The Mankiw-Romer-Weil growth model and the valuation of

human capital.

T.Huw Edwards
Centre for the Study of Globalisation and Regionalisation
Warwick UK
Tel (44)024-7652-4462
Fax 024-7657-2548
T.H.Edwards@warwick.ac.uk
February 2004

Abstract
This note examines the measure of human capital implicit in Mankiw, Romer and
Weils 1992 paper on A Contribution to the Empirics of Economic Growth. It is
argued that MRWs methodology fails to take account of cross-country dierences in
the costs of acquiring human capital, and so implies an excessive dierence in human
capital between advanced countries and developing countries, where acquiring human
capital is cheaper. The implication of this is that the equation which they successfully
t to cross-country data is not, in fact, consistent with the Solow constant returns to
scale growth model, but implies increasing returns to scale and, on plausible factor
share assumptions, is in fact similar in its main properties to some endogenous growth
models, having constant returns to substitution..
KEYWORDS: Growth, Human Capital, Endogenous Growth..
JEL Classication: O11, O41

The author thanks various people at University of Warwick for invaluable comments and suggestions.
Any errors are my own.

1
1 The Mankiw-Romer-Weil growth model and the val-
uation of human capital.

This note examines the measure of human capital implicit in Mankiw, Romer and Weils

(henceforth MRW) 1992 paper on A Contribution to the Empirics of Economic Growth. It

is argued that MRWs methodology fails to take account of cross-country dierences in the

costs of acquiring human capital, and so implies an excessive dierence in human capital

between advanced countries and developing countries, where acquiring human capital is

cheaper.

Mankiw, Romer and Weils paper is seen as a classic contribution to the debate on the

nature of economic growth. The neoclassical growth model, developed by Solow (1956)

explained growth rates of various countries over time a combination of diminishing returns

to substitution, constant returns to scale and exogenous growth rates of technology and

labour supply, combined with savings rates which were constant within a country but varied

across countries. I will refer to these as the neoclassical growth assumptions. This formula

proved useful at accounting for individual countries growth records over time, but was

judged poor at explaining cross-country dierences, particularly between the richer and

poorer countries. The variation in income per head between rich countries and developing

countries was seen as too large to be explicable by dierences in factor endowments in

a constant returns to scale world, and inconsistent with observed factor price patterns

(see Easterly and Levine, 2001).. Consequently, attention has increasingly focused on

endogenous growth models (see Romer, 1986 , Lucas, 1988). Barro and Sala-i-Martin

(1995) discuss an impressive array of empirical backing for models with increasing returns.

2
 The MRW paper was an important challenge to this growing concensus against Solow.

By incorporating human as well as physical capital, they successfully tted a model based

on Solow to cross-country data, indicating that announcements of the death of constant

returns growth theory were perhaps premature.

This note challenges that nding. I argue that, when a misspecication of human

capital is corrected, the MRW model is not, in fact, consistent with the Solow constant

returns to scale, diminishing returns to substitution growth model, and in fact, on plausible

factor share assumptions, similar in its main properties to some endogenous growth models,

notably Barro and Sala-i-Martins (1995) AK model, having constant returns to combined

investment in physical and human capital, even in the presence of a xed labour supply.

2 Outline of the Mankiw-Romer-Weil approach

The MRW paper marked an important contribution to the debate on the nature of eco-

nomic growth: in particular it was argued that the observed empirical shortcomings of the

neoclassical Solow growth model1 - in particular a large underestimate of the dierence in

incomes between advanced and developing countries unless capital is assumed to have a

far larger impact on output than its income share implies - were due to omission of human

capital. Eectively, MRW argued that the traditional Cobb-Douglas formulation

1
There have been a number of criticisms of the MRW model on econometric grounds, summarised in
Aghion and Howitt, 1998.

3
 Yt = Kt (At Lt )1 ; (1)

-where Y is total income, K is capital stock, L is the labour supply and A is a technology

parameter, with L growing at an annual rate n and A growing at rate g - should be rewritten

to include human capital, H:

Y = Kt Ht (At Lt )1 : (2)

Rewriting equation (2) in terms of income, physical and human capital per head, yt =

Yt =Lt , kt = Kt =Lt and ht = Ht =Lt , MRW derived equations for the changes in k and hover

time

kt0 = sk yt (n + g + )kt ; (3)

h0t = sh yt (n + g + )ht (4)

where the prime indicates rate of change and is the proportionate rate of depreciation

(assumed to be equal for physical and human capital). Savings rates for physical and human

capital are sk and sh respectively, and are assumed to be constant over time (though not

across countries). These equations then implied steady state solutions for k and h

4
 1=(1)

k = (sk1 sh )=(n + g + ) ; (5)

1=(1)
h = (sk s1
h )=(n + g + ) ; (6)

and hence it was possible to derive an equation for steady-state income growth

ln yt = ln A0 + gt (( + )=(1 )) ln(n + g + )

+ (=(1 )) ln sk + (=(1 )) ln sh: (7)

The physical capital savings rate, sk , was approximated by the investment share in GDP,

while the human capital savings rate sh was measured by a measure of the proportion of

the workforce at any one time enrolled in secondary school - SCHOOL in the MRW

estimated equations. Estimation of this modied Solow equation on cross-section samples

of 98 and 75 countries respectively in 1985 yielded greatly improved t compared to the

Solow model excluding human capital, and the parameter restrictions implied in equation

(7) were not rejected statistically, while the implied income shares of physical and human

capital, both around 0.3, were judged to be plausible.2 The authors concluded that this

was evidence that the Solow model is more plausible than previously thought.

2
A third regression, on 22 OECD countries, did not perform well.

5
 Given the statistical evidence cited in other studies against models using the neoclassical

constant returns to scale/diminishing returns to substitution/uniform technology assump-

tions (eg Easterly and Levine, 2001), it may perhaps come as a surprise that MRW achieved

such a successful t for a Solow model, only modied to include human capital.

3 Problem with the treatment of human capital

The primary objection here to the MRW approach is their treatment of the valuation of

human capital. Arguably equations (3) and (4) should both contain measures of the costs of

acquiring physical and human capital, since these may dier between countries. However,

it is for human capital that the problem is far more serious.

Essentially, equation (4) assumes that the increase in human capital depends on sk

times y. In other words, human capital investment per head for a given proportion of the

workforce in school is higher when per capita income is higher. A year of schooling in

Norway (1985 GDP per adult $19,723) would be around 40 times more valuable in terms of

units of human capital acquired than a year of schooling in Chad (GDP $462 per adult).3

I suggest it would be more appropriate to deate the value of a years schooling so that

it is people with an equivalent education have the same assumed human capital endowment,

regardless of which country they live in. This implies that rather than gross human capital

investment being sk times y it would be just sk .4 This would then yield an amended

3
One would, of course, expect a person with a secondary education to earn far more in Norway than
in Chad, but it seems sensible to interpret this as implying a higher price for human capital in Norway,
rather than larger amounts for people with the same education.

4
To be precise, we should assume the unit cost of acquiring human capital is yct . However, there is no

6
equation (4)

h0t = sh (n + g + )ht : (8)

Of course, if all countries have the same savings and depreciation rates, technical and

factor share parameters and population growth rates, then in equilibrium their incomes

would be equal and cost of acquring human capital would be equal.However, once we

allow, as MRW do, for exogenous country-specic variations in parameters, then this is

no longer the case, and the issue of human capital measurement becomes important. For

example, if we introduce an exogenous variation in income levels, c for each country c; we

can then rewrite (2) as

Yct = c Kct Hct (AtLct )1 ; (9)

or

yct = c A1
t

kct hct ; (10)

and it follows that the equilibrium conditions for h and k for each country (denoted now with

S
to denote the Solow model equilibrium, as opposed to M RW
to denote the equilibrium

in the model MRW tted) are then

loss of generality if we normalise the scaling factor = 1:

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 h
ct = sh =(n + g + ); (11)

S S
kct = sk yct =(n + g + ) (12)

= (sk sh c )1=1 At (1)=(1)(n + g + )(1+)=(1) : (13)

Substituting for h and k into (14) we therefore obtain y

S =1 =(1)
yct = 1=1
c At (1)=(1) sk sh (n + g + )((+)=(1)) (14)

Taking logs, and assuming the observed value of yct is on the steady-state growth path

for that individual economy, once the residual term c is included, we can write:

S
ln yct = ((1 )=(1 )) ln A0 + ((1 )=(1 ))g

(( + )=(1 )) ln(n + g + ) + (=(1 )) ln sk

+(=(1 )) ln sh + (1=(1 )) ln c : (15)

While this contains the same parameters as equation (7) it can be seen that the parameter

restrictions are dierent, reecting a dierent underlying model. Nevertheless, the coe-

8
cients on lnA0, g, ln(n+ g +); ln sk and ln sh are all in the same proportions as in equation

(7). In fact if we include c in equation (7) it would carry the coecient (1 ):

ln ytM RW = ln A0 + gt (( + )=(1 )) ln(n + g + )

+ (=(1 )) ln sk + (=(1 )) ln sh

+c =(1 ) (16)

It follows that the only dierence is that the terms in equation (15) are just those in

equation (16) scaled up by (1 )=(1 ):

3.1 The model tted by Mankiw et al

Mankiw et al tted rst an unrestricted and then a restricted version of equation (7). On

two of their three subsets of countries, the model performed well, with signicantly improved

t compared to the simple Solow model omitting human capital, and with the parameter

restrictions implied by equation (7) not rejected statistically. However, the discussion in

this paper indicates that MRW have applied a highly questionable implicit valuation of

human capital, and that a Solow model with properly-specied human capital would look

more like equation (16).

Since equation (7) appears to t the data reasonably well, the question arises, if it is

not in fact a properly-specied Solow model with human capital, what is it?

9
 Comparing equations (16) and (15) gives us a very easy comparison.

S =1 =(1)
yct = 1=1
c At (1)=(1) sk sh (n + g + )((+)=(1)) (17)

M RW
yct = 1=1
c Ats=1
k s=(1)
h (n + g + )((+)=(1)): (18)

Hence we can write

M RW S (1)=(1)
yct = (yct ) : (19)

If we apply MRWs ballpark estimates = = 1=3, then the equation can be rewritten

as

M RW S 2
yct = (yct ) : (20)

However, while this implies positive scale eects inconsistent with the Cobb-Douglas

formulation of the Solow model, deriving a new equation for implied y M RW in terms of

k M RW and hM RW is not simply a matter of including a square term. While the stock

of human capital per head (equation (11)) depends on the proportion of the workforce in

school, and is invariant regardless of output level, the stock of physical capital per head

is proportional to output. If we use S

to denote output and physical capital per head in

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the Solow model and M RW
to denote values in the model MRW tted, then let us start by

assuming it is possible to write

yM RW (k M RW ; h ) = (yS (k M RW ; h)) ; (21)

where is a constant power. But we know physical capital is proportional to output per

head,

kcM RW = Kcs (ycM RW =ycS ): (22)

When = = 1=3, the term in brackets is just ycS : Then, applying the Cobb-Douglas

formulation

(yS )2 = (y S (y S )1=3 ) ; (23)

we can write

= 2=(1 + 1=3) = 3=2: (24)

It follows that

M RW 1=2
M RW 1=2 M RW 1=2
yct = "3=2
c At (kct ) (hct ) : (25)

An interesting aspect of this model is that the scale eect in equation (20) exactly

cancels out the substitution eect, so that investing jointly in human and physical capital

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gives constant returns

1=2 gt=2 M RW 1=2 M RW 1=2

YctM RW = "3=2
c A0 e Kct Hct : (26)

This production function shows a combination of constant returns to scale and constant

(rather than diminishing) returns to substitution of combined physical and human capital

for labour.While, if physical or human capital alone is increased, there are diminishing

returns, if both are increased by factor , then output also increases by . This is exactly

the same property implied by many endogenous growth models, such as, e.g. Barro and

Sala-i-Martins (1995) AK model, where there are returns to combined physical/human

capital accumulation. This strongly suggests that, far from undermining the case for an

endogenous growth model, MRW have in fact inadvertently tted a model with properties

very similar to many standard endogenous growth models.

Other items of note are that the exogenous country-specic residual term c appears

in the steady-state level of income equation with the power 3/2: this implies that those

dierences in incomes treated as exogenous and unexplained in the MRW model will have

a greater eect in explaining cross-country income dierences than the R2 term on the

regression of equation (7) might imply. It follows that savings rates and factor endowments

are proportionately less powerful in explaining cross-country dierences than one might

think from the MRW paper.

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4 Conclusions

The Mankiw-Romer-Weil paper represents a noteworthy attempt to reconcile neoclassical

growth theory, as represented by the Solow model, with the extreme observed dierences

in income levels across countries, even in the face of an apparent failure of most poorer

countries to achieve convergence with richer countries over time, and of the many para-

doxical factor price eects (see e.g. Easterly and Levine, 2001). MRW argued that when

human capital is incorporated, observed savings rates produced plausible coecients on

Solow growth equations (consistent with factor income shares) and explained much of the

observed dierences between countries.

The problem with this analysis is that MRW appear to have misspecied the variable

human capital in their model, by ignoring dierences in the cost of acquisition of human

capital. Rather than treating ve years of schooling as producing the same volume of

human capital in any country, their method implies it produces far more human capital in

countries where the opportunity cost of labour in education is higher. This is eectively

confusing cost dierences with volume dierences.

An algebraic reworking of the estimated equations from the MRW model suggests that,

once we specify human capital correctly, the estimated model contains constant returns to

substitution of physical combined with human capital for labour. Indeed, if we assume all

three factors (human and physical capital and labour) have income shares of 1/3 each, the

MRW model turns out to be virtually the same as Barro and Sala-i-Martins AK model,

while exogenous cross-country dierences once again dominate the observed data set.

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References

[1] Aghion, P. and P.Howitt (1998): Endogenous Growth Theory, MIT Press, Cambridge

Mass.

[2] Barro, R.J. and X. Sala-i-Martin (1995): Economic Growth. McGraw Hill, London.

[3] Easterly, W. and R.Levine (2001): Its Not Factor Accumulation: Stylised Facts and

Growth Models. World Bank Economic Review 15(2); pp 177-219.

[4] Lucas, R.E. (1988): On the Mechanics of Economic Development, Journal of Monetary

Economics 22, pp 3-42.

[5] Mankiw, N.G., D.Romer and D.N.Weil (1992): A Contribution to the Empirics of

Economic Growth, Quarterly Journal of Economics, 107 pp 407-437.

[6] Romer, P.M. (1988): Increasing Returns and Long-Run Growth, Journal of Political

Economy 94, pp 1002-38.

[7] Solow, R.M. (1956): A Contribution to the Theory of Economic Growth, Quarterly

Journal of Economics 70, pp 65-94.

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