All else equal, allocating resources more efficiently allows movement from inside a production possibilities frontier to its border–productive capacity is not affected, but total output does rise. In contrast, economic growth occurs when (a) production possibilities frontiers shift outwards, so that more of all goods can be produced, or when (b) the value in exchange of a national output increases for purposes of international trade.
Economic growth entails increases in the value of a nation's productive capacity.
Growth is driven by (a) technological advances, (b) increased availability of resources or improvements in their quality, or (c) increased values for the goods in which a country specializes.
Growth occurs when entrepreneurs implement technologies allowing given resources to produce more output. It may seem surprising, but technological advances in any active industry expand production possibilities for all other industries. The reason is that, say, advanced robotics on an auto assembly line would permit fewer resources to produce more cars.
Resources would be freed from auto making to produce more food, textiles, housing, and other goods. The innovation of new technologies is a key for economic growth–and for successful entrepreneurship.
Expanding the Resource Base
New technology is one path towards growth. Enhancements to the resource base are another.
Natural Resources: Land
Opening up new land could be a source of growth, but there is little unexplored land on Earth and settling other planets remains in the realm of science fiction. However, finding better uses for existing natural resources effectively increases the quality of available "land(.)". For example, intricate networks of dams have allowed the Netherlands to increase its territory–much of its land, once part of the ocean, remains below sea level. Similarly, extensive water desalinization and irrigation projects in Israel transformed arid desert land into productive farms. Increases in quality may be thought of as technological advances, or as comparable to increases in the resources available. Either perspective recognizes that better resource quality will expand the production possibilities frontier.
Wiser land-use policies (another form of technological advance) are also possible ways to boost the productivity of existing land, effectively "increasing" land resources and fostering growth. This could entail reform of overly restrictive zoning laws, or updating inadequate fee structures for use of federal land by ranchers and farmers, as well as logging and mining companies. Or should much of federal land (half or more of all acreage in some states, e.g., Alaska) simply be sold to private developers? Alternatively, should we preserve even more land in public parks? Any resolution of such questions about land use involves trade-offs between economic growth and environmental quality.
Growth of the labor force and, consequently, economic growth, can be fostered through: (a) expanded numbers of workers, or (b) improvements in their productivity. Both the quantity and quality of the work force affect national output–and how it grows. Government could expand the work force by allowing freer immigration into the United States, especially of skilled workers. Other options include such strategies as (a) more support for education or on-the-job training programs to facilitate investment in human capital, (b) more efficient policies in areas such as health care and safety in the workplace. Growth of the work force and the economy, both quantitatively and qualitatively, would also be fostered if less costly daycare became available to parents who want to work, but who, instead, spend most of their time tending their kids.
Capital: Saving and Investment
New capital is a major avenue for growth. National income that is not consumed, freeing resources for new investment, is called saving.
Consuming less than we produce is saving, which allows resources to be channeled into productive investment.
Scarcity forces us to choose between work and leisure, among various commodities–and between current and future consumption. Investment requires saving–forgoing some of our potential current consumption. Positive interest rates make it possible to consume more–if we save, thus waiting a bit before we or our heirs consume. But if perishable consumer goods dominate output, society invests little in new machinery and manufacturing plants. This shrinks the amount of goods available in the future.
Rapid investment boosts production possibilities in two ways. First, more capital is available. Second, new capital usually embodies technology that is superior to that embodied in older buildings and machinery. Higher labor productivity and the availability of new products are common side benefits. But productive capacity is eroded if depreciation exceeds investment; failure to replace worn-out capital yields stagnation. In such cases, the production possibilities frontier shrinks toward the origin. Thus, choices between current consumption and saving (to allow investment) determine future prosperity, as shown in below figure.
The Dilemma of Economic Growth
Panel A depicts possible choices between consuming and investing in the year 2000, with point a reflecting greater consumption (and less investment) than point b, point b more consumption than point c, and so on. Curves PPFa through PPFe in Panel B show the production possibilities for year 2020 that result from choices in 2000 of a, b, c, d, and e, respectively. In sum, growth in an efficient economy is stimulated by rapid investment, which requires more saving (less consumption).
Relatively low U.S. saving rates partially explain why, on average, our economic growth since 1970 has been anemic compared to some other countries. Modern Americans tend to save only 4 to 6 percent of their income, while the Japanese, for example, save and invest 20 percent or so of their national income. Consequently, many U.S. industries now try to compete with foreign firms that use better technology and more machinery. Our auto industry, for example, is reeling under competition from Japanese carmakers, who rely more heavily on industrial robots on their assembly lines.
How people's saving is used is as important as different saving rates in explaining international differences in growth rates. Economic growth is stimulated if saving is channeled into productive investments. Interest rates are signals that help channel investment flows. But if, say, government uses most private saving to fund a war, capital accumulation and economic growth will both be hampered. Religious prohibitions on payments of interest may be one reason the Middle Ages were economically stagnant in Europe. Similar bans against interest may partially account for slow growth in other parts of our world today.
Growth is squelched when saving is funneled into obsolete and inefficient industries. England's experience between 1945 and 1980 provides an example; most private saving was invested in nationalized industries in which England had lost its comparative advantage. The result was stagnation relative to the U.S. economy, despite relatively higher saving rates by the English than by Americans. Similar stagnation prompted drastic reforms in Eastern Europe where, historically, growth was weak despite suppression of consumption to create high rates of saving and investment.
Another reason for sluggish U.S. economic growth in recent decades is that much of private saving has been absorbed by gargantuan federal budget deficits—newly-issued U.S. Treasury bonds absorb financial investment that otherwise would flow into private investment in new economic capital. In the 1990s, the eternal trade-off between guns and butter has given way to a broader controversy–government spending versus private spending. Will the higher taxes or budget deficits needed to finance ambitious new federal programs (e.g., improved environment quality) constrain private investment and consumption too tightly? Most public opinion polls find a majority of voters opposed to tax hikes and favoring broad budget cuts, but every proposal for some cut in spending elicits squeals from "special interest groups." (And we are all members of some such groups). A standard result? Political gridlock. However, the expansion of international trade may provide an alternative path to accelerated growth, but even this path is politically daunting.
Growth and International Trade
International trade is another major source of economic growth–sales to foreigners increase the value in exchange of a country's output, while buying low-cost imports increases the availability of consumer goods and lowers their price. Thus, specialization and exchange according to comparative advantage allows any society's consumption to exceed its PPF in isolation. Figure 6 portrays production possibilities for Alaska and Brazil drawn from a previous example. Note that the relative shapes of the two PPFs reflect these two regions' respective comparative advantages.
If trade results in 1 pound of salmon costing the same as 1 pound of coffee, both Alaskans and Brazilians can consume anywhere on the negatively sloped line abc. Consumers in both countries gain through trade-induced growth of "consumption possibilities" frontiers. As a general rule, the more relative production costs differ among trading countries, the greater will be the gains from trade: Consumers can buy more imported goods that were previously very costly when produced domestically, while producers can sell at relatively higher prices those outputs that, prior to trade, commanded relatively low prices in the domestic market.
Production Possibilities and Comparative Advantage
Attaining a PPF requires technical efficiency in production. Inefficient methods for selecting what and how to produce preclude ever reaching capacity (recall Atilla's "balanced" production formula). But even if production is efficient, some mechanisms for choosing may inhibit allocative or distributive efficiency. (Would you dine at a sushi restaurant that forced you to select food by tossing darts at its menu?) Significant insights into scarcity and choice are gained by examining various mechanisms used to resolve competition among people for scarce goods.
Major exceptions to this statement are cases of technological advances in industries not previously operational.