Economic Growth and

Productivity

A typical family with all their possessions

in the U.K., an advanced economy

Real GDP per capita: $36,600

Life expectancy:
80 years
Adult literacy:
99%

A typical family with all their possessions

in Mexico, a middle income country

Real GDP per capita: $14,800

Life expectancy:
76 years
Adult literacy:
93%

A typical family with all their

possessions in Mali, a poor country

Real GDP per capita: $1,100

Life expectancy:
51 years
Adult literacy:
47%

Incomes
and Growth
Around the
World
FACT 1:
There are
vast
differences
in living
standards
around the
world.

China
Singapore
Japan
Spain
Israel
India
United States
Canada
Colombia
New Zealand
Philippines
Argentina
Saudi Arabia
Rwanda
Haiti

GDP per
capita,
2012
$8,500
60,500
35,200
31,000
31,400
3,700
49,000
41,100
10,400
28,000
4,100
17,700
24,500
1,400
1,300

Growth
rate, 200610
10.6%
2.9%
0.5%
-0.3%
2.2%
7.1%
0.1%
0.1%
3.1%
0.4%
3.2%
5.9%
0%
4.4%
0.5%

Incomes
and Growth
Around the
World
FACT 1:
There are
vast
differences
in growth
rates.

China
Singapore
Japan
Spain
Israel
India
United States
Canada
Colombia
New Zealand
Philippines
Argentina
Saudi Arabia
Rwanda
Haiti

GDP per
capita,
2012
$8,500
60,500
35,200
31,000
31,400
3,700
49,000
41,100
10,400
28,000
4,100
17,700
24,500
1,400
1,300

Growth
rate, 200610
10.6%
2.9%
0.5%
-0.3%
2.2%
7.1%
0.1%
0.1%
3.1%
0.4%
3.2%
5.9%
0%
4.4%
0.5%

Per Capita Real GDP Growth

Rates in Various Countries

U.S. per capita real GDP has remained

higher than other nations because we have
been able to sustain growth over many

Real GDP per capita

Real

GDP per capita real GDP divided by the

population size.
Focus on RGDP per capita to isolate the effects of
changes in the population.
United States RGDP - $15 trillion
RGDP

China

RGDP RGDP - $7.3 trillion

RGDP

Today

per capita - $50,000

per capita - $8,500

more than 50% of the worlds people live in

countries with a lower standard of living than the U.S.
had a century ago.

How Do We Define Economic

Growth? (cont'd)
The

Rule of 70

A rule

stating that the appropriate number of

years required for per capital real GDP to
double is equal to 70 divided by the average
rate of economic growth
Example: At an annual growth rate of 10%, per
capita real GDP should double in about:

Incomes and Growth Around the

World
Since growth rates vary, the country rankings can change over time:

Poor countries are not necessarily doomed to poverty forever e.g.,

Singapore, incomes were low in 1960 and are quite high now.

Rich countries cant take their status for granted:

They may be overtaken

by poorer
but faster-growing countries.

In the late 19

th

century, the United Kingdom was the richest country in the

world.

Today, income per person is lower in the United Kingdom than in the
United States and Canada (2 former colonies of the United Kingdom).

Productivity
A countrys standard

of living depends on its

ability to produce goods & services.

Sustained economic growth in real GDP per capita occurs only when
the amount of output produced by the average worker increases
steadily.
This ability depends on productivity:
the average quantity of goods & services produced per unit of labor
input.
Y = real GDP = quantity of output produced
L = quantity of labor so we can write productivity as Y/L (output per
worker)
Example: Robinson Crusoe
Because he is stranded alone, he must catch his own fish, grow
his own vegetables, and make his own clothes.
His standard of living depends on his ability to produce goods and

Why Productivity Is So
Important

When

a nations workers are very productive,

real GDP is large and incomes are high.
When productivity grows rapidly, so do living
standards.
US has seen an increase in physical capital,
human capital, and technology which have led to
high growth rates.
What, then, determines productivity and its
growth rate?

Four Determinants of Productivity

Physical

Capital
Human Capital
Natural Resources
Technological Knowledge

Physical Capital
Physical

capital the stock of equipment and

structures that are used to produce goods and
services, denoted K.
Example: Crusoe will catch more fish if he has
more fishing poles.
K/L = capital per worker.
Productivity is higher when the average worker
has more capital (machines, equipment, etc.).
i.e., an increase in K/L causes an increase in
Y/L.

Human Capital

Human capital the knowledge and skills that workers

acquire through education, training, and experience.
Example: Crusoe will catch more fish if he has been
trained in the best fishing techniques.
Human capital (H):
the knowledge and skills workers acquire through
education, training, and experience
H/L = the average workers human capital
Productivity is higher when the average worker has more
human capital (education, skills, etc.).
i.e., an increase in H/L causes an increase in Y/L.

Natural Resources Per Worker

Natural resources (N): the inputs into production that nature

provides, e.g., land, mineral deposits

Other things equal, more N allows a country to produce more Y. In

per-worker terms, an increase in N/L causes an increase in Y/L.

Some countries are rich because they have abundant natural

resources (e.g., Saudi Arabia has lots of oil)

But countries need not have much N to be rich (e.g., Japan imports
the N it needs).

Less important in economic theory today

Ex: Crusoe will have better luck catching fish if there is a plentiful
supply around his island.

As the population has grown over time, we have discovered ways to

lower our use of natural resources. Thus, most economists are not

Technological Knowledge
Technological

knowledge: societys
understanding of the best ways to produce g&s
Technological progress does not only mean a
faster computer, a higher-definition TV, or a smaller
cell phone.
It means any advance in knowledge that boosts
productivity (allows society to get more output from
its resources).
e.g.,

Henry Ford and the assembly line.

E.g., Recipe
Ex:

Crusoe will catch

Technological Knowledge vs.

Human Capital
Technological

knowledge refers to
societys understanding of how to produce
g&s.
Human capital results from the effort
people expend to acquire this knowledge.
Both are important for productivity.

The Production Function

The

production function is a graph or equation

showing the relation between output and
inputs:
Y = A F ( L , K, H , N )
F( ) a function that shows how inputs are combined
to produce output
A the level of technology

multiplies the function F( ), so

improvements in technology (increases in A)
allow more output (Y) to be produced from any
given combination of inputs.

The Production Function

Y

= A F(L, K, H, N)
Y = Output
L = quantity of labor
K = quantity of physical capital
H = quantity of human capital
N = quantity of natural resources
A function that shows how inputs are
combined to produce output.

The Production Function

Y = A F(L, K, H, N)
The

production function has the property

constant returns to scale: Changing all inputs by the same
percentage causes output to change by that percentage. For
example,

Doubling

all inputs (multiplying each by 2)

causes output to double:

2Y = A F(2L, 2K, 2H, 2N)

Increasing

all inputs 10% (multiplying each

by 1.1) causes output to increase by 10%:
1.1Y = A F(1.1L, 1.1K, 1.1H, 1.1N)

The Production Function

Y = A F(L, K, H, N)
If

we multiply each input by 1/L, then

output is multiplied by 1/L:
Y/L = A F(1, K/L, H/L, N/L)
This equation shows that productivity
(output per worker) depends on:
the

level of technology (A)

physical capital per worker
human capital per worker
natural resources per worker

Diminishing Returns and the Catch-Up

Effect
The government can implement
policies that raise saving and

investment. Then K will rise, causing productivity and living standards to

rise.
But this faster growth is temporary, due to diminishing returns to
capital: As K rises, the extra output from an additional unit of K falls.
Diminishing returns the property whereby the benefit from an extra
unit of an input declines as the quantity of the input increases. Human
Capital and technology are fixed.
Thus, if workers already have a large amount of capital to work with,
giving them an additional unit of capital will not increase their productivity
by much.
In the long run, a higher saving rate leads to a higher level of productivity
and income, but not to higher growth rates in these variables.

The Production Function & Diminishing

Returns
Y/L
If workers
Output per
have little
K,
worker
giving
them more
(productivity)
increases their
productivity a lot.

If workers already
have a lot of K,
giving them more
increases
productivity
fairly little.

K/L
Capital per worker

The convergence hypothesis: International differences in real

GDP per capita tend to narrow over time.
Y/L

Rich countrys
growth

Poor countrys
growth

Poor country
starts here

K/L

Rich country starts here

Catch-Up Effect
Catch-up

Effect the property whereby poor

countries tend to grow more rapidly than rich ones.
When workers have very little capital to begin with,
an additional unit of capital will increase their
productivity by a great deal.
Over 1960-1990, the U.S. and S. Korea devoted a
similar share of GDP to investment, so you might
expect they would have similar growth performance.
But growth was >6% in Korea and only 2% in the
U.S.
Explanation: the catch-up effect.
In 1960, K/L was far smaller in Korea than
in the U.S., hence Korea grew faster.

Aggregate Output
Growth

Accounting: Estimates the contribution of

each of the major factors (physical and human
capital, labor, and technology) in the aggregate
production function.
Example: the amount of physical capital per worker
grows 3% a year.
The

production function can estimate that each 1% rise in

physical capital per worker, holding technology and human
capital constant, raises output per worker by one-third of
1% or .33%
The increase of 3% in physical capital will increase output
by 1%.
Total

Factor Productivity: the amount of output that

can be achieved with a given amount of factor inputs.

East Asias Miracle

In

1960 South Korea was a poor country.

Real GDP per capita grew about 7% for more
than 30 years.
Living standards increased and today considered
an advanced economy.
This was also the case for Taiwan, Hong Kong,
Singapore, and later China.
Fund education, increase savings-led to increase
in capital
Correct economic policies led to growth

Latin Americas Disappointment

In

1900 Argentina a rich country with

abundant resources, but growth has been
stagnant.
Savings rate has been low, government
has produced too much inflation eroding
savings, education underemphasized, and
political instability.
Many of the Latin American countries have
suffered similar circumstances.

Africas Troubles
Sub-Saharan

Africas real GDP per capita

from 1980 to 1994 feel 13 percent
Very poor, many people do not have living
standards of people in the United States
from 100 years ago.
Major problem is political instability civil
wars, no investment, little education
Property rights?
The Next 50 years?

A C T I V E L E A R N I N G 1:

Discussion question
Which of the following policies do you think would be most
effective at boosting growth and living standards in a poor
country over the long run? Why?
a. offer tax incentives for investment by local firms
b. by foreign firms
c. give cash payments for good school attendance
d. crack down on govt corruption
e. restrict imports to protect domestic industries
f. allow free trade
32

ECONOMIC GROWTH AND PUBLIC

POLICY
Next,
Next, we
we look
look at
at the
the ways
ways
public
public policy
policy can
can affect
affect
long-run
long-run growth
growth in
in productivity
productivity
and
and living
living standards.
standards.

Saving and Investment

We

can boost productivity by increasing K(capital),

which requires investment.

Since

resources scarce, producing more capital

requires producing fewer consumption goods.

Reducing

consumption = increasing saving. This

extra saving funds the production of investment
goods. Hence, a tradeoff between current and
future consumption.

2009

China 44% of GDP was investment

spending, US 18% of GDP was investment
spending.
China grows at rapid rate.

Investment from Abroad

Saving

by domestic residents is not the only way for

a country to invest in new capital.
To raise K/L and hence productivity, wages, and
living standards, the government can also encourage
Foreign

direct investment:
a capital investment (e.g., factory) that is
owned & operated by a foreign entity.
Foreign portfolio investment:
a capital investment financed with foreign money but
operated by domestic residents.

Investment from Abroad

Some of the returns from these investments flow back to

the foreign countries that supplied the funds. But the
economy still experiences an increase in the capital stock,
which leads to higher productivity and higher wages.

Especially

beneficial in poor countries that cannot

generate enough saving to fund investment
projects themselves.
Also helps poor countries learn state-of-the-art
technologies developed in other countries.
The World Bank is an organization that tries to
encourage the flow of investment to poor countries.

Education
Government can increase productivity by promoting
educationinvestment in human capital (H).
public schools, subsidized loans for college
Education not only increases the productivity of the
recipient, it may provide a positive externality. An
externality occurs when the actions of one person affect
the well-being of a bystander.
An educated individual may generate ideas that become
useful to others. This is an argument for public education.

Education has significant effects: In the U.S., each year of

schooling raises a workers wage by 10%.

Education

Poor countries may suffer from brain drain.

Brain drain the emigration of many of the most highly

educated workers to rich countries, where these workers
can enjoy a higher standard of living.

Children in very poor countries may work instead of going

to school because the opportunity cost of going to school
is too great.

Paying parents for sending their children to school may

both reduce child labor and increase the education of
very poor children.

But investing in H also involves a tradeoff

between the present & future:
Spending a year in school requires sacrificing a years
wages now to have higher wages later.

Can we have too much Human

Capital?

Health and Nutrition

Health

care expenditure is a type of investment in

human capital healthier workers are more
productive.
In countries with significant malnourishment,
raising workers caloric intake raises productivity:
Over

1962-95, caloric consumption rose 44% in S.

Korea, and economic growth was spectacular.

Nobel

winner Robert Fogel:

30% of Great Britains growth from 1790-1980 was due
to improved nutrition.

Property Rights and Political

Stability
Recall:

Markets are usually a good

way to organize economic activity.
The price system allocates resources
to their most efficient uses.

This requires respect for property rights,

the ability of people to exercise authority
over the resources they own.

Property Rights and Political

Stability
In

many poor countries, the justice system

doesnt work very well:
contracts

arent always enforced

fraud, corruption often go unpunished
in some, firms must bribe govt officials for
permits
Political

instability (e.g., frequent coups)

creates uncertainty over whether property
rights will be protected in the future.
Revolutionary government might confiscate
property physical capital.

Property Rights and Political

Stability
When

people fear their capital may be stolen

by criminals or confiscated by a corrupt govt,
there is less investment, including from abroad,
and the economy functions less efficiently.
Result: lower living standards.
Economic stability, efficiency, and healthy
growth require law enforcement, effective
courts,a stable constitution, and honest govt
officials.

A C T I V E L E A R N I N G 2:

Productivity
List

the determinants of productivity.

List three policies that attempt to raise
living standards by increasing one of the
determinants of productivity.

45

A C T I V E L E A R N I N G 2:

Answers

Determinants of productivity:
physical capital per worker (K/L)
human capital per worker (H/L)
natural resources per worker (N/L)
technological knowledge (A)
Policies to boost productivity:
Encourage

saving and investment, to raise

K /L
Encourage investment from abroad, to
raise K/L
Provide public education, to raise H/L

46

A C T I V E L E A R N I N G 2:

Answers

Determinants of productivity:
physical capital per worker (K/L)
human capital per worker (H/L)
natural resources per worker (N/L)
technological knowledge (A)
Policies to boost productivity:
Patent

laws or grants, to increase A

Control population growth, to increase
K /L
47

Free Trade
Inward-oriented

policies
(e.g., tariffs, limits on investment from
abroad) aim to raise living standards by
avoiding interaction with other countries.
Outward-oriented policies (e.g., the
elimination of restrictions on trade or
foreign investment) promote integration
with the world economy.

Free Trade
Recall:

Trade can make everyone better off.

Trade

has similar effects as discovering

new technologies it improves productivity
and living standards.
Countries with inward-oriented policies
have generally failed to create growth.
e.g., Argentina

during the 20th century.

Countries

with outward-oriented policies

have often succeeded.
e.g.,

South Korea, Singapore, Taiwan after

1960.

Research
and
Development
Spending to create and implement new technologies.
Technological

progress is the main reason why living standards

rise over the long run.
One reason is that knowledge is a public good: Ideas can be
shared freely, increasing the productivity of many. We can all
use it at the same time without diminishing anothers benefits.
Policies to promote tech. progress:

patent laws
tax incentives or direct support for
private sector R&D
grants for basic research at universities

Alternatively, it might be encouraged by simply maintaining property rights

and political stability.

Government Spending
Government

plays an direct role in

economic growth by building roads, power
lines, information networks, and other
parts of a economys physical capital.
Infrastructure: roads, power lines, ports,
information networks, and other
underpinnings for economic activity.
Better infrastructure leads to greater
productivity.

Is World Growth Sustainable?

Sustainable:

describes continued long-run

economic growth in the face of limited
supply of natural resources and the impact
of growth on the environment.
If we run out of a natural resource will that
stop economic growth?
Population growth?

Population Growth
may affect living standards in 3 different ways:
1. Stretching natural resources
200 years ago, Malthus argued that pop. growth
would strain societys ability to provide for itself.
Since then, the world population has increased
sixfold. If Malthus was right, living standards
would have fallen. Instead, theyve risen.
Malthus failed to account for technological
progress and productivity growth.

Population Growth
2. Diluting the capital stock
more population = higher L = lower K/L
= lower productivity & living standards.
This applies to H as well as K:
fast pop. growth = more children
= greater strain on educational system.
Countries with fast pop. growth tend to have
lower educational attainment.
Any attempt to alleviate poverty will simply
cause the poor to have more children, returning
them to poverty.

Population Growth

2. Diluting the capital stock

To combat this, many developing countries

use policy to control population growth.
Chinas one

child per family laws

contraception
promote

education & availability

female literacy to raise opportunity cost

of having babies

Population Growth
3. Promoting tech. progress

A larger population may promote technological progress.

Throughout history, most technological progress has come from
larger population centers where there are more people to
discover things and exchange ideas.
= more scientists, inventors, engineers
= more frequent discoveries
= faster tech. progress & economic growth

Evidence from Michael Kremer:

Over the course of human history,
growth rates increased as the worlds population increased
more populated regions grew faster than
less populated ones

Are Natural Resources a Limit to

Growth?
Some

argue that population growth is depleting the

Earths non-renewable resources, and thus will limit
growth in living standards.
But technological progress often yields ways to avoid
these limits:
Hybrid

cars use less gas.

Better insulation in homes reduces the energy required to
heat or cool them.
As

a resource becomes scarcer, its market price rises,

which increases the incentive to conserve it and develop
alternatives.

Productivity Growth
The

rate of productivity growth is not steady.

Productivity grew quickly during the 1950s and
60s, slowly from 1970-1995, and then quickly
again from 1995 to the present. Many
economists attribute the changes in productivity
to changes in the growth of technology. Others
argue that growth during the period 1950-1970
was unusually high and that we have just
returned to normal.

Economic Growth and the

Environment
China

has achieved tremendous economic

growth, but has also increased air pollution in
that nations cities.
Burning oil and coal for energy that fuels
economic growth releases carbon dioxide into
the atmosphere.
Causes a greenhouse effect, which can lead to
higher temperatures create droughts and other
extreme weather events.
These events damage economic growth.

Chinas Pollution

Figure 40.1 Actual and Potential Output f

Ray and Anderson: Krugmans Macroecon

Long Run Growth with Models

Production

Possibilities Curve shifts outward

to show economic growth

CONCLUSION
In

the long run, living standards are

determined by productivity.
Policies that affect the determinants of
productivity will therefore affect the next
generations living standards.
One of these determinants is saving and
investment.
In the next chapter, we will learn how
saving and investment are determined, and
how policies can affect them.