4.

2 A Model of Production
Chapter 4

A Model of
Production
By Charles I. Jones

Media Slides Created By

Vast oversimplifications of the real world

in a model can still allow it to provide
important insights.
Consider the following model
Single, closed economy
One consumption good

Dave Brown
Penn State University

4.1 Introduction
In this chapter, we learn:
How to set up and solve a macroeconomic model.
How a production function can help us understand
differences in per capita GDP across countries.
The relative importance of capital per person
versus total factor productivity in accounting for
these differences.
The relevance of returns to scale and
diminishing marginal products.
How to look at economic data through the lens of
a macroeconomic model.

A model:
Is a mathematical representation of a
hypothetical world that we use to study
economic phenomena.
Consists of equations and unknowns with real
world interpretations.

Setting Up the Model

A certain number of inputs are used in
the production of the good
Inputs
Labor (L)
Capital (K)

Production function
Shows how much output (Y) can be
produced given any number of inputs

Others variables with a bar are parameters.

Production function:

Macroeconomists:
Document facts.
Build a model to understand the facts.
Examine the model to see how effective it is.
Output

Productivity
parameter

Inputs

 The Cobb-Douglas production function is

the particular production function that
takes the form of

Assumed to be 1/3.
Explained later.

A production function exhibits constant

returns to scale if doubling each input
exactly doubles output.

Returns to Scale Comparison

Find the sum of
exponents on the inputs

In general for any production function.

Show what happens to the output if we
double the inputs:
If the output is exactly double
constant RS
If the output is less than double
decreasing RS
If the output is more than double
increasing RS

Allocating Resources

Result

sum to 1

the function has constant

returns to scale

sum to more than 1

the function has

increasing returns to
scale

sum to less than 1

Returns to Scale (RS)

the function has

decreasing returns to
scale

Standard replication argument

A firm can build an identical factory, hire
identical workers, double production stocks,
and can exactly double production.
Implies constant returns to scale.

Firm chooses inputs

to maximize profit

Rental rate
of capital

Wage rate

The rental rate and wage rate are taken as

given under perfect competition.
For simplicity, the price of the output is
normalized to one.

The marginal product of labor (MPL)

The additional output that is produced when
one unit of labor is added, holding all other
inputs constant.

The marginal product of capital (MPK)

The additional output that is produced when
one unit of capital is added, holding all other
inputs constant.

Solving the Model:

General Equilibrium
The solution is to use the following hiring
rules:
Hire capital until the MPK = r
Hire labor until MPL = w

If the production function has constant

returns to scale in capital and labor, it will
exhibit decreasing returns to scale in
capital alone.

The model has five endogenous

variables:
Output (Y)
the amount of capital (K)
the amount of labor (L)
the wage (w)
the rental price of capital (r)

The model has five equations:

The production function
The rule for hiring capital
The rule for hiring labor
Supply equals the demand for capital
Supply equals the demand for labor

The parameters in the model:

The productivity parameter
The exogenous supplies of capital and labor

 A solution to the model

A new set of equations that express the five
unknowns in terms of the parameters and
exogenous variables
Called an equilibrium

General equilibrium
Solution to the model when more than a
single market clears

In this model
The solution implies firms employ all the
supplied capital and labor in the economy.
The production function is evaluated with the
given supply of inputs.
The wage rate is the MPL evaluated at the
equilibrium values of Y, K, and L.
The rental rate is the MPK evaluated at the
equilibrium values of Y, K, and L.

Interpreting the Solution

If an economy is endowed with more
machines or people, it will produce
more.
The equilibrium wage is proportional to
output per worker.
Output per worker = (Y/L)

The equilibrium rental rate is

proportional to output per capital.
Output per capital = (Y/K)

Case Study: What Is the Stock Market?

Economic profit
Total payments from total revenues

Accounting profit
Total revenues minus payments to all
inputs other than capital.

The stock market value of a firm

Total value of its future and current
accounting profits
The stock market as a whole is the value of
the economys capital stock.

In the United States, empirical evidence

shows:
Two-thirds of production is paid to labor.
One-third of production is paid to capital.
The factor shares of the payments are equal
to the exponents on the inputs in the CobbDouglas function.

All income is paid to capital or labor.

Results in zero profit in the economy
This verifies the assumption of perfect
competition.
Also verifies that production equals spending
equals income.

4.3 Analyzing the Production

Model
Per capita = per person
Per worker = per member of the labor
force.
In this model, the two are equal.

We can perform a change of variables

to define output per capita (y) and
capital per person (k).

 Output per person equals the productivity

parameter times capital per person raised to
the one-third power.

Our model takes factors capital, K, and labor, L, as

inputs and returns output, Y
The special functional form that describes output so
well, the Cobb-Douglas production function, tells us that

In words: output per person, y, equals a productivity

constant, A, times capital per person, k, to the one-third
y will be higher if A or k is higher
But there are diminishing returns to scale in capital per
worker, k

Output per person

Productivity
parameter

A recap of last class:

Capital per person

Next, we will use this model to understand why

some countries are so much richer than others

What does the model say about per capita GDP?

Lets use lowercases to show variables per capita. Then our model
reveals that

Output per worker, y, is a function of productivity, A, and capital per

What makes a country rich or poor?

Output per person is higher if the
productivity parameter is higher or if the
amount of capital per person is higher.
What can you infer about the value of the
productivity parameter or the amount of
capital in poor countries?

worker, k = K/L

(But there are diminishing returns to capital per worker!)

Our model says countries are richer if A or k is higher

Part 2

Comparing Models with Data

The model is a simplification of reality,
so we must verify whether it models the
data correctly.
The best models:
Are insightful about how the world works
Predict accurately

The Empirical Fit of the Production Model

Development accounting:
The use of a model to explain differences
in incomes across countries.

Set productivity
parameter = 1

Diminishing returns to capital implies that:

Countries with low K will have a high MPK
Countries with a lot of K will have a low MPK,
and cannot raise GDP per capita by much
through more capital accumulation

If the productivity parameter is 1, the

model overpredicts GDP per capita.

Case Study: Why Doesnt Capital Flow

from Rich to Poor Countries?

If MPK is higher in poor countries with

low K, why doesnt capital flow to those
countries?
Short Answer: Simple production model
with no difference in productivity across
countries is misguided.
We must also consider the productivity
parameter.

Productivity Differences: Improving

the Fit of the Model
The productivity parameter measures
how efficiently countries are using their
factor inputs.
Often called total factor productivity
(TFP)
If TFP is no longer equal to 1, we can
obtain a better fit of the model.

However, data on TFP is not collected.

It can be calculated because we have data on
output and capital per person.
TFP is referred to as the residual.

A lower level of TFP

Implies that workers produce less output for
any given level of capital per person

Output differences between the richest

and poorest countries?
Differences in capital per person explain
about one-quarter of the difference.
TFP explains the remaining three-quarters.

Thus, rich countries are rich because:

They have more capital per person.
More importantly, they use labor and capital
more efficiently.

4.4 Understanding TFP

Differences
Why are some countries more efficient
at using capital and labor?

Institutions
Even if human capital and technologies
are better in rich countries, why do they
have these advantages?
Institutions are in place to foster human
capital and technological growth.
Property rights
The rule of law
Government systems
Contract enforcement

Human Capital
Human capital
Stock of skills that individuals accumulate
to make them more productive
Education, training, etc.

Returns to education
Value of the increase in wages from
additional schooling

Accounting for human capital reduces

the residual from a factor of 18 to a
factor of 9.

Technology
Richer countries may use more modern
and efficient technologies than poor
countries.
Increases productivity parameter

Misallocation
Misallocation
Resources not being put to their best use

Examples
Inefficiency of state-run resources
Political interference

Case Study: A Big Bang or

Gradualism? Economic Reforms in
Russia and China

When transitioning from a planned to a

market economy, the change can be
sudden or gradual.
A big bang approach is one where all old
institutions are replaced quickly by
democracy and markets.
A gradual approach is one where the
transition to a market economy occurs
slowly over time.

Russia followed a big bang approach,

yet GDP per capita has declined since the
transition.
China has seen accelerated economic
growth using the gradual approach.

4.5 Evaluating the Production

Model
Per capita GDP is higher if capital per
person is higher and if factors are used
more efficiently.
Constant returns to scale imply that
output per person can be written as a
function of capital per person.
Capital per person is subject to strong
diminishing returns because the
exponent is much less than one.

Weaknesses of the model:

In the absence of TFP, the production
model incorrectly predicts differences in
income.
The model does not provide an answer
as to why countries have different TFP
levels.

Summary
Per capita GDP varies by a factor of 50 between
the richest and poorest countries of the world.
The key equation in our production model is the
Cobb-Douglas production function:

Output

Productivity
parameter

Inputs

10

 The exponents in this production

function:

The production model implies that

output per person in equilibrium is the
product of two key forces:

One-third of GDP is paid out to capital.

Two-thirds is paid to labor.

Total factor productivity (TFP)

Capital per person

Exponents sum to 1, implying constant

returns to scale in capital and labor.

The complete production model consists

of five equations and five unknowns:

Output Y
Capital K
Labor L
Wage rate w
Rental rate r

The solution to this model is called an

equilibrium.
The prices w and r are determined by
the clearing of labor and capital
markets.
The quantities of K and L are
determined by the exogenous factor
supplies.
Y is determined by the production
function.

Assuming the TFP is the same across

countries, the model predicts that
income differences should be
substantially smaller than we observe.
Capital per person actually varies
enormously across countries, but the
sharp diminishing returns to capital per
person in the production model
overwhelm these differences.

Making the production model fit the

data requires large differences in TFP
across countries.
Economists also refer to TFP as the
residual, or a measure of our
ignorance.

11

 Understanding why TFP differs so much

across countries is an important question
at the frontier of current economic
research.
Differences in human capital (such as
education) are one reason, as are
differences in technologies.
These differences in turn can be partly
explained by a lack of institutions and
property rights in poorer countries.

This concludes the Lecture

Slide Set for Chapter 4

Macroeconomics
Third Edition
by
Charles I. Jones

W. W. Norton & Company

Independent Publishers Since 1923

12