Reading: Lesson 2 - Four Reasons Why GDP Varies across Countries

1. Four reasons why GDP varies across countries

1. We started this unit with the following question: “Why are some countries rich and other countries poor?” The aggregate production function and the story of Juan help us to understand what determines the amount of output that an economy can produce, taking us the first step toward explaining why some countries are richer than others. The production function tells us that if we know four things—the size of the workforce, the amount of physical capital, the amount of human capital, and the level of technology—then we know how much output we are producing. When comparing two countries, if we find that one country has more physical capital, more labor, a better educated and trained workforce (that is, more human capital), and superior technology, then we know that country will have more output.

2. Differences in these inputs are often easy to observe. Large countries obviously have bigger workforces than small countries. Rich countries have more and better capital goods. In the farmlands of France, you see tractors and expensive farm machinery, while you see plows pulled by oxen in Vietnam; in Hong Kong, you see skyscrapers and fancy office buildings, while the tallest building in Burkina Faso is about 12 stories high; in the suburbs of the United States, you see large houses, while you see shacks made of cardboard and corrugated iron in the Philippines. Similarly, rich countries often have well-equipped schools, sophisticated training facilities, and fine universities, whereas poorer countries provide only basic education. We want to be able to say more, however. We would like to know how much these different inputs contribute to overall economic performance.
   

3. To get some sense of this, we look at some rough numbers for the United States, India, and Niger. We carried out this exercise using data from 2003, but the fundamental message does not depend on the year that we have chosen; we would get very similar conclusions with data from any recent year. To start, let us look at the different levels of output in these countries. The Table below "Real GDP in the United States, India, and Niger" gives real gross domestic product (real GDP) in these countries. Note that we are now looking at the overall level of GDP, rather than GDP per person as we did at the beginning of this chapter. Real GDP in the United States was about $10.2 trillion. In India, real GDP was about one-third of US GDP: $3.1 trillion. In Niger, real GDP was under $10 billion. In other words, the United States produces about 1,000 times as much output as Niger. 
   

   
   

4. In the following subsections, we look at how the different inputs contribute to bring about these large differences in output. We go through a series of thought experiments in which we imagine putting the amount of each input available in the United States into the production functions for the Indian and Niger economies.
   

2. Differences in the Workforce Across Countries

1. The United States, India, and Niger differ in many ways. One is simply the number of people in each country. The workforce in the United States is about 150 million people. The workforce in India is more than three times greater—about 478 million in 2010—while the workforce in Niger is only about 5 million people. Thus India has much more labor to put into its production function than does Niger.
   
   
2. In the Table below "Real GDP in 2003 in the United States, India, and Niger if All Three Countries Had the Same Workforce" we look at what would happen to output in India and Niger if—counterfactually—each had a workforce the size of that in the United States while their other inputs were unchanged. Output in the United States is, of course, unchanged in this experiment. India’s output would decrease to about $1.4 trillion because they would have a smaller workforce. Niger’s output would increase about tenfold to $88 trillion. Differences in the workforce obviously matter but do not explain all or even most of the variation across the three countries. Niger’s output would still be less than 1 percent of output in the United States. 
   

   
   

3. Differences in Physical Capital across Countries

1. Not surprisingly, the United States also has a much larger capital stock than does Niger. The capital stock in the United States is worth about $30 trillion. India’s capital stock is about $3 trillion, and Niger’s capital stock is much, much smaller—about $9 billion. So what would happen if we also gave India and Niger the same amount of physical capital as the United States? Table 6.3 "Real GDP in the United States, India, and Niger if All Three Countries Had the Same Workforce and Physical Capital Stock" shows the answer. 
   

   
   

2. India’s GDP, in this thought experiment, goes back to something close to its actual value of around $3 trillion. In other words, the extra capital compensates for the smaller workforce. Real GDP in the United States is still more than three times larger than that in India. The extra capital makes a big difference in Niger, increasing its output about ten-fold. Even if Niger had the same size workforce and the same amount of capital as the United States, however, it would still have only a tenth of the amount of output. The other two inputs—human capital and technology—evidently matter as well.
   

4. Differences in Human Capital across Countries

1. Differences in education and skills certainly help to explain some of the differences among countries. Researchers have found evidence that measures of educational performance are correlated with GDP per person. The causality almost certainly runs in both directions: education levels are low in Niger because the country is so poor, and the country is poor because education is low.
   
   
2. We can include measures of education and training in an attempt to measure the skills of the workforce. In fact, economists Robert Hall and Chad Jones have constructed a measure that allows us to compare the amount of human capital in different countries.To estimate relative human capital levels in different countries, we use the figures in Robert Hall and Chad Jones, “Why Do Some Countries Produce So Much More Output per Worker Than Others?” Quarterly Journal of Economics 114, no. 1 (1999): 83–116. In Table 6.4 "Real GDP in 2003 in the United States, India, and Niger if All Three Countries Had the Same Workforce, Physical Capital Stock, and Human Capital Stock", we bring the human capital level in India and Niger up to the level in the United States and, as before, suppose that all three countries have the same amount of labor and physical capital. Real GDP in India would climb to about $5.2 trillion, or a little over half the level in United States. Niger’s real GDP would equal about $2.8 trillion, meaning the increased human capital would more than double Niger’s GDP. However, real GDP in the United States would still be more than three times greater than that of Niger. 
   

   
   

5. Differences in Technology across Countries

1. To summarize, even after we eliminate differences in labor, physical capital, and human capital, much is still left to be explained. According to our production function, the remaining variation is accounted for by differences in technology—our catchall term for everything apart from labor, physical capital, and human capital.
   
   
2. Just as firms accumulate physical capital, they also accumulate knowledge in various ways. Large firms in developed countries develop new knowledge through the activities of their research and development (R&D) divisions.Gains in productivity of this form sometimes end up embodied in capital stock—think of a computer operating system, such as Windows or Linux. Such knowledge increases the value of capital stock and is already captured by looking at the ratio of capital stock to GDP. In poorer countries, firms may access existing knowledge by importing technology from more developed countries.
   
   
3. Differences in knowledge help to explain differences in output per worker. The rich countries of the world tend to have access to state-of-the-art production techniques. We say that they are on the technology frontier; they use the most advanced production technologies available. Factories in poor countries often do not use these production techniques and lack modern machinery. They are inside the technology frontier.
   
   
4. As economists have researched the differences in economic performance in rich and poor countries, they have found that success depends on more than physical capital, human capital, and knowledge. Appropriate institutions—the social infrastructure—also need to be in place. These are institutions that allow people to hold property and write and enforce contracts that ensure they can enjoy the fruits of their investment. Key ingredients are a basic rule of law and a relative lack of corruption. An ability to contract and trade in relatively free markets is also important.
   
   
5. Particularly in more advanced countries, we need the right institutions to encourage technological progress. This is complicated because there is a trade-off between policies to encourage the creationof knowledge and policies to encourage the dissemination of knowledge. Knowledge is typically a nonexcludable good, so individuals and firms are not guaranteed the rights to new knowledge that they create. This reduces the incentive to produce knowledge. To counter this problem, governments establish certain property rights over new knowledge, in the form of patent and copyright laws. Knowledge is also typically a nonrival good, so everyone can, in principle, benefit from a given piece of knowledge. Once new knowledge exists, the best thing to do is to give it away for free. Patent and copyright laws are good for encouraging the development of knowledge but bad for encouraging the dissemination of knowledge. Current debates over intellectual property rights (file sharing, open source, downloading of music, etc.) reflect this trade-off.
   
   
6. Differences in natural resources can also play a role in explaining economic performance. Some countries are lucky enough to possess large amounts of valuable resources. Obvious examples are oil-producing states such as Saudi Arabia, Kuwait, Venezuela, the United States, and the United Kingdom. Yet there are many countries with considerable natural resources that have not enjoyed great prosperity. Niger’s uranium deposits, for example, have not helped that country very much. At the same time, some places with very little in the way of natural resources have been very successful economically: examples include Luxembourg and Hong Kong. Natural resources help, but they are not necessary for economic success, nor do they guarantee it.
   

Key Takeaway's

• Differences in real GDP across countries can come from differences in population, physical capital, human capital, and technology.
• After controlling for differences in labor, physical capital, and human capital, a significant difference in real GDP across countries remains.