7.4Economic Convergence

7.4 Economic Convergence

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain economic convergence
• Analyze various arguments for and against economic convergence
• Evaluate the speed of economic convergence between high-income countries and the rest of the world

Some low-income and middle-income economies around the world have shown a pattern of convergence, in which their economies grow faster than those of high-income countries. GDP increased by an average rate of 2.7% per year in the 1990s and 1.7% per year from 2010 to 2019 in the high-income countries of the world, which include the United States, Canada, the European Union countries, Japan, Australia, and New Zealand. Table 7.5 lists eight countries that belong to an informal “fast growth club.” These countries averaged GDP growth (after adjusting for inflation) of at least 5% per year in both the time periods from 1990 to 2000 and from 2010 to 2019. Since economic growth in these countries has exceeded the average of the world’s high- income economies, these countries may converge with the high-income countries. The second part of Table 7.5 lists the “slow growth club,” which consists of countries that averaged GDP growth of 2% per year or less (after adjusting for inflation) during the same time periods. The final portion of Table 7.5 shows GDP growth rates for the countries of the world divided by income. (Note that the reason there is no data for 2001–2009 is because of the Great Recession, which lasted from 2007–2009. Many country’s GDP shrank during these years.) Country Average Growth Rate of Real GDP 1990–2000 Average Growth Rate of Real GDP 2010–2019 Fast Growth Club (5% or more per year in both time periods) Cambodia 7.1% 7.0% China 10.6% 7.3% India 6.0% 6.7% Ireland 7.5% 6.3% Laos 6.5% 7.3% Mozambique 6.4% 5.6% Uganda 7.1% 5.4% Vietnam 7.9% 6.3% Slow Growth Club (2% or less per year in both time periods) Central African Republic 2.0% –0.2% France 2.0% 1.4% Germany 1.8% 2.0% Haiti –1.5% 1.5% TABLE 7.5Economic Growth around the World(Source: http://databank.worldbank.org/data/views/ variableSelection/selectvariables.aspx?source=world-development-indicators#c_u) Country Average Growth Rate of Real GDP 1990–2000 Average Growth Rate of Real GDP 2010–2019 Italy 1.6% 0.3% Jamaica 0.9% 0.7% Japan 1.3% 1.3% Switzerland 1.0% 2.0% United States (for reference) 3.2% 2.3% World Overview (Notice that high income countries tend to grow at slower rates than low- and middle-income countries, which supports the idea of convergence.) High income 2.7% 1.7% Low income 3.8% 4.5% Middle income 4.7% 4.0% TABLE 7.5Economic Growth around the World(Source: http://databank.worldbank.org/data/views/ variableSelection/selectvariables.aspx?source=world-development-indicators#c_u) Each of the countries in Table 7.5 has its own unique story of investments in human and physical capital, technological gains, market forces, government policies, and even lucky events, but an overall pattern of convergence is clear. The low-income countries have GDP growth that is faster than that of the middle-income countries, which in turn have GDP growth that is faster than that of the high-income countries. Two prominent members of the fast-growth club are China and India, which between them have nearly 40% of the world’s population. Some prominent members of the slow-growth club are high-income countries like France, Germany, Italy, and Japan. Will this pattern of economic convergence persist into the future? This is a controversial question among economists that we will consider by looking at some of the main arguments on both sides.

Arguments Favoring Convergence

Several arguments suggest that low-income countries might have an advantage in achieving greater worker productivity and economic growth in the future. A first argument is based on diminishing marginal returns. Even though deepening human and physical capital will tend to increase GDP per capita, the law of diminishing returns suggests that as an economy continues to increase its human and physical capital, the marginal gains to economic growth will diminish. For example, raising the average education level of the population by two years from a tenth-grade level to a high school diploma (while holding all other inputs constant) would produce a certain increase in output. An additional two-year increase, so that the average person had a two-year college degree, would increase output further, but the marginal gain would be smaller. Yet another additional two-year increase in the level of education, so that the average person would have a four-year-college bachelor’s degree, would increase output still further, but the marginal increase would again be smaller. A similar lesson holds for physical capital. If the quantity of physical capital available to the average worker increases, by, say, $5,000 to $10,000 (again, while holding all other inputs constant), it will increase the level of output. An additional increase from $10,000 to $15,000 will increase output further, but the marginal increase will be smaller. Low-income countries like China and India tend to have lower levels of human capital and physical capital, so an investment in capital deepening should have a larger marginal effect in these countries than in high- income countries, where levels of human and physical capital are already relatively high. Diminishing returns implies that low-income economies could converge to the levels that the high-income countries achieve. A second argument is that low-income countries may find it easier to improve their technologies than high- income countries. High-income countries must continually invent new technologies, whereas low-income countries can often find ways of applying technology that has already been invented and is well understood. The economist Alexander Gerschenkron (1904–1978) gave this phenomenon a memorable name: “the advantages of backwardness.” Of course, he did not literally mean that it is an advantage to have a lower standard of living. He was pointing out that a country that is behind has some extra potential for catching up. Finally, optimists argue that many countries have observed the experience of those that have grown more quickly and have learned from it. Moreover, once the people of a country begin to enjoy the benefits of a higher standard of living, they may be more likely to build and support the market-friendly institutions that will help provide this standard of living. LINK IT UP View this video (https://openstax.org/l/tedhansrosling) to learn about economic growth across the world.

Arguments That Convergence Is neither Inevitable nor Likely

If the economy's growth depended only on the deepening of human capital and physical capital, then we would expect that economy's growth rate to slow down over the long run because of diminishing marginal returns. However, there is another crucial factor in the aggregate production function: technology. Developing new technology can provide a way for an economy to sidestep the diminishing marginal returns of capital deepening. Figure 7.7 shows how. The figure's horizontal axis measures the amount of capital deepening, which on this figure is an overall measure that includes deepening of both physical and human capital. The amount of human and physical capital per worker increases as you move from left to right, from C1 to C2 to C3. The diagram's vertical axis measures per capita output. Start by considering the lowest line in this diagram, labeled Technology 1. Along this aggregate production function, the level of technology is held constant, so the line shows only the relationship between capital deepening and output. As capital deepens from C1 to C2 to C3 and the economy moves from R to U to W, per capita output does increase—but the way in which the line starts out steeper on the left but then flattens as it moves to the right shows the diminishing marginal returns, as additional marginal amounts of capital deepening increase output by ever-smaller amounts. The shape of the aggregate production line (Technology 1) shows that the ability of capital deepening, by itself, to generate sustained economic growth is limited, since diminishing returns will eventually set in.

FIGURE 7.7Capital Deepening and New Technology Imagine that the economy starts at point R, with the level of physical and human capital C1 and the output per capita at G1. If the economy relies only on capital deepening, while remaining at the technology level shown by the Technology 1 line, then it would face diminishing marginal returns as it moved from point R to point U to point W. However, now imagine that capital deepening is combined with improvements in technology. Then, as capital deepens from C1 to C2, technology improves from Technology 1 to Technology 2, and the economy moves from R to S. Similarly, as capital deepens from C2 to C3, technology increases from Technology 2 to Technology 3, and the economy moves from S to T. With improvements in technology, there is no longer any reason that economic growth must necessarily slow down. Now, bring improvements in technology into the picture. Improved technology means that with a given set of inputs, more output is possible. The production function labeled Technology 1 in the figure is based on one level of technology, but Technology 2 is based on an improved level of technology, so for every level of capital deepening on the horizontal axis, it produces a higher level of output on the vertical axis. In turn, production function Technology 3 represents a still higher level of technology, so that for every level of inputs on the horizontal axis, it produces a higher level of output on the vertical axis than either of the other two aggregate production functions. Most healthy, growing economies are deepening their human and physical capital and increasing technology at the same time. As a result, the economy can move from a choice like point R on the Technology 1 aggregate production line to a point like S on Technology 2 and a point like T on the still higher aggregate production line (Technology 3). With the combination of technology and capital deepening, the rise in GDP per capita in high- income countries does not need to fade away because of diminishing returns. The gains from technology can offset the diminishing returns involved with capital deepening. Will technological improvements themselves run into diminishing returns over time? That is, will it become continually harder and more costly to discover new technological improvements? Perhaps someday, but, at least over the last two centuries since the beginning of the Industrial Revolution, improvements in technology have not run into diminishing marginal returns. Modern inventions, like the internet or discoveries in genetics or materials science, do not seem to provide smaller gains to output than earlier inventions like the steam engine or the railroad. One reason that technological ideas do not seem to run into diminishing returns is that we often can apply widely the ideas of new technology at a marginal cost that is very low or even zero. A specific worker or group of workers must use a specific additional machine, or an additional year of education. Many workers across the economy can use a new technology or invention at very low marginal cost. The argument that it is easier for a low-income country to copy and adapt existing technology than it is for a high-income country to invent new technology is not necessarily true, either. When it comes to adapting and using new technology, a society’s performance is not necessarily guaranteed, but is the result of whether the country's economic, educational, and public policy institutions are supportive. In theory, perhaps, low-income countries have many opportunities to copy and adapt technology, but if they lack the appropriate supportive economic infrastructure and institutions, the theoretical possibility that backwardness might have certain advantages is of little practical relevance. LINK IT UP Visit this website (https://openstax.org/l/Indiapoverty) to read more about economic growth in India.

The Slowness of Convergence

Although economic convergence between the high-income countries and the rest of the world seems possible and even likely, it will proceed slowly. Consider, for example, a country that starts off with a GDP per capita of $40,000, which would roughly represent a typical high-income country today, and another country that starts out at $4,000, which is roughly the level in low-income but not impoverished countries like Indonesia, Guatemala, or Egypt. Say that the rich country chugs along at a 2% annual growth rate of GDP per capita, while the poorer country grows at the aggressive rate of 7% per year. After 30 years, GDP per capita in the rich country will be $72,450 (that is, $40,000 (1 + 0.02)30) while in the poor country it will be $30,450 (that is, $4,000 (1 + 0.07)30). Convergence has occurred. The rich country used to be 10 times as wealthy as the poor one, and now it is only about 2.4 times as wealthy. Even after 30 consecutive years of very rapid growth, however, people in the low-income country are still likely to feel quite poor compared to people in the rich country. Moreover, as the poor country catches up, its opportunities for catch-up growth are reduced, and its growth rate may slow down somewhat. The slowness of convergence illustrates again that small differences in annual rates of economic growth become huge differences over time. The high-income countries have been building up their advantage in standard of living over decades—more than a century in some cases. Even in an optimistic scenario, it will take decades for the low-income countries of the world to catch up significantly. BRING IT HOME Calories and Economic Growth We can tell the story of modern economic growth by looking at calorie consumption over time. The dramatic rise in incomes allowed the average person to eat better and consume more calories. How did these incomes increase? The neoclassical growth consensus uses the aggregate production function to suggest that the period of modern economic growth came about because of increases in inputs such as technology and physical and human capital. Also important was the way in which technological progress combined with physical and human capital deepening to create growth and convergence. The issue of distribution of income notwithstanding, it is clear that the average worker can afford more calories in 2020 than in 1875. Aside from increases in income, there is another reason why the average person can afford more food. Modern agriculture has allowed many countries to produce more food than they need. Despite having more than enough food, however, many governments and multilateral agencies have not solved the food distribution problem. In fact, food shortages, famine, or general food insecurity are caused more often by the failure of government macroeconomic policy, according to the Nobel Prize-winning economist Amartya Sen. Sen has conducted extensive research into issues of inequality, poverty, and the role of government in improving standards of living. Macroeconomic policies that strive toward stable inflation, full employment, education of women, and preservation of property rights are more likely to eliminate starvation and provide for a more even distribution of food. Because we have more food per capita, global food prices have decreased since 1875. The prices of some foods, however, have decreased more than the prices of others. For example, researchers from the University of Washington have shown that in the United States, calories from zucchini and lettuce are 100 times more expensive than calories from oil, butter, and sugar. Research from countries like India, China, and the United States suggests that as incomes rise, individuals want more calories from fats and protein and fewer from carbohydrates. This has very interesting implications for global food production, obesity, and environmental consequences. Affluent urban India has an obesity problem much like many parts of the United States. The forces of convergence are at work.

Key Terms

aggregate production function the process whereby an economy as a whole turns economic inputs such as human capital, physical capital, and technology into output measured as GDP per capita capital deepening an increase by society in the average level of physical and/or human capital per person compound growth rate the rate of growth when multiplied by a base that includes past GDP growth contractual rights the rights of individuals to enter into agreements with others regarding the use of their property providing recourse through the legal system in the event of noncompliance convergence pattern in which economies with low per capita incomes grow faster than economies with high per capita incomes human capital the accumulated skills and education of workers Industrial Revolution the widespread use of power-driven machinery and the economic and social changes that occurred in the first half of the 1800s infrastructure a component of physical capital such as roads and rail systems innovation putting advances in knowledge to use in a new product or service invention advances in knowledge labor productivity the value of what is produced per worker, or per hour worked (sometimes called worker productivity) modern economic growth the period of rapid economic growth from 1870 onward physical capital the plant and equipment that firms use in production; this includes infrastructure production function the process whereby a firm turns economic inputs like labor, machinery, and raw materials into outputs like goods and services that consumers use rule of law the process of enacting laws that protect individual and entity rights to use their property as they see fit. Laws must be clear, public, fair, and enforced, and applicable to all members of society special economic zone (SEZ) area of a country, usually with access to a port where, among other benefits, the government does not tax trade technological change a combination of invention—advances in knowledge—and innovation technology all the ways in which existing inputs produce more or higher quality, as well as different and altogether new products

Key Concepts and Summary

7.1 The Relatively Recent Arrival of Economic Growth

Since the early nineteenth century, there has been a spectacular process of long-run economic growth during which the world’s leading economies—mostly those in Western Europe and North America—expanded GDP per capita at an average rate of about 2% per year. In the last half-century, countries like Japan, South Korea, and China have shown the potential to catch up. The Industrial Revolution facilitated the extensive process of economic growth, that economists often refer to as modern economic growth. This increased worker productivity and trade, as well as the development of governance and market institutions.

7.2 Labor Productivity and Economic Growth

We can measure productivity, the value of what is produced per worker, or per hour worked, as the level of GDP per worker or GDP per hour. The United States experienced a productivity slowdown between 1973 and 1989. Since then, U.S. productivity has rebounded for the most part, but annual growth in productivity in the nonfarm business sector has been less than one percent each year between 2011 and 2016. It is not clear what productivity growth will be in the coming years. The rate of productivity growth is the primary determinant of an economy’s rate of long-term economic growth and higher wages. Over decades and generations, seemingly small differences of a few percentage points in the annual rate of economic growth make an enormous difference in GDP per capita. An aggregate production function specifies how certain inputs in the economy, like human capital, physical capital, and technology, lead to the output measured as GDP per capita.