Macro233 - JAFGAC Growth, Productivity, and the Wealth Of Nations Chapter 8

Macro233 - JAFGAC 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

Macro233 - JAFGAC General Observations about Growth n Growth increases the economy’s potential output.

Macro233 - JAFGAC Growth and the Economy’s Potential n Growth is an increase in the amount of goods and services an economy produces. n Growth is an increase in potential output.

Macro233 - JAFGAC Growth and the Economy’s Potential n Potential output – the highest amount of output an economy can produce from the existing production function and existing resources. n When an economy is at its potential output, it is operating on its production possibility curve.

Macro233 - JAFGAC Growth and the Economy’s Potential n Long-run growth focuses on supply. n It assumes Say’s Law – supply creates its own demand.

Macro233 - JAFGAC Growth and the Economy’s Potential n In the short run, economists consider potential output fixed. n They focus on how to get the economy operating at its potential if it is not.

Macro233 - JAFGAC Importance of Growth for Living Standards n Growth improves living standards. n It makes more goods available to more people. n Because of compounding, long-term growth rates matter a lot.

Macro233 - JAFGAC Importance of Growth for Living Standards n The Rule of 72 is used to determine how long it takes for income to double at different growth rates. n 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.

Macro233 - JAFGAC Markets, Specialization, and Growth n Markets, specialization and the division of labor increase productivity and growth. l Specialization – the concentration of individuals on certain aspects of production l Division of labor – the splitting up of a task to allow for specialization of production.

Macro233 - JAFGAC Economic Growth, Distribution, and Markets n Markets are often seen to be unfair because of the effect they have on the distribution of income.

Macro233 - JAFGAC Economic Growth, Distribution, and Markets n Markets may not provide equality of income but they make the poor better off. n There is strong evidence that the poor benefit enormously from the growth that markets foster.

Macro233 - JAFGAC Economic Growth, Distribution, and Markets n Just because the poor benefit from growth does not mean they might not be better off if income were distributed more in their favor.

Macro233 - JAFGAC Cost of Goods in Hours of Work Price in minutes of work 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)

Macro233 - JAFGAC Per Capita Growth n Per capita output is total output divided by total population. n Per capita growth means producing more goods and services per person.

Macro233 - JAFGAC Per Capita Growth n Per capita growth equals the percent change in output minus the percent change in population Per capita growth = % change in output - % change in population

Macro233 - JAFGAC Per Capita Growth n In many developing nations, the population is rising faster than GDP, resulting in a lower per capita growth rate.

Macro233 - JAFGAC Per Capita Growth n Some economists have argued that per capita (mean) output is not what we should be focusing on. n We should focus on median income instead.

Macro233 - JAFGAC Per Capita Growth n Median income is a better measure because it takes into account how income is distributed.

Macro233 - JAFGAC Per Capita Growth n If the growth in income goes mostly to a small minority of individuals, the mean will rise but the median will not. n Because statistics on median income is generally not collected, economists use per capita income.

Macro233 - JAFGAC The Sources of Growth n 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.

Macro233 - JAFGAC Investment and Accumulated Capital n Years ago it was thought that physical capital and investment were the keys to growth. n The flow of investment lead to the growth of the stock of capital.

Macro233 - JAFGAC Investment and Accumulated Capital n Capital accumulation does not necessarily lead to growth. n Products change, and useful buildings and machines in one time period may be useless in another.

Macro233 - JAFGAC Investment and Accumulated Capital n 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. l Social capital – the habitual way of doing things that guides people in how they approach production.

Macro233 - JAFGAC Investment and Accumulated Capital n All economists agree that the right kind of investment at the right time is a central element of growth.

Macro233 - JAFGAC Available Resources n For an economy to grow it will need resources. n What constitutes a resource at one time may not be a resource at another time.

Macro233 - JAFGAC Available Resources n Technology plays an enormous role here. n Greater participation in the market is another way by which available resources are increased.

Macro233 - JAFGAC Growth-Compatible Institutions n Markets and private ownership of property foster economic growth. n When individuals get much of the gains of growth themselves, they work harder.

Macro233 - JAFGAC Growth-Compatible Institutions n Another growth-compatible institution is the corporation. n Because of limited liability, corporations give owners and incentive to invest their savings in large enterprises.

Macro233 - JAFGAC Growth-Compatible Institutions n Mercantilist economic policies inhibit economic growth.

Macro233 - JAFGAC Technological Development n Growth isn’t just getting more of the same thing. n It’s also getting some things that are different.

Macro233 - JAFGAC Technological Development n Growth involves changes in technology. n Technology – changes the way we make goods and supply services, and in the goods and services we buy.

Macro233 - JAFGAC Entrepreneurship n Entrepreneurship is the ability to get things done. n That ability involves creativity, vision, and a talent for translating that vision into reality.

Macro233 - JAFGAC Turning the Sources of Growth into Growth n In order to be effective, the five sources of growth must be mixed in the right proportions.

Macro233 - JAFGAC Turning the Sources of Growth into Growth n It is the combination of investing in machines, people, and technological change that plays a central role in the growth of any economy.

Macro233 - JAFGAC The Production Function and Theories of Growth n The production function shows the relationship between the quantity of inputs used in production and the quantity of output resulting from production.

Macro233 - JAFGAC The Production Function and Theories of Growth n The production function for growth has land, labor, and capital as factors of production. n “A” is an adjustment factor that captures the effect of technology. Output = A f (Labor, Capital, Land)

Macro233 - JAFGAC Describing Production Functions n Scale economies describe what happens in a production function when all inputs increase equally. l Constant returns to scale. l Increasing returns to scale. l Decreasing returns to scale.

Macro233 - JAFGAC Describing Production Functions n Constant returns to scale means that output will rise by the same proportionate increase in all inputs.

Macro233 - JAFGAC Describing Production Functions n Increasing returns to scale occurs when output rises by a greater proportionate increase as all inputs.

Macro233 - JAFGAC Describing Production Functions n Decreasing returns to scale occurs when output rises by a smaller proportionate increase as all inputs.

Macro233 - JAFGAC Describing Production Functions n Diminishing marginal productivity describes what happens when more of one input is added without increasing any other inputs.

Macro233 - JAFGAC Describing Production Functions n The law of diminishing marginal productivity states that increasing one output, keeping all others constant, will lead to smaller and smaller gains in output.

Macro233 - JAFGAC The Classical Growth Model n The Classical growth model focuses on capital accumulation in the growth process. n The more capital an economy has, the faster it will grow. n Because of this emphasis on capital, market economies are called capitalist economies.

Macro233 - JAFGAC The Classical Growth Model n Classical economists focused their analysis and their policy advice, on how to increase investment: savings  investment  increases in capital  growth

Macro233 - JAFGAC Focus on Diminishing Marginal Productivity of Labor n The Classical growth model focused on how diminishing marginal productivity of labor placed limitations on growth. n Farming was the major economic activity and land was relatively fixed.

Macro233 - JAFGAC Focus on Diminishing Marginal Productivity of Labor n Since land was fixed, diminishing marginal productivity would set in as population grew. n As output per person declines, at some point available output is no longer sufficient to feed the population.

Macro233 - JAFGAC Focus on Diminishing Marginal Productivity of Labor n This belief is called the iron law of wages. n The long run was called the stationary state.

Macro233 - JAFGAC Diminishing Returns and Population Growth Output Labor Subsistence level of output per worker Production function Q1Q1 Q2Q2 L1L1 L*

Macro233 - JAFGAC Diminishing Marginal Productivity of Capital n The predictions of the stationary state turned out to be wrong. n Increases in technology and capital overwhelmed the law of diminishing marginal productivity.

Macro233 - JAFGAC Diminishing Marginal Productivity of Capital n 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

Macro233 - JAFGAC Diminishing Marginal Productivity of Capital n Diminishing marginal productivity would be stronger for richer nations than for poor ones. n Poor countries with little capital should grow faster than countries with lots of capital.

Macro233 - JAFGAC Diminishing Marginal Productivity of Capital n Eventually per capita incomes among nations would converge. n This has not happened either: l The ambiguity in the definition of inputs. l Technological progress.

Macro233 - JAFGAC Ambiguities in the Definition of the Factors of Production n The definition of the factors of production are ambiguous. n It would seem that the definition of labor would be straightforward – the hours of work that go into production.

Macro233 - JAFGAC Ambiguities in the Definition of the Factors of Production n Economists separate labor into two components. n Standard labor – the actual number of hours worked. n Human capital – the skills embedded in workers through experience, education, and on-the-job training.

Macro233 - JAFGAC Ambiguities in the Definition of the Factors of Production n Increases in human capital have allowed labor to keep pace with capital. n This allows economies to avoid the diminishing productivity of capita.

Macro233 - JAFGAC Ambiguities in the Definition of the Factors of Production n If skills are increasing faster in a rich country than in a poor one, incomes would not be expected to converge.

Macro233 - JAFGAC Technology n Technology overwhelms diminishing marginal productivity so that growth rates can increase over time.

Macro233 - JAFGAC Empirical Estimates of Factor Contribution to Growth n Economist Edward Denison estimated the importance of each of the sources of growth.

Macro233 - JAFGAC Sources of Real U.S. GDP Growth, Human capital (13%)Physical capital (19%) Technology (35%)Labor (33%)

Macro233 - JAFGAC New Growth Theory n New growth theory emphasizes the role of technology rather than capital in the growth process.

Macro233 - JAFGAC Technology n Technology is the result of investment in creating technology (research and development). n Investment in technology increases the technological stock of an economy.

Macro233 - JAFGAC Technology n Growth theory separates investment in capital and investment in technology. n Increases in technology are not as directly linked to investment as is capital.

Macro233 - JAFGAC Technology n Increases in technology often have enormous positive spillover effects. n Technological advances in one sector of the economy lead to advances in completely different sectors.

Macro233 - JAFGAC Technology n Technological advances have positive externalities. l Positive externalities – positive effects on others not taken into account by the decision maker.

Macro233 - JAFGAC Technology n Some basic research is protected by patents. l 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.

Macro233 - JAFGAC Technology n Once people have seen the new technology, they figure out sufficiently different way to achieving the same end to avoid the patent.

Macro233 - JAFGAC Learning by Doing n New growth theory also highlights learning by doing. n Learning by doing – improving the methods of production through experience.

Macro233 - JAFGAC Learning by Doing n By increasing the productivity of workers, learning by doing overcomes the law of diminishing marginal productivity.

Macro233 - JAFGAC Increasing Returns to Scale Production function with increasing returns Output All inputs

Macro233 - JAFGAC Technological Lock-In n Technological lock-in is an example of how sometimes the economy does not use the best technology available.

Macro233 - JAFGAC Technological Lock-In n Technological lock-in occurs when old technologies become entrenched in the market. n They become locked into new products despite the fact that more efficient technologies are available.

Macro233 - JAFGAC Technological Lock-In n One reason for technological lock-in is network externalities. n Network externalities – an externality in which the use of a good by one individual makes that technology more valuable to other people.

Macro233 - JAFGAC Technological Lock-In n Switching from a technology exhibiting network externalities to a superior technology is expensive and sometimes nearly impossible.

Macro233 - JAFGAC Economic Policies to Encourage Per Capita Growth n Encourage saving and investment. n Control population growth. n Increase the level of education. n Create institutions that encourage technological innovation. n Provide funding for basic research. n Increase the economy’s openness to trade.

Macro233 - JAFGAC Policies to Encourage Saving and Investment n Modern growth theories have downplayed the importance of capital in the growth process. n However, all agree that it is important. n Policy makers are eager to encourage both saving and investment.

Macro233 - JAFGAC Policies to Encourage Saving and Investment n The U.S. has used tax incentives to increase saving. n Because they don’t have much discretionary income, it is difficult for poor countries to generate saving and investment.

Macro233 - JAFGAC A Case Study: Micro Credit n 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.

Macro233 - JAFGAC A Case Study: Micro Credit n 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.

Macro233 - JAFGAC Growth Through Foreign Investment n 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.

Macro233 - JAFGAC Policies to Control Population Growth n Developing nations whose populations are rapidly growing have difficulty providing enough capital and education for everyone. n Thus, per capita income is low.

Macro233 - JAFGAC Policies to Control Population Growth n 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.

Macro233 - JAFGAC Policies to Control Population Growth n Some economists argue that to reduce population growth, a nation must grow first. l As income and work opportunities rise, especially for women, the opportunity cost of having children rises and families will choose to have fewer children.

Macro233 - JAFGAC Policies to Increase the Level of Education n Increasing the educational level and skills of the workforce increases labor productivity.

Macro233 - JAFGAC Policies to Create Institutions That Encourage Technological Innovation n Unlike capital, technological innovation can occur without investment. n Conversely, investment in technology can result in no technological innovation.

Macro233 - JAFGAC Create Patents and Protect Property Rights n Patents and protecting property rights are two ways to encourage innovation. n Patents are not costless to society. n Patents allow innovators to charge high prices for their use.

Macro233 - JAFGAC Create Patents and Protect Property Rights n Societies must find a middle ground between providing incentives to create new technologies and allowing everyone to take advantage of the benefits of technology.

Macro233 - JAFGAC Patents and Developing Countries n Poor nations are reluctant to enforce U.S. patents. n The U.S. often uses trade policy to attempt to force developing countries to do so.

Macro233 - JAFGAC The Corporation and Financial Institutions n Limited liability encourages investors to pool their funds. n Bringing technological innovations to markets often requires large amounts of investment over a number of years.

Macro233 - JAFGAC The Corporation and Financial Institutions n Well-developed financial institutions such as stock markets create liquidity and encourage investment.

Macro233 - JAFGAC Provide Funding for Basic Research n Individual firms have little incentive to do basic research because of technology’s “common knowledge” aspect. n This is where the government steps in. n The U.S. government provides 60 percent of the basic research in the country.

Macro233 - JAFGAC Policies to Increase Openness to Trade n Free trade increases growth by broadening the market and by fostering competition. n In order to specialize, you need a large market. n Large markets allow firms to take advantage of economies of scale.

Macro233 - JAFGAC Growth, Productivity, and the Wealth Of Nations End of Chapter 8