Production,Economic Growth

and Trade

We live in a consumer world. Everywhere you look people are purchasing andconsuming things. Everything from plastic wrap to baseballs, from artichokes to cellularphones, gets produced, traded, and consumed. Whether an economy is a capitalistic mar-ket economy as in the United States, a capitalist marketplace with a strong touchof socialism as in many European countries, or a predominately communisteconomy as is true of many of China’s markets, goods and services mustchange hands. Several centuries ago, individuals produced most of whatthey consumed. Today, most of us produce little of what we consume.Instead we work at specialized jobs, and then use our wages to purchase thegoods we need. And purchase we do.

Though newspapers frequently report consumption excesses—andthese excesses occur in rich and poor countries around the globe—weshould not let these excesses obscure the fact that consumption is a greatdriver of economic growth. In many respects, consumption is simply a wayfor people to better themselves, to make their lives less of a drudgery or toenrich their lives. Farmers in poor countries move from a precarious exis-tence as subsistence farmers to producers of cash crops—keeping enough tolive on but generating a surplus to sell—in order to obtain those consump-tion goods that better their lives.

Another great driver of economic growth is technological change. In1950, only a small minority of households had television sets. Today, nearly every home hasat least one color television set, and the average home has nearly three! In response to theresulting change in demand for programming, channels have multiplied; programmingchoices are almost limitless. But what brought about these changes in the first place?

22

““

The ideas of economics and political philosophers,

both when they are right and when they are wrong,

are right and when they are wrong, are more

powerful than is commonly understood. Indeed, the

world is ruled by little else. I am sure that the power

of vested interests isvastly exaggerated

compared to the gradual encroachment of ideas.

—John Maynard Keynes

27

BASIC ECONOMIC QUESTIONS AND PRODUCTION

Regardless of the country, its circumstances, or its precise economic structure, every econ-omy must answer three basic questions.

Basic Economic QuestionsThe three basic economic questions that each society must answer are:

n What goods and services are to be produced?

n How are these goods and services to be produced?

n Who will receive these goods and services?

The response an economy makes to the first question—What to produce?—depends on thegoods and services a society wants. In a communist state, the government will decide whata society wants, but in a capitalist economy consumers are allowed to signal what productsthey want by way of their demands for specific commodities. In the next chapter, we willinvestigate how the consumer demand for individual products is determined and howmarkets meet these demands. For now, we will assume that consumers, individually and asa society, are able to decide on the mix of goods and services they most want, and that pro-ducers supply these items at acceptable prices.

Once we know what goods a society wants, the next question its economic systemmust answer is how these goods and services are to be produced. In the end, this problemcomes down to the simple question of how labor, capital, and land should be combined toproduce the desired products. If a society demands a huge amount of corn, say, we canexpect its utilization of land, labor, and capital will be different from a society that demandsdigital equipment. But even an economy devoted to corn production could be organized indifferent ways, perhaps relying on extensive use of human labor, or perhaps relying onautomated capital equipment.

Once an economy has determined what goods and services to produce and how toproduce them, it is faced with the distribution question: Who will get the resulting prod-ucts? Distribution refers to the way an economy allocates the goods and services it producesto consumers. In a capitalist economy, most products are distributed through private mar-kets. In a socialist economy, many goods are produced in state-owned facilities.Theoretically, governments in socialist economies use tax monies to subsidize producers,to consumers. In a capitalist economy, most products are distributed through privatemaron their efficiency and the quality of their products.

Resources, Production and EfficiencyHaving answered the three basic economic questions, let’s take a look at the productionprocess. Production involves turning resources into products and services that people want.Let’s begin our discussion of this process by examining the scarce resources used to pro-duce goods and services.

LandFor economists, the term land includes both land in the usual sense, but it also includes allother natural resources that are used in production. Natural resources like mineraldeposits, oil and natural gas, and water are all included by economists in the definition ofland. Economists refer to the payment to land as rents.

LaborLabor as a factor of production includes both the mental and physical talents of people. Fewgoods and services can be produced without labor resources. Improvement to labor capabili-ties from training, education, and apprenticeship programs, typically called human capital, alladd to labor’s productivity and ultimately to a higher standard of living. Labor is paid wages.

Technological advances from 1950 through the present day have led to cheaper, higher perfor-mance television sets. This has allowed more families to afford, not just one TV, but flat screenHDTVs with huge screens and theater quality surround sound that are a fraction of the weightand size of older sets. New devices permit viewers to record and watch programs at their leisure.

Technological advances have similarly led to a telecommunications industry that sim-ply was not dreamed of fifty years ago. In 1950, long distance phone calls were placed withthe assistance of live operators, every minute costing the average consumer several hours’worth of pay. Today, fiber-optic cables allow thousands of calls to be made on one cable,thus drastically reducing the cost of telephone service. Cell phones, meanwhile, havebecome business necessities because of their convenience and productivity. The globe isshrinking as communications bring us closer together.

Another factor reducing the size of the world is airline travel. Fifty years ago, few peo-ple flew cross-country or overseas. Jets were nonexistent, tickets were expensive—theequivalent of a month’s wages to fly coast to coast—and flights took forever. Today, becauseof technological change, jet aircraft can whisk us across the country or overseas at a pricewell within the budgets of most Americans.

A further driver of economic growth—trade—is less obvious. Yet its effect is clear.Nearly every country engages in commercial trade with other countries to expand theopportunities for consumption and production by its people. As products are consumed,new products must be produced, so increased consumption in one country can spur eco-nomic growth in another. Given the ability of global trade to open economic doors andraise incomes, it is vital for growth in developing nations.

In the previous chapter we noted that a reduction in America’s growth rate of only 1percentage point each year since 1930 would have significant consequences today. Figure 1shows real (adjusted for inflation) Gross Domestic Product (GDP) since 1930 and realGDP if the rate of growth was just 1 percentage point less. As the graph shows, real GDPwould be roughly half today. One important point to get from the graph is that the 1 per-centage point reduction had minimal impact for the first 20 years or so, but the impactwidens as time marches forward. Policies that affect economic growth today and in thefuture have their biggest impact several generations later.

This chapter will give you a framework for understanding economic growth. It pro-vides a simple model for thinking about production, and then applies this model toeconomies at large so you will know how to think about economic growth and its determi-nants. It then goes on to analyze international trade as a special case of economic growth.By the time you finish this chapter, you should understand the importance of economicgrowth and what drives it. To start, we turn to an examination of the three basic questionsthat every economy, no matter how it is organized, must solve.

After studying thischapter you shouldbe able to:

n Describe the three basic questionsthat must be answered for anyeconomy.

n Describe production and thefactors that go into producingvarious goods and services.

n Describe the opportunity cost aneconomy incurs to increase theproduction of one product.

n Use a production possibilitiesfrontier (PPF) or curve to analyzethe limits of production.

n Describe economic growth and theimpacts of expanding resourcesthrough increasing humanresources, capital accumulation,and technological improvements.

n Describe the concepts of absoluteand comparative advantage andexplain what they tell us about thegains from trade when countriesspecialize in certain products.

n Describe the practical constraintson free trade and how someindustries might be affected.

28 Chapter 2 Production, Economic Growth and Trade 29

Quantity

Pric

e

Panel B Total Revenue and Relatively Elastic Demand

0

Ch5-Fig 3[Worth]

D

a

b

c

Revenue Lost

Quantity

Pric

e

Panel A Total Revenue and Relatively Inelastic Demand

0

D

a

b

c

Revenue Lost 1

2

3

4

5

100 200 300 400 500 600 100 200 300 400 500 600

Revenue Gained

1

2

3

4

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Figure 3 Elasticity of Demand and Total Revenue

Revenue Gained

Product ion: the process of convertingresources (factors of production) -- land,labor, capital, and entrepreneurial ability -- into goods and services.

Resources: Productive resourcesinclude land (land and natural resources),labor (mental and physical talents of peo-ple), capital (manufactured products usedto produce other products), and entre-preneurial ability (the combining of theother factors to produce products andassume the risk of the business).

Land: Includes natural resources such asmineral deposits, oil, natural gas, waterand land in the usual sense of the word.The payment to land as a resource iscalled rents.

Labor : Includes the mental and physicaltalents of individuals that are used to pro-duce products and services. Labor ispaid wages.

training fit into this category. Improving human capital means people are more productive,resulting in higher wages, a higher standard of living, and an expanded PPF for society.

Capital Accumulation Increasing the capital used throughout the economy, usuallybrought about by investment, would similarly shift the PPF outward as shown in Figure 4.Additional capital makes each unit of labor more productive and thus results in higher pos-sible production throughout the economy. Adding robotics and computer controlledmachines to production lines, for instance, means each unit of labor produces many moreunits of output.

Production, Economic Growth and Trade 33

ing 2,000 microcomputers and 4,000 jackets. Clearly some resources are not being used—unemployment exists. When fully employed, the economy’s resources could produce moreof both goods (point d).

Because the PPF represents a maximum output, the economy could not produce 4,000microcomputers and still produce 10,000 leather jackets. This situation, shown by point h,lies to the right of the PPF and hence outside the realm of possibility. Anything to the rightof the PPF is impossible for our economy to attain; all points along the curve represent fullemployment.

Opportunity CostWhenever a country reallocates resources to change production patterns, it does so at aprice. This price is called opportunity cost. Opportunity cost is the price an economy or anindividual must pay, measured in units of one product, to increase its production (or con-sumption) of another product. In moving from point b to point e in Figure 2, microcom-puter production increases by 3,000 units, from 1,000 units to 4,000 units. In contrast, ourcountry must forego producing 6,000 leather jackets because production falls from 10,000jackets to 4,000 jackets. Giving up 6,000 jackets for 3,000 more computers represents anopportunity cost of 6000 jackets, or of 2 jackets for each microcomputer.

Opportunity cost thus represents the trade-off required when an economy wants toincrease its production of any single product. Governments must choose between guns andbutter, or between military spending and social spending. Since there are limits to what tax-payers are willing to pay, spending choices are necessary. Think of opportunity costs aswhat you or the economy must give up to have more of a product or service.

When the electric light bulb was invented, it not only created a new industry (some-one had to produce light bulbs), but it also revolutionized other industries. Factories couldstay open longer since they no longer had to rely on the sun for light. Workers could seebetter, thus improving the quality of their work. The result was that resources operatedmore efficiently throughout the entire economy.

The modern day equivalent to the light bulb might be the cellular phone. Widespreaduse of these devices enables people all across the world to produce goods and services moreefficiently. Insurance agents can file claims instantly from disaster sites, deals can be closedwhile one is stuck in traffic, and communications have been revolutionized. Thus, this newtechnology has ultimately expanded time, the most finite of our resources. A similar argu-ment could be made for the internet. It has profoundly changed how many products arebought, sold, and delivered, and has expanded communications and the flow of information.

Expanding ResourcesThe production possibilities frontier represents the constraints on an economy at a specifictime. But economies are constantly changing, and so are PPFs. Capital and labor are the prin-cipal resources that can be changed through government action. Land and entrepreneurialtalent are important factors of production, but neither is easy to change by government poli-cies. The government can make owning a business easier or more profitable by reducing reg-ulations, or by offering low-interest loans or favorable tax treatment to small businesses.However, it is difficult to turn people into risk-takers through government policy.

Increasing Labor and Human Capital A clear increase in population, the number ofhouseholds, or the size of the labor force will shift the PPF outward, as shown in Figure 4.With added labor, the production possibilities available to the economy expand from PPF0to PPF1. Such a labor increase can be caused by higher birthrates, increased immigration,or an increased willingness of people to enter the labor force. This last type of increase hasoccurred over the past several decades as more women have entered the labor force on apermanent basis. America’s high immigration (legal and illegal) fuels our strong rate ofeconomic growth.

Rather than simply increasing the number of people working, however, the labor factorcan also be increased by improving workers’ skills. Economists refer to this as investment inhuman capital. Activities such as education, on-the-job training, and other professional

32 Chapter 2

C A S E S T U D YApplication Issue: Increasing Opportunity Costs

I n m o s t c a s e s , land, labor, and capital cannot easily be shifted from producing one

good or service to another. You cannot take a semi-truck and use it to plow a farm field, even

though the semi and a top-notch tractor cost about the same money. The fact is that some

resources are suited to specific sorts of production, just as some people seem to be better

suited to performing one activity over another. Some people have a talent for music or art,

and they would be miserable—and inefficient—working as accountants or computer pro-

grammers. Some people find they are more comfortable working outside, while others require

the amenities of an environmentally controlled, ergonomically correct office.

Thus, a more realistic production possibilities frontier is shown in Figure 3. This PPF

curve is bowed out from the origin since opportunity costs rise as more factors are used to

produce increasing quantities of one product. Let us consider why this is so.

Let’s begin at a point where the economy’s resources are strictly devoted to leather jack-

et production (point a). Now assume that society decides to produce 3,200 microcomputers.

This will require a move from point a to point b. As we can see, 2,000 leather jackets must be

given up to get the added 3,200 microcomputers. This means the opportunity cost of 1 micro-

computer will be .625 leather jackets (2,000 ÷ 3,200 = 0.625). This is a low opportunity cost,

because those resources that are better suited to producing microcomputers will be the first

ones shifted into this industry, resulting in rapidly increasing returns from specialization.

But what happens when this society decides to produce an additional 2,000 computers,

or moves from point b to point c on the graph? As Figure 3 illustrates, each additional com-

puter costs 2 leather jackets since producing 2,000 more computers requires the society to

sacrifice 4,000 leather jackets. Thus, the opportunity cost of computers has more than tripled

due to diminishing returns on the computer side, which arise from the unsuitability of these

new resources as more resources are shifted to microcomputers.

To describe what has happened in plain terms, when the economy was producing 12,000

leather jackets, all its resources went into jacket production. Those members of the labor

force who are engineers and electronic assemblers were probably not well suited to produc-

ing jackets. As the economy backed off of jackets to start producing microcomputers, the

opportunity cost of computers was low, since the resources first shifted, including workers,

were likely to be the ones most suited to computer production and least suited to jacket man-

ufacture. Eventually, however, as computers became the dominant product, manufacturing

more computers required shifting leather workers to the computer industry. Employing these

less suitable resources drives up the opportunity costs of computers.

Product ion: the process of convertingresources (factors of production) -- land,labor, capital, and entrepreneurial ability -- into goods and services.

Resources: Productive resourcesinclude land (land and natural resources),labor (mental and physical talents of peo-ple), capital (manufactured products usedto produce other products), and entre-preneurial ability (the combining of theother factors to produce products andassume the risk of the business).

Production, Economic Growth and Trade 3736 Chapter 2

ical improvements as we have been discussing in this chapter. It then looked at some ben-efits from good government policies that stimulate growth, and finally examined the indus-try and individual firm level for clues to the microeconomic sources of growth. Some ofthe findings include:

n A one percentage point increase in business investment as a percentof Gross Domestic Product (GDP) would lead to an increase in percapita GDP of 1.3 percent.

n An additional one-year increase in average education levelsincreases per capita GDP by 4 to 7 percent.

n A 0.1 percentage point increase in research and development as apercent of GDP increases per capita GDP by 1.2 percent.

n Reducing both the level and variability of inflation by one percent-age point leads to an increase in per capita GDP of 2.3 percent.

n A 1 percentage point increase in the tax burden as a percent of GDPleads to a 0.3 percent reduction in per capita GDP.

n An increase in trade exposure ( a combined measure of importsand exports as a percent of GDP) of 10 percentage points increas-es per capita GDP by 4 percent.

The Gains from TradeTo see how specialization and trade can benefit both trading partners, even when one hasthe ability to produce more of both goods than the other, assume each country is at first(before trade) operating at point a in Figure 7. At this point, both countries are producingand consuming only their own output; the U.S. produces and consumes 20 million barrelsof oil and 20 million computer chips, Mexico 5 million barrels of oil and 2 million com-puter chips. Table 1 summarizes these initial conditions. When the United States signed theNorth American Free Trade Agreement with Canada and Mexico, many people experiencedwhat we have just been discussing. Some American jobs went south to Mexico because oflow production costs. By opening up more markets for American products, however,NAFTA did stimulate economic growth, such that retrained workers may end up with newand better jobs.

Economic growth in the United States has slowed over the second half of the twentiethcentury, but our standard of living has nonetheless risen dramatically. Expansion of our sug-gests. Women have entered the work force in droves, immigration has expanded, and tech-nd consuming only their own output; the U.S. produces and consumes 20 million barrelsof oil and 20 million computer chips, Mexico 5 million barrels of oil and 2 million com-puter chips. Table 1 summarizes these initial conditions. When the United States signed thenology has advanced by leaps and bounds, thus spurring the production of more goods andservices. Expanding global trade has opened up new markets for our products and increasedimports from areas with lower production costs. These developments have contributed tonology has advanced by leaps and bounds, thus spurring the production of more goods andAmerica’s economic growth and improved the economic welfare of its people.

As you can see, there are many ways to stimulate economic growth. A society canexpand its output by using more resources, perhaps encouraging more people to enter thework force or raising educational levels of workers. The government can encourage peopleto invest more, as opposed to devoting their earnings to immediate consumption. The pub-lic sector can spur technological advances by providing incentives to private firms to doresearch and development or underwrite research investments of its own.

Estimating the Sources of Economic GrowthBut just how important are each of these factors? A recent study by the Organization forEconomic Co-operation and Development focused on what has been driving economicgrowth in 21 nations over the last several decades. The study first looked at contribution toeconomic growth from the macroeconomic perspective of added resources and technolog-

All societies have toanswer the three basiceconomic questions. The1974 Nobel-prize winnersFriedrich von Hayek andGunnar Myrdal proposedvery different answers.Karl Marx was the fore-most advocate of freemarkets and classical eco-nomics during the heyday

of the Keynesian revolution. Born in 1899, Hayekwas the son of a botanist. After serving in WorldWar I, he studied law and political science at theUniversity of Vienna, later joining a group of youngacademics in a private seminar conducted by theeminent economist Ludwig von Mises. From 1932until his death in 1992, Hayek taught at severalschools including the London School of Economicsand the University of Chicago.

Hayek’s early work was primarily concernedwith business cycles. Hayek argued that economicbooms could lead to financial conditions in whichinvestment exceeded savings, resulting in a mis-match between consumption and output and, con-sequently, an economic contraction while a balancebetween the two was being achieved. Hayekviewed this “concertina effect” as the primaryexplanation for business cycles. He was one of thefew economists of his era to predict the GreatDepression.

After the mid-1930s, Hayek focused on cri-tiques of socialism and centralist economic plan-ning. His impassioned defense of libertarian eco-

nomics in the Road to Serfdom is, if anything, morewidely read today than it was in 1940, the year ofpublication. Hayek attributed failures in socialism toan inefficient use of knowledge and information.Central planners, in his view, were no match for thepricing mechanism as a means of communicatinginformation. The pricing system evolved sponta-neously from the interplay of individuals with limitedand particular information. A decentralized systemwith competition and price freedom, therefore, wasthe most efficient and socially beneficial way toorganize an economy. He also saw markets asadvancing human liberty and freedom.

In contrast to Hayek, Swedish economist andsociologist Gunnar Myrdal argued for a differentway to organize an economy. He advocated a moreactive role for government. Myrdal established hisreputation with the 1944 publication of his book onrace relations in the United States, An AmericanDilemma. Considered a classic of social scientificliterature, the work has been compared to Alexis deTocqueville’s Democracy in America. Myrdal’s criti-cisms of the doctrine of “separate but equal” had amajor influence on the 1954 Supreme Court rulingin “Brown v. Board of Education,” which outlawedsegregation in public schools.

Born in Sweden in 1898, Myrdal received hisdegree in law and economics in 1927 from Stfor theTwentieth Century Fund, which led to the book,Asian Drama: An inquiry into the Poverty of Nationsand the Challenge of World Poverty, where headvocated a major role for government in directingeconomies. Myrdal died in 1987.

Karl Marx (1818–1883)

TABLE 1 Initial Consumption-Production Pattern

U.S. Mexico Total

Oil 20 5 25

Chips 20 2 22