Economics NINTH EDITION Chapter 8 Why Do Economies

Economics NINTH EDITION Chapter 8 Why Do Economies Grow? Prepared by Brock Williams Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

Learning Objectives 8. 1 Calculate economic growth rates. 8. 2 Explain the role of capital in economic growth. 8. 3 Explain the importance of technological progress to economic growth. 8. 4 Discuss the sources of technological progress. 8. 5 Assess the role of government in assisting economic growth. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 1 ECONOMIC GROWTH RATES (1 of 5) • 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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

▼FIGURE 8. 1 What Is Economic Growth? Economic growth means an expanded production possibilities curve (PPC). Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 1 ECONOMIC GROWTH RATES (2 of 5) Measuring Economic Growth • Real GDP per capita Gross domestic product 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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 1 ECONOMIC GROWTH RATES (3 of 5) 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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 1 ECONOMIC GROWTH RATES (4 of 5) Comparing the Growth Rates of Various Countries Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 1 ECONOMIC GROWTH RATES (5 of 5) 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. 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. SOURCE: M. Obstfeld and K. Rogoff, Foundations of International Macroeconomics (Cambridge, MA: MIT Press, 1996), Table 7. 1. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

APPLICATION 2 BEHAVIORAL INCENTIVES IN DEVELOPMENT APPLYING THE CONCEPTS #2: How can we persuade very poor people in developing countries to immunize their children? • • Public health officials in India noticed that parents typically would begin to get vaccines for their children, but often failed to finish the entire sequence of vaccines. Were their incentives that might work? Ester Duflo and Abhijit Banerjee of MIT persuaded a group trying to increase immunizations to experiment with economic incentives. In the experiment, parents would receive some dal (a common Indian food) after each shot for their children. When they completed the entire sequence of shots, they would receive a set of cooking pans. The incentive worked extremely well in increasing the success rate for immunizations. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 2 CAPITAL DEEPENING (1 of 3) 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 W 1 to W 2, and potential output will increase from Y 1 to Y 2. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 2 CAPITAL DEEPENING (2 of 3) Saving and Investment • Saving Income that is not consumed. C+S=Y C+I=Y S=I Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 2 CAPITAL DEEPENING (3 of 3) 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. 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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 3 THE KEY ROLE OF TECHNOLOGICAL PROGRESS (1 of 4) How Do We Measure Technological Progress? Y = F(K, L) Y = F(K, L, A) • Growth accounting • A method to determine the contribution to economic growth from increased capital, labor, and technological progress. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 3 THE KEY ROLE OF TECHNOLOGICAL PROGRESS How Do We Measure Technological Progress? Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved (2 of 4)

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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 3 THE KEY ROLE OF TECHNOLOGICAL PROGRESS (3 of 4) 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 1970 s. • 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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

Using Growth Accounting (4 of 4) Labor productivity Output per hour of work, labor productivity is a simple measure of how much a typical worker can produce given the amount of capital in the economy and the state of technological progress. From 1947 to the worldwide oil crisis in 1973, labor productivity grew rapidly. Productivity growth fell in the remainder of the 1970 s and slowly increased over the next two decades. Since 2007, productivity growth has also slowed from recent trends, partly due to the recession. Economists have used growth accounting to help explain these trends in productivity growth in the United States. Economic research suggests that the oil shocks in the 1970 s reduced technological progress but the information revolution in the 1980 s and 1990 s led to a resurgence of technological progress. SOURCE: Bureau of Labor Statistics, 2015. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

APPLICATION 4 THE END OF GROWTH? APPLYING THE CONCEPTS #4: Can we predict future productivity growth from past historical episodes? • • Robert J. Gordon a professor of economics at Northwestern University, has recently predicted that economic growth in the U. S. in this century will be only slightly positive and very close to zero. Why is Gordon so pessimistic? Gordon notes that economic growth as we know it is a fairly recent phenomenon in world history. The U. S. has had robust growth over its history, but major innovations were concentrated in three waves. The first wave, 1750– 1830, centered on steam generation and railroads. The second wave, 1870– 1900, was driven by electricity ad communications. The third wave, 1960–present, was generated by telecommunications and computers. Based on work in growth accounting, Gordon thinks we may have exhausted the benefits of the third wave of innovations. Others believe that computer technology and global interconnectedness of the Internet will allow room or more growth. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 4 WHAT CAUSES TECHNOLOGICAL PROGRESS? Research and Development Funding 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. SOURCE: National Science Foundation, National Patterns of R&D Resources, 2002, Washington D. C. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved (1 of 3)

8. 4 WHAT CAUSES TECHNOLOGICAL PROGRESS? (2 of 3) 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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

8. 4 WHAT CAUSES TECHNOLOGICAL PROGRESS? (3 of 3) 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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

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 © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

KEY TERMS Capital deepening Convergence Creative destruction Growth accounting Growth rate Human capital Labor productivity New growth theory Real GDP per capita Rule of 70 Saving Technological progress Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

APPENDIX A A MODEL OF CAPITAL DEEPENING (1 of 4) 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. Holding labor constant, increases in the stock of capital increase output, but at a decreasing rate. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

▼FIGURE 8 A. 2 Saving and Depreciation as Functions of the Stock of Capital Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

APPENDIX A A MODEL OF CAPITAL DEEPENING (2 of 4) Change in the stock of capital = salving - depreciation = s. Y - d. K Starting at K 0, saving exceeds depreciation. The stock of capital increases. This process continues until the stock of capital reaches its long-run equilibrium at K*. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

APPENDIX A A MODEL OF CAPITAL DEEPENING (3 of 4) A higher saving rate will lead to a higher stock of capital in the long run. Starting from an initial capital stock of K 1, the increase in the saving rate leads the economy to K 2. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved

APPENDIX A A MODEL OF CAPITAL DEEPENING (4 of 4) Technological progress shifts up the saving function and promotes capital deepening. Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved