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Classical Theory of Economic Growth

Question:

Discuss About The Classical Neo Theories Of Economic Growth?

Economic growth refers to the increase in the capability of an economy in the production of goods and services from one time period to another. It is usually measured in the percentage rate of increase in the real or nominal terms of gross domestic product (GDP) (Kuznets 2016). There are two major branches of economics that explain the economic growth in two different angles. One of them is the Classical theory of economic growth. The pioneers of economics, Adam Smith, David Ricardo, Thomas R. Malthus and J. S. Mill provided the essence of economic growth, known as, classical theory of economic growth.

As stated by North (2016), the theme of classical theory is that the growth of an economy depends on capital accumulation, increasing returns to scale and specialization. Adam Smith first proposed the idea of economic growth in his 1776 book, ‘Wealth of Nations’. He argued that there are several elements in the economy that can lead to increased growth. Those elements are:

  • Markets playing important role in the determination of demand and supply
  • Productivity of labor and its influence on per capita income
  • Significant role of trade in enabling more specialization
  • Increasing returns to scale, resulting in more specialization in the modern world (Rosen and Gayer 2014).

The classical model was developed by Malthus and Ricardo. In this model, they assumed that the change in technology is constant and expansion in the inputs results in diminishing returns to scale. Malthus highlighted in his theory that, the world’s population would grow faster than the capacity to feed itself because he did not consider any technological improvement (Chakravarty 2017).

Rosen and Gayer (2014) stated that according to the classical economists, one of the major features of a growing economy is the higher level of capital accumulation. This allows increase in the total output for the community by increasing the productivity of land and labor and increasing the allocation of available productive resources. Along with that, the total amount of profit is dependent on two factors, namely, total product of labor and wage level (Scully 2014). Thus, in turn it also depends on the marginal productivity of labor. The productivity of labor in turn depends on the capital stock and available techniques. The market wages could rise above the subsistence level in the short run and this would bring an increase in the population. However, in the long run, as the population growth increases, the wage reaches the subsistence level and then the growth in the population would stop. Hartwell (2017) pointed out that the surplus that is earned by the capitalists will be reinvested again in the production and the entire process will come to a stop when the diminishing returns set in the production process.

Neo-classical Theory of Economic Growth

In the above diagram, the line OW shows the subsistence level of wage, and TP1 is the total product curve. When the population level is at OM, the level of total product is OP. The per capita wage is MS, and surplus or profit is ST. At this stage, the capital formation starts and that results in increase in the demand for labor, leading to a rise in the wages, as the economy moves from T to B. With this movement, the level of working force increases and it shifts to the right, from OM to ON. Increase in population results in more amount of surplus and it is reinvested in the economy. The process will continue till it reaches the point E. With every step in the movement, the amount of surplus capital gets decreased. At E, there will be no capital or surplus, and output and wage become equal. It is a stationary situation where there will be no economic growth, and the population would remain stagnant at OV. TP2 represents the total product curve when there is another factor, that is technological factor and that increases the level of total product of the economy. According to the classical economists, even if there is technological factor, the economy would still reach the stagnation when there is no capital surplus (Keynes 2016).

The neo-classical theory of economic growth is established on the basis of the understanding that, growth in the output of an economy depends on the capital formation, labor and technology. According to this theory, an economy can achieve the state of equilibrium by changing the amount of labor and capital in the production function. In this theory, the role of technology on the production has been accepted.

The neo-classical growth theory is a combination of the works of Solow, Meade, Tobin, Phelps, Johnson and Swan. They formed their theories on the basis of the neo-classical economists, Marshall, Wicksell and Pigou. The neo-classical theory is based on the assumptions that,

  • The commodity and the factor markets have perfect competition,
  • Factor payments are equal to the marginal revenue,
  • The ratio between capital and quantity produced is variable, and
  • There is full employment in the economy (Keynes 2016).

As stated by McCombie and Thirlwall (2016), the major point of neo-classical theory of economic growth is the inclusion of technology along with the variable amount of labor and capital. It also puts emphasis on the event of capital formation and the related decisions of saving and investment, being one of the important determinants of economic growth (Higgins 2017). The model considers that the production function contains two factors, capital and labor and it also has an exogenously determined factor, that is, technology (Peet and Hartwick 2015). The production function is written as:

Production Function

Where Y is the total product, K is the capital, L is the unskilled labor and A is the level of technology. A change in the exogenously determined factor, that is, technology can shift the production function and thereby, changes the level of output (Yang and Ng 2015).

In the following diagram, the effect of technology is shown by two labor productivity curve. Labor productivity shifts upwards when there is increase in the level of technology. Due to technological advancement, the economy moves from point A to point E, and the level of investment and savings increases. The labor productivity increases at this point as the capital per labor hour increases from k0 to k*. The basic concept, stated by Benería, Berik and Floro (2015), is that, technology leads to new opportunities for profit. Thus, savings and investment increases, real GDP per capita increases and the diminishing returns to the capital per labor hour reduce the real rate of interest.

The economy starts at A and at this point, the real interest rate equals target rate of return. Technological advance pushes the economy upwards to E and the economy moves from E to B as there is an increase in the labor productivity due to technological advancement and increase in capital per labor hour. At point B, again the target return rate and real interest rate becomes equal and growth ends.

There is a major difference between the two schools of thought in economics. The well known economists explained the concept of economic growth in two very distinct ways. The classical theory of economic growth was applicable to the societies during the 18th and 19th centuries, when production took place by using primitive ways. On the other hand, the neo-classical theory of economic growth was established in the 20th century when the technological revolution was taking place (Dopfer and Potts 2015). It is relevant till today.

The classical economists believed in a free market or self regulating economy without any government intervention. They believed in optimal allocation of productive resources for optimum level of production. The neoclassical economists, on the other hand, believed that individuals in the society are working to maximize the utility and the organizations want to maximize profits with perfect information in the market. Hence, it can be said that, in the classical theory, the emphasis is put on the production of products and services with only two factors, labor and capital, while in the neoclassical theory, the actions of the individuals in the society and the decisions regarding savings and investment are considered as important factors determining the level of production and profit (Borner, Brunetti and Weder 2016).

Difference between Classical Theory and Neo-classical Theory

A major distinction between the two theories is the consideration of technological advancement in the production process. In the classical theory, the economists did not consider the technological factor and analyzed the growth process on the basis of labor and capital productivity only. However, technology plays an important role in the neoclassical theory. Technological advancement increases the total production, and thereby increasing the scope for capital accumulation. Hence, the productivity of labor increases shifting the labor productivity upwards. Thus, economic growth depends on labor productivity, capital productivity, savings, investment and technological progress (Dopfer and Potts 2015).


There are some differences between the two theories, from the point of view of institutional analysis. The institutional analysis refers to the analysis of the structure and mechanisms of the institutions in an economy. This analysis deals with the functioning of the individuals and groups, constructing institutions and their effects on the economy (Powell et al. 2016). Using the institutional analysis, the difference between the two economic growth theories are as follows:

Classical theory of economic growth

Neo- Classical theory of economic growth

Institutional structure is mechanical and impersonal (North 2016)

Institutions form a social system

The institutions mainly focus on the work and the economic needs of the labor or workers (Scully 2014).

Institutions mainly focus on small groups within the organization as well as in the society and on the human and emotional qualities of the employees

Organizations put emphasis on rationality and order

Organizations put emphasis on the personal and social needs of the workers along with fulfilling the organizational objectives

Organizational behavior originates from rules and regulations

Organizational behavior originates from feelings, attitudes and sentiment (Lundahl and Wadensjo 2015)

Authoritarian practices are used to accomplish the results (Lukacovic and Francis  2016)

Democratic practices, recognition of human values and dignities and involvement of workers in decision making are important to accomplish the organizational goals.

Dissatisfaction and work alienation arise in the institutions.

Satisfied employees focus on increasing the productivity of the institutions.

Thus, it can be said that, in the light of institutional approach, there are some important differences between the two theories. While in the classical theory, the institutions followed authoritarian practices to achieve the organizational goals, the institutions, under the neoclassical theory, followed a modern approach to deal with the organizational functions and making profits. Since, there is application of technology in the modern production process; hence, the institutions need to incorporate advanced technology along with the human values in the institutional activities.

The classical school of thought focuses on the economic growth that results from the efficient and optimum allocation of productive resources in the economy. They did not consider the technological progress and the involvement of human decisions about the savings and investment. However, in the neoclassical theory, the economists incorporated the technological advancement and other human decisions that can cause major impact on the economy. The modern economies today follow the neoclassical theory of economic growth. The decisions regarding investments and savings as well as rapid technological progress determine the direction and magnitude of the economic growth.

References

Benería, L., Berik, G. and Floro, M., 2015. Gender, development and globalization: economics as if all people mattered. Routledge.

Borner, S., Brunetti, A. and Weder, B., 2016. Political credibility and economic development. Springer.

Chakravarty, S., 2017. Alternative approaches to a theory of economic growth: Marx, Marshall and Schumpeter. Orient Longman (1980).

Dopfer, K. and Potts, J., 2015. The general theory of economic evolution. Routledge.

Hartwell, R.M., 2017. The Industrial Revolution and economic growth (Vol. 4). Taylor & Francis.

Rosen, H. and Gayer, T., 2014. Public Finance. 10th ed. McGraw-Hill Education.

Higgins, B., 2017. Regional development theories and their application. Routledge.

Keynes, J.M., 2016. General theory of employment, interest and money. Atlantic Publishers & Dist.

Kuznets, S., 2016. Six lectures on economic growth. Routledge.

Lukacovic, I.I. and Francis, J., 2016. From the Classical School to Today: The Evolution of Stagnation Theories.

Lundahl, M. and Wadensjo, E., 2015. Unequal Treatment (Routledge Revivals): A Study in the Neo-Classical Theory of Discrimination. Routledge.

McCombie, J. and Thirlwall, A.P., 2016. Economic growth and the balance-of-payments constraint. Springer.

North, D.C., 2016. Institutions and economic theory. The American Economist, 61(1), pp.72-76.

Peet, R. and Hartwick, E., 2015. Theories of development: Contentions, arguments, alternatives. Guilford Publications.

Powell, W.W., Oberg, A., Korff, V.P., Oelberger, C. and Kloos, K., 2016. Institutional analysis in a digital era: Mechanisms and methods to understand emerging fields. New themes in institutional analysis: Topics and issues from European research. Cheltenham, UK: Edward Elgar.

Scully, G.W., 2014. Constitutional environments and economic growth. Princeton University Press.

Yang, X. and Ng, Y.K., 2015. Specialization and economic organization: A new classical microeconomic framework (Vol. 215). Elsevier.

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