Ten Principles of Economics - Part 53

Nonetheless, because capital accumula-tion affects productivity so clearly and directly, many economists interpret these data as showing that high investment leads to more rapid economi

investment (Or, perhaps, high growth and high investment are both caused by a

third variable that has been omitted from the analysis.) The data by themselves

cannot tell us the direction of causation Nonetheless, because capital

accumula-tion affects productivity so clearly and directly, many economists interpret these

data as showing that high investment leads to more rapid economic growth.

D I M I N I S H I N G R E T U R N S A N D T H E C AT C H - U P E F F E C T

Suppose that a government, convinced by the evidence in Figure 24-1, pursues

policies that raise the nation’s saving rate—the percentage of GDP devoted to

saving rather than consumption What happens? With the nation saving more,

fewer resources are needed to make consumption goods, and more resources are

available to make capital goods As a result, the capital stock increases, leading to

rising productivity and more rapid growth in GDP But how long does this higher

rate of growth last? Assuming that the saving rate remains at its new higher level,

does the growth rate of GDP stay high indefinitely or only for a period of time?

The traditional view of the production process is that capital is subject to

diminishing returns: As the stock of capital rises, the extra output produced from

an additional unit of capital falls In other words, when workers already have a

large quantity of capital to use in producing goods and services, giving them an

additional unit of capital increases their productivity only slightly Because of

diminishing returns, an increase in the saving rate leads to higher growth only for

a while As the higher saving rate allows more capital to be accumulated, the

ben-efits from additional capital become smaller over time, and so growth slows down.

In the long run, the higher saving rate leads to a higher level of productivity and income,

but not to higher growth in these variables Reaching this long run, however, can take

quite a while According to studies of international data on economic growth,

increasing the saving rate can lead to substantially higher growth for a period of

several decades.

The diminishing returns to capital has another important implication: Other

things equal, it is easier for a country to grow fast if it starts out relatively poor.

This effect of initial conditions on subsequent growth is sometimes called the

catch-up effect. In poor countries, workers lack even the most rudimentary tools

and, as a result, have low productivity Small amounts of capital investment would

substantially raise these workers’ productivity By contrast, workers in rich

coun-tries have large amounts of capital with which to work, and this partly explains

their high productivity Yet with the amount of capital per worker already so high,

additional capital investment has a relatively small effect on productivity Studies

of international data on economic growth confirm this catch-up effect: Controlling

for other variables, such as the percentage of GDP devoted to investment, poor

countries do tend to grow faster than rich countries.

This catch-up effect can help explain some of the puzzling results in Figure 24-1.

Over this 31-year period, the United States and South Korea devoted a similar

share of GDP to investment Yet the United States experienced only mediocre

growth of about 2 percent, while Korea experienced spectacular growth of more

than 6 percent The explanation is the catch-up effect In 1960, Korea had GDP per

person less than one-tenth the U.S level, in part because previous investment had

been so low With a small initial capital stock, the benefits to capital accumulation

were much greater in Korea, and this gave Korea a higher subsequent growth rate.

d i m i n i s h i n g r e t u r n s

the property whereby the benefit from an extra unit of an input declines as the quantity of the input increases

c a t c h - u p e f f e c t

the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich

This catch-up effect shows up in other aspects of life When a school gives an end-of-year award to the “Most Improved” student, that student is usually one who began the year with relatively poor performance Students who began the year not studying find improvement easier than students who always worked hard Note that it is good to be “Most Improved,” given the starting point, but it is even better to be “Best Student.” Similarly, economic growth over the last several decades has been much more rapid in South Korea than in the United States, but GDP per person is still higher in the United States.

I N V E S T M E N T F R O M A B R O A D

So far we have discussed how policies aimed at increasing a country’s saving rate can increase investment and, thereby, long-term economic growth Yet saving by domestic residents is not the only way for a country to invest in new capital The other way is investment by foreigners.

Investment from abroad takes several forms Ford Motor Company might build a car factory in Mexico A capital investment that is owned and operated by

a foreign entity is called foreign direct investment Alternatively, an American might

buy stock in a Mexican corporation (that is, buy a share in the ownership of the corporation); the Mexican corporation can use the proceeds from the stock sale to build a new factory An investment that is financed with foreign money but

oper-ated by domestic residents is called foreign portfolio investment In both cases,

Amer-icans provide the resources necessary to increase the stock of capital in Mexico That is, American saving is being used to finance Mexican investment.

When foreigners invest in a country, they do so because they expect to earn a return on their investment Ford’s car factory increases the Mexican capital stock and, therefore, increases Mexican productivity and Mexican GDP Yet Ford takes some of this additional income back to the United States in the form of profit Sim-ilarly, when an American investor buys Mexican stock, the investor has a right to

a portion of the profit that the Mexican corporation earns.

Investment from abroad, therefore, does not have the same effect on all mea-sures of economic prosperity Recall that gross domestic product (GDP) is the income earned within a country by both residents and nonresidents, whereas gross national product (GNP) is the income earned by residents of a country both

at home and abroad When Ford opens its car factory in Mexico, some of the income the factory generates accrues to people who do not live in Mexico As a result, foreign investment in Mexico raises the income of Mexicans (measured by GNP) by less than it raises the production in Mexico (measured by GDP).

Nonetheless, investment from abroad is one way for a country to grow Even though some of the benefits from this investment flow back to the foreign owners, this investment does increase the economy’s stock of capital, leading to higher pro-ductivity and higher wages Moreover, investment from abroad is one way for poor countries to learn the state-of-the-art technologies developed and used in richer countries For these reasons, many economists who advise governments in less developed economies advocate policies that encourage investment from abroad Often this means removing restrictions that governments have imposed

on foreign ownership of domestic capital.

An organization that tries to encourage the flow of investment to poor coun-tries is the World Bank This international organization obtains funds from the

world’s advanced countries, such as the United States, and uses these resources to

make loans to less developed countries so that they can invest in roads, sewer

sys-tems, schools, and other types of capital It also offers the countries advice about

how the funds might best be used The World Bank, together with its sister

orga-nization, the International Monetary Fund, was set up after World War II One

les-son from the war was that economic distress often leads to political turmoil,

international tensions, and military conflict Thus, every country has an interest in

promoting economic prosperity around the world The World Bank and the

Inter-national Monetary Fund are aimed at achieving that common goal.

E D U C AT I O N

Education—investment in human capital—is at least as important as investment

in physical capital for a country’s long-run economic success In the United States,

each year of schooling raises a person’s wage on average by about 10 percent In

less developed countries, where human capital is especially scarce, the gap

between the wages of educated and uneducated workers is even larger Thus, one

way in which government policy can enhance the standard of living is to provide

good schools and to encourage the population to take advantage of them.

Investment in human capital, like investment in physical capital, has an

opportunity cost When students are in school, they forgo the wages they could

have earned In less developed countries, children often drop out of school at an

early age, even though the benefit of additional schooling is very high, simply

because their labor is needed to help support the family.

Some economists have argued that human capital is particularly important for

economic growth because human capital conveys positive externalities An

exter-nality is the effect of one person’s actions on the well-being of a bystander An

edu-cated person, for instance, might generate new ideas about how best to produce

goods and services If these ideas enter society’s pool of knowledge, so everyone

can use them, then the ideas are an external benefit of education In this case, the

return to schooling for society is even greater than the return for the individual.

This argument would justify the large subsidies to human-capital investment that

we observe in the form of public education.

One problem facing some poor countries is the brain drain—the emigration of

many of the most highly educated workers to rich countries, where these workers

can enjoy a higher standard of living If human capital does have positive

exter-nalities, then this brain drain makes those people left behind poorer than they

oth-erwise would be This problem offers policymakers a dilemma On the one hand,

the United States and other rich countries have the best systems of higher

educa-tion, and it would seem natural for poor countries to send their best students

abroad to earn higher degrees On the other hand, those students who have spent

time abroad may choose not to return home, and this brain drain will reduce the

poor nation’s stock of human capital even further.

P R O P E R T Y R I G H T S A N D P O L I T I C A L S TA B I L I T Y

Another way in which policymakers can foster economic growth is by protecting

property rights and promoting political stability As we first noted when we

discussed economic interdependence in Chapter 3, production in market economies arises from the interactions of millions of individuals and firms When you buy a car, for instance, you are buying the output of a car dealer, a car manu-facturer, a steel company, an iron ore mining company, and so on This division of production among many firms allows the economy’s factors of production to be used as effectively as possible To achieve this outcome, the economy has to coor-dinate transactions among these firms, as well as between firms and consumers Market economies achieve this coordination through market prices That is, mar-ket prices are the instrument with which the invisible hand of the marmar-ketplace brings supply and demand into balance.

An important prerequisite for the price system to work is an economy-wide

respect for property rights Property rights refer to the ability of people to exercise

authority over the resources they own A mining company will not make the effort

to mine iron ore if it expects the ore to be stolen The company mines the ore only

if it is confident that it will benefit from the ore’s subsequent sale For this reason, courts serve an important role in a market economy: They enforce property rights Through the criminal justice system, the courts discourage direct theft In addition, through the civil justice system, the courts ensure that buyers and sellers live up to their contracts.

Although those of us in developed countries tend to take property rights for granted, those living in less developed countries understand that lack of property rights can be a major problem In many countries, the system of justice does not work well Contracts are hard to enforce, and fraud often goes unpunished.

In more extreme cases, the government not only fails to enforce property rights but actually infringes upon them To do business in some countries, firms are expected to bribe powerful government officials Such corruption impedes the coordinating power of markets It also discourages domestic saving and invest-ment from abroad.

One threat to property rights is political instability When revolutions and coups are common, there is doubt about whether property rights will be respected

in the future If a revolutionary government might confiscate the capital of some businesses, as was often true after communist revolutions, domestic residents have less incentive to save, invest, and start new businesses At the same time, foreign-ers have less incentive to invest in the country Even the threat of revolution can act

to depress a nation’s standard of living.

Thus, economic prosperity depends in part on political prosperity A country with an efficient court system, honest government officials, and a stable constitu-tion will enjoy a higher economic standard of living than a country with a poor court system, corrupt officials, and frequent revolutions and coups.

F R E E T R A D E Some of the world’s poorest countries have tried to achieve more rapid economic

growth by pursuing inward-oriented policies These policies are aimed at raising

pro-ductivity and living standards within the country by avoiding interaction with the rest of the world As we discussed in Chapter 9, domestic firms sometimes claim they need protection from foreign competition in order to compete and grow This infant-industry argument, together with a general distrust of foreigners, has at

times led policymakers in less developed countries to impose tariffs and other

trade restrictions.

Most economists today believe that poor countries are better off pursuing

outward-oriented policies that integrate these countries into the world economy.

Chapters 3 and 9 showed how international trade can improve the economic

well-being of a country’s citizens Trade is, in some ways, a type of technology When a

country exports wheat and imports steel, the country benefits in the same way as

if it had invented a technology for turning wheat into steel A country that

elimi-nates trade restrictions will, therefore, experience the same kind of economic

growth that would occur after a major technological advance.

The adverse impact of inward orientation becomes clear when one considers

the small size of many less developed economies The total GDP of Argentina,

for instance, is about that of Philadelphia Imagine what would happen if the

Philadelphia City Council were to prohibit city residents from trading with people

living outside the city limits Without being able to take advantage of the gains

from trade, Philadelphia would need to produce all the goods it consumes.

It would also have to produce all its own capital goods, rather than importing

state-of-the-art equipment from other cities Living standards in Philadelphia

would fall immediately, and the problem would likely only get worse over time.

This is precisely what happened when Argentina pursued inward-oriented

poli-cies throughout much of the twentieth century By contrast, countries pursuing

outward-oriented policies, such as South Korea, Singapore, and Taiwan, have

enjoyed high rates of economic growth.

The amount that a nation trades with others is determined not only by

gov-ernment policy but also by geography Countries with good natural seaports find

trade easier than countries without this resource It is not a coincidence that many

of the world’s major cities, such as New York, San Francisco, and Hong Kong, are

located next to oceans Similarly, because landlocked countries find international

trade more difficult, they tend to have lower levels of income than countries with

easy access to the world’s waterways.

T H E C O N T R O L O F P O P U L AT I O N G R O W T H

A country’s productivity and living standard are determined in part by its

popu-lation growth Obviously, popupopu-lation is a key determinant of a country’s labor

force It is no surprise, therefore, that countries with large populations (such as the

United States and Japan) tend to produce greater GDP than countries with small

populations (such as Luxembourg and the Netherlands) But total GDP is not a

good measure of economic well-being For policymakers concerned about living

standards, GDP per person is more important, for it tells us the quantity of goods

and services available for the typical individual in the economy.

How does growth in the number of people affect the amount of GDP per

per-son? Standard theories of economic growth predict that high population growth

reduces GDP per person The reason is that rapid growth in the number of

work-ers forces the other factors of production to be spread more thinly In particular,

when population growth is rapid, equipping each worker with a large quantity of

capital is more difficult A smaller quantity of capital per worker leads to lower

productivity and lower GDP per worker.

This problem is most apparent in the case of human capital Countries with high population growth have large numbers of school-age children This places

a larger burden on the educational system It is not surprising, therefore, that educational attainment tends to be low in countries with high population growth.

The differences in population growth around the world are large In devel-oped countries, such as the United States and western Europe, the population has risen about 1 percent per year in recent decades, and it is expected to rise even more slowly in the future By contrast, in many poor African countries, population growth is about 3 percent per year At this rate, the population doubles every

23 years.

Reducing the rate of population growth is widely thought to be one way less developed countries can try to raise their standards of living In some countries, this goal is accomplished directly with laws regulating the number of children families may have China, for instance, allows only one child per family; couples who violate this rule are subject to substantial fines In countries with greater

You may have heard economics called “the dismal science.”

The field was pinned with this label many years ago be-cause of a theor y proposed

by Thomas Rober t Malthus (1766–1834), an English min-ister and early economic thinker In a famous book

called An Essay on the

Princi-ple of Population as It Affects the Future Improvement of Society, Malthus offered what

may be histor y’s most chilling forecast Malthus argued that

an ever increasing population would continually strain

soci-ety’s ability to provide for itself As a result, mankind was

doomed to forever live in pover ty.

Malthus’s logic was ver y simple He began by noting

that “food is necessar y to the existence of man” and that

“the passion between the sexes is necessar y and will

remain nearly in its present state.” He concluded that “the

power of population is infinitely greater than the power in the

ear th to produce subsistence for man.” According to

Malthus, the only check on population growth was “miser y

and vice.” Attempts by charities or governments to alleviate

pover ty were counterproductive, he argued, because they

merely allowed the poor to have more children, placing even

greater strains on society’s productive capabilities.

For tunately, Malthus’s dire forecast was far off the

mark Although the world population has increased about

sixfold over the past two centuries, living standards around

the world are on average much higher As a result of economic growth, chronic hunger and malnu-trition are less common now than they were in Malthus’s day.

Famines occur from time to time, but they are more often the result

of an unequal income distribution

or political instability than an inad-equate production of food.

Where did Malthus go wrong?

He failed to appreciate that growth

in mankind’s ingenuity would exceed growth in population New ideas about how to produce and even the kinds of goods to produce have led to greater prosperity than Malthus—or anyone else of his era—ever imagined Pesticides, fer tiliz-ers, mechanized farm equipment, and new crop varieties have allowed each farmer to feed ever greater numbers of people The wealth-enhancing effects of technological progress have exceeded whatever wealth-diminishing effects might be attributed to population growth.

Indeed, some economists now go so far as to suggest that population growth may even have helped mankind achieve higher standards of living If there are more people, then there are more scientists, inventors, and engineers to contribute to technological progress, which benefits ever y-one Perhaps world population growth, rather than being a source of economic deprivation as Malthus predicted, has actually been an engine of technological progress and eco-nomic prosperity.

T HOMAS M ALTHUS

F Y I

Thomas

Malthus on

Population

Growth

C A S E S T U D Y THE PRODUCTIVITY SLOWDOWN

From 1959 to 1973, productivity, as measured by output per hour worked in

U.S businesses, grew at a rate of 3.2 percent per year From 1973 to 1998,

pro-ductivity grew by only 1.3 percent per year Not surprisingly, this slowdown in

productivity growth has been reflected in reduced growth in real wages and

family incomes It is also reflected in a general sense of economic anxiety.

freedom, the goal of reduced population growth is accomplished less directly by

increasing awareness of birth control techniques.

The final way in which a country can influence population growth is to apply

one of the Ten Principles of Economics: People respond to incentives Bearing a child,

like any decision, has an opportunity cost When the opportunity cost rises, people

will choose to have smaller families In particular, women with the opportunity to

receive good education and desirable employment tend to want fewer children

than those with fewer opportunities outside the home Hence, policies that foster

equal treatment of women are one way for less developed economies to reduce the

rate of population growth.

R E S E A R C H A N D D E V E L O P M E N T

The primary reason that living standards are higher today than they were a

cen-tury ago is that technological knowledge has advanced The telephone, the

tran-sistor, the computer, and the internal combustion engine are among the thousands

of innovations that have improved the ability to produce goods and services.

Although most technological advance comes from private research by firms

and individual inventors, there is also a public interest in promoting these efforts.

To a large extent, knowledge is a public good: Once one person discovers an idea,

the idea enters society’s pool of knowledge, and other people can freely use it Just

as government has a role in providing a public good such as national defense, it

also has a role in encouraging the research and development of new technologies.

The U.S government has long played a role in the creation and dissemination

of technological knowledge A century ago, the government sponsored research

about farming methods and advised farmers how best to use their land More

recently, the U.S government has, through the Air Force and NASA, supported

aerospace research; as a result, the United States is a leading maker of rockets and

planes The government continues to encourage advances in knowledge with

research grants from the National Science Foundation and the National Institutes

of Health and with tax breaks for firms engaging in research and development.

Yet another way in which government policy encourages research is through

the patent system When a person or firm invents a new product, such as a new

drug, the inventor can apply for a patent If the product is deemed truly original,

the government awards the patent, which gives the inventor the exclusive right to

make the product for a specified number of years In essence, the patent gives the

inventor a property right over his invention, turning his new idea from a public

good into a private good By allowing inventors to profit from their inventions—

even if only temporarily—the patent system enhances the incentive for

individu-als and firms to engage in research.

Because it has accumulated over so many years, this fall in productivity growth

of 1.9 percentage points has had a large effect on incomes If this slowdown had not occurred, the income of the average American would today be about 60 per-cent higher.

The slowdown in economic growth has been one of the most important problems facing economic policymakers Economists are often asked what caused the slowdown and what can be done to reverse it Unfortunately, despite much research on these questions, the answers remain elusive.

Two facts are well established First, the slowdown in productivity growth

is a worldwide phenomenon Sometime in the mid-1970s, economic growth slowed not only in the United States but also in other industrial countries, including Canada, France, Germany, Italy, Japan, and the United Kingdom Although some of these countries have had more rapid growth than the United States, all of them have had slow growth compared to their own past experi-ence To explain the slowdown in U.S growth, therefore, it seems necessary to look beyond our borders.

Second, the slowdown cannot be traced to those factors of production that are most easily measured Economists can measure directly the quantity of physical capital that workers have available They can also measure human cap-ital in the form of years of schooling It appears that the slowdown in produc-tivity is not primarily attributable to reduced growth in these inputs.

Technology appears to be one of the few remaining culprits That is, having ruled out most other explanations, many economists attribute the slowdown in economic growth to a slowdown in the creation of new ideas about how to pro-duce goods and services Because the quantity of “ideas” is hard to measure, this explanation is difficult to confirm or refute.

In some ways, it is odd to say that the last 25 years have been a period of slow technological progress This period has witnessed the spread of computers across the economy—an historic technological revolution that has affected almost every industry and almost every firm Yet, for some reason, this change has not yet been reflected in more rapid economic growth As economist Robert Solow put it, “You can see the computer age everywhere but in the productivity statistics.”

What does the future of economic growth hold? An optimistic scenario is that the computer revolution will rejuvenate economic growth once these new machines are integrated into the economy and their potential is fully under-stood Economic historians note that the discovery of electricity took many decades to have a large impact on productivity and living standards because people had to figure out the best ways to use the new resource Perhaps the computer revolution will have a similar delayed effect Some observers believe this may be starting to happen already, for productivity growth did pick up a bit

in the late 1990s It is still too early to say, however, whether this change will persist.

A more pessimistic scenario is that, after a period of rapid scientific and technological advance, we have entered a new phase of slower growth in knowledge, productivity, and incomes Data from a longer span of history seem

to support this conclusion Figure 24-2 shows the average growth of real GDP per person in the developed world going back to 1870 The productivity slow-down is apparent in the last two entries: Around 1970, the growth rate slowed from 3.7 to 2.2 percent But compared to earlier periods of history, the anomaly

is not the slow growth of recent years but rather the rapid growth during the

1950s and 1960s Perhaps the decades after World War II were a period of

unusually rapid technological advance, and growth has slowed down simply

because technological progress has returned to a more normal rate.

Growth Rate

(percent

per year)

1.0 1.5 2.0 2.5 3.0 3.5 4.0

1870–

1890

1890–

1910

1910–

1930

1930–

1950

1950–

1970

1970–

1990 0

F i g u r e 2 4 - 2

PER PERSON This figure shows the average growth rate of real GDP per person for 16 advanced economies, including the major countries of Europe, Canada, the United States, Japan, and Australia Notice that the growth rate rose substantially after 1950 and then fell after 1970.

S OURCE : Robert J Barro and Xavier

Sala-i-Martin, Economic Growth (New York:

McGraw-Hill, 1995), p 6.

Q U I C K Q U I Z : Describe three ways in which a government policymaker

can try to raise the growth in living standards in a society Are there any

drawbacks to these policies?

C O N C L U S I O N :

T H E I M P O R TA N C E O F L O N G - R U N G R O W T H

In this chapter we have discussed what determines the standard of living in a

nation and how policymakers can endeavor to raise the standard of living through

policies that promote economic growth Most of this chapter is summarized in one

of the Ten Principles of Economics: A country’s standard of living depends on its

ability to produce goods and services Policymakers who want to encourage

growth in standards of living must aim to increase their nation’s productive ability

by encouraging rapid accumulation of the factors of production and ensuring that

these factors are employed as effectively as possible.

Economists differ in their views of the role of government in promoting eco-nomic growth At the very least, government can lend support to the invisible hand by maintaining property rights and political stability More controversial is whether government should target and subsidize specific industries that might be

ECONOMIST JEFFREY SACHS HAS BEEN A

prominent adviser to governments

seeking to reform their economies and

raise economic growth He has also

been a critic of the World Bank and the

International Monetary Fund (IMF), the

international policy organizations that

dispense advice and money to

strug-gling countries Here Sachs discusses

how the countries of Africa can escape

their continuing poverty.

G r o w t h i n A f r i c a : I t C a n B e D o n e

BY JEFFREY SACHS

In the old story, the peasant goes to

the priest for advice on saving his

dy-ing chickens The priest recommends

prayer, but the chickens continue to

die The priest then recommends music

for the chicken coop, but the deaths

continue unabated Pondering again,

the priest recommends repainting the

chicken coop in bright colors Finally, all

the chickens die “What a shame,” the

priest tells the peasant “I had so many

more good ideas.”

Since independence, African coun-tries have looked to donor nations—

often their former colonial rulers—and to the international finance institutions for guidance on growth Indeed, since the onset of the African debt crises of the 1980s, the guidance has become a kind

of economic receivership, with the poli-cies of many African nations decided in a seemingly endless cycle of meetings with the IMF, the World Bank, donors, and creditors.

What a shame So many good ideas, so few results Output per head fell 0.7 percent between 1978 and 1987, and 0.6 percent during 1987–1994.

Some growth is estimated for 1995 but only at 0.6 percent—far below the faster-growing developing countries The IMF and World Bank would be absolved of shared responsibility for slow growth if Africa were structurally incapable of growth rates seen in other parts of the world or if the continent’s low growth were an impenetrable mys-tery But Africa’s growth rates are not huge mysteries The evidence on cross-country growth suggests that Africa’s chronically low growth can be explained by standard economic vari-ables linked to identifiable (and remedi-able) policies .

Studies of cross-country growth show that per capita growth is related to:

• the initial income level of the coun-try, with poorer countries tending to grow faster than richer countries;

• the extent of overall market orienta-tion, including openness to trade, domestic market liberalization, private rather than state owner-ship, protection of private property rights, and low marginal tax rates;

• the national saving rate, which in turn is strongly affected by the gov-ernment’s own saving rate; and

• the geographic and resource struc-ture of the economy .

These four factors can account broadly for Africa’s long-term growth predicament While it should have grown faster than other developing areas because of relatively low income per head (and hence larger opportunity for

“catch-up” growth), Africa grew more slowly This was mainly because of much

I N T H E N E W S

A Solution to

Africa’s Problems