Judith Thornton

Measuring Economic Performance

What are the goals of economic systems? How do we measure performance? Social scientists use a variety of aggregate and disaggregate measures of economic performance to assess how well a society fosters the economic welfare of its citizens. If you wished to compare the performance of the U.S. with another country, such as China, what would you consider important indicators of success and how would you measure them? Some criteria on most lists would include: a) level of economic welfare, b) economic growth, c) poverty or inequality, d) social indicators, such as health, infant mortality, and education, e) economic and political freedom, f) freedom from violence. How would we measure each of these criteria? What other criteria do you consider important? Level of Economic Performance One measure of economic performance is output per capita. We measure the economys output by the Gross National Product, the market value of the sum of all the goods and services produced in the economy:
i i GNP = p t qt

What is the economic logic for assigning a weight to each good equal to its market price? In a competitive market, the price of a commodity equals both the marginal cost to the producer of producing the good and the marginal benefit to the consumer of consuming an additional unit of the good. Consumers signal their demand for commodities with their dollar votes, which, of course, depend on consumer income. Producers expand the supply of profitable goods and reduce the supply of unprofitable ones. What about the value of pure drinking water that flows from a mountain stream? Pure water is a scarce and valuable resource that has competing uses, but if no one has the right to restrict access to its use, then it will be treated as a common property resource and depleted. The role of restricting overuse of a common resource may be assigned to direct government regulation, using taxes, use charges, or regulation of access. Another set of goods, called public goods, lack rivalry. Your viewing of a TV show does not exclude anyone else from viewing the same show. The social demand for a public good differs from the private demand. The social marginal benefit of a private good will equal the marginal benefit of the individual. But the social marginal benefit of a public good equals the sum of the marginal benefits of all the individuals who consume the good. (The social demand curve is the vertical sum of individual demand curves.) What determines the supply of public goods? Economists can estimate the cost, but it is harder to estimate the benefit. Until we know something about the incentives facing decision makers in the public sector, we dont know how government will choose the level and mix of public goods to provide. Output per capita is an imperfect measure of consumption. For example, in the former Soviet Union, only 47 percent of GNP went to private consumption.1 The state divided the balance between public consumption, military spending, and investment. As the share of military spending grew to exceed 15 percent of GNP, civilian national income accounted for the difference, and, as 1
/opt/scribd/conversion/tmp/scratch6266/62060630.doc 7/2/2011

Judith Thornton

the productivity of investment declined during the 1970s and 1980s, the future consumption expected from each ruble of investment fell. Moreover, the aggregation of consumption or output across countries with different currencies varies by methodology. Exchange rate measures of relative national income are volatile, reflecting short-run changes in macroeconomic indicators and capital markets. The World Bank uses the Atlas method, which takes a three-year average of exchange rates, to smooth this volatility. It also compares income using purchasing power parity (PPP), converting output at indices measuring the cost of a fixed basket of goods. These measures yield very different results. Further, since the structure of production and consumption varies greatly from country to country, our measures of performance will depend on the relative weights assigned to different sectors of the economy. We discuss this index number problem below. Economic Growth In a country with low per capita income, achieving rapid economic growth is a top priority. If per capita output is rising, then, on average, the economic well being of children will be higher than the well being of their parents. A key question for economists is what determines the growth of output. We describe the production of output by a production function, an equation specifying how stocks of productive resourcesland, labor, capital goods, raw materials, and technology produce a flow of output. In order for this flow of output to increase over time, the quantity or quality (productivity) of some inputs must increase. Growth of output per capita, then, requires that the quantities of physical and human capital and/or the technology embodied in some of the inputs be growing more rapidly than labor force. Without the gains from technological change, we might expect the marginal product of capital to fall as the ratio of capital to labor becomes larger. At some point, further additions to saving and investment would produce little additional consumption in the future. Our investigation of why some countries are rich and others are poor begins with the production function. As always, the economists measures of growth of outputs and inputs are imprecise, reflecting both the weights we give to components in the index and our ability to capture underlying changes in the quality or productivity of outputs and inputs. As per capita incomes rise, the mix of goods consumed by households changes. Household demand for goods reflects both substitution effectsthe response of individuals to changes in the relative prices of goodsand income effectsthe response to increased income. Empirical studies of growth show that increases in the relative quantities of goods consumed tend to move inversely to relative prices, as the theory of demand predicts. Consumers tend to shift their consumption mix toward goods whose relative costs are falling. For example, as the costs of manufactured goods, such as motor bikes, electronics, or computers, fall relative to other products, consumers will shift their consumption toward these products. This process of substitution in consumption in response to changing relative prices means that measures of growth depend on the relative weights the components of consumption. A simple numerical example demonstrates this index number effect.

2
/opt/scribd/conversion/tmp/scratch6266/62060630.doc 7/2/2011

Judith Thornton

3
P0 $5 $15 Q0 40 10 P1 $5 $5 Q1 50 60

Pizza CDs

Suppose that the consumption of food and manufactures (pizza and CDs) in Shanistan were 40 units of pizza and 10 CDs when the relative prices were $5 and $15. In prices of the base year, the value of consumption is: 1 2 = P01Q0 + P02Q0 = 5(40) + 15(10) = 350 At the prices of the given year, the quantities of both goods consumed have increased, but prices have changed as well, so the current price value of output reflects changes in both the prices and quantities of output. To estimate change in quantity alone, we ask: What is the relative change in the output of Shanistan, if we weight the importance of each good by the relative prices of a single year? Weighting the production of each good by its relative price in the base year, we attempt to measure the increase in societys production possibilities and level of utility on the assumption that relative prices and costs remained unchanged at base year values. This calculation is called a Laspeyres quantity index:

P Q L= P Q
i 0 i 0

i 1 i 0

5(50) + 15(60) 1150 = = 3.29 5(40) + 15(10) 350

Giving CDs a high relative weight yields an estimate that output has more than tripled. However, the increased demand for CDs was a response to a fall in their relative price. Had we measured the relative importance of our sectors by their relative prices in the second year, our index of change would have been smaller. Using the price weights of the second year, results in a Paasche quantity index: P=

P Q P Q
i 1 i 1

i 1 i 0

5(50) + 5(60) 550 = = 2.50 5(40) + 5(10) 250

Giving CDs a relatively smaller weight estimates that output more than doubled. The difference in estimates is shown on the diagram, below, with pizza on the x-axis and CDs on the y-axis. The flat budget lines with a slope of (1/3) represent the outward shift of the money value of given year consumption at the prices of the first year. The steeper budget constraints measure the change in the money value of output at second year prices. Assuming that the relative prices of each year reflect both the ratio of marginal utilities of consumers and the marginal costs of producers in that year, then the observed data implies that societys production-possibilities in the production of manufactures have increased relatively more than the production-possibilities for food. (This change in relative prices is inconsistent with a parallel expansion of the capacity to produce both goods.) Thus, if a policy maker asked the economist, What is the true growth of output? The economist might ask, Are you interested in production possibilities or social welfare? How shall 3
/opt/scribd/conversion/tmp/scratch6266/62060630.doc 7/2/2011

Judith Thornton

we weight the components of output? What are the difficulties in estimating change in the quality of products?
120

100

80 Q of CDs

60

40

20

0 0 20 40 60 Q of Pizza 80 100 120

Poverty and Inequality A primary goal of economic growth is a reduction in the absolute amount of poverty in an economy. However, if the process of economic growth is associated with increasing inequality of income, improvement in average welfare might be associated with little or no improvement in the well being of low income individuals. The World Development Report of the World Bank provides measures of both absolute poverty and income inequality. Absolute poverty is measured by the percentage of the population living below some benchmark, such as $1 per day or $2 per day, using purchasing power parity (PPP) as the benchmark. For example, in 2000, Russia is estimated to have 2% of its people living at less than $1 per day and 10.9% living at less than $2 per day, while the corresponding numbers for China in 2000 were 22.2% below $1 and 57.8% below $2 per day. Societies develop social insurance mechanisms to reduce the number of people living in poverty, usually by taxing people with higher incomes to provide a social safety net. However, even in a country with a strong social safety net, inequality may result in unequal opportunities. Which is more important income inequality or wealth inequality? Wealth inequality and income inequality are correlated, but wealth has a greater impact on childrens opportunities. In 4
/opt/scribd/conversion/tmp/scratch6266/62060630.doc 7/2/2011

Judith Thornton

developing countries with weak property rights and weak financial markets, it is often difficult for households to invest and accumulate secure claims to wealth. How do we measure income inequality? We often use the Lorenz curve to describe inequality of income. A Lorenz curve maps the distribution of population by income. If we order the population from lowest income to highest, putting share of the population on the x-axis and share of the income received on the y-axis, then the deviation of the curve from perfect equality (a straight 45 degree line) shows the degree of inequality of income. A Gini coefficient, which is the ratio between the area enclosed by the 45degree line of equality and the Lorenz curve, and the total triangular area under the line of equality, summarizes our measure of inequality. For example, Russias Gini coefficient in 1996 was 48, Chinas was 41.5, and the US was 40.1, a lower ratio implying greater equality.2 To calculate a Gini coefficient, turn to data on the shares of income received by income groups in a population, available at the World Bank, http://iresearch.worldbank.org/PovcalNet/povcalSvy.html. For example, consider a population, such as Chinese rural households in 2005. Order population by income decile, record the share of income received by each population group, and then sum up the cumulative distributions of population and income, below. The Gini index for rural China in 2005 was 35.85, slightly larger than for the urban population, with a Gini of 34.8. Although Chinas inequality has increased in the past decades, it is lower than a sample of countries in the following diagram. Gini coefficients in the next table are: US, 46.6; Nigeria, 42.93; and Russian Federation, 37.51. Coefficients for some advanced industrial countries are: Japan, 24.9; Sweden, 25.0; France, 32.7; UK, 36.0.
Share of income China rural 3.11 4.28 5.22 6.2 7.25 8.47 9.95 11.89 15 28.63 Cumulative income share China rural 0 3.11 7.39 12.61 18.81 26.06 34.53 44.48 56.37 71.37 100

Distribution decile (percentile) 0-10 10 to 20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100

5
/opt/scribd/conversion/tmp/scratch6266/62060630.doc 7/2/2011

Judith Thornton

120
Lorenz curves 2005
Percent of income/cons 120 100 80 60 40 20 0 0 5 Cumulative share China rural Equality Line Cumulative share Nigeria

Percent of population

100
10

Cumulative share Russ Federation Cumulative share US

15

me/cons

We can also track changes in income over time. For example, looking at changes in the shares of income in the top and bottom quintiles in China, we can observe the growing inequality. Between 1978 and 1998, Sala-i-Martin (2002) shows that the income share of the bottom quintile fell steadily, while the share of the top quintile rose.

80

/opt/scribd/conversion/tmp/scratch6266/62060630.doc 7/2/2011

Judith Thornton

Sala-i-Martin shows that world median income rose between 1970 and 1998, with the share of world population living below an absolute poverty threshold falling.

Economist have explored empirically whether inequality appears to be systematically related to economic growth. One difficult issue is that causation might go either way or that inequality and 7
/opt/scribd/conversion/tmp/scratch6266/62060630.doc 7/2/2011

Judith Thornton

growth might both be affected by other exogenous forces. For example, an authoritarian government run for the benefit of elites might generate both high inequality and low growth. Empirically, measurement error, endogeneity, and omitted variables make it difficult to draw any firm conclusions. What are the effects of inequality? Societies signal that they consider inequality bad. They seek to reduce poverty and inequality through their social insurance program. In addition to concern for others, inequality might weaken social institutions, lead to social conflict, and restrict access of talented people to productive skills. Whether in a democracy or a dictatorship, it matters what groups hold a majority of political power. To investigate relationships between inequality and growth, economists need to build in some assumptions about political processes. David Dollar, the World Banks director of Development Policy shows that, while rising per capita income was often associated with an increase in inequality, growth, nevertheless, reduced the share of a countrys population living below the poverty line. For example, he estimates that in China the number of rural poor fell from 250 million in 1978 to 34 million in 1999. Social Indicators Indicators of quality of life and health do not vary on a one-to-one basis with income, but higher income is an important determinant of many social indicators, such as infant mortality, life expectancy at birth, and education. The table, below, graphs under-5 mortality against per capita income for a sample of 21 formerly socialist economies. Data for Japan (GNP per capita of $25550 and Under-5 mortality of 6 per 1000) were included to represent a high-income economy at the top tail of the distribution. Controlling for differences in per capita income, states with higher measures of governance (property rights, rule of law, and quality of bureaucratic performance) tend to spend a larger share of their government budgets on social investment, which spending is correlated with improved social indicators. While observers may differ in their evaluations of the relative performance of different economies, the gap between the per capita income of an industrial economy, such as Denmark, at $28490, and a developing country, such as resource-rich Nigeria, at $790, leaves much to be explained. No wonder that the question, Why are some countries rich and others poor? remains as important today as it was in the time of Adam Smith.

8
/opt/scribd/conversion/tmp/scratch6266/62060630.doc 7/2/2011

Judith Thornton

160 140 120 100 80 60 40 20 0 0 5000 10000 15000 GNP Per Capita 2001 y = 15468x-0.7615 R 2 = 0.6875 20000 25000 30000

Economic and Political Institutions In the measurement of economic growth, economists often estimate a production function in which the level of output is explained by the stocks of productive resources. These resources include the quantity and quality of physical capital stocks, human capital, land and natural resources and the underlying technology and productivity of these resources. Early research on economic development focused on the accumulation of productive resources. If households would only save and invest, then they could be more productive and improve their welfare, policy-makers argued. However, economists recognized that, at a fundamental level, household decisions to invest and educate their children were determined by underlying social institutions providing people with security of person and property. Thus, modern development theory seeks to understand how institutions promote investment, technical advance, and risking productivity. One of the key lessons of the Twentieth Century is the importance of economic institutions to the promotion of capital formation and growth. The collection of systematic data across a wide variety of countries shows the close relationships between institutions and levels of per capita output.3 Disaggregating individual institutions shows that property rights, rule of law, type of political regime, and governmental accountability (freedom from corruption) all are systematically related to per capita output4 Yet, if many dimensions of social capital are also endogenously determined by rising income, then the puzzle remains: How can a society break out of a poverty trap? 9
/opt/scribd/conversion/tmp/scratch6266/62060630.doc 7/2/2011

Under-5 Mortality

Judith Thornton

10

Property rights are a key institution underpinning economic growth. Economic growth requires capital formation, but people will not invest when they expect the government to confiscate their assets. The incentive to create property rights becomes larger as the potential value of wealth increases. However, Acemoglu, Johnson and Robinson (2001) use a sophisticated econometric instrument to show that security of property rights is an exogenous determinant of long run economic growth.5 Moreover, Dollar and Kraay (2002) show that security of property rights raises the incomes of rich and poor equally.6 Political democracy seems to affect income and growth indirectly by making government policies more responsive to the concerns of the citizens. Governments that are not subject to the influence of their citizens might be less likely to pursue growth-promoting policies. Blanchard and Schleifer (2000) argue that government decision-makers with a short-run time horizon will attempt to extract rents from the economy, while governments with a longer time horizon can improve their well being by taxing less in the short-run and benefiting from higher long-run growth of output.7 Barzels Theory of the State argues that government incentives to profit from growth contributed to the growth-supporting institutions of the industrial revolution.8 Conflict and Violence In Prelude to Political Economy, Kaushik Basu describes a trip on the Grand Trunk Road in India in which her car and driver were stopped at a road-block manned by young men with iron bars and swords. In order to pass, drivers had to pay the hoodlums a rangdari tax, under threat of violence.9 Similarly, in a lecture at the University of Washington in 2002, Deputy Prime Minister of the Russian Federation, Boris Nemtsov, recounted his experience driving to a meeting 300 km outside of Moscow. During the course of the trip, he claims, his driver was stopped nine times by traffic police seeking a bribe. Security of person and property is a vital function provided by government. Insecurity may result from a government that fails to provide protection or from a corrupt government whose authorities use state authority to hold up citizens. In either case, its lack has devastating effects on society. Civil war is an extreme case in the breakdown of order. Collier and Hoeffler estimate that the average incident of Civil War lasts seven years, leaves the economy 15% smaller than pre-war, and imposes a total income loss equal to 105% of initial national income on the society.10 Civil War also takes the lives of combatants and civilians through warfare, starvation, and disease. It destroys capital and infrastructure, leaves citizens disabled, and re-directs subsequent government spending away from social goals and toward military spending. When do civil wars occur? Both ethnic division and a high share of national income originating in natural resources, such as oil and diamonds, increase the probability of civil war. In contrast, government policies increasing the transparency of public management of resource wealth reduce the risk of violent conflict as a means of capturing resource rents. Countries differ enormously in their economic performance. Clearly, the sources of differing performance and the role of governance and misgovernance in accounting for these differences is a vital question to explore.

10
/opt/scribd/conversion/tmp/scratch6266/62060630.doc 7/2/2011

1
2

World Bank. Statistical Handbook; States of the Former USSR. 1992, 310.
y

The Lorenz curve is used in economics to describe inequality in income or wealth. The Lorenz curve is a function of the cumulative proportion of ordered individuals mapped onto the corresponding cumulative proportion of their size. Given a sample of n ordered individuals, x ' , then the sample Lorenz curve can be expressed as L( y ) =
i 0

xdF ( x )

where F(y) is the cumulative distribution

function of ordered individuals and x is the average value. If all individuals have the same income, the Lorenz curve is a straight diagonal line, called the line of equality. If there is any inequality in size, then the Lorenz curve falls below the line of equality. The total amount of inequality can be summarized by the Gini coefficient, which is the ratio between the area enclosed by the line of equality and the Lorenz curve, and the total triangular area under the line of equality. The Gini coefficient is most easily calculated from unordered size data as the "relative mean difference," i.e., the mean of the difference between every possible pair of individuals, divided by the mean size, .

G=
n i =1

n j =1 2

xi x j

2n

Alternatively, if the data is ordered by increasing size of individuals, G is given by:

The Gini coefficient ranges from a minimum value of zero, when all individuals are equal, to a theoretical maximum of one in an infinite population in which every individual except one has n income of zero. (Christian Darngaard at <http://mathworld.wolfram.com/LorenzCurve.html> (Dixon et al. 1988, Damgaard and Weiner 2000)).
3

Hall, Robert and Charles I. Jones (1999). Why Do Some Countries Produce So Much More Output than Others? Quarterly Journal of Economics 114:1, 83-116. 4 Knack, Stephen and Philip Keefer (1995). Institutions and Economic Performance: Cross-Country Tests Using Alternative Institutional Measures. Economics and Politics 7:3, 207-228. 5 Acemoglu, Daron, Simon Johnson and James Robinson (2001). The Colonial Origins of Comparative Development: An Empirical Investigation. American Economic Review 91, 1369-1401. 6 Dollar, David and Aart Kraay (2002). Growth is Good for the Poor. Journal of Economic Growth 7(3): 193-225.
7

Blanchard, Olivier and Andrei Schleifer (2000). Federalism With and Without Political Centralization: China versus Russia. NBER Working Paper 2000-15. 8 Barzel, Yoram (2003). A Theory of the State: Economic Rights, Legal Rights, and the Scope of the State. Cambridge: Cambridge University Press. 9 Basu, Kaushik (2000). Prelude to Political Economy. Oxford: Oxford University Press, 3. 10 Collier, Paul and Anke Hoeffler, The Challenge of Reducing the Global Incidence of Civil War, (2004). The Copenhagen

Consensus. <http://www.copenhagenconsensus.com>j