Chapter 6: Long-Run Economic Growth - Sources and Policies

Question 1

What was GDP like in primitive circumstances?

Answer 1

GDP per capita was only the bare amount necessary to sustain life, and remained that way until the year AD 1300. In other words, no sustained economic growth occurred for thousands and thousands of years. Peasants toiling on farms in France in the year 1300, were no better off than their ancestors thousands of years before.

Question 2

When did significant economic growth begin?

Answer 2

During the industrial revolution.

Question 3

What is the industrial revolution?

Answer 3

The application of mechanical power to the production of goods, beginning in Britain during the mid to late 1700s.

Question 4

What was the effect of the industrial revolution?

Answer 4

The use of mechanical power spread to the production of many other goods, greatly increasing the quantity of goods each worker could produce. First Britain, and then other countries such as the US, France and Germany, experienced long-run economic growth with sustained increases in real GDP per capita that eventually raised living standards in these countries to the high level of today.

Question 5

Why are small differences in growth rates important?

Answer 5

Between 1800 and 1900 long-run growth in real GDP per capita was 1.3% , whilst between 1900 and 2000 it grew to 2.3%, this may seem like a small change, however, it actually has a large impact.

Question 6

Why do growth rates matter?

Answer 6

Growth rates matter because an economy that grows too slowly fails to raise living standards. In some countries in Africa and Asia, very little economic growth has occurred in the past 60 years, so many people remain in severe poverty. In high-income countries, only 6 out of every 1000 babies die before the age of one. In low income countries, more than 50 out of every 1000 babies die before the age of one.

Question 7

How can we divide the world’s economies into groups?

Answer 7

High-income countries: AKA industrial countries or developed countries, this includes Australia Canada, Japan, New Zealand, the United States and the countries of Western Europe.
Low-income countries: AKA developing countries, this includes most of the countries of Africa, Asia and Latin America.

Question 8

What determines how fast economies grow?

Answer 8

To explain changes in economic growth rates over time within countries and differences in growth rates between countries, we need o develop an economic growth model.

Question 9

What is an economic growth model?

Answer 9

A model that explains changes in real GDP per capita in the long run. The economic growth model focuses on the causes of long-run increases in labour productivity. As a result, this model focuses on technological change and changes over time in the quantity of capital per hour worked (since this is what economist believe determine labour productivity).

Question 10

What is labour productivity?

Answer 10

The quantity of goods and services that can be produced by one worker or by one hour of work. Because of the importance of the labour productivity in explaining economic growth, the economic growth model focuses on the causes of long-run increases in labour productivity.

Question 11

What two key factors do economics believe determine labour productivity?

Answer 11

1. The quantity of capital per hour worked.

2. The level of technology.

Question 12

What is technological change?

Answer 12

A change in the ability of a firm to produce output with a given quantity of inputs.

Question 13

What are the three main sources of technological change?

Answer 13

1. Better machinery and equipment
2. Increases in human capital
3. Better means of organising and managing production.

Question 14

Explain the following source of technological change: better machinery and equipment.

Answer 14

Beginning with the steam engine during the Industrial Revolution, the invention of new machinery has been important source of rising labour productivity. Today continuing improvements in computers, software, factory machines, tools, and many other machines contribute to increases in labour productivity.

Question 15

Explain the following source of technological change: increases in human capital.

Answer 15

Capital refers to physical capital, including computers, office furniture, machines, tools, warehouses and trucks. The more physical capital workers have available, the more output they can produce.

Question 16

What is human capital?

Answer 16

Human capital is the accumulated knowledge and skills workers acquire from education and training or from their life experiences. As workers increase their human capital through education or on-the-job training, their productivity will also increase. The more educated and experienced workers are, the greater is their human capital.

Question 17

Explain the following source of technological change: better means of organising and managing production.

Answer 17

Labour productivity will increase if managers can do a better job of organising production. For example, the just-in-time system, first developed by Toyota Motor Corporation, involves assembling goods from parts that arrive at the factory at exactly the time they are needed. With tis system, Toyota needs fewer workers to store and keep track of parts in the factory, so the quantity of goods produced per hour worked increases.

Question 18

Is technological change the same as physical change?

Answer 18

No, it is not the same. New capital can embody technological change, such as when a faster computer chip is embodied into a new computer. But simply adding more capital that is the same as existing capital is not technological change.

Question 19

When analysing economic growth, what do we often look at?

Answer 19

Increases in real GDP per hour worked and increases in capital per hour worked.

Question 20

Why do we measure GDP per hour and capital per hour rather than per person?

Answer 20

So we can analyse changes in the underlying ability of an economy to produce more goods with a given amount of labour without having to worry about changes in proportion of the population working or in the length of the working day.

Question 21

How can we illustrate the economic growth model?

Answer 21

By using the per-worker production function.

Question 22

What is the per-worker production function?

Answer 22

The relationship between real GSP, or output, per hour worked and capital per hour worked, holding the level of technology constant.

Question 23

Explain figure 6.3: The per-worker production function.

Answer 23

This shows the relationship between capital per hour worked and real GDP per hour worked, holding technology constant. Increases in capital per hour worked increase output per hour worked, but at a diminishing rate. For example, an increase in capital per hour worked for $20k to $30k increases real GDP per hour worked from $200 to $350. An increase in capital per hour worked from $30k to $40k increases real GDP per hour worked only from $350 to $475. Each additional $10k increase in capital per hour worked results in progressively smaller increases in output per hour worked.
Y-axis = Real GDP per hour worked (Y/L)
X-axis = Capital per hour worked (K/L)
Per-worker production function = log function starting at 0

Question 24

Which is more important for economic growth, more capital or technological change?

Answer 24

Technological change helps economics avoid diminishing returns to capital. E.g. the replacement of existing capital with more productive capital is an example of technological change. Reorganising how production takes place in order to increase output is also an example of technological change.

Question 25

What is technological changes’ effect on the per-worker production function?

Answer 25

Technological change shifts up the per-worker production function and allows an economy to produce more real GDP per hour worked with the same quantity of capital per hour worked. For example, along production function 1 with $50k in capital per hour worked, the economy can produce $575 in real GDP per hour worked. However, an increase in technology that shifts the economy to production function 2 makes it possible to produce $675 n real GDP per hour worked with the same level of capital per hour worked
Because of diminishing returns to capital, continuing increases in real GDP per hour worked can be sustained only if there is technological change.
Y-axis = Real GDP per hour worked (Y/L)
X-axis = Capital per hour worked (K/L)
Per-worker production functions 1-4 = log functions starting at 0, each one higher then the prior

Question 26

What important conclusion can we draw?

Answer 26

In the long run, a country will experience an increasing standard of living only if it experiences continuing technological change.

Question 27

What explains the economic failure of the Soviet Union?

Answer 27

Under Communism the Soviet Union was a centrally planned economy where the government owned nearly every business and made all production and pricing decisions. Capital per hour worked grew rapidly in the Soviet Union from 1950-1980s. at first, these increases in capital per hour worked also produced rapid increases in real GDP per hour worked. This caused some economists in the US to incorrectly predict that the Soviet Union would someday surpass the US economically.
In fact, diminishing returns to capital meant that the additional factories the Soviet Union was building resulted in smaller and smaller increases in real GDP per hour worked. The Soviet Union did experience some technological change, but at a rate much slower than in the US and other high-income countries.
Since it was a centrally planned economy, the people in charge of running most businesses were government employees and not entrepreneurs or independent business people. As a result, soviet managers had less incentive to adopt new ways of doing things. Their pay depended on producing the quantity of output specified n the governments economic plan, not discovering new, better and lower-cost ways to produce goods. Additionally, these managers did not have to worry about competition from either domestic or foreign firms.

Question 28

What is the new growth theory (AKA endogenous growth theory)?

Answer 28

A model of long-run economic growth that emphasises that technological change is influenced by economic incentives, and so is determined by the working of the market system. This was developed by economist Paul Romer to provide a better explanation of the sources of productivity change. Romer argued that the rat of technological change is influenced by how individuals an firms respond to economic incentives. Romer argued that the accumulation of knowledge capital is a key determinant of economic growth. He also argued that this has diminishing returns at the firm level (as firms add o their stock of knowledge capital, they will increase their output but at a decreasing rate). However, he thought that knowledge capital is subject to increasing returns at the level for the entire economy.

Question 29

How to firms contribute to an economy’s stock of knowledge?

Answer 29

By engaging in research and development or otherwise contribute to technological change.

Question 30

Why does physical capital and knowledge capital have different returns?

Answer 30

Increasing returns can exist because knowledge, once discovered, becomes available to everyone. The use of physical capital, such as a computer, machine or factory is rival because if one firm uses it other firms cannot, and excludable because the firm that owns the capital can keep other firms from using it.
The use of knowledge capital, such as the chemical formula for a drug that cures cancer, is non-rival, however, because one firm’s use of this knowledge does not prevent another firm from using it. Knowledge capital is also non-excludable because once something like chemical formula becomes known, it becomes widely available for other firms to use.

Question 31

What ways can government policy help increase the accumulation of knowledge capital?

Answer 31

1. Protecting intellectual property
2. Subsidising research and development
3. Subsidising education

Question 32

Explain the following way government policy can help increase the accumulation of knowledge capital: protecting intellectual property

Answer 32

Governments can increase the incentive to engage in R&D by giving firms the exclusive rights to their discoveries for a period of years. The Australian Federal Government, through its Department of IP, grants patents to companies that develop new products or new was of making existing products. The patent system ahs drawbacks, however. In filing for a patent, firms must disclose information about the product or process. This information enters the public record and may help competing firms develop products that are similar but do not infringe on the patent. Hence why some firms try to keep the results of their research secret (without patenting) to avoid this problem).

Question 33

What is a patent?

Answer 33

The exclusive legal right to produce a product for a period of time from the date the product was invented.

Question 34

What is copyright?

Answer 34

The legal right of the creator of a book, movie, piece of music or software program to the exclusive right t use the creation during the creator’s lifetime, plus an additional period of time for their heirs.

Question 35

Explain the following way government policy can help increase the accumulation of knowledge capital: subsidising research and development

Answer 35

The government can use subsides to increase the quantity of R&D that takes place. For example, the federal government’s National Health and Medical Research Council subsidises research institutes and universities to carry out medical research. The government also provides tax benefits to firms that invest in R&D.

Question 36

Explain the following way government policy can help increase the accumulation of knowledge capital: subsidising education

Answer 36

People with technical training carry out R&D. if firms are unable to capture all the profits from R&D, the wages and salaries paid to technical workers will be reduced. These lower wages and salaries reduce the incentive to workers to receive this training. If the government subsidises education it can increase the number of workers with technical training. In Australia, the government subsidises education by directly providing free education from kindergarten to Year 12, and by providing substantial financial support for Technical and Further Education (TAFE) colleges and universities. The government also pays a portion of the full cost of student tertiary education fees and provides interest-free student loans, the repayment of which are indexed to inflation. Furthermore, there is a range of schemes and subsidies for apprenticeships and on-the-job training.

Question 37

What is a downside to increases in knowledge capital?

Answer 37

Joseph Schumpeter developed a model of growth that emphasised his view that new products unleash a ‘gale of creative destruction’ that drives older products – and often the firms that produced them – out of the market. According to Schumpeter, the key to rising living standards is not small changes to existing products but, rather, products that meet consumer wants in qualitatively better way.
For example, in the early 20th century, he car displaced the horse-drawn carriage by meeting consumer demand for personal transportation in a way that was qualitatively better. In the early 21t century, the DVD and DVD player displaced the VHS tape and the VCR by meeting consumer demand for watching movies in a higher quality format at home. Downloading or streaming movies from the internet is now in the process of displacing the DVD, just as DVD displaced the VHS tape.

Question 38

Why did Schumpeter see the entrepreneur as central to economic growth?

Answer 38

This is because the profit an entrepreneur hopes to earn provides the incentive for bringing together the factors of production – labour, capital, natural resources and entrepreneurial ability – to start new firms and introduce new goods and services. Successful entrepreneurs can use their profits to finance the development of new products and are better able to attract funds from investors.

Question 39

What caused the productivity slowdown of the 1970s and 1980s in Australia?

Answer 39

• High oil prices
• Regulated markets
• Trade protection.

Question 40

What is multifactor productivity (MFP)?

Answer 40

The quantity of goods and services produced per combined input of labour and capital.

Question 41

Why isn’t the whole world rich?

Answer 41

The economic growth model tells us that economic growth when the quantity of capital per hour worked increases and when technological change takes place. This Model seems to provide a good blueprint for developing countries to become rich:
1. Increase the quantity of capital per hour worked
2. Use the best available technology.
There are economic incentives for both of these things to happen in poor countries. The profitability of using additional capital or better technology is generally greater in a developing country than in a high-income country.
e.g. replacing an existing an existing computer with a new, faster computer will generally have a relatively small payoff for a firm in Aus. In contrast, installing a new computer in a Zambian firm where records where kept by hand is likely to have an enormous payoff.
This observation leads to the following important conclusion: the economic growth model predicts that poor countries will grow faster than rich countries (‘catch-up’).

Question 42

What is ‘Catch-Up’?

Answer 42

The prediction that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries. Has this catch up – or convergence – actually occurred? Here we come to a paradox: if we only look at the countries that currently have high incomes, we see that lower-income countries have been catching up to the higher-income countries, but the developing countries as a group have not been catching up to the high-income countries as a group.

Question 43

Catch-up among the high-income countries.

Answer 43

If we look at only the countries that currently have high incomes, we can see the catch-up predicted by the economic growth model. We can see that countries such as Taiwan, South Korea and Singapore had the lowest incomes in 1960 grew the fastest between 1960 and 2011. Countries such as Switzerland, Australia and the United States had the highest incomes in 1960 and grew the slowest.

Question 44

Why do high-income countries grow slowly?

Answer 44

This can be explained by figure 6.6: the catch-up predicted by the economic growth model.
Y-axis = growth in real GDP per capita
X-axis = initial level of real GDP per capita
Catch-up line = downward sloping diagonal line
This line holds the prediction that: low income countries should be in the upper-left section of the line because they would have low initial levels of real GDP per capita but fast growth rates. While high-income countries should be in the lower-right section of the line because they would have high initial levels of real GDP per capita but slow growth rates.

Question 45

Are the developing countries catching up to the industrialised countries?

Answer 45

If we look at al countries for which statistics are available, we do not see the catch-up predicted by the economic growth model. Some countries that had low levels of real GDP per capita, such as Niger and the Democratic Republic of Congo, actually experiences negative economic growth. Other countries that started with low levels of real GDP per capita, such as Malaysia and China, grew rapidly. Some middle-income countries in 1960, such as Venezuela, hardly grew between 1960 and 2011, while others, such as Ireland, experienced significant growth.

Question 46

Why don’t more low-income countries experience rapid growth?

Answer 46

The economic growth model predicts that the countries that were vey poor in 1960 should have grown rapidly over the next 50 years. As we have just seen, some did, but many did not. There is no single answer as to why many low-income countries grow so slowly, but most economists point to five key factors:

1. Failure to enforce the rule of law
2. Wars and revolutions
3. Poor public education and health
4. Slow technological development
5. Low rates of saving and investments.

Question 47

Explain the following reason why low-income countries don’t experience rapid growth: failure to enforce the rule of law.

Answer 47

In the years since 1960, increasing numbers of developing countries, including India, have abandoned centrally planned economic in favour of more market-oriented economies. For entrepreneurs in a market economy to succeed, the government must guarantee (through the rule of law) private property rights and enforce contracts. This is because this allows entrepreneurs to feel secure in their property and will risk starting a business.
Unfortunately, the rule of law is undermined by corruption in many developing countries.

Question 48

What are property rights?

Answer 48

The legal rights of individuals or businesses to the exclusive use of their property, including the right to buy or sell it.

Question 49

What is the rule of law?

Answer 49

The ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts.

Question 50

What are ways for developing countries to break out of the vicious cycle of poverty?

Answer 50

• Foreign direct investment
• Foreign portfolio investment
• Globalisation

Question 51

What is foreign direct investment?

Answer 51

The ownership of, or controlling interest in, assets, such as factories, businesses or farms, in a foreign country.

Question 52

What is foreign portfolio investment?

Answer 52

The purchase by an individual of firm of financial securities. Such as shares or bonds, issued in another country.

Question 53

What is globalisation?

Answer 53

The interaction and integration between businesses, governments and people of different countries as they become open to foreign investment and international trade.