3η παρουσίαση Neoclassical Growth Theory

Kaldor Facts in industrialized countries

• Output per worker grows over time
• Capital per worker grows over time
• Capital-output ratio does not change much over time
• Rate of return to capital(interest rate) is steady
• Constant shares of labor and capital expenditures in National Income
• Wide disparities in growth rates across countries

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Three Facts Used To Construct the Neoclassical Growth Model

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 The Solow Growth Model
Famous model which got Solow the Nobel and many find it more relevant than many other “new theories”.
 The basis for empirical estimation of growth determinants i.e. growth accounting.
 Has a number of empirically testable propositions that stand up well.
 The Income convergence prediction is very relevant to the real world.
 The building block for many New Growth Theory models.
Introduction
• Economic growth has been one of the most hotly debated topics in the economic theory history.

• The importance of studying economic growth is due to the vast differences in standards of living
over time and across countries.
• The goal of research on economic growth is to determine whether there are possibilities for rising
overall growth or bringing standards of living in poor countries closer to those in the world leaders.
Solow’s Model(Modeling economic growth)
• Solow model is the starting point for almost all analyses on long-run growth and first-order cross country
differences
• The principal conclusion of the Solow model is that the accumulation of physical capital cannot
account for either the vast growth over time in output per person or the vast geographic differences in
output per person.
Assumptions of the model
1. The evolution of labour and knowledge is exogenous.
2. Population equals labour force
3. Labour and Knowledge grow at constant rates
Lt  nLt
At  gAt
4. Effective labour grows at the rate (g +n), the combined rates of technical change and population growth.

Solow Diagram and Production Function

y
y*
(n+d)k
consumption
sy
sy*

gross
investment

k* k

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the Solow diagram with technical progress

f (k)

  k 
y  f (k)

(d  n  g)k
  sk 
sf (k)

k

transition dynamics


k / k
n+g+d

sy / k  sk 1

k *

Implications of the model

• The economy converges, over time, to its steady state.
– If the economy starts BELOW the steady state, it accumulates capital until it reaches the steady
state.
– If the economy starts ABOVE the steady state, it reduces capital until it reaches the steady state.
Comparative statistics
Parameters of the model: s, n,g, 
Predictions of the model:
• In steady state:
– Higher savings rate implies higher income per worker
– Higher population growth implies lower income per worker
– Growth rates decrease as the country approaches the steady state
– Countries that start further away from the steady state grow faster

Investment Anyway? Solow says no.

1956-7: Robert Solow presents theory of growth (Nobel Prize, 1987)
• Multiple inputs to growth, so any single input experiences diminishing returns
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• Long-term growth is a function of technological change, not investment.

Solow developed the model to explain U.S. growth, not differences between countries. He never applied
the model to other countries – but that didn’t stop others from trying.
Convergence
There are three reasons for convergence:
a. Countries converge to their BGP
b.The rate of return on capital is lower in countries with more capital per worker. Capitals flow from rich
to poor countries.
c. Diffusion of knowledge converges the effectiveness of labour.
What’s Missing?
• Growth! The steady-state growth rates of y (output/worker) and k (capital/worker) are zero in this
simple model.
• Solow introduced “technological progress” -- an increase in the level of knowledge that allows us to
get more output out of a given level of capital and labor -- into the model.
• Add a technology variable (A) to the production function:

Y  F ( K , AL)  K  ( AL)1
y  k  A1

Implications of Solow’s Growth Model

1.The model’s inner forces (the diminishing returns to scale of capital, in particular) take the economy
smoothly to its Steady State. This is the state where output and capital grow at the same rate which match
exactly with the rate of population (labour) growth. This means that per-capita income and capital-labour
ratio (K/L = k) will be constant in the steady state (i.e. zero growth in per-capita income). Once the steady
state is reached, growth in per-capita income can come only from (the exogenous and un-explainable)
technical progress.
2. The increase in saving rate (or any policy change affecting the characteristics of the economy) will
increase the per-capita income but not the long-run growth. The economy will move to a new steady state
(with higher per-capita income, higher k and lower marginal productivity of capital). Once the economy
reaches the new steady state, per-capita growth will to zero (i.e income will increase again at the same rate
as the population.
3. When the steady state is reached, higher population growth will lead to lower per-capita income and
lower k. But the economy will settle again at a new steady state whereby K and Y will be growing at the
same new rate of population growth: per-capita income will be constant again.
4.The level of per-capita income depends on k (K relative to labour) and the per-capita growth rate (before
the point of steady state) depends on the marginal productivity of capital (thus also on k). This means that
countries with relatively low k (low volume of capital stock relative to labour, as the LDCs) will have lower
per-capita income but will exercise faster per capita growth rate (because lower K means higher capital
productivity) than countries with high k.
5.In absence of international capital mobility, various countries will reach the steady state at different levels
of k, thus at different levels of per-capita income. However, since per-capita growth in the steady state
depends exclusively on the exogenous technological progress available to all, then all countries will grow at
the same rate.

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6. If full capital mobility exists (thus all countries will have identical k and the same capital productivity)
then per-capita income as well as growth rate of per capita income (at the steady state) will be the same in
each and every country.
Growth Accounting

Start with a Cobb-Douglas production function: Y =A Kα . L1-α

Where Y is output, K is capital , L is labour, A is a constant (to secures homogeneity of measuring units)
and α is a parameter.

Cobb-Douglas function is a standard neoclassical function which exhibits:

•A considerable substitution possibility between the two inputs K and L. The elasticity of substitution is
constant and equal one.
•Constant returns to scale with respect to all production inputs: α + (1 - α ) = 1.
•Diminishing returns to scale with respect to each input: α < 1 and 1- α < 1. This means that successive
increases in K (or in L) lead to smaller and smaller increases in Y. Technically, the same can be expressed
by saying that the first partial derivative of Y (with respect to L or to K) is positive, while the second is
negative.

Y =A Kα . L 1-α
The first partial derivative of Y, with respects to K, measures the increase in output due from deploying an
extra unit of capital. This is the marginal productivity of capital (MPC):
ΔY/Δ K = (α Kα-1 ) . A L 1- α = α . A Kα . L1- α / K = α . (Y/K)
On the other hand, MPC = real rental cost of capital (the real interest rate) in equilibrium: α(Y/K) = r / p
(1)

The partial derivative of Y with respect to labour gives the marginal productivity of labour
(MPL):
ΔY/ΔL = (1- α) L1- α -1 . A Kα = (1- α ) . A Kα . L1- α / L = (1 - α ) . (Y/L).
On the other hand, MPL matches the real wage rate in equilibrium. Thus: (1- α ) Y/L = w/p (2)
•Competitive equilibrium secures that production factors receive their ‘fair’ shares of income, i.e. rewards
to labour and capital equal their contributions in the production. I.e. the factors of production are paid
according to their marginal productivities.
• The share of labour in total income is (MPL) . L/Y or (w/p) . (L /Y)
• Substituting the value of w/p from (2), the share of labour in Y (in the GDP) would equal (1- α) .

This is an interesting result. It affirms that the parameters of the Cobb-Douglas production function, 1- α
and α, are non other than the shares of labour and capital in total GDP. Empirically, the actual share of
labour in the GDP was found to be about 2/3 in the US. This means that (1- α ) = 2/3, and therefore the
share of capital in the GDP is α = 1/3.

•The production function becomes then Y = AK1/3 . L2/3.

• Logarithmically this can be written as: lnY = ln A + 1/3 ln K + 2/3 ln L.
• Thus, income growth during a certain period should match the growth in capital weighted by the share of
capital in the GDP (1/3) plus the growth rate of the deployed labour weighted by its share in the GDP (2/3).

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Once we know the extra amounts of K and L deployed, the production function Y = A K 1/3 . L2/3 gives
the increase in Y (or GDP) due from the extra inputs. However, when the actual past growth rates of all the
three variables, Y, K and L are inserted, the exercise can help us to test the accuracy of the equation, or to
estimate the effects of other variables (not necessarily cited in the function), on the growth of GDP.
When actual historic growth rates of capital, labour and GDP in the US, for the period 1890-1995, were
inserted in the production function, it appeared that some 55% of the actual growth in the GDP was not
explained by the function, i.e. was neither due from deployment of more capital or more labour.

This unexplained growth is called Solow’s Residual: the portion of actual growth in GDP which is not
explained by the use of more inputs. Solow referred to it as “a measure of our ignorance”. Economists argue
that this unexplained growth results from improvements in total factor productivity (TFP). The increases in
TFP refer to improvements in efficiency, in inputs’ productivities. The efficiency gains allow for producing
more output from the use of the same amounts of inputs.

•Several empirical studies have been conducted (on basis of the above explained methodology) to figure out
the sources of actual growth in various parts of the world.
•For example, average annual growth rate in Latin America during 1944-85 was 5.3%. The sources of this
growth were as follow:

Needless to say that the TFP is the most critical factor in determining long term growth, since all societies
will confront ultimate limits on the amounts of labour and capital they can deploy. Some studies argued
recently that the Asian Miracle was not much of a miracle because the remarkable growth of the South-East
Asian countries was not generated by TFP increase. For an overview of growth accounting in the LDCs see
Agénor et. al. (1996) chapter 15.

Growth trends and driving factors with the Solow framework

Insights from the growth accounting framework (Jorgenson, 2001, U.S.)

Sources of average labour productivity growth

0
1948-1973 1973-1990 1990-1995 1995-1999

labour quality non-IT capital deepening

IT capital deepening non-IT productivity
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IT productivity
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 Convergence
One of the most important implications of the neoclassical growth model is the convergence hypothesis:
•Absolute convergence: poorer countries (i.e. regions with lower k, thus lower per-capita income y) will
grow faster than richer countries until they reach their steady states. Thus, the levels of per-capita income in
various countries will converge .
•Conditional convergence: when countries are reasonably close to their steady states, the country which is
further away from k* will grow faster than the one which is closer. This is a weaker proposition than the
earlier because it allows, under some conditions, rich countries to grow faster than the poor.

Numerous empirical studies are devoted to test these hypothesis. The results are mixed: convergence is well
documented with respect to regions in a single country. Also the conditional convergence is more or less
proved among the rich countries, although at a much slower rate than predicted by the model. As to the
LDCs, the difficulties of identifying the steady state (at which per-capita income?) in each country lead to
widely contradicting results. (see, for example, Mankiew, Romer & Weil, 1992)

Endogenous Growth Models

All the strong implications of the neoclassical growth model (policy irrelevance, convergence, steady states,
etc.) are results of one single assumption: the diminishing marginal productivity of capital. Endogenizing
technical progress (knowledge) in the model requires neutralizing this assumption: it opens the possibility
for continuous capital accumulation and for un-limited growth in per-capita income.

But neutralizing the diminishing marginal productivity of capital implies also that the production function
would exhibit then increasing returns to scale (rather than a constant returns when capital has diminishing
marginal product). The fact that production with increasing retunes is overly incompatible with the
competitive general equilibrium framework explains the reluctant of economists to explicitly endogenize
technical progress.

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In other words, to secure boundless growth (thus no inevitable convergence), a non-diminishing (increasing
or constant) capital productivity should be incorporated in the model. This can be done via introducing
technical progress and assuming that this progress depends on capital accumulation. Once this is done, the
production function (with capital, labour and technical progress as inputs) would exhibit increasing returns
to scale. With increasing returns, perfect competitive solution (where products are priced at their marginal
production costs, and production factors are rewarded in accordance with their marginal productivities)
cannot be secured.

Endogenous growth: two approaches

In their attempts to endogenize growth (and thus neutralize the diminishing marginal productivity of
capital), economists have followed two different approaches: The first approach (AK models) neutralize
the diminishing marginal productivity of capital while maintaining the overall environment of perfect
competitive equilibrium. The second, endogenized growth and abandoned perfect competition altogether.

The AK models. Allowing for increasing returns while the norms of competitive equilibrium are
maintained is done in a somewhat ”tricky” manner. The approach assumes that capital has two different
effects on output: a direct (private) effect which is rewarded by the usual marginal productivity, and an
indirect social effect. The social effect is a by-product, accidental and unintended by those who make
investment decisions. This by-product effect leads to higher capital productivity for the economy as a whole
and eliminate the diminishing returns. The indirect effect works either via improving investment
effectiveness (Phelps’s “embodied technical progress”), or via improving labour effectiveness (Arrow’s
”learning by doing”) or via cultivating the ”human capital” (Lucas model). These models attempt then to
solve the dilemma between the increasing returns and the competitive equilibrium by suggesting that
private investment decisions correspond with externalities, in form of technical progress which benefits the
economy as a whole. Capital is thus rewarded by its (direct) marginal productivity, although its total
productivity is much higher. This approach is known as AK, because it suggests a production function of
the type Y = AK, with no diminishing marginal product or inevitable convergence.

The AK approach was successful in escaping the strong, and probably unrealistic, implications of Solow’s
model. It also allowed public policies to play a role in affecting growth (in encouraging investment of high
‘social’ returns). Yet, its treatment of the problem remained highly problematic and not totally convincing.,

A true endogenous growth approach. The second approach abandoned the competitive framework
explicitly (Romer, Grossman & Helpman). Technical progress (or knowledge) is taken here explicitly as a
separate and independent production factor, rather than as an accidental by-product. Knowledge (ideas) has
its own stock and own production (generation) process. Investment in creating new ideas is a conscious
effort carried out by firms in order to acquire monopoly rent. The deployment of new ideas in producing
consumers goods has increasing returns, and therefore growth can be limitless and is internally regenerated.
The production and consumption of knowledge are substantially different than the case of other normal
goods. Creating new ideas requires high initial cost, but once discovered, using them and reproducing them
are almost costless. Consumption of ideas, is non-rivalrous, although potentially excludable (by patents).
These unique characteristics of producing and consuming knowledge violate the principles of marginal cost
pricing in the perfect competitive model.
The Significance of Endogenous Growth Theory
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”By placing technological change at the heart of the theory of growth, by postulating that the generation of
new knowledge results from conscious decisions by economic agents, and by highlighting the special
characteristics of this new knowledge, Romer is able to show that economic growth is no longer captive to
the saving ratio or to exogenous technology but can indeed be directly influenced by a conscious policy of
investment in new designs and, more generally, in knowledge-generating activities. In addition, because of
the special nature of knowledge itself, achieving growth may require specific policy intervention to promote
innovation. … Additional works is ... just beginning to enrich our understanding of the complex process of
growth and to explain the facts of recent growth experiences better: … That differences in growth rates can
persist for long periods of time, that globalization does promote growth, that large population size may not
be sufficient for economies of scale, that intra-industry trade among the developed countries is more
important than trade between developed and developing nations, that quality of human capital migrates
from areas where it is scarce to areas where it is abundant, and that the spread of technology corresponds to
the observed product cycle in international trade”. G. Abed, IMF

New growth theory

•New growth theory attempts to look inside the ‘black box’ of technological progress.
Is it exogenous, or is it influenced by the economic environment?
•Three key factors are R&D, openness to foreign ideas, human capital.
•Early models often predicted that growth in income per capita could continue in the long-run even in the
absence of population growth. Later models have attempted to do without this somewhat undesirable
growth effect of scale.
•Nonetheless, even if there are only levels effects of scale, policymakers should still pay attention.
Levels of income matter!
Why Increasing Returns Makes Sense
•Geographical effects of technology
–Areas where technology initially develops may have increasing returns
•Hollywood, the Tropics
•Learning by doing
–The more one does something, the more productive one becomes
•Textiles in Bangladesh, toys in China
•Agglomeration effects
–Concentration of similar firms increases the productivity for all area firms
•Silicon Valley, Liverpool
New growth evidence
•This lecture surveys the evidence on economic growth performance across the world. It examines 4 issues:
•Development as Freedom, Growth Miracles and Disasters:
–Does growth matter? Who has done well and badly?
•Growth Accounting, R&D Accounting and Standing on Shoulders:
–How can you account for growth?
•Convergence, Galton’s Fallacy and Twin Peaks;
–Do countries converge? How can you measure convergence?
•Two Million Regressions and the Correlates of High Income.
–What factors are correlated with rapid growth and high income?

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Mauritious: Growth Theory and Growth Empirics

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