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Answer Posted / vivek ambastha iima

Economic Growth
by vivek ambastha Indian Istitute OF Management,Ahmedabad
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.
Every generation has perceived the limits to growth that
finite resources and
undesirable side effects would pose if no new recipes or
ideas were discovered. And
every generation has underestimated the potential for
finding new recipes and ideas.
We consistently fail to grasp how many ideas remain to be
discovered. The difficulty
is the same one we have with compounding: possibilities do
not merely add up; they
In a branch of physical chemistry known as exploratory
synthesis, chemists try
mixing selected elements together at different temperatures
and pressures to see
what comes out. About a decade ago, one of the hundreds of
compounds discovered
this way—a mixture of copper, yttrium, barium, and oxygen—
was found to be a
superconductor at temperatures far higher than anyone had
previously thought
possible. This discovery may ultimately have far-reaching
implications for the storage
and transmission of electrical energy.
To get some sense of how much scope there is for more such
discoveries, we can
calculate as follows. The periodic table contains about a
hundred different types of
atoms, which means that the number of combinations made up
of four different
elements is about 100 × 99 × 98 × 97 = 94,000,000. A list
of numbers like 6, 2, 1,
7 can represent the proportions for using the four elements
in a recipe. To keep
things simple, assume that the numbers in the list must lie
between 1 and 10, that
no fractions are allowed, and that the smallest number must
always be 1. Then there
are about 3,500 different sets of proportions for each
choice of four elements, and
3,500 × 94,000,000 (or 330 billion) different recipes in
total. If laboratories around
the world evaluated 1,000 recipes each day, it would take
nearly a million years to
go through them all. (If you like these combinatorial
calculations, try to figure out
From The Concise Encyclopedia of Economics, David R.
Henderson, ed. Liberty Fund,
2007. Reprinted by permission of the copyright holder.
how many different coffee drinks it is possible to order at
your local shop. Instead of
moving around stacks of cup lids, baristas now spend their
time tailoring drinks to
each individual palate.)
In fact, the previous calculation vastly underestimates the
amount of exploration
that remains to be done because mixtures can be made of
more than four elements,
fractional proportions can be selected, and a wide variety
of pressures and
temperatures can be used during mixing.
Even after correcting for these additional factors, this
kind of calculation only begins
to suggest the range of possibilities. Instead of just
mixing elements together in a
disorganized fashion, we can use chemical reactions to
combine elements such as
hydrogen and carbon into ordered structures like polymers
or proteins. To see how
far this kind of process can take us, imagine the ideal
chemical refinery. It would
convert abundant, renewable resources into a product that
humans value. It would
be smaller than a car, mobile so that it could search out
its own inputs, capable of
maintaining the temperature necessary for its reactions
within narrow bounds, and
able to automatically heal most system failures. It would
build replicas of itself for
use after it wears out, and it would do all of this with
little human supervision. All we
would have to do is get it to stay still periodically so
that we could hook up some
pipes and drain off the final product.
This refinery already exists. It is the milk cow. And if
nature can produce this
structured collection of hydrogen, carbon, and
miscellaneous other atoms by
meandering along one particular evolutionary path of trial
and error (albeit one that
took hundreds of millions of years), there must be an
unimaginably large number of
valuable structures and recipes for combining atoms that we
have yet to discover.
Objects and Ideas
Thinking about ideas and recipes changes how one thinks
about economic policy
(and cows). A traditional explanation for the persistent
poverty of many less
developed countries is that they lack objects such as
natural resources or capital
goods. But Taiwan stared with little of either and still
grew rapidly. Something else
must be involved. Increasingly, emphasis is shifting to the
notion that it is ideas, not
objects, that poor countries lack. The knowledge needed to
provide citizens of the
poorest countries with a vastly improved standard of living
already exists in the
advanced countries. If a poor nation invests in education
and does not destroy the
incentives for its citizens to acquire ideas from the rest
of the world, it can rapidly
take advantage of the publicly available part of the
worldwide stock of knowledge. If,
in addition, it offers incentives for privately held ideas
to be put to use within its
borders—for example, by protecting foreign patents,
copyrights, and licenses, by
permitting direct investment by foreign firms, by
protecting property rights, and by
avoiding heavy regulation and high marginal tax rates—its
citizens can soon work in
state-of-the-art productive activities.
Some ideas such as insights about public health are rapidly
adopted by less
developed countries. As a result, life expectancy in poor
countries is catching up with
the leaders faster than income per capita. Yet governments
in poor countries
continue to impede the flow of many other kinds of ideas,
especially those with
commercial value. Automobile producers in North America
clearly recognize that they
can learn from ideas developed in the rest of the world.
But for decades, car firms in
From The Concise Encyclopedia of Economics, David R.
Henderson, ed. Liberty Fund,
2007. Reprinted by permission of the copyright holder.
India operated in a government-created protective time
warp. The Hillman and
Austin cars produced in England in the 1950s continued to
roll off production lines in
India through the 1980s. After independence, India's
commitment to closing itself off
and striving for self-sufficiency was as strong as Taiwan's
commitment to acquiring
foreign ideas and participating fully in world markets. The
poverty in India and opulence in Taiwan—could hardly be
more disparate.
For a poor country like India, enormous increases in
standards of living can be
achieved merely by letting in the ideas held by companies
from industrialized
nations. With a series of economic reforms that started in
the early 1990s, India has
begun to open itself up to these opportunities. For some of
its citizens such as the
software developers who now work for firms located in the
rest of the world, these
improvements in standards of living have become a reality.
This same type of
opening up is causing a spectacular transformation of life
in China. Its growth in the
last 25 years of the twentieth century was driven to a very
large extent by foreign
investment by multinational firms.
Leading countries like the United States, Canada, and the
members of the European
Union cannot stay ahead merely by adopting ideas developed
elsewhere. They must
offer strong incentives for discovering new ideas at home,
and this is not easy to do.
The same characteristic that makes an idea so valuable—
everybody can use it at the
same time—also means that it is hard to earn an appropriate
rate of return on
investments in ideas. The many people who benefit from a
new idea can too easily
free-ride on the efforts of others.
After the transistor was invented at Bell Labs, many
applied ideas had to be
developed before this basic science discovery yielded any
commercial value. By now,
private firms have developed improved recipes that have
brought the cost of a
transistor down to less than a millionth of its former
level. Yet most of the benefits
from those discoveries have been reaped not by the
innovating firms, but by the
users of the transistors. In 1985, I paid a thousand
dollars per million transistors for
memory in my computer. In 2005, I paid less than ten
dollars per million, and yet I
did nothing to deserve or help pay for this windfall. If
the government confiscated
most of the oil from major discoveries and gave it to
consumers, oil companies
would do much less exploration. Some oil would still be
found serendipitously, but
many promising opportunities for exploration would be
bypassed. Both oil companies
and consumers would be worse off. The leakage of benefits
such as those from
improvements in the transistor acts just like this kind of
confiscatory tax and has the
same effect on incentives for exploration. For this reason,
most economists support
government funding for basic scientific research. They also
recognize, however, that
basic research grants by themselves will not provide the
incentives to discover the
many small applied ideas needed to transform basic ideas
such as the transistor or
web search into valuable products and services.
It takes more than scientists in universities to generate
progress and growth. Such
seemingly mundane forms of discovery as product and process
engineering or the
development of new business models can have huge benefits
for society as a whole.
There are, to be sure, some benefits for the firms that
make these discoveries, but
not enough to generate innovation at the ideal rate. Giving
firms tighter patents and
copyrights over new ideas would increase the incentives to
make a new discovery,
but might also make it much more expensive to build on
previous discoveries.
From The Concise Encyclopedia of Economics, David R.
Henderson, ed. Liberty Fund,
2007. Reprinted by permission of the copyright holder.
Tighter intellectual property rights could therefore be
counter-productive and slow
growth down.
The one safe measure that governments have used to great
advantage has been to
use subsidies for education to increase the supply of
talented young scientists and
engineers. They are the basic input into the discovery
process, the fuel that fires the
innovation engine. No one can know where newly trained
young people will end up
working, but nations that are willing to educate more of
them and let them follow
their instincts can be confident that they will accomplish
amazing things.
Perhaps the most important ideas of all are meta-ideas.
These are ideas about how
to support the production and transmission of other ideas.
The British invented
patents and copyrights in the seventeenth century. North
Americans invented the
modern research university and the agricultural extension
service in the nineteenth
century, and peer-reviewed competitive grants for basic
research in the twentieth
century. The challenge now facing all of the industrialized
countries is to invent new
institutions that encourage a higher level of applied,
commercially relevant research
and development in the private sector.
As national markets for talent and education merge into
unified global markets,
opportunities for important policy innovation will surely
emerge. In basic research,
the United States is still the undisputed leader, but in
key areas of education, other
countries are surging ahead. Many of them have already
discovered how to train a
larger fraction of their young people as scientists and
We do not know what the next major idea about how to
support ideas will be. Nor do
we know where it will emerge. There are, however, two safe
predictions. First, the
country that takes the lead in the twenty-first century
will be the one that
implements an innovation that more effectively supports the
production of new ideas
in the private sector. Second, new meta-ideas of this kind
will be found.
Only a failure of imagination—the same one that leads the
man on the street to
suppose that everything has already been invented—leads us
to believe that all of
the relevant institutions have been designed and that all
of the policy levers have
been found. For social scientists, every bit as much as for
physical scientists, there
are vast regions to explore and wonderful surprises to

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