ECONOMIC GROWTH

Chapter 16
A FEW BASICS ABOUT ECONOMIC
GROWTH
 Absolute Real Economic Growth is an increase in Real GDP from one
period to the next.
 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

Do Economic Growth Matter?

 If can a country goes at a certain percentage rate every year, we can find
by how many years its Real GDP will double.
 E.g. Bolivia and Malaysia in 1960 and 2000.

 If a country’s growth rate is 5%/yr, its Real GDP will double in 14 years

 •If a country’s growth rate is 2%, is Real GDP will double in 35 years

 •To calculate the time required for any variable to double, divide its
percentage growth rate into 70; (The rule of 70)
 Basing judgments of Standard of Living on growth rates is erroneous
because it ignores income distribution and quality of life.
EXHIBIT 1ABSOLUTE REAL ECONOMIC GROWTH
RATES FOR THE U.S., 2002-2012
PRODUCTION FUNCTION AND
ECONOMIC GROWTH
 Production Function: A function that specifies the
relation between technology and the quantity of factor
inputs to output, or Real GDP
 Example of production function:

Real GDP = T (L, K)

where T stands for Technology, L stands for Labour and K
stands for capital.
 Example: If L = 4, K = 2 and T = 0.4, how many units of
output (Real GDP) is produced?
 What happens when any one of these are changed?
THE GRAPHICAL REPRESENTATION
OF THE PRODUCTION FUNCTION

Changes in labour represent a movement along the production function,

with higher labour bringing in more Real GDP and vice versa.
Changes in capital and technology represent a shift in the
production function, with higher capital and technology
represented by a shift up and higher Real GDP and vice
versa.
FROM THE PRODUCTION FUNCTION TO THE LRAS CURVE
(INCREASING LABOUR)

 At Q1 and L1  Natural Rate of Unemployment, hence LRAS1.

 Labour increases, hence Real GDP increases, movement along existing production function,
LRAS shifts right.
 If AD curve was present, higher Real GDP at lower price level.
FROM THE PRODUCTION FUNCTION TO THE
LRAS CURVE (INCREASING TECHNOLOGY)

 At Q1 and L1  Natural Rate of Unemployment, hence LRAS1.

 Technology increases, hence Real GDP increases, shifting the existing production function
upwards, LRAS shifts right.
 If AD curve was present, higher Real GDP at lower price level.
EMPHASIS ON LABOR
 We have seen that a rise in labor would lead to a rightward
shift in the LRAS curve; a rise in labor would result in
economic growth.
 One such factor is taxes; some economists propose promoting
economic growth by cutting taxes on activities like working.
A cut in marginal tax rates will mean labor will work more,
output will rise, and economic growth will occur.
 Lower taxes on income means overall return on working
increasing due to a drop in income taxes. More people decide
to go work and those who work will want to work more.
Hence labor supply increases.
 Lower income taxes shift the labor supply to the right, raising
the equilibrium quantity of labor, which produces more Real
GDP, or shifts the LRAS curve to the right: economic growth
THE LABOR MARKET, THE PRODUCTION
FUNCTION, AND THE LRAS CURVE
THE LABOR MARKET, THE PRODUCTION
FUNCTION, AND THE LRAS CURVE (CONT)
EMPHASIS ON CAPITAL

 As taxes decline on the returns from capital, more capital

is utilized in the production process, shifting the
production function upward and thereby shifting the
LRAScurve to the right

 A decline in interest rates prompts firms to borrow more;

firms use the borrowed funds to purchase capital goods;
the production function shifts upward and the LRAScurve
shifts rightward
EMPHASIS ON OTHER RESOURCES: NATURAL
RESOURCES AND HUMAN CAPITAL
 Natural Resources should enter the production function as
production of my goods require use of natural resources.
Also remember, one of the main resources is land (land,
labour, capital, entrepreneurship).

 Human Capital: The knowledge and skills a person

acquires through education, training, and experience.
 Note: this is different from the Capital that is already
included in the production function, which includes
machines, computers, factories, etc.

 Therefore, production function is

Real GDP = T (L, K, NR, H)
EMPHASIS ON THE TECHNOLOGY
COEFFICIENT AND IDEAS
 Beginning in the 1980s, economists began discussing a new
growth theory, placing more attention on technology, ideas,
institutions and education
 Neoclassical growth theory, which preceded it, emphasized two
resources: labor and physical capital; technology was said to be
exogenous (determined outside the economic system, beyond
our control).
 New growth theory holds that technology is endogenous, a
central part of the economic system; the amount and quality of
technology that is developed depend on the amount of resources
devoted to it. The more resources that go to develop technology,
the more and better technology that is developed.
 Think of someone randomly finding gold, compared to people
being appointed to find gold in different geographical locations.
When are the higher chances of finding gold?
EMPHASIS ON THE TECHNOLOGY
COEFFICIENT AND IDEAS (CONT)
 Hence, if a person is trying to advance technology, his or
her chances of success are much smaller than if hundreds
or thousands of persons are trying.
 New growth theory also emphasizes the process of
discovering and formulating ideas as they relate to
technological advances. The emphasis is on ideas rather
than on objects, which are material, tangible things such
as natural resources and capital goods.
 However, some countries are poor because they lack
natural resources and capital goods.
 On the other hands, a country like Japan, that has less
natural resources and capital goods have economically
grown owing to technology and ideas.
DISCOVERY AND IDEAS
 One way to promote the discovery process is for business
firms not to get locked into doing things in one way only;
they must let their employees, all of them, try new ways of
getting the job done and create an environment where
employees are receptive to new ideas.

 The discovery process is seen in the amount of time and

effort firms devote to discovery in contrast to the time they
devote to actual manufacturing goods.
 E.g. computer software business. More money is invested
in developing new software than what is spent in making,
copying and shipping the disks or CDs that contain the
software.
EXPANDING OUR HORIZONS
 Romer has said that “economic growth occurs whenever
people take resources and rearrange them in ways that
are more valuable.

 We should think of ways to make the process of

discovering ideas, experimenting with different ways of
doing things and developing new technology more
likely. Without this kind of effort, growth potential will
be diminished.
 Romer calls these “meta-ideas”: ideas about how to
support production and transmission of other ideas.
INSTITUTIONS MATTER
 Institution: The rules of the game in a society or, more formally,
the humanly devised constraints that shape human interaction; the
rules and regulations, laws, customs, and business practices of a
country

 Economists argue that some environments are more conducive to

economic growth than others; here are a few institutions that
most economists agree are conductive to economic growth:
 Property rights structure
 The legal system
 Growth-promoting policies v transfer-promoting policies
 Other institutions

o Consider two countries, A where rule of law operates, contracts

are enforced, private property rights are protected and free
international trade is permitted. Country B, lacks all of this.
PROPERTY RIGHTS STRUCTURE
 The property rights structure that permit individuals to own
property will be more conducive to production and
economic growth than those that do not.
 Consider countries X and Y. In X, people are allowed to
own property, and in Y there are not. In which case, people
are more likely to invest and produce more output?

 The more secure the private property rights are, the greater
the incentive is to produce.
 Consider countries A and A. In A, people’s property is not
well protected and government tends to confiscate property,
and in B this is not the case. In which case, people are more
likely to invest and produce more output?
THE LEGAL SYSTEM
 A legal system that is dependable, honest, and dedicated
to enforcing legitimate contracts, and protecting private
property reduces transaction costs of dealing with others,
thus providing individuals with a greater incentive to
engage in activities conducive to economic growth.
 In country A, the legal system is dependable, honest,
and dedicated to enforcing legitimate contracts, and
protecting private property. In country B, it’s the polar
opposite. In which country, are individuals more likely to
have a greater incentive to start business, lend and borrow
funds, invest, produce goods and innovate?
GROWTH PROMOTING POLICIES
VERSUS TRANSFER PROMOTING
POLICIES
 A growth-promoting policy increases Real GDP and
enlarges the size of the economic pie; a transfer-
promoting policy leaves the size of the pic unchanged,
but increases the size of the slice that one group gets
relative to another
 Lets say that the economic pie is $1000 and special
interest group A gets (1/1000)th of the pie, hence they
get a $1 slice. Which policy would A opt for? A transfer-
promoting policy where it will get $2 slice at the expense
of some other group or a growth-promoting policy where
total pie will increase from $1000 to $1500, and they
will still get (1/1000)th of the pie, which is $1.5 and not
the full increase of $500?
GROWTH PROMOTING POLICIES
VERSUS TRANSFER PROMOTING
POLICIES (CONT)
 Therefore, the more special interest groups are there in a
country, the more likely transfer-promoting policies will
be lobbied for instead of growth-promoting policies.
 Individuals will try to get a larger slice of a constant-
sized economic pie, rather than trying to increase the size
of the economic pie.
 In short, numerous and politically strong special interest
groups are detrimental to economic growth.
OTHER INSTITUTIONS

 Also conducive to economic growth: open and

competitive markets, free (international) trade, policies
that promote economic freedom, a stable monetary
system, taxes and regulations that are not burdensome,
and a strong and effective educational system