1. MODERN PRINCIPLES OF ECONOMICS Third Edition The Wealth of Nations and Economic Growth Chapter 7

2. Outline  Key Facts about the Wealth of Nations and Economic Growth  Understanding the Wealth of Nations  Incentives and Institutions 2

3. Introduction  Economic growth brings wealth, which increases societal well-being.  Wealthier nations have: Higher infant survival rates, life expectancy, and nutrition. More educational opportunities, leisure, and entertainment. Fewer conflicts such as civil wars and riots. More material goods. 3

4. Introduction Wealthier countries have higher infant survival rates. 4 Penn World Tables and World Bank Group, World Development Indicators, 2005

5. Key Facts  Key facts about the wealth of nations and economic growth : 1.GDP per capita varies enormously among nations. 2.Everyone used to be poor. 3.There are growth miracles and growth disasters. 5

6. 1. GDP Growth Varies  Most of the world’s population is poor relative to the United States.  About a billion people have incomes of less than $2 per day.  About 67% of the world’s population lived in a country with a GDP per capita equal to or less than $7,826, about the level in China.  Fully 75% of the world’s population lived in a country with a GDP per capita less than average. 6

7. 1. GDP Growth Varies The Distribution of World Income 7

8. 2. Everyone Used To Be Poor  The distribution of world income tells us that poverty is normal, while wealth is unusual.  GDP per capita in the year 1 is estimated around $700–$1,000 per year in 2010 dollars.  This was approximately the same in all major regions of the world.  For most of recorded human history, there was no long-run growth in real per capita GDP.  Today, GDP per capita is 50 times larger in the richest countries than in the poorest. 8

9. 2. Everyone Used To Be Poor Economic Growth in Major World Regions 9

10. Growth Rates  Economic growth is measured as the growth rate of real GDP per capita.  Even slow growth, sustained over time, produces big differences in wealth.  Growth builds on top of growth through “compounding” or “exponential growth.” 10

11. Measuring Growth Economic growth is measured as: where: g t = growth rate of real GDP per capita y t = real GDP per capita in time period t 11

12. Measuring Growth Example: Year real GDP per capita 2008$15,000 billion 2009 $15,500 billion 12

13. Self-Check 13 Real GDP per capita was $22,000 in Year 1 and $23,000 in Year 2. The growth rate was: a.4.35% b.4.55% c.4.75% Answer: b – the growth rate was [(23,000 – 22,000) / 22,000] x 100 = 4.55%

14. Measuring Growth  The rule of 70 approximates the length of time necessary for a growing variable to double:  Example: If real GDP per capita is growing at an annual growth rate of 3.5%, it will double in: 14

15. The Rule of 70 Small changes in the growth rate lead to large changes over time. 15

16. Self-Check 16 According to the rule of 70, a sum of money invested at 12.5% would double in: a.5.6 years. b.17.86 years. c.56 years. Answer: a – the money would double in 70 / 12.5 = 5.6 years.

17. Self-Check 17 How long it will take for the average Indian to be as wealthy as the average Western European is today? Note that all numbers are adjusting for inflation. India's GDP per capita is $3,000, and let's say that real output per person there grows at 5 percent per year. Using the rule of 70, how many years will it take for India to reach Italy's current level of GDP per capita, about $24,000 per year? a)42 years b)14 years c)28 years. d)12 years

18. Economic Growth Growth miracles and growth disasters. 18

19. Economic Growth Two Growth Miracles  The United States is one of the wealthiest countries in the world because the United States has grown slowly but relatively consistently for more than 200 years.  From 1950 to 1970, Japan grew 8.5% per year.  Today, Japan is one of the richest countries in the world.  In 1950, South Korea had GDP per capita about the same as that of Nigeria.  Between 1970 and 1990, it grew at a rate of 7.2% per year.  Today, South Korea is on a par with many European economies. 19

20. Economic Growth Two Growth Disasters  Nigeria has barely grown since 1950.  It was poorer in 2005 than in 1974 when high oil prices briefly bumped up its per capita GDP.  In 1900, Argentina was one of the richest countries in the world.  By 1950, Argentina’s per capita GDP had fallen to half that of the U.S.  By 2000 Argentina’s per capita GDP was less than one-third of that of the U.S. 20

21. Economic Growth The Bad News:  Most of the world is poor.  More than 1 billion people live on incomes of less than $2 per day.  These people have greatly reduced prospects for health, happiness, and peace. 21

22. Economic Growth The Good News:  Despite being quite recent, economic growth has transformed the world.  It has raised the standard of living of most people in developed nations many times above the historical norm.  It can happen quite quickly.  Understanding the wealth of nations is critical if we are to improve the human condition. 22

23. Self-Check 23 Most of the world is: a.Relatively well-off. b.Wealthier than the U.S. c.Poor. Answer: c – most of the world is poor.

24. Self-Check 24  Would you rather live in a country that has high taxes and a generous social safety net or a country with low taxes and little social safety? a)High tax, generous social safety b)Low tax, low level of social safety

25. The Wealth of Nations 25 The causes of growth in GDP per capita include factors of production, incentives, and institutions.

26. Definition Physical capital : the stock of tools including machines, structures, and equipment. 26 Human capital : the productive knowledge and skills that workers acquire through education, training, and experience.

27. Factors of Production  Countries with a high GDP per capita have a lot of factors of production: physical capital, human capital, and technological knowledge.  More and better physical capital make workers more productive.  Human capital enables workers to take advantage of more sophisticated tools.  Greater quantities of physical and human capital per worker makes workers more productive.  We increase human capital with education. 27

28. Definition Technological knowledge : knowledge about how the world works, that is used to produce goods and services. 28

29. Factors of Production  Improved technological knowledge increases productivity, and is potentially boundless.  Better technological knowledge has allowed U.S. farms to increase their output two and a half times since 1950, while using less land.  We increase technological knowledge with research and development.  The organization of factors of production depends on incentives and institutions. 29

30. Self-Check 30 Knowledge that is used to produce goods and services is called: a.Technological knowledge. b.Human capital. c.Factors of production. Answer: a – technological knowledge.

31. Definition Institutions : the “rules of the game” that structure economic incentives. 31

32. Incentives and Institutions  Institutions include laws and regulations but also customs, practices, organizations, and social mores.  Institutions that promote growth create incentives that align self-interest with the social interest.  Wealthy countries have institutions that make it in people’s self-interest to invest in physical capital, human capital, and technological knowledge. 32

33. Incentives and Institutions  Institutions of economic growth include: Property rights Honest government Political stability A dependable legal system Competitive and open markets 33

34. Korea’s Experiment Before division after WWII: similar Culture, physical capital, technology. North Korea became a communist state with a centrally planned economy. South Korea adopted the capitalist free market model. 34

35. Property Rights  Property rights are important institutions for encouraging investment in physical and human capital.  Under communal property, effort is divorced from payment so there is incentive to free ride.  When China switched from communal to individual farms, food production increased by 50% and 170 million people were lifted above the lowest poverty line. 35

36. Definition Free rider : someone who consumes a resource without working or contributing to the resource’s upkeep. 36

37. China’s “Free Rider” Problem China’s “Great Leap Forward”- which introduced farming collectives- reduced incentives. 20-40 million starved. 1978, farmers in Xiaogang met in secret to devise a plan to keep some of their produce. Productivity improved so quickly the government allowed the experiment to proceed. Food production increased 50% in 5 years 1978- 1983. 37

38. Property Rights  Savers won’t save and investors won’t invest if they don’t expect that they will receive a return for their savings and investment.  Property rights are also important for encouraging technological innovation.  Companies will not undertake research and development unless they expect to profit from it. 38

39. Property Rights No one must “own” you for economic freedom to exist. Ownership is right to shape, use, and dispose. You wouldn’t think you really owned it if the government controlled its use The government would be the de facto owner. Ownership is control, without it, you don’t “own” it. 39

40. Property Rights Mongolian Yaks – were owned by the government for decades (the People’s Yaks) Total Yak population did not change from 1920s to 1990s After the collapse of central planning, property rights were assigned. The Yak population soared from 25 to 32 million in a few short years When it’s your yak, not “everybody’s” yak, you take care of the yak and make more yaks You “share” your Yaks with other people with mutually beneficial trades involving yak products. “No one ever washed a rental car” 40

41. Property Rights “Sharing” when done at gun point (i.e. government confiscation of property) is not the proper term to use. Nor is the word “compassion” appropriate “No one ever washed a rental car” 41

42. Honest Government  Corruption is like a tax that bleeds resources away from productive entrepreneurs.  Resources “invested” in bribing cannot be invested in machinery and equipment.  Corruption makes it more profitable to be a corrupt politician or bureaucrat.  Few people want to be entrepreneurs because they know that their wealth will be stolen.  Corruption explains much of the poverty in various countries 42

43. Honest Government 43

44. Honest Government Corrupt countries have lower GDP per capita. 44

45. Self-Check 45 Rules, regulations, and customs that structure incentives are called: a.Human capital. b.Institutions. c.Investment. Answer: b – institutions.

46. Political Stability 46 Changing governments without the rule of law creates uncertainty which leads to less investment in physical and human capital. In many nations civil war, military dictatorship, and anarchy have destroyed the institutions necessary for economic growth.

47. Dependable Legal System  A good legal system facilitates contracts and protects private parties from expropriating one another.  Poorly protected property rights can stem from either too much or too little government.  Some legal systems are of such low quality that no one knows for certain who owns what.  It is difficult to borrow money if lenders can’t get their money back. 47

48. Dependable Legal System 48 “Rule of Law” – crucial to economic growth The rule of law is the general concept that government as well as the governed are subject to the law and that all are to be equally protected by the law. Otherwise…..the worst kinds of corruption occur Power does not equal wisdom or good judgment

49. Dependable Legal System 49 Most of human history the rules by which life was governed were usually determined by force and fraud He who had the power made the rules. Absolute monarch or tyrannical despots “Divine right of Kings” subjects accepted their rule without question

50. Competitive and Open Markets  About half the differences in per capita income across countries are explained by differences in the amount of physical and human capital.  Half the differences are explained by a failure to use capital efficiently.  Competitive and open markets are one of the best ways to encourage the efficient organization of resources. 50

51. Competitive and Open Markets  Some reasons for inefficient organization include: Inefficient and unnecessary regulations. Red tape, or the time and cost to do tasks such as starting a business or enforcing a contract in a court of law. Barriers to free trade. 51

52. Competitive and Open Markets  Why do poor countries use their capital inefficiently?  One study found: if India used its physical and human capital as efficiently as the U.S., India would be 4x richer than it is today. Whether inadvertently or not, inefficient and unnecessary regulations: Create monopolies and impede markets Example: until recently in India, it was illegal to produce shirts using large-scale production 52

53. Definition Economies of scale : the advantages of large-scale production that reduce average cost as quantity increases. i.e. as output increases, cost per unit falls 53

54. Ultimate Causes of Wealth  Natural resources may help explain why a country is able to accumulate physical and human capital.  Transport is cheaper over water than over land, so countries with access to water are more open to trade.  Landlocked countries have lower per capita GDP than countries with access to a coast.  History, ideas, geography, and luck are also important to economic growth. 54

55. England and the Industrial Revolution  Why did England’s Industrial Revolution bring us:  large scale factories  mass production  the steam engine  the railroad  the beginnings of a consumer society  the first sustained rise in human living standards above subsistence? 55

56. England and the Industrial Revolution  Property rights?  England’s geography and Navy helped protect property rights  Honest government  Growth of Parliament (and religious changes) reduced royal tyranny  Political stability  Middle class developed from growth  A dependable legal system  Less corruption as royal and Catholic power is reduced  Competitive and open markets  England opened itself more to trade 56

57. Video – Economic Progress and Freedom Hans Rosling: “The Magic Washing Machine” https://www.youtube.com/watch?v=BZoKfap4g4w 57

58. Takeaway  Economic growth has raised billions of people out of poverty.  Poor countries can catch up to rich countries and in a surprisingly short period.  Countries with a high GDP per capita have lots of physical and human capital per worker, organized using the best technological knowledge. 58

59. Takeaway  Countries with a high GDP per capita have institutions that encourage investment in physical capital, human capital, technological innovation, and the efficient organization of resources.  Institutions for increasing economic growth are property rights, honest government, political stability, a dependable legal system, and competitive and open markets.. 59