Chapter 14

Questions
1. Identify and explain the main sources of economic growth? What are the
main sources of growth in your economy?
Economic growth is achieved through investment in physical capital, technological
innovation and improvements in techniques, and a larger and/or more highly skilled
labour force. At the level of the individual firm good management is vital and at the
national level adequate infrastructure. In the UK economy in recent years the main
source of growth has been a highly innovative financial sector. Since the financial
crisis of 2007 -9 it remains to be seen whether or not the financial sector will recover.
Whether it does or not, most observers see a highly educated, skilled and adaptable
workforce as the main source of potential growth in a developed economy.
2. Economic growth through a higher utilization of current economic
resources comes with what problems, or opportunity costs?
Growth can be achieved through the higher utilization of current resources if some of
them, land, capital and particularly labour, are unemployed. In this situation fiscal
stimulation and monetary expansion, the Keynesian approach, will produce growth.
However, once the full employment level is reached, monetarists argue that further
real (physical) growth cannot be achieved by expansionary policies. The long run
supply curve is perfectly inelastic and all that further expansionary policies will
achieve is higher prices, or inflation.
3. Which are equivalent, the production possibility frontier and aggregate
demand, or the production possibility frontier and aggregate supply?
The production possibility frontier and aggregate supply.
4. Explain why GDP per hour worked is a useful measure of productivity.
GDP per hour worked is useful in comparing productivity between industries and,
particularly, in making international comparisons. Different industries and economies
my work different numbers of hours per day, or have different periods of holiday.
Output per hour worked takes account of these differences, and therefore gives a
more accurate measurement of productivity than output per person employed.
Per capita GDP also gives some indication of productivity in an economy. France and
the UK have very similar GDPs per capita. However, the French utilization of labour is
25% lower than in the UK. This is offset by the French workers being 30% more
productive than UK workers. Once again GDP per hour worked gives a better picture
of the relative productivity of the two economies.
5. What distinguishes the UK from France and the US in terms of R&D
funding and the provision of R&D activities?

Productivity is not just a question of how hard people work. A worker with an old
fashioned machine that is always breaking down may work very hard but have a
lower rate of productivity than a less industrious colleague with a more up-todate
and reliable machine. Thus research and development, and investment in the new
techniques discovered, are vital elements in increasing productivity. In this field the
US is substantially well ahead of most of the European Union, including the UK and
France. It must be remembered that research, development, innovation and
investment do not relate only to physical capital. The development of human
resources through education and training, improvements in management techniques,
the creation of intellectual property and, above all, the actual application of
innovations, all play an important part.
6. The Solow model of growth predicts long-run steady state growth rates.
What justification can be provided for this prediction?
In the 1950s Robert Solow argued that the rate of economic growth would not
increase for ever but would reach a steady state. He based this conclusion on the
idea that labour and capital need to increase at the same rate. However, as the
capital stock increases more and more resources have to be devoted to maintaining
and replacing it. In the short term providing workers with more productive capital
improves productivity and increases economic growth. In the long run a greater
proportion of economic output must be devoted to the renewal of existing capital and
as a result economic growth slows and reverts to a steady state growth rate.
7. Explain the convergence hypothesis. Does the convergence hypothesis
hold in reality?
The convergence hypothesis states that poor countries grow more quickly than
average, but rich countries grow more slowly than average. Evidence for the
hypothesis is mixed. The Asian Tigers (Hong Kong, Singapore etc.) grew at
spectacular rates in the second half of the 20th Century, and China and India are
growing rapidly at the beginning of the 21st Century. On the other hand many poor
economies, particularly in Africa, are not growing at all
8. What does the endogenous growth model assume about returns to scale?
Is this assumption reasonable?
It assumes that returns to scale are constant. Continuous investment by one firm
may experience diminishing returns but this investment may have positive
externalities. Therefore constant returns to capital are possible. For example, if one
firm invests heavily in broadband infrastructure for the Internet, then all other firms
who wish to use the Internet to deliver media, online shopping and even teaching
materials, will also receive a positive boost to their online investments. This way, an
increase in investment from one firm leads to increases in productivity across many
firms. The economic growth rate can now increase over time through positive
externalities. Hence the assumption is reasonable.
9. How do the Solow and endogenous models of growth differ in their
prescriptions for the role of government in economic growth?

The Solow model assumes that scientific and technological discoveries which can
promote economic growth arise by chance. However, endogenous theory recognises
a role for the government in creating the conditions for these discoveries to be made
by directing economic decision makers to investment activities with positive
externalities. For business this is important because industrial planning, initiatives for
training and tax breaks for R&D become critical components of governments policies
to increase potential output and, therefore, aggregate supply .

10. What are supply side policies? Provide examples of current supply side
policies and assess how you would measure the success of such policies on
promoting economic growth.
Supply side polices include a whole range of initiatives to promote the efficiency of
the factors of production and their efficient combination.
Measures to improve the quality of the labour force start with education, not just at
graduate and post-graduate level, but for all ranges. Attempts to improve the skills
of the workforce at all level are key ingredients of supply-side policies.
Even with a highly skilled labour force it is important to improve the operation of the
labour market. A key instrument to achieve this in the UK in the 1980s was the
systematic reduction of trade union power. A more positive approach might be the
creation of a stake-holder society in which the ambitions of workers, managers and
owners were all directed to the same end. Crucially, better management and
communications would avoid many industrial disputes.
Research and development play a key role in improving the supply side and tax
breaks to encourage innovation and investment are helpful, as would be a banking
system which was willing to invest in long-run projects rather than concentrate on
short-run returns.
Privatization has been a key element in supply side reforms in the belief, albeit based
on very little evidence, that the private sector is more efficient than the public sector.
Attempts have been made to introduce market systems in areas such as the NHS
which, so far, it has not been seen as politically expedient to privatize.
Low taxation and the removal of regulations (red-tape) have also been seen as
incentives for supply side efficiency.
The success of supply side-policies overall would be measured by measuring the
annual percentage growth of real GDP (i.e. adjusted for inflation), but the assessment
of success must be modified by attention to the level of employment achieved and
an evaluation of how rewards are shared by the community. If GDP grows only by
reward the rich, and sections of society fail to share in any prosperity generated, then
those sections may not have such a positive evaluation of the policies.
11. Is R&D important for economic growth, or is the willingness of
consumers to be innovative in their consumption that is important for
economic growth?
Both. A dynamic economy needs not only to improve techniques and produce
innovative products, but must also have the means of persuading both firms and

households to consume them. Advertising, promotions and marketing play a key role
here.
12. Consider whether there is a simple link between more R&D and higher
economic growth.
Not necessarily. The UK, for example, has a good record in scientific and
technological discoveries, but has not always followed them up with the successful
commercial applications which would lead to economic growth.
13. Does neoclassical growth theory provide an adequate understanding of
economic growth? Is endogenous growth theory any better than the
neoclassical approach?
Neoclassical growth theory views economic growth as dependent upon the growth
rate in labour and technical progress. Without randomly occurring technical progress,
economic growth across the world will converge to a common rate. Convergence is
not observed and it would appear sensible to assume that technical progress is not
entirely random. The size of the economy and the involvement of the government,
firms and the education system could all play a role in the progress of technology.
Endogenous growth theories assume that investments made by one firm, in some
instances, can have positive externalities and improve the productivity of other firms.
Furthermore, the rate of technical progress is not entirely random and can be
reasonably influenced by government policies relating to R&D, the education system,
the labour market and perhaps even financial services. However, a drawback of the
endogenous approach is the assumption of constant returns, which appears to some
as ad hoc and convenient, rather than determined by theory.
14. Does it matter if growth occurs through increased utilization of
resources or higher productivity of resources?
When thinking of finite resources it is better to increase growth through more
efficient utilisation of resources rather than using more of them. This is an important
argument for conservation.
However, in terms of human resources, if there is unemployment it can be argued
that economic welfare is increased by employing more people rather than by
increasing the productivity of those already employed. Similarly in terms of
agricultural land. there may be welfare advantages in utilizing all available land, even
if only for meadows, rather than cultivating some of it intensively and letting the rest
return to the wild state.

15. What are the key benefits associated with privatization and private
finance initiatives.
Privatization is justified on the grounds that the private sector is more efficient than
the public sector. The evidence for this is much disputed.

Private finance initiatives are justified on the grounds that funds from private sources
do not show up on the public accounts and therefore lower the governments
borrowing requirement, which, monetarists claim, if too high causes inflation and
crowding out. However borrowing on the private market is more expensive than on
the public market, and future taxpayers, who will have to pay off the loan in either
case, are faced with a higher burden. The wisdom of the policy is much disputed.
It is hard to see the logic of privatizing an enterprise that cannot be allowed to go
bankrupt as the re-taking into public ownership of the East Coast Main Line franchise
in 2009 demonstrates. The private partners in some PFI projects have proved to be
highly incompetent and demanded government bail-outs in order to complete their
projects.

Exercises
1. True or false?
a) An annual growth rate of 2 per cent p.a. leads to a sevenfold increase in real
output in less than a century.
b) Sustained growth where r is the rate of growth and n is the number of years
cannot occur if production relies on a factor whose supply is largely fixed.
c) In the neoclassical growth theory, output, capital and labour all grow at the
same rate.
d) Higher savings enables a higher long-run rate of growth.
e) Given the convergence hypothesis, we can expect all poor countries to catch
up with the richer countries.
f) Growth may be stimulated by capital externalities: that is, higher capital in one
firm increases capital productivity in other firms.
a)
b)
c)
d)
e)
f)

True
True
True
True, but it does not guarantee it. The savings have to be invested.
True
True (role of positive externalities)

2. Which of the following policy suggestions are appropriate for improving

economic growth in an economy?
a) The encouragement of R&D.

b) A reduction in marginal tax rates to increase labour supply.

c) Investment grants.
d) The establishment of training and education schemes to improve human
capital.
e) An expansion of aggregate demand to increase the level of employment.
f) The encouragement of dissemination of new knowledge and techniques.
All of them, though monetarists may argue that e) would have no long-term effect.
3. Refer to Box 14.5 when considering the following questions:
a) What is the difference between product innovation and consumer
innovation?
Product innovation is the development of new or the improvement of existing
products by suppliers. Consumer innovation, according to the article, is the
willingness of consumers, whether individuals or firms, to try new products and
services.

b) For a modern economy to grow, which consumers need to be innovative,

retail or wholesale?
Both retail and wholesale consumers need to be innovative. For the economy to
prosper all sections of the economy need to be dynamic. Not only do producers need
to be innovative in generating new products or improving the technologies of
producing the existing ones, but consumers - other businesses, wholesalers, retailers
and households need to be venturesome consumers. This has been the strength
of the US economy for at least 100 years, and may be one of the reasons why growth
in the British economy has been relatively sluggish.
Vibrant advertising and marketing sectors play an important part in promoting this
venturesome consumption, though much of it can be regarded as frivolous. With
increasing concerns about global warming, pollution, global inequality and the
depletion of the earths scarce resources it may be that this style of dynamism may
become less fashionable.

c) For an economy to prosper the supply and demand of innovation have to

be in balance. Discuss.
If supply of innovation runs ahead of demand for innovation, firms will be unable to
sell their products and may go bankrupt. However, if consumer demand for
innovation runs ahead of supplier provision of innovation (and innovative goods and

services) this may encourage the more alert entrepreneurs to be more responsive to
consumer demands, which should encourage growth and dynamism. However, in an
open economy venturesome consumers may satisfy their wants from imports, in
which case the domestic economy may suffer.