Economic Growth Flashcards
Definition of Diminishing Returns
The decrease in the marginal output of a production process as the amount of a single input of production is incrementally increased while the amount of all other factors of production stay constant
- At some point, an additional unit doesn’t really make you happier
- Diminishing marginal utility: “The fifth cup of coffee won’t make you as happy as the first”
- Diminishing marginal product of capital: “Having more computers doesn’t mean you can type more essays over a fixed period of time”
- Diminishing product of labour: “Having more cooks in the kitchen doesn’t mean you can cook more food given a fixed amount of equipment”
Effect of Diminishing returns in an economy
- At low capital, the marginal product of capital is the highest
- An additional unit of capital to low capital leads to a higher increase in outputs
- Growth will be faster when ***input is lower
Growth Model
- To produce an output, you will always need labour and capital
Y = f(Capital, Labour) - Household saves a portion of their outputs to invest and consumer the rest - saving rate cannot be more than 1 (100%) or otherwise everyone starves to death
C(consumption) + S(saving) = 1 - Investments can be spent to improve the inputs (capital: production technology or labour: training) derived from household. However, investments can also be from external (**i.e. foreign debt) sources
What is Investment
Investment Rate: Investment as a portion of GDP
- Investment = Addition of new capital
Growth of Capital Stock: Rate of change between capital
- Growth does not equal accumulation
Depreciation: Wear and tear of capital stock
- If investments do not cover depreciation, capital stock may decrease (destruction is faster than replacement)
Investment may still see decreasing GDP if it doesn’t cover the depreciation (if depreciation is faster)
Who do we need investment?
Effects of investment on capital stock
- There is diminishing returns to usage of any individual inputs
- Capital stock will depreciate due to wear and tear
- Diminishing Returns: adds new types of capital stock
- Depreciation: replace and improve existing capital stock
Investment and Technological Progress
Technological progress is very costly and relies on upfront investments
Public policy can help by:
1) granting patents
2) subsidies for research and development
Intellectual property rights gives incentive for development and innovation:
1) Preventing copying of new technologies
2) Encourage foreign investments
3) Encourage new development and innovations
Growth rates
GDP per worker - GDP per worker (n-1)/GDP per worker (n-1)
Annual growth rate of GDP per worker has remained stable and consistent but fluctuates and has ups and downs (e.g. depressions/wars)
Capital and Investment definitions
- Capital is the stock of equipment and structures
- Investment is the addition to the stock of equipment and structures
Why we need Capital Accumulation and Growth
- Workers use capital
- Investment leads to growth in capital per worker
- Growth in capital per workers leads to growth in GDP per worker
The Sacrifice of Investment
- Some of the workers and capital produce new capital instead of producing goods and services for immediate use
- Investment implies a sacrifice of current consumption (or at least leisure) to achieve greater future consumption
- The investment rate is investment/GDP, and it is a measure of this sacrifice
Limits to growth via capital accumulation
- Decreasing marginal productivity of capital
- If the investment rate is constant, growth slows down (due to opportunity cost from not consuming)
- The investment rate would need to grow to keep growth constant (as marginal returns would set in otherwise)
- Cannot be sustained in the LR
- Not itself an engine of growth
Also:
- Poor countries should grow faster than rich countries as they have higher marginal productivity of capital
- Should be a concave reaction between increase in capital and gdp per worker
Investment in an open economy
- Use imports to invest without sacrificing current consumption
- E.g. all domestic workers produce consumption goods and capital goods are imported
- Borrow -> debt accumulation (in order to pay for capital)
- Foreign debt cannot be accumulated indefinitely
- Consumption sacrifice is only postponed
- Marginal increase of consumption is very high for poor countries thus they borrow and pay back when richer (Gains due to consumption > debt burden)
- Venezuela and Greece have had recent foreign debt crises
Innovation and Technological change
- Innovation: introduction of new ways of doing more with less (not an addition to a stock of tools)
- In modern economies it is the outcome of basic research and R&D
- More important than capital accumulation
- Innovation increases GDP as new products with greater marginal utility command greater prices and thus contribute to GDP
Economics of R&D
- Key characteristics of innovation: upfront research costs, non-rivalry
- Solutions: patents, subsidies, intellectual property rights (all incentivise growth)
Economics of basic research
- Typical case of positive externalities
(the spill over affects of research) - Heavily subsidies by government
