CHAPTER
12
Why Do Economies
Grow?
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
Capital Deepening and Technological
Progress

There are two basic
mechanisms which increase
GDP per capita over the long
term:
1. Capital deepening
2. Technological progress
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
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Capital Deepening and Technological
Progress
 Capital deepening refers to an
increase in the economy’s stock of
capital—plant and equipment—
relative to its workforce (capital
per worker)

Technological progress is the
ability to produce more output
without using any more inputs—
capital or labor
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
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The Diversity of Economic Experience

Throughout the world, there are
vast differences in standards of
living and in rates of economic
growth.
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Measuring Economic Growth

A meaningful measure of the standard
of living in a given country is real GDP
per capita, or real GDP per person.

The growth rate (or percentage change)
of real GDP per capita is a widely used
measure of economic growth.
GDP in year 2  GDP in year 1
% GDP 
x100%
GDP in year 1
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The Rule of 70

How many years would it take for GDP to
double?

The answer is given by the rule of 70
(derived from the mathematics of
logarithms):
70
Years to double 
( percentage growth rate)

For example, for an economy that grew at 5% a
year, it would take
70
Years to double 
 14 years
5
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The Diversity of Economic Experience



Making comparisons of real GDP across
countries is difficult. Each country has its
own currency and its own price system.
It is difficult, therefore, to calculate the
true variations in the cost of living across
countries.
It takes a large team of economists to
collect data on prices, identify identical
quality products, and express the GDP of
each country in U.S. prices.
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Growth Rates & Patterns of Growth

One question economists ask is
whether poorer countries can close the
gap between their level of GDP per
capita and the GDP per capita of richer
countries.

Closing the gap is called convergence.
To converge, poorer countries have to
grow at more rapid rates than richer
countries are growing.
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GDP Per Capita & Economic Growth
Country
United States
GDP per Capita
in 1999 Dollars
Average per Capita Growth
Rate, 1960-1999 (%)
$31,910
2.13
Japan
25,170
4.43
France
23,020
2.76
Italy
22,200
2.07
United Kingdom
22,000
3.00
Mexico
8,070
2.36
Costa Rica
7,880
2.23
Pakistan
1,860
1.04
Zimbabwe
2,610
1.28
India
2,230
1.98
720
-1.31
Zambia
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GDP Per Capita and Economic Growth
© 2005 Prentice Hall Business Publishing
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
The relationship
between growth rates
and per capita income
in 1870 is downwardsloping.

Catch-up: countries
with lower levels of
GDP in 1870 grew
faster than countries
with higher levels of
GDP.
O’Sullivan & Sheffrin
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Capital Deepening


With a given supply of labor, increases in the
stock of capital raise real wages and lead to
increases in output.
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.
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Capital Deepening

By definition, consumption plus saving equals
income.
Y=C+S

At the same time, income—which is equivalent to
output—also equals consumption plus investment:
Y=C+I

Thus, saving must equal investment:
S=I
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Capital Deepening



The stock of capital increases with any gross
investment spending but decreases with any
depreciation.
It follows that in order for the stock of capital
to increase, gross investment must exceed
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.
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Population Growth, Government, &
Trade

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 be
less. This concept reflects the principle of
diminishing returns.
PRINCIPLE of Diminishing Returns
Suppose that output is produced with two or more
inputs and that we increase one input while holding the
other inputs fixed. Beyond some point—called the
point of diminishing returns—output will increase at a
decreasing rate.
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Population Growth, Government, &
Trade

Assuming that households save a fixed fraction
of their income, an increase in taxes will cause
savings—the amount of money that would have
been available for investment—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.

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Population Growth, Government, and
Trade

If the government taxes the private sector to
increase investment—for example, to build
valuable infrastructure such as roads, buildings,
and airports, it is promoting capital deepening.

The foreign sector can also play a role in capital
deepening.
An economy can run a trade deficit and import
investment goods to aid capital deepening.
The economy 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.


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Population Growth, Government, and
Trade

There are natural limits to
capital deepening. Capital is
subject to diminishing returns
just as labor.
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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.
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Growth Accounting

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.
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Growth Accounting

Technological progress is difficult to
measure, but if we know how much are
the contributions of capital and labor to
economic growth, the remaining growth
which we cannot explain must have been
caused by increases in technological
progress.
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Sources of U.S. Real GDP Growth,
1929-1982 (average annual percentage
rates)
Due to capital
growth
0.56
Percentage Contributions to Real GDP Growth
Due to labor
growth
1.34
Technological
progress
35%
+ Technological
progress
1.02
Output growth
2.92
© 2005 Prentice Hall Business Publishing
Labor growth
46%
Capital growth
19%
Survey of Economics, 2/e
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Growth Accounting: Three Examples

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.
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Growth Accounting: Three Examples


Singapore’s growth was attributed to
increases in labor and capital, while in
Hong Kong technological progress was
the key to growth.
This means that residents of Hong
Kong could enjoy the same level of
GDP but consume, not save, a higher
fraction of their GDP.
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Labor Productivity
 Labor
productivity is defined as
output per hour of work for the
economy as a whole.

It measures how much a typical
worker can produce with the
current amount of capital and
given the state of technological
progress.
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U.S. Annual Productivity Growth,
1959-2000
Years
Annual Growth
Rate
1959-1968
1968-1973
1973-1980
1980-1986
1986-1994
1994-2000
3.5
2.5
1.2
2.1
1.4
2.5
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U.S. Annual Productivity Growth,
1959-2000

Productivity growth was extremely
high during the 1960s. It slowed
down a bit in the late 1960s and then
slowed dramatically after the oil
shocks in the 1970s.

In recent years there has been a
resurgence in productivity growth,
which reached 2.5% from 19942000.
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A new Economy?

Proponents of the “new economy”
claim that the computer and
Internet revolution had led to a
permanent increase in productivity
growth.

Skeptics question whether the
increase in productivity growth
was truly permanent or
temporary
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U.S. Annual Productivity Growth,
1959-2000

The slowdown in productivity growth
also meant slower growth in real wages
since 1973.

Employees received lower wages but
higher benefits, but the rate of growth of
total compensation was less than the
growth rate of real hourly earnings in
the pre-1973 period.
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Real Hourly Earnings and Total Compensation
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U.S. Annual Productivity Growth,
1959-2000


The slowdown in labor productivity,
in the United States and abroad,
cannot be explained by reduced rates
of capital deepening or changes in the
quality and experience of the labor
force.
The failure of productivity growth to
increase despite rapid investment in
new technology is a mystery that has
baffled many economists.
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What Causes Technological Progress?
1. Research and development (R&D) in
science.
2. Monopolies that reward high profits spur
innovation (Joseph Schumpeter).
3. The scale of the market is important for
economic development (Adam Smith).
4. Induced innovations, or inventive activity
designed specifically to reduce costs.
5. Education and accumulation of
knowledge.
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R&D as a Share of GDP, 1998
Research and Development as a Share of GDP, 1995
3.00
Total
Non-defense
3.0
2.58
2.5
2.28
2.2
2.34
2.2
2.05
Percent
2.0
1.78
1.61 1.58
1.5
1.14 1.11
1.0
0.5
0.0
United States
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Japan
Germany
Survey of Economics, 2/e
France
United
Kingdom
O’Sullivan & Sheffrin
Italy
Canada
32
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 too 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.
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