Causes of Economic Growth

Economic growth occurs when the economy realizes greater production levels. In the graph below, the production possibilities curve shifts outward to the right (for instance, through point F), so that the country’s production capacity level rises. For the curve to shift outward, resources (land, labor, capital, and raw materials) must increase, or we must improve the way we use these resources (technology). Therefore, economic growth is made possible by advances in technology and/or increases in resources, such as natural resources (land, oil, trees, etc.), workers, and capital goods, including machinery, equipment, assembly lines, office buildings, factories, roads, highways, and airports.

How does a country increase its capital goods, and how does it achieve advances in technology? Let’s take a look at increases in capital goods first.

Increases in Capital Goods

Capital goods are produced just like other goods, such as cars or food. If a country is producing at full employment (operating on the curve), more capital goods can be produced only if the country produces fewer consumption goods. Looking at the diagram in the previous section, this is reflected by a move from a point on the curve from the lower right to the upper left (for example, from point D to point A, or from point B to point C). A government can encourage more production of capital goods by, for example, providing tax breaks for the production of capital goods, or by increasing taxes on the production or sale of non-capital (consumption) goods.

Advances in Technology

Advances in technology occur because of inventions and improvements in producing goods and services. Inventions and improvements take place when entrepreneurs have incentives to produce more efficiently and lower their costs. When lower costs lead to higher profits and greater rewards, entrepreneurs are motivated to continue to improve their products and production processes. Countries that allow entrepreneurs to keep most of these rewards (by limiting taxation and limiting government involvement) have been shown to experience greater rates of technological growth. Advances in human technology also stimulate economic growth. When people become more productive (for example, by gaining skills and becoming more educated), the production possibilities curve shifts outward.

Economic Growth and Economic Systems

As evidenced by the 2008/2009 recession and the recent pandemic related downturn, we don’t have economic growth all the time. However, during most years, industrialized countries experience economic growth (an increase in overall production). Economies such as Taiwan, Singapore, China, Vietnam, Chile, the United Arab Emirates, South Africa, and several East bloc countries have increased their production capacities significantly during the past several decades. China adopted significant free market elements primarily starting in the late 1980s, and as a result has experienced record growth. India has also become more capitalist and opened its borders to increased free international trade in the 1990s. These countries’ production possibilities curves have shifted out considerably because of freer markets, greater incentives to produce and innovate, and increases in capital stock.

Communist (or command economy) countries, such as North Korea, Venezuela, and Cuba, have experienced far less economic growth than their capitalist counterparts. People in these countries have little freedom and few opportunities to advance, and the incentive to work hard and innovate is minimal.

Many third-world countries that have struggled with civil strife and governmental corruption have been unable to shift their production possibility curves outward, because the political instability has made it difficult for capitalism and free markets to properly function. For capitalism to succeed, a country needs a stable economic and political climate in which its government provides essential conditions, such as a just legal system, a just reward system (taxes and regulations that reward work and entrepreneurship), a proper infrastructure, strong national security, and protection of individual and property rights. Even the United States has felt the effects of uncertainty regarding the security of the country. When a country, its citizens, and its property are not protected properly, it can have a devastating effect on productivity and the motivation of its people to work hard. As security and stability improve, the conditions for a positive economic climate improve.

Conditions for Economic Growth
With the economic demise of many non-capitalist and often dictatorial statist countries, it has become clear during the past several decades that certain economic conditions must exist for healthy economic growth to occur. The free or mostly free countries and areas in our world, such as Japan, Taiwan, the United States, Germany, the United Kingdom, Canada, Switzerland, Poland, Sweden, South Korea, and Singapore, have per capita (per person) earnings, that are much higher than the per capita earnings in statist countries, such as Cuba, Venezuela, Iran, and North Korea. The life expectancy in freer countries is higher than in statist countries, and even the large majority of the poor in the freer, capitalist countries lives at a level well beyond that of the average citizen in a statist country. Countries with the highest per capita earnings are characterized by all or most of the following:

1. Strong private property rights.
Societies experience the most economic growth when their citizens have optimal incentives to work. Hard and smart work then translates into greater wealth (a house, a car, a computer, a smart phone, stocks, bonds, etc.). These properties must be protected though, otherwise the incentive to work hard and smart disappears. Countries that protect their citizens’ properties experience greater economic growth and have less absolute poverty than countries that have weak protection.

Andrew Bernstein in his “Capitalist Manifesto” states that: “Men often understand that an individual’s life belongs to him and cannot be disposed of by society, but fail to grasp that his property must similarly belong to him and be protected against confiscation by society. In fact, men cannot live without an inalienable right to own property. The right to life is the source of all rights – and the right to property is their only implementation. Without property rights, no other rights are possible” (page 34). Note that Bernstein’s mention of “men” in the above quote refers to people in general, not only men of course.

2. Free markets, free international trade, and a healthy price level.
Free markets are markets in which prices of goods and services, as well as wages, rents, interest rates, and foreign exchange rates, are determined by the interaction of private sector demand and supply.

Free international trade requires a free exchange of goods and services and resources between countries. Governments accomplish this by avoiding protectionism (trade obstacles, such as tariffs and quotas). A healthy price level is achieved when there is no increase in the country’s average price level. The country’s central monetary agency can accomplish this by keeping its money supply constant. Unlike most countries’ goal of achieving two percent inflation, this text does not support this. Instead, it supports falling average prices. This is explained in more detail in units 7 and 9.

3. Essential government regulations and reasonable levels of taxation.
The government must enforce clear and effective rules (laws) in order to safeguard economic and financial stability, product safety, and consumer, worker, business, and property protection. Taxes must be collected in order for the government to provide its essential functions. However, excessive taxes and regulations discourage business start-ups and can cause businesses to fail or move abroad.  Regulations and taxation must be reasonable and cost-effective to encourage businesses to start or continue production, with rewards that provide incentives for hard work, innovation, and sound training and education.

4. Little corruption.
A stable and secure environment is an essential condition for a free market and a productive society. If the government of a country is corrupt or allows corruption by private groups, and initiates force by taking away citizens’ and businesses’ private property, then there is no incentive for potentially hard-working and innovative workers to produce and accumulate wealth.

Why Do Statist Countries Continue to Exist?
If economic growth and wealth accumulation are so much higher in capitalist countries than in statist countries, why then don’t statist countries change to capitalism and free markets? The answer is that capitalism requires freedom, and statist rulers and corrupt dictators are fearful that with freedom among their citizens, they would lose their control and position of power. Dictators in statist countries mostly think of themselves and not the well-being of their citizens.

The Money Supply, Government Spending and the Production Possibilities Curve
The production possibilities curve does not shift outward with an increase in the nation’s money supply or with increases in government spending. If this were the case, we would just need to print an unlimited amount of money or to increase government spending indefinitely. We will learn in later units that printing additional money and increasing government spending from an economic growth point of view can benefit the economy in the short-run, but has distinct economic disadvantages in the long-run. The only causes of long-term economic growth and outward shifts in the production possibilities curve are increases in resources and advances in technology. More and better resources allow businesses to produce more efficiently and effectively, lower costs, increase real incomes and increase consumers’ purchasing power.

Potential Versus Actual Production
A country that experiences an outward shift of its production possibilities curve will increase its potential to produce. This does not mean that the country will increase its actual production. A country could be at a point inside of the curve and experience unemployment and inefficiency. North Korea, Iran and several other heavily government controlled states have large amounts of resources. However, due to limited economic and political freedom, these resources are not used at their maximum efficiency. Consequently, the real Gross Domestic Products of these countries (a measure of a country’s overall productivity) are far less than that of freer countries. If they allow more capitalist elements and freedom into their economy, they will be able to shift their production possibilities curves outward, as well as to produce closer to their maximum efficiency level.

Natural Disasters and Military Conflicts
When natural disasters (hurricanes, floods, pandemics, etc.) occur, it takes away production resources. This shifts the production possibilities curve to the left and decreases an economy’s capacity to produce. Wars and terrorist activities that destroy production capacities also shift the curve to the left.