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The Solow Neoclassical Growth Model Economics Essay

In a society institutions are the rules of the game or the family are the humanly devised constraints that shape human interaction. In consequence they structure incentives in human exchange, whether political, social, or economic. Institutional change shapes the way societies evolve through time and hence is the key to understanding historical change.


In LDCs , north definition points face many institutional problems . Mostly these nations are Rodrick (2000) notes, without a ‘clearly delineated system of property rights’ , or ‘a regular apparatus curbing the worst forms of fraud, anti-competitive-behavior, and moral hazard, a moderately cohesive society exhibiting trust and social cooperation , social and political institutions that mitigate risk and manage social conflicts, the rule of law and clean government ‘. These societies always lack a sense of social justice . Western cultures are evolved with these systems along with the marketplace often replacing inefficient systems.

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Due to the embedded nature of both formal and informal institutions and their reliance upon each other, successful blue prints can’t be done by one and apply them to other nations. The paper will explore how much monocropping failed , by providing a criticisim of capital fundamentalist.

Industrial revolution with western style market economies have been out performing other nations, consistently providing the benefits of modern health care and a standard of living which is technologically advance and freedom it allows. Ideas are established by some as to why economic developments can stagnate will be explored, such as how it is institutions rather than geography which provides economic destiny, within a institutional framework how trade developed and natural resources are utilized by good institutions. Some analysis will provide by this paper that how policy can be developed by international institutions working with and understanding both the formal and informal rules of institutions.

Trade Development Models-Taking the fun out of ‘capital fundamentalism’

With the issues of economic development ,Neoclassical economics was never intended to deal . It began in the late nineteeth century and it’s objectives was to explain efficient resource allocation in developed economies.

The Harrod-Domar Model

To analyze short-term U.S recessions , the Harrod-Domar Model was constructed assumed incorrectly that :’ production capacity was proportional to the stock of machinery’ : Growth in GDP is dependent on the share of investment spending implicitly savings. Therefore increasing savings this year increases growth next year through investment.

The model ignores labour force growth/decline and productivity as well as technological change. It makes the common assumption that institutions are in place. However, it can describe the possibilities of short-term growth in a western situation as well. Investment can indeed provide growth so long as there is an available productive workforce. However, due to its imperfections the model does not work especially in the end as Domar admitted by 1957. Rostow who advised that the ideas behind the model were proof of the exponential growth available through investment in the financing gap, available due to the lack of savings in LDCs. Rostow argued that one simple market had been established , there infrastructure could be utilized through doubling capital investment fostering development , he ignored that these institutions might not have history of external capital endowments. The model is interesting because it was a ready model to provide for LDCs when the west was in competition for allies with the soviets and was used in the i990’s by Europe to project growth in former soviet nations. Essentially, savings and investment are necessary but not sufficient conditions for growth while functioning tested.

The Solow Neoclassical Growth Model

Domar himself endorsed ‘Solow’s long run model’. Solow conjectured that there were diminishing returns to capital and therefore investment cannot be the source of growth. Growth in output is not sustainable by throwing machine at people rather technological changes keeps making a given amount of labour go further.

Solow’s argument was that there is a steady state of economic growth ‘z’. In the Solow diagram when savings are greater then the capital sock’s depreciation the economy moves to ‘z’ and vice versa: the steady state. If the rate of savings is increased the savings function moves upward but we return ta a steady state ‘b’ at a higher rate of output in each later year. Conversely, if the population rate increases then output per worker decreases with available capital per worker and steady state moves to ‘c’. This argument makes sense when describing how technological progress allowed the U.S. to develop given its developed institutions where the effective number of worker keeps up with the increasing number of machines. In the above graph this can be seen by the upward shifts in the savings as a function of capital curve and therefore continually higher steady states .

‘A Big-Push’

But what If the assumptions of the Solow model hold way in LDCs where economic and political institution are less developed. It assumes diminishing returns to capital per worker yet if f”(K)<0 does not hold then output may look like the second diagram. There are multiple steady states in the second diagram. To get to ‘c’ , a massive capital injection would be needed to push the economy past ‘b’ or it will naturally return to ‘a’. Yet without good institutions it may never get past. If the savings rate or the population rate depends upon the capital stock alone a more unfathomable picture emerges. Without developed institutions neo-classical economic models might infer a quagmire of poverty traps where capital injections could lead to negative growth over time.

What the Solow model has implied to ‘capital fundamentalists’ is that there are huge returns to capital available in LDCs as they coverage to their steady state. What this interpretation misses is that capital is not on its own a source of growth. Within Solow’s technological argument can be applied the observation that technology, which allows for long-run continuous growth in developed countries, actually relies upon institutions as a fundamental component. Therefore is a society’s institutions are both poor and without the framework that allow technology to prosper, capital’s diminishing return to scale with deplete positive capital . Institutional change is requires to change the long-run position of the economy.

‘Geography is not Destiny’

Sachs and Warner (2001) show that ‘direct controls for geography and climate variables do not

eliminate the natural resource’ curse26 (more below). Easterly & Levine (2002), reject the

common analysis that economic development depends on geographical location. By focusing on

the level of institutional infrastructure they are able to show that tropics, germs and cash crops

affect development only through institutions, and that once institutions are accounted for in their

analysis of 72 post colonial nations even policy seems to have no affect on economic

development, in that ‘bad policies are only symptoms of longer-run institutional factors’27.

Acemoglu et al (2002) describe how former colonies developed post-colonially depending on the

institutions that were established. They use the level of urbanization and population density in

1500 (as a substitute for inestimable aboriginal income levels). They find that there has been an

‘institutional reversal’28, in that the poorer countries 500 years ago are now amongst the richest

countries, and the richer countries 500 years ago are less developed institutionally. The

conclusion points to the fact that wealthier countries were resource rich and therefore ‘extractive

institutions’ developed which were focused on resource extraction, whilst the poorer countries

were settled in that population movements were more agricultural and permanent,and therefore’ institutions of private property’ were developed; it was these institutions that lead to an institutional destiny which fostered an environment of economic development.

Conversely, man’s interaction with geography can have detrimental effects when institutions are

Not in place to administer policy ideas. As Easterly (2001) notes, Ghana created the world’s

Largest man-made lake when building a hydro-electric dam on the river Volta to power an

Aluminum smelter. Projections in 1967 were that Ghanaian growth would reach 7%. No bauxite

Mine or aluminum refinery has been built, which resulted in the smelter being run on subsidized

Electricity and imported minerals. By 1982 the 80,000 farmers who had been displaced from

3,500 square miles of land were living beside the failed fishery of the lake suffering from

‘Waterborne illnesses like river blindness, hookworm, malaria and schistosomiasis’30. The

Institutional support for anything but the core elements of the project were simply not in place.

Trade Relies Upon Good Institutions

Rodrik et al (2002), argue similarly that while geography does not have a direct effect on

Economic growth it does have an effect through institutions. Oddly they find that trade seems to

Have a negligible effect when institutions are accounted for in their statistical analysis. This

Comes as no surprise to them because with trade, both formal and informal institutions are all

Important. As North notes: ‘Many rules of merchant law developed because common law interfered with trade’. Greif (1997) tracks the development of international trade from the commercial revolution in medieval Europe. He describes how merchants required ‘ex-anti’ protection before trade would commence, and how both formal and informal institutions developed, including, as Bardhan (2005) explains: ‘self enforcing institutions of collected punishment for malfeasance in long-distance trade. These were ‘self enforcing stable systems that were not prone to respond to welfare-enhancing opportunities in that one couldn’t be seen to cheat as that would hinder future trade.

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As North (2003) notes, ‘informal constraints do not show up in formal terms within institutions, yet we rely on the informal rules of trade in our day-to-day lives. Depending on cultural expectations, we may greet and thank a merchant over small purchases or we might receive credit in various establishments, as relationships build. As Li (2003) describes such informal rules or constraints can evolve into economic, social and political systems where ‘agreements are largely implicit, personal, and enforced outside of courtrooms; and government, banks, and firms have close relations’. As commerce advances and specializes, these practices, although efficient at achieving economic goals such as the East-Asia boom, become more costly. On the other hand formal structures, such as contracts, are costly to begin with but become cheaper when replicated within the system. Li’s point is that societies that develop more formally, may take longer to develop over time but are better able to withstand asymmetric shocks (such as the East Asia recession). Relations become costly as society develops. Institutions need to adapt and robust formal institutions are better able to cope. Whilst trade is essential for development it is the framework that trade is institutionalized within that is key to development’s success.

Aid needs to offer incentives; its effectiveness is driven by the policy within institutions.

Birdsall (2004), notes ‘African policymakers would benefit from clear incentives to consolidate what are now at least a dozen trade agreements within the region’, and argues that donor aid should be conditional on good institutional frame works. Among the seven deadly sins of donors she lists ‘impatience with institution building’ at the top, arguing that’ impatience for policy change, leads donors and official creditors to undermine the efforts of reformers rather then supporting them. She argues that donors are impatient for results and therefore the focus is on spending rather than ,say,long term health gains. These are institutional failings which even transnational donor principles could improve, albeit amongst necessary cooperation with indigenous institutions.

As the failure of the economic models above suggests funding financial gaps and big pushes are all very well but need to be explicitly tied to policy goals through local institutions. Aid for economic development fails for a multitude of reasons, yet most failures can be explained in the context of institutions, whether formal or informal. Acemoglu and Robinson show by tracing institutional development through the nineteeth century that elites will block development if threatened with replacement through the erosion of their ‘incumbency advantage’ over suppressed populations. Svensson (1998) finds that the ‘more expectation of aid according to the recipients’ future needs may increase rent dissipation and reduce the expected number of periods in which efficient policies

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