Why do economies grow?

Today’s post is about what drives long-term economic growth. In economics, one of the most famous tools we use to understand long-term growth is the Solow growth model. At its core, the model says that the size of an economy depends on capital, labor, and technology.

Let’s start with capital and labor. If a country builds more factories, buys more machines, or hires more workers, it can produce more. But here’s the catch: this kind of growth slows over time. As you add more and more machines or workers, each new unit contributes less than the last. Economists call this diminishing returns.

Education matters too. A more skilled workforce is better at adopting and spreading new ideas. But just like capital and labor, there’s diminishing marginal returns — we wouldn’t want most people to spend half their life learning.

So if capital and labor can’t power growth forever, what can? The answer is technological progress. When we find new ways of doing things better, faster, or more efficiently, we break through the limits of capital and labor. In other words, growth is not just about more workers or machines — it’s about more productive ones.

Think of breakthroughs like the steam engine, electricity, the internet, or AI. These don’t just add to capital, they allow the same amount of labor and capital to create more economic activity or output. In the Solow model, technological progress is the key engine of sustained economic growth.

There’s also something important the basic Solow model doesn’t capture: institutions matter too. Things like the rule of law, property rights, political stability, and well-functioning markets all play a critical role in fostering innovation and investment. If entrepreneurs fear their inventions will be stolen, or investors don’t trust the legal system, technological progress slows-no matter how smart the scientists are.

To sum up, if we want to grow the economy sustainably, we should be focused on facilitating technological progress while also ensuring that our laws and institutions create and maintain a level and predictable playing field.

Originally published at https://mytwocentsandcounting.substack.com.