THINKING LIKE AN ECONOMIST
concept. It helps in understanding the importance of designing appropriate supply-side policies: policies that focus on increasing aggregate supply rather than manag- ing aggregate demand. It is easy to worry too much about the short term.
This is not to say that the short term should be neglected.
The famous economist John Maynard Keynes argued that it was fundamentally important to focus on aggregate demand and the short term to avoid severe economic fluc- tuations, with the twin problems of high unemployment in recessions and high inflation in periods of unsustainably high growth. He used the famous phrase ‘In the long term we’re all dead.’
But although we all have to die sometime, we may have many years left to reap the benefits of appropriate supply- side policy. And even if we don’t, our children will.
1. Give some examples of supply-side policy (see Chapter 23 for some ideas if you are stuck).
2. If there is an increase in aggregate supply, will this result in an increase in potential growth?
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In the short term, economic growth is likely to be influ- enced by changes in aggregate demand. If the economy is in recession, an expansion in aggregate demand will help to bring the economy out of recession and move it closer to full employment.
Actual output, however, cannot continue growing faster than potential output over the longer term. Firms will start reaching capacity and actual growth will then have to slow. The rate of potential growth thus places a limit to the rate of actual growth over the longer term.
What then determines the rate of growth in potential out- put? The answer lies on the supply side. It depends on the rate of growth of factors of production. There are two key elements here. The first is growth in the simple quantity of factors: growth in the size of the workforce, of the avail- able land and raw materials, and of the stock of capital.
The second is productivity growth. This involves elements such as growth in the educational attainments and skills of the workforce, growth in technology, and growth in the efficiency with which resources are used.
To recognise the importance of resources and their pro- ductivity in determining long-term growth is a threshold
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BOX 14.5 THEORIES OF GROWTH
From dismal economics to the economics of optimism
EXPLORING ECONOMICS
New growth theory
Economists today are more optimistic about the prospects for economic growth. This is partly based on a simple appeal to the evidence. Despite a rapid growth in world population, most countries have experienced sustained economic growth. Over the past hundred years the industrialised countries have seen per-capita growth rates averaging from just over 1 per cent to nearly 3 per cent per annum. This has resulted in per-capita real incomes many times higher than in the nineteenth century.
This worldwide experience of economic growth has stimulated the development of new growth theories.
These stress two features:
• The development and spread of new technology.
The rapid advances in science and technology have massively increased the productivity of factors of production. What is more, new inventions and innovations stimulate other people, often in other countries, to copy, adapt and improve on them in order to stay competitive. Growth through technical progress stimulates more growth.
• The positive externalities of investment. If one firm invests in training in order to raise labour productivity, other firms will benefit from the improved stock of
‘human capital’. There will be better-trained labour that can now be hired by other firms. Similarly, if one firm invests in research and development, the benefits can spill over to other firms (once any patents have expired). These spillover benefits to other firms can be seen as the positive externalities of investment.
New growth theories seek to analyse the process of the spread of technology and how it can be influenced.
Given that technological progress allows the spectre of diminishing returns to be banished, or at least indefinitely postponed, it is no wonder that many economists are more optimistic about growth.
Nevertheless, there are still serious grounds for concern.
• If the benefits of investment spill over to other firms (i.e. if there are positive externalities), the free market will lead to too little investment: firms considering investing will take into account only the benefits to themselves, not those to other firms. There is thus an important role for governments to encourage or provide training, research and capital investment.
(We consider such policies in Chapter 23.)
• Potential growth may not translate into actual growth.
A potentially growing economy may be languishing in a deep recession.
• There may be serious costs of economic growth: see Box 14.6.
Can growth go on for ever, given that certain resources are finite in supply?
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The classical theory of growth
The classical economists of the nineteenth century were very pessimistic about the prospects for economic growth.
They saw the rate of growth petering out as diminishing returns to both labour and capital led to low wages and a falling rate of profit. The only gainers would be landlords, who, given the fixed supply of land, would receive higher and higher rents as the demand for scarce land rose.
The classical position can be shown graphically. The size of the working population is plotted on the horizontal axis. If it is assumed that there is a basic minimum
‘subsistence’ wage that workers must earn in order to survive, then the line WStraces out the total subsistence wage bill. It is a straight line because a doubling in the number of workers would lead to a doubling of the subsistence wage bill.
The line Yshows the total level of income that will be generated as more workers are employed, after subtracting rents to landlords. In other words, it is total wages plus profits. It gets less and less steep due to diminishing returns to labour and capital given the fixed supply of land.
As long as Yis above WS(say, at a population of N1), firms can make a profit. They will try to expand and will thus take on more labour.
Initially this will bid up the wage and will thus erode the level of profits. But the higher wages will encourage the population to expand. This increased supply of labour will compete wages back down to the subsistence level and will thus allow some recovery in profits. But profits will not be as high as they were before because, with an increase in workers, the gap between Yand WSwill have narrowed.
Firms will continue to expand and the population will continue to grow until point eis reached. At that point, even with wages at bare subsistence level, no profit can be made. Growth will cease. The economy will be in a long-run stationary state.
No wonder economics became dubbed ‘the dismal science’.
Long-run stationary state in the classical model
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BOX 14.6 THE COSTS OF ECONOMIC GROWTH Is more necessarily better?
Society may feel that it can afford to care more for the environment. As people grow richer, they may become less preoccupied with their own private consumption and more concerned to live in a clean environment. The regulation of pollution tends to be tougher in developed countries than in the developing world.
The costs of growth
In practice, more consumption may not make people happier; economies may be no less crisis-riven; income may not be redistributed more equally; the environment may not be better protected. More than this, some people argue that growth may worsen these problems and create additional problems besides.
It has current opportunity costs. To achieve faster growth, firms will probably need to invest more. This will require financing. The finance can come from more saving, higher retained profits or higher taxes. Either way, there must be a cut in consumption. In the short run, therefore, higher growth leads to less consumption, not more.
In the diagram, assume that consumption is currently at a level of C1. Its growth over time is shown by the line For many developing countries, economic growth is
a necessity if they are to remove mass poverty. When the majority of their population is underfed and poorly housed, with inadequate health care and little access to education, few would quarrel with the need for an increase in productive potential. The main query is whether the benefits of economic growth will flow to the mass of the population, or whether they will be confined to the few who are already relatively well off.
For developed countries, the case for economic growth is less clear cut. Economic growth is usually measured in terms of the growth in GDP. The problem is that there are many ‘goods’ and ‘bads’ that are not included in GDP (see Box 14.7). Economic growth, therefore, is not the same as growth in a nation’s welfare.
So, what are the benefits and costs of economic growth?
The benefits of growth
It leads to increased levels of consumption. Provided economic growth outstrips population growth, it will lead to higher real income per head. This can lead to higher levels of consumption of goods and services. If human welfare is related to the level of consumption, then growth provides an obvious gain to society.
It can help avoid other macroeconomic problems.
People aspire to higher living standards. Without a growth in productive potential, people’s demands for rising incomes are likely to lead to higher inflation, balance of payments crises (as more imports are purchased), industrial disputes, etc. Growth in productive potential helps to meet these aspirations and avoid macroeconomic crises.
It can make it easier to redistribute incomes to the poor.
If incomes rise, the government can redistribute incomes from the rich to the poor without the rich losing. For example, as people’s incomes rise, they automatically pay more taxes. These extra revenues for the government can be spent on programmes to alleviate poverty. Without a continuing rise in national income, the scope for helping the poor is much more limited.
High and low growth paths
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CASE STUDIES AND APPLICATIONS
minerals and fossil fuels, present growth may lead to shortages for future generations (see Box 9.10).
It has effects on the distribution of income. While some people may gain from a higher standard of living, others are likely to lose. If the means to higher growth are greater incentives (such as cuts in higher rates of income tax), then the rich might get richer, with little or no benefit
‘trickling down’ to the poor.
Growth involves changes in production, both in terms of the goods produced and in terms of the techniques used and the skills required. The more rapid the rate of growth, the more rapid the rate of change. People may find that their skills are no longer relevant. Their jobs may be replaced by machines. People may thus find themselves unemployed and need to retrain, or they may be forced to take low-paid, unskilled work.
Conclusion
So should countries pursue growth? The answer depends on (a) just what costs and benefits are involved, (b) what weighting people attach to them, and (c) how opposing views are to be reconciled.
A problem is that the question of the desirability of economic growth is a normative one. It involves a judgement about what a ‘desirable’ society should look like.
A simpler point, however, is that the electorate seems to want economic growth. As long as that is so, governments will tend to pursue policies to achieve growth. That is why we need to study the causes of growth and the policies that governments can pursue.
One thing the government can do is to view the problem as one of constrained optimisation. It sets constraints: levels of environmental protection, minimum wages, maximum rates of depletion of non- renewable resources, etc. It then seeks policies that will maximise growth, while keeping within these constraints.
1. Is a constrained optimisation approach a practical solution to the possible costs of economic growth?
2. Are worries about the consequences of economic growth a ‘luxury’ that only rich countries can afford?
?
out from C1. Now assume that the government pursues a policy of higher growth. Consumption has to fall to finance the extra investment. Consumption falls to, say, C2. The growth in consumption is now shown by the line out from C2. Not until time t1is reached (which may be several years into the future) does consumption overtake the levels that it would have reached with the previous lower growth rate.
It may simply generate extra demands. ‘The more people have, the more they want.’ If this is so, more consumption may not increase people’s utility at all. (Diagrammatically, indifference curves may move outwards as fast as, or even faster than, consumers’ budget lines: see section 4.3.) It is often observed that happiness depends on relative rather than absolute incomes. Thus as developed countries get richer their citizens do not get happier.
It has social effects. Many people claim that an excessive pursuit of material growth by a country can lead to a more greedy, more selfish and less caring society. As society becomes more industrialised, violence, crime, loneliness, stress-related diseases, suicides, divorce and other social problems are likely to rise.
By contrast, a life that is less materialistic may be more fulfilling. The term ‘gross national happiness’ was coined by King Jigme Singye of Bhutan. He argued that his people, although poor in materialistic terms, have a high quality of life living in harmony with their environment according to Buddhist philosophy.
It has environmental costs. A richer society may be more concerned for the environment, but it is also likely to do more damage to it. The higher the level of consumption, the higher is likely to be the level of pollution and waste.
What is more, many of the environmental costs are likely to be underestimated due to a lack of scientific knowledge. Acid rain and the depletion of the ozone layer have been two examples.
It uses non-renewable resources. If growth involves using a greater amount of resources, rather than using the same amount of resources more efficiently, certain non-renewable resources will run out more rapidly.
Unless viable alternatives can be found for various
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The effects of actual growth on potential growth
Some economists argue that potential growth is not influenced by actual growth. It depends largely on growth in factor productivity, and that in turn depends on sci- entific and technical advance. Such advances, they argue, are independent of the state of the economy.
Other economists, however, argue that actual growth stimulates investment and the development of new tech- nology. For these economists, therefore, it is vital for the achievement of high long-term growth rates that the eco- nomy experiences continuous and stable growth in actual output. Recessions breed pessimism and a lack of invest- ment, a lack of research and a lack of innovation (see Box 14.4 on page 402).
Policies to achieve growth
How can governments increase a country’s growth rate?
Policies differ in two ways.
First, they may focus on the demand side or the supply side of the economy. In other words, they may attempt to create sufficient aggregate demandto ensure that firms wish to invest and that potential output is realised. Alternatively they may seek to increase aggregate supplyby concentrating on measures to increase potential output: measures to en- courage research and development, innovation and training.
Second, they may be market-orientated or interven- tionist policies. Many economists and politicians, especi- ally those on the political right, believe that the best environment for encouraging economic growth is one where private enterprise is allowed to flourish: where entrepreneurs are able to reap substantial rewards from investment in new techniques and new products. Such economists, therefore, advocate policies designed to free up the market. Others, however, argue that a free market will be subject to considerable cyclical fluctuations. The resulting uncertainty will discourage investment. These economists, therefore, tend to advocate active intervention by the government to reduce these fluctuations.
We focus on demand-side policies in Chapter 20 and on supply-side policies in Chapter 23. In each case we look at both interventionist and market-orientated policies.
Postscript: The role of investment
Investment plays a dual role in economic growth. It is a component of aggregate demand and thus helps determine the level of actual output. It is also probably the major determinant of potential output, since investment both increases the capital stock and also leads to the develop- ment of new technology. It is important, therefore, that when investment rises, the resulting rise in aggregate demand matches the resulting rise in aggregate supply.
There is a problem of timing here, however. Generally the effects on aggregate demand happen more quickly than those on aggregate supply.