PRODUCTION AND GROWTH

Introduction

The average person in a rich country has an income more than ten times as high as the average person in a poor country. Large differences in income are reflected in large differences in the quality of life (better nutrition, better health care, and longer life expectancy).

Even within a country, there are large changes in the standard of living over time. A growth rate of GDP per person by 2% (7%) per year implies that average income doubles every 35 (10) years.

Growth:       1%   2%   3%   4%   5%   6%   7%

Time:            70    35    23    18    14    12   10

Growth rates vary substantially from country to country. In some East Asian countries (Singapore, S K, China), average income has risen about 7% per year. Average income doubles every 10 years. These countries have, in the length of one generation, gone from being among the poorest in the world to being among the richest. By contrast, in some African countries, average income has been stagnant for many years.

What explains these diverse experiences?  What policies should the poor countries pursue to promote more rapid growth in order to join the developed world? These are among the most important questions in macroeconomics.

ECONOMIC GROWTH AROUND THE WORLD

PRODUCTIVITY: ITS ROLE AND DETERMINANTS

The large variation in living standards around the world is due to productivity.

To explain why incomes are so much higher in some countries than in others, we must look at the many factors that determine a nation’s productivity.

The term productivity refers to the quantity of goods and services that a worker can produce for each hour of work.

Why are some economies so much better at producing goods and services than others?

 

HOW PRODUCTIVITY IS DETERMINED

Physical Capital:

Workers are more productive if they have tools with which to work.

Human capital:

 The knowledge and skills that workers acquire through education, training and

experience.

Natural Resources:

 Inputs into production that are provided by nature, such as land, rivers, and mineral deposits.

 Natural resources take two forms: renewable and nonrenewable.  Oil is an example of a nonrenewable resource.  Once the supply of oil is depleted, it is impossible to create more. Although natural resources can be important, they are not necessary for an economy to be highly productive in producing goods and services.

v Japan, is one of the richest countries in the world, despite having few natural resources.  International trade makes Japan’s success possible.

Technological Knowledge: the understanding of the best ways to produce goods and services.

A century ago, most Americans worked on farms.  Today, thanks to advances in the technology of farming, a small fraction of the population can produce enough food to feed the entire country. This technological change made labor available to produce other goods and services.

   What can government policy do to raise productivity and living standards?

One way to raise future productivity is to invest more current resources in the production of capital.

   For society to invest more in the capital, it must consume less and save more of its current income.

    Encouraging saving and investment is one way that a government can encourage growth and, in the long run, raise the economy’s standard of living.

The importance of investment for economic growth: the correlation between growth and investment, although not perfect, is strong.

    Interpreting these data  

A correlation between two variables does not establish which variable is the cause and which the effect is.

It is possible that high investment causes high growth, but it is also possible that high growth causes high investment. Perhaps, high growth and high investment are both caused by a third variable that has been omitted from the analysis.

Nonetheless, because capital accumulation affects productivity so clearly and directly, many economists interpret these data as showing that high investment leads to more rapid economic growth.

DIMINISHING RETURNS AND THE CATCH-UP EFFECT

What happens if the government pursues policies that raise the nation’s saving rate (S/GDP)?

The capital stock increases, leading to rising productivity and more rapid growth in GDP.

As the higher saving rate allows more capital to be accumulated, the benefits from additional capital become smaller over time, and so growth slows down.

According to studies of international data, increasing the saving rate can lead to substantially higher growth for a period of several decades.

The diminishing return to capital has another important implication: Other things equal, it is easier for a country to grow fast if it starts out relatively poor.

Catch-up effect:

the property whereby countries that start off poor tend to grow faster than countries that start off rich.

In poor countries, workers lack even the most rudimentary tools. Small amounts of capital investment would substantially raise these workers’ productivity.

By contrast, workers in rich countries have large amounts of capital. Additional capital investment has a relatively small effect on productivity.

INVESTMENT FROM ABROAD

Saving by domestic residents is not the only way for a country to invest in new capital. The other way is investment by foreigners.

A capital investment that is owned and operated by a foreign entity is called foreign direct investment.

An investment that is financed with foreign money but operated by domestic residents is called foreign portfolio investment.

In both cases, foreigners provide the resources necessary to increase the stock of capital in the country.

Investment from abroad is one way for a country to grow. Even though some of the benefits from this investment flow back to the foreign owners.

Investment from abroad does not have the same effect on all measures of economic prosperity:

·        GDP is the income earned within a country by both residents and nonresidents.

·        GNP is the income earned by residents of a country both at home and abroad.

When a foreign company opens a factory in the country, some of the income the factory generates accrues to people who do not live in the country.

Foreign investment in the country raises the income of the country (measured by GNP) by less than it raises the production in the country (measured by GDP).

EDUCATION

Investment in human capital is at least as important as investment in physical capital for a country’s long-run economic success.

One way in which government policy can enhance the standard of living is to provide good schools and to encourage the population to take advantage of them.

Investment in human capital, like investment in physical capital, has an opportunity cost. When students are in school, they forgo the wages they could have earned.

Human capital is particularly important for economic growth because human capital conveys positive externalities.

Ø An educated person, for instance, might generate new ideas about how best to produce goods and services. If these ideas enter society’s pool of knowledge, so everyone can use them, then the ideas are an external benefit of education. In this case, the return to schooling for society is even greater than the return for the individual.

One problem facing some poor countries is the brain drain.

PROPERTY RIGHTS AND POLITICAL STABILITY

Another way in which policymakers can foster economic growth is by protecting property rights and promoting political stability.

One threat to property rights is political instability. When revolutions are common, there is doubt about whether property rights will be respected in the future. If a revolutionary government might confiscate the capital of some businesses, domestic residents have less incentive to save, invest, and start new businesses. At the same time, foreigners have less incentive to invest in the country.

Economic prosperity depends in part on political prosperity. A country with an efficient court system, honest government officials, and a stable constitution will enjoy a higher economic standard of living.

FREE TRADE

Most economists today believe that poor countries are better off pursuing outward-oriented policies that integrate these countries into the world economy.

Countries pursuing outward-oriented policies, such as SK, Singapore, and Taiwan, have enjoyed high rates of economic growth.

Trade is, in some ways, a type of technology. When a country exports wheat and imports steel, the country benefits in the same way as if it had invented a technology for turning wheat into steel.

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

THE CONTROL OF POPULATION GROWTH

High population growth reduces GDP per person. The reason is that rapid growth in the number of workers forces the other factors of production to be spread more thinly.  A smaller quantity of capital per worker leads to lower productivity and lower GDP per worker

High population growth places a larger burden on the educational system.  Educational attainment tends to be low.

The differences in population growth around the world are large. In developed countries, the population has risen about 1% per year in recent decades. By contrast, in many poor countries, population growth is about 3% percent per year.

 Reducing the rate of population growth is one way less developed countries can raise their standards of living. In some countries, this goal is accomplished directly with laws regulating the number of children (China), in others by increasing awareness of birth control techniques.

RESEARCH AND DEVELOPMENT

The primary reason that living standards are higher today than they were a century ago is that technological knowledge has advanced.

To a large extent, knowledge is a public good: Once one person discovers an idea, the idea enters society’s pool of knowledge, and other people can freely use it.

Just as the government has a role in providing a public good such as national defense, it also has a role in encouraging the research and development of new technologies.

The government may encourage advances in knowledge with research grants. Yet another way in which government policy encourages research is through the patent system. The patent gives the inventor a property right over his invention, turning his new idea from a public good into a private good.

Summary

Economic prosperity, as measured by GDP per person, varies substantially around the world. The average income in the world’s richest countries is more than ten times that in the world’s poorest countries.

The standard of living in an economy depends on the economy’s ability to produce goods and services. Productivity, in turn, depends on the amounts of physical capital, human capital, natural resources, and technological knowledge available to workers.

Government policies can influence the economy’s growth rate in many ways:

v Encouraging saving and investment (local and foreign).

v Fostering education.

v Maintaining property rights and political stability.

v Allowing free trade.

v Controlling population growth.

v Promoting the R&D of new technologies.

The accumulation of capital is subject to diminishing  returns:

• The more capital an economy has, the less additional output the economy gets from an extra unit of capital.
• Because of diminishing returns, higher saving leads to higher growth for a period of time, but growth eventually slows down as the economy approaches a  higher level of capital, productivity, and income.

Also because of diminishing returns, the return to capital is especially high in poor countries.

Other things equal,  these countries can grow faster because of the catch-up effect.