Growth, Capital Accumulation, and the Economics of Ideas: Catching Up vs. the Cutting Edge

1. Growth, Capital Accumulation, and the Economics of Ideas: Catching Up vs. the Cutting Edge

2. The Solow Model and Catch-Up Growth The Solow Model- Details and Further Lessons (Optional Section) Growing on the Cutting Edge: the Economics of Ideas The Future of Economic Growth For applications, click here To Try it! questions To Video

4. Introduction • In 2010 China: GDP per capita grew by 10% • U.S: GDP per capita grew by 2.2 % • United States has never grown as fast as the Chinese economy is growing today. • Why is China growing more rapidly than the U.S.? • Is there something wrong with the U.S. economy?

5. Introduction • There are two types of growth • Catch-up growth • takes advantage of ideas, technologies, or methods of management already in existence • focuses on capital accumulation • Cutting-edge growth • developing new ideas • focuses on developing new technology for resources.

6. The Solow Model and Catch-Up Growth • Robert Solow (Nobel Prize Laureate) • Total Output, Y, of an economy depends on: • Physical capital: K • Human capital: education x Labor = eL • Ideas: A • This can be expressed as the following “production function”:

7. The Solow Model and Catch-Up Growth • For now, ignore changes in ideas, education, and labor so that A, e, andL are constant. The production function becomes: • If L is constant, then increases in K mean more capital per worker • MPK: marginal product of capital : The additional output resulting from using an additional unit of capital. • MPK diminishes the more capital is added.

8. The Solow Model and Catch-Up Growth

9. Growth in China and United States • The “iron logic of diminishing returns”largely explains why… • The Chinese economy is able to grow so rapidly. • It turned toward markets which increased incentives. • The capital stock was low. • The MPK was high. • China will not be able to achieve these high growth rates indefinitely.

10. The Solow Model and Catch-Up Growth • Why Bombing a Country Can Raise Its Growth Rate: • Much of the capital stock was destroyed during WWII- so MPKwas high. • After the war, Germany and Japan had much higher growth rates than the U.S. as they “caught-up.”

11. To next Try it! The adoption of computers in the workplace has lead to a(n) increase in the supply of labor because people are needed to operate the computers. increase in labor productivity because computers are a capital good. decrease in labor productivity because computers are a capital good. decrease in human capital because computers are physical capital.

12. The first $500 spent on a computer for each of these kids yields a lot. The second $500? Not as big an increase.

13. The Solow Model and Catch-Up Growth • Capital Growth Equals Investment minus Depreciation • Capital is “output that is saved and invested.” • Let gbe the fraction of output that is invested in new capital. • The next figure shows how output is divided between consumption and investment when g= 0.3. (30% of additional output is saved and put into new capital)

14. The Solow Model and Catch-Up Growth Output, Y Capital Growth Equals Investment Minus Depreciation 20 15 10 5 3 2 0 When K = 100, Output = 10 Consumption = (1- 0.3) x 10 = 7 Investment = 0.3∙Y Investment = (0.3) x 10 = 3 Capital, K 0 100 200 300 400

15. The Solow Model and Catch-Up Growth • Capital Growth Equals Investment minus Depreciation (cont.). • Depreciation: amount of capital that wears out each period • Let dbe the fraction of capital that wears out each period. This is called the depreciation rate so that:

16. The Solow Model and Catch-Up Growth Capital Depreciation Depends on the Amount of Capital Depreciation Depreciation = 0.02∙K 6 4 2 0 Capital, K 0 100 200 300 400

17. The Solow Model and Catch-Up Growth • Capital Alone Cannot be the Key to Economic Growth. Why? • As capital increases, • depreciation increases at a constantrate of d • output increases at a diminishingrate. • Because investment is a constant fraction of output, at some point depreciation will equal investment. • The capital stock will stop growing & output slows.

18. The Solow Model and Catch-Up Growth Capital Increases or Decreases Until Investment = Depreciation GDP, Y Depreciation = 0.02∙K 8 6 4.5 4 3 2 0 At K = 400, Inv. < Dep. → ↓ K Investment = 0.3∙Y Result: equilibrium at K = 225, Y = 4.5 investment = depreciation =4.5 At K = 100, Inv. > Dep. → ↑ K Capital, K 0 100 200 225 300 400

19. Capital Adjusts Until Investment = Depreciation • Check the Math • At K = 100, Y =√100 = 10 • Depreciation = 0.02∙100 = 2 • Investment = 0.3x10 = 3 • Investment > Depreciation • Result: K and Y grow. • Check the Math • At K = 225, Y =√225 =15 • Depreciation = 0.02x225 = 4.5 • Investment = 0.3x15 = 4.5 • Investment = Depreciation • Result: • Investment = Depreciation • K and Y are constant. • This is steady state. • Check the Math • At K = 400, Y =√400 = 20 • Depreciation = 0.02x400 = 8 • Investment = 0.3x20 = 6 • Investment < Depreciation • Result: K and Y decrease.

20. The Solow Model and Catch-Up Growth • The logic of diminishing returns means that eventually capital and output will cease growing. • Therefore, other factors must be responsible for long run economic growth. • Consider: • Human capital:knowledge, skills, experience • Technological knowledge:better ideas

21. Human Capital Investment Pays Off

22. The Solow Model and Catch-Up Growth • Better Ideas Drive Long Run Economic Growth • Human Capital • Like capital, it is subject to diminishing returns and it depreciates. • Logic of diminishing returns also applies to human capital. • Conclusion: Human capital also cannot alone drive long-run economic growth. • (What about technological knowledge?)

23. The Solow Model and Catch-Up Growth • Better Ideas Drive Long Run Economic Growth • Technological knowledge: • Is a way of getting more output from the same input (an increase in productivity). • We represent this in our model by letting Astand for ideas that increase productivity. Now the production function is:

24. The Solow Model and Catch-Up Growth Increasing technology (even while holding K constant) creates a higher growth rate.

25. The Solow Model and Catch-Up Growth • An Increase in A Increases Output Holding K Constant • Conclusion: • Technological knowledge / better ideas are the key to long run economic growth. • Solow estimated that better ideas are responsible for ¾ of our increased standard of living.

26. Click below for one of the authors’ TED talks….The "dismal science" truly shines in this optimistic talk, as economist Alex Tabarrok argues free trade and globalization are shaping our once-divided world into a community of idea-sharing more healthy, happy and prosperous than anyone's predictions. (14:37 minutes)

27. Roman aquaducts: ushering in an era of economic growth… Aquaducts were sophisticated feats of engineering that enabled population and industry to thrive. -Roman Aquaduct in Segovia, Spain, built in 2nd century A.D./C.E.

28. The Solow Model –Details and Further Lessons • What we know so far: • If Investment > Depreciation → K and Y grow. • If Investment < Depreciation → K and Y fall. • If Investment = Depreciation → K and Y are constant. • Two important conclusions: • Steady state equilibrium occurs when investment equals depreciation. • When K is in steady state equilibrium, Y is in steady state equilibrium.

29. The Solow Model – Details and Further Lessons • When K is in steady state equilibrium, Y is in steady state equilibrium. Output, Y Depreciation = 0.02∙K 8 6 4.5 4 3 2 0 Investment = 0.3∙Y The Steady State K is found where Investment = Depreciation Capital, K 0 100 200 225 300 400

30. The Solow Model – Details and Further Lessons • When K is in steady state equilibrium, Y is in steady state equilibrium. Output, Y 20 Steady state output 15 Depreciation = 0.02∙K 10 5 Steady state capital stock Capital, K 225 0 100 200 300 400

31. The Solow Model – Details and Further Lessons • The Solow Model and an Increase in the Investment Rate • What happens when g, (the fraction of output that is saved and invested) increases? • ↑ g K ↑ Y • Conclusion: an increase in the investment rate increases a country’s steady state level of GDP. • Countries with higher rates of investment will be wealthier.

32. The Solow Model – Details and Further Lessons GDP per Capita is Higher in Countries with Higher Investment Rates

33. An Increase in the Investment Rate Increases Steady State Output Output, Y 20 15 Depreciation = 0.02∙K 10 5 Capital, K 400 0 100 200 225 300

34. To next Try it! In the Solow model, if the depreciation rate increases, what happens to the steady state capital level and output level? they both increase they both decrease The steady state capital stock will increase and the output will decrease. The steady state capital stock will decrease and the output will increase.

35. The Solow Model – Details and Further Lessons • Note: • An increase in the investment rate = ↑ steady state level of output. • As the economy moves from the lower to the higher steady state output = ↑ growth rate of output. • This higher growth rate is temporary. • Conclusion: ↑ investment rate = ↑ steady state level of output but not its long-run growth rate.

36. The Solow Model – Details and Further Lessons • The Case of South Korea • In 1950, South Korea was poorer than Nigeria. • 1950s: the investment rate was < 10%. • 1970s: Investment rate more than doubled. • 1990s: Investment rate increased to over 35%. • South Korea’s GDP increased rapidly. • As GDP reached Western levels, the growth rate has slowed…

37. What economic growth looks like at night

38. The Solow Model – Details and Further Lessons • The Solow Model and Conditional Convergence • Conditional Convergence:Among countries with similar steady state levels of output, poorer countries tend to grow faster than richer countries, and so converge in income. • The Solow model predicts that a country will grow faster the farther its capital stock is below its steady state value. • Solow predicts conditional convergence.

39. The Solow Model – Details and Further Lessons The poorer the OECD country in 1960, the faster its growth.

40. The Solow Model – Details and Further Lessons • Solow and the Economics of Ideas in one diagram • New ideas results in long run economic growth. • Let’s see how this works: • We begin at steady state equilibrium. • New ideas → ↑A → ↑Output at every level of K • ↑ Output → ↑Investment → Investment > Depreciation →↑ K→ ↑ Output (movement along new production function). • As ideas continue to grow, output continues to grow.

41. Solow and the Economics of Ideas in One Diagram Effect of ↑A from 1 to 1.5 Output, Y c 33.7 b Output ↑ Better Ideas 15 a Capital Accumulation Depreciation = 0.02∙K 225 506 Capital, K Old steady state capital stock New steady state capital stock

42. The Solow Model – Details and Further Lessons • The Big Question: What Determines High Investment Rates? • Incentives which include: • Low real interest rates • Low marginal tax rates • Institutions which include: • Honest government • Secure property rights • Effective financial intermediaries (banks)

43. Growing on the Cutting Edge: The Economics of Ideas • The Economics of Ideas • Ideas for increasing output are primarily researched, developed, and implemented by profit-seeking firms. • Spillovers mean that ideas are underprovided. • Government has a role in improving the production of ideas. • The larger the market, the greater the incentive to research and develop new ideas.

44. Growing on the Cutting Edge: The Economics of Ideas • Research and development is investment for profit. • Keys to increasing technological knowledge: • Incentives • Institutions that encourage investment in physical and human capital and R&D. • 70% of scientists and engineers in the U.S. work for private firms.

45. Growing on the Cutting Edge: The Economics of Ideas • Research and development is investment for profit (continued) • All kinds of people come up with new ideas. • Business culture and institutions are also important. • Appreciation of entrepreneurs is a relatively recent phenomenon. • Institutions that are especially important: • Commercial settings that help innovators to connect with capitalists • Intellectual property rights • A high-quality education system

46. John Kay (1704-1780) invented the “flying shuttle”used in cotton weaving, the single most important invention launching the industrial revolution. Kay was rewarded for his efforts by having his house destroyed by “machine breakers,” afraid of job loss. He died a poor man. John Kay, “destroyer of jobs.”

47. Growing on the Cutting Edge: The Economics of Ideas • Institutions that increase R & D • A commercial setting that helps innovators connect with capitalists. • Ideas without financial backers are dead. • The U.S. is good at connecting innovators with businessmen and venture capitalists. • American culture supports entrepreneurs.

48. Growing on the Cutting Edge: The Economics of Ideas • Intellectual property rights • New processes, products, and methods can be copied by competitors. • World’s first MP3 player was the Eiger Labs “MPMan” introduced in 1998. • Eiger Labs lost out to competition. • Patentsgrant temporary monopoly. • But they can slow down the spread of technology.

49. Profits provide incentive to invest in R&D: Property rights, honest government, political stability, a dependable legal system, and competitive open markets create profit and so help drive the generation of technological knowledge. “The patent system…added the fuel of interest to the fire of genius” -Abraham Lincoln, 1859 (only U.S. President to have been granted a patent)

50. Growing on the Cutting Edge: The Economics of Ideas • A high-quality education system • Important at all levels of education. • Creates necessary talent. • Universities generate basic and applied research.