Understanding the Pattern of Economic Growth

By: Bikal Dhungel

The general question of why some countries are rich and others are poor is the matter of how growth was achieved in some places and not in others. In other articles I have answered this question with a broader perspective where the roles of economic, social and cultural aspects were dealt. This article only deals with the growth pattern, the economic growth itself and this is not fully my idea. I summarize the theories of other scholars from previous decades to answer the question and leave it to the readers to analyse it themselves.

The father of the theory of economic growth is Robert Solow, a Nobel Prize winning Economist who published a paper in 1956 called ‘A Contribution to the theory of Economic Growth’. Years following, he continually contributed to the growth theory and for his work, got a Nobel Prize in 1987. His model is called The Solow Model. Models represent the complex reality in a simplest way possible mostly with figures and some mathematics. Solow Model is also the mathematical representation of real life economics, only in a simpler form.

The Solow Model consist of two functions, production function and a capital accumulation function. Capital simply means tools or knowledge that generate income. For example the sewing machine is a capital because it can be used to sew cloths. Similarly, the skill of a doctor is also a capital, but it is called human capital because the doctor uses her skill to generate income. The production function of a Solow Model describes how inputs are combined to produce output. As an example, to produce a Pencil, we need wood, we need lid, we need rubber and we need colours to colour the pencil. With these inputs, we produce a output, in this case, the Pencil. To produce this output, we combined Capital and Labour. How many percentage of capital was used and how many percentage of labour was used varies in individual cases. Some goods are labour intensive so they need more labour whereas others are capital intensive and need more capital and less labour. The firm pays wages to the labour and rent to the capital. It is also logical, with more capital, a firm can produce more output, however in a diminishing rate.

But the question is, how to accumulate capital ? Well, in reality, when a firm makes some profit, it invests a part of its income to acquire new machines, better technology and can even invests in research and technology. It can even borrow to invest in better technology hoping for higher profit in the future. With time, the capital a firm is using will rust, it needs reparations or in economical term, it depreciates. So, a constant upgrading is necessary. Considering a world of only workers and firms, the workers get wages by working in a firm and they consume a part of their income and save the rest. They save in a bank and the firm borrow from the bank to invest in better technology. So, indirectly, the same workers are lending a part of their income to the firm. So, this process continues, which we call running an economy. What we can conclude from this over simplified story is, firms must continue investing and workers must continue working and the availability of capital is important. How much capital per worker is available in the economy is what explains the difference between the worker in one country from the other. The US has more capital per worker than India. That is why the productivity of an American worker is also higher than the productivity of the Indian worker.

Solow Model tells that the economy will continue growing until the amount of capital per worker needed is equal to the real capital growth, which is called Steady State, and after that the economy cannot grow. It can only grow if there is new technology. So, it concludes that every country should or will reach the steady state sooner or later, but to achieve economic growth after that, there should be technological development. Then the growth rate equals to the growth of technology. Comparing this to the real world, let us take an example of China. Since 1979, China is growing rapidly. It built factories, production lines, developed its agriculture, service sector etc. It has employed available capital to produce more and more. it is bringing rural farmers to work in industries and consequently, China is growing at a rate of 8% on average. Now, China achieved a certain living standard, most of its workforce are employed and growth has slowed. Now growth rate is lower. It will soon reach 0%. 0% growth means, next year China will be as rich as today, and not richer. But, if somebody develop a technology which is able to produce more goods efficiently, growth rate will be equal to that. So, growth will be equal to technological growth. This answers why the US is richer than China though it had only 1 or 2 % economic growth in the last one hundred year. Because this is the growth rate of technology and sustaining a growth rate of 1-2% for such a long time makes you rich. So, first answer of our initial question of why some countries are rich and why others are poor is because they have higher labour capital ratio, meaning more capital per worker than other countries which are poor and they had a constant technological development.

But the story is far more complex than it was presented in this model. We have assumed a fixed number of workers and firms and all workers have same skills and the firm remains there for always. The reality is often different. Workers grow because population grow. With the amount of technology remaining the same but the number of people increasing, the rate of capital per worker declines. From this theory we can say that, population growth is seen as bad for the economy because the per capita income will be decreased. However, it should also be considered that more people are likely to create more ideas which in turn can help the economy. But in this model, it is assumed that countries that have higher population growth tend to be poorer and countries with lower population growth tend to be richer. Second factor which was also not considered was the skills of workers. All workers were considered to have equal amount of labour. However, in reality, people have different level of human capital. Some are highly educated hence high productive while others are not. Some are more healthy and can work longer while others cannot. We also considered a firm to be constantly there. In reality, firms might or might not be there for a long time because times change, technology change, demands and rules change. Imagine firms that produced Cassette players before. They used to be popular because people listened to cassette player. Today people don’t buy any cassette players because there are better technologies. So, Firms that produced Cassette Player disappeared and new firms arrived that produced smartphones.

So, more considerations within the Solow Model was done in consequent studies that Solow himself and other researchers did later. One of them is the Romer Model , done by Paul Romer and others from Gregory Mankiw and company who included things like human capital in Solow Model to enrich our understanding about the patterns of economic growth. To repeat, the process of economic growth is, firms acquire capital, then the workers acquire skills to use that capital in a best possible way, they learn better while they work, which we call 'learning by doing', they increase productivity, then the capital rust, the firm will upgrade capital and the workers continue working. When they reach the steady state, there should be new technology and the growth rate will be equal to the growth of technology. During this process, when the population growth is higher than the growth of capital or technology, the country gets poorer and when the population declines, more capital will be available to the workers, so, in per capita terms, they become richer. What rich countries did to sustain growth is, they supplied better qualified labour by investing in their education and health. A firm cannot do this by itself, so the government step in. This means, a responsible government that fulfilled its duty to educate its people, provide security and so on helped the government to grow. The social infra-structure which was provided and better economic policies, better coordination between the government and private firms helped rich countries grow. poor countries in contrast have failed to provide quality education to its citizens, healthcare is absent and there is lack of security, as a result the firms do not invest. Moreover, the patents and property rights law do not exist everywhere. There are also frequent disturbances to the firms in the form of political pressure individual acts like asking for money. In this case, firms have incentive to relocate to another country or to shut down. There can also be political groups like the leftists who tag the firms as violators of social justice whose aim is to exploit the society to generate private profits. This all results in low investment, which is correlated to lower employment and then poverty.