Download Chapter 17 - McGraw Hill Higher Education

Chapter 17: Economic
Growth
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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
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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
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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 20th
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 19th and 20th century
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Output per Person, 1980–2009
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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.
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Output per Worker, 1980–2009
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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.
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Real GDP per Capita
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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.
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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.
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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
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Compound Interest
 Differences in interest rates matter
Interest Rate (%)
Value of $10 after 205 years
2
$579.48
4
$31,033.77
6
$1,540,644.29
 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
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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
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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
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Average Labor Productivity and Share of Population with
Jobs in the United States, 1950–2010
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Average Labor Productivity and Share of Population with
Jobs in the United States, 1950–2010
 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.
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Average Labor Productivity and Share of Population
with Jobs in Morocco, 1960–2010
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Average Labor Productivity and Share of Population
with Jobs in Morocco, 1960–2010
 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.
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Average Labor Productivity and Share of Population
with Jobs in Egypt, 1960–2010
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Average Labor Productivity and Share of Population
with Jobs in Egypt, 1960–2010
 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.
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Average Labor Productivity and Share of Population
with Jobs in Turkey, 1955–2010
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Average Labor Productivity and Share of Population
with Jobs in Turkey, 1955–2010
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.
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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)
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Female Labor Force Participation, 1980–2008
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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.
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Understanding Growth
In the long run,
increases in output per person
arise primarily from
increases in average labor productivity
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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.
2.
3.
4.
5.
6.
Human capital
Physical capital
Land and other natural resources
Technology
Entrepreneurship and management
Political and legal environment
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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.
2.
3.
For Hala
For Jana
For Hala and Jana as a team
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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
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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
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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
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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
0
16,000
80
200
1
32,000
80
400
2
40,000
80
500
3
40,000
80
1. More capital increases output per hour
2. Diminishing returns to capital
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Output per
Hour
Worked
500
33
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
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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?
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Growth and Diminishing Returns to Capital
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Capital and Output per Worker, 1990
High capital/worker,
High GDP per worker
Low capital/worker,
Low GDP per worker
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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
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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
18th century transport
• Horse power
19th century transport
• Steam engine
• Rail
• River
20th century transport
• Road network
• Air
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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
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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 HewlettPackard scientific calculator, for a total of $1,300
 The

result was the first personal computer: Apple
The rest is history
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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
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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
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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
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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
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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
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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
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Promote Growth with Savings and Investment
 Government policies can encourage new
capital formation and saving in the private
sector
 Government
credits
periodically offers investment tax
 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
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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
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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
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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
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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
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Mexico City Air Quality
 Research indicates that pollution
increases up to a point with
increased GDP per person
 After
 Beyond a certain level of
income, citizens value a cleaner
environment and they are willing
and able to pay for it
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A
Air pollution
A, air pollution decreases
and air quality improves
 Estimates suggest Mexico is
close to point A
Real GDP per capita
53