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Theories of Growth


Growth has been a major concern on economic theorists for centuries.

Adam Smith Inquiry into the Nature and Causes of the Wealth of Nations (1776):

        Advocated division of labour, specialisation (absolute advantage) & accumulation of capital

        Advocated Laissez Faire - minimum government interference

        Emphasised importance of a stable legal framework, within the market could function


David Ricardo:

        Formalised notion of diminishing returns, but did not take innovation into account

        Showed some of the welfare gains from specialisation and international trade based on comparative advantage


Robert Solow: Neo-classical growth model:

        Growth depends on capital accumulation - increasing the stock of capital goods to expand productive capacity

        Net investment and the need for sufficient saving to finance investment

        Higher savings - postponing consumption to finance increased allocation of resources towards investment

        Capital widening: capital stock rising at rate which keeps pace with labour force growth.

        Capital deepening: capital stock grows faster than labour force. Considered more important.

        Quality of capital goods - improvements due to R&D & innovation



Acombination of capital deepening & technological improvement explains major trends in economic growth

        Prediction - Adding more capital goods to a fixed amount of labour will lead to diminishing returns to capital.

        Increased capital accumulation drives the rate of return on capital down

        Eventually, the rate of return may be so low that no further net capital accumulation takes place.

        In which case the rate of technological progress determined the rate of growth of output

        Technological progress is assumed to be exogenous i.e. lies outside the growth model



Schumpeterian innovation - an explanation of technological progress


        Long waves of innovation - "gales of creative destruction"

        Increased profits arise because of constant birth of new products and new markets.

        Technology raises productivity by increasing quantity and quality of all those resources to which it is applied.



Associated with economists such as Paul Romer and Paul Ormerod

Seeking to make technological progress endogenous.

        A firm will not innovate unless it thinks it can steal a march on its competition & earn higher profits.

        Inconsistent with Neo-Classical assumption of perfect competition - no "abnormal profits".

        Attention shifted to conditions under which a firm will innovate most productively:


Endogenous growth theory says that government policy to increase capital or foster right kinds of investment in physical capital can permanently raise economic growth.

        If capital broadened to include human capital, law of diminishing returns may not apply - increasing returns to investment from education & efficiency - innovation not necessary.

        Extent of capacity usage - government encouragement of open markets




E-mail Steve Margetts