Chapter 12 Production and Growth
• Economic Growth Around the World
• Productivity: Its role and determinants
• Economic Growth and Public Policy
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A country’s standard of living depends on its ability to
produce goods and services. Richer countries have more
automobiles, more telephones, more televisions, better
nutrition, safer housing, better health care, and longer life
expectancy.
Within every country there are large changes in the standard
of living over time. In Canada over the past century, average
income (measured in real GDP) per person has grown by
about 2% per year. Because of this growth, average income
today is about 8 times as high as average income a century
ago.
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Economic Growth Around the World
See Table 12-1 on page 241
Living standards, as measured by per capita real GDP, vary
significantly among nations.
The most developed countries have real per capita GDP that
is ten to twenty times that of the poorest countries..
The countries in Table 12-1 are ordered by their growth rate
from the most to the least rapid. Japan tops the list, with a
growth rate of 2.82% per year. Because of differences in
growth rates, the ranking of countries by income changes
substantially over time. Japan is a country that has risen
relative to others. One country that has fallen behind is the
United Kingdom. The data show that the world’s richest
countries have no guarantee that they will stay the richest
and that the world’s poorest countries are not doomed
forever to remain in poverty.
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• The process of creating a high living standard is keyed to
productivity
FYI: The Rule of 70
Annual growth rates that seem small become large when
compounded for many years.
– Compounding refers to the accumulation of a rate over a
period of time.
Rule of 70: The value of a variable will double in
approximately (70 ÷ annual growth rate) years.
• Example
$5,000 invested at 7 percent interest per year, will double in
size in 10 years
70 ÷ 7 = 10
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Productivity: Its Role and Determinants
To understand the large differences in living standards we
must focus on the production of goods and services.
Productivity refers to the quantity of goods and services that
a worker can produce for each hour of work.
The inputs used to produce goods and services are called the
factors of production. The Factors of Production include:
– Physical Capital
– Human Capital
– Natural Resources
– Technological Knowledge
Capital is a produced factor of production, i.e. capital
is an input into the production process that in the past
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was an output from production.
• Physical Capital
The stock of equipment and structures that are used to
produce goods and services.
Examples:
– Tools used to build or repair automobiles
– Tools used to build homes or buildings
– Buildings, e.g. office, schools, etc.
• 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.
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• Natural Resources
Inputs used in production that are provided by nature, such
as land, rivers, and mineral deposits. They are not
necessary for an economy to be highly productive.
Renewable Resources:
Trees, forests
Non-Renewable Resources:
Oil, coal
• Technological Knowledge
The understanding of the best ways to produce goods and
services.
Technological Knowledge refers to society’s understanding
about how the world works.
Human Capital refers to the resources expended
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transmitting this understanding to the labour force.
• Knowledge is the quality of society’s textbooks, whereas
human capital is the amount of time that the population has
devoted to reading them.
• Workers’ productivity depends on both the quality of
textbooks they have available and the amount of time they
have spent studying them.
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.
• EX: Y = A* F( L, K, H, N) where F(.) is a function that
shows how the inputs are combined to produce output. A is
a variable that reflects the available production technology.
As technology improves, A rises, so the economy produces
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more output from any given combination of inputs.
• Y denotes the quantity of output, L the quantity of labour, K
the quantity of physical capital, H the quantity of human
capital, and N the quantity of natural resources.
• Constant returns to scale: a doubling of all the inputs
causes the amount of output to double as well.
xY = A* F(x L, xK, xH, xN)
• Set X = 1/L
• Then Y/L = A* F( L/L, K/L, H/L, N/L)
= A* F( 1, K/L, H/L, N/L) where Y/L is output
per worker, which is a measure of productivity. This
equation says that productivity depends on physical
capital per worker (K/L), human capital per worker (H/L)
and natural resources per worker (N/L). Productivity also
depends on the state of technology, A.
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Economic Growth and Public Policy
Public policies, laws, traditions, and institutions are critical
to transforming resources into useful output.
Governments can do many things to encourage or impede
the attainment of high living standards.
Government policies:
– Encourage saving and investment
– Encourage education and training
– Establish secure property rights and political stability
– Promote free trade policies
– Control of population growth
– Promote research and development
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•
Encourage saving and investment
One way to raise future productivity is to invest more
current resources in the production of capital.
See Figure 12-1 on page 248.
Countries that devote a large share of GDP to investment
such as Singapore and Japan tend to have high grow rates.
Countries that devote a small share of GDP to investment
such as Bangladesh and Rwanda tend to have low grow
rates. The figure shows that investment and growth are
positively correlated.
Governments can encourage capital accumulation:
• from domestic sources by imposing low taxes on interest
and dividend income.
• from foreign sources by making such capital secure and
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welcome domestically.
Cautions:
• As the stock of capital rises, the extra output produced from
an additional unit of capital falls (diminishing returns). In
other words, when workers already have a large quantity of
capital to use in producing goods and services, giving them
an additional unit of capital increases their productivity only
slightly.
• Because of diminishing returns, an increase in the saving
rate leads to higher growth only for a while.
• As the higher saving rate allows more capital to be
accumulated, the benefits from additional capital become
smaller over time, and so growth slows down.
• In the long run, the higher saving rate leads to a higher level
of productivity and income but not to higher growth in
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these variables.
• Reaching this long run, however, can take quite a while.
According to studies of international data on economic
growth, increasing the saving rate can lead to substantially
higher growth for a period of several decades.
• Catch-up effect: the property whereby countries that start
off poor tend to grow more rapidly than countries that start
off rich.
• This catch-up effect can help explain some of the puzzling
results in Figure 12-1. Over this 31 year period, Canada and
South Korea devoted a similar share of GDP to investment.
Yet Canada experienced only about 2.5% growth while
Korea experienced growth of 7%.
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• Encourage education and training
Education is at least as important as investment in physical
capital.
Many times it is necessary for countries to provide basic
education so that the work force can acquire the specialized
skills leading to higher productivity.
• Brain Drain: the emigration of many of the most highly
educated workers to rich countries.
• Establish secure 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. 14
• It is necessary for investors to feel that their investments are
secure and safe from political instability.
• Promote Free Trade
To exploit comparative advantage and maximize production
and efficiency, it is important for countries to have the
opportunity to sell abroad and to be able to purchase from
lower opportunity cost producers.
Some countries engage in:
– Inward-orientated trade policies: aim at raising
productivity and living standards within the country by
avoiding interaction with the rest of world.
– Outward-orientated trade policies: to integrate into the
world economy.
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• Control of Population Growth
Population is a key determinant of a country’s labour force.
Large populations tend to produce greater total GDP,
however. . .
– Higher GDP doesn’t mean “higher well-being”, GDP per
person is more accurate.
– High population growth reduces GDP per person
• Research and Development
The advancement of technological knowledge has led to
higher standards of living. Technological advancement
comes from private firms and public agencies.
Government’s role is to encourage the research and
development of new technologies through research grants,
tax breaks, and the patent system.
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See Figure 12-2 on page 260. (The Growth in Real GDP per
person)
This figure shows that average growth rate of real GDP per
person for 16 advanced economies. The growth rate rose
substantially after 1950 and then fell after 1970.
Conclusion
Living standards, as measured by real GDP per capita, vary
substantially from country to country.
Government policies and actions can facilitate or impede
economic growth.
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