Gross Domestic Product and Economic Growth

economics IN CONTEXT H as the growth in technological innovation affrcttd tht cconom'( as a whole? Yes, by increasing the productivity of the economy. labor productivity in manufacturing, icta11 and wholesale trade, financc, business services. and other sectors of the tconomy has risen as a rtsult of technological advances, 1mprovtd organiz.1tional practicts, and 1ncrca�d global competition. As we have leamcd, a more cffici,nt tconomy can product more output with a givtn amount of rcsourcts. The changts witne�d in the stecl industry excmplify thesc updates in production proec55es and management practices. The fundamtntal prore� of stcelma�ing remain much as they always were-: melting raw mattrial, forming it into an intermt'diate- product, and shaping and trHting that product to produce tht final good, But a numbe-r of technological advancts, many incorporating computtr lcchnotogy to measure, monitor, and control these processes, havt affecttd almost tvtry step in the production or stetl. As rec,ntly as 1990, ste,lm.iking invol\',d ,xtcnsivc manual control and setup and rtli,d htavily 011 operat0rs· experien�. observation, and intuition in dcttrm1ning how to control the process. Computer processing of data from sensors, using innovative software, has 1mprovtd the ability to control the process, allowing for taster, mort efficient operation. For example, the availability of computing power to quick.Iv process data has tnablcd steelmakers to redu� both energy consumption and wear and tear on the equipment. The setup for casting molten steel into an intermediate product haschangro from a process in which stVeral operators would •wale the line,• setting tht controls for every motor and pump, to one lll which a single operator uses an automatic control svsttm that synchronizes and sets tht equipment The rolling process now inco,poratcs sensors that constantly inspect the sttcl for deviations from the desired shape, allowing operitors to makt corrections before material is wasted. Optralors can remottly control the spttd and clearance of the rolls using computtr•controllcd rnot�rs to correct problems as they occur. The rtSutt or this computtr integration into stcelmaking has been a significant improvemcnt in st"lmaking performance. Togeth,r with other technological chang� such ilS larger furnaces and improvements in casting practic�, as well as the closing of ()Ider, Inefficient plant), the new technologies have C(lntributed t(I higher product quality and productivity, Steelmake� today requirt fewer than four worker-hours to produce a ton of steel, d(lwn fr(lm six work.er-hours in 1990. The best• performing mills can produce a ton of steel in less than one worker-hour. In tAs chapter, we will learn how producti\'ity influ�nces thr- performance of not onty a particular industry but also the «:onomy as a whole. Just as a doctor givt:s a physical uam to dtt:crmine how well a patient is, economists use statistics to gtt a quantitative mrasurc of the tconomy's pcriormance. This :hapter will introduce the broadest measure of tt"r total output of an tconomy-that is, gross domestic product-and discuss the factors that dttcrmine the long•run growth rate of an ttonomy. MEASURING AN ECONOMY'S OUTPUT The output of an economy includes millions of different gocds.We could tabulate how much of each product an economy produced in a given year: 3,600,224 houses, 2,436,789 radios, 40,987,345 apples, and so for1h.Although such data may be useful for some purposes, they don't accurately measure an economy's output. Suppose tha; next year, the output of houses Part J I h 1\lJrrt'lec "Ill >111v falls by 4 percent, rhe omput of radi05 falls by 8 percent, and the output of :apples rises by 2 percent. Has tot� output increased or decreased? By how much? We need a single statistic to measure the output of an economy. But how do we add up ::ill the houses, r:idios, :apples, and miUiom of other goods produced in an economy?To make such a calculation, we compute what is known as gro" domestic product.or GDP. GROSS DOMESTIC PRODUCT What exactly ii GOP? GDP is the market 11r1/ue of afl j,ial goods aml services prodmed withi,1 a cou11try i11 a giw11 year. All of the words in this definitior. are important. GDP Is the Market Value You have Likely heard the cxpresgon, "You can't conpare apples and oranges." However. GDP m�kesjmt such a comparison. COP combines th: diCferent types of goods and services that m economy produced into a single measure of ec:momic activity. To do this, it uses the total "market Y.llue" of 1he economy's output. Total market value means that we take the quantities of goods produced, multiply them by their respective prices. and add up the totals. For example. if an economy produced 200 apples at $0.20 an apple and 400 oranges at $0.15 an orange. the market value of these goods would be: Adding the market v.1.lue of all goods and services gives the total market value, or GDP.The reason we multiply the quantity of goods by their respective prices is that we cannot simply add the number of apples and the number of oranges. Using prices permits us to express everything in a common standard of valut:, in th.iii cast: tlullan. Of All Final Goods and Services GDP is a comprehensive measure of a nation's outpu1. It me:isures the muket VJlue of not only apples and oranges but also many other goods, such as jetliners, cilculators, :ind cloth­ ing. GDP also accounts for imangible services such a banking, engineering, medic:il, and legal services. When you purchase a video of your favorite rock concert, you are purchuing a good, and the purchase is part of CDP. When you go to a football g:ime, you :i.re buying 2 service, and the ticket price is :i.lso part of CDP. Note that only "final" goods and services :ire included in CDP. Many goods md services arc purchased for use as inputS in the production of ct:her goods. For ex:ample, McDomild's buys ground beef to make Big Macs. lfwe counted :he v:i.lue of the ground beef and the value of the Big Mac, we would be counting the ground beef twice, thereby overs�ting the value of the production. Fiml goods therefore are finished goods and services tha t are produced for the end consumer. Produced GDP measures the current production ofan economy.Many fimncial traruactions take plact:, but they do not directly genente current output, and so they must be excluded from GDP. These transactions include transfer payments such as welfare payments and So<.ial Security payments that the go\•ernment makes to individuals. The)' also include a college student's yearly subsidy from his family to finance his college educatbn. Moreover, purchases and sales of stocks and bonds are not part of GDP because they do not represent the production of new goods and services. Within a Country GDP includes the value of production within the boundaries of a country. ,vhen a Mexican citizen works temporarily in the United States, her produ::tion is put of U.S. GDP.When General Motors owns an assembly plant in Canada, the aut:>s produced at that plant are part of Canada's GDP rather than U.S. GDP. In a Given Year Because GDP is expressed as a rate of current production, goods produced in previous years are not included in this year's GDP. If you sell your 2006 Honda Accord to a relative. chis transaction would not be included in this year's GDF because no current production ha1 occurred. CHECK POINT 1. How do economists define gros.s domts­ tic product (GDP)? 2. What is the significance of the following definitional characteristics of GDP? a. b. c. d. Market value Final goods and services Produced within a country In a givtn year THE COMPONENTS OF GDP The GDP of an economy can be calculated by totaling the expenditures on goods and ser­ vices produced during the current year. National income aocountants refer to this method of calculating GDP as the c-xpenditure approach. When GDP is derived by the expenditure approach, its four components are (1) personal consumption expenditures, (2) gross private dome�tic investment, (3) government purchases of goods ar.d services, and (4) net expom to foreigners.1 Table 10.1 shows the components of GDP for :he United States in 2014. Let us examine each of these components. Penunal 1.u1uu111ptiun vxpt"11Jiturn (C) arc purcha;cs of final goods aJ1d services by households and individuals. Some items are durable goods,such as refrigerators, that last for a number of years. Nondurable goods are items that consumcn use soon after purchase, such as gasoline and food. Services include intangible items such as the services of mechanics and engineers. For the United States, personal consumption el'.penditurcs typically account for two-thirds or more of GDP. 1. GDP can also be derived by the income approach. This approach calculates GOP by adding together the income payments to the resource suppliers and the other costs of prodJcing those goods and services. Table 10.1 Gross Domestic Product, 2014 (billions of dollars) Comporient Amc,unt Percent of lotat Personal consumption expenditures 11,ll28 68 Goods Services 3,!:69 7,!:59 Gross private domestic investment 2,ESG fb(t:d investment {plant.equipment) 2,/65 Business Inventories 91 Government purchases of goods and services 3,175 Federal 1,219 State and local 1,956 Net exports of goods and services -538 Exports 2,334 lmpOl"tS -2,872 Gross domestic product 17,421 16 18 -2 100 Sour�: Economic Report of the President, 2015. ava· Jble- at htlp�:/lwww.whitehousc.qov/;idministraton/ eop/ctafttanomk. • report-of- the-President/2015. Gross priv.11e don1Hlic- inve,tnwnt (T), <:nmmnnly known as gross investment. con­ sists of all private-sector spending on investment. Gro!n investment includes the purchase of capital equipment and strucmres, such as an IBM assembly plant, as well as purchases of new homes by households, a type of capital good. Moreover, gross investment includes changes in business inventories during the year. When General Motors' automobile inventories increase from one year to the next, they are added to invcst1T.ent. Increases in business inventories represent goods produced durmg the current year that have not yet been sold to buyers in the market. Conversely, decreases in business invertories during the year are counted as negative investment. Gonrnr11ent purcluues of good� and 'icn1.('t'S (G) include spending on final output by federal, state, and loca l governme111s. .Each tank, filing cabintl, calculator, and desk purchased by government is part of the government purchases portion of GDP. Also included is the entire payroll of all governrnent1, representing the purchases oflabor services by governmen1s. Recall that government i::urchases exclude lr,rnsfer payments, such as welfare and Social Security payments, because l11cy do nol represent newly produced goods. Net exports (X-!Vf) are the last componeut of GDP. Sales of a counlry's goods and ser­ vices to foreignen during a particular tiine period re�resem iu exports (X). For Lhc Un..ilcd Scates, exports include lhe sa.k of m IDM compult:r L,:> a M�xic.an buyer or the purchase of a tick:et co Disneyland by a 1ourist frorn Germany. Pud1�cs of foreign-produced goods and services by a country's residcnu c;on.stitute iu imports tiW). U.S. import5 include the purchase ofanA..irbusjetlim:r by Unitc:dAirlinc:s,or a ltay in aTc,ronto motel by the New YorkYankees baseball team. Subtracting imporu from cxporu yields net e:xport5. . economics IN ACTION Why Are Some Countries Rich and Others Poor? There are great discrepancies in living standards throughout the world, as Table 10.2 makes clear. If we ask a simple question such as "Why are some economies rich and others poor?" w, get a simple answer: Rich economies have greater resources per capita-that is, they have more human capital [skills) and physical capital (machinery) and better technology. But this answer only begs another question: "Why do some economies have high levels of capital and technology, whereas others do not?' A nation's choice of institutions greatly influences its wealth and development. What separates the Tablt 10.2 e:onomic "haves" from the ·nave-nots" is whether a1 economy's institutions, especially its public institutions, facilitate or confiscate the production of wealth. What elements must a government put in place to allow an economy to take full advantage of the p:>ssible gains from trade? Economists note that a 11.ell-functioning economy requires a foundation of enforceable property rights, generally accepted a:e:ounting principles, sound financial institutions, a stable currency, and the like. Throughout the world, there are great disparities in these institutions, which tend to promote differences i11 living standards. Therefore, the question naturally a·ises: how ca11 a government create the sort of e1vironment in which people find it worthwhile to accumulate human and physical capital and carry out technological development. thus creating economic prosperity? Comparisons of Living Standards Throughout the World -------------Gross Nat1onai Income per Person· Country _ Luxembourg ·M,aiurrda1 p- _ 2014 2010 $59,642 $55,020 United States 55,860 48,880 Canada 43,400 39,280 Japan 37,920 34,650 Russia 24,710 19,860 Mexico 16,710 14,630 Sierra Leone 1,830 1,330 Ethiopia 1,500 1,060 iii.Ing wer pantf. As shown in Table 10.1, in 2014 foreign buyers purchmed $2,334 billion of goods and services from the United States.That same year,Americans J:urchased $2,872 billion ofgoods and services from foreign countries. The difference betweer: these two figures, -$538 billion, represents the net exports of the United States in 2014. Net exports were ne£{1tive because imports exceeded expom. Conversely, net exports would be positive if exports exceed imports. In the past three decades, U.S. net exports have consistently been negative. A Formula for GDP GDP is the sum of purchases in the four sectors of the -!:COnomy.Thercfore, we can write the following equation for GDP: ,IW c +1 (, .\ _\fl Applying this formula to 2014, the U.S. GDP equaled 517.421 billion. This equation is :t key clement .in :tn:tlyzing mac:oeconomic problem!; :tnd formu\:11ing m::icroeconornic policy. When econonllits :m:alyze the economy at large, they apply this equation ro predict the beh:1.vior of the major secton t1fthe economy: households, business, government, and foreign commerce. WHAT GDP DOES NOT MEASURE COP is our best single measure of the value of output r-roduced by an economy.Yet it is not a perfect measure.There arc several flaws in the construc1lon of GDP. First, GDP ignores trans­ actions that do not take place in organized markets. If you grow your own vegetables, repair your car, paint your house, clean your apartment, or 1ierform similar productive househ old activities, your labor services add nothing to GDP, bec�me no market transaction is fovolved Such nonmarket productive activities are siz�ble--l0 percent of total GOP or more GOP also ignores the underground economy in which unreported barter and cash transactions take place outside recorded market channels. For example, owners of flea mar­ kets m:i.y make "und�r the table" cash tr:m�ctiom wir.h their c.uJ.tnmers. The underground economy also includes transactions involving illegal goods and services, such as prostitution, g;imbling, and drugs.These illegal goods and services are find products that are not part of GDP. Estimates of the value ofthe transactions that take place in the underground economy are as high as one-third ofGDI� GDP does not value changes in the environment that arise through the production of output. Pollution and other aspects of indmtrial activity impose costs on society. However, these costs are not subtracted from the market value of final goods when GDP is calculated. For example, suppose that a chemical firm produces Sl million worth of output but pollutes the water and decreases its value by $2 million. Rather th:m indicating a loss co society, GDP will show a $1 millio11 increase GDP also excludes leisure, a good that is valuablt to each of us. Suppose that Canada achieves a $25,000 per-capita GDP, with an average W)rkweek of 35 hours. Germany might achieve an identical per-capita GDP with a 40-hour workweek. With regard to economic well-being, Canada is better off, because it generates additional leisl1re time while producing the same output per person. However, GDP does not ,ccount for this fact. Anorher problem of using GDP as a measure of wdl-bting is that it does not �how how much output is available per person. for cxample,supposc that Nigeria and Kuwait have the same GDP-say, $40 billion. Kuwai1 has a populdtion of2 m.irnon people, and Nigeria has a population of124 milHou people.Thi, suggests that pt:ople i.11 Kuwait will have more than 60 lilllc5 a� many goods per pcrsc,11. In Kuwait, the $40 billion GDP must be divided among 2 million people, resulting b $20,000 worth of GDP per person (.$40 billion / 2 million = $20,000). In Nigeria, h;:,wever, there is just $323 worth of GDP per person ($40 billion / 124 million= $323). The people in Kuwait, on average, are better off than the people in Nigeria,even though the total value of GDP is the same for both nations. The distribution of goods among differem people in a nation also poses a problem for GDP. If most of a nation's GDP is consumed by a very small fraction of the people, there will be few rich people and many poor people. If a nation's GDP IS more evenly distributed, however, the number of poor people will be smaller md the middle class will be larger. GDP is btind as to whether a small fraction of the citizenry consu:nes most of the nation's GDP or whether consumption is evenly divided. Finally, GDP does not reflect the quality and lcinds of goods that make up a nation's output Today, new cars are s1fer and more fuel-efficient than the automobiles of 30 years ago. Dental procedures are usually less painful than th ey \.Vere 20 years ago. Moreover, the efficiency ofthe workplace has improved as a result of new produces such as persona1 com­ puters, scanners, fax machines, and the Internet. In short, GDP is a qumtitative, rather than a qualitative, indicator of the output of goods and services. In spite of these limitations, GDP is a n:asonable estimate of the rate of output in the economy. GDP was never intended to be a complete mcasu1c of economic well-being or the happiJ1es:s of a nation's residents. Real CDP versus Nominal CDP We often want to compare GDP figures from year to year. Many people think that we are economically better off if GDP increases from one year to the next. However, we must exer­ cise caution when making such a comparison. So far, we have expressed GDP in terms of the prices existing in the year in which the goods and services were produced. Such an expres�on gives what is known as nominAI GOP, or current-dollar GDP. To make comparisons over time when prices are changing, we must adjust nominal GDP so that it reflects only changes in output and not changes in prices. Real GDP, or constant-dollar GDP, is nollUnal GDP adjusted to ehminate changes in prices. It measures actual (real) production and shows how :;ictual production-rather than the prices of what is produced-has changed. Real GDP is thus superior to nominal GDP for assessing the performance of the economy, especially rates of economic growth. Suppose, for example, 1hat in 2014 a computer costs $2,CXX). The identical computer in 2015 costs $2,200.When the computer ms counted as part of GDP in 2015, each computer added $200 more to GDP than it did in 2014. Even if the same number of computers were sold in 2015, GDP would have increased in 2015. The accua1 amount of goods available in 1he economy would not have increased, but the dollar value would have risen. The increase in the GDP would dius be the result of a rise in prices radu:r than an increase in output. When using GDP to assess growd1, we mu.st realize that pan of the growth d1at we observe may be the result of rising prices. In order to convert nominal GDP to real GDP, it is necessary to have a measure of price changes over the year:i:. Economists use a price index to adjust GDP figures so that 1he figures show only changes in actual output. The broadest price index used to calculate real GDP is called the GOP deflfltor.2 It equals c.he ratio of the cost of buying all fina1 goods and services in the current year to the cost of buying d1e identical goods at base-year prices. The GDP deflater is a weighted average of the prices of all final goods and services produced 2. In more technical jargon, tht GOP dtflator is known as the GDP chiin price index. This index is a moving average of a price lcvel's "dcflator" index calculated by a complex chain-weighted geometric mies. in an economy. consumer goods, business investment, government purchases of goods and services, and net exports. It is a weighted average because the various goods and services are not of equal importance. In the base year,the GDP defhtor has a value of 100. Current!)� the base year for the GDP deflater is 2009. Now let's calculate real GDP, or the GDP adjusted for price changes. To do so, we value the current-year output at the base-year prices.Thus, w:. divide the nominal GDP for a given year by the GDP deflater for elm )'ear, and then multiply that answer by 100. Table 10.3 shows the nominal GDP, real GDl� anc GDP deflater for the United States during the 2009-2014 period. Let us first calculate real GDP in 2009, the base year.To cal­ culate real GDP, we divide nominal GDP in 2009 {$14,419 billion) by the GDP deilator in 2009 (100), and multiply that answer by l00, as follow�: Real GDP in 2009 was $14,419 bill.ion, the same as nominal GDP in that year. In the base year, real GDP will always equal nominal GDP. Now we will calculate real GDP in 2014.To compi.:.te real GDP, we divide nominal GDP in 2014 ($17,421 billion) by the GDP deflator in 201, (108.3), and multiply that answer by 100. Therefore From 2009 to 2014, nominal GDP increased fror.t 514,419 billion to $17,421 billion. However, the GDP deflator increased from 100.0 to 108.3 over this period, which suggests an 8.3 percent increase in prices.To calculate real GDP in 2014, therefore, we must thus sub­ tract rhe incre ase in prices th.at occurred from 2009 to 2014.As a result, real GDP increased from $14,419 billion to only 116,086 billion over tlus period. This example illustrates the usefulness of real GDP as a measure of economic growth. lt 1s apparent that real GDP grew between 2009 and 2014, but not by a1 much as the growth in nominal GDP suggested. t;ourcr· F�onomir Ri ,ortof the Pres dent. 2015. availablr: at ht:ps:1/www.wh1teho1.1sr.qov1admin1stra1ion/ i:opfttaf,c:ono mic-rrport-of-thr-Prrside nti201 5. CHECK POINT 1. How do economists calculate GDP according to the expenditure approach? 2. What are the major weaknesses of GDP as an indicator of economic well-being? 3. Di;tinguish between nominal GDP and real GDP. Which measure of GDP is supe­ ric,r for assessing the performance of the ewnomy, especially rates of economic gr>wth? LONG-RUN ECONOMIC GROWTH In the p:nt 25 years, we have �een the development of man/ new products,such :u personal computers, cell phones, and fax machine.'I. Indeed, new products are a reflection of our eco­ nomic progress. Over rime, we produce not only more goods :md services but also new :md better goods and services.As a result, our material standard )fliving increases. A nation realizes eco110111ic growth when it increases i.� full production level ofoutput over time. Recall &om Chapter 1 that economic growth can be expressed in terms of the production possibilities model, When economic growth occun, a nation's production possi­ bilities curve shifts outward, or to the right. Economic growth is a long-rm1 objective that can be achieved over a period of time. Although economic growth suggests an increase in full production output over time, a more accurately definition is a rise in full production ouq:ut per perso11 over time. Suppose that output rises by 10 percent over time, but population grows at 12 percent over the same period. As a result, output per person would decrease. Eve:i with more goods and services available, the average person would be worse off. The Rate of Economic Growth Let us now calcuhte the rue of growth in :m economy. Th� rat• of �anomic- growth is the percent:ige change in the level of economic :ictivity from one year to the next.Typically, analysts look at the rate of growth in an economy's real GDP. The rate of economic growth is simply the change in real GDP between two periods divided by real GDP in the first period.To illustrate,supposethat in ye.u 1 rea1 GDP is Sl.000 and in year 2 rea1 GDP is $1,100. Hence, the rate of growth between years 1 and 2 would be: YC",1r2r 1ICIW· Yurlr,,tl(;llP Yc:-.1rlrc-Jl(J)!' S1 IDH S ii.IMO 11(10 11.l Thus, the rate of growth for the economy between yean 1 and 2 would be 10 percent. A useful rule of thumb can help us appreciate the power of growth rates. Suppose that you know the constant ra1e of growth ofreal GDP, but you wanted to know the number of years it will take for the level ofreal GDP to double.The answer is given by the rule of 70: Yl 1 tv,kubk--= P�·rc at. i:c tuowth r.nc . economics INACTION Produc u"ity Ga I"�: Work•ng T T ..I Compare America today with earlier times and one fact stands out: We live better. Give most of the credit to productivity. Through better productivity, we get more goods and services from every bit of work. Through it, we secure economic progress and earn bigger paychecks. We've taken plenty of our added productivity as material gains-more cars, bigger and better-equipped houses, sophisticated computers, and the like. Also, we: wod:: less. Over the past frw generations, the typical workc::r has gone from a six-day workweek with little vacation, to an average of 34 hours per workweek plus three weeks off. Indeed, the power of productivity has made the United States a rich nation. Consider these examples of productivity gains: With ATMs. electronic fund transfers, and the Internet, banks can handle more transactions using ft:wer tellers and support staff. Output per hour In commercial banking has doubh:d �im:t 1970. Electronic telephone switches have taken over much of the nation's long-distance and toll-call traffic. Calls per operator have risen from 17 per day in 1950 to about 2,100 today. Dr Pepper/Seven Up Bottling Group Inc. grew more productive by using huge machines that fill and package 800 bottles or 1,500 cans per minute, almost double the previous generation. Day in and day out, markets encourage companies to pu.sh for greater output per hour. Do the job faster, redu::e inputs, improve quality, and trim a few cents off the cost of production. The relentless march of productivity comes in myriad ways, limited 01ly by technology and human ingenuity. Indeed, as prod1..ctivity reorganizes the economy, it changes how we: use our innate skills and talents in the workplilct. Eilch generation of inventions produces tools to take on more of the tasks once done by human beings. Americ.1ns adjust by taking jobs that put OlX other talents to work. Over time, our work moves up a hierarchy of human talents, focusing on ne� tasks that require higher-order skills, ones that machinery can't do as well. By redefining tlie �ay we work, the economy creates a new a nd more productive mix of technology and human talents. =or example, workers once used muscle power to dig with picks and shovels. Over time, ever-larger digging and lo.iding machines have allowed a single operator to do what once required legions of laborers. This serves as a lesson for today's college students. Americans who want to prepare for the better jobs of thc: future sh)uld concentrate on developing skills that allow them to ascend the hierarchy of human talents. college education is a window of opportunity that can help you improve your producfa1ity. °' So11rcc:From W. Mchad Cox end Richard Alm, •A Better Way: Productivity and Rmrgani1ation in the: American Eronomy,• Federal Rc:sc:r,,e Bank of Dallas, pp, 3-23. 2003 Annual Repo.t, As an example, suppose that real CDP grew :i.t 3 percent a yen. Thus, it would t:ake :about 23 years for the real GDP to double (70 / 3 = 23 1/3). How fast cm the U.S. economy grow on :a smtainable OOsis? Most ma.imtream an:i.lysts believe that real GDP cm grow :ibout 2.5 percent per year. However, some analysts ha,·e asserted that much more npid growth, possibly as much :as 5 percent per ye:i.r, m:ay be sm­ t:1.in2ble.Tlie answer to this question h:as profound im?lications for the future well-being of the American people If the 1112im.rre�m view i1 corre:t, real output will double only every 28 ye:an or so �ccording to the "rule of 70." But if the alternative view is correct. real output could double every 14 years. WHAT DETERMINES ECONOMIC GROWTH The output level of :m economy is determined by the level of inputs 0:md, hbor, Clpital, ::ind entrepreneurship) used :md the production methods emphyed to com.,ert the inpms into goods :md services. Output c::in only be increased through additional inputs or more efficient rn:e ofthe av:.iilable inputs. How fast we can increase inputs i: limited, however: Land is essen­ tially fixed. Population growth and participation rates detern.ine the size of the labor force. In less-developed economies such as Ecuador or Honduras. a large fraction of inputs are underutilized and the level of c::ipital is usually low. These economies can grow rapidly by increasing inputs and/or increasing production efficiency-for example, by moving toward state-of-the-ut technology and raising the level of educaton. A deveJoped economy, such as the United States or Germany. which is starting from a higher level of input use and efficiency, has more difficulty sustaining high ntes of economic growth. Innovation :md in1provements in existing technology are the keys to increased growth rates. In the final analysis. the keys to long-run economic growth are the incentives that induce individuals to work and firms to invest in production techr.ology, within the limits imposed by demographics and the rate of technological advancement. Let us consider the major determinants of economic growth. Natural Resources The first pillar of economic growth is n:itural resources, vrhich are gifts of nature that are usable in the production process. Resources such as mineral deposits, land, forests, md riven come under th.is d::mi6cat:ion. Some natural rcsourcet, such u oil, are nonrenew::ible. Because it t:1.ke; nnure thousands of years to produce oil, there is a limited supply. When a barrel of oil is extracted &om a well, it is impossible to produce more. Other mtunl resources, such as forests, att renewable. When we cut down :i. tree, we c::in replace it by pl:mting a seedling in the ground to be harvened in the ye:i.rs ahead. Although countries rely on natunl resources as productive inpuu, a domestic supply of natural resources is not crnci:i.l for :m economy to produce goods :md services. For ex;imple, Japan is: a highly productive and wealthy nation. even tho:.igh it has few natural resources. International trade aUowsJapan to be a productive nation.Japan imports natural resources, such as iron ore and oil, and transforms them into steel. attomobiles. electronics. and other manufactured goods to be exported to nations that are abundant in natural resources. You may wonder whether natural resources are a limit to growth. lf the world has :a fixed supply of nonrenewable resources, how can production, population, and standards of living continue to increase in the years ahead? Won't the supplies of re$ources eventually dry up, thus halting economic growth and causing living standards to decrease? Although such arguments are appealing, most economis:s are optimistic about the econ­ omy's capacity to grow. They contend that technological progress often provides alternatives to the scarcity of resources. Comparing our current economy to that of yean ago, we see many ways in which resources are better utilized. More productive oil rig; have increased the amount of oil harvested from wells. Modern automobiles have more efficient engines that allow them to run on less gasoline. New houses are better insulated and require less energy to cool or heat them. The recycling of oil, aluminum, tin, rlastic, glass, cardboard, :and paper permit:s the conservation of resources.Technological progreis has also allowed us to substitute abundant resources for scarce resources. For example, plastic has replaced tin as an input used to manufacture food containers, and telephone calls often travel over fiber-optic cables that are made from sand. In short, technological progress bs contributed to the more efficient use of crucial resources. Physical Capital The second pillar of economic growth is increases in Fhyric:i.l c:ipit:il, which enable workers to produce more goods :md services. No muter how educ:ued workers are, they still need computers, machinery, :md other equipment to produce goods md services. Capital invest­ ment is thus a key deternUn:mt of both productivity :md growth. For ex�mp\e, when workers build hou�e. they use saws, hammers, electric drills, and other tools. Additional investment provides workers with more :md better tools Productivity incre�ses through capital investment lnve often involved exploiting econo-­ mies of large-scale production. Industries such as electricity generation, food processing, and beverage,; are ca�es in point. In the bever:ige industry, fur example. high-speed canning lines have raised productivity, but their contribution has been made possible in part by the devel­ opment of forge markers. To operate efficiently. these lines must produce nearly 500 nul.lion cans per year! Of course. investment is not a free gift of nature; a, opportunity cost is involved. When additional resources are used co produce equipment and manufacturing plants, fewer resources are available for the production ofament�consumpcioo goods such as hamburgers. However, those who save and invest will be able to produce mor: in the future. Besides the economy's private sector, government 1s also a source of physical capital for the economy. Historically, investment in public capital such as roads, bridges, airports, and u1ilities has made a significant contribution to the natiln's productivity growth. Such public capital is called infra,tructure. :i. Human Capital A tttird pillar of t:conomic growlii is la um.in \:illpitdl: lhe knowledge, experience, and skills of tht: workforct:. fu the economy li;as changt:d, the demands imposed on the brainpower of the Amcricm workforce have increased cnormomly. Increases in the hourly output of tht: average worker cu1 rt:Occt an improvement in the characteristics that allow workers to accomplish the same tasks in less time, to adapt to changing situations with greater Oexibility, and lo become engineers of change themselves. The importance of human capital can be seen in 1hc shipbuilding that took pbce dur­ ing World War II. Between 1941 and 1944, U.S. shipy:irds prnduced more than 2,500 uniu of a cargo ship, known as the Liberty Ship, to a standardized design. In 1941, i t required 1.2 million labor hours to construct a ship. By 1943,it required ortly 500,000.Thous:mds of workers learned from experience and :itt:ained hunan capit:il, more th:m doubling their productivity in two years. Providing individuals with a formal educ1tion is one w:iy to increase their hun1:111 capiul, thus contributing to aggregate productivity growth. Es:inute5 suggest that investment in U.S. education boosted U.S. labor productivity about 0.3 �ercent:ige points per year, on average, betv.•een 1963 and 1995. Another way of increasing human capital is tr:iining workers on the job. Research has found that companies tlut offer more triining enjoy higher rates of productivity growth. The returns to e duction, :is measured by the di·Te rence in incomes between college and high school graduates, have risen sharply i11 the \:st 20 ye:m.Today, the 3verage college graduate can expect to earn between 5 percent and 15 percent more than the average high school graduate. Much of this difference probably reflects the increasing importance of computer skills in the workplace. Moreover, the payoff from formal training, inclucUng apprenticeships, can be quite subsrnntial: A year of training typically provides returns of a similar magnitude to those offered by a year of formal schooling. Perhaps it would be worthwhile if you obtained a summer internship with a local employer. Productivity A fourth pillar of growth is greater producth·i1y.Economi1ts think of productivity as a ratio that measures the quantity of output produced relative to :he amount of work required to produce it. Mathematically, it appears as follows: Tot.1ltmtpu1 110111,w, k1 t An increase in productivity occurs when total output .ncreases faster than the amount of work required to produce it. For example, an increase in the quantity of output with no increase in hours worked would result in an increase in productivity.3 Rearr1nging the terms can help illustrate the signi6can::e of productivity for economic growth as follows: This shows that tota1 output depends on both work and productivity.Any increase in total output must come from an increase in either hours worked or productivity. As seen in Table 10.4, U.S. productivity growth has been erratic. During the 1960s, pro­ ductivity grew by 3.2 percent per yen. But during the next three decades, productivity growth fell to less thw 2 percent per ye:u only to improw at the turn of the century, and then weaken. Higher rates of productivity growth permit ri.ing real compensation for labor, as this table illustrates. What factors contribute to changes in productivity? Clearly, technological advance­ ment has much to do with productivity gains. During th� past century, the development of power-driven machmes such as tractors, improvements i:i transportation such as railroads and airlines, and the growing stock of computers have increased the productivity of workers. Obviously, technological advancement requires invention-that is, the discovery ofa new process or product.Yet it also encompasses innovation, the uccessful introduction and adop­ tion of a new process or product. Henry Ford did not in1ent the automobile; instead, he was an innov.itor who pioneered assembly-line production techniques that allowed workers to produce more automobiles in the space of an hour, resulting in falling costs for each automobile produced. Improving the productivity of the economy is not just a matter of improving technology. How the economy is organized plays an important role ir. creating incentives for firms to use their capital and labor as efficiently :1.s possible. lfthe maket economy is to deliver on its promise of growth and prosperity, markets have to be competitive, for it is competition that motivates firms co be efficient and innovative. Firms, however, often find it easier to increase 3. The most popular m�sure of productivity for tht U.S. economy is ave:rage labor productivity. Labor produc­ tivity is measurtd in terms of average output per hour. It is a ratio of the quantity of output to the hours of work done. The quantity of output is based on real GOP, as discussed in this chapttr. Table 10.4 Annual Rates of Growth in U.S. Labor Productivity and Real Compensation per Hour in the Business Sector, 1960-2014 Ytars Labor Producuv1ty Growth Rate (per year) Real Compcnsatlori p,r Hour G,owth Rati: (per year) 1960-1969 3.1<\b 1.9<\b 1970-1979 1.8 1.3 1980-1989 1.1 0.1 1990-1999 1.9 1.1 1000-2009 2.5 1.4 1010-2014 1.3 0.1 \rim,-.: Frnnrm1c Rl"portoft! PrNdenr. 2015. ava·labir at htlpo:.://wv.w.whitt.houst..l]ovfadm1ni�trat1on/ eo 1/Cf /,rnnomi, •rtpr t-ot-thr-Prt• r nt/201 i:; profits by reducing competition than by improving efficiency in response to competition. Monopolies and oligopolies nm only can charge inefficiently high prices ;:and restrict output, but also may Juve a diminished drive to innovate. Another source ofincreasing producti\'ity in the eccnomy is reorganization resulting from international trade. As competition forces producers co seek comparative advantage in the ma rketplace, resources shift m their best uses, creating a more efficient deployment. of L1bor in the economy. As the economy reorganizes to prodLce more, it also lowers prices relati\'e to wages, so that our pay checks buy more. Indeed, ir.ternatioml trade can be every bit as powerful as technology in making us productive. Trade's productivily gains provide among justification for open markc1s. Econom..ists widely agree that enonnous beneflls a.re losl when countries bow to their producers' narrow interests and enact proteCLionist 1m:a.sures Lhn block imports or raise their prices. Economists at Harvard University and the Fcdcn! Reserve Dank of New York ha,·e examined the sources of US. productivity growtli during the 1990s. They analyzed three classic sources of prodm.:tivity growth: capita.I investment, b.bor quality, and technological progress. They found that major gains came from Le:lmologica.l pmgrcss. Breaking down productivity even further, they found tl1at 44 pc1ccnt o:"the gains from technological progress were directly re.lated to productivity gdirn in the infonnation technology sector-including co1nputers, soft\V"Jrc, and c;onunu11icatio1u cquipmcnt.1 The Significance of Technological Innovation We have learned how technological gains result in increased productivit y. Over the long run, economjc progress in advanced countries such as the United States hinges largely on technological progress. Each of the grea1 industrial revolutions of the past \','.IS founded on innovation.The lace 1800s and early 1900s, for example, witnessed d1e invention and general usage of electricity, the radio, the telephone, the intermJ combustion engine, the automobile, lhe factory assembly line, and the airplane.The surge of innovation that took place in the late 1900s was powered by the mjcroprocessor, which ga,e rise to information technology and npid growth in productivity. 4. Dale Jorgenson and Keven Stlroh, Raising the �ed Limit U.S. iconomic Growth the: lnformotio11 Age, f'cderal Reserv� Bank of New York, May ,, 2000. economics IN ACTION Intel's Microprocessor and the Computer Revolution Th, computer revolution of the late 1900s is often cited as a source of economic growth. Indeed, increased computing power has raised the productivity of households, busines5's, and government What spurred the computer revolution was the development of the microprocessor by Intel Corporation. A microprocessor is a tiny electronic device that serves as an engine for computation. It consists of millions of transistors attached to a silicon chip as small as a fingernail. The microprocessor is often called a "computer on a chip." Intel's first microprocessor was produced in 1971 for use in handheld calculators. The chip contained 2,300 transistors and was capable of executing 60,000 operations a second. These calculators were very expensive and few people could afford them. However, advanced manufacturing techniques soon decreased the cost of manufacturing microprocessors. The low cost, small size, and modest power requirements of microprocessors soon led to their use in hundreds of other products besides calculators. These products included microwave ovens, digital watches, telephones, sewing machines, and video games. Microprocessors also made possible the computerization of store chtckout lines, bank records, gasoline pumps, medlcal instruments, and many other products that made the economy rnore productive. By the early 1980s, the microprocessor made possible the development of the personal computer. Intel saw great potential for its technological breakthrough. If a bundle of transistors could be made to fit on a silicon chip, ways could be found to double the capacity of a single chip, and then quadruple It. Intel's goal has been to double: the power of memory chips about every two years. E�rly microprocessors could execute up to 100,000 instructions pc:r second. Today, microprocessors carry out more: than 7 billion instructions per second. Because Intel was the first firm to produce rnicroprocessors, it could charge a premium price that resulted in large profit margins. By the 1980s, however, firms such as Motorola and Texas l11struments, as well as some Japanese companies, had developed their own microprocessors. Silicon c1ips thus became: a commodity, with many different c,mpanies manufacturing them. This resulted in lower chip prices and falling profits for Intel. T,e advent of competition has forced Intel to operate ai if it were a research institution. The: firm plows much of its profit into product development to stay ahead of the competition. Like a jogger running on an accelerating treadmill, Intel has to run faster just to maintain its position, and even faster to stay ahead of its competitors. s,urcc:s:Tlm Jackson, Inside: /ntc:l{Nc:w York: Plume: Books, 1997); Andre:w Grovt, Only tht!! Paranoid Suf'lliVt!! INe:w York: Dlubleday, 1996); T. R. Re:id, The Chip: How Two Americans ,�vented the Microchip ond Launched a Revolution (New York: Rmdom House, 1985). Growth without technological advancement winds up becoming sluggish. If an economy continues to produce the same goods even with modest imp:ovements, the result is stagnation. Without technological breakthroughs, the strategy of improving and refining existing pro­ duction methods runs into diminishing returns and eventualy fizzles out Simply put, it's the jump to a new technology, such as computers or perhaps solar power, that radically improves people's lives. If the pace of technological advance dwindles, there will be less need for college-educated workers. Jobs will be routinized, and companies will replace expensi\1e college-educated workers with cheaper workers with associate degrees or even less education. Companies ,vill also have greater incentives to outsource routine jobs to foreign workers, whose wages are a fraction of those of domestic workers.Advances in technology create better-paying jobs that require analytical reasoning, unagination, creativity, and people skills. Economists often quote an old saying:'There is no such thing as a free lunch."The notion is that you generally get what }t)ll pay for. Ho.....-ever, technological gains provide an excep­ tion 10 the free-lunch concept, furnishing a stimulus to growth and higher living mndards. Simply put. rising productivity makes it easier to pay for thing5 such as Social Security, better education, and other goods that improve our quality of bfc.s lbe Role of Government Without a doubt, the future nte of increase in an econ::imy's productive capacity will largely be dctcrm.incd by the decisions of millions of individual businesses :111d household, in the priv:ne sector of the economy. In addition, governmea- cm help promote the growth of an economy. Let us consider gover1unent policies that might speed up economic gmwth Boosting productivity by inm�asing domMliC' sa1i1ina. Historically, nations that have saved the most have also invested the most, and in1i1estment is strongly C'Orrelated with producti1i1ity. To stimulate national saving, government could reduce it\ spending, thus freeing resources to be used for investment. Government C"ou1d also induce the private sector to save more by providing tax incentives. • Improving the skills of the workforce. To help workers invest in skill acquisition, the gov­ ernment could adopt policies to promote lifelong learning. By funding basic education and by setting high standards in basic skills such as mathematics, science, and language, the govern­ ment could improve the nation's production capabilitifS. • Stimulating research and dnelo pment. Increasing irvestment in research and development is one way to promote technological Innovation and productMry growth. Since the 1800s, tht: US. government has sponsored ,esearch on agriculti.ral practices and advised farmers how best to manage their land. The government has also supported aerospace research through NASA. and the U.S. Air Force and has provided tax treaks for firms practicing rfiearch and development. • Working to reduce trade barriers. Economists have fcund that a country can raisi:: it� growth rate t:Jy increasing its opennt:ss to international trade, the education of ih people, and its supply of telecommunications infrastructure. The impact on growth can be as much as 4 perce:ntagi:: points for a country that progresses from significantly below the average to significantly above the average on alt of these indicators.6 As a result, economists genC'rally argue for the reduction of trade barriers and the opening of marlceb to global competition. • Improving the i::fficiency of r�ulation. In many cases, an improvement in government reg­ ulation can simultaneously promote the more effective attainment of policy objectives and increase the efficiency of the economy. For example, c traditional approach to the problem of reducing p ollution from the air might have entailed mcndatory investment in costly new pollu­ tion-reduction equipment by all polluters. Instead, a s�tem that is based on tradeable emissions ci::rtificates {see Chapter 8) can achieve the same results while encouraging the efficient allocation of pollution reduction amon g polluters. 5. Michael Mandel. Rational Exu�rancc (New York: HarperCollim, 2004). 6. The World Bank, World Development Repoa (Washington, D.C., 1999), p. 23. 1. Describe the concept of long-run eco­ nomic growth. How do economists measure the rate of economic growth? 2. Of what significance is the ·rule of 70" for economic growth? :J 3. Identify the major determinants of econcmic growth. 4. What policies might govtrnment enact to speed up economic growth? THEORIES OF ECONOMIC GROWTH The traditional theory of economic growth has its origins in the writings of Adam Smith, who wrote The Wealth of Nario11s in 1776.7 According to Smith, larger markets encounge individuals to specialize in different parts of the production process and coordinate their labor. In turn, specialization is the chief engine of increased productivity. It foster. produc­ tivity gains by aUowing workers to save time that would be lost in shifting from one type of work to another. In Smith's view, the inventive activity that improves production techniques is a by-product of specialization, because, as a worker concmtrates attention on one activity, time-saving inventions often come to mind. Simply put, Smith's principles of economic growth emphasized two resources-labor and capital. 'Technology is discussed, but only in a superficial manner. ln the early 1900s, economisu began formulating a diffc:�m theory of economic growth. Considering technological progress to be: witl1in the scope: of econom.ic tl1cory, lhcy began to view innovation and creativity as economic activities. This perspective on economics found its foremost advocates in a Harvard profcs.sor named Joseph Schumpctcr in 1942, and professor Paul Romer of Stanford University in the 1980s.8 Schumpelcr eorutructcd a theory ofeconomic growth ir. which technological innovation is the prime source of growth in a modern economy and pro6ts arc the fuel. I-le argued that what is most important about a capitalist market sy�tcm is precisely that it rewards change by allowing those who create new products and processes to capture some of the benefits of their creations in the form of monopoly profits. They provide entrepreneur,; with 1he means to (1) fund creative :ictivities in response to perceived opportunities; (2) ovetride the natura.1 conservatism of other par1ies who must cooperate with tht new product's launch as well as the opposition of those whose mnrkets may be harmed by the new products; and (3) widen and deepen their sales networks so that new products can b� quickly made known to :i large number of customer,;. Competition, if too vigorous, would deny these rewards to creators :md instead pass them on to consumers, in which case firms would h:ive scant re:ison to cre,.te new products. The drive to temporarily capture monopoly profit5 promote�, in Schumpeter's words, cr•ali�l' dettruction, :.s old technologies, goods, :md l.velihoods are replaced by new ones. Thus, where:is Smith s:iw monopoly profits :is :m indication of economic inefficiency, Schumpeter s::riw them as evidence of viluable entreprenemial :icrivity in healthy, dynamic :;i 7. Adam Smith, The Wealth of Nations (New York: Modtrn library, 1931). 8. Joseph Schumptter, Capitalism, Socialism, and Democracy {Ntw fork: Harper, 1942); and Paul Romer, •Economic Growth,' in David R. Henderson, ed., The Fortune Encyclapc/ia (�ew York: Warner Books, 1993). economy. Indeed. in Schumpeter's view. new techndogies and products are so valuable to consumers that governments of coun1ries should encourage entrepreneurs by granting temporary monopolies over innovations and inventiom. Given that technological innovation tends to provide benefits to consumers, why are the forces opposing it so strong? One factor limiting ttchnological innovation is that it puts existing products at risk. An example is the personal computer, whose power and speed have been rising at rnpid rates ror more than 20 years. In the competition to supply com­ ponents of che personal computer, such as modems md memory, any firm chat wants to play the game has to invest in creating new, faster, and smaller versions of the component. To earn profits and to justify this investment and its tu1certainties, the resulting innovation must leapfrog the competition by creating a new gentration. The first firm to market with the new generation can often grab the bulk of the entire market and, with it, almost all the profits to be had. Of course, this typically wipes om the profitability of the previous generation a.nd sets the stage for the next leapfrogger, who will then destroy the profits of the current leader. Also, being creative is inherently risky. You don't know what will work until you try it. Although successful new products may earn immense returns, others inevitably fail and create losses for their creators md supporters. An example of a product that was expected to fare well in the marketplace but did not was the Betamax, which looked like a tech­ nology winner to most experts when videocassette recorders were invented in the late 1970s. Beta was competing with VHS, and insiders knew that Sony had the opportunity to develop either Beta or VHS and had chosen Beta as the superior technology. But the corporations developing VHS were able to more rapidly lengthen videocassette playback times. Consumers who did adopt Beta eventually fomd chat they had to switch to VHS, as Sony was forced to abandon the system as a result of the greater availability of prerecorded videocassettes on VHS. Simply put, when consumers choose one system, its rivals may suffer irreversible setbacks, as the Beta system did. Moreover, VHS WJS being replaced by DVD systems by 2000. IS GROWTH DESIRABLE? Our analysis of economic growth in this chapter mak(s it appear to be bene6cia1. Is it? The main justification for economic growth is that 1t allows a nation to realize rising material abundance and increased standards of living. Expanding output and rising incomes allow households to purchase additional medical care education, recreation and travel, and higher-quality consumer goods. Gcowth is also an avenue for supporting more of the arts, including theater, music, and drama. The high hving standard that growth permits increases our leisure and provides additional time for �elf-fulfil.lnent. Growth also helps generate more resources for na:ional defense, police and fire protec­ tion, care of the disabled and sick, and improvements in our nation·s infrastrucrure, such as roads and communications. In today's world, the addit.onal jobs made possible by economic growth may be the onJy achievable method for dccrea;ing poverty, given society's reluctance to increase the amount of national income that it shares with the poor. Although economic growth may provide benefits, it can also entail costs. Some individuals maintain that additional economic growth results in more pollution, more Cl'owdcd cities, excessive emphasis on materialism,and psychological 1=roblcms that result in suicide ;ind drug usage. They contend thac the counLry would be bette1 off wilh less growth rali1er than with more.Wha1's wrong with a slower and more peaceful life? Antigrowth advocates :Liso contend that economic grov,th has not solved society's prob­ lems such as poverty, discrimination, and homelessness. According co the antigrowth view, poverty in the United States is largely attribuuble to the cfutribution oftbe nation's income rather than the growth of prociuction and income. To allc:vine poverty, society must be will­ ing to adopt policies 10 reclistribute income and wealth in favor of die poor rather t.han making investments in new technologies more profitable fer du: rich. Another concern is the relationship between econonUC growth and the availability of resources. Recall that many people argue th;it continued increases in population and the size of the economy will cause us to run out of scarce rciourccs. At some point, the time will come when there is uo more dean air and pure watCI, no more natun.l resources, and no more open 5pacc in which to live comfortably. As a result, die nation'5 living standard will decline. These people contend that we must reduce the rate of economic growth and Others argue that economic growth docs not cause th,�e problems. They maintain that growth brings about many favorable things such aJ hightr real income, less poverty, and greater economic security. Moreover, if the government would strictly enforce environmen­ tal laws, pollution would not be n major problem. Finally, vre :ire not running out of natural resources. If and when the scarcity of resources becomes a barrier to growth, the rising rela­ tive prices of these resources will force household,; to conserve them and develop alternative resources.As you c:m see, there :ire no simple :mswers to the question of the optimal nite of economic growth. This chapter has considered the U.S. economy's g�s Cornestic product and the role of economic growth. The next chapter will examine the imptcts of the business cycle, unem­ ployment, :md inflation on the economy. CHECK POINT Distinguish between the traditional the­ ory of economic growth and new growth theory. 3. ld�ntify some the of disadvantages economic: growth. Describe the principle of creative destruc­ tion. Why art: the fore� opposing creativity so strong? Chapter Summary 1. Economist5 have developed a single statistic to measure the output of an economy. This statistic is known as gross domestic product, or GOP. GDP is the market value of all final goods and services produced within a country in a given year. 2. The GDP of an economy can be calculated by totaling the expenditures on goods and services produced during the current year. When GDP is derived by the expenditure approach, it has four components: personal consumption expenditures, gross private domestic investment, government purchases of goods and services, and net exports to f o J i foreigners. For the United States, personal consumption expenditures are the largest component of GDP, typically accounting for two-thirds or more of GDP. 3. Although GDP is our best single measure of the value of the output produced by an economy, it is not a perfect measure of economic well-being. For example, GDP ignores transactions that do not take place in organized narkets. GDP also ignores the under­ ground economy as well as changes in the environrrent that arise through the production of output. Furthermore, GOP does not account for leisure, nor does it show how much output is available per person. Finally, GDP does not reflect the quality and kinds of goods that compose a nation's output. 4. Nominal GDP, or current-dollar GDP. is e)(pressed in terms of the prices existing in the yea r in which goods and services were produced. Real GDP, or constant-dollar GDP. is nominal GDP adjusted to eliminate changes in prices. It measures actual {real) production a nd shows how actual production-rather than the prices of what is produced-has changed. Real GDP is superior to nominal GDP for assessing rates of economic growth. 5. An economy realizes economic growth when it increases its full production level of output over time. The rate of economic growth is the percentage change in the level of economic activity from one year to the next. Typica 1y, analysts look at the rate of growth in an economy's real GDP. 6. lhe keys to long-run economic growth are the incentives that induce individuals to work and firms to invest in production technology, within the limits imposed by demographics and the rate of technological advancement. Ament the major determinants of economic growth are natural resources, physical capital, hunan capital, and economic efficiency. Government may enact policies to foster economic growth, such as boosting productivity by increasing domestic saving, stimulating research and development. working to reduce trade barriers, and improving tht:: t:ffidtnLy of rt'yulation. Guvemmt'nb rnay abu target and subsidize specific industries that might be especially important for technological progress. 7. According to the traditional theory of economic growth as pioneered by Adam Smith, economic efficiency is spurred by perfect competition. Traditional growth theory empha­ sizes two resources-labor and capital. Technological progress is viewed as being outside the scope of economic theory, and thus something that we accept as a given. 8. According to the neYJ growth theory, pioneered by Joseph Schumpeter, technological progress is within the scope of economic theory, and creativity is an economic activity. According to Schumpeter, ideas and creativity are the prime sources of growth in a modern economy and profits are the fuel. The drive to capture monopoly profits pro­ motes creative destruction, as old goods and livelihoods are replaced by new ones. Thus, whereas Adam Smith saw monopoly profits as an indication of economic inefficiency, Schumpeter saw them as evidence of valuable entrepreneurial activity in a healthy, dynamic economy. 9. Although economic growth may provide benefits for a nation, it can also entail costs. Critics maintain that additional economic groV1th promotes more pollution, more crowded cities, excessive emphasis on materialism, and psychological problems that 1esult in suicide and drug use. Economic growth may also cause the depiction of scarce resources, eventually resulting in a decline in the nation's standard of living. However, proponents argue that economic growth does not cause these problems; rather, it fosters higher real income, less poverty, and greater cconcmic security. Key Terms and Concepts gross domestic product (GDP) (236) price index (241) expenditure approach (237) GDP duter to Mary The purchases of new office equipment by the U.S. government Unemployment compensation benefits received bya former autoworker A new apartment building built by a construction firm Travel by people in Canada to the United States to visit Disneyland 2. Table 10.5 shows hypothetical GDP data for the United Statc::s. On the: basis of this information, calculate GDP. Tablt 10.5 Gross Domestic Product Data (billions of dollars) Govt:rnment purchases of goods and services 360 Compensation of employtes 210 U.S. import� of goods and services Interest and dividend income Personal consumption expenditures 40 23 720 Social security t:arnings 13 Gross private dom,stiC" investment 77 Household saving 12 U.S. exports of goods and servictS 2B Household taxes 45 6,079 97.3 6,244 100.0 6,386 6,609 102.6 105.0 3. Table 10.6 shows the nominal GDP and the GC>P deflator for the United States for selected years. On the basis of this information, calculate real GDP. 4. Assume that the average workweek declines by 20 percent because U.S. citizens decide to take life a little easier. How will this affect GOP for the United States? How will it affect the welfare of the United States? 5. Assume that the United States produces only radios and calculators. In 2001, it pro• duced 100 radios at a price of $25 and 50 cal cu ators at a price of $30. In 2005, the United Statc:s produced 120 radios at a price of$30 and 60 calculators at a price of $35. Calculate the nominal GDP for each year. 6. Why do economists prefer to compare real GDP figures for different years instead of nominal GOP figures? 7. !f real GDP is $8,880 'oillion and nominal GOP is $9,988 billion, what does the GDP deflator equal? 8. Suppose that GDP for a given year equals $9,650 billion. What does this mean? 9. Why would removing a barrier to trade, such as a tariff, result in more rapid economic growth? 10. Explain how higher saving can promote a faster r�te of economic growth.