Neo Classical Theory of Economic

Development

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 The term was originally introduced by Thorstein Veblen in 1900,
in his article-
'Preconceptions of Economic Science', to distinguish
marginalists in the tradition of Alfred Marshall from those in
the Austrian School.

1857 1929- American economist and sociologist, and

a leader of the institutional economics movement

Besides his technical work ,he was a critic of

capitalism, as shown by his best known book
The Theory of the Leisure Class (1899).

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 Other Neoclassical economic theorists- Robert Solow & T.W.
Swan, HarrodDomar, Ricardo, Keynes, Gilpin, North,
Samuelson.

Term was used in 1900 matures through 1940s Most

implemented in 1990s Economic Liberalization.

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 In neoclassical economics, the entire
edifice of the theory of growth is built
on a concept of decline DRS
The concept of diminishing returns- DRS Paradox
concept of diminishing returns, in
growth theory is confusing. Increase in
Decreasing
Problem is - it is difficult to describe
how something increases if the main Value
process used to describe the increase is
a process of decreasing values.

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 Samuelson - the law of diminishing returns: Paul Anthony
Samuelson, 1st
American to
An increase in some inputs relative to other win Nobel
fixed inputs will, in a given state of technology, Memorial Prize
in Economic
cause total output to increase; Sciences.

but after a point, the extra output resulting from the same
additions of extra inputs is likely to become less and less.

This falling off of extra returns is a consequence of the fact

that the new doses of the varying resources have less and
less of the fixed resources to work with
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 Example-

If one has a particular fixed area of land, the addition of

more and more labor will result in diminishing returns to
each additional unit of labor. -- Ricardo

However, If both land and labor are increased at the

same rate, there may be no diminishing returns; there
may be constant returns to scale.

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 Important contributions to the model The neo-classical
came from Robert Solow and T.W. Swan model was an
who independently developed relatively
simple growth models Solow - Swan
extension to the
Model. HarrodDomar
Model -1946 that
Solow was also the first economist to included a new
develop a growth model which term:
distinguished between vintages capital
vs. New Capital.
Productivity
Growth.

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 The Solow-Swan model augmented
The SolowSwan Model with human capital predicts that the
is an exogenous growth income levels of poor countries will
model tend to catch up/ or converge
towards the income levels of rich
countries.
An economic model of
long-run economic Provided, the poor countries have
growth of neoclassical similar savings rates for both
economics. physical capital & human capital as
a share of output.

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 because Capital is produced based on known Solow's Model-
technology.

Technology improves with time new capital New Capital is

will be more productive than old capital. more valuable
than old
Both Paul Romer and Robert Lucas, Jr. (vintage) capital
subsequently developed alternatives to Solow's
neo-classical growth model.
Separate effects of
technological
Today, economists use Solow's sources-of-
change, capital,
growth accounting to estimate the separate
effects on economic growth of technological and labor on
change, capital, and labor. Economic Growth.

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Neo Classical Idea!

Neoclassical economics is characterized by several

assumptions common to many schools of economic
thought.

There is not a complete agreement on what is meant by

neoclassical economics, and the result is a wide range
of neoclassical approaches to various problem areas
and domainsranging from neoclassical theories of
labor to neoclassical theories of demographic changes
etc.
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 Neoclassical economics largely
rests on 3 Assumptions- Neoclassical
economics dominates
1. People have rational preferences microeconomics &
among outcomes that can be together with
identified and associated with a value. Keynesian economics
forms the neoclassical
2. Individuals maximize utility and firms synthesis, which
maximize profits. dominates
mainstream
3. People act independently on the basis economics today.
of full and relevant information.
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 Based on the assumptions focuses on the
determination of --- Forces & Factors-
Prices, Outputs, and income distributions Supply & Demand
in markets through supply and demand
and .. 1
Out Put & Prices
Often mediated through a hypothesized
maximization of utility by income- Income Constrained
constrained individuals .. 2 Individuals

and of profits by cost-constrained firms Cost Constrained Firms

employing available information and
factors of production, in accordance with Rational Choice Theory
rational choice theory.3
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To Determine

Supply & Demand Forces .. income-constrained individuals

Determine .. Mediate
Prices, Outputs, and income through a hypothesized
distributions in markets maximization of utility by

Employing available
Cost-constrained & Profit information and factors of
Maximizing Firms production, in accordance with
Rational Choice Theory.

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 Rational choice theory
Also known as choice
theory or rational action
theory is a framework for
understanding and often
formally modeling social
and economic behavior.
Also used in modern
political science ,sociology
and philosophy.
Rationality
(here equated with
"wanting more rather than
less of a good")
widely used as an assumption
of the behavior of individuals
in microeconomic models and
analysis of human decision-
making.
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 Normally, "rationality" means "sane,"
"in a thoughtful clear-headed manner,"
or knowing and doing what's healthy in
the long term.
Neoclassical Economics takes a narrow
view of Rationality.
It attaches "wanting more" to
instrumental rationality, which involves
seeking the most cost-effective means to personal advantage
achieve a specific goal without reflecting
on the worthiness of that goal.
Rational choice theory
uses a specific and
narrower definition of
"rationality" simply to
mean that
An individual acts as if
balancing costs against
benefits to arrive at
action that maximizes
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Example

buying a new dress, or committing a

travel, business deals etc. Amartya Sen

In rational choice theory, all decisions, sees the model

crazy or sane, are postulated as a and people who
"rational" process. follow rational
choice model as
Thus rationality is seen as a property of "rational fools."
patterns of choices, rather than of
individual choices:
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 Implication to Developing Countries
1. Neoclassical Approach talks of Qualitative Productivity &
Growth which is more refined than Smith & Ricardo.

2. Incorporates Malthusian Demand Approach. That means

Case of China,
they incorporate role of Supply & Demand. India etc.
vs.
3. Since they use Rational Choice Theory, they talk of Free Singapore, Hong
Market Economy - Smith.
Kong, Malaysia,
South vs. North
4. Price Sensitive Individuals vs. Cost Cutting & Profit
seeking Industries Korea.

5. Also analyses sources-of-growth to estimate the separate

effects on economic growth of technological change,
capital, and labor.
6. Incorporates role of Technology for productivity.

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 Conclusion
Opportunity of Productivity is available provided right strategy is
adopted.

Factors of Production must be free to optimize their productivity.

Market based on Demand & Supply shall set its equilibrium.

Technology has to be incorporated towards growth & Productivity.

Value Interpretation.

Classical Economists Productivity & Growth vs. Neoclassical

Economists Productivity Growth Approach.
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