Economic Growth, Productivity, and Living Standards

CHAPTER 7: Economic Growth, Productivity, and Living Standards

LEARNING OBJECTIVES

  • Present the following learning goals related to the chapter's themes:
    • Demonstrate how even small differences in growth rates can result in large disparities in living standards.
    • Explain the decomposition of GDP per capita into average labor productivity and employment proportion, discussing sources of economic growth.
    • Identify determinants of average labor productivity in a specific country and analyze differences in per capita GDP across various countries.
    • Assess the costs associated with boosting economic growth.
    • Evaluate government policies aimed at promoting economic growth.
    • Analyze implications of limited resources on growth potential.

LIVING STANDARDS

  • Definition of Living Standards: Living standards relate to the amount of goods and services that the average person can enjoy.
  • Measurement of Living Standards:
    • Living standards are often quantified using Real GDP per person, which reflects the economic output per individual in inflation-adjusted terms.
    • Significant historical context: The GDP per person in 2010 was 12 times higher than that in 1870.

REAL GDP PER PERSON IN THE U.S., 1929-2022

  • Graphical Analysis: Shows a long-term upward trend in Real GDP per person with occasional short-run fluctuations (recessions).
  • Historical Context: This trend illustrates the overall growth trajectory of the U.S. economy over the decades.

IMPORTANCE OF GROWTH RATES

  • Small Growth Rate Impact:
    • Economic growth operates similarly to compound interest, where small differences in growth rates can lead to dramatic disparities later.
    • Compound Interest Explanation: It accrues interest not just on the original principal but on all accrued interest.

COMPARISON OF SIMPLE AND COMPOUND INTEREST

  • Simple Interest Defined:

    • Interest is calculated solely on the initial principal.
    • Formula:
    • Simple Interest Amount = Principal × (1 + rt)
      • where:
      • r = interest rate
      • t = time period
    • Example:
      • Principal = $10, Interest Rate = 0.04, Time = 200 years
      • Final Amount Calculation:
        Final ext{ }Amount = 10 + (10 imes 0.04 imes 200) = 90
      • Growth is linear.

  • Compound Interest Defined:

    • Interest is calculated on the principal and previously accumulated interest.
    • Formula:
    • Final ext{ }Amount = Principal imes (1 + r)^t
    • Example:
      • $10 at 4% for 200 years results in:
        10 imes (1 + 0.04)^{200} = 25507.50

  • Key Astonishment:

    • Identical principal, interest rate, and time period yield:
    • Simple interest yields $90.
    • Compound interest yields $25,507.50.
    • Analogy: Simple interest growth is compared to walking, whereas compound interest resembles a snowball rolling downhill.

ECONOMIC GROWTH AS COMPOUND INTEREST

  • Connection to Economic Growth:
    • Economic growth resembles compound interest, highlighting the significance of growth rates:
    • Small growth rates over long periods can produce significant differences in living standards.
    • This emphasizes the economists' focus on the rates of growth.

WHAT IS GDP PER CAPITA?

  • Definition:
    • GDP per capita represents average output per employed worker, expressed as:
    • GDP ext{ }per ext{ }capita = rac{Y}{POP} = rac{Y}{N} imes rac{N}{POP}
      • where:
      • Y = real GDP
      • N = number of people employed
      • POP = total population.

ENGINES OF GROWTH: 1960-2022

  • Statistics on Growth Components:
    • Over this period:
    • GDP per capita rose by 233%.
    • Productivity increased by 155%.
    • Employment share rose from 30% to 47%.
    • Contributors to Employment Increases:
    • Women's participation in the workforce.
    • Baby boomers aging into the labor force.

DETERMINANTS OF AVERAGE LABOR PRODUCTIVITY

  • U.S. Productivity Comparison:
    • U.S. productivity is 5 times higher than Indonesia and 11 times higher than Bangladesh.
  • Key Determinants of Productivity:
    1. Human Capital
    2. Physical Capital
    3. Land & Natural Resources
    4. Technology
    5. Entrepreneurship
    6. Political & Legal Environment

1. HUMAN CAPITAL

  • Definition:
    • Encompasses the sum of education, skills, and training possessed by the workforce.
  • Importance:
    • Skilled workers tend to produce more effective work output, thereby earning higher wages.
    • Application of the Cost-Benefit Principle when investing in human capital is crucial for enhancing productivity.

2. PHYSICAL CAPITAL

  • Description:
    • Investment in better tools and machinery increases worker productivity.
    • Example: An owner of a candy factory adds capital (machines), allowing each machine to yield greater output per worker.
  • Impact of Diminishing Returns to Capital:
    • As more machines are added, each additional unit of capital yields less output than the last if other inputs are held constant.
    • Formula for Diminishing Returns:
    • If additional capital increases output less than previous increments, productivity declines.

3. LAND AND OTHER NATURAL RESOURCES

  • Contribution to Productivity:
    • Availability of land and natural resources such as oil and minerals enhances productivity (e.g., farmland).
    • Some countries (e.g., Japan, Hong Kong, Switzerland) achieve high GDP per capita despite limited resources, indicating that resources are crucial but not the sole factors affecting productivity growth.

4. TECHNOLOGY

  • Significance:
    • Technology serves as the primary driver of economic growth by enhancing the efficiency of various industries, leading to advancements in areas like transportation, medicine, and electronics.

5. ENTREPRENEURSHIP AND MANAGEMENT

  • Role of Entrepreneurs:
    • Entrepreneurs initiate businesses, take risks, and foster innovation; effective policy enhances entrepreneurship's positive contributions to growth.
  • Policy Recommendation:
    • Strong taxation and regulatory frameworks can encourage productive entrepreneurship.

6. POLITICAL AND LEGAL ENVIRONMENT

  • Impact on Growth:
    • Well-defined property rights and stable political conditions are essential for an environment conducive to growth.
    • The absence of sound institutions leads to lower economic growth rates.

COSTS OF ECONOMIC GROWTH

  • Opportunity Costs:
  • Increased capital production results in:
    • Fewer consumer goods available presently.
    • Reduced leisure time.
    • Environmental risks associated with growth activities.
    • Financial investment in R&D and education.

GOVERNMENT & GROWTH

  • Government's Role:
    • Governments support education and job training to enhance workforce capabilities, recognizing the positive externalities associated with an educated population.
    • Through progressive taxation, governments can accumulate revenue from increased incomes to invest in further growth.

PROMOTING GROWTH THROUGH SAVINGS AND INVESTMENT

  • Policies to Encourage Growth:
    • Promotion of new capital formation and savings via investment tax credits offered by the government.
    • Direct government investment in infrastructure projects such as roads and bridges is essential.

PROMOTING GROWTH WITH R&D SUPPORT

  • Importance of R&D:
    • Supporting research and development fosters innovation and creates opportunities for advancements.
    • Government funding in basic science and technologies often leads to breakthroughs that individual companies cannot monetize alone (e.g., space technologies).

LIMITS TO GROWTH

  • Concerns Regarding Sustainability:
    • Key issues include resource depletion, climate change, and various forms of environmental degradation that lead economists to question the sustainability of current growth trajectories.
    • Strategies for growth can be optimized to reduce environmental impact.

APPLICATION OF ECONOMIC GROWTH TO LIVING STANDARDS

  • Essence of Inquiry:
    • Understanding how minor growth differences impact long-term living standards.
    • Identity the equation for GDP per capita decomposition to clarify its components.
    • Evaluate how participation in the labor force influences overall economic growth dynamics.

DETERMINANTS OF PRODUCTIVITY RECAP

  • Summary of the six key determinants:
    1. Human capital
    2. Physical capital
    3. Land & resources
    4. Technology
    5. Entrepreneurship
    6. Political & Legal environment

COSTS OF ECONOMIC GROWTH (RECAP)

  • Explore the opportunity costs involved in