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ECON 105 – Principles of Macroeconomics

Junjie Liu – Econ 105

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Difference in Living Standards Across Countries A typical family with all their possessions in the U.K., a developed economy

GDP per capita: $36,130 Life expectancy: 80 years Adult literacy: 99% Junjie Liu – Econ 105

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Difference in Living Standards Across Countries A typical family with all their possessions in Mexico, a middle income country

GDP per capita: $14,270 Life expectancy: 76 years Adult literacy: 86% Junjie Liu – Econ 105

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Difference in Living Standards Across Countries A typical family with all their possessions in Mali, a poor country

GDP per capita: $1,090 Life expectancy: 52 years Adult literacy: 46% Junjie Liu – Econ 105

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Economic Growth Across the World

Junjie Liu – Econ 105

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A larger, zoom-able version can be found at http://thedoghousediaries.com/large/5414.png.

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Economic Growth Across the World

1) There are great differences in living standards around the world.

2) Growth rates of real GDP also vary substanWally, and as a result, the ranking of countries by income per person changes dramaWcally over Wme. Ø Poor countries are not necessarily doomed to poverty forever. Ø Rich countries may be overtaken by poorer but faster-­‐growing countries.

Junjie Liu – Econ 105

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QuesWons to Answer • Why are some countries richer than others? • Why do some countries grow quickly while others seem stuck in a poverty trap? • What policies may help raise growth rates and long-­‐run living standards?

Junjie Liu – Econ 105

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ProducWvity ProducWvity is the amount of goods and services produced for each unit of a worker’s Kme.

Why producWvity is so important?

• A country’s standard of living depends on its ability to produce goods and services.

• As producWvity increases, workers can produce more goods and services for each unit of their Wme. As a result, the output and income increase.

Junjie Liu – Econ 105

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Determinants of ProducWvity 1) Physical capital (K) per worker (L) =

Physical capital = the stock of equipment and structures that are used to produce goods and services.

2) Human capital (H) per worker = Human capital = the knowledge and skills that workers acquire through educaWon, training, and experience.

Junjie Liu – Econ 105

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Determinants of ProducWvity 3) Natural resources per worker =

Natural resources = the inputs that are provided by nature, such as land, water, and mineral deposits.

4) Technological knowledge Technological knowledge = society’s understanding of the best way to produce goods and services.

Junjie Liu – Econ 105

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ProducWon FuncWon A producWon funcWon describes the relaWonship between the quanKty of inputs used in producKon and the quanKty of output produced.

Y = output L = quanWty of labour K = quanWty of physical capital H = quanWty of human capital N = quanWty of natural resources A reflects the available technology F( ) denotes a func,on that shows how

inputs are combined to produce output.

Junjie Liu – Econ 105

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ProducWon FuncWon All firms hire labour (L), rent capital (K), and use other inputs to produce output.

But the composiWon of these inputs differs across countries because different countries have different resources and different opportunity costs of using each resource.

E.g. In Bangladesh firms use labour-­‐intensive method of producWon, whereas in Canada firms use capital-­‐intensive method of producWon.

Junjie Liu – Econ 105

Bangladesh: lots of labour

Canada: lots of natural resources and capital
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Example Production Function
Suppose Y = A(2L + 3K + H + 0.5N)
If A = 1.4, L = 10, K = 5, H = 4, and N = 12, then
Y = 1.4(20 + 15 + 4 + 6)
= 63
If there is an increase in any of the variables then Y will increase.
What if all the resource inputs double?
Y = 1.4(40 + 30 + 8 + 12)
= 126
When inputs and output both increase by the same factor the production function is said to have constant returns to scale.
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Example ProducWon FuncWon Y = A(2L + 3K + H + 0.5N)
Now
divide both sides by L:

Y/L = A(2 + 3K/L + H/L + 0.5N/L)

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), the amount of natural resources per worker (N/L), and technology (A).

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Economic Growth and Public Policy: What the Government can do to Encourage Growth 1. Saving and investment

We can boost producWvity by increasing K, which requires investment.

More investment requires more saving, which requires less consumpKon.

There is a trade-­‐off between current consumpWon and future consumpWon.

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Diminishing Returns to Capital BUT there are diminishing returns to capital:

as the capital stock rises, the extra output produced from an addiKonal unit of capital falls.

Thus, if workers already have a large amount of capital to work with, giving them an addiWonal unit of capital increases their producWvity only slightly.

So more saving and investment leads to faster

growth rates only in countries that start with

low levels of capital per worker.

Junjie Liu – Econ 105

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Diminishing Returns to Capital If workers already have a lot of K, giving them more increases producWvity fairly lihle.

Y/L

Output per worker

If workers have lihle K, giving them more increases their producWvity a lot.

K/L

Capital per worker Junjie Liu – Econ 105

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The Catch-­‐up Effect Catch-­‐up effect = countries that start off poor tend to grow more rapidly than countries that start off rich.

Because of diminishing returns to capital, the return to capital is very high in poor countries, so poor countries can grow more rapidly.

Example: Over 1960-­‐1990, Canada and South Korea devoted a similar share of GDP to investment, but growth was > 6% in Korea and only 2.5% in Canada.

ExplanaWon:

In 1960, K/L was far smaller in Korea than in Canada, so Korea grew faster.

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The Catch-­‐up Effect Y/L

Rich country’s growth

Poor country’s growth

K/L

Poor country starts here

Rich country starts here

Junjie Liu – Econ 105

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Economic Growth and Public Policy 2. Investment from abroad

Investment from abroad takes two forms:

• Foreign direct investment: A physical capital investment that is owned and operated by a foreign enKty.

• Foreign porcolio investment: A capital investment that is financed with foreign money but operated by domesKc residents.

• Foreign investment can be good in countries that are unable to generate enough capital themselves, although some people oppose having the foreign control. 22

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Economic Growth and Public Policy 3. EducaKon

Government can increase producWvity by promoWng educaWon – investment in human capital.

In Canada, each year of schooling has historically raised a person’s wage on average by about 10 percent.

Overinvestment in human capital is possible if the skill level of the workforce exceeds the skills demanded by firms.

The type of educaWon promoted should match the type needed in the economy. 23

Economic Growth and Public Policy 4. Health and NutriKon

Government can increase producWvity by promoWng health because healthier workers are more producKve.

Example: It is believed that 30% of Great Britain’s growth from 1790-­‐1980 was due to improved nutriWon.

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Economic Growth and Public Policy 5. Property rights and poliKcal stability

If businesses are not safe from thel or damage then there is liele incenKve to produce products or invest in a business.

Countries with quesWonable enforcement of property rights or an unstable poliWcal climate will also have difficulty in ahracWng foreign (or even domesWc) investment.

In many poor countries, the jusWce system does not work very well: • Contracts are not always enforced • CorrupWon olen goes unpunished • Firms may have to bribe government officials for permits

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Economic Growth and Public Policy 6. Free trade Trade allows a country to specialize and thus consume beyond its producWon possibiliWes. Inward-­‐oriented policies = aim to avoid interacKon with other countries (e.g., tariffs, limits on investment from abroad). Outward-­‐oriented policies = aim to promote integraKon with the world economy (e.g., the eliminaKon of restricKons on trade or foreign investment). Countries with inward-­‐oriented policies have generally failed to create growth. Countries with outward-­‐oriented policies have olen succeeded.

Junjie Liu – Econ 105

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Economic Growth and Public Policy 7. Research and development

Technological progress is the main reason why living standards rise over the long run because beeer technology increases producKvity.

Policies to promote technological progress: • Patent laws give incenKve to create. • Tax incenWves or direct support for research and development

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Economic Growth and Public Policy 8. PopulaKon growth

• If there is more L without more K then producKvity will decrease. • More L creates a strain on natural resources. • The growing populaWon will require more resources to educate. How to decrease ferKlity? Look at the reasons why people have many children: • Lack of affordable contracepKon • Lack of old age security • Poor opportuniKes for women à low opportunity cost of women’s Kme 28

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Summary 1) Economic prosperity, as measured by GDP per person, varies substanWally around the world.

2) The standard of living in an economy depends on its ability to produce goods and services. ProducWvity (output per unit of labour) is the main determinant of living standards in the long run.

3) ProducWvity depends on the amounts of physical capital, human capital, natural resources, and available technology.

4) Growth in these factors – especially technological progress – causes growth in living standards over the long run.

Junjie Liu – Econ 105

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