Chapter 22 Study Questions

Problem 1 1. Consider the history of the world from 1 million b.c. until now. Although limited data exists from early history, we still have some information about how people lived and how much they consumed. a. Has the global rate of economic growth remained constant throughout history? b. Which of the following time periods experienced the highest average annual growth rate? 1 million b.c. to 1200 a.d. 1200 to 1800 a.d. 1800 to 1950 a.d. 1950 to 1975 a.d.

Solution 1 1. a. No. In fact, for most of history, very little economic growth occurred. Around 12,000 years ago, humans made the first big innovational revolution with agriculture. Before 1200 a.d., GDP per person was roughly constant at $200, implying little or no economic growth. From 1200 to 1800 a.d., GDP per person approximately doubled. From 1800 until now, growth has increased substantially. b. The growth rate was highest from 1950 to 1975 a.d. From 1200 to 1800 a.d., GDP per person approximately doubled. This implies an average annual growth rate of about 0.12%. From 1800 to, GDP per person again doubled (0.47% average annual growth). GDP per person again doubled over a shorter time frame from 1950 to 1975, indicating an average annual growth of 2.8%.

Question 1 1. Since the Industrial Revolution, economic growth has increased tremendously. Discuss some of the outcomes of that economic growth.

Solution 1 1. Economic growth brought electricity, sanitation, and better health care. Machinery reduced strenuous manual labor. Economic growth allowed humans to progress beyond a daily search for food into other activities and live longer, more fulfilling lives. Economic growth led to markets, infrastructure, modern advances in communication, enabling those in wealthier countries to travel like never before. Overall, because of economic growth, people produce more and consume more (food, goods, and services). However, agricultural and economic revolutions didn't result in economic growth everywhere, leading to big differences between rich and poor countries. Environmental degradation and income inequality are two negative outcomes that accompanied economic growth.

Problem 10 10. For years, Invisalign faced no direct competitors and was an industry leader within its niche in the orthodontics appliances market, earning $231 million profit in 2017. Invisalign pioneered the creation of clear dental trays that straighten teeth without the use of metal braces. What type of government policy fostered Invisalign's innovation and provided protection from competition? Why does the government provide protection to companies like Invisalign who can dominate a market? What do you expect to happen when the government protection expires?

Solution 10 10. Governmental policy to encourage innovation includes providing intellectual property laws and research subsidies. The government protected Invisalign's technology through numerous patents (intellectual property law). The U.S. government granted Invisalign patents because it realized a great social benefit resulted from doing so. The patents also increased Invisalign's marginal benefit of innovation. In fact, Invisalign enjoyed more than 400 U.S.-issued patents. However, after some time, patents expire to encourage more innovation and competition. The result is lower costs for consumers. Patents for Invisalign began expiring in October 2017, with more expiring throughout 2018. As a result, other companies, such as SmileDirectClub, entered the market.

Problem 2 2. For each of the following, identify which inputs into the production function changed and their effects on economic growth. a. The government passes a new program that encourages more employers to provide on-the-job training. b. Improvements to health care cause an increasing share of older people to work instead of retiring. c. The federal government increases spending on national infrastructure. d. A large baby boom occurred two decades ago.

Solution 2 2. a. Human capital. On-the-job training increases human capital, which increases output. b. Labor. Less retirement is an increase in labor, which increases output. c. Physical capital. Providing physical capital enhances worker productivity. d. Labor. An increase in population increases the size of the labor force, which increases the amount of output the economy can produce, and as a result real GDP per capita increases. However, an increase in the size of the population also changes the denominator of GDP per capita, so a population increase does not lead to an increase in GDP per person.

Question 2 2. All U.S. states require children to attend school. Mandatory school attendance ends at ages 16-18, depending on the state. The adult literacy rate in North America was 100% in 2016. Discuss how compulsory education impacts labor productivity, the aggregate production function, and overall economic growth.

Solution 2 2. In school, children develop literacy and communication skills, increasing human capital, which allows the economy to be more productive. This is one of the main reasons the United States has shifted into a primarily skilled workforce and service economy.

Question 3 3. An example of U.K. foreign investment was a state-of-the-art manufacturing plant that was opened in Austin, TX, but owned by the U.K.-owned BAE systems. Describe how this investment affects the three inputs into the aggregate production function and GDP growth.

Solution 3 3. Foreign investment grows the capital stock in the United States and capital is a complement to labor. Therefore, foreign investment from BAE systems will lead to increases in the growth rate of GDP.

Problem 3 3. The U.S. savings rate has fallen from an annual rate of around 13% in the mid-1970s to 6% at the end of 2018. What are the consequences of a declining savings rate for economic growth?

Solution 3 3. The savings rate determines how much is available for investment and investment is what ultimately determines the amount of capital each worker has to work with. A country's capital stock is a key determinant of economic growth and it changes as a result of investment and depreciation. Investments in new equipment and structures boost the capital stock, and, hence, the economy's capacity to produce output. Savings are necessary to boost the capital stock. Moreover, because machines break down, factories crumble, and roads get potholes, each year some proportion of the existing capital stock is destroyed by depreciation, and savings are needed to replenish it. The capital stock can only grow—that is, capital can only continue to accumulate—as long as investment exceeds depreciation. But if the U.S. savings rate falls below the depreciation rate of the stock of physical capital, a declining savings rate doesn't just mean lower economic growth, it can actually lead the economy to shrink until the point that additional investment is enough to keep up with depreciation.

Problem 4 4. What can you tell about an aggregate production function if real GDP per worker increases by 10% in response to all of the inputs increasing by 10%? What would you expect to happen if you doubled all the inputs? Explain your answer.

Solution 4 4. A 10% increase in output per worker from a 10% increase in all inputs indicates that the aggregate production function exhibits constant returns to scale. According to the replication argument, if you want to increase the amount of a good you produce by a certain amount, you can simply increase all your inputs by that amount (labor, factory, equipment, etc.). This can be applied to the entire economy; if the number of business in an economy increases by 10% and their output increases proportionally, then total output for the economy will increase by 10%.

Question 4 4. Discuss an example of technological progress not mentioned in the chapter and how it impacted economic growth.

Solution 4 4. Student answers may vary. The example should emphasize that technical progress is a change in the recipe for combining inputs to make output. Technological progress should lead to an increase in economic growth.

Problem 5 5. In the movie Avengers: Infinity War, antagonist Thanos believes that he can limit suffering and starvation by erasing half the population from existence. You've just watched the film with your pessimistic pal Owen. "Thanos did the right thing," Owen tells you, again claiming that humanity would be better off if the population were smaller. Use the aggregate production function presented in the chapter to show Owen how an economist would analyze Thanos's decision.

Solution 5 5. Halving the population seems like a quick solution for starvation. However, reducing population reduces the number of workers, and according to the aggregate production function, a reduction in labor will reduce output in the economy. It is possible that halving the population will have no impact on starvation if the output generated by an economy is also perfectly halved. You could end up right back where you started with just fewer people around! Whether the population reduction does boost growth depends on the diminishing marginal returns from capital per worker. Capital per worker increases because there are fewer workers but the same amount of capital as before.

Question 5 5. Your friend Owen is a bit of a pessimist. "The world already has 7 billion people," he says. "The population is growing too fast. Soon, there will be a food shortage—especially for people in undeveloped countries. They are too far behind modern times." Using what you've learned about economic growth, why might Owen be wrong?

Solution 5 5. If technological progress in food production grows faster than population growth, then it will take even fewer resources to feed a person in the future, allowing food production to easily keep up with population growth. Thomas Malthus thought that as more food was produced, the population would grow such that the amount of resources required to feed a person would always be the same and people would not be able to move beyond subsistence living. But technological progress in agriculture meant that food production took fewer and fewer resources even as the population grew. The key was that technological progress—which enables people to have more outputs with fewer inputs, or "do more with less"—outpaced population growth. While suffering does continue in many parts of the world, there are many technological improvements that remain to be made in agriculture around the world, leaving room for further improvements in agricultural production.

Question 6 6. One analyst predicts that self-driving cars will ultimately reduce the number of cars that are produced. She argues that because self-driving cars can drive other people rather than sitting in people's driveways and garages, the United States will need to produce fewer cars. She argues that growth will slow because we are producing a decreasing number of cars each year. Do you agree? Why or why not?

Solution 6 6. Self-driving cars are the result of technological progress. Technological progress shifts the production function, increasing the output that's produced from any given level of inputs. The development of new production methods creates new ways to combine existing resources to produce more valuable output. Technological progress leads to more output from existing inputs, and also spurs capital accumulation, raising the level of inputs. If there are no limits to technological progress, there are no limits to economic growth. As long as we keep coming up with ways to do more with less, the economy can keep growing, so growth should not slow because we are producing a decreasing number of cars each year.

Question 7 7. In early 2019, The Economist reported that Venezuela's GDP had fallen by 50% over just five years. During the same time period, charges of bribery and corruption were piling up upon members of the Venezuelan government, including President Nicolás Maduro, whose reelection that year was widely perceived as illegitimate. Using what you learned in the chapter, discuss how bribery and corruption in the Venezuelan government could lead to declines in GDP. What are some of the crucial elements that governments must provide to encourage innovation and growth?

Solution 7 7. Government corruption and bribery can impact the incentives people face when making investment decisions. For example, if you have to pay a hefty bribe to get approved for a business permit or receive actual protection from law enforcement, you may not be willing to risk investing in innovative ideas. The lack of investment will lead to long-term economic decline as GDP falls. Additionally, if the government itself extracts productive resources for their own political or economic gain, then those resources cannot be used to generate additional output and grow the economy. Lack of faith in the judicial system is a clear indication that people don't feel that their property rights will be upheld by the legal system. Lack of well-defined property rights creates additional risk when deciding whether to invest in new businesses, ideas, capital, or anything else that could be protected by both physical and intellectual property rights. This will cause investment spending to decrease and GDP growth to stagnate or decline.

Problem 7 7. In Uganda GDP per person is $1,280 per year, and in Japan it is $39,100. What do you think is likely to happen to each country's GDP per person if they both increase their physical capital per person by 20%? Which country do you expect to have a larger relative change in its output per person? Explain your answer.

Solution 7 7. Uganda will likely benefit more from the increased capital per person than Japan due to diminishing returns to capital. A 20% increase in capital per person will have a much smaller relative impact on GDP per person in Japan since the Japanese economy already has a large capital stock compared to Uganda.

Problem 8 8. In the debate over the Tax Cuts and Job Act of 2018, Republicans argued that businesses needed an incentive to invest more in physical capital in order for the United States to see much faster economic growth. In a rich country like the United States, why is investing in physical capital both important and yet unlikely to lead to a large increase in economic growth?

Solution 8 8. Countries cannot continue to grow simply by adding more physical capital. Because a rich country like the United States already has a large amount of physical capital, a large amount of new investment in physical capital is simply replacing depreciated physical capital. As the capital stock grows, there are more machines and because a fixed fraction of them fail each year, total depreciation will grow. That means the economy will need to generate larger and larger amounts of investment merely to replace the capital lost to depreciation. Second, there's the problem of diminishing returns. Each increment of capital creates a smaller and smaller increment to output. This combination of diminishing returns and depreciation means that at some point the amount of new investment the economy generates will no longer exceed the amount of capital lost to depreciation. When investment and depreciation are equal, the capital stock stops growing.

Question 8 8. You've started developing an app that examines students' personalities and other characteristics, and sorts them into highly effective study groups. Using the cost-benefit principle, compare your incentives to innovate and develop the software if (1) anyone could just copy your code and sell it or (2) the government allowed you to patent your code. How do your marginal benefits differ with and without intellectual property laws?

Solution 8 8. The marginal benefit of investing your time and efforts into developing the app are greater when your app is protected under intellectual property law. You are allowed to be the sole producer of the app you made and reap all the benefits from your costly investment in time, money, and effort. Without patents, you could spend just as much developing the app just for someone else to copy your code and sell it (maybe even for cheaper!), which could drastically decrease your benefits. Your costs are likely to be the same with or without patent protection. You still have to hire developers, secure financing, market the app, and so on. Applying the cost-benefit principle, you are likely to innovate more when your intellectual property is protected than when it is not.

Problem 9 9. The International Monetary Fund (IMF) publishes World Economic Outlook Updates biannually. According to the July 2018 Update, the expected annual growth rate of advanced countries was 2.2% for 2019. On the other hand, expected annual growth for developing countries was 5.1%. Explain why developing countries might be growing so much faster than developed countries.

Solution 9 9. Developing countries might be growing so much faster than developed countries because of diminishing returns to capital. When workers don't have many tools to work with or a high level of education, the marginal benefit of adding one more unit of capital per person will lead to large gains in output. But once each worker has a lot of capital, adding more capital has a smaller effect. Diminishing returns means that additional investments in physical capital don't boost output much in rich countries which already have a lot of capital. The investments can lead to a much bigger gain in poor countries which have very little capital to start with.

Question 9 9. For each of the following institutions, provide a real-world example and explain how it promotes economic growth. a. Enforceable property rights b. Predictable and stable government c. Efficient regulation

Solution 9 9. Student answers will vary, but they should focus on each of the following. a. Enforceable property rights. People don't want to purchase things or make investments if they will struggle to hold onto them. In fact, when property rights aren't enforced, a lot of societal resources go to trying to hang onto what you have. b. Predictable and stable government. Constantly changing government regimes, such as through coups, wars, and political unrest, discourage investment and redirect resources away from productive endeavors. c. Efficient regulation. Some types of regulation are needed for the benefit of society, such as preventing excess pollution, preventing dangerous drugs from entering the prescription market, and so forth. However, regulation should not be unnecessarily cumbersome or time consuming or it can discourage investment in new business which could increase output.