Introduction Thinking Like an Economist CHAPTER 10 The

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Introduction: Thinking Like an Economist CHAPTER 10 The Classical Long-Run Policy Model: Growth and

Introduction: Thinking Like an Economist CHAPTER 10 The Classical Long-Run Policy Model: Growth and Supply-Side Policies Queen Elizabeth owned silk stockings. The capitalist achievement does not typically consist in providing more silk stockings for queens but in bringing them within the reach of factory girls in return for steadily decreasing amounts of effort. — Joseph Schumpeter Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Growth and the

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Growth and the Economy’s Potential Output Ø Growth is an increase in potential output Ø Potential output is the highest amount of output an economy can produce from existing production processes and resources Ø Productivity is output per unit of input Ø The long-run growth focus is on how to increase potential output Ø The short-run focus is on how to get the economy operating at its potential 10 -2

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Importance of Growth

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Importance of Growth for Living Standards Ø Growth in income improves average living standards Ø Because of compounding, long-term growth rates can make huge differences Ø The rule of 72 states: • The # of years to double income = 72/growth rate Ø If China’s per capita income of $8, 500 grows 8% per year and the U. S. per capita income of $50, 000 grows 1% per year: • Within 27 years per capita income in China will surpass that in the U. S. and after 9 more years will be significantly higher 10 -3

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Markets, Specialization, and

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Markets, Specialization, and Growth Ø Markets, specialization, and the division of labor increase productivity and growth • Specialization is the concentration of individuals on certain aspects of production • Division of labor is the splitting up of a task to allow for specialization of production 10 -4

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Per Capita Growth

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Per Capita Growth Ø Per capita output is total output divided by total population Ø Per capita growth means the country is producing more goods and services person • Per capita growth = % Δ in output – % Δ in population Ø Some suggest that median income is a better measure because it takes into account how income is distributed 10 -5

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 The Sources of

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 The Sources of Growth Economists identify five important sources of growth: 1. Growth-compatible institutions 2. Investment and accumulated capital 3. Available resources 4. Technological development 5. Entrepreneurship 10 -6

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Investment and Accumulated

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Investment and Accumulated Capital Ø Although capital is a key element in growth, capital accumulation does not necessarily lead to growth Ø Capital may become obsolete Ø Capital is much more than physical machines and includes: • Human capital are skills that workers gain from experience, education, and on-the-job training • Social capital is the habitual way of doing things that guides people in how they approach production 10 -7

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Technological Development Ø

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Technological Development Ø Technology is the way we make goods and supply services: may account for up to 86% of growth in US history, as changes in technology and changes in the goods and services we buy fuel growth Ø Advances in technology shift the production possibility curve outward by making workers more productive Ø Important developments in biotechnology, computers, and communications have helped fuel U. S. growth 10 -8

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 The Classical Growth

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 The Classical Growth Model Ø The Classical growth model is a model of growth that focuses on the role of capital accumulation in the growth process Ø Classical economists focused their analysis and their policy advice on how to increase investment because saving leads to growth Savings Investment Increase in capital GROWTH 10 -9

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 The Law of

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 The Law of Diminishing Marginal Productivity Ø The predictions for the long term were incorrect because increases in technology and capital overwhelmed diminishing marginal productivity Ø The focus changed to technology, not labor or capital Ø Without growth in technology, investment will not generate sustained growth • Eventually the per capita growth would stagnate 10 -10

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Technology Ø Technological

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Technology Ø Technological advance is the result of what the economy does, it: • Invests in research and development • Makes advances in pure science • Works out new ways to organize production Ø The common knowledge aspect of technology creates positive externalities which is the key to growth • Positive externalities are positive effects on others not taken into account by the decision maker 10 -11

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Land Natural Capital

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 Land Natural Capital Ø The least considered factor of production Ø Limits to growth from a finite planet, with finite natural resources Ø Nothing is 100% recyclable Ø Role of climate change and other global concerns Ø Obsession with growth, as opposed to development 10 -12

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 New Growth Theory

The Classical Long-Run Policy Model: Growth and Supply-Side Policies 1 10 New Growth Theory Ø New growth theory is a theory that emphasizes the role of technology in the growth process Ø Technology is recognized as an important ingredient in growth Ø Modern growth theory is named new growth theory Tech Advance Investment Further Tech Advance GROWTH 10 -13