1. Determinants of the long run real GDP per person:
Econ 100
Lecture 13
Determinants of the long run real GDP per person:
Production and growth

2. There is a tremendous variation in the standard of living (measured by real GDP per person) across countries.
Standard of living also varies within the same country over time.
Finally, there are significant differences between the growth rates of real GDP per person in different countries.

3. In this lecture, we will consider factors that determine or affect
the level
and
the growth rate
of the real GDP per person.

4. Because of differences in growth rates, the ranking of countries by real GDP per person (or by income per person) changes over time.
What explains these changes?
Economists have put forward several different theories to explain how economies grow. We will try to list and discuss the main factors emphasized in these theories.

5. We can start with the observation that
Real GDP depends on a country's resources,
and the country's resources include labor.
The higher the productivity of labor (the more productive workers are), the higher will the real GDP be for a given amount of labor employed and a given population.

6. Labor productivity is defined simply as the quantity of goods and services that is produced by each unit of labor employed.
Therefore, we could say that the higher the labor productivity for a given ratio of labor employed to the population, the higher will the real GDP per person be.

7. This implies that to understand why the real GDP per person in a given year is high or low in a certain country we can try to see why the productivity is high or low,
and to understand why the real GDP per person grows rapidly of slowly over time we can focus on why the productivity is changing rapidly or slowly in that country.
This brings us to the question of how (by what factors) the productivity is determined.

8. How productivity is determined
The following is a list of the main factors that determine productivity in a country (that is, workers in the country are more productive if they have more...):
Physical capital
Human capital
Natural resources
Technological knowledge

9. Physical capital
The stock (the total amount at a given point in time of) machinery, equipment,and buildings that are used to produce good and services is called physical capital.
Notice that physical capital which is necessary to produce goods and services in the present is itself produced in the past. And once it is acquired by the producers (firms) and installed, for example, in the factories, it can be used to produce consumers goods or new physical capital goods.

10. Human capital
Human capital is the knowledge and skills that workers acquire through education, training, and experience.
Just like physical capital can be produced, human capital can also be produced. The inputs used to produce human capital would include teachers, lectures, schools, time (labor) spent by students studying.

11. Natural resources
Natural resources include Inputs used in production of goods and services provided by nature, such as land, water resources, forests, and mines.
Natural resources can be renewable or non- renewable.
A forest is a renewable resource.
Oil or minerals are non-renewable.

12. Technological knowledge
Technological knowledge is the understanding of the best ways to produce goods and services.
Technological knowledge can take different forms:
Common knowledge
Proprietary (if no one other than the discoverer has the means to make the same discovery)
Proprietary for short time (throughout the period of the patent right)

13. Human capital and technological knowledge are related (they are both about knowledge after all),
but there is an interesting difference between them:
If someone discovers a new way of producing certain goods or services, technological knowledge increases.
And if this new information is translated into professional skills of workers, human capital is increased.

14. Are natural resources a limit to growth?
Since some resources with fixed supply are non- renewable, and some other resources are renewable but it takes time to renew them,
whereas the world population and therefore the amount of goods and services necessary to produce increases very fast,
will the world real GDP per person stop sometime soon and even begin to decrease?

15. Those who do not think so may point out that
Technological progress causes us to use less of non-renewable natural resources and use (and re-use by recycling) more of renewable resources,
Inputs used and critical commodities produced change over time before natural resources of certain kinds that were used intensively in the past are being depleted,
The prices of natural resources (adjusted for inflation) have not increased over the long run.

16. What can we do to increase the growth of real GDP per person?
Investment and saving
Diminishing returns and catch-up effect
Investment from abroad
Education
Health and nutrition
Property rights, political stability, and good governance
Free trade (among countries)
Research and development
Population growth

17. Investment and saving
The physical capital goods that we produce today will make our stock of physical capital goods increase in future. Therefore, as we produce more physical capital goods today, the increase in our stock of physical capital goods tomorrow will be larger and so will the increase in our production of goods an services tomorrow – real GDP per person will grow faster.
But there is a tradeoff: Producing more I means producing less C. To produce more tomorrow, we have to consume less today.
Empirical research suggests that countries who save and invest a larger fraction of their GDP tend to grow faster.

18. In principle, we should be cautious when interpreting the correlation between growth rate and investment. It is possible that higher investment leads to higher growth, but it is also possible that higher growth causes higher investment.
Nevertheless, since higher capital stock per worker increases worker productivity, there is little doubt that increasing saving and investment will positively affect (speed up) growth.

19. Diminishing returns and the catch-up effect
Consider a country whose real GDP per person is relatively low and is growing at a relatively low rate (say, 3% per year) because its saving rate is low and a smaller fraction of GDP is devoted to investment in physical capital.
Suppose now the saving rate is suddenly increased and stays increased year after year for the long run. As a result, a higher fraction of GDP is invested, capital stock begins to grow faster and real GDP per person begins to grow faster (say, 7% per year).
Question: Does the growth rate stays at 7% per year in the long run also?

20. Unfortunately, no. The growth rate that has jumped to 7% at first will gradually diminish toward a lower rate although it may not necessarily drop back to the initial 3%.
The reason has something to do with the so-called “diminishing returns to capital”: As the stock of capital per worker grows, the additional output per worker from an additional unit of capital per worker falls.
But even though the increase in saving and investment will lead to a growth that slows down over time, a higher level of productivity and a higher level of real GDP will be achieved.

21. This will be reflected also by the so-called catch-up effect: Consider two countries with substantially different levels of physical capital per worker and real GDP per person, but the same growth rate (such as 3% per year).
The same increase in physical capital per worker in both countries will lead to a significantly higher growth rate (to, say, 7%) in the country with the low capital and GDP levels than the growth rate in the country with high capital and GDP levels (to, say, 4%).
Consequently, the country with low GDP has a chance to catch up with the country with high GDP.

22. Investment from abroad
A country's physical capital stock can be made to increase also by investment from abroad (by foreigners).
Foreign investment can take two forms:
Foreign direct investment
Foreign portfolio investment
Recall that GDP includes both the income of residents and non-resident foreigners. Therefore, foreign investment can cause the GDP to increase by the same amount as domestic investment can do, but foreigners will take their profits home and therefore the income of residents only will not grow as much as it will do with domestic investment.

23. Education Education can be seen as investment in human capital.
In western countries, an extra year of schooling can lead on average to a 10% increase in a worker's income.
As always, there are opportunity costs associated with this investment also. The opportunity costs from the point of view of the students take the form of wages forgone that could have been earned by working instead of being in school.
Education benefits not only the people who are educated but also others. Therefore, education (and human capital) is said to have an externality effect. Example: Education may positively affect people's creativity leading to new ideas and new technologies.

24. Therefore, governments or policy makers try to support, provide for, and subsidize their citizens' education, doing this also by sending the country's best students to abroad if they have the chances of getting better education there.
But this may not have the desired outcome: If students choose to stay abroad (the so-called “brain drain”), the country's human capital will be reduced, and those who are left behind will lose all the positive externality effects of human capital and will become poorer than they would otherwise be: The action of the students who choose to leave affects those who are left behind.

25. Health and nutrition
We have seen that higher real GDP per person is correlated with better health and nourishment of the population.
But expenditures made by a country to improve people's health and nourishment also lead to more productive generations. Therefore, health expenditures may also be seen as investment in human capital.
And healthier and more productive people can produce higher real GDP levels – causing the younger generations raised to be more productive.

26. Property rights, political stability, and good governance
A market economy functions with a price system and it works with private ownership of resources.
In order that such a system works as best as it can, property rights must be well protected:
Buyers must be sure that they will receive the goods and services they paid for
Sellers must be sure that they will be paid for the goods and services they sold
Lenders must be sure that they will receive the interest income that the lending entitles them to
Savers must be sure that they will receive the full amount of the returns that their savings will enable them to earn

27. In short, contracts must be enforced.
This requires a well functioning system of justice that
punishes those who violate their contractual obligations,
compensates for the losses of those to whom the violaters have any liabilities,
and does these rather quickly than slowly.
Corrupted governments or political instability in the country have similar effects of a poorly functioning system of justice.

28. Especially in extreme cases such as coups, political instability creates at least an uncertainty as to whether the property rights will be protected adequately, negatively affecting for example saving and investment.
To summarize, economists are convinced that a country with
an efficient court system
honest government officials
and stable constitution
will enjoy a higher standard of living in the long run.

29. Free trade
A country can try to achieve rapid economic growth by pursuing
inward-oriented policies or
outward-oriented policies
After many decades of experience in different countries, outward oriented policies seem to foster growth comparatively more strongly by making the country benefit from gains from trade.
Among others, trade gives a relatively small country the same advantage that a big country with a large internal market has.

30. Research and development
Standard of living become higher as technological knowledge has advanced
which happens as a result of research
which in turn comes from
private firms
government owned and funded research facilities
The government can promote and encourage research and development of new technologies by
research grants
tax breaks for firms engaging in research
patent rights

31. Population growth Population growth has two obvious effects:
More people mean more workers and more labor to produce goods and services
It also means more people to consume those goods and services
As a result of these two effects, does the real GDP per person decrease or increaase as a result of population growth?
Based on what we have discussed so far, we can say that the answer depends on how productivity is affected by population growth.

32. If productivity (or real GDP per worker) is affected negatively, real GDP per person will also be affected negatively.
Note that we are not talking about the real GDP but the real GDP per person. Real GDP itself may still increase as population (and hence labor) increases even if productivity falls (the decrease in productivity has to be faster than the increase in labor in order that real GDP falls).
But real GDP per person may still fall even if real GDP increases. As we have seen before, we need to kno about what happens to productivity to see what will happen to real GDP per person.

33. From this perspective, there are at least three ways how population growth may affect productivity.
Diluting the capital stock
Promoting technological progress
Stretching natural resources