Production and Growth
The first vital process of an economy is production which must go on continuously. “Production includes any activity, and the provision of any service, which satisfies and is expected to satisfy a want.” In this wider sense, production includes products produced on farms like wheat, vegetables, pulses, etc. and those manufactured in the factories such as clothes, bicycles, television sets, electric appliances, and the like. It also includes the services of shopkeepers, traders, transporters, actors, doctors, civil servants, teachers, engineers and the like who help in satisfying the wants of the people in the economy through their services.
But the term ‘production’ excludes certain goods and services though they satisfy human wants. First, domestic work done within the family by the housewife, husband or children. Second, production of hobby articles, like paintings.
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Third, production of vegetables in the kitchen garden. Last but not the least, voluntary work or Shramdan. Though these are productive activities, yet they are not included in production because no payment is made for such goods and services. If all these goods and services are paid for, they will be included in the production of the economy. Sir John Hicks defines production in this sense when he writes: “Production is any activity directed to the satisfaction of other people’s wants through exchange.” Thus we include in production all consumers’ goods, producers’ goods and the services of all kinds which are exchanged for money.
2. Consumption:
The second vital process of an economy is consumption. Consumption means the use of economic goods and services in the satisfaction of human wants.
The consumption that goes on in the economy may be of various types. Prof. Hicks classifies consumption goods into two categories: single-use goods, and durable-use goods. ‘Single-use goods’ are those which are used up in a single act. Such goods are food stuffs, cigarettes, matches, fuel, etc. They are the articles of direct consumption because they directly satisfy human wants.
Similarly, the services of doctors, bus drivers or waiters are included under ‘single-use goods.’ ‘Durable-use goods’ are those which can be used for a considerable period of time. It is immaterial whether the period is short or long. Such goods are pens, bicycles, clothes, fans, television sets, furniture, etc.
Real GDP depends on the amount of each product that is produced, so we need some way of describing how all that producing of products occurs. In practice, we know that real GDP is calculated using many products. Conceptually, we could set up a production function for each individual product that describes how each is produced using capital, labor, natural resources, and perhaps other products.
For example, we could describe a production function for a Taco Cabana restaurant that depends on capital (e.g. the building, the refigerators, the registers, the grill), labor (e.g. those lovely people who assemble your tacos), energy (something has to power the spinning tortilla machine), and other products (e.g. the lettuce and beans they purchase from some food supplier like Sysco). And now that we’ve done that, we could describe the production function for the Starbucks located next door. And then describe production at the Verizon store across the street, and so on and so on and so on.
We could do that in theory, but in practice it is unmanageable. What we’re going to do instead is concentrate on an aggregate production function that summarizes all of the individual production going on at each individual location (the Taco Cabana, the Starbucks, the Verizon store, and so on) and relates that to the sum of all the inputs used like capital and labor. We’re not ignoring the fact that real GDP is really the summation of the relative values of all the different products, but we are sweeping that detail under the rug so we can concentrate on the larger picture. Think of it a little like weather models. While a weather forecaster cannot tell you exactly where each drop of rain is going to fall, they can give you a decent idea of roughly where it is going to rain and when.
Here is our aggregate production function, and it is so central to what we’re going to do that I’m going to set it off with it’s own little marker.
Let’s go through each of the pieces of this.
Kt�� is the total stock of capital in the economy at time t�. This combines the values of all structures, equipment, and intellectual property used by all the establishments. More capital, more real GDP.
Lt�� is the total amount of labor in the economy at time t�. This could be a count of the number of workers, or we can get fancy and think of it as a combined stock of skills and abilities that those workers bring with them. Either way, more labor, more real GDP.
At�� is the level of productivity at time t�. We’ll have more to say later about what this really measures, but for now keep in mind that is measures how efficiently we use the capital and labor in the economy. Higher productivity, higher real GDP.
Notice that I didn’t include anything explicit about natural resources or raw materials here. We could, but they tend to not be as important for growth in real GDP as we think. For the time being we’ll leave them out, and later on can incorporate information about them into the production function.
What about the remaining parameters, α� and 1−α1−�? Those dictate how sensitive real GDP is to the amount of capital (α�) or to productivity and labor (1−α1−�). Their role is quite important, and will be easiest to see if we do a little mathematical work first.
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