Growth & Productivity

Production and Growth
(Chapter 25 in Mankiw & Taylor)
We have looked in previous lectures at how

economists measure macroeconomic quantities and
prices
Now we look at the forces that determine these
variables in the long-run
Later we’ll look at short-run fluctuations
•www.le.ac.uk •1
Economic Growth
• Real GDP per person
– A measure of living standards
– Varies widely from country to country; and
over time
• Growth rate
– How rapidly real GDP per person grew in
the typical year
• Because of differences in growth rates
– Ranking of countries by income changes
substantially over time 2
Economic growth
• Economists tend to distinguish between:

– Long run or trend growth
• N.B. a one-percentage point change in a
country’s growth rate can make a significant
difference over several generations due to
compounding
– Short run or cyclical movements – the
business cycle
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4
Source: Mitchell, Solomou and Weale (2012): http://ideas.repec.org/p/cam/camdae/1155.html 5
Table 1
The Variety of Growth Experiences across the World
Economic growth
• So there is no guarantee that a rich country
will remain rich; and that a poor country will
remain poor
• What determines (long-run) economic growth?
– Many theories
• Neoclassical theory: the role of productivity in
growth (Solow exogenous growth model)
• Endogenous growth theory: investment in
human capital is the key driver of growth
• Trade
7
Productivity
• Productivity
– Quantity of goods and services produced
from each unit of labour input
• Why productivity is so important
– Key determinant of living standards
– Growth in productivity is the key
determinant of growth in living standards
– An economy’s income is the economy’s
output
Determinants of productivity
1. Physical capital
• Stock of equipment and structures used to
produce goods and services
• Based on previous investments: capital is a
produced factor of production
2. Human capital
• Knowledge and skills that workers acquire
through education, training, and experience
• Less tangible than physical capital; but again
it’s a produced factor of production, since
education, for example, is an investment
9
Productivity
• Determinants of productivity
3. Natural resources
• Inputs into the production of goods and
services provided by nature, such as land,
rivers, and mineral deposits
• Distinguish renewable (trees) and non-
renewable (oil: takes longer to produce)
natural resources
4. Technological knowledge
• Society’s understanding of the best ways to
produce goods and services
Are natural resources a limit to growth?
• Argument
– Natural resources - will eventually limit
how much the world’s economies can
grow
• Fixed supply of nonrenewable natural
resources – will run out
• Stop economic growth
• Force living standards to fall
• Technological progress
– Often yields ways to avoid these limits
• Improved use of natural resources over time
• Recycling of non-renewables (like oil)
• New materials: plastic (which is produced)
replaced tin and copper (which are not)
• Are these efforts enough to permit
continued economic growth?
• To answer this, need to look at the prices
of natural resources
– Scarcity – should be reflected in (rising)
market prices
– Natural resource prices (in real terms)
• Substantial short-run fluctuations
• Stable or falling - over long spans of time
– Our ability to conserve these resources
• Growing more rapidly than their supplies are
dwindling
Production function
• The production function generally is written
like this:
where Y = output, L = quantity of labour, 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
Summing up
– A society’s standard of living depends on

its ability to produce goods and services
– Its productivity depends on physical
capital, human capital, natural resources
and technological knowledge
– But how can (and should) a Government
raise productivity and living standards?
• Economists differ in their views, but as we shall
see the Government can, at the minimum, lend
support to the ‘invisible hand’
15
Saving and Investment
• Raise future productivity
– Invest more current resources in the
production of capital
– Trade-off
• This involves devoting fewer resources to produce
goods and services for current consumption
• To invest more in capital, a society must consume
less and save more of its current income
• Financial markets coordinate S and I in market
economies. As we discuss later, governments can
also affect S and I, and therefore economic growth
16
Diminishing Returns
• Higher savings rate
– Fewer resources are need to make
consumption goods
– So there are more resources to make capital
goods
– Capital stock increases
– Rising productivity
– More rapid growth in GDP
• But there can be difficulties in inferring causation from
correlation (in principle, GDP could be causing
Investment, not the other way round)
17
Diminishing Returns
• Diminishing returns
– Benefit from an extra unit of an input
declines as the quantity of the input
increases
• In the long run, higher savings rate →
– Higher level of productivity
– Higher level of income but not higher
growth in productivity or income
– But the long-run can be a long time
coming
Figure 1
Illustrating the Production Function
Output
per Worker
1 2. When the economy has a
high level of capital, an extra
unit of capital leads to a small
increase in output.
1. When the economy has a low level of

capital, an extra unit of capital leads to a
1 large increase in output.
Capital per Worker

This figure shows how the amount of capital per worker influences the amount of
output per worker. Other determinants of output, including human capital, natural
resources, and technology, are held constant. The curve becomes flatter as the
amount of capital increases because of diminishing returns to capital.
19
Old style growth models
∆Y=savings rate ×MPK – depreciation rate
Harrod-Domar 1946 growth model
Problems:
Endogeneity of savings (depends on Y)
Ignores productivity, unlike neoclassical
(Solow) model
20
Diminishing Returns explains…
• … The “catch-up” effect
– Countries that start off poor tend to grow
more rapidly than countries that start off
rich
• This is because poor countries have
– Low productivity
– Even small amounts of capital investment
increase workers’ productivity substantially
– Over the last 50 years China has grown faster
than Japan despite lower investment rates
21
Diminishing Returns
• Rich countries
– High productivity
– Additional capital investment
• Small effect on productivity
• Poor countries
– Tend to grow faster than rich countries
Investment from Abroad
• Investment from abroad
– This is another way for a country to invest
in new capital (get the savings they need)
– Foreign direct investment (FDI)
• Capital investment that is owned and
operated by a foreign entity
– Foreign portfolio investment
• Investment financed with foreign money but
operated by domestic residents
• Benefits from investment
– Some flow back to the foreign capital
owners
• FDI in UK raises UK GNP by less than UK
GDP since the foreigners expect a return on
their investment
– Increase the economy’s stock of capital
– Higher productivity and higher wages
– A way to learn about state-of-the-art
technologies
• World Bank
– Encourages flow of capital to poor
countries
– Takes funds from world’s advanced
countries
– Makes loans to less developed countries
• Roads, sewer systems, schools, other types
of capital
– Offers advice about how the funds might
best be used
• World Bank and the International
Monetary Fund
– Set up after World War II
– Economic distress leads to:
• Political turmoil, international tensions and
military conflict
– Every country has an interest in promoting
economic prosperity around the world
Education
– Investment in human capital (schools etc.).
Improves long-run economic prospects
– Gap between wages of educated and uneducated
workers: private benefit
– Opportunity cost: wages forgone
– Conveys positive externalities
• Return to schooling higher for society than an individual
– Public education - large subsidies to human-capital
investment
– Problem for poor countries: Brain drain
• A dilemma for governments; as they lose some of their
human capital despite the investment
27
Health and Nutrition
• Human capital
– Normally taken to refer to education
– But can also be used to describe investments that
lead to a healthier population
• Healthier (and stronger, smarter) workers
– are more productive
– Robert Fogel found that improved nutrition explains
about a 1/3 of income growth per capita in the UK
from 1790 to 1980
• Wages
– Reflect a worker’s productivity (and health/height?)
28
• Right investments in the health of the
population
– Another way for governments to increase
productivity
– Raise living standards
• Historical trends: long-run economic growth
– Improved health – from better nutrition
– Taller workers – higher wages – better
productivity
• 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
• Virtuous circle
– Policies that lead to more rapid economic
growth would naturally improve health
outcomes
– Which in turn would further promote
economic growth
Property Rights, Political Stability
• To foster economic growth
– Protect property rights
• 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
• Lack of property rights
– Major problem
– Contracts are hard to enforce
– Fraud goes unpunished
– Corruption
• Impedes the coordinating power of markets
• Discourages domestic saving
• Discourages investment from abroad
• Political instability
– A threat to property rights
– Revolutions and coups
– Revolutionary government might
confiscate the capital of some businesses
– Domestic residents - less incentive to
save, invest, and start new businesses
– Foreigners - less incentive to invest
Restricting Free Trade
• Some countries have tried economic
growth by adopting inward-oriented
policies
– Avoid interaction with the rest of the world
– Infant-industry argument: protect domestic
firms which will then grow
• Tariffs
• Other trade restrictions
– But has had adverse effects on economic
growth. Imagine Leicestershire deciding it was illegal to
trade with those outside the County 35
Promoting Free Trade
• Outward-oriented policies
– Integrate into the world economy
– International trade in goods and services
is like technology
→Economic growth
• Amount of trade – determined by
– Government policy
– Geography
• Easier to trade for countries with natural
seaports/rivers
36
Research and Development
• Knowledge – public good
– Government – encourages research and
development, via
• Publicly operated research institutes
• Research grants
– to universities etc.
• Tax breaks
• Patent system; by allowing inventors to profit
from their invention, if only temporarily, the
patent increases the incentive to undertake
R&D
• The final determinant of long-run
economic growth is…
38
Population Growth
• Large population
– More workers to produce goods and
services
• Larger total output of goods and services
– But this means there are also more
consumers
• Stretching natural resources
– Malthus: an ever-increasing population
• Strain society’s ability to provide for itself
• Mankind - doomed to forever live in poverty
Where did Malthus go wrong?
• Assumed correctly that world population would
rise exponentially
• But assumed incorrectly that food production
could rise only linearly
• But productivity has kept on increasing (new
fertilisers, hybrid crops, machines etc.)
• Kremer (1993, QJE) argues that productivity, in
fact, increases with population
• While Malthus worried about the effects of
population on the use of natural resources,
others worry about its effect on capital
accumulation… 40
Population Growth
• Diluting the capital stock (not just natural resources)
– High population growth
• Spreads the capital stock more thinly (think of human
capital and then imagine more students in a class)
• Lower productivity per worker. Lower GDP per worker
• Reducing the rate of population growth

– Government regulation (e.g. China). But rather than
coercion, economists often prefer the use of incentives
• Increased awareness of birth control
• Equal opportunities for women; better options outside the home
for women (due to educational & employment equality) increase
the opportunity cost of having children and lead to smaller families
41
Population Growth
• But while rapid population growth may
dilute the capital stock, it may also have
benefits
• It could promote technological progress
– World population growth
• Is an engine for technological progress and
economic prosperity
– More people = More scientists, more inventors,
more engineers; a higher probability of more new
bright ideas which improve technological progress

Growth & Productivity

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Growth & Productivity

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Production and Growth

(Chapter 25 in Mankiw & Taylor)

We have looked in previous lectures at how

• Economists tend to distinguish between:

where Y = output, L = quantity of labour, K =

– A society’s standard of living depends on

1. When the economy has a low level of

Capital per Worker

∆Y=savings rate ×MPK – depreciation rate

Harrod-Domar 1946 growth model

• Reducing the rate of population growth

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