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© 2003 McGraw-Hill Ryerson Limited. Growth, Growth, Productivity, and Productivity, and the Wealth Of the Wealth Of Nations Nations Chapter 8 Chapter 8
© 2003 McGraw-Hill Ryerson Limited.
Growth, Growth, Productivity, and the Productivity, and the
Wealth Of NationsWealth Of Nations
Chapter 8Chapter 8
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Laugher CurveLaugher CurveWe 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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Growth and the Growth and the Economy’s PotentialEconomy’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 labour and capital are fully employed.
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Growth and the Growth and the Economy’s PotentialEconomy’s Potential Growth is an increase in potential
output. When an economy is at its potential
output, it is operating on its production possibility curve.
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Growth and the Growth and the Economy’s PotentialEconomy’s Potential Long-run growth focuses on supply; it
assumes Say’s Law – demand is sufficient to buy whatever is supplied.
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Growth and the Growth and the Economy’s PotentialEconomy’s Potential In the short run, economists consider
potential output fixed. They focus on how to get the economy
operating at its potential if, for some reason, it is not.
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Importance of Growth Importance of Growth for Living Standardsfor Living Standards Growth is important for living standards. Long-term growth rates matter a lot
because of compounding. 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.
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Importance of Growth Importance of Growth for Living Standardsfor 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.
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Markets, Markets, Specialization, and Specialization, and GrowthGrowth Markets and specialization lead to
growth. Economic growth began when markets
developed (early 1800s), and as they expanded, growth accelerated.
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Markets, Markets, Specialization, and Specialization, and GrowthGrowth Markets increase productivity through
specialization and the division of labour. Specialization – the concentration of
individuals on certain aspects of production
Division of labour – the splitting up of a task to allow for specialization of production.
Productivity – output per unit of input.
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Markets, Markets, Specialization, and Specialization, and GrowthGrowth With increasing specialization and
division of labour comes increasing productivity which creates a higher standard of living.
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Markets, Markets, Specialization, and Specialization, and GrowthGrowth This argument is reinforced by the
principle of comparative advantage. Production possibilities rise when people
concentrate on producing those goods for which their skills and other resources are suited, and trade for those goods for which they do not have a comparative advantage.
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Economic Growth, Economic Growth, Distribution, and Distribution, and MarketsMarkets 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, Economic Growth, Distribution, and Distribution, and MarketsMarkets Would the poor be better off without
markets? Historically, judged from an absolute
standard, there is strong evidence that the poor benefit enormously from the growth that markets foster.
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Economic Growth, Economic Growth, Distribution, and Distribution, and MarketsMarkets 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 GrowthPer 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 GrowthPer Capita Growth Per capita growth equals the percent
change in output minus the percent change in population
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Per Capita GrowthPer 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.
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Per Capita GrowthPer Capita Growth Some economists have argued that per
capita (mean) output is not what we should be focusing on.
Instead we should focus on median income.
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Per Capita GrowthPer Capita Growth Median income is a better measure
because it takes into account how income is distributed.
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Per Capita GrowthPer 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.
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Per Capita GrowthPer Capita Growth Unfortunately, statistics on median
income is generally not collected so economists use per capita income.
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The Sources of GrowthThe 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 Investment and Accumulated CapitalAccumulated 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 Investment and Accumulated CapitalAccumulated Capital Capital accumulation does not
necessarily lead to growth. Take the former Soviet Union, for
example. They invested a lot, but did not grow much.
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Investment and Investment and Accumulated CapitalAccumulated Capital Products change, and useful buildings
and machines in one time period may be useless in another.
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Investment and Investment and Accumulated CapitalAccumulated 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, on-the-job training, and:
Social capital – the habitual way of doing things that guides people in how they approach production.
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Investment and Investment and Accumulated CapitalAccumulated 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 ResourcesAvailable 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 ResourcesAvailable 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 Growth Compatible InstitutionsInstitutions 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.
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Growth Compatible Growth Compatible InstitutionsInstitutions Markets that feature private ownership
of property foster economic growth. Mercantilist economies that feature
bribes inhibit economic growth.
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Technological Technological DevelopmentDevelopment 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.
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Technological Technological DevelopmentDevelopment Technological change does more than
cause economic growth, it changes the entire social and political dimensions of society.
As in other things, there are tradeoffs when new technology is introduced.
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EntrepreneurshipEntrepreneurship 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 Turning the Sources of Growth into GrowthGrowth 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.
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The Production The Production Function and Theories Function and Theories of Growthof 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 The Production Function and Theories Function and Theories of Growthof Growth This production function has land,
labour, and capital as factors of production, and an adjustment factor, “A”, to capture the effect of technology:
Output = A• f(Labour, Capital, Land)
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The Production The Production Function and Theories Function and Theories of Growthof Growth In talking about production functions,
economists use a couple of terms: scale economies and diminishing marginal productivity.
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The Production The Production Function and Theories Function and Theories of Growthof Growth Scale economies describe what happens
when all inputs increase equally. Constant returns to scale means that
output will rise by the same proportionate increase as all inputs.
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The Production The Production Function and Theories Function and Theories of Growthof Growth Increasing returns to scale occur if
output rises by a greater proportionate increase than all inputs.
Decreasing returns to scale occur if output rises by a smaller proportionate increase than all inputs.
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The Production The Production Function and Theories Function and Theories of Growthof Growth Diminishing marginal productivity
describes what happens when more of one input is added without increasing any other inputs.
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The Production The Production Function and Theories Function and Theories of Growthof Growth The law of diminishing marginal
productivity states that increasing one input, keeping all others constant, will lead to smaller and smaller gains in output.
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The Classical Growth The Classical Growth ModelModel The Classical growth model is the
standard theory of growth. The Classical growth model focuses on
capital accumulation.
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The Classical Growth The Classical Growth ModelModel Since investment leads to the increase
in capital, Classical economists focused their analysis and their policy advice, on how to increase investment.
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The Classical Growth The Classical Growth ModelModel The linkage was as follows:
savings investment increases in capital growth
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Diminishing Marginal Diminishing Marginal Productivity of LabourProductivity of Labour The Classical growth model focuses on
diminishing marginal productivity of labour.
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Diminishing Marginal Diminishing Marginal Productivity of LabourProductivity of Labour 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 Diminishing Marginal Productivity of LabourProductivity of Labour Since land was fixed, he predicted that
diminishing marginal productivity would set in as population grew.
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Diminishing Marginal Diminishing Marginal Productivity of LaborProductivity of Labor The linkage was:
economic surplus population increases output increases lower per capita
income too many people starvation
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Diminishing Returns Diminishing Returns and Population Growth, and Population Growth, Fig. 8-2, p 197Fig. 8-2, p 197
Output
Labour
Subsistence level of output per worker
Production function
Q1
Q2
L1 L*
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Diminishing Marginal Diminishing Marginal Productivity of LaborProductivity 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.
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Diminishing Marginal Diminishing Marginal Productivity of CapitalProductivity of Capital The Classical economists’ predictions
were wrong. Increases in technology and capital
overwhelmed the law of diminishing marginal productivity.
The focus turned to the marginal productivity of capital, not labour.
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Diminishing Marginal Diminishing Marginal Productivity of CapitalProductivity of Capital The linkage was:capital grows faster than labour capital
is less productive slower economic output per capita growth stagnates
per capita income stops rising
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Diminishing Marginal Diminishing Marginal Productivity of CapitalProductivity of Capital The Classical growth model also
predicted that diminishing marginal productivity would be stronger for richer nations than for poorer ones.
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Diminishing Marginal Diminishing Marginal Productivity of CapitalProductivity of Capital Poor countries with little capital should
grow faster than countries with lots of capital.
Eventually per capita incomes among nations would converge.
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Diminishing Marginal Diminishing Marginal Productivity of CapitalProductivity of Capital This prediction was not true either,
owing to the ambiguity in the definition of inputs and/or technological progress.
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Ambiguities in the Ambiguities in the Definition of the Definition of the Factors of ProductionFactors of Production The definition of the factors of
production are ambiguous. It would seem that the definition of
labour would be straightforward – the hours of work that go into production.
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Ambiguities in the Ambiguities in the Definition of the Definition of the Factors of ProductionFactors of Production But what of the difference between
educated workers and workers who are less educated?
To answer this, economists separate labour into two components.
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Ambiguities in the Ambiguities in the Definition of the Definition of the Factors of ProductionFactors of Production Standard labour – 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 Ambiguities in the Definition of the Definition of the Factors of ProductionFactors of Production Increases in human capital have
allowed labour to keep pace with capital.
This allows economies to avoid the diminishing productivity of capital.
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Ambiguities in the Ambiguities in the Definition of the Definition of the Factors of ProductionFactors of Production If skills are increasing faster in a rich
country than in a poor one, incomes would not converge.
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TechnologyTechnology Technology overwhelms diminishing
marginal productivity so that growth rates can increase over time.
Technology is growing faster in rich countries than in poor countries.
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Sources of Real GDP Sources of Real GDP Growth, 1928-1998, Growth, 1928-1998, Fig. 8-Fig. 8-3, p 1993, p 199
Human capital (13%)Physical capital (19%)
Technology (35%)Labor (33%)
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New Growth TheoryNew Growth Theory New growth theory emphasizes the
role of technology rather than capital in the growth process.
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TechnologyTechnology 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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TechnologyTechnology 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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TechnologyTechnology 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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TechnologyTechnology Technological advances have positive
externalities – positive effects on others not taken into account by the decision maker.
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TechnologyTechnology 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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TechnologyTechnology Once people have seen the new
technology, they figure out sufficiently different ways to achieving the same end to avoid the patent.
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Learning by DoingLearning 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 DoingLearning 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 Increasing Returns to Scale, Scale, Fig. 8-4, p 201Fig. 8-4, p 201
Output
All inputs
Production function with increasing returns
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Technological Lock-InTechnological 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-InTechnological 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. The best example is the QWERTY
keyboard.
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Technological Lock-InTechnological 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-InTechnological Lock-In Switching from a technology exhibiting
network externalities to a superior technology is expensive and sometimes nearly impossible. The Windows operating system
exhibits network externalities.
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Economic Policies to Economic Policies to Encourage Per Capita Encourage Per Capita GrowthGrowth Policies to encourage saving and
investment. Policies to control population growth. Policies to increase the level of
education.
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Economic Policies to Economic Policies to Encourage Per Capita Encourage Per Capita GrowthGrowth Policies to increase the level of
education Policies to create institutions that
encourage technological innovation. Policies to provide funding for basic
research. Policies to increase the economy’s
openness to trade.
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Policies to Encourage Policies to Encourage Saving and InvestmentSaving 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 Policies to Encourage Saving and InvestmentSaving and Investment Canada has used tax incentives to
increase saving. These include retirement savings plans
(RSPs) that allow individuals to save without incurring taxes on contributions until they are withdrawn.
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Policies to Encourage Policies to Encourage Saving and InvestmentSaving and Investment Some economists have proposed
switching from an income tax to a consumption tax.
By taxing individuals only when they consume, all saving is exempt from taxation.
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Policies to Encourage Policies to Encourage Saving and InvestmentSaving and Investment It is difficult for poor countries to
generate saving and investment. The poor have subsistence income
while the rich in those countries place their savings abroad for fear of confiscation by government.
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The Borrowing CircleThe 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 CircleThe Borrowing Circle 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 Growth Through Foreign InvestmentForeign 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 Policies to Control Population GrowthPopulation 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 Policies to Control Population GrowthPopulation 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 Policies to Control Population GrowthPopulation Growth Some economists argue that to reduce
population growth, a nation must grow first. As income and work opportunities,
especially for women, rise, the opportunity cost of having children rises and families will choose to have fewer children.
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Policies to Increase the Policies to Increase the Level of EducationLevel 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 Policies to Increase the Level of EducationLevel of Education In Canada, it is estimated that an
additional year of school increases a worker’s wages by an average of 10 percent.
An additional year of school in developing nations will increase income by 15-20 percent.
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Policies to Increase the Policies to Increase the Level of EducationLevel of Education Technical training in improved farming
methods or construction is more important than higher education.
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Policies to Create Policies to Create Institutions That Institutions That Encourage Encourage Technological Technological InnovationInnovation 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.
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Create Patents and Create Patents and Protect Property RightsProtect 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.
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Patents and Developing Patents and Developing CountriesCountries Should poor nations accept patent
laws? 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.
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The Corporation and The Corporation and Financial InstitutionsFinancial Institutions The corporation and financial
institutions encourage innovation.
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The Corporation and The Corporation and Financial InstitutionsFinancial Institutions The corporation was invented to limit
liability to its owners. Corporations bring technological
innovations to markets.
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The Corporation and The Corporation and Financial InstitutionsFinancial Institutions Well-developed financial institutions
such as stock markets create liquidity and encourage investment.
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Policies to Provide Policies to Provide Funding for Basic Funding for Basic ResearchResearch Individual firms have little incentive to
do basic research because of technology’s “common knowledge” aspect.
This is where the government steps in.
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Policies to Provide Policies to Provide Funding for Basic Funding for Basic ResearchResearch The Canadian government provides the
lion’s share of the basic research in the country.
Much of the funding is channeled through universities.
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Policies to Increase Policies to Increase Openness to TradeOpenness 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 Policies to Increase Openness to TradeOpenness 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.
© 2003 McGraw-Hill Ryerson Limited.
Growth, Growth, Productivity, and the Productivity, and the
Wealth Of NationsWealth Of Nations
End of Chapter 8End of Chapter 8
