Economic Growth

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CHAPTER 33
Economic Growth
The Economic Problem
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Definition

• Economic Growth is defined as the long-run
  increase in per capita real output of a society
  (standard of living).
• Real per capita output (GDP) Total real GDP
• 
  Population
• The growth in real per capita GDP means that the
  average standard of living is higher.

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The Nature of Economic Growth

• There are 3 ways of increasing the GDP
• 1. Policies that increase Aggregate Demand to
  remove a recessionary gap.
• 2. Policies that reduce structural or frictional
  unemployment and thus increase potential output.
• 3. Over the long-run, the main cause of rising
  national income is economic growth the increase
  in potential output due to increases in factor
  supplies and productivity (this results in a
  continuous shift LRAS to the right).

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• We must note that the first 2 ways might cause a
  once-and-for-all increase in national income at
  the very most 5 to 10, while a growth rate of
  3 raises potential output by 10 in three years
  and double it in about 24 years.
• Economic growth can go indefinitely and is more
  powerful method of raising living standards.

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Figure 33-1Three Ways of Increasing National
Income
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• Growth is much more powerful method of raising
  the living standards than the removal of a
  recessionary gap or structural unemployment.
• A small differences in growth rate make big
  differences in the level of potential national
  income over few decades .

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Example

• If two countries (A and B) start with the same
  level of income or GDP say 100 million . And if
  country A grows at 3 per year while country B
  grows at 2 per year than country As income will
  be twice Bs income in 72 years as shown in the
  following table.

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Economic Growth
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Example 2
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Efficiency, Equity, and Economic Growth

• Reducing Inefficiency inefficiencies may act to
  reduce the growth rate. Example government
  subsidies to failing firms, that may be
  criticized on grounds of productive and
  allocative efficiency, may lower growth rates by
  reducing incentives to innovate.
• Improving equity governments in most countries
  continue to have policies to redistribute income
  and make education and health care available to
  all people regardless of their ability to pay.

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• Interrelationships Among the Goals
• Economists must be careful when designing
  their policies because they might have a negative
  impact on economic growth.
• Examples
• Governments might create allocative inefficiency
  by subsidizing failing firms which adversely
  affects economic growth.
• Policies that redistribute income to the poor
  might provide disincentives to work and thus,
  adversely affect economic growth.

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Benefit of Growth

• Over the Long-term, economic growth is the
  primary engine for raising the general standard
  of living.
• Economic growth reduces income inequalities
  without actually having to lower anyones income.
  When there is economic growth, governments might
  redistribute only the increment in rich peoples
  income.
• Economic growth may change the whole societys
  consumption patterns.

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Cost of Growth

• The opportunity cost of growth
• Growth requires heavy investment of resources in
  capital goods as well as in activities such as
  education. Often these investments yield no
  immediate return in terms of goods and services
  for consumption.
• Growth which promises more goods tomorrow, is
  achieved by consuming fewer goods today.
  Therefore, for the economy as a whole this
  sacrifice of current consumption is the primary
  cost of growth.

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The Opportunity Cost of Growth
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Social and Personal Costs of Growth

• A growing economy is also a changing economy.
• Part of the economic growth is accounted for by
  existing firms producing more output, using more
  machines, and hiring more workers.
• But another part of growth is accounted for by
  existing firms being overtaken and made obsolete
  by new firms, by old products being made
  obsolete by new products, and by existing workers
  being made obsolete by new workers.
• The process of innovation that is central to
  economic growth renders some machines, and some
  workers, obsolete.

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Inputs, Technological Progress and Economic Growth

• To increase average income, a country has to
  increase its output.
• The countrys output depends on its resources or
  inputs and on the techniques it employs for
  transforming inputs into output.
• The relationship between inputs and outputs is
  called Production Function .

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Factors of Production

• 1. Land or Natural Resources .
• 2. Labor
• 3. Capital
• Countries can not achieve rapid and sustained
  economic growth by increasing their stock of
  natural resources .
• But, countries can and do experience fluctuations
  in income as a result of fluctuations in the
  prices of their natural resources .

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Economic Growth

• To achieve long-term sustained income growth,
  countries have to look beyond their natural
  resources . For example, a sustained increase in
  labor input a country can produce more output if
  its population of workers grows .

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Capital Growth

• Population growth on its own does not lead to
  higher per capita output.
• The input that is most responsible for rapid and
  sustained economic growth is the capital.
• There are two broad types of capital
• 1. Physical capital .
• 2. Human capital .

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Physical Capital

• Includes such things as highways, railways, dams,
  tractors, factories, trucks, cars, and buildings .

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Human Capital

• Is the accumulated knowledge and skills of the
  working population that enable them to increase
  their output .
• As individuals accumulate more capital their
  income grow .
• As nations accumulate more capital per worker,
  labor productivity and output per capita grow .

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Technological Change

• Although rich countries have much more capital
  than the poor countries, that is not the only
  difference between them .
• Typically, rich countries uses more productive
  technologies than do poor countries. AS a result,
  even if both countries have the same per capita
  capital, the rich countries produce more output
  than the poor

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Established Theories of Economic Growth

• The four fundamental determinants of growth of
  total output are
• 1. Growth in the Labor Force
• 2. Growth in Human capital
• 3.Growth in Physical capital
• 4. Technological improvement

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1. Growth in the Labor Force

• This may be caused by growth in the population or
  increase in the fraction of the population that
  chooses to participate in the labor force .

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2. Growth in Human Capital

• This is the increase in skills that workers have
  either through formal education or on-the-job
  experience .

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3. Growth in Physical Capital

• Such as factories, machines, transportation, and
  communications facilities. These are increase
  only through process of investment.

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4. Technological Improvement

• This may be brought about by innovation that
  introduces new product, new ways of producing
  existing product and new forms of business
  organization .

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Short-Run and Long-Run Effects of Investment

• There is a contrast between the short run and
  long run aspects of investment.
• In the short run, any activity that puts income
  into peoples hands will raise aggregate demand.
  For example, a firm that spends more money to
  hire workers to dig holes and then hire more
  workers to refill them would raise aggregate
  demand as if it hires them to build a new
  factory.
• But in the long run, growth of potential income
  is affected only by the part of spending that
  adds to a nations productivity capacity.

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• The theory of economic growth is a long-run
  theory. It concentrates on effects of investment
  in raising potential output and ignores short run
  fluctuations of actual output around potential.
• Recall
• In the long run, there is no paradox of
  thrift, societies with high rates of national
  saving have high investment rates and, other
  things being equal, high growth rates of real
  GDP.

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Neoclassical Growth Theory

• The aggregate production function could be
  expressed as follows
• GDP FT (L, K, H)
• Where L is the labor force, K is physical
  capital, H is the quality of labors human
  capital, and T is the state of technology
  (exogenous).
• The notation FT is a way of indicating that the
  production function relating L, K, and H to GDP
  depends on a given state of technology.

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Neoclassical Theory Assumptions

• Early Neoclassical growth theory assumes that
  technological knowledge (T) is constant (no
  innovations).
• GDP in the aggregate production function is
  interpreted as potential GDP (the theory ignores
  short run fluctuations of output around the
  potential GDP).
• The aggregate production function displays
  diminishing returns when only one factor is
  increases and constant returns when all factors
  are increases together in the same proportion.

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• Whenever diminishing returns applies, the
  employment of additional units of labor (for
  example) will eventually add less to total output
  than the previous unit.
• The law of diminishing returns applies to any
  factor that is varied while the other factors
  held constant.

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Figure 33-2Cross-Country Investment and Growth
Rates, 1970-1997