Capital vs. consumer goods and economic growth | Microeconomics | Khan Academy

We've learned a little bit already about how a production possibilities curve can be used to illustrate the concept of economic growth. Let's review the definition of economic growth. Then we're going to go into some more depth about the trade-offs that society faces today between the production of different types of goods and how that can affect the level of economic growth in the future.

You'll recall that economic growth is defined as an increase in the ability of a nation to produce goods and services over time. You've already learned that in the production possibilities curve model, economic growth can be illustrated as a shift outward in the nation's PPC over time. In the graph on our left here, economic growth would be shown as a shift from the white curve to the pink curve. This represents an increase in the ability of a nation to produce both the goods shown on its PPC over time.

The question we want to discuss is, what are the sources of economic growth, and how does a nation's decision about how to allocate its resources today affect its level of potential output in the future? To help us answer this question, we're going to put some different goods on our production possibilities curve here. For today's lesson, we'll be looking at two types of goods. The rubber ducky on the vertical axis represents what we're going to call consumer goods. We're going to define these in just a moment.

Let's look down at the horizontal axis first. The tractor here, it's a tool. This is a good that is used to produce other goods. It's used to produce agricultural products, which could be used to produce all sorts of goods the society needs. A tractor and any other tools like tractors are what we call capital goods. Let's define consumer goods and capital goods before moving on with our analysis.

A rubber ducky in our PPC is a consumer good. This is a good intended to be sold to households. Consumer goods are used for consumption, and ultimately, consumer goods are disposed of. How does this contrast with capital goods, though? Capital goods are a bit different. Capital goods are any goods sold to firms. Capital goods, unlike consumer goods, are used to produce other goods. Therefore, if society allocates more resources towards capital goods today, society is essentially choosing to produce more goods and services in the future, and the trade-off being less goods and services produced today.

So let's look back at our white PPC here. Let's assume that this represents today's production possibilities for a hypothetical country. A country can choose to produce more consumer goods today. By doing so, it would be producing at a point such as point A. Notice that at point A, the country is producing more rubber duckies, but the opportunity cost is the capital goods or the tools that it could be producing instead.

Or society can choose to allocate its resources at a point such as point B. Allocating its resources at point B means society is choosing to produce more capital goods today, with the opportunity cost being fewer consumer goods. Notice that if a country were to move from point A to point B, it would give up all these rubber duckies—all the toys, all the consumer goods that it could have produced if it had chosen to produce at point A instead. So this is the opportunity cost of producing at point B.

Now what if society moved in the other direction and chose to produce more consumer goods today? What if society went from point B to point A, in other words? Well, in that case, the opportunity cost would be the capital goods that it could have enjoyed if it had chosen to produce at point B. The PPC once again illustrates this very basic concept of opportunity cost. It shows us what is given up in order to have anything.

So let's do some analysis over here of the consequences of this country choosing to produce at point A or choosing to produce at point B. What happens if society chooses to allocate more resources towards consumer goods today? Essentially, what it's choosing is current consumption of goods and services over future consumption. What do I mean by this? Essentially, by producing at point A, society is giving up all those capital goods that could have been used to produce other goods in the future. Therefore, society is choosing a higher standard of living today rather than a higher standard of living sometime in the future.

Let's contrast that with point B on our production possibilities curve. If society chooses to allocate more resources towards capital goods today, society is choosing future consumption over current consumption. What do we mean by that? By allocating more of its scarce resources towards capital goods and tools, equipment, and technology that can be used to produce other goods today, society is giving up the current consumption that it could enjoy by producing more toys or consumer goods today. The benefit, though, the benefit of producing more capital goods today is likely to be higher rates of economic growth in the future.

Why is that the case? Because capital goods are those things which are used to produce other goods. Capital is a factor of production; consumer goods are not a factor of production. Consumer goods are fun to consume; they're fun to enjoy. We love playing with our toys, but ultimately, they get consumed and thrown away. Capital goods aren't quickly disposed of; they instead are used in factories, they're used in the fields, they're used in the mines, they're used in all the different ways that we produce goods and services that society benefits from. By allocating more resources towards capital goods today, a country would be choosing future consumption over current consumption.

Now, to illustrate this concept, we can look at some real-world data. What I'm about to show you is some data for two countries that shows how those countries are choosing to allocate their resources today. We can then compare the rates of economic growth over the last 15 years to show that one of those countries has in fact experienced higher rates of economic growth.

Let's look at our data first. Here we've got the output data of two countries: China on the left and the United States on the right. What can we learn from this information? First, let's look at China. Notice that in 2016, the year for which this data applies, China invested 43 percent of its entire GDP. What does that mean? It means that 43.7 dollars out of every hundred dollars spent in China was spent on capital goods. Compare that to the level of consumption in China.

Only 37 percent of China’s total spending went towards household consumption. China is choosing to allocate more of its resources towards the production of capital goods than it is towards the production of consumer goods. Let's look over at the United States. In the United States, in 2016, only 15.9 percent of total spending went towards capital goods. On the other hand, 68.6 percent of America's total spending went towards—you guessed it—household consumption. America has essentially chosen rubber duckies over tractors, or consumer goods over capital goods.

So this is one data point. It's not the only thing that affects the rates of economic growth in a country, but if we look at the actual rates of economic growth since the year 2000 for China and the United States, an interesting fact emerges: China has enjoyed significantly higher rates of economic growth. The blue line here represents China's economic growth rates from 2000 to 2015, and we can see that China has average rates of economic growth of between 8 and 14 percent a year. That means that every year, China's economy has produced approximately 10 percent more stuff than it did the year before.

Compare that to the United States. In the United States, growth rates have averaged between negative two percent and four percent—significantly lower. The United States has achieved economic growth for most of the last 15 years, but the rate of economic growth was quite a bit lower than China. China has, of course, a much larger population. Also, China is at a lower level of economic development than the United States, so it has more room to grow. There are more unused resources in China.

But that aside, China also chooses to allocate more of its resources towards investment in capital goods than it does production of consumer goods for households. This fact, going back to our production possibilities curve, supports the idea that by choosing to produce more capital goods today, a country is essentially choosing future consumption over current consumption. Economic growth has many causes. Economists have been discussing the source of economic growth for over 200 years now. Increases in the population, increases in the education level, the skill level, the amount of technology, and the availability of resources are significant sources of economic growth.

However, a country's decision as to how it allocates its resources today also impacts its rate of economic growth.