Chapter 1 Economic Growth:
An Introduction to Scarcity and Choice
What's in This Chapter and Why
This chapter shows that the U.S. economy has the highest productivity and real wages among the
large industrial countries. Productivity growth and real wage growth however are slower than in
many other industrial countries and in the growing economies of East Asia.
Partly as a consequence of the rapid employment growth, productivity growth and real-wage
growth have been slow. Part of the slow productivity growth has resulted from a slowing of
technical change. Students may be surprised, however, to learn that productivity growth and
technical change in the manufacturing sector increased rapidly in the 1980s.
The chapter points out that the United States is in control of its economic destiny. Individuals,
of course, always have the option of saving and realizing a return to savings in the future.
Similarly, as a society, we can increase our saving and investment. If we do, we will have more
rapid productivity and wage growth in the future.
Some students will be surprised to learn that hourly productivity in the United States is much
higher than in Japan. It is true that productivity growth is lower in the United States, but to a
certain extent, it is natural that economies with lower productivity will have faster productivity
growth than economies with higher productivity. The chapter states that there is no reason to think
that productivity growth in other countries comes at the expense of productivity growth in the
United States.
Finally, the chapter attempts to identify the factors that help developing countries grow.
Instructional Objectives
After completing this chapter, your students should know:
1. That productivity growth depends upon growth in the capital-labor ratio and technical change,
which consists of technological improvement and efficiency improvement.
2. That productivity growth is the main determinant of real wage growth.
3. The reasons why productivity growth has declined in the United States and the prospects of
growth with the “new economy.”
4. That productivity growth is lower in the United States than in many other advanced countries,
but that productivity levels are higher.
5. That developing countries with a market orientation seem to be more successful in terms of
economic growth.
6. That technology transfer helps developing countries grow, but faster population growth makes
per capita economic growth difficult.
Key Terms
These terms are introduced in this chapter:
Land
Labor
Physical capital
Human capital
Opportunity cost
Production possibilities curve
Best technology
Marginal cost
Scarcity
Marginal benefit
Marginal product
Technological improvement
Efficiency improvement
Capital intensity
Technical change
Suggestions for Teaching
In teaching this material, we like to challenge students' beliefs. For instance, some students believe
that the U. S. economy has somehow become second rate. We show that this belief is wrong. For
example, many students believe that Western Europe and Japan have more advanced economies.
More rapid employment growth and a higher productivity level in the United States contradict their
belief.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following.
1. "American Growth: More than Meets the Eye," The Economist 91 (December 26, 1992).
2. Barry Bosworth, George L. Perry, and Matthew D. Shapiro, "Productivity and Real Wages: Is
there a Puzzle?" Brookings Papers on Economic Activity (1994), pp. 317-344.
3. Stanley Fischer, "Symposium on the Slowdown in Productivity Growth," The Journal of
Economic Perspectives 2 (Fall 1988), pp. 3-97.
4. Charles R. Hulten, "Is the U.S. Economy in Decline?" The American Enterprise 1 (May/June
1990), pp. 62-69.
5. Paul Krugman, "The Myth of Asia's Miracle," Foreign Affairs 73 (November 1994), pp. 62-78.
6. Robert Samuelson, "The Rediscovery of the U.S. Economy," Newsweek 123 (February 28,
1994), p. 67.
7. Karl Zinsmeister, "Shadows on the Rising Sun," The American Enterprise 1 (May/June 1990),
pp. 52-61.
Outline
I.
RECENT GROWTH EXPERIENCES
A. Economic growth has a tremendous ability to raise living standards.
B. Since 1973, economic growth has slowed in high-income countries, but may have picked
up in the United States after 1990.
C. GDP per capita in some countries may be catching up to that in the United States.
1. This has occurred because some countries have experienced economic growth rates
significantly greater than that of the United States
D. Some countries are experiencing significant growth, but others appeared trapped at low
growth rates. Considerations of the recent growth experiences in the selected countries
raises at least three important questions:
1. What are the sources of economic growth in the United States and what are the
prospects?
2. What are the similarities among countries that are successful in growth?
3. What are the similarities among countries that have failed to achieve steady economic
growth?
II. SOURCES OF ECONOMIC GROWTH
A. Production Possibilities for the Economy
1. The economy uses resources to produce goods and services.
a. Land, labor, and capital (physical and human) are the three primary resources.
1. Land is all natural resources and raw materials.
2. Labor includes efforts and services of people in the production of goods and
services.
3. Physical capital consists of durable produced goods used in the production
process. Human capital consists of the knowledge and skills embodies in
people, as applied to the production of goods and services.
2. A production possibilities curve shows the maximum combinations of two goods and
services that an economy can produce when resources are fully used and the best
technology is applied.
a. The best technology is the technology that requires the fewest resources to produce
a given combination of goods and services.
b. The opportunity cost of gaining more of one kind of output is the value of what
must be given up in order to obtain it.
B. The Best Combination of Goods and Services: Consumption vs. Growth
1. The best combination of goods and services is the combination that satisfies wants as
fully as possible.
2. In order to achieve the best combination, the economy should produce at the point
where marginal benefit and marginal cost are equal.
a. These values depend on both the amounts of goods and services sacrificed and
gained and also on the values that individuals place on present and future
consumption.
C. Resource Accumulation, Technological Improvement, and Efficiency Improvement
1. Economic growth, a rightward shift in the production possibilities curve, will occur if
resources expand.
2. Technological progress, an improvement in the best technology that allows more
output to be produced with a given amount of resources, will result in economic
growth.
3. Efficiency improvement, a change from the use of less than the best to the best
technology, results in an increase in output.
a. Unlike an expansion of resources and technological progress, technical efficiency
improvement moves an economy from a point inside the production possibilities
curve to a point on the curve. The curve does not shift.
D. The Importance of Productivity Growth
1. Productivity growth is important because it determines how fast compensation per
hour can grow.
2. From 1960 to 1973, real output per hour grew by about 3 percent per year. From 1973
to 1990, it grew by about 1.3 percent per year. Over these periods, compensation per
hour grew at about the same rate as output per hour–hence their close correspondence.
3. Since 1990, productivity and thus compensation have grown faster–at 2 percent annual
rate. Some observers believe that the more rapid growth suggests that we are in a “new
economy” and expect a long period of rapid economic growth.
III. PRODUCTIVITY GROWTH: WHAT CAN WE EXPECT IN THE “NEW ECONOMY”?
A. The Contribution of Capital Intensity Growth: The New Economy?
1. From 1995 to 1999, the use of information technology (IT) grew at almost 20 percent
per year, while non-IT capital services grew at 3 percent a year, and labor services
grew at about 2 percent.
2. These growth rates imply an increase in capital intensity, and specifically, IT capital
intensity.
3. Experts conclude that labor productivity has grown faster in the 1990s because of
technical change contribution.
B. The Contribution of Technical Change: The New Economy?
1. Changes in labor productivity growth caused by fluctuations in technical change
limited our prosperity from the 1970s through early 1990s and may have enhanced it
since then.
2. Technical change is more than scientific and engineering advances. It is anything that
increases output from a fixed amount of resources.
3. By the mid 1980s the IT revolution probably begun a new wave of economic progress
introducing new technologies and discarding old ones. These new technologies have
their impacts over a long period of time, hence the impact of rapid technical change of
mid 1990s may be yet to come.
4. The technological advances in the IT sector and build up in IT assets have played a
role in productivity acceleration. However, retail, banking, and hotel sectors have
invested heavily in IT but are not realizing productivity benefits.
5. The prospects are encouraging, but the existence of the new technology is not
sufficient to guarantee the results.
IV. ECONOMIC AND PRODUCTIVITY GROWTH IN VARIOUS PARTS OF THE WORLD
A. Growth in Europe and Japan: Catching Up
1. Other countries have converged rapidly towards productivity levels in the United
States because they have had a more rapid growth rate in capital intensity.
a. Fast employment growth in the United States has led to a slower growth rate of
capital intensity.
b. More rapid investment can help the United States maintain both a rising standard
of living and its leading position in productivity.
2. Both Germany and Japan get a greater boost to labor productivity growth from
technical change than does the United States.
a. Structural effects help to account for differences in technical change in the United
States and technical change in Germany and Japan.
1. The large shifts in economic activity away from the agricultural industry in
Germany and Japan have tended to raise overall productivity.
b. Technological diffusion or catch-up effects help to account for differences in
technical change in the United States and technical change in Germany and Japan.
1. Technology transfer from the United States to Germany and Japan has also
increased their productivity growth.
c. The foreign trade effect helps to account for differences in technical change in the
United States and technical change in Germany and Japan.
1. Free trade after World War II gave an advantage to follower countries because
it increased competition in smaller economies where monopolies once
flourished and because it allowed smaller countries to take advantage of large
size.
B. Developing Countries after 1950: Some Grow. Some Don’t.
1. Korea and Taiwan have moved well ahead of many African and Latin American
countries in terms of income growth since 1950.
2. Those countries with the most success at catching up with the United States since 1950
have place emphasis on an educated work force and investment in human and physical
capital; moreover, they are open to foreign influences.
3. Compared with the past, developing countries may have a disadvantage in
experiencing rapid economic growth.
a. Economic growth requires that either a) labor grow faster than the population, b)
capital grow faster than labor, or c) technical change. Population growth in
developing countries (caused by improved health care), makes it more difficult to
fulfill the first two requirements for economic growth.
4. In the area of technical change, developing countries may have an advantage relative to
the past.
a. They must simply adapt technology to their economies rather than develop it.
Answers to Review Questions
1. Compare the economic growth of Japan, Korea, and the United States since 1960.
Since 1820, the United States has had a lower growth rate than Japan. The annual growth rate
of the United States over this period was about 1.6 percent. Japan, on the other hand,
experienced annual growth rates of about 1.9 percent. This may seem like a small difference,
but in 1820, per capita income in the U.S. was 100 percent greater than in Japan; in 1992, it
was only 16 percent greater. Since 1960, the U.S. has had an average annual growth rate of 1.9
percent while Japan’s average annual growth rate has been over 4 percent. Korea has had an
average annual growth rate of over 6 percent.
It should further be noted that since 1973, growth rates in both the United States and
Japan have declined significantly. Korea’s growth rates have declined slightly. Both Korea and
Japan experienced rapid growth from 1960 through 1990, which caused the absolute income
gap between these countries and the U.S. to narrow substantially. Since 1990, the Japanese
economy has stagnated, and Korea suffered from economic crises in the late 1990s. The result
is that the United States’ advantage in terms of absolute income is again growing.
2. Define each of the following terms:
a. production possibilities curve.
b. technological improvement
c. efficiency improvement
a. A production possibilities curve is a curve showing the maximum combinations of two
goods (or services) that can be produced by an economy when its resources are fully
employed and the best technology is used.
b. Technological improvement is an improvement in the best technology that allows more to
be produced with a given amount of resources. The best technology is the technology that
requires the fewest resources to produce a given combination of goods and services.
c. Efficiency improvement is a change from the use of less than the best technology to the
best technology. It allows more output to be produced with the same resources.
3. Is a faster rate of economic growth always desirable? Explain carefully using the
production possibilities curve.
A faster rate of economic growth is not always desirable. One way economic growth occurs is
through an increase in capital resources. This occurs as more capital goods are produced. It is
only desirable to increase the production of capital goods, if the marginal benefit of increased
production outweighs the marginal cost. This is illustrated in the following example.
Coffee
(Pounds)
.A
300
.B
290
100
101
Robots
Note that two goods, robots (a capital good) and coffee (a consumption good), are
produced. Suppose the economy is currently operating at point A where 100 robots and 300
pounds of coffee are being produced. In order to produce one more robot, the economy must
move from point A to point B. This requires that 10 pounds of coffee be given up. Thus, the
marginal cost of the robot is the value of the 10 pounds of coffee. The marginal benefit of the
robot is the value of increased coffee production that can be produced in the future because
more capital equipment will be available in the future.
If the marginal benefit of the robot exceeds the marginal cost, it pays to move from
point A to point B. On the other hand, if the marginal cost (the consumption we give up in the
present) exceeds the marginal benefit (the value of future consumption) we should not move
from A to B. In this case, a faster rate of economic growth would not be desirable. These
values will depend on both the amounts of goods and services sacrificed and gained as well as
on the values that individuals place on present and future consumption.
4. Use the accompanying graph to answer questions a through d.
Capital Goods
per Year
8
0
.B
.C
10
.D
.
A
100
120
Consumption Goods
per Year
a. What point would represent a combination of goods and services that cannot be
produced with the economy's given resources and technology?
b. What point would represent a combination of goods and services that might be
produced if the economy were experiencing unemployment? What else could cause
the economy to be at that point?
c. Suppose the economy is currently producing at point C and would like to have the
consumption goods represented by point D. What must be given up to obtain the
increased consumption goods?
d. Suppose the economy is at point D. What might be done to increase the chances of
being at B next year? What are other ways to get to B?
a. Any point, such as point B, which lies beyond the boundary of the production possibilities
curve represents a combination of goods and services that cannot not be produced with the
economy's given resources and technology.
b. Any point within the boundary of the production possibilities curve, such as point A,
would represent a combination of goods and services that might be produced if the
economy were suffering from unemployment. Anytime the economy is not using the best
technology or resources are not fully employed, the economy will be operating at a point
inside the production possibilities curve.
c. If the economy is at point C, it is producing 10 million units of capital goods and 100
million units of consumption goods. If the economy moves to point D, it will produce 80
million units of capital goods and 120 million units of consumption goods. To increase the
production of consumption goods by 20 million units, 2 million units of capital goods must
be given up.
d. One thing that can be done to increase the chances of being at point B next year is to
decrease the production of consumption goods and increase the production of capital
goods. As a result, capital resources will grow, and the production possibilities curve will
shift out. In addition, improvements in technology will also shift the production
possibilities curve. As improvements in the economy's best technology improve, the
chances of reaching point B will be enhanced.
5. Why did compensation per hour not grow as fast after 1973 as it did from 1960 to 1973?
Growth in productivity, output per hour, limits how fast compensation per hour can grow.
From 1960 to 1973, real output per hour grew about 2.5 percent per year. After 1973, it grew
by less than 1 percent per year. Compensation per hour grew at about the same rate as
productivity. From 1960 to 1973, real compensation per hour grew at an annual rate of 2.5
percent. Compensation growth, mirroring growth in productivity, collapsed to about 0.8
percent per year after 1973.
6. According to the box titled, "Were the Good Old Days Really Better?" the growth in the
American standard of living since the early 1970s has been greater than suggested by
government statistics that use the CPI to adjust for inflation. Explain.
The standard of living since the early 1970s has grown faster than suggested by government
statistics because of problems with the CPI. Specifically, the CPI may overstate changes in the
cost of living by as much as 1.1 percent per year. If this is the case, then instead of falling by
13 percent, real earnings actually grew by 13 percent. Instead of falling by 4 percent, real
median family income grew by 24 percent.
There are several problems with the CPI. First, there is a substitution bias. The
substitution bias arises because the CPI does not take into account the fact that people will
substitute relatively cheaper goods for relatively more expensive goods when price changes.
Other biases arise because of changes in consumer shopping behavior. For example, the CPI
ignores price decreases that occur as consumers shop more at discount stores or make more
gasoline purchases from self-serve stations. The CPI also has problems accounting for new
goods and quality changes. New products enter the index only every 10 to 15 years. Price
increases caused by improvements in quality are not fully accounted for. Because of these
problems, the CPI tends to overstate the cost of living. As a result, the growth in the standard
of living tends to be understated.
7. What caused the slowdown in labor productivity growth in the United States after 1973?
In order to understand the slowdown in labor productivity growth, we must first understand its
components. Changes in labor productivity growth can be attributed to changes in the growth
of capital relative to labor and to technical change: technological and efficiency improvements.
After 1973, labor inputs grew much more rapidly than in previous periods. This reduced the
growth rate of capital equipment available per worker. The contribution of growth of capital
intensity to labor productivity growth fell by about 20 percent. It should be noted that until
1979, the slower growth in capital intensity was due solely to a rapid growth in labor inputs.
However, since 1979, the growth rate of capital has declined significantly.
In addition to a decline in the contribution of capital relative to labor, the contribution
of technical change to labor productivity growth in the manufacturing sector collapsed to zero
after 1973. Since 1979, the contribution of technical change to labor productivity growth in the
manufacturing sector has rebounded to previous levels.
8. Explain the sources of the increased productivity growth in the United Stated in the 1990s
after 1995.
The growth of labor productivity can be divided into two parts: one part caused by the growth
of capital (human and physical) relative to labor and another part caused by technological and
efficiency improvements. Human capital accumulation contributes to growth because it means
that workers have greater education and experience. Physical capital accumulation contributes
to growth because it means that workers have more capital to work with—more equipment.
The growth of human and physical capital relative to labor is referred to as growth in capital
intensity, and technological and efficiency improvements as technical change.
Information technology (IT) has transformed the work place and the nature of work in
the U.S. economy. The use of IT capital services (computers, software, and communications
equipment) grew at almost 20 percent per year from 1995 to 1999, almost doubling the rate of
the previous 5 years. Non-IT capital services grew at about 3 percent a year and labor services
grew at about 2 percent. The growth rates imply that labor works with more non IT capital and
substantially more IT capital than in did in 1990 or even 1995. Thus, the growth of capital
intensity makes an additional contribution to productivity after 1995. Expert economists
conclude that an increasing and now large portion of the capital intensity effect on productivity
is tied to increases in capital services from IT assets.
In addition the increased growth due to changes in capital intensity, labor productivity
has grown faster in the 1990s because of technical change contribution. Technical change is
more than scientific and engineering advances, it is anything that increases output from a fixed
amount of resources. Improved or new products based on research and development, greater
efficiency in the economy, or improved management techniques might cause it. Developments
and productivity in the semiconductor and telecommunications industries coupled with
competitive pressures have played an important role in driving productivity in those industries,
as well as the retailing, wholesaling, and securities sectors. However, other sectors, such as the
retail banking and hotel, have invested heavily in IT and are not realizing productivity benefits.
Whether or not we are in a new period of rapid economic growth due to advancing productivity
related to IT investments is still to be determined.
9. "Productivity growth in Japan is greater than productivity growth in the United States
because its workers are more productive." Is this statement true or false? Defend your
answer.
The above statement is false. Japanese workers are actually less productive than their
American counterparts. It is the growth rate of productivity in Japan that exceeds that of the
United States. The more rapid growth in Japan's productivity can be attributed to several
factors. First, there has been a more rapid growth in Japan's capital-labor ratio. The capitallabor ratio contributes much more to labor productivity growth in Japan than it does in the
United States. Technical change has also contributed to Japan's rapid growth in productivity.
The contribution of technical change in Japan is also much greater than in the United States.
Angus Maddison argues that the higher rates in productivity growth in Japan are due to
structural effects, technological diffusion or catch-up effects, and the foreign trade effect.
Japan has had much larger shifts out of agricultural than has the United States. This structural
shift from agriculture tends to raise overall productivity. The technological diffusion or catchup effect occurs as a result of technology transfer. The United States has tended to be the
leader in technological advances. As Japan has adapted this technology, their productivity
rates have begun to grow at a faster rate. Finally, free trade after World War II has given Japan
an advantage because increased competition decreased monopoly power in the country and
because increased competition allowed the country to take advantage of large size.
10. What factors explain why labor productivity in Japan and Western Europe has grown
faster than in the United States?
Since 1950, productivity growth in Japan has grown almost 2.5 times faster than in the U. S.,
and Europe's productivity growth has been over 1.5 times faster than the United States'. Europe
and Japan also get a greater boost to labor productivity growth from technical change than does
the United States. This is due to the structural effect, the technological diffusion effect, and the
foreign trade effect. Since the 1950s, both Europe and Japan had much larger structural
effects, shifts out of agriculture, than the United States. This shift from agriculture tends to
raise overall productivity. The technological diffusion effect is the result of technology
transfer. Since the devastation of World War II, Europe and Japan have adopted some U. S.
technology and production methods, thereby raising productivity. Finally, there is the foreign
trade effect. Since World War II, freer trade has increased competition in Europe and Japan.
This increased competition has worked to increase productivity in these countries.
11. According to the box entitled "Economic Freedom and Economic Growth in Developing
Countries," countries with more economic freedom have higher levels of per capita
income. Does this prove that economic freedom causes prosperity? Defend your answer.
The box also states that countries with increased economic freedom subsequently
experience faster economic growth. Does this give you any more information about
economic freedom and economic growth? Explain.
Studies show a strong positive correlation between economic freedom and prosperity.
Countries with more economic freedom have higher levels of per capita income. However, this
does not prove that economic freedom causes prosperity. It may be that economic and political
freedoms are luxuries that only prosperous economies can afford. If that is the case, it is
prosperity that cause economic freedom.
Although we cannot prove that economic freedom results in greater prosperity, there is
some evidence to support this argument. In countries where economic freedom increased,
GDP per capita grew at higher rates. In countries where economic freedom declined, per capita
GDP grew at lower rates. It may be that the incentives and efficiencies created by greater
economic freedom promotes economic growth. The correlation of changes in economic
freedom with changes in growth rates of per capita GDP does provide additional evidence for
the proposition that economic freedom results in economic prosperity.
12. Discuss one advantage and one disadvantage that developing counties have as they try to
encourage economic growth. What policies have proven successful in promoting
economic growth?
Compared to the past, developing countries have an advantage in technology catch up.
Technical change in today's developing countries can be the result of efficiency improvement
rather than technological improvement. This is because the more advanced technology already
exists. It is now a matter of adapting it to a particular economy rather than developing it from
scratch.
Compared to the past, developing countries may be at a disadvantage. This
disadvantage arises because today's improvements in health care have increased life
expectancy and accelerated population growth. Recall that in order for per capita GDP to
increase either a) labor must grow faster than the population, b) capital must grow faster than
labor, or c) there must be technical change. Growing population and increased life
expectancies make it more difficult to fulfill these first two requirements.
Several policies have proved successful in promoting economic growth. These policies
include emphasizing primary and later secondary education for boys and girls, encouraging the
establishment of a private business sector, establishing secure property rights, encouraging
domestic saving and investment, and pursing monetary and fiscal policies to avoid extreme
inflation. In other words, policies that have encouraged the rapid accumulation of human and
physical capital and policies enhancing economic stability have proven successful in promoting
economic growth.
13. Economic News Online-- http://www.swcollege.com/bef/econ_news.html. Go to this site
and choose the Equilibrium category under Fundamentals and choose an EconNews story
that interests you. Read the full summary and answer the questions posed.
Choices of articles and answers will vary.