CFA Level II Exam · Economic Growth

Classical, Neoclassical and Endogenous Growth Theories Explained

Updated 7 October 2026 · Fact-checked

Classical theory (Malthus) says population growth erodes any gain in income per person. Neoclassical (Solow) theory says capital has diminishing returns, so economies reach a steady state where only technology lifts per-capita growth. Endogenous theory says R&D and human capital create increasing or constant returns, so growth can continue permanently.

Understand Classical, Neoclassical and Endogenous Growth Theories

Growth theories answer one question: why does output per person rise, and can it keep rising? Each theory gives a different answer about what limits growth.

Classical (Malthusian) theory says growth in output is temporary. When income per person rises above subsistence, population grows faster, and the extra workers push income back down. Land is fixed, so labour has diminishing returns. Income per person stays near subsistence. Modern data contradict this, because technology and fertility changes broke the link.

Neoclassical (Solow) theory uses a production function with capital, labour and technology. It assumes diminishing marginal returns to each input separately, and constant returns to scale for capital and labour together. As capital per worker rises, each extra unit adds less output. Investment eventually only covers depreciation and equipping new workers. The economy reaches a steady state, where capital per worker and output per worker are constant. In a Cobb-Douglas setting, total output grows at θ ÷ (1 − α) + n, where θ is the growth rate of technology (TFP), α is capital's share and n is labour force growth. Output per worker grows at θ ÷ (1 − α), so it is set only by technology (scaled by capital's share). Technology is exogenous: it comes from outside the model.

Two results matter for the exam. First, a higher saving rate raises the level of output per worker in the steady state, but it does not change the long-run growth rate. It only causes faster growth during the transition. Second, conditional convergence: countries with the same saving rate, population growth and technology converge to the same level of income per person, and poorer countries grow faster on the way because their capital is scarcer. Countries with different parameters converge to different steady states.

Endogenous growth theory makes technology a result of choices inside the economy: R&D spending, human capital and knowledge. Investment in these creates positive externalities because ideas can be used by many firms at once, and knowledge is non-rival. This removes diminishing returns to the broad measure of capital, so returns to capital are constant or increasing. Higher saving or investment in R&D can therefore raise the long-run growth rate itself. There is no steady state in the neoclassical sense, and convergence is not guaranteed.

Key formulas to remember

Neoclassical production function: Y = A × F(K, L); Y is output, A is total factor productivity (technology), K is capital, L is labour. Constant returns to scale in K and L together.
Per-worker form: y = Y ÷ L = A × f(k), where k = K ÷ L; Diminishing returns: f(k) rises at a decreasing rate as k rises.
Steady-state condition: s × y = (δ + n) × k (technology constant). With technology growth: s × y = (δ + n + g) × k; s is saving rate, δ is depreciation rate, n is labour force growth. The first form holds when A is constant. When technology grows, measure k and y per effective worker. Then g is the growth rate of labour-augmenting technology, which equals θ ÷ (1 − α) in a Cobb-Douglas function. Investment must cover depreciation, new workers and the rise in technology. Capital and output per effective worker are then constant, while output per worker grows at g.
Steady-state growth of total output: ΔY ÷ Y = θ ÷ (1 − α) + n; θ is the growth rate of technology (TFP) and α is capital's share of output in a Cobb-Douglas function. The first term is the growth of output per worker.
Steady-state growth of output per worker: Δy ÷ y = θ ÷ (1 − α); Depends only on technology growth and capital share. It does not depend on the saving rate.
Endogenous (AK) model: Y = A × K; Constant returns to capital (broadly defined). Output per worker can grow indefinitely, and a higher saving rate raises the long-run growth rate.

How to solve Classical, Neoclassical and Endogenous Growth Theories questions

Use this method for any question that asks you to classify a theory, predict the effect of a change, or compare growth paths.

1Identify which theory the vignette describes. Look for clues: subsistence and population (classical), diminishing returns and steady state (neoclassical), R&D, human capital or externalities (endogenous).
2Find the key assumption on returns to capital: diminishing (neoclassical) or constant/increasing (endogenous).
3Find whether technology is treated as exogenous or as a result of investment inside the economy.
4Identify the change in the question: a higher saving rate, faster population growth, more R&D, or a technology shock.
5Apply the theory. In Solow, a change in saving or population changes the steady-state level but not the long-run per-worker growth rate. Only technology changes that rate.
6If the question gives numbers, check whether it wants output growth or output per worker growth, and use θ ÷ (1 − α) with or without the n term.
7Choose the option that matches both the direction of the change and whether it is a level effect or a growth-rate effect.

Quickest way: Level effect or growth effect test

When to use it: Use when an option says a policy raises growth permanently or only temporarily.

Ask: does the theory have diminishing returns to capital?
If yes (neoclassical): saving and investment give a higher level and temporary faster growth. Only technology changes lasting growth.
If no (endogenous): investment in R&D or human capital can raise the permanent growth rate.
If classical: any rise in income per person is temporary because population catches up.
For numbers, per-worker growth = θ ÷ (1 − α). Add n for total output.

Common mistakes in Classical, Neoclassical and Endogenous Growth Theories

Saying a higher saving rate raises the long-run growth rate in the Solow model.
It feels intuitive that more investment means more growth, and it is true in the early transition.
Fix: In Solow, saving changes the steady-state level of output per worker only. Long-run per-worker growth comes from technology.
Forgetting that technology is exogenous in the neoclassical model.
Students mix up Solow with endogenous models where R&D matters.
Fix: If the model explains technology by choices inside the economy, it is endogenous. If technology is simply given, it is neoclassical.
Using θ ÷ (1 − α) + n for output per worker growth.
The two formulas look similar and students add n automatically.
Fix: Add n only for total output growth. Output per worker growth is θ ÷ (1 − α).
Claiming endogenous growth has no diminishing returns to anything.
The summary line says constant or increasing returns to capital.
Fix: Say that returns to the broad measure of capital (physical, human and knowledge) are not diminishing because of externalities. Individual narrow inputs can still face diminishing returns.
Treating convergence as unconditional in the neoclassical model.
Poorer countries grow faster in the theory, so students assume all countries end at the same income.
Fix: Convergence is conditional. Countries with different saving rates, population growth or technology reach different steady states.
Describing Malthus as predicting stagnation in total output.
Students read 'no growth in income per person' as 'no growth in output'.
Fix: Total output and population can both grow. Income per person returns to subsistence.

Worked examples

Example 1

Vignette: Economy A has a Cobb-Douglas production function with capital share α = 0.40. Total factor productivity grows at 1.2% a year and the labour force grows at 0.8% a year. The economy is in its Solow steady state. Q1: What is the growth rate of output per worker? Q2: What is the growth rate of total output? Q3: If the saving rate rises permanently, what happens to the long-run growth rate of output per worker?

Show the solution

Q1: Per-worker growth = θ ÷ (1 − α) = 1.2% ÷ (1 − 0.40) = 1.2% ÷ 0.60 = 2.0%.
Q2: Total output growth = θ ÷ (1 − α) + n = 2.0% + 0.8% = 2.8%.
Q3: The saving rate is not in the growth formula. A higher saving rate raises the steady-state level of output per worker and causes faster growth only during the transition.

Answer: Q1: 2.0%. Q2: 2.8%. Q3: No change in the long-run growth rate; only the level of output per worker rises.

Example 2

Vignette: An analyst compares two models for Country B. Model 1 assumes diminishing returns to capital and technology that is given from outside. Model 2 assumes firms' R&D creates knowledge that spills over to other firms, so returns to broad capital are constant. The government is considering a permanent subsidy for R&D. Q1: Which model is neoclassical? Q2: Under which model can the subsidy raise the long-run growth rate? Q3: Why does Model 2 not reach a steady state with zero per-worker growth?

Show the solution

Q1: Diminishing returns and exogenous technology describe the Solow model, so Model 1 is neoclassical.
Q2: Model 2 treats technology as a result of R&D. Spillovers mean broad capital does not face diminishing returns, so more R&D investment can raise the permanent growth rate.
Q3: In Model 2 the positive externalities offset diminishing returns, so extra investment keeps adding output at a constant or rising rate. Per-worker growth does not fade to zero.

Answer: Q1: Model 1. Q2: Model 2 (endogenous growth). Q3: Externalities from knowledge offset diminishing returns, so growth does not fade out.

Exam tips

Most questions test one idea: level effect versus growth-rate effect. Decide which it is before reading the options.
Read the vignette for how technology is treated. Exogenous means neoclassical. Driven by R&D or human capital means endogenous.
For calculations, check whether the question asks for output per worker or total output before deciding whether to add n.
Watch for the word conditional in convergence questions. Unconditional convergence is not a Solow result.
You are not penalised for wrong answers, so never leave an item blank.

Classical, Neoclassical and Endogenous Growth Theories: frequently asked questions

What is the main difference between neoclassical and endogenous growth theory?

Neoclassical theory assumes diminishing returns to capital and treats technology as given, so long-run growth depends on outside technology change. Endogenous theory explains technology through R&D and human capital, and allows constant or increasing returns, so policy can change the permanent growth rate.

What is the steady state in the Solow model?

It is the point where capital per worker and output per worker stop changing. Investment per worker equals what is needed to replace depreciated capital and equip new workers. Output per worker then grows only through technology.

How does Malthus differ from endogenous growth theory?

Malthus says gains in income per person are temporary because population grows and pushes income back to subsistence. Endogenous theory says investment in knowledge and human capital can keep income per person rising without limit.

Does a higher saving rate raise growth in the Solow model?

It raises growth only during the move to a new steady state. The steady-state level of output per worker is higher, but the long-run growth rate of output per worker is unchanged.