Chapter 3: Production and Growth

Why countries have different growth rates and exhibited such wide
variations in living standards???---Robert E. Lucas
Simply finding enough food and water to maintain life is a challenge.

What explains these diverse experiences??

The level and growth of real GDP is one gauge of economic prosperity.
Hence now we focus on the long-run determinants of the level and
growth of real GDP.

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Real GDP: Measure of Prosperity

GDP per capita = Real GDP/ Total Population

GDP per worker = Real GDP/ Number of people in employment

Countries with a relatively high per capita GDP often have relatively low
levels of annual growth.

Rich countries won’t always be richer, and poor countries won’t always
be poor.

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Economic Growth Around The
World
A country’s standard of living depends on its ability to produce
goods and services.
Within a country there are large changes in the standard of living
over time.
Annual growth rates that seem small become significant when
compounded for many years.

Productivity refers to the amount of goods and services produced

for each hour of a worker’s time.
◦ A nation’s standard of living is determined by the productivity of its
workers.

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 Economic Growth Around The
World
The average growth rate for 2020 based on 177 countries was -4.83 percent.
The highest value was in Guyana: 43.48 percent and the lowest value was in
Macao: -56.31 percent.
The average for 2001 based on 189 countries was 3.29 percent. The highest
value was in Equatorial Guinea: 63.38 percent and the lowest value was in
Palestine: -9.31 percent.
Living standards, as measured by real GDP per person, vary significantly
among nations.
◦ The United Kingdom is an advanced economy. In 2014, its GDP per person was
$45,630.
◦ Poland is a middle-income country. In 2014, its GDP per person was $14,423.
◦ The Central African Republic is a poor country. In 2014, its GDP per person was
only $371.

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Table 1. Real GDP Per Capita, Current US$, Selected Countries
(Source World Bank)

For use withCopyright©2014

Mankiw and Taylor,
Copyright © Cengage
2016 Cengage
 There Have Been Large Changes In
Living Standards Over Time
The ranking of countries by income per person
changes over time due to different growth rates.
◦ The poorest countries have average levels of income that have
not been seen in the developed countries for many decades.
◦ The UK, the richest country in the world in 1870, has been
overtaken since its average growth is around 1.3%.
Because of compounding it only takes a small difference
in percentage growth to see changes in rank order.
◦ The Rule of 70 means a growth rate of 7% would see income
per person doubling in 10 years (70 divided by 7) compared to
54 years for a a 1.3% growth (70 / 1.3)

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Table 2. Annual Real GDP Growth (%) for Selected Countries (Source
World Bank)

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Copyright © 2016 Cengage
Growth Theory
The trend rate of growth is:
◦ The average sustainable rate of economic growth over a period of
time.
◦ Found by taking GDP in some time period, subtracting GDP from an
earlier time period, dividing the result by the initial time period and
expressing the figure as percentage.

The annual growth does not necessarily need to be high but it has
to be consistent.

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Growth Theory
The Solow theory has been used to explain economic
growth.
◦ It identifies the rate of human and physical capital
and population growth as being key determinants of
economic growth.

◦ Other factors
◦ Level of macroeconomic stability
◦ Trade policy
◦ Nature and quality of institutions and governance

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Neo Classical Theory of Growth :
Why Productivity Is so Important
To understand the large differences in living
standards across countries, we must focus on
the production of goods and services.
A nation can enjoy a high standard of living if it
can produce a large quantity of goods and
services.
Hence, to understand the large differences in
living standards across countries or over time, we
focus on the production of goods and services.

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Production Function
Economists often use a production function to describe the relationship
between the quantity of inputs used in production and the quantity of
output from production.

Y = A F(L, K, H, N)
Y = quantity of output
A = available production technology
L = quantity of labor
K = quantity of physical capital
H = quantity of human capital
N = quantity of natural resources
F( ) is a function that shows how the inputs are combined.

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 Factors of production
 The inputs used to produce goods and services are called
the factors of production.
◦ Physical capital makes workers more productive.
◦ Human capital is the knowledge and skills that workers acquire
through education, training and experience.
◦ Natural resources are inputs into production that are provided
by nature, such as land, rivers and mineral deposits
Technological knowledge – the understanding of the best
ways to produce goods and services.
◦ Technical progress means that the quality of physical and human
capital is improved.

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CRS Production Function
A production function has constant returns to scale if, for any positive
number x,

xY = A F(xL, xK, xH, xN)

That is, a doubling of all inputs causes the amount of output to double
as well.
• Setting x = 1/L,
Y/ L = A F(1, K/ L, H/ L, N/ L)
where:Y/L = output per worker; K/L = physical capital per
worker; H/L = human capital per worker; N/L = natural
resources per worker

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The Determinants Of Economic
Growth
The Solow model of growth helps us
understand some key elements of the
determinants of economic growth .
◦ GDP in any country can be assumed to be an
extension of a firm’s production function where the
level of output is dependent on the factors of
production employed.
◦ Assumptions are that there are constant returns to
scale, a closed economy (so Y = C+S) and that
increases in capital and labour are subject to
diminishing marginal product.

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 The Determinants Of Economic
Growth
◦ Output level (GDP) = Y, A = technology, K = capital and L =
labour
◦ The resulting aggregate production function can be represented
as in Figure 1.
◦ Assuming technology is given, an increasing physical capital stock is
associated with a rising GDP, relatively quickly at first but then slows
due to the law of diminishing marginal product.
◦ The level of investment in capital stock is shown by the line I.
◦ Levels of physical capital stock are associated with levels of GDP.
a) If the capital stock is K1, for example, GDP will be Y1.
b) The distance between the level of GDP at K1 and the
investment level is consumption, and the remainder is
investment.

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Figure 1 The Aggregate Production Function and Investment

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Long-run Equilibrium
For an economy with a given level of physical capital,
the growth path will be dependent on the:

◦ Level of technology.
◦ Productivity of labour and capital.
◦ Savings rate which determines investment in
physical capital.

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Figure 2 Steady-state Equilibrium

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 Long-run Equilibrium
 For an economy with a given level of physical capital,
the growth path will be dependent on the level of
technology, the productivity of labour and capital and
the savings rate which determines investment in
physical capital.
◦ Countries like Korea and Vietnam have a supply of relatively cheap
labour and have invested in capital and as a result:
◦ Labour productivity is relatively high.
◦ There is strong economic growth.
◦ In many African countries investment in capital stock is extremely
low and so:
◦ Labour productivity is also very low.
◦ There is weak economic growth.

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 Long-run Equilibrium
 Steady-state equilibrium is the point in a growing economy
where investment spending is the same as spending on
depreciation and the capital-output ratio remains constant.
 The Solow model provides a means of understanding the
transition of economies over time.
• Less developed economies will have lower capital-output ratios.
• Investment in capital will increase the capital per worker and lead to growth
(see figure 2), but capital investment needs to be higher than the steady
state equilibrium.
• However, investment is determined by the savings ratio.
• In less developed countries this may be relatively low because incomes are
low.
• Also it is difficult to do business in these countries, so their economies
continue to be poor and do not reach the steady state equilibrium.

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Causes Of Growth
The causes of growth can be listed:
◦ Changes in savings rates.
◦ Increase in population.
◦ Dilution of capital stock.
◦ Promoting technical progress.
◦ An increase in Technology.

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Changes in the Savings Rate
Refer to figure 3.
 An increase in the savings rate from I to I1
leads to:
◦ An increase in investment above the depreciation
rate and …
◦ ….increases the capital-output ratio.
◦ The economy moves to a new steady-state
equilibrium of K**.

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Figure 3 An Increase in the Savings Rate

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An Increase in the Population
 Populations can rise through birth rates being higher than
death rates and through net migration.
 The age of the population helps determine the labour force.
 The Solow growth model shows that if the labour force is
rising, then in order for the capital-output ratio to remain
constant, investment must cover depreciation and provide
more capital.
◦ If investment does not keep pace with the rise in the
population, people will become poorer.
◦ In part, this helps to explain why many less developed
countries experience continued high levels of poverty
because their population rises but investment fails to keep
pace.

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Dilution of Capital Stock
 Some theories say high population growth
reduces GDP per worker because rapid
growth in the number of workers forces the
capital stock to be spread more thinly.
 For example countries with high population
growth have large numbers of school-age
children. This places a larger burden on the
educational system.

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Promoting Technology
 If there are more people, then:
◦ The greater the probability that some of those
people will come up with new ideas.
◦ This will lead to technological progress.
◦ Everyone benefits.

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An Increase In Technology
 Increases in technology can be seen as a public
good.
 Technology can offset the effects of diminishing
marginal product and lead to proportional increases
in productive capacity.
 Thomas Malthus.
◦ Malthus argued that an ever-increasing population meant
that the world was doomed to live in poverty forever.
◦ He failed to understand that new ideas would be developed
to increase the production of food and other goods,
fertilizers, mechanized equipment, and new crop varieties.

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Endogenous Growth Theory
 Endogenous growth theory is a theory of
long-run economic growth which results from
the creation of new knowledge and
technology which impacts on everyone and
makes them more productive as a result.

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Long-run Growth Is Generated By
Changes In Technology
 Long-run economic growth can result from the creation of new
knowledge and technology.
• This impacts on everyone and makes them more productive
as a result.
 Innovation and R&D are important ways in which technology
growth can arise and can provide competitive advantage for
firms over rivals which are both distinctive and defensible.
• There are therefore incentives for firms to innovate.
 If technology is a public good with the characteristic of being
non-rival then there are policy implications for governments.
• Government policies include protection of property rights,
encouraging foreign investment and promoting R&D.

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Economic Growth And Public Policy
Government Policies That Raise Productivity and Living
Standards.
◦ Encourage saving and investment.
◦ Encourage investment from abroad.
◦ Encourage education and training.
◦ Establish secure property rights and maintain political stability.
◦ Promote free trade.
◦ Promote research and development.

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The Importance of Saving and
Investment
One way to raise future productivity is to invest more current
resources in the production of capital.
If resources are used to produce capital goods, fewer goods and
services are produced for current consumption.
Countries that devote a large share of GDP to investment tend to
have high growth rates.
◦ But is this the cause or the effect?

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Diminishing Returns and the Catch-
Up Effect
As the stock of capital rises, the extra output produced from an
additional unit of capital falls; this property is called diminishing
returns.
◦ Because of diminishing returns, an increase in the saving rate leads to
higher growth only for a while.
◦ In the long run, the higher saving rate leads to a higher level of
productivity and income, but not to higher growth in these areas.

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Diminishing Returns and the Catch-
Up Effect
The catch-up effect refers to the property whereby countries that
start off poor tend to grow more rapidly than countries that start off
rich.
◦ This helps explain why China had a higher growth rate than Japan even
though both countries devoted a similar share of GDP to investment

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Investment from Abroad
Governments can increase capital accumulation and long-term
economic growth by encouraging investment from foreign
sources.

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 Investment from Abroad
Investment from abroad takes several forms:
◦ Foreign Direct Investment
◦ Capital investment owned and operated by a
foreign entity.
◦ Foreign Portfolio Investment
◦ Investments financed with foreign money but
operated by domestic residents.
The World Bank is an organization that tries to
encourage the flow of investment to poor countries.

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Education
For a country’s long-run growth, education is at least as important
as investment in physical capital.
◦ In the developed economies of Western Europe and North America
States, each year of schooling raises a person’s wage, on average, by
about 10 percent.
◦ Thus, one way the government can enhance the standard of living is to
provide schools and encourage the population to take advantage of
them.

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Education
An educated person might generate new ideas about how best to
produce goods and services, which in turn, might enter society’s
pool of knowledge and provide an external benefit to others.
◦ This is a positive externality.

One problem facing some poor countries is the brain drain—the

emigration of many of the most highly educated workers to rich
countries.

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Health and Nutrition
Human capital usually refers to education but it can also refer to
other investments in people such as investments in improved
health.
◦ Robert Fogel, suggested that a significant factor in long-run economic
growth is improved health from better nutrition.
◦ He estimates that in Great Britain in 1780 about one in five people
were so malnourished that they were incapable of manual labour.

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Property Rights and Political
Stability
Property rights refer to the ability of people to exercise
authority over the resources they own.
◦ An economy-wide respect for property rights is an important
prerequisite for the price system to work.
◦ It is necessary for investors to feel that their investments are
secure.

Transparency international’s corruption index paints a

fairly disturbing picture in many countries.
◦ An index of 100 being totally clean.
◦ In 2014 the Scandinavian countries come out high from 86 to
92, the UK has an index of 78, but Somalia has an index of 8
and Afghanistan of 12.

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Free Trade
A country that eliminates trade restrictions will
experience the same kind of economic growth that
would occur after a major technological advance.
◦ When a country exports wheat and imports steel, the
country benefits in the same way as if it had invented a
technology for turning wheat into steel.
Some countries engage in . . .
◦ . . . inward-orientated trade policies, avoiding interaction
with other countries.
◦ . . . outward-orientated trade policies, encouraging
interaction with other countries.

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Research and Development
The advance of technological knowledge has led to higher
standards of living.
◦ Most technological advance comes from private research by firms and
individual inventors.
◦ Government can encourage the development of new technologies
through research grants, tax breaks, and the patent system.

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Population Growth
Economists and other social scientists have long debated how
population growth affects a society.
Population growth interacts with other factors of production:
◦ Stretching natural resources.
◦ Diluting the capital stock.
◦ Promoting technological progress.

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Summary
① Economic prosperity, as measured by real GDP per person, varies
substantially around the world.
② The average income of the world’s richest countries is more than ten
times that in the world’s poorest countries.
③ The standard of living in an economy depends on the economy’s ability
to produce goods and services.
④ Productivity depends on the amounts of physical capital, human
capital, natural resources, and technological knowledge available to
workers.
⑤ Government policies can influence the economy’s growth rate in many
different ways.
⑥ The Solow model notes that the accumulation of capital is subject to
diminishing returns.

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Summary
⑦ Because of diminishing returns, higher saving leads to a higher
growth for a period of time, but growth will eventually slow down.
⑧ Also because of diminishing returns, the return to capital is
especially high in poor countries.
⑨ Endogenous growth theory explains how technology can change
and offset the effects of diminishing marginal productivity.
Innovation and R&D are important ways in which technology
growth can arise.
⑩ Government policies can try to influence the economy’s growth rate in
many ways: by encouraging saving and investment, encouraging
investment from abroad, fostering education, maintaining property rights
and political stability, allowing free trade, promoting the research and
development of new technologies, and controlling population growth

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