Transcript Growth, Productivity, and the Wealth Of Nations

Growth, Productivity, and
the Wealth Of Nations
Chapter 8
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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
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General Observations about
Growth

Growth increases the economy’s potential
output.
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Growth and the Economy’s
Potential
Growth is an increase in the amount of
goods and services an economy produces.
 Growth is an increase in potential output.

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Growth and the Economy’s
Potential
Potential output – the highest amount of
output an economy can produce from the
existing production function and existing
resources.
 When an economy is at its potential
output, it is operating on its production
possibility curve.

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Growth and the Economy’s
Potential
Long-run growth focuses on supply.
 It assumes Say’s Law – supply creates its
own demand.

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Growth and the Economy’s
Potential
In the short run, economists consider
potential output fixed.
 They focus on how to get the economy
operating at its potential if it is not.

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Importance of Growth for
Living Standards
Growth improves living standards.
 It makes more goods available to more
people.
 Because of compounding, long-term
growth rates matter a lot.

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Importance of Growth for
Living Standards
The Rule of 72 is used to determine how
long it takes for income to double at
different growth rates.
 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.

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Markets, Specialization, and
Growth

Markets, specialization and the division of
labor increase productivity and growth.
Specialization – the concentration of
individuals on certain aspects of production
 Division of labor – the splitting up of a task to
allow for specialization of production.

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Economic Growth,
Distribution, and Markets

Markets are often seen to be unfair
because of the effect they have on the
distribution of income.
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Economic Growth,
Distribution, and Markets
Markets may not provide equality of
income but they make the poor better off.
 There is strong evidence that the poor
benefit enormously from the growth that
markets foster.

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Economic Growth,
Distribution, and Markets

Just because the poor benefit from growth
does not mean they might not be better off
if income were distributed more in their
favor.
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Cost of Goods in Hours of
Work
Milk (½ gallon)
Beef (1 pound)
Eggs (1 dozen)
Bread (1 pound)
1919
Chicken (3 lb. fryer)
Milk (½ gallon)
Beef (1 pound)
Eggs (1 dozen)
Bread (1 pound)
Chicken (3 lb. fryer)
1997
0
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50
100
Price in minutes of work
150
200
Per Capita Growth
Per capita output is total output divided by
total population.
 Per capita growth means producing more
goods and services per person.

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Per Capita Growth

Per capita growth equals the percent
change in output minus the percent change
in population
Per capita growth =
% change in output - % change in population
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Per Capita Growth

In many developing nations, the population
is rising faster than GDP, resulting in a
lower per capita growth rate.
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Per Capita Growth
Some economists have argued that per
capita (mean) output is not what we should
be focusing on.
 We should focus on median income
instead.

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Per Capita Growth

Median income is a better measure
because it takes into account how income
is distributed.
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Per Capita Growth
If the growth in income goes mostly to a
small minority of individuals, the mean will
rise but the median will not.
 Because statistics on median income is
generally not collected, economists use per
capita income.

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The Sources of Growth

Economists identify five important sources
of growth:
Capital accumulation – investment in
productive capacity.
 Available resources.
 Growth compatible institutions.
 Technological development.
 Entrepreneurship.

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Investment and Accumulated
Capital
Years ago it was thought that physical
capital and investment were the keys to
growth.
 The flow of investment lead to the growth
of the stock of capital.

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Investment and Accumulated
Capital
Capital accumulation does not necessarily
lead to growth.
 Products change, and useful buildings and
machines in one time period may be
useless in another.

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Investment and Accumulated
Capital

Capital is much more than machines – it
includes human and social capital.
Human capital – the skills that are embodied
in workers through experience, education, onthe-job training.
 Social capital – the habitual way of doing
things that guides people in how they
approach production.

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Investment and Accumulated
Capital

All economists agree that the right kind of
investment at the right time is a central
element of growth.
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Available Resources
For an economy to grow it will need
resources.
 What constitutes a resource at one time
may not be a resource at another time.

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Available Resources
Technology plays an enormous role here.
 Greater participation in the market is
another way by which available resources
are increased.

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Growth-Compatible
Institutions
Markets and private ownership of property
foster economic growth.
 When individuals get much of the gains of
growth themselves, they work harder.

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Growth-Compatible
Institutions
Another growth-compatible institution is the
corporation.
 Because of limited liability, corporations
give owners and incentive to invest their
savings in large enterprises.

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Growth-Compatible
Institutions

Mercantilist economic policies inhibit
economic growth.
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Technological Development
Growth isn’t just getting more of the same
thing.
 It’s also getting some things that are
different.

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Technological Development
Growth involves changes in technology.
 Technology – changes the way we make
goods and supply services, and in the
goods and services we buy.

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Entrepreneurship
Entrepreneurship is the ability to get things
done.
 That ability involves creativity, vision, and a
talent for translating that vision into reality.

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Turning the Sources of Growth
into Growth

In order to be effective, the five sources of
growth must be mixed in the right
proportions.
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Turning the Sources of Growth
into Growth

It is the combination of investing in
machines, people, and technological
change that plays a central role in the
growth of any economy.
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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.
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The Production Function and
Theories of Growth
The production function for growth has
land, labor, and capital as factors of
production.
 “A” is an adjustment factor that captures
the effect of technology.

Output = A• f(Labor, Capital, Land)
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Describing Production
Functions

Scale economies describe what happens
in a production function when all inputs
increase equally.
Constant returns to scale.
 Increasing returns to scale.
 Decreasing returns to scale.

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Describing Production
Functions

Constant returns to scale means that
output will rise by the same proportionate
increase in all inputs.
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Describing Production
Functions

Increasing returns to scale occurs when
output rises by a greater proportionate
increase as all inputs.
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Describing Production
Functions

Decreasing returns to scale occurs when
output rises by a smaller proportionate
increase as all inputs.
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Describing Production
Functions

Diminishing marginal productivity
describes what happens when more of one
input is added without increasing any other
inputs.
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Describing Production
Functions

The law of diminishing marginal
productivity states that increasing one
output, keeping all others constant, will
lead to smaller and smaller gains in output.
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The Classical Growth Model
The Classical growth model focuses on
capital accumulation in the growth process.
 The more capital an economy has, the
faster it will grow.
 Because of this emphasis on capital,
market economies are called capitalist
economies.

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The Classical Growth Model

Classical economists focused their
analysis and their policy advice, on how to
increase investment:
savings  investment 
increases in capital  growth
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Focus on Diminishing
Marginal Productivity of Labor
The Classical growth model focused on
how diminishing marginal productivity of
labor placed limitations on growth.
 Farming was the major economic activity
and land was relatively fixed.

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Focus on Diminishing
Marginal Productivity of Labor
Since land was fixed, diminishing marginal
productivity would set in as population
grew.
 As output per person declines, at some
point available output is no longer sufficient
to feed the population.

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Focus on Diminishing
Marginal Productivity of Labor
This belief is called the iron law of wages.
 The long run was called the stationary
state.

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Diminishing Returns and
Population Growth
Subsistence level of output
per worker
Output
Production
function
Q2
Q1
L1
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L*
Labor
Diminishing Marginal
Productivity of Capital
The predictions of the stationary state
turned out to be wrong.
 Increases in technology and capital
overwhelmed the law of diminishing
marginal productivity.

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Diminishing Marginal
Productivity of Capital

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
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Diminishing Marginal
Productivity of Capital
Diminishing marginal productivity would be
stronger for richer nations than for poor
ones.
 Poor countries with little capital should
grow faster than countries with lots of
capital.

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Diminishing Marginal
Productivity of Capital
Eventually per capita incomes among
nations would converge.
 This has not happened either:

The ambiguity in the definition of inputs.
 Technological progress.

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Ambiguities in the Definition
of the Factors of Production
The definition of the factors of production
are ambiguous.
 It would seem that the definition of labor
would be straightforward – the hours of
work that go into production.

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Ambiguities in the Definition
of the Factors of Production
Economists separate labor into two
components.
 Standard labor – the actual number of
hours worked.
 Human capital – the skills embedded in
workers through experience, education,
and on-the-job training.

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Ambiguities in the Definition
of the Factors of Production
Increases in human capital have allowed
labor to keep pace with capital.
 This allows economies to avoid the
diminishing productivity of capita.

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Ambiguities in the Definition
of the Factors of Production

If skills are increasing faster in a rich
country than in a poor one, incomes would
not be expected to converge.
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Technology

Technology overwhelms diminishing
marginal productivity so that growth rates
can increase over time.
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Empirical Estimates of Factor
Contribution to Growth

Economist Edward Denison estimated the
importance of each of the sources of
growth.
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Sources of Real U.S. GDP
Growth, 1928-2000
Physical capital (19%)
Labor (33%)
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Human capital (13%)
Technology (35%)
New Growth Theory

New growth theory emphasizes the role
of technology rather than capital in the
growth process.
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Technology
Technology is the result of investment in
creating technology (research and
development).
 Investment in technology increases the
technological stock of an economy.

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Technology
Growth theory separates investment in
capital and investment in technology.
 Increases in technology are not as directly
linked to investment as is capital.

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Technology
Increases in technology often have
enormous positive spillover effects.
 Technological advances in one sector of
the economy lead to advances in
completely different sectors.

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Technology

Technological advances have positive
externalities.

Positive externalities – positive effects on
others not taken into account by the decision
maker.
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Technology

Some basic research is protected by
patents.

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.
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Technology

Once people have seen the new
technology, they figure out sufficiently
different way to achieving the same end to
avoid the patent.
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Learning by Doing
New growth theory also highlights learning
by doing.
 Learning by doing – improving the
methods of production through experience.

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Learning by Doing

By increasing the productivity of workers,
learning by doing overcomes the law of
diminishing marginal productivity.
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Increasing Returns to Scale
Output
Production function
with increasing
returns
All inputs
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Technological Lock-In

Technological lock-in is an example of how
sometimes the economy does not use the
best technology available.
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Technological Lock-In
Technological lock-in occurs when old
technologies become entrenched in the
market.
 They become locked into new products
despite the fact that more efficient
technologies are available.

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Technological Lock-In
One reason for technological lock-in is
network externalities.
 Network externalities – an externality in
which the use of a good by one individual
makes that technology more valuable to
other people.

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Technological Lock-In

Switching from a technology exhibiting
network externalities to a superior
technology is expensive and sometimes
nearly impossible.
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Economic Policies to Encourage
Per Capita Growth
Encourage saving and investment.
 Control population growth.
 Increase the level of education.
 Create institutions that encourage
technological innovation.
 Provide funding for basic research.
 Increase the economy’s openness to trade.

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Policies to Encourage Saving
and Investment
Modern growth theories have downplayed
the importance of capital in the growth
process.
 However, all agree that it is important.
 Policy makers are eager to encourage both
saving and investment.

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Policies to Encourage Saving
and Investment
The U.S. has used tax incentives to
increase saving.
 Because they don’t have much
discretionary income, it is difficult for
poor countries to generate saving and
investment.

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A Case Study: Micro Credit

The borrowing circle of Grameen bank is
an example of how to increase investment
in a developing nation.
The traditional way of lending money is to ask
for collateral.
 In Bangladesh, potential borrowers had no
collateral.

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A Case Study: Micro Credit

The bank officer replaced collateral with
the borrowing circle concept.
Borrowing circle concept – a credit system
that replaces traditional collateral with
guarantees by friends of the borrower.
 In case of a default, the friends had to make
the loan good.

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Growth Through Foreign
Investment

Foreign investment provides another
source of saving.
Developing nations can borrow from the IMF,
the World Bank, or from private sources.
 None of these are perfect solutions since they
come with large strings attached.

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Policies to Control Population
Growth
Developing nations whose populations are
rapidly growing have difficulty providing
enough capital and education for everyone.
 Thus, per capita income is low.

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Policies to Control Population
Growth

Policies that reduce population growth
include:
Free family–planning services.
 Increasing the availability of contraceptives.
 Harsh mandatory one-child-per-family
policies such as China adopted in 1980.

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Policies to Control Population
Growth

Some economists argue that to reduce
population growth, a nation must grow first.

As income and work opportunities rise,
especially for women, the opportunity cost of
having children rises and families will choose
to have fewer children.
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Policies to Increase the Level of
Education

Increasing the educational level and skills
of the workforce increases labor
productivity.
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Policies to Create Institutions
That Encourage Technological
Innovation
Unlike capital, technological innovation can
occur without investment.
 Conversely, investment in technology can
result in no technological innovation.

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Create Patents and Protect
Property Rights
Patents and protecting property rights are
two ways to encourage innovation.
 Patents are not costless to society.
 Patents allow innovators to charge high
prices for their use.

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Create Patents and Protect
Property Rights

Societies must find a middle ground
between providing incentives to create new
technologies and allowing everyone to take
advantage of the benefits of technology.
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Patents and Developing
Countries
Poor nations are reluctant to enforce U.S.
patents.
 The U.S. often uses trade policy to attempt
to force developing countries to do so.

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The Corporation and Financial
Institutions
Limited liability encourages investors to
pool their funds.
 Bringing technological innovations to
markets often requires large amounts of
investment over a number of years.

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The Corporation and Financial
Institutions

Well-developed financial institutions such
as stock markets create liquidity and
encourage investment.
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Provide Funding for Basic
Research
Individual firms have little incentive to do
basic research because of technology’s
“common knowledge” aspect.
 This is where the government steps in.
 The U.S. government provides 60 percent
of the basic research in the country.

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Policies to Increase Openness
to Trade
Free trade increases growth by broadening
the market and by fostering competition.
 In order to specialize, you need a large
market.
 Large markets allow firms to take
advantage of economies of scale.

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Growth, Productivity, and
the Wealth Of Nations
End of Chapter 8
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