Unit Three

3
Classic, Neoclassical and New Theories
of Economic Growth and Development
Instructor : Badassa W.(PhD)
 The classical (Harro-Domar) growth model

 HDM is based on the assertion that every economy

must save a certain proportion to its national income to
replace worn-out or impaired capital goods (buildings,
equipment, and materials)
 Finance new investments representing net additions to
the capital stock that is required to bring about growth
in GDP

2
 The classical(Harro-Domar) growth model

 Any net additions to the capital stock in the form of

new investment financed from saving will bring about
corresponding increases in the flow of national output
 This relationship between the K stock and total GNP is
known incremental capital output ratio (ICOR).

3
 The classical(Harro-Domar) growth model

 The HDM is outlined as follows

Yt = total output at time t
Ct = consumption at time t
St = saving at time t
It = investment at time t
 In a closed economy, total output is the sum of
consumption and saving (income side)
 Yt = Ct + St …………………………….(1)
 Total output is defined as the sum of consumption and
investment Yt = Ct + It …………………………….(2)

4
 The classical(Harrod Harro-Domar) growth model

From (1) and (2) above

St = It …………………………………..(3)
The accumulation of capital stock
=> Kt + 1 = Kt – δKt + It
=> Kt + 1 = (1 – δ)Kt + It …………………..(4)
δ = the rate of depreciation
Kt = capital stock at time t (current period)
Kt + 1 = capital stock at time next period
s = St / Yt => St = sYt ………………..(5)
θ = Kt /Yt => Kt = θYt ………………..(6)
where s is saving rate and θ is ICOR 5
 The classical(Harrod Harro-Domar) growth model

From (3), (4), (5), and (6) above, we get

=> (Yt + 1 – Yt) / Yt = (s - δ θ)/ θ
=> g = (s/ θ) - δ ...……………………….. (7)
 s/ θ = g + δ ……………………………. (8)
 Equation (8) is known as Harrod-Domar growth
equation
 The policy implication of the model is that growth of
GDP can be raised by pushing up saving rate.
 Note that for an open economy, policy options related to
overseas borrowing and foreign investment can be
considered in case it faces financial gap i.e. difference
between required saving and actual saving 6
 Criticisms of HDM

1. Though necessary conditions, investment and saving

are not sufficient conditions for economic growth. We
need some kind of skills and managerial capacity to
transform the potentials of capital investment (saving)
into growth in GDP.
2. There is no consideration for population and
demographic explosion.
3. In reality, saving rate and ICOR are not as exogenous as
treated in HDM. Specifically, since in the real world we
are likely to encounter diminishing returns to scale,
ICOR cannot be a fixed parameter as assumed in the
model
7
 Solow growth model

 Expanded on Harrod-Domar by adding a second factor,

labor, and introducing a third independent variable,
technology, to the growth equation.
 Unlike the fixed-coefficient, constant-returns-to-scale
assumption of the HDM, it exhibited diminishing returns to
labor and capital separately and constant returns to both
factors jointly. This implies that θ is not fixed, rather it
depends on the economy-wide relative endowment of
capital and labor whereby it is small when labor is plenty
relative to capital and vice versa.
 Assumes technology as a variable whose level is
determined exogenously, that is, independently of all
other factors, and technological progress is absent
8
 Solow growth model

 Let production function of the economy is given by

Y  f(K, P)  AK α P 1-α
where :
α is such that 0    1
 K is capital and P is working population
 A is a measure of efficiency of both K and P i.e. it shows total
factor productivity. A simply represents level of technology.
 A doesn’t grow i.e., there is no technological progress and P
grows at a rate of n.

9
 Solow growth model

 Dividing the whole by P we get

α
Y AK α P 1-α K
  A 
P P P
 y  Ak α  f(k) .........................................................................................(9)
where y and k represent per capita income and capital per worker respectively and f ' (k)  0 and
f '' (k)  0. The equation y  Ak α  f(k) states that output per worker is a function that depends
on the amount of capital per worker. The more capital with which each worker has to work, the
more output that worker can produce.

10
 Solow growth model

 Recall From equation (3), (4), and (5) of HDM that

=> Kt + 1 = (1 – δ)Kt + sYt
=> Kt + 1 - Kt = sYt - δKt
=> ΔKt = sYt - δKt ………………………………………… (10)

11
 Solow growth model

 Equation (10) states that the total capital stock grows when
savings are greater than depreciation.
 As the labor force (P) grows at the rate n per year, the change
in capital per worker (k) is given by:
=> Δkt = syt – (δ + n)kt
=> Δkt = sAkαt – (δ + n)kt ………………………………...(11)
 Equation (11) states that capital per worker grows when
savings are greater than what is needed to equip new
workers with the same amount of capital as existing workers
have.

12
 Solow growth model

 Consider a state in which output and capital per worker are

not changing. This state is known as steady state. To find
this steady state, set Δkt = 0. That is:
Δkt = syt - (δ + n)kt = 0
sAk t = (δ + n)kt
1
 As  1
k*   
  n
 where k* means the level of capital per worker when the
economy is in its steady state. Here we note that k* is a
constant function. If per capita capital stock converges to k*,
then the per capita income will be y* where

13
 Solow growth model

 Note that at the steady state, capital-labor ratio (k) and thus
per capita income (y) are constant in the long run.
 The above equilibrium (steady state) can be seen from the
following figure
f(k)=Akα

(n + δ)k

y* sf(k)= sAkα

k* k
14
 Solow growth model

 The capital per worker k* represents the steady state.

 If k is higher or lower than k*, the economy will return to it;
thus k* is a stable equilibrium.
 This stability is seen in the diagram by noting that to the left
of k*, k < k* and to the right of k*, k > k*
 In this case, (n + δ)k < sf(k); and when this happens Δkt > 0
and thus k in the economy is growing toward the
equilibrium point k*.
 What happens to k if it is initially to the right of k*.

15
 Solow growth model

 Now, let’s see how the change in s, n, and δ affect the steady
state using simple derivatives.
 And then we will deal with the same issue using graphs.
 If we increase the rate of savings s a temporary increase in
the rate of per capita output growth is realized.
 But, change in s doesn’t affect the long run growth rate of k*
and y* because after the economy has time to adjust, the
capital-labor ratio increases, and so does the output-labor
ratio, but not their rate of growth.

16
 Solow growth model

 But, the effect of change in the rate of saving on the level of

capital per person at steady state is positive.
 Since capital per person and per capita income are positively
related to each other, we conclude that change in the rate of
saving on the level of per capita income at steady state is also
positive.
 The key implication is that, unlike Harrod-Domar analysis,
in the Solow model an increase in s will not increase growth
in the long run; it will only increase the equilibrium level of k
and y.

17
Solow growth model

18
 Solow growth model

 An Increase in the s implies that the amount of investment for

any given capital stock is higher.
 It therefore shifts the saving function upward. At the initial
steady state k1 *, investment now exceeds depreciation.
 The capital stock rises until the economy reaches a new steady
state k2 * with more capital and output.

19
International Evidence on Investment Rates and
Income per Person

20
 Solow growth model

 The changes in n and δ again don’t affect the growth of

k* and y* for the same reason given above.
 But they too affect the level of these steady state
variables as shown below.

dk *
 
1
1
 As(  n) 2 1 0
d 1
dk *
 
1
1
 As(  n) 2 1 0
dn 1

21
International Evidence on Population Growth
and Income per Person

22
 Solow growth model

 Thus, the effect of change in the rate of growth of population

and rate of depreciation on the level of capital per person
and thus on per capita income at steady state is negative.
 Next, let’s see how the change in s, n, and δ affect the steady
state using graphs.

f(k)=Akα

(n + δ)k
s'f(k)= s'Akα

y**
y* sf(k)= sAkα

k* k** 23
 Solow growth model

 The graph shows that an increase in s to s' leads to an

increase in k and y from k* and y* to k** and y**
respectively.
 Thus a change in s has a positive impact on the level of
k* and y*.
f(k)=Akα

(n' + δ)k

(n + δ)k

y* sf(k)= sAkα

y**

k* k** 24
 Solow growth model

 The above diagram shows that an increase/decrease in rate

of population growth to n' leads to a decline/rise in per
capita capital stock and per capita national income. A change
in δ has similar effect.
 As discussed above, when the economy is at its steady state
per capita capital and per capita income don’t grow or
simply the rate of growth of capital per worker and per
capita income is zero.
 What about the total capital stock and national income? Both
grow at the rate of population growth.

25
 Solow growth model

1
K  As  1
Recall k *
  
P   n
1
 As  1
 K   P
  n
1  As 
 log( K )  log   log P
1   n
 d log( K )  d log( P )
dK dP
   n
K P

Y  As  1
Recall y*   A 
P   n

 As  1
 Y  A  P
  n
  As 
 log(Y )  log( A)  log   log P
1   n
 d log(Y )  d log( P )
dY dP
  n
Y P

26
 Solow growth model

 Implication of the model are

1) There is a steady state level of per capita capital and per
capita national income to which the economy converges.
2) Saving rate doesn’t have a rate effect; in fact, this simple
Solow model predicts that there is no per capita growth in
the long-run.
3) However, it has a level effect in that it affects the level of k
and y.
4) This is due to Solow’s heroic assumption of absence of
technological progress.

27
 Solow growth model

 Regardless of the initial per capita income and capital

per worker, according to Solow model, countries with
the same level of s, n, and δ will converge to the same
level of living standard or per capita income (PCI).
 This is known as convergence hypothesis.
 The empirical support for Solow’s claim of convergence
of PCI of countries to the same steady state is weak.

28
 Conclusion on HDM and Solow Model

 In HDM, the ratio of capital to output is constant and in the

Solow model it increases as per capita increases because of
the diminishing marginal returns to capital.
 Theoretical predictions of HDM and Solow model :
Parameters such s do have rate effect in HDM but only level
effect in Solow model
 Unlike HDM, Solow model predicts convergence between
per capita income of countries given that they the same s, n,
etc.

29
 Problems with the neoclassical theory of
development

1. Primary problem: Markets are efficient but not

necessarily equitable
2. Problem of market failures ignored
- widespread externalities ;
- barriers to economies of scale
- market power ;
- multinational corporations
- subsistence producers (not participating in market
economy)
- lack of information; profit maximization may be low
priority 30
 Problems with the neoclassical theory of
development

3. Much growth not accounted for by growth in labor or

capital stock
- The Solow Residual: Increases in GNP not accounted for by
adjustments in L or K stock attributed to some "residual”.
- The residual is the result of unexplained exogenous process
of technological progress
- Large % of historical growth not explained
- Determinants of the technical progress undefined
- Large differences in residuals across countries

31
 Technical progress in the Solow model

 We introduce a new variable: E = labor efficiency

 Assume:
Technological progress is labor-augmenting: it
increases labor efficiency at the exogenous rate g:
E
g
E

slide 32
 Technical progress in the Solow model

 We now write the production function as:

Y  F (K , L  E )
 where L  E = the number of effective
workers.
– Hence, increases in labor efficiency have the
same effect on output as increases in the
labor force.

slide 33
 Technical progress in the Solow model

 Notation:
y = Y/LE = output per effective worker
k = K/LE = capital per effective worker
 Production function per effective worker:
y = f(k)
 Saving and investment per effective worker:
s y = s f(k)

slide 34
 Tech. progress in the Solow model

 ( + n + g)k = break-even investment:

the amount of investment necessary
to keep k constant. Where:
  k to replace depreciating capital
 n k to provide capital for new workers
 g k to provide capital for the new “effective”
workers created by technological progress

slide 35
 Technical progress in the Solow model

k = s f(k)  ( +n +g)k
Actual
Investment,
( +n +g ) k
break-even
investment sf(k)

k*
Capital per worker, k
slide 36
 The Golden Rule

To find the Golden Rule capital stock,

express c* in terms of k*: In the Golden
c* = y*  i* Rule Steady State,
the marginal
= f (k* )  ( + n + g) k* product of capital
net of depreciation
c* is maximized when
equals the
MPK =  + n + g population growth
or equivalently, rate plus the rate of
technical progress.
MPK   = n + g

slide 37
 Evaluating the Rate of Saving

 To evaluate saving, we need to compare

(MPK   ) to (n + g ).
 If (MPK   ) > (n + g ), then the economy is below
the Golden Rule steady state and there is a need to
increase s.
 If (MPK   ) < (n + g ), the economy is above the
Golden Rule steady state and there is a need to
reduce s.

slide 38
 Endogenous Growth Theory

 Solow model:
 sustained growth in living standards is due to
technical progress
 the rate of tech progress is exogenous
 Endogenous growth theory:
 a set of models in which the growth rate of
productivity and living standards is
endogenous

slide 39
 A basic model

 Production function: Y = A K
where A is the amount of output for each unit
of capital (A is exogenous & constant)
 Key difference between this model & Solow:
MPK is constant here, diminishes in Solow
 Investment: sY
 Depreciation:  K
 Equation of motion for total capital:
K*=sY K

slide 40
 A basic model

K = s Y   K
 Divide through by K and use Y = A K to get:
Y K
  sA  
Y K
 If s A > , then income will grow forever,
and investment is the “engine of growth.”
 Here, the permanent growth rate depends
on s. In Solow model, it does not.

slide 41
 Does capital have diminishing returns or not?

 Yes, if “capital” is narrowly defined

(plant & equipment).
 Perhaps not, with a broad definition of
“capital” (physical & human capital,
knowledge).
 Some economists believe that knowledge
exhibits increasing returns.

slide 42
 A two-sector model

 Two sectors:
 manufacturing firms produce goods
 research universities produce knowledge that
increases labor efficiency in manufacturing
 u = fraction of labor in research
(u is exogenous)
 Manufactured goods production function:
Y = F [K, (1-u )EL]
 Knowledge production function: E * = g (u)E
 Cap accumulation: K* = s Y   K
slide 43
 A two-sector model

 In the steady state, manufacturing output per

worker and the standard of living grow at rate
E/E = g (u ).
 Key variables:
s: affects the level of income, but not its growth
rate (same as in Solow model)
u: affects level and growth rate of income
 Question: Would an increase in u be
unambiguously good for the economy?

slide 44
 Three facts about R&D in the real world

1. Much research is done by firms seeking profits.

2. Firms profit from research because
• new inventions can be patented, creating a stream
of monopoly profits until the patent expires
• there is an advantage to being the first firm on
the market with a new product
3. Innovation produces externalities that reduce
the cost of subsequent innovation .
 Much of the new endogenous growth theory attempts to
incorporate these facts into models to better understand
tech progress.
slide 45
 Is the private sector doing enough R&D?

 The existence of positive externalities in the

creation of knowledge suggests that the
private sector is not doing enough R&D.
 But, there is much duplication of R&D effort
among competing firms.
 Estimates: The social return to R&D is at
least 40% per year. Thus, many believe
government should encourage R&D

slide 46
 Encouraging technological progress

 Patent laws:
encourage innovation by granting temporary
monopolies to inventors of new products
 Tax incentives for R&D (knowledge production)
 Grants to fund basic research at universities
 Industrial policy:
encourage specific industries that are key for
rapid technical progress

slide 47
 Summary main points

1. Key results from Solow model with tech progress

 steady state growth rate of income per person
depends solely on the exogenous rate of tech
progress
2. Ways to increase the saving rate
 increase public saving (reduce budget deficit)
 tax incentives for private saving
3. Endogenous growth theory: models that examine the
determinants of the rate of technical progress, which
Solow takes as given explain decisions that determine
the creation of knowledge through R&D

slide 48