Principles of Economics

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Transcript Principles of Economics

Principles of Economics
Economic Growth and Development
Tomislav Herceg
Theories of Economic Growth
• Economic growth (gy) is the expansion of a
country’s potential GDP (outward shift of PPF
• Growth rate of output per person (gy p.c.)
shows how living standards rise.
• In the 20th century GDP increased 30 times.
4 wheels of growth
• Aggregate production function (AFP) relates
country’s output to inputs and technology:
Y = A×f(K, HL, N)
Where A stands for technology, K for capital, HL
for labour and human capital and N for natural
resources and Y for national output.
• One can increase production by increasing
inputs K, N or HL, or by improving technology
1. Human resources, HL
• Labour consists of workers (L) and of the skills of
the workforce (human capital, H)
• In order to use capital efficiently it has to be
matched with human capital.
• Human capital is increased by education, training
and health care, thus increasing HL input.
2. Natural Resources (N)
• N consists of arrable land, oil & gas, forests,
water and minerals.
Capital formation (K)
• Capital is formed through investment and depreciated
over the years (δ)
• Investment is sacrifice of current consumption
 =  +
• Investments can be private (equipment and factories)
or government made (social overhead capital, SOC).
• SOC aim is to make spillovers (positive externalities)
• Some of private investment cause network
externalities (the more users the greater productivity)
Technology change and innovation (A)
• Improvement ion technology raises output at the
same level of inputs
• Several major technological advancements:
electricity, television, computers, cell phones,
Internet – they all have ∫ shaped pattern.
• Technological change denotes change in the
processes of production or introduction of new
products or services.
• Entrepreneurship is crucial for technological
Theories of Economic Growth
• Classical theory (Malthus, Smith): land is
crucial for growth.
• Smith: when there is ample space there are
constant returns to scale (Golden Era)
• Malthus: population keeps growing and land is
limited: adding new workers rises production
with diminishing returns (Dismal science)
Neoclassical growth model
• capital accumulation and technology advancements
overcome diminishing returns to labour
• Assumptions: full employment, labour growth rate
given, inputs labour and capital:
• Y (K, L) = A×f(K, L), or Y (K/L) = A×f(K/L) (leave A fixed
for the time being)
• K/L = capital per worker
• The increase in K/L = capital deepening
• Capital deepening causes the increase in labour
productivity, hence salaries (w) rise, but causes
diminishing returns to capital
Economic growth through capital
deepening & technology change
Technology improvement
• Without technology
change capital
deepening stops and
economy gets to the
steady state (no
change in output and
• Technology change
(A↑) can overcome
diminishing returns to
capital and move
economy from steady
Endogenous growth theory
• New growth theory that says that
technological change is an output of a
production process, with many attempt –
mistake cases.
• Technology is thus public good (expensive to
produce, but cheap to reproduce) – hence
protection of intelectual property exists to
protect developers’ extra profits
7 basic trends in economic growth
K has grown more rapidly than population
w increased significantly in the last century
Share of wages in output has been stable
Real interest rates oscillate, but there is no
• K/Y declined in the past century
• S/Y is stable
• Average gy has been 3%
Sources of economic growth
• Growth accounting is a method to separate impacts of
different variables on growth
• It was found out that labour contributes for ¾ of
economic growth, while capital contributes for ¼ of
• Growth accounting equation:
gY = ¾ gL + ¼ gK + g A
Where gY, gL, gK and gA stand for growth of output, labour,
capital and technology (total factor productivity growth).
Growth accounting equation for GDP p.c.:
gY/L = ¼ gK/L + gA
Economic development
• Developing country is a country with low per capita income
(GDP p.c.), mostly related to low levels of literacy, to
malnutrition, poor health and low capital stocks
• GDP p.c. is compared purchasing power parity is used (PPP)
because exchange rates understate incomes in developing
• E.g. bread in Egypt costs 1 EGP. Bread in UK costs 2 GBP. How
many loafs can an average Egyptian or an average Brit buy?
Average salary in Egypt is 100 EGP, in UK 2000 GBP and the
exchange rate EGP/GBP is 10.
• Answer: Egyptian can buy 100 loafs of bread, Brit 1000 loafs
of bread – Brit is 10 times better off. If salaries are compared,
Egyptian earns 100/10 = 10 GBP which is 200 times less than
a Brit.
Groups of developing countries
• East Asia and Pacific, Central Asia and parts of
Eastern Europe, Latin America and the Caribbean,
Middle East and North Africa. South Asia and
Sub-Saharan Africa
• Sub-Saharan Africa is the poorest, with lowest life
expectancy and the highest illiteracy rate of youth
• Human development: Development should
include also factors like health, life expectancy,
school enrollment, adult literacy, independence
of women, since GDP p.c. doesn’t tell everything.
• E.g. Greece has greater life expectancy than USA.
4 elements of development
1. Human resources
• Malthusian trap still holds for developing
countries since growth of population matches or
exceeds growth of income.
• One way to reduce population growth is active
birth control policy (China)
• The other way is to improve education which
causes birth rate to drop.
• Human capital is the quality of workforce,
increased by health and nutrition policy as well as
education policy.
2. Natural resources
• Developing countries mostly have little natural
resources, mostly arrable land
• The use can be improved through increase in
• Oil resources are mostly used by corrupt rulers
and not put into the economy, unlike
indeveloped countries like Norway, UK and
3. Capital formation
• Developing countries save too little, hence investment
is low (5%, as compared to developed countries with
• Vicious circle: low income – low savings – low
investment – low capital – low productivity – low
4. Technological change and innovation
• Developing countries can benefit from technological
development of developed countries – technology
• Entrepreneurial spirit is necessary to make country
receptive to new technologies
Strategies of economic development
1. The Backwardness Hypothesis – developing
countries can grow faster because they can use
technologies made in developed countries –
convergence occurs (low income countries grow
more rapidly)
2. Industrialization vs. Agriculture – income per
worker in industry and services is twice as big as
in agriculture – but how to make that shift?
3. State vs. Market – developing countries are
hostile towards market, which is the most
effective in distribution of resources and triggers
4. Growth and Outward Orientation
• Should developing countries attempt import
substitution with domestic production?
• How? By imposing quotas and high tariffs.
• East Asian countries overcome Latin countries in
GDP p.c. because they saved more and had open
economies, while Latin countries did import
• Too much openness can be a problem too:
Financial openness in 1998 it caused recession in
East Asia
• Open economy is an economy with low tariffs, no
quotas and open financial markets
• Government should provide healthy economic
- Rule of law
- Promote competition and innovation
- Government led investment in human capital
(education, health) and infrastructure
- Focus on market failures
- Deregulate in areas where government has
comparative disadvantage
Alternative models for development
Laissez faire – mixed capitalism – managed markets
– socialism - communism
• Alternative strategies:
1. Asian managed market approach: strong
government oversight & free market
2. Socialism (Western Europe, ex Yugoslavia):
welfare state, nationalized industry – recently
moved back to free market
3. Soviet – style communism – Entirely planned
Problem 1
• Nominal GDP of Croatia in 2014 was 57.865
Bill. USD and in the previous year it was
58.156 Bill. USD. What is nominal GDP growth
rate in Croatia in 2014?
gy = (GDPt/GDPt-1 -1)×100% =
(57.865/ 58.156 -1)×100% = -0.5%
Problem 2
• Let contribution of labour be 70% and
contribution of capital in an economy be 30%. A)
Find GDP and GDP p.c. growth rates if growth of
labour is -0.1%, growth of capital 0.5% and total
factor productivity growth 3%.
gY = 0.7gL + 0.3gK + gA = 0.7×(-0.1)+0.3×0.5+3=3,08%
gYpc = 0.3gK/L + gA = 0.3×0.5+3=3,15%
B) What would be the result if contribution of
labour and capital are equal and TFP growth fell
down to 1%?
gY = 0.5gL + 0.5gK + gA = 0.5×(-0.1)+0.5×0.5+1=1.2%
gYpc = 0.3gK/L + gA = 0.5×0.5+1=1.25%
Problem 3
• Slovenia had HDI (human development index)
0.876 in 2012 and United Arab Emirates 0.823 in
the same year, when Slovenia had 23100 USD
GDP per capita and UAE 41692 USD of GDP p.c.
What do you conclude?
• Slovenia has lower GDP p.c. but higher level of
development. It shows that GDP p.c. sometimes
fails to show the true level of development of an
economy. It also shows that there is high level of
inequality and a few own almost everything in
Problem 4
• How many years are needed to double GDP if
gy = 3.5%?
Yt = Y0×(1+gy)t
2Y = Y×1.035t
ln 2 = t ln 1.035
t = 20.15
It will take more than 20 years