Growth, Productivity, and the Wealth Of Nations

1. Growth, Productivity, and the Wealth Of Nations Chapter 8

2. 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

3. General Observations about Growth Growth increases the economy�s potential output.

4. Growth and the Economy�s Potential Growth is an increase in the amount of goods and services an economy produces. The study of growth is the study of why that increase comes about assuming that both labor and capital are fully employed.

5. Growth and the Economy�s Potential Growth is an increase in potential output.

6. Growth and the Economy�s Potential Long-run growth focuses on supply; it assumes Say�s Law � demand is sufficient to buy whatever is supplied.

7. Growth and the Economy�s Potential In the short run, economists consider potential output fixed.

8. Importance of Growth for Living Standards Growth is important for living standards. Long-term growth rates matter a lot because of compounding.

9. Importance of Growth for Living Standards This means that growth is based not only on original levels of income in a country, but also on the accumulation of previous years� increases in income.

10. Importance of Growth for Living Standards According to the rule of 72, dividing 72 by the rate of growth will give the number of years in which income will double.

11. Markets, Specialization, and Growth Markets and specialization lead to growth. Economic growth took off when markets began (early 1800s), and as they expanded, growth accelerated.

12. Markets, Specialization, and Growth Markets increase productivity through specialization and the division of labor.

13. Markets, Specialization, and Growth With increasing specialization and division of labor comes increasing productivity which creates a higher standard of living for everyone.

14. Markets, Specialization, and Growth This argument is reinforced by the principle of comparative advantage.

15. Economic Growth, Distribution, and Markets Markets are often seen to be unfair because of the effect they may have on the distribution of income. Markets may not provide equality of income but they do make the poor better off.

16. Economic Growth, Distribution, and Markets Would the poor be better off without markets?

17. Economic Growth, Distribution, and Markets Judged from a relative standard, it is not at all clear that markets require the large differentials in pay that has accompanied growth in market economies.

18. Per Capita Growth Per capita output is total output divided by total population. Per capita growth means producing more goods and services per person.

19. Per Capita Growth Per capita growth equals the percent change in output minus the percent change in population

20. Per Capita Growth The problem in many developing nations is that although GDP is rising, the population is rising even faster resulting in a lower per capita growth rate.

21. Per Capita Growth Some economists have argued that per capita (mean) output is not what we should be focusing on.

22. Per Capita Growth Median income is a better measure because it takes into account how income is distributed.

23. Per Capita Growth If the growth in income goes to a small majority of individuals who receive the majority of income, the mean will rise but the median will not.

24. Per Capita Growth Unfortunately, statistics on median income is generally not collected so economists use per capita income.

25. 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.

26. 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.

27. Investment and Accumulated Capital Capital accumulation does not necessarily lead to growth. Take the former Soviet Union, for example.

28. Investment and Accumulated Capital Products change, and useful buildings and machines in one time period may be useless in another.

29. Investment and Accumulated Capital Capital is much more than machines � it includes human and social capital.

30. Investment and Accumulated Capital All economists agree that the right kind of investment at the right time is a central element of growth.

31. 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.

32. Available Resources Technology plays an enormous role here.

33. Growth Compatible Institutions Growth-compatible institutions have built-in incentives that lead people to put forth effort and discourage loafing. When individuals get much of the gains of growth themselves, they work harder.

34. Growth Compatible Institutions Markets that feature private ownership of property foster economic growth.

35. Technological Development A larger aspect of growth involves changes in technology � changes in the goods and services we buy, and the way we create goods and services.

36. Technological Development Technological change does more than cause economic growth, it changes the entire social and political dimensions of society.

37. Entrepreneurship Entrepreneurship is the ability to get things done. That ability involves creativity, vision, and a talent for translating that vision into reality.

38. Turning the Sources of Growth into Growth In order to be effective, the five sources of growth must be mixed in the right proportions. It is the combination of investing in machines, people, and technological change that plays a central role in the growth of any economy.

39. The Production Function and Theories of Growth Economists� theories of growth have emphasized the production function. Production function �shows the relationship between the quantity of inputs used in production and the quantity of output resulting from production.

40. The Production Function and Theories of Growth This production function has land, labor, and capital as factors of production, and an adjustment factor, �A�, to capture the effect of technology: Output = A� f(Labor, Capital, Land)

41. The Production Function and Theories of Growth In talking about production functions, economists uses a couple of terms: scale economies and diminishing marginal productivity.

42. The Production Function and Theories of Growth Scale economies describe what happens when all inputs increase equally.

43. The Production Function and Theories of Growth Constant returns to scale means that output will rise by the same proportionate increase in all inputs.

44. The Production Function and Theories of Growth Increasing returns to scale occurs if output rises by a greater proportionate increase as all inputs.

45. The Production Function and Theories of Growth Decreasing returns to scale occurs if output rises by a smaller proportionate increase as all inputs.

46. The Production Function and Theories of Growth Diminishing marginal productivity describes what happens when more or one input is added without increasing any other inputs.

47. The Production Function and Theories of Growth The law of diminishing marginal productivity states that increasing one output, keeping all others constant, will lead to smaller and smaller gains in output.

48. The Classical Growth Model The Classical growth model is the standard theory of growth. The Classical growth model focuses on capital accumulation.

49. The Classical Growth Model Since investment leads to the increase in capital, Classical economists focused their analysis and their policy advice, on how to increase investment.

50. The Classical Growth Model The linkage was as follows: savings � investment � increases in capital � growth

51. Diminishing Marginal Productivity of Labor The Classical growth model focuses on diminishing marginal productivity of labor. See Figure 24-2.

52. Diminishing Marginal Productivity of Labor When farming was the major activity in the economy, Thomas Malthus, an early economist, emphasized the limitation land placed on growth.

53. Diminishing Marginal Productivity of Labor Since land was fixed, he predicted that diminishing marginal productivity would set in as population grew.

54. Diminishing Marginal Productivity of Labor The linkage was: economic surplus � population increases � output increases � lower per capita income � too many people � starvation

55. Diminishing Marginal Productivity of Labor This belief is called the iron law of wages Combined with diminished marginal productivity it led to the belief that in the long run there would be no surplus and therefore no growth. The long run was called the stationary state.

56. Diminishing Returns and Population Growth

57. Diminishing Marginal Productivity of Capital The Malthusians were dead wrong. Increases in technology and capital overwhelmed the law of diminishing marginal productivity. The focus turned to the marginal productivity of capital, not labor.

58. Diminishing Marginal Productivity of Capital The linkage was: capital grows faster than labor � capital is less productive � slower economic output � per capita growth stagnates � per capita income stops rising

59. Diminishing Marginal Productivity of Capital The Classicals also had a story about growth rates among nations.

60. Diminishing Marginal Productivity of Capital Poor countries with little capital should grow faster than countries with lots of capital.

61. Diminishing Marginal Productivity of Capital This has not happened either owing to the ambiguity in the definition of inputs and/or technological progress.

62. 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.

63. Ambiguities in the Definition of the Factors of Production But what of the difference between educated workers and workers less educated?

64. Ambiguities in the Definition of the Factors of Production Standard labor � the actual number of hours worked.

65. Ambiguities in the Definition of the Factors of Production Increases in human capital have allowed labor to keep pace with capital.

66. 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.

67. Ambiguities in the Definition of the Factors of Production Economists have estimates of the contribution of the factors to growth.

68. Technology Technology overwhelms diminishing marginal productivity so that growth rates can increase over time. Technology is growing faster in rich countries than in poor countries.

69. Sources of Real U.S. GDP Growth, 1928-1998

70. New Growth Theory New growth theory emphasizes the role of technology rather than capital in the growth process.

71. Technology Technology is the result of investment in creating technology (research and development). Investment in technology increases the technological stock of an economy.

72. Technology Growth theory separates investment in capital and investment in technology. Increases in technology are not as directly linked to investment as is capital.

73. Technology Increases in technology often have enormous positive spillover effects.

74. Technology Technological advances have positive externalities � positive effects on others not taken into account by the decision maker.

75. Technology Some basic research is protected by 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.

76. Technology Once people have seen the new technology, they figure out sufficiently different way to achieving the same end to avoid the patent.

77. Learning by Doing Learning by doing also leads to growth. New growth theory also highlights learning by doing � improving the methods of production through experience.

78. Learning by Doing If positive externalities flowing from learning by doing and new technologies overwhelm diminishing marginal productivity, economics can be called the �optimistic science,� not the �dismal science.�

79. Increasing Returns to Scale

80. Technological Lock-In Technological lock-in is an example of how sometimes the economy does not use the best technology available.

81. Technological Lock-In Technological lock-in occurs when old technologies become entrenched in the market, or locked into new products despite the fact that more efficient technologies are available.

82. Technological Lock-In One reason for technological lock-in is network externalities.

83. Technological Lock-In Switching from a technology exhibiting network externalities to a superior technology is expensive and sometimes nearly impossible.

84. Six Economic Policies to Encourage Per Capita Growth Policies to encourage saving and investment. Policies to control population growth. Policies to increase the level of education.

85. Six Economic Policies to Encourage Per Capita Growth Policies to create institutions that encourage technological innovation.

86. Policies to Encourage Saving and Investment Modern growth theories have downplayed the importance of capital in the growth process. All agree that it is important, however. Policy makers are eager to encourage both saving and investment.

87. Policies to Encourage Saving and Investment The U.S. has used tax incentives to increase saving.

88. Policies to Encourage Saving and Investment Some economists have proposed switching from an income tax to a consumption tax.

89. Policies to Encourage Saving and Investment It is difficult for poor countries to generate saving and investment.

90. The Borrowing Circle 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.

91. The Borrowing Circle The bank officer replaced collateral with the borrowing circle concept.

92. 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.

93. 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.

94. Policies to Control Population Growth Policies that reduce population growth include:

95. Policies to Control Population Growth Some economists argue that to reduce population growth, a nation must grow first.

96. Policies to Increase the Level of Education In developing nations, the return on investments in education is much higher than in developed nations.

97. Policies to Increase the Level of Education In the U.S., it is estimated that an additional year of school increases a worker�s wages by an average of 10 percent.

98. Policies to Increase the Level of Education Technical training in improved farming methods or construction is more important than higher education.

99. Policies to Create Institutions That Encourage Technological Innovation While all agree that that technology is important, no one is sure what the best technological growth policies are. Not only is research uncertain, so is its application.

100. Create Patents and Protect Property Rights Creating patents and protecting property rights are two ways to encourage innovation. However: Patents are not costless to society. Patents allow innovators to charge high prices for their use.

101. Patents and Developing Countries Should poor nations enforce U.S. patent law? Societies must find a middle ground between giving individuals appropriate incentives to create new technologies and allowing everyone to take advantage of the benefits of technology.

102. The Corporation and Financial Institutions The corporation and financial institutions encourage innovation.

103. The Corporation and Financial Institutions The corporation was invented to limit liability to its owners.

104. The Corporation and Financial Institutions Well-developed financial institutions such as stock markets create liquidity and encourage investment.

105. 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.

106. Provide Funding for Basic Research The U.S. government provides 60 percent of the basic research in the country.

107. Policies to Increase Openness to Trade In order to specialize, you need a large market. Large markets allow firms to take advantage of economies of scale.

108. Policies to Increase Openness to Trade The effect of markets on growth is an important reason why economists support policies that keep domestic markets as regulation free as possible and support international trade.

109. Growth, Productivity, and the Wealth Of Nations End of Chapter 8