Chapter Two
ROOTS AND BRANCHES
Outline
Chapter 2
Traces the history of economic growth
theory
Begins with Adam Smith who started it all
Shows how Smith’s theory evolved, and
culminated in the Harrod-Domar model
Explains why Solow rebelled against
classical growth theory …
… and why and how endogenous-growth
theory came about
Roots and Branches
The proximate causes of economic growth are the effort
to economize, the accumulation of knowledge, and
the accumulation of capital.
ARTHUR LEWIS
To change the rate of growth of real output per head
you have to change the rate of technical progress.
ROBERT SOLOW
The first revolution:
Adam Smith
Saving and
investment are
by-products and
precursors of
domestic and
foreign trade
Theory of wealth
creation, public policy,
and economic growth
size of the market
division of labour
efficiency
The first revolution:
Adam Smith
Saving and investment stimulate
growth
direct effects through accumulation
of capital
indirect effects through labour
productivity
further indirect effects through
interaction with exchange and trade,
through foreign investment
domestic market can take the place
of foreign markets
The first revolution:
Adam Smith
Smith’s reference to ‘private
misconduct’ and the ‘publick
extravagance of government’
Distinction between quantity and
quality
Mutual advantages of trade and
growth, links to geography
The first revolution:
Adam Smith
Benefits from division of labour
If specialization increases efficiency
and wealth and, thereby, economic
growth, then ...
... just about anything that increases efficiency
by the same amount, other things being equal,
should be expected to have the same effect on
growth.
The first revolution:
Adam Smith
Benefits from division of labour
So, if foreign trade enlarges the
market and thus facilitates further
division of labour à la Smith, thereby
increasing wealth and growth, then ...
... all other equivalent means of
increasing the efficiency or quality
of labour, capital, and land should be
expected to affect economic growth in the
same way.
The effort to economize
Arthur Lewis
The first revolution:
Adam Smith
Smith on education, efficiency, and growth
Distinction between the quantity and quality of
labour  education, by increasing labour
productivity, increases also efficiency and growth
Smith feared the economic, political, and social
consequences of inferior education among the
masses
He favoured public support for education
The first revolution:
Adam Smith - Summing up
Economic growth = increase in the
quantity and quality of the three main
factors of production: labour, capital,
and land
Growth accounting is based on this
classification
Two shortcomings:
quantity of land
increase in the labour force does not really
count as a source of economic growth
Adam Smith’s followers
Thomas Malthus
Question of population
David Ricardo
Distribution of wealth and foreign trade
Adam Smith’s followers
John Stuart Mill
rejected Malthus’s prediction
that population would
outgrow productive capacity
more and better education
would restrain population
growth
distribution a different matter
than production but can be
changed through policy
Adam Smith’s followers
Karl Marx
Economic mechanisms driving
production and distribution are
closely related
The limits to growth observed
by Malthus are inescapable 
‘technological unemployment’
Adam Smith’s followers
Alfred Marshall
organization as a fourth factor of
production
made explicit the connection between
education and growth
distribution of income and wealth matters
for efficiency and growth
‘Knowledge is our most powerful engine of
production ... Organization aids knowledge’
Adam Smith’s followers
Joseph Schumpeter
technology through invention, innovation,
and entrepreneurship
rent-seekers motivated by monopoly profits
perfectly competitive markets … may not be
very conducive to economic growth
No rent to capture under perfect competition
Static efficiency does not go along with
dynamic efficiency, but ...
Adam Smith’s followers
John Maynard Keynes
Accumulation of capital
‘Science and technical inventions’
‘I draw the conclusion that, assuming no
important wars and no important increase
in population, the economic problem may
be solved, or be at least within sight of
solution, within a hundred years.’
Enter mathematics:
Harrod and Domar
Paul Samuelson’s
Foundations of Economic Analysis (1948)
laid the basis for mathematical economics, including
the modelling of ...
... dynamic interactions among
macroeconomic variables
New lines of thought 
Enter mathematics:
Harrod and Domar
Net investment equals the increase in the capital stock
… net of depreciation due to physical or
economic wear and tear
High level of investment entails an
increasing level of the capital stock
High levels of saving and investment are good for growth
even if they are stationary, that is, not increasing
By continuously augmenting the capital stock ...
… even stationary levels of saving and investment
relative to output drive output higher and higher,
thus generating economic growth
Enter mathematics:
Harrod and Domar
Efficiency is crucial for growth
High level of efficiency stimulates growth by ...
… amplifying the effects of a given level of saving and
investment on the rate of growth of output
All that is required is a steady
accumulation of capital through
saving and investment
A given level of efficiency, including the state
of technology will, then translate the capital
accumulation into economic growth
Enter mathematics:
Harrod and Domar
... neatly formalized, simplified, and summarized
the essence of almost 200 years’ theorizing
about economic growth
Harrod and Domar expressed the
dynamic relationship between saving,
efficiency, and growth in a simple
equation which ...
The Harrod-Domar model 
The Harrod-Domar model
Economic growth depends on three
factors:
A. the saving rate
B. the capital/output ratio
C. the depreciation rate
So, it is essentially all here, from Adam Smith
onwards, in a single, simple equation: Growth
depends on saving and efficiency, including
depreciation
The Harrod-Domar model
Shortcomings:
Neither theory nor empirical evidence seemed to
provide much support for the capital/output
ratio as an exogenous behavioural parameter in
the model
Proved fatal to
the HarrodDomar model,
as Solow was
to show in
1956, or so it
seemed
a more elaborate formulation of the link between
capital and output was called for
The model did not leave much room for the other
crucial factor of production, labour
population or labour-force growth is absent from the
formula, which explains output growth solely by
saving and efficiency
The second revolution:
The neoclassical model
Since population growth is basically a demographic phenomenon
and, hence, exogenous from an economic point of view, it must
follow that economic growth is also exogenous
According to Solow, saving behaviour was no
longer relevant for long-run growth, nor was
efficiency in a broad sense, except insofar as it
mattered for technology
Economic growth was considered immune
to economic policy, good or bad
Even so, saving and efficiency play an
important role for growth over long periods,
that is, the medium term
The second revolution:
The neoclassical model
Solow showed how the capital/output ratio, rather than being
exogenously fixed as in the Harrod-Domar model,
… is better viewed as an endogenous
variable, which moves over time and
ultimately reaches long-run equilibrium
Once attained, the long-run equilibrium is
consistent with not only a constant
capital/output ratio
… but also with a constant rate of growth
of output per capita, a constant rate of
interest, and a constant distribution of
national income between labour and
capital, all of which seemed to apply to
the real world
The second revolution:
The neoclassical model
The capital/output ratio is exogenous
… possible to view growth as an
endogenous variable: growth adjusts to
the exogenously given capital/output
ratio
Solow reversed the roles of the rate of
growth and the capital/output ratio
He treated the capital/output ratio as an
endogenous variable that adjusts over
time to the exogenously given growth
rate of output
Growth is exogenous because its two main
determinants, population growth and
technological progress, are exogenous
The third revolution:
Endogenous growth
The neoclassical growth model seemed unable to answer
some burning questions about economic growth
Is technological change exogenous from an economic point of
view?
Do economists really have nothing to say about economic growth
in the long run?
If output per capita grows at a rate that depends solely on
- in fact, is equal to - the rate of technological progress,
then why is it that the growth performance of different
countries differs so radically over long periods?
What does the neoclassical model tell us about relative growth
performance anyway?
The third revolution:
Endogenous growth
Do poor countries grow more
rapidly than rich countries?
What is the empirical evidence?
Called for new thinking
about economic growth

The third revolution:
Endogenous growth
Key idea
Technology is probably not exogenous
More probably
Technology depends on economic factors: the
amount of capital available to workers - the
capital/labour ratio
The capital/output ratio turns
out to be a constant after all
The third revolution:
Endogenous growth
Economic growth free to respond to changes in
saving and efficiency, and depreciation, even in
the long run
The Harrod-Domar model has thus been restored
Endogenous technology makes economic growth
also endogenous
Throws all windows wide open
The third revolution:
Endogenous growth and development
Arthur Lewis
The effort to economize
Accumulation of knowledge
Accumulation of capital
Economic growth responds to
economic policy
Economic growth obeys the same
laws as economic development
The third revolution:
Endogenous growth - Summary
Growth theory and the origins of economics
Classical economists: viewed economic
growth as endogenous
The classical view was neatly summarized
in a simple equation by Harrod and Domar
Solow: economic growth depends on
technology, and is exogenous in the long run
Economic theorists went back to their
drawing boards, and re-endogenized growth
Questions for review
1. Suppose foreign trade stimulates economic growth as
argued by Adam Smith, other things being equal. Does
it follow that large countries with limited trade with the
rest of the world should be expected to grow less
rapidly than small countries with extensive foreign
trade?
Why not?
2. ‘A high saving rate ensures rapid economic growth.’ Is
this statement true or false? Discuss.
Questions for review
3. Explain how more and better education affects (a) the
level of per capita GNP in the long run and (b) its
long-run rate of growth according to
I. the Harrod-Domar model;
II. the Solow model;
III. the endogenous-growth model.
4. Why does increased depreciation of capital reduce
economic growth, other things being equal? Does it
matter whether the depreciation is physical or
economic? - i.e. whether it results from physical wear
and tear or from low-quality investment decisions in
the past.
Classroom discussion