CHAPTER TWENTY-FIVE ECONOMIC GROWTH

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1 CHAPTER TWENTY-FIVE ECONOMIC GROWTH CHAPTER OVERVIEW This chapter explores the causes of economic growth and the kinds of institutions and other factors that can sustain that growth. Although modern economic growth is a recent phenomenon, the distribution of that growth has been very uneven, causing significant differences among nations in terms of output, employment, and standards of living. Increases in productivity are a focus of growth, and the chapter examines causes of increasing economic growth rate in the United States. The chapter concludes with a discussion of the debate over whether continued economic growth is desirable or sustainable. PACING GUIDE Both the AP Microeconomics and AP Macroeconomics Exams include a few multiple-choice questions, and an occasional free-response question, about economic growth. Be sure that students can illustrate economic growth on the production possibilities curve. Students must be able to link changes in capital and technology to increases in potential and long-run growth. These concepts form the foundation for discussions of the AD/AS model, the long-run aggregate supply curve, and the long-run Phillips curve in later chapters. Take a few days to carefully emphasize the factors that promote economic growth, to ensure students have the basis for discussing the applications of these concepts in the macroeconomy. INSTRUCTIONAL OBJECTIVES After completing this chapter, students should be able to: ne two measures of economic growth. ain why growth is a desirable goal. ain and apply the rule of 70. average long-term growth rates for United States and qualifications of raw data. ribe the growth record of the American economy since 1950 in terms of real GDP and real GDP per capita. ain the reasons for disparity among nations in terms of modern economic growth and the potential for poorer nations to catch up with high-growth nations. tify six major institutional structures that promote economic growth. tify supply, demand, and efficiency factors that contribute to economic growth. strate economic growth using a production possibilities curve. ain reasons for increased productivity. uate the potential for increase in the rate of productivity growth to be a permanent phenomenon.

2 ain the arguments for and against economic growth. ne and identify terms and concepts at the end of the chapter. McConnell, Economics 19e, AP* Edition 377 Economic Growth

3 COMMENTS AND TEACHING SUGGESTIONS ecord of American economic growth is made more meaningful if you can take time to put it in comparative perspective. The CIA World Factbook online and World Bank publications such as the World Development Report or World Bank Atlas give population and growth statistics for most countries of the world. al Perspective 25.1 gives an interesting (although not unfamiliar) comparison of academic achievement of eighth-grade Math and Science students. It may be useful to discuss how the United States still manages to achieve solid economic growth and what numbers like these suggest for long-term growth prospects. teresting source for debate on whether or not growth is desirable would be the classic, E.F. Schumacher s Small is Beautiful. Other books that touch on American economic growth issues are Lester Thurow s Zero-Sum Society and Zero-Sum Solution and Wallace Peterson s Our Overloaded Economy. Many articles and books related to environmental issues highlight the gap between rich and poor nations. nformation economy raises many questions about concepts we teach in economics. Two excellent books are Information Rules and Blown to Bits. The January 1, 2000, issue of the Wall Street Journal had an entire section entitled Good-Bye Supply and Demand. tudents to list technological changes in just their lifetimes you d be surprised how many they are able to discuss. Ask what might drive the future. STUDENT STUMBLING BLOCKS if the production possibilities curve was covered in the introduction to the course, some students may still be confused about the difference between a reduction in unemployment (moving from a point inside the curve onto the curve) and economic growth (shifting the entire curve outward). It is important for students to understand that economic growth doesn t just mean producing at the current potential; economic growth actually increases the potential output. ents may need additional practice in working with formulas. It may take some students a little time to keep the numbers and formulas straight. Practice in calculating percentage increases and using the rule of 70 can help. McConnell, Economics 19e, AP* Edition378 Economic Growth

4 LECTURE NOTES I. Learning Objectives In this chapter students will learn: A. Two ways that economic growth is measured. B. The definition of modern economic growth and the institutional structures needed for an economy to experience it. C. The general supply, demand, and efficiency forces that give rise to economic growth. D. About growth accounting and the specific factors accounting for economic growth in the United States. E. Why the trend rate of U.S. productivity growth has increased since the earlier period. F. Differing perspectives as to whether growth is desirable and sustainable. II. Economic Growth A. Economic growth can be defined two ways. 1. An increase in real GDP over time

5 2. An increase in real GDP per capita over time a. Per capita GDP real GDP divided by the population is the superior definition to compare living standards. For example, China s 2008 GDP was $4326 billion compared to Denmark s $343 billion, but per capita GDPs were $3267 and $62,118, respectively. b. Growth in real GDP does not guarantee growth in real GDP per capita. If the growth in population exceeds the growth in real GDP, real GDP per capita will fall. B. Growth is an important economic goal because it means more material abundance and ability to meet the economizing problem. Growth lessens the burden of scarcity. C. The arithmetic of growth is impressive. The rule of 70 calculates how long it takes a nation s GDP to double: 70 / rate of growth. Using the rule of 70, an economy would require 35 years to double if the annual growth rate is 2 percent; an annual growth rate of 4 percent would allow the GDP to double in only 18 years. D. Growth in the United States 1. Real GDP increased sixfold between 1950 and 2009, and real per capita GDP rose more than threefold (Table 25.1). 2. Real GDP grew at a rate of 3.2 percent per year between 1950 and 2009, while real GDP per capita grew about 2 percent per year during the same period. But these raw numbers must be qualified. a. Growth doesn t measure improvements in the quality of products. b. Growth doesn t measure increased leisure time. c. Growth doesn t take into account effects on the environment or quality of life. 3. Growth rates are not constant or smooth over time, and the historically recent occurrence of sustained growth is not shared equally by all countries. III. Modern Economic Growth A. Modern economic growth is characterized by sustained, ongoing increases in living standards that can cause dramatic increases in the standard of living within a single lifetime. B. Economic historians informally date the start of the industrial revolution to 1776, when Scottish inventor James Watt perfected a powerful and efficient steam engine. This engine could drive industrial factory equipment, steam ships, and steam locomotives. C. Industrial factories could mass-produce goods. Resources could flow to factories, and final goods could be shipped to distant consumers at low cost. Major population shifts occurred as people left farms to work in urban industries. D. In earlier times, material standards of living changed very little over hundreds of years. Modern economic growth has caused dramatic changes in culture, society, and politics. 1. Vast increases in wealth and living standards have allowed ordinary people to have significant time for leisure activities and the arts. 2. Social changes have included an end of feudalism, the institution of universal public education, and acceptance of women and minorities into the workforce and positions of power. 3. Politically, countries with modern economic growth have tended toward democracy, a form of government that was extremely rare before the industrial revolution. E. The Uneven Distribution of Growth McConnell, Economics 19e, AP* Edition 379 Economic Growth

6 1. Modern economic growth has spread only slowly from its British birthplace. It advanced to Western Europe in the early 1800s, the United States, Canada, and Australia in the mid- 1800s, Asia, Central and South America, and the Middle East in the early 1900s, and Africa in the past few decades. 2. 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 (Figure 25.1). F. Catching Up is Possible 1. Countries that began modern economic growth more recently are not doomed to be permanently poorer than the countries that began modern economic growth earlier. 2. The poorer follower countries can grow much faster because they can simply adopt existing technologies from rich leader countries. 3. The growth rates of leader countries are constrained by the rate of technological progress, while follower countries have been able to catch up by adopting more advanced technologies and growing rapidly (Table 25.2). 4. The United States GDP is much higher than other leader countries primarily because a larger fraction of citizens are employed and employees work more hours per week than in many other countries. 5. Consider This Economic Growth Rates Matter even small differences in growth rates are compounded over time to cause large differences in GDP. IV. Institutional Structures That Promote Growth A. Strong property rights people will not invest if they believe thieves or government will steal their investments or expected returns. B. Patents and copyrights giving inventors and authors the exclusive right to market and sell their work creates a strong financial incentive to invent and create. C. Efficient financial institutions needed to channel household savings toward the businesses, entrepreneurs, and investors who do most of the country s investing and inventing. D. Literacy and widespread education highly educated inventors develop new technologies, and a highly educated workforce implements the new technologies for productive use. E. Free trade countries can specialize so that different kinds of output can be produced in the countries where they can be made most efficiently, and new ideas and innovations can be quickly spread to other countries. F. A competitive market system firms have considerable autonomy to follow market signals in deciding on current production and investment to produce what consumers will demand. G. Other difficult-to-measure factors influence a nation s capacity for growth, including political stability, positive cultural beliefs about material progress, and positive attitudes about work and risk taking. H. Consider This Patents and Innovation 1. Patents protect pharmaceutical companies for the invention of medicines, giving them 20- year monopolies to recover their research and development costs. 2. Some follower countries, like India, allow their firms to copy and market drugs that are still under patent protection in the United States. 3. The copying of drugs allows Indian consumers to get more drugs at lower prices, but the lack of patent protection discourages firms from innovating new drugs. McConnell, Economics 19e, AP* Edition380 Economic Growth

7 V. Determinants of Growth A. Four supply factors relate to the physical ability of the economy to expand. 1. Increases in the quantity and quality of natural resources 2. Increases in the quantity and quality of human resources 3. Increases in the supply (or stock) of capital goods 4. Improvements in technology B. Two demand and efficiency factors also determine growth. 1. Households, businesses, and government must increase their demand for the nation s growing output of goods and services. 2. Full employment of resources and productive and allocative efficiency are necessary to get the maximum amount of production at the lowest cost, with the mix of goods society wants. VI. Production Possibilities Analysis A. Growth can be illustrated with a production possibilities curve (Figure 25.2), where growth is indicated as an outward shift of the curve from AB to CD. 1. Demand must increase to sustain full employment at each new level of possible production. 2. Additional resources that shift the curve outward must be employed efficiently to make the maximum possible contribution to domestic output. 3. For the economy to achieve the maximum increase in value, the optimal combination of goods must be achieved (allocative efficiency). B. The American labor force has increased by 1.5 to 2 million workers per year, raising production capacity. Demand must be high enough to reach full employment, in order to completely realize the production potential. C. Society can increase its real output and income in two fundamental ways: 1. Increasing its inputs of resources 2. Raising the productivity of those inputs D. Real GDP = hours of work x labor productivity (Figure 25.3) 1. Hours of work depends on the length of the workweek and the labor force participation rate the percentage of the working-age population actually in the labor force. 2. Labor productivity is determined by technological progress, the quantity of capital goods available to workers, the quality of labor, and the efficiency with which inputs are allocated, combined, and managed. VII. Accounting for Growth A. More labor input is one source of growth. The labor force has grown by 1.6 million workers per year for the past 56 years and accounts for about 1/3 of total economic growth. B. The growth of labor productivity contributed 2/3 of the growth, half of the growth, 2/3 of the growth, all of the growth, and is expected to account for about nearly all of the growth (Table 25.3). C. Factors Responsible for Productivity Growth McConnell, Economics 19e, AP* Edition 381 Economic Growth

8 1. Technological advance 40 percent of productivity growth results from innovative production techniques, new management methods, and new forms of business organization. Technological advance usually promotes investment in new machinery and equipment. 2. Quantity of capital 30 percent of productivity growth comes from an increase in the availability of capital goods per worker. Infrastructure government investment in highways and other public structures complements private investment. 3. Education and training 15 percent of productivity growth is derived from investment in human capital the knowledge and skills that make a worker productive (Figure 25.4 and Global Perspective 25.1). 4. Economies of scale and improved resource allocation 15 percent of productivity growth occurs as a result of more efficient production, the movement of workers to higherproductivity jobs, and the reduction of trade barriers. D. Consider This Women, the Labor Force, and Economic Growth 1. The percentage of women working in the paid labor force has risen from 40 percent in 1960 to 60 percent today. 2. Greater investments in human capital have raised the productivity of women, raising women s wages and increasing the opportunity cost of staying home. 3. Reduced birthrates, growth in industries typically attracting women workers, urban migration, increased availability of part-time jobs, and antidiscrimination laws have all increased labor market access for women. VIII. The Rise in the Average Rate of Productivity Growth A. Labor productivity increased 1.4 percent per year ; productivity significantly increased by 2.8 percent per year This is important because productivity growth is the economy s main route for improving the standard of living (Figure 25.5). B. Many economists believe the higher productivity growth resulted from a significant new wave of technological advance, coupled with global competition. 1. Microchips and information technology are the basis for improved productivity. Many new inventions are based on microchip technology. 2. New firms and increasing returns from economies of scale characterize the new economy. Sources of increasing returns include: a. More specialized inputs b. Ability to spread development costs over large output quantities c. Simultaneous consumption by many customers at the same time d. Network effects make widespread use of information goods more valuable as more consumers use the products e. Learning increases with practice 3. Global competition encourages innovation and efficiency (Global Perspectives 25.2). C. Even if average growth rates in productivity and real output remain higher over time, business cycle fluctuations can still occur. D. Skepticism about long-term continued growth remains, and only time will tell. IX. Is Growth Desirable and Sustainable? McConnell, Economics 19e, AP* Edition382 Economic Growth

9 A. The Antigrowth View 1. Growth causes pollution, climate change, ozone depletion, and other environmental problems. 2. Growth has not solved sociological problems such as poverty, homelessness, and discrimination; these are problems of the distribution of income, not an increase in income. 3. Growth creates a frantic job pace, worker burnout, alienated employees, and worker anxiety and insecurity. 4. High growth rates are unsustainable when resources are depleted more quickly than they can be renewed. B. In Defense of Economic Growth 1. Growth leads to an improved standard of living. 2. Growth may be the only realistic way to reduce poverty, because there is only limited political support for greater redistribution of income. 3. Growth has improved working conditions; machinery is less taxing and less dangerous. 4. Growth allows more leisure and less alienation from work. 5. Environmental concerns are important, but growth actually has allowed more sensitivity to environmental concerns and the ability to deal with them. C. Is growth sustainable? Yes, say proponents of growth. 1. Resource prices are not rising. 2. Growth today has more to do with expansion and application of knowledge and information, so it is limited only by human imagination. X. LAST WORD: Economic Growth in China A. Over the past 25 years, China s real output has grown at an annual rate of nearly 9 percent, quadrupling real output over that period. 1. Rising income has led to more saving, greater capital investment, and more direct foreign investment, which have helped fuel growth. 2. Per capita income has increased at an annual rate of 8 percent since 1980, despite China s population expanding by 14 million people per year. 3. Increased use of capital, improved technology, labor reallocation from agriculture, and increased privatization have all contributed to greater productivity and higher per capita incomes. 4. China s growth has been supported by a dramatic increase in exports ($5 billion in 1978 to $1.2 trillion in 2009). B. Despite its success, China faces a number of important problems. 1. Inflation rates have been high at times (15 to 25 percent per year) because of too much spending relative to capacity. Central banking reform has helped keep inflation low in recent years. 2. State-owned enterprises and banks operate unprofitably, likely necessitating a government bailout. McConnell, Economics 19e, AP* Edition 383 Economic Growth

10 3. Substantial unemployment and underemployment have resulted from the transition from the agricultural to industrial economy. 4. China has a poor record of protecting intellectual property rights, and it keeps its currency artificially undervalued. These issues have caused tension with the United States and threaten to disrupt trade if they are not resolved. 5. China s growth and development has been uneven, meaning that that the majority of Chinese people have not benefited from the nation s rising incomes. ANSWERS TO END-OF-CHAPTER QUESTIONS 25-1 How is economic growth measured? Why is economic growth important? Why could the difference between a 2.5 percent and a 3 percent annual growth rate be of great significance over several decades? Economic growth is measured as an increase in real GDP, or real GDP per capita, over time. Economic growth means a higher standard of living, provided population does not grow even faster; if it does, then economic growth is even more important to maintain the current standard of living. Economic growth helps to reduce poverty even without an outright redistribution of income. If population is growing at 2.5 percent a year, as it is in some of the poorest nations, then a 2.5 percent growth rate of real GDP means no change in living standards. A 3 percent growth rate means a gradual rise in living standards. For a wealthy nation such as the United States, with a GDP in the neighborhood of $14 trillion, the 0.5 percentage point difference between 2.5 and 3 percent amounts to $70 billion a year, or more than $233 per person per year. Using the rule of 70, it would take 28 years for output to double with a 2.5 percent growth rate, and just over 23 years with 3 percent growth When and where did modern economic growth first happen? What are the major institutional factors that form the foundation for modern economic growth? What do they have in common? Modern economic growth dates back to 1776 in Scotland, with the development of the steam engine. Institutional factors to promote growth include strong property rights, patents and copyrights, efficient financial institutions, literacy and widespread education, free trade, and a competitive market system. They have economic freedom and incentives to produce in common Why are some countries today much poorer than other countries? Are today s poor countries destined to always be poorer than today s rich countries? If so, explain why. If not, explain how today s poor countries can catch up or even pass today s rich countries. Most of the difference can be explained by the difference in starting dates for modern economic growth. Today s poor countries are able to catch up to today s rich countries because they can simply adapt the most current technology that has been developed by the rich countries, rather than going through all of the steps of development that the rich countries did (Key Question) What are the four supply factors of economic growth? What is the demand factor? What is the efficiency factor? Illustrate these factors in terms of the production possibilities curve. The four supply factors are the quantity and quality of natural resources, the quantity and quality of human resources, the stock of capital goods, and the level of technology. The demand factor is the level of purchases needed to maintain full employment. The efficiency factor refers to both productive and allocative efficiency. Figure 25.3 illustrates these growth factors by showing movement from curve AB to curve CD. McConnell, Economics 19e, AP* Edition384 Economic Growth

11 25-5 Suppose that Alpha and Omega have identically sized working-age populations but that total annual hours of work are much greater in Alpha than in Omega. Provide two possible reasons for this difference. One reason might be that Omega s labor force is underemployed, producing at a point inside the production possibilities curve. Another reason could be that the two populations have different attitudes and preferences about work and leisure, with Omega workers placing a higher value on leisure than those in Alpha (Key Question) What is growth accounting? To what extent have increases in U.S. real GDP resulted from more labor inputs? From greater labor productivity? Rearrange the following contributors to the growth of productivity in order of their quantitative importance: economies of scale, quantity of capital, improved resource allocation, education and training, and technological advance. Growth accounting assesses the relative importance of the supply-side elements that contribute to changes in GDP. The American labor force grew by an average of about 1.6 million workers per year for the past 56 years, and this explains some of the growth in real GDP. The majority is from productivity growth (Table 25.3). Other factors, in order of importance: (1) technological advance; (2) the quantity of capital; (3) education and training; (4) economies of scale; (5) improved resource allocation True or false? If false, explain why. a. Technological advance, which to date has played a relatively small role in U.S. economic growth, is destined to play a more important role in the future. b. Many public capital goods are complementary to private capital goods. c. Immigration has slowed economic growth in the United States. (a) The first part is false because technology has played the most important role in American economic growth of any growth factor. However, the second part of the statement is probably true. (b) True. (c) False; immigration has been a source for an expanded labor force and also for expansion in aggregate demand Explain why there is such a close relationship between changes in a nation s rate of productivity growth and changes in its average real hourly wage. Average real hourly wage represents the average purchasing power of the wage each worker receives. Purchasing power refers to the amount of output that can be obtained with that wage. If output per worker is not increasing, then the amount of output available per capita for workers to buy will not be growing either. In other words, the real wage changes only if there is an increase in productivity. Nominal wages don t represent purchasing power (Key Question) Relate each of the following to the recent increase in the trend rate of productivity growth: a. Information technology b. Increasing returns c. Network effects d. Global competition (a) The rate of productivity growth has grown substantially due to innovations using microchips, computers, new telecommunications devices, and the Internet. All of these innovations McConnell, Economics 19e, AP* Edition 385 Economic Growth

12 describe features of information technology, which connects information in all parts of the world with information seekers. New information products are often digital in nature and can be easily replicated once they have been developed. (b) The start-up cost of new firms and new technology is high, but expanding production has a very low marginal cost, which leads to economies of scale firms output grows faster than their inputs. (c) Network effects refer to a type of economy of scale whereby certain information products become more valuable to each user as the number of buyers grows. For example, a fax machine is more useful to you when lots of other people and firms have one; the same is true for compatible word-processing programs. (d) Global competition is a feature of the new economy because both transportation and communication can be accomplished at much lower cost and faster speed than previously. This expands market possibilities for both consumers and producers who are not very limited by national boundaries today What, if any, are the benefits and costs of economic growth, particularly as measured by real GDP per capita? Benefits include a greater abundance of material goods, higher standards of living, better education, more leisure and recreation, and more care for the sick and elderly. It also may be the only realistic way to reduce poverty, because there is only limited political support for greater redistribution of income. Costs include an increase in pollution and environmental problems. It has not solved poverty, and it only increases worker alienation, burnout, and insecurity, as workers are pushed to a frantic pace in their jobs. Critics also argue that growth is not sustainable, as resources are used more quickly than they can be replenished (LAST WORD) Based on the information in this chapter, contrast the economic growth rates of United States and China over the last 25 years. How does the real GDP per capita of China compare with that of the United States? Why is there such a huge disparity of per capita income between China s coastal cities and its interior regions? Over the last 25 years, the real GDP of the United States has grown about 3 percent per year; China s real GDP has grown about 9 percent per year. China s annual income per capita was $3678 in 2009, approximately 1/13 of the real GDP per capita of the United States. China s coastal areas are more industrialized, with greater access to international markets. Some of these areas have been designated special economic zones, with greater freedom and support to engage in high productivity economic activity. The poorer interior regions are heavily agricultural. ANSWERS TO END-OF-CHAPTER PROBLEMS 25-1 (Key Question) Suppose an economy s real GDP is $30,000 in year 1 and $31,200 in year 2. What is the growth rate of its real GDP? Assume that population was 100 in year 1 and 102 in year 2. What is the growth rate of real GDP per capita? Growth rate of real GDP is 4 percent (= [$31,200 - $30,000] / $30,000). GDP per capita in year 1 is $300 (= $30,000 / 100). GDP per capita in year 2 is $ (= $31,200 / 102). The growth rate of real GDP per capita is 1.96 percent (= [$ $300] / 300) What annual growth rate is needed for a country to double its output in 7 years? In 35 years? In 70 years? In 140 years? McConnell, Economics 19e, AP* Edition386 Economic Growth McConnell, Economics 19e, AP* Edition 387

13 The growth rate necessary for a country to double its output in 7 years is 10 percent (= 70 / 10). To double its output in 35 years is 2 percent (= 70 / 2). To double its output in 70 years is 1 percent (= 70 / 1). To double its output in 140 years is 0.5 percent (= 70 / 0.5) Assume that a leader country has real GDP per capita of $40,000, whereas a follower country has real GDP per capita of $20,000. Next suppose that the growth of real GDP per capita falls to zero percent in the leader country and rises to 7 percent in the follower country. If these rates continue for long periods of time, how many years will it take for the follower country to catch up to the living standard of the leader country? It will take 10 years (= 70 / 7) Refer to Figure 25.2 and assume that the values for points a, b, and c are $10 billion, $20 billion, and $18 billion respectively. If the economy moves from point a to point b over a 10-year period, what must have been its annual rate of economic growth? If, instead, the economy was at point c at the end of the 10-year period, by what percentage did it fall short of its production capacity? The rate of growth must have been 7 percent (= 70 / 10). It fell 10 percent short of its production capacity (= $2 billion / $20 billion) Suppose that work hours in New Zombie are 200 in year 1 and productivity is $8 per hour worked. What is New Zombie s real GDP? If work hours increase to 210 in year 2 and productivity rises to $10 per hour, what is New Zombie s rate of economic growth? New Zombie s real GDP in year 1 is $1600 (= 200 x $8); GDP in year 2 is $2100 (= 210 x $10). The rate of growth (assuming constant prices) is percent (= [ ] / 1600) The per-unit cost of an item is its average total cost (= total cost / quantity). Suppose that a new cell phone application costs $100,000 to develop and only $.50 per unit to deliver to each cell phone customer. What will be the per-unit cost of the application if it sells 100 units? 1000 units? 1 million units? The per-unit cost of 100 units is $ (= [$100,000 + {$0.50 x 100}] / 100). The per-unit cost of 1000 units is $ (= [$100,000 + {$0.50 x 1000}] / 1000). The per-unit cost of 1 million units is $0.60 (= [$100,000 + {$0.50 x 1,000,000}] / 1,000,000).