Growth and Convergence Theories

Theories of economic growth are largely separated into three models with differing views on the steady state growth potential of an economy.

Classical Growth Theory

Based on Malthusian economics, classical growth theory posits that, in the long term, population growth increases whenever there are increases in per capita income above subsistence level due to an increase in capital or technological progress. Subsistence level is the minimum income needed to maintain life. Classical growth theory contends that growth in real GDP per capita is not permanent, because when real GDP per capita rises above the subsistence level, a population explosion occurs.

Population growth leads to diminishing marginal returns to labor, which reduces productivity and drives GDP per capita back to the subsistence level. This mechanism would prevent long term growth in per capita income. Classical growth theory is not supported by empirical evidence.

Neoclassical Growth Theory

Neoclassical growth theory’s primary focus is on estimating the economy’s long term steady state growth rate (sustainable growth rate or equilibrium growth rate). The economy is at equilibrium when the output to capital ratio is constant. When the output to capital ratio is constant, the capital to labor ratio and output per capita also grow at the equilibrium growth rate, g*.

Under neoclassical theory, population growth is independent of economic growth.

Based on the Cobb Douglas function discussed earlier, neoclassical growth theory states that:

• Sustainable growth of output per capita (or output per worker)(g*) is equal to the growth rate in technology (θ) divided by labor’s share of GDP (1 − α).

• Sustainable growth rate of output (G*) is equal to the sustainable growth rate of output per capita, plus the growth of labor (ΔL).

Endogenous Growth Theory

In contrast to the neoclassical model, endogenous growth theory contends that technological growth emerges as a result of investment in both physical and human capital (hence the name endogenous which means coming from within). Technological progress enhances productivity of both labor and capital. Unlike the neoclassical model, there is no steady state growth rate, so that increased investment can permanently increase the rate of growth.

The driving force behind the endogenous growth theory result is the assumption that certain investments increase TFP (i.e., lead to technological progress) from a societal standpoint. Increasing R&D investments, for example, results in benefits that are also external to the firm making the R&D investments. Those benefits raise the level of growth for the entire economy.

The endogenous growth model theorizes that returns to capital are constant and not diminishing. The key implication of constant returns to capital is the effect of an increase in savings: unlike the neoclassical model, the endogenous growth model implies that an increase in savings will permanently increase the growth rate.

The difference between neoclassical and endogenous growth theory relates to total factor productivity. Neoclassical theory assumes that capital investment will expand as technology improves (i.e., growth comes from increases in TFP not related to the investment in capital within the model). Endogenous growth theory, on the other hand, assumes that capital investment (R&D expenditures) may actually improve total factor productivity.

Empirical evidence indicates that there are large differences between productivity (output per capita) of different countries, with less developed countries experiencing much lower output per capita than their developed counterparts. The economic question is whether productivity, and hence, living standards tend to converge over time. Will less developed countries experience productivity growth to match the productivity of developed nations?

The absolute convergence hypothesis states that less developed countries will converge to the level of per capita output of more developed countries. The neoclassical model assumes that every country has access to the same technology. This leads to countries having the same growth rates but not the same per capita income and as such, the neoclassical model does not imply absolute convergence.

The neoclassical model supports the conditional convergence hypothesis, which states that the convergence in living standards will only occur for countries with the same savings rates, population growth rates, and production functions. Under the conditional convergence hypothesis, the growth rate will be higher for less developed countries until they catch up and achieve a similar standard of living. Under the neoclassical model, once a developing country’s standard of living converges with that of developed countries, the growth rate will then stabilize to the same steady state growth rate as that of developed countries.

An additional hypothesis is club convergence. Under this hypothesis, countries may be part of a “club” (i.e., countries with similar institutional features such as savings rates, financial markets, property rights, health and educational services, etc.). Under club convergence, poorer countries that are part of the club will grow rapidly to catch up with their richer peers.

Countries can “join” the club by making appropriate institutional changes. Those countries that are not part of the club may never achieve the higher standard of living.

Empirical evidence shows that developing economies often (but not always) reach the standard of living of more developed ones. Over the past half century, about two thirds of economies with a lower standard of living than the United States grew at a faster pace than the United States. Though they have not converged to standard of living of the United States, their more rapid growth provides at least some support for the convergence hypothesis.

The club convergence theory may explain why some countries that have not implemented appropriate economic or political reforms still lag behind.

Firms accept projects when they provide an expected return greater than their risk adjusted cost of capital. Under endogenous growth theory, private sector investments in R&D and knowledge capital benefit the society overall. For example, a new technology may initially benefit the firm that developed it but may also boost the country’s overall productivity.

The effects of “social returns” or externalities are captured in the endogenous growth theory model, which concludes that economies may not reach a steady state growth but may permanently increase growth by expenditures that provide both benefits to the company (private benefits) and benefits to society (externalities).

When the external benefits to the economy (the social returns) of investing in R&D are not considered, many possible R&D projects do not have expected returns (private benefits) high enough to compensate firms for the inherent riskiness of R&D investments. From an aggregate, economy wide viewpoint, the resultant level of R&D investment will be sub optimal or too low. Government incentives that effectively subsidize R&D investments can theoretically increase private spending on R&D investments to its optimal level.

None of the growth theories that we have discussed account for potential trade and capital flows between countries. Removing trade barriers and allowing for free flow of capital is likely to have the following benefits for countries:

• Increased investment from foreign savings.
• Allows focus on industries where the country has a comparative advantage.
• Increased markets for domestic products, resulting in economies of scale.
• Increased sharing of technology and higher total factor productivity growth.
• Increased competition leading to failure of inefficient firms and reallocation of their assets to more efficient uses.

The neoclassical model’s predictions in an open economy (i.e., an economy without any barriers to trade or capital flow) focus on the convergence. Since developing economies have not reached the point of significant diminishing returns on capital, they can attract capital through foreign investment and experience productivity growth as a result. Eventually, these economies will develop; their growth will slow and will converge to the steady state growth rate of developed economies.

The endogenous growth model also predicts greater growth with free trade and high mobility of capital since open markets foster increased innovation. As foreign competition increases, more efficient and innovative firms will survive. Those firms permanently increase the growth rate of the international economy by providing benefits beyond those simply captured by the firm.

Economies of scale also increase output as firms serve larger markets and become more efficient.

In terms of convergence, removing barriers on capital and trade flows may speed the convergence of standard of living of less developed countries to that of developed countries. Research has shown that as long as countries follow outward oriented policies of integrating their industries with the world economy and increasing exports, their standard of living tends to converge to that of more developed countries. Countries following inward oriented policies and protecting domestic industries, can expect slower GDP growth and convergence may not occur.