PART 7
CHAPTER 19
How do economies grow and flourish?©Martin Ruegner/Photodisc/Getty Images
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Show how small differences in growth rates can lead to large differences in living standards.
2. LO2Explain why GDP per capita is the product of average labor productivity and the proportion of the population that is employed and use this decomposition to discuss the sources of economic growth.
3. LO3List the determinants of average labor productivity within a particular country and use these concepts to analyze per capita GDP differences across countries.
4. LO4Identify the costs of increasing economic growth.
5. LO5Evaluate government policies that promote economic growth.
6. LO6Analyze whether having finite resources implies that there are limits to growth.
One of us once attended a conference on the effects of economic growth and development on society. A speaker at the conference posed the following question: “Which would you rather be? An ordinary, middle-class American living today, or the richest person in America at the time of George Washington?”
A member of the audience spoke out immediately: “I can answer that question in one word. Dentistry.”
The answer drew a laugh, perhaps because it reminded people of George Washington’s famous wooden teeth. But it was a good answer. Dentistry in early America—whether the patient was rich or poor—was a primitive affair. Most dentists simply pulled a patient’s rotten teeth, with a shot of whiskey for anesthetic.
Other types of medical care were not much better than dentistry. Eighteenth-century doctors had no effective weapons against tuberculosis, typhoid fever, diphtheria, influenza, pneumonia, and other communicable diseases. Such illnesses, now quite treatable, were major killers in Washington’s time. Infants and children were particularly susceptible to deadly infectious diseases, especially whooping cough and measles. Even a well-to-do family often lost two or three children to these illnesses. Washington, an unusually large and vigorous man, lived to the age of 67, but the average life expectancy during his era was probably not much more than 40 years.
Medical care is not the only aspect of ordinary life that has changed drastically over the past two centuries. Author Stephen Ambrose, in his account of the Lewis and Clark expedition, described the limitations of transportation and communication in early America:
A critical fact in the world of 1801 was that nothing moved faster than the speed of a horse. No human being, no manufactured item, no bushel of wheat, no side of beef (or any beef on the hoof for that matter), no letter, no information, no idea, order, or instruction of any kind moved faster, and, as far as Jefferson’s contemporaries were able to tell, nothing ever would.
And except on a racetrack, no horse moved very fast. Road conditions in the United States ranged from bad to abominable, and there weren’t very many of them. The best highway in the country ran from Boston to New York; it took a light stagecoach . . . three full days to make the 175-mile journey. The hundred miles from New York to Philadelphia took two full days.1
Today, New Yorkers can go to Philadelphia by train in slightly more than an hour. What would George Washington have thought of that? And how would nineteenth-century pioneers, who crossed the continent by wagon train, have reacted to the idea that their great-grandchildren would be able to have breakfast in New York and lunch the same day in San Francisco?
No doubt you can think of other enormous changes in the way average people live, even over the past few decades. The Internet, mobile and cloud computing, tablets and smartphones have changed the ways people work and study in just a few years, for example. Though these changes are due in large part to scientific advances, scientific discoveries by themselves usually have little effect on most people’s lives. New scientific knowledge leads to widespread improvements in living standards only when it is commercially applied. Better understanding of the human immune system, for example, has little impact unless it leads to new therapies or drugs. And a new drug will do little to help unless it is affordable to those who need it.
An illustration of this point—with both tragic and more optimistic aspects—is the AIDS epidemic in Africa. Although some new drugs that moderate the effects of the virus that causes AIDS were developed in the late 1990s, they were so expensive that they were of little practical value in poverty-stricken African nations grappling with the disease. And even if affordable, the drugs would have limited benefit without modern hospitals, trained health professionals, and adequate nutrition and sanitation. Nowadays, more than 20 years after the first effective treatments were developed, around a million people a year still die from AIDS. But this number is finally declining. The reversal resulted from a combination of the scientific discovery of new potential treatments and their effective implementation through international aid programs funded by industrialized countries.2 In short, most improvements in a nation’s living standard are the result not just of scientific and technological advances, but of an economic system that makes the benefits of those advances available to the average person.
Would you rather be a rich person living in the eighteenth century or a middle-class person living in the twenty-first century?
In this chapter, we will explore the sources of economic growth and rising living standards in the modern world. We will begin by reviewing the remarkable economic growth in the industrialized countries, as measured by real GDP per person. Since the mid-nineteenth century (and earlier in some countries), a radical transformation in living standards has occurred in these countries. What explains this transformation? The key to rising living standards is a continuing increase in average labor productivity, which depends on several factors, from the skills and motivation workers bring to their jobs to the legal and social environment in which they work. We will analyze each of these factors and discuss its implications for government policies to promote growth. We will then discuss the costs of rapid economic growth and consider whether there may be limits to the amount of economic growth a society can achieve.
THE REMARKABLE RISE IN LIVING STANDARDS: THE RECORD
For millennia, the great majority of the world’s inhabitants eked out a meager existence by tilling the soil. Only a small proportion of the population lived above the level of subsistence, learned to read and write, or traveled more than a few miles from their birthplaces. Large cities grew up, serving as imperial capitals and centers of trade, but the great majority of urban populations lived in dire poverty, subject to malnutrition and disease.
Then, about three centuries ago, a fundamental change occurred. Spurred by technological advances and entrepreneurial innovations, a process of economic growth began. Sustained over many years, this growth in the economy’s productive capacity has transformed almost every aspect of how we live—from what we eat and wear to how we work and play.
The advances in health care and transportation mentioned in the beginning of this chapter illustrate only a few of the impressive changes that have taken place in people’s material well-being over the past two centuries, particularly in industrialized countries like the United States. To study the factors that affect living standards systematically, however, we must go beyond anecdotes and adopt a specific measure of economic well-being in a particular country and time.
In Chapter 17, Measuring Economic Activity: GDP and Unemployment, we introduced the concept of real GDP as a basic measure of the level of economic activity in a country. Recall that, in essence, real GDP measures the physical volume of goods and services produced within a country’s borders during a specific period, such as a quarter or a year. Consequently, real GDP per person provides a measure of the quantity of goods and services available to the typical resident of a country at a particular time. Although real GDP per person is certainly not a perfect indicator of economic well-being, as we will see later in this chapter, it is positively related to a number of pertinent variables, such as life expectancy, infant health, and literacy. Lacking a better alternative, economists have focused on real GDP per person as a key measure of a country’s living standard and stage of economic development.
Figure 19.1, which reproduces the blue line from Figure 16.2, shows the remarkable growth in real GDP per person that occurred in the United States between 1929 and 2016. For comparison, Table 19.1 and Figure 19.2 show real GDP per person in eight countries in selected years from 1870 to 2010.
FIGURE 19.1 Real GDP per Person in the United States, 1929–2016.The red line shows the real GDP per person in the U.S. economy since 1929. Real GDP per person today is almost six times what it was 1929.Source: Bureau of Economic Analysis, www.bea.gov.
The data in Table 19.1 and Figure 19.2 tell a dramatic story. For example, in the United States (which was already a relatively wealthy industrialized country in 1870), real GDP per person grew more than 12-fold between 1870 and 2010. In Japan, real GDP per person grew almost 30 times over the same period. Underlying these statistics is an amazingly rapid process of economic growth and transformation, through which, in just a few generations, relatively poor agrarian societies became highly industrialized economies—with average standards of living that could scarcely have been imagined in 1870. As Figure 19.2 shows, a significant part of this growth has occurred since 1950, particularly in Japan and China. Further, both China and India have grown significantly faster since 1990 than they did in earlier periods.
FIGURE 19.2 Real GDP per Person in a Sample of Countries, 1870–2010.The United States, the United Kingdom, and Germany began with high levels of GDP per person in 1870 and remained high-income countries throughout the period. Economic growth has been especially rapid since the 1950s in Japan and since 1980 in China and India. Ghana and the rest of sub-Saharan Africa experienced very low growth rates.
A note of caution is in order. The farther back in time we go, the less precise are historical estimates of real GDP. Most governments did not keep official GDP statistics until after World War II; production records from earlier periods are often incomplete or of questionable accuracy. Comparing economic output over a century or more is also problematic because many goods and services that are produced today were unavailable—indeed, inconceivable—in 1870. How many nineteenth-century horse-drawn wagons, for example, would be the economic equivalent of a BMW i8 plug-in hybrid sports car or a Boeing 787 Dreamliner jet? Despite the difficulty of making precise comparisons, however, we can say with certainty that the variety, quality, and quantity of available goods and services increased enormously in industrialized countries during the nineteenth and twentieth centuries, a fact reflected in the data on real GDP per capita.
WHY “SMALL” DIFFERENCES IN GROWTH RATES MATTER
The last three columns of Table 19.1 show annual growth rates of real GDP per person for both the entire 1870–2010 period and two more recent periods. At first glance, these growth rates don’t seem to differ much from country to country. For example, for the period 1870–2010, the highest growth rate is 2.5 percent (Japan) and the lowest is 1.1 percent (Ghana).
But consider the long-run effect of this seemingly “small” difference in annual growth rates. For example, in 1870 China’s output per person was roughly 120 percent that of Ghana, yet by 2010 China had more than four times the output per person of Ghana. This widening of the gap between these two countries is the result of the difference between China’s 2.0 percent annual growth rate and Ghana’s 1.1 percent annual growth rate, maintained for almost 140 years. The fact that what seem to be small differences in growth rates can have large long-run effects results from what is called the power of compound interest. A good illustration of this power is the effect of compound interest on a bank deposit.
EXAMPLE 19.1Compound Interest: Part 1
What is compound interest?
In 1815, one of your ancestors deposited $10.00 in a checking account at 4 percent interest. Interest is compounded annually (so that interest paid at the end of each year receives interest itself in later years). Your ancestor’s will specified that the account be turned over to his most direct descendant (you) in the year 2015. When you withdrew the funds in that year, how much was the account worth?
The account was worth $10.00 in 1815; $10.00 × 1.04 = $10.40 in 1816; $10.00 × 1.04 × 1.04 = $10.00 × (1.04)2 = $10.82 in 1817; and so on. Since 200 years elapsed between 1815, when the deposit was made, and the year 2015, when the account was closed, the value of the account in the year 2015 was $10.00 × (1.04)200, or $10.00 × 1.04 to the 200th power. Using a calculator, you will find that $10.00 times 1.04 to the 200th power is $25,507.50—a good return for a $10.00 deposit!
Compound interest—an arrangement in which interest is paid not only on the original deposit but on all previously accumulated interest—is distinguished from simple interest, in which interest is paid only on the original deposit. If your ancestor’s account had been deposited at 4 percent simple interest, it would have accumulated only 40 cents each year (4 percent of the original $10.00 deposit), for a total value of $10.00 + 200 × $0.40 = $90.00 after 200 years. The tremendous growth in the value of his account came from the compounding of the interest—hence the phrase “the power of compound interest.”
EXAMPLE 19.2Compound Interest: Part 2
What is the difference between 2 percent interest and 6 percent interest, compounded annually?
Refer to Example 19.1. What would your ancestors’ $10.00 deposit have been worth after 200 years if the annual interest rate had been 2 percent? 6 percent?
At 2 percent interest the account would be worth $10.00 in 1815; $10.00 × 1.02 = $10.20 in 1816; $10.00 × (1.02)2 = $10.40 in 1817; and so on. In the year 2015, the value of the account would be $10.00 × (1.02)200, or $524.85. If the interest rate were 6 percent, after 200 years the account would be worth $10.00 × (1.06)200, or $1,151,259.04. Let’s summarize the results of Examples 19.1 and 19.2:
The power of compound interest is that even at relatively low rates of interest, a small sum, compounded over a long enough period, can greatly increase in value. A more subtle point, illustrated by this example, is that small differences in interest rates matter a lot. The difference between a 2 percent and a 4 percent interest rate doesn’t seem tremendous, but over a long period of time it implies large differences in the amount of interest accumulated on an account. Likewise, the effect of switching from a 4 percent to a 6 percent interest rate is enormous, as our calculations show.
Economic growth rates are similar to compound interest rates. Just as the value of a bank deposit grows each year at a rate equal to the interest rate, so the size of a nation’s economy expands each year at the rate of economic growth. This analogy suggests that even a relatively modest rate of growth in output per person—say, 1 to 2 percent per year—will produce tremendous increases in average living standard over a long period. And relatively small differences in growth rates, as in the case of Ghana and China, will ultimately produce very different living standards.
Economists employ a useful formula for approximating the number of years it will take for an initial amount to double at various growth or interest rates. The formula is 72 divided by the growth or interest rate. Thus, if the interest rate is 2 percent per year, it will take roughly 72/2 = 36 years for the initial sum to double. If the interest rate is 4 percent, it will take roughly 72/4 = 18 years. This formula is a good approximation only for small and moderate interest rates. Over the long run, then, the rate of economic growth is an extremely important variable. Hence, government policy changes or other factors that affect the long-term growth rate even by a small amount will have a major economic impact.
CONCEPT CHECK 19.1
Suppose that real GDP per capita in the United States had grown at 2.5 percent per year, as Japan’s did, instead of the actual 1.8 percent per year, from 1870 to 2010. How much larger would real GDP per person have been in the United States in 2010?
RECAP
THE REMARKABLE RISE IN LIVING STANDARDS
Real GDP per person, a basic indicator of living standards, has grown dramatically in the industrialized countries. This growth reflects the power of compound interest: Even a modest growth rate, if sustained over a long period of time, can lead to large increases in the size of the economy.
WHY NATIONS BECOME RICH: THE CRUCIAL ROLE OF AVERAGE LABOR PRODUCTIVITY
What determines a nation’s economic growth rate? To get some insight into this vital question, we will find it useful to express real GDP per person as the product of two terms: average labor productivity and the share of the population that is working.
To do this, let Y equal total real output (as measured by real GDP, for example), N equal the number of employed workers, and POP equal the total population. Then real GDP per person can be written as Y/POP; average labor productivity, or output per employed worker, equals Y/N; and the share of the population that is working is N/POP. The relationship between these three variables is
which, as you can see by canceling out N on the right-hand side of the equation, always holds exactly. In words, this basic relationship is
This expression for real GDP per person tells us something very basic and intuitive: The quantity of goods and services that each person can consume depends on (1) how much each worker can produce and (2) how many people (as a fraction of the total population) are working. Furthermore, because real GDP per person equals average labor productivity times the share of the population that is employed, real GDP per person can grow only to the extent that there is growth in worker productivity and/or the fraction of the population that is employed.
Figures 19.3 and 19.4 show the U.S. figures for the three key variables in the relationship above and for a fourth variable that was mentioned in Chapter 17, Measuring Economic Activity: GDP and Unemployment (the labor force participation rate), for the period 1960–2016. Figure 19.3, which reproduces part of Figure 16.2, shows both real GDP per person and real GDP per worker (average labor productivity). Figure 19.4 shows the portion of the entire U.S. population (not just the working-age population) that was employed, and the portion of the (civilian, noninstitutional) adult population (16+) that participated in the labor force during that period. Once again, we see that the expansion in output per person in the United States has been impressive. Between 1960 and 2016, real GDP per person in the United States tripled, growing by 200 percent. Thus in 2016, the average American enjoyed three times as many goods and services as in 1960. Figures 19.3 and 19.4 show that until the year 2000 or so, increases in both labor productivity and the share of the population holding a job contributed to this rise in living standard. But as Figure 19.4 shows, more recently things have changed.
FIGURE 19.3 Real GDP per Person and Average Labor Productivity in the United States, 1960–2016.Real GDP per person in the United States grew 200 percent between 1960 and 2016, and real GDP per worker (average labor productivity) grew by 133 percent.Source: Federal Reserve Bank of St. Louis Economic Research, https://fred.stlouisfed.org.
Let’s look a bit more closely at these two contributing factors, beginning with the share of the population that is employed. As Figure 19.4 shows, between 1960 and 2000, the number of people employed in the United States rose from 36 to more than 48 percent of the entire population, a remarkable increase. The growing tendency of women to work outside the home was the most important reason for this rise in employment. Another factor leading to higher rates of employment was an increase in the share of the general population that is of working age (ages 16 to 65). The coming of age of the “baby boom” generation, born in the years after World War II, and to a lesser extent the immigration of young workers from other countries helped cause this growth in the workforce.
FIGURE 19.4 Share of the U.S. Population Employed and Labor Force Participation Rate, 1960–2016.The share of the U.S. population holding a job increased from 36 percent in 1960 to more than 48 percent in 2000 and was 47 percent in 2016. The labor force participation rate increased from 59 percent in 1960 to 67 percent in the late 1990s; since 2000, it has been declining, falling below 63 percent in recent years.Source: Federal Reserve Bank of St. Louis Economic Research, https://fred.stlouisfed.org.
Although the rising share of the U.S. population with jobs contributed significantly to the increase in real GDP per person during the last four decades of the twentieth century, that trend has started to reverse. The reversal is more apparent when looking at the labor force participation rate, which differs from the share of the population with jobs in two ways. First, rather than counting only people with jobs, it counts also people looking for a job. In other words, rather than counting only the employed, it counts both the employed and the unemployed—the entire labor force. The size of the labor force is more stable year to year than the number of people with jobs (because during expansions and recessions, many people move in and out of employment without moving in and out of the labor force). Indeed, in Figure 19.4 the labor force participation rate fluctuates less than the other curve, making the reversal (around the year 2000) of the long-term trend more apparent.
The second difference between the labor force participation rate and the share of the population with jobs is that the labor force participation rate is the labor force as a share of only the (civilian noninstitutional) adult population. Economists are interested in this share because it tells them what portion of those in the population who could in principle be in the labor force are, in fact, in the labor force. (Notice that relative to the share of the population with jobs, the labor force participation rate counts more people, and reports their number as a share of a smaller population. For these two reasons, it is always higher than the share of people employed.)
The labor force participation rate increased from below 60 percent in 1960 to more than 67 percent in the late 1990s, and then leveled off. Since 2000, it has been on a steady decline, and in 2014, it fell to below 63 percent—for the first time since 1977. Some of the factors that we discussed earlier when explaining the increase in employed people prior to 2000 also explain the decline after 2000. The baby boomers have been aging and have recently started retiring. The participation rate of women could not increase forever, and it eventually leveled off. But the aging population and women cannot be the whole explanation because participation has been on a long-term decline also among younger men. Economists are still trying to understand all the reasons. Potential explanations include young people staying longer in school—and spending more time on schoolwork while in school—and a decline in the demand for workers with certain skills and education. We will return to these issues in the next chapter, where we use supply and demand analysis to understand long-term trends in the labor market. For now, we note that the recent downward trends in Figure 19.4 are expected to continue in the future. In the long run, then, the improvement in living standards brought about by the rising share of Americans with jobs was transitory.
What about the other factor that determines output per person, average labor productivity? As Figure 19.3 shows, between 1960 and 2016, average labor productivity in the United States increased by 133 percent, accounting for a sizable share of the overall increase in GDP per person. In other periods, the link between average labor productivity and output per person in the United States has often been even stronger because, in most earlier periods, the share of the population holding jobs was more stable than it has been recently. (See Figure 16.2 for the behavior of real GDP per person and average labor productivity in the United States over the period 1929–2016.)
This quick look at recent data supports a more general conclusion. In the long run, increases in output per person arise primarily from increases in average labor productivity. In simple terms, the more people can produce, the more they can consume. To understand why economies grow, then, we must understand the reasons for increased labor productivity.
RECAP
THE CRUCIAL ROLE OF AVERAGE LABOR PRODUCTIVITY
Output per person equals average labor productivity times the share of the population that is employed. Since 1960, the share of the U.S. population with jobs has risen significantly, but it has declined since 2000. In the long run, increases in output per person and hence living standards arise primarily from increases in average labor productivity.
THE DETERMINANTS OF AVERAGE LABOR PRODUCTIVITY
What determines the productivity of the average worker in a particular country at a particular time? Popular discussions of this issue often equate worker productivity with the willingness of workers of a given nationality to work hard. Everything else being equal, a culture that promotes hard work certainly tends to increase worker productivity. But intensity of effort alone cannot explain the huge differences in average labor productivity that we observe around the world. For example, according to 2016 estimates from the International Labor Organization, average labor productivity in the United States is about 24 times what it is in Indonesia and 53 times what it is in Bangladesh, though there is little doubt that Indonesians and Bangladeshis work very hard.
In this section, we will examine six factors that appear to account for the major differences in average labor productivity, both between countries and between generations. Later in the chapter we will discuss how economic policies can influence these factors to spur productivity and growth.
HUMAN CAPITAL
To illustrate the factors that determine average labor productivity, we introduce two prototypical assembly-line workers, Lucy and Ethel.
EXAMPLE 19.3Assembly-Line Productivity
Are Lucy and Ethel more productive as a team or by themselves?
Lucy and Ethel have jobs wrapping chocolate candies and placing them into boxes. Lucy, a novice wrapper, can wrap only 100 candies per hour. Ethel, who has had on-the-job training, can wrap 300 candies per hour. Lucy and Ethel each work 40 hours per week. Find average labor productivity, in terms of candies wrapped per week and candies wrapped per hour, (a) for Lucy, (b) for Ethel, and (c) for Lucy and Ethel as a team.
How productive are these workers?©CBS via Getty Images
We have defined average labor productivity in general terms as output per worker. Note, though, that the measurement of average labor productivity depends on the time period that is specified. For example, the data presented in Figure 19.3 tell us how much the average worker produces in a year. In this example we are concerned with how much Lucy and Ethel can produce per hour of work or per week of work. Any one of these ways of measuring labor productivity is equally valid, as long as we are clear about the time unit we are using.
Lucy’s and Ethel’s hourly productivities are given in the problem: Lucy can wrap 100 candies per hour and Ethel can wrap 300. Lucy’s weekly productivity is (40 hours/week) × (100 candies wrapped/hour) = 4,000 wrapped candies per week. Ethel’s weekly productivity is (40 hours/week) × (300 candies wrapped/hour), or 12,000 candies per week.
Together Lucy and Ethel can wrap 16,000 candies per week. As a team, their average weekly productivity is (16,000 candies wrapped)/(2 weeks of work), or 8,000 candies per week. Their average hourly productivity as a team is (16,000 candies wrapped)/(80 hours of work) = 200 candies per hour. Notice that, taken as a team, the two women’s productivity lies midway between their individual productivities.
Ethel is more productive than Lucy because she has had on-the-job training, which has allowed her to develop her candy-wrapping skills to a higher level than Lucy’s. Because of her training, Ethel can produce more than Lucy can in a given number of hours.
CONCEPT CHECK 19.2
Suppose Ethel attends additional classes in candy wrapping and learns how to wrap 500 candies per hour. Find the output per week and output per hour for Lucy and Ethel, both individually and as a team.
Economists would explain the difference in the two women’s performance by saying that Ethel has more human capital than Lucy. Human capital comprises the talents, education, training, and skills of workers. Workers with a large stock of human capital are more productive than workers with less training. For example, an auto mechanic who is familiar with computerized diagnostic equipment will be able to fix engine problems that less well-trained mechanics could not.
The Economic Naturalist 19.1
Why did West Germany and Japan recover so successfully from the devastation of World War II?
Germany and Japan sustained extensive destruction of their cities and industries during World War II and entered the postwar period impoverished. Yet within 30 years, both countries not only had been rebuilt, but had become worldwide industrial and economic leaders. What accounts for these “economic miracles”?
Many factors contributed to the economic recovery of West Germany and Japan from World War II, including the substantial aid provided by the United States to Europe under the Marshall Plan and to Japan during the U.S. occupation. Most economists agree, however, that high levels of human capital played a crucial role in both countries.
At the end of the war, Germany’s population was exceptionally well educated, with a large number of highly qualified scientists and engineers. The country also had (and still does today) an extensive apprentice system that provided on-the-job training to young workers. As a result, Germany had a skilled industrial workforce. In addition, the area that became West Germany benefited substantially from an influx of skilled workers from East Germany and the rest of Soviet-controlled Europe, including 20,000 trained engineers and technicians. Beginning as early as 1949, this concentration of human capital contributed to a major expansion of Germany’s technologically sophisticated, highly productive manufacturing sector. By 1960, West Germany was a leading exporter of high-quality manufactured goods, and its citizens enjoyed one of the highest standards of living in Europe.
Japan, which probably sustained greater physical destruction in the war than Germany, also began the postwar period with a skilled and educated labor force. In addition, occupying American forces restructured the Japanese school system and encouraged all Japanese to obtain a good education. Even more so than the Germans, however, the Japanese emphasized on-the-job training. As part of a lifetime employment system, under which workers were expected to stay with the same company their entire career, Japanese firms invested extensively in worker training. The payoff to these investments in human capital was a steady increase in average labor productivity, particularly in manufacturing. By the 1980s, Japanese manufactured goods were among the most advanced in the world and Japan’s workers among the most skilled.
Although high levels of human capital were instrumental in the rapid economic growth of West Germany and Japan, human capital alone cannot create a high living standard. A case in point is Soviet-dominated East Germany, which had a level of human capital similar to West Germany’s after the war but did not enjoy the same economic growth. For reasons we will discuss later in the chapter, the communist system imposed by the Soviets utilized East Germany’s human capital far less effectively than the economic systems of Japan and West Germany.
Human capital is analogous to physical capital (such as machines and factories) in that it is acquired primarily through the investment of time, energy, and money. For example, to learn how to use computerized diagnostic equipment, a mechanic might need to attend a technical school at night. The cost of going to school includes not only the tuition paid but also the opportunity cost of the mechanic’s time spent attending class and studying. The benefit of the schooling is the increase in wages the mechanic will earn when the course has been completed. We know by the Cost-Benefit Principle that the mechanic should learn how to use computerized diagnostic equipment only if the benefits exceed the costs, including the opportunity costs. In general, then, we would expect to see people acquire additional education and skills when the difference in the wages paid to skilled and unskilled workers is significant.
Cost-Benefit
PHYSICAL CAPITAL
Workers’ productivity depends not only on their skills and effort, but on the tools they have to work with. Even the most skilled surgeon cannot perform open-heart surgery without sophisticated equipment, and an expert computer programmer is of limited value without a computer. These examples illustrate the importance of physical capital, such as factories and machines. More and better capital allows workers to produce more efficiently, as Example 19.4 shows.
EXAMPLE 19.4Physical Capital and Efficiency
Will the introduction of a candy-wrapping machine make Lucy and Ethel more productive?
Continuing with Example 19.3, suppose that Lucy and Ethel’s boss acquires an electric candy-wrapping machine, which is designed to be operated by one worker. Using this machine, an untrained worker can wrap 500 candies per hour. What are Lucy’s and Ethel’s hourly and weekly outputs now? Will the answer change if the boss gets a second machine? A third?
Suppose for the sake of simplicity that a candy-wrapping machine must be assigned to one worker only. (This assumption rules out sharing arrangements, in which one worker uses the machine on the day shift and another on the night shift.) If the boss buys just one machine, she will assign it to Lucy. (Why? Solve Concept Check 19.3.) Now Lucy will be able to wrap 500 candies per hour, while Ethel can wrap only 300 per hour. Lucy’s weekly output will be 20,000 wrapped candies (40 hours × 500 candies wrapped per hour). Ethel’s weekly output is still 12,000 wrapped candies (40 hours × 300 candies wrapped per hour). Together they can now wrap 32,000 candies per week, or 16,000 candies per week each. On an hourly basis, average labor productivity for the two women taken together is 32,000 candies wrapped per 80 hours of work, or 400 candies wrapped per hour—twice their average labor productivity before the boss bought the machine.
With two candy-wrapping machines available, both Lucy and Ethel could use a machine. Each could wrap 500 candies per hour, for a total of 40,000 wrapped candies per week. Average labor productivity for both women taken together would be 20,000 wrapped candies per week, or 500 wrapped candies per hour.
What would happen if the boss purchased a third machine? With only two workers, a third machine would be useless: It would add nothing to either total output or average labor productivity.
CONCEPT CHECK 19.3
Using the assumptions made in Examples 19.3 and 19.4, explain why the boss should give the single available candy-wrapping machine to Lucy rather than Ethel. (Hint: Apply the Principle of Increasing Opportunity Cost, introduced in Chapter 2, Comparative Advantage.)
Increasing Opportunity Cost
The candy-wrapping machine is an example of a capital good, which was defined in Chapter 17, Measuring Economic Activity: GDP and Unemployment, as a long-lived good, which is itself produced and used to produce other goods and services. Capital goods include machines and equipment (such as computers, earthmovers, or assembly lines) as well as buildings (such as factories or office buildings).
Capital goods like the candy-wrapping machine enhance workers’ productivity. Table 19.2 summarizes the results from Examples 19.3 and 19.4. For each number of machines the boss might acquire (column 1), Table 19.2 gives the total weekly output of Lucy and Ethel taken together (column 2), the total number of hours worked by the two women (column 3), and average output per hour (column 4), equal to total weekly output divided by total weekly hours.
Table 19.2 demonstrates two important points about the effect of additional capital on output. First, for a given number of workers, adding more capital generally increases both total output and average labor productivity. For example, adding the first candy-wrapping machine increases weekly output (column 2) by 16,000 candies and average labor productivity (column 4) by 200 candies wrapped per hour.
The second point illustrated by Table 19.2 is that the more capital is already in place, the smaller the benefits of adding extra capital. Notice that the first machine adds 16,000 candies to total output, but the second machine adds only 8,000. The third machine, which cannot be used since there are only two workers, does not increase output or productivity at all. This result illustrates a general principle of economics, called diminishing returns to capital. According to the principle of diminishing returns to capital, if the amount of labor and other inputs employed is held constant, then the greater the amount of capital already in use, the less an additional unit of capital adds to production. In the case of the candy-wrapping factory, diminishing returns to capital imply that the first candy-wrapping machine acquired adds more output than the second, which in turn adds more output than the third.
Diminishing returns to capital are a natural consequence of firms’ incentive to use each piece of capital as productively as possible. To maximize output, managers will assign the first machine that a firm acquires to the most productive use available, the next machine to the next most productive use, and so on—an illustration of the Principle of Increasing Opportunity Cost. When many machines are available, all the highly productive ways of using them already have been exploited. Thus adding yet another machine will not raise output or productivity by very much. If Lucy and Ethel are already operating two candy-wrapping machines, there is little point to buying a third machine, except perhaps as a replacement or spare.
Increasing Opportunity Cost
The implications of Table 19.2 can be applied to the question of how to stimulate economic growth. First, increasing the amount of capital available to the workforce will tend to increase output and average labor productivity. The more adequately equipped workers are, the more productive they will be. Second, the degree to which productivity can be increased by an expanding stock of capital is limited. Because of diminishing returns to capital, an economy in which the quantity of capital available to each worker is already very high will not benefit much from further expansion of the capital stock.
LAND AND OTHER NATURAL RESOURCES
Besides capital goods, other inputs to production help to make workers more productive, among them land, energy, and raw materials. Fertile land is essential to agriculture, and modern manufacturing processes make intensive use of energy and raw materials.
In general, an abundance of natural resources increases the productivity of the workers who use them. For example, a farmer can produce a much larger crop in a land-rich country like the United States or Australia than in a country where the soil is poor or arable land is limited in supply. With the aid of modern farm machinery and great expanses of land, today’s American farmers are so productive that even though they constitute less than 1 percent of the workforce, they provide enough food not only to feed the country but to export to the rest of the world.
Although there are limits to a country’s supply of arable land, many other natural resources, such as petroleum and metals, can be obtained through international markets. Because resources can be obtained through trade, countries need not possess large quantities of natural resources within their own borders to achieve economic growth. Indeed, a number of countries have become rich without substantial natural resources of their own, including Japan, Hong Kong, Singapore, and Switzerland. Just as important as possessing natural resources is the ability to use them productively—for example, by means of advanced technologies.
TECHNOLOGY
Besides human capital, physical capital, and natural resources, a country’s ability to develop and apply new, more productive technologies will help to determine its productivity. Consider just one industry, transportation. Two centuries ago, as suggested by the quote from Stephen Ambrose in the beginning of the chapter, the horse and wagon were the primary means of transportation—a slow and costly method indeed. But in the nineteenth century, technological advances such as the steam engine supported the expansion of riverborne transportation and the development of a national rail network. In the twentieth century, the invention of the internal combustion engine and the development of aviation, supported by the construction of an extensive infrastructure of roads and airports, have produced increasingly rapid, cheap, and reliable transport. Technological change has clearly been a driving force in the transportation revolution.
New technologies can improve productivity in industries other than the one in which they are introduced. Once farmers could sell their produce only in their local communities, for example. Now the availability of rapid shipping and refrigerated transport allows farmers to sell their products virtually anywhere in the world. With a broader market in which to sell, farmers can specialize in those products best suited to local land and weather conditions. Similarly, factories can obtain their raw materials wherever they are cheapest and most abundant, produce the goods they are most efficient at manufacturing, and sell their products wherever they will fetch the best price. Both these examples illustrate the Principle of Comparative Advantage, that overall productivity increases when producers concentrate on those activities at which they are relatively most efficient.
Comparative Advantage
Numerous other technological developments led to increased productivity, including advances in communication and medicine, the introduction of computer technology, and most recently the emergence of global networks that connect mobile computing, communication, and even health devices around the world. In fact, most economists would probably agree that new technologies are the single most important source of productivity improvement and, hence, of economic growth in general.
However, economic growth does not automatically follow from breakthroughs in basic science. To make the best use of new knowledge, an economy needs entrepreneurs who can exploit scientific advances commercially, as well as a legal and political environment that encourages the practical application of new knowledge.
CONCEPT CHECK 19.4
A new kind of wrapping paper has been invented that makes candy-wrapping quicker and easier. The use of this paper increases the number of candies a person can wrap by hand by 200 per hour, and the number of candies a person can wrap by machine by 300 per hour. Using the data from Examples 19.3 and 19.4, construct a table like Table 19.2 that shows how this technological advance affects average labor productivity. Do diminishing returns to capital still hold?
The Economic Naturalist 19.2
Why did U.S. labor productivity grow so rapidly in the late 1990s?
During the 1950s and 1960s, most industrialized countries experienced rapid growth in real GDP and average labor productivity. Between 1948 and 1973, for example, U.S. labor productivity grew by 2.5 percent per year.3 Between 1973 and 1995, however, labor productivity growth in the United States fell by more than half to 1.1 percent per year. Other countries experienced similar productivity slowdowns, and many articles and books were written trying to uncover the reasons. Between 1995 and 2000, however, there was a rebound in productivity growth, particularly in the United States, where productivity grew 2.4 percent per year. What caused this resurgence in productivity growth? Can it be sustained?
Economists agree that the pickup in productivity growth between 1995 and 2000 was the product of rapid technological progress and increased investment in new information and communication technologies (ICT). Research indicates that productivity grew rapidly in both those industries that produced ICT, such as silicon chips and fiber optics, and those industries that most intensively used ICT. The application of these advances had ripple effects in areas ranging from automobile production to retail inventory management. The rapid growth of the Internet, for example, made it possible for consumers to shop and find information online. But it also helped companies improve their efficiency by improving coordination between manufacturers and their suppliers. On the other hand, there was no acceleration in labor productivity growth in those industries that neither produced nor used much ICT.4
Although technological progress continued after 2000, productivity growth slowed to 1.5 percent per year from 2000 to 2007, and to 1.0 percent per year from 2007 to 2016. Why? While economists are still trying to understand all the reasons, it appears that the gains in productivity in the 1990s, which came from both improved production of ICT equipment and its use in ICT-intensive industries, were followed by smaller gains coming from broader application of ICT to other industries. It is also possible that the implosion of the NASDAQ (the “dot-com collapse”) in 2000 and the mild recession of 2001 and, on a much larger scale, the global financial crisis and the recession of 2007–2009, contributed to slowing productivity growth. Indicators such as the number of new companies starting up and the amount invested in new technologies decreased somewhat during and following the 2001 recession and decreased dramatically during and following the 2007–2009 recession, impeding the introduction of new products and production techniques. In addition, the global financial crisis brought tighter credit conditions, making it difficult for companies to maintain or upgrade their equipment, and the high unemployment rates during and following the 2007–2009 recession may have caused the skills of some workers to deteriorate. If these factors are indeed the reason for the lower rates of productivity growth in recent years, then the higher rates of the late 1990s may return as the recovery from the crisis and the recession continues.
Optimists argue that advances in mobile computing, communications, biotechnology, and other ICT fields will allow productivity growth to return to the elevated rate of the late 1990s. Others are more cautious, arguing that the increases in productivity growth from these developments may be temporary rather than permanent. A great deal is riding on which view will turn out to be correct.
ENTREPRENEURSHIP AND MANAGEMENT
The productivity of workers depends in part on the people who help to decide what to produce and how to produce it: entrepreneurs and managers. Entrepreneurs are people who create new economic enterprises. Because of the new products, services, technological processes, and production methods they introduce, entrepreneurs are critical to a dynamic, healthy economy. In the late nineteenth and early twentieth centuries, individuals like Henry Ford and Alfred Sloan (automobiles), Andrew Carnegie (steel), John D. Rockefeller (oil), and J. P. Morgan (finance) played central roles in the development of American industry—and, not incidentally, amassed huge personal fortunes in the process. These people and others like them (including contemporary entrepreneurs like Bill Gates) have been criticized for some of their business practices, in some cases with justification. Clearly, though, they and dozens of other prominent business leaders of the past century have contributed significantly to the growth of the U.S. economy. Henry Ford, for example, developed the idea of mass production, which lowered costs sufficiently to bring automobiles within reach of the average American family. Ford began his business in his garage, a tradition that has been maintained by thousands of innovators ever since. Larry Page and Sergey Brin, the cofounders of Google, revolutionized the way people conduct research by developing a method to prioritize the list of websites obtained in a search of the Internet.
Entrepreneurship, like any form of creativity, is difficult to teach, although some of the supporting skills, like financial analysis and marketing, can be learned in college or business school. How, then, does a society encourage entrepreneurship? History suggests that the entrepreneurial spirit will always exist; the challenge to society is to channel entrepreneurial energies in economically productive ways. For example, economic policymakers need to ensure that taxation is not so heavy, and regulation not so inflexible, that small businesses—some of which will eventually become big businesses—cannot get off the ground. Sociological factors may play a role as well. Societies in which business and commerce are considered to be beneath the dignity of refined, educated people are less likely to produce successful entrepreneurs. In the United States, for the most part, business has been viewed as a respectable activity. Overall, a social and economic milieu that allows entrepreneurship to flourish appears to promote economic growth and rising productivity, perhaps especially so in high-technology eras like our own.
EXAMPLE 19.5Inventing the Personal Computer
Does entrepreneurship pay?
In 1975, Steve Jobs and Steve Wozniak were two 20-year-olds who designed computer games for Atari. They had an idea to make a computer that was smaller and cheaper than the closet-sized mainframes that were then in use. To set up shop in Steve Jobs’s parents’ garage and buy their supplies, they sold their two most valuable possessions, Jobs’s used Volkswagen van and Wozniak’s Hewlett-Packard scientific calculator, for a total of $1,300. The result was the first personal computer, which they named after their new company (and Jobs’s favorite fruit): Apple. The rest is history. Clearly, Jobs’s and Wozniak’s average labor productivity as the inventors of the personal computer eventually became many times what it was when they designed computer games. Creative entrepreneurship can increase productivity just like additional capital or land.
The Economic Naturalist 19.3
Why did medieval China stagnate economically?
The Sung period in China (a.d. 960–1270) was one of considerable technological sophistication; its inventions included paper, waterwheels, water clocks, gunpowder, and possibly the compass. Yet no significant industrialization occurred, and in subsequent centuries, Europe saw more economic growth and technological innovation than China. Why did medieval China stagnate economically?
According to research by economist William Baumol,5 the main impediment to industrialization during the Sung period was a social system that inhibited entrepreneurship. Commerce and industry were considered low-status activities, not fit for an educated person. In addition, the emperor had the right to seize his subjects’ property and to take control of their business enterprises—a right that greatly reduced his subjects’ incentives to undertake business ventures. The most direct path to status and riches in medieval China was to go through a system of demanding civil service examinations given by the government every three years. The highest scorers on these national examinations were granted lifetime positions in the imperial bureaucracy, where they wielded much power and often became wealthy, in part through corruption. Not surprisingly, medieval China did not develop a dynamic entrepreneurial class, and consequently, its scientific and technological advantages did not translate into sustained economic growth. China’s experience shows why scientific advances alone cannot guarantee economic growth; to have economic benefits, scientific knowledge must be commercially applied through new products and new, more efficient means of producing goods and services.
Although entrepreneurship may be more glamorous, managers—the people who run businesses on a daily basis—also play an important role in determining average labor productivity. Managerial jobs span a wide range of positions, from the supervisor of the loading dock to the CEO (chief executive officer) at the helm of a Fortune 500 company. Managers work to satisfy customers, deal with suppliers, organize production, obtain financing, assign workers to jobs, and motivate them to work hard and effectively. Such activities enhance labor productivity. For example, in the 1970s and 1980s, Japanese managers introduced new production methods that greatly increased the efficiency of Japanese manufacturing plants. Among them was the just-in-time inventory system, in which suppliers deliver production components to the factory just when they are needed, eliminating the need for factories to stockpile components. Japanese managers also pioneered the idea of organizing workers into semi-independent production teams, which allowed workers more flexibility and responsibility than the traditional assembly line. Managers in the United States and other countries studied the Japanese managerial techniques closely and adopted many of them.
THE POLITICAL AND LEGAL ENVIRONMENT
So far we have emphasized the role of the private sector in increasing average labor productivity. But government too has a role to play in fostering improved productivity. One of the key contributions government can make is to provide a political and legal environment that encourages people to behave in economically productive ways—to work hard, save and invest wisely, acquire useful information and skills, and provide the goods and services that the public demands.
One specific function of government that appears to be crucial to economic success is the establishment of well-defined property rights. Property rights are well defined when the law provides clear rules for determining who owns what resources (through a system of deeds and titles, for example) and how those resources can be used. Imagine living in a society in which a dictator, backed by the military and the police, could take whatever he wanted, and regularly did so. In such a country, what incentive would you have to raise a large crop or to produce other valuable goods and services? Very little, since much of what you produced would likely be taken away from you. Unfortunately, in many countries of the world today, this situation is far from hypothetical.
Political and legal conditions affect the growth of productivity in other ways, as well. Political scientists and economists have documented the fact that political instability can be detrimental to economic growth. This finding is reasonable, since entrepreneurs and savers are unlikely to invest their resources in a country whose government is unstable, particularly if the struggle for power involves civil unrest, terrorism, or guerrilla warfare. On the other hand, a political system that promotes the free and open exchange of ideas will speed the development of new technologies and products. For example, some economic historians have suggested that the decline of Spain as an economic power was due in part to the advent of the Spanish Inquisition, which permitted no dissent from religious orthodoxy. Because of the Inquisition’s persecution of those whose theories about the natural world contradicted Church doctrine, Spanish science and technology languished, and Spain fell behind more tolerant nations like the Netherlands.
CONCEPT CHECK 19.5
A Bangladeshi worker who immigrates to America is likely to find that his average labor productivity is much higher in the United States than it was at home. The worker is, of course, the same person he was when he lived in Bangladesh. How can the simple act of moving to the United States increase the worker’s productivity? What does your answer say about the incentive to immigrate?
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DETERMINANTS OF AVERAGE LABOR PRODUCTIVITY
Key factors determining average labor productivity in a country include:
· The skills and training of workers, called human capital.
· The quantity and quality of physical capital—machines, equipment, and buildings.
· The availability of land and other natural resources.
· The sophistication of the technologies applied in production.
· The effectiveness of management and entrepreneurship.
· The broad social and legal environment.
Labor productivity growth slowed throughout the industrialized world in the early 1970s and remained slow for more than two decades. Between 1995 and 2000, labor productivity rebounded (especially in the United States), largely because of advances in information and communication technology. Since then, labor productivity in the United States has again slowed. It remains to be seen if this recent slowdown is temporary (for example, due to factors that include the last financial crisis and recession) or the beginning of a new period of slower productivity growth.
THE COSTS OF ECONOMIC GROWTH
Both this chapter and Chapter 17, Measuring Economic Activity: GDP and Unemployment, emphasized the positive effects of economic growth on the average person’s living standard. But should societies always strive for the highest possible rate of economic growth? The answer is no. Even if we accept for the moment that increased output per person is always desirable, attaining a higher rate of economic growth does impose costs on society.
What are the costs of increasing economic growth? The most straightforward is the cost of creating new capital. We know that by expanding the capital stock we can increase future productivity and output. But, to increase the capital stock, we must divert resources that could otherwise be used to increase the supply of consumer goods. For example, to add more robot-operated assembly lines, a society must employ more of its skilled technicians in building industrial robots and fewer in developing medical assistance robots. To build new factories, more carpenters and lumber must be assigned to factory construction and less to finishing basements or renovating family rooms. In short, high rates of investment in new capital require people to tighten their belts, consume less, and save more—a real economic cost.
Should a country undertake a high rate of investment in capital goods at the sacrifice of consumer goods? The answer depends on the extent that people are willing and able to sacrifice consumption today to have a bigger economic pie tomorrow. In a country that is very poor, or is experiencing an economic crisis, people may prefer to keep consumption relatively high and savings and investment relatively low. The midst of a thunderstorm is not the time to be putting something aside for a rainy day! But in a society that is relatively well off, people may be more willing to make sacrifices to achieve higher economic growth in the future.
Consumption sacrificed to capital formation is not the only cost of achieving higher growth. In the United States in the nineteenth and early twentieth centuries, periods of rapid economic growth were often times in which many people worked extremely long hours at dangerous and unpleasant jobs. While those workers helped to build the economy that Americans enjoy today, the costs were great in terms of reduced leisure time and, in some cases, workers’ health and safety.
Other costs of growth include the cost of the research and development that is required to improve technology and the costs of acquiring training and skill (human capital). The fact that a higher living standard tomorrow must be purchased at the cost of current sacrifices is an example of the Scarcity Principle. Because achieving higher economic growth imposes real economic costs, we know from the Cost-Benefit Principle that higher growth should be pursued only if the benefits outweigh the costs.
Scarcity
Cost-Benefit
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THE COSTS OF ECONOMIC GROWTH
Economic growth has substantial costs, notably the sacrifice of current consumption that is required to free resources for creating new capital and new technologies. Higher rates of growth should be pursued only if the benefits outweigh the costs.
PROMOTING ECONOMIC GROWTH
If a society decides to try to raise its rate of economic growth, what are some of the measures that policymakers might take to achieve this objective? Here is a short list of suggestions, based on our discussion of the factors that contribute to growth in average labor productivity and, hence, output per person.
POLICIES TO INCREASE HUMAN CAPITAL
Because skilled and well-educated workers are more productive than unskilled labor, governments in most countries try to increase the human capital of their citizens by supporting education and training programs. In the United States, government provides public education through high school and grants extensive support to postsecondary schools, including technical schools, colleges, and universities. Publicly funded early intervention programs like Head Start also attempt to build human capital by helping disadvantaged children prepare for school. To a lesser degree than some other countries, the U.S. government also funds job training for unskilled youths and retraining for workers whose skills have become obsolete.
The Economic Naturalist 19.4
Why do almost all countries provide free public education?
All industrial countries provide their citizens free public education through high school, and most subsidize college and other postsecondary schools. Why?
Americans are so used to the idea of free public education that this question may seem odd. But why should the government provide free education when it does not provide even more essential goods and services, such as food or medical care, for free, except to the most needy? Furthermore, educational services can be, and indeed commonly are, supplied and demanded on the private market, without the aid of the government.
An important argument for free or at least subsidized education is that the private demand curve for educational services does not include all the social benefits of education. (Recall the Equilibrium Principle, which states in part that a market in equilibrium may not exploit all gains achievable from collective action.) For example, the democratic political system relies on an educated citizenry to operate effectively—a factor that an individual demander of educational services has little reason to consider. From a narrower economic perspective, we might argue that individuals do not capture the full economic returns from their schooling. For example, people with high human capital, and thus high earnings, pay more taxes—funds that can be used to finance government services and aid the less fortunate. Because of income taxation, the private benefit to acquiring human capital is less than the social benefit, and the demand for education on the private market may be less than optimal from society’s viewpoint. Similarly, educated people are more likely than others to contribute to technological development, and hence to general productivity growth, which may benefit many other people besides themselves. Finally, another argument for public support of education is that poor people who would like to invest in human capital may not be able to do so because of insufficient income.
Equilibrium
The late Nobel laureate Milton Friedman, among many economists, suggested that these arguments may justify government grants, called educational vouchers, to help citizens purchase educational services in the private sector, but they do not justify the government providing education directly, as through the public school system. Defenders of public education, on the other hand, argue that the government should have some direct control over education in order to set standards and monitor quality. What do you think?
Why do almost all countries provide free public education?
POLICIES THAT PROMOTE SAVING AND INVESTMENT
Average labor productivity increases when workers can utilize a sizable and modern capital stock. To support the creation of new capital, government can encourage high rates of saving and investment in the private sector. Many provisions in the U.S. tax code are designed expressly to stimulate households to save and firms to invest. For example, a household that opens an Individual Retirement Account (IRA) is able to save for retirement without paying taxes on either the funds deposited in the IRA or the interest earned on the account. (However, taxes are due when the funds are withdrawn at retirement.) The intent of IRA legislation is to make saving more financially attractive to American households. Similarly, at various times Congress has instituted an investment tax credit, which reduces the tax bills of firms that invest in new capital. Private-sector saving and investment are discussed in greater detail in Chapter 21, Saving and Capital Formation.
Government can contribute directly to capital formation through public investment, or the creation of government-owned capital. Public investment includes the building of roads, bridges, airports, dams, and, in some countries, energy and communications networks. The construction of the U.S. interstate highway system, begun during the administration of President Eisenhower, is often cited as an example of successful public investment. The interstate system substantially reduced long-haul transportation costs in the United States, improving productivity throughout the economy. Today, the web of computers and communications links we call the Internet is having a similar effect. This project, too, received crucial government funding in its early stages. Many research studies have confirmed that government investment in the infrastructure, the public capital that supports private-sector economic activities, can be a significant source of growth.
POLICIES THAT SUPPORT RESEARCH AND DEVELOPMENT
Productivity is enhanced by technological progress, which in turn requires investment in research and development (R&D). In many industries private firms have adequate incentive to conduct research and development activities. There is no need, for example, for the government to finance research for developing a better underarm deodorant.
But some types of knowledge, particularly basic scientific knowledge, may have widespread economic benefits that cannot be captured by a single private firm. The developers of the silicon computer chip, for example, were instrumental in creating huge new industries, yet they received only a small portion of the profits flowing from their inventions.
Because society in general, rather than the individual inventors, may receive much of the benefit from basic research, government may need to support basic research, as it does through agencies such as the National Science Foundation. The federal government also sponsors a great deal of applied research, particularly in military and space applications. To the extent that national security allows, the government can increase growth by sharing the fruits of such research with the private sector. For example, the Global Positioning System (GPS), which was developed originally for military purposes, is now available in most cellphones, helping people find their way almost anywhere.
THE LEGAL AND POLITICAL FRAMEWORK
Although economic growth comes primarily from activities in the private sector, the government plays an essential role in providing the framework within which the private sector can operate productively. We have discussed the importance of secure property rights and a well-functioning legal system, of an economic environment that encourages entrepreneurship, and of political stability and the free and open exchange of ideas. Government policymakers should also consider the potential effects of tax and regulatory policies on activities that increase productivity, such as investment, innovation, and risk taking. Policies that affect the legal and political framework are examples of structural macroeconomic policies.
THE POOREST COUNTRIES: A SPECIAL CASE?
Radical disparities in living standards exist between the richest and poorest countries of the world. Achieving economic growth in the poorest countries is thus particularly urgent. Are the policy prescriptions of this section relevant to those countries, or are very different types of measures necessary to spur growth in the poorest nations?
To a significant extent, the same factors and policies that promote growth in richer countries apply to the poorest countries as well. Increasing human capital by supporting education and training, increasing rates of saving and investment, investing in public capital and infrastructure, supporting research and development, and encouraging entrepreneurship are all measures that will enhance economic growth in poor countries.
However, to a much greater degree than in richer countries, most poor countries need to improve the legal and political environment that underpins their economies. For example, many developing countries have poorly developed or corrupt legal systems, which discourage entrepreneurship and investment by creating uncertainty about property rights. Taxation and regulation in developing countries are often heavy-handed and administered by inefficient bureaucracies, to the extent that it may take months or years to obtain the approvals needed to start a small business or expand a factory. Regulation is also used to suppress market forces in poor countries; for example, the government, rather than the market, may determine the allocation of bank credit or the prices for agricultural products. Structural policies that aim to ameliorate these problems are important preconditions for generating growth in the poorest countries. But probably most important—and most difficult, for some countries—is establishing political stability and the rule of law. Without political stability, domestic and foreign savers will be reluctant to invest in the country, and economic growth will be difficult if not impossible to achieve.
Can rich countries help poor countries to develop? Historically, richer nations have tried to help by providing financial aid through loans or grants from individual countries (foreign aid) or by loans made by international agencies, such as the World Bank. Experience has shown, however, that financial aid to countries that do not undertake structural reforms, such as reducing excessive regulation or improving the legal system, is of limited value. To make their foreign aid most effective, rich countries should help poor countries achieve political stability and undertake the necessary reforms to the structure of their economies.
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PROMOTING ECONOMIC GROWTH
Policies for promoting economic growth include policies to increase human capital (education and training); policies that promote saving and capital formation; policies that support research and development; and the provision of a legal and political framework within which the private sector can operate productively. Deficiencies in the legal and political framework (for example, official corruption or poorly defined property rights) are a special problem for many developing countries.
ARE THERE LIMITS TO GROWTH?
Earlier in this chapter, we saw that even relatively low rates of economic growth, if sustained for a long period, will produce huge increases in the size of the economy. This fact raises the question of whether economic growth can continue indefinitely without depleting natural resources and causing massive damage to the global environment. Does the basic truth that we live in a finite world of finite resources imply that, ultimately, economic growth must come to an end?
The concern that economic growth may not be sustainable is not a new one. An influential 1972 book, The Limits to Growth,6 reported the results of computer simulations that suggested that unless population growth and economic expansion were halted, the world would soon be running out of natural resources, drinkable water, and breathable air. This book, and later works in the same vein, raise some fundamental questions that cannot be done full justice here. However, in some ways its conclusions are misleading.
One problem with the “limits to growth” thesis lies in its underlying concept of economic growth. Those who emphasize the environmental limits on growth assume implicitly that economic growth will always take the form of more of what we have now—more smoky factories, more polluting cars, more fast-food restaurants. If that were indeed the case, then surely there would be limits to the growth the planet can sustain.
But growth in real GDP does not necessarily take such a form. Increases in real GDP can also arise from new or higher-quality products. For example, not too long ago, tennis rackets were relatively simple items made primarily of wood. Today they are made of newly invented synthetic materials and designed for optimum performance using sophisticated computer simulations. Because these new high-tech tennis rackets are more valued by consumers than the old wooden ones, they increase the real GDP. Likewise, the introduction of new pharmaceuticals has contributed to economic growth, as have the expanded number of web-based services and apps. As people switch, for example, from frequent visits to the bank or the mall to frequent visits to the bank’s or store’s website (or mobile app), GDP may increase while the number of cars and of brick-and-mortar stores decreases. Thus, economic growth need not take the form of more and more of the same old stuff; it can mean newer, better, and perhaps cleaner and more efficient goods and services.
A second problem with the “limits to growth” conclusion is that it overlooks the fact that increased wealth and productivity expand society’s capacity to take measures to safeguard the environment. In fact, the most polluted countries in the world are not the richest but those that are in a relatively early stage of industrialization. At this stage countries must devote the bulk of their resources to basic needs—food, shelter, health care—and continued industrial expansion. In these countries, clean air and water may be viewed as a luxury rather than a basic need. In more economically developed countries, where the most basic needs are more easily met, extra resources are available to keep the environment clean. Thus continuing economic growth may lead to less, not more, pollution.
A third problem with the pessimistic view of economic growth is that it ignores the power of the market and other social mechanisms to deal with scarcity. During the oil- supply disruptions of the 1970s, newspapers were filled with headlines about the energy crisis and the imminent depletion of world oil supplies. Yet 40 years later, the world’s known oil reserves are actually greater than they were in the 1970s.
Today’s energy situation is so much better than was expected 40 years ago because the market went to work. Reduced oil supplies led to an increase in prices that changed the behavior of both demanders and suppliers. Consumers insulated their homes, purchased more energy-efficient cars and appliances, and switched to alternative sources of energy. Suppliers engaged in a massive hunt for new reserves, opening up major new sources in Latin America, China, the North Sea, and more recently North America’s large shale oil deposits. In short, market forces solved the energy crisis, at least for now.
In general, shortages in any resource will trigger price changes that induce suppliers and demanders to deal with the problem. Simply extrapolating current economic trends into the future ignores the power of the market system to recognize shortages and make the necessary corrections. Government actions spurred by political pressures, such as the allocation of public funds to preserve open space or reduce air pollution, can be expected to supplement market adjustments.
Despite the shortcomings of the “limits to growth” perspective, most economists would agree that not all the problems created by economic growth can be dealt with effectively through the market or the political process. Probably most important, global environmental problems, such as the possibility of global warming or the ongoing destruction of rain forests, are a particular challenge for existing economic and political institutions. Environmental quality is not bought and sold in markets and thus will not automatically reach its optimal level through market processes. Nor can local or national governments effectively address problems that are global in scope. Unless international mechanisms are established for dealing with global environmental problems, these problems may become worse as economic growth continues.
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ECONOMIC GROWTH: ARE THERE LIMITS?
Some have argued that finite resources imply ultimate limits to economic growth. This view overlooks the facts that growth can take the form of better, rather than more, goods and services; that increased wealth frees resources to safeguard the environment; and that political and economic mechanisms exist to address many of the problems associated with growth. However, these mechanisms may not work well when environmental or other problems arising from economic growth are global in scope.
SUMMARY
· Over the past two centuries, the industrialized nations saw enormous improvements in living standards, as reflected in large increases in real GDP per person. Because of the power of compound interest, relatively small differences in growth rates, if continued over long periods, can produce large differences in real GDP per person and average living standards. Thus, the rate of long-term economic growth is an economic variable of critical importance. (LO1)
· Real GDP per person is the product of average labor productivity (real GDP per employed worker) and the share of the population that is employed. Growth in real GDP per person can occur only through growth in average labor productivity, in the share of the population that is working, or both. In the period from 1960 to 2000, increases in the share of the U.S. population holding a job contributed significantly to rising real GDP per person. But, as in most periods, the main source of the increase in real GDP per person was rising average labor productivity. (LO2)
· Among the factors that determine labor productivity are the talents, education, training, and skills of workers, or human capital; the quantity and quality of the physical capital that workers use; the availability of land and other natural resources; the application of technology to the production and distribution of goods and services; the effectiveness of entrepreneurs and managers; and the broad social and legal environment. Because of diminishing returns to capital, beyond a certain point expansion of the capital stock is not the most effective way to increase average labor productivity. Economists generally agree that new technologies are the most important single source of improvements in productivity. (LO3)
· Since the 1970s, the industrial world has experienced a slowdown in productivity growth. Productivity growth rebounded between 1995 and 2000, largely as a result of advances in information and communication technology, before slowing down again. (LO3)
· Economic growth has costs as well as benefits. Prominent among them is the need to sacrifice current consumption to achieve a high rate of investment in new capital goods; other costs of growing more quickly include extra work effort and the costs of research and development. Thus, more economic growth is not necessarily better; whether increased economic growth is desirable depends on whether the benefits of growth outweigh the costs. (LO4)
· Among the ways in which government can stimulate economic growth are by adopting policies that encourage the creation of human capital; that promote saving and investment, including public investment in infrastructure; that support research and development, particularly in the basic sciences; and that provide a legal and political framework that supports private-sector activities. The poorest countries, with poorly developed legal, tax, and regulatory systems, are often in the greatest need of an improved legal and political framework and increased political stability. (LO5)
· Are there limits to growth? Arguments that economic growth must be constrained by environmental problems and the limits of natural resources ignore the fact that economic growth can take the form of increasing quality as well as increasing quantity. Indeed, increases in output can provide additional resources for cleaning up the environment. Finally, the market system, together with political processes, can solve many of the problems associated with economic growth. On the other hand, global environmental problems, which can be handled neither by the market nor by individual national governments, have the potential to constrain economic growth. (LO6)
KEY TERMS
average labor productivity
compound interest
diminishing returns to capital
entrepreneurs
human capital
physical capital
REVIEW QUESTIONS
1. What has happened to real GDP per person in the industrialized countries over the past century? What implications does this have for the average person? Are there implications for different countries in different regions (e.g., Japan versus Ghana)? (LO1)
2. Why do economists consider growth in average labor productivity to be the key factor in determining long-run living standards? (LO2)
3. What is human capital? Why is it economically important? How is new human capital created? (LO3)
4. You have employed five workers of varying physical strength to dig a ditch. Workers without shovels have zero productivity in ditchdigging. How should you assign shovels to workers if you don’t have enough shovels to go around? How should you assign any additional shovels that you obtain? Using this example, discuss (a) the relationship between the availability of physical capital and average labor productivity and (b) the concept of diminishing returns to capital. (LO3)
5. Discuss how talented entrepreneurs and effective managers can enhance average labor productivity. (LO3)
6. What are the costs of increasing economic growth? (LO4)
7. What major contributions can the government make to the goal of increasing average labor productivity? (LO5)
8. Discuss the following statement: “Because the environment is fragile and natural resources are finite, ultimately economic growth must come to an end.” (LO6)
PROBLEMS
1. Richland’s real GDP per person is $10,000, and Poorland’s real GDP per person is $5,000. However, Richland’s real GDP per person is growing at 1 percent per year and Poorland’s is growing at 3 percent per year. Compare real GDP per person in the two countries after 10 years and after 20 years. Approximately how many years will it take Poorland to catch up to Richland? (LO1)
2. Suppose labor productivity in the United States was $110,000 per worker in 2015. Calculate the value of labor productivity in the year 2035 (20 years later) if: (LO1)
a. Productivity continues to grow by 2.6 percent per year.
b. Productivity growth falls to 2 percent per year, its average rate during the period 1970–2009. (Note: You do not need to know the actual values of average labor productivity in any year to solve this problem.)
c. How much larger would labor productivity per worker be in 2035 with the higher growth rate as compared to the lower growth rate?
3. The “graying of America” will substantially increase the fraction of the population that is retired in the decades to come. To illustrate the implications for U.S. living standards, suppose that over the 56 years following 2016, the share of the population that is working returns to its 1960 level, while average labor productivity increases by as much as it did during 1960–2016. Under this scenario, what would be the net change in real GDP per person between 2016 and 2072? The following data will be useful: (LO2)
4. Consider the following table containing data for Germany and Japan on the ratio of employment to population in 1980 and 2010:
Using data from Table 19.1, find average labor productivity for each country in 1980 and 2010. How much of the increase in output per person in each country over the 1980 to 2010 period is due to increased labor productivity? To increased employment relative to population? (LO2)
5. Joanne has just completed high school and is trying to determine whether to go to junior college for two years or go directly to work. Her objective is to maximize the savings she will have in the bank five years from now. If she goes directly to work she will earn $20,000 per year for each of the next five years. If she goes to junior college, for each of the next two years she will earn nothing—indeed, she will have to borrow $6,000 each year to cover tuition and books. This loan must be repaid in full three years after graduation. If she graduates from junior college, in each of the subsequent three years, her wages will be $38,000 per year. Joanne’s total living expenses and taxes, excluding tuition and books, equal $15,000 per year. (LO3)
a. Suppose for simplicity that Joanne can borrow and lend at 0 percent interest. On purely economic grounds, should she go to junior college or work?
b. Does your answer to part a change if she can earn $23,000 per year with only a high school degree?
c. Does your answer to part a change if Joanne’s tuition and books cost $8,000 per year?
d. *Suppose that the interest rate at which Joanne can borrow and lend is 10 percent per year, but other data are as in part a. Savings are deposited at the end of the year they are earned and receive (compound) interest at the end of each subsequent year. Similarly, the loans are taken out at the end of the year in which they are needed, and interest does not accrue until the end of the subsequent year. Now that the interest rate has risen, should Joanne go to college or go to work?
6. The Good’n’Fresh Grocery Store has two checkout lanes and four employees. Employees are equally skilled, and all are able either to operate a register (checkers) or bag groceries (baggers). The store owner assigns one checker and one bagger to each lane. A lane with a checker and a bagger can check out 40 customers per hour. A lane with a checker only can check out 25 customers per hour. (LO3)
a. In terms of customers checked out per hour, what is total output and average labor productivity for the Good’n’Fresh Grocery Store?
b. The owner adds a third checkout lane and register. Assuming that no employees are added, what is the best way to reallocate the workers to tasks? What is total output and average labor productivity (in terms of customers checked out per hour) now?
c. Repeat part b for the addition of a fourth checkout lane, and a fifth. Do you observe diminishing returns to capital in this example?
7. Harrison, Carla, and Fred are housepainters. Harrison and Carla can paint 100 square feet per hour using a standard paintbrush, and Fred can paint 80 square feet per hour. Any of the three can paint 200 square feet per hour using a roller. (LO3)
a. Assume Harrison, Carla, and Fred have only paintbrushes at their disposal. What is the average labor productivity, in terms of square feet per painter-hour, for the three painters taken as a team? Assume that the three painters always work the same number of hours.
b. Repeat part a for the cases in which the team has one, two, three, or four rollers available. Are there diminishing returns to capital?
c. An improvement in paint quality increases the area that can be covered per hour (by either brushes or rollers) by 20 percent. How does this technological improvement affect your answers to part b? Are there diminishing returns to capital? Does the technological improvement increase or reduce the economic value of an additional roller?
8. Hester’s Hatchery raises fish. At the end of the current season, Hester has 1,000 fish in the hatchery. She can harvest any number of fish that she wishes, selling them to restaurants for $5 apiece. Because big fish make little fish, for every fish that she leaves in the hatchery this year she will have two fish at the end of next year. The price of fish is expected to be $5 each next year as well. Hester relies entirely on income from current fish sales to support herself. (LO3)
a. How many fish should Hester harvest if she wants to maximize the growth of her stock of fish from this season to next season?
b. Do you think maximizing the growth of her fish stock is an economically sound strategy for Hester? Why or why not? Relate to the text discussion on the costs of economic growth.
c. How many fish should Hester harvest if she wants to maximize her current income? Do you think this is a good strategy?
d. Explain why Hester is unlikely to harvest either all or none of her fish, but instead will harvest some and leave the rest to reproduce.
9. Discuss the following statement, using concrete examples where possible to illustrate your arguments: For advances in basic science to translate into improvements in standards of living, they must be supported by favorable economic conditions. (LO3, LO4, LO5)
10. Write a short essay evaluating the United States. economy in terms of each of the six determinants of average labor productivity discussed in the text. Are there any areas in which the U.S. is exceptionally strong, relative to other countries? Areas where the U.S. is less strong than some other countries? Illustrate your arguments with numbers from the Statistical Abstract of the United States (available online at www.census.gov/library/publications/time-series/statistical_abstracts.html) and other sources, as appropriate. (LO3, LO4, LO5)
*Denotes more difficult problem.
ANSWERS TO CONCEPT CHECKS
19.1If the United States had grown at the Japanese rate for the period 1870–2010, real GDP per person in 2010 would have been ($2,445) × (1.025)140 = $77,556.82. Actual GDP per person in the United States in 2010 was $30,491, so at the higher rate of growth output per person would have been $77,556.82/$30,491 = 2.54 times higher. (LO1)
19.2As before, Lucy can wrap 4,000 candies per week, or 100 candies per hour. Ethel can wrap 500 candies per hour, and working 40 hours weekly, she can wrap 20,000 candies per week. Together Lucy and Ethel can wrap 24,000 candies per week. Since they work a total of 80 hours between them, their output per hour as a team is 24,000 candies wrapped per 80 hours = 300 candies wrapped per hour, midway between their hourly productivities as individuals. (LO3)
19.3Because Ethel can wrap 300 candies per hour by hand, the benefit of giving Ethel the machine is 500 − 300 = 200 additional candies wrapped per hour. Because Lucy wraps only 100 candies per hour by hand, the benefit of giving Lucy the machine is 400 additional candies wrapped per hour. So the benefit of giving the machine to Lucy is greater than of giving it to Ethel. Equivalently, if the machine goes to Ethel, then Lucy and Ethel between them can wrap 500 + 100 = 600 candies per hour, but if Lucy uses the machine the team can wrap 300 + 500 = 800 candies per hour. So output is increased by letting Lucy use the machine. (LO3)
19.4Now, working by hand, Lucy can wrap 300 candies per hour and Ethel can wrap 500 candies per hour. With a machine, either Lucy or Ethel can wrap 800 candies per hour. As in Concept Check 19.3, the benefit of giving a machine to Lucy (500 candies per hour) exceeds the benefit of giving a machine to Ethel (300 candies per hour), so if only one machine is available, Lucy should use it.
The table analogous to Table 19.2 now looks like this:
Relationship of Capital, Output, and Productivity in the Candy-Wrapping Factory
Comparing this table with Table 19.2, you can see that technological advance has increased labor productivity for any value of K, the number of machines available.
Adding one machine increases output by 20,000 candies wrapped per week, adding the second machine increases output by 12,000 candies wrapped per week, and adding the third machine does not increase output at all (because there is no worker available to use it). So diminishing returns to capital still hold after the technological improvement. (LO3)
19.5Although the individual worker is the same person he was in Bangladesh, by coming to the United States, he gains the benefit of factors that enhance average labor productivity in this country, relative to his homeland. These include more and better capital to work with, more natural resources per person, more advanced technologies, sophisticated entrepreneurs and managers, and a political-legal environment that is conducive to high productivity. It is not guaranteed that the value of the immigrant’s human capital will rise (it may not, for example, if he speaks no English and has no skills applicable to the U.S. economy), but normally it will.
Since increased productivity leads to higher wages and living standards, on economic grounds, the Bangladeshi worker has a strong incentive to immigrate to the United States if he is able to do so. (LO3)
1Stephen E. Ambrose, Undaunted Courage: Meriwether Lewis, Thomas Jefferson, and the Opening of the American West [New York: Touchstone (Simon & Schuster), 1996], p. 52.
2For an interesting point of view, see “How Was the AIDS Epidemic Reversed?” The Economist, September 26, 2013.
3Data refers to labor productivity growth in the nonfarm business sector and can be found at www.bls.gov.
4Kevin J. Stiroh, “Information Technology and the U.S. Productivity Revival: What Do the Industry Data Say?” American Economic Review 92 (December 2002), pp. 1559–76.
5W. Baumol, “Entrepreneurship: Productive, Unproductive, and Destructive,” Journal of Political Economy, October 1990, pp. 893–921.
6Donella H. Meadows, Dennis L. Meadows, Jørgen Randers, and William W. Behrens III, The Limits to Growth (New York: New American Library, 1972).