GROWTH THEORY

GROWTH THEORY

In a recent article (What do we know about economic growth? Or,
why don’t we know very much? by Kenny and Williams, in World
Development, 2001) two economists list what mainstream
economics has come up with to explain economic development
worldwide. In chronological order, from the 1940s up to the 1990s,
the key factors explaining growth have been: ‘physical capital,
human capital, policy reform, institutional reform and social development’.
They add that ‘a cynic might note that this list moves
from the relatively simple to overcome toward the impossible to
change (even more so if we take the story into the later 1990s and
add geographic factors).’ There is much theorising and debate
summarised in this pithy comment. Some of the key points are
drawn out below.Physical Capital
Investment in capital goods has always been emphasised as essential
for economic growth. If a wheat farmer wants to increase production
next year he must save some seed from this year’s crop, plant it –
along with quantities of fertiliser, water and other inputs – and wait
for the following year to harvest the result. The more seed is saved
and not consumed but invested, the more future outputs can
increase. Seed capital is thus vital for growth.
The economic history of the Soviet Union shows the importance
of investment in physical capital. This nation grew to become a
world power after the debacle of the First World War due mainly to
the Stalinist system of ruthless central planning that devoted
increasing resources to building up capital goods in oil, iron and
steel, transport and communications, machine tools, defence, and so
on. (Rates of investment in the Soviet Union in the interwar years
were the highest in the world.) Individual civil rights were trampled
upon but enormous economic and military might was thus
constructed. Recognising this, mainstream economics in the post
Second World War era made capital accumulation central to its
growth models also. NEOCLASSICAL GROWTH THEORY, however, emphasises
the free market (not central command) as the key allocating
© 2004 Tony Cleaver
mechanism. The decision whether to consume or invest resources
is thus dependent on market price signals, not on orders from
government.
Neoclassical theory assumes perfect competition, mobile
resources, fixed technology and prices determined in free markets.
An important constraint on economic growth in this simple model
is the fact that investment in capital is subject to the law of diminishing
returns (see Chapter 3). For example, in the example given
earlier, a farmer cannot keep ploughing-in more and more seed on
his land every year and expect that outputs will grow in constant
proportion. Future outputs are instead likely to grow in smaller and
smaller increments (unless, of course, the farmer adopts some new
revolutionary technology – which for the time being we assume he
does not).
What determines the level of investment as opposed to
consumption in any given year? It all depends on market rates of
return. A business may decide to invest past profits in new capital
goods if the expected return from taking such a decision is greater
than any alternative. Alternatives in a market society include
distributing these profits to shareholders for their own consumption,
or the return that might be expected by placing these profits in
a bank. Note that if the rate of return anticipated on a new investment
project is likely to be above the going rate of interest in the
financial markets, the entrepreneur is likely to back his investment.
The market rate of interest is a measure of how the economy as
a whole values future versus present funds. Suppose you loaned out
£100 for one year to a friend. What interest would you charge? If
you say you wanted £105 back in a year’s time you have just
expressed a RATE OF TIME PREFERENCE. That is, you have placed a price –
of 5 per cent per year – on time. If now you as a shareholder can
consume £100 today or can invest and receive, say, £110 in a year’s
time then you will opt for the latter. The rate of return on the
proposed investment is greater than the interest needed to persuade
you to wait. You will thus prefer more money in the future to the
lesser amount now.
Putting all these elements together in 1956, Nobel prize-winner
Robert Solow derived a theory of economic growth. Investment in
capital will take place so long as the rate of return on each project
envisaged is above the market rate of interest/rate of time preference.
Given an unchanging population growth rate, if capital stock grows
© 2004 Tony Cleaver
faster than the labour force then eventually the rate of return on
capital will fall as a result of diminishing returns. (As more and
more capital is employed for each person, the optimum ratio of
labour to capital is passed. Average productivity will fall.) The rate
of economic growth must slow down and eventually stop. There
must evolve a steady state where investment, and thus the stock of
capital, grows just fast enough to equal that needed to equip the
labour force. Faster than that means increasing capital stock, diminishing
returns and thus a fall in investment. Slower than that, and
there will be higher than equilibrium returns, so investment will
increase – see Figure 7.1.
In Figure 7.1, the AP curve illustrates the diminishing returns to
capital, that is, the higher the level of capital per worker the lower is
its average productivity.
The market determines a rate of time preference equal to 5 per
cent per annum and thus the equilibrium quantity of capital per
person equal to k*.
If the capital stock is as yet insufficient to equip all the labour
force such that capital per person is less than k* then productivity
of capital will be above 5 per cent and investment will increase.
There will be positive growth in the economy. Conversely, if the
capital stock increases above k* then productivity will fall, investment
will fall and the capital stock will eventually decrease as the

economy shrinks (negative growth). Eventually, the economy
evolves a steady state where the rate of growth of capital just equals
the rate of growth of the labour force such that capital per worker is
constant at k*.
The conclusion to neoclassical growth theory is therefore
pessimistic but consistent with the law of diminishing returns: if
capital and labour both grow at constant and equal rates, capital per
person must be constant and, since physical capital is the cause of
growth in the economy, income per head must remain constant.
That is, living standards can improve in the short run only – up until
capital per person has reached equilibrium value (k*). Thereafter,
living standards are condemned to stay the same. No further growth
is possible unless exogenous technological progress occurs.