1. 18 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Long-Run Growth

2. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 40 Long-Run Growth Economic growth refers to an increase in the total output of an economy. Defined by some economists as an increase of real GDP per capita.

3. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 40 Long-Run Growth 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.

4. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 40 The Growth Process: From Agriculture to Industry The production possibility frontier (ppf) shows all the combinations of output that can be produced if all society’s scarce resources are fully and efficiently employed. Economic growth expands society’s production possibilities, shifting the ppf up and to the right.

5. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 40 The Growth Process: From Agriculture to Industry 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. More could be produced with fewer resources, leading to new products, more output, and wider choice.

6. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 40 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.

7. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 40 The Sources of Economic Growth 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 (the amount of product produced by each unit of capital or labor)

8. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 40 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).

9. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 40 An Increase in Labor Supply 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.

10. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 40 An Increase in Labor Supply 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 and a lower standard of living.

11. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 40 An Increase in Labor Supply 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 1100 3003.0 21101003202.9 31201003392.8 41301003572.7

12. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 40 An Increase in Labor Supply Labor productivity is the output per worker hour; the amount of output produced by an average worker in 1 hour.

13. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 40 An Increase in Labor Supply Employment, Labor Force, and Population Growth, 1947 – 2002 CIVILIAN NONINSTITUTIONAL POPULATION OVER 16 YEARS OLD (MILLIONS) CIVILIAN LABOR FORCE EMPLOYMENT (MILLIONS) Number (Millions) Percentage of Population 1947101.859.458.357.0 1960117.369.659.365.8 1970137.182.860.478.7 1980167.7106.963.799.3 1990189.2125.866.5118.8 2002214.0142.566.6134.3 Percentage change, 1947 – 2002+ 110.2+ 139.9+ 135.6 Annual rate+ 1.4%+1.6%+ 1.6% Source: Economic Report of the President, 2003, Table B-35.

14. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 40 An Increase in Labor Supply As long as the economy and the capital stock are expanding rapidly enough, new entrants into the labor force do not displace other workers.

15. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 40 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.

16. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 40 Increases in Physical Capital 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 1100 3003.0 21001103103.1 31001203193.2 41001303273.3

17. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 40 Increases in Physical Capital The increase in capital stock is the difference between gross investment and depreciation. Capital has been increasing faster than the labor force since 1960. 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.

18. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 40 Increases in Physical Capital Fixed Private Nonresidential Net Capital Stock, 1960 – 2001 (Billions of 1996 Dollars) EQUIPMENTSTRUCTURES 1960672.72,015.7 19701,154.82,744.2 19801,989.83,589.1 19902,722.54,703.5 20014,480.05,682.5 Percentage change, 1960 – 2001+ 566.0+ 181.9 Annual rate+ 4.7%+ 2.6% Source: Survey of Current Business, September 2002, Table 15, p. 37.

19. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 40 Increases in Human Capital Years of School Completed by People Over 25 Years Old, 1940 – 2000 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 194013.724.54.6 195011.134.36.2 19608.341.17.7 19705.552.310.7 19803.666.516.2 1990NA77.621.3 2000NA84.125.6 NA = not available. Source: Statistical Abstract of the United States, 1990, Table 215; and 2002, Table 208.

20. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 40 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.

21. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 40 Increases in Productivity 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.

22. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 40 Increases in Productivity Technological change affects productivity in two stages: 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. There are capital-saving innovations, and labor-saving innovations.

23. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 40 Increases in Productivity 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.

24. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 40 Growth and Productivity in the United States Growth of Real GDP in the United States, 1871 – 2000 PERIOD AVERAGE GROWTH RATE PER YEARPERIOD AVERAGE GROWTH RATE PER YEAR 1871-18895.51950-19603.5 1889-19094.01960-19704.2 1909-19292.81970-19803.2 1929-19401.61980-19903.2 1940-19505.61990-20003.2 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.

25. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 40 Growth and Productivity in the United States Growth of Real GDP in the United States and Other Countries, 1981 – 1998 COUNTRY AVERAGE GROWTH RATE PER YEAR United States3.2 Japan2.3 Germany2.2 France2.1 Italy2.0 United Kingdom2.6 Canada3.1 Africa2.7 Asia (excluding Japan)7.2 Source: Economic Report of the President, 2002, computed from Table B-112.

26. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 40 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 – 19821929 – 19481948 – 19731973 – 1979 Increases in inputs53494594 Labor 20261447 Capital 1431629 Education (human capital) 19201518 Increases in productivity4751556 Advances in knowledge 3130398 Other factors a 162116  2 Annual growth rate2.82.43.62.6 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).

27. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 40 Labor Productivity: 1952 – 2003

28. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 40 Labor Productivity: 1952 – 2003 Some of the explanations for the slowdown in productivity growth in the 1970s include: A low rate of saving Increased environmental and government regulations Lack of spending in R&D High energy costs

29. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 40 Labor Productivity: 1952 – 2003 Many of these factors turned around in the 1980s and 1990s, yet productivity growth remained low.

30. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 40 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.

31. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 40 Economic Growth and Public Policy Policies to increase the saving rate include individual retirement accounts that accumulate earnings without paying income tax.

32. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 40 Economic Growth and Public Policy 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.

33. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 33 of 40 Economic Growth and Public Policy Some public finance economists favor shifting to a system of consumption taxation rather than income taxation to reduce the tax burden on saving.

34. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 34 of 40 Economic Growth and Public Policy Other public policies to stimulate economic growth include: Policies to stimulate investment Policies to increase research and development Reduced regulations Industrial policy, or government involvement in the allocation of capital across manufacturing sectors.

35. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 35 of 40 The Progrowth Argument 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.

36. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 36 of 40 The Progrowth Argument Growth saves the most valuable commodity—time. Growth also improves the quality of things that yield satisfaction directly.

37. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 37 of 40 The Progrowth Argument 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.

38. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 38 of 40 The Antigrowth Argument Growth has negative effects on the quality of life. Growth encourages the creation of artificial needs. Consumer sovereignty is the notion that people are free to choose, and that things that people do not want will not sell. “The consumer rules.”

39. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 39 of 40 The Antigrowth Argument Growth means the rapid depletion of a finite quantity of resources. Growth requires an unfair income distribution and propagates it.

40. C H A P T E R 18: Long-Run Growth © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 40 of 40 Review Terms and Concepts aggregate production function aggregate production function consumer sovereignty consumer sovereignty economic growth economic growth industrial policy industrial policy innovation invention labor productivity labor productivity modern economic growth modern economic growth productivity of an input productivity of an input