1. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. GROWTH, PRODUCTIVITY, AND THE WEALTH OF NATIONS Chapter 8

2. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-2 Today’s lecture will: Define growth and relate it to living standards. Discuss the five sources of growth. Distinguish diminishing marginal productivity from decreasing returns to scale. Explain the convergence hypothesis and four reasons why it has occurred. Distinguish Classical growth theory from new growth theory. Discuss six government policies to promote growth.

3. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-3 Economic Growth Growth is an increase in potential output. Potential output – the maximum output an economy can produce from the existing production function and existing resources. The short-run focus is on how to get the economy operating at its potential. The long-run growth focus is on how to increase potential output.  It assumes Say’s Law – supply creates its own demand.

4. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-4 Importance of Growth for Living Standards Growth improves average living standards. Because of compounding, long-term growth rates can make huge differences. Rule of 72 – # years to double= 72/ growth rate. If China’s economy grows 9% per year and the U.S. grows 2% per year, in 72 years  U.S. per capita income = $160,000  China’s per capita income = $512,000

5. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-5 Markets, Specialization, and Growth Markets, specialization, and the division of labor increase productivity and growth.  Specialization – the concentration of individuals on certain aspects of production.  Division of labor – the splitting up of a task to allow for specialization of production. Markets may seem to be unfair because of the effect that they have on the distribution of income.

6. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-6 Economic Growth, Distribution, and Markets Markets may not provide equality of income, but they make the poor better off. There is strong evidence that the poor benefit enormously from the growth that markets foster. Just because the poor benefit from growth does not mean that they might not benefit more is income were distributed more in their favor.

7. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-7 Cost of Goods in Hours of Work Price in minutes of work 050100150200 1919 Milk (½ gallon) Beef (1 pound) Eggs (1 dozen) Bread (1 pound) Chicken (3 lb. fryer) 2005 Beef (1 pound) Eggs (1 dozen) Bread (1 pound) Chicken (3 lb. fryer) Milk (½ gallon)

8. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-8 Per Capita Growth Per capita output is total output divided by total population. Per capita growth means producing more goods and services per person. Per capita growth = % Δ in output - %Δ in population Median income is a better measure because it takes into account how income is distributed.

9. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-9 The Sources of Growth Capital accumulation – investment in productive capacity Available resources Growth compatible institutions Technological development Entrepreneurship

10. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-10 Investment and Accumulated Capital Investment and Accumulated Capital Although capital is a key element in growth, capital accumulation does not necessarily lead to growth. Capital may become obsolete. Capital is much more than machines. It includes:  Human capital – skills that workers gain from experience, education, and on-the-job training.  Social capital – the habitual way of doing things that guides people in how they approach production.

11. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-11 Available Resources The growth in the U.S. in the 20 th century was due in part to its large supply of natural resources. New technology can overcome a lack of resources. Greater participation in the market may increase the labor force participation rate.

12. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-12 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. Corporations are a growth-compatible institution because of limited liability, which gives stockholders an incentive to invest their savings in large enterprises.

13. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-13 Technological Development Technology - changes in the way we make goods and supply services, and in the goods and services we buy. Advances in technology shift the production possibilities curve outward by making workers more productive. Important developments in biotechnology, computers, and communications have helped fuel U.S. growth.

14. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-14Entrepreneurship Entrepreneurship is the ability to get things done using creativity, vision, and a talent for translating vision into reality. Examples of American entrepreneurs include:  Thomas Edison – generation and use of electricity  Henry Ford – automobile production  Bill Gates – computers and software

15. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-15 Sources of Real U.S. Growth, 1928-2005 The five sources of growth must be mixed in the right proportions. Economist Edward Denison estimated the importance of four sources of growth. Human capital (13%) Physical capital (19%) Technology (35%) Labor (33%)

16. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-16 The Production Function Production function shows the relationship between inputs and outputs. Growth is shown by a shift in the production function. Output = A●F(labor, capital, land)

17. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-17 Describing Production Functions Constant returns to scale – output will rise by the same proportionate increase as all inputs. Increasing returns to scale – output will rise by a greater proportionate increase as all inputs. Decreasing returns to scale – output will rise by a smaller proportionate increase as all inputs. The law of diminishing marginal productivity – increasing one input, keeping all others constant, will lead to smaller and smaller gains in output.

18. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-18 The Classical Growth Model According to the Classical growth model, the more capital an economy has, the faster it will grow. Classical economists focused their analysis and their policy advice on how to increase investment: savings investment increase in capitalgrowth

19. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-19 Diminishing Marginal Productivity of Labor The Classical growth model focused on how diminishing marginal productivity of labor would limit growth. Since the amount of farm land is fixed, diminishing marginal productivity would set in as population grew. The iron law of wages - as output per person declines, at some point available output is no longer sufficient to feed the population. This long-run outcome was called the stationary state.

20. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-20 Diminishing Returns and Population Growth Output Labor Subsistence level of output per worker Production function Q1Q1 Q2Q2 L1L1 L*

21. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-21 Diminishing Marginal Productivity of Capital The predictions for the long term were incorrect because increases in technology and capital overwhelmed diminishing marginal productivity. The focus became the diminishing marginal productivity of capital, not labor. Capital grows faster than labor Capital is less productive Slower growth of output Per capita growth stagnates

22. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-22 The Convergence Hypothesis The diminishing marginal productivity of capital leads to the convergence hypothesis – per capita income in countries with similar institutional structures will converge to the higher level. The U.S. will grow slower because the marginal product of capital is higher in developing countries, hence costs of production are lower. This difference causes capital investment flows and production to move from the U.S. to developing countries.

23. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-23 The Convergence Hypothesis As of the early 2000s the predictions of convergence have not come true. Economists have several explanations of why convergence has not taken place:  Lack of factor mobility  Differing institutional structure  Incomparable factors of production  Technological agglomeration effects

24. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-24 Lack of Factor Mobility and Differing Institutional Structure The transfer of capital and technology causes convergence. If there are barriers to factor mobility, convergence is slowed down or reduced. The more similar the institutional structures, the more likely convergence will occur because firms are more likely to move production to countries that are well-suited to business.

25. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-25 Incomparable Factors of Production Labor in various countries differ in skills, education, experience, and effort. When a society’s workers become more educated, that country’s human capital increases even though labor hours may not change. Increases in human capital allow labor to keep pace with capital and avoid the diminishing marginal productivity of capital.

26. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-26 Technological Agglomeration Technological agglomeration – the tendency of technological advance to spawn further technological advances, creating a concentration of new technologies in a specific location. As long as new technological advances occur faster in developed countries than older technologies diffuse into less developed countries, convergence need not take place.

27. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-27 New Growth Theory Unlike Classical growth theory, which left technology outside of economic analysis, new growth theory emphasizes the role of technology rather than capital in the growth process. Technological advanceInvestment Further technological advance Growth

28. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-28 Technology Doesn’t Just Happen Investment in research and development increases technology. Patents provide incentives for innovation. New technology leads to newer technology, which leads to accelerating growth. Basic research has positive externalities.

29. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-29 Learning by Doing New growth theory also highlights learning by doing. Learning by doing – improving the methods of production through experience. Learning by doing overcomes the law of diminishing marginal productivity. Learning by doing leads to increasing returns to scale.

30. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-30 Does an Economy Always Use the Best Technology? Technological lock-in occurs when old technologies become entrenched in the market. More efficient technologies may be available. Network externalities ( the use by one individual makes a technology more valuable to others) lead to technological lock-in.

31. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-31 Economic Policies to Encourage Per Capita Growth Encourage saving and investment. 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.

32. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-32 Policies to Encourage Saving and Investment The U.S. has used tax incentives to increase saving to provide funds for investment. It is difficult for poor countries with low incomes to generate saving and investment. In developing countries, microcredit banks, banks that make small loans to poor people using alternate forms of collateral, have been successful in encouraging investment by small businesses. Foreign investment in loans from the IMF or World Bank are sources of foreign investment for developing countries.

33. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-33 Policies to Control Population Growth Developing nations whose populations are rapidly growing have difficulty providing enough capital and education for everyone. Policies that reduce population growth include:  Free-family planning services.  Increasing the availability of contraceptives.  Harsh mandatory one-child-per-family policies such as China adopted in 1980.

34. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-34 Policies to Increase the Level of Education Increasing the educational level and skills of the workforce increases labor productivity. An additional year of education increases wages by 10% in the U.S.; by 15-20% in developing countries. In the U.S. policies to increase education include free mandatory education through high school and financial support for students in higher education.

35. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-35 Policies to Create Institutions that Encourage Technological Innovation Create patents and protect property rights. Corporations and financial institutions.  The limited liability of corporations encourages savers to make their funds available for investment.

36. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-36 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 government is involved, funding 60% of basic research in the U.S.

37. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-37 Policies to Increase Openness to Trade Free trade encourages growth by broadening the market and by fostering competition. In order to specialize, you need to sell your product to a large number of people. Large markets allow firms to produce and sell more output so that they can take advantage of economies of scale.

38. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-38Summary Growth is an increase in the amount of goods and services an economy can produce when both labor and capital are fully employed. Growth increases potential output and shifts the production possibility curve out, allowing an economy to produce more goods. Per capita growth means producing more goods and services per person.

39. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-39Summary The production function shows the relationship between the quantity of resources and the output. Output = A●f(Labor, Capital, Land) The law of diminishing marginal productivity states that increasing one input, keeping all others constant, will lead to smaller and smaller gains in output. Returns to scale describes what happens to output when all inputs increases equally.

40. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-40Summary The convergence hypothesis is that per capita income in countries with similar institutional structures will converge. Convergence has not taken place because of:  the lack of factor mobility.  differing institutional structures.  incompatible factors of production.  technological agglomeration.

41. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-41Summary The Classical growth model focuses on the role of capital accumulation in the growth process. The law of diminishing productivity limits growth of per capita income. New growth theory emphasizes the role of technology in the growth process. Advances in technology, which account for 35% of growth, have overwhelmed the effects of diminishing returns.

42. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-42Summary Six government policies to promote growth are:  Encourage saving and investment.  Control population growth.  Increase the level of education.  Create institutions that encourage technological innovation.  Fund basic research.  Increase openness to trade.

43. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-43 Review Question 8-1 Explain the difference between the Classical growth theory and new growth theory. Classical growth theory is a model of growth that focuses on the role of capital accumulation in growth. According to the Classical theory, the more capital an economy has, the faster it will grow. New growth theory emphasizes the role of technology rather than capital in the growth process. Increases in technology can shift the production possibilities curve out and allow the society to produce more output without new resources. Review Question 8-2 List six government policies that can promote growth. Government policies to promote growth include: encourage saving and investment, control population growth, increase the level of education, create institutions that encourage technological innovation, fund basic research, and increase openness to trade.