Economic Growth in the Developed and Developing Economies

Economic growth is an increase in the production of economic goods and services, compared from one time period to another. Economic growth is calculated as the annual percentage change in real GDP or in real per capita GDP, where per capita GDP is simply the GDP divided by the total population in a country. The real GDP per capita reflects the average standard of living of people in a given economy.

On the basis of economic growth, countries can be categorized into developed and developing economies.

Developed vs. Developing Countries

A developed country is a nation whose economy has highly progressed as indicated by a relatively higher GDP (and per capita GDP) as compared to other nations. It has a great technological infrastructure and a high rate of industrialization. Examples of such countries include the USA, Canada, Japan, and Australia.

On the other hand, a developing country is a country with a low per capita GDP and a low rate of industrialization. Examples of such countries include countries in Asia, Latin America, and Africa.

The table below presents differences between developed and developing economies in greater detail:

$$\small{\begin{array}{l|l|l|I|} \textbf{Basis for Comparison} & \textbf{Developed Economies} & \textbf{Developing Economies} \\ \hline \text{Unemployment} & \text{Low}& \text{High} \\ \hline
\text{Source of Revenue} & \text{Industrial sector} & \text{Service sector}\\ \hline
\text{Standard of living} & \text{High} &\text{Low} \\ \hline \text{Mortality rates} & \text{High} & \text{Low} \\ \hline \text{Income distribution} & \text{Equal}&\text{Unequal}\\ \end{array}}$$

The rate of growth (and level of the GDP) is determined by the following factors:

1. Savings and Investment

There is a direct relationship between savings and investments on one hand and economic growth on the other. For a country’s economy to grow, private and public sector investments must provide a sufficient level of capital per worker. 

If there aren’t sufficient domestic savings, a country needs foreign investment to spur growth.

2. Financial Markets and Intermediaries

The function of financial markets (such as banks) in an economy is to direct funds from the savers towards viable projects leading to economic growth. Financial markets achieve this by:

• Filtering those who seek funding while supervising those who successfully acquire the funds to make sure that they engage in projects that generate risk-adjusted returns.
• Promoting savings and risk-taking by constructing viable investment instruments.
• Reducing credit blocks that stand in the way for companies seeking capital.

Intermediaries such as investment banks, mutual funds, and insurance companies create financial instruments that attract investors by providing returns, liquidity, and opportunities for risk reduction.

3. Political Stability, Rule of Law, and Property Rights

A stable political climate, a well-established legal system, and property rights are all key ingredients for economic growth.

A stable political environment boosts both domestic and foreign investment. Such an environment assures investors that their capital is safe and that the right governance structures exist to ensure resources are used in an efficient and sustainable manner.

To attract capital, a country needs a well-developed system of both physical and intellectual property rights.

A functioning legal system protects the rights of everyone at all levels of production.

5. Free Trade and Unrestricted Capital Flows

An open economy is one that has little or no barriers to free-market activity. Goods and services are traded with other countries without rules or limits.

Opening up an economy to foreign investment provides an opportunity for financing domestic investments, which in turn boost domestic savings and income.

Foreign investment comes in two ways:

1. Foreign firms or investors can buy physical domestic properties or build plants, buildings, and equipment.
2. Foreign companies or individuals can invest in domestic financial assets such as shares and bonds, thereby giving local companies the capital needed to engage in production. 

6. Tax and Regulatory Systems

Limited tax regulations breed business activities and encourage the entry of new companies into a market, thus increasing the productivity levels of a country.

If the tax system is too strict, it could discourage entrepreneurial activities and the entry of new players into a market. This is often the case in some of the world’s poorest economies.

Factors Limiting Growth in Developing Countries

From the above discussions, the factors that limit economic growth in developing countries include:

1. Poor public education and health systems.
2. Political instability and lack of property rights.
3. The existence of tax and regulatory policies that discourage entrepreneurship.
4. The existence of restrictions on international trade and capital flows.
5. A corrupt and weak legal system coupled with the failure to enforce laws.
6. Existence of poorly developed financial markets.
7. Low rates of saving and investment.

It is important to note that these factors can be experienced in developed countries, but they are comparatively more common in developing countries.

Question

The government of a developing country is working to stimulate growth in its economy. It allocates more funds to education, infrastructure, and healthcare. However, the ministry of trade discourages foreign investment. Moreover, the legal system and private ownership have been ignored. Which of the following is most likely true about this economy?

1. Economic growth is unlikely.
2. The economy will grow at a faster rate than surrounding countries.
3. Unemployment in this country is probably low.

Solution

The correct answer is A.

If the government of this country invests in infrastructure, its physical capital will increase, which will in return increase labor productivity. Moreover, better education and healthcare policies will increase human capital and productivity, thereby spurring economic growth.

However, since the legal system is ignored, there will be problems in multiple areas, including property rights, international trade, foreign investment, and efficiency in the use of resources.

Therefore, economic growth is unlikely.

C is incorrect. Unemployed is probably high in this country since it seems to be a developing economy. Refer to the table above for further explanation.

Reading 7: Economic Growth 

LOS 7(a) Compare factors favoring and limiting economic growth in developed and developing economies.