Chap17 Production Growth

7/26/2019 Chap17 Production Growth

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9THE REAL ECONOMY IN THE LONG RUN


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17Production and

Growth


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Production and Growth

Examine the long-run determinants of both thelevel 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 theproductivity of their citizens.


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Production and Growth

A countrys standard of living depends on its abilityto produce goods and services.

Within a country there are large changes in the

standard of livingover 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?


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GDP per

cap ita, 2011

Grow th rate,

19702011

China $8,442 7.5%

Singapore $61,103 4.8%India $3,650 3.3%

Japan $34,278 2.1%

Spain $32,701 2.0%

Israel $28,007 2.1%Colombia $10,103 2.0%

United States $48,442 1.8%

Canada $40,541 1.7%

Philippines $4,140 1.3%

Rwanda $1,251 1.2%

New Zealand $30,108 1.2%

Argentina $17,674 1.4%

Saudi Arabia $24,434 0.6%

Chad $1,531 0.7%

Incomes

and Growth

Around the World

FACT 1:

There are

vast

differencesin living

standards

around the

world.


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GDP per

cap ita, 2011

Grow th rate,

19702011

China $8,442 7.5%

Singapore $61,103 4.8%India $3,650 3.3%

Japan $34,278 2.1%

Spain $32,701 2.0%

Israel $28,007 2.1%Colombia $10,103 2.0%

United States $48,442 1.8%

Canada $40,541 1.7%

Philippines $4,140 1.3%

Rwanda $1,251 1.2%

New Zealand $30,108 1.2%

Argentina $17,674 1.4%

Saudi Arabia $24,434 0.6%

Chad $1,531 0.7%

FACT 2:

There is alsogreat

variation

in growth

rates acrosscountries.

Incomes

and Growth

Around the World


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8ECONOMIC GROWTH AROUNDTHE WORLD

Living standards, as measured by real GDP perperson, vary significantly among nations.

The poorest countries have average levels of income that

have not been seen in the United States for manydecades.

Growth rates are also reported in the table. Japan

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


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9ECONOMIC GROWTH AROUNDTHE WORLD

Because of different growth rates, the rankingofcountries 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 rateover

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.


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10Are You Richer than the RichestAmerican?

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 airconditioning.

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.


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11PRODUCTIVITY: ITS ROLE ANDDETERMINANTS

Productivity plays a key role in determining livingstandards 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 standardsacross countries, we must focus on the differences in

productivity.


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How Productivity Is Determined

Productivity is directly determined by theavailability and quality of the factors of production.

Factors of productionare the inputs used to produce

goods and services. The Factors of Production

Physical capital

Human capital Natural resources

Technological knowledge


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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.


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14


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.


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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.

Renewableresources include trees and forests.

Nonrenewableresources include petroleum and coal.

Are Natural Resources a Limit to Economic Growth?

As the population has grown over time, we have discoveredways to lower our use of natural resources.

Thus, most economists are not worried about shortages of

natural resources.

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Technological Knowledge

societys understanding of the best ways to produce

goods and services.

Example: Crusoe will catch more fish if he has inventeda better fishing lure.

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Examples

Which capital inputs are necessary to produce each of thefollowing?

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.

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FYI: The Production Function

Economists often use a production function to describe therelationshipbetweenthe quantity of inputsused in

production and the quantity of outputfrom 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

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Many production functions have a property calledconstant returns to scale.

A production function has constant returns to scale if,

for any positive numberx,

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)

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Production functions with constant returns to scale have aninteresting implication.

If we want to examine output per worker, Y/L,we could set x =

1/Land 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)

=>laborproductivity (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).

21ECONOMIC GROWTH AND


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21ECONOMIC GROWTH ANDPUBLIC POLICY

Which of the following policies do you think wouldbe most effective at boosting growth and living

standards in a poor country over the long run?

a. Offer tax incentives for investment by local firmsb. Offer tax incentives for investment by foreign firms

c. Give cash payments for good school attendance

d. Crack down on govt corruptione. Restrict imports to protect domestic industries

f. Allow free trade

g. Give away condoms

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1. The Importance of Saving and Investment

One way to raise future productivity is to investmore current resources in the production of capital.

Capital is a reproduciblefactor 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


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Economic growth rates and investment amounts of15 countries for 1960 to 2011

(a)GrowthRate19602011 (b) Investment 19602011

South Korea

SingaporeJapan

Israel

Canada

Brazil

West Germany

Mexico

United KingdomNigeria

United States

India

Bangladesh

Chile

Rwanda

South Korea

SingaporeJapan

Israel

Canada

Brazil

West Germany

Mexico

United KingdomNigeria

United States

India

Bangladesh

Chile

Rwanda

Investment (percent of GDP)Growth Rate (percent)

0 1 2 3 4 5 6 7 0 10 20 30 40

1. 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.

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Diminishing Returns and the Catch-Up Effect

As the stock of capital rises, the extra output producedfrom 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 theirproductivity 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 higherlevelof productivity and income, but notto higher growth

in these areas.


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Output perworker

(productivity)

The Production Function & Diminishing Returns

K/L

Y/L

Capital per worker

If workershave little K,

giving them more

increases their

productivity a lot.

If workers already

have a lot of K,

giving them moreincreases

productivity

fairly little.

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Diminishing Returns and the Catch-Up Effect

The catch-up effect refers to the property wherebycountries that start off poor tend to grow more

rapidly than countries that start off rich.

When workers have very little capital to begin with, anadditional 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 countriesdevoted a similar share of GDP to investment.


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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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the property whereby poor

countries tend to grow more rapidly than rich ones

The catch-up effect:

K/L

Y/L

Poor country

starts here Rich country starts here

Poor countrys

growth

Rich countrys

growth

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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.

Butthe economy still experiences an increase in the capital stock, which

leads to higher productivity and higher wages.

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An example

Suppose that an auto company owned entirely by Germancitizens 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 productionin the United States.

Would the effect of this investment on U.S. GNP be largeror smaller than the effect on U.S. GDP? The effect on U.S. GNP would be smallerthan the effect on U.S.

GDP since the German owners would get paid a return on theirinvestment that would be part of German GNPrather than U.S.GNP.

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Investment and Economic Development

The World Bank is an organization that encouragesthe flow of investment to poor countries.

The WB obtains fundsfrom developed countriesand

makes loansto less-developed countriesso 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.

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3. Education

For a countrys long-run growth, education is at least as important asinvestment 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.

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Brain drain

A serious problem facing some poor countries is the braindrainthe 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.

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4. Property Rights and Political Stability

Property rightsrefer to the ability of people toexercise 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 havedifficulty in attracting foreign (or even domestic)

investment.

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5. Free Trade

Trade allows a country to specialize in what it doesbest 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.

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5. Free Trade

Some countries engage in . . .

. . . inward-orientatedtrade 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-orientatedtrade policies, encouraging interaction with othercountries 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.

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6. Research and Development

The advance of technological knowledge has led tohigher 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.

Thepatent systemencourages research by granting an inventor

the exclusive right to producethe product for a specified

number of years.

But knowledge can be considered to be apublic good.

=>Government should encourage the development of new

technologies through research grants and tax breaks.

37The Jeffrey Sachs Solution to the


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The Jeffrey Sachs Solution to theAfrican Problem

A well known Columbia University economist recentlywrote 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)

38The Jeffrey Sachs Solution to the


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The Jeffrey Sachs Solution to theAfrican Problem

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

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Population Growth

Economists and other social scientists have longdebated how population growth affects a society

Population growth interacts with other factors of

production: Stretching natural resources

Diluting the capital stock

Promoting technological progress

43Population growth interacts with other factors of


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Population growth interacts with other factors ofproduction

Stretching natural resources Thomas Malthus (an English early economic thinker) argued that an

ever-increasing population meant that the world was doomed to live inpoverty forever.

But he failed to understand that new ideas would be developed toincrease 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 morethinly.

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 driventechnological progress and economic prosperity.

In a 1993 journal article, economist Michael Kremer provided evidencethat increases in population lead to technological progress.

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Summary

Economic prosperity, as measured by real GDP perperson, varies substantially around the world.

The average income of the worlds richest countries

is more than ten times that in the worlds poorestcountries.

The standard of living in an economy depends on

the economys ability to produce goods andservices.

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Summary

Productivity depends on the amounts of physicalcapital, human capital, natural resources, and

technological knowledge available to workers.

Government policies can influence the economysgrowth rate in many different ways.

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Summary

The accumulation of capital is subject todiminishing returns.

Because of diminishing returns, higher saving leads

to a higher growth for a period of time, but growthwill eventually slow down.

Also because of diminishing returns, the return to

capital is especially high in poor countries.

Chap17 Production Growth

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