9-1 Technological Progress in

the Solow Model

So far, our presentation of the Solow model has assumed an
unchanging relationship between the inputs of capital and labour and
the output of goods and services. Yet the model can be modified to
include exogenous technological progress, which over time expands
society’s production capabilities.

The Efficiency of Labour

To incorporate technological progress, we must return to the
production function that relates total capital and total labour to
total output Thus far, the production function has been

We now write the production function as

where is a new (and somewhat abstract) variable called the

efficiency of labour. The efficiency of labour is meant to reflect
society’s knowledge about production methods: as the available
technology improves, the efficiency of labour rises, and each hour of
work contributes more to the production of goods and services. For
instance, the efficiency of labour rose when assembly-line
production transformed manufacturing in the early twentieth century,
and it rose again when computerization was introduced in the late
twentieth century. The efficiency of labour also rises when there are
improvements in the health, education, or skills of the labour force.

579
The term can be interpreted as measuring the effective number
of workers. It takes into account the number of actual workers and
the efficiency of each worker In other words, measures the
number of workers in the labour force, whereas measures both
the workers and the technology with which the typical worker comes
equipped. This new production function states that total output
depends on the inputs of capital and effective workers

The essence of this approach to modelling technological progress is

that increases in the efficiency of labour are analogous to increases
in the labour force Suppose, for example, that an advance in
production methods makes the efficiency of labour double
between 1980 and 2015. This means that a single worker in 2015 is,
in effect, as productive as two workers were in 1980. That is, even if
the actual number of workers stays the same from 1980 to 2015,
the effective number of workers doubles, and the economy
benefits from the increased production of goods and services.

The simplest assumption about technological progress is that it

causes the efficiency of labour to grow at some constant rate
For example, if then each unit of labour becomes 2 percent
more efficient each year: output increases as if the labour force had
increased by 2 percent more than it really did. This form of
technological progress is called labour augmenting, and is called
the rate of labour-augmenting technological progress. Because the
labour force is growing at rate and the efficiency of each unit of
labour is growing at rate the effective number of workers
is growing at rate

580
The Steady State with Technological
Progress
Because technological progress is modelled here as labour
augmenting, it fits into the model in much the same way as
population growth. Technological progress does not cause the actual
number of workers to increase, but because each worker in effect
comes with more units of labour over time, technological progress
causes the effective number of workers to increase. Thus, the
analytic tools we used in Chapter 8 to study the Solow model with
population growth are easily adapted to studying the Solow model
with labour-augmenting technological progress.

We begin by reconsidering our notation. Previously, before we added

technological progress, we analyzed the economy in terms of
quantities per worker; now we can generalize that approach by
analyzing the economy in terms of quantities per effective worker.
We now let stand for capital per effective worker and
stand for output per effective worker. With these
definitions, we can again write

Our analysis proceeds just as it did when we examined population

growth. The equation showing the evolution of over time becomes

As before, the change in the capital stock equals investment

minus break-even investment Now, however, because
break-even investment includes three terms: to keep
constant, is needed to replace depreciating capital, is needed

581
to provide capital for new workers, and is needed to provide
capital for the new “effective workers” created by technological
progress.1

As shown in Figure 9-1, the inclusion of technological progress does

not substantially alter our analysis of the steady state. There is one
level of denoted at which capital per effective worker and
output per effective worker are constant. As before, this steady state
represents the long-run equilibrium.

FIGURE 9-1

Technological Progress and the Solow Growth Model Labour-augmenting

technological progress at rate enters our analysis of the Solow growth model in
much the same way as did population growth at rate Now that is defined as the
amount of capital per effective worker, increases in the effective number of workers
because of technological progress tend to decrease In the steady state, investment
exactly offsets the reductions in attributable to depreciation, population
growth, and technological progress.

582
 Description
The horizontal axis is labeled time. The vertical axis has the
following markings: output, y; consumption, c; investment, i. A
line starts from the point output, y, takes a bend, and rises to
continue as a curve that extends rightward. Another line starts
from the point consumption, c, drops at a certain point, and
continues to flow as a curve that rises and extends rightward. The
line that starts from the point investment, I, extends until a certain
point then rises vertically. It then takes a bend and continues to
flow as a curve that extends rightward. A dotted horizontal lines
flow from the turning point of each line and intersects the
horizontal axis at a point labeled t subscript 0, the saving rate is
increased.

The Effects of Technological

Progress
Table 9-1 shows how four key variables behave in the steady state
with technological progress. As we have just seen, capital per
effective worker is constant in the steady state. Because
output per effective worker is also constant. It is these quantities per
effective worker that are steady in the steady state.

TABLE 9-1 Steady-State Growth Rates in the Solow

Model with Technological Progress
Variable Symbol Steady-
State
Growth
Rate

583
 Capital per 0
effective worker

Output per 0
effective worker

Output per
worker

Total output

From this information, we can also infer what is happening to

variables that are not expressed in units per effective worker. For
instance, consider output per actual worker Because
is constant in the steady state and is growing at rate output per
worker must also be growing at rate in the steady state. Similarly,
the economy’s total output is Because is constant
in the steady state, is growing at rate and is growing at rate
total output grows at rate in the steady state.

With the addition of technological progress, our model can finally

explain the sustained increases in standards of living that we
observe. That is, we have shown that technological progress can lead
to sustained growth in output per worker. By contrast, a high rate of
saving leads to a high rate of growth only until the steady state is
reached. Once the economy is in steady state, the rate of growth of
output per worker depends only on the rate of technological
progress. According to the Solow model, only technological progress

584
can explain sustained growth and persistently rising living
standards.

The introduction of technological progress also modifies the

criterion for the Golden Rule. The Golden Rule level of capital is
now defined as the steady state that maximizes consumption per
effective worker. Following the same arguments that we have used
before, we can show that steady-state consumption per effective
worker is

Steady-state consumption is maximized if

or

That is, at the Golden Rule level of capital, the net marginal product
of capital equals the rate of growth of total output
Because actual economies experience both population growth and
technological progress, we must use this criterion to evaluate
whether they have more or less capital than they would at the Golden
Rule steady state.

585
9-2 From Growth Theory to
Growth Empirics
So far in this chapter we have introduced exogenous technological
progress into the Solow model to explain sustained growth in
standards of living. Let’s now discuss what happens when this theory
is forced to confront the facts.

Balanced Growth
According to the Solow model, technological progress causes the
values of many variables to rise together in the steady state. This
property, called balanced growth, does a good job of describing the
long-run data for the Canadian economy.

Consider first output per worker and the capital stock per
worker According to the Solow model, in the steady state both
variables grow at the rate of technological progress. Canadian
data for the past half-century show that output per worker and the
capital stock per worker have in fact grown at approximately the
same rate—about 2 percent per year. In other words, the capital–
output ratio has remained approximately constant over time.

Technological progress also affects factor prices. Problem 4(d) at the

end of this chapter asks you to show that, in the steady state, the real
wage grows at the rate of technological progress. The real rental
price of capital, however, is constant over time. Again, these

586
predictions hold true for Canada. Over the past 50 years, the real
wage has increased about 2 percent per year; it has increased at
about the same rate as real GDP per worker. Yet the real rental price
of capital (measured as real capital income divided by the capital
stock) has remained about the same.

The Solow model’s prediction about factor prices—and the success

of this prediction—is especially noteworthy when contrasted with
Karl Marx’s theory of the development of capitalist economies.
Marx predicted that the return to capital would decline over time and
that this would lead to economic and political crisis. Economic
history has not supported Marx’s prediction, which partly explains
why we now study Solow’s theory of growth rather than Marx’s.

Convergence
If you travel around the world, you will see vast differences in living
standards. These income disparities are reflected in most measures of
the quality of life—from the prevalence of TVs, cell phones, and
Internet access to clean water availability, infant mortality, and life
expectancy.

Much research has been devoted to the question of whether

economies move toward one another over time. That is, do
economies that start off poor subsequently grow faster than
economies that start off rich? If they do, then the world’s poor
economies will tend to catch up with the world’s rich economies.
This process of catch-up is called convergence. If convergence does

587
not occur, then countries that start off behind are likely to remain
poor.

The Solow model predicts when convergence should occur.

According to the model, whether two economies will converge
depends on why they differ in the first place. On the one hand,
suppose two economies happen by historical accident to start off
with different capital stocks, but they have the same steady state, as
determined by their saving rates, population growth rates, and
efficiency of labour. In this case, we should expect the two
economies to converge; the poorer economy with the smaller capital
stock will naturally grow more quickly to reach the steady state. (In
Chapter 8, we applied this logic to explain rapid growth in Germany
and Japan after World War II.) On the other hand, if two economies
have different steady states, perhaps because the economies have
different rates of saving, then we should not expect convergence.
Instead, each economy will approach its own steady state.

Experience is consistent with this analysis. In samples of economies

with similar cultures and policies, studies find that economies
converge to one another at a rate of about 2 percent per year. That is,
the gap between rich and poor economies closes by about 2 percent
each year. An example is the economies of individual American
states. For historical reasons, such as the Civil War of the 1860s,
income levels varied greatly among states at the end of the
nineteenth century. Yet these differences have slowly disappeared
over time. This convergence can be explained with the Solow model

588
under the assumption that those state economies had different
starting points but are approaching a common steady state.

Outside of North America, a more complex picture emerges. When

researchers examine only data on income per person, they find little
evidence of convergence: countries that start off poor do not grow
faster on average than countries that start off rich. This finding
suggests that different countries have different steady states. If
statistical techniques are used to control for some of the determinants
of the steady state, such as saving rates, population growth rates, and
accumulation of human capital (education), then once again the data
show convergence at a rate of about 2 percent per year. In other
words, the economies of the world exhibit conditional convergence:
they appear to be converging to their own steady states, which in
turn are determined by such variables as saving, population growth,
and human capital.2

Factor Accumulation versus

Production Efficiency
As a matter of accounting, international differences in income per
person can be attributed to either differences in the factors of
production, such as the quantities of physical and human capital, or
differences in the efficiency with which economies use their factors
of production. That is, a worker in a poor country may be poor
because she lacks tools and skills or because the tools and skills she
has are not being put to their best use. To describe this issue in terms
of the Solow model, the question is whether the large gap between

589
rich and poor is explained by (1) differences in capital accumulation
(including human capital) or (2) differences in the production
function.

Much research has attempted to estimate the relative importance of

these two sources of income disparities. The exact answer varies
from study to study, but both factor accumulation and production
efficiency appear to be important. Moreover, a common finding is
that they are positively correlated: nations with high levels of
physical and human capital also tend to use those factors efficiently.3

There are several ways to interpret this positive correlation. One

hypothesis is that an efficient economy may encourage capital
accumulation. For example, a person in a well-functioning economy
may have greater resources and incentive to stay in school and
accumulate human capital. Another hypothesis is that capital
accumulation may induce greater efficiency. If there are positive
externalities to physical and human capital, then countries that save
and invest more will appear to have better production functions
(unless the research study accounts for these externalities, which is
hard to do). Thus, greater production efficiency may cause greater
factor accumulation—or the other way around.

A final hypothesis is that both factor accumulation and production

efficiency are driven by a common third variable. Perhaps the
common third variable is the quality of the nation’s institutions,
including the government’s policymaking process. As one economist
put it, when governments screw up, they screw up big time. Bad

590
policies, such as high inflation, excessive budget deficits,
widespread market interference, and rampant corruption, often go
hand in hand. We should not be surprised that economies exhibiting
these maladies both accumulate less capital and fail to use the capital
they have as efficiently as they might.

CASE STUDY
Good Management as a Source of
Productivity
Incomes vary around the world in part because some nations have higher
production efficiency than others. A similar phenomenon is observed within
nations: some firms exhibit greater production efficiency than others. Why
might that be?

One possible answer is management practices. Some firms are well run;
others less so. A well-run firm uses state-of-the-art operations, monitors the
performance of its workers, sets challenging but reasonable targets for
performance, and provides incentives for workers to put forth their best
efforts. Good management means that a firm is getting the most it can from
the factors of production it uses.

An influential study by Nicholas Bloom and John Van Reenen documents the
importance of good management, as well as some of the reasons that not all
firms have it. Bloom and Van Reenen began by surveying 732 medium-sized
manufacturing firms in four nations: France, Germany, the United Kingdom,
and the United States. They asked various questions about how firms were
managed and then graded each firm on how well it conformed to best
practices. For example, a firm that promoted employees based on
performance was graded higher than one that promoted employees based on
how long they had been at the firm.

591
9-3 Policies to Promote
Growth
So far we have used the Solow model to uncover the theoretical
relationships among the different sources of economic growth, and
we have discussed some of the empirical work that describes actual
growth experiences. We can now use the theory and evidence to help
guide our thinking about economic policy.

Evaluating the Rate of Saving

According to the Solow growth model, how much a nation saves and
invests is a key determinant of its citizens’ standard of living. So
let’s begin our policy discussion with a natural question: Is the rate
of saving in the Canadian economy too low, too high, or just right?

As we have seen, the saving rate determines the steady-state levels

of capital and output. One particular saving rate produces the Golden
Rule steady state, which maximizes consumption per worker and
thus economic well-being. The Golden Rule provides the benchmark
against which we can compare the Canadian economy.

To decide whether the Canadian economy is at, above, or below the

Golden Rule steady state, we need to compare the marginal product
of capital net of depreciation with the growth rate of total
output As we established in Section 9-1, at the Golden Rule
steady state, If the economy is operating with less

594
capital than in the Golden Rule steady state, then diminishing
marginal product tells us that In this case,
increasing the rate of saving will increase capital accumulation and
economic growth and, eventually, lead to a steady state with higher
consumption (although consumption will be lower for part of the
transition to the new steady state). On the other hand, if the economy
has more capital than in the Golden Rule steady state, then
In this case, capital accumulation is excessive:
reducing the rate of saving will lead to higher consumption both
immediately and in the long run.

To make this comparison for a real economy, such as the Canadian

economy, we need an estimate of the growth rate of output
and an estimate of the net marginal product of capital
Real GDP in Canada has grown at an average of 3 percent since
1960 so We can estimate the net marginal product of
capital from the following three facts:

1. The capital stock is about 3 times one year’s GDP.

2. Depreciation of capital is about 10 percent of GDP.
3. Capital income is about 33 percent of GDP.

Using the notation of our model (and the result from Chapter 3 that
capital owners earn income of MPK for each unit of capital), we can
write these facts as

1.
2.

595
 3.

We solve for the rate of depreciation by dividing equation 2 by

equation 1:

And we solve for the marginal product of capital MPK by dividing

equation 3 by equation 1:

Thus, about 3.33 percent of the capital stock depreciates each year,
and the marginal product of capital is about 11 percent per year. The
net marginal product of capital is about 7.67 percent per
year.

We can now see that the return to capital percent

per year) is well above the economy’s average growth rate
percent per year). This fact, together with our previous analysis,
indicates that the capital stock in the Canadian economy is well
below the Golden Rule level. In other words, if Canada saved and
invested a higher fraction of its income, it would grow more rapidly
and eventually reach a steady state with higher consumption.

This conclusion is not unique to the Canadian economy. When

similar calculations are done for other economies, the results are
much the same. The possibility of excessive saving and capital
accumulation beyond the Golden Rule level is intriguing as a matter
of theory, but it appears not to be a problem that actual economies

596
face. In practice, economists are more often concerned with
insufficient saving. It is this kind of calculation that provides the
intellectual foundation for this concern.5

Changing the Rate of Saving

The preceding calculations show that to move the Canadian
economy toward the Golden Rule steady state, policymakers should
enact policies to encourage national saving. But how can they do
that? We saw in Chapter 3 that, as a matter of simple accounting,
higher national saving means higher public saving, higher private
saving, or some combination of the two. Much of the debate over
policies to increase growth centres on which of these options is
likely to be most effective.

The most direct way in which the government affects national saving
is through public saving—the difference between what the
government receives in tax revenue and what it spends. When its
spending exceeds its revenue, the government runs a budget deficit,
which represents negative public saving. As we saw in Chapter 3, a
budget deficit raises interest rates and crowds out investment; the
resulting reduction in the capital stock is part of the burden of the
national debt on future generations. Conversely, if it spends less than
it raises in revenue, the government runs a budget surplus, which it
can use to retire some of the national debt and stimulate investment.
This influence of government budget policy on capital accumulation
explains why our federal government made reducing the budget
deficit an important priority during the 1990s, and why there was

597
much public concern about the federal government’s record annual
budget deficit of $55 billion in 2009.

The government also affects national saving by influencing private

saving, the saving done by households and firms. How much people
decide to save depends on the incentives they face, and these
incentives are altered by various public policies. Many economists
argue that high tax rates on capital, including the corporate income
tax, the federal income tax, the estate tax, and many state income
and estate taxes, discourage private saving by reducing the rate of
return that savers earn. On the other hand, tax-exempt retirement
accounts, such as Registered Retirement Savings Plan (RRSP), are
designed to encourage private saving by giving preferential
treatment to income saved in these accounts. Some economists have
proposed increasing the incentive to save by replacing the current
system of income taxation with a system of consumption taxation.

Many disagreements over public policy are rooted in different views

about how much private saving responds to incentives. For example,
suppose the government increased the amount that people can
contribute to their RRSP for retirement. Would people respond to
this incentive by saving more? Or, instead, would people merely
transfer saving already done in taxable savings accounts into these
tax-advantaged accounts, reducing tax revenue, and thus public
saving without any stimulus to private saving? The desirability of the
policy depends on the answers to these questions. Unfortunately,
despite much research on this issue, no consensus has emerged.

598
 owe to the U.S. government. Thus, a tax break offered by the Canadian
government makes the tax credit in the United States precisely that much
smaller. The Canadian government is simply transferring revenue to the U.S.
government. Since these firms are no better off as a result of the Canadian
government’s generosity, we cannot expect the policy to stimulate investment
spending on the part of these firms.

Allocating the Economy’s

Investment
The Solow model makes the simplifying assumption that there is
only one type of capital. In the world, of course, there are many
types. Private businesses invest in traditional types of capital, such as
bulldozers and steel plants, and newer types of capital, such as
computers and robots. The government invests in various forms of
public capital, called infrastructure, such as roads, bridges, and
sewer systems.

In addition, there is human capital—the knowledge and skills that

workers acquire through education, from early childhood programs
such as Head Start to on-the-job training for adults in the labour
force. Although the capital variable in the Solow model is usually
interpreted as including only physical capital, in many ways human
capital is analogous to physical capital. Like physical capital, human
capital increases our ability to produce goods and services. Raising
the level of human capital requires investment in the form of
teachers, libraries, and student time. Research on economic growth

602
has emphasized that human capital is at least as important as
physical capital in explaining international differences in standards
of living. One way of modelling this fact is to give the variable we
call “capital” a broader definition that includes both human and
physical capital.6

Policymakers trying to promote economic growth must confront the

issue of what kinds of capital the economy needs most. In other
words, what kinds of capital yield the highest marginal products? To
a large extent, policymakers can rely on the marketplace to allocate
the pool of saving to alternative types of investment. Those
industries with the highest marginal products of capital will naturally
be most willing to borrow at market interest rates to finance new
investment. Many economists advocate that the government should
merely create a “level playing field” for different types of capital—
for example, by ensuring that the tax system treats all forms of
capital equally. The government can then rely on the market to
allocate capital efficiently.

Other economists have suggested that the government should

promote specific forms of capital. Suppose, for instance, that
technological advance occurs as a byproduct of certain activities.
This would happen if new and improved production processes are
devised during the process of building capital (a phenomenon called
learning by doing) and if these ideas become part of society’s pool of
knowledge. Such a byproduct is called a technological externality
(or a knowledge spillover). In the presence of such externalities, the
social returns to capital exceed the private returns, and the benefits

603
of capital accumulation to society are greater than the Solow model
suggests.7 Moreover, some types of capital accumulation may yield
greater externalities than others. If, for example, installing robots
yields greater technological externalities than building a new steel
mill, then perhaps the government should use the tax laws to
encourage investment in robots. The success of such an industrial
policy, as it is sometimes called, depends on the government’s ability
to accurately measure the externalities of different economic
activities so that it can give the correct incentives.

Most economists are skeptical about industrial policies for two

reasons. First, measuring the externalities from different sectors is
hard. If policy is based on poor measurements, its effects might be
close to random and, thus, worse than no policy at all. Second, the
political process is far from perfect. Once the government gets into
the business of rewarding specific industries with subsidies and tax
breaks, the rewards are as likely to be based on political clout as on
the magnitude of externalities.

One type of capital that necessarily involves the government is

public capital. Municipal, provincial and federal governments are
always deciding if and when they should borrow to finance new
roads, bridges, and transit systems.

In 2015, when the Liberals were elected, Prime Minister Justin

Trudeau’s government promised to spend $100 million on
infrastructure. This policy was motivated partly by a desire to
increase short-run aggregate demand (a goal we will examine later in

604
this book) and partly by a desire to provide public capital and
enhance long-run productivity and economic growth. The
government has claimed that a higher level of infrastructure
investment would make the Canadian economy substantially more
productive. Among economists, this claim has had both defenders
and critics. Yet all of them agree that measuring the marginal product
of public capital is difficult. Private capital generates an easily
measured rate of profit for the firm owning the capital, whereas the
benefits of public capital are more diffuse. Moreover, while private
capital investment is made by investors spending their own money,
the allocation of resources for public capital involves the political
process and taxpayer funding. Often projects are approved simply
because the local member of parliament has managed to get funding
approved.

Establishing the Right Institutions

As we discussed earlier, economists who study international
differences in the standard of living attribute some of these
differences to the inputs of physical and human capital and some to
the productivity with which these inputs are used. One reason
nations may have different levels of production efficiency is that
they have different institutions guiding the allocation of scarce
resources. Creating the right institutions is important for ensuring
that resources are allocated to their best use.

605
 investment line. A dotted vertical line is drawn from the
intersecting point of the line and the curve toward the horizontal
axis. This point in the horizontal axis is labeled k superscript
asterisk, the steady state.

Perhaps the clearest current example of the importance of

institutions is the comparison between North and South Korea. For
many centuries, these two nations were combined with a common
government, heritage, culture, and economy. Yet in the aftermath of
World War II, an agreement between the United States and the
Soviet Union split Korea in two. Above the thirty-eighth parallel,
North Korea established institutions based on the Soviet model of
authoritarian communism. Below the thirty-eighth parallel, South
Korea established institutions based on the American model of
democratic capitalism. Today, the difference in economic
development could not be more stark. GDP per person in North
Korea is less than one-tenth of what it is in South Korea. This
difference is visible in satellite photos taken at night. South Korea is
well lit—its widespread use of electricity a sign of advanced
economic development. North Korea, in contrast, is shrouded in
darkness.

Among democratic capitalist nations, there are important but more

subtle institutional differences. One example is a nation’s legal
tradition. Some countries, such as Canada, the United States,
Australia, India, and Singapore, are former colonies of the United
Kingdom and, therefore, have English-style common-law systems.

607
Other nations, such as Italy, Spain, and most of those in Latin
America, have legal traditions that evolved from the French
Napoleonic Code. Studies have found that legal protections for
shareholders and creditors are stronger in English-style than French-
style legal systems. As a result, the English-style countries have
better-developed capital markets. Nations with better-developed
capital markets, in turn, experience more rapid growth because it is
easier for small and start-up companies to finance investment
projects, leading to a more efficient allocation of the nation’s
capital.8

Another important institutional difference across countries is the

quality of government and honesty of government officials. Ideally,
governments should provide a “helping hand” to the market system
by protecting property rights, enforcing contracts, promoting
competition, prosecuting fraud, and so on. Yet governments can
diverge from this ideal and act more like a “grabbing hand” by using
the authority of the state to enrich the powerful at the expense of the
broader community. Empirical studies have shown that the extent of
corruption in a nation is indeed a significant determinant of
economic growth.9

Adam Smith, the great eighteenth-century economist, was well

aware of the role of institutions in economic growth. He once wrote,
“Little else is requisite to carry a state to the highest degree of
opulence from the lowest barbarism but peace, easy taxes, and a
tolerable administration of justice: all the rest being brought about by

608
the natural course of things.” Sadly, many nations do not enjoy these
three simple advantages.

CASE STUDY

The Colonial Origins of Modern

Institutions
International data show a remarkable correlation between latitude and
economic prosperity: nations closer to the equator typically have lower levels
of income per person than nations farther from the equator. This fact is true in
both the Northern and Southern Hemispheres.

What explains the correlation? Some economists have suggested that the
tropical climates near the equator have a direct negative impact on
productivity. In the heat of the tropics, agriculture is more difficult, and
disease is more prevalent. This makes the production of goods and services
more difficult.

Although the direct impact of geography is one reason tropical nations tend to
be poor, it is not the whole story. Research by Daron Acemoglu, Simon
Johnson, and James Robinson has suggested an indirect mechanism—the
impact of geography on institutions. Here is their explanation, presented in
several steps:

1. In the seventeenth, eighteenth, and nineteenth centuries, tropical

climates presented European settlers with an increased risk of disease,
especially malaria and yellow fever. As a result, when Europeans were
colonizing much of the rest of the world, they avoided settling in
tropical areas, such as most of Africa and Central America. The
European settlers preferred areas with more moderate climates and
better health conditions, such as the regions that are now the United
States, Canada, and New Zealand.

609
 2. In those areas where Europeans settled in large numbers, the settlers
established European-style institutions that protected property rights and
limited the power of government. By contrast, in tropical climates, the
colonial powers often set up “extractive” institutions, including
authoritarian governments, so they could take advantage of the area’s
natural resources. These institutions enriched the colonizers, but they
did little to foster economic growth.
3. Although the era of colonial rule is now long over, the early institutions
that the European colonizers established are strongly correlated with the
modern institutions in the former colonies. In tropical nations, where the
colonial powers set up extractive institutions, there is typically less
protection of property rights even today. When the colonizers left, the
extractive institutions remained and were simply taken over by new
ruling elites.
4. The quality of institutions is a key determinant of economic
performance. Where property rights are well protected, people have
more incentive to make the investments that lead to economic growth.
Where property rights are less respected, as is typically the case in
tropical nations, investment and growth tend to lag behind.

This research suggests that much of the international variation in living

standards that we observe today is a result of the long reach of history.10

Supporting a Pro-growth Culture

A nation’s culture refers to the values, attitudes, and beliefs of its
people. Many social scientists have suggested that culture can have
an important influence on economic growth. For example, in his
classic 1905 book The Protestant Ethic and the Spirit of Capitalism,
sociologist Max Weber argued that the acceleration of economic
growth in northern Europe beginning in the sixteenth century can be

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attributed to the rise of Calvinism, a branch of Protestantism that
emphasizes hard work and frugality.

Culture has many facets and is hard to quantify. Yet there are some
clear ways in which cultural differences can help explain why some
nations are rich and others are poor. Here are four examples:

Societies differ in their treatment of women. In some nations,

prevailing cultural norms keep women poorly educated and out
of the labour force, depressing the standard of living.
Societies differ in their attitudes toward children—both how
many to have and how much to educate them. Higher
population growth can depress incomes, and greater human
capital can increase it.
Societies differ in how open they are to new ideas, especially
ideas from abroad. More open nations can quickly adopt
technological advances wherever they occur, while less open
ones find themselves further from the world’s technological
frontier.
Societies differ in how much people trust one another. Because
the legal system is a costly and imperfect mechanism for
enforcing agreements, it is easier to coordinate economic
activities when trust is high. Indeed, there is a positive
correlation between the level of trust as reported in surveys and
a nation’s income per person. Trust is related to what some
economists call social capital, the network of cooperative
relationships among people, including such diverse groups as
churches and bowling leagues.

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A nation’s culture arises from various historical, anthropological,
and sociological forces and is not easily controlled by policymakers.
But culture evolves over time, and policy can play a supporting role.
The changing attitude toward women in Canada over the past
century is a case in point. Women today get more education and are
more likely to be in the labour force than they were in the past, and
these changes have led to a higher standard of living for Canadian
families. Public policy was not the main cause of these
developments, but laws expanding educational opportunities for
women and protecting women’s rights in the workplace were
complementary with the evolution of culture.

Encouraging Technological Progress

The Solow model shows that sustained growth in income per worker
must come from technological progress. The Solow model, however,
takes technological progress as exogenous; it does not explain it.
Unfortunately, the determinants of technological progress are not
well understood.

Despite this limited understanding, many public policies are

designed to stimulate technological progress. Most of these policies
encourage the private sector to devote resources to technological
innovation. For example, the patent system gives a temporary
monopoly to inventors of new products; the tax code offers tax
breaks for firms engaging in research and development; and
government agencies, such as the Natural Sciences and Engineering
Research Council (NSERC) basic research in universities. In

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addition, as discussed previously, proponents of industrial policy
argue that the government should take a more active role in
promoting specific industries that are key to rapid technological
advance.

In recent years, the encouragement of technological progress has

taken on an international dimension. Many of the companies that
engage in research to advance technology are located in Canada, in
the United States, and other developed nations. Developing nations
such as China have an incentive to “free ride” on this research by not
strictly enforcing intellectual property rights. That is, Chinese
companies often use ideas developed abroad without compensating
the patent holders. The United States, Canada, and other countries
have objected to this practice, and China has promised to step up
enforcement. If intellectual property rights were better enforced
around the world, firms would have more incentive to engage in
research, and this would promote worldwide technological progress.

CASE STUDY

Is Free Trade Good for Economic

Growth?
At least since Adam Smith, economists have advocated free trade as a policy
that promotes national prosperity. Here is how Smith put the argument in his
1776 classic, The Wealth of Nations:

It is a maxim of every prudent master of a family, never to attempt to make at

home what it will cost him more to make than to buy. The tailor does not
attempt to make his own shoes, but buys them of the shoemaker. The shoemaker
does not attempt to make his own clothes but employs a tailor. …

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APPENDIX: Accounting for the
Sources of Economic Growth

Real GDP in the United States has grown an average of about 3 percent per
year over the past 50 years. What explains this growth? In Chapter 3 we
linked the output of the economy to the factors of production—capital and
labour—and to the production technology. Here we develop a technique
called growth accounting that divides the growth in output into three
different sources: increases in capital, increases in labour, and advances in
technology. This breakdown provides us with a measure of the rate of
technological change.

Increases in the Factors of Production

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We first examine how increases in the factors of production contribute to
increases in output. To do this, we start by assuming there is no technological
change, so the production function relating output to capital and labour
is constant over time:

In this case, the amount of output changes only because the amount of capital
or labour changes.

Increases in Capital
First, consider changes in capital. If the amount of capital increases by
units, by how much does the amount of output increase? To answer this
question, we need to recall the definition of the marginal product of capital

The marginal product of capital tells us how much output increases when
capital increases by 1 unit. Therefore, when capital increases by units,
17
output increases by approximately

For example, suppose the marginal product of capital is 1/5; that is, an
additional unit of capital increases the amount of output produced by one-
fifth of a unit. If we increase the amount of capital by 10 units, we can
compute the amount of additional output as follows:

By increasing capital by 10 units, we obtain 2 more units of output. Thus, we

use the marginal product of capital to convert changes in capital into changes
in output.

Increases in Labour

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Next, consider changes in labour. If the amount of labour increases by
units, by how much does output increase? We answer this question the same
way we answered the question about capital. The marginal product of labour
tells us how much output changes when labour increases by 1 unit—
that is,

Therefore, when the amount of labour increases by units, output increases

by approximately

For example, suppose the marginal product of labour is 2; that is, an

additional unit of labour increases the amount of output produced by 2 units.
If we increase the amount of labour by 10 units, we can compute the amount
of additional output as follows:

By increasing labour by 10 units, we obtain 20 more units of output. Thus,

we use the marginal product of labour to convert changes in labour into
changes in output.

Increases in Capital and Labour

Finally, let’s consider the more realistic case in which both factors of
production change. Suppose the amount of capital increases by and the
amount of labour increases by The increase in output then comes from
two sources: more capital and more labour. We can divide this increase into
the two sources, using the marginal products of the two inputs:

The first term in parentheses is the increase in output resulting from the
increase in capital; the second term in parentheses is the increase in output
resulting from the increase in labour. This equation shows us how to attribute
growth to each factor of production.

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We now want to convert this last equation into a form that is easier to
interpret and apply to the available data. First, with some algebraic
rearrangement, the equation becomes18

This form of the equation relates the growth rate of output to the
growth rate of capital and the growth rate of labour

Next, we need to find some way to measure the terms in parentheses in the
last equation. In Chapter 3 we showed that the marginal product of capital
equals its real rental price. Therefore, is the total return to capital,
and is capital’s share of output. Similarly, the marginal
product of labour equals the real wage. Therefore, is the total
compensation that labour receives, and is labour’s share of
output. Under the assumption that the production function has constant
returns to scale, Euler’s theorem (which we discussed in Chapter 3) tells us
that these two shares sum to 1. In this case, we can write

where is capital’s share and is labour’s share.

This last equation gives us a simple formula for showing how changes in
inputs lead to changes in output. It shows, in particular, that we must weight
the growth rates of the inputs by the factor shares. Capital’s share in the
United States is about 30 percent—that is, Therefore, a 10 percent
increase in the amount of capital leads to a 3 percent increase
in the amount of output Similarly, a 10 percent increase in
the amount of labour leads to a 7 percent increase in the
amount of output

Technological Progress

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So far in our analysis of the sources of growth, we have been assuming that
the production function does not change over time. In practice, of course,
technological progress improves the production function. For any given
amount of inputs, we can produce more output today than we could in the
past. We now extend the analysis to allow for technological progress.

We include the effects of the changing technology by writing the production

function as

where is a measure of the current level of technology called total factor

productivity. Output now increases not only because of increases in capital
and labour but also because of increases in total factor productivity. If total
factor productivity increases by 1 percent and if the inputs are unchanged,
then output increases by 1 percent.

Allowing for a changing level of technology adds another term to our

equation accounting for economic growth:

This is the key equation of growth accounting. It identifies and allows us to

measure the three sources of growth: changes in the amount of capital,
changes in the amount of labour, and changes in total factor productivity.

Because total factor productivity is not directly observable, it is measured

indirectly. We have data on the growth in output, capital, and labour; we also
have data on capital’s share of output. From these data and the growth-
accounting equation, we can compute the growth in total factor productivity
to make sure everything adds up:

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 is the change in output that cannot be explained by changes in inputs.
Thus, the growth in total factor productivity is computed as a residual—that
is, as the amount of output growth that remains after we have accounted for
the determinants of growth that we can measure directly. Indeed, is
sometimes called the Solow residual, after Robert Solow, who first showed
how to compute it.19

Total factor productivity can change for many reasons. Changes most often
arise because of increased knowledge about production methods, so the
Solow residual is frequently used as a measure of technological progress. Yet
other factors, such as education and government regulation, can affect total
factor productivity as well. For example, if higher public spending raises the
quality of education, then workers may become more productive and output
may rise, which implies higher total factor productivity. In another example,
if government regulations require firms to purchase capital to reduce
pollution or increase worker safety, then the capital stock may rise without
any increase in measured output, which implies lower total factor
productivity. Total factor productivity captures anything that changes the
relation between measured inputs and measured output.

The Sources of Growth in Canada

Having learned how to measure the sources of economic growth, we now
consider the data. On average, over the course of the twentieth century,
Canadian output has grown at an annual rate of approximately 3 percent.
Roughly speaking, over the same period, labour and capital have grown
annually at 1 percentage point and 3 percentage points, respectively. Taking
at 0.33, we can provide rough estimates of the contribution to output growth
of its three main determinants—growth in labour input, growth in capital
input, and technological change. (The contribution of the latter is calculated
as the residual). Table 9-2 shows the results.

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 TABLE 9-2 Accounting for Economic Growth in Canada
Source of Components Data Share
Growth of
Output
Growth

Output 3%
growth

Labour’s times 0.67

share

Labour 1% 0.67
growth rate
Contribution
of labour

Capital’s times 0.33

share

Capital 3% 0.99
growth rate
Contribution
of capital

Contribution 1.34
of
productivity
growth

Proportion of growth due to increase in total factor productivity

Data from: Authors’ calculations.

We see that about 44 percent of the increase in Canadian output has been due
to increases in productivity. More detailed estimates of this breakdown and
evidence for subperiods within the century are available.20 These studies
show that the contribution of increased productivity to growth has been as

649
low as 23 percent and as high as 69 percent (in particular periods), but the
average is the 44 percent that we have calculated above. It is in the last
quarter of the twentieth century that the contribution of productivity growth
was the smallest. This means that Canada’s slower average growth rate
during this period had more to do with slower productivity growth than it did
with a drop in the level of investment in new capital equipment. This fact
makes it difficult to argue that all Canada needs to return to more rapid
growth is to increase the rate of saving and investment spending.

As already noted, since the early 1970s, Canada’s overall productivity

performance has lagged behind that of our competitors, in particular, that of
the United States. There is growing concern that the productivity gap with
the United States has increased over time. One of the measures of
productivity that is often discussed by economists and the popular press is
labour productivity that is essentially output per hour worked. Although
Canada’s labour productivity has lagged that of the United States for a long
time, various estimates have shown that the gap has widened since 2000.
Canada’s annual labour productivity growth averaged 1.4 percent from 1980–
2000 but it has since grown at a meagre rate of around 1 percent. By
comparison, labour productivity in the United States, although also slowing,
has grown at about 2 percent since 2000. There is no single explanation as to
why labour productivity in Canada has fallen so behind that of the United
States. It is unlikely that there is a quick fix to this problem. There is concern
that if this gap continues in the long-run, Canadian future incomes (and
hence our standard of living compared to the United States) will not grow as
fast.

CASE STUDY
The Increasing Productivity Gap between
Canada and the United States Since the 1990s

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 importing machinery and equipment for many Canadian firms, thereby making it more
difficult for these firms to innovate and invest in productivity enhancing technologies
during that period. Many economists have also suggested that the depreciation of the
dollar allowed firms in Canada to become complacent in their attempts to lower costs
and improve productivity since the exchange rate acted as a cushion for our weaker
productivity and sheltered them from global competition.

Many economists continue to be worried about the labour productivity differential

between the United States and Canada. Although recent data show that the productivity
gap is narrowing, it is primarily because of a fall in U.S productivity. The low level of
labour productivity in Canada will remain an important topic of public policy in Canada
especially as the aging population risks making productivity problems even worse.

The Solow Residual in the Short Run

When Robert Solow introduced his famous residual, his aim was to shed
light on the forces that determine technological progress and economic
growth in the long run. But economist Edward Prescott has looked at the
Solow residual as a measure of technological change over shorter periods of
time. He concludes that fluctuations in technology are a major source of
short-run changes in economic activity.

Figure 9-2 shows the Solow residual and the growth in output using annual
data for the United States during the period 1960 to 2016. Notice that the
Solow residual fluctuates substantially. If Prescott’s interpretation is correct,
then we can draw conclusions from these short-run fluctuations, such as that
technology worsened in 1982 and improved in 1984. Notice also that the
Solow residual moves closely with output: in years when output falls,
technology tends to worsen. In Prescott’s view, this fact implies that
recessions are driven by adverse shocks to technology. The hypothesis that
technological shocks are the driving force behind short-run economic
fluctuations, and the complementary hypothesis that monetary policy has no

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 horizontal axis. Another dotted vertical line is drawn from the intersecting
point of the line labeled delta plus n subscript 2 times k and the curve s f of
k toward the point k subscript 2 asterisk on the horizontal axis. An arrow is
placed between the two lines and is labeled: 1. An increase in the rate of
population growth… A left arrow is placed between the points k subscript 1
asterisk and k subscript 2 asterisk, and is labeled: 2. …reduces the steady-
state capital stock.

Prescott’s interpretation of these data is controversial, however. Many

economists believe that the Solow residual does not accurately represent
changes in technology over short periods of time. The standard explanation
of the cyclical behaviour of the Solow residual is that it results from two
measurement problems.

First, during recessions, firms may continue to employ workers they do not
need so that they will have these workers on hand when the economy
recovers. This phenomenon, called labour hoarding, means that labour input
is overestimated in recessions because the hoarded workers are probably not
working as hard as usual. As a result, the Solow residual is more cyclical
than the available production technology. In a recession, productivity as
measured by the Solow residual falls even if technology has not changed
simply because hoarded workers are sitting around waiting for the recession
to end.

Second, when demand is low, firms may produce things that are not easily
measured. In recessions, workers may clean the factory, organize the
inventory, get some training, and do other useful tasks that standard measures
of output fail to include. If so, then output is underestimated in recessions,
which would also make the measured Solow residual cyclical for reasons
other than technology.

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Thus, economists can interpret the cyclical behaviour of the Solow residual
in different ways. Some economists point to the low productivity in
recessions as evidence for adverse technology shocks. Others believe that
measured productivity is low in recessions because workers are not working
as hard as usual and because more of their output is not measured.
Unfortunately, there is no clear evidence on the importance of labour
hoarding and the cyclical mismeasurement of output. Therefore, different
interpretations of Figure 9-2 persist.21

MORE PROBLEMS AND APPLICATIONS

1. In the economy of Solovia, the owners of capital get two-thirds of national

income, and the workers receive one-third.
a. The men of Solovia stay at home performing household chores, while the
women work in factories. If some of the men started working outside the
home so that the labour force increased by 5 percent, what would happen to
the measured output of the economy? Does labour productivity—defined
as output per worker—increase, decrease, or stay the same? Does total
factor productivity increase, decrease, or stay the same?
b. In year 1, the capital stock was 6, the labour input was 3, and output was
12. In year 2, the capital stock was 7, the labour input was 4, and output
was 14. What happened to total factor productivity between the two years?

2. Labour productivity is defined as the amount of output divided by the

amount of labour input. Start with the growth-accounting equation and show
that the growth in labour productivity depends on growth in total factor
productivity and growth in the capital–labour ratio. In particular, show that

(Hint: You may find the following mathematical trick helpful.) If

then the growth rate of is approximately the growth rate of plus the
growth rate of That is,

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