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9THE REAL ECONOMY IN THE LONG RUN
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17Production and
Growth
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Production and Growth
Examine the long-run determinants of both thelevel and the growth rate of real GDP per person
We will find that capital and labor are among the
primary determinants of output. Analyze the factors that determine the productivity
of workers
Address what governments might do to improve theproductivity of their citizens.
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Production and Growth
A countrys standard of living depends on its abilityto produce goods and services.
Within a country there are large changes in the
standard of livingover time. In the United States over the past century, average
income as measured by real GDP per person has grown
by about 2 percent per year.
What about other countries?
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GDP per
cap ita, 2011
Grow th rate,
19702011
China $8,442 7.5%
Singapore $61,103 4.8%India $3,650 3.3%
Japan $34,278 2.1%
Spain $32,701 2.0%
Israel $28,007 2.1%Colombia $10,103 2.0%
United States $48,442 1.8%
Canada $40,541 1.7%
Philippines $4,140 1.3%
Rwanda $1,251 1.2%
New Zealand $30,108 1.2%
Argentina $17,674 1.4%
Saudi Arabia $24,434 0.6%
Chad $1,531 0.7%
Incomes
and Growth
Around the World
FACT 1:
There are
vast
differencesin living
standards
around the
world.
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GDP per
cap ita, 2011
Grow th rate,
19702011
China $8,442 7.5%
Singapore $61,103 4.8%India $3,650 3.3%
Japan $34,278 2.1%
Spain $32,701 2.0%
Israel $28,007 2.1%Colombia $10,103 2.0%
United States $48,442 1.8%
Canada $40,541 1.7%
Philippines $4,140 1.3%
Rwanda $1,251 1.2%
New Zealand $30,108 1.2%
Argentina $17,674 1.4%
Saudi Arabia $24,434 0.6%
Chad $1,531 0.7%
FACT 2:
There is alsogreat
variation
in growth
rates acrosscountries.
Incomes
and Growth
Around the World
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8ECONOMIC GROWTH AROUNDTHE WORLD
Living standards, as measured by real GDP perperson, vary significantly among nations.
The poorest countries have average levels of income that
have not been seen in the United States for manydecades.
Growth rates are also reported in the table. Japan
has had the largest growth rate over time, 2.8percent per year (on average).
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9ECONOMIC GROWTH AROUNDTHE WORLD
Because of different growth rates, the rankingofcountries by income per person changes over time.
Annual growth rates that seem small become large when
compounded for many years. Compounding refers to the accumulation of a growth rateover
a period of time.
The powerful effects of compounding:
A one percentage point change in a countrys growth rate can
make a significant difference over several generations.
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10Are You Richer than the RichestAmerican?
The richest American of all time is John B.Rockefeller, whose wealth today would be the
equivalent of $200 billion.
Yet he did not have access to television and airconditioning.
Since Rockefeller lived from 1839 to 1937, he did not
get the chance to enjoy many of the conveniences we
take for granted today
Thus, because of technological advances, the
average American today may enjoy a richer life
than the richest American who lived a century ago.
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11PRODUCTIVITY: ITS ROLE ANDDETERMINANTS
Productivity plays a key role in determining livingstandards for all nations in the world.
Productivity refers to the amount of goods and
services produced for each hour of a workers time. A nations standard of living is determined by the
productivity of its workers.
To understand the large differences in living standardsacross countries, we must focus on the differences in
productivity.
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How Productivity Is Determined
Productivity is directly determined by theavailability and quality of the factors of production.
Factors of productionare the inputs used to produce
goods and services. The Factors of Production
Physical capital
Human capital Natural resources
Technological knowledge
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How Productivity Is Determined
Physical Capital It 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.
Example: Crusoe will catch more fish if he has more fishing
poles. It is an input into the production process that in the past
was an output from the production process.
=> can be reproduced.
=>society can choose the amount of capital they want to have.
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How Productivity Is Determined
Human Capital
the economists term for the knowledge and skills that
workers acquire through education, training, and
experience
Like physical capital, human capital raises a nations ability to
produce goods and services.
Example: Crusoe will catch more fish if he has been trained in
the best fishing techniques.
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How Productivity Is Determined
Natural Resources
inputs used in production that are provided by nature
Example: Crusoe will have better luck catching fish if there is
a plentiful supply around his island.
Renewableresources include trees and forests.
Nonrenewableresources include petroleum and coal.
Are Natural Resources a Limit to Economic Growth?
As the population has grown over time, we have discoveredways to lower our use of natural resources.
Thus, most economists are not worried about shortages of
natural resources.
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How Productivity Is Determined
Technological Knowledge
societys understanding of the best ways to produce
goods and services.
Example: Crusoe will catch more fish if he has inventeda better fishing lure.
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Examples
Which capital inputs are necessary to produce each of thefollowing?
Cars
a factory with machines, robots, and an assembly line, as well as human
capital that comes from training workers.
High school education
books and buildings as well as human capital from the teachers.
Plane travel
planes and airports as well as human capital in terms of pilots' knowledge.
Fruits and vegetables
irrigation systems, harvesting machinery, and trucks to transport the goods
to the market, as well as human capital in the form of agricultural
knowledge.
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FYI: The Production Function
Economists often use a production function to describe therelationshipbetweenthe quantity of inputsused in
production and the quantity of outputfrom production.
Y = AF(L, K, H, N)
Y= quantity of output
A= available production technology
F() is a function that shows how the inputs are combined.
L= quantity of labor K= quantity of physical capital
H= quantity of human capital
N= quantity of natural resources
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FYI: The Production Function
Many production functions have a property calledconstant returns to scale.
A production function has constant returns to scale if,
for any positive numberx,
x Y = A F(x L, x K, x H, x N)
=> a doubling of all inputs causes the amount of output
to double as well.
2Y = A F(2L, 2K, 2H, 2N)
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FYI: The Production Function
Production functions with constant returns to scale have aninteresting implication.
If we want to examine output per worker, Y/L,we could set x =
1/Land we would obtain the following:
Y/L = A F(L (1/L), K (1/L), H (1/L), N (1/L))= A F(1, K/L, H/L, N/L)
=>laborproductivity (Y/L) depends on physical capital per worker (K/L),
human capital per worker (H/L),
natural resources per worker (N/L),
the state of technology, (A).
21ECONOMIC GROWTH AND
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21ECONOMIC GROWTH ANDPUBLIC POLICY
Which of the following policies do you think wouldbe most effective at boosting growth and living
standards in a poor country over the long run?
a. Offer tax incentives for investment by local firmsb. Offer tax incentives for investment by foreign firms
c. Give cash payments for good school attendance
d. Crack down on govt corruptione. Restrict imports to protect domestic industries
f. Allow free trade
g. Give away condoms
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1. The Importance of Saving and Investment
One way to raise future productivity is to investmore current resources in the production of capital.
Capital is a reproduciblefactor of production,
=>society can change the amount of capital that it has. 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.
Economic growth rates and investment amounts of
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Economic growth rates and investment amounts of15 countries for 1960 to 2011
(a)GrowthRate19602011 (b) Investment 19602011
South Korea
SingaporeJapan
Israel
Canada
Brazil
West Germany
Mexico
United KingdomNigeria
United States
India
Bangladesh
Chile
Rwanda
South Korea
SingaporeJapan
Israel
Canada
Brazil
West Germany
Mexico
United KingdomNigeria
United States
India
Bangladesh
Chile
Rwanda
Investment (percent of GDP)Growth Rate (percent)
0 1 2 3 4 5 6 7 0 10 20 30 40
1. Countries that devote a large share of GDP to investment tend to
have high growth rates.
2. However, from the data given it is difficult to determine cause
and effect.
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Diminishing Returns and the Catch-Up Effect
As the stock of capital rises, the extra output producedfrom an additional unit of capital falls; this property is
called diminishing returns.
if workers already have a large amount of capital to work with,
giving them an additional unit of capital will not increase theirproductivity by much.
=> Because of diminishing 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 higherlevelof productivity and income, but notto higher growth
in these areas.
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2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Output perworker
(productivity)
The Production Function & Diminishing Returns
K/L
Y/L
Capital per worker
If workershave little K,
giving them more
increases their
productivity a lot.
If workers already
have a lot of K,
giving them moreincreases
productivity
fairly little.
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Diminishing Returns and the Catch-Up Effect
The catch-up effect refers to the property wherebycountries that start off poor tend to grow more
rapidly than countries that start off rich.
When workers have very little capital to begin with, anadditional unit of capital will increase their productivity
by a great deal.
Figure: South Korea had a growth rate more than three times
larger than the United States even though both countriesdevoted a similar share of GDP to investment.
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2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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the property whereby poor
countries tend to grow more rapidly than rich ones
The catch-up effect:
K/L
Y/L
Poor country
starts here Rich country starts here
Poor countrys
growth
Rich countrys
growth
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2. Investment from Abroad
Saving by domestic residents is not the only way for a country
to invest in new capital. Governments can increase capital accumulation and economic
growth by encouraging investment from foreign sources.
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.
Some of the benefits of foreign investment flow back to foreign
owners.
Butthe economy still experiences an increase in the capital stock, which
leads to higher productivity and higher wages.
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An example
Suppose that an auto company owned entirely by Germancitizens opens a new factory in South Carolina.
What sort of foreign investment would this represent? When a German firm opens a factory in South Carolina, it
represents foreign direct investment. What would be the effect of this investment on U.S. GDP?
The investment increases U.S. GDP since it increases productionin the United States.
Would the effect of this investment on U.S. GNP be largeror smaller than the effect on U.S. GDP? The effect on U.S. GNP would be smallerthan the effect on U.S.
GDP since the German owners would get paid a return on theirinvestment that would be part of German GNPrather than U.S.GNP.
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Investment and Economic Development
The World Bank is an organization that encouragesthe flow of investment to poor countries.
The WB obtains fundsfrom developed countriesand
makes loansto less-developed countriesso that they can
invest in roads, sewer systems, schools, and other types
of capital.
The WB also offers these countries advice on how best
to use these funds.
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3. Education
For a countrys long-run growth, education is at least as important asinvestment in physical capital.
In the US, each year of schooling raises a persons wage by about 10 percent.
=>the government can enhance the standard of living by providing schools and
encourage the population to take advantage of them.
Positive externalities from education An educated person might generate new ideas about how best to produce goods
and services,
These ideas enter societys pool of knowledge and provide an external benefit
to others. 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;
=>children often drop out of school at a young age.
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Brain drain
A serious problem facing some poor countries is the braindrainthe emigration of many of the most highly educated
workers to rich countries.
Because of the external benefits form education, the brain drain
leads to a very large loss. Policy dilemma for developing countries:
Send students abroad to earn foreign degrees
But many of them will choose not to return.
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4. Property Rights and Political Stability
Property rightsrefer to the ability of people toexercise authority over the resources they own.
There is little incentive to produce products if there is no
guarantee that they cannot be taken away.
=> Property rights must be respected and contracts must be
enforced.
Countries with questionable enforcement of property
rights or an unstable political climate will also havedifficulty in attracting foreign (or even domestic)
investment.
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5. Free Trade
Trade allows a country to specialize in what it doesbest and thus consume beyond its production
possibilities.
Trade is, in some ways, a type of technology. 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.
A country that eliminates trade restrictions will
experience the same kind of economic growth that
would occur after a major technological advance.
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5. Free Trade
Some countries engage in . . .
. . . inward-orientatedtrade policies that aim to raise living
standards by avoiding interaction with other countries
e.g., tariffs, limits on investment from abroad
Import-substitution strategies.
. . . outward-orientatedtrade policies, encouraging interaction with othercountries and promote integration with the world economy.
e.g., the elimination of restrictions on trade or foreign investment.
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.
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6. Research and Development
The advance of technological knowledge has led tohigher standards of living.
Most technological advance comes from private
research by firms and individual inventors.
Government can encourage the private development of new
technologies through the patent system.
Thepatent systemencourages research by granting an inventor
the exclusive right to producethe product for a specified
number of years.
But knowledge can be considered to be apublic good.
=>Government should encourage the development of new
technologies through research grants and tax breaks.
37The Jeffrey Sachs Solution to the
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The Jeffrey Sachs Solution to theAfrican Problem
A well known Columbia University economist recentlywrote an article for The Economist.
Africa grew more slowly than other developing areas over
the last century
It should have grown faster
relatively low income per head => larger opportunity for 'catch-up' growth
Four factors can account for Africas low growth rates:
Trade barriers
Excessive tax rates
Low savings rates
Adverse geographic and resource structural conditions (15 out 53
African countries are landlocked)
38The Jeffrey Sachs Solution to the
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The Jeffrey Sachs Solution to theAfrican Problem
Adam Smith (1755): Little else is requisite to carrya state to the highest degree of opulence from
lowest barbarism, but peace, easy taxes, and
tolerable administration of justice.
Note that Smith talks about tolerable, not perfect
administration of justice.
=>Market liberalization is the primary key to
strengthening the rule of law. The scope for official corruption is reduced by
Free trade,
Currency convertibility
Automatic incorporation of businesses
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Population Growth
Economists and other social scientists have longdebated how population growth affects a society
Population growth interacts with other factors of
production: Stretching natural resources
Diluting the capital stock
Promoting technological progress
43Population growth interacts with other factors of
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Population growth interacts with other factors ofproduction
Stretching natural resources Thomas Malthus (an English early economic thinker) argued that an
ever-increasing population meant that the world was doomed to live inpoverty forever.
But he failed to understand that new ideas would be developed toincrease the production of food and other goods.
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 morethinly.
Countries with a high population growth have large numbers of
schoolage children, placing a burden on the education system. Promoting technological progress
Some economists have suggested that population growth has driventechnological progress and economic prosperity.
In a 1993 journal article, economist Michael Kremer provided evidencethat increases in population lead to technological progress.
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Summary
Economic prosperity, as measured by real GDP perperson, varies substantially around the world.
The average income of the worlds richest countries
is more than ten times that in the worlds poorestcountries.
The standard of living in an economy depends on
the economys ability to produce goods andservices.
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Summary
Productivity depends on the amounts of physicalcapital, human capital, natural resources, and
technological knowledge available to workers.
Government policies can influence the economysgrowth rate in many different ways.
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Summary
The accumulation of capital is subject todiminishing returns.
Because of diminishing returns, higher saving leads
to a higher growth for a period of time, but growthwill eventually slow down.
Also because of diminishing returns, the return to
capital is especially high in poor countries.