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Economic Growth

Determinants of Economic Growth

The rate of economic growth is determined by several factors, including investment in both physical and human capital, technological progress, the proper use of natural resources, the enforcement of private property rights, and a stable political environment.
As demonstrated by the rule of 70, which states a sum of money growing at X%X\% per year will double in approximately 70/X70/X years, small changes in the economic growth rate can result in large increases in the size of an economy over time. Economists have determined several factors that influence this economic growth. These include investment in physical capital, such as machines and buildings; investment in human capital, including education for workers; technological progress, which leads to increased production efficiency; the proper use of natural resources such as minerals and water; the enforcement of private property rights to ensure investor and producer confidence; and a stable political environment that encourages production and spending.
The economy is made up of the flow of money and resources among businesses, households, the product market (where consumers buy goods and services) and the resource market (where businesses buy materials and labor).

Physical Capital

Physical capital includes all human-made inputs into the production process, such as machinery, tools, and buildings. Because physical capital makes workers more productive, economies with a growing amount of capital per worker will see faster rates of economic growth.

The capital stock (good or assets used to produce other goods) of a nation is an important factor in determining a nation's output (quantity of goods or services created over a specific time period), and increasing it causes the nation's economy to grow. Physical capital includes all man-made inputs into the production process, such as machinery, tools, and buildings. Having capital makes workers more productive. A worker with a bulldozer can dig much more quickly than a worker with a shovel. Capital increases labor productivity (a way to measure growth in an economy through measuring the number of goods and services created in an hour of labor). Therefore, an important determinant of the economic growth rate is the amount of capital per worker in the economy and how it is changing over time. Economies that experience growth in the amount of capital per worker show the fastest rate of economic growth. For example, during World War II, which lasted from 1939 to 1945, the US economy had a lot of economic growth because of increased investment in factories and machinery to make the equipment necessary for the war.

Capital is developed through investment (something purchased with the belief that it will generate income or create a future financial benefit). In order to have capital goods, a society must forgo the production of consumption goods such as food or clothing. However, as people cannot stop using consumption goods altogether and spend all of that money on capital investment, people must instead save money over time to accumulate enough money for the large up-front capital cost. Resources must be used to produce capital, some of which may not immediately increase the productive capacity of an economy. This is the reason investment is important. An investment uses resources for something that does not result in an immediate increase in economic output but will over time increase economic growth. There is an opportunity cost or trade-off for that investment: the amount of current production given up now to have more in the future. For example, a company might invest in new delivery trucks instead of increasing its production. In the short run, the company has spent money without getting more revenue. However, when the company can finally afford to increase production, it will be able to deliver the larger quantity of the product because it has the extra truck capacity.

Human Capital

Human capital involves the education, training, health, and other non-physical assets of workers, increasing their productivity and leading to economic growth.

Human capital is another important factor in an economy's ability to grow. Human capital is the amount of education, training, health and medical care, and other non-physical assets that workers have. As with physical capital, the development of human capital involves an investment and leads to rising output in the future. While workers are gaining education and training, they are giving up working and producing output; this represents an opportunity cost. However, the workers will be more productive in the future. A study of earnings in Canada showed that the average earnings for people who scored highest on a literacy test were nearly double the earnings of people with the lowest scores. This suggests that there is a positive correlation between literacy and average earnings, which reflects an increase in real GDP per capita. Thus, current output is sacrificed to gain even more output in the future.

Human capital investment can be formal or informal. Formal investments include schooling at all levels, from primary education to post-secondary study. While tuition expenses or the costs paid to run schools are often considered the most significant cost of education, the largest cost is really the value of the student's time. That time could be spent working and making money if the student were not in school, so these lost wages should be factored into the cost of education. However, more education is correlated with higher average earnings in the future, so the student's lost wages can be recouped later, justifying the cost of going to college.

Informal training can occur on the job. When workers first start at a job, they need to learn the skills necessary to perform their work. In addition, other workers may be pulled away from their own work to help the new employee develop skills. Therefore, this is again an investment in human capital: current production is being given up in order to gain more in the future.

Technological Progress

Technology is the tools, procedures, education, and knowledge used to transform resources into a final product. Research and development into new technologies is an important part of economic growth.

While having a trained and educated workforce is important for economic growth, it is also vital for an economy to have the best knowledge available of how to produce products in the first place. Technology is the tools, procedures, education, and knowledge used to transform resources into a final product. Finding better ways to build a product will allow an economy to produce goods and services using fewer resources (goods or services needed to create economic products). This frees up resources to produce other goods and services, leading to a growth in output. Therefore, technological progress is a key factor in determining the rate of economic growth for an economy. For example, the assembly line meant that workers could manufacture cars more efficiently, allowing car companies to make and sell more cars in the same amount of time. A more recent example is the addition of self-checkout to many stores, which enables more customers to quickly pay for their items but uses fewer workers, freeing that labor for other tasks.

Technological progress comes from investment, something purchased with the belief that it will generate income or create a future financial benefit. In this case, current production must be given up by shifting some resources from producing goods to researching and developing new technologies. Some of this research may pay off, and some may not. However, having new technologies makes an economy able to produce more in the future; thus, it is worthwhile to give up some production today to make that possible. The rate at which an economy's output per person grows is tied directly to finding the most efficient ways to produce goods and services.

An important incentive in the development of new technology is a patent. A patent is the exclusive right of an inventor to use (or allow others to use) their invention, which creates a temporary monopoly, typically 20 years from the time of submission for the patent. The protection given by patents makes it more worthwhile for researchers and developers to invest in creating new technology because it allows them to be the sole beneficiary of the results of their work. No one can simply copy their technology. Having patents as part of an economy encourages more research and development and leads to faster economic growth. This is a major factor in the development of pharmaceuticals, as the investment of both time and money required to develop and test a new drug can be immense. However, with the promise of being the only company to sell the new drug for a period of time, pharmaceutical companies are willing to make these investments because they trust that they will be able to recoup their costs.

Natural Resources

Natural resources are naturally existing forms of physical capital that provide inputs to production. Developing better ways of managing renewable resources leads to economic growth, while the overuse of nonrenewable resources may lead to a decline in an economy's future output.

Available natural resources are also necessary for an economy to grow. A natural resource is a naturally existing form of physical capital that provides inputs to production, such as land, minerals, water, agricultural products, and forests. The types of natural resources available vary dramatically around the world. Much of the land in the United States is fertile and well-suited to growing crops; the same is not true for many nations in Africa. Japan has few reserves of fossil fuels other than coal. Thus, natural resources not only play a role in how much an economy can produce but also affect the types of goods and services produced.

Natural resources can be renewable or nonrenewable. For example, trees are a renewable resource. Once trees have been harvested, more can be planted to take their place. However, it is important to consider the amount of time it takes for trees to mature in order to properly manage forests. If managed well, forests can continue to provide lumber to an economy year after year. Developing better ways to manage renewable resources is an important way to improve an economy's rate of economic growth.

Nonrenewable resources include fossil fuels such as oil and coal because they take billions of years to redevelop. Once these resources are used, they are gone. The overuse of nonrenewable resources may cause future output to decline, leading to a slowing of economic growth. If a country's supply of fossil fuels begins to run out, it will have to either use less or buy more from another country, both of which indicate a decrease in the country's output. Because this resource is not renewable, that decrease in output can only be recouped through replacement by a new product developed through technological advances.

Property Rights and Political Stability

Property rights and political stability lessen the uncertainty associated with long-term investments and thus increase a country's rate of economic growth.
An important determinant of a nation's rate of economic growth is the legal, social, and political environment in which the economy operates. Specifically, it is important that there be a property right, or the ability of an individual to own and have command over resources such as capital and property in general. Investors will not want to invest in a new factory or business if they believe that they might not be able to retain ownership. People will not forgo current consumption for future consumption if there is a great deal of uncertainty about the future. Thus, it is important that there are laws in place to protect ownership of resources, whether these be capital or labor services. During Hugo Chavez's tenure as the president of Venezuela, he nationalized many industries, making them a part of the government. Although there was some economic growth under Chavez, Venezuela experienced a drop in both the number of new domestic firms created and the amount of foreign investment from other countries who wanted to build new factories or businesses in Venezuela. No one was willing to invest because no one knew if Chavez would simply take their investment and make it part of the government. Importantly, for countries breaking out from colonialism, taking ownership of their own resources (as opposed to another country having control) is an important part of economic development. Thus, property rights must be balanced within the larger picture of the country's political, social, and economic position.
The Venezuelan economy experienced extreme volatility during the time Hugo Chavez was president, from 1999 to 2013. Foreign and private investment in Venezuela has decreased since the nationalization of many businesses, causing Venezuela's economy to fall behind those of its South American neighbors. In 2003-2008 Venezuela experienced temporarily higher GDP growth, mainly due to a boom in oil prices, because Venezuela is a major oil exporter.
A similar issue is the political climate in a country. Because the purchase of capital or the development of new technologies is a long-term decision, it is important for firms to be able to predict the economic climate in which they will be operating in the future. In most developed countries, this is not of great concern. Although power may move from one political party to another, the society's overall structure will likely not be challenged. This is not necessarily the case in many countries where coups may occur; power structures can shift from democracy to dictatorship overnight. This type of political environment leads to tremendous uncertainty and makes individuals and businesses much less likely to consider long-term investments. Businesses may feel that is not worth the risk to give up current production in the hopes of increased production in the future. Political unrest can dampen the amount of economic growth in these economies.