Neoclassical Growth Theory

What is the 'Neoclassical Growth Theory'

Neoclassical growth theory is an economic theory that outlines how a steady economic growth rate can be accomplished with the proper amounts of the three driving forces: labor, capital and technology. The theory states that by varying the amounts of labor and capital in the production function, an equilibrium state can be accomplished. The theory also argues that technological change has a major influence on an economy, and that economic growth cannot continue without advances in technology.

BREAKING DOWN 'Neoclassical Growth Theory'

Neoclassical growth theory starts by outlining the three factors necessary for a growing economy, and it champions the idea that a temporary equilibrium and growth can be achieved with the right allocation mix of the three factors. However, neoclassical growth theory makes it clear that temporary equilibrium is different from long-term equilibrium, which is achieved without any of the three factors needed for short-term growth.

Production Function of the Neoclassical Growth Theory

The neoclassical growth theory is based on the understanding that the accumulation of capital within an economy, and the ways in which people use that capital, is important for economic growth. Further, the relationship between the capital and labor of an economy determines its output. Finally, technology is thought to augment labor productivity in such a way that it increases the output capabilities of labor.

Therefore, the production function of neoclassical growth theory is used to measure the growth and equilibrium of an economy, and is depicted as: Y = AF (K, L). "Y" denotes an economy's gross domestic product (GDP); "K" represents its share of capital; "L" describes the amount of unskilled labor in an economy; and "A" represents a determinant level of technology. However, due to the relationship between labor and technology, an economy's production function is often re-written as: Y = F (K, AL).

Increasing any one of these inputs allows a person to see how it would affect the GDP, and therefore the equilibrium, of an economy. However, it's important to note that the three factors of neoclassical growth theory are not all equal. The returns of both unskilled labor and capital on an economy are diminishing. That means that increases in these two inputs have exponentially decreasing returns. Technology, on the other hand, is boundless in the growth it can add and output it can produce.

If, for example, an industrial economy relies on physical labor to produce its output, it is capped at the amount of jobs available and the amount of workers within the economy. With technology, these caps are nonexistent, and it's possible to realize exponentially high growth and high equilibrium.

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