Eco 1

Chapter 21: Long-Run Economic Growth.

 Why Do Growth Rates Matter?
The difference between 1.3% and
2.3% may not seem like much; but
over a long period, it makes a
remarkable difference.
Over 50 years, a 1.3% growth rate leads to
about a 91% increase in real GDP per capita.
But a 2.3% growth rate leads to about
a 212% increase.

In the long run, small differences in economic

growth rates result in big differences
in living standards.
 The Industrial Revolution
Significant economic growth did not really begin until the
Industrial Revolution, the application of mechanical power to the
production of goods and services which began in England around
1750.
Before this, production of most goods had relied on human or
animal power.

The use of mechanical power allowed England and other

countries—like the United States, France, and Germany—to begin
to experience long-run economic growth.
 Differences in Incomes across Countries
Economists often refer to the high-income countries (or industrial
countries) of Western Europe, Australia, Canada, Japan, New
Zealand, and the United States, in comparison to the poorer
developing countries of the rest of the world.
The 1980s and 1990s have seen some countries progress out of the
developing category, like Singapore, South Korea, and Taiwan;
these are often referred to as newly industrializing countries.
Real GDP per capita is markedly different across the world, even
after correcting for cost of living differences. In 2012 it ranged from
a high of $103,900 in Qatar to a low of $400 in the Democratic
Republic of the Congo.
 Model of Economic Growth
An economic growth model seeks to explain growth rates
in real GDP per capita over time

The key to economic growth is labor productivity: the

quantity of goods and services that can be produced by
one worker or by one hour of work.

Two main factors affect labor productivity:

• The quantity of capital per hour worked, and
• The level of technology.
Technological change: A change in the quantity of output
a firm can produce using a given quantity of inputs.
There are three main sources of technological change:
Better machinery and equipment. Inventions like the steam engine, machine
tools, electric generators, and computers have allowed faster economic growth.
Increases in human capital. Human capital is the accumulated knowledge and
skills that workers acquire from education and training or from their life
experiences.
Better means of organizing and managing production. If managers can do a
better job of organizing production, then labor productivity can increase. An
example of this is the just-in-time system, first developed by Toyota; this involves
assembling goods from parts that arrive at the factory exactly when they are
needed.
Average living standards are determined by average
labor productivity. As workers become more
productive, income per capita rises.
Real GDP per worker Productivity curve 2
Total Output

C Productivity curve 1

labor
Increase in volume of labor, A→B
Increase in labor productivity, A → C
 More Capital or Technological Change?

If a country is relatively lacking in capital—like

many of the developing countries—increases in
capital will be very effective at increasing real
GDP per capita.

In countries where the amount of capital is already

relatively high, technological change becomes a
more effective way to increase output per hour.
 Why are not all countries becoming rich?
There must be a proper environment for efficient market and improved technology.
– Wars and revolutions. Wars and revolutions make investment and technological growth
difficult
– Failure to enforce rule of law. Corruption, incompetence.
– Poor public health, education. Urban bias for schools, hospitals. Workers are less productive.
brain drain
– Low rates of saving and investment. Undeveloped and insecure financial systems create a
“vicious cycle” of low savings and investment, preventing growth.
When governments prioritize low inflation over low unemployment, or low taxes over investment in infrastructure or education, they
are responding to the preferences of the rich.

Focus on:
• Marginal increase in capital.
• Technological changes in existing markets for current goods.
More growth occurs through new products, new markets.
Markets, that people are not aware that they want.
 Creative destruction
Joseph Schumpeter developed a model of growth emphasizing his view that new
products unleashed a “gale of creative destruction”.
Example: The automobile replaced the horse-drawn carriage by serving better the needs of consumers. This
“creation” “destroyed” carriage-makers and associated firms.

According to Schumpeter, the entrepreneur is central to economic growth; and the

profits of entrepreneurs provide the incentive for bringing together the factors of
production—labor, capital, and natural resources—in new ways. More so, the
entrepreneurs:
• Introduce new good, new method of production
• Opening of a new market. Markets may have existed before in another area or
for another product
• Seize a new source of supply or raw materials.
• New organization of any industry. Create a monopoly or brake one!
As a result, entrepreneurs create major economic changes.
 Knowledge together with entrepreneurship leads to
economic growth

Accumulation of human capital is a key determinant of economic

growth. Increases in human capital result from research and
development, and other technological advances.
Physical capital is rival and excludable—a private good—and this
results in its diminishing returns.
But human capital is nonrival and nonexcludable—a public good—
and hence results in increasing returns—not at the firm level, but at
the economy level.
Public goods, such as human capital generation, result in free-riding: benefitting from goods
and services you do not pay for.
Because firms do not enjoy the entire benefit of their knowledge capital, they do not produce
enough of it. The public good nature of knowledge capital leads to a role for government
policy in:
– Protecting intellectual property with patents and copyrights
Patents are the exclusive right to produce a product for a period of 20 years from the date the patent is applied for. This
period of time is designed to balance the chance for firm to benefit from its invention against the need of society to
benefit from it.

Copyrights act similarly for creative works like books and films, granting the exclusive right to use the creation during
and 70 years after the creator’s lifetime.

– Subsidizing research and development

Governments might perform research directly—like NASA and the National Institutes of Health—or subsidize
researchers at institutions like universities. Similarly, they can provide tax-incentives to firms performing R&D.

– Subsidizing education
In order to perform research and development, workers need to be technically trained. If firms provide this training,
they recoup the cost by paying workers lower wages, decreasing the incentive for workers to take such jobs. A solution
to this is to have the government subsidize education, as it does in all high-income countries.
Central assumption of this chapter is that economic growth is
beneficial for citizens.
This seems relatively clear for low-income countries; but some
people maintain that further economic growth may not be desirable
in high-income countries.
Arguments against growth might include:
❖ Negative effects on the environment
❖ Depletion of natural resources
❖ Diminishment of distinctive cultures
Since many of these arguments are normative, economic analysis
can contribute to the debate but cannot settle the issue.