Classical Growth Theories

Smith, Malthus and Ricardo

 Historical Background
• Industrial Revolution (1760 to 1840)
– Manufacturing processes
– Technological innovation
• Colonialism
– Resource, land, cheap inputs and markets
• Rigid division of Society
– Rigid division of society between capitalists
(including landlords) and labours
– Absence of middle class
 Adam Smith

• Father of modern economics

• Scottish
• 1723-90
• The Theory of Moral Sentiments (1759)
– Sympathy for others
• An Inquiry into the Nature and Causes of the
Wealth of Nations (1776)
– Role of self interest
– Giving the colonies their independence and develop
and maintain free trade
 Reflections from Industrial Revolution
One man draws out the wire, another straights it, a third cuts
it, a fourth points it, a fifth grinds it at the top for receiving the
head; to make the head requires two or three distinct
operations; to put it on is a peculiar business, to whiten the
pins is another; it is even a trade by itself to put them into the
paper; and the important business of making a pin is, in this
manner, divided into about eighteen distinct operations.... [An
average factory of ten workers] could make among them
upwards of forty-eight thousand pins in a day. Each person,
therefore...might be considered as making four thousand eight
hundred pins in a day. But if they had all worked separately
and independently, and without any of them having been
educated to this peculiar business, they certainly could not
each of them have made twenty, perhaps not one pin in a day.
(The Wealth of Nations, p. 10)
 Increasing Returns
• Division of labour beneficial
– Increase of dexterity: learning by doing
– Savings of time lost in passing from one species of
work to other
– Higher labour productivity
– Increasing returns
• Increasing returns Division of Labour and
– Industrial activities Increasing returns are two
– Rich countries important notion
• Diminishing returns contributed by Smith
– Land based activity
– Poor countries Division of labour is limited
by extent of market
 Process of Growth
Capital accumulation

Division of labour

Increasing returns

Growth Higher labour productivity

????
process Say’s Law: Supply
Greater scope for capital accumulation
cumulative creates its own
More use of machinery / cost saving demand
machinery

More output

Larger market

profit

Larger savings
• Savings are invested in full in machines and
land
• Only capitalist and landlords are capable to
save and invest
• Labour gets wage funds
– Amount necessary for subsistence
• Reciprocal Model
– Balanced growth between agriculture and
manufacturing is essential
 Banancing
• Supply side
– Agricultural surplus required to sustain industrial
population
– increase in productivity of agriculture supplies
labour to industry
• Demand side
– Agricultural surplus gives rise to demand of
industrial products
 Limits to growth
• Desire for investment falls if profit falls
• Profits falls as
– competition between capitalists increases
– wage rise
• Profits rise as
– New investment opportunities
 Policy Implications
• Invisible hands
– Each individual is guided by invisible hands which
guided market mechanism
– If individuals are set free, will seek to maximize
own wealth, therefore all individuals , if left free,
will maximize aggregate wealth
• Free trade
• Laissez-faire
• No government intervention
 Underdeveloped Countries
• Small size of markets
• Capacity to save and investment low
• Low growth rate
Income elasticity of global trade
 The ghost of Malthus
• Thomas Malthus (1766-1834)
• English
• Essay of the Principal of Population (1798)
– Constant tendency in all animal life to increase
beyond the nourishment prepared for it
– Population increases in geometrical ratio but
subsistence increase in arithmetical ratio

Growth of population 1, 2, 4, 8, 16, 32, 64

Growth of subsistence 1, 2, 3, 4, 5, 6, 7
 Pessimism
• Identified problem of effective demand
• Effective demand must grow in line with
production potential
• Per capita income around subsistence
• Increase in per capita income through
technological progress
– More births
– Reduces per capita income
• Imbalance between savings and investment
– Savings of landlords may exceed demand for fund by
the capitalist for planned investment
• Low demand for product due to low per capita income
 Other Pessimists
• Low level equilibrium trap in 1956
– Richard R. Nelson
• Big push Model in 1943
– Paul Rosenstein-Rodan
• Dismal Science????
 Implications
• Preventive checks
– Sexual abstinence or use of contraception
• Positive (natural) checks
– Pestilence (epidemic), disease and famine
• Population growth was resisted in many parts
of the world and agricultural production
increased more than arithmetic progression
 David Ricardo (1772-1823)

• Production of only corn

• Three groups

Landlords Capitalists Labour

Wages
Rent Profit

Economic Rent: payment to a factor of production in excess of the cost

needed to bring that factor into production
 Economic Rent
People first started cultivating
in A and occupied it

A B
B is relatively unproductive as
compared to A

Population growth takes

place
Difference between
A produces corn of 35 quintals – owner is present
average and
B produces corn of 30 quintals – free land marginal product of
land
To cultivate A, the tenant pays 5 quintals to owner of A
Otherwise use B
Economic rent: 5 quintals
Financial Times Stock Exchange
 Corn

Total Output

wage

L* Labour
L

Fixed proportion of labour and land

 Stationary state
• Profit in agriculture falls
• Capital shift to industry Problem of
• No limit to capital deployment effective demand
– Say’s law not identified
• Wage fund rises Say’s Law
• Population rises
• Wage rise in terms of food (corn price rise)
• Rate of profit in industry falls
• Stationary state
 Implication
• Import cheap food (raw material) if land is
constraining and export manufacturing
product
– Delay stationary state
• Abolition of Corn Law 1846
– Benefit industrialists
– Affected farmers
• famous PL 480 wheat import deal with US was
signed by India in 1956
 Combining Classical Thoeries
Business Cycle and Stationary State

Higher wage
fund
Growth of
population
and labour
Technological
improvement

Decreasing returns
Higher and lower profit
Higher lower
output investment
investment
Lower
output
Higherlower
profitprofit
expectation
expectation
 Missing Demand Side
Say’s Law
• Jean-Baptiste Say (1767-1832)
• French Economist
• Idea of Say’s Law in 1803
– Treatise on Political Economy
• Supply creates its own demand
– ”A product is no sooner created, than it, from that
instant, affords a market for other products to the full
extent of its own value”
– “As each of us can only purchase the productions of
others with his own productions – as the value we can
buy is equal to the value we can produce, the more men
can produce, the more they will purchase”
– No general glut of product
 Keynesian Ideas
• Say’s Law was challenges during
Great Depression
– 25% unemployment in Unites States
• John Maynard Keynes argued in
1936 that Say's law is not true Great Depression
– Demand determines overall economic
• severe worldwide economic
activity depression that took place
• Keynes (1883-1946) - British during the 1930s
• Keynesian economics explains how• longest, deepest, and most
in the short run, and especially widespread depression of the
during recessions, economic 20th century
output is strongly influenced • US Stock market crash on
by aggregate demand October 29, 1929 (known as
– Keynesian Multiplier Black Tuesday)
• Lasted till World War II
 Idea of “Creative Destruction”
Joseph Schumpeter (1883-1950)
• Austrian American - professor at Harvard University in 1932
• When innovations or changes (economic, social, political and technical)
take place in the economy, the stationary equilibrium or circular flow is
displaced and the process of development starts
• Schumpeter’s model starts with the breaking of circular flow with an
innovation in the form of a new product.
• Entrepreneur is the key figure in Schumpeter’s analysis of the process
of development/ breaking of circular flow
• Entrepreneurs is to
– Appreciate the possibilities of innovation
– Overcome the socio-psychological barriers against the introduction of
new things,
– Direct the means of production into new channels
– Persuade the banker to provide him with necessary finance for
innovations.
– Induce other producers in his branch of activity for taking risk.
– Create an environment conducive to the satisfaction of wants as the
normal motive.
– Provide leadership and
– Take high degree of risk in the economic world.
 Creative destruction
• New production units replace outdated ones
 Post-Keynesian Model of Economic Growth:
Harrod-Domar Models
• help analyse the business cycle
• explain economic growth

Demand
Income

Investment Balance
steady growth
Increase through
productive adjustment of
Supply
capacity supply of
demand for
Increase capital
Savings
investment
in long Neutral
term technology
Bank credit
 • goods market equilibrium:
• sY = I s = I/Y
• is income, I investment, s the marginal propensity to save
• I/Y = (I/K)(K/Y), K is capital stock
• (I/K) = g, rate of capacity growth, rate of capital
accumulation
• (K/Y) = v, capital output ratio
• g = s/v, s/v is the "warranted growth rate" of output
• Harrodian "knife-edge“
– actual growth is slower than the warranted rate, invest less, low
demand, further lesser actual growth
– Actual growth higher than the warranted rate, invest more, high
demand, shortage of capital more acute
– unless we have demand growth and output growth at exactly the
same rate, i.e., demand is growing at the warranted rate, then the
economy will either grow or collapse indefinitely.
Aggregate demand must grow at the same rate as the economy's output capacity grows
for "steady state" growt
• Low savings is the reason for low economic growth in
underdeveloped countries
• Harrod-Domar followed in First Five Year Plan (1951–1956)
– One sector: aggregates all types of production into a single total
• Mahalanabis model
– Two sector: consumption good and capital good
– emphasis on the possibility that the overall rate of real
investment in the economy might be constrained by the
level of output in the capital goods industry within the
economy.
– overall rate of growth over a given period of time tended
to vary directly with the overall rate of investment in the
economy
– Government expenditure
 Solow Model
• due to Robert Solow
• Criticism of Harrod-Domar
– Production under fixed proportion: no possibility
of substituting labour for capital in production
– Unstable balance of growth
 Solow Model
• K is no longer fixed:
investment causes it to grow,
depreciation causes it to shrink
• L is no longer fixed:
population growth causes it to grow
• no G or T
 The production function
 In aggregate terms: Y = F (K, L)
 Constant Returns to Scale
 Define: y = Y/L = output per worker
k = K/L = capital per worker
 y = f(k)
 The production function
Output per
worker, y
f(k)

MPK = f(k +1) – f(k)

1

Note: this production function

exhibits diminishing MPK.

Capital per
worker, k
 The consumption function
 s = the saving rate,
the fraction of income that is saved
(s is an exogenous parameter)
Note: s is the only lowercase variable
that is not equal to
its uppercase version divided by L

 Consumption function: c = (1–s)y

(per worker)
 Savings and Investment
• Investment = Savings
• Holds for per worker
• Using the results above,
i = sy = sf(k)
 Output, consumption, and investment

Output per f(k)

worker, y

c1
y1 sf(k)

i1

k1 Capital per
worker, k
 Capital accumulation
The basic idea: Investment increases the capital stock,
depreciation reduces it.

Change in capital stock = investment – depreciation

k = i – k

Since i = sf(k) , this becomes:

k = s f(k) – k
 The equation of motion for k
k = s f(k) – k
• The Solow model’s central equation
• Determines behavior of capital over time…
• …which, in turn, determines behavior of
all of the other endogenous variables
because they all depend on k. E.g.,
income per person: y = f(k)
consumption per person: c = (1–s) f(k)
 The steady state
k = s f(k) – k
If investment is just enough to cover depreciation
[sf(k) = k ],
then capital per worker will remain constant:
k = 0.

This occurs at one value of k, denoted k*,

called the steady state capital stock.

CHAPTER 7

Economic
 The steady state
Investment
and k
depreciation
sf(k)

k* Capital per
worker, k
 Moving toward the steady state

Investment
k = sf(k)  k
and k
depreciation
sf(k)

k
investment

depreciation

k1 k* Capital per
worker, k
 Moving toward the steady state

Investment
k = sf(k)  k
and k
depreciation
sf(k)

k

k1 k2 k* Capital per
worker, k
 Moving toward the steady state

Investment
k = sf(k)  k
and k
depreciation
sf(k)

k

k2 k3 k* Capital per
worker, k
 An increase in the saving rate
An increase in the saving rate raises investment…
…causing k to grow toward a new steady state:
Investment
and k
depreciation s2 f(k)

s1 f(k)

k
k 1* k 2*
 Prediction:

• Higher s  higher k*.

• And since y = f(k) ,

higher k*  higher y* .

• Thus, the Solow model predicts that countries with

higher rates of saving and investment
will have higher levels of capital and income per
worker in the long run.
 Population growth
• Assume that the population (and labor force)
grow at rate n. (n is exogenous.)
L
 n
L
 Break-even investment
• ( + n)k = break-even investment,
the amount of investment necessary
to keep k constant.
• Break-even investment includes:
–  k to replace capital as it wears out
– nk to equip new workers with capital
(Otherwise, k would fall as the existing capital stock
would be spread more thinly over a larger population of
workers.)
 The equation of motion for k
• With population growth,
the equation of motion for k is
k = s f(k)  ( + n) k

actual
break-even
investment
investment
The Solow model diagram
Investment,
k = s f(k)  ( +n)k
break-even
investment
( + n ) k

sf(k)

k* Capital per
worker, k
 The impact of population growth
Investment,
break-even ( +n2) k
investment
( +n1) k
An increase in n
causes an increase sf(k)
in break-even
investment,
leading to a lower
steady-state level of
k.

k 2* k1* Capital per

worker, k
 Prediction:
• Higher n  lower k*.

• And since y = f(k) ,

lower k*  lower y*.

• Thus, the Solow model predicts that countries

with higher population growth rates will have
lower levels of capital and income per worker
in the long run.
 Implications
• Higher growth in countries with
– Higher savings rate
– Lower population growth
– Improvement in technology
• Lags in the diffusion on knowledge.
– Differences in real income might shrink as poor
countries receive better technology and information
• Efficient allocation of international capital flows,
since the rate of return on capital should be
higher in poorer countries.
– In practice, this is seldom observed