Economic Growth and Development

The attention Easterly and Levine give to productivity stems from the obser-
vation by Robert Solow in his influential 1957 article, which stated that
‘investment is not the key to growth’. Solow found that productivity increase
had accounted for nearly 90 per cent of US growth in the first half of the twen-
tieth century. Much subsequent empirical evidence supports the argument that
differences in growth rates between countries are accounted for by differences
in productivity rather than investment (Benhabib and Spiegel, 1994; Klenow
and Rodriquez-Clare, 1997; Easterly and Levine, 2000).
The effect of diminishing returns to investment, illustrated in Figure 3.2,
can partially reconcile the robust empirical results linking investment and
growth with the elusive quest. An important concept in the relation between
capital and output per worker is that of diminishing returns. Figure 3.2 shows
that additions to the stock of physical or human capital (investment) increase
output,but at a diminishing rate. The increase in output (GDP growth) as total
investment increases from B to C is less than the increase from A to B. Each
increment to the capital stock yields an ever smaller increase in output, so that
eventually even substantial increases have only a minimal impact on output.
The economic Law of Diminishing Returns states that incrementing one factor
(here investment) while holding all others constant (here land and labour) will
yield progressively smaller increments in output. Another example is in agri-
culture. Investing in irrigation to reduce reliance on rainfall would generate a
large increase in output,moving from canal to borehole irrigation would make
that irrigation more reliable, moving from borehole to drip-feed irrigation
(where the water is delivered directly to plants) will further boost output and

Domestic and Foreign Direct Investment 67

Figure 3.2 Diminishing returns to investment

Output

(total GDP)

Investment increases

A Investment

GDP incre

ase

s

BC