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Economic Growth

Economic growth is the expansion of the productive capacity of an economy (an outward shift of the PPF curve). This enables a society to produce more goods and services. This can also be seen by an outward shift of the aggregate supply curve which entails an increase in the full employment output.

GDP doesn’t measure economic growth; it just measures output but not an expansion in the potential output capacity of an economy. If an economy is producing inefficiently (behind the PPF curve) in one year and the next year it is producing efficiently (on the PPF curve) then this could be perceived as growth but it isn’t actually economic growth as there hasn’t been an outward shift of the PPF curve (and the potential output remains constant).

Production is made possible through the use of factors of production – capital, labour, land and entrepreneurship. Capacity output is reached when all factors of production are fully and efficiently utilised. Therefore an increase in capacity output can be made possible from an increase in the quantity of the factors of production, or from an improvement in their efficiency or productivity (quality).

Productivity is a measure of the efficiency of a facture of production. Labour productivity measures output per work. Capital productivity measures output per unit of capital. Total factor productivity refers to the average productivity of all factors measured as the total output divided by the total amount of inputs used.

Capital is a critical factor in the production process and thus an increase in capital is a source of economic growth. In order for this to occur investment needs to have taken place.

Investment can be found in the national accounts under Gross Fixed Capital Formation. This covers net additions to the capital stock but also depreciation. This is the fall in value of physical capital equipment over time due to wear and tear. Therefore the Gross Fixed Capital Formation includes the purchase of new capital in order to offset depreciation and isn’t an addition to the capital stock.

If an economy decide to pursue accumulating capital stock through investment to increase its potential output then this is usually at the expense of not producing as much consumer goods.

Labour is also a large contributor to the production process. Apart from increase migration (a long-run policy) it is hard to increase the size of a labour force. Therefore the quality of labour is a better policy to pursue. This can be improved through education and training.

Constraints on Growth

Absence of capital markets – If firms don’t have access to cheap and easily available funds then they will find it hard to invest and expand their operations and hence there will be limited potential and actual growth.

Government Instability – If governments are incompetent or weak then the economy may not attract investment. If the government has high corruption or a fiscal deficit then it may not spend much money which will prohibit growth.

Labour Market Problems – A shortage of skilled labour is a major constraint on growth.

Benefits of Growth

There are benefits for employees, firms and governments from growth. Employees are likely to see a rise in income and wealth as well as a rise in the standard of living. Firms will see larger profits as consumer spending usually rises during economic growth. Finally, governments are likely to see a greater tax revenue which will allow them to spend more, eliminate a deficit, or save for the future.

Costs of Growth

Income Inequality – Some members of society won’t benefit equally from growth and so wages may become unequal. This provides issues for an economy.

Environmental Problems – Depletion of natural resources and pollution is likely to increase with economic growth.

Inflation – Rapid growth can cause short term spikes in prices, which might increase the prices of foods and basic goods, making it harder for poorer citizens in an economy to buy the necessities to survive.

Page last updated on 20/10/13