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
Growth and the Economy’s Potential • Growth is an increase in the amount of goods and services an economy produces. • The study of growth is the study of why that increase comes about assuming that both labour and capital are fully employed.
Growth and the Economy’s Potential • Growth is an increase in potential output. • 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 – demand is sufficient to buy whatever is supplied.
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, for some reason, it is not.
Importance of Growth for Living Standards • Growth is important for living standards. • Long-term growth rates matter a lot because of compounding. • This means that growth is based not only on original levels of income in a country, but also on the accumulation of previous years’ increases in income.
Importance of Growth for Living Standards • According to the rule of 72, dividing 72 by the rate of growth will give the number of years in which income will double.
Markets, Specialization, and Growth • Markets and specialization lead to growth. • Economic growth began when markets developed (early 1800s), and as they expanded, growth accelerated.
Markets, Specialization, and Growth • Markets increase productivity through specialization and the division of labour. • Specialization – the concentration of individuals on certain aspects of production • Divisionof labour – the splitting up of a task to allow for specialization of production. • Productivity– output per unit of input.
Markets, Specialization, and Growth • With increasing specialization and division of labour comes increasing productivity which creates a higher standard of living.
Markets, Specialization, and Growth • This argument is reinforced by the principle of comparative advantage. • Production possibilities rise when people concentrate on producing those goods for which their skills and other resources are suited, and trade for those goods for which they do not have a comparative advantage.
Economic Growth, Distribution, and Markets • Markets are often seen to be unfair because of the effect they may have on the distribution of income. • Markets may not provide equality of income but they do make the poor better off.
Economic Growth, Distribution, and Markets • Would the poor be better off without markets? • Historically, judged from an absolute standard, there is strong evidence that the poor benefit enormously from the growth that markets foster.
Economic Growth, Distribution, and Markets • Judged from a relative standard, it is not at all clear that markets require the large differentials in pay that has accompanied growth in market economies.
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 • The problem in many developing nations is that although GDP is rising, the population is rising even faster 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. • Instead we should focus on median income.
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 to a small majority of individuals who receive the majority of income, the mean will rise but the median will not.
Per Capita Growth • Unfortunately, statistics on median income is generally not collected so 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. • Take the former Soviet Union, for example. They invested a lot, but did not grow much.
Investment and Accumulated Capital • 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, and: • 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 • Growth-compatible institutions have built-in incentives that lead people to put forth effort and discourage loafing. • When individuals get much of the gains of growth themselves, they work harder.
Growth Compatible Institutions • Markets that feature private ownership of property foster economic growth. • Mercantilist economies that feature bribes inhibit economic growth.
Technological Development • A larger aspect of growth involves changes in technology – changes in the goods and services we buy, and the way we create goods and services.
Technological Development • Technological change does more than cause economic growth, it changes the entire social and political dimensions of society. • As in other things, there are tradeoffs when new technology is introduced.
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. • 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 • Economists’ theories of growth have emphasized the production function. • 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 • This production function has land, labour, and capital as factors of production, and an adjustment factor, “A”, to capture the effect of technology: Output = A• f(Labour, Capital, Land)
The Production Function and Theories of Growth • In talking about production functions, economists use a couple of terms: scale economies and diminishing marginal productivity.
The Production Function and Theories of Growth • Scale economies describe what happens when all inputs increase equally. • Constant returns to scale means that output will rise by the same proportionate increase as all inputs.
The Production Function and Theories of Growth • Increasing returns to scale occur if output rises by a greater proportionate increase than all inputs. • Decreasing returns to scale occur if output rises by a smaller proportionate increase than all inputs.
The Production Function and Theories of Growth • Diminishing marginal productivity describes what happens when more of one input is added without increasing any other inputs.
The Production Function and Theories of Growth • The law of diminishing marginal productivitystates that increasing one input, keeping all others constant, will lead to smaller and smaller gains in output.
The Classical Growth Model • The Classical growth model is the standard theory of growth. • The Classical growth model focuses on capital accumulation.
The Classical Growth Model • Since investment leads to the increase in capital, Classical economists focused their analysis and their policy advice, on how to increase investment.
The Classical Growth Model • The linkage was as follows: savings Þ investment Þ increases in capital Þ growth
Diminishing Marginal Productivity of Labour • The Classical growth model focuses on diminishing marginal productivity of labour.
Diminishing Marginal Productivity of Labour • When farming was the major activity in the economy, Thomas Malthus, an early economist, emphasized the limitation land placed on growth.
Diminishing Marginal Productivity of Labour • Since land was fixed, he predicted that diminishing marginal productivity would set in as population grew.
Diminishing Marginal Productivity of Labor • The linkage was: economic surplus Þ population increases Þ output increases Þ lower per capita income Þ too many people Þ starvation