Components of Economic Growth

Over decades and generations, seemingly small differences of a few percentage points in the annual rate of economic growth make an enormous difference in GDP per capita. In this module, we discuss some of the components of economic growth:

• physical capital
• human capital
• technology

Physical Capital: The category of physical capital includes the plant and equipment that firms use as well as things like roads (also called infrastructure). Physical capital can affect productivity in two ways:

(1) an increase in the quantity of physical capital (for example, more computers of the same quality)

(2) an increase in the quality of physical capital (same number of computers but the computers are faster, and so on)

Human capital: refers to the skills and knowledge that make workers productive. Human capital and physical capital accumulation are similar: In both cases, investment now pays off in higher productivity in the future.

Technology: Earlier we described it as the combination of invention and innovation. For example, the invention of new products like the laser, the smartphone, or some new wonder drug come to mind. Technology, as economists use the term, however, includes more: new ways of organizing work, like the invention of the assembly line, new methods for ensuring better quality of output in factories, and innovative institutions that facilitate the process of converting inputs into output. In short, technology comprises all the advances that make the existing machines and other inputs produce more, and at higher quality, as well as altogether new products.

A Healthy Climate for Economic Growth

While physical and human capital deepening and better technology are important, equally important to a nation’s well-being is the climate or system within which these inputs are cultivated. Both the type of market economy and a legal system that governs and sustains property rights and contractual rights are important contributors to a healthy economic climate.

A healthy economic climate usually involves some sort of market orientation at the microeconomic, individual, or firm decision-making level.

Markets that allow personal and business rewards and incentives for increasing human and physical capital encourage overall macroeconomic growth. For example, when workers participate in a competitive and well-functioning labor market, they have an incentive to acquire additional human capital, because additional education and skills will pay off in higher wages. Firms have an incentive to invest in physical capital and in training workers, because they expect to earn higher profits for their shareholders.

Both individuals and firms look for new technologies, because even small inventions can make work easier or lead to product improvement. Collectively, such individual and business decisions made within a market structure add up to macroeconomic growth. Much of the rapid growth since the late nineteenth century has come from harnessing the power of competitive markets to allocate resources.

Important roles for government: There are times when markets fail to allocate capital or technology in a manner that provides the greatest benefit for society as a whole. The government’s role is to correct these failures.

Education. The Danish government requires all children under 16 to attend school. They can choose to attend a public school (Folkeskole) or a private school. Students do not pay tuition to attend Folkeskole. Thirteen percent of primary/secondary (elementary/high) school is private, and the government supplies vouchers to citizens who choose private school.

Savings and Investment. In the United States, as in other countries, the government taxes gains from private investment. Low capital gains taxes encourage investment and so also economic growth.

Infrastructure. The Japanese government in the mid-1990s undertook significant infrastructure projects to improve roads and public works. This in turn increased the stock of physical capital and ultimately economic growth.

Scientific Research. The European Union has strong programs to invest in scientific research. The researchers Abraham García and Pierre Mohnen demonstrate that firms which received support from the Austrian government actually increased their research intensity and had more sales. Governments can support scientific research and technical training that helps to create and spread new technologies. Governments can also provide a legal environment that protects the ability of inventors to profit from their inventions.

There are many more ways in which the government can play an active role in promoting economic growth.. A healthy climate for growth in GDP per capita and labor productivity includes human capital deepening, physical capital deepening, and technological gains, operating in a market-oriented economy with supportive government policies.

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