1.1 Introduction
The contrasting notions of diminishing returns and productivity are at the centre of theoretical analysis of development and growth, and upon these, the whole structure of developmental thought is built.
This chapter is an introduction to the sources of growth and its development. Its purpose is to identify the sources of growth and also to provide a concise, comprehensive understanding of the evolution of the theories of development and growth.
Section 1.2 discusses the concept of diminishing returns and productivity. Section 1.3 identifies and highlights the individual sources of growth,1 which, through their operation, reverse the effects of the principle of diminishing returns and affect productivity. Section 1.4 looks into the roots of development and growth, with particular reference to the role of the cultural background and biological genes. Section 1.5 discusses the functionality of growth sources and their two dimensions that must be considered. One is the dimension of time and refers to the time required to activate their effectiveness. It should be noted that some sources of growth have a short-term effect on the growth of the economy and some longer-term effects. A good example of this is how demand is affected by monetary policy (e.g. benchmark interest rates). Since monetary policy triggers expectations, its effects on economic activity are immediate. These may even be located at the same time as the announcement of relevant measures. On the contrary, many policies have long-term effects, such as those on attitudes and behaviours, which are not easy to change. The sources of growth can be related to the level of operation of the economy. That is, whether these policies are triggered and implemented under conditions of economic activity above or below the potential output. Finally, Sect. 1.6 treats the key questions that arise from developments in global economy and economic theory as it is shaped at the beginning of the twenty-first century. At the same time, the technique of scenario development is presented as a way of approaching and managing the future.
1.2 Diminishing Returns and Productivity
The original formulation of the law of diminishing returns lies in the past. In 1767, Anne Robert Jacques Turgot, considered by many to be the first to introduce the school of classical economics, argued that the output of production would gradually increase at a declining rate when specific inputs of production are constant, and others are increased proportionally (Groenewegen, 1977). A few years later, English classical economists Adam Smith and David Ricardo, studying the conditions of production in England, included the concept of diminishing returns in their analysis. Although Thomas Robert Malthus did not include in his work Essay on the Principle of Populations (1798) the conditions of the particular law in its theoretical delineation, its effect had already been incorporated in his reasoning and in the determination of the possibilities of agricultural production. By contrast, neoclassical economists included this law as the cornerstone of their structure, with particular emphasis on the concept of productivity.
The basic assumptions of the law of diminishing return are as follows: (a) there is no change in technology, (b) the period of application is limited, (c) all units of the different inputs are homogeneous and (d) production is measured in physical units.
The operation of the law of diminishing return can be understood either in the form of a non-continuous increase in the efficiency of the factors of production or in the form of increased production costs. In other words, the more units of production factors are used, the less additional units of product (marginal product) are produced. In an alternative view, we could argue that the average cost of production is increasing.
When this law appeared in the economic literature in the eighteenth century, the way it worked was quite evident. Particularly so when its function was applied to matters of agricultural production (limited land) or mines (specific mining potential), construction of buildings in industrial complexes and so on.
Over time, however, economies have become more complex, and the working of economy is now a complicated system; as a result, the operation of the law of diminishing returns is subject to many factors that overturn or limit its activity. Two concepts, knowledge and innovation, have contributed to the eradication of diminishing returns. Thus, the concepts of knowledge as a result of one’s work and innovation were reasons for the effectiveness of the law to be suspended. At the same time, economic theory has taken care to extend its boundaries so as to include these factors in its models.
This is how endogenous growth models emerged (after the AK growth models of the 1960s up to the present), which now had the potential to alter the equilibrium points that would have arisen if there were no endogenous growth factors. Primarily through these factors, namely the accumulation of knowledge and human capital, output per factor of production continued to increase. This rate of increase in output has become the absolute measure of the efficiency of the economic system. Thus, analysis came to include the concept of productivity, that is, the quantity of goods and services that can be produced per unit of input. As productivity increases, so does the efficiency of the economic system. This is, in fact, the “Holy Grail of Economics”, and as P. Krugman wrote in The Age of Diminishing Expectations (1994): “Productivity is not everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to increase productivity”.
There are five reasons leading to the application of the law of diminishing returns: (a) As long as there is an optimal combination of production factors, and one of them is kept constant, the increase in the others leads to overall marginally reduced returns. (b) If one of the factors of production is scarce, it is reasonable to assume that it will hardly be possible for it to proportionately match the change in the other inputs. (c) If there are no perfect substitutes for the factors of production, then the exhaustion of some of them leads to a restriction in their use. (d) If a combination of productive inputs is optimal in terms of output efficiency, any disturbance of constant and variable inputs will result in output below the optimal level. (e) If size is continually increasing, even in a proportionate way, across all inputs, there is a chance that signs may occur of ineffective management and, consequently, of a gradual decline in returns. The mathematical formulation of the law of diminishing returns is as follows: Given that it is dominated by a double differentiable production function q = f (K,L) that expresses, for a given level of technology, the relationship between K and L, for any given value of K, we can find the value of L, that is, L0_(K) so that fLL<0 for L>L0>(K), and for any given value of L, we can find the value of K, that is K0(L) so that fKK<0 for K>K0(L).
The evolution of productivity in all three of its forms, namely labour productivity, capital productivity and total productivity—total factor productivity (TFP)—shows the extent and rate to which the adverse effects of the law of diminishing returns are addressed. Productivity helps to create a regulatory framework for presenting productivity capacity and efficiency of economies. It therefore gives a picture of their competitiveness.
The evolution of productivity helps determine the capacity of the productive mechanism and thus to determine the position of economies in the economic cycle and predict growth or determine to what extent inflationary pressures will develop in the economy. In other words, an economy with very low or constantly declining productivity is likely to subsequently experience inflationary pressures due to the depletion of effective input combinations.
There are many ways to measure productivity, but the most common one, at the macroeconomic level, is the gross domestic product (GDP) per Working Hours. Several factors may obscure the above measurement. In terms of the gross domestic product, it is important to what extent it derives from the formal or the shadow economy, since if it derives from the shadow economy, it is nowhere recorded, and, therefore, the productivity index may not be fully representative.
When it comes to measuring labour inputs, it depends on many factors such as education, experience and so on. When calculating the contribution of labour and intermediate inputs to the output, it is possible to calculate the contribution of all other factors (technology, innovation, institutional background, etc.) to the residual growth that can take the form of a multi-factor productivity (MFP) index. One widespread type of...