Long-Run Economic Growth: Sources and Policies

Introduction to Economic Growth

Economic growth refers to the sustained increase in a country’s real GDP per capita over time. Understanding the sources and policies that drive long-run economic growth is essential for explaining differences in living standards across countries and over time.

Economic Growth Over Time and Around the World

Defining Economic Growth and Measuring Growth Rates

Economic growth is measured as the percentage increase in real GDP per capita. Most of the world’s economic growth has occurred in the last two centuries, with the Industrial Revolution marking a turning point for sustained increases in living standards.

• Real GDP per capita: Real GDP divided by the population, adjusted for inflation.

• Growth rate formula:

• Small differences in growth rates compound over time, leading to large differences in living standards.

The Industrial Revolution and Its Impact

The Industrial Revolution, beginning in England around 1750, introduced mechanical power to production, replacing human and animal labor. This shift enabled sustained economic growth in England and later in other countries.

• Key institutional changes, such as the establishment of property rights and independent courts, incentivized investment and entrepreneurship.

Global Variation in Living Standards

There are significant differences in real GDP per capita across countries, even after adjusting for cost-of-living differences. High-income countries include Western Europe, North America, Japan, and others, while developing countries have much lower incomes.

What Determines How Fast Economies Grow?

The Economic Growth Model

The economic growth model explains long-run growth in real GDP per capita, focusing on labor productivity, which is determined by:

• The quantity of capital per hour worked

• The level of technology

Labor productivity increases when workers have more capital (machines, tools) and when technology improves.

Sources of Technological Change

• Better machinery and equipment: Innovations like the steam engine and computers.

• Increases in human capital: Education and training improve worker skills.

• Improved organization and management: Efficient production methods, such as just-in-time inventory systems.

The Per-Worker Production Function and Diminishing Returns

The per-worker production function shows the relationship between real GDP per hour worked and capital per hour worked, holding technology constant. Initial increases in capital are highly effective, but additional capital yields diminishing returns.

The Role of Technological Change

Technological change shifts the production function upward, allowing more output per hour worked without additional capital. Unlike capital accumulation, technological change does not face diminishing returns in the long run.

New Growth Theory

New growth theory, developed by Paul Romer, emphasizes that technological change is driven by economic incentives and the accumulation of knowledge capital. Knowledge capital is a public good—nonrival and nonexcludable—leading to increasing returns at the economy level.

• Government policies are needed to encourage knowledge creation, such as protecting intellectual property, subsidizing research and development, and supporting education.

Joseph Schumpeter and Creative Destruction

Schumpeter’s concept of creative destruction describes how new products and technologies replace old ones, driving economic growth. Entrepreneurs play a central role in this process by innovating and reorganizing production.

Economic Growth in the United States

Trends in U.S. Productivity Growth

The United States has experienced fluctuations in productivity growth, with periods of rapid growth driven by technological innovation and investment in research and development. Since the mid-1970s, growth rates have varied, with debates about whether the U.S. is entering a period of slower growth or will return to higher rates.

Measurement Issues and the Role of Information Technology

Some economists argue that productivity growth is understated due to difficulties in measuring service output and the increased consumer surplus from technological advances. Information technology has played a significant role in recent productivity improvements.

Why Isn’t the Whole World Rich?

The Catch-Up Hypothesis

The economic growth model predicts that poorer countries should grow faster than richer ones, a process known as catch-up or convergence. This is because additional capital and available technology have a greater impact in countries starting from a lower base.

Barriers to Catch-Up

Many low-income countries have not experienced rapid growth due to:

• Weak institutions and rule of law

• Wars and revolutions

• Poor public education and health

• Low rates of saving and investment

The Benefits of Globalization

Globalization, or increased openness to foreign trade and investment, has helped many countries escape the cycle of low savings and investment. Foreign direct investment (FDI) and foreign portfolio investment can supplement domestic investment and spur growth.

Growth Policies

Government Policies to Foster Growth

Policies that enhance property rights, the rule of law, health, education, technological change, and savings and investment are essential for promoting long-run economic growth.

• Protecting intellectual property (patents, copyrights)

• Subsidizing research and development and education

• Encouraging foreign direct investment

• Reducing corruption and improving governance

Debates about Economic Growth

While economic growth is generally seen as beneficial, especially for low-income countries, some argue that further growth in high-income countries may have negative effects, such as environmental degradation and loss of cultural identity. These debates involve normative considerations beyond economic analysis.