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Creating an Environment for Growth and Prosperity

GWARTNEY – STROUP – SOBEL – MACPHERSON

To Accompany: “Economics: Private and Public Choice, 15th ed.”

James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson

Slides authored and animated by: James Gwartney & Charles Skipton

Full Length Text —

Macro Only Text —

Part: 3

Chapter: 16

First page

Historical Perspective on the Economic Growth of the Past Two Centuries

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Per Capita Income: The last 1000 years

Income stagnated for the 800 years following year 1000, but growth has exploded during the last 200 years.

(Measured in 1990 dollars) world per capita income was $667 in 1820 – only about 50% higher than year 1000. By 2003, however, income had risen to $6,516 – 10 times the 1820 level.

During the past 200 years, the income growth of the high-income industrial countries (west) has been even higher – nearly 20 fold.

1100

1200

1300

1400

1600

1500

1700

1800

1900

2003

1000

$5,000

$10,000

$15,000

$20,000

$25,000

1820: $667

1820: $1,202

2003: $6,516

2003: $23,710

West GDP per capita

World GDP per capita

GDP Per Capita

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Life Expectancy: The last 1000 years

There is a pattern in the life expectancy data that is similar to that in per capita income.

Life expectancy at birth for the world rose from 24 to 26 years between 1000 and 1820, but it soared to 64 by 2003.

Life expectancy in the high-income industrial countries (West) followed a similar pattern.

1100

1200

1300

1400

1600

1500

1700

1800

1900

2003

1000

1820: 26

1820: 36

2003: 64

2003: 76

West life expectancy

World life expectancy

Life Expectancy (at birth)

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Economic Growth, Production Possibilities, & the Quality of Life

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The Importance of Economic Growth

Economic growth is important because it is a necessary ingredient for higher incomes and higher living standards.

GDP is a measure of output and income. Growth of output is necessary for the growth of income.

Per capita GDP is the nation’s GDP divided by its population. Growth of per capita GDP means more goods & services per person.

In most cases, higher per capita GDP means that the typical person has a better diet, improved health and access to medical services, a longer life expectancy, and greater educational opportunity.

Growth leads to more than just material goods. It also generally leads a cleaner environment and more time for leisure and recreation.

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The Importance of Economic Growth

Economic growth makes larger outputs possible.

This can be illustrated by an outward shift in the PPC (production possibilities curve).

Economic growth means that a larger quantity of goods and services can be produced.

PPC2015

Capital goods

Consumption goods

PPC2025

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The Rule of 70

Economic growth and the Rule of 70:

Dividing 70 by a country’s average growth rate gives the number of years required for an economy’s income level to double.

Example: If the U.S. had a growth rate of 2.5%, how many years would it take for the income level of the U.S. to double?

2.5

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Impact of Economic Growth Rate Differences Over a 30-Year Period

Impact of growth rate differences over 30 years:

Here we illustrate how countries with an initial per capita income of $10,000 differ after 30 years for growth rates of 0%, 1%, 2%, and 4%.

Note how a country growing at a 4% annual rate will have a substantially higher income level than the others 30 years later.

–––––– Per Capita Income Level after 30 years––––––

$10,000

$13,478

$18,114

$32,434

– Annual Growth Rate –

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Sources of Economic Growth and High Incomes

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Sources of Economic Growth

Sources of Economic Growth:

Gains from trade

Entrepreneurial discovery

Investment in physical and human capital

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Sources of Economic Growth

Gains from trade:

Trade makes larger outputs possible because of division of labor, specialization in areas of comparative advantage, and application of mass production techniques.

The gains from trade will be greater when transactions costs are lower and people are permitted to trade over a larger market area.

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Sources of Economic Growth

Entrepreneurial discovery:

Discovery of improved products and lower cost production methods is a driving force of economic growth.

Technological improvement is scientific discovery while innovation is its practical application and dissemination.

Each of these play a role in the development of improved products and better ways of doing things.

Schumpeter referred to this process as "creative destruction."

It is vitally important that entrepreneurs have a chance to try out new ideas, but it is also important that resources are not wasted on inefficient projects. In a market economy, profits and losses perform these functions.

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Sources of Economic Growth

Investment in physical and human capital:

More and better machines and tools can enhance the productivity of people.

Education and training that improves the skill level of workers will also increase output.

Other things constant, countries that invest more will tend to grow more rapidly. But, investment is costly; it involves the sacrifice of current consumption.

High investment rates do not guarantee rapid growth. The investment must be channeled into wealth-creating projects.

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Questions for Thought:

If a country has sustained growth of per capita income of 5% annually, how many years will it take for income to double?

List five new products that have replaced older products and largely rendered them obsolete.

What is "creative destruction"? Explain in your own words how it influences our living standards and the quality of our lives.

In a market economy, what must an entrepreneur do in order to be successful? How do the actions of successful entrepreneurs influence economic growth?

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Questions for Thought:

5. What are the three major sources of economic growth? Can you think of another major source of growth that has significantly increased our living standards? If so, what is it?

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The Institutional Environment

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The Institutional Environment and Economic Growth

Modern growth analysis stresses that institutions and policies influence the realization of gains from trade, discovery and dissemination of improved products and production methods, and the level and productivity of investment.

Modern analysis builds on the work of Nobel Laureate Douglass North and Peter Bauer. Other leading contributors are Daron Acemoglu (MIT), Robert Barro (Harvard), and Barry Weingast (Stanford).

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Economic growth is a complex process that generally involves a combination of several interrelated factors.

Counterproductive policies in one or two key areas can substantially harm the overall performance of an economy.

The Institutional Environment and Economic Growth

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What Institutions and Policies Will Promote Growth?

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Key Elements of a Sound Institutional Environment

Institutional elements that are key to the growth process:

a legal system that protects property rights and enforces contracts even-handedly,

competitive markets,

access to money of stable value,

minimal regulation,

avoidance of high marginal tax rates, and,

trade openness.

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Modern Growth Analysis

Modern growth analysis stresses the importance of institutions and policies.

Consider how the six factors mentioned in the previous slide will influence the gains from trade, discovery of better ways of doing things, and investment.

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Key Element for Growth: -- Legal System

A legal system that protects property rights and enforces contracts even-handedly is necessary for the smooth operation of markets.

Private ownership provides people with a strong incentive to develop and use resources wisely, innovate and discover better ways of doing things, and to invest and conserve for the future.

In contrast, insecure property rights weaken the incentive to invest and to engage in entrepreneurial activity.

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If contracts are not enforced or if they are enforced in a biased manner, transaction costs will be higher, trade will be riskier, and the volume of trade will fall.

The security of property rights is often undermined by political instability, civil unrest, and war.

In recent years, political instability has contributed to the dismal economic performance of several nations, including the Democratic Republic of Congo, Zimbabwe, Haiti, Nicaragua, Russia, and Iraq.

Key Element for Growth: -- Legal System

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When markets are competitive, self-interested individuals have a strong incentive to develop resources and provide goods that are highly valued by others.

In a competitive setting, producers must provide goods at a low cost and serve the interests of consumers because if they don’t, other suppliers will.

The freedom to compete will encourage entrepreneurial activity and provide producers with a strong incentive to produce quality products at a low cost.

Key Element for Growth: -- Competitive Markets

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When the inflation rate is low and highly predictable, the risks of exchange across time periods is reduced.

In contrast, high and variable rates of inflation generate uncertainty and thereby increase the cost of exchanges across time periods and reduce investment. Thus, the gains from trade, entrepreneurial discovery, and investment are diminished.

Key Element for Growth: -- Monetary and Price Stability

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Regulation is a blunt instrument and it often generates harmful secondary effects.

Regulations that restrict entry and interfere with voluntary exchange will reduce the competitiveness of markets and the volume of trade.

Regulations that favor some at the expense of others will encourage rent-seeking and political corruption.

Key Element for Growth: -- Minimal Regulation

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High marginal tax rates reduce the incentive of people to earn, invest, and engage in other productive activities.

High taxes also reduce efficiency by driving productive activity into the underground economy, encouraging tax avoidance, and even inducing highly productive persons to move to other countries.

Key Element for Growth: -- Avoid High Marginal Tax Rates

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Like domestic trade, international trade is mutually advantageous.

With trade, countries can specialize in the production of goods they can produce economically and trade for those that would be costly to produce domestically. As a result, joint output can be expanded and both trading partners can consume a larger, more diverse bundle of goods.

Tariffs, quotas, and other trade restrictions reduce the gains from specialization and international trade and thereby reduce income below its potential.

Key Element for Growth: -- Trade Openness

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What can governments do to promote prosperity?

Governments promote economic progress when they protect individuals & their property, enforce contracts impartially, provide access to money of stable value, avoid high taxes and excessive regulation, and foster competitive markets and free international trade.

Key Element for Growth: -- A Summary

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Other Factors That May Influence Growth and Income

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Other Views on Growth

Through the years, economists have developed several theories about why some countries grow and others stagnate. While some are valid, history has shown others to either be fallacious or incomplete.

This section will consider some of these alternative views.

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In 1798, economist Thomas Malthus argued that if income rose above subsistence level, this would trigger a population boom that would drive income back down to subsistence level.

Malthus argued that population would grow exponentially (e.g. 1, 2, 4, 8, 16, etc.) while the resources required to expand production would grow only linearly (1, 2, 3, 4, etc.). Therefore, any increase of income above subsistence would soon be eliminated by rapid population growth.

Malthus was wrong because he did not understand the importance of technological improvements, innovation, and entrepreneurial discovery.

Population and Growth

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Natural Resources and Growth

There is a tendency to think that income differences across countries are largely the result of natural resources.

While resources may give a country an advantage, the linkage between resources and income is weak.

Many high income countries have few natural resources: Japan, Singapore, and Hong Kong.

Many resource rich countries are poor: Nigeria, Venezuela, Indonesia, and Russia.

Resource Curse: View that abundant resources often lead to the adoption of counterproductive policies. This would weaken the link between the abundance of natural resources & income levels.

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Foreign Aid and Growth

In the ‘50s & ‘60s, it was widely believed aid from high-income countries would help poor countries invest in infrastructure such as roads and power generating facilities and that this would provide the start-up capital needed to trigger the growth process.

While the theory sounded good, studies indicate that the aid was largely ineffective. The aid was often used to prop up corrupt authoritarian regimes and thereby retard needed institutional change.

Further, aid in the form of surplus agricultural products often disrupted markets in less developed countries.

Unless growth-oriented policies are adopted, foreign aid will continue to be ineffective.

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Climate, Location, and Growth

Jeffery Sachs of Columbia University argues that tropical countries are disadvantaged because:

Their hot, humid climates erode the energy level of workers and increase the risk of disabling and life-threatening diseases, and,

Their location is far from the major markets of Western Europe, North America, and Japan.

While income levels of tropical countries are generally lower than incomes in more temperate climates, their institutions and policies are also less consistent with the realization of gains from trade, entrepreneurship, and investment.

The record of Singapore & Hong Kong shows that tropical countries with sound institutions can achieve impressive growth and income.

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Poverty, Foreign Aid, and Quality of Institutions in Africa

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Poverty, Foreign Aid, and Quality of Institutions in Africa

More foreign aid has been directed at Africa than any other region in the world.

But the results have been disappointing. The poverty rate in Africa has declined slower than in other regions of the world.

The institutional environment in Africa is inconsistent with economic growth. Africa is characterized by:

Trade restrictions, a poor legal environment, and extensive regulation of business.

Most sub-Saharan countries rank in the bottom quarter of the Economic Freedom of the World (EFW) index.

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Poverty, Foreign Aid, and Quality of Institutions in Africa

In sub-Saharan Africa, the extreme poverty rate (per person income of $1.25 per day) fell from 61% in 1980 to 51% in 2005.

In the rest of the developing world the extreme poverty rate fell from 58% to 21% during the same period.

The moderate poverty rate (per person income of $2.00 per day) also declined far less rapidly in sub-Saharan Africa than in the rest of the developing world.

Sub-Saharan Africa

World, excluding sub-Saharan Africa

1980

1990

2000

2005

Extreme Poverty Rate (%)

1980

1990

2000

2005

Moderate Poverty Rate (%)

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Institutions, Policies, and Prosperity

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Institutions, Policies, and Prosperity

Institutions and policies matter because they shape incentives and thereby influence whether individuals engage in productive, unproductive, or even counterproductive activities.

When institutions and policies provide secure property rights, a fair and balanced judicial system, monetary stability, and effective limits on government’s ability to transfer wealth through taxation and regulation, individuals are encouraged to engage in productive activities.

When the legal and regulatory environment fails to protect property rights and often favors some at the expense of others, individuals are instead encouraged to engage in rent-seeking, lobbying, bribes, and other counterproductive activities.

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Institutions, Policies, and Prosperity

Unless countries adopt institutions and policies supportive of trade, entrepreneurial discovery, & private investment, they will be unable to sustain long-term growth and achieve high income levels.

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Questions for Thought:

Why will a nation’s legal system influence its growth and prosperity? What would a legal system consistent with strong growth look like?

If the people of a nation are going to get the most from their resources, why is competition important? What must a firm do in order to compete effectively? If a firm is driven out of business because of inability to compete, will this adversely affect growth and prosperity?

When the inflation rate is volatile, how is the volume of trade affected? How will this influence the income levels of people?

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Questions for Thought:

4. When government is heavily involved in the regulation of markets, how will this influence the gains from trade and growth of the economy? How will it influence the degree of rent-seeking by business and labor groups and the campaign contributions available to politicians? Are politicians likely to enact regulations that encourage rent seeking?

5. Why might abundant natural resources generate secondary effects that would make sustained economic growth less likely? Does foreign aid generate similar secondary effects? Why or why not?

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Questions for Thought:

6. Writing at the end of the 18th century, Thomas Malthus argued that income per person would never rise much above the subsistence level. Why did he believe this? Explain why he was wrong?

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End of

Chapter 16

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