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Productivity and Growth

CHAPTER

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© 2003 South-Western/Thomson Learning

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Standard of Living

Economy’s standard of living as measured by the amount of goods and services available per person grows over the long run because of

increases in the amount and quality of resources, especially labor and capitalbetter technologyimprovements in the rules of the game that facilitate production and exchange• tax laws• property rights• patent laws• legal system

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Growth and the PPFRecall that the production possibilities frontier – PPF – shows alternative combinations of goods that an economy can produce if available resources are used efficiently

See Exhibit 1Quantity of resources in the economy fixedLevel of technology fixedRules of the game remain fixedTwo broad categories of goods – consumer goods and capital goods

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Exhibit 1: Economic Growth

When resources are employed efficiently, CI in each of the panels shows the possible combinations of consumer goods and capital goods that can be produced in a given year

Points C and I depict the quantity of consumer and capital goods produced if all resources are used to produce that good, respectively

Economic growth is an outward shift of the PPF in each of the two panels

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Economic GrowthCauses of economic growth

Increase in the availability of resourcesGrowth in the labor supply • Population increases• Existing population supplies more labor

Growth in the capital stock• The more capital goods produced this year, the

more the economy will grow

Improvement in Technology• Expand the frontier by making more efficient

use of existing resources

Improvements in the Rules of the game • Improvements that nurture production and

exchange will promote growth

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Exhibit 1: Capital Produced and Growth

The amount of capital produced this year will affect the location of the PPF next year

In the left panel, the economy has chosen point A from the possible combinations which shifts the PPF from CI this year

to C'I' next year However, if more capital goods are produced this year, as reflected by point B in the right panel, the PPF will shift outward farther next year to C"I"

Thus, an economy that invests more in capital – gives up more consumer goods – will experience larger economic growth

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What is Productivity?

Production is a process that transforms resources into productsProductivity

measures how efficiently resources are employedthe higher the productivity, the more goods and services that can be produced from a given amount of resources the farther out will be the PPFdefined as the ratio of total output to a specific measure of inputtotal output divided by the amount of a particular kind of resource employed

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Labor ProductivityOutput per unit of labor and measures total output divided by the hours of labor employed to produce that output

Most commonly used resource to measure productivity

Accounts for a relatively large share of the cost of production – 70% on averageMore easily measured than other inputsCan be measured as hours per week or full-time workers per year

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Labor Productivity

The resource most responsible for increasing labor productivity is capital

As the economy accumulates more capital per worker, labor productivity increases standard of living increases

Two broad categories of capitalHuman Capital• Accumulated knowledge, skill, and experience of

the labor force• As individual workers acquire more human

capital, their productivity and income increase

Physical Capital• Includes the machines, buildings, roads, airports,

communication networks and other manufactured creations used to produce goods and services

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Exhibit 2: Per-Worker Production Function

y

k

PF

0Capital per worker

Expresses the relationship between the amount of capital per worker (horizontal axis) and the output per worker (vertical axis), other things constant (level of technology and the rules of the game)

Any point on the production function, PF, shows how much output per worker can be produced for a given amount of capital per worker

When there are k units of capital per worker, average output per worker in the economy is y

Upward slope of the curve occurs because an increase in capital per worker helps each worker produce more output

Ou

tpu

t p

er w

ork

er

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Per Worker Production Function

The shape of the per-worker production function reflects the law of diminishing marginal returns

When applied to capital says that the more capital per worker there is already, the less additional output can be gained by increasing capital stock per worker even more

An increase in the amount of capital per worker is called capital capital deepeningdeepening and is one source of rising labor productivity economic growth

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Exhibit 3: Impact of a Technological Breakthrough

k

Ou

t pu

t p

er

wo

r ke

ry

0Capital per worker

PFy'

PF'Technological change usually improves the quality of capital and increases productivity, shown by the upward rotation from PF to PF' more output is produced at each level of capital per worker

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Economic GrowthTwo kinds of changes in capital improve worker productivity

An increase in the quantity of capital per worker• is reflected by a movement along the per-worker

production function• According to Simon Kuznets, changes in the

quantities of labor and capital account for only one-tenth of the increase in economic growth

An improvement in the quality of capital per worker • is reflected by technological change that rotates

the curve upward• Accounts for nine-tenths of the increase in

economic growth• As technological breakthroughs become

embodied in new capital, resources are combined in more efficient ways

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Rules of the GameRefers to the formal and informal institutions that promote economic activity

Laws, customs, conventions, and other institutional elements that encourage people to undertake productive activityStable political environment and system of well-defined property rights

Improvements in the rules of the game could result in more output for each level of capital upward rotation in the per-worker production function

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Productivity / Growth in Practice

Differences in the standard of living among countries are profound

Per capita output in the U.S. is more than fifty times that of the world’s poorest countriesWith only 5% of the world’s population, the U.S. produces more than all the nations comprising the bottom 50% of the world’s population put together

World’s economies can be sorted into two broad groups

Industrial market countries or developed countriesDeveloping or third-world countries

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Industrial market countries

Developed countries which make up about 20% of the world’s population

Economically advanced capitalistic countries

Western Europe, North America, Australia, New Zealand, and Japan

Were the first to experience long-term economic growth and have the highest standard of living

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Developing Countries

80% of the world’s population

Have a lower standard of living because of relatively less human and physical capital

On average, the majority of workers in these countries are employed in agriculture

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Education and Economic Development

Important source of productivity is the quality of labor

What exactly is the contribution of education to the process of economic development

Education makes workers aware of the latest production techniquesMakes workers more receptive to new ideas and methodsCountries with the most advanced educational systems were first to develop while developing economies have far lower levels of education

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Source: Angus Maddison, Phases of Capitalist Development (New York; Oxford University Press, 1982) and Bureau of Labor Statistics. “Since 1990” includes 2000 and 2001.

Exhibit 5: Long-Term Trends in Labor Productivity (Annual Averages by Decade)

Average productivity growth since 1870 is 2.1%

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Exhibit 6: U.S. Labor Productivity Growth Slowed During 1974-1982, then Rebounded

Growth in labor productivity declined from an average of 2.9% per year between 1948 to 1973 to 0.8% in 1974 to 1982

Causes of slowdown: (1) increase in the price of oil between 1973 and 1974(2) in the early 1970s environmental and safety laws required more costly production methods

Rebound during the later years is directly related to the information revolution powered by the computer chip

2.9

0.8

1.7

2.3

0

0.5

1

1.5

2

2.5

3

1948-1973 1974-1982 1983-1995 1996-2001

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Output Per Capita

Even if labor productivity did not increase, total output would grow if the quantity of labor increased

Labor productivity equals real GDP divided by the quantity of labor real GDP equals labor productivity times the quantity of labor

Therefore total output can grow as a result of greater labor productivity, more labor, or both

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Output Per CapitaOutput per capita

Real GDP divided by the populationBest measure of economy’s standard of livingIndicates how much an economy produces on average per person

Relationship between output per capita and labor productivity

Suppose labor productivity is $60,000 per worker per yearIf there is one worker for every two people in the economy, then output per capital equals output per worker divided by 2 $60,000 / 2 = $30,000

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Output Per Capita

Output will increase iflabor productivity increases for a given worker-population ratiothe worker-population ratio increases for given labor productivitylabor productivity and the worker-population both increase

In fact, output per capita would increase as long as an increase in one of these three factors more than offsets any decrease in the other two

24Source: U.S. Dept. of Commerce, Survey of Current Business, 81 (July, 2001).

Exhibit 7: Real GDP Per Capita

Despite the six recessions indicated by the shading, real GDP per capita measured in 1996 dollars has nearly tripled, for an average growth rate of 2.3%

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International Comparisons

0

1

1

2

2

3

U.S. U.K. Italy ermany Japan Canada France

Exhibit 9: U.S. Real GDP Per Capita Outgrew Other Major Economies Since

1983

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rage

An

nu

al P

erce

nt

Gro

wth

Sin

ce 1

983

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

U.S. Canada Japan Germany Italy U.K. France

Exhibit 8: U.S. Real GDP Per Capita Is Tops Among Major Economies

Con

vert

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.S. D

olla

rs

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Technological Change and Unemployment

Technological change usually reduces the number of workers needed to produce a given amount of output

Therefore, some fear that new technology will throw people out of work and lead to higher unemployment

However, it is also true that technological change can also increase production and employment by making products more affordable

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Technological Change and Unemployment

If technological change caused unemployment

Then the slowdown in productivity growth that occurred from 1974 to 1982 should have resulted in lower unemployment than during the period of higher productivity growth from 1996 to 2001In fact, the unemployment rate during the former period was much higher than in the latter periodAlso, if this argument were true, we should expect unemployment rates should be lower in the developing countries. Again, this is not borne out by the facts

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Research and DevelopmentImprovements in technology arise from scientific discovery, which is the fruit of researchWe can distinguish between

Basic research• Search for knowledge without regard to how

that knowledge will be used• First step toward technological

advancement• Less immediate payoff yet yields a higher

rate of return to society as a whole

Applied research• Seeks to answer particular questions or to

apply scientific knowledge to the development of specific products

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Research and DevelopmentSince technological change is the fruit of research and development (R&D), investment in R&D reflects the economy’s efforts to improve productivity

One way to track R&D spending is to measure it relative to GDP

During the 1990s, R&D as a share of GDP in the U.S. ranked second among the major economies, behind only Japan

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Research and DevelopmentBusiness R&D is more likely to be targeted toward applied research and innovations

Averaged 1.9% of GDP in the 1990sOnly Japan had higher business R&D than the U.S.

R&D spending by governments and nonprofits may generate basic knowledge that has specific applications in the long run

For example, the Internet sprang from R&D spending on national defense

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Exhibit 10: R&D Spending - Percentage of GDP

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Convergence Theory

Will poor countries eventually catch up with rich ones?

Convergence theoryConvergence theory argues that developing countries can grow faster than advanced ones should eventually close the gap

It is easier to copy new technology once it is developed than to develop new technologyThus countries that start out far behind can grow faster by copying technology

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Convergence TheoryWhat’s the evidence on convergence?

Some poor countries have begun to catch up with the richer ones• Newly industrialized Asian economies of Hong

Kong, Singapore, South Korea, and Taiwan• However, these “Asian Tigers” are more the

exception than the rule

Among the nations that comprise the poorest third of the world’s population, consumption per capita has grown significantly slower than in the rest of the world the standard of living in these countries has fallen farther behind in relative terms

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Convergence TheoryReasons why the poorest countries have not gained

Birth rates are nearly double those in richer ones the poor economies must produce still more just to keep up with a growing populationVast differences in the quality of human capital across countries• While technology may be portable, the

knowledge, skill, and training required to take advantage of this technology may not be

Some countries lack the stable macroeconomic environment, established institutions, and infrastructures needed to nurture economic growth

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Industrial Policy

Two concerns with respect to technologies of the future

They will require huge sums to develop and implement and firms may not easily raise or put at risk these large sumsSome technological breakthroughs spill over to other firms and other industries; thus the firm that develops the breakthrough may not be in a position to reap benefits from these spillover effects individual firms may under-invest in such research

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Industrial Policy

One possible solution to these two problems was more government involvement through industrial policyIndustrial policy

Idea that government, using taxes, subsidies, regulations, and coordination in the private sector, could help nurture the industries and technologies of the future Gives domestic industries and advantage over foreign competition with the objective one of securing a leading global role for domestic industries