Economic Growth

The sustainability of economic growth is measured by the rate of increase in productive capacity and/or by the potential gross domestic product of the economy.

Sources of Economic Growth

The growth accounting equation emphasizes the main factors that determine growth. These include such factors as technology, capital, and labor. As a result, this neglects other important factors such as natural resources and human capital inputs, which also play a major role in economic growth. Therefore, we can list the main sources of economic growth as discussed below.

Physical Capital Stock

This refers to the accumulated amount of equipment, machinery, and buildings used to produce goods and services. Physical capital increases annually for as long as net investments increase.

Labor Supply

The growth in the number of people available to work is an important source of economic growth.  Note that the size of the labor input can be measured by the number of hours available for work. This is calculated as:

$$ \text{Total hours worked} = \text{Labor force} × \text{Average hours worked per worker}$$

Human Capital

This refers to the accumulated skills and knowledge that workers acquire through training, education, and experience. It gauges the quality of the workforce. For instance, an educated and skilled workforce produces more and can easily adapt to new technologies that emerge over time. Consequently, this factor is improved by investing more in education and on-the-job training.

Natural Resources

Divided into renewable (replenished after use, e.g., a forest) and non-renewable (depleted upon usage, e.g., oil and coal) energy sources.

Technology

This refers to the process employed by companies in the transformation of inputs into goods and services. Technological advancements refer to the discoveries that play a role in producing more and higher quality goods and services. Technological advancements give an economy the capacity to overcome the limits imposed by the effects of diminishing marginal returns.

Measures and Sustainability of Economic Growth

The growth rate of an economy depends on the rate at which technological advancements, labor forces, physical and human capital, and natural resources grow. Therefore, these forces can be summarized to the GDP equation as follows:

$$ \text{Growth in Potential GDP} = \text{Growth in technology} + W_L  + W_C$$

Where:

\(W_L\) = Growth in labor

\(W_C\) = Growth in Capital

Example: Measures and Sustainability of Economic Growth

Assume that the labor percentage share in national income is 75% for a specific country. The growth in technology, labor, and capital are 1%, 2%, and 3%, respectively. Calculate the growth in potential GDP.

 Solution

Using the equation:

$$ \text{Growth in Potential GDP} = \text{Growth in technology} + W_L  + W_C$$

Then,

$$ \text{Growth in potential GDP} = 1\% + (0.75\times2\%) + (0.35\times3\%) = 3.25\%$$

Productivity Brought by the Labor Force

There is no observable data on potential GDP or total-factor productivity (TFP). We, therefore need estimated data for both potential GDP and total-factor productivity (TFP). Therefore, we can alternatively focus on the productivity brought by the labor force since there exists data on labor, calculated as:

$$ \text{Labor productivity} = \frac{\text{Real GDP}}{\text{Aggregate hours}}$$

From the above formula, it is easy to see that labor productivity can be defined as the number of goods and services, that is, the real GDP, that the workers can produce in one hour.

With the same number of workers, the economy will produce more goods and services if labor productivity increases. Also, with rapid growth in productivity levels, more goods and services get produced by the same number of workers. Hence, labor productivity can be used to approximate the rate of sustainable growth in the economy. Potential GDP can be calculated as:

$$\text{Potential  GDP} = \text{Aggregate hours worked} \times \text{Labor productivity}$$

The above equation can be transformed into growth rates as follows:

$$\text{Potential growth rate} = \text{Long-term growth rate of labor force} + \text{Long-term labor productivity growth rate}$$

Question

Which of the following parameters can most likely be measured directly from observed data?

A. Potential GDP.

B. Labor productivity.

C. Total-factor productivity.

Solution

The correct answer is B.

Labor productivity can be calculated directly as output/hour, whereas potential GDP and total-factor productivity need to be estimated.