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 & problem of economic growth.

Adam Smith
David Ricardo
Thomas Malthus
Classical growth theory (a synthesis of Smith and Ricardos
perspectives)

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 Adam Smith - Collectively the individuals in Production
society, each acting in his or her own self-
interest, manage to produce ------
Consumption
and purchase the goods and services that Self
they as a society require ------ Regulation
He called the mechanism by which this
self-regulation occurs the invisible hand,
Invisible Hand

His book, The Wealth of Nations, published Emergence of

in 1776, the year of America's Declaration Market
of Independence.
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 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. BITS Pilani, K K Birla Goa Campus
 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
[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:
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 Production
Interface
Labour= L Function
Land= T or N
Y=(K, L,N or T)
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 So output is related to labor and capital and land inputs.

Consequently output growth (gY)

was driven by population growth (gL),

investment (gK) gY = f(gK, gL, gT)

& land growth (gT)

Increases in overall productivity (g)

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Measuring Real National Income
Smiths 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 Smiths 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 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 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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[Implication for under-developed countries?]
Why some
It can be inferred that one of the causes of economic countries are
differentiation is because some countries are predominantly Poor & Others
agrarian where the DRS(Diminishing Return to Scale) are Rich?
applies while others are industrial where IRS applies.
---------------------------------------------------------

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
Method created the impetus for inventing new technologies.

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 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:

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]

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 Smiths analysis, for e.g. Ricardos production
function is similar to Smiths but with the addition of Technology.

However the major approach difference from Smith is that, Ricardos 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?]

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 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 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, 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
 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.
 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.
 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

5.The
increase in
employme
nt and
6. The increase in
labor productivity
increase real GDP.
 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 PC0.

When capital per hour of labor increases

from $30 to $60, real GDP per hour of
labor increases from $20 to $25.
 SOURCES OF ECONOMIC GROWTH

2. An increase in human capital and/or a

technological advance shift the productivity
curve upward from PC0 to PC1.

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.
 THEORIES OF ECONOMIC GROWTH

Figure 10.3 shows classical growth

theory.

1. The economy starts at point A on

productivity curve PC0 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 levelthe
economy moves to point B.
 THEORIES OF ECONOMIC GROWTH

3. As technological advance (and

human capital accumulate) increase
productivity,the productivity curve
shifts upward to PC1the economy
moves to C.

4. With real GDP above the

subsistence level, the population
grows and capital per hour of labor
decreases downward along PC1.
 THEORIES OF ECONOMIC GROWTH

5. At point D, the economy is

back at the subsistence level of
real GDP per hour of labor.
 Y Progressive Regressive Stationary
Phase Phase Phase
W

Q K
Capital Accumulation

X
O L L1
Employment
 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.

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

on economic growth.

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 Role of
Malthus disagreed with Smith and Ricardo that Demand for
savings automatically resulted in investments and Economic
he also rejected Says law that supply creates its
Growth
own demand.

By doing this he went against the view of the day

that supply of inputs (N, L, K, S) was the sole
Disagrees with
determinant of growth of output.
Smith, Ricardo
& Says role of
Instead he focused on the role of demand for
Supply
economic growth.

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 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 How?
(Y= National Income; & R = profits and W = wages)

R=YW I= Investments,
Cc = Consumption
R = (I + Cc + Cw) Cw, by capitalists
W = Cw since workers spend close to all Cw = consumption
their wages on 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 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
the agricultural and industrial sectors in fostering Industry
economic growth.
&
How? Agriculture
He recognized that the two sectors affect each create
other for e.g. Industries demand agricultural Mutual
products (namely food which needs to feed an Demand
industrial labour force).

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 others
products (provide inputs to each other and act as markets for each
others 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 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
Classical
(because of a number of similarities & over Theory of
lapping areas in their approaches) and put forth Economic
the Classical theory of economic growth.
Growth
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[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 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 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 after initial growth. 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
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

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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