 Theories of Economic Growth

 The Challenge of Economic

Development
 Economic growth represent the expansion
of country’s potential GDP or national
output.
› Economic growth occurs when a nation’s
production possibility frontier (PPF) shift outward.
› A closely related concept is the growth in output
per capita, because it is associated with rising
average real incomes and living standards.
 Human resources: labor supply, education,
discipline, motivation.
 Natural resources: land, mineral, fuels,
environmental quality.
 Capital formation: machines, factories,
roads, intellectual property, social
overhead capital
 Technology: science, engineering,
management, entrepreneurship.
 APF shows the relationship between inputs
and technology, and total national output.
Q = A F(K,L,R)
Where Q = output, K = capital, L = labor,
R=natural resources, A= level of technology
› As technology (A) improves through new
invention or the adoption of technologies
from abroad, this advance allows a country
to produce more output with the same level
of inputs
 Land is primary factor in economic growth
 lands is freely available
 When population doubles, national output exactly
doubles
 as population growth continues, all land will be
occupied
 increasing man-land ratio leads to a declining
marginal product of labor and hence to declining
real wages
 T.R. Malthus thought that population
pressures would drive the economy to a
point where worker were at the minimum
level of subsistence.
› whenever wages were above the
subsistence level, population would expand,
› Wage below subsistence level would lead to
high mortality and population decline
› Thus, only at subsistence wages could there
be a stable equilibrium of population
QC QC

400
300

L=4
200 200
L=4
L=2
L=2

100 200 QF 100 125 QF

(a) Smith’s Golden Age (b) Malthus’s Dismal Science

 The major ingredients in the Neoclassical
model are capital and technological
change.
 Capital consists of durable goods,
including factories and house,
equipment, inventories of finished goods
an goods in process.
Assumptions
 The economy is competitive and always
operate at full employment
 A production function has constant returns
to scale if, for any positive number x,
xQ = A F(xL, xK)
 That is, a doubling of all inputs causes the
amount of output to double as well.
 › Setting x = 1/L,
› Q/ L = A F(1, K/ L)
Where:
Q/L = output per worker
K/L = capital per worker, or
 The preceding equation says that
productivity (Q/L) depends on physical
capital per worker, or the capital –labor
ratio(K/L)as well as the state of
technology, (A).
 In the absence of technological
change, capital deepening will increase
› output per worker
› marginal product of labor
› real wages
› and also will lead to diminishing returns to
capital
 as the amount of
capital per worker
increases, output
per worker also
increases
 as capital
deepening the
marginal product
of capital will fall
 In the long-run,
the economy
enter a steady
state in which
capital
deepening cases,
output per worker
eventually stop
rising (at V in the
figure)
 Technological
progress shift the
APF upward,
raises output per
worker
 Thus, new steady
state with higher
level output per
worker can be
achieved
 This theory is also called Endogenous
Growth Theory
 The new growth theory seeks to
uncover the processes by which
private market forces, public policy
decisions, and alternative institution
lead to different patterns of
technological change.
 This approach emphasizes that
technological change is an output that is
subject to severe market failures
because technology is a public good
that is expensive to produce but cheap
to reproduce.
 The new growth theory has changed the
way we think about the growth process
and public policies.
› If technological differences are the major
reason for differences in living standard
among nations, and if technology is a
produced factor, then economic-growth
policy should focus much more sharply on
how nations can improve their technological
performance.
Growth Accounting Approach (GAA)
 According to this approach, growth in
output(Q) can be decomposed into three
separate terms: growth in labor (L) times it
weight, growth in capital (L) times it weight,
and technological change (TC)
 Suppose that labor’s growth are gets 3
times the weight of capital’s growth, then
equation of growth accounting:
% Q growth = ¾ (% L growth) + ¼ (% K growth) + TC
Where:
› TC represents technological change (or Total
Factor Productivity = TFP) that raises productivity
› ¾ and ¼ are the relative contributions of each
input to economic growth (or equal to the shares
of national income of the two factors)
 How capital deepening would effect per
capita output if technological advance
were zero?
% Q/L growth = % Q growth - % L Growth
since,
% Q growth = ¾ (% L growth) + ¼ (% K growth) + TC
thus,
% Q/L growth = ¼ (% K growth) + TC
› Output per worker would grow only one-
fourth as fast as capital per worker, reflecting
diminishing returns
 How can we measure technological
change (TC)?
Recall:
% Q growth = ¾ (% L growth) + ¼ (% K growth) + TC
thus,
TC = % Q growth - ¾ (% L growth) - ¼ (% K growth)
 The most important characteristic of a
developing countries
› Low per capita income
› Poor health
› Low level of literacy
› Extensive malnutrition
› Little capital to work with
› Weak market and government institution
› Corruption and civil strife
› High population growth, but they suffer from out-
migration, particularly among skilled worker
 Poor countries face great obstacles in
combining factors of growth,
 In addition, this countries find that the
difficulties reinforce each other in a
vicious cycle of poverty,
 Countries that suffer from a vicious cycle
can get caught in a poverty trap
 The quality of human resources
› Control disease and improve health and
nutrition
› Improve education, reduce illiteracy, and
train workers
 capital accumulation
› Encourage saving and investment
› Encourage investment from abroad
 Investment from abroad takes several
forms:
› Foreign Direct Investment
 Capital investment owned and operated by a
foreign entity.
› Foreign Portfolio Investment
 Investments financed with foreign money but
operated by domestic residents.
Diminishing Returns and the Catch-Up Effect
 As the stock of capital rises, the extra output
produced from an additional unit of capital
falls; this property is called diminishing returns.
› Because of diminishing returns, an increase in the
saving rate leads to higher growth only for a while
 The catch-up effect refers to the property
whereby countries that start off poor tend to
grow more rapidly than countries that start off
rich.
 Technological progress
› Promote research and development
› Encourage the development of new
technologies through research grants, tax
breaks, and the patent system
› Promote an entrepreneurship spirit
› Maintain an economy open to trade
› Imitating technology???
 Other policies
› Foster the rule of law
› Make the critical investment in social
overhead capital
 We see how countries must combine
labor, capital, natural resources and
technology in order to grow rapidly
 but, how countries might break out of
the vicious cycle of poverty and begin to
mobilize the four wheels of economic
development.
 The Backwardness Hypothesis: “relative
backwardness itself may aid development”
1. Countries buy modern textile, machinery, etc,
2. They can lean on the technologies of
advanced countries ,
3. They can draw upon the more productive
technologies of the leader
4. They can grow more rapidly than did
advanced countries
 Industrialization vs. Agriculture
› The lesson of decades of attempts to accelerate
industrialization at the expense of agriculture has
led many analysts to rethink the role of farming
› Industrialization is capital-intensive, attracts
workers into crowded cities, and often produces
high levels of unemployment
› Raising productivity on farms may require less
capital, while providing productive employment
for surplus labor
 State vs. Market
› The cultures of many developing countries are
hostile on the operation of markets
› Competition among firms or profit seeking
behavior is contrary to traditional practices,
religious beliefs, or vested interests
› Yet decades of experience suggest that
extensive reliance on markets provides the most
effective way of managing and promoting rapid
economic growth.
 Growth and Outward Orientation
› Outward orientation or openness allowed the
countries to reap economies of scale and the
benefits of international specialization and thus
to increase employment, use domestic
resources effectively, enjoy rapid productivity
growth, and provide enormous gains in living
standards.