No Such Thing as a Free Lunch: Principles of Economics (Part 161)

Exploration is the engine that drives innovation. Innovation drives economic growth. So let's all go exploring.

Edith Widder

Long-Run Growth

(Part B)

by

Charles Lamson

The Sources of Economic Growth

Economic growth occurs when either (1) society requires more resources, or (2) society discovers ways of using available resources more efficiently. For economic growth to increase living standards, the rate of growth must exceed the rate of population increase. Economic growth is generally defined as an increase in real GDP per capita.

As we discuss the factors that contribute to economic growth, it will be helpful to think of an aggregate production function. An individual firm's production function is a mathematical representation of the relationship between the firm's input and its output. Output for an aggregate production function is national output, or GDP. Stated simply, GDP (output) (Y), depends on the amount of labor (L) and the amount of capital (K) available in the economy (assuming the amount of land is fixed).

If you think of GDP as a function of both labor and capital, you can see that:

An increase in GDP can come about through:

1. An increase in the labor supply

2. An increase in physical or human capital

3. An increase in productivity (the amount of product produced by each unit of capital or labor)

An Increase in Labor Supply

Consider what would happen if another person joined Colleen and Bill on their deserted island that they washed up on back in part 7 of this analysis and reintroduced in the last post. That individual would join in the work and produce, and so GDP would rise. Suppose that a person who had not been a part of the labor force were to begin to work and use time and energy to produce pottery. Real output would rise in this case also. An increase in labor supply can generate more output.

Whether output per capita rises when the labor supply increases is another matter. If the capital stock remains fixed while labor increases, the new labor will likely be less productive than the old labor. This is called diminishing returns, and it worried Thomas Malthus, David Ricardo, and other early economists.

Also, recall that in part 7 (and the last post) we defined a society's production possibilities frontier (ppf), which shows all possible combinations of output that can be produced given present technology and if all available resources are fully and efficiently employed. Economic growth expands those limits and shifts society's production possibility frontier out to the right as Figure 1 (from last post and reintroduced below) shows.

Malthus and Ricardo, who lived in England during the nineteenth century, were concerned that the fixed supply of land would lead to diminishing returns. With land in strictly limited supply, the ppf could be pushed out only so far as population increased. To increase agricultural output, people would be forced to farm less productive land or to farm land more intensively. In either case, the returns to successive increases in population would diminish. Both Malthus and Ricardo predicted a gloomy future as population outstripped the lands capacity to produce. What both economists left out of their calculations was technological change and capital accumulation. New and better farming techniques have raised agricultural productivity so much that, as of 2008, less than 2 percent of the U.S. population were directly employed in agriculture (https://en.wikipedia.org/wiki/Agriculture_in_the_United_States).

Diminishing returns can also occur if a nation's capital stock grows more slowly than its workforce. Capital enhances worker's productivity. A person with a shovel digs a bigger hole than a person without one, and a person with a steam shovel outdoes them both. If a society's stock of plant and equipment does not grow and the technology of production does not change, additional workers will not be as productive, because they do not have machines to work with.

Table 1 illustrates how growth in the labor force, without a corresponding increase in the capital stock or technological change, might lead to growth of output but declining productivity and a lower standard of living. As labor increases, output rises from 300 units in period 1 to 320 in period 2, to 339 in period 3, and so forth, but labor productivity (output per worker hour) falls. Output per worker hour, Y/L, is a measure of labor's productivity. 

TABLE 1

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 633-634*

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