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Growth was Accompanied by: Industrialization Capitalism Urbanization Individualism? Growth Models 1
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Page 1: 2012 Summer Econ333 Topic 03

• Growth was Accompanied by: – Industrialization

– Capitalism

– Urbanization

– Individualism?

Growth Models

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From Pangaea to the Modern World

• About 250 million years ago, all the continents were originally together (known as Pangaea) but they have now moved apart.

• About 250 years ago, all the countries were similar in terms of (low) incomes but they have now moved apart.

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Back to the idea of progress

• If we measure progress in terms of material achievements, parts of the world have certainly progressed a great deal in the last 250 years.

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The Origin of Economic Growth Was the “Fertile Crescent.”

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Economic Growth Began Here About 250 Years Ago

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Classical Theories of Growth Started Forming as Income Started Growing

• Industries developed. • Industrial technology developed. • People moved from agriculture to industry. • Industry started hiring people. • Domestic and international trade became very

significant. • People started noticing that that life was

changing.

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Agriculture, Trade and Industry: Relationships

• Agriculture must create surplus to support industrial workers. Industrial workers must depend on food surplus from agriculture. – Agricultural surplus may be exported. So trade

became a significant factor behind growth.

• Industry can produce tools to increase agricultural surplus: a mutually advantageous relationship thus develops. – Industrial goods may also be exported. So trade

became a significant factor behind growth.

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Trade Connects Agriculture and Industry

• Industry must buy agricultural products to feed the workers working in the industry.

• Agricultural workers must demand industrial products to make industrial production worthwhile.

• Industry and Agriculture must trade goods between sectors.

• Thus all three (agriculture, industry and trade) must work together to make economic development possible.

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The Three Musketeers of Development

Agriculture

Trade

Industry

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The Three Musketeers of Development: Agriculture, Trade and Industry

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Athos, Porthos, and Aramis

• Politically, three distinct groups were formed supporting the three sectors.

• Physiocrats thought that agriculture was the most crucial determinant of growth.

• Mercantilists thought trade was the primary force behind economic growth.

• Marx and others placed supremacy on industry: capitalism was spawned by industry.

• We will look at all three groups briefly.

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Mother Nature As Tree

Physiocrats: Mother Nature is the Source of All Growth

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Classical Theory of Growth: French Physiocrats

• Physiocrats argued that growth could only occur in agriculture. • Mother Nature was the source of all growth. • Since in agriculture, input and output are in same units, output –

input = surplus. • If you start with 5 pounds of corn and end up with 10 pounds of

corn in the next year, mother nature must have gifted the extra five pounds.

• Thus more surplus = more growth. • Farmers were key to economic growth. The government should

support farmers. • Industry merely transformed products. Did not create products. • Physiocrats thought industry was “sterile.”

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Physiocrats

• François Quesnay was the most famous physiocrat.

• The French Revolution, led by farmers, was deeply influenced by the Physocratic School.

• You may be tempted to think that the Third World countries with food shortages would do well to pay attention to the Physiocrats.

• To some extent it is true, but…

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But Wait…Land Became Less Important Back in in late 1800s!

• Agricultural Land as a Fraction of Total Wealth in the United Kingdom has fallen drastically.

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So the physiocrats cannot be right because England prospered with only 3% of wealth from agriculture!

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Mercantilists

• Mercantilists were the second musketeer. • They thought trade, specifically exports, created

wealth. • European merchants looked at international trade as

source of personal wealth. • More exports = more gold (gold coins, “bullions”) for

the merchants. • Extrapolate to the country as whole: welfare comes

from maximizing exports and minimizing imports; i.e., maximizing trade surplus.

• Which means: exports are good and imports are bad.

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Mercantilists

• You may be tempted to think that if the Third World countries export more, they will have more income to buy more goods. So every one will be better off. To some extent it is true, but…

• But wait…

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• Mercantilism essentially says that trade is a zero-sum game. Exporters win; importers lose.

• This contradicts the historical observation that trade as whole (not just exports) and economic growth have been closely related.

• Is export surplus good as the mercantilists claimed? • Export surplus → more gold circulates inside the

exporting country → prices rise → export falls → export surplus falls. Maximizing export surplus thus may be a self-defeating strategy!

• Although mercantilists, were wrong, trade as a whole (import + export) is widely regarded as a good thing.

Mercantilism: Problems

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Marx

• There were many fans of industry. • We will talk only about Marx here because he

was a very influential economist. • Marx thought that capitalism was immensely

better than feudalism. • Capitalism was synonymous with

industrialization. • So, according to Marx, industry was the driver

of capitalist economic growth.

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Classical Theory of Growth: Marx

• The first part of Marxian description of growth is relatively uncontroversial.

• Marx describes how hunting gathering societies transformed to feudal societies.

• According to Marx, capitalism was a vast improvement over feudal societies.

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Primitive Communism to Feudalism

• Hunting and Gathering Societies Collapsed as Agriculture Became Important. Land ownership became important.

• Land ownership led to exploitative feudalism.

• Under Feudalism, Landlords Became Important. Landlords Maximized Power.

• Feudalism created a rent-seeking system that did not encourage free entry and free exit.

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Classical Theory of Growth: Marx

• But cities and industries started developing. • Capitalists wanted workers to work in factories. • The landlords had to let his workers move to

factories. • There was thus a conflict between capitalism and

feudalism. • Capitalists made profit by increasing output.

Notice the difference between a rent-seeking society (Feudalism) and a profit-seeking society (Capitalism).

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Classical Theory of Growth: Marx

• Marx did think that capitalism would also eventually collapse because there would be severe demand shortages (severe recessions).

• Capitalism would give rise to socialism and communism – but this part is controversial…

• We will not discuss Marxian criticism of capitalism in this class.

• Marx was one of the first economists to offer a strong theory of history, a theory of progress.

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Marxian Long View of History

Hunting and Gathering Societies (Primitive Communism)

Feudalism

Capitalism

Socialism

Communism

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Marxian Theory of Growth

• Labor is the prime mover in the Marxian growth model.

• Labor creates or adds “value” in the Marxian model.

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Marx’s Analytical Framework

• Marxian variables – V: Value of labour-power

• V for “variable” since labour alone, according to Marx, added new value

– If worker’s weekly means of subsistence take 20 hours to make, and a chair takes a working week to make, then the chair contains 20 hours of v

– C: value of machinery used up in production • C for “constant”, since according to Marx, machinery merely

transfers its value to output – adds to value of output what it loses in depreciation – If machinery which took 10 hours to make wears out in making

the chair, then the chair contains 10 hours of C

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Marx’s Analytical Framework

– S: Surplus-value • difference between what worker is paid (V) and the

number of hours worker actually works

– Three variables determine rate of surplus value and rate of profit.

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Marxian Theory of Growth • Total value after production: W • Value of Capital: C • Value of Labor Power: V • Value of Surplus Created by Labor Power: S • So value of any production: W = C + V + S • Note that labor is the source of growth because labor creates surplus S.

nothing else creates surplus. • Profit is nothing but surplus which the capitalists extract from the workers.

The capitalists invest in workers (pay subsistence wage equal to V), buy physical capital (or, C) and get S out of this investment.

• ∏= profit rate = S/(V + C). • As capitalism progresses, according to Marx, capitalists increase capital-

intensive production. But since C does not raise S, • Profit rate falls as C rises.

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Capitalism is Unique

• One of the contributions of Marx was to point out that capitalism was a productive and a unique system.

• A Capitalist society is very different from a feudal society.

• An important aspect of capitalism is that only economic means, not feudal violence is used to achieve one’s goals.

• Max Weber said it best:

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Max Weber

• Max Weber (1864-1920): “Capitalism is defined by an orientation toward economic activity characterized by rational systematic pursuit of economic gain by purely economic means.”

• According to Max Weber, Protestants became good capitalists and hence prosperous because of the teachings of pastor John Calvin (1509 –1564).

• See http://hirr.hartsem.edu/ency/Protestantism.htm

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Adam Smith

• After Marx, Weber and Physiocrats, we move to explore the Smithian theory of growth.

• The Father of Economics, did not seek an explanation of growth only in agriculture, or only in industry or only in trade.

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Adam Smith’s Theory of Growth

• Technology is the prime mover in the Smithian model.

• Technology depended on market size.

• Smith divided labor into productive (manufacturing labor, agricultural labor etc. that produced something tangible) and unproductive labor (that did not produce any tangible product such as an Opera Performance).

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Adam Smith’s Theory of Growth

• Productive labor can specialize and increase productivity indefinitely. • Any production can be broken down into multiple processes and one

productive worker can specialize in one process. • Example: A bicycle can be produced by using five different production

processes. One worker can specialize in one process only and five workers can together produce one bicycle a day. But if there are ten workers, the production process can be broken down into ten smaller processes and ten workers can produce not two – but four bicycles a day.

• Thus, specialization or division of labor, increases efficiency. • But in order to take advantage of division labor, one must have a large

enough market. • Large countries with large internal markets will perform well. Small

countries with access to international markets will also perform well.

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Adam Smith: Schematic Model of Growth

Labor

Unproductive

Productive

Division of Labor

Better Technology

Size of the Market Higher GDP

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Determinants of Growth in Classical Economics

• A philosophical question: What is growth? Growth must mean that if I start with 10 widgets, and end up with 12 widgets, “growth” must be the extra two widgets. Right?

• If economic growth implies some sort of “creation” of value, where does the additional “value” come from?

• Physiocrats said: Mother nature creates value; there was primacy of agriculture.

• Smith said: Productive labor creates value; (but Smith had a confusion between use-value and exchange value – not addressed here).

• Marx said: Comrade Worker creates value (recall S) ; but Marx was unable to relate his labor theory of value framework to the price system. He could not connect W to actual prices.

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More Modern Theories of Growth

• After Physiocrats, Marx and Smith, we would look at more modern theories of growth (Harrod-Domar, Solow and Lewis)

• But the issue of “What Creates Value?” is a question that still exists, and is somewhat unresolved.

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Modern Theory: Labor and Capital Theory of Value

• Modern Economists have abandoned the Marx-like Labor Theory of Value.

• Both capital and labor are assumed to have marginal products

• They now use Marshallian Marginalist Principles.

• Later, our first encounter with modern growth theory will be: the Harrod Domar Model.

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Why Did Feudalism Collapse?

• Irrespective of whether Marx was right or wrong in his model of progress, it is clear that feudalism did collapse in Europe. And THAT led to economic growth.

• If we know why it collapsed, we will probably have a clue about how Third World feudal societies today may collapse.

• Why did European feudalism collapse?

• Unfortunately, there is no quick and easy answer.

• Religion, population growth and many other factors played important roles.

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Why Did Feudalism Collapse? • We have talked about the role of geography and Cleopatra's nose. • We will now talk about religion, trade, population growth and

psychological theories. • Religion (crusades) played an important role. The Ottoman Empire

flourished in the fertile crescent described before. • As the Ottoman Empire started threatening Europe, Europe was woken up

from its medieval slumber and had to get ready for war. • Warships had to be built. Guns had to be produced. Steel had to be

melted. • Higher agricultural production allowed some farm workers to move to

industrial areas. The industrial workers could now be supported by agricultural surplus.

• Another curious thing happened: medical discoveries and cleaner sanitation systems in urban areas reduced death rates. So population increased – workers were now ready to work in industrial sectors.

• Trade flourished. Spices from the orient were used to preserve food. Better garments (Egyptian Cotton) allowed workers to work in colder areas in Europe. Some people moved away from Mediterranean climates.

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Why Did Feudalism Collapse?

• Psychologists also talk about “Need for Achievement” or N-Ach.

• McClelland and others have emphasized N-Ach. Please see: http://en.wikipedia.org/wiki/N-Ach

• As people moved away from the feudal mores, N-Ach may have increased in some societies.

• So feudalism collapsed for many reasons:

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Why Did Feudalism Collapse In Europe?

Downfall of Feudalism, Rise of Industrialization

and era of growth

Religious Wars

Population Growth

Development of Hydraulic

Societies Importance of Cotton, Spices (mercantilism)

N-Ach Cleopatra’s

Nose

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Geography and Climate

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Has Feudalism Collapsed in Poor

Countries? • Many would argue that feudalism has not

quite collapsed in most poor countries.

• They would argue that rent-seeking behavior is what holds these economies back.

• They would argue that farmers, manufacturing workers and technology are as important as ever to unlock the secrets of capitalist development.

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Why growth matters

• Anything that effects the long-run rate of economic growth – even by a tiny amount – will have huge effects on living standards in the long run.

1,081.4% 243.7% 85.4%

624.5% 169.2% 64.0%

2.5%

2.0%

…100 years …50 years …25 years

percentage increase in standard of living after…

annual growth rate of income

per capita

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Why growth matters

• If the annual growth rate of U.S. real GDP per capita had been just one-tenth of one percent higher during the 1990s, the U.S. would have generated an additional $496 billion of income during that decade.

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Math Preliminaries

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Modern Growth Models

• When we look at modern growth models (post World War II), it is hard not to notice the primacy of INVESTMENT, CAPITAL STOCK and TECHNOLOGY.

• Investment creates capital stock. Capital stock, with the help of technology, creates GDP.

• Labor is also important. More labor creates higher output.

• Modern growth models focus on these.

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Some Definitions

K = Capital: tools, machines, and structures used in production

L = Labor: the physical and mental efforts of workers.

Y = GDP of a country.

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The 3-D graph on the right shows that both capital and labor increase output.

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Math Preliminaries: The Production Function

• An algebraic representation of the graph in the previous slide is given by:

• Y = F(K,L) • Where Y = output or GDP, K = capital, L = labor

and F is a general production function. • Example: Y = √K √L • When K = 100, L = 16, we get Y = 40 • Notice that one needs a lot of capital (100) to

produce Y (40 units) in this example. 49

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Math Preliminaries: The Production Function

• Production function says that to produce total output or GDP of a country, one needs both inputs: labor (L) and capital (K).

• Note that, in general, production function can take many forms:

• Y = AK • Y = 2K + 15L • Y = 2 √K + 15 √L • Y = KαLβ (where α and β are positive numbers). • How do these production functions look like? • For reasons to be made clear later, economists like smooth

production functions like the one on the next slide.

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Have You Seen L?

• Notice that on the previous slide, there is K on the horizontal axis but there is no L visible.

• That’s because we want to see the effect of K on Y - holding L constant.

• What happens to Y when K rises? • When K rises by one unit, MPK (“marginal

product of capital” or the amount by which Y rises for each unit rise of K, becomes smaller and smaller (next slide).

• This is known as the law of Diminishing Marginal Returns (DMR).

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Y output

MPK and the production function

K capital

1

MPK

1

MPK

1 MPK

As more capital is added, MPK ↓

Slope of the production function equals MPK

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DMR

• As a factor input is increased, its marginal product falls (other things equal).

• Intuition: Suppose ↑K while holding L fixed ⇒ more machines per worker. ⇒Relative labor shortage.

⇒Output increases at a decreasing rate.

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Exercise: Compute & Graph MPK

a. Determine MPK at each value of K.

b. Graph the production function.

c. Graph the MPK curve with MPK on the vertical axis and K on the horizontal axis.

K Y MPK 0 0 1 10 ? 2 19 ? 3 27 ? 4 34 ? 5 40 ? 6 45 ? 7 49 ? 8 52 ? 9 54 ? 10 55 ?

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Answers

a. Determine MPK at each value of K.

b. Graph the production function.

c. Graph the MPK curve with MPK on the vertical axis and K on the horizontal axis.

K Y MPK 0 0 n.a. 1 10 10 2 19 9 3 27 8 4 34 7 5 40 6 6 45 5 7 49 4 8 52 3 9 54 2 10 55 1

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Answers

0

10

20

30

40

50

60

0 1 2 3 4 5 6 7 8 9 10

Out

put (

Y)

Capital (K)

Production function

0

2

4

6

8

10

12

0 1 2 3 4 5 6 7 8 9 10M

PK(u

nits

of o

utpu

t)Capital (K)

Marginal Product of Capital

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