Neoclassical Growth Theory

What is the 'Neoclassical Growth Theory'?

Neoclassical growth theory is an economic theory that outlines how a
steady economic growth rate can be accomplished with the proper amounts of
the three driving forces: labor, capital and technology. The theory states that by
varying the amounts of labor and capital in the production function, an equilibrium
state can be accomplished. The theory also argues that technological change
has a major influence on an economy, and economic growth cannot continue
without advances in technology.

Next Up
1. GENERAL EQUILIBRIUM THEORY

2. COMPETITIVE EQUILIBRIUM
3. ECONOMIC EQUILIBRIUM
4. NEW GROWTH THEORY

5.

BREAKING DOWN 'Neoclassical Growth Theory'

Neoclassical growth theory outlines the three factors necessary for a growing
economy. It states that temporary equilibrium and growth can be achieved by
allocating the right mix of the three factors. However, neoclassical growth theory
clarifies that temporary equilibrium is different from long-term equilibrium, which
is achieved without any of the three factors needed for short-term growth.

The Production Function of the Neoclassical Growth

Theory
The neoclassical growth theory is based on the belief 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 and is written as Y = AF (K,
L). "Y" denotes an economy's gross domestic product (GDP), "K" represents its
share of capital, "L" describes the amount of unskilled labor in an economy and
"A" represents a determinant level of technology. 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 these inputs shows the affect 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, which implies that increases in these two inputs have
exponentially decreasing returns. Technology, on the other hand, is boundless in
the growth that it can add and the output it can produce.

If, for example, an industrial economy relies on physical labor to produce its
output, it is capped at the amount of jobs available and the amount of workers
within the economy. With technology, these caps are nonexistent, and it is
possible to realize exponentially high growth and high equilibrium.
Endogenous Growth Theory
What is the 'Endogenous Growth Theory'
The endogenous growth theory is an economic theory which argues
that economic growth is generated from within a system as a direct result of
internal processes. More specifically, the theory notes that the enhancement of a
nation's human capital will lead to economic growth by means of the
development of new forms of technology and efficient and effective means of
production.

Next Up
1. ENDOGENOUS GROWTH

2. EXOGENOUS GROWTH
3. NEW GROWTH THEORY
4. CIRCUITISM

5.

BREAKING DOWN 'Endogenous Growth Theory'

This view contrasts with neoclassical economics, which contends that
technological progress and other external factors are the main sources of
economic growth.

Endogenous growth economists believe that improvements in productivity can be

tied directly to faster innovation and more investments in human capital. As such,
they advocate for government and private sector institutions to nurture innovation
initiatives while offering incentives for individuals and businesses to be more
creative. Under this theory, knowledge-based industries play a particularly
important role — especially telecommunications, software and other high tech
industries — as they are becoming ever more influential in developed and
emerging economies.

Central tenents to endogenous growth theory include:

 Government policies ability to raise a country’s growth rate if they lead to

more intense competition in markets and help to stimulate product and
process innovation.
  There are increasing returns to scale from capital investment especially in
infrastructure and investment in education and health and
telecommunications.
 Private sector investment in research & development is a key source of
technological progress
 The protection of property rights and patents is essential to providing
incentives for businesses and entrepreneurs to engage in research and
development
 Investment in human capital is a vital component of growth
 Government policy should encourage entrepreneurship as a means of
creating new businesses and ultimately as an important source of new
jobs, investment and further innovation

Critics argue endogenous growth models are nearly impossible to validate by

empirical evidence.
New Growth Theory
What is the 'New Growth Theory'
The new growth theory is an economic growth theory that posits humans' desires
and unlimited wants foster ever-increasing productivity and economic growth.
The new growth theory argues that real GDP per person will perpetually increase
because of people's pursuit of profits. As competition lowers the profit in one
area, people have to constantly seek better ways to do things or invent new
products in order to garner a higher profit. This main idea is one of the central
tenets of the theory.

Next Up
1. ACCELERATOR THEORY

2. MECHANISM DESIGN THEORY

3. TIME-PREFERENCE THEORY OF INTEREST
4. ACCOUNTING THEORY

5.

BREAKING DOWN 'New Growth Theory'

The theory also argues that innovation and new technologies do not occur simply
by random chance. Rather, it depends on the number of people seeking out new
innovations or technologies and how hard they are looking for them. In addition,
people also have control over their knowledge capital (i.e., what to study, how
hard to study, etc.). If the profit incentive is great enough, people will choose to
grow human capital and look harder for new innovations.

A significant aspect of the new growth theory is the concept that knowledge is
treated as an asset for growth that is not subject to the finite restrictions or
diminishing returns like other assets such as capital or real estate. In particular,
knowledge is an intangible quality, rather than physical, and can be a resource
grown within an organization or industry.

How the New Growth Theory Values Knowledge and

Innovation
Under the new growth theory, nurturing innovation internally is one of the
reasons for organizations to invest in human capital. By creating opportunities
and making resources available within an organization, the expectation is
that individuals will be encouraged to develop new concepts and technology for
the consumer market.

For example, a large enterprise might allow part of its staff to work on
independent, internal projects that might develop into new innovations or
companies. In some ways, the enterprise lets them function like startups being
incubated inside the organization. The desire of the employees to launch a new
innovation is spurred by the possibility of generating more profits for themselves
and the enterprise.

This can be especially true in the United States, as commerce is increasingly

driven by service-type companies. Software and app development may take
place within companies, following the new growth theory. Achieving such
knowledge-driven growth requires a sustained investment in human capital. This
can create an environment for skilled professionals to have an opportunity to not
only fulfill their primary jobs but also explore the creation of new services that can
be of benefit and use to the broader public.