Principles of Economics

Economic Growth and DevelopmentTomislav Herceg

Theories of Economic Growth

• Economic growth (gy) is the expansion of a country’s potential GDP (outward shift of PPF curve)

• Growth rate of output per person (gy p.c.) shows how living standards rise.

• In the 20th century GDP increased 30 times.

4 wheels of growth

• Aggregate production function (AFP) relates country’s output to inputs and technology:

Y = A×f(K, HL, N)Where A stands for technology, K for capital, HL for labour and human capital and N for natural resources and Y for national output.• One can increase production by increasing

inputs K, N or HL, or by improving technology N

1. Human resources, HL• Labour consists of workers (L) and of the skills of

the workforce (human capital, H)• In order to use capital efficiently it has to be

matched with human capital.• Human capital is increased by education, training

and health care, thus increasing HL input.

• N consists of arrable land, oil & gas, forests, water and minerals.

2. Natural Resources (N)

Capital formation (K)

• Capital is formed through investment and depreciated over the years (δ)

• Investment is sacrifice of current consumption

• Investments can be private (equipment and factories) or government made (social overhead capital, SOC).

• SOC aim is to make spillovers (positive externalities)• Some of private investment cause network

externalities (the more users the greater productivity)

Technology change and innovation (A)

• Improvement ion technology raises output at the same level of inputs

• Several major technological advancements: electricity, television, computers, cell phones, Internet – they all have ∫ shaped pattern.

• Technological change denotes change in the processes of production or introduction of new products or services.

• Entrepreneurship is crucial for technological change

Theories of Economic Growth

• Classical theory (Malthus, Smith): land is crucial for growth.

• Smith: when there is ample space there are constant returns to scale (Golden Era)

• Malthus: population keeps growing and land is limited: adding new workers rises production with diminishing returns (Dismal science)

Neoclassical growth model

• capital accumulation and technology advancements overcome diminishing returns to labour

• Assumptions: full employment, labour growth rate given, inputs labour and capital:

• Y (K, L) = A×f(K, L), or Y (K/L) = A×f(K/L) (leave A fixed for the time being)

• K/L = capital per worker• The increase in K/L = capital deepening• Capital deepening causes the increase in labour

productivity, hence salaries (w) rise, but causes diminishing returns to capital

Economic growth through capital deepening & technology change

APF1

Y/L

K/L(K/L)0 (K/L)1

(Y/L)0,0

(Y/L)0,1

APF0

Technology improvement

Capital deepening

(Y/L)1,1

• Without technology change capital deepening stops and economy gets to the steady state (no change in output and wages)

• Technology change (A↑) can overcome diminishing returns to capital and move economy from steady state

Endogenous growth theory

• New growth theory that says that technological change is an output of a production process, with many attempt – mistake cases.

• Technology is thus public good (expensive to produce, but cheap to reproduce) – hence protection of intelectual property exists to protect developers’ extra profits

7 basic trends in economic growth

• K has grown more rapidly than population• w increased significantly in the last century• Share of wages in output has been stable• Real interest rates oscillate, but there is no

trend• K/Y declined in the past century• S/Y is stable• Average gy has been 3%

Sources of economic growth

• Growth accounting is a method to separate impacts of different variables on growth

• It was found out that labour contributes for ¾ of economic growth, while capital contributes for ¼ of growth

• Growth accounting equation:gY = ¾ gL + ¼ gK + gA

Where gY, gL, gK and gA stand for growth of output, labour, capital and technology (total factor productivity growth).Growth accounting equation for GDP p.c.:gY/L = ¼ gK/L + gA

Economic development• Developing country is a country with low per capita income

(GDP p.c.), mostly related to low levels of literacy, to malnutrition, poor health and low capital stocks

• GDP p.c. is compared purchasing power parity is used (PPP) because exchange rates understate incomes in developing countries.

• E.g. bread in Egypt costs 1 EGP. Bread in UK costs 2 GBP. How many loafs can an average Egyptian or an average Brit buy? Average salary in Egypt is 100 EGP, in UK 2000 GBP and the exchange rate EGP/GBP is 10.

• Answer: Egyptian can buy 100 loafs of bread, Brit 1000 loafs of bread – Brit is 10 times better off. If salaries are compared, Egyptian earns 100/10 = 10 GBP which is 200 times less than a Brit.

Groups of developing countries

• East Asia and Pacific, Central Asia and parts of Eastern Europe, Latin America and the Caribbean, Middle East and North Africa. South Asia and Sub-Saharan Africa

• Sub-Saharan Africa is the poorest, with lowest life expectancy and the highest illiteracy rate of youth

• Human development: Development should include also factors like health, life expectancy, school enrollment, adult literacy, independence of women, since GDP p.c. doesn’t tell everything.

• E.g. Greece has greater life expectancy than USA.

4 elements of development

1. Human resources• Malthusian trap still holds for developing countries

since growth of population matches or exceeds growth of income.

• One way to reduce population growth is active birth control policy (China)

• The other way is to improve education which causes birth rate to drop.

• Human capital is the quality of workforce, increased by health and nutrition policy as well as education policy.

2. Natural resources

• Developing countries mostly have little natural resources, mostly arrable land

• The use can be improved through increase in capital

• Oil resources are mostly used by corrupt rulers and not put into the economy, unlike indeveloped countries like Norway, UK and USA

3. Capital formation

• Developing countries save too little, hence investment is low (5%, as compared to developed countries with 20%)

• Vicious circle: low income – low savings – low investment – low capital – low productivity – low income

4. Technological change and innovation• Developing countries can benefit from technological

development of developed countries – technology imitation

• Entrepreneurial spirit is necessary to make country receptive to new technologies

Strategies of economic development

1. The Backwardness Hypothesis – developing countries can grow faster because they can use technologies made in developed countries – convergence occurs (low income countries grow more rapidly)

2. Industrialization vs. Agriculture – income per worker in industry and services is twice as big as in agriculture – but how to make that shift?

3. State vs. Market – developing countries are hostile towards market, which is the most effective in distribution of resources and triggers growth

4. Growth and Outward Orientation• Should developing countries attempt import

substitution with domestic production?• How? By imposing quotas and high tariffs.• East Asian countries overcome Latin countries

in GDP p.c. because they saved more and had open economies, while Latin countries did import substitution

• Too much openness can be a problem too: Financial openness in 1998 it caused recession in East Asia

• Open economy is an economy with low tariffs, no quotas and open financial markets

Summary

• Government should provide healthy economic environment:

- Rule of law- Promote competition and innovation- Government led investment in human capital

(education, health) and infrastructure- Focus on market failures- Deregulate in areas where government has

comparative disadvantage

Alternative models for development

Laissez faire – mixed capitalism – managed markets – socialism - communism

• Alternative strategies:1. Asian managed market approach: strong

government oversight & free market2. Socialism (Western Europe, ex Yugoslavia): welfare

state, nationalized industry – recently moved back to free market

3. Soviet – style communism – Entirely planned economy

Problem 1

• Nominal GDP of Croatia in 2014 was 57.865 Bill. USD and in the previous year it was 58.156 Bill. USD. What is nominal GDP growth rate in Croatia in 2014?

gy = (GDPt/GDPt-1 -1)×100% =

(57.865/ 58.156 -1)×100% = -0.5%

Problem 2

• Let contribution of labour be 70% and contribution of capital in an economy be 30%. A) Find GDP and GDP p.c. growth rates if growth of labour is -0.1%, growth of capital 0.5% and total factor productivity growth 3%.

gY = 0.7gL + 0.3gK + gA = 0.7×(-0.1)+0.3×0.5+3=3,08%

gYpc = 0.3gK/L + gA = 0.3×0.5+3=3,15%

B) What would be the result if contribution of labour and capital are equal and TFP growth fell down to 1%?gY = 0.5gL + 0.5gK + gA = 0.5×(-0.1)+0.5×0.5+1=1.2%

gYpc = 0.3gK/L + gA = 0.5×0.5+1=1.25%

Problem 3

• Slovenia had HDI (human development index) 0.876 in 2012 and United Arab Emirates 0.823 in the same year, when Slovenia had 23100 USD GDP per capita and UAE 41692 USD of GDP p.c. What do you conclude?

• Slovenia has lower GDP p.c. but higher level of development. It shows that GDP p.c. sometimes fails to show the true level of development of an economy. It also shows that there is high level of inequality and a few own almost everything in UAE.

Problem 4

• How many years are needed to double GDP if gy = 3.5%?

Yt = Y0×(1+gy)t

2Y = Y×1.035t

ln 2 = t ln 1.035t = 20.15It will take more than 20 years