1. Chapter 15 How Economies Grow

2. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-2 Learning Objectives Define economic growth. Explain why small differences in growth rates matter so much. Outline why saving is important for economic growth. Contrast inventions with innovations. Tell why improvement in secondary schooling is so important for developing nations.

3. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-3 Economic Growth Earlier you learned that the growth in real GDP is often called economic growth. However, when a nation grows economically, its citizens must be better off in at least some ways, usually in terms of their material well-being.

4. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-4 Economic Growth (cont.) Economic growth occurs when there are increases in per-capita output per unit time period, usually per year. Economic growth is measured by the annual rate of change in per-capita real GDP.

5. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-5 International Example India has a total national output that is three times as large as that of Switzerland. India’s population, though, is 125 times greater than that of Switzerland. Thus, when we take into account the amount of output that is available to the average person, we can conclude that India is a relatively poor country and Switzerland is a relatively rich country.

6. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-6 Economic Growth and the Magic of Compounding Some countries grow and others do not. You can see this in Table 15-1, next. There you see the annual average rate of economic growth in selected countries.

7. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-7 Table 15-1: Per Capita Growth Rates in Various Countries

8. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-8 Small Differences in Growth Matter A small difference in the rate of economic growth may not matter for next year or the year after, but it surely does matter over longer periods. It all has to do with the power of compounding. The difference of one percentage point in our economic rate of growth over this nation’s history could have lead to three times our current standard of living.

9. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-9 Compounding Example In 1626, Dutchman Peter Minuit arrived in Manhattan, charged by the West India Company with the task of administering the struggling colony. Minuit purchased Manhattan Island from Native American Indians for the now legendary price of 60 guilders, or about $20. That $20 compounded at 6 percent would equal about $130 billion today, and at 7 percent about $5.8 trillion today.

10. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-10 Saving: An Important Determinant of Economic Growth Economic growth does not occur in a vacuum. It is not some predetermined fate of a nation. Rather, economic growth depends on certain fundamental factors. One of the most important factors that affect the rate of economic growth and hence long-term living standards is the rate of saving.

11. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-11 A Basic Economic Growth Proposition To have more consumption in the future, you have to consume less today and save the difference between your consumption and your after-tax income. On a national basis, this implies that higher saving rates eventually mean higher living standards in the long run, all other things held constant.

12. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-12 A Basic Economic Growth Proposition (cont.) Saving is important for economic growth because if all income is consumed each year, there is nothing leftover for saving, which could be used by businesses for investment. If there is no investment in our capital stock, there is little hope of economic growth.

13. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-13 A Basic Economic Growth Proposition (cont.) Data shows that in general, nations that have experienced high rates of saving have had greater economic growth rates than those that have not.

14. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-14 Productivity Increases—It’s What Economic Growth Is All About Labor productivity is normally measured by dividing real GDP by the number of workers or the number of labor hours.

15. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-15 Productivity Increases—It’s What Economic Growth Is All About (cont.) Whenever average output produced per worker during a specified time period increases, we say that labor productivity has increased. Clearly, there is a positive relationship between economic growth and increases in labor productivity.

16. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-16 Separating Different Rates of Growth of Production Inputs If you divide all resources into just capital and labor, economic growth can be defined as the cumulative contribution to per capita real GDP growth of three components: –the rate of growth of capital, –the rate of growth of labor, and –the rates of growth of capital and labor productivity.

17. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-17 Growth in Technology Technology has grown erratically in the United States and elsewhere. Nonetheless, there are some startling statistics about the growth in technology. The greater the reward to those who innovate, the more technological advances we will get.

18. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-18 Growth in Technology: An Example Microprocessor speeds currently exceed 3,000 megahertz. By the year 2011, they will exceed 12,000 megahertz. During the same period, the size of the thinnest circuit line within a transistor will decrease by 80 percent. By 2011, microchip plants will produce 1,500 chips a week for every person on earth

19. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-19 Research and Development A certain amount of technological advance results from research and development (R&D) activities that have as their goal the development of specific new materials, new products, and new machines. How much spending a nation devotes to R&D can have an impact on its long- term economic growth.

20. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-20 Innovation and Knowledge Innovation involves the transformation of something new, such as an invention, into something that benefits the economy either by lowering production costs or by providing new goods and services. Historically, technologies have moved relatively slowly from invention to innovation to widespread use.

21. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-21 The Importance of Human Capital Knowledge, ideas, and productivity are all tied together. One of the threads is the quality of the labor force. Increases in the productivity of the labor force depend on increases in human capital. Human capital is the knowledge and skills that people in the workforce acquire through education, on-the-job training, and self- teaching.

22. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-22 How You Can Invest in Human Capital To increase your own human capital, you have to invest by not working for pay while you attend school. Society also has to invest in libraries and teachers. According to modern economic growth theorists, human capital is at least as important as physical capital, particularly when trying to explain international differences in living standards.

23. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-23 Schooling is Important Researchers have found that one of the most effective ways that developing countries can become developed is by investing in secondary schooling. Teaching more children ages 12 to 18 may be more important than having a large network of colleges and universities in developing countries.

24. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-24 Property Rights and Entrepreneurship If you lived in a country where bank accounts and businesses were periodically expropriated by the government, how willing would you be to leave your money in a savings account or to invest in a business? You would be living in a political and economic system in which your property rights are not well defined and legally supported.

25. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-25 Property Rights and Entrepreneurship (cont.) The more certain property rights are, the more capital accumulation level will be, and therefore there will be greater economic growth. Well defined property rights have usually been necessary for economic growth to occur. Entrepreneurs will not take risks if they believe that their rewards from taking risks will be confiscated.

26. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.15-26 Key Terms and Concepts compounding economic growth human capital innovation labor productivity nationalization property rights research and development (R&D)