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CLASSICAL GROWTH THEORY: ADAM SMITH, DAVID RICARDO & T. MALTHUS Development Economics Jan2014 R P

CLASSICAL GROWTH THEORY:

ADAM SMITH, DAVID RICARDO & T. MALTHUS

Development Economics

Jan2014

R P Pradhan

BITS Pilani, K K Birla Goa Campus

Proposed Objective! To understand the respective perspectives of classical economists on the ideas, issues &

Proposed Objective!

To understand the respective perspectives of classical economists on the ideas, issues & problem of economic growth.

Adam Smith

David Ricardo

Thomas Malthus

Classical growth theory (a synthesis of Smith and Ricardo s perspectives)

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Production Consumption Self Regulation Invisible Hand Emergence of Market Adam Smith - Collectively the

Production

Consumption

Self

Regulation

Invisible Hand

Emergence of Market

Adam Smith - Collectively the individuals in society, each acting in his or her own self- interest, manage to produce ------

in his or her own self- interest, manage to produce ------ and purchase the goods and
in his or her own self- interest, manage to produce ------ and purchase the goods and

and purchase the goods and services that they as a society require ------

He called the mechanism by which this self-regulation occurs the invisible hand,

His book, The Wealth of Nations, published in 1776, the year of America's Declaration of Independence.

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While Smith couldn't prove the existence of this hand (it was, after all, invisible) he

While Smith couldn't prove the existence of this hand (it was, after all, invisible) he presented many instances of its working in society.

Essentially, the butcher, the baker, and the candlestick maker individually go about their business.

Each produces the amount of meat, bread, and candlesticks he judges to be correct Producers or Supply Line

Each buys the amount of meat, bread, and candlesticks that his household needs Consumers or Demand Line

And all of this happens without their consulting one another or without all the king's men telling them how much to produce.

In other words, it's the free market economy in action.

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In making this discovery, Smith founded what is known as classical economics. The key doctrine

In making this discovery, Smith founded what is known as classical economics.

The key doctrine of classical economics is that a laissez-faire attitude by government toward the marketplace will allow the invisible hand to guide everyone in their economic endeavors, create the greatest good for the greatest number of people, and generate economic growth.

Smith also delved into the dynamics of the labor market, wealth accumulation, and productivity growth.

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Classical Growth Theory

Classical Growth Theory [ Background ] Classical Economists were products of the European Enlightenment and shared

[Background]

Classical Economists were products of the European Enlightenment and shared an intellectual concern for human progress.

They were concerned with the problem of economic growth: its sources, forms and effects.

The purpose of their analysis was to identify the forces in society which foster or impede progress.

They included: Adam Smith, David Ricardo, Thomas Malthus, Karl Marx, Jean-Baptiste Say, John Stuart Mill among others.

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Adam Smith:

Adam Smith: Classical Growth Theory & Approach Adam Smith [ first] identifies the main factors of

Classical Growth Theory & Approach

Adam Smith [first] identifies the main factors of production:

i.e. Land, Labour and Capital.

[Thereafter] Smith tries to analyse how these interact with one another to generate economic growth.-

Out Put= Y Capital= K Labour= L Land= T or N Production Production Interface Function
Out Put= Y
Capital= K
Labour= L
Land= T or N
Production
Production
Interface
Function
Function

Y= (K, L,N or T)

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So output is related to labor and capital and land inputs. Consequently output growth (g

So output is related to labor and capital and land inputs.

Consequently output growth (g Y )

was driven by population growth (g L ),

investment (g K )

& land growth (g T )

Increases in overall productivity (g ヲ )

g g Y = f(g K , g L , g T ) = f(g
g
g Y = f(g K , g L , g T )
= f(g
, g
, g
)
Y
K
L
T

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Measuring Real National Income Smith s measure of national wealth was ------- command over labor,

Measuring Real National Income

Smith s measure of national wealth was -------

command over labor,

Defined as the amount of labor that output can buy

Example [if there is $100 of gross product (Y) and the wage rate (w) = $5, then there are Y/w = 20 units of labor Commanded]

Effectively, this made the employed labor force his measure of national wealth (Y/w=N)

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To understand Adam Smith s final growth process, we first need to look into the

To understand Adam Smith s final growth process, we first need to look into the individual components, which have laid the foundation of the theory.

These are Adam Smith's Production Function & process of growth of labour force and capital accumulation in the economy.

Smith argues that economic growth takes place because of the occurrence of a phenomenon called ------

Increasing Returns to Scale (IRS) wherein output

is greater than the amount invested.

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Adam Smith identified 03 major sources of growth: 1. Growth in the L & stock
Adam Smith identified 03 major sources of growth: 1. Growth in the L & stock

Adam Smith identified 03 major sources of growth:

1. Growth in the L & stock of K.

2. Improvement in the efficiency with which K is used in L through greater division of labour and technological progress.

3. Promotion of foreign trade that widens the market & reinforces the other two sources of growth.

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[ How does IRS Work?] Incentive to maximise profit gives rise to a process of

[How does IRS Work?]

Incentive to maximise profit gives rise to a process of capital accumulation (saving and investments) which gives rise to division of labour(Specialisation) through which labour productivity is enhanced thus generating greater output per unit of investment.

Smith identifies two sectors in the economy: Agriculture and Industry

Emphasised that the law of increasing returns applied more to Industry due to repeated improvements through the use of technology and division of labour.

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Why some countries are Poor & Others are Rich? [ Implication for under-developed countries ?]

Why some countries are Poor & Others are Rich?

[Implication for under-developed countries?]

It can be inferred that one of the causes of economic differentiation is because some countries are predominantly agrarian where the DRS(Diminishing Return to Scale) applies while others are industrial where IRS applies.

---------------------------------------------------------

At the core of the economic growth process was the process of capital accumulation (savings
At the core of the economic growth process was the process of
capital accumulation (savings and investments)
Development
which acts as the stimulant for division of labour and which
created the impetus for inventing new technologies.
Method
Also argued that capital accumulation affected population
growth.

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[How?] When capital accumulated quickly there would be an increased demand for labour, and wages

[How?]

When capital accumulated quickly there would be an increased demand for labour, and wages would increase (beyond subsistence) which would stimulate an increase in the population.

The resultant increase in the supply of labour would once again depress wages (to subsistence) thus achieving an equilibrium where population growth would once again be stagnant.

[However]

The productivity of labour is determined by the extent of the market. Which is the reason why Smith advocated free domestic & Int. Trade.

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[ Are there limits to economic growth?] Smith proposes three potential limits to economic growth:

[Are there limits to economic growth?]

Smith proposes three potential limits to economic growth:

1. Insufficient supply of labour (he gave a low possibility)

2. Exhaustion of natural resources (he also gave a low possibility)

3. Decline in the motive of accumulation as a result of declines in the rate of profit, which could happen because of:

(a)

Competition among capitalists or

(b)

Increase in Wages Investor Profit shall decline

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[However]

[ However ] Even if the rate of profit were to decline, Smith felt that new

Even if the rate of profit were to decline, Smith felt that new investment opportunities would again stimulate profits and therefore economic growth would continue.

Smith by and large had an optimistic vision of the economy believing that if at all the economy would reach stagnation it would be a long way off.

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David Ricardo Ricardo accepts much of Adam Smith s analysis, for e.g. Ricardo s production

David Ricardo

Ricardo accepts much of Adam Smith s analysis, for

e.g. Ricardo s production

function is similar to Smith s but with the addition of Technology.

However the major approach difference from Smith is that, Ricardo s production

function is subject to Diminishing Returns to Scale (DRS).

[Why?]

Ricardo first accepts that the Industrial sector is subject to the law of IRS as a result of division of labour (specialisation) and through the application of technologies which enhance productivity.

BUT he then points out that land is fixed in supply (land is inelastic to demand) and as capital accumulates which also leads to the expansion in population there is increasing pressure on land and this eventually negatively affects profits.

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[How?]

[ How? ] 1. With an increase in population, there is increased demand for food which

1. With an increase in population, there is increased demand for food which means demand for land increases.

2. Overtime, once the fertile lands are exhausted less and less fertile land is brought under-cultivation (marginal land).

3. Now agricultural production reaches a stage where for every unit invested in it less and less units of output are produced (DRS).

4. This implies that the cost of food increases as a result of which wages increase (below which labour will not be able to reproduce itself)

5. This means that the rate of producers profit declines and when this happens continually, it reaches a point where the incentive to invest is lost. This results in a stationary stage.

Thus the combination of factors subject to IRS with factors subject to DRS leads eventually to a stationary stage characterized by no surplus formation and zero population growth.

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[However: Change Scenario -1 ] Ricardo suggested that technical progress has a tendency to put

[However: Change Scenario -1]

Ricardo suggested that technical progress has a tendency to put off the stationary stage by preventing declines in profits.

Thus capital accumulation would continue BUT this would not continue indefinitely since ultimately DRS would negatively work on growth.

[Differs with Smith] While Smith views the development of technology as endogenous to capital accumulation, Ricardo sees technology as being developed independently and subsequently applied to production.

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[However: Change Scenario - 2 ] The stationary stage is not reached directly but there

[However: Change Scenario - 2]

The stationary stage is not reached directly but there are many intermediate stationary phases.

[How?]

Progress gets interrupted at short intervals by temporary equilibrium; e.g. this happens when wages stabilize at subsistence levels, the population does not grow but surplus does not fall to zero and thus capital accumulation continues and this induces new investments and demand for labour, thus giving impetus of population to grow and once this happens a new equilibrium is reached.

Important to note that with each successive equilibrium the stock of capital increases and the population grows.

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[Lessons for Developing Countries? ] In case of developing countries who already possess large populations,

[Lessons for Developing Countries?]

In case of developing countries who already possess large populations, capital accumulation would only lead to more population growth which would only make matters worse. Ricardo thus advocated population control for these countries.

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BITS Pilani, K K Birla Goa Campus
BITS Pilani, K K Birla Goa Campus
BITS Pilani, K K Birla Goa Campus

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THEORIES OF ECONOMIC GROWTH

Figure 2. shows that with the wage rate above the subsistence wage, the population increases .

1. The supply of labor increases.

2. The wage rate falls.

3. Employment increases.

wage, the population increases . 1. The supply of labor increases. 2. The wage rate falls.

THEORIES OF ECONOMIC GROWTH

4. The increase in employment

5. Increases real GDP.

The increase in population increases employment and real GDP and lowers the wage rate and real GDP per hour of work.

GDP. The increase in population increases employment and real GDP and lowers the wage rate and

3.The real wage rate rises and

4. The quantity of labor employed increases.

3. The real wage rate rises and 4. The quantity of labor employed increases.

THEORIES OF ECONOMIC GROWTH

3.The real wage rate rises and

4. The quantity of labor employed increases.

THEORIES OF ECONOMIC GROWTH 3. The real wage rate rises and 4. The quantity of labor

THEORIES OF ECONOMIC GROWTH

5.The increase in employme nt and

6. The increase in labor productivity increase real GDP.

THEORIES OF ECONOMIC GROWTH 5. The increase in employme nt and 6. The increase in labor

SOURCES OF ECONOMIC GROWTH

shows how labor productivity grows.

1. An increase in capital per hour of labor brings a movement along the productivity curve PC 0 .

When capital per hour of labor increases from $30 to $60, real GDP per hour of labor increases from $20 to $25.

PC 0 . When capital per hour of labor increases from $30 to $60, real GDP

SOURCES OF ECONOMIC GROWTH

2. An increase in human capital and/or a technological advance shift the productivity curve upward from PC 0 to PC 1 .

With this increase in human capital and/or technological advance, real GDP per hour of labor increases from $20 to $25 when there is $30 of capital per hour of labor and from $25 to $32 when there is $60 of capital per hour of labor.

to $25 when there is $30 of capital per hour of labor and from $25 to

THEORIES OF ECONOMIC GROWTH

Figure 10.3 shows classical growth theory.

1. The economy starts at point A on

productivity curve PC 0 with real GDP at

the subsistence level and the population constant.

2. As capital per hour of labor

increases, real GDP per person rises above the subsistence level the economy moves to point B.

per hour of labor increases, real GDP per person rises above the subsistence level the economy

THEORIES OF ECONOMIC GROWTH

3. As technological advance (and human capital accumulate) increase productivity,the productivity curve shifts upward to PC 1 the economy moves to C.

4. With real GDP above the subsistence level, the population grows and capital per hour of labor decreases downward along PC 1 .

GDP above the subsistence level, the population grows and capital per hour of labor decreases downward

THEORIES OF ECONOMIC GROWTH

5. At point D, the economy is

back at the subsistence level of

real GDP per hour of labor.

THEORIES OF ECONOMIC GROWTH 5. At point D , the economy is back at the subsistence
Y Progressive Regressive Stationary Phase Phase Phase W Q K O L L1 Capital Accumulation
Y
Progressive
Regressive
Stationary
Phase
Phase
Phase
W
Q
K
O
L
L1
Capital Accumulation

Employment

Y Progressive Regressive Stationary Phase Phase Phase W Q K O L L1 Capital Accumulation Employment

X

Thomas Malthus [Background] Malthus is best known for his theory of population . Argues that

Thomas Malthus

[Background]

Malthus is best known for his theory of population.

Argues that while food increases in arithmetic proportions population increases in geometric proportions.

Leading to a crisis situation.

Unless preventive checks control the population, positive checks will come into play to depress population growth.

checks will come into play to depress population growth. However Malthus also had a theory on
checks will come into play to depress population growth. However Malthus also had a theory on

However Malthus also had a theory on the role of effective demand on economic growth.

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Malthus disagreed with Smith and Ricardo that savings automatically resulted in investments and he also
Malthus disagreed with Smith and Ricardo that savings automatically resulted in investments and he also

Malthus disagreed with Smith and Ricardo that savings automatically resulted in investments and he also rejected Say s law that supply creates its own demand.

that savings automatically resulted in investments and he also rejected Say s law that supply creates

Role of Demand for Economic Growth

By doing this he went against the view of the day that supply of inputs (N, L, K, S) was the sole determinant of growth of output.

Instead he focused on the role of demand for economic growth.

Disagrees with Smith, Ricardo

& Say s role of Supply

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Malthus argued that if an economy is to continue growing then Effective Demand (defined as

Malthus argued that if an economy is to continue growing then Effective Demand (defined as both the willingness and ability to spend/consume) plays a critical role.

Y = R + W (Y= National Income; & How? R = profits and W
Y
= R + W
(Y= National Income; &
How?
R = profits and W = wages)
R
= Y W
R
=
(I + Cc + Cw) Cw,
W = Cw since workers spend close to all
their wages on consumption.
I= Investments,
Cc = Consumption
by capitalists
Cw = consumption
by workers
R = I + Cc (shows that profits depend on Investments and
Consumption expenditure)

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When saving are converted into investments, profits can increase and the economy grows but he

When saving are converted into investments, profits can increase and the economy grows but he also showed that excessive savings can stall economic growth.

[How?]

The economy can reach a stage where investment opportunities dry up.

At this stage saving will only aggravate the situation because it will result in reduced consumption (declining effective demand) which would result in economic stagnation.

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Malthus then connects role of effective demand on economic growth to analyse the relationship between

Malthus then connects role of effective demand on economic growth to analyse the relationship between the agricultural and industrial sectors in fostering economic growth.

How?

He recognized that the two sectors affect each other for e.g. Industries demand agricultural products (namely food which needs to feed an industrial labour force).

Industry

&

Agriculture

create

Mutual

Demand

Besides agricultural labour force demand many of the products of the industrial sector.

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In this way he analyzed that the two sectors demand each other s products (provide

In this way he analyzed that the two sectors demand each other s products (provide inputs to each other and act as markets for each other s goods).

Therefore the two must develop simultaneously for each sector to progress.

If this does not happen then there is a problem of dualism

Means where the economy has one modern sector and another traditional sector which ultimately stalls the process of economic growth.

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[Lessons for Developing countries?] In this way he makes the point that limited effective demand

[Lessons for Developing countries?]

In this way he makes the point that limited effective demand in a less developed country can prevent the development of both industrial and agricultural sectors.

Some Economists have combined the insights of Adam Smith, David Ricardo & Malthus (because of a number of similarities & over lapping areas in their approaches) and put forth the Classical theory of economic growth.

Classical Theory of Economic Growth

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[Classical Theory of Economic Growth - Explanation ] According to the theory, an economy grows

[Classical Theory of Economic Growth - Explanation]

According to the theory, an economy grows primarily because of the process of capital accumulation (savings through higher wages)

which results in investments in technological progress (division of labour and new inventions)

which in turn results in greater productivity (IRS) and greater capital accumulation.

In this manner growth perpetuates.

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However economic growth induces population growth which in turn puts pressure on land (a fixed

However economic growth induces population growth which in turn puts pressure on land (a fixed factor of production) which is subject to DRS.

As a result the rate of profit begins to fall which eventually results in a state of stagnation where no further capital accumulation is possible and population does not grow.

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This occurs in phases: Phase 1: when there are IRS, Phase 2: when there are

This occurs in phases:

Phase 1: when there are IRS, Phase 2: when there are DRS, Phase 3: when there are diminishing average returns & Phase 4: when there are diminishing total returns.

Important to note that the stationary state is not a situation of underdevelopment but essentially a mature economy.

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[ Criticisms & appraisal ] Populations in developed countries have shown that they have stabilized

[Criticisms & appraisal]

Populations in developed countries have shown that they have stabilized after initial growth.

Criticism
Criticism

Technological innovations in agriculture have permitted food supplies to sustain large populations.

Rightly pointed to the importance of capital accumulation to the growth process.

Appraisal
Appraisal

Important insights about the inter-sectoral relationship between agriculture and industry (that the growth of industry depends on the development of agriculture).

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REFERENCES

REFERENCES Misra, S. K. and Puri, V. K. (2010), The Classical Theories of Growth and Stagnation

Misra, S. K. and Puri, V. K. (2010), The Classical Theories of Growth and Stagnation , in Development and Planning: Theory and Practices, 13th ed. Himalaya Publishing House Pvt. Ltd. Mumbai, pp. 97-109.

Thirlwall , A. P. (2006) Classical Growth Theory in Growth and Development with Special Reference to Developing Economies. 8th ed. Hampshire: Palgrave Macmillan, pp. 123 129.

Kurz, H. D. & Salvadori, N. (2003) Theories of Economic Growth: Old and New in The Theory of Economic Growth: A Classical Perspective, Salvadori, N. (ed.), Cheltenham, Edward Elgar, pp. 1 22.

Meier, G. M. & Rauch, J. E. (2000) Comment I.C.1: Classical Growth Theory in Leading Issues in Economic Development. 7th ed. New York: OUP, pp. 76 77.

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