Classical growth theory

Growth can occur with and without bounds. Logistic growth is an example for a
bounded growth which is limited by saturation: In the picture the blue curve
could depict the development of the size of an imaginary market with logistic
growth. The red curve then would describe the growth of that market as the 1st
derivative of the market volume. The yellow curve is the growth weighted by the
size of the market. As for logistic growth, the yellow curve shows, that even a
large market size cannot strengthen growth when approaching saturation. Logistic
growth never is negative, but in the saturation area, the growth is as small as
before the market took off. (In the example all curves are scaled to cover the
range between 0 and 1.) The modern conception of economic growth began with the
critique of Mercantilism, especially by the physiocrats and with the Scottish
Enlightenment thinkers such as David Hume and Adam Smith, and the foundation of
the discipline of modern political economy. The theory of the physiocrats was
that productive capacity, itself, allowed for growth, and the improving and
increasing capital to allow that capacity was "the wealth of nations". Whereas
they stressed the importance of agriculture and saw urban industry as "sterile",
Smith extended the notion that manufacturing was central to the entire economy.
David Ricardo would then argue that trade was a benefit to a country, because if
one could buy a good more cheaply from abroad, it meant that there was more
profitable work to be done here. This theory of "comparative advantage" would be
the central basis for arguments in favor of free trade as an essential component
of growth.
Income per capita was essentially flat until the industrial revolution. This
period of time is called the Malthusian period, since it was governed by the
principles explained by Thomas Malthus in his "Essay on the Principle of
Population." In essence, Malthus said that any growth in the economy would
translate into a growth in population. Thus, although aggregate income could
increase, income per capita was bound to stay roughly constant. The mainstream
theory of economic growth states that with the industrial revolution and
advancements in medicine, life expectation increased, infant mortality
decreased, and the payoff to receiving an education was higher. Thus, parents
began to place more value on the quality of their children and not on the
quantity. This led to a drop in the fertility rates of most industrialized
nations. This is known as the breakdown of the Malthusian regime. With income
increasing faster than population growth, industrialised economies substantially
increased their incomes per capita in the next centuries.

The history of economic growth theory

In 1377, the Arabian economic thinker Ibn Khaldun provided one of the earliest
descriptions of economic growth in his famous Muqaddimah (known as Prolegomena
in the Western world):
"When civilization [population] increases, the available labor again
increases. In turn, luxury again increases in correspondence with the
increasing profit, and the customs and needs of luxury increase. Crafts are
created to obtain luxury products. The value realized from them increases,
and, as a result, profits are again multiplied in the town. Production there
is thriving even more than before. And so it goes with the second and third
increase. All the additional labor serves luxury and wealth, in contrast to
the original labor that served the necessity of life."
In the early modern period, some people in Western European nations developed
the idea that economies could "grow", that is, produce a greater economic
surplus which could be expended on something other than mere subsistence. This
surplus could then be used for consumption, warfare, or civic and religious
projects. The previous view was that only increasing either population or tax
rates could generate more surplus money for the Crown or country.
Now it is generally recognized that economic growth also corresponds to a
process of continual rapid replacement and reorganization of human activities
facilitated by investment motivated to maximize returns. This exponential
evolution of our self-organized life-support and cultural systems is remarkably
creative and flexible, but highly unpredictable in many ways. Since science
still has no good way of modeling complex self-organizing systems, various
efforts to model the long term evolution of economies have produced few useful
results.
During much of the "Mercantilist" period, growth was seen as involving an
increase in the total amount of specie, that is circulating medium such as
silver and gold, under the control of the state. This "Bullionist" theory led to
policies to force trade through a particular state, the acquisition of colonies
to supply cheaper raw materials which could then be manufactured and sold.
Later, such trade policies were justified instead simply in terms of promoting
domestic trade and industry. The post-Bullionist insight that it was the
increasing capability of manufacturing which led to policies in the 1700s to
encourage manufacturing in itself, and the formula of importing raw materials
and exporting finished goods. Under this system high tariffs were erected to
allow manufacturers to establish "factories". Local markets would then pay the
fixed costs of capital growth, and then allow them to export abroad,
undercutting the prices of manufactured goods elsewhere. Once competition from
abroad was removed, prices could then be increased to recoup the costs of
establishing the business.
Under this theory of growth, the road to increased national wealth was to grant
monopolies, which would give an incentive for an individual to exploit a market
or resource, confident that he would make all of the profits when all other
extra-national competitors were driven out of business. The "Dutch East India
company" and the "British East India company" were examples of such
state-granted trade monopolies.
In this period the view was that growth was gained through "advantageous" trade
in which specie would flow in to the country, but to trade with other nations on
equal terms was disadvantageous. It should be stressed that Mercantilism was not
simply a matter of restricting trade. Within a country, it often meant breaking
down trade barriers, building new roads, and abolishing local toll booths, all
of which expanded markets. This corresponded to the centralization of power in
the hands of the Crown (or "Absolutism"). This process helped produce the modern
nation-state in Western Europe.
Internationally, Mercantilism led to a contradiction: growth was gained through
trade, but to trade with other nations on equal terms was disadvantageous. This
– along with the rise of nation-states – encouraged several major wars.

Endogenous growth theory

Growth theory advanced again with the theories of economist Paul Romer in the
late 1980s and early 1990s. Other important new growth theorists include Robert
E. Lucas and Robert J. Barro.
Unsatisfied with Solow's explanation, economists worked to "endogenize"
technology in the 1980s. They developed the endogenous growth theory that
includes a mathematical explanation of technological advancement. This
model also incorporated a new concept of human capital, the skills and knowledge
that make workers productive. Unlike physical capital, human capital has
increasing rates of return. Therefore, overall there are constant returns to
capital, and economies never reach a steady state. Growth does not slow as
capital accumulates, but the rate of growth depends on the types of capital a
country invests in. Research done in this area has focused on what increases
human capital (e.g. education) or technological change (e.g. innovation).
Theories of economic growth, the mechanisms that let it take place and its main
determinants abound. One popular theory in the 70's for example was that of the
"Big Push" which suggested that countries needed to jump from one stage of
development to another through a virtuous cycle in which large investments in
infrastructure and education coupled to private investment would move the
economy to a more productive stage, breaking free from economic paradigms
appropriate to a lower productivity stage.
Analysis of recent economies' success shows a close correlation between growth
and climate. It is possible that there is absolutely no actual mechanism between
the two, and the relation may be spurious. In early human history, economic as
well as cultural development was concentrated in warmer parts of the world, like
Egypt.
According to Acemoglu, Johnson and Robinson, the positive correlation between
high income and cold climate is a by-product of history. Former colonies have
inherited corrupt governments and geo-political boundaries (set by the
colonizers) that are not properly placed regarding the geographical locations of
different ethnic groups; this creates internal disputes and conflicts. Also,
these authors contend that the egalitarian societies that emerged in colonies
without solid native populations, and which could be exploited by individual
farmers led to better property rights and incentives for long-term investment
than those where native population was large, and together with the tropical
climate, colonizers were led to plunder and ruin, and to create exploitative
institutions, a situation which did not foster growth or private property
rights. Colonies in temperate climate zones as Australia and USA did not inherit
exploitative governments since Europeans were able to inhabit these territories
and set up governments that mirrored those in Europe. It is important to note
that Sachs, among others, do not believe this to be the case.

Public Goods

Public goods have two distinct aspects: nonexcludability and nonrivalrous consumption. “Nonexcludability” means that the cost of keeping nonpayers from enjoying the benefits of the good or service is prohibitive. If an entrepreneur stages a fireworks show, for example, people can watch the show from their windows or backyards. Because the entrepreneur cannot charge a fee for consumption, the fireworks show may go unproduced, even if demand for the show is strong. The fireworks example illustrates the related free-rider problem. Even if the fireworks show is worth ten dollars to each person, arguably few people will pay ten dollars to the entrepreneur. Each person will seek to “free ride” by allowing others to pay for the show, and then watch for free from his or her backyard. If the free-rider problem cannot be solved, valuable goods and services—ones people otherwise would be willing to pay for—will remain unproduced. The second aspect of public goods is what economists call “nonrivalrous consumption.” Assume the entrepreneur manages to exclude noncontributors from watching the show (perhaps one can see the show only from a private field). A price will be charged for entrance to the field, and people who are unwilling to pay this price will be excluded. If the field is large enough, however, exclusion is inefficient. Even nonpayers could watch the show without increasing the show’s cost or diminishing anyone else’s enjoyment. In other words, the relevant consumption is nonrivalrous. Nonetheless, nonexcludability is usually considered the more important of the two aspects of public goods. If the good is excludable, private entrepreneurs will try to serve as many fee-paying customers as possible, charging lower prices to some customers if need be. One of the best examples of a public good is national defense. To the extent one person in a geographic area is defended from foreign attack or invasion, other people in that same area are likely defended also. This makes it hard to charge people for defense, which means that defense faces the classic free-rider problem. Indeed, almost all economists are convinced that the only way to provide a sufficient level of defense is to have government do it and fund defense with taxes. Many other problems, though, that are often perceived as public-goods problems are not really, and markets handle them reasonably well. For instance, although many people think a television signal is a public good, cable television services scramble their transmissions so that nonsubscribers cannot receive broadcasts easily. In other words, the producers have figured out how to exclude nonpayers. Both throughout history and today, private roads have been financed by tolls charged to road users. Other goods often seen as public goods, such as private protection and fire services, are frequently sold through the private sector on a fee basis. Excluding nonpayers is possible. In other cases, potentially public goods are funded by advertisements, as happens with television and radio. Partially public goods also can be tied to purchases of private goods, thereby making the entire package more like a private good. Shopping malls, for instance, provide shoppers with a variety of services that are traditionally considered public goods: lighting, protection services, benches, and restrooms are examples. Charging directly for each of these services would be impractical. Therefore, the shopping mall finances the services through receipts from the sale of private goods in the mall. The public and private goods are “tied” together. Private condominiums and retirement communities also are market institutions that tie public goods to private services. They use monthly membership dues to provide a variety of public services. Some public goods are provided through fame incentives or through personal motives to do a good job. The World Wide Web offers many millions of home pages and informational sites, and most of their constructors have not received any payment. The writers either want recognition or seek to reach other people for their own pleasure or to influence their thinking. The “reciprocity motive” is another possible solution, especially in small groups. I may contribute to a collective endeavor as part of a broader strategy to signal that I am a public-minded, cooperative individual. You may then contribute in return, hoping that we develop an ongoing agreement—often implicit—to both contribute over time. The agreement can be self-sustaining if I know that my withdrawal will cause the withdrawal of others as well. A large body of anecdotal and experimental evidence suggests that such arrangements, while imperfect, are often effective. Roommates, for instance, often have implicit or explicit agreements about who will take out the trash or do the dishes. These arrangements are enforced not by contract but rather by the hope of continuing cooperation. Other problems can be solved by defining individual property rights in the appropriate economic resource. Cleaning up a polluted lake, for instance, involves a free-rider problem if no one owns the lake. If there is an owner, however, that person can charge higher prices to fishermen, boaters, recreational users, and others who benefit from the lake. Privately owned bodies of water are common in the British Isles, where, not surprisingly, lake owners maintain quality. Well-defined property rights can solve apparent public-goods problems in other environmental areas, such as land use and species preservation. The buffalo neared extinction and the cow did not because cows could be privately owned and husbanded for profit. It is harder to imagine easily enforceable private property rights in schools of fish. For this reason we see a mix of government regulation and privately determined quotas in that area. The depletion of fish stocks nonetheless looms as a problem, as does the more general loss of biodiversity. For environmental problems involving the air, it is difficult to imagine how property rights could be defined and enforced effectively. Market mechanisms alone probably cannot prevent depletion of the Earth’s ozone layer. In such cases economists recognize the likely necessity of a governmental regulatory solution. Contractual arrangements can sometimes be used to overcome what otherwise would be public goods and externalities problems. If the research and development activities of one firm benefit other firms in the same industry, these firms may pool their resources and agree to a joint project (antitrust regulations permitting). Each firm will pay part of the cost, and the contributing firms will share the benefits. Contractual arrangements sometimes fail. The costs of bargaining and striking an agreement may be very high. Some parties to the agreement may seek to hold out for a better deal, and the agreement may collapse. In other cases it is simply too costly to contact and deal with all the potential beneficiaries of an agreement. A factory, for instance, might find it impossible to negotiate directly with each affected citizen to decrease pollution. The imperfections of market solutions to public-goods problems must be weighed against the imperfections of government solutions. Governments rely on bureaucracy, respond to poorly informed voters, and have weak incentives to serve consumers. Therefore they produce inefficiently. Furthermore, politicians may supply public “goods” in a manner to serve their own interests rather than the interests of the public; examples of wasteful government spending and pork barrel projects are legion. Government often creates a problem of “forced riders” by compelling persons to support projects they do not desire. Private means of avoiding or transforming public-goods problems, when available, are usually more efficient than governmental solutions.

Written by : Tyler Cowen (an economics professor at George Mason University and director of the Mercatus Center and the James M. Buchanan Center)