© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 7: Growth, Productivity, and Wealth in the Long Run Prepared by: Kevin Richter, Douglas.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

1

Chapter 7:Growth, Productivity, and Wealth in the Long RunPrepared by:Kevin Richter, Douglas CollegeCharlene Richter, British Columbia Institute of Technology


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General Observations about Growth

Growth is an increase in the amount of goods and services an economy produces.

Growth is an increase in potential output.


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Growth and the Economy’s Potential Potential output – the highest amount of

output an economy can produce from the existing production function and existing resources.

When an economy is at its potential output, it is operating on its production possibility curve.


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Growth and the Economy’s Potential Long-run growth focuses on supply.

It assumes Say’s Law – supply creates its own demand. Demand is sufficient to buy what is produced.


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Growth and the Economy’s Potential In the short run, economists consider

potential output fixed.

They focus on how to get the economy operating at its potential if it is not.


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Importance of Growth for Living Standards

Growth improves living standards.

It makes more goods available to more people.

Because of compounding, long-term growth rates matter a lot.


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Importance of Growth for Living Standards The Rule of 72 is used to determine how long

it takes for income to double at different growth rates.

The Rule of 72 – the number of years it takes for a certain amount to double in value is equal to 72 divided by its annual growth rate.


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Markets, Specialization, and Growth Markets, specialization and the division of

labour increase productivity and growth.

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, Specialization, and Growth Markets and specialization lead to growth.

Economic growth began when markets developed (early 1800s), and as they expanded, growth accelerated.


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Economic Growth, Distribution, and Markets

Markets are often seen to be unfair because of the effect they have on the distribution of income.


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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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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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Just because the poor benefit from growth does not mean they might not be better off if income were distributed more in their favour.


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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.


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Per Capita Growth

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

Per capita growth =

% change in output - % change in population


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Per Capita Growth

In many developing nations, the population is rising faster than GDP, resulting in a lower per capita growth rate.


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Per Capita Growth

Some economists have argued that per capita (mean, average) output is not what we should be focusing on.

We should focus on median income instead.


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Per Capita Growth

Median income is a better measure because it takes into account how income is distributed.

If the growth in income goes mostly to a small minority of individuals, the mean will rise but the median will not.


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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

-- buildings and machinery --was the key to growth.

The flow of investment led to the growth of the stock of capital.


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Investment and Accumulated Capital Capital accumulation does not necessarily

lead to growth.

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 also includes human and social

capital.

Human capital – the skills that are embodied in workers through experience, education, on-the-job training.

Social capital – the habitual way of doing things that guides people in how they approach production.


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Investment and Accumulated 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 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 Resources

Greater participation in the market is another way by which available resources are increased.


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Growth-Compatible Institutions Markets and private ownership of property

foster economic growth.

When individuals get much of the gains of growth themselves, they work harder.


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Growth-Compatible Institutions Another growth-compatible institution is the

corporation.

Because of limited liability, corporations give owners an incentive to invest their savings in large enterprises. Losses are limited.


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Technological Development

Growth involves changes in technology.

Technology – changes the way we make goods and supply services, as well as the goods and services we buy.


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Technological Development

To see how technology translates into growth, we look at Total Factor Productivity (TFP).

Total Factor Productivity (TFP) is the weighted average of real GDP per worker and real GDP per $1000 of capital stock.


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Entrepreneurship

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 Growth into Growth In order to be effective, the five sources of

growth must be mixed in the right proportions.

The combination of investing in machines, people, and technological change plays a central role in the growth of any economy.


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The Production Function and Theories of Growth

The 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 The production function for growth has land,

labour, and capital as factors of production.

“A” is an adjustment factor that captures the effect of technology.

Output = A• f(Labour, Capital, Land)


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Describing Production Functions Scale economies describe what happens in a

production function when all inputs increase equally.

Constant returns to scale.

Increasing returns to scale.

Decreasing returns to scale.


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Describing Production Functions Constant returns to scale means that

output will rise by the same proportionate increase as all inputs.


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Describing Production Functions Increasing returns to scale occurs when

output rises by a greater proportionate increase as all inputs.


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Describing Production Functions Decreasing returns to scale occurs when

output rises by a smaller proportionate increase as all inputs.


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Describing Production Functions Diminishing marginal productivity describes

what happens when more of one input is added without increasing any other inputs.

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 Model

The Classical growth model focuses on capital accumulation in the growth process.

The more capital an economy has, the faster it will grow.

Because of this emphasis on capital, our economic system is called capitalism.


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The Classical Growth Model

Classical economists focused their analysis and their policy advice, on how to increase investment by saving:

saving investment

increase in capital growth


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Focus on Diminishing Marginal Productivity of labour The Classical growth model focused on how

diminishing marginal productivity of labour placed limitations on growth.

Farming was the major economic activity and the amount of land was relatively fixed.


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Focus on Diminishing Marginal Productivity of labour Economists such as Thomas Malthus said

that since land was fixed, diminishing marginal productivity would set in as population grew.

As output per person declines, at some point available output would no longer be sufficient to feed the population.


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Diminishing Returns and Population Growth

Output

Labour

Subsistence level of output per worker

Production function

Q1

Q2

L1 L*


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Focus on Diminishing Marginal Productivity of labour Beyond L*, output per person is no longer

sufficient to feed the population. Starvation and a decline in population would

occur.

Below L*, there is surplus output and population grows.


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Focus on Diminishing Marginal Productivity of labour The iron law of wages suggested that in the

long run, the economy would be driven to a stationary state at L*.


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Diminishing Marginal Productivity of Capital The predictions of the stationary state turned

out to be wrong.

Increases in technology and capital overwhelmed the law of diminishing marginal productivity.


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Diminishing Marginal Productivity of Capital

Modern economists, such as Robert Solow, changed the focus to the diminishing marginal productivity of capital, not labour.

They assumed population grows at a constant rate.


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Diminishing Marginal Productivity of Capital

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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Convergence

Diminishing marginal productivity of capital would be stronger for richer nations than for poor ones, therefore, their growth rate would slow down.

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


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Eventually per capita incomes among nations would converge.

This has not happened.

In fact, per capita incomes of rich and poor countries have diverged.

Convergence


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Why?

defining the inputs (factors of production)

technology

Convergence


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Defining the Factors 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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Economists separate labour into two components.

Standard labour – the actual number of hours worked.

Human capital – the skills embedded in workers through experience, education, and on-the-job training.

Defining the Factors of Production


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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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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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Technology

Technology overwhelms diminishing marginal productivity so that growth rates can increase over time.

Economist Edward Denison estimated the importance of each of the sources of growth:

Labour contributes 33% to growth Technology contributes 35% to growth


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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.


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Technology

New 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.

Technological advances in one sector of the economy lead to advances in completely different sectors.


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Technology

Technological advances have positive externalities.

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.

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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Learning by Doing

New growth theory also highlights learning by doing.

Learning by doing – improving the methods of production through experience.


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Learning by Doing

By increasing the productivity of workers, learning by doing overcomes the law of diminishing marginal productivity.


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Increasing Returns to Scale

Production function with increasing returns

Output

All inputs


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Technological Lock-In

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

It occurs when old technologies become entrenched in the market. despite the fact that more efficient technologies

are available.


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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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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 Encourage Per Capita Growth Encourage saving and investment. Improve incentives to work. Control population growth. Increase the level of education. Create institutions that encourage

technological innovation. Provide funding for basic research. Increase the economy’s openness to trade.


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Policies to Encourage Saving and Investment Modern growth theories have downplayed the

importance of capital in the growth process.

However, all agree that it is important.

Policy makers are eager to encourage both saving and investment.


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Policies to Encourage Saving and Investment

Canada has used tax incentives to increase saving.

These include retirement savings plans (RRSPs) that allow individuals to save without incurring taxes on contributions until they are withdrawn.


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

The poor have subsistence incomes while the rich in those countries place their savings abroad for fear of confiscation by government.


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Foreign investment provides another source of saving.

Developing nations can borrow from the International Monetary Fund (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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A Case Study: 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, but in Bangladesh, potential borrowers had no collateral.


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A Case Study: The 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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Policies to Improve Incentives to Work Using income tax cuts to increase labour

supply is called Supply-side economics.

When tax rates fall, two things happen: The Substitution Effect The Income Effect


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The cost of leisure time increases, because the opportunity cost of leisure is lost work time (and money).

This is the Substitution Effect.

Policies to Improve Incentives to Work


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Individuals can work less and still maintain their current incomes.

The is the Income Effect.



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When the Substitution Effect outweighs the Income Effect, the tax cut will increase labour supplied.



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Arthur Laffer looked at the relationship between income tax rates and the amount of tax collected.

The Laffer Curve illustrates this relationship.



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Laffer Curve

Tax Rate

Tax Collected

$T

t%0% 100%


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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 that reduce population growth include:

Free family–planning services. Increased availability of contraceptives. One-child-per-family policies, such as China

adopted in 1980.


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Some economists argue that to reduce population growth, a nation must grow first.

As income and work opportunities rise, especially for women, the opportunity cost of having children rises and families will choose to have fewer children.


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Policies to Increase the Level of Education

Increasing the educational level and skills of the workforce increases labour productivity.

In developing nations, the return on investments in education is much higher than in developed nations.


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Education must be of the right kind.

Technical training in improved farming methods or construction is more important than higher education in a developing country.



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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 Create Institutions That Encourage Technological Innovation While all agree 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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Patents and protecting property rights are two ways to encourage innovation.

Patents are not costless to society.

Patents allow innovators to charge high prices for their use.

Policies to Create Institutions That Encourage Technological Innovation


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Societies must find a middle ground between providing incentives to create new technologies and allowing everyone to take advantage of the benefits of technology.



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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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Bringing technological innovations to markets often requires large amounts of investment over a number of years.

The corporation offers limited liability protection, and thereby encourages investors to pool their funds.



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Well-developed financial institutions such as stock markets create liquidity and encourage investment.



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Policies to Provide Funding for Basic Research Individual firms have little incentive to do

basic research because of technology’s “common knowledge” aspect.

This is why the Canadian government provides most of the funding for basic research in this country. Canada’s spending on research and development

(R&D) lags other industrialized countries.


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Policies to Increase Openness to Trade Free trade increases growth by broadening

the market and by fostering competition.

In order to specialize, you need a large market.

Large markets allow firms to take advantage of economies of scale.


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Growth, Productivity, and Wealth in the Long Run

End of Chapter 7

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 7: Growth, Productivity, and Wealth in the Long Run Prepared by: Kevin Richter, Douglas.

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