#5 The Neoclassical Growth Model and Global Poverty

Updated October 18, 2015.

David Stone's Entry For The 2004 Moffatt Prize in Economics
When using any economic model to portray
a real world problem and to study the
effects of various resolutions, the
usefulness of the model is most
contingent upon its ability to simulate the
real world without excessive
oversimplification. One of the questions
this may lead to is whether or not the
neoclassical growth model is a useful tool
for economists and policymakers in understanding global poverty and developing
policies to reduce poverty. This will be the topic of discussion in this paper and
we will find that while there are reasons one would use the neoclassical growth
model to analyze the plight of the world's poorest, it fails to account for many
important factors that are key to scrutinizing this problem from every possible
viewpoint.
Foremost on the agenda, we must explore the ideas and concepts that underline
this model. The neoclassical growth model emphasizes the role of technological
progress and labor productivity in maintaining a sustained long-run rate of
growth. Population growth, depreciation of capital, and, most notably,
technological progress directly affect the dynamics of the growth process.
One major idea that encompasses the frameworks of this model underlines the
assumption that over the long run, economic growth is independent of the
savings rate (or equivalently, investment). However, the economy experiences a
transitional state of growth or decline in the capital stock, which could be
prolonged over a period of decades, due to fluctuations in investment generated
from savings that is greater or less than required investment. In steady state,
therefore, the growth rate of output is equal to the rate of population growth
and the rate of technological progress. This shows that output per worker will
grow at the rate of technological progress in a state of balanced growth over
the long run.
The neoclassical growth model is achieved by assuming a diminishing marginal
product of capital, in which the economy gradually moves to a point where
savings provides only sufficient enough investment to cover depreciation. In
order to make saving and investment equal, we assume that the economy is
closed.
This is a significant and unrealistic assumption to make, yet allows the issues of
trades surpluses and deficits to be overlooked. Taxes and government spending

is also ignored in order to put focus on the behavior of private savings. Lastly,
we assume private savings to be proportional to income.
The first idea we want to explore is whether or not the idea of economic growth
is relevant to developing policies that reduce poverty in developing countries.
Indeed, the neoclassical growth model does effectively highlight an important
correlation between economic growth and poverty reduction. This model
theorizes that economic growth is contingent upon the accumulation of capitalboth human and physical-and technological progress. Human capital refers to the
increase in labor productivity due to levels of education, skills and experience,
and the health of people. Physical capital represents the tools used in
production. Lastly, technological progress has a two-fold meaning: it is the
ability of larger quantities of output to be produced with the same quantities of
capital and labor.
Equivalently, technological progress represents the key ingredient in developing
new, better and a larger variety of products for the public to consume. Studies
have shown that "literacy and other indicators of education remain woefully low
across much of the developing world," and a policy that helps poor people acquire
human capital would result in their earning higher wages (Besley and Burgess,
2003). The neoclassical growth model could be used to argue that a climate that
is more conducive to investment and entrepreneurship would help to reduce
poverty. This idea follows from the premise that heavy regulation of business
ownership is not in the public interest because it results in low capital
intensities, low human capital per worker, and low productivity (Bigsten and
Levin, 2000).
The implication that the economy is closed, which is used to develop the
neoclassical growth model, severely limits our ability to accurately portray real
world scenarios related to the plight of the poor.
One of the handicaps that it causes is in our inability to consider foreign capital
inflows along with domestic investment. Developed countries may find it
beneficial to stimulate the economy of a developing nation by investing in
research and development (R&D) in that nation, for instance. The encouragement
of new technologies may help poor people living in agricultural and rural areas
attain higher levels of output per capita and to better maximize their land and
resources.
The incentive for the developed country could be to establish new trading
partners and open up new markets for its own economy. Evidence shows that the
opening up of international markets is conducive to economic growth, as seen in
the fact that "growth problems have been most pronounced in countries that
have pursued an inward-oriented policy" (Bigsten and Levin, 2000). This may be
one of the reasons that many African countries have had low levels of output
per capita, low growth rates, and decreases in standard of living over time.

Other possible reasons for the economic stagnation in African countries will also
be explored to reflect issues of poverty.
Other assumptions in developing the neoclassical growth model come at the price
of simulating the realistic nature of the model in reflecting the real world. Any
major component of social infrastructures or the political arenas of countries
lies primarily outside the workings of this model. This, therefore, limits the
ability of economists and policymakers to explore a full spectrum of ideas
concerning the reduction of poverty. For instance, one major component of
social infrastructure that lies outside the workings of this model is the idea of
"eliminating social barriers for women, ethnic minorities, and socially
disadvantaged groups in making growth broad based" (World Bank, 2001). Other
considerations that lay beyond the reaches of the neoclassical growth model
include such areas as "policies, institutions, history and geography" (World Bank,
2001).
Government policies, for example, play an important role in the level of the
steady state, especially in regards to its influences on property right, public
consumption and on both domestic and international markets. Poor policies could
be the underlying reason that many developed countries have experienced slow
growth or even a low-level steady state (Bigsten and Levin, 2000).
Another problem to consider with the neoclassical growth model is the idea that
investment and various other factors will affect the rate of growth of per
capita output for as long as long as it takes for the economy to adjust from one
steady-state growth path to another. In actuality, investment and other factors
could influence growth in the long run because there are circumstances in which
they could be considered the equivalent to an improvement in technology.
For instance, education and external trade will lift the level of output that can
be produced from given inputs through increased efficiency. Thus, levels of
income per capita (or standard of living) will rise as a result because this is
equivalent to an improvement in technology. As we discovered earlier, low levels
of literacy, characteristic of unskilled workers, has hampered the growth in
much of the developing world.
In conclusion, the neoclassical growth model is of some use in helping economists
and policy makers develop effective policies to reduce poverty. It is extremely
thorough and complete in its manner of analyzing the plight of the poor through
the frameworks of economic growth. Technology is realized in this model to be
the key factor in sustaining long-term economic growth. The idea of investing in
physical and human capital implied by the neoclassical growth model has powerful
implications that could indirectly lead economists and policymakers to suggest
social policies that would promote health, education and other safety nets to
help the poor. The underlying argument against this model is in the fact that
many factors that may indeed influence economic growth and world poverty

simply is not quantifiable, such as legal structures, the political environment and
the social infrastructure. These are very relevant forces in the real world with
lasting impacts on economies, yet we are unable to analyze these effects
through the lens of this model. Nonetheless, the neoclassical growth model does
steer us in the right direction in thinking about the long run effects various
policies have on the welfare of an economy by looking at the situation in terms
of economic growth and technological progress.
Bibliography:
Bigsten, Arne and Levin, Jorgen. 2000. "Growth, Income Distribution, and
Poverty: A Review." Working Papers in Economics 32, Goteborg University,
Department of Economics.
Besley, Timothy and Robin Burgess. 2003. "Halving Global Poverty." Journal of
Economic Perspectives. Summer, 17:3, pp.3-22.
Blanchard, Olivier. 2003. Macroeconomics-3rd Ed. New Jersey: Prentice Hall,
Ch. 11-13.
World Bank, 2001. "Chapter 3. Growth, Inequality and Poverty, in World
Development Report 2000/2001: Attacking Poverty, New York: Oxford
University Press, pp.45-59.
This was an entry for The 2004 Moffatt Prize in Economic Writing. See the
contest rules for more information.
http://economics.about.com/od/economicsglossary/g/poverty.htm