PRODUCTIVITY AND GROWTH

MODULE 38

THE AGGREGATE PRODUCTION FUNCTION

Productivity is higher when workers are equipped with more physical capital, more human capital, better technology, or any combination of the three.

In order to put numbers to productivity, economists make use of estimates of the aggregate production function which shows how productivity depends on the quantities of physical capital per worker and human capital per worker as well as the state of technology.

THE AGGREGATE PRODUCTION FUNCTION

In general, all three factors of production tend to rise over time, as workers are equipped with more machinery, receive more education, and benefit from technological advances.

The aggregate production function allows economies to isolate the effects of these three factors on overall productivity.

EXAMPLE OF AN AGGREGATE PRODUCTION FUNCTION

A comparative study of Chinese and Indian economic growth used the following aggregate production function:

*GDP per worker=T x (physical capital per worker)0.4 x (human capital per

worker)0.6

Where T represented an estimate of the level of technology and they assumed that each year of education raised worker’s human capital by 7%.

*study conducted by Barry Bosworth and Susan Collins of the Brookings Institution

DIMINISHING RETURNS TO PHYSICAL CAPITAL

The estimated aggregate production function exhibits diminishing returns to physical capital.

This means that when the amount of human capital per worker and the state of technology are held fixed, each successive increase in the amount of physical capital per worker leads to a smaller increase in productivity.

DIMINISHING RETURNS TO PHYSICAL CAPITAL

A productivity curve shows a graphical representation of the aggregate production function, placing physical capital on the x-axis and real GDP per worker on the y-axis.

However, diminishing returns may disappear if the amount of human capital is increased, the technology improved, or both, when the amount of physical capital is increased.

DIMINISHING RETURNS TO PHYSICAL CAPITAL

Diminishing returns is a pervasive characteristic of production.

Typical estimates suggest that, in practice, a 1% increase in the quantity of physical capital per worker increases output per worker by only one third of 1%, or 0.33%.

GROWTH ACCOUNTING

All the factors contributing to higher productivity rise during the course of economic growth: both physical capital and human capital per worker increase, and technology advances as well.

Economists use growth accounting to separate the different effects from each of the three major factors in the aggregate production function to economic growth.

EXAMPLE OF GROWTH ACCOUNTING Suppose that the amount of physical

capital per worker grows by 3% a year. If each 1% rise in physical capital per

worker will raise the output per worker by one-third of 1%, then the 3% increase in physical capital will be responsible for 1% or productivity growth per year

(3% x 0.33 = 1%) Similarly, but more complex procedure is

used to estimate the effects of growing human capital. It is more complex because there are no simple $ measures of the quantity of human capital.

GROWTH ACCOUNTING

Growth accounting allows us to calculate the effects of greater physical and human capital on economic growth.

Technological progress is measured by estimating what is left over after the effects of physical and human capital per worker have been taken into account.

TOTAL FACTOR PRODUCTIVITY AND TECHNOLOGICAL PROGRESS

Total factor productivity refers to the amount of output that can be achieved with a given amount of factor inputs.

When total factor productivity increases, the economy can produce more output with the same quantity of physical capital, human capital, and labor.

Increases in total factor productivity are central to a country’s economic growth.

TECHNOLOGICAL PROGRESS

Increases in total factor productivity in fact, measure the economic effects of technological progress.

This implies that technological change is crucial to economic growth.

NATURAL RESOURCES Other thing equal, countries that are

abundant in valuable natural resources have higher GDP per capital than countries that do not possess these resources.

However, other things are not equal. It has proven that natural resources are a much less important determinant of productivity than human or physical capital.

Some nations with very real GDP per capita have very few natural resources (such as Japan) and some resource-rich countries are very poor (such as Nigeria).

THOMAS MALTHUSIn An Essay on the Principle of Population,

English economist Thomas Malthus expounded on the pessimistic prediction about future productivity:

As population grew, he said, the amount of land per worker would decline. This, other things equal, would cause productivity to fall.

Malthus thought that improvements to physical and human capital would only cause temporary improvements in productivity, because they would always be offset by the pressure of rising population and more workers on the limited supply of land.

THOMAS MALTHUS However, it has not turned out this way. Although historians believe that Malthus

prediction of falling productivity was valid for much of human history.

However, any negative effects on productivity from population growth have been far outweighed by other positive factors: advances in technology, increases in human and physical capital, and the opening up of enormous amounts of cultivatable land.

THREE EXPERIENCES WITH ECONOMIC GROWTH

Rates of long-run economic growth differ markedly around the world.

Three countries are analyzed in terms of their economic growth: Argentina, Nigeria, and South Korea.

Each was chosen as an example of what has happened in their region.

SOUTH KOREA South Korea is often referred to as the

East Asian economic miracle. It has taken South Korea only 35 years to achieve economic growth that has taken centuries elsewhere.

In 1960, South Korea was a poor nation. However, in a space of about 30 years, reaching a growth of an average of 7% per year in real GDP per capita.

Today, although still poorer than either United States or Europe, it has become an economically advanced country.

THE ASIAN COUNTRIES Asian countries have achieved high

growth rates because all the sources of productivity growth have been increases constantly:

1. Very high savings rates have allowed the countries to significantly increase the physical capital per worker.

2. Very good basic education have allowed a rapid improvement in human capital.

3. Substantial technological progress characterizes these countries.

THE ASIAN COUNTRIES

This East Asian experience demonstrates that economic growth can be especially fast in countries that are catching up with other countries that have higher real GDP per capita.

On this basis, economists suggest a general principle known as the convergence hypothesis.

According to the convergence hypothesis, international differences in real GDP per capita tend to narrow over time.

THE EAST ASIAN COUNTRIES This East Asian experience demonstrates that

economic growth can be especially fast in countries that are catching up with other countries that have higher real GDP per capita.

On this basis, economists suggest a general principle known as the convergence hypothesis.

According to the convergence hypothesis, international differences in real GDP per capita tend to narrow over time because countries that start with a lower real GDP per capita tend to have higher growth rates (however, starting with a low level of real GDP per capita is no guarantee of rapid growth).

LATIN AMERICA

In 1900, Latin America was not an economically backward region. Natural resources were abundant, including minerals and cultivatable land.

However, since about 1920, growth in Latin America has been disappointing.

The reasons for Latin America’s stagnation are the opposite for the reasons for South Korea’s success story.

LATIN AMERICA The rates of saving and investment

spending in Latin America have been much lower than in East Asia:

1. Irresponsible government policy that has eroded savings through high inflation, bank failures, and other disruptions.

2. Education has been underemphasized.

3. Political instability has led to irresponsible economic policies.

LATIN AMERICA

In 1980, economists believed that Latin America was suffering from excessive government intervention in markets.

They recommended opening the economies to imports, selling government-owned companies, and freeing up private initiative.

However, only Chile has achieved rapid economic growth.

AFRICA Africa possesses about 2 times the population

of the United States (about 780 million people).

Economic progress has been slow and uneven. In fact, real GDP per capita in the sub-Saharan Africa fell by 13 percent from 1980 to 1994, although it has been recovering since then.

The result of this poor economic growth performance has been intense and continuing poverty.

AFRICA

The explanation of this discouraging situation results from:

1. The first and foremost problem has been political instability. Wars have killed millions of people and mad productive investment spending impossible.

2. This threat of war and general anarchy have also inhibited other important conditions for growth, such as education and provision of necessary infrastructure.

AFRICA

3. Property rights: the lack of legal safeguards means that property owners are subject to extortion because of government corruption, so citizens are reluctant to own or improve property.

AFRICAWhile many economists believe that

political instability and government corruption are the leading causes of underdevelopment in Africa.

However, some economists, like Jeffrey Sachs, believe that Africa is politically unstable because it is poor.

He maintains that Africa’s poverty stems from its extremely unfavorable geographic conditions, as much of the continent is landlocked, hot, infested with tropical diseases, and cursed with poor soil.

AFRICAThe example of Africa represents a warning

that long-run economic growth cannot be taken for granted.

However, some countries like Mauritius have been able to achieve economic growth through textile industry.

Several African nations that are dependent on exporting commodities such as oil and coffee have benefitted by their higher prices.

On a happier note: Africa’s economic performance since the mid 1990’s has been generally much better than it was in the preceding decades.