IV. Why Labor Productivity Grows

Preconditions for Labor Productivity Growth

· The institutions of markets, property rights, and monetary exchange create incentives for people to engage in activities that create economic growth and are preconditions for growth in labor productivity. Market prices send signals to buyers and sellers that create incentives to increase or decrease the quantities demanded and supplied. Property rights create incentives save and invest in new capital and develop new technologies. Monetary exchange creates incentives for people to specialize and trade.

· Persistent growth requires that people face incentives to create:

· Physical Capital Growth: Saving and investing in new capital expands production possibilities.

· Human Capital Growth: Investing in human capital speeds growth because human capital is a fundamental source of increased productivity and technological advance.

· Technological Advances: Technological change, the discovery and the application of new technologies and new goods, has made the largest contribution to economic growth.

V. Growth Theories

Classical Growth Theory

Classical growth theory is the view that real GDP growth is temporary and that when real GDP per person rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level.

· A problem with the classical theory is that population growth is independent of economic growth rate.

Neoclassical Growth Theory

Neoclassical growth theory is the proposition that the real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labor grow.

· A technological advance increases productivity. Real GDP per person increases.

· The technological advances increase expected profit. Investment and saving increase so that capital increases. The increase in capital raises real GDP per person.

· As more capital is accumulated, eventually projects with lower rates of return must be undertaken so that the incentive to invest and saving decrease. Eventually capital stops increasing so that economic growth stops.

· The improvement in technology permanently increases real GDP per person.

· A problem with the neoclassical theory is that it predicts that real GDP per person in different nations will converge to the same level. But in reality, convergence does not seem to be taking place for all nations.

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