One of the most famous studies ever conducted in economics was the study done by Edward Denisen. He found that the most important factor accounting for a full 28% of increased productivity, has been technological advance – just as growth theory suggests. And by the way, Denisen’s eighth category (legal-human environment) is a negative number. It estimates the negative impact that legal and regulatory constraints have had on productivity and growth. Which takes us to Ferguson (2012) who states that among the most deadly enemies of the rule of law is bad law (p.77).
- While some economists and policy makers stress the need to increase capital investment,
- others advocate measures to stimulate research and development and technological change.
- Still a third group emphasizes the role of a better educated work force.
The Neoclassical growth model was pioneered by professor Robert Solow of MIT:
- Major model components in this neoclassical growth model: Capital and technological change.
- Primary tool: Aggregate Production Function (APF), which relates technology and inputs, like capital and labor, to total potential GDP.
- Key concept: Capital deepening – the process of increasing the amount of capital per worker, e.g. more farm machinery and irrigation systems in farming, more railroads and highways in transportation, and more computers and communication systems in banking. In each of these industries societies have invested heavily in capital goods. And as a result, the output per worker has grown enormously.
The first major insight of the model is that in the absence of technological change, capital deepening does not lead to a proportional increase in output.
Reason: The law of diminishing returns – the basic idea is that as you add more and more capital to a fixed supply of labor, eventually the marginal product of capital must fall as the law of diminishing returns kicks in.
The second major insight of the neoclassical growth model is that while capital deepening can dramatically increase the productive output of an economy, it will eventually lead to economic stagnation in the absence of technological change.
At this point, the economy enters a steady state in which, without technological change, both capital incomes and wages end up stagnating.
In the long run, equilibrium of the neoclassical growth model makes it clear that if economic growth consists only of accumulating capital through replicating factories with existing methods of production, then people’s standard of living will eventually stop rising. And that’s why we must come to understand the importance of technological change in averting this fate, as modern economies in this century have so obviously done.
This leads to the third major insight of the neoclassical growth model. It is ultimately only through technological change that we can avoid the trap of economic stagnation.
Technological change represents both advances in production processes, and the introduction of new and improved goods and services. It also includes new managerial techniques, as well as new forms of business organisation.