Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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Up to 40-60% more affordable

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$130

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Hardcover print text only

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

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In-Book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

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Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

Read the fully unlocked textbook below, and if you’re interested in learning more, get in touch to see how you can use this textbook in your course today.

Chapter 20: Economic Growth

Figure 20.1: When they are growing, economies produce more and better goods every year, allowing us to consume more. But what causes economies to grow?​ [1]
​“The consequences for human welfare involved in questions [about how to grow more rapidly] are simply staggering; once one starts to think about them, it is hard to think about anything else.”
                                                                                   Robert Lucas, JME, July, 1988.
The U.S. economy in the 1950s and 1960s was the “magic economy.”
                                                                                                Tom Wolfe
“Economic growth is the answer to everything.”
                   Stephen Buckles

Will you be economically better off than your parents are? Are they better off than their parents? Throughout recent history, the amount of stuff being produced and the amount of money people earn has grown year-by-year, enabling people’s standards of living to grow over time. We call this phenomenon economic growth. But what drives it? And what factors will ensure that it continues to make us better off? In this chapter, you will learn the importance of economic growth, the factors that contribute to it, and the appropriate policies to promote it.

20.1​ Objectives for Chapter 20

​ After working through this chapter, you will be able to:

  • Understand the relation between economic growth and changes in average living standards over time.
  • Explain the potential causes of increases in our abilities to produce.
  • Identify economic policies which will have an impact on economic growth.
  • Understand the opportunity costs of economic growth policies.
ECN20_Table20.1_updated.jpg
Table 20.1: This table shows the wide range in average income per person across countries. This disparity is largely due to different rates of economic growth in these countries' pasts.


ECN20_Table20.2_updated.jpg
Table 20.2: U.S. Personal disposable income per capita (in 2012 dollars).

20.2​ Economic Growth Defined

One of the most important, interesting, and difficult questions in economics is why some countries are so rich and some so poor. Behind that question is why some countries’ economies grow significantly more rapidly than others, why we are so much wealthier than we were in our grandparents’ generation, and yet, why we aren’t growing as fast as we once were. Compare Zimbabwe, China, and Namibia with Japan and the U.S. in Table 20.1. Look in Table 20.2 at how much more our after-tax real income per capita is now when compared to when your parents and their parents were your age.

Table 20.3 summarizes the annual rates of change in real GDP in the U.S. since 1963. There were five years in which real GDP for the year was less than the previous year. The largest decrease in those years, or the worst recession, showed a decrease of 2.5 percent. Over the entire period, however, we grew at an average of 3 percent per year. Real GDP (in 2012 dollars) went from $3,703 billion to $18,566 billion – an increase that means the economy is more than four times the size it was in 1963.

ECN20_Table20.3_Updated.jpg
Table 20.3: This table shows the wide range of growth rates in the U.S. over the past fifty years, and also the impact of a high average growth rate.

This increase in incomes has had huge impacts on the living standards of the average person. Over this time frame, life expectancy in the U.S. has increased by nearly a decade. Air conditioning and refrigeration have come into widespread use, along with a host of appliances easing the burden of housework. The average American enjoys more leisure time than ever (hours worked per worker has fallen by 10% since 1963). Food once restricted by geography and seasons can now be enjoyed nearly anywhere. Children can delay entering the workforce and attend school for longer, becoming more likely than ever to earn college degrees. We can now work and access information from anywhere with the advent of the internet and smartphones. Access to entertainment has exploded (consider the advent of streaming services like Netflix). By nearly any concrete measure, American’s economic lives have improved immensely with economic growth.

Figure 20.2 visually illustrates the huge impact that economic growth can have over a long period of time (in this case, in Toronto, ON). A century of consistent economic growth has transformed cityscapes across the globe and the lives of the people in those cities.

Figure 20.2: Consider downtown Toronto in 1898 (left) and 2014 (right). Canada averaged a growth rate of 2-3% in real GDP over this period. The comparison of photographs gives us some idea of the sheer amount of change that this level of economic growth can generate.​ [2]

​Economists and news reporters often use the term “economic growth” to mean two quite different things. Economists normally (but to make things difficult, not always) mean an increase in our capacity to produce, that is, how much we can produce if we are using all of our resources. They use terms like full-employment real GDP, full-employment output, or the potential level of real GDP to refer to the amount we are capable of producing if we produce as much as we can right now. Economists most often use “economic growth” to describe a movement of the production possibilities frontier in such a manner that more output is possible. It is the long-run trend.

News reporters often write stories about too much or too little economic growth. What they really mean is too much or too little change in total spending. In essence, they are referring to whether spending is growing fast enough to provide jobs so that we reach full employment. They are not referring to changes in our capacity to produce, that is, shifts of the production possibilities frontier. They mean movements to and away from the frontier. They mean the booms and recessions and temporary increases and decreases in real GDP. We will have to be clear and careful when reading cases and recommending policy.

The distinction can be clearly illustrated using the production possibilities frontier (PPF) that was introduced in Chapter 2. Recall that the PPF represents the maximum combinations of different goods that can be produced. Figures 20.3 and 20.4 illustrate a production possibilities frontier for goods and services. Figure 20.3 illustrates what most journalists mean when they discuss economic growth. The actual production of the economy (represented by the orange dot) increases by moving from the interior of the PPF closer to (or onto) the frontier. Here, the production of both goods and services has increased, but the capacity to produce has not changed (the PPF remains where it was initially). This is not what economists mean by economic growth. Figure 20.4 illustrates an actual expansion of the frontier itself, which illustrates that the capacity to produce both goods and services has increased. This is the type of economic growth that concerns us here.

Figure 20.3: The economy moves toward the PPF. This is often what journalists mean by economic growth, but not what economists generally mean. The economy is producing more, but the capacity to produce has not increased.​
Figure 20.4: The PPF itself has expanded, and the capacity to produce has increased. This is what economists usually mean by economic growth​.


Question 20.01

Each of the following can increase the amount of spending in the economy. Which of them does not represent an outward shift in the PPF?

A

An improvement in production technology

B

An increase in population

C

A decrease in unemployment

D

An increase in the capital stock

​20.3 The Meaning of One Percent

ECN20_Table20.4_updated.jpg
Table 20.4: The average growth rate has varied considerable at different points in U.S. history. Even a difference of half a percent is very significant over the long run.

​U.S. Real GDP per person grew at a rate of 2.5 percent per year from the end of WWII to 1973. From 1996 to 2018, real GDP per person had increased at an annual rate of 1.5 percent. This doesn’t seem like a huge difference – it is only about one percent less – but let’s look. There is a handy rule that allows us to take growth rates of just about anything – the economy, bank accounts, sales of a business - and calculate how long it will take to double. Using the rule of 72, we divide the number 72 by the average annual percentage rate of increase. The result will be the number of years it will take for the original number to double. For example, at a 4% growth rate real GDP would double every 18 years (72/4=18).

At an annual rate of growth of 2.5 percent, output per person will double about every 29 years (72/2.5 = 28.8). What that means is that during a typical college student’s working lifetime, if she starts working at age 21, we could expect income to double once by the time she is 50 and then double again by the time she is 79. Note that this growth is in addition to the increase in earnings that she would receive from progressing in her career and moving up the salary scale. Suppose she starts with an income of $30,000; without economic growth, her income would increase to $60,000 by age 50, simply by gaining experience and promotions. If we also have economic growth of 2.5%, she should actually expect an income of $120,000 by the time she is 50!

However, if we only experience growth rates of 1.4 percent, then it will take 51 years for average incomes to double (72/1.4 = 51). That is, she will have to work to age 72 (21 + 51) before she fully sees the extra doubling of her income. This is obviously a huge difference and one whose reasons are worth trying to figure out.

Question 20.02

China is currently reporting an annual growth rate of 6.1% in real GDP per capita. Using the rule of 72, how many years will it take for Chinese GDP per capita to quadruple at this rate of growth?

Question 20.03

The U.S. population is currently growing at 0.7% per year. Using the rule of 72, how long will it take the population to double at this rate?

20.4​ What Causes Growth?

Now that we’ve clarified what we mean by economic growth and discussed the importance of growing at a fast rate, we can get to the core economic question of this chapter: how exactly do we get more growth?

Question 20.04

Question 20.04

What causes real GDP to increase? List some ways that we might get more growth through public policy. Think of your hometown as an economy, separate from the rest of the world (probably not a drastic assumption). If you are from Chicago, for example, how can the city increase the Gross Chicago Product? List the ways. Think back to our discussions of the production possibilities frontier.

Hover here to see the hint for Question 20.04.
Click here to see the answer to Question 20.04.

20.4.1 Keys to Thinking About Using "Economic Growth"

Fluctuations in the economy in the short run are primarily determined by changes in total spending.

Economic growth in the long run is largely determined by changes in our capacity to produce.

​Some of these options can only be exploited once and may not add to longer-run growth. In other words, they are examples of moving towards the PPF (as in Figure 20.3 above) instead of expanding the PPF itself (as in Figure 20.4). A decrease in unemployment, for example, moves us toward the production possibilities frontier by putting more of our available resources (in this case, workers) to work. It is not a shift out of the entire frontier. Discovering more natural resources can be useful, but is not always an option. Population growth (convincing more people to live in Chicago) is, in fact, an increase in the city’s capacity to produce, but it is also a double-edged sword. We can increase real GDP with more workers, but a larger population will need more production just to maintain the same level of output per person. If the new workers produce on average only what current workers produce, we will not have more output per person. In other words, we will not be better off. In addition, there may be other costs, including environmental costs or increased congestion. In order to make this distinction, economists will often use the term productivity to refer to the amount of output produced per hour worked. This allows us to talk about how much is produced per unit of labor, so that we can distinguish increases in the capacity to produce per person from simple increases in the number of workers. This also means that policies which increase output by convincing the same workers to work more hours (such as lowering taxes on Chicago’s workers mentioned above) are not truly increases in productivity.

The three primary ways that productivity improves are through:

  • An increase in physical capital
  • An increase in human capital
  • An improvement in technology

However, many of the options mentioned above are actually increases in productivity. For example, if more factories are built in Chicago, this will mean that the city as a whole is able to produce more per worker than it was before, because each worker has more capital to work with. In general, ways to improve productivity fall into three categories: an increase in physical capital (like factories, heavy machinery, or computers), an increase in human capital (such as improved education), and an improvement in technology. Each of these is a key contributor to economic growth, and each can be influenced by public policy. We will discuss each of these in turn.

Question 20.05

Which of the following would not increase real GDP per capita?

A

Population growth

B

An increase in the capital stock

C

More investment in R&D

D

More people choosing to go to college

20.4.2​ Increases in Physical Capital

​Perhaps the most obvious way to improve productivity is simply to build more physical capital. Physical capital refers to the number of factories, tools, machines, and houses that can be used to produce goods and services. To illustrate the importance of physical capital in the production process, let’s imagine that you were assigned to write a research paper for this class. However,  you are only allowed to use pen and paper to write. How much longer would it take you to write the paper than if you could use a computer? It would likely take you quite a while to produce a research paper using only these tools. However, with access to more physical capital, you would be more productive per hour of writing.

Thus, one way to improve productivity in the overall economy is to invest more in building physical capital. But what type of policies might incentivize people to do this? First, governments often create tax incentives to invest in desirable physical capital projects. For example, investment tax credits incentivize businesses to invest in physical capital by lowering their tax bill. Governments can also encourage investment by getting people to save more of their income. To invest in physical capital, individuals and business typically have to borrow money in order to finance the construction. We learned in Chapter 17 that funds borrowed in financial markets are ultimately provided by savers, people that have resources now but don’t wish to use them immediately. The financial system matches savers and borrowers in order to make it possible for individuals and firms to invest in physical capital. Thus, one way to allow more investment in physical capital is to incentivize people to save a larger portion of their income. Various tax policies can encourage people to save rather than spend today. For example, Individual Retirement Accounts (IRAs) allow a certain amount of individual saving to be done tax-free, which encourages individuals to save more. The result is that these savings are made available to be lent out to businesses wishing to build more factories, machinery, and warehouses.

Question 20.06

Suppose that the demand for physical capital in the U.S. increased (recall that we introduced this demand in Chapter 17). What impact would this have on interest rates and on the amount of saving in the economy?

A

Interest rates would decrease and savings would decrease.

B

Interest rates would increase and savings would decrease.

C

Interest rates would decrease and savings would increase.

D

Interest rates would increase and savings would increase.

Question 20.07

In the previous question, what would be the impact on productivity?

A

Productivity would increase.

B

Productivity would decrease.

C

Productivity would not be affected.

Question 20.08

Question 20.08

The personal savings rate in Asian countries is often much higher than in Europe or the U.S. For instance, the personal savings rate in the U.S. is around 5%, while the same rate in China is around 30%. What impact will this have on the growth of capital stock in the U.S. vs. China?

Hover here to see the hint for Question 20.08.
Click here to see the answer to Question 20.08.​

Question 20.09

Question 20.09

In the above question, suppose that savers in China decide to put a significant portion of their savings into financial instruments in the U.S. For example, suppose they decide to buy U.S. government bonds and the bonds of U.S. companies in order to invest their savings. How would that affect the growth of capital stock in the U.S. relative to China?

Hover here to see the hint for Question 20.09.
Click here to see the answer to Question 20.09.

In the developing world, a significant amount of investment in physical capital comes from foreign direct investment (FDI). Foreign direct investment occurs when a firm builds some piece of physical capital in a foreign country. For example, Apple might build an iPhone factory in China. This would add to the stock of physical capital in China and increase the potential of the Chinese economy to produce. This process provides an important avenue for increasing the capital stock (and thus the productivity) of developing economies. Although some of the returns from the investment accrue to people outside of the country (in this case, to Apple executives and shareholders in the U.S.), it is still an important source of physical capital when there is not enough domestic investment.​

Question 20.10

Question 20.10

Suppose you are the head of a major oil company and are considering building a new oil rig in a foreign country with large oil reserves. However, the government of that country has a history of seizing infrastructure owned by foreign countries. How would this history affect your decision to build physical capital there?

Hover here to see the hint for Question 20.10.
Click here to see the answer to Question 20.10.

​The discussion question above highlights an important and underappreciated factor that influences capital growth: the security of property rights and the political stability within the country itself. This is a factor that many people in the developed world take for granted. Producers in the U.S. do not have to worry that their factories will be nationalized (seized by the central government) or that a coup will change the government and put their investments at risk of seizure. However, in many developing countries, this is not the case. Factories or other large pieces of physical capital (such as oil rigs) are seized by the government with some regularity. Often the justice system does not work properly and contracts between businesses are hard to enforce. Also, many people have no well-defined legal right to their property, which would allow them to use it as collateral or be certain about their ability to build or improve upon it. The result of all of this is that fewer people are willing to make large physical investments, because there is less certainty that they will be entitled to use them in the future. An unstable political system with weak or uncertain property rights can severely decrease the incentive to invest in physical capital, both for businesses within the country and for foreigners considering FDI projects there. The result is that productivity (and thus the standard of living) is not as high as it otherwise would be.

20.4.4​ Increases in Human Capital

​Another key way to improve productivity is to invest in human capital. Human capital refers to the skills and education that make workers more productive. For example, this economics course is likely part of a more extensive education which will (hopefully) enable you to be better prepared for your eventual career. People who attain a four-year college degree acquire knowledge and skills which, among other things, generally allow them to be more productive in the future. Technical education plays a similar role for many professions, with degrees that train people to be (for example) electricians or mechanics. In this way, education increases the productivity of workers. Other institutions which also increase worker productivity include on-the-job training, apprenticeships (still common in some countries), and prior experience in the workforce. Thus, one way to increase the productivity in an economy is to invest in the education of the workforce.

There are several common policies which aim to achieve this goal. For example, in the U.S. primary and secondary education (K-12) are generally publicly provided at little or no cost to the student or their family. Public universities are often subsidized by state or local governments, and student loans are often offered at lower, subsidized interest rates in order to make it cheaper to borrow for college. Each of these policies decreases the cost to the student of attaining an education, thus incentivizing more people to become more highly educated and increasing the overall level of human capital in the economy.​

Question 20.11

Question 20.11

Suppose a politician proposes that we make college education free for all students. What impact would this proposal have on the level of human capital and the rate of growth in the country?

Hover here to see the hint for Question 20.11.
Click here to see the answer to Question 20.11.​

Question 20.12

Question 20.12

Several societies around the world make it very difficult for women and girls to become educated. What impact would this have on economic growth in these countries?

Hover here to see the hint for Question 20.12.
Click here to see the answer to Question 20.12.

20.4.5​ Improvements in Technology

​The third method for improving productivity is to improve the level of technology in the economy. By technology, economists generally mean the knowledge of the best and most efficient ways to produce various goods and services. If technology in an economy improves, we will be able to produce more goods per worker even if the amount of physical and human capital doesn’t change. For example, the invention of the internet allowed people to work remotely much more easily and to collaborate on projects even from across the world. Even if the number of computers and the level of education in society hadn’t been increasing, this invention would have still allowed people to be more productive than before.

For an economist, technology doesn’t just include “technical” knowledge like how to build a faster computer or a smaller microchip. It includes any kind of knowledge which can make us more productive. For example, Henry Ford revolutionized the production of automobiles by using methods of mass production such as the assembly line. This knowledge about how to organize the production process itself was a huge technological advance that allowed the same workers with the same amount of factory space to be much more productive.

​Although improvements in technology are vital to productivity growth and thus economic growth, technology might be the most difficult factor to affect using public policy. However, there are still a number of policies which can encourage faster technological progress. For example, developing a system for patents and copyrights that functions well is essential to encourage technological progress. Patents and copyrights allow individuals and companies who invent new technologies to have exclusive rights to these technologies for a defined period of time. This increases the profit they are able to make from new technology, and thus encourages firms to spend more money on research and development (R&D) to develop new technology. However, there is a tradeoff; patents and copyrights also mean that other companies cannot use the technology immediately. If the term of a patent is very long (e.g., twenty years) this can prevent the spread of existing technology and have a negative impact on growth. The government can also spend directly on R&D, as NASA has done consistently throughout its history. Many advances in technology during the last seventy years have been the direct results of technological advancements made at NASA and at other government institutions.​

Question 20.13

Question 20.13

Suppose that the government decides to cut spending on research and development. What impact would this have on future economic growth?

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Click here to see the answer to Question 20.13.

Developing countries might actually have an easier time improving their technology than developed countries. Many developing countries are currently behind the technological frontier; that is, firms in these countries often do not use the most recent technology or the most efficient production processes. However, this provides them with a unique opportunity to “catch up” to developed countries. Because it is significantly faster and less expensive to implement existing technology than to invent new technology, these countries are sometimes able to grow much faster than developed countries for a period of time by simply bringing themselves closer to the technological frontier. For example, consider that the average growth rate in real GDP for developed countries since WWII has been between 2% and 3%. However, economies like those in Hong Kong, Singapore, and South Korea managed real growth rates around 6% from the 1960s to the 1990s. Part of the reason that they were able to achieve this was that their technological starting point was very low, so they were able to improve their technology very rapidly by adopting technology already in use in developed countries. 

So why do all poor countries not grow at these kinds of rates? Recall that developing countries often have political institutions which are not conducive to economic growth. Taking advantage of current technology in order to grow faster requires a foundation of positive political institutions, such as strong protection of property rights and low levels of corruption. Thus, it should not be surprising that a key component in facilitating the success stories of economies like Hong Kong and South Korea was a series of reforms of their political systems which improved property rights and allowed industrialization to occur. These experiences further reinforce the importance of political stability and property rights.​

Question 20.14

Question 20.14

One recent survey of cell phone usage around the world showed that only 4% of people in countries like Uganda and Ethiopia have access to a smartphone. Explain how this presents an opportunity for these countries to attain faster growth.

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Click here to see the answer to Question 20.14.

In summary, improvements in productivity generally occur as a result of increases in physical capital, increases in human capital, or improvements in technology. These types of changes allow an economy to permanently expand its capacity to produce (represented graphically by the PPF) and thus to produce more output per person. Improvements in productivity are essential for increasing a particular country’s standard of living over time. However, improving these factors does not come without a cost.​

Question 20.15

Question 20.15

What are the likely costs of economic growth?

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Click here to see the answer to Question 20.15.

Graphing Question 20.01

Graphing Question 20.02

20.5​ Opportunity Costs

The primary costs of economic growth are in fact opportunity costs. Generally speaking, in order to improve physical capital, human capital, or technology, we will need to forego other uses of our resources. We can summarize the opportunity costs of growth by looking at the components of real GDP below.

​Given the amount of real GDP available in any given year, this formula captures the different types of ways in which it can be spent. Recall that the broad categories are consumption, investment, government spending, and net exports. As we discussed above, one of the ways to grow is to invest more. However, if we are already at potential real GDP, that is producing as much as we possibly can, the only way we can get more resources into investment is to use fewer resources for consumption, government spending, or exports or to get more resources by increasing imports. There is no other way; the cost of increasing investment, if we are already producing as much as we can with our resources and technology, is to give something else up or get more from abroad.

We discussed above that increasing investment usually involves encouraging people to save more. The trade-off here is obvious: when an individual chooses to save more, they must necessarily consume less today. When the government incentivizes people to save via IRAs, lower capital gains taxes, or lower taxes on interest and dividend incomes, they are necessarily also encouraging people to consume less right now. People have to give up things that they want today in order to allow for investment in more production later. This is the primary cost of increasing the amount of physical capital in the economy. Another potential method for discouraging consumption today is to tax current consumption. However, raising taxes to reduce consumption is not very popular and may result in increased government spending instead of investment. A combination of reducing government spending and raising taxes may work to free up more funds for investment, but that means reducing spending on someone’s favorite program, and thus is a political challenge. However, if accomplished, that combination will leave resources left over for investment and can lead to growth, given that the programs to be cut are not public investment, spending on education, or research and development.​

Question 20.16

Question 20.16

Suppose that you are currently getting your undergraduate degree and are considering going on for a graduate degree. You expect that once you have your graduate degree, your income and your economic output will be significantly higher than it otherwise would be. What is the primary cost of going on to get this additional degree?

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Spending on training and education (human capital) requires similar sacrifices to those of increased investment in physical capital. If we are to increase training and education, we will have to give something else up. For example, when you chose to pursue a four-year college degree, you deferred the start of your working life by four years. More people going to college also means more people waiting longer to join the workforce, so they delay producing and earning an income. Improving human capital, which allows more production and higher incomes in the future, generally requires giving up earning today. The tradeoff is similar with technology as well; when companies decide to spend money on research and development in order to become more efficient in the future, they cannot spend that same money on production today. They choose to produce less than they otherwise would today in order to increase their future production. The same is true of an individual inventor; inventing new goods takes time that could be spent working and earning an income now (and therefore consuming more now).

​Referring back to the equation for real GDP, another potential way to increase investment in capital (either physical or human) would be to reduce exports and/or increase imports. Reducing exports is difficult, but increasing imports is possible and in fact for much of the 19th century, the U.S. did just that. Seeing the opportunity for large profits, Europeans were willing to lend us monies to buy imports allowing us to grow by expanding transportation facilities. We will explore more of these options later in the course.

Many politicians and economists have proposed lowering taxes so that incentives to work hard and invest more are increased. If we taxed everyone one hundred percent of their incomes and then redistributed the receipts equally to everyone, total production would surely be less. People with high incomes would not work as hard, because their incentives would be less. People with low earned incomes could stop working because their incomes (including the increased payments) will go up. Thus, distribution of income and income inequality must be related to output. The greater the income inequality the greater output is likely to be. We don't fully understand the exact nature of this relationship and there are presumably limits under which the relationship actually works. We will see later in the semester that reducing taxes under some circumstances can actually reduce saving and investment.

We have said much about the opportunity costs of economic growth, but what about the environmental costs? Suppose that you or an acquaintance is very concerned about the effects of global warming. You know that increased production means that we are using more electricity, coal, oil, and gasoline and thus contributes to the problem. A rally you recently attended included speakers calling for less economic growth.​

Question 20.17

Question 20.17

Should you be opposed to economic growth if you favor taking significant steps to protect the environment?

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20.6​ A Slowdown in Economic Growth

Table 20.5 shows data for 1960 to 1973, 1973 to 1995, 1995 to 2008, and 2008 to 2017. The numbers help us understand some of the differences in what has happened to economic growth in the U.S. during the past half-century. Growth has generally slowed over time, falling from 4.2% per year in the first period to 2.9% in the following two periods, and to 1.5% per year since 2008. This might make it appear that growth has been falling for the same reasons since 1960. However, when we look at the factors that impact growth, we can see that the recent slowdown in growth is very different from the slowdown in the 1970s.

ECN20_Table20.5_Updated.jpg
Table 20.5: This table shows the contributing factors to growth in real GDP over four different periods from 1960 to 2017.

​Growth in the working-age population has slowed over time, from 1.8% per year in the first period to 1.1% per year most recently (line 1). Immediately, this accounts for a portion of the falling growth rate; population growth has been slowing so growth in the overall amount produced has slowed as well. The civilian labor force participation rate (line 2) has played a large role in the slow growth since 2008. In earlier periods, the civilian labor force participation rate (the fraction of people over 16 that participate in the labor force) grew fractionally each year. This was primarily as a result of more women entering the labor force from the 1960s on through the 1990s. However, since 1995 the civilian labor force participation rate actually fell year by year, falling more rapidly since 2008. One major factor causing this to happen has been the retirement of the baby boomer generation. As a larger fraction of the population retires, the portion of the population that is actively working has been falling. Also, following the recession in 2008-2009 many workers became discouraged and stopped looking for jobs, or delayed entering the workforce. This also caused the labor force participation rate to decline faster. This too is a significant reason why growth has been much slower since 2008.

​Changes in the employment rate (line 4) have not significantly affected the growth rate. Unemployment (which is directly related to the employment rate) is a large problem during recessions, but over long periods of time the average unemployment rate doesn’t tend to move much. Average weekly hours have fallen over time, rapidly during the 1960s but less  so more recently (line 6). As the economy has grown, o average people have chosen to work fewer hours per week.

The largest determinant of whether we have high or low growth is usually the change in output per hour (line 8). Recall that this is  productivity growth as we defined it in section 20.4. Productivity grew rapidly over the period from 1960 to 1973 (2.9% per year!), but growth slowed markedly from 1973 to 1995 (to 1.4% per year). Productivity growth recovered over the period from 1995 to 2008, growing at 2.5% per year. However, since 2008 productivity growth has been quite low once again (only 1.2% per year). Recall that productivity growth is determined by changes in either physical capital, human capital, or technology. In section 20.7, we will break down these contributors to productivity in order to analyze what has happened to growth in productivity over time.

Question 20.18

The overall growth rate for real GDP between 1960 and 1973 was 4.2%. Using the rule of 72, how long does it take the economy to double in size if we grow at a 4.2 percent rate?

Question 20.19

The overall growth rate for real GDP between 1973 and 1995 was 2.9%. Using the rule of 72, how long does it take to double if we grow at a 2.9 percent rate?


​Question 20.20

Question 20.20

Is the difference between these two growth rates significant? Why?

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20.7​ The Causes of Slower Productivity Growth

We saw that in the previous section that productivity growth (growth in output per hour worked) has been very high in some years and relatively low in others. What are the causes of the various slowdowns in productivity growth? A number of possibilities exist, but unfortunately researchers have not been able to identify any single cause. The most likely answer is that it may be a number of causes put together. The proposed explanations have included the following:

  • Slowdowns in technological progress
  • Less investment as a part of GDP
  • Increased competition due to increased international trade
  • Less effective education
  • Increased regulation
  • Rising oil prices (specifically during the 1970s slowdown)
ECN20_Table20.6_updated.jpg
Table 20.6: This table shows the average annual percent growth in the output per hour for different historical periods, along with the components which contributed to that growth.

Each of these factors may indeed be relevant, but let’s take a closer look. Recall that productivity changes come from either increase in physical capital, human capital, or technology.

Looking at the above explanations, lower levels of investment would affect the amount of new physical capital being built. Less effective education would harm growth in human capital. Most of the other components would primarily affect technology in some way (remember that economists define technology broadly to mean any factor which is not physical or human capital). Table 20.6 above breaks down the average changes in output per hour according to how much of the change can be attributed to either physical capital, human capital, or technology (the overall totals are slightly different from those in Table 20.5 due to the use of a different source, but the trends between the periods are the same).

Table 20.6 shows that the main driver of productivity changes is technology. During the high growth period of 1960-1973, technology grew at 2.1% per year, accounting for most of the total growth of 3.1%. When productivity growth fell in the second period to 1.5%, it was due to a collapse in technology growth to 0.4% per year. Technology growth picked up from 1995-2008 and fell again since 2008, accounting for much of the overall fluctuation. Understanding why technology growth rises or falls is (almost always) the key to understanding productivity growth.

​Human capital plays a far smaller role in determining productivity growth. The contribution of human capital growth is always quite small, and was relatively constant throughout the entire time period (between 0.1% and 0.3%). This contradicts the idea that the effectiveness of our education system is directly responsible for low productivity growth. Our education system is heavily criticized by many, and most evidence does show that we could do much better. However, its contribution to growth has been very small even in periods of high growth for the U.S., and it is not to blame for slowdowns in productivity growth.

​Changes in physical capital usually do not play a large role in productivity changes either. Physical capital’s contribution to productivity growth fluctuated in the narrow range between 0.8% and 1.1% prior to 2008. However, since 2008, the rate of growth of physical capital has fallen significantly, and this has been a large part of the slow growth over that period. The economy has simply not been building as much capital as it was prior to 2008. It seems that lower levels of investment can indeed explain part of why we have not grown as quickly in the past decade.

​Aside from the importance of physical capital since 2008, the main driver of productivity growth is technology. As we’ve defined it above, technology refers to any element other than physical or human capital. It could be actual technological progress (e.g., making faster and smaller computers every year). However, an improvement in “technology” could also be due to increased international trade, an easier regulatory environment, or global events which affect the price of making goods (such as the severe increase in oil prices during the 1970s). Any one of these components could potentially explain why technological growth has been slower during some periods.

The most obvious cause of slower technological growth would simply be a decrease in the rate of new inventions and the discovery of new technological knowledge. Many people have argued that this is indeed what happened during the 1970s, and what might be happening today. Technological progress was very rapid during the period following World War II. These quick changes were partially a result of the industrial advances during production for the war. Transportation was revolutionized. More efficient methods of distribution were created, and larger stores started replacing small corner operations. This argument would attribute the slowdown in growth to a slowdown in this technological progress during the 1973-1995 period. However, this argument is a little difficult to justify with the dramatic changes in computer technology that occurred from 1973 to 1995. During this period, computer technology advanced greatly, and businesses (and individuals to some extent) began to utilize it much more fully. The increased importance of information technology through computers and the internet has been transformational for our economy and has substantially increased the productivity of those who regularly use IT in their work.

Some economists have blamed a lack of technological progress for the slowdown in growth since 2008. They have argued that, although we seem to have rapid technological progress today, much of it focuses on consumption rather than production. Our iPhones and our internet connections get better and better every year, but how much does this actually increase productivity (versus allowing us to consume more easily)? It is possible that much of the technological progress of recent years has not actually made us more productive.

Increased competition from abroad is sometimes blamed for contributing to slower productivity growth. However, increased trade, as we will see, should increase our well-being as we specialize in producing what we are best at producing. We should actually be better off as a whole, not worse off. Certainly those industries facing increased competition are hurt; but this usually results in shifts between industries rather than an overall fall in full-employment real GDP. As industries decline due to competition from abroad, the demand for goods from abroad tends to lead to expansion in other industries. Because of this, it is hard to point to an overall negative effect. In addition, as increased competition forces us to adopt better, more efficient methods of production, we should increase our output even further. Thus, it is hard to defend the view that increased competition contributed to the slowdown in growth.

Increased regulation of industry is often put forth as another culprit for slower technology growth, as it causes us to devote more resources to satisfy those regulations. Because of that, there may be fewer resources are available for production of goods and services. While it is certainly true that worker safety, product safety and environmental regulations have increased over time, the airline, trucking, and financial industries have all been substantially deregulated since the 1970s. All of those industries experienced significant innovations and price reductions during the 1970s and 1980s. It is hard to argue overall that increased regulation was particularly overbearing during this time period. During the most recent period, the argument is perhaps stronger that the overall level of regulation has increased. The impact of this on productivity growth is a topic which economists disagree on.

The final component which is pointed to (for the slowdown in the 1970s in particular) is high oil prices. Oil prices increased dramatically in 1973 and then again in the late 70s. Some argue that as business had to shift to less costly ways of producing, important productivity advances were lost. However, if this were all of the cause, surely we would have seen a reversal of the trend as oil prices have come back down, as they have. During the recent slowdown, oil prices have generally been very low, and natural gas prices have fallen dramatically as well with the spread of hydraulic fracturing. High energy prices have generally not been an issue for the U.S. economy since the 1970s and 1980s.​

Question 20.21

Question 20.21

Suppose that in the future we wanted to grow as fast as we did in the postwar period (1960-1973). What component of growth should we target to accomplish this?

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Question 20.22

Which of the following policies would not help us to have faster technological growth?

A

More government spending on research and development

B

Stronger protections for patents and copyrights

C

Policies designed to raise the savings rate

D

All of the above would help to generate faster technological growth

20.8​ Conclusion

So, the answer to more growth? We either need more capital per worker (from higher levels of investment), more or better education per worker, or faster technological advancement. To accomplish these, we might increase spending on investment, education, and research and development. Each of these requires that we either consume less today or reduce government spending on items not related to growth. For developing countries, which do not have well-functioning political systems, political reforms which make the government more stable and property rights more secure are essential. Also, developing countries which are not currently at the technological frontier, can focus on adopting technology already in use in more developed nations.

None of these approaches to achieving more growth are easy, and few of them will have large immediate effects. Each one has limits and real costs. As we go on through the semester and examine multiple proposals and policies, we will continually refer back to economic growth as a goal and evaluate alternative policies and their effects on growth. We will need to remember the potential payoffs of increased economic growth and the challenges of finding ways to increase growth.

Question 20.23

Question 20.23

Summarize the issues in economic growth. Why should it be increased? Can economic growth be too high?

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​20.9 Summary

  • Economic growth is a sustained increase in real GDP per capita.
  • A small percentage increase in the rate of growth can make significant differences in standards of living over time.
  • Growth in real GDP can occur through growth in population but that may or may not result in an increase in living standards.
  • Growth in real GDP per capita occurs because of increases in productivity. 
  • Productivity growth comes from increases in the amount of physical capital, in human capital (the level of education and training of the workforce), and improvements in technology.
  • Policies that encourage investment spending on physical capital or education and training can increase economic growth.
  • Policies to encourage R&D can improve technological advancement and spur economic growth.
  • Increases in education, investment in physical capital, and research and development all require that we give up current consumption in order to use resources for future expansion and growth.
  • Developing countries often face unique problems and unique opportunities when it comes to economic growth, such as a lack of basic institutions which protect property rights and incentivize economic investment.
  • Growth has slowed significantly since the decades following WWII.

20.10 Key Concepts

​Economic growth
Productivity
Physical capital
Human capital
Technology
Saving

​20.11 Glossary

Economic growth: An increase in the capacity to produce. More specifically, an increase in the full-employment or potential level of real GDP.

Human capital: The skills and education that make workers more productive.

Physical capital: The number of factories, tools, machines, and houses that can be used to produce goods and services. Investment increases the amount of physical capital.

Productivity: The amount of output produced per hour of work.

Rule of 72: Divide 72 by the rate of annual change of a variable to get the approximate number of years it takes for the variable to double.

Technology: The knowledge of the best and most efficient ways to produce various goods and services.




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Answer Keys:

Answer to Question 20.04

You might have suggested some of the following to expand real gross Chicago product.

  • Convince more people to move to Chicago
  • Use government spending and hiring to put more people to work; that is, decrease unemployment in Chicago
  • Make it easier to start a business in Chicago
  • Increase the quality of Chicago’s schools or on-the-job training
  • Provide incentives for business to invest in capital goods like factories, machines, or computers
  • Encourage businesses to invest in research and development for the goods made in Chicago, so that they can make more or better goods with the same investments.
  • Lower taxes on Chicago’s workers so that they have an incentive to work more.
  • Discover new natural resources in or around Chicago.

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Answer to Question 20.08

China has much more savings relative to total GDP available to be lent out. These savings will enter the financial system and be lent out to individuals and businesses who want to build capital. The result is that the capital stock will increase much more in China than in the U.S.

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Answer to Question 20.09

In this scenario, the U.S. capital stock would grow faster because of China’s savings, and China’s capital stock would grow more slowly than it would if all Chinese savings were invested in China. The fact that Chinese savers are investing part of their savings in the U.S. acts to partially equalize the growth of capital in China and the U.S.

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Answer to Question 20.10

You would probably be less likely to make that investment if you thought there was a significant chance that you would not be able to reap the returns. You might forgo making a foreign direct investment in the country that you otherwise would make.

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Answer to Question 20.11

This would decrease the marginal cost of going to college, and as a result more people would choose to earn a college degree. This would raise the level of human capital in the country. A higher level of human capital would likely lead to economic growth in the long run. However, because more people would choose to attend college over joining the workforce, output and incomes might fall in the short run. Furthermore, the resources used to provide these additional college educations might detract from other areas of government spending or result in higher taxes and lower consumption today.

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Answer to Question 20.12

This would decrease the number of people being educated in these countries, which would result in overall human capital being lower than it otherwise would be. This would have a negative impact on economic growth.

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Answer to Question 20.13

This would likely decrease economic growth in the future. It would slow down the rate of technological advancement and the result would likely be that our capacity to produce would not increase at as fast of a rate. However, this spending decrease might also allow more to be spent in other areas such as investment or education, or allow for tax cuts to encourage more private research and development. If the money were spent in any of these ways, it could mitigate the negative effects on growth.

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Answer to Question 20.14

Because these countries underutilize current technology, they could potentially achieve growth by simply applying technology that already exists rather than trying to invent new technology. If they were to bring themselves closer to the technological frontier for economic production by expanding the use of smartphones, they could achieve higher rates of growth than countries that already heavily utilize this technology. However, this again relies on the existence of political institutions like stable property rights which make economic growth feasible.

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Answer to Question 20.15

To see this, we should ask ourselves what we have to give up in order to increase economic growth. Most likely, we will have to give up some consumption now in order to make the investments or changes that will lead to higher economic growth in the future. Many of the suggestions about increasing Chicago’s economic growth focused on giving up consumption now in order to expand consumption in the future. And, in fact, these opportunity costs are the primary costs of growth. The costs may also include increased congestion, environmental costs, and simply the costs of learning to interact in a new economy, that is, the cost of change.

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Answer to Question 20.16

The primary cost is the lost opportunity to earn an income by working during the years where you attend graduate school instead. Essentially, you are giving up some consumption during those years in exchange for higher levels of consumption in later years.

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Answer to Question 20.17

​There are a number of ways to approach the problem. Certainly, a smaller economy is likely to pollute less and contribute less to global warming. However, with economic growth the increased production could be used to clean up air pollution and reduce the effects of global warming. It is not just growth itself. Using the benefits of economic growth to reduce global warming could be part of the solution.

Click here to return to Question 20.17​.






Answer to Question 20.20

One doubles every 17 years, while the other doubles every 25 years. Another interpretation is that the economy will, at 2.9 percent growth, quadruple in 50 years. At 4.2 percent, the economy will be 8 times larger in 51 years. So after 50 years, one growth rate results in an economy that is double the size of the other. This is a very significant difference.

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Answer to Question 20.21

Our education growth is very similar to where it was during that period. Our capital growth is slower by 0.5%, which is a significant difference. However, the rate of technological growth is far less than it was (lower by 1.5%). Given that we have achieved a very high rate of technological growth in the past, we should attempt to raise the rate of growth of technology in order to raise the economic growth rate.

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Answer to Question 20.23

Your gist statement should explain the benefits of economic growth. Some of the factors that contribute to growth mean that we have to make sacrifices today. We could have “too much growth” if we prefer to use more of resources on current consumption activities. In other words, if we are not willing to give up that much enjoyment for the benefit of future years or generations, then we will not want to attempt to increase future economic well-being.

Click here to return to Question 20.23.



Data Sources:

Table 20.1

Table 20.2

Table 20.3

Table 20.4

Table 20.5

Source: Economic Report of the President January 2017 and author's own calculations.

Table 20.6

Source: Historical Multifactor Productivity Measures and author's own calculations.

Image Citations

[1] Image courtesy of Diariocritico de Venezuela under CC BY 2.0.

[2] Image courtesy of  F.W. Micklethwaite in the Public Domain. 

      Image courtesy of Anthonyd3ca under CC BY-SA 3.0.



An increase in the capacity to produce.
Divide 72 by the rate of annual percentage change of a variable to get the approximate number of years it takes for the variable to double.
Think about way to increase the capacity to produce, along with ways to better utilize the resources that the city already has.
The amount of output produced per hour of work.
The amount of factories, tools, machines, and houses that can be used to produce goods and services. Investment increases the amount of physical capital.
What impact does the amount of savings have on the supply of loans?
What happens to the supply of savings in the U.S. when purchases of U.S. bonds increases?
What happens to the amount of return that you expect to get when the threat of seizure increases?
The skills and education that make workers more productive.
Think about the impact of this policy on the marginal cost of attaining a college education.
Think about the impact of this barrier on the level of human capital in those countries.
The knowledge of the best and most efficient ways to produce various goods and services.
How does research and development affect the rate of technological progress?
Do these countries have to invent new technologies in order to increase the level of technology usage among their population?
Think about what you have to do in order to increase either physical capital, human capital, or technology. What do you have to give up in order to do these things?
What would you be doing instead of going to graduate school if you decided not to go?
How might you use the additional resources produced by economic growth to address the environmental problem?
Think about what the level of GDP will be in 50 years under each growth rate.
Which component has changed the most since the post-war period?
Think about all the ways that we have talked about increasing economic growth, and the impact of higher growth. Recall what the primary cost of economic growth is.