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WHAT’S NEW IN THE EIGHTH EDITION:
There are three new features: Ask the Experts on “Innovation and Growth,” In the News on
“Curmudgeon versus Optimist,” and In the News on “Using Experiments to Evaluate Aid.”
There is also a new question in the Problems and Applications section.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
how much economic growth di'ers around the world.
why productivity is the key determinant of a country’s standard of living.
the factors that determine a country’s productivity.
how a country’s policies in+uence its productivity growth.
CONTEXT AND PURPOSE:
Chapter 25 is the .rst chapter in a four-chapter sequence on the production of output in the
long run. Chapter 25 addresses the determinants of the level and growth rate of output. We
.nd that capital and labor are among the primary determinants of output. In Chapter 26, we
address how saving and investment in capital goods a'ect the production of output, and in
Chapter 27, we learn about some of the tools people and .rms use when choosing capital
projects in which to invest. In Chapter 28, we address the market for labor.
The purpose of Chapter 25 is to examine the long-run determinants of both the level and
the growth rate of real GDP per person. Along the way, we will discover the factors that
determine the productivity of workers and address what governments might do to improve
the productivity of their citizens.
KEY POINTS:
Economic prosperity, as measured by GDP per person, varies substantially around
the world. The average income in the world’s richest countries is more than ten times
that in the world’s poorest countries. Because growth rates of real GDP also vary
substantially, the relative positions of countries can change dramatically over time.
412
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
25 PRODUCTION AND
GROWTH
413 ❖ Chapter 25/Production and Growth
The standard of living in an economy depends on the economy’s ability to produce
goods and services. Productivity, in turn, depends on the amounts of physical capital,
human capital, natural resources, and technological knowledge available to workers.
Government policies can try to in+uence the economy’s growth rate in many ways:
by encouraging saving and investment, encouraging investment from abroad,
fostering education, promoting good health, maintaining property rights and political
stability, allowing free trade, and promoting the research and development of new
technologies.
The accumulation of capital is subject to diminishing returns: The more capital an
economy has, the less additional output the economy gets from an extra unit of
capital. As a result, while higher saving leads to higher growth for a period of time,
growth eventually slows down as capital, productivity, and income rise. Also because
of diminishing returns, the return to capital is especially high in poor countries. Other
things equal, these countries can grow faster because of the catch-up e'ect.
Population growth has a variety of e'ects on economic growth. On the one hand,
more rapid population growth may lower productivity by stretching the supply of
natural resources and by reducing the amount of capital available for each worker.
On the other hand, a larger population may enhance the rate of technological
progress because there are more scientists and engineers.
CHAPTER OUTLINE:
I. Economic Growth around the World
A. Table 1 shows data on real income per person for 13 countries during di'erent
periods of time.
1. The data reveal the fact that living standards vary a great deal between these
countries.
2. Growth rates are also reported in the table. Brazil has had the largest growth rate
over time, 2.61% per year (on average).
3. Because of di'erent growth rates, the ranking of countries by income per person
changes over time.
a. In the late 19th century, the United Kingdom was the richest country in the
world.
b. Today, income per person is lower in the United Kingdom than in the United
States (a former colony of the United Kingdom).
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Table 1
Use Table 1 to make the point that a one-percentage point change in a
country’s growth rate can make a signi.cant di'erence over several
generations. The powerful e'ects of compounding should be used to
underscore the process of economic growth.
Chapter 25/Production and Growth ❖ 414
B. FYI: Are You Richer Than the Richest American?
1. According to the magazine American Heritage, the richest American of all time is
John B. Rockefeller, whose wealth today would be the equivalent of approximately
$200 billion.
2. Yet, because Rockefeller lived from 1839 to 1937, he did not get the chance to
enjoy many of the conveniences we take for granted today such as television, air
conditioning, and modern medicine.
3. Thus, because of technological advances, the average American today may enjoy
a “richer” life than the richest American who lived a century ago.
C. FYI: A Picture Is Worth a Thousand Statistics
1. This box presents three photos showing a typical family in three countries – the
United Kingdom, Mexico, and Mali. Each family was photographed outside their
home, together with all of their material possessions.
2. These photos demonstrate the vast di'erence in the standards of living in these
countries.
II. Productivity: Its Role and Determinants
A. Why Productivity Is So Important
1. Example: Robinson Crusoe
a. Because he is stranded alone, he must catch his own .sh, grow his own
vegetables, and make his own clothes.
b. His standard of living depends on his ability to produce goods and services.
2. De.nition of productivity: the quantity of goods and services produced
from each unit of labor input.
3. Review of Principle #8: A Country’s Standard of Living Depends on Its Ability to
Produce Goods and Services.
B. How Productivity Is Determined
1. Physical Capital per Worker
a. De.nition of physical capital: the stock of equipment and structures
used to produce goods and services.
b. Example: Crusoe will catch more .sh if he has more .shing poles.
2. Human Capital per Worker
a. De.nition of human capital: the knowledge and skills that workers
acquire through education, training, and experience.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
415 ❖ Chapter 25/Production and Growth
b. Example: Crusoe will catch more .sh if he has been trained in the best .shing
techniques or as he gains experience .shing.
3. Natural Resources per Worker
a. De.nition of natural resources: the inputs into production that are
provided by nature, such as land, rivers, and mineral deposits.
b. Example: Crusoe will have better luck catching .sh if there is a plentiful
supply around his island.
4. Technological Knowledge
a. De.nition of technological knowledge: society’s understanding of the
best ways to produce goods and services.
b. Example: Crusoe will catch more .sh if he has invented a better .shing lure.
C. FYI: The Production Function
1. A production function describes the relationship between the quantity of inputs
used in production and the quantity of output from production.
2. The production function generally is written like this:
where Y = output, L = quantity of labor, K = quantity of physical capital, H =
quantity of human capital, N = quantity of natural resources, A re+ects the
available production technology, and F () is a function that shows how inputs are
combined to produce output.
3. Many production functions have a property called constant returns to scale.
a. This property implies that as all inputs are doubled, output will exactly double.
b. This implies that the following must be true:
where x = 2 if inputs are doubled.
c. This also means that if we want to examine output per worker we could set x
= 1/L and we would get the following:
This shows that output per worker depends on the amount of physical capital
per worker (K /L), the amount of human capital per worker (H /L), and the
amount of natural resources per worker (N /L).
4. Case Study: Are Natural Resources a Limit to Growth?
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Y A F(L, K, H, N)=
xY A F(xL, xK, xH, xN)=
Y/L A F(1, K/L, H/L, N/L)=
Chapter 25/Production and Growth ❖ 416
a. This section points out that as the population has grown over time, we have
discovered ways to lower our use of natural resources. Thus, most economists
are not worried about shortages of natural resources.
III. Economic Growth and Public Policy
A. Saving and Investment
1. Because capital is a produced factor of production, a society can change the
amount of capital that it has.
2. However, there is an opportunity cost of doing so; if resources are used to
produce capital goods, fewer goods and services are produced for current
consumption.
B. Diminishing Returns and the Catch-Up E'ect
1. De.nition of diminishing returns: the property whereby the bene4t from
an extra unit of an input declines as the quantity of the input increases.
a. As the capital stock rises, the extra output produced from an additional unit of
capital will fall.
b. This can be seen in Figure 1, which shows how the amount of capital per
worker determines the amount of output per worker, holding constant all
other determinants of output.
c. Thus, if workers already have a large amount of capital to work with, giving
them an additional unit of capital will not increase their productivity by much.
d. In the long run, a higher saving rate leads to a higher level of productivity and
income, but not to higher growth rates in these variables.
2. An important implication of diminishing returns is the catch-up e'ect.
a. De.nition of catch-up e6ect: the property whereby countries that start
o6 poor tend to grow more rapidly than countries that start o6 rich.
b. When workers have very little capital to begin with, an additional unit of
capital will increase their productivity by a great deal.
C. Investment from Abroad
1. Saving by domestic residents is not the only way for a country to invest in new
capital.
2. Investment in the country by foreigners can also occur.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Start out by asking students what factors they believe will lead to greater
economic growth in the future.
Figure 1
417 ❖ Chapter 25/Production and Growth
a. Foreign direct investment occurs when a capital investment is owned and
operated by a foreign entity.
b. Foreign portfolio investment occurs when a capital investment is .nanced with
foreign money but operated by domestic residents.
3. Some of the bene.ts of foreign investment +ow back to foreign owners. But the
economy still experiences an increase in the capital stock, which leads to higher
productivity and higher wages.
4. The World Bank is an organization that tries to encourage the +ow of investment
to poor countries.
a. The World Bank obtains funds from developed countries such as the United
States and makes loans to less-developed countries so that they can invest in
roads, sewer systems, schools, and other types of capital.
b. The World Bank also o'ers these countries advice on how best to use these
funds.
D. Education
1. Investment in human capital also has an opportunity cost.
a. When students are in class, they cannot be producing goods and services for
consumption.
b. In less-developed countries, this opportunity cost is considered to be high; as
a result, children often drop out of school at a young age.
2. Because there are positive externalities in education, the e'ect of lower
education on the economic growth rate of a country can be large.
3. Many poor countries also face a “brain drain”—the best educated often leave to
go to other countries where they can enjoy a higher standard of living.
E. Health and Nutrition
1. Human capital can also be used to describe another type of investment in people:
expenditures that lead to a healthier population.
2. Other things being equal, healthier workers are more productive.
3. Making the right investments in the health of the population is one way for a
nation to increase productivity.
F. Property Rights and Political Stability
1. Protection of property rights and promotion of political stability are two other
important ways that policymakers can improve economic growth.
2. There is little incentive to produce products if there is no guarantee that they
cannot be taken. Contracts must also be enforced.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 25/Production and Growth ❖ 418
3. Countries with questionable enforcement of property rights or an unstable
political climate will also have diUculty in attracting foreign (or even domestic)
investment.
G. Free Trade
1. Some countries have tried to achieve faster economic growth by avoiding
transacting with the rest of the world.
2. However, trade allows a country to specialize in what it does best and thus
consume beyond its production possibilities.
3. When a country trades wheat for steel, it is as well o' as it would be if it had
developed a new technology for turning wheat into steel.
4. The amount a nation trades is determined not only by government policy but also
by geography.
a. Countries with good, natural seaports .nd trade easier than countries without
this resource.
b. Countries with more than 80 percent of their population living within 100
kilometers of a coast have an average GDP per person that is four times as
large as countries with less than 20 percent of their population living near a
coast.
H. Research and Development
1. The primary reason why living standards have improved over time has been due
to large increases in technological knowledge.
2. Knowledge can be considered a public good.
3. The U.S. government promotes the creation of new technological information by
providing research grants and providing tax incentives for .rms engaged in
research.
4. The patent system also encourages research by granting an inventor the
exclusive right to produce the product for a speci.ed number of years.
5. Ask the Experts: Innovation and Growth
a. When asked whether future innovations worldwide would not be
transformational enough to promote sustained per capita economic growth
rates in the US and western Europe in the future as in the past, 59 percent of
economic experts were uncertain, while 7 percent agreed and 34 percent
disagreed.
6. In the News: Curmudgeon versus Optimist
a. Economists’ opinions di'er about future economic growth from innovations.
b. This Wall Street Journal article compares the opinions of Robert Gordon, a
macroeconomist, and Joel Mokyr, an economic historian.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
419 ❖ Chapter 25/Production and Growth
I. Population Growth
1. Stretching Natural Resources
a. Thomas Malthus (an English minister and early economic thinker) argued that
an ever-increasing population meant that the world was doomed to live in
poverty forever.
b. However, he failed to understand that new ideas would be developed to
increase the production of food and other goods, including pesticides,
fertilizers, mechanized equipment, and new crop varieties.
2. Diluting the Capital Stock
a. High population growth reduces GDP per worker because rapid growth in the
number of workers forces the capital stock to be spread more thinly.
b. Countries with a high population growth have large numbers of school-age
children, placing a burden on the education system.
c. Some countries have already instituted measures to reduce population growth
rates.
d. Policies that foster equal treatment for women should raise economic
opportunities for women leading to lower rates of population.
5. Promoting Technological Progress
a. Some economists have suggested that population growth has driven
technological progress and economic prosperity.
b. In a 1993 journal article, economist Michael Kremer provided evidence that
increases in population lead to technological progress.
J. In the News: Using Experiments to Evaluate Aid
1. Using the scienti.c method with policy analysis yields information on the eUcacy
of a policy.
2. This NPR article explains the results of a randomized controlled experiment to lift
people out of extreme poverty with temporary aid.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Start a class discussion of the trade-o's that are necessary to sustain
economic growth. Point out that current consumption must be forgone for
higher consumption in the future. Ask students to examine the trade-o's
involved with each of the public policies discussed.
