© 2007 Thomson South-

Table 1 The Variety of Growth

Experiences
In this chapter, look for the answers to
these questions:
▪ What are the facts about living standards and
growth rates around the world?
▪ Why does productivity matter for living
standards?
▪ What determines productivity and its growth
rate?
▪ How can public policy affect growth and living
standards?

CHAPTER 25 PRODUCTION AND GROWTH 3

Production and Growth
• How can we explain differences in levels
of income and growth rates of income
across countries?
• Levels: Why are some countries rich now
(Japan, Western Europe, US) and others
are poor now?
• Growth Rates: Why are some countries
growing fast (India, China, South Korea)
and others are not growing at all?
Production and Growth
• Productivity is the
amount of goods and
services that an
average worker
produces in one hour.
• A country’s standard
of living is determined
largely by the
productivity of its
workers.
Productivity: Its Role and
Determinants
• Why Productivity Is So Important
■Productivity determines living standards for all
nations in the world.
■To understand the large differences in living
standards across countries, we must focus on
the production of goods and services.
How Productivity Is
Determined
• What determines productivity? The factors
of production determines productivity.
• The inputs used to produce goods and
services are called the factors of
production.
• The factors of production include:
■Physical capital (machinery, equipment,
buildings)
■Human capital (education, training,
experience)
■Natural resources (Land, natural gas, oil, etc.)
■Technological knowledge (expertise)
How Productivity Is
Determined
• Physical capital is the stock of machinery,
equipment and infrastructure that are
used to produce goods and services.
• Physical capital includes:
■ Machines used to manufacture automobiles, furniture,
other machines (lathe), etc.
■ Construction: Office buildings, schools, etc.
■ Infrastructure: Roads, electricity and telecommunication
networks.
• Physical capital is a produced factor of
production.
■ It is both an input into the production process and an
output from the production process.
How Productivity Is
Determined
• Human capital is the knowledge and
skills that workers acquire through
education, training, and experience.
• Like physical capital, human capital raises
amount of goods and services that one
worker can produce.
How Productivity Is
Determined
• Natural resources are inputs used in
production that are provided by nature,
such as arable land, seaports, rivers, oil,
natural gas, copper, iron etc.
■ Renewable resources include trees and forests.
■ Nonrenewable resources include petroleum, gas, coal.
• Natural resources are important but are
not absolutely necessary for an economy
to be highly productive. Consider Japan.
Imports many raw materials and energy.
How Productivity Is
Determined
• Technological knowledge includes society’s
understanding of the best methods to
produce goods and services. Two types:
■ Common knowledge (math, assembly line, tractors)
■ Patented knowledge (BMW engine design, Coca-cola
formula, Intel core duo processor, etc.)
• Consider farming technology in 1970 and
20018.
• Use of tractors, fertilizers, etc. increased
productivity in the sector.
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.
The Production Function
• Y = A F(L, K, H, N)
■Y = quantity of output
■A = level of technology
■L = quantity of labor (number of workers or
hours)
■K = quantity of physical capital
■H = quantity of human capital
■N = quantity of natural resources
■F( ) is a function that shows how the inputs are
combined.
The Production Function
• A production function has constant
returns to scale if, for any positive
number x,
■xY = A F(xL, xK, xH, xN)
• That is, if we double all inputs (if x = 2),
then the amount of output doubles too.
• If xY < (>) A F(xL, xK, xH, xN) then there
is increasing (decreasing) returns to scale.
The Production Function
• Production functions with constant returns
to scale property can be written in ‘per
worker’ terms.
• Setting x = 1/L,
■Y/L = A F(1, K/L, H/L, N/L)
■Where:
• Y/L = output (GDP) per worker
• K/L = physical capital per worker
• H/L = human capital per worker
• N/L = natural resources per worker
The Production Function
• Then Productivity (Output per worker, Y/L)
depends on:
■physical capital per worker (K/L),
■human capital per worker (H/L),
■natural resources per worker (N/L),
■and the level of technology (A).
Economic Growth And Public
Policy
• Government policies that raise
productivity and living standards
■ Encourage saving and investment. (Increase K) Asian
economies have high saving rates.
■ Encourage investment from abroad (two types: FDI and
FPI, which one is better?).
■ Encourage education and training (Increase H).
■ Establish secure property rights and maintain political
stability. Decrease uncertainty about future.
■ Promote free trade.
■ Promote research and development to improve
technology.
Saving and Investment
• One way to raise future productivity is to invest more
current resources in the production of physical capital
(machines, infrastructure: roads, telecommunication, etc.).
But for this we need to consume less now and save more.
Saving and Investment Rates are important.
Diminishing Marginal Returns
and the Convergence Effect
• As the stock of capital rises, the extra
output produced from an additional unit of
capital falls; this property is called
diminishing marginal returns of capital.
• Because of diminishing marginal 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 rate in
these areas.
Illustrating the Production Function
Output
per worker
1

2. When the economy has a

high level of capital, an
extra unit of capital leads to
a small increase in output.

1. When the economy has a low level of capital, an

extra unit of capital leads to a large increase in
output.

Capital per
worker

© 2007 Thomson South-Western

 Diminishing Marginal
Returns and the
Convergence Effect
• The convergence (catch-up) effect is a
property where countries that start off
poor tend to grow more rapidly than
countries that start off rich.
Investment from Abroad
• Governments can increase capital
accumulation and long-term economic
growth by encouraging investment from
foreign sources.
Investment from Abroad
• Investment from abroad takes two
forms:
■Foreign Direct Investment
• Capital investment owned and operated by a foreign
firm. Ex: Toyota plant in California.
■Foreign Portfolio Investment
• Investments financed with foreign money but
operated by domestic residents. Ex: German
residents buy IBM stocks.
Education
• For a country’s long-run growth, education
is at least as important as investment in
physical capital.
• In the United States, each year of
schooling raises a person’s wage, on
average, by about 10 percent.
• Thus, the government can increase the
standard of living by support schools. But
strategically according to the needs of the
economy.
Education
• The social benefit of society from an
educated person might be larger than his
private benefit from education. He
provides an external benefit to others.
This is called a positive externality.
• One problem facing some poor countries is
the brain drain — the emigration of many
of the most highly educated workers to
rich countries. Why do they emigrate?
How can we reverse brain drain?
Property Rights and Political
Stability
• Property rights refer to the ability of
people to exercise authority over the
resources they own.
• Justice system must protect property
rights. An economy-wide respect for
property rights is an important
prerequisite for the price system to work.
Property Rights and Political
Stability
• Also, countries with a history of frequent
revolutions are not rich today. Political
stability is necessary for growth.
• It is necessary for investors to feel that
their investments are secure.
Free Trade
• Some countries engage in . . .
■. . . inward-oriented trade policies, avoiding
trade with other countries. Like Cuba.
■. . . outward-oriented trade policies,
encouraging trade with other countries. Like
Hong Kong.
■Which one is the right policy? Most economists
believe that openness helps development.
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
development of new technologies through
research grants, tax breaks, and the
patent system.
Population Growth
• Economists and other social scientists
have long debated how population growth
affects a society.
■Malthus’ mistaken theory: geometric
population growth, linear food growth.
■Earlier economic theory: faster population
growth causes poverty because it reduces
capital per worker. (if population grows faster
than capital)
■More recent theories by Paul Romer and
Michael Kremer argue that population growth
is the driving force behind technological
growth.
Population Growth
• Slower population growth also creates
risks for the social security system.
Ratio of number of current workers /
number of retirees decreases. Smaller
inflow and larger outflow of money.
• Why do developed countries promote birth
control in less developed countries but
give incentives for more children in their
own countries?
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.
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.
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.