Principles of Economics

Chapter 20 Economic Growth, Productivity and Living Standards

The McGraw-Hill Companies, 2012

The Remarkable Rise in Living Standards: The Record

How might we measure changes in living standards?
Real GDP per person is a useful measure, as it positively relates to a number of variables, such as life expectancy, infant health and literacy.

The McGraw-Hill Companies, 2012

Real GDP per Person in Four Industrialized Countries, 1870 - 2003

The McGraw-Hill Companies, 2012

Real GDP per Person in Selected Countries, 1870-2003 (in US Dollars, 2000)

The McGraw-Hill Companies, 2012

Why Small Differences in Growth Rates Matter

Compound interest
The payment of interest not only on the original deposit but on all previously accumulated interest Suppose a distant relative dies, leaving you 10,000. How much will this be worth in 40 years if you deposit it in a saving account?

The McGraw-Hill Companies, 2012

Why Small Differences in Growth Rates Matter

At a 5% interest rate, your deposit in 40 years will be worth:
10 ,000 (1,05 ) 70 ,399 .89
40

If the interest rate is 6%, your deposit will be worth:

10 ,000 (1,06 ) 40 102 ,857 .20

The McGraw-Hill Companies, 2012

Why Small Differences in Growth Rates Matter

The power of compound interest is that, even at relatively low rates of interest, a small sum increases in value. Very small differences in the interest rate, over the long run, imply large differences in the amount accumulated over time.

The McGraw-Hill Companies, 2012

Why Small Differences in Growth Rates Matter

Government policies that affect the long-term growth rate by a small amount will have a major economic impact.
The McGraw-Hill Companies, 2012

Why Nations Become Rich: the Crucial Role of Average Labour Productivity What determines a nations economic growth rate?
Some definitions:
Y = real GDP N = number of employed workers POP = total population

The McGraw-Hill Companies, 2012

Why Nations Become Rich: the Crucial Role of Average Labour Productivity
Real GDP per person

Y Y N x POP N POP
Real output/person depends on:
How much each worker can produce The percentage of the population that is working

The McGraw-Hill Companies, 2012

Why Nations Become Rich: the Crucial Role of Average Labour Productivity
Average labour productivity and the share of population employed, Japan (1960 2009)

The McGraw-Hill Companies, 2012

Why Nations Become Rich: the Crucial Role of Average Labour Productivity
Average labour productivity and the share of population employed, United Kingdom (1960-2009)

The McGraw-Hill Companies, 2012

Why Nations Become Rich: the Crucial Role of Average Labour Productivity
Average labour productivity and the share of population employed, United States (1960-2009)

The McGraw-Hill Companies, 2012

Why Nations Become Rich: the Crucial Role of Average Labour Productivity What determines a nations economic growth rate in the long run?
average labour productivity!!

The McGraw-Hill Companies, 2012

The Solow Growth Model

The Solow Growth Model starts by postulating a relationship between the quantities of inputs used in the production process and the economys total output (Y). We assume there are only 2 inputs:
Physical capital, denoted as K Labour, denoted as N

The McGraw-Hill Companies, 2012

The Solow Growth Model

The relationship between Y,K and N is known as a production function, and can be written as: Y = F(K,N)

The McGraw-Hill Companies, 2012

The Solow Growth Model

Assumption 1: Diminishing marginal product
If the amount of labour and other inputs employed is held constant, then the greater the amount of capital already in use, the less an additional unit of capital adds to production

The McGraw-Hill Companies, 2012

The Solow Growth Model

capital Holding the labour input constant, the marginal product is defined as:

Y = the change in output K = the change in the amount of

Y MPK = K

The McGraw-Hill Companies, 2012

The Solow Growth Model

Diminishing marginal product

Note: the labour is held constant.

The McGraw-Hill Companies, 2012

The Solow Growth Model

Assumption 2: Constant returns to scale (CRS)
If the labour and capital inputs are both increased by equal proportions, then total output increases by the same proportion. We can write the CRS production function as follows: zY = F(zK,zN)

The McGraw-Hill Companies, 2012

The Solow Growth Model

The y = f(k) curve is known as the production function and shows how average labour productivity y = Y/N increases with the capital per worker or the capital labour ratio k = K/N. For a constant labour force N the slope of this line measures the marginal product of capital MPK. Given the assumption of diminishing marginal product the slope will become smaller and the curve flatter as the capitallabour ratio increases.

The McGraw-Hill Companies, 2012

The Solow Growth Model

The McGraw-Hill Companies, 2012

The Solow Growth Model

Investment and saving
The Solow Model assumes that investment is financed by saving. Saving is a constant fraction of income Y. Let I denote investment in physical capital, S denote total saving & s denote the savings rate. We have
I = S =sY

The McGraw-Hill Companies, 2012

The Solow Growth Model

In long-run equilibrium, investment per worker will just be sufficient to keep the capital-labour ratio constant. How much investment is required to keep the capital-labour ratio constant? The answer depends on two factors:
Depreciation rate Population growth

The McGraw-Hill Companies, 2012

The Solow Growth Model

If capital depreciates at rate d per period then investment must be at least dk to keep the capital-labour ratio from falling. If the labour force grows at a constant rate n per period, then the economy will require an additional investment nk to keep the capital-labour ratio constant.
The McGraw-Hill Companies, 2012

The Solow Growth Model

So, the economy requires investment per head to be (d+n)k to maintain a constant capital-labour ratio. E.g. If 3% of capital stock wears out each
year & the population grows by 2%, Then the required investment per person employed is 5% to keep the capital-labour ratio constant.

The McGraw-Hill Companies, 2012

The Solow Growth Model

Long-run equilibrium condition is: k = i (d+n)k=0 A1 is the steady state. At this point gross investment is just sufficient to maintain a constant labour capital ratio.

The McGraw-Hill Companies, 2012

The Solow Growth Model

The equilibrium capital-labour ratio [k1] determines the equilibrium value of average labour productivity [Y1] E1 becomes steady state.

The McGraw-Hill Companies, 2012

The Solow Growth Model

An Increase in the Saving Rate

The McGraw-Hill Companies, 2012

The Solow Growth Model

Two important conclusions in explaining economic growth:
Average labour productivity depends on the amount of physical capital per head in the workforce.
The more capital available to the workforce, the higher the level of both labour productivity and income per head of the population

In the long run, the economys steady state growth rate should equal the rate of population growth. Why is the 2nd point less intuitive than the 1st?
The McGraw-Hill Companies, 2012

The Solow Growth Model

Over relatively long periods of time, growth in most industrialized economies tends to exceed the rate of population. Between 1950 and 2003 the UK population increased by about 20% (0.4% per year). Real income increased by 2.1% per year. How do we explain the difference?
The McGraw-Hill Companies, 2012

The Solow Growth Model

We have assumed that to achieve higher average labour productivity we need to increase the amount of capital per worker. Is it possible that average labour productivity can increase, even if the capital-labour ratio is constant?
Yes!

The McGraw-Hill Companies, 2012

The Solow Growth Model

Technical progress
An improvement in knowledge that enables a higher output to be produced from existing resources Example: the development of personal computers over the last 20 years has made the labour force more productive.

The McGraw-Hill Companies, 2012

The Solow Growth Model

To add technical progress, we make a change to the production function. Now rewrite as: y = Af(k)
Where A denotes technology

If technology improves by g per cent per year then A = (1+g)

The McGraw-Hill Companies, 2012

The Solow Growth Model

Technical Process in the Solow Model

The McGraw-Hill Companies, 2012

The Solow Growth Model

Human capital
The accumulation of skills, experience and knowledge by the workforce Workers with a large stock of human capital are more productive than workers with less training. Let H denote the stock of human capital: Y = AF(K,N,H)
The McGraw-Hill Companies, 2012

The Solow Growth Model

If the UK has a higher stock of human capital per worker than India, its output per worker and living standards will be higher, even if both countries have the same capital-labour ratio.
The McGraw-Hill Companies, 2012

Total Factor Productivity

Total factor productivity
That part of growth in output which is not accounted for by capital and labour growth

TFP can be measured as follows:

A Y K N (1 ) A Y K N

The McGraw-Hill Companies, 2012

Total Factor Productivity

Total factor productivity can be influenced by factors, such as
entrepreneurship and management skills the political and legal environment

The McGraw-Hill Companies, 2012

Total Factor Productivity

Entrepreneurs are people who create new economic enterprises. Because they introduce new production methods, they are crucial to the economy. How does a society foster entrepreneurship? How do you teach entrepreneurship?
The McGraw-Hill Companies, 2012

Total Factor Productivity

The political and legal environment The establishment of well-defined property rights is crucial for investment. Political instability and wars are detrimental to investment.

The McGraw-Hill Companies, 2012

The Costs of Economic Growth

What are the costs of growth?
The opportunity cost of increasing the production of capital goods is fewer consumer goods. Reduced leisure time, worker safety and health The cost of research & development The cost of education (human capital)

The McGraw-Hill Companies, 2012

Promoting Economic Growth

How policymakers promote growth
Policies that support research and development Policies to increase human capital Policies that promote saving and investment Policies that attract foreign investment The legal and political framework
The McGraw-Hill Companies, 2012

Promoting Economic Growth

The poorest countries: a special case?
Improve the legal and political framework
Corrupt legal systems create uncertainty about property rights. Taxation and regulation discourages entrepreneurship. Markets are not allowed to function. Lack of political stability discourages foreign investment.

Without political stability, foreign aid wont be effective.

The McGraw-Hill Companies, 2012

Is Economic Growth Always Good for You?

Can economic growth continue without depleting natural resources and damaging the global environment? This limits to growth theory assumes economic growth will take the form of what we have now. However,
Growth can involve newer, more efficient goods and services. Increased wealth and productivity expands societys capacity to safeguard the environment.

Environmental quality will not reach its optimal level through market processes. International mechanisms need to be established to deal with global environmental problems.
The McGraw-Hill Companies, 2012