Neoclassical Growth Theory

What is Neoclassical Growth Theory?

Neoclassical growth theory is an economic theory that outlines how stable economic growth rates result from a combination of three driving forces: labor, capital, and technology.National Bureau of Economic Research names Robert Solow and Trevor Swan for having developed and introduced Model Long-term economic growth in 1956. The model first considered exogenous population growth to determine growth rates, but in 1957 Solow incorporated technological change into the model.

  • Neoclassical growth theory was first introduced in 1956 by Robert Solow and Trevor Swan.
  • The theory states that economic growth is the result of three factors – labor, capital, and technology.
  • While an economy has limited resources in terms of capital and labor, the contribution of technology to growth is limitless.

How Neoclassical Growth Theory Works

The theory states that short-run equilibrium is the result of different amounts of labor and capital in the production function. The theory also holds that technological change has a significant impact on the economy and that economic growth cannot be sustained without technological progress.

Neoclassical growth theory outlines three factors necessary for economic growth. They are labor, capital and technology. However, neoclassical growth theory clarifies that a temporary equilibrium is different from a long-run equilibrium, which does not require any of these three factors.

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This growth theory argues that the accumulation of capital in an economy and how people use that capital is important for economic growth. Furthermore, the relationship between an economy’s capital and labor determines its output. Finally, technology is believed to increase labor productivity and increase the output capacity of labor.

Therefore, the production function of neoclassical growth theory is used to measure the growth and equilibrium of an economy. The function is Y = AF (K, L).

  • Y represents the gross domestic product (GDP) of an economy
  • K represents its share of capital
  • L describes the amount of unskilled labor in an economy
  • A represents the decisive level of technology

However, due to the relationship between labor and technology, an economy’s production function is often rewritten as Y = F (K, AL).

Adding any one input shows an impact on GDP, and therefore on the economic balance. However, if the three factors of neoclassical growth theory are not exactly equal, both unskilled labor and capital return to the economy less. These diminishing returns mean that an increase in both inputs leads to an exponential decline in returns, while the contribution of technology to growth and the output it can produce is infinite.

Examples of Neoclassical Growth Theory

A 2016 study published in economic theme Dragoslava Sredojević, Slobodan Cvetanović, and Gorica Bošković, entitled “Technical Change in Economic Growth Theory: Neoclassical, Endogenous, and Evolutionary-Institutional Approaches,” specifically examine the role of technology and its role in neoclassical growth theory.

The authors found that consensus among different economic perspectives points to technological change as a key driver of economic growth. Neoclassicalists, for example, have historically pressured some governments to invest in scientific and research development to enable innovation.

Endogenous theory proponents emphasize factors such as technology spillovers and R&D as catalysts for innovation and economic growth. Finally, evolutionary and institutional economists consider the economic and social environment in their models of technological innovation and economic growth.

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