[MUSIC] To understand how these twin forces of capital accumulation, and technological change can affect an economy, it is helpful to understand the so-called neoclassical model of economic growth. This approach was pioneered by Professor Robert Solow of MIT. Who was awarded the 1987 Nobel Prize for this and other contributions to economic growth theory. The major new ingredients in Solow's neoclassical growth model are, capital and technological change. The approach of this growth model is to use a tool known as the Aggregate Production Function, or APF, which relates technology and inputs like capital and labor, to total potential GDP. We need not get deeply into the mechanics of this APF model here, but it is very useful to first understand the underlying principle of the Neoclassical Growth Model, and then understand three of its major insights. The basic underlying principal of the Neo-Classical growth model is what economists call Capital Deepening. This is the process of increasing the amount of capital per worker. Examples of Capital Deepening include more farm machinery and irrigation systems in farming. More railroads and highways in transportation. And more computers and communication systems in banking. In each of these industries societies have invested heavily in capital goods. And as a result, the output per worker has grown enormously in farming, transportation, and banking. The first major insight of the model is that in the absence of technological change, capital deepening does not lead to a proportional increase in output. Can you think why this might be true? The reason why capital deepening does not lead to a proportional increase in output, is the law of diminishing returns. With this law not apply the land, mind you, as in the Malthusian case, but rather, in this case, apply the capital. The basic idea is that as you add more and more capital to a fixed supply of labor, eventually the marginal product of capital must fall as the law of diminishing returns kicks in. The second major insight of the neoclassical growth model is that while capital deepening can dramatically increase the productive output of an economy, it will eventually lead to economic stagnation in the absence of technological change. To understand this important point we have to answer this question. What happens to worker wages and the return on capital as a result of capital deepening? What do you think the answer is? For workers the news is good. The wage rate paid to workers will tend to rise as capital deepening takes place. Why? Because each worker has more capital to work with and his or her marginal product therefore rises. As a result the competitive wage rate rises along with the marginal product of labor. However, for the owners of capital, the news is less satisfying. As capital deepens, diminishing returns to capital set in. So, the rate of return on capital and the real interest rate fall. What this means, of course, is that in the long run, the economy will enter a so-called steady state in which capital deepening ceases as the capital labor ratio stops rising. This is because even as capital deepening is driving real wages up, the returns to capital are falling, so that at some point, further investments in capital deepening become unprofitable. At this point, the economy enters a steady state in which, without technological change, both capital incomes and wages end up stagnating. Now this is certainly a far better outcome than the nasty and brutish world of subsistence wages predicted by Malthus. Nonetheless, the long run equilibrium of the neoclassical growth model, makes it clear that if economic growth consists only of accumulating capital through replicating factories with existing methods of production, then people's standard of living will eventually stop rising. And that's why we must come to understand the importance of technological change in averting this fate, as modern economies in this century have so obviously done. This leads to the third major insight of the neoclassical growth model. It is ultimately only through technological change that we can avoid the trap of economic stagnation. Technological change represents both advances in production processes, and the introduction of new and improved goods and services. It also includes new managerial techniques, as well as new forms of business organizaton. For example, gas in diesel engines, conveyor belts, and assembly lines were significant developments of the more distant past. While more recently we have bigger, faster and more fuel efficient aircraft, Integrated microcircuits, computers, xerography, containerized shipping, and the internet, not to mention biotechnology, lasers, and superconductivity. This figure uses the concept of the aggregate production function that we have discussed earlier to illustrate the differing roles that capital deepening and technological change play in economic growth. On the horizontal axis, capital deepening is measured by capital for worker, while output per worker is represented on the vertical axis and represents the upward march of economic growth. Now here is where things get a little complicated. The gray line represents the aggregate production function for the technology available in 1950. It traces the pace of economic growth, that would occur because of capital deepening, holding the technology constant. Similarly, the red line represents the aggregate production function for the technology available in 1995. Now, if you can answer these next two questions, you've understood the neoclassical growth model. How is technological change represented in the figure? And, how might we measure the total effect of capital deepening, and technological change on growth? In this case, technological change is represented in the figure by an upward shift of the APF curve. From the gray line, to the red line that is, from APF 1950 to APF 1995. This upward shift shows the advances in productivity that are generated by the vast array of new processes and products, like electronics, computers, advances in metallurgy, improved service technologies, and so forth. As for how we measure the total effect of capital deepening, and technological change on growth. One way to do it is simply by using the arrow in the figure. It indicates the increase in output per worker from q divided by l1950, to q divided by l1995. More broadly, the good news in the figure, is that instead of settling into a steady state of economic stagnation, the economy enjoys rising output per worker, rising wages, and increasing living standards, even as the returns to capital rise as well.
