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# CHAPTER

42
Uzaw Tw The Uzawa Two-Sector Growth Growth Model
INTRODUCTION
The basic neo-classical growth model has been extended by developing two-sector models by Meade, Solow, Hahn, Hahn and Mathews, and Uzawa among others. It this chapter, the Uzawa model1 is discussed.

## THE UZAWA MODEL

The Uzawa two-sector growth model2 is built around four questions : 1. Given a stock of capital from the past and a present labour force, is there a momentary equilibrium at this point of time? 2. Is the momentary equilibrium unique?
1. H. Uzawa, On a Two-sector Model of Economic Growth : I, R.E.S., Vol 29, 1961-62 and On a Twosector Model of Economic Growth : II, R.E.S., Vol. 30, 1963. 2. As the Ozawa Model is highly mathematical and difficult for students to understand, the analysis that follows is also based on R.M. Solow, Note on Uzawas Two-sector Model of Economic Growth, R.E.S., Vol. 29, 1962-63 and F. H. Hahn, On Two-sector Growth Models, R.E.S., Vol. 32, 1965.

3. Is there a unique balanced growth path? 4. Is the system stable? To answer these questions, Uzawa makes the following assumptions : Assumptions. The Uzawa model is based on the following assumptions : 1. The economy consists of two sectors : the investment sector which we call Sector-1 and the consumption sector which we call Sector-2. 2. Sector-1 is producing a homogeneous capital good and Sector-2 is producing a homogeneous consumer good. 3. There are two homogeneous productive factors, a single grade of labour and a single type of capital depreciating at a rate . 4. Labour and capital are perfectly substitutable for each other in the production of consumer goods and capital goods. 5. Labour and capital are freely transferable from one sector to another. 6. An exogenously determined supply of labour is inelastically offered for employment at any point of time. 7. At any point of time, irrevocably existing stock of capital is inelastically offered for employment. 8. There are constant returns to scale in the production of the two goods. 9. All wages (w) are spent (consumed) on consumer goods and all rentals (r) (profits) are spent on capital goods. 10. There is no technical progress. 11. There is perfect competition. 12. The economy is closed. Given these assumptions, the Uzawa model answers the four questions given above thus: 1. The existence of momentary equilibrium depends (i) on the assumption that all wages are consumed and all rentals (profits) are saved, and (ii) on the conditions of the production functions of the consumer goods sector and capital goods sector [assumptions (2), (3) and (4)]. 2. The momentary equilibrium is unique in the sense that the consumer goods sector is more capital-intensive than the capital goods sector. This is a sufficient but not a necessary condition for uniqueness of momentary equilibrium. 3. The balanced growth path is also unique on the assumption that the consumer goods Sector-2 is more capital-intensive than the capital goods Sector-1. 4. Again, this assumption ensures a stable system. EQUATIONS OF THE MODEL3 Before we explain the model, the following are its basic equations where the subscripts 1 and 2 denote the capital goods sector and the consumption goods sector respectively. ....(1) Equation(1) expresses the assumption of a constant proportionate growth rate of population.
K = Y1 K

L = L0 e nt

....(2)

3. As the model is very lengthy, students may skip this section without loss in continuity. But they must read it in order to understand the working of the model.

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## The Economics of Development and Planning

It defines the net increase in the total capital stock ( K ) at any moment of time, given by the output of the capital sector (Y1) minus depreciation ( ) which is assumed to be proportional to the existing stock of capital. ....(3) Equation (3) expresses the production function of the consumption sector where its output depends on quantities of capital and labour employed. Y1 = F1 ( K1 , L1 ) ....(4) Similarly, equation (4) expresses the production function of the capital sector. The production functions in equations (3) and (4) are assumed to be well-behaved because they show constant returns to scale with positive and decreasing marginal productivities. Y = Y2 + pY1 ....(5) Equation (5) defines Gross National Product (Y) measured in terms of the consumption goods, Y2 and p as the price of the capital goods, Y1 , in terms of the consumption goods. K = K1 + K 2 ....(6) L = L1 + L2 ....(7) Equations (6) and (7) express full-employment condition of capital and labour in Sectors 1 and 2 respectively. w= F2 L2 =p F1 L1 ....(8)

Equation (8) determines the wage rate (w) which is equal to the value of the marginal product of labour in both sectors under perfect competition. r= F2 K 2 =p F1 K1 ....(9)

Similarly, equation (9) determines the rental (r) which is equal to the value of the marginal product of capital in both sectors under perfect competition. pY1 = sY ....(10) Equation (10) shows investment-saving ex-ante equality on the assumption that a constant fraction is saved out of GNP (Y) which is automatically invested. At any moment of time, the labour force is given exogenously and the capital stock is given as an outcome of past accumulation so that equations (3) to (10) determine the short-run equilibrium, and equations (1) and (2) determine the long-run equilibrium or the the path of growth equilibrium. As the four questions posed above in the model relate to the long-run equilibrium, we are not concerned with the short-run equilibrium. To explain the working of the model, we first define the following derived variables : k= k1 = K Y w , y = , = L L r K1 Y L , y1 = 1 , l1 = 1 L L L1

## The Uzawa Two-Sector Growth Model

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and n =

L , i.e. labour supply growing geometrically at rate n. L On the assumption of the homogeneous production functions of the first degree, equations (3) and (4) can be expressed as : Y1 = L1 F1 Y1 L L1 L

FK

L1

, l = L1 f 1

FK

L1

so that

f1

FK

L1

Substituting the derived variables y1 , l1 and k 1 in the above equation. y1 = f 1 ( k 1 ) l1 Q From the assumption made on f1, we have f 1 ( k 1 ) > O , f ( k 1 ) > O , f (k1) > O and for both k 1 > O . ( k Y bYF /andfY()k ) = K1
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WORKING OF THE MODEL In the Uzawa model, there are two perfectly substitutable productive factors producing capital goods in Sector-1 and consumer goods in Sector-2. These goods are produced under constant returns to scale. They have homogeneous production functions. There being full employment of labour and capital, a given value of ( w / r ) determines the division of labour force between the two sectors and their outputs ( Y2 and Y1 ) . Both industries make optimal adjustments and these yield unit costs. Competition then sets the price ratio p ( = P2 / P1 ) for the two goods equal to the ratio of unit costs. Thus any ( = w / r ) determines an equilibrium price ratio p with only one set of prices of goods such that no producer makes a profit or loss. The technique of production in Sector-1 is shown by the capital-labour ratio, . Since there are constant returns to scale, the least-cost technique depends on ( w / r ) . Thus there can be only one associated with each and to each there corresponds a unique price-ratio, p, of the two goods. Assuming that the producers in the two sectors plan to supply as much of each good as is demanded at a given (w/r) and associated price-ratio, p, there are two types of incomes, i.e., wL (wages of labour) and rK (rental on capital). A given proportion of each type of income is spent on each type of good . Since the initial capital-labour ratio, k, is known and the price ratio, p, is uniquely determined by ( w / r ) , the ratio in which the two goods are demanded is a function of which is a single-valued and continuous function. It follows

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## The Economics of Development and Planning

that the ratio in which capital and labour are demanded is also a function of (w/r). Thus is a unique wage-rental ratio for which both equilibrium conditions are satisfied. Momentary Equilibrium. We may normalize w and r by taking then to be non-negative and that they add up to one. This can be done as we have seen above because only their ratio (=w/ r) matters. Normalized w* and r* refer to equilibrium prices of wages and rentals in relation to the demands for labour (L' ) and capital (K' ). Nomalized w* and r* are called a momentary equilibrium if at these values the excess demands for labour and capital are each negative. This is because on the assumptions of the model, the Walrus Law takes the form : where w and r represent wage and rental, L and are demands for labour and capital and L and K their given supplies. The above equation shows that labour or capital can be in equilibrium excess supply only if its price is zero. Since the excess demand functions of labour and capital are continuous over the normalized price space, an equilibrium exists. Thus, is a momentary equilibrium. It follows that if if for all is a momentary equilibrium, then it is a unique equilibrium only then ( w w*) YL ( w , r ) + ( r r *) YK ( w , r ) > 0 where YL ( w , r ) and YK ( w , r ) are the excess demand functions for labour and capital respectively. Stability Proposition. The stability proposition states that with the labour supply growing at the rate n ( = L / L ) , the system will eventually approach a situation in which is constant so that the capital stock is also growing at the rate n and the whole economy changes only in scale. By assuming and all rentals are spent on gross investment, , the product-rental of capital in Sector-1 is equal to the marginal product of capital in Sector-1, f 1 ( k 1 ) , since under constant returns to scale it depends only on k 1 ( = K1 / L1 ) . Combining all these, we have

k / k = K / K L / L = f 1' ( k1 ) n
where is depreciation of capital. This is Uzawas stability proposition which asserts that both sides of this equation tend to zero. To prove it, we have to prove that when k is very high, becomes negative and when k is very low, becomes positive. But the marginal product of capital is a decreasing function of k1. Now we have to show that k and k 1 always move in the same direction and f 1( k 1 ) decreases and ultimately becomes equal to or less than (n+ ). There is a possibility that k and always move in the same direction. k 1 increases when ( = w / r ) increases and so does . It means that the capital-labour ratio increases in each sector whenever the wagerental ratio rises. This stability proposition leads to the balanced growth path. Condition for Stability of the Balanced Growth Equilibrium. The stability of the equilibrium growth path is also unique on the assumption that Sector-2 (consumer goods sector) is more

## The Uzawa Two-Sector Growth Model

305

capital-intensive than Sector-1 (capital goods sector). To prove this, suppose that at any ( = w / r ) ratio, K 2 / L2 > K1 / L1 ; so is rK 2 / wL2 > rK1 / wL1 . Under constant returns to scale and perfect increases or decreases according as the competition, when rises, the price ratio, relative share of wages in Sector-2 is greater or smaller than in Sector-1. Thus p falls when rises and vice versa. From the assumption that all wages are spent on consumer goods and all rentals are saved, we have K w P1Y1 and L = r P Y . 2 2

If w/r rises, P1 / P2 will also rise. So K/L must rise unless Y1 / Y2 falls. But if Y1 / Y2 falls, there is a shift in favour of consumption goods which are more capital-intensive. As proved above, with the capital-labour ratio increasing in both sectors and the capital-intensive consumer goods Sector-2 gaining at the expense of Sector-1, k ( = K / L ) must rise. Thus and k must move together and the stability condition for equilibrium growth holds. But the condition that Sector-2 is more capital-intensive than Sector-1 is a sufficient condition for stability and not a necessary condition. How this condition is violated but stability occurs is explained in the following example. Suppose both sectors have Cobb-Douglas production functions with elasticities of 1 and 1 1 for K1 and L1 , and 2 and 1 2 for K 2 and L2 . k =1 P2 / P2 Y2 p 11Y1/ Y1 += 12)P2 Y2 / P1 Y1 Then P( 2 wLP rK P rK and 1 1 wL Then

rK = rK =
2 P1Y1 = 1 P2 Y2 1 P1Y1 P2 Y2 P1Y1 2 = 1 1

and

But

rK P2 Y2 = wL =

So

In the above equation, the right-hand side is a constant. Hence whenever and k move together and r/w falls, k 1 rises and K / L ( = k ) must also rise. So we find that stability occurs. It does not matter whether Sector-2 is more capital-intensive than Sector -1. A CRITICAL APPRAISAL Uzawa extends the basic one-sector neo-classical growth model to a two-sector growth model with a consumer goods sector and a capital goods sector.

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## The Economics of Development and Planning

Limitations. It has certain limitations. 1. It is a highly mathematical model consisting of numerous equations which makes it difficult for readers to understand. 2. The assumptions that there are no savings out of wages and all rentals (profits) are spent on capital goods and nothing is spent on consumption, are not true. 3. The assumption that the consumers goods sector is more capital-intensive than the capital goods sector is highly restrictive. As pointed out by Solow, It seems paradoxical to me that an important characteristic of the equilibrium path should depend on such a casual property of the technology. 4. According to Hahn, the assumptions required to establish uniqueness of momentary equilibrium are all terrible assumptions because people differ in the assets they hold in their age and tastes.