ECONOMIC GROWTH

Week11-12
 outline
 Theories of Economic Growth
 The Challenge of Economic
Development
 Definition of Economic Growth

 Economic growth represent the expansion

of country’s potential GDP or national
output.
› Economic growth occurs when a nation’s
production possibility frontier (PPF) shift
outward.
› A closely related concept is the growth in
output per capita, because it is associated
with rising average real incomes and living
standards.
 The Four Wheels of Growth, or
Factors of Growth

 Human resources: labor supply,

education, discipline, motivation.
 Natural resources: land, mineral, fuels,
environmental quality.
 Capital formation: machines, factories,
roads, intellectual property, social
overhead capital
 Technology: science, engineering,
management, entrepreneurship.
 Aggregate Production Function

 APF shows the relationship between inputs

and technology, and total national output.
Q = A F(K,L,R)
Where Q = output, K = capital, L = labor,
R=natural resources, A= level of technology
› As technology (A) improves through new
invention or the adoption of technologies from
abroad, this advance allows a country to
produce more output with the same level of
inputs
 Theories of Economic
Growth

A. The Classical Dynamics of Smith and

Malthus
B. Economic Growth with Capital
Accumulation: The Neoclassical Model
C. New Growth Theory
 The Classical Dynamics of Smith
and Malthus

 Land is primary factor in economic growth

 lands is freely available
 When population doubles, national output
exactly doubles
 as population growth continues, all land will be
occupied
 increasing man-land ratio leads to a declining
marginal product of labor and hence to declining
real wages
 The Classical Dynamics
of Smith and Malthus
 T.R. Malthus thought that population
pressures would drive the economy to
a point where worker were at the
minimum level of subsistence.
› whenever wages were above the
subsistence level, population would
expand,
› Wage below subsistence level would lead
to high mortality and population decline
› Thus, only at subsistence wages could
there be a stable equilibrium of population
The Classical Dynamics of
Smith and Malthus
QC QC

400
300

L=4
200 200
L=4
L=2
L=2

100 200 QF 100 125 QF

(a) Smith’s Golden Age (b) Malthus’s Dismal Science

The Neoclassical Growth
Theory
 The major ingredients in the
Neoclassical model are capital and
technological change.
 Capital consists of durable goods,
including factories and house,
equipment, inventories of finished
goods an goods in process.
 The Neoclassical Growth
Theory
Assumptions
 The economy is competitive and always
operate at full employment
 A production function has constant
returns to scale if, for any positive number
x,
xQ = A F(xL, xK)
 That is, a doubling of all inputs causes the
amount of output to double as well.
 The Neoclassical Growth
Theory
› Setting x = 1/L,
› Q/ L = A F(1, K/ L)
Where:
Q/L = output per worker
K/L = capital per worker, or
 The preceding equation says that
productivity (Q/L) depends on physical
capital per worker, or the capital –labor
ratio(K/L)as well as the state of
technology, (A).
 The Neoclassical Growth
Theory
 In the absence of technological
change, capital deepening will increase
› output per worker
› marginal product of labor
› real wages
› and also will lead to diminishing returns
to capital
 The Neoclassical Growth
Theory
 as the amount of
capital per worker
increases, output
per worker also
increases
 as capital
deepening the
marginal product
of capital will fall
 The Neoclassical Growth
Theory
 In the long-run,
the economy
enter a steady
state in which
capital deepening
cases, output per
worker eventually
stop rising (at V
in the figure)
 The Neoclassical Growth
Theory
 Technological
progress shift the
APF upward,
raises output per
worker
 Thus, new steady
state with higher
level output per
worker can be
achieved
 New Growth Theory

 This theory is also called

Endogenous Growth Theory
 The new growth theory seeks to
uncover the processes by which
private market forces, public policy
decisions, and alternative institution
lead to different patterns of
technological change.
 New Growth Theory

 This approach emphasizes that

technological change is an output that
is subject to severe market failures
because technology is a public good
that is expensive to produce but cheap
to reproduce.
 New Growth Theory

 The new growth theory has changed

the way we think about the growth
process and public policies.
› If technological differences are the major
reason for differences in living standard
among nations, and if technology is a
produced factor, then economic-growth
policy should focus much more sharply on
how nations can improve their
technological performance.
 The sources of Economic
Growth
Growth Accounting Approach (GAA)
 According to this approach, growth in
output(Q) can be decomposed into three
separate terms: growth in labor (L) times
it weight, growth in capital (L) times it
weight, and technological change (TC)
 The sources of Economic
Growth
 Suppose that labor’s growth are gets 3
times the weight of capital’s growth, then
equation of growth accounting:
% Q growth = ¾ (% L growth) + ¼ (% K growth)
+ TC
Where:
› TC represents technological change (or Total
Factor Productivity = TFP) that raises
productivity
› ¾ and ¼ are the relative contributions of each
input to economic growth (or equal to the
shares of national income of the two factors)
 The sources of Economic
Growth
 How capital deepening would effect per
capita output if technological advance were
zero?
% Q/L growth = % Q growth - % L Growth
since,
% Q growth = ¾ (% L growth) + ¼ (% K growth) + TC
thus,
% Q/L growth = ¼ (% K growth) + TC
› Output per worker would grow only one-fourth
as fast as capital per worker, reflecting
diminishing returns
 The sources of Economic
Growth
 How can we measure technological
change (TC)?
Recall:
% Q growth = ¾ (% L growth) + ¼ (% K growth) +
TC
thus,
TC = % Q growth - ¾ (% L growth) - ¼ (% K
growth)
 The Challenge of
Economic Development

A. Aspects of a Developing Countries

B. Policy to promote economic growth
Aspects of A Developing
Countries
 The most important characteristic of a
developing countries
› Low per capita income
› Poor health
› Low level of literacy
› Extensive malnutrition
› Little capital to work with
› Weak market and government institution
› Corruption and civil strife
› High population growth, but they suffer from out-
migration, particularly among skilled worker
Aspects of A Developing
Countries
Aspects of A Developing
Countries
Aspects of A Developing
Countries
 Poor countries face great obstacles in
combining factors of growth,
 In addition, this countries find that the
difficulties reinforce each other in a
vicious cycle of poverty,
 Countries that suffer from a vicious
cycle can get caught in a poverty trap
The Vicious Cycle of
Poverty
The Poverty Traps
Policy to Promote
Economic Growth
 The quality of human resources
› Control disease and improve health and
nutrition
› Improve education, reduce illiteracy, and
train workers
 capital accumulation
› Encourage saving and investment
› Encourage investment from abroad
Important to note:
 Investment from abroad takes several
forms:
› Foreign Direct Investment
 Capital investment owned and operated by a
foreign entity.
› Foreign Portfolio Investment
 Investments financed with foreign money
but operated by domestic residents.
Important to note:

Diminishing Returns and the Catch-Up

Effect
 As the stock of capital rises, the extra output
produced from an additional unit of capital
falls; this property is called diminishing
returns.
› Because of diminishing returns, an increase in the
saving rate leads to higher growth only for a while
 The catch-up effect refers to the property
whereby countries that start off poor tend to
grow more rapidly than countries that start
off rich.
Policy to Promote Economic
Growth
 Technological progress
› Promote research and development
› Encourage the development of new
technologies through research grants, tax
breaks, and the patent system
› Promote an entrepreneurship spirit
› Maintain an economy open to trade
› Imitating technology???
Policy to Promote Economic
Growth
 Other policies
› Foster the rule of law
› Make the critical investment in social
overhead capital
Strategies of Economic
Development
 We see how countries must combine
labor, capital, natural resources and
technology in order to grow rapidly
 but, how countries might break out of
the vicious cycle of poverty and begin
to mobilize the four wheels of
economic development.
Strategies of Economic
Development
 The Backwardness Hypothesis:
“relative backwardness itself may aid
development”
1. Countries buy modern textile, machinery, etc,
2. They can lean on the technologies of
advanced countries ,
3. They can draw upon the more productive
technologies of the leader
4. They can grow more rapidly than did
advanced countries
Strategies of Economic
Development
 Industrialization vs. Agriculture
› The lesson of decades of attempts to
accelerate industrialization at the expense of
agriculture has led many analysts to rethink
the role of farming
› Industrialization is capital-intensive, attracts
workers into crowded cities, and often
produces high levels of unemployment
› Raising productivity on farms may require less
capital, while providing productive
employment for surplus labor
Strategies of Economic
Development
 State vs. Market
› The cultures of many developing countries are
hostile on the operation of markets
› Competition among firms or profit seeking
behavior is contrary to traditional practices,
religious beliefs, or vested interests
› Yet decades of experience suggest that
extensive reliance on markets provides the
most effective way of managing and
promoting rapid economic growth.
Strategies of Economic
Development
 Growth and Outward Orientation
› Outward orientation or openness allowed the
countries to reap economies of scale and the
benefits of international specialization and
thus to increase employment, use domestic
resources effectively, enjoy rapid productivity
growth, and provide enormous gains in living
standards.
Thank you