Laugher Curve We have two classes of forecasters: Those who don't know, and those who don't know they don't know. John Kenneth Galbraith
General Observations about Growth • Growth increases the economy’s potential output.
Growth and the Economy’s Potential • Growth is an increase in the amount of goods and services an economy produces. • Growth is an increase in potential output.
Growth and the Economy’s Potential • Potential output – the highest amount of output an economy can produce from the existing production function and existing resources. • When an economy is at its potential output, it is operating on its production possibility curve.
Growth and the Economy’s Potential • Long-run growth focuses on supply. • It assumes Say’s Law – supply creates its own demand.
Growth and the Economy’s Potential • In the short run, economists consider potential output fixed. • They focus on how to get the economy operating at its potential if it is not.
Importance of Growth for Living Standards • Growth improves living standards. • It makes more goods available to more people. • Because of compounding, long-term growth rates matter a lot.
Importance of Growth for Living Standards • The Rule of 72 is used to determine how long it takes for income to double at different growth rates. • The Rule of 72 – the number of years it takes for a certain amount to double in value is equal to 72 divided by its annual rate of increase.
Markets, Specialization, and Growth • Markets, specialization and the division of labor increase productivity and growth. • Specialization – the concentration of individuals on certain aspects of production • Divisionof labor – the splitting up of a task to allow for specialization of production.
Economic Growth, Distribution, and Markets • Markets are often seen to be unfair because of the effect they have on the distribution of income.
Economic Growth, Distribution, and Markets • Markets may not provide equality of income but they make the poor better off. • There is strong evidence that the poor benefit enormously from the growth that markets foster.
Economic Growth, Distribution, and Markets • Just because the poor benefit from growth does not mean they might not be better off if income were distributed more in their favor.
Milk (½ gallon) Beef (1 pound) 1919 Eggs (1 dozen) Bread (1 pound) Chicken (3 lb. fryer) Milk (½ gallon) Beef (1 pound) 1997 Eggs (1 dozen) Bread (1 pound) Chicken (3 lb. fryer) 0 50 100 150 200 Price in minutes of work Cost of Goods in Hours of Work
Per Capita Growth • Per capita output is total output divided by total population. • Per capita growth means producing more goods and services per person.
Per Capita Growth • Per capita growth equals the percent change in output minus the percent change in population Per capita growth = % change in output - % change in population
Per Capita Growth • In many developing nations, the population is rising faster than GDP, resulting in a lower per capita growth rate.
Per Capita Growth • Some economists have argued that per capita (mean) output is not what we should be focusing on. • We should focus on median income instead.
Per Capita Growth • Median income is a better measure because it takes into account how income is distributed.
Per Capita Growth • If the growth in income goes mostly to a small minority of individuals, the mean will rise but the median will not. • Because statistics on median income is generally not collected, economists use per capita income.
The Sources of Growth • Economists identify five important sources of growth: • Capital accumulation – investment in productive capacity. • Available resources. • Growth compatible institutions. • Technological development. • Entrepreneurship.
Investment and Accumulated Capital • Years ago it was thought that physical capital and investment were the keys to growth. • The flow of investment lead to the growth of the stock of capital.
Investment and Accumulated Capital • Capital accumulation does not necessarily lead to growth. • Products change, and useful buildings and machines in one time period may be useless in another.
Investment and Accumulated Capital • Capital is much more than machines – it includes human and social capital. • Human capital – the skills that are embodied in workers through experience, education, on-the-job training. • Social capital – the habitual way of doing things that guides people in how they approach production.
Investment and Accumulated Capital • All economists agree that the right kind of investment at the right time is a central element of growth.
Available Resources • For an economy to grow it will need resources. • What constitutes a resource at one time may not be a resource at another time.
Available Resources • Technology plays an enormous role here. • Greater participation in the market is another way by which available resources are increased.
Growth-Compatible Institutions • Markets and private ownership of property foster economic growth. • When individuals get much of the gains of growth themselves, they work harder.
Growth-Compatible Institutions • Another growth-compatible institution is the corporation. • Because of limited liability, corporations give owners and incentive to invest their savings in large enterprises.
Growth-Compatible Institutions • Mercantilist economic policies inhibit economic growth.
Technological Development • Growth isn’t just getting more of the same thing. • It’s also getting some things that are different.
Technological Development • Growth involves changes in technology. • Technology – changes the way we make goods and supply services, and in the goods and services we buy.
Entrepreneurship • Entrepreneurship is the ability to get things done. • That ability involves creativity, vision, and a talent for translating that vision into reality.
Turning the Sources of Growth into Growth • In order to be effective, the five sources of growth must be mixed in the right proportions.
Turning the Sources of Growth into Growth • It is the combination of investing in machines, people, and technological change that plays a central role in the growth of any economy.
The Production Function and Theories of Growth • The production function shows the relationship between the quantity of inputs used in production and the quantity of output resulting from production.
The Production Function and Theories of Growth • The production function for growth has land, labor, and capital as factors of production. • “A” is an adjustment factor that captures the effect of technology. Output = A• f(Labor, Capital, Land)
Describing Production Functions • Scale economies describe what happens in a production function when all inputs increase equally. • Constant returns to scale. • Increasing returns to scale. • Decreasing returns to scale.
Describing Production Functions • Constant returns to scale means that output will rise by the same proportionate increase in all inputs.
Describing Production Functions • Increasing returns to scale occurs when output rises by a greater proportionate increase as all inputs.
Describing Production Functions • Decreasing returns to scale occurs when output rises by a smaller proportionate increase as all inputs.
Describing Production Functions • Diminishing marginal productivity describes what happens when more of one input is added without increasing any other inputs.
Describing Production Functions • The law of diminishing marginal productivitystates that increasing one output, keeping all others constant, will lead to smaller and smaller gains in output.
The Classical Growth Model • The Classical growth model focuses on capital accumulation in the growth process. • The more capital an economy has, the faster it will grow. • Because of this emphasis on capital, market economies are called capitalist economies.
The Classical Growth Model • Classical economists focused their analysis and their policy advice, on how to increase investment: savings Þ investment Þ increases in capital Þ growth
Focus on Diminishing Marginal Productivity of Labor • The Classical growth model focused on how diminishing marginal productivity of labor placed limitations on growth. • Farming was the major economic activity and land was relatively fixed.
Focus on Diminishing Marginal Productivity of Labor • Since land was fixed, diminishing marginal productivity would set in as population grew. • As output per person declines, at some point available output is no longer sufficient to feed the population.
Focus on Diminishing Marginal Productivity of Labor • This belief is called the iron law of wages. • The long run was called the stationary state.
Subsistence level of output per worker Output Production function Q2 Q1 L1 L* Labor Diminishing Returns and Population Growth
Diminishing Marginal Productivity of Capital • The predictions of the stationary state turned out to be wrong. • Increases in technology and capital overwhelmed the law of diminishing marginal productivity.