Question

Question - Discuss the New Growth theory of Paul Romer. How does this theory improve on the Solow Growth Model?

Answer 1

Neo-Classical model of Solow/Swan

The neo-classical theory of economic growth suggests that increasing capital or labour leads to diminishing returns. Therefore, increasing capital has only a temporary and limited impact on increasing the economic growth. As capital increases, the economy maintains its steady-state rate of economic growth.

To increase the rate of economic growth in the Solow/Swan model we need:

• An increase in proportion of GDP that is invested – however, this is limited as higher proportion of investment leads to diminishing returns and convergence on the steady-state of growth
• Technological progress which increases productivity of capital/labour

New Growth Theory

The new growth theory offered a fresh take on what engineers economic prosperity. It emphasizes the importance of entrepreneurship, knowledge, innovation, and technology, challenging the view of exogenous growth in neoclassical economics that economic progress is determined by external, uncontrollable forces.

Competition squeezes profit, so people have to constantly seek better ways to do things or invent new products in order to maximize profitability. This concept is one of the central tenets of the new growth theory.

The theory argues that innovation and new technologies do not occur simply by random chance. Rather, it depends on the number of people seeking out new innovations or technologies and how hard they are looking for them. In addition, people also have control over their knowledge capital—what to study, how hard to study, etc. If the profit incentive is great enough, people will choose to grow human capital and look harder for new innovations.

A significant aspect of the new growth theory is the idea that knowledge is treated as an asset for growth that is not subject to finite restrictions or diminishing returns like other assets such as capital or real estate. Knowledge is an intangible quality, rather than physical, and can be a resource grown within an organization or industry.

The new growth theory improved solow growth theory by polishing the criticisms of the existing solow growth theory.