note_ch25 - Chapter 25 In this chapter we focus on...

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Chapter 25 In this chapter, we focus on understanding differences in real GDP across countries, and how GDP grows over time. We observe enormous differences in income per capita across countries – output per person in the US is about \$40,000 per year, while output in a number of sub-Saharan African countries is less than \$2000 per year. We also observe large differences in the rate of economic growth. We will develop a framework for helping us understand those differences, and will keep the framework as simple as possible. Differences in output across countries boils down to the ability to produce goods and services. We will thus focus on this difference. To keep things simple, we will consider one overall, composite good, “output”. First, let’s rewrite Y as follows, and measure it in per capita terms by dividing by population (pop), and also incorporating the employment level in the country (L):

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Y/pop = (Y/L)*L/pop This decomposition splits output into two pieces that helps us understand why poor countries are poor. The two pieces are: (1) an efficiency factor, which is Y/L, (output per worker), and (2) a labor factor, which is L/pop. This means that poor countries are poor either because their population tends to work much less than those in rich countries -L/pop is low - and/or their efficiency level - output per worker (Y/L) - is low. Data from poor countries show that the labor factor is quite similar between poor and rich countries. That is the rate of employment among the poor countries is similar to the employment rate among the rich countries. This means that poor countries are poor primarily because they have lowworker efficiency . We will return to this a bit later once we further develop the idea of the production function, and we will make some progress in understanding low worker efficiency.
Output in a country is determined by 4 factors: the quantity of labor, L, the quantity of physical capital, K, the quantity of skill, or human capital, H, the amount of natural resources, N, and efficiency, A which represents how efficient society is in using the inputs to production. Economists use the concept of a production function to think about how the productive inputs of labor, capital, and the other factors are turned into output. Essentially, a production function is a recipe for creating output from inputs. For example, to make bread, we need flour, water, yeast, workers, and capital, including ovens. The recipe tells us how to use these inputs to produce bread. Below, we write the production function, which we denote as F: Y = A*F(K,L,H,N) The left hand side is output, on the right hand side we have A*F(K,L,H,N), where A is efficiency, and F is the production function that transforms the inputs

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into output. Note that changes in efficiency scale the production function up or down.
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