Solow Growth Model: Physical Capital

The Solow growth model is comprised of three factors that make up long-run growth of an economy: capital accumulation, population growth and progress in technology. The Solow growth model states that an increase in investment of capital and an increase in the work force will raise the economic growth rate. As long as both of these factors are increasing so will output, in the short run. This is because of the law of diminishing returns. The law of diminishing returns is a decrease in marginal productivity by adding one more factor of production.

via https://leaprate.com/2015/10/big-banks-suffering-big-losses-look-to-raise-big-money-to-shore-up-capital-levels/
via https://leaprate.com/2015/10/big-banks-suffering-big-losses-look-to-raise-big-money-to-shore-up-capital-levels/

Imagine a firm that has one worker. If the firm hires one more worker, productivity immediately increases by two. But if the firm already has 100 workers, then adding that one extra worker will not have as big as an effect as the previous marginal increases of workers. The same principle holds for capital accumulation. If a software firm only has one computer and the firm buys one more computer, the company can now do either the same work in half the time or double the work in the same time. But if the firm already has 10 computers and tries to buy one more, the incremental increase in capital will not produce the same incremental level of output. Countries that already have an enormous amount of capital and labor would not be able to increase output growth as much as a country without as much capital or labor would. This concept is called catch-up growth.

The model forecasts that the hole between countries that are poor and rich will shrink. For instance, the United States output per capita sits at about $54,629.5 while our growth, in 2014, was 2.4% (World Bank). In Cambodia, the countries output in 2014 was $1,084.4, while the economic growth was at a whopping 7.0% (World Bank). This is because the United States has reached what Solow described as the steady state. The steady state is an equilibrium condition where investment is just able to cover capital stock depreciation. It may take awhile for Cambodia to catch up to the U.S. in output, but if there is no increase in technological progress it is possible.

Technological advancement is the other piece of the puzzle. The model predicts that the only way for a country to create continued growth is an increase in technology. An increase in technology growth, holding other variables constant, would change the slope of the yellow line positively (Figure 1).

Figure 1: Solow Growth Model (http://www.claremontportside.com/print-edition/march-2010-issue/incentivizing-investment/)
via http://www.claremontportside.com/print-edition/march-2010-issue/incentivizing-investment/

After the shift, the new short-run point, where the economy is, would be to the left of the previous steady state. This would grant a higher marginal productivity level or economic growth. In the long run the economy will eventually get back to a new steady state with roughly the same economic growth as before, unless there is more technological progress.

 

 

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