NEOCLASSICAL GROWTH THEORY

The neoclassical growth theory was developed by Robert Solow in 1956 as a response to the growth model developed by Harrod Domar. The theory is also known as Solow growth theory. The distinctive feature of this theory is that individual factors of production are subject to diminishing returns⁴ and that the production function exhibits

4 The Law of diminishing returns gives a description of marginal products (marginal returns) of factors of production in the short run. In the short run, with other productive inputs being fixed, the marginal product of the varying productive input, beyond a certain point begins to diminish (decline). In other words, the resulting increment in total product begins to decrease and the average product decreases too (Ahuja, 2017, 397).

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constant returns to scale in the production of goods and services. The theory states that output per worker is a function of capital per worker (Van Den Berg and Lewer, 2015:109). This measure of output gives the per capita output/income in an economy.

The capital per worker is affected by a nation’s level of investment which depends on the level of savings in an economy.

In the neoclassical model, population growth, investment and technological advancement are considered as exogenous variables. Owing to this, an increase in savings (thus, investments) leads to economic growth in the medium run (not permanent growth) as the economy transitions. On the other hand, an economy tends to experience permanent growth when labour-augmenting technical progress is incorporated in the production process. Thus, according to the neoclassical growth model, economic expansion in the medium-run and long-run are positively related to the level of investment and advancements in technology in an economy. In other words, since long-run and permanent growth is determined by technology, growth in the neoclassical model is said to be exogenously determined. The neoclassical growth model is shown below.

𝑌(𝑡) = 𝐹[(𝐾(𝑡), 𝐴(𝑡). 𝐿(𝑡)] (1) The production function above shows output as a function of capital, labour and technology. Y, is output at time t, K is physical capital stock (machinery, factories/plants etc), L is labour stock and A⁵ represents the level of technology which increases the productivity of labour in the production of goods and services. Thus, when the levels of technology (A) is high, per unit output of labour increases.

The production function above can be expressed in terms of per unit of labour⁶. That is,

5 A, as a technology index is an exogenous production input which is labour-augmenting. Technology may include knowledge, abilities and skills necessary for production. Thus, technology improves the efficiency of labour in production. In this way, technology is also a labour-saving production input in the neoclassical growth model. Further, since technology enhances labour, the units of labour going into the production process are referred to as effective labour units (Savvides and Stengos, 2009:33).

6 By dividing equation 1 by this term, 𝐴(𝑡). 𝐿(𝑡), the production function is expressed in per units of effective labour.

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𝑦 = 𝐹(𝑘) (2) Where, y is output per unit of effective labour (worker), k is capital per unit of effective labour.

The neoclassical growth theory can be used to explain how trade affects economic growth. Thus, it is used to explain how international trade or trade openness increases a nation’s welfare as it shifts from restricted trade policies to policies of free trade.

Generally, as an economy undergoes more openness to trade, interacting more with other economies through imports and exports, there is an increase in efficiency in the production of goods and services. This leads to the transformation of available inputs into welfare-improving final products. This transformation is enhanced by the international flow of factors of production from locations with relative abundance of a factor to a location of relative scarcity (Hofmann, 2013:32). In line with the neoclassical model, Mazumdar (1996:1329) adds that if an economy is initially in its steady state, upon liberalising its trade, the economy tends to experience medium-run economic growth besides the usual increase in its income/output.

In light of the neoclassical model, the trade-growth relationship differs depending on the nature of the good being imported/exported (İbid, 1336). When a nations imports consumption goods and exports capital-intensive goods, trade does not lead to growth despite substantial increase in its income. On the other hand, for nations that import capital-intensive goods and export consumption goods, trade leads to growth owing to the reduction in the cost of capital goods which are incorporated into the production process. In other words, nations that export capital-intensive goods and import consumption goods may not increase its growth rate in the medium run whereas nations that import capital-intensive goods and export consumption goods tend to increase the growth rate in the medium run. Thus, it can be deduced that trade openness is likely to be a desirable benefit to developing economies than to developed economies. This is because developing economies tend to export less capital-intensive goods and services compared to developed economies which export capital-intensive goods and services.

In the light of the neoclassical model, trade openness tends to shift an economy’s steady. This leads to medium-run economic growth as an economy experiences transition to a new steady state. However, the effect on economic growth is dependent on the

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composition of trade (whether an economy’s comparative advantage is in producing capital goods or consumption goods). Besides, since permanent economic growth under the neoclassical is possible as an economy experiences sustained technological growth, higher levels of trade openness can lead to permanent economic growth provided it transforms the speed of technical progress. In other words, trade liberalisation or increase in trade openness will positively influence economic growth if it positively affects the speed of technological advancement in an economy.