THIS WEEK: Dive into another input of our simple Solow model -- human capital.

NEXT WEEK: The power of ideas when it comes to driving economic growth.

In our previous macroeconomics video, we said that the accumulation of physical capital only provides a temporary boost to economic growth. Does the same apply to human capital?

To answer that, consider this: what happens to all new graduates, in the end?

For a while, they’re productive members of the economy. Then age takes its toll, retirement rolls around, and eventually, the old workforce is replaced with a new infusion of people. But then, the cycle restarts. You get a new workforce, everyone’s productive for a while, and then they too retire.

Does this ring a bell?

It should, because this is similar to the depreciation faced by physical capital.

Similarly, are there diminishing returns to education? It likely wouldn’t pay off for everyone to have a PhD, or for everyone to master Einstein’s great theories.

That means the logic of diminishing returns, and the idea of a steady state, also applies to human capital.

So, now we can revise our earlier statement.

Now we can say that the accumulation of any kind of capital, only provides a temporary boost in economic growth. This is because all kinds of capital rust. So, one way or another, we’ll reach a point where new investments can only offset depreciation.

It’s the steady state, all over again.

However, what does the journey to steady state look like?

The Solow model predicts that poor countries should eventually catch up to rich countries, especially since they’re growing from a lower base. And given their quicker accumulation of capital, poorer nations should also grow faster, than their more developed neighbors.

And eventually, every country should reach similar steady states.

In other words, we would see growth tracks that all eventually converge.

So, why isn’t this always the case? Why, in some cases, are we seeing “Divergence, Big time,” as coined by economist Lant Pritchett?

The answer to these questions, lies in the institutions of different countries and the incentives they create.

Assuming that a certain set of countries do have similar institutions, that’s where we see the convergence predicted by the Solow model. We see that poorer countries do grow faster than their richer counterparts. And conditional on having similar institutions, eventually, even poorer countries will reach a similar steady state of output as more developed nations. We call this phenomenon conditional convergence.

You can think of it as a national game of catch-up, with catch-up only happening if institutions don’t differ.

What happens though, once all this catching up is done?

Let’s not forget that there’s still another variable in the Solow model. This is variable A: ideas -- the subject of our next video.

There, we’ll show you how ideas can keep a country moving along the cutting edge of growth.

Catch up on the Solow model:

Introduction to the Solow model: http://bit.ly/1SMud3G
Physical Capital and Diminishing Returns: http://bit.ly/1SpLT31
The Solow Model and the Steady State: http://bit.ly/233vDGw
Office Hours video on the Solow model: http://bit.ly/1VQ8XLe

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