4-Production and Growth NGUYEN VINH, PHD

Production and Growth

I. Determinants of Living Standard

1. Economic growth around the world

­ Economic growth measures the increase in output of
economy over time

Y t - Y t -1
g =
t
*100%
Y t -1
where:
• gt is growth rate of period t
• Y is real GDP or real GDP per capita

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4-Production and Growth NGUYEN VINH, PHD

Economic Growth in Some Countries

Question: How can calculate average rate of growth

for real GDP per capita over many year in
Table 1 of Chapter 12 of textbook?

Note: The rule of 70: if a variable grows at x% a year

then it will take approximately ………. years for
the variable to double.

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4-Production and Growth NGUYEN VINH, PHD

Incomes and Growth Around the World

Since growth rates vary, the country rankings can

change over time:
– Poor countries are not necessarily doomed to poverty
forever
– Rich countries can’t take their status for granted:
They may be overtaken by poorer but
faster-growing countries.

2. Determinants of living standard

• Recall, one of the Ten Principles from Chap. 1:

A country’s standard of living depends
on its ability to produce goods & services.
• This ability depends on
productivity, the average quantity of g&s produced
per unit of labor input.
• Y = real GDP = quantity of output produced
L = quantity of labor
so productivity = Y/L (output per worker)

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4-Production and Growth NGUYEN VINH, PHD

Crusoe’s Economy
• Crusoe’s activities: produce and consume fish,
vegetables, and clothing
• Living standard of Crusoe: more fish he catch per hour
ð more he eats, more time he devote to making other
goods.
→ productivity
• Crusoe will be better at caching fish if:

2. Determinants of living standard

• Physical capital (K ): the stock of equipment and

structures that are used to produce goods and services
• K/L = capital per worker.
• Productivity is higher when the average worker has
more capital (machines, equipment, etc.).
• i.e.,

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4-Production and Growth NGUYEN VINH, PHD

2. Determinants of living standard

• Human capital (H): the knowledge and skills that

workers acquire through education, training, and
experience.
• H/L = the average worker’s human capital
• Productivity is higher when the average worker has
more human capital (education, skills, etc.).
• i.e.,

2. Determinants of living standard

• Natural resources (N): the inputs into the production that
are provided by nature (land, forests, mineral deposits,..)
• Other things equal,
more N allows a country to produce more Y.
In per-worker terms,
an increase in N/L causes an increase in Y/L.
• Some countries are rich because they have abundant
natural resources
(e.g., Brunei has lots of oil, natural gas).
• But countries need not have much N to be rich
(e.g., Japan imports the N it needs).
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4-Production and Growth NGUYEN VINH, PHD

2. Determinants of living standard

• Technological knowledge: society’s understanding of
the best ways to produce g&s
• It means any advance in knowledge that boosts
productivity (allows society to get more output from its
resources).

→ help to rise persistently living standard

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2. Determinants of living standard

­ Production Function provides a quantity link between
inputs and outputs
Y = A F(L, K, H, N)
where
Ø F(.) : a function that shows how the inputs are
combined to produce output
Ø A : level of technology, improvements in technology
(increases in “A”) allow more output (Y) to be
produced from any given combination of inputs
Ø L, K, H, N: the quantities of labor, physical capital,
human capital , and natural resources.
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4-Production and Growth NGUYEN VINH, PHD

2. Determinants of living standard

­ The Production Function
Y = A F(L, K, H, N)

• The production function has the property

constant returns to scale:

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2. Determinants of living standard

­ The Production Function
• 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
(output per worker) depends on:
– the level of technology (A)
– physical capital per worker
– human capital per worker
– natural resources per worker
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4-Production and Growth NGUYEN VINH, PHD

2. Determinants of living standard

­ The Production Function
….another property

Diminishing returns to factors: the benefit from an

extra unit of input declines as the quantity of the input
increases.
For example, diminishing returns to capital
As K rises, the extra output from an additional unit
of K falls….

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The Production Function & Diminishing Returns

Y/L
If workers
Output per
have little K,
worker
giving them more
(productivity)
increases their
productivity a lot.

If workers already
have a lot of K,
giving them more
increases
K/L
productivity
fairly little.
Capital per worker
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4-Production and Growth NGUYEN VINH, PHD

II. Economic Growth and Public Policy

1. Encourage Saving and Investment
Saving ñ → Investment ñ → K ñ → Y ñ
• We can boost productivity by increasing K,
which requires investment.
• Since resources scarce, producing more capital
requires producing fewer consumption goods.
• Reducing consumption = increasing saving.
extra saving funds the production of investment
goods ð tradeoff between current and future
consumption.
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II. Economic Growth and Public Policy

1. Encourage Saving and Investment

• The government can implement policies that raise

saving and investment.
ð K will rise, causing productivity and living standards
to rise.
• But this faster growth is temporary,
due to diminishing returns to capital:
As K rises, the extra output from an additional unit of
K falls….
ð Catch-up effect

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4-Production and Growth NGUYEN VINH, PHD

II. Economic Growth and Public Policy

­ Catch-up effect: the property whereby countries that
start off poor tend to grow more rapidly than
countries that start off rich
Capital is subject to diminishing returns → the
higher saving rate lead to higher level of productivity
and income but does not lead to higher growth in
these variables

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The catch-up effect: the property whereby poor

countries tend to grow more rapidly than rich ones
Y/L

Rich country’s
growth

Poor country’s
growth

K/L
Poor country
starts here Rich country starts here

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4-Production and Growth NGUYEN VINH, PHD

II. Economic growth and public policy

2. Investment from abroad

3. Education

4. Heath and Nutrition

5. Property right and political stability

6. International trade

7. Research and Development

8. Population growth
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2. Investment from Abroad

• To raise K/L and hence productivity, wages, and living

standards, the govt can also encourage
– foreign direct investment:
a capital investment (e.g., factory) that is
owned & operated by a foreign entity
– foreign portfolio investment:
a capital investment financed with foreign money but
operated by domestic residents
• Some of the returns from these investments
flow back to the foreign countries that supplied
the funds.
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4-Production and Growth NGUYEN VINH, PHD

3. Education

• Govt can increase productivity by promoting education–

investment in human capital (H).
– Public schools, subsidized loans for college
• Education has significant effects: In the U.S., each year
of schooling raises a worker’s wage by 10%.
• But investing in H also involves a tradeoff between the
present & future:
Spending a year in school requires sacrificing
a year’s wages now to have higher wages later.

4. Health and Nutrition

• Health care expenditure is a type of investment in human

capital – healthier workers are more productive.
• In countries with significant malnourishment, raising
workers’ caloric intake raises productivity:
– Over 1962-95, caloric consumption rose 44% in S.
Korea, and economic growth was spectacular.
– Nobel winner Robert Fogel:
30% of Great Britain’s growth from 1790-1980 was
due to improved nutrition.

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4-Production and Growth NGUYEN VINH, PHD

5. Property Rights and Political Stability

• When people fear their capital may be stolen by criminals or confiscated

by a corrupt govt,
there is less investment, including from abroad, and the economy
functions less efficiently.
ð lower living standards.
• Economic stability, efficiency, and healthy growth require law
enforcement, effective courts,
a stable constitution, and honest govt officials.

6. Free Trade

• Recall: Trade can make everyone better off.

• Trade has similar effects as discovering new
technologies – it improves productivity and living
standards.
• Countries with inward-oriented policies have
generally failed to create growth.
– E.g., Argentina during the 20th century.
• Countries with outward-oriented policies have
often succeeded.
– E.g., South Korea, Singapore, Taiwan after 1960.

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4-Production and Growth NGUYEN VINH, PHD

7. Research and Development

• Technological progress is the main reason why living

standards rise over the long run.
• One reason is that knowledge is a public good: Ideas can
be shared freely, increasing the productivity of many.
• Policies to promote tech. progress:
– Patent laws
– Tax incentives or direct support for private sector
R&D
– Grants for basic research at universities

8. Population Growth

2. Diluting the capital stock

• Bigger population = higher L = lower K/L
= lower productivity & living standards.
• This applies to H as well as K:
fast pop. growth = more children
= greater strain on educational system.
• Countries with fast pop. growth tend to have lower
educational attainment.

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4-Production and Growth NGUYEN VINH, PHD

8. Population Growth

3. Promoting tech. progress

• More people
= more scientists, inventors, engineers
= more frequent discoveries
= faster tech. progress & economic growth
• Evidence from Michael Kremer:
Over the course of human history,
– growth rates increased as the world’s population
increased
– more populated regions grew faster than
less populated ones

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