Applying the Production Function: Achieving Economic Growth

The production function allows us to measure how inputs are converted into outputs. The extent to which inputs are converted into outputs is referred to as productivity. For example, when worker productivity grows, each worker is producing more output for each hour devoted to production.

Productivity is a key driver of wages and incomes. The primary reason that the American standard of living is so high is that American workers produce more per hour than do workers in most other countries. Many people in the developing world eke out a living using tools that would remind us of an earlier century. This lower productivity is reflected in their lower standard of living.

The factors of production discussed in the previous section play an important role in increasing economic growth. As the quantity of each factor rises, output rises according to the production function for each industry. In addition, technology plays an important role in enhancing the productive output of all other resources.

A country’s output is measured by the value of the goods and services it produces, which can increase based on their quantity or quality. In other words, highly productive countries are able to produce many goods that are high in value. One reason why Japan remains one of the world’s richest countries is that its labor force is highly productive—using abundant capital, human capital, and technology, Japan’s labor force produces many high-priced products such as cars, robots, and advanced electronics.

Let’s look at each factor of production in turn to examine what increases productivity and economic growth.

Achieving More Land or Natural Resources

Natural resources are the building blocks of production; however, they are not a significant driver of economic growth. Countries that are abundant in land and natural resources have an advantage that can translate into economic growth only if such resources are used effectively. Countries that discovered new natural resources have experienced higher rates of growth. For example, new oil deposits have been discovered in Angola and Cameroon over the past decade. These discoveries led to significant investment by oil companies from China, India, and the United States in these countries, which contributed to a higher growth rate.

Growth of the Labor Force

Many countries have experienced significant population growth, leading to an increase in the labor supply. In the United States, population growth has been spurred by a relatively open immigration policy compared to other countries. In addition to population growth, labor force participation increased over the last few decades, as more women entered the workforce and as government policies were implemented to make work more attractive. An increase in the labor force generally leads to greater output, but not necessarily more output per person. In order for economic growth to improve the standard of living of its citizens, countries must not only expand the quantity of its labor force, but also the quality of labor to ensure that economic growth exceeds population growth.

Increasing the Quality of the Labor Force

One source of productivity growth comes from improvements to the labor force from investment in human capital. Human capital is a term economists use to describe skills, knowledge, and the quality of workers. On-the-job training and general education can improve the quality of labor. In many ways, increasing capital and a highly skilled labor force go together: Well-trained workers are needed to run the highly productive, often highly complex, machines. Unskilled workers are given the least important jobs and earn the lowest wages.

By investing in human capital, nations can ultimately raise their growth rates by improving worker productivity. Government programs that raise the literacy rate, such as universal public education, also raise the rate of economic growth.

Increasing the Capital-to-Labor Ratio

When a farmer in the small Himalayan country of Bhutan plows his field with a crude plow hitched to a couple of yaks, the amount of land he can plant and harvest is miniscule. American farmers, in contrast, use equipment that allows them to plow, plant, fertilize, water, and harvest thousands of acres; they have a high capital-to-labor ratio. This raises U.S. farm productivity many orders of magnitude above that of poor Bhutanese farmers. The ultimate result of this productivity is that American farmers earn a far higher income than their counterparts in the developing world.

Developing countries have large labor forces, but little capital. Developed nations like the United States, on the other hand, have limited labor supplies, and each worker works with a large array of capital equipment. As a rule, the more capital employed by workers, the greater their productivity and the higher their earnings.

Using expensive tractors and other capital equipment, U.S. farmers are more productive than Bhutanese farmers who rely on wooden plows pulled by yaks.

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Although a powerful contributor to productivity, capital is subject to diminishing returns to capital. For example, suppose that the farmer in Bhutan buys a tractor to replace his yaks. The increase in productivity would be dramatic. Now suppose that the farmer invests in an irrigation system. Surely the irrigation system will further increase productivity, but likely not as much as the tractor did. In other words, a farmer is likely to purchase the most essential equipment first. Each subsequent piece of equipment will increase production but by a smaller amount than the previous one. For this reason, countries with abundant capital will not gain as much per additional piece of capital than countries with little capital with which to start. This is one reason why developing countries may initially grow faster than developed countries, a phenomenon called the catch-up effect.

THOMAS MALTHUS (1766–1834)

Thomas Malthus was raised in Surrey, England, the son of a wealthy eccentric country gentleman. Home-schooled by his father and a tutor, he had learned enough to be accepted to Cambridge University. After attending Cambridge, he spent several years as a clergyman before accepting a teaching post in political economy at the college of the East India Company, making him the first academic economist in history.

In 1793, the pamphleteer William Godwin published Political Justice, describing a utopian future with no war, poverty, crime, injustice, or disease. Malthus argued against the book’s conclusions during a lengthy discussion with his father, who agreed with the book, but nevertheless suggested that Malthus set down his ideas in print.

The result was “An Essay on the Principle of Population as It Affects the Future Improvement of Society.” Malthus argued that the origins of poverty were rooted in an unavoidable contradiction: Population, when allowed to grow without limits, increases geometrically, while the food supply could only increase arithmetically. He argued that English Poor Laws spread pauperism because any improvement in conditions of the poor would simply lead to population increases and to rising food prices and scarcities.

He even went so far as to suggest that “a proclamation should be read out at marriage ceremonies warning couples that they would have to bear the financial burden and consequences of their passion.”

His dire predictions about world starvation led Thomas Carlyle a few decades later to describe the economics profession as the “Dismal Science.” Although the predictions of inadequate food supply did not fully materialize due to the invention of agricultural technologies and fertilizer, the “Dismal Science” remains today as an alternative name for economics.

Sources: Paul Strathern, A Brief History of Economic Genius (New York: Texere), 2002; Howard Marshall, The Great Economists: A History of Economic Thought (New York: Pitman Publishing), 1967; Donald Winch, “Malthus,” in Three Great Economists (Oxford: Oxford University Press), 1997, pp. 105–218.

The catch-up effect describes the idea that developing countries are able to achieve greater productivity for each unit of capital invested because they have the advantage of using technologies that have already been developed by other countries. This has allowed many developing countries to achieve a higher rate of growth compared to developed countries.

An example of the catch-up effect is China’s expanding high-speed rail network. High-speed rail networks were largely invented and perfected by the Japanese, Germans, and French. However, large development costs required substantial government subsidies. China, on the other hand, had the advantage of building its rail network using existing technologies. As a result, China was able to expand its rail network at a lower price per mile, allowing it to catch up and to develop an even more advanced rail network than its predecessors. But because all factors face diminishing returns, the catch-up effect tends to slow over time unless new technologies are developed to keep the growth rate high.

Improvements in Technology and Ideas

Technological improvements can come from various sources and play the major role in improving productivity, raising the standard of living, and increasing economic growth. These include enterprising individuals who discover innovative products and production methods, from Henry Ford’s auto assembly line to Steve Jobs’s role in developing the Apple home computer, iPod, iPhone, and iPad that have changed the way we live, work, and socialize. Technology has also improved as a result of advancements in telecommunications, the Internet, and biotechnology.

Technological progress is the primary explanation for the extraordinary economic growth the United States has enjoyed over the last century. In the production function, technology enhances the productive capacity of all other resources.

Technologies that kept our economy expanding have also helped many other countries to grow. In the developing world, growth most often comes from foreign companies building factories that employ locals at low wages. These companies often pay more than workers could have hoped to earn on their own. These higher earnings become the grubstake to ensure better education and earnings for their children.

Today, new technologies are helping many developing nations accelerate their growth. Wireless service has improved communications, inexpensive vaccinations and health education programs have reduced mortality rates, and the global movement of capital and production facilities has created new job opportunities.

The Role of Social Media in Promoting Economic Growth

Social media have changed the way individuals communicate with friends, co-workers, and family members. They also have changed the way people buy goods and services and the way businesses market their products. Social media allow both individuals and firms to do more with fewer resources, contributing to greater productivity, a driver of economic growth.

It wasn’t that long ago when the most common way to find deals and sales was to comb through the local newspaper and advertising inserts. However, print newspaper readership has declined precipitously as online news sources, including news alerts through social media sites such as Twitter, take their place. Because firms have longed relied on newspapers as a source of advertising, a change was needed to adapt to the growth of social media.

And the collection of information does not stop there. The power of consumer-to-consumer persuasion has made online product feedback an important source of advertising. Customers who rate products and services after their purchase (often following an email solicitation from sellers) provide influential information to potential customers who are likely to trust product reviews from previous users, especially if a large percentage of previous users are satisfied with their purchases.

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Further, businesses have been formed to harness the powerful role of consumer-to-consumer commerce that social media facilitate. Beginning with eBay and Craigslist over a decade ago, today, companies such as Groupon and Angie’s List allow individuals to promote products to other consumers. Combined with global-positioning devices that help potential consumers locate nearby merchants, such changes in the way businesses interact with potential consumers have reduced the time it requires for new products to be introduced into the market.

Much like prior innovations that have changed the way we live, social media have made markets more efficient by allowing buyers and sellers to interact more seamlessly. In doing so, productivity rises and contributes to economic growth. But as we have seen before, inventions sometimes come and go; therefore, the next big invention might be right around the corner.

Including Everything Else: Total Factor Productivity

We have shown that productivity can be measured by how well a country uses its resources to produce goods and services. However, a country’s productivity is not entirely dependent on the amount of inputs it has. True, a country with more inputs such as physical and human capital will likely produce more output. However, external factors influence the ability of inputs to be used effectively. The measure of output that is not explained by the number of inputs used in production is called total factor productivity.

Total factor productivity captures the factors that influence the overall effectiveness of inputs. For example, suppose a major hurricane sweeps through a region, knocking out power and communications for a week. Factories would likely be less productive despite having all of its workers and equipment available. Some equipment might not be able to run without electricity, and the morale of workers after a hurricane might make them less motivated to work. Such effects on output would not be captured by the number of inputs available.

Another factor affecting total factor productivity is the value of new innovations, which increases the efficiency of inputs used in production. For example, social media were originally designed to allow individuals to communicate better with one another through sites such as Facebook and Twitter. However, an external effect occurred when firms began to use these sites to market their products, which led to a dramatic change in how people learn about various products and improved the efficiency of production and consumption. The Issue on the previous page discusses the role social media have had on economic growth.

Total factor productivity also is influenced by the institutions in place within a country. For example, a country can have a very educated labor force but policies in place that prevent its human capital from being used efficiently. The country could be engaged in frequent military conflicts, preventing its resources from being used to improve the lives of its citizens. Or, a country may have a weak legal system or property rights, or a lack of economic freedom that prevents its markets from producing what people want. These institutional factors are largely influenced by the government. In the next section, we discuss government’s role in fostering economic growth.