has been a major concern on economic theorists for centuries.
Adam Smith Inquiry into the Nature and Causes of the Wealth of
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
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
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
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 &
of capital deepening & technological improvement explains major trends in
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
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
innovation - an explanation of technological progress
Long waves of innovation - "gales of creative
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.
ECONOMIC GROWTH THEORY
with economists such as Paul Romer
and Paul Ormerod
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:
growth theory says that government policy to increase capital or foster right
kinds of investment in physical capital can permanently raise economic
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