BECO 4006

The Economics for Development

Faculty of Business Administration

University of Macau

2024 Spring Semester

Instructor: Leona LI
Session 02 – Jan 17th, 2024
 Miscellaneous
• Mid-term exam on March 6th

• Research project group formation

• Any questions
 Roadmap of today
• Production function
• Growth accounting
• The neoclassical growth model: Solow model
• The endogenous growth model: Romer model

• The most model-heavy lecture of the semester

• We will do it step by step
 Modern Economic Growth

“Once you start thinking about growth, it’s hard to think about anything else”
Robert Lucas (Nobel Laureate, 1995)
 Growth vs. Development
• Economic development refers to improvements in living standards and in
the quality of life
• Economic growth measures only growth in economic production (i.e., GDP)

• What is the relationship between growth and development?

• Growth may not reflect all aspects of development
• E.g., growth may result in pollution and urban congestion
• However, development cannot take place without economic growth
• Thus, growth is fundamental to development
 Proximate Cause of Economic Growth
• Why is there huge difference in economic prosperity across countries?

1. Physical capital difference:

– saving & investment
2. Human capital difference:
– skill & education
3. Technology difference:
– R&D & efficient organization of production
4. Markets:
– functioning market
 Proximate Cause of Economic Growth

• But…
• Why don’t certain countries save enough, invest enough, develop
and use technologies, and have functioning markets?

• “The factors we have listed (innovation, economies of scale,

education, capital accumulation, etc.) are not causes of growth;
they are growth.” (North & Thomas, 1993)
 Fundamental Cause of Economic Growth

1. The geography hypothesis

• Exogenous differences of environment
• E.g., country size, natural resources, soil quality, transportation cost,
extreme climate

2. The culture hypothesis

• Differences in beliefs, attitudes and preferences, e.g., religious systems
• Culture affects individual willingness to consume/save, and the degree
of cooperation and trust in societies
 Fundamental Cause of Economic Growth

3. The institutions hypothesis

• Humanly-devised rules shaping incentives
– Economic & political institutions
– Formal & informal institutions
– E.g., enforcement of property rights, legal systems, anti-corruption,
entry barriers, constraints on politicians and political elites, etc.

4. The luck hypothesis

• Similar initial conditions but diverse outcomes
• Multiple equilibria & historic path dependence
• The impact of one specific leader
 Yours Answers

• Proximate causes: labor, human capital, capital, infrastructure, technology

• Fundamental causes: reform and open up, industrial policy and place-based policy
 A Simple Framework: Production Function
• Factors of production ( 生產要素 ) in an economy
• Capital
• Labor
• Land
• Energy

• The production function is a mathematical expression of the joint effect of

the factors of production on output, mostly focusing on the contribution of
capital (K) and labor (L)
 Cobb-Douglas Production Function
• A prominent functional form in characterizing aggregate economy is the Cobb-
Douglas function

• Y=output, A=TFP=total factor productivity, K=capital input, L=labor input

• , is capital income share, 1- is labor income share
• For simplicity, we ignore the time notations for now

• What are the interesting properties of this function?

• It’s multiplicative. Thus, when K=0 or L=0, Y=0
• It’s constant return to scale
• when we multiply each factor input by z, output is also multiplied by z
•
 Factor Productivity
• Average labor productivity
• Obtain by dividing national output (Y) by total employment (L)

• where = is the capital intensity (i.e., capital per worker)

• Why do rich countries have higher labor productivity (output per capita)?
• Rich countries are abundant in capital, with a higher capital intensity
than poor countries.
 Factor Productivity
• Marginal productivity
• The output increase caused by an additional unit of labor or capital
• Marginal productivity of labor (MPL)

• Marginal productivity of capital (MPL)

• Property: MPL (MPK) decrease when labor (capital) increases

• Diminishing return is at the core of many economic observations!
 Factor Shares - Labor
• Factor shares
• The share of national income used as payment for the share of capital
(labor) in production
• Labor income share = , where w=wage rate
• In a perfect competitive market w=MPL

• With Cobb-Douglas production function

 Factor Shares - Capital
• Similarly, we can define
• Capital income share = , where r=interest rate
• In a perfect competitive market r=MPK

• With Cobb-Douglas production function

• For many years, in the advanced economies, the share of capital is

roughly one-third of total income and the share of labor is roughly two-
thirds of total income [i.e., assuming =1/3 in many studies]
Declining labor income share?

What do you think the causes

 Growth Accounting
• The production function is a very useful tool in growth accounting ( 增長
核算 )
Power Point
• Growth accounting estimates what percentage Templategrowth
of an economy’s
rate () we can explain using the growth rate(enter
of thetexts
labor here)
force (), the
growth rate of the capital stock (), and the residual/technology factors ).
• Specifically, we have
 Growth Accounting
• Based on a Cobb-Douglas production function
• Take the logarithm of both sides, and take the derivative of the logarithm
with respect to time Power Point Template
(enter texts here)
• Thus, arriving at

• We can decompose output growth to capital growth, labor growth, and a

residual (that is, growth rate of total factor productivity, TFP).
 Growth Accounting: A Numerical Example

• Suppose =9.5%, =12.6%, =1%, and =0.5

Power Point Template
(enter
• What is the contribution of technology/TFP texts here)
to economic growth?
• TFP growth = 9.5-0.5*12.6-0.5*1=2.7%
• Thus, the contribution of TFP is 2.7/9.5 =0.28, that is, 28% of output
growth is explained by TFP growth
Fill the blank(s) Points: 2

In the past year, an economy has experienced output growth of 5%,

capital stock growth of 3%, and labor growth of 2%. Assuming that the
economy is operating under the Cobb-Douglas production function,
with =0.35.

Through a growth accounting exercise, we can calculate that the TFP

growth rate is [Blank 1] .

Among K, L, and TFP, the biggest contributor to output growth is

[Blank 2] (please insert K, L, or TFP).

Answer
What can we learn from growth accounting?

Power Point Template

(enter texts here)
 The Neoclassical Solow Growth Model
• Robert Solow (1924-2023) developed the neoclassical growth model for
which he received the Nobel Prize in Economics in 1987.
• It is called the neoclassical growth model because it assumes
1. Competitive markets
2. Diminishing marginal product of capital
• This is the workhorse model to understand the mechanics of economic
growth, bringing together the mechanisms of savings, investment,
population growth, and technical change.
• Based on the Cobb-Douglas production function
• Dividing both sides by L, we get

• Takeaway:
[1] labor productivity (output per worker) is increasing with capital intensity, thus
capital accumulation is important for growth and development
[2] Diminishing return: the slope of y flattens as capital intensity increases
 Equilibrium in the Solow Model
• From the perspective of households, national income is divided between
consumption (C) and saving (S)

• Assuming national savings are a constant share of income, with a saving rate s,

• Investment (I) is the addition to the capital stock (K), with a depreciation rate

• I is flow ( 流量 ), K is stock ( 存量 )
• From basic macro, when aggregate supply and aggregate demand are in
equilibrium,

• Rearranging, we will obtain

+ (Eqn*)
• Takeaway:
• Next period’s capital stock will be equal to this period’s capital stock (that has
not depreciated) plus the investment generated from an economy’s saving.
• Let’s assume that everyone works, and that the population (L) grows at rate n,

• Now divide (Eqn*) by

/+
+
+
Takeaway:
• Next period’s capital intensity will be equal to this period’s capital intensity (net
of depreciation) plus saving per capita minus the negative impact of the
population growth rate on capital intensity.
• For intuition, let’s first consider a scenario without population growth (n=0)
+

 When more capital accumulation,

increasing capital intensity

 When less capital accumulation,

decreasing capital intensity
𝛿𝑘𝑡
𝑠 𝑦𝑡  Equilibrium at k*, where
 This point is called the steady state
The Steady State in the Solow Growth Model

• With population growth (n>0), the

increase in capital from savings (sy) has to
compensate both the depreciation in
existing capital (k) and the lower per
capita capital intensity driven by
increasing population (nk)

• The steady state is at k(t+1)=k(t)=k*

• In steady state, capital intensity remains
constant
 The Steady State in the Solow Growth Model
• To solve the steady state of a Solow model algebraically,
• Replace in +
• We have
+

• The corresponding steady state level of output per capita is

 The Steady State in the Solow Growth Model
• Steady state level of output per capita

• All else being equal,

• a country with high technology (A) and high saving rate (s)
• a country with low population growth (n) and lower depreciation rate ()
• will achieve high output per labor (y) in the long term
 Varying Saving Rates and the Steady State Output Level
• Assume country 1 saves 5% of its
national income and country 2 saves
15%, and that =1/3, what is the
implied output/income per capita
difference?

• Is saving sufficient?
• Please work out other implications
on n, A, and differences
 Implication on Income Convergence
• Note that in the steady state, the growth rate of income (Y) is necessarily
equal to the rate of population growth (n)
• In Solow model, it’s best to think of growth on the path toward the
steady state, i.e., the transition growth path

• Due to diminishing return to capital, the

lower capital intensity (relative to steady state
level), the high the growth rate.
• Thus, the Solow model predicts income convergence: poor countries should
grow faster than rich countries because they have a higher marginal product
of capital, all else being equal.
• Does it hold in reality?
Johnson, P., & Papageorgiou, C. (2020). What remains of cross-country convergence?. Journal
of Economic Literature, 58(1), 129-175.
• Absolute convergence? No.
• Conditional convergence? Some evidences.
Fill the blank(s) Points: 2

Exercise: Initially, country A’s saving rate is 20%, depreciation rate is

5%, population growth is 2%, and its TFP level is 1. [α=0.3]

[1] Please calculate the steady state level of output per capita: [Blank
1]

[2] The country experienced significant TFP growth and now TFP=1.5,
what is the level of steady state output per capita now? [Blank 2]

Answer
 Total Factor Productivity
• From the previous exercise, we know that TFP growth is very important
• Compare vs. and assume
• when saving rate doubles (s from 1 =>2),
• when TFP doubles (A from 1=>2),
• Back to the growth accounting formula , is also referred to as the Solow
residual
• Solow residual: The proportion of long-term economic growth not
explained by growth in labor or capital and therefore assigned primarily to
exogenous ( 外生 ) technological change.
 Endogenous Growth Theory
• So, what causes technological improvement?
• Contrary to the Solow model where technology is exogenous,
endogenous growth theory ( 內生增長理論 Power) Point
suggests that growth is
Template
generated by endogenous technical change resulting
(enter textsfrom
here)
entrepreneurial innovation.

• In general, endogenous growth theory is more optimistic

• It predicts that growth can be boundless
 Endogenous Growth Theory
• What is the difference between human capital and knowledge?
• Human capital exists in people, thus cannot grow much faster than the
population in the long term
Power Point Template
• When people die or become unproductive because of old age, their human
capital will become idle (enter texts here)

• Knowledge is not necessarily embodied in people. It exists in books, files,

patents, computer codes, etc.
• In principle, knowledge can grow boundlessly and accumulate indefinitely
• There is no obvious diminishing return
 Endogenous Growth Theory – The Romer Model
• How is knowledge created?
• People have to produce knowledge through research, thus growth of
knowledge is constrained by the number of people doing research
Power Point Template
(enter texts here)
• Basics of the Romer Model (Nobel Prize 2018)
• Dividing the number of workers in the economy into two sectors, the
production sector () and the research sector ()
+
• The production function is specified as

Note that is endogenous and depends on innovation

• The growth rate of knowledge is given by

Power Point Template
=
(enter texts here)

where denotes labor force in the research sector and is an indicator of

research efficiency
• Takeaway: countries with a higher stock of knowledge will add more to knowledge
than countries with a lower stock of knowledge, thus no diminishing return as in the
Solow model (and therefore no convergence!).
• What else is needed in the Romer model?
• Imperfect competition! Why?
• Knowledge is a non-rival and excludable good
• Non-rival: can still be consumed by the seller even after it is sold
• Power
Excludable: a seller can exclude others from Point Template
its consumption
(enter texts here)
• How? Patents, intellectual property rights
• For innovation incentives to work properly, innovators must expect monopoly
rents, i.e., extra profits derived from monopoly status

• Imperfect competition is necessary for innovation (and for growth in the endogenous
growth theory) was first put forward by Joseph Schumpeter
 To sum up: Romer Model vs. Solow model
Romer Model Solow Model
Endogenous TFP growth
(depends on stock of knowledge and Exogenous TFP growth
R&D effort and efficiency)
Power Point Template
Imperfect competition Perfect competition
(enter texts here)
Poorer countries play catch-up and
Rich countries can grow faster, thus converge at the income level of richer
income divergence countries (due to diminishing return)

• Discussion: Which model is a better characterization of the reality?

 Thank you
• Here are some useful references in the suggested reading list:
• Johnson, P., & Papageorgiou, C. (2020). What remains of cross-
country convergence?. Journal of Economic Literature, 58(1), 129-
175.
• Jones, C. I. (2023). The Outlook for Long-Term Economic
Growth (No. w31648). National Bureau of Economic Research.