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The Wealth of Nations and
Economic Growth
Chapter 6
© 2010 WORTH PUBLISHERS MODERN PRINCIPLES: MACROECONOMICS COWEN AND TABARROK
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SEE THE INVISIBLE HAND
Economic growth is a matter of life and death to the 1.8 million children
who die of diarrhea each year globally.
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Chapter Outline
• Key Facts about the Wealth of Nations and
Economic Growth
• Understanding the Wealth of Nations
• Incentives and Institutions
• Takeaway
• Appendix: The Magic of Compound Growth Using
a Spreadsheet
• See the Invisible Hand Blog (click) for more examples
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Key Facts about the Wealth of
Nations and Economic Growth
Fact One: GDP per Capita Today Varies Enormously among Nations
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Go here to watch a 20 minute TED video about economic growth data.
Key Facts about the Wealth of
Nations and Economic Growth
Wealth and Health go Together.
Source: Penn World Tables and World Bank Group, World Development Indicators, 2005
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Key Facts about the Wealth of
Nations and Economic Growth
Fact Two: Everyone Used to be Poor
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Key Facts about the Wealth of
Nations and Economic Growth
• A Primer on Growth Rates
– How is economic growth measured?
y t  y t 1
gt 
 100
y t 1
– Where yt is per capita real GDP in year t
– Example:
Year
2008
2009
g2009
real GDP per capita
$15,000
$15,500
15,500  15,000

 100  3.33%
15,000
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The Rule of 70 (The Magic of
Compounding)
• The rule of 70:
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
– The moral? Small improvements in growth add
up fast (the power of compounding).
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A Little Growth Goes
a Long Way
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Key Facts about the Wealth of
Nations and Economic Growth
Fact Three: There are Growth Miracles and Growth Disasters
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Understanding the Wealth
of Nations
• The Factors of Production are important
– Physical capital: the stock of tools including
machines, 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.
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What Causes Economic Growth?
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Understanding the Wealth
of Nations
• Why do some nations have faster growth
than others?
– Besides factors of production, incentives and
institutions matter.
• Institutions = “rules of the game” that
structure economic incentives.
Institutions of Economic Growth
1.
2.
3.
4.
5.
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
• Shared the same people and culture.
• Had similar levels of physical capital.
• Had 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 is dramatic as seen
in the following photo from outer space.
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SEE THE INVISIBLE HAND
North and
South
Korea at
night
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Institutions
1. Property rights: the right to benefit from one’s
effort.
• Provide incentives to work hard.
• Encourage investment in physical and
human capital.
• Are important for encouraging technological
innovation.
– Without property rights:
– Effort is divorced from payment, reducing
incentives.
– Free riders become a problem.
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Institutions
• Free Rider = someone who consumes a
resources without working or contributing to
the resource’s upkeep.
– China’s “Great Leap Forward”- which
introduced farming collectives- reduced
incentives to work. 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 1978-1983.
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Institutions
2. 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.
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Corruption and Growth
Don’t go Together
Source: Penn World Tables and World Bank Group, World Development Indicators, 2005
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Corruption Who’s Who List
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Institutions
3. 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.
Bullet casings from Liberia’s Civil War: Bad soil
for anything to grow.
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Institutions
4. Dependable Legal System
• A good legal system facilitates
contracts and protects property from
others (including government).
• Poorly protected property rights can
result from too much government or too
little government.
– In India, residents who purchase land have
to do so more than once because of lack of
proper record keeping.
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Institutions
5. 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.
• 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.
• Click here for Alex Tabarrok’s TED talk about
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competition and economic growth (15 mins).
Institutions
• Why do poor countries use their capital
inefficiently?
– 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
• Economies of scale = the advantages of
large-scale production that reduce
average cost as quantity increases
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Try it!
• Think-pair-share: Why do you
think expensive red tape is
hard to get rid of in many poor
countries?
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Key Concepts
•
•
•
•
•
•
•
Economic growth
Physical capital
Human capital
Technological knowledge
Institutions
Free rider
Economies of scale
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Try it!
If a nation doubles its GDP per capita in
20 years, what is its annual growth
rate?
a) 3.5%
b) 4.2%
c) 6.5%
d) 7%
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Try it!
If a nation doubles its GDP per capita in
20 years, what is its annual growth
rate?
a) 3.5%
b) 4.2%
c) 6.5%
d) 7%
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Try it!
What is the most proximate (or direct)
cause of growth in real GDP per capita?
a) the factors of production
b) political system in the economy
c) institutions
d) incentives
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Try it!
What is the most proximate (or direct)
cause of growth in real GDP per capita?
a) the factors of production
b) political system in the economy
c) institutions
d) incentives
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Try it!
Human capital is the
a) stock of tools including machines,
structures, and equipment.
b) productive knowledge and skills that
workers acquire through education,
training, and experience.
c) knowledge about how the world works
that is used to produce goods and
services.
d) organization skills of business owners.
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Try it!
Human capital is the
a) stock of tools including machines,
structures, and equipment.
b) productive knowledge and skills that
workers acquire through education,
training, and experience.
c) knowledge about how the world works
that is used to produce goods and
services.
d) organization skills of business owners.
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Try it!
Which of the below is not directly
related to human capital?
a) a life-saving drug
b) schooling
c) work experience
d) an understanding of chemistry
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Try it!
Which of the below is not directly
related to human capital?
a) a life-saving drug
b) schooling
c) work experience
d) an understanding of chemistry
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Try it!
Why did so many Chinese farmers and
workers starve under “The Great Leap
Forward”?
a) The number of workers on communes was
reduced.
b) The Chinese people did not know how to
farm in certain geographic areas.
c) The incentive to work hard was low since
the rewards were so minimal.
d) All of the answers are correct.
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Try it!
Why did so many Chinese farmers and
workers starve under “The Great Leap
Forward”?
a) The number of workers on communes was
reduced.
b) The Chinese people did not know how to
farm in certain geographic areas.
c) The incentive to work hard was low since
the rewards were so minimal.
d) All of the answers are correct.
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