Part III—Macroeconomics

Section II—The Macroeconomic Framework

Chapter 24—Growth, Productivity, and the Wealth of Nations

I. General Observations About Growth

• According to The Wealth of Nations, market economies raise a societies standard of living

A. Growth And The Economy’s Potential Output

• Growth is and increase in the amount of goods and services an economy produces

• Potential Growth—the highest amount of output an economy can produce from the existing production
function and the existing resources

• In the aggregate, potential growth and potential income are identical

• The analysis of growth focuses on forces that shift out the production possibilities curve

• Productivity (output per unit of input)

• Say’s Law (supply creates its own demand)

• According to Say’s Law, aggregate demand will always equal aggregate supply

B. The Importance Of Growth For Living Standards

• Growth in income improves lives by fulfilling basic needs and making more goods available to more
people

• The Rule of 72 states: the number of years it takes for a certain amount to double in value is equal to 72
divided by its annual rate of increase

• Compounding means that growth is based not only on the original level of income but also on the
accumulation of previous-year increases in income.

C. Markets, Specialization, and Growth

• Specialization (the concentration of individuals on certain aspects of production)

• Division of Labor (the splitting up of a task to allow for specialization of production)

• Specialization and the division of labor that accompany markets increase productivity and growth

D. Economic Growth, Distribution, and Markets

• Even though growth isn’t evenly distributed, it generally raises the income of the poor

• Just because the poor benefit from growth doesn’t mean they might not be better off if income were
distributed more in their favor

E. Per Capita Growth

• Per Capita Growth means producing more goods and services per person

• Per capita growth = % change in output – % change in population

II. The Sources Of Growth

• The five important sources of growth are:

1. Capital accumulation—investment in productive capacity
2. Available resources
3. Growth-compatible institutions
4. Technological development
5. Entrepreneurship

A. Investment And Accumulated Capital

• The three types of capital are:

1. Physical capital (private and public capital)
2. Human Capital (the skills that are embodied in workers through experience, education,
and on-the-job training)
3. Social Capital (the habitual way of doing things that guides people in how they approach
production)

B. Available Resources

• What is a resource depends on the production processes of an economy and technology

C. Growth-Compatible Institutions

• Growth compatible institutions must have incentives built into them that lead people to put forth effort
and discourage people from spending a lot of their time in leisure pursuits.

• Private property is an essential incentive created by the market economy

D. Technological Development

• Technology—the way we make goods and supply services

• Growth isn’t just getting more of the same thing. It’s also getting some things that are different

E. Entrepreneurship

• When a country’s population demonstrates entrepreneurship, it can overcome growth deficiencies

F. Turning The Sources Of Growth Into Growth

• Investing leads to more future output with less effort

III. The Production Function And Theories Of Growth

• The Production Function shows the relationship between the quantity of inputs used in production and
the quantity of output resulting form production

• Output = A • f(Labor, Capital, Land)

• “A” is an adjustment factor and “f” stands for function of

A. Describing Production Functions

• Constant Returns To Scale means output will rise by the same proportionate increases as all inputs

• Increasing Returns To Scale means output rises by a greater proportionate increase than all inputs
 • Decreasing Returns To Scale means output rises by a smaller proportionate increase as all inputs

• Law of Diminishing Marginal Productivity (increasing one input, keeping all others constant, will lead
to smaller and smaller gains in output

B. The Standard Theory Of Growth—The Classical Growth Model

• The Classical Growth Model is a model of growth that focuses on the role of capital accumulation in
the growth process

• Saving, investment, and capital are central to the Classical growth model

• Saving → Investment → Increase in capital → Growth

• Technological progress and increases in capital have overwhelmed diminishing marginal productivity of
labor

• Increases in human capital have allowed labor to keep pace with capital, allowing economies to avoid
diminishing productivity of capital

• Technological growth shifts the production function up

C. New Growth Theory

• New Growth Theory is a theory that emphasizes the role of technology rather than capital in the growth
process

• Positive Externalities—positive effects on the others not taken into account by the decision maker

• Patents—legal ownership of a technological innovation that gives the owner of the patent sole rights to
its use and distribution for a limited time

• Learn By Doing means to improve the methods of production through experience

• Learning by doing overcomes the law of diminishing marginal productivity because learning by doing
increases the productivity of workers

IV. Economic Policies To Encourage Per Capita Growth

A. Policies To Encourage Saving And Investment

• Developing countries have a much harder time designing saving policies than do developed countries

B. Policies To Control Population Growth

• Developing countries whose populations are rapidly growing have difficulty providing enough capital
and education for everyone. Consequently, income per capita is low.

C. Policies To Increase The Level Of Education

• Increasing education of the workforce increases productivity

D. Policies To Create Institutions That Encourage Technological Innovation

• Unlike capital, technological innovation can occur without investment; conversely, investment in
technology can also result in no technological innovation
 • Finding a middle ground between allowing patents which create incentives for developing countries’ new
technologies and exploiting the common knowledge aspect of technology is a difficult policy problem

E. Policies To Provide Funding For Basic Research

• U.S. government agencies provide about 60% of all research and development funds for basic research

F. Policies To Increase The Economy’s Openness To Trade

• Stating a policy rule is easy; applying it to specific cases is difficult

V. Conclusion

• National income accounting is an essential tool of economist