Foundations of Economics Eighth Edition, Global Edition

Foundations of Economics
Eighth Edition, Global Edition
Chapter 25
Economic Growth
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Why are Some Nations Rich and Others
Poor?

25. Economic Growth
Chapter Checklist
When you have completed your study of this chapter, you will be able to
1. Define and calculate the economic growth rate, and explain the implications
of sustained growth.
2. Explain the sources of labor productivity growth.
3. Review the theories of economic growth.
4. Describe policies that speed economic growth.

25.1 The Basics of Economic Growth (1 of 9)
Economic growth is a sustained expansion of production possibilities measured
as the increase in real GDP over a given period.
Calculating Growth Rates
Economic growth rate is the annual percentage change of real GDP.

To calculate this growth rate, we use the formula:
Growth of Real GDP in current year − Real GDP in previous year

= × 100
real GDP Real GDP in previous year
For example, if real GDP in the current year is $8.4 trillion and if real GDP in
the previous year was $8.0 trillion, then the growth rate of real GDP is
$8.4 trillion − $8.0 trillion

Growth of real GDP = × 100 = 5 percent.
$8.0 trillion

The standard of living depends on real GDP per person.
Real GDP per person is real GDP divided by the population.
The contribution of real GDP growth to the change in the standard of living
depends on the growth rate of real GDP per person.

We use the above formula to calculate this growth rate, replacing real GDP
with real GDP per person.
Suppose, for example, that in the current year, when real GDP is $8.4 trillion,
the population is 202 million.
Then real GDP per person is $8.4 trillion divided by 202 million, which equals
$41,584.
And suppose that in the previous year, when real GDP was $8.0 trillion, the
population was 200 million.
Then real GDP per person in that year was $8.0 trillion divided by 200 million,
which equals $40,000.

Use these two values of real GDP per person in the growth formula to calculate
the growth rate of real GDP per person. It is
Growth rate of real $41,584 − $40,000 × 100 = 4 percent.

=
GDP per person $40,000

The growth rate of real GDP per person can also be calculated by using the
formula:
Growth of real GDP per person = Growth rate of real GDP − Growth rate of
population
202 million − 200 million × 100 = 1 percent.

Growth of population =
200 million

This formula makes it clear that real GDP per person grows only if real GDP
grows faster than the population grows.
Growth of real GDP per person = 5 percent − 1 percent = 4 percent.
If the growth rate of the population exceeds the growth of real GDP, real GDP
per person falls.

The Magic of Sustained Growth
Sustained growth of real GDP per person can transform a poor society into a
wealthy one. The reason is that economic growth is like compound interest.
Rule of 70 is the number of years it takes for the level of any variable to double,
which is approximately 70 divided by the annual percentage growth rate of the
variable.

Table 25.1 Growth Rates

25.2 Labor Productivity Growth (1 of 16)
What determines the growth rate of real GDP?
The growth rates of the factors of production and the rate of increase in their
productivity.
Real GDP growth contributes to improving our standard of living.
But our standard of living improves only if we produce more goods and services
with each hour of labor.
So our main concern is to understand what makes labor more productive.

Labor Productivity
Labor productivity is the quantity of real GDP produced by one hour of labor.
It is calculated by using the formula:
Real GDP
Labor productivity =
Aggregate hours

For example, if real GDP is $8,000 billion and aggregate hours are 200 billion,
then we can calculate labor productivity as
$8,000 billion
Labor productivity = = $40 per hour.
200 billion

When labor productivity grows, real GDP per person grows, so the growth in
labor productivity is the basis of rising living standards.
The growth of labor productivity depends on two things:
• Saving and investment in physical capital
• Expansion of human capital and discovery of new technologies

Saving and Investment in Physical Capital
Saving and investment in physical capital increase the capital per worker and
increase labor productivity.
But additional capital will not bring sustained economic growth because the
law of diminishing returns applies to capital:
If the quantity of capital is small, an increase in capital brings a large increase in
production.
If the quantity of capital is small, an increase in capital brings a large increase in
production.

Figure 25.1 illustrates the
relationship between capital and
productivity.
The curve PC is the productivity
curve.
1. With a small amount of capital an
increase in the capital brings a
large increase in real GDP per hour
of labor.

2. With a large amount of capital, an
increase in the capital brings a small
increase in real GDP per hour of
labor.
If capital per hour of labor keeps

increasing, labor productivity increases
by ever smaller amounts and
eventually stops rising.

Expansion of Human Capital and Discovery of New Technologies
Human capital—the accumulated skill and knowledge of people—comes from
three sources:
• Education and training
• Job experience
• Health and diet
Expansion of human capital and the discovery of new technologies has

increased labor productivity.

The discovery of new technologies have made an even greater contribution to
economic growth than the growth of human capital.
Combined Influences Bring Labor Productivity Growth
• To reap the benefits of technological change, capital must increase.
• Some of the most powerful technologies are embodied in human capital, but
most technologies are embodied in physical capital.

Figure 25.2 illustrates the effects of
increased human capital and
technological change.
The curve PC0 is the productivity
curve in 1960.
$180 of capital per hour of labor
produced $40 of goods and
services—real GDP per hour of labor.

The curve PC1 is the productivity
curve in 2015.
$180 of capital per hour of labor
produced $80 of goods and
services—real GDP per hour of labor.
The expansion of human capital and
discovery of new technologies shift
the PC curve upward and are not
subject to diminishing returns.

Figure 25.3 illustrates how labor
productivity grows.
In 1960, workers had $80 of capital
per hour of labor and produced $25
of real GDP per hour of labor.
1. When capital increased to $180
per hour of labor in 2015, real GDP
per hour of labor increased to $40.

2. The expansion of human capital and
discovery of new technologies
shifted the productivity curve
upward to PC1 in 2015 and …
increased real GDP per hour of labor to
$80.

Real GDP grows because labor becomes more productive and also because the
quantity of labor increases.
Figure 25.4 summarizes the sources of real GDP growth.
Real GDP growth depends on quantity of labor growth and on labor
productivity growth.

Quantity of labor growth depends on
• Population growth
• The labor force participation rate
• Average hours per worker

Labor productivity growth depends on
• Physical capital growth
• Human capital growth
• Technological advances

25.3 Economic Growth Theories: Old and
New (1 of 16)
Old Growth Theory
Classical growth theory is the theory that the clash between an exploding
population and limited resources will eventually bring economic growth to an
end.
Malthusian theory is another name for classical growth theory—named for
Thomas Robert Malthus.

New (2 of 16)
The Basic Idea
Advances in technology and the accumulation of capital bring increased
productivity and increased real GDP per person.
Classical growth theory says that the increase in real GDP per person will be
temporary because prosperity will induce a population explosion.
The population explosion will decrease real GDP per person.

New (3 of 16)
New Growth Theory
New growth theory is that our unlimited wants will lead us to ever greater
productivity and perpetual economic growth.
According to new growth theory, real GDP per person grows because of the
choices people make in the pursuit of profit.

New (4 of 16)
Choices and Innovation
The new theory of economic growth emphasizes three facts about market
economies:
• Human capital grows because of choices.
• Discoveries result from choices.
• Discoveries bring profit, and competition destroys profit.

New (5 of 16)
Human Capital Expansion and Choices
People decide how long to remain in school, what to study, and how hard to
study.
Discoveries and Choices
The pace at which new discoveries are made—and at which technology
advances—is not determined by chance.
The pace at which new discoveries are made depends on how many people are
looking for a new technology and how intensively they are looking.

New (6 of 16)
Discoveries and Profits
The forces of competition squeeze profits, so to increase profit, people
constantly seek either lower cost methods of production or new and better
products for which people are willing to pay a higher price.
Two other facts play a key role in the new growth theory:
• Many people can use discoveries at the same time.
• Physical activities can be replicated.

New (7 of 16)
Figure 25.5 illustrates new growth
theory in terms of a perpetual
motion machine.
1. People want a higher standard of
living and are spurred by ...
2. Profit incentives to make the ...
3. Innovations that lead to ...

New (8 of 16)
4. New and better techniques and
new and better products, which in
turn lead to ...
5. The birth of new firms and the
death of some old firms,

New (9 of 16)
6. New and better jobs, and ...
7. More leisure and more
consumption goods and services.

New (10 of 16)
The result is ...
8. A higher standard of living.
But people want a yet higher standard
of living, and the growth process
continues.

New (11 of 16)
Economic Growth and the Distribution of Income
Does the gap between high and low incomes widen or narrow as real GDP
grows?
And what determines the long-term level and trends of income inequality?
Simon Kuznets showed that between 1880 and 1950, the top 5 percent’s share
of total income shrank from 31 percent to 20 percent in America and from 46
percent to 24 percent in Britain.

New (12 of 16)
The Data
Starting in the early 1980s, income inequality increased in a process that has
been called the Great Divergence.
The share of total income received by the top 1 percent of Americans moved
up from 8 percent in 1980 to 18 percent in 2014.
The Great Divergence is the reverse of the Great Compression that preceded it.
From 1913 to 1980, the income share of the top 1 percent decreased from 18
percent to 8 percent.

New (13 of 16)
The Explanation
Kuznets: Market forces in a dynamic economy create income growth.
Everyone is free to create a business. Some succeed and some fail. A greater
number of hungry low-income entrepreneurs succeed than do rich ones, so
inequality shrinks.

New (14 of 16)
Paul Krugman says the Kuznets explanation of a compression does not fit the
timing.
Krugman: Progressive income taxation, a strengthening of labor unions, and
World War II wage and price controls created the compression.
But timing poses a problem for Krugman’s policy induced explanation …. the
largest convergence occurred in the late 1930s, well before the political events
that are claimed to have caused it.

New (15 of 16)
Krugman: Great Divergence was caused by lower taxes on the rich, erosion of
welfare programs, a decline in union membership, and soaring executive pay.
Piketty: Great Divergence arises from the relationship between the interest
rate, r, and the growth rate, g.
The wealthy get income from capital, which grows at r. Others get income from
labor, which grows at g.
Because r > g, the incomes of the rich grow faster than everyone else’s income.
For Piketty, no automatic mechanism works against the steady concentration
of wealth.

New (16 of 16)
Economists do not yet have sound answers to the questions Simon Kuznets
posed 60 years ago.
We don't know enough to say where inequality is heading.

25.4 Achieving Faster Growth (1 of 8)
Preconditions for Economic Growth
Economic freedom is the fundamental precondition for creating the incentives
that lead to economic growth.
Economic freedom is a condition in which people are able to make personal
choices, their private property is protected, and they are free to buy and sell in
markets.

Economic freedom requires the protection of private property—the factors of
production and goods that people own.
Property rights are the social arrangements that govern the protection of
private property.
Economic freedom also requires free markets.

Policies to Achieve Faster Growth
To achieve faster economic growth, we must increase
• The growth rate of capital per hour of labor or
• The growth rate of human capital or
• The pace of technological advance.

The main actions that governments can take to achieve these objectives are
• Create incentive mechanisms
• Encourage saving
• Encourage research and development
• Encourage international trade
• Improve the quality of education

Create Incentive Mechanisms
Economic growth occurs when the incentive to save, invest, and innovate is
strong enough. These incentives exist only when private property is protected.
Encourage Saving
Saving finances investment, which brings capital accumulation.
Tax incentives can encourage saving, increase the growth of capital, and
stimulate economic growth.

Encourage Research and Development
Everyone can use the fruits of basic research and development efforts.
Because basic inventions can be copied, the inventor’s profit is limited and so
the market allocates too few resources to this activity.
Governments can direct public funds toward financing basic research, but it
requires a mechanism for allocating public funds to their highest-valued use.

Encourage International Trade
Free international trade stimulates economic growth by extracting all the
available gains from specialization and trade.
Improve the Quality of Education
By funding basic education and by ensuring high standards in skills such as
language, mathematics, and science, governments can contribute enormously
to a nation’s growth potential.

How Much Difference Can Policy Make?
A well-intentioned government cannot dial up a big increase in the growth rate.
But it can pursue policies that will nudge the growth rate upward.
And over time, the benefits from these policies will be large.

Eye on Rich and Poor Nations (1 of 4)
Why Are Some Nations Rich and Others Poor?
Political stability, property rights protected by the rule of law, limited
government intervention in markets are the key features of the economies that
enjoy high incomes …
and they are the features missing in those that remain poor.
Most of the rich nations have experienced sustained economic growth over
many decades.
Europe’s Big 4 economies (France, Germany, Italy, and the United Kingdom)
have been enjoying economic growth for 200 years.
The United States started to grow rapidly 150 years ago and overtook Europe in
the early 20th century.

Why Are Some Nations Rich and
Others Poor?
In the past 50 years, the gaps between
these countries haven’t changed much.

Others Poor?
Real GDP per person in three Asian
economies has converged toward
that in the United States.
These economies are like fast trains
running on the same track at similar
speeds with roughly constant gaps.

Others Poor?
Between 1960 and 2015, Hong Kong
and some other Asian economies
transformed themselves from poor
developing economies to take their
places among the world’s richest
economies.

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Foundations of Economics

Eighth Edition, Global Edition

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

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Growth of Real GDP in current year − Real GDP in previous year

$8.4 trillion − $8.0 trillion

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Growth rate of real $41,584 − $40,000 × 100 = 4 percent.

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202 million − 200 million × 100 = 1 percent.

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If capital per hour of labor keeps

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Expansion of human capital and the discovery of new technologies has

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