# Understanding Neoclassical Growth Theory: Key Drivers and Predictions

![Neoclassical Growth Theory: The concept that economic growth is the result of labor, capital, and technology.](https://www.investopedia.com/thmb/Kr7gG-YQebra7h8LvZynovTukHs=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/neoclassical-growth-theory.asp-final-aaf43794ed984585b1cd5dd21960a67c.png)

*— Investopedia / Zoe Hansen*

> **Definition**
>
> Neoclassical growth theory is an economic framework that explains how labor, capital, and technological advancements contribute to long-term economic growth.

## What Is the Neoclassical Growth Theory?

Neoclassical growth theory explains that steady [economic growth](https://www.investopedia.com/terms/e/economicgrowthrate.asp) comes from three main factors: labor, capital, and technology.

Robert Solow and Trevor Swan are credited by the National Bureau of Economic Research for developing the long-run economic growth model in 1956. The model first considered exogenous population increases to set the growth rate but, in 1957, Solow incorporated technology change into the model that plays a crucial role.

Understanding this theory is important for economic analysis and policy-making.

### Key Takeaways

*   Neoclassical growth theory explains that a steady economic growth rate depends on labor, capital, and technology.  
    
*   The theory highlights technological change as crucial for sustaining long-term economic growth.  
    
*   Robert Solow and Trevor Swan introduced the neoclassical growth theory in 1956, later incorporating technological advancements.  
    
*   The production function Y = AF (K, L) illustrates the relationship between GDP, capital, labor, and technology in an economy.  
    
*   As capital and labor increase, their returns diminish unless technological innovation boosts productivity.

## Understanding the Mechanics of Neoclassical Growth Theory

The theory states that short-term equilibrium results from varying amounts of labor and capital in the production function. The theory also argues that technological change has a major influence on an economy, and economic growth cannot continue without technological advances.

Neoclassical growth theory identifies three essential factors for economic growth. These are labor, capital, and technology. However, neoclassical growth theory clarifies that temporary equilibrium is different from long-term equilibrium, which does not require any of these three factors.

## Key Components and Their Influence in Neoclassical Growth

The theory suggests that accumulating capital and how it is used are vital for economic growth. Additionally, the interaction between capital and labor affects an economy's output. Finally, technology is thought to augment [labor productivity](https://www.investopedia.com/terms/l/labor-productivity.asp) and increase the output capabilities of labor.

Therefore, the production function of neoclassical growth theory is used to measure the growth and equilibrium of an economy. That function is Y = AF (K, L).

*   Y denotes an economy's [gross domestic product](https://www.investopedia.com/terms/g/gdp.asp) (GDP)
*   K represents its share of capital
*   L describes the amount of unskilled labor in an economy 
*   A represents a determinant level of technology

Due to the link between labor and technology, the production function is often rephrased as Y = F (K, AL).

Increasing any input affects GDP and thus the economy's equilibrium. However, if the three factors of neoclassical growth theory are not all equal, the returns of both unskilled labor and capital on an economy diminish. These diminished returns imply that increases in these two inputs have exponentially decreasing returns while technology is boundless in its contribution to growth and the resulting output it can produce.

## Real-World Applications of Neoclassical Growth Theory

A 2016 study in _Economic Themes_ studied technology's role in neoclassical growth theory and its specifics.

The authors find a consensus among different economic perspectives all pointing to technological change as a key generator of economic growth. Neoclassicists have traditionally urged governments to invest in scientific research and innovation.

[Endogenous theory](https://www.investopedia.com/terms/e/endogenousgrowththeory.asp) supporters emphasize factors such as technological spillover and research and development as catalysts for innovation and economic growth. Lastly, evolutionary and institutional economists consider the economic and social environment in their models for technological innovation and economic growth.

## The Bottom Line

The core components of the neoclassical growth theory are labor, capital, and technology as drivers of economic growth. Technology plays a critical role in sustaining long-term growth despite the limited nature of labor and capital resources. The theory signifies a point of equilibrium that an economy can achieve by optimizing the use of these key factors. Technological advancements contribute infinitely to economic output, distinguishing them from the diminishing returns of labor and capital.

Understanding the balance and interplay of these factors helps individuals, businesses, and policymakers foster economic stability and improvement.

> **Article Sources**
>
> 1.  National Bureau of Economic Research. "[Trevor Swan and the Neoclassical Growth Model](https://www.nber.org/papers/w13950.pdf)," Pages ii, 2-3, 10-11, 13.
>     
> 2.  National Bureau of Economic Research. "[Trevor Swan and the Neoclassical Growth Model](https://www.nber.org/papers/w13950.pdf)," Page ii.
>     
> 3.  Simon Fraser University. "[Chapter 1 Neoclassical Growth Theory](https://www.sfu.ca/~bkrauth/econ808/808_lec1.pdf)," Pages 2-4.
>     
> 4.  ResearchGate. "[Technological Changes in Economic Growth Theory: Neoclassical, Endogenous, and Evolutionary-Institutional Approach](https://www.researchgate.net/publication/305677305_Technological_Changes_in_Economic_Growth_Theory_Neoclassical_Endogenous_and_Evolutionary-Institutional_Approach)."