Chapter One

CLASSICAL GROWTH THEORY:

ADAM SMITH,
DAVID RICARDO
&
THOMAS MALTHUS
Modern Economics
Begins from here.
Development Economics
R P Pradhan
BITS Pilani, K K Birla Goa Campus
Focus!

To understand the respective perspectives of classical economists

on the ideas, issues & problem of economic growth.

 Adam Smith
 David Ricardo
 Thomas Malthus
 Classical Growth Theory (a synthesis of Smith & Ricardo’s
perspectives) + Malthusian Views

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 Mercantilism was Adam Smith-
the prevailing
 Wealth of World is
Economic Notion
Unlimited
 Wealth of Nations
 They can be
were believed to
created
be limited.
 End of
 Extortion & Export
Mercantilism
led Economy was
method to
 Beginning of Free
Economic Growth
Market Economy
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 Adam Smith - Collectively the individuals in Production
society, each acting in his or her own self-
interest, manage to produce ------
Consumption
 & purchase the goods and services that they
as a society require ------
Self Regulation

 He called the mechanism by which this self- Phenomena of

regulation occurs “the invisible hand,” Equilibrium

Invisible Hand
 His book, ‘Nature & Causes of The Wealth of
Nations’, published in 1776, the year of Emergence of
America's Declaration of Independence. Market
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 What Adam Smith Proposed?
 Essentially, the butcher, the baker, and the candlestick
Marginal
maker individually go about their business. Revolution
S
 Each produces the amount of meat, bread, and candlesticks
he judges to be correct – Producers or Supply Line

 On the other hand, each consumer buys the amount of

meat, bread, and candlesticks that his household needs –
D
Consumers or Demand Line
1oo Years later
 And all of this happens without their consulting one it became
another or without all the king's men telling them how Marginal
much to produce. Revolution in
 In other words, it's the free market economy in action.
Economics
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 In making this observation, Smith founded what is
known as classical economics.

 The key doctrine of classical economics is that ----

Market
1. laissez-faire attitude by government toward the
market place which will allow the “invisible hand” to
guide everyone in their economic endeavors,
2. Create the greatest goods for the greatest number of
people,
3. & generate economic growth.
Origin of
Classical
 Smith also delved into the dynamics of the labor Economics
market, wealth accumulation, and productivity
growth.
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Classical Growth Theory
Background

 Classical Economists were products They included:

of the European Enlightenment
and shared an intellectual concern  Adam Smith,
for human progress.  David Ricardo,
 Thomas Malthus,
 They were concerned with the  Karl Marx,
problem of economic growth: its  Jean-Baptiste Say,
sources, forms and effects.
 John Stuart Mill

 The purpose of their analysis was among others.

to identify the forces in society
which foster or impede progress.
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Adam Smith:
Classical Growth Theory & Approach
Adam Smith (first) identifies the main factors of
production: i.e. Land, Labour and Capital.

Thereafter, Smith tries to analyse how these interact

with one another to generate economic growth.-

Interface

Y=ʄ(K, L,N or T)
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So output is related to labor and capital and land inputs.

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Measuring Real National Income
 Smith’s measure of national wealth was -------
“command over labor,”

Mercantilism VS.
Classical Growth
Approach
 Defined as the amount of labor that output can buy

Example
(if there is $100 of gross product (Y)
and the wage rate (w) = $5,
then there are Y/w = 20 units of labor Commanded)

 Effectively, this made the employed labor force his

measure of national wealth Y/w=N (national wealth)

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 Smith’s Methodology
 To appreciate Adam Smith’s Smith argues that
final growth process & economic growth takes
methodology, we examine his place because of the
growth variables/ components,
occurrence of a
which provided the foundation
of the theory. phenomenon called ------

 These are Adam Smith's Increasing Returns to

Production Function / & process of Scale (IRS)
growth of labour force /and capital wherein output is greater
accumulation in the economy.
than the amount invested-
Notion of Investment

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 Adam Smith identified 03
major sources of growth:

1. Growth in the L & stock of K.

2. Improvement in the efficiency

with which K is used in L
through greater division of
labour and technological
progress(i.e. N or T Efficiency)

3. Promotion of foreign trade

widens the market and
reinforces the other two
sources of growth.

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How does IRS Work?
Smith identifies two sectors in
the economy: i.e.
 Incentive to maximise profit gives
rise to a process of capital Agriculture & Industry
accumulation (saving &
investments or K Formation)  Emphasizes that the law of
IRS is more applied to
 which gives rise to division of Industry due to repeated
labour(Specialisation) through improvements through the
which labour productivity is use of technology &
enhanced
division of labour.
 thus generating greater output per
 IRS does not work in
unit of investment.
Agriculture
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Implication for under-developed countries?
Why some
 It can be inferred that one of the causes of economic countries are
differentiation is because some countries are Poor & Others
predominantly agrarian where the DRS (Diminishing are Rich?
Return to Scale) applies while others are industrial where
IRS applies.
 At the core of the economic growth process is the process of K
accumulation or K Surplus (savings and investments)

 which acts as the stimulant for division of labour and create the
Development impetus for inventing new technologies.
Method

 Also argued that K accumulation affected population growth &

shall affect Wage & Productivity.
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How?
 capital accumulation leads to increased demand for labour


& wages would increase (beyond subsistence)
Higher Wages will stimulate population increase.
K+
 The resultant increase in the supply of labour would once again
depress wages (to subsistence)
+W
 Thus achieving equilibrium where population growth would once
again be stagnant.
L+
However +P
 The productivity of labour is determined by the extent of the
market.
-W
 Which is the reason why Smith advocated free domestic & Int.
Trade.

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BITS Pilani, K K Birla Goa Campus
 Smith proposes three potential limits to
economic growth:

1. Insufficient supply of labour (low possibility/ Unlikely

to happen)
2. Exhaustion of natural resources (he also gave a low
Are there limits possibility)
to economic 3. Decline in the motive of K accumulation -
growth? (Savings) as a result of declines in the rate of profit,
which could happen because of:

(a) Competition among capitalists or

(b) Increase in Wages – Investor Profit shall
decline
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However!

 Even if the rate of profit were

to decline------
Smith by & large had an
optimistic vision of the
 Smith felt that new investment economy believing that if
opportunities would again
stimulate profits at all, the economy would
reach stagnation, it would
 & therefore economic growth
would continue.
be a long way off.

Foundation for Modern Economics; Source of Economic

Growth & Challenges are established from Smith’s
analogy to be refined later…
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David Ricardo

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 Principles of Political Economy
and Taxation -1817

1. Ricardo analyzed the laws determining

the distribution of everything that
could be produced by the “three
classes of the community”
2. Namely landlords workers David Ricardo -English political
economist. He was one of the most
the owners of K influential of the classical
economists, along with Thomas
Findings- Malthus, Adam Smith, and James
 concludes that profits vary inversely with Mill
wages
 Rent tends to increase as population grows
 Comparative Advantage Theory

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 David Ricardo

 Ricardo accepts much of Adam Smith’s analysis, for e.g. Ricardo’s production
function is similar to Smith’s but with the addition of Technology.

 However the major approach difference from Smith is that, Ricardo’s production
function is subject to Diminishing Returns to Scale (DRS).

How?
• Ricardo first accepts that the Industrial sector is subject to the law of IRS as a
result of division of labour (specialization) and through the application of
technologies which enhance productivity.

• BUT he then points out that land is fixed in supply (land is inelastic to demand)
and as capital accumulates which also leads to the expansion in population
there is increasing pressure on land and this eventually negatively affects profits.

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 Consequence: cyclical Stages of Growth
1. With an increase in population, there is increased demand for
food which means demand for land increases. Factor Productivity
Decline leading to
2. Overtime, once the fertile lands are exhausted, less and less stationary stage of
fertile land is brought under-cultivation (marginal land). Economic Growth

3. Now agricultural production reaches a stage where for  Thus the

every unit invested in it, less and less units of output are combination of
produced (DRS). factors subject to IRS
with factors subject
4. This implies that a- cost of food increases as a result of which---- to DRS leads
------- eventually to a
5. wages increase (below which labour will not be able to
stationary stage
reproduce itself)
characterized by no
surplus formation
6. This means that the rate of producers profit declines & when
this happens continually, it reaches a point where the incentive and zero population
to invest is lost. growth.
7. This results in a stationary stage.
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  Ricardo suggested that technology progress has a
tendency to put off the stationary stage by
preventing declines in profits.

 Thus capital accumulation would continue BUT

However:
Change not indefinitely. Ultimately DRS would negatively
Scenario -1 work on growth. – Tech too has limitations

• Differs with Smith - While Smith views the

development of technology as endogenous
(within) to capital accumulation, Ricardo sees
technology as being developed independently and
subsequently applied to production.
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 The stationary stage is not reached directly but there are many
intermediate stationary phases.
However: How?
Change  Progress gets interrupted at short intervals by temporary
equilibrium; e.g. this happens when wages stabilize at
Scenario - 2 subsistence levels, the population does not grow but surplus
does not fall to ‘zero’

 and thus capital accumulation continues and this induces new

investments and demand for labour, thus giving impetus of
population to grow and once this happens a new equilibrium is
reached.

 Important to note that with each successive equilibrium, the

stock of capital increases and the population grows.

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Lessons for Developing Countries?

 In the case of developing countries ----

 who already possess large populations, capital accumulation

would only lead to more population growth
 which would only make matters worse.
 Ricardo thus advocated population control for these countries.

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 Y Progressive Regressive Stationary
Phase Phase Phase
W

Q K
Capital Accumulation

X
O L L1
Employment
 THEORIES OF ECONOMIC GROWTH
These Graphs are only indicative and not to be used in Exams. All graphs in the
Exam have to be as done in the Class. It is a necessary note to all those who do
not attend classes.

Figure 2. shows that with the

wage rate above the
subsistence wage, the
population increases .
1. The supply of labor increases.

2. The wage rate falls.

3. Employment increases.
 THEORIES OF ECONOMIC GROWTH
These Graphs are only indicative and not to be used in Exams. All graphs in the
Exam have to be as done in the Class. It is a necessary note to all those who do
not attend classes.
4. The increase in employment …

5. Increases real GDP.

The increase in population increases

employment and real GDP and lowers the
wage rate and real GDP per hour of work.
These Graphs are only indicative and not to be used in Exams. All graphs in the
Exam have to be as done in the Class. It is a necessary note to all those who do
not attend classes.

– 3.The real
wage rate
rises and
4. The quantity of
labor employed
increases.
 THEORIES OF ECONOMIC GROWTH
Do not use. It is a necessary note to all those
who do not attend classes.
– 3.The real
wage rate
rises and
4. The quantity of
labor employed
increases.
 THEORIES OF ECONOMIC GROWTH
These Graphs are only indicative and not to be used in Exams. All graphs in the
Exam have to be as done in the Class. It is a necessary note to all those who do not
attend classes.
– 5.The
increase in
employme
nt and
6. The increase in
labor productivity
increase real GDP.
 SOURCES OF ECONOMIC GROWTH
These Graphs are only indicative and not to be used in Exams. All graphs in the
Exam have to be as done in the Class. It is a necessary note to all those who do
not attend classes.
shows how labor productivity
grows.
1. An increase in capital per hour of labor
brings a movement along the productivity
curve PC0.

When capital per hour of labor increases

from $30 to $60, real GDP per hour of
labor increases from $20 to $25.
 SOURCES OF ECONOMIC GROWTH
These Graphs are only indicative and not to be used in Exams. All graphs in the
Exam have to be as done in the Class. It is a necessary note to all those who do
not attend classes.
2. An increase in human capital and/or a
technological advance shift the productivity
curve upward from PC0 to PC1.

With this increase in human capital and/or

technological advance, real GDP per hour of
labor increases from $20 to $25 when there is
$30 of capital per hour of labor and from $25
to $32 when there is $60 of capital per hour of
labor.
 THEORIES OF ECONOMIC GROWTH
These Graphs are only indicative and not to be used in Exams. All graphs in the
Exam have to be as done in the Class. It is a necessary note to all those who do
not attend classes.
Figure 10.3 shows classical growth
theory.

1. The economy starts at point A on

productivity curve PC0 with real GDP at
the subsistence level and the
population constant.

2. As capital per hour of labor

increases, real GDP per person rises
above the subsistence level—the
economy moves to point B.
 THEORIES OF ECONOMIC GROWTH
These Graphs are only indicative and not to be used in Exams. All graphs in the
Exam have to be as done in the Class. It is a necessary note to all those who do
not attend classes.
3. As technological advance (and
human capital accumulate) increase
productivity,the productivity curve
shifts upward to PC1—the economy
moves to C.

4. With real GDP above the

subsistence level, the population
grows and capital per hour of labor
decreases downward along PC1.
 THEORIES OF ECONOMIC GROWTH

5. At point D, the economy is

back at the subsistence level of
real GDP per hour of labor.

These Graphs are only

indicative and not to be used in
Exams. All graphs in the Exam
have to be as done in the Class.
It is a necessary note to all
those who do not attend
classes.
 Y Progressive Regressive Stationary
Phase Phase Phase
W

Q K
Capital Accumulation

X
O L L1
Employment
Thomas Malthus 1766-1834
Thomas Robert Malthus
was an English cleric,
scholar and influential
economist in the fields of
political economy and
demography.

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 Thomas Malthus
Context!
 Malthus is best known for his theory of population.

 Argues that while food increases in arithmetic proportions,

population increases in geometric proportions.

 Leading to a crisis situation.

 Unless preventive checks control the population, positive checks

will come into play to depress population growth.

 However Malthus also had a theory on the role of effective demand

on economic growth.
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 Role of
 Malthus disagreed with Smith and Ricardo that Demand for
savings automatically resulted in investments Economic
and he also rejected Say’s law that supply
Growth
creates its own demand.

 By doing this he went against the view of the

day that supply of inputs (N, L, K, S) was the Disagrees with
sole determinant of growth of output.
Smith, Ricardo
& Say’s role of
 Instead he focused on the role of demand for
Supply
economic growth.

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 Malthus argued that if an economy is to continue growing then Effective
Demand (defined as both the willingness and ability to spend/consume) plays
a critical role.

Y=R+W How?
(Y= National Income; & R = profits and W = wages)

R=Y–W I= Investments,
Cc = Consumption
R = (I + Cc + Cw) – Cw, by capitalists
W = Cw since workers spend close to all Cw = consumption
their wages on consumption. by workers

R = I + Cc (shows that profits depend on Investments and

Consumption expenditure)
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 When saving are converted into investments, profits can
increase and the economy grows
 On the other hand, he also showed that excessive savings can
stall economic growth.----------- Case Japan’s Surplus K Now

How?

 The economy can reach a stage where investment

opportunities dry up.

 At this stage saving will only aggravate the situation because it

will result in reduced consumption (declining effective
demand) which would result in economic stagnation.
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• Malthus then connects role of effective demand on
economic growth to analyse the relationship between
the agricultural and industrial sectors in fostering
economic growth.
How? Industry
 He recognizes that the two sectors affect &
each other for e.g. Industries demand Agriculture
agricultural products (namely food which create
needs to feed an industrial labour force). Mutual
Demand
 Besides, agricultural labour force demand
many of the products of the industrial sector.
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 In this way he analyzed that the two sectors demand each other’s
products (provide inputs to each other and act as markets for
each other’s goods)- Mutuality

 Therefore the two must develop simultaneously for each

sector to progress.

 If this does not happen then there is a problem of Dualism –

 Means where the economy has one modern sector and another
traditional sector which ultimately stalls the process of economic
growth.
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Lessons for Developing countries?

 In this way he makes the point that limited

effective demand in a less developed country
can prevent the development of both
industrial and agricultural sectors. Classical
Theory of
Economists combined the insights of Adam Economic
Smith, David Ricardo & Malthus (because of
a number of similarities & over lapping areas
Growth
in their approaches) & put forth the Classical
theory of economic growth.

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Classical Growth Theory: Summary

Savings through
According to the theory, an economy grows ---
Higher Wages
1. primarily because of the process of K
Accumulation (savings through higher wages) Leads to
Investments
2. which results in investments in technological Leads to Tech/
progress (division of labour & new inventions) Labour
Specialization
3. which in turn results in greater productivity (IRS)
and greater capital accumulation. Results in greater
productivity (IRS) &
4. In this manner growth perpetuates.
greater K formation.
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 However economic growth This occurs in phases:
induces population growth
1. Phase 1: when there are IRS,
 which in turn puts pressure on 2. Phase 2: when there are DRS,
land (a fixed factor of production) 3. Phase 3: when there are
which is subject to DRS.
diminishing average returns &
4. Phase 4: when there are
 As a result the rate of profit
begins to fall
diminishing total returns.

Important to note that the

 which eventually results in a state
stationary state is not a situation
of stagnation where no further
capital accumulation is possible of underdevelopment but
and population does not grow. essentially a mature economy.
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 (Criticisms & appraisal)
 Populations in developed countries have shown that they
have stabilized after initial growth.

Criticism
 Technological innovations in agriculture have permitted
food supplies to sustain large populations.

 Rightly pointed to the importance of capital accumulation

to the growth process.
Appraisal
 Important insights about the inter-sectoral relationship
between agriculture and industry (that the growth of
industry depends on the development of agriculture).

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 Four Assignments
1. Wage Increase Leading to Productivity & GDP Growth. (5 Candidates Team)
Task- First time rise of Wage (Formal & Informal) in Industrial Revolution Countries &
their Impact on Productivity & GDP.

2. Wage Increase Leading to Productivity & GDP Growth: Case of India. (5 Candidates
Team).

3. Economies must Shift from Agriculture to Industrial Sector & both Agriculture &
Industry must simultaneously grow to take advantage of IRS. Indentify
Countries/Cluster of Countries that adopted this & Map their Implication on
Productivity & GDP Growth. Clusters can be – a- South East Asia; China; India; Japan;
South Korea; EU or any other Country or Cluster

4. Mapping of Middle Income Trap Countries Today- 5 Candidates

Submission Method: Pure Empirical Work. Total 5 Pages of Data; Graphs & Findings
only. Data & Graphs have to be given Source.
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 REFERENCES

 Misra, S. K. and Puri, V. K. (2010), ‘The Classical Theories of Growth and Stagnation’,
in Development and Planning: Theory and Practices, 13th ed. Himalaya Publishing
House Pvt. Ltd. Mumbai, pp. 97-109.

 Thirlwall, A. P. (2006) ‘Classical Growth Theory’ in Growth and Development with

Special Reference to Developing Economies. 8th ed. Hampshire: Palgrave Macmillan,
pp. 123 – 129.

 Kurz, H. D. & Salvadori, N. (2003) ‘Theories of Economic Growth: Old and New’ in
The Theory of Economic Growth: A ‘Classical’ Perspective, Salvadori, N. (ed.),
Cheltenham, Edward Elgar, pp. 1 – 22.

 Meier, G. M. & Rauch, J. E. (2000) ‘Comment I.C.1: Classical Growth Theory’ in

Leading Issues in Economic Development. 7th ed. New York: OUP, pp. 76 – 77.

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