3.3: Free Markets – Enhanced Growth

The similarities between economics and biology (or ecology) should be apparent by now. Just like any biological life forms, economies have states of health, vital signs, and life cycles.

Economic growth is a very important health indicator (i.e., vital sign). An economy growing at its potential is a very good signal that it is making effective use of its scarce resources.

Determining if a country’s actual growth rate is up to its potential can be a bit tricky. This is mainly because every economy has a different potential. There are many reasons why one country’s economic potential may differ from another. One significant reason for this difference is the fact that national economies can differ in stages of economic development. A developed economy has significantly different capabilities than a developing economy.

There is no official method of matching a country with a particular stage of economic development. One economist who has spent a great deal of time on economic development is Jeffrey Sachs of Columbia University. In the following excerpt from a speech given at the Chinese Academy of Arts and Sciences in Beijing, China on June 19, 2004, Professor Sachs summarized his approach to identifying and differentiating between different economic stages:

I consider three transformations that economies go through as countries move from extreme poverty to wealth. These three different transformations involve a re-structuring of the economy at different levels of development and pose different challenges for economic policy and strategy. The three stages are the commercial stage, the industrial stage, and the knowledge-based stage. Economies can get trapped at each of those steps of development, either at a pre-commercial level of development, a pre-industrial level, or a pre-knowledge level of development. The countries with the highest income are all now knowledge economies; they are very much driven by innovation, which is in turn driven by a high input of science and technology. The poorest countries, however, are dealing with very different challenges. The diagram below is a crude attempt at graphically showing what I will describe. The four stages of an economy are: pre-commercial, commercial, industrial, and knowledge. Between each stage, there is a transition, which some countries can have tremendous difficulty in overcoming.

The following graphic shows each economic stage of development and several countries which fall into a particular stage.

Figure 2

Developed countries like the U.S. and Japan can expect a potential growth in their economies of about 2-3 percent. A lesser developed economy like China can expect much faster growth (about 9-10 percent). The main reason for the difference between potential growth rates is mainly because many lesser developed countries (sometimes referred to as LCDs) have vast amount of unused or underutilized factors of production (land, labor, capital, and entrepreneurship). As these factors of production are utilized, huge gains are made in production and development. In the case of developed economies, most of the factors of production are already used in the production process, so gains in growth must come mostly from the refinement in, rather than simply adding more resources to, the production process.

When waste occurs in an economy, this has a depressing effect on the potential growth rate. An efficiently run economy cannot possibly grow as fast as an efficient one. And this goes for developed and lesser developed economies.

Since the free-market system relies on enhanced communication and competition, resources tend to be better utilized when compared to other economic systems. So, an LDC with a free market will tend to have a higher potential growth rate than a LDC with another type of economics system.

Figure 3

The previous graph shows the positive relationship between economic freedom (horizontal axis) and income as measured by per capital GDP (vertical axis). Significant parts of economic freedom are communication and competition. And the data confirms that countries with an abundance of both make better use of their resources and therefore achieve higher living standards.