Economic Growth

Per capita real economic growth is an increase from one period to the next in per capita Real
GDP, which is Real GDP divided by population.
Real GDP
Per capita Real GDP = Population

Sources or determinants of Economic growth

1. Natural Resources: a nation rich in natural resources is likely to experience growth,
ceteris paribus. For example, if a place such as Hong Kong, which has few natural
resources, had been blessed with much fertile soil.
Note: Countries rich in natural resources are not guaranteed economic growth, and countries
poor in natural resources may grow economically.

Graphs:

2. Labour
• An increase in labor productivity tends to lead to an increase in per capita Real GDP.
How then do we achieve an increase in labor productivity? One way is through increased
education, training, and experience, which are called human capital. Another way is through
(physical) capital investment
Measurement of labour productivity: Average product of labour

Q
AP = .
L L
 3. Capital (Physical)
• There is a link between non consumption, or saving, and capital formation. As the saving
rate increases, capital formation increases and so does economic growth. (Neoclassical
growth)
• INCENTIVES: (FOR FIRMS TO INCREASE INVESTMENT IN CAPITAL)
1. Tax rate could be decreased (corporate profit tax)

2. Interest rate that firm must pay to acquire physical capital should be declined.

4. Technological Advances
Technological advances may be the result of new capital goods or of new ways of
producing goods. The use of computers is an example of a technological advancement
that is the result of a new capital good. New and improved management techniques are
an example of a new way of producing goods.
Technological advances usually come as the result of investing research and
development (R&D). Research and development, in general terms, encompasses such
things for example, working in a lab to develop a new product and managers figuring
out, through experience, how to motivate workers to work to their potential.

5. Property Rights Structure (Governance)

Property rights consist of the range of laws, rules, regulations that define rights for the use
and transfer of resources.
• Consider two property rights structures. In one structure, people are allowed to keep
the full monetary rewards of their labor. In the other, people are allowed to keep only
half. the first property rights structure would stimulate more economic activity than the
second, ceteris paribus. (Other things are held constant)(Countries with better legal
system , financial system , monetary system , stable political system have better PRS)
(The country is under GOOD GOVERNANCE)
• Individuals will invest more, take more risks, and work harder when the property rights
structure allows them to keep more of the monetary rewards

Neoclassical growth theory

 • Neoclassical growth theory emphasized two resources: labor and capital. Technology
was said to be exogenous; that is, it came from outside the economic system.
This theory focuses on capital deepening which means giving more capital (physical) per unit of
labour or labour hour. This is the way to boost growth of per capita real GDP. So neoclassical
growth theory focuses on capital labour ratio. But this growth theory developed by Robert
Solow dominated the literature in 60’s and 70’s.
During early 80’s a group of Economists (guided by Paul Romer) proposed an alternative growth
theory which was called New growth /Endogenous growth theory.

Capital –labour ratio

K
• k = L [k= capital –labour ratio]
• You need to increase the savings rate. There will be MORE capital formation. Capital
deepening OR capital intensity. Growth rate of real GDP per capita will be promoted.
Y K
Production function: L = f ( L ) = f (k) …… (I) Neoclassical growth approach failed to explain
the cross –country income differences.

• Because neoclassical growth failed to explain the cross country income differences of
many economies. These Economies increased capital intensity in same way but their
growth outcomes were different.
• New growth theory proposed that technological progress is determined within the
economic system and it is driven by Research and development (R&D) activities. The
more resources that go to develop technology, the more and better technology is
developed.

• New growth theory also emphasizes the process of discovering and formulating ideas.
According to Romer, discovering and implementing new ideas are what causes
economic growth.
For example, in the 1950s, Japan had few natural resources and capital goods (and still doesn’t
have an abundance of natural resources), but it grew economically. Some economists believe
that Japan grew because it had access to ideas or knowledge.

• Q1. What are the sources of Economic growth?( Broad question)

• Q2. What is the basic difference between Neoclassical growth and New growth theory?
(short question)
 • You will discuss the answer on the basis of technological development.
• Technological progress is driven endogenously by R &D activities that’s why the new
growth theory is known as Endogenous Growth theory.

How to promote process of discovery?(Basic idea of new growth

theory)
One way is for business firms not to get locked into doing things one way and one way only.
They must let their employees—from the inventor in the lab to the worker on the assembly line
—try new ways of doing things. Some would carry this further: Businesses need to create an
environment that is receptive to new ideas. They need to encourage their employees to try new
ways of doing things.
Romer has said that “economic growth occurs whenever people take resources and rearrange
them in ways that are more valuable.”
We need to increase the productivity of the existing resources. OR we can try to increase the
existing resource base.