1. THE REAL ECONOMY IN THE LONG RUN
Part 11
THE REAL ECONOMY IN THE LONG RUN

2. 22
Production and Growth
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3. Production And Growth
A country’s standard of living depends on its ability to produce goods and services.
Within a country there are large changes in the standard of living over time.
In the UK over the past century or so, average income has grown by about 1.3 per cent per year.
It means that GDP per person doubles every 50 years.
Annual growth rates that seem small become significant when compounded for many years.
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4. Production and Growth
Productivity refers to the amount of goods and services produced for each hour of a worker’s time.
A nation’s standard of living is determined by the productivity of its workers.
The EU countries had a trend of increasing living standards until the recession hit.
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5. Economic Growth Around The World
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6. Table 1. Real GDP Per Capita, Current US$, Selected Countries (Source World Bank)
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7. There Have Been Large Changes In Living Stands Over Time
The ranking of countries by income per person changes over time due to different growth rates.
The poorest countries have average levels of income that have not been seen in the UK for many decades.
The UK, the richest country in the world in 1870, has been overtaken since its average growth is around 1.3%.
Because of compounding it only takes a small difference in percentage growth to see changes in rank order.
The Rule of 70 means a growth rate of 7% would see income per person doubling in 10 years 70 divided by 7 compared to 54 years for a a 1.3% growth (70 / 1.3)
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8. Table 2. Annual Real GDP Growth (%) for Selected Countries (Source World Bank)
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9. Growth Theory
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10. Growth Theory
The Solow theory has been used to explain economic growth.
It identifies the rate of human and physical capital and population growth as being key determinants of economic growth.
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11. Growth Theory
Economists have identified other factors that may influence economic growth.
How open to trade a country is.
How easy it is to do business and how and the extent to which corruption is minimised.
The extent to which violence, war and conflict exist in a country,
Regional characteristics such as whether the country is part of Europe, North America, Asia or sub-Saharan Africa.
Geographical factors such as physical resource endowments and climate.
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12. Productivity
Productivity plays a key role in determining living standards for all nations in the world.
Productivity refers to the amount of goods and services that a worker can produce from each hour of work.
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13. Why Productivity Is So Important
To understand the large differences in living standards across countries, we must focus on the production of goods and services.
A nation can enjoy a high standard of living if it can produce a large quantity of goods and services.
Hence, to understand the large differences in living standards we observe across countries or over time, we focus on the production of goods and services.
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14. How Productivity is Determined
The determinants of the productivity are:
Physical capital per worker
Human capital per worker
Natural resources per worker
Technological knowledge
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15. How Productivity is Determined
The inputs used to produce goods and services are called the factors of production.
Physical capital makes workers more productive.
Human capital is the knowledge and skills that workers acquire through education, training and experience.
Natural resources are inputs into production that are provided by nature, such as land, rivers and mineral deposits
Technological knowledge – the understanding of the best ways to produce goods and services.
Technical progress means that the quality of physical and human capital is improved.
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16. The Determinates Of Economic Growth
The Solow model of growth helps us understand some key elements of the determinants of economic growth .
GDP in any country can be assumed to be an extension of a firm’s production function where the level of output is dependent on the factors of production employed.
Assumptions are that there are constant returns to scale, a closed economy (so Y = C+S) and that increases in capital and labour are subject to diminishing marginal product.
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17. Causes Of Growth The causes of growth can be listed:
Changes in savings rates.
Increase in population.
Dilution of capital stock.
Promoting technical progress.
An increase in Technology.
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18. Changes in the Savings Rate
An increase in the savings rate leads to:
An increase in investment and increases the capital-output ratio.
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19. An Increase in the Population
Populations can rise through birth rates being higher than death rates and through net migration.
The age of the population helps determine the labour force.
The Solow growth model shows that if the labour force is rising, then in order for the capital-output ratio to remain constant, investment must cover depreciation and provide more capital.
If investment does not keep pace with the rise in the population, people will become poorer.
In part, this helps to explain why many less developed countries experience continued high levels of poverty because their population rises but investment fails to keep pace.
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20. Dilution of Capital Stock
For example countries with high population growth have large numbers of school-age children. This places a larger burden on the educational system.
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21. Promoting Technology If there are more people, then:
The greater the probability that some of those people will come up with new ideas.
This will lead to technological progress.
Everyone benefits.
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22. An Increase In Technology
Increases in technology can be seen as a public good.
Technology can offset the effects of diminishing marginal product and lead to proportional increases in productive capacity.
Thomas Malthus.
Malthus argued that an ever-increasing population meant that the world was doomed to live in poverty forever.
He failed to understand that new ideas would be developed to increase the production of food and other goods, fertilizers, mechanized equipment, and new crop varieties.
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23. Long-run Growth Is Generated By Changes In Technology
Long-run economic growth can result from the creation of new knowledge and technology.
This impacts on everyone and makes them more productive as a result.
Innovation and R&D are important ways in which technology growth can arise and can provide competitive advantage for firms over rivals which are both distinctive and defensible.
There are therefore incentives for firms to innovate.
If technology is a public good with the characteristic of being non-rival then there are policy implications for governments.
Government policies include protection of property rights, encouraging foreign investment and promoting R&D.
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24. Economic Growth And Public Policy
Government Policies That Raise Productivity and Living Standards.
Encourage saving and investment.
Encourage investment from abroad.
Encourage education and training.
Establish secure property rights and maintain political stability.
Promote free trade.
Promote research and development.
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25. The Importance of Saving and Investment
One way to raise future productivity is to invest more current resources in the production of capital.
If resources are used to produce capital goods, fewer goods and services are produced for current consumption.
Countries that devote a large share of GDP to investment tend to have high growth rates.
But is this the cause or the effect?
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26. Diminishing Returns and the Catch-Up Effect
As the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns.
Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while.
In the long run, the higher saving rate leads to a higher level of productivity and income, but not to higher growth in these areas.
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27. Diminishing Returns and the Catch-Up Effect
The catch-up effect refers to the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich.
This helps explain why China had a higher growth rate than Japan even though both countries devoted a similar share of GDP to investment
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28. Investment from Abroad
Governments can increase capital accumulation and long- term economic growth by encouraging investment from foreign sources.
Investment from abroad takes several forms:
Foreign Direct Investment
Capital investment owned and operated by a foreign entity.
Foreign Portfolio Investment
Investments financed with foreign money but operated by domestic residents.
The World Bank is an organization that tries to encourage the flow of investment to poor countries.
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29. Education
For a country’s long-run growth, education is at least as important as investment in physical capital.
In the developed economies of Western Europe and North America States, each year of schooling raises a person’s wage, on average, by about 10 percent.
Thus, one way the government can enhance the standard of living is to provide schools and encourage the population to take advantage of them.
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30. Education
An educated person might generate new ideas about how best to produce goods and services, which in turn, might enter society’s pool of knowledge and provide an external benefit to others.
This is a positive externality.
One problem facing some poor countries is the brain drain—the emigration of many of the most highly educated workers to rich countries.
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31. Health and Nutrition
Human capital usually refers to education but it can also refer to other investments in people such as investments in improved health.
Robert Fogel, suggested that a significant factor in long-run economic growth is improved health from better nutrition.
He estimates that in Great Britain in 1780 about one in five people were so malnourished that they were incapable of manual labour.
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32. Property Rights and Political Stability
Property rights refer to the ability of people to exercise authority over the resources they own.
An economy-wide respect for property rights is an important prerequisite for the price system to work.
It is necessary for investors to feel that their investments are secure.
Transparency international’s corruption index paints a fairly disturbing picture in many countries.
An index of 100 being totally clean.
In 2014 the Scandinavian countries come out high from 86 to 92, the UK has an index of 78, but Somalia has an index of 8 and Afghanistan of 12.
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33. Free Trade
A country that eliminates trade restrictions will experience the same kind of economic growth that would occur after a major technological advance.
When a country exports wheat and imports steel, the country benefits in the same way as if it had invented a technology for turning wheat into steel.
Some countries engage in . . .
. . . inward-orientated trade policies, avoiding interaction with other countries.
. . . outward-orientated trade policies, encouraging interaction with other countries.
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34. Research and Development
The advance of technological knowledge has led to higher standards of living.
Most technological advance comes from private research by firms and individual inventors.
Government can encourage the development of new technologies through research grants, tax breaks, and the patent system.
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35. Population Growth
Economists and other social scientists have long debated how population growth affects a society.
Population growth interacts with other factors of production:
Stretching natural resources.
Diluting the capital stock.
Promoting technological progress.
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36. Summary
Economic prosperity, as measured by real GDP per person, varies substantially around the world.
The average income of the world’s richest countries is more than ten times that in the world’s poorest countries.
The standard of living in an economy depends on the economy’s ability to produce goods and services.
Productivity depends on the amounts of physical capital, human capital, natural resources, and technological knowledge available to workers.
Government policies can influence the economy’s growth rate in many different ways.
The Solow model notes that the accumulation of capital is subject to diminishing returns.
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37. Summary
Because of diminishing returns, higher saving leads to a higher growth for a period of time, but growth will eventually slow down.
Also because of diminishing returns, the return to capital is especially high in poor countries.
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, maintaining property rights and political stability, allowing free trade, promoting the research and development of new technologies, and controlling population growth
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