Origin of the Idea

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8.1 Growth Theory

One of the first economists to develop a theory of economic growth was Joseph Schumpeter (1883-1950). Known by his family and friends as Jozsi (pronounced Yoshi), Schumpeter was born in the Austrian province of Moravia (now part of the Czech Republic). He studied law and economics at the University of Vienna and went on to practice law and teach political economy. He also worked briefly as the minister of finance of the Austrian Republic in 1919. In 1932 he joined the economics faculty at Harvard, where he taught until his death. Schumpeter also has the distinction of being the first foreign-born president of the American Economic Association.

Schumpeter argued that innovation was the key to growth, and that the entrepreneur was central to the process of innovation. Schumpeter recognized that innovation goes beyond invention. Invention creates new technology, but innovation applied it to the production and distribution of goods and services. Invention alone, according to Schumpeter, is not sufficient to spur economic growth.

In the late 1940s, Sir Roy Harrod (1900-1978) and Evsey Domar (1914-1997), working independently, contributed to what is now referred to as the Harrod-Domar growth model. Building on a Keynesian framework of analysis, Harrod and Domar emphasized the role of investment in economic growth. They identified that on one side, investment expands productive capacity. On the other side, it also generates demand for output. Balanced growth (defined as the growth rate compatible with long-run full employment) occurs when the change in production capacity equals the change in demand resulting from the investment. While they identified the condition that would create balanced growth, Harrod and Domar were not convinced that the economy would automatically move toward that condition. Someone who did believe that the economy would self-correct to maintain full employment was Robert Solow (b. 1924). Solow argued that there exists a rate of investment, which he called balanced investment, that keeps the growth of the capital stock equal to the growth of the labor force. If actual investment exceeds balanced investment, the amount of capital per worker will grow until it reaches a level consistent with full employment – what Solow called the steady-state point. Solow has had a distinguished career. After receiving his Ph.D. from Harvard in 1951, he went on to teach at MIT, where he has remained ever since. He has at times worked with Paul Samuelson, their most famous joint effort being the application of the Phillips curve to the U.S. economy. For his work on growth theory, Solow won the Nobel Prize in 1987.

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Schumpeter and Solow developed more general theories of economic growth. Other economists focused specifically on economic growth in developing nations. Among them was Ragnar Nurske (1907-1959), an Estonian who argued that poor nations remained poor because of a "vicious circle of poverty." Poor nations often have a malnourished workforce and insufficient saving to invest in modern technology. The lack of human and physical capital results in low labor productivity, preventing the economic growth that could bring these nations out of poverty.

Two others known for their work on growth in developing nations were Arthus Lewis (1915-1991) and Theodore Schultz (1902-1998), who shared the Nobel Prize in economics in 1979. Lewis developed the two-sector model, which divided the economy into a rural subsistence sector and an urban industrial sector. Lewis argued that surplus labor from the rural sector could be moved to the urban sector to fuel the development of industry and economic growth. Schultz focused on investment in human capital (the acquisition of skills and knowledge, or improvements in health, for example) as a means for poorer nations to develop and grow.

Photograph courtesy of: (c)Corbis # ARE0077;