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Why are some nations rich and others poor?

© 2013 Pearson 25 When you have completed your study of this chapter, you will be able to 1 Define and calculate the economic growth rate, and explain the implications of sustained growth. 2 Explain the sources of labor productivity growth. 3 Review the theories of economic growth. 4Describe policies that speed economic growth. CHAPTER CHECKLIST Economic Growth

© 2013 Pearson 25.1 THE BASICS OF ECONOMIC GROWTH Economic growth is a sustained expansion of production possibilities measured as the increase in real GDP over a given period.  Calculating Growth Rates Economic growth rate is the annual percentage change of real GDP.

© 2013 Pearson 25.1 THE BASICS OF ECONOMIC GROWTH To calculate this growth rate, we use the formula: Growth of real GDP = Real GDP in current year Real GDP in previous year x 100 Real GDP in previous year – For example, if real GDP in the current year is $8.4 trillion and if real GDP in the previous year was $8.0 trillion, then the growth rate of real GDP is Growth of real GDP = $8.4 trillion – $8.0 trillion $8.0 trillion x 100= 5 percent.

© 2013 Pearson 25.1 THE BASICS OF ECONOMIC GROWTH The standard of living depends on real GDP per person. Real GDP per person is real GDP divided by the population. The contribution of real GDP growth to the change in the standard of living depends on the growth rate of real GDP per person.

© 2013 Pearson 25.1 THE BASICS OF ECONOMIC GROWTH We use the above formula to calculate this growth rate, replacing real GDP with real GDP per person. Suppose, for example, that in the current year, when real GDP is $8.4 trillion, the population is 202 million. Then real GDP per person is $8.4 trillion divided by 202 million, which equals $41,584. And suppose that in the previous year, when real GDP was $8.0 trillion, the population was 200 million. Then real GDP per person in that year was $8.0 trillion divided by 200 million, which equals $40,000.

© 2013 Pearson 25.1 THE BASICS OF ECONOMIC GROWTH Use these two values of real GDP per person in the growth formula to calculate the growth rate of real GDP per person. It is Growth rate of real GDP per person $41,584 – $40,000 $40,000 x 100= 4 percent. =

© 2013 Pearson 25.1 THE BASICS OF ECONOMIC GROWTH The growth rate of real GDP per person can also be calculated by using the formula: Growth of real GDP per person Growth rate of real GDP Growth rate of population – = Growth of population 202 million – 200 million 200 million x 100= 1 percent. =

© 2013 Pearson 25.1 THE BASICS OF ECONOMIC GROWTH This formula makes it clear that real GDP per person grows only if real GDP grows faster than the population grows. If the growth rate of the population exceeds the growth of real GDP, real GDP per person falls. Growth of real GDP per person 5 percent – 1 percent= 4 percent.=

© 2013 Pearson 25.1 THE BASICS OF ECONOMIC GROWTH  The Magic of Sustained Growth Sustained growth of real GDP per person can transform a poor society into a wealthy one. The reason is that economic growth is like compound interest. Rule of 70 is the number of years it takes for the level of any variable to double, which is approximately 70 divided by the annual percentage growth rate of the variable.

© 2013 Pearson 25.1 THE BASICS OF ECONOMIC GROWTH Table 25.1 Growth Rates Growth rateYears for level (% per year) to doubleExample 2 35 U.S. real GDP per person 7 10China real GDP per person

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH To understand what determines the growth rate of real GDP, we must understand what determines the growth rates of the factors of production and rate of increase in their productivity. Real GDP growth contributes to improving our standard of living. But our standard of living improves only if we produce more goods and services with each hour of labor. So our main concern is to understand what makes labor more productive.

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH  Labor Productivity Labor productivity is the quantity of real GDP produced by one hour of labor. It is calculated by using the formula : Aggregate hours Labor productivity = Real GDP

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH For example, if real GDP is $8,000 billion and aggregate hours are 200 billion, then we can calculate labor productivity as 200 billion Labor productivity = $8,000 billion = $40 per hour

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH When labor productivity grows, real GDP per person grows, so the growth in labor productivity is the basis of rising living standards. The growth of labor productivity depends on two things: Saving and investment in physical capital Expansion of human capital and discovery of new technologies

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH  Saving and Investment in Physical Capital Saving and investment in physical capital increase the capital per worker and increase labor productivity. But additional capital will not bring sustained economic growth because the law of diminishing returns applies to capital: If the quantity of capital is small, an increase in capital brings a large increase in production; and If the quantity of capital is small, an increase in capital brings a large increase in production.

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH Figure 25.1 illustrates the relationship between capital and productivity. The curve PC is the productivity curve. 1.With a small amount of capital an increase in the capital brings a large increase in real GDP per hour of labor.

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25.2 LABOR PRODUCTIVITY GROWTH 2.With a large amount of capital, an increase in the capital brings a small increase in real GDP per hour of labor. If capital per hour of labor keeps increasing, labor productivity increases by ever smaller amounts and eventually stops rising.

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH  Expansion of Human Capital and Discovery of New Technologies Human capital—the accumulated skill and knowledge of people—comes from three sources: Education and training Job experience Health and diet Expansion of human capital and the discovery of new technologies has increased labor productivity.

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH The discovery of new technologies have made an even greater contribution to economic growth than the growth of physical capital and the expansion of human capital. To reap the benefits of technological change, capital must increase. Some of the most powerful and far-reaching technologies are embodied in human capital. For example, language, writing, and mathematics. But most technologies are embodied in physical capital.

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH Figure 25.2 illustrates the effects of human capital and technological change. The curve PC 0 is the productivity curve in $180 of capital per hour of labor produced $25 of goods and services—real GDP per hour of labor.

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25.2 LABOR PRODUCTIVITY GROWTH The curve PC 1 is the productivity curve in $180 of capital per hour of labor produced $60 of goods and services—real GDP per hour of labor. The expansion of human capital and discovery of new technologies shift the PC curve upward and are not subject to diminishing returns.

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH Figure 25.3 illustrates how labor productivity grows. In 1960, workers had $80 of capital per hour of labor and produced $20 of real GDP per hour of labor. 1. When capital increased to $180 per hour of labor in 2010, real GDP per hour of labor increased to $25.

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25.2 LABOR PRODUCTIVITY GROWTH 2. The expansion of human capital and discovery of new technologies shifted the productivity curve upward and … increased real GDP per hour of labor to $60.

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH Real GDP grows because labor becomes more productive and because the quantity of labor increases. Figure 25.4 summarizes the sources of real GDP growth. Real GDP growth depends on quantity of labor growth and on labor productivity growth.

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25.2 LABOR PRODUCTIVITY GROWTH Quantity of labor growth depends on Population growth The labor force participation rate Average hours per worker

© 2013 Pearson 25.2 LABOR PRODUCTIVITY GROWTH Labor productivity growth depends on Physical capital growth Human capital growth Technological advances

© 2013 Pearson 25.3 ECONOMIC GROWTH THEORIES: OLD AND NEW  Old Growth Theory Classical growth theory is the theory that the clash between an exploding population and limited resources will eventually bring economic growth to an end. Malthusian theory is another name for classical growth theory—named for Thomas Robert Malthus.

© 2013 Pearson 25.3 ECONOMIC GROWTH THEORIES: OLD AND NEW The Basic Idea Advances in technology and the accumulation of capital bring increased productivity and increased real GDP per person. Classical growth theory says that the increase in real GDP per person will be temporary because prosperity will induce a population explosion. The population explosion will decrease real GDP per person.

© 2013 Pearson 25.3 ECONOMIC GROWTH THEORIES: OLD AND NEW  New Growth Theory New growth theory The theory that our unlimited wants will lead us to ever greater productivity and perpetual economic growth. According to new growth theory, real GDP per person grows because of the choices people make in the pursuit of profit.

© 2013 Pearson 25.3 ECONOMIC GROWTH THEORIES: OLD AND NEW Choices and Innovation The new theory of economic growth emphasizes three facts about market economies: Human capital grows because of choices. Discoveries result from choices. Discoveries bring profit, and competition destroys profit.

© 2013 Pearson 25.3 ECONOMIC GROWTH THEORIES: OLD AND NEW Human Capital Expansion and Choices People decide how long to remain in school, what to study, and how hard to study. Discoveries and Choices The pace at which new discoveries are made—and at which technology advances—is not determined by chance. The pace at which new discoveries are made depends on how many people are looking for a new technology and how intensively they are looking.

© 2013 Pearson 25.3 ECONOMIC GROWTH THEORIES: OLD AND NEW Discoveries and Profits The forces of competition squeeze profits, so to increase profit, people constantly seek either lower cost methods of production or new and better products for which people are willing to pay a higher price. Two other facts play a key role in the new growth theory: Many people can use discoveries at the same time. Physical activities can be replicated.

© 2013 Pearson 25.3 ECONOMIC GROWTH THEORIES: OLD AND NEW 1. People want a higher standard of living and are spurred by Profit incentives to make the Innovations that lead to... Figure 25.5 illustrates new growth theory in terms of a perpetual motion machine.

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25.3 ECONOMIC GROWTH THEORIES: OLD AND NEW 4. New and better techniques and new and better products, which in turn lead to The birth of new firms and the death of some old firms,

© 2013 Pearson 25.3 ECONOMIC GROWTH THEORIES: OLD AND NEW 6. New and better jobs, and More leisure and more consumption goods and services.

© 2013 Pearson 25.3 ECONOMIC GROWTH THEORIES: OLD AND NEW The result is A higher standard of living. But people want a yet higher standard of living, and the growth process continues.

© 2013 Pearson 25.4 ACHIEVING FASTER GROWTH  Preconditions for Economic Growth Economic freedom is the fundamental precondition for creating the incentives that lead to economic growth. Economic freedom is a condition in which people are able to make personal choices, their private property is protected, and they are free to buy and sell in markets.

© 2013 Pearson 25.4 ACHIEVING FASTER GROWTH Economic freedom requires the protection of private property—the factors of production and goods that people own. Property rights are the social arrangements that govern the protection of private property. Economic freedom also requires free markets.

© 2013 Pearson 25.4 ACHIEVING FASTER GROWTH  Policies to Achieve Faster Growth To achieve faster economic growth, we must increase The growth rate of capital per hour of labor or The growth rate of human capital or The pace of technological advance.

© 2013 Pearson 25.4 ACHIEVING FASTER GROWTH The main actions that governments can take to achieve these objectives are Create incentive mechanisms Encourage saving Encourage research and development Encourage international trade Improve the quality of education

© 2013 Pearson 25.4 ACHIEVING FASTER GROWTH Create Incentive Mechanisms Economic growth occurs when the incentive to save, invest, and innovate is strong enough. These incentives exist only when private property is protected. Encourage Saving Saving finances investment, which brings capital accumulation. Tax incentives can encourage saving, increase the growth of capital, and stimulate economic growth.

© 2013 Pearson 25.4 ACHIEVING FASTER GROWTH Encourage Research and Development Everyone can use the fruits of basic research and development efforts. Because basic inventions can be copied, the inventor’s profit is limited and so the market allocates too few resources to this activity. Governments can direct public funds toward financing basic research, but it requires a mechanism for allocating public funds to their highest-valued use.

© 2013 Pearson 25.4 ACHIEVING FASTER GROWTH Encourage International Trade Free international trade stimulates economic growth by extracting all the available gains from specialization and trade. Improve the Quality of Education By funding basic education and by ensuring high standards in skills such as language, mathematics, and science, governments can contribute enormously to a nation’s growth potential.

© 2013 Pearson 25.4 ACHIEVING FASTER GROWTH  How Much Difference Can Policy Make? A well-intentioned government cannot dial up a big increase in the growth rate. But it can pursue policies that will nudge the growth rate upward. And over time, the benefits from these policies will be large.

© 2013 Pearson Political stability, property rights protected by the rule of law, and limited government intervention in markets: Are key features of the economies that enjoy high incomes and they are the features missing in those that remain poor. Most of the rich nations have experienced sustained economic growth over many decades. Europe’s Big 4 economies (France, Germany, Italy, and the United Kingdom) have been enjoying economic growth for 200 years. The United States started to grow rapidly 150 years ago and overtook Europe in the early 20th century. Why Are Some Nations Rich and Others Poor?

© 2013 Pearson In the past 50 years, the gaps between these countries haven’t changed much. In a transition from Communism to a market economy, Central Europe is now growing faster. Why Are Some Nations Rich and Others Poor?

© 2013 Pearson Economic growth in Central and South America and Africa has been persistently slow. The gap between the United States and these regions has widened. Why Are Some Nations Rich and Others Poor?

© 2013 Pearson Real GDP per person in East Asian economies has converged toward that in the United States. These economies are like fast trains running on the same track at similar speeds with roughly constant gaps. Why Are Some Nations Rich and Others Poor?

© 2013 Pearson Hong Kong and Singapore are the lead trains and run about 15 years in front of Taiwan, 20 years in front of South Korea, and almost 40 years in front of China. Why Are Some Nations Rich and Others Poor?

© 2013 Pearson Between 1960 and 2010, Hong Kong and Singapore transformed themselves from poor developing economies to take their places among the world’s richest economies. Why Are Some Nations Rich and Others Poor?