The neoclassical growth theory builds five major variables into its time-sensitive production formula. The first is total output, which is approximately equal to gross domestic product, or GDP. Another variable is typically called "total factor productivity, " which tries to measure technological improvement in the economy. A third variable is total capital, or economic capital, not financial capital. The fourth is labor, as measured by wages and the last is simply the percentage of total output attributable to capital, rather than labor.
Economist Robert Solow first formally introduced the neoclassical growth theory in 1956. His model, like many 20th century production models, was highly mathematical and operated on a series of simplifying assumptions about the economy. His aim was to find a way to model economic activity in such a way that could explain the discrepancies between output levels and growth rates for different countries or different time periods.
Solow began by identifying the primary implications of neoclassical assumptions about growth. These implications included constant returns to scale, complete information among economic actors, no substantive external economies and perfect competition. Solow's work was a modification of the classical growth theory. It was built with one homogeneous consumer block and one homogeneous firm, each with infinite lifetimes. The firm's total output was equal to the consumer's total income.
Capital investment is treated as a temporary, rather than perpetual, benefit to the economy. This is the crux of how the Solow model explains the difference between output and growth. Once new capital is introduced into the economy, the ratio of capital to labor increases. Unfortunately, at least according to this model, the marginal product of capital declines due to diminishing returns. This forces the economy to eventually regress back to the long-term growth path.
The real explanation of differences in economic output between countries, therefore, is attributed to the pace of technological change and labor growth. Oddly, Solow's model treats productivity improvements as completely exogenous, or independent of capital investment. This strange treatment of capital is perhaps the most consistent and damning critique of the neoclassical growth theory.
Impact of the Solow Model
Robert Solow won the Nobel prize in economics for his work. His declaration that only about "one-eighth of productive increase is due to capital" while "the remaining seven-eighths is technical change" was very influential in creating public emphasis on the role of technology in the economy.
By the time the dot-com bubble burst in 1999-2000 and the "new economy" was found to be much less revolutionary than expected, economists re-evaluated Solow's assumptions about the importance of technology and devaluation of capital.
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