Topic 6

Technological Progress, Employment, and Living Standards in the Long Run

Introduction

Robert Lucas's quote emphasizes the significance of understanding economic development to improve human welfare. This involves identifying opportunities and necessities that drive economic growth across different countries like India, Indonesia, and Egypt.

Roadmap

The lecture will cover:

• Stylized facts of economic growth:

  • Measurement

  • Relevance

  • Evolutions across time/countries

• Understanding these facts through basic economic theory:

  • Exogenous growth models

  • Endogenous growth models

The Facts of Growth

• In the short and medium run, economic fluctuations dominate.

• In the long run, growth dominates.

• Growth is the steady increase in aggregate output over time.

Measuring the Standard of Living

• How to compare GDP over time.

  • Adjust for inflation using a price index like the CPI or GDP deflator.

  • Use real GDP to compare output, removing the effects of price changes.

• How to compare GDP across countries.

  • Use a common set of prices and expenditures.

  • International dollar prices from “Penn World Tables”.

• The most widely used measure: output per person (GDP/population or GDP/capita) over time and across countries

  • Provides a general sense of the economic well-being of individuals in a country.

  • Useful for tracking changes in living standards over long periods.

Measuring the Standard of Living

• Output per capita equals GDP divided by population.

• To compare GDP across countries, a common set of prices and expenditures is used for all countries (international dollar prices from “Penn World Tables”).

• Adjusted real GDP numbers are measures of purchasing power across countries, also called purchasing power parity (PPP) numbers.

  • PPP helps to control for differences in the cost of living.

  • PPP is essential when comparing income or consumption levels.

Comparing real GDP across countries and the “Penn Effect”

• Let $P$ be the price of goods and services in the US.

• Let $P^*$ be the price of goods and services in Mexico.

• Let $E$ be the exchange rate of US dollars for Mexican pesos (the price of pesos in dollars).

• Then $EP^*$ is the cost of Mexican goods in US dollars.

• If $P = EP^*$, then the law of one price or PPP holds.

• However, we often observe that P > EP^*, particularly for non-tradables.

  • Non-tradables include services like haircuts, local transportation, and housing.

  • The price differences are due to factors like productivity differences and regulations.

• Penn Effect: Prices tend to be higher in high-income countries than in low-income countries.

• International GDP comparisons are based on PPP by multiplying nominal quantities for Mexico by $P/P^*$ rather than by E.

  • This PPP adjustment ensures a more accurate comparison of real living standards.

  • It reflects the actual purchasing power of income in each country.

Measuring the Standard of Living

Does GDP per capita reflect welfare?

• What matters for people’s welfare is their consumption rather than their income.

  • Consumption is a more direct measure of the goods and services individuals can access.

  • Income is important, but consumption better reflects actual living conditions.

• Resources that help us fulfill our potential include health and education.

  • Health allows individuals to be productive and enjoy life.

  • Education enhances skills and opportunities.

• The reason we ultimately care about the standard of living is presumably that we care about happiness.

• Thinking about the production side of GDP, one may also be interested in differences in productivity rather than in differences in the standard of living across countries.

  • Productivity measures how efficiently resources are used to produce output.

  • Higher productivity can lead to higher living standards.

The Human Development Index (HDI)

• Developed by the United Nations.

• Includes information about:

  • Education

  • Mean years of schooling

  • Expected years of schooling

  • Life expectancy (proxy for health)

  • Average number of years a newborn is expected to live

  • Reflects healthcare quality and living conditions

  • GDP per capita

  • Indicator of economic resources

  • Adjusted for PPP

• It is an index between 0 and 1.

• It is a weighted average of the 3 components.

• Provides a broader measure of human well-being.

  • Captures more dimensions of development than GDP alone.

  • Useful for assessing progress in different aspects of quality of life.

• There is a very high correlation (94%) between HDI and GDP/capita rankings.

  • Suggests that GDP per capita is a strong, but not perfect, indicator of human development.

  • High GDP often translates to better health and education outcomes.

STYLIZED FACTS: LONG-RUN GROWTH

• Average World GDP per Capita from 1 Million BCE until Now (in 1990 International Dollars).

• Innovation and Growth Across Time and Space: GDP per person in Western Europe, $’000, 1990 prices shows the take-off of economic growth.

STYLIZED FACTS: CORRELATES OF PER CAPITA INCOME

• Across countries, real per capita income and the investment rate are positively correlated.

  • Higher investment rates (as a % of GDP) tend to lead to higher economic growth

  • Investment in physical and human capital are important for long-term prosperity.

• Across countries, real per capita income and the population growth rate are negatively correlated.

  • Higher population growth can strain resources and slow down per capita income growth.

  • Demographic transitions can influence economic development.

• Across countries, there is considerable dispersion in growth rates.

STYLIZED FACTS: CONVERGENCE IN PER CAPITA INCOME

• Growth in Rich Countries since 1950 showing convergence of output per person across rich countries.

• Real output per capita has increased significantly since 1950: by a factor of 3.1 in the United States, by a factor of 4.3 in France, and by a factor of 10.2 in Japan.

• These numbers illustrate the force of compounding e.g. $(1 + 0.02)^{100} = 7.24$ while $(1 + 0.04)^{100} = 50.5$. This shows small differences in growth rates lead to much larger differences over longer time spans.

The Rule of 70

• $T = 70/R$ where $T$ = doubling time (in years) and $R$ = the annual percentage growth rate (multiplied by 100).

  • Provides a quick way to estimate how long it takes for a variable to double.

  • Useful for understanding the implications of different growth rates.

• Example: if GDP/capita is growing at 7% per year, it will double in approximately $T = 70/7 = 10$ years.

Examples

• If France's GDP/capita has grown at 3.3% over a long period, the doubling time is approximately $70/3.3 <br><br>eq 21.2$ years.

• If China’s GDP/capita has been growing at 8%, the doubling time is approximately $70/8 <br><br>eq 8.75$ years.

Convergence of Output per Person since 1950

• Growth rates of GDP per person since 1950 versus GDP per person in 1950 (OECD countries).

Growth Across Many Countries

• Growth rates of GDP per person since 1950 versus GDP per person in 2000 dollars for 70 countries.

• Kremer, Willis and Yang (2021) “Converging to Convergence” NBER Macroeconomics Annual.

Observations

1. Nearly all OECD countries start at high levels of output per person and there is clear evidence of convergence.

2. Convergence is also visible for most Asian countries: Almost all the countries with growth rates above 4% over the period are in Asia.

   • Starting in the 60’s a group of countries sometimes called the four tigers: Singapore, Taiwan, Hong Kong and South Korea started catching up to the high output of Japan.

   • Economies with high growth rates but low output per person are often called emerging economies.

3. Convergence is certainly not the rule in Africa.

Summary of stylized facts

• Before the Industrial Revolution, standards of living differed little over time and across countries.

• Since the Industrial Revolution, per capita income growth has been sustained in the richest countries.

• Most regions in the world have experienced convergence in income per capita.

• Dispersion in income per capita remains significant.

• Growth experiences are also very diverse.

• The share of people in extreme poverty has declined dramatically.

• The increase in standards of living came with environmental costs.

• As economies develop, they undergo a transformation of the industrial structure, with a higher share of services in GDP and a lower share of agriculture.

Development accounting: What drives output per capita?

• $\frac{Y}{population} = \frac{Y}{hours worked} * \frac{hours worked}{employment} * \frac{employment}{population}$

Thinking about Growth: A Primer

To think about the facts presented we use the framework of analysis developed by Robert Solow in the late 1950s

Particularly:

• What determines growth?

  • The Solow model emphasizes the roles of capital accumulation, labor force growth, and technological progress

• What is the role of capital accumulation?

  • Initial increases in capital stock increase economic growth

• What is the role of technological progress?

  • Sustained technological progress is required for long-run economic growth

The Aggregate Production Function

• A specification of the relation between aggregate output and the inputs in production.

• $Y = zF(K, N)$

• $z$ = Total Factor Productivity (TFP)

• $Y$ = aggregate output.

• $K$ = capital – the value of all the machines, plants and office buildings in the economy.

• $N$ = labor – the number of workers (or hours worked) in the economy.

• Tells us how much output is produced for given quantities of capital and labor.

Total Factor Productivity (TFP)

Total Factor Productivity depends on:

1. The state of the technology:

   • The set of blueprints defining the range of products and the techniques available to produce them.

   • Advances in technology allow more output to be produced with the same inputs.

2. Natural endowments:

   • Climate, geography, soil quality.

   • Abundance of natural resources can boost economic output.

3. Government policies, quality of institutions, social norms.

   • Strong property rights and rule of law promote investment and innovation.

   • Stable political environment encourages long-term economic planning.

The Aggregate Production Function

• Both physical capital (K) and labor (L) are subject to decreasing returns.

• Decreasing returns to capital: keeping labor constant, increases in capital lead to smaller and smaller increases in output as the level of capital increases.

• Decreasing returns to labor: keeping capital constant, increases in labor lead to smaller and smaller increases in output as the level of labor increases.

• The aggregate production function displays constant returns to scale.

• This a property of the economy in which, if the scale of operation is doubled – that is, if the quantities of both capital and labor are doubled – then output will also double.

• $xY = zF(xK, xN)$

• Or more generally, for any number, x.

The Cobb-Douglas case

• $Y = z K^{\alpha} N^{1-\alpha}$

• Output = TFP * Capital Stockα * Labor Hours(1-α)

• Real GDP = Total Factor Productivity * Capital Stock * Labor Hours

Implications

• What is the output produced with the first 500 units of capital?

  • The output increase is relatively large with the initial capital investment

• What is the extra output obtained when adding another 500 units of capital?

  • Due to the decreasing return to scale, the increase in output will be smaller

Output per worker and capital per worker

• Constant returns to scale implies that we can rewrite the aggregate production function as:

• $\frac{Y}{N} = zF(\frac{K}{N}, 1)$

• The amount of output per worker, Y/N depends on the amount of capital per worker, K/N.

• As capital per worker increases, so does output per worker.

• $\frac{GDP}{Labor Hours} = TFP * (\frac{Capital}{Labor Hours})^{\alpha}$

Growth Accounting

An approach that uses the production function and measurements of aggregate inputs and outputs to attribute economic growth to:

1. growth in factor inputs

2. total factor productivity growth.

What drives growth in labor productivity?

• $\frac{Y}{N} = TFP * (\frac{K}{N})^{\alpha}$

• Then, in growth rates:

• $g<em>{Y/N} = g</em>{TFP} + \alpha g_{K/N}$

• Since we have data on Y, N and K, we can estimate the contribution of TFP to the growth of labor productivity $g_{Y/N}$.

The Sources of Growth

• Increases in output per worker (Y/N) can come from increases in capital per worker (K/N): Capital accumulation.

• Or they can come from improvements in the state of technology that shift the production function, F, and lead to more output per worker given capital per worker: Technological progress.

Summary

• These two factors play very different roles in the growth process:

• Capital accumulation by itself cannot sustain growth.

• Sustained growth requires sustained technological progress.

• The economy’s rate of growth of output per person is eventually determined by the economy’s rate of technological progress.

Innovation and Growth Across Time and Space

• Technological change: Portable (!) computer ZLOG (1982) vs iPhone (2007)

• ZLOG weighs 100x iPhone

• 500x larger in volume

• Costs 10x more (in real terms)

• 1/100 the clock frequency

• If innovation leads to economic growth, why was there stagnation (lack of economic growth) before the Industrial Revolution?

• One explanation: the Malthusian trap

  • Productivity gains are diluted through an increase in fertility.

  • Population growth offsets productivity gains, keeping living standards stagnant.

• What drives innovation?

• The fertility of the research process

• How easy it is to appropriate profits from new ideas

• The speed of diffusion of new ideas

Technological Change

• “The fishing out” effect: the more we innovate, the more difficult it becomes

• “Standing on the shoulders of giants” effect – innovation gets easier

Main Points

• Compare Standard of living across countries measuring GDP at some common set of prices (PPP).

• Output per capita grows at a