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Chapter 7
The Wealth of Nations
and Economic Growth
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline
 Key Facts about the Wealth of Nations and
Economic Growth
 Understanding the Wealth of Nations
 Incentives and Institutions
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Introduction
 Economic growth brings wealth, which increases
societal well-being.
 Wealthier nations have:
• Higher infant survival rates, life expectancy,
and nutrition.
• More educational opportunities, leisure, and
entertainment.
• Fewer conflicts such as civil wars and riots.
• More material goods.
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Introduction
Penn World Tables and World Bank Group, World Development Indicators, 2005
Wealthier countries have higher infant survival rates.
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Key Facts
 Key facts about the wealth of nations and
economic growth:
1. GDP per capita varies enormously among
nations.
2. Everyone used to be poor.
3. There are growth miracles and growth
disasters.
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1. GDP Growth Varies
 Most of the world’s population is poor relative to
the United States.
 About a billion people have incomes of less
than $2 per day.
 About 67% of the world’s population lived in a
country with a GDP per capita equal to or less
than $7,826, about the level in China.
 Fully 75% of the world’s population lived in a
country with a GDP per capita less than
average.
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1. GDP Growth Varies
The Distribution of World Income
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2. Everyone Used To Be Poor
 The distribution of world income tells us that
poverty is normal, while wealth is unusual.
 GDP per capita in the year 1 is estimated
around $700–$1,000 per year in 2010 dollars.
 This was approximately the same in all major
regions of the world.
 For most of recorded human history, there was
no long-run growth in real per capita GDP.
 Today, GDP per capita is 50 times larger in the
richest countries than in the poorest.
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2. Everyone Used To Be Poor
Economic Growth in Major World Regions
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Growth Rates
 Economic growth is measured as the growth
rate of real GDP per capita.
 Even slow growth, sustained over time,
produces big differences in wealth.
 Growth builds on top of growth through
“compounding” or “exponential growth.”
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Measuring Growth
Economic growth is measured as:
y t  y t 1
gt 
 100
y t 1
where:
gt = growth rate of real GDP per capita
yt = real GDP per capita in time period t
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Measuring Growth
Example:
Year
2008
2009
real GDP per capita
$15,000 billion
$15,500 billion
y t  y t 1
gt 
 100
y t 1
g2009
15,500  15,000

 100  3.3%
15,000
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Self-Check
Real GDP per capita was $22,000 in Year 1 and
$23,000 in Year 2. The growth rate was:
a. 4.35%
b. 4.55%
c. 4.75%
Answer: b – the growth rate was
[(23,000 – 22,000) / 22,000] x 100 = 4.55%
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Measuring Growth
 The rule of 70 approximates the length of time
necessary for a growing variable 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
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The Rule of 70
Small changes in the growth rate lead to
large changes over time.
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Self-Check
According to the rule of 70, a sum of money
invested at 12.5% would double in:
a. 5.6 years.
b. 17.86 years.
c. 56 years.
Answer: a – the money would double in 70 / 12.5
= 5.6 years.
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Self-Check
How long it will take for the average Indian to be
as wealthy as the average Western European is
today? Note that all numbers are adjusting for
inflation. India's GDP per capita is $3,000, and
let's say that real output per person there grows
at 5 percent per year. Using the rule of 70, how
many years will it take for India to reach Italy's
current level of GDP per capita, about $24,000 per
year?
a) 42 years
b) 14 years
c) 28 years.
d) 12 years
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Economic Growth
Growth miracles and growth disasters.
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Economic Growth
Two Growth Miracles
 The United States is one of the wealthiest countries in
the world because the United States has grown slowly
but relatively consistently for more than 200 years.
 From 1950 to 1970, Japan grew 8.5% per year.
 Today, Japan is one of the richest countries in the world.
 In 1950, South Korea had GDP per capita about the
same as that of Nigeria.
 Between 1970 and 1990, it grew at a rate of 7.2% per
year.
 Today, South Korea is on a par with many European
economies.
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Economic Growth
Two Growth Disasters
 Nigeria has barely grown since 1950.
 It was poorer in 2005 than in 1974 when high oil
prices briefly bumped up its per capita GDP.
 In 1900, Argentina was one of the richest
countries in the world.
 By 1950, Argentina’s per capita GDP had fallen
to half that of the U.S.
 By 2000 Argentina’s per capita GDP was less
than one-third of that of the U.S.
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Economic Growth
The Bad News:
 Most of the world is poor.
 More than 1 billion people live on incomes of
less than $2 per day.
 These people have greatly reduced prospects
for health, happiness, and peace.
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Economic Growth
The Good News:
 Despite being quite recent, economic growth
has transformed the world.
 It has raised the standard of living of most
people in developed nations many times above
the historical norm.
 It can happen quite quickly.
 Understanding the wealth of nations is critical if
we are to improve the human condition.
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Self-Check
Most of the world is:
a. Relatively well-off.
b. Wealthier than the U.S.
c. Poor.
Answer: c – most of the world is poor.
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Self-Check
 Would you rather live in a country that has
high taxes and a generous social safety net or
a country with low taxes and little social
safety?
a) High tax, generous social safety
b) Low tax, low level of social safety
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The Wealth of Nations
The causes of growth in
GDP per capita include
factors of production,
incentives, and
institutions.
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Definition
Physical capital:
the stock of tools including machines,
structures, and equipment.
Human capital:
the productive knowledge and skills that
workers acquire through education,
training, and experience.
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Factors of Production
 Countries with a high GDP per capita have a lot
of factors of production: physical capital,
human capital, and technological knowledge.
 More and better physical capital make workers
more productive.
 Human capital enables workers to take
advantage of more sophisticated tools.
 Greater quantities of physical and human capital
per worker makes workers more productive.
 We increase human capital with education.
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Definition
Technological knowledge:
knowledge about how the world works,
that is used to produce goods and
services.
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Factors of Production
 Improved technological knowledge increases
productivity, and is potentially boundless.
 Better technological knowledge has allowed
U.S. farms to increase their output two and a
half times since 1950, while using less land.
 We increase technological knowledge with
research and development.
 The organization of factors of production
depends on incentives and institutions.
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Self-Check
Knowledge that is used to produce goods and
services is called:
a. Technological knowledge.
b. Human capital.
c. Factors of production.
Answer: a – technological knowledge.
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Definition
Institutions:
the “rules of the game” that structure
economic incentives.
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Incentives and Institutions
 Institutions include laws and regulations but
also customs, practices, organizations, and
social mores.
 Institutions that promote growth create
incentives that align self-interest with the social
interest.
 Wealthy countries have institutions that make it
in people’s self-interest to invest in physical
capital, human capital, and technological
knowledge.
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Incentives and Institutions
 Institutions of economic growth include:
•
•
•
•
•
Property rights
Honest government
Political stability
A dependable legal system
Competitive and open markets
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Korea’s Experiment
Before division after WWII: similar
Culture, physical capital, technology.
North Korea became a communist state with a
centrally planned economy.
South Korea adopted the capitalist free market
model.
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Property Rights
 Property rights are important institutions for
encouraging investment in physical and human
capital.
 Under communal property, effort is divorced
from payment so there is incentive to free ride.
 When China switched from communal to
individual farms, food production increased by
50% and 170 million people were lifted above
the lowest poverty line.
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Definition
Free rider:
someone who consumes a resource
without working or contributing to the
resource’s upkeep.
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China’s “Free Rider” Problem
China’s “Great Leap Forward”- which
introduced farming collectives- reduced
incentives. 20-40 million starved.
1978, farmers in Xiaogang met in secret to
devise a plan to keep some of their produce.
Productivity improved so quickly the
government allowed the experiment to
proceed.
Food production increased 50% in 5 years 19781983.
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Property Rights
 Savers won’t save and investors won’t invest if
they don’t expect that they will receive a return
for their savings and investment.
 Property rights are also important for
encouraging technological innovation.
 Companies will not undertake research and
development unless they expect to profit from it.
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Property Rights
• No one must “own” you for economic freedom to exist.
• Ownership is right to shape, use, and dispose.
• You wouldn’t think you really owned it if the government
controlled its use
• The government would be the de facto owner.
• Ownership is control, without it, you don’t “own” it.
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Property Rights
• Mongolian Yaks – were owned by the government for
decades (the People’s Yaks)
• Total Yak population did not change from 1920s to 1990s
• After the collapse of central planning, property rights were
assigned.
• The Yak population soared from 25 to 32 million in a few
short years
• When it’s your yak, not “everybody’s” yak, you take care of
the yak and make more yaks
• You “share” your Yaks with other people with mutually
beneficial trades involving yak products.
• “No one ever washed a rental car”
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Property Rights
•
“Sharing” when done at gun point (i.e. government
confiscation of property) is not the proper term to
use.
•Nor is the word “compassion” appropriate
• “No one ever washed a rental car”
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Honest Government
 Corruption is like a tax that bleeds resources
away from productive entrepreneurs.
 Resources “invested” in bribing cannot be
invested in machinery and equipment.
 Corruption makes it more profitable to be a
corrupt politician or bureaucrat.
 Few people want to be entrepreneurs because
they know that their wealth will be stolen.
 Corruption explains much of the poverty in
various countries
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Honest Government
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Honest Government
Corrupt countries have lower GDP per capita.
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Self-Check
Rules, regulations, and customs that structure
incentives are called:
a. Human capital.
b. Institutions.
c. Investment.
Answer: b – institutions.
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Political Stability
Changing governments without the
rule of law creates 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.
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Dependable Legal System
 A good legal system facilitates contracts and
protects private parties from expropriating one
another.
 Poorly protected property rights can stem from
either too much or too little government.
 Some legal systems are of such low quality that
no one knows for certain who owns what.
 It is difficult to borrow money if lenders can’t get
their money back.
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Dependable Legal System
“Rule of Law” – crucial to economic growth
The rule of law is the general concept that
government as well as the governed are
subject to the law and that all are to be
equally protected by the law.
Otherwise…..the worst kinds of corruption
occur
Power does not equal wisdom or good
judgment
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Dependable Legal System
• Most of human history the rules by which
life was governed were usually
determined by force and fraud
• He who had the power made the rules.
Absolute monarch or tyrannical despots
• “Divine right of Kings” subjects accepted
their rule without question
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Competitive and Open Markets
 About half the differences in per capita income
across countries are explained by differences in
the amount of physical and human capital.
 Half the differences are explained by a failure to
use capital efficiently.
 Competitive and open markets are one of the
best ways to encourage the efficient
organization of resources.
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Competitive and Open Markets
 Some reasons for inefficient organization
include:
• Inefficient and unnecessary regulations.
• Red tape, or the time and cost to do tasks
such as starting a business or enforcing a
contract in a court of law.
• Barriers to free trade.
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Competitive and Open Markets
 Why do poor countries use their capital
inefficiently?
 One study found: if India used its physical and
human capital as efficiently as the U.S., India
would be 4x richer than it is today.
Whether inadvertently or not, inefficient and
unnecessary regulations:
Create monopolies and impede markets
Example: until recently in India, it was
illegal to produce shirts using large-scale
production
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Definition
Economies of scale:
the advantages of large-scale production
that reduce average cost as quantity
increases.
i.e. as output increases, cost per unit falls
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Ultimate Causes of Wealth
 Natural resources may help explain why a
country is able to accumulate physical and
human capital.
 Transport is cheaper over water than over land,
so countries with access to water are more open
to trade.
 Landlocked countries have lower per capita
GDP than countries with access to a coast.
 History, ideas, geography, and luck are also
important to economic growth.
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England and the Industrial Revolution
Why did England’s Industrial Revolution
bring us:






large scale factories
mass production
the steam engine
the railroad
the beginnings of a consumer society
the first sustained rise in human living
standards above subsistence?
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England and the Industrial Revolution
Property rights?
England’s geography and Navy helped protect property
rights
Honest government
Growth of Parliament (and religious changes) reduced
royal tyranny
Political stability
Middle class developed from growth
A dependable legal system
Less corruption as royal and Catholic power is reduced
Competitive and open markets
England opened itself more to trade
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Video – Economic Progress and Freedom
•
Hans Rosling: “The Magic Washing Machine”
• https://www.youtube.com/watch?v=BZoKfap4g4w
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Takeaway
 Economic growth has raised billions of people
out of poverty.
 Poor countries can catch up to rich countries
and in a surprisingly short period.
 Countries with a high GDP per capita have lots
of physical and human capital per worker,
organized using the best technological
knowledge.
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Takeaway
 Countries with a high GDP per capita have
institutions that encourage investment in
physical capital, human capital, technological
innovation, and the efficient organization of
resources.
 Institutions for increasing economic growth are
property rights, honest government, political
stability, a dependable legal system, and
competitive and open markets..
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