Chapter 12- Production & Growth

Variations in standard of living- among countries

Average income in rich countries= 10x more than that of poor countries

What is the real GDP per person growth in the US?

2% per year

Productivity

the ability of a country to produce goods and services

Productivity formula

Y/L= outputs per worker (real GDP/quantity of labor)

Productivity is the key determinant of:

standard of living

4 determinants of productivity

Physical capital, human capital, natural resources, technological knowledge

Physical capital

K- stock of equipment and structure used to produce goods and services (computer, desk, building, etc)

Physical capital per worker

K/L- Productivity increases when average worker’s capital increases

Human capital

knowledge and skills a worker acquires through education, training, and experience

Human capital per worker

H/L- productivity increases when average worker has more human capital

Natural resources

N- inputs into production of goods and services that are provided by nature

Technological knowledge

society’s understanding of the best ways to produce goods and services

Two types of technological knowledge

Common knowledge (after one person uses the tech, everyone becomes aware of it)

Proprietary (it is known only by the company that discovers it)

Main idea of productivity

Productivity → Economic Growth → Standard of Living

Saving and Investment trade off

Increased investment in capital goods (K) requires a decrease in consumption goods (we sacrifice current consumption to increase future consumption)

Symbol for capital goods

K

Diminishing returns

As K increases, the extra output from an additional unit of K decreases

• fewer resources are used to make consumption goods

• more resources to make capital goods

• K increases due to increased productivity and living standards

What happens if workers have little K at the beginning?

Giving them more K increases their productivity a lot (as in the case with poor countries)

What happens if workers have a lot of K at the beginning?

Giving them more K only increases their productivity a little (as in the case with rich countries)

Catch up effect

Countries that start off poor tend to grow more rapidly than countries that start off rich- but ONLY if they have the same level of technology

Foreign direct investment

capital investment that is owned and operated by a foreign entity (Ford opens in Mexico but sends US people/equipment to work there)

Foreign portfolio investment

Investment financed with foreign money but operated by domestic residents (Ford opens in Mexico but uses Mexican workers and equipment)

Benefits of investment from abroad

• increases economy’s stock of capital

• increases productivity/wages

• state of the art technology developed in other countries

• poor countries that cannot generate enough saving to fund investment projects themselves can benefit

Education

investment in human capital (increases wage in future)

Opportunity cost of education (in the moment)

wages forgone

Benefits of education

Confers positive externalities which funds public education (subsidies to human capital investment)

Positive externality example- education

When you live in a community of well educated people, you are less worried about crime and feeling unsafe

Brain drain

Higher educated people in poor countries migrate to richer countries who often offer them jobs/scholarships, etc, but they don’t really return to their home country

What happens to productivity when a country is healthy?

It increases

Vicious cycle in poor countries

poor countries are often poor because their populations aren’t healthy, which is because they are poor and can’t afford better healthcare

Virtuous cycle in rich countries

Policies that lead to increased economic growth increase health outcomes which in turn increases economic growth

What is a good way to organize economic activity?

Markets

Property rights

the ability of people to exercise authority over the resources they own

What happens when there are no property rights in a country?

Contracts are hard to enforce, fraud/corruption goes unpunished, firms must bribe government officials for permits

What does political instability create?

uncertainty over whether or not property rights will be protected in the future

Inward oriented policies

when government aims to raise living standards by avoiding interaction with other countries (examples: tariffs, limits on investment from abroad)- NOT successful

Outward oriented policies

promote integration with the world economy (examples: elimination of restrictions on trade or foreign investment)

How does increased knowledge affect productivity?

It increases productivity (because knowledge is a public good)

Policies to promote technological progress

• patent laws

• tax incentives or direct support for private sector research and development

• grants for basic research or universities

How does population growth affect living standards?

1. stretches natural resources

2. dilutes capital stock (higher population → less capital stock → decreases productivity/living standards)

3. promotes technological progress (increased population leads to more scientists/engineers/inventors which leads to increased discoveries)