Chapter 21

Production and growth

Productivity: refers to the amount of goods and services produced for each hour
of a worker’s time

A nation's standard of living is determined by the productivity of its workers

Policy makers are interested in:

● Can good growth rates be sustained?
● What policies should other countries pursue to achieve better growth?

The magic of compounding and the rule of 70

Because of compounding, it only takes a small difference in % growth to see

changes in rank order

Rule of 70: a growth rate of 1% would see income per person doubling in 70 years,
compared to 23 years for a 3% growth (70/3)

The trend rate of growth :

● The average sustainable rate of economic growth over a period of time
● Found by taking GDP in some time period, subtracting GDP from an earlier
time period, dividing the result by the initial time period and expressing the
figure as percentage

A country needs sustained growth over a period to experience considerable

improvements in living standards

Factors that influence economic growth:

● How open to trade, a country is
● How easy it is to do business and the extent to which corruption is minimized
● The extent to which violence, war, and conflict exist in a country
● Regional characteristics such as whether the country is part of Europe, etc
● Geographical factors such as physical resource endowments and climate
 Why productivity is so important
To understand the large difference in living standards across countries, we must
focus on the production of goods and services.
- A nation can enjoy high standard of living if it can produce a large quantity
of goods and services
- Productivity plays a key role in determining living standards for all nations in
the world

Productivity: refers to the amount of goods and services that a worker can
produce from each hour of work

How productivity is determined

Factors of production: the inputs used to produce good and services are called
the factors of production

Physical capital Makes workers more productive

Human capital The knowledge and skills that workers acquire through education,
training and experience

Natural resources Are inputs into production that are provided by nature, such as land,
rivers, and mineral deposits

Technological knowledge The understanding of the best ways to produce goods and services

Technical progress The quality of physical and human capital is improved

Model of growth ⇒ Solow and Swan

Output level GDP=Y, A=Technology, K=Capital and L=Labour
 Long-run equilibrium

For an economy with a given level of physical capital, the growth path will be
dependent on the:
- Level of technology
- Productivity of labour and capital
- Savings rate which determines investment in physical capital

Cause of growth

The causes of growth can be listed:

- Changes in savings rates - Increase in population
- Dilution of capital stock - Promoting technical progress
- An increase in technology

An increase in the population

➥ Populations can rise through birth rates being higher than death rates and
through net migration

● The age of the population helps determine the labour force

● The solow growth model shows that if the labour force is rising, then in
order for capital
- If investment does not keep pace with the rise in the population, people will
become poorer

Promoting technological progress

If there are more people, then:

- The greater the probability that some of those people will come up with new ideas
- This will lead to technological progress, which everyone benefits from

An increase in technology
● Increases in technology can be seen as a public good
● Technology can offset the effects of diminishing marginal product and lead
to proportional increases in productive capacity
 Thomas Malthus
- Argued that an ever-increasing population meant that the world was doomed
to live in poverty forever
- He failed to understand that these new ideas would increase the production
of food, etc

Endogenous growth theory: a theory of long-run economic growth which results

from the certain of new knowledge and technology which impacts on everyone and
makes them more productive as a result

Long-run economic: is generated by changes in technology.

Innovation and R&D are important ways in which technology growth can arise
- This can provide competitive advantage for firms over rivals which are both
distinctive and defensible
- There are therefore incentives for firms to innovate

If technology is a public good with the characteristics of being non-rival, then

there are policy implications for governments ➥ include protection of property
rights, encouraging foreign investment and promoting R&D

Creative destruction: the process where new technologies replace old ones and
new skills are needed which render existing skills obsolete

Economic growth and public policy

Government Policies That Raise Productivity and Living Standards.

➔ Encourage saving and investment. ➔ Establish secure property rights and
➔ Encourage investment from abroad. maintain political stability.
➔ Encourage education and training. ➔ Promote free trade.
➔ Promote research and development.

The importance of saving and investment

One way to raise future productivity is to invest more current resources in the
production of capital. If resources are used to produce capital goods, fewer goods
and services are produced for current consumption. Countries that devote a large
share of GDP to investment tend to have high growth rates.
Diminishing returns and the catch-up effect

Diminishing returns: As the stock of capital rises, the extra output produced from
an additional unit of capital falls.
● 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 higher level of productivity
and income, but not to higher growth in these areas.

Catch-up effect: refers to the property whereby countries that start off poor
tend to grow more rapidly than countries that start off rich.

Governments can increase capital accumulation and long-term economic growth by

encouraging investment from foreign sources.

Investment in the Country by Foreigners

Foreign Direct Investment: is when capital investment owned and operated by a

foreign entity.
Foreign Portfolio Investment: is when Investments financed with foreign money
but operated by domestic residents.

- Some benefits of foreign investment flow back to foreign owners. But the
economy still experiences an increase in the capital stock ⇒ higher
productivity/wages.
- 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.

Education
For a country’s long-run growth, education is at least as important as investment in
physical capital.
➥ The government can enhance the standard of living by providing schools and
encourage the population to take advantage of them.
A positive externality ⇒ An educated person might generate new ideas about how
best to produce goods and services, which, might, enter society’s pool of knowledge
and provide an external benefit to others.

➥ the problem is the Brain drain: the emigration of many of the most highly
educated workers to rich countries

Property rights and political stability

Property rights: refer to 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 government officials for permits
● Political instability (e.g., frequent coups) creates uncertainty over whether
property rights will be protected in the future

Free trade
A country that eliminates trade restrictions will experience the same kind of
economic growth that would occur after a major technological advance.

Some countries engage in . . .

- Inward-orientated trade policies ⇾ avoiding interaction with other countries.
- Outward-orientated trade policies ⇾ encouraging interaction with other
countries.

Population growth
Population growth interacts with other factors of production:
➔ Stretching natural resources.
➔ Diluting the capital stock.
➔ Promoting technological progress.
 Chapter 22

Categories of unemployment

What is unemployment?
- Someone who does not have a job and is willing and available for work at the
going rate.
- Unemployment rate is expressed as a percentage of the labour force.
- Labour force is the total number of people in work plus those who are
unemployed.

How is unemployment measured?

Unemployment may be measured in 2 ways:
1. The claimant count ⇒ asking for government benefits
2. A monthly survey of household ⇒ the labour force survey in the UK

Economically inactive people: People who are not in employment or unemployed due
to reasons such as being in full-time education, being full-time careers and raising
families.

Labour force (CBS): the total number of workers, including both the employed and
the unemployed.
 Eurostat divides population into 3 groups:
1. Employed: paid employees, self-employed and unpaid workers in a family business
2. Unemployed: people not working who have looked for work during previous 4 weeks
3. Not in labour force: everyone else

What does the u-rate really measures?

The u-rate is not a perfect indicator for joblessness or the health of the labor
market, because:
- It excludes discouraged workers
- It doesn’t distinguish between full-time and part-time work, or people working
part-time because full-time job is not available
- People misreport their work status in the BLS Survey
The u-rate is still a very useful barometer of the labor market economy

In an ideal labour market:

- Wages would adjust so that the quantity of labour supplied, and the quantity of
labour demanded, would be equal.
- At equilibrium, therefore, there is no unemployment.
- Changes in the supply of and demand for labour would create surpluses and
shortages in the labour market, and the adjustment of the wage rate would
ensure that all workers are always fully employed.
 Then why are there always people unemployed?
Labour markets do not clear instantly

Frictional unemployment: refers to the unemployment that results from the time
that it takes to match workers with jobs

- Search unemployment is inevitable because the economy is always changing

Job search: is the process by which workers find appropriate jobs given their
tastes and skills
➥ it is not caused by wage rate higher than equilibrium but by finding the right job

Voluntary unemployment: where people choose to remain unemployed rather than

take jobs which are available

Involuntary unemployment: where people want work at going market wage rates
but cannot find employment
Structural unemployment
Structural unemployment: occurs because the number of jobs available in some
labour markets is insufficient to provide a job for everyone who wants one

3 possible reason for above equilibrium wage are:

1. Minimum wage 2. Unions 3. Efficiency wages
laws

Workers who lose their jobs in one industry may find that jobs that are available:
- Occupational⇒ Requires skills and experience they do not possess
- Geographic immobility⇒ are not in the immediate region where they live

Technological change⇒ Losers are those whose knowledge, skills and experience
are redundant, which in result they have to seek new employment
Structural change in economy:
- Over time structural change affect the make-up of economies
- It can be caused by competition from abroad or by changes in technology
and changes in societal norms and trends

Labour market imperfection

Unemployment can be caused by wages being above the market equilibrium

Imperfection labour market:

- Prevent the wage rate from adjusting to equate the demand and supply of labour
- Another imperfection are the unions and collective bargaining

When the wage is above the equilibrium level:

- The quantity of labour supplied exceeds the quantity of labour demanded
- Workers are unemployed because they are waiting for jobs to open up

Minimum wage:
● When it is set above the level that balances supply and demand, it creates
unemployment
● Are binding most often for the least skilled and least experienced members
of the labour force, such as teenagers

Union: a worker association that bargains with employers over wages and working
conditions ⇉ It is a type of cartel attempting to exert its market power
➥ They typically earn more then workers who do not belong to unions

Collective bargaining: the process by which unions and firms agree on the terms
of employment

Strike: may be organized if the union and the firm cannot reach an agreement
➥ refers to when the union organizes a withdrawal of labour from the firm
 Are unions good or bad?
Critics argue that unions cause the allocation of labour to be inefficient and
inequitable

- Wages above the competitive level reduce the quantity of labour demanded and
cause unemployment
- Some workers benefit at the expense of other workers

Advocaters of unions:
- Contend that unions are a necessary antidote to the market power of firms
that hire workers
- They claim that unions are important for helping firms respond efficiently to
workers concerns

The theory of efficiency wages

Efficiency wages: are above equilibrium wages paid by firms in order to increase
worker productivity, therefore firms operate more efficiently

Firms may prefer higher than equilibrium wages because:

- Worker health: better paid workers eat a better diet and thus are more
productive
- Worker turnover: a higher paid worker is less likely to look for another job
- Worker effort: higher wages motivate workers to put forward their best effort
- Worker quality: higher wages attract a better pool of workers to apply for jobs

Natural rate of unemployment ( 2 important definitions)

1. Natural rate of unemployment: unemployment that does not go away on its own
even in the long-run
➥ it is the amount of unemployment that the economy normally experience
2. Cyclical unemployment: refers to the year-to-year fluctuations in unemployment
around its natural rate
➥ it is associated with short-term ups and owns of the business cycle
 How long are the unemployed without work? ⇒ It can be short or long term

- Most of the economies unemployment problem is attributable to relatively

few workers who are jobless for long periods of time

Hysteresis: refers to the effect is that the longer people are without work, the
less likely they are to be hired by firms

Sectoral shifts: are changes in the composition of demand across industries or

regions of the country
- Such sifts displace some workers, who must search for new jobs appropriate
for their skills and tastes
- The economy is always changing, so such frictional unemployment is
inevitable
- The result of this transition is temporary unemployment

Public policy and job search

Government programs can affect the time it takes unemployed workers to find new
jobs

These programs include the following:

● Government-run employment agencies: give out information about job vacancies
in order to match workers and jobs more quickly
● Public training programs: aim to ease the transition of workers from declining to
growing industries and to help disadvantaged groups escape proverty
● Unemployment insurance: a government program that partially protects workers
incomes when they become unemployed

➥ Offers workers partial protection against job losses and partial payment of
former wages for limited time to those who are laid off
➥ ⬆ the amount of search unemployment, ⬇ the search effort of the
unemployed, it may improve the chances of workers being matched with the right
job
 Cost of unemployment to individuals
- Loss of earnings ⇒ increased risk of slipping into poverty
- Self-esteem and health problems
- Drug abuse and alcohol abuse and crime
- Family breakdown
- De-skilling ⇒ the individual loses touch with changes in work practices and
technology

Cost of unemployment to society and economy

- The opportunity cost of unemployment ⇒ lost output
- The tax and benefits effect ⇒ lower tax revenues, higher welfare payments
- The reverse multiplier effect

Reverse multiplier effect

When people experience unemployment, they cut back their spending on luxuries
and switch their spending to substitute goods which may be seen as inferior goods

Effects of cutting back spending on luxuries:

- Goods with a relatively high-income elasticity of demand are likely to be affected
more significantly.
- These businesses cut back orders, lay off workers, take a hit on profits.
- So an increase in unemployment can produce a multiplied impact on economic
activity as a whole.
- Knock on effect can be local as those supplying goods and services have to cut
back and lay off workers.

Effect of switching to substitute goods:

- Some firms might see demand increase for example budget supermarkets