Chapter 26 Economic growth ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Economic growth Economic growth is often measured by the rate of change of real GDP, although this has many deficiencies. It omits output that is not bought/sold e.g. leisure, pollution, congestion. It also neglects income distribution . So, higher GDP per capita does not necessarily mean greater happiness, but it helps. ©McGraw-Hill Companies, 2010 2

The production function shows the maximum output that can be produced using specified quantities of inputs, given existing technical knowledge Output = f (capital, labour, land, raw materials, technology) This is to be read as: output is a function of capital, labour, etc. ©McGraw-Hill Companies, 2010 3

©McGraw-Hill Companies, 2010 Increasing output Capital output per worker may increase with capital per worker Labour population growth participation rates human capital Land fixed supply, but quality may be improved ©McGraw-Hill Companies, 2010 4

©McGraw-Hill Companies, 2010 Increasing output (2) Raw materials important distinction between depletable resources (coal, oil) renewable resources (timber, fish) Technical knowledge inventions, R&D Economies of scale may reinforce the long-run growth process ©McGraw-Hill Companies, 2010 5

©McGraw-Hill Companies, 2010 Technical knowledge The state of technical knowledge changes through time because of: inventions embodiment of knowledge in capital learning by doing Research and development (R&D) patent systems address a market failure which otherwise would lead to there being too little R&D. ©McGraw-Hill Companies, 2010 6

Growth and accumulation Suppose Y = A × f(K, L) i.e. variable inputs capital (K) and labour (L) combine to produce a given output. A represents technical knowledge. At very low levels of income, savings may be zero as all resources are needed for consumption. So capital cannot be created through investment, and output may not be able to grow through time. ©McGraw-Hill Companies, 2010 7

Theories of growth: some key terms Along a steady-state path output, capital and labour are all growing at the same rate, so output per worker and capital per worker are constant. Capital-widening extends the existing capital per worker to new extra workers. Capital deepening raises capital per worker for all workers. ©McGraw-Hill Companies, 2010 8

The Solow (neoclassical) growth model Assume labour grows at a constant rate n constant savings ratio s capital per worker is k; this is constant in the steady state adding more capital per worker increases output per worker (y) but with diminishing returns. ©McGraw-Hill Companies, 2010 9

The Solow (neoclassical) growth model y shows output per person y Per capita output is y*, and output and capital grow with population. y* nk shows the investment per person that maintains capital per person while labour grows nk k* In the steady state E, investment is just sufficient to keep capital per person constant at k*. E sy shows both saving and investment per person sy Output per person, y Capital per person, k ©McGraw-Hill Companies, 2010 10

©McGraw-Hill Companies, 2010 A higher savings rate y E y* k* Suppose the original steady state is at E. y** k** F takes the economy to a new steady state at F. nk s'y An increase in the savings ratio to s' sy Output per person, y Capital per person and output per person have increased ... Capital per person, k But y** is constant, and thus the growth rate is unchanged. Output and labour continue to grow at the rate n. ©McGraw-Hill Companies, 2010 11

The convergence hypothesis … asserts that poor countries will grow more quickly than average, but rich countries will grow more slowly than average. i.e. poor countries should ‘catch up’ but social and political differences may enable some economies to catch up more effectively than others. ©McGraw-Hill Companies, 2010 12

©McGraw-Hill Companies, 2010 Convergence? Ratio of 2 years 1998 2008 East Asian economies such as China and South Korea grew very quickly during the last 30 years. Bangladesh Poor 0.3 0.5 1.67 Nigeria 0.42 0.7 1.68 China 0.35 2.17 6.22 Indonesia 0.78 1.35 1.72 Turkey Middle 3.28 5.71 1.71 S. Korea 6.23 16.8 2.7 Portugal 9.92 17.4 1.75 Spain Rich 14.84 26.9 1.81 Ireland 15.27 40.9 2.68 Italy 21.83 31.5 1.42 UK 21.23 39.9 1.88 France 27.13 38.2 1.39 USA 29.92 45.2 1.61 Switzerland 46.17 59.4 1.29 Yet convergence cannot be a powerful force in the world, or the very poorest countries would all be growing very rapidly. Generally, growth seems to be fostered by two conditions: absence of internal strife and openness to the world economy. 13

©McGraw-Hill Companies, 2010 Convergence? (2) The ratio of per capita income in 2008 relative to 1987 is on the horizontal axis, 1987 per capital income on the vertical axis. 1987 per capita income On average countries that have become rich then grow more slowly. but individual country performance can depart significantly from this underlying relationship. Ratio of per capita incomes ©McGraw-Hill Companies, 2010 14

Convergence in the future By 2025, China will have overtaken the USA, and by 2050 will have a significant economic lead. With the fastest population growth and the second largest population to start with, India will overtake the US eventually, but not before 2050. Source: PwC ©McGraw-Hill Companies, 2010 15

Endogenous growth theory … recognises that there may be significant externalities to capital Higher capital in one firm increases productivity in other firms. known as ‘endogenous’ growth theory because it suggests that growth may depend on parameters that can be influenced by private behaviour or public policy governments should subsidise human and physical capital formation ©McGraw-Hill Companies, 2010 16

The costs of economic growth Malthus, in the 18th century, warned of limits to growth, but he underestimated the potential impact of technical change. The price system helps to ensure a proper use of finite resources. Growth may bring costs pollution, congestion, poor quality of life, But lack of growth may impose costs also. The assessment of the desirable growth rate remains a normative issue. ©McGraw-Hill Companies, 2010 17

©McGraw-Hill Companies, 2010 Zero growth? The zero-growth proposal argues that, because higher measured GNP imposes environmental costs, it is best to aim for zero growth of measured GNP. This fails to distinguish between measured outputs accompanied by social costs and measured outputs without additional social costs. It does not provide the correct incentives. when there is too much pollution, congestion, environmental damage or stress, the best solution is to provide incentives that directly reduce these phenomena. ©McGraw-Hill Companies, 2010 18