ECO121- MACROECONOMICS

Session 6
Chapter 25: Production and Growth

Taught by Que Anh Nguyen - FPT School of Business (FSB)

Original Slides by Ron Cronovich

Based on: N. Gregory Mankiw, Principles of Economics (6ed)

OBJECTIVES

1. What are the facts about living standards and growth rates around the world?

2. Why does productivity matter for living standards?

3. What determines productivity and its growth rate?

4. How can public policy affect growth and living standards?

 RECALL CHAPTER 1

A well-living person is
defined via his own
income

Life expectancy at birth

90
85
80
75
70
A wealthy economy (a collection 65
of individuals) is defined via the 60
total income of everyone in the 55
economy 50
- 20,000 40,000 60,000 80,000 100,000 2
120,000
A typical family with all their possessions in
the U.K., an advanced economy
GDP per capita: $40,284
Life expectancy: 81.2 years
Expected years of schooling 17.5 yrs

3
A typical family with all their possessions in Mexico, a middle
income country

GDP per capita: $8,346

Life expectancy: 75.1 years
Expected years of schooling 14.8 yrs
years

4
A typical family with all their possessions in Mali, a poor country

GDP per capita: $858.9

Life expectancy: 59.3 years
Expected years of schooling 7.5 yrs
years
5
 1. Incomes and Growth Around the World

FACT 1:
There are vast differences in living
standards around the world.

FACT 2:
There is also great variation
in growth rates across countries.

Since growth rates vary, the country

rankings can change over time:
- Poor countries are not necessarily
doomed to poverty forever
- Rich countries can’t take their status
for granted because of faster-growing
countries.
6
1. Incomes and Growth Around the World

1. Why are some countries richer than others?

2. Why do some countries grow quickly while others
seem stuck in a poverty trap?
3. What policies may help raise growth rates and long-
run living standards?

7
2. Productivity: Its Role and Determinants
2.1. Why Productivity Is So Important?
▪ Recall one of the Ten Principles from Chap. 1:
A country’s standard of living depends on its ability to produce g&s.
▪ This ability depends on productivity, the average quantity of g&s produced per unit of labor
input.
▪ Y = real GDP = quantity of output produced
L = quantity of labor
so productivity = Y/L (output per worker)
→ When a nation’s workers are very productive, real
GDP is large and incomes are high.
→ When productivity grows rapidly, so do living
standards.
What, then, determines productivity and its growth
rate?

8
2. Productivity: Its Role and Determinants

2.1. How Productivity Is Determined?

Physical Capital (K)

▪ Recall: The stock of equipment and structures used to produce g&s is called
[physical] capital, denoted K.
▪ K/L = capital per worker.
▪ Productivity is higher when the average worker has more capital (machines,
equipment, etc.).
▪ i.e., an increase in K/L causes an increase in Y/L.

9
2. Productivity: Its Role and Determinants

2.1. How Productivity Is Determined?

Human capital (H):

▪ the knowledge and skills workers acquire through education, training, and experience
▪ H/L = the average worker’s human capital
▪ Productivity is higher when the average worker has more human capital (education,
skills, etc.).
▪ i.e., an increase in H/L causes an increase in Y/L.

10
2. Productivity: Its Role and Determinants

2.1. How Productivity Is Determined?

Natural resources (N):
▪ the inputs into production that nature provides,
e.g., land, mineral deposits
▪ Other things equal, more N allows a country to
produce more Y.
In per-worker terms, an increase in N/L causes
an increase in Y/L.
▪ Some countries are rich because they have
abundant natural resources
(e.g., Saudi Arabia has lots of oil).
▪ But countries need not have much N to be rich
(e.g., Japan imports the N it needs).
11
 2. Productivity: Its Role and Determinants

2.1. How Productivity Is Determined?

Are Natural Resources a Limit to Growth?

▪ Some argue that population growth is depleting the Earth’s non-renewable resources → limit growth
in living standards.
▪ But technological progress often yields ways to avoid these limits: hybrid cars use less gas, better
insulation in homes reduces the energy
▪ As a resource becomes scarcer, its market price rises, which increases the incentive to conserve it
and develop alternatives. 12
2. Productivity: Its Role and Determinants

2.1. How Productivity Is Determined?

Technological knowledge (A)
▪ society’s understanding of the best ways to produce g&s
▪ Technological progress does not only mean a faster computer, a higher-definition
TV, or a smaller cell phone.
▪ It means any advance in knowledge that boosts productivity (allows society to get
more output from its resources).
▪ E.g., Henry Ford and the assembly line.

13
2. Productivity: Its Role and Determinants

2.1. How Productivity Is Determined?

Tech. Knowledge vs. Human Capital

▪ Technological knowledge refers to society’s understanding of how to produce

g&s.
▪ Human capital results from the effort people expend to acquire this knowledge
→ Transmit technology understanding to labor force
▪ Both are important for productivity.

14
2. Productivity: Its Role and Determinants

2.1. How Productivity Is Determined?

The Production Function

▪ The production function is a graph or equation showing the relation between output
and inputs:
Y = A F(L, K, H, N)
F( ) – a function that shows how inputs are combined to produce output
“A” – the level of technology
▪ “A” multiplies the function F( ),
so improvements in technology (increases in “A”) allow more output (Y) to be
produced from any given combination of inputs.

15
2. Productivity: Its Role and Determinants

2.1. How Productivity Is Determined?

The Production Function
Y = A F(L, K, H, N)
▪ The production function has the property constant returns to scale: Changing all
inputs
by the same percentage causes output to change by that percentage. For example,
▪ Doubling all inputs (multiplying each by 2) causes output to double:

2Y = A F(2L, 2K, 2H, 2N)

▪ Increasing all inputs 10% (multiplying each by 1.1) causes output to increase by
10%:
1.1Y = A F(1.1L, 1.1K, 1.1H, 1.1N)

16
2. Productivity: Its Role and Determinants

2.1. How Productivity Is Determined?

The Production Function

Y = A F(L, K, H, N)
▪ If we multiply each input by 1/L, then output is multiplied by 1/L:
Y/L = A F(1, K/L, H/L, N/L)
▪ This equation shows that productivity (output per worker) depends on:
▪ the level of technology (A)
▪ physical capital per worker
▪ human capital per worker
▪ natural resources per worker

17
ACTIVE LEARNING 1 – Discussion Question

Which of the following policies do you think would be most effective at boosting growth and living
standards in a poor country over the long run?
a. Offer tax incentives for investment by local firms
b. Offer tax incentives for investment by foreign firms
c. Give cash payments for good school attendance
d. Crack down on govt corruption
e. Restrict imports to protect domestic industries
f. Allow free trade
g. Give away condoms

18 18
3. Economic Growth and Public Policy

3.1. Saving and Investment

One of the Ten Principles of Economics in Chapter 1 is that people face tradeoffs.

▪ We can boost productivity by increasing K, which requires investment.

▪ Since resources scarce, producing more capital requires producing fewer
consumption goods.
▪ Reducing consumption = increasing saving.
This extra saving funds the production of investment goods. (More details in
the next chapter.)
▪ Hence, a tradeoff between current and future consumption.

19
 3. Economic Growth and Public Policy

3.2. Diminishing Returns and the Catch-Up Effect

▪ The govt can implement policies that raise

saving and investment. (Details in next
chapter.)
Then K will rise, causing productivity and
living standards to rise.

▪ But this faster growth is temporary, due to

diminishing returns to capital:
As K rises, the extra output from an
additional unit of K falls…. In the long run
20
 3. Economic Growth and Public Policy

3.2. Diminishing Returns and the Catch-Up Effect

▪ Catch-Up Effect: the property whereby poor

countries tend to grow more rapidly than rich ones

▪ Over 1960-1990, the U.S. and S. Korea devoted a

similar share of GDP to investment, so you might
expect they would have similar growth performance.
▪ But growth was >6% in Korea and only 2% in the
U.S.
▪ Explanation: the catch-up effect. In 1960, K/L was
far smaller in Korea than in the U.S., hence Korea
grew faster.

21
3. Economic Growth and Public Policy

3.3. Investment from Abroad

▪ To raise K/L and hence productivity, wages, and living standards, the govt can also
encourage
▪ foreign direct investment: a capital investment (e.g., factory) that is owned &
operated by a foreign entity
▪ foreign portfolio investment: a capital investment financed with foreign money but
operated by domestic residents
▪ Some of the returns from these investments flow back to the foreign countries that supplied
the funds → Investment from abroad, therefore, does not have the same effect on all
measures of economic prosperity.
▪ Especially beneficial in poor countries that cannot generate enough saving to fund
investment projects themselves.
▪ Also helps poor countries learn state-of-the-art technologies developed in other countries.

22
3. Economic Growth and Public Policy

3.4. Education
▪ Govt can increase productivity by promoting education–investment in human capital
(H).
▪ Public schools, subsidized loans for college
▪ Education has significant effects: In the U.S., each year of schooling raises a
worker’s wage by 10%.
▪ But investing in H also involves a tradeoff between the present & future:
Spending a year in school requires sacrificing a year’s wages now to have higher
wages later (opportunity cost)
▪ An externality is the effect of one person’s actions on the well-being of a bystander.
▪ One problem facing some poor countries is the brain drain—the emigration ofmany
of the most highly educated workers to rich countries
23
 3. Economic Growth and Public Policy

3.5. Health and Nutrition

▪ Health care expenditure is a type of investment in human capital – healthier workers are
more productive.
▪ In countries with significant malnourishment, raising workers’ caloric intake raises
productivity:
▪ Over 1962-95, caloric consumption rose 44% in S. Korea, and economic growth was
spectacular.
▪ Nobel winner Robert Fogel:
Great Britain in 1780, about 1/5 people were so malnourished that they were incapable
of manual labor
→ 30% of Great Britain’s growth from 1790-1980 was due to improved nutrition.

24
3. Economic Growth and Public Policy

3.6. Property Rights and Political Stability

▪ Recall:
Markets are usually a good way to organize economic activity.
The price system allocates resources to their most efficient uses.
▪ This requires respect for property rights, the ability of people to exercise authority over the
resources they own.

▪ In many poor countries, the justice system doesn’t work very well:
▪ Contracts aren’t always enforced
▪ Fraud, corruption often go unpunished
▪ In some, firms must bribe govt officials for permits
▪ Political instability (e.g., frequent coups) creates uncertainty over whether
property rights will be protected in the future.
25
3. Economic Growth and Public Policy

3.6. Property Rights and Political Stability

▪ When people fear their capital may be stolen by criminals or confiscated by a corrupt
govt, there is less investment, including from abroad, and the economy functions less
efficiently.
Result: lower living standards.
▪ Economic stability, efficiency, and healthy growth require law enforcement, effective
courts, a stable constitution, and honest govt officials.

26
3. Economic Growth and Public Policy
3.7. Free Trade
▪ Inward-oriented policies Recall: Trade can make everyone better off.
(e.g., tariffs, limits on investment from abroad) aim to raise living standards by avoiding
interaction with other countries.
▪ Countries with inward-oriented policies have generally failed to create growth. E.g., Argentina
during the 20th century.
▪ Outward-oriented policies (e.g., the elimination of restrictions on trade or foreign investment)
promote integration with the world economy.
▪ Countries with outward-oriented policies have often succeeded. E.g., South Korea, Singapore,
Taiwan after 1960.
▪ Trade has similar effects as discovering new technologies – it improves productivity and living
standards.
▪ The amount that a nation trades with others is determined not only by government policy but also
by geography.
27
3. Economic Growth and Public Policy
3.8. Research and Development

▪ Technological progress is the main reason why living standards rise over the long run.
▪ One reason is that knowledge is a public good: Ideas can be shared freely, increasing the
productivity of many.
▪ Policies to promote tech. progress:
▪ Patent laws
▪ Tax incentives or direct support for
private sector R&D
▪ Grants for basic research at universities

28
3. Economic Growth and Public Policy
3.9. Population Growth
…may affect living standards in 3 different ways:
1. Stretching natural resources
▪ 200 years ago, Malthus argued that pop. growth would strain society’s ability to provide for
itself. Since then, the world population has increased sixfold. If Malthus was right, living
standards would have fallen. Instead, they’ve risen.
▪ Malthus failed to account for technological progress and productivity growth.

29
 3. Economic Growth and Public Policy
3.9. Population Growth
2. Diluting the capital stock
▪ Bigger population = higher L = lower K/L → when
population growth is rapid, each worker is equipped
with less capital → lower productivity & living
standards.
▪ This applies to H as well as K: fast pop. growth =
more children
= greater strain on educational system.
▪ Countries with fast pop. growth tend to have lower
educational attainment.

To combat this, many developing countries use policy to control population growth.
1. China’s one child per family laws
2. Contraception education & availability
3. Promote female literacy to raise opportunity cost of having babies
30
3. Economic Growth and Public Policy
3.9. Population Growth

3. Promoting tech. progress

▪ More people → more scientists, inventors,
engineers → more frequent discoveries → faster
tech. progress & economic growth
▪ Evidence from Michael Kremer: Over the course of
human history,
▪ growth rates increased as the world’s population
increased
▪ more populated regions grew faster than less
populated ones

31
ACTIVE LEARNING 2 – Review productivity concepts

▪ List the determinants of productivity.

▪ List three policies that attempt to raise living standards by increasing one of
the determinants of productivity.

32 32
ACTIVE LEARNING 2 – Review productivity concepts

Determinants of productivity:
K/L, physical capital per worker
H/L, human capital per worker
N/L, natural resources per worker
A, technological knowledge
Policies to boost productivity:
▪ Encourage saving and investment, to raise K/L
▪ Encourage investment from abroad, to raise K/L
▪ Provide public education, to raise H/L

33 33
ACTIVE LEARNING 2 – Review productivity concepts

Determinants of productivity:
K/L, physical capital per worker
H/L, human capital per worker
N/L, natural resources per worker
A, technological knowledge
Policies to boost productivity:
▪ Patent laws or grants, to increase A
▪ Control population growth, to increase K/L

34 34
CONCLUSION

▪ In the long run, living standards are determined by productivity.

▪ Policies that affect the determinants of productivity will therefore affect the next
generation’s living standards.
▪ One of these determinants is saving and investment.
▪ In the next chapter, we will learn how saving and investment are determined, and
how policies can affect them.

35
Summary

▪ There are great differences across countries in living standards and growth
rates.
▪ Productivity (output per unit of labor) is the main determinant of living
standards in the long run.
▪ Productivity depends on physical and human capital per worker, natural
resources per worker, and technological knowledge.
▪ Growth in these factors – especially technological progress – causes growth
in living standards over the long run.

36
Summary

▪ Policies can affect the following, each of which has important effects on growth:
▪ Saving and investment
▪ International trade
▪ Education, health & nutrition
▪ Property rights and political stability
▪ Research and development
▪ Population growth
▪ Because of diminishing returns to capital, growth from investment eventually slows
down, and poor countries may “catch up” to rich ones.

37
Homework

HOMEWORK:
- Problem 5, 6, 8, pg.563;
(Mankiw 9th ed)

38