CHAPTER
22
Why Do Economies Grow?
Prepared by: Fernando and Yvonn Quijano
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
C H A P T E R 1: Introduction: What is Economics?
Why Do Economies Grow?
• Economists believe that there are two basic
mechanisms that increase GDP per capita
over the long term:
1. Capital deepening: an increase in the economy’s
stock of capital—plant and equipment—relative to
its workforce.
2. Technological progress: the ability to produce
more output without using any more inputs—capital
or labor.
• The role of education and investment in
human beings in fostering economic
development is called human capital.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
2 of 42
C H A P T E R 1: Introduction: What is Economics?
Economic Growth Rates
• A meaningful measure of the standard of
living in a given country is real GDP per
capita, or real GDP per person.
• Real GDP per capita typically grows over
time. The growth rate of a variable is the
percentage change in that variable from
one period to another.
GDP in year 2  GDP in year 1
%GDP 
x100%
GDP in year 1
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
3 of 42
C H A P T E R 1: Introduction: What is Economics?
Measuring Economic Growth
• If the economy started at 100 and grew
at a rate g for n years, then real GDP
after n years equals:
GDPn YEARS LATER  (1  g)n (100)
• At 4% for the next ten years, GDP will be:
GDP 10 YEARS LATER  (1  0.04) (100) = 148
10
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
4 of 42
C H A P T E R 1: Introduction: What is Economics?
Measuring Economic Growth
• To find out how many years it would
take for GDP to double, we use the
rule of 70: If an economy grows at x
percent per year, output will double
in 70/x years.
70
Years to double 
( percentage growth rate)
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
5 of 42
Comparing the Growth Rates
of Various Countries
C H A P T E R 1: Introduction: What is Economics?
Table 22.1 GNP Per Capita and Economic Growth
Country
United States
GNP Per Capita
in 2001 dollars
$34,280
Per Capita Growth Rate,
1960-2001
2.18%
Japan
25,550
4.16
Italy
24,530
3.07
United Kingdom
24,340
2.17
France
24,080
2.70
Costa Rica
9,260
2.50
Mexico
8,240
2.27
India
2,820
2.43
Zimbabwe
2,220
.82
Pakistan
1,860
.98
750
-1.15.
Zambia
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
6 of 42
C H A P T E R 1: Introduction: What is Economics?
Are Poor Countries Catching Up?
• Economists question whether poorer
countries can close the gap between their
level of GDP per capita and that of richer
countries.
• The process by which poorer countries
catch up with richer countries in terms of
real GDP per capita is called convergence.
• To converge, poor countries have to grow at
more rapid rates than richer countries are
growing.
• In the last twenty years, there has been little
convergence.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
7 of 42
C H A P T E R 1: Introduction: What is Economics?
Countries with Lower Income
in 1870 Grew Faster
• The relationship between
growth rates and per capita
income in 1870 is
downward-sloping.
• Countries with higher
levels of GDP in 1870 grew
more slowly than countries
with lower levels of GDP.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
8 of 42
C H A P T E R 1: Introduction: What is Economics?
Capital Deepening
• One of the most important
mechanisms of economic growth
economists have identified is
increases in the amount of capital
per worker due to capital deepening.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
9 of 42
C H A P T E R 1: Introduction: What is Economics?
Capital Deepening
• An increase in capital
means more output can be
produced.
• Firms will increase their
demand for labor and, as
they compete for a fixed
labor supply, real wages
will rise.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
10 of 42
C H A P T E R 1: Introduction: What is Economics?
Capital Deepening
• How does an economy increase its
stock of capital?
• The economy must increase its net
investment.
• To increase net investment, gross
investment must also rise.
• The amount of income available for
investment comes from saving.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
11 of 42
C H A P T E R 1: Introduction: What is Economics?
Saving and Investment
• Total income minus consumption is saving. By
definition, consumption plus saving equals
income:
C+S=Y
• At the same time, income—which is equivalent
to output—also equals consumption plus
investment:
C+I=Y
• Thus, saving must equal investment:
S=I
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
12 of 42
C H A P T E R 1: Introduction: What is Economics?
Saving and Investment
• This means, whatever consumers decide to
save goes directly into investment.
• It follows that in order for the stock of capital to
increase, gross investment must exceed
depreciation.
• The stock of capital increases with any gross
investment spending but decreases with any
depreciation.
• However, as capital grows, depreciation also
grows, eventually catching up to the level of
gross investment, and putting a stop to the
growth of capital deepening.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
13 of 42
C H A P T E R 1: Introduction: What is Economics?
How Does Population Growth
Affect Capital Deepening?
• Population growth, which increases the
size of the labor force, will cause the
capital per worker ratio to decrease.
• With less capital per worker, output per
worker will also tend to be less because
each worker has fewer machines to use.
This is an illustration of the principle of
diminishing returns.
PRINCIPLE of Diminishing Returns
Suppose output is produced with two or more inputs
and we increase one input while holding the other
input or inputs fixed. Beyond some point—called
the point of diminishing returns—output will increase
at a decreasing rate.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
14 of 42
C H A P T E R 1: Introduction: What is Economics?
How Does the Government
Affect Capital Deepening?
• The government can affect the process of capital
deepening in several ways:
• Higher taxes will reduce total income. Assuming that
households save a fixed fraction of their income, an
increase in taxes will cause savings to fall.
• As the government drains savings from the private
sector, the amount of total investment decreases, and
there is less capital deepening.
• This occurs when the government uses the taxes
collected from the private sector to engage in
consumption spending, not investment. However, if the
government taxes the private sector in order to increase
investment, then it will be promoting capital deepening.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
15 of 42
C H A P T E R 1: Introduction: What is Economics?
How Does Trade Affect Capital Deepening?
• The foreign sector can also affect capital
deepening.
• An economy can run a trade deficit and import
investment goods to aid capital deepening. It
can finance the purchase of those goods by
borrowing and, as investment raises, GDP
and economic wealth rises and the country
can afford to pay back the borrowed funds.
• Trade deficits that fund current consumption
do not aid in the process of capital deepening.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
16 of 42
C H A P T E R 1: Introduction: What is Economics?
Limits to Capital Deepening
• There is a limit to growth through capital
deepening because even though at higher
rate of saving can increase the level of real
GDP, eventually the process comes to a
halt.
• However, it takes time—decades—for this
point to be reached. Capital deepening
can be an important source of economic
growth for a long time.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
17 of 42
C H A P T E R 1: Introduction: What is Economics?
The Key Role of
Technological Progress
• Technological progress is the ability of an
economy to produce more output without
using any more inputs.
• With higher output per person, we enjoy a
higher standard of living.
• Technological progress, or the birth of new
ideas, is what makes us more productive.
Per capita output will rise when we
discover new and more effective uses of
capital and labor.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
18 of 42
C H A P T E R 1: Introduction: What is Economics?
How Do We Measure
Technological Progress?
• Robert Solow, a Nobel laureate in economics
from MIT, developed a method for determining the
contributions to economic growth from increased
capital, labor, and technological progress, called
growth accounting.
Y = F(K,L,A)
• Increases in A represent technological progress,
or more output produced from the same level of
inputs, K and L.
• We can measure technological progress indirectly
by observing increases in capital, labor, and
output.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
19 of 42
How Do We Measure
Technological Progress?
C H A P T E R 1: Introduction: What is Economics?
Percentage Contributions to Real GDP Growth
Technological
Progress
35%
Capital Growth
19%
Labor Growth
46%
•
Table 22.2 Sources of Real GDP
Growth, 1929-1982
(average annual percentage rates)
Growth due to capital growth
0.56%
Growth due to labor growth
1.34
+ technological progress
1.02
Total output growth
2.92
Total output grew at a rate of nearly 3%. Because capital
and labor growth are measured at 0.56% and 1.34%,
respectively, the remaining portion of output growth, 1.02%,
must be due to technological progress. That means that
approximately 35% of output growth came directly from
technological progress.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
20 of 42
C H A P T E R 1: Introduction: What is Economics?
Examples of Growth Accounting
• From 1980 to 1985, the economies of Hong
Kong and Singapore both grew at impressive
rates of about 6%, yet the causes and results
of growth in each country were very different.
• Singapore’s growth was attributed to increases
in labor and capital, while in Hong Kong
technological progress was the key to growth.
• Residents of Hong Kong could enjoy the same
level of GDP but consume, not save, a higher
fraction of their GDP.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
21 of 42
C H A P T E R 1: Introduction: What is Economics?
What Caused Lower
U.S. Labor Productivity?
• Labor productivity is defined as output per
hour of work for the economy as a whole.
• Labor productivity measures how much a
typical worker can produce with the current
amount of capital and given the state of
technological progress.
• A significant slow-down in productivity in the
United States since 1973 meant slow growth
in real wages and in GDP.
• In recent years, there has been a resurgence
in productivity growth, which reached 2.5%
from 1994-2000.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
22 of 42
C H A P T E R 1: Introduction: What is Economics?
What Caused Lower
U.S. Labor Productivity?
Table 22.3 U.S. Annual
Productivity Growth, 1959-2002
Years
Annual Growth Rate
1959-1968
3.5%
1968-1973
2.5
1973-1980
1.2
1980-1986
2.1
1986-1994
1.4
1994-2000
2.6
• The period of slower labor
productivity growth cannot
be explained by reduced
rates of capital deepening,
nor by changes in the
quality of the labor force.
• A slowdown in
technological progress
and higher energy prices
have been linked by some
economists to the
slowdown in productivity.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
23 of 42
C H A P T E R 1: Introduction: What is Economics?
Real Hourly Earnings and Total
Compensation in the United States
• The slowdown in
productivity growth also
meant slower growth in
real wages and in GDP
since 1973.
• Total compensation did
continue to rise through
the 1980s and 1990s.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
24 of 42
C H A P T E R 1: Introduction: What is Economics?
How Have the Internet and Information
Technology Affected GDP?
• “New economy” proponents believe the
computer and Internet revolution are
responsible for the increase in productivity
growth in the last half of the 1990s.
• Productivity growth continued to be rapid,
even during the recessionary period at the
beginning of this century, when most
economists believed it would slow down.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
25 of 42
C H A P T E R 1: Introduction: What is Economics?
What Causes Technological Progress?
•
Research and development in science.
•
Government or large firms who employ
workers and scientists to advance physics,
chemistry, and biology are engaged in
technological progress in the long run.
•
The United States has the highest
percentage of scientists and engineers in the
labor force in the world.
•
Not all technological progress is “high tech.”
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
26 of 42
Research and Development Funding as a Percent
of GDP, 1999
Total
3.5
Non-Defense
3
2.5
2
1.5
1
0.5
an
a
da
ly
C
gd
Ki
n
U
ni
te
d
Ita
om
ce
Fr
an
y
m
an
n
pa
Ja
G
er
ni
te
d
St
a
te
s
0
U
Percent of GDP
C H A P T E R 1: Introduction: What is Economics?
Research and Development
Funding as a Percent of GDP, 1999
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
27 of 42
C H A P T E R 1: Introduction: What is Economics?
What Causes Technological Progress?
• Monopolies that spur innovation
(Joseph Schumpeter).
• The process by which competition for
monopoly profits leads to technological
progress is called creative destruction
by Schumpeter.
• By allowing firms to compete to be
monopolies, society benefits from
increased innovation.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
28 of 42
C H A P T E R 1: Introduction: What is Economics?
What Causes Technological Progress?
• The scale of the market.
• Adam Smith stressed the importance of
the size of a market for economic
development.
• There are more incentives for firms to
come up with new products and
methods of production in larger
markets.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
29 of 42
C H A P T E R 1: Introduction: What is Economics?
What Causes Technological Progress?
• Induced innovations.
• Some economists emphasize that
innovations come about through
inventive activity designed specifically
to reduce costs.
• Education and the accumulation of
knowledge.
• Modern theories of growth that try to
explain the origins of technological
progress are know as new growth
theory.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
30 of 42
C H A P T E R 1: Introduction: What is Economics?
A Key Governmental Role:
Getting the Incentives Right
• Governments must design institutions in a
society in which individuals and firms work,
save, and invest.
• One of the basic laws of economics is that
individuals and firms respond to incentives.
• Policies that tax exports, lead to rampant
inflation, or inhibit the growth of the
banking and financial sectors, can cripple
the economy’s growth prospects.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
31 of 42
C H A P T E R 1: Introduction: What is Economics?
Human Capital
• Human capital is an investment in human
beings—in their knowledge, skills and health.
• In terms of understanding economic growth,
human capital investment has two
implications:
• Not all labor is equal. Individuals with more
education will, on average, be more productive.
• Health and fitness affect productivity. If workers
are frail and ill, they can’t contribute much to
national output.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
32 of 42
C H A P T E R 1: Introduction: What is Economics?
New Growth Theory
• The work of economists that developed
models of growth that contained
technological progress as essential
features came to be known as new growth
theory, which accounts for technological
progress within a model of growth.
• Economists in this field study how
incentives for research and development,
new product development, or international
trade interact with the accumulation of
physical capital.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
33 of 42
C H A P T E R 1: Introduction: What is Economics?
Appendix:
A Model of Capital Deepening
• The Solow model shows that:
• Capital deepening, the increase in the
stock of capital per worker, will occur as
long as total saving exceeds
depreciation. Capital deepening
results in economic growth and
increased real wages.
• Eventually, the process of capital
deepening will come to a halt as
depreciation catches up with total
saving.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
34 of 42
C H A P T E R 1: Introduction: What is Economics?
Appendix:
A Model of Capital Deepening
• A higher saving rate will promote
capital deepening.
• If a country saves more, it will have
a higher output (until the process of
economic growth through capital
deepening ends).
• Technological progress not only
causes output to increase but
also allows capital deepening to
continue.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
35 of 42
C H A P T E R 1: Introduction: What is Economics?
Diminishing Returns to Capital
• The relationship between
output and the stock of
capital, holding the labor
force constant, shows
that as the stock of
capital increases, output
increases at a
decreasing rate.
PRINCIPLE of Diminishing Returns
Suppose output is produced with two or more inputs and we
increase one input while holding the other input or inputs fixed.
Beyond some point—called the point of diminishing returns—
output will increase at a decreasing rate.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
36 of 42
C H A P T E R 1: Introduction: What is Economics?
Appendix:
A Model of Capital Deepening
• Output increases with the stock of capital,
and the stock of capital increases as long as
gross investment exceeds depreciation.
• In the absence of government or the foreign
sector, private-sector saving equals gross
investment.
• In order to determine the level of investment,
we need to find out how much of output is
saved and how much is consumed.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
37 of 42
C H A P T E R 1: Introduction: What is Economics?
Saving and Depreciation as Functions
of the Stock of Capital
• Essential relationships in the
• Also, total depreciation as a function
Solow model include output (Y) as
of the stock of capital (dK), where d
a function of the stock of capital
is the depreciation rate per year,
(K), and saving as a function of
which is constant and proportional to
the stock of capital (sY).
the stock of capital (K).
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
38 of 42
C H A P T E R 1: Introduction: What is Economics?
Basic Growth Model
Change in the stock of capital
= sY – dK
• At K0, sY > dK then
K will rise.
• At K1, sY > dK then K
continues to rise.
• At K*, sY = dK then K no
longer increases.
• As long as total saving exceeds depreciation,
economic growth, through capital deepening, will
continue. The process continues until the stock of
capital reaches its long-run equilibrium K*.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
39 of 42
C H A P T E R 1: Introduction: What is Economics?
Increase in the Saving Rate
• A higher saving rate will
lead to a higher stock of
capital in the long run.
• Starting from an initial
capital stock of K1, the
increase in the saving rate
leads the economy to K2.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
40 of 42
C H A P T E R 1: Introduction: What is Economics?
Technological Progress and Growth
• Technological
progress shifts up the
saving schedule and
promotes capital
deepening.
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
41 of 42
Key Terms
C H A P T E R 1: Introduction: What is Economics?
capital deepening
convergence
creative destruction
growth accounting
growth rate
human capital
labor productivity
new growth theory
real GDP per capita
rule of 70
saving
technological progress
© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4th ed.
42 of 42