Part 2

Per capita Cobb-Douglas production function

00.5

11.5

22.5

33.5

44.5

0 10 20 30 40 50 60 70 80 90 100

Capital per capita

Ou

pu

t p

er c

apit

a

In Easterly's discussion of diminishing returns, when is diminishing returns more severe?

Explain.

In cases where the variable input is of minor importance in comparison to the fixed input, diminishing returns can be more severe. Easterly’s notes that if one tries to increase pancake production by only increasing salt (ceteris paribus) the result would be disastrous.

Thus it is important to ask, for the US (and many countries ) what is capital income as a % of GDP? It is only about 1/3 – the rest is labor income.

This means that diminishing returns are going to be more severe if countries try to increase savings/investment to boost capital!

When machines are plentiful, the additional output of adding one more machine is very very low.

Explain Solow’s view on what would not sustain growth.

How did this lead to Solow’s surprise? Explain how Solow’s surprise can solve the problem of diminishing returns and leads to growth.

Increasing machines would not sustain growth. It may be high at first if machines are scarce; but diminishing returns means that the growth would fall as machines become abundant.

Savings will not sustain growth because this just diverts expenditures from consumption today into more machines…But while higher saving economies will have higher income (level effect) than a low-saving economy, growth would not be sustained by savings.

The Solow surprise is that the growth of output per worker (output per capita) could not be sustained. This leads to the question of “but what does sustain growth”?

Answer: technological change. It is this change in technology that may stave off diminishing returns to capital because it effectively gives us “new workers” - really the workers can each produce more with this new technology, so there is no diminishing returns to capital.

Solow’s model shows that the poor will eventually catch up to the rich. What does the data show has actually happened?

Include in your answer Baumol’s findings.

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Evidence against Solow’s model was the continued lack of growth in many poor countries. Romer used data from 1960-1981 to show that Solows prediction of growth failed in the tropics.

Pritchett also showed that even as far back as 1820, countries that are wealthy by 1992 were also the wealthy in 1820 – income divergence has just intensified.

But…Baumol showed that a group of 16 industrial countries had caught up to the leader over the past century; the poor had grown faster than the rich and thus there was a tendency toward conversion of national incomes.

Baumol’s Findings

Question continued:

So did the poor catch up with the rich?

Include in your answer Baumol’s findings and de Long’s critique.

Evidence against Solow’s model was the continued lack of growth in many poor countries. Romer used data from 1960-1981 to show that Solows prediction of growth failed in the tropics.

Pritchett also showed that even as far back as 1820, countries that are wealthy by 1992 were also the wealthy in 1820 – income divergence has just intensified.

Baumol showed that a group of 16 industrial countries had caught up to the leader over the past century; the poor had grown faster than the rich and thus there was a tendency toward conversion of national incomes.

de Long of Berkeley pointed out the mistake; Baumol chose for his study countries that had become wealthy – thus “proved” his conclusion by selecting only countries that had become wealthy – selected countries that had converged. This is called “sample selection bias”.

De Long’s Criticism