Neoclassical Theory Of Economic Development (1)

Neo Classical Theory of Economic Development

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 The term was originally introduced by Thorstein Veblen in 1900, in his article 'Preconceptions of Economic Science', to distinguish marginalists in the tradition of Alfred Marshall from those in the Austrian School. 1857 –1929- American economist and sociologist, and a leader of the institutional economics movement Besides his technical work ,he was a critic of capitalism, as shown by his best known book The Theory of the Leisure Class (1899).

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 Other Neoclassical economic theorists- Robert Solow & T.W. Swan, Harrod–Domar, Ricardo, Keynes, Gilpin, North, Samuelson.  Term was used in 1900 – matures through 1940s – Most implemented in 1990s Economic Liberalization.

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 In neoclassical economics, the entire edifice of the theory of growth is built on a concept of decline –  The concept of diminishing returns- DRS  concept of diminishing returns, in growth theory is confusing.  Problem is - it is difficult to describe how something increases if the main process used to describe the increase is a process of decreasing values.

DRS Paradox – Increase in Decreasing Value BITS Pilani, K K Birla Goa Campus

 Samuelson - “the law of diminishing returns: An increase in some inputs relative to other fixed inputs will, in a given state of technology, cause total output to increase;

Paul Anthony Samuelson, 1st American to win Nobel Memorial Prize in Economic Sciences.

 but after a point, the extra output resulting from the same additions of extra inputs is likely to become less and less.  This falling off of extra returns is a consequence of the fact that the new “doses” of the varying resources have less and less of the fixed resources to work with” BITS Pilani, K K Birla Goa Campus

 Example If one has a particular fixed area of land, the addition of more and more labor will result in diminishing returns to each additional unit of labor. -- Ricardo  However, If both land and labor are increased at the same rate, there may be no diminishing returns; there may be “constant returns to scale”.

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 Important contributions to the model came from Robert Solow and T.W. Swan who independently developed relatively simple growth models – Solow - Swan Model.  Solow was also the first economist to develop a growth model which distinguished between vintages capital vs. New Capital.

The neo-classical model was an extension to the Harrod–Domar Model -1946 that included a new term:

Productivity Growth.

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The Solow–Swan Model is an exogenous growth model An economic model of long-run economic growth of neoclassical economics.

The Solow-Swan model augmented with human capital predicts that the income levels of poor countries will tend to catch up/ or converge towards the income levels of rich countries. Provided, the poor countries have similar savings rates for both physical capital & human capital as a share of output. BITS Pilani, K K Birla Goa Campus

 because — Capital is produced based on known technology.  Technology improves with time —new capital will be more productive than old capital.  Both Paul Romer and Robert Lucas, Jr. subsequently developed alternatives to Solow's neo-classical growth model.  Today, economists use Solow's sources-ofgrowth accounting to estimate the separate effects on economic growth of technological change, capital, and labor.

Solow's ModelNew Capital is more valuable than old (vintage) capital Separate effects of technological change, capital, and labor on Economic Growth. BITS Pilani, K K Birla Goa Campus

Neo Classical Idea!  Neoclassical economics is characterized by several assumptions common to many schools of economic thought.  There is not a complete agreement on what is meant by neoclassical economics, and the result is a wide range of neoclassical approaches to various problem areas and domains—ranging from neoclassical theories of labor to neoclassical theories of demographic changes etc. BITS Pilani, K K Birla Goa Campus

Neoclassical economics largely rests on 3 Assumptions1. People have rational preferences among outcomes that can be identified and associated with a value. 2. Individuals maximize utility and firms maximize profits. 3. People act independently on the basis of full and relevant information.

Neoclassical economics dominates microeconomics & together with Keynesian economics forms the neoclassical synthesis, which dominates mainstream economics today. BITS Pilani, K K Birla Goa Campus

 Based on the assumptions focuses on the determination of -- Prices, Outputs, and income distributions in markets through supply and demand and ….. 1  Often mediated through a hypothesized maximization of utility by incomeconstrained individuals ….. 2  and of profits by cost-constrained firms employing available information and factors of production, in accordance with rational choice theory….3

Forces & FactorsSupply & Demand Out Put & Prices Income Constrained Individuals Cost Constrained Firms Rational Choice Theory BITS Pilani, K K Birla Goa Campus

To Determine Supply & Demand Forces ….. Determine Prices, Outputs, and income distributions in markets

income-constrained individuals ….. Mediate through a hypothesized maximization of utility by

Cost-constrained & Profit Maximizing Firms

Employing available information and factors of production, in accordance with Rational Choice Theory. BITS Pilani, K K Birla Goa Campus

Rational choice theory  Also known as choice theory or rational action theory is a framework for understanding and often formally modeling social and economic behavior.  Also used in modern political science ,sociology and philosophy.

Rationality (here equated with "wanting more rather than less of a good") widely used as an assumption of the behavior of individuals in microeconomic models and analysis of human decisionmaking.

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 Normally, "rationality" means "sane," "in a thoughtful clear-headed manner," or knowing and doing what's healthy in the long term.  Neoclassical Economics takes a narrow view of Rationality.

Rational choice theory uses a specific and narrower definition of "rationality" simply to mean that –

An individual acts as if balancing costs against  It attaches "wanting more" to benefits to arrive at instrumental rationality, which involves action that maximizes seeking the most cost-effective means to personal advantage achieve a specific goal without reflecting on the worthiness of that goal. BITS Pilani, K K Birla Goa Campus

Example –  buying a new dress, or committing a travel, business deals etc.  In rational choice theory, all decisions, crazy or sane, are postulated as a "rational" process.  Thus rationality is seen as a property of patterns of choices, rather than of individual choices:

Amartya Sen sees the model and people who follow rational choice model as "rational fools."

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Implication to Developing Countries 1.

Neoclassical Approach talks of Qualitative Productivity & Growth which is more refined than Smith & Ricardo.

2.

Incorporates Malthusian Demand Approach. That means they incorporate role of Supply & Demand.

3.

Since they use Rational Choice Theory, they talk of Free Market Economy - Smith.

4.

Price Sensitive Individuals vs. Cost Cutting & Profit seeking Industries

5.

Also analyses sources-of-growth to estimate the separate effects on economic growth of technological change, capital, and labor. Incorporates role of Technology for productivity.

6.

Case of China, India etc. vs. Singapore, Hong Kong, Malaysia, South vs. North Korea.

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Conclusion  Opportunity of Productivity is available provided right strategy is adopted.  Factors of Production must be free to optimize their productivity.  Market based on Demand & Supply shall set its equilibrium.  Technology has to be incorporated towards growth & Productivity.  Value Interpretation.  Classical Economists Productivity & Growth vs. Neoclassical Economists Productivity Growth Approach. BITS Pilani, K K Birla Goa Campus