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Chapter 8
GROWTH,
PRODUCTIVITY,
AND THE WEALTH
OF NATIONS
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
8-2
Today’s lecture will:
• Define growth and relate it to living
standards.
• Discuss the five sources of growth.
• Distinguish diminishing marginal
•
•
•
productivity from decreasing returns to
scale.
Explain the convergence hypothesis and
four reasons why it has occurred.
Distinguish Classical growth theory from
new growth theory.
Discuss six government policies to promote
growth.
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8-3
Economic Growth
• Growth is an increase in potential output.
• Potential output – the maximum output an
•
•
economy can produce from the existing
production function and existing resources.
The short-run focus is on how to get the
economy operating at its potential.
The long-run growth focus is on how to
increase potential output.
 It assumes Say’s Law – supply creates its own
demand.
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8-4
Importance of Growth for
Living Standards
• Growth improves average living standards.
• Because of compounding, long-term growth
•
•
rates can make huge differences.
Rule of 72 – # years to double= 72/ growth rate.
If China’s economy grows 9% per year and the
U.S. grows 2% per year, in 72 years
 U.S. per capita income = $160,000
 China’s per capita income = $512,000
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8-5
Markets, Specialization, and
Growth
• Markets, specialization, and the division of
labor increase productivity and growth.
 Specialization – the concentration of individuals on

certain aspects of production.
Division of labor – the splitting up of a task to allow
for specialization of production.
• Markets may seem to be unfair because of the
effect that they have on the distribution of
income.
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8-6
Economic Growth,
Distribution, and Markets
• Markets may not provide equality of
•
•
income, but they make the poor better off.
There is strong evidence that the poor
benefit enormously from the growth that
markets foster.
Just because the poor benefit from growth
does not mean that they might not benefit
more is income were distributed more in
their favor.
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8-7
Cost of Goods in Hours of Work
Milk (½ gallon)
Beef (1 pound)
Eggs (1 dozen)
Bread (1 pound)
1919
Chicken (3 lb. fryer)
Milk (½ gallon)
Beef (1 pound)
Eggs (1 dozen)
Bread (1 pound)
Chicken (3 lb. fryer)
2005
0
McGraw-Hill/Irwin
50
100
150
Price in minutes of work
200
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
8-8
Per Capita Growth
• Per capita output is total output divided by
•
•
total population.
Per capita growth means producing more
goods and services per person.
Per capita growth =
% Δ in output - %Δ in population
Median income is a better measure because it
takes into account how income is distributed.
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8-9
The Sources of Growth
• Capital accumulation – investment in
•
•
•
•
productive capacity
Available resources
Growth compatible institutions
Technological development
Entrepreneurship
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8-10
Investment and Accumulated Capital
• Although capital is a key element in growth,
•
•
capital accumulation does not necessarily lead
to growth.
Capital may become obsolete.
Capital is much more than machines. It
includes:
 Human capital – skills that workers gain from

experience, education, and on-the-job training.
Social capital – the habitual way of doing things that
guides people in how they approach production.
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8-11
Available Resources
• The growth in the U.S. in the 20th
•
•
century was due in part to its large
supply of natural resources.
New technology can overcome a lack
of resources.
Greater participation in the market
may increase the labor force
participation rate.
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8-12
Growth-Compatible Institutions
• Markets and private ownership of property
•
•
foster economic growth.
When individuals get much of the gains of
growth themselves, they work harder.
Corporations are a growth-compatible
institution because of limited liability,
which gives stockholders an incentive to
invest their savings in large enterprises.
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8-13
Technological Development
• Technology - changes in the way we make
•
•
goods and supply services, and in the goods
and services we buy.
Advances in technology shift the production
possibilities curve outward by making workers
more productive.
Important developments in biotechnology,
computers, and communications have helped
fuel U.S. growth.
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8-14
Entrepreneurship
• Entrepreneurship is the ability to get
•
things done using creativity, vision, and a
talent for translating vision into reality.
Examples of American entrepreneurs
include:
 Thomas Edison – generation and use of
electricity
 Henry Ford – automobile production
 Bill Gates – computers and software
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8-15
Sources of Real U.S. Growth,
1928-2005
• The five sources of
•
growth must be
mixed in the right
proportions.
Economist Edward
Denison estimated
the importance of
four sources of
growth.
McGraw-Hill/Irwin
Physical
capital
(19%)
Human
capital (13%)
Technology (35%)
Labor (33%)
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8-16
The Production Function
•
•
•
McGraw-Hill/Irwin
Production function
shows the relationship
between inputs and
outputs.
Growth is shown by a
shift in the production
function.
Output =
A●F(labor, capital, land)
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8-17
Describing Production Functions
• Constant returns to scale – output will rise by
•
•
•
the same proportionate increase as all inputs.
Increasing returns to scale – output will rise by
a greater proportionate increase as all inputs.
Decreasing returns to scale – output will rise
by a smaller proportionate increase as all
inputs.
The law of diminishing marginal productivity –
increasing one input, keeping all others
constant, will lead to smaller and smaller gains
in output.
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8-18
The Classical Growth Model
• According to the Classical growth model, the
•
more capital an economy has, the faster it will
grow.
Classical economists focused their analysis
and their policy advice on how to increase
investment:
savings
investment
increase in capital
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8-19
Diminishing Marginal
Productivity of Labor
• The Classical growth model focused on how
•
•
•
diminishing marginal productivity of labor
would limit growth.
Since the amount of farm land is fixed,
diminishing marginal productivity would set in
as population grew.
The iron law of wages - as output per person
declines, at some point available output is no
longer sufficient to feed the population.
This long-run outcome was called the
stationary state.
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8-20
Diminishing Returns and
Population Growth
Subsistence level of output
per worker
Output
Production
function
Q2
Q1
L1
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L*
Labor
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8-21
Diminishing Marginal
Productivity of Capital
• The predictions for the long term were incorrect
•
because increases in technology and capital
overwhelmed diminishing marginal productivity.
The focus became the diminishing marginal
productivity of capital, not labor.
Capital grows faster than labor
Capital is less productive
Slower growth of output
Per capita growth stagnates
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8-22
The Convergence Hypothesis
• The diminishing marginal productivity of
•
•
capital leads to the convergence hypothesis –
per capita income in countries with similar
institutional structures will converge to the
higher level.
The U.S. will grow slower because the marginal
product of capital is higher in developing
countries, hence costs of production are lower.
This difference causes capital investment flows
and production to move from the U.S. to
developing countries.
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8-23
The Convergence Hypothesis
• As of the early 2000s the predictions of
•
convergence have not come true.
Economists have several explanations of
why convergence has not taken place:
 Lack of factor mobility
 Differing institutional structure
 Incomparable factors of production
 Technological agglomeration effects
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8-24
Lack of Factor Mobility and
Differing Institutional Structure
• The transfer of capital and technology
•
•
causes convergence.
If there are barriers to factor mobility,
convergence is slowed down or reduced.
The more similar the institutional
structures, the more likely convergence
will occur because firms are more likely
to move production to countries that are
well-suited to business.
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8-25
Incomparable Factors
of Production
•
•
•
Labor in various countries differ in skills,
education, experience, and effort.
When a society’s workers become more
educated, that country’s human capital
increases even though labor hours may not
change.
Increases in human capital allow labor to keep
pace with capital and avoid the diminishing
marginal productivity of capital.
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8-26
Technological Agglomeration
• Technological agglomeration – the tendency of
•
technological advance to spawn further
technological advances, creating a
concentration of new technologies in a specific
location.
As long as new technological advances occur
faster in developed countries than older
technologies diffuse into less developed
countries, convergence need not take place.
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8-27
New Growth Theory
• Unlike Classical growth theory, which left
technology outside of economic analysis,
new growth theory emphasizes the role
of technology rather than capital in the
growth process.
Technological advance
Further technological advance
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Investment
Growth
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8-28
Technology Doesn’t Just Happen
• Investment in research and development
•
•
•
increases technology.
Patents provide incentives for
innovation.
New technology leads to newer
technology, which leads to accelerating
growth.
Basic research has positive externalities.
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8-29
Learning by Doing
• New growth theory also highlights
•
•
•
learning by doing.
Learning by doing – improving the
methods of production through
experience.
Learning by doing overcomes the law of
diminishing marginal productivity.
Learning by doing leads to increasing
returns to scale.
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8-30
Does an Economy Always Use
the Best Technology?
• Technological lock-in occurs when old
•
•
technologies become entrenched in the market.
More efficient technologies may be available.
Network externalities ( the use by one
individual makes a technology more valuable
to others) lead to technological lock-in.
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8-31
Economic Policies to
Encourage Per Capita Growth
• Encourage saving and investment.
• Control population growth.
• Increase the level of education.
• Create institutions that encourage
•
•
technological innovation.
Provide funding for basic research.
Increase the economy’s openness to
trade.
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8-32
Policies to Encourage
Saving and Investment
• The U.S. has used tax incentives to increase
saving to provide funds for investment.
• It is difficult for poor countries with low
incomes to generate saving and investment.
• In developing countries, microcredit banks,
•
banks that make small loans to poor people
using alternate forms of collateral, have been
successful in encouraging investment by small
businesses.
Foreign investment in loans from the IMF or
World Bank are sources of foreign investment
for developing countries.
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8-33
Policies to Control
Population Growth
• Developing nations whose populations are
•
rapidly growing have difficulty providing
enough capital and education for everyone.
Policies that reduce population growth
include:
 Free-family planning services.
 Increasing the availability of contraceptives.
 Harsh mandatory one-child-per-family policies such
as China adopted in 1980.
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8-34
Policies to Increase the
Level of Education
• Increasing the educational level and skills of
•
•
the workforce increases labor productivity.
An additional year of education increases
wages by 10% in the U.S.; by 15-20% in
developing countries.
In the U.S. policies to increase education
include free mandatory education through high
school and financial support for students in
higher education.
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8-35
Policies to Create Institutions that
Encourage Technological
Innovation
• Create patents and protect property
•
rights.
Corporations and financial
institutions.
 The limited liability of corporations
encourages savers to make their funds
available for investment.
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8-36
Provide Funding for
Basic Research
• Individual firms have little incentive
•
to do basic research because of
technology’s “common knowledge”
aspect.
This is why the government is
involved, funding 60% of basic
research in the U.S.
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8-37
Policies to Increase
Openness to Trade
• Free trade encourages growth by
•
•
broadening the market and by fostering
competition.
In order to specialize, you need to sell
your product to a large number of people.
Large markets allow firms to produce and
sell more output so that they can take
advantage of economies of scale.
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8-38
Summary
• Growth is an increase in the amount of
•
•
goods and services an economy can
produce when both labor and capital are
fully employed.
Growth increases potential output and
shifts the production possibility curve
out, allowing an economy to produce
more goods.
Per capita growth means producing more
goods and services per person.
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8-39
Summary
• The production function shows the
•
•
relationship between the quantity of resources
and the output.
Output = A●f(Labor, Capital, Land)
The law of diminishing marginal productivity
states that increasing one input, keeping all
others constant, will lead to smaller and
smaller gains in output.
Returns to scale describes what happens to
output when all inputs increases equally.
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8-40
Summary
• The convergence hypothesis is that per
•
capita income in countries with similar
institutional structures will converge.
Convergence has not taken place
because of:
 the lack of factor mobility.
 differing institutional structures.
 incompatible factors of production.
 technological agglomeration.
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8-41
Summary
• The Classical growth model focuses on the
•
•
•
role of capital accumulation in the growth
process.
The law of diminishing productivity limits
growth of per capita income.
New growth theory emphasizes the role of
technology in the growth process.
Advances in technology, which account for
35% of growth, have overwhelmed the effects
of diminishing returns.
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8-42
Summary
• Six government policies to promote
growth are:
 Encourage saving and investment.
 Control population growth.
 Increase the level of education.
 Create institutions that encourage
technological innovation.
 Fund basic research.
 Increase openness to trade.
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8-43
Review Question 8-1 Explain the difference between the Classical
growth theory and new growth theory.
Classical growth theory is a model of growth that focuses on the
role of capital accumulation in growth. According to the Classical
theory, the more capital an economy has, the faster it will grow.
New growth theory emphasizes the role of technology rather than
capital in the growth process. Increases in technology can shift the
production possibilities curve out and allow the society to produce
more output without new resources.
Review Question 8-2 List six government policies that can
promote growth.
Government policies to promote growth include: encourage saving
and investment, control population growth, increase the level of
education, create institutions that encourage technological
innovation, fund basic research, and increase openness to trade.
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