CHAPTER 9: ECONOMIC GROWTH II: TECHNOLOGY, EMPIRICS, AND POLICY

Chapter 3: Capital, labor, and technology determine a nation’s production of goods and services
Chapter 8: Changes in capital (savings and investment) and labor force (population growth) affect output
Chapter 9: Changes in technology
- Solow model can shed much light on international growth experiences, but it is far from the last
word on the subject (there are many factors that influence it)
Technological Progress in the Solow Model
The Efficiency of Labor
- Production Function: Y =F (K , L)
o Y =F ( K , L x E) where E is the Efficiency of Labor – society’s knowledge about
production methods (technology improves -> efficiency of labor rises -> each hour of
work contributes more to the production of goods and services)
 Total output Y depends on the inputs of capital K and effective workers L x E
 Manufacturing transformations, computerization, improvements in health,
education, or skills of the labor force
 L x E – interpreted as measuring the Effective Number of Workers – number of
each worker and the efficiency of each worker
 g=0.02 -> each unit of labor becomes 2% more efficient -> output increases as
if labor force increased by 2%; technological progress called Labor Augmenting
 Where g is called the rate of Labor-Augmenting Technological Progress
 Labor force L grows at rate n and efficiency E grows at rate g -> effective
number of workers L x E grows at rate n+ g
The Steady State with Technological Progress
- Technological progress causes the effective number of workers to increase
o Analytic tools used in Chapter 8 to study SGM for population growth can be adapted
- ∆ k=sf ( k )− ( δ+n+ g ) k

- Inclusion of technological progress does not substantially alter our analysis of the steady state.
There is one level of k, denoted k*, at which capital per effective worker and output per
effective worker are constant. As before, this steady state represents the long-run equilibrium of
the economy
The Effects of Technological Progress
- Variables in a steady-state with technological progress
Y
o Output per actual worker =yx E
L
o y is constant and E is growing at rate g, output per worker must also be growing at rate
g in the steady-state

o Similarly, economy’s total output is Y = y x (E x L). Because y is constant in the steady

state, E is growing at rate g, and L is growing at rate n , total output grows at rate n+ g
in the steady state
- With the addition of technological progress, model can finally explain sustained increases in
standards of living that we observe (tech. progress -> sustained growth in output/worker)
o High rate of saving -> high rate of growth only until steady state (once in steady state,
the rate of growth of output per worker depends on technological progress)
- SGM: only tech. progress can explain sustained growth and persistently rising living standards
- At the Golden Rule level of capital, the net marginal product of capital, MPK −δ , equals the
rate of growth of total output,n+ g . Because actual economies experience both population
growth and technological progress, we must use this criterion to evaluate whether they have
more or less capital than they would at the Golden Rule steady state
From Growth Theory to Growth Empirics
Balanced Growth
- Balanced Growth – property that causes the values of many variables to rise together in the SS
- SGM: Both output and capital per worker should grow at g (rate of tech. progress) in the SS
o US: capital-output has indeed remained approximately constant over time
- Tech. progress also affects other variables in the SS
o Real wage grows at the rate of technological progress
o Yet real rental price of capital remains constant (US) even though GDP & real wage grew
Convergence
- Income inequality makes quality of life differ so much
- Convergence – poor economies catching up with the rich economies
o If there is no convergence, poor countries that start off behind are likely to remain poor
- SGM: convergence depends on similarity of the countries
o If 2 economies start off with different capitals but they have the same steady state, as
determined by their saving rates, population growth rates, and efficiency of labor, they
have the tendency to converge (poorer economy will catch up with the richer)
- Countries converge with each other at a rate of 2% (gap between the rich and the poor closes by
2% each year)
 - Countries that start off poor do not grow faster on average than countries that start off rich
o Different countries have different steady states
o Economies experience Conditional Convergence: they converge to their own steady
states (determined by saving, population growth, and human capital)
Factor Accumulation Versus Production Efficiency
- International differences in income per person are attributed to differences in factors of
production (quantities of physical and human capital) or differences in efficiency with which
economies use their factors of production
o Worker in a poor country may be poor because she lacks tools or skills or because he
does not use it in the best way
o Thus, gap is explained by difference in capital accumulation and/or production function
 The two are positively correlated, more capital -> high efficiency
- Interpretations of the positive correlation of capital and efficiency
o An efficient economy may encourage capital accumulation: people with a great
economy have incentives to stay in school and accumulate human capital
o Capital accumulation may induce greater efficiency: if there are positive externalities to
physical & human capital, countries that save & invest more have better prod. Functions
o Both capital accumulation and production function are driven by a third variable—
quality of nation’s institutions (including policymaking process)
 High inflation, budget deficits, widespread market interference, & rampant
corruption go hand in hand -> fail to accumulate capital and use it efficiently
Policies to Promote Growth
Evaluating the Rate of Saving
- SGM: saving and investment determine a citizen’s standard of living
- Saving rate determines steady state level of capital and output
o One particular saving rate determines GRSS that maximize consumption and well-being
- GRSS: MPK −δ=n+ g or Marginal Product of Capital Net of Depreciation = Growth Rate of
Total Output
o If capital < GRSS: MPK −δ> n+g . Increase rate of saving to increase capital
accumulation and economic growth -> steady state with higher consumption
o If capital > GRSS: MPK −δ< n+g . Excessive capital accumulation; reduce rate of saving
-> higher consumption immediately and in the long run
- US: MPK −δ > n+g -> US should save and invest more to reach a steady state level with a
higher consumption
o Excessive saving and capital accumulation beyond Golden Rule level appears not to be a
problem that actual economies face
o Economists are more often concerned with insufficient saving
Changing the Rate of Saving
- Chapter 3: higher national saving = higher public saving and/or higher private saving
- Government affects national saving through public saving – tax revenue−spending
o If spending>revenue: trade deficit -> raises interest rate -> crowds out investment ->
reduced capital stock -> burden of national debt on future generations
o If revenue>spending: trade surplus -> retire national debt and stimulate investment
- Government also affects national saving by influencing private saving (by households & firms)
 o People save depend on incentives which are altered by public policies
o High tax rates on capital (corporate, federal, estate taxes) reduce rate of return savers
can earn -> discourage private saving
o Tax-exempt retirement accounts give preferential treatment to income saved in these
accounts -> encourage private saving
 Economists propose changing the tax system from income to consumption
taxation to encourage saving
- Some argue that private saving does not respond much to incentives
o Example: government increased the amount that people can put into tax-exempt
retirement accounts
 Would people save more and respond to the incentive or would they merely
transfer saving already done in taxable savings accounts into these tax-
advantaged accounts, reducing tax revenue and thus public saving without any
stimulus to private saving? No consensus yet despite much research
Allocating the Economy’s Investment
- SGM: simplified assumption that there’s only one type of capital
o Traditional Capital – bulldozers, steel plants, computers, robots (business)
o Infrastructure – roads, bridges, sewer systems (government)
o Human Capital – knowledge and skills that workers acquire through education
- SGM usually refers to physical capital, but physical and human capital are analogous
o Human c. increases our ability to produce goods & services like physical c. does -> HC is
as important as PC in explaining international differences in standards of living
- What kind of capital does the economy need the most—yields the highest marginal products
o Policymakers can rely on the marketplace to allocate the pool of saving to alternative
types of investment
 Industries with the highest marginal products of capital will naturally be most
willing to borrow at market interest rates to finance new investment
o Many economists advocate that the government should merely create a “level playing
field” for different types of capital – ensuring that the tax system treats all forms of
capital equally -> rely on the market to allocate efficiently
- Other economists have suggested that the government should actively encourage particular
forms of capital
o New and improved production processes -> learning by doing-> technological externality
/ knowledge spillover -> technological progress -> social returns to capital exceeds
private returns -> use tax laws to encourage these (or other investments that yield
greater externalities)
o Government should be able to accurately measure the externalities of different
economic activities so it can give the correct incentive to each activity
- Industrial Policy – policies on economic activities of public and private sectors
- Most economists are skeptical about industrial policies for two reasons
o Measuring the externalities from different sectors is virtually impossible
 Poor measurements -> random effects -> worse than no policy at all
o Political process is far from perfect
 Rewards might be based on political clout when rewarding subsidies/tax breaks
 - Public Capital – capital that necessarily involves the government
o When to finance new roads, bridges, transit systems
o Increased spending on infrastructure (have defenders and critics but both agree that
measuring marginal product of public capital is difficult)
o Allocation of resources involves the political process and taxpayer funding (corruption)
- Private Capital – generates an easily measured rate of profit for the firm owning the capital
o Investment is made by investors spending their own money
Establishing the Right Institutions
- Nations may have different levels of production efficiency because they have different
institutions guiding the allocation of scarce resources
- GDP per person in North Korea is less than 1/10 of South Korea’s: SK is well lit -> advanced
economic development while NK is shrouded in darkness
- Democratic capitalist nations have important but more subtle institutional differences
o Legal Tradition – legal protections for shareholders and creditors are stronger in English-
style than French-style legal systems -> former have more better-developed capital
markets -> more rapid growth since it is easier for small and start-up companies to
finance investment projects -> more efficient allocation of the nation’s capital
o Quality of Government and Honesty of Government Officials – government should lend
a helping hand to the market system by protecting rights but some act like grabbing
hand by using the authority to enrich a few powerful individuals at the expense of a
broader community; corruption affects economic growth
Encouraging Technological Progress
- SGM: sustained growth of income per worker comes from technological progress
o But tech. progress is exogenous in SGM -> does not explain it
- Despite little understanding, many public policies are designed to stimulate tech. progress
o Most of which encourage private sectors to devote resources to tech. innovation
o Patent gives temporary monopoly to investors of new products
o Tax code offers tax breaks for firms engaging in research and development
- Proponents of industrial policy argue that the government should take a more active role in
promoting specific industries that are key to rapid technological advance
- Countries like China have an incentive to free ride on research-focused nations by using ideas
developed abroad without compensating the patent holders (does not enforce property rights)
- If intellectual property rights were better enforced -> more countries will invest in research ->
promote technological progress and thus economic growth
Beyond the Solow Model: Endogenous Growth Theory
- Technological progress stimulates economic growth based on SGM, but tech. progress is
exogenous and is just assumed. But where does it come from?
- Endogenous Growth Model – models that explain technological advance
- Y = AK or output equals amount of output produced for each unit of capital times capital stock
o No diminishing marginal returns to capital: one extra output K produces A extra units
of capital regardless of how much capital there is
o This is the main difference between endogenous growth model & Solow Growth Model
- As long as sA> δ , economy’s income grows forever, even without the assumption of exogenous
technological progress
 - SGM: saving temporarily leads to growth, but diminishing returns to capital eventually force the
economy to approach a steady state in which growth depends only on exogenous technological
progress
- EGM: saving and investment can lead to persistent growth
- Abandoning the diminishing returns to capital in EGM
o Traditional: K includes only the economy’s stock of plants and equipment, assume DRTC
 A worker with 10 computers will not be as productive as she is with one
o If K is interpreted as knowledge, can abandon DRTC. Knowledge can produce both goods
& services and production of new knowledge (knowledge has increasing returns)
A Two-Sector Model
- Example: economy has 2 sectors: a manufacturing firm and a university
- There are two key decision variables in this model. As in the Solow model, the fraction of output
used for saving and investment, s, determines the steady-state stock of physical capital. In
addition, the fraction of labor in universities, u, determines the growth in the stock of
knowledge. Both s and u affect the level of income, although only u affects the steady-state
growth rate of income. Thus, this model of endogenous growth takes a small step in the
direction of showing which societal decisions determine the rate of technological change
The Microeconomics of Research and Development
1. Knowledge is a public good but much research is done in firms driven by the profit motive
2. Research is profitable since innovations give firms temporary monopolies (patent or first firm)
3. When one firm innovates, other firms build on that innovation to produce the next generation
of innovations
- Is social return to research greater or smaller than private returns?
o Firms creating a new technology makes other firms better off by giving them a base of
knowledge on which to build in future research (standing on shoulder of giants)
o Firms creating a new technology make other firms worse off if it does little more than
become the first to discover a technology that another firm would have invented in due
course (stepping on toes)
The Process of Creative Destruction
- Creative Destruction – entrepreneur’s firm becomes an incumbent, enjoying high profitability
until its product is displaced by another entrepreneur with the next generation of innovation
- Technological progress has winners and losers
o Can reduce cost in salaries but make other workers useless -> unemployed
o Reduce cost for big companies -> smaller companies cannot compete with the low price
Conclusion
- Long-run economic growth is the single most important determinant of the economic well-being
of a nation’s citizens. Everything else that macroeconomists study—unemployment, inflation,
trade deficits, and so on—pales in comparison.
Summary
1. In the steady state of the Solow growth model, the growth rate of income per person is
determined solely by the exogenous rate of technological progress.
2. Many empirical studies have examined the extent to which the Solow model can help explain
long-run economic growth. The model can explain much of what we see in the data, such as
balanced growth and conditional convergence. Recent studies have also found that international
 variation in standards of living is attributable to a combination of capital accumulation and the
efficiency with which capital is used.
3. In the Solow model with population growth and technological progress, the Golden Rule
(consumption-maximizing) steady state is characterized by equality between the net marginal
product of capital MPK −δ and the steady-state growth rate of total income n+ g . In the U.S.
economy, the net marginal product of capital is well in excess of the growth rate, indicating that
the U.S. economy has a lower saving rate and less capital than it would have in the Golden Rule
steady state.
4. Policymakers in the United States and other countries often claim that their nations should
devote a larger percentage of their output to saving and investment. Increased public saving and
tax incentives for private saving are two ways to encourage capital accumulation. Policymakers
can also promote economic growth by setting up the appropriate legal and financial institutions
to allocate resources efficiently and by ensuring proper incentives to encourage research and
technological progress.
5. Modern theories of endogenous growth attempt to explain the rate of technological progress,
which the Solow model takes as exogenous. These models try to explain the decisions that
determine the creation of knowledge through research and development.