Topic 4

Production and Growth

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University

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Production and Growth

A countrys standard of living depends on
its ability to produce goods and services
GDP of the original Asian tigers (Taiwan,
Singapore, South Korea) averaged 7%
annually allowing them to double per
capita income every 10 years
12% for China over the last 20 years
Growth has been stagnant in many
African countries who remain poor
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Economic Growth Around the World

Real GDP per person
Living standards vary widely from country to country;
some are rich, others poor; Philippines was $3661 in
2008
Because of differences in growth rates
Ranking of countries by income changes substantially
over time
Why do some countries zoom ahead while others lag
behind?
Japan used to be relatively poor; it is now rich; United
Kingdom used to be the richest; its per capita income
now is 20% below that of the US
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Table 1
The Variety of Growth Experiences

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Productivity
Productivity
Quantity of goods and services
Produced from each unit of labor input

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Why productivity is so
important
Growth in productivity is the key
determinant of growth in living standards
A higher living standard comes from
producing larger quantities of goods and
service
Higher productivity means each worker
produces more, earns more, and can
consume more goods and services

How Productivity Is Determined

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
The factors of production directly determine
productivity.

An Increase in Physical
Capital/Worker

Physical capital per worker is the stock of

equipment and structures that are used to
produce goods and services.
Physical capital includes:
Machines used to build or repair automobiles
Tools used to build furniture, factories, etc.
Office buildings, schools, roads, irrigation, etc.

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.
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Capital Per Worker

Workers using hand tools produce less than workers using
sophisticated machinery

Human Capital per Worker

Knowledge and skills that workers
acquire through education, training,
and experience
The process of transmitting societys
technological knowledge to the work
force
Producing human capital requires
schools, teachers, libraries and
student time
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Natural Resources Per Worker

Natural resources are 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.
Natural resources can be important but are
not necessary for an economy to be highly
productive in producing goods and services.

Technological Knowledge
Technological knowledge includes
societys understanding of the best ways
to produce goods and services.
Because of advances in farming
technology, US has only 5% of the labor
force in agriculture, allowing labor to be
free to produce other goods
Fire, wheel, telephones, internal
combustion engine, radio, computer,
electricity, airplane, seeds, genetics

Are natural resources a limit to growth?

Argument
Natural resources - will eventually limit
how much the worlds economies can
grow
Fixed supply of nonrenewable natural
resources will run out
Stop economic growth
Force living standards to fall

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Are natural resources a limit to growth?

Technological progress
Often yields ways to avoid these limits
Improved use of natural resources over time
Recycling
New materials

Are these efforts enough to permit

continued economic growth?

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Are natural resources a limit to growth?

Prices of natural resources

Scarcity - reflected in market prices
Natural resource prices
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

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What can governments do to raise

productivity and living standards?

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Saving and Investment

Raise future productivity
Invest more current resources in the
production of capital
Trade-off
Devote fewer resources to produce goods

and services for current consumption

Demonstrate through the production

possibilities frontier
Need to increase domestic and foreign
savings
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Diminishing Returns
Higher savings rate
Fewer resources are used to make
consumption goods
More resources are used to make capital
goods
Capital stock increases
Rising productivity
More rapid growth in GDP

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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
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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
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.
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Diminishing Returns: Catch Up Effect

Catch-up effect
Countries that start off poor
Tend to grow more rapidly than countries
that start off rich

Poor countries
Low productivity
Even small amounts of capital investment
Increase workers productivity substantially

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Catch up Effect
Rich countries
High productivity
Additional capital investment
Small effect on productivity
Poor countries
Tend to grow faster than rich countries
Example
US and South Korea had same ratio of
investment to GDP, 1960-1990. Average annual
growth rate is 2% for US and 6% for S. Korea
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Investment from Abroad

Investment from abroad; foreign savings
Another way for a country to invest in new
capital
Foreign direct investment
Capital investment that is owned and

operated by a foreign entity

Foreign portfolio investment (stocks and

bonds)
Investment financed with foreign money but

operated by domestic residents

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Investment from Abroad

Benefits from foreign investment
Some flow back to the foreign capital
owners; Hence, DIs give higher returns
than FDIs to a country
Increase the economys stock of capital
State-of-the-art technologies
Higher productivity
Higher wages

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Investment from Abroad

World Bank
Encourages flow of capital to poor
countries
Funds from worlds advanced countries
Makes loans to less developed countries
Roads, sewer systems, schools, other types

of capital

Advice about how the funds might best be

used
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Investment from Abroad

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

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Education
Education
Investment in human capital
Gap between wages of educated and
uneducated workers is large in poor countries
Opportunity cost: wages forgone
Vicious cycle; poverty perpetuated thru next
generation
Conveys positive externalities; new ideas
Hence, public education and large subsidies to
human-capital investment

Problem for poor countries: Brain drain

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Health and Nutrition

Human capital
Education
Expenditures that lead to a healthier
population

Healthier workers
More productive

Wages
Reflect a workers productivity
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Health and Nutrition

Right investments in the health of the
population
Increase productivity
Raise living standards

Historical trends: long-run economic

growth
Improved health from better nutrition
Taller workers higher wages better
productivity
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Health and Nutrition

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

Fogel, Nobel Prize in 1993, 30% of per capita
income growth from improved nutrition

In rich countries
Obesity is the bigger problem
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Health 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

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Property Rights, Political Stability

To foster economic growth
Protect property rights
Ability of people to exercise authority over the

resources they own

Courts tasked to enforce property rights
especially the sanctity of contracts

Promote political stability

Economy-wide respect for property rights

Prerequisite for the price system to work
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Property Rights, Political Stability

Lack of property rights
Major problem
Contracts are hard to enforce
Fraud goes unpunished
Corruption
Impedes the coordinating power of markets
Increases the cost of doing business
Discourages domestic saving
Discourages investment from abroad
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Property Rights, Political Stability

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

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Property Rights
High Growth
Countries

Low Growth
Countries

Efficient court system

Honest government
officials
Stable government
and constitution

Poor court system

Corrupt government
officials
Frequent
revolutions, coups,
and social unrest

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Free Trade
Inward-oriented policies
Avoid interaction with the rest of the world
Infant-industry argument
Tariffs
Other trade restrictions
Adverse effect on economic growth

Free trade has the same effect as

technological advances
Allows an economy to transform rice into bread
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Free Trade
Outward-oriented policies
Integrate into the world economy
International trade in goods and services
Economic growth
Otherwise, need to produce all the goods it
needs

Argentina vs. Taiwan, Hong Kong, and

Singapore

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Magnitude of External Trade

Determined by
Government policy
Geography
Easier to trade for countries with natural

seaports; New York, S. Francisco, Hong

Kong
Countries with 80% of population living near
the coast are richer
Many landlocked African countries are poor

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Research and Development

Knowledge is a public good
Part of the success of the US is due to a
government that encourages research and
development
Farming methods
Aerospace research (Air Force; NASA)

Thru
Research grants

National Science Foundation

National Institutes of Health
Tax breaks
Patent system
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Population Growth
Large population
More workers to produce goods and services
Larger total output of goods and services
More consumers

Stretching natural resources

Malthus (1766-1834): an ever-increasing
population
Strain societys ability to provide for itself
Mankind - doomed to forever live in poverty
Technological advances proved him wrong
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Population Growth
Diluting the capital stock
High population growth
Spreads the capital stock more thinly
Lower productivity per worker
Lower GDP per worker

Investment in human capital also suffers

with high population growth rates
1% for rich nations; 3% for poor nations

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Population Growth

Reducing the rate of population growth

Government regulation as in China
Increased awareness of birth control
Equal opportunities for women in
education and employment; increases the
opportunity cost of having children
Main reason why fertility rates are low in
rich countries

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Benefit of Population Growth

Promotes technological progress
according to some economists
How?
World population growth
Engine for technological progress and

economic prosperity
More people = More scientists, more inventors,
more engineers

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