Long-Run Economic Growth

Introduction

Long-run economic growth is a fundamental driver of improvements in health, wealth, and living standards across the globe. The relationship between economic growth and outcomes such as child mortality is direct: higher GDP per capita is associated with greater survival rates for newborns. This section explores the vast differences in living standards and growth rates among countries, and investigates the determinants and policies that influence long-run growth.

Incomes and Growth Around the World

Differences in Living Standards

There are significant disparities in GDP per capita across countries, reflecting vast differences in living standards. For example, Singapore's GDP per capita is over $130,000, while Chad's is just over $2,600. These differences are shaped by historical, institutional, and policy factors.

• GDP per capita: The value of goods and services produced per person in a country.

• Living standards: Higher GDP per capita generally means better access to health, education, and infrastructure.

• Example: Countries like the United States and Singapore have high GDP per capita and high living standards, while countries like Chad and Rwanda have much lower figures.

Variation in Growth Rates

Growth rates also vary widely. China has experienced rapid growth (8.2% annually since 1990), while Japan's growth rate has been much lower (0.8%). These differences affect how quickly countries can improve their living standards over time.

• Growth rate: The annual percentage increase in GDP per capita.

• Example: Rapid growth in China and India has lifted millions out of poverty, while stagnant growth in some countries has left them in a poverty trap.

Productivity: The Key to Growth

Definition and Importance

Productivity is the average quantity of goods and services produced per unit of labor input. It is the most important determinant of a country's standard of living.

• Formula: , where is real GDP and is the quantity of labor.

• High productivity leads to higher incomes and improved living standards.

• Growth in productivity is essential for sustained increases in living standards.

Determinants of Productivity

• Physical Capital per Worker (K/L): The stock of equipment and structures used to produce goods and services. More capital per worker increases productivity.

• Human Capital per Worker (H/L): The knowledge and skills acquired through education, training, and experience. Higher human capital per worker boosts productivity.

• Technological Knowledge: Society's understanding of the best ways to produce goods and services. Technological progress increases productivity by enabling more efficient production.

Economic Growth and Public Policy

Saving and Investment

Increasing physical capital requires investment, which is funded by saving. There is a tradeoff between current consumption and future productivity: producing more capital means consuming less today to enjoy higher living standards tomorrow.

• Investment: Spending on capital goods that will be used to produce goods and services in the future.

• Saving: Foregoing current consumption to fund investment.

• Tradeoff: Reducing consumption today to increase future output and living standards.

Investment from Abroad

Foreign investment can help raise capital per worker and boost productivity. There are two main types:

• Foreign Direct Investment (FDI): Capital investment owned and operated by a foreign entity (e.g., a factory built by a multinational corporation).

• Foreign Portfolio Investment: Investment financed with foreign money but operated by domestic residents.

• International organizations like the World Bank and IMF facilitate foreign investment in developing countries.

Education

Investment in human capital through education increases productivity and wages. Governments can promote education by funding public schools and providing subsidized loans.

• Human capital: Each year of schooling raises a worker’s wage by about 10% in the U.S.

• Tradeoff: Time spent in school means sacrificing current wages for higher future earnings.

Incentives and Institutions

Institutions are the rules and structures that shape economic incentives. Strong institutions are essential for economic growth.

• Key institutions: Property rights, honest government, political stability, and a dependable legal system.

• Corruption: Countries with corrupt governments tend to have lower growth and living standards.

Proof That Institutions Matter

The contrast in economic development between countries can be stark and visible even from space. For example, the Korean peninsula at night shows South Korea brightly lit, indicating high economic activity, while North Korea is mostly dark, reflecting low development and poor institutions.

Free Trade

Trade policies significantly affect economic growth. Inward-oriented policies (e.g., tariffs, restrictions on foreign investment) tend to hinder growth, while outward-oriented policies (e.g., free trade, open investment) promote integration and productivity.

• Trade: Makes everyone better off by allowing countries to specialize and benefit from comparative advantage.

• Example: South Korea, Singapore, and Taiwan experienced rapid growth after adopting outward-oriented policies.

• Inward-oriented policies: Often lead to stagnation, as seen in Argentina during the 20th century.

Research and Development (R&D)

Technological progress is the main driver of long-run increases in living standards. Knowledge is a public good, and policies that promote R&D can have widespread benefits.

• Patent laws: Protect inventors and encourage innovation.

• Tax incentives and grants: Support private and university research.

• Example: Advances in agricultural technology, such as AI drones, can boost productivity and living standards.

Active Learning: Policy Discussion

Effective Policies for Growth

Consider which policies might be most effective at boosting growth and living standards in a poor country over the long run:

• Offer tax incentives for investment by local firms

• Offer tax incentives for investment by foreign firms

• Give cash payments for good school attendance

• Crack down on government corruption

• Restrict imports to protect domestic industries

• Allow free trade

• Give away condoms

Policies that promote investment, education, honest government, and free trade are generally most effective at raising long-run growth and living standards.