P ROFESSOR X AVIER P RESENTS ...

PROBLEM SET 2

T HIS PROBLEM SET IS DUE ON MONDAY, O CTOBER 7 TH DURING THE LECTURE . Y OU MUST BRING A HARD COPY OF YOUR SOLUTIONS . N O ELECTRONIC SUBMISSIONS . N O LATE P ROBLEM S ETS . A BOVE ALL , H AVE F UN !!!!!

Problem 1.
Consider an economy with an aggregate wage bill of 200 billion dollars and an aggregate GDP of 400 billion. The aggregate GDP growth rate for this economy over the last 10 years was 8 percent (that is Y/ Y=0.08) and the growth rates of capital and labor were 5 percent (K/ K=0.05) and 5 percent (L/L=0.05) respectively. (a) What are the capital share () and the labor share (1 )? (b) What was the growth rate of A for this country? (c) Imagine now that aggregate GDP is the SAME, but the wage bill is 300 billion. What is the growth rate of productivity now if the growth rates of GDP, capital and labor are still .08, 0.05 and 0.05 respectively? Explain intuitively why your answer is or is not different from (b). (d) Repeat part (b) under the assumption that K/K=0.10. Explain intuitively why your answer is or is not different from (b).

Problem 2.
Consider the Solow-Swan growth model, with a savings rate, s, a depreciation rate, , and a population growth rate, n. The production function is given by Y = AK + BK 0.5 L0.5 where A and B are positive constants. Note that this production is a mixture of Romers AK model and the neoclassical Cobb-Douglas production function. (i) Does this production function exhibit constant returns to scale? Explain why. (ii) Does it exhibit diminishing returns to capital? Explain why. (iii) Express output per person, y = Y /L, as a function of capital per person, k = K/L. 1

 (iv) Write down an expression for y/k as a function of k and graph. (Hint: as k goes to innity, does the ratio y/k approach zero?) (v) Use the production function in per capita terms to write the fundamental equation of the Solow-Swan model. (vi) Suppose rst that sA < + n. Draw the savings curve and the depreciation curve. What number does the savings curve approach as k goes to zero? As k goes to innity, the savings curve approaches a number: what number is that? Is it zero? (vii) Under these parameters, will there be positive growth in the long run? (Remember that A and B are constants). Why? (viii) Imagine that we have two countries with the same parameters (same A, B, s, , and n). One of them is rich and the other is poor. Which one of the two will grow faster? Why? Will those two countries eventually catch up? (ix) Suppose now that sA > + n. Draw the savings and depreciation curves. Under these circumstances, will there be positive growth in the long run? Why? (x) If s = 0.4, A = 1, B = 2, = .18 and n = 0.02, the growth rate converges to some value as time goes to innity. What is this value?

Problem 3.
Discuss the following economic concepts: (A) Public Good (B) Non-Rival Good (C) Non-Excludable good. In your discussion, you may provide examples of each type of goods. Is technology a Rival or non-Rival good? Is it always non-excludable? Discuss the role of excludability as it relates to the incentives may have to develop new ideas.

Problem 4.
In class we argued that if people could accumulate human as well as physical capital, the production function would look like the AK production function. (a) If the production function is AK and the savings rate is constant at rate s, and the rates of depreciation and population growth are and n respectively, what would the growth rate of the economy be? (b) What would be the macroeconomic consequences of increasing the savings rate in this economy? (c) What would be the consequences of a decrease in fertility in this economy? (d) Would the consequences of decreasing fertility be UNAMBIGUOUSLY GOOD? (e) Can human capital grow without bounds? Explain why or why not (make sure you discuss the physical nature of human capital). (f) What is the growth rate of the economy (in the absence of technological progress) if human capital cannot grow without bounds?

Problem 5.
Assume that an economy has the production function Y = AK 1/3 L1/3 G1/3 , where K is physical capital, L is labor (which we assume to be equal to population), A is the level of technology, and G is the stock of public infrastructure (G stands for Government infrastructure). Does this production function exhibit constant returns to scale? Write down the production function in per capita terms (use the per capita notation: y = Y /L,k = K/L and g = G/L). Imagine that the economy is closed, that the saving rate is the constant fraction s and the depreciation rate is . Population growth is an exogenous constant number n. Write down the fundamental equation of Solow-Swan for the GROWTH RATE of capital stock per person, k , as a function of the parameters A, s, n, , the capital stock k , and the level of infrastructures per person, g . Consider the parameters A = 1, s = 0.2, = 0.09, n = 0.01. Imagine that the amount of infrastructures per person is constant at g = 8. Graph the savings line and depreciation line. Is there a steady state? Is it unique? What is the steady state capital stock per person, k , in this economy? Imagine that the economy is stuck at the steady state with no growth. Imagine that the World Bank gives aid to this country. We are going to analyze the consequences of this aid. Imagine that the aid takes the form of physical capital k (for example, machinery) and in particular, imagine that g remains constant at g = 8 but, after the aid, the economy has a stock of capital equal to k +1. How does the economy behave after this donation? Explain why. Imagine instead that aid takes the form of public infrastructures. In particular imagine that g increases from g = 8 to g = 27. How does the economy behave after this donation? Is your answer different from before? Imagine now that instead of aid, it is the government of the country that increases the stock of infrastructures per person. What happens to this economy in the short term and in the long term? Why do you think governments in developing countries do not continuously invest in infrastructures?

Economics W3213. Intermediate Macro

Problem Set 2 - Solutions

(1) Growth Accounting

(a) You should remember that (1 ) is the share of GDP that is used to pay to workers. Then, given that the wage bill, wL = 200 and GDP, Y = 400,

(1 ) (b) You have to use the Solow Residual equation,

= =

200 = 0.5 400 0.5

A A A A

= = =

Y K L (1 ) Y K L 0.08 0.5 0.05 0.5 0.05 0.03

So, total factor productivity, or technology experienced a rate of growth of 3%. (c) In this case, (1 ) = 0.75. Then, A = 0.08 0.25 0.05 0.75 0.05 = 0.03 A The intuition says that, given that both rival inputs, capital and labor, grow at the same rate, it does not matter which is the weight that we assign to them. For any weight, and since they grow at the same rate, (1 ) 0.05 + 0.05 = 0.05. Then, does not matter. (d) Now, A = 0.08 0.5 0.1 0.5 0.05 = 0.005 A Given that the rate of growth of GDP is still the same, we observe that one of the rival factors has grown faster than before. Then, this factor is explaining a bigger part of the growth of GDP, and therefore, productivity growth has been less important in this economy.

(2) Diminishing Returns

(Please, see attached) IMPORTANT CLARIFICATION The solutions that I attach now come from past years. I agree with them 99% of the times. In this case, there is something very important that I and the other TAs for the class do not agree with. So, I am going to write the proper solution here for part (b). When you have to show diminishing returns, the argument in the solutions is quite naive, and it is not very accurate. Even if in the Recitations we start using that in order to give you the intuition, you should remember that we have always used rst and second derivatives to solve for this. IN THE EXAM YOU SHOULD TAKE THE DERIVATIVES!!! Then, for this model, Y 1 = A + BK 1/2 L1/2 > 0 K 2 1 1 2Y 1 = BK 3/2 L1/2 = BK 3/2 L1/2 < 0 2 K 2 2 4 Therefore, we have diminishing returns to the marginal product of capital.

(A/A) = 0.1 - 0.20.1 - 0.80.1 = 0. In both cases capital and labor are growing at the same rate. Since the Cobb-Douglas function exhibits constant returns to scale, output must be growing at the same rate. Hence, no growth is attributed to changes in productivity.

2. I Can't Wait to be King

i. If we double both capital and labor, output also doubles: A(2K) + B(2K)1/2(2L)1/2 = 2AK + B21/2K1/221/2L1/2 = 2(AK + BK1/2L1/2) = 2Y. Hence, this production function exhibits constant returns to scale (CRS). ii. If we double only capital without doubling labor, output will less than double: A(2K) + B(2K)1/2L1/2 = 2AK + 21/2BK1/2L1/2 < 2(AK + BK1/2L1/2) = 2Y, because 21/2 = 1.41... . iii. Substitute an expression for total output Y into the defintion of output per person y = Y/L:

iv. Divide the expression for y from the previous section by k:

When k becomes bigger and bigger, i.e. when k goes to infinity, the square root of k also becomes bigger and bigger. The constant B divided by a bigger and bigger number approaches 0. Hence, the expression for y/k approaches A. We say that the limit of y/k as k goes to infinity is A:

v. Substitute an expression for y/k into the Solow-Swan fundamental equation, i.e. into the expression for the growth rate of capital per person:

vi. As k goes to 0, the savings curve sy/k approaches infinity as usual because the constant B is divided by a smaller and smaller number:

As k goes to infinity, sy/k approaches sA because y/k approaches A and gets multiplied by a constant s:

Since sA < + n by assumption, the savings curve and the depreciation and population growth line ( + n) must cross once and only once.

vii. Growth stops in the long run because the savings curve and the depreciation and population

growth line intersect once and only once at the steady state level of capital per person k*. viii. The poor country will grow faster than the rich one, as seen in the diagram above, assuming that sA < + n. Because of diminishing returns to capital savings will be just enough to compensate for depreciation and population growth in the long run. The model predicts conditional convergence because if a poor country grows faster than a rich one with the same parameters, eventually they will converge to the same steady state. ix. If sA > + n, the savings curve is always above the depreciation and population growth line as shown below. Therefore, growth in the long run is positive. Although there are still diminishing returns to capital and hence the savings curve is downward-sloping, depreciation and population growth are low enough to permit long-run growth.

x. We know that the savings curve converges to sA in the long run. Therefore, the growth rate k/k converges to sA - ( + n) in the long run. Substituting numerical values, we get k/k = sA - ( + n) = 0.41 - (0.18 + 0.02) = 0.4 - 0.2 = 0.2. Growth rate converges to 20 percent per year in the long run.

3. Hakuna Matata
A. A public good is both non-rival and non-excludable. (For definitions see parts (B) and (C) below.) Examples of public goods and services are national defense, lighthouses, and basic mathematical formulas. B. A non-rival good is a good that can be used by more than one person at the same time without reducing each other's utility. Examples of non-rival goods are cable TV, computer software, and mathematical formulas. C. A good is non-excludable if one party cannot prevent other parties from using it. Examples of non-excludable goods are fish in the sea, national parks, and basic mathematical formulas. Notice that at least four different combinations are possible. Goods can be rival and excludable (most everyday goods such as cookies, housing, computer hardware, etc.), rival and nonexcludable (fish in the sea, which is usually subject to "the Tragedy of the Commons"), non-rival

and excludable (cable TV), or non-rival and non-excludable (basic science, which is called a public good). It is also possible to come up with examples in between these categories. For example, computer software is non-rival, but its excludability depends on copyright law enforcement. Similarly, books are rival but may or may not be excludable. Some non-excludable goods, such as toll-free roads, are subject to congestion and are therefore somewhat rival. Technology is a non-rival good, but it may or may not be excludable. For instance, in the majority of developed countries a system of patents and intellectual property rights (IPR) gives the inventor of an idea exclusive right to produce the commodity for a certain number of years or to collect royalties from those who produce it. Thus technology is excludable in these countries, at least for the number of years specified in the patent. It gives inventors and firms sufficient incentives to invest in research and development (R&D) and develop new ideas. But technology may nonexcludable, for instance, when countries don't respect patents officially. An example that we saw in class was the decision of South Africa not to recognize patents for AIDS antiretroviral drugs and to allow production of their generic versions. Thus pharmaceutical companies that invented the drugs would not be able to receive any return on their investment in R&D from sales in South Africa. This creates a disincentive for them to develop similar drugs for diseases, such as malaria, that are primarily prevalent in poor countries. Other countries may have the legal framework mostly in place but lack resources or political will for law enforcement. An example is software pirating in the former Soviet Union and many other countries.

Problem 4.
a) Given that we have an AK production function, Y = AK . In per capita terms, it can be written as y = Ak . Then, the fundamental equation, which provides us with the rate of growth of capital per capita, k = sA (n + ) If sA > n + , then this economy will experience positive growth forever If sA < n + , then this economy will experience negative growth forever b) An increase in s will increase the rate of growth if sA > n + or make it less negative if sA < n + c) Remember that n = f ertility mortality + netmigration. Then, if the fertility rate goes down, n will decrease, and we have the same consequences as in part b). d) Too much of a decrease in n means that in the long run there could be shortage of labor force to the economy, holding mortality and net migration constant. At worst, negative population growth rate by way of decreasing fertility rate leads to 0 population and the country disappears and so, it cannot be unambigously good. e) Human capital has a number of characteristics: First, everybody is born with zero human capital or skill. Second, unlike physical capital skills cannot be transmitted from parents to children (when a parent dies, the BMW stays with his children. His skills as a doctor die with him). Third, human capital accumulation requires time (especially, student time). And nally, lifetimes are nite so there is a nite amount of time within which skills need to be. This means that there is a limited amount of skills that people in the economy can acquire with a constant technology and within a lifetime. Once that point is reached, human capital must remain constant at that maximum level. Then, it cannot grow without bounds. Remember that we can get the AK production function from Y = AK H (1) where H = hL. We obtain the AK production function assuming that K and H grow at the same rate, since people want to equate the returns of physical capital to the returns of human capital (if not, there are investment opportunities in one of the types of capital). However, once H reaches its bound, and it cannot grow more, the production function becomes, (1) Y = AK H 1

 is xed. In per capita terms, where H (1) y = Ak h (1) which is constant, to get = Ah Call A y = Ak which is a Cobb-Douglas production function in per capita terms. Then, we go back to the normal Solow Model, so that in the long run the rate of growth is 0, because we have again diminishing marginal product to capital.

Problem 5.
a) Yes. A(K )1/3 (L)1/3 (G)1/3 = AK 1/3 L1/3 G1/3 = Y b) 1/3 1/3 y=Y g L = Ak c) k y = s (n + ) = sAk 2/3 g 1/3 (n + ) k k d) (The graph is the standard one). Yes, there exists one steady state and it is unique. The reason is that we have diminishing returns to capital. This will imply that for a given level of public infrastructures, the average product of capital will decreasing, so that the savings curve will be decreasing too. The limits of the savings curve are innity and zero, so that there will be for sure one cross point, and since the savings curve is always decreasing, that steady state is unique. e) Plug the numbers, 0.2k 2/3 81/3 0.1 0.4k
2/3

= = = =

0 0.1 4 43/2 = 8

2/3

f) In this case, the curves will not shift. However, with k + 1 units of capital, the depreciation line will be higher than the savings curve. On average, more machines are breaking than the new machines that the country buys. Thus, the country will experience a negative growth rate. (Graph!!) g)

This will shift the savings curve to the right. Suddenly, the savings curve is higher than the depreciation line at the steady state, and the country experiences positive growth in capital per capita. In the long run, the growth rate will be zero, but the steady state will be bigger than before the change. h) The eect is the same as in part g). The problem is that developing countries usually dont have the resources to build public infrastructures. They will also need to tax the citizens, which will also distort the economy (and also, in developing countries, people can barely save, so a tax increase might reduce consumption a lot)