7.2Labor Productivity and Economic Growth

Contractual rights, then, are based on property rights and they allow individuals to enter into agreements with others regarding the use of their property providing recourse through the legal system in the event of noncompliance. One example is the employment agreement: a skilled surgeon operates on an ill person and expects payment. Failure to pay would constitute property theft by the patient. The theft is property the services that the surgeon provided. In a society with strong property rights and contractual rights, the terms of the patient–surgeon contract will be fulfilled, because the surgeon would have recourse through the court system to extract payment from that individual. Without a legal system that enforces contracts, people would not be likely to enter into contracts for current or future services because of the risk of non-payment. This would make it difficult to transact business and would slow economic growth. The World Bank considers a country’s legal system effective if it upholds property rights and contractual rights. The World Bank has developed a ranking system for countries’ legal systems based on effective protection of property rights and rule-based governance using a scale from 1 to 6, with 1 being the lowest and 6 the highest rating. In 2020, the world average ranking was 2.9. The three countries with the lowest ranking of 1.0 were Somalia and Eritrea, with South Sudan at 1.5. Their GDP per capita was $875, $1,625, and $1,234.70 respectively. The World Bank also cites Afghanistan (GDP per capita $2,087.60) as having a low standard of living, weak government structure, and lack of adherence to the rule of law, which has stymied its economic growth. The landlocked Central African Republic (GDP per capita $979.60) has poor economic resources as well as political instability and is a source of children used in human trafficking. Zimbabwe (GDP per capita $2,895.40) has had declining and often negative growth for much of the period since 1998. Land redistribution and price controls have disrupted the economy, and corruption and violence have dominated the political process. Although global economic growth has increased, those countries lacking a clear system of property rights and an independent court system free from corruption have lagged far behind.

7.2 Labor Productivity and Economic Growth

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Identify the role of labor productivity in promoting economic growth
• Analyze the sources of economic growth using the aggregate production function
• Measure an economy’s rate of productivity growth
• Evaluate the power of sustained growth

Sustained long-term economic growth comes from increases in worker productivity, which essentially means how well we do things. In other words, how efficient is your nation with its time and workers? Labor productivity is the value that each employed person creates per unit of their input. The easiest way to comprehend labor productivity is to imagine a Canadian worker who can make 10 loaves of bread in an hour versus a U.S. worker who in the same hour can make only two loaves of bread. In this fictional example, the Canadians are more productive. More productivity essentially means you can do more in the same amount of time. This in turn frees up resources for workers to use elsewhere. What determines how productive workers are? The answer is pretty intuitive. The first determinant of labor productivity is human capital. Human capital is the accumulated knowledge (from education and experience), skills, and expertise that the average worker in an economy possesses. Typically the higher the average level of education in an economy, the higher the accumulated human capital and the higher the labor productivity. The second factor that determines labor productivity is technological change. Technological change is a combination of invention—advances in knowledge—and innovation, which is putting those advances to use in a new product or service. For example, the transistor was invented in 1947. It allowed us to miniaturize the footprint of electronic devices and use less power than the tube technology that came before it. Innovations since then have produced smaller and better transistors that are ubiquitous in products as varied as smart- phones, computers, and escalators. Developing the transistor has allowed workers to be anywhere with smaller devices. People can use these devices to communicate with other workers, measure product quality or do any other task in less time, improving worker productivity. The third factor that determines labor productivity is economies of scale. Recall that economies of scale are the cost advantages that industries obtain due to size. (Read more about economies of scale in Production, Cost and Industry Structure (http://openstax.org/books/principles-microeconomics-ap-courses-2e/pages/ 7-introduction-to-production-costs-and-industry-structure).) Consider again the case of the fictional Canadian worker who could produce 10 loaves of bread in an hour. If this difference in productivity was due only to economies of scale, it could be that the Canadian worker had access to a large industrial-size oven while the U.S. worker was using a standard residential size oven. Now that we have explored the determinants of worker productivity, let’s turn to how economists measure economic growth and productivity.

Sources of Economic Growth: The Aggregate Production Function

To analyze the sources of economic growth, it is useful to think about a production function, which is the technical relationship by which economic inputs like labor, machinery, and raw materials are turned into outputs like goods and services that consumers use. A microeconomic production function describes a firm's or perhaps an industry's inputs and outputs. In macroeconomics, we call the connection from inputs to outputs for the entire economy an aggregate production function.

Components of the Aggregate Production Function

Economists construct different production functions depending on the focus of their studies. Figure 7.2 presents two examples of aggregate production functions. In the first production function in Figure 7.2 (a), the output is GDP. The inputs in this example are workforce, human capital, physical capital, and technology. We discuss these inputs further in the module, Components of Economic Growth.

FIGURE 7.2Aggregate Production Functions An aggregate production function shows what goes into producing the output for an overall economy. (a) This aggregate production function has GDP as its output. (b) This aggregate production function has GDP per capita as its output. Because we calculate it on a per-person basis, we already figure the labor input into the other factors and we do not need to list it separately.

Measuring Productivity

An economy’s rate of productivity growth is closely linked to the growth rate of its GDP per capita, although the two are not identical. For example, if the percentage of the population who holds jobs in an economy increases, GDP per capita will increase but the productivity of individual workers may not be affected. Over the long term, the only way that GDP per capita can grow continually is if the productivity of the average worker rises or if there are complementary increases in capital. A common measure of U.S. productivity per worker is dollar value per hour the worker contributes to the employer’s output. This measure excludes government workers, because their output is not sold in the market and so their productivity is hard to measure. It also excludes farming, which accounts for only a relatively small share of the U.S. economy. Figure 7.3 shows an index of output per hour, with 2012 as the base year (when the index equals 100). The index equaled 110.5 in 2020. In 1977, the index equaled about 50, which shows that workers have more than doubled their productivity since then.

FIGURE 7.3Output per Hour Worked in the U.S. Economy, 1947–2020Output per hour worked is a measure of worker productivity. In the U.S. economy, worker productivity rose more quickly in the 1960s and the mid-1990s compared with the 1970s and 1980s. However, these growth-rate differences are only a few percentage points per year. Look carefully to see them in the changing slope of the line. The average U.S. worker produced over twice as much per hour in 2020 than they did in the 1970s. (Source: U.S. Department of Labor, Bureau of Labor Statistics.) Access multimedia content (http://openstax.org/books/principles-macroeconomics-3e/pages/7-2-labor- productivity-and-economic-growth) A graph has an X-axis with years progressing from 1955 to 2020 and a Y axis labeled Percent Change at Annual Rate. The graphed data moves up and down across a zero line indicating change year over year. In 1970, 1974, 1981, 1983, 2008, and 2020, the rate was quite low, as the U.S. was undergoing recessions. According to the Department of Labor, U.S. productivity growth was fairly strong in the 1950s but then declined in the 1970s and 1980s before rising again in the second half of the 1990s and the first half of the 2000s. In fact, the rate of productivity measured by the change in output per hour worked averaged 2.8% per year from 1947 to 1973; dropped to 1.2% per year from 1973 to 1979; increased to 1.5% per year from 1979 to 1990; increased again to 2.2% from 1990 to 2000; increased even more to 2.7% from 2000 to 2007; and then decreased to 1.4% from 2007 to 2020 Figure 7.4 shows average annual rates of productivity growth averaged over time since 1947.

FIGURE 7.4Productivity Growth Since 1947U.S. growth in worker productivity was very high between 1947 and 1973. It then declined to lower levels in the later 1970s and the 1980s. The late 1990s and early 2000s saw productivity rebound, but then productivity sagged a bit between 2001 and 2020. Some think the productivity rebound of the late 1990s and early 2000s marks the start of a “new economy” built on higher productivity growth, but we cannot determine this until more time has passed. (Source: U.S. Department of Labor, Bureau of Labor Statistics.)

The “New Economy” Controversy

In recent years a controversy has been brewing among economists about the resurgence of U.S. productivity in the second half of the 1990s. One school of thought argues that the United States had developed a “new economy” based on the extraordinary advances in communications and information technology of the 1990s. The most optimistic proponents argue that it would generate higher average productivity growth for decades to come. The pessimists, alternatively, argue that even five or ten years of stronger productivity growth does not prove that higher productivity will last for the long term. It is hard to infer anything about long-term productivity trends during the later part of the 2000s, because the steep 2008-2009 recession, with its sharp but not completely synchronized declines in output and employment, complicates any interpretation. While productivity growth was high in 2009 and 2010 (around 3%), it has slowed down over the last decade. Productivity growth is also closely linked to the average level of wages. Over time, the amount that firms are willing to pay workers will depend on the value of the output those workers produce. If a few employers tried to pay their workers less than what those workers produced, then those workers would receive offers of higher wages from other profit-seeking employers. If a few employers mistakenly paid their workers more than what those workers produced, those employers would soon end up with losses. In the long run, productivity per hour is the most important determinant of the average wage level in any economy. To learn how to compare economies in this regard, follow the steps in the following Work It Out feature. WORK IT OUT Comparing the Economies of Two Countries The Organization for Economic Co-operation and Development (OECD) tracks data on the annual growth rate of real GDP per hour worked. You can find these data on the OECD data webpage “Growth in GDP per capita, productivity and ULC” at this (http://stats.oecd.org/Index.aspx?DataSetCode=PDB_GR) website. Step 1. Visit the OECD website given above and select two countries to compare. Step 2. On the drop-down menu “Subject,” select “ GDP per capita, constant prices,” and under “Measure,” select “Annual growth/change.” Then record the data for the countries you have chosen for the five most recent years. Step 3. Go back to the drop-down “Subject” menu and select “GDP per hour worked, constant prices,” and under “Measure” again select “Annual growth/change.” Select data for the same years for which you selected GDP per capita data. Step 4. Compare real GDP growth for both countries. Table 7.2 provides an example of a comparison between Australia and Belgium. Australia 2011 2012 2013 2014 2015 Real GDP/Capita Growth (%) 2.3% 1.5% 1.3% 1.4 0.1% Real GDP Growth/Hours Worked (%) 1.7% −0.1% 1.4% 2.2% −0.2% Belgium 2011 2012 2013 2014 2015 Real GDP/Capita Growth (%) 0.9 −0.6 −0.5 1.2 1.0 Real GDP Growth/Hours Worked (%) −0.5 −0.3 0.4 1.4 0.9 TABLE 7.2 Step 5. For both measures, growth in Australia is greater than growth in Belgium for the first four years. In addition, there are year-to-year fluctuations. Many factors can affect growth. For example, one factor that may have contributed to Australia's stronger growth may be its larger inflows of immigrants, who generally contribute to economic growth.

The Power of Sustained Economic Growth

Nothing is more important for people’s standard of living than sustained economic growth. Even small changes in the rate of growth, when sustained and compounded over long periods of time, make an enormous difference in the standard of living. Consider Table 7.3, in which the rows of the table show several different rates of growth in GDP per capita and the columns show different periods of time. Assume for simplicity that an economy starts with a GDP per capita of 100. The table then applies the following formula to calculate what GDP will be at the given growth rate in the future: For example, an economy that starts with a GDP of 100 and grows at 3% per year will reach a GDP of 209 after 25 years; that is, 100 (1.03)25 = 209. The slowest rate of GDP per capita growth in the table, just 1% per year, is similar to what the United States experienced during its weakest years of productivity growth. The second highest rate, 3% per year, is close to what the U.S. economy experienced during the strong economy of the late 1990s and into the 2000s. Higher rates of per capita growth, such as 5% or 8% per year, represent the experience of rapid growth in economies like Japan, Korea, and China. Table 7.3 shows that even a few percentage points of difference in economic growth rates will have a profound effect if sustained and compounded over time. For example, an economy growing at a 1% annual rate over 50 years will see its GDP per capita rise by a total of 64%, from 100 to 164 in this example. However, a country growing at a 5% annual rate will see (almost) the same amount of growth—from 100 to 163—over just 10 years. Rapid rates of economic growth can bring profound transformation. (See the following Clear It Up feature on the relationship between compound growth rates and compound interest rates.) If the rate of growth is 8%, young adults starting at age 20 will see the average standard of living in their country more than double by the time they reach age 30, and grow more than sixfold by the time they reach age 45. Growth Value of an original 100 in 10 Value of an original 100 in 25 Value of an original 100 in 50 Rate Years Years Years 1% 110 128 164 3% 134 209 438 5% 163 339 1,147 8% 216 685 4,690 TABLE 7.3Growth of GDP over Different Time Horizons CLEAR IT UP How are compound growth rates and compound interest rates related? The formula for GDP growth rates over different periods of time, as Figure 7.3 shows, is exactly the same as the formula for how a given amount of financial savings grows at a certain interest rate over time, as presented in Choice in a World of Scarcity. Both formulas have the same ingredients:

• an original starting amount, in one case GDP and in the other case an amount of financial saving;
• a percentage increase over time, in one case the GDP growth rate and in the other case an interest rate;
• and an amount of time over which this effect happens.

Recall that compound interest is interest that is earned on past interest. It causes the total amount of financial savings to grow dramatically over time. Similarly, compound rates of economic growth, or the compound growth rate, means that we multiply the rate of growth by a base that includes past GDP growth, with dramatic effects over time. For example, in 2020, the Central Intelligence Agency's World Fact Book reported that South Korea had a GDP of $2.2 trillion. With a growth rate of 2.8% per year, South Korea's GDP will be $2.5 trillion in five years. If we apply the growth rate to each year’s ending GDP for the next five years, we will calculate that at the end of year one, GDP is $2.3 trillion. In year two, we start with the end-of-year one value of $2.3 trillion and increase it by 2.8%. Year three starts with the end-of-year two GDP, and we increase it by 2.8% and so on, as Table 7.4 depicts. Year Starting GDP Growth Rate 2.8% Year-End Amount 1 $2.2 Trillion × (1+0.028) $2.26 Trillion 2 $2.3 Trillion × (1+0.028) $2.32 Trillion 3 $2.3 Trillion × (1+0.028) $2.38 Trillion TABLE 7.4 Year Starting GDP Growth Rate 2.8% Year-End Amount 4 $2.4 Trillion × (1+0.028) $2.44 Trillion 5 $2.5 Trillion × (1+0.028) $2.50 Trillion TABLE 7.4 Another way to calculate the growth rate is to apply the following formula: Where “future value” is the value of GDP five years hence, “present value” is the starting GDP amount of $2.2 trillion, “g” is the growth rate of 2.8%, and “n” is the number of periods for which we are calculating growth.

7.3 Components of Economic Growth

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Discuss the components of economic growth, including physical capital, human capital, and technology
• Explain capital deepening and its significance
• Analyze the methods employed in economic growth accounting studies
• Identify factors that contribute to a healthy climate for economic growth

Over decades and generations, seemingly small differences of a few percentage points in the annual rate of economic growth make an enormous difference in GDP per capita. In this module, we discuss some of the components of economic growth, including physical capital, human capital, and technology. The category of physical capital includes the plant and equipment that firms use as well as things like roads (also called infrastructure). Again, greater physical capital implies more output. Physical capital can affect productivity in two ways: (1) an increase in the quantity of physical capital (for example, more computers of the same quality); and (2) an increase in the quality of physical capital (same number of computers but the computers are faster, and so on). Human capital refers to the skills and knowledge that make workers productive. Human capital and physical capital accumulation are similar: In both cases, investment now pays off in higher productivity in the future. The category of technology is the “joker in the deck.” Earlier we described it as the combination of invention and innovation. When most people think of new technology, the invention of new products like the laser, the smartphone, or some new wonder drug come to mind. In food production, developing more drought-resistant seeds is another example of technology. Technology, as economists use the term, however, includes still more. It includes new ways of organizing work, like the invention of the assembly line, new methods for ensuring better quality of output in factories, and innovative institutions that facilitate the process of converting inputs into output. In short, technology comprises all the advances that make the existing machines and other inputs produce more, and at higher quality, as well as altogether new products. It may not make sense to compare the GDPs of China and say, Benin, simply because of the great difference in population size. To understand economic growth, which is really concerned with the growth in living standards of an average person, it is often useful to focus on GDP per capita. Using GDP per capita also makes it easier to compare countries with smaller numbers of people, like Belgium, Uruguay, or Zimbabwe, with countries that have larger populations, like the United States, the Russian Federation, or Nigeria. To obtain a per capita production function, divide each input in Figure 7.2(a) by the population. This creates a

Simpler explanation — Cambridge AS & A Level Economics

Economic growth is a key indicator of macroeconomic performance. Economic growth is an increase in an economy’s output. The economic growth rate is the annual percentage change in output. For people to enjoy more goods and services, output has to increase by more than any growth in population. In such a case, GDP per head (per capita) would increase.

For many years, it was assumed that poverty would be eradicated if countries managed to sustain economic growth. As a result, economic growth and economic development were seen as the same thing. It was assumed that if economies grew they would also experience development. The increased availability of goods and services in an economy would lead to a ‘trickle down’ effect that would have an impact upon all, including the poor members of society, in terms of jobs and other economic benefits. In reality, however, economic growth does not result in a rise in the living standards and quality of life of everyone in an economy.

It is also possible for a high proportion of people to achieve an improvement in their living standards and quality of life even if economic growth does not occur, for example, if there is a more equal distribution of income or a reduction in pollution. As a result, a wider definition of economic development is now accepted that is related to, but distinct from, economic growth. In other words, economic development is the process of improving people’s economic well-being and quality of life. KEY CONCEPT LINK Progress and development: Economic growth is perhaps the key measure of progress in an economy. This can be assessed by examining economic data.