Chapter

10

Long-Run Economic Growth: Sources and Policies

SOLUTIONS TO END-OF-CHAPTER EXERCISES
Chapter 10 Answers to Thinking Critically Questions
1. This policy would likely increase European entrepreneurship and, hence, innovation. This is because, under the current policy, entrepreneurs or, those who wish to become entrepreneurs have little incentive to organize factors of production, including labor, in order to innovate and, by doing so, increase economic activity and employment in Europe. 2. Government can provide the structurally unemployed retraining and educational opportunities, as well as unemployment, childcare and healthcare benefits while these individuals develop their skill sets.

Review Questions
1.1 A countrys economic growth matters because living standards tend to rise with economic growth. Higher economic growth provides a country with more opportunities to improve the lives of its citizens by, for example, increasing average life expectancy. 1.2 The total percentage increase is the percentage increase in real GDP from 1997 to 2007. It is not an annual growth rate. The average annual growth rate is the growth rate at which the value for real GDP in 1997 would have to grow on average each year to end up with the value for real GDP in 2007.

Problems and Applications

200 CHAPTER 10 (22) | Long-Run Economic Growth: Sources and Policies 1.3 The finding of the importance of market efficiency in long-run economic growth by Shiue and Keller supports Norths argument that a government can promote economic growth by protecting private property rights and wealth, as the British government did beginning with the Glorious Revolution of 1688.

CHAPTER 10 (22) | Long-Run Economic Growth: Sources and 201 Policies 1.4 Growth Rates Country Australia Hungary Poland 2003 2004 2005 2006 Average Annual Growth Rate 2.63% 4.36 4.88

2.67% 4.98 5.26

2.80% 4.22 3.28

2.41% 3.88 6.10

a. During 2004, Poland experienced the highest economic growth rate of 5.26%. b. During 2005, Hungary experienced the highest economic growth rate of 4.22%. c. Between 2004 and 2006, Poland experienced the highest average annual growth rate of 4.88%. 1.5 You will have earned more on your Lowell Bank CDs. Bank Andover Bank Lowell Bank 1.6 Year Real GDP per capita Annual (2000 prices) growth rate $34,861 35,385 36,415 37,241 38,154 Value of CD at end of year 2007 2008 2009 $1,020.00 $1,111.80 $1,222.98 $1,070.00 $1,144.90 $1,225.04

2002 2003 2004 2005 2006

1.50% 2.91 2.27 2.45

a. The percentage increase in real GDP per capita between 2002 and 2006 was

$38,154 $34,861 100 = 9.45% . $34,861

b. The average annual growth rate in GDP per capita between 2002 and 2006 can be measured as the average of the annual growth rates in the above table, which is 2.28%. 1.7 The answer depends on several factors: Whether country A sustains high rates of growth relative to country B, on how long a period of time has passed since rapid economic growth first began in country A, and on how long a period of time there was between rapid economic growth beginning in country A and rapid economic growth beginning in country B. For example, the standard of living in China can catch up with that in Japan if China continues to sustain an economic growth rate that is higher than the growth rate in Japan.

202 CHAPTER 10 (22) | Long-Run Economic Growth: Sources and Policies

Review Questions
2.1

A movement from A to B shows the effect on real GDP per hour worked of an increase in capital per hour worked, holding technology constant. A movement from A to C shows the effect of an increase in productivity, holding the quantity of capital per hour worked constant. 2.2 Diminishing returns to capital imply that, holding technology constant, additional capital per hour worked results in smaller and smaller increases in real GDP per hour worked. Therefore, sustained increases in real GDP per hour worked require more than continuing increases in capital per hour worked. To maintain high growth rates despite diminishing returns to capital, economies must experience technological change. 2.3 Initially, the increases in capital per hour worked in the Soviet Union produced rapid increases in real GDP per hour worked. The prediction did not adequately consider diminishing returns to capital and the crucial role of technological change. 2.4 Firms are likely to under invest in research and development because much of the additional return from the research and development will be gained by other firms. To increase the accumulation of knowledge capital, governments can protect intellectual property with patents and copyrights, subsidize research and development, and subsidize education.

CHAPTER 10 (22) | Long-Run Economic Growth: Sources and 203 Policies

Problems and Applications

2.5 Changes in work rules represent a better means of organizing and managing production, which economists consider an improvement in technology. 2.6 a. results in a movement along the per-worker production function. b. and c. result in a shift in the per-worker production function because they are likely to lead to technological change, or an increase in real GDP per hour worked, holding capital per hour worked constant. 2.7 a. False, because technology is assumed constant along a given per-worker production function. b. False, because the movement from point B to point C represents technological change, which occurs despite the existence of diminishing returns to capital. c. True, because point C represents both a higher level of capital per worker and a higher level of technology than point A.

2.8 This strategy ran into the problem of diminishing returns to capital. The policy of very high rates of investment with little emphasis on technological change meant that the capital stock was increasing much more rapidly than technology. As a result, diminishing marginal returns set in and the growth rate of real GDP per capita stagnated. 2.9 In the traditional economic growth model, technological change is exogenous. This means that the traditional model does not try to explain technological change. Technological change is endogenous in the new growth theory and the entrepreneur plays a key role in the development and adoption of new technology. 2.10 Because even though they are not spending their own money, salaried managers in the United States are judged by the profitability of the company, which often depends on the adoption of new technologies. 2.11 Managers would have to be rewarded for discovering and using new technologies rather than just for fulfilling quantitative production goals. This is difficult to do, however. Measuring the amount of output is easy compared with measuring the use of new technologies.

Review Questions
3.1 The growth rate of productivity increased from 1800 through the mid-1970s, then slowed for 20 years, and increased again in the mid-1990s. The slowdown in productivity growth from the mid-1970s to the mid-1990s most likely resulted from the measurement problem of the economy producing a larger share of services relative to goods and stricter environmental and health standards that may have increased overall well-being, but not measured GDP. In response to higher oil prices, some firms switched to production technologies which were less energy intensive, but which also produced less output per worker hour. The scores on some standardized exams declined during this time period which may indicate a declining quality of the labor force. Lower quality workers may have more difficulty adapting to new technology, which could reduce the growth rate of productivity. After 1995, the rapid spread of information technology may have spurred productivity increases. 3.2 U.S. productivity growth, measured by the average annual growth rate of labor productivity, was about 2.5 percent in the period between 1996 and present. This rate of growth was much higher than that

204 CHAPTER 10 (22) | Long-Run Economic Growth: Sources and Policies in Europe, possibly because of the greater flexibility of U.S. labor markets and the greater efficiency of the U.S. financial system.

Problems and Applications

3.3 The growth rates might be lower if they were calculated for real GDP per capita instead of per hour worked because the number of hours worked per person in the United States has decreased in the years since 1900. 3.4 Because labor productivity is measured by real GDP per hour worked, slower growth in real GDP and more rapid growth in the number of hours worked than previously estimated imply a decrease in the new estimate of the growth rate in labor productivity. 3.5 Use of the kiosks increased output per worker at the airlines. Future increases in productivity at the airlines would likely slow down as the percentage increase in the share of passengers using the kiosk continues to grow only slowly. 3.6 The annual rate of labor productivity in Germany from 1996 to 2006 equaled less than 1 percent. At a growth rate of less than 1 percent, it would take more than 70 years for labor productivity to double in value. Slow rates of productivity growth result in slow rates of increase in living standards.

Review Questions
4.1 Increases in the quantity of capital per hour worked and the adoption of new technology should occur at a high rate in the developing countries, because the profitability of using additional capital or better technology is generally greater in a developing country than in a high-income country. Some poor countries have been catching up to rich countries, but many have not. 4.2 The main reasons many poor countries have experienced slow growth are the failure to enforce the rule of law, wars and revolutions, poor public education and health, and low rates of saving and investment. 4.3 Globalization refers to the process of countries becoming more open to foreign trade and investment. Globalization can help a developing country break out of the vicious cycle of low saving and investment and low growth by providing access to funds and technology from foreign direct investment and foreign portfolio investment.

Problems and Applications

4.4 The catch-up effect is that countries with a lower level of GDP per capita will grow faster than countries with a higher level of GDP per capita. In the table, Chinas GDP per capita in 1960 was the lowest at $448 and its growth between 1960 and 2004 was the highest at an average annual rate of 5.79%, which is consistent with catch-up. On the other hand, some countries with relatively low GDP per capita in 1960, such as Uganda and Madagascar, also experienced relatively low growth rates, which is not consistent with catch-up. Overall, these data are not consistent with the economic growth models prediction of catch-up.

CHAPTER 10 (22) | Long-Run Economic Growth: Sources and 205 Policies 4.5 a. Not over the entire range, because the countries with the highest initial levels of real GDP per capita have growth rates of real GDP per capita similar to the countries with average initial levels of real GDP per capita. b. Yes, because the countries with the lower initial level of real GDP per capita have the higher growth rates of real GDP per capita. c. No, the countries have roughly the same growth rates of real GDP per capita regardless of their initial levels of real GDP per capita.

4.6 Globalization makes it possible for poor countries to attract foreign investment and gain access to the best technology. Without the free flow of trade and investment that globalization represents, poor countries would have to rely primarily on their own resources. Refer to Figure 10-11 for the relationship between the level of globalization and the growth rate of real GDP per capita. 4.7 The multinationals can help break the vicious cycle of poverty by providing foreign direct investment and access to new technologies. 4.8 The experience of Bangladesh highlights the importance of globalization in spreading technology in poor countries and subsequently raising the ability of those countries to catch up to the income levels of rich countries. From this perspective, government policies that make an economy more open, particularly to foreign investment, can help poor countries to catch up. 4.9 Legal structures refer to the rule of law, which is the ability of a government to enforce the laws of the country, particularly with respect to protection of private property and enforcement of contracts. Unless the rule of law prevails in a country, the country is very unlikely to develop. See Figure 10-10 for the relationship between the strength of legal institutions and average annual growth rate of real GDP per capita. 4.10 The free-trade negotiations and investors can enhance foreign direct investment, foreign portfolio investment, and access to new technologies. See Figure 10-11 for the relationship between the level of globalization and the average annual growth rate of real GDP per capita. 4.11 For the most part, the Roman Empire lacked the secure private property rights required for a market system to work. If modern economic growth had begun 1700 years earlier than it did, the standard of living today would be many times higher than it is.

Review Questions
5.1 Governments can aid economic growth through policies that enhance property rights and the rule of law, improve health and education, subsidize research and development, and provide incentives for saving and investment. 5.2 Economic growth has been arguably contributing to global warming, deforestation, and other environmental problems. Whether continued economic growth will always improve economic well-being is a normative question and cannot be settled by economic analysis.

Problems and Applications

206 CHAPTER 10 (22) | Long-Run Economic Growth: Sources and Policies 5.3 Excess public sector borrowing will reduce the savings available to domestic businesses to finance capital investments. Corruption and a politicized judicial system make it difficult for the market system to work efficiently because they undermine the rule of law and property rights. 5.4 It is likely to be easier for the typical developing country to improve the state of public health than to improve the average level of education. Improvement in public health involves increased vaccinations against infectious diseases, improved access to treated water, and improved sanitation. Improving the average level of education, on the other hand, typically requires building new and better schools, purchasing textbooks and other educational materials, and hiring large numbers of teachers. The expense and organizational resources involved have often made it difficult for developing countries to significantly improve the average level of education. 5.5 a. and c. are likely to increase the rate of economic growth in the United States because both situations are likely to result in increasing quantities of goods and services and better goods and services. 5.6 A free press could serve as a watchdog against corruption, which undermines the rule of law and property rights. Over time, crusading newspapers could help reduce corruption and improve the rule of law. 5.7 The environment might be considered as a normal good, whose demand increases as a consumers income increases. From this perspective, more people in high-income countries than in lowincome countries tend to be concerned about the environment and thus consider rapid economic growth less desirable.