Key Concepts and Summary

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. Compound interest and compound growth rates behave in the same way as productivity rates. Seemingly small changes in percentage points can have big impacts on income over time.

7.3 Components of Economic Growth

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. Capital deepening refers to an increase in the amount of capital per worker, either human capital per worker, in the form of higher education or skills, or physical capital per worker. Technology, in its economic meaning, refers broadly to all new methods of production, which includes major scientific inventions but also small inventions and even better forms of management or other types of institutions. A healthy climate for growth in GDP per capita consists of improvements in human capital, physical capital, and technology, in a market-oriented environment with supportive public policies and institutions.

7.4 Economic Convergence

When countries with lower GDP levels per capita catch up to countries with higher GDP levels per capita, we call the process convergence. Convergence can occur even when both high- and low-income countries increase investment in physical and human capital with the objective of growing GDP. This is because the impact of new investment in physical and human capital on a low-income country may result in huge gains as new skills or equipment combine with the labor force. In higher-income countries, however, a level of investment equal to that of the low income country is not likely to have as big an impact, because the more developed country most likely already has high levels of capital investment. Therefore, the marginal gain from this additional investment tends to be successively less and less. Higher income countries are more likely to have diminishing returns to their investments and must continually invent new technologies. This allows lower-income economies to have a chance for convergent growth. However, many high-income economies have developed economic and political institutions that provide a healthy economic climate for an ongoing stream of technological innovations. Continuous technological innovation can counterbalance diminishing returns to investments in human and physical capital.

Self-Check Questions

1 . Explain what the Industrial Revolution was and where it began. 2 . Explain the difference between property rights and contractual rights. Why do they matter to economic growth? 3 . Are there other ways in which we can measure productivity besides the amount produced per hour of work? 4 . Assume there are two countries: South Korea and the United States. South Korea grows at 4% and the United States grows at 1%. For the sake of simplicity, assume they both start from the same fictional income level, $10,000. What will the incomes of the United States and South Korea be in 20 years? By how many multiples will each country’s income grow in 20 years? 5 . What do the growth accounting studies conclude are the determinants of growth? Which is more important, the determinants or how they are combined? 6 . What policies can the government of a free-market economy implement to stimulate economic growth? 7 . List the areas where government policy can help economic growth. 8 . Use an example to explain why, after periods of rapid growth, a low-income country that has not caught up to a high-income country may feel poor. 9 . Would the following events usually lead to capital deepening? Why or why not? a. A weak economy in which businesses become reluctant to make long-term investments in physical