Chapter 7:
Growth, Productivity,
and Wealth in the
Long Run
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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1
General Observations about Growth

Growth is an increase in the amount of
goods and services an economy produces.

Growth is an increase in potential output.
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2
Growth and the Economy’s Potential

Potential output – the highest amount of
output an economy can produce from the
existing production function and existing
resources.

When an economy is at its potential output, it
is operating on its production possibility
curve.
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3
Growth and the Economy’s Potential

Long-run growth focuses on supply.

It assumes Say’s Law – supply creates its
own demand.

Demand is sufficient to buy what is produced.
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4
Growth and the Economy’s Potential

In the short run, economists consider
potential output fixed.

They focus on how to get the economy
operating at its potential if it is not.
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5
Importance of Growth for Living
Standards

Growth improves living standards.

It makes more goods available to more
people.

Because of compounding, long-term growth
rates matter a lot.
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6
Importance of Growth for Living
Standards

The Rule of 72 is used to determine how long
it takes for income to double at different
growth rates.

The Rule of 72 – the number of years it
takes for a certain amount to double in value
is equal to 72 divided by its annual growth
rate.
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7
Markets, Specialization, and Growth

Markets, specialization and the division of
labour increase productivity and growth.



Specialization – the concentration of individuals
on certain aspects of production
Division of labour – the splitting up of a task to
allow for specialization of production.
Productivity – output per unit of input.
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8
Markets, Specialization, and Growth

Markets and specialization lead to growth.

Economic growth began when markets
developed (early 1800s), and as they
expanded, growth accelerated.
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9
Economic Growth, Distribution, and
Markets

Markets are often seen to be unfair because
of the effect they have on the distribution of
income.
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10
Economic Growth, Distribution, and
Markets

Would the poor be better off without markets?

Historically, judged from an absolute
standard, there is strong evidence that the
poor benefit enormously from the growth that
markets foster.
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11
Economic Growth, Distribution, and
Markets

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.
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12
Economic Growth, Distribution, and
Markets

Just because the poor benefit from growth
does not mean they might not be better off if
income were distributed more in their favour.
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13
Per Capita Growth

Per capita output is total output divided by
total population.

Per capita growth means producing more
goods and services per person.
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14
Per Capita Growth

Per capita growth equals the percent change
in output minus the percent change in
population.
Per capita growth =
% change in output - % change in population
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15
Per Capita Growth

In many developing nations, the population is
rising faster than GDP, resulting in a lower
per capita growth rate.
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16
Per Capita Growth

Some economists have argued that per
capita (mean, average) output is not what we
should be focusing on.

We should focus on median income instead.
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17
Per Capita Growth

Median income is a better measure because
it takes into account how income is
distributed.

If the growth in income goes mostly to a small
minority of individuals, the mean will rise but
the median will not.
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18
The Sources of Growth

Economists identify five important sources of
growth:





Capital accumulation – investment in productive
capacity.
Available resources.
Growth-compatible institutions.
Technological development.
Entrepreneurship.
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19
Investment and Accumulated Capital

Years ago it was thought that physical capital
-- buildings and machinery --was the key to
growth.

The flow of investment led to the growth of
the stock of capital.
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20
Investment and Accumulated Capital

Capital accumulation does not necessarily
lead to growth.

Products change, and useful buildings and
machines in one time period may be useless
in another.
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21
Investment and Accumulated Capital

Capital also includes human and social
capital.


Human capital – the skills that are embodied in
workers through experience, education, on-the-job
training.
Social capital – the habitual way of doing things
that guides people in how they approach
production.
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22
Investment and Accumulated Capital

All economists agree that the right kind of
investment at the right time is a central
element of growth.
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23
Available Resources

For an economy to grow it will need
resources.

What constitutes a resource at one time may
not be a resource at another time.
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24
Available Resources

Greater participation in the market is another
way by which available resources are
increased.
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25
Growth-Compatible Institutions

Markets and private ownership of property
foster economic growth.

When individuals get much of the gains of
growth themselves, they work harder.
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26
Growth-Compatible Institutions

Another growth-compatible institution is the
corporation.

Because of limited liability, corporations give
owners an incentive to invest their savings in
large enterprises.

Losses are limited.
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27
Technological Development

Growth involves changes in technology.

Technology – changes the way we make
goods and supply services, as well as the
goods and services we buy.
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28
Technological Development

To see how technology translates into growth,
we look at Total Factor Productivity (TFP).

Total Factor Productivity (TFP) is the
weighted average of real GDP per worker
and real GDP per $1000 of capital stock.
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29
Entrepreneurship

Entrepreneurship is the ability to get things
done.

That ability involves creativity, vision, and a
talent for translating that vision into reality.
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30
Turning the Sources of Growth into
Growth

In order to be effective, the five sources of
growth must be mixed in the right
proportions.

The combination of investing in machines,
people, and technological change plays a
central role in the growth of any economy.
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31
The Production Function and
Theories of Growth

The production function shows the
relationship between the quantity of inputs
used in production and the quantity of output
resulting from production.
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32
The Production Function and
Theories of Growth

The production function for growth has land,
labour, and capital as factors of production.

“A” is an adjustment factor that captures the
effect of technology.
Output = A• f(Labour, Capital, Land)
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33
Describing Production Functions

Scale economies describe what happens in a
production function when all inputs increase
equally.

Constant returns to scale.

Increasing returns to scale.

Decreasing returns to scale.
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34
Describing Production Functions

Constant returns to scale means that
output will rise by the same proportionate
increase as all inputs.
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35
Describing Production Functions

Increasing returns to scale occurs when
output rises by a greater proportionate
increase as all inputs.
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36
Describing Production Functions

Decreasing returns to scale occurs when
output rises by a smaller proportionate
increase as all inputs.
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37
Describing Production Functions

Diminishing marginal productivity describes
what happens when more of one input is
added without increasing any other inputs.

The law of diminishing marginal
productivity states that increasing one input,
keeping all others constant, will lead to
smaller and smaller gains in output.
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38
The Classical Growth Model

The Classical growth model focuses on
capital accumulation in the growth process.

The more capital an economy has, the faster
it will grow.

Because of this emphasis on capital, our
economic system is called capitalism.
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39
The Classical Growth Model

Classical economists focused their analysis
and their policy advice, on how to increase
investment by saving:
saving  investment 
increase in capital  growth
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40
Focus on Diminishing Marginal
Productivity of labour

The Classical growth model focused on how
diminishing marginal productivity of labour
placed limitations on growth.

Farming was the major economic activity and
the amount of land was relatively fixed.
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41
Focus on Diminishing Marginal
Productivity of labour

Economists such as Thomas Malthus said
that since land was fixed, diminishing
marginal productivity would set in as
population grew.

As output per person declines, at some point
available output would no longer be sufficient
to feed the population.
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42
Diminishing Returns and Population
Growth
Subsistence level of
output per worker
Output
Production
function
Q2
Q1
L1
L*
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Labour
43
Focus on Diminishing Marginal
Productivity of labour

Beyond L*, output per person is no longer
sufficient to feed the population.


Starvation and a decline in population would
occur.
Below L*, there is surplus output and
population grows.
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44
Focus on Diminishing Marginal
Productivity of labour

The iron law of wages suggested that in the
long run, the economy would be driven to a
stationary state at L*.
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45
Diminishing Marginal Productivity of
Capital

The predictions of the stationary state turned
out to be wrong.

Increases in technology and capital
overwhelmed the law of diminishing marginal
productivity.
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46
Diminishing Marginal Productivity of
Capital

Modern economists, such as Robert Solow,
changed the focus to the diminishing
marginal productivity of capital, not labour.

They assumed population grows at a
constant rate.
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47
Diminishing Marginal Productivity of
Capital





capital grows faster than labour 
capital is less productive 
slower economic output 
per capita growth stagnates 
per capita income stops rising.
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48
Convergence

Diminishing marginal productivity of capital
would be stronger for richer nations than for
poor ones, therefore, their growth rate would
slow down.

Poor countries with little capital should grow
faster than countries with lots of capital.
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49
Convergence

Eventually per capita incomes among nations
would converge.

This has not happened.

In fact, per capita incomes of rich and poor
countries have diverged.
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50
Convergence

Why?

defining the inputs (factors of production)

technology
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51
Defining the Factors of Production

The definition of the factors of production are
ambiguous.

It would seem that the definition of labour
would be straightforward – the hours of work
that go into production.
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52
Defining the Factors of Production

Economists separate labour into two
components.

Standard labour – the actual number of
hours worked.

Human capital – the skills embedded in
workers through experience, education, and
on-the-job training.
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53
Defining the Factors of Production

Increases in human capital have allowed
labour to keep pace with capital.

This allows economies to avoid the
diminishing productivity of capital.
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54
Defining the Factors of Production

If skills are increasing faster in a rich country
than in a poor one, incomes would not be
expected to converge.
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55
Technology

Technology overwhelms diminishing marginal
productivity so that growth rates can increase
over time.

Economist Edward Denison estimated the
importance of each of the sources of growth:


Labour contributes 33% to growth
Technology contributes 35% to growth
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56
New Growth Theory

New growth theory emphasizes the role of
technology rather than capital in the growth
process.
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57
Technology

Technology is the result of investment in
creating technology (research and
development).

Investment in technology increases the
technological stock of an economy.
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58
Technology

New Growth Theory separates investment in
capital and investment in technology.

Increases in technology are not as directly
linked to investment as is capital.
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59
Technology

Increases in technology often have enormous
positive spillover effects.

Technological advances in one sector of the
economy lead to advances in completely
different sectors.
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60
Technology

Technological advances have positive
externalities.

Positive externalities – positive effects on
others not taken into account by the decision
maker.
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61
Technology

Some basic research is protected by patents.

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.
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62
Learning by Doing

New growth theory also highlights learning by
doing.

Learning by doing – improving the methods
of production through experience.
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63
Learning by Doing

By increasing the productivity of workers,
learning by doing overcomes the law of
diminishing marginal productivity.
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64
Increasing Returns to Scale
Output
Production function
with increasing
returns
All inputs
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65
Technological Lock-In

Technological lock-in is an example of how
sometimes the economy does not use the
best technology available.

It occurs when old technologies become
entrenched in the market.

despite the fact that more efficient technologies
are available.
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66
Technological Lock-In

One reason for technological lock-in is
network externalities.

Network externalities – an externality in
which the use of a good by one individual
makes that technology more valuable to other
people.
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67
Technological Lock-In

Switching from a technology exhibiting
network externalities to a superior technology
is expensive and sometimes nearly
impossible.

The Windows operating system exhibits network
externalities.
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68
Economic Policies to Encourage Per
Capita Growth







Encourage saving and investment.
Improve incentives to work.
Control population growth.
Increase the level of education.
Create institutions that encourage
technological innovation.
Provide funding for basic research.
Increase the economy’s openness to trade.
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69
Policies to Encourage Saving and
Investment

Modern growth theories have downplayed the
importance of capital in the growth process.

However, all agree that it is important.

Policy makers are eager to encourage both
saving and investment.
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70
Policies to Encourage Saving and
Investment

Canada has used tax incentives to increase
saving.

These include retirement savings plans
(RRSPs) that allow individuals to save
without incurring taxes on contributions until
they are withdrawn.
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71
Policies to Encourage Saving and
Investment

It is difficult for poor countries to generate
saving and investment.

The poor have subsistence incomes while the
rich in those countries place their savings
abroad for fear of confiscation by
government.
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72
Policies to Encourage Saving and
Investment

Foreign investment provides another source
of saving.

Developing nations can borrow from the
International Monetary Fund (IMF), the World
Bank, or from private sources.

None of these are perfect solutions since they
come with large strings attached.
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73
A Case Study: The Borrowing Circle

The borrowing circle of Grameen bank is an
example of how to increase investment in a
developing nation.

The traditional way of lending money is to ask for
collateral, but in Bangladesh, potential borrowers
had no collateral.
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74
A Case Study: The Borrowing Circle

The bank officer replaced collateral with the
borrowing circle concept.

Borrowing circle 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.
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75
Policies to Improve Incentives to
Work

Using income tax cuts to increase labour
supply is called Supply-side economics.

When tax rates fall, two things happen:


The Substitution Effect
The Income Effect
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76
Policies to Improve Incentives to
Work

The cost of leisure time increases, because
the opportunity cost of leisure is lost work
time (and money).

This is the Substitution Effect.
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77
Policies to Improve Incentives to
Work

Individuals can work less and still maintain
their current incomes.

The is the Income Effect.
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78
Policies to Improve Incentives to
Work

When the Substitution Effect outweighs the
Income Effect, the tax cut will increase labour
supplied.
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79
Policies to Improve Incentives to
Work

Arthur Laffer looked at the relationship
between income tax rates and the amount of
tax collected.

The Laffer Curve illustrates this relationship.
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80
Laffer Curve
Tax Collected
$T
0%
t%
100%
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Tax Rate
81
Policies to Control Population Growth

Developing nations whose populations are
rapidly growing have difficulty providing
enough capital and education for everyone.

Thus, per capita income is low.
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82
Policies to Control Population Growth

Policies that reduce population growth
include:



Free family–planning services.
Increased availability of contraceptives.
One-child-per-family policies, such as China
adopted in 1980.
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83
Policies to Control Population Growth

Some economists argue that to reduce
population growth, a nation must grow first.

As income and work opportunities rise, especially
for women, the opportunity cost of having children
rises and families will choose to have fewer
children.
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84
Policies to Increase the Level of
Education

Increasing the educational level and skills of
the workforce increases labour productivity.

In developing nations, the return on
investments in education is much higher than
in developed nations.
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85
Policies to Increase the Level of
Education

Education must be of the right kind.

Technical training in improved farming
methods or construction is more important
than higher education in a developing
country.
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86
Policies to Increase the Level of
Education

In Canada, it is estimated that an additional
year of school increases a worker’s wages by
an average of 10 percent.

An additional year of school in developing
nations will increase income by 15-20
percent.
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87
Policies to Create Institutions That
Encourage Technological Innovation

While all agree that technology is important,
no one is sure what the best technological
growth policies are.

Not only is research uncertain, so is its
application.
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88
Policies to Create Institutions That
Encourage Technological Innovation

Patents and protecting property rights are two
ways to encourage innovation.

Patents are not costless to society.

Patents allow innovators to charge high
prices for their use.
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89
Policies to Create Institutions That
Encourage Technological Innovation

Societies must find a middle ground between
providing incentives to create new
technologies and allowing everyone to take
advantage of the benefits of technology.
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90
Policies to Create Institutions That
Encourage Technological Innovation

Should poor nations accept patent laws?

Societies must find a middle ground between
giving individuals appropriate incentives to create
new technologies and allowing everyone to take
advantage of the benefits of technology.
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91
Policies to Create Institutions That
Encourage Technological Innovation

Bringing technological innovations to markets
often requires large amounts of investment
over a number of years.

The corporation offers limited liability
protection, and thereby encourages investors
to pool their funds.
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92
Policies to Create Institutions That
Encourage Technological Innovation

Well-developed financial institutions such as
stock markets create liquidity and encourage
investment.
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93
Policies to Provide Funding for Basic
Research


Individual firms have little incentive to do
basic research because of technology’s
“common knowledge” aspect.
This is why the Canadian government
provides most of the funding for basic
research in this country.

Canada’s spending on research and development
(R&D) lags other industrialized countries.
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94
Policies to Increase Openness to
Trade

Free trade increases growth by broadening
the market and by fostering competition.

In order to specialize, you need a large
market.

Large markets allow firms to take advantage
of economies of scale.
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95
Growth, Productivity, and
Wealth in the Long Run
End of Chapter 7
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96