Movement without change

Neo-classical growth theory is an attempt to explain the conditions in which dynamically stable, or equilibrium growth, may be achieved. A key feature of the method of analysis used in neo-classical economic theory is the application of marginal techniques to the demand side (explaining commodity prices in terms of variations in marginal utility to consumers, for example) as well as the supply side (factor returns explained by their marginal products), rather than just to the supply side, as with classical theory.

Very broadly, the picture of the growth process envisioned in neo-classical theory is as follows. The level of savings in the current period is conditioned by the level of income from the previous period of production. This determines the size of funds available for current investment, all current savings being absorbed for this purpose. Investment may be used either to equip new workers with the same level of capital as all other workers, in this way maintaining the capital-labour ratio (capital widening), or to increase the level of capital per worker, in this way increasing the capital-output ratio (capital deepening). Capital widening can increase the absolute level of output produced, but not the rate of growth of output per worker. Capital deepening can increase productivity in the short run, but market mechanisms will adjust the relative prices of capital and labour in such as way as to encourage firms to economise of one or the other, bringing the capital-labour ratio to its long-run average—that is, the one consistent with dynamically stable, equilibrium growth—so that, without technological progress, only capital widening can occur.

In the long run, therefore, for a given level of technology, an economy will tend to grow at a rate determined by the growth rate of the population (the causes of which lay outside the field of enquiry of the model), because, assuming full employment of all factors of production, all other variables with potential to influence the level or rate of growth of economic output will adjust. To put this in another way, in the long run, only technological progress can permanently increase the rate of growth of output and income per head, because it increases the average product of labour for any given capital-labour ratio, raising also the capital-output ratio. Counter intuitively, the rate of saving has no effect on the long-run rate of growth of the economy.

To reach these conclusions, the neo-classicists make a number of simplifying assumptions; some of the most important ones are as follows.

1. Output is of a single homogeneous commodity. The level of output depends on the quantities of inputs of labour and capital, and is subject to constant returns to scale (ie by doubling the quantity of inputs of capital and labour, output is exactly doubled).
2. The supply of labour—which is also homogeneous in character—grows at a constant rate. This is the most important “exogenously determined” variable, the one to which the other variables, conditioning one-other within the confines of the model, must adjust. There is always full employment of labour, such that any extra contribution to productive capacity from this source translates exactly into actual contributions to output.
3. The rate of saving is constant. Whatever the level of income from the previous production period, in each new period, the same proportion of income is saved and the same proportion consumed. The current level of saving is determined by the level of income achieved in the previous period—that is, it is explained by processes at work within the model.
4. All current savings are employed as current investment in capital. This is so because interest rates on the capital market adjust to equate the two; if there is an excess of savings, interest rates will fall, raising the relative profitability and thus attractiveness of investment.
5. Capital does not to depreciate, but the “capital-deepening” process is subject to diminishing returns; that is, as the average capital per worker increases, the increase in output for each new unit of capital added to the production process is less than the last (ie the capital-output ratio begins to decline). The explanation for this for neo-classical economists lies in the low substitutability of labour and capital inputs.
6. The rates of reward to production factors are not constant; on the contrary, the movement of relative prices is the mechanism of adjustment by which a steady-state growth path is achieved.