7-Production and Growth

A country’s standard of living depends on its real GDP per

capita or on production of G&S which its labor force can
produce in the long run.
Solution to a macroeconomic problem depends on
– whether you want a quick solution.
– whether you are looking far into the future.
In the short run, GDP per capita and GDP per worker that is
also called productivity can be increased by extending
work hours or by decreasing wages and medical benefits.
However, it may not be feasible in the long run.
In the long run, productivity depends on:
1- capital per worker 2- human capital per worker
3- natural resources 4- technology & 5- governmant
 Differences in standard of living
Vast differences in real GDP per capita and in standard of
living among countries can be attributed to productivity.
For any given country, standard of living can change
dramatically over time if productivity of its workers
increases significantly.
Even within a country, big differences in standard of living can
be attributed to differences in productivity.
Rich people usually have more capital to work with, they are
more educated and skilled, they make use of the latest
technology.
A poor person can become rich if he strives hard for all or
any of the determinants of productivity.
Similarly a developing country can move to the list of
developed countries by concentrating on these factors.
Economic growth around the world
Computation of average annual growth rate
•   methods with respect to compounding frequency; one-
Three
time, annual and instantaneous.
simple GR = × 100 = = × 100 = 2.46%
one-time compounding GDPe = GDPb + (GDPb × GR × t)
Here e & b stand for end & beginning values and t stands for
total time period.
com GR = {(– 1}×100 = (– 1}×100 =1.2%
annual compounding GDPe = GDPb ×
Inst GR = {ln() ÷ t } × 100 = {ln()÷110}×100 = 1.19%
instantaneous compounding GDPe = GDPb ×
The annual compounding formula is used most often.
Determinants of productivity: natural resources
Natural Resources are inputs used in the production process.
Unlike physical capital, they are provided by nature.
Natural Resources include land, sea ports, trees and forests,
oil and gas reserves, and other mineral deposits. A
country having more of them can produce more G&S.
For example, Saudi Arabia is rich mainly because of oil
reserves, USA is rich mainly because of having a big chunk
of land.
However, natural resources are not must for economic
growth. For example, Japan and South Korea are not rich
because of their natural resources but because of other
factors of productivity.
Natural resources are divided into two categories; renewable
and non-renewable.
Renewable vs. non-renewable natural resources
Renewable resources include trees and forests. They do not limit
economic growth because their renewal depends on human
effort.
Nonrenewable resources include oil and coal reserves. Many
economists are afraid that they can limit growth. However,
history shows that human mind has explored substitutes for
many non-renewable recourses.
For example, packing is now mostly prepared by plastic material
rather than tin having limited supply, cables are now fiber-optic
made of sand rather than copper having limited supply.
That is why prices of most natural resources (adjusted for overall
inflation) have actually been stable or falling
Also, contrary to Malthus theory, agricultural output has
increased more rapidly than population growth. So there is no
hunger and fights on food as he predicted.
Determinants of productivity: physical capital
Physical Capital is the stock of equipment and structures that
are used to produce G&S. It is different from natural
resources or primary inputs as it is a produced or man-
made factor of production.
Its production means fewer consumer goods. That is, people
have to sacrifice current consumption if they want to have
more physical capital for future production of G&S. It
includes:
1- Tools and equipment used to build or repair things
2- Computer and mobile software
3- Office & factory buildings, shopping malls, schools,
hospitals and courts
4- Infrastructure, such as roads, railway lines, bridges, ship
yards and airports
Determinants of productivity: human capital
Human Capital refers to the knowledge and skills that healthy
workers acquire through education, training, and
experience. It is probably the best investment to raise GDP
and the standard of living in a country.
Like physical capital, human capital raises a nation’s ability to
produce G&S and its acquisition also requires sacrifice of
current consumption.
A worker who attends a reputed school, attains good grades,
then gets on-the-job training and has easy access to health
facilities usually has much higher productivity than a
worker who is illiterate, uneducated, unskilled and has no
access to health facilities.
The same is true for countries. Developed countries spend a
bigger percentage of their GDP to develop human capital.
 Determinants of Productivity: Technology
Technology refers to overall scientific understanding of the
society of the best ways to produce various G&S.
Education and skill acquisition are at individual level
whereas technology is at firm, industry and national levels.
Human capital refers to resources expended by individuals to
achieve higher productivity whereas technology refers to
resources expended by a firm, industry and country to
improve existing methods of production.
Increases in technological knowledge require investment in
research and development that requires a sacrifice of
current consumption
Both technological knowledge and human capital are closely
related. Creation of a new idea is due to human capital
and its commercialization is due to technolgy.
Determinants of Productivity: Government
The availability of physical capital, human capital, natural
resources, and technology does not guarantee that these
resources will be properly utilized.
Govt. is must to ensure law and order situation in the country
and to enforce property rights.
In addition, govt. is must to provide proper incentives to
individuals so that they can achieve collective good.
Therefore, govt. formulates public policies such as trade
policy, agriculture policy, labor policy, commercial policy
and industrial policy.
Govt. also gives subsidies to those firms which generate
positive externalities such as export promotion and
investment credit and penalizes those firms which
generate negative externalities such as tax on cigarettes.
 Role of public policy in economic growth
Government policies to raise productivity include:
Encourage saving & investment & highlight ‘catch up’ effect.
Encourage investment from abroad as it accelerates
economic activity and may lead to transfer of technology.
Promote education and training.
Provide health facilities and better nutrition.
Ensure property rights and maintain political stability.
Promote free regional and international trade.
Promote research and development at individual, firm,
industry and country levels.
Provide roads, bridges, and other infrastructure.
Provide incentives for population control and subsidies for
development of human capital.
 Encourage saving & investment
More saving means less current consumption and more
resources to
Produce physical capital
Acquire human capital through education, training and health
Increase technological knowledge by doing research and
development.
Since less current consumption means a sacrifice by current
generation in favor of future generations, therefore
voluntary saving is not significant.
As a result, govt. has to introduce taxes such as sales tax to
discourage consumption and to give tax rebates on saving
such as contribution to pension fund is usually exempted
from income tax and reinvestment of corporate profits is
exempted from corporate taxes.
Diminishing returns and the catch-up effect
Like diminishing marginal utility, accumulation of physical
capital is subject to diminishing returns.
As the stock of capital rises, the extra output produced from
an additional unit of capital falls.
Because of diminishing returns, an increase in the rate of
investment in physical capital leads to gradually less and
less growth rate in GDP.
The catch-up effect implies that the same amount of
investment in poor countries results in a higher economic
growth rate than that in rich countries.
For example, 1960 to 1990, USA and South Korea devoted a
similar share of GDP to investment. Yet USA experienced
mediocre annual growth rate of about 2%, while South
Korea experienced spectacular growth rate of 6%.
Graphical illustration of diminishing returns
Output
per worker
1

2. When the economy has a

high level of capital, an
extra unit of capital leads to
a small increase in output.

1. When the economy has a low level of capital, an

extra unit of capital leads to a large increase in output.

Capital per
worker
Numerical illustration of diminishing returns
Capital Total Marginal Growth rate
output output
0 0
10 8 8-0 = 8
20 15 15-8 = 7 (7÷8)×100= 87.5%
30 21 6
40 26 5
50 30 4 (4÷26)×100= 15.4%
60 33 3
70 35 2
80 36 1 (1÷35)×100= 2.9%
 Explanation of numerical illustration
Suppose there are 3 countries; rick, middle income and poor.
Their initial capital stock is 10, 40 and 70 respectively.
Each country invests the same amount (10) in the current
period. Due to diminishing returns to capital, the increase
in their outputs is 7 (15 - 8), 4 (30 - 26) and 1 (36 - 35)
respectively.
Their growth rates are 87.5%, 15.4%, and 2.9% respectively.
It can be concluded from this example that if students with
high, average and low grades start devoting an extra hour
to their studies at home, then improvement rate in grades
of low grade students will be the highest. That is why
some universities, in addition to highest achiever award,
also give highest improvement award to motivate low
grade students for hard work.
 Encourage foreign investment
Since investment is an indicator of future prosperity or an
increase in GDP of coming years, therefore every govt.
tries to have maximum investment.
That is why govt. also encourages investment from foreign
sources by removing barriers to foreign investment.
Although foreigners take away profits back to their countries,
yet foreign investment creates jobs and raises
productivity and wages in home country.
For poor countries, foreign investment may be the only route
to progress, especially if their incomes are barely enough
to cover their essential consumption needs.
Also foreign investment is one way for poor countries to learn
new technologies but, in some cases, multinationals
compete out local competitors with unfair means.
 Two categories of foreign investment
Foreign investment is categorized under 2 heads:
Foreign Direct Investment: Investments owned and managed
partially or fully by foreign individuals or by foreign firms
such as Toyota Motors and KFC in Pak.
Technically, if a foreigner owns more than a given percentage
of outstanding shares of a domestic firm, then he/she is
supposed to have influence on managerial decisions,
therefore such investment is categorized as FDI.
Foreign Portfolio Investment: If a foreigner owns less than a
given percentage of outstanding shares, then he/she is
supposed to have no influence on managerial decisions,
therefore such investment is counted as FPI.
Promote education and control brain drain
Govt. should build and subsidize schools and provide
scholarships to students because education generates
positive externality for the rest of society.
An educated person usually comes up with new ideas that
might expand society’s pool of knowledge.
Brain drain: Many highly educated workers of developing
countries emigrate to rich countries. It means that these
countries do not benefit from their investment in the form
of subsidies. So they should create jobs and provide better
job environment to control brain drain.
However, if emigrants send back their incomes, then the loss
of brain drain is compensated to some extent. The increase
in forex reserves raises the sovereign rating of home
countries that is a pre-requisite for FDI.
 Promote health and nutrition
Less healthy workers cannot work long hours and cannot do
tough jobs, they also infect others. Thus they generate
negative externality for the society.
Developing countries are caught in a vicious cycle. People
are poor, so they cannot afford health expenses and
nutritious diet. People are weak, so they cannot earn good
income.
Therefore, govt. should subsidize hospitals and provide
minimum calorie intake to everyone.
Fogel empirically verified that productivity of mal-nourished
workers is less than that of well-nourished workers. As
nutrition of a worker improves, so does his productivity.
The causation is both ways: better nutrition makes a worker
more productive and higher productivity makes better
Ensure property rights and political stability
Property rights refer to the ability of people to have control
and exercise authority over the resources they own.
If property rights are not well-defined and not enforced duly
in a country, then workers become less willing to work
hard and earn property.
Therefore, govt. should define and enforce property rights
strictly. Their enforcement is an important prerequisite for
the free-market system to work.
Political stability matters a lot for investment decision-making
because return on investment comes after a gestation
period. If investors foresee any political upset over the
time or reversal of already stated govt. policies, then they
abstain from investing. They move their investment to
safe heavens that are politically stable countries.
 Encourage international trade
A country that eliminates trade restrictions gains benefits as
if it would gain after a major technological advance.
Suppose that home country’s opportunity cost of a ton of
wheat is 5 tons of rice and foreign country’s opportunity
cost is only 2 tons of rice. If home country can import a ton
of wheat by exporting 3 tons of rice, it is as if home as well
as foreign country’s technology has improved.
Initially many countries including Pakistan followed import-
substitution policies. They tried to produce those G&S in
which foreign countries had comparative advantage.
Countries having seaports such as Hong Kong & Singapore
adopted export-promotion policies and progressed a lot.
Export-promotion policy is in line with free trade which
World Trade Organization (WTO) aims to promote.
 Promote research and development
The advance of technological knowledge has led to higher
standards of living.
Most technological advances are results of research by
individuals and private firms.
In other words, motivated individuals and firms do research
for their own benefit, but transformation of their research
into new technologies benefit the whole economy.
Therefore, govt. should encourage research & development
through grants, tax breaks, and the patent system.
Moreover, govt. should subsidize or fully fund research,
especially on basic or fundamental science that is valuable
but will not be done by private businesses. Govt. should also
sponsor conferences and dialogues among researchers within
the country and outside the country.
 Negative impacts of high pop. growth rate
On one hand, high population growth reduces per capita natural
resources and physical capital.
That is why Malthus (1766–1834) argued that, because of
diminishing returns in agriculture, food production would not
keep pace with population growth, so the result would be
widespread famines and wars.
However, history has proven him wrong at aggregate level but
not at individual level.
Overall the increase in world population has been less than the
increase in output of food & other G&S mainly due to
technological progress but individual families & countries
with large number of children have to allocate more income
on feeding them and less income to develop their human &
physical capital. So they remain poor.
Therefore, govt. should discourage high pop. growth rate.
 Positive impact of high pop. growth rate
On the other hand, high pop. growth rate means that there
are more scientists, inventors, and engineers to contribute
to technological advance. Also it means that there is a
larger market for innovative goods. This increases the
incentive to innovate.
Therefore, govt. should neither restrict families to one child
as in China and previously in some European countries,
nor should encourage them to more then 4 or 5 children.
If pop. growth is below the desirable rate, then country has
to invite foreign workers who usually develop cultural and
religious tensions with locals. The rate of technological
progress slows down.
If pop. growth is above the desirable rate, then country is
caught in vicious circle of poverty and faces brain drain.
 To promote people friendly public policies
Instinctively every one focuses mainly on his/her own self-
interests ignoring society’s interests at large, therefore
govt. has to play a pro-active role to promote society’s
interests.
Some economists strongly believe that people of a country
are poor because they elect or accept incompetent rulers
and policy makers.
Such govts. give them wrong policies and incentives;
consequently they make wrong choices and their country
remains poor.
It means that if a nation wants to fix its economic problems,
then it should first of all fix the govt. by electing loyal and
sincere people. Only such rulers can think of public
policies which aim at the welfare of a common person.
 Summary
Economic prosperity, as measured by real GDP per person,
varies substantially around the world.
The average income of the world’s richest countries is more
than ten times that in the world’s poorest countries.
Standard of living in an economy depends on its productivity,
the economy’s ability to produce G&S.
Productivity depends on physical capital, human capital,
natural resources, technological knowledge available to
workers and govt. policies.
Govt. can raise productivity by promoting education, health
and research, by enforcing property rights, by maintaining
political stability, by allowing free trade, by developing
infrastructure, by providing incentives for a moderate pop.
growth rate, and by inducting able & honest policy makers.