Chapter 25

Production and Growth

Economic growth around the world
 Why productivity is so important
• Imagine someone was stranded on an island
• They would need to catch their own fish, grown
their own vegetables, make their own clothes,
construct somewhere to live etc
• What determines how well he lives (standard of
living) is determined by his productivity
• :Quantity of goods and services produced from
each unit of labor input
 Productivity and its importance
• If the people are good at the previous tasks,
they will live good, if not they live poorly
• Productivity is key determinant of living
standards, and growth in productivity is key
determinant of growth in living standards
• Increased productivity means less time spent
on a single task, and more time to spend on
other tasks
• To understand differences in living standards,
we must focus on production of goods and
services
• How can some produce more than others?
 How productivity is determined
• Physical capital per worker- stock of equipment and
structures that are used to produce goods and
services
• Human capital- knowledge and skills that workers
acquire through education, training and experience
• Natural resources-inputs into the production of
goods and services that are provided by nature
• Technological knowledge – society’s understanding
of the best ways to produce goods and services
 Economic growth and public policy
• What can government policy do to raise
productivity and living standards?
• Saving and investment
• Diminishing returns and catch up effect
• Investment from abroad
• Education
• Health and nutrition
• Property rights and political stability
• Free trade
• Research and development
• Population growth
 Savings and investment
• Capital can change based in its society
• If an economy produces a larger amount of capital
goods today, tomorrow it will have a larger stock of
capital to produce more goods and services
• Future productivity can be raised by investing more
current resources in the production of capital
• This leads to society dealing with a tradeoff
between consumption and investment
• Due to scarce resources, for a society to invest
more in capital, it must consume less and save
more of its current income.
• To enjoy higher consumption in the future, a
society needs to sacrifice goods and services in
the present
 Diminishing returns and the catch up effect:

• Traditional view of production process is that

capital is subject to diminishing returns:
• :Property whereby the benefit from an extra
unit of an output declines as the quantity of
the input increases
• As stock of capital rises, the extra output
produced from an additional unit of input falls
• When workers have a large stock of capital, an
additional unit increases productivity only
slightly
• Due to this, increase in growth rate leads to
higher growth only for a while
• This could also help us in understanding why
some countries grow quicker than others
• This is known as the catch-up effect: property
whereby countries that start off poor tend to
grow more rapidly than countries that start off
rich
 Investment from abroad
• A country can get funds to invest from the local
economy, or from the international economy as
well
• It could be done through
• : Foreign direct investment: capital investment that
is owned and operated by a foreign entity
• : Foreign portfolio investment: investment that is
financed with foreign money but operated by
domestic residents (owning stock in a foreign
company)
• Foreign direct investment increases mexican
capital stock, and as such increases
productivity and the overall GDP
• Also allows developing countries to access
technology used in developed countries
• World Bank and International Monetary Fund
try to encourage the flow of capital to
developing countries
 Education
• Investment in human capital
• In the US, every year spent in school raises the
person’s wage by an average of 10%
• Gap between the wage of an educated and
uneducated worker tends to be larger in
developing countries
• Education comes with an opportunity cost; the
foregone wages
• In developing countries, individuals tend to drop
out of school due to them needing income to assist
their family.
• How does public education benefit a society? The
educated person brings new perspectives and
critical thinking, and as such could come up with a
new method of production, benefitting everyone
• Leads to brain drain- emigration of many high
educated workers to rich countries where they can
enjoy a higher standard of living
 Health and nutrition
• Falls under human capital
• Healthy workers tend to be productive workers
• In developing nations, poor health and inadequate
nutrition remain obstacles to higher productivity and
improved living standards
• Vicious cycle: poor countries are poor in part because
their population is not healthy, and they are
unhealthy in part because they are poor and cannot
afford adequate healthcare and nutrition
 Property rights and political stability
• Protecting property rights and promoting
political stability can foster economic growth
• Prices are used to coordinate buyers and sellers
of goods
• The invisible hand uses market prices to stabilize
the supply and demand of goods/services
• Prerequisite for the price system to work is
respect for property rights
• Property rights: ability of people to exercise
authority over resource they own
• Miners only extract goods because they know it is
theirs and they will reap the benefits, it cannot
simply be taken away from them
• Property rights are enforced by the court system
• Courts discourage direct theft through the
criminal justice system
• If the government fails to enforce these
property rights or infringes on rights of others,
it might cause domestic saving and investment
from abroad to fall
• Political instability can be seen as a threat to
property rights. If a coup d’etat happens, there
is doubt whether the property rights will be
respected by new regime
• Revolutions might lead to nationalization, and
reduces investment (local and foreign) and
reduces the incentive to save, invest and start
new businesses
 Free trade
• Inward oriented policies: attempt to increase
productivity and living standards by avoiding
interacting with the rest of the world.
• They tend to use the infant industry argument
(small firms need protection from foreign firms
since they cannot compete as yet)
• Outward oriented policies: integrates a country
into the world economy.
• Trade can be seen as a type of technology, and
as we know, technology increases productivity
• Allows for countries to specialize and be more
efficient
 Research and development
• Advancement in technical knowledge has
allowed for a higher standard of living
• It improves the ability to produce goods and
services
• Knowledge could be considered a public good,
once an idea is made, it enters society’s pool of
knowledge
• R&D is costly to firms, so how might the
government encourage it?
• Through the patent system: if the product is
deemed as truly original, it gives the inventor
the exclusive right to make the product for a
specified number of years.
• Can be seen as property rights to that
idea/invention, turning his idea from a public
good, to a private one.
• Patent system encourages and provides
incentive for firms to invest in R&D
 Population growth
• Large population can mean more workers to
produce goods and services
• But, it does not mean an increased/higher
standard of living for the typical citizen
• Why?
• Stretching natural resources: Malthus argued
that an ever increasing population would
continually strain society’s ability to provide
for itself.
• Malthus was not 100% accurate, he did not
take into account the new technology we have
today.
• Even though the population has grown, fewer
farmers will be necessary as each has become
more productive
• Diluting capital stock: as population grows,
each worker has less capital to work with.
• This lowers productivity, lowering GDP
• Rapid population growth (as can be seen in
developing countries) tend to keep less
developed countries poor as it is harder to
provide workers with tools and skills needed to
achieve high levels of productivity
• Regulated in China with the one child policy, or
could also be done by increased awareness of
birth control techniques
• Promoting technological progress:
• Simply put, the more individuals there are, the
more scientists, inventors, engineers to
contribute to the advancement of technology
which benefits everyone