Review of the previous lecture

The financial system is made up of financial institutions such as the bond

market, the stock market, banks, and mutual funds.

All these institutions act to direct the resources of households who want to
save some of their income into the hands of households and firms who want
to borrow.

National income accounting identities reveal some important relationships

among macroeconomic variables.

In particular, in a closed economy, national saving must equal investment.

Financial institutions attempt to match one persons saving with another

persons investment.

Review of the previous lecture

The interest rate is determined by the supply and demand for loanable
funds.

The supply of loanable funds comes from households who want to save
some of their income.

The demand for loanable funds comes from households and firms who want
to borrow for investment.

National saving equals private saving plus public saving.

A government budget deficit represents negative public saving and,

therefore, reduces national saving and the supply of loanable funds.

When a government budget deficit crowds out investment, it reduces the

growth of productivity and GDP.

Lecture 16

Production and Growth

Instructor: Prof.Dr.Qaisar Abbas
Course code: ECO 400

Lecture Outline

1. Economic Growth Around The World

2. Productivity: Its Role And Determinants
3. The Production Function
4. Economic Growth And Public Policy

Production and Growth

A countrys 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.

In the United States over the past century, average income as measured by
real GDP per person has grown by about 2 percent per year.

Productivity refers to the amount of goods and services produced for each
hour of a workers time.

A nations standard of living is determined by the productivity of its workers.

Economic Growth Around The World

Living standards, as measured by real GDP per person, vary significantly
among nations.

The poorest countries have average levels of income that have not been seen
in the United States for many decades.

Annual growth rates that seem small become large when compounded for
many years.

Compounding refers to the accumulation of a growth rate over a period of

time.

Productivity: Its Role And Determinants

Productivity plays a key role in determining living standards for all nations in
the world.

Productivity refers to the amount of goods and services that a worker can
produce from each hour of work.

To understand the large differences in living standards across countries, we

must focus on the production of goods and services.

The inputs used to produce goods and services are called the factors of
production.

The factors of production directly determine productivity.

Productivity: Its Role And Determinants

The Factors of Production
1.

Physical capital

2.

Human capital

3.

Natural resources

4.

Technological knowledge

Productivity: Its Role And Determinants

Physical Capital
is a produced factor of production.
It is an input into the production process that in the past was an
output from the production process.
is the stock of equipment and structures that are used to produce
goods and services.
Tools used to build or repair automobiles.
Tools used to build furniture.
Office buildings, schools, etc.
Human Capital
the economists term for the knowledge and skills that workers acquire
through education, training, and experience
Like physical capital, human capital raises a nations ability to
produce goods and services.

Productivity: Its Role And Determinants

Natural Resources
inputs used in production that are provided by nature, such as land,
rivers, and mineral deposits.
Renewable resources include trees and forests.
Nonrenewable resources include petroleum and coal.
can be important but are not necessary for an economy to be highly
productive in producing goods and services.

Technological Knowledge
societys understanding of the best ways to produce goods and
services.
Human capital refers to the resources expended transmitting this
understanding to the labor force.

The 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

The 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.

Production functions with constant returns to scale have an interesting

implication.
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

The preceding equation says that productivity (Y/L) depends on physical

capital per worker (K/L), human capital per worker (H/L), and natural
resources per worker (N/L), as well as the state of technology, (A).

Economic Growth And Public Policy

Governments can do many things to raise productivity and living standards.
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.

One way to raise future productivity is to invest more current resources in

the production of capital.

Economic Growth And Public Policy

Growth and Investment

Economic Growth And Public Policy

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.
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.

Investment from Abroad

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

Economic Growth And Public Policy

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.
Education
For a countrys long-run growth, education is at least as important as
investment in physical capital.
In the United States, each year of schooling raises a persons 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.
An educated person might generate new ideas about how best to produce
goods and services, which in turn, might enter societys pool of knowledge and
provide an external benefit to others.

Economic Growth And Public Policy

One problem facing some poor countries is the brain drainthe emigration of
many of the most highly educated workers to rich countries.
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.
Free Trade
Trade is, in some ways, a type of technology.
A country that eliminates trade restrictions will experience the same kind of
economic growth that would occur after a major technological advance.

Economic Growth And Public Policy

Some countries engage in . . .
. . . inward-orientated trade policies, avoiding interaction with other
countries.
. . . outward-orientated trade policies, encouraging interaction with other
countries.
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.

Economic Growth And Public Policy

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

Summary

Economic prosperity, as measured by real GDP per person, varies

substantially around the world.

The average income of the worlds richest countries is more than ten times
that in the worlds poorest countries.

The standard of living in an economy depends on the economys ability to

produce goods and services.

Productivity depends on the amounts of physical capital, human capital,

natural resources, and technological knowledge available to workers.

Summary

Government policies can influence the economys growth rate in many

different ways.

The accumulation of capital is subject to diminishing returns.

Because of diminishing returns, higher saving leads to a higher growth for a

period of time, but growth will eventually slow down.

Also because of diminishing returns, the return to capital is especially high

in poor countries.