ECONOMICS OF GROWTH & DEVELOPMENT
THIRD SEMESTER 2024
INSTRUCTOR: DR. DICKSON DAVID
Theory of economic growth of Adam Smith
Adam Smith analyzes the dynamics of wealth of nations and welfare of individuals
and societies. It is clear that modern economic growth theory has still benefited
from Smith's views on the economic growth which are division of labour, education,
human capital, learning by doing, increasing returns to scale, technological change,
externalities, institutional factors such as global free competitive market economy,
the role of government etc. Smith also stated the importance of a stable legal
framework in which the invisible hand of the market could function, and open
trading system. Even if we are not on the same wave with Smith, it is still very
important to review Smith’s views on the determinants of economic growth in order
to design a better economic and political environment for economic agents to
increase the wealth of nations.
According to Smith, the fundamental economic determinant of growth is the rate of
capital formation. On the other hand, the rate of capital formation depends
crucially upon the relationship between the market rate of net profits (r) and the
minimum consistent with compensation for risk bearing (𝑟). Both of these
quantities are dependent upon the institutional set up.
In Smith’s world, a favourable political and legal environment, on the other hand,
can contribute significantly toward increasing the flow of investment. Furthermore,
by permitting international division of labour, free trade also contributed toward
1
, raising the output of the world as a whole. Domestically, Smith favoured a policy of
non-intervention. Smith supported free competition because according to him, it
would extend the market, promote the division of labour, accumulate capital, and
consequently increase the wealth of nations.
Smith’s economic growth model can be formalized as follows
Y = f (K, L, N) (1)
where, K: Capital, L: Labour, N: Land
The production function (F) is not subject to the restriction of diminishing marginal
productivity, but subject to the increasing returns to scale. Technological progress,
development in machinery and the market size affect division of labour and
therefore affect productivity and the internal and external economies ,which lead
to increasing returns to scale. Adam Smith also emphasized the role of the
institutional structure (U) of the economy affecting economic growth level.
δ𝑓 δ𝑓
δ𝐿
= 𝑔(K, U) ; δ𝑁
= ℎ(𝐾, 𝑈) (2)
Marginal productivity of labour and land are functionally related to the amounts of
capital (K) employed and to the institutional framework (U) of the economy.
The growth rate of economy by the time is as follows,
𝑑𝑌 δ𝑓 𝑑𝐿 δ𝑓 𝑑𝐾 δ𝑓 𝑑𝑁
𝑑𝑡
= δ𝐿 𝑑𝑡
+ δ𝐾 𝑑𝑡
+ δ𝑁 𝑑𝑡
(3)
applying the restrictions,
𝑑𝑌 𝑑𝐿 δ𝑓 𝑑𝐾 𝑑𝑁
𝑑𝑡
= 𝑔(𝐾, 𝑈) 𝑑𝑡
+ δ𝐾 𝑑𝑡
+ ℎ(𝐾, 𝑈) 𝑑𝑡
(4)
In the Smith's economy, institutional framework (laissez faire) is important and
given, exogenously:
2
THIRD SEMESTER 2024
INSTRUCTOR: DR. DICKSON DAVID
Theory of economic growth of Adam Smith
Adam Smith analyzes the dynamics of wealth of nations and welfare of individuals
and societies. It is clear that modern economic growth theory has still benefited
from Smith's views on the economic growth which are division of labour, education,
human capital, learning by doing, increasing returns to scale, technological change,
externalities, institutional factors such as global free competitive market economy,
the role of government etc. Smith also stated the importance of a stable legal
framework in which the invisible hand of the market could function, and open
trading system. Even if we are not on the same wave with Smith, it is still very
important to review Smith’s views on the determinants of economic growth in order
to design a better economic and political environment for economic agents to
increase the wealth of nations.
According to Smith, the fundamental economic determinant of growth is the rate of
capital formation. On the other hand, the rate of capital formation depends
crucially upon the relationship between the market rate of net profits (r) and the
minimum consistent with compensation for risk bearing (𝑟). Both of these
quantities are dependent upon the institutional set up.
In Smith’s world, a favourable political and legal environment, on the other hand,
can contribute significantly toward increasing the flow of investment. Furthermore,
by permitting international division of labour, free trade also contributed toward
1
, raising the output of the world as a whole. Domestically, Smith favoured a policy of
non-intervention. Smith supported free competition because according to him, it
would extend the market, promote the division of labour, accumulate capital, and
consequently increase the wealth of nations.
Smith’s economic growth model can be formalized as follows
Y = f (K, L, N) (1)
where, K: Capital, L: Labour, N: Land
The production function (F) is not subject to the restriction of diminishing marginal
productivity, but subject to the increasing returns to scale. Technological progress,
development in machinery and the market size affect division of labour and
therefore affect productivity and the internal and external economies ,which lead
to increasing returns to scale. Adam Smith also emphasized the role of the
institutional structure (U) of the economy affecting economic growth level.
δ𝑓 δ𝑓
δ𝐿
= 𝑔(K, U) ; δ𝑁
= ℎ(𝐾, 𝑈) (2)
Marginal productivity of labour and land are functionally related to the amounts of
capital (K) employed and to the institutional framework (U) of the economy.
The growth rate of economy by the time is as follows,
𝑑𝑌 δ𝑓 𝑑𝐿 δ𝑓 𝑑𝐾 δ𝑓 𝑑𝑁
𝑑𝑡
= δ𝐿 𝑑𝑡
+ δ𝐾 𝑑𝑡
+ δ𝑁 𝑑𝑡
(3)
applying the restrictions,
𝑑𝑌 𝑑𝐿 δ𝑓 𝑑𝐾 𝑑𝑁
𝑑𝑡
= 𝑔(𝐾, 𝑈) 𝑑𝑡
+ δ𝐾 𝑑𝑡
+ ℎ(𝐾, 𝑈) 𝑑𝑡
(4)
In the Smith's economy, institutional framework (laissez faire) is important and
given, exogenously:
2
