1 Productivity and Growth Chapter 21 © 2006 Thomson/South-Western

2 Standard of Living  Standard of living: measured by the amount of goods and services available on average per person  Grows over the long run because of:  increases in the amount and quality of resources, especially labor and capital  better technology  improvements in the rules of the game that facilitate production and exchange  tax laws  property rights  patent laws  legal system

3 Economic Growth  Growth in the labor supply  Growth in the capital stock  Improvements in technology  Expand the frontier by making more efficient use of existing resources  Improvements in the rules of the game  Improvements that nurture production and exchange will promote growth

4 Exhibit 1: Capital Produced and Growth  In the left panel, the economy has chosen point A, which shifts the PPF from CI this year to C'I' next year  If more capital goods are produced this year, (point B), the PPF will shift outward farther next year to C"I"  An economy that invests more in capital – gives up more consumer goods – will experience larger economic growth

5 What is Productivity?  Production is a process that transforms resources into products  Productivity: the ratio of a specific measure of output, such as real GDP, to a specific measure of input  measures how efficiently resources are employed  the higher the productivity, the more goods and services that can be produced from a given amount of resources and the farther out will be the PPF  total output divided by the amount of a particular kind of resource employed

6 Labor Productivity  Output per unit of labor and measures total output divided by the hours of labor employed to produce that output  Most commonly used resource to measure productivity  Accounts for a relatively large share of the cost of production  More easily measured than other inputs  Statistics more readily available

7 Labor Productivity  Resource most responsible for increasing labor productivity is capital  As economy accumulates more capital per worker, labor productivity increases  Two broad categories of capital  Human Capital Accumulated knowledge, skill, and experience of the labor force More human capital the higher the productivity  Physical Capital  Includes the machines, buildings, roads, airports, communication networks and other manufactured creations used to produce goods and services

8 Per-Worker Production Function  The relationship between the amount of capital per worker in the economy and average output per worker

9 Exhibit 2: Per-Worker Production Function  Any point on the production function, PF, shows how much output per worker can be produced for a given amount of capital per worker  When there are k units of capital per worker, average output per worker in the economy is y  Upward slope of the curve occurs because an increase in capital per worker helps each worker produce more output  Shape reflects the law of diminishing returns

10 Exhibit 3: Impact of a Technological Breakthrough k  More output is produced at each level of capital per worker  Technological change usually improves the quality of capital and increases productivity, shown by the upward rotation from PF to PF'

11 Economic Growth  Two kinds of changes in capital improve worker productivity:  Increase in the quantity of capital per worker Reflected by a movement along the per-worker production function  An improvement in the quality of capital per worker  Reflected by technological change that rotates the curve upward

12 Rules of the Game  Refers to the formal and informal institutions that promote economic activity  Laws, customs, conventions, and other institutional elements that encourage people to undertake productive activity  Stable political environment and system of well- defined property rights  Improvements in the rules of the game could result in more output for each level of capital  upward rotation in the per-worker production function

13 Productivity / Growth in Practice  World economies sorted into two broad groups:  Industrial market countries or developed countries 20% of world’s population first to experience long-term economic growth  Developing countries  80% of worlds population  Majority of workers employed in agriculture

14 Education and Economic Development  Important source of productivity is the quality of labor  Contribution of education to the process of economic development:  Makes workers aware of the latest production techniques  Makes workers more receptive to new ideas and methods  Countries with the most advanced educational systems were first to develop, while developing economies have far lower levels of education

15 Exhibit 4: Average Years of Education of Working Age Population

16 Exhibit 5: Long-Term Trend in U.S. Labor Productivity Growth: Annual Average by Decade

17 U.S. Labor Productivity  Over long periods, small differences in productivity can make huge differences on the economy’s ability to produce and therefore on the standard of living.

18 Exhibit 6: U.S. Productivity Growth Slowed From 1974 to 1982, and Then Rebounded

19 Output Per Capita  If labor productivity did not increase, total output would still grow if the quantity of labor increased  Labor productivity equals real GDP divided by the quantity of labor  Real GDP equals labor productivity times the quantity of labor  Therefore total output can grow as a result of greater labor productivity, more labor, or both

20 Output Per Capita  Output per capita  Real GDP divided by the population  Best measure of economy’s standard of living  Indicates how much an economy produces on average per person

21 Output Per Capita  Output will increase if  labor productivity increases for a given worker- population ratio  the worker-population ratio increases for given labor productivity  labor productivity and the worker-population both increase  Output per capita would increase as long as an increase in one of these three factors more than offsets any decrease in the other two

22 Exhibit 7: Real GDP Per Capita Has Nearly Tripled Since 1959

23 Exhibit 8: U.S. GDP Per Capita is Highest of Major Economies

24 Exhibit 9: U.S. Real GDP Per Capita Outgrew Most Other Major Economies Since 1982

25 Technological Change and Unemployment  Technological change usually reduces the number of workers needed to produce a given amount of output  Technological change also can increase production and employment by making products more affordable

26 Research and Development  Basic research  Search for knowledge without regard to how that knowledge will be used  First step toward technological advancement  Less immediate payoff yet yields a higher rate of return to society as a whole  Applied research  Seeks to answer particular questions or applies scientific knowledge to development of specific products

27 Exhibit 10: R&D Spending as a Percentage of GDP for Major Economies During the 1980s and 1990s

28 Convergence Theory  Convergence theory: predicts that the standard of living in economies around the world will grow more similar over time, with poorer countries eventually catching up with richer ones  What’s the evidence on convergence?  Some poor countries have begun to catch up with the richer ones  Among the nations that comprise the poorest third of the world’s population, the standard of living in these countries has grown somewhat in absolute terms, but fallen farther behind in relative terms

29 Convergence Theory  Reasons why the poorest countries have not gained:  Birth rates are nearly double those in richer ones  Vast differences in the quality of human capital across countries While technology may be portable, knowledge, skill, and training required to take advantage of it may not be  Some countries lack the stable macroeconomic environment, established institutions, and infrastructures needed to nurture economic growth

30 Industrial Policy  Industrial policy: the view that government—using taxes, subsidies, and regulations—should nurture industries and technologies of the future, giving them an advantage over foreign competition  Two concerns about technologies of the future:  They will require huge sums to develop and implement and firms may not easily raise or put at risk these large sums  Some technological breakthroughs spill over to other firms and other industries