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Chapter8 Economic Growth People living in rich countries tend to take economic growth and rising standards of living for granted. Recessions—periods during which output declines—are normally infrequent and temporary, usually lasting less than a year. Once they pass, modern capitalistic economies return to growing, and living standards continue their seemingly inexorable rise. But a look back at history or a look around the world today quickly dispels any confidence that economic growth and rising standards of living are automatic or routine. Historically, continually rising living standards are a recent phenomenon, seen only during the last century or two. Before that time, living standards barely rose —if at all—from one generation to the next. And a look around the world today reveals huge differences in standards of living resulting from the disturbing fact that, although some countries have enjoyed decades or even centuries of steadily rising per capita income levels, other countries have experienced hardly any economic growth at all. This chapter investigates the causes of economic growth, what institutional structures appear to promote economic growth, and the controversies surrounding the benefits and costs of economic growth. As you will see, economic growth has been perhaps the most revolutionary and powerful force in history. Consequently, no study of economics is complete without a thorough understanding of the causes and consequences of economic growth. Economic Growth LO8.1 List Page 159 two ways that economic growth is measured. Economists define and measure economic growth as either:

• An increase in real GDP occurring over some time period.

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• An increase in real GDP per capita occurring over some time period.

With either definition, economic growth is calculated as a percentage rate of growth per quarter (3-month period) or per year. For the first definition, for example, real GDP in the United States was $15,961.7 billion in 2014 and $16,348.9 in 2015. So the U.S. economic growth rate for 2015 was 2.4 percent {= [(16,348.9 billion − $15,961.7 billion)/ $15,961.7 billion] × 100}. Growth rates normally are positive, but not always. In recession year 2009, for instance, the U.S. rate of economic growth was a minus 2.4 percent. The second definition of economic growth in the bulleted list takes into consideration the size of the population. Real GDP per capita (or per capita output) is the amount of real output per person in a country. It is calculated, as follows.

For example, in 2014 the real GDP in the United States was $15,961.7 billion and population was 319.4 million. Therefore, real GDP per capita in that year was $49,974. In 2015 real GDP per capita increased to $50,820. So the growth rate of real GDP per capita in 2015 was 1.7 percent {= [($50,820 − $49,974)/$49,974] × 100}. In contrast, real GDP per capita fell by 3.3 percent in recession year 2009. For measuring expansion of military potential or political preeminence, the growth of real GDP is more useful. Unless specified otherwise, growth rates reported in the news and by international agencies use this definition of economic growth. For comparing living standards, however, the second definition is superior. While China’s GDP in 2015 was $10,983 billion compared with Denmark’s $295 billion, Denmark’s real GDP per capita was $64,186 compared with China’s strikingly lower $8,211. And in some cases real GDP growth statistics can be misleading, even when accurate. The African nation of Eritrea had real GDP growth of 1.3 percent per year from 2000–2008. But over the same period its annual growth of population was 3.8 percent, resulting in a decline in real GDP per capita of roughly 2.5 percent per year. Growth as a Goal

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Growth is a widely held economic goal. The expansion of total output relative to population results in rising real wages and incomes and thus higher standards of living. An economy that is experiencing economic growth is better able to meet people’s wants and resolve socioeconomic problems. Rising real wages and income provide richer opportunities to individuals and families—a vacation trip, a personal computer, a higher education—without sacrificing other opportunities and pleasures. A growing economy can undertake new programs to alleviate poverty, embrace diversity, cultivate the arts, and protect the environment without impairing existing levels of consumption, investment, and public goods production. In short, growth lessens the burden of scarcity. A growing economy, unlike a static economy, can consume more today while increasing its capacity to produce more in the future. By easing the burden of scarcity —by relaxing society’s constraints on production—economic growth enables a nation to attain its economic goals more readily and to undertake new endeavors that require the use of goods and services to be accomplished. Arithmetic of Growth Why do economists pay so much attention to small changes in the rate of economic growth? Because those changes really matter! For the United States, with a current nominal GDP of about $17.9 trillion, the difference between a 3 percent and a 4 percent rate of growth is about $179 billion of output each year. For a poor country, a difference of one-half of a percentage point in the rate of growth may mean the difference between starvation and mere hunger. The mathematical approximation called the rule of 70 provides a quantitative grasp of the effect of economic growth. The rule of 70 tells us that we can find the number of years it will take for some measure to double, given its annual percentage increase, by dividing that percentage increase into the number 70:

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Examples: A 3 percent annual rate of growth will double real GDP in about 23 (= 70 ÷ 3) years. Growth of 8 percent per year will double real GDP in about 9 (= 70 ÷ 8) years. The rule of 70 is applicable generally. For example, it works for estimating how long it will take the price level or a savings account to double at various percentage rates of inflation or interest. When compounded over many years, an apparently small difference in the rate of growth thus becomes highly significant. Suppose China and Italy start with identical GDPs, but then China grows at an 8 percent yearly rate, while Italy grows at 2 percent. China’s GDP would double in about 9 years, while Italy’s GDP would double in 35 years. Growth in the United States Table 8.1 gives an overview of economic growth in the United States since 1950. Column 2 reveals strong growth as measured by increases in real GDP. Note that between 1950 and 2015 real GDP increased more than sevenfold. But the U.S. population also increased. Nevertheless, in column 4 we find that real GDP per capita rose more than threefold over these years. Page 160 TABLE 8.1 Real GDP and Real GDP per Capita, Selected Years, 1950– 2015

Source: Data are from the Bureau of Economic Analysis, www.bea.gov, and the U.S. Census Bureau, www.census.gov. All data are subject to government revision. What has been the rate of U.S. growth? Real GDP grew at an annual rate of about 3.1 percent between 1950 and 2015. Real GDP per capita increased at roughly 2.0 percent per year over that time. But we must qualify these raw numbers in several ways:

• Improved products and services Since the numbers in Table 8.1 do not fully account for improvements in products and services, they understate the growth of economic well-being. Such purely quantitative data do not fully compare an era of vacuum tube computers and low-efficiency V8 hot rods with an era of digital cell phone networks and fuel-sipping, hybrid-drive vehicles.

• Added leisure The increases in real GDP and per capita GDP identified in Table 8.1 were accomplished despite increases in leisure. The average workweek, once 50 hours, is now about 35 hours (excluding overtime hours). Again the raw growth numbers understate the gain in economic well-being.

• Other impacts These measures of growth do not account for any effects growth may have had on the environment and the quality of

life. If growth debases the physical environment, excessively warms the planet, and creates a stressful work environment, the bare growth numbers will overstate the gains in well-being that result from growth. On the other hand, if growth leads to stronger environmental protections or a more secure and stress-free lifestyle, these numbers will understate the gains in well-being.

In Chapter 16, we made two other key points about U.S. growth rates. First, they are not constant or smooth over time. Like those of other countries, U.S. growth rates vary quarterly and annually depending on a variety of factors such as the introduction of major new inventions and the economy’s current position in the business cycle. Second, many countries share the U.S. experience of positive and ongoing economic growth. But sustained growth is both a historically new occurrence and also one that is not shared equally by all countries. QUICK REVIEW 8.1 ✓ Economists measure economic growth as either (a) an increase in real GDP over time or (b) an increase in real GDP per capita over time. ✓ Real GDP in the United States has grown at an average annual rate of about 3.1 percent since 1950; real GDP per capita has grown at roughly a 2 percent annual rate over that same period. Modern Economic Growth LO8.2 Define “modern economic growth” and explain the institutional structures needed for an economy to experience it. We now live in an era of wireless high-speed Internet connections, genetic engineering, and space exploration. New inventions and new technologies drive continual economic growth and ongoing increases in living standards. But it wasn’t always like this. Economic growth and sustained increases in living standards are a historically recent phenomenon that started with the Industrial Revolution of the late 1700s. Before the Industrial Revolution, living standards were basically flat over long periods of time so that, for instance, Greek peasants living in the year 300 B.C. had about the same material standard of living as Greek peasants living in the year A.D. 1500. By contrast, our current era

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of modern economic growth is characterized by sustained and ongoing increases in living standards that can cause dramatic increases in the standard of living within less than a single human lifetime. Economic historians informally date the start of the Industrial Revolution to the year 1776, when the Scottish inventor James Watt perfected a powerful and efficient steam engine. This steam engine inaugurated the modern era since the device could be used to drive industrial factory equipment, steamships, and steam locomotives. The new industrial factories mass-produced goods for the first time. This meant that nearly all manufacturing shifted from items produced by hand by local craftsmen to items Page 161 mass-produced in distant factories. The new steamships and steam locomotives meant that resources could easily flow to factories and that the products of factories could be shipped to distant consumers at low cost. The result was a huge increase in long-distance trade and a major population shift as people left farms to go work in the towns and cities where the new industrial factories were concentrated. Steam power would later be largely replaced by electric power, and many more inventions would follow the steam engine that started the Industrial Revolution. These included railroads, motorized vehicles, telephones, airplanes, container ships, computers, the Internet, and many more. But the key point is that the last 200 or so years of history have been fundamentally different from anything that went before. The biggest change has been change itself. Whereas in earlier times material standards of living and the goods and services that people produced and consumed changed very little even over the course of an entire human life span, today people living in countries experiencing modern economic growth are constantly exposed to new technologies, new products, and new services. What is more, modern economic growth has vastly affected cultural, social, and political arrangements.

• Culturally, the vast increases in wealth and living standards have allowed ordinary people for the first time in history to have significant time for leisure activities and the arts.

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• Socially, countries experiencing modern economic growth have abolished feudalism, instituted universal public education, and largely eliminated ancient social norms and legal restrictions against women and minorities doing certain jobs or holding certain positions.

• Politically, countries experiencing modern economic growth have tended to move toward democracy, a form of government that was extremely rare before the start of the Industrial Revolution.

In addition, the average human lifespan has more than doubled, from an average of less than 30 years before modern economic growth began in the late 1700s to a worldwide average of over 71 years today. Thus, for the first time in world history, the average person can expect to live into old age. These and other changes speak to the truly revolutionary power of economic growth and naturally lead economists to consider the causes of economic growth and what policies could be pursued to sustain and promote it. Their desire is intensified by the reality that economic growth is distributed so unevenly around the world. The Uneven Distribution of Growth Modern economic growth has spread only slowly from its British birthplace. It first advanced to France, Germany, and other parts of western Europe in the early 1800s before spreading to the United States, Canada, and Australia by the mid-1800s. Japan began to industrialize in the 1870s, but the rest of Asia did not follow until the early to mid-1900s, at which time large parts of Central and South America as well as the Middle East also began to experience modern economic growth. Most recent has been Africa, which for the most part did not experience modern economic growth until the last few decades. Notably, some parts of the world have yet to experience modern economic growth at all. The different starting dates for modern economic growth in various parts of the world are the main cause of the vast differences in per capita GDP levels seen today. The current huge gaps between rich countries like the United States and Japan and poor countries like North Korea and Burundi were shown previously in Global Perspective 26.1. But the huge divergence in living standards caused by the fact that different

countries started modern economic growth at different times is best seen in Figure 8.1, which shows how GDP per capita has evolved since 1820 in the United States, western Europe, Latin America, Asia, and Africa. FIGURE 8.1 The great divergence in standards of living. Income levels around the world were very similar in 1820. But they are now very different because certain areas, including the United States and western Europe, began experiencing modern economic growth much earlier than other areas.

Source: Angus Maddison, The World Economy: A Millennial Perspective (Paris: OECD, 2001), p. 264. To make the comparison of living standards easier, income levels in all places and at all times have been converted into 1990 U.S. dollars. Using this convention, it is clear that in 1820 per capita incomes in all areas were quite similar, with the richest area in the world in 1820, western Europe, having an average per capita income of $1,232, while the poorest area of the world at that time, Africa, had an average per capita income of $418. Thus, in 1820, average incomes in the richest area were only about three times larger than those in the poorest area.

But because western Europe and the United States started experiencing modern economic growth earlier than other areas, they have now ended up vastly richer than other areas, despite the fact that per capita incomes in nearly all places have increased at least a bit. For instance, per capita GDP in the United States in 1998 was $27,331 while it was only $1,368 in Africa. Thus, because modern economic growth has occurred for nearly two centuries in the United States compared to a few decades in Africa, average living standards in the United States in 1998 were nearly 20 times higher than those in Africa. Catching Up Is Possible Do not get the wrong impression looking at Figure 8.1. Countries that began modern economic growth more recently are not doomed to be permanently poorer than the countries that began modern economic growth at an earlier date. This is true because people can adopt technology more quickly than they can invent it. Broadly speaking, the richest countries today have achieved that status because they have the most advanced technology. But because they already have the most advanced technology, they must invent new technology to get even richer. Page 162 Because inventing and implementing new technology is slow and costly, real GDP per capita in the richest leader countries typically grows by an average annual rate of just 2 or 3 percent per year. By contrast, poorer follower countries can grow much faster because they can simply adopt existing technologies from rich leader countries. For instance, in many places in Africa today, the first telephones most people have ever been able to use are cell phones. That is, these countries have not even bothered to install the copper wires necessary for land-line telephones, which are basically a nineteenth-century technology. Instead, they have gone directly for Internet-capable mobile phone networks, a twenty-first-century technology. By doing so, they skip past many stages of technology and development that the United States and other currently rich countries had to pass through. In effect, they jump directly to the most modern, most highly productive technology. The result is that, under the right circumstances, it is

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possible for poorer countries to experience extremely rapid increases in living standards. This can continue until they have caught up with the leader countries and become leader countries themselves. Once that happens, their growth rates fall down to the 2 or 3 percent rate typical of leader countries. This happens because once they are also rich and using the latest technology, their growth rates are limited by the rate at which new technology can be invented and applied.

Table 8.2 shows both how the growth rates of leader countries are constrained by the rate of technological progress as well as how certain follower countries have been able to catch up by adopting more advanced technologies and growing rapidly. Table 8.2 shows real GDP per capita in 1960 and 2010 as well as the average annual growth rate of

Page 163 real GDP per capita between 1960 and 2010 for three countries—the United States, the United Kingdom, and France—that were already rich leader countries in 1960 as well as for five other nations that were relatively poor follower countries at that time. To make comparisons easy, the GDPs and GDPs per capita for all countries are expressed in terms of 2005 U.S. dollars. The countries are ordered by their respective GDPs per capita in 1960, so that the richest country in the world at the time, the United States, is listed first while the poorest of the eight selected countries at the time, South Korea, is listed last. TABLE 8.2 Real GDP per Capita in 1960 and 2010 plus Average Annual Growth Rates of Real GDP per Capita from 1960–2010 for Selected Countries. (Figures are in 2005 dollars.)

Note: GDP figures for all countries are measured in “international dollars” of equal value to U.S. dollars in 2005. Source: Alan Heston, Robert Summers, and Bettina Aten, Penn World Table Version 6.3, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, August 2009. First, notice that the average annual growth rates of the three leader countries—the United States, the United Kingdom, and France—have all been between 2.1 and 2.5 percent per year because their growth rates are limited by the rate at which new technologies can be invented and applied. By contrast, the five countries that were follower countries in 1960 have been able to grow much faster, between 3.3 percent per year and 5.4 percent per year. This has had remarkable effects on their standards of living relative to the leader countries. For instance, Ireland’s GDP per capita was only 60 percent that of its neighbor, the United Kingdom, in 1960. But because Ireland grew at a 3.3 percent rate for the next 50 years while the United Kingdom grew at only a 2.2 percent rate over that time period, by 2010 Ireland’s GDP per capita was actually

higher than the United Kingdom’s GDP per capita. Ireland had become a leader country, too. The growth experiences of the other four nations that were poor in 1960 have been even more dramatic. Hong Kong, for instance, moved from a GDP per capita that was less than one-third of that enjoyed by the United Kingdom in 1960 to a GDP per capita 13 percent higher than that of the United Kingdom in 2010. The Consider This box emphasizes both how quickly small differences in growth rates can change the level of real GDP per capita and how countries stand in relation to each other in terms of real GDP per capita. Finally, you may be puzzled as to why the GDP per capita of the United States in 2010 in Table 8.2 is so much higher than that of other rich leader countries. Why, for instance, is U.S. GDP per capita 32 percent higher than French GDP per capita? One important reason is that U.S. citizens put in substantially more labor time than do the citizens of most other leader countries. First, a much larger fraction of the U.S. population is employed than in other rich leader countries. Second, U.S. employees work many more hours per year than do employees in other rich leader countries. For example, 58 percent of the working-age population of the United States was employed in 2010 compared to 51 percent in France. That’s a difference of about 14 percent. And American employees worked an average of 1,778 total hours during 2010, compared to an average of 1,478 total hours for French workers. That’s a difference of about 20 percent. Added together, these two differences between U.S. and French labor supply imply about a 34 percent difference in the total number of hours worked in the French and American economies. Thus, differences in labor supply help explain differences between rich leader countries in terms of their differing levels of GDP per person. CONSIDER THIS . . . Economic Growth Rates Matter!

Source: © Todd Warshaw/Getty Images Sport/Getty Images When compounded over many decades, small absolute differences in rates of economic growth add up to substantial differences in real GDP and standards of living. Consider three hypothetical countries—Slogo, Sumgo, and Speedo. Suppose that in 2014 these countries have identical levels of real GDP ($6 trillion), population (200 million), and real GDP per capita ($30,000). Also, assume that annual real GDP growth is 2 percent in Slogo, 3 percent in Sumgo, and 4 percent in Speedo. How will these alternative growth rates affect real GDP and real GDP per capita over a long period, say, a 70-year life-span? By 2084 the 2, 3, and 4 percent growth rates would boost real GDP from $6 trillion to:

• $24 trillion in Slogo. • $47 trillion in Sumgo. • $93 trillion in Speedo.

For illustration, let’s assume that each country experienced an average annual population growth of 1 percent over the 70 years. Then, in 2084 real GDP per capita would be about:

• $60,000 in Slogo. • $118,000 in Sumgo. • $233,000 in Speedo.

Even small differences in growth rates matter! Buy why do Americans supply so much more labor than workers in France and some of the other rich leader countries? Explanations put forth by economists include cultural differences regarding the proper

balance between work and leisure, stronger unions in France and other rich leader countries, and more generous unemployment and welfare programs in France and other rich leader countries. France and other rich leader countries also tend to have higher tax rates than the United States —something that may significantly discourage employment. And, finally, the legal workweek is shorter in some countries than it is in the United States. QUICK REVIEW 8.2 ✓ Before the advent of modern economic growth starting in England in the late 1700s, living standards showed no sustained increases over time. ✓ Large differences in standards of living exist today because certain areas like the United States have experienced nearly 200 years of modern economic growth while other areas have had only a few decades of economic growth. ✓ Poor follower countries can catch up with and even surpass the living standards of rich leader countries by adopting the cutting- edge technologies and institutions already developed by rich leader countries. ✓ Substantial differences in GDP per capita among technologically advanced leader countries are often caused by differences in the amount of labor supplied. Institutional Structures That Promote Modern Economic Growth Table 8.2 Page 164 demonstrates that poor follower countries can catch up and become rich leader countries by growing rapidly. But how does a country start that process and enter into modern economic growth? And once it has started modern economic growth, how does it keep the process going? Economic historians have identified several institutional structures that promote and sustain modern economic growth. Some structures increase the savings and investment that are needed to fund the construction and maintenance of the huge amounts of infrastructure required to run

modern economies. Other institutional structures promote the development of new technologies. And still others act to ensure that resources flow efficiently to their most productive uses. These growth- promoting institutional structures include:

• Strong property rights These appear to be absolutely necessary for rapid and sustained economic growth. People will not invest if they believe that thieves, bandits, or a rapacious and tyrannical government will steal their investments or their expected returns.

• Patents and copyrights Before patents and copyrights were first issued and enforced, inventors and authors usually saw their ideas stolen before they could profit from them. By giving inventors and authors the exclusive right to market and sell their creations, patents and copyrights give a strong financial incentive to invent and create.

• Efficient financial institutions These are needed to channel the savings generated by households toward the businesses, entrepreneurs, and inventors that do most of society’s investing and inventing. Banks as well as stock and bond markets appear to be institutions crucial to modern economic growth.

• Literacy and widespread education Without highly educated inventors, new technologies do not get developed. And without a highly educated workforce, it is impossible to implement those technologies and put them to productive use.

• Free trade Free trade promotes economic growth by allowing countries to specialize so that different types of output can be produced in the countries where they can be made at the lowest opportunity cost. In addition, free trade promotes the rapid spread of new ideas so that innovations made in one country quickly spread to other countries.

• A competitive market system Under a market system, prices and profits serve as the signals that tell firms what to make and how much of it to make. Rich leader countries vary substantially in terms of how much government regulation they impose on markets, but in all cases, firms have substantial autonomy to follow market signals in deciding on current production and in making

investments to produce what they believe consumers will demand in the future.

Several other difficult-to-measure factors also influence a nation’s capacity for economic growth. The overall social-cultural-political environment of the United States, for example, has encouraged economic growth. Beyond the market system that has prevailed in the United States, the United States also has had a stable political system characterized by democratic principles, internal order, the right of property ownership, the legal status of enterprise, and the enforcement of contracts. Economic freedom and political freedom have been “growth-friendly.” In addition, and unlike some nations, there are virtually no social or moral taboos on production and material progress in the United States. The nation’s social philosophy has embraced wealth creation as an attainable and desirable goal and the inventor, the innovator, and the businessperson are accorded high degrees of prestige and respect in American society. Finally, Americans have a positive attitude toward work and risk taking, resulting in an ample supply of willing workers and innovative entrepreneurs. A flow of energetic immigrants has greatly augmented that supply. The following Consider This box deals with how fast-growing follower countries such as India sometimes alter their growth-related institutional structures as they grow richer. CONSIDER THIS . . . Patents and Innovation

Source: © Stockbyte/Getty Images RF It costs U.S. and European Page 165 drug companies about $1 billion to research, patent, and safety- test a new drug because literally thousands of candidate drugs fail for each drug that succeeds. The only way to cover these costs is by relying on patent protections that give a drug’s developer the exclusive monopoly right to market and sell the new drug for 20 years following the patent application. The revenues over that time period will hopefully be enough to cover the drug’s development costs and—if the drug is popular—generate a profit for the drug company. Leader and follower countries have gotten into heated disputes over patented drugs, however, because the follower countries have often refused to recognize the patents granted to pharmaceutical companies in rich countries. India, for instance, has allowed local drug companies to copy and sell drugs that were developed by U.S. companies and are still under patent protection in the United States. That policy benefits Indian consumers because competition among the local drug companies drives down the price to below the monopoly price that would be charged by the patent owner. But the weak patent protections in India have a side effect. They

make it completely unprofitable for local drug producers to try to develop innovative new drugs. Local rivals would simply copy the new drugs and sell them at very low prices. So India has recently moved to strengthen its patent protections to try to provide financial incentives to transform its local drug companies from copycats into innovators. But note that the innovative new drugs that may result from the increased patent protections are not without a cost. As patent protections in India are improved, inexpensive local drugs copied from the leader countries will no longer be available to Indian consumers. Determinants of Growth LO8.3 Identify the general supply, demand, and efficiency forces that give rise to economic growth. Our discussion of modern economic growth and the institutional structures that promote it has purposely been general. We now want to focus our discussion on six factors that directly affect the rate and quality of economic growth. These determinants of economic growth can be grouped into four supply factors, one demand factor, and one efficiency factor. Supply Factors The first four determinants of economic growth relate to the physical ability of the economy to expand. They are:

• Increases in the quantity and quality of natural resources. • Increases in the quantity and quality of human resources. • Increases in the supply (or stock) of capital goods. • Improvements in technology.

Any increases or improvements in these supply factors will increase the potential size of an economy’s GDP. The remaining two factors are necessary for that potential to be fulfilled not just in terms of the overall quantity of output but also in terms of the quality of that output and whether it is properly directed toward producing the items most highly valued by society. Demand Factor The fifth determinant of economic growth is the demand factor:

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• To actually achieve the higher production potential created when the supply factors increase or improve, households, businesses, and the government must also expand their purchases of goods and services so as to provide a market for all the new output that can potentially be produced.

If that occurs, there will be no unplanned increases in inventories and resources will remain fully employed. The demand factor acknowledges that economic growth requires that increases in total spending must occur if we are to actually realize the output gains made available by increased production capacity. Efficiency Factor The sixth determinant of economic growth is the efficiency factor:

• To reach its full production potential, an economy must achieve economic efficiency as well as full employment.

The economy must use its resources in the least costly way (productive efficiency) to produce the specific mix of goods and services that maximizes people’s well-being (allocative efficiency). The ability to expand production, together with the full use of available resources, is not sufficient for achieving maximum possible growth. Also required is the efficient use of those resources. The Page 166 supply, demand, and efficiency factors in economic growth are related. Unemployment caused by insufficient total spending (the demand factor) may lower the rate of new capital accumulation (a supply factor) and delay expenditures on research (also a supply factor). Conversely, low spending on investment (a supply factor) may cause insufficient spending (the demand factor) and unemployment. Widespread inefficiency in the use of resources (the efficiency factor) may translate into higher costs of goods and services and thus lower profits, which in turn may slow innovation and reduce the accumulation of capital (supply factors). Economic growth is a dynamic process in which the supply, demand, and efficiency factors all interact. Production Possibilities Analysis

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To put the six factors affecting the rate of economic growth into better perspective, let’s use the production possibilities analysis introduced in Chapter 1. Growth and Production Possibilities Recall that a curve like AB in Figure 8.2 is a production possibilities curve. It indicates the various maximum combinations of products an economy can produce with its fixed quantity and quality of natural, human, and capital resources and its stock of technological knowledge. An improvement in any of the supply factors will push the production possibilities curve outward, as from AB to CD. FIGURE 8.2 Economic growth and the production possibilities curve. Economic growth is made possible by the four supply factors that shift the production possibilities curve outward, as from AB to CD. Economic growth is realized when the demand factor and the efficiency factor move the economy from points such as a and c that are inside CD to the optimal output point, which is assumed to be point b in this figure.

But the demand factor reminds us that an increase in total spending is needed to move the economy from a point like a on curve AB to any of the points on the higher curve CD. And the efficiency factor reminds us that we need least-cost production and an optimal location on CD for the

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resources to make their maximum possible dollar contribution to total output. You will recall from Chapter 1 that this “best allocation” is determined by expanding the production of each good until its marginal benefit equals its marginal cost. Here, we assume that this optimal combination of capital and consumer goods occurs at point b. If the efficiency factor is in full effect, then the economy will produce at point b rather than at any other point along curve CD. Example: The net increase in the size of the labor force in the United States in recent years has been 1.5 to 2 million workers per year. That increment raises the economy’s production capacity. But obtaining the extra output that these added workers could produce depends on their success in finding jobs. It also depends on whether or not the jobs are in firms and industries where the workers’ talents are fully and optimally used. Society does not want new labor-force entrants to be unemployed. Nor does it want pediatricians working as plumbers or pediatricians producing pediatric services for which marginal costs exceed marginal benefits. Normally, increases in total spending match increases in production capacity, and the economy moves from a point on the previous production possibilities curve to a point on the expanded curve. Moreover, the competitive market system tends to drive the economy toward productive and allocative efficiency. Occasionally, however, the economy may end up at some point such as c in Figure 8.2. That kind of outcome occurred in the United States during the severe recession of 2007–2009. Real output fell far below the amount of output that the economy could have produced if it had achieved full employment and operated on its production possibilities curve. Labor and Productivity Although the demand and efficiency factors are important, discussions of economic growth focus primarily on supply factors. Society can increase its real output and income in two fundamental ways: (1) by increasing its inputs of resources and (2) by raising the productivity of those inputs. Figure 8.3 concentrates on the input of labor and provides a useful framework for discussing the role of supply factors in growth. A nation’s real GDP in any year depends on the input of labor (measured in

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hours of work) multiplied by labor productivity (measured as real output per hour of work): FIGURE 8.3 The supply determinants of real output. Real GDP is usefully viewed as the product of the quantity of labor inputs (hours of work) multiplied by labor productivity.

Real GDP = hours of work × labor productivity Thought of this way, a nation’s economic growth from one year to the next depends on its increase in labor inputs (if any) and its increase in labor productivity (if any). Illustration: Assume that the hypothetical economy of Ziam has 10 workers in year 1, each working 2,000 hours per year (50 weeks at 40 hours per week). The total input of labor therefore is 20,000 hours. If productivity (average real output per hour of work) is $10, then real GDP in Ziam will be $200,000 (= 20,000 × $10). If work hours rise to 20,200 and labor productivity rises to $10.40, Ziam’s real GDP will increase to $210,080 in year 2. Ziam’s rate of economic growth will be about 5 percent [= ($210,080 − $200,000)/$200,000] for the year. Hours of Work What Page 167

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determines the number of hours worked each year? As shown in Figure 8.3, the hours of labor input depend on the size of the employed labor force and the length of the average workweek. Labor-force size depends on the size of the working-age population and the labor-force participation rate—the percentage of the working-age population actually in the labor force. The length of the average workweek is governed by legal and institutional considerations and by collective bargaining agreements negotiated between unions and employers. Labor Productivity Figure 8.3 tells us that labor productivity is determined by technological progress, the quantity of capital goods available to workers, the quality of labor itself, and the efficiency with which inputs are allocated, combined, and managed. Productivity rises when the health, training, education, and motivation of workers improve; when workers have more and better machinery and natural resources with which to work; when production is better organized and managed; and when labor is reallocated from less-efficient industries to more-efficient industries.

Accounting for Growth LO8.4 Describe “growth accounting” and the specific factors accounting for economic growth in the United States. The president’s Council of Economic Advisers uses a system called growth accounting to assess the relative importance of the supply-side elements that contribute to changes in real GDP. This system groups these elements into two main categories:

• Increases in hours of work. • Increases in labor productivity.

Labor Inputs versus Labor Productivity Table 8.3 provides the relevant data for the United States for five periods. The symbol “Q” in the table stands for “quarter” of the year. The beginning points for the first four periods are business-cycle peaks, and the last period includes future projections by the Council of Economic Advisers. It is clear from the table that both increases in the quantity of labor and increases in labor productivity are important sources of economic growth. Between 1953 and 2015, the labor force increased from 63 million to 158 million workers. Over that period the

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average length of the workweek remained relatively stable. Falling birthrates slowed the growth of the native population, but increased immigration partly offset that slowdown. As indicated in the nearby Consider This box, of particular significance was a surge of women’s participation in the labor force. Partly as a result, U.S. labor-force growth averaged 1.5 million workers per year over those 62 years. TABLE 8.3 Accounting for the Growth of U.S. Real GDP, 1953–2015 plus Projection from 2015 to 2026 (Average Annual Percentage Changes)

Source: Derived from Economic Report of the President, 2008, p. 45, https:// www.gpo.gov/fdsys/pkg/ERP-2008/pdf/ERP-2008.pdf; Economic Report of the President 2016, p. 113, https://www.whitehouse.gov/sites/default/files/docs/ ERP_2016_Book_Complete%20JA.pdf; Bureau of Economic Analysis; and Bureau of Labor Statistics. The growth of labor productivity also has been important to economic growth. In fact, Page 168 productivity growth has usually been the more significant factor. For example, between 2007 and 2015, labor inputs increased by just 0.1 percent per year. As a result, almost all of the 1.2 percent average annual growth rate of GDP over that time period was due to increases in labor productivity. As can be calculated from the data in the far right column of Table 8.3, productivity growth is projected to account for 88 percent of the growth of real GDP between 2015 and 2026. Because increases in labor productivity are so important to economic growth, economists go to the trouble of investigating and assessing the relative importance of the factors that contribute to productivity growth. There are five factors that, together, appear to explain changes in productivity growth rates: technological advance, the amount of capital each worker has to work with, education and training, economies of scale, and resource allocation. We will examine each factor in turn, noting how much each factor contributes to productivity growth.

Technological Advance The largest contributor to productivity growth is technological advance, which is thought to account for about 40 percent of productivity growth. As economist Paul Romer stated, “Human history teaches us that economic growth springs from better recipes, not just from more cooking.” Technological advance includes not only innovative production techniques but new managerial methods and new forms of business organization that improve the process of production. Generally, technological advance is generated by the discovery of new knowledge, which allows resources to be combined in improved ways that increase output. Once discovered and implemented, new knowledge soon becomes available to entrepreneurs and firms at relatively low cost. Technological advance therefore eventually spreads through the entire economy, boosting productivity and economic growth. Technological advance and capital formation (investment) are closely related, since technological advance usually promotes investment in new machinery and equipment. In fact, technological advance is often embodied within new capital. For example, the purchase of new computers brings into industry speedier, more powerful computers that incorporate new technology. Technological advance has been both rapid and profound. Gas and diesel engines, conveyor belts, and assembly lines are significant developments of the past. So, too, are fuel-efficient commercial aircraft, integrated microcircuits, personal computers, digital photography, and containerized shipping. More recently, technological advance has exploded, particularly in the areas of computers, photography, wireless communications, and the Internet. Other fertile areas of recent innovation are medicine and biotechnology. Quantity of Capital A second major contributor to productivity growth is increased capital, which explains roughly 30 percent of productivity growth. More and better plant and equipment make workers more productive. And a nation acquires more capital by saving some of its income and using that savings to invest in plant and equipment.

CONSIDER THIS . . . Women, the Labor Force, and Economic Growth

Source: © Dynamic Graphics/JupiterImages RF The substantial rise in the number of women working in the paid workforce in the United States has been one of the major labor market trends of the last 50 years. In 1960, about 40 percent of women worked full-time or part-time in paid jobs. Today, that number is about 60 percent. Women have greatly increased their productivity in the workplace, mostly by becoming better educated and professionally trained. Rising productivity has increased women’s wage rates. Those higher wages have raised the opportunity costs—the forgone wage earnings—of staying at home. Women have therefore substituted employment in the labor market for traditional home activities. This substitution has been particularly pronounced among married women. (Single women have always had high labor-force participation rates.) Furthermore, changing lifestyles and the widespread availability of birth control have freed up time for greater labor-force participation by women. Women not only have fewer children, but those children are spaced closer together in age. Thus women who leave their jobs during their children’s early years return to the labor force sooner.

Greater access to jobs by women also has raised the labor-force participation of women. Service industries—teaching, nursing, and office work, for instance—that traditionally have employed many women have expanded rapidly in the past several decades. Also, the population in general has shifted from farms and rural regions to urban areas, where jobs for women are more abundant and more geographically accessible. Additionally, occupational barriers to professions have greatly eroded, resulting in many more women becoming business managers, lawyers, professors, and physicians. In summary, women in the United States are better educated, more productive, and more efficiently employed than ever before. Their greater presence in the labor force has contributed greatly to U.S. economic growth. Although some capital substitutes for labor, most capital is complementary to labor—it makes labor more productive. A key determinant of labor productivity is the amount of capital goods available per worker. If both the aggregate stock of capital goods and the size of the labor force increase over a given period, the individual worker is not necessarily better equipped and productivity will not necessarily rise. But the quantity of capital equipment available per U.S. worker has increased greatly over time. (In 2014 it was about $149,286 per worker.) Public Page 169 investment in the U.S. infrastructure (highways and bridges, public transit systems, wastewater treatment facilities, water systems, airports, educational facilities, and so on) has also grown over the years. This publicly owned capital complements private capital. Investments in new highways promote private investment in new factories and retail stores along their routes. Industrial parks developed by local governments attract manufacturing and distribution firms. Private investment in infrastructure also plays a large role in economic growth. One example is the tremendous growth of private capital relating to communications systems over the years.

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Education and Training Ben Franklin once said, “He that hath a trade hath an estate,” meaning that education and training contribute to a worker’s stock of human capital—the knowledge and skills that make a worker productive. Investment in human capital includes not only formal education but also on-the-job training. Like investment in physical capital, investment in human capital is an important means of increasing labor productivity and earnings. An estimated 15 percent of productivity growth derives from investments in people’s education and skills. One measure of a nation’s quality of labor is its level of educational attainment. Figure 8.4 shows large gains in education attainment over the past several decades. In 1960 only 41 percent of the U.S. population age 25 or older had at least a high school education, and only 8 percent had a college or post-college education. By 2015, those numbers had increased to 88 and 33 percent, respectively. Clearly, more people are receiving more education than ever before. FIGURE 8.4 Changes in the educational attainment of the U.S. adult population. The percentage of the U.S. adult population, age 25 or older, completing high school and college has been rising over recent decades.

Source: U.S. Census Bureau, www.census.gov

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GLOBAL PERSPECTIVE 8.1 Average Test Scores of Eighth-Grade Students in Math and Science, Top 10 Test-Taking Countries The test performance of U.S. eighth-grade students did not compare favorably with that of eighth-graders in several other nations in the Fifth International Math and Science Study (2011).

Source: US Department of Education, Fifth International Math and Science Study (2011). But all is not upbeat with education in the United States. Many observers think that the quality of education in the United States has declined. For example, U.S. students perform poorly on science and math tests relative

to students in many other nations (see Global Perspective 8.1). And the United States has been producing fewer engineers and scientists, a problem that may trace back to inadequate training in math and science in elementary and high schools. For these reasons, much recent public policy discussion and legislation have been directed toward improving the quality of the U.S. education and training system. Economies of Scale and Resource Allocation Economies Page 170 of scale and improved resource allocation are a fourth and fifth source of productivity growth, and together they explain about 15 percent of productivity growth. Economies of Scale Reductions in per-unit production costs that result from increases in output levels are called economies of scale. Markets have increased in size over time, allowing firms to increase output levels and thereby achieve production advantages associated with greater size. As firms expand their size and output, they are able to use larger, more productive equipment and employ methods of manufacturing and delivery that increase productivity. They also are better able to recoup substantial investments in developing new products and production methods. Examples: A large manufacturer of autos can use elaborate assembly lines with computerization and robotics, while smaller producers must settle for less-advanced technologies using more labor inputs. Large pharmaceutical firms greatly reduce the average amount of labor (researchers, production workers) needed to produce each pill as they increase the number of pills produced. Accordingly, economies of scale result in greater real GDP and thus contribute to economic growth. Improved Resource Allocation Improved resource allocation means that workers over time have moved from low-productivity employment to high-productivity employment. Historically, many workers have shifted from agriculture, where labor productivity is low, to manufacturing, where it is quite high. More recently, labor has shifted away from some manufacturing industries to even higher-productivity industries such as computer software, business

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consulting, and pharmaceuticals. As a result of such shifts, the average productivity of U.S. workers has increased. Also, discrimination in education and the labor market has historically deterred some women and minorities from entering high-productivity jobs. With the decline of such discrimination over time, many members of those groups have shifted from lower-productivity jobs to higher- productivity jobs. The result has been higher overall labor productivity and real GDP. Finally, things such as tariffs, import quotas, and other barriers to international trade tend to relegate resources to relatively unproductive pursuits. The long-run movement toward liberalized international trade through international agreements has improved the allocation of resources, increased labor productivity, and expanded real output, both here and abroad. QUICK REVIEW 8.3 ✓ Institutional structures that promote growth include strong property rights, patents, efficient financial institutions, education, and a competitive market system. ✓ The determinants of economic growth include four supply factors (increases in the quantity and quality of natural resources, increases in the quantity and quality of human resources, increases in the stock of capital goods, and improvements in technology), one demand factor (increases in total spending), and one efficiency factor (achieving allocative and productive efficiency). ✓ Improvements in labor productivity accounted for about two- thirds of the increase in U.S. real GDP between 1990 and 2012; the use of more labor inputs accounted for the remainder. ✓ Improved technology, more capital, greater education and training, economies of scale, and better resource allocation have been the main contributors to U.S. productivity growth and thus to U.S. economic growth.

Recent Fluctuations in the Average Rate of Productivity Growth LO8.5 Explain how the average rate of U.S. productivity growth has fluctuated since 1973. Figure 8.5 shows the growth of labor productivity (as measured by changes in the index of labor productivity) in the United States from 1973 to 2015, along with separate trend lines for 1973–1995, 1995– 2010, and 2010–2015. Labor productivity in the business sector grew by an average of only 1.5 percent yearly over the 1973–1995 period. But productivity growth averaged a much higher 2.6 percent per year between 1995 and 2010 before plummeting to just 0.4 percent between 2010 and 2015. Many economists believe that the rapid productivity growth experienced between 1995 and 2010 resulted from a significant new wave of technological advances, coupled with global competition. By contrast, the dramatic decline in productivity growth that followed the Great Recession of 2007–2009 was perhaps due to a slowdown in the rate at which productive new technologies were being implemented by businesses. FIGURE 8.5 Growth of labor productivity in the United States, 1973– 2012. U.S. labor productivity (here, for the business sector) increased at an average annual rate of only 1.5 percent from 1973 to 1995. But between 1995 and 2010, it rose at an annual rate of 2.6 percent before decreasing to just 0.4 percent per year after the Great Recession of 2007–2009.

Source: U.S. Bureau of Labor Statistics, www.bls.gov.

Robust productivity growth is important because real output, real income, and real wages are linked to labor productivity. To see why, suppose you are alone on an uninhabited island. The number of fish you can catch or coconuts you can pick per hour—your productivity—is your real wage (or real income) per hour. By increasing your productivity, you can improve your standard of living because you can gather more fish and more