1. INTRODUCTION *

2. Old Growth Theory *

2.1 Theoretical Factors that Influence the Income Level *

2.2 The Empirical Evidence of Convergences *

3. Does the Old Growth Theory

Adequately Explain Growth? *

4. The New Growth Theory *

4.1 Departing From the Old Growth Model *

4.2 Other Factors Behind Economic Growth *

5. CONCLUSION *

6. LIST OF REFERENCES *

1.    INTRODUCTION

Recently, a great deal of attention has been paid in economics literature to convergence, or the tendency for poorer countries to grow faster than (and eventually catching up with) richer ones, and hence, for their levels of income to converge.

In modelling economic growth for this analysis, economists have identified two broad interpretations of the relationship between accumulation and output growth, the neoclassical view and the endogenous growth approach.

The neoclassical view, represented by works of Robert Solow, emphasises capital accumulation and exogenous rates of change in population and technical progress. It assumes that as physical (and human) capital are accumulated, their incremental contribution to output experience diminishing return. If this is the case, poor economies (those with smaller endowments of physical and human capital per worker) will grow faster than rich economies for the same level of investment in physical and human assets (World Bank 1993, p. 49), leading to the development of convergence hypothesis.

On the other hand, the new growth theory since advocated by Paul Romer generally does not prophesy that output per capita will eventually converge across all economies.

This assignment shall attempt to examine in greater details the differences between old and new growth theory especially their implications for convergence of level of per capita income across economies. In addition, the factors that promote convergence as well as their opposite forces shall be discussed.

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2. Old Growth Theory

Does the world take determinants of technology progress and growth exogenously? We shall first look at the principles behind the neoclassical model.

2.1 Theoretical Factors that Influence the Income Level

In a simple Solow growth model where economy produce a single output, it exhibits constant return to scale in production and diminishing marginal returns in the two factors of production, effective labour and physical capital. Increasing the capital to effective labour ratio means increasing the amount of capital per worker, thus increasing productivity and per capita incomes but at a decreasing rate because of the law of diminishing return. The savings rate and the population growth determine the rate of investment and the labour force growth rate, both exogenous to the model. By increasing the rate of investment beyond the rate of population growth, the capital to labour ratio would be increased and growth will occur but only during the transition phase until the steady state (k^*) is reached (where all economic variables grow at the same rate). This process can be represented by the figure below:



Algebraically, the rate of change of capital to labour ratio with respect to time is given by the equation:

(Romer, 1996, p. 13)

The term sf ( k(t)) is the amount of investment per unit of effective labour, and the term (n + g + d ) k(t) is the break-even investment per worker needed to maintain the capital to labour ratio, k = K/L. When k is below (above) k^*, actual investment per worker exceeds (falls short) that required to keep k constant, so k rises (falls). Thus the economy drifts toward k^*.

In the Solow growth model where technological progress is exogenous, income will rise with the level of physical or human capital but the rise will not generate ever increasing growth rate. As Gould & Ruffin (1993) illustrates, skill workers increase the level of income just like any other productive factor, but they do not increase growth in the long run because technological progress does not depend on the presence of a skilled work force. They summed up by concluding that the rate of growth of an economy in the long run "simply equals the rate of growth in the labour force plus the rate of exogenously determined technological progress".

If the neoclassical model is relevant in the real world, empirically it should support a number of hypotheses. Firstly, it predicts that the growth rates of various countries will ultimately converge. In a free market environment, each country will have access to similar technologies and mobile factors of production will be drawn to areas where they are able to earn the highest rate of return. Poorer countries (given their initial position) are in a better position to exploit the gains from more capital since they have a relatively low capital to labour ratio. Given the usual neoclassical assumptions, countries with less capital will have higher returns to this capital and any investment capital will exhibit higher marginal returns. Thus, income convergence should occur over time as the increase in the capital stock takes hold in low capital regions.

Secondly, countries with high rates of population growth should exhibit slower per capita GDP growth as the capital stock, after spreading out among larger number of people will decrease the k. Thirdly, increasing the rate of investment will increase the stock of capital and therefore capital deepening will occur, resulting in higher growth rates.

2.2 The Empirical Evidence of Convergences

The convergence in per capita GDP between countries, as predicted by the old growth theory, has failed to materialise on a truly global scale. If income levels of countries tend to converge, poor countries should grow faster than richer ones as they catch up to reach the higher level of income. As Barro (1991) have shown using data from Summers & Heston (1988) international comparison project, there does not appear to be any strong negative relationship between per capita growth rates and the starting level of income (per capita), which may indicate that convergence is not taking place. However, if we examine the relationship again but this time holding the human capital constant, we find that the poor countries appear to be catching up with the rich countries.

Population Growth

In the old growth theory, increasing the capital to labour ratio is what leads to growth. Thus, increasing the population results in a decrease in k which leads to lower per capita income growth. Brander and Dowrick (1991, p. 815) have shown that decline in fertility (presumably highly correlated with the population growth rate) precede income growth in their sample of countries.

Investment in Physical Capital

As discussed, the traditional growth theory holds that capital deepening will lead to growth. Increasing investments leads to an increased stock of capital, which increases the productivity of labour, thus leading to economic growth. De Long and Summer (1991) find that investment in equipment is strongly associated with growth. They explain that new technologies have tended to be embodied in new types of machines.

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3.    Does the Old Growth Theory Adequately Explain Growth?

Looking at initial GDP per capita, population growth and the investment to GDP ratio in isolation show only limited support for the neoclassical model of growth empirically. This is because the regression on the above data sets displayed a relatively low R² value suggesting that a great deal of the variation between the 98 sampled countries has been left unexplained (Barro, 1991; Gould & Ruffin, 1993; World Bank, 1993; Summer & Heston, 1991). Old growth theory accredits this unexplained variation (or the Solow residual) to technological changes. It is commonly known as Total Factor Productivity which is estimated "in a neoclassical framework by subtracting from output growth the portion of growth due to capital accumulation, to human capital accumulation, and labour force growth" (World Bank, 1993, p. 54). But still, this unexplained variation is too large for many.

New theories have been developed to deal explicitly with this technological change. Since the three variables under consideration (Y, K, and L) fail to explain the complete growth experience, technological changes (for eg., A) was thought to account for the remainder. In particular, if the difference is due to changes in the state of technology between countries, why do different countries have different rates of technological progress? This is what the new growth theory addresses.

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4.    The New Growth Theory

The new endogenous growth theory attempts to deal with the major shortcomings of the traditional growth theory. Namely, it explicitly attempts to endogenise the role of technological change into the model.

4.1 Departing From the Old Growth Model

The Solow model suffers from its assumption that technological progress is not explained and determined by economic forces. Recently developed endogenous growth models have attempted to link technological progress with economic process.

Technological progress exists, according to Schumpeter and Schmookler, because innovators find it profitable to discover new ways of doing things (Grossman & Helpman, 1991, p. 5). But every new invention adds on to the existing stock of knowledge, which translates to falling cost of innovation as this knowledge accumulates (Davies, 1988).

A distinct difference from the Solow model is that there are no diminishing returns to capital when other factors are held constant. There may also exist increasing returns to scale in output and growth rate by raising capital (Gould & Ruffin, 1993, p. 30). Thus, economic growth will tends to be faster "among countries with a relatively large capital stock, large educated population, or an economic environment that is favourable to the accumulation of human knowledge". It is dependent on changes in "behaviour parameters" or policy intervention that can influence the long-term rate of growth (Skott & Auerbach, 1995). In addition, the market structure that firms operate in is also important. A non-competitive market or effective protection of intellectual property rights may allow firms to capture economic rents from the development of its products, thus increasing the potential rewards of R&D (Cameron, 1996). These are the variables that endogenous growth attempts to include. This is summed up by Cameron (1996) that endogenous growth theory is based on the assumption that long run growth is based on economic incentives provided by the economic environment within which economic actors work.

Romer (1986) presented a theoretical argument that, even with a constant state of technology and population, growth in per capita incomes can be ever increasing. He accomplishes this by dropping the diminishing returns assumption in the neoclassical growth model. Thus, the rate of technological change becomes endogenised in his model, not exogenously determined as in the old growth model. This is owing to the hypotheses that investment in knowledge will have increasing return to scale. In addition, increasing the stock of knowledge creates a public good whereby positive externalities are derived (Bureau of Industry Economics, 1992, p. 27). For example, investment in R&D will result in firm-specific knowledge that is used to develop a certain product, and at the same time also increases the stock of such knowledge, thus increasing the possibilities for development of new products or cheaper process (Grossman & Helpman, 1991, p. 335). As world research spillovers increase, the result will be "greater convergence among countries that share this world pool of knowledge but greater divergence between those have access to this pool and those that do not" (Park & Walter, 1996). Opening an economy to international trade thus has positive growth implications, increasing the transfer of knowledge and the positive externalities that it produces.

4.2    Other Factors Behind Economic Growth

The new growth theory is especially relevant when studying developing economies, since it provides a firm foundation on which to answer the question of why growth rates have differed across countries contrary to the traditional growth theory, which says that income convergence between countries will occur. However, due to absence of firm’s empirical data, these models shall remain "largely theoretical and untestable" (Harris, 1993). Nonetheless, they do present a number of ideas that are important for our understanding of the growth processes in developing countries. The development of the new growth theory has prompted us to look again into the factors responsible for the endogenously determined growth.

                    Investment in Human Capital

Since Adam Smith, economists tend to focus only on physical capital in designing growth models (Ekelund & Hebert, 1997, p. 117). In the 1960s, the definition of capital began to expand to include human capital. The better the quality of labour, the more productive it will be when combined in the proper proportions with capital. It is a complement to physical capital in the production process which, if not present, physical capital may not be attracted to capital-poor regions as predicted by the neoclassical model. This shortage of complementary human capital could be what is preventing some countries from achieving higher growth rates (Lucas, 1990). Borro (1991, p. 416-7) also suggests empirically that development of human capital is highly correlated with growth rates in developing countries. This explains why some economies (like the HPAEs) achieve a higher steady state growth path than other economies and why incomes per capita between countries may not converge to the degree predicted by the neoclassical growth model (Pritchett, 1996).

International Trade

Gould & Ruffin (1993) examined the works of De Long & Summers (1991) and Roubini & Sala-i-Martin (1991) and conclude that "a country open to international trade may experience faster technological progress and increased economic growth because the cost of developing new technology falls as more high-tech goods are available". Thus, countries that are open to international trade grow faster than closed economies. Empirically, the HPAEs who practice export-push trade strategies experienced much higher growth rates than the relatively closed economies of Africa and Latin America (Gould & Ruffin, 1993; World Bank 1993).

The Role of Government

The governments have played a greater or lesser role in the development of all developing economies. Both the political environment and the economic policies pursued by government can be important in determining the growth potential of an economy. This stand differs from the Solow growth theory where government and economic agents have little role to play. An important factor for economic growth may be the degree of political stability that is exhibited by a country. Barro (1991) shows that political instability is negatively related to investment and growth rates.

For the new growth theory, it is possible for government policies on competition, trade, taxation, education and property rights to innovations to increase the sustainable rate of economic growth (Bureau of Industry Economics, 1992). However, De Long & Summers (1992) have shown that much of the variation in growth rates between countries cannot be traced to macroeconomic policies, but must be attributed to structural and external factors. "Bad macroeconomic policies can result in poor economic performance, while good macroeconomic policies are a necessary, but insufficient, condition for productivity growth".

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5. CONCLUSION

So far, it was proven empirical that there is a strong relationship between investment (particularly human capital investment) and growth. Other factors like having an open economy, political stability, promoting R&D and sound government policies are also found to possess that positive relationship with growth. Gould & Ruffin (1993) have attributed these finding to be consistent with "the long run predictions of endogenous growth model but are also consistent, in the short run, with [the] Solow model". They also pointed out that it might take decades before one has enough detailed long run data to distinguish clearly between the two theories.

The Solow growth model has also predicted that the level of per capita income will converge across economies. In contrast, the endogenous growth models tend to produce more complex results where convergence does not occurs, and may allow for the possibility that countries that start off richer and have more resources (such as human or physical capital) to be always ahead of less developed countries, citing a divergence in per capita incomes across nations. (Cameron, 1996, p.10).

 

Number of words (content only): 2500

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6.    LIST OF REFERENCES

Barro, Robert J. (1991) ‘Economic Growth in a Cross Section of Countries’, Quarterly Journal of Economics, 106, p. 407-443.

 

Brander, James A and Dowrick, Steeve (1991) ‘The Role of Fertility and Population in

Economic Growth: New Results from Aggregate Cross-National Data’, MIMEO, University of British Columbia.

 

Bureau of Industry Economics (1992) Recent Developments in the Theory of 

Economic Growth: Policy Implications, Occasion Paper No. 11, AGPS, Ch. 4.

 

Cameron, Gavin (1996) ‘Innovation and Economic Growth’, Centre for Economic

Performance, Discussion paper No. 277, Feb.

 

Davies, Stephen (1998) Technical Change, Productivity and Market Structure in

S. Davies and B. Lyons, eds., Economics of Industrial Organisation, Ch. 6

 

De Long, J. Bradford and Summers, Lawrence H. (1991) ‘Equipment Investment and

Economic Growth’, Quarterly Journal of Economics, Vol. 106, No. 425, May, p. 445-502

 

De Long, J. Bradford and Summers, Lawrence H. (1992) ‘Macroeconomic Policy and

Long-Run Growth’, Federal Reserve Bank of Kansas City Economic Review, Vol. 77, No. 4, 4^th Quarter, p. 5-29

 

Ekelund , Robert B Jr. and Hebert, Robert F. (1997) A History of Economic Theory and

Method, 4^th International ed., McGraw-Hill, USA.

 

Gould, David M. and Ruffin, Roy J. (1993) ‘What determines economic growth?’,

Economic Review Federal Reserve Bank of Dallas, 2^nd Quarter, p. 25-40.

 

Grossman, Gene M. and Helpman, Elhanan (1991) Innovation and Growth in the

Global Economy, MIT Press, Ch. 2, 3 and 13.

 

Harris, Richard G. (1993) ‘Globalization, Trade and Income’, Canadian Journal of

Economics, Vol. 26, No. 4, Nov, p. 555-576.

 

Lucas, Robert E. Jr. (1990) ‘Why Doesn’t Capital Flow from Rich to Poor Countries?’,

American Economic Review, Vol. 80, No. 2, May, p. 92-96.

 

Park, Walter G. and Brat David A. (1996) ‘Cross-country R&D and growth: Variations

on a theme of Mankiw-Romer-Weil’, Eastern Economic Journal, Summer, Vol. 22, No. 3, p. 345-354.

 

Pritchett, Lant (1996) ‘Forget convergence: Divergence past, present, and future’,

Finance and Development, Jun., Vol 33, No. 2, p. 40-43.

 

Romer, David (1996) Advance Macroeconomics, McGraw-Hill, Ch. 1.

 

Romer, Paul M. (1986) ‘Increasing Returns and Long-Run Growth’, Journal of

Political Economy, Vol. 94, No. 5, Oct., p. 1002-1037.

 

Skott, Peter and Auerbach, Paul (1995) ‘ Cumulative causation on the "new" theories

of economic growth’, Journal of Post Keynesian Economies, Spring, Vol. 17, No. 3, p. 381-402.

 

Summers, Robert and Heston, Alan (1991) ‘The Penn World Table (Mark 5): An

Expanded Set of International Comparisons, 1950-1988’, Quarterly Journal of Economics, 106, May, p. 327-368.

 

World Bank (1992) World Development Report 1992, Oxford University Press, New York.

 

World Bank (1993) The East Asian Miracle – Economic Growth and Public Policy,

A World Bank Policy Research Report, Oxford University Press, New York.

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