University of Kelaniya. Session Two. Economic Growth

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1 Session Two Economic Growth The session two will be focused on explaining ingredients of growth, production possibility analysis, accounting growth, productivity and technological conversion and growth rates in Sri Lanka. Ingredients of Growth According to Campbell McConnell and Stanly L Brue (2002), economic growth is determined on three main factors and six elements as follows; Supply Factors 1. Increase in the quantity and quality of natural resources 2. Increase in the quantity and quality of human resources 3. Increase in the supply of capital gods 4. Improvements in technology Demand Factor 1. To achieve the higher production potential created by the supply factors, households, business, and government must purchase economy s expanding outputs of goods and services. Efficiency Factor 1. To reach the production potential, and economy must achieve economic efficiency and full employment. The economy must use its resources in the least cost methods (productive efficiency) and for well-being of people (allocative efficiency). The supply, demand and efficiency factors are interrelated. For instance, unemployment created by insufficient total spending due to demand factor, may

2 lower the new capital accumulation (supply factor) and decline research and innovations (efficiency factor). Similarly, low spending on investment (supply factor) may cause insufficient spending and unemployment (demand factor) and consequent inefficiency in use of resources (efficiency factor). Thus economic growth becomes a dynamic process that interacted supply, demand and efficiency factors which could be illustrated by production possibility curve. Production Possibility Analysis As shown in figure 2.1, AB is the PPF that indicates the various combinations of products made by an economy with fixed quantity and quality of materials, human capital and technological knowhow. An improvements in any supply factor caused to move PPF outwards as shown in figure 2.1. Fig. 2.1 Economic Growth and Production Possibility Curve Capital Goods C A b Q B D Consumer goods Thus original PPF of the economy is indicated by AB curve and point Q and it moves towards CD curve and to point b as increased any supply factors. But it is necessary

3 to increase demand and efficiency factors too in order to reach the maximum potential position of the economy. If the demand and efficiency factors remained at point Q while increasing only supply factors, growth potentials should be achieved through improving demand and efficiency factors of the economy. It could be realized by increasing total spending to sustain full employment and allocating additional resources efficiently. Fig 2.2: Effects of growth of labou Fig. 2.3 Effects of Technology on PPF Capital Land Labour Technology Effects of supply, demand and efficiency factors on the economic development could be illustrated in the production possibility frontiers separately (Todaro, M. and Smith S. C. 2008). Fig. 2.2 shows the effects of increasing labor on PPF and fig. 2.3 shows the effects of technology development on the production possibility curve. Labour and Labour Productivity Although demand and efficiency factors are important, growth analysis were focused mainly on the supply factors. Thus the total output and income of a society can increase by increasing resources and its productivity. Labour as the

4 main inputs both classical and neo classical growth analysis highlight how labour and labour productivity relate to real GDP of an economy. It is measured by counting total labour hours and labour productivity. Total labour hours is estimated by multiplying labour force (Number of workers) with wage rates and productivity is measured by knowledge, skill and technology used. Thus, a nation s economic growth from one year to next year depends on increasing its labour inputs and its labour productivity. Almost one third of estimated sources of growth of US real output in was determined by labour inputs (McConnell, c. r. Brue, S. L.2002). Since PPF analysis is based on supply oriented approach,economists used the production function approach to find the reasons for why the capital, labour and technology differ over the time among the countries. Thus the growth accounting is based on the production function analysis. Growth Accounting Economic growth is occurred from growth in inputs such as labour, capital and improvements in technology. This relationship is illustrated by production function which indicates the functional relationship between input and output. Y=AF (K, N) (1) Y= Output N= Labour A= Level of technology More inputs means more outputs. Thus increase in the marginal product of labour or MPN and the marginal product of capital or MPK increase outputs. Equation (1) relates the level of output to the level of inputs and the level of technology. Thus the production function of (1) can transformed into a growth accounting equation as summarized in equation (2).

5 Y = [(1 θ) N/N] + (θ K K ) + A/A Output Growth= (Labour share Labour Growth) + (Capital share Capital Growth) + Technical Progress (2) Where (1 θ) and θ are weights equal to labours share of income and capital s share of income. Usually it is assumed that capital s share of income is.25 and the labor s share of income as.75 The first and second terms of equation shows amount of labour and capital each contribute and it is multiplied by the shares that inputs in income. The third term in equation shows technical progress (the rate of improvement of technology) which also called as factor productivity or the technical progress. The growth rate of total factor productivity is the amount by which output would increase as a result of improvements in methods of production, with all inputs unchanged. That means more output could receive from the same factors of production. Example In an economy, labour force growth rate ( N ) is 1.2 percent N Its capital share ( K ) is 3 percent and the factor productivity is 1.5 K The values of θ is =.25 and 1 θis =.75 By applying equation 2, growth rate could be estimated as follows; Y = [ ] + (. 25 3) = 3.15 percent

6 Cobb-Douglas Production function As a neoclassical growth model Cobb-Douglas Production function which has been used by many economist is based on this method and economists use this formula for counting growth. It is based on constant returns to scale. Y= AK θ N 1 θ In USA, θ =.25 and 1 θ =.75 So the above equation interprete as Y = AK.25 N.75 It is also written in labour intensive form by dividing both sides of the equation by L to give output per head as a function of capital per head. Y/N= bk θ N 1 θ /N =b (K/N)θType equation here. Per Capita output; per capita is the ratio of GDP to the population The growth rate of GDP equals the growth rate of percapita GDP plus the growth rate of the population as shown in the following equation: Y = y y + N N, and K K = k k + N/N To translate the growth accounting equation in to per capita terms, subtract the population growth N N, from both sides as shown below. Y N n = θ K K N N + A A y y = θ k k + A/A The number of machines per worker (k) is also called the capital labour ratio, is a key determinant of the amount of output produce by worker. Since, uggest θ is.25, it suggest that 1 percent increase in the amount of capital available to worke increase only about a quarter of per capita output. Per capita output can calculated using growth figures related to GDP per capita and per capita capital.

7 Theories of Economic Growth Theories of economic growth are presented three main categories. 1. Classical Growth Theories; Thoughts presented by classical economists such as Adam Smith (1776), David Ricardo (1818) Robert Malthus, Carl Marks and Stuart Mill 2. Neoclassical growth theories: Theories presented after World War II and upto 1980s 3. New growth theories: theories presented after 1990s