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CHAPTER 8 Why do Economies Grow? Copyright © 2012 Pearson Prentice Hall. All rights reserved. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-1 CHAPTER Why do Economies Grow? 8 For many people, the thought of poverty conjures up poor, African children, but since 1995, African poverty rates have been falling steadily. PREPARED BY Brock Williams Copyright © 2012 Pearson Prentice Hall. All rights reserved. CHAPTER 8 Why do Economies Grow? APPLYING THE CONCEPTS 1 How my global warming affect economic growth? Global Warming, Rich Countries and Poor Countries 2 Does economic growth necessarily cause more inequality? Growth Need Not Cause Increased Inequality 3 How can we use economic analysis to understand the sources of growth in different countries? Sources of Growth in China and India 4 How much did the information revolution contribute to U.S. productivity growth? Growth Accounting and Information Technology 5 How do varying political institutions affect economic growth? The Role of Political Factors in Economic Growth 6 Did cultural or evolution spark the Industrial Revolution? Culture, Evolution, and Economic Growth 7 Why are clear property rights important for economic growth in developing countries? Lack of Property Rights Hinders Growth in Peru Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-3 CHAPTER 8 Why do Economies Grow? 8.1 ECONOMIC GROWTH RATES ● capital deepening Increases in the stock of capital per worker. ● technological progress More efficient ways of organizing economic affairs that allow an economy to increase output without increasing inputs. ● human capital The knowledge and skills acquired by a worker through education and experience and used to produce goods and services. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-4 CHAPTER 8 Why do Economies Grow? 8.1 ECONOMIC GROWTH RATES (cont’d) FIGURE 8.1 What Is Economic Growth? Economic growth means an expanded production possibilities curve (PPC). Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-5 CHAPTER 8 Why do Economies Grow? 8.1 ECONOMIC GROWTH RATES (cont’d) Measuring Economic Growth ● real GDP per capita Gross domestic product per person adjusted for changes in prices. It is the usual measure of living standards across time and between countries. ● growth rate The percentage rate of change of a variable from one period to another. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-6 CHAPTER 8 Why do Economies Grow? 8.1 ECONOMIC GROWTH RATES (cont’d) Measuring Economic Growth ● rule of 70 A rule of thumb that says output will double in 70/x years, where x is the percentage rate of growth. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-7 CHAPTER 8 Why do Economies Grow? 8.1 ECONOMIC GROWTH RATES (cont’d) Comparing the Growth Rates of Various Countries Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-8 CHAPTER 8 Why do Economies Grow? APPLICATION 1 GLOBAL WARMING, RICH COUNTRIES, AND POOR COUNTRIES APPLYING THE CONCEPTS #1: How may global warming affect economic growth? The effects of global warming on economic development are very complex ▪ The effect of increases in temperature seem to be confined to poor countries ▪ In Latin and South America, each 1 degree Celsius increase resulted in a 1.2 to 1.9 percent decline in per capita income ▪ Exports also declined between 2.0 and 5.7 percent. ▪ By deferring global warming into the future, poor countries may have time to develop and avoid the worst of the impact. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-9 CHAPTER 8 Why do Economies Grow? 8.1 ECONOMIC GROWTH RATES (cont’d) Are Poor Countries Catching Up? ● convergence The process by which poorer countries close the gap with richer countries in terms of real GDP per capita. ► FIGURE 8.2 Growth Rates versus Per Capita Income, 1870–1979 Each point on the graph represents a different currently developed country. Notice that the countries with the lowest per capita incomes in 1870 (shown along the horizontal axis) are plotted higher on the graph. In other words, the tendency was for countries with lower levels of initial income to grow faster. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-10 CHAPTER 8 Why do Economies Grow? APPLICATION 2 GROWTH NEED NOT CAUSE INCREASED INEQUALITY APPLYING THE CONCEPTS #2: Does economic growth necessarily cause more inequality? Economists believed that as a country developed, inequality within a country followed an inverted “U” pattern—inequality initially increased and then narrowed over time. Recent research challenges the assumption that this phenomenon is solely the result of growth: ▪ Inequality increased from 40 percent at the beginning of the 1920s to 45 percent through the end of the Great Depression. ▪ During World War II inequality fell to 32 percent by 1944 and remained at that level until the early 1970s, at which time it began to again increase. ▪ Wage and price controls during World War II reduced differentials in wages and salaries and thereby reduced inequality. ▪ After the 1970s, salaries at the top of the income distribution increased sharply. Inequality does not naturally accompany economic development. Other factors also play a role: ▪ Social norms ▪ Perceived fairness of compensation ▪ Nature of the tax system Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-11 CHAPTER 8 Why do Economies Grow? 8.2 CAPITAL DEEPENING ► FIGURE 8.3 Increase in the Supply of Capital An increase in the supply of capital will shift the production function upward, as shown in Panel A, and increase the demand for labor, as shown in Panel B. Real wages will increase from W1 to W2, and potential output will increase from Y1 to Y2. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-12 CHAPTER 8 Why do Economies Grow? 8.2 CAPITAL DEEPENING (cont’d) Saving and Investment ● saving Income that is not consumed. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-13 CHAPTER 8 Why do Economies Grow? 8.2 CAPITAL DEEPENING (cont’d) How Do Population Growth, Government, and Trade Affect Capital Deepening? PRINCIPLE OF DIMINISHING RETURNS Suppose output is produced with two or more inputs, and we increase one input while holding the other input or inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate. ► FIGURE 8.4 Taxes and Government Investment If the government raises taxes by $100 and the people tend to save 20 percent of changes in income, then private savings and investment will fall by $20. However, if the government invests the funds, then total investment— private and public— will increase by $80. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-14 CHAPTER 8 Why do Economies Grow? 8.3 THE KEY ROLE OF TECHNOLOGICAL PROGRESS How Do We Measure Technological Progress? ● growth accounting A method to determine the contribution to economic growth from increased capital, labor, and technological progress. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-15 CHAPTER 8 Why do Economies Grow? 8.3 THE KEY ROLE OF TECHNOLOGICAL PROGRESS (cont’d) How Do We Measure Technological Progress? ► FIGURE 8.5 Contributions to Real GDP Growth, 1929– 1982 (average annual percentage rates) Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-16 CHAPTER 8 Why do Economies Grow? 8.3 THE KEY ROLE OF TECHNOLOGICAL PROGRESS (cont’d) Using Growth Accounting •Growth accounting is a useful tool for understanding different aspects of economic growth. •As an example, economic growth slowed throughout the entire world during the 1970s. •Using growth accounting methods, economists typically found the slowdown could not be attributed to changes in the quality or quantity of labor inputs or to capital deepening. •Either a slowdown in technological progress or other factors not directly included in the analysis, such as higher worldwide energy prices, must have been responsible. •This led economists to suspect that higher energy prices were the primary explanation for the reduction in economic growth. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-17 CHAPTER 8 Why do Economies Grow? APPLICATION 3 SOURCES OF GROWTH IN CHINA AND INDIA APPLYING THE CONCEPTS #3: How can we use economic analysis to understand the sources of growth in different countries? China and India are the two most populous countries and have also grown very rapidly in recent years. From 1978 to 2004, GDP in China grew at the rate of 9.3 percent per year while India’s GDP grew at a lower rate of 5.4 percent per year. Economists Barry Bosworth from the Brookings Institution and Susan Collins from the University of Michigan used growth accounting to answer this question. ▪ China’s rapid growth was caused by more rapid accumulation of physical capital and more rapid technological progress. ▪ China invested much more in physical capital and was able to increase its technological progress at a more rapid rate. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-18 CHAPTER 8 Why do Economies Grow? APPLICATION 4 GROWTH ACCOUNTING AND INFORMATION TECHNOLOGY APPLYING THE CONCEPTS #4: How much did the information revolution contribute to U.S. productivity growth? FIGURE 8.6 U.S. Annual Productivity Growth, 1959–2007 In recent years, there has been a resurgence of productivity growth in part caused by the information technology revolution. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-19 CHAPTER 8 Why do Economies Grow? 8.4 WHAT CAUSES TECHNOLOGICAL PROGRESS? Research and Development Funding ▼ FIGURE 8.7 Research and Development as a Percent of GDP, 1999 The United States spends more total money than any other country on research and development. However, when the spending is measured as a percentage of each nation’s GDP, Japan spends more. A big part of U.S. spending on research and development is in defense-related areas. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-20 CHAPTER 8 Why do Economies Grow? 8.4 WHAT CAUSES TECHNOLOGICAL PROGRESS? (cont’d) Monopolies That Spur Innovation ● creative destruction The view that a firm will try to come up with new products and more efficient ways to produce products to earn monopoly profits. The Scale of the Market •Adam Smith stressed that the size of a market was important for economic development. •In larger markets, firms have more incentives to come up with new products and new methods of production. The lure of profits guides the activities of firms, and larger markets provide firms the opportunity to make larger profits. •This supplies another rationale for free trade. With free trade, markets are larger, and there is more incentive to engage in technological progress. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-21 CHAPTER 8 Why do Economies Grow? 8.4 WHAT CAUSES TECHNOLOGICAL PROGRESS? (cont’d) Induced Innovations Some economists have emphasized that innovations come about through inventive activity designed specifically to reduce costs. This is known as induced innovation. Education, Human Capital, and the Accumulation of Knowledge Education can contribute to economic growth in two ways. ▪ First, the increased knowledge and skills of people complement our current investments in physical capital. ▪ Second, education can enable the workforce in an economy to use its skills to develop new ideas or to copy ideas or import them from abroad. New Growth Theory ● new growth theory Modern theories of growth that try to explain the origins of technological progress. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-22 CHAPTER 8 Why do Economies Grow? APPLICATION 5 THE ROLE OF POLITICAL FACTORS IN ECONOMIC GROWTH APPLYING THE CONCEPTS #5 How do varying political institutions affect economic growth? Growth can, and has, occurred in both authoritarian and participatory governments. Transformative economic growth like the Industrial Revolution usually requires participatory institutions. ▪ Sustained technological progress is disruptive and authoritarian regimes have difficulty dealing with the change. ▪ The old monarchies of Europe fell and were replaced with democracies or limited monarchies. ▪ Can China maintain strong economic growth without political transformation? Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-23 CHAPTER 8 Why do Economies Grow? APPLICATION 6 CULTURE, EVOLUTION. AND ECONOMIC GROWTH APPLYING THE CONCEPTS #6: Did culture or evolution spark the Industrial Revolution? In studying the economic history of England before the Industrial Revolution, Professor Clark discovered an interesting fact. ▪ He found that children of the more affluent members of English society were more likely to survive than those of the less affluent. ▪ With the slow growth of population over several centuries, this differential survival of the wealthy had the effect of creating downward mobility for the rich, as their sons and daughters increasingly populated the society. This change had profound effects on English society. The cultural habits of the rich filtered through the entire society. ▪ Social virtues such as thrift, prudence, and hard work became more commonplace, while impulsive and violent behaviors were reduced. ▪ Eventually, these changes in culture became sufficiently pronounced that a qualitative change took place in society. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-24 CHAPTER 8 Why do Economies Grow? 8.5 A KEY GOVERNMENTAL ROLE: PROVIDING THE CORRECT INCENTIVES AND PROPERTY RIGHTS What is the connection between property rights and economic growth? • Without clear property rights, there are no proper incentives to invest in the future—the essence of economic growth. What else can go wrong? • Governments in developing countries often: • Adopt policies that effectively tax exports • Pursue policies that lead to rampant inflation • Enforce laws that inhibit the growth of the banking and financial sectors Results: • Fewer exports • Uncertain financial environment • Reduced saving and investment With the right incentives, individuals and firms in developing countries will take actions that promote economic growth. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-25 CHAPTER 8 Why do Economies Grow? APPLICATION 7 LACK OF PROPERTY RIGHTS HINDERS GROWTH IN PERU APPLYING THE CONCEPTS #7: Why are clear property rights important for economic growth in developing countries? Throughout the developing world, property is often not held with clear title. Without clear title, property cannot be used as collateral for loans. • Result: The poor living on very valuable land may be unable to borrow against that land to start a new business. • Producing palm oil in Peru is very profitable, but it depends upon the ability to borrow funds. • Production of coca paste—an ingredient to cocaine—does not take as much time and does not depend on finance. • Switching farmers away from production of coca paste to palm oil also requires improvements in finance, which are very difficult without clear property rights. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-26 CHAPTER 8 Why do Economies Grow? KEY TERMS capital deepening labor productivity convergence new growth theory creative destruction real GDP per capita growth accounting rule of 70 growth rate saving human capital technological progress Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-27 CHAPTER 8 Why do Economies Grow? APPENDIX A A MODEL OF CAPITAL DEEPENING PRINCIPLE OF DIMINISHING RETURNS Suppose output is produced with two or more inputs, and we increase one input while holding the other input or inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate. ► FIGURE 8A.1 Diminishing Returns to Capital Holding labor constant, increases in the stock of capital increase output, but at a decreasing rate. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-28 CHAPTER 8 Why do Economies Grow? APPENDIX A A MODEL OF CAPITAL DEEPENING FIGURE 8A.2 Saving and Depreciation as Functions of the Stock of Capital Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-29 CHAPTER 8 Why do Economies Grow? APPENDIX A A MODEL OF CAPITAL DEEPENING ► FIGURE 8A.3 Basic Growth Model Starting at K0, saving exceeds depreciation. The stock of capital increases. This process continues until the stock of capital reaches its long-run equilibrium at K*. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-30 CHAPTER 8 Why do Economies Grow? APPENDIX A A MODEL OF CAPITAL DEEPENING FIGURE 8A.4 Increase in the Saving Rate A higher saving rate will lead to a higher stock of capital in the long run. Starting from an initial capital stock of K1, the increase in the saving rate leads the economy to K2. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-31 CHAPTER 8 Why do Economies Grow? APPENDIX A A MODEL OF CAPITAL DEEPENING FIGURE 8A.5 Technological Progress and Growth Technological progress shifts up the saving function and promotes capital deepening. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-32