Topic 3 – Production and

Growth

Content

◉ What are the facts about living standards and growth

rates around the world?
◉ Why does productivity matter for living standards?
◉ What determines productivity and its growth rate?
◉ How can public policy affect growth and living standards?

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 Long Run and Short Run

◉ The solution to a macroeconomic problem depends on

o whether you want a quick solution or
o whether you are looking far into the future.
◉ In the next several lectures, we will look at long-run
problems and their solutions.

The United Kingdom

 Advanced economy (high income
country)
 GDP per capita in 2022 (constant 2015
$US): $47,232
 A negligible share of the population
lives in extreme poverty (living less
than $2.15 per day at 2017 PPP)
 A baby born in the United Kingdom
can expect a relatively healthy
childhood: Only 4 out of 1,000
children die before reaching age 5 in
2021.
 80% of the population ages over 25
completed high school in 2020.
Mexico
 Upper middle-income country
 GDP per capita in 2022 (constant 2015
$US): $9,756
 About 3 percent of the population
lives on less than $2.15 a day in 2020.
 13 out of 1,000 children die before
reaching age 5 in 2021.
 39% of the population ages over 25
completed high school in 2020.

Vietnam
 Lower middle-income country
 GDP per capita in 2022 (constant 2015
$US): $3,655
 About 0.7 percent of the population
lives on less than $2.15 a day in 2020.
 21 out of 1,000 children die before
reaching age 5 in 2021.
 32% of the population ages over 25
completed high school in 2019.
Mali
 Poor country (low-income country)
 GDP per capita in 2022 (constant 2015
$US): $749
 About 15 percent of the population
lives on less than $2.15 a day in 2018.
 97 out of 1,000 children die before
reaching age 5 in 2021.
 5% of the population ages over 25
completed high school in 2020.

Watch the video

◉ Basic Facts of Wealth

(4:27)
◉ https://youtu.be/PzA
r_mL0Qd8

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 Variations in the Standard of Living

◉ Among countries
o Average income in a rich country (U.S., Japan, or Germany) is
about 10 times the average income in a poor country (India,
Nigeria, or Nicaragua)
■ Differences are reflected in large differences in the quality of
life: nutrition, housing, healthcare, life expectancy, etc.
◉ Within a country, over time
o The U.S.: real GDP per person growth: 2% per year (for the
past 100 years)
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Incomes and growth around the world

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 Economic Growth around the World

◉ Because of differences in growth rates

o Ranking of countries by income changes substantially over time
■ Poor countries are not necessarily doomed to poverty forever, e.g. Japan
incomes were low in 1860 and are quite high now
■ Rich countries can’t take their status for granted: They may be overtaken by
poorer but faster-growing countries
◉ Differences in annual growth rates that seem small become large when
compounded for many years.
o Compounding refers to the accumulation of a growth rate over a period of
time.
o Even small increases in growth rates can have a significant effect in the end.
11

Watch the video

◉ Growth Rate Are

Crucial (6:21)
◉ https://youtu.be/VN
WGEIXSuEQ

12
 Productivity: Role and Determinants

A country’s standard of living depends on its ability to

produce goods and services
◉ Productivity, Y/L (Y = output, L = quantity of labor)
o Quantity of goods and services produced from each unit of labor
input
o Key determinant of living standards: when a nation’s workers are
very productive, real GDP is large and incomes are high

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How Productivity Is Determined – Physical Capital

◉ Physical capital, K
o Stock of equipment and structures used to produce goods and services
■ Tools used to build or repair things.
■ Computer software
■ Office buildings, factory buildings, shopping malls, schools, etc.
■ Infrastructure, such as roads, railway lines, bridges, etc.
● These are usually provided by governments
◉ Physical capital per worker, K/L
o Productivity is higher when the average worker has more capital (machines,
equipment, etc.).
■ An increase in K/L causes an increase in Y/L
o Production of physical capital requires reduced production of consumer goods or
reduced leisure  unavoidable tradeoff.
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 How Productivity Is Determined – Human Capital

◉ Human capital, H
o Knowledge and skills workers acquire through education,
training, and experience
◉ Human capital per worker, H/L
o Productivity is higher when the average worker has more human
capital (education, skills, etc.)
■ An increase in H/L causes an increase in Y/L.
o Human capital can be acquired only by sacrificing current
consumption or leisure

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How Productivity Is Determined – Natural Resources

◉ Natural resources, N
o Inputs into production that nature provides
■ Examples: land, rivers, and mineral deposits.
■ Renewable resources include trees and forests.
■ Nonrenewable resources include petroleum and coal.
◉ Natural resources per worker, N/L
o Other things equal, more N allows a country to produce more Y
■ An increase in N/L causes an increase in Y/L
◉ The search for and retrieval of natural resources such as petroleum
and coal—or the purchase of these resources from elsewhere—usually
requires a sacrifice of consumption or leisure
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 How Productivity Is Determined – Technological Knowledge

◉ Technological knowledge, A
o Technological Knowledge refers to our scientific understanding of the
best ways to produce various goods and services.
o Increases in technological knowledge require investment in research and
development
o And further investment may be needed
■ to train workers to use the new technology and
■ to install the new machinery that embodies the new technology
o All this usually requires a sacrifice of consumption and leisure

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Technological knowledge vs. Human capital

◉ Technological knowledge
o Refers to society’s understanding of how to produce goods and
services
◉ Human capital
o Results from the effort people expend to acquire this knowledge
◉ Both are important for productivity

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 Review Question 3.1

Increases in the amount of human capital in the economy tend to

_________ real incomes because they increase the _________ of
labor.
a. increase; bargaining power
b. increase; productivity
c. decrease; bargaining power
d. decrease; productivity

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Watch the video

◉ Puzzle of Growth:
Rich Countries and
Poor Countries (8:32)
◉ https://youtu.be/u5P
8AZRBLac

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 The Production Function – 1

◉ Production function Y = A × F(L, K, H, N)

o A graph or equation showing the relation between output and inputs
o F( ) is a function that shows how inputs are combined to produce output
o “A” is the level of technology
o “A” multiplies the function F( ), so improvements in technology (increases in “A”)
allow more output (Y) to be produced from any given combination of inputs.
◉ Constant returns to scale:
o Changing all inputs by the same percentage causes output to change by that
percentage.
■ Doubling all inputs (multiplying each by 2) causes output to double:
2Y = A × F(2L, 2K, 2H, 2N)
■ Increasing all inputs 10% (multiplying each by 1.1) causes output to increase by 10%:
1.1Y = A × F(1.1L, 1.1K, 1.1H, 1.1N)

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The Production Function - 2

◉ If we multiply each input by 1/L, then output is multiplied by 1/L:

Y/L = A × F(1, K/L, H/L, N/L)
◉ This equation shows that productivity (Y/L, output per worker)
depends on:
o The level of technology, A
o Physical capital per worker, K/L
o Human capital per worker, H/L
o Natural resources per worker, N/L

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 Determinants of Productivity: Government

◉ The availability of physical capital, human capital, natural

resources, and technology does not guarantee that these
resources will be properly utilized
◉ Government must:
o provide proper incentives to households and firms in private
sector
o provide public goods
o conserve common resources
o ensure law and order
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What Makes a Nation Rich?

◉ According to Daron Acemoglu, an MIT economist, the

answer is … government!
◉ Poor people are poor because they made the wrong
choices
◉ They made the wrong choices because their governments
gave them the wrong incentives
◉ Fix government to fix poverty

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 What Makes a Nation Rich?

◉ The Mexico-USA border fence splits Nogales into two

halves that are identical in every way except government
◉ Median household income is $30,000 on the USA side
and $10,000 on the Mexico side
◉ China has been transformed in recent decades pretty
much entirely because government policies have changed

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Watch the video

◉ The Importance of
Institutions (5:17)
◉ https://youtu.be/wd
KBfXRpNsk

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 Economic Growth and Public Policy
◉ A society’s standard of living depends on
o Its ability to produce goods and services
o Productivity depends on
■ Physical capital per worker, human capital per worker, natural resources per worker, and
technological knowledge
◉ What can government policy do to raise productivity and living standards?
o Encourage saving and investment
o Encourage education and training.
o Secure property rights and maintain political stability.
o Ensure free trade.
o Encourage research and development.
o Population growth

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Saving and Investment

◉ If we use fewer resources to produce consumption goods, we will

have more resources to
o Produce physical capital
o Increase human capital through education
o Increase technological knowledge through research and development
◉ But there is a trade-off: less current consumption for more future
consumption
o Reducing consumption = increasing saving
o This extra saving funds the production of investment goods
◉ The accumulation of physical capital is subject to diminishing returns
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 EXAMPLE1: The production Y/L Output per worker
function (productivity)

If workers already have a lot of K,

giving them more increases
productivity fairly little.

If workers have little K, giving

them more increases their
productivity a lot.
K/L
Capital per
worker
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Diminishing Returns

◉ As a country’s stock of physical capital rises, the extra output produced from
an additional unit of capital falls
o this property is called diminishing returns.
◉ Because of diminishing returns, an increase in the rate of investment in
physical capital leads to higher growth but only for a while.
◉ In the long run, a higher rate of investment in physical capital leads to a higher
level of productivity and income, but not to faster growth of productivity and
income.
◉ Saving and investment must be used intelligently, not just to accumulate more
and more physical capital, but to pay for education and research and
automation.
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 The Catch-Up Effect

◉ Diminishing returns also leads to the catch-up effect

◉ The catch-up effect
o The property whereby countries that start off poor tend to grow more
rapidly than countries that start off rich
◉ 1960–1990: the U.S. and S. Korea - similar share of GDP devoted to
investment
o Expect: similar growth performance
o Growth was >6% in Korea; only 2% in the U.S.
o The catch-up effect: in 1960, K/L was far smaller in Korea than in the
U.S., hence Korea grew faster

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EXAMPLE 2: The catch-up effect

Y/L

Rich country’s
growth

Poor country’s
growth

K/L
Poor country
starts here Rich country starts here
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 Review Question 3.2

Because capital is subject to diminishing returns, higher

saving and investment do not lead to higher
a. income in the long run.
b. income in the short run.
c. growth in the long run.
d. growth in the short run.

33

Watch the video

◉ Growth Miracles and

Growth Disasters
(4:25)
◉ https://youtu.be/5X5
v7vRYQjc

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 Investment from Abroad – 1

◉ Another way for a country to invest in new capital

◉ For poor countries, foreign investment may be the only route to
progress
◉ If their incomes are barely enough to cover their essential consumption
needs, then they would not be able to invest for their future needs
◉ Investment from abroad takes several forms:
o Foreign direct investment
■ Businesses owned and operated by a foreign entity
o Foreign portfolio investment
■ Businesses financed with foreign money but owned and operated by domestic
residents.
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Investment from Abroad – 2

◉ Benefits from investment from abroad

o Some benefits (interest and profit) flow back to the foreign capital owners
o Increase the economy’s stock of capital
o Creates jobs for domestic workers and raises their productivity and wages.
o State-of-the-art technologies developed in other countries
o Especially good for poor countries that cannot generate enough saving to fund
investment projects themselves
◉ To attract foreign investment, governments must
o protect the property rights of investors and
o provide adequate infrastructure (roads, ports, etc.)

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 Education

◉ Education = investment in human capital

o Gap between wages of educated and uneducated workers
o Opportunity cost of education: wages forgone
o Confers positive externalities
■ An educated person might generate new ideas that might expand society’s
pool of knowledge and provide an external benefit to others.
o Subsidies to human-capital investment: public education.
◉ Problem for poor countries: Brain drain
o The emigration of many of the most highly educated workers to rich
countries.

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Health and Nutrition – 1

◉ Less healthy workers are less productive.

People are poor
◉ Less healthy workers impose an external cost on
the rest of society: they can infect others
◉ Countries can get caught in a vicious cycle.
o This provides a justification for government efforts to
encourage saving and investment to push economic People cannot
afford adequate
growth
health care and
o More rapid economic growth would naturally improve nutritious food
health outcomes, which in turn would further promote
economic growth

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 Health and Nutrition – 2

◉ Health care expenditure

o Is a type of investment in human capital: healthier workers are more
productive
◉ In countries with significant malnourishment, raising workers’ caloric
intake raises productivity:
o 1962–1995, caloric consumption rose 44% in S. Korea, and economic
growth was spectacular.
o Nobel winner Robert Fogel: 30% of Great Britain’s growth from 1790–
1980 was due to improved nutrition

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Property Rights and Political Stability

Markets are usually a good way to organize economic activity.

◉ To foster economic growth
o Protect property rights (the ability of people to exercise authority
over the resources they own)
■ Prerequisite for the free-market system to work
■ Courts: enforce property rights
o It is necessary for investors to feel that their investments are
secure.
■ This requires a stable political and judicial system

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 Free Trade – 1

◉ Trade has similar effects as discovering new technologies

o Improves productivity and living standards
o Suppose a country’s opportunity cost of a ton of wheat is 5 tons of rice.
If this country can import a ton of wheat by exporting 3 tons of rice, it is
as if the country’s technology has improved
◉ Countries with inward-oriented policies: avoiding interaction with
other countries.
o Make everything it needs, including the things it can’t produce efficiently
o Examples: tariffs, limits on investment from abroad
o Have generally failed to create growth: Argentina throughout the 20th century.

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Free Trade – 2

◉ Countries with outward-oriented policies: encouraging interaction

with other countries.
o Example: elimination of restrictions on trade or foreign investment
o Have often succeeded: South Korea, Singapore, Taiwan
◉ Trade depends not only on government policy but also on geography
o Countries with natural seaports and navigable waterways find it easier to
trade and prosper
o Many of the world’s major cities are located close to oceans
o Africa has suffered because many of its countries are landlocked

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 Watch the video

◉ Geography and
Economic Growth
(2:47)
◉ https://youtu.be/B8z
6XS2jieE

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Research and Development

◉ The advance of technological knowledge has led to higher standards

of living.
o Most technological advance comes from research by private firms and individual
inventors.
o Government can encourage the development of new technologies through
research grants, tax breaks, and the patent system.
◉ New knowledge has external benefits
o Private researchers will consider only the gains that they can get from their
innovations; they will ignore the external benefits
o Therefore, it makes sense for the government to subsidize or fully fund research,
especially on basic or fundamental science that is valuable but will not be done
by private businesses
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 Population Growth – 1

◉ Population growth affects the per capita availability of other factors of

production by:
o Stretching natural resources
o Diluting the capital stock
o More workers, more consumers
o Promoting technological progress:
■ More people = More scientists, more inventors, more engineers = More
frequent discoveries
■ Larger market for innovative goods. This increases the incentive to innovate

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Population Growth – 2

◉ Polices
o Discourage population growth
■ Government regulation (China’s one child law 1980-2015)
■ Increased awareness of birth control
■ Equal opportunities for women (Promote female literacy to raise opportunity cost of
having babies)
o Encourage population growth:
■ Some countries are using economic incentives to encourage population growth.
Example: Greece, Hungary, Italy (video)
◉ Over the broad span of human history, the world’s rate of economic growth
has increased as world population has.
◉ It is unclear whether governments should encourage or discourage population
growth
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 LECTURE IN A NUTSHELL

◉ Economic prosperity, GDP per person, varies substantially around the world. Because
growth rates of real GDP also vary substantially, the relative positions of countries can
change dramatically over time.
◉ The standard of living in an economy depends on the economy’s ability to produce
goods and services.
◉ Productivity depends on the physical capital, human capital, natural resources, and
technological knowledge available to workers.
◉ Government policies can try to influence the economy’s growth rate in many ways: by
encouraging saving and investment, facilitating investment from abroad, fostering
education, promoting good health, maintaining property rights and political stability,
allowing free trade, and supporting the research and development of new technologies.

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LECTURE IN A NUTSHELL

◉ The accumulation of capital is subject to diminishing returns: The more capital

an economy has, the less additional output the economy gets from an extra
unit of capital.
◉ Although higher saving leads to higher growth for a period of time, growth
eventually slows down as capital, productivity, and income rise.
◉ The return to capital is especially high in poor countries. Other things being
equal, these countries can grow faster because of the catch-up effect.

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End of Topic 3