Week 4 Economic Development PDF

COURSE LEARNING MODULE ECON 1023 (Economic Development) AY 2024-2025 Lesson 4: Understanding Growth Topic: Import...

COURSE LEARNING MODULE ECON 1023 (Economic Development) AY 2024-2025 Lesson 4: Understanding Growth Topic: Important Concepts in Understanding growth - Components of Income and Output - Total Factor Productivity - Economic Efficiency - Technical Progress Learning Outcomes: At the end of this module, you are expected to: - Identify important concepts in understanding growth. - Classify components of income and output. - Comprehend the idea on total factor productivity, economic efficiency, and technical progress. LEARNING CONTENT Introduction: As mentioned earlier, it is sometimes said that there can be growth without development. The cases of the oil sheikhdoms in the Middle East are good examples. Income and income per capita are much higher now than they were before the first oil shock, but the basic structure of these economies has not changed. Fortunately, because of small populations and high income, poverty is not a problem. In some other economies, there can be rapid growth of a mineral based subsector, as in Papua New Guinea, and yet there are almost no signs of economic development. Often, growth without development occurs when there is dualism in the economy-that is, when one sector is growing strongly but it has no strong linkages with the rest of the economy. This is the case with the mining sector in Papua New Guinea. The strong sector is either capital-intensive or has linkages with overseas investors, while the rest of the economy is underdeveloped, depends on local markets, and has a large agricultural sector. Recent rapid developments in technology may also lead to the growth of dualism across economies. Inevitably, there will be a dichotomy between those economies that are able to take advantage of technological developments and those who lag behind because of their inability to access computers, the Internet, and other technologies. This kind of duality can also occur at a global level. Lesson Proper: Why do economies grow? Why should they grow? Why do we want them to grow faster? These are the sorts of questions that economic development and macroeconomic subjects are concerned with. Of course, there are many other subjects that economists are interested in, but we will be primarily looking at economic growth and economic development. Some economists like to distinguish between growth and development. IMPORTANT CONCEPTS FOR UNDERSTANDING GROWTH ECON 1023-Economic Development | 1  We will study a number of theories that may explain the growth experiences of countries over time. To facilitate understanding of these theories, we first discuss some fundamental economic concepts. Components of Income and Output Output is derived by combining various factors of production, which include land, capital and labor. Normally, we take the supply of land as fixed and assume that its productivity can be enhanced by the application of labor or capital, the two variable inputs which are combined in a standard production function. The production function is a useful tool for analyzing the process of economic growth. A production function relates the inputs of the production process, such as labor (L) and capital (K), to the output/income (Y) from the process. This relationship can be stated in a number of ways. A general function (f) without any functional form can be stated as: Y= f(K, L) As labor and capital grow over time, so will income. What are some of the attributes of this relationship? To a large extent, the law of diminishing returns governs the growth process. As each worker acquires more capital, it follows that there would be diminishing returns to that capital. If this process were to continue for a long enough period, growth would slow to zero. However, this has not been the experience of the industrialized nations. Why? This is principally because of changes in the nature of the capital and labor and the way they are organized to produce output. The former is sometimes called embodied technical progress, and the latter disembodied technical progress. Embodied technical progress is reflected by the fact that labor forces have tended to become more educated over time as more resources are spent on upgrading the skills of the existing labor force and also on educating the young. Technological developments also tend to increase the productivity of capital. These developments are the result of innovation and invention. In the last decade, advances in information and computer technology have been the most apparent sources of innovation. These have both changed the nature of capital and labor inputs and the way that they are combined to create output. In terms of the kind of disembodied technical progress seen in applications in information and computer technology, there have been advances in management and industrial organization that have increased the level of output even when the amounts of labor and capital are fixed. The Internet as a tool for communication, information collection, and dissemination has increased in importance, and the use of computers to monitor and control production has become widespread. As a result, production processes have been streamlined, the need to keep large inventory of raw and semi-finished goods has been reduced, and the flexibility of production processes has increased. To summarize, at any level of capital and labor inputs, there will be an associated level of output. When the output increases at the same rate as the inputs, we refer to the production function as having constant returns to scale. This means that in Equation Y=f(K, L) we could multiply each input by some constant and the output would increase by that constant amount. In what follows, we will explore various aspects of the production function and technology that can change the relationship. For example, researchers have studied the rate of increase in labor, capital, and output. The evidence from these studies suggests that output increases more rapidly than inputs. If technology were fixed, this would imply that there would be increasing returns to scale, that is, that output would increase faster than inputs. However, as technology has changed, we have to interpret the difference between input and output growth in a slightly different way. ECON 1023-Economic Development | 2  The size of the labor force will increase over time as a lagged consequence of the natural increase in population. The capital stock will also increase as a result of investment. While it depends on how these factors are combined and the shape of the production function, increases in labor and capital will result in an increase in output and income. Historically, there has been a significant rate of growth per-capita income over time and this has resulted in higher standards of living more goods and services per capita-for many regions of the world. The Contribution of the two kinds of technological advance has also played a critical role in raising the standards of living. The next section will discuss how these two distinct contributing factors of embodied and disembodied technical progress can be measured. Total Factor Productivity By investigating the rate of growth of labor and capital together with income and output, economists have observed that there is some growth in output that is unaccounted for by the growth of labor and capital in the standard production functions, even when adjustments are made in the quality of the labor and capital inputs. In some cases, this discrepancy or residual is quite large. This residual has been called total factor productivity (TFP), or multifactor productivity. TFP pertains to the efficiency with which the inputs are combined to produce output. These efficiency gains can be due to a number of factors, including greater economies of scale, better management, marketing or organizational abilities, shifts in production from low productivity activities to higher productivity activities with the same amount of labor and capital, or the impact of new technology which enables greater output to be obtained with the same capital and labor inputs. If we call this TFP, or multifactor productivity, term A, and denote capital and labor by K and L respectively, then the production function can be rewritten as Y=f(K, L, A). This equation is a general expression. Often, economists assume that competitive conditions exist in capital and labor markets and there are constant returns to scale. If this is the case, then we can show that the growth rate of income is equal to the growth rates of the capital and labor inputs weighted by their shares in national income: g(Y) =g(K) W(K) +g(L) W(L) + A where g(Y) is the growth rate of income, g(K) is the growth rate of capital (investment), g(L) is the growth rate of labor, and W(K) and W(L) are the weighted shares of capital and labor in the economy. The growth rate of income thus equals the sum of the three terms. The first term is the growth rate of capital multiplied by the ratio of capital to labor, and by a term that is the marginal product of capital. The second term is similar to the first term except that it is for labor. The third term involves the efficiency factor, A. If we assume that labor and capital are paid the value of their marginal products, the result would be that the growth in output would be equal to the sum of three factors: the growth rate of capital multiplied by its share of output plus the growth rate of labor multiplied by labor’s share in output plus a residual term. Notice that this residual term measures both embodied and disembodied technical progress. To the extent that we can adjust the labor and capital inputs to reflect changes in the level of skill of the labor force and the quality of capital inputs, we can incorporate embodied technical progress into the first two terms. However, to the extent that we miss out on some of this embodied technical progress, it will be included in the efficiency term A. Working through an example, suppose a country has a growth rate of income of 6 percent, a growth rate of capital (net of depreciation) of 10 percent, and capital’s share of income is 30-percent, labor’s share is 70 percent and labor grows at 1 percent, then the sum of the terms on the right-hand side, apart from A, will be 0.06 = A + 0.3(0.10) + 0.7(0.01) ECON 1023-Economic Development | 3  In this example, A = 0.023 and technical progress accounts for just a little less than 40 percent of the output growth of 6 percent. There are, of course, many assumptions in this model. The biggest assumption is that factors are paid the value of their marginal product and that the two factors, K and L, exhaust total output, in the sense that their coefficients add up to one. This is essentially a constant return to scale argument so that we do not allow for output growth to exceed the rate of growth of labor and capital. Notice also that the growth in income will be raised if the investment rate is increased or if the labor force increases more rapidly. Efficiency, meanwhile, is assumed to be unchanged. Economic Efficiency The production possibility frontier (PPF) is a curve depicting the best possible combination of goods that is produced in an economy-best in the sense that the combination utilizes all the available inputs efficiently and minimizes waste. The case for an economy that produces only two goods-cell phones and jeans-is shown in Figure 3.1. In Figure 3.1a, the point A on the y axis is the production option where all inputs are used to manufacture cell phones only, while the point D on the x axis is the production option that uses all available inputs for the productions of jeans alone. The points B and C are production options where all available inputs are used for the production of some cell phones and jeans. Each point-A, B, C, and D (as well as other combinations on the curve)--trace the PPF curve of the economy. Each point on this curve represents the maximum number of jeans and/or cell phones that can be produced according to the inputs to the production process. In this sense, these combinations are efficient and the PPF, therefore, represents the “best practice” firms in the economy. In contrast, a production combination represented by a point inside the PPF curve, say B, does not utilize all the available resources for economic production; With some resources remaining idle, this production option is considered inefficient. Economic efficiency is boosted in a static sense (static efficiency) if firms move from inside the production possibility frontier, say point B, toward the frontier itself, to point E’. An improvement in economic efficiency of this type could lead to a one-time increase in income but it would not arrest the tendency toward decreasing returns. This drift toward decreasing returns is one reason that richer economies tend to grow more slowly than some poorer economies. There are, of course, many other factors involved in growth, which is why many poor countries, particularly in Africa and Latin America, have also experienced slow or even negative growth in per-capita income Improvements in economic efficiency can take place in a number of ways, including the move toward best practice through better management and organization. This could be done by implementing better inventory-control measures, better relations between management and labor, new methods of organizing the way products are assembled (within the existing capital structure and labor-force configurations), and so on. By contrast with static efficiency, dynamic efficiency takes place when there is economic growth and the scale of production increases (scale efficiencies), or production shifts from a low productivity sector to a ECON 1023-Economic Development | 4 more productive sector. In Figure 3.1b, this is represented by an outward shift of the PPF curve (the dotted line). In Asia, much of the dynamic efficiency resulted from a shift from the less efficient agricultural sector to a more efficient industry. Such inter-industry shifts usually take place quickly when an economy is growing rapidly. Dynamic efficiency can also result from new innovations and inventions which boost total factor productivity. It can also be due to more effective marketing and distribution arrangements, sometimes with foreign outlets. Large-scale operations also allow bulk purchasing and quantity discounts that are unavailable to smaller-scale operations. Many multinational firms also use different production sites to manufacture different components of a product in order to take advantage of lower costs. These components are then shipped to other locations where they are assembled and delivered to buyers. Since dynamic efficiency leads to an outward shift of the production possibility frontier, it leads to a higher level of output for the same level of capital and labor inputs. Dynamic efficiency may also involve the use of new technology and innovations as old capital equipment is replaced and older workers are either replaced or retrained. Technical Progress As noted above, there are two kinds of technical progress or innovation that can be achieved by an economy. Embodied technical progress has to do with the changing nature of the inputs into the production process. These would include more highly skilled and computer-literate workers, or less stressed and more congenial workers, or the installation of new innovations in capital equipment. Disembodied technical progress, on the other hand, relates to the way factors are combined together in the workplace, such as management or organizational innovations. This type of technical progress would be contained in the residual, A, in Equation Y= f(K, L, A) and would arise from the way in which factors are combined together within the firm and the industry. Practically, it is unlikely that all the embodied technical progress will be captured in the measures of labor and capital. Usually, it is hard to get good estimates of the capital stock as we tend to rely on investment figures to measure the increment to capital. These figures are measured in a monetary unit and therefore do not tell much about the amount of new innovation or technology contained in this new capital. Similarly, labor input is usually measured in terms of man-hours or man-years worked. However, new, more highly trained and educated workers enter the workforce all the time and older workers retire. These figures are not ordinarily used to construct a new labor series each year that reflects this higher embodiment of education and skill into the hours or years worked. There are, nevertheless, attempts to use a range of educational attainment variables to measure these labor-force effects separately. There have also been attempts to measure what are called vintage production function that is, production functions which assume that each year has a new vintage of capital that has higher innate productivity than do capital investments in previous years. By constructing a vintage capital model, some economists have been able to reduce quite substantially the size of the residual, A, in the neoclassical production in Equation Y= f(K, L, A). However, similar attempts to construct vintage labor production functions have not been widely made, primarily because people, unlike capital, can increase their productivity during their lifetime. Therefore, it is unrealistic to assume that each new cohort of graduates is more qualified than older workers. Thus, in practice, the residual term will probably contain elements of both disembodied and embodied technical progress. In growth accounting, the shares of the different factors of production are assumed to be known and are not estimated as they would be in, say, a Cobb-Douglas constant elasticity of substitution, or variable elasticity of substitution model. These growth accounting models assume that the shares of labor and capital in the national accounts are marginal products of these factors and are simply added to the factors contributing to ECON 1023-Economic Development | 5 output. The contribution of other factors, such as education and technological innovation, can also be incorporated by constructing a new series or by adjusting the existing series. For example, the labor input can be adjusted by multiplying the labor series by an index of rising educational attainment over time, or by introducing a new factor of production, such as education, and measuring its separate contribution to output. Growth accounting is useful because it is a shorthand method for assessing technical progress. It does not require calculating a production function, which can often be complicated by the lack of reliable information on capital stock and labor supply, and difficulties in empirical estimation. *** END of LESSON *** REFERENCES Textbooks Dowling, J.Malcolm, Valenzuela, Ma.R.,Brux, J. (2019) Economic Development Philippine Edition. Cengage learning Asia Pte Ltd. WARNING: No part of this E-module/LMS Content can be reproduced, or transported or shared to others without permission from the University. Unauthorized use of the materials, other than personal learning use, will be penalized. Please be guided accordingly. ECON 1023-Economic Development | 6