The Wealth of Nations and Economic Growth

Chapter 6

1© 2010 WORTH PUBLISHERS MODERN PRINCIPLES: MACROECONOMICS COWEN AND

TABARROK

SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

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Economic growth is a matter of life and death to the 1.8 million children who die of diarrhea each year globally.

Chapter OutlineChapter Outline

• Key Facts about the Wealth of Nations and Economic Growth

• Understanding the Wealth of Nations• Incentives and Institutions• Takeaway• Appendix: The Magic of Compound Growth

Using a Spreadsheet• See the Invisible Hand Blog (click) for more

examples

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Key Facts about the Wealth of Key Facts about the Wealth of Nations and Economic GrowthNations and Economic Growth

Go here to watch a 20 minute TED video about economic growth data.4

Fact One: GDP per Capita Today Varies Enormously among Nations

Key Facts about the Wealth of Key Facts about the Wealth of Nations and Economic GrowthNations and Economic Growth

5Wealth and Health go Together. Source: Penn World Tables and World Bank Group, World Development Indicators, 2005

Key Facts about the Wealth of Key Facts about the Wealth of Nations and Economic GrowthNations and Economic Growth

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Fact Two: Everyone Used to be Poor

Key Facts about the Wealth of Key Facts about the Wealth of Nations and Economic GrowthNations and Economic Growth

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• A Primer on Growth Rates– How is economic growth measured?

– Where yt is per capita real GDP in year t

– Example: Year real GDP per capita

2008 $15,000 2009 $15,500

100y

yyg

1t

1ttt

%33.3100000,15

000,15500,152009

g

The Rule of 70 (The Magic of The Rule of 70 (The Magic of Compounding)Compounding)

• The rule of 70:

– Example: If real GDP per capita is growing at an annual growth rate of 3.5%, it will double in:

– The moral? Small improvements in growth add up fast (the power of compounding).

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% 70

time Doublinginrategrowth

years. 20 5.3

70

A Little Growth Goes A Little Growth Goes a Long Waya Long Way

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Key Facts about the Wealth of Key Facts about the Wealth of Nations and Economic GrowthNations and Economic Growth

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Fact Three: There are Growth Miracles and Growth Disasters

Understanding the Wealth Understanding the Wealth of Nationsof Nations

• The Factors of Production are important– Physical capital:Physical capital: the stock of tools including

machines, structures, and equipment.– Human capital:Human capital: is the productive knowledge

and skills that workers acquire through education, training and experience.

– Technological knowledge:Technological knowledge: knowledge about how the world works that is used to produce goods and services.

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What Causes Economic What Causes Economic Growth?Growth?

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Understanding the Wealth Understanding the Wealth of Nationsof Nations

• Why do some nations have faster growth than others? – Besides factors of production, incentives

and institutions matter.

• InstitutionsInstitutions = “rules of the game” that structure economic incentives.

Institutions of Economic Growth1. Property rights2. Honest government3. Political stability4. A dependable legal system5. Competitive and open markets

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Korea’s ExperimentKorea’s Experiment

• Before division after WWII• Shared the same people and culture.• Had similar levels of physical capital.• Had access to the same technology.

– North Korea became a communist state with a centrally planned economy.

– South Korea adopted the capitalist free market model.

• The result 50 years later is dramatic as seen in the following photo from outer space.

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SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

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North and South Korea at night

InstitutionsInstitutions

1.Property rights: the right to benefit from one’s effort.• Provide incentives to work hard.• Encourage investment in physical and

human capital.• Are important for encouraging

technological innovation.

– Without property rights:– Effort is divorced from payment,

reducing incentives.– Free riders become a problem.

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InstitutionsInstitutions

• Free Rider Free Rider = someone who consumes a resources without working or contributing to the resource’s upkeep.– China’s “Great Leap Forward”- which

introduced farming collectives- reduced incentives to work. 20-40 million starved.

– 1978, farmers in Xiaogang met in secret to devise a plan to keep some of their produce.• Productivity improved so quickly the government

allowed the experiment to proceed.– Food production increased 50% in 5 years 1978-1983.

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InstitutionsInstitutions

2. Honest Government• Property rights are meaningless

unless government guarantees property rights.

• Corruption bleeds resources away from productive entrepreneurs.

• Corruption takes resources away from more productive government activity.

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Corruption and Growth Corruption and Growth Don’t go TogetherDon’t go Together

19Source: Penn World Tables and World Bank Group, World Development Indicators, 2005

Corruption Who’s Who ListCorruption Who’s Who List

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InstitutionsInstitutions

3.Political Stability• Changing governments without the

rule of law creates uncertainty which leads to less investment in physical and human capital.

• In many nations civil war, military dictatorship, and anarchy have destroyed the institutions necessary for economic growth.

21Bullet casings from Liberia’s Civil War: Bad soil for anything to grow.

InstitutionsInstitutions

4.Dependable Legal System• A good legal system facilitates

contracts and protects property from others (including government).

• Poorly protected property rights can result from too much government or too little government.– In India, residents who purchase land

have to do so more than once because of lack of proper record keeping.

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InstitutionsInstitutions

5.Competitive and Open Markets• Encourage the efficient organization of

resources.– About half the differences in per capita income

across countries is explained by a failure to use capital efficiently.

• One study found that if India used its physical and human capital as efficiently as the U.S., India would be four times richer than it is today.

• Click here for Alex Tabarrok’s TED talk about competition and economic growth (15 mins).

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InstitutionsInstitutions

• Why do poor countries use their capital inefficiently?–Whether inadvertently or not,

inefficient and unnecessary regulations:–Create monopolies and impede markets• Example: until recently in India, it was illegal to produce shirts using large-scale production• Economies of scale Economies of scale = the advantages of large-scale production that reduce average cost as quantity increases

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Try it!Try it!

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• Think-pair-share: Why do you think expensive red tape is hard to get rid of in many poor countries?

Key ConceptsKey Concepts

• Economic growth• Physical capital• Human capital• Technological knowledge• Institutions• Free rider• Economies of scale

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Try it!Try it!

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If a nation doubles its GDP per capita in 20 years, what is its annual growth rate?

a)3.5% b)4.2% c)6.5% d)7%

Try it!Try it!

28

If a nation doubles its GDP per capita in 20 years, what is its annual growth rate?

a)a)3.5% 3.5% b)4.2% c)6.5% d)7%

Try it!Try it!

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What is the most proximate (or direct) cause of growth in real GDP per capita?a)the factors of productionb)political system in the economyc)institutionsd)incentives

Try it!Try it!

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What is the most proximate (or direct) cause of growth in real GDP per capita?

a)a)the factors of productionthe factors of productionb)political system in the economyc)institutionsd)incentives

Try it!Try it!

31

Human capital is the a)stock of tools including machines,

structures, and equipment.b)productive knowledge and skills that

workers acquire through education, training, and experience.

c)knowledge about how the world works that is used to produce goods and services.

d)organization skills of business owners.

Try it!Try it!

32

Human capital is the a)stock of tools including machines,

structures, and equipment.

b)b)productive knowledge and skills that productive knowledge and skills that workers acquire through education, workers acquire through education, training, and experience.training, and experience.

c)knowledge about how the world works that is used to produce goods and services.

d)organization skills of business owners.

Try it!Try it!

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Which of the below is not directly related to human capital? a)a life-saving drugb)schoolingc)work experienced)an understanding of chemistry

Try it!Try it!

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Which of the below is not directly related to human capital? 

a)a)a life-saving druga life-saving drugb)schoolingc)work experienced)an understanding of chemistry

Try it!Try it!

35

Why did so many Chinese farmers and workers starve under “The Great Leap Forward”?a)The number of workers on communes was reduced.b)The Chinese people did not know how to farm in certain geographic areas.c)The incentive to work hard was low since the rewards were so minimal.d)All of the answers are correct.

Try it!Try it!

36

Why did so many Chinese farmers and workers starve under “The Great Leap Forward”?a)The number of workers on communes was reduced.b)The Chinese people did not know how to farm in certain geographic areas.

c)c)The incentive to work hard was low The incentive to work hard was low since the rewards were so minimal.since the rewards were so minimal.d)All of the answers are correct.