Production and Growth - University of Leicester growth • Economists tend to distinguish between:...

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Production and Growth

(Chapter 25 in Mankiw & Taylor)

We have looked in previous lectures at how economists measure macroeconomic quantities and prices Now we look at the forces that determine these variables in the long-run Later we’ll look at short-run fluctuations

•1

Economic Growth

• Real GDP per person

– A measure of living standards

– Varies widely from country to country; and

over time

• Growth rate

– How rapidly real GDP per person grew in

the typical year

• Because of differences in growth rates

– Ranking of countries by income changes

substantially over time 2

Economic growth

• Economists tend to distinguish between:

– Long run or trend growth

• N.B. a one-percentage point change in a

country’s growth rate can make a significant

difference over several generations due to

compounding

– Short run or cyclical movements – the

business cycle

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4

5 Source: Mitchell, Solomou and Weale (2012): http://ideas.repec.org/p/cam/camdae/1155.html

Table 1



The Variety of Growth Experiences across the World

Economic growth

• So there is no guarantee that a rich country

will remain rich; and that a poor country will

remain poor

• What determines (long-run) economic growth?

– Many theories

• Neoclassical theory: the role of productivity in

growth (Solow exogenous growth model)

• Endogenous growth theory: investment in

human capital is the key driver of growth

• Trade

7

Productivity

• Productivity

– Quantity of goods and services produced

from each unit of labour input

• Why productivity is so important

– Key determinant of living standards

– Growth in productivity is the key

determinant of growth in living standards

– An economy’s income is the economy’s

output



Determinants of productivity

1. Physical capital

• Stock of equipment and structures used to

produce goods and services

• Based on previous investments: capital is a

produced factor of production

2. Human capital

• Knowledge and skills that workers acquire

through education, training, and experience

• Less tangible than physical capital; but again

it’s a produced factor of production, since

education, for example, is an investment

9

Productivity

• Determinants of productivity

3. Natural resources

• Inputs into the production of goods and

services provided by nature, such as land,

rivers, and mineral deposits

• Distinguish renewable (trees) and non-

renewable (oil: takes longer to produce)

natural resources

4. Technological knowledge

• Society’s understanding of the best ways to

produce goods and services 10 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Are natural resources a limit to growth?

• Argument

– Natural resources - will eventually limit

how much the world’s economies can

grow

• Fixed supply of nonrenewable natural

resources – will run out

• Stop economic growth

• Force living standards to fall




• Technological progress

– Often yields ways to avoid these limits

• Improved use of natural resources over time

• Recycling of non-renewables (like oil)

• New materials: plastic (which is produced)

replaced tin and copper (which are not)

• Are these efforts enough to permit

continued economic growth?




• To answer this, need to look at the prices

of natural resources

– Scarcity – should be reflected in (rising)

market prices

– Natural resource prices (in real terms)

• Substantial short-run fluctuations

• Stable or falling - over long spans of time

– Our ability to conserve these resources

• Growing more rapidly than their supplies are

dwindling



Production function

• The production function generally is written

like this:

where Y = output, L = quantity of labour, K =

quantity of physical capital, H = quantity of

human capital, N = quantity of natural

resources, A reflects the available production

technology, and F () is a function that shows

how inputs are combined to produce output



Summing up

– A society’s standard of living depends on

its ability to produce goods and services

– Its productivity depends on physical

capital, human capital, natural resources

and technological knowledge

– But how can (and should) a Government

raise productivity and living standards?

• Economists differ in their views, but as we shall

see the Government can, at the minimum, lend

support to the ‘invisible hand’

15

• Raise future productivity

– Invest more current resources in the

production of capital

– Trade-off

• This involves devoting fewer resources to produce

goods and services for current consumption

• To invest more in capital, a society must consume

less and save more of its current income

• Financial markets coordinate S and I in market

economies. As we discuss later, governments can

also affect S and I, and therefore economic growth

Saving and Investment

16

Diminishing Returns

• Higher savings rate

– Fewer resources are need to make

consumption goods

– So there are more resources to make capital

goods

– Capital stock increases

– Rising productivity

– More rapid growth in GDP

• But there can be difficulties in inferring causation from

correlation (in principle, GDP could be causing

Investment, not the other way round)

17

Diminishing Returns

• Diminishing returns

– Benefit from an extra unit of an input

declines as the quantity of the input

increases

• In the long run, higher savings rate →

– Higher level of productivity

– Higher level of income but not higher

growth in productivity or income

– But the long-run can be a long time

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Figure 1

19

Illustrating the Production Function

Output

per Worker

Capital per Worker

This figure shows how the amount of capital per worker influences the amount of

output per worker. Other determinants of output, including human capital, natural

resources, and technology, are held constant. The curve becomes flatter as the

amount of capital increases because of diminishing returns to capital.

1

1

1. When the economy has a low level of

capital, an extra unit of capital leads to a

large increase in output.

2. When the economy has a

high level of capital, an extra

unit of capital leads to a small

increase in output.

Old style growth models

20

∆Y=savings rate ×MPK – depreciation rate

Harrod-Domar 1946 growth model

Problems:

Endogeneity of savings (depends on Y)

Ignores productivity, unlike neoclassical

(Solow) model

Diminishing Returns explains…

• … The “catch-up” effect

– Countries that start off poor tend to grow

more rapidly than countries that start off

rich

• This is because poor countries have

– Low productivity

– Even small amounts of capital investment

increase workers’ productivity substantially

– Over the last 50 years China has grown faster

than Japan despite lower investment rates

21

Diminishing Returns

• Rich countries

– High productivity

– Additional capital investment

• Small effect on productivity

• Poor countries

– Tend to grow faster than rich countries



Investment from Abroad

• Investment from abroad

– This is another way for a country to invest

in new capital (get the savings they need)

– Foreign direct investment (FDI)

• Capital investment that is owned and

operated by a foreign entity

– Foreign portfolio investment

• Investment financed with foreign money but

operated by domestic residents




• Benefits from investment

– Some flow back to the foreign capital

owners

• FDI in UK raises UK GNP by less than UK

GDP since the foreigners expect a return on

their investment

– Increase the economy’s stock of capital

– Higher productivity and higher wages

– A way to learn about state-of-the-art

technologies




• World Bank

– Encourages flow of capital to poor

countries

– Takes funds from world’s advanced

countries

– Makes loans to less developed countries

• Roads, sewer systems, schools, other types

of capital

– Offers advice about how the funds might

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• World Bank and the International

Monetary Fund

– Set up after World War II

– Economic distress leads to:

• Political turmoil, international tensions and

military conflict

– Every country has an interest in promoting

economic prosperity around the world



Education

– Investment in human capital (schools etc.).

Improves long-run economic prospects

– Gap between wages of educated and uneducated

workers: private benefit

– Opportunity cost: wages forgone

– Conveys positive externalities

• Return to schooling higher for society than an individual

– Public education - large subsidies to human-capital

investment

– Problem for poor countries: Brain drain

• A dilemma for governments; as they lose some of their

human capital despite the investment

27

Health and Nutrition

• Human capital

– Normally taken to refer to education

– But can also be used to describe investments that

lead to a healthier population

• Healthier (and stronger, smarter) workers

– are more productive

– Robert Fogel found that improved nutrition explains

about a 1/3 of income growth per capita in the UK

from 1790 to 1980

• Wages

– Reflect a worker’s productivity (and health/height?) 28


• Right investments in the health of the

population

– Another way for governments to increase

productivity

– Raise living standards

• Historical trends: long-run economic growth

– Improved health – from better nutrition

– Taller workers – higher wages – better

productivity




• Vicious circle in poor countries

– Poor countries are poor

• Because their populations are not healthy

– Populations are not healthy

• Because they are poor and cannot afford

better healthcare and nutrition




• Virtuous circle

– Policies that lead to more rapid economic

growth would naturally improve health

outcomes

– Which in turn would further promote

economic growth



Property Rights, Political Stability

• To foster economic growth

– Protect property rights

• Ability of people to exercise authority over the

resources they own

• Courts – enforce property rights

– Promote political stability

• Property rights

– Prerequisite for the price system to work




• Lack of property rights

– Major problem

– Contracts are hard to enforce

– Fraud goes unpunished

– Corruption

• Impedes the coordinating power of markets

• Discourages domestic saving

• Discourages investment from abroad




• Political instability

– A threat to property rights

– Revolutions and coups

– Revolutionary government might

confiscate the capital of some businesses

– Domestic residents - less incentive to

save, invest, and start new businesses

– Foreigners - less incentive to invest



Restricting Free Trade

• Some countries have tried economic

growth by adopting inward-oriented

policies

– Avoid interaction with the rest of the world

– Infant-industry argument: protect domestic

firms which will then grow

• Tariffs

• Other trade restrictions

– But has had adverse effects on economic

growth. Imagine Leicestershire deciding it was illegal to

trade with those outside the County 35

Promoting Free Trade

• Outward-oriented policies

– Integrate into the world economy

– International trade in goods and services

is like technology

→Economic growth

• Amount of trade – determined by

– Government policy

– Geography

• Easier to trade for countries with natural

seaports/rivers 36

Research and Development

• Knowledge – public good

– Government – encourages research and

development, via

• Publicly operated research institutes

• Research grants

– to universities etc.

• Tax breaks

• Patent system; by allowing inventors to profit

from their invention, if only temporarily, the

patent increases the incentive to undertake

R&D 37 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


• The final determinant of long-run

economic growth is…

38

Population Growth

• Large population

– More workers to produce goods and

services

• Larger total output of goods and services

– But this means there are also more

consumers

• Stretching natural resources

– Malthus: an ever-increasing population

• Strain society’s ability to provide for itself

• Mankind - doomed to forever live in poverty 39 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Where did Malthus go wrong?

• Assumed correctly that world population would

rise exponentially

• But assumed incorrectly that food production

could rise only linearly

• But productivity has kept on increasing (new

fertilisers, hybrid crops, machines etc.)

• Kremer (1993, QJE) argues that productivity, in

fact, increases with population

• While Malthus worried about the effects of

population on the use of natural resources,

others worry about its effect on capital

accumulation…

40

Population Growth

• Diluting the capital stock (not just natural resources)

– High population growth • Spreads the capital stock more thinly (think of human

capital and then imagine more students in a class)

• Lower productivity per worker. Lower GDP per worker

• Reducing the rate of population growth – Government regulation (e.g. China). But rather than

coercion, economists often prefer the use of incentives

• Increased awareness of birth control

• Equal opportunities for women; better options outside the home

for women (due to educational & employment equality) increase

the opportunity cost of having children and lead to smaller families

41

Population Growth

• But while rapid population growth may

dilute the capital stock, it may also have

benefits

• It could promote technological progress

– World population growth

• Is an engine for technological progress and

economic prosperity

– More people = More scientists, more inventors,

more engineers; a higher probability of more new

bright ideas which improve technological progress



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