I. Asking the Right Questions
In a world of unbelievable wealth, widespread poverty exists. As Americans raised in one of the wealthiest societies in human history, we may fail to understand the nature of our situation. We see the television reports of extreme poverty in Bangladesh or sub-Saharan Africa – or even in Appalachia or Mississippi or Cairo, Illinois – and we ask "What causes such poverty?" Why are some countries, or some areas within our own country, so poor, when so many of us are so wealthy?
Younger Americans, especially, may not fully appreciate how wealthy they are. Even middle-aged Americans, such as your professor, have lived long enough to experience massive improvements in the material standard of living. Even I, a solidly middle-class American, was raised in a house that lacked running water and plumbing until I was six years old. Most Americans my age didn’t experience the pleasure of using an outhouse – most houses had indoor plumbing in the 1950s – but I was far from alone. A sizable minority of rural houses lacked plumbing even in 1960.
Now we see stories, such as one a couple of years ago in the Champaign-Urbana News Gazette, in which we are expected to feel sorry for a young preschool special-education teacher whose apartment rent consumes so much of her income that she can no longer afford to subscribe to all the specialty channels on cable TV. In all seriousness, the journalist who wrote the article presents this as a problem to be addressed by government.
Just how wealthy have we become? Here are a few statistics that might begin to answer that question. The following table shows the percentage of U.S. households that owned particular appliances in 1992. The percentages are now, of course, higher in all categories.
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| Clothes washer |
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| Dishwasher |
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| Microwave |
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| Radio |
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| Television |
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| Clothes Dryer |
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| Vacuum Cleaner |
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| VCR |
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| Personal Computer |
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Furthermore, in 1996 there were 63 telephones for every 100 Americans; 128.4 cell phones per 1000 people (that’s surely gone up a great deal since then!); 776 TVs per 1000 people; and 57 automobiles per 100 people. (These data come from Myths of Rich and Poor by W. Michael Cox and Richard Alm, pp. 97-98. They provide the same data for a number of other countries as well.)
Do such statistics make it safe to say that most Americans are, in a material sense, quite well off? In an absolute sense, the answer is surely Yes. But how does we measure up in a relative sense? To answer that question, we need to compare our current standard of living with the current standard of living in other countries and with the standard of living of our forebears.
Comparing standards of living across countries is difficult, partly because different countries use different moneys (dollars vs. yen vs. pesos, and so on) and partly because different climates have different requirements for living comfortably. Nevertheless, we can derive a reasonable rough measure of the standard of living across countries by looking at per capita GDP figures. Table 2 presents estimated per capita real GDP in U.S. dollars of 1990 buying power for a number of countries for the year 1992. Note the wide range of values across countries.
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Although one would probably find little difference between the standard of living of an "average" American and an "average" German, one would find an almost unimaginable difference between the American or the German and an "average" Ethiopian or Bangladeshi. In fact, most people in the world live on an income much closer to the average Ethiopian income than to the average American income. In short, most of the people in the world are poor.
Before asking, "Why are they poor?", you should realize that, until relatively recent times, nearly everyone in the world was poor. Such evidence as economic historians have been able to gather indicates that what is remarkable is not that the world houses so many poor people today but that it is home to so many wealthy people. Never before in the history of mankind has such a large percentage of the world’s population not been poor. Thus, from an historical perspective, the question we should be asking is, "Why are so many people wealthy today?" Or, if you prefer, "Why did some economies produce so much wealth over the last three or four centuries, when never in previous history had such an increase in wealth occurred?"
II. Historical Perspective
Sustained economic growth is a relatively recent phenomenon. Around the time of Christ, people throughout the world lived precariously. A drought (or an unusually severe flood) that reduced harvests frequently led to starvation for some of the poorest people. A two- or three-year drought meant widespread starvation for people in particular locations. Even in the Mediterranean world, where Rome reigned supreme, and where ships plied the Mediterranean Sea carrying grain from the fertile fields of North Africa (I’m not joking) to other parts of the Empire, famine was a very real possibility. In less-developed parts of the world, such as Europe north of the Alps or Africa south of the Sahara, life was a day-to-day, year-to-year struggle.
A thousand years later, conditions hadn’t changed much in most places. But by AD 1000 the Chinese had learned to harness the great rivers of China for use in growing rice. For the most part, the Han people (whom we today call Chinese) were reasonably well fed and clothed, although their rice culture was susceptible to disruption by floods. But they were the exception. Throughout Asia, Africa, Europe, and, we suppose, North and South America, famine was a specter haunting the land.
Over the next few centuries, the rate of technological innovation increased both in Europe and in China. The medieval European economy, bound as it was to feudalism and battered by political conflicts, did not seem a likely place for the growth of technology. However, innovations in agriculture, mining, metallurgy, and textile manufacture slowly but surely raised the standard of living. The Chinese progressed much faster. The Chinese educational system was superior, and the resources of a large imperial government were available to pursue ideas of merit. On the whole, the Chinese were well ahead of the Europeans technologically in the period 1000-1500.
Examples of Chinese Technology
Despite all these advantages, China failed to progress economically in subsequent centuries. In fact, by the 18th and 19th centuries, the Chinese had forgotten much of what they had known about technological processes a few centuries earlier.
Why did the Chinese economy stagnate? The primary reason seems to be that, to an unusually large extent, the development of Chinese technology depended on the support and encouragement of the Chinese government. Because of China’s peculiar "hydraulic economy," the economy had for centuries been centrally directed. That the system worked so well as it did is surprising. But when the emperors of the Ming and Manchu dynasties lost interest in technology, the government withdrew its support. The loss of interest may have resulted from a desire to maintain social stability. Economic growth, especially growth driven by technological change, is always a disturbing force. Perhaps the Chinese ruling class simply did not wish to incur the social costs of continued growth. Certainly, the xenophobic attitude displayed by the Chinese in the 18th and 19th centuries indicates their preference for social stability.
The Rise of Europe
As China began a slow decline into economic stagnation, the pace of economic growth quickened in Europe. Unlike the majestic Chinese Empire, Europe was a hodge-podge of relatively small political units, created and frequently re-created from the feudal realms that arose during the Middle Ages. Frequently hostilities broke out among states, and for several centuries, wars may have been more common in Europe than anywhere else in the world.
Ironically, the competition among kingdoms produced one beneficial effect: Competition enhances economic efficiency. States that wished to be European powers had to promote economic growth. Thus, with frequent, temporary setbacks, European governments instituted policies that favored their productive citizens. Laws that had, for political and religious reasons, suppressed markets were replaced by laws that acknowledged property rights – the right to use personal property as the owner saw fit, within broad limits. Governments also developed commercial law and the court systems needed to enforce the laws. This promoted honesty in trading and encouraged more people to trade.
In the wake of the Renaissance and the Protestant Reformation, a new dedication to scientific discovery and a new ethic of personal responsibility arose. Both contributed to the increasing pace of technological innovation and business creation. Even warfare itself contributed to economic gain, as European military might was used to colonize large areas of the Americas and Asia. (African colonization came later.) European shipping was unparalleled, enabling the Dutch and British, in particular, to sell to world markets.
The inventions that drove European growth after 1500 were mostly what Joel Mokyr (author of The Lever of Riches) calls "microinventions" – improvements and adaptations of ideas discovered previously. New agricultural techniques increased food supplies. Small, but cumulatively important, innovations in shipbuilding gave rise to faster, safer, larger, more mobile ships. The winds and water were harnessed more effectively because of improvements in windmills and waterwheels. Slow but cumulative gains were made in textile production, mining, metallurgy, optics, and mechanics. Slowly but surely these technological improvements raised the European standard of living far above what it had been only a couple of centuries before. To modern people, used to continual improvements in the standard of living, this might not seem like much. To the Europeans living in the 16th, 17th, and 18th centuries, the improvements were wonderful to behold.
Why Europe? The simplest answer may be that more individual freedom existed there than anywhere else in the world. Individuals had real possibilities in Europe, thanks to the growing respect for human liberty. Freedom brought prosperity.
III. Thinking About Growth
Our framework will be summarized by a simple equation: Y/L = A . F (K/L, H/L).
In this equation, A represents "ideas," or technology in a very broad sense. Formally, economists call A total factor productivity. It is a measure of how much output per worker is forthcoming from the quantity of factor inputs being used. F(.) is a function. It says that Y/L depends on the factor inputs K/L and H/L.
K stands for physical capital, such as plant and equipment. The more physical capital per worker, the more the average worker should be able to produce. H stands for human capital, the skills and training that enable workers to solve problems and work effectively. More highly trained workers – workers with more human capital – should be able to produce more output than unskilled workers. K and H are "things" that affect production.
The growth equation separates the factors affecting growth into two categories: Ideas and Things. Economists who attempt to model the growth process have discovered that this is a fruitful way to consider the forces affecting economic growth.
Ideas can be used simultaneously by many people. An idea is like a recipe. Many different bakers can use the same recipe at the same time, even though they cannot all use the same material inputs or ovens. Ideas can be shared. Because of this, good ideas can produce large effects on output per worker. Huge numbers of workers can benefit from the same good idea.
Things can be put to only one use at any given time. An oven is extremely important to cake production, but adding a single oven will have a limited effect on the well-being of all bakers in the economy. Since things cannot be used by everyone at once, they have smaller effects on Y/L. (See Paul M. Romer, "Theory, History, and the Origins of Modern Economic Growth," AEA Papers and Proceedings, May 1996: 202-06.)
An Example
Suppose Y/L = A.(K/L).5(H/L).5, where raising a factor to the power of .5 is taking the square root of the factor. Also suppose that A = 2, K/L = 2, and H/L = 2. Then Y/L = 2 x 2.5 x 2.5 = 4 (since the square root of 2 times the square root of 2 is 2).
Now, let’s increase one of the "things." Suppose K/L rises to 3. Y/L = 2 x 3.5 x 2.5 = 2(1.73)(1.41) = 4.9. Increasing K/L by 50 percent increases Y/L by 22.5 percent. If we had instead raised H/L to 3, the same result would have occurred.
Now, instead of increasing a factor input (a "thing"), let’s increase total factor productivity, our measure of technology (our "ideas"). If A increases from 2 to 3, Y/L increases to 3(2.5)(2.5) = 3 x 2 = 6. What does this demonstrate? A fifty percent increase in technological knowledge produces a 50 percent increase in Y/L. Improvements in "ideas" have the potential to increase output per worker by more than increases in "things."
Why? Because ideas can be shared. Ideas are "non-rivalrous goods," in the jargon of economics. Because many people can use an idea at once, a really good idea can have immense effects on output per worker. This is why Joel Mokyr calls technological innovation "the lever of riches." Just as a lever increases the force a person can apply to an object, improved technology increases the effectiveness of factor inputs ("things") in producing outputs.
Three Growth Processes
Economic growth is not a simple process driven by a single cause. Economists who have studied economic growth have located a number of different sources of growth. We will concentrate on three processes. Even as we separate growth into three growth processes, you should realize that, in the real world, all three processes interact.
1. Solovian Growth
Growth that is driven by investment in physical capital or investment in human capital is called Solovian Growth. In the 1950s, MIT economist Robert Solow developed a mathematical model to describe such a growth process, hence the name. As we have seen, increases in K/L or H/L provide workers with more physical or mental capital with which to work, thereby increasing output per worker.
Capital investment is necessary for any type of growth to occur. Even if the growth process is being driven by technological innovations, those innovations typically make their way into the production process in the form of better machines (or at least different machines). New ideas usually lead to investment in capital.
High rates of investment can lead to strong growth for extended periods. For example, during the 1950s and 1960s, the West German economy invested heavily in physical capital, raising the K/L ratio dramatically. Output per worker grew apace. Similarly, the Soviet Union achieved some of the highest growth rates in the world from the 1950s into the 1970s by investing heavily in "heavy industry" – steel production, oil production, coal production, and various other industries that used lots of steel, oil, and coal. In 1961, Nikolai Khrushev, while speaking before the General Assembly of the United Nations, took off his shoe and pounded it on the podium, declaring "We will bury you." He meant that the Soviet Union would bury the West economically, since the USSR was growing so much faster than the western economies.
However, investment-driven growth has one serious drawback: diminishing marginal productivity. The principle of diminishing marginal productivity states that increasing one input while holding other inputs constant will eventually result in smaller and smaller output gains from additional units of investment. Thus, the Solow growth model predicts investment-driven growth will slow over time. Of course, that’s exactly what happened to the Soviet economy in the 1980s. Growth basically evaporated – at a time when the U.S. economy was beginning to grow faster than it had in years. This led to rather severe political problems for the Soviet leadership.
The Asian Miracle(?)
The fastest-growing area in the world from around 1960 to about 1995 was the Pacific Rim. Not only Japan, the most-productive economy in the East, but Taiwan, South Korea, Hong Kong, and Singapore grew at astounding rates. Per capita growth rates of 6-to-8 percent per year enable an economy to double its standard of living every nine-to-twelve years. In less than three decades, the "Asian Tigers" turned themselves from poor countries into relatively wealthy economies, knocking on the door of "first-world" status.
The spectacular growth of the Asian Tigers led to a spate of books on the "Asian miracle." Some writers argued that cultural factors underlay the Tigers’ success. Asian workers were believed to be more disciplined and harder working than western workers. Others argued that the Asian style of management was the source of their great success. Nearly everyone predicted that, within a couple more decades, the Asian economies would surpass the U.S. economy.
In 1993, while the Asian Tigers were still flying high, economist Alwyn Young published research on the sources of Asian growth. Using data on investment in physical and human capital, output, and population growth, Young demonstrated that nearly all of the Tigers’ gains in output per worker could be explained by increases in K/L and H/L. In other words, the Asian growth was investment driven, just like the earlier Soviet growth. Young argued that the Tigers had been able to grow so rapidly because they had increased all inputs simultaneously. They devoted nearly 40 percent of output to capital investment (forgoing consumption); they doubled their years of schooling; and they doubled their labor force participation rates, thus expanding the number of workers. But such doubling of inputs could not continue. Labor force growth was slowing already; so were the percentage increases in K and H. Thus, Young predicted, diminishing marginal productivity would set in, and the Asian Tigers’ incredible growth rates would fall.
Professor Young was, of course, correct. Growth rates of Pacific-Rim economies were falling even before the financial crisis of the mid-1990s threw the economies into a deep recession. After some initial indignation, the leaders of the Asian Tigers admitted that their growth had been input-driven. But they argued that much of their investment had laid the groundwork for increases in total factor productivity in the future. If that doesn’t occur – if A doesn’t grow – Asian growth will indeed be slow in the future.
2. Smithian Growth
The patron saint of economists is the Scottish moral philosopher Adam Smith (1723-1790). In his masterpiece on economics, An Inquiry into the Nature and Causes of the Wealth of Nations, Smith investigated the manner in which nations generate economic growth. Smith wrote before the first industrial revolution, and his theory focused on commercial expansion – economic growth driven by increasing trade in growing markets.
Smith’s theory is based on the concept of the division of labor. Smith understood that small workshops, which were the typical industrial enterprise in the 18th century, were not very efficient. Workers had to perform multiple tasks, and they were rather slow in performing them. If smaller workshops could be replaced by a single factory, labor productivity would increase. Each worker could specialize in one task, thereby becoming extremely proficient at that task. In combination with other workers, the quantity of output that could be produced would rise dramatically. Smith illustrated this in the first chapter of The Wealth of Nations with his example of the pin factory.
In modern parlance, Smith was focusing on economies of scale. He recognized that producing larger quantities could reduce the per-unit cost of production. In other words, the average total cost curve falls as output in a single factory is expanded. The catch was that the larger quantity of output had to be sold. It does no good to produce huge quantities of pins cheaply if only a small portion of the pins can be sold.
If a firm was to engage successfully in large-scale production, it had to have a market large enough to absorb the goods produced. Thus, Smith recognized that efficient was likely to take place in large cities or in locations with access to relatively cheap transportation, i.e., seaports.
In Smith’s terminology, the division of labor is limited by the extent of the market. If markets can be extended by increasing the demand for the product; through population growth; or through innovations in transportation that reduce the cost of shipping the product, then more-efficient production processes can be used. Greater efficiency leads to economic growth.
Example
The Dutch, in the 17th century, and the English, in the 18th, demonstrated the power of market expansion to stimulate economic growth. Both the Dutch and English were master sailors. They opened trade between Southern Asia (the "Spice Islands") and Europe by sailing around the Horn of Africa into the Indian Sea. There they acquired (by fair means or foul) the spices so desired by Europeans in an age lacking refrigeration. Both the Dutch and the English became wealthy by operating a re-export business: Shipping in huge quantities of spices and (later) tea, breaking them down into smaller units, and re-exporting them at a large profit. These profits were plowed back into the shipping trade and used to build up businesses in the Netherlands and England. The Scots built up Glasgow in the same manner, trading tobacco.
A somewhat more problematic example was the explosive growth of the British textile trade. The First Industrial Revolution occurred in England in the opening decades of the 19th century, and cotton textile manufacturing was the industry that revolutionized production.
English spinners and weavers had been working cotton in the West of England for decades. Mostly rural peasants, the spinners and weavers worked on farms during the planting and harvest seasons. But during the down times in agriculture, they spun yarn or wove yarn into cloth in their homes. Small-time capitalists would purchase the raw cotton to be spun and provide it to the spinners, paying them at a piece rate for their work. They would carry the spun yarn to the weavers, also paying them piece rate for their weaving.
The invention of water-powered looms enabled the capitalists to move the weaving operation into factories, where they could better control the quality of the cloth being produced. Water-powered looms were much larger than hand looms, so the scale of operation increased greatly. Now, this isn’t a clean example of Smithian growth, because a technological innovation started the process. But the greater efficiency of water-powered textile mills enabled the English textile industry to increase the production of cotton goods many times over. The English mills could produce far more cotton than the English market could absorb. But, of course, England occupies an island, and water transportation was (and still is) the most efficient transportation on earth. So the British marketed their cotton textiles around the world, generating a huge increase in the size of the market and speeding economic growth in Great Britain.
Smithian growth appears in the output equation as an increase in A. Factor inputs are used more efficiently, and output per worker increases.
3. Schumpeterian Growth
In 1912, the Austrian economist Joseph Schumpeter wrote an influential book describing yet another growth process. Schumpeterian growth is growth driven by increases in knowledge. These increases in knowledge include technological innovations proper and changes in institutions that revolutionize the ways goods are produced or marketed.
Technological innovations come in two forms. Process innovations improve the efficiency of producing goods or services. That is, they lower the costs of production. The water-powered cotton looms discussed above are an example of a process innovation. Product innovations result in new or improved products that partially or completely replace existing products in the market. An example of a product innovation is the cassette tape and cassette player, which entirely displaced 8-track tapes and largely displaced reel-to-reel tape players.
Examples
The invention of the microchip created whole new industries. Not only do we have a flourishing computer industry, but our houses are filled with all sorts of electronic devices that use microchips as the "brains" to perform various tasks. The invention of the microchip completely destroyed the vacuum tube industry over the course of a few years. This was an example of what Schumpeter termed "creative destruction." The creation of a new product led to the elimination of another industry.
Today, fiber optics is revolutionizing telecommunications. Over time, ordinary phone cable will be replaced with fiber optic cables that carry far more information. This has already occurred to a significant extent. Fiber optics open up the possibility of information transmission on a scale never before contemplated, at prices much lower than thought possible. A large fiber optics industry already exists, and it is growing rapidly.
On an entirely different plane, the development of markets in Europe in the late Middle Ages revolutionized the way goods are produced and distributed. As markets grew in geographic penetration and efficiency of exchange, the self-sufficient feudal system gave way to an interdependent system based on trade. The consequences for Europe were immense. Markets opened up possibilities never contemplated by serfs on the great manors of Europe, unleashing creative powers that had lain dormant for centuries.
Schumpeterian innovations increase Y/L by increasing total factor productivity, A. Since innovations in knowledge are non-rival goods – ideas – they can be shared widely and can have huge effects on economic growth.
As we saw in Economic Growth: Background, growth is not automatic. For more than a millennium, China was the most technologically progressive nation on earth. Then, sometime after 1400, the Chinese economy began to lose its creativity. By 1600 it was becoming technologically stagnant. By 1800, China was technologically backward compared to Europe. Of course, the pattern in Europe was just the opposite. Technological creativity had risen in the 12th and 13th centuries, subsided in the 14th century (devastated by the plague), and resumed in the 15th century, becoming more rapid over time.
Joel Mokyr lists three conditions for technological creativity.
We will consider these conditions in turn.
1. Cultural Factors
Mokyr’s first condition might be termed "cultural factors," since it gets at the manner in which individuals in the society view their condition in life. Cultural traits that are conducive to technological creativity include the following:
2. Institutional Factors
The institutions of society – the laws, habits, and behavioral patterns that frame the way we interact with one another – are vitally important to the success of an economy. Institutions can either promote personal initiative, creativity, and interaction or thwart them. Two particularly important economic institutions are the following:
The Importance of Markets
Markets provide incentives for people to use resources efficiently. Acquiring productive resources is costly. Just how costly depends upon the prices at which different resources sell. The price system induces producers to utilize those resources that are relatively most abundant – that have the lowest relative prices – while leaving the relatively scarcer resources – those with higher relative prices – to their most valuable uses. Efficient production enables the economy to produce a greater value of goods and services than inefficient production.
Economists have understood the resource-allocation benefits of the price system since the time of Adam Smith. But it wasn’t until the 1930s and 1940s that an Austrian economist named Friedrich Hayek pointed out another major positive aspect of markets.
Hayek argued that markets enable traders to make use of huge amounts of dispersed knowledge. Each of the producers and consumers in a market know particular things that no one else knows, but no one knows very much about the particular conditions prevailing in the entire market.
Every person working in a firm understands certain elements of the production process in a way that no one else does. Much of this personal knowledge is tacit; the person with the knowledge cannot articulate it and so cannot explain it fully to others. However, the person is capable of making use of the knowledge. The genius of the market is that it brings together the knowledge of millions of market participants in the form of prices and quantities.
Without markets, most of the knowledge in the economic world would go unused. In effect, the knowledge wouldn’t exist. Thus, it is fair to say that markets transmit and create knowledge. The market is a discovery process.
3. Diversity and Tolerance
Technological innovation is a disruptive process. It alters the status quo, overturning the power of the social elite and establishing a new elite. Many societies are unwilling to tolerate such constant social upheaval. Consequently, the ruling classes in such societies attempt to suppress technological innovation. Thus, technological advance occurs primarily in societies that are willing to tolerate change and the strange sorts of people who promote change.
The leader in this area in early-modern Europe was the Netherlands. The Dutch were, at that time, largely a homogeneous people. Devout Calvinists, the saw everything they did through the lens of the Bible. They were called to do their best for the glory of God. But devout as the Dutch were, they were extremely tolerant of both social mobility and of foreigners who wanted to share in the political and economic freedom that the Netherlands afforded. Thus, the Dutch Republic was largely controlled by merchants and manufacturers, who promoted the institutions on which economic growth thrives. Furthermore, the Netherlands acted as a magnet for those in other European nations who found themselves persecuted either for their success or for their beliefs. French protestants (Huguenots), Jews and others streamed into Amsterdam and other Dutch cities and contributed greatly to the inventiveness that made the Netherlands the world’s premier economy in the 17th century.
The importance of tolerance should not be underestimated, as a quotation from George Gilder’s Wealth and Poverty (p. 109) makes clear:
One of the little probed mysteries of social history is society’s hostility to its greatest benefactors, the producers of wealth. On every continent and in every epoch the peoples who have excelled in creating wealth have been the victims of some of society’s greatest brutalities. Recent history has seen, in Germany, the holocaust of Jews; in Russia, the pogroms of Kulaks and Jews; in northern Nigeria, the eviction and slaughter of Ibo tribesmen, in Indonesia, the killing of near a million overseas Chinese; in China itself, the Red Guard rampages against the productive; in Uganda, the massacre of whites and Indians; in Tanzania, their expropriation and expulsion; in Bangladesh, the murder and confinement of the Biharis. And as the seventies drew to a close, much of the human wealth and capital of both Cuba and Southeast Asia was relegated to the open seas.
The foregoing suggests a three-point summary of what we have learned about the conditions necessary for economic growth.
1. Necessary institutional framework. This includes at least the following:
a. Political stability. Economies cannot function if society is riven constantly by political strife, revolution, or civil war.
b. Meaningful property rights. People will take risks and engage in productive activity only if they enjoy most of the fruits of their activities.
c. Tolerance of innovative behavior. Innovation requires change from the status quo. A society that represses change won’t be innovative and won’t grow.
2. Proper incentive structure. Of especial importance is
a. Reward for risk taking
3. Efficient way to develop and utilize knowledge. In a practical sense, this boils means
a. Market determination of prices. Without market prices, resources will be misallocated, and entrepreneurs will lack the information needed to respond to the wants of consumers.
Perhaps no American industry better illustrates the growth process than the automobile industry. American mechanics began producing automobiles before the turn of the century. The Duryea brother of Springfield, MA, who were bicycle mechanics, built a carriage driven by a one-cylinder engine in 1893. By 1899, many individuals and some thirty companies had build around 2,500 automobiles. Important producers included Ransom Olds (father of the Oldsmobile); the Dodge brothers, Horace and John, who made transmissions for Olds and later became partners with Henry Ford; the five Mack Brothers of New York, who produced their first truck in 1900; the Studebaker Brothers of South Bend, IN; Walter Chrysler, who worked for General Motors until 1919 and later started his own company; and, of course, Henry Ford himself.
(1) During the first phase of automobile production, the market was highly fragmented. In 1909, at the peak of the fragmentation, some 274 companies were manufacturing cars in the United States, mostly with low volumes, high margins, and high prices. Production took place in factories that essentially were collections of workshops. Auto production was still a craft, and the targeted consumer base was small but wealthy. Cars were becoming more than toys, but nothing resembling a mass market existed.
The second phase began when Henry Ford revolutionized the production process. Ford’s revolution began with a vision for what the automobile market could be and what the automobile itself should be. He believed that the car could be a mass-consumer product, that the average working person could be put behind the wheel of an automobile. But he also knew that, to accomplish such a market transformation, he would have to standardize automobile design and construction and develop a new production process.
(2) Ford’s solution to the product problem was the Model T – "the ultimate standardized machine." Extremely simple – small, light, and strong – it contained the barest minimum of moving parts. Production of the Model T was carried out on an assembly line. Ford demanded that all parts be manufactured precisely, so that perfect interchangeability enabled workers to assemble cars rapidly. The results were remarkable. In October 1913, it had taken 12 hours, 28 minutes to assemble a chassis. In the spring of 1914, with the assembly line, it took 1 hour, 33 minutes.
(2) Ford’s giant Highland Park, MI, plant employed more than 15,000 in 1915. The plant’s work force eventually grew to more than 65,000 workers. To reduce labor turnover, Ford instituted the "five-dollar day," paying more than twice the going rate for mechanical labor. He also shortened the day from nine to eight hours, and eventually cut back the workweek from six to five days. In exchange for all these benefits, Ford expected "strength-sapping, mind-numbing" work, which, before the "generous" wage increase and reduction of the work day, had led to an annual turnover rate of 300-400 percent.
(2) Ford’s production process catapulted Ford Motor Co. into a class of its own. Ford’s costs were so much lower than its competitors’ costs that Ford could sell its cars at prices dramatically lower than its competitors’ prices. [Draw ATC curves and explain.] Henry Ford believed that the only thing that kept working families from buying a car was a high price. So he lowered the price. In 1908, a Model T sold for $850. By 1912 the price had dropped to $600, by 1920 to $440, and by 1924 to only $290. Ford ruled the auto industry.
Ford’s development of the assembly-line process is an instance of Schumpeterian creative destruction. With its drastically lower costs, Ford drove most competing auto manufacturers out of business. To build his huge assembly lines, Ford invested large sums in a conveyer system to move the growing auto along the assembly line and in machinery to manufacture many of the standardized parts that went into the Model T. Thus, a Solovian growth process was also underway. Finally, by greatly increasing specialization and thereby reducing costs, and by paying a wage high enough to enable workers to purchase a Model T, thereby extending the market for cars, Ford generated Smithian growth.
(3) General Motors, under the direction of Alfred P. Sloan, began its assault on Ford’s market position first by emulating Ford’s production techniques. GM established assembly-line operations and standardized all parts production. GM costs then came into line with Ford’s. This illustrates an important fact about the real-world process of economic growth: Not all companies use the same technologies. At any given time, one or two companies will have cutting-edge technologies, while all the rest of their competitors will be using technologies that are far inferior. Until the competitors catch up, the leaders will enjoy a large cost advantage and will earn the profits that go with such a cost advantage.
(4) Having matched (or nearly so) Ford in production efficiency, Sloan’s GM went Ford one better. Sloan developed the technique of market segmentation and used it to sell differentiated, flashier GM cars to people who had previously owned Fords. All Model T’s were black; black paint dried faster than any other. But had du Pont Chemical Co. invented colored lacquer that dried quickly. GM began offering its cars in different colors. Furthermore, GM offered several model lines, beginning with Chevrolet at the bottom, and proceeding upward through Pontiac, Oldsmobile, and Buick to Cadillac. These cars shared many of the same parts, which held down production costs, but they gave customers a choice.
(4) Car buyers liked choice. In 1917, Ford had a 42.4% of the U.S. market, while GM had an 11.2% share. By 1937, Ford’s share was down to 21.4%, while GM’s was up to 41.8%.
(4) GM’s development of a segmented market is another example of a Smithian growth process. The total market for GM products was extended, and GM achieved economies of scale in several product lines at once. GM’s contribution to Schumpeterian growth was Sloan’s development of the multi-division organizational structure. No such corporation existed before. Sloan’s genius, in creating a single corporation with multiple divisions, was to give individual division chiefs a lot of responsibility and then hold them accountable for the profitability of their divisions. Thus, Schumpeterian innovation can be institutional, as well as technological.
(5) The growth of the American auto manufacturing industry provides an excellent example of how our three growth processes intertwine. Since it was an industry that was large relative to the size of the U.S. economy, growth of the auto industry was important to the growth of the U.S. economy as a whole.
As our bedtime story indicates, economic growth is a disruptive, messy process. As Schumpeter said, it is a process of creative destruction.
The economy doesn’t simply get bigger, adding more and more of what already exists. Rather, it changes qualitatively as it expands quantitatively. New industries arise and displace old industries, thereby displacing the workers who earned their living from the old industries, while at the same time creating new jobs and new opportunities for those looking for employment.
Source for Bedtime Story: Thomas K. McGraw, ed., Creating Modern Capitalism: How Entrepreneurs, Companies, and Countries Triumphed in Three Industrial Revolutions (Harvard U. Press, 1997), Chapter 8: "Henry Ford, Alfred Sloan, and the Three Phases of Marketing," by Thomas K. McGraw and Richard S. Tedlow.
In 1870, U.S. real GDP per capita (in 1985 dollars) was $2,244. This gave Americans one of the highest standards of living in the world. Not the highest, mind you – the British enjoyed a per capita real GDP of $2,693 in 1870 – but still enough to attract immigrants from all over the world. Over the next 120 years, U.S. per capita real GDP grew at an annual rate of 1.76%. By 1990, U.S. per capita real GDP had reached $18,258. In the UK, real GDP per capita had grown a bit slower, at 1.36% per year. The result was a 1990 income of $13,589.
Obviously, 0.4% difference in the growth rate makes a huge difference, given enough time. Compounding builds incomes much faster if the growth rate is even a little larger. Thus, we can infer that policies to increase the growth rate even a little bit are important.
Any wealthy economy must have many of the basic institutions needed for growth; otherwise, it would not have become wealthy in the first place. The most important institutions are those that accompany true economic and political freedom: property rights and markets.
A government that wishes to encourage growth should encourage risk taking. Both process and, especially, product innovation are risky endeavors. Most attempted innovations fail. Those economies that grow tend to have many innovators, so that some innovations succeed, even as most fail. Governments can encourage innovation in a variety of ways. One of the most important is by establishing and protecting patents and copyrights that enable successful innovators to reap the rewards from their innovations for a period of time. Monopoly profits are a strong incentive to product innovation. Another way innovations may be encouraged is by reducing the taxes of firms that engage in research activities.
Governments should also promote competition. Frequently this means that the government itself should not create monopoly situations by preventing firms from competing in particular markets. Antitrust actions against firms that attempt to "buy up the competition" may also increase competition. However, innovation is driven by profits, so a government shouldn’t be too eager to hamper innovative firms simply because they are earning large profits. If these firms are in dynamic markets, their monopoly profits won’t last long, even if the government does nothing to reduce them.
Many governments of wealthy nations themselves invest heavily in research and development. Basic research – "science" – often can be better carried out by government funded projects that link numerous private organizations together than by any single firm. Universities play an important role in the growth process in the United States. After basic innovations have been made – "macroinventions" – the development phase of R&D typically is best left to the firms that can find ways to make use of the new knowledge.
Since economic growth of any type requires investment, another way a government can encourage growth is to encourage saving. If all income is consumed, nothing is left to invest in productive capital. This applies to human capital as well as physical capital. The acquisition of skills and training must be financed, just as the acquisition of machines and buildings must be.
Finally, governments can contribute to growth by maintaining low inflation rates. Studies have shown that high inflation retards economic growth. What is high? No specific cut-off between "low" and "high" inflation exists, although it’s clear that even a 10 percent inflation rate doesn’t seem to have significant negative effects on growth. However, inflation of 20% or more is another matter. Inflation reduces the efficiency of the price system. Firms don’t understand what price changes mean. Has demand for a particular product increased (increasing relative price), or has spending in general increased, forcing all prices upward? In the first case, the firm should respond by producing more; in the second case, it probably should not produce more. The confusion created by such price movements leads firms to make more mistakes, reducing efficiency and economic growth.
Poor economies generally have many problems that wealthy economies overcame decades, if not a century or more, ago. A major problem throughout Africa, parts of Asia, and much of Latin America has been political instability. An economy cannot thrive if a nation is torn by political strife. Thus, the first priority in promoting economic growth is to establish political stability. (By the way, that doesn’t mean democracy in the form to which Americans are accustomed. Economic freedom is important, but governments that are a good deal more autocratic than the United States’ government have permitted enough economic freedom to promote tremendous growth. Three examples are Singapore, South Korea, and Chile.)
The second step, after establishing political stability, is to allow markets to work. Governments must set the rules by which market participants play, but the economy is more likely to prosper the less the government is directly involved as a market participant. In particular, central planning stunts growth, the experience of the Soviet Union during the 1950s-1970s notwithstanding. The Soviet economy produced a lot of stuff, but, as we eventually learned, it wasn’t stuff that the Soviet citizens wanted. That hardly qualifies as economic growth.
Since most poor countries have autocratic governments, an important step toward wealth creation is reducing bureaucratic control over the economy. India, for example, has the potential to develop into a medium-income country, perhaps even into a high-income country. They have more than enough labor, and a significant portion of the labor force is well educated. Indians who have emigrated to the United States and other developed countries have proven to be extremely productive workers and, frequently, extremely effective inventors and entrepreneurs. The simple truth is that the Indian bureaucracy stifles creativity in their own country.
Economic research has demonstrated that economies that are open to international trade grow faster than those that are closed. International trade appears to enhance growth by increasing the rate at which better technologies are acquired and utilized. Trade brings contact with foreigners who are familiar with the superior technologies, making technology transfers easier and more likely. Trade also increases competition within economies, thus encouraging domestic firms to produce more efficiently.
Since investment in physical and human capital must be financed, and many poor countries find it difficult to accumulate savings, it is important that the government not squander the economy’s savings through deficit spending on "consumption goods." Government’s may borrow justifiably to invest in public capital goods, such as roads, water and sewage systems, and harbors. But government spending on goods that do not contribute to future production amounts to a waste of savings.
Finally, economic research has also shown that a sound financial system contributes to economic growth. Poor economies have no need for an ultra-sophisticated financial sector such as that found in the United States. However, a sound banking system is very important. Banks encourage ordinary people to save by providing safe, liquid assets for savers to hold. The funds collected by issuing savings and checking deposits can be used to finance investment. Well-regulated banks operating on a profit-making basis tend to increase saving while channeling credit to borrowers who propose to engage in profitable ventures. In this way, banks not only increase investment, they help to allocate funds to the most-profitable projects, thereby increasing the overall efficiency of the economy.
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