The Solow model is governed by the iron logic of diminishing returns. When the capital stock is low, the marginal product of capital is high and capital accumulates, leading to economic growth. But as capital accumulates, its marginal product declines until per-period investment is just equal to depreciation, and growth stops.

Despite the simplicity of the Solow model, it tells us three important things about economic growth. First, countries that devote a larger share of output to investment will be wealthier. The Solow model doesn’t tell us why some countries might devote a larger share of output to investment, but we know from Chapter 27 that wealthy countries have institutions that promote investment in physical capital, human capital, and technological knowledge. We will also say more about how financial intermediaries channel saving into investment in Chapter 29.

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Second, growth will be faster the farther away a country’s capital stock is from its steady-state value. This explains why the German and Japanese economies were able to catch up to other advanced economies after World War II, why countries that reform their institutions often grow very rapidly (growth miracles), and why poor countries grow faster than rich countries with similar levels of steady-state output.

Third, the Solow model tells us that capital accumulation cannot explain long-run economic growth. Holding other things constant, the marginal product of physical and human capital will eventually diminish, thereby leaving the economy in a zero-growth steady state. If we want to explain long-run economic growth, we must explain why other things are not held constant.

New ideas are the driving force behind long-run economic growth. Ideas, however, aren’t like other goods: Ideas can be easily copied and ideas are non-rivalrous. The fact that ideas can be easily copied means that the originator of a new idea won’t receive all the benefits of that idea so the incentive to produce ideas will be too low. Governments can play a role in supporting the production of new ideas by protecting intellectual property and subsidizing the production of new ideas when spillovers are most likely to be present.

The non-rivalry of ideas, however, means that once an idea is created, we want it to be shared, which is a nice way of saying copied, as much as possible. There is thus a trade-off between providing appropriate incentives to produce new ideas and providing appropriate incentives to share new ideas.

An important lesson from the economics of ideas is that the larger the market, whether in terms of people or wealth, the greater the incentive to invest in research and development. Similarly, having more people and wealthier countries increases the number of people devoted to the production of new ideas. Thus, the increased wealth of many developing nations, the move to freer trade in global markets, and the spread of better institutions throughout the world are all encouraging for the future of economic growth.