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Case J1 Introducing Theories of Economic Growth From dismal economics to the economics of optimism The classical theory of growth The classical economists of the nineteenth century were very pessimistic about the prospects for economic growth. They saw the rate of growth petering out as diminishing returns to both labour and capital led to low wages and a falling rate of profit. The only gainers would be landlords, who, given the fixed supply of land, would receive higher and higher rents as the demand for scarce land rose. £ WS e Y Y1 WS 1 O N1 NL Working population Long-run stationary state in the classical model The classical position can be shown graphically. The size of the working population is plotted on the horizontal axis. If it is assumed that there is a basic minimum ‘subsistence’ wage that workers must earn in order to survive, then the line WS traces out the total subsistence wage bill. It is a straight line because a doubling in the number of workers would lead to a doubling of the subsistence wage bill. The line Y shows the total level of income that will be generated as more workers are employed, after subtracting rents to landlords. In other words, it is total wages plus profits. It gets less and less steep due to diminishing returns to labour and capital given the fixed supply of land. As long as Y is above WS (say, at a population of N1), firms can make a profit. They will try to expand and will thus take on more labour. Initially this will bid up the wage and will thus erode the level of profits. But the higher wages will encourage the population to expand. This increased supply of labour will compete wages back down to the subsistence level and will thus allow some recovery in profits. But profits will not be as high as they were before because, with an increase in workers, the gap between Y and WS will have narrowed. Firms will continue to expand and the population will continue to grow until point e is reached. At that point, even with wages at bare subsistence level, no profit can be made. Growth will cease. The economy will be in a long-run stationary state. No wonder economics became dubbed ‘the dismal science’. New growth theory Economists today are more optimistic about the prospects for economic growth. This is partly based on a simple appeal to the evidence. Despite a rapid growth in world population, most countries have experienced sustained economic growth. Over the last hundred years the industrialised countries have seen per-capita growth rates averaging from just over 1 per cent to nearly 3 per cent per annum. This has resulted in per-capita real incomes many times higher than in the nineteenth century. This worldwide experience of economic growth has stimulated the development of new growth theories. These stress two features: The development and spread of new technology. The rapid advances in science and technology have massively increased the productivity of factors of production. What is more, new inventions and innovations stimulate other people, often in other countries, to copy, adapt and improve on them in order to stay competitive. Growth through technical progress stimulates more growth. The positive externalities of investment. If one firm invests in training in order to raise labour productivity, other firms will benefit from the improved stock of ‘human capital’. There will be better-trained labour that can now be hired by other firms. Similarly, if one firm invests in research and development, the benefits can spill over to other firms (once any patents have expired). What is more, firms trade with other firms. If a firm that supplies components invests in better equipment, it might be able to supply better and/or cheaper components. The firms it supplies will thus benefit from the first firm’s investment. These spillover benefits to other firms can be seen as the positive externalities of investment. New growth theories seek to analyse the process of the spread of technology and how it can be influenced. Given that technological progress allows the spectre of diminishing returns to be banished, or at least indefinitely postponed, it is no wonder that many economists are more optimistic about growth. Nevertheless, there are still serious grounds for concern. If the benefits of investment spill over to other firms (i.e. if there are positive externalities), the free market will lead to too little investment: firms considering investing will take into account only the benefits to themselves, not those to other firms. There is thus an important role for governments to encourage or provide training, research and capital investment. (We consider such policies in section 31.4.) Potential growth may not translate into actual growth. A potentially growing economy may be languishing in a deep recession. There may be serious costs of economic growth: for those whose jobs are replaced by machines; for society, as new production and consumption patterns cause social upheavals; for the environment, as new production generates more waste and more pollution, and uses up scarce natural resources (see Case Study J2). Question Can growth go on for ever, given that certain resources are finite in supply? 2