A FRAMEWORK FOR ANALYSIS Chapter 2

Explaining why some countries are rich and some are poor will require us to weigh the
importance of many different factors.
Imagine that you want to discover why is the Monarchy of Sylvania so much poorer
than its neighbor, the Republic of Freedonia?
You carefully measure the value of all the goods and services produced in each
country (i.e., gross domestic product [GDP]).
You find that GDP in Freedonia is eight times as large as GDP in Sylvania.
A quick check of the two countries censuses shows that they have almost exactly the
same population, so you conclude that the important differences between them must
be on a per-capita
basis: Freedonias level of GDP per capita is eight times that of Sylvania.
Now that the dimensions of the problem are clear, you look for explanations.
In both countries, goods and services are produced using two inputs.
One of these inputs is the labor of workers.
The other is the tools that the workers have at their disposal: machines, vehicles,
buildings, and other pieces of equipment that are collectively called capital.
You notice that, on average, each worker in Freedonia has much more capital to work
with than his
or her counterpart in Sylvania. Further, in both countries, the more capital that a
worker has to work with, the more output the worker produces.
These observations suggest that differences in the capital available to each worker
could explain the difference in income between Freedonia and Sylvania.
But what is the source of this difference in capital per worker?
Investmentthat is, the goods and services devoted to the production of new capital
rather than consumed. In Freedonia is much higher than in Sylvania. Indeed, your staff
calculates that each
year Freedonia invests 32 times as much as Sylvania.
Using basic economics, you know that the investment in new capital taking place in
each country must represent saving by the citizens in that country.
The fact that Freedonia saves more than Sylvania is really not such a mystery,
because Freedonia is, after all, a much wealthier country.
But looking at the numbers, you see that Freedonia saves a higher fraction of its
income than does Sylvania: Its investment is 32 times as high, whereas its income is
only eight times as high.
Therefore, its investment rate (the fraction of its income that it invests) must be four
times as high.
You evaluate this theory: Sylvania saves (and invests) a lower fraction of its income
than does its
neighbor. Because its investment rate is lower, its capital per worker is lower, and so is
its total income.
But the difference in investment can explain some, but not all, of the difference in
income between the two countries.

This residual difference is not a result of how much capital each country has but rather
the productivitythat is, the amount of output produced with each unit of capital.
Clearly, productivity is important. But what determines productivity? perhaps the
reason a given amount of capital per worker in Sylvania produces so much less than in
Freedonia is that Sylvania is backward in its technologythe available knowledge
about how inputs can be combined to produce output. technological progress should
enable a country to produce more output
with the same amount of inputs.
So, of the difference in productivity of a factor of four, half (a factor of two) is the
result of technology. What about the rest?
In addition to having more capital and better technology, Freedonia simply seems to
have its act together. People work harder at their jobs, the quality of their products is
higher, and less time is wasted than in Sylvania. Even comparing factories that use the
same amount of capital per worker
and the same technology, those in Freedonia produce more output. We call this
slippery but nonetheless significant attribute efficiency: how the available technology
and inputs into production are actually used in producing output. Differences in
productivity between the two countries that cannot be explained by differences in
technology can well be explained by efficiency.
You can do a simple decomposition of productivity into two pieces: Productivity is
equal to technology multiplied by efficiency. Because productivity differs between
Freedonia and Sylvania by a factor of four and technology differs by a factor of two,
efficiency must also differ by a factor of two.
You explain that Sylvanias relative poverty has three sources: a lower rate of
investment (leading to a lower quantity of capital), inferior technology, and lower
efficiency. Each of these problems contributes a factor of two to Sylvanias relative
poverty. If any one of these problems could be eliminated, Sylvania would be onefourth as rich as its neighbor; if two could be eliminated, it would be half as rich; and if
all three problems could be eliminated, Sylvania would be just as rich as Freedonia.
But we have not told the source of the problem.
What are the deeper, underlying factorsthe fundamentalsthat make Sylvania so
much poorer than Freedonia? Your previous research told you how these deeper
factors will be expressed:
in a lower saving rate, which leads to less capital accumulation; in a failure to develop
new technologies as quickly as other countries; and in inefficient use of the capital and
technologies that are available. But what are the factors themselves?
To get to the bottom of this question, you embark on a broad program of research,
measuring possible fundamentals in a large number of countries and seeing how they
correlate with saving, technology, and efficiency.
You sift through an array of possibilities.
Perhaps the countries have differences in culture (e.g., in thriftiness or in the effort
that people put into their work).
Perhaps the two countries economic policies (taxes, tariffs, and regulations) are the
explanation. Maybe differences in geography (natural resources, climate, or proximity
to world markets) are to blame for Sylvanias relative poverty.

Sorting out these possible fundamentals is a delicate business. Statistical analysis

shows that some factors do not explain differences in income among countries. There
is only one
measure in which the two countries differ that also turns out to be an important
explanation of income differences among countries.
The root cause of Sylvanias relative poverty, you write, is its form of government.
Compared to Freedonias democracy, the monarchy of Sylvania exacts a high price on
the countrys economic development.
Residents of Sylvania are a naturally thrifty people, but they are reluctant to save their
money and accumulate capital because at any time the king may expropriate their
wealth.
In Freedonia, by contrast, property is protected, and the citizens know they will be able
to enjoy the fruits of their thrift. In Freedonia clever inventors are paid well to create
new productive technologies, whereas Sylvanias equally talented scientists spend
their efforts creating new weapons for the kings wars.
Finally, in Sylvania the most reliable route to wealth and status is to win the kings
favor, and this is where the best efforts of the most capable men and women are
directed. In Freedonia, by contrast, the route to success is through concrete
accomplishmentdoing your job well. This explains why things run so much more
efficiently in Freedonia.
In practice
A countrys form of government (monarchy, democracy, or something else) is only one
of the fundamental determinants of income that we will consider in this book.
This example wanted to show how one can analyze and weigh the relative importance
of different factors that lead to differences in incomes among countries.
There are three key ideas from the parable that we will carry with us throughout the
book:
We can distinguish between two specific things that can make a country richer: the
accumulation of inputs into production versus the productivity with which those inputs
are used. In the example, the only input into production other than labor was capital,
but we will see that there are other inputs as well.
We can further break down differences in productivity among countries into two
components: differences in technology and differences in efficiency. Technology can be
discussed in terms of research and development, dissemination of knowledge, and
scientific advancement. Efficiency relates to the organization of the economy,
institutions, and so on.
We can learn much by looking beyond the immediate determinants of a countrys
income to examine what fundamental or deeper characteristics shape these. We can
think of the distinction as one between proximate and ultimate factors affecting
growth. (A proximate cause is an event that is immediately responsible for causing
some observed result. An ultimate cause is something
that affects an observed result through a chain of intermediate events.)
THE PRODUCTION FUNCTION
The parable of Freedonia and Sylvania introduced the idea that countries can differ in
their income per capita for two reasons: because they differ in their accumulation of

inputs used in producing output or because they differ in the productivity with which
those inputs are used.
In the parable, there was only one input to production other than labor: capital. As we
will see in Part II, capital is just one of several inputs into production that a country can
accumulate. Collectively, these inputs are referred to as factors of production.
We use a production function to express the relationship between factors of production
and the quantity of output produced. In microeconomics, a production function is a
mathematical description of how the inputs a firm uses are transformed into its output.
We will use the same idea here, although now the output we will consider is the output
of an entire country.
The horizontal axis is labeled Factors of production per worker (considering any
particular factor of production or all of them taken together).
The vertical axis measures Output per worker.
The production function slopes upward, illustrating that a country with more factors of
production is able to produce more output.
The production function also becomes flatter as the quantity of factors of production
per worker increases (reasons explained in Chapter 3).
FROM INCOME LEVELS TO GROWTH RATES
The parable of Freedonia and Sylvania was about differences between countries levels
of income. But as we saw in Chapter 1, many of the interesting facts in the data are
about differences in growth rates among countries.
How can we use the framework introduced in the parable to examine variations in the
rate of economic growth?
After a Sylvanian monarchy deposition, we would not really expect the Sylvanian
economy to catch up right away. The gradual adjustment of levels of income can be
the basis for a story about growth rates. Because nothing has changed in Freedonia, it
will continue to grow at the same rate as it did before the revolution in Sylvania. But
Sylvanias catching up will be reflected in faster growth of income. Indeed, Sylvania
will continue to grow faster than Freedonia until it has caught up.
Over time, as it remains a democracy, the damage done by that past bad policy
(monarchy) fades away. And this fading away takes the form of rapid growth.
Generalizing from this example, we can easily turn our model of the determinants of
income levels into a model of the determinants of income growth.
Specifically, if two countries are the same in their fundamentals (or, more generally, if
we would expect them to have equal levels of income based on their fundamentals),
we can expect the country with a lower level of income to grow faster.
This analysis makes it clear why discussions of policies to affect economic growth can
often be confusing. For example to grow the economy one potential target could be a
low saving rate. An increase in saving would raise the growth rate of output in the
years immediately after it takes place, but eventually the growth rate would return to
its baseline level (i.e., the level in the absence of an increase in saving). However,
even though growth would be the same in the long run, the level of output would be
higher than it would have been had saving not increased.
WHAT CAN WE LEARN FROM DATA?
Economic theories are often stated in the form of economic models, which are
simplified representations of reality that can be used to analyze how economic
variables are determined, how

a change in one variable will affect others, and so on.

One use of data is in testing economic theory. By comparing a theorys predictions
with what the data show, we can assess the accuracy of the theory.
Economists also use data in assigning magnitudes to the different parts of an
economic model. This method is called quantitative analysis. Without this sort of
quantitative analysis, theory is often
useless.
For these reasons, economists are voracious consumers of data. But economists are
also aware of many of the difficulties in using data to learn the things they want to
know.
One problem is that economists never have enough good data. Many of the things
economists would like to know about are not measured. For example, many economic
theories are based on the idea of maximizing happiness, or utility, as it is called in
economists jargon. But an individuals happiness cannot be observed directly. In other
cases, the things we want to know about are measured only inaccurately.
Another problem is that the data economists have at their disposal are almost always
observational, in contrast to experimental. That is, economists can observe the world
around them but usually cannot do controlled experiments in the way that biologists,
chemists, and physicists can. This often makes it difficult for economists to figure out
what is causing what.
SCATTER PLOTS AND CORRELATIONS
Economists often examine data by using a scatter plot. In a scatter plot, each
observation (e.g., each country) is represented by a single point. One variable (i.e., a
characteristic of the observation that we are examining) is measured along the
horizontal axis, and one variable is measured along the vertical axis. A scatter plot
allows us to see the overall relationship between two variables, as well as which
observations are consistent with that overall relationship and which fall outside the
usual relationship. The observations that are inconsistent are called outliers.
One of our fundamental tools will be to look at the correlation between variables.
Correlation describes the degree to which two variables tend to move together.
Two variables are positively correlated if high values of one tend to be associated with
high values of the other.
They are negatively correlated if high values of one variable tend to be associated with
low values of the other. For example, the number of hours that a student studies per
week is positively correlated with his or her grade point average.
The degree of correlation between two variables is measured by the correlation
coefficient, which is a number between 1 and 1. A correlation coefficient of 1
indicates perfect positive correlation; a correlation coefficient of 1 indicates perfect
negative correlation. A value of 0 indicates that there is no tendency for the two
quantities to vary together.
Examining the correlation between two variables is often a useful starting point for
thinking about how they are related. But correlations have to be interpreted with care.
Consider a positive correlation between two variables, X and Y.
There are three possible explanations (which are not mutually exclusive) for the
correlation that we observe in the data:

1. X causes Y. Variable X affects variable Y, so that if it were possible to change

variable X, variable Y would change as well. For example, in cities where it rains a lot
(X), people tend to own more umbrellas (Y).
2. Y causes X. One might think that X causes Y when in fact the opposite is true. This
situation is called reverse causation.
3. There is no direct causal relationship between X and Y, but some third
variable, Z, causes both X and Y. This third variable (Z) is known as an omitted
variable.
The difficulties in learning about causation from observational datasummarized in
the aphorism Correlation does not imply causationare formidable. Yet if causation
is what we are interested in learning about, correlation is often a good place to start
looking.
BOX Randomized Controlled Trials
There are several advantages to using RCTs. Most significantly, RCTs can solve the problem of
teasing out causation from correlation that is discussed in the text. Because who gets which
treatment is random, there is no danger that the treatment is correlated with omitted variables
or subject to reverse causation.
That means that if we observe groups that received different treatments having different
outcomes, we can be sure that the treatment has had a causal impact.
A second advantage of RCTs is that they allow for smallscale testing and refining of program
designs that, if successful, can later be scaled up to have a large-scale impact.
RCTs are at their most effective in comparing different policies, all of which in principle will
accomplish good things.
RCTs can also be used to probe the underlying determinants of economic behavior. Different
theories about why people behave in certain ways (e.g., what determines how many children
they have or how much money they save) imply that people will respond in different ways
when their environment changes.
Researchers can use RCTs to vary the environment people face in one dimension at a time to
test different theories.
Although RCTs are excellent tools for answering some questions that economists face, they are
far from a universal solution. One problem with RCTs is the issue of external validity, that is,
whether a treatment that works in one setting (e.g., a particular region) will work in other
places. A more serious problem is that there are sharp limits on the kinds of hypotheses that
can be tested using RCTs. Economic policies that affect an entire country, rather than just a
single family or village, are hard to assess using RCTs.
RCTs are also not informative when one is considering deep factors that affect the level of
development of the economy as a whole (i.e.,fundamentals in the language of this chapter).
BOX Learning from historical data
Much of the data in this book are crosssectional datathat is, observations of different units
(e.g., countries or people) at a single point in time. An alternative to using cross-sectional data
is to examine how economic variables change over time, either a period of decades or longer
expanses of history.
Historical data are particularly useful for thinking about why countries differ in their levels of
income today
because, as we saw in the last chapter, much of the variation in income today has its roots in
the last 200 years of economic growth.
One problem in interpreting historical data (as with any other data) is that when two things
happened at the same time, we do not know which event caused which, or even whether they
were causally related at all.
An additional problem with historical data is that, for many questions we are interested in,
history effectively provides only one data point.
Because history happened only once, it is hard to eliminate completely the effect of luck.
The bottom line is that, like any other data, history has to be interpreted with caution.