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What makes productivity grow

Why living standards depend on productivity, and the four things that determine how much a worker can produce.

FinanceA company's marketAbout 5 min: 3 reading, 2 practiceUpdated

General education, not financial advice.

After this lesson you can
  • Explain why productivity determines living standards
  • Name the four determinants of productivity
  • Use the rule of 70 to compare growth rates

Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.

A company's market: pricing power, taxes and trade: lesson 13 of 15
  1. A company's market
  2. Price elasticity of demand 6 min
  3. Elasticity and total revenue 5 min
  4. Consumer and producer surplus 4 min
  5. Market efficiency 5 min
  6. Price ceilings and floors 6 min
  7. Who really pays a tax 5 min
  8. Deadweight loss 5 min
  9. How tax size changes the loss 5 min
  10. Absolute and comparative advantage 5 min
  11. Why trade helps both sides 5 min
  12. Winners and losers from trade 5 min
  13. Tariffs and quotas 5 min
  14. What makes productivity grow 5 min
  15. Growth policy 5 min
  16. Why unemployment exists 6 min

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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 12

What it is

Living standards differ hugely across countries and over time. Mankiw notes that average income in a rich country such as the United States, Japan or Germany is more than ten times that in a poor country such as India, Indonesia or Nigeria. And over the past century, US real GDP per person has grown by about 2% a year, which doubles income roughly every 35 years.

What explains this? Productivity: the amount of goods and services a worker produces in each hour. A nation can enjoy a high standard of living only if it can produce a large quantity of goods and services. This is Mankiw's Principle 8: a country's standard of living depends on its ability to produce goods and services.

The four determinants of productivity:

  1. Physical capital per worker: the equipment and buildings used to produce goods. A woodworker with power tools makes more than one with hand tools.
  2. Human capital per worker: the knowledge and skills workers gain through education, training and experience.
  3. Natural resources per worker: land, rivers and minerals. Renewable resources (such as forests) can be replaced; non-renewable ones (such as oil) cannot.
  4. Technological knowledge: society's understanding of the best ways to produce goods. It differs from human capital: technology is like the quality of society's textbooks; human capital is the time the population spends reading them.

Physical and human capital are themselves produced: they come from past investment.

Quick check

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  1. A country trains more engineers. Which determinant of productivity rises?

    Show answer

    Human capital. Education and training build human capital.

Why it matters

The production function. Mankiw writes output as Y = A F(L, K, H, N): output depends on labour (L), physical capital (K), human capital (H) and natural resources (N), and A reflects the available technology. If the function has constant returns to scale, doubling all inputs doubles output, so output per worker depends on capital per worker, human capital per worker, natural resources per worker and technology.

Are natural resources a limit on growth? Mankiw notes that technological progress has often found ways around scarce resources, for example cars that use less petrol. And if resources were running out, their prices would be expected to rise sharply over time; in fact, prices of most natural resources have been stable or falling, after adjusting for inflation.

Small rates, big differences. Growth compounds. Using the rule of 70, income growing at 2% a year doubles in about 35 years; at 1%, in about 70 years. Over a century, the faster-growing country ends up far richer.

Worked example

Two countries start with the same income per person, 10,000.

  • Country A grows 1% a year. After 70 years (the rule of 70: 70 ÷ 1 = 70): about 20,000.
  • Country B grows 3.5% a year. 70 ÷ 3.5 = 20 years to double, so in 70 years it doubles 3.5 times: about 10,000 × 2³·⁵ ≈ 113,000.

A difference of 2.5 points a year leaves B more than five times richer after one long lifetime.

Common mistake

Thinking a country's income depends mainly on how much natural resources it has. Some countries with few resources, such as Japan, are rich because of their capital, skills and technology; they import the resources they need.

Key terms

productivity
the quantity of goods and services produced from each unit of labour input
physical capital
the stock of equipment and structures used to produce goods and services
human capital
the knowledge and skills workers acquire through education, training and experience
natural resources
inputs provided by nature, such as land, rivers and mineral deposits
technological knowledge
society's understanding of the best ways to produce goods and services
production function
the relationship between the quantity of inputs and the quantity of output
constant returns to scale
doubling all inputs doubles output

Practise the key terms

Tap a card to turn it over. 7 cards.

FrontBack
productivitythe quantity of goods and services produced from each unit of labour input
physical capitalthe stock of equipment and structures used to produce goods and services
human capitalthe knowledge and skills workers acquire through education, training and experience
natural resourcesinputs provided by nature, such as land, rivers and mineral deposits
technological knowledgesociety's understanding of the best ways to produce goods and services
production functionthe relationship between the quantity of inputs and the quantity of output
constant returns to scaledoubling all inputs doubles output

Practice

Work it through

Income per person grows 1.4% a year in one country and 3.5% in another. Use the rule of 70.

Sort it

Which group does this belong to?

  1. A factory's machines

    Show answer

    Physical capital. Equipment used to produce goods

  2. A nurse's training

    Show answer

    Human capital. Skills gained through education

  3. A country's farmland

    Show answer

    Natural resources. An input provided by nature

  4. A better method for making steel, published in a journal

    Show answer

    Technological knowledge. Society's understanding of how to produce

  5. An office building

    Show answer

    Physical capital. A structure used in production

Quick quiz

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  1. Why does Mankiw say productivity determines living standards?

    Show answer

    A country can consume only what it produces, so output per worker sets how well people can live. Principle 8: a country's standard of living depends on its ability to produce.

  2. With constant returns to scale, what happens if all inputs double?

    Show answer

    Output doubles. So output per worker depends on inputs per worker and technology.

In short

  • Living standards depend on productivity: output per hour of work.
  • Four determinants: physical capital, human capital, natural resources, technological knowledge.
  • Y = A F(L, K, H, N); with constant returns, output per worker depends on inputs per worker.
  • Small growth differences compound into large income differences.

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  1. Name the four determinants of productivity.

    Show answer

    Physical capital, human capital, natural resources and technological knowledge per worker.

  2. How is technological knowledge different from human capital?

    Show answer

    Technology is society's understanding of how to produce; human capital is the skill workers have gained to use it.

  3. By the rule of 70, how long does income growing at 2% a year take to double?

    Show answer

    About 35 years.

Further reading