Answer to Question #65403 in Microeconomics for pva

Question

What is meant by steady state in the Solow model? Derive conditions for steady state in
an economy. What is the significance of decreasing returns in the Solow model?

Answer 1

The central idea of the Solow growth model is an economy which is reaching steady state. We define the steady state as a situation when the capital stock rises at a constant rate, though capital per capita does not rise.

It means a situation when the diminishing returns to factor kick in to an extent and the economy will not become more productive in per capita through simply adding more capital. The conditions for steady state in an economy are the following ones:
1. Growth of labour force at a constant proportional rate.
2. Prevailing of full employment at all times.
3. Constant saving-income ratio
4. Fixed coefficients of productions. Lack of possibility of the substitution of labour and capital.
5. Lack of technical change.

The economy will become in a steady state when there are diminishing returns on the investment curve.

As capital increases, diminishing returns influence that investment and production increase by less and less, though depreciation increases by the same amount. But the main fact is that net investment is zero that’s why the economy is in steady state.