What are the main limitations of the Solow model? Discuss with reference to theory and evidence.
The Solow Model, also known as the neoclassical growth model or exogenous growth model is a neoclassical attempt created in the mid twentieth century, to explain long run economic growth by examining productivity, technological progress, capital accumulation and population growth. This model was contributed to by the works of Robert Solow, in his essay ‘A Contribution to the Theory of Economic Growth’ and by Trevor Swan in his work, ‘Economic Growth and Capital Accumulation’, both published in 1956. The model is perceived to be an extension of the 1946 Harrod-Domar model, which Solow (1956) describes as a ‘model of long-run growth which accepts all the Harrod-Domar assumptions except that of fixed proportions.’ Instead Solow (1956) supposes that a ‘single composite commodity is produced by labour and capital under the standard neoclassical conditions.’ This notion will be elaborated on further in the course of this essay. Economists today use the Solow model source of growth accounting to estimate the individual effects on economic growth of capital, labour and technological change and thus the model is contemporarily significant. This essay aims to first and foremost outline the assumptions and features of the Solow Model and explain them. It will follow with a discussion of the determinants of economic growth within the model and highlight the limitations within the framework of the model. Finally, this essay will evaluate the effectiveness of the model in determining long-term growth.
In this model, Solow makes a number of assumptions that have been critiqued by many theorists as being limitations of the model it self. The first of these is that the model is constructed amidst a one good economy and the good is homogenous in nature. As there is only one good produced, consumed and invested in, the economy is abstracted from any trade.
The model also tends to ignore the demand side of production therefore the model assumes output (Y) is a function of labour (L) and capital (K):
Y= F (K, L)
However, there are two key assumptions of the production function crucial to the structure of the model. The first assumption is that the production function exhibits constant returns to scale for capital and effective labour, i.e. a doubling of inputs leads to a doubling of output). In the production function below, this assumption can be mathematically proven by the ‘1-+.’
Y = F [K, L] = Kα L1-α
This assumption itself can too be segmented into two separate assumptions about the economy, first being, gains from specialisation have a minimal impact on the economy. Secondly, inputs such as land or natural resources are nonessential (Romer, 2006, pg.10). Romer (2006) warrants this consideration on the basis that in practice, natural resources do not tend to prove as a constraint on growth.
A second assumption of the production function is that there are diminishing returns to each factor individually; decreasing marginal returns to factor accumulation (adding extra capital with labour being constant yields ever-smaller increases in output):
Henceforth, the flattening of the graph below, illustrates the phenomenon, diminishing returns to capital, which Jones explains to as, ‘each additional unit of capital we give to a single worker increases the output of that worker by less and less’ (Jones, 1998, pg.21).
Another key assumption of the model is that all savings are invested,
S = I = s. Y
Therefore, the savings rate is constant and thus is the investment rate; this notion will be described below when discussing the structure of the model.
As Robert Solow was a neoclassical economist, some assumptions common to the school of thought apply to this model as well. These include perfect competition in the labour and capital markets, hence assuming that perfect...
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