Tag Archive: capital

A Production Possibilities Frontier

The engine of economic progress must ride on the same four wheels (supply side factors), no matter how rich or poor the country:

  • Human resources (including labor supply, education, discipline and motivation)

Labor inputs include, of course the quantity of workers. However, many economists believe that the quality of labor inputs, the skills, knowledge, and discipline of the labor force, is the single most important element in economic growth. capital goods can be effectively used and maintained only by skilled and trained workers.

Improvements in literacy, health, and discipline, and most recently, the ability to use computers, add greatly to the productivity of labor.

  • Natural resources (including land, minerals, fuels and environmental quality)

The important resources here are, arable land, oil and gas, forests, water, and mineral resources.
But the possession of natural resources is hardly necessary for economic success in the modern world. New York City prospers primarily on its high density service industries. While many countries that have virtually no natural resources, such as Japan, have thrived by concentrating on sectors that depend more on labor and capital than on indigenous resources.

  • Capital formation (including machines, factories and roads)

Tangible capital includes structures like roads, and power plants, and equipment, like trucks and computers. In this regard, some of the most dramatic stories in economic history, often involve the rapid accumulation of capital.
Accumulating capital requires a sacrifice of current consumption over many years. Countries that grow rapidly tend to invest heavily in new capital goods. In the most rapidly growing countries, 10 to 20% of output may go into capital formation. In this regard when we think of capital we must not concentrate only on private sector investment. In fact, many investments are undertaken only be governments, and provide the necessary social overhead capital and infrastructure for businesses to prosper. Roads, irrigation and water projects, and public health measures are important.

Government projects involve external benefits that private firms cannot capture so government is necessary to provide them.

  • Technology (from science and engineering to management and entrepreneurship)

Historically, growth has definitely not been a process of simple replication, adding rows of steel mills, or power plants next to each other. Rather, a never-ending stream of inventions and technological advances led to a vast improvement in the production possibilities of Europe, North America, and Japan. Technological change denotes changes in production processes or the introduction of new products or services.

Technological change is a continuous process of small and large improvements.

While the four supply factors of growth relate to the physical ability of the economy to expand, there are two other factors that are equally important:

  • First, there is the demand factor

To realize its growing production potential, a nation must fully employ its expanding supply of resources. This requires a growing level of aggregate demand.

  • Second, there is the efficiency factor

To reach its production potential, a nation must not only achieve full employment, but also two kinds of economic efficiency. Specifically, a country must achieve productive efficiency. That is, it must use its existing and new resources in the least costly way to produce what it does. And it must also achieve allocative efficiency, meaning that the specific mix of goods and services it produces must maximize society’s well-being.

Technological Advance

One of the most famous studies ever conducted in economics was the study done by Edward Denisen. He found that the most important factor accounting for a full 28% of increased productivity, has been technological advance – just as growth theory suggests. And by the way, Denisen’s eighth category (legal-human environment) is a negative number. It estimates the negative impact that legal and regulatory constraints have had on productivity and growth. Which takes us to Ferguson (2012) who states that among the most deadly enemies of the rule of law is bad law (p.77).

  • While some economists and policy makers stress the need to increase capital investment,
  • others advocate measures to stimulate research and development and technological change.
  • Still a third group emphasizes the role of a better educated work force.

The Neoclassical growth model was pioneered by professor Robert Solow of MIT:

  • Major model components in this neoclassical growth model: Capital and technological change.
  • Primary tool: Aggregate Production Function (APF), which relates technology and inputs, like capital and labor, to total potential GDP.
  • Key concept: Capital deepening – the process of increasing the amount of capital per worker, e.g. more farm machinery and irrigation systems in farming, more railroads and highways in transportation, and more computers and communication systems in banking. In each of these industries societies have invested heavily in capital goods. And as a result, the output per worker has grown enormously.

The first major insight of the model is that in the absence of technological change, capital deepening does not lead to a proportional increase in output.

Reason: The law of diminishing returns – the basic idea is that as you add more and more capital to a fixed supply of labor, eventually the marginal product of capital must fall as the law of diminishing returns kicks in.

The second major insight of the neoclassical growth model is that while capital deepening can dramatically increase the productive output of an economy, it will eventually lead to economic stagnation in the absence of technological change.

At this point, the economy enters a steady state in which, without technological change, both capital incomes and wages end up stagnating.
In the long run, equilibrium of the neoclassical growth model makes it clear that if economic growth consists only of accumulating capital through replicating factories with existing methods of production, then people’s standard of living will eventually stop rising. And that’s why we must come to understand the importance of technological change in averting this fate, as modern economies in this century have so obviously done.

This leads to the third major insight of the neoclassical growth model. It is ultimately only through technological change that we can avoid the trap of economic stagnation.

Technological change represents both advances in production processes, and the introduction of new and improved goods and services. It also includes new managerial techniques, as well as new forms of business organisation.