In a different scenario, the household learns from a neighboring farmer that it has the right kind of farmland, climate, and soil to produce vanilla beans, with a much higher income. After some deliberation, the household decides to shift to vanilla as a cash crop. The next year the household earns $800 in vanilla, and uses $600 to buy four tons of grain for food. As more vanilla farmers arise in the region, a new group of trading firms also forms, specializing in shipping and storage of vanilla, food, and farm inputs.
This pattern exemplifies Adam Smith's insight into the two-way link from specialization to expanded markets back to increased specialization. The farm household specializes in high-value vanilla farming because it lives in favorable ecological conditions for vanilla trees. It relies on the market to trade with other households, which instead specialize in producing food. As incomes rise, and the "extent of the market" increases, to use Smith's phrase, there is room for further specialization, in this case in transport services. Later on, economic activities will be further divided among firms specializing in housing construction, clothing manufacturing, road maintenance, plumbing, electricity, water and sanitation systems, and so forth.
Alternatively, an agricultural extension officer teaches the farm household how to manage the soil nutrients in a new and improved manner by planting special nitrogen-fixing trees that replenish the vital nitrogen nutrients of the soil, and to multiply the benefits by using improved grains. The new cereal varieties are faster maturing and pest resistant, and they flourish with the replenished soil nutrients. As a result, the crop yield rises in a single year to three tons of maize per hectare, or six tons in total. The income per capita therefore rises to $150 (three tons per hectare times two hectares at $150 per ton divided by six people).
The farm household is able to move to a much larger and more fertile farm after the government's success in controlling the breeding of black flies, which spread African river blindness. Suddenly there are thousands of hectares of new farmland and a significant expansion of production capacity as a result. Incomes rise and hunger falls as each household in the newly opened region is able to triple its previous food output.
These four pathways to higher income are the main ways that economies grow, albeit in much more complicated settings than I have just described. In actual economies, a rise in gross domestic product (GDP)
per capita is typically the result of most or all of these four processes simultaneously at work: saving and capital accumulation, increasing specialization and trade, technological advance (and a resulting rise in output for a given amount of inputs), and greater natural resources per person (and a resulting increase in the level of output per person). Although I have illustrated these pathways to rising income at the level of an individual household, in fact each of these processes operates through the interactions of thousands or millions of households linked together by markets and collective actions through public policies and public investments.
What, instead, could lead to a reduction of household income per capita? In general, an economy can rewind the clock, moving backward rather than forward. Here are a number of ways that this might happen.
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