1. ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 17: Economic Growth

2. ©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives 1.Show how small differences in growth rates lead to large differences in living standards 2.Explain why GDP per capita is the product of average labor productivity and the proportion of the population that is employed and use this decomposition to discuss the sources of economic growth 3.Discuss the determinants of average labor productivity within a particular country and use these concepts to analyze per capita GDP differences across countries

3. ©2012 The McGraw-Hill Companies, All Rights Reserved 3 Learning Objectives 4.Compare and contrast the benefits and costs of economic growth 5.Discuss and evaluate government policies that promote growth 6.Understand the trade-offs between economic growth and environmental quality

4. ©2012 The McGraw-Hill Companies, All Rights Reserved 4 Living Standards Use an economic model to study the remarkable rise in living standards  Real GDP per capita is a measure of the goods available to a typical person One clue to growing prosperity in the 20 th century – GDP per capita over time has roughly the same pattern as output per worker Comparisons across long periods is complicated by lack of data  The variety, quantity, and quality of goods increased enormously in the 19 th and 20 th century

5. ©2012 The McGraw-Hill Companies, All Rights Reserved 5 Output per Person, 1980–2009

6. ©2012 The McGraw-Hill Companies, All Rights Reserved 6 Output per Person - Trends Remarkable growth in the U.S. from about $25,531 in 1980 to $43,662 in 2006, before dipping slightly in 2008 and 2009. UAE’s GDP per person in 1980 declined from $95,434 to just $52,434 in 2009. Saudi Arabia’s GDP per person declined from $34,598 in 1980 to $19,162 in 1990, then fluctuated tightly around $20,000 through 2009. Egypt’s GDP per person increased from $2,431 in 1980 to $5,151 in 2009. Turkey’s GDP per person increased from $5,693 in 1980 to $11,208 in 2009.

7. ©2012 The McGraw-Hill Companies, All Rights Reserved 7 Output per Worker, 1980–2009

8. ©2012 The McGraw-Hill Companies, All Rights Reserved 8 Output per Worker - Trends Real GDP per worker in the United States increased from $41,649 in 1980 to $65,480 in 2008. In Saudi Arabia, it decreased from $52,476 in 1980 to $28,460 in 2008. In the UAE, it decreased from $55,466 in 1980 to $21,001 in 2008. Egypt’s increased from $7,627 in 1980 to $13,248 in 2008. Turkey’s increased from $11,322 in 1980 to $26,187 in 2008.

9. ©2012 The McGraw-Hill Companies, All Rights Reserved 9 Real GDP per Capita

10. ©2012 The McGraw-Hill Companies, All Rights Reserved 10 Output per Worker, 1870-2008 Japan’s real GDP per person grew more than 30 times between 1870 and 2008. China’s grew more than12 times. In the United States it grew 12 times. Germany’s grew more than 11 times. Turkey’s and Iran’s grew about 10 times. Egypt’s and Morocco’s grew only about 6 times.

11. ©2012 The McGraw-Hill Companies, All Rights Reserved 11 Why “Small” Differences in Growth Rates Matter In the previous table, the annual growth rates do not really differ  Highest growth rate is 2.51 percent (Japan) and lowest rate is 1.27 percent (Egypt).  However, consider the long-run effect of this seemingly “small” difference in terms of output per person  In 1870, output in person in Germany was about 3 times as large as Morocco’s. Yet, by 2008, Germany’s became 6 times as large as Morocco’s  This is from the power of compounding, often illustrated by compound interest.

12. ©2012 The McGraw-Hill Companies, All Rights Reserved 12 Why “Small” Differences in Growth Rates Matter Compound interest pays interest on the original deposit and all previously accumulated interest  Interest paid in year 1 earns interest in year 2  $10 deposited at 4% interest in 1800 is $31,033.77 in 2005  $10 x (1.04) 205 = $31,033.77

13. ©2012 The McGraw-Hill Companies, All Rights Reserved 13 Compound Interest Differences in interest rates matter Growth rates in GDP per capita have the same effect as interest rates  Relatively small growth in GDP per capita has a very large effect over a long period In the long run, the growth rate of an economy matters Interest Rate (%)Value of $10 after 205 years 2$579.48 4$31,033.77 6$1,540,644.29

14. ©2012 The McGraw-Hill Companies, All Rights Reserved 14 Why Nations Become Rich: The Crucial Role of Average Labor Productivity What determines a nation’s economic growth rate?  To get some insight into this question, we express real GDP per person as the product of two terms:  Average labor productivity  Share of the population that is working Assume the following notation  Y = real GDP  N = number of people employed  POP = population

15. ©2012 The McGraw-Hill Companies, All Rights Reserved 15 Real GDP per Capita In other words, Real GDP per person = Average labor productivity × Share of population employed This expression tells us something very basic and intuitive: The quantity of goods and services that each person can consume depends on:  How much each worker produces and  The share of people working

16. ©2012 The McGraw-Hill Companies, All Rights Reserved 16 Average Labor Productivity and Share of Population with Jobs in the United States, 1950–2010

17. ©2012 The McGraw-Hill Companies, All Rights Reserved 17 Between 1950 and 2010, average labor productivity in the United States grew 184 percent from $36,350 to $103,320. Thus, in 2010, the average American enjoyed almost 3 times as many goods and services as in 1950. The share of the population holding a job grew 12.5 percent, from 40 percent in 1950 to 45 percent in 2010, down from a peak of 49 percent in 1998–2001 and 2006–2007. Overall, such simultaneous increases in both labor productivity and the share of the population holding a job have clearly contributed to the rise in living standards in the United States. Average Labor Productivity and Share of Population with Jobs in the United States, 1950–2010

18. ©2012 The McGraw-Hill Companies, All Rights Reserved 18 Average Labor Productivity and Share of Population with Jobs in Morocco, 1960–2010

19. ©2012 The McGraw-Hill Companies, All Rights Reserved 19 Real GDP per worker in Morocco grew 133 percent from $5,500 in 1960 to $12,815 in 2010. The share of the population holding a job grew 27.6 percent from 29 percent to 37 percent between 1960 and 2010. Thus, in 2010, the average Moroccan enjoyed more than 2 times as many goods and services as in 1960. Both the average labor productivity and the share of the population with jobs have clearly contributed to the growth in Morocco’s output per person. Average Labor Productivity and Share of Population with Jobs in Morocco, 1960–2010

20. ©2012 The McGraw-Hill Companies, All Rights Reserved 20 Average Labor Productivity and Share of Population with Jobs in Egypt, 1960–2010

21. ©2012 The McGraw-Hill Companies, All Rights Reserved 21 Average labor productivity in Egypt grew 314 percent from $4,617 in 1960 to $19,122 in 2010. The share of the population with jobs grew only 3 percent from 32 percent to 33 percent. Hence, in 2010, Egyptians enjoyed more than 4 times as many goods and services as in 1960 despite no observable improvements in the share of the population with jobs. Once again, average labor productivity is the driving force in the growth of Egypt’s standards of living, as measured by output per person. Average Labor Productivity and Share of Population with Jobs in Egypt, 1960–2010

22. ©2012 The McGraw-Hill Companies, All Rights Reserved 22 Average Labor Productivity and Share of Population with Jobs in Turkey, 1955–2010

23. ©2012 The McGraw-Hill Companies, All Rights Reserved 23 Average labor productivity in Turkey grew by 556 percent from $6,706 in 1955 to $44,040 in 2010. The share of the population with jobs declined by 40 percent from 50 percent to 30 percent. Turkey clearly owes its increase in standards of living solely to its average labor productivity. Average Labor Productivity and Share of Population with Jobs in Turkey, 1955–2010

24. ©2012 The McGraw-Hill Companies, All Rights Reserved 24 Understanding Growth There are two factors that help explain the previous graphs  Increase in the share of the population that is employed  The growing tendency of women to work outside the home was the most important reason for the rise in employment in the US  Increase in the share of the general population that is of working age (ages 16 to 65) (baby boomers in the US)

25. ©2012 The McGraw-Hill Companies, All Rights Reserved 25 Female Labor Force Participation, 1980–2008

26. ©2012 The McGraw-Hill Companies, All Rights Reserved 26 Understanding Growth in the MENA MENA countries suffer from a number of symptoms that may prevent the share of the population with jobs from contributing positively to the standard of living. 1.Major social, political, and economic changes may be required to reverse the downward trend in female labor force participation.  Such changes take time and a substantial amount of resources.  In the absence of immediate reforms, this process is likely to be slow, potentially extending over generations. 2.These countries have youth-bulged populations that will present further challenges going into the future as the younger generations enter the workforce.

27. ©2012 The McGraw-Hill Companies, All Rights Reserved 27 Understanding Growth In the long run, increases in output per person arise primarily from increases in average labor productivity

28. ©2012 The McGraw-Hill Companies, All Rights Reserved 28 The Determinants of Average Labor Productivity US average labor productivity is  24 times Indonesia's  100 times Bangladesh's Six factors determine average labor productivity 1. Human capital 2. Physical capital 3. Land and other natural resources 4. Technology 5. Entrepreneurship and management 6. Political and legal environment

29. ©2012 The McGraw-Hill Companies, All Rights Reserved 29 1. Human Capital Hala and Jana have jobs wrapping candies and placing them into boxes. Hala is a novice wrapper and can wrap 100 candies per hour. Jana is an experienced wrapper and can wrap 300 candies per hour. Both work 40 hours per week. What is average labor productivity, in terms of candies wrapped per week and per hour: 1. For Hala 2. For Jana 3. For Hala and Jana as a team

30. ©2012 The McGraw-Hill Companies, All Rights Reserved 30 1. Human Capital Hourly productivity is already given.  Hala: 100 candies  Jana: 300 candies Weekly productivity  Hala: 40 x 100 = 4,000 candies  Jana: 40 x 300 = 12,000 candies  Together: 16,000 candies for two weeks  Average weekly productivity: 16,000/2 = 8,000  Average hourly productivity: 16,000/80 = 200

31. ©2012 The McGraw-Hill Companies, All Rights Reserved 31 1. Human Capital Human capital comprises the talents, education, training, and skills of workers  Human capital increases workers' productivity Germany and Japan used human capital to rebuild after World War II  Professional scientists and engineers  Apprentice and on-the-job training emphasized  Japanese increased emphasis on early education

32. ©2012 The McGraw-Hill Companies, All Rights Reserved 32 1. Human Capital Human capital is analogous to physical capital (such as machines and factories)  It is primarily acquired through the investment of time, energy, and money  Example: The cost of going to school includes not only the tuition paid but also the opportunity cost Cost – Benefit Principle applies to building human capital  Premium paid to skilled workers

33. ©2012 The McGraw-Hill Companies, All Rights Reserved 33 2. Physical Capital More and better capital increases worker productivity Factory owner employs two people and adds capital  Each machine requires one dedicated operator Number of Machines Output per Week Hours Worked per Week Output per Hour Worked 016,00080200 132,00080400 240,00080500 340,00080500 1.More capital increases output per hour 2.Diminishing returns to capital

34. ©2012 The McGraw-Hill Companies, All Rights Reserved 34 Diminishing Returns to Capital Diminishing returns to capital occurs if an addition of capital with other inputs held constant increases output by less than the previous increment of capital  Assumption: all inputs except capital are held constant  Result: output increases at a decreasing rate When a firm has many machines, the most productive uses have already been filled  The increment in capital will necessarily be assigned to a less productive use than the previous increment  Principle of Increasing Opportunity Cost

35. ©2012 The McGraw-Hill Companies, All Rights Reserved 35 Growth and Diminishing Returns to Capital Implications of diminishing returns  Increasing capital will increase output and labor productivity  Positive contribution to growth  There are limits to increasing productivity by adding capital because of diminishing returns  Is there empirical evidence that giving workers more capital makes them more productive?

36. ©2012 The McGraw-Hill Companies, All Rights Reserved 36 Growth and Diminishing Returns to Capital

37. ©2012 The McGraw-Hill Companies, All Rights Reserved 37 Capital and Output per Worker, 1990 Low capital/worker, Low GDP per worker High capital/worker, High GDP per worker

38. ©2012 The McGraw-Hill Companies, All Rights Reserved 38 3. Land and Other Natural Resources Inputs other than capital increase worker productivity  An abundance of natural resources increases the productivity of the workers who use them  Land for farming  If not endowed with natural resources, these can be obtained through international markets  Petroleum, metals etc..  Countries like Japan, Hong Kong, Singapore and Switzerland have become rich without substantial natural resources of their own

39. ©2012 The McGraw-Hill Companies, All Rights Reserved 39 4. Technology New technologies are the single most important source of productivity improvement Technical change can affect industries beyond the primary application  Transportation expanded markets for farm produce  Medicine  Communications  Electronics and computers  Internet

40. ©2012 The McGraw-Hill Companies, All Rights Reserved 40 5. Entrepreneurship and Management Entrepreneurs create new economic enterprises  Essential to a dynamic, healthy, growing economy Examples:  Henry Ford and mass production  Bill Gates and standardized graphical user interface operating system  Larry Page and Sergey Brin and Google's search Policies should channel entrepreneurship in productive ways  Taxation policy and regulatory regime  Value innovation

41. ©2012 The McGraw-Hill Companies, All Rights Reserved 41 Inventing the Personal Computer Steve Jobs and Steve Wozniak  Had an idea to make a computer that was smaller and cheaper than the closet-sized mainframes that were then in use  To set up shop in Steve Jobs’s parents’ garage and buy their supplies, they sold their two most valuable possessions  Jobs’s used Volkswagen van and Wozniak’s Hewlett- Packard scientific calculator, for a total of $1,300  The result was the first personal computer: Apple  The rest is history

42. ©2012 The McGraw-Hill Companies, All Rights Reserved 42 Medieval China Sung period (960 – 1270 AD) was technically sophisticated  Paper ■ Gunpowder  Water wheels ■ Compass? Economic stagnation followed  Social system limited entrepreneurship  Emperor retained property rights to business  Seizure possible without notice Scientific advances alone do not ensure technical change and growth

43. ©2012 The McGraw-Hill Companies, All Rights Reserved 43 6. Political and Legal Environment Government too has a role to play in fostering improved productivity  Provide a political and legal environment that encourages people to behave in economically productive ways  Work hard / save and invest wisely / acquire useful information and skills / provide the goods and services that the public demands  Encourage people to be economically productive

44. ©2012 The McGraw-Hill Companies, All Rights Reserved 44 6. Political and Legal Environment One specific function of government that appears to be crucial to economic success is  Well-defined property rights are essential  Who owns what and how those things can be used  Reliable recourse through courts Other vital government functions are to  Maintain political stability  Promote free and open exchange of ideas

45. ©2012 The McGraw-Hill Companies, All Rights Reserved 45 Communism Failed Output per person in the Soviet Union was probably less than one-seventh the US rate in 1991 The Soviet Union had ingredients for growth – human capital, physical capital, natural resources, technology Two main flaws  Communal ownership of capital stock  General absence of private property rights  Incentive Principle could not work  Government planning replaced market system  Abundant unexploited opportunities Political instability and appropriate legal framework

46. ©2012 The McGraw-Hill Companies, All Rights Reserved 46 The Costs of Economic Growth We know that increasing the capital stock will increase GDP  Opportunity cost of producing more capital goods is  Fewer consumer goods People may be willing to forego present consumption to have more in the future  Reduced leisure time  Possible risks of health and safety from rapid capital production  The cost of R&D to improve technology  The cost of education to develop and use new capital

47. ©2012 The McGraw-Hill Companies, All Rights Reserved 47 Promote Growth with Human Capital Governments support education and training programs  Government grants and scholarships  Job training and retraining programs Government pays because education has externalities  A democracy works better with educated voters  Progressive taxes capture some of the higher income  Increases chances of technical innovation  Poor families could not pay

48. ©2012 The McGraw-Hill Companies, All Rights Reserved 48 Promote Growth with Savings and Investment Government policies can encourage new capital formation and saving in the private sector  Government periodically offers investment tax credits Government can invest directly in capital formation  Construction of infrastructure such as roads, bridges, airports, and dams  Interstate highway system reduced costs of transporting goods, making markets more efficient

49. ©2012 The McGraw-Hill Companies, All Rights Reserved 49 Promote Growth with R&D Support Research and development promotes innovation  Some types of research, such as basic science, create externalities that a private firm cannot capture  Basic scientific knowledge (medical, pharmaceutical)  Fund basic science with National Foundations and other government grants Maintain political and legal framework to support growth

50. ©2012 The McGraw-Hill Companies, All Rights Reserved 50 The Legal and Political Framework Governments can play an essential role in securing property rights and a well-functioning legal system. They can also help create an economic environment that encourages entrepreneurship, and of political stability and the free and open exchange of ideas. Government policymakers also should consider the potential effects of tax and regulatory policies on activities that increase productivity, such as investment, innovation, and risk taking

51. ©2012 The McGraw-Hill Companies, All Rights Reserved 51 Promoting Economic Growth in Least Developed Prescription for more human and physical capital is broadly correct  Appropriate technology and education Most countries need institutions to support growth  Corruption creates uncertainty about property rights and drains financial resources out of the country  Regulation discourages entrepreneurship  Taxes discourage risk-taking  Markets do not function efficiently  Lack of political stability discourages foreign investment

52. ©2012 The McGraw-Hill Companies, All Rights Reserved 52 Limits to Growth Can growth be sustained?  Depletion of some natural resources  Environmental damage and global warming Computer models suggested growth is not sustainable  Did not adequately treat new and better products  Greater income can pay for better environmental quality  Ignored the market's response to increasing scarcity  High prices trigger a response  Strong response to energy crisis in mid 1970s Government action needed in case of externalities

53. ©2012 The McGraw-Hill Companies, All Rights Reserved 53 Mexico City Air Quality Research indicates that pollution increases up to a point with increased GDP per person  After A, air pollution decreases and air quality improves  Estimates suggest Mexico is close to point A Beyond a certain level of income, citizens value a cleaner environment and they are willing and able to pay for it Real GDP per capita Air pollution A