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Mastering Growth Theories in Economics
Dive into the world of economic growth theories. Understand key models, factors driving growth, and how nations foster sustainable development. Start with our introductory video for a clear overview.

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Intros
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  1. Classical Growth Theory
    • Temporary GDP Per Person Growth
    • Sudden Increase in Population
    • Run Out of Resources
    • Goes Back to Subsistence Level
  2. Neoclassical Growth Theory
    • Technological change is by chance
    • Rapid advance in technology   \, →  \, more saving and investment
    • Low/Halt in technology   \, →  \, less saving and investment
    • Diminishing marginal return to capital
Calculating economic growth
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Notes

We will be looking at three theories of economic growth:
  1. Classical Growth Theory
  2. Neoclassical Growth Theory
  3. New Growth Theory


Classical Growth Theory

Classical Growth Theory is the idea that growth rate of GDP per person is only temporary. Once it increases above a subsistence level, then a sudden increase in population size will bring it back to that level.

Note: subsistence level is the standard of living that provides only the bare necessities of life.

Why is this the case?

If there are sudden increase in population sizes, then we will eventually run out of resources for everyone. This means the standard of living (real GDP per person) must decrease and we will start to live in a lower standard of living than before.

Neoclassical Growth Theory

Neoclassical Growth Theory is the idea that real GDP per person grows because technological advances causes saving and investment, which in return make capital per hour of labor increase.

Why is this the case? Assume that technological advances are by chance.

When there is a rapid advance in technology, businesses expand, and new businesses are made to play around with the new profitable technologies. In this case, investments and savings increase, thus capital per hour of labor increase, and real GDP per person increases and continues to growth.

However, when the advances in technology are slowed or at a halt, the opposite happens. Since we had high investments and savings to begin with, we have a high rate of capital accumulation. With a high rate of capital accumulation, more projects are undertaken which gives lower return (diminishing marginal return to capital). When firms see that they are not making a high return like before, they investment less, and so the rate of capital accumulation decreases. In the end, the capital accumulation is slowed enough that it only keeps up with population growth.

New Growth Theory

New Growth Theory is the idea that real GDP per person grows because of the choices people make for profit. Growth will happen endlessly.

Unlike the neoclassical growth theory, advances in technology is not by chance. It varies on whether people are looking for new technology and how much effort they are putting to look for it. Profit is what causes technological advances.

Competition of firms eventually causes firms to break-even. So in order to increase profit, they must either sell a better product and sell at a higher price, or find a method to produce goods at a lower cost.

Inventors can earn profit for years by taking out a patent or a copyright. However, once a new discovery is made, they will stop earning profit. This forces them to do more research and discover something new again to earn more profits.

In addition, when more and more new discoveries are made, we gain more knowledge. Knowledge is a public good that everyone can access and can make labor and machines more productive.

If there is an incentive to earn more profit and incentive to discover, growth never stops.

Policies to Reach Faster Growth

From last section, we know that in order to have faster economic growth, we must have physical capital growth, human capital growth, and technological advances.

To achieve this, we must
  1. Encourage saving: saving will increase economic growth.
  2. Encourage research and development: Since basic inventions can be copied, inventors’ profits are very minimal, therefore not much activity happens for research and development. Therefore, we can get the government to direct their public funds towards financing basic research.
  3. Encourage International Trade: trading with others stimulate economic growth. Generally, the richer the nation, the less reluctant they are to international trade. However, fast-growing nations are most open to trade.
  4. Encourage international aid to developing nations: If rich countries provide financial aid to developing countries, then investment and growth will increase. However, it doesn’t seem to be the case since research has shown that effects of aid show that the growth to next to 0 or negative.
  5. Encourage improvement in quality of education: When we improve basic education in language, mathematics, and science, the nation’s growth potential is higher.
Concept

Introduction to Growth Theories

Welcome to our exploration of growth theories in economics! These theories are fundamental to understanding how economies develop and expand over time. As we dive into this fascinating topic, I'd like to draw your attention to our introduction video, which serves as an excellent starting point. This video provides a clear, concise overview of the key concepts we'll be discussing. Growth theories encompass various models and ideas, such as the Solow-Swan model, endogenous growth theory, and the Harrod-Domar model. Each of these theories offers unique insights into the factors driving economic growth, including capital accumulation, technological progress, and human capital development. By studying these theories, you'll gain a deeper understanding of how nations can foster sustainable economic growth and improve living standards. Remember, while these concepts may seem complex at first, our video breaks them down into easily digestible segments, making your learning journey both enjoyable and informative. Let's embark on this exciting exploration of growth theories together!

FAQs

  1. What are the main differences between classical and neoclassical growth theories?

    Classical growth theory, developed by economists like Adam Smith and David Ricardo, focuses on capital accumulation, labor, and land as key drivers of growth. It predicts eventual stagnation due to diminishing returns and resource constraints. Neoclassical growth theory, introduced by Solow and Swan, incorporates technological progress as a crucial factor. It suggests that long-term growth is primarily driven by technological advancements, which can offset diminishing returns. Neoclassical theory is more optimistic about sustained growth and predicts convergence to a steady-state growth rate.

  2. How does the New Growth Theory differ from earlier growth models?

    New Growth Theory, also known as Endogenous Growth Theory, differs from earlier models by treating technological progress as an endogenous factor. It emphasizes the role of knowledge, innovation, and human capital in driving economic growth. This theory suggests that growth can be sustained indefinitely through factors like research and development, education, and knowledge spillovers. Unlike neoclassical theory, which views technology as exogenous, New Growth Theory explains how economic incentives and policies can influence the pace of technological progress.

  3. What are some key policies that can promote faster economic growth?

    Several policies can contribute to faster economic growth: 1. Encouraging savings to increase available capital for investment. 2. Promoting research and development to drive innovation. 3. Encouraging international trade to expand markets and increase competition. 4. Providing aid to developing nations to create new markets and global stability. 5. Improving education quality to develop a skilled and productive workforce. These policies aim to boost productivity, innovation, and human capital, which are crucial for sustained economic growth.

  4. How does the concept of steady-state growth apply to economic development?

    Steady-state growth is a key concept in neoclassical growth theory. It refers to a situation where an economy's per capita output grows at a constant rate, determined by technological progress and population growth. In this state, the capital-to-labor ratio remains constant. The theory suggests that economies with lower capital-to-labor ratios tend to grow faster, eventually converging to their steady state. This concept helps explain why developing economies might experience rapid growth initially, but their growth rates slow as they approach the steady state of more developed economies.

  5. What role does human capital play in economic growth theories?

    Human capital plays a crucial role in modern growth theories, particularly in the New Growth Theory. It refers to the skills, knowledge, and experience possessed by individuals in an economy. Human capital is seen as a key driver of innovation, productivity, and technological progress. Investments in education, training, and health care are considered vital for enhancing human capital. The theory suggests that economies with higher levels of human capital are more likely to experience sustained growth through increased innovation and efficiency. This emphasis on human capital has significant implications for policy, highlighting the importance of education and skill development in fostering economic growth.

Prerequisites

Before delving into the complex world of growth theories, it's crucial to have a solid foundation in key economic concepts. Two fundamental prerequisites that significantly contribute to comprehending growth theories are economic growth and comparative advantage. These topics provide essential context and analytical tools necessary for grasping the intricacies of various growth models and their implications.

Understanding economic growth is paramount when studying growth theories. This concept forms the bedrock of many growth models, as it encompasses the factors that contribute to an economy's expansion over time. Familiarity with the concept of steady state economic growth is particularly relevant, as it plays a crucial role in long-term growth projections and policy considerations. By grasping the fundamentals of economic growth, students can better appreciate the nuances of different growth theories and their predictions.

Similarly, the principle of comparative advantage is integral to understanding growth theories, especially those that incorporate international trade and specialization. This concept explains why countries benefit from trade and how specialization can lead to increased productivity and economic growth. Many growth theories build upon the idea of comparative advantage to explain differences in growth rates between countries and the role of international trade in fostering economic development.

By mastering these prerequisite topics, students will be better equipped to analyze and interpret various growth theories. For instance, the Solow growth model, a cornerstone of growth theory, heavily relies on the concept of steady state economic growth. Understanding this prerequisite allows students to grasp the model's implications for long-term economic growth and the factors that influence it.

Moreover, theories of endogenous growth often incorporate elements of comparative advantage to explain how knowledge spillovers and technological progress drive economic growth. A solid grasp of this concept enables students to comprehend how specialization and trade can contribute to sustained economic expansion.

In conclusion, a thorough understanding of economic growth and comparative advantage is essential for anyone seeking to master growth theories. These prerequisite topics provide the necessary foundation for analyzing complex economic models, evaluating policy implications, and critically assessing the various factors that contribute to long-term economic development. By investing time in these fundamental concepts, students will find themselves better prepared to engage with and contribute to discussions on growth theories and their real-world applications.