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Case J1
Introducing Theories of Economic Growth
From dismal economics to the economics of optimism
The classical theory of growth
The classical economists of the nineteenth century were very pessimistic about the prospects
for economic growth. They saw the rate of growth petering out as diminishing returns to both
labour and capital led to low wages and a falling rate of profit. The only gainers would be
landlords, who, given the fixed supply of land, would receive higher and higher rents as the
demand for scarce land rose.
£
WS
e
Y
Y1
WS
1
O
N1
NL
Working population
Long-run stationary state in the classical model
The classical position can be shown graphically. The size of the working population is
plotted on the horizontal axis. If it is assumed that there is a basic minimum ‘subsistence’
wage that workers must earn in order to survive, then the line WS traces out the total
subsistence wage bill. It is a straight line because a doubling in the number of workers would
lead to a doubling of the subsistence wage bill.
The line Y shows the total level of income that will be generated as more workers are
employed, after subtracting rents to landlords. In other words, it is total wages plus profits. It
gets less and less steep due to diminishing returns to labour and capital given the fixed supply
of land.
As long as Y is above WS (say, at a population of N1), firms can make a profit. They will
try to expand and will thus take on more labour.
Initially this will bid up the wage and will thus erode the level of profits. But the higher
wages will encourage the population to expand. This increased supply of labour will compete
wages back down to the subsistence level and will thus allow some recovery in profits. But
profits will not be as high as they were before because, with an increase in workers, the gap
between Y and WS will have narrowed.
Firms will continue to expand and the population will continue to grow until point e is
reached. At that point, even with wages at bare subsistence level, no profit can be made.
Growth will cease. The economy will be in a long-run stationary state.
No wonder economics became dubbed ‘the dismal science’.
New growth theory
Economists today are more optimistic about the prospects for economic growth. This is partly
based on a simple appeal to the evidence. Despite a rapid growth in world population, most
countries have experienced sustained economic growth. Over the last hundred years the
industrialised countries have seen per-capita growth rates averaging from just over 1 per cent
to nearly 3 per cent per annum. This has resulted in per-capita real incomes many times
higher than in the nineteenth century.
This worldwide experience of economic growth has stimulated the development of new
growth theories. These stress two features:
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The development and spread of new technology. The rapid advances in science and
technology have massively increased the productivity of factors of production. What is
more, new inventions and innovations stimulate other people, often in other countries,
to copy, adapt and improve on them in order to stay competitive. Growth through
technical progress stimulates more growth.
The positive externalities of investment. If one firm invests in training in order to raise
labour productivity, other firms will benefit from the improved stock of ‘human
capital’. There will be better-trained labour that can now be hired by other firms.
Similarly, if one firm invests in research and development, the benefits can spill over
to other firms (once any patents have expired). What is more, firms trade with other
firms. If a firm that supplies components invests in better equipment, it might be able
to supply better and/or cheaper components. The firms it supplies will thus benefit
from the first firm’s investment. These spillover benefits to other firms can be seen as
the positive externalities of investment.
New growth theories seek to analyse the process of the spread of technology and how it
can be influenced.
Given that technological progress allows the spectre of diminishing returns to be
banished, or at least indefinitely postponed, it is no wonder that many economists are more
optimistic about growth. Nevertheless, there are still serious grounds for concern.
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If the benefits of investment spill over to other firms (i.e. if there are positive
externalities), the free market will lead to too little investment: firms considering
investing will take into account only the benefits to themselves, not those to other
firms. There is thus an important role for governments to encourage or provide
training, research and capital investment. (We consider such policies in section 31.4.)
Potential growth may not translate into actual growth. A potentially growing economy
may be languishing in a deep recession.
There may be serious costs of economic growth: for those whose jobs are replaced by
machines; for society, as new production and consumption patterns cause social
upheavals; for the environment, as new production generates more waste and more
pollution, and uses up scarce natural resources (see Case Study J2).
Question
Can growth go on for ever, given that certain resources are finite in supply?
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