Economic Growth

Compound Rates of Growth In the modern version of an old legend, an investment banker asks to be paid by placing one penny on the first square of a chess board, two pennies on the second square, four on the third, etc. If the banker had asked that only the white squares be used, the initial penny would have doubled in value thirty-one times, leaving $21.5 million on the last square. Using both the black and the white squares would have made the penny grow to $92,000,000 billion. People are reasonably good at forming estimates based on addition, but for operations such as compounding that depend on repeated multiplication, we systematically underestimate how quickly things grow. As a result, we often lose sight of how important the average rate of growth is for an economy. For an investment banker, the choice between a payment that doubles with every square on the chess board and one that doubles with every other square is more important than any other part of the contract. Who cares whether the payment is in pennies, pounds, or pesos? For a nation, the choices that determine whether income doubles with every generation, or instead with every other generation, dwarf all other economic policy concerns. Growth in Income Per Capita You can figure out how long it takes for something to double by dividing the growth rate into the number 72. In the 25 years between 1950 and 1975, income per capita in India grew at the rate of 1.8% per year. At this rate, income doubles every 40 years because 72 divided by 1.8 equals 40. In the 25 years between 1975 and 2000, income per capita in China grew at almost 6% per year. At this rate, income doubles every 12 years. These differences in doubling times have huge effects for a nation, just as they do for our banker. In the same 40-year timespan that it would take the Indian economy to double at its slower growth rate, income would double three times, to eight times its initial level, at China's faster growth rate. From 1950 to 2000, growth in income per capita in the United States lay between these two extremes, averaging 2.3% per year. From 1950 to 1975, India, which started at a level of income per capita that was less than 7% of that in the United States, was falling even farther behind. Between 1975 and 2000, China, which started at an even lower level, was catching up. China grew so quickly partly because it started from so far behind. Rapid growth could be achieved in large part by letting firms bring in ideas about how to create value that were already in use in the rest of the world. The interesting question is why India couldn't manage the same trick, at least between 1950 and 1975.

From The Concise Encyclopedia of Economics , David R. Henderson, ed. Liberty Fund, 2007. Reprinted by permission of the copyright holder. Growth and Recipes Economic growth occurs whenever people take resources and rearrange them in ways that are more valuable. A useful metaphor for production in an economy comes from the kitchen. To create valuable final products, we mix inexpensive ingredients together according to a recipe. The cooking one can do is limited by the supply of ingredients, and most cooking in the economy produces undesirable side effects. If economic growth could be achieved only by doing more and more of the same kind of cooking, we would eventually run out of raw materials and suffer from unacceptable levels of pollution and nuisance. Human history teaches us, however, that economic growth springs from better recipes, not just from more cooking. New recipes generally produce fewer unpleasant side effects and generate more economic value per unit of raw material. Take one small example. In most coffee shops, you can now use the same size lid for small, medium, and large cups of coffee. That wasn't true as recently as 1995. That small change in the geometry of the cups means that a coffee shop can serve customers at lower cost. Store owners need to manage the inventory for only one type of lid. Employees can replenish supplies more quickly throughout the day. Customers can get their coffee just a bit faster. Such big discoveries as the transistor, antibiotics, and the electric motor attract most of the attention, but it takes millions of little discoveries like the new design for the cup and lid to double average income in a nation.download