Solow Growth Model

Adjusted GDP measures: Purchasing Power Parity

People’s welfare: consumption rather than income, consumption per person rather than
output per person

For the production side, maybe differences in productivity rather than differences in standard
of living: output per hour worked (per worker)

Aggregate Production Function:

Capital accumulation by itself cannot sustain growth.
A higher savings rate cannot permanently increase the growth rate of output.
A higher savings rate can sustain a higher level of output.
Sustained growth requires sustained technological progress.

The amount of capital determines the amount of output being produced.

The amount of output determines the amount of saving and, in turn, the amount of capital
being accumulated over time.

The labour force is equal to population times the participation rate.

(If population is constant and the participation rate is constant, the labour force is constant).
Employment is equal to the labour force times 1 minus the unemployment rate.
Assuming no technological progress, the production function 𝑓 does not change over time.

The level of capital per worker this year determines the output per worker this year. Given
the savings rate, output per worker determines the amount of savings per worker, and thus
the investment per worker this year.
The capital stock per worker determines the amount of depreciation per worker this year.

The savings rate has no effect on the long-run growth rate of output per worker, which is
equal to zero. (Eventually, the economy converges to a constant level of output per worker.
In the long run, the growth rate of output equals zero, no matter the savings rate.)
The savings rate determines the level of output per worker in the long run. (Other things being
equal, countries with a higher saving rate will have higher output per worker in the long run.)
An increase in the savings rate will lead to higher growth of output per worker than steady-
state growth rate for some time until the economy reaches its new higher path.

In an economy with technological progress, long-run growth rate is independent of the

savings rate.

An economy in which the savings rate is (and has always been) zero is an economy in which
capital is equal to zero. Output is also equal to zero, and so is consumption. A saving rate
equal to zero implies zero consumption in the long run.

An economy with savings rate equal to one, people save all their income. The level of capital,
and thus output, will be very high. But consumption is equal to zero. Economy is carrying an
excessive amount of capital, maintaining that level of output requires all output to replace
depreciation. A saving rate equal to one also implies zero consumption in the long run.

Golden-Rule Level of Capital: Maximum Steady-State Consumption per Worker

For 𝑠 between zero and 𝑠𝐺 , a higher savings rate leads to higher capital per worker, higher
output per worker, and higher consumption per worker.
For 𝑠 larger than 𝑠𝐺 , a higher savings rate leads to higher capital per worker, higher output
per worker, but lower consumption per worker.
Because the increase in output is more than offset by the increase in depreciation due to the
larger capital stock

Trade-Off: An increase in the savings rate leads to lower consumption for some time, but
higher consumption later.

A higher savings rate and a lower depreciation rate both lead to higher steady-state capital
per worker and higher steady-state output per worker.

Education is partly consumption and partly investment.

Spending on education should include actual cost of education and also opportunity cost.
Actual costs and opportunity costs of on-the-job training should also be included.
We should compare investment rates net of depreciation. Human capital also depreciates,
but slower than physical capital.

Models of Endogenous Growth: Models that generate steady growth even without
technological progress.

East Asian Miracle

HPAEs’ High-Income Growth Rates

Fundamentalists: Dominant role of factor accumulation, noting efficient allocation of
resources, and accumulations. Policies that increased physical and human capital per worker
and that provided for efficient allocation. Provided a stable macroeconomic environment and
a reliable legal framework to promote domestic and international competition. The
orientation of the HPAEs toward international trade and the absence of price controls and
other distortionary policies have led to low relative price distortions. Policies relatively
constant.
Mystics: Role of acquisition and mastery of technology, acknowledges the importance of
accumulation. Markets consistently fail to guide investment to industries that generate the
highest growth. Dynamic gains of activist government policies to alter industrial structure and
promote technological learning, sometimes at the expense of static allocative efficiency.
Policies diverse and flexible.
Macroeconomic management was unusually good and macroeconomic performance
unusually stable, providing the essential framework for private investment.
Policies to increase the integrity of the banking system and to make it more accessible to
nontraditional savers, increased the levels of financial savings.
Education policies that focused on primary and secondary education generated rapid
increases in labour force skills.
Agricultural policies stressed productivity change and did not tax the rural economy
excessively.
All the HPAEs kept price distortions within reasonable bounds and were open to foreign ideas
and technology.
In one form or another, the government intervened – systematically and through multiple
channels – to foster development, and in some cases the development of specific industries.

There was feedback from high growth. Rapid growth increased the demand for financial
assets, able to absorb higher levels of monetary financing without a rapid rise in inflation.
Rapid growth in GDP raised the level of sustainable domestic and external borrowing.
There was feedback from high financial savings. Savings rates were high and majority went
into the domestic financial system (opposed to real assets or capital flight). Further increased
the demand for money and other domestic financial assets, making increased domestic
financing of the deficit possible without resort to inflationary financing.
There were low initial debt ratios. External financing available when needed.

Responding effectively to macroeconomic shocks. HPAEs’ capacity to maintain

macroeconomic stability has been their prompt and effective responses. HPAEs made definite
policy decisions to keep the macroeconomy under control, rather than simply benefitting
from a feedback from rapid growth to macroeconomic stability.
First, limiting transfers to public enterprises and tightly supervising banks, governments
reduced the spillover from the real sector into the financial sector that otherwise exacerbated
fiscal woes.
Second, flexible labour and capital markets enabled the real sector to react quickly to
government initiatives, setting off new growth cycles that eased the recessionary impact of
stabilization measures.

Broadly Based Education Strategies

Focusing educational spending.
The broad base of human capital.

Promotion of manufactured exports was a significant source of measured TFP change.

Industrial policies mattered relatively little in the overall record of HPAEs’ high growth.

Institutions

1.
Economic institutions matter for economic growth because they shape the incentives of key
economic actors in society. They influence investments in physical and human capital,
technology, and the organization of production. Differences in economic institutions are the
major source of cross-country differences in economic growth and prosperity.
Economic institutions determine the aggregate economic growth potential of the economy,
and also an array of economic outcomes, including the distribution of resources in the future.

2.
Economic institutions are endogenous. They are determined as collective choices of the
society. Different economic institutions lead to different distributions of resources. There will
typically be a conflict of interest among various groups and individuals over the choice of
economic institutions. Equilibrium economic institution depends on the political power.

3.
Commitment problems inherent in the use of political power. Individuals who have political
power cannot commit not to use it in their best interests, and this commitment problem
creates an inseparability between efficiency and distribution because credible compensating
transfers and side-payments cannot be made to offset the distributional consequences of any
particular set of economic institutions.

4.
The distribution of political power in society is also endogenous. De jure (institutional)
political power originates from the political institutions in society. Political institutions
determine the constraints on and the incentives of key actors in the political sphere.

5.
De facto political power refers to a group of individuals, even if they are not allocated power
by political institutions, possess political power. It has two sources. First, it depends on the
ability of the group in question to solve its collective action problem, to ensure that people
act together even when any individual may have an incentive to free ride. Second, the de
factor power of a group depends on its economic resources, which determine both their
ability to use (or misuse) existing political institutions and also their option to hire and use
force against different groups.

6.
A natural concept of a hierarchy of institutions, with political institutions influencing
equilibrium economic institutions, which then determines economic outcomes. Political
institutions are collective choices. Political institutions allocate de jure political power, and
those who hold political power influence the evolution of political institutions, and they will
generally opt to maintain the political institutions that give them political power. De facto
political power occasionally creates changes in political institutions.
7.

Two sources of persistence in the behaviour of the system. First, political institutions are
durable, and typically a sufficiently large change in the distribution of political power is
necessary to cause a change in political institutions. Second, when a particular group is rich
relative to others, this will increase its de facto political power and enable it to push for
economic and political institutions favourable to its interests. This will tend to reproduce the
initial relative wealth disparity in the future.
Despite these, the framework also emphasizes the potential for change. “Shocks”, including
changes in technologies and the international environment, that modify the balance of (de
facto) political power in society can lead to major changes in political institutions and
therefore in economic institutions and economic growth.

First Fundamental Cause: Economic Institutions

The structure of markets is endogenous, and partly determined by property rights. Once
individuals have secure property rights and there is equality of opportunity, the incentives
will exist to create and improve markets (although achieving perfect markets would be
typically impossible). We expect differences in markets to be an outcome of differing systems
of property rights and political institutions, not unalterable characteristics responsible for
cross-country differences in economic performance.

Second Fundamental Cause: Geography

First, climate. Second, geography may determine the technology available to a society,
especially in agriculture. Third, geography links poverty in many areas of the world to their
“disease burden”.

Third Fundamental Cause: Culture

Different societies have different cultures, because of different shared experiences or
different religions. Culture is viewed as a key determinant of the values, preferences and
beliefs of individuals and societies, and these differences play a key role in shaping economic
performance. Culture thought to influence equilibrium outcomes for a given set of institutions.
Differences in culture mean that different societies will coordinate on different equilibria.

The Reversal of Fortune among Former Colonies

Relatively rich places got relatively worse economic institutions, and if these institutions are
important, we should see them become relatively poor over time. Economic institutions
should become more important when there are major new investment opportunities.
Countries that are rich today are those that industrialised successfully during this critical
period.
Second-Best Institutions

Developing nations are different from advanced countries in that they face greater challenges
and more constraints.
A focus on best-practice institutions can create blind spots, leading to overlook reforms that
might achieve the desired ends at lower cost, but can also backfire.

Courts and Contract Enforcement

Although there are commercial laws that govern the settlement of contractual disputes,
courts are highly inefficient, costly to use, and potentially corruptible. Lacking legal recourse,
firms resort to relational contracting. They build long-term, personalized relationships with
their suppliers or consumers, and sustain cooperation through repeated interaction. They
screen potential business partners by gathering information about them, inspect goods on
delivery prior to payment, and are often willing to negotiate when contract terms are not
fulfilled.
An effort to strengthen judicial (third-party) enforcement can easily do more harm than good
in the presence of relational contracting.
Perhaps more effective to enhance relational contracting than to invest in first-class legal
institutions (at the current stage of a country’s development at least).

Entry Regulations and Entrepreneurship

Entry costs may be high, property rights may not be well protected, contracting environment
may be poor, or the perceived returns may be low.
A moderate amount of entry restrictions helps because foregone efficiency gains are more
than offset by improvements in dynamic incentives.
A single-minded effort to reduce entry regulations may not only fail to produce the intended
effects, it may also backfire when the binding constraint is expected returns that are too small
rather than inadequate competition. Appropriate reform strategy requires having a good fix
on the binding constraint.

Import Liberalisation and Global Integration

Alternative paths to global integration is they generate supply incentives at the margin for
new tradeable activities, without removing protection for existing activities.
The Asian model of liberalization protects employment in the transition to the new long-run
equilibrium. When new export-oriented activities are slow to arise – due either to overvalued
exchange rates or to market failures that hinder supply incentives for nontraditional products
– import liberalisation may result in workers in previously protected industries being
displaced and transferred into even less productive activities such as the informal sector or
unemployment.
The sequential, marginal nature of the Asian model of liberalisation blunts the adverse impact
on the firms in import-competing sectors and therefore removes an important obstacle to
trade reform.
A particular economic objective (outward orientation) can be achieved through a number of
different institutional designs, and sometimes worth doing things in an unorthodox,
roundabout way if this serves to relax other constraints elsewhere in the system.
Credibility of Monetary Policy and Economic Performance
The spread of independent central banks operating under strict rules. Central bank
independence removes monetary policy from the day-to-day control of politicians, and
therefore enhances credibility of anti-inflationary policies. Along with improved fiscal policies,
macroeconomic stability returned to economies suffering from high inflation.
But very difficult to get the central bank to respond to currency concerns when it has been
locked into a price-stability objective and when its responsiveness to the government has
been diminished through independence.
Institutional rigidity pays off when lack of credibility and time inconsistency are the main
problems of the day, but can eventually become a drag on growth. No single set of best
practices will serve the needs of all countries at all times.

Integration of Trade and Disintegration of Production

The disintegration of production itself leads to more trade, as intermediate inputs cross
borders several times during the manufacturing process.

Outsourcing has a qualitatively similar effect on reducing the demand for unskilled relative to
skilled labour within an industry as does skill-based technological change.

Outsourcing activity move factor prices towards greater equality, same as the movement of
factor between countries. The position of low-skilled workers in the industrial countries is
worsened by the complementary combination of globalisation and new technology.

Strategy: the actions that managers take to attain the goals of the firm
Profitability = net profits of firm / total invested capital
Profit Growth = % increase in net profits over time
Primary Activities: related to the design, creation, and delivery of the product, its marketing,
and its support and after-sale service.
Support Activities: provide inputs that allow the primary activities to occur

Firms that Operate Internationally

1. Expand the market for their domestic product offerings by selling those products in
international markets
2. Realise location economies by dispersing individual value creation activities to those
locations around the globe where they can be performed most efficiently and effectively
3. Realise greater cost economies from experience effects by serving an expanded global
market from a central location, thereby reducing the costs of value creation
4. Earn a greater return by leveraging any valuable skills developed in foreign operations and
transferring them to other entities within the firm’s global network of operations

Core Competence: skills within the firm that competitors cannot easily match or imitate, may
exist in any of the firm’s competitive advantage, they enable a firm to reduce the costs of
value creation and/or to create perceived value in such a way that premium pricing is possible

Location Economies: the firm will benefit by basing each value creation activity it performs at
that location where economic, political, and cultural conditions, including relative factor costs,
are most conducive to its performance; economies that arise from performing a value
creation activity in the optimal location for that activity
Can lower the costs of value creation and help the firm achieve a low-cost position (lower C)
and/or can enable the firm to differentiate its product offering form those of competitors
(increase V), both of which boost profitability
Creating a Global Web of Value-Creation Activities: dispersing different stages of the value
chain to those locations around the globe where perceived value is maximized or where the
costs of value creation are minimised

Theoretically, a firm that realises location economies should have a competitive advantage.
It should be able to better differentiate its product offering (raising perceived value V) and
lower its cost structure (C) than its single-location competitor.

Leveraging Subsidiary Skills

Pressures for Cost Reduction:

Particularly in industries producing commodity-type products where meaningful
differentiation on non-price factors is difficult and price is the main competitive weapon.
Usually for products that serve universal needs, exists when the tastes and preferences of
consumers in different nations are similar if not identical.

Pressures for Local Responsiveness:

Differences in customer tastes and preferences
Differences in infrastructure and traditional practices
Differences in distribution channels
Host government demands

Global Standardisation Strategy:

Focus on increasing profitability and profit growth by reaping the cost reductions that come
from economies of scale, learning effects, and location economies.
Their strategic goal is to pursue a low-cost strategy on a global scale.
Firms try not to customize their product offering and market strategy to local conditions
because customization involves shorter production runs and the duplication of function that
tend to raise costs. They prefer to market a standardized product worldwide so that they can
reap the maximum benefits from economies of scale and learning effects. They tend to use
their cost advantage to support aggressive pricing in world markets.
Strategy makes most sense when there are strong pressures for cost reductions and minimal
demands for local responsiveness.

Localisation Strategy:
Focus on increasing profitability by customizing the firm’s goods or services so they provide a
good match to tastes and preferences in different national markets.
Most appropriate where consumer tastes and preferences differ substantially across nations
and cost pressures are not too intense.
By customizing the product offering to local demands, the firm increases the value of that
product in the local market.
But because it involves some duplication of functions and smaller production runs,
customization limits the ability of the firm to capture the cost reductions associated with
mass-producing a standardized product for global consumption.
If the added value associated with local customization supports higher pricing, which enables
the firm to recoup its higher costs, or if it leads to substantially greater local demand, enabling
the firm to reduce costs through the attainment of some scale economies in the local market.

Transnational Strategy:
Firms trying to simultaneously achieve low costs through location economies, economies of
scale, and learning effects, differentiate their product offering across geographic markets to
account for local differences, and foster a multidirectional flow of skills between different
subsidiaries in the firm’s global network of operations.
Differentiating the product to respond to local demands in different geographic markets
raises costs, which runs counter to the goal of reducing costs.
Not an easy strategy since it places conflicting demands on the company.

International Strategy:
Taking products first produced for their domestic market and selling them internationally with
only minimal local customization.
Many such firms are selling a product that serves universal needs, but they do not face
significant competitors. Unlike firms pursuing a global standardization strategy, they are not
confronted with pressures to reduce their cost structure.
Firms tend to centralize product development functions e.g. R&D at home, manufacturing
and marketing functions in each major country or geographic region in which they do business.
The resulting duplication can raise costs, but less of an issue if the firm does not face strong
pressures for cost reductions. Local customization of product offering and marketing strategy
rather limited in scope. Head office retains fairly tight control over marketing and product
strategy.

Organisation

Organisational Structure
1. Vertical Differentiation: the location of decision-making responsibilities within a structure,
centralization/decentralization
2. Horizontal Differentiation: the formal division of the organisation into subunits
3. Integrating Mechanisms: mechanisms for coordinating subunits, strategy and coordination,
formal integrating mechanisms, informal integrating mechanisms: knowledge networks
transmit information within an organization that is based not on formal organization
structure, but on informal contacts between managers within an enterprise and on
distributed information systems

Competition did not drive badly managed firms out of the market because the inability to
delegate decisions away from the owners of the firm impeded the growth of more efficient
firms and thereby, interfirm reallocation. Firms had not adopted these management practices
before because of informational constraints. For many of the more widespread practices,
they had heard of them before but were skeptical of their impact. For less common
management practices, they simply had not heard of them.

Entry Strategy

Which Foreign Markets

Value depends on the suitability of its product offering to that market and the nature of
indigenous competition. Greater value translates into an ability to charge higher prices or to
build sales value more rapidly.

Timing of Entry
First-mover advantages, Pioneering costs

Scale of Entry and Strategic Commitments

Strategic Commitments: the consequences of entering on a significant scale – entering rapidly,
has a long-term impact and difficult to reverse

The large-scale entrant is more likely than the small-scale entrant to be able to capture first-
mover advantages associated with demand preemption, economies of scale, and switching
costs.
Small-scale entry helps gather information about a foreign market before deciding whether
to enter on a significant scale and how best to enter.
But the lack of commitment associated with small-scale entry may make it more difficult to
build market share and to capture first-mover or early-mover advantages.
The risk-averse firm that enters a foreign market on a small scale may limit its potential losses,
but it may also miss the chance to capture first-mover advantages.

Having improved its performance through learning and differentiated its product offering, the
firm from a developing nation may then be able to pursue its own international expansion
strategy. Although the firm may be a late entrant into many countries, by benchmarking and
then differentiating itself from early movers in global markets, the firm from the developing
nation may still be able to build a strong international business presence.

Technological Know-How
If a firm’s advantage (its core competency) is based on control over proprietary technological
know-how, it should avoid licensing and join-venture arrangements to minimise the risk of
losing control over that technology.

Management Know-How
The risk of losing control over the management skills to franchisees or joint-venture partners
is not that great. These firms’ valuable asset is their brand name, generally well protected by
international laws pertaining to trademarks.
Most service firms have found that joint ventures with local partners work best for controlling
subsidiaries. A joint venture is often politically more acceptable and brings a degree of local
knowledge to the subsidiary.

Wholly-Owned Subsidiary
By building a subsidiary from the ground up called greenfield strategy, or by acquiring an
enterprise in the target market

Acquisitions:
Quick to execute.
Preempt competitors.
Believed less risky than greenfield ventures.
Often overpay for the assets of the acquired firm.
A clash between the cultures of the acquiring and acquired firms.
Inadequate preacquisition screening.

Greenfield Ventures:
Gives the firm a much greater ability to build the kind of subsidiary company that it wants.
Less potential for unpleasant surprises.
Slower to establish.
May be preempted by more aggressive global competitors that enter via acquisitions and
build a big market presence that limits the market potential for the greenfield venture.

If the firm is seeking to enter a market in which there are already well-established incumbent
enterprises, and in which global competitors are also interested in establishing a presence,
then acquisition.
If the firm is considering entering a country in which there are no incumbent competitors to
be acquired, then greenfield. Even if incumbents exist, but the competitive advantage of the
firm is based on the transfer of organizationally embedded competencies, skills, routines, and
culture, greenfield.
Things such as skills and organizational culture, based on significant knowledge that is difficult
to articulate and codify, are much easier to embed in a new venture than in an acquired entity
(where the firm may have to overcome the established routines and culture of the acquired
firm).

Product market competition has critical influence in increasing aggregate management

quality by thinning the ranks of the badly managed and incentivizing the survivors to improve.
Taxes and other distortive policies that favour family-run firms appear to hinder better
management, while general education and multinational presence seem valuable in
improving management practices.