1. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 7: Growth, Productivity, and Wealth in the Long Run Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology

2. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 General Observations about Growth Growth is an increase in the amount of goods and services an economy produces. Growth is an increase in potential output.

3. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 Growth and the Economy’s Potential Potential output – the highest amount of output an economy can produce from the existing production function and existing resources. When an economy is at its potential output, it is operating on its production possibility curve.

4. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 Growth and the Economy’s Potential Long-run growth focuses on supply. It assumes Say’s Law – supply creates its own demand.  Demand is sufficient to buy what is produced.

5. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 Growth and the Economy’s Potential In the short run, economists consider potential output fixed. They focus on how to get the economy operating at its potential if it is not.

6. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 Importance of Growth for Living Standards Growth improves living standards. It makes more goods available to more people. Because of compounding, long-term growth rates matter a lot.

7. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 Importance of Growth for Living Standards The Rule of 72 is used to determine how long it takes for income to double at different growth rates. The Rule of 72 – the number of years it takes for a certain amount to double in value is equal to 72 divided by its annual growth rate.

8. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 Markets, Specialization, and Growth Markets, specialization and the division of labour increase productivity and growth.  Specialization – the concentration of individuals on certain aspects of production  Division of labour – the splitting up of a task to allow for specialization of production.  Productivity – output per unit of input.

9. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 Markets, Specialization, and Growth Markets and specialization lead to growth. Economic growth began when markets developed (early 1800s), and as they expanded, growth accelerated.

10. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Economic Growth, Distribution, and Markets Markets are often seen to be unfair because of the effect they have on the distribution of income.

11. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 Economic Growth, Distribution, and Markets Would the poor be better off without markets? Historically, judged from an absolute standard, there is strong evidence that the poor benefit enormously from the growth that markets foster.

12. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 Economic Growth, Distribution, and Markets Judged from a relative standard, it is not at all clear that markets require the large differentials in pay that has accompanied growth in market economies.

13. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 Economic Growth, Distribution, and Markets Just because the poor benefit from growth does not mean they might not be better off if income were distributed more in their favour.

14. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14 Per Capita Growth Per capita output is total output divided by total population. Per capita growth means producing more goods and services per person.

15. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15 Per Capita Growth Per capita growth equals the percent change in output minus the percent change in population. Per capita growth = % change in output - % change in population

16. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Per Capita Growth In many developing nations, the population is rising faster than GDP, resulting in a lower per capita growth rate.

17. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Per Capita Growth Some economists have argued that per capita (mean, average) output is not what we should be focusing on. We should focus on median income instead.

18. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 Per Capita Growth Median income is a better measure because it takes into account how income is distributed. If the growth in income goes mostly to a small minority of individuals, the mean will rise but the median will not.

19. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 The Sources of Growth Economists identify five important sources of growth:  Capital accumulation – investment in productive capacity.  Available resources.  Growth-compatible institutions.  Technological development.  Entrepreneurship.

20. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 20 Investment and Accumulated Capital Years ago it was thought that physical capital -- buildings and machinery --was the key to growth. The flow of investment led to the growth of the stock of capital.

21. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 Investment and Accumulated Capital Capital accumulation does not necessarily lead to growth. Products change, and useful buildings and machines in one time period may be useless in another.

22. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 Investment and Accumulated Capital Capital also includes human and social capital.  Human capital – the skills that are embodied in workers through experience, education, on-the-job training.  Social capital – the habitual way of doing things that guides people in how they approach production.

23. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 Investment and Accumulated Capital All economists agree that the right kind of investment at the right time is a central element of growth.

24. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 24 Available Resources For an economy to grow it will need resources. What constitutes a resource at one time may not be a resource at another time.

25. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 Available Resources Greater participation in the market is another way by which available resources are increased.

26. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 26 Growth-Compatible Institutions Markets and private ownership of property foster economic growth. When individuals get much of the gains of growth themselves, they work harder.

27. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 27 Growth-Compatible Institutions Another growth-compatible institution is the corporation. Because of limited liability, corporations give owners an incentive to invest their savings in large enterprises.  Losses are limited.

28. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 Technological Development Growth involves changes in technology. Technology – changes the way we make goods and supply services, as well as the goods and services we buy.

29. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 Technological Development To see how technology translates into growth, we look at Total Factor Productivity (TFP). Total Factor Productivity (TFP) is the weighted average of real GDP per worker and real GDP per $1000 of capital stock.

30. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 Entrepreneurship Entrepreneurship is the ability to get things done. That ability involves creativity, vision, and a talent for translating that vision into reality.

31. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 31 Turning the Sources of Growth into Growth In order to be effective, the five sources of growth must be mixed in the right proportions. The combination of investing in machines, people, and technological change plays a central role in the growth of any economy.

32. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 32 The Production Function and Theories of Growth The production function shows the relationship between the quantity of inputs used in production and the quantity of output resulting from production.

33. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 The Production Function and Theories of Growth The production function for growth has land, labour, and capital as factors of production. “A” is an adjustment factor that captures the effect of technology. Output = A f (Labour, Capital, Land)

34. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 Describing Production Functions Scale economies describe what happens in a production function when all inputs increase equally.  Constant returns to scale.  Increasing returns to scale.  Decreasing returns to scale.

35. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 Describing Production Functions Constant returns to scale means that output will rise by the same proportionate increase as all inputs.

36. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 36 Describing Production Functions Increasing returns to scale occurs when output rises by a greater proportionate increase as all inputs.

37. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 37 Describing Production Functions Decreasing returns to scale occurs when output rises by a smaller proportionate increase as all inputs.

38. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 38 Describing Production Functions Diminishing marginal productivity describes what happens when more of one input is added without increasing any other inputs. The law of diminishing marginal productivity states that increasing one input, keeping all others constant, will lead to smaller and smaller gains in output.

39. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 39 The Classical Growth Model The Classical growth model focuses on capital accumulation in the growth process. The more capital an economy has, the faster it will grow. Because of this emphasis on capital, our economic system is called capitalism.

40. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 40 The Classical Growth Model Classical economists focused their analysis and their policy advice, on how to increase investment by saving: saving  investment  increase in capital  growth

41. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 41 Focus on Diminishing Marginal Productivity of labour The Classical growth model focused on how diminishing marginal productivity of labour placed limitations on growth. Farming was the major economic activity and the amount of land was relatively fixed.

42. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 42 Focus on Diminishing Marginal Productivity of labour Economists such as Thomas Malthus said that since land was fixed, diminishing marginal productivity would set in as population grew. As output per person declines, at some point available output would no longer be sufficient to feed the population.

43. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 43 Diminishing Returns and Population Growth Output Labour Subsistence level of output per worker Production function Q1Q1 Q2Q2 L1L1 L*

44. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 44 Focus on Diminishing Marginal Productivity of labour Beyond L*, output per person is no longer sufficient to feed the population.  Starvation and a decline in population would occur. Below L*, there is surplus output and population grows.

45. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 45 Focus on Diminishing Marginal Productivity of labour The iron law of wages suggested that in the long run, the economy would be driven to a stationary state at L*.

46. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 46 Diminishing Marginal Productivity of Capital The predictions of the stationary state turned out to be wrong. Increases in technology and capital overwhelmed the law of diminishing marginal productivity.

47. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 47 Diminishing Marginal Productivity of Capital Modern economists, such as Robert Solow, changed the focus to the diminishing marginal productivity of capital, not labour. They assumed population grows at a constant rate.

48. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 48 Diminishing Marginal Productivity of Capital capital grows faster than labour  capital is less productive  slower economic output  per capita growth stagnates  per capita income stops rising.

49. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 49 Convergence Diminishing marginal productivity of capital would be stronger for richer nations than for poor ones, therefore, their growth rate would slow down. Poor countries with little capital should grow faster than countries with lots of capital.

50. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 50 Eventually per capita incomes among nations would converge. This has not happened. In fact, per capita incomes of rich and poor countries have diverged. Convergence

51. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 51 Why?  defining the inputs (factors of production)  technology Convergence

52. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 52 Defining the Factors of Production The definition of the factors of production are ambiguous. It would seem that the definition of labour would be straightforward – the hours of work that go into production.

53. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 53 Economists separate labour into two components. Standard labour – the actual number of hours worked. Human capital – the skills embedded in workers through experience, education, and on-the-job training. Defining the Factors of Production

54. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 54 Increases in human capital have allowed labour to keep pace with capital. This allows economies to avoid the diminishing productivity of capital. Defining the Factors of Production

55. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 55 If skills are increasing faster in a rich country than in a poor one, incomes would not be expected to converge. Defining the Factors of Production

56. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 56 Technology Technology overwhelms diminishing marginal productivity so that growth rates can increase over time. Economist Edward Denison estimated the importance of each of the sources of growth:  Labour contributes 33% to growth  Technology contributes 35% to growth

57. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 57 New Growth Theory New growth theory emphasizes the role of technology rather than capital in the growth process.

58. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 58 Technology Technology is the result of investment in creating technology (research and development). Investment in technology increases the technological stock of an economy.

59. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 59 Technology New Growth Theory separates investment in capital and investment in technology. Increases in technology are not as directly linked to investment as is capital.

60. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 60 Technology Increases in technology often have enormous positive spillover effects. Technological advances in one sector of the economy lead to advances in completely different sectors.

61. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 61 Technology Technological advances have positive externalities. Positive externalities – positive effects on others not taken into account by the decision maker.

62. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 62 Technology Some basic research is protected by patents. Patents – legal ownership of a technological innovation that gives the owner of the patent sole rights to its use and distribution for a limited time.

63. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 63 Learning by Doing New growth theory also highlights learning by doing. Learning by doing – improving the methods of production through experience.

64. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 64 Learning by Doing By increasing the productivity of workers, learning by doing overcomes the law of diminishing marginal productivity.

65. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 65 Increasing Returns to Scale Production function with increasing returns Output All inputs

66. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 66 Technological Lock-In Technological lock-in is an example of how sometimes the economy does not use the best technology available. It occurs when old technologies become entrenched in the market.  despite the fact that more efficient technologies are available.

67. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 67 Technological Lock-In One reason for technological lock-in is network externalities. Network externalities – an externality in which the use of a good by one individual makes that technology more valuable to other people.

68. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 68 Technological Lock-In Switching from a technology exhibiting network externalities to a superior technology is expensive and sometimes nearly impossible.  The Windows operating system exhibits network externalities.

69. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 69 Economic Policies to Encourage Per Capita Growth Encourage saving and investment. Improve incentives to work. Control population growth. Increase the level of education. Create institutions that encourage technological innovation. Provide funding for basic research. Increase the economy’s openness to trade.

70. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 70 Policies to Encourage Saving and Investment Modern growth theories have downplayed the importance of capital in the growth process. However, all agree that it is important. Policy makers are eager to encourage both saving and investment.

71. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 71 Policies to Encourage Saving and Investment Canada has used tax incentives to increase saving. These include retirement savings plans (RRSPs) that allow individuals to save without incurring taxes on contributions until they are withdrawn.

72. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 72 Policies to Encourage Saving and Investment It is difficult for poor countries to generate saving and investment. The poor have subsistence incomes while the rich in those countries place their savings abroad for fear of confiscation by government.

73. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 73 Foreign investment provides another source of saving.  Developing nations can borrow from the International Monetary Fund (IMF), the World Bank, or from private sources.  None of these are perfect solutions since they come with large strings attached. Policies to Encourage Saving and Investment

74. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 74 A Case Study: The Borrowing Circle The borrowing circle of Grameen bank is an example of how to increase investment in a developing nation.  The traditional way of lending money is to ask for collateral, but in Bangladesh, potential borrowers had no collateral.

75. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 75 A Case Study: The Borrowing Circle The bank officer replaced collateral with the borrowing circle concept.  Borrowing circle concept – a credit system that replaces traditional collateral with guarantees by friends of the borrower. In case of a default, the friends had to make the loan good.

76. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 76 Policies to Improve Incentives to Work Using income tax cuts to increase labour supply is called Supply-side economics. When tax rates fall, two things happen:  The Substitution Effect  The Income Effect

77. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 77 The cost of leisure time increases, because the opportunity cost of leisure is lost work time (and money). This is the Substitution Effect. Policies to Improve Incentives to Work

78. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 78 Individuals can work less and still maintain their current incomes. The is the Income Effect. Policies to Improve Incentives to Work

79. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 79 When the Substitution Effect outweighs the Income Effect, the tax cut will increase labour supplied. Policies to Improve Incentives to Work

80. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 80 Arthur Laffer looked at the relationship between income tax rates and the amount of tax collected. The Laffer Curve illustrates this relationship. Policies to Improve Incentives to Work

81. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 81 Laffer Curve Tax Rate Tax Collected $T t% 0%100%

82. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 82 Policies to Control Population Growth Developing nations whose populations are rapidly growing have difficulty providing enough capital and education for everyone. Thus, per capita income is low.

83. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 83 Policies to Control Population Growth Policies that reduce population growth include:  Free family–planning services.  Increased availability of contraceptives.  One-child-per-family policies, such as China adopted in 1980.

84. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 84 Policies to Control Population Growth Some economists argue that to reduce population growth, a nation must grow first.  As income and work opportunities rise, especially for women, the opportunity cost of having children rises and families will choose to have fewer children.

85. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 85 Policies to Increase the Level of Education Increasing the educational level and skills of the workforce increases labour productivity. In developing nations, the return on investments in education is much higher than in developed nations.

86. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 86 Education must be of the right kind. Technical training in improved farming methods or construction is more important than higher education in a developing country. Policies to Increase the Level of Education

87. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 87 In Canada, it is estimated that an additional year of school increases a worker’s wages by an average of 10 percent. An additional year of school in developing nations will increase income by 15-20 percent. Policies to Increase the Level of Education

88. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 88 Policies to Create Institutions That Encourage Technological Innovation While all agree that technology is important, no one is sure what the best technological growth policies are. Not only is research uncertain, so is its application.

89. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 89 Patents and protecting property rights are two ways to encourage innovation. Patents are not costless to society. Patents allow innovators to charge high prices for their use. Policies to Create Institutions That Encourage Technological Innovation

90. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 90 Societies must find a middle ground between providing incentives to create new technologies and allowing everyone to take advantage of the benefits of technology. Policies to Create Institutions That Encourage Technological Innovation

91. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 91 Should poor nations accept patent laws?  Societies must find a middle ground between giving individuals appropriate incentives to create new technologies and allowing everyone to take advantage of the benefits of technology. Policies to Create Institutions That Encourage Technological Innovation

92. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 92 Bringing technological innovations to markets often requires large amounts of investment over a number of years. The corporation offers limited liability protection, and thereby encourages investors to pool their funds. Policies to Create Institutions That Encourage Technological Innovation

93. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 93 Well-developed financial institutions such as stock markets create liquidity and encourage investment. Policies to Create Institutions That Encourage Technological Innovation

94. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 94 Policies to Provide Funding for Basic Research Individual firms have little incentive to do basic research because of technology’s “common knowledge” aspect. This is why the Canadian government provides most of the funding for basic research in this country.  Canada’s spending on research and development (R&D) lags other industrialized countries.

95. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 95 Policies to Increase Openness to Trade Free trade increases growth by broadening the market and by fostering competition. In order to specialize, you need a large market. Large markets allow firms to take advantage of economies of scale.

96. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.96 Growth, Productivity, and Wealth in the Long Run End of Chapter 7