What Is the Neoclassical Growth Theory?

What Is the Neoclassical Growth Theory?

Let me explain neoclassical growth theory directly: it's an economic framework that shows how a steady growth rate comes from labor, capital, and technology working together. You should know that Robert Solow and Trevor Swan get the credit for developing this model in 1956, according to the National Bureau of Economic Research. Initially, it factored in exogenous population growth to drive the rate, but by 1957, Solow added technological change to make it more complete.

I want you to remember these key points: Solow and Swan introduced it in 1956. The theory boils down to growth from labor, capital, and technology. And while capital and labor are limited resources in any economy, technology's impact on growth has no bounds.

How the Neoclassical Growth Theory Works

Here's how it operates: the theory says short-term equilibrium comes from different levels of labor and capital in the production process. It also stresses that technology plays a huge role, and without advances in technology, economic growth can't keep going.

You need to understand that neoclassical growth theory identifies labor, capital, and technology as the essentials for a growing economy. But it makes a clear distinction: temporary equilibrium differs from long-term equilibrium, and the long-term one doesn't even need those three factors in the same way.

Special Considerations

Consider this: the theory argues that building up capital in an economy, and how people deploy it, matters a lot for growth. The link between capital and labor sets the economy's output. Technology boosts labor productivity and expands what labor can achieve overall.

That's why we use the production function Y = AF(K, L) to gauge an economy's growth and equilibrium. Here, Y is GDP, K is capital share, L is unskilled labor, and A is the technology level. Often, because of how labor and technology interact, we rewrite it as Y = F(K, AL).

If you increase any input, you'll see the effect on GDP and thus the economy's equilibrium. But if the three factors aren't balanced, returns from unskilled labor and capital drop off. These diminishing returns mean that pumping more into labor or capital gives exponentially less bang for the buck, while technology keeps contributing without limits to growth and output.

Example of the Neoclassical Growth Theory

Take this example from a 2016 study in Economic Themes by Dragoslava Sredojević, Slobodan Cvetanović, and Gorica Bošković, titled 'Technological Changes in Economic Growth Theory: Neoclassical, Endogenous, and Evolutionary-Institutional Approach.' They looked specifically at technology's role in neoclassical theory.

What they found is a shared view across economic schools that technology drives growth. For instance, neoclassicists have pushed governments to fund science and R&D for innovation. Endogenous theorists focus on things like tech spillovers and R&D as sparks for innovation and growth. And evolutionary and institutional economists factor in the broader economic and social context for tech innovation and growth.