Chapter 25

Question 1

But before we go on . . . what does it mean to be poor? How do we measure poverty?

Answer 1

• is it by income - “per capita income of less than $5 per day”
• is it relative - “you’re poor if your income is in the lowest 10% of your country.”
• is it by consumption - “you have to spend a high % of your income on necessities.

Question 2

By income in $$$

Answer 2

• different people have different standards. Consensus seems to have formed around living on <$10 per day.
o Ravillion, M. (2010). The developing world’s bulging (but vulnerable) middle class. World Development 38(4) 445-54.
o Kharas, H., and Gertz, G. (2010). The new global middle class: A cross-over from west to east. Wolfensohn Center for Development.
o Milanovic, B. and Yitzhaki, S. (2002). Decomposing world income distribution: Does the world have a middle class? Review of Income and Wealth 48(2), 155-78.

Question 3

By relative income

Answer 3

• Consensus is having an income <75% of your country’s median
income.
o Ravillion, M. (2010). The developing world’s bulging (but vulnerable) middle class. World Development 38(4) 445-54.

Question 4

Alimentary poverty, capability poverty, and patrimony poverty

Answer 4

Alimentary
poverty: can’t afford food
Capability poverty: can’t afford food + health care + education
Patrimony poverty: can’t afford food + health care + education + clothes + housing + transportation

Question 5

But all this raises the questions:
• why are some countries richer than others?
• why do some countries grow quickly while others seem stuck in poverty?
• what policies may help raise growth rates and long-run living standards?

Answer 5

Labor productivity
• this ability depends on productivity, the average quantity of goods + services produced per unit of labor input.

Question 6

What does productivity mean?

Answer 6

• standards of living depend on productivity, the average quantity of goods + services produced per unit of labor input.
• ask: how much stuff does each worker make in a work day?
• when a nation’s workers are productive, real GDP is high and so are incomes.
• when productivity grows rapidly, so do living standards.
• so the question is: if productivity is so important, how can we improve it?

Question 7

What are the many pieces of productivity

Answer 7

• let’s look at a few
• productivity = the average quantity of goods + services produced per unit of labor input.
• how much stuff can each worker make in a day?
• let:
Y = real GDP = quantity of output produced
L = quantity of labor (how many people are
working)
so productivity = Y/L (output per worker)

Question 8

Physical Capital Per Worker

Answer 8

• recall: physical assets (like equipment and structures) used to produce goods + services is called [physical] capital
- we call it ‘K’.
•K/L = capital per worker -> physical capital / number of workers.

• productivity is higher when the average worker has more and better capital to work with (machines, equipment, etc.).
• this means that as capital per worker increases, so does income.
o an increase in K/L causes an increase in Y/L. o in English -> if physical capital per worker increases, then income per worker should increase also.
o but beware of the law of diminishing marginal product of capital!!!

Question 9

What does human capital per worker mean

Answer 9

• Human capital (H): the knowledge and skills workers acquire through education, training, and experience.
• H/L = the average worker’s human capital >
human capital / number of workers

• productivity is higher when the average worker has more and better human capital to rely on (education, skills, etc.).
• this means that as human capital per worker increases, so does income.
o an increase in H/L causes an increase in Y/L. o in English -> if human capital per worker increases, then income per worker should increase also
o but beware of the law of diminishing marginal product of capital!!!

Question 10

Natural Resources Per Worker

Answer 10

• Natural resources (N): the factors of production that nature provides, e.g., land, oil, mineral deposits, good soil.
• 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.
• Natural resources (N): the factors of production that nature provides, e.g., land, oil, mineral deposits, good soil.
• some countries are rich because they have abundant natural resources
o Saudi Arabia has lots of oil - and not much else.
• but countries doesn’t need much N to be rich o Japan imports the N it needs.

Question 11

What does Technological Knowledge mean

Answer 11

• Technological knowledge: society’s understanding of the best ways to produce goods + services
o I have sometimes seen this as ‘A’ -> think of this as ‘know how.”
• technological progress is more than a faster computer, a higher-definition TV, or a smaller cell phone.
• it’s any advance in knowledge that boosts productivity (which allows society to get more output from its resources).
o Henry Ford and the assembly line.

Question 12

How is technological knowledge different from human capital?

Answer 12

• technological knowledge (A) refers to society’s understanding of how to produce goods + services.
• A can be shared among producers -> we call it ‘spillover’ o this is one reason why tech firms cluster together in
Silicon Valley -> to enjoy the spillover effect
• human capital (H) results from a person’s own brain power skills + experience + knowledge

• A is general knowledge about how to do things.
• H is personal to the person who acquires it.
• H goes home at the end of the day. A sticks around and can be used by anyone at the firm. both are important for productivity.

Question 13

The Production Function

Answer 13

•the production function is a graph or equation showing the
relation between output and inputs: Y = A f(L, K, H, N)
• notice a few things:
• fl) is a mathematical equation (a “function” that shows how inputs combine to produce output
A
o if we know the quantity of inputs (L, H, K, A, N), a production function should predict how much stuff we can make.

Question 14

The Production Function … notice something?

Answer 14

• the production function is a graph or equation showing the relation
between output and inputs: Y = A fiL, K, H, N)
• notice a few things:
o all the inputs are positively correlated > if LT, Y 1 o fis a multiplicative function -> we need all of these things to
make anything -> if any input = 0, then Y = 0.
• a machine (K) without anyone to work it (L) is useless.

Question 15

The Production Function

Answer 15

• the production function is a graph or equation showing the
relation between output and inputs: Y = A f{L, K, H, N)
• notice a few things:
o A multiplies the function fl), so improvements in technology (increases in A) allow more output (Y) to be produced from any given combination of inputs

Y = A fL, K, H, N)
• the production function displays 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)

Question 16

What does the production function exhibit

Answer 16

The Production Function
Y = A fL, K, H, N)
• the production function exhibits constant returns to scale:
Changing all inputs by the same percentage causes output to change by that percentage. For example,
o increasing all inputs 10% (multiplying each by 1.1) causes
output to increase by 10%: 1.1Y = A f1.1L, 1.1K, 1.1H, 1.1N)
NOTE WELL -all the inputs MUST CHANGE BY THE SAME AMOUNT. This does not work if we simply change one variable!.

Question 17

What does productivity (output per worker) depend on?

Answer 17

• and so productivity (output per worker) depends on:
o the level of technology (A)
o physical capital per worker (K)
o human capital per worker (H)
o natural resources per worker (N)

Question 18

Diminishing Returns and the Catch-Up Effect

Answer 18

• the government can implement policies that can, for example, raise saving and investment > more on this in the next chapter.
• K will rise, causing productivity and living standards to rise in the long run.
• But this faster growth is temporary, due to diminishing returns to capital (remember this from micro?)
• as Krises, the extra output from an additional unit of K falls.

Question 19

Education

Answer 19

• government can increase productivity by promoting education - which is really an investment in human capital (H).
o public schools
o subsidized loans for college or the Excelsior Scholarship!
• investing in H also involves a tradeoff between the present &
future
o spending a year in school requires sacrificing a year’s wages now to have higher wages later -> this is the opportunity cost of education.
o the expectation is that education pays off, but not right away. o in fact, for a while, the return on your education will be negative.

Question 20

Health and Nutrition

Answer 20

• money spent on health care is another type of investment in human capital -> healthier workers are more productive.
• if people in a country are malnourished, raising caloric intake raises productivity:
over 1962-95, caloric consumption rose 44% in S. Korea, and economic growth was spectacular [again, this is not the only reason for this growth, though].

• expenditures for health care is another type of investment in human capital -> healthier workers are more productive.
• in countries with significant malnutrition, raising caloric intake raises productivity:
• Nobel winner Robert Fogel: 30% of Great Britain’s growth from 1790-1980 was due to improved nutrition.
o note that the causation could go the other way -> instead of people getting richer because they are healthier, it could also be that people are healthier because they are richer.

Question 21

3 possible fundamental causes of economic growth:

Answer 21

-Culture
-Geography
-Institutions

Question 22

Culture as a fundamental cause

Answer 22

• in modern times - some countries reward innovation (and do not punish failure so much).
• historical view - countries are rich because their people share common experiences and religion.
• example: Protestant religion values hard work, thrift, savings.
• “being rich means being favored by God.”

Question 23

Geography as a fundamental cause

Answer 23

• climate - a hot climate affects people’s work effort.
- cold or temperate weather allows people to work.
- hot weather makes people listless and passive and not interested in working hard.
• natural resources - countries are rich because they are abundant in natural resources.
• minerals, timber, favorable growing conditions.

Question 24

Institutions as a fundamental cause

Answer 24

• North (1990): “institutions are the rules of the game in a society, or more formally, are the humanly devised constraints that shape human interactions.”
• Two types:
o political: structure of government, rule of law, certainty + stability
o economic: quality of markets, protection of property rights, certainty + stability

Question 25

Property Rights and Political Stability

Answer 25

• recall: Markets are usually a good way to organize economic activity.
• the price system tends to allocate resources to their most efficient uses.
• this requires respect for property rights -> the ability of people to exercise authority over the resources they own.

• in many poor countries, the justice system doesn’t work very well:
• contracts aren’t always enforced.
o fraud + corruption often go unpunished.
o in some, firms must bribe government officials to get anything done -> licenses and permits, ability to hire employees, etc.
• political instability (e.g., frequent coups) creates uncertainty over.
whether property rights will be protected in the future.

Question 26

More about property rights and political stability

Answer 26

• when people fear their stuff may be stolen by criminals or confiscated by a corrupt government:
o there is less investment, including from abroad o the economy functions less efficiently.
• result -> lower living standards.
• economic stability, efficiency, and healthy growth:
o require law enforcement;
o effective courts;
o functioning markets and a readily accepted currency;
o a stable constitution; and
• [relatively] honest government officials.
• take Eco 330 - Economics of Development - to learn more o or see me - this is my field!

Question 27

Why are institutions useful?

Answer 27

• relying on rules and laws make the economy efficient: o increases predictability and reduces uncertainty.
o reduces costs for people seeking to guard their own property and for those seeking to appropriate others’ property (since they won’t succeed, they won’t try).
o people don’t have to pursue political power to gain commercial advantage.

Question 28

Population Growth

Answer 28

• generally good for population to grow (moderately)
• a vibrant population promotes technological progress.
o more people
= more scientists, inventors, engineers
= more frequent discoveries
= faster technological progress & economic growth

Question 29

Rev. Doom - the Rev. Thomas Malthus

Answer 29

• his 1798 work - An Essay on the Principle of Population - argued that population growth is exponential while the growth of the food supply is arithmetic.
• in other words, he predicted that population would grow faster than our ability to feed ourselves.
• he thought the natural way of things was that poor people would starve to death, restoring population balance.

Question 30

More about Rev. Doom

Answer 30

• Malthus thought the natural way of things was that poor people would starve to death, restoring population balance.
• this was a common attitude of his time, when society thought that poor people were a problem to be managed, instead of people to be helped.

Question 31

What did Rev. Doom advise

Answer 31

• population needed to be “checked” to keep it at a sustainable level. o “preventive checks” > moral restraints (abstinence, delayed marriage until finances become balanced), and restricting marriage for persons suffering from poverty and/or defects.

• population needed to be
“checked” to keep it at a sustainable level.
o “positive checks” >
‘premature’ death from disease, starvation, war.

Question 32

Was Malthus right? Well, yes and no!

Answer 32

• Malthus argued that population growth would strain society’s ability to provide for itself.
• since his writing, the world population has increased six times!
o if Malthus’s theory was right, living standards should have fallen. o instead, they’ve risen.
• he was right, based on what he had observed up to the time he was
writing.
• BUT he was wrong because he failed to account for technological progress and productivity growth - he failed to observe the Industrial Revolution!

Question 33

And eventually the great Norman Borlaug ..

Answer 33

• the most important person you’ve never heard of.
• US born agronomist.
• combatted crop disease and improved crop yields.
• helped increase food production in Latin America and Asia.

• the most important person you’ve never heard of.
• is credited for saving 1 billion+ lives (yes, you read that right).
• won Nobel Peace Prize in 1970
• “You can’t build peace on an empty stomach.

Question 34

Malthus was not 100% wrong - population growth does have an effect

Answer 34

• diluting the capital stock
o bigger population -> higher L = lower K/L -> lower
productivity & living standards.
o this applies to Has well as K -> fast population growth -> more children - greater strain on educational system.
• countries with fast population growth tend to have lower educational attainment.

Question 35

More on population growth

Answer 35

• diluting the capital stock - too many people, too little capital
• to combat this, many developing countries use policy to control population growth.
* o China’s one child law (since repealed)
o contraception education & availability
o promote female literacy to raise opportunity cost of having babies

But be careful - population growth that is TOO low can have disastrous results also!
• countries need to strike a balance.

Question 36

Research and Development

Answer 36

• 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 everyone’s productivity.
• policies to promote technological progress:
o patent laws (they protect inventions from being stolen and so encourage inventors to innovate).
o tax incentives or direct support for private sector R&D. o grants for basic research at universities.

Question 37

The most successful venture capital firm in history

Answer 37

• it funded (among many other things) basic research leading to:
o the first computer o the internet o speech recognition software o mapping the human genome o solar and wind power improvements
• since 2010, the cost of
> solar power has dropped 85%
> wind power has dropped
50%.

Question 38

In sum.

Answer 38

• 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.
• next, we’ll look at how saving and investment are determined, and how policies can affect them.