Chapter 8
Economic Growth
Economic Growth
-- measured by % change in real GDP
-- common measurement is real GDP per capita (known as
the avg standard of living)
Real GDP per capita = Real GDP
Population
-- Economic growth occurs when real GDP per capita is
increasing  increase in avg standard of living
Growth Rates in real GDP per capita are determined by
one of two methods:
1) % ∆ Real GDP Per Capita
-- traditional % ∆ formula that is computed for relatively
short time frames
Example:
If in 1996, real GDP per capita = $31,403
in 2000, real GDP per capita = $34,788
% ∆ Real GDP/Capita = ($34,788 - $31,403)
$31,403
= 10.8%
2) Avg Annual Growth Rate (Compound Avg Growth
Rate)
-- used primarily for longer time frames
Example:
If in 1954, real GDP per capita = $10,300
in 2000, real GDP per capita = $34,788
Interpretation:
Factors Causing Economic Growth
1) Increase in employment or # of population working
2) Increase in labor productivity
labor productivity: quantity of goods and services that can
be produced per worker
Note: Labor
productivity
is more commonly measured as
=
x
output per hr worked vs. per worker to smooth out
fluctuations in work days and # employees.
Labor Productivity is influenced by:
1) Amount of Human Capital
-- knowledge, skills, education, experience and other
qualities of work force
-- influx of human capital provides the foundation for rapid
economic growth or increase in labor productivity
-- By itself, it may not be strong enough to positively
influence labor productivity
2)
Physical Capital
-- Increase or accumulation of capital stock (machines,
equipment, factories, etc used to produce other goods and
services) normally leads to increased labor productivity
-- coupled with Human Capital, the existence of ample
physical capital can lead to high levels of labor productivity
Per-Worker Production Function
-- Relationship between real GDP per hour worked
and capital per hr worked, with technology held
constant.
-- used to illustrate increase in labor productivity
(drives economic growth) due to increase in
capital
-- as capital stock per hr worked increases, labor
productivity increases (i.e. adding additional
machines can generate more output per hr
worked).
Real GDP per hr
worked (Y/L)
$160
C
Production
Function
$140
B
$100
A
$50
$10,000 $20,000 $30,000 $40,000
Capital per hr
worked (K/L)
Let K = Capital; L = Labor and; Y = Real GDP
Impact of Increase in Capital
-- ↑ in quantity of capital per hr worked increases quantity of
output each worker produces, but at a diminishing rate
A to B  ∆ Capital per hr worked is $10,000
∆ Output per hr worked is $50
B to C  ∆ Capital per hr worked is $10,000
∆ Output per hr worked is $40
Observation: Equal incremental changes in capital per
hr worked results in smaller changes in output per hr
worked.
-- reflects the law of diminishing returns  adding
more of a variable input (capital) to a fixed amount of
another input (labor), causes the marginal product of
the variable input to decline
-- eventually marginal real GDP per hr worked is
nearly $0
3) Technological Change
-- technology is defined as the quantity of output
firms can produce with a given quantity of inputs
-- ability to develop and apply new technology and
production methods with goal of increasing
productivity is the essence of technological
change
-- most powerful agent for economic change
-- shifts the production function upward (given the
same amount of capital per hr worked, real GDP
per hr worked increases)
-- major factor is the level of R & D spending by
firms
2) Impact of Technological Change
-- shifts the production function upward (assume positive
change)
-- given the same amount of capital per hr worked, real
GDP per hr worked increases
Observation:
-- Increase in technology shifts the production function
from Production Function 1 to Production Function 2
and further technological changes pushes it up to
Production Function 3
-- Since each production function reaches diminishing
returns to capital, to maintain increase in avg standard
of living, there must be technological change.
4) Land and Other Natural Resources
-- includes land, energy and raw materials
-- ability to buy or harness domestically increases
productivity
-- productivity is magnified as quality improves
5)
Entrepreneurship and Management
Entrepreneurship: individuals involved in new
business ventures
-- level or number of entrepreneurs depends on the
existence and amount of incentives for risk involved
-- must create an environment that promotes activity
through a balance of risks and rewards
Management
-- Day-to-day operations are run by managers and
their philosophies, actions and direction has the ability
to increase labor productivity.
-- Japan, for instance, has been instrumental in
adopting effective production management styles that
both motivates employees and is productively efficient
(i.e. “The Toyota Way”)
-- also includes the organization of a production
system such that operations are run in the most
efficient manner.
Eg.) work stations and parts are organized in the
most strategic places to promote efficiency (in
Toyota’s terms eliminating “muda” or waste)
-- Actions can make a very direct effect on productivity
and within a short time frame
6) Political and Legal Environment
-- Gov’t role in creating an environment that promotes increased
productivity
1) Enforce Property Rights and Rule of Law
Rule of Law
-- ability of a Gov’t to enforce laws relating to
private property and contracts
-- properties are protected and can not be
arbitrarily seized
-- clearly defined rules for determining who owns the
resources and how they are used helps to create a stable
climate for production
2) Political Stability
-- leads to increased productivity through sustained confidence
of investors in the political environment where they are
conducting business
-- less likely to invest money or resources in a country that has
ongoing political issues
Promoting Economic Growth
1) High Standards of Health and Education
-- old cliché holds true…healthy individuals are
more productive individuals
-- highly educated and skilled workers promote
technological change
-- rising incomes from economic growth can
limit the amount of “brain drain” (highly
educated people leaving one country for
another which holds greater opportunity)
-- free public education and Gov’t subsidies for
higher education
2)
Technology Policies
i) Countries relaxing restrictions to FDI (Foreign Direct
Investment)
-- allowing foreign firms to build factories or to buy
domestic firms
-- gain access to technology that can be used for
domestic-owned industries
ii) Subsidization of R & D / Increased R & D
a) Increased Gov’t funds to universities and tax
incentives to private research labs
b) Enhance patent protection
Patents are exclusive rights to a new product
for 20 yrs from date patent is approved
c) Gov’t expansion of own R & D spending
d) Implement any Gov’t policy that stimulates
investment spending
3)
Policies Leading to Increased Saving and Investment
Techniques aimed at household saving
-- household savings are used to supply funds to firms for
investment
1) Behavioral change in savings due to security of
employment, anticipation of early retirement, increased in
life expectancy, etc
2) Gov’t decrease in Capital Gains Tax
-- Capital Gains Tax is a tax on profits earned when a
financial asset is sold at more than the acquisition price
-- stocks and bonds become more rewarding to own
3) Convert U.S. Income Tax to Consumption tax
-- deduct your savings from your income so only income
spent is taxed (tax on part of income spent)
Techniques aimed at Firms
-- targets increase in planned investment spending
1) Reduce Corporate Profits Tax
-- allows corporations to retain more profits to
make further investments
2) Introduce Investment Credits
-- reduction in taxes for firms that invest in certain
types of capital
Economic Growth in U.S. and
Abroad
Real GDP per Capita, 1870-2003 (in 2000 US
Dollars)
Growth of Real GDP per Capita,
1870 - 2003
Country
Annual %
Change
1870 – 2003
Annual %
Change
1950 – 2003
Annual %
Change
1979 - 2003
US
1.9%
2.1%
1.8%
UK
1.4
2.1
2.0
Germany
1.8
3.1
1.3
Japan
2.6
4.6
2.0
Brazil
1.6
2.3
0.5
China
1.7
4.6
6.6
Ghana
0.9
0.4
0.5
Real GDP per Capita, 1870 2003
Country
1870
1913
1950
1979
2003
US
$2,936
$6,366
$11,484
$22,567
$34,875
UK
3,899
6,014
8,481
16,093
26,046
Germany
2,420
2,800
5,106
18,411
25,188
Japan
835
1,571
2,176
14,912
24,037
Brazil
923
100
2,165
6,336
7,205
China
548
571
464
1,076
4,970
Ghana
464
826
1,187
1,281
1,440
Using Compound Interest Rates to Demonstrate
Magnitude of Long-Term Growth
• In 1870, Brazil's GDP per capita was twice Ghana's
– By 2003, the multiple increased to 5 times
– Brazil's growth over the period was 1.6% and Ghana's
was 0.9%
• Compound interest pays interest on the original deposit
and all previously accumulated interest
-- payment of interest on initial deposit and all previous
interest (cumulative)
-- Interest paid in year 1 earns interest in year 2
# yrs
Initial Deposit x (1+interest)
Eg) $50 deposited at 4% interest in 1800 is $ in 2005
$50 x (1.04)205 = $155,169
Small differences in annual growth
rates add up over time
GDP per capita is about $400 now.
In 50 years, it would grow to about:
_________ if the growth rate were 1%.
_________ if the growth rate were 3%.
_________ if the growth rate were 5%.
The Rule of 70
• The Rule of 70 is useful for financial as well as
demographic analysis. It states that to find the
doubling time of a quantity growing at a given
annual percentage rate, divide the percentage
number into 70 to obtain the approximate
number of years required to double. For
example, at a 10% annual growth rate, doubling
time is 70 / 10 = 7 years.
Similarly, to get the annual growth rate, divide 70
by the doubling time. For example, 70 / 14 years
doubling time = 5, or a 5% annual growth rate.
The following table shows some common
doubling times:
Globalization Has Opened the Doors to
Economic Growth
-- Process of countries becoming more
open to foreign trade and investment
 FDI (Foreign Direct Investment):
allowing foreign firms to build
factories or to buy domestic firms
-- lead many countries to experience
economic growth or achieving
increases in real GDP per capita