Transcript Neo classical theory of development

The neoclassical growth model, also known as the Solow–Swan growth
model or exogenous growth model, is a class of economic models of
long-run economic growth set within the framework of neoclassical
economics. Neoclassical growth models attempt to explain long run
economic growth by looking at productivity, capital accumulation,
population growth and technological progress. The neo-classical model
was an extension to the 1946 Harrod–Domar model that included a new
term: productivity growth. Important contributions to the model came from
the work done by Robert Solow and T.W. Swan who independently
developed relatively simple growth models. Solow's model fitted available
data on US economic growth with some success. In 1987, Solow received
the Nobel Prize in Economics for his work.
Robert solow
T.W.Swan
The key assumption of the neoclassical growth model is that capital is
subject to diminishing returns in a closed economy.
Given a fixed stock of labor, the impact on output of the last unit of
capital accumulated will always be less than the one before.
Assuming for simplicity no technological progress or labor force
growth, diminishing returns implies that at some point the amount of
new capital produced is only just enough to make up for the amount
of existing capital lost due to depreciation. At this point, because of
the assumptions of no technological progress or labor force growth,
the economy ceases to grow.
Assuming non-zero rates of labor growth complicates matters
somewhat, but the basic logic still applies – in the short-run the rate
of growth slows as diminishing returns take effect and the economy
converges to a constant "steady-state" rate of growth (that is, no
economic growth per-capita).
Including non-zero technological progress is very similar to the
assumption of non-zero workforce growth, in terms of "effective
According to solow, net investment refers to the rate of
increase in capital stock and is denoted by K’. The
proportion of real income saved is denoted by ‘s’ and
is regarded as constant. The rate of saving , therefore,
would b Sy. The basic identity between saving and
investment can be expressed as
K’= Sy
...(1)
Production is function of two factors i.e. capital (K)
and labour (L) or
Y = F(K,L)
…(2)
Solow assumes that composite product with multiple
use is produced in the economy A part of it is saved
and invested. Substituting the value of Y in (1) it
becomes
Equation (3) represents the supply side of the
system. Solow’s demand side is represented by
L(t) = Lo ent
...(4)
In this equation, L(T) represents the number of
workers employed in ‘t’ period of time. Lo implies the
level of employment or number of workers employed
in initial period of time. N represents the growth of
labour at a constant exogenous rate. The right hand
side of equation (4) implies that labour force
expands at exponential rate n from initial period to
the ‘t’ period of time. By substituting the value of L(t)
in equation (3), it can be expressed as
K’ = sF(K, Lo ent)
...(5)
Solow regards equation (5) as the basic equation as it
helps in determining the volume of capital stock
Graphical representation of the model
The model starts with a neoclassical production function Y/L = F(K/L),
rearranged to y = f(k), which is the red curve on the graph. (Errata: The graph
on the right should probably have a k rather than a K as the variable on the
horizontal axis and a y as the variable on the vertical axis) From the
production function; output per worker is a function of capital per worker. The
production function assumes diminishing returns to capital in this model, as
denoted by the slope of the production function.
n = population growth rate
δ = depreciation
k = capital per worker
y = output/income per worker
L = labor force
s = saving rate
Capital per worker change is determined by
three variables:
Investment (saving) per worker
Population growth, increasing population
decreases the level of capital per worker.
Depreciation – capital stock declines as it
depreciates.
When sy > (n + δ)k, in other words, when the savings rate is greater
than the population growth rate plus the depreciation rate, when the
green line is above the black line on the graph, then capital (k) per
worker is increasing, this is known as capital deepening. Where
capital is increasing at a rate only enough to keep pace with
population increase and depreciation it is known as capital widening.
The curves intersect at point A, the "steady state". At the steady state,
output per worker is constant. However total output is growing at the
rate of n, the rate of population growth.
The optimal savings rate is called the golden rule savings rate and is
derived below. In a typical Cobb–Douglas production function the
golden rule savings rate is alpha.
Left of point A, point k1 for example, the saving per worker is greater
than the amount needed to maintain a steady level of capital, so
capital per worker increases. There is capital deepening from y1 to y0,
and thus output per worker increases.
Right of point A where sy < (n + δ)k, point k2 for example, capital per
worker is falling, as investment is not enough to combat population
growth and depreciation. Therefore output per worker falls from y2 to
y0.
The model and changes in the saving rate
The graph is very similar to the above, however, it now has a second
savings function s1y, the blue curve. It demonstrates that an increase in
the saving rate shifts the function up. Saving per worker is now greater
than population growth
plus depreciation, so capital
accumulation increases, shifting
the steady state from point A to B.
As can be seen on the graph,
output per worker
correspondingly moves from y0 to
y1. Initially the economy expands
faster, but eventually goes back to
the steady state rate of growth
which equals n. There is now
permanently higher
capital and productivity per worker,
but economic growth is the same as
before the savings increase.
The model and changes in population
This graph is again very similar to the first one,
however, the population growth rate has now
increased from n to n1, this introduces a new capital
widening line (n1 + δ)
Solow-Swan, or neoclassical, growth model,
implies countries converge to steady state GDP
per worker (if no growth in technology)
if countries have same steady states, poorer
countries grow faster and ‘converge’
call this classical convergence or ‘convergence to
steady state in Solow model’
changes in savings ratio causes “level effect”,
but no long run growth effect
higher labour force growth, ceteris paribus,
implies lower GDP per worker
Golden rule: economies can over- or undersave
Criticisms of the
model
Empirical
evidence offers mixed support for
the model. Limitations of the model include
its failure to take account of entrepreneurship
(which may be a catalyst behind economic
growth) and strength of institutions (which
facilitate economic growth). In addition, it
does not explain how or why technological
progress occurs. This failing has led to the
development of endogenous growth theory,
which endigenizes technological progress
and/or knowledge accumulation