9
THE REAL ECONOMY IN THE LONG RUN
Production and
Growth
25
Copyright © 2011 Cengage Learning
Production and Growth
• A country’s standard of living depends on its
ability to produce goods and services.
Copyright © 2011 Cengage Learning
Production and Growth
• Within a country there are large changes in the
standard of living over time.
Copyright © 2011 Cengage Learning
Production and Growth
• In the UK over the past century or so, average
income as measured by real GDP per person
has grown by about 1.3 per cent per year.
• This rate of increase might not sound very
impressive but it means that GDP per person
doubles every 50 years.
• Annual growth rates that seem small become
significant when compounded for many years.
Copyright © 2011 Cengage Learning
Production and Growth
• Growth rates vary greatly.
• In some East Asian countries GDP per person
has grown at a rate of about 7 per cent per year
in recent decades.
• At this rate, GDP person doubles in just ten
years.
Copyright © 2011 Cengage Learning
Production and Growth
• Productivity refers to the amount of goods and
services produced for each hour of a worker’s
time.
• A nation’s standard of living is determined by
the productivity of its workers.
Copyright © 2011 Cengage Learning
Table 1 The Variety of Growth Experiences
Copyright©2011 South-Western
ECONOMIC GROWTH AROUND
THE WORLD
• Living standards, as measured by real GDP per
person, vary significantly among nations.
• The United Kingdom is an advanced economy. In
2006, its GDP per person was $35,580.
• Mexico is a middle-income country. In 2006, its
GDP per person was $11,410.
• Mali is a poor country. In 2006, its GDP per person
was only $1,130.
Copyright © 2011 Cengage Learning
ECONOMIC GROWTH AROUND
THE WORLD
• The poorest countries have average levels of
income that have not been seen in the UK for
many decades.
Copyright © 2011 Cengage Learning
PRODUCTIVITY: ITS ROLE AND
DETERMINANTS
• Productivity plays a key role in determining
living standards for all nations in the world.
Copyright © 2011 Cengage Learning
Why Productivity Is So Important
• Productivity refers to the amount of goods and
services that a worker can produce from each
hour of work.
Copyright © 2011 Cengage Learning
Why Productivity Is So Important
• To understand the large differences in living
standards across countries, we must focus on
the production of goods and services.
Copyright © 2011 Cengage Learning
How Productivity Is Determined
• The inputs used to produce goods and services
are called the factors of production.
• The factors of production directly determine
productivity.
Copyright © 2011 Cengage Learning
How Productivity Is Determined
• The Factors of Production
• Physical capital
• Human capital
• Natural resources
• Technological knowledge
Copyright © 2011 Cengage Learning
How Productivity Is Determined
• Physical Capital
• is a produced factor of production.
• It is an input into the production process that in the past
was an output from the production process.
• is the stock of equipment and structures that are
used to produce goods and services.
• Tools used to build or repair automobiles.
• Tools used to build furniture.
• Office buildings, schools, etc.
Copyright © 2011 Cengage Learning
How Productivity Is Determined
• Human Capital
• the economist’s term for the knowledge and skills
that workers acquire through education, training,
and experience
• Like physical capital, human capital raises a nation’s
ability to produce goods and services.
Copyright © 2011 Cengage Learning
How Productivity Is Determined
• Natural Resources
• inputs used in production that are provided by
nature, such as land, rivers, and mineral deposits.
• Renewable resources include trees and forests.
• Nonrenewable resources include petroleum and coal.
• can be important but are not necessary for an
economy to be highly productive in producing
goods and services.
Copyright © 2011 Cengage Learning
How Productivity Is Determined
• Technological Knowledge
• society’s understanding of the best ways to produce
goods and services.
• Human capital refers to the resources expended
transmitting this understanding to the labor force.
Copyright © 2011 Cengage Learning
FYI: 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 from production.
Copyright © 2011 Cengage Learning
FYI: The Production Function
• Y = A F(L, K, H, N)
• Y = quantity of output
• A = available production technology
• L = quantity of labour
• 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.
Copyright © 2011 Cengage Learning
FYI: 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, a doubling of all inputs causes the
amount of output to double as well.
Copyright © 2011 Cengage Learning
FYI: The Production Function
• Production functions with constant returns to
scale have an interesting implication.
• Setting x = 1/L,
• Y/ L = A F(1, K/ L, H/ L, N/ L)
Where:
Y/L = output per worker
K/L = physical capital per worker
H/L = human capital per worker
N/L = natural resources per worker
Copyright © 2011 Cengage Learning
FYI: The Production Function
• The preceding equation says that productivity
(Y/L) depends on physical capital per worker
(K/L), human capital per worker (H/L), and
natural resources per worker (N/L), as well as
the state of technology, (A).
Copyright © 2011 Cengage Learning
ECONOMIC GROWTH AND
PUBLIC POLICY
• Governments can do many things to raise
productivity and living standards.
Copyright © 2011 Cengage Learning
ECONOMIC GROWTH AND
PUBLIC POLICY
• Government Policies That Raise Productivity
and Living Standards
• Encourage saving and investment.
• Encourage investment from abroad
• Encourage education and training.
• Establish secure property rights and maintain
political stability.
• Promote free trade.
• Promote research and development.
Copyright © 2011 Cengage Learning
The Importance of Saving and Investment
• One way to raise future productivity is to invest
more current resources in the production of
capital.
Copyright © 2011 Cengage Learning
Figure 1 Growth and Investment
Copyright©2011 South-Western
Diminishing Returns and the Catch-Up Effect
• As the stock of capital rises, the extra output
produced from an additional unit of capital
falls; this property is called diminishing returns.
• Because of diminishing returns, an increase in
the saving rate leads to higher growth only for a
while.
Copyright © 2011 Cengage Learning
Diminishing Returns and the Catch-Up Effect
• In the long run, the higher saving rate leads to a
higher level of productivity and income, but not
to higher growth in these areas.
Copyright © 2011 Cengage Learning
Diminishing Returns and the Catch-Up Effect
• The catch-up effect refers to the property
whereby countries that start off poor tend to
grow more rapidly than countries that start off
rich.
Copyright © 2011 Cengage Learning
Investment from Abroad
• Governments can increase capital accumulation
and long-term economic growth by encouraging
investment from foreign sources.
Copyright © 2011 Cengage Learning
Investment from Abroad
• Investment from abroad takes several forms:
• Foreign Direct Investment
• Capital investment owned and operated by a foreign
entity.
• Foreign Portfolio Investment
• Investments financed with foreign money but operated by
domestic residents.
Copyright © 2011 Cengage Learning
Education
• For a country’s long-run growth, education is at
least as important as investment in physical
capital.
• In the developed economies of Western Europe and
North America States, each year of schooling raises
a person’s wage, on average, by about 10 percent.
• Thus, one way the government can enhance the
standard of living is to provide schools and
encourage the population to take advantage of them.
Copyright © 2011 Cengage Learning
Education
• An educated person might generate new ideas
about how best to produce goods and services,
which in turn, might enter society’s pool of
knowledge and provide an external benefit to
others.
Copyright © 2011 Cengage Learning
Education
• One problem facing some poor countries is the
brain drain—the emigration of many of the
most highly educated workers to rich countries.
Copyright © 2011 Cengage Learning
Health and Nutrition
• Human capital usually refers to education but it
can also refer to other investments in people
such as investments in improved health.
• Robert Fogel, has suggested that a significant
factor in long-run economic growth is improved
health from better nutrition. He estimates that in
Great Britain in 1780 about one in five people
were so malnourished that they were incapable
of manual labour.
Copyright © 2011 Cengage Learning
Health and Nutrition
• From 1775 to 1975, the average caloric intake
in Great Britain rose by 26 per cent and the
height of the average man rose by 3.6 inches
(around 10 cm).
• Fogel won the Nobel Prize in Economics in
1993 for his work in economic history. In his
Nobel lecture he concluded that ‘improved
gross nutrition accounts for roughly 30 per cent
of the growth of per capita income in Britain
between 1790 and 1980’.
Copyright © 2011 Cengage Learning
Property Rights and Political Stability
• Property rights refer to the ability of people to
exercise authority over the resources they own.
• An economy-wide respect for property rights is an
important prerequisite for the price system to work.
• It is necessary for investors to feel that their
investments are secure.
Copyright © 2011 Cengage Learning
Free Trade
• A country that eliminates trade restrictions will
experience the same kind of economic growth
that would occur after a major technological
advance.
• When a country exports wheat and imports steel,
the country benefits in the same way as if it had
invented a technology for turning wheat into steel.
Copyright © 2011 Cengage Learning
Free Trade
• Some countries engage in . . .
• . . . inward-orientated trade policies, avoiding
interaction with other countries.
• . . . outward-orientated trade policies, encouraging
interaction with other countries.
Copyright © 2011 Cengage Learning
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.
Copyright © 2011 Cengage Learning
Population Growth
• Economists and other social scientists have
long debated how population growth affects a
society
Copyright © 2011 Cengage Learning
Population Growth
• Population growth interacts with other factors
of production:
• Stretching natural resources
• Diluting the capital stock
• Promoting technological progress
Copyright © 2011 Cengage Learning
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.
Copyright © 2011 Cengage Learning
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.
Copyright © 2011 Cengage Learning
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.
Copyright © 2011 Cengage Learning