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209
WHAT’S NEW IN THE SEVENTH EDITION:
There is a new
In the News
box on “Does Food Aid Help or Hurt?”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ how much economic growth differs 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 influence its productivity growth.
CONTEXT AND PURPOSE:
Chapter 12 is the first chapter in a four-chapter sequence on the production of output in the long run.
Chapter 12 addresses the determinants of the level and growth rate of output. We find that capital and
labor are among the primary determinants of output. In Chapter 13, we address how saving and
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.
12
PRODUCTION AND
GROWTH
210 ❖ Chapter 12/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 influence 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 effect.
CHAPTER OUTLINE:
I. Economic Growth around the World
A. Table 1 shows data on real GDP per person for 13 countries during different 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. Japan has had the largest growth rate over time,
2.65% per year (on average).
3. Because of different 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.
Table 1
Use Table 1 to make the point that a one-percentage point change in a country’s
growth rate can make a significant difference over several generations. The powerful
effects of compounding should be used to underscore the process of economic
growth.
Chapter 12/Production and Growth ❖ 211
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.
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 difference 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 fish, grow his own vegetables, and
make his own clothes.
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. Definition of physical capital: the stock of equipment and structures used to
produce goods and services.
b. Example: Crusoe will catch more fish if he has more fishing poles.
2. Human Capital per Worker
a. Definition of human capital: the knowledge and skills that workers acquire
through education, training, and experience.
b. Example: Crusoe will catch more fish if he has been trained in the best fishing techniques
or as he gains experience fishing.
212 ❖ Chapter 12/Production and Growth
3. Natural Resources per Worker
4. Technological Knowledge
a. Definition of technological knowledge: society’s understanding of the best ways
to produce goods and services.
b. Example: Crusoe will catch more fish if he has invented a better fishing 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:
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?
xY A F(xL, xK, xH, xN)
=
Y/L A F(1, K/L, H/L, N/L)
=
Chapter 12/Production and Growth ❖ 213
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 Effect
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 effect.
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.
a. Foreign direct investment occurs when a capital investment is owned and operated by a
foreign entity.
Figure 1
Start out by asking students what factors they believe will lead to greater economic
growth in the future.
214 ❖ Chapter 12/Production and Growth
3. Some of the benefits of foreign investment flow 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 flow of investment to poor
countries.
a. The World Bank obtains funds from developed countries such as the United States and
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 effect 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.
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.
3. Countries with questionable enforcement of property rights or an unstable political climate
will also have difficulty in attracting foreign (or even domestic) investment.
Chapter 12/Production and Growth ❖ 215
4.
In the News: Does Food Aid Help or Hurt?
a. Economic policies designed to improve productivity sometimes have adverse unintended
effects.
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 off 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 find trade easier than countries without this
resource.
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 firms engaged in research.
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.
216 ❖ Chapter 12/Production and Growth
2. Diluting the Capital Stock
3. Some countries have already instituted measures to reduce population growth rates.
4. 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: One Economist’s Answer
1. Why do some nations thrive while others do not?
2. This article by economist Daron Acemoglu provides his ideas on the answers to this question.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. The approximate growth rate of real GDP per person in the United States is 1.77 percent
Start a class discussion of the trade-offs 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-offs involved with each of the public
policies discussed.
Chapter 12/Production and Growth ❖ 217
Questions for Review
1. The level of a nation’s GDP measures both the total income earned in the economy and the
5. A higher rate of saving leads to a higher growth rate temporarily, not permanently. In the
218 ❖ Chapter 12/Production and Growth
Quick Check Multiple Choice
1. b
Problems and Applications
1. The facts that countries import many goods and services yet must produce a large quantity
3. a. Private consumption spending includes buying food and buying clothes; private
find is managing a restaurant.
Chapter 12/Production and Growth ❖ 219
7. a. Individuals with higher incomes have better access to clean water, medical care, and
8. Peace would promote economic growth because it is an indication that property rights will be
