6.1 The Relatively Recent Arrival of Economic Growth

Since the early nineteenth century, there has been a spectacular process of long-run economic growth during which the world’s leading economies, mostly those in Western Europe and North America—expanded GDP per capita at an average rate of about two percent per year. In the last half-century, countries like Japan, South Korea, and China have shown the potential to catch up. The extensive process of economic growth, often referred to as modern economic growth, was facilitated by the Industrial Revolution, which increased worker productivity and trade, as well as the development of governance and market institutions.

6.2 Labor Productivity and Economic Growth

Productivity, the value of what is produced per worker, or per hour worked, can be measured as the level of GDP per worker or GDP per hour. The United States experienced a productivity slowdown between 1973 and 1989. Since then, U.S. productivity has rebounded—the current global recession notwithstanding. It is not clear whether the current growth in productivity will be sustained. The rate of productivity growth is the primary determinant of an economy’s rate of long-term economic growth and higher wages. Over decades and generations, seemingly small differences of a few percentage points in the annual rate of economic growth make an enormous difference in GDP per capita. An aggregate production function specifies how certain inputs in the economy, like human capital, physical capital, and technology, lead to the output measured as GDP per capita.

Compound interest and compound growth rates behave in the same way as productivity rates. Seemingly small changes in percentage points can have big impacts on income over time.

6.3 Components of Economic Growth

Over decades and generations, seemingly small differences of a few percentage points in the annual rate of economic growth make an enormous difference in GDP per capita. Capital deepening refers to an increase in the amount of capital per worker, either human capital per worker, in the form of higher education or skills, or physical capital per worker. Technology, in its economic meaning, refers broadly to all new methods of production, which includes major scientific inventions but also small inventions and even-better forms of management or other types of institutions. A healthy climate for growth in GDP per capita consists of improvements in human capital, physical capital, and technology, in a market-oriented environment with supportive public policies and institutions.

6.4 Economic Convergence

When countries with lower levels of GDP per capita catch up to countries with higher levels of GDP per capita, the process is called convergence. Convergence can occur even when both high- and low-income countries increase investment in physical and human capital with the objective of growing GDP. This is because the impact of new investment in physical and human capital on a low-income country may result in huge gains, as new skills or equipment are combined with the labor force. In higher-income countries, however, a level of investment equal to that of low income country is not likely to have as big an impact, because the more developed country most likely has high levels of capital investment. Therefore, the marginal gain from this additional investment tends to be successively less and less. Higher-income countries are more likely to have diminishing returns to their investments and must continually invent new technologies; this allows lower-income economies to have a chance for convergent growth. However, many high-income economies have developed economic and political institutions that provide a healthy economic climate for an ongoing stream of technological innovations. Continuous technological innovation can counterbalance diminishing returns to investments in human and physical capital.