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Growth, Productivity, Growth, Productivity, and the Wealth Of and the Wealth Of

NationsNations

Chapter 8

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Laugher CurveLaugher Curve

We have two classes of forecasters:

Those who don't know, and those who don't know they don't know.

John Kenneth Galbraith

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General Observations General Observations about Growthabout Growth Growth increases the economy’s potential

output.

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Growth and the Growth and the Economy’s PotentialEconomy’s Potential Growth is an increase in the amount of

goods and services an economy produces. Growth is an increase in potential output.

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Growth and the Growth and the Economy’s PotentialEconomy’s Potential Potential output – the highest amount of

output an economy can produce from the existing production function and existing resources.

When an economy is at its potential output, it is operating on its production possibility curve.

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Growth and the Growth and the Economy’s PotentialEconomy’s Potential Long-run growth focuses on supply. It assumes Say’s Law – supply creates its

own demand.

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Growth and the Growth and the Economy’s PotentialEconomy’s Potential In the short run, economists consider

potential output fixed. They focus on how to get the economy

operating at its potential if it is not.

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Importance of Growth for Importance of Growth for Living StandardsLiving Standards Growth improves living standards. It makes more goods available to more

people. Because of compounding, long-term

growth rates matter a lot.

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Importance of Growth for Importance of Growth for Living StandardsLiving Standards The Rule of 72 is used to determine how

long it takes for income to double at different growth rates.

The Rule of 72 – the number of years it takes for a certain amount to double in value is equal to 72 divided by its annual rate of increase.

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Markets, Specialization, Markets, Specialization, and Growthand Growth Markets, specialization and the division of

labor increase productivity and growth. Specialization – the concentration of

individuals on certain aspects of production

Division of labor – the splitting up of a task to allow for specialization of production.

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Economic Growth, Economic Growth, Distribution, and MarketsDistribution, and Markets Markets are often seen to be unfair

because of the effect they have on the distribution of income.

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Economic Growth, Economic Growth, Distribution, and MarketsDistribution, and Markets Markets may not provide equality of

income but they make the poor better off. There is strong evidence that the poor

benefit enormously from the growth that markets foster.

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Economic Growth, Economic Growth, Distribution, and MarketsDistribution, and Markets Just because the poor benefit from growth

does not mean they might not be better off if income were distributed more in their favor.

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Cost of Goods in Hours of Cost of Goods in Hours of WorkWork

Price in minutes of work0 50 100 150 200

1919

Milk (½ gallon)Beef (1 pound)

Eggs (1 dozen)Bread (1 pound)

Chicken (3 lb. fryer)

1997Beef (1 pound)Eggs (1 dozen)Bread (1 pound)

Chicken (3 lb. fryer)

Milk (½ gallon)

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Per Capita GrowthPer Capita Growth

Per capita output is total output divided by total population.

Per capita growth means producing more goods and services per person.

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Per Capita GrowthPer Capita Growth

Per capita growth equals the percent change in output minus the percent change in population

Per capita growth = % change in output - % change in population

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Per Capita GrowthPer Capita Growth

In many developing nations, the population is rising faster than GDP, resulting in a lower per capita growth rate.

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Per Capita GrowthPer Capita Growth

Some economists have argued that per capita (mean) output is not what we should be focusing on.

We should focus on median income instead.

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Per Capita GrowthPer Capita Growth

Median income is a better measure because it takes into account how income is distributed.

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Per Capita GrowthPer Capita Growth

If the growth in income goes mostly to a small minority of individuals, the mean will rise but the median will not.

Because statistics on median income is generally not collected, economists use per capita income.

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The Sources of GrowthThe Sources of Growth

Economists identify five important sources of growth: Capital accumulation – investment in

productive capacity. Available resources. Growth compatible institutions. Technological development. Entrepreneurship.

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Investment and Investment and Accumulated CapitalAccumulated Capital Years ago it was thought that physical

capital and investment were the keys to growth.

The flow of investment lead to the growth of the stock of capital.

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Investment and Investment and Accumulated CapitalAccumulated Capital Capital accumulation does not necessarily

lead to growth. Products change, and useful buildings and

machines in one time period may be useless in another.

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Investment and Investment and Accumulated CapitalAccumulated Capital Capital is much more than machines – it

includes human and social capital. Human capital – the skills that are

embodied in workers through experience, education, on-the-job training.

Social capital – the habitual way of doing things that guides people in how they approach production.

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Investment and Investment and Accumulated CapitalAccumulated Capital All economists agree that the right kind of

investment at the right time is a central element of growth.

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Available ResourcesAvailable Resources

For an economy to grow it will need resources.

What constitutes a resource at one time may not be a resource at another time.

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Available ResourcesAvailable Resources

Technology plays an enormous role here. Greater participation in the market is

another way by which available resources are increased.

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Growth-Compatible Growth-Compatible InstitutionsInstitutions Markets and private ownership of property

foster economic growth. When individuals get much of the gains of

growth themselves, they work harder.

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Growth-Compatible Growth-Compatible InstitutionsInstitutions Another growth-compatible institution is the

corporation. Because of limited liability, corporations

give owners and incentive to invest their savings in large enterprises.

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Growth-Compatible Growth-Compatible InstitutionsInstitutions Mercantilist economic policies inhibit

economic growth.

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Technological Technological DevelopmentDevelopment Growth isn’t just getting more of the same

thing. It’s also getting some things that are

different.

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Technological Technological DevelopmentDevelopment Growth involves changes in technology. Technology – changes the way we make

goods and supply services, and in the goods and services we buy.

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EntrepreneurshipEntrepreneurship

Entrepreneurship is the ability to get things done.

That ability involves creativity, vision, and a talent for translating that vision into reality.

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Turning the Sources of Turning the Sources of Growth into GrowthGrowth into Growth In order to be effective, the five sources of

growth must be mixed in the right proportions.

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Turning the Sources of Turning the Sources of Growth into GrowthGrowth into Growth It is the combination of investing in

machines, people, and technological change that plays a central role in the growth of any economy.

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The Production Function The Production Function and Theories of Growthand Theories of Growth The production function shows the

relationship between the quantity of inputs used in production and the quantity of output resulting from production.

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The Production Function The Production Function and Theories of Growthand Theories of Growth The production function for growth has

land, labor, and capital as factors of production.

“A” is an adjustment factor that captures the effect of technology.

Output = A• f(Labor, Capital, Land)

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Describing Production Describing Production FunctionsFunctions Scale economies describe what happens

in a production function when all inputs increase equally. Constant returns to scale. Increasing returns to scale. Decreasing returns to scale.

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Describing Production Describing Production FunctionsFunctions Constant returns to scale means that

output will rise by the same proportionate increase in all inputs.

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Describing Production Describing Production FunctionsFunctions Increasing returns to scale occurs when

output rises by a greater proportionate increase as all inputs.

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Describing Production Describing Production FunctionsFunctions Decreasing returns to scale occurs when

output rises by a smaller proportionate increase as all inputs.

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Describing Production Describing Production FunctionsFunctions Diminishing marginal productivity

describes what happens when more of one input is added without increasing any other inputs.

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Describing Production Describing Production FunctionsFunctions The law of diminishing marginal

productivity states that increasing one output, keeping all others constant, will lead to smaller and smaller gains in output.

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The Classical Growth The Classical Growth ModelModel The Classical growth model focuses on

capital accumulation in the growth process. The more capital an economy has, the

faster it will grow. Because of this emphasis on capital,

market economies are called capitalist economies.

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The Classical Growth The Classical Growth ModelModel Classical economists focused their

analysis and their policy advice, on how to increase investment:

savings investment

increases in capital growth

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Focus on Diminishing Focus on Diminishing Marginal Productivity of Marginal Productivity of LaborLabor The Classical growth model focused on

how diminishing marginal productivity of labor placed limitations on growth.

Farming was the major economic activity and land was relatively fixed.

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Focus on Diminishing Focus on Diminishing Marginal Productivity of Marginal Productivity of LaborLabor Since land was fixed, diminishing marginal

productivity would set in as population grew.

As output per person declines, at some point available output is no longer sufficient to feed the population.

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Focus on Diminishing Focus on Diminishing Marginal Productivity of Marginal Productivity of LaborLabor This belief is called the iron law of wages. The long run was called the stationary

state.

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Diminishing Returns and Diminishing Returns and Population GrowthPopulation Growth

Output

Labor

Subsistence level of output per worker

Production function

Q1

Q2

L1 L*

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Diminishing Marginal Diminishing Marginal Productivity of CapitalProductivity of Capital The predictions of the stationary state

turned out to be wrong. Increases in technology and capital

overwhelmed the law of diminishing marginal productivity.

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Diminishing Marginal Diminishing Marginal Productivity of CapitalProductivity of Capital The focus then turned to the diminishing

marginal productivity of capital, not labor:

capital grows faster than labor capital is less productive slower economic output

per capita growth stagnates per capita income stops rising

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Diminishing Marginal Diminishing Marginal Productivity of CapitalProductivity of Capital Diminishing marginal productivity would be

stronger for richer nations than for poor ones.

Poor countries with little capital should grow faster than countries with lots of capital.

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Diminishing Marginal Diminishing Marginal Productivity of CapitalProductivity of Capital Eventually per capita incomes among

nations would converge. This has not happened either:

The ambiguity in the definition of inputs. Technological progress.

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Ambiguities in the Ambiguities in the Definition of the Factors Definition of the Factors of Productionof Production The definition of the factors of production

are ambiguous. It would seem that the definition of labor

would be straightforward – the hours of work that go into production.

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Ambiguities in the Ambiguities in the Definition of the Factors Definition of the Factors of Productionof Production Economists separate labor into two

components. Standard labor – the actual number of

hours worked. Human capital – the skills embedded in

workers through experience, education, and on-the-job training.

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Ambiguities in the Ambiguities in the Definition of the Factors Definition of the Factors of Productionof Production Increases in human capital have allowed

labor to keep pace with capital. This allows economies to avoid the

diminishing productivity of capita.

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Ambiguities in the Ambiguities in the Definition of the Factors Definition of the Factors of Productionof Production If skills are increasing faster in a rich

country than in a poor one, incomes would not be expected to converge.

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TechnologyTechnology

Technology overwhelms diminishing marginal productivity so that growth rates can increase over time.

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Empirical Estimates of Empirical Estimates of Factor Contribution to Factor Contribution to GrowthGrowth Economist Edward Denison estimated the

importance of each of the sources of growth.

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Sources of Real U.S. GDP Sources of Real U.S. GDP Growth, 1928-2000Growth, 1928-2000

Human capital (13%)Physical capital (19%)

Technology (35%)Labor (33%)

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New Growth TheoryNew Growth Theory

New growth theory emphasizes the role of technology rather than capital in the growth process.

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TechnologyTechnology

Technology is the result of investment in creating technology (research and development).

Investment in technology increases the technological stock of an economy.

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TechnologyTechnology

Growth theory separates investment in capital and investment in technology.

Increases in technology are not as directly linked to investment as is capital.

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TechnologyTechnology

Increases in technology often have enormous positive spillover effects.

Technological advances in one sector of the economy lead to advances in completely different sectors.

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TechnologyTechnology

Technological advances have positive externalities. Positive externalities – positive effects

on others not taken into account by the decision maker.

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TechnologyTechnology

Some basic research is protected by patents. Patents – legal ownership of a

technological innovation that gives the owner of the patent sole rights to its use and distribution for a limited time.

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TechnologyTechnology

Once people have seen the new technology, they figure out sufficiently different way to achieving the same end to avoid the patent.

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Learning by DoingLearning by Doing

New growth theory also highlights learning by doing.

Learning by doing – improving the methods of production through experience.

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Learning by DoingLearning by Doing

By increasing the productivity of workers, learning by doing overcomes the law of diminishing marginal productivity.

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Increasing Returns to Increasing Returns to ScaleScale

Production function with increasing returns

Output

All inputs

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Technological Lock-InTechnological Lock-In

Technological lock-in is an example of how sometimes the economy does not use the best technology available.

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Technological Lock-InTechnological Lock-In

Technological lock-in occurs when old technologies become entrenched in the market.

They become locked into new products despite the fact that more efficient technologies are available.

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Technological Lock-InTechnological Lock-In

One reason for technological lock-in is network externalities.

Network externalities – an externality in which the use of a good by one individual makes that technology more valuable to other people.

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Technological Lock-InTechnological Lock-In

Switching from a technology exhibiting network externalities to a superior technology is expensive and sometimes nearly impossible.

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Economic Policies to Economic Policies to Encourage Per Capita Encourage Per Capita GrowthGrowth Encourage saving and investment. Control population growth. Increase the level of education. Create institutions that encourage

technological innovation. Provide funding for basic research. Increase the economy’s openness to trade.

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Policies to Encourage Policies to Encourage Saving and InvestmentSaving and Investment Modern growth theories have downplayed

the importance of capital in the growth process.

However, all agree that it is important. Policy makers are eager to encourage both

saving and investment.

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Policies to Encourage Policies to Encourage Saving and InvestmentSaving and Investment The U.S. has used tax incentives to

increase saving. Because they don’t have much

discretionary income, it is difficult for poor countries to generate saving and investment.

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A Case Study: Micro A Case Study: Micro CreditCredit The borrowing circle of Grameen bank is

an example of how to increase investment in a developing nation. The traditional way of lending money is

to ask for collateral. In Bangladesh, potential borrowers had

no collateral.

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A Case Study: Micro A Case Study: Micro CreditCredit The bank officer replaced collateral with

the borrowing circle concept. Borrowing circle concept – a credit

system that replaces traditional collateral with guarantees by friends of the borrower.

In case of a default, the friends had to make the loan good.

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Growth Through Foreign Growth Through Foreign InvestmentInvestment Foreign investment provides another

source of saving. Developing nations can borrow from the

IMF, the World Bank, or from private sources.

None of these are perfect solutions since they come with large strings attached.

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Policies to Control Policies to Control Population GrowthPopulation Growth Developing nations whose populations are

rapidly growing have difficulty providing enough capital and education for everyone.

Thus, per capita income is low.

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Policies to Control Policies to Control Population GrowthPopulation Growth Policies that reduce population growth

include: Free family–planning services. Increasing the availability of

contraceptives. Harsh mandatory one-child-per-family

policies such as China adopted in 1980.

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Policies to Control Policies to Control Population GrowthPopulation Growth Some economists argue that to reduce

population growth, a nation must grow first. As income and work opportunities rise,

especially for women, the opportunity cost of having children rises and families will choose to have fewer children.

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Policies to Increase the Policies to Increase the Level of EducationLevel of Education Increasing the educational level and skills

of the workforce increases labor productivity.

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Policies to Create Policies to Create Institutions That Institutions That Encourage Technological Encourage Technological InnovationInnovation Unlike capital, technological innovation can

occur without investment. Conversely, investment in technology can

result in no technological innovation.

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Create Patents and Create Patents and Protect Property RightsProtect Property Rights Patents and protecting property rights are

two ways to encourage innovation. Patents are not costless to society. Patents allow innovators to charge high

prices for their use.

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Create Patents and Create Patents and Protect Property RightsProtect Property Rights Societies must find a middle ground

between providing incentives to create new technologies and allowing everyone to take advantage of the benefits of technology.

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Patents and Developing Patents and Developing CountriesCountries Poor nations are reluctant to enforce U.S.

patents. The U.S. often uses trade policy to attempt

to force developing countries to do so.

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The Corporation and The Corporation and Financial InstitutionsFinancial Institutions Limited liability encourages investors to

pool their funds. Bringing technological innovations to

markets often requires large amounts of investment over a number of years.

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The Corporation and The Corporation and Financial InstitutionsFinancial Institutions Well-developed financial institutions such

as stock markets create liquidity and encourage investment.

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Provide Funding for Provide Funding for Basic ResearchBasic Research Individual firms have little incentive to do

basic research because of technology’s “common knowledge” aspect.

This is where the government steps in. The U.S. government provides 60 percent

of the basic research in the country.

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Policies to Increase Policies to Increase Openness to TradeOpenness to Trade Free trade increases growth by broadening

the market and by fostering competition. In order to specialize, you need a large

market. Large markets allow firms to take

advantage of economies of scale.

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Growth, Productivity, Growth, Productivity, and the Wealth Of and the Wealth Of

NationsNations

End of Chapter 8