9

THE REAL ECONOMY IN THE LONG RUN

Production and
Growth

17

Production and Growth

Examine the long-run determinants of both the
level and the growth rate of real GDP per person
We will find that capital and labor are among the
primary determinants of output.

Analyze the factors that determine the productivity

of workers
Address what governments might do to improve the
productivity of their citizens.

Production and Growth

A countrys standard of living depends on its ability
to produce goods and services.
Within a country there are large changes in the
standard of living over time.
In the United States over the past century, average
income as measured by real GDP per person has grown
by about 2 percent per year.

What about other countries?

Incomes
and Growth
Around the World

FACT 1:
There are
vast
differences
in living
standards
around the
world.

GDP per
Growth rate,
capita, 2011 19702011

China
Singapore
India
Japan
Spain
Israel
Colombia
United States
Canada
Philippines
Rwanda
New Zealand
Argentina
Saudi Arabia
Chad

$8,442
$61,103
$3,650
$34,278
$32,701
$28,007
$10,103
$48,442
$40,541
$4,140
$1,251
$30,108
$17,674
$24,434
$1,531

7.5%
4.8%
3.3%
2.1%
2.0%
2.1%
2.0%
1.8%
1.7%
1.3%
1.2%
1.2%
1.4%
0.6%
0.7%

Incomes
and Growth
Around the World

FACT 2:
There is also
great
variation
in growth
rates across
countries.

GDP per
Growth rate,
capita, 2011 19702011
China
Singapore
India
Japan
Spain
Israel
Colombia
United States
Canada
Philippines
Rwanda
New Zealand
Argentina
Saudi Arabia
Chad

$8,442
$61,103
$3,650
$34,278
$32,701
$28,007
$10,103
$48,442
$40,541
$4,140
$1,251
$30,108
$17,674
$24,434
$1,531

7.5%
4.8%
3.3%
2.1%
2.0%
2.1%
2.0%
1.8%
1.7%
1.3%
1.2%
1.2%
1.4%
0.6%
0.7%

ECONOMIC GROWTH AROUND

THE WORLD

Living standards, as measured by real GDP per

person, vary significantly among nations.
The poorest countries have average levels of income that
have not been seen in the United States for many
decades.

Growth rates are also reported in the table. Japan

has had the largest growth rate over time, 2.8
percent per year (on average).

ECONOMIC GROWTH AROUND

THE WORLD

Because of different growth rates, the ranking of

countries by income per person changes over time.
Annual growth rates that seem small become large when
compounded for many years.
Compounding refers to the accumulation of a growth rate over
a period of time.

The powerful effects of compounding:

A one percentage point change in a countrys growth rate can
make a significant difference over several generations.

Are You Richer than the Richest

American?

10

The richest American of all time is John B.

Rockefeller, whose wealth today would be the
equivalent of $200 billion.
Yet he did not have access to television and air
conditioning.
Since Rockefeller lived from 1839 to 1937, he did not
get the chance to enjoy many of the conveniences we
take for granted today

Thus, because of technological advances, the

average American today may enjoy a richer life
than the richest American who lived a century ago.

PRODUCTIVITY: ITS ROLE AND

DETERMINANTS

11

Productivity plays a key role in determining living

standards for all nations in the world.
Productivity refers to the amount of goods and
services produced for each hour of a workers time.
A nations standard of living is determined by the
productivity of its workers.
To understand the large differences in living standards
across countries, we must focus on the differences in
productivity.

12

How Productivity Is Determined

Productivity is directly determined by the
availability and quality of the factors of production.
Factors of production are the inputs used to produce
goods and services.

The Factors of Production

Physical capital
Human capital
Natural resources
Technological knowledge

13

How Productivity Is Determined

Physical Capital
It is the stock of equipment and structures that are used
to produce goods and services.

Tools used to build or repair automobiles.

Tools used to build furniture.
Office buildings, schools, etc.
Example: Crusoe will catch more fish if he has more fishing
poles.

It is an input into the production process that in the past

was an output from the production process.
=> can be reproduced.
=> society can choose the amount of capital they want to have.

14

How Productivity Is Determined

Human Capital
the economists term for the knowledge and skills that
workers acquire through education, training, and
experience
Like physical capital, human capital raises a nations ability to
produce goods and services.
Example: Crusoe will catch more fish if he has been trained in
the best fishing techniques.

15

How Productivity Is Determined

Natural Resources
inputs used in production that are provided by nature
Example: Crusoe will have better luck catching fish if there is
a plentiful supply around his island.
Renewable resources include trees and forests.
Nonrenewable resources include petroleum and coal.

Are Natural Resources a Limit to Economic Growth?

As the population has grown over time, we have discovered
ways to lower our use of natural resources.
Thus, most economists are not worried about shortages of
natural resources.

16

How Productivity Is Determined

Technological Knowledge
societys understanding of the best ways to produce
goods and services.
Example: Crusoe will catch more fish if he has invented
a better fishing lure.

17

Examples
Which capital inputs are necessary to produce each of the
following?
Cars
a factory with machines, robots, and an assembly line, as well as human
capital that comes from training workers.

High school education

books and buildings as well as human capital from the teachers.

Plane travel
planes and airports as well as human capital in terms of pilots' knowledge.

Fruits and vegetables

irrigation systems, harvesting machinery, and trucks to transport the goods
to the market, as well as human capital in the form of agricultural
knowledge.

18

FYI: The Production Function

Economists often use a production function to describe the
relationship between the quantity of inputs used in
production and the quantity of output from production.
Y = AF(L, K, H, N)

Y = quantity of output
A = available production technology
F() is a function that shows how the inputs are combined.
L = quantity of labor
K = quantity of physical capital
H = quantity of human capital
N = quantity of natural resources

19

FYI: The Production Function

Many production functions have a property called
constant returns to scale.
A production function has constant returns to scale if,
for any positive number x,
x Y = A F(x L, x K, x H, x N)
=> a doubling of all inputs causes the amount of output
to double as well.
2Y = A F(2L, 2K, 2H, 2N)

20

FYI: The Production Function

Production functions with constant returns to scale have an
interesting implication.
If we want to examine output per worker, Y/L, we could set x =
1/L and we would obtain the following:

Y/L = A F L (1/L), K (1/L), H (1/L), N (1/L)

= A F(1, K/L, H/L, N/L)
=> labor productivity (Y/L) depends on
physical capital per worker (K/L),
human capital per worker (H/L),

natural resources per worker (N/L),

the state of technology, (A).

ECONOMIC GROWTH AND

PUBLIC POLICY
Which of the following policies do you think would
be most effective at boosting growth and living
standards in a poor country over the long run?
a. Offer tax incentives for investment by local firms
b. Offer tax incentives for investment by foreign firms
c. Give cash payments for good school attendance

d. Crack down on govt corruption

e. Restrict imports to protect domestic industries
f. Allow free trade

g. Give away condoms

21

22

1. The Importance of Saving and Investment

One way to raise future productivity is to invest
more current resources in the production of capital.
Capital is a reproducible factor of production,
=> society can change the amount of capital that it has.

However, there is an opportunity cost of doing so;

if resources are used to produce capital goods, fewer
goods and services are produced for current
consumption.

Economic growth rates and investment amounts of

15 countries for 1960 to 2011
( b ) I n v e s t m e n t 1 9 6 0 2011

( a) Gr ow t h R at e 19 60 2011

South Korea
Singapore
Japan
Israel
Canada
Brazil
West Germany
Mexico
United Kingdom
Nigeria
United States
India
Bangladesh
Chile
Rwanda
0

1.

South Korea
Singapore
Japan
Israel
Canada
Brazil
West Germany
Mexico
United Kingdom
Nigeria
United States
India
Bangladesh
Chile
Rwanda
1

4
5
6 7
Growth Rate (percent)

10

20
30
40
Investment (percent of GDP)

Countries that devote a large share of GDP to investment tend to

have high growth rates.
2. However, from the data given it is difficult to determine cause
and effect.

24

Diminishing Returns and the Catch-Up Effect

As the stock of capital rises, the extra output produced
from an additional unit of capital falls; this property is
called diminishing returns.
if workers already have a large amount of capital to work with,
giving them an additional unit of capital will not increase their
productivity by much.
=> Because of diminishing returns, an increase in the saving rate
leads to higher growth only for a while.

In the long run, the higher saving rate leads to a higher

level of productivity and income, but not to higher growth
in these areas.

The Production Function & Diminishing Returns

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

Y/L

If workers already
have a lot of K,
giving them more
increases
productivity
fairly little.
2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

K/L
Capital per worker
25

26

Diminishing Returns and the Catch-Up Effect

The catch-up effect refers to the property whereby
countries that start off poor tend to grow more
rapidly than countries that start off rich.
When workers have very little capital to begin with, an
additional unit of capital will increase their productivity
by a great deal.
Figure: South Korea had a growth rate more than three times
larger than the United States even though both countries
devoted a similar share of GDP to investment.

The catch-up effect: the property whereby poor

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

Rich countrys
growth

Poor countrys
growth

K/L

Poor country
starts here

Rich country starts here

2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27

28

2. Investment from Abroad

Saving by domestic residents is not the only way for a country
to invest in new capital.
Governments can increase capital accumulation and economic
growth by encouraging investment from foreign sources.
Investment from abroad takes several forms:
Foreign Direct Investment
Capital investment owned and operated by a foreign entity.

Foreign Portfolio Investment

Investments financed with foreign money but operated by domestic
residents.

Some of the benefits of foreign investment flow back to foreign

owners.
But the economy still experiences an increase in the capital stock, which
leads to higher productivity and higher wages.

29

An example
Suppose that an auto company owned entirely by German
citizens opens a new factory in South Carolina.
What sort of foreign investment would this represent?
When a German firm opens a factory in South Carolina, it
represents foreign direct investment.

What would be the effect of this investment on U.S. GDP?

The investment increases U.S. GDP since it increases production
in the United States.

Would the effect of this investment on U.S. GNP be larger

or smaller than the effect on U.S. GDP?
The effect on U.S. GNP would be smaller than the effect on U.S.
GDP since the German owners would get paid a return on their
investment that would be part of German GNP rather than U.S.
GNP.

30

Investment and Economic Development

The World Bank is an organization that encourages
the flow of investment to poor countries.
The WB obtains funds from developed countries and
makes loans to less-developed countries so that they can
invest in roads, sewer systems, schools, and other types
of capital.
The WB also offers these countries advice on how best
to use these funds.

31

3. Education
For a countrys long-run growth, education is at least as important as
investment in physical capital.
In the US, each year of schooling raises a persons wage by about 10 percent.
=> the government can enhance the standard of living by providing schools and
encourage the population to take advantage of them.

Positive externalities from education

An educated person might generate new ideas about how best to produce goods
and services,
These ideas enter societys pool of knowledge and provide an external benefit
to others.

Investment in human capital also has an opportunity cost.

When students are in class, they cannot be producing goods and services for
consumption.
In less-developed countries, this opportunity cost is considered to be high;
=>children often drop out of school at a young age.

32

Brain drain
A serious problem facing some poor countries is the brain
drainthe emigration of many of the most highly educated
workers to rich countries.
Because of the external benefits form education, the brain drain
leads to a very large loss.

Policy dilemma for developing countries:

Send students abroad to earn foreign degrees
But many of them will choose not to return.

33

4. Property Rights and Political Stability

Property rights refer to the ability of people to
exercise authority over the resources they own.
There is little incentive to produce products if there is no
guarantee that they cannot be taken away.
=> Property rights must be respected and contracts must be
enforced.

Countries with questionable enforcement of property

rights or an unstable political climate will also have
difficulty in attracting foreign (or even domestic)
investment.

34

5. Free Trade
Trade allows a country to specialize in what it does
best and thus consume beyond its production
possibilities.
Trade is, in some ways, a type of technology.
When a country trades wheat for steel, it is as well off as
it would be if it had developed a new technology for
turning wheat into steel.
A country that eliminates trade restrictions will
experience the same kind of economic growth that
would occur after a major technological advance.

35

5. Free Trade
Some countries engage in . . .
. . . inward-orientated trade policies that aim to raise living
standards by avoiding interaction with other countries
e.g., tariffs, limits on investment from abroad
Import-substitution strategies.
. . . outward-orientated trade policies, encouraging interaction with other
countries and promote integration with the world economy.
e.g., the elimination of restrictions on trade or foreign investment.

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.

36

6. Research and Development

The advance of technological knowledge has led to
higher standards of living.
Most technological advance comes from private
research by firms and individual inventors.
Government can encourage the private development of new
technologies through the patent system.
The patent system encourages research by granting an inventor
the exclusive right to produce the product for a specified
number of years.

But knowledge can be considered to be a public good.

=> Government should encourage the development of new
technologies through research grants and tax breaks.

The Jeffrey Sachs Solution to the

African Problem

37

A well known Columbia University economist recently

wrote an article for The Economist.
Africa grew more slowly than other developing areas over
the last century
It should have grown faster
relatively low income per head => larger opportunity for 'catch-up' growth

Four factors can account for Africas low growth rates:

Trade barriers
Excessive tax rates
Low savings rates
Adverse geographic and resource structural conditions (15 out 53
African countries are landlocked)

The Jeffrey Sachs Solution to the

African Problem

38

Adam Smith (1755): Little else is requisite to carry

a state to the highest degree of opulence from
lowest barbarism, but peace, easy taxes, and
tolerable administration of justice.
Note that Smith talks about tolerable, not perfect
administration of justice.
=> Market liberalization is the primary key to
strengthening the rule of law.
The scope for official corruption is reduced by
Free trade,
Currency convertibility
Automatic incorporation of businesses

42

Population Growth
Economists and other social scientists have long
debated how population growth affects a society
Population growth interacts with other factors of
production:
Stretching natural resources
Diluting the capital stock
Promoting technological progress

Population growth interacts with other factors of

production
Stretching natural resources

43

Thomas Malthus (an English early economic thinker) argued that an

ever-increasing population meant that the world was doomed to live in
poverty forever.
But he failed to understand that new ideas would be developed to
increase the production of food and other goods.

Diluting the capital stock

High population growth reduces GDP per worker because rapid growth
in the number of workers forces the capital stock to be spread more
thinly.
Countries with a high population growth have large numbers of
schoolage children, placing a burden on the education system.

Promoting technological progress

Some economists have suggested that population growth has driven
technological progress and economic prosperity.
In a 1993 journal article, economist Michael Kremer provided evidence
that increases in population lead to technological progress.

44

Summary
Economic prosperity, as measured by real GDP per
person, varies substantially around the world.
The average income of the worlds richest countries
is more than ten times that in the worlds poorest
countries.
The standard of living in an economy depends on
the economys ability to produce goods and
services.

45

Summary
Productivity depends on the amounts of physical
capital, human capital, natural resources, and
technological knowledge available to workers.
Government policies can influence the economys
growth rate in many different ways.

46

Summary
The accumulation of capital is subject to
diminishing returns.
Because of diminishing returns, higher saving leads
to a higher growth for a period of time, but growth
will eventually slow down.
Also because of diminishing returns, the return to
capital is especially high in poor countries.