What is Economic Growth?

Economic growth is like adding chickens to the coop…

If you had one chicken laying eggs, you'd get about a dozen eggs every two weeks. While you could adjust the nutrition and other factors, there would be limits to how much you could increase the output from one chicken. But you could add another chicken to the coop. That would roughly double the number of eggs you get. If you compared the number of eggs you got before adding the second hen to what you obtain afterward, you would see an increase in output. Economic growth works the same way.

Economic growth is what happens when an economy (a collection of buyers and sellers who trade with one another) can increase its output. It’s the result of something changing in the economic system that allows its people to improve their production. In general, economic growth leads to higher wages and improved living standards for people living within that economy.

Economic growth happens when there's an increase in an economy’s factors of production (land, labor, capital, and entrepreneurship), or when the available factors of production are used more efficiently.

Land refers to the soil, the things grown from the earth and the resources extracted from beneath the ground. Every tangible product we use comes from growing or mining these resources, then turning them into higher-value products. Finding new resources, or finding better ways to develop and use the existing resources, can lead to economic growth.

An economy uses labor to till the soil, sow seeds, harvest crops, mine minerals, transform resources into products, and provide services to others. An economy can grow by increasing the amount of available labor or improving labor productivity.

For example, a growing population will have more people with which to make products. An economy that creates jobs for unemployed people might also experience economic growth without increasing the labor force. And an economy that improves the skill level of its people can experience economic growth as well.

Capital, as a factor of production, refers to the equipment that people use to make products. Because capital tends to increase a person’s productivity, investments in capital can grow the economy. When people have better tools, they can get more done.

Innovation comes from enterprise, which is the ability to combine labor and resources in new ways to make better products. Technological progress is a typical example that improves the way we work, reduces costs, and increases productivity.

Through innovation, the global economy can produce higher-value products and can free up resources to do other things. New technology has contributed to the significant amount of economic growth the world has experienced since the Industrial Revolution.

An increase in the value of the products a country makes can also lead to economic growth without an increase in the volume of production. If the nation's products see a higher level of demand, or if alternative sources of supply for that product get disrupted, the nation can see economic growth without any real change to what the workforce is doing. For example, if the price of oil goes up, oil producing countries see an increase in the value of their exports. That increase in value would show up as economic growth, even though the country made no changes to its oil production.

Measuring economic growth requires looking at the market value of everything produced within a country’s borders. The macroeconomic statistic used to determine that value is called the gross domestic product (GDP). If a country’s GDP increases from one year to the next, then the economy has grown. It’s vital to use GDP as the measure for growth for two reasons.

First, counting up the number of things that a country makes wouldn’t tell you much. A country that goes from making a million airplanes to making ten million pencils isn’t necessarily better off. The value of the things that get made is a much better way to compare apples to apples.

Second, counting up the number of people that are working within an economy also doesn’t tell you much. Take this example from Milton Friedman: Imagine a few workers digging a trench with shovels. If you only wanted to create more jobs, taking away everyone’s shovels and making people dig with spoons would be considered economic growth. Clearly, it’s not.

Economists often adjust GDP for inflation, which is called real gross domestic product. Adjusting for inflation makes sure that an increase in the value of production is really growth and not just a general increase in prices. In other situations, there may also be an adjustment for population.

While a growing population does create economic growth, it may not help the average person within the economy. Dividing the real GDP by the number of people in the population is called the real GDP per capita.

Economic growth comes in two ways and over two time horizons. First, economic growth can be the result of increasing the number of resources the economy uses, or it can come from getting more out of the same amount of resources. Second, economic growth can be a temporary improvement in output over the short-run, or it can be a structural shift that permanently improves the economy over the long-run.

Intensive economic growth refers to the ability to get more production without changing the number of resources that are available to the economy. There are several ways that can happen. First, technology can improve the productivity of the workforce. Things like the internet improve productivity — as did the invention of the steam engine, electricity, the airplane, the telephone, GPS, and other innovations. There are less dramatic examples of technological innovation driving economic growth as well. Any technology that reduces waste or labor can lead to intensive economic growth.

Similarly, gaining new knowledge and skills can increase the productivity of the people working in an economy. The level of education and skilled labor in an economy is called its human capital. Intensive economic growth increases the intensity of output with the same number of people, the same level of capital, and the same amount of resources. Because there is more wealth created by the same number of people, the average person in the economy is better off. That leads to higher consumer spending, which results in a better standard of living and quality of life.

Unlike intensive growth, extensive economic growth occurs when there is an increase in the factors of production (land, labor, and capital). The most straight-forward example of extensive economic growth is population growth. With more people in the labor market, there is more labor to use. That increased labor produces more goods. Other examples would be the discovery and development of new resources. Those resources can become new products, or can be sold to other countries. In either case, the economy expands.

An investment in new tools and equipment can also increase the level of economic output from a country. That increased capital can reduce the amount of labor needed for one product, which frees it up to make other products. Extensive economic growth might lead to improved wealth for the residents of the country, or it can simply add more output without increasing the condition of the average worker.

In the short-run, an economy typically sees fluctuations in its level of economic output. Economies often experience ups and downs over time — which is called the business cycle. During a recession (downturn in economic activity), more people are unemployed, and many businesses slow down their production. So, the economy has idle resources. As the economy begins to recover, those resources are put back to work. As unused resources are deployed, the economy grows.

There are many ways that those untapped resources can become useful. It can be a result of urbanization (people moving from rural areas to big cities), an increase in demand for the products the country makes, or even from the government using economic policy. One way that can happen is for the government to use fiscal policy (changing tax and spending levels to influence the economy).

An example of this is the building of major public infrastructure projects to stimulate the economy. Another approach is to use monetary policy (changing the interest rate to encourage more borrowing). All of these types of economic growth are short-term. They don't add resources to the economic system or improve the productivity of the workforce. They merely bring the economy toward its natural level of output or encourage it to overproduce in an unsustainable way.

Long-term economic growth is sustainable. It comes from increasing the size of the workforce or its productivity. Technological improvements are among the most common ways that long-term economic growth can occur. Increasing the size of the workforce, usually through migration, is another typical factor.

Finally, purchasing better tools and equipment can lead to long-term economic growth. But, doing so often requires a temporary reduction in the economy. That’s because money that would go toward spending in the present goes toward increasing future production.

One famous model that tries to explain how economies grow was put forward in 1959 by W.W. Rostow. The Rostow model outlines five stages of economic growth.

In the first stage, an economy is mostly focused on food production. There’s little trade, and the vast majority of the population spends its time doing manual labor. The economy doesn’t have much equipment to help the population be more productive.

As society embraces technology, it begins to move from an agrarian focus toward manufacturing. People begin to increase their productivity and start making higher-valued products.

During this short stage, industrialization intensifies, and the population becomes centralized in urban centers. Most of the economic activity focuses on manufacturing, and international trade becomes more important.

The fourth stage occurs over a long time. The economy advances technologically and becomes wealthier. Productivity reaches increasing levels, which creates higher standards of living and more diversification in the economy.

When an economy advances to the last stage, its economy shifts its focus. The workforce tends to provide more services rather than making products. These tend to be high-income jobs. Because the people are comparatively rich, they tend to import goods manufactured from countries in lower stages of development.

Economic growth is important because it often leads to a better quality of life for the residents of a country. As an economy grows, the people within that economy tend to see their per capita incomes rise. With that income growth, they can afford more things that make them happy.

Rising levels of economic production tend to correlate with longer lifespans, healthier populations, lower levels of pollution, less starvation, better working conditions, and many other things that are widely considered to be positive. While a country’s gross domestic product isn't a measure of social wellbeing, countries that experience economic growth are generally better off because of it.

Economic growth is the increase in a country’s gross domestic product, or GDP (the monetary value of everything produced within a country’s borders during a specified time). On the other hand, economic development refers to an improvement in the quality of life for those people living within an economy.

Economic development happens when people live longer, happier lives. They're wealthier and have access to food, shelter, medicine, and education. And they spend more of their time on personal passions rather than manual labor. While the concepts are related, they aren’t the same.