Technological Change, Economic Growth, and Living Standards: A Study Guide

Technological Change, Creative Destruction, and Rising Living Standards

Introduction

Technological change and creative destruction are central to understanding how economies grow and living standards rise. The story of Blockbuster Video illustrates how innovation and competition can transform industries and impact firms' survival.

• Creative destruction refers to the process by which new products and technologies replace outdated ones, leading to the decline of established firms.

• Example: Blockbuster Video, once a dominant movie rental company, was overtaken by new services like Netflix due to technological innovation and changing consumer habits.

• Other firms, such as Apple, Facebook, and GM, may also face similar challenges if they fail to adapt to technological change.

Obtaining Economic Growth

Government Policy and Long-Term Growth

• Economic growth is not automatic; history shows periods of stagnation with little improvement in output per capita.

• Some countries have achieved rapid increases in real GDP per capita, while others have lagged behind.

• The model of economic growth helps explain these differences and the role of government policy in fostering growth.

Economic Growth Over Time and Around the World

Historical Perspective

• Most global economic growth has occurred in the last two centuries.

• For much of human history, living standards remained largely unchanged over long periods.

Average Annual Growth Rates for the World Economy

Growth Rate Comparisons

• British economist Angus Maddison estimated worldwide growth rates starting from year 1 C.E.

• The Industrial Revolution led to sustained increases in real GDP per capita.

• Small differences in annual growth rates (e.g., 1.61% vs. 2.2%) lead to large differences in living standards over time due to compounding.

• For example, over 50 years, a 1.61% growth rate leads to a 122% increase in real GDP per capita, while a 2.2% rate leads to a 197% increase.

The Industrial Revolution

Origins and Impact

• The Industrial Revolution began in England around 1750, marking the application of mechanical power to production.

• Before this, production relied on human or animal power.

• Mechanical power enabled long-run economic growth in England, the United States, France, and Germany.

Why Did the Industrial Revolution Begin in England?

• Nobel Laureate Douglass North argued that the Glorious Revolution of 1688 was pivotal, shifting power from the king to Parliament and establishing an independent court system.

• This allowed the government to credibly protect property rights and wealth, incentivizing entrepreneurs to invest and innovate.

The Effects of Different Growth Rates on Living Standards

Comparative Table

Country	Real GDP per Capita, 1960 (2017 US$)	Growth in Real GDP per Capita, 1960–2019 (%)	Real GDP per Capita, 2019 (2017 US$)
Ghana	4,409	0.4	5,547
Mexico	6,472	1.9	19,308
Turkey	5,051	2.7	26,700

Main purpose: To illustrate how small differences in growth rates can lead to large differences in living standards over time.

• Countries with similar starting points can diverge significantly in living standards due to differences in growth rates.

The Problem with Slow Economic Growth

• Slow growth prevents significant improvements in living standards, affecting not just luxury goods but also health and life expectancy.

• High-income countries have much lower infant mortality rates compared to low-income countries.

• Poor growth can lead to higher poverty, lower life expectancy, and higher infant mortality.

The Variation in Per Capita Income Around the World

• Economists distinguish between high-income (developed) and developing countries.

• Some countries, like Singapore, South Korea, and Taiwan, have transitioned to newly industrializing countries.

• Real GDP per capita varies widely, even after adjusting for cost-of-living differences.

Is Income All That Matters?

• While income is important, other factors such as health, education, and civil liberties also contribute to living standards.

• Technological and knowledge advances can improve living standards even without significant income growth.

• However, there are limits to improvements in living standards if income remains stagnant.

What Determines How Fast Economies Grow?

• An economic growth model explains long-run growth in real GDP per capita.

• The key factor is labor productivity: the amount of goods and services produced per worker or per hour worked.

• Two main determinants of labor productivity:

  1. The quantity of capital per hour worked

  2. The level of technology

• Technological change is defined as a positive or negative change in a firm's ability to produce output with a given set of inputs.

Three Main Sources of Technological Change

1. Better machinery and equipment: Innovations such as the steam engine, machine tools, electric generators, and computers.

2. Increases in human capital: The accumulated knowledge and skills from education, training, and experience.

3. Better means of organizing and managing production: For example, the just-in-time system developed by Toyota, which improves efficiency by assembling goods as needed.

The Per-Worker Production Function

Definition and Properties

• The per-worker production function shows the relationship between real GDP per hour worked and capital per hour worked, holding technology constant.

• The first units of capital are most effective, leading to the largest increases in output per hour.

• Subsequent increases in capital result in diminishing returns: each additional unit of capital adds less to output than the previous one.

Example: In a pizza shop, adding a second oven increases productivity, but adding a twentieth oven when you already have nineteen adds little.

Technological Change Increases Output per Hour Worked

• In countries with low capital, increases in capital are very effective at raising real GDP per capita.

• In countries with high capital, technological change is more effective for increasing output per hour.

• Technological change is not subject to diminishing returns in the same way as capital.

• Long-run increases in living standards require ongoing technological change.

What Explains the Economic Failure of the Soviet Union?

• The Soviet Union, a centrally planned economy, focused on increasing capital stock but neglected competition and innovation.

• Lack of incentives for technological change led to slowing growth rates despite initial gains in output per hour.

New Growth Theory

• Developed by Paul Romer, new growth theory emphasizes that technological change is driven by economic incentives and market forces, not just random discoveries.

• Robert Solow's earlier model treated technological change as exogenous (outside the model).

Knowledge Capital

• Accumulation of knowledge capital (from research and development) is a key driver of economic growth.

• Physical capital is rival and excludable (private good), leading to diminishing returns.

• Knowledge capital is nonrival and nonexcludable (public good), leading to increasing returns at the economy level.

Government's Role in Knowledge Capital Generation

• Knowledge capital as a public good leads to free riding: individuals or firms benefit from others' investments in knowledge without paying for them.

• Governments can address this by:

  • Protecting intellectual property (patents and copyrights)

  • Subsidizing research and development (R&D)

  • Subsidizing education

Protecting Intellectual Property

• Patents: Exclusive legal rights to produce a product for 20 years from the patent application date.

• Copyrights: Exclusive rights for creative works, lasting the creator's lifetime plus 70 years.

Subsidizing R&D and Education

• Governments may fund research directly or provide tax incentives for private R&D.

• Subsidizing education ensures a technically skilled workforce, essential for innovation and growth.

Joseph Schumpeter and Creative Destruction

• Schumpeter emphasized the role of the entrepreneur in economic growth through creative destruction.

• New products and processes replace old ones, driving progress but also causing some firms to fail.

• Example: The automobile replaced the horse-drawn carriage, disrupting existing industries.

Economic Growth in the United States

• The U.S. experience illustrates how capital accumulation and technological change drive growth.

• Growth rates were modest before 1900, then increased with investment in research and development.

• Growth slowed after the mid-1970s but picked up in the mid-1990s.

Is the United States Headed for a Long Period of Slow Growth?

• There is debate among economists:

  • Optimistic view: Productivity is harder to measure, but long-run growth will continue to raise living standards.

  • Pessimistic view: Productivity growth has slowed since the 1970s, with only a brief boost from information technology.

Measurement Issues

• Growth in services is harder to measure than goods, possibly understating productivity gains.

• Improvements in convenience and quality (e.g., ATMs, internet) are not fully captured in GDP statistics.

The Role of Information Technology

• Technological advances (computers, communication) have driven productivity since the 1980s.

• Artificial intelligence (AI) may further boost productivity, though some economists are skeptical about future gains.

Secular Stagnation or Return to Faster Growth?

• Some economists (e.g., Larry Summers) argue that growth rates will remain low due to slowing population growth, less need for capital, and lower capital prices.

• Others believe investment will rebound, especially as the effects of recessions fade.

Why Isn't the Whole World Rich?

• The economic growth model predicts that poor countries should grow faster than rich countries (the catch-up effect).

• This is due to higher returns from additional capital and access to existing technologies.

The Catch-Up Predicted by the Economic Growth Model

• If poorer countries grow faster, they will converge with richer countries in terms of GDP per capita.

• However, not all countries have caught up, indicating other factors at play.

Evidence of Catch-Up

• Among high-income countries, those with lower initial GDP per capita have generally grown faster, supporting the catch-up hypothesis.

• However, many countries have not caught up, suggesting the model is incomplete.

Why Are Other High-Income Countries Not Catching Up to the U.S.?

• U.S. labor markets are more flexible, allowing easier hiring and firing.

• The U.S. is more willing to accept creative destruction and adopts new technologies quickly.

• The U.S. financial system is efficient and liquid, making it attractive for investment and supporting small firms.

Why Don't More Low-Income Countries Experience Rapid Growth?

• Key barriers include:

  • Weak institutions (lack of rule of law and property rights)

  • Wars and revolutions

  • Poor public education and health

  • Low rates of saving and investment

Weak Institutions

• The rule of law is essential for protecting property rights and enforcing contracts.

• Without secure property rights, entrepreneurs are less likely to invest and innovate.

• An independent court system is also important for economic growth.

Summary Table: Factors Affecting Economic Growth

Factor	Effect on Growth
Technological Change	Increases productivity, not subject to diminishing returns
Capital Accumulation	Raises output, but with diminishing returns
Institutions	Secure property rights and rule of law encourage investment
Education & Health	Improves labor productivity
Globalization	Facilitates technology transfer and investment

Key Formulas

• Growth Rate Formula:

$\text{Growth Rate} = \frac{\text{GDP}_{t} - \text{GDP}_{t-1}}{\text{GDP}_{t-1}} \times 100$

• GDP per Capita:

$\text{GDP per Capita} = \frac{\text{Real GDP}}{\text{Population}}$

• Per-Worker Production Function:

$Y = A \cdot F(K, L)$ Where $Y$ = output, $A$ = technology, $K$ = capital, $L$ = labor

Practice Questions

• What is the best measure of a country's standard of living? Answer: Real GDP per capita.

• If a country's real GDP is rising by 2% per year while its population is rising at 3% per year, what happens to its standard of living? Answer: The standard of living is falling.

• Which of the following is an example of foreign direct investment? Answer: An American airline builds a hub in China.

Additional info: This study guide expands on the provided slides and notes, adding definitions, examples, and formulas for clarity and completeness.