The Neoclassical

Growth Theory

Solow, R., A contribution to the theory

of Economic Growth, QJE, Feb, 1956,
vol. 70, pp. 65-94.
Technical change and the
Aggregate Production Function,
RES , August 1957, vol. 39, pp. 312320.
Meade, J., A Neo-classical Theory of
Economic Growth, Allen&Unwin,
London 1961.

1Introduction

developed by R.Solow (1956)

and James Meade (1961) in
order to correct the instability
problem inherent in the H-D by
relaxing the H-D assumptions of
fixed K/Y and nonsubstitutability of labor and
capital(by the changes in
relative resource prices).

SOLOW MODEL OF
GROWTH
He builds his model of economic growth as an
alternative to the Harrod Domar line of
thought without its crucial assumptions of
fixed proportions in production. Solow
postulates a continuous production function
linking output to the inputs of capital and
labour which are substitutable.

Theme
States that the rate of growth
of an economy is influenced by
the rate of growth of the
factors of production (labor,
capital, land , technology)
weighted by the elasticity of
production of each factor.

alternatively, economic growth

rate depends on the rate of
growth of labor force, capital
stock, technical know how over
time weighted by the
bof1each
b
respective elasticity
AK L
factor.
Y = A f(K, L) =

= rate of income growth

= rate of technological change

b= output elasticity of capital

1-b = output elasticity of labor

L
L

= rate of growth of labor force

= rate of growth of capital

3Assumptions the Neoclassical

Growth Model
-Perfect substitution of factors of
production (K/L)
-Perfect competition in the
resources market facilitates the
price adjusting mechanism
-Full employment
-Flexibility of K/Y unlike the
Harrod-Domar case.

Given: b L1b
ln Y = ln A +b ln K + (1-b)ln L
Total differentiation with respect to
time(t)
1
1
1 L
b
(1 b)
yields:

L
Note:

output elasticity of
b=

output elasticity of
(1-b)= L

capital

labor

(1) the rate of income growth

not only on the rate of capital
formation and the rate of labor
growth, but also the rate of
technological change.
(2)Income per capita growth
rate depends on the rate of
technological progress and the
growth rate of capital per capita
L
L

(
)

(3)Technological progress can

rescue the economy from the trap
of diminishing returns.
(4)Output-capital ratio depends
on technology and labor-capital

L
ratio
( )1

i.e.

Some Implications of the

Neoclassical Model
-Does not reflect the long-run
effect of rapid labor force growth
on gainful employment and
growth
-The decision to save is
automatically taken as the
decision to invest.
i.e. S = I (classical view)

-The perfect factor substitution

assumption implies that forces
of competition are sufficiently
strong.
-Direct application to LDCs is
doubtful.

-There is a limit to income

growth through K and L due to
the law of diminishing returns
(LDR). K and L must be
accompanied by technological
improvements.

Differences between the H-D

and the Neoclassical Growth
-K/L can change in the
neoclassical model unlike the HD model
-The neoclassical model
assumes that population grows
independently of income

Unlike the H-D model, the

neoclassical model assumes
that structural flaws or
constraints can be overcome by
the operation of free markets
-Both capital and labor can be
used to produce output unlike
the H-D model which is based
on the capital theory of value.

The neoclassical growth model

does not suffer from the
instability problem

(1 )

3.1=2.1 +.25(2) +.75(.7)

.5
.525
.5
Output growth due to capital =.16
3 .1
.525 =
Output growth due to labor
.16
3.1
Output growth due to tech.2.1 =
.68
3.1
progress

In the model, technological

progress is disembodied or
taken as being independent of
L and K. K and L are also
assumed to be homogeneous.

In practice, technology is embodied

and L , especially in capital.
Moreover, K accumulation and
improvement of L quality enable
technological development and its
installation.
Embodied technological change tech. Change embodied in the form of
the capital good itself. For instance,
the diesel locomotive replaced the
steam locomotive Jet airliners
replaced the propeller variety. The
electronic calculator has made slide
rule obsolete.

Disembodied tech. Change technological change that takes the

form of new procedures or
techniques for producing goods &
services. Example the use of
contour-farming to prevent soil
erosion on farms, the development
of new management techniques in
business, the pasteurization of milk.

the equation r*= sF (r, 1) nr

states that the rate of change of
capital-labour ratio (r*) is the
difference of two terms.
One representing the increment of
capital
sF (r, 1) and the other
increment of labour (nr)

The ray through the origin is the

function nr. The other curve

represents the function sF (r, 1). It is
so drawn as to show diminishing
marginal productivity of capital. At the
point of intersection of the two curves
nr is equal to sF (r, 1) so capital
labour ratio is constant and the
capital stock must expand at the
same rate as the labour force.

Once the capital labour ratio is

established, it will be maintained,

and capital and labour will grow in
proportion. Assuming constant
returns to scale, real output will also
grow at the same relative rate n,
and output per head of labour force
will be constant. So at nr is equal to
sF (r, 1) , there will be the balanced
growth equilibrium.

Comment
The major source of growth
per worker in developing
countries is capital per worker
(K/L)
The major source of growth in
DCs is increased productivity
due to technological progress.

8Evaluation of the Neoclassical

Model
-Some of the assumptions are
more realistic than others
(factor substitution, diminishing
returns, output-capital ratio, level
of technology)
-Some assumptions are less
realistic
(full employment, S=I at full
employment output perfect
competition)

-Inclusion of more variables

gives better insights into the
growth process
-Importance of technological
progress made clearer, but the
importance of savings and
investment less clear.
-Income distribution can be
learned more from the modelshare of labor and capital in the
national income