Neoclassical Growth Theory

What Is the Neoclassical Growth Theory?

Neoclassical growth theory is an economic theory that outlines how a steady economic growth rate results from a combination of three driving forces — labor, capital, and technology. The National Bureau of Economic Research names Robert Solow and Trevor Swan as having the credit of developing and introducing the model of long-run economic growth in 1956. The model first considered exogenous population increases to set the growth rate but, in 1957, Solow incorporated technology change into the model.

How the Neoclassical Growth Theory Works

The theory states that short-term equilibrium results from varying amounts of labor and capital in the production function. The theory also argues that technological change has a major influence on an economy, and economic growth cannot continue without technological advances.

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

Special Consideration

This growth theory posits that the accumulation of capital within an economy, and how people use that capital, is important for economic growth. Further, the relationship between the capital and labor of an economy determines its output. Finally, technology is thought to augment labor productivity and increase the output capabilities of labor.

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

However, because of the relationship between labor and technology, an economy's production function is often re-written as Y = F (K, AL).

Increasing any one of the inputs shows the effect on GDP and, therefore, the equilibrium of an economy. However, if the three factors of neoclassical growth theory are not all equal, the returns of both unskilled labor and capital on an economy diminish. These diminished returns imply that increases in these two inputs have exponentially decreasing returns while technology is boundless in its contribution to growth and the resulting output it can produce.

Example of the Neoclassical Growth Theory

A 2016 study published in Economic Themes by Dragoslava Sredojević, Slobodan Cvetanović, and Gorica Bošković titled "Technological Changes in Economic Growth Theory: Neoclassical, Endogenous, and Evolutionary-Institutional Approach" examined the role of technology specifically and its role in the neoclassical growth theory.

The authors find a consensus among different economic perspectives all points to technological change as a key generator of economic growth. For example, neoclassicists have historically pressured some governments to invest in scientific and research development toward innovation.

Endogenous theory supporters emphasize factors such as technological spillover and research and development as catalysts for innovation and economic growth. Lastly, evolutionary and institutional economists consider the economic and social environment in their models for technological innovation and economic growth.