Text transcription of Chapter 7 – Production and Growth

Welcome to the Chapter 7 Lecture on Production and Growth.

Differences in income reflect differences in quality of life. You know this. When you have more cash in your wallet, you can go out to eat, buy things and have a good time. When your broke, you can’t go out and purchasing the necessities becomes difficult. Standards of living are different between countries and also change within countries over time. Standard of living is the availability of the basics (food, clothing and shelter) to the average person. If you have ever traveled outside of the United States, you know that people living in South America or Asia have a different standard of living than we do in the U.S. Standard of living has also changed greatly in our own country. Think about what is like to live back during the Industrial Revolution compared to today. U.S. average income measured by real GDP per person has grown by 2% per year. 2% per year may not sound like a lot, but that rate of growth implies that incomes double every 35 years.

That is roughly every generation. If we continue on this growth path, you should be twice as wealthy as your parents when you get to your parents age. The Asian Tigers, which consist of Singapore, South Korea, Taiwan and Hong Kong, have seen their average income increase by 7% per year. This rate of growth implies that incomes with double every 10 years. This is a huge growth rate. Imagine your income doubling every 10 years! The African countries, like Chad and Nigeria, have stagnated and average incomes have not changed over the last few decades.

In chapter seven, we are going to explore what causes these differences. Economists want to know how do rich countries, like the U.S., continue to grow? What can poor countries (like Chad and Nigeria) do to promote growth? And what policies should be in place to help promote growth? Two key terms before we get into the material for this chapter. Real GDP is a good measure to gauge economic welfare. Growth of Real GDP is a good gauge of economic progress.

The answer to what explains the differences in living standards is actually quite simple. This chapter focuses on the role of productivity and what determines productivity. Variations in living standards can be summed up in one word – Productivity. If we say that people in the U.S. have a greater standard of living compared to those who live in India, what we are really saying is the U.S. is more productive than India. Productivity is defined as the quantity of goods and services produced from each unit of labor input. Think of the example from the movie Cast Away. Tom’s standard of living is directly tied to his level of productivity. The more productive he is, the more fish he can catch, the more vines he can braid into rope, the bigger fire he can build. His standard of living will be relatively high. If Tom is not very productive and he can’t catch very many fish or make rope or build a fire, then his living standard will be relatively low.

There are four main factors that determine productivity. The first is the amount of physical capital per worker. Workers are more productive if they have tools to work with. Imagine if Tom had a fishing pole or a knife. He would much more productive in catching fish and cutting vines with those tools. Next is human capital per worker. Human capital is defined as the knowledge and skills workers acquire through education, training and experience. An example of human capital would be if Tom had taken a survival-training course. He would already have the education and training to survive in the wild. He might already know how to build a fire without a match or how to catch fish, increasing his level of productivity.

The third determinant of productivity is natural resources per worker. Natural resources are inputs into production provided by nature. Examples include physical land, rivers and mineral deposits to name a few. An example would be the number of fish in the lagoon or the number of banana trees on the island. If there are only a few fish in the entire lagoon, then the probability of Tom catching one is relatively low. If there are hundreds of fish in the lagoon, then the probability of Tom catching one is relatively high. Same goes for the number of banana trees. The more natural resources, the greater the probability of being productive. The last determinant of productivity is technological knowledge. Technological knowledge is understanding the best ways to produce goods and services. There are many ways to get things done, but knowing the best way will increase productivity. Think about spearing fish and making rope. Lots of ways to do those activities, but understanding the best way to spear fish will yield the most fish caught. Understanding the best way to make rope will result in more rope.

Well-designed public policy can enhance economic growth. The last half of the chapter describes ways the government can raise productivity and living standards. The first type of public policy is Savings and

Investment. Remember, “investment” to an economist means the purchase of capital. My investing current resources into the production of capital, the economy will increase it’s physical capital per worker, therefore increasing productivity. However, there is a trade-off. To invest more in capital, a society must consume less and save more current income. The economy will sacrifice consumption today to enjoy greater consumption in the future.

If economy that cannot handle the trade-off between consuming less and saving more, they can have investment from abroad rather than domestic savings and investment. There are two kinds of foreign investment. First is called “foreign direct investment”, which is a capital investment owned and operated by a foreign entity. An example of this would be an American company opening and operating the day-to-day activities of a production plant in a foreign country. The other type of foreign investment is called “foreign portfolio investment” which is an investment that is financed with foreign money but operated by domestic residents. An example of this would be an American investing in a company in Taiwan whose day-to-day activities are operated by Taiwanese residents. Investment from abroad is a great way for poor countries to learn state-of-the-art technologies developed and used in rich countries. Rather than developing the technology themselves, they are able to duplicate existing production technology to work in their own markets.

The third way the government can help increase productivity is by promoting education, which increases human capital. In the U.S., each year of schooling, on average, increases wages by 10%. There is a positive correlation between education, human capital, higher levels of productivity and wages. “Brain drain” is a problem facing poor countries, which occurs when highly educated workers immigrate to rich countries. This leaves the poor country will a lower level of human capital. The forth way the government can improve productivity is by promoting health and nutrition. Healthier workers are more productive than unhealthy workers. The causal link between health and wealth runs in both directions, meaning that healthier workers are wealthier because they produce more output AND wealthier workers are healthier because they can afford health care.

The government can increase productivity by enforcing property rights and remaining political stable. A stable government, one without corruption, establishes and enforcing property rights, which encourages investment by owners which increases productivity and therefore wealth. Free trade is another public policy that can increase

productivity. A closed economy is an economy that does not trade with others therefore the society can only consume what it produces. An open economy is an economy that freely trades with other economies without government restriction in the form of tariffs or quotas. When economies trade, each economy can focus on producing goods for which they have the comparative advantage and enjoy a greater variety of goods and services. Lastly, the government can promote Research and Development to increase productivity. The government can sponsor research of new technologies, like it does with NASA, offer tax breaks to private firms conducting research and development, like it does with many pharmaceutical companies, or issue patents as incentives for individuals to engage in research and development.

There is a problem with first public policy, savings and investment. Investing current resources into the production of capital has different effects on rich versus poor countries. Production is subject to diminishing returns. As the amount of capital increases, the EXTRA output produced from each additional unit of capital falls. There is a diagram of diminishing returns on page 145 of the textbook. Diminishing returns is the idea that as you have more and more tools to work with, each individual tool produces less ADDITIONAL output.

Since production is subject to diminishing returns, increases in savings only lead to higher growth temporarily. This implies that it is easier for a country to grow fast it is starts off relatively poor. This phenomenon is called the “catch-up effect”, meaning that poor countries tend to grow at a faster rate than rich countries. Here’s an example. Between 1960 and 1990, U.S. and South Korea devoted a similar share of GDP to investment. The U.S. was already relatively rich therefore we grew at a slow pace, about 2% per year. South Korea was relatively poor therefore they grew at a much faster pace, about 6% per year.

This is the end of the chapter 7 lecture on Production and Growth. If you have any questions about the concepts covered in this chapter please email me or post a question in the “Ask Professor Pakula” discussion board.