Theory of Economic Growth

Economic growth actually has many theories but only few theories which are famous among the economist. Some of those theories are bellow:

       1.      Classical Growth Theory

       2.      Harrod - Domar Growth Model

       3.      New Endogenous Growth Model

Classical Growth Theory

This theory was presented by four famous economists. They are Adam Smith, Thomas Malthus, David Ricardo and Karl Marx. Adam Smith became famous by his theory of labor division, Thomas Malthus became famous because of his theory related to food supply and population, then David Ricardo became famous because of his book related to political economy and Karl Marx became a famous economist because of his theory of socialism. But all those three economist were judged as Pessimist Economist except Adam Smith, because they predicted that in future will be a decreasing in return of investment (negative future). But although Adam Smith believed that there will be development of economy in future but after passage of time there will be also decrease in return on investment.

The major preoccupations of this classical model were macroeconomic issues of the growth and the distribution of income between wages and profits. Those four economists have different views in order to explain this classical growth theory. Let’s start elaborate that theory firstly from Adam Smith who has positive view of development in future and then explain the theory of the pessimist of economists.

Adam Smith

He was a professor of model philosophy and he wrote two famous book ‘The Theory of Model Sentiments’ and ‘an Inquiry into The Nature and The Cost of Wealth of Nations’. In his theory he believed that there will be development and increasing return in the future. According to him increasing return can be lead by the efficient division of labor or specialization in labor. Then growth of output depends on investment and capital accumulation further depends on saving which generated by industry and agriculture. And those two factors depend on degree of labor specialization and this specialization determines the level of productivity. If the labor is efficient, increasing in return will occur. Increasing in return can be attained from industrial activities while decreasing return caused by land base activities such as agriculture and mining because the land is fixed.

Adam Smith purposed three points on the sources of increasing in return on the basis of labor division. First point is Increasing the dexterity which related by working experience of the labor. Second point is related to saving of time which can make efficient of time in order to produce more and more goods. And the last point is about new modern invention of technology which can increase the efficiency of production then finally provoke more investment to the economy. 

Thomas Malthus

            He was very famous because of his essay on principle of population in 1798. According to him demand must grow in line with productive potential, because if population goes on doubling every twenty five years or increase in geometrical ratio but food production only grows in arithmetic ratio, this implies decreasing return in agriculture. The imbalance between population growth and food supply will lead to the per capita income of countries oscillating the subsistence level. Any increases in per capita income will increase more birth rate then finally will reduce per capita income back to subsistence level.

David Ricardo

            He wrote a book ‘Principle of Political Economy and Taxation’ in 1817. He said that there will be a time when the capitalist will end up in a stationary state due to diminishing return in agriculture. Further he explained that growth and development depend on capital accumulation, and capital accumulation depends on reinvested profit. But profits are squeezing between subsistence wages and the payment rent to the land lord which can increase the cost food price. If food price increase the labors will demand more wage to them then finally the farmer will loss the profit or diminishing in return. So he gave a solution to avoid a stationary state by keeping the price in low level. But still there were a problem of his solution, if the price keep in low level so the revenue will be decrease then the wage of labor will decrease then finally the profit will also decrease.

Karl Marx

            He wrote a famous book ‘Das Kapital’ in 1867 which contained his prediction of collapse of capitalism. According to him capital surplus is sources of capital accumulation and it leads to higher growth rate then the population wage keep wages down and finally it will cause decrease in profit. Marx established Marx Model, which wage of labor determine at subsistence minimum level and the surplus value is difference between output per worker and the minimum wage per worker, the surplus of value is given by s/v. if an economy become more and more capital intensive then capital over variable of capital will increase over the period of time and then the rate of profit will fall until unless the surplus value raises. Again according to him, he does not have any problem in increase in capital until unless the surplus labor exist to keep wages down, but he predicted that as capital accumulation increase, the reserve army of labor will decrease which will lead to increase in wages and finally profit will decrease then in the future there will be no investment.

            In conclusion he said capitalism will collapse through decline in rate of profit and immiseration of workers leading to social revolution and there will be break down in economy. The capitalism will collapse because of its inner contradictions.

Harrod – Domar Growth Model

Harrod and Domar were two different economists and they have different objectives and approaches but they come up with same result. 

Harrod Model

His model was actually the extension of Keynesian dynamic static model which the equilibrium of income and output will occur when plant to invest equal to plant to save. Actually Harrod had questions about Keynesian model and later these questions became the base of Harrod model.

Questions of Harrod:

      1.     If changes in income induce investment then what must be the rate of growth which will make sure plan to invest equal to plant to save for moving constant equilibrium?

      2.      What is guarantee that is growth rate will prevail?

      3.      If this growth rate does not prevail then what will happen?

      4.      If growth equilibrium disturb then will it be self correcting?

      5.      Will this equilibrium gives the maximum rate of growth that an economy can attain by given capital?    

   

Then to give answer of those basic questions Harrod distinguish three different model of growth rate:

     1.      Actual Growth Rate

He defined it as (g=s/C) where ‘s’ is equal to ratio of saving to national income or MPs = S/Y. ‘C’ is equal to actual incremental capital output ratio. So further he denote the function as (g = change in Y divided by Y)

     2.      Warranted Growth Rate

Actually this is the model which is made due to his worried about actual growth rate whether it will keep the plan to invest and plan to save in line with full employment or not. So the warranted growth rate is that the rate which if occur will leave all parties satisfied that they have produced neither more nor less than right amount or the state metal. Simply warranted growth is that which will induced in investment to match the plans to save, so capital remain fully employed then there will be no under or over employed.

            He determine the warranted growth rate as (gw = s/Cr) where Cr is require amount of capital to produce unit flow of output at given rate of interest. He used this equation was actually to attain the PPF (Productivity Possible Frontier).

 3.      Natural Growth Rate

Still there is a problem in warranted growth rate so he offered this natural growth rate. If warranted growth rate can attain PPF or full utilization of capital stocks, still there is no guarantee that is there full employment of labor or not. So this natural growth rate derive from this function (Y*=L*.[Y/L]*). Then by taking first derivative the function of growth become (Y*=L + q). So this growth rate plays two important roles in Harrod model. Firstly it defines the long run equilibrium if the economy at full employment level. Secondly it solves the problem of short term trade cycle in Harrod model by setting upper limit for actual growth. 

Dommar Countribution for this Growth Model

            Actually Domar only gave small contribution in overall Harrod-Domar Model so some economists named the Harrod-Domar Model only Harrod Model. According to Domar the investment works through two channels. First is increase in demand through multiply effect and second is investment increase the supply by expanding the productive capacity. So here Domar asked a question that what rate of growth of investment must be prevail in order for supply to grow in line with demand? Then Domar explained that the rate of growth has crucial rate of growth of investment described as [change in Yd = change in I divided by s] and [change in Ys = I into Sigma]. So in equilibrium D = S the function become [change in I/s = I x Sigma] or [change in I/I = s x Sigma]. Simply in other word it explains investment must grow at a rate equal to the saving ratio and the productivity of capital. With constant savings-investments ratio (equilibrium), this also implies output growth at the rate s into Sigma. If Sigma = 1/Cr at full employment then this function will be equal to Harrod Model (change in Y/Y = s/Cr). So this is the result of Domar model which have same result with Harrod model.

New Endogenous Growth Model

            Since the mid-1980s there were many research and outpouring of literatures which related to development on the applied economic growth, explain the difference in the rate of output growth and per capita income growth. Then later it called as new growth theory or endogenous growth theory. This model was pioneered by Robert Lucas in 1988 and Paul Romer in 1986. There are assumed to be positive externalities associated with human capital formation (education and training) and research and development that prevent the marginal product of capital from falling and the capital output ratio rising. Here there is a function (Y = A . K^alpha), where K is a composite measure of capital (i.e. physical capital plus other types of reproducible capital), and alpha is 1. As Martin (1995) put it, the global absence of diminishing return may seem unrealistic, but the idea become more reasonable if we think of K in sense to include human capital. It can be seen from the function of the capital, (K/Y = K/L . L/Y). So anything that raises the productivity of labor (Y/L) in the same portion as K/L will keep the capital-output ratio constant. Learning by doing and embodied technical progress as well as technological spillovers from trade and FDI, are other possibilities in addition to education and research and development. Then finally all those factors will prevent the marginal product of capital from falling and keep the capital output ratio constant.