Understanding The Solow Economic Growth Model

Robert Solow developed the neo-classical theory of economic growth and Solow won the Nobel Prize in Economics in 1987. He has made a huge contribution to our understanding of the factors that determine the rate of economic growth for different countries.

Growth comes from adding more capital and labour inputs and also from ideas and new technology.

What are the basic points about the Solow Economic Growth Model?

• The Solow model believes that a sustained rise in capital investment increases the growth rate only temporarily: because the ratio of capital to labour goes up.
• However, the marginal product of additional units of capital may decline (there are diminishing returns) and thus an economy moves back to a long-term growth path, with real GDP growing at the same rate as the growth of the workforce plus a factor to reflect improving productivity.
• A 'steady-state growth path' is reached when output, capital and labour are all growing at the same rate, so output per worker and capital per worker are constant.
• Neo-classical economists believe that to raise the trend rate of growth requires an increase in the labour supply + a higher level of productivity of labour and capital.
• Differences in the pace of technological change between countries are said to explain much of the variation in growth rates that we see.

Productivity growth

The neo-classical model treats productivity improvements as an 'exogenous' variable – they are assumed to be independent of the amount of capital investment.

Catch up growth

• The Solow Model features the idea of catch-up growth when a poorer country is catching up with a richer country – often because a higher marginal rate of return on invested capital in faster-growing countries.
• The Solow model predicts some convergence of living standards (measured by per capita incomes) but the extent of catch up in living standards is questioned – not least the existence of the middle-income trap when growing economies find it hard to sustain growth and rising per capita incomes beyond a certain level.