Now add another country, Solovakia (with a single inhabitant named Una), and compare it to Solovenia. We can compare Solovenia and Solovakia by investigating which is producing more output per person and why. Imagine, for example, that Solovenia is a relatively poor country, and Solovakia is richer. Using our knowledge of the aggregate production function, we can understand how this difference might arise. It might be because Una has more human capital or knowledge than Juan, or because Una has a larger stock of physical capital.
Another basis for comparison is the rate at which the two economies are growing. If Solovakia is richer, and if it is also growing faster than Solovenia, then the gap between the two countries will become wider over time. We call such a process divergence. Conversely, if Solovenia is growing faster than Solovakia, then the gap between Juan’s and Una’s living standards will become smaller over time. Such a situation, where poorer countries catch up to richer ones, is called convergence.
Why might we see either convergence or divergence? Part of the answer has to do with the marginal product of capital in the two countries. Suppose that Solovakia is richer because it has a larger stock of physical capital than Solovenia. In that case, we expect the marginal product of capital to be larger in Solovenia. Solovenia is a more competitive economy than Solovakia. Juan will want to invest at home, while Una will take some of the output that she produces in Solovakia and invest it in Solovenia. Therefore we expect capital to migrate from Solovakia to Solovenia. As a consequence, it is likely that Solovenia will grow faster than Solovakia, leading to convergence.
KEY TAKEAWAY
The capital stock increases through investment.
Because physical capital is an input in the aggregate production function, growth in capital stock is one source of output growth. The other sources are the accumulation of human capital and increases in technology.
In a closed economy, investment equals national savings. In an open economy, investment equals national savings plus inflows of funds from abroad. So in an open economy, growth in the capital stock and hence output growth can be financed both by domestic savings and borrowing from other countries.
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Checking Your Understanding
Draw a version of ***Figure 6.3 "The Aggregate Production Function: Output as a Function of the Physical Capital Stock" with labor hours instead of physical capital on the horizontal axis. Explain how the figure illustrates the positive marginal product of labor and diminishing marginal product of labor. How would you illustrate a change in the capital stock using this figure?
Explain how an economy can have an investment rate of 10 percent but a savings rate of only 3 percent.
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