Growth, Productivity, and the Wealth Of Nations Chapter 24

Laugher 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

General Observations about Growth Growth increases the economy’s potential output.

Growth and the Economy’s Potential Growth is an increase in the amount of goods and services an economy produces. Growth is an increase in potential output.

Growth and the Economy’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.

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

Growth and the Economy’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.

Importance of Growth for Living Standards Growth improves living standards. It makes more goods available to more people. Because of compounding, long-term growth rates matter a lot.

Importance of Growth for Living 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.

Markets, Specialization, and 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.

Economic Growth, Distribution, and Markets Markets are often seen to be unfair because of the effect they have on the distribution of income.

Economic Growth, Distribution, 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.

Economic Growth, Distribution, 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.

Cost of Goods in Hours of Work Price in minutes of work 50 100 150 200 1919 Milk (½ gallon) Beef (1 pound) Eggs (1 dozen) Bread (1 pound) Chicken (3 lb. fryer) 1997 Beef (1 pound) Eggs (1 dozen) Bread (1 pound) Chicken (3 lb. fryer) Milk (½ gallon)

Per Capita Growth Per capita output is total output divided by total population. Per capita growth means producing more goods and services per person.

Per 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

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

Per 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.

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

Per 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.

The Sources of Growth Economists identify five important sources of growth: Capital accumulation – investment in productive capacity. Available resources. Growth compatible institutions. Technological development. Entrepreneurship.

Investment and Accumulated 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.

Investment and Accumulated 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.

Investment and Accumulated 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.

Investment and Accumulated Capital All economists agree that the right kind of investment at the right time is a central element of growth.

Available 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.

Available Resources Technology plays an enormous role here. Greater participation in the market is another way by which available resources are increased.

Growth-Compatible Institutions Markets and private ownership of property foster economic growth. When individuals get much of the gains of growth themselves, they work harder.

Growth-Compatible Institutions Another growth-compatible institution is the corporation. Because of limited liability, corporations give owners and incentive to invest their savings in large enterprises.

Growth-Compatible Institutions Mercantilist economic policies inhibit economic growth.

Technological Development Growth isn’t just getting more of the same thing. It’s also getting some things that are different.

Technological Development Growth involves changes in technology. Technology – changes the way we make goods and supply services, and in the goods and services we buy.

Entrepreneurship Entrepreneurship is the ability to get things done. That ability involves creativity, vision, and a talent for translating that vision into reality.

Turning the Sources of Growth into Growth In order to be effective, the five sources of growth must be mixed in the right proportions.

Turning the Sources of Growth 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.

The Production Function and 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.

The Production Function and 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)

Describing Production Functions 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.

Describing Production Functions Constant returns to scale means that output will rise by the same proportionate increase in all inputs.

Describing Production Functions Increasing returns to scale occurs when output rises by a greater proportionate increase as all inputs.

Describing Production Functions Decreasing returns to scale occurs when output rises by a smaller proportionate increase as all inputs.

Describing Production Functions Diminishing marginal productivity describes what happens when more of one input is added without increasing any other inputs.

Describing Production Functions The law of diminishing marginal productivity states that increasing one output, keeping all others constant, will lead to smaller and smaller gains in output.

The Classical Growth Model 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.

The Classical Growth Model Classical economists focused their analysis and their policy advice, on how to increase investment: savings Þ investment Þ increases in capital Þ growth

Focus on Diminishing Marginal Productivity of Labor 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.

Focus on Diminishing Marginal Productivity of Labor 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.

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

Diminishing Returns and Population Growth Output Labor Subsistence level of output per worker Production function Q1 Q2 L1 L*

Diminishing Marginal Productivity 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.

Diminishing Marginal Productivity of Capital The focus then turned to the diminishing marginal productivity of capital, not labor: capital grows faster than labor Þ capital is less productive Þ slower economic output Þ per capita growth stagnates Þ per capita income stops rising

Diminishing Marginal Productivity 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.

Diminishing Marginal Productivity of Capital Eventually per capita incomes among nations would converge. This has not happened either: The ambiguity in the definition of inputs. Technological progress.

Ambiguities in the Definition of the Factors of 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.

Ambiguities in the Definition of the Factors of 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.

Ambiguities in the Definition of the Factors of Production Increases in human capital have allowed labor to keep pace with capital. This allows economies to avoid the diminishing productivity of capita.

Ambiguities in the Definition of the Factors of Production If skills are increasing faster in a rich country than in a poor one, incomes would not be expected to converge.

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

Empirical Estimates of Factor Contribution to Growth Economist Edward Denison estimated the importance of each of the sources of growth.

Sources of Real U.S. GDP Growth, 1928-2000 Physical capital (19%) Human capital (13%) Labor (33%) Technology (35%)

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

Technology Technology is the result of investment in creating technology (research and development). Investment in technology increases the technological stock of an economy.

Technology Growth theory separates investment in capital and investment in technology. Increases in technology are not as directly linked to investment as is capital.

Technology Increases in technology often have enormous positive spillover effects. Technological advances in one sector of the economy lead to advances in completely different sectors.

Technology Technological advances have positive externalities. Positive externalities – positive effects on others not taken into account by the decision maker.

Technology 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.

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

Learning by Doing New growth theory also highlights learning by doing. Learning by doing – improving the methods of production through experience.

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

Increasing Returns to Scale Output All inputs Production function with increasing returns

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

Technological 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.

Technological 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.

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

Economic Policies to Encourage Per Capita Growth 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.

Policies to Encourage Saving 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.

Policies to Encourage Saving 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.

A Case Study: Micro Credit 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.

A Case Study: Micro Credit 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.

Growth Through Foreign Investment 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.

Policies to Control Population Growth Developing nations whose populations are rapidly growing have difficulty providing enough capital and education for everyone. Thus, per capita income is low.

Policies to Control Population 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.

Policies to Control Population 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.

Policies to Increase the Level of Education Increasing the educational level and skills of the workforce increases labor productivity.

Policies to Create Institutions That Encourage Technological Innovation Unlike capital, technological innovation can occur without investment. Conversely, investment in technology can result in no technological innovation.

Create Patents and Protect 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.

Create Patents and Protect 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.

Patents and Developing Countries 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.

The Corporation and Financial 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.

The Corporation and Financial Institutions Well-developed financial institutions such as stock markets create liquidity and encourage investment.

Provide Funding for Basic 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.

Policies to Increase Openness 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.

Growth, Productivity, and the Wealth Of Nations End of Chapter 24