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 economys potential output.

4
Growth and the Economys 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 Economys Potential

• Growth is an increase in potential output.

6
Growth and the Economys Potential

• Long-run growth focuses on supply it assumes
  Says Law demand is sufficient to buy whatever
  is supplied.

7
Growth and the Economys 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.

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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.

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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.

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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.

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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.
• Take the former Soviet Union, for example.

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Investment and Accumulated Capital

• 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.

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.

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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 Þ investment Þ increases in capital Þ
  growth

51
Diminishing Marginal Productivity of Labor

• The Classical growth model focuses on diminishing
  marginal productivity of labor. See Figure 24-2.

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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.

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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 Þ population increases Þ output
  increases Þ lower per capita income Þ too many
  people Þ 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
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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.

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Diminishing Marginal Productivity of Capital

• The linkage was
• capital grows faster than labor Þ capital is less
  productive Þ slower economic output Þ per capita
  growth stagnates Þ per capita income stops rising

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Diminishing Marginal Productivity of Capital

• The Classicals also had a story about growth
  rates among nations.

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Diminishing Marginal Productivity of Capital

• Poor countries with little capital should grow
  faster than countries with lots of capital.

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Diminishing Marginal Productivity of Capital

• This has not happened either owing to the
  ambiguity in the definition of inputs and/or
  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

• But what of the difference between educated
  workers and workers less educated?

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Ambiguities in the Definition of the Factors of
Production

• Standard labor the actual number of hours
  worked.

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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.

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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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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.

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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.

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.

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Technology

• Increases in technology often have enormous
  positive spillover effects.

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Technology

• Technological advances have 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
  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

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

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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.

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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.

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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.

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Technological Lock-In

• One reason for technological lock-in is network
  externalities.

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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.

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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.

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Policies to Encourage Saving and Investment

• The U.S. has used tax incentives to increase
  saving.

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Policies to Encourage Saving and Investment

• Some economists have proposed switching from an
  income tax to a consumption tax.

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Policies to Encourage Saving and Investment

• It is difficult for poor countries to generate
  saving and investment.

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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.

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The Borrowing Circle

• The bank officer replaced collateral with the
  borrowing circle concept.

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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.

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.

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Policies to Control Population Growth

• Policies that reduce population growth include

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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.

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Policies to Increase the Level of Education

• In the U.S., it is estimated that an additional
  year of school increases a workers wages by an
  average of 10 percent.

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Policies to Increase the Level of Education

• Technical training in improved farming methods or
  construction is more important than higher
  education.

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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.

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The Corporation and Financial Institutions

• The corporation was invented to limit liability
  to its owners.

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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 technologys 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.

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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.

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Growth, Productivity, and the Wealth Of Nations

• End of Chapter 8

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