Economic Growth

Economic growth has two meanings:

1. Firstly, and most commonly, growth is defined as an increase in the output that an economy produces over a period of time, the minimum being two consecutive quarters.
2. The second meaning of economic growth is an increase in what an economy can produce if it is using all its scarce resources. An increase in an economy’s productive potential can be shown by an outward shift in the economy’s production possibility frontier (PPF).

The simplest way to show economic growth is to bundle all goods into two basic categories, consumer and capital goods. An outward shift of a PPF means that an economy has increased its capacity to produce.

What creates growth?

When using a PPF, growth is defined as an increase in potential output over time, and illustrated by an outward shift in the curve.  An outward shift of a PPF means that an economy has increased its capacity to produce all goods. This can occur when the economy undertakes some or all of the following:

Employs new technology

Investment in new technology increases potential output for all goods and services because new technology is inevitably more efficient than old technology. Widespread ‘mechanisation’ in the 18th and 19th centuries enabled the UK to generate vast quantities of output from relatively few resources, and become the world’s first fully industrialised economy. In recent times, China’s rapid growth rate owes much to the application of new technology to the manufacturing process.

An economy will not be able to grow if an insufficient amount of resources are allocated to capital goods. In fact, because capital depreciates some resources must be allocated to capital goods for an economy to remain at its current size, let alone for it to grow.

Employs a division of labour, allowing specialisation

A division of labour refers to how production can be broken down into separate tasks, enabling machines to be developed to help production, and allowing labour to specialise on a small range of activities. A division of labour, and specialisation, can considerably improve productive capacity, and shift the PPF outwards.

See also: Adam Smith

Employs new production methods

New methods of production can increase potential output. For example, the introduction of team working to the production of motor vehicles in the 1980s reduced wastage and led to considerable efficiency improvements. The widespread use of computer controlled production methods, such as robotics, has dramatically improved the productive potential of many manufacturing firms.

Increases its labour force

Growth in the size of the working population enables an economy to increase its potential output. This can be achieved through natural growth, when the birth rate exceeds the death rate, or through net immigration, when immigration is greater than emigration.

Discovers new raw materials

Discoveries of key resources, such as oil, increase an economy’s capacity to produce.

An inward shift of a PPF

A PPF will shift inwards when an economy has suffered a loss or exhaustion of some of its scarce resources. This reduces an economy’s productive potential.

A PPF will shift inwards if:

Resources run out

If key non-renewable resources, like oil, are exhausted the productive capacity of an economy may be reduced. This happens more quickly as a result of the application of ultra-efficient production methods, and when countries over-specialise in producing goods from non-renewable resources.

Sustainable growth means that the current rate of growth is not so fast that future generations are denied the benefit of scarce resources, such as non-renewable resources, and a clean environment.

Failure to invest

A failure to invest in human and real capital to compensate for depreciation will reduce an economy’s capacity. Real capital, such as machinery and equipment, wears out with use and its productivity falls over time. As the output from real capital falls, the productivity of labour will also fall. The quality and productivity of labour also depends on the acquisition of new skills. Therefore, if an economy does not invest in people and technology its PPF will slowly move inwards.

Erosion of infrastructure

A military conflict is likely to destroy factories, people, communications, and infrastructure.

Natural disaster

If there is a natural disaster, such as the 2005 boxing-day tsunami, or the Haiti earthquake of 2010, an economy’s PPF will shift inwards.

Investment and economic growth

Allocating scarce funds to capital goods, such as machinery, is referred to as real investment. If an economy chooses to produce more capital goods than consumer goods, at point A in the diagram, then it will grow by more than if it allocated more resources to consumer goods, at point B, below.

To achieve long run growth the economy must use more of its capital resources to produce capital rather than consumer goods. As a result, standards of living are reduced in the short run, as resources are diverted away from private consumption. However, the increased investment in capital goods enables more output of consumer goods to be produced in the long run. This means that standards of living can increase in the future by more than they would have if the economy had not made such as short-term sacrifice. Hence economies face a choice between high levels of consumption in the short run and the long run.

Investment

If an economy chooses to produce more capital goods than consumer goods, at point A in the diagram, then it will grow by more than if it allocated more resources to consumer goods, at point B.

There is a trade-off between the short and the long run. In the short run, the economy must use resources to produce capital rather than consumer goods. Standards of living are reduced in the short run, as resources are diverted away from private consumption. However, in the longer run the increased investment in capital goods enables more output of consumer goods to be produced. This means that standards of living can increase by more than they would have if the economy had not made the short-term sacrifice.

Asymmetric growth

An economy can grow because of an increase in productivity in one sector of the economy – this is called asymmetric growth.

For example, an improvement in technology applied to industry Y, such as motor vehicles, but not to X, such as food production, would be illustrated by a shift of the PPF from the Y-axis only.

Factor mobility

If workers, or other resources, are moved from one sector to another, then the position of the PPF will change, with an increase in the maximum output in the industry receiving the resources, and a fall in the maximum output of the industry losing resources.