Economics 3213 Answers to Problem Set 1

(1) When you Wish Upon a Star

(a) (i) In 2007 the five richest countries in the world in terms of GDP per capita at purchasing power parity (PPP) are Lu em!ourg" #orway" $ingapore" %ong &ong" and the 'nited $tates( (ii) In 2007 the five poorest countries in the world are the Democratic )epu!lic of *ongo" Guinea+ ,issau" ,urundi" -adagascar" and #iger( (iii) .he average person in Lu em!ourg is almost 200 times richer than the average person in the Democratic )epu!lic of *ongo( (!) (i) .he countries that have grown the most from /010 to 2007 are 23uatorial Guinea" .aiwan" *hina" the )epu!lic of &orea" and ,otswana( (ii) .he countries that have e perienced the most negative growth are the Democratic )epu!lic of *ongo" 4im!a!we" *entral 5frican )epu!lic" #iger" and $enegal( (c)" (d)" (e)" (f)" (g)6(((7 (h) $ince e plaining why some countries are rich and others are poor is !asically what economics is all a!out" the following few paragraphs cannot !e considered e haustive( .he ma8ority of the countries that are rich today were already richer than others a hundred years ago( .hese are the countries in 9estern 2urope and #orth 5merica that !enefited the most from the Industrial )evolution in the /:th and /0th centuries and had the most advanced technology at the time( .he most nota!le e ception is 2ast 5sian ;.igers; that grew spectacularly after 9orld 9ar II( -any people agree that sta!le governments" legal systems" and the protection of property and intellectual property rights !enefited economic growth in the rich countries( 9e can analy<e poor countries in two categories( .he first one consists of former socialist countries (the former $oviet 'nion" *hina" India" and satellite countries)" and the second are e3uatorial countries( $ince 9orld 9ar II to the late /0:0s e +socialist countries adopted a system of planned or administrative command economy that was fundamentally different from mar=et capitalism( $ince it is virtually impossi!le even for the most well+intentioned central planning authority to have enough information a!out all economic activities in a country" central planning inevita!ly led to an inefficient allocation of resources( $ince the government was the main decision+ma=er" many economic decisions were !ased on political or military grounds( 9idespread inefficiencies often necessitated rationing in consumption and led to a !rea=down in the incentives system( La!or productivity and conse3uently capital productivity fell( .herefore" these economies have !een !rought down to low wealth levels( .he second set of poor countries is tropical countries( 5lthough many of them were also socialists at some point" these countries can !lame more differentiated causes( $ome of them are unfavora!le climatic conditions" such as hot weather that ma=es wor=ing very difficult> tropical diseases" such as malaria" which wea=en the la!or force> distance from e panding mar=ets in the post+ 99II period> and a particularly e ploiting attitude of 2uropean colonialism in these regions( )emem!er that the '($(" 5ustralia" #ew 4ealand" and some other rich countries were also colonies( %owever" favora!le climate in those countries allowed 2uropeans to settle and therefore set up sustaina!le institutions" such as local or municipal governments( In countries with particularly hostile climate" such as *ongo" 2uropeans did not settle and set up institutions that allowed them to e tract natural resources( 5ll these features reduced la!or productivity" then capital productivity" and therefore the growth potential of these economies(

(2) Figaro an !leo

(a) .here are many definitions of poverty( ?ne is the situation of having ;few; resources to ma=e a living( 9hat ;few; means" however" varies( $ome people say that ;few; means less than one dollar a day> others use two dollars or three dollars as the main definition( 5ny 3uantitative definition of poverty will !e ar!itrary( -ost people" however" agree that !eing una!le to provide for sufficient calorie inta=e" !asic clothing" shelter" and !asic health care 3ualifies as a!solute poverty( (!) Growth is" essentially" the only way to achieve poverty reduction( 5ggregate economic growth and poverty reduction tend to go hand+in+hand" as growing economies provide opportunities for the poor to increase their income( (c) Growth tends #?. to !e associated with ine3uality( 2ven if ine3uality increases" it usually does not increase enough to offset the growth of mean income( .he lower part of the distri!ution shifts to the right when the mean shifts to the right( %ence poverty falls(

(3) "iminy !ric#et

(a) )eturns to scale refer to the relationship !etween inputs ta=en all together and production( 9e say that a production process e hi!its constant returns to scale (*)$) whenever an increase in all inputs in the same proportion implies an increase in output in the same proportion( @or e ample" if the production function is YAF(A, K, L)" and we dou!le K and L" we will also dou!le outputB 2YAF(A" 2K" 2L)( #otice that technology (A) does not have to dou!le to o!tain dou!le product( .his is !ecause it is a nonrivalgood and hence cannot !e appropriated !y a single entrepreneur( )eturns to scale only refer to rival factors of production that cannot !e used in two places at the same time( )eturns to capital instead refer to the effect on production of the increase of capital alone" =eeping la!or constant( 9e say that returns to capital are diminishing if successive increases of capital cause smaller and smaller increases of production( .he idea is that the same num!er of wor=ers has to wor= with more and more machines" and hence the productivity of additional machines gets lower and lower( (!) In principle" it is always possi!le to replicate a production process and to dou!le output( 9e can !uild a factory identical to the one we have" hire the same num!er of wor=ers" and we will get twice as much output( In this sense the assumption of constant returns to scale is sensi!le( Diminishing returns to capital can !e 8ustified as follows( *onsider a very simple case in which one unit of capital (e(g( a computer) is given to each wor=er( %is or her productivity compared with the case in which he or she used no machines is much higher( If we now give another machine to each of these wor=ers (e(g( another computer)" it is li=ely that the wor=ers will not !e a!le to use this second unit of capital as effectively as the first one( .hin= of a secretary with two computers" a coo= with two =itchens" and so on( .he increase in output caused !y the second machine is lower than the one associated with the first machine( $ince we can repeat this empirical reasoning forever" it is sensi!le to assume that the contri!ution of e tra capital to production (capital productivity) is a decreasing function of the capital already present in the economy( (c) .o demonstrate that a function e hi!its constant returns to scale (*)$)" it is sufficient to demonstrate that output dou!les whenever capital and la!or !oth dou!le at the same timeB (2K)0(C(2L)0(7 A 20(CK0(C20(7L0(7 A 20(CD0(7K0(CL0(7 A 2K0(CL0(7 A 2Y( (*apital and la!or can !e multiplied !y a varia!le E rather than 2 for a more general proof() .o demonstrate diminishing returns to capital" first thin= of what would happen if capital had constant returns instead of diminishing( 2ach additional unit of capital would !ring e3ual !oost to output( ,y dou!ling capital alone we would !e a!le to dou!le output( ,ut since capital" in fact" has diminishing returns" dou!ling capital alone less than doubles outputB (2&)0(CL0(7 A 20(CK0(CL0(7 6 2K0(CL0(7 A 2Y !ecause 20(C A /(2C((( ( (5lternately" one can show that the second derivative of the production function with respect to capital is negative()

(d) @ollowing the same reasoning as in (c)" (2K)(2L)/+ A 2K2/+L/+ A 2D/+KL/+ A 2KL/+ A 2Y( ($u!stitute E for 2 for a more general proof() (2K)L/+ A 2KL/+ 6 2KL/+ A 2Y !ecause 2 6 2 for any 0 6 6 /( (*an also !e proved !y ta=ing the second derivative of F with respect to &" and showing that it is negative()

($) Stromboli
(a) .he e3uation says that the increase in capital (net investment) is e3ual to total savings (which is gross investment in a country with no government and no foreign sector) minus whatever is used to replace capital that !ro=e down and whatever is needed to e3uip newly !orn people (n) with the same level of capital that the people already alive have( In other words" we ta=e whatever we saved" replace the !ro=en machines" and give capital to new people( 9hat is left increases capital per person or capital+la!or ratio k( (!) In the long run growth cannot last forever !ecause of diminishing returns( 5s the capital stoc= grows !igger" it is less and less productive> eventually" this will !ring us to a situation where all the savings have to !e used only to replace old capital that !ro=e down and to e3uip new people( #othing is left to increase the capital stoc= per person(

Problem 5.
(a) y= (b) f (A, k ) (n + ) = k = sAk 0.5 (n + ) = = (c) 0.3Ak 0.5 0.15 0.3Ak
0.5

Y AK 0.5 L0.5 = = Ak 0.5 L L

= s

0.3Ak 0.5 0.15

= = = =

0 0.15 0.15k 0.5 2A 4 A2

0.3A = k 0.5 k

(d) Capital-labor ratio k suddenly increases. Output and savings per capita (y and sy ) also suddenly increase but less than proportionately because of decreasing returns to capital. As the amount of capital per person lost to depreciation (k ) and to the newly born (nk ) instead grows in the same proportion as capital, actual savings will not be enough for replacement and for the newborn. As a result, part of the capital stock cannot be maintained. The country will experience negative growth. Every year more capital will break down than built. This will go on until all the additional capital per person is destroyed, and the economy settles to the initial steady state level. To phrase it another way, when a country is at its steady state, this means that savings is perfectly oset by depreciation and population growth. Additional capital, due to diminishing returns, would produce less than enough to oset depreciation and population growth. Therefore, the donation by the World Bank pushes the economy to a state where more capital depreciates each period than is created, until the economy converges back to the steady state. This process can be shown graphically, with the growth rate represented by the dierence between the savings and depreciation lines. Note that the growth rate becomes negative immediately after the donation of capital.