Prepared for Principles of Economics, University of the West Indies, Mona. © Damien King, December 2014.

Perhaps the most important, and difficult, question in economics is,

why are some countries rich and others poor? Living standards are
usually compared by using the total annual production of goods
and services in a country, known as gross domestic product or GDP,
and dividing it by the population to get GDP per capita. This gives a
rough idea of the average amount of product that each person has
to live on. While Somalia has an annual GDP per capita of around
US$600, the figure for Botswana is just over US$7,000, and for
Singapore it is almost US$44,000.

The rate at which the GDP of a country increases from one year to
the next is referred to as its rate of economic growth. Since
Botswana
Botswana and Singapore had similar standards of living a half
century ago, Singapore’s much higher current GDP per capita must
have come about because its economic growth rate was higher than
Singapore Botswana’s. So when we ask the question, why are some countries
richer than others, we are really asking why have some countries
managed to have higher rates of economic growth than others?
Thailand
A remarkable economic fact about the world is the variety of
Kenya growth experiences. While much of Europe and North America
enjoyed sustained economic growth over the last 250 years, large
Mexico parts of the rest of the world – in Latin America and the Caribbean,
Portugal Africa, and Asia – experienced much lower rates of economic
growth, if any at all. By the middle of the last century, these
Barbados
hopefully-designated “developing countries” lagged far behind
their more prosperous northern counterparts.
Jamaica
Over the last half century, rates of economic growth have varied
greatly, not only across countries at any particular time, but also in
the same countries at different points in time. While Jamaica, for
1960 1970 1980 1990 2000 2010 example, has recently been growing at a meagre annual average of
less than 1 percent, Portugal has managed more than 3 percent,
Figure 1: GDP Index (log scale)
Brazil over 4 percent, and Thailand an impressive 6 percent. Figure
1 highlights these differences by comparing how GDP has grown for
a sampling of countries (scaling their 1960 levels so it seems as if
they are starting at the same level.)

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The Importance of Growth
The rate of economic growth is important, not only because growth
raises the material standard of living of a country’s citizens, but
also because many other indicators of well-being improve with
higher levels of GDP. As GDP per capita rises in a country, the
health of its citizens tends to improve – the incidence of disease
falls, infant and child mortality declines, and life expectancy rises.
In addition, on average, the incomes of the poor rise
proportionately with growth of GDP.1

Growth can make a big difference in a short time. When Ireland

was growing at near 9 percent per annum between 1995 and 2007,
it went from being one of the poorest countries in the European
Union to one of the wealthiest. Growth at that rate doubles the
national income in only eight years!

Even small differences in economic growth rates accumulate

rapidly over time to make a big difference in standards of living.
The difference between one and two percent annual growth yields
a 22 percent difference in national income levels after only 20
years.

So, economic growth is of great importance, both quantitatively and

qualitatively. What accounts for the vast differences we observe in
growth and prosperity amongst countries?

PRODUCTIVITY
How well off the residents of a country are, that is, how high an
income level they have on average, is directly related to the amount
of goods and services that the country produces. The amount of
production, in turn, is determined by the productivity of the
residents. Productivity refers to output per working person. Since,
an unskilled, single person without tools of any kind living on a
bare landscape can produce very little, raising such a person’s
productivity requires enhancing his natural ability – with tools and
skills, with ideas, and with facilitating institutions.

2

Kalahari labour with capital
The Role of Capital
One of the most obvious ways in which productivity can be raised is
with the use of tools. From the poison tipped spear to the voice
activated smartphone, tools allow a worker to create more output
than could have been produced with a pair of bare hands. A hunter
can kill more prey with a poison tipped spear than without one;
and can kill more with two spears than with one. Up to a point,
each additional spear carried by the hunter raises his productivity
in making kills. In a similar manner, being able to instruct your
phone or your computer with a voice request allows the user to
accomplish more than having to enter all instructions with a
keyboard or even with a touch screen.
Much of the wealth of modern societies, compared to that of our
ancestors, rests on the higher productivity afforded by large stocks
of capital. Look around you and you will see the buildings, vehicles,
machinery, appliances, tools, and computers that are part of that
stock. Included also in the stock of capital is the public
infrastructure – roads, bridges, airports, electricity grids, and water
pipelines. This capital allows each person to be more productive at
manufacturing goods, producing services, and transporting
commodities than would be possible without it.
Amongst countries today, there are vast differences in the amount
of capital that each has accumulated, especially when represented
on a per person basis. It’s obvious, even to the casual observer, that
Germany has more capital per person than Colombia, which in turn
has more than Niger. Further, these differences in stocks of capital
are broadly consistent with levels of income. The greater the stock
of capital, the richer the country seems to be.
There is another kind of capital that equally well has the power to
make a pair of hands more productive – knowledge and skills. The
various skills that people learn increase their capacity to produce.
Expert machete wielders cut coconuts faster; trained pianists play
better; skilled seamstresses make more dresses. In this way, the
collection of skills embedded in a country’s labour force is a factor
in determining that country’s productivity and standard of living.
Knowledge and skills are often complementary to physical capital.
Knowing how to drive a car is more useful if one actually has a car.
At the same time, having the car is not of much use if no one
around knows how to drive it. In this way, the combination of
physical and human capital raises productivity by a greater amount
than the two types of capital working separately.
Capital, whether in the form of the poison tipped spears of
Namibia’s San, the towering 452 meters of the Petronas Towers in
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 Indonesia, or the deft skills of the master brewers at Presidente in
the Dominican Republic, is an important determinant of
productivity. Differences in the size of their capital stocks, physical
and human, are therefore a key element in understanding why
some countries’ residents can produce greater wealth than others.
We will come to why these differences may have arisen later in this
chapter.

The Role of Technology

The production of any good or service can be accomplished in a
variety of ways, that is to say, with a variety of technologies. These
different technologies, with a given amount of labour and capital,
will yield different amounts of output. In other words, the different
technologies can raise or lower the productivity of the labour and
capital at hand.

An example of how the mere organization of production can make

a difference to productivity comes from one of the most famous
passages in the history of economics. Adam Smith, writing in The
Wealth of Nations in 1776, describes the manufacture of pins.

[A] workman… could scarce, perhaps, with his utmost industry, make
one pin in a day… . But in the way in which this business is now
carried on…, not only the whole work is a peculiar trade, but it is
divided into a number of branches, of which the greater part are
likewise peculiar trades.

One man draws out the wire, another straights it, a third cuts it, a
fourth points it, a fifth grinds it at the top for receiving the head; to
make the head requires two or three distinct operations; to put it on,
is a peculiar business, to whiten the pins is another; it is even a trade
by itself to put them into the paper; and the important business of
making a pin is, in this manner, divided into about eighteen distinct
operations.

I have seen a small manufactory of this kind where ten men only
were employed…. But though they were very poor, and therefore but
Adam Smith indifferently accommodated with the necessary machinery, they
could… make among them… upwards of forty-eight thousand pins in
a day. Each person, therefore…, might be considered as making four
thousand eight hundred pins in a day. But if they had all wrought
separately and independently…, they certainly could not each of them
have made twenty, perhaps not one pin in a day.

Smith compares two technologies for pin making, and comes to the
conclusion that the one in which each worker specializes in only a
small part of the pin making process results in a considerable
increase in productivity.

4

Institutions
The laws, regulations, and unwritten
codes of conduct that govern
economic activity.
Hapi IV, King of Bana, Cameroon
We are accustomed to thinking of advances in technology in terms
of gadgets of increasing sophistication, such as the technology of
computers. But Adam Smith’s example reveals that a more
advanced technology of production does not require that the
underlying idea be embedded in new hardware. Indeed, it is useful
to separate the contribution of more advanced machinery into
separate components – the underlying idea and the capital to
embody it, each making its distinct contribution to productivity.
The impressive increases in living standards that has occurred in
many parts of the world since the industrial revolution began in
England in the late 18th century is due to continuous changes in the
technology of production which has raised productivity. The
inventions of the steam engine, electricity, the assembly line, and
the internet have all contributed to boosting productivity and
therefore afforded higher living standards.
The Role of Institutions
Any particular stock of capital, in the presence of whatever is the
prevailing technology of production, may produce either a smaller
or a larger quantity of output depending on the presence of
restrictions on commercial activity. Wherever people go about their
economic activities, they are governed by laws, rules, and customs.
These constitute the institutional framework within which work,
production, and trade occur, and may either constrain or facilitate
the respective activities.
Gender roles in Saudi Arabia originate from a strict Sunni form of
Islamic tradition known as the way of the Salaf. As a consequence
of this, women are effectively prohibited from driving cars. This
restriction reduces the commercial productivity of half of the
labour force. In the United Kingdom, investigative reporting has
revealed that job applicants with identifiable non-white names,
despite resumes that revealed that the candidate was born and
raised in the UK, had greater difficulty securing interviews.2 The
pervasiveness of such a prejudice, which results in economic
opportunities being offered on bases other than strict merit,
reduces the productivity of the labour force. These are ways in
which the institutional environment can affect productivity.
The effect of institutions on productivity can take many forms: an
independent central bank can better maintain the value of the
currency, and stable currency increases confidence in the future; a
government that engages in arbitrary property seizures diminishes
the incentive to invest and get rich; a slow and a corrupt justice
system makes all economic participants reluctant to enter into
contractual arrangements.
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The institutional environment relevant to economic activity can
originate in a nation’s culture or dominant religion, its legal and
regulatory codes, or simply the habits and norms of its people. The
source of Saudi Arabia’s disapproval of women’s driving is
religious; legislation determines the rules governing the treatment
of insolvent companies; unwritten norms and habits determine that
citizens from one social group may not be allowed to mix socially or
even commercially with others.

The varied experience with economic growth in many countries

has revealed the importance of particular institutional elements. An
emerging consensus on the institutions that are good for economic
growth includes the following.

• Secure property rights

• Impartial enforcement of the rule of law
• Merit-based allocation of economic opportunities
• Independent, speedy justice system
• Constitutional limits to the arbitrary exercise of power
• An independent, competent central bank
• Social safety nets and channels for economic inclusion
These institutions are important because they influence the ability
and the incentive of citizens to work, invest, and innovate and in so
doing influence the country’s rate of economic growth. Prohibitions
that underutilize a portion of the population reduce its productivity
and constrain investment opportunities. Insecurity of property
rights reduces the incentive to invest in and accumulate property.
Many wealth-creating opportunities depend on the ability to
enforce contractual obligations over long periods of time. Poor
monetary policy can result in high inflation which undermines
efficiency and increases uncertainty.

A set of simple, stable rules that facilitates and protects the pursuit
and ownership of wealth is therefore key to prosperity. In the
absence of such rules, investment in physical and human capital
will be retarded and so not all wealth creating opportunities would
be exploited. The incentive to bring improved technology to
commerce will be diminished. Prosperity is best achieved when
people are allowed to pursue their material desires without fear
that the fruits of their efforts will confiscated, nationalized, stolen,
frowned upon, or undermined by arbitrary change of regulation,
directive, or subsidy.

The stock of capital, the technology of production, and the

institutional framework all contribute to the high levels of
productivity that are observed in the wealthiest countries in the
world. But each of those factors contributes to economic growth in

6
different ways and those differences are important to
understanding why some countries are rich while others are poor.
It is to those differences that we now turn.

CAPITAL INVESTMENT
The greater the stock of capital, the more productive each worker
will be and therefore the larger will be the amount of output
produced. Growth of output can therefore be accomplished by
adding to the country’s stock of capital, which can be achieved by
investing in new equipment, structures, knowledge, and skills. How
can investment rates be raised so that everyone can have more
capital? We know that savings provides the resources from which
investment occur. so everyone should save more. To understand
the full consequence of saving more, though, we must first recall an
important property of factor use.

Diminishing Returns to Capital

Recall that the idea of diminishing returns suggests that, if all other
contributing factors are fixed in amount, increasing only one factor
will eventually yield smaller benefits. This basic idea, which applies
to the consumption of ice cream on a hot day as well as to the use of
labourers when clearing a field using a limited supply of machetes,
applies just as well to a country’s investments in capital in the
presence of a given population size.

The paving of roads in a country with few paved roadways to begin

with will facilitate the transportation of goods and people greatly
and stimulate commerce. Road construction is one of the easiest
ways for a government in an impoverished country or region to
encourage some growth. Roads reduce the cost of transporting
workers and raw materials to the factory or farm and finished
goods to markets.

Once most of the arteries within and between cities, towns and
villages are paved, however, additional road construction stimulate
nearly as much new commercial activity. Indeed, after a point,
additional roads will hardly have cars on them. The road network
will allow the country to become much wealthier. But later
additions to the road network, even if still adding to a country’s
productivity, will have a smaller effect than the initial investment.

Additions to capital, therefore, will eventually exhaust the ability of

other factors to make use of it, as long as there is a limit to the
availability of other factors. The size of the potential labour force is
one such limit, but the set of particular skills within that labour is
limiting factor as well. Machine operators are limited in supply, as
is computer-literate call centre workers and managerial talent.

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Each of these limits implies that after a while, adding more
machines, computers, or offices becomes less economically
beneficial.

While these examples apply to additional investment in the same

type of capital, whether roads or machines, diminishing returns
will apply even when considering investment across different types
of capital. When comparing different types of capital, investment
will naturally flow first into the projects with the highest returns.
Once those opportunities are exploited, though, later investments
necessarily are left with projects that yield a lower return. In this
way, additional investment necessarily yields lower returns in an
economy at any point in time.

The Effect of Diminishing Returns

The most straight-forward way for the citizens of a country to
become wealthy is to save. Savings increases investment and
investment in turn increases the stock of physical and human
capital that can produce a larger amount of goods and services in
the future.

Savings rates differ greatly around the world. Whereas Brazilians

save only 7 percent of their total production, in India, by contrast,
nearly 35 percent of income is set aside for the future.3 That high
savings rate is fueling the expansion of productive capacity in India
without the need for Indians to borrow internationally to fund the
investment.

While investment funded by high savings is an easy way to increase

wealth, however, it cannot be the source of continuous high growth
rates, and this is due to diminishing returns. A country can save a
set amount of its income each period, and those savings can build
and manufacture and educate so that the capital stock grows, but
the amount of additional goods and services that will be produced
by that capital will, after some point, start to diminish.

The Soviet Union – the federation of Russia and several nearby

states that existed for much of the 20th century – provided a natural
experiment in both the power and limit of capital accumulation. A
communist country, the Soviet Union employed central planning of
almost all production with a prohibition on private ownership of
productive resources. Because of central control of production and
wages, the Soviet government in the early part of the 20th century
extracted extremely high rates of savings from the population
which it invested massively in infrastructure and heavy industry.
Industrial capacity expanded rapidly and spurred economic growth
that transformed the country from a poor, largely agricultural

8
 producer to industrial and military might. At its peak in the 1950s,
the economy grew at nearly six percent per year.
5.8 The problem was that, without private ownership of productive
resources, there was no incentive for managers to invest in new
technology, so adding capital was the only source of growth. And
after a while, diminishing returns set in. Figure 2 shows how the
3.0 growth rate declined every decade right up until the collapse of the
regime in 1989.4
2.1
1.4 Saving and investment, therefore, eventually become subject to
diminishing returns. The paving of roads, training in vocational
skills, and other capital investments can have a dramatic effect on
1950s 1960s 1970s 1980s the wealth of a country, but such investments eventually begin to
have only a small, incremental effect on the economy’s total
Figure 2: Annual Average Growth Rate,
Soviet Union production. Indeed, by itself, high levels of savings could eventually
cease to have any effect on growth at all. If the returns to
investment become sufficiently low, even though still positive,
savings may be directed to higher-yielding investments abroad or,
as we will now see, investment may be sufficient only to replace
worn-out capital .

The Effect of Depreciation

Depreciation of Capital
The reduction in the productive value
of capital over time, usually due wear
and tear.
Diminishing returns is not the only reason why capital investment
alone cannot sustain high growth rates indefinitely. Depreciation
plays an important role, too. Physical capital often deteriorates with
use. Moving parts wear out; paint gets dirty and strips; breakable
items break. The cost of maintenance and repair to keep capital
working like new is referred to as depreciation.

Different types of capital may depreciate at different rates.

Machinery with lots of moving parts wears out relatively quickly;
concrete and brick buildings depreciate much more slowly. Skills
usually don’t depreciate at all, except that some knowledge based
skills may become less current and therefore less useful without re-
training.

The tendency of most forms of capital to require repairs and

maintenance further reduces the likelihood that saving and capital
investment can produce endless economic growth. The larger is the
stock of buildings and equipment, the greater is the need for and
the cost of maintenance. Indeed, the cost of depreciation should rise
proportionately with the stock of capital.

If the cost of maintenance and repairs keeps getting larger, an

increasing amount of savings has to be devoted to keeping capital
running or simply replacing machinery that is beyond repair,
Depreciated Capital leaving less savings left over to expand the stock of capital. With a

9
sufficiently large capital stock, repairs and maintenance will use up
all savings and no further expansion of capital will occur. In
addition to the effect of diminishing returns, therefore,
depreciation is another reason why saving and investment cannot
be the source of endless economic growth.

Foreign Direct Investment

The level of savings is not the only determinant of the amount of
investment in an economy. There is a loophole to the constraint
imposed by the level of domestic savings – foreigners may want to
use their own savings to make investments in your economy.
Foreign direct investment (FDI) refers to investment by foreigners
in productive capacity in the local economy.

BP of Britain extracts crude oil in Saudi Arabia; India’s Bharti Airtel

delivers mobile services in Congo; France’s Total retails petrol in
Columbia. Little of the funding for these investments drew upon the
pool of local savings. For this reason, many governments try to
attract foreign investment to break the constraint upon growth
imposed by limited local savings.

The foreign source of the investment does not, however, exempt it

from the imperative of diminishing returns. Even foreign
investment is constrained by the limited supply of local labour and
other factors. And, like domestic investment, FDI will try to enter
the most lucrative industries first. Both of those considerations will
ensure that returns to investment will gradually fall if there is no
other economic stimulant.

Saving and investing can, therefore, make a country rich, but it

cannot sustain a continuously high rate of economic growth. After a
while, diminishing returns and rising depreciation combine to
throttle the boost that investing in capital alone can provide. If we
want to understand how Europe and North America has been able
to maintain at least moderate rates of economic growth for more
than two centuries, we will have to look elsewhere.

INNOVATION AND INSTITUTIONAL REFORM

Simply saving more and waiting for the fruit of the resulting
investment seems not to yield the key to sustained economic
growth that we seek. But there remain two other explanations of
productivity differences – technology and institutions – to be
investigated as potential sources of economic growth

10
 The Effect of Innovation
Adam Smith’s visit to a pin factory demonstrated that the way in
which production is carried out – the technology of production –
influences the productivity of the capital and labour used.
Economic growth may therefore arise from seeking and
implementing new and better ways of producing goods and
services, that is, by innovating.

Innovation stimulates economic growth in a many different ways.

First, the innovation, whether it is a farm’s irrigation method or
supermarket’s barcode scanner, directly raises the productivity of
the workers and the capital. The farmer’s yields will rise and the
shop owner’s cashier will process more customers. So the
innovation will produce a burst of economic growth as it spreads
throughout the economy.

The greater output and incomes that are produced by the

innovation will also allow people to save more. The availability of
more savings will stimulate additional investment, either because
banks will be eager to lend it out or because government may tax
some of it to provide better roads and utilities. Moreover, the
innovation itself is often embedded in hardware and so requires
additional capital spending. In this way, the adoption of a new
technology permits and stimulates new investment which expands
the country’s productive capacity. As productive capacity grows
over time, the effect that a new technology has on economic growth
is extended beyond the immediate productivity boost that came
directly from the innovation. The effect is not indefinite, though,
since the larger stock of capital both diminishes the return to
further investment and raises the provision for depreciation.

Another reason why a single innovation may have a long lasting

effect is that new ideas can themselves stimulate even newer ones.
When 17th century scientist Sir Isaac Newton credited his
considerable achievements to him having stood “on the shoulders
of giants,” he was referring to a peculiar characteristic of ideas.
Knowledge of elementary ideas facilitates discovery of more
complex ones. Knowledge of the ideas in Karl Benz’s 1885
motowagen were a key element in the design improvements that
have occurred in automobiles since then.

Since the growth in output that comes from both the boost to
Karl Benz’s motowagen
productivity and from the additional investment in capital tends to
peter out after a while, a sustained rate of economic growth
requires a constant stream of innovation. The levels of productivity
in the developed economies of Europe and North America and in
the more successful once developing ones such as South Korea and
Singapore are due to a relentless ability to continually implement

11
better ways of producing. Many production techniques now being
employed in the most advanced factories and farms around the
world were unheard of 20 years ago, some even 10 years ago.

Sources of Innovation
With new ideas playing such an important role in economic
growth, you may be wondering where new ideas come from. There
are two possibilities. In the most technologically advanced
countries, new ideas have to be invented. While some inventions
are accidental, for the most part researchers have to choose to
devote time and effort to the specific goal of coming up with a new
technology. The more resources that are devoted to research and
development rather than to the production of goods and services,
the more new ideas will be discovered and the faster technology
will improve.

Most countries in the world have another option for improving

their technology of production. Any country that is not itself at the
forefront of technology, such as developing or emerging economies,
can simply copy the technology of the more advanced ones.
Trinidad & Tobago extracts oil from the southern part of the
country using sophisticated drilling technology that it did not itself
invent. Nor did it need to. It could copy the technology by importing
the appropriate machinery and investing in the training in the
technical knowledge required to operate it.

In most cases, it is cheaper and faster for countries to adopt and

adapt the technology of other, more advanced countries than it is to
engage in the research and development necessary to re-invent it
for itself. Technology transfers can occur by mimicking the
processes of more advanced firms, by importing the capital
equipment that embodies the technology, or by foreign investors
bringing the company’s technology with them when they set up
business in the local economy.

Since copying technology is cheaper and faster than discovering or

inventing it, technological laggards have the potential for faster
growth than technological leaders. This is an important factor
limiting the rate of growth in the world’s richest countries. Growth
rates higher than eight percent are unheard of in the most
advanced countries; yet, more than two dozen developing and
emerging economies have managed that feat in recent years.

Most of this commercial innovation is carried out by entrepreneurs

seeking to profit from it. While universities and publicly-funded
institutes do a fair amount of research, it is the likes of Apple in the
United States, Tata in India, Cemex in Mexico and their private
sector cohorts throughout the world that do the vast majority of it.

12
And it is done for the same reason they established their businesses
in the first place – the pursuit of profit.

The Effect of Institutional Reform

The decision to invest or innovate is motivated by the incentive of
the expected return relative to the risk involved in making the
required financial commitment. We noted above that a country’s
rules of economic engagement, its institutions, affect both the
return and the risk. If those institutions change in ways that
facilitate or incentivize economic activity, therefore, the economy
will grow as investors and innovators move to take advantage of
the new opportunities opened up by the reform. The nature and
strength of institutions is the main determinant of prosperity and
positive institutional change is the surest way to promote economic
growth.

The institutions that are important for economic activity, whether

strong or weak, good or bad, tend to be persistent over long periods
of time. Countries with weak rule of law one decade tend to still
have it the next. Most of those with secure property rights now
have enjoyed it for a long time, in some cases, for over a century.

Because of this persistence, the quality and character of a country’s

institutions are difficult to change. For example, the respect for
constitutional authority is derived from decades of peaceful
constitutional changes of power. Without that history, usurpers
may seek any opportunity to overthrow an elected government
with a reasonable expectation that the society will tolerate such a
transition.

The persistence of economic institutions is because they are the

outcomes of political institutions which themselves derive from the
distribution of political power. Whatever is the source of that
power in each society, whether it is resources, culture, or military,
it tends to have permanence.

Moreover, every existing set of rules and circumstances will have a

class of persons who benefit from that situation and have become
powerful within that context. That is to say, every institutional
arrangement, however impoverishing, will have its vested interests.
Those persons therefore represent a class of interests that will
resist institutional change.

Effecting Institutional Change

Despite the persistence of the economically relevant institutions,
change does occasionally occur and produce dramatic economic
results. Witness the impressive growth of Singapore after 1970 and

13

Manmohan Singh, Minister of Finance in
India, 1991 (and later, Prime Minister).
China after 1990. How, then, does a country’s institutional
framework for economic activity change?
Revolutionary change can sweep old institutional structures and
permit radical change in the rules governing economic activity. The
Cuban revolution of 1959, which all but eliminated private
property, and the collapse of communism in Russia under the
Soviet Union in 1991, which introduced private property, both
exemplify revolutionary change, albeit in opposite directions.
Occasionally, a confluence of propitious political economy forces
and effective leadership can bring about institutional reform. India
emerged from a period of economic stagnation and political crisis
in the early 1990s and was able to garner broad support for a series
of reforms that abolished the state monopoly in many sectors and
liberalized the import licensing regime under the guidance of its
finance minister, Manmohan Singh.
In the absence of political accident or social fortune, a few steps can
be taken. Any action that promotes the adoption of or fidelity to the
institutions that facilitate commerce, outlined above, will stimulate
innovation and investment. Any extent to which, therefore, respect
for property rights, the rule of law, impartial justice, and the rest of
the list can be encouraged, and even more, embedded in
constitutional law, will promote higher economic growth.
Without reform, in the presence of institutional obstacles in the
way of investment and innovation, potential surplus savings may
go unsaved or be saved in unproductive ways. People prefer to
“waste” their earnings on consumption rather than make
investments from which they may not be able to enjoy all their
earnings. Innovators turn to less entrepreneurial pursuits or even
migrate. Facilitating institutions is at the root of why some
countries have high rates of investment and innovation, and can
therefore achieve a high standard of living, while many others do
not. And so reform of those institutions is the key to promoting
sustained economic growth.
A MODEL OF ECONOMIC GROWTH
All the considerations articulated above that promote, and limit,
economic growth can be neatly represented on a set of graphs that
were first suggested by the Nobel prize winning economist, Robert
Solow. Here, we can see again the interplay between investment
and depreciation, the need for innovation, and the role of a
facilitating institutional environment. To construct the model, we
first need to introduce the idea of a production function.
14
 The Production Function
A production function relates quantities of inputs, such as the
amount of capital and labour, to the quantity of output that can be
produced by them. If you have capital consisting of 2 sewing
machines, a few long rulers, and a pair of scissors, as well as 80
hours of labour, then the production function can tell you that in
the course of a week you can produce, say, 25 garments.

Since we are interested in the question of economic growth at the

national level, we need a production function for the national
economy. For this reason, our production function won’t vary the
size of the labour force, which is largely determined by the size of
the population and other factors that not amenable to being
changed easily. Capital, however, is a produced factor of production
Y which can be varied easily. Therefore, our attention focuses on the
effect of combining different amounts of capital with the given
labour force.

A production function that relates each possible level of the capital

stock, designated by K, to the corresponding amount of output, Y,
that it can produce in combination with the labour force, is shown
in Figure 3. The production function captures a number of features
of the relationship between capital and output that we have
discussed. It shows that capital raises productivity – the more
capital the labour force is provided with, the greater the amount of
output that can be produced. This is reflected by the production
K function having a positive slope along its entire length – more
capital always yields more output.
Figure 3: A Production Function

The production curve also shows that increments to the capital

stock add less to output when the capital stock is already high than
when it is low – the law of diminishing returns. The two dashed
Y lines in Figure 3 illustrate the point. Both represent equal increases
Output in capital – the horizontal portion of the dashed line; but each adds
different amounts to output – the vertical portion of the line.

Depreciation Savings, Investment, and Growth

Since savings is the source of the investment that is to produce the
higher level of output, we need to be able to determine the amount
S* Savings of savings at any point. This is accomplished by assuming that
S0 savings is a constant fraction of income. If savings are, say, 25
D0 percent of income, and recognizing that output and income are
always equal, then the savings curve can be drawn such that each
point on the curve is a quarter of the height of the corresponding
K0 K* K
point on the production function above it. This is shown in Figure 4.
Figure 4: A Model of Economic Growth The equality of savings and investment means that once we have

15
determined the amount of savings, we have also determined the
gross level of investment in capital.

Depreciation, it was noted earlier, is proportional to the amount of

capital in the economy. The curve showing the amount of
depreciation is therefore a straight line from the origin in Figure 4,
showing that as the capital stock rises, the cost of repairing or
replacing depreciated capital rises proportionately.

Now we can use the information in Figure 4: A Model of Economic

Growth to describe how and when the economy will grow over
time. At low levels of capital, such as is represented by K0, the
capital is stock is sufficiently small that the amount of investment
that has to be devoted to replacing the depreciated portion is low,
represented by D0. As a consequence, the amount of savings and
investment, S0 is large enough to be able to replace depreciated
machinery and still have some investment left over that represents
net additions to the capital stock. The extra investment is the gap
between S0 and D0. Because of that net investment over and above
capital replacement, the total capital stock, and therefore the
economy’s productive capacity, will increase. The expanded
capacity will produce a greater amount of goods and services. In
other words, as K increases, the production function indicates, so
will Y. The economy has experienced economic growth.

However, as the capital stock grows (that is, as the economy moves
to the right on the horizontal axis), the flattening savings curve
shows that that growth adds less to savings each time. Worse, the
growing capital stock requires ever larger amounts those savings to
be used simply to repair or replace depreciated capital. This is what
is illustrated by the rising height of the depreciation curve. So,
despite the fact that a larger economy with a higher income can
save and invest more, the additional investment is too small and
the amount required just to replace depreciation becomes too large,
that the portion left over for further expansion keeps shrinking.
Thus, we see the vertical distance between the savings and
depreciation curves diminishing.

Eventually, the increase in savings is so small and the capital stock

so large that the entire pool of savings is devoted to replacing and
repairing depreciated capital. This is shown at K* and S*. Since
there is no extra savings left over to invest in new capital, then the
further expansion of the capital stock and therefore growth in this
economy comes to a halt.

Solow’s model of economic growth corroborates the conclusion

drawn earlier. If we depend only on savings and the consequent
expansion of the stock of capital to generate economic growth, it

16
 can do so for a while. But eventually, the economy will stagnate.
Mere investment in more productive capacity that is not a
technological improvement may make a poor country wealthier,
but it will not keep it growing indefinitely.

Innovation in the Growth Model

Each production function represents the relationship between
Y different amounts of capital and their corresponding levels of
output, using the prevailing production technology. We have already
Y1 discovered that technology affects productivity; that if technology
Output
of production improves, then the existing labour force and capital
Y0 will be able to produce a greater amount goods and services. So a
change in technology changes the relationship between any
particular amount of capital and its associated amount of output.

Figure 5 shows such a relationship, in which K0 of capital, along

with the labour force, could produce Y0 of output. But with a
production innovation, the same amounts of productive factors
may now produce the greater amount of output denoted by Y1. This
change is shown as a point on a new, higher production function.
K0 K
The improvement in technology shifts the production function
Figure 5: Effect of Technological upward.
Improvement on the Production Function
We noted above that the higher incomes allowed by the more
Y advanced production techniques would permit people to save
more. This is depicted in Figure 6 which shows, corresponding to
the upward shift of the production function, an upward shift of the
savings curve. Consequently, whereas as the level of savings at K 0
Depreciation was previously S0, the greater income now allows the level of
S* savings to be S1.
S1
The extra savings sets the model, and the economy previously in
S0 Savings equilibrium, in motion once again. Because the higher amount of
savings, S1, is now greater than the amount needed just to replace
depreciated capital, equivalent to S0, the extra savings can be
invested in new equipment. In this way, the capital stock will grow.
As before, capital will grow only until depreciation is absorbing all
K0 K* K
savings, which occurs at K*, at which point growth ceases once
Figure 6: Effect of Technological again, at least until the next technological innovation comes along.
Improvement on the Equilibrium Capital Note, however, that, notwithstanding the return to stagnant level of
Stock output, the economy has become wealthier due to both higher
productivity and also a larger capital stock.

Institutional reform in the Growth Model

As long as laws, prejudices, and habits hinder investment and
discourage innovation, an economy may remain stuck with a low
level of capital and inferior technology. Look again at Figure 6 and
view the low level of savings of S0 as due to institutional

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 impediments to and disincentives for investment. As long as the
country’s institutions limit the opportunities for high-yield
investments, there is no incentive to save.

Reforms that open up new avenues for economic activity will

motivate investment in those activities and therefore in the higher
savings required to finance them. The reform there raises the
savings rate, shifting the savings curve upwards in the same way
that is shown in Figure 6 above (but in this case not caused by
higher incomes). And, again as in Figure 6, the additional
investment raises the economy’s stock of capital and output
increases accordingly.

At the same time, the same reform that increases the incentive to
investment by local entrepreneurs will also make opportunities
attractive to foreign investors. As a result, foreign direct investment
will also rise, further expanding productive capacity without any
need for local savings.

The same institutional reforms that open up and incentivize new

business opportunities, and so motivate its citizens to invest, will
equally well motivate them to seek out more efficient production
technologies. Consequently, the pace of technological innovation
will also rise. We saw above that more productive technology shifts
the production function upwards. Institutional reform, therefore,
by stimulating a flow of innovations, will allow for the production
function to shift upwards at greater pace (similar to what is shown
in Figure 5 above), causing a steady increase in the equilibrium
output on the vertical axis.

Improving the justice system and securing property rights,

therefore, can raise the production function and the rate of savings
out of the resultant income, and so increase investment, innovation,
and the economic growth.

EXPERIENCES OF ECONOMIC GROWTH

South Korea
In 1960, South Korea was one of the poorest countries in the world.
Its per capita GDP, at just over US$1,000, was only twice the level of
the average for sub-Saharan Africa and poorer than most of the
Caribbean and Latin America.

In contrast to the totalitarian North, South Korea established itself

as a democracy with accountable, elected officials. In the 1960s, the
administration of Park Chung Hee established the economic
South Korea
foundation as one of markets and incentives, high savings rates,
good education, and targeted industrial policies.

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The Korean government strongly encouraged a high savings rate
with large public investments in infrastructure and education. In
the 1970’s, its industrial policy targeted heavy industries with an
accompanying focus on expanding technical and vocational
training to create a complementarily-skilled work force. At the
same time, foreign direct investment was encouraged as a way to
climb up the technological ladder. Later on, the focus of Korea’s
industrial policy switched to more technologically advanced
industries with the government investing heavily in information
technology infrastructure. Korea has maintained a relatively open
stance with respect to international trade (notwithstanding
selective domestic protection of certain manufactures early on)
since export promotion was a key element of its strategy.

The relentless pursuit of adopted technology has been at the core of

Korean development from the first industrial plan to the latest
corporate strategy of Samsung. The targets of its industrial policy,
the encouragement of foreign direct investment, and its education
and training programme, all were dedicated to mimicking the
technology of the advanced West. And all this in a society where
private property was sacrosanct and the rule of law was ironclad.

Korea’s impressive growth began in the 1960s and continued

almost without let up for several decades. By 2013, GDP per capita
had reached US$26,000, making it equal to the average for the
European Union. In a generation, Korea moved from one of the
poorest to one of the wealthiest countries in the world.

But the relentless copying of foreign technology as a means of rapid

growth works only as long as you are technologically backward. As
Korea has caught up with the technologically advanced countries, it
can no longer grow faster than they do by copying their technology.
It has to switch to pursuing in its own breakthroughs, which is a
more difficult business. Whereas in the 1970s, it enjoyed annual
growth of 10 percent, in the 2000s its rate of growth has fallen to
less than 5 percent.

Chile
In the 1960s, the Chilean economy was typical of the poorly
performing region in which it is located. By the early 1970s, output
was falling and prices were hyper-inflating. In 1973, Salvador
Allende’s elected government was overthrown by Augusto
Pinochet, who instituted an absolute military dictatorship. Both the
military backing and General Pinochet’s ruthlessness meant that all
other political forces and interests could be ignored or overtly

19
 repressed, leaving the General with a completely free and brutal
hand. Institutional legacies were not a constraint.

A series of reforms were introduced during Pinochet’s 17-year

term. In the 1970s, Chile eliminated import barriers and welcomed
foreign investment. At a stroke, Chile went from being one of the
most protected economies in the world, with average import tariffs
of more than 100 percent and hundreds of restricted items to one of
the most open trade regimes with a flat 10 percent import tariff
across the board. Also in the 1970s, the system of domestic price
controls was dismantled and market forces were allowed to
determine the prices of all goods and services.

Recognizing the importance of the institutional environment to

economic growth, the government promulgated a new constitution
in 1980 in which it embedded its key reforms. The security of
private property and the independence of the central bank (the
better to focus on sound monetary policy without fear of a
meddling government) were entrenched. The constitution also
limited the power of the legislature to easily change certain laws
and also limited the power of the government to spend.

The 1980s witnessed pension reform and privatization. The pay-as-

you-go pension scheme was turned into a fully funded, privately
Chile managed scheme, considerably boosting the country’s level of
savings. As a result, investment rose steadily. There was also a
massive privatization programme that returned hundreds of state-
controlled enterprises to private ownership.

GDP growth accelerated during the late 1970s and, following a

severe recession, again from the mid-1980s to reach more than 7
percent per year for most of the nineties. After the turn of the
century, as we should have come to expect from the theory outlined
in this chapter, GDP growth fell off to around half its earlier pace,
but not before Chile had become the richest country in Latin
America.

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 Zimbabwe
Institutional reform that affects the economy and impacts the lives
of citizens can change in either direction. Zimbabwe has recently
provided an example of the wrong kind of change. Along with
South Africa, Zimbabwe had one of the strongest institutional
regimes for economic activity in sub-Saharan Africa, even in the
presence of massive inequality of incomes and opportunities.
Zimbabwe had strong rule of law, secure property rights, and
competent economic institutions. As a result, GDP growth averaged
4.3 percent per year after independence in 1980.

Zimbabwe exemplified the importance of property rights even

before what they euphemistically call “land reform” undermined
that security completely. The vast difference in the productivity of
commercial farms compared to communal lands was due largely to
the institution of land ownership. the latter were communally
Zimbabwe owned, without any individual being able to exercise secure
control. In that case, there was no incentive to invest in the land
since the fruits of that investment did not accrue to a single, secure
property owner. At the same time, since any losses were shared,
communal lands become victims of overuse and degradation – an
example of the tragedy of the commons.

In any event, under the dictate of its president, Robert Mugabe, and
starting in earnest in the year 2000, the government authorized the
seizure of some 4,500 commercial farms owned by white farmers
for re-distribution to indigenous Africans. In addition to
undermining the key institutional foundation that is the incentive
for economic activity – secure property rights – Mugabe went on to
undermine the independence of the central bank and the court
system that tried to constrain his unconstitutional exercise of
power.

Once the rule of law and property rights began to be undermined in

2000, the collapse of the Zimbabwe economy was swift. Once a
major food exporter, Zimbabwe’s food production collapsed.
Commercial farm land lost nearly three-quarters of its value in a
single year.5 And Zimbabwe rapidly became much poorer. The
economy contracted every year from 2000 to 2009, by the end of
which Zimbabwe’s economy was not even half the size it was at the
start of the decade.

SUMMARY
The vast differences in living standards observed across the globe
and over time, as reflected in each country’s GDP per capita, are
due to differences in capital, technology, and institutions. Capital –

21
tools, buildings, and skills – leverage the abilities each person to
produce a much greater amount of output than could be
accomplished on his or her own. The technology of production – the
way in which production is carried out – can elevate the total
productivity of all productive inputs. Institutions – the rules
governing economic activity – can inhibit or facilitate production,
investment, or innovation.

Since capital, technology, and institutions are the foundations of

wealth, then investment (in capital), innovation (in technology),
and reform (of institutions) are the sources of economic growth.
Investment in capital is the easiest way to raise productivity and
incomes, but does not sustain growth indefinitely. A steady stream
of innovation can maintain moderate rates of growth seemingly
indefinitely. The closer to the technological frontier a country is, the
more it must innovate by discovery and invention; whereas if a
country is less technically advanced than its neighbours, it can
grow faster by importing their productive ideas. Institutions that
are either weak or obstructive are the biggest obstacle to economic
growth in poor countries. This is because rules, customs, and
capacity tend to be persistent over long periods of time and
entrenched interests that benefit from the status quo resist change.

Nonetheless, institutions occasionally get reformed, technological

leaps are made, and both foreign and domestic capital is invested to
spur significant and sustained growth in many countries once poor.
Singapore, Botswana, South Korea, Ireland, and Chile are only a few
of many examples. With better understanding of the forces at work,
poor countries can strive for a better outcome.

1
David Dollar and Aart Kray, “Trade, Growth, and Poverty.” The
Economic Journal, February 2004.
2
The Observer, United Kingdom, October 18, 2009
3
Businessweek.com, “Savers and Spenders”, June 10, 2010, 5:00pm
EST
4
Vladimir Popov, “Life Cycle of the Centrally Planned Economy:
Why Soviet Growth Rates Peaked in the 1950s,” CEFIR/NES Working
PaperSeries, No. 152, Centre for Economic and Financial Research at
New Economic School, November 2010.
5
Craig Richardson, “How the Loss of Property Rights Caused
Zimbabwe’s Collapse” Economic Development Bulletin, Cato
Institute, November 14, 2005.

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