Growth and Convergence Theories

LOS 6.i: Compare classical growth theory, neoclassical growth

theory, and endogenous growth theory.

Theories of economic growth are largely separated into three models with
differing views on the steady state growth potential of an economy.

Classical Growth Theory

Based on Malthusian economics, classical growth theory posits that, in the

long-term, population growth increases whenever there are increases in per
capita income above subsistence level due to an increase in capital or
technological progress. Subsistence level is the minimum income needed to
maintain life. Classical growth theory contends that growth in real GDP per
capita is not permanent, because when real GDP per capita rises above the
subsistence level, a population explosion occurs. Population growth leads to
diminishing marginal returns to labor, which reduces productivity and drives
GDP per capita back to the subsistence level. This mechanism would prevent
long-term growth in per capita income. Classical growth theory is not
supported by empirical evidence.

Neoclassical Growth Theory

Neoclassical growth theory's primary focus is on estimating the

economy's long-term steady state growth rate (sustainable growth rate or
equilibrium growth rate). The economy is at equilibrium when the output-to-
capital ratio is constant. When the output-to-capital ratio is constant, the
capital-to-labor ratio and output per capita also grow at the equilibrium
growth rate, g*. Under neoclassical theory, population growth is independent
of economic growth.

Professor's Note

Steady state growth rate for the purpose of neoclassical growth theory does
not assume a constant level of technology and hence differs from the
definition of steady state discussed earlier.

Based on the Cobb-Douglas function discussed earlier, neoclassical growth

theory states that:
  Sustainable growth of output per capita (or output per worker)(g*) is
equal to the growth rate in technology (θ) divided by labor's share of
GDP (1 – α).

g*=θ(1−α)g*=θ(1−α)

 Sustainable growth rate of output (G*) is equal to the sustainable

growth rate of output per capita, plus the growth of labor (ΔL).

G*=θ(1−α)+ΔLG*=θ(1−α)+ΔL

Professor's Note

In the equations for sustainable growth (per capita or total), growth rate is
not affected by capital (K). Hence, we say that capital deepening is occurring
but it does not affect growth rate once steady state is achieved.

Example: Estimating steady state growth rate

An analyst is forecasting steady state growth rates for Country X and Country
Y and has collected the following estimates:

TFP
Countr Labor Force Labor Cost as a Proportion of
Growth
y Growth Rate Total Factor Cost
Rate

X 2.0% 1.2% 0.60

Y 1.0% 2.6% 0.52

Calculate and comment on sustainable growth rates for the two countries.

Answer:

Sustainable growth rates:

Country X = (2.0% / 0.60) + 1.2% = 4.53%

Country Y = (1.0% / 0.52) + 2.6% = 4.52%

Thus, the sustainable growth rates for the two countries are comparable.
Country X's sustainable growth rate is primarily driven by higher growth rate
in TFP. Country Y's sustainable growth rate is mostly driven by a higher
population growth rate.

Under neoclassical theory:

  Capital deepening affects the level of output but not the growth rate in
the long run. Capital deepening may temporarily increase the growth
rate, but the growth rate will revert back to the sustainable level if
there is no technological progress.

 An economy's growth rate will move towards its steady state

regardless of the initial capital to labor ratio or level of technology.

 In the steady state, the growth rate in productivity (i.e., output per
worker) is a function only of the growth rate of technology (θ) and
labor's share of total output (1 − α).

 In the steady state, marginal product of capital (MPK) = αY/K is

constant, but marginal productivity is diminishing.

 An increase in savings will only temporarily raise economic growth.

However, countries with higher savings rates will enjoy higher capital
to labor ratio and higher productivity.

 Developing countries (with a lower level of capital per worker) will be

impacted less by diminishing marginal productivity of capital, and
hence have higher growth rates as compared to developed countries;
there will be eventual convergence of growth rates.

Endogenous Growth Theory

In contrast to the neoclassical model, endogenous growth

theory contends that technological growth emerges as a result of
investment in both physical and human capital (hence the
name endogenous which means coming from within). Technological progress
enhances productivity of both labor and capital. Unlike the neoclassical
model, there is no steady state growth rate, so that increased investment
can permanently increase the rate of growth.

The driving force behind the endogenous growth theory result is the
assumption that certain investments increase TFP (i.e., lead to technological
progress) from a societal standpoint. Increasing R&D investments, for
example, results in benefits that are also external to the firm making the
R&D investments. Those benefits raise the level of growth for the entire
economy.

The endogenous growth model theorizes that returns to capital are constant.
The key implication of constant returns to capital is the effect of an increase
in savings: unlike the neoclassical model, the endogenous growth model
implies that an increase in savings will permanently increase the growth rate.

The difference between neoclassical and endogenous growth theory relates

to total factor productivity. Neoclassical theory assumes that capital
investment will expand as technology improves (i.e., growth comes from
increases in TFP not related to the investment in capital within the model).
Endogenous growth theory, on the other hand, assumes that capital
investment (R&D expenditures) may actually improve total factor
productivity.

LOS 6.j: Explain and evaluate convergence hypotheses.

Empirical evidence indicates that there are large differences between

productivity (output per capita) of different countries, with less developed
countries experiencing much lower output per capita than their developed
counterparts. The economic question is whether productivity, and hence,
living standards tend to converge over time. Will less developed countries
experience productivity growth to match the productivity of developed
nations?

The absolute convergence hypothesis states that less-developed countries

will converge to the level of per capita output of more-developed countries.
The neoclassical model assumes that every country has access to the same
technology. This leads to countries having the same growth rates but not the
same per capita income and as such, the neoclassical model does not imply
absolute convergence. The neoclassical model supports the conditional
convergence hypothesis, which states that the convergence in living
standards will only occur for countries with the same savings rates,
population growth rates, and production functions. Under the conditional
convergence hypothesis, the growth rate will be higher for less developed
countries until they catch up and achieve a similar standard of living. Under
the neoclassical model, once a developing country's standard of living
converges with that of developed countries, the growth rate will then
stabilize to the same steady state growth rate as that of developed
countries.

An additional hypothesis is club convergence. Under this hypothesis,

countries may be part of a "club" (i.e., countries with similar institutional
features such as savings rates, financial markets, property rights, health and
educational services, etc.). Under club convergence, poorer countries that
are part of the club will grow rapidly to catch up with their richer peers.
Countries can "join" the club by making appropriate institutional changes.
Those countries that are not part of the club may never achieve the higher
standard of living.

Empirical evidence shows that developing economies often (but not always)
reach the standard of living of more developed ones. Over the past half
century, about two-thirds of economies with a lower standard of living than
the United States grew at a faster pace than the United States. Though they
have not converged to standard of living of the United States, their more
rapid growth provides at least some support for the convergence hypothesis.
The club convergence theory may explain why some countries that have not
implemented appropriate economic or political reforms still lag behind.

LOS 6.k: Describe the economic rationale for governments to

provide incentives to private investment in technology and
knowledge.

Firms accept projects when they provide an expected return greater than
their risk-adjusted cost of capital. Under endogenous growth theory, private
sector investments in R&D and knowledge capital benefit the society overall.
For example, a new technology may initially benefit the firm that developed
it but may also boost the country's overall productivity. The effects of "social
returns" or externalities are captured in the endogenous growth theory
model, which concludes that economies may not reach a steady state growth
but may permanently increase growth by expenditures that provide both
benefits to the company (private benefits) and benefits to society
(externalities).

When the external benefits to the economy (the social returns) of investing
in R&D are not considered, many possible R&D projects do not have
expected returns (private benefits) high enough to compensate firms for the
inherent riskiness of R&D investments. From an aggregate, economy-wide
viewpoint, the resultant level of R&D investment will be sub-optimal or too
low. Government incentives that effectively subsidize R&D investments can
theoretically increase private spending on R&D investments to its optimal
level.

LOS 6.l: Describe the expected impact of removing trade barriers on

capital investment and profits, employment and wages, and growth
in the economies involved.

None of the growth theories that we have discussed account for potential
trade and capital flows between countries. Removing trade barriers and
allowing for free flow of capital is likely to have the following benefits for
countries:

 Increased investment from foreign savings.

 Allows focus on industries where the country has a comparative

advantage.

 Increased markets for domestic products, resulting in economies of

scale.

 Increased sharing of technology and higher total factor productivity

growth.

 Increased competition leading to failure of inefficient firms and

reallocation of their assets to more efficient uses.

The neoclassical model's predictions in an open economy (i.e., an economy

without any barriers to trade or capital flow) focus on the convergence. Since
developing economies have not reached the point of significant diminishing
returns on capital, they can attract capital through foreign investment and
experience productivity growth as a result. Eventually, these economies will
develop; their growth will slow and will converge to the steady state growth
rate of developed economies.

The endogenous growth model also predicts greater growth with free trade
and high mobility of capital since open markets foster increased innovation.
As foreign competition increases, more efficient and innovative firms will
survive. Those firms permanently increase the growth rate of the
international economy by providing benefits beyond those simply captured
by the firm. Economies of scale also increase output as firms serve larger
markets and become more efficient.

In terms of convergence, removing barriers on capital and trade flows may

speed the convergence of standard of living of less developed countries to
that of developed countries. Research has shown that as long as countries
follow outward-oriented policies of integrating their industries with the world
economy and increasing exports, their standard of living tends to converge
to that of more developed countries. Countries following inward-oriented
policies and protecting domestic industries, can expect slower GDP growth
and convergence may not occur.