Macroeconomics analysis II, EC3102

Tutorial 2 Solution
Question 1

a. The profit functions for all the periods are:

𝜌𝜌1 = 𝑃𝑃1 𝑓𝑓(𝑘𝑘1 , 𝑛𝑛1 ) − 𝑃𝑃1 [𝑘𝑘2 − (1 − 𝛿𝛿)𝑘𝑘1 ] − 𝑃𝑃1 𝑤𝑤1 𝑛𝑛1
𝜌𝜌2 = 𝑃𝑃2 𝑓𝑓(𝑘𝑘2 , 𝑛𝑛2 ) − 𝑃𝑃2 [𝑘𝑘3 − (1 − 𝛿𝛿)𝑘𝑘2 ] − 𝑃𝑃2 𝑤𝑤2 𝑛𝑛2
𝜌𝜌3 = 𝑃𝑃3 𝑓𝑓(𝑘𝑘3 , 𝑛𝑛3 ) − 𝑃𝑃3 [𝑘𝑘4 − (1 − 𝛿𝛿)𝑘𝑘3 ] − 𝑃𝑃3 𝑤𝑤3 𝑛𝑛3
…
𝜌𝜌𝑖𝑖 = 𝑃𝑃𝑖𝑖 𝑓𝑓(𝑘𝑘𝑖𝑖 , 𝑛𝑛𝑖𝑖 ) − 𝑃𝑃𝑖𝑖 [𝑘𝑘𝑖𝑖+1 − (1 − 𝛿𝛿)𝑘𝑘𝑖𝑖 ] − 𝑃𝑃𝑖𝑖 𝑤𝑤𝑖𝑖 𝑛𝑛𝑖𝑖
…

The dynamic profit function is given as:

𝜌𝜌2 𝜌𝜌3 𝜌𝜌4
Π(choice variables) = 𝜌𝜌1 + + + +⋯
1 + 𝑖𝑖1 (1 + 𝑖𝑖1 )(1 + 𝑖𝑖2 ) (1 + 𝑖𝑖1 )(1 + 𝑖𝑖2 )(1 + 𝑖𝑖3 )

b.

The firm will maximize the sum of the present values of profit. So the maximization problem would
be:
𝜌𝜌2 𝜌𝜌3 𝜌𝜌4
𝑀𝑀𝑀𝑀𝑀𝑀 Π(choice variables) = 𝜌𝜌1 + + + +⋯
1 + 𝑖𝑖1 (1 + 𝑖𝑖1 )(1 + 𝑖𝑖2 ) (1 + 𝑖𝑖1 )(1 + 𝑖𝑖2 )(1 + 𝑖𝑖3 )
by choosing the values for choice variables
which are the relevant capitals and labours in each period

Comments:
- Here we need to be careful about the choice variables. Note that time 1 is analogous to the
present. Since the firm decided the amount of investment for time 1 in the past (as firms
usually do), the present capital level, 𝑘𝑘1 , therefore, is fixed – that is, the firm should not
decide 𝑘𝑘1 again. But the capital levels from period 2 onwards need to be decided by the firm.
- Meanwhile, the firm can decide on the hiring as it operates in each period. As such, the firm
need to decide the present level of labour, 𝑛𝑛1 .
- So, the choice variables are 𝑘𝑘2 , 𝑘𝑘3 … and 𝑛𝑛1 , 𝑛𝑛2 … (Please take note of the time indices)
- To discount a profit in period 𝑖𝑖, we need to divide by the compound interest rate from period
1 (or now) to period 𝑗𝑗. This is reasonable because if we invest $1 today, after 𝑗𝑗 periods, we
will earn a compounding value equal to $1 ⋅ (1 + 𝑖𝑖1 ) ⋅ (1 + 𝑖𝑖2 ) ⋅ … ⋅ (1 + 𝑖𝑖𝑗𝑗 ). Or you can say
that the present value of $1 ⋅ (1 + 𝑖𝑖1 ) ⋅ (1 + 𝑖𝑖2 ) ⋅ … ⋅ �1 + 𝑖𝑖𝑗𝑗 � is $1. We can write (1 + 𝑖𝑖1 ) ⋅
(1 + 𝑖𝑖2 ) ⋅ … ⋅ �1 + 𝑖𝑖𝑗𝑗 � = ∏𝑗𝑗𝑡𝑡=1(1 + 𝑖𝑖𝑗𝑗 ). Where ∏ is the product symbol, just as ∑ the
summation. But you don’t need to use ∏ in this course.
The formal way of writing the maximization is:
𝜌𝜌2 𝜌𝜌3 𝜌𝜌𝑗𝑗
𝑀𝑀𝑀𝑀𝑀𝑀 𝜌𝜌1 + + + ⋯+ +⋯
𝑘𝑘2 ,𝑘𝑘3 … 1 + 𝑖𝑖1 (1 + 𝑖𝑖1 )(1 + 𝑖𝑖2 ) (1 + 𝑖𝑖1 )(1 + 𝑖𝑖2 ) … (1 + 𝑖𝑖𝑗𝑗 )
𝑛𝑛1 ,𝑛𝑛2 …

Substituting profits, 𝜌𝜌𝑖𝑖 , with the formulas

𝑀𝑀𝑀𝑀𝑀𝑀 {𝑃𝑃1 𝑓𝑓(𝑘𝑘1 , 𝑛𝑛1 ) − 𝑃𝑃1 [𝑘𝑘2 − (1 − 𝛿𝛿)𝑘𝑘1 ] − 𝑃𝑃1 𝑤𝑤1 𝑛𝑛1 }
𝑘𝑘2 ,𝑘𝑘3 …
𝑛𝑛1 ,𝑛𝑛2 …
𝑃𝑃2 𝑓𝑓(𝑘𝑘2 , 𝑛𝑛2 ) − 𝑃𝑃2 [𝑘𝑘3 − (1 − 𝛿𝛿)𝑘𝑘2 ] − 𝑃𝑃2 𝑤𝑤2 𝑛𝑛2
+
1 + 𝑖𝑖1
𝑃𝑃3 𝑓𝑓(𝑘𝑘3 , 𝑛𝑛3 ) − 𝑃𝑃3 [𝑘𝑘4 − (1 − 𝛿𝛿)𝑘𝑘3 ] − 𝑃𝑃3 𝑤𝑤3 𝑛𝑛3
+
(1 + 𝑖𝑖1 )(1 + 𝑖𝑖2 )
+⋯
As usual, in order to maximize a function, we need to identify the variables (or the choice variables)
in this case. Let’s work out the FOC w.r.t (with respect to) 𝑘𝑘2 .

That is:
𝑃𝑃1 𝑓𝑓(𝑘𝑘1 , 𝑛𝑛1 ) − 𝑃𝑃1 [𝒌𝒌𝟐𝟐 − (1 − 𝛿𝛿)𝑘𝑘1 ] − 𝑃𝑃1 𝑤𝑤1 𝑛𝑛1
⎧ ⎫
⎪ + 𝑃𝑃2 𝑓𝑓(𝒌𝒌𝟐𝟐 , 𝑛𝑛2 ) − 𝑃𝑃2 [𝑘𝑘3 − (1 − 𝛿𝛿)𝒌𝒌𝟐𝟐 ] − 𝑃𝑃2 𝑤𝑤2 𝑛𝑛2 ⎪
1 + 𝑖𝑖1
⎨ 𝑃𝑃 𝑓𝑓(𝑘𝑘 , 𝑛𝑛 ) − 𝑃𝑃 [𝑘𝑘 − (1 − 𝛿𝛿)𝑘𝑘 ] − 𝑃𝑃 𝑤𝑤 𝑛𝑛 ⎬
⎪+ 3 3 3 3 4 3 3 3 3
+ ⋯ ⎪
𝜕𝜕Π(𝑘𝑘2 , 𝑘𝑘3 , 𝑘𝑘4 … ; 𝑛𝑛1 , 𝑛𝑛2 , 𝑛𝑛3 … ) ⎩ (1 + 𝑖𝑖1 )(1 + 𝑖𝑖2 ) ⎭
= 𝜕𝜕 =0
𝜕𝜕𝑘𝑘2 𝜕𝜕𝑘𝑘2

Comment: Though it looks very complicated but actually the above partial differentiation is rather
simple. We just need to find and partially differentiate the terms that involve 𝑘𝑘2 . Those terms which
do not include 𝑘𝑘2 , when partially differentiated with respect to 𝑘𝑘2 , will become zeros.

𝜕𝜕Π(𝑘𝑘2 , 𝑘𝑘3 , 𝑘𝑘4 … ; 𝑛𝑛1 , 𝑛𝑛2 , 𝑛𝑛3 … ) 𝑃𝑃2 𝜕𝜕𝜕𝜕(𝑘𝑘2 , 𝑛𝑛2 ) 1

= −𝑃𝑃1 + � + 𝑃𝑃2 (1 − 𝛿𝛿)� =0
𝜕𝜕𝑘𝑘2 𝜕𝜕𝑘𝑘2 1 + 𝑖𝑖
𝑃𝑃2 𝜕𝜕𝜕𝜕(𝑘𝑘2 , 𝑛𝑛2 ) 1
𝑃𝑃1 = � + 𝑃𝑃2 (1 − 𝛿𝛿)�
𝜕𝜕𝑘𝑘2 1 + 𝑖𝑖
dividing both sides by P2 and multiplying both side by (1 + i1 )
𝑃𝑃1 𝜕𝜕𝜕𝜕(𝑘𝑘2 , 𝑛𝑛2 )
(1 + 𝑖𝑖1 ) = + (1 − 𝛿𝛿)
𝑃𝑃2 𝜕𝜕𝑘𝑘2
1
(1 + 𝑖𝑖1 ) ⋅ = 𝑓𝑓1 (𝑘𝑘2 , 𝑛𝑛2 ) + (1 − 𝛿𝛿)
1 + 𝜋𝜋2
Using Fisher equation, we can rewrite:
1 + r1 = 𝑓𝑓1 (𝑘𝑘2 , 𝑛𝑛2 ) + 1 − 𝛿𝛿
 𝜕𝜕𝜕𝜕(𝑘𝑘2 ,𝑛𝑛2 )
Comment: In mathematical notation, we can write 𝜕𝜕𝑘𝑘2
as 𝑓𝑓𝟏𝟏 (𝑘𝑘2 , 𝑛𝑛2 ) – which means

differentiation of function 𝑓𝑓(𝑘𝑘2 , 𝑛𝑛2 ) with respect to the first (thus, the number 1) argument. We can
write it as 𝑓𝑓𝒌𝒌𝟐𝟐 (𝑘𝑘2 , 𝑛𝑛2 ) as well. Note this is a notation, mathematical language that one needs to
know.

Likewise we can work out the FOC of 𝑘𝑘3 :

𝑃𝑃1 𝑓𝑓(𝑘𝑘1 , 𝑛𝑛1 ) − 𝑃𝑃1 [𝑘𝑘2 − (1 − 𝛿𝛿)𝑘𝑘1 ] − 𝑃𝑃1 𝑤𝑤1 𝑛𝑛1
⎧ ⎫
⎪ 𝑃𝑃 𝑓𝑓(𝑘𝑘2 , 𝑛𝑛2 ) − 𝑃𝑃2 [𝒌𝒌𝟑𝟑 − (1 − 𝛿𝛿)𝑘𝑘2 ] − 𝑃𝑃2 𝑤𝑤2 𝑛𝑛2 ⎪
+ 2 1 + 𝑖𝑖1
⎨ 𝑃𝑃 𝑓𝑓(𝒌𝒌 , 𝑛𝑛 ) − 𝑃𝑃 [𝑘𝑘 − (1 − 𝛿𝛿)𝒌𝒌 ] − 𝑃𝑃 𝑤𝑤 𝑛𝑛 ⎬
⎪+ 3 𝟑𝟑 3 3 4 𝟑𝟑 3 3 3
+ ⋯ ⎪
𝜕𝜕Π(𝑘𝑘2 , 𝑘𝑘3 , 𝑘𝑘4 … ; 𝑛𝑛1 , 𝑛𝑛2 , 𝑛𝑛3 … ) ⎩ (1 + 𝑖𝑖1 )(1 + 𝑖𝑖2 ) ⎭
= 𝜕𝜕 =0
𝜕𝜕𝑘𝑘3 𝜕𝜕𝑘𝑘3
𝑃𝑃3 𝜕𝜕𝜕𝜕(𝑘𝑘3 , 𝑛𝑛3 )
𝑃𝑃2 � + 𝑃𝑃3 (1 − 𝛿𝛿)�
𝜕𝜕𝑘𝑘3
− + =0
1 + 𝑖𝑖1 (1 + 𝑖𝑖1 )(1 + 𝑖𝑖2 )

𝑃𝑃3 𝜕𝜕𝜕𝜕(𝑘𝑘3 , 𝑛𝑛3 )

−𝑃𝑃2 (1 + 𝑖𝑖2 ) + + 𝑃𝑃3 (1 − 𝛿𝛿) = 0
𝜕𝜕𝑘𝑘3
𝑃𝑃3 𝜕𝜕𝜕𝜕(𝑘𝑘3 , 𝑛𝑛3 )
𝑃𝑃2 (1 + 𝑖𝑖2 ) = + 𝑃𝑃3 (1 − 𝛿𝛿)
𝜕𝜕𝑘𝑘3
𝑃𝑃2 𝜕𝜕𝜕𝜕(𝑘𝑘3 , 𝑛𝑛3 )
(1 + 𝑖𝑖2 ) = + (1 − 𝛿𝛿)
𝑃𝑃3 𝜕𝜕𝑘𝑘3
1 + 𝑖𝑖2 𝜕𝜕𝜕𝜕(𝑘𝑘3 , 𝑛𝑛3 )
= + (1 − 𝛿𝛿)
1 + 𝜋𝜋3 𝜕𝜕𝑘𝑘3
𝜕𝜕𝜕𝜕(𝑘𝑘3 , 𝑛𝑛3 )
1 + 𝑟𝑟2 = + 1 − 𝛿𝛿
𝜕𝜕𝑘𝑘3
𝜕𝜕𝜕𝜕(𝑘𝑘3 , 𝑛𝑛3 )
𝑟𝑟2 = − 𝛿𝛿 = 𝑓𝑓1 (𝑘𝑘3 , 𝑛𝑛3 ) − 𝛿𝛿
𝜕𝜕𝑘𝑘3
𝑟𝑟2 + 𝛿𝛿 = 𝑓𝑓1 (𝑘𝑘3 , 𝑛𝑛3 )

From () and (), we can observe pattern in the result here. You can work out similar expressions for
𝑟𝑟3 , 𝑟𝑟4 , … but you do not have to, because the pattern applies to all, that is:

𝑟𝑟𝑡𝑡−1 + 𝛿𝛿 = 𝑓𝑓1 (𝑘𝑘𝑡𝑡 , 𝑛𝑛𝑡𝑡 )

The real interest rate of the period t-1 (or 𝑟𝑟𝑡𝑡−1 ) investment plus the depreciation rate is equal to the
marginal productivity of capital in period t, 𝑓𝑓1 (𝑘𝑘𝑡𝑡 , 𝑛𝑛𝑡𝑡 ). This result is intuitive because 𝑟𝑟𝑡𝑡−1 + 𝛿𝛿 is the
marginal cost of capital (rental rate for each unit of capital) while 𝑓𝑓1 (𝑘𝑘3 , 𝑛𝑛3 ) (or 𝑀𝑀𝑀𝑀𝑀𝑀 of period 3) is
the marginal benefit of capital; so in each period, the firm maximises the period’s profit using very
famous principle in economics MB=MC.

Likewise we can work out the FOC of 𝑛𝑛1 :

𝑃𝑃1 𝑓𝑓(𝑘𝑘1 , 𝒏𝒏𝟏𝟏 ) − 𝑃𝑃1 [𝑘𝑘2 − (1 − 𝛿𝛿)𝑘𝑘1 ] − 𝑃𝑃1 𝑤𝑤1 𝒏𝒏𝟏𝟏

⎧ ⎫
⎪ 𝑃𝑃 𝑓𝑓(𝑘𝑘2 , 𝑛𝑛2 ) − 𝑃𝑃2 [𝒌𝒌𝟑𝟑 − (1 − 𝛿𝛿)𝑘𝑘2 ] − 𝑃𝑃2 𝑤𝑤2 𝑛𝑛2 ⎪
+ 2 1 + 𝑖𝑖1
⎨ 𝑃𝑃 𝑓𝑓(𝒌𝒌 , 𝑛𝑛 ) − 𝑃𝑃 [𝑘𝑘 − (1 − 𝛿𝛿)𝒌𝒌 ] − 𝑃𝑃 𝑤𝑤 𝑛𝑛 ⎬
⎪+ 3 𝟑𝟑 3 3 4 𝟑𝟑 3 3 3
+ ⋯ ⎪
𝜕𝜕Π(𝑘𝑘2 , 𝑘𝑘3 , 𝑘𝑘4 … ; 𝑛𝑛1 , 𝑛𝑛2 , 𝑛𝑛3 … ) ⎩ (1 + 𝑖𝑖1 )(1 + 𝑖𝑖2 ) ⎭
= 𝜕𝜕 =0
𝜕𝜕𝑛𝑛1 𝜕𝜕𝑛𝑛1
𝑃𝑃1 𝜕𝜕𝜕𝜕(𝑘𝑘1 , 𝑛𝑛1 )
− 𝑃𝑃1 𝑤𝑤1 = 0
𝜕𝜕𝑛𝑛1
𝜕𝜕𝜕𝜕(𝑘𝑘1 , 𝑛𝑛1 )
= 𝑤𝑤1
𝜕𝜕𝑛𝑛1

Thus, we have: 𝑤𝑤1 = 𝑓𝑓2 (𝑘𝑘1 , 𝑛𝑛1 ). We can see here the MB=MC appears here as well. 𝑤𝑤1 is the wage
rate or the cost of hiring one extra unit of labour – in other words, marginal cost (MC) whereas
𝑓𝑓2 (𝑘𝑘1 , 𝑛𝑛1 ) is the marginal benefit gained from employing one extra unit of labour (MB).

Again, you can work out the FOCs for 𝑛𝑛2 , 𝑛𝑛3 and so on but that is not necessary because the pattern,
𝑤𝑤𝑡𝑡 = 𝑓𝑓2 (𝑘𝑘𝑡𝑡 , 𝑛𝑛𝑡𝑡 ) applies to all periods in the decision of hiring labour.

Question 2

Given that the representative firm uses the Cobb-Douglas production function:
𝛼𝛼 1−𝛼𝛼𝑡𝑡
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 = 𝐴𝐴𝑡𝑡 𝑓𝑓(𝑘𝑘𝑡𝑡 , 𝑛𝑛𝑡𝑡 ) = 𝐴𝐴𝑡𝑡 𝐾𝐾𝑡𝑡 𝑡𝑡 𝑛𝑛𝑡𝑡 (1)

Given that real wage rates and real interest rates remain unchanged (assuming zero depreciation),
for profit maximization, the marginal product of capital must equate the real interest rate for each
period. That is:
𝛼𝛼 −1 1−𝛼𝛼𝑡𝑡
𝑀𝑀𝑀𝑀𝐾𝐾𝑡𝑡 = 𝐴𝐴𝑡𝑡 𝛼𝛼𝑡𝑡 𝑘𝑘𝑡𝑡 𝑡𝑡 𝑛𝑛𝑡𝑡 = 𝑟𝑟𝑡𝑡 (2)

where t =1 for 20th century and, t=2 for 21st century, and r is the real interest rate for both periods.
Note that 𝛼𝛼 is also changing with time and thus we have a subscript 𝑡𝑡.

For profit maximization, the marginal product of labour must equate the real wage rate for each
period. That is:
𝛼𝛼 −𝛼𝛼𝑡𝑡
𝑀𝑀𝑀𝑀𝑁𝑁𝑡𝑡 = 𝐴𝐴𝑡𝑡 (1 − 𝛼𝛼)𝑘𝑘𝑡𝑡 𝑡𝑡 𝑛𝑛𝑡𝑡 = 𝑤𝑤𝑡𝑡 (3)

where t =1 for 20th century and, t=2 for 21st century, and 𝑤𝑤𝑡𝑡 is the real wage for both periods.
Comment: One key observation that needs to be made is:
𝛼𝛼 −1 1−𝛼𝛼𝑡𝑡
𝑀𝑀𝑀𝑀𝐾𝐾𝑡𝑡 ⋅ 𝑘𝑘𝑡𝑡 = 𝑟𝑟𝑡𝑡 ⋅ 𝑘𝑘𝑡𝑡 = 𝐴𝐴𝑡𝑡 𝛼𝛼𝑡𝑡 𝑘𝑘𝑡𝑡 𝑡𝑡 𝑛𝑛𝑡𝑡 ⋅ 𝑘𝑘𝑡𝑡
𝛼𝛼 1−𝛼𝛼𝑡𝑡
= 𝛼𝛼𝑡𝑡 𝐴𝐴𝑡𝑡 𝑘𝑘𝑡𝑡 𝑡𝑡 𝑛𝑛𝑡𝑡 = 𝛼𝛼𝑡𝑡 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑡𝑡𝑡𝑡 (4)

In the equation (3), 𝑟𝑟𝑡𝑡 . 𝑘𝑘𝑡𝑡 is the amount the economy has to pay for renting capital. Therefore, we can
say that the share of capital in output is:

𝑟𝑟𝑡𝑡 𝑘𝑘𝑡𝑡 𝛼𝛼𝑡𝑡 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑡𝑡𝑡𝑡

= = 𝛼𝛼𝑡𝑡
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑡𝑡𝑡𝑡 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑡𝑡𝑡𝑡

In the same manner, we can show that the share of labour in output is:
𝑤𝑤𝑡𝑡 𝑛𝑛𝑡𝑡 (1 − 𝛼𝛼𝑡𝑡 )𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑡𝑡𝑡𝑡
= = 1 − 𝛼𝛼𝑡𝑡
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑡𝑡𝑡𝑡 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑡𝑡𝑡𝑡

Due to the nature of the function (Cobb-Douglas) that we use for production function, the share of
capital in output is the exponent to the capital (𝛼𝛼𝑡𝑡 ) and the share of labour in output is the exponent
to the labour (1 − 𝛼𝛼𝑡𝑡 ) and the sum of the shares is equal to 1.

Here, the share of capital in output (and hence too the share of labour in output) is potentially time
varying. That is 𝛼𝛼1 need not equal 𝛼𝛼2 .

Hence the ratio for capital expenditure to labour expenditure at the time of 𝑡𝑡 is:
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑟𝑟𝑡𝑡 𝑘𝑘𝑡𝑡
=
𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑤𝑤𝑡𝑡 𝑛𝑛𝑡𝑡
𝛼𝛼 −1 1−𝛼𝛼
𝐴𝐴𝑡𝑡 𝛼𝛼𝑡𝑡 𝑘𝑘𝑡𝑡 𝑡𝑡 𝑛𝑛𝑡𝑡 𝑡𝑡 ⋅ 𝑘𝑘𝑡𝑡
= 𝛼𝛼 −𝛼𝛼
𝐴𝐴𝑡𝑡 (1 − 𝛼𝛼)𝑘𝑘𝑡𝑡 𝑡𝑡 𝑛𝑛𝑡𝑡 𝑡𝑡 ⋅ 𝑛𝑛𝑡𝑡
𝛼𝛼 1−𝛼𝛼𝑡𝑡
𝐴𝐴𝑡𝑡 𝛼𝛼𝑡𝑡 𝑘𝑘𝑡𝑡 𝑡𝑡 ⋅ 𝑛𝑛𝑡𝑡
= 𝛼𝛼 1−𝛼𝛼𝑡𝑡
𝐴𝐴𝑡𝑡 (1 − 𝛼𝛼)𝑘𝑘𝑡𝑡 𝑡𝑡 𝑛𝑛𝑡𝑡
𝛼𝛼𝑡𝑡
= (5)
1 − 𝛼𝛼𝑡𝑡
Note the question’s assumptions: total factor productivity 𝐴𝐴𝑡𝑡 , real wage 𝑤𝑤𝑡𝑡 and real interest rate 𝑟𝑟𝑡𝑡
did not change over the century, and firms use a larger ratio of capital to labour. That means:
𝑘𝑘2
𝑘𝑘2 𝑘𝑘1 𝑛𝑛2
> ⟹ >1
𝑛𝑛2 𝑛𝑛1 𝑘𝑘1
𝑛𝑛1
𝑘𝑘2 𝑟𝑟2 ⋅ 𝑘𝑘2 𝑟𝑟2 ⋅ 𝑘𝑘2
𝑛𝑛2 𝑤𝑤 𝑛𝑛 𝑤𝑤 𝑛𝑛
also, = 2 2 (∵ 𝑟𝑟2 = 𝑟𝑟1 and 𝑤𝑤2 = 𝑤𝑤1 ) ⟹ 2 2 > 1
𝑘𝑘1 𝑟𝑟1 ⋅ 𝑘𝑘1 𝑟𝑟1 ⋅ 𝑘𝑘1
𝑛𝑛1 𝑤𝑤1 ⋅ 𝑛𝑛1 𝑤𝑤1 ⋅ 𝑛𝑛1
 𝑟𝑟2 ⋅ 𝑘𝑘2 𝛼𝛼2
𝑟𝑟𝑡𝑡 𝑘𝑘𝑡𝑡 𝛼𝛼𝑡𝑡 𝑤𝑤2 𝑛𝑛2 1 − 𝛼𝛼2
and since = ⟹ = 𝛼𝛼 >1 (6)
𝑤𝑤𝑡𝑡 𝑛𝑛𝑡𝑡 1 − 𝛼𝛼𝑡𝑡 𝑟𝑟1 ⋅ 𝑘𝑘1 1
𝑤𝑤1 ⋅ 𝑛𝑛1 1 − 𝛼𝛼1

k2
n2 α α
Thus we can say that the reason for k1 > 1 is 1−α2 > 1−α1 , and:
2 1
n1

𝛼𝛼2 𝛼𝛼1
>
1 − 𝛼𝛼2 1 − 𝛼𝛼1

𝛼𝛼2 (1 − 𝛼𝛼1 ) 𝛼𝛼1 (1 − 𝛼𝛼2 )

⟹ >
(1 − 𝛼𝛼2 )(1 − 𝛼𝛼1 ) (1 − 𝛼𝛼1 )(1 − 𝛼𝛼2 )

⟹ 𝛼𝛼2 (1 − 𝛼𝛼1 ) > 𝛼𝛼1 (1 − 𝛼𝛼2 )

⟹ 𝛼𝛼2 > α1

k2
n2
Thus we can say that the reason for k1 > 1 is α2 > α1
n1
𝑘𝑘
Therefore, the reason for higher ratio of capital to labour, , in the 21st century – in other words,
𝑛𝑛
𝑘𝑘2 𝑘𝑘
𝑛𝑛2
> 𝑛𝑛1 is due to the increase in 𝛼𝛼 or in other words, the share of capital expenditure in GDP
1
production has increased from the 20th century to the 21st century. In terms of economics, this
means that in the early 21st century, capital plays a more “important” role in production process in
United States than labour as compared to that of the 20th century. This means that U.S. has become
more capital-intensive.

A plausible explanation to this change in the aggregate production include

- Outsourcing of labour intensive work to other countries

- Increase in the use of automations in production lines.