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.
