economic growth, productivity, and living standards principles of macroeconomics dr. gabriel x....

Economic Growth, Productivity, and Living Standards

Economic Growth, Productivity, and Living Standards

Principles of Macroeconomics

Dr. Gabriel X. Martinez

Ave Maria University

Chapter 20: Economic Growth, PrChapter 20: Economic Growth, Productivity, and Living Standardsoductivity, and Living Standards

22Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

Potential Output and the Long RunPotential Output and the Long Run

Potential output, as we know, is not Potential output, as we know, is not influenced by inflation.influenced by inflation.

An economy’s productive capacity is An economy’s productive capacity is determined bydetermined by– Human capital, Physical capital, Social capitalHuman capital, Physical capital, Social capital– Land and natural resourcesLand and natural resources– Technology, Management and entrepreneurshipTechnology, Management and entrepreneurship– Population, Social and legal environment.Population, Social and legal environment.



IntroductionIntroduction

Why is economic growth good?Why is economic growth good?– More medicines:More medicines:

longer life expectancy and better healthlonger life expectancy and better health

– More schools and school materials:More schools and school materials: you know more, your friends know more.you know more, your friends know more.

– More economic stabilityMore economic stability No need to worry about feeding your family.No need to worry about feeding your family.



IntroductionIntroduction

However…However…– More production may also mean that society More production may also mean that society

becomes obsessed with production and not with becomes obsessed with production and not with other good things in life.other good things in life.

– More production may come at the cost of social More production may come at the cost of social cohesion or the environment.cohesion or the environment.



Real GDP per Person in Five Real GDP per Person in Five Industrialized Countries, 1870 - 2000Industrialized Countries, 1870 - 2000

Historical estimates are less precise: our accounting improved over time.Historical estimates are less precise: our accounting improved over time.Comparing economic output over a century cannot account for new Comparing economic output over a century cannot account for new goods and services; and we are not accounting for pollution, more stress, goods and services; and we are not accounting for pollution, more stress, etc.etc.



Real GDP per Person In Selected Real GDP per Person In Selected Countries, 1870-2000 (in 1995 U.S. Dollars)Countries, 1870-2000 (in 1995 U.S. Dollars)

Country

Australia 5,626 7,385 9,561 18,033 24,708 1.1 1.9

Canada 2,447 5,791 9,362 20,899 26,604 1.8 2.1

France 2,249 4,401 6,049 17,801 22,447 1.8 2.6

Germany 1,205 2,320 5,005 18,014 23,247 2.3 3.1

Italy 2,248 3,167 4,042 13,331 21,930 1.8 3.4

Japan 963 1,825 2,216 16,899 24,772 2.5 4.8

United Kingdom 3,500 5,374 7,832 14,889 21,142 1.4 2.0

United States 2,843 6,745 11,921 22,480 32,629 1.9 2.0

Annual % change

1950-2000

Annual % change

1870-20001870 1913 1950 1979 2000

Observations•1870: Australia had the highest per capital real GDP and Japan the lowest•2000 real per capita GDP in Japan exceeded Australia•Note the difference in the growth rate of 1.1% for Australia and 2.5% for Japan



Notice:Notice:– In 1870, Canada and the US had similar per In 1870, Canada and the US had similar per

capita GDPs.capita GDPs.– But the US grew slightly faster on average (1.9 But the US grew slightly faster on average (1.9

percent versus 1.8 percent per year).percent versus 1.8 percent per year).– Now the US is significantly richer than Canada.Now the US is significantly richer than Canada.

Why “Small” Differences in Growth Why “Small” Differences in Growth Rates MatterRates Matter



Why “Small” Differences in Growth Rates MatterWhy “Small” Differences in Growth Rates Matter

Year Initial GDPAdded GDP(3% growth

rate)Final GDP Initial GDP

Added GDP(3.5% growth

rate)

Final GDP

1 10,000 300 10,300 10,000 350 10,350

2 10,300 309 10,609 10,350 361 10,711

3 10,609 318 10,927 10,711 371 11,082

4 10,927 328 11,255 11,082 382 11,464

5 11,255 338 11,593 11,464 394 11,858

6 11,593 348 11,941 11,858 406 12,264

7 11,941 358 12,299 12,264 418 12,682

8 12,299 369 12,668 12,682 430 13,112

9 12,668 380 13,048 13,112 443 13,556

10 13,048 391 13,439 13,556 457 14,012



Growth rate (%) Value of $10,000 after 200 years

1.8 $354,450

2 $524,850

2.2 $776,570

Observations•A small sum compounded over long periods can greatly increase in value.•Small differences in growth rates have a very large impact on value.•If a country manages to grow merely 0.4 percentage points faster, it will be twice as rich in 200 years.




– The growth rate applies not only on the original The growth rate applies not only on the original GDP but on all previously accumulated growth.GDP but on all previously accumulated growth.

– Government policies that affect the long-term Government policies that affect the long-term growth rate by a small amount will have a major growth rate by a small amount will have a major economic impact.economic impact.




Why Nations Become Rich: The Crucial Why Nations Become Rich: The Crucial Role of Average Labor ProductivityRole of Average Labor Productivity

QuestionQuestion– What determines a nation’s economic growth What determines a nation’s economic growth

rate?rate?– Some definitions:Some definitions:

YY = real GDP = real GDP NN = number of employed workers = number of employed workers POPPOP = total population = total population




Real GDP Per PersonReal GDP Per Person

POP

Nx

N

Y

POP

Y

ObservationsReal output/person depends on:

How much each worker can produce.The percent of the population that is working.

GDPper

capita=

# of employedpopulationx

averagelabor

productivity




N/POPN/POP– Increases in female labor force participation contribute Increases in female labor force participation contribute

to increasing GDP per capita.to increasing GDP per capita.– Immigration may contribute to increasing N/POP Immigration may contribute to increasing N/POP

because immigrants are often of working age.because immigrants are often of working age.– The massive retirement of baby-boomers reduces the The massive retirement of baby-boomers reduces the

percentage of population employed and GDP per capita.percentage of population employed and GDP per capita.

POP

Nx

N

Y

POP

Y




Y/NY/N– In the long run, increases in output per person In the long run, increases in output per person

arise primarily from increases in average labor arise primarily from increases in average labor productivity (Y/N).productivity (Y/N).

POP

Nx

N

Y

POP

Y

The Determinants of Average The Determinants of Average Labor ProductivityLabor Productivity



The Determinants of Average Labor The Determinants of Average Labor ProductivityProductivity

Human CapitalHuman Capital

Social CapitalSocial Capital

Physical CapitalPhysical Capital

Land and Natural ResourcesLand and Natural Resources



The Determinants of Average Labor The Determinants of Average Labor ProductivityProductivity

TechnologyTechnology

PopulationPopulation

Management and EntrepreneurshipManagement and Entrepreneurship

Social and Legal EnvironmentSocial and Legal Environment



Human CapitalHuman Capital– The talents, education, training, and skills of The talents, education, training, and skills of

workers.workers. Remember that physical capital is “produced and Remember that physical capital is “produced and

durable goods that are used to produce other goods.”durable goods that are used to produce other goods.” Education (or training) is like capital because it is Education (or training) is like capital because it is

“produced”, it is durable, and it helps us produce “produced”, it is durable, and it helps us produce more goods than we would have produced without more goods than we would have produced without education.education.




ExampleExample– James and Kate draw graphs in MS Word.James and Kate draw graphs in MS Word.

James (a novice) draws 1 graph/hr or 40 James (a novice) draws 1 graph/hr or 40 graphs/week.graphs/week.

Kate (has taken many economics courses) draws Kate (has taken many economics courses) draws 30/hr or 1200/week.30/hr or 1200/week.

Average labor productivity/week = (40+1200)/2 = Average labor productivity/week = (40+1200)/2 = 620/week620/weekor 1240/80 hrs = 15.5 graphs/hr.or 1240/80 hrs = 15.5 graphs/hr.

Kate (with training) is more productive than James.Kate (with training) is more productive than James.




ExampleExample– South Korea and Nicaragua since WWIISouth Korea and Nicaragua since WWII– Both are a tiny countries close to economic Both are a tiny countries close to economic

giants.giants.– Korean culture (emphasizes order and learning) Korean culture (emphasizes order and learning)

encouraged economic growth much more than encouraged economic growth much more than Nicaragua’s.Nicaragua’s.

– Now Korea is in the “club for rich countries”, the Now Korea is in the “club for rich countries”, the OECD. OECD.




Social CapitalSocial Capital– Social capital is important because all Social capital is important because all

production processes require many people production processes require many people working together.working together. Without trust, contracts fail and ideas don’t get Without trust, contracts fail and ideas don’t get

developed.developed.

– Social Capital is the habitual way of doing Social Capital is the habitual way of doing things that guides people in how they approach things that guides people in how they approach production and economic life.production and economic life. Trust, conventions, agreed expectations.Trust, conventions, agreed expectations.




Physical CapitalPhysical Capital– Worker productivity depends not only on their Worker productivity depends not only on their

skills (human capital) but on the tools (physical skills (human capital) but on the tools (physical capital) they have to work with.capital) they have to work with.

– Tools.Tools.– Buildings.Buildings.– Factories.Factories.– Machines.Machines.– Software.Software.




ExampleExample– James gets better software.James gets better software.

Microsoft produces a new kind of graphing utility for Microsoft produces a new kind of graphing utility for WordWord

An untrained student using the new software can An untrained student using the new software can draw 20 graphs/hour.draw 20 graphs/hour.

James uses the new software and Kate graphs with James uses the new software and Kate graphs with the old software.the old software.




ExampleExample– James gets better software James gets better software (AMU buys 1 license).(AMU buys 1 license).

James’s weekly output (40 hrs x 20) = 800 graphs.James’s weekly output (40 hrs x 20) = 800 graphs. Kate’s weekly output (40 hrs x 30) = 1200 graphs.Kate’s weekly output (40 hrs x 30) = 1200 graphs.

Total output = 2,000 graphs/weekTotal output = 2,000 graphs/week or average labor productivity = 1,000 graphs/week or average labor productivity = 1,000 graphs/week or 2,000/80 hrs. = 25 graphs/hr.or 2,000/80 hrs. = 25 graphs/hr.

– James’s use of the new software increases average James’s use of the new software increases average productivity 62 percent.productivity 62 percent.




– James and Kate get better softwareJames and Kate get better software(AMU buys 2 licenses).(AMU buys 2 licenses). Kate’s hourly productivity increases to 50 graphs/hr.Kate’s hourly productivity increases to 50 graphs/hr. James’s weekly output (40 hrs x 20) = 800 graphs.James’s weekly output (40 hrs x 20) = 800 graphs. Kate’s weekly output (40 hrs x 50) = 2000 graphs.Kate’s weekly output (40 hrs x 50) = 2000 graphs.

Total output = 2,800 graphs/weekTotal output = 2,800 graphs/week or average labor productivity = 1,400 graphs/weekor average labor productivity = 1,400 graphs/week or 2,800/80 hrs. = 35 graphs/hr.or 2,800/80 hrs. = 35 graphs/hr.

– James’s and Kate’s use of the new software increases James’s and Kate’s use of the new software increases average productivity 40 percent.average productivity 40 percent.




Capital, Output, and Productivity Capital, Output, and Productivity in the Computer Clusterin the Computer Cluster

(1) Number of licencse (capital)

0 1240 80 15.5

1 2,000 80 25

2 2,800 80 35

3 2,800 80 35

(2) Total number of

graphs drawn each week (output)

(3) Total hours worked per

week

(4) Graphs drawn per

hour worked (productivity)

Observations• For a given number of workers, adding capital will generally increase output and average labor productivity.

• The more capital that is already in place, the smaller the benefits of adding extra capital.



Diminishing Returns to CapitalDiminishing Returns to Capital– If the amount of labor and other inputs If the amount of labor and other inputs

employed is held constant, then the greater the employed is held constant, then the greater the amount of capital already in use, the less an amount of capital already in use, the less an additional unit of capital adds to production.additional unit of capital adds to production.




The Determinants of Average The Determinants of Average Labor ProductivityLabor ProductivityO

utpu

t

Amount of Capital

More capital adds more output.

But each unit of extra capital adds less extra output.



Physical CapitalPhysical Capital– Public policy designed to stimulate growth Public policy designed to stimulate growth

should consider that:should consider that: Increasing the amount of capital available to the Increasing the amount of capital available to the

workforce will tend to increase output and average workforce will tend to increase output and average labor productivity.labor productivity.

The degree to which productivity can be increased by The degree to which productivity can be increased by an expanding stock of capital is limited.an expanding stock of capital is limited.




Average Labor Productivity and Capital Average Labor Productivity and Capital per Worker in 15 Countries, 1990per Worker in 15 Countries, 1990

Using Econometrics: Statistical theory applied to economics helps us find relations between variables.

For example, it can help us explain the approximate effect more Real Capital per Worker on Real GDP per worker…

… and to explain why the US has more per-worker GDP (and Germany less per-worker GDP) than just the level of capital would predict.



Land and Other Natural ResourcesLand and Other Natural Resources– Generally, an abundance of natural resources Generally, an abundance of natural resources

increases the productivity of workers.increases the productivity of workers.– Sometimes, abundance of natural resources is Sometimes, abundance of natural resources is

not necessary or useful:not necessary or useful: A country might get “lazy” because everything comes A country might get “lazy” because everything comes

out of the land.out of the land. Resources can be obtained throughResources can be obtained through

international markets.international markets.




TechnologyTechnology– Technology isTechnology is

the the body of knowledge available to a civilization – body of knowledge available to a civilization – skills, scientific methods and materials – for skills, scientific methods and materials – for making goods and supplying services.making goods and supplying services.




TechnologyTechnology

New technologies are the single most New technologies are the single most important source of productivity important source of productivity improvement.improvement.

– A new technology will expand the productivity in A new technology will expand the productivity in many sectors by stimulating greater many sectors by stimulating greater specialization.specialization.




PopulationPopulation– Some economists have argued that an Some economists have argued that an

important factor in technological development is important factor in technological development is population growth.population growth. More population implies a greater demand for goods, More population implies a greater demand for goods,

and therefore a demand for new technologies.and therefore a demand for new technologies. Moreover, more population increases opportunities Moreover, more population increases opportunities

for scientific and social cooperation.for scientific and social cooperation. This means that natural resourcesThis means that natural resources

won’t get exhausted.won’t get exhausted.





A more highly populated country gives more opportunities for scientific interaction.

Comparing technological development over a billion years, economist Michael Kremer of Harvard (1993) found that

Higher Initial Population and Population Growth Higher Technological Development



Entrepreneurship and ManagementEntrepreneurship and Management– Entrepreneurship is the ability to get things done.Entrepreneurship is the ability to get things done.

It’s having creativity and visionIt’s having creativity and vision It also involves a talent for translating that vision into reality.It also involves a talent for translating that vision into reality. Factors influencing entrepreneurshipFactors influencing entrepreneurship

– Social CustomsSocial Customs

– TaxationTaxation

– RegulationRegulation

– Management:Management: Influence productivity by implementing more efficient methods Influence productivity by implementing more efficient methods

of production.of production.




Economic Growth:Economic Growth: what does it cost us? what does it cost us?

There is no such thing as a free lunchThere is no such thing as a free lunch– To increase the stock of physical or human capital, we To increase the stock of physical or human capital, we

must divert resources that could otherwise be used to must divert resources that could otherwise be used to increase the supply of consumer goods.increase the supply of consumer goods. More machines or industrial software means less butter and More machines or industrial software means less butter and

fewer sports cars.fewer sports cars. More education to earn a higher income tomorrow means less More education to earn a higher income tomorrow means less

time to earn a high income today.time to earn a high income today.



Economic Growth:Economic Growth: what does it cost us? what does it cost us?

There is no such thing as a free lunchThere is no such thing as a free lunch– Research and Development of new Research and Development of new

technologies involves sacrifice of current goods.technologies involves sacrifice of current goods.– Many countries have achieved a high standard Many countries have achieved a high standard

of living through allowing great income of living through allowing great income inequalities in the past.inequalities in the past.



The Role of Government in Fostering The Role of Government in Fostering ProductivityProductivity– Establish:Establish:

Well-defined property rightsWell-defined property rights Maintain Maintain political stabilitypolitical stability Promote Promote free and open exchange of ideasfree and open exchange of ideas




Economic NaturalistEconomic Naturalist– Why did communism fail?Why did communism fail?

Output per person in the Soviet Union was probably Output per person in the Soviet Union was probably less than one-seventh the U.S. rateless than one-seventh the U.S. rate

The Soviet Union had:The Soviet Union had:– Human capital.Human capital.– Physical capital.Physical capital.– Natural resources.Natural resources.– Technology.Technology.




Economic NaturalistEconomic Naturalist– Why did communism fail?Why did communism fail?

There was an absence of:There was an absence of:– Private property rights.Private property rights.– Free markets.Free markets.– Political stability.Political stability.– Modern legal framework.Modern legal framework.


Policies for Economic GrowthPolicies for Economic Growth



Promoting Economic GrowthPromoting Economic Growth

Promoting GrowthPromoting Growth– Promote saving and investmentPromote saving and investment

Physical capitalPhysical capital Human CapitalHuman Capital

– Support research and developmentSupport research and development– Improve the legal and political frameworkImprove the legal and political framework



Promoting Economic GrowthPromoting Economic Growth Capital is important for the growth process.Capital is important for the growth process. The U.S. has used tax incentives to The U.S. has used tax incentives to

increase saving.increase saving.– Social Security and IRAs are forms of Social Security and IRAs are forms of

encouragement.encouragement.

Respect for private property is necessary Respect for private property is necessary to encourage people to accumulate capital to encourage people to accumulate capital for long-run benefits.for long-run benefits.




Greater educational level and skills of the Greater educational level and skills of the workforce workforce higher labor productivity. higher labor productivity.– Accumulation of Human Capital.Accumulation of Human Capital.– Education also is an important source of Social Education also is an important source of Social

Capital.Capital.




Create Institutions That Encourage Create Institutions That Encourage Technological InnovationTechnological Innovation– PatentsPatents

Patents allow innovators to charge high prices Patents allow innovators to charge high prices profits are the incentive for innovation.profits are the incentive for innovation.

Patents also Patents also fewer positive externalities to fewer positive externalities to technology.technology.

– Protecting property rightsProtecting property rights Innovators need incentives to innovate: enjoying the Innovators need incentives to innovate: enjoying the

fruits of their labors.fruits of their labors.




The State may need to provide funding for The State may need to provide funding for basic research basic research

Technology’s “common knowledge” aspect Technology’s “common knowledge” aspect little incentive to do basic research (for little incentive to do basic research (for individuals).individuals).– ““Free riders” take advantage of others’ work.Free riders” take advantage of others’ work. Technology is a public good.Technology is a public good.

U.S. government finances 60 percent of the basic U.S. government finances 60 percent of the basic research in the country.research in the country.



Promoting Economic GrowthPromoting Economic Growth The Poorest Countries: A Special Case?The Poorest Countries: A Special Case?

– Improve the legal and political frameworkImprove the legal and political framework Corrupt legal systems create uncertainty about Corrupt legal systems create uncertainty about

property rightsproperty rights Taxation and regulation discourages Taxation and regulation discourages

entrepreneurshipentrepreneurship Markets are not allowed to functionMarkets are not allowed to function Lack of political stability discourages foreign Lack of political stability discourages foreign

investment and makes foreign aid less effective.investment and makes foreign aid less effective.

– ECO 320 studies Development Economics.ECO 320 studies Development Economics.

Limits to Economic GrowthLimits to Economic Growth




Can a country grow forever without Can a country grow forever without depleting its natural resources and depleting its natural resources and damaging the environment?damaging the environment?– The historical experience in many countries that The historical experience in many countries that

have grown rich is that the environment does have grown rich is that the environment does suffer substantially.suffer substantially.

– Evidently, non-renewable resources can be Evidently, non-renewable resources can be depleted. depleted.



Limits to Economic GrowthLimits to Economic Growth The mistake of this way of thinking is that it The mistake of this way of thinking is that it

assumes that “more GDP” means “more of assumes that “more GDP” means “more of the same stuff”.the same stuff”.

In fact, much of the economic growth we In fact, much of the economic growth we see is see is different different stuff, often stuff that is stuff, often stuff that is environmentally sounder.environmentally sounder.– Richer countries tend to demand “greener” Richer countries tend to demand “greener”

technologies – and are able to afford them.technologies – and are able to afford them.



Limits to Economic GrowthLimits to Economic Growth Another problem with the “limits to growth” idea is Another problem with the “limits to growth” idea is

that it assumes that technology is constant.that it assumes that technology is constant.– In fact, technology changes frequently.In fact, technology changes frequently.– Technological advances often follow periods of scarcity.Technological advances often follow periods of scarcity.– For example, when oil became scarce in the 1970s, For example, when oil became scarce in the 1970s,

firms and consumers reacted by demanding machines firms and consumers reacted by demanding machines that used less oil.that used less oil.

– The price of oil fell dramatically The price of oil fell dramatically over timeover time..– Today, industrialized nations use ½ the oil they used to Today, industrialized nations use ½ the oil they used to

per unit of GDP.per unit of GDP.




OPEC Oil Embargo

Iranian Revolution

First Gulf War

Second Gulf War

Price of Oil in 2005 US$



Limits to GrowthLimits to Growth

Unlike technology, environmental quality Unlike technology, environmental quality cannot be bought and sold, but is protected cannot be bought and sold, but is protected only by government policy.only by government policy.– Government policy can be misdirected, too late, Government policy can be misdirected, too late,

or simply ineffective.or simply ineffective.– Do we tell the Brazilians to stop eating so we Do we tell the Brazilians to stop eating so we

can protect the rain forest?can protect the rain forest?



Limits to GrowthLimits to Growth Another problem is “human ecology.”Another problem is “human ecology.” Economic growth tends to become its own Economic growth tends to become its own

end.end.– Societies give up traditions, customs, social Societies give up traditions, customs, social

ties;ties;– Religion loses its value and gets squashed by Religion loses its value and gets squashed by

advertising, by laws, or it’s forced away from the advertising, by laws, or it’s forced away from the public sphere.public sphere.

– Loss of a sense of community and human Loss of a sense of community and human dignity in the workplace;dignity in the workplace;




– A devaluation of the family, which becomes just A devaluation of the family, which becomes just a convenient social arrangement or an a convenient social arrangement or an economic tool or hindrance;economic tool or hindrance;

– ConsumerismConsumerism: possession and comfort as the : possession and comfort as the end of life. Drugs are an extreme example.end of life. Drugs are an extreme example. ““a style of life which is presumed to be better when it a style of life which is presumed to be better when it

is directed towards "having" rather than "being", and is directed towards "having" rather than "being", and which wants to have more, not in order to be more which wants to have more, not in order to be more but in order to spend life in enjoyment as an end in but in order to spend life in enjoyment as an end in itself ” (Centesimus Annus, 36)itself ” (Centesimus Annus, 36)




The solution is neither to shrug one’s The solution is neither to shrug one’s shoulders and deny the problemshoulders and deny the problem– ( “if they choose it, who am I to say anything?”)( “if they choose it, who am I to say anything?”)

Nor to stop economic growthNor to stop economic growth– (“stop the world, I want to get off”)(“stop the world, I want to get off”)

Rather, remember Growth is an important Rather, remember Growth is an important means to achieve an end.means to achieve an end.– Societies need to remain sane about what the Societies need to remain sane about what the

end of human life is.end of human life is.

Theories of Economic GrowthTheories of Economic Growth



The Production Function and The Production Function and Theories of GrowthTheories of Growth

The The production functionproduction functionshows the relationship between the quantity of shows the relationship between the quantity of inputs used in production and the quantity of inputs used in production and the quantity of output resulting from production.output resulting from production.

InputsInputs OutputsOutputs

11 1010

22 1818

33 2424

44 2828



The Production Function and The Production Function and Theories of GrowthTheories of Growth

The production function for growth has land, The production function for growth has land, labor, and capital as factors of production.labor, and capital as factors of production.

Output = A• Output = A• ff(Labor, Land, Capital)(Labor, Land, Capital)

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



Describing Production FunctionsDescribing Production Functions

Remember: what happens when more of Remember: what happens when more of one input is added one input is added withoutwithout increasing any increasing any other inputs?other inputs?

The The law of diminishing returns law of diminishing returns states that states that increasing one output, increasing one output, keeping all others keeping all others constantconstant, will lead to smaller and smaller , will lead to smaller and smaller gains in output.gains in output.


The Classical Growth ModelThe Classical Growth Model



The Classical Growth ModelThe Classical Growth Model The The Classical growth modelClassical growth model focuses on focuses on

the interaction between land and labor.the interaction between land and labor.

It also stresses the role of capital It also stresses the role of capital accumulation in the growth process.accumulation in the growth process.– This capital accumulation is exogenous This capital accumulation is exogenous

(generated outside of the model).(generated outside of the model).– The more capital an economy has, the faster it The more capital an economy has, the faster it

will grow.will grow.




The Classical growth model focused onThe Classical growth model focused onhow diminishing returns to labor placed how diminishing returns to labor placed limitations on growthlimitations on growth..– It’s typically associated with the work of Thomas It’s typically associated with the work of Thomas

Malthus.Malthus. Land was assumed to be relatively fixed.Land was assumed to be relatively fixed.

– Therefore, additional workers were less and Therefore, additional workers were less and less productive: output per capita would fall as less productive: output per capita would fall as population grew.population grew.



Diminishing Returns of Diminishing Returns of LaborLabor

Output per person

Labor

Production function

Q1

Q2

L1 L*



Focus on Diminishing Marginal Focus on Diminishing Marginal Productivity of Productivity of LaborLabor

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

This belief is called the This belief is called the iron law of wagesiron law of wages.. The long run was called the The long run was called the stationary stationary

statestate..



Focus on Diminishing Marginal Focus on Diminishing Marginal Productivity of Productivity of LaborLabor

Thomas Malthus, in his essay “On Thomas Malthus, in his essay “On Population” (c. 1800) argued that the great Population” (c. 1800) argued that the great majority of the population would always majority of the population would always live at the subsistence level.live at the subsistence level.– If wages rose above subsistence, people If wages rose above subsistence, people

would multiply like roaches.would multiply like roaches.– As population rose and output/worker fell, As population rose and output/worker fell,

“war, famine, and pest” would bring population “war, famine, and pest” would bring population back to subsistence.back to subsistence.



Diminishing Returns of Diminishing Returns of LaborLabor and and Population GrowthPopulation Growth

Output

Labor

Subsistence level of output per worker

Production function

L*

Q1

Q2

L1

Surplus of food

Shortage of food



Malthus versus the Industrial Malthus versus the Industrial RevolutionRevolution

These predictions turn out to be wrong.These predictions turn out to be wrong.– Malthus could not foresee the Industrial Malthus could not foresee the Industrial

Revolution.Revolution.– Dramatic changes in the world’s capacity to Dramatic changes in the world’s capacity to

produce expand the boundaries of life.produce expand the boundaries of life.

Increases in capitalIncreases in capital returns to the extra returns to the extra unit of unit of laborlabor does not decline, even with does not decline, even with fixed fixed landland supplies. supplies.




Classical economists (such as J.S. Mill or A. Classical economists (such as J.S. Mill or A. Marshall 1850 - 1900) focused their analysis, and Marshall 1850 - 1900) focused their analysis, and their policy advice, on how to increase investment:their policy advice, on how to increase investment:

– Policies, therefore should encourage saving and Policies, therefore should encourage saving and investment.investment.

– Countries that save more, invest more and grow faster.Countries that save more, invest more and grow faster.

savings savings investment investment

capital accumulation capital accumulation growth growth


The Neo-Classical Growth ModelThe Neo-Classical Growth Model



Neo-Classical Theory of Neo-Classical Theory of Economic GrowthEconomic Growth

The Classical School realized that capital The Classical School realized that capital was important.was important.– But it did not have a theory of how capital is But it did not have a theory of how capital is

accumulated.accumulated. This gave rise to the This gave rise to the Neo-Classical Theory Neo-Classical Theory

of Economic Growthof Economic Growth– Robert Solow (in the 1950s – 1960s)Robert Solow (in the 1950s – 1960s)– The level of Capital/Worker is explained The level of Capital/Worker is explained

endogenouslyendogenously to grow to a steady level. to grow to a steady level.




The idea is that:The idea is that:– If Capital is highly productive If Capital is highly productive workers can save workers can save

a lot a lot savings become capital savings become capital capital / worker capital / worker increases.increases. What happens to returns to the extra unit of capital as What happens to returns to the extra unit of capital as

capital / worker increases?capital / worker increases?




The idea is that:The idea is that:– If Capital is not very productive If Capital is not very productive workers don’t workers don’t

save much save much capital accumulation slows down capital accumulation slows down capital / worker decreases.capital / worker decreases. What happens to returns to the extra unit of capital as What happens to returns to the extra unit of capital as

capital / worker decreases?capital / worker decreases?




The focus turns to the diminishing returns to The focus turns to the diminishing returns to capital:capital:

If capital / worker increases If capital / worker increases capital grows faster than labor capital grows faster than labor

extra unit of capital is less productiveextra unit of capital is less productive

As each worker uses more machines, each As each worker uses more machines, each additional machine turns out to be less additional machine turns out to be less productive.productive.



Neo-Classical Theory of Economic Neo-Classical Theory of Economic GrowthGrowth



Diminishing Returns of Diminishing Returns of CapitalCapital

Capital / Worker tomorrow

Capital / Worker today

Capital accumulation per

worker



Diminishing Marginal Productivity Diminishing Marginal Productivity of Capitalof Capital

If capital / worker increases If capital / worker increases capital grows faster than labor capital grows faster than labor

extra unit of capital is less productive extra unit of capital is less productive slower capital / worker growth slower capital / worker growth

capital / worker growth comes to a steady capital / worker growth comes to a steady levellevel

capital / worker income stops risingcapital / worker income stops rising



Diminishing Returns of Diminishing Returns of CapitalCapital and Population Growthand Population Growth



Population growth x Capital / Worker

Capital accumulation

per worker

Q1

Q2

K/LPoor K/L*

Surplus of Capital

K/LRich




– Diminishing returns to capital be stronger for richer Diminishing returns to capital be stronger for richer nations than for poor ones.nations than for poor ones.

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

Eventually per capita incomes among nations Eventually per capita incomes among nations would would convergeconverge..

This has not happened because of differences in This has not happened because of differences in hhuman capitaluman capital and and technological progresstechnological progress..

If skills and technology increase faster in a rich country than in a If skills and technology increase faster in a rich country than in a poor one, incomes will not converge.poor one, incomes will not converge.



Technology, Human Capital, and Technology, Human Capital, and GrowthGrowth

Population growth x Capital / Worker

Q1

Q2

K/L1 K/L2



Capital accumulation

per worker

Better Technology increases productivity



Technology, Human Capital, and Technology, Human Capital, and GrowthGrowth



Sources of Real U.S. GDP Sources of Real U.S. GDP Growth, 1928-2000Growth, 1928-2000

Human capital (13%)Physical capital (19%)

Technology (35%)Labor (33%)


New Growth TheoryNew Growth Theory




Neo-Classical growth theory realized that Neo-Classical growth theory realized that Technology and Human Capital were Technology and Human Capital were important for economic growth.important for economic growth.– But it did not have a theory of how technology But it did not have a theory of how technology

and human capital were accumulated.and human capital were accumulated.

This gave rise to This gave rise to New Growth TheoryNew Growth Theory– NGT explains technology NGT explains technology endogenously.endogenously.




New growth theoryNew growth theory emphasizes the role of emphasizes the role of technology rather than capital in the growth technology rather than capital in the growth process.process.

Technology is the result of investment in Technology is the result of investment in creating technology (research and creating technology (research and development).development).– Technology is more complicated than capital Technology is more complicated than capital

because of externalities and learning-by-doing.because of externalities and learning-by-doing.



New Growth theory distinguishes between New Growth theory distinguishes between investment in capital and investment in investment in capital and investment in technology.technology.– Some technological breakthroughs may Some technological breakthroughs may

happen with little investment.happen with little investment.– Large amounts of investment are not a Large amounts of investment are not a

guarantee of finding good ideas.guarantee of finding good ideas.




Increases in technology often have Increases in technology often have enormous positive spillover effects.enormous positive spillover effects.– Technological advances in one sector of the Technological advances in one sector of the

economy lead to advances in completely economy lead to advances in completely different sectors.different sectors.

– For example, military research in computers For example, military research in computers led to the mainframe, the personal computer, led to the mainframe, the personal computer, the internet, etc…the internet, etc…




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

workers.workers.– This counteracts the law of diminishing marginal This counteracts the law of diminishing marginal

productivity.productivity.




Network ExternalitiesNetwork Externalities NetworksNetworks

– The use of a good by one individual makes The use of a good by one individual makes that technology more valuable to other people.that technology more valuable to other people.

Switching from a technology Switching from a technology exhibiting network externalities exhibiting network externalities to a superior technology is to a superior technology is expensive and sometimes expensive and sometimes nearly impossible.nearly impossible.This is a reason why This is a reason why technology is subject to technology is subject to uncertainty but also a source of uncertainty but also a source of great benefits.great benefits.



Policy ConsequencesPolicy Consequences

The Classical school is right in part.The Classical school is right in part.– More natural resources per person (and better More natural resources per person (and better

use thereof) will increase standards of living.use thereof) will increase standards of living. The NeoClassical school is right in partThe NeoClassical school is right in part

– More savings and capital encourage growth, but More savings and capital encourage growth, but up to a point.up to a point.

– Technology is key.Technology is key. New Growth theory is right in partNew Growth theory is right in part

– Property rights and networks are key to Property rights and networks are key to technological development.technological development.

economic growth, productivity, and living standards principles of macroeconomics dr. gabriel x....

Documents

economic growth good

copyright c

mcgrawhill companies

economic output

economic stability

growth rate

living standards

capital real gdp