Chapter 8 MODERN PRINCIPLES OF ECONOMICS

Third Edition

Growth, Capital
Accumulation, and the
Economics of Ideas
 Outline

 The Solow Model and Catching-Up Growth

 The Investment Rate and Conditional
Convergence
 New Ideas and Cutting-Edge Growth
 The Economics of Ideas
 The Future of Economic Growth

2
 Introduction

 In 2010:
• U.S. GDP per capita grew by 2.3%.
• China’s GDP per capita grew by 10%.
 The U.S. has never grown as fast as the
Chinese economy is growing today.
 China is growing much faster than the U.S.
because:
• The U.S. economy is on the cutting edge.
• The Chinese economy is catching up.

3
 Definition

Cutting-edge growth:
Growth due to new ideas.

Catching-up growth:
Growth due to capital accumulation.

4
The Solow Model and Catching-Up Growth

 The Solow model begins with a production

function.
 The total output of an economy (Y) depends on:
• Physical capital (K)
• Human capital, or education x Labor (eL)
• Ideas (A)
 A production function expresses a
relationship between output and the factors of
production:
Y  F(A, K, eL)
5
 The Solow Model

 If we assume that A, e, and L are constant, then

we can simplify our expression for output as:
Y  F K 
 More capital (K) should produce more output
(Y) but at a diminishing rate.
• Because L is constant, an increase in K always
implies an increase in the amount of capital per
worker, K/L, and an increase in Y is also always an
increase in output per worker, Y/L.

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 Self-Check

Catching-up growth is growth due to:

a. New ideas.
b. Capital accumulation.
c. Adoption of new technologies.

Answer: b – capital accumulation.

7
 Definition

Marginal product of capital:

The increase in output caused by the
addition of one more unit of capital. The
marginal product of capital diminishes
as more and more capital is added.

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 The Solow Model:
Capital, Production and Diminishing Returns
 More capital (K) should produce more output
(Y) but at a diminishing rate.
 The MPK diminishes because the first unit of
capital is applied where it is most productive,
the second where it is slightly less productive,
and so on.
 The following graph shows the production
function Y = F (K )  K
 In this case, output is the square root of the
capital input:
If K = 4, then Y = 4 = 2
If K increases to 16, then Y = 16 = 4 9
 Diminishing Returns
Output, Y
3.2 Y K
3
Creates just
a little output

1
Creates a lot
of output

0 Capital, K
0 1 2 3 4 5 6 7 8 9 10 11 12
The first unit The tenth unit
of input of input 10
Growth in China and the United States
 Chinese growth has been rapid because:
• China began with very little capital, so the marginal product
of capital was very high
• With new reforms the investment rate increased
dramatically (property rights, mostly)
• China has benefited by opening up to trade and investment
with the developed world.
• Improved productivity in agriculture.
Growth in China and the United States
 China’s growth rate will fall because:
• The marginal product of capital will fall
• A poor banking system
• A lack of experience with the rule of law
• A poorly educated population.

 “Ghost” cities?
 Capital and Investment
 Capital is output that is saved and invested rather
than consumed.
 For example, out of 10 units produced, 7 are
consumed and 3 are invested in new capital.
 We write the fraction of output that is invested in
new capital as gamma (ɣ), and in the example just
given, ɣ = 3/10 = 0.3
 Capital also depreciates, or wears out.
 For example, if there are 100 units of capital, 2
units might depreciate, leaving 98 for the next
period.

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 Self-Check

Output that is invested rather than consumed is

called:
a. Capital.
b. Depreciation.
c. Marginal product.

Answer: a – output that is invested is called

capital.
14
 Consumption and Investment
Output Y

When K = 100, Y K
15 Output = 10

10
Consumption = (1- 0.3) x 10 = 7
Investment
5
= 0.3Y
3 Investment = (0.3) x 10 = 3
Capital K
0 0 100 200 300 400
15
 Capital and Depreciation
 Capital also depreciates, or wears out.
 For example, if there are 100 units of capital, 2
units might depreciate, leaving 98 for the next
period.
 We write the fraction of capital that wears out or
depreciates as delta (δ ); in the example just
given, δ = 2/100 = 0.02.
 capital depreciation increases the greater the
capital stock—this will turn out to place another
constraint on economic growth

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 Depreciation
Depreciation
8 Depreciation = 0.02K

0 Capital K
0 100 200 300 400
17
 Steady-State Level of Capital

Steady-State Level of Capital:

When the capital stock is neither increasing nor
decreasing.

 At some point, the capital stock will reach a level such

that every unit of investment is needed just to replace
the capital that depreciates in that period.
 When investment just covers capital depreciation, the
capital stock stops growing, and when the capital stock
stops growing, output stops growing as well.

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 Steady-State Level of Capital

 Investment > Depreciation— The capital stock grows

and output next period is bigger.

 Investment = Depreciation— The capital stock and

output are constant(the steady state).

 Investment < Depreciation— The capital stock shrinks

and output next period is smaller.

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 Steady-State Level of Capital
GDP Y Depreciation = 0.02 x K

At
At K
K == 100,
100,
7 investment
investment >> depreciation
depreciation
→ Investment
→ increase
increase in
in K
K
= 0.3 x Y
5

3
2

0
0 100 200 225 300 400 Capital K
20
 Steady-State Level of Capital
GDP Y Depreciation = 0.02 x K

7 Investment
= 0.3 x Y
5
At
At K
K == 300,
300,
3 investment
investment << depreciation
depreciation
→→ decrease
decrease inin K
K
2

0
0 100 200 225 300 400 Capital K
21
 Steady-State Level of Capital
GDP Y Depreciation = 0.02 x K

The steady-state
stock of capital is where
7 investment = depreciation Investment
= 0.3 x Y
5

3
2

0
0 100 200 225 300 400 Capital K
22
 Steady-State Level of Capital
Check the Math
Check the Math
• At K = 100, Y =√100 = 10
• Depreciation = 0.02∙100 = 2 • At K = 225, Y =√225 =15
• Investment = 0.3x10 = 3 • Depreciation = 0.02x225 = 4.5
• Investment > Depreciation • Investment = 0.3x15 = 4.5
Result: K and Y grow. • Investment = Depreciation
Result:
Check the Math 1. Investment = Depreciation
• At K = 400, Y =√400 = 20 2. K and Y are constant.
• Depreciation = 0.02x400 = 8
• Investment = 0.3x20 = 6 This is steady state.
• Investment < Depreciation
Result: K and Y decrease. 23
 Steady-State Level of Capital

 As the capital stock gets larger, investment

increases but at a diminishing rate.
 Depreciation, however, increases with the
capital stock at a linear (constant) rate.
 At some point investment = depreciation.
 This is the steady-state level of capital.
 There is no new (net) investment and economic
growth stops.

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 Steady-State Level of Capital

The logic of diminishing returns means that

eventually capital and output will cease
growing.
Therefore, other factors must be responsible for
long run economic growth.
Consider:
Human capital: knowledge, skills, experience
Technological knowledge: better ideas
25
 Catching-up Growth

 Long-run economic growth cannot be due to

capital accumulation.
 Diminishing returns mean that eventually capital
and output will cease growing.
 The logic of diminishing returns applies to
human capital as well.
 Changes in the capital stock drive output, so
when Investment = Depreciation and K is at its
steady-state level, then so is output.

26
 Definition

Steady-state level of capital:

Where the capital stock is neither
increasing nor decreasing.

27
 Steady-State Level of Capital
Output Y Depreciation = 0.02 x K

The
The steady-state
steady-state
stock
stock of
of capital
capital is
is where
where
investment
investment == depreciation
depreciation
7 Investment
= 0.3 x Y
5

3
2

0
0 100 200 225 300 400 Capital K
28
 Steady-state Level of Output
Output Y
20
Steady state output Y K
15

When
When capital
capital is
is in
in the
the Depreciation
10 steady
steady state,
state, output
output isis = 0.02 x K
in
in the
the steady
steady state.
state.

Investment
5 = 0.3 x Y
Steady state capital stock
Capital K
0 100 200225300 400 29
 List of Equations
 Output: Y = F (K )

 Investment: I = ɣY = ɣ *

 Depreciation: D = δ * K

 Capital Stock in Year T: KT = KT-1 + I – D

 Where ɣ is the savings rate, δ is the

depreciation rate
30
 Self-Check

If investment is greater than depreciation, the

stock of capital K will:
a. increase.
b. decrease.
c. remain the same.

Answer: a – the stock of capital will increase.

31
 The Investment Rate

 In the Solow model, a greater investment rate

means more capital, which means more output.
 This increases a country’s steady-state level of
GDP.
 Thus the Solow model predicts that countries
with higher rates of investment will be wealthier.
 The level of the capital stock determines the
output level but not its growth rate, at least not
in the very long run.

32
 Steady-state Level of Output
Output Y
20
Y K
15

Increased investment
10 raises steady-state output Depreciation = 0.02K

Investment = 0.4Y

5 Investment = 0.3Y

Capital K
0 100 200225300 400 33
 Investment and GDP

GDP per Capita Is Higher in Countries with Higher Investment Rates

34
 Self-Check

A higher rate of investment will:

a. Increase capital but decrease output.
b. Decrease capital but increase output.
c. Increase both capital and output.

Answer: c – higher investment will increase

both capital and output.
35
 Definition

Conditional convergence:
The tendency—among countries with
similar steady-state levels of output—for
poorer countries to grow faster than
richer countries and thus for poor and
rich countries to converge in income.

36
 Conditional Convergence
This
This figure
figure is
is using
using data
data from
from 18
18 of
of
the
the 20
20 founding
founding members
members of of the
the
OECD
OECD (Organisation
(Organisation for
for Economic
Economic
Co-operation
Co-operation andand Development).
Development).

Over
Over time
time the
the OECD
OECD countries
countries
have
have converged
converged to
to aa similar
similar level
level
of
of GDP
GDP per
per capita.
capita.

The poorer the country was in 1950, the faster growth was between 1960 –
2000. 37
 Cutting-edge Growth

 The simplest form of the Solow model predicts

zero economic growth in the long run.
 The United States, however, has been growing
for more than 200 years.
 Better ideas can keep the economy growing
even in the long run.
 A computer today has about the same amount
of silicon and labor input as 20 years ago, but
today’s computer is much better - the difference
is ideas.
38
 Cutting-edge Growth
 A stands for ideas that increase productivity, our
production function is:
Y = A √

 Better ideas or technological knowledge—as

represented by increases in A—increases output
even while holding K constant, that is, an
increase in A represents an increase in
productivity.
 Cutting-edge Growth
An Increase in A Increases Output Holding K
Constant
Conclusion:
Technological knowledge / better ideas are
the key to long run economic growth.
Solow estimated that better ideas are
responsible for ¾ of our increased standard
of living.
 Cutting-edge Growth

Output Y
33 Outputnew
b
27

Better
Better ideas
ideas
Outputold
a
15

Depreciation

Investmentold

225 506 Capital K

41
 Cutting-edge Growth

Output Y
c
33 Outputnew
More
More capital,
capital,
b more
more output
output
27

Better
Better ideas
ideas
Outputold
a
15

Depreciation
Investmentnew
Investmentold

225 506 Capital K

42
 Self-Check

Long-run economic growth is largely due to:

a. Better ideas.
b. Lower depreciation.
c. Higher investment.

Answer: a – long-run growth is largely due to

better ideas.
43
 The Economics of Ideas

1. Ideas for increasing output are primarily

researched, developed, and implemented by
profit-seeking firms.
2. Ideas can be freely shared, but spillovers
mean that ideas are underprovided.
3. Government has a role in improving the
production of ideas.
4. The larger the market, the greater the
incentive to research and develop new ideas.

44
 1. Research for Profit

 Institutions and incentives drive the generation of

technological knowledge.
 These institutions include:
• A setting that helps innovators to connect with
capitalists.
• Intellectual property rights.
• A high-quality educational system.
 The U.S. has a very good cultural and
commercial infrastructure for supporting new
ideas and their commercialization.
45
 1. Research for Profit
• All kinds of people come up with new ideas.
• Business culture and institutions are also
important.
• Ideas without financial backers are dead.
• The U.S. is good at connecting innovators
with businessmen and venture capitalists.
• American culture supports entrepreneurs.

46
 1. Research for Profit

Patents
 New processes, products, and methods can be
copied by competitors.
 Imitators have lower costs and tend to drive
innovators out of the market unless barriers
prevent quick imitation.
 Patents give innovators temporary monopoly
rights, typically 20 years.

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 1. Research for Profit

Patents
 Patents increase the incentive to develop new
products, but they also increase monopoly
power.
 Monopoly power raises prices and slows the
spread of innovations throughout the economy.
 The trade-off between creating incentives for
R&D while avoiding too much monopoly power
is one of the trickiest in economic policy.
48
 1. Research for Profit

John Kay (1704-1780) invented

the “flying shuttle” used in cotton
weaving, the single most important
invention launching the industrial
revolution.
Kay was rewarded for his
efforts by having his house
destroyed by “machine breakers,”
John
John Kay,
Kay, afraid of job loss. He died a poor
“destroyer
“destroyer of
of man.
jobs.”
jobs.”
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 2. Spillovers

STOCK MONTAGE/GETTY IMAGES

“He who receives an idea from me, receives instruction

himself without lessening mine; as he who lights his
taper at mine, receives light without darkening me.”
50
Thomas Jefferson
 Definition

Non-rivalrous:
When one person’s consumption of a
good does not limit another person’s
consumption.

51
 2. Spillovers

 Even with patents, ideas tend to spill over and

benefit other firms and consumers.
 Since ideas are non-rivalrous and many can be
shared at low cost, they should be shared.
 However, if the originator doesn’t get enough of
the benefits, ideas will be underprovided.
 Economists know that idea spillovers are good,
they also know that spillovers mean that too few
good ideas are produced in the first place.

52
2. Spillovers
 3. Government’s Role

 The Government can increase the incentive to

produce new ideas through patents.
 The government could also encourage the
production of new ideas through subsidies or
tax breaks.
 Universities train the scientists who research
and develop new products.
 The large spillovers to basic science suggest a
role for government subsidies to universities.

54
 3. Government’s Role

 The Government can increase the incentive to

produce new ideas through patents.
 The government could also encourage the
production of new ideas through subsidies or
tax breaks.
 Universities train the scientists who research
and develop new products.
 The large spillovers to basic science suggest a
role for government subsidies to universities.

55
 Self-Check

Governments should play a role in encouraging

new ideas because new ideas provide:
a. Non-rivalry.
b. Spillovers.
c. Market power.

Answer: b – governments should encourage

new ideas because of spillover effects.
56
 4. Market Size

 Larger markets mean increased incentives to

invest in research and development.
Innovations like pharmaceuticals, new computer
chips, software, and chemicals require large R&D
expenditures.

 Companies will avoid investing in innovations

with small potential markets.
 As countries become wealthier, companies will
increase their worldwide R&D investments.
57
 The Future of Economic Growth

 Growth in per capita world GDP has been

increasing.
 Worldwide per capita GDP is currently growing
by a little over 3% per year.
 The number of new ideas is a function of the
number of people, the incentives to innovate,
and the number of ideas per hour that each
person has.
A(ideas) = Population × Incentives × Ideas per hour
58
 The Future of Economic Growth

 The number of people is increasing.

 As the world gets richer, the number of people
whose job it is to produce new ideas is
increasing.
 Because of spillovers, these ideas will benefit
everyone.
 Increased consumer wealth and integrated
markets boost the incentive to innovate.
 Economic growth might be even faster in the
future than it has been in the past.
59
 The Future of Economic Growth
Many people say that if people save too much, the
economy will be hurt. They often refer to the fact
that consumer spending is two-thirds of GDP to
make this point. This is sometimes called the
“paradox of thrift.”
Do you agree with the “paradox of thrift” for long-
run growth?

a) Yes, since a high savings rate makes a country

poorer in the long run.
b) No, since a high savings rate makes a country
richer in the long run.
60
 Takeaway

 The Solow model tells us that:

• Countries that devote a larger share of output
to investment will be wealthier.
• Growth will be faster the farther away a
country’s capital stock is from its steady-state.
• Capital accumulation cannot explain long-run
economic growth.
 New ideas are the driving force behind long-run
economic growth.
61
 Takeaway

 Ideas can be easily copied, so the originator of a

new idea won’t receive all the benefits and the
incentive to produce ideas will be too low.
 Governments can play a role in supporting the
production of new ideas.
 There is a trade-off between providing incentives
to produce new ideas and providing incentives to
share new ideas.

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