Department of Economics, HU

CHAPTER-6

LONG RUN GROWTH

INTRODUCTION

The amount of output produced per worker has risen over time in almost all countries. We distinguish
output growth, which is the growth rate of output of the entire economy, and per-capita output
growth, which is the growth rate of output per person in the economy. Another measure is labor
productivity growth which is the growth rate of output per worker.

Output per capita is a useful measure because it tells us how much output each person would receive if
total output were evenly divided across the entire population. Whereas how much output each worker
on average is producing is measured by output per worker.

Thus economic growth is the steady increase in aggregate output over time as measured by the growth
rate, the rate of change of real GDP expressed as a percentage per year. The reason we care about
growth is that we care about the standard of living, in turn we about happiness.

A Broader Look at Growth across Time and Space

There is agreement among economic historians about the main economic evolutions over the last 2,000
years:

– From the end of the Roman Empire to roughly the year 1500, there was essentially no
growth of output per person in Europe.

– From about 1500 to 1700, growth of output per person turned positive, about 0.1% per
year. It increased to 0.2% per year from 1700 to 1820. This period of stagnation of
output per person is often called the Malthusian era. Europe was in a Malthusian trap,
unable to increase its output per person.

– On the scale of human history, the growth of output per capita is a recent phenomenon.

Looking at Growth across Many Countries

Looking at patterns by groups yields three main conclusions:

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―Nearly all OECD countries start at high levels of output per person (say, at least one-third of the
U.S. level in 1960), and there is clear evidence of convergence.
― Convergence is also visible for most Asian countries: All the countries with growth rates
above 4% over the period are in Asia. Starting in the 60’s a group of countries sometimes
called the four tigers: Singapore, Taiwan, Hong Kong, and South Korea started catching up to
the high output of Japan. (Economies with high growth rates but low output per person are
often called emerging economies.
― Convergence is certainly not the rule in Africa- growth disasters.
Convergence theory:
The theory stating that the growth rates of less developed countries will exceed the growth rates of
developed countries, allowing the less developed countries to catch up. Accordingly, gaps in national
incomes tend to close over time.

A Primer on Growth Rates

How is economic growth measured?

Example: y t − y t−1 Year real GDP per capita
gt = ×100
y t−1 2008 $15,000
2009 $15,500
15, 500−15, 000
g2009 = ×100=3. 33%
15, 000
For a quantity growing at a constant rate the level in year t is given by:

y t = y 0 ( 1+ ḡ)t

( )
1/ t
yt
ḡ= −1
y0
The Rule of 70 and Doubling Time

If income/output starts at y0 and grows at a constant rate of g, then how many years it takes until y
become doubled? I.e. y = 2yo
y t =2 y 0 = y 0 ( 1+ ḡ )t
Take the natural logarithm both sides and approximate to get:
ln 2=t ln ( 1+ ḡ )
ln2 ≈ 0.7 and ln (1 + g) ≈ g, thus t = 70/g
Bottom line: For any variable growing at a constant rate, the number of years it takes to double is

70
t =2
ḡ
Department of Economics, HU
This relation is called the rule of 70.

Thinking about Growth

To think about growth, economists start from an aggregate production function relating aggregate output
to two factors of production: capital and labor. How much output is produced given these inputs depends
on the state of technology.

The framework of analysis used was developed by Robert Solow, in the 1956. Particularly:

– What determines growth?

– What is the role of capital accumulation?

– What is the role of technological progress?

The Aggregate Production Function

The aggregate production function is a specification of the relation between aggregate output and the
inputs in production.

Y = aggregate output. K = capital- the sum of all the machines, plants, and office buildings in the
economy. N = labor—the number of workers in the economy.
The function F, which tells us how much output is produced for given quantities of capital and labor, is
the aggregate production function.
The aggregate production function depends on the state of technology- thus, the higher the state of
technology, the higher for a given K and a given N.

The state of technology is a set of blue prints defining the range of products and the techniques
available to produce them.
Returns to Scale and Returns to Factors
Constant returns to scale is a property of the economy in which, if the scale of operation is doubled—
that is, if the quantities of capital and labor are doubled—then output will also double.

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Or more generally, for any number, x,

Diminishing returns to capital refers to the property that increases in capital lead to smaller and smaller
increases in output as the level of capital increases. Diminishing returns to labor refers to the property
that increases in labor, given capital, lead to smaller and smaller increases in output as the level of labor
increases.
A constant return to scale implies that we can rewrite the aggregate production function as:

The amount of output per worker, Y/N depends on the amount of capital per worker, K/N. As capital per
worker increases, so does output per worker.

Figure 1: Output and

Capital per Worker
Increases in capital per
worker lead to smaller and
smaller increases in output
per worker.

The Sources of Growth

Increases in output per worker (Y/N) can come from increases in capital per worker (K/N). Or they can
come from improvements in the state of technology that shift the production function, F, and lead to
more output per worker given capital per worker.

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We can think of growth as coming from capital accumulation and from technological progress —the
improvement in the state of technology. These two factors play very different roles in the growth
process:

– Capital accumulation by itself cannot sustain growth. Because of diminishing returns to

capital, sustaining a steady increase in output per worker will require larger and larger
increases in the level of capital per worker. At some stage, the economy will be unwilling
or unable to save and invest enough to further increase capital. Thus, it is true that a
higher saving rate cannot permanently increase the growth rate of output. But a higher
saving rate can sustain a higher level of output.

– Sustained growth requires sustained technological progress. The economy’s rate of

growth of output per person is eventually determined by the economy’s rate of
technological progress. Technological progress itself is determined by R &D, property
rights and other institutions, education and training.

Figure 2፡ The Effects

of an improvement in
the state of technology.
An improvement in
technology shifts the
production function up,
leading to an increase in
output per worker for a given
level of capital per worker

NEW GROWTH THEORY

The theory that states our unlimited wants will lead us to ever greater productivity and perpetual
economic growth. According to new growth theory, real GDP per person grows because of the choices
people make in the pursuit of profit.

Choices and Innovation

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The new theory of economic growth emphasizes three facts about market economies:

• Human capital grows because of choices.

• Discoveries result from choices.

• Discoveries bring profit, and competition destroys profit.

Human Capital Expansion and Choices

People decide how long to remain in school, what to study, and how hard to study.

Discoveries and Choices

The pace at which new discoveries are made—and at which technology advances—is not determined by
chance. The pace at which new discoveries are made depends on how many people are looking for a
new technology and how intensively they are looking.

Discoveries and Profits

The forces of competition squeeze profits, so to increase profit, people constantly seek either lower cost
methods of production or new and better products for which people are willing to pay a higher price.

Two other facts play a key role in the new growth theory:

• Many people can use discoveries at the same time.

• Physical activities can be replicated.

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Figure 3 illustrates new

growth theory in terms
of a perpetual motion
machine.

Preconditions for Economic Growth

Incentives and Institutions

Institutions are the “rules of the game” that structure economic incentives. Institutions of Economic
Growth include among other things: Property rights, honest government, Political stability, a
dependable legal system, Competitive and open markets.

Property rights: the right to benefit from one’s effort. Put differently property right refers to a bundle of
entitlements defining the owner’s rights, privileges, and limitations for use of the resource. Well defined
property rights provide incentives to work hard encourage investment in physical and human capital, are
important for encouraging technological innovation. Without property rights effort is divorced from
payment → ↓incentive to work. i.e. Free riders become a problem.

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An efficient structure has three main characteristics:

1. Exclusivity—all benefits and costs accrued as a result of owning and using the resources should
accrue to the owner, and only to the owner, either directly or indirectly by sale to others.
2. Transferability—all property rights should be transferable from one owner to another in a
voluntary exchange.
3. Enforceability—Property rights should be secure from involuntary seizure or encroachment by
others.

Honest Government

Property rights are meaningless unless government guarantees property rights. Corruption bleeds
resources away from productive entrepreneurs. Corruption takes resources away from more productive
government activity.

Political Stability

Changing governments without the rule of law results in uncertainty leads to less investment in physical
and human capital. In many nations civil war, military dictatorship, and anarchy have destroyed the
institutions necessary for economic growth.

Dependable Legal System

A good legal system facilitates contracts and protects property from others including government.
Poorly protected property rights can result from too much government or too little government. The
legal system in some governments is so poor that no one knows who owns what.

Competitive and Open Markets

Competitive and Open Markets encourage the efficient organization of resources. About half the
differences in per capita income across countries is explained by a failure to use capital efficiently.

Poor countries use their capital inefficiently because of inefficient and unnecessary regulations, create
monopolies, impede markets, expensive red tape increases time and cost.

Example: until recently in India, it was illegal to produce shirts using large-scale production.