Chapter 11: Long-run Economic Growth: Sources and Policies Yulei Luo SEF of HKU February 25, 2013
Learning Objectives 1. Define economic growth, calculate economic growth rates, and describe trends in global economic growth. 2. Use the economic growth model to explain why growth rates differ across countries. 3. Discuss fluctuations in productivity growth in the United States. 4. Explain economic catch-up, and discuss why many poor countries have not experienced rapid economic growth. 5. Discuss government policies that foster economic growth.
Economic Growth Over Time and Around the World Real GDP per capita (p. c.) is the best measure of a country s standard of living. Economic growth occurs when real GDP p. c. increases. We consider EG both over time and around the world, and then discuss why different countries/regions have different growth patterns: high SOL initially and continued to grow rapidly (USA, Canada, UK, etc.); high SOL initially but failed to keep pace (Argentina); low SOL initially and still very low today (Some African countries); low SOL initially but become much richer today (Japan, Hong Kong, Korea, Taiwan, Singapore, etc.).
EG from 1,000,000 B.C. to the Present No sustained EG occurred between 1, 000, 000 B.C. and 1300 A.D. It was estimated that real GDP p.c. was the same (about $140 in 2008 dollars) in both years. It was the minimum amount necessary to sustain life. Significant EG did not begin until the industrial revolution. Industrial Revolution (IR): The application of mechanical power to the production of goods, beginning in England around 1750. Following the IR, other countries in addition to England, such as the U.S., France, and Germany, experienced long-run economic growth, with sustained increases in real GDP per capita that eventually raised living standards in those countries to the high levels of today.
Figure 11.1 Average Annual Growth Rates for the World Economy World economic growth was essentially zero in the years before 1300, and it was very slow an average of only 0.2 percent per year before 1800. The Industrial Revolution made possible the sustained increases in real GDP per capita that have allowed some countries to attain high standards of living. 2013 Pearson Education, Inc. Publishing as Prentice Hall 8of 47
Why did the Industrial Revolution Occur in England? IR was a key turning point in human history: Before it, EG is slow and halting. After it, EG is rapid and sustained. No consensus so far: why did IR occur in England then? Some arguments: Institutions in England differed significantly from those in other countries in ways that greatly stimulated EG. After the Glorious revolution, the British Parliament controlled the gov. and the court system also became independent of the king. The British gov. was able to credibly to commit to upholding private property rights, protecting wealth, and eliminating arbitrary increases in taxes. These changes strengthened entrepreneurs s incentive to make new investments.
Small Differences in Growth Rates Are Important Small differences in growth rates can have a large impact. Compounding: The higher interest rate is applied to a larger amount; the lower interest rate is applied to a small amount. E.g., Invest $100 in a savings account, two interest rates: 1.3% or 2.3%. The compounding process magnifies even small difference in growth rates over long periods of time: E.g., in 1950 real GDP p.c. in Argentina was $6942 (measured in 2000 dollars), while real GDP in France was $5921. Over the next 58 years, the EG rate in France averaged 2.7% per year, while in Arg. it was only 1%. This small difference has a large impact on the SOL in both countries: in 2008, real GDP p.c. in France had risen to $27, 274, while real GDP in Arg, was only $12, 994.
(cont.) Growth rates matter because an economy that grows too slowly fails to raise living standards. We can divide the world s economies into two groups: 1. The high-income countries (the industrial or developed countries); 2. the developing counties. In the 1980s and 1990s, a small group of countries, mostly East Asian countries/regions such as Hong Kong, South Korea, Taiwan, and Singapore, experienced high rates of growth and are sometimes referred to as the newly industrializing countries and regions.
The Rich Get Richer and... We can divide the world s economies into two groups: the high-income countries, sometimes also referred to as the industrial countries, and the poorer countries, or developing countries. In the 1980s and 1990s, a small group of mostly East Asian countries experienced high rates of growth and are sometimes referred to as the newly industrializing countries. Figure 11.2 GDP per Capita, 2010 GDP per capita is measured in U.S. dollars, corrected for differences across countries in the cost of living. 2013 Pearson Education, Inc. Publishing as Prentice Hall 10 of 47
What Determines How Fast Economies Grow? Economic growth (EG) model: A model that explains growth rates in real GDP per capita over the long run. Labor productivity (LP): The quantity of goods and services that can be produced by one worker or by one hour of work. Economists believe two key factors determine labor productivity: the quantity of capital per hour worked and the level of technology. Due to the importance of LP, the EG model focuses on the causes of long-run increases in LP. Technological change: Change in the ability of a firm to produce output with a given quantity of inputs (capital and labor).
(cont.) Three main sources of technological change: 1. Better machinery and equipment: Today, continuing improvements in computers, machine tools, electronic generators, and other machines contribute to increases in L.P. 2. Increases in human capital: H.C. is the accumulated knowledge and skills that workers acquire from education and training or from their life experience. As workers increase their H.C. through education and training, their productivity will also increase. Tthe more educated workers are, the greater their human capital is and thus their productivity. 3. Better means of organizing and managing production: L.P. will increase if managers can do a better job of organizing production. E.g., with some effi cient system, fewer workers are needed to produce the same amount of products and then the quantity produced per hour worked will increase.
The Per-Worker Production Function Per-worker production function: The relationship between real GDP, or output, per hour worked and capital per hour worked, holding the level of technology constant. When holding technology constant, equal increases in the amount of capital p.h. worked lead to diminishing increases in output p.h. worked. At very high levels of capital p.h. worked, further increases in capital p.h. will not result in any increase in real GDP p.h. This effect results from the law of diminishing returns: as we add more of one input (capital) and let another inputs unchanged, output increases by smaller additional amounts.
Per-worker production function The relationship between real GDP per hour worked and capital per hour worked, holding the level of technology constant. Figure 11.3 The Per-Worker Production Function The per-worker production function shows the relationship between capital per hour worked and real GDP per hour worked, holding technology constant. Increases in capital per hour worked increase output per hour worked but at a diminishing rate. For example, an increase in capital per hour worked from $20,000 to $30,000 increases real GDP per hour worked from $200 to $350. An increase in capital per hour worked from $30,000 to $40,000 increases real GDP per hour worked only from $350 to $475. Each additional $10,000 increase in capital per hour worked results in a progressively smaller increase in output per hour worked. 2013 Pearson Education, Inc. Publishing as Prentice Hall 15 of 47
At very high levels of capital per hour worked, further increases in capital per hour worked will not result in any increase in real GDP per hour worked. This effect results from the law of diminishing returns, which states that as we add more of one input in this case, capital to a fixed quantity of another input in this case, labor output increases by smaller additional amounts. Which Is More Important for Economic Growth: More Capital or Technological Change? Technological change more efficiently helps economies avoid diminishing returns to capital. Replacing existing capital with more productive capital and reorganizing how production takes place so as to increase output are examples of technological change. 2013 Pearson Education, Inc. Publishing as Prentice Hall 16 of 47
Technological Change: The Key to Sustaining Economic Growth Figure 11.4 Technological Change Increases Output per Hour Worked Technological change shifts up the production function and allows more output per hour worked with the same amount of capital per hour worked. For example, along Production function 1 with $50,000 in capital per hour worked, the economy can produce $575 in real GDP per hour worked. However, an increase in technology that shifts the economy to Production function 2 makes it possible to produce $675 in real GDP per hour worked with the same level of capital per hour worked. In the long run, a country will experience an increasing standard of living only if it experiences continuing technological change. 2013 Pearson Education, Inc. Publishing as Prentice Hall 17 of 47
Which is More Important for EG: More Capital or Technological Change? Technological change can help economies avoid diminishing return to capital (DRTC). Some examples of TC include: the replacement of existing capital with more productive capital; reorganizing how production takes place so as to increase output. Because of DRTC, continuing increases in real GDP p.h. can be sustained only if there is technological change.
Making the Connection What Explains the Economic Failure of the Soviet Union? Capital per hour worked grew rapidly in the Soviet Union from 1950 through the 1980s, but diminishing returns to capital resulted in smaller and smaller increases in real GDP per hour worked due to a slow rate of technological change. Soviet managers had little incentive to adopt new ways of doing things because they didn t have to worry about competition and because their pay didn t depend on discovering new, better, and lower-cost ways to produce goods. Developing and using new technologies is an important way to gain a competitive edge and higher profits, the drive for which provides an incentive for technological change that centrally planned economies are unable to duplicate. The fall of the Berlin Wall in 1989 symbolized the failure of Communism. Contemporary Russia now has a more market-oriented system, although the government continues to play a large role in the economy. MyEconLab Your Turn: Test your understanding by doing related problem 2.10 at the end of this chapter. 2013 Pearson Education, Inc. Publishing as Prentice Hall 18 of 47
Solved Problem 11.2 Using the Economic Growth Model to Analyze the Failure of the Soviet Economy Use the economic growth model and the information in the preceding Making the Connection to analyze the economic problems the Soviet Union encountered. Solving the Problem Step 1: Review the chapter material. Step 2: Draw a graph like Figure 11.3 to illustrate the economic problems of the Soviet Union. For simplicity, assume that the Soviet Union experienced no technological change. The Soviet Union experienced rapid increases in capital per hour worked from 1950 through the 1980s, but its failure to implement new technology meant that output per hour worked grew at a slower and slower rate. 2013 Pearson Education, Inc. Publishing as Prentice Hall 19 of 47
Solved Problem 11.2 Using the Economic Growth Model to Analyze the Failure of the Soviet Economy Its strategy for raising the standard of living of its citizens was to make continuous increases in the quantity of capital available to its workers. The economic growth model helps us understand the flaws in this policy for achieving economic growth. MyEconLab Your Turn: For more practice, do related problems 2.7 and 2.8 at the end of this chapter. 2013 Pearson Education, Inc. Publishing as Prentice Hall 20 of 47
Endogenous Growth Theory The Economic Growth model: Technological change (TC) is the key factor in explaining long-run growth in real GDP p.c. It was first developed in the 1950s by Robert Solow. Recently, some economists have become unsatisfied with it because it doesn t explain the factors that determine TC. New growth theory (Endogenous growth theory): A model of long-run economic growth that emphasizes that technological change is influenced by how individuals and firms respond to economic incentives, and so is determined by the working of the market system. Endogenous growth theory proposed by Paul Romer, who argues that the accumulation of knowledge capital is the key determinant of EG.
(cont.) The use of physical capital, such as computer, is: rival because if one firm uses it other firms cannot; excludable because the firm that owns the capital can keep other firms from using it. However, knowledge capital, such as a chemical formula, is non-rival and non-excludable because: one firm s using this knowledge doesn t prevent another firm s using it; once it becomes known, it becomes widely available for other firms to use (unless the gov. gives the firm the legal right to exclusive use of it).
(cont.) Patent: The exclusive right to a product for a period of 20 years from the date the product was invented. Because KC is non-rival and non-excludable, firms can free ride on the R&D of other firms (They benefit from the results of R&D they didn t pay for). Firms are thus unlikely to invest in R&D up to the optimal/effi cient level and there is likely to be an ineffi ciently small amount of R&D, slowing the accumulation of KC and economic growth. However, government policy can help increase the accumulation of KC.
(cont.) Government policy can help increase KC closer to the optimal level in three ways: 1. Protecting intellectual property with patents and copyrights: They can increase the firm s incentive to engage in R&D and then reduce the ineffi ciency caused by KC. 2. Subsidizing R&D: It can increase the quantity of R&D. In US, the gov carries out some research directly (NIH). It can also provide grants to researchers in universities through NSF and other agencies. Finally, it provides tax benefits. 3. Subsidizing education: It can increase the number of workers with technical training. The gov. can subsidize edu by directly providing free education, support for public colleges and univ, or loans.
Joseph Schumpeter and Creative Destruction Schumpeter developed a model of growth in which new products will lead to creative destruction in which older products and firms that produced them are driven out of the market. E.g., DVD player displaced VHS and VCR by better meeting consumer demand for watching films at home. To Schumpeter, the entrepreneur is central to economic growth: They have incentives (profits) for bringing together the factors of production to start new firms and introduce new products. Successful entrepreneurs can use their profits to finance the development of new products and attract more funds from investors.
Economic Growth in the United States The continuing TC led to rapid EG in the US until the 1970s. Actually, the growth rate of the US accelerated over time until then. Productivity in the US grew rapidly from the end of WW II until the mid-1970. Growth then slowed down for 20 years before increasing again after 1995.
Figure 11.5 Average Annual Growth Rates in Real GDP per Hour Worked in the United States The growth rate in the United States increased from 1800 through the mid-1970s. Then, for more than 20 years, growth slowed before increasing again in the mid-1990s. Economic Growth in the United States since 1950 Continuing technological change allowed the U.S. economy to avoid the diminishing returns to capital that stifled growth in the Soviet economy. 2013 Pearson Education, Inc. Publishing as Prentice Hall 25 of 47
What Caused the Productivity Slowdown of 1973-1995? Was it a measurement problem? Productivity really didn t slow down during these years. It only appears to have slowed down because of problems in measuring productivity accurately. E.g., The fraction of services in GDP became larger and The fraction of goods in GDP became smaller. It is more diffi cult to measure services in GDP. There may also be a measurement problem in accounting for improvements in the environment and in health and safety. New laws required firms to spend more to reduce pollution, improving workplace safety, and so on.
(cont.) Was it the effect of high oil prices? In 1973, OPEC (an organization that exports oil) increased the price of oil significantly. The higher oil prices increased production costs for many firms in the US (They use oil directly or indirectly). However, the productivity slowdown continued after US firms had fully adjusted to high oil prices. In fact, it continued into the late 1980s and early 1990s when oil prices declined. Was it the declining quality of labor? Deterioration in the US educational system may have contributed to the slowdown. However, it is diffi cult to estimate how much of the slowdown may have been due to this effect. The productivity slowdownn affected all industrial countries: Therefore, there must have common reasons that can explain the slowdown experienced in all leading industrial countries. Hence, the measurement problem become more plausible.
Catch-up The prediction that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries. Catch-up: Sometimes, but Not Always Figure 11.6 The Catch-up Predicted by the Economic Growth Model According to the economic growth model, countries that start with lower levels of real GDP per capita should grow faster (points near the top of the line) than countries that start with higher levels of real GDP per capita (points near the bottom of the line). 2013 Pearson Education, Inc. Publishing as Prentice Hall 28 of 47
Figure 11.7 There Has Been Catch-up among High-Income Countries If we look only at countries that currently have high incomes, we see that countries such as Taiwan, Korea, and Singapore that had the lowest incomes in 1960 grew the fastest between 1960 and 2009. Countries such as Switzerland and the United States that had the highest incomes in 1960 grew the slowest. Note: Data are real GDP per capita in 2005 dollars. Each point in the figure represents one high-income country. 2013 Pearson Education, Inc. Publishing as Prentice Hall 29 of 47
Are the Developing Countries Catching Up to the High-Income Countries? Figure 11.8 Most of the World Hasn t Been Catching Up If we look at all countries for which statistics are available, we do not see the catch-up predicted by the economic growth model. Some countries that had low levels of real GDP per capita in 1960, such as Niger, Madagascar, and the Democratic Republic of the Congo, actually experienced negative economic growth. Other countries that started with low levels of real GDP per capita, such as Malaysia and South Korea, grew rapidly. Some middle-income countries in 1960, such as Venezuela, hardly grew between 1960 and 2009, while others, such as Israel, experienced significant growth. Note: Data are real GDP per capita in 2005 dollars. Each point in the figure represents one country. 2013 Pearson Education, Inc. Publishing as Prentice Hall 30 of 47
Solved Problem 11.4 The Economic Growth Model s Prediction of Catch-up The economic growth model makes predictions about the relationship between an economy s initial level of real GDP per capita relative to other economies and how fast the economy will grow in the future. a. Consider the statistics in the following table: Country Real GDP per Capita in 1960 (2005 dollars) Annual Growth in Real GDP per Capita, 1960 2009 Taiwan $1,826 5.78% Panama 2,171 3.21 Brazil 2,877 2.43 Algeria 4,077 0.81 Venezuela 6,662 0.64 Are these statistics consistent with the economic growth model? Briefly explain. Solving the Problem Step 1: Review the chapter material. Step 2: Explain whether the statistics in the table are consistent with the economic growth model. These statistics are consistent with the economic growth model. The countries with the lowest levels of real GDP per capita in 1960 had the fastest growth rates between 1960 and 2009, and the countries with the highest levels of real GDP per capita had the slowest growth rates. 2013 Pearson Education, Inc. Publishing as Prentice Hall 31 of 47
Solved Problem 11.4 The Economic Growth Model s Prediction of Catch-up b. Now consider the statistics in the following table: Country Real GDP per Capita in 1960 (2005 dollars) Annual Growth in Real GDP per Capita, 1960 2009 Japan $6,094 3.44% Belgium 10,241 2.52 United Kingdom 12,842 1.97 New Zealand 13,803 1.44 Are these statistics consistent with the economic growth model? Briefly explain. Step 3: Explain whether the statistics in the table in part b. are consistent with the economic growth model. These statistics are also consistent with the economic growth model. Once again, the countries with the lowest levels of real GDP per capita in 1960 had the fastest growth rates between 1960 and 2009, and the countries with the highest levels of real GDP per capita had the slowest growth rates. c. Construct a new table that lists all nine countries, from lowest real GDP per capita in 1960 to highest, along with their growth rates. 2013 Pearson Education, Inc. Publishing as Prentice Hall 32 of 47
Solved Problem 11.4 The Economic Growth Model s Prediction of Catch-up Step 4: Construct a table that includes all nine countries from the tables in parts a. and b. and discuss the results. Country Real GDP per Capita in 1960 (2005 dollars) Annual Growth in Real GDP per Capita, 1960 2009 Taiwan $1,826 5.78% Panama 2,171 3.21 Brazil 2,877 2.43 Algeria 4,077 0.81 Japan 6,094 3.44 Venezuela 6,662 0.64 Belgium 10,241 2.52 United Kingdom 12,842 1.97 New Zealand 13,803 1.44 Are the statistics in your new table consistent with the economic growth model? The statistics in the new table are not consistent with the predictions of the economic growth model. There has been catch-up among the high-income countries, but there has not been catchup if we include in the analysis all the countries of the world. MyEconLab Your Turn: For more practice, do problems 4.5 and 4.6 at the end of this chapter. 2013 Pearson Education, Inc. Publishing as Prentice Hall 33 of 47
Why has Productivity Growth Been Faster in the U.S. than in Other Countries? 1. The greater flexibility of US labor markets: In most Euro. countries, gov. regulations make it diffi cult to fire workers. Consequently, firms are reluctant to hire workers and then younger workers have diffi culty finding jobs. In contrast, in the US, gov regulations are less restrictive. Workers can find jobs easily and also change jobs more frequently that ensures a better match between workers and jobs and then increases LP. 2. The greater effi ciency of the US financial system: TC is essential to rapid EG. The effi cient FS in the US aids firms to borrow funds to implement new technology.
1. (conti.) The level of legal protection of investors is relatively high in U.S. financial markets, which encourages both U.S. and foreign investors to buy stocks and bonds issued by U.S. firms. The volume of trading in U.S. financial markets also ensures that investors will be able to quickly sell the stocks and bonds they buy. This liquidity serves to attract investors to U.S. markets. The ability of venture capital firms to finance technology-driven start-up firms may be giving the U.S. an advantage in bringing new products and new processes to market.
Why Haven t Most Western European Countries, Canada, and Japan Caught Up to the United States? Figure 11.9 Other High-Income Countries Have Stopped Catching Up to the United States The blue bars show real GDP per capita in 1990 relative to the United States. The red bars show real GDP per capita in 2010 relative to the United States. In each case, relative levels of real GDP per capita are lower in 2010 than they were in 1990, which means that these countries have ceased catching up to the United States. 2013 Pearson Education, Inc. Publishing as Prentice Hall 34 of 47
Why don t More Low-Income Countries Experience Rapid Growth? 1. Failure to enforce the rule of law Rule of Law: The ability of a gov. to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts. 2. Wars and revolutions made it impossible for countries to accumulate enough capital stock or adopt new technologies. And conducting any kind of businesses was very diffi cult. 3. Poor public education and health Many low-income countries have weak public school systems, so many workers are unable to read and write. People who are sick work less and are less productive when they do work. 4. Low rates of saving and investment: The low savings rates in developing countries contribute to a vicious cycle of poverty.
The Benefits of Globalization Foreign direct investment: When corporations build or purchase facilities in foreign countries. Foreign portfolio investment: The purchase by an individual or firm of stock or bonds issued in another country. Globalization: The process of countries becoming more open to foreign trade and investment.
Figure 11.10 Globalization and Growth Developing countries that were more open to foreign trade and investment grew much faster during the 1990s than developing countries that were less open. 2013 Pearson Education, Inc. Publishing as Prentice Hall 40 of 47
Growth Policies Even small differences in growth rates compounded over the years can lead to major differences in SOL. Therefore, there is potentially a very high payoff to government policies that increase growth rates: Enhancing property rights and the rule of law increased political stability is a necessary prerequisite to EG. Improving health and education: As people s health improves, they will become more productive. Lucas argued that productivity increases as H.C. increases. Gov. should subsidize education to promote EG. Policies with respect to technology: Subsidizing R&D. Policies with respect to saving and investment Increase the incentives to save and invest.
Is Economic Growth Good or Bad? It seems undeniable that increasing the growth rates of very low-income countries would help relieve the daily suffering that many people in those countries endure, but many people are concerned that economic growth may contribute to global warming, deforestation, and other environmental problems. Some people see multinational firms that locate in low-income countries as unethical because they claim the firms are paying very low wages and are failing to follow the same safety and environmental regulations they are required to follow in high-income countries. Whether economic growth is good or bad is a normative question still debated.