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Economic Growth

The Long-Term Significance of


Growth

Continuing rapid economic growth enables advanced industrial


countries to provide more of everything to their citizens - better
food and bigger homes, more resources for medical care and
pollution control, universal education for children, better
equipment for the military, and public pension for retirees.

Because economic growth is so important for living standards, it is


a central objective of policy. In fact, economic growth is the single
most important factor in the success of nations in the long run.

Economic growth represents the expansion of a countrys potential


GDP or national output. Put differently, economic growth occurs
when a nations production possibility frontier (PPF) shifts
outward.

A closely related concept is the growth rate of output per person;


the rate at which the countrys living standards are rising.
Countries are primarily concerned with growth in per capita output
because this leads to rising average incomes.

Economic growth involves the growth of potential output over the


long run. The growth in output per capita is an important objective
of government because it is associated with rising average real
incomes and rising living standards.

The Four Wheels of Growth

The engine of economic progress must ride on the following


four wheels, or factors of growth:
1. Human resources (labor supply, education, skills,
discipline, motivation)
2. Natural resources (land, minerals, fuels,
environmental quality)
3. Capital (factories, machinery, roads, intellectual
property)
4. Technological change and innovation (science,
engineering, management, entrepreneurship)

This relationship between growth and its determinants is


written in terms of an aggregate production function
(APF), which relates total national output to inputs and
technology. Algebraically, the APF is

Q = AF(K,L,R)
Where Q = output, K = productive services of capital, L =
labor inputs, R = natural-resource inputs, A represents
the level of technology in the economy and F is the
production function.

The Four Wheels of Growth


Human Resources - Labor inputs consist of quantities of workers

and of the skills of the workforce.Improvements in literacy, health,


and discipline, and most recently the ability to use computers add
greatly to the productivity of labor. Productivity denotes the ratio
of output to a weighted average of inputs.

Natural Resources - These include arable land, oil, gas, forests,


water, and mineral deposits.

Capital - includes tangible capital goods like roads, power plants,

and equipment like trucks and computers, as well as intangible


items such as patents, trademarks, and computer software.
Accumulating capital requires a sacrifice of current consumption
over many years. Capital also includes investments undertaken by
the government which are necessary for the efficient functioning
of the private sector. These investments are called social overhead
capital and consist of the large scale projects that precede trade
and commerce. These projects may involve external economies, or
spillovers that private firms cannot capture, so the government
must step in to ensure that these social overhead or infrastructure
investments are effectively undertaken. Some investments involve
network externalities in which productivity depends upon the
fraction of the population which uses or has access to the network.

Technological Change and Innovation - Technological change

denotes changes in the processes of production or introduction of


new products or services.

Theories of Economic Growth

The Classical Dynamics of Smith and Malthus - stressed the


critical role of land in economic growth. However, as
population growth continues, land becomes scarce and
rents rise to ration it among different users. The population
still grows and so does the national output but the pace of
growth of output is slower. The increasing labor-lang ratio
leads to a declining marginal product of labor and hence to
declining real wage rates. Malthus thought that the
population pressures would drive the economy to a point
where workers were at the minimum level of subsistence;
whenever wages were above the subsistence level,
population would expand; below-subsistence wages would
lead to high mortality and population decline. Only at
subsistence wages could there by a stable equilibrium of
population.

(b) Malthuss Dismal


Science

(a) Smiths Golden Age

Clothing production

Clothing production

400

L=4

200
L=2

100

200

300

L=4

200
L=2

100125
Food Production

In (a), unlimited land on the frontier means that when population


doubles, labor can simply spread out and produce twice the quantity
of any food and clothing combination. In (b), limited land means that
increasing population from 2 million to 4 million triggers diminishing
returns. Note that potential food production rises by only 25 percent
with a doubling of labor inputs.

Theories of Economic Growth

Economic Growth with Capital Accumulation: The Neoclassical Growth Model Pioneered by Robert Solow, this model serves as the basic tool for
understanding the growth process in advanced countries and has been applied
in empirical studies of the sources of economic growth. It describes an economy
in which a single homogeneous output is produced by two types of inputs capital and labor. In contrast to the Malthusian analysis, labor growth is
assumed to be a given. It is also assumed that the economy is competitive and
always operates at full employment, technology remains constant and that
there is a single kind of capital good (K). Measuring, then, the aggregate stock
of capital as the total quantity of capital goods means approximating the
universal capital good as the total dollar value of capital goods (i.e., the
constant-dollar value of equipment, structures, and inventories). If L is the
number of workers, then (K/L) is equal to the quantity of capital per worker, or
the capital-labor ratio. The aggregate production function for the neoclassical
growth model without technological change could be written as Q = F(K,L).It is
important to consider the need for capital deepening in the economic growth
process - a process by which the quantity of capital per worker increases over
time. The wage rate tends to rise as capital deepening occurs because each
worker has more capital to work with and the marginal product therefore rises.
As a result, the competitive wage rate rises along with the marginal product of
labor.Capital deepening occurs when the stock of capital grows more rapidly
than the labor force. In the absence of technological change, capital deepening
will produce a growth of output per worker, of the marginal product of labor, and
of real wages; it will also lead to diminishing returns on capital and therefore to
a decline in the rate of return on capital.

Output per worker

Q/L

(Q/L)1
(Q/L)0

.
.

.
.
.
V

E```
E` E``

(K/L)0

(K/L)1

APF

Economic Growth Through


Capital Deepening
As the amount of capital per
worker increases, output
per worker also increases.
This
graph
shows
the
importance
of
capital
deepening, or increasing
the amount of capital each
worker
has
on
hand.
Remember, however, that
other
factors
are
held
constant,
such
as
technology, quality of the
labor force, and natural
resources.
K/L

Capital per worker


Without technological change, output per worker and the wage
rate stagnate. This is certainly a far better outcome than the
world of subsistence predicted by Malthus. But the long-run
equilibrium of the neoclassical growth model makes it clear that if
economic growth consists only of accumulating capital through
replicating factories with existing methods of production, then
the standard of living will eventually stop rising.

Geometric Analysis of the Neoclassical Model

Output per worker

The Central Role of


Technological Change

(Q/L)2000

(Q/L)1950

APF2000
E2000

APF1950

E1950

(K/L)1950 (K/L)2000
Capital per worker

K/L

Technological
Advance
Shifts Up the Production
Function
As a result of improvements
in
technology,
the
aggregate
production
function shifts upward over
time. Hence improvements
in technology combine with
capital deepening to raise
output per worker and real
wages.