Chapter 8 Economic Growth

-- measured by % change in real GDP -- common measurement is real GDP per capita (known as the avg standard of living) Real GDP per capita = Real GDP Population -- Economic growth occurs when real GDP per capita is increasing  increase in avg standard of living Growth Rates in real GDP per capita are determined by one of two methods: 1) % ∆ Real GDP Per Capita -- traditional % ∆ formula that is computed for relatively short time frames

Example: If in 1996, real GDP per capita = $31,403 in 2000, real GDP per capita = $34,788 % ∆ Real GDP/Capita = ($34,788 - $31,403) $31,403 = 10.8% 2) Avg Annual Growth Rate (Compound Avg Growth Rate) -- used primarily for longer time frames

Example: If in 1954, real GDP per capita = $10,300 in 2000, real GDP per capita = $34,788 Interpretation:

Factors Causing Economic Growth 1)Increase in employment or # of population working 2)Increase in labor productivity labor productivity: quantity of goods and services that can be produced per worker Note: Labor productivity is more commonly measured as output per hr worked vs. per worker to smooth out fluctuations in work days and # employees. x=

Labor Productivity is influenced by: 1)Amount of Human Capital -- knowledge, skills, education, experience and other qualities of work force -- influx of human capital provides the foundation for rapid economic growth or increase in labor productivity -- By itself, it may not be strong enough to positively influence labor productivity 2)Physical Capital -- Increase or accumulation of capital stock (machines, equipment, factories, etc used to produce other goods and services) normally leads to increased labor productivity -- coupled with Human Capital, the existence of ample physical capital can lead to high levels of labor productivity

Per-Worker Production Function -- Relationship between real GDP per hour worked and capital per hr worked, with technology held constant. -- used to illustrate increase in labor productivity (drives economic growth) due to increase in capital -- as capital stock per hr worked increases, labor productivity increases (i.e. adding additional machines can generate more output per hr worked).

Let K = Capital; L = Labor and; Y = Real GDP Impact of Increase in Capital -- ↑ in quantity of capital per hr worked increases quantity of output each worker produces, but at a diminishing rate A to B  ∆ Capital per hr worked is $10,000 ∆ Output per hr worked is $50 B to C  ∆ Capital per hr worked is $10,000 ∆ Output per hr worked is $40

Observation: Equal incremental changes in capital per hr worked results in smaller changes in output per hr worked. causes the marginal product of the variable input to decline -- reflects the law of diminishing returns  adding more of a variable input (capital) to a fixed amount of another input (labor), causes the marginal product of the variable input to decline -- eventually marginal real GDP per hr worked is nearly $0

3) Technological Change -- technology is defined as the quantity of output firms can produce with a given quantity of inputs -- ability to develop and apply new technology and production methods with goal of increasing productivity is the essence of technological change -- most powerful agent for economic change -- shifts the production function upward (given the same amount of capital per hr worked, real GDP per hr worked increases) -- major factor is the level of R & D spending by firms

2) Impact of Technological Change -- shifts the production function upward (assume positive change) -- given the same amount of capital per hr worked, real GDP per hr worked increases

Observation: -- Increase in technology shifts the production function from Production Function 1 to Production Function 2 and further technological changes pushes it up to Production Function 3 -- Since each production function reaches diminishing returns to capital, to maintain increase in avg standard of living, there must be technological change.

4) Land and Other Natural Resources -- includes land, energy and raw materials -- ability to buy or harness domestically increases productivity -- productivity is magnified as quality improves 5)Entrepreneurship and Management Entrepreneurship: individuals involved in new business ventures -- level or number of entrepreneurs depends on the existence and amount of incentives for risk involved -- must create an environment that promotes activity through a balance of risks and rewards

Management -- Day-to-day operations are run by managers and their philosophies, actions and direction has the ability to increase labor productivity. -- Japan, for instance, has been instrumental in adopting effective production management styles that both motivates employees and is productively efficient (i.e. “The Toyota Way”) -- also includes the organization of a production system such that operations are run in the most efficient manner. Eg.) work stations and parts are organized in the most strategic places to promote efficiency (in Toyota’s terms eliminating “muda” or waste) -- Actions can make a very direct effect on productivity and within a short time frame

6) Political and Legal Environment -- Gov’t role in creating an environment that promotes increased productivity 1) Enforce Property Rights and Rule of Law Rule of Law -- ability of a Gov’t to enforce laws relating to private property and contracts -- properties are protected and can not be arbitrarily seized -- clearly defined rules for determining who owns the resources and how they are used helps to create a stable climate for production 2)Political Stability -- leads to increased productivity through sustained confidence of investors in the political environment where they are conducting business -- less likely to invest money or resources in a country that has ongoing political issues

Promoting Economic Growth 1)High Standards of Health and Education -- old cliché holds true…healthy individuals are more productive individuals -- highly educated and skilled workers promote technological change -- rising incomes from economic growth can limit the amount of “brain drain” (highly educated people leaving one country for another which holds greater opportunity) -- free public education and Gov’t subsidies for higher education

2)Technology Policies i) Countries relaxing restrictions to FDI (Foreign Direct Investment) -- allowing foreign firms to build factories or to buy domestic firms -- gain access to technology that can be used for domestic-owned industries ii) Subsidization of R & D / Increased R & D a) Increased Gov’t funds to universities and tax incentives to private research labs b) Enhance patent protection Patents are exclusive rights to a new product for 20 yrs from date patent is approved c) Gov’t expansion of own R & D spending d) Implement any Gov’t policy that stimulates investment spending

3)Policies Leading to Increased Saving and Investment Techniques aimed at household saving -- household savings are used to supply funds to firms for investment 1) Behavioral change in savings due to security of employment, anticipation of early retirement, increased in life expectancy, etc 2) Gov’t decrease in Capital Gains Tax -- Capital Gains Tax is a tax on profits earned when a financial asset is sold at more than the acquisition price -- stocks and bonds become more rewarding to own 3) Convert U.S. Income Tax to Consumption tax -- deduct your savings from your income so only income spent is taxed (tax on part of income spent)

Techniques aimed at Firms -- targets increase in planned investment spending 1) Reduce Corporate Profits Tax -- allows corporations to retain more profits to make further investments 2) Introduce Investment Credits -- reduction in taxes for firms that invest in certain types of capital

Economic Growth in U.S. and Abroad

Real GDP per Capita, (in 2000 US Dollars)

Growth of Real GDP per Capita, Country Annual % Change 1870 – 2003 Annual % Change 1950 – 2003 Annual % Change US1.9%2.1%1.8% UK Germany Japan Brazil China Ghana

Real GDP per Capita, Country US $2,936$6,366$11,484$22,567$34,875 UK 3,8996,0148,48116,09326,046 Germany 2,4202,8005,10618,41125,188 Japan 8351,5712,17614,91224,037 Brazil ,1656,3367,205 China ,0764,970 Ghana ,1871,2811,440

Using Compound Interest Rates to Demonstrate Magnitude of Long-Term Growth In 1870, Brazil's GDP per capita was twice Ghana'sIn 1870, Brazil's GDP per capita was twice Ghana's –By 2003, the multiple increased to 5 times –Brazil's growth over the period was 1.6% and Ghana's was 0.9% Compound interest pays interest on the original deposit and all previously accumulated interestCompound interest pays interest on the original deposit and all previously accumulated interest -- payment of interest on initial deposit and all previous interest (cumulative) -- Interest paid in year 1 earns interest in year 2 Initial Deposit x (1+interest) Eg) $50 deposited at 4% interest in 1800 is $ in 2005 $50 x (1.04) 205 = $155,169 $50 x (1.04) 205 = $155,169 # yrs

Small differences in annual growth rates add up over time GDP per capita is about $400 now. In 50 years, it would grow to about: _________ if the growth rate were 1%. _________ if the growth rate were 3%. _________ if the growth rate were 5%.

The Rule of 70 The Rule of 70 is useful for financial as well as demographic analysis. It states that to find the doubling time of a quantity growing at a given annual percentage rate, divide the percentage number into 70 to obtain the approximate number of years required to double. For example, at a 10% annual growth rate, doubling time is 70 / 10 = 7 years. Similarly, to get the annual growth rate, divide 70 by the doubling time. For example, 70 / 14 years doubling time = 5, or a 5% annual growth rate. The following table shows some common doubling times:

Globalization Has Opened the Doors to Economic Growth -- Process of countries becoming more open to foreign trade and investment  FDI (Foreign Direct Investment): allowing foreign firms to build factories or to buy domestic firms -- lead many countries to experience economic growth or achieving increases in real GDP per capita