Chap17 Production Growth

9 THE REAL ECONOMY IN THE LONG RUN

Production and Growth

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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.

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Production and Growth • A country’s 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.

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GDP per Growth rate, capita, 2011 1970–2011

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.

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GDP per Growth rate, capita, 2011 1970–2011 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

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• 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

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• 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 country’s growth rate can make a significant difference over several generations.

Are You Richer than the Richest American?

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• 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

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• 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 worker’s time. • A nation’s 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.

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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

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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.

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How Productivity Is Determined • Human Capital • the economist’s term for the knowledge and skills that workers acquire through education, training, and experience • Like physical capital, human capital raises a nation’s 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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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.

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How Productivity Is Determined • Technological Knowledge • society’s understanding of the best ways to produce goods and services. • Example: Crusoe will catch more fish if he has invented a better fishing lure.

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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.

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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 = AF(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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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)

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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).

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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

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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

2

3

4 5 6 7 Growth Rate (percent)

0

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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.

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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

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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 country’s growth

Poor country’s 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.

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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. • But the 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 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.

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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.

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3. Education • For a country’s long-run growth, education is at least as important as investment in physical capital. • In the US, each year of schooling raises a person’s 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 society’s 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 brain drain—the 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 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.

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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.

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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.

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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

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• 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 Africa’s 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

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• 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

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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

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• 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.

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

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

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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.