Introduction

1. Chapter 7Growth, Capital Accumulation, and the Economics of Ideas: Catching Up vs. the Cutting Edge

2. Introduction • In 2006: • China: GDP per capita grew by 10% • United States: GDP per capita grew by 2.3% • 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? • Do the Chinese have a magical potion for growth?

3. Introduction • There are two types of growth • Catch-up growth • Takes advantage of ideas, technologies, or methods of management already in existence • Cutting-edge growth • Primarily about developing new ideas • China is growing much faster than the U.S. because: • The U.S. economy is on the cutting edge. • The Chinese economy is catching up.

4. Introduction • What do we learn in this chapter? • A model based on capital accumulation. • Explains catch-up growth. • Allows us to answer the following questions: • Why China is growing faster than the U.S. • Why the losers of WWII grew much faster than the winner. • How poor and rich countries can converge in income over time. • About cutting-edge growth and the economics of ideas.

5. The Solow Model and Catch-Up Growth • Robert Solow – Nobel Prize in Economics • 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”:

6. The Solow Model and Catch-Up Growth • For now, ignore changes in ideas, education, and labor so that A, e, and L are constant. The production function becomes: • MPK: marginal product of capital • The additional output resulting from using an additional • unit of capital. • As more capital is accumulated, the MPK gets smaller and smaller. • We draw a particular production function in the next slide where:

7. The Solow Model and Catch-Up Growth The “Iron Logic” of Diminishing Returns Output, Y 3.2 3 Conclusion: as more capital is added, MPK declines. 1 Capital, K 0 1 2 3 4 5 6 7 8 9 10 11 12

8. The Solow Model and Catch-Up Growth • Growth in China and the 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.

9. The Solow Model and Catch-Up Growth • Why Bombing a Country Can Raise Its Growth Rate. • Also explained by the “iron law”… • Much of the capital stock was destroyed during WWII. Therefore the MPKwas high. • Following the war, both Germany and Japan were able to achieve much higher growth rates than the U.S. as they “caught up”. • Check out the following table.

10. The Solow Model and Catch-Up Growth • Conclusions: • Catch-up growth (Germany, Japan) is much greater than cutting-edge growth (U.S.) • 2. Eventually the catch-up growth slows down.

11. 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.

12. The Solow Model and Catch-Up Growth • Capital Growth Equals Investment Minus Depreciation Output, Y 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

13. 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: • The next diagram shows that the amount of depreciation depends on the capital stock.

14. Capital Depreciation Depends on the Amount of Capital The Solow Model and Catch-Up Growth Depreciation Depreciation = 0.02∙K 8 6 4 2 0 Capital, K 0 100 200 300 400

15. The Solow Model and Catch-Up Growth • Capital Alone Cannot be the Key to Economic Growth • Again, the “iron logic of diminishing returns” explains this insight. Let’s see how this works. • As capital increases, • depreciation increases at a constant rate = d. • output increases at a diminishing rate. • Because investment is a constant fraction of output, at some point depreciation will equal investment. • The capital stock will stop growing. • Output will stop growing.

16. Capital Increases or Decreases Until Investment = Depreciation The Solow Model and Catch-Up Growth 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 inv. = dep. =4.5 At K = 100, Inv. > Dep. → ↑ K 0 100 200 225 300 400 Capital, K

17. Capital Increases or Decreases Until Investment = Depreciation The Solow Model and Catch-Up Growth • Check the Math • At K = 100, Y =√100 = 10 • Depreciation = 0.02x100 = 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 a 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.

18. The Solow Model and Catch-Up Growth • Capital Alone Cannot be the Key to Economic Growth (cont.) • 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

19. The Solow Model and Catch-Up Growth

20. 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 drive long-run economic growth. • What about technological knowledge?

21. The Solow Model and Catch-Up Growth • Better Ideas Drive Long-Run Economic Growth (cont.) • Technological knowledge • A way of getting more output from the same input (an increase in productivity). • We can include technological knowledge in our model by letting A stand for ideas that increase productivity. Therefore, let the production function be:

22. The Solow Model and Catch-Up Growth

23. The Solow Model and Catch-Up Growth • An Increase in A Increases Output Holding K Constant (cont.) • Conclusion: • Technological knowledge or more generally 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.

24. What happens to the marginal product of capital as more capital is added? • Why does capital depreciate? What happens to the total amount of capital depreciation as the capital stock increases?

25. The Solow Model – Details and Further Lessons • Let’s review what we know now: • 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. • These results are illustrated in the next two diagrams.

26. The Solow Model – Details and Further Lessons • When K is in steady state equilibrium, Y is in steady state equilibrium. • 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

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

28. What happens when the capital • stock is 400? • What is investment? • What is depreciation? • What happens to output?

29. The Solow Model – Details and Further Lessons • 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. • We show this result in the next diagram.

30. An Increase in the Investment Rate Increases Steady State Output The Solow Model – Details and Further Lessons Output, Y 20 15 Depreciation = 0.02∙K 10 5 Capital, K 0 100 200 225 300 400

31. The Solow Model – Details and Further Lessons • An Increase in the Investment Rate Increases Steady State Output (cont.) • The results presented in the previous diagram predict that: • An increase in investment rate, g, causes output to increase. • Because labor is held constant, output per capita also increases. • An important test of our model: • Are its predictions consistent with real world data? • The next figure suggests that they are.

32. The Solow Model – Details and Further Lessons

33. The Solow Model – Details and Further Lessons • An Increase in the Investment Rate Increases Steady State Output (cont.) • An Important Idea • 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. • These points are illustrated in following case study of South Korea.

34. 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.

35. The Solow Model – Details and Further Lessons • What Determines High Investment Rates? • Incentives which include • Low real interest rates • Low marginal tax rates • Institutions which include • Honest government • Secure property rights • One of the reasons that the investment rate increased in South Korea is that capitalists believed that their investments would be protected. • Effective financial intermediaries

36. 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 grow faster than richer countries. • The Solow model predicts that a country will grow faster the farther its capital stock is below its steady state value. • Conclusion: Conditional convergence is a prediction of the Solow model. • The next figure presents evidence of convergence.

37. The Solow Model – Details and Further Lessons

38. The Solow Model – Details and Further Lessons • From Catching Up to Cutting Edge • Several predictions of Solow model are consistent with the evidence. • Countries with higher investment rates have higher GDP per capita. • Countries grow faster the farther their capital stock is from the steady state level. • One prediction is NOT consistent with the evidence: • Steady state: Long-run growth = 0 • What explains the observed long-run growth? • Answer: Better ideas

39. The Solow Model – Details and Further Lessons • Solow and the Economics of Ideas in One diagram • Generation of 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.

40. The Solow Model – Details and Further Lessons • Solow and the Economics of Ideas in One diagram (cont.) Effect of ↑A from 1 to 1.5 Output, Y c 33.7 b Output ↑ Better Ideas 15 a Depreciation = 0.02∙K Capital Accumulation 225 506 Capital, K

41. What happens to investment and depreciation at the steady state level of capital? • In Figure 7.9, how much is consumed in the old steady state? How much is consumed in the new steady state? • Do countries grow faster if they are far below their steady state or if they are close? • Do countries with higher investment rates have a lower or higher GDP per capita?

42. Growing on the Cutting Edge: The Economics of Ideas • The United States and other developed regions such as Japan and Western Europe are on the cutting edge of economic growth. • In order to keep on growing these countries must develop new ideas to increase the productivity of capital and labor. • Conclusion: The economics of ideas becomes the key to growth on the cutting edge.

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. • Profits provide incentive to invest in R&D • Implication: Property rights, honest government, political stability, a dependable legal system, and competitive open markets help drive the generation of technological knowledge.

45. Growing on the Cutting Edge: The Economics of Ideas • Research and Development Is Investment for Profit (cont.). • Not just the number of scientists and engineers that are important • All kinds of people come up with new ideas. • Business culture and institutions are also important. • Institutions that are especially important: • Commercial settings that help innovators to connect with capitalists • Intellectual property rights • A high-quality education system

46. Growing on the Cutting Edge: The Economics of Ideas • Research and Development is Investment for Profit (cont.). • A commercial setting that helps innovators connect with capitalists. • Ideas without financial backers are sterile. • The U.S. is good at connecting innovators with businessmen and venture capitalists. • American culture supports entrepreneurs: • People like Apple CEO Steve Jobs are lauded in the popular media. • Contrast this to the treatment of 18th century British entrepreneur John Kay.

47. Growing on the Cutting Edge: The Economics of Ideas John Kay (1704-1780) invented the “flying shuttle” used in cotton weaving, the single most important invention launching the industrial revolution. Kay, however, was not rewarded for his efforts. His house was destroyed by “machine breakers,” who were afraid that his invention would put them out of a job. Kay was forced to flee to France where he died a poor man.

48. Growing on the Cutting Edge: The Economics of Ideas • Institutions that are especially important • 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. • Copied by other firms and Eiger Labs lost out in the competition. • Patents • Grant temporary monopoly. • Can slow down spread of technology. • Trade-off between creating incentives to research and develop new products and avoiding too much monopoly power = one of trickiest in economic policy

49. Growing on the Cutting Edge: The Economics of Ideas • Institutions that are especially important (cont.) • A high-quality education system • Important at all levels of education. • Creates necessary talent. • Universities generate basic and applied research.

50. Growing on the Cutting Edge: The Economics of Ideas • Spillovers, and Why There Aren’t Enough Good Ideas • Ideas are non-rivalrous. • Ideas can be used simultaneously. • Use of an idea by one individual does not mean less of the idea available to someone else. • The spillover or diffusion of new ideas generates widespread economic growth. • Implication: Spillovers mean that the generator of the idea doesn’t get all of the benefits. • Result: Too few ideas are produced. • Let’s see why.