Production Function Approach to Analyzing the Sources of Economic Growth

The production function (or Solow growth model) is used to determine the economy’s underlying source of growth. It attributes the growth of the gross domestic product (GDP) and productive capacity to:

• the application and discovery of new technologies that enhance the production capacity of inputs; and
• the accumulation of raw materials, labor, and capital (inputs).

The production function explains that the gross domestic product depends on technology and different macroeconomics inputs. When technology advances or inputs increase, the production of goods will increase.

Assumptions of the Production Function

The production function is based on two main assumptions. First, we suppose that the production function acts as evidence for a decline in input when the extra output will be obtained (diminishing marginal productivity). This, in return, exhibits what capital and labor contribute to economic growth.

Secondly, a percentage increase in input leads to an increase in the output by the same percentage. The production function has positive returns to scale.

Argument

In 1798, Thomas Malthus argued that economic growth becomes stranded at a certain level of input. If capital grows at a higher rate than labor, then capital will end up being less productive. It is therefore noteworthy that lessening of marginal productivity of capital has two main effects on GDP:

• growth rates in emerging economies should be tuned to catch up with that of developed countries. As a result, incomes between less-developed countries and developed countries should converge.
• lessening marginal productivity of capital leads to no ground for reliable economic growth. This is because returns will disappear due to the increase in supply in other inputs relative to others.

Therefore, the only way to maintain long-term growth in potential GDP per capita is technological advancements, which increase workers’ productivity.

Question

Given the Solow growth model, the gross domestic product (GDP) increases as a function of which of the following?

I. Accumulation of raw materials

II. Discovery of new technologies

III. Accumulation of capital

IV. Accumulation of labor

A. II only

B. II, III & IV only

C. I, II, III & IV only

Solution

The correct answer is C.

According to the Solow growth model, the application and discovery of new technologies enable inputs to be more productive. Moreover, the accumulation of raw materials, labor, and capital (inputs) all play a role in increasing the GDP and productive capacity.