The Supply Side of the Economy

The Supply Side of the Economy

• We start by studying the supply side of the economy.
• Economy’s capacity to produce goods and services
• Defer demand-side issues for now
• Supply-side theory of Gross Domestic Product (GDP)
• GDP measures both production and income
• Key questions:
• What explains the level of GDP?
• How is the economy’s total income distributed?
• Why is there growth in GDP per person over time?
• Why does GDP per person differ so much across countries?
 A Model of the Economy’s Supply Side
• Supply-side model has two main ingredients:
1. Supplies of factors of production
• Factors of production are basic inputs into production process
• Labour
• Land
• Capital
2. Production function
• How factors of production combined to produce final output
• Production/use of intermediates embedded in production function
• Overall productivity of factors: total factor productivity (TFP)
 Factors of Production
• Supply-side model takes as given available supplies of
the factors of production:
• Capital ()
• Goods produced to produce other goods in the future
• Eg, machinery, tools, buildings, computers, vehicles
• Land ()
• Including natural resources
• Labour ()
• Number of workers
• Hours worked
• Skills and training (sometimes counted separately as “human capital”)
 The Production Function
• Production function describes how output is produced:

• Assuming factors are fully employed, factor supplies , , and are

inputs to production function .
• Total factor productivity is coefficient of production function
• Can represent level of technology, and how efficiently factors of
production are allocated to their best use.
• The production function together with the factor supplies
and TFP determine (real) GDP .
• Make assumptions about the function .
 Constant Returns to Scale
• The first assumption is that the production function has
constant returns to scale.
• If the economy is able to double its supplies of all factors
of production then it should be able to double its output.
• More generally, scaling all inputs scales output in same way
• “Replication principle”: Use the same production
techniques and technologies with the additional factors
organized in the same way as with the original factors.
• If all factors have been accounted for, should be able to make
double the original output
Positive But Diminishing Marginal Products
• Second assumption is increasing the supply of one factor
of production without changing the amounts of the other
factors available raises output (less than proportionately).
• Extra output produced per extra unit of one factor is the
marginal product of that factor:
• Mathematically, the partial derivative of the production function

• Each factor’s marginal product is positive, but diminishes

as the supply of that factor increases.
 Diminishing Marginal Products
• Why are factors’ marginal products decreasing?
• Consider for example, the use of capital in an office job
• Without a computer, it is very difficult to perform many tasks.
• Giving an office worker a computer has a large effect on that
worker’s output, so marginal product of capital initially high.
• And while a more powerful computer may allow the worker to
produce more, given the task performed by the worker, the
extra computing power is unlikely to raise the worker’s output
proportionately: the marginal product of capital declines.
• This argument takes as fixed the number of workers, their
skills, and state of technology.
 Inada Conditions
• Third assumption is known as the “Inada conditions”.
• This is essentially a stronger version of the diminishing
marginal products assumption.
• Rather than just assuming the marginal product of a
factor declines as the supply of that factor increases, the
Inada conditions assume the marginal product declines all
the way to zero.
• And the marginal product is extremely high (“infinite”)
when the supply of the factor is close to zero.
• Means that some of each factor is essential to obtain output.
 Properties of the Production Function
• Constant returns to scale:

• Positive but diminishing marginal returns to factors:

• And same for , , and ,

• Inada conditions:

• And same for and

• A production function that meets all three conditions is a
“neoclassical production function”.
 Graph of a Production Function
𝑌
𝑀 𝑃 𝐾=𝑧 𝐹 𝐾 (𝐾 , 𝐿0 ,𝑁 0 )
1 𝑧𝐹(𝐾 ,𝐿0, 𝑁0)

0
0 𝐾
 Cobb-Douglas Production Function
• The Cobb-Douglas production function is a commonly
used specific example of a production function:

• It satisfies the three neoclassical assumptions:

• Constant returns to scale:

• Marginal product of capital:

• Positive, but diminishes with higher

• Converges to infinity for and zero for
 Per-Worker Production Function
• Focus on just two factors: capital and labour .
• Neoclassical production function:
• Output per worker in terms of capital per worker :

• Uses constant returns to scale

• The function stands in for
• For the Cobb-Douglas production function
so
 Per-Worker Production Function (cont.)
• If the production function is neoclassical, the per-worker
production function has an increasing and concave shape
• Output:
• Marginal product of capital:
• is positive but diminishing (in and )
• Implies is an increasing and concave function of
The Supply Side of the Economy

The End
The Distribution of Income
 The Distribution of Income
• Real GDP is also the total income generated in the
economy.
• How is that income distributed among owners of the
factors of production?
• Start with a model where payments to factors of
production (factor prices) are determined in perfectly
competitive markets.
• Supplies of factors of production taken as given.
 Competitive Markets
• Assume firms hire factors of production in competitive
markets (firms do not own any factors themselves):
• Rental price of capital ()
• Rental price of land ()
• Wages of labour ()
• Production function:
• Profits of a firm:

• First-order conditions to maximise profits:

, ,
 Factor Demand Curves
• Maximisation of profits implies downward-sloping factor
demand curves.
• Demand curves are given by the marginal products of the
factors.
• Taking the supplies of the factors as given, competitive
markets determine the factor prices.
 Factor Market Diagram
𝑅

𝑀 𝑃𝐾
𝐾
𝐾
 Profits
• For firms that do not own any factors of production,
perfect competition and constant returns to scale imply
profits will be zero.
• Given constant-returns-to-scale production function:

• Perfect competition:

• Payments to factors use up all output:

• Economic profits zero, though accounting profits still
positive when firms own factors of production
 Cobb-Douglas Production Function
• Taking a Cobb-Douglas production function for example:

• Marginal products of factors:

• Perfect competition implies constant shares of income:

• Income shares given by parameters and

The Distribution of Income

The End
Population Growth According to Malthus
 Population Growth
• Population growth affects the available supply of workers
• Look at the theory of population growth by Malthus
• The theory predicts population growth holds down living
standards when land in fixed supply used for production
• Labour and land are key factors of production in the
predominantly agricultural economies of the past
• Explains stagnation in per-capita incomes seen prior to
the 19th century
• Technological progress leads to population growth, but
not rising living standards
 Determinants of Population Growth
• Malthus argued (1798) that per-capita income and
consumption affect population growth.
• Lower consumption per person leads to worse nutrition and
health, hence higher death rate and infant mortality, and lower
(or negative) population growth rate.
• Lower income per person induces families to have fewer
children they would struggle to support, hence lower birth rate,
and lower population growth rate.
• Higher income and consumption have the opposite effects and
raise the population growth rate.
• Effects are larger when people are close to subsistence.
 Demographic Equation
• Current population (and also number of workers)
• Future population
• Population growth rate
• If is aggregate consumption, measures average
consumption per person (average living standards)
• Demographics assumed by Malthus:
, so population growth rate
• The function is increasing in
Demographics and Living Standards
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𝑁

𝑔 (𝑐 )

Rising population
1
Falling population

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 Agricultural Economy
• Malthus’s demographic assumption is particularly relevant
for an agricultural economy
• Land and labour are the key factors of production.
• Land is in fixed supply.
• Neoclassical production function:
• No capital, so no investment (and ignore government and
international trade), hence average consumption per
person is equal to income per worker
 Diminishing Returns to Labour
• For the same amount of land, more workers can produce
more output, but there are diminishing returns to labour
• Additional workers need to use lower quality land, or land
already in use is worked by more people.
• Per-worker production function:

• Note that is a shorthand for , increasing in .

• Per-worker output diminishes as the population rises because
available land per worker declines.
Per-Worker Production Function

𝑦
𝑧𝑓 ( 𝑙 )

𝑙
 Population Dynamics
• Using and , the change in the population over time is
determined by:

• For low , is high and is greater than , so , which means the

population is increasing over time.
• For high , is low and is less than , so , which means the
population is falling over time.
• Given , the population converges to a steady state .
 Steady State
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𝑁
𝑦

𝑔 (𝑐 ) 𝑧𝑓 ( 𝑙 )

1 *

𝑐 𝑙
* *
 Stagnation in Per-Capita Income
• Since the population converges to a steady state, per-
capita income and consumption also reach a steady state
which must be the solution of equation .
• If then the population rises, pushing down and .
• Given , land per worker is the solution of .
• The population in steady state is .
• Stagnation in is consistent with historical evidence prior
to the 19th century.
 What Does (or Does Not) Help?
• The conclusion that stagnates continues to hold even if
technology improves: is independent of .
• Higher ultimately leads to a larger population (lower )
• The discovery of new land does not help either.
• Simply leads to a higher population (no change in )
• Weakening the link between the birth rate and living
standards would help: shift down the line.
• Structural transformation of economy: Industrialisation
reduces dependence on land, accumulate capital instead.
• Adding to capital avoids diminishing returns to labour problem
Population Growth According to Malthus

The End
Hours of Work and the Supply of Labour
 Labour Supply
• As well as changes in the population, the supply of labour
also depends on how many hours people work:
• Full-time versus part-time work?
• Participate or not in the labour market?
• Early retirement or continue working?
• Here, we take as given the skills, education, and training
of workers and return later to human capital accumulation
• Key trade-off: More hours of work, more income, but less
time for other things, eg, leisure
 Model
• We use a simple static model (no saving or borrowing) to
study the choice of labour supply by households.
• Supply of labour by household (in units of time, eg, hours)
• Time used for leisure
• Leisure is defined as anything other than time spent earning wages, so
it also includes cooking, cleaning, childcare, etc (home production)
• The total fixed amount of time available
• Wage paid per unit of time (in real terms)
• Consumption of goods and services
• Non-wage income (financial income, or earned by partner)
• Taxes paid (lump-sum amount)
 Budget and Time Constraints
• Available time used for work or leisure (anything but work)

• Household earns wage income from hours of work

• Also other income and taxes to pay
• Maximum amount of consumption affordable:

• Since , can write a combined constraint in terms of the

things and the household values:
 Diagram With Constraint
𝐶

𝑤
1

𝜋−𝑇

0 𝑙
0 h
 Household Preferences
• Household likes more consumption and more leisure , but
constraints imply there is a trade-off between them
• To study optimal choice of leisure (and hence labour supply),
need to say more about preferences
• Describe preferences with indifference curves over and :
• Downward sloping
• Assumed to be convex to the origin
• Diminishing marginal rate of substitution (MRS) between and
• Consumption and leisure assumed to be normal goods
• Upward-sloping income expansion path implied by indifference curves
 Indifference Curves
𝐶

𝑀𝑅𝑆𝑙,𝐶
1

𝑙
 Optimisation
• A household wants to reach the highest indifference curve
subject to the constraints.
• In general, there are two possible points in the diagram
where this can occur:
1. Participate in labour market (): The optimal consumption-
leisure choice is where an indifference curve is tangent to the
constraint; mathematically, where .
2. Do not participate in labour market (): The optimal choice of
and is at the corner of constraint.
 Optimal Choice

𝐶 Participate 𝐶 Do not participate

*
𝑙 *
𝑙
 Participation Decision
• Participation in the labour market should increase with:
• Higher wages
• Smaller transfer payments (negative of ) from government
• Smaller other income
• Lower wealth
• Less income earned by partner
• Stronger preference for consumption over leisure (low MRS)
• For those choosing to participate, we can also analyse
how number of hours depends on these considerations.
Hours of Work and the Supply of Labour

The End
The Effects of Wages on Labour Supply
 The Effect of Wages on Labour Supply
• How do wages affect the supply of labour?
• What does the supply curve for labour look like?
• Two aspects of labour supply response to wages:
• Hours worked by those participating in the labour market.
• Decision to participate or not in the labour market.
 The Effect of Wages on Hours Worked
• To trace out the supply curve for participants in the labour
market, look at the effects of an increase in the real wage:
• Pivots budget constraint upwards, making household better off.
• Consider income and substitution effects.
• Substitution effect: the price of leisure rises, so an individual
substitutes from leisure to consumption, hence works more.
• Income effect: since consumption and leisure are both normal
goods, higher income increases demand for both consumption
and leisure, hence work less.
• Overall: Consumption must rise, but leisure may rise or
fall, thus the effect on labour supply is ambiguous.
Income and Substitution Effects
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∗
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 Income and Substitution Effects (cont.)
• Higher wage pivots budget constraint, making it steeper.
• Substitution effect (SE) results from steeper gradient:
• Isolate this by also making parallel shift downwards of budget
line to be tangent to the original indifference curve.
• Income effect (IE) results from upward shift of budget line:
• Isolate this by reversing parallel shift down used for substitution
effect, and reach tangency point on higher indifference curve.
• In example shown in the diagram, income and
substitution effects exactly cancel out for leisure and
labour supply.
•
The Effect of Wages on Participation
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∗
𝐶2
∗
𝐶1 𝐼2
𝐼1
∗
𝑙 2 𝑙∗ 𝑙
1
 The Effect of Wages on Participation
(cont.)
• Higher wage makes budget constraint steeper, pivoting it
around the point of non-participation.
• Since indifference curve needs to be steeper than budget
constraint for non-participation to be chosen, a sufficiently
high wage triggers participation in the labour market.
• No offsetting income effect on the participation decision
because higher wage does not make non-participants better off
• Unless some income comes from a partner who works, in which case
higher wages have an income effect on the household labour supply.
 Labour Supply Curve
• The labour supply curve shows the optimal choice of at
each level of wages .
• For those participating in the labour market, hours worked
increase if the substitution effect is larger than the income
effect
• For those not participating initially, no income effect until some
labour is supplied
• curve upward sloping if SE dominates IE.
• If everyone participates, given by equation .
Labour Supply Curve (cont.)
𝑤
𝑠
𝑁

𝑁
 Wages and Labour Supply in Long Run (UK)
70 2500
65
60 2000
55
50 1500
45
40 1000
35
30 500
25
20 0
18561863187018771884189118981905191219191926193319401947195419611968197519821989199620032010

Workers' average hours per week (left axis) Employment/population (left axis, %)
Average real hourly earnings (right axis, index 1856=100)
The Effects of Wages on Labour Supply

The End
Equilibrium and Efficiency
 A Macroeconomic Model
• Look at a first macroeconomic model putting together the
optimising behaviour of households and firms.
• Static model: one time period
• Suppose that all households share same preferences and all
have equal claims on non-wage income (from capital or land)
• It is said there is a “representative household”.
• Utility maximisation implies a labour supply curve
• Fixed supply of land or capital (no depreciation, no investment)
• Profit maximisation by firms implies a labour demand curve
• Government expenditure financed by lump-sum tax
• Everyone faces same tax , no redistribution.
 Equilibrium
• In the goods market:
• Firms produce
• Households and the government demand
• Equilibrium:
• In the labour market:
• Firms demand , determined by
• Households supply , determined by
• Equilibrium:
• Budget constraints: , , and , combined:
 Labour Market
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𝑀𝑅 𝑆 𝐿, 𝐶( 𝑁 𝑠 )

𝑀 𝑃(𝑁𝑁 𝑑 )

*
𝑁
 Equilibrium
• The real wage adjusts to where .
• The budget constraints with imply that
• The goods market must also be in equilibrium.
• Since , it follows that .
• This says that at the market-clearing real wage, the marginal
value (measured in goods) that households put on a unit of
their time is equal to what goods firms can produce with that
unit of time.
• This makes the market equilibrium Pareto-efficient.
 Efficiency
• Suppose the government could control all decisions
(consumption, employment, etc) made in the economy
• The government is said to be the “social planner” in this case
• Assume the government acts benevolently with the aim of
maximising representative-household utility, given:
• Production possibilities:
• Need for public services
• Resource constraint and time constraint
• Reduces to a single constraint:
• Gradient:
 Efficiency (cont.)
• To make representative-household utility as high as
possible subject to the constraint, the social planner
would choose such that
• Where an indifference curve is tangent to constraint
• Since market equilibrium has (and constraints are
satisfied), the market equilibrium and the benevolent
planner’s choice coincide
• Not possible to make representative household better off
• Market equilibrium is efficient
 Social Planner
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00 h 𝑙
*

−𝐺
 Efficiency
• Without representative household simplification, market
equilibrium is said to be Pareto-efficient if no one can be
made better off without making someone else worse off.
• First welfare theorem – economy is equilibrium efficient if:
• Markets are perfectly competitive
• No externalities
• No missing markets or restrictions on trade
Equilibrium and Efficiency

The End
Understanding Inequality in Wages
The Returns to College Education
 Understanding Inequality in Wages
• The last few decades have seen rising income inequality
within many countries. Why?
• Focus on inequality in wages rather than income inequality
more broadly (including capital income) or wealth inequality.
• One important dimension of the rise in wage inequality is
the increase in the relative wages of highly skilled workers
compared to those with more basic skills.
• Increase in “college wage premium” in the US and elsewhere.
• Crucial to debate on the returns to higher education: returns
might be higher even if the cost of education has risen.
 College Wage Premium
• In the US, an average college-educated worker earned
less than 60% more than an average worker without a
college education prior to 1980, while by the 2010s, this
college wage premium had risen close to 100%.
• At first glance, this is puzzling because there has been a
substantial increase in the fraction of college-educated
workers during this period (20% to 50%).
• With diminishing returns to individual factors of production,
increased supply pushes down factor payment, all else equal.
• What else changed after 1980? Shift in relative demand?
 Production Using Skilled and Unskilled Labour
• Separate the supply of labour into high-skilled workers
and unskilled workers .
• Supply of related to concept of “human capital” studied later.
• Production function is assumed to be:

• , between 0 and 1, is importance of capital relative to labour.

• total factor productivity – affects all marginal products.
• skill-biased technology – affects marginal product of .
• Cobb-Douglas production function not used as cannot
build in skill-biased technological change.
 Relative Wages
• Competitive markets imply wages and for skilled and
unskilled labour are equal to their marginal products:
• Unskilled labour:
• Skilled labour:
• Implications for the relative wage :

• Declines with relative supply of high-skilled labour .

• But increases with skill-biased technological change (higher ).
 Skill-Biased Technological Change
• One explanation for the rising skill premium (relative wage
increasing) is skill-biased technological change.
• Skill-biased technological change is improvements in
technology that disproportionately boost the productivity
of skilled workers compared to unskilled workers.
• For example, advances in computing, telecommunications,
data science, and e-commerce may increase demand for high-
skilled workers, but not unskilled workers.
• Earlier technological progress was more uniform in its effects.
• Higher can raise even with increase in relative supply of
skilled workers.
 International Trade
• Skill-biased technological progress is not the only
explanation for the rising skill premium.
• Globalization owing to lower barriers to international trade
is another explanation.
• Even if labour is not mobile internationally, free trade in goods
tends to equalize the skill premium across countries through
equalizing the relative prices of goods that are produced more
or less intensively using skilled labour.
• Skill premium then determined by relative supply of skilled
labour at world level, where there are relatively fewer skilled
workers than within advanced economies.
Understanding Inequality in Wages

The End
A 14th-Century Pandemic
 A 14th-Century Pandemic
• Around 1350, Europe, North Africa, and Western Asia, are
struck by a bubonic plague pandemic (the “Black Death”).
• This pandemic is believed to have killed more than a third
of the population of the affected areas.
• The main economic effect of the pandemic comes from
the shortages of labour it creates.
 A Pandemic in the Malthusian Model
• In the Malthusian model, a pandemic causes a temporary
downward shift of the demographic function .
• The population growth rate is , so more deaths can be
represented by lower for each value of .
• Starting from steady state, lower means falling population.
• With fixed supply of land , land per worker rises, so output and
consumption per worker are higher.
• For the survivors, more output per worker because land was scarce.
• Even though total GDP declines when the population falls.
• Once pandemic is over, returns to normal and population and
living standards ultimately go back to former steady state.
 Demographics and Output Per Worker
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𝑔2 ( 𝑐 ) 𝑧𝑓 ( 𝑙 )
1

∗
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∗
𝑐 ∗ 𝑙
𝑐 𝑙
Wages and Rents in the Malthusian Model
• The pandemic also has significant distributional effects.
• How is total output distributed among workers and
owners of land in the Malthusian model?
• Workers do not get all of as income unless they own land.
• If competition determines factor payments, wages and
rents are equal to the marginal products and .
• is diminishing in (neoclassical production function).
• Given a supply of land , a lower population means the
marginal product of labour is higher, so rises.
• What about rents ?
 Factor Payments and Relative Factor Supplies
• Per-worker production function implies .
• Marginal products (using the chain rule):
• Land:
• Labour:
• Implies , output per worker minus rent times land per worker.
• Depend on relative supply of land to labour .
• is diminishing in because , so .
• is increasing in because derivative of with respect to is .
 Wages and Rents with Lower Population
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𝑀 𝑃𝑁
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𝑤1

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𝑥2
𝑀 𝑃𝐿
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𝑙= 𝑙=
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A 14th-Century Pandemic

The End
Do Higher Tax Rates Raise More Revenue?
 Labour Income Tax
• So far, we assumed taxes have a lump-sum form.
• In practice, tax paid depends on individual behaviour.
• Proportional labour income tax: Tax paid is constant
percentage of labour income, so tax bill increases when
household chooses to work more.
• Tax rate ; pre-tax wage ; labour supply .
• Tax revenue .
• Labour supplied up to point where .
• Higher tax rate reduces after-tax wage , so effects of tax are
similar to lower wages.
 Tax Rates and Tax Revenue
• Since the tax rate affects revenue directly as well as
indirectly through its impact on behaviour , the
relationship between and is not always positive.
• Leads to a “Laffer curve”:
• 0% tax rate generates no revenue.
• 100% tax rate implies no incentive to supply labour, so no tax
revenue is obtained.
• Tax revenue maximised for a tax rate between 0% and 100%.
• Although the Laffer curve implies ever higher tax rates
eventually result in lower revenue, it does not give specific
guidance at which tax rate revenue will start to fall as rises.
 Laffer Curve
𝑇

0
0% 𝜏
100%
Do Higher Tax Rates Raise More Revenue?

The End
Should Wages or Rents Be Taxed to Pay for Public Expenditure?
 How to Pay for Public Expenditure?
• Suppose government needs to pay for public services .
• Assume output produced using land and labour .
• Land is in fixed supply.
• Labour is labour supply of a representative household.
• Production function:
• Linear in both and (not neoclassical, but useful for illustration).
• Marginal products are and (where and are positive constants).
• Pre-tax wage and rent determined in competitive markets:
 Sources of Tax Revenue
• Government can only levy proportional taxes on incomes:
• tax on wages; tax on rents.
• Total tax revenue raised .
• Budget constraint of government: .
• Representative household supplies labour and owns land.
• Income received after tax .
• Budget constraint of representative household:

• With :
Switch from Taxes on Wages to Taxes on Rents
• Initially only wage income taxed: and
• Optimal choice of and at tangency of budget constraint
and indifference curve: .
• On budget constraint, so .
• Switch to tax on rents: and
• Assuming , so enough rental income to tax.
• Budget constraint steeper; shifts down at .
• Observe that same choice of and remains affordable:
• Original and satisfy .
• Because .
Taxes on Rents Instead of Taxes on Wages
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 Optimal Source of Public Finance
• Analysis suggests a switch from taxing wages to taxing
rents makes the representative household better off.
• This is because labour supply is distorted by a
proportional income tax.
• Supply of land is inelastic and does not respond to tax.
• Removal of distortion allows representative household to
reach higher indifference curve.
• In practice, rental income may not be high enough to shift
tax burden completely away from wages (need ).
• Analysis also ignores distributional consequences of tax.
Should Wages or Rents Be Taxed to Pay for Public Expenditure?

The End
Capital Accumulation
 Capital Accumulation
• Modern industrial or service-based economies produce
mainly using capital and labour rather than land
• Capital defined as goods used for production of goods
and services in the future (not immediately used up)
• Examples of capital:
• Machinery, buildings, computers, aeroplanes
• Can economic growth be explained through a process of
accumulating capital?
• Do different levels of capital accumulation across
countries explain differences in income levels?
 Capital, Investment, and Depreciation
• Capital used for production is a stock, not a flow
• Adding new capital to the stock is investment (a flow)
• While capital is not immediately used up in producing
other goods, it does not last forever: there is depreciation
• Depreciation equals loss of capital from wear and tear or
obsolescence, or maintenance cost to avoid this loss
• Assume depreciation occurs at constant rate
• Capital accumulation equation:

• Next year’s capital stock is denoted by

 Production Function
• Focusing on capital and labour as the factors of production and
ignoring land, the production function is:

• Gross domestic product (GDP) is , the labour force is (number of

workers), the capital stock is , and total factor production (TFP) is
• The production function is neoclassical
• Diminishing returns to capital
• For example, the Cobb-Douglas production function:

• Parameter estimated using capital share of income

 Measuring the Capital Stock
• How to measure the capital stock ? Two approaches:
1. Perpetual inventory method
• Change in capital stock from one year to the next is
• Starting from , add investment and subtract estimate of depreciation
rate multiplied by , which gives estimate of
• Apply this method iteratively to construct a time series of estimates
2. Imputation from capital income
• Measure of GDP and capital share of GDP denoted by
• Estimate of (gross) percentage return on capital
• Implied capital stock is
 Per-Worker Production Function
• Focus on output per worker , not total output .
• Since the production function has constant returns to
scale, output per worker is:

• depends on capital per worker and TFP .

• is the “per-worker production function”.
• The function is defined by .
• It is an increasing and concave function because is the
marginal product of capital.
Per-Worker Production Function (cont.)
𝑦
𝑀 𝑃 𝐾 =𝑧𝑓 ′ (𝑘)
1 𝑧𝑓 ( 𝑘 )

𝑘
Capital Accumulation

The End
The Solow Model
 The Solow Model
• The Solow model explains the level of capital accumulation
and the implications for the level and growth rate of GDP.
• To begin with, suppose that TFP is constant over time.
• Later, we consider a version of the Solow model where is
increasing over time owing to technological progress.
• The Solow model considers:
• A closed economy with no government sector
• Implies investment is equal to household saving
• Labour force grows at rate over time
• Households save a fraction of income
 Equations of the Model
• Neoclassical production function:
• Capital accumulation equation:
• Investment equals saving:
• Labour force grows at a constant rate:
• Households’ saving behaviour:

• Putting together the production function, investment

equals saving, and the saving rate:
 Capital per Worker
• With equations for and in terms of and , we can
calculate how supplies of factors of production evolve
over time in the economy
• Output per worker depends on the ratio of to
• Per-worker production function:
• Since is the ultimate variable of interest, we only need to
keep track of ratio over time
 Dynamics of Capital per Worker
• Combining equations for and :

• Using , the right-hand side depends on only:

• Subtract from both sides to find change in over time:

 Capital Accumulation
• Changes in the amount of capital accumulated per worker
are explained by the difference between:
• amount of saving, and hence investment, per worker
• Saving rate multiplied by per-worker production function .
• amount of investment per worker needed to sustain same level
of capital per worker next year
• A fraction of all capital depreciates, so an amount of capital per worker
must be replaced to keep the capital per worker unchanged.
• The number of workers increases by a percentage each year, so if
existing workers use capital each, there needs to be investment per
existing worker to give future workers the same capital each.
 Solow Model Diagram
• The evolution of capital per worker over time can be
studied using the Solow model diagram that plots:
• The per-worker production function
• An increasing and concave function of
• The “saving line”
• A scaled-down version of because
• Increasing and concave function of
• The “effective depreciation line”
• An upward-sloping straight line
• Gradient is given by effective depreciation rate of capital per worker:
sum of depreciation rate plus growth rate of labour force
 Solow Model Diagram (cont.)

*
𝑧𝑓 ( 𝑘 )

𝑦0 (𝑑+𝑛)𝑘
𝑠𝑧𝑓 ( 𝑘 )

𝑘
𝑘0 *
 Growth From Capital Accumulation
• Starting from a low level of capital per worker, the saving
line is above the effective depreciation line, so
• Capital per worker is increasing over time, which leads to
higher output per worker since
• By adding more capital per worker, the economy can
raise workers’ productivity
• Growth from capital accumulation
• However, the Solow model predicts such growth cannot
continue indefinitely
 Steady State
• There is a steady state where the saving line crosses the
effective depreciation line.
• If the economy reaches this level of capital per worker , it
will remain at that level of unless something changes.
• If then .
• With no further change in , there is no further growth in
output per worker unless something else changes.
• This is because .
• Note that both GDP and the total capital stock are still
growing in line with the labour force at rate .
Existence and Uniqueness of Steady State
• Since the production function is neoclassical, the gradient of
is extremely large for close to zero, but declines as
increases, and approaches zero as becomes large.
• The gradient of the effective depreciation line is constant.
• Consequently, there exists only one positive steady state
where the saving and effective depreciation lines cross.
• The saving line is above the effective depreciation line for
below , so the economy converges to in the long run.
• There is always a steady state with zero capital per worker,
but diverges from this no matter how close.
 No Long-Run Growth in Solow Model
• While the Solow model explains how a country can
become richer starting from a low level of capital
accumulation, it cannot explain long-run growth.
• Returns to capital are high when capital is scarce, so
investment leads to large increases in income.
• But diminishing returns to capital means that further
investment has lower returns.
• With less extra output generated per unit of capital, while
the maintenance cost of capital increases proportionately,
a point is reached where capital stock cannot rise further.
The Solow Model

The End
The Asian Tiger Economies
 The “Asian Tiger” Economies
• Asian Tiger economies (Singapore, Taiwan, Hong Kong,
South Korea) experienced very fast economic growth in
the period from 1960 to 1990.
• But growth rates subsequently declined.
• Singapore’s development provides a good example of the
mechanisms at work in the Solow model.
• Very high saving rate and rapid capital accumulation,
starting from a low base.
Singapore: National Saving Rate
Singapore: Capital Per Worker
Singapore: Real GDP Per Person
Singapore: Log Real GDP Per Person
Singapore: Average Growth Rates By Decade
The Asian Tiger Economies

The End
Interest Rates in the Long Run
 Interest Rates in the Long Run
• The Solow model predicts that capital per worker
converges to a steady state in the long run.
• Starting from a low initial level, the stock of capital rises over
time relative to the number of workers as the economy
converges to its steady state.
• Implications for the returns earned by savers?
• In closed economy with no government debt, all savings
used to finance investment in capital.
• Real interest rate is real return earned from ownership of
capital.
 Real Return on Capital
• Rental price of capital with competitive markets:
• Real return on capital is rental price minus cost of capital
lost through depreciation ( per unit of capital).

• Production function:
• In terms of per-worker production function where , aggregate
output is .
• Marginal product of capital:
• Real interest rate:
Real Interest Rate Over Time
𝑟 𝑟

′
( 𝑑+𝑛 ) 𝑘 𝑧 𝑓 ( 𝑘) − 𝑑
𝑠𝑧𝑓 (𝑘)

∗ 𝑘 𝑘
𝑘 Time
 Real Interest Rate in Long Run (UK)
10

2
%
0

-2

-4

-6
1710172417381752176617801794180818221836185018641878189219061920193419481962197619902004
Interest Rates in the Long Run

The End