are increasing returns to scale from capital investment in the “knowledge industries” of education, health, and telecommunications.

Private sector investment in R&D is a vital source of technological progress for the economy.

Additional Resources

Thank you for reading CFI’s guide to the Theories of Growth. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

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