Capital Expansion, Rate of Growth, and Employment Author(s): Evsey D. Domar Source: Econometrica, Vol. 14, No. 2 (Apr.

, 1946), pp. 137-147 Published by: The Econometric Society Stable URL: http://www.jstor.org/stable/1905364 . Accessed: 12/04/2011 18:01
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CAPITAL EXPANSION, RATE OF GROWTH, AND EMPLOYMENT'

By EVSEY D. DOMAR
I. INTRODUCTION

Thispaperdealswith a problem thatis bothold and new-the relaIn economic tionbetween andemployment. accumulation capital literature ithasbeendiscussed a number oftimes, themost notable contributo Marx.Morerecently, tionbelonging it wasbrought forth byKeynes and hisfollowers. A thorough ofeconomic analysis aspectsof capitalaccumulation is a tremendous theproblem canbe examined job. The onlywayin which at all in a short it from thegeneral paperlikethisis by isolating ecoand introducing nomic structure a number ofsimplifying assumptions. Some of themare not entirely necessary and, as the argument prowillsee howtheycan be modified gresses, thereader or removed. The following assumptions and definitions shouldbe notedat the is a constant outset:(a) there general pricelevel; (b) no lags are presand investment to theincome refer ofthesameperiod; ent; (c) savings (d) bothare net,i.e., overand above depreciation; (e) depreciation is measured notin respect to historical costs,but to the costofreplacementof the depreciated asset by another one of thesameproductive capacity;2 (f) productive ofan assetor ofthewholeeconomy capacity is a measurable concept. The last assumption, on which(e) also depends, is notentirely safe. a certain Whether or thewholeeconomy pieceofcapitalequipment is their considered, productive capacities depend notonlyonphysical and technical but on thewholeinterplay ofeconomic factors, and institutionalforces, such as distribution of income, consumers' preferences,
1 This is a summary of a paper presented beforea joint sessionof the Econometric Societyand the American StatisticalAssociation in Clevelandon January 24, 1946. It containsthe logical essence of the argumentwith relativelylittle economicdetail. I hope to developthe latterin a separatepaper to be published in one of the othereconomicjournals. Many thanksforhelp and criticism go to my fellowmembersof the "Little Seminar": Paul Baran, Svend Laursen,Lloyd A. Metzler,RichardA. Musgrave, Mary S. Painter,Melvin W. Reder,Tibor de Scitovszky, Alfred Sherrard, Mary Wise Smelker,MerlinSmelker, and mostof all to JamesS. Duesenberry. 2 If the original machineworth$1,000 and producing 100 unitsis replacedby anotherone worthalso $1,000, but producing120 units, only $833.33 will be regardedas replacement, and the remaining $166.67 as new investment. A similar correction is made whenthe new machinecostsmoreor less than the original one. The treatment of depreciation, when accompaniedby sharp particularly technological and price changes,presentsan extremely difficult problem.It is quite possible that our approach, while convenient forpresentpurposes,may give rise to seriousdifficulties in the future.

137

138

EVSEY D. DOMAR

ofindustry, and so on, manyof wagerates,relative prices, structure analyzed of the variables whichare in turnaffected by the behavior assumeall theseconditions as givenand here.We shallnevertheless capacity ofan economy (or an asset)its shallmeanby theproductive these factors arefully employed under totaloutput when all productive conditions.3 willbe said to be in equilibrium whenits productive The economy P equals its national incomeY. Our first taskis to discover capacity ormore under canbe maintained, theconditions which thisequilibrium inorder at which theeconomy must expand precisely, therateofgrowth in a continuous to remain stateoffullemployment.
II. THE PROBLEM OF GROWTH

in a capitalist The idea that the preservation of fullemployment oranother) a growing income goesback (in oneform economy requires studies in numerous at least to Marx. It has been fullyrecognized of and elsewhere) of the magnitude (recently made in Washington But full employment. grossnational productneeded to maintain thevariousauthorscometo different numerical results, they though theirproblem all approach from the pointof view of the size of the The laborforce and its productivity laborforce. (man-hours worked) and if to increase or another, to one formula according are supposed is to be maintained, fullemployment nationalincomemustgrowat thisis a rate.For practical short-run thecombined relatively purposes butitsanalytical becauseit presents merits arenothigh, goodmethod, in laborforce or a theoretically sincean increase incomplete system: in its productivity capacityand does not by onlyraisesproductive the to that produced by investment), itself generate income(similar side oftheequationis missing. Nor is the difficulty demand disposed increase ofby Mr. Kalecki'smethod to which according capitalshould As in laborforce and its productivity.4 proportionally to the increase of in productivity wellremarked, Mrs.Robinson "The rateofincrease is nota by Nature."6 Laborproductivity laboris notsomething given of technological in the abstract, but technological function progress in capitalgoods, and theamount ofcapitalgoodsin progress embodied
3 It should undoubtedly of be possibleto workout a moreprecisedefinition to leave the matteropen,because a morepreproductivecapacity,but I prefer necessaryin this paper and can be workedout as is not entirely cise definition and whenneeded. 4 See his essay, "Three Ways to Full Employment" in The Economics of Full by Stimulating 1944,p. 47, and also his "Full Employment Oxford, Employment, EconomicPapers, March, 1945,pp. 83-92. in Oxford Private Investment?" 5 See herreviewof The Economics Vol. Journal, Economic ofFull Employment, 55, April,1945,p. 79.

CAPITAL

EXPANSION,

RATE OF GROWTH,

AND EMPLOYMENT

139

inEven without capitalaccumulation technological progress, general. at least to a certain point,bothbecause creaseslabor productivity, in each industry and becausethere morecapitalis usedperworkman is a shift oflaborto industries thatuse morecapitaland can afford to bycapitalaccumis affected paya higher wage.So iflaborproductivity should at thesamerateas thatthelatter theformula proceed ulation, inlaborforce) is notas helpful as it aptheformer (and as theincrease pears. us withanytools system doesnotprovide The standard Keynesian rateofgrowth. The problem ofgrowth is theequilibrium forderiving it becauseoftheexplicit thatemployabsent assumption from entirely can be justified ment is a function ofnational income. Thisassumption of time;it willresult in serious errors overa onlyovershort periods a full-employment level of incomeof periodof a fewyears.Clearly, today.Weshall considerable unemployment five years agowould create ratioofnational inassume instead is a function employment ofthe that cometo productive Whilethisapproachseemsto me to be capacity. to thatof Keynes, it shouldbe lookeduponas a secondapsuperior solution: it doesnotallowus toseparate proximation rather thana final and idle men; depending unusedcapacityinto idle machines upon to capacity thesameratioofincome various mayyield circumstances, different oflaborforce employed. fractions an instruin the Keynesian is merely system Because investment mentforgenerating income, the system does not take into account and well-known factthatinvesttheextremely essential, elementary, This dual character of the mentalso increases capacity.6 productive rate of investment processmakes the approachto the equilibrium promising: if (capital)pointofviewmore growth from theinvestment and generates income, bothincreases productive capacity investment ofwhich may sidesoftheequation thesolution it provides us with both yieldtherequired rateofgrowth. at therateI peryear,and let theratioof Let investment proceed netvalue added (after thepotential i.e., oftheproducdepreciation), in them, ofthenewprojects to capitalinvested tivecapacity i.e., to oftheseprojects output I, be indicated by s.? The netannualpotential ofthewhole willthen econcapacity be equal to Is. But theproductive
6 Whether a capaoityis essentially everydollarinvestedincreasesproductive taken as a wholecermatterof definition. It can safelybe said that investment hold in regardto residentialhousing, imtainly does. To make this statement puted rentshould be includedin the nationalincome.See also note 19. 7 The use ofthe word"project" does not implythat investment is done by the I am using"project" or thatit is alwaysmade in newundertakings. government, can mean the act ofinvest(in the absenceof a betterterm)because investment ing and the resultof the act.

140

EVSEY D. DOMAR

becausetheoperation ofthese omymayincrease by a smaller amount, oflabor(and other factors) from newprojects mayinvolve a transfer We shall is therefore reduced.8 other plants, whose productive capacity
as definea-,the potential social averageinvestment productivity dP dt

(1)

The following characteristics ofo-shouldbe noted: factors ofproduction and tech1. Its use doesnotimply thatother its magnitude depends to a nology remain constant. On thecontrary, on technological It wouldbe morecorrect verygreatextent progress. in capacity rather refers to an increase which accompanies to saythatothanone which is causedby investment. capacity. Whether or notthis 2. o-refers to theincrease in potential in a larger income depends on the behavior potential increase results ofmoney expenditures. in productive capacityof the 3. o-is concerned withthe increase from and not or return derived expected whole society, with therateof in distribuodirectly by changes investment. Therefore is notaffected tionofincome. them between 4. s is themaximum thata-can attain.The difference willdependon the magnitude on the one of the rate of investment suchas labor, natural resources, hand,and thegrowth ofother factors, and technological on the other.A misdirection ofinvestment progress willalso produce a difference s and o-. between We shallmaketheheroic thats and a are constant. assumption From(1) it follows that dP (2) I. dt It is important dP/dt is a function of to notethat,witha giveno-, or negative, dP/dtis I, and not of dI/dt.Whether dI/dtis positive so longas a and I are positive. alwayspositive in productive capacity is essenExpression (2) showing theincrease sideofoursystem. On thedemand sidewe have the tiallythesupply too familiar exceptforan multiplier theory, to need any comment, on theobvious factthatwithanygiven emphasis but often forgotten we havethesimple that constant,9 relationship
notof I, butof dI/dt. marginalpropensity to save, dY/dtis a function themarginal it to be Indicating propensity to save bya, and assuming

8 I am disregarding the externaleconomies and diseconomiesof the older plants due to the operationof the new projects. ' Overthe period1879-1941the averagepropensity to save (ratioofnetcapital

CAPITAL

EXPANSION,

RATE OF GROWTH,

AND EMPLOYMENT

141

(3)=__

dY dt

dI 1 dt a

Let theeconomy be in an equilibrium position so that10

(4) Po = Yo. dP dt dY dt dl 1

To retain theequilibrium position, we musthave

Substituting (2) and (3) into(5) we obtainourfundamental equation (X6) thesolution ofwhich gives
(7) I
=

- -,

dt a

Ioeaat.

percent,theequilibrium rateofgrowth willbe some3.6 percentper lOa year. The reader a and afis willnowsee thatthe assumption ofconstant notentirely necessary, and thatthewhole problem can be worked out a and a. withvariable

themaintenance offull employment requires investment to growat a constantcompound-interest rate. If, as a crudeestimate, a is takenat 12 per centand a-at some30

ao-is theequilibrium rateofgrowth. So longas it remains constant,

formation to nationalincome) was fairlyconstantand approximately equal to some 12 per cent. See Simon Kuznets, National ProductSince 1869, National Bureau of EconomicResearch (mimeographed, 1945) p. II-89 and the Survey of Current Business,Vol. 22, May, 1942, and Vol. 24, April,1944. In a problemof cyclicalcharacter, an assumption ofa constant propensity to save wouldbe very bad. Since we are interested herein a secularproblem of continuous fullemployment,this assumption is not too dangerous. 10 The problem can be also workedout forthe case whenPO> YO. lOa After this paper was sent to the printer, I founda veryinteresting article by E. H. Stern,"Capital Requirements in Progressive Economies,"Economica, Vol. 12, August,1945, pp. 163-171, in whichthe relationbetweencapital and outputin the U. S. during 1879-1929is expressed(in billions ofdollars)as capital =3.274 income-3.55. My estimatesgave roughlysimilarresults.This would place s around30 per cent,thoughthisfigure shouldbe raisedto accountforthe underutilization of capital duringa part of that period.It is also not clear how the junkingprocess(see p. 144) was reflected in thesefigures. The averagerate ofgrowth of real nationalincomeoverthe period1879-1941 was some 3.3 per cent. See Table V, p. 818, and AppendixB, pp. 826-827,in my paper,"The 'Burden'ofthe Debt and the National Income," American Economic Vol. 34, December,1944. Review,

142
III.

EVSEY

D. DOMAR OF GROWTH

THE EFFECTS

We shall considerfirstthe special simple case a-= s, and then the more generalcase when -<8s.11 = s. SinceI = oert,capital, Case 1: abeing thesumofall netinvest-

Ournextproblem is to explore whathappens when does investment grow at someconstant percentage rater,which, however, is notnecessarily equal to theequilibrium rateac-. It willbe necessary to introduce two additionalconcepts:average propensity to save IIY and the averageratioof productive capacity to capitalP/K. To simplify the problem, we shallassume that 1. IIY= a, so thataverage to save is equal to marginal. propensity 2. P/K=s, i.e., the ratioof productive capacityto capitalforthe wholeeconomy is equal to thatofthenewinvestment projects.

ments, equals
(8)

K =Ko + IoJ

rt

ertdt = Ko

+-

10

~~~~r

(ert-1).

As t becomes K willapproach large, theexpression

(9)
-

ert,

so thatcapitalwillalso growat a rateapproaching r. As Y= (l/a)Ioert, theratioofincome to capitalis

Y
.
-

1
a

Ioert

(10)

and
t(11

Ko +-(ert-1) r
limgoo

Thus so long as r and a remainconstant (or changein the same proportion) no "deepening"of capital takes place. This, roughly speaking, was thesituation in theUnitedStatesoverthelast seventy yearsor so prior to thiswar.
11It is also possiblethat,owingto capital-saving inventions in existing plants, a>s. Formallythis case can be excluded by fallingback on the definition of depreciation givenin note 2. This, however, is not a veryhappy solution,but the approachused in thispaper willhardlyoffer a betterone. I think,however, that a in our societyis sufficiently highto make of>s in a continuous state offull employment morean exceptionthan a rule.

CAPITAL EXPANSION, RATE OF GROWTH, AND EMPLOYMENT

143

Substituting K = P/s into(11) we obtain (12) Y lim-=

t-*O

r
aS

Sincein thepresent case o=s, (13) The expression (14) 0 =r

t- o P

Y r lim-=-*
ao

may be calledthe coefficient of utilization. Whenthe economy grows at theequilibrium rate,so thatr= ao-, 0 = 100percentand productive is fully utilized. capacity But as r fallsbelowao-,a fraction ofcapacity is (1-0) left gradually unused.12 Thusthe failure ofthe economy togrow at the ratecreates required unused capacity and unemployment. Case 2: o-<s. As investment at the rate I, new projects proceeds witha productive capacity ofIs arebuilt.Sincetheproductive capacity ofthe wholeeconomy increases onlyby Io, it follows thatsomewherein the economy (not excluding the new projects)productive capacityis reducedby I(s - o). Therefore everyyear an amountof capitalequal to I(s - o-)/s becomes useless. The problem can nowbe approached from twopointsofview.The amounts I(s-o)/s, can be lookedupon as capitallosses,whichare nottakenintoaccount in calculating income and investment.13 In this case,I stillindicates therateofnetinvestment, and all other symbols retain their old meaning, except thatcapitalhas to be redefined as the integral of investment minuscapital losses: everyyear chunksof capital(overand above depreciation) off and junked.The are written annualaddition to capitalwillthenbe (15) and
(16) K = Ko + Io-f s = Ko + Io -(e't ertdt

~ I- =

dK dt

I(s-) s

= I-, s

Of

sr

- 1).

0 is also a constant.Even 1 It shouldbe notedthat ifr, a, and o are constant, thoughthe economyfails to grow at the requiredrate, the relative disparity betweenits capacity and income does not become wider,because its capital also growsnot at the ao but at the r rate. 18 These losses are not necessarily losses in the accountingsense. See note 14.

144

EVSEY

D. DOMAR

Also,
(17) )K

lim-

-.-,

r s
a

and (18)

Y r lim-=-,
t c P ao

which is exactly thesameresult we had in (13). in treating The second approach consists theamounts I(s - o)/s not as capitallossesbutas a specialallowance Net investfor obsolescence. mentwouldthenhave to be defined notas I, but as IoIs. Other symbols wouldhave to be redefined and the wholeproblem accordingly, couldthenbe reworked outin thesamewayas on pp. 142-143. In a sensethe choicebetween thesetwo methods is a matterof bookkeeping; depending in hand, upon the character of the problem oneortheother I suspect can be used,though thatthesecond method willbe the can easilybecomemisleading. The natureof the process samewhichever method to a difference is used.The factis that,owing s and o-,the construction between ofnewinvestment makes projects certain assets(notexcluding bethenewprojects themselves) useless, in demand, causeunder thenewconditions brought aboutby changes ora risein thewagerates, oftheseassetscannot orboth, theproducts be sold.'4 s and o-is created As stated on p. 140thedifference between either by misdirection of investment orbythelackofbalancebetween thepropensity oflabor,disto save on theone hand,and thegrowth of naturalresources, covery on the other. and technological progress So longas mistakes aremadeorthislackofbalanceexists, thejunking process is inevitable. Froma socialpointof view,thejunking is not necessarily process undesirable. In thiscountry, littlehardship, it where savinginvolves may be perfectly justified. a seriousobstacleto But it may present the achievement of capital of fullemployment, becausethe owners assetsheadedforthejunk pilewilltryto avoid thelosses.So longas theyconfine themselves in theiraccounting no to changes practices, willfollow. specialconsequences But it is morelikelythattheywill theirown contryto accumulate larger reserves either by reducing
14 To be strictly true, the statementin the text would requireconsiderable divisibility of capital assets. In the absence of such divisibility, the expression "junking" shouldnot be taken too literally. The fact that these assets may still be operatedto some extentor that their productsare sold at lower pricesor that both these conditionsexist,does not in real terms, invalidateour argument, because o, beingexpressed willbe higher than it would be if the assets wereleftcompletely unused.

CAPITAL EXPANSION, RATE OF GROWTH, AND EMPLOYMENT

145

because important, men.But unemployed capitalis extremely unemployed a gravedanger to a It presents its presence inhibitsnew investment.'6

lowerwages).As a or by charging higher prices(or paying sumption the to save mayrise.This willbe exactly result, thetotalpropensity whatis neededto avoid the junking process, from opposite measure I am notprepared to lead to greater trouble, though and willofcourse will succeedin passingon these say to what extentcapital owners losses. newinvestment, theywilltry In so faras theyare able to control therateofgrowth may to avoidlossesbypostponing it. Consequently, willdeao-,and unusedcapacity belowtherequired wellbe depressed model doesnotallowus to separate capacity unused velop.Ourpresent most likely bothwillbe present.'" though intoidlecapitalandidlemen, with we are moreconcerned considerations, Becauseofhumanitarian

in a capitalist society. equilibrium full-employment

IV. GUARANTEED GROWTH OF INCOME

In thepreceding thata stateoffullemploysections it was shown ifinvestment and income grow at an annual mentcan be maintained can theargument nowarisesas to whatextent rateao. The question at theao rate;will is guaranteed to grow income be reversed: suppose investment to generate thatcall forth sufficient theneededincome? where investherewitha situation We are concerned spontaneous shifts to changes in technique, madein response ment(i.e.,investment etc.) is notsuffidiscovery ofnewresources, in consumers' preferences, ofinduced and therefore a certain amount investment (madein cient, thearguTo simplify response to a risein income)is also required." investment is absentaltogether. ment, letus assumethatspontaneous is treated from a theoIt shouldalso be madeclearthattheproblem questhenumerous practical without considering retical pointofview, would raise. tions thattheincome guarantee rise If an economy an equilibrium an expected position, starts from equal to Yao/s.As before, in income an investment ofYao willrequire two caseshave to be considered.
15 The presence utilization men may be obscuredby inefficient of unemployed of labor, as in agriculture. 16 It is truethat a givencapital owner may oftenhave a hardtimedistinguishing betweencapital idle because of a<s, and capital idle because of r< aa. The and cannotbe corrected permanent, is relatively kindof idleness,however, first (it is hoped) and is due whilethe second is temporary by greaterexpenditures, policies. to poor fiscaland monetary 17 Cf. Alvin H. Hansen, Fiscal Policy and Business Cycles,New York, 1944, p. 297. Part Three,and particularly

146

EVSEY D. DOMAR

and equilibrium willbe destroyed. The difficulty arises savings because rateofinvestment in thefaceofa u <s makesthe a full-employment whilea mere junkingprocess(discussedon pp. 143-145)inevitable, of a risein income, as a general guarantee rule,lackstheinstrument thecapitalowners to discard to force their equipment. Theywillsimply investYao-Isinsteadof Ya. Onlyifin theeconomy as a wholethere ofproducts is a considerable number the demand forwhich is highly to income, and therefore a goodnumber ofothers elasticwithrespect is negatively for will thedemand which with to income, elastic respect than YaorIs be invested and a corresponding a larger amount amount if therisein income of capitaljunked.Of course, is accompanied by in consumers' the appearanceof new products, shifts preferences, willbe and other thejunking aggressive competition, changes, process do take place theymaygiveriseto speededup, but ifthesechanges investment oftheir ownand theguaranteed riseinincome spontaneous willnotbe important. ofa highand rising Still,theassurance income is undoubtedly one of the best methods forencouraging investment. a substantial s and uf As explained before, difference between simply indicates thatwiththe availablelaborforce and the current progress of technology, the maintenance of fullemployment undera givena requires theaccumulation ofcapitalat a faster ratethanit canbe used. As a ge.neral rule,thisappliesequallywellto bothprivate and public investment, though theremay be special cases when,owingto the ofparticular development consumers' preferences (e.g.,forvacations), or to technological reasons(e.g.,need forpower),or to institutional conditions (as in urbanredevelopment), considerable needforpublic investment stillexists.'9
18 There is a slighterror in the magnitudes in the text because of the use of discontinuous functions. 19As soon as the government in a maze of entersthe picturewe find ourselves definitional problems.From the point of view of this paper, saving and investto the whole economy,includingthe ment should be understoodin reference and not to its privatesectoronly.But whichgovernment government, expendiis presentin the private turesshouldbe regardedas investment? The difficulty in formaldefinitions, sectoras well,exceptthat therewe can take refuge which cannot be well applied to government. I leave the question open. Certainly, need not be limitedto inventories, investment steel,and concrete.

mereguarantee of a rise in income(if taken seriouslyby the investors) investment will actually and income tomaketheguarantee generate enough to a government goodwithout necessarily resorting deficit. 2. If uis appreciably belows, investment willprobably fallshort of

1. If a is equal or reasonably close to s, the resulting amountof investment of Ya willequal thevolumeofsavingsthatwillbe made at thatlevelofincome, and equilibrium willbe maintained.18 Thusa

CAPITAL EXPANSION, RATE OF GROWTH, AND EMPLOYMENT

147

I am not prepared to say whether we alreadyare or shallsoonbe facedwitha serious difference between s and o-,though I doubtthat it was an important in thepast,except problem perhaps fortheshort boomyears. My ownguessis thatwe shallbe more with concerned the ao-and r, thatis withthefailure disparity between ofincome to grow at therequired rate. a-and s becomes If, however, thedifference between andinserious hibitsinvestment, or if the junking process proceeds at a faster rate thanis deemedsocially desirable, thesociety willhave at itsdisposal two methods not mutually exclusive:(1) the reduction of the proto save,or (2) thespeeding pensity up oftechnological I hope progress. thatthemainemphasis willbe placedon thelatter. This paperattempted to analyzethe relation between investment, rate of growth, and employment. The analysiswas carried out on a and simplified abstract very level-a procedure which maybe justified at thebeginning ofan investigation, butwhich mustbe corrected later on. In general, there is no sucha thing as an absolutely good or bad whatmaybe safein one kindof a problem assumption: can become fatalin another. Oftheseveral madehere, thatregarding assumptions is likely to cause thegreatest depreciation but it is by no difficulties, meanstheonlyone. I hopeto developthewholesubjectfurther at a laterdate. The central themeof the paper was therateof growth, a concept whichhas been littleused in economic theory, and in whichI put muchfaithas an extremely usefulinstrument of economic analysis. One does not have to be a Keynesian to believethatemployment is somehow on national dependent and thatnational has income, income to do with something investment. But as soonas investment in, comes growth cannotbe leftout,becauseforan individual firm investment maymeanmore capitaland lesslabor, butfortheeconomy as a whole (as a general case) investment meansmore capitaland notlesslabor.If bothareto be profitably a growth ofincome employed, must takeplace. D. C. Washington,