Production and Growth - Comprehensive Notes

Variations in the Standard of Living

• Significant differences exist in average income between rich and poor countries.
  • Rich countries (U.S., Japan, Germany) have incomes about ten times higher than poor countries (India, Nigeria, Nicaragua).
• These income disparities lead to differences in quality of life, including nutrition, housing, healthcare, and life expectancy.
• Within a country, like the U.S., real GDP per person has grown at an average of 2% per year over the past 100 years.

Economic Growth Around the World

• Differences in growth rates cause substantial changes in the ranking of countries by income over time.
• Poor countries are not necessarily permanently impoverished.
  • Example: Japan had low incomes in 1860 but has high incomes now.
• Rich countries cannot assume their status is guaranteed and may be overtaken by faster-growing, poorer countries.

Why is so much of Africa poor?

• Sub-Saharan Africa faces significant poverty issues.

  • In 2017, GDP per person was only $3,489$ (23% of the world average).
  • 41% of the population lives on less than $1.90$ per day.

• Reasons for low economic development in this area:

  • Low capital investment.
  • Low educational attainment.
  • Poor health.
  • High population growth.
  • Geographic disadvantages.
  • Restricted freedom.
  • Rampant corruption.
  • Legacy of colonization.

Productivity: Role and Determinants

• A country’s standard of living depends on its ability to produce goods and services.
• Productivity (Y/L): Quantity of goods and services produced from each unit of labor input.
• Key determinant of living standards: When a nation’s workers are highly productive, real GDP is large and incomes are high.

Productivity Is Important

• Growth in productivity is the key determinant of growth in living standards.
• When productivity grows rapidly, so do living standards.
• An economy’s income is the economy’s output.
• A nation can enjoy a high standard of living only if it can produce a large quantity of goods and services.

How Productivity Is Determined

• Physical capital (K): Stock of equipment and structures used to produce goods and services.
  • Physical capital per worker (K/L): Productivity is higher when the average worker has more capital (machines, equipment, etc.).
  • An increase in K/L causes an increase in Y/L.
• Human capital (H): Knowledge and skills workers acquire through education, training, and experience.
  • Human capital per worker (H/L): Productivity is higher when the average worker has more human capital (education, skills, etc.).
  • An increase in H/L causes an increase in Y/L.
• Natural resources (N): Inputs into production that nature provides (land, rivers, and mineral deposits).
  • Natural resources per worker (N/L): Other things equal, more N allows a country to produce more Y.
  • An increase in N/L causes an increase in Y/L.
• Technological knowledge (A): Society’s understanding of the best ways to produce goods and services.
  • Common knowledge: after one person uses it, everyone becomes aware of it.
  • Proprietary: it is known only by the company that discovers it.
  • Any advance in knowledge that boosts productivity and allows society to get more output from its resources.

Technological Knowledge vs. Human Capital

• Technological knowledge refers to society’s understanding of how to produce goods and services.
• Human capital results from the effort people expend to acquire this knowledge.
• Both are important for productivity.

The Production Function

• Production function: $Y = A \times F(L, K, H, N)$
  • A graph or equation showing the relation between output and inputs.
  • $F($ ) is a function that shows how inputs are combined to produce output.
  • "A" is the level of technology.
  • "A" multiplies the function $F($ ), so improvements in technology (increases in "A") allow more output (Y) to be produced from any given combination of inputs.
• Constant returns to scale:
  • Changing all inputs by the same percentage causes output to change by that percentage.
  • Doubling all inputs (multiplying each by 2) causes output to double: $2Y = A \times F(2L, 2K, 2H, 2N)$
  • Increasing all inputs 10% (multiplying each by 1.1) causes output to increase by 10%: $1.1Y = A \times F(1.1L, 1.1K, 1.1H, 1.1N)$
• If we multiply each input by 1/L, then output is multiplied by 1/L: $Y/L = A \times F(1, K/L, H/L, N/L)$
• This equation shows that productivity (Y/L, output per worker) depends on:
  • The level of technology, A
  • Physical capital per worker, K/L
  • Human capital per worker, H/L
  • Natural resources per worker, N/L

Economic Growth and Public Policy

• A society’s standard of living depends on its ability to produce goods and services.
• Productivity depends on physical capital per worker, human capital per worker, natural resources per worker, and technological knowledge.
• Policymakers: What can government policy do to raise productivity and living standards?

What Policymakers Can Do

• Saving and Investment: Domestic and abroad
• Education
• Property Rights and Political Stability
• Free Trade
• Research and Development
• Population Growth

Saving and Investment

• To raise future productivity, encourage saving and investment and invest more current resources in the production of capital (K).
• Producing more capital requires producing fewer consumption goods.
• Trade-off: Sacrifice current consumption to increase future consumption.
• Reducing consumption = increasing saving.
• This extra saving funds the production of investment goods.

Diminishing Returns

• Policies that raise saving and investment:
  • Fewer resources are used to make consumption goods.
  • More resources are used to make capital goods.
  • K increases, rising productivity and living standards.
• This faster growth is temporary due to diminishing returns to capital: As K rises, the extra output from an additional unit of K falls.

The Catch-Up Effect

• The catch-up effect is the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich.
• Example: 1960–1990: the U.S. and S. Korea dedicated a similar share of GDP to investment, but Korea's K/L was far smaller in 1960, hence Korea grew faster.
• In that time frame growth was >6% in Korea; only 2% in the U.S.

Investment from Abroad

• Investment from abroad is another way for a country to invest in new capital.
  • Foreign direct investment: Capital investment that is owned and operated by a foreign entity.
  • Foreign portfolio investment: Investment financed with foreign money but operated by domestic residents.
• Benefits from investment from abroad:
  • Some benefits flow back to the foreign capital owners.
  • Increase the economy’s stock of capital.
  • Higher productivity and higher wages.
  • State-of-the-art technologies developed in other countries.
  • Especially good for poor countries that cannot generate enough saving to fund investment projects themselves.

Education

• Education = investment in human capital.
• There is a gap between wages of educated and uneducated workers.
• Opportunity cost of education: wages forgone.
• Education confers positive externalities.
• Subsidies to human-capital investment: public education
• Problem for poor countries: Brain drain

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.
  • Example: 1962–1995, 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.
• Vicious circle in poor countries:
  • Poor countries are poor because their populations are not healthy.
  • Populations are not healthy because they are poor and cannot afford better healthcare and nutrition.
• Virtuous circle:
  • Policies that lead to more rapid economic growth would naturally improve health outcomes, which in turn would further promote economic growth.

Property Rights and Political Stability

• Markets are usually a good way to organize economic activity.
• To foster economic growth:
  • Protect property rights (the ability of people to exercise authority over the resources they own).
    • Prerequisite for the price system to work.
    • Courts enforce property rights.
  • Promote political stability.
• Major problem: lack of property rights
  • Contracts are hard to enforce
  • Fraud, corruption often goes unpunished.
  • Firms must bribe government officials for permits.
• Political instability (e.g., frequent revolutions, coups) creates uncertainty over whether property rights will be protected in the future.

Free Trade

• Trade can make everyone better off
• Inward-oriented policies:
  • Aim to raise living standards by avoiding interaction with other countries.
  • Examples: tariffs, limits on investment from abroad.
• Outward-oriented policies:
  • Promote integration with the world economy.
  • Example: elimination of restrictions on trade or foreign investment.
• Trade has similar effects as discovering new technologies, improving productivity and living standards.
• Countries with inward-oriented policies have generally failed to create growth: Argentina throughout the 20th century.
• Countries with outward-oriented policies have often succeeded: South Korea, Singapore, Taiwan.

Rekindling US Productivity

• Boosting US productivity represents a $10 trillion$ opportunity.
  • A potential cumulative increase in US GDP between now and 2030—equivalent to $15,000$ per household—that could result from regaining the long-term productivity growth rate of 2.2 percent annually.
• Looming challenges make productivity growth an imperative.
  • Workforce shortages, debt, inflation, and the cost of the energy transition are powerful headwinds to economic growth.
• Since 2005, US labor productivity has grown at a lackluster 1.4 percent.
  • At the same time, real wages have slowed and workforce participation has declined.
• Focusing on long-term productivity growth could add $10 trillion$ in output, as shown by some states, cities, and sectors maintaining growth near 2.2 percent.
• Productivity growth in US sectors is linked to digital adoption.
• Averages obscure important variation across states, cities, sectors, and firms.
  • In many sectors the most productive firms are fivefold more productive (or more) than the least productive.
• Achieving and equalizing productivity gains will require concerted action.
  • Priorities include: Unlocking the power of existing technology, Investing in intangibles, Improving workforce reskilling and labor mobility, Implementing place-based approaches tuned to specific geographies

Research and Development

• Technological progress is the main reason why living standards rise over the long run.
• Knowledge is a public good; ideas can be shared freely, increasing the productivity of many.
• Policies to promote technological progress:
  • Patent laws.
  • Tax incentives or direct support for private sector R&D.
  • Grants for basic research at universities.

Population Growth

• Large population implies more workers to produce goods and services, leading to a larger total output.
• Population growth may affect living standards in 3 different ways.
  1. Stretching natural resources:
     • 200 years ago, Malthus argued that population growth will strain society’s ability to provide for itself.
     • Malthus failed to account for technological progress and productivity growth.
  2. Diluting the capital stock:
     • High population growth (higher L) spreads the capital stock more thinly (lower K/L), lowering productivity and living standards.
     • Many developing countries have policies like government regulation (China’s one child law 1980-2015), increased awareness of birth control and equal opportunities for women.
  3. Promoting technological progress:
     • World population growth can be an engine for technological progress and economic prosperity.
     • More people equal more scientists, more inventors, more engineers, leading to more frequent discoveries.

Chapter in a Nutshell

• Economic prosperity, GDP per person, varies substantially around the world.
• Because growth rates of real GDP also vary substantially, the relative positions of countries can change dramatically over time.
• The standard of living in an economy depends on the economy’s ability to produce goods and services.
• Productivity depends on the physical capital, human capital, natural resources, and technological knowledge available to workers.
• Government policies can try to influence the economy’s growth rate in many ways.
• The accumulation of capital is subject to diminishing returns.
• Although higher saving leads to higher growth for a period, growth eventually slows down as capital, productivity, and income rise.
• The return to capital is especially high in poor countries.
• Other things being equal, these countries can grow faster because of the catch-up effect.