Question

In the Solow growth model, capital exhibits diminishing returns. In a basic endogenous growth model, capital exhibits constant returns. What is the main implication of these differences to economic growth of a country/countries?

Answer 1

Solow model works on the assumption of diminishing returns of capital. Which means that if an economy invest on whether human capital or physical capital each additional investment would provide marginally less returns. For example a new education policy facilitating two more years of high school education would provide good returns in improved job prospects. Now, two more years of college education is provided to the same students would again improve their productivity but the rate of improvement would be lower than before. Now, again these students are provided with two more years of college education that is four years of bachelor's degree will then improve their productivity but at slower rate than before. In the same way by investing more and more on machine and other technological equipments would start giving diminishing returns to scale.

The endogenous growth model on the other hand assumes constant returns to scale. Here, premise of the mode is that a country's development depends on it's institutional and structural frameworks. If the people of a country works great deal of economic advancements they will achieve higher growth rate. It is the indefinite investment in human capital that will provide for spillover effects which will offset diminishing returns to capital accumulation.

Implications of solow model is that the rich countries have already invested enough in both their human and physical capital due to which extra investment does not provide for high rate of marginal returns, but a very low rate of marginal returns hence, lower growth rate. Developing countries on the other hand receive way higher returns out of small investments in capital and thus, a higher growth rate . This higher growth rate in course of time will increase total GDP of country to a level of convergence with the rich countries. Meaning one day due to high growth rate of China it's GDP will become too close to that of America and will become a rich country in a very small span of time by taking advantage of lower human and physical capital stock at the sart of their development journey.

Implications of endogenous theory is that there are endogenous factors responsible for growth of a country rather than it's ability to catch up on advanced world class technology. A country with rich resources and abundant population is still not able to grow to it's potential. We, can take curious case of India. There is no clear cut explanation of why such country's economy is not able to excel in it's gorwth rate. Reason being judicial , institutional bottlenecks, lack of trust and confidence among investors , corruption etc. Thus, until and unless a country doesn't work on it's shortfalls at social, poltipoli as well as individual level it won't be able to grow at the economic level.