# Economics: Theory Through Applications, v. 1.0 (2 Volume Set)

by Russell Cooper and A. Andrew John

## 21.2 Four Reasons Why GDP Varies across Countries

### Learning Objectives

After you have read this section, you should be able to answer the following questions:

1. What are the main possible explanations for real GDP differences across countries?
2. How important are differences in technology for explaining differences in real GDP across countries?

We started this chapter 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.

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.

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. Table 21.3 Real GDP in the United States, India, and Niger if All Three Countries Had the Same Workforce and Physical Capital Stock Country Real GDP in 2003 (Billions of Year 2000 US Dollars) United States 10,205 India 3,054 Niger 1,304 ## Differences in Human Capital across Countries 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. 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 21.4 "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.

Table 21.4 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

Country Real GDP in 2003 (Billions of Year 2000 US Dollars)
United States 10,205
India 5,170
Niger 2,758

## Differences in Technology across Countries

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.

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.

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 frontierWhere the most advanced production technologies are available.; 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.

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.