Growth policy
What governments can do to raise productivity, from saving and education to property rights, trade and research, and the debate over population.
FinanceA company's marketAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Explain diminishing returns and the catch-up effect
- List the policies Mankiw discusses for raising growth
- Weigh the arguments about population growth
Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.
A company's market: pricing power, taxes and trade: lesson 14 of 15
- A company's market
- Price elasticity of demand 6 min
- Elasticity and total revenue 5 min
- Consumer and producer surplus 4 min
- Market efficiency 5 min
- Price ceilings and floors 6 min
- Who really pays a tax 5 min
- Deadweight loss 5 min
- How tax size changes the loss 5 min
- Absolute and comparative advantage 5 min
- Why trade helps both sides 5 min
- Winners and losers from trade 5 min
- Tariffs and quotas 5 min
- What makes productivity grow 5 min
- Growth policy 5 min
- Why unemployment exists 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 12
What it is
Saving and investment. Capital is produced, so a country can build more by saving more and investing it. But that means consuming less today: a trade-off between the present and the future.
Diminishing returns. As capital per worker rises, each extra unit adds less output. So a higher saving rate raises growth for a while, but as capital builds up the extra growth fades. In the long run, a higher saving rate leads to a higher level of productivity and income, not permanently faster growth.
The catch-up effect. Because of diminishing returns, an extra unit of capital adds more in a poor country, where workers have few tools, than in a rich one. So, other things equal, countries that start poor tend to grow faster. Mankiw's example: from 1960 to 1990, the United States and South Korea invested a similar share of GDP, but South Korea grew far faster (over 6% a year against about 2%), partly because it started poorer.
Quick check
Tap an answer to check it.
Two countries raise their saving rate by the same amount. One is poor, one rich. Which should see the bigger boost to growth, other things equal?
- Diminishing returns mean extra capital adds less where there is already a lot
- Higher saving raises growth at least for a while
Show answer
The poor one: extra capital adds more where there is little. The catch-up effect.
Why it matters
Policies Mankiw discusses for raising growth:
- Investment from abroad. Foreign direct investment (a foreign firm building and running a factory) and foreign portfolio investment (foreigners buying shares or bonds) add capital. Some of the income goes back abroad, but workers get more capital to work with. The World Bank, set up with the IMF after the Second World War, lends funds from rich countries to poorer ones for roads, schools and other capital.
- Education. It raises human capital and may have positive externalities: an educated person can spread ideas to others. Poor countries also face a brain drain when educated workers leave.
- Health and nutrition. Healthier workers are more productive. The economic historian Robert Fogel suggested that better nutrition was a significant factor in long-run growth.
- Property rights and political stability. Markets work only if people can trust that contracts will be enforced and their property won't be taken. Corruption, weak courts and coups discourage investment.
- Free trade. Mankiw notes that most economists favour outward-oriented policies; South Korea, Singapore and Taiwan grew rapidly by trading with the world. Trade works like a technology that turns one good into another.
- Research and development. Knowledge is largely a public good: once found, others can use it. Patents, research funding and tax breaks encourage it.
Population growth: a debate.
- Thomas Malthus (1766–1834) predicted that population would always outrun food, keeping people in poverty. Mankiw notes this has been wrong so far, because technological progress raised food output faster than population.
- A fast-growing population dilutes capital: more workers share the same capital and schools, so capital per worker falls.
- But a larger population may also promote technological progress, since there are more people to make discoveries.
Worked example
Diminishing returns in numbers. Output per worker as capital per worker rises (made up):
| Capital per worker | Output per worker | Extra output |
|---|---|---|
| 1 | 10 | — |
| 2 | 16 | 6 |
| 3 | 20 | 4 |
| 4 | 22 | 2 |
- A poor country moving from 1 to 2 units of capital gains 6.
- A rich country moving from 3 to 4 gains only 2.
- The same investment raises output three times as much in the poor country: the catch-up effect.
Text description
A curve of output per worker against capital per worker, from the worked example: 10 with 1 unit of capital, 16 with 2, 20 with 3 and 22 with 4. The curve rises but flattens: the second unit adds 6, the third 4 and the fourth only 2. That is why extra capital raises output more in a poor country than in a rich one.
Common mistake
Thinking a higher saving rate raises growth forever. Because of diminishing returns, it raises growth for a while and leaves the economy at a higher level of income; long-run growth then depends on technological progress.
Key terms
- diminishing returns
- the benefit from an extra unit of an input falls as the quantity of the input rises
- catch-up effect
- countries that start poor tend to grow faster than countries that start rich
- foreign direct investment
- capital investment owned and operated by a foreign entity
- foreign portfolio investment
- investment financed with foreign money but operated by domestic residents
- brain drain
- the emigration of many of a country's most highly educated workers
- public good
- here, knowledge that, once discovered, others can use too
- property rights
- the ability of people to control and use what they own
Practise the key terms
Tap a card to turn it over. 7 cards.
| Front | Back |
|---|---|
| diminishing returns | the benefit from an extra unit of an input falls as the quantity of the input rises |
| catch-up effect | countries that start poor tend to grow faster than countries that start rich |
| foreign direct investment | capital investment owned and operated by a foreign entity |
| foreign portfolio investment | investment financed with foreign money but operated by domestic residents |
| brain drain | the emigration of many of a country's most highly educated workers |
| public good | here, knowledge that, once discovered, others can use too |
| property rights | the ability of people to control and use what they own |
Practice
Work it through
Using the table: a country with 2 units of capital per worker adds one more unit.
- From the table
- From the table
- 20 − 16
- 4 ÷ 16 × 100
Quick quiz
Tap an answer to check it.
In the long run, what does a higher saving rate change, in Mankiw's account?
- Diminishing returns make the extra growth fade
Show answer
The level of productivity and income, not the long-run growth rate. Long-run growth then depends on technological progress.
Why is research and development often supported by governments?
- Most research is private; the public-good feature means there may be too little
Show answer
Knowledge is largely a public good: others benefit from discoveries they didn't pay for. Patents and funding help encourage it.
What was Malthus's prediction, and how has it fared?
- Malthus feared population growth
Show answer
Population would outrun food; so far, technology has raised food output faster. Technological progress has kept ahead.
In short
- Saving and investment build capital, but diminishing returns make the growth boost temporary.
- Poor countries can grow faster: the catch-up effect.
- Policies: foreign investment, education, health, property rights and stability, free trade, research.
- Population growth can dilute capital or spur ideas; Malthus's gloomy forecast has not come true so far.
Mastery check
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Check yourself
Answer in your head first, then open the answer. Nothing is saved.
What are diminishing returns?
Show answer
Each extra unit of an input adds less output than the one before.
Name the two kinds of investment from abroad.
Show answer
Foreign direct investment and foreign portfolio investment.
In the worked example, how much extra output does the move from 1 to 2 units of capital bring?
Show answer
6.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 12.
- On this site: What makes productivity grow.
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