Economic Growth Model

What Determines How Fast Economies Grow?

To explain changes in economic growth rates Opens in new window over time within countries, and differences in growth rates between countries, we need to develop an economic growth model.

An economic growth model is a model that explains growth rates seen in changes in real GDP per capita in the long run Opens in new window.

The average person can buy more goods and services only if the average worker produces more goods and services.

Labor productivity is the quantity of goods and services that can be produced by one worker or by one hour of work.

Because of the importance of labor productivity in explaining economic growth, the economic growth model focuses on the causes of long-run increases in labor productivity.

How can a country’s workers become more productive?

Economists believe two key factors determine labor productivity:

  1. the quantity of capital per hour worked and
  2. the level of technology.

Therefore, the economic growth model will focus on technological change and changes over time in the quantity of capital per hour worked in explaining changes in real GDP per capita.

Technological Change

Technological change is a change in the ability of a firm to produce output with a given quantity of inputs.

There are three main sources of technological change:

1.   Better machinery and equipment

Beginning with the steam engine during the Industrial Revolution, the invention of new machinery has been an important source of rising labor productivity.

Today, continuing improvements in computers, factory machines, tools, electric generators and many other machines contribute to increases in labor productivity.

2.   Increases in human capital

Capital refers to physical capital, including computers, factory buildings, machines, tools, warehouses and trucks.

The more physical capital Opens in new window workers have available, the more output they can produce.

Human capital is the accumulated knowledge and skills that workers acquire from education and training or from their life experiences.

As workers increase their human capital through education or on-the-job training, their productivity will also increase. The more educated workers are the greater is their human capital.

3.   Better means of organizing

Labor productivity will increase if managers can do a better job of organizing production.

For example, the just-in-time system Opens in new window, first developed by Toyota Motor Corporation, involves assembling goods from parts that arrive at the factory at exactly the time they are needed.

With this system Toyota needs fewer workers to store and keep track of parts in the factory, so the quantity of goods produced per hour worked increases.

Note that technological change is not the same thing as more physical capital.

New capital can embody technological change, such as when a faster computer chip is embodied in a new computer. But simply adding more capital that is the same as existing capital Opens in new window is not technological change Opens in new window.

To summarize, we can say that a country’s standard of living will be higher the more capital workers have available, the better the capital, the more human capital workers have and the better job business managers do in organizing production.

The Per-Worker Production Function

The economic growth model explains increases in real GDP per capita over time as resulting from increases in just two factors:

  1. the quantity of physical capital available to workers and
  2. technological change.

Often when analyzing economic growth we look at increases in real GDP per hour worked and increases in capital per hour worked.

We use measures of GDP per hour and capital per hour rather than per person so we can analyze changes in the underlying ability of an economy Opens in new window to produce more goods with a given amount of labor without having to worry about changes in the proportion of the population working or in the length of the working day.

We can illustrate the economic growth model using the per-worker production function.

Per-worker production fucntion is the relationship between real GDP, or output, per hour worked and capital per hour worked, holding the level of technology constant.

Figure I shows the per-worker production function as a graph.

Figure I, The per-worker production function Figure I, The per-worker production function | Source: the Internet

In the figure we measure capital per hour worked along the horizontal axis and real GDP per hour worked along the vertical axis.

Letting K stand for capital, L stand for labor and Y stand for real GDP, real GDP per hour worked is Y/L and capital per hour worked is K/L.

The curve represents the production function. Notice that we do not explicitly show technological change in the figure.

We assume that as we move along the production function the level of technology remains constant. As we will see, we can illustrate technological change using this graph by shifting up the curve representing the production function.

The figure shows that increases in the quantity of capital per hour worked result in movements up the per-worker production function, increasing the quantity of output each worker produces.

When holding technology constant, however, equal increases in the amount of capital per hour worked lead to diminishing increases in output per hour worked.

For example, increasing capital per hour worked from $20 000 to $30 000 increases real GDP per hour worked from $200 to $350, an increase of $150. Another $10 000 increase in capital per hour worked, from $30 000 to $40 000, increases real GDP per hour worked from $350 to $475, an increase of only $125.

Each additional $10 000 increase in capital per hour worked results in progressively smaller increases in real GDP per hour worked.

In fact, at very high levels of capital per hour worked further increases in capital per hour worked will not result in any increase in real GDP per hour worked.

This effect results from the law of diminishing return, which states that as we add more of one input—in this case, capital—to a fixed quantity of another input—in this case, labor—output increases by smaller additional amounts.

Why are there diminishing returns to capital?

Consider a simple example in which you own a photocopying store. At first you have 10 employees but only one photocopier, so each of your workers is able to produce relatively few copies per day. When you buy a second photocopier your employees will be able to produce more copies.

Adding additional photocopiers will continue to increase your output but by increasingly smaller amounts.

For example, adding a twentieth photocopier to the 19 you already have will not increase the copies each worker is able to make by nearly as much as adding a second photocopier did. Eventually, adding additional photocopying machines will not increase your output at all.

Which Is more Important for Economic Growth: More Capital or Technological Change?

Technological change helps economies avoid diminishing returns to capital.

Let’s consider two simple examples of the effects of technological change. First, suppose you have 10 photocopiers in your photocopying store. Each of the photocopiers can produce 30 copies per minute.

You don’t believe that adding an eleventh machine, identical to the 10 you already have, will significantly increase the number of copies your employees can produce in a day.

Then you find out that a new photocopier has become available that produces 60 copies per minute. If you replace your existing machines with the new machines the productivity of your workers will increase.

The replacement of existing capital with more productive capital is an example of technological change.

Or suppose you realize that the layout of your store could be improved. Perhaps the paper for the machines is on shelves at the back of the store, which requires your workers to spend time walking back and forth whenever the machines run out of paper. By placing the paper closer to the photocopiers you will also improve the productivity of your workers.

Reorganizing how production takes place in order to increase output is also an example of technological change.