1. Economic Growth, Productivity, and Living Standards Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University

2. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards2 Potential Output and the Long Run  Potential output, as we know, is not influenced by inflation.  An economy’s productive capacity is determined by –Human capital, Physical capital, Social capital –Land and natural resources –Technology, Management and entrepreneurship –Population, Social and legal environment.

3. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards3 Introduction  Why is economic growth good? –More medicines:  longer life expectancy and better health –More schools and school materials:  you know more, your friends know more. –More economic stability  No need to worry about feeding your family.

4. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards4 Introduction  However… –More production may also mean that society becomes obsessed with production and not with other good things in life. –More production may come at the cost of social cohesion or the environment.

5. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards5 Real GDP per Person in Five Industrialized Countries, 1870 - 2000 Historical estimates are less precise: our accounting improved over time. Comparing economic output over a century cannot account for new goods and services; and we are not accounting for pollution, more stress, etc.

6. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards6 The Remarkable Rise in Living Standards: The Record  The variety, quality, and quantity of goods and services increased enormously during the 19th and 20th centuries, as reflected in real per capita GDP.

7. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards7 Real GDP per Person In Selected Countries, 1870-2000 (in 1995 U.S. Dollars) Country Australia5,6267,3859,56118,03324,7081.11.9 Canada2,4475,7919,36220,89926,6041.82.1 France2,2494,4016,04917,80122,4471.82.6 Germany1,2052,3205,00518,01423,2472.33.1 Italy2,2483,1674,04213,33121,9301.83.4 Japan9631,8252,21616,89924,7722.54.8 United Kingdom3,5005,3747,83214,88921,1421.42.0 United States2,8436,74511,92122,48032,6291.92.0 Annual % change 1950-2000 Annual % change 1870-2000 18701913195019792000 Observations 1870: Australia had the highest per capital real GDP and Japan the lowest 2000 real per capita GDP in Japan exceeded Australia Note the difference in the growth rate of 1.1% for Australia and 2.5% for Japan

8. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards8  Notice: –In 1870, Canada and the US had similar per capita GDPs. –But the US grew slightly faster on average (1.9 percent versus 1.8 percent per year). –Now the US is significantly richer than Canada. Why “Small” Differences in Growth Rates Matter

9. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards9  Compound Growth Rates –Suppose:  In 1800 GDP was 10,000 and it grew at 3% per year  (present value) x (1 + growth rate) # of years = future value  $10,000 x (1.03) 200 = $3,693,550  In 2000 GDP is $3,693,550 –Suppose:  In 1800 GDP was 10,000 and it grew at 3.5% per year  $10,000 x (1.035) 200 = $9,729,040  In 2000 GDP is $9,729,040 Why “Small” Differences in Growth Rates Matter

10. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards10 Why “Small” Differences in Growth Rates Matter YearInitial GDP Added GDP (3% growth rate) Final GDPInitial GDP Added GDP (3.5% growth rate) Final GDP 110,00030010,30010,00035010,350 210,30030910,60910,35036110,711 310,60931810,92710,71137111,082 410,92732811,25511,08238211,464 511,25533811,59311,46439411,858 611,59334811,94111,85840612,264 711,94135812,29912,26441812,682 812,29936912,66812,68243013,112 912,66838013,04813,11244313,556 1013,04839113,43913,55645714,012

11. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards11 Growth rate (%)Value of $10,000 after 200 years 1.8$354,450 2$524,850 2.2$776,570 Observations A small sum compounded over long periods can greatly increase in value. Small differences in growth rates have a very large impact on value. If a country manages to grow merely 0.4 percentage points faster, it will be twice as rich in 200 years. Why “Small” Differences in Growth Rates Matter

12. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards12 –The growth rate applies not only on the original GDP but on all previously accumulated growth. –Government policies that affect the long-term growth rate by a small amount will have a major economic impact. Why “Small” Differences in Growth Rates Matter

13. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards13 Why Nations Become Rich: The Crucial Role of Average Labor Productivity  Question –What determines a nation’s economic growth rate? –Some definitions:  Y = real GDP  N = number of employed workers  POP = total population

14. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards14 Why Nations Become Rich: The Crucial Role of Average Labor Productivity  Real GDP Per Person Observations Real output/person depends on:  How much each worker can produce.  The percent of the population that is working. GDP per capita = # of employed population x average labor productivity

15. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards15 Why Nations Become Rich: The Crucial Role of Average Labor Productivity  N/POP –Increases in female labor force participation contribute to increasing GDP per capita. –Immigration may contribute to increasing N/POP because immigrants are often of working age. –The massive retirement of baby-boomers reduces the percentage of population employed and GDP per capita.

16. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards16 Why Nations Become Rich: The Crucial Role of Average Labor Productivity  Y/N –In the long run, increases in output per person arise primarily from increases in average labor productivity (Y/N).

17. The Determinants of Average Labor Productivity

18. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards18 The Determinants of Average Labor Productivity  Human Capital  Social Capital  Physical Capital  Land and Natural Resources

19. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards19 The Determinants of Average Labor Productivity  Technology  Population  Management and Entrepreneurship  Social and Legal Environment

20. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards20  Human Capital –The talents, education, training, and skills of workers.  Remember that physical capital is “produced and durable goods that are used to produce other goods.”  Education (or training) is like capital because it is “produced”, it is durable, and it helps us produce more goods than we would have produced without education. The Determinants of Average Labor Productivity

21. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards21  Example –James and Kate draw graphs in MS Word.  James (a novice) draws 1 graph/hr or 40 graphs/week.  Kate (has taken many economics courses) draws 30/hr or 1200/week.  Average labor productivity/week = (40+1200)/2 = 620/week or 1240/80 hrs = 15.5 graphs/hr.  Kate (with training) is more productive than James. The Determinants of Average Labor Productivity

22. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards22  Example –South Korea and Nicaragua since WWII –Both are a tiny countries close to economic giants. –Korean culture (emphasizes order and learning) encouraged economic growth much more than Nicaragua’s. –Now Korea is in the “club for rich countries”, the OECD. The Determinants of Average Labor Productivity

23. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards23  Social Capital –Social capital is important because all production processes require many people working together.  Without trust, contracts fail and ideas don’t get developed. –Social Capital is the habitual way of doing things that guides people in how they approach production and economic life.  Trust, conventions, agreed expectations. The Determinants of Average Labor Productivity

24. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards24  Physical Capital –Worker productivity depends not only on their skills (human capital) but on the tools (physical capital) they have to work with. –Tools. –Buildings. –Factories. –Machines. –Software. The Determinants of Average Labor Productivity

25. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards25  Example –James gets better software.  Microsoft produces a new kind of graphing utility for Word  An untrained student using the new software can draw 20 graphs/hour.  James uses the new software and Kate graphs with the old software. The Determinants of Average Labor Productivity

26. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards26  Example –James gets better software (AMU buys 1 license).  James’s weekly output (40 hrs x 20) = 800 graphs.  Kate’s weekly output (40 hrs x 30) = 1200 graphs.  Total output = 2,000 graphs/week  or average labor productivity = 1,000 graphs/week  or 2,000/80 hrs. = 25 graphs/hr. –James’s use of the new software increases average productivity 62 percent. The Determinants of Average Labor Productivity

27. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards27 –James and Kate get better software (AMU buys 2 licenses).  Kate’s hourly productivity increases to 50 graphs/hr.  James’s weekly output (40 hrs x 20) = 800 graphs.  Kate’s weekly output (40 hrs x 50) = 2000 graphs.  Total output = 2,800 graphs/week  or average labor productivity = 1,400 graphs/week  or 2,800/80 hrs. = 35 graphs/hr. –James’s and Kate’s use of the new software increases average productivity 40 percent. The Determinants of Average Labor Productivity

28. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards28 Capital, Output, and Productivity in the Computer Cluster (1) Number of licencse (capital) 012408015.5 12,0008025 22,8008035 32,8008035 (2) Total number of graphs drawn each week (output) (3) Total hours worked per week (4) Graphs drawn per hour worked (productivity) Observations For a given number of workers, adding capital will generally increase output and average labor productivity. The more capital that is already in place, the smaller the benefits of adding extra capital.

29. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards29  Diminishing Returns to Capital –If the amount of labor and other inputs employed is held constant, then the greater the amount of capital already in use, the less an additional unit of capital adds to production. The Determinants of Average Labor Productivity

30. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards30 The Determinants of Average Labor Productivity Output Amount of Capital More capital adds more output. But each unit of extra capital adds less extra output.

31. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards31  Physical Capital –Public policy designed to stimulate growth should consider that:  Increasing the amount of capital available to the workforce will tend to increase output and average labor productivity.  The degree to which productivity can be increased by an expanding stock of capital is limited. The Determinants of Average Labor Productivity

32. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards32 Average Labor Productivity and Capital per Worker in 15 Countries, 1990 Using Econometrics: Statistical theory applied to economics helps us find relations between variables. For example, it can help us explain the approximate effect more Real Capital per Worker on Real GDP per worker… … and to explain why the US has more per-worker GDP (and Germany less per-worker GDP) than just the level of capital would predict.

33. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards33  Land and Other Natural Resources –Generally, an abundance of natural resources increases the productivity of workers. –Sometimes, abundance of natural resources is not necessary or useful:  A country might get “lazy” because everything comes out of the land.  Resources can be obtained through international markets. The Determinants of Average Labor Productivity

34. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards34  Technology –Technology is the body of knowledge available to a civilization – skills, scientific methods and materials – for making goods and supplying services. The Determinants of Average Labor Productivity

35. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards35  Technology New technologies are the single most important source of productivity improvement. –A new technology will expand the productivity in many sectors by stimulating greater specialization. The Determinants of Average Labor Productivity

36. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards36  Population –Some economists have argued that an important factor in technological development is population growth.  More population implies a greater demand for goods, and therefore a demand for new technologies.  Moreover, more population increases opportunities for scientific and social cooperation.  This means that natural resources won’t get exhausted. The Determinants of Average Labor Productivity

37. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards37 The Determinants of Average Labor Productivity A more highly populated country gives more opportunities for scientific interaction. Comparing technological development over a billion years, economist Michael Kremer of Harvard (1993) found that Higher Initial Population and Population Growth  Higher Technological Development

38. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards38  Entrepreneurship and Management –Entrepreneurship is the ability to get things done.  It’s having creativity and vision  It also involves a talent for translating that vision into reality.  Factors influencing entrepreneurship –Social Customs –Taxation –Regulation –Management:  Influence productivity by implementing more efficient methods of production. The Determinants of Average Labor Productivity

39. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards39 Economic Growth: what does it cost us?  There is no such thing as a free lunch –To increase the stock of physical or human capital, we must divert resources that could otherwise be used to increase the supply of consumer goods.  More machines or industrial software means less butter and fewer sports cars.  More education to earn a higher income tomorrow means less time to earn a high income today.

40. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards40 Economic Growth: what does it cost us?  There is no such thing as a free lunch –Research and Development of new technologies involves sacrifice of current goods. –Many countries have achieved a high standard of living through allowing great income inequalities in the past.

41. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards41 Average Labor Productivity Growth Rates in Selected Countries, 1960-2000 Country France4.62.31.8 Germany4.02.62.0 Japan7.62.72.0 United Kingdom2.81.31.7 United States2.30.61.7 1960-19731973-19791979-2000 Percentage growth, annual rates

42. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards42 The Worldwide Productivity Slowdown -- and Recovery  Why the decline in worldwide productivity? –Short-term economic instability  Higher prices of oil and raw materials;  Inflation, exchange rate instability;  Two severe recessions. –Poor measurement of productivity –Technological depletion hypothesis –Decrease in the quality of public education

43. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards43  The Role of Government in Fostering Productivity –Establish:  Well-defined property rights  Maintain political stability  Promote free and open exchange of ideas The Determinants of Average Labor Productivity

44. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards44  Economic Naturalist –Why did communism fail?  Output per person in the Soviet Union was probably less than one-seventh the U.S. rate  The Soviet Union had: –Human capital. –Physical capital. –Natural resources. –Technology. The Determinants of Average Labor Productivity

45. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards45  Economic Naturalist –Why did communism fail?  There was an absence of: –Private property rights. –Free markets. –Political stability. –Modern legal framework. The Determinants of Average Labor Productivity

46. Policies for Economic Growth

47. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards47 Promoting Economic Growth  Promoting Growth –Promote saving and investment  Physical capital  Human Capital –Support research and development –Improve the legal and political framework

48. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards48 Promoting Economic Growth  Capital is important for the growth process.  The U.S. has used tax incentives to increase saving. –Social Security and IRAs are forms of encouragement.  Respect for private property is necessary to encourage people to accumulate capital for long-run benefits.

49. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards49 Promoting Economic Growth  It is difficult for poor countries to generate saving and investment (lack of discretionary income). –Financial development seeks to encourage private saving by encouraging the banking sector.  Foreign investment provides another source of saving. –Rich-country corporations can set up factories, branches, etc. in developing countries. –The IMF, the World Bank, and rich-country governments. –Private banks or institutional investors.

50. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards50 Promoting Economic Growth  Greater educational level and skills of the workforce  higher labor productivity. –Accumulation of Human Capital. –Education also is an important source of Social Capital.

51. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards51 Promoting Economic Growth  Create Institutions That Encourage Technological Innovation –Patents  Patents allow innovators to charge high prices  profits are the incentive for innovation.  Patents also  fewer positive externalities to technology. –Protecting property rights  Innovators need incentives to innovate: enjoying the fruits of their labors.

52. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards52 Promoting Economic Growth  Financial Development  Technological innovations  large amounts of investment over many years. –Limited liability encourages investors to pool their funds. –Well-developed financial institutions create liquidity and encourage investment.  Rule of Law and property rights  healthy financial and corporate life.

53. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards53 Promoting Economic Growth  The State may need to provide funding for basic research  Technology’s “common knowledge” aspect  little incentive to do basic research (for individuals). –“Free riders” take advantage of others’ work. –  Technology is a public good.  U.S. government finances 60 percent of the basic research in the country.

54. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards54 Promoting Economic Growth  Increase openness to trade  Free trade  broader market and more competition  growth  Large market  possible to specialize.  Large market  possible to take advantage of economies of scale.

55. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards55 Promoting Economic Growth  The Poorest Countries: A Special Case? –Improve the legal and political framework  Corrupt legal systems create uncertainty about property rights  Taxation and regulation discourages entrepreneurship  Markets are not allowed to function  Lack of political stability discourages foreign investment and makes foreign aid less effective. –ECO 320 studies Development Economics.

56. Limits to Economic Growth

57. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards57 Limits to Economic Growth  Can a country grow forever without depleting its natural resources and damaging the environment? –The historical experience in many countries that have grown rich is that the environment does suffer substantially. –Evidently, non-renewable resources can be depleted.

58. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards58 Limits to Economic Growth  The mistake of this way of thinking is that it assumes that “more GDP” means “more of the same stuff”.  In fact, much of the economic growth we see is different stuff, often stuff that is environmentally sounder. –Richer countries tend to demand “greener” technologies – and are able to afford them.

59. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards59 Limits to Economic Growth  Another problem with the “limits to growth” idea is that it assumes that technology is constant. –In fact, technology changes frequently. –Technological advances often follow periods of scarcity. –For example, when oil became scarce in the 1970s, firms and consumers reacted by demanding machines that used less oil. –The price of oil fell dramatically over time. –Today, industrialized nations use ½ the oil they used to per unit of GDP.

60. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards60 Limits to Economic Growth OPEC Oil Embargo Iranian Revolution First Gulf War Second Gulf War Price of Oil in 2005 US$

61. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards61 Limits to Growth  Unlike technology, environmental quality cannot be bought and sold, but is protected only by government policy. –Government policy can be misdirected, too late, or simply ineffective. –Do we tell the Brazilians to stop eating so we can protect the rain forest?

62. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards62 Limits to Growth  Another problem is “human ecology.”  Economic growth tends to become its own end. –Societies give up traditions, customs, social ties; –Religion loses its value and gets squashed by advertising, by laws, or it’s forced away from the public sphere. –Loss of a sense of community and human dignity in the workplace;

63. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards63 Limits to Growth –A devaluation of the family, which becomes just a convenient social arrangement or an economic tool or hindrance; –Consumerism: possession and comfort as the end of life. Drugs are an extreme example.  “a style of life which is presumed to be better when it is directed towards "having" rather than "being", and which wants to have more, not in order to be more but in order to spend life in enjoyment as an end in itself ” (Centesimus Annus, 36)

64. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards64 Limits to Growth  The solution is neither to shrug one’s shoulders and deny the problem –( “if they choose it, who am I to say anything?”)  Nor to stop economic growth –(“stop the world, I want to get off”)  Rather, remember Growth is an important means to achieve an end. –Societies need to remain sane about what the end of human life is.

65. Theories of Economic Growth

66. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards66 The Production Function and Theories of Growth  The production function shows the relationship between the quantity of inputs used in production and the quantity of output resulting from production. InputsOutputs 110 218 324 428

67. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards67 The Production Function and Theories of Growth  The production function for growth has land, labor, and capital as factors of production. Output = A f (Labor, Land, Capital) –“A” is an adjustment factor that captures the effect of technology.

68. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards68 Describing Production Functions  Remember: what happens when more of one input is added without increasing any other inputs?  The law of diminishing returns states that increasing one output, keeping all others constant, will lead to smaller and smaller gains in output.

69. Theories of Economic Growth The Classical Growth Model

70. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards70 The Classical Growth Model  The Classical growth model focuses on the interaction between land and labor.  It also stresses the role of capital accumulation in the growth process. –This capital accumulation is exogenous (generated outside of the model). –The more capital an economy has, the faster it will grow.

71. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards71 The Classical Growth Model  The Classical growth model focused on how diminishing returns to labor placed limitations on growth. –It’s typically associated with the work of Thomas Malthus.  Land was assumed to be relatively fixed. –Therefore, additional workers were less and less productive: output per capita would fall as population grew.

72. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards72 The Classical Growth Model

73. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards73 Diminishing Returns of Labor Output per person Labor Production function Q1Q1 Q2Q2 L1L1 L*

74. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards74 Focus on Diminishing Marginal Productivity of Labor  As output per person declines, at some point available output is no longer sufficient to feed the population.  This belief is called the iron law of wages.  The long run was called the stationary state.

75. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards75 Focus on Diminishing Marginal Productivity of Labor  Thomas Malthus, in his essay “On Population” (c. 1800) argued that the great majority of the population would always live at the subsistence level. –If wages rose above subsistence, people would multiply like roaches. –As population rose and output/worker fell, “war, famine, and pest” would bring population back to subsistence.

76. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards76 Diminishing Returns of Labor and Population Growth Output Labor Subsistence level of output per worker Production function L* Q1Q1 Q2Q2 L1L1 Surplus of food Shortage of food

77. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards77 Malthus versus the Industrial Revolution  These predictions turn out to be wrong. –Malthus could not foresee the Industrial Revolution. –Dramatic changes in the world’s capacity to produce expand the boundaries of life.  Increases in capital  returns to the extra unit of labor does not decline, even with fixed land supplies.

78. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards78 The Classical Growth Model

79. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards79 The Classical Growth Model  Classical economists (such as J.S. Mill or A. Marshall 1850 - 1900) focused their analysis, and their policy advice, on how to increase investment: –Policies, therefore should encourage saving and investment. –Countries that save more, invest more and grow faster. savings  investment  capital accumulation  growth

80. Theories of Economic Growth The Neo-Classical Growth Model

81. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards81 Neo-Classical Theory of Economic Growth  The Classical School realized that capital was important. –But it did not have a theory of how capital is accumulated.  This gave rise to the Neo-Classical Theory of Economic Growth –Robert Solow (in the 1950s – 1960s) –The level of Capital/Worker is explained endogenously to grow to a steady level.

82. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards82 Neo-Classical Theory of Economic Growth  The idea is that: –If Capital is highly productive  workers can save a lot  savings become capital  capital / worker increases.  What happens to returns to the extra unit of capital as capital / worker increases?

83. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards83 Neo-Classical Theory of Economic Growth  The idea is that: –If Capital is not very productive  workers don’t save much  capital accumulation slows down  capital / worker decreases.  What happens to returns to the extra unit of capital as capital / worker decreases?

84. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards84 Neo-Classical Theory of Economic Growth  The focus turns to the diminishing returns to capital: If capital / worker increases  capital grows faster than labor  extra unit of capital is less productive  As each worker uses more machines, each additional machine turns out to be less productive.

85. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards85 Neo-Classical Theory of Economic Growth

86. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards86 Diminishing Returns of Capital Capital / Worker tomorrow Capital / Worker today Capital accumulation per worker

87. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards87 Diminishing Marginal Productivity of Capital If capital / worker increases  capital grows faster than labor  extra unit of capital is less productive  slower capital / worker growth  capital / worker growth comes to a steady level  capital / worker income stops rising

88. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards88 Diminishing Returns of Capital and Population Growth Capital / Worker tomorrow Capital / Worker today Population growth x Capital / Worker Capital accumulation per worker Q1Q1 Q2Q2 K/L Poor K/L* Surplus of Capital K/L Rich

89. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards89 Neo-Classical Theory of Economic Growth –Diminishing returns to capital be stronger for richer nations than for poor ones. –Poor countries with little capital should grow faster than countries with lots of capital.  Eventually per capita incomes among nations would converge.  This has not happened because of differences in human capital and technological progress.  If skills and technology increase faster in a rich country than in a poor one, incomes will not converge.

90. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards90 Technology, Human Capital, and Growth Population growth x Capital / Worker Q1Q1 Q2Q2 K/L 1 K/L 2 Capital / Worker tomorrow Capital / Worker today Capital accumulation per worker Better Technology increases productivity

91. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards91 Technology, Human Capital, and Growth

92. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards92 Sources of Real U.S. GDP Growth, 1928-2000 Human capital (13%)Physical capital (19%) Technology (35%)Labor (33%)

93. Theories of Economic Growth New Growth Theory

94. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards94 New Growth Theory  Neo-Classical growth theory realized that Technology and Human Capital were important for economic growth. –But it did not have a theory of how technology and human capital were accumulated.  This gave rise to New Growth Theory –NGT explains technology endogenously.

95. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards95 New Growth Theory  New growth theory emphasizes the role of technology rather than capital in the growth process.  Technology is the result of investment in creating technology (research and development). –Technology is more complicated than capital because of externalities and learning-by-doing.

96. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards96  New Growth theory distinguishes between investment in capital and investment in technology. –Some technological breakthroughs may happen with little investment. –Large amounts of investment are not a guarantee of finding good ideas. New Growth Theory

97. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards97  Increases in technology often have enormous positive spillover effects. –Technological advances in one sector of the economy lead to advances in completely different sectors. –For example, military research in computers led to the mainframe, the personal computer, the internet, etc… New Growth Theory

98. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards98  Learning by doing – improving the methods of production through experience. –Learning by doing increases the productivity of workers. –This counteracts the law of diminishing marginal productivity. New Growth Theory

99. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards99 Network Externalities  Networks –The use of a good by one individual makes that technology more valuable to other people.  Switching from a technology exhibiting network externalities to a superior technology is expensive and sometimes nearly impossible.  This is a reason why technology is subject to uncertainty but also a source of great benefits.

100. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Economic Growth, Productivity, and Living Standards100 Policy Consequences  The Classical school is right in part. –More natural resources per person (and better use thereof) will increase standards of living.  The NeoClassical school is right in part –More savings and capital encourage growth, but up to a point. –Technology is key.  New Growth theory is right in part –Property rights and networks are key to technological development.