5.4 Other Inputs in the Aggregate Production Function

Learning Objectives

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

  1. How does the amount of human capital in a country change over time?
  2. How is knowledge created?
  3. How do property rights influence the aggregate production function?

We have less to say about the other inputs into the aggregate production function, so we group them together.

Human Capital

Education makes the most important contribution to human capital in an economy. Kindergarteners learning to count are acquiring human capital, as are high-school students learning algebra, undergraduate students learning calculus, and experienced workers studying for an MBA. People also acquire human capital on the job—either as a result of explicit company training programs or simply because of practice and experience (sometimes called “learning by doing”).

The education policy of national governments therefore plays a big part in determining how much human capital there is in a country. In the United States and Europe, education is typically compulsory up to age 15 or 16. In other countries, the school-leaving age is lower: 10 in Bangladesh, 11 in Iran, and 13 in Honduras, for example. In still other countries, education is not compulsory at all.“At What Age…? Comparative Table,” Right to Education Project, accessed June 28, 2011, http://www.right-to-education.org/node/279. One of the aims of the American Competitiveness Initiative, mentioned at the beginning of this chapter, was to “provide American children with a strong foundation in math and science.”

There are many similarities between human capital and physical capital. Human capital, like physical capital, is accumulated through a process of investment. Basic education is an investment made by parents and governments. University education is an investment made by individuals and households. When you go to college, you give up time that you could have spent working or having fun. This is one cost of education. The other cost is the expense of tuition. The gain from education—the return on your investment—is that sometime in the future you will be more productive and earn more income. An individual decision to go to college is based on an evaluation of the costs (such as tuition and foregone time) and the benefits (such as higher salary after graduation and the joy of studying fascinating subjects like economics).

Firms also invest in human capital. They seek to increase the productivity of their workers by in-house training or by sending workers to external training courses. Large firms typically devote substantial resources to the training and development of their employees. Some of the skills that workers acquire are transferable to other firms if the worker moves to another job. For example, workers who have attended a training course on accounting would be able to use the knowledge they acquired from that course at many different firms. Other skills are specific to a particular firm (such as knowing exactly where to hit a particular machine with a hammer when it jams).

Human capital, like physical capital, can depreciate. People forget things that they learned, or their knowledge becomes obsolete. VisiCalc was once a leading spreadsheet software, so people skilled in its use had valuable human capital; yet knowledge of this program is of little use today. Human capital that is specific to a particular firm is particularly prone to depreciation because it becomes worthless if the worker leaves or if the firm goes out of business. One reason why factory closures—such as those in the food retailing sector in the United Kingdom—arouse such concern is that laid-off workers may see their useful human capital decline and end up with lower paying jobs as a result.

While there are similarities between physical and human capital, there are also differences. Most importantly, human capital is trapped inside people. Economists say that such skills are “embodied” in the labor force. You cannot sell the human capital that you own without selling your own labor time as well. The implication for government policy is that importing human capital means importing people. Dubai is trying to attract human capital—so it advertises the things that make the country attractive to individuals who own that human capital. Thus their website speaks of the “cosmopolitan lifestyle” in Dubai, together with the quality of the hospitals, schools, shops, and so on.


Many large firms contain research and development (R&D) divisions. Employees in these divisions engage in product development and process development. Product developmentDeveloping new products and improving a firm’s existing products. consists of developing new products and improving a firm’s existing products. Process developmentFinding improvements in a firm’s operations and methods of manufacture to reduce the costs of production. consists of finding improvements in a firm’s operations and methods of manufacture to reduce the costs of production.

An example of product development is the development and testing of a new pharmaceutical compound to treat cancer. An example of process development is the way in which transportation firms now use global positioning systems (GPSs) to better manage the movements of their trucks. In either case, firms invest today in the hope of gains in the future from lower production costs and better products.

Knowledge of this kind is also created by independent research laboratories, universities, think tanks, and other such institutions. In many cases, governments subsidize these institutions: policymakers actively intervene to encourage the production of new knowledge. Governments get involved because new knowledge can benefit lots of different firms in an economy. Think of how the invention of electric power, the internal combustion engine, the microchip, or the Internet benefits almost every firm in the economy today.

Economists say that basic knowledge is a nonrivalA good for which one person’s consumption of that good does not prevent others from also consuming it.. A good is nonrival if one person’s consumption of that good does not prevent others from also consuming it. A good is rival if one person’s consumption prevents others from also consuming it. The fact that one marketing manager is using economic theory to set a profit-maximizing price doesn’t prevent another manager in a different firm from using the same piece of knowledge. (Contrast this with, say, a can of Coca-Cola: if one person drinks it, no one else can drink it.)

Knowledge is also often nonexcludable. A nonexcludable goodA good (or resource) for which it is impossible to selectively deny access. is one for which it is impossible to selectively deny access. In other words, it is not possible to let some people consume a good while preventing others from consuming it. An excludable good is one to which we can selectively allow or deny access. Once a piece of knowledge is out in the world, it is difficult to prevent others from obtaining access to it. Nobody has patents on basic economic principles of price setting.

Together, these two properties of knowledge mean that a discoverer or inventor of new knowledge may not get all, or even most, of the benefits of that knowledge. As a result, there is insufficient incentive for individuals and firms to try to create new knowledge.

Social Infrastructure

Social infrastructure is a catchall term for the general business environment within a country. Is the country relatively free of corruption? Does it possess a good legal system that protects property rights? In general, is the economy conducive to the establishment and operation of business?

Economists have found that social infrastructure is a critical input into the aggregate production function. Why does it matter so much? When a firm in the United States or another advanced country builds a factory, there is an expectation of revenues generated by this investment that will make the investment profitable. The owners of the firm expect to obtain the profits generated by the activities in that plant. They also expect that the firm has the right to sell the plant should it wish to do so. The firm’s owners may confront uncertainty over the profitability of the plant—the product manufactured there might not sell, or the firm’s managers might miscalculate the costs of production. But it is clear who owns the plant and has the rights to the profits that it generates.

If the owners of firms are unsure if they will obtain these profits, however, they have less incentive to ensure that firms are well managed, and indeed they have less incentive to establish firms in the first place. Output in an economy is then lower. Governments take many actions that influence whether owners will indeed receive the profits from their firms. First, in most countries, governments tax the profits of firms. High tax rates reduce the return on investment. Uncertainty in tax rates also matters because it effectively lowers the return on investment activities. Economists have found that countries with high political turnover tend to be relatively slow growing. One key reason is that frequent changes in political power lead to uncertainty about tax rates.

Governments can also enact more drastic policies. The most extreme example of a policy that affects the return on investment is called expropriation—the taking of property by the government without adequate compensation. Although both domestically owned and foreign-owned firms could be subject to expropriation, expropriation is more often about the confiscation of the assets of foreign investors. The World Bank has an entire division dedicated to settling disputes over expropriation.It is called the International Centre for Settlement of Investment Disputes (http://icsid.worldbank.org/ICSID/Index.jsp). For example, it is arbitrating on a $10 million dispute between a Cypriot investment firm and the government of Turkey: in 2003 the Turkish government seized without compensation the assets of two hydroelectric utilities that were majority owned by the Cypriot firm. Such settlements can take a long time; at the time of this writing (mid-2011), the dispute has not yet been settled.

There are also more subtle challenges to the rights of foreign investors. Governments may limit the amount of profits that foreign companies can distribute to their shareholders. Governments may limit currency exchanges so that profits cannot be converted from local currencies into dollars or euros. Or governments may establish regulations on foreign-owned firms that increase the cost of doing business. All such actions reduce the attractiveness of countries as places for foreign investors to put their funds.

Economists group these examples under the heading of property rights. An individual (or institution) has property rightsAn individual’s (or institution’s) legal right to make all decisions regarding the use of a particular resource. over a resource if, by law, that individual can make all decisions regarding the use of the resource. The return on investment is higher when property rights are protected. In economies without well-established property rights, the anticipated rate of return on investment must be higher to induce firms and households to absorb the investment risks they face.

As a consequence, countries with superior social infrastructure are places where firms will prefer to do business. Conversely, countries that have worse infrastructure are less attractive and will tend to have a lower output. On the website for Dubai at the beginning of the chapter, we see that Dubai touts its free enterprise system, for example. (Dubai’s website reveals that physical infrastructure, which is part of the Emirate’s capital stock, also plays a critical role: the website touts the superior transport, financial, and telecommunications infrastructure to be found in Dubai.) As another example, Singapore has a project known as Intelligent Nation 2015 that aims to “fuel creativity and innovation among businesses and individuals”“Singapore: An Intelligent Nation, A Global City, powered by Infocomm,” iN2015, accessed June 29, 2011, http://www.ida.gov.sg/About%20us/20100611122436.aspx. through improved information technology, including making the entire country Wi-Fi enabled.

An illustration of the importance of social infrastructure comes from the vastly different economic performance of artificially divided economies. At the time that North Korea and South Korea were divided, the two countries were in very similar economic circumstances. Obviously, they did not differ markedly in terms of culture or language. Yet South Korea went on to be one of the big economic success stories of the past few decades, while North Korea is now one of the poorest countries in the world. The experience of East Germany and West Germany is similar: East Germany stagnated under communism, while West Germany prospered.

Natural Resources

There is less to say about what determines the amount of natural resources in the production function. The natural resources available to a country are largely accidents of geography. The United States is fortunate to have high-quality agricultural land, as well as valuable deposits of oil, coal, natural gas, and other minerals. South Africa has deposits of gold and diamonds. Saudi Arabia, Iraq, Kuwait, the United Arab Emirates, and other Middle Eastern countries have large reserves of oil. The United Kingdom and Norway have access to oil and natural gas from the North Sea. For every country, we can list its valuable natural resources.

Natural resources are divided into those that are renewable and those that are nonrenewable. A renewable resourceA resource that regenerates over time. is a resource that regenerates over time. A nonrenewable (exhaustible) resourceA resource that does not regenerate over time. is one that does not regenerate over time. Forests are an example of a renewable resource: with proper management, forests can be maintained over time by judicious logging and replanting. Solar and wind energy are renewable resources. Coal, oil, and minerals are nonrenewable; diamonds taken from the ground can never be replaced.

It is difficult to measure the natural resources that are available to an economy. The availability of oil and mineral reserves is dependent on the technologies for extraction. These technologies have developed rapidly over time. The economic value of these resources, meanwhile, depends on their price in the marketplace. If the price of oil decreases, the value of untapped oil fields decreases as well.

Economists and others sometimes use real gross domestic product (real GDP) as an indicator of economic welfare. One problem with real GDP as an indicator of economic welfare is that it fails to take into account declines in the stock of natural resources.In Chapter 3 "The State of the Economy", we note several of these. If the stock of natural resources is viewed—as it should be—as part of the wealth of a country, then depreciation of that stock should be viewed as a loss in income. (The same argument, incidentally, applies to depreciation of a country’s physical capital stock. Real GDP also does not take this into account. However, national accounts do report other statistics that adjust for the depreciation of physical capital, whereas they do not report any adjustment for natural resource depletion.)

Key Takeaways

  • The human capital of a country can be accumulated by education, the training of workers, and immigration of workers into that country.
  • Knowledge about new products and new processes is created by R&D activities within firms, universities, and government agencies.
  • Property rights influence the amount of capital in the aggregate production function. In an economy where property rights are not well defined, there is a lower incentive to invest and hence less capital.

Checking Your Understanding

  1. How does on-the-job experience affect the human capital of an economy?
  2. Why is it difficult to measure the natural resources available in an economy?