Lecture #1: The Importance of Productivity and National Saving The ultimate goals of economic activity are to (1) provide for a longer existence and (2) to provide for a higher level of utility during one's existence. Some people would add that long and prosperous lifetimes should be spread evenly and equitably throughout the population. These goals may also be extended to include one's offspring and parents. A longer life with higher utility (having greater quantity and quality of consumption) during that life is the very Figure 1: US Male Life Expectancy Note: Figures refer to the average life expectancy of a male American child born at the year indicated by decade. Data are taken from Sources: Department of Health and Human Services, National Center for Health Statistics; National Vital Statistics Reports meaning of having a higher "standard of living" as economists use the term. However, changes in average life expectancy tend to be slow and efforts to extend life expectancy
display diminishing returns. It is now becoming harder and costlier to extend life in the developed world. Figure 1 shows the changes in the life expectancy in the US during the 20 th century. While interesting, we should not simply extrapolate the trend shown in the figure. The quadratic regression line in Figure 1 is much too pessimistic about the extension of life expectancy in the future. In fact it predicts a maximum life expectancy of 76.3 years around 2030, whereas we know that by 2004 the life expectancy for a male child born in the US in 2004 was 76.5. Nevertheless, Figure 1 indicates that there are probably diminishing returns to our efforts at extending life. As real income rises, technology improves, and people choose healthier lifestyles, life expectancies will naturally increase, but not dramatically so. Questions: What are some of the ways that people in developed countries extend their life expectancies? What are the costs involved in doing these things? Extending life can be a personal endeavor or it can be n externality resulting from others' actions. Give some examples of this. To extend life, is it true that people and societies must save more? Does the government have a role in helping people extend their life expectancies? If we cannot improve our life expectancy much, then we must alternatively find ways to improve the quantity and quality of goods and services that we have to consume over our limited lifetime, as well as promote means of generating more equitable distributions of welfare in society including a better deal for our children. This brings us directly to the issue of productivity. Rising productivity gives higher utility and typically generates a more even distribution of gains. The goal we have is to secularly increase consumption per person within our society. By doing so we will be able to ensure a higher long run level of average utility in the population. It will not be useful to pursue means that raise consumption for a short while only to see this level drop significantly later on. What we desire is a sustainable growth in consumption per head. Naturally, it will always be possible to squander our wealth on short term bursts in consumption. Indeed, if we knew the world would end next year, due to say the impact of a large comet with the earth, then consuming everything would become a virtue. But in the absence of this, consuming our children's birthright would be totally inequitable to future generations. We should not act as if there were no tomorrow. How then can we obtain a high sustainable growth in consumption per person?
We can get a simple overview of things by referencing the following set of implications Goal: where = instantaneous per capita utility, = instantaneous consumption per person, and = instantaneous per capita output per person. For the moment we are not considering the distribution of income, consumption and utility, so that averages are what are relevant. Thus, to get higher average utility, we need greater output per person. Moreover, we need high, sustainable, and balanced growth of these things over time. Questions: Some output in our economy is produced merely to balance the counter-productivity of criminals and miscreants. Police, lawyers, judges, and prison employees produce some of our national output because other individuals are trying or are threatening to steal it. Explain how that productivity in society would benefit from a major reduction in crime and the number of criminals. Would this improvement in productivity appear in the national income statistics? How would this improvement in productivity affect average utility? The goal of a rising standard of living is seen to depend crucially on a rising level of real output per person. We can decompose this into three separate parts, which allows us to clarify the major factors affecting output per person. In the above equation, (r1) = ratio 1 = and refers to the number of workers in the population. One way to raise secularly is to raise (r1). We can do this by lowering the age for people to work. If the current law states that people below the age of 15 cannot work, we could lower this regulation to 13 years of age. Many people would believe that this is a
bad policy because children need to be in school, not on some job working. This is why we have child labor laws. Alternatively, we could raise the retirement age. This solution is somewhat more palatable. People are living longer and are healthier. Therefore, these people should be allowed to work into their 70s. Yet another way to raise (r1) is to import foreign workers. Note that while both the numerator and denominator of (r1) increases, the ratio (r1) must nevertheless increase. Obviously, there are many diverse costs involved in using foreign labor which impinge on the benefits to productivity. Finally, we should note that regardless of how much we seek to increase (r1) it will always be limited above by 1. The ratio can never exceed 1. Thus, in the long run, we cannot use growth in (r1) to ensure growth in output per person. Another means of increasing output per person is to increase (r2). This measures the average number of hours each worker is employed. A good example is the average work week. It might be that we could have workers extend their hours from 38 hours per week to 40 hours Figure 2 Average Weekly Hours: Total Private Industries, SA Source: St. Louis Federal Reserve: Shaded areas denote periods of recession according to NBER dating of the business cycle. per week. This is about a 5.26% increase in (r2) and therefore would represent a 5.26% increase in output per person assuming all else is unchanged. Most countries however are experiencing a declining workweek. During the dot-com boom of the 1990's the US saw a significant increase in the average workweek as people spent more time on the job
developing businesses that paid in stock options. The overall trend has been for a declining average workweek. The slight rise in productivity caused by the rise in workweek during the 1990's helped to keep a lid on inflation as the stock market boomed. Figure 3 shows the dramatic decline in average work hours (indexed) for Japan, France and Taiwan. This decline cannot be helpful in raising output per person, but it allows workers a Figure 3: Japan, France, and Taiwan Average Hours Index in Manufacturing
chance for greater leisure. If we include leisure,, in the utility function say then we can show that utility may be rising even though productivity and output per person is declining. So, while each laborer is working less and therefore producing less goods and services per person, he is nonetheless also enjoying more leisure and this is a good thing, as well. Even so, people can only enjoy so much leisure on the margin and at some point they begin to want more goods and services rather than more leisure. At some point they are willing and able to work more at the current wage. The rise in work hours contributes to a growth in production through a growth in (r2). Yet, once again, this growth is limited from above since there is a limit on the size of (r2). After all, there are only 24 hours in a day. One can cut back on sleep, eating, and leisure, but this cannot be carried too far if the workforce is to remain healthy and productive. The ratio (r2) can rise, but in the long run increases in (r2) are limited and cannot be relied upon to increase output per person. Since (r1) and (r2) are limited in the long run, and in some cases are decreasing over time, the only way to ensure a long run sustainable growth in output per person (and hence the standard of living) is to have sustainable growth in the ratio (r3). The ratio (r3) is simply the average product of labor. It is computed by taking total real output of the economy and dividing by the total number of labor hours used to produce that output. We often convert this to an index with reference to some base year (say index for year 2002 = 100). If the index were 105 in 2003, we would say that productivity grew 3% from the year
2000. If in 2004 the index were 111, we would find that the growth in productivity in 2004 Questions: Malcolm Muggeridge, the English journalist and Christian apologist, once said " I never met a rich man who was happy, and I never met a poor man who didn't want to be rich." The Chinese leader Teng Xiao-Ping once said " Poverty is not socialism. To be rich is glorious". Should we be so concerned with being rich? Is a rising standard of living the most important thing in Life? Can policymakers think otherwise? was 5.71% (which is computed as [111/105-1]*100%). Theoretically, there is no limit on the growth of (r3). Productivity depends on many factors, by it is not limited above. This makes the growth of productivity the single most important indicator of the progress of an economy. In fact, we might well define progress as growth in productivity. Our study of how to raise the standard of living has brought us to the central issue of how we can promote a rising level of productivity. From 1987 to 2000, the growth of Figure 4: Average Labor Productivity in US Manufacturing (index year 2005 = 100, SA) productivity in the US was about 5%. However, after 2000, the average growth in productivity was about 2.5% and was much more variable than prior to 2000.
How then can we increase the growth of average labor productivity? If we were to simplify the discussion on productivity, we would find that there are about five major factors which affect its growth. These factors include the amount of capital each worker has to use, changes in technology, the level of competition in the economy, the extent of specialization and division of labor, and the degree of regulation of business. Let's look at each of these a little closer. First, the stock of physical capital in an economy is composed of all the buildings, houses, equipment, tools, and machines used to produce the national output. If the amount of physical capital in the economy increases, then each worker on average will have more capital to use and will become more productive. Productivity will rise. But, in addition to physical capital, there is also human capital. Human capital is basically the stock of knowledge and intellect which we possess. Note that if you own a machine (physical capital), then you can sell the machine to someone else. But, you cannot sell your intellect (human capital) to someone else. This is a major difference between physical and human capital. Note also that if you teach someone something, then the total stock of knowledge grows -- that is, teaching does not require you to give up your own knowledge. It just means that you share it. Many things which we take for granted, such as mathematics and language, are examples of human capital. Without mathematics, the world would be a very different place. Another important factor affecting productivity is the growth of technology. Technical advance usually involves one of two phenomena -- invention and innovation. Invention occurs when a totally new idea or process is created. Innovation occurs when an existing invention is further developed and improved so that it can be marketed. Both invention and innovation result from the force of competition which keeps firms focused on developing high quality products at the lowest possible cost. Technical advance allows firms to substitute new and more efficient forms of production, thus raising the productivity of the labor employed. A century ago Marxists predicted that such technical advance would create a "reserve army" of unemployed workers, as machines and new technology would reduce the need for workers. However, the country exhibiting the fastest growing technology -- the United States -- is currently experiencing the lowest unemployment rates its has had in thirty years! Technology does not appear to raise unemployment rates, but it does raise productivity. The third factor affecting productivity is competition. A company which is forced to face brutal competition from its business opponents will always seek to produce output efficiently. It will not waste its labor and capital resources. Since its utilizes the least amount of labor and capital to produce its output, such firms will help to bolster the overall level of labor
productivity. Free trade and the avoidance of monopoly is the best policy to help stimulate efficient production, thus leading to high levels of productivity. The fourth factor affecting productivity is the specialization of industry and the division of labor. Whenever the size of the market grows and demand increases, firms have an incentive to produce more. But, what is interesting about this is that larger production allows labor to specialize in a particular part of the production process. Rather than doing five different jobs, the typical worker can focus on doing one or two specific jobs. This allows the worker a chance to develop human capital and know-how. The worker learns by doing his or her job over and over again. In addition, small companies begin to form which feed raw materials and components to the larger firms. This growth in out-sourcing also allows firms to specialize in the production of a small number of goods, and specialization raises the productivity of the workers in each firm. Overall productivity grows much faster. In short, whenever there is a substantial increase in market size, specialization of industry and greater division of labor takes place, and this raises the productivity of labor. Finally, the regulation of business can affect productivity. Business is regulated for a number of different reasons. For example, businesses face numerous health, safety, and environmental controls. If these regulations become excessive and burdensome, then productivity growth will slow down. However, regulations also help to ensure that monopolies do not form and that competition prevails. Thus, we cannot say that all types of regulation hinder the growth of productivity. A healthy and safe work environment may also lead to higher productivity, so that even these types of regulations may stimulate productivity growth. Now that we have seen the importance of productivity to the economy and have seen some of the factors which can affect productivity, it is essential that we understand the connection between productivity growth and national saving. Many of the above factors influencing productivity require society to forego current consumption and save instead. To have more machines, we must produce capital instead of consumer goods. To get more human capital, we must build schools and not use our resources to produce consumer goods. To create more and better technology, we must devote resources to research and development, not to the production of consumer goods. We just have to save, if we are going to make progress in lifting labor productivity. But, as each of us knows, saving is hard because it requires patience and sacrifice. For the economy as a whole, national saving consists of three parts. Household saving, business saving, and government saving. When we add these three types of saving together,
we get the total resources that can be used for domestic and net foreign investment. We summarize this by saying that saving equals investment. What this means is that we save today, and these resources are used to produce machines and other capital, which will be used later to produce the goods we intend to purchase in the future. Household saving is just the amount of after-tax income left over after deducting current consumption. Business saving consists of profits retained in the firm (i.e., not paid out as dividends) and depreciation expenses. Government saving consists of government revenue minus government spending. Usually, government saving is negative, since government spends more than its revenue, and often borrows money by issuing bonds. If national saving is so important, then how can we increase national saving? This is a particularly hard question to answer. The trouble is that one policy might increase household saving, but at the same time reduce business and government saving. That is, the three types of saving are closely related, and attempting to raise one might cause another to fall. One possible answer to this question is to tax consumption. By taxing consumption, one may be able to raise the level of saving if income is not adverse affected. Probably, a rise in the sales tax coupled with a fall in the income tax might help to spur national saving. Below is a Figure Comparing Saving Rates for the Areas of the Global Main Economy 0.6 0.5 0.4 0.3 0.2 0.1 EU_saving_rate US_Saving_Rate Japan_Saving_Rate China_Saving_Rate 0 2004 2005 2006 2007 2008 Source: United Nations Economic Statistics, My calculations,