1.1 Module 53: Sources of Long-Run Economic Growth

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Comparing Economies Across Time and Space

Before we analyze the sources of long-run economic growth, it’s useful to have a sense of just how much the U.S. economy has grown over time and how large the gaps are between wealthy countries like the United States and countries that have yet to achieve comparable growth. So let’s take a look at the numbers.

Real GDP per Capita

The key statistic used to track economic growth is real GDP per capita—real GDP divided by the population size. We focus on GDP because, as we learned, GDP measures the total value of an economy’s production of final goods and services as well as the income earned in that economy in a given year. We use real GDP because we want to separate changes in the quantity of goods and services from the effects of a rising price level. We focus on real GDP per capita because we want to isolate the effect of changes in the population. For example, other things equal, an increase in the population lowers the standard of living for the average person—there are now more people to share a given amount of real GDP. An increase in real GDP that only matches an increase in population leaves the average standard of living unchanged.

Although we also learned that growth in real GDP per capita should not be a policy goal in and of itself, it does serve as a very useful summary measure of a country’s economic progress over time. Figure 53-1 shows real GDP per capita for the United States, India, and China, measured in 1990 dollars, from 1900 to 2010. The vertical axis is drawn on a logarithmic scale so that equal percent changes in real GDP per capita across countries are the same size in the graph.

Real GDP per capita from 1900 to 2010, measured in 1990 dollars, is shown for the United States, India, and China. Equal percent changes in real GDP per capita are drawn the same size. As the steeper slopes of the lines representing China and India show, since 1980 India and China had a much higher growth rate than the United States. In 2000, China attained the standard of living achieved in the United States in 1900. In 2010, India was still poorer than the United States was in 1900. (The break in the China data from 1940 to 1950 is due to war.)

Source: Maddison Project, http://www.ggdc.net/maddison.

To give a sense of how much the U.S. economy grew during the last century, Table 53-1 shows real GDP per capita at selected years, expressed two ways: as a percentage of the 1900 level and as a percentage of the 2010 level. In 1920, the U.S. economy already produced 136% as much per person as it did in 1900. In 2010, it produced 745% as much per person as it did in 1900, a more than sevenfold increase. Alternatively, in 1900 the U.S. economy produced only 13% as much per person as it did in 2010.

The income of the typical family normally grows more or less in proportion to per capita income. For example, a 1% increase in real GDP per capita corresponds, roughly, to a 1% increase in the income of the median or typical family—a family at the center of the income distribution. In 2010, the median American household had an income of about $50,000. Since Table 53-1 tells us that real GDP per capita in 1900 was only 13% of its 2010 level, a typical family in 1900 probably had a purchasing power only 13% as large as the purchasing power of a typical family in 2010. That’s around $6,100 in today’s dollars, representing a standard of living that we would now consider severe poverty. Today’s typical American family, if transported back to the United States of 1900, would feel quite a lot of deprivation.

Yet about 50% of the world’s people live in countries with a lower standard of living than the United States had a century ago. That’s the message about China and India in Figure 53-1: despite dramatic economic growth in China over the last three decades and the less dramatic acceleration of economic growth in India, China has only recently exceeded the standard of living that the United States enjoyed in the early twentieth century, while India is still poorer than the United States was at that time. And much of the world today is poorer than China or India.

You can get a sense of how poor much of the world remains by looking at Figure 53-2, a map of the world in which countries are classified according to their 2010 levels of GDP per capita, in U.S. dollars. As you can see, large parts of the world have very low incomes. Generally speaking, the countries of Europe and North America, as well as a few in the Pacific, have high incomes. The rest of the world, containing most of its population, is dominated by countries with GDP less than $3,976 per capita—and often much less.

Although the countries of Europe and North America—along with a few in the Pacific—have high incomes, much of the world is still very poor. Today, about 50% of the world’s population lives in countries with a lower standard of living than the United States had a century ago.

Source: International Monetary Fund.

Growth Rates

How did the United States manage to produce over seven times as much per person in 2010 than in 1900? The answer is a little bit at a time. Long-run economic growth is normally a gradual process in which real GDP per capita grows at most a few percent per year. From 1900 to 2010, real GDP per capita in the United States increased an average of 1.9% each year.

To have a sense of the relationship between the annual growth rate of real GDP per capita and the long-run change in real GDP per capita, it’s helpful to keep in mind the Rule of 70, a mathematical formula that tells us how long it takes real GDP per capita, or any other variable that grows gradually over time, to double. The approximate answer is:

(Note that the Rule of 70 can only be applied to a positive growth rate.) So if real GDP per capita grows at 1% per year, it will take 70 years to double. If it grows at 2% per year, it will take only 35 years to double.

In fact, U.S. real GDP per capita rose on average 1.9% per year over the last century. Applying the Rule of 70 to this information implies that it should have taken 37 years for real GDP per capita to double; it would have taken 111 years—three periods of 37 years each—for U.S. real GDP per capita to double three times. That is, the Rule of 70 implies that over the course of 111 years, U.S. real GDP per capita should have increased by a factor of 2 × 2 × 2 = 8. And this does turn out to be a pretty good approximation of reality. Between 1899 and 2010—a period of 111 years—real GDP per capita rose just about eightfold.

Figure 53-3 shows the average annual rate of growth of real GDP per capita for selected countries from 1980 to 2010. Some countries were notable success stories: for example, China, though still quite a poor country, has made spectacular progress. India, although not matching China’s performance, has also achieved impressive growth, as discussed in the following Economics in Action.

The average annual rate of growth of real GDP per capita from 1980 to 2010 is shown here for selected countries. China and, to a lesser extent, India and Ireland achieved impressive growth. The United States and France had moderate growth. Once considered an economically advanced country, Argentina had more sluggish growth. Still others, such as Zimbabwe, slid backward.

Source: International Monetary Fund.
*Data for Zimbabwe is average annual growth rate 2000–2010 due to data limitations.

Some countries, though, have had very disappointing growth. Argentina was once considered a wealthy nation. In the early years of the twentieth century, it was in the same league as the United States and Canada. But since then it has lagged far behind more dynamic economies. And still others, like Zimbabwe, have slid backward.

What explains these differences in growth rates? To answer that question, we need to examine the sources of long-run economic growth.

!world_eia!INDIA TAKES OFF

India achieved independence from Great Britain in 1947, becoming the world’s most populous democracy—a status it has maintained to this day. For more than three decades after independence, however, this happy political story was partly overshadowed by economic disappointment. Despite ambitious economic development plans, India’s performance was consistently sluggish. In 1980, India’s real GDP per capita was only about 50% higher than it had been in 1947; the gap between Indian living standards and those in wealthy countries like the United States had been growing rather than shrinking.

India’s high rate of economic growth has raised living standards and led to the emergence of a rapidly growing middle class.

Lionel Derimais/Alamy

Since then, however, India has done much better. As Figure 53-3 shows, real GDP per capita has grown at an average rate of 4.2% a year, more than tripling between 1980 and 2010. India now has a large and rapidly growing middle class. And yes, the well-fed children of that middle class are much taller than their parents.

What went right in India after 1980? Many economists point to policy reforms. For decades after independence, India had a tightly controlled, highly regulated economy. Today, things are very different: a series of reforms opened the economy to international trade and freed up domestic competition. Some economists, however, argue that this can’t be the main story because the big policy reforms weren’t adopted until 1991, yet growth accelerated around 1980.

Regardless of the explanation, India’s economic rise has transformed it into a major new economic power—and allowed hundreds of millions of people to have a much better life, better than their grandparents could have dreamed.

The big question now is whether this growth can continue. Skeptics argue that there are bottlenecks in the Indian economy that may constrain future growth. They point to the still low education level of much of India’s population and inadequate infrastructure—that is, the poor quality and limited capacity of the country’s roads, railroads, power supplies, and so on. But India’s economy has defied the skeptics for several decades and the hope is that it can continue doing so.

What Are the Sources of Long-Run Growth?

Long-run economic growth depends almost entirely on one ingredient: rising productivity. However, a number of factors affect the growth of productivity. Let’s look first at why productivity is the key ingredient and then examine what affects it.

The Crucial Importance of Productivity

Sustained economic growth occurs only when the amount of output produced by the average worker increases steadily. The term labor productivity, or productivity for short, is used to refer either to output per worker or, in some cases, to output per hour. (The number of hours worked by an average worker differs to some extent across countries, although this isn’t an important factor in the difference between living standards in, say, India and the United States.)

In this book we’ll focus on output per worker. For the economy as a whole, productivity—output per worker—is simply real GDP divided by the number of people working.

You might wonder why we say that higher productivity is the only source of long-run growth. Can’t an economy also increase its real GDP per capita by putting more of the population to work? The answer is, yes, but.…For short periods of time, an economy can experience a burst of growth in output per capita by putting a higher percentage of the population to work.

That happened in the United States during World War II, when millions of women who previously worked only in the home entered the paid workforce. The percentage of adult civilians employed outside the home rose from 50% in 1941 to 58% in 1944, and you can see the resulting bump in real GDP per capita during those years in Figure 53-1.

Over the longer run, however, the rate of employment growth is never very different from the rate of population growth. Over the course of the twentieth century, for example, the population of the United States rose at an average rate of 1.3% per year and employment rose 1.5% per year. Real GDP per capita rose 1.9% per year; of that, 1.7%—that is, almost 90% of the total—was the result of rising productivity. In general, overall real GDP can grow because of population growth, but any large increase in real GDP per capita must be the result of increased output per worker. That is, it must be due to higher productivity.

So increased productivity is the key to long-run economic growth. But what leads to higher productivity?

Explaining Growth in Productivity

There are three main reasons why the average U.S. worker today produces far more than his or her counterpart a century ago. First, the modern worker has far more physical capital, such as machinery and office space, to work with. Second, the modern worker is much better educated and so possesses much more human capital. Finally, modern firms have the advantage of a century’s accumulation of technical advancements reflecting a great deal of technological progress.

Let’s look at each of these factors in turn.

Increase in Physical CapitalEconomists define physical capital as manufactured resources such as buildings and machines. Physical capital makes workers more productive. For example, a worker operating a backhoe can dig a lot more feet of trench per day than one equipped only with a shovel.

The average U.S. private-sector worker today is backed up by more than $150,000 worth of physical capital—far more than a U.S. worker had 100 years ago and far more than the average worker in most other countries has today.

Increase in Human CapitalIt’s not enough for a worker to have good equipment—he or she must also know what to do with it. Human capital refers to the improvement in labor created by the education and knowledge embodied in the workforce.

The human capital of the United States has increased dramatically over the past century. A century ago, although most Americans were able to read and write, very few had an extensive education. In 1910, only 13.5% of Americans over 25 had graduated from high school and only 3% had four-year-college degrees. By 2010, the percentages were 87% and 30%, respectively. It would be impossible to run today’s economy with a population as poorly educated as that of a century ago.

Analyses based on growth accounting, described in the next module, suggest that education—and its effect on productivity—is an even more important determinant of growth than increases in physical capital.

Technological ProgressProbably the most important driver of productivity growth is technological progress, which is broadly defined as an advance in the technical means of the production of goods and services. We’ll see shortly how economists measure the impact of technology on growth.

Marty Bucella/Cartoonstock

Workers today are able to produce more than those in the past, even with the same amount of physical and human capital, because technology has advanced over time. It’s important to realize that economically important technological progress need not be flashy or rely on cutting-edge science. Historians have noted that past economic growth has been driven not only by major inventions, such as the railroad or the semiconductor chip, but also by thousands of modest innovations, such as the flat-bottomed paper bag, patented in 1870, which made packing groceries and many other goods much easier, and the Post-it^® note, introduced in 1981, which has had surprisingly large benefits for office productivity. Experts attribute much of the productivity surge that took place in the United States late in the twentieth century to new technology adopted by retail companies like Walmart rather than to high-technology companies.

Module 53 Review

Check Your Understanding

PITFALLS: CHANGE IN LEVEL VERSUS RATE OF CHANGE

CHANGE IN LEVEL VERSUS RATE OF CHANGE

What’s the difference between a change in the level of real GDP and a change in the growth rate?

When you hear that real GDP “grew,” it means that the level of real GDP increased. When you hear statements about economic growth over a period of years, you are almost always hearing about changes in the growth rate. Consider this example. We might say that U.S. real GDP grew during 2010 by $385 billion. If we knew the level of U.S. real GDP in 2009, we could also represent the amount of 2010 growth in terms of a rate of change. So, if U.S. real GDP in 2009 was $12,703 billion, then U.S. real GDP in 2010 was $12,703 billion + $385 billion = $13,088 billion. We could calculate the rate of change, or the growth rate, of U.S. real GDP during 2010 as: ($13,088 billion − $12,703 billion)/$12,703 billion) × 100 ($385 billion/$12,703 billion) × 100 = 3.03%.

When talking about growth or growth rates, economists often use phrases that appear to mix the two concepts. Admittedly, this can be confusing. For example, when economists say that “U.S. growth fell during the 1970s,” they are really saying that the U.S. growth rate of real GDP was lower in the 1970s in comparison to the 1960s. When they say that “growth accelerated during the early 1990s,” what they mean is that the growth rate increased year after year in the early 1990s—for example, going from 3% to 3.5% to 4%.

To learn more, see pages 174 and 175.