Growth, Productivity, and
the Wealth Of Nations
Chapter 8
© 2003 McGraw-Hill Ryerson Limited.
8-2
Laugher Curve
We have two classes of forecasters:
Those who don't know, and those who
don't know they don't know.
John Kenneth Galbraith
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8-3
Growth and the Economy’s
Potential
 Growth
is an increase in the amount of
goods and services an economy
produces.
 The study of growth is the study of why
that increase comes about assuming
that both labour and capital are fully
employed.
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8-4
Growth and the Economy’s
Potential
 Growth
is an increase in potential
output.
 When an economy is at its potential
output, it is operating on its production
possibility curve.
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8-5
Growth and the Economy’s
Potential
 Long-run
growth focuses on supply; it
assumes Say’s Law – demand is
sufficient to buy whatever is supplied.
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8-6
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, for some
reason, it is not.
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8-7
Importance of Growth for
Living Standards
 Growth
is important for living standards.
 Long-term growth rates matter a lot
because of compounding.
 This means that growth is based not
only on original levels of income in a
country, but also on the accumulation of
previous years’ increases in income.
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8-8
Importance of Growth for
Living Standards
 According
to the rule of 72, dividing 72
by the rate of growth will give the
number of years in which income will
double.
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8-9
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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8 - 10
Markets, Specialization, and
Growth
 Markets
increase productivity through
specialization and the division of labour.
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 - 11
Markets, Specialization, and
Growth
 With
increasing specialization and
division of labour comes increasing
productivity which creates a higher
standard of living.
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8 - 12
Markets, Specialization, and
Growth
 This
argument is reinforced by the
principle of comparative advantage.

Production possibilities rise when people
concentrate on producing those goods for
which their skills and other resources are
suited, and trade for those goods for which
they do not have a comparative advantage.
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8 - 13
Economic Growth,
Distribution, and Markets
 Markets
are often seen to be unfair
because of the effect they may have on
the distribution of income.
 Markets may not provide equality of
income but they do make the poor
better off.
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8 - 14
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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8 - 15
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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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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8 - 17
Per Capita Growth
 Per
capita growth equals the percent
change in output minus the percent
change in population
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8 - 18
Per Capita Growth
 The
problem in many developing
nations is that although GDP is rising,
the population is rising even faster
resulting in a lower per capita growth
rate.
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8 - 19
Per Capita Growth
 Some
economists have argued that per
capita (mean) output is not what we
should be focusing on.
 Instead we should focus on median
income.
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8 - 20
Per Capita Growth
 Median
income is a better measure
because it takes into account how
income is distributed.
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8 - 21
Per Capita Growth
 If
the growth in income goes to a small
majority of individuals who receive the
majority of income, the mean will rise
but the median will not.
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8 - 22
Per Capita Growth
 Unfortunately,
statistics on median
income is generally not collected so
economists use per capita income.
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8 - 23
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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8 - 24
Investment and Accumulated
Capital
 Years
ago it was thought that physical
capital and investment were the keys to
growth.
 The flow of investment lead to the
growth of the stock of capital.
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8 - 25
Investment and Accumulated
Capital
 Capital
accumulation does not
necessarily lead to growth.
 Take the former Soviet Union, for
example. They invested a lot, but did
not grow much.
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8 - 26
Investment and Accumulated
Capital
 Products
change, and useful buildings
and machines in one time period may
be useless in another.
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8 - 27
Investment and Accumulated
Capital
is much more than machines – it
includes human and social capital.
 Capital
Human capital – the skills that are
embodied in workers through experience,
education, on-the-job training, and:
 Social capital – the habitual way of doing
things that guides people in how they
approach production.

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8 - 28
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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8 - 29
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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8 - 30
Available Resources
 Technology
plays an enormous role
here.
 Greater participation in the market is
another way by which available
resources are increased.
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8 - 31
Growth Compatible
Institutions
 Growth-compatible
institutions have
built-in incentives that lead people to put
forth effort and discourage loafing.
 When individuals get much of the gains
of growth themselves, they work harder.
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8 - 32
Growth Compatible
Institutions
 Markets
that feature private ownership
of property foster economic growth.
 Mercantilist economies that feature
bribes inhibit economic growth.
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8 - 33
Technological Development
 A larger
aspect of growth involves
changes in technology – changes in
the goods and services we buy, and the
way we create goods and services.
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8 - 34
Technological Development
 Technological
change does more than
cause economic growth, it changes the
entire social and political dimensions of
society.
 As in other things, there are tradeoffs
when new technology is introduced.
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8 - 35
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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8 - 36
Turning the Sources of
Growth into Growth
 In
order to be effective, the five sources
of growth must be mixed in the right
proportions.
 It is the combination of investing in
machines, people, and technological
change that plays a central role in the
growth of any economy.
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8 - 37
The Production Function and
Theories of Growth
 Economists’
theories of growth have
emphasized the production function.

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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8 - 38
The Production Function and
Theories of Growth
 This
production function has land,
labour, and capital as factors of
production, and an adjustment factor,
“A”, to capture the effect of technology:
Output = A• f(Labour, Capital, Land)
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8 - 39
The Production Function and
Theories of Growth
 In
talking about production functions,
economists use a couple of terms: scale
economies and diminishing marginal
productivity.
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8 - 40
The Production Function and
Theories of Growth
 Scale
economies describe what happens
when all inputs increase equally.
 Constant
returns to scale means that
output will rise by the same proportionate
increase as all inputs.
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8 - 41
The Production Function and
Theories of Growth
 Increasing
returns to scale occur if
output rises by a greater proportionate
increase than all inputs.
 Decreasing returns to scale occur if
output rises by a smaller proportionate
increase than all inputs.
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8 - 42
The Production Function and
Theories of Growth
 Diminishing
marginal productivity
describes what happens when more of
one input is added without increasing
any other inputs.
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8 - 43
The Production Function and
Theories of Growth
 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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8 - 44
The Classical Growth Model
 The
Classical growth model is the
standard theory of growth.
 The Classical growth model focuses on
capital accumulation.
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8 - 45
The Classical Growth Model
 Since
investment leads to the increase
in capital, Classical economists focused
their analysis and their policy advice, on
how to increase investment.
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8 - 46
The Classical Growth Model
 The
linkage was as follows:
savings  investment  increases in
capital  growth
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8 - 47
Diminishing Marginal
Productivity of Labour
 The
Classical growth model focuses on
diminishing marginal productivity of
labour.
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8 - 48
Diminishing Marginal
Productivity of Labour
 When
farming was the major activity in
the economy, Thomas Malthus, an early
economist, emphasized the limitation
land placed on growth.
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8 - 49
Diminishing Marginal
Productivity of Labour
 Since
land was fixed, he predicted that
diminishing marginal productivity would
set in as population grew.
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8 - 50
Diminishing Marginal
Productivity of Labor
 The
linkage was:
economic surplus  population increases
 output increases  lower per capita
income  too many people 
starvation
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8 - 51
Diminishing Returns and
Population Growth, Fig. 8-2, p 197
Subsistence level of
output per worker
Output
Production
function
Q2
Q1
L1
L*
Labour
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8 - 52
Diminishing Marginal
Productivity of Labor
 This
belief is called the iron law of
wages
 Combined with diminished marginal
productivity it led to the belief that in the
long run there would be no surplus and
therefore no growth.
 The long run was called the stationary
state.
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8 - 53
Diminishing Marginal
Productivity of Capital
 The
Classical economists’ predictions
were wrong.
 Increases in technology and capital
overwhelmed the law of diminishing
marginal productivity.
 The focus turned to the marginal
productivity of capital, not labour.
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8 - 54
Diminishing Marginal
Productivity of Capital
 The
linkage was:
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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8 - 55
Diminishing Marginal
Productivity of Capital
 The
Classical growth model also
predicted that diminishing marginal
productivity would be stronger for richer
nations than for poorer ones.
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8 - 56
Diminishing Marginal
Productivity of Capital
 Poor
countries with little capital should
grow faster than countries with lots of
capital.
 Eventually per capita incomes among
nations would converge.
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8 - 57
Diminishing Marginal
Productivity of Capital
 This
prediction was not true either,
owing to the ambiguity in the definition
of inputs and/or technological progress.
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8 - 58
Ambiguities in the
Definition of 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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8 - 59
Ambiguities in the
Definition of the Factors of
Production
 But
what of the difference between
educated workers and workers who are
less educated?
 To answer this, economists separate
labour into two components.
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8 - 60
Ambiguities in the
Definition of the Factors of
Production
labour – the actual number
of hours worked.
 Human capital – the skills embedded in
workers through experience, education,
and on-the-job training.
 Standard
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8 - 61
Ambiguities in the
Definition of 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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8 - 62
Ambiguities in the
Definition of the Factors of
Production
 If
skills are increasing faster in a rich
country than in a poor one, incomes
would not converge.
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8 - 63
Technology
 Technology
overwhelms diminishing
marginal productivity so that growth
rates can increase over time.
 Technology is growing faster in rich
countries than in poor countries.
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8 - 64
Sources of Real GDP
Growth, 1928-1998, Fig. 8-3, p 199
Physical capital (19%)
Labor (33%)
Human capital (13%)
Technology (35%)
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8 - 65
New Growth Theory
 New
growth theory emphasizes the
role of technology rather than capital in
the growth process.
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8 - 66
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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8 - 67
Technology
 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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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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8 - 69
Technology
 Technological
advances have positive
externalities – positive effects on
others not taken into account by the
decision maker.
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Technology
 Some
basic research is protected by
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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8 - 71
Technology
 Once
people have seen the new
technology, they figure out sufficiently
different ways to achieving the same
end to avoid the patent.
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8 - 72
Learning by Doing
 Learning
by doing also leads to growth.
 New growth theory also highlights
learning by doing – improving the
methods of production through
experience.
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8 - 73
Learning by Doing
 If
positive externalities flowing from
learning by doing and new technologies
overwhelm diminishing marginal
productivity, economics can be called
the “optimistic science,” not the “dismal
science.”
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8 - 74
Increasing Returns to Scale,
Fig. 8-4, p 201
Output
Production function
with increasing
returns
All inputs
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8 - 75
Technological Lock-In
 Technological
lock-in is an example of
how sometimes the economy does not
use the best technology available.
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8 - 76
Technological Lock-In
 Technological
lock-in occurs when old
technologies become entrenched in the
market, or locked into new products
despite the fact that more efficient
technologies are available.

The best example is the QWERTY
keyboard.
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8 - 77
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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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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8 - 79
Economic Policies to
Encourage Per Capita Growth
 Policies
to encourage saving and
investment.
 Policies to control population growth.
 Policies to increase the level of
education.
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8 - 80
Economic Policies to
Encourage Per Capita Growth
 Policies
to increase the level of
education
 Policies to create institutions that
encourage technological innovation.
 Policies to provide funding for basic
research.
 Policies to increase the economy’s
openness to trade.
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8 - 81
Policies to Encourage Saving
and Investment
 Modern
growth theories have
downplayed the importance of capital in
the growth process.
All agree that it is important, however.
 Policy makers are eager to encourage both
saving and investment.

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8 - 82
Policies to Encourage Saving
and Investment
 Canada
has used tax incentives to
increase saving.
 These include retirement savings plans
(RSPs) that allow individuals to save
without incurring taxes on contributions
until they are withdrawn.
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8 - 83
Policies to Encourage Saving
and Investment
 Some
economists have proposed
switching from an income tax to a
consumption tax.
 By taxing individuals only when they
consume, all saving is exempt from
taxation.
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8 - 84
Policies to Encourage Saving
and Investment
 It
is difficult for poor countries to
generate saving and investment.
 The poor have subsistence income
while the rich in those countries place
their savings abroad for fear of
confiscation by government.
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8 - 85
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.
 In Bangladesh, potential borrowers had no
collateral.

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8 - 86
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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8 - 87
Growth Through Foreign
Investment
 Foreign
investment provides another
source of saving.
Developing nations can borrow from the
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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8 - 88
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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8 - 89
Policies to Control
Population Growth
 Policies
that reduce population growth
include:
Free family–planning services.
 Increasing the availability of
contraceptives.
 Harsh mandatory one-child-per-family
policies such as China adopted in 1980.

© 2003 McGraw-Hill Ryerson Limited.
8 - 90
Policies to Control
Population Growth
 Some
economists argue that to reduce
population growth, a nation must grow
first.

As income and work opportunities,
especially for women, rise, the opportunity
cost of having children rises and families
will choose to have fewer children.
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8 - 91
Policies to Increase the Level
of Education
 In
developing nations, the return on
investments in education is much higher
than in developed nations.
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8 - 92
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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8 - 93
Policies to Increase the Level
of Education
 Technical
training in improved farming
methods or construction is more
important than higher education.
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8 - 94
Policies to Create Institutions
That Encourage
Technological Innovation
 While
all agree that 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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8 - 95
Create Patents and Protect
Property Rights
 Creating
patents and protecting
property rights are two ways to
encourage innovation.
 However:
Patents are not costless to society.
 Patents allow innovators to charge high
prices for their use.

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Patents and Developing
Countries
 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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8 - 97
The Corporation and
Financial Institutions
 The
corporation and financial
institutions encourage innovation.
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8 - 98
The Corporation and
Financial Institutions
 The
corporation was invented to limit
liability to its owners.
 Corporations bring technological
innovations to markets.
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8 - 99
The Corporation and
Financial Institutions
 Well-developed
financial institutions
such as stock markets create liquidity
and encourage investment.
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8 - 100
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 where the government steps in.
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8 - 101
Policies to Provide Funding
for Basic Research
 The
Canadian government provides the
lion’s share of the basic research in the
country.
 Much of the funding is channeled
through universities.
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Policies to Increase Openness
to Trade
 In
order to specialize, you need a large
market.
 Large markets allow firms to take
advantage of economies of scale.
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8 - 103
Policies to Increase Openness
to Trade
 The
effect of markets on growth is an
important reason why economists
support policies that keep domestic
markets as regulation free as possible
and support international trade.
© 2003 McGraw-Hill Ryerson Limited.
Growth, Productivity, and
the Wealth Of Nations
End of Chapter 8
© 2003 McGraw-Hill Ryerson Limited.