Classical Growth Theory - Adam Smith When Adam Smith wrote...

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Adam Smith When Adam Smith wrote his famous 1776 treatise, he called it An Inquiry into Nature and Causes of the Wealth of Nations. Some have taken this as indicating that he was concerned primarily with economic growth . In this way, Smith moved away from the Cantillon- Physiocratic system which concentrated on "natural equilibrium" of circular flows, and brought back into economics what had been the Mercantilists' pet concern. Smith posited a supply-side driven model of growth. Succinctly we can lay out the story via the simplest of production functions: Y = ¦(L, K, T) where Y is output, L is labor, K is capital and T is land, so output is related to labor and capital and land inputs. Consequently output growth (gY) was driven by population growth (gL), investment (gK) and land growth (gT) and increases in overall productivity (g¦). Succinctly: gY = f(g¦, gK, gL, gT) Population growth, Smith proposed in the traditional manner of the time, was endogenous: it depends on the sustenance available to accommodate the increasing workforce. Investment was also endogenous: determined by the rate of savings (mostly by capitalists); land growth was dependent on conquest of new lands (e.g. colonization) or technological improvements of fertility of old lands. Technological progress could also increase growth overall: Smith's famous thesis that the division of labor (specialization) improves growth was a fundamental argument. Smith also saw improvements in machinery and international trade as engines of growth as they facilitated further specialization. Smith also believed that "division of labor is limited by the extent of the market" - thus positing an economies of scale argument. As division of labor increases output (increases "the extent of the market") it then induces the possibility of further division and labor and thus further growth. Thus, Smith argued, growth was self-reinforcing as it exhibited increasing returns to scale. Finally, because savings of capitalists is what creates investment and hence growth, he saw income distribution as being one of the most important determinants of how fast (or slow) a nation would grow. However, savings is in part determined by the profits of stock: as the capital stock of a country increases, Smith posited, profit declines - not because of decreasing marginal productivity, but rather because the competition of capitalists for workers will bid wages up. So lowering the living standards of workers was another way to maintain or improve growth (although the counter-effect would be to reduce labor supply growth). Despite increasing returns, Smith did not see growth as eternally rising: he posited a ceiling (and floor) in the form of the "stationary state" where population growth and capital accumulation were zero.
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David Ricardo Smith's model of growth remained the predominant model of Classical Growth. David Ricardo (1817) modified it by including diminishing returns to land. Output growth requires growth of factor inputs, but, unlike labor,
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Classical Growth Theory - Adam Smith When Adam Smith wrote...

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