Problem Set #1.

a. From the file “dataset for problem set 1.xls” get the data series for the real investment
rate (ki) and GDP per worker (rgdpwok) for every country in 2003. You can delete the
observations for which the data is missing. Plot the investment rate (on the y-axis)
against the log of GDP per worker (on the x-axis). Do poor countries have higher or
lower investment rates compared to rich countries?

b. Let's assume that the return to capital may be different across countries, but is
constant for a given country (this is not always a realistic assumption but is a useful
shortcut). Under the assumption that g = 0.02 (2 percent), the depreciation rate is .1 (10
percent), calculate the productivity of capital (Y/K) for each country. Plot Y/K (on the y-
axis) against the log of GDP per worker (on the x-axis). Is the productivity of capital
higher in poor countries or in rich countries? Can you explain why and what it tells you?

c. Now read “Capital Productivity: Why the US Leads And Why It Matters,” McKinsey
Quarterly 1996.” Focus on pages. 39-43. Suppose that output in Germany, Japan, and
the US is given by Y  AK  L1 . Show that output per worker can be written as

Y K
 A   (this is straight from your class notes). The McKinsey team calls A “total
L L
factor productivity” and K/L “total factor input per capita.” (See exhibit 1).

d. McKinsey then argues that we can decompose total factor productivity (what we call
“A”) into “labor productivity” and “capital productivity”. The definition of labor
productivity is Y/L and the definition of capital productivity is Y/K. Show that total
factor productivity can be written as:

1 
Y  Y 
A   
L K

This derivation seems to imply that a high productivity of capital (Y/K) increases total
factor productivity and thus presumably output per worker. Yet in b), you should have
shown that it is the poor countries that have a high productivity of capital. Can you
reconcile your findings with the logic of the McKinsey team?

e. Use your class notes to show that if the return to capital is equal to the cost of capital
then we can show the following: (1) the capital labor ratio (K/L) can be written as a
function of total factor productivity (A), the cost of capital R, and α and ; (2) productivity
of capital (Y/K) can be written as a function of R and α. Explain the intuition behind
these two expressions.

f. Assume that  is the same in the three countries and that the cost of capital in the US
is 9.1 percent. What is the cost of capital in Germany and Japan if the “capital
productivity” in Germany is 65% that of the US and “capital productivity” in Japan is
63% that of the US (see exhibit 1).

g. Now look at McKinsey’s estimates of the return to capital in the three countries in
exhibit 2 (pg. 41). Assuming that McKinsey’s estimates are correct, why are your
estimates (that you derived in part f) different from McKinsey’s numbers? (Hint: What
assumption did you have to make to derive your answer in part f).

h. Let’s go back to the differences in Y/K across the three countries. With the
expression you derived in part (e), how much do differences in Y/K between Germany,
Japan, and the US matter for differences in K/L? That is, if the only thing that differed
between the three countries is Y/K, would K/L be higher or lower in Japan and Germany
than in the US (and by how much)?

i. Still maintaining the assumption that the only thing that differed between Japan and
Germany is Y/K, show that lower Y/K in Japan and Germany has the effect of increasing
output per worker (Y/L) in Japan and Germany relative to the US. If we assume that
  1/ 3 , calculate how much higher would Y/L be in Germany and Japan relative to the
US?

j. The focus of the McKinsey article is on lower capital productivity in Japan and
Germany, and they argue that lower capital productivity explains why Japan and
Germany have a lower output per worker compared to the US. According to your
answer in part i, why is the McKinsey article completely wrong?

k. Suppose you want to rescue the logic of the McKinsey team? What is the intuition
behind their argument that higher capital productivity means that the country as a whole
is more productive? Can you think of an assumption under which McKinsey’s intuition
is correct?