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Chapter 7 The Wealth of Nations and Economic Growth Second Edition Chapter Outline Key Facts About the Wealth of Nations and Economic Growth Understanding the Wealth of Nations Incentives and Institutions Appendix: The Magic of Compound Growth Using a Spreadsheet. 2 Introduction Every year 1.8 million children die from diarrhea. Preventing these deaths requires only one thing: economic growth. Health and wealth go together. • The next figure shows that the higher the GDP per capita the greater is the survival rate of newborns. 3 Introduction 4 Introduction Wealth is clearly important. This leads us to ask three questions: • • • Why are some nations wealthy while others are poor? Why are some nations getting wealthier faster than others? Can anything be done to help poor nations become wealthy? In this chapter and the next, we will try to answer some of these questions. 5 Wealth of Nations and Economic Growth Three Key Facts 1. GDP per Capita Today Varies Enormously among Nations 2. Everyone Used to Be Poor 3. There are Growth Miracles and Growth Disasters Let’s look at each of these in turn. 6 GDP Per Capita Varies Among Nations 7 Everyone Used to Be Poor 8 A Primer on Growth Rates How is economic growth measured? y t y t 1 gt 100 y t 1 Example: Year 2008 2009 g2009 real GDP per capita $15,000 billion $15,500 billion 15,500 15,000 100 3.3% 15,000 9 The Rule of 70 The time it takes a quantity to double 70 Doubling time growth rate in % • Example: If real GDP per capita is growing at an annual growth rate of 3.5%, it will double in: 70 20 years. 3 .5 10 The Rule of 70 As the table shows, small changes in the growth rate → large changes over time. 11 Growth Miracles and Growth Disasters Two Growth Miracles • Japan: annual rate of real growth1950-70 = 8.5% • South Korea: annual rate of real growth1950-70 = 7.2% Two Growth Disasters • Argentina 1900: one of the richest countries in the world Now: per capita real GDP is 1/3 that of the U.S. • Nigeria Has barely grown since 1950 Poorer now than it was in 1974 12 Growth Miracles and Growth Disasters 13 Summarizing the Facts: Good and Bad News Bad News • Most of the world is poor. • More than a billion people live on less than $2 a day. Good News • Relatively recent economic growth (since 1900) dramatically raised the standard of living of most people in developed nations. • Korea was as poor as Nigeria 1950. • There is no reason that currently poor countries cannot achieve similar results. 14 Check Yourself According to Figure 7.2 (Slide 6) , approximately what percentage of the world’s population lived in China in 2000? If you earn 5% on your savings in a bank account, how many years will it take for your savings to double? How about if you make 8%? In figure 7.4, (slide 12) when did Japan’s real GDP per capita cross the $10,000 barrier? What was Japan’s growth rate in that time span? 15 Understanding the Wealth of Nations 16 Understanding the Wealth of Nations The Factors of Production • Physical capital: the stock of tools, structures, and equipment. • Human capital: is the productive knowledge and skills that workers acquire through education, training and experience. • Technological knowledge: knowledge about how the world works that is used to produce goods and services. 17 Incentives and Institutions The amount of available resources only tells part of the story. • Why do some countries have more physical and human capital and use more advanced technology? • Why do some countries obtain greater output from the resources they have than others? • The answers lie in the institutions and incentives that countries adopt. 18 Check Yourself Which country has more physical capital per worker: the United States or China? China or Nigeria? What are the three primary factors of production? 19 Incentives and Institutions A natural experiment: North and South Korea • Same people and culture. • Similar levels of physical capital and access to the same technology. • North Korea became a communist state with a centrally planned economy. • South Korea adopted the capitalist free market model. The result 50 years later 20 North and South Korea at Night 21 Incentives and Institutions Institutions - the “rules of the game” that structure economic incentives. Institutions of Economic Growth 1. Property rights 2. Honest government 3. Political stability 4. A dependable legal system 5. Competitive and open markets We will now look at each of these in turn. 22 Institutions of Economic Growth Property rights - the right to benefit from one’s effort. • Provide incentives to work hard. • Encourage investment in physical and human capital. • Encourage technological innovation. Without property rights: • Effort is divorced from reward • Free riders become a problem 23 The Xiaogang Revolution Denied property rights farmers agreed secretly to divide communal land and assign it to individuals. They could keep all they produced over the quota assigned by the government. Result: Xiaogang became a model for the rest of China. The agreement was signed in blood. 24 The Xiaogang Revolution 25 Institutions of Economic Growth Honest Government • Property rights are meaningless unless government guarantees property rights. • Corruption bleeds resources away from productive entrepreneurs. • Corruption takes resources away from more productive government activity. • Next is a list of the 10 most and the 10 least corrupt countries. Are you surprised to see who is or who isn’t on these lists? 26 Honest Government: The Good and the Bad 27 Honest Government 28 Institutions of Economic Growth Political Stability – change of government within the rule of law. • Changing governments without the rule of law results in uncertainty which leads to less investment in physical and human capital. • In many nations civil war, military dictatorship, and anarchy have destroyed the institutions necessary for economic growth. 29 Political Instability 30 Institutions of Economic Growth Dependable Legal System • Facilitates contracts • Protects property from others including government. The legal system in some governments is so poor that no one knows who owns what. Example: In India, residents who purchase land may have to do so more than once because of lack of proper record keeping. 31 Institutions of Economic Growth Competitive and Open Markets • Encourage the efficient organization of resources. • About half the differences in per capita income across countries is explained by a failure to use capital efficiently. • Example: One study found that if India used its physical and human capital as efficiently as the U.S., India would be four times richer than it is today. 32 Institutions of Economic Growth Why do poor countries use their capital inefficiently? • Inefficient and unnecessary regulations… Create monopolies Impede markets • Example: until recently in India, it was illegal to produce shirts using large-scale production • Expensive red tape increases time and cost 33 Institutions and Growth Miracles Revisited China changed from collective farming to individual farming – Agricultural productivity increased dramatically. America inherited a tendency toward a market economy and democratic institutions from England. America’s open frontier and freedom encouraged new ideas and an entrepreneurial spirit. 34 Institutions and Growth Miracles Revisited Industrial revolution • Brought large scale production and important innovations in transportation. • Centered in Britain, developed a strong culture of science and engineering. • Brought the scientific method to bear on economic production. • Profits were invested in new ideas and innovations so economic growth and improvements in standards of living continued. 35 Institutions and Growth Miracles Revisited • Economic growth would become more common if more countries changed their institutions. • Where do institutions come from? • Culture? • History? • Geography? • Luck? • How can they be changed? 36 Check Yourself List the five institutions that promote economic growth. In England during the Wars of the Roses (late 1400s), two parties fought for the crown. Contrast the prospects for economic growth during this period and after this period when Henry VII became the unquestioned head of the country. 37 Check Yourself When the pilgrims landed at Plymouth Rock, they established a system of collective farming in which all corn production was shared. Given your understanding of incentives, what do think happened to the Pilgrims? 38 Takeaway Economic growth has resulted in GDP per capita today being 50 times higher in the rich countries than in the poorest. Economic growth has lifted billions out of near-starvation poverty but billions still remain in dire poverty. Poor countries can catch up to the rich countries in a surprisingly short period of time. Accumulation of human and physical capital is key but not sufficient. 39 Takeaway Countries with institutions that encourage the efficient use of human and physical capital will succeed. • These institutions are: Property rights Honest Government Political stability Dependable legal system Competitive and open markets. 40 Second Edition End of Chapter 7