Production and Growth
Introduction
We have learned

How to measure a nation’s income

GDP is market value of all final goods and services produced within geographic
area over specified time period

Y=C+I+G+NX

Real GDP is distinct from nominal GDP
o Real GDP is preferred measure

We have learned about inflation, changes in the cost of living
o We use the CPI to measure price levels
o Minor inflation is acceptable and normal


Hyperinflation and deflation are dangerous
We will now learn about growth and productivity
o Wide variation of economic growth across countries and over time
o Standard of living is primarily a function of productivity
o Productivity is a function of:

physical capital,

human capital,

natural resources,

technological knowledge
o Countries can enact policies to affect producitivity growth
Economic Growth around the World
Per Capita GDP
(World Bank 2010)
Niger
Ethiopia
Chad
Cambodia
India
West Bank and Gaza
China
Russian Federation
Mexico
Saudi Arabia
Argentina
Germany
United Kingdom
United States
Japan
0



5000
10000
15000
20000
25000
30000
35000
40000
45000
Notice the incredible divide between the low income countries and the OECD
countries
Notice that Mexico is wealthier than China (in per capita terms)
U.S. per capita gdp is ≥ Saudi Arabia, Mexico ….Niger combined!
Per Capita GDP Growth
(World Bank 2010)
China
Argentina
Ethiopia
India
Niger
Cambodia
Russian Federation
Mexico
Japan
Germany
United States
Chad
United Kingdom
Saudi Arabia
0
2
4
6
8
10
12


Generally lower growth in advanced economies
China is booming

Because of different growth rates, the ranking of countries by income per person
changes over time.
o In the late 19th century, the United Kingdom was the richest country in
the world.
o Today, income per person is lower in the United Kingdom than in the
United States (a former colony of the United Kingdom).
Are You Richer Than the Richest American?

Richest American of all time is John B. Rockefeller, whose wealth today would be
the equivalent of approximately $200 billion.

No television, air conditioning, internet, jet travel, or modern medicine.

Thus, because of technological advances, the average American today may enjoy a
“richer” life than the richest American who lived a century ago.
Productivity: Its Role and Determinants

Why Productivity Is So Important?
o Example: Robinson Crusoe

Because he is stranded alone, he must catch his own fish, grow his
own vegetables, and make his own clothes.

His standard of living depends on his ability to produce goods and
services.
o productivity: the amount of goods and services a worker produces in
each hour of work.

How Productivity Is Determined
o Physical Capital,
o Human Capital,
o Natural Resources,
o Technological knowledge P

Physical Capital per Worker

physical capital: the stock of equipment and structures that are
used to produce goods and services.

Crusoe will catch more fish if he has more fishing poles.
Gross Capital Formation
in millions $
(World Bank 2010)
Cambodia
Ethiopia
Argentina
Russian Federation
Mexico
United Kingdom
India
Germany
Japan
China
United States
0

400000
800000
1200000
1600000
2000000
It is clear from the above graph which countries are preparing for future growth
Internet Users per 100
(World Bank 2010)
United Kingdom
Germany
Japan
United States
Russian Federation
Saudi Arabia
Kuwait
West Bank and Gaza
Argentina
China
Mexico
India
Chad
Cambodia
Niger
Ethiopia
0
10
20
30
40
50
60
70
80
90
Mobile Cellular Subsctriptions
per 1,000
Saudi Arabia
Russian Federation
Kuwait
Argentina
United Kingdom
Germany
Japan
United States
Mexico
India
China
Cambodia
Niger
Chad
Ethiopia
188
168
161
142
130
128
95
90
81
64
64
58
25
23
8
0
20
40
60
80
100
120
140
160
180
200

Human Capital per Worker

human capital: the knowledge and skills that workers acquire
through education, training, and experience.

Crusoe will catch more fish if he has been trained in the best fishing
techniques or as he gains experience fishing.
% Labor Force w/ Secondary Education
(World Bank 2010)
Germany
Russian Federation
Japan
United Kingdom
United States
Argentina
Kuwait
Mexico
West Bank and Gaza
Ethiopia
Chad
Saudi Arabia
Cambodia
Niger
0
10
20
30
40
50
60

Natural Resources per Worker
o natural resources: the inputs into the production of goods and services
that are provided by nature, such as land, rivers, and mineral deposits.
o Crusoe will have better luck catching fish if there is a plentiful supply
around his island.
Natural Resources Rents
% of GDP
(World Bank 2010)
Saudi Arabia
Kuwait
Chad
Russian Federation
Argentina
Mexico
India
Ethiopia
China
United Kingdom
United States
Niger
Cambodia
Germany
Japan
0

10
20
30
40
50
60
For some countries, natural resources are THE source of product
70
80

Technological Knowledge
o technological knowledge: society’s understanding of the best ways to
produce goods and services.
Crusoe will catch more fish if he has invented a better fishing lure.
Are Natural Resources a Limit to Growth?

As the population has grown over time, we have discovered ways to lower our use
of natural resources.

Thus, most economists are not worried about shortages of natural resources.
Energy Use (kg of oil equivalent) per $1000 GDP
1400
1200
1000
800
600
400
200
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
0
China
India
United Kingdom
United States
Fossil Fuel Energy Usage % Total
(World Bank 2010)
100
90
80
70
60
50
40
30
20
10
0
China
India
United Kingdom
United States
GDP/unit Energy Use
$/kg of oil equivalent
(World Bank 2010)
12
10
8
6
4
2
0
China
India
United Kingdom
United States
The Production Function
A production function describes the relationship between the quantity of inputs
used in production and the quantity of output from production.
The production function generally is written like this:
Y  A F(L, K, H, N)
Y = output,
L = quantity of labor,
K = quantity of physical capital,
H = quantity of human capital,
N = quantity of natural resources,
A reflects the available production technology, and
F () is a function that shows how inputs are combined to produce output.
Many production functions have a property called constant returns to scale.
This property implies that as all inputs are doubled, output will exactly
double.
This implies that the following must be true:
xY  A F(xL, xK, xH, xN)
where x = 2 if inputs are doubled.
o This also means that if we want to examine output per worker we would
set x = 1/L and we would get the following:
Y/L  A F(1, K/L, H/L, N/L)
o This shows that output per worker depends on:

the amount of physical capital per worker (K /L),

the amount of human capital per worker (H /L), and

the amount of natural resources per worker (N /L).
Economic Growth and Public Policy
How can public policy shape long-term economic growth?
Saving and Investment
o Because capital is a produced factor of production, a society can change
the amount of capital that it has.
o However, there is an opportunity cost of doing so; if resources are used to
produce capital goods, fewer goods and services are produced for current
consumption.
Diminishing Returns and the Catch-Up Effect
o diminishing returns: the property whereby the benefit from an extra
unit of an input declines as the quantity of the input increases.

As the capital stock rises, the extra output produced from an
additional unit of capital will fall.

This can be seen in Figure 1, which shows how the amount of capital
per worker determines the amount of output per worker, holding
constant all other determinants of output.

Thus, if workers already have a large amount of capital to work
with, giving them an additional unit of capital will not increase their
productivity by much.

In the long run, a higher saving rate leads to a higher level of
productivity and income, but not to higher growth rates in these
variables.
o An important implication of diminishing returns is the catch-up effect.

Also called convergence

catch-up effect: the property whereby countries that start off poor
tend to grow more rapidly than countries that start off rich.

When workers have very little capital to begin with, an additional
unit of capital will increase their productivity by a great deal.
Investment from Abroad
o Saving by domestic residents is not the only way for a country to invest in
new capital
o Investment in the country by foreigners can also occur.

Foreign direct investment occurs when a capital investment is
owned and operated by a foreign entity.

Foreign portfolio investment occurs when a capital investment
is financed with foreign money but operated by domestic residents.
o Some of the benefits of foreign investment flow back to foreign owners.
But the economy still experiences an increase in the capital stock, which
leads to higher productivity and higher wages.
o The World Bank is an organization that tries to encourage the flow of
investment to poor countries.

The World Bank obtains funds from developed countries such as
the United States and makes loans to less-developed countries so
that they can invest in roads, sewer systems, schools, and other
types of capital.

The World Bank also offers these countries advice on how best to
use these funds.
Education

Investment in human capital also has an opportunity cost.

When students are in class, they cannot be producing goods and
services for consumption.

In less-developed countries, this opportunity cost is considered to be
high; as a result, children often drop out of school at a young age.
% Male Children Working
Ages 7-14
(World Bank 2010)
Chad
Ethiopia
Niger
Cambodia
Argentina
Mexico
India
United States
United Kingdom
Saudi Arabia
Kuwait
Japan
0
10
20
30
40
50
60
70

Because there are positive externalities in education, the effect of lower
education on the economic growth rate of a country can be large.

Many poor countries also face a “brain drain”—the best educated often leave
to go to other countries where they can enjoy a higher standard of living.

Human capital is a key to economic growth.
Journal Articles
(World Bank 2010)
United States
China
Japan
United Kingdom
Germany
India
Russian Federation
Mexico
Argentina
Saudi Arabia
Kuwait
Ethiopia
Cambodia
Niger
Chad
0
50000
100000
150000
200000
250000
Health and Nutrition

Human capital can also be used to describe another type of investment in
people: expenditures that lead to a healthier population.

Other things being equal, healthier workers are more productive.

Making the right investments in the health of the population is one way for a
nation to increase productivity.
Undernourishment
% of population
(World Bank 2010)
Ethiopia
Chad
Cambodia
West Bank and Gaza
India
Niger
China
United States
United Kingdom
Saudi Arabia
Russian Federation
Mexico
Kuwait
Japan
Germany
Argentina
0
10
20
30
40
50
Malaria/100,000
(World Bank 2010)
0
0
0
0
0
0
3
3
7
Germany
Kuwait
United States
Mexico
India
1124
1798
Ethiopia
11509
37958
39508
Chad
0
5000
10000
15000
20000
Series1
25000
30000
35000
40000
45000
Property Rights and Political Stability

Protection of property rights and promotion of political stability are two other
important ways that policymakers can improve economic growth.

There is little incentive to produce products if there is no guarantee that they
cannot be taken. Contracts must also be enforced.

Countries with questionable enforcement of property rights or an unstable
political climate will also have difficulty in attracting foreign (or even
domestic) investment.
http://www.heritage.org/index/
Free Trade

Some countries have tried to achieve faster economic growth by avoiding
transacting with the rest of the world.

However, trade allows a country to specialize in what it does best and thus
consume beyond its production possibilities.

When a country trades wheat for steel, it is as well off as it would be if it had
developed a new technology for turning wheat into steel.

The amount a nation trades is determined not only by government policy but also
by geography.
o Countries with good, natural seaports find trade easier than countries
without this resource.
o Countries with more than 80 percent of their population living within 100
kilometers of a coast have an average GDP per person that is four times as
large as countries with 20 percent of their population living near a coast.
Tariff Rate %
(World Bank 2010)
Ethiopia
Chad
Argentina
Niger
Cambodia
India
China
Russian Federation
Mexico
Kuwait
Saudi Arabia
Japan
United States
United Kingdom
Germany
0
2
4
6
8
10
12
14
16
18
20
Research and Development

The primary reason why living standards have improved over time has been due
to large increases in technological knowledge.

Knowledge can be considered a public good.

The U.S. government promotes the creation of new technological information by
providing research grants and providing tax incentives for firms engaged in
research.

The patent system also encourages research by granting an inventor the exclusive
right to produce the product for a specified number of years.
R&D Technicians/million
(World Bank 2010)
Germany
United Kingdom
Japan
Russian Federation
Argentina
Mexico
India
Kuwait
Ethiopia
Niger
0
200
400
600
800
1000
1200
1400
Population Growth
o Stretching Natural Resources

Thomas Malthus (an English minister and early economic thinker)
argued that an ever-increasing population meant that the world was
doomed to live in poverty forever.

However, he failed to understand that new ideas would be developed to
increase the production of food and other goods, including pesticides,
fertilizers, mechanized equipment, and new crop varieties.
o Diluting the Capital Stock


High population growth reduces GDP per worker because rapid growth
in the number of workers forces the capital stock to be spread more
thinly.
Countries with a high population growth have large numbers of schoolage children, placing a burden on the education system.
o Some countries have already instituted measures to reduce population growth
rates.
Contraception Use %
woman aged 18-49
(World Bank 2010)
China
Russian Federation
United Kingdom
United States
Argentina
Mexico
Germany
India
Japan
Kuwait
West Bank and Gaza
Cambodia
Saudi Arabia
Ethiopia
Niger
Chad
0
10
20
30
40
50
60
70
80
90
o Policies that foster equal treatment for women should raise economic
opportunities for women leading to lower rates of population.
o Promoting Technological Progress

Some economists have suggested that population growth has driven
technological progress and economic prosperity.

In a 1993 journal article, economist Michael Kremer provided evidence
that increases in population lead to technological progress.
Birth Rate/1000
(World Bank 2010)
45
40
35
30
25
20
15
10
5
0
China
India
Japan
Mexico
United States
Financial Development
o Financial markets improve allocation of resources by funneling financial
capital to those projects that deliver the greatest benefits
Market Cap of Listed Firms: % of GDP
(World Bank 2010)
United States
Saudi Arabia
Japan
Mexico
Argentina
Ethiopia
Cambodia
0
20
40
60
80
100
120
140
Domestic Credit to Private Sector-% of GDP
(World Bank 2010)
United Kingdom
Japan
Germany
India
Russian Federation
Mexico
Argentina
Chad
0
50
100
150
200
250
Is There a Place for Government Spending?
Government Consumption % of GDP
(World Bank 2010)
United Kingdom
Saudi Arabia
Japan
Kuwait
Germany
Russian Federation
United States
Argentina
Chad
China
Mexico
India
Niger
Ethiopia
Cambodia
0
5
10
15
20
25