Economic Growth & Development Structure
Economic growth is the inflation-adjusted increase of the final market value of all goods and services produced in an economy over time and the common statistical measure used is GDP (gross domestic product). GDP is adjusted to eliminate distortions caused by higher nominal money prices paid for inputs. Nominal prices reflect the real subjective valuations of consumers based on supply and demand. These adjustments (from nominal to real values) help to conduct useful comparisons over time.
The rate of economic growth is the percentage change in real GDP between any two points in time. Economic growth due to more efficient use of inputs is called intensive growth, whilst growth caused by the expansion of available inputs is called expansive growth. This chapter will outline how GDP is used as a measure of economic growth.
GDP can be measured using product, income or expenditure methods. Real GDP is at current prices, whilst nominal GDP considers inflation (adjustments to provide constant prices). Countries are usually classified as “more” or “less” developed based on their GDP per capita, specifically considering their “purchasing power parity” (PPP) level. PPP looks to examine how the cost of living also shapes GDP differences. In simple terms, someone earning $10,000 per annum In Chile is likely to be considered as being much wealthier (in relative terms) than someone living in the United States. Such comparisons provides important information to multinational firms making salary and other budget decisions for overseas divisions.
Actual growth is the percentage annual increase in national output actually produced, whilst potential growth refers to the speed at which the economy could grow. Potential output refers to the sustainable level of output that could be produced in an economy. The difference between actual and potential output/GDP is referred to as the output gap.
If the actual output is lower than the potential output (negative gap), there will be a greater than natural level of employment as organisations and companies are operating below their normal level of capacity utilization. There will nonetheless be a downward pressure on inflation because of lower than normal levels of demand. If the actual output is over the potential output (positive gap), there will be excess demand and increasing inflation.
In the short-term, fluctuations in growth can be attributed to variations in aggregate demand (AD). AD is the total demand for goods and services in an economy and comprises constitutes of Consumption (C), Investment (I), Government Spending (G) and Exports less Imports (M). In short:
- Consumption - An increase in consumption lead to firms increasing outputs. However, without an associated increase in real earnings, economic growth built on consumption will fail (e.g. buying on credit is essentially imaginary wealth!). It has also been argued that economic growth is the cause of increased consumption rather than a product of it.
- Investment - Increased investment can increase labour productivity.
- Government spending - includes all government investment, consumption, and transfer payments.
- Net trade (M) - GDP increases when the value of goods/services that domestic producers sell to foreigners surpasses the total value of goods and services that domestic households purchase from overseas (trade surplus).
A rapid increase in AD will create shortages, which encourages firms to increase outputs. Low AD is considered a recession and high AD a boom. However, in the long run, a rapid rise in AD is not considered sufficient to sustain high growth levels over several years.
To sustain growth, potential output must increase. If it doesn’t, actual output will only rise to levels that utilise spare capacity. This potential can be increased through supply-side economic approaches i.e. considering labour and capital productivity.
Sociological factors that support stability and development have economic impacts e.g. family stability and literacy rates. Population growth is also necessary for growth and this is further reinforced by the importance of intellectual capital to innovation and enterprise. Economists also view adult immigration as important for economic growth, as new labour arrives without the costs associated with their education and development, but this must also be seen as potentially lowering growth potential in the countries they emigrate from (the so called ‘brain drain’).
Technology can improve economic development through the emergence of new industries and services (e.g. information and communications technology), direct job creation (e.g. designing mobile applications) and business innovation (e.g. efficient on-line operations)
If a single factor of production expands in supply whilst others remain fixed then diminishing returns will arise. For example, if the amount of capital increases but there are no associated increases elsewhere then the rate of return (margin/profit) for using that capital will fall. Therefore, unless the sum components of production increases, the rate of development/growth is likely to slow.
The Solow Growth Model (Solow, 1956) illustrates how growth can occur from individual savings, investment and productivity, assuming a closed economy with no government expenditure affecting GDP. In essence, people invest and that investment supports growth, but there is a trade-off as the investment returns need to exceed depreciation to encourage such activity. The point at which the marginal product of capital equals the depreciation rate is known as the golden rule level of capital. However, the model also argues that long-term economic growth cannot be sustained without population and labor force growth.
Interestingly, with low amounts of initial capital, depreciation becomes a less influential factor. If large inputs of new capital are added, then economic growth will be faster as the margins are likely to be greater. This reflects what happens when capital is invested in developing rather than developed countries: growth is higher and more rapid. Also, higher rates of savings can deliver higher growth rates in the short-term, but in the long-term it can reduce consumption and therefore national outputs.
This model has been adapted to consider the impact of technical progress which increases the efficiency of human capital and investment. In this Solow-Swan model (Swan, 1956), economic growth is a function of population increases, savings, capital investment and technological efficiency or productivity. Importantly, it is an exogenous growth model, ensuring the consideration of external factors.
Endogenous growth theory suggests that knowledge, innovation and increases in personal productivity (through education, perfection of technological skills and processes) are significant contributors to economic growth. This theory argues that the long-term growth rate of an economy will depend on public policy choices, such as research and development subsidies and education investment, thus increasing the drive for innovation.
The AK approach features the absence of diminishing returns to capital. Of key importance is the generation of new technologies, labor productivity and efficiency. More advanced models consider spillover effects and positive externalities, benefits to third parties that do not pay for them, along with increases in varieties and qualities of goods. These theories imply that policies that stimulate openness, competition, change and innovation will promote economic growth. Conversely, policies that restrict or slow change by protectionism are likely to slow growth and disadvantage consumers.
Sustaining economic growth required a process of continual transformation, with the Industrial Revolution cited as the clearest example. Such arguments introduce the importance of the entrepreneur as being key to economic development and growth through their flexibility, mobility and creation of new inputs (Schumpeter 1971).
Economic development refers to the process by which a country improves its economic efficiency. Whilst it is primarily a function of growth, other factors are also important such as pollution levels, crime, natural disasters, ability to meet basic population needs (e.g. food, water and shelter), the creation of Government institutions, education, infrastructure, transportation and access to energy.
Trade policies are a key growth determinant and trade liberalisation permits nations to specialise in producing goods and services where they have a comparative advantage. ‘Rent seeking’ or ‘privilege’, where firms seek to gain state-granted economic privileges through the manipulation of democratic processes, can undermine this balance leading to protectionist/isolationist responses. State supported monopolies can face tariff barriers and any efforts to create artificial demands for goods and services (e.g. through legislation) can lower both social welfare and economic development.
Many economists believe that there is a link between development and income/wealth equality. Inequality might impair development if those with low incomes experience low productivity, poor health and poor education as a result. The Gini Coefficient, a statistical measure of a country’s income or wealth inequality, is frequently used to judge economic development. Other indices used include those focused on economic freedom and corruption perceptions which seek to demonstrate how addressing these issues supports economic development and general prosperity.
For economists, the importance of effective national and international institutions is a key determinant, since lower costs of social cooperation and doing business tend to lead to greater economic growth and development.
Mises (1966) and Hayek (1945) contend that the market’s price system is the only efficient means of allocating resources and engendering growth. Market process requires competition that is analytically inseparable from entrepreneurial activity (Kirzner 1973). However, human minds are essential for economic growth and development and entrepreneurs have a special ‘alertness gift’ that makes them essential to knowledge discovery. Entrepreneurs are more likely to thrive within free markets and institutions that guarantee strong property rights and rule of law.
Progressive entrepreneurial action yields efficient and effective resource allocation, promoting economic growth. Entrepreneurs notice maladjusted prices before others do and engage in arbitrage. Their profits are realized when their judgement of the future correctly determines what are undervalued inputs of production. The speculative nature of entrepreneurship is inherent in all entrepreneurial action and successful entrepreneurs possess dynamic abilities, react to change, correctly foresee future demand and subordinate other interests to effectively serve consumers.
- Increased consumption. Higher incomes can prompt higher consumption which has traditionally been seen as a social ‘good’, although this view is increasingly challenged.
- Income redistribution. Government taxation policies, if supported by strong growth, make it easier to support disadvantaged communities without undermining investment and consumption activities of more affluent groups.
- Avoid macroeconomic problems. People strive for higher living standards and if wages do not match productive potential there will be inflationary pressures, industrial disputes, balance of payments issues (as individuals import more) and other issues. Growth can minimize the emergence of such issues.
- Opportunity costs. To grow, firms need to invest. This requires financing, which can come from higher taxes, higher retained profits or savings. All these options constrain consumption.
- Environment. Higher consumption-led growth can increase waste and pollution. Increased capital and labour could also lead to an unsustainable demand n natural resources and raw materials.
It has been argued that an exclusive push for material growth by a nation can lead to a more selfish, greedier and less caring society. Gross National Happiness (a term developed by His Majesty the Fourth King of Bhutan) proposes that development and growth should take a more comprehensive and sustainable approach, giving equal importance to non-economic measures of well-being.
Economists commonly discuss developed, less developed, underdeveloped and developing countries. These terms reflect historical interpretations of the “First World” (the United States, Canada, Western Europe, Israel, Australia, New Zealand, Hong Kong, Singapore, Taiwan, Japan and South Korea), the “Second World” (the Soviet Union and its communist satellites, China, North Korea, Vietnam and other progressive socialist countries) and the “Third World” (all other poor countries of the Caribbean, Latin America, Africa and Asia). These lines of demarcation have changed significantly and given the range of economic and social measures that can be applied may not deliver any real utility in academic terms.
This Chapter has only been able to provide the briefest, most general overview of an extremely complex area of study. Further reading will be essential to develop a more comprehensive understanding and this effort should be supported by a review of relevant case studies.
Hayek, F.A. (1945). The Use of Knowledge in Society, American Economic Review 35(4), pp. 519-530.
Kirzner, I.M. (1973). Competition and Entrepreneurship, University of Chicago Press: Chicago.
Mises, L. (1966). Human Action: A Treatise on Economics, Contemporary Books: Chicago.
Schumpeter, J.A. (1971). The Fundamental Phenomenon of Economic Development, in P. Kilby (ed.), Entrepreneurship and Economic Development, The Free Press, New York.
Solow, R.M. (1956). A Contribution to the Theory of Economic Growth, Quarterly Journal of Economics, 70(1), pp. 65-94.
Swan, T.W. (1956). Economic Growth and Capital Accumulation, Economic Record, 32(2), pp. 334-361.
Aghion, P. (2004). Growth and Development: A Schumpeterian Approach, Annals of Economics and Finance, 5, p.1-25.
Aghion, P., Howitt, P. (1992). A model of growth through creative destruction, Econometrica, 60(2), pp. 323-351.
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Kent, C.A. (Ed.) (1984). The Environment for Entrepreneurship, Massachusetts: Lexington Books.
Kilby, P. (Ed.) (1971). Entrepreneurship and Economic Development, New York: The Free Press.
Kirzner, I.M. (1989). Discovery, Capitalism, and Distributive Justice, New York: Basil Blackwell.
Kirzner, I.M. (1992). The Meaning of Market Process: Essays in the Development of Modern Austrian Economics, New York: Routledge.
North, D.C. (1992). Institutions and Economic Theory, American Economist, Spring, pp. 3-6.
O’Driscoll, G.P., Rizzo, M.J. (1996). The Economics of Time and Ignorance, New York: Routledge.
Papanek, G.F. (1962). The Development of Entrepreneurship, American Economic Review, 52(2), pp. 45-58.
Schumpeter, J.A. (1942). Capitalism, Socialism, and Democracy, New York: Harper & Brothers.
Schumpeter, J.A. (1911). The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle, London: Transaction Publishers.
Simmons, R.T. (2012). Beyond Politics: The Roots of Government Failure, Oakland: Independent Institute.
Simon, J. (1996). The Ultimate Resource 2,New Jersey: Princeton University Press.
Tullock, G. (1975). The Transitional Gains Trap, The Bell Journal of Economics, 6, pp. 671-678.
Tullock, G. (1988). Wealth, Poverty, and Politics, New York: Basil Blackwell.
Weber, M. (1958). The Protestant Ethic and the Spirit of Capitalism, New York: Charles Scribner & Sons.
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