December 11, 2011

Theory of Economic Growth

Theory of Adam Smith

Adam started with the golden age where only Labor is the important factor. Nature which is represented by Land in economics is plentiful and is not a consideration. In such an company every items trades at prices to proportional to the amount of labor that is needed to produce. If labor doubles output also double as nature is not a constraint. Real wages will hold steady. If any invention increases labor productivity, real wages will rise.

Scarce Land
The next development of the theory is that as population expands, land will become scarce due to limited supply. More labor will work on the same land and hence marginal output will fall. Landowning class emerges, and they will pay subsistence wages to workers. Malthus reasoned that whenever wages were above subsistence, population would expand and drive down wages. As wages go below subsistence level, mortality and will increase and population will decline.

Neoclassical Growth Model

Neoclassical growth accepts the fixed amount of land, but now the growth drivers are labor, capital and technological progress. If capital increases relative to labor, labor productivity will increase. Capital is the great variety of durable tangible goods used to make other goods. For modeling purpose, it is assumed to be homogeneous and total capital is approximated by constant dollar value of capital stock in an economy.

Capital deepening occurs when the supply of capital grows more rapidly than the labor force. In the absence of technological change, capital deepening will produce a growth of output per worker, of the marginal product of labor, and of wages;
As capital deepening goes on occurring,  it will lead to diminishing returns on capital and a consequent decline in the real interest rate till there is no incentive to create further capital. This theory prophesies a better living condition for the masses in contrast to the limited land held by landlords theory.

In history or economic history, we witnessed technological progress whereby capital produced by the same inputs is giving more units of output in combination with the same amount of labor. Hence, capital productivity increases and labor productivity also increases and wages expand in the presence of technological progress.

Growth accouting

Growth in out can be decomposed into three separate sources, growth in labor, growth in capital and technological progress.


Paul Samuelson and William D. Nordhaus, Economics, 13th Edition, McGraw-Hill, 1989

Updated 23.12.2012


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