Classical Growth Theory

What Is Classical Growth Theory?

Classical growth theory is a modern category of economic theory that is applied to the work of several economists who wrote about the process and sources of economic growth in their time, roughly the 18th and 19th centuries. Two important theorists associated with these ideas include Adam Smith and David Ricardo.

Understanding Classical Growth Theory

Classical growth theory was developed alongside the Industrial Revolution in Great Britain. Analysis of the process of economic growth was a central focus of these classical economists. Classical economists sought to provide an account of the broad forces that influenced economic growth and of the mechanisms underlying the growth process.

The division of labor, the gains from trade, and the accumulation of capital were seen as the main driving forces of economic growth. Productive investment and the reinvestment of profits were the mechanisms that produced continuous economic growth, so changes in the rate of profit were a decisive reference point for an analysis of the long-term evolution of the economy. 

They argued that individual initiative, under freely competitive conditions to promote individual ends, would produce beneficial results to society as a whole. Their conclusions supported the adoption of free trade, respect for private property, and individual free enterprise. Meanwhile, conflicting economic interests could be reconciled by the operation of competitive market forces and the limited activity of responsible government. 

These economists' ideas diverged from previous economic ways of thinking. Their critique of feudal society that came before them was based on the observation among others: that a large portion of the social product was not so well invested but was consumed unproductively by the ruling class. They followed the French physiocrats in studying the economic welfare of a nation as a whole, as opposed to the mercantilist focus on the accumulation of gold for the king. They split from the physiocrats by focusing on, and celebrating, industry and capital accumulation as a source of economic prosperity.

Adam Smith and the Wealth of Nations

Scottish economist Adam Smith was the leading figure of the classical theory of growth. Smith wrote that the division of labor among workers into more specialized tasks was the driver of growth in the transition to an industrial, capitalist economy. As the Industrial Revolution matured, Smith argued that the availability of specialized tools and equipment would allow workers to further specialize and thereby increase their productivity. In order for this to happen, ongoing capital accumulation was necessary, which depended on the owners of capital being able to keep and reinvest profits from their investments. He explained this process with the metaphor of the "invisible hand" of profits, which would push capitalists to engage in this process of investment, productivity gains, and reinvestment by seeking their own personal gain, and indirectly the benefit of the entire nation.

David Ricardo and the Gains from Trade

David Ricardo extended Smith's theory to demonstrate how trade could lead to further economic prosperity on top of the gains from specialization and the division of labor. He developed the concept of comparative advantage as a basis for specialization and applied this not only to workers in a single economy but to separate nations that could trade with one another. Ricardo argued that by specializing in activities for which they each had the lowest opportunity cost and then trading their surplus product, nations (and by extension workers and firms within an economy) could all be made better off. Ricardo's theory of comparative advantage strengthened the foundation of Smith's theory of specialization and division of labor as a source of economic growth.