Chapter 7 Notes

Chapter 7: Economic growth, productivity, and living standards.
Standard of living:
o Most improvements in the nations living standard are the result not just of scientific and
technological advances but an economic system that makes the benefits of those advances
available to the average person.
o Real GDP measures the physical volume of goods and services produced within a country’s
border during a specific period such as a quarter or year.
o Real GDP per person provides a measure of the quality of goods and services available the
typical residents of a country at a particular time.
o Real GDP per person is certainly not a perfect indicator of economic wellbeing.
o Real GDP per person is positively related to a number of pertinent variables such as life
expectancy, infant health, and literacy.
o Economist have focused on real GDP per person as a key measure of the country’s living
standard and stage of economic development.
Compound Interest Rates
o Power of compound interest is when what seems to be small differences in growth rates
can have large, long-run effects results.
 Equation of compound interest: (Base amount) (1+interest rate%) ^years
o Compound interest pays interest on the original deposit and all previously accumulated
interests.
o compounding interest rates are a main cause of economic growth which results in an
increase in the standard of living
o Differences in interest rates matter

o Growth rates in GDP per capita have the same effect as interest rates
o Relatively small growth in GDP per capita has a very large effect over a long
period
o In the long run, the growth rate of an economy matters
Years to double:
o Useful formula to approximate the number of years it takes an initial amount to double
o Given some annual interest rate
o Years to double = 72 / interest rate
o If the interest rate equals 2% then it takes 36 years for your money to double
o If GDP grows at 3% then it takes 24 years for GDP to double
o Growth rates matter
Real GDP per Capita:
• Average labor productivity: output per employed worker

 Y = real GDP
 N = number of people employed
 POP = population
Y
POP = Y
×
N
N POP
 GDP per capita is the product of output per worker and the share of the total population
that is working
• GDP= output per worker x share of population that’s working
 Consumption per person depends on

 How much each worker produces
 The share of people working
• GDP per capita increases when

– Output per worker (Y / N) increases
– The share of the population employed (N / POP) increases
Determinants of Average Labor Productivity
 In the long run, increases in output per person and hence living
standards arise primarily from increases in average labor
productivity
 Six factors determine average labor productivity

1. Human capital
2. Physical capital
3. Land and other natural resources
4. Technology
5. Entrepreneurship and management
6. Political and legal environment
1) Human Capital
• Human capital comprises the talents, education, training, and skills of
workers
– Human capital increases workers' productivity
• Cost-Benefit Principle applies to building human capital
– Premium paid to skilled workers
2) Physical Capital
• More and better capital increases worker productivity

Diminishing Returns to Capital
• Diminishing returns to capital occurs if an addition of capital with other inputs held
constant increases output by less than the previous increment of capital
– Assumption: all inputs except capital are held constant
– Result: output increases at a decreasing rate
• Implications of diminishing returns

– Increasing capital will increase output and labor productivity
• Positive contribution to growth
– There are limits to increasing productivity by adding capital because of
diminishing returns
3) Land and Other Natural Resources

• Inputs other than capital increase worker productivity:
– Land for farming
• Farmers are less than 3% of the population and they supply the U.S. and
export the surplus
• Manufacturing requires raw materials and energy
– Resources can be obtained through international markets

• Japan, Hong Kong, Singapore and Switzerland have high levels of GDP per
capita with a limited resource base
4) Technology
• New technologies are the single most important source of productivity improvement
• Technical change can affect industries beyond the primary application
– Transportation expanded
markets
– Medicine
– Communications
– Electronics and computers
5) Entrepreneurship and Management
 Entrepreneurs create new economic enterprises
– Essential to a dynamic, healthy, growing economy
• Examples
– Henry Ford and mass production
– Bill Gates and standardized graphical user interface operating system
– Larry Page and Sergey Brin and Google's search
• Policies should channel entrepreneurship in productive ways

– Taxation policy and regulatory regime
– Value innovation
• Scientific advances alone do not ensure technical change and
growth
6) Political and Legal Environment

• Encourage people to be economically productive
• Well-defined property rights are essential
– Who owns what and how those things can be used
– Reliable recourse through courts
• Maintain political stability
• Promote free and open exchange of ideas
Costs of Economic Growth:

• Increasing the capital stock will increase GDP
• Opportunity cost of producing more capital goods is
– Fewer consumer goods
• People may be willing to forego present consumption to have more in the
future
– Reduced leisure time
– Possible risks of health and safety from rapid capital production
– The cost of research and development (R&D) to improve technology
– The cost of education to develop and use new capital
Promote Growth with Human Capital:
• Governments support education and training programs
– U.S. public education support extends from kindergarten through institutions of
higher learning
– Head Start program for pre-school children
– Job training and retraining programs
• Government pays because education has externalities
– A democracy works better with educated voters
– Progressive taxes capture some of the higher income
– Increases chances of technical innovation
– Poor families could not pay
Promote Growth with Savings and Investment:
• Government policies can encourage new capital formation and saving in

the private sector
– Individual Retirement Accounts (IRAs) are an incentive for individuals
to save
– Government periodically offers investment tax credits
• Government can invest directly in capital formation
– Construction of infrastructure such as roads, bridges, airports, and
dams
– U.S. interstate highway system reduced costs of transporting goods,
making markets more efficient
Promote Growth with R&D Support
• Research and development promotes innovation
– Some types of research, such as basic science, create externalities that a private
firm cannot capture
• Silicon chip
– Fund basic science with National Science Foundation (NSF) and other
government grants
• Government sponsors research for military and space applications
– Government owns GPS satellites
• Maintain political and legal framework to support growth
Promoting Economic Growth in Least Developed:

• Prescription for more human and physical capital is broadly correct
– Appropriate technology and education
• Most countries need institutions to support growth
– Corruption creates uncertainty about property rights and drains financial
resources out of the country
– Regulation discourages entrepreneurship
– Taxes discourage risk-taking
– Markets do not function efficiently
– Lack of political stability discourages foreign investment
Limits to Growth:
• Can growth be sustained?

– Depletion of some natural resources
– Environmental damage and global warming
• Computer models suggested growth is not sustainable
– Did not adequately treat new and better products
– Greater income can pay for better environmental quality
– Ignored the market's response to increasing scarcity
• High prices trigger a response
• Strong response to energy crisis in mid 1970s
• Government action needed in case of externalities

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Chapter 7: Economic growth, productivity, and living standards.

Compound Interest Rates

 Equation of compound interest: (Base amount) (1+interest rate%) ^years

o Differences in interest rates matter

Real GDP per Capita:

• Average labor productivity: output per employed worker

 Consumption per person depends on

• GDP per capita increases when

 Six factors determine average labor productivity

• More and better capital increases worker productivity

• Implications of diminishing returns

3) Land and Other Natural Resources

– Resources can be obtained through international markets

• Policies should channel entrepreneurship in productive ways

6) Political and Legal Environment

Costs of Economic Growth:

Promote Growth with Savings and Investment:

• Government policies can encourage new capital formation and saving in

Promoting Economic Growth in Least Developed:

• Can growth be sustained?

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