Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 7: Production and Growth

Econ 202 Dr. Ugur Aker 2 Income Differences Per capita income around the world varies vastly. –US per capita income in – per capita income in Within each country, there are vast differences between the earnings of the poor and the rich. Average income does not say anything about distribution.

Econ 202 Dr. Ugur Aker 3 Per Capita Incomes According to the World Bank, the Per capita incomes for selected countries in 1999 were as given. Instead of using the existing exchange rate between USD and the country’s currency, the World Bank uses the prices within the countries to better gauge the standard of living. Purchasing Power Parity means that. Source:

Econ 202 Dr. Ugur Aker 4 Why Do Per Capita Incomes Differ? The short answer is “productivity.” –Productivity is amount of goods and services produced by a typical (average) worker. –Calculated by the ratio of GDP to total hours worked. –Increase in population may or may not increase productivity. If the newcomers produce at the level of average worker, per capita income stays the same. If the newcomers produce at a lower level than the average worker, per capita income drops.

Econ 202 Dr. Ugur Aker 5 Why Do Per Capita Incomes Differ? The faster the productivity growth, the faster will GDP rise. Per capita income may not rise even with increasing productivity. –If population growth is faster than GDP growth, per capita income falls.

Econ 202 Dr. Ugur Aker 6 Doubling Standard of Living Even small increases in per capita income per year, if sustained for a long period, can improve standard of living tremendously. How long does it take to double per capita income? –If per capita GDP growth is 1%? –If per capita GDP growth is 2%? –If per capita GDP growth is 3.5%?

Econ 202 Dr. Ugur Aker 7 Growth in Selected Countries Source:

Econ 202 Dr. Ugur Aker 8 What Determines Productivity? Physical Capital: total amount of equipment, tools, machines, buildings in a country. Human Capital: total amount of knowledge, skills people of a country has. Natural Resources: the amount of arable land, water resources, minerals, oil, etc. Technology: how goods and services are produced. An increase in output without increasing inputs is a technological improvement.

Econ 202 Dr. Ugur Aker 9 Some Questions Is it possible to have a very technologically advanced nation with a low human capital? –When students don’t learn what is in their textbooks. Which is better? –Technology or human capital? –Natural resources or physical capital? –Human capital or physical capital?

Econ 202 Dr. Ugur Aker 10 Formal Presentation of Productivity Y = A f(L,K,H,N) If production function has constant returns to scale, doubling inputs will double output. 2Y = A f(2L, 2K, 2H, 2N) or xY = A f(xL, xK, xH, xN) Suppose x=(1/L) (Y/L) = A f(1, K/L, H/L, N/L) Productivity, (Y/L), therefore, depends on increases of physical capital per worker, human capital per worker, and natural resources per worker.

Econ 202 Dr. Ugur Aker 11 Growth and Environment What happens when we run out of oil? Some analogies –17th century England: what happens when we run out of land? –19th century: what happens when we run out of coal? –20th century: what happens when we run out of tin and copper? Prices of goods that become relatively scarce rise. –Incentives to find alternative sources.

Econ 202 Dr. Ugur Aker 12 Growth and Environment What if prices of natural resources do not rise because of market failure? –The costs of production or usage do not reflect the costs imposed to third parties. –Global warming, acid rain. Political and economic power allows some populations to impose their costs on others that are weaker.

Econ 202 Dr. Ugur Aker 13 How Can We Improve Well Being? Saving and Investment Catching up of poorer countries Diminishing returns on growth Foreign Investment Education Property Rights Political Stability Free Trade Population Growth Research and Development

Econ 202 Dr. Ugur Aker 14 Trade-off Between Consumption and Saving The more a society devotes its resources to consumption, the less will be available for saving and capital formation (investment). The more a society devotes resources to investment today, the more it can produce next year because the PPF would shift farther out.

Econ 202 Dr. Ugur Aker 15 Investment and Growth

Econ 202 Dr. Ugur Aker 16 Diminishing Returns As capital increases, the additional output from an additional unit of capital will eventually be diminishing. Traditionally, this has been observed with roads, railroads, and other kinds of capital increases. When diminishing returns set in, growth may slow down. New economy theories discard this assumption.

Econ 202 Dr. Ugur Aker 17 Catch-up Effect Societies starting from a lower level of per capita income, capital and technology may grow faster than the historical rates for wealthy societies because they can adopt the newer and tried technology right away. Diminishing returns and catch-up effect can explain why rich societies have low growth rates while poorer societies, with the same investment percentage, have higher growth rates.

Econ 202 Dr. Ugur Aker 18 Investment From Abroad Foreign Direct Investment –Foreign nationals establish firms, plants to produce in your country. Foreign Portfolio Investment –Foreign nationals buy stocks and bonds or put their money in the banks of your country. Both forms increase the investment in your country. –Foreign direct investment by increasing the buildings, machines, tools, equipment directly. –Foreign portfolio investment by providing funds for local businesses to expand their operations.

Econ 202 Dr. Ugur Aker 19 Investment from Abroad The output created by the extra investment from abroad raises the GDP of the country. When profits are repatriated to the country of origin, the receiving country’s GNP is reduced by that amount. GDP is output produced in US. GNP is output produced by American residents.

Econ 202 Dr. Ugur Aker 20 Education Investment in human capital is more important than investment in physical capital. –If there is no one who can run or fix the machines, what good are they? In poor countries, elementary education contributes to future income many times the initial investment. The more educated a population is the easier it can adjust to technological change.

Econ 202 Dr. Ugur Aker 21 Education and Positive Externalities Educated people might generate more new ideas that become part of the knowledge of the society. The more educated a society, the lower violent crimes may be. That increases the security of the rest of the population and saves them from spending time, effort and income on security.

Econ 202 Dr. Ugur Aker 22 Property Rights and Political Stability Productivity of individuals fall when they do not expect to reap the benefits of their own efforts. Well defined and court protected property rights and contract enforcement allow the market system work efficiently where many different specialized activities produce and distribute goods and services. Lack of property rights encourages people to produce for their own consumption. Lack of property rights discourages savings and also foreign investment. Political instability undermines property rights.

Econ 202 Dr. Ugur Aker 23 Free Trade Engaging in trade raises the average standard of living; it is similar to technological advance. Newly independent countries in the fifties, sixties and seventies pursued a self-sufficiency policy and enacted high tariffs to discourage imports. These inward oriented policies slowed their growth, created incentives for corruption. The success of outward oriented countries during this time convinced many countries in the eighties and nineties to move toward free trade.

Econ 202 Dr. Ugur Aker 24 Population Growth High population growth reduces K/L, H/L and N/L. High population growth creates a large percentage of school age children, requiring resources diverted toward education. Population growth was controlled through western birth control methods in India without much success. China has been more successful with severe disincentives for more children. Urbanization, education of women seem to influence population growth more than birth control education.

Econ 202 Dr. Ugur Aker 25 Research and Development Knowledge is a public good - once it is available, one person’s use of it doesn’t reduce another person’s use. Public goods are not privately produced unless they can be made private. –Patents, copyrights, intellectual property rights laws are efforts to make a public good private. Governments can provide public goods through taxes. Government support of research and development can improve technology.