Long-Run Economic Growth: Sources and Policies

Introduction to Economic Growth

Economic growth refers to the sustained increase in a country's output of goods and services, typically measured as real GDP per capita. 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

Definition and Measurement of Economic Growth

• Economic growth is the increase in real GDP per capita over time.

• Growth rates are calculated as the percentage change in real GDP per capita from one period to another.

• Most global economic growth has occurred in the last two centuries, especially since the Industrial Revolution.

The Industrial Revolution and Its Impact

• The Industrial Revolution began in England around 1750, marking the shift from human and animal power to mechanical power in production.

• This transition enabled sustained long-run economic growth in England and later in other countries.

Global Trends in Living Standards

• Small differences in growth rates can lead to large differences in living standards over time.

• High-income countries have much higher real GDP per capita than developing countries, even after adjusting for cost-of-living differences.

Beyond Income: Other Measures of Well-Being

• While income is a key indicator, improvements in health, education, and civil liberties also contribute to higher living standards.

• Technological and knowledge advances can improve well-being even without significant income growth.

What Determines How Fast Economies Grow?

The Economic Growth Model

An economic growth model explains long-run growth in real GDP per capita by focusing on labor productivity, which is the amount of goods and services produced per worker or per hour worked.

• Two main factors affect labor productivity:

  • The quantity of capital per hour worked

  • The level of technology

Sources of Technological Change

• Better machinery and equipment (e.g., steam engine, computers)

• Increases in human capital (education, training, experience)

• Improved organization and management of production (e.g., just-in-time systems)

The Per-Worker Production Function

The per-worker production function shows the relationship between real GDP per hour worked and capital per hour worked, holding technology constant. The function exhibits diminishing returns: as capital increases, the additional output from each new unit of capital decreases.

The Role of Technological Change

• Technological change shifts the per-worker production function upward, allowing more output per hour worked for any given amount of capital.

• Unlike capital accumulation, technological change does not suffer from diminishing returns in the long run.

Case Study: The Soviet Union

• The Soviet Union focused on increasing capital but lacked incentives for technological innovation, leading to slower long-term growth.

New Growth Theory

• Developed by Paul Romer, this theory emphasizes that technological change results from economic incentives and market forces.

• Knowledge capital (ideas, research, and development) is a public good—nonrival and nonexcludable—leading to increasing returns at the economy level.

Government’s Role in Fostering Growth

• Protecting intellectual property (patents, copyrights)

• Subsidizing research and development (R&D)

• Subsidizing education

Creative Destruction

• Joseph Schumpeter described economic growth as a process of creative destruction, where new products and technologies replace old ones, driving progress but also causing some firms to fail.

• Entrepreneurs play a central role in this process by innovating and combining resources in new ways.

Economic Growth in the United States

Trends in U.S. Productivity Growth

• Growth rates were modest before 1900, increased in the 20th century due to R&D, and fluctuated after the 1970s.

• Information technology has been a major driver of productivity since the 1990s.

• Debate exists over whether the U.S. is entering a period of slow growth (secular stagnation) or will return to faster growth.

Measurement Issues

• Service output is harder to measure than goods output, possibly understating productivity growth.

• Technological advances may increase consumer surplus not captured in GDP statistics.

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, leading to convergence in living standards.

• This is called catch-up or convergence.

Barriers to Catch-Up

• Not all countries experience rapid growth due to:

  • Weak institutions (poor rule of law, corruption)

  • Wars and revolutions

  • Poor public education and health

  • Low rates of saving and investment

The Role of Globalization

• Globalization—greater openness to trade and investment—has helped many countries grow faster.

• Foreign direct investment (FDI) and foreign portfolio investment can supplement domestic investment and spur growth.

Growth Policies

Policies to Foster Economic Growth

• Enhancing property rights and the rule of law

• Improving health and education

• Promoting technological change (including encouraging FDI)

• Promoting savings and investment (e.g., through tax incentives)

Challenges for Developing Countries

• Developing countries often face brain drain, where skilled workers emigrate to high-income countries.

• Improved governance, political stability, and absence of violence are essential for sustained growth.

Debate: Is Economic Growth Always Good?

• While growth is clearly beneficial for low-income countries, some argue that further growth in high-income countries may have negative effects (e.g., environmental harm, resource depletion, cultural loss).

• These are normative debates, and economic analysis can inform but not resolve them.

Summary Table: Key Factors Affecting Economic Growth