THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Land

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Introduction to Economics ECO401

Lesson 11.6

THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS

(CONTINUED.......)

Link between growth and the various factors of production:

Before we move to neo-classical and endogenous growth theories, let us gain a better

understanding of the link between growth and the various factors of production. We begin by

recalling the familiar Cobb-Douglas constant returns to scale production function: Y = KαL1-α for

a hypothetical economy. Here Y denotes output, K denotes capital (machines, buildings etc.),

L denotes labour, and α is a parameter that lies between 0 and 1. Dividing both sides by L and

substituting Y/L = y (per capita output), and K/L = k (per capita capital), we have the per capita

production function y = kα.

Labor and Capital:

Now for a given L and no depreciation, an increase in K should translate into an increase in k

and through it an increase in y. This is an example of capital deepening induced growth.

However, when there is depreciation (say at a rate d% p.a.) of the capital stock and the labour

supply is growing at n% p.a., capital must grow at least by (d+n)% p.a. in order keep K/L, or k,

constant. This is called capital widening, i.e. more capital being created but spread over a

larger population so as to deliver the same K/L. The per capita output impact of capital

widening is zero, because k remains the same.

Now taking capital as fixed, let's analyze the ways in which labour can serve as the engine of

growth. It is obvious that an increase in the no. of labour hours worked would expand output.

However, historically, the working week has been shortened from 6 to 5 days so it would be

incorrect to cite this as the major source of world economic growth over the last century. What

else could therefore have driven the rapid expansion of production in the 20th century. It might

be the case that there are now more people on the labour force, due to perhaps a larger

proportion of women doing marketable jobs (which is historically accurate). Then it might be

that the quality of human capital has gone up. The same workers, because they are better

educated and have better skills, can produce more output using the same amount of capital.

Japan and Germany are prime examples of this i.e. of countries which achieved very high

growth rates despite having very low levels of physical capital left after World War II. It was the

quality of these countries' human capital which made the difference.

Land:

Let's now concentrate on land. The earliest thinking on this was all doom and gloom. Malthus

(1798), for instance, noted that the supply of land, esp. agricultural land, was fixed, whereas

world population was rising fast. Given diminishing returns (in terms of marginal food product)

to labour, the implication was obvious: world hunger. While the starvation hypothesis did come

true for come countries, it did not happen for the whole world. Why? Predominantly because

of unanticipated productivity improvements in agricultural production. Technological

breakthroughs, like tractors, fertilizers, etc. increased yields per acre by many 100s of

percents permitting a food output that far exceeded world food requirements even with a larger

population. Today, land does not feature centrally in growth theory, as many countries (e.g.

European countries, Japan, Singapore, Hong Kong, etc.) were seen to achieve very high

growth rates while geographically much larger South Asian, Latin American and African

countries lagged behind.

Land is one type of natural resource that goes into production. The other type is raw materials

like mineral wealth or timber. The important point about these resources is that some of them

they are not renewable (like oil, coal, gas and other minerals), while others are: timer, fish etc.

It is important to take these concerns into consideration when talking about the ability of a

particular type of natural resource to act as the engine of growth.

The above is not true for technical progress, however, which neither depletes nor requires

renewing. An essential and important ingredient in the production process, the technical

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Introduction to Economics ECO401

knowledge/stock of a country is additive and cumulative and depends on the pace of invention,

innovation and learning by doing that is happening in the economy. In order to protect the

incentive to invent and innovate, governments introduce patent and copyright laws which grant

the inventor monopoly production rights for a certain period. Also governments directly or

indirectly fund research and development activities which are the engine for invention and

innovation.

Neo-classical thinking on growth:

Neo-classical thinking on growth is owed to Robert Solow whose exogenous growth

models in the mid-20th century remained the most influential work in the area till the late 1980s

when endogenous growth theories revolutionized thinking in this area.

Based on the principle of diminishing returns to capital, the main theses of the neo-classical

exogenous growth theory were:

a. The steady-state growth rate of real GDP depends on n and t, the exogenous rates of

growth of population and technology. By exogenous, we mean determined outside the

model. Thus, there were no policy insights for how governments could affect the steady

state growth rates of countries. In particular, the model suggested that higher savings

could only have a level effect on income, not a long-term growth effect as had been

earlier thought. The reason was that savings-enabled investment and capital

accumulation eventually banged into diminishing returns.

b. If one country started with lower income and capital than another country, then the

poorer country would grow faster in order to catch up with the richer country.

Eventually, both would grow at the same rate.

Major Weaknesses of Exogenous Growth Model:

Exogenous growth theory suffered from three major weaknesses:

i. It could not explain why the gap between the poor and rich countries had widened

(anti-catch up),

ii. It could not explain why some countries in East Asia had apparently grown

consistently on the back of higher saving rates, and

iii. It modeled technology as exogenous, and beyond the influence of policy.

The first weakness was answerable within the neo-classical framework: the key insight was

that convergence would only be witnessed among countries with similar capital and income

levels to start with; countries with very low capital to start with might actually never grow out of

their poverty and could see their capital stock falling over time.

The second weakness was addressed by endogenous growth theory (endogenous because

the steady state growth rate was determined inside the model, not determined by factors

exogenous to it) which set up the model in a way that the steady state growth rate now

depended directly on the saving rate and level of technology. A permanent increase in the

saving rate, therefore, meant a permanent increase in the growth rate.

The third weakness was also addressed by endogenous growth theory, which by using

different industry structures and technology functions specifications could link technological

progress to conscious R&D effort by firms and government. Non-diminishing returns to

technical progress would then generate endogenous growth.

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