Chapter 7 - Production and Growth

Example of the Catch-Up Effect

1960-1990 - The U.S. and S. Korea devoted a similar share of GDP to investment • Expect: similar growth performance - But growth was >6% in Korea and only 2% in the U.S. - Explanation: the catch-up effect • In 1960, K/L was far smaller in Korea than in the U.S., hence Korea grew faster

Stretching natural resources

- 200 years ago, Malthus argued that population growth will: • Strain society's ability to provide for itself • Mankind - doomed to forever live in poverty - Since then, the world population has increased sixfold and living standards increased • Malthus failed to account for technological progress and productivity growth

Investment from abroad

- 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

Lack of property rights, a major problem

- Contracts are hard to enforce - Fraud, corruption often goes unpunished • Firms must bribe government officials for permits

Diminishing Returns : Policies that raise saving and investment

- Fewer resources are used to make consumption goods - More resources: 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....

Education, investment in human capital

- Gap between wages of educated and uneducated workers • In the U.S., each year of schooling raises a worker's wage by 10% - Opportunity cost: wages forgone • Spending a year in school requires sacrificing a year's wages now to have higher wages later Problem for poor countries: Brain drain

Countries with inward-oriented policies

- Have generally failed to create growth. • e.g., Argentina during the 20th century.

Countries with outward-oriented policies

- Have often succeeded • e.g., South Korea, Singapore, Taiwan after 1960

Diluting the capital stock

- High population growth (higher L) - Spread the capital stock more thinly (lower K/L) - Lower productivity and living standards • To combat this, many developing countries use policy to control population growth - Government regulation (China's one child law) - Increased awareness of birth control - Equal opportunities for women (Promote female literacy to raise opportunity cost of having babies)

Natural resources, N

- Inputs into production that nature provides (land, rivers, and mineral deposits)

Raise future productivity

- Invest more current resources in the production of capital, K - Trade-off: since resources scarce, producing more capital requires producing fewer consumption goods - Reducing consumption = increasing saving • This extra saving funds the production of investment goods (More details in the next chapter.)

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: - 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

Why productivity is so important

- Key determinant of living standards • When a nation's workers are very productive, real GDP is large and incomes are high - 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

When people fear their capital may be stolen by criminals/confiscated by a corrupt government

- Less investment, including from abroad, and the economy functions less efficiently - Result: lower living standards

Large population

- More workers to produce goods and services: larger total output of goods and services - More consumers

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

Policies to promote technological progress:

- Patent laws; Tax incentives or direct support for private sector R&D - Grants for basic research at universities

Determinants of Productivity

- Physical capital, K - Physical capital per worker, K/L - Human capital, H - Human capital per worker, H/L - Natural resources, N - Natural resources per worker, N/L - Technological knowledge

Virtuous circle

- Policies that lead to more rapid economic growth would naturally improve health outcomes, which in turn would further promote economic growth

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

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 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.

Productivity

- Quantity of goods and services - Produced from each unit of labor input - Productivity = Y/L (output per worker), where • Y = real GDP = quantity of output produced • L = quantity of labor

Because of differences in growth rates

- Ranking of countries by income changes substantially over time • Poor countries are not necessarily doomed to poverty forever, e.g. Singapore incomes were low in 1960 and are quite high now • Rich countries can't take their status for granted: They may be overtaken by poorer but faster-growing countries

Technological knowledge

- Society's understanding of the best ways to produce goods and services - Technological progress means: • A faster computer, a higher-definition TV, or a smaller cell phone • Also, any advance in knowledge that boosts productivity: allows society to get more output from its resources • e.g., Henry Ford and the assembly line.

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

Physical capital, K

- Stock of equipment and structures used to produce goods and services

Outward-oriented policies

- i.e. elimination of restrictions on trade or foreign investment - Promote integration with the world economy

Inward-oriented policies

- i.e. tariffs, limits on investment from abroad - Aim to raise living standards by avoiding interaction with other countries

Promoting technological progress

-World population growth • Engine for technological progress and economic prosperity • More people = More scientists, more inventors, more engineers = More frequent discoveries • Michael Kremer, human history: - Growth rates increased as the world's population increased - More populated regions grew faster than less populated ones

Population growth may affect living standards in 3 different ways...

1. Stretching natural resources 2. Diluting the capital stock 3. Promoting technological progress

What is Productivity

A country's standard of living depends on its ability to produce goods and services

Political instability (e.g., frequent coups)

Creates uncertainty over whether property rights will be protected in the future

Knowledge is a public good

Ideas can be shared freely, increasing the productivity of many

Trade has similar effects as discovering new technologies

Improves productivity and living standards

Human capital, H

Knowledge and skills workers acquire through education, training, and experience

Technological progress

Main reason why living standards rise over the long run

Economic stability, efficiency, and healthy growth

Require law enforcement, effective courts, a stable constitution, honest government officials

Free trade

Trade can make everyone better off

Conclusion

• In the long run Conclusion - Living standards are determined by productivity • Policies that affect the determinants of productivity - Will therefore affect the next generation's living standards • One of these determinants: saving & investment - Next chapter: how saving and investment are determined, and how policies can affect them

The ways public policy can affect long-run growth in productivity and living standards:

• Saving and investment • Diminishing returns and the catch-up effect • Investment from abroad; Education • Health and nutrition • Property rights and political stability • Free trade; Research and development • Population growth

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

Summary

• There are great differences across countries in living standards and growth rates. • Productivity (output per unit of labor) is the main determinant of living standards in the long run. • Productivity depends on physical and human capital per worker, natural resources per worker, and technological knowledge. • Growth in these factors—especially technological progress—causes growth in living standards over the long run. • Policies can affect the following, each of which has important effects on growth: • Saving and investment; International trade • Education, health & nutrition • Property rights and political stability • Research and development • Population growth • Because of diminishing returns to capital, growth from investment eventually slows down, and poor countries may "catch up" to rich ones.

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) • Courts - enforce property rights - Promote political stability • Property rights: - Prerequisite for the price system to work