Economic Growth

Chapter 7

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
The Economy in the Long Run

Money
Economic
and
Growth
Prices

Saving and
Capital
Formation

7-2
 Learning Objectives
1. Show how small differences in growth rates
lead to large differences in living standards
2. Explain why GDP per capita is average labor
productivity times the proportion of the
population employed
– Use this to discuss the sources of growth
3. Discuss the determinants of average labor
productivity
– Analyze differences in GDP per capita across
countries

7-3
 Learning Objectives
4. Discuss and evaluate government policies that
promote economic growth
5. Compare and contrast the benefits and costs of
economic growth
6. Describe the trade-offs between economic
growth and environmental quality

7-4
 Benefits of Growth
• In the late 18th and early 19th century
– Life expectancy was 40 years
• Most families had 2 or 3 children die
– Nothing moved faster than the speed of a horse
– The best highway was from Boston to New York
• A stagecoach made the 175-mile trip in 3 days
• Pace of technical change is accelerating
– Inventions are not sufficient to create growth
– Products must be commercialized and sold

7-5
 Living Standards
• Use an economic model to study the remarkable
rise in living standards
– Real GDP per person is a measure of the goods
available to a typical person
• One clue to growing prosperity in the 20th
century – GDP per person today is five times
greater than it was in 1929
• Comparisons across long periods are
complicated by lack of data
– The variety, quantity, and quality of goods
increased enormously in the 19th and 20th century
7-6
Real GDP per Person, 1870-
2008 (in US Dollars)

7-7
Real GDP per Person, 1870 - 2008
Country 1870 1913 1950 1979 1990 2008

US $2,445 $5,301 $9,561 $18,789 $23,201 31,178

UK 3,190 4,921 6,939 13,167 16,430 23,742

Germany 1,839 3,648 3,881 13,993 15,929 20,801

Japan 737 1,387 1,921 13,163 18,789 22,816

China 530 552 448 1,039 1,871 6,725

Brazil
713 811 1,672 4,890 4,920 6,429

India 533 673 619 895 1,309 2,975

Ghana 439 781 1,122 1,210 1,062 1,650

7-8
Growth of Real GDP per Person,
1870 - 2008
Annual % Change Annual % Change Annual % Change
Country
1870 – 2008 1950 – 2008 1979 - 2008

US 1.9% 2.1% 1.8%

UK 1.5 2.1 2.1

Germany 1.8 2.9 1.4

Japan 2.5 4.4 1.9

China 1.9 4.8 6.7

Brazil 1.6 2.3 0.9

India 1.3 2.7 4.2

Ghana 1.0 0.7 1.1

7-9
 Compound Interest Rates
• In 1870, Brazil's GDP per person was twice
Ghana's
– By 2008, the multiple increased to 4 times
– Brazil's growth over the period was 1.6% and
Ghana's was 1.0%
• Compound interest pays interest on the
original deposit and all previously accumulated
interest
– Interest paid in year 1 earns interest in year 2
– $10 deposited at 4% interest in 1800 is $37,757.33 in
2010
• $10 x (1.04)210 = $37,757.33
7-10
 Compound Interest
• Differences in interest rates matter
Interest Rate
Value of $10 after 210 years
(%)
2 $639.79
4 $37,757.33
6 $2,061,729.60

• Growth rates in GDP per capita have the same

effect as interest rates
– Relatively small growth in GDP per capita has a
very large effect over a long period
• In the long run, the growth rate of an economy
matters
7-11
 Years to Double
• Useful formula to approximate the number of
years it takes an initial amount to double
• Given some annual interest rate
• Years to double = 72 / interest rate
• If the interest rate equals 2% then it takes 36
years for your money to double
• If GDP grows at 3% then it takes 24 years for
GDP to double
• Growth rates matter

7-12
 Real GDP per Capita
• Notation
– Y = real GDP
– N = number of people employed
– POP = population

• GDP per capita is the product of output per worker

and the share of the total population that is working
• Consumption per person depends on
– How much each worker produces and
– The share of people working
7-13
 Understanding Growth
• GDP per capita increases when
– Output per worker (Y / N) increases OR
– The share of the population employed (N / POP)
increases
• Between 1960 and 2008,
– GDP per capita increased 176%
– Output per worker increased 116%
– The share of the population employed increased
from 36% to 48%
• Larger working age population
• Increase in female labor force participation
7-14
Y / POP and Y / N, 1960 - 2008

7-15
N / POP, 1960 - 2008

7-16
 Understanding Growth

In the long run,

increases in output per person
arise primarily from
increases in average labor productivity

7-17
 Average Labor Productivity
• US average labor productivity is
– 24 times that of Indonesia
– 100 times that of Bangladesh
• Six factors determine average labor productivity
1.Human capital
2.Physical capital
3.Land and other natural resources
4.Technology
5.Entrepreneurship and management
6.Political and legal environment
7-18
 1. Human Capital
• Human capital comprises the talents, education,
training, and skills of workers
– Human capital increases workers' productivity
• Germany and Japan used human capital to
rebuild after World War II
– Professional scientists and engineers
– Apprentice and on-the-job training emphasized
– Japanese increased emphasis on early education
• Cost – Benefit Principle applies to building
human capital
– Premium paid to skilled workers
7-19
 2. Physical Capital
• More and better capital increases worker
productivity
• Factory owner employs two people and adds capital
– Each machine requires one dedicated operator
Number of Output per Hours Worked Output per
Machines Week per Week Hour Worked
0 16,000 80 200
1 32,000 80 400
2 40,000 80 500
3 40,000 80 500
• More capital increases output per hour
• Diminishing returns to capital
7-20
 Diminishing Returns to Capital
• Diminishing returns to capital occurs if an addition
of capital with other inputs held constant increases
output by less than the previous increment of capital
– Assumption: all inputs except capital are held constant
– Result: output increases at a decreasing rate
• When a firm has many machines, the most
productive uses have already been filled
– The increment in capital will necessarily be assigned to
a less productive use than the previous increment
– Principle of Increasing Opportunity Cost

7-21
 Growth and Diminishing
Returns to Capital
• Implications of diminishing returns
– Increasing capital will increase output and labor
productivity
• Positive contribution to growth
– There are limits to increasing productivity by adding
capital because of diminishing returns

7-22
Capital and Output per Worker,
1990

High capital/worker,
High GDP per worker

Low capital/worker,
Low GDP per worker

7-23
 3. Land and Other Natural
Resources
• Inputs other than capital increase worker
productivity
– Land for farming
• Farmers are less than 3% of the population and they
supply the US and export the surplus
• Manufacturing requires raw materials and energy
– Resources can be obtained through international
markets
• Japan, Hong Kong, Singapore and Switzerland have
high levels of GDP per capita with a limited resource
base

7-24
 4. Technology
• New technologies are the single most important
source of productivity improvement
• Technical change can affect
18th century transport
industries beyond the primary
• Horse power
application
19th century transport
– Transportation expanded
markets for farm produce • Steam engine
• Rail
– Medicine • River
– Communications 20th century transport
– Electronics and computers • Road network
• Air
7-25
 Productivity Puzzle
• US labor productivity grew 2.8% from 1947 – 1973
– Slowed to 1.4% from 1973 – 1995
– Resurgence to 3% since 1995
• Slow-down remains a mystery
• Growth since 1995 is largely attributed to
information and communications technologies
making workers more productive
– Growth seen in industries that produce these
technologies and industries that use them
– Slower growth in sectors that do not use much
information and communications technologies
7-26
 5. Entrepreneurship and
Management
• Entrepreneurs create new economic enterprises
– Essential to a dynamic, healthy, growing economy
• Examples
– Henry Ford and mass production
– Bill Gates and standardized graphical user interface
operating system
– Larry Page and Sergey Brin and Google's search
• Policies should channel entrepreneurship in
productive ways
– Taxation policy and regulatory regime
– Value innovation
7-27
 Medieval China
• Sung period (960 – 1270 AD) was technically
sophisticated
 Paper ■ Gunpowder

 Water wheels ■ Compass?

• Economic stagnation followed
– Social system limited entrepreneurship
– Emperor retained property rights to business
• Seizure possible without notice
• Scientific advances alone do not ensure
technical change and growth
7-28
 6. Political and Legal
Environment
• Encourage people to be economically productive
• Well-defined property rights are essential
– Who owns what and how those things can be used
– Reliable recourse through courts
• Maintain political stability
• Promote free and open exchange of ideas

7-29
 Communism Failed
• Output per person in the Soviet Union was probably
less than one-seventh the US rate in 1991
• The Soviet Union had ingredients for growth –
human capital, physical capital, natural resources,
technology
• Two main flaws
– Communal ownership of capital stock
• General absence of private property rights
• Incentive Principle could not work
– Government planning replaced market system
• Abundant unexploited opportunities
• Political instability and appropriate legal framework
7-30
 Promote Growth with Human
Capital
• Governments support education and training
programs
– US public education support extends from kindergarten
through institutions of higher learning
– Head Start program for pre-school children
– Job training and retraining programs
• Government pays because education has
externalities
– A democracy works better with educated voters
– Progressive taxes capture some of the higher income
– Increases chances of technical innovation
– Poor families could not pay
7-31
 Promote Growth with Savings
and Investment
• Government policies can encourage new capital
formation and saving in the private sector
– Individual Retirement Accounts (IRAs) are an
incentive for individuals to save
– Government periodically offers investment tax credits
• Government can invest directly in capital
formation
– Construction of infrastructure such as roads, bridges,
airports, and dams
– US interstate highway system reduced costs of
transporting goods, making markets more efficient
7-32
 Promote Growth with R & D
Support
• Research and development promotes innovation
– Some types of research, such as basic science,
create externalities that a private firm cannot capture
• Silicon chip
– Fund basic science with National Science Foundation
(NSF) and other government grants
• Government sponsors research for military and
space applications
– Government owns GPS satellites
• Maintain political and legal framework to support
growth
7-33
 Promoting Economic Growth in
Least Developed
• Prescription for more human and physical capital
is broadly correct
– Appropriate technology and education
• Most countries need institutions to support growth
– Corruption creates uncertainty about property rights
and drains financial resources out of the country
– Regulation discourages entrepreneurship
– Taxes discourage risk-taking
– Markets do not function efficiently
– Lack of political stability discourages foreign
investment
7-34
The Costs of Economic Growth
• Increasing the capital stock will increase GDP
• Opportunity cost of producing more capital goods
is
– Fewer consumer goods
• People may be willing to forego present consumption to
have more in the future
– Reduced leisure time
– Possible risks of health and safety from rapid capital
production
– The cost of research and development (R&D) to
improve technology
– The cost of education to develop and use new capital
7-35
 Limits to Growth
• Can growth be sustained?
– Depletion of some natural resources
– Environmental damage and global warming
• Computer models suggested growth is not
sustainable
– Did not adequately treat new and better products
– Greater income can pay for better environmental quality
– Ignored the market's response to increasing scarcity
• High prices trigger a response
• Strong response to energy crisis in mid 1970s
• Government action needed in case of externalities

7-36
 Mexico City Air Quality
• Research indicates that pollution increases up to a
point with increased GDP per person
– After A, air pollution decreases and air quality improves
– Estimates suggest Mexico is
close to point A
A
• Beyond a certain level of income,
citizens value a cleaner

Air pollution
environment and they are willing
and able to pay for it

Real GDP per capita

7-37
 Economic Growth
Pro - Growth
Policies
Real GDP
per Capita Economic
Growth

Share of Compound
Population Growth
Standard of Rates
Employed
Living

Average
6 Determinants of
Product of
Average Product
Labor
of Labor
7-38