Global Economy Lecture 3 & 4: Models of Long Run Growth

Question 1

List the key growth models

Answer 1

• Classical Growth Models:
  1. The Malthusian Model
  2. The Smithian Model
• Neoclassical Growth Models
  1. The Lewis Model
  2. The Solow Model (Exogenous Growth)
• New Growth Models
  1. Endogenous Growth Models
  2. Demography Models
  3. New Institutional Economics and New Economic Geography

Question 2

Describe & explain the Malthusian model

Answer 2

• The power of the population is so superior to the power of the earth to produce subsistence for man, that premature death must be in some shape or other visit the human race (Malthus, 1798)
• Key features:
  1. “Unchanging attraction between the sexes”
  2. Population grows geometrically whist food grows arithmetically
  3. Land is in fixed supply - diminishing returns to labour
  4. Any increase in income per capita will result in population
  growth
  5. Population growth will be halted by “positive” and
  “preventative” checks

Question 3

Discuss how successful the Malthusian model was

Answer 3

• Malthus was broadly correct about the pre-industrial world
• However, his theory “failed” to predict growth for 3 main reasons:
  (1) Assumption that shocks to income are eaten entirely by population growth
• Failure to foresee scale of the gains in labour productivity
  based on specialisation and factor accumulation
• Need for Smithian, Lewis or Solow type models
  (2) Assumption that increases in income always lead to more
  children
• Failure to foresee changes in the “market” for children
• Need for Unified Growth type models
  (3) Assumption that shocks to income are intermittent
• Failure to foresee sustained IRS and technological change
• Need for Harrod-Domar, Schumpeter or Romer type models

Question 4

What’s ‘unified growth theory’?

Include historical context

Answer 4

Unified growth theory was developed in light of the alleged failure of endogenous growth theory to capture key empirical regularities in the growth processes and their contribution to the momentous rise in inequality across nations in the past two centuries.
Unified growth theory suggests that during most of human existence, technological progress was offset by population growth, and living standards were near subsistence across time and space

Question 5

Explain what the Harrod-Domar model is

Include historical context

Answer 5

The Harrod–Domar model is a Keynesian model of economic growth. It is used in development economics to explain an economy’s growth rate in terms of the level of saving and of capital. It suggests that there is no natural reason for an economy to have balanced growth. The model was developed independently by Roy F. Harrod in 1939, and Evsey Domar in 1946, although a similar model had been proposed by Gustav Cassel in 1924. The Harrod–Domar model was the precursor to the exogenous growth model.

Neoclassical economists claimed shortcomings in the Harrod–Domar model—in particular the instability of its solution[5]—and, by the late 1950s, started an academic dialogue that led to the development of the Solow–Swan model.[6][7]

According to the Harrod–Domar model there are three kinds of growth: warranted growth, actual growth and natural rate of growth.

Warranted growth rate is the rate of growth at which the economy does not expand indefinitely or go into recession. Actual growth is the real rate increase in a country’s GDP per year. (See also: Gross domestic product and Natural gross domestic product). Natural growth is the growth an economy requires to maintain full employment. For example, If the labor force grows at 3 percent per year, then to maintain full employment, the economy’s annual growth rate must be 3 percent

Question 6

Describe & explain the Smithian growth model

Answer 6

• The greatest improvements in the productive powers of labour, and the greater part of the skill, dexterity, and judgement with which it is any where directed, or applied, seem to have been
  the effects of the division of labour. (Smith, 1776)
• Key features:
  1. Specialisation is central to growth - growth in residual (A)
  2. Gains from trade are linked to specialisation - absolute and
  comparative advantage
  3. Larger scale production is linked to specialisation - division of
  labour
  4. Good institutions are linked to specialisation - property rights,
  currency etc.
  5. Technological change can increase with specialisation

Question 7

Describe & explain the Lewis model

Answer 7

• The central problem in the theory of economic
  development…is to understand the process whereby a
  community which was previously saving and investing 5
  percent or less of its national income, converts itself into an
  economy where voluntary saving is about 15 per cent or more
  of the national income. (Lewis, 1954)
• Key features:
  1. The economy has “traditional” (agriculture) and “modern”
  (industrial)
  2. Traditional sector uses fixed land and unlimited labour to
  produce food
  3. Modern sector is characterised by market wages (MPL)
  4. Traditional sector is characterised by surplus labour and
  “institutional” wages (APL)
  5. Labour can freely (at low cost) move to the modern sector
  6. Modern sector profits using low cost labour from the
  traditional sector
  7. Profits generated in the modern sector are reinvested

Question 8

Explain what MPL is

Answer 8

The marginal product of a factor of production is generally defined as the change in output resulting from a unit or infinitesimal change in the quantity of that factor used, holding all other input usages in the production process constant.

The marginal product of labor is then the change in output (Y) per unit change in labor (L). In discrete terms the marginal product of labor is:

{\displaystyle {\frac {\Delta Y}{\Delta L}}.}

In continuous terms, the MPL is the first derivative of the production function:

∂Y/∂L

Graphically, the MPL is the slope of the production function

Question 9

Describe & explain the relation between MPL and APL

Answer 9

The average product of labor (APL) is the total product of labor divided by the number of units of labor employed, or Q/L.[2] The average product of labor is a common measure of labor productivity.[4][5] The APL curve is shaped like an inverted “u”. At low production levels the APL tends to increase as additional labor is added. The primary reason for the increase is specialization and division of labor.[6] At the point the APL reaches its maximum value APL equals the MPL.[7] Beyond this point the APL falls.

During the early stages of production MPL is greater than APL. When the MPL is above the APL the APL will increase. Eventually the MPL reaches it maximum value at the point of diminishing returns. Beyond this point MPL will decrease. However, at the point of diminishing returns the MPL is still above the APL and APL will continue to increase until MPL equals APL. When MPL is below APL, APL will decrease.

Graphically, the APL curve can be derived from the total product curve by drawing secants from the origin that intersect (cut) the total product curve. The slope of the secant line equals the average product of labor, where the slope = dQ/dL.[6] The slope of the curve at each intersection marks a point on the average product curve. The slope increases until the line reaches a point of tangency with the total product curve. This point marks the maximum average product of labor. It also marks the point where MPL (which is the slope of the total product curve)[8] equals the APL (the slope of the secant).[9] Beyond this point the slope of the secants become progressively smaller as APL declines. The MPL curve intersects the APL curve from above at the maximum point of the APL curve. Thereafter, the MPL curve is below the APL curve.

Question 10

Describe & explain the Solow-Swan model

Answer 10

• aka Neoclassical Model
• The business cycle has receded in importance, partly because
  the large industrial economies have sprouted a more stable
  structure, and partly because the lessons that Keynes taught
  have been learned by central banks and finance ministries.
  Instead, long-term economic growth has moved to the top of
  the political and intellectual agenda. (Solow, 2007)
• Key features:
  1. Individual factors of production face diminishing returns
  2. Temporary rapid growth can result from capital accumulation
  3. Capital accumulation will accelerate initially and then slow
  4. Eventually economies will reach a steady state rate of growth
  5. At the steady state, technological change will determine
  growth
  6. Technological change is exogenous to the model

Question 11

Explain the limitations of exogenous growth models

Answer 11

(1) Endogenous technological change (R&D)
* Technology is an endogenous variable
* Innovations are non-rivalrous requiring monopoly profits
* Technological change is determined by monopolistic firms in
the market for innovation
(2) Human and Physical Capital Virtuous Circles
* Skilled labour, unskilled labour and capital face diminishing
returns
* Overall non-diminishing returns due to investment spillovers
* Investment in BOTH human and physical capital can produce
unconstrained growth
(3) Externalities and Spillovers
* Technology is a function of capital
* Spillovers from capital investment produce unconstrained
growth

Question 12

What’s ‘demographic transition’?

Answer 12

When an income shock results in a larger number of children

Question 13

What’s the name for ‘when an income shock results in a larger number of children’?

Answer 13

Demographic Transition

Question 14

What are the stages of demographic transition?

Answer 14

(1) Stage 1 - High birth rate ≈ High death rate
(2) Stage 2 - High birth date > Moderate death rate
(3) Stage 3 - Moderate birth rate > Low death rate
(4) Stage 4 - Low birth rate ≈ Low death rate
(5) Stage 5 - Very low birth rate < Low death rate

Question 15

What’s the overall effect of demographic transition?

Answer 15

The world will depopulate

Question 16

Describe Galor and Weil’s description of modelling demography and growth

Answer 16

We view unified modelling of this long transition process, from
thousands of years of stagnation through the demographic
transition to modern growth, as one of the most significant
research challenges facing economists interested in growth and
development (Galor and Weil, 2000)

Question 17

Describe & explain Malthus’ failure to explain changes in the “market” for children. Include more suitable, alternative models.

Answer 17

Malthus’ theory relied on a positive income elasticity of
demand for children
* Many households have a negative income elasticity of demand
for children
* This observation helps to explain why long term growth can be
sustained
- There have been two influential economic models of this type
of behaviour:
1. Becker’s Q-Q model - first to model the “market for children”
2. Galor’s Unified Growth Theory - first to link Malthusian with
post-Malthusian patterns

Question 18

Explain income elasticity of demand, including: equation, interpretation and use

Answer 18

• In economics, the income elasticity of demand (YED) is the responsivenesses of the quantity demanded for a good to a change in consumer income
• Equation: epsilondbottom right = % change in quanitity demanded / % change in income
• The most commonly used elasticity in economics, the price elasticity of demand, is almost always negative, but many goods have positive income elasticities, many have negative.
• A negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the quantity demanded.
• A positive income elasticity of demand is associated with normal goods; an increase in income will lead to a rise in quantity demanded.
• If income elasticity of demand of a commodity is less than 1, it is a necessity good.
• If the elasticity of demand is greater than 1, it is a luxury good or a superior good.
• A zero income elasticity of demand means that an increase in income does not change the quantity demanded of the good.
• Income elasticity of demand can be used as an indicator of future consumption patterns and as a guide to firms’ investment decisions
• Being a normal good (elasticity > 0) means that with higher income, consumption of the good will rise, but it does not mean that the good’s share of the consumer’s budget will rise with income. That depends on whether the elasticity is below or above +1. If the elasticity is negative, such as margarine’s -.20 (from the “Selected income elasticities” section of this article), then it is obvious that margarine’s share of the consumer’s budget will fall if his income rises 10%. If the elasticity is tobacco’s +.42, however, an income increase of 10% generates a spending increase of 4.2%, so tobacco’s share of the budget falls. His purchases of books, with an elasticity of +1.44, will rise 14.4%, however, and so will have a higher budget share after his income rises.
• In aggregate, food has an income elasticity of demand between zero and one, so expenditure increases with income, but not as fast as income does. This observation is known as Engel’s law.
• Income elasticities are closely related to the population income distribution and the fraction of the product’s sales attributable to buyers from different income brackets. When buyers in a certain income bracket get a pay raise, the income elasticity can be used to predict how much more the market will consume of that product. If the income share elasticity is defined as the negative percentage change in individuals given a percentage increase in income bracken the income-elasticity, after some computation, becomes the expected value of the income-share elasticity with respect to the income distribution of purchasers of the product. When the income distribution is described by a gamma distribution, the income elasticity is proportional to the percentage difference between the average income of the product’s buyers and the average income of the population
• Income elasticities can vary as household income changes, particularly in the case of goods and commodities such as food and energy.[6] At low levels of per capita income, elasticities of demand for food, energy, or other products can be high. As per capita income increases, however, income elasticities fall. At high levels, the marginal elasticities may go to zero, or even negative.[12] These differences can be observed by comparing countries at different income levels. For example, estimates of the income elasticity of cereals ranges from 0.62 in Tanzania to 0.47 in Georgia, 0.28 in Slovenia, and 0.05 in the United States.[13]
• The decline in elasticities as income increases is a form of Kuznet’s curve. As economies industrialize and get wealthier, consumer demand changes. At low levels of income, demand for energy or other goods increases very rapidly. However, as income rises further, consumption requirements (e.g. for food or energy) are increasingly satisfied. In addition, consumption patterns shift toward services rather than goods, which require fewer commodities to produce.

Question 19

What’s the name for ‘the responsivenesses of the quantity demanded for a good to a change in consumer income’?

Answer 19

Income elasticity of demand

Question 20

Describe & explain the Q-Q model

Answer 20

• Stands for the ‘Quantity-Quality model’
• Key features:
  1. Parents derive utility from both child quantity and quality
  2. There is a low income elasticity of child quantity and high
  income elasticity of child quality
  3. Quality is a normal good (good whose consumption rises when the income increases) but quantity is an inferior good (a good whose demand decreases when consumer income rises)
  4. A rise in household income will increase quality but the
  substitution effect will dominate and actually lower quantity
• This explains why population growth no longer eats up
  income growth
• As households become richer they invested in quality over
  quantity
• Unfortunately it cannot explain why or when income elasticity
  changes from positive (Malthusian) to negative
  (neo-Malthusian)
• The Q-Q model uses micro-foundations that are unable to
  explain long run growth
• Unified growth theory draws upon Q-Q micro-foundations and
  attempts to link the two fertility patterns within a
  macroeconomic framework

Question 21

What are the key features of ‘Unified Growth Theory’?

Answer 21

• Key features:
  1. Technological change is a function of population and education
  2. Education is a function of technological change - level of
  technological change determines returns to education
  3. Malthusian state is characterised by slow technical progress -
  benefits of technological change are offset by population
  growth (low returns to quality)
  4. Rise in the population generated higher demand for education
  and returns to innovation - benefits of technological change
  are not offset by population growth (high returns to quality)
  5. Eventually a threshold is reached where returns to education
  and extremely high - substitution effects dominate
  6. Higher levels of education generate higher technological
  change - virtuous cycle of high technology high growth

Question 22

Describe & explain what might explain long-run growth?

Answer 22

1. Institutions (NIE) - New Institutional Economics
   * Security of property rights - constraints on the executive, risk
   of expropriation
   * Social capital - Putnam’s “trust” and civic society
   * English language - Anglo-American
   * British Legal System - Common Law vr. Civil Law
   * Religion - Protestant vs. Catholic, Hindu, Muslim
   * Origin of Coloniser - AJR’s Britain vrs. France/Spain/Portugal
2. Geography (NEG) - New Economic Geography
   * Market Potential - incomes are still spatially correlated
   * Transport Costs - core vs. periphery production (low, medium,
   high)
   * Distance to equator - Disease (Malaria), crops
   * Miles of coastline - access to sea
   * “Resource curse” - Prebisch-Singer hypothesis and Dutch Disease

Question 23

Who’s Robert Putnam?

Answer 23

Robert David Putnam[a] (born January 9, 1941) is an American political scientist specializing in comparative politics. He is the Peter and Isabel Malkin Professor of Public Policy at the Harvard University John F. Kennedy School of Government.

Putnam developed the influential two-level game theory that assumes international agreements will only be successfully brokered if they also result in domestic benefits. His most famous work, Bowling Alone, argues that the United States has undergone an unprecedented collapse in civic, social, associational, and political life (social capital) since the 1960s, with serious negative consequences.[5] In March 2015, he published a book called Our Kids: The American Dream in Crisis that looked at issues of inequality of opportunity in the United States.[6] According to the Open Syllabus Project, Putnam is the fourth most frequently cited author on college syllabi for political science courses