© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 28 Prepared by: Fernando Quijano and Yvonn Quijano Long-Run Growth

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Growth Economic growth refers to an increase in the total output of an economy. Defined by some economists as the increase of real GDP per capita.Economic growth refers to an increase in the total output of an economy. Defined by some economists as the increase of real GDP per capita. Modern economic growth is the period of rapid and sustained increase in real output per capita that began in the Western World with the Industrial Revolution.Modern economic growth is the period of rapid and sustained increase in real output per capita that began in the Western World with the Industrial Revolution.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Growth The production possibility frontier shows all the combinations of output that can be produced if all society’s scarce resources are fully and efficiently employed.The production possibility frontier shows all the combinations of output that can be produced if all society’s scarce resources are fully and efficiently employed. Economic growth shifts society’s production possibility frontier up and to the right.Economic growth shifts society’s production possibility frontier up and to the right.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Growth Process: From Agriculture to Industry Before the Industrial Revolution in Great Britain, every society in the world was agrarian.Before the Industrial Revolution in Great Britain, every society in the world was agrarian. Beginning in England around 1750, technical change and capital accumulation increased productivity in two important industries: agriculture and textiles.Beginning in England around 1750, technical change and capital accumulation increased productivity in two important industries: agriculture and textiles. More could be produced with fewer resources, leading to new products, more output, and wider choice.More could be produced with fewer resources, leading to new products, more output, and wider choice.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Sources of Economic Growth An aggregate production function is the mathematical representation of the relationship between inputs and national output, or gross domestic product.An aggregate production function is the mathematical representation of the relationship between inputs and national output, or gross domestic product. If you think of GDP as a function of both labor and capital, you can see that an increase in GDP can come about through:If you think of GDP as a function of both labor and capital, you can see that an increase in GDP can come about through: 1. An increase in the labor supply 2. An increase in physical or human capital 3. An increase in productivity

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair An Increase in Labor Supply An increasing labor supply can generate more output, but if the capital stock remains fixed, the new labor will be less productive (diminishing returns).An increasing labor supply can generate more output, but if the capital stock remains fixed, the new labor will be less productive (diminishing returns). Malthus and Ricardo predicted a gloomy future as population outstripped the land’s capacity to produce. However, they forgot the impact of technological change and capital accumulation.Malthus and Ricardo predicted a gloomy future as population outstripped the land’s capacity to produce. However, they forgot the impact of technological change and capital accumulation.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Growth From an Increase in Labor Growth in the labor force, without a corresponding increase in the capital stock or technological change might lead to growth of output but declining productivity.Growth in the labor force, without a corresponding increase in the capital stock or technological change might lead to growth of output but declining productivity. Economic Growth from an Increase in Labor – More Output but Diminishing Returns and Lower Labor Productivity PERIOD QUANTITY OF LABOR L (HOURS) QUANTITY OF CAPITAL K (UNITS) TOTAL OUTPUT Y (UNITS) MEASURED LABOR PRODUCTIVITY Y/L

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Growth From an Increase in Labor Employment, Labor Force, and Population Growth, 1947 – 1999 CIVILIAN NONINSTITUTIONAL POPULATION OVER 16 YEARS OLD (MILLIONS) CIVILIAN LABOR FORCE EMPLOYMENT (MILLIONS) Number (Millions) Percentage of Population Percentage change, 1947 – Annual rate + 1.4%+1.7%.7% Source: Economic Report of the President, 2000, Table B-33.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Increases in Physical Capital An increase in the stock of capital can increase output, even if it is not accompanied by an increase in the labor force.An increase in the stock of capital can increase output, even if it is not accompanied by an increase in the labor force. Economic Growth from an Increase in Capital – More Output, Diminishing Returns to Added Capital, Higher Measured Labor Productivity PERIOD QUANTITY OF LABOR L (HOURS) QUANTITY OF CAPITAL K (UNITS) TOTAL OUTPUT Y (UNITS) MEASURED LABOR PRODUCTIVITY Y/L

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Increases in Physical Capital The increase in capital stock is the difference between gross investment and depreciation.The increase in capital stock is the difference between gross investment and depreciation. Capital has been increasing faster than the labor force since When capital expands more rapidly than labor, the ratio of capital to labor (K/L) increases, and this too is a source of increasing productivity.Capital has been increasing faster than the labor force since When capital expands more rapidly than labor, the ratio of capital to labor (K/L) increases, and this too is a source of increasing productivity.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Increases in Physical Capital Fixed Private Nonresidential Net Capital Stock, 1960 – 1998 (Billions of 1996 Dollars) EQUIPMENTSTRUCTURES , , ,988.93, ,721.04, ,797.35,389.2 Percentage change, 1960 – Annual rate + 4.7% + 2.6% Source: Survey of Current Business, April 2000, computed from Tables 1 and 2, p. 21.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Increases in Human Capital Years of School Completed by People Over 25 Years Old, 1940 – 1998 PERCENTAGE WITH LESS THAN 5 YEARS OF SCHOOL PERCENTAGE WITH 4 YEARS OF HIGH SCHOOL OR MORE PERCENTAGE WITH 4 YEARS OF COLLEGE OR MORE NA NA NA = not available. Source: Statistical Abstract of the United States, 1990, Table 215; and 1999, Table 263.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Increases in Productivity Growth that cannot be explained by increases in the quantity of inputs can be explained only by an increase in the productivity of those inputs.Growth that cannot be explained by increases in the quantity of inputs can be explained only by an increase in the productivity of those inputs. The productivity of an input is the amount produced per unit of an input.The productivity of an input is the amount produced per unit of an input. Factors that affect the productivity of an input include technological change, other advances in knowledge, and economies of scale.Factors that affect the productivity of an input include technological change, other advances in knowledge, and economies of scale.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Increases in Productivity Technological change affects productivity in two stages:Technological change affects productivity in two stages: First there is an advance in knowledge, or an invention. First there is an advance in knowledge, or an invention. Then there is innovation, or the use of new knowledge to produce a new product or to produce an existing product more efficiently. Then there is innovation, or the use of new knowledge to produce a new product or to produce an existing product more efficiently. There are capital-saving innovations, and labor-saving innovations.There are capital-saving innovations, and labor-saving innovations.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Increases in Productivity External economies of scale are cost savings that result from increases in the size of industries.External economies of scale are cost savings that result from increases in the size of industries. Production abatement requirements divert capital and labor from the production of measured output, therefore reducing measured productivity.Production abatement requirements divert capital and labor from the production of measured output, therefore reducing measured productivity.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Growth and Output in the United States Growth of Real GDP in the United States, 1871 – 1999 PERIOD AVERAGE GROWTH RATE PER YEAR PERIOD Sources: Historical Statistics of the United States: Colonial Times to 1970, Tables F47-70, F98-124; U.S. Department of Commerce, Bureau of Economic Analysis.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Growth and Output in the United States Growth of Real GDP in the United States and Other Countries, 1981 – 1998 COUNTRY AVERAGE GROWTH RATE PER YEAR United States 3.1 Japan2.8 Germany2.1 France2.0 Italy1.8 United Kingdom 2.4 Canada2.5 Africa2.5 Asia (excluding Japan) 7.3 Source: Economic Report of the President, 2000, computed from Table B-110.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Sources of Growth in the U.S. Economy, 1929 – 1982 Sources of Growth in the United States, 1929 – 1982 PERCENT OF GROWTH ATTRIBUTABLE TO EACH SOURCE 1929 – – – – 1979 Increases in inputs Labor Capital Education (human capital) Increases in productivity Advances in knowledge Other factors a  2 2 2 2 Annual growth rate in real national income a Economies of scale, weather, pollution abatement, worker safety and health, crime, labor disputes, and so forth. Source: Edward Denison, Trends in American Economic Growth, 1929 – 1982 (Washington: Brookings Institution, 1985).

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Labor Productivity, 1952 – 2000

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Labor Productivity, 1952 – 2000 Some of the explanations for the slowdown in productivity growth in the 1970s include:Some of the explanations for the slowdown in productivity growth in the 1970s include: a low rate of saving a low rate of saving increased environmental and government regulations increased environmental and government regulations lack of spending in R&D lack of spending in R&D high energy costs high energy costs However, many of these factors turned around in the 1980s and 1990s yet productivity growth remained low.However, many of these factors turned around in the 1980s and 1990s yet productivity growth remained low.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Growth and Public Policy Policy provisions to improve the quality of education include the new Education Individual Retirement Account that allows savings to earn tax free returns as long as the balance is used to pay for educational expenses.Policy provisions to improve the quality of education include the new Education Individual Retirement Account that allows savings to earn tax free returns as long as the balance is used to pay for educational expenses. Policies to increase the saving rate include individual retirement accounts that accumulate earnings without paying income tax.Policies to increase the saving rate include individual retirement accounts that accumulate earnings without paying income tax.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Growth and Public Policy The amount of capital accumulation is ultimately constrained by its rate of saving.The amount of capital accumulation is ultimately constrained by its rate of saving. The tax system and the social security system in the United States are biased against saving.The tax system and the social security system in the United States are biased against saving. Some public finance economists favor shifting to a system of consumption taxation rather than income taxation to reduce the tax burden on saving.Some public finance economists favor shifting to a system of consumption taxation rather than income taxation to reduce the tax burden on saving.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Growth and Public Policy Other public policies to stimulate economic growth include:Other public policies to stimulate economic growth include: policies to stimulate investment policies to stimulate investment policies to increase research and development policies to increase research and development reduced regulations reduced regulations industrial policy, or government involvement in the allocation of capital across manufacturing sectors. industrial policy, or government involvement in the allocation of capital across manufacturing sectors.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Pro-Growth Argument Advocates of growth believe growth is progress.Advocates of growth believe growth is progress. New technologies and production methods lead to new and better products. Capital accumulation and new technology improve the quality of life.New technologies and production methods lead to new and better products. Capital accumulation and new technology improve the quality of life. In 1995, real GDP per capita was more than twice what it was in Since the 1950s, incomes have grown twice as fast as prices.In 1995, real GDP per capita was more than twice what it was in Since the 1950s, incomes have grown twice as fast as prices.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Pro-Growth Argument Advocates of growth believe growth is progress.Advocates of growth believe growth is progress. Growth gives us more choices.Growth gives us more choices. New technologies and production methods lead to new and better products. Capital accumulation and new technology improve the quality of life.New technologies and production methods lead to new and better products. Capital accumulation and new technology improve the quality of life. Since the 1950s, incomes have grown twice as fast as prices so we can buy that much more.Since the 1950s, incomes have grown twice as fast as prices so we can buy that much more.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Pro-Growth Argument Growth saves the most valuable commodity—time.Growth saves the most valuable commodity—time. Growth also improves the quality of things that yield satisfaction directly.Growth also improves the quality of things that yield satisfaction directly. Growth produces jobs and higher incomes. With higher incomes we can better afford the sacrifices needed to help the poor.Growth produces jobs and higher incomes. With higher incomes we can better afford the sacrifices needed to help the poor. When population growth is not accompanied by growth in output, unemployment and poverty increase.When population growth is not accompanied by growth in output, unemployment and poverty increase.

© 2001 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Anti-Growth Argument Growth has negative effects on the quality of life.Growth has negative effects on the quality of life. Growth encourages the creation of artificial needs.Growth encourages the creation of artificial needs. Growth means the rapid depletion of a finite quantity of resources.Growth means the rapid depletion of a finite quantity of resources. Growth requires an unfair income distribution and propagates it.Growth requires an unfair income distribution and propagates it.