What you should know about growth

1. Basic facts about economic growth
2. The drivers of growth rates and levels
3. The drivers of productivity growth
4. Rich countries and poor countries

This is my attempt to distill the material in this course into a set of relatively simple statements and claims without resorting to any math. If you know these, then you have a great baseline set of knowledge about how economic growth works. If you understand why these hold, then you have a deep understanding on why economic growth works.

The material is broken up into several subsections that align with material in the course.

Basic facts about economic growth

The level of GDP per capita and the growth rate of GDP per capita are different things.

Be careful to distinguish which one of these we are talking about. A high level doesn’t mean a high growth rate, and vice versa. Very often, a low level makes it easier to have a high growth rate. When my daughter was born, the level of her height was low, as she was only like 2 feet tall. The level of my height was high, 6 feet. But the growth rate of her height was much higher than mine.

Rich countries have a high level of GDP per capita and consistent growth rates of about 1-2% per year in GDP per capita, and that rate can persist for many decades.

“Many decades” can mean 150 years. The average growth rate of GDP per capita in the United States has been like 1.8% per year since 1870, at least.

Middle income and poor countries have a lower level of GDP per capita than rich countries. They also have average growth rates of about 1-2% per year in GDP per capita, meaning they are not catching up to rich countries. They also are more likely to have big fluctuations in growth rates year after year, with short periods of rapid growth or short periods of very low or negative growth.

Some middle income and poor countries are able to maintain very high growth rates of around 5-10% per year for a limited time, usually around 20-30 years. That period of rapid growth shifts them from the middle or poor group to the rich group of countries. But once they reach the same level of GDP per capita as rich countries their growth rates decline to 1-2% per year, in line with other rich countries.

Examples of this are places like Japan, South Korea, and now China. The first two experienced very rapid growth rates during the 20th century, and they moved from poor/middle income countries (a low level of GDP per capita) to rich countries (a high level of GDP per capita similar to the US), and now their growth rates are in line with places like the US and Western Europe. China appears to be in the middle of this transition, but don’t expect their growth rates to remain around 5-7% per year forever.

Even within the group of rich countries there is variation in the level of GDP per capita that tends to persist over time as they all have similar growth rates. The variation is small compared to the difference between the group of rich countries and the group of middle income or poor countries.

The drivers of growth rates and levels

What determines the level and growth rate of GDP per capita?

The level of GDP per capita depends on factors of production like physical capital, human capital (e.g. skills or education), natural resources, and the population. It also depends on productivity, which is about how you use those factors of production.

Factors are the ingredients, productivity is the recipe. Just like you can increase the quality or quantity of food you have by using different recipes, we can increase the quality and quantity of goods and services we produce (thus raising GDP) by using them in smarter ways. Productivity is like a measure of how smart we are at using our factors of production.

A significant share of the goods and services that make up GDP are used to create more factors of production: building new structures like offices, homes, and factories, educating workers, and extracting natural resources.

When Amazon builds a warehouse in 2024, that construction contributes to GDP in 2024. The business activity that the warehouse allows for (e.g. all your orders and packages) counts towards GDP in 2025, 2026, and beyond.

The long-run growth rate of any country, regardless of the level of GDP per capita, depends on the growth rate of productivity, not the share of GDP devoted to accumulating more factors of production.

Long-run growth depends on better recipes, not on how fast you can accumulate ingredients. It’s not that we don’t or can’t accumulate factors of production over time. It’s just that it becomes too hard to accumulate them fast enough to push GDP per capita up and cause growth.

The share of GDP devoted to accumulating factors of production does help determine the level of GDP per capita, and variation in that share does help determine variation across countries in the level of GDP per capita, and hence why some countries are relatively rich and some are relatively poor.

Don’t get confused. Factors of production matter for living standards and the level of GDP per capita. You’d rather have more than less. But accumulating them can’t sustain growth in GDP per capita in the long run.

The level of productivity also helps determine the level of GDP per capita.

Think of the level of productivity like natural athletic ability, and the growth rate of productivity as coming from training and practice. Even if Lebron James and I train the same and have the same growth rate in our abilities, he’ll always be a much better basketball player than me. The level of productivity in the economy is like that natural athletic ability, but depends on things like technology, policy, and culture.

Non-renewable or fixed natural resources that we rely on to produce GDP do slow down the growth rate of GDP per capita because we cannot accumulate more of them to keep up with population. However, historically that drag has not been big enough to elimiate positive growth in GDP per capita, and we often innovate away from using those resources to mitigate or eliminate that drag.

The drivers of productivity growth

Productivity growth is what drives long-run growth in GDP per capita, so understanding it is crucial. The ultimate explanation tends to be counter-intuitive.

The reason factors do not determine the growth rate is because factors are rival goods, meaning they can only be used in one place at one time. Productivity depends on non-rival ideas; good ideas can be used by anyone anywhere at any time without diminishing their usefulness.

Think ingredients versus recipes again. Ingredients are rival. If I use the flour, eggs, and sugar, I can make a cake, but you cannot use those same ingredients. You need your own ingredient to make your own cake. But we can both use the same recipe for cake without stopping each other.

Productivity growth - innovation - comes from deliberate efforts by individuals and/or firms to come up with better ideas for using their factors. The amount of innovation depends on the scale of the economy. The bigger the economy, the more innovation will occur.

Innovation isn’t just new technologies or gadgets. Innovation can be identifying a new location for a store, or implementing a new technique to better manage inventories. A new dish at a restaurant - a literal recipe - is innovation.

Scale matters because it determines how many factors are available to pursue innovation (i.e. more workers means more possible ideas) and how lucrative the rewards are to innovation (i.e. more consumers means bigger profits from a good idea). Because scale matters, the growth rate of productivity in the long run depends on the growth rate of population.

The quality and variety of food tends to be better in big cities. That’s because there are lots of people with lots of different backgrounds coming up with ideas for restaurants, but also because there are enough potential customers to support a Japanese-Nigerian fusion ramen take-out place.

The level of productivity depends, in part, on the scale of the economy. Countries that have larger markets and bigger pools of innovators have higher productivity. Those markets and pools may extend beyond their borders due to trade, immigration, historical ties, etc.

This is the power of non-rivalry. That Japanese-Nigerian place can exist because using Japanese or Nigerian recipes here doesn’t limit the ability of anyone in Japan or Nigeria to use the same recipes. Belgium is a small country with a high GDP per capita because they can share ideas and products easiliy with the European Union as well as with the US, Japan, and others. North Korea is a small country with a low GDP per capita in part because they limit themselves to only the ideas and products that they have locally.

Firms and individuals will only innovate if they can earn some rewards from those innovations, at least enough to cover the fixed cost from doing research and development. For them to earn those rewards they have to sell products of those innovations at a price higher than marginal cost. Charging prices higher than marginal cost implies some level of imperfect competition. Long run growth in productivity and GDP per capita depends on there being imperfect competition.

Perfect competition might increase the amount of economic activity today by giving us cheap copies of existing products (e.g. a $200 iPhone clone), but it would limit innovation and reduce the growth rate of GDP per capita, meaning we wouldn’t be as rich in the future.

The ideas coming from innovation are non-rival, but they are also often non-excludable, meaning they are very easy to copy. We often use policy tools to make ideas excludable, which prevents the copying and competition that would limit the rewards of innovation.

Excludability is what creates the imperfect competition that drives growth. Patents, for example, grant a firm a monopoly over a product for a certain amount of time. Copyright, trademark, patents, and other forms of intellectual property are all examples of policy rules/laws that act to create excludability.

The degree of imperfect competition that we allow using those policy tools influences the level of productivity, but not the growth rate of productivity in the long run. There is no clear answer to the right amount of imperfect competition to have.

Either too much competition or too little competition in the economy will reduce incentives to innovate. It’s possible that if we took our policies to extremes we would also influence the growth rate of productivity by shutting it down entirely; that could occur if we had zero intellectual property rights so no one wanted to innovate (way too much competition) or if we had extreme property rights or regulations that prevented any new firms or products from being introduced (way too little competition).

Rich countries and poor countries

In considering why some countries are rich and others are medium or poor, we can think about two questions. Why is the level of GDP per capita different across countries? What changes that allows some countries to shift from one level to another - creating periods of rapid growth?

Most of the difference between rich, medium, and poor countries in levels of GDP per capita is due to differences in the level of productivity, with less due to differences in the share of GDP devoted to accumulating factors.

Rich countries definitely have more physical and human capital than poor countries, but by itself that isn’t sufficient to explain the differences in GDP per capita we observe. Most of the gaps can be explained by productivity.

Countries that make the shfit from poor or medium to rich tend to have several things in common. They increase the share of GDP devoted to accumulating factors like physical capital and human capital, they reduce their population growth rate, they create scale by allowing more internal and external trade, and they shift away from having too little competition.

That’s a very general conclusion, because each situation is unique. It also raises the question of why all poor countries don’t do these things. Again, there is no clear answer. It probably has to do with the fact that incumbent firms and/or individuals benefit from the existing situation - possibly through a lack of competition - and block changes.