SOLOW MODEL WITH
TECHNOLOGY AND THE NEW
GROWTH THEORY
TECHNOLOGICAL PROGRESS IN THE SOLOW
MODEL
• The model can be modified to include exogenous technological
progress, which over time expands society’s production capabilities.
The Efficiency of Labor
• We now write the production function as
• Y = F(K, L × E),
• where E is a new (and somewhat abstract) variable called the
efficiency of labor.
THE EFFICIENCY OF LABOR
• The efficiency of labor is meant to reflect society’s knowledge about production
methods
• as the available technology improves, the efficiency of labor rises, and each
hour of work contributes more to the production of goods and services.
• The efficiency of labor also rises when there are improvements in the health,
education, or skills of the labor force.
• The term L × E can be interpreted as measuring the effective number of
workers.
• L × E measures both the workers and the technology with which the typical worker
comes equipped.
• This new production function states that total output Y depends on the inputs of
capital K and effective workers L × E.
LABOR-AUGMENTING TECHNOLOGICAL
PROGRESS
• The simplest assumption about technological progress is that it causes
the efficiency of labor E to grow at some constant rate g.
• For example, if g = 0.02, then each unit of labor becomes 2 percent
more efficient each year: output increases as if the labor force had
increased by 2 percent more than it really did.
• This form of technological progress is called labor augmenting, and g is
called the rate of labor-augmenting technological progress.
• Labor force L is growing at rate n, and the efficiency of each unit of
labor E is growing at rate g, the effective number of workers L × E is
growing at rate n + g.
THE STEADY STATE WITH TECHNOLOGICAL
PROGRESS
• Technological progress causes the effective number of workers to
increase
• Previously, when there was no technological progress, we analyzed the
economy in terms of quantities per worker; now we can generalize
that approach by analyzing the economy in terms of quantities per
effective worker.
• We now let k = K/(L × E) stand for capital per effective worker
and y = Y/(L × E) stand for output per effective worker.
• With these definitions, we can again write y = f(k).
THE STEADY STATE WITH TECHNOLOGICAL
PROGRESS
• The equation showing the evolution of k over time becomes
• Δk = sf (k) − (d + n + g)k.
• The change in the capital stock Δk, equals investment sf(k) minus
breakeven investment (d + n + g)k.
• Because k = K/(L × E), the break-even investment includes three
terms
• to keep k constant, dk is needed to replace depreciating capital, nk is
needed to provide capital for new workers, and gk is needed to provide
capital for the new “effective workers” created by technological
progress
THE STEADY STATE WITH TECHNOLOGICAL
PROGRESS
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THE STEADY STATE WITH TECHNOLOGICAL
PROGRESS
• Capital per effective worker k is constant in the steady state.
• y = f(k) – output per effective worker is also constant.
• These quantities per effective worker are steady in the steady state.
• Now, consider output per actual worker Y/L = y × E
• E is growing at rate g, output per worker must also be growing at rate g
in the steady state.
• Economy’s total output is Y = y × (E × L) – E is growing at rate g, and
L is growing at rate n, total output grows at rate n + g in the steady
state.
THE STEADY STATE WITH TECHNOLOGICAL
PROGRESS
• Technological progress can lead to sustained growth in output per
worker
• A high rate of saving leads to a high rate of growth only until the
steady state is reached
• According to the Solow model, only technological progress can
explain sustained growth and persistently rising living
standards.
PROBLEMS OF SOLOW MODEL
• In the steady state of the Solow growth model, the growth rate of income per
person is determined solely by the exogenous rate of technological progress.
• Many empirical studies have examined to what extent the Solow model can help
explain long-run economic growth
• The model can explain much of what we see in the data, such as balanced
growth and conditional convergence.
• Recent studies have also found that international variation in standards of living is
attributable to a combination of capital accumulation and the efficiency with
which capital is used.
PROBLEMS OF SOLOW MODEL
• MPK eventually declines
• Technological Advances(TA) may eliminate convergence, but they are
Exogenous in the model
• The growth model itself does not explain the TA, and technical
innovation happens out of blue, and is injected into Solow Model.
ENDOGENOUS GROWTH THEORY
• To understand fully the process of economic growth, we need to go
beyond the Solow model and develop models that explain technological
advance.
• Models that do this often go by the label endogenous growth theory
because they reject the Solow model’s assumption of exogenous
technological change.
• Modern theories of endogenous growth attempt to explain the rate of
technological progress, which the Solow model takes as exogenous.
• These models try to explain the decisions that determine the creation
of knowledge through research and development.
ENDOGENOUS GROWTH THEORY
• A “new growth theory” (endogenous growth) was developed to extend
neoclassical growth theory (exogenous growth).
• It extends the neoclassical growth model to allow for endogenously
driven growth (Romer, Lucas).
ENDOGENOUS ECONOMIC GROWTH MODEL
NEW EXPLANATORY VARIABLES: HUMAN CAPITAL AND
KNOWLEDGE
Human Capital with Knowledge; It is separate from the Physical
Capital with Technical Innovation; we can have an
accumulation/evolution function for Human Capital
• No convergence – MPK does not have to decline if there is an
increase in Human Capital
The contribution of this model is that it emphasizes the link between
Technical innovation, Human Capital, and Institutions including
Government.
THE BASIC MODEL
• Simple production function - Y = AK
• Where Y is output, K is the capital stock, and A is a constant measuring
the amount of output produced for each unit of capital
• This production function does not exhibit the property of diminishing
returns to capital.
• One extra unit of capital produces A extra units of output, regardless of
how much capital there is.
THE BASIC MODEL
• we assume a fraction s of income is saved and invested
ΔK = sY − dK.
• The change in the capital stock (ΔK) equals investment (sY ) minus
depreciation (dK).
• Combining this equation with the Y = AK production function, we
obtain, after a bit of manipulation, ΔY/Y = ΔK/K = sA − d.
• As long as sA > d, the economy’s income grows forever, even without
the assumption of exogenous technological progress
THE BASIC MODEL
• In the Solow model, saving leads to growth temporarily, but diminishing
returns to capital eventually force the economy to approach a steady
state in which growth depends only on exogenous technological
progress.
• By contrast, in this endogenous growth model, saving and
investment can lead to persistent growth.
THE BASIC MODEL
• But is it reasonable to abandon the assumption of diminishing
returns to capital?
• The answer depends on how we interpret the variable K in the
production function Y = AK.
• If we take the traditional view that K includes only the economy’s stock
of plants and equipment, then it is natural to assume diminishing
returns.
THE BASIC MODEL
• Advocates of endogenous growth theory, however, argue that the assumption
of constant (rather than diminishing) returns to capital is more palatable if K is
interpreted more broadly.
• The endogenous growth models view knowledge as a type of capital.
• Clearly, knowledge is an important input into the economy’s production—both
its production of goods and services and its production of new knowledge.
• Compared to other forms of capital, however, it is less natural to assume
that knowledge exhibits the property of diminishing returns
• Therefore, endogenous growth model with its assumption of constant
returns to capital becomes a more plausible description of long-run
economic growth.
WHY KNOWLEDGE DOES NOT DIMINISH
• The Learning –by-Doing and Knowledge Spillover Hypothesis come to the
action.
• The Hypothesis of “Learning-by-Doing” by Romer/Frankel starts from Arrow’s
hypothesis that accumulation of knowledge is largely the result of
mechanization.
• Why?
• Because each new machine is capable of modifying the production environment
in such a way that learning (& often innovation) receives continuous stimuli.
• Suppose a firm has 20 workers and 2 machineries and a new machine is
brought in(thus raising the firm’s level of mechanization, i.e., higher Κ/L ratio).
WHY KNOWLEDGE DOES NOT DIMINISH
• This may lead to – as workers work on the new machine, they progressively
accustomed to it better; learn how to get the best out of it. (learn the new technique by
actually using it/ doing it)
• In the process of adopting the new devise, new forms of organization of production and/or
find new ideas to improve on the equipment itself (say change in structure of its
components)
• This process is known as “learning-by-doing” or more accurately “learning-and-
inventing by inventing-and-doing”
• Hence higher level of mechanization(↑ K/L ) and increase in the stock of knowledge are
two faces of the process of capital formation [note then Y is linear in K or K/L] – an AK
model.