Solow- Swan Model of Growth

This model assumed that Harrod-Domar’s model was based on some unrealistic assumptions like fixed factor
proportions, constant capital output ratio, constant technical coefficients of production etc. Solow has dropped these
assumptions and shown that if technical coefficients of production are assumed to be variable, the capital labour ratio
may adjust itself to equilibrium ratio in course of time.

Assumptions
1. The production takes place according to the linear homogeneous production function of first degree of the form
Y = F (K, L)
Y = Output
K = Capital Stock
L = Supply of labour force
The above function is neo-classic in nature. There is constant returns to scale based on capital and labour
substitutability and diminishing marginal productivities.
2. The relationship between the behaviour of savings and investment in relation to changes in output implies that
saving is the constant fraction of the level of output. In this way, Solow adopts the Harrod assumption that
investment is in direct and rigid proportion to income. In symbolic terms, it can be expressed as follows:

I = dk/ dt = sY
Where
s—Propensity to save
K—Capital Stock
3. The growth rate of labour force is exogenously determined. It grows at an exponential rate given by
L = L0 ent
Where L = Total available supply of labour.
n = Constant relative rate at which labour force grows.
4. There is full employment in the economy.
5. The two factors of production are capital and labour and they are paid according to their physical productivities.
6. Labour and capital are substitutable for each other.
7. Investment is not of depreciation and replacement charges.
8. Technical progress does not influence the productivity and efficiency of labour.
9. There is flexible system of price-wage Following these above assumptions, Prof. Solow tries to show that with
variable technical co-efficient, capital labour ratio will tend to adjust itself through time towards interest.
10. Available capital stock is fully utilized.
11. the direction of equilibrium ratio. If the initial ratio of capital labour ratio is more, capital and output will grow
more slowly than labour force and vice-versa.

To achieve sustained growth, it is necessary that the investment should increase at such a rate that capital and labour
grow proportionately i.e. capital labour ratio is maintained.

A. Non-Mathematical Explanation
According to Prof. Solow, for attaining long run growth, let us assume that capital and labour both increase but capital
increases at a faster rate than labour so that the capital labour ratio is high. As the capital labour ratio increases, the
output per worker declines and as a result national income falls. The savings of the community decline and in turn
investment and capital also decrease. The process of decline continues till the growth of capital becomes equal to the
growth rate of labour. Consequently, capital labour ratio and capital output ratio remain constant and this ratio is
popularly known as “Equilibrium Ratio”.

If the capital labour ratio is larger than equilibrium ratio, than that of the growth of capital and output capital would be
lesser than labour force. At some time, the two ratios would be equal to each other. According to Prof. Solow as there is
the steady growth there is a tendency to the equilibrium path.

It must be noted here that the capital-labour ratio may be either higher or lower. Like other economies, Prof. Solow also
considers that the most important feature of an underdeveloped economy is dual economy. This economy consists of
two sectors-capital sector or industrial sector and labour sector or agricultural sector. In industrial sector, the rate of
accumulation of capital is more than rate of absorption of labour.

With the help of variable technical coefficients many employment opportunities can be created. In agricultural sector,
real wages and productivity per worker is low. To achieve sustained growth, the capital labour ratio must be high and
underdeveloped economies must follow Prof. Solow to attain the steady growth.

This model also exhibits the possibility of multiple equilibrium positions. The position of unstable equilibrium will arise
when the rate of growth is not equal to the capital labour ratio. There are other two stable equilibrium points with high
capital labour ratio and the other with low capital labour ratio.

If the growth process starts with high capital labour ratio, then the development variables will move in forward direction
with faster speed and the entire system will grow with high rate of growth. On the other hand, if the growth process
starts with low capital labour ratio then the development variables will move in forward direction with lesser speed.

To conclude the discussion, it is said that high capital labour ratio or capital intension is very beneficial for the
development and growth of capitalist sector and on the contrary, low capital-labour ratio or labour-intensive technique
is beneficial for the growth of labour sector.

In the figure, X-axis represents Capital per worker (k) and Y-axis represents Output per worker (y).
saving/investment is equal to required investment at K*, so it the equilibrium point. To the left of K*,
saving/actual investment is greater than required investment so output per worker increases at decreasing rate
and reaches at K*. To the right of K*, actual investment is less than required investment so output declines and
reaches to point K*. Therefore, K* is the stable equilibrium.

A. Mathematical Explanation:
Assumptions

1. The production function of the economy is given by Y= f(K, L)

where Y = National income, K = Capital and L = Labour
- There are only two factors of production, capital and labor & are homogeneous.
- Both the factors are indispensable for production, i.e. f(0 ,L) = 0 & f (K, 0)= 0
- Marginal product of capital and labor is positive and declining,
dY dY
i.e. > 0, and >0 meaning that MPK and MPL are positive.
dK dL
2 2
d Y d Y
2 < 0, and 2 < 0 meaning that productivity of both capital and labour is diminishing.
dK dL
- The production function is linearly homogeneous of degree one (constant returns to scale).
i.e. Y= f (K, L) γ Y= f(γ K, γ L)
K
- Capital and labor are substitutable to each other. There is possibility of variation in .
L
2. Labor force is growing at n exogenous rate.
1 dL
=n
L dt
Lt = Loent
Where Lt is the total supply of labor at time t, but in production function L stands for labor employment.
Labor market is assumed to be fully employed, Lt = L
3. Aggregate saving (S) is a constant function of aggregate income.
S= sY, 0 < s
Where, s = MPS, which is constant.
4. Investment is the change in capital stock.
dK
Kt – Kt-1 = I = =K
dt
5. There is no leakages in the economy. i. e. all saving are invested. Therefore,
dK
S = sY = I = =K
dt
A part of output is saved which is turn is invested and it increases the stock of capital.

We have from assumption 1,

 Y = f(K, L)
Y
Or, = f¿, 1) dividing both side by L.
L
Y
Or, = f(K*, 1)
L
Y
Or, = f(K*) K* = K/L (i)
L
Y
Where = per capita output and K* = per capita capital
L

Equation (i) is the per capita output which depends on K* (= K/L). So, long as fk* > 0 and fk*k* < 0, the function
exhibits the usual production function meaning that marginal productivity of per capita capital is positive and
diminishing.

The Solow-Swan model demonstrates a positive relationship between per capita output and per capita capital in
the short run. As economies accumulate more per capita capital (increase in K/L), the production function shifts
upwards leading to a temporary rise in per capita output (Y/L).

This happens because additional capital augments the productivity of labor, allowing for more output with the
same amount of labor input.

Derivation of equilibrium condition

We have, from equation (i)

K
K* =
L
Or K = K* L
Differentiating both side with respect to t, we have
¿
dK ¿ dL dK
=K +L
dt dt dt
¿
¿ dL dK dK
I =K +L ∵ =I ¿ assumption(5)
dt dt dt
¿
¿ dL dK
sY =K +L
dt dt
Substituting Y= Lf(K*) from equation (1), we get
¿
¿ ¿ dL dK
s L f ( K )=K +L
dt dt
¿
¿ 1 dL ¿ dK
s f (K )= K+ dividing both side by L
L dt dt
¿
¿ ¿ dK
s f (K )=K n+ from assumption (2)
dt
¿
dK ¿
=s f (K ¿¿ ¿)−K n ¿ (ii)
dt
Where,
 ¿
dK
isthe change ∈ per capita capital between two time period . It is the growth rate of capital per worker. It
dt
shows whether capital per worker is increasing or decreasing.

sf(K*) is the required investment per worker. The fraction s of the output per unit of labour is saved and
invested.

K* n is the growth rate of per capita capital over the period. As the number of workers increases at rate n, more
capital is needed just to maintain the same capital per worker. Thus it is also known as the saving rate.
Equation (ii) is the fundamental equation of the model. It also known as the capital accumulation equation.
The difference between investment per worker [s f(K*)] and the factors that reduce capital per worker ( K ¿ n )
represents the net investment per worker.

For dynamic equilibrium and stability of the model

¿
dK n ¿
If =0 Then, s f (K ¿¿ ¿)=K ¿ n ¿ f (K ¿¿ ¿)= K ¿ (iii)
dt s
It shows capital per worker is constant. It represents steady state equilibrium. Equation (iii) is the dynamic
equilibrium condition in Solow-Swan growth model.
¿
dK n ¿
If >0 , s f (K ¿¿ ¿)> K ¿ n ¿ or f (K ¿¿ ¿)> K ¿
dt s

It shows capital per worker is increasing. In this situation, K* (i.e. K*1 )is increasing at decreasing rate over
the time and process continues until the system reaches to the level of equilibrium K*.
¿
dK n
If <0 , s f (K ¿¿ ¿)< K ¿ n ¿ or f (K ¿¿ ¿)< ¿
dt s

It shows capital per worker is decreasing (decline). In this situation, K* is below the equilibrium and the
negative forces works until the system reaches back to the level of K*.
Output per worker Y/L is measured along the vertical axis and capital per worker (capital-labour ratio), K*, is
measured along the horizontal axis.
The Y/L = f(K*) curve is the production function which shows that output per worker increases at a diminishing
rate as K* increases due to the law of diminishing returns.
The term sf(K*) curve represents saving per worker or actual investment. The term n/s K* is the investment
requirement that must be invested to prevent k from falling.
The steady state level of capital is determined where the sf(K*) curve intersects the n/s K* line at point E. The
steady state income is with output per worker P, as measured by point P on the production function Y/L =
f(K*).
In order to understand why is a steady state situation, suppose the economy starts at the capital-labour ratio
K*1. Here saving per worker K*1B exceeds the investment required to keep the capital-labour ratio constant,
K*1A, (K*1B >K*1A).
Thus, K* and Y/L increase until K* is reached when the economy is in the steady state at point E. Alternatively,
if the capital-labour ratio is K*2, the saving per worker, K*2C, will be less than the investment required to keep
the capital-labour ratios constant, K*2D, (K*2C < K*2D). Thus Y/L will fall as capital per worker falls to K* and
the economy reaches the steady state E.
The Solow-Swan model shows that the growth process is stable. No matter where the economy starts, forces
exist that will push the economy over time to a steady state.