Summary of Lecture Notes from Chapter 7 and Practice Questions
1. Economic prosperity, as measured by GDP per person, varies substantially around the world. The
average income in the world’s richest countries is more than ten times that in the world’s poorest
countries. Because growth rates of real GDP also vary substantially, the relative positions of
countries can change dramatically over time.
2. The standard of living in an economy depends on the economy’s ability to produce goods and
services. Productivity, in turn, depends on the amounts of physical capital, human capital, natural
resources, and technological knowledge available to workers.
3. 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, controlling population growth, and
promoting the research and development of new technologies.
4. The accumulation of capital is subject to diminishing returns: The more capital an economy has, the
less additional output the economy gets from an extra unit of capital. Because of diminishing
returns, higher saving leads to higher growth for a period of time, but growth eventually slows down
as the economy approaches a higher level of capital, productivity, and income. Also because of
diminishing returns, the return to capital is especially high in poor countries. Other things equal,
these countries can grow faster because of the catch-up effect.
I. Economic Growth Around the World
A. Table 1 shows data on real GDP per person for 13 countries during different periods of
1. The data reveal the fact that living standards vary a great deal between these
2. Growth rates are also reported in the table. Japan has had the largest growth
rate over time, 2.8 percent per year (on average).
3. Because of different growth rates, the ranking of countries by income per person
changes substantially over time.
a. In the late 19th century, the United Kingdom was the richest country in
1 2 ☞ Chapter 7/Production and Growth
b. Today, income per person is lower in the United Kingdom than in the
United States and Canada (two former colonies of the United Kingdom).
II. Productivity: Its Role and Determinants
A. Why Productivity Is So Important
1. Example: Robinson Crusoe
a. Because he is stranded alone, he must catch his own fish, grow his own
vegetables, and make his own clothes.
b. His standard of living depends on his ability to produce goods and
2. Definition of productivity: the amount of goods and services produced
for each hour of a worker’s time.
3. Review of Principle #8: A Country’s Standard of Living Depends on Its Ability to
Produce Goods and Services.
B. How Productivity Is Determined
1. Physical Capital
a. Definition of physical capital : the stock of equipment and
structures that are used to produce goods and services.
b. Example: Crusoe will catch more fish if he has more fishing poles.
2. Human Capital
a. Definition of human capital : the knowledge and skills that
workers acquire through education, training, and experience.
b. Example: Crusoe will catch more fish if he has been trained in the best
fishing techniques. Chapter 7/Production and Growth ☞ 3
3. Natural Resources
a. Definition of natural resources: the inputs into the production of
goods and services that are provided by nature, such as land,
rivers, and mineral deposits.
b. Example: Crusoe will have better luck catching fish if there is a plentiful
supply around his island.
c. Case Study: Are Natural Resources a Limit to Growth? This section points
out that as the population has grown over time, we have discovered
ways to lower our use of natural resources. Thus, most economists are
not worried about shortages of natural resources.
4. Technological Knowledge
a. Definition of technological knowledge : society’s understanding of
the best ways to produce goods and services.
b. Example: Crusoe will catch more fish if he has invented a better fishing
C. FYI: The Production Function
1. A production function describes the relationship between the quantity of inputs
used in production and the quantity of output from production.
2. The production function generally is written like this:
Y = A F(L, K, H, N)
where Y = output, L = quantity of labour, K = quantity of physical capital, H =
quantity of human capital, N = quantity of natural resources, A reflects the
available production technology, and F( ) is a function that shows how inputs are
combined to produce output.
3. Many production functions have a property called constant returns to scale.
a. This property implies that as all inputs are doubled, output will exactly
b. This implies that the following must be true:
xY = A F(xL, xK, xH, xN)
where x =2 if inputs are doubled.
c. This also means that if we want to examine output per worker, we could
set x = 1/L and we would get the following:
Y/L = A F(1, K/L, H/L, N/L) 4 ☞ Chapter 7/Production and Growth
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),
and the amount of natural resources per worker ( N/L).
III. Economic Growth and Public Policy
A. The Importance of Saving and Investment
1. Because capital is a produced factor of production, a society can change the
amount of capital that it has.
2. However, there is an opportunity cost of doing so; if resources are used to
produce capital goods, fewer goods and services are produced for current
a. Countries that devote a large share of GDP to investment tend to have
high growth rates in GDP per person.
b. However, from the data given, it is difficult to determine cause and
B. Diminishing Returns and the Catch-Up Effect
1. Definition of diminishing returns : the property whereby the benefit from
an extra unit of an input declines as the quantity of the input increases.
a. As the capital stock rises, the extra output produced from an additional
unit of capital will fall.
b. Thus, if workers already have a large amount of capital to work with,
giving them an additional unit of capital will not increase their
productivity by much.
c. In the long run, a higher saving rate leads t