Lecture Outline:  Chapter 8

I.  General Observations about Growth.

A.  Growth increases the economy's potential output.
1.  Growth is an increase in the amount of goods and services an economy produces
2.  The study of growth is the study of why that increase comes about assuming that both labor and capital are fully employed.
3.  Growth is an increase in potential output.  When an economy is at its potential output, it is operating on its production possibility curve.
4.  Long run growth focuses on supply; it assumes Say's Law -- demand is sufficient to buy whatever is supplied.
5.  In the short run, economists consider potential output fixed.  They focus on how to get the economy operating at its potential if, for some reason, it is not.

B.  Growth is important for living standards .
1.  Long term growth rates matter a lot because of compounding.
2.  This means that growth is based not only on original levels of income in a country, but also on the accumulation of previous years’ increases in income.
3.  A quick way of determining in how many years a nation's growth rate will cause a doubling of income, divide 72 by the rate of growth.  This is called the Rule of 72.

C.  Markets and specialization lead to growth.
1.  Economic growth took off when markets began (early 1800s), and as they expanded, growth accelerated.
2.  Adam Smith argued that markets allowed for specialization – the concentration of individuals on certain aspects of production, and on division of labor – the splitting up of a task to allow for specialization of production.  These lead to increased productivity – output per unit of input.
3.  With increasing specialization and division of labor comes increasing productivity which creates a higher standard of living for everyone.
4.  This argument is reinforced by the principle of comparative advantage.  By concentrating on the production of those goods for which a person's skills and other resources are suited, and then trading for those goods for which one does not have a comparative advantage, the possibilities of production rise.

D.  Economic growth, distribution, and markets.
1.  Markets are often seen to be unfair because of the effect they may have on the distribution of income.
2.  Markets may not provide equality of income but they do make the poor better off.  Would the poor be better off without markets?
3.  Historically, judged from an absolute standard, there is strong evidence that the poor benefit enormously from the growth that markets foster.
4.  Judged from a relative standard, it is not at all clear that markets require the large differentials in pay that has accompanied growth in market economies.

E.  Per capita growth.
1.  Per capita output is total output divided by total population.
2.  Per capita growth means producing more goods and services per person.
3.  The problem in many developing nations is that although GDP is rising, the population is rising even faster resulting in a lower per capita growth rate.
4.  Per capita growth = percent change in output – percent change in population
5.  Some economists have argued that per capita (mean) output is not what we should be focusing on.  Instead we should focus on median income.
a.  Median income is a better measure because it takes into account how income is distributed.
b.  If the growth in income goes to a small majority of individuals who receive the majority of income, the mean will rise but the median will not.
c.  Unfortunately, statistics on median is generally not collected so economists use per capita income.
 

II.  The Sources of Growth.
Economists have five important sources of growth: (1) capital accumulation – investment in productive capacity, (2) available resources, (3) institutions with incentives compatible with growth, (4) technological development, and (5) entrepreneurship

A.  Investment and accumulated capital.
1.  Years ago it was thought that physical capital and investment were the keys to growth.  The flow of investment lead to the growth of the stock of capital.
2.  The growth recipe is far more complicated.
a.  Capital accumulation does not necessarily lead to growth.  Take the former Soviet Union, for example.
b.  Products change, and useful buildings and machines in one time period may be useless in another.
c.  Capital includes much more than buildings and machines.
(1) It includes human capital – the skills that are embodied in workers through experience, education, on-the-job training, and:
(2) Social capital – the habitual way of doing things that guides people in how they approach production.
d.  All economists agree that the right kind of investment at the right time is a central element of growth.

B.  Available resources.
1.  For an economy to grow it will need resources.  What constitutes a resource at one time may not be a resource at another time.  Technology plays an enormous role here.
2.  Greater participation in the market is another way by which available resources are increased.

C.  Institutions with incentives compatible with growth.
1.  Growth - compatible institutions must have incentives built into them that lead people to put forth effort, and that discourage people loafing and encouraging others to loaf.
2.  When individuals get much of the gains of growth themselves, they work harder.
3.  Markets that feature private ownership of property foster economic growth.
4.  Mercantilist economies that feature bribes inhibit economic growth.

D.  Technological development.
1.  A larger aspect of growth involves changes in technology – changes in the goods and services we buy, and the way we create goods and services.
2.  Technological change does more than cause economic growth, it changes the entire social and political dimensions of society.
3.  As in other things, there are tradeoffs when new technology is introduced.

E.  Entrepreneurship is the ability to get things done.  That ability involves creativity, vision, and a talent for translating that vision into reality.

F.  Turning the sources of growth into growth.
1.  In order to be effective, the five sources of growth must be mixed in the right proportions.
2.  It is the combination of investing in machines, people, and technological change that plays a central role in the growth of any economy.

III.  The Production Function and Theories of Growth.

A.  Economists’ theories of growth have emphasized the production function – an abstraction that shows the relationship between the quantity of inputs used in production and the quantity of output resulting from production.
Output = A * f (Labor, Capital, Land)
1.  This production function has land, labor, and capital as factors of production, and an adjustment factor, “A”, to capture the effect of technology.
a.  “A” is outside the production function since it can effect the production of all factors.
b.  The production function emphasizes the same issues as the sources of growth.
(1) Entrepreneurship is captured by labor.
(2) Land by available resources.
(3) Capital by capital accumulation..
(4) Technology and the production function by institutions and technological development.
2.  In talking about production functions, economists uses a couple of terms:
a.  Scale economies describe what happens when all inputs increase equally.
(1) Constant returns to scale means that output will rise by the same proportionate increase in all inputs.
(2) Increasing returns to scale occurs if output rises by a greater proportionate increase as all inputs.
(3) Decreasing returns to scale occurs if output rises by a smaller proportionate increase as all inputs.
b.  The second term describes what happens when more or one input is added without increasing any other inputs.  The law of diminishing marginal productivity states that increasing one output, keeping all others constant, will lead to smaller and smaller gains in output.

B.  The standard theory of growth – the Classical growth model – focuses on capital accumulation).
1.  Since investment leads to the increase in capital, they focused their analysis and their policy advice, on how to increase investment.  The linkage was as follows:
savings -- investment -- increases in capital -- growth
2.  The Classical growth model focuses on diminishing marginal productivity of labor.
a.  When farming was the major activity in the economy, Parson Thomas Robert Malthus, an early economist, emphasized the limitation land placed on growth.
b.  Since land was fixed, as population grew, he predicted that diminishing marginal productivity would set in.
c.  The linkage was: economic surplus-- population increases -- output increases -- lower per capita income -- too many people -- starvation.
d.  This belief, called the iron law of wages, combined with the diminished marginal productivity, led to the belief that in the long run there would be no surplus and therefore no growth.  The long run was called the stationary state.
3.  The Classical growth model focus on diminishing marginal productivity of capital.
a.  The Malthusians were dead wrong.  Increases in technology and capital overwhelmed the law of diminishing marginal productivity.
b.  The focus turned to the marginal productivity of capital, not labor.
c.  The linkage was: capital grows faster than labor ? capital is less productive ? slower economic output ? per capita growth stagnates ? per capita income stops rising.
d.  The classicals also had a story about growth rates among nations.  Poor countries with little capital should grow faster than countries with lots of capital because diminishing marginal productivity would be stronger for richer nations than for poor ones.  Eventually per capita incomes among nations would converge.
e.  This has not happened either owing to the ambiguity in the definition of inputs and/or technological progress.
4. The definition of the factors of production are ambiguous.
a.  It would seem that the definition of labor would be straightforward – the hours of work that go into production.
b.  But what of the difference between educated workers and workers less educated?  To answer this, economists separate labor into two components.
(1) Standard labor – the actual number of hours worked.
(2) Human capital – the skills embedded in workers through experience, education, and on-the-job training.
c.  If skills are increasing faster in a rich country than in a poor one, incomes would not be expected to converge.
5.  Economists have estimates of the contribution of the factors to growth. Granted, these estimates are rough.  However, it is clear that technology plays a major role in economic growth.
B.  New growth theories focus on technology.
1.  Technology is the result of investment in creating technology.
a.  Investment in technology, called research and development, increases the capital stock of an economy.
b.  Growth theory separates investment in capital and investment in technology. Why?
(1) Increases in technology are not as directly linked to investment as is capital.
(2) Increases in technology often have enormous positive spillover effects.  Technological advances in one sector of the economy lead to advances in completely different sectors.
c.  Technological advances have positive externalities – positive effects on others not taken into account by the decision maker.
d.  Some basic research is protected by patents – legal ownership of a technological innovation that gives the owner of the patent sole rights to its use and distribution for a limited time.
e.  Once people have seen the new technology, they figure out sufficiently different way to achieving the same end to avoid the patent.
2.  Learning by doing also leads to growth.
a.  New growth theory also highlights learning by doing – improving the methods of production through experience.
b.  If positive externalities flowing from learning by doing and new technologies overwhelm diminishing marginal productivity, we can begin calling ourselves the “optimistic science,” not the “dismal science.”.
3.  Technological lock-in is an example of how sometimes the economy does not use the best technology available.
a.  When old technologies become entrenched in the market, or locked into new products despite the fact that more efficient technologies are available, this is known as technological lock-in.
b.  The best example is the QWERTY keyboard.  Others include beta format videos, Windows operating systems, and English measurement systems.
c.  One reason for technological lock - is network externalities – an externality in which the use of a good by one individual makes that technology more valuable to other people.  Switching from a technology exhibiting network externalities to a superior technology is expensive and sometimes nearly impossible.  The Windows operating system exhibits network externalities.

IV.  Six Economic Policies to Encourage Per Capita Growth.

A.  Policies to encourage saving and investment.
1.  Modern growth theories have downplayed the importance of capital in the growth process.  All, however, agree that it is important.  Policy makers are eager to encourage both saving and investment.
a.  The U.S. has used tax incentives for saving.
(1) These include IRAs, or investment retirement accounts, and 401k plans, another form of investment retirement accounts.
(2) Some economists have proposed switching from an income tax to a consumption tax which taxes individuals only when they consume, thereby exempting all saving from taxation.
b.  In poor countries the poor have subsistence income while the rich in those countries place their savings abroad for fear of confiscation by government.
2.  The borrowing circle of Grameen bank is an example of how to increase investment in a developing nation.
a.  The traditional way of lending money is to ask for collateral.  In Bangladesh, potential borrowers had no collateral.
b.  The bank officer replaced collateral with the borrowing cycle concept - a credit system that replaces traditional collateral with guarantees by friends of the borrower.  In case of a default, the friends had to make the loan good.
3.  Foreign investment provides another source of saving.
a.  Developing nations can borrow from the IMF, the World Bank, or from private sources.
b.  None of these are perfect solutions since they come with large strings attached.

B.  Policies to control population growth.
1.  Developing nations whose populations are rapidly growing have difficulty providing enough capital and education for everyone.  Thus, capital income is low.
2.  Policies that reduce population growth include:
a.  Free family planning services.
b.  Increasing the availability of contraceptives.
c.  Harsh mandatory one child per family policies such as China adopted in 1980.
3.  Some economists argue that to reduce population growth, a nation must grow first.  As income and work opportunities, especially for women, rise, the opportunity cost of having children rises and families will choose to have fewer children.

C.  Policies to increase the level of education.
1.  In developing nations, the return on investments in education is much higher than in developed nations.
a.  In the U.S., it is estimated that an additional year of school increases a worker's wages by an average of 10 percent.
b.  An additional year of school in developing nations will increase income by 15-20 percent.
2.  For economic development it is better that the schooling be in practical subjects not in the classical curriculum (literature, Greek, Latin).

D.  Policies to create institutions that encourage technological innovation.
1.  While all agree that that technology is important, no one is sure what the best technological growth policies are.
2.  Not only is research uncertain, so is its application.
3.  Creating patents and protecting property rights are two ways to encourage innovation, however:
a.  Patents are not costless to society.
b.  Patents create incentives to innovators who charge high prices for their use.
4.  Developing countries face difficult issues with patents.
a.  Should poor nations enforce U.S. patent law?
b.  Societies must find a middle ground between giving individuals appropriate incentives to create new technologies that will make them rich and allowing everyone to take advantage of the benefits of technology.
c.  This problem is especially acute when the patents involve life-saving drugs.
5.  The corporation and financial institutions encourage innovation.

a.  The corporation was invented to limit liability to its owners.  Corporations bring technological innovations to markets.  These innovations are often enormously expensive.
b.  Well developed financial institutions such as stock markets create liquidity and encourage investment.

E.  Provide funding for basic research.
1.  Individual firms have little incentive to do basic research because of technology's “common knowledge” aspect.
2.  This is where the government steps in.  The U.S. government provides 60 percent of the basic research in the country.
3.  Much of the funding is channeled through universities.

F.  Policies to increase the economy's openness to trade.
1.  In order to specialize, you need a large market.
2.  Large markets allow firms to take advantage of economies of scale.
3.  The effect of markets on growth is an important reason why economists support policies that keep domestic markets as regulation free as possible and support international trade.