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COURSE OUTLINE
Part 1. Overview of economics
•Chapter 1. Introduction to macroeconomics
MACROECONOMICS •Chapter 2. The data of macroeconomics
Part 2. Real economy in long run
•Chapter 3. Production and growth
•Chapter 4. Open economy: Basic concepts
•Chapter 5. Money and inflation
Tran Thi Thanh Huyen (Dr.)
Part 3. Short run Fluctuation
Faculty of Economics - Banking Academy of Vietnam
Mobile number: 098 383 0104 •Chapter 6. Aggregate Demand and Aggregate Supply
Email: [email protected] •Chapter 7. IS – LM model
Interactive PowerPoint Slides by:
V. Andreea Chiritescu •Chapter 8. Macroeconomic policy in open economy
Eastern Illinois University
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Reading materials

Chapter 25. Mankiw, N.G (2021), Principles of

Economics, 9th Edition, Cengage Learning.

CHAPTER

3 Production and growth

Interactive PowerPoint Slides by:

V. Andreea Chiritescu
Eastern Illinois University
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Purpose Learning objectives

By the end of this chapter, students should :
Questions we are trying to answer:
– Explain how productivity influences economic growth.
Why are some countries richer than others?
– Describe the catch-up effect.
Why do some countries grow quickly while others – Explain how a change in a productivity determinant
seem stuck in a poverty trap? impacts productivity.
What policies may help raise growth rates and long- – Explain the impact of public policies (including
run living standards? investments in education and R&D, the enforcement of
property rights, savings and investment, government
structure and stability) on growth.

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I LIVING STANDARDS AND GROWTH RATES

Contents
AROUND THE WORLD
• Among countries
1. Living standards and growth rates – Average income in a rich country (U.S., Japan, or
around the world Germany) is about ten times the average income in a
poor country (India, Nigeria, or Nicaragua)
• Differences are reflected in large differences in the
2. Productivity: Role and determinants quality of life: nutrition, housing, healthcare, life
expectancy, and so on
• Within a country, over time
– The U.S.: real GDP per person growth: 2% per year (for
3. Economic growth and public policy the past 100 years)
– The Vietnam real GDP per person growth: 7% per year
(for the past 27 years)

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LIVING STANDARDS AND GROWTH RATES

I AROUND THE WORLD II PRODUCTIVITY: ROLE AND DETERMINANTS
• Because of differences in growth rates A country’s standard of living depends on its ability to produce
goods and services
– Ranking of countries by income changes substantially
over time • Productivity = Y/L (output per worker)
where Y = real GDP = quantity of output produced
• Poor countries are not necessarily doomed to poverty L = quantity of labor
forever, e.g. Japan incomes were low in 1860 and are – Key determinant of living standards: when a nation’s workers
quite high now are very productive, real GDP is large and incomes are high
• Rich countries can’t take their status for granted: They • Growth in productivity is the key determinant of growth in
may be overtaken by poorer but faster-growing living standards
countries – When productivity grows rapidly, so do living standards
– An economy’s income is the economy’s output
– A nation can enjoy a high standard of living only if it can
produce a large quantity of goods and services

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+II PRODUCTIVITY: ROLE AND DETERMINANTS II PRODUCTIVITY: ROLE AND DETERMINANTS

Determinants of Productivity – 1
Technological • Physical capital, K
knowledge – Stock of equipment and structures used to produce
Human goods and services
capital
• Physical capital per worker, K/L
Physical – Productivity is higher when the average worker has
capital more capital (machines, equipment, etc.).
Natural
• An increase in K/L causes an increase in Y/L
resources

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II PRODUCTIVITY: ROLE AND DETERMINANTS II PRODUCTIVITY: ROLE AND DETERMINANTS

Determinants of Productivity – 2 Determinants of Productivity – 3

• Human capital, H • Natural resources, N
– Knowledge and skills workers acquire through – Inputs into production that nature provides (land,
education, training, and experience rivers, and mineral deposits)
• Human capital per worker, H/L • Natural resources per worker, N/L
– Productivity is higher when the average worker has – Other things equal, more N allows a country to produce
more human capital (education, skills, etc.) more Y
• An increase in H/L causes an increase in Y/L. • An increase in N/L causes an increase in Y/L

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II PRODUCTIVITY: ROLE AND DETERMINANTS II PRODUCTIVITY: ROLE AND DETERMINANTS

Determinants of Productivity – 4 Technological knowledge vs. Human capital
• Technological knowledge, A • Technological knowledge
– Society’s understanding of the best ways to produce
– Refers to society’s understanding of how to produce
goods and services
goods and services
– Common knowledge: after one person uses it,
everyone becomes aware of it • Human capital
– Proprietary: it is known only by the company that – Results from the effort people expend to acquire this
discovers it knowledge
– Any advance in knowledge that boosts productivity • Both are important for productivity
and allows society to get more output from its
resources

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II PRODUCTIVITY: ROLE AND DETERMINANTS III PRODUCTION FUNCTION

• Production function Y = A × F(L, K, H, N) Returns to scale

– A graph or equation showing the relation between Initially Y1 = F (L1, K1 , H1, N1)
output and inputs
Suppose all inputs were to increase by the same factor z:
L: labor K: Capital
L2 = zL1, K2 = zK1, H2 = zH1 and N2 = zN1
H: human resource N: Natural resource
(e.g., if z = 2, then all inputs are doubled)
A: level of technology
– F( ) is a function that shows how inputs are combined to What happens to output, Y2 = Y1 = F (L2, K2 , H2, N2)?
produce output • If constant returns to scale, Y2 = zY1
– “A” is the level of technology • If increasing returns to scale, Y2 > zY1
“A” multiplies the function F( ), so improvements in • If decreasing returns to scale, Y2 < zY1
technology (increases in “A”) allow more output (Y) to be
produced from any given combination of inputs.
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Example 1 Example 2
F (K , L)  KL F (K , L)  K L
F (zK , zL)  (zK )(zL)
F (zK , zL)  zK  zL
2
 z KL  z K z L
2
 z KL
 z  K L 
 z KL
 z F (K , L)
 z F (K , L)
decreasing returns to scale for any z > 1
constant returns to scale for any z > 0
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Example 3 EXERCISE

F (K , L)  K 2  L2 • Determine whether constant, decreasing, or increasing

returns to scale for each of these production functions:
F (zK , zL)  (zK )2  (zL)2
K2
(a) F (K , L) 
L
 z 2  K 2  L2 
(b) F (K , L)  K  L
 z 2 F (K , L)
increasing returns to scale for any z > 1

III PRODUCTION FUNCTION Why “A” is outside the production function and not be
divided to “ L” in the productivity function?
- Unlike physical capital or other resources,
• If we multiply each input by 1/L, then output is multiplied
technological knowledge can be freely shared among
by 1/L:
all workers.
Y/L = A × F(1, K/L, H/L, N/L)
- If the number of workers increases, you must purchase
• This equation shows that productivity (Y/L, output per new capital for the new workers (or spread the existing
worker) depends on: capital more thinly), but technological knowledge can
– The level of technology, A be freely shared with the new workers, so there is A,
– Physical capital per worker, K/L not A/L in the productivity function
– Human capital per worker, H/L
– Natural resources per worker, N/L

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IV ECONOMIC GROWTH AND PUBLIC POLICY IV ECONOMIC GROWTH AND PUBLIC POLICY

Saving and Investment - 1

• A society’s standard of living depends on
– Its ability to produce goods and services • To raise future productivity
– Productivity depends on – Encourage saving and investment
• Physical capital per worker, – Invest more current resources in the production of
capital, K
• human capital per worker,
• Producing more capital requires producing fewer
• natural resources per worker,
consumption goods
• and technological knowledge
• Trade-off: sacrifice current consumption to increase
• Policymakers future consumption
– What can government policy do to raise productivity • Reducing consumption = increasing saving
and living standards? • This extra saving funds the production of investment
goods
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EXAMPLE1: The production function

IV ECONOMIC GROWTH AND PUBLIC POLICY

Saving and Investment - 2

Output per
• Policies that raise saving and investment Y/L
worker
– Fewer resources are used to make consumption goods (productivity)
If workers already have a lot
– More resources: to make capital goods of K, giving them more
– K increases, rising productivity and living standards increases productivity fairly
– Note: This faster growth is temporary, due to little.
diminishing returns to capital. That means when K rises,
the extra output from an additional unit of K falls.
If workers have little K,
giving them more increases K/L
Capital per
their productivity a lot. worker

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EXAMPLE 2: The catch-up effect

IV ECONOMIC GROWTH AND PUBLIC POLICY

• The catch-up effect

Y/L
– The property whereby countries that start off poor tend
to grow more rapidly than countries that start off rich Rich
country’s
• Eg.: 1960–1990, the U.S. and S. Korea - similar growth
share of GDP devoted to investment
Poor
– Expect: similar growth performance country’s
– Growth was >6% in Korea; only 2% in the U.S. growth
– The catch-up effect: in 1960, K/L was far smaller in
K/L
Korea than in the U.S., hence Korea grew faster Poor
country Rich country starts
starts here here

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IV ECONOMIC GROWTH AND PUBLIC POLICY IV ECONOMIC GROWTH AND PUBLIC POLICY

Investment from Abroad – 1 Investment from Abroad – 2

• Investment from abroad • Benefits from investment from abroad
– Another way for a country to invest in new capital – Some benefits flow back to the foreign capital owners
– Foreign direct investment – Increase the economy’s stock of capital
• Capital investment that is owned and operated by a – Higher productivity and higher wages
foreign entity – State-of-the-art technologies developed in other
– Foreign portfolio investment countries
• Investment financed with foreign money but operated – Especially good for poor countries that cannot generate
by domestic residents enough saving to fund investment projects themselves

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IV ECONOMIC GROWTH AND PUBLIC POLICY IV ECONOMIC GROWTH AND PUBLIC POLICY

Education Health and Nutrition – 1

• Education = investment in human capital • Health care expenditure
– Gap between wages of educated and uneducated – Is a type of investment in human capital: healthier
workers workers are more productive
– Opportunity cost of education: wages forgone • In countries with significant malnourishment,
– Confers positive externalities raising workers’ caloric intake raises
– Subsidies to human-capital investment: public productivity:
education. – 1962–1995, caloric consumption rose 44% in S. Korea,
• Problem for poor countries: Brain drain and economic growth was spectacular.
– Nobel winner Robert Fogel: 30% of Great Britain’s
growth from 1790–1980 was due to improved nutrition

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IV ECONOMIC GROWTH AND PUBLIC POLICY IV ECONOMIC GROWTH AND PUBLIC POLICY
Health and Nutrition – 2 Property Rights and Political Stability – 1
• Vicious circle in poor countries
Markets are usually a good way to organize
– Poor countries are poor because their populations are
economic activity.
not healthy
– Populations are not healthy because they are poor and • To foster economic growth
cannot afford better healthcare and nutrition – Protect property rights (the ability of people to exercise
authority over the resources they own)
• Virtuous circle
• Prerequisite for the price system to work
– Policies that lead to more rapid economic growth would
naturally improve health outcomes, which in turn would • Courts: enforce property rights
further promote economic growth – Promote political stability

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IV ECONOMIC GROWTH AND PUBLIC POLICY IV ECONOMIC GROWTH AND PUBLIC POLICY

Property Rights and Political Stability – 2 Free Trade – 1

• Major problem: lack of property rights Trade can make everyone better off
– Contracts are hard to enforce • Inward-oriented policies
– Fraud, corruption often goes unpunished – Aim to raise living standards by avoiding interaction
– Firms must bribe government officials for permits with other countries
• Political instability (e.g., frequent revolutions, – Examples: tariffs, limits on investment from abroad
coups) • Outward-oriented policies
– Creates uncertainty over whether property rights will – Promote integration with the world economy
be protected in the future
– Example: elimination of restrictions on trade or foreign
investment

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IV ECONOMIC GROWTH AND PUBLIC POLICY IV ECONOMIC GROWTH AND PUBLIC POLICY

Free Trade – 2 Research and Development

• Trade has similar effects as discovering new • Technological progress: main reason why living
technologies standards rise over the long run
– Improves productivity and living standards • Knowledge is a public good
• Countries with inward-oriented policies – Ideas can be shared freely, increasing the productivity
– Have generally failed to create growth: Argentina of many
throughout the 20th century. • Policies to promote technological progress:
• Countries with outward-oriented policies – Patent laws
– Have often succeeded: South Korea, Singapore, Taiwan – Tax incentives or direct support for private sector R&D
– Grants for basic research at universities

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IV ECONOMIC GROWTH AND PUBLIC POLICY IV ECONOMIC GROWTH AND PUBLIC POLICY

Population Growth – 1 Population Growth affect living standards

• Large population 1. Stretching natural resources
– More workers to produce goods and services: larger – 200 years ago, Malthus argued that population growth
total output of goods and services will:
– More consumers • Strain society’s ability to provide for itself
• Population growth may affect living standards in 3 • Mankind: doomed to forever live in poverty
different ways. – Since then, the world population has increased sixfold
and living standards increased
• Malthus failed to account for technological progress
and productivity growth

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IV ECONOMIC GROWTH AND PUBLIC POLICY IV ECONOMIC GROWTH AND PUBLIC POLICY

Population Growth affect living standards Population Growth affect living standards
2. Diluting the capital stock 3. Promoting technological progress
– High population growth (higher L) – World population growth = Engine for technological
– Spread the capital stock more thinly (lower K/L) progress and economic prosperity
– Lower productivity and living standards • More people = More scientists, more inventors, more
• Many developing countries – policies: engineers = More frequent discoveries
– Government regulation (China’s one child law 1980- • Michael Kremer, human history:
2015) – Growth rates increased as the world’s population
– Increased awareness of birth control increased
– Equal opportunities for women (Promote female – More populated regions grew faster than less
literacy to raise opportunity cost of having babies) populated ones

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Active Learning: Answers Active Learning: Answers

1.Capital investment < world average. 5. Geographic disadvantages: 25% are landlocked (>7%
Because of the low income and capital per worker, we
world)
expect high returns to capital, so attractive for investment,
6.Restricted freedom: low index of reliability of the justice
but that is not the case.
system, personal security and safety, freedom of
2.Low educational attainment: only 5.6 years of schooling (<
8.4 world’s average); Low quality of schooling (student-
expression, the right to engage in international trade, etc.
teacher ratio is 39 > world average of 23); Only 60% of 7.Rampant corruption. High levels of corruption discourage
adults in sub-Saharan Africa are literate (< 82% adults domestic residents from saving and investing and deter
worldwide) Less educated workers are less productive. investment from abroad.
3.Poor health: Low levels of immunizations, High malnutrition 8.The legacy of colonization: Colonists established
rate, 4.5% of adults are infected with HIV. Less healthy extractive institutions, such as authoritarian governments,
workers are less productive. designed to exploit the region’s population and natural
4.High population growth: 2.8% per year: population doubles resources. Even after the colonizers left, the extractive
every 25 years (World population grows 1.2% per year, institutions remained and were taken over by new ruling
doubling every 58 years. ) Rapid population growth makes elites, impeding economic development.
it hard to equip workers with the physical and human capital
needed to achieve high productivity 58 59

SUMMARY
• Economic prosperity, GDP per person, varies
substantially around the world. Because growth rates of
real GDP also vary substantially, the relative positions of
countries can change dramatically over time.
• The standard of living in an economy depends on the
economy’s ability to produce goods and services.
• Productivity depends on the physical capital, human
capital, natural resources, and technological knowledge
available to workers.

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