Lecture 4

Production & Growth (Part 2)

(Ch:12; P.O.M.E)

ECO 104
Faculty: Asif Chowdhury

Government Policies to Promote

Economic Growth:
Previously we have seen the factors that influence
productivity. We shall now look at some government
policies that are oriented towards driving those
previously mentioned factors:
Saving & Investment: Producing more capital will lead
to higher productivity, since the productive capacity of
the economy will increase & more goods & services
can be produced. Investment can be increased by
increasing the level of saving, however increasing the
level of saving will reduce the level of current level of
consumption. So current generation has to lower
consumption for the benefit of future generation.

Diminishing Return & the Catch Up

Effect:
If government pursues a policy of
maintaining a higher level of saving, it
will lead to higher level of investment
& this will lead to Economic growth.
However this growth will not continue
indefinitely. Capital is subject to
diminishing returns, continued higher
level of investment will lead to higher
level of productivity & output/income,
but the growth of productivity leading

Diminishing Return: the property

whereby the benefit from an extra
unit of an input declines as the
quantity of the input increases.
o From the concept of diminishing
return, we get another conceptcatch up effect.
Catch Up Effect: the property
whereby the countries that start off
poor tends to grow more rapidly then

(From this part you can only refer to the slides,

no need to refer to the book from this point)
Investment from abroad: domestic savings is one way
to increase investment, another way is investment by
foreigners. If an US company sets up a factory in
Malaysia, then it will be a case of capital investment
owned & operated by a foreign entity. This type of
investment is known as Foreign Direct Investment
(FDI.) Another way foreigners can invest is buy buying
stocks issued by a Malaysian firm. If the Malaysian firm
uses the fund it received from US investors, to set up a
factory in Malaysia, then its a situation known as
Foreign Portfolio Investment. Both FDI & FPI increases
the level of capital stock in a country ( directly or
indirectly.) This in turn leads to higher productivity.

 Another way foreign investment

benefits a country is by introducing
new technologies available to them.
So the recipient country can benefit
from new technology. Considering
the benefits associated with foreign
investment, governments of less
developed countries generally try to
devise policies to attract foreign
investments.

 Education: the process of investing in

human capital & developing human capital.
As is the case with physical capital, higher
level of human capital improves productivity
of workforce & hence leads to better
standard of living. Workers with more
education tends to be more productive than
workers with less education. So government
has an incentive to invest on educationproviding public educational institutions.

 Education has an opportunity cost-the chance to earn

wages. Children in less developed countries drop out
from schools early since they have to earn to support
their families. So the workforce of less developing
countries often dont receive the benefits of attending
farther education & developing human capital. Another
effect of education is the positive externality it can pass
on to the society. An externality is defined as the effects
of one persons action on the well being of others. If an
educated person can come up with better ways of
producing goods & services, this knowledge will benefit
the society as a whole. So it will be a case of positive
externality on the society, arising from the person
receiving education. Hence the return to the society of
that person getting educated will be higher than the

 However their can arise the problem

of brain drain educated people
emigrating to richer developed
countries. So if people from less
developing
countries
goes
to
developed countries for education,
there is the possibility that they
might stay back their rather than
coming back. This will farther lower
the human capital level of the less

 Health & Nutrition: besides education, human capital also

depends on how healthy is the workforce. A workforce
which gets adequate nutrition is healthy & is more
productive ( other things remaining unchanged). So
expenditures on maintaining the health of the workforce is a
considerations for the government. People in many less
developed countries suffers from malnutrition or are under
nourished. This affects their productivity which leads to
lower levels of living standard. The issue of health follows a
vicious cycle, poor country workforces are under nourished
because they are poor, this in turn affects their productivity,
& this in turns keeps them poor ( as a country.) However if
government can take initiative to promote economic growth
this situation of health & nutrition can be improved.

 Property Rights: to make a product more than

one firm is generally involved in the production
process or chain-including the firms making the
intermediate products. e.g. a car manufacturer
is linked with a steel company, a tire company
& so on. So production process involves
interaction between different firms & also
between firms & consumers/buyers. These type
of interactions are coordinated through the
market price, which equilibrates market
demand to market supply. However the price
mechanism requires the existence of property
rights. Property rights refer to rights of people
over the resource or assets they own. A firm
will have no incentive to undertake production

 Similarly if contracts are not deemed as enforceable or

legally binding then firms will be hesitant to undertake
contracts. Such issues can arise when the legal system
of the country is not strong. Another factor that tends to
deter firms to undertake a business venture is the
presence of corruption. Situations like requiring to bribe
government officials for facilitating business is a
deterrent factor for firms. So a weak legal system &
corruption in a country can put away both foreign &
domestic firms from undertaking investments & starting
a production venture. So to ensure investment activity &
hence higher productivity in an economy, government
has to improve the legal system & prevent corruption.

 Free Trade: some developing countries practiced inwardoriented policies-not participating in international trade
with other countries & restricting such trades. The
objective behind this was to protect domestic sectors/firms
in the country from foreign competitions, so that the
domestic sectors can grow & promote economic growth.
However there are benefits associated with international
trading such as the introduction of new technologies. When
a new product embodying new technology is imported,
that technology in turn can be learned by the domestic
firms. The same advantage can apply if the country
imports any raw materials representing new technology. In
both cases the importing country can benefit from the new
technology.

 With the introduction of new technology,

the importing country will enjoy the same
benefits that are associated with
technological advancements. Therefore
engaging in trade & removing trade
restrictions can benefit a country in the
form of higher productivity & hence
economic growth. For this reason many
countries engage in trade & follow
outward oriented policy.

 Another problem with not engaging in trade is

that, a country refraining from trade has to
produce both consumption goods, some of which
it could have traded according to comparative
advantage, as well as investment goods, in
which case the country could have traded latest
technology in the form of capital equipment. So
giving up on the benefits of trade & managing
production of both consumption & investment
goods will eventually lead to lower productivity &
hence lower standard of living.

 Research & Development: technological progress improves

the productivity & this leads to more production of goods &
services & eventually economic growth. Such R&D activities
are undertaken by private firms & inventors. Knowledge /
technological knowledge is a form of public good. Once
somebody comes up with an idea, the society can also
share the idea & so the knowledge of the individual adds to
the knowledge of the society as a whole. Since government
is responsible for public goods, it is also responsible for
encouraging technological progress through research &
development. It can do so by providing grants to research
institutions. By providing tax exemptions to firms for
undertaking R&D activities, more research activities will be
encouraged, leading to more technological knowledge.

 Patent is another way to encourage R&D

activities. If firms have the option to receive
patient grant from the government, provided they
can come up with a new product, then they will
have the incentive to research & come up with
new products, since through the patent they will
be able to enjoy exclusive production & sales right
of the product for a fixed period of time. After the
expiry of the patent the technology of the product
will become available to the society. So through
patents government can generate technological
knowledge for the society.