Write an analysis about homeless related to the text provided

Chapter8 Economic Growth People living in rich countries tend to take economic growth and rising standards of living for granted. Recessions—periods during which output declines—are normally infrequent and temporary, usually lasting less than a year. Once they pass, modern capitalistic economies return to growing, and living standards continue their seemingly inexorable rise. But a look back at history or a look around the world today quickly dispels any confidence that economic growth and rising standards of living are automatic or routine. Historically, continually rising living standards are a recent phenomenon, seen only during the last century or two. Before that time, living standards barely rose —if at all—from one generation to the next. And a look around the world today reveals huge differences in standards of living resulting from the disturbing fact that, although some countries have enjoyed decades or even centuries of steadily rising per capita income levels, other countries have experienced hardly any economic growth at all. This chapter investigates the causes of economic growth, what institutional structures appear to promote economic growth, and the controversies surrounding the benefits and costs of economic growth. As you will see, economic growth has been perhaps the most revolutionary and powerful force in history. Consequently, no study of economics is complete without a thorough understanding of the causes and consequences of economic growth. Economic Growth LO8.1 List Page 159 two ways that economic growth is measured. Economists define and measure economic growth as either:

• An increase in real GDP occurring over some time period.

• An increase in real GDP per capita occurring over some time period.

With either definition, economic growth is calculated as a percentage rate of growth per quarter (3-month period) or per year. For the first definition, for example, real GDP in the United States was $15,961.7 billion in 2014 and $16,348.9 in 2015. So the U.S. economic growth rate for 2015 was 2.4 percent {= [(16,348.9 billion − $15,961.7 billion)/ $15,961.7 billion] × 100}. Growth rates normally are positive, but not always. In recession year 2009, for instance, the U.S. rate of economic growth was a minus 2.4 percent. The second definition of economic growth in the bulleted list takes into consideration the size of the population. Real GDP per capita (or per capita output) is the amount of real output per person in a country. It is calculated, as follows.

For example, in 2014 the real GDP in the United States was $15,961.7 billion and population was 319.4 million. Therefore, real GDP per capita in that year was $49,974. In 2015 real GDP per capita increased to $50,820. So the growth rate of real GDP per capita in 2015 was 1.7 percent {= [($50,820 − $49,974)/$49,974] × 100}. In contrast, real GDP per capita fell by 3.3 percent in recession year 2009. For measuring expansion of military potential or political preeminence, the growth of real GDP is more useful. Unless specified otherwise, growth rates reported in the news and by international agencies use this definition of economic growth. For comparing living standards, however, the second definition is superior. While China’s GDP in 2015 was $10,983 billion compared with Denmark’s $295 billion, Denmark’s real GDP per capita was $64,186 compared with China’s strikingly lower $8,211. And in some cases real GDP growth statistics can be misleading, even when accurate. The African nation of Eritrea had real GDP growth of 1.3 percent per year from 2000–2008. But over the same period its annual growth of population was 3.8 percent, resulting in a decline in real GDP per capita of roughly 2.5 percent per year. Growth as a Goal

Growth is a widely held economic goal. The expansion of total output relative to population results in rising real wages and incomes and thus higher standards of living. An economy that is experiencing economic growth is better able to meet people’s wants and resolve socioeconomic problems. Rising real wages and income provide richer opportunities to individuals and families—a vacation trip, a personal computer, a higher education—without sacrificing other opportunities and pleasures. A growing economy can undertake new programs to alleviate poverty, embrace diversity, cultivate the arts, and protect the environment without impairing existing levels of consumption, investment, and public goods production. In short, growth lessens the burden of scarcity. A growing economy, unlike a static economy, can consume more today while increasing its capacity to produce more in the future. By easing the burden of scarcity —by relaxing society’s constraints on production—economic growth enables a nation to attain its economic goals more readily and to undertake new endeavors that require the use of goods and services to be accomplished. Arithmetic of Growth Why do economists pay so much attention to small changes in the rate of economic growth? Because those changes really matter! For the United States, with a current nominal GDP of about $17.9 trillion, the difference between a 3 percent and a 4 percent rate of growth is about $179 billion of output each year. For a poor country, a difference of one-half of a percentage point in the rate of growth may mean the difference between starvation and mere hunger. The mathematical approximation called the rule of 70 provides a quantitative grasp of the effect of economic growth. The rule of 70 tells us that we can find the number of years it will take for some measure to double, given its annual percentage increase, by dividing that percentage increase into the number 70:

Examples: A 3 percent annual rate of growth will double real GDP in about 23 (= 70 ÷ 3) years. Growth of 8 percent per year will double real GDP in about 9 (= 70 ÷ 8) years. The rule of 70 is applicable generally. For example, it works for estimating how long it will take the price level or a savings account to double at various percentage rates of inflation or interest. When compounded over many years, an apparently small difference in the rate of growth thus becomes highly significant. Suppose China and Italy start with identical GDPs, but then China grows at an 8 percent yearly rate, while Italy grows at 2 percent. China’s GDP would double in about 9 years, while Italy’s GDP would double in 35 years. Growth in the United States Table 8.1 gives an overview of economic growth in the United States since 1950. Column 2 reveals strong growth as measured by increases in real GDP. Note that between 1950 and 2015 real GDP increased more than sevenfold. But the U.S. population also increased. Nevertheless, in column 4 we find that real GDP per capita rose more than threefold over these years. Page 160 TABLE 8.1 Real GDP and Real GDP per Capita, Selected Years, 1950– 2015

Source: Data are from the Bureau of Economic Analysis, www.bea.gov, and the U.S. Census Bureau, www.census.gov. All data are subject to government revision. What has been the rate of U.S. growth? Real GDP grew at an annual rate of about 3.1 percent between 1950 and 2015. Real GDP per capita increased at roughly 2.0 percent per year over that time. But we must qualify these raw numbers in several ways:

• Improved products and services Since the numbers in Table 8.1 do not fully account for improvements in products and services, they understate the growth of economic well-being. Such purely quantitative data do not fully compare an era of vacuum tube computers and low-efficiency V8 hot rods with an era of digital cell phone networks and fuel-sipping, hybrid-drive vehicles.

• Added leisure The increases in real GDP and per capita GDP identified in Table 8.1 were accomplished despite increases in leisure. The average workweek, once 50 hours, is now about 35 hours (excluding overtime hours). Again the raw growth numbers understate the gain in economic well-being.

• Other impacts These measures of growth do not account for any effects growth may have had on the environment and the quality of

life. If growth debases the physical environment, excessively warms the planet, and creates a stressful work environment, the bare growth numbers will overstate the gains in well-being that result from growth. On the other hand, if growth leads to stronger environmental protections or a more secure and stress-free lifestyle, these numbers will understate the gains in well-being.

In Chapter 16, we made two other key points about U.S. growth rates. First, they are not constant or smooth over time. Like those of other countries, U.S. growth rates vary quarterly and annually depending on a variety of factors such as the introduction of major new inventions and the economy’s current position in the business cycle. Second, many countries share the U.S. experience of positive and ongoing economic growth. But sustained growth is both a historically new occurrence and also one that is not shared equally by all countries. QUICK REVIEW 8.1 ✓ Economists measure economic growth as either (a) an increase in real GDP over time or (b) an increase in real GDP per capita over time. ✓ Real GDP in the United States has grown at an average annual rate of about 3.1 percent since 1950; real GDP per capita has grown at roughly a 2 percent annual rate over that same period. Modern Economic Growth LO8.2 Define “modern economic growth” and explain the institutional structures needed for an economy to experience it. We now live in an era of wireless high-speed Internet connections, genetic engineering, and space exploration. New inventions and new technologies drive continual economic growth and ongoing increases in living standards. But it wasn’t always like this. Economic growth and sustained increases in living standards are a historically recent phenomenon that started with the Industrial Revolution of the late 1700s. Before the Industrial Revolution, living standards were basically flat over long periods of time so that, for instance, Greek peasants living in the year 300 B.C. had about the same material standard of living as Greek peasants living in the year A.D. 1500. By contrast, our current era

of modern economic growth is characterized by sustained and ongoing increases in living standards that can cause dramatic increases in the standard of living within less than a single human lifetime. Economic historians informally date the start of the Industrial Revolution to the year 1776, when the Scottish inventor James Watt perfected a powerful and efficient steam engine. This steam engine inaugurated the modern era since the device could be used to drive industrial factory equipment, steamships, and steam locomotives. The new industrial factories mass-produced goods for the first time. This meant that nearly all manufacturing shifted from items produced by hand by local craftsmen to items Page 161 mass-produced in distant factories. The new steamships and steam locomotives meant that resources could easily flow to factories and that the products of factories could be shipped to distant consumers at low cost. The result was a huge increase in long-distance trade and a major population shift as people left farms to go work in the towns and cities where the new industrial factories were concentrated. Steam power would later be largely replaced by electric power, and many more inventions would follow the steam engine that started the Industrial Revolution. These included railroads, motorized vehicles, telephones, airplanes, container ships, computers, the Internet, and many more. But the key point is that the last 200 or so years of history have been fundamentally different from anything that went before. The biggest change has been change itself. Whereas in earlier times material standards of living and the goods and services that people produced and consumed changed very little even over the course of an entire human life span, today people living in countries experiencing modern economic growth are constantly exposed to new technologies, new products, and new services. What is more, modern economic growth has vastly affected cultural, social, and political arrangements.

• Culturally, the vast increases in wealth and living standards have allowed ordinary people for the first time in history to have significant time for leisure activities and the arts.

• Socially, countries experiencing modern economic growth have abolished feudalism, instituted universal public education, and largely eliminated ancient social norms and legal restrictions against women and minorities doing certain jobs or holding certain positions.

• Politically, countries experiencing modern economic growth have tended to move toward democracy, a form of government that was extremely rare before the start of the Industrial Revolution.

In addition, the average human lifespan has more than doubled, from an average of less than 30 years before modern economic growth began in the late 1700s to a worldwide average of over 71 years today. Thus, for the first time in world history, the average person can expect to live into old age. These and other changes speak to the truly revolutionary power of economic growth and naturally lead economists to consider the causes of economic growth and what policies could be pursued to sustain and promote it. Their desire is intensified by the reality that economic growth is distributed so unevenly around the world. The Uneven Distribution of Growth Modern economic growth has spread only slowly from its British birthplace. It first advanced to France, Germany, and other parts of western Europe in the early 1800s before spreading to the United States, Canada, and Australia by the mid-1800s. Japan began to industrialize in the 1870s, but the rest of Asia did not follow until the early to mid-1900s, at which time large parts of Central and South America as well as the Middle East also began to experience modern economic growth. Most recent has been Africa, which for the most part did not experience modern economic growth until the last few decades. Notably, some parts of the world have yet to experience modern economic growth at all. The different starting dates for modern economic growth in various parts of the world are the main cause of the vast differences in per capita GDP levels seen today. The current huge gaps between rich countries like the United States and Japan and poor countries like North Korea and Burundi were shown previously in Global Perspective 26.1. But the huge divergence in living standards caused by the fact that different

countries started modern economic growth at different times is best seen in Figure 8.1, which shows how GDP per capita has evolved since 1820 in the United States, western Europe, Latin America, Asia, and Africa. FIGURE 8.1 The great divergence in standards of living. Income levels around the world were very similar in 1820. But they are now very different because certain areas, including the United States and western Europe, began experiencing modern economic growth much earlier than other areas.

Source: Angus Maddison, The World Economy: A Millennial Perspective (Paris: OECD, 2001), p. 264. To make the comparison of living standards easier, income levels in all places and at all times have been converted into 1990 U.S. dollars. Using this convention, it is clear that in 1820 per capita incomes in all areas were quite similar, with the richest area in the world in 1820, western Europe, having an average per capita income of $1,232, while the poorest area of the world at that time, Africa, had an average per capita income of $418. Thus, in 1820, average incomes in the richest area were only about three times larger than those in the poorest area.

But because western Europe and the United States started experiencing modern economic growth earlier than other areas, they have now ended up vastly richer than other areas, despite the fact that per capita incomes in nearly all places have increased at least a bit. For instance, per capita GDP in the United States in 1998 was $27,331 while it was only $1,368 in Africa. Thus, because modern economic growth has occurred for nearly two centuries in the United States compared to a few decades in Africa, average living standards in the United States in 1998 were nearly 20 times higher than those in Africa. Catching Up Is Possible Do not get the wrong impression looking at Figure 8.1. Countries that began modern economic growth more recently are not doomed to be permanently poorer than the countries that began modern economic growth at an earlier date. This is true because people can adopt technology more quickly than they can invent it. Broadly speaking, the richest countries today have achieved that status because they have the most advanced technology. But because they already have the most advanced technology, they must invent new technology to get even richer. Page 162 Because inventing and implementing new technology is slow and costly, real GDP per capita in the richest leader countries typically grows by an average annual rate of just 2 or 3 percent per year. By contrast, poorer follower countries can grow much faster because they can simply adopt existing technologies from rich leader countries. For instance, in many places in Africa today, the first telephones most people have ever been able to use are cell phones. That is, these countries have not even bothered to install the copper wires necessary for land-line telephones, which are basically a nineteenth-century technology. Instead, they have gone directly for Internet-capable mobile phone networks, a twenty-first-century technology. By doing so, they skip past many stages of technology and development that the United States and other currently rich countries had to pass through. In effect, they jump directly to the most modern, most highly productive technology. The result is that, under the right circumstances, it is

possible for poorer countries to experience extremely rapid increases in living standards. This can continue until they have caught up with the leader countries and become leader countries themselves. Once that happens, their growth rates fall down to the 2 or 3 percent rate typical of leader countries. This happens because once they are also rich and using the latest technology, their growth rates are limited by the rate at which new technology can be invented and applied.

Table 8.2 shows both how the growth rates of leader countries are constrained by the rate of technological progress as well as how certain follower countries have been able to catch up by adopting more advanced technologies and growing rapidly. Table 8.2 shows real GDP per capita in 1960 and 2010 as well as the average annual growth rate of

Page 163 real GDP per capita between 1960 and 2010 for three countries—the United States, the United Kingdom, and France—that were already rich leader countries in 1960 as well as for five other nations that were relatively poor follower countries at that time. To make comparisons easy, the GDPs and GDPs per capita for all countries are expressed in terms of 2005 U.S. dollars. The countries are ordered by their respective GDPs per capita in 1960, so that the richest country in the world at the time, the United States, is listed first while the poorest of the eight selected countries at the time, South Korea, is listed last. TABLE 8.2 Real GDP per Capita in 1960 and 2010 plus Average Annual Growth Rates of Real GDP per Capita from 1960–2010 for Selected Countries. (Figures are in 2005 dollars.)

Note: GDP figures for all countries are measured in “international dollars” of equal value to U.S. dollars in 2005. Source: Alan Heston, Robert Summers, and Bettina Aten, Penn World Table Version 6.3, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, August 2009. First, notice that the average annual growth rates of the three leader countries—the United States, the United Kingdom, and France—have all been between 2.1 and 2.5 percent per year because their growth rates are limited by the rate at which new technologies can be invented and applied. By contrast, the five countries that were follower countries in 1960 have been able to grow much faster, between 3.3 percent per year and 5.4 percent per year. This has had remarkable effects on their standards of living relative to the leader countries. For instance, Ireland’s GDP per capita was only 60 percent that of its neighbor, the United Kingdom, in 1960. But because Ireland grew at a 3.3 percent rate for the next 50 years while the United Kingdom grew at only a 2.2 percent rate over that time period, by 2010 Ireland’s GDP per capita was actually

higher than the United Kingdom’s GDP per capita. Ireland had become a leader country, too. The growth experiences of the other four nations that were poor in 1960 have been even more dramatic. Hong Kong, for instance, moved from a GDP per capita that was less than one-third of that enjoyed by the United Kingdom in 1960 to a GDP per capita 13 percent higher than that of the United Kingdom in 2010. The Consider This box emphasizes both how quickly small differences in growth rates can change the level of real GDP per capita and how countries stand in relation to each other in terms of real GDP per capita. Finally, you may be puzzled as to why the GDP per capita of the United States in 2010 in Table 8.2 is so much higher than that of other rich leader countries. Why, for instance, is U.S. GDP per capita 32 percent higher than French GDP per capita? One important reason is that U.S. citizens put in substantially more labor time than do the citizens of most other leader countries. First, a much larger fraction of the U.S. population is employed than in other rich leader countries. Second, U.S. employees work many more hours per year than do employees in other rich leader countries. For example, 58 percent of the working-age population of the United States was employed in 2010 compared to 51 percent in France. That’s a difference of about 14 percent. And American employees worked an average of 1,778 total hours during 2010, compared to an average of 1,478 total hours for French workers. That’s a difference of about 20 percent. Added together, these two differences between U.S. and French labor supply imply about a 34 percent difference in the total number of hours worked in the French and American economies. Thus, differences in labor supply help explain differences between rich leader countries in terms of their differing levels of GDP per person. CONSIDER THIS . . . Economic Growth Rates Matter!

Source: © Todd Warshaw/Getty Images Sport/Getty Images When compounded over many decades, small absolute differences in rates of economic growth add up to substantial differences in real GDP and standards of living. Consider three hypothetical countries—Slogo, Sumgo, and Speedo. Suppose that in 2014 these countries have identical levels of real GDP ($6 trillion), population (200 million), and real GDP per capita ($30,000). Also, assume that annual real GDP growth is 2 percent in Slogo, 3 percent in Sumgo, and 4 percent in Speedo. How will these alternative growth rates affect real GDP and real GDP per capita over a long period, say, a 70-year life-span? By 2084 the 2, 3, and 4 percent growth rates would boost real GDP from $6 trillion to:

• $24 trillion in Slogo. • $47 trillion in Sumgo. • $93 trillion in Speedo.

For illustration, let’s assume that each country experienced an average annual population growth of 1 percent over the 70 years. Then, in 2084 real GDP per capita would be about:

• $60,000 in Slogo. • $118,000 in Sumgo. • $233,000 in Speedo.

Even small differences in growth rates matter! Buy why do Americans supply so much more labor than workers in France and some of the other rich leader countries? Explanations put forth by economists include cultural differences regarding the proper

balance between work and leisure, stronger unions in France and other rich leader countries, and more generous unemployment and welfare programs in France and other rich leader countries. France and other rich leader countries also tend to have higher tax rates than the United States —something that may significantly discourage employment. And, finally, the legal workweek is shorter in some countries than it is in the United States. QUICK REVIEW 8.2 ✓ Before the advent of modern economic growth starting in England in the late 1700s, living standards showed no sustained increases over time. ✓ Large differences in standards of living exist today because certain areas like the United States have experienced nearly 200 years of modern economic growth while other areas have had only a few decades of economic growth. ✓ Poor follower countries can catch up with and even surpass the living standards of rich leader countries by adopting the cutting- edge technologies and institutions already developed by rich leader countries. ✓ Substantial differences in GDP per capita among technologically advanced leader countries are often caused by differences in the amount of labor supplied. Institutional Structures That Promote Modern Economic Growth Table 8.2 Page 164 demonstrates that poor follower countries can catch up and become rich leader countries by growing rapidly. But how does a country start that process and enter into modern economic growth? And once it has started modern economic growth, how does it keep the process going? Economic historians have identified several institutional structures that promote and sustain modern economic growth. Some structures increase the savings and investment that are needed to fund the construction and maintenance of the huge amounts of infrastructure required to run

modern economies. Other institutional structures promote the development of new technologies. And still others act to ensure that resources flow efficiently to their most productive uses. These growth- promoting institutional structures include:

• Strong property rights These appear to be absolutely necessary for rapid and sustained economic growth. People will not invest if they believe that thieves, bandits, or a rapacious and tyrannical government will steal their investments or their expected returns.

• Patents and copyrights Before patents and copyrights were first issued and enforced, inventors and authors usually saw their ideas stolen before they could profit from them. By giving inventors and authors the exclusive right to market and sell their creations, patents and copyrights give a strong financial incentive to invent and create.

• Efficient financial institutions These are needed to channel the savings generated by households toward the businesses, entrepreneurs, and inventors that do most of society’s investing and inventing. Banks as well as stock and bond markets appear to be institutions crucial to modern economic growth.

• Literacy and widespread education Without highly educated inventors, new technologies do not get developed. And without a highly educated workforce, it is impossible to implement those technologies and put them to productive use.

• Free trade Free trade promotes economic growth by allowing countries to specialize so that different types of output can be produced in the countries where they can be made at the lowest opportunity cost. In addition, free trade promotes the rapid spread of new ideas so that innovations made in one country quickly spread to other countries.

• A competitive market system Under a market system, prices and profits serve as the signals that tell firms what to make and how much of it to make. Rich leader countries vary substantially in terms of how much government regulation they impose on markets, but in all cases, firms have substantial autonomy to follow market signals in deciding on current production and in making

investments to produce what they believe consumers will demand in the future.

Several other difficult-to-measure factors also influence a nation’s capacity for economic growth. The overall social-cultural-political environment of the United States, for example, has encouraged economic growth. Beyond the market system that has prevailed in the United States, the United States also has had a stable political system characterized by democratic principles, internal order, the right of property ownership, the legal status of enterprise, and the enforcement of contracts. Economic freedom and political freedom have been “growth-friendly.” In addition, and unlike some nations, there are virtually no social or moral taboos on production and material progress in the United States. The nation’s social philosophy has embraced wealth creation as an attainable and desirable goal and the inventor, the innovator, and the businessperson are accorded high degrees of prestige and respect in American society. Finally, Americans have a positive attitude toward work and risk taking, resulting in an ample supply of willing workers and innovative entrepreneurs. A flow of energetic immigrants has greatly augmented that supply. The following Consider This box deals with how fast-growing follower countries such as India sometimes alter their growth-related institutional structures as they grow richer. CONSIDER THIS . . . Patents and Innovation

Source: © Stockbyte/Getty Images RF It costs U.S. and European Page 165 drug companies about $1 billion to research, patent, and safety- test a new drug because literally thousands of candidate drugs fail for each drug that succeeds. The only way to cover these costs is by relying on patent protections that give a drug’s developer the exclusive monopoly right to market and sell the new drug for 20 years following the patent application. The revenues over that time period will hopefully be enough to cover the drug’s development costs and—if the drug is popular—generate a profit for the drug company. Leader and follower countries have gotten into heated disputes over patented drugs, however, because the follower countries have often refused to recognize the patents granted to pharmaceutical companies in rich countries. India, for instance, has allowed local drug companies to copy and sell drugs that were developed by U.S. companies and are still under patent protection in the United States. That policy benefits Indian consumers because competition among the local drug companies drives down the price to below the monopoly price that would be charged by the patent owner. But the weak patent protections in India have a side effect. They

make it completely unprofitable for local drug producers to try to develop innovative new drugs. Local rivals would simply copy the new drugs and sell them at very low prices. So India has recently moved to strengthen its patent protections to try to provide financial incentives to transform its local drug companies from copycats into innovators. But note that the innovative new drugs that may result from the increased patent protections are not without a cost. As patent protections in India are improved, inexpensive local drugs copied from the leader countries will no longer be available to Indian consumers. Determinants of Growth LO8.3 Identify the general supply, demand, and efficiency forces that give rise to economic growth. Our discussion of modern economic growth and the institutional structures that promote it has purposely been general. We now want to focus our discussion on six factors that directly affect the rate and quality of economic growth. These determinants of economic growth can be grouped into four supply factors, one demand factor, and one efficiency factor. Supply Factors The first four determinants of economic growth relate to the physical ability of the economy to expand. They are:

• Increases in the quantity and quality of natural resources. • Increases in the quantity and quality of human resources. • Increases in the supply (or stock) of capital goods. • Improvements in technology.

Any increases or improvements in these supply factors will increase the potential size of an economy’s GDP. The remaining two factors are necessary for that potential to be fulfilled not just in terms of the overall quantity of output but also in terms of the quality of that output and whether it is properly directed toward producing the items most highly valued by society. Demand Factor The fifth determinant of economic growth is the demand factor:

• To actually achieve the higher production potential created when the supply factors increase or improve, households, businesses, and the government must also expand their purchases of goods and services so as to provide a market for all the new output that can potentially be produced.

If that occurs, there will be no unplanned increases in inventories and resources will remain fully employed. The demand factor acknowledges that economic growth requires that increases in total spending must occur if we are to actually realize the output gains made available by increased production capacity. Efficiency Factor The sixth determinant of economic growth is the efficiency factor:

• To reach its full production potential, an economy must achieve economic efficiency as well as full employment.

The economy must use its resources in the least costly way (productive efficiency) to produce the specific mix of goods and services that maximizes people’s well-being (allocative efficiency). The ability to expand production, together with the full use of available resources, is not sufficient for achieving maximum possible growth. Also required is the efficient use of those resources. The Page 166 supply, demand, and efficiency factors in economic growth are related. Unemployment caused by insufficient total spending (the demand factor) may lower the rate of new capital accumulation (a supply factor) and delay expenditures on research (also a supply factor). Conversely, low spending on investment (a supply factor) may cause insufficient spending (the demand factor) and unemployment. Widespread inefficiency in the use of resources (the efficiency factor) may translate into higher costs of goods and services and thus lower profits, which in turn may slow innovation and reduce the accumulation of capital (supply factors). Economic growth is a dynamic process in which the supply, demand, and efficiency factors all interact. Production Possibilities Analysis

To put the six factors affecting the rate of economic growth into better perspective, let’s use the production possibilities analysis introduced in Chapter 1. Growth and Production Possibilities Recall that a curve like AB in Figure 8.2 is a production possibilities curve. It indicates the various maximum combinations of products an economy can produce with its fixed quantity and quality of natural, human, and capital resources and its stock of technological knowledge. An improvement in any of the supply factors will push the production possibilities curve outward, as from AB to CD. FIGURE 8.2 Economic growth and the production possibilities curve. Economic growth is made possible by the four supply factors that shift the production possibilities curve outward, as from AB to CD. Economic growth is realized when the demand factor and the efficiency factor move the economy from points such as a and c that are inside CD to the optimal output point, which is assumed to be point b in this figure.

But the demand factor reminds us that an increase in total spending is needed to move the economy from a point like a on curve AB to any of the points on the higher curve CD. And the efficiency factor reminds us that we need least-cost production and an optimal location on CD for the

resources to make their maximum possible dollar contribution to total output. You will recall from Chapter 1 that this “best allocation” is determined by expanding the production of each good until its marginal benefit equals its marginal cost. Here, we assume that this optimal combination of capital and consumer goods occurs at point b. If the efficiency factor is in full effect, then the economy will produce at point b rather than at any other point along curve CD. Example: The net increase in the size of the labor force in the United States in recent years has been 1.5 to 2 million workers per year. That increment raises the economy’s production capacity. But obtaining the extra output that these added workers could produce depends on their success in finding jobs. It also depends on whether or not the jobs are in firms and industries where the workers’ talents are fully and optimally used. Society does not want new labor-force entrants to be unemployed. Nor does it want pediatricians working as plumbers or pediatricians producing pediatric services for which marginal costs exceed marginal benefits. Normally, increases in total spending match increases in production capacity, and the economy moves from a point on the previous production possibilities curve to a point on the expanded curve. Moreover, the competitive market system tends to drive the economy toward productive and allocative efficiency. Occasionally, however, the economy may end up at some point such as c in Figure 8.2. That kind of outcome occurred in the United States during the severe recession of 2007–2009. Real output fell far below the amount of output that the economy could have produced if it had achieved full employment and operated on its production possibilities curve. Labor and Productivity Although the demand and efficiency factors are important, discussions of economic growth focus primarily on supply factors. Society can increase its real output and income in two fundamental ways: (1) by increasing its inputs of resources and (2) by raising the productivity of those inputs. Figure 8.3 concentrates on the input of labor and provides a useful framework for discussing the role of supply factors in growth. A nation’s real GDP in any year depends on the input of labor (measured in

hours of work) multiplied by labor productivity (measured as real output per hour of work): FIGURE 8.3 The supply determinants of real output. Real GDP is usefully viewed as the product of the quantity of labor inputs (hours of work) multiplied by labor productivity.

Real GDP = hours of work × labor productivity Thought of this way, a nation’s economic growth from one year to the next depends on its increase in labor inputs (if any) and its increase in labor productivity (if any). Illustration: Assume that the hypothetical economy of Ziam has 10 workers in year 1, each working 2,000 hours per year (50 weeks at 40 hours per week). The total input of labor therefore is 20,000 hours. If productivity (average real output per hour of work) is $10, then real GDP in Ziam will be $200,000 (= 20,000 × $10). If work hours rise to 20,200 and labor productivity rises to $10.40, Ziam’s real GDP will increase to $210,080 in year 2. Ziam’s rate of economic growth will be about 5 percent [= ($210,080 − $200,000)/$200,000] for the year. Hours of Work What Page 167

determines the number of hours worked each year? As shown in Figure 8.3, the hours of labor input depend on the size of the employed labor force and the length of the average workweek. Labor-force size depends on the size of the working-age population and the labor-force participation rate—the percentage of the working-age population actually in the labor force. The length of the average workweek is governed by legal and institutional considerations and by collective bargaining agreements negotiated between unions and employers. Labor Productivity Figure 8.3 tells us that labor productivity is determined by technological progress, the quantity of capital goods available to workers, the quality of labor itself, and the efficiency with which inputs are allocated, combined, and managed. Productivity rises when the health, training, education, and motivation of workers improve; when workers have more and better machinery and natural resources with which to work; when production is better organized and managed; and when labor is reallocated from less-efficient industries to more-efficient industries.

Accounting for Growth LO8.4 Describe “growth accounting” and the specific factors accounting for economic growth in the United States. The president’s Council of Economic Advisers uses a system called growth accounting to assess the relative importance of the supply-side elements that contribute to changes in real GDP. This system groups these elements into two main categories:

• Increases in hours of work. • Increases in labor productivity.

Labor Inputs versus Labor Productivity Table 8.3 provides the relevant data for the United States for five periods. The symbol “Q” in the table stands for “quarter” of the year. The beginning points for the first four periods are business-cycle peaks, and the last period includes future projections by the Council of Economic Advisers. It is clear from the table that both increases in the quantity of labor and increases in labor productivity are important sources of economic growth. Between 1953 and 2015, the labor force increased from 63 million to 158 million workers. Over that period the

average length of the workweek remained relatively stable. Falling birthrates slowed the growth of the native population, but increased immigration partly offset that slowdown. As indicated in the nearby Consider This box, of particular significance was a surge of women’s participation in the labor force. Partly as a result, U.S. labor-force growth averaged 1.5 million workers per year over those 62 years. TABLE 8.3 Accounting for the Growth of U.S. Real GDP, 1953–2015 plus Projection from 2015 to 2026 (Average Annual Percentage Changes)

Source: Derived from Economic Report of the President, 2008, p. 45, https:// www.gpo.gov/fdsys/pkg/ERP-2008/pdf/ERP-2008.pdf; Economic Report of the President 2016, p. 113, https://www.whitehouse.gov/sites/default/files/docs/ ERP_2016_Book_Complete%20JA.pdf; Bureau of Economic Analysis; and Bureau of Labor Statistics. The growth of labor productivity also has been important to economic growth. In fact, Page 168 productivity growth has usually been the more significant factor. For example, between 2007 and 2015, labor inputs increased by just 0.1 percent per year. As a result, almost all of the 1.2 percent average annual growth rate of GDP over that time period was due to increases in labor productivity. As can be calculated from the data in the far right column of Table 8.3, productivity growth is projected to account for 88 percent of the growth of real GDP between 2015 and 2026. Because increases in labor productivity are so important to economic growth, economists go to the trouble of investigating and assessing the relative importance of the factors that contribute to productivity growth. There are five factors that, together, appear to explain changes in productivity growth rates: technological advance, the amount of capital each worker has to work with, education and training, economies of scale, and resource allocation. We will examine each factor in turn, noting how much each factor contributes to productivity growth.

Technological Advance The largest contributor to productivity growth is technological advance, which is thought to account for about 40 percent of productivity growth. As economist Paul Romer stated, “Human history teaches us that economic growth springs from better recipes, not just from more cooking.” Technological advance includes not only innovative production techniques but new managerial methods and new forms of business organization that improve the process of production. Generally, technological advance is generated by the discovery of new knowledge, which allows resources to be combined in improved ways that increase output. Once discovered and implemented, new knowledge soon becomes available to entrepreneurs and firms at relatively low cost. Technological advance therefore eventually spreads through the entire economy, boosting productivity and economic growth. Technological advance and capital formation (investment) are closely related, since technological advance usually promotes investment in new machinery and equipment. In fact, technological advance is often embodied within new capital. For example, the purchase of new computers brings into industry speedier, more powerful computers that incorporate new technology. Technological advance has been both rapid and profound. Gas and diesel engines, conveyor belts, and assembly lines are significant developments of the past. So, too, are fuel-efficient commercial aircraft, integrated microcircuits, personal computers, digital photography, and containerized shipping. More recently, technological advance has exploded, particularly in the areas of computers, photography, wireless communications, and the Internet. Other fertile areas of recent innovation are medicine and biotechnology. Quantity of Capital A second major contributor to productivity growth is increased capital, which explains roughly 30 percent of productivity growth. More and better plant and equipment make workers more productive. And a nation acquires more capital by saving some of its income and using that savings to invest in plant and equipment.

CONSIDER THIS . . . Women, the Labor Force, and Economic Growth

Source: © Dynamic Graphics/JupiterImages RF The substantial rise in the number of women working in the paid workforce in the United States has been one of the major labor market trends of the last 50 years. In 1960, about 40 percent of women worked full-time or part-time in paid jobs. Today, that number is about 60 percent. Women have greatly increased their productivity in the workplace, mostly by becoming better educated and professionally trained. Rising productivity has increased women’s wage rates. Those higher wages have raised the opportunity costs—the forgone wage earnings—of staying at home. Women have therefore substituted employment in the labor market for traditional home activities. This substitution has been particularly pronounced among married women. (Single women have always had high labor-force participation rates.) Furthermore, changing lifestyles and the widespread availability of birth control have freed up time for greater labor-force participation by women. Women not only have fewer children, but those children are spaced closer together in age. Thus women who leave their jobs during their children’s early years return to the labor force sooner.

Greater access to jobs by women also has raised the labor-force participation of women. Service industries—teaching, nursing, and office work, for instance—that traditionally have employed many women have expanded rapidly in the past several decades. Also, the population in general has shifted from farms and rural regions to urban areas, where jobs for women are more abundant and more geographically accessible. Additionally, occupational barriers to professions have greatly eroded, resulting in many more women becoming business managers, lawyers, professors, and physicians. In summary, women in the United States are better educated, more productive, and more efficiently employed than ever before. Their greater presence in the labor force has contributed greatly to U.S. economic growth. Although some capital substitutes for labor, most capital is complementary to labor—it makes labor more productive. A key determinant of labor productivity is the amount of capital goods available per worker. If both the aggregate stock of capital goods and the size of the labor force increase over a given period, the individual worker is not necessarily better equipped and productivity will not necessarily rise. But the quantity of capital equipment available per U.S. worker has increased greatly over time. (In 2014 it was about $149,286 per worker.) Public Page 169 investment in the U.S. infrastructure (highways and bridges, public transit systems, wastewater treatment facilities, water systems, airports, educational facilities, and so on) has also grown over the years. This publicly owned capital complements private capital. Investments in new highways promote private investment in new factories and retail stores along their routes. Industrial parks developed by local governments attract manufacturing and distribution firms. Private investment in infrastructure also plays a large role in economic growth. One example is the tremendous growth of private capital relating to communications systems over the years.

Education and Training Ben Franklin once said, “He that hath a trade hath an estate,” meaning that education and training contribute to a worker’s stock of human capital—the knowledge and skills that make a worker productive. Investment in human capital includes not only formal education but also on-the-job training. Like investment in physical capital, investment in human capital is an important means of increasing labor productivity and earnings. An estimated 15 percent of productivity growth derives from investments in people’s education and skills. One measure of a nation’s quality of labor is its level of educational attainment. Figure 8.4 shows large gains in education attainment over the past several decades. In 1960 only 41 percent of the U.S. population age 25 or older had at least a high school education, and only 8 percent had a college or post-college education. By 2015, those numbers had increased to 88 and 33 percent, respectively. Clearly, more people are receiving more education than ever before. FIGURE 8.4 Changes in the educational attainment of the U.S. adult population. The percentage of the U.S. adult population, age 25 or older, completing high school and college has been rising over recent decades.

Source: U.S. Census Bureau, www.census.gov

GLOBAL PERSPECTIVE 8.1 Average Test Scores of Eighth-Grade Students in Math and Science, Top 10 Test-Taking Countries The test performance of U.S. eighth-grade students did not compare favorably with that of eighth-graders in several other nations in the Fifth International Math and Science Study (2011).

Source: US Department of Education, Fifth International Math and Science Study (2011). But all is not upbeat with education in the United States. Many observers think that the quality of education in the United States has declined. For example, U.S. students perform poorly on science and math tests relative

to students in many other nations (see Global Perspective 8.1). And the United States has been producing fewer engineers and scientists, a problem that may trace back to inadequate training in math and science in elementary and high schools. For these reasons, much recent public policy discussion and legislation have been directed toward improving the quality of the U.S. education and training system. Economies of Scale and Resource Allocation Economies Page 170 of scale and improved resource allocation are a fourth and fifth source of productivity growth, and together they explain about 15 percent of productivity growth. Economies of Scale Reductions in per-unit production costs that result from increases in output levels are called economies of scale. Markets have increased in size over time, allowing firms to increase output levels and thereby achieve production advantages associated with greater size. As firms expand their size and output, they are able to use larger, more productive equipment and employ methods of manufacturing and delivery that increase productivity. They also are better able to recoup substantial investments in developing new products and production methods. Examples: A large manufacturer of autos can use elaborate assembly lines with computerization and robotics, while smaller producers must settle for less-advanced technologies using more labor inputs. Large pharmaceutical firms greatly reduce the average amount of labor (researchers, production workers) needed to produce each pill as they increase the number of pills produced. Accordingly, economies of scale result in greater real GDP and thus contribute to economic growth. Improved Resource Allocation Improved resource allocation means that workers over time have moved from low-productivity employment to high-productivity employment. Historically, many workers have shifted from agriculture, where labor productivity is low, to manufacturing, where it is quite high. More recently, labor has shifted away from some manufacturing industries to even higher-productivity industries such as computer software, business

consulting, and pharmaceuticals. As a result of such shifts, the average productivity of U.S. workers has increased. Also, discrimination in education and the labor market has historically deterred some women and minorities from entering high-productivity jobs. With the decline of such discrimination over time, many members of those groups have shifted from lower-productivity jobs to higher- productivity jobs. The result has been higher overall labor productivity and real GDP. Finally, things such as tariffs, import quotas, and other barriers to international trade tend to relegate resources to relatively unproductive pursuits. The long-run movement toward liberalized international trade through international agreements has improved the allocation of resources, increased labor productivity, and expanded real output, both here and abroad. QUICK REVIEW 8.3 ✓ Institutional structures that promote growth include strong property rights, patents, efficient financial institutions, education, and a competitive market system. ✓ The determinants of economic growth include four supply factors (increases in the quantity and quality of natural resources, increases in the quantity and quality of human resources, increases in the stock of capital goods, and improvements in technology), one demand factor (increases in total spending), and one efficiency factor (achieving allocative and productive efficiency). ✓ Improvements in labor productivity accounted for about two- thirds of the increase in U.S. real GDP between 1990 and 2012; the use of more labor inputs accounted for the remainder. ✓ Improved technology, more capital, greater education and training, economies of scale, and better resource allocation have been the main contributors to U.S. productivity growth and thus to U.S. economic growth.

Recent Fluctuations in the Average Rate of Productivity Growth LO8.5 Explain how the average rate of U.S. productivity growth has fluctuated since 1973. Figure 8.5 shows the growth of labor productivity (as measured by changes in the index of labor productivity) in the United States from 1973 to 2015, along with separate trend lines for 1973–1995, 1995– 2010, and 2010–2015. Labor productivity in the business sector grew by an average of only 1.5 percent yearly over the 1973–1995 period. But productivity growth averaged a much higher 2.6 percent per year between 1995 and 2010 before plummeting to just 0.4 percent between 2010 and 2015. Many economists believe that the rapid productivity growth experienced between 1995 and 2010 resulted from a significant new wave of technological advances, coupled with global competition. By contrast, the dramatic decline in productivity growth that followed the Great Recession of 2007–2009 was perhaps due to a slowdown in the rate at which productive new technologies were being implemented by businesses. FIGURE 8.5 Growth of labor productivity in the United States, 1973– 2012. U.S. labor productivity (here, for the business sector) increased at an average annual rate of only 1.5 percent from 1973 to 1995. But between 1995 and 2010, it rose at an annual rate of 2.6 percent before decreasing to just 0.4 percent per year after the Great Recession of 2007–2009.

Source: U.S. Bureau of Labor Statistics, www.bls.gov.

Robust productivity growth is important because real output, real income, and real wages are linked to labor productivity. To see why, suppose you are alone on an uninhabited island. The number of fish you can catch or coconuts you can pick per hour—your productivity—is your real wage (or real income) per hour. By increasing your productivity, you can improve your standard of living because you can gather more fish and more coconuts (goods) for each hour of work. So it is Page 171 for the economy as a whole: Over long periods, the economy’s labor productivity determines its average real hourly wage, which includes fringe benefits such as health care insurance and contributions to pensions. The economy’s income per hour is equal to its output per hour. So productivity growth is the economy’s main route for improving the living standards for its workers. It allows firms to pay higher wages without lowering their business profits. Reasons for the Rise in the Average Rate of Productivity Growth between 1995 and 2010 Why did productivity growth increase rapidly between 1995 and 2010? The Microchip and Information Technology The core element of the productivity speedup between 1995 and 2010 was an explosion of entrepreneurship and innovation based on the microprocessor, or microchip, which bundles transistors on a piece of silicon. Some observers liken the invention of the microchip to that of electricity, the automobile, air travel, the telephone, and television in importance and scope. The microchip has found its way into thousands of applications. It has helped create a wide array of new products and services and new ways of doing business. Its immediate results were the pocket calculator, the bar-code scanner, the personal computer, the laptop computer, and more powerful business computers. But the miniaturization of electronic circuits also advanced the development of many other products such as cell phones and pagers, computer-guided lasers, global positioning equipment, energy conservation systems, Doppler radar, digital cameras, and machines to decipher the human genome.

Perhaps of greatest significance, the widespread availability of personal and laptop computers stimulated the desire to tie them together. That desire promoted rapid development of the Internet and all its many manifestations, such as business-to-household and business-to-business electronic commerce (e-commerce). The combination of the computer, fiber-optic cable, wireless technology, and the Internet constitutes a spectacular advance in information technology, which has been used to connect all parts of the world. New Firms and Increasing Returns Hundreds of new start-up firms advanced various aspects of the new information technology. Many of these firms created more “hype” than goods and services and quickly fell by the wayside. But a number of firms flourished, eventually to take their places among the nation’s largest firms. Examples of those firms include Intel (microchips); Apple and Dell (personal computers); Microsoft and Oracle (computer software); Cisco Systems (Internet switching systems); America Online (Internet service provision); Yahoo and Google (Internet search engines); and eBay, PayPal, and Amazon.com (electronic commerce). There are scores more! Most of these firms were either “not on the radar” or “a small blip on the radar” 30 years ago. Today each of them has large annual revenue and employs thousands of workers. Successful new firms often experience increasing returns, a situation in which a given percentage increase in the amount of inputs a firm uses leads to an even larger percentage increase in the amount of output the firm produces. For example, suppose that a company called Techco decides to double the size of Page 172 its operations to meet the growing demand for its services. After doubling its plant and equipment and doubling its workforce, say, from 100 workers to 200 workers, it finds that its total output has tripled from 8,000 units to 24,000 units. Techco has experienced increasing returns; its output has increased by 200 percent, while its inputs have increased by only 100 percent. That is, its labor productivity has gone up from 80 units per worker (= 8,000 units/100 workers) to 120 units per worker (= 24,000 units/200 workers). Increasing returns boost labor productivity

and reduce per-unit production costs. Since these cost reductions result from increases in output levels, they are examples of economies of scale. Both emerging firms as well as established firms can exploit several different sources of increasing returns and economies of scale:

• More specialized inputs Firms can use more specialized and thus more productive capital and workers as they expand their operations. A growing new e-commerce business, for example, can purchase highly specialized inventory management systems and hire specialized personnel such as accountants, marketing managers, and system maintenance experts.

• Spreading of development costs Firms can spread high product development costs over greater output. For example, suppose that a new software product costs $100,000 to develop and only $2 per unit to manufacture and sell. If the firm sells 1,000 units of the software, its per-unit cost will be $102 [= ($100,000 + $2,000)/ 1,000], but if it sells 500,000 units, that cost will drop to only $2.20 [= ($100,000 + $1 million)/500,000].

• Simultaneous consumption Many recently developed products and services can satisfy large numbers of customers at the same time. Unlike a gallon of gas that needs to be produced for each buyer, a software program needs to be produced only once. It then becomes available at very low expense to thousands or even millions of buyers. The same is true of books delivered to electronic reading devices, movies distributed on DVDs, and information disseminated through the Internet.

• Network effects Software and Internet service become more beneficial to a buyer the greater the number of households and businesses that also buy them. When others have Internet service, you can send e-mail messages to them. And when they also have software that allows display of documents and photos, you can attach those items to your e-mail messages. These interconnectivity advantages are called network effects, which are increases in the value of a product to each user, including existing users, as the total number of users rises. The domestic and global expansion of the Internet in particular has produced network effects, as have cell phones, pagers, tablet computers, and other

aspects of wireless communication. Network effects magnify the value of output well beyond the costs of inputs.

• Learning by doing Finally, firms that produce new products or pioneer new ways of doing business experience increasing returns through learning by doing. Tasks that initially may have taken firms hours may take them only minutes once the methods are perfected.

Whatever the particular source of increasing returns, the result is higher productivity, which tends to reduce the per-unit cost of producing and delivering products. Global Competition The recent economy is characterized not only by information technology and increasing returns but also by heightened global competition. The collapse of the socialist economies in the late 1980s and early 1990s, together with the success of market systems, has led to a reawakening of capitalism throughout the world. The new information technologies have “shrunk the globe” and made it imperative for all firms to lower their costs and prices and to innovate in order to remain competitive. Free- trade zones such as NAFTA and the European Union (EU), along with trade liberalization through the World Trade Organization (WTO), have also heightened competition internationally by removing trade protection from domestic firms. The larger geographic markets, in turn, have enabled firms to expand beyond their national borders. Implications for Economic Growth Other things equal, stronger productivity growth and heightened global competition allow the economy to achieve a higher rate of economic growth. A glance back at Figure 8.2 will help make this point. Suppose that the shift of the production possibilities curve from AB to CD reflects annual changes in potential output levels before the recent increase in growth rates. Then the higher growth rates of the more recent period of accelerated productivity growth would be depicted by a larger outward shift of the economy’s production possibilities from AB to a curve beyond CD. When coupled with economic efficiency and increased total spending, the economy’s real GDP would rise by even more than what is shown.

The Recent Productivity Slowdown It is not clear whether the dramatic slowdown in productivity growth that took place after the Great Recession is permanent or transitory. Some economists have argued that the high productivity growth rates observed between 1995 and 2010 were a one-time anomaly due to the information technology revolution. But even if information technology caused an unusual burst of growth for 15 years, it is still surprising that post-2010 productivity growth rates have been so very low, much lower in fact than the rates that prevailed before the information technology revolution.

GLOBAL PERSPECTIVE 8.2 Global Competitiveness Index The Global Competitiveness Index, published annually by the World Economic Forum, measures each country’s potential for economic growth. The index uses various factors—such as innovativeness, the capability to transfer technology among sectors, the efficiency of the financial system, rates of investment, and the degree of economic integration with the rest of the world —to measure a country’s ability to achieve economic growth over time. Here is the top 10 list for 2015–2016.

Source: World Economic Forum, www.weforum.org. By Page 173 the mid-2010s, several possible explanations had been put forward to explain why productivity growth rates had fallen so low. One possible culprit is the high debt levels that accumulated before the Great Recession. Under this hypothesis, individuals and firms are now too busy paying down debts to make productive investments. At the same time, entrepreneurs who might be able to improve productivity may be unable to obtain loans because banks are reluctant to lend after having made so many bad loans prior to the Great Recession. Overcapacity may be another possible explanation for the productivity slowdown. During the boom that preceded the Great Recession, worldwide productive capacity increased massively as many new factories were built. But the additional capacity may have exceeded the amount of consumer demand that would have been necessary to purchase the additional output made possible by the additional capacity. If so, firms would have been reluctant to install newer, more productive equipment or build newer, more productive factories after the Great Recession because they already had more than enough production

capacity. Under this hypothesis, productivity stagnated because producers continued to rely on aging machinery and equipment. Another possible explanation for the slowdown in measured productivity has to do with the fact that many recent products—especially Internet apps—do not generate much of a measurable effect on GDP. Consider Facebook, YouTube, and Instagram. They are for the most part totally free to consumers. So even if billions of people are using these products, measured output won’t go up very much because there is no monetary payment being made by users. Under this hypothesis, things aren’t so bad. Measured productivity growth is low, but the new products are in fact innovative and bring with them a huge amount of consumer surplus; we just can’t discern those benefits in the GDP and productivity statistics. Finally, it is also possible that technological progress itself may have stalled. Under this hypothesis, productivity growth will remain slow until invention and innovation speed up again. QUICK REVIEW 8.4 ✓ Over long time periods, labor productivity growth determines an economy’s growth of real wages and its standard of living.   ✓ Labor productivity grew at an average rate of 1.5 percent from 1973 to 1995, 2.6 percent from 1995 to 2010, and 0.4 percent from 2010 to 2015. ✓ The high productivity growth rate observed between 1995 and 2010 is attributed to the information technology revolution, increasing returns, and heightened global competition.   ✓ Possible explanations for the low productivity growth rate after 2010 include high debt levels, overcapacity, the rise of “free” Internet products, and a slowdown in technological progress. Is Growth Desirable and Sustainable? LO8.6 Discuss differing perspectives as to whether growth is desirable and sustainable. Economists usually take for granted that economic growth is desirable and sustainable. But not everyone agrees. The Antigrowth View

Critics of growth say industrialization and growth result in pollution, climate change, ozone depletion, and other environmental problems. These adverse negative externalities occur because inputs in the production process reenter the environment as some form of waste. The more rapid our growth and the higher our standard of living, the more waste the environment must absorb—or attempt to absorb. In an already wealthy society, further growth usually means satisfying increasingly trivial wants at the cost of mounting threats to the ecological system. Page 174

LAST WORD Can Economic Growth Survive Population Decline? The Demographic Transition Is Causing Greying Populations, Shrinking Labor Forces, and Overall Population Decreases in Many Nations. Can Economic Growth Survive? As you know from this chapter, Real GDP = hours of work × labor productivity. The number of hours of work depends heavily, however, on the size of the working-age population. If it begins to shrink, the number of hours of work almost always falls. In such cases, the only way real GDP can rise is if labor productivity increases faster than hours of work decreases. The world is about to see if that can happen in countries that have populations that are greying and shrinking. The historical background has to do with the fact that as nations industrialize, their economies shift from agriculture to industry. As that happens, fertility levels plummet because the shift to modern technology transforms children from being economically essential farm hands that can contribute to their families’ incomes from a young age to expensive investment goods that require many years of costly schooling before they can support themselves.

Source: © Agencja Fotograficzna Caro/Alamy Stock Photo As people react to this change, birthrates tend to fall quite dramatically. The key statistic is the total fertility rate that keeps track of the average number of births that women have during their lifetimes. To keep the population stable in modern societies, the total fertility rate must be about 2.1 births per woman per lifetime (= 1 child to replace mom, 1 child to replace dad, and 0.1 child to compensate for those people who never end up reproducing as adults). Every rich industrial nation has now seen its total fertility rate drop below the replacement level of 2.1 births per woman per lifetime. In Japan and many eastern European countries, the number has been so low for so long that there are no longer enough children being born each year to replace the old folks who are dying. As a result, their overall populations are shrinking. Economists only expect that pattern to become more common and more rapid, so that by the year 2050 the majority of nations will have decreasing populations. But decades before a nation’s overall population begins to decrease, it faces a situation in which the labor force shrinks while the elderly population swells.

That pattern is the result of each generation being smaller than the one before. As an example, the baby boom generation born between 1946 and 1964 is much larger than the “baby bust” generation that followed it. So as the boomers retire over the next two decades, there will be a lot of retirees as compared to working-age adults. This trend can be quantified by the inverse dependency ratio, which is defined as the number of people of working age (ages 20 to 64) divided by the number of dependents (seniors over age 65 plus youths under age 20). In the United States, the inverse dependency ratio is set to fall from 1.5 people of working age per dependent in 2010 to just 1.16 people of working age per dependent in 2050. That is extremely problematic because it implies that worker productivity will have to rise dramatically just to make up for the relative decline in the number of workers as compared to dependents. If productivity doesn’t keep up with the fall in the inverse dependency ratio, living standards will have to decline because there will simply be too many nonworking consumers relative to working-age producers. The place where this problem is likely to show up first is Social Security. There are currently 2.9 workers paying into the Social Security system for each retiree receiving Social Security benefits. But that number is set to fall to just 2.0 workers per retiree in 2030. So worker productivity would have to increase by almost a third in under 20 years just to keep up with the decline in the number of workers relative to retirees. Economists are uncertain about whether such large productivity increases will be forthcoming. The problem is that consumption competes with investment. A society with a larger fraction of dependents is a society that is likely to devote an increasingly high fraction of total output toward consumption rather than investment. If so, productivity growth may slow considerably. Another possible problem is that, historically, most transformative new technologies and businesses have been created by energetic young people under the age of 40. With each generation getting smaller, there will be fewer people in that age range and thus, possibly, less innovation and slower productivity growth.

Other economists are more hopeful, however. They view old people as consumers and demanders. As their numbers swell, inventors may simply switch from inventing products for young people to inventing products for old people. If so, productivity growth and living standards could keep on rising at the rates we have come to expect. Critics of growth also argue that there is little compelling evidence that economic growth has solved sociological problems such as poverty, homelessness, and discrimination. Consider poverty: In the antigrowth view, American poverty is a problem of distribution, not production. The requisite for solving the problem is a firm commitment to redistribute wealth and income, not further increases in output. Antigrowth sentiment also says that while growth may permit us to “make a better living,” it does not give us “the good life.” We may be producing more and enjoying it less. Growth means frantic paces on jobs, worker burnout, and alienated employees who have little or no control over decisions affecting their lives. The changing technology at the core of growth poses new anxieties and new sources of insecurity for workers. Both high-level and low-level workers face the prospect of having their hard-earned skills and experience rendered obsolete by onrushing technology. High-growth economies are high-stress economies, which may impair our physical and mental health. Finally, critics of high rates of growth doubt that they are sustainable. The planet Earth has finite amounts of natural resources available, and they are being consumed at alarming rates. Higher rates of economic growth simply speed up the degradation and exhaustion of the earth’s resources. In this view, slower economic growth that is environmentally sustainable is preferable to faster growth. In Defense of Economic Growth The primary defense of growth is that it is the path to the greater material abundance and higher living standards desired by the vast majority of people. Rising output and incomes allow people to buy more education, recreation, and travel, more medical care, closer communications, more skilled personal and professional services, and better-designed as well as more numerous products. It also means more

art, music, and poetry, theater, and drama. It can even mean more time and resources devoted to spiritual growth and human development.1 Growth Page 175 also enables society to improve the nation’s infrastructure, enhance the care of the sick and elderly, provide greater access for the disabled, and provide more police and fire protection. Economic growth may be the only realistic way to reduce poverty, since there is only limited political support for greater redistribution of income. The way to improve the economic position of the poor is to increase household incomes through higher productivity and economic growth. Also, a no-growth policy among industrial nations might severely limit growth in poor nations. Foreign investment and development assistance in those nations would fall, keeping the world’s poor in poverty longer. Economic growth has not made labor more unpleasant or hazardous, as critics suggest. New machinery is usually less taxing and less dangerous than the machinery it replaces. Air-conditioned workplaces are more pleasant than steamy workshops. Furthermore, why would an end to economic growth reduce materialism or alienation? The loudest protests against materialism are heard in those nations and groups that now enjoy the highest levels of material abundance! The high standard of living that growth provides has increased our leisure and given us more time for reflection and self-fulfillment. Does growth threaten the environment? The connection between growth and environment is tenuous, say growth proponents. Increases in economic growth need not mean increases in pollution. Pollution is not so much a by-product of growth as it is a “problem of the commons.” Much of the environment—streams, lakes, oceans, and the air—is treated as common property, with insufficient or no restrictions on its use. The commons have become our dumping grounds; we have overused and debased them. Environmental pollution is a case of negative externalities, and correcting this problem involves regulatory legislation, specific taxes (“effluent charges”), or market-based incentives to remedy misuse of the environment. Those who support growth admit there are serious environmental problems. But they say that limiting growth is the wrong solution.

Growth has allowed economies to reduce pollution, be more sensitive to environmental considerations, Page 176 set aside wilderness, create national parks and monuments, and clean up hazardous waste, while still enabling rising household incomes. (See the Last Word in Chapter 19.) Is growth sustainable? Yes, say the proponents of growth. If we were depleting natural resources faster than their discovery, we would see the prices of those resources rise. That has not been the case for most natural resources; in fact, the prices of most of them have declined (see Figure 19.1). And if one natural resource becomes too expensive, another resource will be substituted for it. Moreover, say economists, economic growth has to do with the expansion and application of human knowledge and information, not of extractable natural resources. In this view, economic growth is limited only by human imagination. QUICK REVIEW 8.5 ✓ Critics of growth argue that it adds to environmental degradation, increases human stress, and exhausts the earth’s finite supply of natural resources. ✓ Defenders of growth say that it is the primary path to the rising living standards, that it need not debase the environment, and that there are no indications that we are running out of resources. ✓Defenders of growth argue that it is sustainable because growth

is based on the expansion and application of human knowledge, which is limited only by human imagination.

Unemployment LO9.2 Illustrate how unemployment is measured and explain the different types of unemployment. Two problems that arise over the course of the business cycle are unemployment and inflation. Let’s look at unemployment first. Measurement of Unemployment The U.S. Bureau of Labor Statistics (BLS) conducts a nationwide random survey of some 60,000 households each month to determine

who is employed and who is not employed. In a series of questions, it asks which members of the household are working, unemployed and looking for work, not looking for work, and so on. From the answers, it determines an unemployment rate for the entire nation.

Figure 9.2 helps explain the mathematics. The BLS divides the total U.S. population into three groups. One group is made up of people under 16 years of age and people who are institutionalized, for example, in mental hospitals or correctional institutions. Such people are not considered potential members of the labor force. FIGURE 9.2 The U.S. labor force, employment, and unemployment, 2015.* The labor force consists of persons 16 years of age or older who are not in institutions and who are (1) employed or (2) unemployed but seeking employment.

*Civilian labor-force data, which excludes military employment. Source: Bureau of Labor Statistics, www.bls.gov. A second group, labeled “Not in labor force,” is composed of adults who are potential workers but are not employed and are not seeking work. For example, they are stay-at-home parents, full-time students, or retirees. The third group is the labor force, which constituted slightly more than 50 percent of the total population in 2009. The labor force consists of

people who are able and willing to work. Both those who are employed and those who are unemployed but actively seeking work are counted as being in the labor force. The unemployment rate is the percentage of the labor force unemployed:

The statistics underlying the rounded numbers in Figure 9.2 show that in 2015 the unemployment rate averaged

Despite the use of scientific sampling and interviewing techniques, the data collected in this survey are subject to criticism:

• Part-time employment The BLS lists all part-time workers as fully employed. In 2015 about 30 million people worked part-time as a result of personal choice. But another 6 million part-time workers either wanted to work full-time and could not find suitable full- time work or worked fewer hours because of a temporary slack in consumer demand. These last two groups were, in effect, partially employedPage 183 
 and partially unemployed. By counting them as fully employed, say critics, the official BLS data understate the unemployment rate.

• Discouraged workers You must be actively seeking work in order to be counted as unemployed. An unemployed individual who is not actively seeking employment is classified as “not in the labor force.” The problem is that many workers, after unsuccessfully seeking employment for a time, become discouraged and drop out of the labor force. The number of such discouraged workers was roughly 664,000 in 2015, up from 396,000 in 2007. By not counting discouraged workers as unemployed, say critics, the official BLS data understate the unemployment problem.

Types of Unemployment There are three types of unemployment: frictional, structural, and cyclical. Frictional Unemployment

At any given time some workers are “between jobs.” Some of them will be moving voluntarily from one job to another. Others will have been fired and will be seeking reemployment. Still others will have been laid off temporarily because of seasonal demand. In addition to those between jobs, many young workers will be searching for their first jobs. As these unemployed people find jobs or are called back from temporary layoffs, other job seekers and laid-off workers will replace them in the “unemployment pool.” It is important to keep in mind that while the pool itself persists because there are always newly unemployed workers flowing into it, most workers do not stay in the unemployment pool for very long. Indeed, when the economy is strong, the majority of unemployed workers find new jobs within a couple of months. One should be careful not to make the mistake of confusing the permanence of the pool itself with the false idea that the pool’s membership is permanent, too. On the other hand, there are workers who do remain unemployed and in the pool for very long periods of time—sometimes for many years. As we discuss the different types of unemployment below, notice that certain types tend to be transitory while others are associated with much longer spells of unemployment. Economists use the term frictional unemployment—consisting of search unemployment and wait unemployment—for workers who are either searching for jobs or waiting to take jobs in the near future. The word “frictional” implies that the labor market does not operate perfectly and instantaneously (without friction) in matching workers and jobs. Frictional unemployment is inevitable and, at least in part, desirable. Many workers who are voluntarily between jobs are moving from low- paying, low-productivity jobs to higher-paying, higher-productivity positions. That means greater income for the workers, a better allocation of labor resources, and a larger real GDP for the economy. CONSIDER THIS . . . Downwardly Sticky Wages and Unemployment

Source: © JGI/Jamie Grill/Getty Images RF Labor markets have an important quirk that helps to explain why unemployment goes up so much during a recession. The quirk is that wages are flexible upward but sticky downward. On the one hand, workers are perfectly happy to accept wage increases. So when the economy is booming and firms start bidding for the limited supply of labor, wages rise—often quite rapidly. On the other hand, workers deeply resent pay cuts. So if the economy goes into a recession and firms need to reduce labor costs, managers almost never cut wages because doing so would only lead to disgruntled employees, low productivity, and—in extreme cases—workers stealing supplies or actively sabotaging their own firms. Instead, managers usually opt for layoffs. The workers who are let go obviously don’t like being unemployed. But those who remain

get to keep their old wages and, consequently, keep on being as productive and cooperative as they were before. This preference that firms show for layoffs over wage cuts results in downwardly sticky wages and an informal price floor that helps to explain why unemployment goes up so much during a recession. The problem is that when the demand for labor falls during a recession, the informal price floor prevents wages from falling. As a result, there is no way for falling wages to help entice at least some firms to hire a few more workers. Thus, when a recession hits, employment falls more precipitously than it would if wages were downwardly flexible and falling wages could help to increase hiring. Structural Unemployment Frictional unemployment blurs into a category called structural unemployment. Here, economists use “structural” in the sense of “compositional.” Changes over time in consumer demand and in technology alter the “structure” of the total demand for labor, both occupationally and geographically. Occupationally, the demand Page 184 for certain skills (for example, sewing clothes or working on farms) may decline or even vanish. The demand for other skills (for example, designing software or maintaining computer systems) will intensify. Unemployment results because the composition of the labor force does not respond immediately or completely to the new structure of job opportunities. Workers who find that their skills and experience have become obsolete or unneeded thus find that they have no marketable talents. They are structurally unemployed until they adapt or develop skills that employers want. Geographically, the demand for labor also changes over time. An example: the migration of industry and thus of employment opportunities from the Snowbelt to the Sunbelt over the past few decades. Another example is the movement of jobs from inner-city factories to suburban industrial parks. And a final example is the so- called offshoring of jobs that occurs when the demand for a particular

type of labor shifts from domestic firms to foreign firms. As job opportunities shift from one place to another, some workers become structurally unemployed. The distinction between frictional and structural unemployment is hazy at best. The key difference is that frictionally unemployed workers have marketable skills and either live in areas where jobs exist or are able to move to areas where they do. Structurally unemployed workers find it hard to obtain new jobs without retraining, gaining additional education, or relocating. Frictional unemployment is short-term; structural unemployment is more likely to be long-term and consequently more serious. Cyclical Unemployment Unemployment that is caused by a decline in total spending is called cyclical unemployment and typically begins in the recession phase of the business cycle. As the demand for goods and services decreases, employment falls and unemployment rises. Cyclical unemployment results from insufficient demand for goods and services. The 25 percent unemployment rate in the depth of the Great Depression in 1933 reflected mainly cyclical unemployment, as did significant parts of the 9.7 percent unemployment rate in 1982, the 7.5 percent rate in 1992, the 5.8 percent rate in 2002, and the 9.3 percent rate in 2009. Cyclical unemployment is a very serious problem when it occurs. We will say more about its high costs later, but first we need to define “full employment.” Definition of Full Employment Because frictional and structural unemployment are largely unavoidable in a dynamic economy, full employment is something less than 100 percent employment of the labor force. Economists say that the economy is “fully employed” when it is experiencing only frictional and structural unemployment. That is, full employment occurs when there is no cyclical unemployment. Economists describe the unemployment rate that is consistent with full employment as the full-employment rate of unemployment, or the natural rate of unemployment (NRU). At the NRU, the economy is

said to be producing its potential output. This is the real GDP that occurs when the economy is “fully employed.” Note that a fully employed economy does not mean zero unemployment. Even when the economy is fully employed, the NRU is some positive percentage because it takes time for frictionally unemployed job seekers to find open jobs they can fill. Also, it takes time for the structurally unemployed to achieve the skills and geographic relocation needed for reemployment. “Natural” does not mean, however, that the economy will always operate at this rate and thus realize its potential output. When cyclical unemployment occurs, the economy has much more unemployment than that which would occur at the NRU. Moreover, the economy can operate for a while at an unemployment rate below the NRU. At times, the demand for labor may be so great that firms take a stronger initiative to hire and train the structurally unemployed. Also, some parents, teenagers, college students, and retirees who were casually looking for just the right part-time or full-time jobs may quickly find them. Thus the unemployment rate temporarily falls below the natural rate. Also, the NRU can vary over time as demographic factors, job-search methods, and public policies change. In the 1980s, the NRU was about 6 percent. Today, it is 5 to 6 percent. Economic Cost of Unemployment Unemployment that is excessive involves great economic and social costs. GDP Gap and Okun’s Law The basic economic cost of unemployment is forgone output. When the economy fails to create enough jobs for all who are able and willing to work, potential production of goods and services is irretrievably lost. In terms of Chapter 1’s analysis, unemployment above the natural rate means that society is operating at some point inside its production possibilities curve. Economists call this sacrifice of output a GDP gap— the difference between actual and potential GDP. That is: GDP gap = actual GDP − potential GDP The GDP gap can be either negative (actual GDP < potential GDP) or positive (actual GDP > potential GDP). In the case of unemployment

above the natural rate, it is negative because actual GDP falls short of potential GDP. Potential GDP is determined by assuming that the natural rate of unemployment prevails. The growth of potential GDP is simply projected forward on the basis of the economy’s “normal” growth rate of real GDP. Figure 9.3 shows the GDP gap for recent years in the United States. It also indicates the close correlation between the actual unemployment rate (Figure 9.3b) and the GDP gap (Figure 9.3a). The higher the unemployment rate, the larger is the GDP gap. Page 185 FIGURE 9.3 Actual and potential real GDP and the unemployment rate. (a) The difference between actual and potential GDP is the GDP gap. A negative GDP gap measures the output the economy sacrifices when actual GDP falls short of potential GDP. A positive GDP gap indicates that actual GDP is above potential GDP. (b) A high unemployment rate means a large GDP gap (negative), and a low unemployment rate means a small or even positive GDP gap.

Source: Congressional Budget Office, www.cbo.gov; Bureau of Economic Analysis, www.bea.gov; and the Bureau of Labor Statistics, www.bls.gov. Note that the data for actual real GDP and potential real GDP above differ from the real GDP data in the previous two chapters. The data above are in 2009 dollars, but do not reflect the 2013 redefinition of investment expenditures in the National Income and Product Accounts to include research and development spending.

Macroeconomist Arthur Okun Page 186 was the first to quantify the relationship between the unemployment rate and the GDP gap. Okun’s law indicates that for every 1 percentage point by which the actual unemployment rate exceeds the natural rate, a negative GDP gap of about 2 percent occurs. With this information, we can calculate the absolute loss of output associated with any above- natural unemployment rate. For example, in 2009 the unemployment rate was 9.3 percent, or 4.3 percentage points above that period’s 5.0 percent natural rate of unemployment. Multiplying this 4.3 percent by Okun’s 2 indicates that 2009’s GDP gap was 8.6 percent of potential GDP (in real terms). By applying this 8.6 percent loss to 2009’s potential GDP of $13,894 billion, we find that the economy sacrificed $1,195 billion of real output because the natural rate of unemployment was not achieved. As you can see in Figure 9.3, sometimes the economy’s actual output will exceed its potential or full-employment output. Figure 9.3 reveals that an economic expansion in 1999 and 2000, for example, caused actual GDP to exceed potential GDP in those years. There was a positive GDP gap in 1999 and 2000. Actual GDP for a time can exceed potential GDP, but positive GDP gaps create inflationary pressures and cannot be sustained indefinitely. Unequal Burdens An increase in the unemployment rate from 5 to, say, 9 or 10 percent might be more tolerable to society if every worker’s hours of work and wage income were reduced proportionally. But this is not the case. Part of the burden of unemployment is that its cost is unequally distributed.

Table 9.2 examines unemployment rates for various labor market groups for 2 periods. In 2007, the economy achieved full employment, with a 4.6 percent unemployment rate. The economy receded in December 2007 and two years later was feeling the full unemployment impact of the Great Recession. By observing the large variance in unemployment rates for the different groups within each period and comparing the rates between the 2 periods, we can generalize as follows: TABLE 9.2 Unemployment Rates by Demographic Group: Full Employment Year (2007) and Recession Year (2009)*

*Civilian labor-force data. †People age 25 or over.

Source: Economic Report of the President; Bureau of Labor Statistics, www.bls.gov; Census Bureau, www.census.gov.

• Occupation Workers in lower-skilled occupations (for example, laborers) have higher unemployment rates than workers in higher- skilled occupations (for example, professionals). Lower-skilled workers have more and longer spells of structural unemployment than higher-skilled workers. They also are less likely to be self- employed than are higher-skilled workers. Moreover, lower-skilled workers usually bear the brunt of recessions. Manufacturing, construction, and mining tend to be particularly hard-hit, and businesses generally retain most of their higher-skilled workers, in whom they have invested the expense of training.

• Age Teenagers have much higher unemployment rates than adults. Teenagers have lower skill levels, quit their jobs more frequently, are more frequently fired, and have less geographic mobility than adults. Many unemployed teenagers are new in the labor market, searching for their first jobs. Male African-American teenagers, in particular, have very high unemployment rates. The unemployment rate for all teenagers rises during recessions.

• Race and ethnicity The unemployment ratesPage 187 
 for African Americans and Hispanics are higher than that for whites. The causes of the higher rates include lower rates of educational attainment, greater concentration in lower-skilled occupations, and discrimination in the labor market. In general, the unemployment rate for African Americans is twice that of whites and rises by more percentage points than for whites during recessions.

• Gender The unemployment rates for men and women normally are very similar. But in the recent recession, the unemployment rate for men significantly exceeded that for women.

• Education Less-educated workers, on average, have higher unemployment rates than workers with more education. Less education is usually associated with lower-skilled, less-permanent jobs; more time between jobs; and jobs that are more vulnerable to cyclical layoff.

• Duration The number of persons unemployed for long periods— 15 weeks or more—as a percentage of the labor force is much lower than the overall unemployment rate. But that percentage rises significantly during recessions. Notice from Table 9.2 that it rose from 1.5 percent of the labor force in 2007 to 4.7 percent in 2009.