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MBA34 Managerial Excellence – 1° Term Why are some countries rich and others poor? How to predict growth? The firm and its environment - Francesco Giavazzi Copyright SDACopyright Bocconi 2004 SDA Bocconi 2006 1 Growth in living standards: a 20th century phenomenon Copyright SDA Bocconi 2004 2 Yet growth not equally fast for everybody Our question: why do growth rates differ? Why are some countries rich today and others poor? Copyright SDA Bocconi 2004 3 Actual growth rates are result of two forces Force #1: Poor countries have more scope for catching up Other countries have developed new technologies, which – once invented - can be imported by followers who may save resources and more easily catch up Convergence hypothesis: poor countries grow faster than rich ones Force #2: a really poor country may stay poor forever If a country is unable to import high technology for it lacks human capital, infrastructures and institutions or is closed to foreign trade, catching up may not occur Which force prevails is empirical matter What do the data say? Copyright SDA Bocconi 2004 4 Growth rate, 1980 – 2000 (per annum) The “bubbles in a knocked-over flute” diagram 6% China India Usa 4% 2% 0% -5000 -2% -4% 5000 15000 25000 Nigeria -6% GDP per capita, US $$ Copyright SDA Bocconi-2004 Data points weighted by size of population – show no convergence 5 Catch up amongst Europe’s big 4 10 Log of GDP per capita 10 10 9 9 9 9 8 8 8 8 7 7 1861 1869 1877 1885 1893 1901 19091917 1925 1933 1941 1949 1957 1965 1973 1981 1989 1997 Year France Copyright SDA Bocconi 2004 Germany Italy United Kingdom 6 Catch up in Europe Log of GDP per capita 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 1921 1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 Year United Kingdom Copyright SDA Bocconi 2004 Ireland Greece Portugal Spain 7 Which economies converge? The US States Copyright SDA Bocconi 2004 8 Which economies converge? Japanese Prefectures Copyright SDA Bocconi 2004 9 Which economies converge? European Regions Copyright SDA Bocconi 2004 10 Summing up so far Big differences in GDP growth rates across countries No evidence in favor of strict convergence hypothesis (“income of the the poor guys grows faster than the rich guys”) Instead: evidence of convergence within clubs. “Similar enough” countries show tendency to converge Hence: need theory of growth consistent with: worldwide divergence and club convergence We develop this theory next Copyright SDA Bocconi 2004 11 First step: per-capita GDP up for three reasons Demographics GDP per capita = product of three components GDP GDP Hours Pop(15 64) Pop Hours Pop(15 64) Pop Capital accumulation and efficiency gains Our main focus today Copyright SDA Bocconi 2004 = Hours per employed times employment rate. It depends on labor market functioning 12 Three potential sources of growth Labor productivity Hours worked Demographics Demographics potentially important, but left out of economics Trends in hours worked do not explain club convergence (see slides) We are left with labor productivity growth as a convergence driver Important and relevant for economists NEXT: develop a theory (based on MIT Nobel laureate Robert Solow’s model) of how labor productivity evolves and then check whether this matches data Copyright SDA Bocconi 2004 13 What determines labor productivity? Question “What determines growth in living standards?” boils down to asking smaller question: “What determines growth in labor productivity?” Answer to smaller question: Two things behind labor productivity growth • Accumulation of capital (machines, factories, construction) • Technical and organizational changes, including human capital improvements Copyright SDA Bocconi 2004 14 Aggregate production function Trick: link sources of GDP growth through the aggregate production function Aggregate production function: efficient combinations of factors of production (capital, labor) and technology to give long-run GDP GDP = TF(K, L) T=efficiency + improved capital and labor quality, L=total hours worked, K=capital stock close counterpart of firm-level concept T often called TFP (Total Factor Productivity); not merely technological, also organizational and managerial variable Copyright SDA Bocconi 2004 15 The production function: properties The “F” function: is linearly homogeneous by doubling inputs, output doubled as well is subject to positive marginal productivity in each factor (for given technology) return on extra machine always positive. If K stock increases for given L so does output. Same for L. is subject to diminishing marginal productivity in each factor (for given technology) if economy has few machines, new machines add a lot of output; if many installed, new machines add little (congestion effect). Same for L Copyright SDA Bocconi 2004 16 From the Production Function to the Determinants of Labor Productivity Divide both sides by L, get expression for “Labor productivity” (GDP per hour worked) GDP/L = T f(K/L) In words Labor productivity goes up for two reasons: K/L for given technology also known as: ‘capital deepening’ T (efficiency) for given capital-labor ratio Efficiency = social institutions, culture, financial structure, technology. More discussion next. Copyright SDA Bocconi 2004 17 The determinants of labor productivity GDP per hour worked 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 0.0 10.0 20.0 30.0 40.0 50.0 60.0 Capital per hour worked Production function 1995 Copyright SDA Bocconi 2004 Production function 2005 18 From levels to growth rates GDP per hour from production function in levels GDP/L = Tf(K/L) Can be reinterpreted in terms of growth rates: Growth rate of GDP/L = growth rate of T + + (elasticity of output with respect to capital) x x (growth rate of K/L) (maths not crucial for the rest of the argument) Copyright SDA Bocconi 2004 19 Useful algebra ‘Elasticity of output with respect to capital’ 1/3 (=share of capital income over total GDP in most countries) Hence: g(GDP/L)=g(T)+(1/3)g(K/L) Very useful formula: with data for K, L and GDP, g(T) computed as a residual g(T)= g(GDP/L) - (1/3)g(K/L) g(T) (or TFP growth) is also known as ‘Solow residual’ (from Solow, 1957). It is the macroeconomists’ measure of technical and organizational change Others – more prosaically – label TFP: “a summary of our ignorance” Copyright SDA Bocconi 2004 20 Growth accounting Decomposition of labor productivity growth in its ‘capital deepening’ and TFP components is called ‘growth accounting’ Growth accounting crucial to: understand sources of long-run growth How much is TFP and how much is K deepening in the overall growth rate of a country? make growth projections and discuss growth prospects in an informed way Project past TFP and investment growth (or make assumptions) to obtain predictions of future growth Copyright SDA Bocconi 2004 21 Accounting for labor productivity growth in the USA Growth of labor productivity 1/3 times TFP, tech. & growth of K/L organizational change 1956-1975 2.5 1.1 1.4 1976-1995 1.2 0.6 0.6 1996-2005 2.6 1.1 1.5 US labor productivity growth mainly driven by TFP Copyright SDA Bocconi 2004 22 Capital accumulation with no TFP growth eventually kills growth: the former USSR Growth of labor productivity 1/3 times TFP, tech. & growth of K/L organizational change 1971-1975 4.5 3.0 1.5 1976-1980 3.3 3.9 -0.6 1981-1985 2.7 3.5 -0.8 USSR: LP growth mainly driven by K-deepening Copyright SDA Bocconi 2004 23 Our theory of growth In the US, growth mostly due to TFP. In the USSR mainly by K. Same as USSR often applies to poorer countries Is this consistent with production function model? YES US is K-abundant (L scarce, rich country) productivity of additional units of capital is low growth NOT driven by capital or resource accumulation, technical and organizational changes needed In K-scarce (L-abundant) poor countries: scope for “catching-up” through K accumulation, growth driven by K Copyright SDA Bocconi 2004 24 No wonder that: growth mostly explained by TFP in rich countries and mostly by K/L in poor countries OECD 1947-1973 Latin America 1940-1980 East Asia 1966-1990 0 5 10 15 20 25 30 35 40 45 TFP growth as a % of total GDP growth Copyright SDA Bocconi 2004 50 25 The story runs as follows Flute diagram shows no worldwide convergence Why? African and Latin American countries couldn’t catch up with the rich guys • “Poor country advantage” more than offset by other TFP-related gaps Asian countries did catch up instead • Huge investment rates more than offset TFP gap Within the OECD, most countries shared same (US) technology in an open-economy environment. This is “club convergence” • As a result, poorer countries (Gre, Spa, Ita, Ger, Jap) caught up with the US and the UK Copyright SDA Bocconi 2004 26 TFP differences explain a lot of the differences in output per head TFP relative to United States Why Are Some Countries so Much Richer? 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 0 0.2 0.4 0.6 0.8 1 Output per Worker relative to United States Copyright SDA Bocconi 2004 27 What’s behind a name: “TFP” Data suggest that TFP differences are very important when explaining differences in output per worker But what is “TFP”? It is the efficiency with which factors of production are used A country may be relatively inefficient because: (a) Endowed with inferior technology – available technology may be efficiently used but the technology itself may not be the best practice (b) Its chosen technology is adopted inefficiently – there may be bad work and business practices, bureaucratic obstacles, bad policies. All such things lead to inefficient ways of doing things Copyright SDA Bocconi 2004 28 Socio-economic and techno-managerial determinants of TFP (1) The socio-economic efficiency of countries – the extent to which institutions affect the efficiency of the economy. We will refer to this as “institutions” and “policy” - “Institutions” refers to the broader institutional settings including historical factors that help shape society - “Policy” refers to the policies implemented, given the institutional background (2) Technology and management – the technologies that are used, how they are implemented, and the organizational structure of the firm Copyright SDA Bocconi 2004 29 Institutions? • Legal system: Rule of law is key for making the economy work: one key aspect is protection of property rights • Political Institutions: If power is highly concentrated, the elite may protect their own rights (also important that “bad rulers” can be `punished’) • Educational Institutions and Allocation of Talent: With the “wrong incentives” talent will not necessarily be allocated to the socially best activities (rent seeking and pirates) • Financial Institutions: Finance matters for the allocation of capital. Inefficient institutions do not allocate capital to the most productive projects Copyright SDA Bocconi 2004 30 Example: If rule of law holds, productivity is higher … Copyright SDA Bocconi 2004 31 … and factor accumulation too Copyright SDA Bocconi 2004 32 “Good” policies for TFP growth Policy affects efficiency - Property rights protection – without properly defined property rights, no incentives to do things efficiently or to invest in capital or in new technology - Competition / deregulation – will in general promote efficiency, particularly at times of fast technical change -Political stability – instability creates uncertainty and holds back efficiency and investment Copyright SDA Bocconi 2004 33 More of “good” policies for TFP growth Trade policy: The lack of restrictions on foreign trade are often found to be an important determinant of TFP • In next classes, we will see that foreign trade allows a country to specialize itself in activities where it is efficient Can also build a direct relationship to TFP (a) Protectionism often the result of inefficient firms / sectors lobbying for protection against foreign competition – (US steel tariffs, EU?): trade restrictions allow such inefficient firms to survive (b) When shielded from foreign competition, domestic firms may not feel the need to be efficient Copyright SDA Bocconi 2004 34 Finance and TFP Also financial markets matter • Financial markets provide funding for private enterprises in two ways • Bring together lenders and borrowers. This raises efficiency by lowering costs of starting new projects. Also promote growth through savings and investment • Screen good vs. bad projects. Lenders (banks, financial institutions) assess the prospects of projects • Evidence indicates that “good” financial markets bear positive correlation with better economic performance. Probably because of better allocation of capital – ie. give rise to higher TFP Copyright SDA Bocconi 2004 35 Summing up Poor countries would have more scope for catching up (unexploited profit opportunities) Typically, catching-up forces most powerful in poor countries with growth-conducive institutions But many examples teach us that a really poor country may stay poor forever, if engines of TFP growth disregarded As catching-up forces exhausted, TFP growth engines should gain momentum Copyright SDA Bocconi 2004 36