Review of Development Economics, 4(3), 365–375, 2000

Productive Consumption and Growth in

Developing Countries

Thomas M. Steger*

Abstract
Productive consumption enables the satisfaction of current needs and increases the productive potential of
labor. The productive-consumption hypothesis is of fundamental interest because it modifies the “harsh”
intertemporal consumption tradeoff traditionally assumed. The incorporation of the productive-
consumption hypothesis into a simple endogenous growth model reveals the following implications: (i) the
possibility of a poverty-trap; (ii) the rule of optimal consumption turns into a modified Keynes–Ramsey rule;
(iii) the (effective) IES is based on, inter alia, the technological opportunities to enhance human capital due
to productive consumption; (iv) a rising saving rate; and (v) transitional dynamics to an asymptotic balanced-
growth path.

1. Introduction
The common interest of nearly all development and growth theories is the fundamental
concept of a harsh intertemporal consumption tradeoff: current consumption
inevitably reduces future consumption possibilities in a with-or-without sense. This is
true for the early low-level equilibrium-trap theories (e.g., Nelson, 1956), the neoclas-
sical growth theory (e.g., Koopmans, 1965; Solow, 1956) as well as the endogenous
growth theories (e.g., Lucas, 1988; Romer, 1990).
In contrast, since the 1950s the possibility of productive consumption has been rec-
ognized within the development literature (Nurkse, 1953, 1962).1 Productive con-
sumption enables the satisfaction of current needs and, at the same time, increases the
productive potential of labor. As a consequence, the potential for the satisfaction of
future needs rises. Gersovitz (1988, pp. 394–400) distinguishes three forms of produc-
tive consumption: (i) nutrition, (ii) health effort, and (iii) education. All three forms
serve the satisfaction of current needs, and consequently can be labeled as consump-
tion expenditures; occasionally this might be assessed differently in the case of educa-
tion. Simultaneously, the productive potential of labor increases. From this point of
view, the underlying consumption expenditures can be classified as productive.
From the perspective of growth theory, the productive-consumption hypothesis
seems to be of fundamental interest because it systematically modifies the intertem-
poral consumption tradeoff. After reviewing empirical evidence for a positive nutri-
tion–productivity relation, Fogel (1994, pp. 385–6) stated: “Although largely neglected
by theorists of both the ‘old’ and the ‘new’ growth economics, these factors can easily
be incorporated into standard growth models.”2 The growth model presented in this
paper represents a first step to incorporating the productive-consumption hypothesis
into simple endogenous growth models and to analyzing the implications for capital
accumulation and growth in DCs.

* Steger: University of Ulm, Helmholtzstrasse 20, 89081 Ulm, Germany. Tel: ++49-(0)731-50-24264; Fax: ++49-
(0)731-50-24262; E-mail: steger@mathematik.uni-ulm.de. I would like to thank Martin Bohl, Lucas
Bretschger, Sunwoong Kim, Rainer Klump, two anonymous referees, and especially Karl-Josef Koch for
helpful comments. Naturally, I am solely responsible for all remaining errors. Support from the Friedrich-
Naumann Foundation is gratefully acknowledged.

© Blackwell Publishers Ltd 2000, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA
366 Thomas M. Steger

2. A Sketch of Productive Consumption in the Literature

The relation between labor productivity as well as output growth, on the one hand,
and nutrition, health, and education, on the other hand, has been analyzed empirically
mainly against the background of two different questions. (i) In the wake of the
traditional efficiency wage theory, it was attempted to uncover empirical evidence
supporting or refuting the impact of nutrition and health expenditures on labor
productivity within the framework of microeconomic empirical analyses (e.g.,
Behrman and Deolalikar, 1988). (ii) In the context of growth accounting, the contri-
bution of nutrition, health, and education to output growth was examined on a macro-
economic level (Hicks, 1979; Wheeler, 1980).
The implications of the productive-consumption hypothesis for consumption/saving
behavior has hardly been considered in the economic literature. Gersovitz (1983) rep-
resents an important exception. He discusses two complementary approaches, which
explicitly analyze the importance of productive consumption for consumption/saving
behavior within the framework of discrete two-period models. Both models are based
on the notion that consumption might have a second positive effect beside the direct
satisfaction of current needs.

3. A Linear Growth Model with Productive Consumption

The Human-Capital-Enhancement Function

The empirical studies investigating the relationship between labor productivity and
output growth, on the one hand, and nutrition, health, and education, on the other
hand, clarify two essential points. First, a rise in the level of nutrition, health, and edu-
cation increases the productive potential of labor. Second, with an increasing level of
nutrition, health, and education, the importance of the marginal effect concerning the
productive potential of labor decreases.
To analyze the implications of productive consumption in the context of growth,
the productive consumption effect is interpreted as enhancing the stock of human
capital. This hypothesis is specified in the form of a human-capital-enhancement
function. In its intensive form this concave and twice continuously differentiable
function reads:

k˙ h (t ) = f[ c (t )] - (d + n)kh (t ), with f ¢(c ) > 0 and f ¢¢(c ) < 0, (1)

where kh(t) denotes the stock of human capital per capita at time t, c(t) is consump-
tion per capita, d is the depreciation rate of human capital, and n is the population
growth rate. Equation (1) represents the equation of motion for the average stock of
human capital. As a result of productive consumption activities, the stock of human
capital per capita increases according to the function f[c(t)], while it decreases due to
depreciation and population growth. Consequently, f[c(t)] can be designated as the
gross human-capital-enhancement function. The hypothesis of productive consump-
tion in the form of equation (1) constitutes the crucial assumption for the growth model
presented in the next subsection.

The Model
A modified linear growth model extended by productive consumption is presented
in a general form. The representative consumer–producer household has access to a

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 PRODUCTIVE CONSUMPTION 367

one-sector production technology with capital (k) as the only input, which is employed
to produce an output good (y) that can be used universally for investment or
consumption purposes. The production function in its intensive form reads:

y(t ) = f [ k(t )] with f (0) = 0 and f ¢(k) = A. (2)

The absence of diminishing returns is crucial for the generation of endogenous

growth and can be justified mainly by two interpretations. First, capital is thought to
exhibit positive spillover effects; or, second, capital can be interpreted broadly. Fol-
lowing this second interpretation, capital is defined to encompass physical as well as
human capital. In addition, both types of capital can be additively aggregated if they
are assumed to be perfect substitutes in production:

k(t ) = k p (t ) + kh (t ). (3)

Physical capital per capita (kp) increases as a consequence of the renunciation of

consumption, taking into account the rate of depreciation (d ) as well as the rate of
population growth (n):

k˙ p (t ) = f [k(t )] - (d + n)k p (t ) - c(t ). (4)

Human capital per capita (kh) is formed by productive consumption; the equation
of motion for human capital equals the human-capital-enhancement function (1). The
gross human-capital-enhancement function f[c(t)] is assumed to be strictly concave
and twice continuously differentiable with asymptotically vanishing first and second
derivatives:

f ¢(c) > 0, f ¢¢(c) < 0, lim f ¢(c) = 0, lim f ¢¢(c) = 0. (5)

cƕ cƕ

Even though kp is called physical capital and kh is called human capital, technically
the key distinction between the two types of capital is that kp is produced on the basis
of the same technology which is used to produce consumption goods, and its accumu-
lation necessarily requires, at least in part, the renunciation of consumption; while kh
results from (productive) consumption. In this respect, kp could equally be interpreted
as physical and human capital which requires the renunciation of consumption for its
accumulation. Using the simplifying assumption of identical depreciation rates, the
equation of motion for the whole stock of capital per capita according to (3) reads as
follows:

k˙ (t ) = f [k(t )] - (d + n)k(t ) - y [c(t )],

y [c(t )] ∫ c(t ) - f [c(t )]. (6)

Usually, consumption is costly because it fully reduces net investments, that is the
accumulation of capital. In the present context, consumption partially contributes to
the accumulation of human capital. Consequently, y(c) can be designated as the net
cost of consumption (NCC), which consists in consumption less the human-capital-
enhancement effect of consumption.3
The representative household is assumed to maximize its dynastic lifetime utility.
The corresponding dynamic optimization problem is a concave, infinite-time problem
of optimal control with one control variable (c) and one state variable (k) as well as
a bounded control set:

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368 Thomas M. Steger

•
max Ú u[ c (t )]e -( r -n )t dt
{ c ( t )} 0

s.t. k˙ (t ) = f [ k(t )] - (d + n)k(t ) - y [ c (t )]

k(0) = k0 , k(t ) ≥ 0
0 £ c (t ) £ f [ k(t )], (7)

where u(c) denotes the instantaneous utility function and r the time preference rate.4
The instantaneous utility function is assumed to be strictly concave and to possess a
constant elasticity of the marginal utility (s), that is a constant intertemporal elas-
ticity of substitution (1/s).
The marginal NCC [y ¢(c) = 1 - f¢(c)] is negative as long as the marginal human-
capital-enhancement effect of consumption is greater than one. In this case, it clearly
makes no sense to refrain from consumption, and saving must be zero. Moreover, ratio-
nal individuals would try to dissave whenever this possibility arises. However, since
only human capital has been accumulated in the past and the transformation of human
capital into consumption goods seems to be impossible, the (state-dependent) inequal-
ity constraint on the control [c £ f(k)] must be imposed and will turn out to be effec-
tively binding at early stages of economic development.
In the following, three ranges are distinguished: the no-saving range, the transition
range, and the asymptotic range.

No-Saving Range
The first-order conditions of the maximization problem (7) imply a boundary solution
with c = f(k) if the following weak inequality holds:
u ¢(c ) ≥ ly ¢(c ). (8)

As long as the marginal utility of consumption exceeds the marginal NCC measured
in units of utility, an increase in consumption approaching the upper limit of the control
set [k ≥ 0, 0 £ c £ f(k)] seems to be rational.
Within the no-saving range, the evolution of the economy is determined by the equa-
tion of motion for capital (6), taking into account that saving is zero:

k˙ = f [ f (k)] - (d + n)k. (9)

As a consequence of the properties of the human-capital-enhancement function, the

differential equation in the capital stock (9) possesses a stable equilibrium whenever
d + n > 0. If the stationary value of capital lies inside the no-saving range, the economy
runs into a poverty-trap: Individuals do not save during this early stage of economic
development and no physical capital is accumulated. However, human capital is
created as a consequence of productive consumption activities. Because of the dimin-
ishing marginal human-capital-enhancement effect of consumption, the net human
capital accumulation decreases and may approach zero before the end of the no-saving
range is reached and the accumulation of physical capital sets in.
The growth rates of consumption and output are equal to the growth rate of capital:

c˙ y˙ k˙ f [ f (k)]
= = = - (d + n). (10)
c y k k

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 PRODUCTIVE CONSUMPTION 369

Transition Range
The first-order conditions imply an interior solution (0 < c < y) if the following
equality holds:5

u ¢(c) = ly ¢(c). (11)

As soon as the marginal utility of consumption equals the marginal NCC measured in
units of utility, the optimal trajectory runs into the interior of the open control set; pro-
vided that the poverty-trap did not become binding. Along the optimal trajectory,
equality (11) holds as a necessary optimum condition. Taking into account the defini-
tion of the marginal NCC as well as the concavity of the utility function, and compar-
ing (11) with the usual optimum condition [u¢(c) = l], it becomes clear that the level
of consumption is higher than in a situation without productive consumption effects.
The optimal growth rate of consumption reads:

c˙ 1
= ( f ¢(k) - d - r),
c s - hy (c)
cy ¢¢(c) cf ¢¢(c)
hy (c) ∫ - = < 0.6 (12)
y ¢(c) 1 - f ¢(c)

The evolution of the economy in the case of interior solutions is governed by

the differential equations in the state (6) and in the control (12). The second expres-
sion of the denominator on the right-hand side of (12) denotes the elasticity of
the marginal NCC with respect to consumption [hy(c)]. Corresponding to the nature
of the human-capital-enhancement function, hy(c) is negative while its absolute
value decreases with an increasing level of consumption and asymptotically
approaches zero.
Equation (12) represents the modified Keynes–Ramsey rule of optimal consump-
tion. The ratio on the right-hand side of (12) can be designated effective IES (eIES).
It is worth noting that the eIES is not exclusively determined by the instantaneous
utility function but that it is additionally dependent on the technological possibilities
to enhance the stock of human capital as a result of productive consumption. The eIES
expresses the willingness to substitute consumption intertemporally, taking into
account a change in the marginal utility as well as a change in the marginal NCC.
With respect to (12), one could argue that productive consumption has no impact
on growth rates if one only assumes the human-capital-enhancement function to imply
a constant elasticity of the marginal NCC. The class of human-capital-enhancement
functions which give rise to a constant elasticity of the marginal NCC has the follow-
ing form:
a1 1-h
f (c) = c - c + a2 , (13)
1-h

where a1 and a2 are some positive constants and h denotes the (constant) elasticity of
the marginal NCC. However, it can be shown that (13) cannot fulfill the requirements
of f¢(c) > 0 and f≤(c) < 0, stated in (5). The conventional case of consumption induc-
ing no productive effects at all can be considered as a special case with a1 = 1, a2 = 0,
and h = 0.
In order to give a clear economic interpretation of the modified Keynes–Ramsey
rule, equation (12) is slightly reworded to

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370 Thomas M. Steger

u ¢¢(c)c˙ y ¢¢(c)c˙
f ¢(k) = r + d - + . (14)
u ¢(c) y ¢(c)

The third term on the right-hand side of (14) is the percentage time rate of change
of the marginal utility which represents “the psychic cost of saving.” The last term on
the right-hand side is the percentage time rate of change of the marginal NCC. Holding
an additional unit of capital during a short interval of time causes a rising consump-
tion profile and induces a rise in the marginal NCC.
The saving rate is zero at the beginning of the transition process and can be shown
to converge asymptotically toward a positive constant, which equals the saving rate of
the original linear growth model.
What about the growth rate of income? Whether it decreases or increases seems not
to be unequivocal a priori. Differentiation of the growth rate of income with respect
to time yields

d k˙ d f (c) d c
= - . (15)
dt k dt k dt k
It can be shown that the first term on the right-hand side of (15) represents the time
rate of change of the growth rate of human capital, while the second term represents
the time rate of change of the growth rate of physical capital.

Asymptotic Range
The model does not possess a balanced-growth equilibrium defined by constant growth
rates. However, its asymptotic properties are characterized by the asymptotic
balanced-growth path (BGP•). Inside the interior of the control region, the optimal
trajectory asymptotically converges to this BGP•. In order to get an idea of the asymp-
totic behavior of the extended linear growth model, consider the growth rate of capital
as time approaches infinity and consumption as well as capital grow without bounds:

k˙ c f (c)
lim = f ¢(k) - d - n - lim + lim . (16)
tƕ k tƕ k tƕ k
The last term on the right-hand side of (16) eventually vanishes. With respect to the
relation between the asymptotic growth rate of consumption (g *) c and the asymptotic
growth rate of capital (g k*), three cases can be distinguished: (i) g *c < g k*, (ii) g *c > g k*,
and (iii) g *c = g k*.
It can be shown that neither case (i) nor case (ii) can be optimal. Consequently, the
only remaining possibility is case (iii). That is, the (unique) BGP• is characterized by
identical growth rates of consumption and capital. Equation (12) shows the asymptotic
growth rate of consumption, taking into account the disappearance of the elasticity of
the marginal NCC as time approaches infinity. The relation g *c = g k* together with the
production function (2) imply that all endogenous variables grow asymptotically with
the same growth rate:7
c˙ k˙ y˙
lim = lim = lim = s -1 ( f ¢(k) - d - r). (17)
tƕ c tƕ k tƕ y

In summary, Figure 1 sketches the phase diagram of the extended linear growth
model. The two rays starting from the origin represent. the production function and the
BGP•, respectively.The concave curve represents the k = 0 locus.The horizontal broken

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 PRODUCTIVE CONSUMPTION 371

Figure 1. Phase Diagram of the Linear Growth Model with Productive Consumption

line marks the level of consumption for which the marginal human-capital-
enhancement effect of consumption equals one. The region below this line necessarily
belongs to the no-saving range and the dynamics of the system is governed by (10) and
c = f(k). Starting with an initial stock of capital k0, which is chosen sufficiently small to
give rise to a boundary solution, the corresponding level of consumption, c0, is located
on the boundary of the control set. The optimal trajectory (equilibrium growth path,
EGP) moves along the production function to the north-east and enters into the inte-
rior of the control region as soon as the marginal utility of consumption equals the
marginal NCC measured in units of utility. However, if this critical point is located in
the north-east in relation to the poverty-trap coordinates (c̃, k̃ ), the economy would
run into a poverty-trap. Provided that the poverty-trap did not become binding, the
EGP enters into the interior of the control region and converges to the BGP• as time
approaches infinity.

4. Simulation Results
In order to illustrate the dynamics of the model, the transition process for an interior
solution is simulated. This signifies that the system of differential equations (6) and
(12) is approximated numerically. The following functions and parameter values are
employed: u(c) = (c1-s - 1)/(1 - s), f(k) = Ak, f(c) = cb, A = 0.1, s = 3, d = 0.02, r = 0.01,
n = 0.03, and b = 0.05 or 0.35. Figure 2 shows the time paths of the consumption/capital
ratio (c/k), the saving rate (s), the growth rate of capital (grk), and the elasticity of the
marginal NCC (h). Several points are worth noting.
First, all variables converge monotonically to their asymptotic balanced-growth-
equilibrium values. The speed of convergence measured by the use of the consump-
tion/capital ratio is l @ -ln(0.5)/15 @ 0.046. The broken line in Figure 2(a) shows the
time path of the consumption/capital ratio for the case of b = 0.35. The speed of

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372 Thomas M. Steger

Figure 2. Time Paths

convergence in this case is l @ -ln(0.5)/20 @ 0.035. Therefore, the speed of convergence

seems to be inversely related to the efficiency of the human-capital-enhancement
process.8
Second, Rebelo (1992) argues that an important shortcoming of a “broad class of
endogenous growth models” is that they cannot explain different growth experiences
in the presence of international capital markets. Provided that some symmetry with
respect to technology and preferences holds, all economies face the same real rate of
return and, consequently, exhibit the same rate of growth of income. The linear growth
model with productive consumption shows transitional dynamics which survive inter-
national capital markets and identical real rates of return.
Third, as Figure 2(b) demonstrates, the (gross) saving rate increases from zero at the
beginning of the transition and converges to its asymptotic balanced-growth value. The
rising time path of the saving rate in turn implies a positive correlation between
the saving rate and income as shown by Figure 3; based on b = 0.05. The empirical evi-
dence in favor of a positive correlation between the saving rate and the level of income
is overwhelming (Ogaki et al., 1996; Rebelo, 1992).
Fourth, the growth rate of capital (and thus income) decreases during the transition
process (Figure 2(c)). This result is somewhat surprising. Intuitively, a rising saving rate
induces two effects on the growth rate of capital. First, as time proceeds a rising portion
of output (saving rate) is used for gross physical capital investments; and second, a
falling portion of output (consumption rate) can be used for gross human-capital-
enhancements due to productive consumption. As the marginal human-capital-
enhancement effect of consumption is smaller than one for interior solutions, one
would at first glance expect that the first effect dominates over the second. However,
as (15) indicates, the crucial point is whether the time rate of change of the human-
capital component exceeds the time rate of change of the physical-capital component.

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 PRODUCTIVE CONSUMPTION 373

Figure 3. The Savings Function

Obviously, Figure 2(c) shows that in the present case the model implies (conditional)
b-convergence.
Fifth, Figure 2(d) shows the elasticity of the marginal NCC which is negative and
asymptotically converges to zero. As a consequence, according to (12) the eIES is low
at early stages of economic development, increases and asymptotically approaches a
constant. Note that for boundary solutions the IES is effectively zero (equation (10)).
Several authors have reported empirical evidence in favor of IES values which do not
significantly differ from zero in the case of low-income countries (Giovannini, 1985)
as well as empirical evidence in favor of a positive relation between the IES and
income (Ogaki et al., 1996).
Sixth, King and Rebelo (1993, p. 908) express very clearly a well-known quantita-
tive problem of the neoclassical growth model: “Generally, when one tries to explain
sustained economic growth with transitional dynamics, there are extremely counter-
factual implications. These result from the fact that implied marginal products are
extraordinarily high in the early stages of development.” The extended linear growth
model with productive consumption does not bear this implication. Sustained eco-
nomic growth with transitional dynamics is compatible with a constant marginal
product of the reproducible factors.

5. Summary and Conclusion

Empirical evidence clearly indicates that productive inputs are not exclusively accu-
mulated as a result of the renunciation of consumption. Especially at early stages of
economic development, consumption can, in a specific sense, be regarded as a source
of the accumulation of a productive input (human capital) and thus output growth.
The model presented above sheds some light on the importance and implications of
productive consumption, capital accumulation, and growth in DCs. Specifically, the
incorporation of the productive-consumption hypothesis into a simple endogenous
growth model reveals the following implications:
1. The harsh intertemporal consumption tradeoff traditionally assumed is modified;
the rule of optimal consumption turns into a modified Keynes–Ramsey rule.
2. The technological opportunities to enhance the stock of human capital addition-
ally determine the effective IES (eIES). Consequently, the eIES consists in the

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374 Thomas M. Steger

elasticity of marginal utility as well as the elasticity of the marginal net cost of
consumption.
3. As Gersovitz (1983) has demonstrated within the framework of discrete two-period
models, the saving rate increases with income if consumption is productive. In con-
trast to Gersovitz, this is shown within the framework of a continuous growth model
and no special parameter restrictions are necessary for this result.
4. The model does not imply unrealistically high values of the marginal product of
capital for low incomes like the neoclassical growth model (King and Rebelo, 1993).
Neither are identical real rates of return across economies due to international
capital markets inconsistent with diverging growth rates for different countries
(Rebelo, 1992).

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Notes
1. In addition, see Gersovitz (1983) and Wheeler (1980).
2. To the best of my knowledge the only exception is Wichmann (1996), who formulates a
two-sector growth model with the labor efficiency being dependent on nutrition. However,
Wichmann interprets the nutrition–productivity relation as an external effect which is not rele-
vant for the individual choice of an optimal consumption path. Therefore, this model does not
capture the crucial point considered in this paper, which is the modification of the harsh
intertemporal consumption tradeoff.
3. I thank Karl-Josef Koch for suggesting the clarifying expression “net cost of consumption.”
4. In order to simplify the notation the time index is suppressed in the following.
5. The third possibility of c = 0 would require u¢(c) £ ly¢(c). On account of the characteristics
of the utility function and the human-capital-enhancement function as well as a positive shadow
price of capital, the case of c = 0 does not emerge.
6. The validity of the so-called growth condition f ¢(k) > r + d is assumed. Equation (12) is valid
only for an interior solution, where the marginal NCC must be smaller than one. Consequently,
the denominator of hy(c) cannot become negative and hy(c) is well defined.
7. The production function is assumed to be sufficiently productive to guarantee permanent
growth, and overall utility is assumed to be bounded. This requires: f ¢(k) - d > r > [(1 -
s)/s](f ¢(k) - d - r) + n (Barro and Sala-i-Martin, 1995, p. 142).
8. A possible economic explanation for this result is as follows. The higher the marginal human-
capital-enhancement effect of consumption, the stronger is the bias against saving. Consequently,
because the marginal human-capital-enhancement effect of consumption is smaller than one for
interior solutions, the accumulation of (physical and human) capital is smaller on balance.

© Blackwell Publishers Ltd 2000