Question

(Related to Solved Problem 22.2 on page 747) Shortly before the fall of the Soviet Union, the economist Gur Ofer of Hebrew University of Jerusalem wrote, "The most outstanding characteristic of Soviet growth strategy is its consistent policy of very high rates of investment, leading to a rapid growth rate of [the] capital stock." Explain why this strategy turned out to be a very poor way to sustain economic growth in the long run.

Short answer

The Soviet Union's strategy of high investment rates leading to rapid growth in capital stock turned out to be a poor way to sustain economic growth in the long run due to several reasons: - possible overinvestment in low-return industries, - neglect of other growth drivers like technological progress and human capital enhancement, - potential resource misallocation and wastage due to lack of market forces.

Step-by-step solution

Breaking down the Soviet Union's economic strategy

The Soviet Union employed a strategy of high investment rates, which led to a rapid increase in their capital stock. This means they focused a large portion of their national income on creating new physical capital (machinery, buildings, infrastructure, etc.).

Understanding the implications of this strategy

The implications of such a strategy are significant. In the short run, this strategy could stimulate economic growth as the increased capital would boost productivity. However, over time, the diminishing returns to capital would set in, meaning that each additional unit of capital invested would produce less output than the previous unit.

Identifying the flaws of the strategy

In the long run, this strategy turned out to be a poor method to sustain economic growth for several reasons. Firstly, the policy of consistent and intense investing might have led to overinvestment in industries with little returns and neglect of key sectors like consumer goods and services. Secondly, the overemphasis on physical capital and neglect of other growth drivers like technological progress and human capital enhancement (education, skills, health) might have stunted the potential for more balanced, sustainable growth. Thirdly, there could also be an inefficiency in resource allocation due to a lack of market forces leading to wastages and inefficiencies.

Key concepts

Investment Strategy

The Soviet Union's investment strategy was centered on consistently high investment rates. This approach allocated a significant portion of national income towards developing new physical capital, such as machinery, infrastructure, and factories. Initially, this strategy appeared beneficial, as it enabled a rapid boost in economic output.
However, an investment strategy that overemphasizes physical capital can overlook other essential areas. A balanced approach would also focus on improving technology, workforce skills, and consumption sectors.

• Too much emphasis on physical investments could lead to neglecting technological and human capital advancements.
• An ideal investment strategy should stimulate all aspects of the economy proportionally to ensure sustainable long-term growth.

For a truly sustainable strategy, there must be a balance to enhance overall economic health and adaptability.

Physical Capital

Physical capital forms the backbone of any economy. It comprises tangible assets like buildings, machinery, and infrastructure. These investments initially help in increasing productivity, as new technology or more efficient machinery can convert inputs into outputs more effectively.
However, focusing solely on building up physical capital without upgrading it or balancing the productivity factors might lead to challenges.

• An economy overly reliant on physical capital can face obsolescence if there's no continuous innovative input.
• Physical investments without equal focus on training the workforce could result in inefficiencies.

Hence, while physical capital is critical, it should be accompanied by investments in technology and education for continual progress.

Diminishing Returns

The concept of diminishing returns is crucial in understanding why the Soviet Union's strategy faltered. Initially, adding more physical capital increases productivity, but after a certain point, each new addition yields less and less output. Diminishing returns occur because each extra unit of input adds progressively smaller increases to output. This pattern is crucial to recognize in economic strategy.

• Diminishing returns are inevitable when there's an oversaturation of inputs without matching improvements elsewhere.
• Recognizing this effect helps in deciding when to diversify investments beyond just physical capital.

This concept underscores the importance of comprehensive strategies that improve every economic facet, from tech advancements to skill-building.

Resource Allocation Inefficiency

Resource allocation refers to how an economy distributes its assets across different sectors, pivotal in determining growth and productivity. In the Soviet Union, central planning often meant inefficient allocation, as decisions were not necessarily influenced by market demands or efficiencies. Improper resource allocation can lead to overproduction in some sectors, like heavy industry, while underfunding others, such as consumer goods. This inefficiency leads to

• Wastage of resources that could have been more effectively deployed elsewhere.
• A lack of market signals, which makes it difficult to adjust to consumer needs and technological shifts.

Addressing these inefficiencies requires a more market-driven approach, which allows for flexible reallocation that can meet changing economic conditions and optimize growth.