Development Economics – Eco501 VU

Lesson 19

PRODUCTION FUNCTION APPROACH TO THE ANALYSIS OF GROWTH

The approach disaggregates the sources of growth into the contribution of labor, capital,
technical progress and other factors.

 It is a supply-oriented approach
 The sources of growth are treated as exogenous
 A macroeconomic hypothesis should be consistent with and derivable from
microeconomic theory

This is what we call the production function approach to the analysis of growth.
Y=f(R, K, L, T)

Where R is land, K is capital, L is labor and T is technology.

 Commonly
Y = f(K, L)

THE PRODUCTION FUNCTION

Before going on to discuss the types of function that may be employed, however, let us examine
in a little more detail the properties of production function. We have established so far that the
aggregate production function expresses the functional relation between aggregate output and
stock of inputs. If land is submitted into capital, and technology is held constant, we are left with
two factors, and the production function may be drawn on a two-dimensional diagram, as in
fingure5.5. Capital (K) is measured on the vertical axis and labour (L) on horizontal axis and
each function represents a given level of output that can be produced with different

combinations of capital and labour. The function slope negatively from left to right on the
assumption the marginal additions of either factor will increase total output that is, factors have

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positive marginal product and they are drawn convex to the origin on the assumption that
factors have a diminishing marginal productivity as their supply increases, so that if one unit is
withdrawn it needs to submitted by more and more of the other factor to keep output constant.
The position of the functions broadly reflects the level of technology. The more advanced the
technology, the greater the level of output per unit in total inputs, and the closer to the origins
will be the production function representing a given output.

From the simple production function diagram it is easy to see how output may increase. First,
there may be a physical increase in factor inputs, L and K, permitting a higher level of
production. Either or both factors may increase. If only one factor increases, the movement to a
higher production function will involve a change in the combination of factors, and output will not
be able to increase forever, because ultimately the marginal product of the variable factor will
fall to zero. This is illustrated in fig 5.6, where, with a given stock of capital 0K1, output cannot
increase beyond 200 with increases in the supply of labour (0L1,0L2 and so on0 beyond the limit
indicated. the diminishing productivity of the variable factor, labour, with capital fixed, is shown
by the flatter and flatter slope of the production function is horizontal and the marginal product of
labour is zero.

If both factors increase in supply, however, there is no reason why output should not go on
increasing indefinitely. In fact, if both factors increase in supply there is a possibility that

production may be subject to increasing returns, such that output rises more than
proportionately to the increase in combination inputs. If this is the case, output per unit of total
inputs will increase and the production functions representing equal additional amounts of
production, for example 100, 200, 300 and so on, must be drawn closer and closer together, as
in Figure 5.7.

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THE COBB-DOUGLAS PRODUCTION FUNCTION

 Charles Cobb (a mathematician) and Paul Douglas (an economist) (1928)

Yt  Tt K t Lt
 The effect of technical progress is neutral on the factor intensity of production
 If α + β = 1 → constant returns to scale
 If α + β < 1 → decreasing returns to scale
 If α + β > 1 → increasing returns to scale

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Let
d [ln u]/dx = 1/u. du/dx

ry = rt + α rk + β rL

Example: 5.0 = rT + 0.25 (5.0) + 0.75 (1.0)

LIMITATIONS OF THE COBB-DOUGLAS PRODUCTION FUNCTION

 Only one combination of factor inputs can be observed at one time

 The assumption that technical progress is independent of increases in factor inputs has
been questioned
 The production function assumes constant unit elasticity of substitution between factors
 Aggregation of heterogeneous factor inputs and output

SCHOOLS OF THOUGHT IN CONTEXT: SOUTH KOREA AND ARGENTINA

 Critical analysis of the two countries indicate that the first four broad approaches to
development—stages of growth, structural patterns of development, dependence, and
neoclassical—provides important insights about development processes and policy.
 Both are midsize in population (40 million in Argentina and 49 million in South Korea in
2008)
 Both were long classified as middle-income countries
 But South Korea, now designated by the World Bank as a high-income country with
about $28,000 PPP in 2008, has double the per capita income of Argentina, with about
$14,000 PPP in 2008

SOUTH KOREA

 Linear-stages, albeit in a limited way.

 In recent years, its share of investment in national income has been among the highest
in the world
 Investment rate which is 15%, was still below takeoff levels in 1965. Yet it rose
dramatically to 37% of GNI by 1990 and remained close to 40% in the 2000–2007
period.

STRUCTURAL PATTERNS

South Korea also confirms some patterns-of-development structural-change models. South

Korea’s per capita income grew by more than 7% annually for the whole 1965–1990 period.

DEPENDENCE REVOLUTION

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It was strongly dependent in international relations—it was a Japanese colony until 1945 and
thereafter wholly dependent on maintaining the goodwill of the United States for defense against
invasion by North Korea.

NEOCLASSICAL COUNTERREVOLUTION

South Korea likewise poses a strong challenge to the neoclassical counterrevolution models.
The nation was highly interventionist at home and in international trade, with the government
making extensive use of development planning, using a wide range of tax breaks and incentives
to induce firms to follow government directives and interventions

ARGENTINA

STAGES OF GROWTH

Takeoff ―in some sense‖ began in the First World War, but ―in the mid 1930s. A sustained take-
off was inaugurated, which by and large can now [1960] be judged to have been successful.
According to World Bank data, Argentina had a negative growth rate throughout the 1965–1990
period, and in the 1980s, domestic investment shrank at a -8.3% rate, falling back well below
Rostow’s threshold takeoff investment levels.

STRUCTURAL PATTERNS

Argentina did exhibit many of the usual structural patterns of development as agricultural
productivity rose, industrial employment grew (albeit slowly), urbanization took place, fertility fell,
and so on.

DEPENDENCE REVOLUTION

In contrast to South Korea, the case of Argentina offers some vindication for dependence
theories in that the country relied to a large extent on exporting primary goods, and the real
prices of these goods fell compared to imports. Multinational corporations played a large role,
and Argentina was unable to create its own viable manufacturing export industries, ultimately
having to submit to stringent structural-adjustment programs, sell state industries to foreign
companies, and other constraints.

NEOCLASSICAL COUNTERREVOLUTION

But Argentina also offers some vindication for neoclassical counterrevolution theory in that faulty
interventionist restrictions, inefficient state enterprise, bias against production for exports, and
unnecessary red tape ended up hurting industry and entrepreneurship.

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