Neoclassical Theory vs. Classical Economics

This assignment delves into the contrasting perspectives of classical and neoclassical economic thought. It examines how classical institutions employed authoritarian practices to achieve goals, while neoclassical institutions adopted a modern approach emphasizing efficiency and profit maximization. The comparison highlights the role of technological advancement and human decisions in shaping economic growth under both theories. The assignment concludes by asserting that modern economies largely adhere to the neoclassical theory, where investment, savings, and technological progress drive economic development.

Running head: ECONOMICS
Classical and Neo-Classical Theories of Economic Growth
Name of the Student:
Name of the University:
Author note:

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Classical Theory of Economic Growth
Economic growth refers to the increase in the capability of an economy in the production
of goods and services from one time period to another. It is usually measured in the percentage
rate of increase in the real or nominal terms of gross domestic product (GDP) (Kuznets 2016).
There are two major branches of economics that explain the economic growth in two different
angles. One of them is the Classical theory of economic growth. The pioneers of economics,
Adam Smith, David Ricardo, Thomas R. Malthus and J. S. Mill provided the essence of
economic growth, known as, classical theory of economic growth.
As stated by North (2016), the theme of classical theory is that the growth of an economy
depends on capital accumulation, increasing returns to scale and specialization. Adam Smith first
proposed the idea of economic growth in his 1776 book, ‘Wealth of Nations’. He argued that
there are several elements in the economy that can lead to increased growth. Those elements are:
 Markets playing important role in the determination of demand and supply
 Productivity of labor and its influence on per capita income
 Significant role of trade in enabling more specialization
 Increasing returns to scale, resulting in more specialization in the modern world (Rosen
and Gayer 2014).
The classical model was developed by Malthus and Ricardo. In this model, they assumed
that the change in technology is constant and expansion in the inputs results in diminishing
returns to scale. Malthus highlighted in his theory that, the world’s population would grow faster
than the capacity to feed itself because he did not consider any technological improvement
(Chakravarty 2017).

W
Total product (TP),
total wage (W)
LaborO
P
TP1
TP2
E
M N
A
B
S
T
V
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Rosen and Gayer (2014) stated that according to the classical economists, one of the
major features of a growing economy is the higher level of capital accumulation. This allows
increase in the total output for the community by increasing the productivity of land and labor
and increasing the allocation of available productive resources. Along with that, the total amount
of profit is dependent on two factors, namely, total product of labor and wage level (Scully
2014). Thus, in turn it also depends on the marginal productivity of labor. The productivity of
labor in turn depends on the capital stock and available techniques. The market wages could rise
above the subsistence level in the short run and this would bring an increase in the population.
However, in the long run, as the population growth increases, the wage reaches the subsistence
level and then the growth in the population would stop. Hartwell (2017) pointed out that the
surplus that is earned by the capitalists will be reinvested again in the production and the entire
process will come to a stop when the diminishing returns set in the production process.

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Figure 1: Classical theory of economic growth
(Source: Author)
In the above diagram, the line OW shows the subsistence level of wage, and TP1 is the
total product curve. When the population level is at OM, the level of total product is OP. The per
capita wage is MS, and surplus or profit is ST. At this stage, the capital formation starts and that
results in increase in the demand for labor, leading to a rise in the wages, as the economy moves
from T to B. With this movement, the level of working force increases and it shifts to the right,
from OM to ON. Increase in population results in more amount of surplus and it is reinvested in
the economy. The process will continue till it reaches the point E. With every step in the
movement, the amount of surplus capital gets decreased. At E, there will be no capital or surplus,
and output and wage become equal. It is a stationary situation where there will be no economic
growth, and the population would remain stagnant at OV. TP2 represents the total product curve
when there is another factor, that is technological factor and that increases the level of total
product of the economy. According to the classical economists, even if there is technological
factor, the economy would still reach the stagnation when there is no capital surplus (Keynes
2016).
Neo-Classical Theory of Economic Growth
The neo-classical theory of economic growth is established on the basis of the
understanding that, growth in the output of an economy depends on the capital formation, labor
and technology. According to this theory, an economy can achieve the state of equilibrium by
changing the amount of labor and capital in the production function. In this theory, the role of
technology on the production has been accepted.

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The neo-classical growth theory is a combination of the works of Solow, Meade, Tobin,
Phelps, Johnson and Swan. They formed their theories on the basis of the neo-classical
economists, Marshall, Wicksell and Pigou. The neo-classical theory is based on the assumptions
that,
 The commodity and the factor markets have perfect competition,
 Factor payments are equal to the marginal revenue,
 The ratio between capital and quantity produced is variable, and
 There is full employment in the economy (Keynes 2016).
As stated by McCombie and Thirlwall (2016), the major point of neo-classical theory of
economic growth is the inclusion of technology along with the variable amount of labor and
capital. It also puts emphasis on the event of capital formation and the related decisions of saving
and investment, being one of the important determinants of economic growth (Higgins 2017).
The model considers that the production function contains two factors, capital and labor and it
also has an exogenously determined factor, that is, technology (Peet and Hartwick 2015). The
production function is written as:
Where Y is the total product, K is the capital, L is the unskilled labor and A is the level of
technology. A change in the exogenously determined factor, that is, technology can shift the
production function and thereby, changes the level of output (Yang and Ng 2015).
In the following diagram, the effect of technology is shown by two labor productivity
curve. Labor productivity shifts upwards when there is increase in the level of technology. Due
to technological advancement, the economy moves from point A to point E, and the level of
Y = AF (K, L)

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Labor productivity (Real GDP per labor hour)
Capital per labor hourO
Growth in labor productivity
Less technology
More technology
E
k0
B
k*
A Effect of change in technology
Slope = Target rate of return
Slope = Real interest rate at E
investment and savings increases. The labor productivity increases at this point as the capital per
labor hour increases from k0 to k*. The basic concept, stated by Benería, Berik and Floro (2015),
is that, technology leads to new opportunities for profit. Thus, savings and investment increases,
real GDP per capita increases and the diminishing returns to the capital per labor hour reduce the
real rate of interest.
Figure 2: Neo-classical model of economic growth
(Source: Author)
The economy starts at A and at this point, the real interest rate equals target rate of return.
Technological advance pushes the economy upwards to E and the economy moves from E to B
as there is an increase in the labor productivity due to technological advancement and increase in

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capital per labor hour. At point B, again the target return rate and real interest rate becomes equal
and growth ends.
Difference between the two theories (Using Institutional Analysis)
There is a major difference between the two schools of thought in economics. The well
known economists explained the concept of economic growth in two very distinct ways. The
classical theory of economic growth was applicable to the societies during the 18th and 19th
centuries, when production took place by using primitive ways. On the other hand, the neo-
classical theory of economic growth was established in the 20th century when the technological
revolution was taking place (Dopfer and Potts 2015). It is relevant till today.
The classical economists believed in a free market or self regulating economy without
any government intervention. They believed in optimal allocation of productive resources for
optimum level of production. The neoclassical economists, on the other hand, believed that
individuals in the society are working to maximize the utility and the organizations want to
maximize profits with perfect information in the market. Hence, it can be said that, in the
classical theory, the emphasis is put on the production of products and services with only two
factors, labor and capital, while in the neoclassical theory, the actions of the individuals in the
society and the decisions regarding savings and investment are considered as important factors
determining the level of production and profit (Borner, Brunetti and Weder 2016).
A major distinction between the two theories is the consideration of technological
advancement in the production process. In the classical theory, the economists did not consider
the technological factor and analyzed the growth process on the basis of labor and capital
productivity only. However, technology plays an important role in the neoclassical theory.

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Technological advancement increases the total production, and thereby increasing the scope for
capital accumulation. Hence, the productivity of labor increases shifting the labor productivity
upwards. Thus, economic growth depends on labor productivity, capital productivity, savings,
investment and technological progress (Dopfer and Potts 2015).
There are some differences between the two theories, from the point of view of
institutional analysis. The institutional analysis refers to the analysis of the structure and
mechanisms of the institutions in an economy. This analysis deals with the functioning of the
individuals and groups, constructing institutions and their effects on the economy (Powell et al.
2016). Using the institutional analysis, the difference between the two economic growth theories
are as follows:
Classical theory of economic growth Neo- Classical theory of economic growth
Institutional structure is mechanical and
impersonal (North 2016)
Institutions form a social system
The institutions mainly focus on the work and
the economic needs of the labor or workers
(Scully 2014).
Institutions mainly focus on small groups
within the organization as well as in the society
and on the human and emotional qualities of
the employees
Organizations put emphasis on rationality and
order
Organizations put emphasis on the personal
and social needs of the workers along with
fulfilling the organizational objectives
Organizational behavior originates from rules Organizational behavior originates from

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and regulations feelings, attitudes and sentiment (Lundahl and
Wadensjo 2015)
Authoritarian practices are used to accomplish
the results (Lukacovic and Francis 2016)
Democratic practices, recognition of human
values and dignities and involvement of
workers in decision making are important to
accomplish the organizational goals.
Dissatisfaction and work alienation arise in the
institutions.
Satisfied employees focus on increasing the
productivity of the institutions.
Thus, it can be said that, in the light of institutional approach, there are some important
differences between the two theories. While in the classical theory, the institutions followed
authoritarian practices to achieve the organizational goals, the institutions, under the neoclassical
theory, followed a modern approach to deal with the organizational functions and making profits.
Since, there is application of technology in the modern production process; hence, the
institutions need to incorporate advanced technology along with the human values in the
institutional activities.
The classical school of thought focuses on the economic growth that results from the
efficient and optimum allocation of productive resources in the economy. They did not consider
the technological progress and the involvement of human decisions about the savings and
investment. However, in the neoclassical theory, the economists incorporated the technological
advancement and other human decisions that can cause major impact on the economy. The
modern economies today follow the neoclassical theory of economic growth. The decisions

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regarding investments and savings as well as rapid technological progress determine the
direction and magnitude of the economic growth.

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References
Benería, L., Berik, G. and Floro, M., 2015. Gender, development and globalization: economics
as if all people mattered. Routledge.
Borner, S., Brunetti, A. and Weder, B., 2016. Political credibility and economic development.
Springer.
Chakravarty, S., 2017. Alternative approaches to a theory of economic growth: Marx, Marshall
and Schumpeter. Orient Longman (1980).
Dopfer, K. and Potts, J., 2015. The general theory of economic evolution. Routledge.
Hartwell, R.M., 2017. The Industrial Revolution and economic growth (Vol. 4). Taylor &
Francis.
Rosen, H. and Gayer, T., 2014. Public Finance. 10th ed. McGraw-Hill Education.
Higgins, B., 2017. Regional development theories and their application. Routledge.
Keynes, J.M., 2016. General theory of employment, interest and money. Atlantic Publishers &
Dist.
Kuznets, S., 2016. Six lectures on economic growth. Routledge.
Lukacovic, I.I. and Francis, J., 2016. From the Classical School to Today: The Evolution of
Stagnation Theories.
Lundahl, M. and Wadensjo, E., 2015. Unequal Treatment (Routledge Revivals): A Study in the
Neo-Classical Theory of Discrimination. Routledge.