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The Global Economy The Production Function

The Global Economy The Production Function. Roadmap. Questions to answer Production function theory Capital and labor inputs Productivity. What can growth theory tell us?. Why do some countries grow quickly? What produces a growth “miracle?” Can miracles be replicated?

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The Global Economy The Production Function

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  1. The Global EconomyThe Production Function

  2. Roadmap • Questions to answer • Production function theory • Capital and labor inputs • Productivity

  3. What can growth theory tell us? • Why do some countries grow quickly? • What produces a growth “miracle?” • Can miracles be replicated? • Does a country save “too much?” • How can we forecast long-run growth?

  4. Why theory? • Theory is a tool to help organize thoughts • Theory is a framework for analyzing data • Theory helps simplify a complex world

  5. Theory: the moving parts GDP Capital & Labor Productivity Political Process “Institutions”

  6. Production function • Idea: relate output to inputs • Mathematical version: • Definitions: • K = quantity of physical capital used in production (plant and equipment) • L = quantity of labor used in production • A = total factor productivity (everything else)

  7. Production function properties • More inputs lead to more output • Positive marginal products of capital and labor • Marginal product = partial derivative of production function • Diminishing marginal products • If we increase one input, each increase leads to less additional output • Constant returns to scale • If we double **both** inputs, we double output

  8. Production function properties

  9. What is labor’s income share? • Cobb-Douglas production function has several special properties • An important one: when firm’s maximize profits • The share of value added paid to labor is • The share of value added paid to capital is • From last week: • Labor is paid 2/3 of GDP (value added) • So

  10. What is labor’s income share? • Profit maximization • First order conditions (marg. rev = marg. cost)

  11. What is labor’s income share? • Work with the second condition • Multiply each side by L • Substitute Y on left side and note that right side is payments to labor to estimate alpha:

  12. GDP by income type labor compensation rentalincome corp. profits interest

  13. Inputs: capital • Meaning: physical capital; plant and equipment • Why does it change? • Depreciation/destruction • New investment • Mathematical version:

  14. Investment composition

  15. What is the return to capital? • Real return = interest rate - depreciation

  16. Inputs: labor • Labor = units of work effort • Why does it change? • Population growth • Fraction of population employed (extensive margin) • Hours worked per worker (intensive margin)

  17. Inputs: labor • Adjustments for quality? • Skill: education? experience? • Mathematical version • Human capital = H (years of school?)

  18. GDP per capita Mexico China

  19. GDP per working age person Mexico China

  20. GDP Mexico GDP per Working Age Person Mexico GDP per Capita China GDP per Working Age Person China GDP per Capita

  21. Productivity • Standard number: • Average product of labor: Y/L • Our number: • Total Factor Productivity: Y/F(K,L) • How do we measure it? • Solve the production function for A • Measure Y, K, L from the data, then compute A

  22. Productivity • Example (US): Y/L = 33, K/L = 65 • Note: the TFP number by itself is meaningless, but comparisons across countries or time are useful.

  23. Production function takeaways • The production function links output to inputs and productivity: • The capital input (K): • Plant and equipment, a consequence of investment (I) • The labor input (L): • Population growth, age distribution, participation and hours • TFP (A) can be inferred from data on output and inputs • TFP is “everything else”

  24. The Global EconomySolow Growth Model

  25. What can growth theory tell us? • Why do some countries grow quickly? • What produces a growth “miracle?” • Can miracles be replicated? • Does a country save “too much?” • How can we forecast long-run growth?

  26. A brief history of time Source: Maddison website. For life expectancy, Maddison, 2001. Life expectancy shown in 2008 is for the year 2000.

  27. Trends are important Source: Maddison, “Historical Statistics for the World Economy”

  28. GDP per capita Source: Maddison website.

  29. Where we are, how we got there • In the beginning, and for a long time, we were • Very poor • Short-lived • Around 1800, growth occurs in some countries • Transition to a “modern” economy differs across countries • Result: large differences in GDP per capita levels across countries today • Some countries overcame their late start, e.g., South Korea, Japan

  30. GDP growth rates, 1975-2010 Source: World Bank, World Development Indicators, 2000 prices in USD

  31. Long run growth facts • Huge variation in cross-country income • Large variation in growth rates • Poor countries grow slowly • Rich countries grow moderately • Some poor countries grow very fast

  32. Capital accumulation and growth • Can capital accumulation sustain growth? • Can capital accumulation explain miracles? • How does population growth affect growth? • How do saving rates affect growth? • Reoccurring themes in politics

  33. Simple model • Production function • Capital accumulation equation • Saving flow equation

  34. Savings rates • Assumption: constant saving rate • Is this a good assumption? • How would we check? • Savings identity

  35. Savings Private + Government Consumption Investment = Saving - NX Net Exports

  36. Solow model • Production function • Capital accumulation equation • Saving=investment equation • Saving determined by

  37. Solow model • Combining the equations • Evolution of the capital stock • Two forces: investment, depreciation

  38. Solow model: dynamics output saving depreciation

  39. Solow model: steady state • Eventually: constant K, => Y, K/L, and Y/L • Eventually K stops changing • This is the steady state

  40. Solow model: steady state output saving depreciation

  41. Solow model: convergence • Do we see convergence? • What data could we use to test this implication of the theory? • GDP per capita • GDP per capita vs. growth rates • What would we see?

  42. Convergence?Log of Real Per Capita GDP (PPP, 2005 Chained US$) Source: Penn World Tables 6.3

  43. Convergence?Log of Real Per Capita GDP (PPP, 2005 Chained US$)

  44. Saving? • How does the saving rate affect growth? • See Solow.xls

  45. Solow model: saving output high saving low saving depreciation

  46. Population growth? • More on this next week, but… • Increases GDP, decreases GDP per capita • Must invest more to provide capital for new workers • In data, doesn’t vary enough to account for growth experiences

  47. Solow model takeaways • Solow model • Growth from saving-financed increases in capital • Convergence property: growth eventually stops • Conclusion: capital can’t be the key to growth • Value: tool for exploring growth of emerging economies • What are we missing? • TFP growth

  48. For the ride home • Is aid ($$) good for developing countries? • Bono: yes • Bill Easterly (NYU faculty): maybe, proof? • In the Solow model • Is money/capital helpful? • What else might be?

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