ED <Lecture Note 4> 13.3.29

1. ED <Lecture Note 4> 13.3.29 ED: Capitals and Investment*Some parts of this note are borrowed from references for teaching purpose only. Semester: Spring 2013 Time: Friday 9:00~12:00 am Class Room: No. 322 Professor: YooSoo Hong Office Hour: By appointment Mobile: 010-4001-8060 E-mail: yshong123@gmail.com Home P.: //yoosoohong.weebly.com

2. Income Level by Region and Country World Bank Scheme- ranks countries on GNI/capita

3. Factors of Economic Development • Understanding Economic Development • Overall understanding (‘seeing the forest’): • Understanding of main macro indicators such as economic growth • Partial Understanding (‘seeing the trees’): • Understanding of main components as a point of the whole • Main Factors for Enhancing Development/Barriers • Resources (physical/human capital, labor, land, natural resources, etc.) • Technologies (productive technology, know-how, knowledge, etc.) • Institutions (law, regulation, etc.) • Cultures (custom, morality, life style, etc.) • Others (politics, international relations, etc.)

4. Key Factors of Economic Development Resources (Production factors) Technology (Production function) Institutions (Rules, Laws) Culture (Value system)

5. Stages of Economic Development Factor-driven Economy Investment - driven Economy Innovation - driven Economy • Basic factor conditions (low cost labor, natural resources, geographic location) are the dominant sources of competitive advantage • Technology is assimilated through imports, FDI and imitation • Companies have limited roles in the value chain, and focus on assembly, labor intensive manufacturing, and resource extraction • The economy is highly sensitive to world economic cycles, commodity prices, and exchange rates • Efficiency in producing standard products and services is the dominant source of competitive advantage • Foreign technology is accessed through licensing, joint ventures, FDI, and imitation • The nation is not only assimilating foreign technology, but has the capacity to improve on it • Heavy investment is made in efficient infrastructure, modern production process, and ease of doing business • Innovative products and services at the global technology frontier are the dominant sources of competitive advantage • Characterized by strengths in all areas together with the presence of deep clusters • Companies compete with unique strategies that are often global in scope • The economy has a high service share, and is resilient to external shocks Source: Porter, Michael E. Competitive Advantage of Nations, 1990.

6. Changes in Production Capacity Physical Capital Accumulation EAP& HR Investment Production (Capital, Labor, Technology) Population Support R&D Savings Consumption EAP=Economically Active Population

7. Population growth and depreciation Consumption Economic growth Impoverished household Capital per person Household savings Tax payments Public budget Public investment Basic Relationship of Capital Accumulation and Growth

8. Poverty Trap Basic needs Impoverished household Decline in capital per person Negative economic growth Zero household savings Zero tax payments Zero public investment budget Population growth and depreciation

9. Role of ODA in Breaking the Poverty Trap Basic needs Household savings Economic growth Impoverished household Economic growth Microfinance Humanitarian relief Public investment Public budget Official development assistance Budget support Population growth and depreciation

10. Private and Public Investments in Capital Business capital Human capital Knowledge capital Infrastructure Natural capital Institutional and Social capital Household income Tax payments Public budget

11. Social Capital Human Capital Networks Membership Political Rights Knowledge Skills Health Shelter Machinery Infrastructure Land Water Livestock Natural Capital Physical Capital Savings Pensions Insurance Financial Capital Source: DFID Sustainable livelihoods Guidance Sheets

12. How Inter-relationship of Society’s Assets

13. Factors Accounting for Economic Growth in Selected Regions Source: International Monetary Fund.

14. Capitals  Three types of capital, or resources, are used to produce goods and services. • Natural capital includes resources and services produced by the earth’s natural processes, which support all economies and all life. • Human capital, or human resources, includes people’s physical and mental talents that provide labor, innovation, culture, and organization. • Physical capital, or manufactured resources, are items such as machinery, equipment, and factories made from natural resources with the help of human resources. • Most economic systems use three types of resources to produce goods and services.

15. Concept of Capital and Human Capital • Concepts of Capital • Broad meaning: All sources generating future income flows • Narrow meaning: Physical capital and human capital only • Accumulation of physical capital, human capital and technology • (knowledge) increase in production and income  increase in • accumulation ……(virtuous circle) • The ability embodied in individuals as a result of investment in the • form of education, training, health, regional movement (migrant),etc. • that increases quality of labor. • Capital and Technology Accumulation • Human Capital

16. Physical Capital • Economic growth requires and depends, in part, on inputs of capital. The rate of growth implied by a given capital formation proportion depends on the capital/output ratio and the rate of growth of the labor force. • The process of growth involves saving to create a surplus for capital formation. Saving is not tightly related to incomes per capita. • Saving can be undertaken by government, and it can be forced upon households and businesses by inflation. All economies have a limited capacity to absorb new investments, but most do not ever test the limits. • When investment increases continuously, additional (marginal) rates of return to capital tends to fall because better opportunities have been exploited already.

17. Physical capital is a scarce resource, in rich and poor countries alike. It is also an input into the production process. In general, the higher the level of inputs, the higher will be the level of output. The poverty of physical resources obviously characterizes poor countries. Thus conventional views would urge higher rates of capital formation to overcome poverty. • Physical capital takes the form of long-lived goods such as machinery used to produce other goods. Capital goods are themselves the result of the process of capital formation, a process that takes time and that uses resources. • In an efficient economy, higher rates of capital formation (and thus, the higher potential rates of growth of overall output in the future) mean lower production of consumer goods in the present. Thus, there are trade-offs between current consumption and future consumption.

18. Capital andInvestment • Importance of Capital • Harrod-Domar’s Model • Interested in investment conditions for achieving sustainable growth without inflation and unemployment • The View called ‘capital fundamentalism’ • Claim that capital formation is the key factor for economic growth. • The issue of economic development is essentially to gain investment resources necessary to achieve the target (minimum) rate of economic growth needed for desirable employment and income distribution. • They assume that high economic growth is expected to automatically reduce unemployment and excessive income inequality. • Adding the concept of human capital • In principle, human capital is the same as physical capital so that it reinforces the importance of capital for economic development.

19. Problems of ‘capital fundamentalism’ • High investment and capital formation do not necessarily guarantee desirable economic growth and income distribution. • There are many cases of inefficient investments or investments for mainly demonstration purpose that are not appropriate for the reality of developing countries. • Required Investment • In developed countries (during 1960-1975), 50% of economic growth was resulted from capital investment. In developing countries (newly industrial countries), 25-35%of economic growth was resulted from capital accumulation. • Investment rate of 15-20% should be maintained for sustainable development for a long period. • Capital-Intensive Investment vs. Labor-Intensive Investment • In developing countries lacking capital, if more emphasis is given to capital- intensive production, economic growth rate may be lowered and/or consumption may be constrained.

20. Saving: A Fundamental Determinant of Economic Growth To have more consumption in the future, people must consume less today and save the difference between consumption and income.

21. Relationship Between Rate of Saving and Per Capita Real GDP Source: World Bank.

22. Relationship between Savings and Investment at the Macro-Economic Level Investment ( by firm, government, person, etc. ) Savings Financial Intermediaries Bank deposit Domestic private savings Domestic bank Domestic borrowing from banks or individuals ( these are debt ) and invested in capital or operation Stock purchase Cash holding Stock market Through domestic stock market, new stocks are issued and invested as equity Person to person Domestic government savings FDI Foreign financial institutions Foreign borrowing or equity investment Foreign savings From foreign bank

23. Savings and Growth in 90 Developing Countries Source: IMF World Economic Outlook, May 1993 (Annual data, 1971-92). Savings and Economic Growth

24. Diversity of Economic Outturn across SSA groupings • Real GDP growth has outstripped population growth since 2004. Because of better oil prices, real GDP growth has been high in Oil exporting countries • Improved macro policies, low income countries have been growing at higher rates • Gross national savings are low, perhaps constraining total investment

25. Accumulation Speed of Physical Capital (Unit: Real Domestic Investment/Real GDP, %) Note: 1. Measured in 1985 constant dollars. 2. Average Annual Growth Rate for the period, 1960-1990. Source: Summers and Heston Data Set 5.6.

26. Roles of Remittances • Count as the 2nd largest source of capital inflow to many developing countries. • Only foreign direct investment account for more sources of external finance. • Remittances exceeds inflows that come from international aid. • Receiving countries become more dependent on global economies rather than sustaining their own local economies. • Promotes economic growth in developing countries. • World Bank estimates $240 billion in total remittances in 2007, a staggering jump from only $31.2 billion in 1990. • Remittances exceed all other imports of private and public capital in 36 developing countries.

27. Advantages of Remittances • Finance much needed investment in recipient countries to contribute to increased productivity. • Believed to reduce poverty. Mainly due to the poor that migrate and send back remittances. • Increase of income in households also increase consumption. • Remittances do not have to pay interest. • More stable than foreign direct investment or foreign portfolio investments. These are highly volatile in developing countries. • Unskilled workers may return to their home countries with useful skills acquired abroad. • Recipients have a higher propensity to own bank accounts.

28. Disadvantages • Promotes idleness among the recipients. • May cause appreciation of receiving country’s currency. Thus leading to lower net exports and negative economic growth. • Some emigrants may be educated or highly skilled causing what commonly known as “brain drain”. • Loss of human capital lowers productivity and economic growth. • Home country invested time, effort and money on their education. • Migration of skilled workers worsens the distribution of income between rich and poor countries.

29. Top Remittances Countries • Developing countries receive the highest amount of remittances. • One-third of remittances to the developing world go to India, China, and Mexico.

30. Trends of Remittance Flows Source: World Bank • Most of the developing world has been increasing flows of remittances by double digits annually between 1990-2005.

31. Remittances by Area

32. Labor and Human Capital • While physical capital may be the scarcest input to development, labor is usually plentiful. Usually low-income countries are characterized by capital-poor and labor-rich. • Productivity of workers is dependent on their native ability, the amount of raw labor they bring to the marketplace, and the returns to their stock of human capital. • Investments in human capital include formal schooling, on-the-job training, health care, and nutrition, among others. (=> human development) • Intensity of effort also affects output and is influenced by labor supply. Backward-bending supply curves for labor seem less accurately descriptive of current low-income countries.

33. Managing the process of human capital formation is a challenge to policymakers. Educational requirements depend in an indirect but quantifiable way on future output and its prospective composition. • Poor countries have lost some trained workers through emigration. The results of the so-called brain drain are amenable to economic analysis. • Unions affect the development process through both the economic and noneconomic roles they play. Their organizational capabilities seem more limited in poor countries than rich countries. • The use of political instruments to gain their ends is more pronounced. Early hopes that unions might act on behalf of the society as a whole have proved unrealistic.

34. Population Changes • The Importance of Population Issue • The relationship between population growth rate and economic growth rate • The inter-relationship between the two variables is important, but the casual relationship is complicated. • The size and growth rate of population affect economic growth rate and economic development, and vice versa. • The relationship between population and income • Population and income distribution (Y/P): moving in the opposite direction • However, population size is positively related to production scale, market size and defense power. • Higher population density may lower productivity. In contrast, it may encourage technological innovation.

35. Population and Per Capita Income C B  A Y Output Slope indicates per capita income (Y/P) P Population

36. Population and resource depletion • Resource depletion = Population size X Per capita income X Intensity • Pessimistic view: • The report by the Club of Rom, The Limits to Growth warned a gloomy future of mankind. • Optimistic view of neo-classical economists: • Supply of resource is determined by resource market price mechanism. (E.g. Recent oil price fluctuations) • Dissemination of technology positively affects resource utilization. • Population Growth Rate • Population growth rate = Birth rate - Death rate  Migration rate

37. Distribution and Growth Rate of Population by Region in the World

38. Demographic Transition • Shortening Demographic Transition Period • Compared to demographic transition in developed countries in the past, the transition process in developing countries is more radical and fast due to fast decrease in both birth rate and death rate so that the transition process tends to be shortened. • Increase in Young Population vs. Old Population • The increase in young population results in increasing dependency rate which in turn requires job creating and human capital investment. Relative increase in old age group also increases dependency rate and results in negative effects on economic growth. • Determinants of Birth rate • Malthusian hypothesis: Population growth rate is constrained by food production. Population growth is geometric whereas food production growth is arithmetic so that income increase (and economic growth) above the subsistence level is impossible in the long run, since population will increase faster if food (income) per capita increases due to some reason.

39. Modern Theory of Birth Rate : Birth rate is affected by many factors. • Economics of human behavior: Are children investment goods of parents?! • Decision and preference of women are most important: culture, income level, education level, opportunity costs, etc.

40. Demographic Transition Process % Demographic transition Birth rate Death rate Population growth rate Time

41. Demographic Transition and Population

42. Estimated Human Population Growth

43. Five Features of World Migration • Major world migration is from less to more developed regions of the world. • New demands for immigrants in highly developed countries are increasing due to demographic transitions. • Globalization creates contradictory labour demands and displacements, creating mobility opportunities for some and uprooting others. • Economic globalization creates contradictory tendencies in international migration. • World migration has added racial and cultural diversity to historically homogeneous populations.

44. Source: United Nations, International Migration, 2009

45. Human Capital Definitions • Human capital is the accumulation of skill and knowledge imbedded in labor performance in order to produce economic value. • “the acquired and useful abilities of all the inhabitants or members of the society. The acquisition of such talents, by the maintenance of the acquirer during his education, study, or apprenticeship, always costs a real expense, which is a capital fixed and realized, as it were, in his person.” - Adam Smith, The wealth of the nations (Short title of the book) • Human capital refers to the collection of innate and acquired individual abilities that are substantially durable, persisting over some significant portion of the life of the possessor

46. Role of HC and Measurement • Economic growth closely depends on the relation between new knowledge and human capital, which is why large increases in education and training have accompanied major advances in technological knowledge in all countries that have achieved significant economic growth. • Quantitatively, the early studies compared school enrollment ratios or literacy rates. The problem with that, is there is no adequate measure of aggregate stock of human capital available as an input of production. • Technological progress is invaluable when there are only few skilled workers that know how to benefit from it.

47. Component of HC

48. The Human Capital Model C (3) Incremental earnings H Annual earnings (2) Opportunity cost H 18 22 (1) Direct cost 65 Age C Age-Earnings Profiles with and without college education

49. Age-earnings Profiles by Level of Education (Venezuela, 1989)

50. Comparison Of Human Capital And Physical Capital  Differences • There are major differences in terms of the returns obtained from the investment in human capital and physical capital. The investment in physical capital has only monetary and market returns whereas investment in human capital has non-monetary as well as non-market returns. • The returns to human and physical capital tend to behave differently. When individual invest in physical capital, they are return-takers i.e. the owners accepts the return dictated by the market and cannot influence them. Since there are no market for the stock of human capital, investors in human capital become return-maker, as the amount, the quality and the maintenance of their human capital will dictate what the market will be willing to offer for their services.