Neoclassical Theory

The neoclassical theory of economic growth began its career in the fifties and since the mid fifties a sizeable literature has developed. The theory largely grew as result of the criticisms of the Harrod Domar growth theory which assumed a single production process carried on by employing capital and labour in rigidly fixed ratio neoclassical growth theorists attacked this assumption as being unrealistic. In its place they employed a production function that allowed for changed in the proportion in which both labour and capital may be used in the production of goods and services in the economy. In other words, while the Harrod Domar theory assumed non substitutability between labour and capital, the neoclassical theory allowed for finite substitutability among the factors of production used in the production process. The neoclassical theory also assume that the rate of capital accumulation depends on the thriftiness of the economy at full employment.

According to the neoclassical growth theory, capital is a unique abstract factor of production with can be adjusted at any time absorb any size of labour into employment . since labour and capital can be combined in a varying proportion. The theory assumes an indefinitely large number of production processes, each process being characterised by a different labour capital ratio. It therefore follows that in place of the fixed output capital ratio assumed by Harrod and Domar, the neoclassical growth theorists assume that the output capital ratio can be continuously varied. With a given capital stock the employment of more labour into production would entail a diminishing output labour ratio and a higher output capital ratio. Conversely the smaller labour employment with a given capital stock would raise the productivity of labour and would lower the productivity of capital. All this follow from the law of diminishing returns.

The theory also adopts the classical approach to saving and investment equilibrium which is required for the continued full utilisation of factors in the economy. The theory assumes perfect competition in the product and factor markets. With the flexible prices of output and inputs the aggregate output depends on the supply of available inputs which under the assumption of flexible prices find employment. Thus having assumed full employment of resources through the classical approach, the theory analysis the growth path which will be followed by a fully resource employed economy as the endowment of economy resources grows over time. Unlike the Harrod Domar theory these is no need in the neoclassical growth theory to distinguish between the growth rate of the potential or capacity output and the growth of the actual or realised output of the economy because the latter becomes identical with the former.