Sources of Economic Growth

Sources of Economic Growth

One way for an economy to produce more output is to obtain more resources. Even with the same resources, however, it is possible for an economy to produce more output if workers become more productive. Productivity is the quantity of goods and services produced from a typical hour of a worker’s labor. Improvements in productivity allow an economy to produce more output and thus earn more income. This increased income represents an improved standard of living. Thus an increased standard of living usually depends on increasing a country’s productivity. Thus, improved productivity is the key to economic growth.

Increases in productivity fall into three categories:

1. Investment in physical capital – “Build more machines.”
2. Investment in human capital (education and skills) – “Make workers more productive.”
3. Investment in technology – “Build more productive machines.”


Investment in physical capital

Physical capital is anything man-made that makes labor more productive. Fiscal policies to increase investment in physical capital include direct government spending on infrastructure (e.g., roads, bridges, hospitals) and tax incentives to encourage private businesses to invest (e.g., new factories or machinery). Monetary policies that achieve low interest rates also encourage businesses to invest more in physical capital by decreasing its opportunity cost.


Investment in human capital

Human capital is the education, training, and skills people acquire that makes them more productive. Fiscal policies to increase investment in human capital include direct government spending on education and job training or tax incentives to encourage education and skills training. Monetary polices that keep interest rates low may also make it easier for people to acquire more education by lowering the cost of loans to pay tuition and other expenses.


Investment in technology

Technological innovations usually create increases in productivity. For example, scientists have developed agricultural crops that are more disease-resistant and have thus increased the yields from our farmland. Fiscal policies that promote investment in technology include direct government spending on research and development [e.g., National Science Foundation (NSF) grants] and tax incentives to encourage private businesses to invest in discovering new technologies. Monetary policies that keep interest rates low also encourage businesses to invest in technology by decreasing the cost of borrowing money.

Economic Growth - Topics

Technological Innovation

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Technological Innovation

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Capital - the manufactured economic resources

In its broadest sense, capital is anything that increases productivity. Capital allows workers to produce more output with an hour of labor. Economists divide capital into four categories: physical capital, human capital, technology, and financial capital.

Physical capital is anything tangible and man-made that makes workers more productive. Examples of physical capital are computers, cars, pencils, microwave ovens, factories, and machinery. For example, a postal worker delivering mail to houses that are far apart can do it more efficiently with a truck rather than walking. In an hour of time, the mailman with a vehicle could deliver to more homes than the postal worker on foot.

Education and training also make most workers more productive. Human capital is the education, skills, and training that workers acquire that make them more productive. For example, skilled workers can construct more framing for a new building in an hour of time than the same number of unskilled workers. Similarly, a professionally trained nurse may be able to assist more patients in an hour at a hospital emergency room than someone without that education.

Technology is the knowledge and methodology of means of production. For example, sweaters can be knitted by hand or by factory machines. And the machines can be operated by people or controlled by computers. At a give point in time, some countries may have access to technologies, such as computer-controlled machinery, that are not available in other parts of the world. The adoption of new technologies often leads to an increase in productivity.

Financial capital is the money or other financial assets used to purchase the physical capital, human capital, and technology that make workers more productive. When a business considers increasing its physical capital, for example by buying machinery or building a new factory, it may not have enough money to pay for the entire purchase. Consequently, a business may need to raise financial capital in order to purchase physical capital. For relatively small purchases of physical capital, businesses may be able to use retained earnings as the source of financial capital. Retained earnings are the portion of a company’s profits that are not distributed to the owners of the business. For relatively large purchases of physical capital, businesses may borrow financial capital. The most common example of this is a business loan from a commercial bank. Corporations have two other options for raising financial capital, however. Corporations can issue corporate bonds, in which they borrow money directly from the public without using commercial banks as financial intermediaries. A bond is a financial asset that represents a loan from the purchaser of the bond to the issuer of the bond. Purchasers of bonds are lending money to the issuers of the bonds. Corporations also can raise financial capital by selling additional shares of stock. A stock is a financial asset that represents a share of ownership of a corporation. The owners of stock are called stockholders. A dividend is the share of corporate profit that is distributed to each stockholder.

The word capital is often used to refer to human capital, physical capital, technology, or financial capital. The correct meaning of the word is determined by the context of its usage.