Economic Growth

Factors for Economic Growth

Now we are going to look at what factors matter for economic growth. Real GDP grows when the quantities of the factors of production grow or when persistent advances in technology make them increasingly productive. Our standard of living improves only if growth occurs because of increases in labor productivity. (1)

Labor Productivity

Labor productivity is the quantity of real GDP produced by one hour of labor.

Labor productivity = (Real GDP) ÷ (Aggregate hours worked)

Real GDP = (Aggregate hours worked) x (Labor productivity)

Note: Using the rearranged formula shows that growth in Real GDP can be divided into growth in aggregate hours worked and growth in labor productivity.

Recall,

Growth (A x B) is approximately = Growth A + Growth B

The growth of labor productivity is influenced by saving and investment in physical capital, expansion of human capital, and discovery of new technologies. More saving and investment in physical capital increases labor productivity. The law of diminishing returns states that if the quantity of capital is small, an increase in capital brings a large increase in production; and if the quantity of capital is large, an increase in capital brings a small increase in production. This fact about capital means that saving and investment in additional capital will not bring sustained economic growth without an accompanying expansion of human capital and technological change.

  • Expansion of human capital : Human capital is the accumulated skills and knowledge of people. Human capital is the most fundamental source of economic growth because it directly increases labor productivity and is the source of the discovery of new technologies. Human capital comes from education and training, job experience, and health and diet.
  • Discovery of new technologies : New technologies increase labor productivity. Often these new technologies require new and better capital, such as personal computers replacing typewriters. (1)

Economic Growth Theories: Old and New

Old Growth Theory

An old growth theory is the classical growth theory . This theory predicts that the clash between an exploding population and limited resources will eventually bring economic growth to an end. According to this theory, labor productivity growth will increase real GDP per person above the subsistence level, which will bring a population explosion. Eventually, the population growth will decrease capital per worker hour and labor productivity will fall and real GDP per person will return to the subsistence level. Malthusian theory is another name for classical growth theory — named after Thomas Robert Malthus . Malthus predicted that population growth would result in people having a primitive standard of living at the subsistence level of real GDP per person. (1)

New Growth Theory

New growth theory is the theory that our unlimited wants will lead us to ever greater productivity and perpetual economic growth.

The new growth theory emphasizes the role played by choices and innovation. It emphasizes three key aspects of market economies:

  • Human capital grows because of choices.
  • Discoveries result from choices.
  • Discoveries bring profit, and competition destroys profit.

Once a new discovery has been made, it can be used by everyone. In addition, production activities can be replicated so that identical firms can each produce the same quantity of an item and so the economy does not suffer from diminishing returns. Economic growth is driven by insatiable wants, which lead us to pursue profit and to innovate. The new and better products mean that old firms go out of business. New firms start up, which creates new and better jobs and leads to greater consumption and leisure. But insatiable wants simply start the growth cycle all over again. (1)

Preconditions for Economic Growth

Three necessary preconditions for economic growth are:

  1. Economic freedom is a condition in which people are able to make personal choices, their private property is protected, and they are free to buy and sell in markets. What countries are considered economically free? Who is in control of economic decisions? Are people free to do what they want and to work where they want? Are businesses free to produce when they want and what they choose, and to hire and fire as they wish? Are banks free to choose who will receive loans? Or, does the government control these kinds of choices? Each year, researchers at the Heritage Foundation and the Wall Street Journal look at 50 different categories of economic freedom for countries around the world. They give each nation a score based on the extent of economic freedom in each category. The 2013 Heritage Foundation’s Index of Economic Freedom report ranked 177 countries around the world: some examples of the most free and the least free countries are listed in Table 3.5.

Table 3.5 The 2013 Heritage Foundation’s Index of Economic Freedom report ranked 177 countries around the world.

Most Economic Freedom

  1. Hong Kong
  2. Singapore
  3. Australia
  4. New Zealand
  5. Switzerland
  6. Canada
  7. Chile
  8. Mauritius
  9. Denmark
  10. United States

Least Economic Freedom

  1. Iran
  2. Turkmenistan
  3. Equatorial Guinea
  4. Democratic Republic of Congo
  5. Burma
  6. Eritrea
  7. Venezuela
  8. Zimbabwe
  9. Cuba
  10. North Korea

The Heritage Foundation, 2013 Index of Economic Freedom, Country Rankings

  1. Markets enable people to trade and to save and invest. Markets cannot operate without property rights. Markets and government regulations are always entangled. There is no such thing as an absolutely free market. Regulations always define the “rules of the game” in the economy. Economies that are primarily market-oriented have fewer regulations — ideally just enough to maintain an even playing field for participants. At a minimum, these laws govern matters like safeguarding private property against theft, protecting people from violence, enforcing legal contracts, preventing fraud, and collecting taxes.
  2. Property rights are the social arrangements that govern the protection of private property. Clearly established and enforced property rights provide people with the incentive to work and save.

These three preconditions for economic growth are necessary for growth but do not guarantee that economic growth will occur. For growth to occur and to persist, people need incentives to save and invest, to accumulate human capital, and to develop new technologies.(1)

Policies to Achieve Faster Growth

Government policies to achieve economic growth must provide people with the incentives to save and investment, accumulate human capital, and develop new technologies. Below are listed some growth promoting policies:

  • Create Incentive Mechanisms : Enforce property rights with a well-functioning legal system.
  • Encourage Saving : Increased saving can increase the growth of capital and stimulate economic growth. East Asian countries have the highest growth rates and saving rates; some African economies have the lowest saving rates and the lowest economic growth rates.
  • Encourage Research and Development : More research and development creates technological advances. Governments can direct public funds toward financing basic research.
  • Encourage International Trade : International trade extracts all the available gains from specialization and exchange.
  • Improve the Quality of Education : The social benefits of education go beyond the benefits accrued to the individuals who receive the education. The government can help by financing more basic education to raise skills in language, math and science. (1)