There are several competing theories of economic growth. Some use the Solow-Swan model, while others focus on the “invisible hand” of Adam Smith. While both are plausible, neither can be considered the only theory. Some theories include factors such as supply-and-demand balance, Adam Smith’s “invisible hand,” and Rostow’s theory of economic growth. Read on to learn more. This article will briefly discuss each.
Solow-Swan growth theory focuses on the effects of technological progress and capital accumulation on long-run economic growth. In a world that’s experiencing an increasing supply of labor, Solow argues that technological progress and capital accumulation are mutually reinforcing. This theory explains economic growth in a way that’s consistent with human nature. But it doesn’t fully explain the growth of the United States.
To understand how the model works, let’s start with the definition of steady-state equilibrium. In Solow’s model, investment is a function of capital replenishment needs and starts at k(0). Once investment equals capital replenishment needs, f(0) is concave. This equation is known as a steady-state equilibrium, and this satisfies Assumption 1. The Simple Result proves that the economy is stable at any k.
Adam Smith’s “invisible hand”
The invisible hand metaphor is used to explain many aspects of economics, including the division of labor and the natural tendency to exchange. Adam Smith explained how these patterns of commerce are generated by local circumstances, such as a need for goods or a supply of them. But today, the invisible hand metaphor can also explain social phenomena like environmental degradation. It is important to understand the underlying principles of the invisible hand theory, so that we can make informed decisions on how to use it.
Invisible hand theory assumes rational people and efficient markets. The invisible hand doesn’t always work, and price increases may not necessarily result in lower demand. In fact, people often do not react to price increases in predictable ways. They consider many variables in split seconds, and they may not respond in the same way when prices go up. As a result, the invisible hand theory often fails to explain economic growth.
Schumpeter’s “invisible hand”
In a market economy, the “invisible hand” shifts resources from less productive sectors to more profitable ones. Monopolies are susceptible to competition, as are start-up companies. These firms offer a different product than the monopoly and thus compete for the same consumers. Competition creates a better product, and more consumers choose it over a less efficient version. In the long run, competition spurs technological change and a stronger economy.
Although Schumpeter wrote many years before the formal beginnings of economics, his ideas were cited by early scholars. One of these early scholars, Anthony Downs, attributed some of his ideas to Schumpeter. His premise remained unchanged for the next 50 years, even though he used a different term for entrepreneurship. Today, the theory of the “invisible hand” has been widely adapted to fit into dynamic capitalism.
Rostow’s theory of growth posited five stages of economic development. The first stage involved take-off, which was driven by rapidly growing, leading sectors. These sectors pulled along less dynamic parts of the economy, thereby causing a supply response. In a second stage, the capital-output ratio increased, causing total revenues to rise disproportionately to the increase in incomes. Third, the economy’s external economy stimulates demand within its linked sectors.
The theory of economic development was initially inspired by the theories of Hoffman and Ricardo, who had developed the modernisation model. However, Rostow’s conclusions were inconsistent with these earlier theories. Both theories focused on an increasing net output of capital goods. Further, Rostow did not see stages as mutually exclusive and stressed that human behaviour was essentially a balancing act between competing objectives. But these ideas have been challenged by economic historians and development experts alike.
Tinbergen’s “target-instrument” models
The target-instrument model for the theory of growth is a theory of economic growth developed by Dutch economist Jan Tinbergen. The target-instrument model assumes that government regulation of demand and supply determines full employment and growth. The model assumes that the government can adjust supply to meet rising demand, resulting in increased demand. This model does not consider government intervention, but instead assumes that the demand for capital and labor is fixed.
Since World War II, growth and inflation are causally related. When governments are concerned about inflation, they often implement policies that reduce output and investment, thereby reducing growth. These policies also lead to high unemployment, low investment, and poor productivity growth. Thus, both growth theories have their shortcomings. Tinbergen’s “target-instrument” model of the theory of growth should not be the only way to explain the history of growth.
The conditional convergence theory of growth has many merits. In addition to explaining the differences between rich and poor countries, it also explains why there are no growth accelerations in many developing economies since the late 1990s. This theory has many applications in economic policy, including the promotion of innovation and free competition. However, it is not without its flaws. For example, conditional convergence does not work well in a situation where countries have a high share of education or skilled labor.
First, the conditional convergence hypothesis is based on a paradox. Countries with the same technological potential and comparable savings propensities will eventually converge to the same growth rates. At the same time, they will have different consumption per capita, but their population growth rates will be similar. Therefore, it is erroneous to assume that the conditional convergence hypothesis works only in the industrialized world. This theory doesn’t work in underdeveloped countries.