Economic Growth and
Rising Living Standards
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
1
Economic Growth and Rising Living
Standards
• Economist Thomas Malthus, writing in 1798, came to a
striking conclusion
– “Population, when unchecked, goes on doubling itself every
twenty-five years, or increases in a geometrical ratio…The means
of subsistence…could not possibly be made to increase faster than
in an arithmetic ratio”
• Prognosis was so pessimistic that it led Thomas Carlyle,
one of Malthus’s contemporaries, to label economics “the
dismal science”
• History has proven Malthus wrong…at least in part
• Economists today are optimistic about industrialized
nations’ long-run material prospects
• Achieving a higher rate of growth in long-run generally
requires some sacrifice in short-run
2
The Importance of Growth
• Why should we be concerned about economic growth?
– When output grows faster than population, GDP per capita will rise
• When output grows more slowly than population, average standard of living will
fall
• Measuring standard of living by GDP per capita may seem limiting
• Still, many aspects of our quality of life are counted in GDP such as
– Food, housing, medical care, education, transportation services, and
movies and video games
• Economic growth is especially important in countries with income
levels far below those of Europe, Japan, and United States
– Other than emigration, economic growth is their only hope
• Growth is a high priority in prosperous nations, too
– When output per capita is growing, it’s at least possible for everyone to
enjoy an increase in material well-being without having to cut back
3
The Importance of Growth
• When output per capita stagnates, material gains become a fight over
a fixed pie
– The more purchasing power my neighbor has, the less is left for me
• In 1950s and 1960s, economic growth in wealthier nations seemed to
be taking care of itself
• All of that changed starting in 1970s
– Economic growth became a national and international preoccupation
• Over most of postwar period, output in more prosperous industrialized
countries grew by 2 or 3% per year
– Beginning in mid-1970s, all of these nations saw their growth rates slip
• In late 1990s and early 2000s, only United States and United Kingdom
returned to their previous high rates of growth
– Other industrialized countries continued to grow more slowly than their
historical averages
• Seemingly small differences in growth rates matter a great deal
4
What Makes Economies Grow?
• Useful way to start thinking about long-run growth
– Look at what determines our potential GDP in any given period
• Real GDP depends on
–
–
–
–
Amount of output average worker can produce in an hour
Number of hours average worker spends at the job
Fraction of population that wants to work
Size of population
• Amount of output the average worker produces in an hour
is called labor productivity, or productivity
– Measured by taking total output (real GDP) of economy over a
period of time and dividing by total number of hours that everyone
worked during the period to produce that output
• Productivity = Output per hour = Total output ÷ Total hours worked
5
What Makes Economies Grow?
• Hours of the average worker can be found by
dividing total hours worked over a period by total
employment, number of people who worked
during the period
– Average Hours = Total hours worked ÷ Labor Force
• Fraction of population working is labor force
participation rate (LFPR)
– Found by dividing labor force (all those who want to
work) by population
• LFPR = Labor Force ÷ Population
6
What Makes Economies Grow?
• Multiply these variables together
– Total output = Total output ÷ Total hours worked
x Total hours worked ÷ Labor Force x Labor
Force ÷ Population x Population
• Can write equation for total output as
– Total output = Productivity x Average Hours x
LFPR x Population
• Over long-run, when total output tracks
closely with potential output, this will give us
an equation for potential output
7
What Makes Economies Grow?
• Mathematics states that if two variables A
and B are multiplied together
– Percentage change in their product is
approximately equal to sum of their percentage
changes
• % Δ (A x B) ≈ % ΔA + % ΔB
• Applying this rule to all four variables in right
side of our equation, as well as to total
output on left
– Find that growth rate of output (% Δ Total
Output) over any period of time is
• % Δ Total Output ≈ % Δ productivity + % Δ average
hours + % Δ LFPR + % Δ Population
8
Economic Growth and Living
Standards
• Ultimately, growth in potential output does not by
itself account for a rise in living standards
– What matters for a rising standard of living is real GDP
per capita
• Which—over long-run—will equal our potential output divided
by population
• Total output = Productivity x Average Hours x LFPR x Population
• If we divide both sides by the population, we get
– Total output ÷ Population = Productivity x Average Hours x LFPR
• In terms of percentage growth rates
– % Δ Output per person ≈ % Δ Productivity + % Δ Average hours + % Δ LFPR
• Notice that population drops out of the equation
– Only way to raise living standards is to increase productivity,
average hours, or labor force participation rate
9
Economic Growth and Living
Standards
• If output per person grew due to growth in average work
hours, it’s not clear that living standard would increase
– In most developed countries, average hours are slowly decreasing,
not increasing
– So our last simplification is to ignore changes in average hours in
growth equation
• % Δ Output per person ≈ % Δ productivity + % Δ LFPR
• To explain why U.S.—or any developed country—has
enjoyed continual rises in living standards over long
periods of time
– Must look to growth in productivity and growth in labor force
participation rate
10
Growth in the Labor Force
Participation Rate (LFPR)
• With a constant population, any policy that increases total
number of workers in economy will, by definition, increase
labor force participation rate
• Over past 50 years, as labor supply curve has shifted
rightward, labor demand curve has shifted rightward as
well
– Why?
• Changes have increased amount of output a worker can
produce in any given period
– So firms have wanted to hire more of them at any wage
• Over past century, increases in labor demand have
outpaced increases in labor supply
– So that, on balance, average wage has risen and employment has
increased
11
Growth in the Labor Force
Participation Rate (LFPR)
• Impact of these changes on total employment has
been dramatic
• Currently, U.S. Bureau of Labor Statistics predicts
employment growth of 1% per year until 2010—
about the same as growth rate of population
– Is there anything we can do to make it grow over the
next several years, and thus increase our rate of
economic growth?
• Yes
– But, keep in mind that these measures to increase
employment would also have costs
• Costs that Americans may or may not be willing to pay
12
Figure 1: An Increase in Labor
Supply
13
Figure 2: An Increase in Labor
Demand
14
Figure 3: The U.S. Labor Market
Over A Century
Real
Hourly
Wage
S
S
L1
L2
B
W2
W1
A
D
L2
D
L1
L1
L2
Millions
of Workers
15
How To Increase Employment and
the LFPR
• One set of policies to increase employment focuses on changing labor
supply
– An often-proposed example of this type of policy is a decrease in income
tax rates
– Tax cut would be just what was needed to get you to seek work
• When we extend your reaction to population as a whole
– Can see that a cut in income tax rate can convince more people to seek
jobs at any given wage
• Shifting labor supply curve rightward
– Many American workers must pay combined federal, state, and local taxes
of more than 40¢ out of each additional dollar they earn
• This may be discouraging work effort in United States
• In addition to tax rate changes, some economists have advocated
changes in government transfer programs to speed growth in
employment
– Redesigning these programs might stimulate growth in labor supply
• This reasoning was an important motive behind the sweeping reforms
in U.S. welfare system in August 1996
16
How To Increase Employment and
the LFPR
• A cut in tax rates increases reward for working
– While a cut in benefits to the needy increases hardship
of not working
– Either policy can cause a greater rightward shift in the
economy’s labor supply curve than would otherwise
occur and create growth in labor force participation and
output
• Government policies can also affect labor demand
curve
– Government policies that help increase skills of the
workforce or that subsidize employment more directly
shift the economy’s labor demand curve to the right
• Increasing employment and output
17
How To Increase Employment and
the LFPR
• Efforts to create growth in labor force participation
are controversial
– In recent decades, those who prefer an activist
government have favored policies to increase labor
demand
• Through government-sponsored training programs, more aid to
college students, employment subsidies to firms, etc.
– Those who prefer a more laissez-faire approach have
generally favored policies to increase labor supply by
decreasing government involvement
• Lower taxes or a less generous social safety net
18
Employment Growth: LFPR vs.
Population
• Increases in employment have been an important source of economic
growth in United States and many other countries
• Has been almost entirely due to increases in population, rather than
increases in labor force participation
• Labor force participation rate did account for growth in living standards
during 1970s and 1980s as women—especially married women—
entered labor force at much higher rates than previously
– But by 1990, this source of growth in living standards was exhausted
• LFPR did not rise during 1990s and is not projected to rise in near future
• Efforts to increase living standards by raising LFPR have two serious
drawbacks
– LFPR cannot create rapid growth in living standards indefinitely, because
there is a logical upper limit of 100%
– In developed economies, raising LFPR means that people who currently
do not want jobs must change their minds and want to work
19
Growth in Productivity
• We eliminated variables that could not explain rising living
standards over long-run
– Ruled out population growth
• Based on logic of equation for total output per person
– Ruled out growth in average hours
• Because of upper limit on this variable’s growth and high opportunity
cost paid to raise hours per worker when most of labor force is already
working full-time
– Ruled out increases in labor force participation
• At least as a source of continual, rapid economic growth
• Only one variable remains
– Productivity
• Can we do anything to make productivity grow even
faster?
20
Figure 4: Capital Accumulation and
Labor Productivity
21
Growth in the Capital Stock
• One key to productivity growth is growth in nation’s capital
stock
– Amount of capital available for average worker
– With more capital a given number of workers can produce more
output than before
• Since same number of workers are working same number
of hours, but producing more output than before,
productivity rises
• Growth in capital stock will increase productivity as long as
it increases amount of capital per worker
– If capital stock grows faster than labor force then capital per
worker will rise
• Labor productivity will increase along with it
– But if capital stock grows more slowly than labor force, then capital
per worker will fall
• Labor productivity will fall as well
22
Investment and the Capital Stock
• An increase in capital stock plays a central role in
economists’ thinking about growth
– Contributes to a rise in labor productivity and helps to
raise living standards
• A stock variable measures a quantity at a moment
in time
– Capital stock is a measure of total plant and equipment
in economy at any moment
– Planned investment is a flow variable
• Measures a process that takes place over a period of time
– As long as investment is greater than depreciation, total
stock of capital will rise
– The greater the flow of investment, the faster will be the
rise in capital stock
23
Targeting Businesses: Increasing
the Incentive to Invest
• One kind of policy to increase investment targets the
business sector itself
– With goal of increasing planned investment spending
• Corporate profits tax
– Tax on profits earned by corporations
• Investment tax credit
– A reduction in taxes for firms that invest in certain favored types of
capital
• Reducing business taxes or providing specific investment
incentives can shift the investment curve rightward
– Speeding growth in physical capital
– Increasing growth rate of living standards
24
Figure 5: An Increase In Investment
Spending
25
Targeting Households: Increasing
the Incentive to Save
• While firms make decisions to purchase new capital, it is largely
households that supply firms with funds, via personal saving
– An increase in investment spending can originate in household sector,
through an increase in desire to save
• If households decide to save more of their incomes at any given
interest rate
– Supply of funds curve will shift rightward
• What might cause households to increase their saving?
–
–
–
–
–
Greater uncertainty about economic future
Increase in life expectancy
Anticipation of an earlier retirement
Change in tastes toward big-ticket items
Change in attitude about saving
• Any of these changes—if they occurred in many households simultaneously—
would shift saving curve to the right
• But government policy can increase household saving as well
– One often-proposed idea is to decrease capital gains tax
26
Targeting Households: Increasing
the Incentive to Save
• Another frequently proposed measure is to switch from
current U.S. income tax
– Taxes all income whether it is spent or saved
• To a consumption tax
• Would tax only the income that households spend
• Another proposal to increase household saving is to
restructure U.S. Social Security system
– Provides support for retired workers who have contributed funds to
system during their working years
• Government can alter tax and transfer system to increase
incentives for saving
– If successful, these policies would
• Make more funds available for investment
• Speed growth in capital stock
• Speed rise in living standards
27
Figure 6: An Increase In Savings
28
Figure 7: Deficit Reduction and
Investment Spending
Interest
Rate
5%
Supply
of Funds
(Saving)
E
A
B
3%
Investment
Investment
Spending Spending + Deficit
1.0
1.5 1.75
Funds
($ Trillions)
29
Shrinking the Government’s Budget
• A final pro-investment measure is directed at government
sector itself
– A decrease in government purchases results in
• Raising consumption and investment
• Link between government budget, interest rate, and
investment spending is major reason why U.S.
government, and governments around the world, try to
reduce and, if possible, eliminate budget deficits
– Shrinking deficit or rising surplus tends to reduce interest rates and
increase investment
• Speeding growth in capital stock
• In 1990s, Congress set strict limits on growth of
government spending
– Budget deficit began shrinking
30
Shrinking the Government’s Budget
• When George W. Bush took office in 2001, direction of
growth policy shifted away from preserving budget
surpluses and toward lower tax rates
– A second tax cut in 2003—amounting to $350 billion over 10
years—increased current and project deficits further
• Tax cuts included some elements to increase investment
spending
– Such as a lower tax rate for capital gains and tax incentives for
investment by small businesses
• But the tax cuts
– By raising current and future budget deficits would increase
interest rates
• Worked in opposition to the growth benefits of tax cut
31
An Important Proviso About the
Government Budget
• A reduction in the deficit or an increase in the surplus—
even if they stimulate private investment—are not
necessarily pro-growth measures
– Depends on how the budget changes
– The answers can make a big difference to the impact on growth
• Government investment in new capital and in maintenance
of existing capital makes an important contribution to
economic growth
• Impact of deficit reduction on economic growth depends
on which government programs are cut
– Shrinking deficit by cutting government investment will not
stimulate growth as much as would cutting other types of
government spending
32
Human Capital and Economic
Growth
• Human capital
– Skills and knowledge possessed by workers
• An increase in human capital works like an increase in physical capital
to increase output
– Causes production function to shift upward
• Raises productivity and increases average standard of living
• Another similarity between human and physical capital
– Both are stocks that are increased by flows of investment
• Human capital investments are made by business firms, by
government, and by households
• Human capital, unlike physical capital, cannot be separated from the
person who provides it
• Many pro-growth policies discussed earlier are also effective in
promoting investment in human capital
– Policies that increase employment or increase investment in physical
capital
33
Technological Change
• Another source of growth is technological change
– Invention or discovery of new inputs, new outputs, or new methods
of production
• New technology affects economy in much the same way
as do increases in capital stock
– Shifts production function upward
• Since it enables any given number of workers to produce more output
• In many cases, new technology requires acquisition of
physical and human capital before it can be used
• In some instances, however, a new technology can be
used without any additional equipment or training
– As when a factory manager discovers a more efficient way to
organize workers on the factory floor
• The faster the rate of technological change
– The greater the growth rate of productivity, and
– The faster the rise in living standards
34
Technological Change
• Might seem that technological change is one of those things that just
happens
– But pace of technological change is not as haphazard as it seems
• Rate of technological change in economy depends largely on firms’
total spending on R&D
– Policies that increase R&D spending will increase pace of technological
change
• What can government do to increase spending on R&D?
– Can increase its own direct support for R&D by carrying out more research
in its own laboratories or increasing funding for universities and tax
incentives to private research labs
– Can enhance patent protection
• Increases rewards for those who create new technology by giving them
exclusive rights to use it or sell it
• Encourages developers to spend more on R&D
– R&D spending is in many ways just like other types of investment
spending
• Funds are drawn from the financial market, and R&D programs require firms to
buy something now (laboratories, the services of research scientists, materials
to build prototypes) for uncertain prospect of future profits
35
The Cost of Economic Growth
• Why don’t all nations pursue these policies and push their
rates of economic growth to the maximum?
• Promoting economic growth involves unavoidable trade
offs
– Requires some groups, or nation as a whole, to give up something
else that is valued
– In order to decide how fast we want our economy to grow we must
consider growth’s costs as well as benefits
• One of the most important things you will learn in your
introductory economics course is that there are no
costless solutions to society’s problems
– What are the costs of growth?
36
Budgetary Costs
•
•
•
•
Cutting income tax rate
Cutting taxes on capital gains or corporate profits
Cutting taxes on saving
Implementing any of these tax cuts would force
the government to choose among three
unpleasant alternatives
– Increase some other tax to regain lost revenue, cut
government spending, or permit budget deficit to rise
• While properly targeted tax cuts can increase rate
of economic growth
– Will force us to either redistribute tax burden or cut
government programs
37
Consumption Costs
• Any pro-growth policy that works by increasing
investment—private or government, in physical
capital, human capital, or R&D—requires a
sacrifice of current consumption spending
• Role of this trade-off in economic growth can be
clearly seen with production possibilities frontier
(PPF)
• Greater investment in physical capital, human
capital, or R&D will lead to faster economic growth
and higher living standards in the future
– But we will have fewer consumer goods to enjoy in the
present
38
Figure 8: Consumption, Investment,
and Economic Growth
Production
of Capital
Goods
D
K
E
B
A
C
Production
of Consumption
Goods
39
Opportunity Costs of Workers’ Time
• Living standards will also rise if a greater fraction
of population works or if those who already have
jobs begin working longer hours
– But this increase in living standards comes at a cost
• Decrease in time spent in nonmarket activities
• Thus, when economic growth comes about from
increases in the labor force participation rate (or in
average hours), we face a trade-off
– Can enjoy higher incomes and more goods and
services
– Will have less time to do things other than work in the
market
40
Sacrifice of Other Social Goals
• Rapid economic growth is an important social goal, but not
the only goal
– Some policies that quicken the pace of growth require us to
sacrifice other goals that we care about
• But, just as government policies to stimulate investment
require us to sacrifice other goals, so, too, can pursuit of
other goals impede investment spending and economic
growth
• We can achieve greater worker safety, a cleaner
environment, and other social goals, but we may have to
sacrifice some economic growth along the way
– Alternatively, we can achieve greater economic growth, but we will
have to compromise on other things we care about
41
Using the Theory: Economic Growth
in the Less-Developed Countries
• In most countries, Malthus’s dire predictions have not
come true
– Less-developed countries (LDCs)
• How does a nation go about increasing its capital stock?
– Shifting resources away from consumer-goods production toward
capital-goods production
• Some countries that were once LDCs have applied the
formula very effectively
• But other LDCs have had great difficulty raising living
standards
• Much of the explanation for low growth rates of many
LDCs lies with three characteristics that they share
– Very low current output per capita
– High population growth rates
– Poor infrastructure
42
Using the Theory: Economic Growth
in the Less-Developed Countries
• These characteristics interact to create a vicious circle of continuing
poverty
– Which we can understand with the help of the familiar PPF between
capital goods and consumption goods
• In order to have rising capital per worker—an important source of
growth in productivity and living standards
– A nation’s stock of capital must not only grow, but grow faster than its
population
• Poorest LDCs are too poor to take advantage of the trade-off between
consumption and capital production in order to increase their living
standards
– Since they cannot reduce consumption below current levels, they cannot
produce enough capital to keep up with their rising population
• In recent history, countries have attempted several methods to break
out of this vicious circle of poverty
– During 1930s, dictator Joseph Stalin simply forced Soviet economy from a
point like H to one like J in Figure 9
– Millions who complained too loudly, or who otherwise represented a
political threat, were rounded up and executed
43
Using the Theory: Economic Growth
in the Less-Developed Countries
• A less-brutal solution to problem of LDCs is to make wealthy bear
more of the burden of increasing growth
– These moves often backfire in long-run
• Since restrictions on personal and economic freedom are remembered long
after they are removed
– Makes the public—especially foreigners—hesitant to invest in that country
• A third alternative—and the one used increasingly since 1940s—is
foreign investment or foreign assistance
• Variation on this strategy
– Foreign nations provide consumer goods so that poorer nation can shift its
own resources out of producing them (and into capital production) without
causing consumption levels to fall
• Another alternative is slowing growth in population
– Has been an important (and successful) part of China’s growth strategy
• Although it has required severe restrictions on rights of individual families to
have children
44
Figure 9: LDC Growth and Living
Standards
45
Figure 10: Growth Options for LDCs
(b)
(a)
Production
of Capital
Goods
K
Production
of Capital
Goods
K
F
H
N
T
N
N
´
S
C
Production
of Consumption
Goods
S
C
Production
of Consumption
Goods
46