FBAH: CH7

TOPIC 4: ECONOMIC GROWTH,

DETERMINANTS OF PRODUCTIVITY

Zhang Xuyao
Asia Competitiveness Institute
LKY School Of Public Policy

Prepared by
Dr. Xu Le
NUS Business School
QUESTIONS
Would you rather be a rich person living in the eighteenth century or a
middle-class person living in the twenty-first century?
ECONOMIC “WONDERLAND” IN THE LONG RUN
• All problems and economic difficulties will be solved if we have economic
growth?

• What determines economic growth and how to finance economic expansion?

REAL GDP PER CAPITA, 1870-2010
(IN US DOLLARS)
REAL GDP PER CAPITA, 1870 - 2010

Countr
1870 1913 1950 1980 1990 2010
y
US $18,57 $23,20
$2,445 $5,301 $9,561 30,491
7 1
UK 3,190 4,921 6,939 12,931 16,430 23,777
Germa
1,839 3,648 3,881 14,114 15,929 20,661
ny
Japan 737 1,387 1,921 13,428 18,789 21,935
China 530 552 448 1,061 1,871 8,032
Brazil 713 811 1,672 5,195 4,920 6,879
India 533 673 619 938 1,309 3,372
Ghana 439 781 1,122 1,157 1,062 1,922
GROWTH OF REAL GDP PER CAPITA, 1870 - 2010

Annual % Annual % Annual %

Country Change Change Change
1870 – 2010 1950 – 2010 1980 - 2010
US 1.8% 2.0% 1.7%
UK 1.4 2.1 2.1
Germany 1.7 2.8 1.3
Japan 2.5 4.1 1.6
China 2.0 4.9 7.0
Brazil 1.6 2.4 0.9
India 1.3 2.9 4.4
Ghana 1.1 0.9 1.7
USEFUL RULES OF THUMB
The “72 by x” rule Years to Double:
• If GDP is 100 and is growing at 3% per year, how many years more before GDP
doubles to 200?
• A good ‘rough’ approximation is (72/3) = 24 years.
• If the growth rate equals 2% then it takes (72/2) = 36 years for GDP to double.
Growth Rate ‘algebra’:
• Revenue (R) is the product of price (P) and quantity (Q), i.e. R = P x Q.
• If P increases by 2% and Q increases by 3%, what is the rate of R?
• A good approximation of the growth in revenue, g(R) is the sum of the growth rate of
P and growth rate of Q; i.e. g(R) = g(P) + g(Q) = 2% + 3% = 5%.
• Approximation is good when g(P) and g(Q) are each less than 10%.
• An example with Cobb-Douglas Production function:
g(Y) = g(A) + α.g(K) + β.g(N)
REAL GDP PER CAPITA
• Notation
 Y = real GDP
 N = number of people employed
 POP = population

Y Y N
 
POP N POP
• Real GDP per capita (Y/POP) is the product of output per worker (Y/N) and the share
of the total population that is working (N/POP).
 Real GDP per capita : related to standard of living
 Output per worker : Productivity
 Share of population with jobs : related to labour force participation rate
U.S. REAL GDP PER CAPITA AND AVERAGE
LABOR PRODUCTIVITY, 1960-2016
U.S. POPULATION EMPLOYED AND LABOR
FORCE PARTICIPATION RATE, 1960-2016
UNDERSTANDING GROWTH

In the long run,

increases in output per person
and hence living standards
arise primarily from
increases in average labor productivity
UNDERSTANDING GROWTH
• For USA, between 1960 and 2011,
 GDP per capita increased at 3.0% per annum g(Y/POP)
 Output per worker increased at 2.5% p.a. g(Y/N)
 Share of the population employed increased at 0.5% p.a. g(N/POP)

• Growth in real GDP per person is the sum of growth of labour productivity (Y/N) and
the growth in the share of employed in the population(N/POP).
• Larger working age population
 Increase in labour force participation (esp. female)
 Policies that help to reduce natural rate of unemployment, u*
DETERMINANTS OF AVERAGE LABOR
PRODUCTIVITY
• U.S. average labor productivity is
 24 times that of Indonesia
 53 times that of Bangladesh
• Six factors determine average labor productivity
1.Human capital (H)
2.Physical capital per worker (K/N)
3.Land and other natural resources (R)
4.Technology (Tech)
5.Entrepreneurship and management (Mgte)
6.Political and legal environment (Pole)
HUMAN CAPITAL
• Human capital comprises the talents, education, training, health
and skills of workers
 Human capital increases workers' productivity
• Germany and Japan used human capital to rebuild after World
War II
 Professional scientists and engineers
 Apprentice and on-the-job training emphasized
 Japanese increased emphasis on early education
• Cost – Benefit Principle applies to building human capital
 Premium paid to skilled workers
PHYSICAL CAPITAL
• Output per worker (Y/N) is positively related to capital per worker (K/N).

• Diminishing capital productivity, i.e. as more capital is deployed, the additional

output per unit of capital decline. The simple production relation is modified as:

• Holding labor input constant, more capital increases output per hour;
• But output per hour increases at a diminishing rate.
DIMINISHING RETURNS TO CAPITAL
• Diminishing returns to capital occurs if an addition of capital with other inputs
held constant increases output by less than the previous increment of capital
 Assumption: all inputs except capital are held constant
 Result: output increases at a decreasing rate
GROWTH AND DIMINISHING RETURNS TO
CAPITAL
Implications of diminishing returns
 Increasing capital will increase output and labor productivity
•Positive contribution to growth
 There are limits to increasing productivity by adding capital because of diminishing
returns
CAPITAL AND OUTPUT PER WORKER, 1990
LAND AND OTHER NATURAL RESOURCES
• Inputs other than capital increase worker productivity
 Land for farming
Farmers are less than 3% of the population and they supply the US and export the
surplus
 Manufacturing requires raw materials and energy
 Resources can be obtained through international markets
Japan, Hong Kong, Singapore and Switzerland have high levels of GDP per capita
with a limited resource base
 Locational Advantages
 Strategic trading location -geography
 Climatic endowment –e.g. grapes & wine
TECHNOLOGY
• New technologies are the single most
important source of productivity
improvement
• Technical change can affect
industries beyond the primary
application
 Transportation expanded
markets for farm produce
 Medicine
 Communications
 Electronics and computers

• Ever more important factor for growth in

developed
ENTREPRENEURSHIP AND MANAGEMENT
• Entrepreneurs create new economic enterprises
 Essential to a dynamic, healthy, growing economy
• Examples
 Henry Ford and mass production
 Bill Gates and standardized graphical user interface operating system
 Larry Page and Sergey Brin and Google's search
• Policies should channel entrepreneurship in productive ways
 Taxation policy and regulatory regime
 Value innovation
MEDIEVAL CHINA
• Sung period (960 – 1270 AD) was technically sophisticated
 Paper
 Gunpowder
 Water wheels
 Compass
• In the 18th century, Adam Smith claimed China had long been one of the richest, that
is, one of the most fertile, best cultivated, most industrious, most prosperous and
most urbanized countries in the world. However, beginning in the 16th century the
Chinese economy stagnated and even declined in absolute terms in the nineteenth
century and much of the twentieth century
• Economic stagnation followed
 Social system limited entrepreneurship
 Emperor retained property rights to business
 Seizure possible without notice
• Scientific advances alone do not ensure technical change and growth
POLITICAL AND LEGAL ENVIRONMENT
• Encourage people to be economically productive
• Well-defined property rights are essential
 Who owns what and how those things can be used
 Reliable recourse through courts
• Maintain political stability
• Promote free and open exchange of ideas
COMMUNISM FAILED?
• Output per person in the Soviet Union was probably less than one-seventh the US
rate in 1991
• The Soviet Union had ingredients for growth –human capital, physical capital, natural
resources, technology
• Two main flaws
 Communal ownership of capital stock
General absence of private property rights
Incentive Principle could not work
 Government planning replaced market system
Abundant unexploited opportunities
• Political instability and inappropriate legal framework
WHAT DETERMINES LABOR PRODUCTIVITY
Y/N = f(K/N, H, R, Tech, Mgte, Pole)
• K/N = Physical capital per worker
• H = Human capital
• R = Land and other Natural Resources
• Tech = Technology, R&D
• Mgte = Management & Entrepreneurship
• Pole = Political and legal environment
COBB-DOUGLAS PRODUCTION FUNCTION &
GROWTH ACCOUNTING

Where A is total factor productivity (TFP) which is dependent on all other 5

factors: A=f(H, R, Tech, Mgte, Pole). The parameter is the capital share in
national income, given competitive condition.

Multiplying both sides of the first equation by N, we have the following:

Cobb Douglas Production Function:

The growth accounting formula is:

TABLE : SINGAPORE: GROWTH ACCOUNTING,
2010 -2015