EC304: Economic Growth and Development

Semester I, 2016

Week 3: Lecture 2 and 3

Economic Growth: Concepts and Patterns
What will we discuss?

– Divergent Patterns of Economic Growth since 1960

– Factor Accumulation, Productivity Growth, Economic Growth
– Saving, Investment, and Capital Accumulation
– Sources of Growth Analysis
– Characteristics of Rapidly Growing Countries
• Macroeconomic and Political Stability
• Investment in Health and Education
• Effective Governance and Institutions
• Favorable Environment for Private Enterprise
• Favorable Geography ??
– Diminishing Returns and the Production Function
– The Convergence Debate
– Economic Growth and Structural Change
 Divergent Patterns of Economic Growth since 1960

• After 1960s LDCs begin to diverge (see Graph and Table next slide)
GDP/Capita Growth Rates by Region (Compare
growth rates by region to identify divergence)
Region-wise as well as country-wise comparisons can be made

• For example per capita income in Thailand was

$1100 in 1960 and that of Zambia was about $1200
(see Table 3.1 in textbook)
• Thailand now has per capita income of $7000, but
Zambia is about $900?
• What happened due to growth difference between
the two economies? Thailand grew by over 4.5% and
Zambia’s growth was -0.6% (negative).
 See Table 3.1 for Average Growth Rates across countries
1960-2003:

• Negative Growth (<0) for Nigeria, Zambia, Chad, etc.

• Slow Growth (0.12<G<1.3) see Kenya, Ghana, Rwanda,

Argentina

• Moderate growth (2.1<G< 2.75) see Lesotho, Egypt, Brazil,

India

• Rapid Growth (Botswana, Malaysia, South Korea, Singapore

<3.32 G< 6.3

• Industrial Countries (Japan USA, Canada, UK) Japan = 4.11;

USA= 2.42
Why is/was Botswana Successful? (Read Box 3.1)

• Between 1970-90, Botswana was the fastest growing

country in the world at about 8% per year.
• But at independence in 1965, it was poor it had 100 high
school graduates and 22 college graduates.
• What is the main source of success: Good policies and
strong institution and democratic government
• Protection of property rights and minimal corruption
including civil service base on merit not on patronage
• These has led to highest per capital income and best HDI
• Recent challenge: High HIV/AIDS infection rate has
reversed this.
 Factor Accumulation, Productivity
Growth, Economic Growth
• Economists model output as a function of productive
factors.
• A productive factor is an input into production that is not
itself produced during the current production period.
• The two most commonly invoked productive factors are:
labor and capital
• A country’s output is thus determined by labour, capital
and how productively it uses them

Y = F(Labor, Capital) = F(K,L)

 Factor Accumulation, Productivity
Growth, Economic Growth
• Factor Accumulation: increase in the size of the capital stock and labor force.
More machines, factories, buildings, roads, electricity, computers and tools
along with better trained workers.
• Productivity Growth: Amount of output per unit of machine or worker.
Increases in 3 ways: by (i) greater efficiency-specialization, (ii) increase in
labour skills and (iii) technological progress.
• Growth in labour alone will not increase per capita GDP in a sustained
fashion. Thus the production function is expressed in intensive form:
y=f(Capital/Worker) = f(k)

• Increases in capital/worker or what is known as capital accumulation is one of

the fundamental drivers of economic growth
Fig. 3.1 Basic Sources of Growth: Production function
Q = f (K - capital accumulation)

Production Function
Fig. 3.1: Productivity Gains
 Saving, Investment and Capital Accumulation

Key Elements of Economic Growth

• New investment increases the capital stock
• Investment (I) is financed through savings (S) I = S
• Savings comes from income of GDP S= f (GDP)=sY
• These decisions are made by consumers, firms corporations and
governments
• Sustaining Growth requires both generating new investment and
making sure it is productive and creates employment.
• A decision to postpone consumption into the future helps the
economy acquire resources for investment and generates growth.
 Sources of Growth Analysis

• Solow Model: Explores the contribution of each factor to

increase output: Q(K, L, Productivity gains)
• Growth Accounting or Source of Growth Analysis
• gy= (WK x gK) + (WL x gL)+ a
• gY = growth of income
• gK, gL = growth of capital and labor
• WK, WL = share of capital and labor
• a= Rate of productivity of Inputs = Residual Growth
 Sources of Growth Analysis
• The value of all output produced = sum of income paid out to owners
of productive factors
• Two factors: Labour and Capital
• Owners of labour receive wages + salaries
• Owners of capital receive interest + dividends.
• Labour’s Share = Value of Wage and Salary Payments ÷ Value of
Output (WL)
• Capital’s Share = Value of Interest and Dividends ÷ Value of Output
(WK)
• These reflect the relative contribution of each factor to production.
Estimates are WL= 60-70%; WK=30-40%
 Example of Growth Accounting

• Assume that gY=0.05 (GDP)

• gK=0.07 (7 percent), gL= 0.02 (labor growth)
• WL=0.6 share of labor in income (60%)
• Wk= 0.4 (share of capital in income (40%)
• Substitute in gY= WkgK + WLgL +a
• 0.05= (0.4 x 0.07) +( 0.6 x0.02) + a
• a = 0.01 or 1 percent
 Growth in Worker Skills
• Suppose that each worker embodies a certain skill level, T.
• Then we can define the effective labour force as TxL and the
production function can be written as Y=F(K, TxL).
• T can increase if workers are more skilled and/or better educated.
• The intensive form of the production function is y=f(k,T) where y is
output per worker, k is capital per worker and T is the skill level per
worker.
• In this framework the sources of growth equation becomes:
• where :Gy= Wkgk+WLgT+a
• gy is the growth rate of output per worker; gk is the growth rate of
capital per worker, gT is the growth rate of worker skills, Wk is the
share of capital in output, WL is the share of labour and a is the
growth of TFP.
 Sources of Growth Across Countries (1980s) based on Table 3.2

• Country/Region: Output/Worker (Q) k=K/Worker Education TFP

• Brazil -1.63 0.16 0.68 -2.47 (Discuss)
• Ethiopia -1.74 1.11 0.27 -3.12 (Discuss)
• Ghana -1.14 -1.23 0.15 -0.07
• Africa -1.06 -0.07 0.42 -1.41
• East Asia 4.36 2.45 0.66 1.25
• Latin America -1.77 0.04 0.47 -2.28
• Middle East 1.15 0.55 0.53 0.07
• South Asia 0.68 1.02 0.42 2.25 (Discuss)
 Empirical results
Author Country Capital share
under TFP share
study problem
Solow US More share to TFP than capital
Other Developed More share to TFP than capital
studies country
Other developing More prominence to capital than TFP
studies
Other Around TFP – developed country
studies world Capital – developing country & some
developed country
-East Asia – capital 2/3
-East Asian recorded faster TFP
growth than developing country
- negative TFP in Africa, Latin
America
 Limitations of TFP Analysis
• It represents a black box: a combination of influences that
cannot be identified from the available data.
• It is invariably measured inaccurately, since it is the residual in
the equation.
• Moses Abramovitz: TFP is a measure of our ignorance of the
growth process
• In the last two decades, a new branch of growth theory has
emerged called endogenous growth theory. It attempts to
explain the sources of productivity growth:
– Research and Development expenditures by firms
– Dynamic economies of scale and learning by doing
 Implication
• Developing country should adopt capital
mobilization policy
• Negative productivity is direct result of ideal
capital and labor e.g. in war, political tension
• Negative productivity could also be result of
accumulation of unproductive assets.
 EC304: Economic Growth and Development

Semester I, 2016

Week 3: Lecture 2 and 3

Characteristics of Rapidly Growing Countries

• 1. Macroeconomic stability (see discussion next slide)

• 2. Investment in Health and Education
• 3. Effective Governance and Institutions (PICs)
• 4. Favorable Environment to Private Enterprise
• 5. Favorable Geography or location?
 Macroeconomic stability

• Macroeconomic implies avoiding inflation and recession.

An extreme case of high inflation: Zaire/Congo=2800%,
more recently Zimbabwe 4000%! Primarily by printing too
much money to pay for deficit
• Political instability in the form of civil war, military coups,
cross-border wars are rampant in Africa
• 2/3 of African states suffer from conflict
• See figures 3.2, 3.3

What about in the PICs?

Fig. 3.2: Inflation and Growth in 1990s
GDP/Capita before and after conflict
 Investment in Education and Health ( Human Capital)

• While growth in sheer labour numbers will not promote

per capita growth, investment in the human capital of
existing workers is as important as physical capital
accumulation.

• Health and Education are both input or means and

outcome (goal) of development.

• Increase in the level and quality of Education and health is

crucial better outcomes
Fig. 3.4: Growth and Life Expectancy Relations
 Effective Governance and Institutions

• Douglas North study shows relationship between economic growth,

the rule of law, extent of corruption , property rights and quality of
government bureaucracy, and other measures of institutional quality
• Economic Growth = F(K, L Institutions..)
• Other factors: effective private sector, civil society groups, and free
press, political competition, etc..
Fig. 3.5: Governance and Growth
 Institutions, Governance and Growth read box 3.2
on page 82-83
5 institutions are necessary according to Rodrik and Sumbramanian (2003-
Finance and Development)

• 1. market institutions that protect property rights

• 2. Market regulating institutions that deal with market failure

• 3. Market stabilizing institutions to control inflation

• 4. Market legitimizing institutions such as social protection and insurance

• 5.Political institutions determine how a country is governed: level of

democracy, transparency, free press, participatory politics, and
competitive parties. See Figure 3.5 Governance and Growth
 Favorable Environment for Private Enterprise
• Growth depends on private citizens making decisions to save,
invest, work, educate, etc.
• Agricultural policies are central since 50-80% of the population live
in rural areas and depend directly on agriculture but governments
often prefer food prices to stay low.
• Heavy business regulation (red tape and high taxes) and weak
property rights undermine or kill businesses (Hernando de Soto)
• Government investment in infrastructure is core to capital
formation
• The degree of openness to international trade and political stability
matters greatly for how private enterprise performs (see Figure
3.6).
•  
Fig. 3.6: Degree of Openness
 Does Geography Matter?
• Most economically developed states are in Temperate climate Zone.
Most developing countries are in the tropics. Climatic conditions
matter (read textbook) – there is difference in activity levels due to
climatic conditions.
• Does being land locked matter? (no coast line). Yes and no! It depends
of the types of industries and cross-border relations.
• Botswana is land locked but it is most successful African Economy
• Switzerland and Austria are land locked yet they are wealthy
countries.
• What about Oceanic isolation? PICs face added transport costs and
small domestic market syndrome – economic scale is much harder to
establish for Island based firms.
Fig. 3.7: The Destiny of Geography?
Fig. 3.8: Growth and Geography
 Production Function and Diminishing Returns

• The Concept of Production function

• Q = Output = f ( Labor, Capital, Land, etc)
• Principle of Diminishing Marginal Product (See Figure 3.9)
• Implications of diminishing returns of capital for developing
and African countries
Implications of Diminishing marginal product of Capital

• Poor countries have a potential to grow more rapidly since they

face capital scarcity
• Richer countries with abundance of capital grow at a slower
rate compared to developing countries
• Since poor countries have more potential to grow faster they can
catch up with rich countries (this is what the theory of
economics convergence states – we discuss this a little later)
• Examples: China, India, etc. However, this has not happened in
Africa, except in Botswana and Ghana to some extent now. Why
is this the case?
Fig. 3.9: The effect of Diminishing Marginal Product of
Capital

Compare MPK1, MPK2 and MPK3

 Convergence debate

• Poorer countries could grow fast while richer countries

experience slower growth, poorer countries (at least those in
which “all else is equal”) could begin to catch up and see their
income levels begin to converge with rich countries.
• Example Japan; in the 1960’s Japan’s income per capita was
only about 35% of average US income, and it had a much
smaller capital stock, giving it the potential for very rapid
growth.
 The Convergence Debate: Is there convergence?

• There may be convergence among open economies that

share the same features
• For example East Asian Economies since 1965 (Sachs
and Warner, 1995)
• Other studies show there no evidence of absolute
convergence but there may be conditional convergence.
(See figure 3.2)
 Conditional convergence

• Some broad characteristics are:

– Simlar rates of savings, population growth, depriciation, and
technology growth.
– Some poor countries for example have low savings rate

• Conditional convergence implies that a country or a region

is converging to its own steady state while the
unconditional convergence(absolute convergence) implies
that all countries or regions are converging to a common
steady state potential level of income.
Fig. 3.10: Growth and Initial Per capital level
Fig. 3.11: Conditional Convergence Among OECD Countries
Fig. 3.12
 Economic Growth and Structural Change
• Growth involves more than increases in per capita income
and rise in factor productivity
• Structural change take place in a number of ways
1.Proportion of output from agriculture declines, share of manufacturing
and services rise

2.Proportion of Labor engaged in agriculture declines and labor force in

industry rises

3.Population becomes more urbanized and cities and towns grow over
time

4. Greater share of output is sold in markets.

5. Ignoring agriculture in early stage is a mistake

 Reasons for the Decline of Share of Agriculture
Note that Agri production may increase in absolute terms but by proportion it
declines as economies grows and undergo structural change.

• 1. Engel’s Law: as income rises the share of expenditure on food declines

and expenditure on non-food such as recreation, clothing, housing, etc
rises. [Go look for the data on Fijian economy and state whether this
transformation has occurred in the last 20 years]

• 2. Productivity gains in agriculture frees labor for non-agricultural goods

or manufacturing and service production. Technology (improved seeds,
fertilizer, machinery,etc) allows less labor to produce food

• Example in 18th & 19th century the majority of Americans were in

agriculture, now only 3% of US population is engaged in agriculture and
97% in industry and services.
Fig. 3.13: Structural transformation among
four developing countries
Fig. 3.14
Fig. 3.15: Decreasing Share of Rural Population with
income rise
 Economic Growth Summary
• 1. A nontechnical overview of economic growth. The main questions posed are
Why are some countries rich and others poor, and why do some countries grow
quickly and others grow slowly? The chapter broadly observes the performance
of groups of countries and divides their growth into the following categories:
negative, slow, moderate, and rapid.
• 2. Basic mechanisms of economic growth and break them down into factor
accumulation and productivity growth. Basic features of the production function
and the concept of diminishing returns. The key ideas and implications of the
Solow model are presented in a nontechnical manner. Followed by the idea of
diminishing returns to convergence and explores the convergence debate.
• 3. The analysis of the sources of growth decomposition is shown, and the idea
of total factor productivity is introduced. The authors then trace the results of the
empirical work on sources of growth from Solow to Collins and Bosworth (who
find that developing countries rely more on capital accumulation).
• 4.The five main characteristics of rapidly developing countries: macroeconomic
and political stability, investment in health and education, effective governance
and institutions, favorable business environment, and favorable geography.
Using new data, the text explains the idea of structural change.
• 5Boxed Examples: There are two boxed examples. 1,The economic success of
Botswana. 2.Summary of the recent research on institutions and economic
growth