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A Lecture Presentation to accompany Exploring Economics 3 Edition by Robert L. Sexton rd Copyright © 2005 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, 3rd Edition by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-324-26086-5 Copyright © 2002 by Thomson Learning, Inc. Chapter 19 Economic Growth in the Global Economy Copyright © 2002 by Thomson Learning, Inc. 19.1 Economic Growth John Maynard Keynes primarily concerned with explaining and reducing short-term fluctuations in the level of business activity once said, “in the long run we are all dead.” He wanted to smooth out the business cycle, largely because of the implications that cyclical fluctuations had for buyers and sellers in terms of unemployment and price instability. Copyright © 2002 by Thomson Learning, Inc. Short Run Versus Long Run Keynes’ concerns were important and legitimate. At the same time, his flippant remark about the long run ignores the fact that human welfare is greatly influenced by long-term changes in a nation's capacity to produce goods and services. Copyright © 2002 by Thomson Learning, Inc. Emphasis on the short-run business cycle ignores the longer term dynamic changes that affect output, leisure, real incomes and life styles. Many would argue that in the long run, economic growth is a crucial determinant of well-being. Copyright © 2002 by Thomson Learning, Inc. What are the determinants of long-run economic change in our ability to produce goods and services? What are some of the consequences of rapid economic change? Why are some nations rich while others are poor? Does growth in output improve our economic welfare? Copyright © 2002 by Thomson Learning, Inc. Defining Economic Growth Economic growth is usually measured by the annual percent change in real output of goods and services per capita (real GDP per capita). Along the production possibilities curve, the economy is producing at its potential output. Copyright © 2002 by Thomson Learning, Inc. How much the economy will produce at its potential output, sometimes called its natural level of output, depends on the quantity and quality of an economy’s resources, including labor, capital, and natural resources. Copyright © 2002 by Thomson Learning, Inc. 13.1 Economic Growth Technology can increase the economy’s production capabilities. Improvements in and greater stocks of land, labor, and capital can shift out the production possibilities curve. Another way of saying that economic growth has shifted the production possibilities curve out is to say that growth has increased potential output. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. The Rule of 70 A nation with greater economic growth will end up with a much higher standard of living, ceteris paribus. The Rule of 70 can tell how long it will take a nation to double its output. The number of years necessary is approximately equal to the nation’s growth rate divided into 70. For example, if a nation grows at 3.5% per year, then the economy will double every 20 years (70/3.5) Copyright © 2002 by Thomson Learning, Inc. The “richest” or “most-developed” countries today have many times the per capita output of the “poorest” or “least-developed” countries. The international differences in income, output, and wealth are striking and have caused a great deal of friction between developed and less-developed countries. Copyright © 2002 by Thomson Learning, Inc. Standard of living is closely correlated with productivity growth Productivity is the amount of good and services a worker can produce per hour Slow growth of capital investment can lead to lower labor productivity and consequently lower wages While increases in productivity, and consequently higher wages, can occur as a result of carefully crafted economic policies— tax policies that stimulate investment or programs that encourage R&D. Copyright © 2002 by Thomson Learning, Inc. The link between productivity and the standard of living can be easily understood by recalling our circular flow model. In the circular flow model aggregate values of all goods and services produced in the economy must equal the payments made to the factors of production. So the only way an economy can increase its rate of consumption in the long run is if they increase the amount they produce. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. 19.2 Determinants of Economic Growth Many separate explanations of economic growth have been proposed, but none of them, by themselves, can completely explain economic growth. However, each of the explanations may be part of a more complicated reality. Economic growth is a complex process involving many important factors, no one of which completely dominates. Copyright © 2002 by Thomson Learning, Inc. Nearly everyone agrees that several factors have contributed to economic growth in some or all countries. growth in the quantity and quality of labor resources used increase in the use of inputs provided by land growth in physical capital inputs technological advances allowing greater output than previously possible Copyright © 2002 by Thomson Learning, Inc. Labor is needed in all forms of productive activity. Other things being equal, an increase in labor input does not necessarily increase output per capita. Copyright © 2002 by Thomson Learning, Inc. If the increase in labor input results from an increase in population, per capita growth might not occur because the increase in output could be offset by the increase in population. Copyright © 2002 by Thomson Learning, Inc. If a greater proportion of the population works or if workers put in longer hours, output per capita will increase—assuming that the additional work activity adds something to output. Copyright © 2002 by Thomson Learning, Inc. Qualitative improvements in workers (learning new skills, for example) can also enhance output. It has become popular to view labor as "human capital" that can be augmented or improved by education and on-the-job training. Copyright © 2002 by Thomson Learning, Inc. Abundant natural resources also can enhance output whereas a limited resource base is an important obstacle to economic growth. Copyright © 2002 by Thomson Learning, Inc. Resources are not the whole story. The natural resource base can affect the initial development process, but sustained growth is influenced by other factors. There is nearly universal agreement that capital formation has played a significant role in the economic development of nations. Copyright © 2002 by Thomson Learning, Inc. Technological advances stem from man's ingenuity and creativity in developing new ways of combining the factors of production to enhance the amount of output from a given quantity of resources. It involves invention and innovation. Innovation is the adoption of a new product or process. Copyright © 2002 by Thomson Learning, Inc. New technology must be introduced into productive use by managers or entrepreneurs who must weigh their estimates of benefits of the new technology against their estimates of costs. The entrepreneur is an important economic factor in the growth process. Copyright © 2002 by Thomson Learning, Inc. Technological advances permit us to economize on one or more inputs used in the production process. It can permit savings of labor, as occurs when a new machine is invented that does the work of many workers. It can also be land (natural resource) saving or even capital saving. Copyright © 2002 by Thomson Learning, Inc. Nuclear fission has permitted us to build power plants that economize on the use of coal, a natural resource. Copyright © 2002 by Thomson Learning, Inc. The reduction in transportation time that accompanied the invention of the railroad allowed businesses to reduce the capital they needed in the form of inventories. Because goods could be obtained quickly, businesses could reduce the stock kept on their shelves. Copyright © 2002 by Thomson Learning, Inc. 19.3 Raising the Level of Economic Growth Economic growth means more than an increase in the real income (output) of the population. Changes in output are accompanied by a number of other important changes. There are a number of policies that a nation can pursue to increase economic growth. Copyright © 2002 by Thomson Learning, Inc. Saving Rates, Investment, Capital Stock, And Economic Growth One of the most important determinants of economic growth is the saving rate. In order to consume more in the future, we must save more now. Generally speaking, higher levels of saving will lead to higher levels of investment and capital formation and, therefore, to greater economic growth. Copyright © 2002 by Thomson Learning, Inc. Sustained rapid economic growth is associated with high rates of saving and investment around the world. Investment alone does not guarantee economic growth, which hinges importantly on the quality and the type of investment as well as on investment in human capital and improvements in technology. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. Research And Development Some scholars believe that the importance of research and development (R&D) is understated. It can include new products management improvements production innovations simply learning by doing Copyright © 2002 by Thomson Learning, Inc. It is clear that investments in R&D and rewarding innovators with patents has paid big dividends in the past 50 to 60 years. Copyright © 2002 by Thomson Learning, Inc. There is an important link between research and development and capital investment. When capital depreciates over time, it is replaced with new equipment that embodies the latest technology. Consequently, R&D may work hand-inhand with investment to improve growth and productivity. Copyright © 2002 by Thomson Learning, Inc. The Protection Of Property Rights Impacts Economic Growth Economic growth rates tend to be higher in countries where the government enforces property rights. In most developed countries, property rights are effectively protected by the government, but in developing countries, this is not normally the case. Copyright © 2002 by Thomson Learning, Inc. And if the government is not enforcing property rights, the private sector must respond in costly ways that stifle economic growth. private security bribes corruption confiscation the risk of takeovers from a new government Copyright © 2002 by Thomson Learning, Inc. Free Trade And Economic Growth Free trade can lead to greater output because of the principle of comparative advantage. If two nations or individuals with different resource endowments and production capabilities specialize in producing a smaller number of goods and services, then they are relatively better at and engage in trade. Both parties will benefit as total output rises. Copyright © 2002 by Thomson Learning, Inc. Education Education, investment in human capital, is just as important as improvements in physical capital. Accepting a reduction in current income to acquire education and training can increase future earning ability, which can raise the standard of living. Copyright © 2002 by Thomson Learning, Inc. With economic growth, illiteracy rates fall and formal education grows. The correlation between per capita output and the proportion of the population that is unable to read or write is striking. Improvements in literacy stimulate economic growth by reducing barriers to the flow of information and raise labor productivity. Copyright © 2002 by Thomson Learning, Inc. Since children in developing countries are an important part of the labor force at a young age, there is a higher opportunity cost of education in terms of forgone contribution to family income. Education is a consequence of economic growth, becoming a consumption good, as well as a cause of economic growth, creating human capital. Copyright © 2002 by Thomson Learning, Inc. 19.4 Population and Economic Growth At the beginning of the English Industrial Revolution (around 1750), the world’s population was approximately 700 million. It took 150 years (to 1900) for that population to slightly more than double to 1.6 billion. Just 64 years later (in 1964), it had doubled again to 3.2 billion. Copyright © 2002 by Thomson Learning, Inc. Population Growth And Economic Growth After another 40 years (in 2004), it is likely that the population will have doubled yet again to more than 6.4 billion (the world population was 6.2 billion in 2001). We have had economic development amidst all this growth in population, but what role does population play in economic growth? Copyright © 2002 by Thomson Learning, Inc. If population were to expand faster than output, per capita output would fall; population growth would inhibit growth. With a larger population, however, comes a larger labor force. Certainly, very rapid population growth—more than 3 percent a year— did not seem to impede U.S. economic growth in the mid-19th century. Copyright © 2002 by Thomson Learning, Inc. U.S. economic growth until at least World War I was accompanied by population growth that was among the highest in the world for the time. There is a general feeling that in many of the developing countries today, rapid population growth threatens the possibility of attaining sustained economic growth. Copyright © 2002 by Thomson Learning, Inc. These countries are predominantly agricultural with very modest natural resources, especially land. The landlabor ratio is very low. Why is population growth a threat in these countries? Copyright © 2002 by Thomson Learning, Inc. The Malthusian Prediction Malthus formulated a theoretical model that predicted that per capita economic growth would eventually become negative and that wages would ultimately reach equilibrium at a subsistence level, or just large enough to provide enough income to stay alive. Copyright © 2002 by Thomson Learning, Inc. Malthus made three assumptions: 1. 2. 3. The economy was agricultural, with goods produced by two inputs, land and labor The supply of land was fixed Human sexual desires worked to increase population Copyright © 2002 by Thomson Learning, Inc. The Law Of Diminishing Marginal Returns As population increases, the number of workers increases, and with greater labor inputs available, output also goes up. Copyright © 2002 by Thomson Learning, Inc. A some point, however, output will increase by diminishing amounts because of the law of diminishing returns, which states that you add variable amounts of one input (in this case, labor) to fixed quantities of another input (in this case, land), output will rise but by diminishing amounts (because as the land-labor ration falls, there is less land per worker). Copyright © 2002 by Thomson Learning, Inc. Avoiding Malthus’s Prediction Malthus’s theory proved wrong for much of the world. The quantity or quality of cultivable land is not completely fixed. Malthus implicitly assumed there would be no technological advances and ignored the real possibility that improved technology could overcome the impact of the law of diminishing returns. Copyright © 2002 by Thomson Learning, Inc. The Malthusian assumption that sexual desire would necessarily lead to population increase is not accurate because the number of births can be reduced by birth control techniques. Copyright © 2002 by Thomson Learning, Inc. In some countries, a larger population may lead to more entrepreneurs, engineers, and scientists who will contribute to even greater economic growth through technological progress. Copyright © 2002 by Thomson Learning, Inc. Do Some Developing Countries Still Fit Malthus’s Prediction Today? Some developing nations of the world are having substantial population increases, with a virtually fixed supply of land, slow capital growth, and few technological advances. In fact, some have tried to reduce the rate of population growth to achieve greater economic growth per capita and higher standards of living. Copyright © 2002 by Thomson Learning, Inc. While high population growth rates may be one explanation for lower standards of living, there are many non-Malthusian explanations for the recurring poverty that exists in developing countries today: Political instability Lack of defined and enforceable property rights Inadequate investment in human capital Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc.