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Don’t Make A Production About GDP April 11, 2011

Posted by tomflesher in Macro, Teaching.
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I’ve often heard people complain that economics growth models assume that the economy can grow infinitely. Some of these arguments sound plausible – what happens when we run out of resources? – but others seem to fall into the fallacy that wealth exists and is spread around, rather than created. The title of this post – Where does growth come from? – might well be restated as, “How is wealth created?”

To answer that question, think back to how electricity is produced. There’s a small amount of input electricity that’s required to produce any extra electricity, along with natural resources like coal and water to produce steam. It’s possible to recapture some of the electricity produced and use it as input in the next procedure. Note that this doesn’t imply there’s some sort of perpetual motion machine or a finite amount of electricity being used to produce an infinite amount, just that sometimes you need to use a small amount of the final product to prepare more of it. In that case, we could say that the amount of electricity produced is a function of the inputs, which are coal, water, land to produce the plant, and electricity.

In the same way, businesses produce goods and services. There’s a fancy term for production. It’s … production. You can also think of production as real GDP, which is equivalent to the amount of stuff produced in a certain division. Generally GDP will be production within a country over the course of one year.

The input factors for production can be a couple of things. First of all, you need money, but what do you use the money for? Generally, companies use money to buy one of a couple of different things.

  • A factory, for example, requires machinery. Even offices need machinery, like copiers and printers. That’s called capital (more properly, physical capital) and (because Marx wrote Das Kapital in German) abbreviated K.
  • Any company needs well-trained people who have skills and can operate the machinery or perform services. That’s called human capital and abbreviated H. Human capital is, at the broadest level, synonymous with special skills or (especially) education. It refers to talent or skill, not to the people themselves.
  • Companies need to know how to produce whatever it is they produce. This is called technological knowledge and abbreviated with the letter A or occasionally z. Technological knowledge allows everyone to be more productive.
  • Companies need natural resources, abbreviated N, to operate their machinery or keep their employees comfortable.
  • Finally, companies need people to do the work. This is called labor and abbreviated L.

There are many ways to express this relationship. The broadest is to say that we can put a bunch of machines and raw materials in a room with some laborers, some people who have special talent, and the energy to run them, and the people will produce something. How much they produce is a function of how much of each of those factors of production is available, and then there will be a bonus for extra technological knowledge that represents what level of production our factory was already at. We can express that mathematically, using Y to represent output as usual, as

Y = A \times F(K, H, N, L)

This represents all of the production of our factory or country. We could, then, figure out how much we’re producing per worker. This has a special name: productivity. We can represent productivity mathematically simply by dividing each factor through by the number of workers (which is the exact plain-sense meaning of “production per worker”):

\frac{Y}{L} = A \times F(\frac{K}{L}, \frac{H}{L}, \frac{N}{L}, 1)

(This requires an assumption called constant returns to scale, which is in turn related to the assumption that when we produce, we produce at around an optimal point where we’re as efficient as we can be given our current level of technology.)

Basically, we produce goods, which are a form of capital. To do so, we use capital and natural resources, which can be used up, along with technological knowledge, labor, and the special skills and talents we call human capital, none of which are used up. Any economy can continue to grow as long as it continues to operate efficiently. That means, as we mentioned in the Comparative Advantage entry, that a country like the US, which has easy access to capital and human capital, should produce things that make the best use of those factors. China, on the other hand, is best off producing labor-intensive goods. India is spread thin with respect to natural resources but has a lot of labor and a lot of human capital.

The key here is that we may see changes in what a country produces over time, but growth can continue indefinitely, as long as we make good choices about production.

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