Pearson Edexcel International Advanced Level Economics: Causes, benefits and costs of economic growth (YEC11)

This guide teaches the first three statements of 2.3.5 Economic growth in the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics specification (Issue 2, June 2018): causes of growth, benefits of growth and costs of growth. They sit in Unit 2, Macroeconomic performance and policy. The specification lists Unit 1 and Unit 2 as International AS (IAS) units, and Unit 3 and Unit 4 as the extra International A2 (IA2) content. This topic is therefore IAS content that also forms part of the full International Advanced Level. Every figure below is invented and illustrative.

Related pages: the revision notes, the practice questions, the course hub, the printable checklist, and our guide to measuring growth for real GDP, per capita and PPP. Not sure where you stand? Take a free diagnostic.

What the specification asks for

Ref	You must be able to
2.3.5 (1a)	Distinguish actual from potential growth
2.3.5 (1b)	Explain actual growth caused by rises in the components of AD
2.3.5 (1c)	Explain why international trade matters for export-led growth
2.3.5 (1d)	Explain causes of potential growth: domestic investment and foreign direct investment (FDI), innovation, labour force growth including net migration, and the degree of competition
2.3.5 (1e)	Explain why productivity matters for the rate of growth
2.3.5 (2a)	Assess possible benefits: living standards, unemployment, profits, investment, tax revenues, public services
2.3.5 (3a)	Assess possible costs: opportunity costs, environmental costs, trade deficits, inequality, inflation

Output gaps and the multiplier have their own statements and are not taught here.

Actual and potential growth (1a)

Actual growth is the percentage change in real GDP from one period to the next. Potential growth is the rate at which the economy’s productive capacity, the maximum output it can sustain, is rising. Actual growth is a movement of the AD curve against a given AS curve; potential growth is a rightward shift of long-run aggregate supply (LRAS) or of the production possibility frontier (PPF).

Worked example 1. In Country A, real GDP is 800 units in year 1 and 836 in year 2. Productive capacity is 880 in year 1 and rises 3% a year.

Actual growth    = (836 - 800) / 800 x 100 = 4.5%
Potential output = 880 x 1.03 = 906.4 in year 2
Potential growth = 3.0%

Actual growth (4.5%) exceeds potential growth (3.0%). That is only possible while there is spare capacity, such as idle workers or underused factories. Once capacity is used up, actual growth cannot stay above potential growth without inflation.

Actual growth from AD (1b)

AD = C + I + G + (X - M). A rise in any component raises actual growth, provided the economy has spare capacity.

Worked example 2. Country A’s AD components (illustrative):

	Year 1	Year 2	Change
Consumption (C)	480	498	+18
Investment (I)	120	130	+10
Government spending (G)	160	164	+4
Exports (X)	140	150	+10
Imports (M)	100	106	+6
Net exports (X - M)	40	44	+4
Real GDP	800	836	+36

Each component’s contribution to growth is its change divided by year 1 GDP:

C: 18/800 = 2.25 percentage points
I: 10/800 = 1.25
G:  4/800 = 0.50
Net exports: 4/800 = 0.50
Total = 4.50 percentage points, matching the 4.5% above

Chain of reasoning for consumption: lower interest rates or higher confidence, so households borrow and spend more, so firms sell more and hire, so real GDP rises. The same chain works for investment (expected profits), government spending (a policy choice) and net exports (competitiveness, foreign incomes).

Export-led growth (1c)

Export-led growth means growth driven mainly by rising exports. International trade matters because:

• Foreign demand adds to a small home market, so firms can reach economies of scale.
• Export earnings pay for imported capital goods and raw materials.
• Competing abroad pushes firms to cut costs and innovate.
• Specialisation by comparative advantage uses resources more efficiently.

Worked example 3. Country B has GDP of 500, of which exports are 150 (30%). Exports rise 9%.

Rise in exports = 150 x 0.09 = 13.5
Contribution to growth = 13.5/500 = 2.7 percentage points (if imports are unchanged)
If imports rise by 4 as incomes grow: (13.5 - 4)/500 = 1.9 percentage points

Evaluation: heavy reliance on exports leaves the country exposed to a fall in foreign demand or a rise in its exchange rate. Growth also depends on what is exported: manufactured goods with scope for rising productivity differ from a single commodity with a volatile price.

Causes of potential growth (1d)

Potential growth needs more or better factors of production. Use the four bullets in the specification as four separate chains.

Domestic investment and FDI. Investment adds to the capital stock.

Worked example 4. Capital stock 2,200; gross investment 165; depreciation 5% of the stock.

Depreciation = 2,200 x 0.05 = 110
Net investment = 165 - 110 = 55
Capital stock grows 55/2,200 = 2.5%
If the capital-output ratio stays at 2.5 (2,200 / 880), potential output rises 55/2.5 = 22

FDI is investment by a foreign firm in the home economy. A foreign plant that adds 40 to the capital stock raises potential output by 40/2.5 = 16, and may also bring technology, management skills and export links. The cost is that profits flow abroad and local firms may be crowded out.

Innovation. New products and methods raise output per unit of input. If a new process cuts the time to make a unit from 5 hours to 4, output per hour rises from 0.20 to 0.25, a 25% rise. Innovation needs research spending, skilled workers and incentives such as patent protection, so results arrive with a lag.

Labour force growth and net migration. Net migration is immigration minus emigration. A net inflow of 80,000 working-age people into a labour force of 10 million adds 0.8% to labour supply if they find work. Other sources are higher participation and a rising working-age population. Evaluation: GDP per head rises only if the new workers are at least as productive as existing ones and capital grows alongside them.

The degree of competition. Competition pressures firms to cut waste (reducing X-inefficiency), invest and innovate. If a firm’s average cost falls 5% from 12 to 11.40 per unit, it can supply more at each price. Evaluation: very intense competition may leave firms without the profits to fund investment, and some research-heavy industries are dominated by a few large firms.

Productivity (1e)

Productivity is output per unit of input, usually output per worker or per hour. Because real GDP = employment x output per worker, growth is roughly employment growth plus productivity growth.

Worked example 5. Labour force 10.0m to 10.2m; output per worker 40,000 to 41,200.

Labour force growth = 2.0%;  productivity growth = 3.0%
GDP: 10.0m x 40,000 = 400bn;  10.2m x 41,200 = 420.24bn
Growth = (420.24 - 400)/400 = 5.06%, close to 2% + 3%

Productivity matters most because a country cannot keep adding workers, whereas productivity can keep rising through capital, skills and technology. It is also what lifts GDP per head.

Benefits of growth (2a)

For each benefit, state the link and then a limit.

• Higher living standards. More goods and services per person. If GDP rises 4.5% from 800 to 836 and population is 40m, real GDP per head rises from 20.0 to 20.9 (4.5%). If population rises 1% to 40.4m, per head is 20.69, a rise of 3.47%. Growth only helps living standards if it outpaces population growth and is shared.
• Lower unemployment. Output growth of 4.5% with productivity up 3% implies employment up about 1.5%. Limit: structural unemployment will not fall if the unemployed lack the skills required.
• Higher profits. Rising sales spread fixed costs, so profit per unit may rise.
• Higher investment. Profits and confidence encourage investment, which then raises potential growth: a virtuous circle.
• Higher tax revenues. If tax is 30% of GDP, revenue rises from 240 to 250.8, an extra 10.8 without raising tax rates.
• Improved public services. The extra revenue can fund health, education and infrastructure. Limit: it depends on government choices.

Costs of growth (3a)

• Opportunity costs. Resources used for investment or training cannot be used for current consumption. Moving along the PPF towards capital goods means forgone consumer goods today.
• Environmental costs. Resource depletion, pollution and climate effects are negative externalities. If emissions per unit of output fall 2% but GDP rises 5%, total emissions change by 0.98 x 1.05 = 1.029, a rise of 2.9%. Cleaner technology can offset, but not always outrun, growth.
• Trade deficits. Rising incomes pull in imports. With a marginal propensity to import of 0.35, an income rise of 36 raises imports by 12.6. If exports rise by less, the deficit widens.
• Inequality. Average income can rise while the poorest gain little. Example (illustrative, monthly income): bottom group 9 to 9.18 (+2%), top group 52 to 57.2 (+10%). The ratio of top to bottom widens from 5.78 to 6.23.
• Inflation. If AD rises faster than potential output, demand-pull inflation builds as firms bid for scarce labour and materials.

Evaluate by asking: how fast, how sustained, what kind of growth, and who gains?

Common errors

• Treating actual and potential growth as the same thing.
• Writing “GDP rises” without saying real GDP.
• Listing benefits without a chain of reasoning.
• Saying growth always causes inequality or inflation; both depend on its source and speed.
• Giving only one side. Evaluation needs a judgement with a reason.

Next: use the revision notes to memorise, then the practice questions. For essay technique see exam preparation.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics, Specification, Issue 2, June 2018, Pearson Education Limited: Unit 2, section 2.3.5 Economic growth, statements 1 to 3.