Aggregate Incomes: Questions

Chapter IX
Aggregate Incomes
Questions
1. Suppose you are comparing income per capita in the United States and Ghana. You first convert the
values into U.S. dollars using the current exchange rate between the U.S. dollar and the Ghanaian
cedi. You also convert both values to U.S. dollars using the purchasing power parity-adjusted
exchange rate. Which measure is likely to give you a more accurate picture of the living standards in
both countries? Explain your answer.
Answer: The nominal exchange rate converts Ghanaian cedi into U.S. dollars but does not take into
account differences in prices and consumption patterns. Also, the nominal exchange rate can fluctuate
for reasons that are not related to the relative price levels in either country. The purchasing power
parity-adjusted exchange rate, however, is estimated by calculating how much a representative bundle
of commodities costs in various countries. So, the purchasing power parity-adjusted exchange rate
will show how much it will cost residents of the United States and Ghana to purchase the same
bundle of goods. This means that the purchasing power parity-adjusted exchange rate is likely to be a
more accurate measure of living standards in the United States and Ghana.
A-head: INEQUALITY AROUND THE WORLD
Concept: Purchasing power parity
2. What are the disadvantages of using Big Macs to measure purchasing power parity?
Answer: The price of a Big Mac is used as an alternative measure of the exchange rate between two
countries. One of the problems with using Big Macs to measure purchasing power parity is that,
instead of a bundle of diverse goods, this index simply compares a bundle consisting of just one good.
Also, Big Macs are only a very small fraction of people’s consumption, so their prices will not reflect
true cost-of-living differences across countries.
Concept: The Big Mac index, purchasing power parity
3. Suppose that country A has higher income per capita than country B. Explain why this does not imply
that most citizens of country A have higher income than most citizens of country B. Try to construct
an example in which both countries have 10 citizens to demonstrate this point.
Answer: Although income per capita does correlate strongly with various measures of the quality of
life, it does not give a complete picture of the standard of living of all of a country’s citizens. Income
inequality can make income per capita a deceptive measure of economic well-being. Individual
incomes can vary widely within a country and may not be reflected in a simple measure of income
per capita.
Imagine that countries A and B each have ten people (or ten equally large groups of people) with
incomes distributed as follows:
54 Acemoglu, Laibson, and List | Macroeconomics
Person Country A Income Country B Income

1 $ 1,000 $ 5,000
2 $ 1,500 $ 6,000
3 $ 2,000 $ 7,000
4 $ 2,500 $ 9,000
5 $ 3,000 $ 9,500
6 $ 3,500 $10,000
7 $ 4,000 $11,000
8 $15,000 $12,000
9 $30,000 $14,000
10 $45,000 $15,000
Country A’s income per capita is $10,750, while country B’s is only $9,850. But notice that income
appears to be much more equally distributed in country B than in country A. The median income in
country A is $3,250, whereas the median in country B is $9,750. Hence, most of the citizens in
country B have a higher income than most citizens in country A have.
Concept: Incomes and the standard of living
4. Is income per capita more relevant in understanding differences in international living standards than
income per worker?
Answer: Yes, per capita income is likely to be a better measure of differences in living standards. Per
capita income is estimated by dividing the country’s aggregate output by the total population, while
income per worker divides aggregate output by the number of people in employment. Income per
worker is a good measure of how productive an economy is as it considers the average output
produced by the workforce. Per capita income, however, might be a better measure of welfare as it
considers the conditions of the whole population, including children and the elderly.
Concept: Per capita income, income per working age population
5. What is the correlation between income per capita and welfare measures like absolute poverty and life
expectancy? What does this suggest about income per capita as a measure of welfare?
Answer: Income per capita shows a strong correlation with measures like absolute poverty and life
expectancy. However, income per capita might hide inequalities between countries and within
countries. Also, it doesn’t take into account factors like the quality of health care, the environment,
and public safety. Although per capita income is by itself not a perfect measure of welfare, it does
give us a lot of information about the living standards in a country. Therefore, it makes sense to first
focus on income per capita and then look more deeply into data on health, education, poverty, and
inequality within and across countries.
Concept: Income per capita, poverty, life expectancy
Chapter 6 | Aggregate Incomes 55
6. What does the Human Development Index measure? What is the correlation between this index and
income per capita in a country?
Answer: The Human Development Index was developed by the United Nations to measure living
standards across various countries. It combines income per capita, life expectancy, and measures of
education (the mean of years of schooling for adults aged 25 years and expected years of schooling
for children of school-entering age). Data on per capita income and HDI of various countries show a
strong positive correlation between HDI and income per capita.
Concept: The Human Development Index
7. What is productivity? Why does it vary across countries?

Answer: Productivity refers to the value of goods and services that a worker generates for each hour
of labor.
There are three main reasons why productivity differs across countries:
i. Human capital: Workers differ in terms of human capital, which is their stock of skills to produce
output or economic value. Differences in human capital across countries result in differences in
productivity.
ii. Physical capital: Physical capital is any good, including machines (equipment) and buildings
(structures) used for production. Workers will be more productive when the economy has a
bigger physical capital stock, enabling each worker to work with more (or better) equipment and
structures.
iii. Technology: An economy with better technology uses its labor and capital more efficiently and
thus achieves higher productivity
A-head: Productivity and the Aggregate Production Function
Concept: Technology
8. What are the two components of technology?

Answer: Technology has two very distinct components: the first is knowledge that society has
acquired and applied to its production process. This knowledge is embedded partly in the capital
stock of firms. The second component has to do with the efficiency of production. The efficiency of
production refers to the ability of society to produce the maximal amount of output at a given cost or
for given levels of factors of production.
A-head: PRODUCTIVITY AND THE AGGREGATE PRODUCTION FUNCTION
Concept: Technology
9. What are factors of production? What does the aggregate production function describe?
Answer: A factor of production is an input used in producing output in an economy. An aggregate
production function describes the relationship between a nation’s GDP (Y) and its factors of
production, such as physical capital (K) and total efficiency units of labor (H). It is written as follows:
Y  A  F ( K , H ). A is an index of technology. A higher level of A implies that the economy produces
more GDP with the same level of physical capital stock and total efficiency units of labor.
Concept: The aggregate production function
10. What are the total efficiency units of labor? What is the relationship between this concept and human
capital?
Answer: Because the workers in an economy have different levels of human capital, we would not be
able to gauge how much the economy can produce only by looking at the number of workers it has.
Total efficiency units of labor accounts for the number of workers as well as the level of human
capital. Denoting total efficiency units by H, the total number of workers in the economy by L, and
the average efficiency or human capital of workers by h, total efficiency units of labor is calculated
using the formula: H  L  h.
Concept: Human capital, the total efficiency units of labor
11. Use the following diagram to explain the relationship between a country’s physical capital stock and
GDP.
Answer: The diagram shows the aggregate production function, holding total efficiency units of labor
constant. This graph shows both the positive relationship between capital and output as well as the
law of diminishing marginal product. Holding labor constant, if capital stock increases, the level of
output produced also increases. However, the marginal contribution of an additional unit of capital to
output—how much output increases as a result of a unit increase in the capital stock—eventually
decreases. This can be seen by comparing a unit increase in output at two different points on the
aggregate production function. At a point closer to the origin, when there is less capital in the
economy, an increase in capital stock will lead to a relatively large increase in output. When we have
the same unit increase starting with a larger capital stock—farther to the right on the horizontal axis—
the corresponding increase in output is smaller.
Concept: The aggregate production function, capital stock, aggregate output
12. Explain the difference between the terms “physical capital” and “human capital.”
Answer: Physical capital is any good, including machines (equipment) and buildings (structures),
used for production. Human capital, on the other hand, refers to workers’ skills that enable them to
produce output or economic value.
Concept: Capital vs. capital stock vs. natural resources
13. Explain what distinguishes physical capital from natural resources.

Answer: Physical capital is not given to a country by nature; it must be produced. In fact, it is
sometimes called “produced means of production.” This is what the authors mean when they say that
capital is not given to us as an “endowment,” as are natural resources.
Concept: Capital vs. capital stock vs. natural resources
14. How do increases in technology affect the aggregate production function?

Answer: An increase in technology means that the economy can generate more output from the same
set of inputs. Exhibit 6.9 shows the implications of better technology for the aggregate production
function: Again holding the efficiency units of labor, H, constant, the relationship between GDP and
the physical capital stock shifts upward. Therefore, for every level of K, the physical capital stock, a
better technology implies that the economy will be able to produce more GDP.
A-head: THE ROLE AND DETERMINANTS OF TECHNOLOGY
Concept: The effect of a change in technology on the aggregate production function
15. What does Moore’s law state? Is Moore’s law borne out by historical data?
Answer: Moore’s Law, named after Intel cofounder Gordon Moore, predicts that the number of
transistors on a chip will double approximately every two years. The number of transistors is a key
determinant of how fast a computer processor is. So Moore’s Law implies that computer processor
power should double approximately every two years. Gordon Moore made this prediction in 1965.
Moore’s law has turned out to be fairly accurate, with the number of transistors packed in a computer
chip doubling approximately every two years. Several other measures of technological advances in
computing have also behaved according to Moore’s Law.
Concept: Moore’s law
16. Why is the average American so much richer than the average Indian?
Answer: The difference between the average income of an American and an Indian can be explained
by differences in physical capital stock per worker, total efficiency units of labor, and technology in
the United States and in India. Compared to the United States, India’s aggregate production function
shows that India has significantly lower levels of capital stock per worker, human capital, and
technology. If an Indian had access to the same level of technology as an American does, the average
income level in India would more than double.
A-head: EVIDENCE-BASED ECONOMICS: WHY ARE AMERICANS SO MUCH RICHER THAN
INDIANS?
Concept: Aggregate production function, income disparities
17. What policies can be used to raise GDP in a country?

Answer: Four types of policies can be used to raise a country’s GDP:
i. Increasing physical capital: Countries can increase their capital stock by increasing their
savings rate.
ii. Raising efficiency units of labor: Increasing the levels of schooling and education would help
countries increase their levels of human capital thus their efficiency units of labor.
iii. Improving efficiency in the allocation of resources to improve the efficiency of production: By
increasing the competitiveness of markets, countries can make resource allocation more
efficient.
iv. Improving technology: Investing in research and development as well as using technology
transfers can improve the technology that is used in the production process.
Concept: Sources of increases in GDP
Problems
1. You read a newspaper report that compares wages paid to employees at Starbucks in India and in the
United Kingdom. At the time, 1 pound was equal to 87 rupees. The report says that Starbucks baristas
in India are paid a mere 56 pence an hour, which is lower than the cheapest coffee that Starbucks sells
in the United Kingdom. A friend of yours who read the report is appalled by this information and
thinks that Starbucks ought to raise its salaries substantially in India. Is your friend necessarily
correct? Explain your answer.
Answer: No, your friend is not necessarily correct. The flaw in the report is that it converts the wages
paid in India to pounds using the current exchange rate but does not account for the cost of living (or
the prices of goods) in India. So, while the wages paid to Starbucks employees in India may seem
extremely low or exploitative, it is entirely possible that the cost of living in India is lower than the
cost of living in the United Kingdom. If the cost of living in India is substantially lower than that in
the United Kingdom, then the Starbucks employee in India is not necessarily worse off than a
Starbucks employee in the United Kingdom.
Based on: http://www.firstpost.com/business/is-starbucks-milking-its-employees-not-really-

522717.html & http://www.mirror.co.uk/news/world-news/starbucks-paying-staff-25p-an-hour-
1429212
Concept: Exchange-rate based measures of GDP
Problem-type: Real-world scenario
Difficulty: Easy/Moderate
2. The following table lists 2012 GDP per capita for four countries. The data are given in the national
currencies of the countries. It also lists the price of a Big Mac burger in local currency in each country
in 2012.
The price of a Big Mac in the United States in 2012 was $4.20.
Using the Big Mac burger as a representative commodity common to the countries, calculate the
purchasing power parity (PPP)-adjustment factor for each country, and then the PPP level of per
capita GDP in each country.
Answer: Following the procedure given in the text, we first calculate the ratio of the U.S. Big Mac
price and the Big Mac price in the country in question. For example, for Norway, the calculation
would be $4.20/41 krone = 0.102. This is the PPP adjustment factor, which we then multiply by per
capita GDP stated in the local currency. For Norway, the calculation is 0.102 × 579,162 =
$59,328.79.
Here is the table showing the results for all the countries:
2012 GDP 2012 Big PPP Adjustment PPP

Country (currency) per Capita Mac Price Factor (rounded) GDP/Capita
Norway (krone) 579,162 41 0.102 59,328.79
Poland (zloty) 41,398 9.1 0.462 19,106.77
Turkey (Turkish lira) 19,580 6.6 0.636 12,460.00
United Kingdom (British pound) 24,740 2.49 1.687 41,730.12

Concept: Purchasing Power Parity
Problem-type: ‘Real-world’ scenario/calculation
Difficulty: Hard
3. Let us use what we have learned in the first part of the chapter to compare living standards in the
United States and a hypothetical country, Argonia, in 2008.
a. The U.S. GDP in 2008 was approximately 14 trillion dollars and the U.S. population was
approximately 300 million. What was the per capita GDP in the United States in 2008?
b. Suppose that in the local currency, Argonian dollars, Argonia’s GDP in 2008 was 1 trillion, and
its population was 10 million. What was Argonia’s GDP per capita in Argonian dollars? What
problems do you foresee in comparing this number to the United States’ GDP per capita in U.S.
dollars computed in part (a)?
c. The Argonian dollar/U.S. dollar exchange rate was equal to 6 on January 1, 2008 (meaning that 1
U.S. dollar is worth 6 Argonian dollars) and reached 9 on August 1, 2008. Compute an exchange-
rate-based measure of the GDP per capita in Argonia in U.S. dollars on these two dates. Do you
think the change in Argonia’s exchange-rate-based measure of GDP per capita between these two
dates reflects a true change in living standards?
d. McDonald’s has a thriving business in Argonia and sold a Big Mac for 7 Argonian dollars in
2008, while at the same time, a Big Mac sold for $3.50 in the United States. Using this
information, provide an alternative estimate of GDP per capita in Argonia. Would you trust this
estimate better than the one based on exchange rates? Why or why not?
Answer: Per capita GDP  Aggregate income or GDP

Total population = $14 trillion
300 million = $46,667
a.
= 1 trillion Argonian dollars
b. Per capita GDP  Aggregate income or GDP 10 million
Total population
= 100,000 Argonian dollars
U.S. per capita GDP, which is in dollars, cannot be compared to the per capita GDP in
Argonia, which is in Argonian dollars. To facilitate comparison, we would have to convert
both values into a common unit of measurement.
c. January 1, 2008: Argonia’s per capita GDP in U.S. dollars = 100,000 × 1/6 = $16,666.67
August 1, 2008: Argonia’s per capita GDP in U.S. dollars = 100,000 × 1/9 = $11,111.11
No, the change in Argonia’s exchange-rate-based measure of per capita GDP is unlikely to
reflect a change in living standards. This fluctuation is likely to have little to do with
changes in prices in Argonia or the United States; instead, the significant fluctuation in the
income per capita in Argonia relative to the United States is just a consequence of
converting Argonian incomes into dollars using the current exchange rate, which fluctuates
for a variety of reasons unrelated to differences in costs of living.
d. This information can be used to arrive at a PPP-adjusted exchange rate between the United
States and Argonia. If a Big Mac costs $7 in Argonia and $3.50 in the United States, then
1 U.S. dollar = 2 Argonian dollars. It follows that the per capita GDP in Argonia in U.S.
dollars = 100,000 × 1/2 = $50,000.
Yes. The Big Mac index is commonly used as an alternative measure of exchange rates. It is
a very simple example of purchasing power parity adjustment. PPP-adjustments account for
the relative differences in the cost of living in various countries. Because it involves the
prices of an actual good in the two countries, it is more reliable than the estimate based on
exchange rates.
Concept: GDP per capita, purchasing power parity
Problem-type: Fictional ‘real-world’ scenario
Difficulty: Moderate/Hard
4. Suppose you are given the following information for the country, Lusitania:
2011
Population; total in Lusitania 190 million
Employment 80 million
Gross Domestic Product (GDP) 2,476 billion U.S. dollars
a. What is the income per capita in Lusitania?
b. What is the income per worker in Lusitania?

The following table gives you the same information for the country, Arctica.
2011
Population; total in Arctica 80 million
Employment 40 million
Gross Domestic Product (GDP) 3,600 billion U.S. dollars
c. What is the income per capita in Arctica?
d. What is the income per worker in Arctica?
e. Based on the given information, would Arctica be considered more productive than Lusitania?
Explain your answer.
f. How would you use the information given in both these tables to compare living standards in
Lusitania and Arctica?
Answer:
GDP
a. Income per capita  total population
= 2, 476 billion
190 million
= 2, 476, 000, 000, 000 = $13,032 (approx.)
190, 000, 000
Aggregate income number = 2, 476 billion = $30,950
80 million
b. Income per worker  of people in employment
GDP
c. Income per capita in Arctica  total population
= 3, 600, 000, 000, 000

80,000,000
= $45,000
Aggregate income Number
d. Income per worker in Arctica  of people in employment
= 3, 600 billion
40 million
= $90,000
e. Income per worker in Arctica is much higher than Lusitania. Therefore, it can be concluded
that workers in Arctica are more productive than workers in Lusitania.
f. Income per capita takes into account the whole population, including children and the
elderly, and so can be used to understand differences in living standards. The per capita
income in Arctica is higher than that in Lusitania. This implies that the standard of living in
Arctica is higher than that in Lusitania.
Concept: Income per capita; income per worker
Problem-type: Fictional ‘real-world’ scenario and calculation problem
Difficulty: Hard
5. Suppose that the GDP in current dollars for Polonia is higher than Ruritania’s GDP. However, using
purchasing-power-parity-adjusted dollars, Ruritania’s GDP is higher than Polonia’s GDP. Based on
this information, what would you conclude about living standards in Polonia and Ruritania?
Answer: The purchasing-power-parity adjustment constructs the cost of a representative bundle of
commodities in each country and uses these relative costs for comparing income across countries.
This means that purchasing-power-parity measures adjust nominal GDP for the cost of living in a
country. So, if Ruritania’s PPP-adjusted GDP is higher, this means that the standard of living in
Ruritania is likely to be better than Polonia’s standard of living.
Concept: Purchasing-power-parity-adjusted GDP
Difficulty: Easy
6. In 2011, China revised its poverty line upward to 2,300 yuan per year, or 6.3 yuan per day. At the
prevailing exchange rate, this was equal to a little less than a single U.S. dollar. Some commentators
felt that China’s poverty line fell short of the World Bank’s poverty line of $1.25 per day, in 2005
purchasing-power-parity (PPP) U.S. dollars. Would you agree? What other information would you
need to evaluate this claim?
Answer: The World Bank’s poverty line is based on PPP-adjusted U.S. dollars. This means that
people whose purchasing power is so low that they cannot afford to buy the same goods and services
that could be bought in the United States in 2005 for $1.25 are considered to be below the poverty
line. To check whether China’s poverty line falls below the World Bank’s poverty line, we need to
use the PPP-adjusted exchange rate for Chinese yuan and the U.S. dollar.
Based on http://www.economist.com/blogs/freeexchange/2011/12/chinas-poverty-line
Concept: One dollar a day poverty line
Problem-type: Real-world scenario
Difficulty: Easy
7. In this question, we will use what you learned in the second part of the chapter to compare the
performance of an economy in two different time periods, as its physical capital stock and efficiency
units of labor change.
a. Suppose that from period 1 to period 2, the unemployment rate in the economy increases.
Everything else remains unchanged. What happens to the total efficiency units of labor? Express
your results formally as an inequality, using the formula for total efficiency units of labor
presented in the chapter (in particular, recall that total efficiency units of labor in two periods can
be written as H1 = L1 × h1 and H2 = L2 × h2; where L is the total number of employed workers).
b. What are the consequences of this increase in unemployment for GDP? Express your results
formally as an inequality, using the aggregate production function presented in the chapter.
c. What are the consequences for GDP per capita and GDP per worker?
d. Suppose that there is a technological advance from period 1 to period 2 but, at the same time, a
decrease in physical capital stock? Can you say whether GDP will increase or decrease? Why or
why not?
Answer:
a. The total efficiency units of labor is the product of average efficiency units of workers and
the total number of workers in the economy. An increase in unemployment implies a
decrease in the number of workers. Everything else remaining unchanged, a decrease in the
number of workers reduces the total efficiency units of workers. This can be expressed
formally as follows: L1 > L2 implies H1 = L1 × h1 > H2 = L2 × h2
b. The aggregate production function is expressed as Y =A×F(K,H), where Y stands for GDP,
K is capital stock, H is efficiency units of labor, and A is a technology index. With an
increase in unemployment in period 2, the efficiency units of labor will fall. This means that
GDP will also fall as there is a direct relationship between capital, labor, and aggregate
output. Formally, this can be expressed as follows: H2 < H1 implies F(K,H2) < F(K,H1),
which implies A×F(K,H2)< A×F(K,H1), which implies Y2 < Y1.
c. Other things remaining the same, the fall in GDP will reduce GDP per capita. The effect on
GDP per worker is harder to determine. That is because both GDP and the number of
workers are decreasing.
d. Technological progress means that the economy can generate more output from the same set
of inputs. It is difficult to conclude whether GDP will increase when physical capital stock
falls but technology progresses. This is because with technological progress, more output
can be produced with a smaller level of capital. It is also possible that, with technological
progress, the same (or even a higher) level of GDP can be achieved, even if the capital stock
declines.
Concept: Capital stock, efficiency units of labor, technology
Difficulty: Hard
8. The following table shows the change in GDP in Lithasia with changes in efficiency units of human
capital.
GDP (in millions Stock of physical Efficiency units
of dollars) capital (units) of labor
100 15,000 16,000
150 15,000 20,000
180 15,000 24,000
200 15,000 28,000
210 15,000 32,000
a. Comment on the rate of change in GDP as the economy uses more efficiency units of labor.
b. How would the aggregate production function of this economy look if GDP is measured along the
vertical axis and efficiency units of labor on the horizontal axis?
c. What explains the shape of this aggregate production function?

Links : http://www.worldbank.org/depweb/english/beyond/global/chapter15.html
http://data.worldbank.org/indicator/NY.GNP.PCAP.PP.CD
http://www.worldbank.org/depweb/english/beyond/global/chapter2.html
Answer:
a. GDP increases with an increase in the efficiency units of labor. However, the rate of
increase in GDP gradually decreases as the efficiency units of labor increase.
b. The aggregate production function of the economy will be an upward-sloping curve that
gradually becomes less steep, as we move up along the curve.
c. The law of diminishing marginal product explains the shape of the aggregate production
function. It states that holding the stock of physical capital constant, the relationship
between aggregate product and efficiency units of labor becomes less and less steep as the
total efficiency units of labor increases.
Concept: Law of Diminishing Marginal Product
Difficulty: Moderate
9. The old Soviet Union devoted enormous resources exclusively to increasing its physical capital stock,
and yet eventually the increase in the country’s GDP came to an end. Based on the discussion in the
chapter, explain why this was inevitable.
Answer: The Soviet Union had many problems that would have slowed economic growth: corruption,
lack of incentives, etc. Even without these issues, however, the emphasis on capital accumulation
could not have spurred robust economic growth indefinitely.
Recall from the chapter that capital is subject to the law of diminishing marginal product. This means
that each additional unit of capital produces less and less additional output. In the absence of
technological innovation, the increase in GDP per hour worked as capital accumulates gets smaller
and smaller until it is virtually constant. Thus, economic growth in the Soviet Union was doomed to
slow and eventually to stagnate.
Concept: Diminishing marginal returns to capital
Problem-type: Application of concept to real world
10. Draw a graph showing the aggregate production function, assuming diminishing marginal returns to
physical capital. Label the axes.
Answer:

Concept: Diminishing marginal returns to capital
Problem-type: Graphical
Difficulty: Easy
11. Redraw your graph from Problem 10. Now show what would happen if there is a technological
advance. Make sure to label the axes once again, and indicate clearly the direction of any changes to
your graph.
Answer:

Concept: Effect of improvements in technology on the aggregate production function
Problem-type: Graphical
Difficulty: Easy
12. First Japan, then Korea, and now China, have managed to grow very rapidly without devoting many
resources to research and development (R & D). Given the importance noted in the text of
technological advance as an engine of growth, this seems to be a contradiction. Explain how rapid
growth in these countries (and others as well) could have been achieved without a substantial R&D
commitment on their part.
Answer: Although technological change is indeed vital for sustainable economic growth, that change
need not come about primarily through domestic R&D. Technology developed in other, more
advanced countries, can be adopted and adapted by poor countries to serve local industry in local
circumstances. This is called “technology transfer.”
For example, Japan was especially adept at “reverse engineering” products developed in the United
States. This involved acquiring innovative American products (VCRs and CDs were two such
products), “taking them apart” to see exactly how they had been made, and then figuring out how to
produce them more cheaply and efficiently. Thus, poor countries can save the time and resources that
would be involved in fostering their own R&D industry and devote themselves to exploiting
technology invented elsewhere.
Another plausible explanation could be that these countries began with a very low capital stock. As a
result, ongoing investment in physical capital added much more to output and growth before they
reached a point of diminishing marginal returns.
Concept:Increasing knowledge; technology transfer
Problem-type: Application of concept to real world
13. Give an algebraic and an intuitive explanation of the concept of “efficiency of production.” Why is
efficiency of production so important to GDP?
Answer: Given the aggregate production, function Y=A×F(K,H), higher productive efficiency implies
that A is higher. Therefore, for a given level of K and H, a higher level of A implies a higher level of
Y, or GDP.
“Efficiency of production” is defined as the ability of an economy to produce the maximal amount of
output at a given cost or from a given amount of factors of production.
This is important for GDP because the greater productive efficiency in an economy, the more goods
and services that can be produced from a given input, or combination of inputs. For example, with a
given labor force, a country with greater efficiency will be able to produce more goods and services
than a country with lower efficiency and, therefore, will have a larger GDP than a country where such
efficiency remains low.
When a nation’s workers are more productive, real GDP (Y) is larger, and therefore incomes are
higher than they would otherwise have been. Higher incomes mean higher living standards. So, when
the efficiency of production grows rapidly, so do living standards.
Concept: Efficiency of Production
Problem-type: Short essay/explanation
Difficulty: Moderate/Hard

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Chapter IX

Person Country A Income Country B Income

7. What is productivity? Why does it vary across countries?

8. What are the two components of technology?

13. Explain what distinguishes physical capital from natural resources.

14. How do increases in technology affect the aggregate production function?

17. What policies can be used to raise GDP in a country?

Based on: http://www.firstpost.com/business/is-starbucks-milking-its-employees-not-really-

2012 GDP 2012 Big PPP Adjustment PPP

A-head: INEQUALITY AROUND THE WORLD

Answer: Per capita GDP  Aggregate income or GDP

a. What is the income per capita in Lusitania?

b. What is the income per worker in Lusitania?

c. What is the income per capita in Arctica?

d. What is the income per worker in Arctica?

= 3, 600, 000, 000, 000

c. What explains the shape of this aggregate production function?

A-head: PRODUCTIVITY AND THE AGGREGATE PRODUCTION FUNCTION

A-head: PRODUCTIVITY AND THE AGGREGATE PRODUCTION FUNCTION

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