How can developed countries sustain growth? Let’s take a look at Robert Solow’s Growth Model.
Have we progressed?
If we travel a hundred years back, 7 out of every 10 people lived in poverty. These days, we’re down to 1 in every 10. Though headlines constantly make it seem like the world is falling apart, humanity has come a long way in terms of economic growth. Living standards are much better, be it in terms of literacy, health, or democracy. We are without a doubt better off than our ancestors.
That said, numbers show that countries have not grown at the same pace. On the aggregate, we are better off. But some countries have stayed flat, like Malawi and Liberia. Worse, a few have actually had negative growth, while South Korea and Taiwan have grown more than 30-fold.
The good thing though is that we now live in a world where we can, thanks to economic growth, share the wealth. Whereas before, a man’s wealth was to the detriment of his neighbor, which is something we call a zero-sum economy, neighbors these days can improve their economic conditions in lockstep. But the question is, for those countries that have fallen behind, what elements are required to achieve economic growth?
The right ingredients
What do developing countries need to catch up to the world’s richest economies? Factors of production are key. Think about how books were made before the printing press. The industry relied heavily on human capital to write each word by hand. But, with the addition of physical capital – machines, equipment, buildings – processes became efficient, and labor requirements significantly reduced. But it’s not enough to have laborers working all day without a clear objective in mind. Organization matters too. This is where entrepreneurs come in, to put these ingredients together and produce something of value to society.
Of course, businesses don’t grow out of thin air. A nation must have the right environment in place to encourage the formation of industry. In this regard, the government plays a crucial role in setting up a dependable legal system, enforcing property rights, maintaining political stability, and fostering open and competitive markets. Getting all of this in place is no easy feat; it occurs in stages. Without societal support and buy-in, the power of institutions is shaky at best.
Achieving long-term economic growth
Economist and Nobel Laureate Robert Solow posited in his growth model that countries playing catch-up can grow dramatically with the right components in place. We see this with post-World War II Japan. Its economy recovered quickly, seeing annual growth rates of 7.1% over the next decade. South Korea also transformed itself in a short span of time and is often touted as an economic miracle.
But catching up to other countries is not the end goal. Once a country is at the cutting edge, it needs to sustain long-term growth, lest stagnation or decline take over. But catching up is the easier part. The further economies progress, the smaller the benefits of capital accumulation. Achieving growth takes more than just investing resources in industry at this stage.
In Solow’s Growth Model, economic growth, represented by GDP, is achieved through a combination of labor, capital, and technology. The model demonstrates how technology plays a pivotal role in allowing developed economies to achieve long-term growth.
Investing in physical and human capital
The first factor of production in Solow’s Growth Model is physical capital. Capital investment is a strong driver of production efficiency. Having a computer for each employee boosts office productivity more than if the entire staff were to share a single screen. Adding a second production line to a factory can double its output.
But, at some point, additional capital sees diminishing returns. If, at any time, a factory only has enough raw materials to use 2 production lines, a third line won’t see much use. It can serve as an alternative when other units go down, but that’s the extent of its utility. An economy only needs so much capital. The larger capital investment grows, the smaller its marginal utility. This is the logic of diminishing returns.
Workers are the second factor of production. They, too, require investment – to educate and train for their tasks. Likewise, we see diminishing returns for human capital. Society needs a certain number of PhD graduates to advance our body of knowledge, but imagine a world where everyone holds a PhD!
Slowing into a steady state
Another characteristic of physical and human capital is that they wear out over time. Machines get old, and people retire. As they exceed their useful lives, they need to be replaced. The Solow Growth Model accounts for this. It acknowledges that, whatever gains an economy achieves from its output, it reinvests a portion, thereby reinvigorating capital.
So, while an economy is still developing, it starts with low capital stock – it could use more investment in machinery and transportation, or better education for its workforce. As it starts to grow, the economy pumps investment into these resources, allowing for a higher level of output. But, at some point, growth will slow down.
Over time, the economy will reach a point where capital stock wears down just as quickly as the economy is reinvesting into it. At this point, capital reaches a steady state. It is no longer increasing because any investment being made is just enough to offset wear and tear. When an economy reaches steady state, growth grinds to a halt.
Pushing for innovation
The final component of Solow’s production formula is technological advancement. It is a crucial piece of the puzzle, as it can save an economy from a steady state. An economy can accumulate as much capital as it wants, but it will eventually hit a ceiling on productivity. But if an economy focuses on the quality of capital, this can have a far greater impact on productivity.
Technological advancements include ideas and processes, techniques and other improvements. Think back to when Henry Ford invented the assembly line. This idea caused a massive shift in industries, resulting in dramatic leaps in productivity. Now, imagine a world without the assembly line but with significantly more workers and machines crowding factories. Output would most likely be a far cry from the first scenario.
By giving a boost in productivity, good ideas breathe new life into capital stock. It shifts the production curve just that bit higher so that an economy is safe from the steady state for a bit longer. Innovation and ideas sustain growth at the cutting edge.