523
Chapter
25
W
hen you travel around the world, you see tremendous variation in the
standard of living. The average income in a rich country, such as the United
States, Japan, or Germany, is more than ten times the average income in
a poor country, such as India, Indonesia, or Nigeria. These large differences in
income are reflected in large differences in the quality of life. People in richer
countries have better nutrition, safer housing, better healthcare, and longer life
expectancy as well as more automobiles, more telephones, and more televisions.
Even within a country, there are large changes in the standard of living over
time. In the United States over the past century, average income as measured
by real GDP (gross domestic product) per person has grown by about
2 percent per year. Although 2 percent might seem small, this rate of growth
­implies that average income doubles every 35 years. Because of this growth,
most Americans enjoy much greater economic prosperity than did their
­parents, grandparents, and great-grandparents.
Production and
Growth
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524	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
As a starting point for our study of long-run growth, let’s look at the experiences
of some of the world’s economies. Table 1 shows data on real GDP per person for
thirteen countries. For each country, the data cover more than a century of history.
The first and second columns of the table present the countries and time periods.
(The time periods differ somewhat from country to country because of differences
in data availability.) The third and fourth columns show estimates of real GDP per
person about a century ago and for a recent year.
The data on real GDP per person show that living standards vary widely from
country to country. Income per person in the United States, for instance, is about
six times that in China and about fourteen times that in India. The poorest countries
have average levels of income not seen in the developed world for many
decades. The typical citizen of India in 2010 had less real income than the typical
Growth rates vary substantially from country to country. In recent history,
some East Asian countries, such as Singapore, South Korea, and Taiwan, have
experienced economic growth of about 7 percent per year; at this rate, average
income doubles every 10 years. Over the past two decades, China has enjoyed an
even higher rate of growth—about 12 percent per year, according to some estimates.
A country experiencing such rapid growth can, in one generation, go from
being among the poorest in the world to being among the richest. By contrast, in
some nations in sub-Saharan Africa, average income has been stagnant for many
years. Zimbabwe has had one of the worst growth experiences: From 1991 to 2011,
income per person fell by a total of 38 percent.
What explains these diverse experiences? How can rich countries maintain
their high standard of living? What policies should poor countries pursue to promote
more rapid growth and join the developed world? These are among the
most important questions in macroeconomics. As the Nobel-Prize-winning economist
Robert Lucas put it, “The consequences for human welfare in questions like
these are simply staggering: Once one starts to think about them, it is hard to
think about anything else.”
In the previous two chapters, we discussed how economists measure
­macroeconomic quantities and prices. We can now begin to study the forces that
­determine these variables. As we have seen, an economy’s GDP measures both
the total income earned in the economy and the total expenditure on the economy’s
output of goods and services. The level of real GDP is a good gauge of
economic ­prosperity, and the growth of real GDP is a good gauge of economic
progress. In this chapter we focus on the long-run determinants of the level and
growth of real GDP. Later, we study the short-run fluctuations of real GDP around
its long-run trend.
We proceed here in three steps. First, we examine international data on real
GDP per person. These data will give you some sense of how much the level and
growth of living standards vary around the world. Second, we examine the role
of productivity—the amount of goods and services produced for each hour of a
worker’s time. In particular, we see that a nation’s standard of living is determined
by the productivity of its workers, and we consider the factors that determine
a nation’s productivity. Third, we consider the link between productivity
and the economic policies that a nation pursues.
25-1 Economic Growth around the World	THEREAETHERii	THEREAETHER	THEREAETHER
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	 CHAPTER 25 Production and Growth 525
The Variety of Growth
ExperiencesCountry Period
Real GDP per
Person at Beginning
of Perioda
Real GDP per
Person at End
of Perioda
Growth Rate
(per year)
Japan 1890–2010 $1,517 $34,810 2.65%
Brazil 1900–2010 785 10,980 2.43
Mexico 1900–2010 1,169 14,350 2.31
China 1900–2010 723 7,520 2.15
Germany 1870–2010 2,204 38,410 2.06
Canada 1870–2010 2,397 38,370 2.00
United States 1870–2010 4,044 47,210 1.77
Argentina 1900–2010 2,314 15,470 1.74
India 1900–2010 681 3,330 1.45
United Kingdom 1870–2010 4,853 35,620 1.43
Indonesia 1900–2010 899 4,180 1.41
Pakistan 1900–2010 744 2,760 1.20
Bangladesh 1900–2010 629 1,800 0.96
a
Real GDP is measured in 2010 dollars.
Source: Robert J. Barro and Xavier Sala-i-Martin, Economic Growth (New York: McGraw-Hill, 1995), Tables 10.2 and 10.3; World Development Indicators
online; and author’s calculations.
Table 1
resident of England in 1870. The typical person in Bangladesh in 2010 had less
than half the real income of a typical American a century ago.
The last column of the table shows each country’s growth rate. The growth
rate measures how rapidly real GDP per person grew in the typical year. In the
United States, for example, where real GDP per person was $4,044 in 1870 and
$47,210 in 2010, the growth rate was 1.77 percent per year. This means that if real
GDP per person, beginning at $4,044, were to increase by 1.77 percent for each of
140 years, it would end up at $47,210. Of course, real GDP per person did not rise
exactly 1.77 percent every year: Some years it rose by more, other years it rose by
less, and in still other years it fell. The growth rate of 1.77 percent per year ignores
short-run fluctuations around the long-run trend and represents an average rate
of growth for real GDP per person over many years.
The countries in Table 1 are ordered by their growth rate from the most to
the least rapid. Japan tops the list, with a growth rate of 2.65 percent per year.
A hundred years ago, Japan was not a rich country. Japan’s average income was
only somewhat higher than Mexico’s, and it was well behind Argentina’s. The
standard of living in Japan in 1890 was less than half of that in India today. But
because of its spectacular growth, Japan is now an economic superpower, with
average income more than twice that of Mexico and Argentina and similar to that
of Germany, Canada, and the United Kingdom. At the bottom of the list of countries
are Pakistan and Bangladesh, which have experienced growth of 1.2 percent
per year or less over the past century. As a result, the typical resident of these
countries continues to live in abject poverty.	 Poucionnow	 Poucionnow	 Poucionnow
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526	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
Are You Richer Than
the Richest American?
American Heritage magazine once published a list of the richest
Americans of all time. The number 1 spot went to John D. Rockefeller,
the oil entrepreneur who lived from 1839 to 1937. According to the
magazine’s calculations, his wealth would today be the equivalent of
about $200 billion, almost three times that of Bill Gates, the software
entrepreneur who is today’s richest American.
Despite his great wealth, Rockefeller did not enjoy many of the
conveniences that we now take for granted. He couldn’t watch television,
play video games, surf the Internet, or send e-mail. During the
heat of summer, he couldn’t cool his
home with air-­conditioning. For much
of his life, he couldn’t travel by car or
plane, and he couldn’t use a telephone
to call friends or family. If he became
ill, he couldn’t take advantage of many
medicines, such as antibiotics, that
doctors today routinely use to prolong
and enhance life.
Now consider: How
much money would someone
have to pay you to give
up for the rest of your life all the modern
conveniences that Rockefeller lived without?
Would you do it for $200 billion? Perhaps not. And if you wouldn’t, is it
fair to say that you are better off than John D. Rockefeller, allegedly the
richest American ever?
The preceding chapter discussed how standard price indexes,
which are used to compare sums of money from different points in
time, fail to fully reflect the introduction of new goods in the economy.
As a result, the rate of inflation is overestimated. The flip side
of this observation is that the rate of real economic growth is underestimated.
Pondering Rockefeller’s life shows how significant this
problem might be. Because of tremendous technological advances,
the average American today is arguably “richer” than the richest
American a century ago, even if that fact is lost in standard economic
statistics.
FYI
John D. Rockefeller
APPhotos
Because of differences in growth rates, the ranking of countries by income
changes substantially over time. As we have seen, Japan is a country that has
risen relative to others. One country that has fallen behind is the United Kingdom.
In 1870, the United Kingdom was the richest country in the world, with average
income about 20 percent higher than that of the United States and more than twice
Canada’s. Today, average income in the United Kingdom is 25 percent ­below that
of the United States and 7 percent below Canada’s.
These data show that the world’s richest countries have no guarantee they will
stay the richest and that the world’s poorest countries are not doomed to forever
remain in poverty. But what explains these changes over time? Why do some
countries zoom ahead while others lag behind? These are precisely the questions
that we take up next.
Quick Quiz  What has been the approximate long-run growth rate of real GDP per person
in the United States? Name a country that has had faster growth and a country that has
had slower growth.
25-2 Productivity: Its Role and Determinants
Explaining why living standards vary so much around the world is, in one sense,
very easy. The answer can be summarized in a single word—productivity. But in
another sense, the international variation in living standards is deeply puzzling. 	THEREAETHERii	THEREAETHER	THEREAETHER
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	 CHAPTER 25 Production and Growth 527
To explain why incomes are so much higher in some countries than in others, we
must look at the many factors that determine a nation’s productivity.
25-2a Why Productivity Is So Important
Let’s begin our study of productivity and economic growth by developing a simple
model based loosely on Daniel Defoe’s famous novel Robinson Crusoe about
a sailor stranded on a desert island. Because Crusoe lives alone, he catches his
own fish, grows his own vegetables, and makes his own clothes. We can think
of ­Crusoe’s activities—his production and consumption of fish, vegetables, and
clothing—as a simple economy. By examining Crusoe’s economy, we can learn
some lessons that also apply to more complex and realistic economies.
What determines Crusoe’s standard of living? In a word, productivity, the
quantity of goods and services produced from each unit of labor input. If Crusoe
is good at catching fish, growing vegetables, and making clothes, he lives well. If
he is bad at doing these things, he lives poorly. Because Crusoe gets to consume
only what he produces, his living standard is tied to his productivity.
In the case of Crusoe’s economy, it is easy to see that productivity is the key
determinant of living standards and that growth in productivity is the key determinant
of growth in living standards. The more fish Crusoe can catch per hour,
the more he eats at dinner. If Crusoe finds a better place to catch fish, his productivity
rises. This increase in productivity makes Crusoe better off: He can eat the
extra fish, or he can spend less time fishing and devote more time to making other
goods he enjoys.
Productivity’s key role in determining living standards is as true for nations as
it is for stranded sailors. Recall that an economy’s GDP measures two things at
once: the total income earned by everyone in the economy and the total expenditure
on the economy’s output of goods and services. GDP can measure these two
things simultaneously because, for the economy as a whole, they must be equal.
Put simply, an economy’s income is the economy’s output.
Like Crusoe, a nation can enjoy a high standard of living only if it can produce
a large quantity of goods and services. Americans live better than ­Nigerians
because American workers are more productive than Nigerian workers. The
Japanese have enjoyed more rapid growth in living standards than Argentineans
because Japanese workers have experienced more rapid growth in productivity.
Indeed, one of the Ten Principles of Economics in Chapter 1 is that a country’s standard
of living depends on its ability to produce goods and services.
Hence, to understand the large differences in living standards we observe
across countries or over time, we must focus on the production of goods and
services. But seeing the link between living standards and productivity is only
the first step. It leads naturally to the next question: Why are some economies so
much better at producing goods and services than others?
25-2b How Productivity Is Determined
Although productivity is uniquely important in determining Robinson ­Crusoe’s
standard of living, many factors determine Crusoe’s productivity. Crusoe will be
better at catching fish, for instance, if he has more fishing poles, if he has been
trained in the best fishing techniques, if his island has a plentiful fish supply,
or if he invents a better fishing lure. Each of these determinants of Crusoe’s
productivity—which we can call physical capital, human capital, natural resources,
and ­technological knowledge—has a counterpart in more complex and realistic
­economies. Let’s consider each factor in turn.
productivity
the quantity of goods and
services produced from
each unit of labor input	 Poucionnow	 Poucionnow	 Poucionnow
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528	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
A Picture Is Worth
a Thousand Statistics
George Bernard Shaw once said, “It is the mark of a truly intelligent
person to be moved by statistics.” Most of us, however, have trouble
being moved by data on GDP—until we see with our own eyes what
these statistics represent.
The three photos on these pages show a typical family from each
of three countries—the United Kingdom, Mexico, and Mali. Each family
was photographed outside their home, together with all their material
possessions.
These nations have very different standards of living, as judged by
these photos, GDP, or other statistics.
•	 The United Kingdom is an advanced economy. In 2011, its GDP per
person was $36,010. A negligible share of the population lives in
extreme poverty, defined here as less than $2 a day. A baby born
in the United Kingdom can expect a relatively healthy childhood:
Only 5 out of 1,000 children die before reaching age 5. Educational
attainment is high:
Among children of high
school age, 98 percent
are in school.
•	 Mexico is a middle-income country. In 2011, its GDP per person was
$15,390. About 5 percent of the population lives on less than $2 a
day, and 16 out of 1,000 children die before age 5. Among those of
high school age, 71 percent are in school.
•	 Mali is a poor country. In 2011, its GDP per person was only $1,040.
Extreme poverty is the norm: More than three-quarters of the population
lives on less than $2 per day. Life is often cut short: 176 out of
1,000 children die before age 5. And educational attainment in Mali
is low: Among those of high school age, only 31 percent are in school.
Economists who study economic growth try to understand what causes
such large differences in the standard of living.
FYI
A Typical Family in the United Kingdom
DavidReed-fromMATERIALWORLD	THEREAETHERii	THEREAETHER	THEREAETHER
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	 CHAPTER 25 Production and Growth 529
A Typical Family in Mexico
A Typical Family in Mali
PeterMenzel/menzelphoto.comPeterMenzel/menzelphoto.com	 Poucionnow	 Poucionnow	 Poucionnow
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530	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
Physical Capital per Worker  Workers are more productive if they have tools
with which to work. The stock of equipment and structures used to produce goods
and services is called physical capital, or just capital. For example, when woodworkers
make furniture, they use saws, lathes, and drill presses. More tools allow
the woodworkers to produce their output more quickly and more accurately:
A worker with only basic hand tools can make less furniture each week than a
worker with sophisticated and specialized woodworking equipment.
As you may recall, the inputs used to produce goods and services—labor, capital,
and so on—are called the factors of production. An important feature of capital
is that it is a produced factor of production. That is, capital is an input into the production
process that in the past was an output from the production process. The
woodworker uses a lathe to make the leg of a table. Earlier, the lathe itself was the
output of a firm that manufactures lathes. The lathe manufacturer in turn used
other equipment to make its product. Thus, capital is a factor of production used
to produce all kinds of goods and services, including more capital.
Human Capital per Worker  A second determinant of productivity is human
capital. Human capital is the economist’s term for the knowledge and skills that
workers acquire through education, training, and experience. Human capital includes
the skills accumulated in early childhood programs, grade school, high
school, college, and on-the-job training for adults in the labor force.
Education, training, and experience are less tangible than lathes, bulldozers,
and buildings, but human capital is like physical capital in many ways. Like
physical capital, human capital raises a nation’s ability to produce goods and services.
Also like physical capital, human capital is a produced factor of production.
Producing human capital requires inputs in the form of teachers, libraries, and
student time. Indeed, students can be viewed as “workers” who have the important
job of producing the human capital that will be used in future production.
Natural Resources per Worker  A third determinant of productivity is natural
resources. Natural resources are inputs into production that are provided by nature,
such as land, rivers, and mineral deposits. Natural resources take two forms:
renewable and nonrenewable. A forest is an example of a renewable resource.
When one tree is cut down, a seedling can be planted in its place to be harvested in
the future. Oil is an example of a nonrenewable resource. Because oil is produced
by nature over many millions of years, there is only a limited supply. Once the
supply of oil is depleted, it is impossible to create more.
Differences in natural resources are responsible for some of the differences in
standards of living around the world. The historical success of the United States
was driven in part by the large supply of land well suited for agriculture. Today,
some countries in the Middle East, such as Kuwait and Saudi Arabia, are rich simply
because they happen to be on top of some of the largest pools of oil in the
world.
Although natural resources can be important, they are not necessary for an
economy to be highly productive in producing goods and services. Japan, for instance,
is one of the richest countries in the world, despite having few natural resources.
International trade makes Japan’s success possible. Japan imports many
of the natural resources it needs, such as oil, and exports its manufactured goods
to economies rich in natural resources.
Technological Knowledge  A fourth determinant of productivity is technological
knowledge—the understanding of the best ways to produce goods and
physical capital
the stock of equipment
and structures that are
used to produce goods
and services
human capital
the knowledge and skills
that workers acquire
through education,
training, and experience
natural resources
the inputs into the
production of goods and
services that are provided
by nature, such as land,
rivers, and mineral
deposits
technological knowledge
society’s understanding of
the best ways to produce
goods and services	THEREAETHERii	THEREAETHER	THEREAETHER
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	 CHAPTER 25 Production and Growth 531
services. A hundred years ago, most Americans worked on farms because farm
technology required a high input of labor to feed the entire population. Today,
thanks to advances in farming technology, a small fraction of the population can
produce enough food to feed the entire country. This technological change made
labor available to produce other goods and services.
Technological knowledge takes many forms. Some technology is common
knowledge—after one person uses it, everyone becomes aware of it. For example,
once Henry Ford successfully introduced assembly-line production, other
carmakers quickly followed suit. Other technology is proprietary—it is known
only by the company that discovers it. Only the Coca-Cola Company, for instance,
knows the secret recipe for making its famous soft drink. Still other technology is
proprietary for a short time. When a pharmaceutical company discovers a new
drug, the patent system gives that company a temporary right to be its exclusive
manufacturer. When the patent expires, however, other companies are allowed to
make the drug. All these forms of technological knowledge are important for the
economy’s production of goods and services.
It is worthwhile to distinguish between technological knowledge and human
capital. Although they are closely related, there is an important difference.
­Technological knowledge refers to society’s understanding about how the world
works. Human capital refers to the resources expended transmitting this understanding
to the labor force. To use a relevant metaphor, technological knowledge
is the quality of society’s textbooks, whereas human capital is the amount of time
that the population has devoted to reading them. Workers’ productivity depends
on both.
The Production Function
Economists often use a production function to describe the relationship
between the quantity of inputs used in production and the
quantity of output from production. For example, suppose Y denotes the
quantity of output, L the quantity of labor, K the quantity of physical
capital, H the quantity of human capital, and N the quantity of natural
resources. Then we might write
Y = AF(L, K, H, N),
where F ( ) is a function that shows how the inputs are combined to
produce output. A is a variable that reflects the available production
technology. As technology improves, A rises, so the economy produces
more output from any given combination of inputs.
Many production functions have a property called constant returns
to scale. If a production function has constant returns to scale, then
doubling all inputs causes the amount of output to double as well.
Mathematically, we write that a production function has constant
­returns to scale if, for any positive number x,
xY = AF(xL, xK, xH, xN).
A doubling of all inputs
would be represented in
this equation by x = 2.
The right side shows the inputs doubling,
and the left side shows output doubling.
Production functions with constant returns to scale have an interesting
and useful implication. To see this implication, set x = 1/L so
that the preceding equation becomes
Y/L = AF(1, K/L, H/L, N/L).
Notice that Y/L is output per worker, which is a measure of productivity.
This equation says that labor productivity depends on physical
capital per worker (K/L), human capital per worker (H/L), and natural
resources per worker (N/L). Productivity also depends on the state of
technology, as reflected by the variable A. Thus, this equation provides
a mathematical summary of the four determinants of productivity we
have just discussed.
FYI
	 Poucionnow	 Poucionnow	 Poucionnow
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532	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
Are Natural Resources a Limit to Growth?
Today, the world’s population is almost 7 billion, more than four
times what it was a century ago. At the same time, many people are
­enjoying a much higher standard of living than did their great-­grandparents.
A perennial debate concerns whether this growth in population and living
standards can continue in the future.
Many commentators have argued that natural resources will eventually limit
how much the world’s economies can grow. At first, this argument might seem
hard to ignore. If the world has only a fixed supply of nonrenewable natural
­resources, how can population, production, and living standards continue to
grow over time? Eventually, won’t supplies of oil and minerals start to run out?
When these shortages start to occur, won’t they stop economic growth and, perhaps,
even force living standards to fall?
Despite the apparent appeal of such arguments, most economists are less
concerned about such limits to growth than one might guess. They argue that
­technological progress often yields ways to avoid these limits. If we compare
the economy today to the economy of the past, we see various ways in which
the use of natural resources has improved. Modern cars have better gas mileage.
New houses have better insulation and require less energy to heat and cool.
More ­efficient oil rigs waste less oil in the process of extraction. Recycling allows
some nonrenewable resources to be reused. The development of alternative fuels,
such as ethanol instead of gasoline, allows us to substitute renewable for nonrenewable
resources.
Seventy years ago, some conservationists were concerned about the excessive
use of tin and copper. At the time, these were crucial commodities: Tin was used to
make many food containers, and copper was used to make telephone wire. Some
people advocated mandatory recycling and rationing of tin and copper so that
supplies would be available for future generations. Today, however, plastic has
replaced tin as a material for making many food containers, and phone calls often
travel over fiber-optic cables, which are made from sand. Technological progress
has made once crucial natural resources less necessary.
But are all these efforts enough to permit continued economic growth? One
way to answer this question is to look at the prices of natural resources. In a
market economy, scarcity is reflected in market prices. If the world were running
out of natural resources, then the prices of those resources would be rising
over time. But in fact, the opposite is more often true. Natural resource prices
exhibit substantial short-run fluctuations, but over long spans of time, the prices
of most ­natural resources (adjusted for overall inflation) are stable or falling. It
appears that our ability to conserve these resources is growing more rapidly than
their supplies are dwindling. Market prices give no reason to believe that natural
­resources are a limit to economic growth.
case
study
Quick Quiz  List and describe four determinants of a country’s productivity.
25-3 Economic Growth and Public Policy
So far, we have determined that a society’s standard of living depends on its
ability to produce goods and services and that its productivity in turn depends
on physical capital per worker, human capital per worker, natural resources per 	THEREAETHERii	THEREAETHER	THEREAETHER
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 25 Production and Growth 533
worker, and technological knowledge. Let’s now turn to the question faced by
policymakers around the world: What can government policy do to raise productivity
and living standards?
25-3a Saving and Investment
Because capital is a produced factor of production, a society can change the
amount of capital it has. If today the economy produces a large quantity of new
capital goods, then tomorrow it will have a larger stock of capital and be able to
produce more goods and services. Thus, one way to raise future productivity is to
invest more current resources in the production of capital.
One of the Ten Principles of Economics presented in Chapter 1 is that people face
trade-offs. This principle is especially important when considering the accumulation
of capital. Because resources are scarce, devoting more resources to producing
capital requires devoting fewer resources to producing goods and services for
current consumption. That is, for society to invest more in capital, it must consume
less and save more of its current income. The growth that arises from capital
accumulation is not a free lunch: It requires that society sacrifice consumption of
goods and services in the present to enjoy higher consumption in the future.
The next chapter examines in more detail how the economy’s financial markets
coordinate saving and investment. It also examines how government policies influence
the amount of saving and investment that takes place. At this point, it is
important to note that encouraging saving and investment is one way that a government
can encourage growth and, in the long run, raise the economy’s standard
of living.
25-3b Diminishing Returns and the Catch-Up Effect
Suppose that a government pursues policies that raise the nation’s saving
rate—the percentage of GDP devoted to saving rather than consumption. What
happens? With the nation saving more, fewer resources are needed to make consumption
goods, and more resources are available to make capital goods. As a
result, the capital stock increases, leading to rising productivity and more rapid
growth in GDP. But how long does this higher rate of growth last? Assuming that
the saving rate remains at its new, higher level, does the growth rate of GDP stay
high indefinitely or only for a period of time?
The traditional view of the production process is that capital is subject to
­diminishing returns: As the stock of capital rises, the extra output produced from
an additional unit of capital falls. In other words, when workers already have a
large quantity of capital to use in producing goods and services, giving them an
additional unit of capital increases their productivity only slightly. This is illustrated
in Figure 1, which shows how the amount of capital per worker determines
the amount of output per worker, holding constant all the other determinants of
output.
Because of diminishing returns, an increase in the saving rate leads to higher
growth only for a while. As the higher saving rate allows more capital to be
­accumulated, the benefits from additional capital become smaller over time, and
so growth slows down. In the long run, the higher saving rate leads to a higher level of
productivity and income but not to higher growth in these variables. Reaching this long
run, however, can take quite a while. According to studies of international data
on economic growth, increasing the saving rate can lead to substantially higher
growth for a period of several decades.
The property of diminishing returns to capital has another important implication:
Other things being equal, it is easier for a country to grow fast if it starts out
diminishing returns
the property whereby the
benefit from an extra unit
of an input declines as
the quantity of the input
increases	 Poucionnow	 Poucionnow	 Poucionnow
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534	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
relatively poor. This effect of initial conditions on subsequent growth is sometimes
called the catch-up effect. In poor countries, workers lack even the most rudimentary
tools and, as a result, have low productivity. Thus, small amounts of capital
investment can substantially raise these workers’ productivity. By contrast, workers
in rich countries have large amounts of capital with which to work, and this
partly explains their high productivity. Yet with the amount of capital per worker
already so high, additional capital investment has a relatively small effect on productivity.
Studies of international data on economic growth confirm this catch-up
effect: Controlling for other variables, such as the percentage of GDP devoted to
investment, poor countries tend to grow at faster rates than rich countries.
This catch-up effect can help explain some otherwise puzzling facts. Here’s an
example: From 1960 to 1990, the United States and South Korea devoted a similar
share of GDP to investment. Yet over this time, the United States experienced
only mediocre growth of about 2 percent, while South Korea experienced spectacular
growth of more than 6 percent. The explanation is the catch-up effect. In
1960, South Korea had GDP per person less than one-tenth the U.S. level, in part
­because previous investment had been so low. With a small initial capital stock,
the benefits to capital accumulation were much greater in South Korea, and this
gave South Korea a higher subsequent growth rate.
This catch-up effect shows up in other aspects of life. When a school gives an
end-of-year award to the “Most Improved” student, that student is usually one
who began the year with relatively poor performance. Students who began the
year not studying find improvement easier than students who always worked
hard. Note that it is good to be “Most Improved,” given the starting point, but it is
even better to be “Best Student.” Similarly, economic growth over the last several
FIGURE 1
Illustrating the Production
Function
This figure shows how the
amount of capital per worker
influences the amount of output
per worker. Other determinants
of output, including human
capital, natural resources, and
technology, are held constant.
The curve becomes flatter as
the amount of capital increases
because of diminishing returns
to capital.
Output
per Worker
1
1
Capital per
Worker
1. When the economy has a low level of capital, an extra unit
of capital leads to a large increase in output.
2. When the economy has a high
level of capital, an extra unit of
capital leads to a small increase
in output.
catch-up effect
the property whereby
countries that start off
poor tend to grow more
rapidly than countries
that start off rich	THEREAETHERii	THEREAETHER	THEREAETHER
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	 CHAPTER 25 Production and Growth 535
decades has been much more rapid in South Korea than in the United States, but
GDP per person is still higher in the United States.
25-3c Investment from Abroad
So far, we have discussed how policies aimed at increasing a country’s saving rate
can increase investment and, thereby, long-term economic growth. Yet saving by
domestic residents is not the only way for a country to invest in new capital. The
other way is investment by foreigners.
Investment from abroad takes several forms. Ford Motor Company might
build a car factory in Mexico. A capital investment that is owned and operated
by a foreign entity is called foreign direct investment. Alternatively, an American
might buy stock in a Mexican corporation (that is, buy a share in the ownership
of the corporation); the Mexican corporation can use the proceeds from the stock
sale to build a new factory. An investment that is financed with foreign money
but operated by domestic residents is called foreign portfolio investment. In both
cases, Americans provide the resources necessary to increase the stock of capital
in Mexico. That is, American saving is being used to finance Mexican investment.
When foreigners invest in a country, they do so because they expect to earn a
return on their investment. Ford’s car factory increases the Mexican capital stock
and, therefore, increases Mexican productivity and Mexican GDP. Yet Ford takes
some of this additional income back to the United States in the form of profit.
Similarly, when an American investor buys Mexican stock, the investor has a right
to a portion of the profit that the Mexican corporation earns.
Investment from abroad, therefore, does not have the same effect on all measures
of economic prosperity. Recall that gross domestic product (GDP) is the income
earned within a country by both residents and nonresidents, whereas gross
national product (GNP) is the income earned by residents of a country both at
home and abroad. When Ford opens its car factory in Mexico, some of the income
the factory generates accrues to people who do not live in Mexico. As a result, foreign
investment in Mexico raises the income of Mexicans (measured by GNP) by
less than it raises the production in Mexico (measured by GDP).
Nonetheless, investment from abroad is one way for a country to grow. Even
though some of the benefits from this investment flow back to the foreign owners,
this investment does increase the economy’s stock of capital, leading to higher
productivity and higher wages. Moreover, investment from abroad is one way
for poor countries to learn the state-of-the-art technologies developed and used
in richer countries. For these reasons, many economists who advise governments
in less developed economies advocate policies that encourage investment from
abroad. Often, this means removing restrictions that governments have imposed
on foreign ownership of domestic capital.
An organization that tries to encourage the flow of capital to poor countries is
the World Bank. This international organization obtains funds from the world’s
advanced countries, such as the United States, and uses these resources to make
loans to less developed countries so that they can invest in roads, sewer systems,
schools, and other types of capital. It also offers the countries advice about how
the funds might best be used. The World Bank, together with its sister organization,
the International Monetary Fund, was set up after World War II. One lesson
from the war was that economic distress often leads to political turmoil, international
tensions, and military conflict. Thus, every country has an interest in
promoting economic prosperity around the world. The World Bank and the International
Monetary Fund were established to achieve that common goal.	 Poucionnow	 Poucionnow	 Poucionnow
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536	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
25-3d Education
Education—investment in human capital—is at least as important as investment
in physical capital for a country’s long-run economic success. In the United States,
each year of schooling has historically raised a person’s wage by an average of
about 10 percent. In less developed countries, where human capital is especially
scarce, the gap between the wages of educated and uneducated workers is even
larger. Thus, one way government policy can enhance the standard of living is to
provide good schools and to encourage the population to take advantage of them.
Investment in human capital, like investment in physical capital, has an
­opportunity cost. When students are in school, they forgo the wages they could
have earned as members of the labor force. In less developed countries, children
often drop out of school at an early age, even though the benefit of additional
schooling is very high, simply because their labor is needed to help support the
family.
Some economists have argued that human capital is particularly important
for economic growth because human capital conveys positive externalities. An
­externality is the effect of one person’s actions on the well-being of a bystander.
An educated person, for instance, might generate new ideas about how best to
produce goods and services. If these ideas enter society’s pool of knowledge so
that everyone can use them, then the ideas are an external benefit of education. In
this case, the return from schooling for society is even greater than the return for
the individual. This argument would justify the large subsidies to human-capital
investment that we observe in the form of public education.
One problem facing some poor countries is the brain drain—the emigration of
many of the most highly educated workers to rich countries, where these workers
can enjoy a higher standard of living. If human capital does have positive
externalities, then this brain drain makes those people left behind even poorer.
This problem offers policymakers a dilemma. On the one hand, the United States
and other rich countries have the best systems of higher education, and it would
seem natural for poor countries to send their best students abroad to earn higher
­degrees. On the other hand, those students who have spent time abroad may
choose not to return home, and this brain drain will reduce the poor nation’s stock
of human capital even further.
25-3e Health and Nutrition
The term human capital usually refers to education, but it can also be used to
­describe another type of investment in people: expenditures that lead to a healthier
population. Other things being equal, healthier workers are more productive.
The right investments in the health of the population provide one way for a ­nation
to increase productivity and raise living standards.
According to the late economic historian Robert Fogel, improved health from
better nutrition has been a significant factor in long-run economic growth. Fogel
estimated that in Great Britain in 1780, about one in five people were so malnourished
that they were incapable of manual labor. Among those who could work,
insufficient caloric intake substantially reduced the work effort they could put
forth. As nutrition improved, so did workers’ productivity.
Fogel studied these historical trends in part by looking at the height of the population.
Short stature can be an indicator of malnutrition, especially during gestation
and the early years of life. Fogel found that as nations develop economically,
people eat more and the population gets taller. From 1775 to 1975, the average 	THEREAETHERii	THEREAETHER	THEREAETHER
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	 CHAPTER 25 Production and Growth 537
caloric intake in Great Britain rose by 26 percent and the height of the average
man rose by 3.6 inches. Similarly, during the spectacular economic growth in
South Korea from 1962 to 1995, caloric consumption rose by 44 percent and average
male height rose by 2 inches. Of course, a person’s height is determined by a
combination of genetics and environment. But because the genetic makeup of a
population is slow to change, such increases in average height are most likely due
to changes in the environment—nutrition being the obvious explanation.
Moreover, studies have found that height is an indicator of productivity.
­Looking at data on a large number of workers at a point in time, researchers have
found that taller workers tend to earn more. Because wages reflect a worker’s
productivity, this finding suggests that taller workers tend to be more productive.
The effect of height on wages is especially pronounced in poorer countries, where
malnutrition is a bigger risk.
Fogel won the Nobel Prize in Economics in 1993 for his work in economic
history, which includes not only his studies of nutrition but also his studies of
American slavery and the role of railroads in the development of the American
economy. In the lecture he gave when he was awarded the prize, he surveyed the
evidence on health and economic growth. He concluded that “improved gross
nutrition accounts for roughly 30 percent of the growth of per capita income in
Britain between 1790 and 1980.”
Today, malnutrition is fortunately rare in developed nations such as Great
­Britain and the United States. (Obesity is a more widespread problem.) But for
people in developing nations, poor health and inadequate nutrition remain
­obstacles to higher productivity and improved living standards. The United
Nations estimates that almost a third of the population in sub-Saharan Africa is
undernourished.
The causal link between health and wealth runs in both directions. Poor countries
are poor in part because their populations are not healthy, and their populations
are not healthy in part because they are poor and cannot afford adequate
healthcare and nutrition. It is a vicious circle. But this fact opens the possibility of
a virtuous circle: Policies that lead to more rapid economic growth would naturally
improve health outcomes, which in turn would further promote economic
growth.
25-3f Property Rights and Political Stability
Another way policymakers can foster economic growth is by protecting property
rights and promoting political stability. This issue goes to the very heart of how
market economies work.
Production in market economies arises from the interactions of millions of
­individuals and firms. When you buy a car, for instance, you are buying the
output of a car dealer, a car manufacturer, a steel company, an iron ore mining
company, and so on. This division of production among many firms allows the
economy’s factors of production to be used as effectively as possible. To achieve
this outcome, the economy has to coordinate transactions among these firms, as
well as between firms and consumers. Market economies achieve this coordination
through market prices. That is, market prices are the instrument with which
the invisible hand of the marketplace brings supply and demand into balance in
each of the many thousands of markets that make up the economy.
An important prerequisite for the price system to work is an economy-wide
respect for property rights. Property rights refer to the ability of people to exercise 	 Poucionnow	 Poucionnow	 Poucionnow
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538	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
authority over the resources they own. A mining company will not make the
­effort to mine iron ore if it expects the ore to be stolen. The company mines the ore
only if it is confident that it will benefit from the ore’s subsequent sale. For this
reason, courts serve an important role in a market economy: They enforce property
rights. Through the criminal justice system, the courts discourage theft. In
addition, through the civil justice system, the courts ensure that buyers and sellers
live up to their contracts.
Those of us in developed countries tend to take property rights for granted, but
those living in less developed countries understand that a lack of property rights
can be a major problem. In many countries, the system of justice does not work
well. Contracts are hard to enforce, and fraud often goes unpunished. In more
extreme cases, the government not only fails to enforce property rights but actually
infringes upon them. To do business in some countries, firms are expected to
bribe government officials. Such corruption impedes the coordinating power of
markets. It also discourages domestic saving and investment from abroad.
One threat to property rights is political instability. When revolutions and
coups are common, there is doubt about whether property rights will be respected
in the future. If a revolutionary government might confiscate the capital of some
businesses, as was often true after communist revolutions, domestic residents
Food Aid to Developing
Nations May Increase
Armed Conflict
By Justin Lahart
The country is torn by conflict. The people
are hungry.
Our natural response is to send food, but in
practice that can be problematic. For decades,
aid workers, journalists and others have documented
cases where food aid has been misappropriated
by armed groups who use it to feed
their soldiers and buy weapons. Convoy trucks
and other equipment are often captured.
Such reports are, in the end, merely
­anecdotal, and may only represent ­extreme,
outlying cases. Moreover, there are chickenand-egg
problems such as the question of
whether the food aid heightened the conflict,
or whether the brewing conflict brought in the
food aid.
But Harvard’s Nathan Nunn and Yale’s
Nancy Qian devised a way to sidestep such issues
and more directly measure what is happening.
Their results are sobering.
The flow of American food aid, the economists
found, has a lot to do with the wheat
crop. In bumper years, the U.S. government
accumulates wheat as part of its price support
program. In the following year, the surplus is
shipped to developing countries as food aid.
This allowed the economists to tease out the
effects of the flow of food to 134 ­developing
countries from 1972 through 2006.
They found that an increase in food aid
raises the incidence, onset and duration of
armed civil conflict in a recipient country.
The problem is particularly acute in countries
where there are few roads—giving aid
convoys fewer opportunities to circumvent
­problems—and ones where there are stark
ethnic divisions.
The economists note that food, because
it is bulky and needs to be transported
across territories a country may have little
control over, is an especially attractive target
for armed groups. As a result, they say,
“our ­results should not be extrapolated as
evidence of the impacts of foreign aid in
­general.”
Source: The Wall Street Journal, Real Time Economics blog,
January 30, 2012.
Does Food Aid Help
or Hurt?
Economic policies often have unintended consequences.
Here is an example.
In the News
	THEREAETHERii	THEREAETHER	THEREAETHER
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	 CHAPTER 25 Production and Growth 539
have less incentive to save, invest, and start new businesses. At the same time, foreigners
have less incentive to invest in the country. Even the threat of revolution
can act to depress a nation’s standard of living.
Thus, economic prosperity depends in part on political prosperity. A country
with an efficient court system, honest government officials, and a stable constitution
will enjoy a higher economic standard of living than a country with a poor
court system, corrupt officials, and frequent revolutions and coups.
25-3g Free Trade
Some of the world’s poorest countries have tried to achieve more rapid economic
growth by pursuing inward-oriented policies. These policies attempt to increase
productivity and living standards within the country by avoiding interaction
with the rest of the world. Domestic firms often advance the infant-industry
­argument, claiming they need protection from foreign competition to thrive and
grow. ­Together with a general distrust of foreigners, this argument has at times
led policymakers in less developed countries to impose tariffs and other trade
restrictions.
Most economists today believe that poor countries are better off pursuing
­outward-oriented policies that integrate these countries into the world economy.
­International trade in goods and services can improve the economic well-being of
a country’s citizens. Trade is, in some ways, a type of technology. When a country
exports wheat and imports textiles, the country benefits as if it had invented a
technology for turning wheat into textiles. A country that eliminates trade restrictions
will, therefore, experience the same kind of economic growth that would
occur after a major technological advance.
The adverse impact of inward orientation becomes clear when one considers
the small size of many less developed economies. The total GDP of Argentina,
for instance, is about that of Houston, Texas. Imagine what would happen if the
Houston city council were to prohibit city residents from trading with people living
outside the city limits. Without being able to take advantage of the gains from
trade, Houston would need to produce all the goods it consumes. It would also
have to produce all its own capital goods, rather than importing state-of-the-art
equipment from other cities. Living standards in Houston would fall immediately,
and the problem would likely only get worse over time. This is precisely
what happened when Argentina pursued inward-oriented policies throughout
much of the 20th century. In contrast, countries that pursued outward-oriented
policies, such as South Korea, Singapore, and Taiwan, enjoyed high rates of economic
growth.
The amount that a nation trades with others is determined not only by government
policy but also by geography. Countries with natural seaports find trade
easier than countries without this resource. It is not a coincidence that many of
the world’s major cities, such as New York, San Francisco, and Hong Kong, are
located next to oceans. Similarly, because landlocked countries find international
trade more difficult, they tend to have lower levels of income than countries
with easy access to the world’s waterways. For example, countries with more
than 80 percent of their population living within 100 kilometers of a coast have
an ­average GDP per person about four times as large as countries with less than
20 percent of their population living near a coast. The critical importance of access
to the sea helps explain why the African continent, which contains many landlocked
countries, is so poor.	 Poucionnow	 Poucionnow	 Poucionnow
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540	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
25-3h Research and Development
The primary reason that living standards are higher today than they were a ­century
ago is that technological knowledge has advanced. The telephone, the transistor,
the computer, and the internal combustion engine are among the thousands of
­innovations that have improved the ability to produce goods and services.
Most technological advances come from private research by firms and individual
inventors, but there is also a public interest in promoting these efforts.
To a large extent, knowledge is a public good: That is, once one person discovers
an idea, the idea enters society’s pool of knowledge and other people can freely
use it. Just as government has a role in providing a public good such as national
defense, it also has a role in encouraging the research and development of new
technologies.
The U.S. government has long played a role in the creation and dissemination
of technological knowledge. A century ago, the government sponsored research
about farming methods and advised farmers how best to use their land. More
recently, the U.S. government, through the Air Force and NASA, has supported
aerospace research; as a result, the United States is a leading maker of rockets
and planes. The government continues to encourage advances in knowledge with
­research grants from the National Science Foundation and the National Institutes
of Health and with tax breaks for firms engaging in research and development.
Yet another way in which government policy encourages research is through
the patent system. When a person or firm invents a new product, such as a new
drug, the inventor can apply for a patent. If the product is deemed truly original,
the government awards the patent, which gives the inventor the exclusive right to
make the product for a specified number of years. In essence, the patent gives the
inventor a property right over her invention, turning her new idea from a public
good into a private good. By allowing inventors to profit from their inventions—
even if only temporarily—the patent system enhances the incentive for individuals
and firms to engage in research.
25-3i Population Growth
Economists and other social scientists have long debated how population affects
a society. The most direct effect is on the size of the labor force: A large population
means more workers to produce goods and services. The tremendous size of the
Chinese population is one reason China is such an important player in the world
economy.
At the same time, however, a large population means more people to consume
those goods and services. So while a large population means a larger total output
of goods and services, it need not mean a higher standard of living for a typical
citizen. Indeed, both large and small nations are found at all levels of economic
development.
Beyond these obvious effects of population size, population growth interacts
with the other factors of production in ways that are more subtle and open to
debate.
Stretching Natural Resources  Thomas Robert Malthus (1766–1834), an
­English minister and early economic thinker, is famous for his book called An
­Essay on the Principle of Population as It Affects the Future Improvement of Society. In
it, he offered what may be history’s most chilling forecast. Malthus argued that an
ever-increasing population would continually strain society’s ability to provide
for itself. As a result, mankind was doomed to forever live in poverty.	THEREAETHERii	THEREAETHER	THEREAETHER
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	 CHAPTER 25 Production and Growth 541
Malthus’s logic was simple. He began by noting that “food is necessary to the
existence of man” and that “the passion between the sexes is necessary and will
remain nearly in its present state.” He concluded that “the power of population
is infinitely greater than the power in the earth to produce subsistence for man.”
According to Malthus, the only check on population growth was “misery and
vice.” Attempts by charities or governments to alleviate poverty were counterproductive,
he argued, because they merely allowed the poor to have more children,
placing even greater strains on society’s productive capabilities.
Malthus may have correctly described the world at the time when he lived,
but fortunately, his dire forecast was far off the mark. The world population has
­increased about sixfold over the past two centuries, but living standards around
the world are on average much higher. As a result of economic growth, chronic
hunger and malnutrition are less common now than they were in Malthus’s day.
Modern famines occur from time to time but are more often the result of an ­unequal
income distribution or political instability than inadequate food production.
Where did Malthus go wrong? As we discussed in a case study earlier in this
chapter, growth in human ingenuity has offset the effects of a larger population.
Pesticides, fertilizers, mechanized farm equipment, new crop varieties, and other
technological advances that Malthus never imagined have allowed each farmer to
feed ever greater numbers of people. Even with more mouths to feed, fewer farmers
are necessary because each farmer is much more productive.
Diluting the Capital Stock  Whereas Malthus worried about the effects of population
on the use of natural resources, some modern theories of economic growth
emphasize its effects on capital accumulation. According to these theories, high
population growth reduces GDP per worker because rapid growth in the number of
workers forces the capital stock to be spread more thinly. In other words, when population
growth is rapid, each worker is equipped with less capital. A smaller quantity
of capital per worker leads to lower productivity and lower GDP per worker.
This problem is most apparent in the case of human capital. Countries with
high population growth have large numbers of school-age children. This places a
larger burden on the educational system. It is not surprising, therefore, that educational
attainment tends to be low in countries with high population growth.
The differences in population growth around the world are large. In developed
countries, such as the United States and those in Western Europe, the population
has risen only about 1 percent per year in recent decades and is expected to rise
even more slowly in the future. By contrast, in many poor African countries, population
grows at about 3 percent per year. At this rate, the population doubles
every 23 years. This rapid population growth makes it harder to provide workers
with the tools and skills they need to achieve high levels of productivity.
Rapid population growth is not the main reason that less developed countries
are poor, but some analysts believe that reducing the rate of population growth
would help these countries raise their standards of living. In some countries, this
goal is accomplished directly with laws that regulate the number of children families
may have. China, for instance, allows only one child per family; couples who
violate this rule are subject to substantial fines. In countries with greater freedom,
the goal of reduced population growth is accomplished less directly by increasing
awareness of birth control techniques.
Another way in which a country can influence population growth is to ­apply
one of the Ten Principles of Economics: People respond to incentives. Bearing a child,
like any decision, has an opportunity cost. When the opportunity cost rises, people
Thomas Robert Malthus
2002ARPL/Topham/TheImageWorks	 Poucionnow	 Poucionnow	 Poucionnow
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542	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
What Makes a Nation
Rich?
By Daron Acemoglu
We are the rich, the haves, the developed.
And most of the rest—in Africa, South
Asia, and South America, the Somalias and
Bolivias and Bangladeshes of the world—are
the nots. It’s always been this way, a globe
divided by wealth and poverty, health and
sickness, food and famine, though the extent
of inequality across nations today is unprecedented:
The average citizen of the United
States is ten times as prosperous as the average
Guatemalan, more than twenty times as
prosperous as the average North Korean, and
more than forty times as prosperous as those
living in Mali, Ethiopia, Congo, or Sierra Leone.
The question social scientists have
­unsuccessfully wrestled with for centuries
is, Why? But the question they should have
been asking is, How? Because inequality
is not predetermined. Nations are not like
children—they are not born rich or poor. Their
governments make them that way.
You can chart the search for a theory of
inequality to the French political philosopher
Montesquieu, who in the mid-eighteenth century
came up with a very simple explanation:
People in hot places are inherently lazy. Other
no less sweeping explanations soon followed:
Could it be that Max Weber’s Protestant work
ethic is the true driver of economic success?
Or perhaps the richest countries are those
that were former British colonies? Or maybe
it’s as simple as tracing which nations have
the largest populations of European descent?
The problem with all of these theories is that
while they superficially fit some specific
cases, others radically disprove them.
It’s the same with the theories put forth
today. Economist Jeffrey Sachs, director of
Columbia University’s Earth Institute, attributes
the relative success of nations to
­geography and weather: In the poorest parts
of the world, he argues, nutrient-starved
tropical soil makes agriculture a challenge,
and tropical climates foment disease, particularly
malaria. Perhaps if we were to fix
these problems, teach the citizens of these
nations better farming techniques, eliminate
malaria, or at the very least equip them with
artemisinin to fight this deadly disease, we
could eliminate poverty. Or better yet, perhaps
we just move these people and abandon their
inhospitable land altogether.
Jared Diamond, the famous ecologist and
best-selling author, has a different theory:
The origin of world inequality stems from the
historical endowment of plant and animal
species and the advancement of technology.
In Diamond’s telling, the cultures that
first learned to plant crops were the first to
learn how to use a plow, and thus were first to
adopt other technologies, the engine of every
successful economy. Perhaps then the solution
to world inequality rests in technology—
wiring the developing world with Internet and
cell phones.
And yet while Sachs and Diamond offer
good insight into certain aspects of poverty,
they share something in common with Montesquieu
and others who followed: They ignore
incentives. People need incentives to invest
and prosper; they need to know that if they
work hard, they can make money and actually
keep that money. And the key to ensuring
those incentives is sound institutions—the
rule of law and security and a governing
system that offers opportunities to achieve
and innovate. That’s what determines the
haves from the have-nots—not geography or
weather or technology or disease or ethnicity.
Put simply: Fix incentives and you will fix
poverty. And if you wish to fix institutions, you
have to fix governments.
How do we know that institutions are
so central to the wealth and poverty of nations?
Start in Nogales, a city cut in half by
the ­Mexican-American border fence. There is
no difference in geography between the two
halves of Nogales. The weather is the same.
The winds are the same, as are the soils. The
types of diseases prevalent in the area given
its geography and climate are the same, as
One Economist’s Answer
This article offers one perspective on the profound question of why
some nations thrive while others do not.
In the News
will choose to have smaller families. In particular, women with the opportunity to
receive a good education and desirable employment tend to want fewer children
than those with fewer opportunities outside the home. Hence, policies that foster
equal treatment of women may be one way for less developed economies to
­reduce the rate of population growth and, perhaps, raise their standards of living.
Promoting Technological Progress  Rapid population growth may depress
economic prosperity by reducing the amount of capital each worker has, but it
	THEREAETHERii	THEREAETHER	THEREAETHER
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	 CHAPTER 25 Production and Growth 543
is the ethnic, cultural, and linguistic background
of the residents. By logic, both sides
of the city should be identical economically.
And yet they are far from the same.
On one side of the border fence, in Santa
Cruz County, Arizona, the median household
income is $30,000. A few feet away, it’s
$10,000. On one side, most of the teenagers
are in public high school, and the majority
of the adults are high school graduates.
On the other side, few of the residents have
gone to high school, let alone college. Those
in Arizona enjoy relatively good health and
Medicare for those over sixty-five, not to mention
an efficient road network, electricity,
telephone service, and a dependable sewage
and public-health system. None of those
things are a given across the border. There,
the roads are bad, the infant-mortality rate
high, electricity and phone service expensive
and spotty.
The key difference is that those on the
north side of the border enjoy law and order
and dependable government services—they
can go about their daily activities and jobs
without fear for their life or safety or property
rights. On the other side, the inhabitants
have institutions that perpetuate crime, graft,
and insecurity.
Nogales may be the most obvious
­example, but it’s far from the only one. Take
Singapore, a once-impoverished tropical
­island that became the richest nation in Asia
after British colonialists enshrined property
rights and encouraged trade. Or China,
where decades of stagnation and famine
were reversed only after Deng Xiaoping began
introducing private-property rights in agriculture,
and later in industry. Or Botswana,
whose economy has flourished over the past
forty years while the rest of Africa has withered,
thanks to strong tribal institutions and
farsighted nation building by its early elected
leaders.
Now look at the economic and political
failures. You can begin in Sierra Leone, where
a lack of functioning institutions and an overabundance
of diamonds have fueled decades
of civil war and strife and corruption that
continue unchecked today. Or take communist
North Korea, a geographical, ethnic, and
cultural mirror of its capitalist neighbor to the
south, yet ten times poorer. Or Egypt, cradle
of one of the world’s great civilizations yet
stagnant economically ever since its colonization
by the Ottomans and then the Europeans,
only made worse by its post-independence
governments, which have restricted all economic
activities and markets. In fact, the theory
can be used to shed light on the patterns
of inequality for much of the world.
If we know why nations are poor, the resulting
question is what can we do to help
them. Our ability to impose institutions from
the outside is limited, as the recent U.S.
­experiences in Afghanistan and Iraq demonstrate.
But we are not helpless, and in many
instances, there is a lot to be done. Even the
most repressed citizens of the world will stand
up to tyrants when given the opportunity. We
saw this recently in Iran and a few years ago
in Ukraine during the Orange Revolution.
The U.S. must not take a passive role in
encouraging these types of movements. Our
foreign policy should encourage them by
punishing repressive regimes through trade
­embargoes and diplomacy…. At the microlevel,
we can help foreign citizens by educating
them and arming them with the modern
tools of activism, most notably the Internet,
and perhaps even encryption technology and
cell-phone platforms that can evade firewalls
and censorship put in place by repressive
governments, such as those in China or Iran,
that fear the power of information.
There’s no doubt that erasing global
­inequality, which has been with us for millennia
and has expanded to unprecedented levels
over the past century and a half, won’t be
easy. But by accepting the role of failed governments
and institutions in causing poverty,
we have a fighting chance of reversing it.
Mr. Acemoglu is an economics professor at
the Massachusetts Institute of Technology.
Source: Esquire, November 18, 2009.Daron Acemoglu
DaronAcemoglu
may also have some benefits. Some economists have suggested that world population
growth has been an engine of technological progress and economic prosperity.
The mechanism is simple: If there are more people, then there are more scientists,
inventors, and engineers to contribute to technological advance, which benefits
everyone.
Economist Michael Kremer has provided some support for this hypothesis
in an article titled “Population Growth and Technological Change: One ­Million
b.c. to 1990,” which was published in the Quarterly Journal of Economics in 1993. 	 Poucionnow	 Poucionnow	 Poucionnow
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
544	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
Kremer begins by noting that over the broad span of human history, world
growth rates have increased with world population. For example, world growth
was more rapid when the world population was 1 billion (which occurred around
the year 1800) than when the population was only 100 million (around 500 b.c.).
This fact is consistent with the hypothesis that a larger population induces more
technological progress.
Kremer’s second piece of evidence comes from comparing regions of the
world. The melting of the polar icecaps at the end of the Ice Age around 10,000 b.c.
flooded the land bridges and separated the world into several distinct regions that
could not communicate with one another for thousands of years. If technological
progress is more rapid when there are more people to discover things, then larger
regions should have experienced more rapid growth.
According to Kremer, that is exactly what happened. The most successful
­region of the world in 1500 (when Columbus reestablished contact) comprised the
“Old World” civilizations of the large Eurasia-Africa region. Next in technological
development were the Aztec and Mayan civilizations in the Americas, followed
by the hunter-gatherers of Australia, and then the primitive people of Tasmania,
who lacked even fire-making and most stone and bone tools.
The smallest isolated region was Flinders Island, a tiny island between
­Tasmania and Australia. With the smallest population, Flinders Island had the
fewest opportunities for technological advance and, indeed, seemed to regress.
Around 3000 b.c., human society on Flinders Island died out completely. A large
population, Kremer concludes, is a prerequisite for technological advance.
Quick Quiz  Describe three ways a government policymaker can try to raise the growth
in living standards in a society. Are there any drawbacks to these policies?
25-4 Conclusion: The Importance of
Long-Run Growth
In this chapter, we have discussed what determines the standard of living in a
nation and how policymakers can endeavor to raise it through policies that promote
economic growth. Most of this chapter is summarized in one of the Ten Principles
of Economics: A country’s standard of living depends on its ability to produce
goods and services. Policymakers who want to encourage growth in living standards
must aim to increase their nation’s productive ability by encouraging rapid
accumulation of the factors of production and ensuring that these factors are employed
as effectively as possible.
Economists differ in their views of the role of government in promoting economic
growth. At the very least, government can lend support to the invisible
hand by maintaining property rights and political stability. More controversial is
whether government should target and subsidize specific industries that might
be especially important for technological progress. There is no doubt that these issues
are among the most important in economics. The success of one generation’s
policymakers in learning and heeding the fundamental lessons about economic
growth determines what kind of world the next generation will inherit.	THEREAETHERii	THEREAETHER	THEREAETHER
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 25 Production and Growth 545
•	 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.
•	 The standard of living in an economy depends on
the economy’s ability to produce goods and services.
Productivity, in turn, depends on the physical capital,
human capital, natural resources, and technological
knowledge available to workers.
•	 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, promoting good health,
maintaining property rights and political stability, allowing
free trade, and promoting the research and development
of new technologies.
•	 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. As a result, although higher saving leads to
higher growth for a period of time, growth eventually
slows down as capital, productivity, and income rise.
Also because of diminishing returns, the return to capital
is especially high in poor countries. Other things
being equal, these countries can grow faster because of
the catch-up effect.
•	 Population growth has a variety of effects on economic
growth. On the one hand, more rapid population
growth may lower productivity by stretching the supply
of natural resources and by reducing the amount of
capital available for each worker. On the other hand,
a larger population may enhance the rate of technological
progress because there are more scientists and
engineers.
Summary
productivity, p. 527
physical capital, p. 530
human capital, p. 530
natural resources, p. 530
technological knowledge, p. 530
diminishing returns, p. 533
catch-up effect, p. 534
Key Concepts
  1.	 What does the level of a nation’s GDP measure? What
does the growth rate of GDP measure? Would you
rather live in a nation with a high level of GDP and a
low growth rate or in a nation with a low level of GDP
and a high growth rate?
  2.	 List and describe four determinants of productivity.
  3.	 In what way is a college degree a form of capital?
  4.	 Explain how higher saving leads to a higher standard
of living. What might deter a policymaker from trying
to raise the rate of saving?
  5.	 Does a higher rate of saving lead to higher growth
temporarily or indefinitely?
  6.	 Why would removing a trade restriction, such as a
­tariff, lead to more rapid economic growth?
  7.	 How does the rate of population growth influence the
level of GDP per person?
  8.	 Describe two ways the U.S. government tries to
­encourage advances in technological knowledge.
Questions for Review
  1.	 Over the past century, real GDP per person in the
United States has grown about ________ percent per
year, which means it doubles about every ________
years.
a.	 2, 14
b.	 2, 35
c.	 5, 14
d.	 5, 35
  2.	 The world’s rich countries, such as Japan and
­Germany, have income per person that is about
________ times the income per person in the world’s
poor countries, such as Pakistan and India.
a.	 3
b.	 6
c.	 12
d.	 36
Quick Check Multiple Choice
	 Poucionnow	 Poucionnow	 Poucionnow
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
546	 PART IX	 THE REAL ECONOMY IN THE LONG RUN
  1.	 Most countries, including the United States, import
substantial amounts of goods and services from other
countries. Yet the chapter says that a nation can enjoy
a high standard of living only if it can produce a large
quantity of goods and services itself. Can you reconcile
these two facts?
  2.	 Suppose that society decided to reduce consumption
and increase investment.
a.	 How would this change affect economic growth?
b.	 What groups in society would benefit from this
change? What groups might be hurt?
  3.	 Societies choose what share of their resources to
devote to consumption and what share to devote to
investment. Some of these decisions involve private
spending; others involve government spending.
a.	 Describe some forms of private spending that
represent consumption and some forms that represent
investment. The national income accounts
include tuition as a part of consumer spending.
In your opinion, are the resources you devote to
your education a form of consumption or a form
of investment?
b.	 Describe some forms of government spending
that represent consumption and some forms that
represent investment. In your opinion, should we
view government spending on health programs as
a form of consumption or investment? Would you
distinguish between health programs for the young
and health programs for the elderly?
  4.	 What is the opportunity cost of investing in capital?
Do you think a country can “overinvest” in capital?
What is the opportunity cost of investing in human
capital? Do you think a country can “overinvest” in
human capital? Explain.
  5.	 In the 1990s and the first decade of the 2000s, investors
from the Asian economies of Japan and China
made significant direct and portfolio investments in
the United States. At the time, many Americans were
unhappy that this investment was occurring.
a.	 In what way was it better for the United States
to ­receive this foreign investment than not to
receive it?
b.	 In what way would it have been better still for
Americans to have made this investment?
  6.	 In many developing nations, young women have
lower enrollment rates in secondary school than do
young men. Describe several ways in which greater
educational opportunities for young women could
lead to faster economic growth in these countries.
  7.	 International data show a positive correlation between
income per person and the health of the population.
a.	 Explain how higher income might cause better
health outcomes.
b.	 Explain how better health outcomes might cause
higher income.
c.	 How might the relative importance of your two
hypotheses be relevant for public policy?
  8.	 The great 18th-century economist Adam Smith wrote,
“Little else is requisite to carry a state to the highest
degree of opulence from the lowest barbarism but
peace, easy taxes, and a tolerable administration of
justice: all the rest being brought about by the natural
course of things.” Explain how each of the three conditions
Smith describes would promote economic growth.
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Problems and Applications
  3.	 Most economists are ________ that natural resources
will eventually limit economic growth. As evidence,
they note that the prices of most natural resources,
adjusted for overall inflation, have tended to
______________________ over time.
a.	 concerned, rise
b.	 concerned, fall
c.	 not concerned, rise
d.	 not concerned, fall
  4.	 Because capital is subject to diminishing returns,
higher saving and investment does not lead to higher
a.	 income in the long run.
b.	 income in the short run.
c.	 growth in the long run.
d.	 growth in the short run.
  5.	 When the Japanese car maker Toyota expands one of
its car factories in the United States, what is the likely
impact of this event on the GDP and GNP of the
United States?
a.	 GDP rises and GNP falls.
b.	 GNP rises and GDP falls.
c.	 GDP shows a larger increase than GNP.
d.	 GNP shows a larger increase than GDP.
  6.	 Thomas Robert Malthus believed that population
growth would
a.	 put stress on the economy’s ability to produce food,
dooming humans to remain in poverty.
b.	 spread the capital stock too thinly across the labor
force, lowering each worker’s productivity.
c.	 promote technological progress, because there
would be more scientists and inventors.
d.	 eventually decline to sustainable levels, as birth
control improved and people had smaller families.	THEREAETHERii	THEREAETHER	THEREAETHER
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.