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24 Measuring the Cost of Living PRINCIPLES OF FOURTH EDITION N. G R E G O R Y M A N K I W Power. Point® 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? CHAPTER 24 MEASURING THE COST OF LIVING 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 cost of basket 2003 \$10 \$2. 00 \$10 x 4 + \$2 x 10 = \$60 2004 \$11 \$2. 50 \$11 x 4 + \$2. 5 x 10 = \$69 2005 \$12 \$3. 00 \$12 x 4 + \$3 x 10 = \$78 CHAPTER 24 MEASURING THE COST OF LIVING 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 cost of basket in current year 100 x 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: 2003: 100 x (\$60/\$60) = 100 2004: 100 x (\$69/\$60) = 115 2005: 100 x (\$78/\$60) = 130 Inflation rate: 15% 13% CHAPTER 24 MEASURING THE COST OF LIVING 10

A C T I V E L E A R N I N G 1: Calculate the CPI The basket contains 20 movie tickets and 10 textbooks. The table shows their prices for 2004 -2006. 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

A C T I V E L E A R N I N G 1: Answers A. How much did the basket cost in 2004? textbooks 2004 \$10 \$50 2005 The basket contains 20 movie tickets and 10 textbooks. movie tickets \$10 \$60 2006 \$12 \$60 (\$10 x 20) + (\$50 x 10) = \$700 12

A C T I V E L E A R N I N G 1: Answers B. What is the CPI in 2005? textbooks 2004 \$10 \$50 2005 The basket contains 20 movie tickets and 10 textbooks. movie tickets \$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

A C T I V E L E A R N I N G 1: Answers The basket contains 20 movie tickets and 10 textbooks. C. What is the inflation rate from 2005 -2006? movie tickets textbooks 2004 \$10 \$50 2005 \$10 \$60 2006 \$12 \$60 cost of basket in 2006 = (\$12 x 20) + (\$60 x 10) = \$840 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 CHAPTER 24 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. 23 CHAPTER 24 MEASURING THE COST OF LIVING

A C T I V E L E A R N I N G 2: CPI vs. GDP deflator 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

A C T I V E L E A R N I N G 3: Exercise 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

A C T I V E L E A R N I N G 3: Answers 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. CHAPTER 24 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 FOURTH EDITION N. G R E G O R Y M A N K I W Power. Point® 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 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 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 person in 1900, but over the next 100 years economic growth person was about 2. 2% per year in France and about 1. 1 percent per year in Argentina. Today, income 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 1913 1950 1996 Annual Growth Rate CHAPTER 25 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 PRODUCTION AND GROWTH 66

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: 2 Y = A F(2 L, 2 K, 2 H, 2 N) § Increasing all inputs 10% (multiplying each by 1. 1) causes output to increase by 10%: 1. 1 Y = A F(1. 1 L, 1. 1 K, 1. 1 H, 1. 1 N) CHAPTER 25 PRODUCTION AND GROWTH 67

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? CHAPTER 25 PRODUCTION AND GROWTH 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 CHAPTER 25 PRODUCTION AND GROWTH 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. CHAPTER 25 PRODUCTION AND GROWTH 70

A C T I V E L E A R N I N G 1: Discussion question 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. b. c. d. e. f. g. offer tax incentives for investment by local firms …by foreign firms give cash payments for good school attendance crack down on govt corruption restrict imports to protect domestic industries allow free trade 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. CHAPTER 25 PRODUCTION AND GROWTH 72

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. CHAPTER 25 PRODUCTION AND GROWTH 73

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”. CHAPTER 25 PRODUCTION AND GROWTH 74

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…. CHAPTER 25 PRODUCTION AND GROWTH 75

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. CHAPTER 25 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 starts here CHAPTER 25 PRODUCTION AND GROWTH K/L Rich country starts here 77

This coming Thursday, 1 st 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 CHAPTER 25 PRODUCTION AND GROWTH 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. CHAPTER 25 PRODUCTION AND GROWTH 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. CHAPTER 25 PRODUCTION AND GROWTH 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. CHAPTER 25 PRODUCTION AND GROWTH 81

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. CHAPTER 25 PRODUCTION AND GROWTH 82

CHAPTER 25 PRODUCTION AND GROWTH 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. CHAPTER 25 PRODUCTION AND GROWTH 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. CHAPTER 25 PRODUCTION AND GROWTH 85

caloric consumption CHAPTER 25 PRODUCTION AND GROWTH 86

Nobel winner Robert Fogel § 30% of Great Britain’s growth from 1790 -1980 was due to improved nutrition. CHAPTER 25 PRODUCTION AND GROWTH 87

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. CHAPTER 25 PRODUCTION AND GROWTH 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. CHAPTER 25 PRODUCTION AND GROWTH 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. CHAPTER 25 PRODUCTION AND GROWTH 90

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. CHAPTER 25 PRODUCTION AND GROWTH 91

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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 20 th century. § Countries with outward-oriented policies have often succeeded. • e. g. , South Korea, Singapore, Taiwan after 1960. CHAPTER 25 PRODUCTION AND GROWTH 93

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 CHAPTER 25 PRODUCTION AND GROWTH 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 CHAPTER 25 PRODUCTION AND GROWTH 95

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. CHAPTER 25 PRODUCTION AND GROWTH 96

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. CHAPTER 25 PRODUCTION AND GROWTH 97

Population Growth 2. Diluting the capital stock To combat this, many developing countries use policy to control population growth. • China’s one child per family laws • contraception education & availability • promote female literacy to raise opportunity cost of having babies CHAPTER 25 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 CHAPTER 25 PRODUCTION AND GROWTH 99

A C T I V E L E A R N I N G 2: Productivity § List the determinants of productivity. § List three policies that attempt to raise living standards by increasing one of the determinants of productivity. 100

A C T I V E L E A R N I N G 2: Answers 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

A C T I V E L E A R N I N G 2: Answers 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. CHAPTER 25 PRODUCTION AND GROWTH 103

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. CHAPTER 25 PRODUCTION AND GROWTH 104

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. CHAPTER 25 PRODUCTION AND GROWTH 105

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. CHAPTER 25 PRODUCTION AND GROWTH 106