© 2003 McGraw-Hill Ryerson Limited. Growth, Productivity, and the Wealth Of Nations Chapter 8

8 - 2 © 2003 McGraw-Hill Ryerson Limited. 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

8 - 3 © 2003 McGraw-Hill Ryerson Limited. Growth and the Economy’s Potential u Growth is an increase in the amount of goods and services an economy produces. u The study of growth is the study of why that increase comes about assuming that both labour and capital are fully employed.

8 - 4 © 2003 McGraw-Hill Ryerson Limited. Growth and the Economy’s Potential u Growth is an increase in potential output. u When an economy is at its potential output, it is operating on its production possibility curve.

8 - 5 © 2003 McGraw-Hill Ryerson Limited. Growth and the Economy’s Potential u Long-run growth focuses on supply; it assumes Say’s Law – demand is sufficient to buy whatever is supplied.

8 - 6 © 2003 McGraw-Hill Ryerson Limited. Growth and the Economy’s Potential u In the short run, economists consider potential output fixed. u They focus on how to get the economy operating at its potential if, for some reason, it is not.

8 - 7 © 2003 McGraw-Hill Ryerson Limited. Importance of Growth for Living Standards u Growth is important for living standards. u Long-term growth rates matter a lot because of compounding. u This means that growth is based not only on original levels of income in a country, but also on the accumulation of previous years’ increases in income.

8 - 8 © 2003 McGraw-Hill Ryerson Limited. Importance of Growth for Living Standards u According to the rule of 72, dividing 72 by the rate of growth will give the number of years in which income will double.

8 - 9 © 2003 McGraw-Hill Ryerson Limited. Markets, Specialization, and Growth u Markets and specialization lead to growth. u Economic growth began when markets developed (early 1800s), and as they expanded, growth accelerated.

© 2003 McGraw-Hill Ryerson Limited. Markets, Specialization, and Growth u Markets increase productivity through specialization and the division of labour. l Specialization – the concentration of individuals on certain aspects of production l Division of labour – the splitting up of a task to allow for specialization of production. l Productivity – output per unit of input.

© 2003 McGraw-Hill Ryerson Limited. Markets, Specialization, and Growth u With increasing specialization and division of labour comes increasing productivity which creates a higher standard of living.

© 2003 McGraw-Hill Ryerson Limited. Markets, Specialization, and Growth u This argument is reinforced by the principle of comparative advantage. l Production possibilities rise when people concentrate on producing those goods for which their skills and other resources are suited, and trade for those goods for which they do not have a comparative advantage.

© 2003 McGraw-Hill Ryerson Limited. Economic Growth, Distribution, and Markets u Markets are often seen to be unfair because of the effect they may have on the distribution of income. u Markets may not provide equality of income but they do make the poor better off.

© 2003 McGraw-Hill Ryerson Limited. Economic Growth, Distribution, and Markets u Would the poor be better off without markets? u Historically, judged from an absolute standard, there is strong evidence that the poor benefit enormously from the growth that markets foster.

© 2003 McGraw-Hill Ryerson Limited. Economic Growth, Distribution, and Markets u Judged from a relative standard, it is not at all clear that markets require the large differentials in pay that has accompanied growth in market economies.

© 2003 McGraw-Hill Ryerson Limited. Per Capita Growth u Per capita output is total output divided by total population. u Per capita growth means producing more goods and services per person.

© 2003 McGraw-Hill Ryerson Limited. Per Capita Growth u Per capita growth equals the percent change in output minus the percent change in population

© 2003 McGraw-Hill Ryerson Limited. Per Capita Growth u The problem in many developing nations is that although GDP is rising, the population is rising even faster resulting in a lower per capita growth rate.

© 2003 McGraw-Hill Ryerson Limited. Per Capita Growth u Some economists have argued that per capita (mean) output is not what we should be focusing on. u Instead we should focus on median income.

© 2003 McGraw-Hill Ryerson Limited. Per Capita Growth u Median income is a better measure because it takes into account how income is distributed.

© 2003 McGraw-Hill Ryerson Limited. Per Capita Growth u If the growth in income goes to a small majority of individuals who receive the majority of income, the mean will rise but the median will not.

© 2003 McGraw-Hill Ryerson Limited. Per Capita Growth u Unfortunately, statistics on median income is generally not collected so economists use per capita income.

© 2003 McGraw-Hill Ryerson Limited. The Sources of Growth u Economists identify five important sources of growth: l Capital accumulation – investment in productive capacity. l Available resources. l Growth-compatible institutions. l Technological development. l Entrepreneurship.

© 2003 McGraw-Hill Ryerson Limited. Investment and Accumulated Capital u Years ago it was thought that physical capital and investment were the keys to growth. u The flow of investment lead to the growth of the stock of capital.

© 2003 McGraw-Hill Ryerson Limited. Investment and Accumulated Capital u Capital accumulation does not necessarily lead to growth. u Take the former Soviet Union, for example. They invested a lot, but did not grow much.

© 2003 McGraw-Hill Ryerson Limited. Investment and Accumulated Capital u Products change, and useful buildings and machines in one time period may be useless in another.

© 2003 McGraw-Hill Ryerson Limited. Investment and Accumulated Capital u Capital is much more than machines – it includes human and social capital. l Human capital – the skills that are embodied in workers through experience, education, on-the-job training, and: l Social capital – the habitual way of doing things that guides people in how they approach production.

© 2003 McGraw-Hill Ryerson Limited. Investment and Accumulated Capital u All economists agree that the right kind of investment at the right time is a central element of growth.

© 2003 McGraw-Hill Ryerson Limited. Available Resources u For an economy to grow it will need resources. u What constitutes a resource at one time may not be a resource at another time.

© 2003 McGraw-Hill Ryerson Limited. Available Resources u Technology plays an enormous role here. u Greater participation in the market is another way by which available resources are increased.

© 2003 McGraw-Hill Ryerson Limited. Growth Compatible Institutions u Growth-compatible institutions have built-in incentives that lead people to put forth effort and discourage loafing. u When individuals get much of the gains of growth themselves, they work harder.

© 2003 McGraw-Hill Ryerson Limited. Growth Compatible Institutions u Markets that feature private ownership of property foster economic growth. u Mercantilist economies that feature bribes inhibit economic growth.

© 2003 McGraw-Hill Ryerson Limited. Technological Development u A larger aspect of growth involves changes in technology – changes in the goods and services we buy, and the way we create goods and services.

© 2003 McGraw-Hill Ryerson Limited. Technological Development u Technological change does more than cause economic growth, it changes the entire social and political dimensions of society. u As in other things, there are tradeoffs when new technology is introduced.

© 2003 McGraw-Hill Ryerson Limited. Entrepreneurship u Entrepreneurship is the ability to get things done. u That ability involves creativity, vision, and a talent for translating that vision into reality.

© 2003 McGraw-Hill Ryerson Limited. Turning the Sources of Growth into Growth u In order to be effective, the five sources of growth must be mixed in the right proportions. u It is the combination of investing in machines, people, and technological change that plays a central role in the growth of any economy.

© 2003 McGraw-Hill Ryerson Limited. The Production Function and Theories of Growth u Economists’ theories of growth have emphasized the production function. l Production function –shows the relationship between the quantity of inputs used in production and the quantity of output resulting from production.

© 2003 McGraw-Hill Ryerson Limited. The Production Function and Theories of Growth u This production function has land, labour, and capital as factors of production, and an adjustment factor, “A”, to capture the effect of technology: Output = A f(Labour, Capital, Land)

© 2003 McGraw-Hill Ryerson Limited. The Production Function and Theories of Growth u In talking about production functions, economists use a couple of terms: scale economies and diminishing marginal productivity.

© 2003 McGraw-Hill Ryerson Limited. The Production Function and Theories of Growth u Scale economies describe what happens when all inputs increase equally. u Constant returns to scale means that output will rise by the same proportionate increase as all inputs.

© 2003 McGraw-Hill Ryerson Limited. The Production Function and Theories of Growth u Increasing returns to scale occur if output rises by a greater proportionate increase than all inputs. u Decreasing returns to scale occur if output rises by a smaller proportionate increase than all inputs.

© 2003 McGraw-Hill Ryerson Limited. The Production Function and Theories of Growth u Diminishing marginal productivity describes what happens when more of one input is added without increasing any other inputs.

© 2003 McGraw-Hill Ryerson Limited. The Production Function and Theories of Growth u The law of diminishing marginal productivity states that increasing one input, keeping all others constant, will lead to smaller and smaller gains in output.

© 2003 McGraw-Hill Ryerson Limited. The Classical Growth Model u The Classical growth model is the standard theory of growth. u The Classical growth model focuses on capital accumulation.

© 2003 McGraw-Hill Ryerson Limited. The Classical Growth Model u Since investment leads to the increase in capital, Classical economists focused their analysis and their policy advice, on how to increase investment.

© 2003 McGraw-Hill Ryerson Limited. The Classical Growth Model u The linkage was as follows: savings  investment  increases in capital  growth

© 2003 McGraw-Hill Ryerson Limited. Diminishing Marginal Productivity of Labour u The Classical growth model focuses on diminishing marginal productivity of labour.

© 2003 McGraw-Hill Ryerson Limited. Diminishing Marginal Productivity of Labour u When farming was the major activity in the economy, Thomas Malthus, an early economist, emphasized the limitation land placed on growth.

© 2003 McGraw-Hill Ryerson Limited. Diminishing Marginal Productivity of Labour u Since land was fixed, he predicted that diminishing marginal productivity would set in as population grew.

© 2003 McGraw-Hill Ryerson Limited. Diminishing Marginal Productivity of Labor u The linkage was: economic surplus  population increases  output increases  lower per capita income  too many people  starvation

© 2003 McGraw-Hill Ryerson Limited. Diminishing Returns and Population Growth, Fig. 8-2, p 197 Output Labour Subsistence level of output per worker Production function Q1Q1 Q2Q2 L1L1 L*

© 2003 McGraw-Hill Ryerson Limited. Diminishing Marginal Productivity of Labor u This belief is called the iron law of wages u Combined with diminished marginal productivity it led to the belief that in the long run there would be no surplus and therefore no growth. u The long run was called the stationary state.

© 2003 McGraw-Hill Ryerson Limited. Diminishing Marginal Productivity of Capital u The Classical economists’ predictions were wrong. u Increases in technology and capital overwhelmed the law of diminishing marginal productivity. u The focus turned to the marginal productivity of capital, not labour.

© 2003 McGraw-Hill Ryerson Limited. Diminishing Marginal Productivity of Capital u The linkage was: capital grows faster than labour  capital is less productive  slower economic output  per capita growth stagnates  per capita income stops rising

© 2003 McGraw-Hill Ryerson Limited. Diminishing Marginal Productivity of Capital u The Classical growth model also predicted that diminishing marginal productivity would be stronger for richer nations than for poorer ones.

© 2003 McGraw-Hill Ryerson Limited. Diminishing Marginal Productivity of Capital u Poor countries with little capital should grow faster than countries with lots of capital. u Eventually per capita incomes among nations would converge.

© 2003 McGraw-Hill Ryerson Limited. Diminishing Marginal Productivity of Capital u This prediction was not true either, owing to the ambiguity in the definition of inputs and/or technological progress.

© 2003 McGraw-Hill Ryerson Limited. Ambiguities in the Definition of the Factors of Production u The definition of the factors of production are ambiguous. u It would seem that the definition of labour would be straightforward – the hours of work that go into production.

© 2003 McGraw-Hill Ryerson Limited. Ambiguities in the Definition of the Factors of Production u But what of the difference between educated workers and workers who are less educated? u To answer this, economists separate labour into two components.

© 2003 McGraw-Hill Ryerson Limited. Ambiguities in the Definition of the Factors of Production u Standard labour – the actual number of hours worked. u Human capital – the skills embedded in workers through experience, education, and on-the-job training.

© 2003 McGraw-Hill Ryerson Limited. Ambiguities in the Definition of the Factors of Production u Increases in human capital have allowed labour to keep pace with capital. u This allows economies to avoid the diminishing productivity of capital.

© 2003 McGraw-Hill Ryerson Limited. Ambiguities in the Definition of the Factors of Production u If skills are increasing faster in a rich country than in a poor one, incomes would not converge.

© 2003 McGraw-Hill Ryerson Limited. Technology u Technology overwhelms diminishing marginal productivity so that growth rates can increase over time. u Technology is growing faster in rich countries than in poor countries.

© 2003 McGraw-Hill Ryerson Limited. Sources of Real GDP Growth, , Fig. 8-3, p 199 Human capital (13%)Physical capital (19%) Technology (35%)Labor (33%)

© 2003 McGraw-Hill Ryerson Limited. New Growth Theory u New growth theory emphasizes the role of technology rather than capital in the growth process.

© 2003 McGraw-Hill Ryerson Limited. Technology u Technology is the result of investment in creating technology (research and development). u Investment in technology increases the technological stock of an economy.

© 2003 McGraw-Hill Ryerson Limited. Technology u Growth theory separates investment in capital and investment in technology. u Increases in technology are not as directly linked to investment as is capital.

© 2003 McGraw-Hill Ryerson Limited. Technology u Increases in technology often have enormous positive spillover effects. u Technological advances in one sector of the economy lead to advances in completely different sectors.

© 2003 McGraw-Hill Ryerson Limited. Technology u Technological advances have positive externalities – positive effects on others not taken into account by the decision maker.

© 2003 McGraw-Hill Ryerson Limited. Technology u Some basic research is protected by 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.

© 2003 McGraw-Hill Ryerson Limited. Technology u Once people have seen the new technology, they figure out sufficiently different ways to achieving the same end to avoid the patent.

© 2003 McGraw-Hill Ryerson Limited. Learning by Doing u Learning by doing also leads to growth. u New growth theory also highlights learning by doing – improving the methods of production through experience.

© 2003 McGraw-Hill Ryerson Limited. Learning by Doing u If positive externalities flowing from learning by doing and new technologies overwhelm diminishing marginal productivity, economics can be called the “optimistic science,” not the “dismal science.”

© 2003 McGraw-Hill Ryerson Limited. Increasing Returns to Scale, Fig. 8-4, p 201 Output All inputs Production function with increasing returns

© 2003 McGraw-Hill Ryerson Limited. Technological Lock-In u Technological lock-in is an example of how sometimes the economy does not use the best technology available.

© 2003 McGraw-Hill Ryerson Limited. Technological Lock-In u Technological lock-in occurs when old technologies become entrenched in the market, or locked into new products despite the fact that more efficient technologies are available. l The best example is the QWERTY keyboard.

© 2003 McGraw-Hill Ryerson Limited. Technological Lock-In u One reason for technological lock-in is network externalities. u Network externalities – an externality in which the use of a good by one individual makes that technology more valuable to other people.

© 2003 McGraw-Hill Ryerson Limited. Technological Lock-In u Switching from a technology exhibiting network externalities to a superior technology is expensive and sometimes nearly impossible. l The Windows operating system exhibits network externalities.

© 2003 McGraw-Hill Ryerson Limited. Economic Policies to Encourage Per Capita Growth u Policies to encourage saving and investment. u Policies to control population growth. u Policies to increase the level of education.

© 2003 McGraw-Hill Ryerson Limited. Economic Policies to Encourage Per Capita Growth u Policies to increase the level of education u Policies to create institutions that encourage technological innovation. u Policies to provide funding for basic research. u Policies to increase the economy’s openness to trade.

© 2003 McGraw-Hill Ryerson Limited. Policies to Encourage Saving and Investment u Modern growth theories have downplayed the importance of capital in the growth process. l All agree that it is important, however. l Policy makers are eager to encourage both saving and investment.

© 2003 McGraw-Hill Ryerson Limited. Policies to Encourage Saving and Investment u Canada has used tax incentives to increase saving. u These include retirement savings plans (RSPs) that allow individuals to save without incurring taxes on contributions until they are withdrawn.

© 2003 McGraw-Hill Ryerson Limited. Policies to Encourage Saving and Investment u Some economists have proposed switching from an income tax to a consumption tax. u By taxing individuals only when they consume, all saving is exempt from taxation.

© 2003 McGraw-Hill Ryerson Limited. Policies to Encourage Saving and Investment u It is difficult for poor countries to generate saving and investment. u The poor have subsistence income while the rich in those countries place their savings abroad for fear of confiscation by government.

© 2003 McGraw-Hill Ryerson Limited. The Borrowing Circle u The borrowing circle of Grameen bank is an example of how to increase investment in a developing nation. l The traditional way of lending money is to ask for collateral. l In Bangladesh, potential borrowers had no collateral.

© 2003 McGraw-Hill Ryerson Limited. The Borrowing Circle u The bank officer replaced collateral with the borrowing circle concept. l Borrowing circle concept – a credit system that replaces traditional collateral with guarantees by friends of the borrower. l In case of a default, the friends had to make the loan good.

© 2003 McGraw-Hill Ryerson Limited. Growth Through Foreign Investment u Foreign investment provides another source of saving. l Developing nations can borrow from the IMF, the World Bank, or from private sources. l None of these are perfect solutions since they come with large strings attached.

© 2003 McGraw-Hill Ryerson Limited. Policies to Control Population Growth u Developing nations whose populations are rapidly growing have difficulty providing enough capital and education for everyone. u Thus, per capita income is low.

© 2003 McGraw-Hill Ryerson Limited. Policies to Control Population Growth u Policies that reduce population growth include: l Free family–planning services. l Increasing the availability of contraceptives. l Harsh mandatory one-child-per-family policies such as China adopted in 1980.

© 2003 McGraw-Hill Ryerson Limited. Policies to Control Population Growth u Some economists argue that to reduce population growth, a nation must grow first. l As income and work opportunities, especially for women, rise, the opportunity cost of having children rises and families will choose to have fewer children.

© 2003 McGraw-Hill Ryerson Limited. Policies to Increase the Level of Education u In developing nations, the return on investments in education is much higher than in developed nations.

© 2003 McGraw-Hill Ryerson Limited. Policies to Increase the Level of Education u In Canada, it is estimated that an additional year of school increases a worker’s wages by an average of 10 percent. u An additional year of school in developing nations will increase income by percent.

© 2003 McGraw-Hill Ryerson Limited. Policies to Increase the Level of Education u Technical training in improved farming methods or construction is more important than higher education.

© 2003 McGraw-Hill Ryerson Limited. Policies to Create Institutions That Encourage Technological Innovation u While all agree that that technology is important, no one is sure what the best technological growth policies are. u Not only is research uncertain, so is its application.

© 2003 McGraw-Hill Ryerson Limited. Create Patents and Protect Property Rights u Creating patents and protecting property rights are two ways to encourage innovation. u However: l Patents are not costless to society. l Patents allow innovators to charge high prices for their use.

© 2003 McGraw-Hill Ryerson Limited. Patents and Developing Countries u Should poor nations accept patent laws? l Societies must find a middle ground between giving individuals appropriate incentives to create new technologies and allowing everyone to take advantage of the benefits of technology.

© 2003 McGraw-Hill Ryerson Limited. The Corporation and Financial Institutions u The corporation and financial institutions encourage innovation.

© 2003 McGraw-Hill Ryerson Limited. The Corporation and Financial Institutions u The corporation was invented to limit liability to its owners. u Corporations bring technological innovations to markets.

© 2003 McGraw-Hill Ryerson Limited. The Corporation and Financial Institutions u Well-developed financial institutions such as stock markets create liquidity and encourage investment.

© 2003 McGraw-Hill Ryerson Limited. Policies to Provide Funding for Basic Research u Individual firms have little incentive to do basic research because of technology’s “common knowledge” aspect. u This is where the government steps in.

© 2003 McGraw-Hill Ryerson Limited. Policies to Provide Funding for Basic Research u The Canadian government provides the lion’s share of the basic research in the country. u Much of the funding is channeled through universities.

© 2003 McGraw-Hill Ryerson Limited. Policies to Increase Openness to Trade u In order to specialize, you need a large market. u Large markets allow firms to take advantage of economies of scale.

© 2003 McGraw-Hill Ryerson Limited. Policies to Increase Openness to Trade u The effect of markets on growth is an important reason why economists support policies that keep domestic markets as regulation free as possible and support international trade.

© 2003 McGraw-Hill Ryerson Limited. Growth, Productivity, and the Wealth Of Nations End of Chapter 8