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Chapter 7 Summary.pdf

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Bridget O' Shaughnessy

Summary of Lecture Notes from Chapter 7 and Practice Questions KEY POINTS: 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 time. 1. The data reveal the fact that living standards vary a great deal between these countries. 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 the world. 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 services. 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 lure. 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 double. 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 consumption. 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 effect. 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
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