One neoclassical economic model for national economic growth is the Solow growth model. Like movie franchises, it runs on the idea of diminishing returns. This means that each subsequent outlay typically will generate a smaller profit than the one preceding it.
The Solow growth model is named after Nobel Prize for Economics winner Robert Solow of the Massachusetts Institute of Technology. It began as the Harrod-Domar model, which was created in 1946 and ran on the basic idea of labor and capital affecting a country's gross domestic product (GDP). Solow, in the 1950s, added into the equation man’s developing knowledge, especially regarding technology. He distinguished between old knowledge and new knowledge.
Three variables affect the accumulation of GDP in Solow’s model: labor, capital and knowledge. The model assumes that the growth rates of labor and knowledge are constant, and it assumes that tripling one variable will triple output. These assumptions are called the constant return to scale (CRTS).
A simple economic framework is derived from the Solow growth model. The visual graphic produces a graph with labor along the horizontal axis and capital along the vertical axis. The interaction between them produces a curved effect. As capital and labor grow from zero, GDP rises at a fast rate before it reaches a midpoint on the graph and begins to tail off, producing a gentler curve. As this GDP curve tails off, the increased labor produces less of an increase in capital.
Growth in the Solow growth model is strong when capital is being accumulated, but it does not last forever. The model has been used to examine the how poorer countries are catching up with the West. Prime examples of the Solow growth model are seen in Hong Kong, Taiwan, Singapore and Japan.
Under the model’s predictions, countries such as Japan began saving capital and developing their labor and knowledge bases. This led to high GDP growth rates in the 1950s and '60s that slowed down later. In Japan’s case, growth stopped altogether around 1990, when its financial bubble burst. With Japan, Singapore, Hong Kong and Taiwan, Solow was correct that living standards and GDP would converge as all of the variables increased.
The model explains the differences between rich and poor countries as well. Rich countries have larger amounts of savings and relatively low population growth rates. Poor countries have low saving rates and high population growth rates. The model, however, made several false predictions as well. Based on savings and labor, it predicted that the Soviet Union would outperform the United States in the late 20th century.
Several economic factors are not taken into account in the Solow growth model. It fails to examine geography, natural resources, government and social institutions. It also fails to anticipate the effects of an aging population and a diminishing labor workforce.