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Why Do Economies Grow? PREPARED BY: FERNANDO QUIJANO, YVONN QUIJANO, KYLE THIEL & APARNA SUBRAMANIAN © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez chapter 1 How does economic growth affect social indicators such as child labor? Increased Growth Leads to Less Child Labor in Developing Countries 2 Does economic growth necessarily cause more inequality? Growth Need Not Cause Increased Inequality 3 How can we use economic analysis to understand the sources of growth in different countries? How Growth in Singapore and Hong Kong Differed 4 Why did labor productivity in the United States fall sharply during the 1970s and 1980s? Worldwide Factors Slowed U.S. Productivity Growth 5 How did the emergence of the Internet affect economic growth in the United States? The Internet and Information Technology Raised Productivity Throughout the Economy 6 How are economic growth and health related to one another? A Virtuous Circle: GDP and Health 7 Why are clear property rights important for economic growth in developing countries? Lack of Property Rights Hinders Growth in Peru © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 2 of 34 chapter 8.1 ECONOMIC GROWTH RATES • capital deepening Increases in the stock of capital per worker. • technological progress More efficient ways of organizing economic affairs that allow an economy to increase output without increasing inputs. • human capital The knowledge and skills acquired by a worker through education and experience and used to produce goods and services. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 3 of 34 chapter 8.1 ECONOMIC GROWTH RATES FIGURE 8.1 What Is Economic Growth? © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 4 of 34 chapter Extra Application 11 ‘BIOCRUDE’ FROM ALGAE BY 2010 The Department of Energy is partnering with LiveFuels Inc., a private company in California, in a venture designed to turn algae into oil. The joint venture intends to produce an “economically feasible” biocrude fuel from algae that would also be “low on greenhouse gas emissions.” • Turning algae into oil is a similar process to making soybean oil but algae has the added benefit of being cultivated on marginal lands that are unsuitable for other types of agriculture. • If the venture is successful, early estimates indicate that algae biocrude could replace all U.S. oil imports and ultimately produce biocrude for less than $60 a barrel. Technological progress can spur economic growth. This growth can be represented by an outward movement of the production possibilities curve as shown in the graph and would represent a commensurate increase in standard of living. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 5 of 34 chapter From the weird mind of me The collective noun for a group of students Class © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 6 of 34 chapter 8.1 ECONOMIC GROWTH RATES Measuring Economic Growth • real GDP per capita Gross domestic product per person adjusted for changes in constant prices. It is the usual measure of living standards across time and between countries. • growth rate The percentage rate of change of a variable from one period to another. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 7 of 34 chapter 8.1 ECONOMIC GROWTH RATES Measuring Economic Growth • rule of 70 A rule of thumb that says output will double in 70/x years, where x is the percentage rate of growth. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 8 of 34 chapter 8.1 ECONOMIC GROWTH RATES Comparing the Growth Rates of Various Countries © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 9 of 34 chapter Extra Application 8 FIRST-QUARTER ECONOMIC GROWTH REVISED UP The U.S. economy grew at an annual pace of 5.3% during the first quarter of 2006. The gross domestic product (GDP) numbers were lower than initially estimated but far better than 1.7% gains posted during the final quarter of 2005. Consumer and business spending appear to be up overall with the largest gains coming from business spending on equipment and software up almost 14%. Business profits were up almost 9% for the first quarter. • The Federal Reserve is expected to continue monitoring these results closely after the recent increase in inflation. • Policy-makers are particularly worried about the possibility of high energy costs filtering through the economy in the form of higher consumer prices for all goods. • Economic growth could stagnate as a result of consumers cutting back on spending as fuel costs consume larger fractions of their budgets. As businesses spend more on equipment and software (capital), productivity per worker should increase. Typically we see diminishing returns to this investment. Less developed economies get a tremendous boost from additional increments of capital while highly developed economies see a smaller benefit. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 10 of 34 chapter Extra Application 9 CHINA’S ECONOMY GROWS 8.5 PCT. China’s growth rate slowed to 8.5 percent for the first quarter of 2006. Last year’s pace of 9.9 percent growth in the gross domestic product was too fast according to Chinese officials. The country intends to rein in growth to a more manageable level by controlling real estate investments through spending and lending restrictions. China’s five-year plan calls for GDP growth to be only 7.5 percent by the year’s end. • Most officials expect growth to exceed the target since some sectors like steel and aluminum have excess spending. • The country’s investment in fixed assets is only slightly lower than last year’s increase of 25.7 percent. Why has China’s economy grown so rapidly? China’s rapid economic growth, fueled by a booming domestic economy and exports to other countries, is growing faster than the Chinese government would like to see. As indicated in the graph, increasing demand for Chinese goods represented by a shift in aggregate demand (AD), should also push prices higher (i.e. inflation). © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 11 of 34 chapter Extra Application 10 HUMANS WILL NEED TWO EARTHS BY 2050 The earth’s population is consuming resources faster than the earth can regenerate. A report conducted by the World Wildlife Fund and the Global Footprint Network (GFN) indicates that we have been over-consumptive and are currently living unsustainable lifestyles. The report calculated that it would take about one year and three months for the earth to regenerate the natural resources we consume in one year. Will the time come when we really do run out of resources? • “This ecological overshoot” is projected to continue increasing and according to the report “humanity will be using two planets’ worth of resources by 2050.” • The head of GFN stated “Humanity is living off its ecological credit card” and went on to say that while possible in the short run, it was not sustainable in the long run. • Conservation groups are hopeful that China will lead the world in environmental responsibility among developing nations since the country has pledged “to reduce its energy consumption by 20 percent over the next five years.” • However, given the country’s extremely high economic growth rate, reducing energy consumption will be a challenge. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 12 of 34 chapter INCREASED GROWTH LEADS TO LESS CHILD LABOR IN DEVELOPING COUNTRIES APPLYING THE CONCEPTS #1: How does economic growth affect social indicators such as child labor? Economists have studied the factors that lead to changes in child labor in developing countries: • Most child labor occurs in agriculture, with parents as employers, rather than in manufacturing plants. • As the incomes of the parents increase, they tend to rely less on their children and more on substitutes for child labor, such as fertilizer and new machinery. • Studies in Vietnam revealed a significant drop in child labor during the 1990s, with the bulk of that decrease accounted for by higher family incomes. Their findings suggest that we should think of child labor as a phenomenon that accompanies extreme poverty and that, over time, as economies grow, child labor will tend to disappear. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 13 of 34 chapter 8.1 ECONOMIC GROWTH RATES Are Poor Countries Catching Up? FIGURE 8.2 Growth Rates Versus Per Capita Income, 1870–1979 • convergence The process by which poorer countries close the gap with richer countries in terms of real GDP per capita. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 14 of 34 chapter 8.2 CAPITAL DEEPENING FIGURE 8.3 Increase in the Supply of Capital © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 15 of 34 chapter 8.2 CAPITAL DEEPENING Saving and Investment • saving Income that is not consumed. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 16 of 34 chapter GROWTH NEED NOT CAUSE INCREASED INEQUALITY APPLYING THE CONCEPTS #2: Does economic growth necessarily cause more inequality? Economists believed that as a country develops, inequality within a country followed an inverted “U” pattern—it initially increased as a country developed and then narrowed over time. Recent research casts doubt that this phenomenon is solely the result of growth: • Inequality increased from 40 percent at the beginning of the 1920s to 45 percent through the end of the Great Depression. • During World War II the share fell to 32 percent by 1944 and remained at that level until the early 1970s, at which time inequality began to again increase. • Wage and price controls during World War II reduced differentials in wages and salaries and thereby reduced inequality. • After the 1970s, salaries at the top of the income distribution increased sharply. Inequality does not naturally accompany economic development. Other factors also play a role: • Social norms • Perceived fairness of compensation • Nature of the tax system © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 17 of 34 chapter From the weird mind of me In Venice Italy, it is illegal to sit on a sidewalk and eat a sandwich © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 18 of 34 chapter 8.2 CAPITAL DEEPENING How Do Population Growth, Government, and Trade Affect Capital Deepening? Limits to Capital Deepening © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 19 of 34 chapter 8.3 THE KEY ROLE OF TECHNOLOGICAL PROGRESS How Do We Measure Technological Progress? • growth accounting A method to determine the contribution to economic growth from increased capital, labor, and technological progress. Using Growth Accounting © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 20 of 34 chapter HOW GROWTH IN SINGAPORE AND HONG KONG DIFFERED APPLYING THE CONCEPTS #3: How can we use economic analysis to understand the sources of growth in different countries? Singapore and Hong Kong have both had phenomenal post–World War II economic growth, but the sources of growth in each country were very different: • Investment was high in Singapore. Nearly all the growth was accounted for by increases in labor and capital. • Hong Kong had a much lower investment rate and technological progress made an important contribution. • Result: Residents of Hong Kong were enjoying higher consumption than residents of Singapore were, despite the similarity in growth rates. Concerns: • Singapore realized it would eventually find it difficult to keep increasing inputs to production. Economic leaders became concerned that unless they managed to increase their rate of technological progress, their long-term growth prospects would be poor. • Technological progress has been the driving force for growth in Hong Kong. Now that it has become part of China, Hong Kong’s residents hope its economy will remain free and open to sustain the system that produced technological innovation. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 21 of 34 chapter WORLDWIDE FACTORS SLOWED U.S. PRODUCTIVITY GROWTH APPLYING THE CONCEPTS #4: Why did labor productivity in the United States fall sharply during the 1970s and 1980s? • labor productivity Output produced per hour of work. FIGURE 8.4 Real Hourly Earnings and Total Compensation for U.S. Employees, 1964–2005 © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 22 of 34 chapter WORLDWIDE FACTORS SLOWED U.S. PRODUCTIVITY GROWTH APPLYING THE CONCEPTS #4: Why did labor productivity in the United States fall sharply during the 1970s and 1980s? The decrease in the growth of labor productivity was the primary factor behind this pattern of real wages, because wages can rise with a growing labor force only if output per worker continues to increase. What can explain this decrease in the growth rate? • Declines in the education and skills of the workforce. • Lower levels of investment, and thus a lower level of capital. • Less spending on infrastructure, such as highways and bridges. • Slowdown in technological progress. • Higher worldwide energy prices. • Many other factors. The productivity slowdown remains a bit of a mystery despite the use of growth accounting methods to try to explain it. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 23 of 34 chapter THE INTERNET AND INFORMATION TECHNOLOGY RAISED PRODUCTIVITY THROUGHOUT THE ECONOMY APPLYING THE CONCEPTS #5: How did the emergence of the Internet affect economic growth in the United States? Higher investment in computer technology began in the mid-1980s, but until recently there was little sign of increased productivity growth. Had the investment in information technology finally paid off? • Robert J. Gordon of Northwestern University was originally skeptical that we were now operating in a “new economy” with permanently higher productivity growth. • He found that there had been increases in technological progress. • In subsequent studies he found that productivity growth had spread to other sectors of the economy, suggesting that the increase was likely to be permanent. Why did productivity growth continue to be rapid, even during the recessionary period at the beginning of this century? • Possible explanation: It took a substantial period of time before businesses began to harness the use of modern computer technology and the Internet. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 24 of 34 chapter 8.4 WHAT CAUSES TECHNOLOGICAL PROGRESS? Research and Development Funding FIGURE 8.5 Research and Development as a Percent of GDP, 1999 © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 25 of 34 chapter 8.4 WHAT CAUSES TECHNOLOGICAL PROGRESS? Monopolies That Spur Innovation • creative destruction The view that a firm will try to come up with new products and more efficient ways to produce products to earn monopoly profits. The Scale of the Market Induced Innovations Education, Human Capital, and the Accumulation of Knowledge © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 26 of 34 chapter A VIRTUOUS CIRCLE: GDP AND HEALTH APPLYING THE CONCEPTS #6: How are economic growth and health related to one another? Men and women have grown taller and heavier in the last 300 years. • An average American male adult today stands at approximately 5 feet 10 inches tall, which is nearly 4.5 inches taller than the typical Englishman in the late 18th century. • The average weight of English males in their thirties was about 134 pounds in 1790— 20 percent below today’s average. • A typical Frenchman in his thirties at that time weighed only 110 pounds! Lower weights and heights were due to inadequate food supplies and chronic malnutrition. • Led to smaller physical stature. • Higher incidence of chronic disease. • Limited labor productivity. Result: In France, 20 percent of the labor force lacked enough physical energy to put in more than three hours of light work a day. Economic growth increased food supplies, enabling workers to become more productive and increase GDP even more. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 27 of 34 chapter 8.4 WHAT CAUSES TECHNOLOGICAL PROGRESS? New Growth Theory • new growth theory Modern theories of growth that try to explain the origins of technological progress. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 28 of 34 chapter 8.5 A KEY GOVERNMENTAL ROLE: PROVIDING THE CORRECT INCENTIVES AND PROPERTY RIGHTS What is the connection between property rights and economic growth? • Without clear property rights, there are no proper incentives to invest in the future— the essence of economic growth. What else can go wrong? • Governments in developing countries often: • Adopt policies that effectively tax exports • Pursue policies that lead to rampant inflation • Enforce laws that inhibit the growth of the banking and financial sectors Results: • Fewer exports • Uncertain financial environment • Reduced saving and investment With the right incentives, individuals and firms in developing countries will take actions that promote economic growth. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 29 of 34 chapter LACK OF PROPERTY RIGHTS HINDERS GROWTH IN PERU APPLYING THE CONCEPTS #7: Why are clear property rights important for economic growth in developing countries? Throughout the developing world, property is often not held with clear titles. Without clear title, property cannot be used as collateral for loans. • Result: The poor living on very valuable land may be unable to borrow against that land to start a new business. • Producing palm oil in Peru is very profitable, but it depends upon the ability to borrow funds. • Production of coca paste—an ingredient to cocaine—does not take as much time and does not depend on finance. • Switching farmers away from production of coca paste to palm oil also requires improvements in finance, which are very difficult without clear property rights. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 30 of 34 chapter capital deepening labor productivity convergence new growth theory creative destruction real GDP per capita growth accounting rule of 70 growth rate saving human capital technological progress © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 31 of 34 chapter A MODEL OF CAPITAL DEEPENING FIGURE 8A.1 Diminishing Returns to Capital Holding labor constant, increases in the stock of capital increase output, but at a decreasing rate. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 32 of 34 chapter A MODEL OF CAPITAL DEEPENING FIGURE 8A.2 Saving and Depreciation as Functions of the Stock of Capital © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 33 of 34 chapter A MODEL OF CAPITAL DEEPENING FIGURE 8A.3 Basic Growth Model Starting at K0, saving exceeds depreciation. The stock of capital increases. This process continues until the stock of capital reaches its long-run equilibrium at K*. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 34 of 34 chapter A MODEL OF CAPITAL DEEPENING FIGURE 8A.4 Increase in the Saving Rate A higher saving rate will lead to a higher stock of capital in the long run. Starting from an initial capital stock of K1, the increase in the saving rate leads the economy to K2. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 35 of 34 chapter A MODEL OF CAPITAL DEEPENING FIGURE 8A.5 Technological Progress and Growth Technological progress shifts up the saving schedule and promotes capital deepening. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 36 of 34