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24
Measuring the Cost of Living
PRINCIPLES OF
ECONOMICS
FOURTH EDITION
N. G R E G O R Y M A N K I W
PowerPoint® Slides
by Ron Cronovich
© 2007 Thomson South-Western, all rights reserved
In this chapter, look for the answers to
these questions:
 What is the Consumer Price Index (CPI)?
How is it calculated? What’s it used for?
 What are the problems with the CPI? How serious
are they?
 How does the CPI differ from the GDP deflator?
 How can we use the CPI to compare dollar
amounts from different years? Why would we
want to do this, anyway?
 How can we correct interest rates for inflation?
CHAPTER 24
MEASURING THE COST OF LIVING
1
The Consumer Price Index (CPI)
 Measures the typical consumer’s cost of living.
 The basis of cost of living adjustments (COLAs)
in many contracts and in Social Security.
CHAPTER 24
MEASURING THE COST OF LIVING
2
How the CPI Is Calculated
1. Fix the “basket.”
The Bureau of Labor Statistics (BLS) surveys
consumers to determine what’s in the typical
consumer’s “shopping basket.”
Example: {4 pizzas, 10 lattes}
In the real world…
CHAPTER 24
MEASURING THE COST OF LIVING
3
What’s in the CPI’s Basket?
4%
4%
Housing
6%
Transportation
6%
Food & Beverages
42%
6%
Medical care
Recreation
Education and
communication
Apparel
15%
17%
CHAPTER 24
MEASURING THE COST OF LIVING
Other
4
How the CPI Is Calculated
2. Find the prices.
The BLS collects data on the prices of all the
goods in the basket.
For example:
year
price of
pizza
price of
latte
2003
$10
$2.00
2004
$11
$2.50
2005
$12
$3.00
CHAPTER 24
MEASURING THE COST OF LIVING
5
In the real world
Every month, 400 data collectors are visiting
stores, recording prices on the items in the CPI
baskets such as eggs, coffee, cloths, glasses,
shoes…
In total, over 85,000 price quotes flow into BLS
every month.
CHAPTER 24
MEASURING THE COST OF LIVING
6
How the CPI Is Calculated
3. Compute the basket’s cost.
Use the prices to compute the total cost of the
basket.
For example,
year
price of
pizza
price of
latte
2003
$10
$2.00
$10 x 4 + $2 x 10
2004
$11
$2.50
$11 x 4 + $2.5 x 10 = $69
2005
$12
$3.00
$12 x 4 + $3 x 10
CHAPTER 24
cost of basket
MEASURING THE COST OF LIVING
= $60
= $78
7
In the real world…
 AT BLS, around 40 commodity price specialists
hunch over reports with the 85,000 price quotes
gathered by data collectors, to compute and
publish CPI.
CHAPTER 24
MEASURING THE COST OF LIVING
8
How the CPI Is Calculated
4. Choose a base year and compute the index.
The CPI in any year equals
100 x
cost of basket in current year
cost of basket in base year
Compute CPI in each year:
2003: 100 x ($60/$60) = 100
2004: 100 x ($69/$60) = 115
2005: 100 x ($78/$60) = 130
CHAPTER 24
MEASURING THE COST OF LIVING
9
How the CPI is Calculated
5. Compute the inflation rate.
The percentage change in the CPI from the
preceding period.
CPI this year – CPI last year
inflation
x 100%
=
rate
CPI last year
In the previous example:
Inflation rate:
2003: 100 x ($60/$60) = 100
2004: 100 x ($69/$60) = 115
2005: 100 x ($78/$60) = 130
CHAPTER 24
15%
13%
MEASURING THE COST OF LIVING
10
ACTIVE LEARNING
Calculate the CPI
The basket contains
20 movie tickets
and 10 textbooks.
The table shows their
prices for 2004-2006.
1:
movie
tickets
textbooks
2004
$10
$50
2005
$10
$60
2006
$12
$60
The base year is 2004.
A. How much did the basket cost in 2004?
B. What is the CPI in 2005?
C. What is the inflation rate from 2005-2006?
11
ACTIVE LEARNING
Answers
The basket contains
20 movie tickets
and 10 textbooks.
A. How much did
the basket cost
in 2004?
1:
movie
tickets
textbooks
2004
$10
$50
2005
$10
$60
2006
$12
$60
($10 x 20) + ($50 x 10) = $700
12
ACTIVE LEARNING
Answers
The basket contains
20 movie tickets
and 10 textbooks.
B. What is the CPI
in 2005?
1:
movie
tickets
textbooks
2004
$10
$50
2005
$10
$60
2006
$12
$60
cost of basket in 2005
= ($10 x 20) + ($60 x 10) = $800
CPI in 2005 = 100 x ($800/$700) = 114.3
13
ACTIVE LEARNING
Answers
The basket contains
20 movie tickets
and 10 textbooks.
1:
movie
tickets
textbooks
2004
$10
$50
2005
$10
$60
C. What is the
2006
$12
inflation rate
from 2005-2006?
cost of basket in 2006
= ($12 x 20) + ($60 x 10) = $840
$60
CPI in 2006 = 100 x ($840/$700) = 120
Inflation rate = (120 – 114.3)/114.3 = 5%
14
Problems With the CPI:
Substitution Bias
 Over time, some prices rise faster than others.
 Consumers substitute toward goods that
become relatively cheaper.
 The CPI misses this substitution because it uses
a fixed basket of goods.
 Thus, the CPI overstates increases in the cost of
living.
CHAPTER 24
MEASURING THE COST OF LIVING
15
Problems With the CPI:
Introduction of New Goods
 When new goods become available,
variety increases,
allowing consumers to find products
that more closely meet their needs.
 This has the effect of making each dollar more
valuable. The purchasing power of dollars
goes up.
 The CPI misses this effect because it uses a
fixed basket of goods.
 Thus, the CPI overstates increases in the cost
of living.
CHAPTER 24
MEASURING THE COST OF LIVING
16
Problems With the CPI:
Unmeasured Quality Change
 Improvements in the quality of goods in the
basket increase the value of each dollar.
 The BLS tries to account for quality changes,
but probably misses some quality improvements,
as quality is hard to measure.
 Thus, the CPI overstates increases in the cost of
living.
CHAPTER 24
MEASURING THE COST OF LIVING
17
Problems With the CPI
 Each of these problems causes the CPI to
overstate cost of living increases.
 The BLS has made technical adjustments,
but the CPI probably still overstates inflation
by about 0.5 percent per year.
CHAPTER 24
MEASURING THE COST OF LIVING
18
A lot of debates…
 Economists/statisticians/government argue that,
due to the substitution bias, new product bias,
and the quality change bias, CPI overestimates
the cost of living.
 Many are against it.
 Who are they?
Retirees: because they receive social security
adjusted for inflation based on CPI.
Labor Unions: because they bargain over nominal
wages according to CPI.
CHAPTER 24
MEASURING THE COST OF LIVING
19
Desperate Collectors…
Every month, 400 data collectors are visiting stores,
recording prices on the items in the CPI baskets such as
eggs, coffee, cloths, glasses, shoes…
But old models keep disappearing and often they can no
longer find the old model they used to have the price
record. Hence, they try to find the price of the closest
model.
For example, to accurately calculate the price of TVs, they
go through a four-page checklist of TV features such as
the screen size, type of remote controls.
CHAPTER 24
MEASURING THE COST OF LIVING
20
Optional Homework: the student price
index
 Choose five (or more) different products that you
purchase most frequently.
— be specific e.g., unleaded gasoline, Budweiser beer
 2.Pick a quantity for each product. This will be your
market basket.
— e.g., 15 gallons gasoline, 12 pack of Budweiser
 3.Find the actual price for each product (I want to see
the receipts).
 4.Calculate the total cost of buying these products for
January, February, and March.
 5. Calculate the inflation rate based on the SPI.
CHAPTER 24
MEASURING THE COST OF LIVING
21
Two Measures of Inflation
15
Percent
per Year
10
5
0
-5
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
CPI
CHAPTER 24
GDP deflator
MEASURING THE COST OF LIVING
22
Contrasting the CPI and GDP Deflator
Imported consumer goods:
 included in CPI
 excluded from GDP deflator
Capital goods:
 excluded from CPI
 included in GDP deflator
(if produced domestically)
The basket:
 CPI uses fixed basket
 GDP deflator uses basket of
currently produced goods & services
This matters if different prices are
changing by different amounts.
CHAPTER 24
MEASURING THE COST OF LIVING
23
ACTIVE LEARNING
CPI vs. GDP deflator
2:
In each scenario, determine the effects on the
CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. The price of the industrial tractors is raised at
an Illinois factory.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
24
Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
 Due to inflation, dollars have different
purchasing powers at different times.
 The purpose of measuring the overall level of
price in the economy is to permit comparison
between dollar figures from different times.
 We can use the CPI to adjust figures so that
they can be compared.
CHAPTER 24
MEASURING THE COST OF LIVING
25
EXAMPLE: The High Price of Gasoline
 Price of a gallon of regular unleaded gas:
$1.42 in March 1981
$2.50 in August 2005
 One dollar in 1981 is not the same as one
dollar in 2005.
 What is the 1981 price of regular
unleaded gas in 2005 dollars?
CHAPTER 24
MEASURING THE COST OF LIVING
26
EXAMPLE: The High Price of Gasoline
date
Price of gas
CPI
Gas price in
2005 dollars
3/1981
$1.42/gallon
88.5
$3.15/gallon
8/2005
$2.50/gallon
196.4
$2.50/gallon
 1981 gas price in 2005 dollars
= $1.42 x 196.4/88.5
= $3.15
 After correcting for inflation, gas was more
expensive in 1981.
CHAPTER 24
MEASURING THE COST OF LIVING
27
ACTIVE LEARNING
Exercise
3:
1980: CPI = 90,
avg starting salary for econ majors = $24,000
Today: CPI = 180,
avg starting salary for econ majors = $50,000
Are econ majors better off today or in 1980?
28
ACTIVE LEARNING
Answers
3:
1980: CPI = 90,
avg starting salary for econ majors = $24,000
Today: CPI = 180,
avg starting salary for econ majors = $50,000
Solution
Convert 1980 salary into “today’s dollars”
$24,000 x (180/90) = $48,000.
After adjusting for inflation, salary is higher today
than in 1980.
29
Correcting Variables for Inflation:
Indexation
A dollar amount is indexed for inflation
if it is automatically corrected for inflation
by law or in a contract.
For example, the increase in the CPI automatically
determines
• the COLA in many multi-year labor contracts
• the adjustments in Social Security payments
and the brackets of the federal income tax.
CHAPTER 24
MEASURING THE COST OF LIVING
30
Interest rate
 Dollars value differently at different points of
time, because
1. Price is changing so that the same amount of
money has different purchasing power;
2. Holding price constant, they can create more
purchasing power in addition to the one they
already represent.
We receive interest by depositing money in a
bank;
We pay interest by borrowing from a bank.
CHAPTER 24
MEASURING THE COST OF LIVING
31
Hence…
 Interest rate measures the growth rate of the
purchasing power of money.
 However, while the purchasing power of money
grows, the price grows over time as well!
Suppose the interest rate is 3% and the inflation
rate is also 3%.
Would you get more money by depositing $100?
Would you get more purchasing power?
CHAPTER 24
MEASURING THE COST OF LIVING
32
Correcting Variables for Inflation:
Real vs. Nominal Interest Rates
The nominal interest rate:
• the interest rate not corrected for inflation
• the rate of growth in the dollar value of a
deposit or debt
The real interest rate:
• corrected for inflation
• the rate of growth in the purchasing power of a
deposit or debt
Real interest rate
= (nominal interest rate) – (inflation rate)
CHAPTER 24
MEASURING THE COST OF LIVING
33
Real and Nominal Interest Rates:
EXAMPLE
 Deposit $1,000 for one year.
 Nominal interest rate is 9%.
 During that year, inflation is 3.5%.
 Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
 The purchasing power of the $1000 deposit
has grown 5.5%.
CHAPTER 24
MEASURING THE COST OF LIVING
34
Real and Nominal Interest Rates in the U.S.
Interest Rates
(percent per year)
15
10
5
0
-5
-10
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Nominal interest rate
CHAPTER 24
Real interest rate
MEASURING THE COST OF LIVING
35
CHAPTER SUMMARY
 The Consumer Price Index is a measure of the
cost of living. The CPI tracks the cost of the
typical consumer’s “basket” of goods & services.
 The CPI is used to make Cost of Living
Adjustments, and to correct economic variables for
the effects of inflation.
 The real interest rate is corrected for inflation,
and is computed by subtracting the inflation rate
from the nominal interest rate.
CHAPTER 24
MEASURING THE COST OF LIVING
36
 Min’s office hours:
 Thursdays: 3:30 to 5:30 pm
CHAPTER 25
PRODUCTION AND GROWTH
38
Road map for the rest of the quarter
We explore what determine the producing power
and purchasing power of an economy;
• In the long run ----- Growth
• In the short run ----- Business Cycles
CHAPTER 25
PRODUCTION AND GROWTH
39
CHAPTER 25
PRODUCTION AND GROWTH
40
25
Production and Growth
PRINCIPLES OF
ECONOMICS
FOURTH EDITION
N. G R E G O R Y M A N K I W
PowerPoint® Slides
by Ron Cronovich
© 2007 Thomson South-Western, all rights reserved
In this chapter, look for the answers to
these questions:
 What are the facts about living standards and
growth rates around the world?
 Why does productivity matter for living
standards?
 What determines productivity and its growth
rate?
 How can public policy affect growth and living
standards?
CHAPTER 25
PRODUCTION AND GROWTH
42
A typical family with all their possessions in the
U.K., an advanced economy
Real GDP per capita:
Life expectancy:
Adult literacy:
$30,800
78 years
99%
43
A typical family with all their possessions in
Mexico, a middle income country
Real GDP per capita:
Life expectancy:
Adult literacy:
$9,800
74 years
92%
44
A typical family with all their possessions in
Mali, a poor country
Real GDP per capita:
Life expectancy:
Adult literacy:
$1,000
41 years
46%
45
Incomes
and Growth
Around the
World
FACT 1:
There are
vast
differences
in living
standards
around the
world.
China
Singapore
Japan
Spain
Israel
India
United States
Canada
Colombia
New Zealand
Philippines
Argentina
Saudi Arabia
Rwanda
Haiti
GDP per
Growth rate,
capita, 2004 1960-2004
$5,495
5.6%
27,273
5.4%
29,539
3.9%
25,341
3.2%
24,082
2.6%
3,115
2.5%
39,618
2.2%
31,129
2.1%
7,121
1.8%
22,912
1.4%
4,558
1.3%
12,723
0.8%
14,022
0.8%
1,326
0.2%
1,685
–1.3% 46
Incomes
and Growth
Around the
World
FACT 2:
There is
also great
variation
in growth
rates across
countries.
China
Singapore
Japan
Spain
Israel
India
United States
Canada
Colombia
New Zealand
Philippines
Argentina
Saudi Arabia
Rwanda
Haiti
GDP per
Growth rate,
capita, 2004 1960-2004
$5,495
5.6%
27,273
5.4%
29,539
3.9%
25,341
3.2%
24,082
2.6%
3,115
2.5%
39,618
2.2%
31,129
2.1%
7,121
1.8%
22,912
1.4%
4,558
1.3%
12,723
0.8%
14,022
0.8%
1,326
0.2%
1,685
–1.3% 47
Why do we care about the Growth?
 Two countries: Country A and Country B.
 Individuals in both countries earn $2500 per year and their income has been growing
by 1.5% per year. Each country has a choice:
• Choice 1: take a year off from work and have a year-long party. Resume work at
the end of the year and continue to enjoy the 1.5% annual increase in income
per person for year to come;
• Choice 2: spend that year investing in things that increase productivity, such as
clearing land, building factories, and improving machinery, so that income per
person can rise to 2.5% per year. In exchange, that country must give up the
year-long party.
 Country A goes for Choice 1 and Country B goes for Choice 2.
•
•
Country A gets a year-long party and individuals in Country A earn
$2500*(1+1.5%)=$2537.5 in the year that follows;
Country B gives up the party and individuals in Country B earn
$2500*(1+2.5%)=$2562.5 in the year that follows.
 However, after 100 years:
•
•
Individuals in Country A earn on average $2500*(1+1.5%)^100=11,000;
Individuals in Country B earn on average $2500*(1+2.5%)^100=30,000;
 France and Argentina had roughly equal income per person in 1900, but over the
next 100 years economic growth per person was about 2.2% per year in France and
about 1.1 percent per year in Argentina. Today, income per person in France is
$24000, compared with only $8000 in Argentina.
CHAPTER 25
PRODUCTION AND GROWTH
48
Incomes and Growth Around the World
Since growth rates vary, the country rankings can
change over time:
•
•
Poor countries are not necessarily doomed to
poverty forever – e.g., Singapore, incomes
were low in 1960 and are quite high now.
Rich countries can’t take their status for
granted: They may be overtaken by poorer
but faster-growing countries.
CHAPTER 25
PRODUCTION AND GROWTH
49
Long-Term Growth Trends
Levels of Real GDP per
Capita
(1995 U.S. dollars)
Country
1870
Australia
3,123 4,523 5,931 15,076
1.3
Canada
1,347 3,560 6,113 17,453
2.1
France
1,571 2,734 4,149 14,631
1.8
Germany
1,300 2,606 3,339 15,313
2.0
618 1,114 1,563 17,346
2.7
Sweden
1,316 2,450 5,331 14,912
1.9
United
Kingdom
2,610 4,024 5,651 14,440
1.4
United States
2,247 4,854 8,611 19,638
1.7
Japan
CHAPTER 25
1913
1950
1996
Annual Growth
Rate
PRODUCTION AND GROWTH
1870–1996
50
Incomes and Growth Around the World
Questions:
 Why are some countries richer than others?
 Why do some countries grow quickly while
others seem stuck in a poverty trap?
 What policies may help raise growth rates and
long-run living standards?
CHAPTER 25
PRODUCTION AND GROWTH
51
Robinson-Crusoe Economy
CHAPTER 25
PRODUCTION AND GROWTH
52
Robinson-Crusoe Economy
 Robinson Crusoe lives alone on an island;
 He makes a living by fishing.
 The amount of fish he catches everyday is the
total product, total income and total expenditure
of the Robinson-crusoe economy.
 What makes this economy grow? Or, what gives
Robinson higher level of living standard?
CHAPTER 25
PRODUCTION AND GROWTH
53
Productivity
 A country’s standard of living depends on its ability to
produce g & s.
• Robinson’s living standard depends on his fishcatching ability.
 This ability depends on productivity:
the average quantity of g&s produced
per unit of labor input.
•
How much fish can Robinson catch every hour?
 Y = real GDP = quantity of output produced
L = quantity of labor
productivity = Y/L (output per worker)
CHAPTER 25
PRODUCTION AND GROWTH
54
Productivity Is Important!
 When a nation’s workers are very productive, real GDP
is large and incomes are high.
• If Robinson is very productive, he catches a lot of fish
everyday.
 When productivity grows rapidly, so do living standards.
• Robinson becomes more and more productive so that
he enjoys more and more fish everyday. Or, he will even
have some time to build himself a house.
 What, then, determines productivity and its growth rate?
• What helps Robinson to be more productive?
CHAPTER 25
PRODUCTION AND GROWTH
55
Physical Capital Per Worker
 Recall: The stock of equipment and structures
used to produce g&s is called [physical] capital,
denoted K.
 K/L = capital per worker.
 Productivity is higher when the average worker
has more capital (machines, equipment, etc.).
 i.e.,
an increase in K/L causes an increase in Y/L.
 Robinson gets more/better fishing nets! That
helps him to catch more fish.
CHAPTER 25
PRODUCTION AND GROWTH
56
Human Capital Per Worker
 Human capital (H):
the knowledge and skills workers acquire
through education, training, and experience
 H/L = the average worker’s human capital
 Productivity is higher when the average worker
has more human capital (education, skills, etc.).
 i.e.,
an increase in H/L causes an increase in Y/L.
 A smarter and more experienced Robinson.
CHAPTER 25
PRODUCTION AND GROWTH
57
Natural Resources Per Worker
 Natural resources (N): the inputs into production that
nature provides, e.g., land, mineral deposits
 Other things equal,
more N allows a country to produce more Y.
In per-worker terms,
an increase in N/L causes an increase in Y/L.
 Some countries are rich because they have abundant
natural resources
(e.g., Saudi Arabia has lots of oil)
 But countries need not have much N to be rich
(e.g., Japan imports the N it needs).
 Robinson lives on an island where there is a lot of fish
nearby.
CHAPTER 25
PRODUCTION AND GROWTH
58
Technological Knowledge
 Technological knowledge: society’s
understanding of the best ways to produce g&s
 Technological progress does not only mean
a faster computer, a higher-definition TV,
or a smaller cell phone.
 It means any advance in knowledge that boosts
productivity (allows society to get more output
from its resources).
• e.g., Henry Ford and the assembly line.
CHAPTER 25
PRODUCTION AND GROWTH
59
Things that improve productivity
 Physical Capital per worker
•
The stock of equipment and structure used to produce goods and
services. Robinson gets more/better fishing nets.
 Human Capital per worker
•
•
the knowledge and skills workers acquire through education, training,
and experience
A smarter and more experienced Robinson.
 Natural Resources per worker
•
the inputs into production that nature provides, e.g., land, mineral
deposits
•
Robinson lives on an island where there is a lot of fish nearby.
 Technological Knowledge
•
•
society’s understanding of the best ways to produce g&s
Robinson used to catch fish by hand, now he use fishing nets, he will
use fishing boats.
CHAPTER 25
PRODUCTION AND GROWTH
60
Tech. Knowledge vs. Human Capital
 Technological knowledge refers to society’s
understanding of how to produce g&s.
 Human capital results from the effort people expend to
acquire this knowledge.
 Both are important for productivity.
 technological knowledge can easily be shared among
infinitely many producers. Human capital is generally
tied to the individuals that expend the effort to acquire it.
Tech. Knowledge vs. Physical Capital
 Technological knowledge is often embodied in
physical capital.
CHAPTER 25
PRODUCTION AND GROWTH
61
Robert Solow: the
winner of Nobel
Memorial Prize in
1987
 Best Known for his work
on Neoclassical growth
models.
 He argues technological
progress as the driving
force for long-run
growth.
CHAPTER 25
PRODUCTION AND GROWTH
62
Case Study:
Henry Ford and the assembly line
 The first car of Ford Motor Company, Model T, was
less expensive than most other cars, but it was still not
attainable for the "multitude." Ford realized he'd need a
more efficient way to produce the car in order to lower
the price.
 Ford divided the labor by breaking the assembly of the
Model T into 84 distinct steps. Each worker was
trained to do just one of these steps.
 The production process was arranged so that as one
task was finished, another began, with minimum time
spent in set-up.
CHAPTER 25
PRODUCTION AND GROWTH
63
Creating cars at record-breaking rate!
Moving assembly line at Ford Motor Company's Michigan plant
CHAPTER 25
PRODUCTION AND GROWTH
64
Assembly line
was Henry Ford's
masterpiece.
 the Model T produced by the assembly line was
inexpensive and could fit a family. It only was about
$200.00 which even in 1924 was inexpensive.
 Without his creation, not many of us would have cars
in fact none of us would probably have a car.
CHAPTER 25
PRODUCTION AND GROWTH
65
The Production Function
 The production function is a graph or equation
showing the relation between output and inputs:
Y = A F(L, K, H, N)
F( ) – a function that shows how inputs are
combined to produce output
“A” – the level of technology
 “A” multiplies the function F( ),
so improvements in technology (increases in “A”)
allow more output (Y) to be produced from any
given combination of inputs.
CHAPTER 25
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The Production Function
Y = A F(L, K, H, N)
 The production function has the property
constant returns to scale: Changing all inputs
by the same percentage causes output to change
by that percentage. For example,
 Doubling all inputs (multiplying each by 2)
causes output to double:
2Y = A F(2L, 2K, 2H, 2N)
 Increasing all inputs 10% (multiplying each by 1.1)
causes output to increase by 10%:
1.1Y = A F(1.1L, 1.1K, 1.1H, 1.1N)
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Some Examples
Y = A F(L, K, H, N)
F(
) is a function.
It can be linear:
Y=A×(L+K+H+N)
Or not linear:
Y=A×(L^0.25)×(K^0.25)×(H^0.25)×(N^0.25)
Question: do these two production functions have
the property of constant returns to scale?
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68
The Production Function
Y = A F(L, K, H, N)
 If we multiply each input by 1/L, then
output is multiplied by 1/L:
Y/L = A F(1, K/L, H/L, N/L)
 This equation shows that productivity
(output per worker) depends on:
• the level of technology (A)
• physical capital per worker
• human capital per worker
• natural resources per worker
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69
Things that improve productivity
 Physical Capital per worker
•
The stock of equipment and structure used to produce goods and
services. Robinson gets more/better fishing nets.
 Human Capital per worker
•
•
the knowledge and skills workers acquire through education, training,
and experience
A smarter and more experienced Robinson.
 Natural Resources per worker
•
the inputs into production that nature provides, e.g., land, mineral
deposits
•
Robinson lives on an island where there is a lot of fish nearby.
 Technological Knowledge
•
•
society’s understanding of the best ways to produce g&s
Robinson used to catch fish by hand, now he use fishing nets, he will
use fishing boats.
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70
ACTIVE LEARNING
Discussion question
1:
Which of the following policies do you think would
be most effective at boosting growth and living
standards in a poor country over the long run?
a. offer tax incentives for investment by local firms
b. …by foreign firms
c. give cash payments for good school attendance
d. crack down on govt corruption
e. restrict imports to protect domestic industries
f. allow free trade
g. give away condoms
71
ECONOMIC GROWTH AND PUBLIC POLICY
Next, we look at the ways
public policy can affect
long-run growth in productivity
and living standards.
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Saving and Investment
 We can boost productivity by increasing K,
which requires investment.
 Since resources scarce, producing more capital
requires producing fewer consumption goods.
 Reducing consumption = increasing saving.
This extra saving funds the production of
investment goods. (More details in the next chapter.)
 Hence, a tradeoff between
current and future consumption.
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Case Study: Social Security Reform
 Question: does social
security tax
discourage or
encourage saving?
 Pay-as-you-go
system and fullyfunded system.
 Additional Reading:
“growing old
expensively”.
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Diminishing Returns and the Catch-Up Effect
 The govt can implement policies that raise
saving and investment. (Details in next chapter.)
Then K will rise, causing productivity and living
standards to rise.
 But this faster growth is temporary,
due to diminishing returns to capital:
As K rises, the extra output from an additional
unit of K falls….
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The Production Function & Diminishing Returns
If workers
Output per
have little
K,
worker
giving
them more
(productivity)
increases their
productivity a lot.
Y/L
If workers already
have a lot of K,
giving them more
increases
productivity
fairly little.
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PRODUCTION AND GROWTH
K/L
Capital per worker
76
The catch-up effect: the property whereby poor
countries tend to grow more rapidly than rich ones
Y/L
Rich country’s
growth
Poor country’s
growth
K/L
Poor country
starts here
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PRODUCTION AND GROWTH
Rich country starts here
77
This coming Thursday, 1st Midterm
 Preparations:
• Ink pens
• Non-programmable calculator
• Picture ID.
• 1 hour and 10 minutes.
• Regular lecture time and lecture room.
 Key materials:
• GDP: product approach, income approach, and
•
expenditure approach;
Growth and Social Security Reform
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78
Example of the Catch-Up Effect
 Over 1960-1990, the U.S. and S. Korea devoted
a similar share of GDP to investment, so you
might expect they would have similar growth
performance.
 But growth was >6% in Korea and only 2% in
the U.S.
 Explanation: the catch-up effect.
In 1960, K/L was far smaller in Korea than
in the U.S., hence Korea grew faster.
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79
Investment from Abroad
 To raise K/L and hence productivity, wages, and
living standards, the govt can also encourage
• Foreign direct investment:
•
a capital investment (e.g., factory) that is
owned & operated by a foreign entity.
Foreign portfolio investment:
a capital investment financed with foreign
money but operated by domestic residents.
 Some of the returns from these investments
flow back to the foreign countries that supplied
the funds.
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80
Investment from Abroad
 Especially beneficial in poor countries that cannot
generate enough saving to fund investment
projects themselves.
 Also helps poor countries learn state-of-the-art
technologies developed in other countries.
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Sizing Up Foreign Direct Investment
 Of all the kinds of
capital which flows into
developing countries,
foreign direct
investment (FDI) is the
most advantageous to
the host country.
 When it comes to FDI,
the developing country
is under no obligation
to keep up foreign
currency payments for
dividends — or pay off
any debt.
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83
Education
 Govt can increase productivity by promoting
education–investment in human capital (H).
• public schools, subsidized loans for college
 Education has significant effects: In the U.S., each
year of schooling raises a worker’s wage by 10%.
 But investing in H also involves a tradeoff
between the present & future:
Spending a year in school requires
sacrificing a year’s wages now
to have higher wages later.
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84
Health and Nutrition
 Health care expenditure is a type of
investment in human capital – healthier
workers are more productive.
 In countries with significant malnourishment,
raising workers’ caloric intake raises
productivity:
• Over 1962-95, caloric consumption rose
44% in S. Korea, and economic growth
was spectacular.
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85
caloric consumption
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86
Nobel winner Robert Fogel
 30% of Great
Britain’s growth
from 1790-1980
was due to
improved nutrition.
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Property Rights and Political Stability
 Recall: Markets are usually a good
way to organize economic activity.
The price system allocates resources
to their most efficient uses.
 This requires respect for property rights,
the ability of people to exercise authority
over the resources they own.
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88
Property Rights and Political Stability
 In many poor countries, the justice system doesn’t
work very well:
•
•
•
contracts aren’t always enforced
fraud, corruption often go unpunished
in some, firms must bribe govt officials for permits
 Political instability (e.g., frequent coups) creates
uncertainty over whether property rights will be
protected in the future.
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89
Property Rights and Political Stability
 When people fear their capital may be stolen by
criminals or confiscated by a corrupt govt,
there is less investment, including from abroad,
and the economy functions less efficiently.
Result: lower living standards.
 Economic stability, efficiency, and healthy growth
require law enforcement, effective courts,
a stable constitution, and honest govt officials.
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Free Trade
 Inward-oriented policies
(e.g., tariffs, limits on investment from abroad) aim to
raise living standards by avoiding interaction with other
countries.
 Outward-oriented policies (e.g., the elimination of
restrictions on trade or foreign investment) promote
integration with the world economy.
 The World Trade Organization is the only global
international organization dealing with the rules of trade
between nations. At its heart are the WTO agreements,
negotiated and signed by the bulk of the world’s trading
nations and ratified in their parliaments.
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92
Free Trade
 Recall: Trade can make everyone better off.
 Trade has similar effects as discovering new
technologies – it improves productivity and living
standards.
 Countries with inward-oriented policies have
generally failed to create growth.
• e.g., Argentina during the 20th century.
 Countries with outward-oriented policies have
often succeeded.
• e.g., South Korea, Singapore, Taiwan after 1960.
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Now, the key
“ I am looking for a lot of men who have
infinite capacity to not know what
can't be done.”
-- Henry Ford
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94
Research and Development
 Technological progress is the main reason why
living standards rise over the long run.
 One reason is that knowledge is a public good:
Ideas can be shared freely, increasing the
productivity of many.
 Policies to promote tech. progress:
• patent laws
• tax incentives or direct support for
•
private sector R&D
grants for basic research at universities
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Population Growth
…may affect living standards in 3
different ways:
1. Stretching natural resources
 200 years ago, Malthus argued
that pop. growth would strain
society’s ability to provide for
itself.
 Since then, the world population
has increased sixfold. If Malthus
was right, living standards would
have fallen. Instead, they’ve
risen.
 Malthus failed to account for
technological progress and
productivity growth.
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Population Growth
2. Diluting the capital stock
 more population = higher L = lower K/L
= lower productivity & living standards.
 This applies to H as well as K:
fast pop. growth = more children
= greater strain on educational system.
 Countries with fast pop. growth tend to have lower
educational attainment.
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Population Growth
2. Diluting the capital stock
To combat this, many
developing countries use
policy to control population
growth.
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•
China’s one child per
family laws
•
contraception education
& availability
•
promote female literacy to
raise opportunity cost of
having babies
PRODUCTION AND GROWTH
98
Population Growth
3. Promoting tech. progress
 More people
= more scientists, inventors, engineers
= more frequent discoveries
= faster tech. progress & economic growth
 Over the course of human history,
• growth rates increased as the world’s
•
population increased
more populated regions grew faster than
less populated ones
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99
ACTIVE LEARNING
Productivity
2:
 List the determinants of productivity.
 List three policies that attempt to raise living
standards by increasing one of the determinants
of productivity.
100
ACTIVE LEARNING
Answers
2:
Determinants of productivity:
physical capital per worker (K/L)
human capital per worker (H/L)
natural resources per worker (N/L)
technological knowledge (A)
Policies to boost productivity:
 Encourage saving and investment, to raise K/L
 Encourage investment from abroad, to raise K/L
 Provide public education, to raise H/L
101
ACTIVE LEARNING
Answers
2:
Determinants of productivity:
physical capital per worker (K/L)
human capital per worker (H/L)
natural resources per worker (N/L)
technological knowledge (A)
Policies to boost productivity:
 Patent laws or grants, to increase A
 Control population growth, to increase K/L
102
Are Natural Resources a Limit to Growth?
 Some argue that population growth is depleting the
Earth’s non-renewable resources, and thus will limit
growth in living standards.
 But technological progress often yields ways to
avoid these limits:
•
•
Hybrid cars use less gas.
Better insulation in homes reduces the energy
required to heat or cool them.
 As a resource becomes scarcer, its market price
rises, which increases the incentive to conserve it
and develop alternatives.
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CONCLUSION
 In the long run, living standards are determined by
productivity.
 Policies that affect the determinants of productivity
will therefore affect the next generation’s living
standards.
 One of these determinants is saving and
investment.
 In the next chapter, we will learn how saving and
investment are determined, and how policies can
affect them.
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CHAPTER SUMMARY
 There are great differences across countries in
living standards and growth rates.
 Productivity (output per unit of labor) is the main
determinant of living standards in the long run.
 Productivity depends on physical and human
capital per worker, natural resources per worker,
and technological knowledge.
 Growth in these factors – especially technological
progress – causes growth in living standards over
the long run.
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CHAPTER SUMMARY
 Policies can affect the following, each of which has
important effects on growth:
• saving and investment
• international trade
• education, health & nutrition
• property rights and political stability
• research and development
• population growth
 Because of diminishing returns to capital,
growth from investment eventually slows down,
and poor countries may “catch up” to rich ones.
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