Unit 03: Fundamental Concepts of Macroeconomics

SESSION 18
ECONOMIC GROWTH AND TECHNOLOGY

Contents
Introduction 1
18.1 Long run economic growth 2
18.2 Determinants of economic growth 3
18.2.1 Human Resources 4
18.2.2 Natural Resources 5
18.2.3 Capital 5
18.2.4 Technological Change and Innovation 6
18.3 Growth and public policy 7
18.4 Theories of economic growth 8
18.4.1 The Classical Dynamics of Smith and Malthus 9
18.4.2 The Neoclassical Growth Model 10
18.5 Technology 11
18.5.1 Sources of technological change: New growth theory 11
18.5.2 Growth accounting 12
18.5.3 Growth in developing countries 13
18.5.4 Strategies of economic development 14
18.6 Sustainability of growth & environment 15
Summary 15
Review questions 16

Learning outcomes
After having read this introductory session, you should be able to
1. Understand the concept of economic growth, its importance for people in a country
and measuring economic growth
2. Identify the determinants of productivity as the pillars of economic growth
3. Understand the reasons for having different growth rates among countries
4. Understand the theories of economic growth and sustainability of growth
Key concepts

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Economic growth, physical capital, human capital, natural resources, technological
innovations, capital accumulation, diminishing returns, vicious cycle of poverty
Introduction

When we compare different time frames, the facilities people enjoyed during different time
periods are quite different. For example, in each country, the bundle of facilities enjoyed by
an average household 100 years from today and 50 years from today are not equal. We
generally see that it has improved over time. We call this improvement a ‘growth’. We
measure this improvement using the change in real GDP per capita (per person) which is a
measure of economy’s output and it is used as an indicator of economic growth. A country’s
ability to provide health, education, transport and other facilities are determined by the
income or the output which is measured by real GDP. Therefore, a country’s policy focus is
extremely important as it directly influences the living standards of people.
If we take countries around the world, the differences in their living standards is clearly visible.
The quality of the facilities they enjoy for example, health, nutritious food, housing, clothing,
transport and education are highly variable across the countries. This is mainly due to the
variations in income of the countries.
We see that some countries have achieved higher standards of living for its people over the
centuries while other countries remain at lower standards. The reasons for these temporal
and spatial variations in improvements of standards of living can be attributed to the level of
income and its growth.
Economic growth of a country is determined by productivity which is driven by many factors.
Those are physical capital per person, human capital per person, natural resource availability
per person and technological knowledge. These are considered as the pillars of economic
growth. Different countries have achieved their growth using different approaches while
other countries are still struggling to realize. In this session, we will discuss the concepts of
economic growth, factors that govern the economic growth and what is neglected in
measuring economic growth.

18.1 Long run economic growth

Economic growth considers the expansion of potential output of a country over time. It is
measured in real per capita output or the real GDP per capita growth over time. When the
average real income of a person increases, the living standards of that person increases.
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Taking real value compensates the increase in price level while the per capita value
compensates the increase in population.
If a country can maintain an upward trend in per capita real GDP, that country achieves long
term economic growth. Otherwise, the countries stagnate or decline in their real income and
standards of living. Therefore, a country’s economic policy is keen on achieving a positive
economic growth.
When the history of high income countries is considered, those countries maintained an
economic growth over a long period of time. Countries such as UK, USA, Australia, Germany
and Canada sustained a positive growth over centuries. Some countries declined due to
inconsistencies in political environment and changed their approach for example Soviet Union
and Eastern Europe.

18.2 Determinants of economic growth

Economic growth is determined by the productivity, which is defined as the quantity of output
produced from a unit of labour input. It decides the living standards of people. When the
workers in a country become more productive, their standards of living rises compared to the
other country. In order to understand the differences of standards of living across the
countries and across time periods, it is crucial to identify factors that determine the
productivity of workers. Those are namely; human capital, natural resources, physical capital
and technological knowledge.
A production function is used to explain the input output relationship of a production process;
given a specific technology.
𝑌 = 𝐴(𝐿, 𝐾, 𝐻, 𝑁)
Dividing the equation by L gives the productivity of labour force
𝑌 𝐿 𝐾 𝐻 𝑁
=𝐴 , , ,
𝐿 𝐿 𝐿 𝐿 𝐿
Productivity = A (1, Physical capital per worker, Human capital per worker,
Natural resources per worker )
Y - Quantity of output
A - Technology
L - Quantity of labour
K - Quantity of physical capital

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H - Quantity of human capital
N - Quantity of natural resources
Therefore, given a certain technology, the above factors determine the productivity of output.
The production possibility frontier shows the economy’s capability of production and the
technology can shift the production possibility frontier outwards.

18.2.1 Human Resources

Human resources is termed as the human capital. The knowledge, skills and experiences
acquired from early childhood, school education, university education, on the job training and
life experiences contribute to improve the ability to work. Similar to physical capital, human
capital is an output of a production process which come through the inputs of education. Then
it is an input in the production process.

18.2.2 Natural Resources

These are the resources provided by nature for the production process. For instance, land,
water, mineral deposits, soils, fossil fuels, vegetation and animals contribute as inputs in the
production process. Those can be categorised as renewable and non-renewable resources.
Renewable resources can be reproduced, for instance forests and animals. However, fossil
fuels and mineral deposits which took millions of years to form; depletes with use. A country’s
natural resource endowments is an important factor in determining the standards of living.
For example, success behind USA was mainly attributed to the availability of a large land area
suitable for agriculture. Most of the rich middle east countries have fossil-fuels. However,
there are countries which achieved higher standards of living with less natural resources.
Japan and Singapore are examples which developed through international trade, skilled
labour and most importantly through stable economic policies.

18.2.3 Capital
A country’s stock of equipment and structures used in producing goods and services is termed
as capital or the physical capital. Workers become more productive when they have the
appropriate tools to do their work. For example, if the workers are provided with more
sophisticated machines to do the task, their output per day is greater than the worker who

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are using hand tools to make the same product. Capital is also an output of a production
process. It is used as a factor of production in a production process as well.

18.2.4 Technological Change and Innovation

Technological knowledge shows the understanding of a society on best ways of producing
goods and services. When the best technologies are available in a country, the worker
productivity is increased. For example, before mechanisation in agriculture, the labour force
involvement in agricultural activities was quite high. After mechanisation, few workers could
do the task while the excess labour force could engage in other sectors. Some technologies
are freely available for others to use after innovation. In some situations, it is proprietary and
the inventors keep it a secret and they can earn a huge income. Patent rights for
pharmaceutical products give the right of producing the drug to the inventing company for a
specific period. Other patent rights for different technologies works the same. Technology
can overcome the scarcity of resources through enhancing overall efficiency and finding
alternatives for the scarce resources.

18.3 Growth and public policy

We have discussed so far the factors that can drive economic growth and thereby the living
standards of people in a country. However, government policies play a vital role in improving
the living standards of a country. For example, capital accumulation is promoted by
enhancing the investment of a country. In order to do that people have to consume less at
present and need to save more. Therefore, the direction of a country’s monetary policies are
important in economic growth.
When the savings rate in an economy is high, less of consumption goods are produced while
more of capital goods are accumulated. This capital accumulation helps to increase the
productivity through the increased availability of capital for a worker. If a poor country is
considered, the workers will get the required equipment to work and the worker productivity
will be improved. Compared to a rich country, those countries can achieve a higher rate of
growth. This is called the catch-up effect. It will take much time for such a country to observe
a diminishing return for capital. Most of the rich countries achieved their growth over decades
through capital accumulation.

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Another option is facilitating foreign direct investments and foreign portfolio investments. It
enhances the capital accumulation of a country and increases the GDP. Therefore, the
productivity and wages of a country are increased. Additionally, a poor country learns the
novel technologies used in developed countries. However, part of the profit is taken back to
the foreign country. Considering the positive side to the economy, poor countries encourage
policies for attracting foreign investments.
Investment on human capital development is equally important as physical capital
development. Education improves the standards of living by increased wage rates. It provides
positive externalities to the society through new knowledge generation by the educated
person on better producing the goods and services. Therefore, countries provide better
schools and subsidies for education. However, poor countries face problems in retaining the
educated people since they immigrate to rich countries which we call brain-drain. Some
workers sent for better education do not return. Therefore, the human capital in those
countries further reduces and people who retain in the country become worse off.
Having a healthy workforce improves the labour productivity. For this reason, investment in
improving health facilities and nutrition of people is important for economic growth. Poor
countries do not have a healthy workforce and they have become poor due to the unhealthy
population.
Another aspect of growth is political stability and property rights. If there are uncertainties of
governing political parties and their decisions, people tend to do less investments and foreign
investors are discouraged as well. Property rights are equally important for making
investments. Having an efficient system of justice, honest government officials (with least
corruption) and a stable Constitution are important in realizing high standards of living.
Small countries find it difficult to influence the markets and to be self-sufficient. The standards
of living declines due to inward looking policies. Small countries such as Singapore, South
Korea and Taiwan adopted free trade policies in achieving a higher growth rate. Having sea
ports facilitates international trade which is a limitation for some landlocked countries.
Research and development policy influences the technological knowledge generation which
is necessary for productivity shifts. The efforts of private persons is encouraged and
supported by the government.

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Population growth is argued to be positive on improving the workforce of a country and
thereby the output. For example, China’s population helped to achieve the economic growth
of that country.

18.4 Theories of economic growth

Economic growth is basically the improvements in real GDP or the output. Per capita
availability of income shows the standards of living of its citizens. In other words, when the
production possibility frontier of an economy moves outwards, it achieves a growth. Different
countries have achieved the growth through different ways and at different rates of growth.
For example, countries have used policies that increased capital investments or that
stimulated technological innovations or workforce enhancement. However, the best way to
achieve the economic growth is in debate among policy makers and they came up with the
driving forces of economic growth as we discussed earlier.

18.4.1 The Classical Dynamics of Smith and Malthus

Adam Smith and T. R. Malthus are the early economists who highlighted the importance of
land in achieving economic growth. They have developed this theory when the land was freely
available and no capital accumulation was considered. More the people who entered to
cultivate the lands, more the output of the country has been increasing. Since no rental is
paid for the land, the total income increases with the population increase and the real wage
remains constant. In other words when the population doubles, the production of the country
doubles shifting the production possibility frontier outwards. However, when the population
further increased, the land become a scarce resource and the per capita availability of land
and there by the real wages decline showing diminishing marginal returns. Production
possibility frontier moves outward by a lesser amount. Finally the wage rates will reach to a
minimum subsistence level or an equilibrium level. The population will expand when the
wages are above this equilibrium and the population will contract below the subsistence level
due to high mortality rate.

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Figure 1: Economic growth through increased land utilisation (adapted from Samuelson &
Nordhaus, 2010). a) Represents the shift in production possibility frontier through increase of
used lands for production with the population increase. b) When the population increases,
land will become a scarce resource and the returns are diminishing

18.4.2 Economic Growth with Capital Accumulation: The Neoclassical Growth Model
Malthus has ignored the role of capital accumulation and technological innovation in
addressing the diminishing marginal returns from lands. Therefore, with the industrial
revolution, land did not become a limiting factor. Invention of power driven machines, steel
and iron opened up new employment. Rail roads and steam ships increased the link with
other countries. The second revolution was the invention of telephone, electricity and
automobiles. The neoclassical model of economic growth by Robert Solow explained this
economic phenomena.
The model assumes that a single homogeneous output is produced with capital and labour. It
is assumed that labour growth is given and the economy is competitive and operating at the
full employment level. Capital includes durables that are used to produce other goods.
Examples are machineries, structures, inventories of finished and unfinished goods in the
process. Constant dollar value of the capital goods are taken as the value of capital (K) and

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number of workers is taken as the labour (L) that determines the outputs. The aggregate
production function is as below.
Q = F (K, L)

Q- Quantity of output
L- Labour (number of workers)
K- Capital (constant dollar value)
Capital deepening which is defined as the increase of capital per worker is considered as a
crucial factor in growth. In the absence of a technological change, when the amount of capital
available per worker increases, the labour productivity increases. It increases the real wage
of the workers. Therefore, it creates a growth of output per worker. However, the returns to
capital declines showing diminishing marginal returns after some stage of capital investment
becomes constant when the other factors such as land, natural resources, quality of labour
and technology becomes constant (Figure 2).

Figure 2: Economic growth through capital deepening (adapted from Samuelson & Nordhaus,
2010)
Eventually, the economy reaches a steady state of growth where returns to capital is constant.
Then the wages are constant and the living standards become constant. It is a better condition
than Malthus’s subsistence wage where availability of land was the determinant of real wage.

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However, the neoclassical model or a simple capital accumulation model does not explain the
ability of achieving economic growth through technological innovations.

18.5 Technology
An economy stagnates when it attempts to achieve economic growth solely through capital
accumulation. It faces diminishing marginal returns for capital. Technological innovations shift
the production possibility frontier outward through increased capital productivity. Therefore,
the real world examples does not show stagnating economies over the time. Instead
increasing real wages are evident. The increase in real wages and growth of the economies
over the years can be explained when the capital accumulation is coupled with the
technological changes (Figure 3). Movement from A to C is due to capital accumulation and C
to D is due to technology advancement.

Figure 3: Capital accumulation and technological change increase the output (Krugman &
Wells, 2015)

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18.5.1 Sources of technological change: New Growth Theory
The New Growth Theory or the Theory of Endogenous Technological Change attempts to
identify the sources of technological change. The prevailing economic system is considered
as the input for different patterns in technological change. Hence, technological change is
treated as an output of the country’s economic system. It is formed by several policy decisions
by the government, market forces and other institutions.
These inventions sometimes bring about enormous profits for the inventor while many of
them ends up with losing their investments. Generally, technology is considered as a public
good. When it is invented at a great cost, it can easily be reproduced by the others. For this
reason, governments consider about intellectual property rights providing patent rights and
copy rights for the inventors. Governments provide public grants for conducting basic
research and incentives for profit oriented work.
The new growth theory was formulated by Paul Romer of Stanford University who won the
Nobel Prize for Economics for developing this theory. He showed the ability of non-rival
nature of ideas to boost the endogenous economic growth. The differences in technology
lead to differences in growth and living standards among the countries. Factors that
encourage technological change are the factors that produce new technologies. With this
inference, technology is considered as a produced factor. Therefore, a country’s growth
policies have to be well focused on enhancing technological improvements.

18.5.2 Growth accounting:

Sources of economic growth are identified as capital, labour and technology. However, the
relative contribution of each factor on growth is not visible. Therefore, a country needs to
analyse relative contribution of these factors to economic growth which is called growth
accounting. Following aggregate production function is used to find the contribution of each
factor on growth.
Q = AF (K, L, R)
Q- Growth in output
L- Growth in labour * weight
K- Growth in capital * weight
TC- technological change
R- Lands (resources) are a constant

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If we assume that the contribution or the weights of labour and capital for output as three
fourth and one fourth respectively, the growth accounting equation can be written as follows.
It assumes that three fourth of national income and one fourth of national income comes
from labour and capital respectively under the perfect competitive conditions.
% Q growth = ¾ (% L growth) + ¼ (% K growth) + T.C
Contribution of technological change for growth can obtained by rearranging the equation as below.
It indirectly measures the contribution of technological advances on economic growth. This residual
effect is taken as total factor productivity.
T.C. = % Q growth - ¾ (% L growth) - ¼ (% K growth)
For example, 60 percent of USA’s growth is attributed to labour and capital while the rest 0
percent is attributed for other factors which come under factors that determine technological
innovations or the total factor productivity (investments on education, research &
development, advances is knowledge , innovations and other factors).

18.5.3 Growth in developing countries

The four wheels of development in both rich and poor countries remain the same. However,
the combination of these factors and strategies they use varies depending on the state of
development.
Generally, developing countries are characterised by high population growth rates, poor
standards of living with poor health, education, life expectancy, labour outmigration and high
rates of corruption.

Human resources:
In poor countries birth rates are at a higher rate. Therefore, the growth of economy does not
increase the per capita income of the people and thereby the standards of living. Therefore,
some countries adopt measures to slow down growth rates through education and birth
control. It is considered as a substitute of quality for quantity. When the number of children
in a family is reduced, parents have much time and income to allocate for the education and
other needs of few children. Also women education discourages the time spending on
childbearing.

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The quality of human resources is also poor in developing countries. A healthy population
improves the labour productivity. Health care facilities and safe drinking water are crucial for
this. When the people are educated, labour productivity goes high. They are capable of
learning new technologies and inventions. However, labour outmigration is an issue for the
developing countries.

Natural resources:
Most of the developing nations are characterised by poor resource endowments compared
to the developed world. Arable lands are the main resource for the majority. However, even
in the presence of some valuable resources, some countries failed to accumulate wealth due
to the corrupted rulers who earned rent from the resources which were used for personal
benefits. For example, Nigeria and Congo failed to get the benefit of their mineral resources.

Capital:
Most of the developed economies invest nearly 20 percent of their income on capital
formation. This is nearly 5 percent for developing nations since their savings are very low with
the need for current consumption needs. Basically they invest little on housing and simple
tools rather than on productive capital. It is crucial for developing countries to first develop
their social overhead capital which includes roads, schools, hospitals, public parks and
libraries.

Technological change and innovation:

This is an important aspect from which developing countries can get benefits. They can reach
the technologies used in developed nations for their own countries. For example, USA and
Japan entered the automobile market although the initial inventions were in foreign
countries. They adapted the technology to the local context. In order to adapt the technology
to local context, there should be an encouraging environment for entrepreneurs to invest
with skilled labour and other inputs. The governments can nurture entrepreneurship through
extension and education services for farmers, training the workforce and establishing
management schools.
Corruption is another aspect that hinders economic growth. It is found in varying degrees at
different countries. However, when corruption is practised, it destroys the economic growth.

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Vicious cycle of poverty
In addition to the difficulties of combining the four elements of economic growth, poor
countries are trapped into a vicious cycle of poverty. Figure 4 describes the vicious cycle of
poverty. Low productivity leads to low average incomes and low saving. Low savings reduces
the capital accumulation which results in low productivity. Therefore, a big push is required
to break this cycle.

Figure 4: Vicious cycle of poverty

18.5.4 Strategies of economic development

It is difficult to recommend an exact strategy or a mix of growth elements for a country to
achieve economic development. Different countries have used different paths to achieve
economic growth. The most prominent factor that prevent economic growth is lack of strong
decision structures and having interest groups that prevent social and economic change of a
country. There are some approaches developed over a period in achieving economic growth
breaking the vicious cycle.

The Backwardness Hypothesis: It explains the ability of developing countries to adopt new
technologies developed in the rich countries. Since it is always expensive to invent a
technology, the poor countries can adapt their technologies to aggravate economic growth.
For example, they can purchase machineries, seeds and software from the developed world.

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Industrialisation vs Agriculture: Many of the developed countries get substantial income
through industrial and service sector. However, it does not conclude that shifting to these
sectors will aggravate the economic growth. If the productivity in agriculture can be improved
substantially, the real wages in agriculture sector employees can be increased. The excess
labour can be diverted to other sectors which will cater to the increased consumption demand
from the agriculture sector workers.

Promoting a market economy: Government should facilitate the functioning of market

mechanism with less restrictions and allowing competition. Openness of the economy and
consistency or the predictability of macroeconomic structures are most important factors for
the investors.

Outward orientation of economies: This is a country’s consideration on international trade.

They have a dilemma in whether to achieve self-sufficiency or to open up the economies with
less trade barriers which facilitate efficiency and competitiveness. The success of outward
oriented policies are shown by Singapore, Taiwan and South Korea. However, opening up the
economy does not merely make any sense unless the governments have careful planning and
a selective intervention.

18.6 Sustainability of growth & environment

It is argued that growth is a continuous process given the limited natural resources. However,
it is found that resources become available with new inventions for example energy sector
has many alternatives. On the other hand, people tend to be conservative and use the
resources efficiently inventing resource efficient technologies.
Economic growth increases the impact on environment. For example, with the rapid
economic development in China, air pollution in the cities also increased rapidly. This kind of
incidences were reported in London and USA when they were achieving a higher growth rate
with industrial development. However, this is when the other things remain constant.
Currently, the developed economies have achieved better water and air quality through
environmental regulations. These negative impacts of production activities are included in
market prices as externalities. Therefore, creating market based instruments value the cost
of negative impacts to balance the economic growth.

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Summary
Economic growth is the major determinant of living standards of people. There are four
elements in economic growth namely; human resources, natural resources, capital and
technology. Countries are in different stages of development due to the differences in above
factors. The strategies used by the developed nations vary from country to country.
Therefore, recommending a specific strategy for a country is difficult. Having a carefully
planned stable policy structure remains the most important factor in achieving economic
growth.

Review questions:
1. What are the four pillars of economic growth?
2. Why do we see different standards of living in different countries and across different
time frames?
3. Briefly explain the importance of the policy structure of an economy in achieving
economic development
4. What do the theories of Smith and Malthus say about economic growth?
5. How does the neoclassical growth model explain economic growth? Does it explain
the impact of technology or the total factor productivity on output?
6. What are determinants of technological innovations?
7. What are limitations of developing countries in achieving economic growth? What do
you mean by the viscous cycle of growth?
8. What are the strategies for economic development? Briefly explain with examples
from the world economies.
9. Do you think Sri Lana’s economy is growing over the past decades? Can you graphically
show the real GDP and real wage rates over the last 50-70 years? What has happened
to our real interest rates and savings over the years?
10. Suppose that a country decided to reduce consumption expenditure to promote
economic growth. How does this support economic growth and which groups get
affected by the policy?

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