Page 525 - The Principle of Economics

investment. (Or, perhaps, high growth and high investment are both caused by a third variable that has been omitted from the analysis.) The data by themselves cannot tell us the direction of causation. Nonetheless, because capital accumula- tion affects productivity so clearly and directly, many economists interpret these data as showing that high investment leads to more rapid economic growth.
DIMINISHING RETURNS AND THE CATCH-UP EFFECT
Suppose that a government, convinced by the evidence in Figure 24-1, pursues policies that raise the nation’s saving rate—the percentage of GDP devoted to saving rather than consumption. What happens? With the nation saving more, fewer resources are needed to make consumption goods, and more resources are available to make capital goods. As a result, the capital stock increases, leading to rising productivity and more rapid growth in GDP. But how long does this higher rate of growth last? Assuming that the saving rate remains at its new higher level, does the growth rate of GDP stay high indefinitely or only for a period of time?
The traditional view of the production process is that capital is subject to diminishing returns: As the stock of capital rises, the extra output produced from an additional unit of capital falls. In other words, when workers already have a large quantity of capital to use in producing goods and services, giving them an additional unit of capital increases their productivity only slightly. Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while. As the higher saving rate allows more capital to be accumulated, the ben- efits from additional capital become smaller over time, and so growth slows down. In the long run, the higher saving rate leads to a higher level of productivity and income, but not to higher growth in these variables. Reaching this long run, however, can take quite a while. According to studies of international data on economic growth, increasing the saving rate can lead to substantially higher growth for a period of several decades.
The diminishing returns to capital has another important implication: Other things equal, it is easier for a country to grow fast if it starts out relatively poor. This effect of initial conditions on subsequent growth is sometimes called the catch-up effect. In poor countries, workers lack even the most rudimentary tools and, as a result, have low productivity. Small amounts of capital investment would substantially raise these workers’ productivity. By contrast, workers in rich coun- tries have large amounts of capital with which to work, and this partly explains their high productivity. Yet with the amount of capital per worker already so high, additional capital investment has a relatively small effect on productivity. Studies of international data on economic growth confirm this catch-up effect: Controlling for other variables, such as the percentage of GDP devoted to investment, poor countries do tend to grow faster than rich countries.
This catch-up effect can help explain some of the puzzling results in Figure 24-1. Over this 31-year period, the United States and South Korea devoted a similar share of GDP to investment. Yet the United States experienced only mediocre growth of about 2 percent, while Korea experienced spectacular growth of more than 6 percent. The explanation is the catch-up effect. In 1960, Korea had GDP per person less than one-tenth the U.S. level, in part because previous investment had been so low. With a small initial capital stock, the benefits to capital accumulation were much greater in Korea, and this gave Korea a higher subsequent growth rate.
diminishing returns
the property whereby the benefit from an extra unit of an input declines as the quantity of the input increases
CHAPTER 24 PRODUCTION AND GROWTH 539
catch-up effect
the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich