Ch. 11 - 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 significant economic growth has occurred in the last two centuries, especially after the Industrial Revolution.

Historical Trends and the Industrial Revolution

• Before the Industrial Revolution, living standards changed very little over centuries.

• The Industrial Revolution (beginning in England around 1750) marked the application of mechanical power to production, leading to sustained economic growth.

• Key factors included technological innovation and institutional changes that protected property rights and encouraged investment.

Growth Rates and Living Standards

• Small differences in annual growth rates can lead to large differences in living standards over time due to compounding effects.

• For example, a 1.61% growth rate over 50 years leads to a 122% increase in real GDP per capita, while a 2.2% rate leads to a 197% increase.

Global Variation in Income

• 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; developing countries have much lower incomes.

Beyond Income: Other Measures of Living Standards

• Improvements in health, education, and civil liberties can occur even without significant income growth.

• However, there are limits to how much living standards can improve without rising incomes.

What Determines How Fast Economies Grow?

The Economic Growth Model

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

• Two main determinants of labor productivity:

  • Quantity of capital per hour worked

  • 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 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 subsequent increases yield diminishing returns.

The Role of Technological Change

• Technological change shifts the 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.

Case Study: The Soviet Union

• The Soviet Union focused on increasing capital but neglected incentives for technological innovation, leading to slowing growth rates over time.

New Growth Theory

• Developed by Paul Romer, this theory emphasizes that technological change is driven by economic incentives and the accumulation of knowledge capital.

• Physical capital is rival and excludable (private good), while knowledge capital is nonrival and nonexcludable (public good), 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 organizing production 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.

• Recent debates focus on whether the U.S. is entering a period of slow growth or will return to higher growth rates.

Measurement Issues

• Growth in services is harder to measure than goods, possibly understating improvements in living standards.

• Technological advances (e.g., IT, AI) may not be fully 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.

Evidence on Catch-Up

• Among high-income countries, there is evidence of catch-up.

• However, many low-income countries have not experienced rapid growth, and some high-income countries have stopped catching up to the U.S.

Barriers to Growth in Low-Income Countries

• Weak institutions (poor rule of law, corruption, weak property rights)

• 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 achieve higher growth rates.

• 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 and Case Studies

• China’s rapid growth may slow due to diminishing returns to capital, demographic changes, and institutional challenges.

• Sub-Saharan Africa’s growth prospects depend on improved governance and attracting investment in productive sectors.

Is Economic Growth Always Good?

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

• These debates are often normative and cannot be settled by economic analysis alone.