Growth theories

  1. Classical Growth Theory
    • Temporary GDP Per Person Growth
    • Sudden Increase in Population
    • Run Out of Resources
    • Goes Back to Subsistence Level
  2. Neoclassical Growth Theory
    • Technological change is by chance
    • Rapid advance in technology   \,   \, more saving and investment
    • Low/Halt in technology   \,   \, less saving and investment
    • Diminishing marginal return to capital
  3. New Growth Theory
    • Technological change is not by chance
    • Firms   \,   \, need to produce goods at lower cost
    • Inventors   \,   \, need to research/discover more
    • Incentive to Earn More Profit   \,   \, Growth Never Stops
  4. Policies to Reacher Faster Growth
    • Encourage Savings
    • Encourage Research and Development
    • Encourage International Trade
    • Encourage International Aid to Developing Nations
    • Encourage Improvement in Quality of Education
Topic Notes

We will be looking at three theories of economic growth:
  1. Classical Growth Theory
  2. Neoclassical Growth Theory
  3. New Growth Theory

Classical Growth Theory

Classical Growth Theory is the idea that growth rate of GDP per person is only temporary. Once it increases above a subsistence level, then a sudden increase in population size will bring it back to that level.

Note: subsistence level is the standard of living that provides only the bare necessities of life.

Why is this the case?

If there are sudden increase in population sizes, then we will eventually run out of resources for everyone. This means the standard of living (real GDP per person) must decrease and we will start to live in a lower standard of living than before.

Neoclassical Growth Theory

Neoclassical Growth Theory is the idea that real GDP per person grows because technological advances causes saving and investment, which in return make capital per hour of labor increase.

Why is this the case? Assume that technological advances are by chance.

When there is a rapid advance in technology, businesses expand, and new businesses are made to play around with the new profitable technologies. In this case, investments and savings increase, thus capital per hour of labor increase, and real GDP per person increases and continues to growth.

However, when the advances in technology are slowed or at a halt, the opposite happens. Since we had high investments and savings to begin with, we have a high rate of capital accumulation. With a high rate of capital accumulation, more projects are undertaken which gives lower return (diminishing marginal return to capital). When firms see that they are not making a high return like before, they investment less, and so the rate of capital accumulation decreases. In the end, the capital accumulation is slowed enough that it only keeps up with population growth.

New Growth Theory

New Growth Theory is the idea that real GDP per person grows because of the choices people make for profit. Growth will happen endlessly.

Unlike the neoclassical growth theory, advances in technology is not by chance. It varies on whether people are looking for new technology and how much effort they are putting to look for it. Profit is what causes technological advances.

Competition of firms eventually causes firms to break-even. So in order to increase profit, they must either sell a better product and sell at a higher price, or find a method to produce goods at a lower cost.

Inventors can earn profit for years by taking out a patent or a copyright. However, once a new discovery is made, they will stop earning profit. This forces them to do more research and discover something new again to earn more profits.

In addition, when more and more new discoveries are made, we gain more knowledge. Knowledge is a public good that everyone can access and can make labor and machines more productive.

If there is an incentive to earn more profit and incentive to discover, growth never stops.

Policies to Reach Faster Growth

From last section, we know that in order to have faster economic growth, we must have physical capital growth, human capital growth, and technological advances.

To achieve this, we must
  1. Encourage saving: saving will increase economic growth.
  2. Encourage research and development: Since basic inventions can be copied, inventors’ profits are very minimal, therefore not much activity happens for research and development. Therefore, we can get the government to direct their public funds towards financing basic research.
  3. Encourage International Trade: trading with others stimulate economic growth. Generally, the richer the nation, the less reluctant they are to international trade. However, fast-growing nations are most open to trade.
  4. Encourage international aid to developing nations: If rich countries provide financial aid to developing countries, then investment and growth will increase. However, it doesn’t seem to be the case since research has shown that effects of aid show that the growth to next to 0 or negative.
  5. Encourage improvement in quality of education: When we improve basic education in language, mathematics, and science, the nation’s growth potential is higher.