©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 17: Economic Growth

©2012 The McGraw-Hill Companies, All Rights Reserved

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Chapter 17: Economic Growth


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Learning Objectives

1. Show how small differences in growth rates lead to large differences in living standards

2. Explain why GDP per capita is the product of average labor productivity and the proportion of the population that is employed and use this decomposition to discuss the sources of economic growth

3. Discuss the determinants of average labor productivity within a particular country and use these concepts to analyze per capita GDP differences across countries


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Learning Objectives

4. Compare and contrast the benefits and costs of economic growth

5. Discuss and evaluate government policies that promote growth

6. Understand the trade-offs between economic growth and environmental quality


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Living Standards

Use an economic model to study the remarkable rise in living standards Real GDP per capita is a measure of the

goods available to a typical personOne clue to growing prosperity in the

20th century – GDP per capita over time has roughly the same pattern as output per worker

Comparisons across long periods is complicated by lack of data The variety, quantity, and quality of

goods increased enormously in the 19th and 20th century


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Output per Person, 1980–2009


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Output per Person - Trends

Remarkable growth in the U.S. from about $25,531 in 1980 to $43,662 in 2006, before dipping slightly in 2008 and 2009.

UAE’s GDP per person in 1980 declined from $95,434 to just $52,434 in 2009.

Saudi Arabia’s GDP per person declined from $34,598 in 1980 to $19,162 in 1990, then fluctuated tightly around $20,000 through 2009.

Egypt’s GDP per person increased from $2,431 in 1980 to $5,151 in 2009.

Turkey’s GDP per person increased from $5,693 in 1980 to $11,208 in 2009.


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Output per Worker, 1980–2009


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Output per Worker - Trends

Real GDP per worker in the United States increased from $41,649 in 1980 to $65,480 in 2008.

In Saudi Arabia, it decreased from $52,476 in 1980 to $28,460 in 2008.

In the UAE, it decreased from $55,466 in 1980 to $21,001 in 2008.

Egypt’s increased from $7,627 in 1980 to $13,248 in 2008.

Turkey’s increased from $11,322 in 1980 to $26,187 in 2008.


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Real GDP per Capita


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Output per Worker, 1870-2008

Japan’s real GDP per person grew more than 30 times between 1870 and 2008.

China’s grew more than12 times. In the United States it grew 12 times.Germany’s grew more than 11 times. Turkey’s and Iran’s grew about 10

times. Egypt’s and Morocco’s grew only about

6 times.


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Why “Small” Differences in Growth Rates Matter

In the previous table, the annual growth rates do not really differ Highest growth rate is 2.51 percent (Japan)

and lowest rate is 1.27 percent (Egypt). However, consider the long-run effect of this

seemingly “small” difference in terms of output per person

In 1870, output in person in Germany was about 3 times as large as Morocco’s. Yet, by 2008, Germany’s became 6 times as large as Morocco’s

This is from the power of compounding, often illustrated by compound interest.


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Why “Small” Differences in Growth Rates Matter

Compound interest pays interest on the original deposit and all previously accumulated interest Interest paid in year 1 earns interest

in year 2 $10 deposited at 4% interest in 1800

is $31,033.77 in 2005 $10 x (1.04)205 = $31,033.77


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Compound Interest

Differences in interest rates matter

Growth rates in GDP per capita have the same effect as interest rates Relatively small growth in GDP per

capita has a very large effect over a long period

In the long run, the growth rate of an economy matters

Interest Rate (%)

Value of $10 after 205 years

2 $579.48

4 $31,033.77

6 $1,540,644.29


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Why Nations Become Rich: The Crucial Role of Average Labor

Productivity

What determines a nation’s economic growth rate? To get some insight into this question, we

express real GDP per person as the product of two terms:

Average labor productivity Share of the population that is working

Assume the following notation Y = real GDP N = number of people employed POP = population


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Real GDP per Capita

In other words,

Real GDP per person = Average labor productivity × Share of population employed

This expression tells us something very basic and intuitive: The quantity of goods and services that each person can consume depends on: How much each worker produces and The share of people working


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Average Labor Productivity and Share of Population with Jobs in the United States,

1950–2010


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Between 1950 and 2010, average labor productivity in the United States grew 184 percent from $36,350 to $103,320.

Thus, in 2010, the average American enjoyed almost 3 times as many goods and services as in 1950.

The share of the population holding a job grew 12.5 percent, from 40 percent in 1950 to 45 percent in 2010, down from a peak of 49 percent in 1998–2001 and 2006–2007.

Overall, such simultaneous increases in both labor productivity and the share of the population holding a job have clearly contributed to the rise in living standards in the United States.

Average Labor Productivity and Share of Population with Jobs in the United States,

1950–2010


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Average Labor Productivity and Share of Population with Jobs in Morocco, 1960–

2010


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Real GDP per worker in Morocco grew 133 percent from $5,500 in 1960 to $12,815 in 2010.

The share of the population holding a job grew 27.6 percent from 29 percent to 37 percent between 1960 and 2010.

Thus, in 2010, the average Moroccan enjoyed more than 2 times as many goods and services as in 1960.

Both the average labor productivity and the share of the population with jobs have clearly contributed to the growth in Morocco’s output per person.

Average Labor Productivity and Share of Population with Jobs in Morocco, 1960–

2010


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Average Labor Productivity and Share of Population with Jobs in Egypt, 1960–2010


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Average labor productivity in Egypt grew 314 percent from $4,617 in 1960 to $19,122 in 2010.

The share of the population with jobs grew only 3 percent from 32 percent to 33 percent.

Hence, in 2010, Egyptians enjoyed more than 4 times as many goods and services as in 1960 despite no observable improvements in the share of the population with jobs.

Once again, average labor productivity is the driving force in the growth of Egypt’s standards of living, as measured by output per person.

Average Labor Productivity and Share of Population with Jobs in Egypt, 1960–2010


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Average Labor Productivity and Share of Population with Jobs in Turkey, 1955–2010


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Average labor productivity in Turkey grew by 556 percent from $6,706 in 1955 to $44,040 in 2010.

The share of the population with jobs declined by 40 percent from 50 percent to 30 percent.

Turkey clearly owes its increase in standards of living solely to its average labor productivity.

Average Labor Productivity and Share of Population with Jobs in Turkey, 1955–2010


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Understanding Growth

There are two factors that help explain the previous graphs Increase in the share of the population

that is employed The growing tendency of women to work

outside the home was the most important reason for the rise in employment in the US

Increase in the share of the general population that is of working age (ages 16 to 65) (baby boomers in the US)


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Female Labor Force Participation, 1980–2008


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Understanding Growth in the MENA

MENA countries suffer from a number of symptoms that may prevent the share of the population with jobs from contributing positively to the standard of living.

1.Major social, political, and economic changes may be required to reverse the downward trend in female labor force participation. Such changes take time and a substantial amount

of resources. In the absence of immediate reforms, this process

is likely to be slow, potentially extending over generations.

2.These countries have youth-bulged populations that will present further challenges going into the future as the younger generations enter the workforce.


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Understanding Growth

In the long run, In the long run, increases in output per person increases in output per person

arise primarily from arise primarily from increases in average labor increases in average labor

productivityproductivity


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The Determinants of Average Labor Productivity

US average labor productivity is 24 times Indonesia's 100 times Bangladesh's

Six factors determine average labor productivity1.Human capital2.Physical capital3.Land and other natural resources4.Technology5.Entrepreneurship and management6.Political and legal environment


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1. Human Capital

Hala and Jana have jobs wrapping candies and placing them into boxes.

Hala is a novice wrapper and can wrap 100 candies per hour.

Jana is an experienced wrapper and can wrap 300 candies per hour.

Both work 40 hours per week. What is average labor productivity, in

terms of candies wrapped per week and per hour:

1. For Hala2. For Jana3. For Hala and Jana as a team


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1. Human Capital

Hourly productivity is already given. Hala: 100 candies Jana: 300 candies

Weekly productivity Hala: 40 x 100 = 4,000 candies Jana: 40 x 300 = 12,000 candies Together: 16,000 candies for two weeks Average weekly productivity: 16,000/2 =

8,000 Average hourly productivity: 16,000/80 =

200


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1. Human Capital

Human capital comprises the talents, education, training, and skills of workers Human capital increases workers'

productivityGermany and Japan used human capital

to rebuild after World War II Professional scientists and engineers Apprentice and on-the-job training

emphasized Japanese increased emphasis on early

education


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1. Human Capital

Human capital is analogous to physical capital (such as machines and factories) It is primarily acquired through the

investment of time, energy, and money Example: The cost of going to school

includes not only the tuition paid but also the opportunity cost

Cost – Benefit Principle applies to building human capital Premium paid to skilled workers


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2. Physical Capital

More and better capital increases worker productivity

Factory owner employs two people and adds capital Each machine requires one dedicated operator

Number of Machines

Output per Week

Hours Worked per

Week

Output per Hour

Worked

0 16,000 80 200

1 32,000 80 400

2 40,000 80 500

3 40,000 80 500

1. More capital increases output per hour2. Diminishing returns to capital


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Diminishing Returns to Capital

Diminishing returns to capital occurs if an addition of capital with other inputs held constant increases output by less than the previous increment of capital Assumption: all inputs except capital are held

constant Result: output increases at a decreasing rate

When a firm has many machines, the most productive uses have already been filled The increment in capital will necessarily be

assigned to a less productive use than the previous increment

Principle of Increasing Opportunity Cost


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Growth and Diminishing Returns to Capital

Implications of diminishing returns Increasing capital will increase output

and labor productivity Positive contribution to growth

There are limits to increasing productivity by adding capital because of diminishing returns

Is there empirical evidence that giving workers more capital makes them more productive?


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Growth and Diminishing Returns to Capital


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Capital and Output per Worker, 1990

Low capital/worker,Low GDP per worker

High capital/worker,High GDP per worker


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3. Land and Other Natural Resources

Inputs other than capital increase worker productivity An abundance of natural resources

increases the productivity of the workers who use them

Land for farming If not endowed with natural resources,

these can be obtained through international markets

Petroleum, metals etc.. Countries like Japan, Hong Kong, Singapore

and Switzerland have become rich without substantial natural resources of their own


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4. Technology

New technologies are the single most important source of productivity improvement

Technical change can affect

industries beyond the primary application Transportation expanded

markets for farm produce Medicine Communications Electronics and computers

Internet


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5. Entrepreneurship and Management

Entrepreneurs create new economic enterprises Essential to a dynamic, healthy, growing

economyExamples:

Henry Ford and mass production Bill Gates and standardized graphical user

interface operating system Larry Page and Sergey Brin and Google's

searchPolicies should channel entrepreneurship

in productive ways Taxation policy and regulatory regime Value innovation


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Inventing the Personal Computer

Steve Jobs and Steve Wozniak Had an idea to make a computer that was

smaller and cheaper than the closet-sized mainframes that were then in use

To set up shop in Steve Jobs’s parents’ garage and buy their supplies, they sold their two most valuable possessions

Jobs’s used Volkswagen van and Wozniak’s Hewlett-Packard scientific calculator, for a total of $1,300

The result was the first personal computer: Apple

The rest is history


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Medieval China

Sung period (960 – 1270 AD) was technically sophisticated Paper ■ Gunpowder Water wheels ■ Compass?

Economic stagnation followed Social system limited entrepreneurship Emperor retained property rights to

business Seizure possible without notice

Scientific advances alone do not ensure technical change and growth


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6. Political and Legal Environment

Government too has a role to play in fostering improved productivity Provide a political and legal environment

that encourages people to behave in economically productive ways

Work hard / save and invest wisely / acquire useful information and skills / provide the goods and services that the public demands

Encourage people to be economically productive


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6. Political and Legal Environment

One specific function of government that appears to be crucial to economic success is Well-defined property rights are essential

Who owns what and how those things can be used

Reliable recourse through courts

Other vital government functions are to Maintain political stability Promote free and open exchange of ideas


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Communism Failed

Output per person in the Soviet Union was probably less than one-seventh the US rate in 1991

The Soviet Union had ingredients for growth – human capital, physical capital, natural resources, technology

Two main flaws Communal ownership of capital stock

General absence of private property rights Incentive Principle could not work

Government planning replaced market system Abundant unexploited opportunities

Political instability and appropriate legal framework


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The Costs of Economic Growth

We know that increasing the capital stock will increase GDP Opportunity cost of producing more capital

goods is Fewer consumer goods

• People may be willing to forego present consumption to have more in the future

Reduced leisure time Possible risks of health and safety from rapid capital

production The cost of R&D to improve technology The cost of education to develop and use new capital


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Promote Growth with Human Capital

Governments support education and training programs Government grants and scholarships Job training and retraining programs

Government pays because education has externalities A democracy works better with educated

voters Progressive taxes capture some of the

higher income Increases chances of technical innovation Poor families could not pay


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Promote Growth with Savings and Investment

Government policies can encourage new capital formation and saving in the private sector Government periodically offers

investment tax creditsGovernment can invest directly in

capital formation Construction of infrastructure such as

roads, bridges, airports, and dams Interstate highway system reduced costs

of transporting goods, making markets more efficient


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Promote Growth with R&D Support

Research and development promotes innovation Some types of research, such as basic

science, create externalities that a private firm cannot capture

Basic scientific knowledge (medical, pharmaceutical)

Fund basic science with National Foundations and other government grants

Maintain political and legal framework to support growth


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The Legal and Political Framework

Governments can play an essential role in securing property rights and a well-functioning legal system.

They can also help create an economic environment that encourages entrepreneurship, and of political stability and the free and open exchange of ideas.

Government policymakers also should consider the potential effects of tax and regulatory policies on activities that increase productivity, such as investment, innovation, and risk taking


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Promoting Economic Growth in Least Developed

Prescription for more human and physical capital is broadly correct Appropriate technology and education

Most countries need institutions to support growth Corruption creates uncertainty about

property rights and drains financial resources out of the country

Regulation discourages entrepreneurship Taxes discourage risk-taking Markets do not function efficiently Lack of political stability discourages foreign

investment


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Limits to Growth

Can growth be sustained? Depletion of some natural resources Environmental damage and global warming

Computer models suggested growth is not sustainable Did not adequately treat new and better products Greater income can pay for better environmental

quality Ignored the market's response to increasing

scarcity High prices trigger a response Strong response to energy crisis in mid 1970s

Government action needed in case of externalities


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Mexico City Air Quality

Research indicates that pollution increases up to a point with increased GDP per person After A, air pollution decreases

and air quality improves Estimates suggest Mexico is

close to point ABeyond a certain level of

income, citizens value a cleaner

environment and they are willingand able to pay for it Real GDP per capita

Air

pollu

tion

A

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©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 17: Economic Growth