An Alternative Framework for Understanding the Performance of Nations
Chapter 2: Neoclassical and ‘New’ Growth Theory: A Critique
Our task in this chapter is to outline formally the assumptions and predictions of neoclassical growth theory as a background to showing, firstly, how the neoclassical production function is used for analysing growth rate differences between countries, and its weaknesses; and secondly, how neoclassical growth theory forms the basis for ‘new’ endogenous growth theory – the only major difference being that the assumption of diminishing returns to capital is relaxed, so that ‘new’ growth theory is subject to the same major criticisms as conventional neoclassical theory as far as analysing and understanding growth rate differences between countries is concerned. The Neoclassical Model The neoclassical growth model is based on three key assumptions. The first is that the labour force (l) and labour-saving technical progress (t) grow at a constant exogenous rate. The second assumption is that all saving is invested: S = I = sY. There is no independent investment function. The third 20 Thirlwall 02 chaps rprnt 20 28/6/07 15:02:00 Neoclassical and ‘new’ growth theory: a critique 21 assumption is that output is a function of capital and labour, where the production function exhibits constant returns to scale, and diminishing returns to individual factors of production. The most commonly used neoclassical production function, with constant returns to scale, is the so-called Cobb–Douglas production function, named after Charles Cobb, a mathematician, and Paul Douglas, a well-known Chicago economist before World War II (who later became a US senator). The function takes the form: Y = TKαL1–α, (2.1) where Y is...
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