TheSolowGrowth Model

ApEc 3006, Spring2006

Michinori Uwasu
1 I ntroduction
Objective
Howto explain economic growth has been oneof themost enduringquestions in macroeconomics.
When looking around the world, we nd huge dierences in economic performance (particularly
GDP per capita or individuals income). Key observations are seen in both time series data and
cross sectional data. Three examples include; 1) Sub-Saharan (no growth since 1950s) vs. East
Asia(highgrowthsince1960s) fromtimeseriesdata; 2) OECD(over $10,000) vs. LDCs(less$300)
fromcross sectional data; and 3) Steady economic growth for thelast decades for most developed
countries. (SeeAppendix for graphs). Theseobservations raisethefollowing questions:
Why somecountries growfast whileothers do not?
Why somecountries arerich whileothers arenot?
Howto explain sustained economic growth?
Theobjectiveof mylectureistounderstandthebasicmechanismof economicgrowthbylearning
the Solow growth model. In particular, we learn the mechanismof capital accumulation and the
roles of population and technological progress in economic growth. Learning thebasic mechanism
of economic growth may not besucient, but necessary to answer thesequestions.
The Solow model
Toknowthefeaturesof theSolowmodel isof importance. First, theSolowmodel isvery neoclassic
in that it focusesprimarily on thesupply side. TheSolowmodel implicitly assumesthat, aslongas
supply of goodsincreases, economic growth can beattained. So, it isvery dierent fromKeynesian
models of which focus is on the demand side of an economy such as unemployment and ination.
Second, theSolowmodel is a DYNAMIC model (not static). Economic growth by naturecontains
1
dynamic aspects, which makes themodel complicated. Therefore, wearegoingto learn themodel
in steps to copewith thecomplication. In particular, werst study thebasic model that has only
a capital stock accumulation mechanism. After the basic model, we aregoing to incorporate new
factors, population growth and technology into the model and see how these factors change the
results obtained in thebasic model.
TheSolow model is named after an economist Robert Solow. Originally, hecameup with the
model based on the observation of US data between 1950s and 1970s, nding that (1) savings
rates and input factor shares were almost constant, and (2) per capita GDP growth rates were
steady. The punch lineof the Solow model is thus to systematically explain the two observations
(wewill soon seethis). His work has been inuential and thus been followed by a largenumber of
growth models including endogenous and multi-sector models. Robert Solow won theNobel prize
in economics in 1986 due to his contribution to growth theory. The Solow model is simple (no
complex math needed), but provides signicant implications for economic growth. Therefore, it is
theperfect placeto start leaning economic growth.
2 An Economy
The Solow model considers an simple economy that consists of a supply side and a demand side.
This section describes a static version of theeconomy beforeintroducing a dynamic aspect.
The supply side
The economy has one aggregate output and two input factors, capital stock and labor. The pro-
duction function is given by:
1
c
=1(1, 1)
where 1
c
= aggregate output supply, 1 = capital stock, 1 = labor. The Solow model has three
important assumptions on theproduction function.
Theproduction function is increasing in each input, and has diminishing marginal product.
I.e.,
oY
o1
0,
oY
o1
0,
o
2
Y
o1
2
< 0,
o
2
Y
o1
2
< 0.
When zero units of input is used for either 1 or 1, then nothingis produced. I.e., 1(0, 1) =
1(1, 0) =1(0, 0) =0.
The production function exhibits constant returns to scale (CRS). A production function
exhibits CRS if a proportionate increase in all input factors increase in output of the same
proportion.
2
Example 1 Suppose a production function is given by 1 =1
0.5
1
0.5
. Since
oY
o1
=0.51
0.5
1
0.5

0,
oY
o1
= 0.51
0.5
1
0.5
0,
o
2
Y
o1
2
= 0.251
1.5
1
0.5
< 0, and
o
2
Y
o1
2
= 0.251
0.5
1
1.5
< 0, the rst
assumption is met. Clearly, the second one is also met. To check if it is CRS, let us multiply
each input factor by c 0 : (1c)
0.5
(1c)
0.5
= 1
0.5
1
0.5
c
0.5
c
0.5
= c1
0.5
1
0.5
= c1
c
. Since a
proportionate increase in each factor increase in output of the same proportion, it is CRS.
Two reasons for having the assumptions are in order. First, there are many empirical studies
that support theassumptions. Second, it bringsanalytical convenience. Specically, usingtheCRS
property, wecan obtain a simpleformof production function on a per worker basis:
1
c
= 1(1, 1)
Multiply both sides by
1
1
1
c
1
= 1(
1
1
, 1
|{z}
)iaco
)
(Theabovelineuses theCRS property)
1
c
1
= 1(
1
1
) ! j
c
=)(/)
where j
c
= output supply per worker, and / = capital stock per worker. This implies that per
worker output supply is determined only by capital stock per worker.
Example 2 Assume 1 =1
0.5
1
0.5
is given. Then the per worker production function is
1
1
=
1
0.5
1
0.5
1
=
1
0.5
1
0.5
1
0.5
1
0.5
=
1
0.5
1
0.5
=(
1
1
)
0.5
! j =/
0.5
Remark. In what follows, webasically look at per worker units of factors: this makes sensein
that weareinterested morein individuals living standards (e.g., your income) than in thesizeof
an economy (e.g., GDP). So, pleasekeep in mind thedierencesbetween capital letters(1, 1, 1, 1)
and small letters (j, /, i).
3
The demand side
The demand side of the economy assumes no disposal of income, so the output demand must be
equal to thesumof consumption and investment:
1
o
C +1 (identication)
! j
o
c +i (divided both sides by 1)
where1
o
is output demand, C is consumption, 1 is investment, j
o
is per worker output demand,
c is per worker consumption and i is per worker investment. Each individual is assumed to either
consumeor savegiven his income:
j
o
= c +:j
o
! c =j
o
:j
o
(consumption function)
where0 : 1isa savings rate(so, : jd is theamount of savings for each individual). Plugging
c into theidentication yields
i =:j
o
(investment function)
Equilibrium
In equilibrium, supply equals demand. So, plugging j
o
= j
c
=)(/) into the investment function
to obtain
i =: )(/)
This holds in equilibriumof the static economy. Figure 1 represents the static equilibriumof the
economy.
3 Capital Accumulation
We introduce a dynamic aspect into the static economy. In particular, we incorporate a capital
accumulation mechanisminto thestatic model. Two factors involvein thecapital stock accumula-
tion.
1 Investment: increases capital stock.
2 Depreciation: a certain proportion of capital stock wears out.
4
k
y=f(k)
i=s*f(k) c
i
y
k 0
y, i
Figure1: Static Equilibrium
Let c denotethedepreciation ratein onetimeperiod and let /
t
denotea capital stock level in
period t. Theruleof changein capital stock in oneperiod of timecan then beexpressed as:
/
t+1
/
t
oc)
= 4 /
t
= i
t
c/
t
! 4 /
t
=: )(/
t
) c/
t
or /
t+1
= /
t
+: )(/
t
)
Transition of the economy and steady state
A graphical representation isthebest way to showhowan economy changes over timegiven initial
capital stock. Figure 2 represents an economy that is given the production function j = )(/),
savings rate :, depreciation rate c, and the initial capital stock /
0
. Using this amount of capital
stock, theeconomy produces j
0
(units) of output and i
0
(units) of investment. With this amount
of investment, theeconomy is goingto have/
1
=(i
0
c/
0
) +/
0
units of capital stock in period 1.
Theeconomy can thus producej
1
units of output and i
1
units of investment in period 1. Likewise,
the economy will have the new capital stock level /
2
= (i
1
c/
1
) +/
1
in period 2, by which the
economy will producej
2
units of output and i
2
units of investment in period 2(not shown in the
gurethough). Repeating this shows that thecapital stock level is increasing until it reaches one
point (state) denoted by, /
cc
. Oncetheeconomy gets to thestate, it will not movefromthestate
because the amount of capital that wears out is equal to the amount of investment in the state.
Wecall such a statesteady state. Theformal denition is:
Denition 1 Steady stateis an equilibriumstate where / ( per worker capital stock) is invariant.
5
*k
y
ss
k
ss
k
0
y
0
k0
i
0
*k0
k
1
=k
0
+k
1
y
1
k
1
y=f(k)
i=s*f(k)
k 0
y, i
Figure2: Steady State(Long-TermEquilibrium)
Thus in steady stateno changein / occurs. Mathematically,
4 / = 0
! : )(/) c/ =0
We call this a steady state condition. If a specic functional formof )(/), and values of : and
c aregiven, wecan solvethecondition for /.
Example 3 Suppose j =/
0.5
, : =0.2, and c =0.05. The steady state condition implies
:/
0.5
c/ = 0! 0.2/
0.5
=0.05/
/
0.5
= 0.25! /
cc
=16
This further implies that the steady state level of per worker output is calculated as
j
cc
=/
0.5
cc
=16
0.5
=4.
Some comments
If aninitial capital stock isnot zero, aneconomyapproachestoapositivesteadystate. (When
/ =0, )(/) =0by assumption. So, when / =0, thesteady statecondition is met, meaning
/ =0is also a steady state.)
6
Once an economy gets to a positive steady state, it will not leave the steady state. (This
implies that the positive steady state is stable.) Thus steady state can be thought of as a
long-termequilibrium.
4 Golden Rule of Capital Stock
Comparative Static
This section demonstrates comparativestatic with respect to a savings rate. What is comparative
static? As you notice, any models havevariables. In theSolowmodel, wehave; /, j, i, :, c, /
0
. And
any variables in a model can be divided into two categories; exogenous variables, and endogenous
variables. Exogenous variables areones that are determined outsidea model whereas endogenous
variables are ones that are determined in the model. Comparative static demonstrates how one
exogenous variablechangeaects an equilibrium. In theSolowmodel, wehave:
Exogenous variables :, c, /
0
Endogenous variables /, j, i
How do we show the eect of change in savings rates on steady state? First, note that since
the investment level is given by i = : )(/), change in savings rates shifts the investment curve.
Clearly, the higher savings rate shifts the investment curve upward, and vice versa. Second, the
correspondingsteadystatealsoshifts. For example, supposewehaveaproductionfunctionj =/
0.5
.
By thesteady state condition : /
0.5
c/ =0, we havesteady state capital stock /
cc
=(
c
c
)
2
(To
showthis will bea homework question). Theequation indicates, as : increases, /
cc
increases.
This can be graphically. In Figure 3, there are three levels of savings rates, :
1
< : < :
1
.
When a savings rateis :, theinvestment curveis i =: )(/) and thecorrespondingsteady stateis
given by /
cc
. Similarly, when :
1
is given thesteady statecapital stock is /
1cc
. When :
1
is given,
thecorresponding steady statecapital stock is /
1cc
. Clearly, it shows /
1cc
< /
cc
< /
1cc
; in other
words, thehigher thesavingsrateis, thehigher thesteady statelevel of capital stock per worker is.
Figure7-6in Mankiw(p191) presents international evidence: countries with high investment rates
tend to have higher income per worker, which might support the prediction by the Solow model.
(Why "might"?)
Golden Rule
Supposeyou werea policy maker. Supposealso that you can changea savings ratethrough scal
policy or monetary policy. Then, what savings rate would you choose? One answer may be that
you want tochoosethesavingsratesuch that per worker consumptionin steady stateismaximized.
7
y=f(k)
k
i=s
L
f(k)
i=s
H
f(k)
i=sf(k)
k
Lss
k
Hss
k
ss
y, i
k 0
Figure3: ComparativeStatc Analysis for Savings Rates
Denition 2 Thegolden rulecapital is thesteady statecapital stock level, /
cc
such that consump-
tion in steady state, c
cc
is maximized.
The immediate question is then: How do we nd such a savings rate? We take the following
two steps.
Step 1 Find thegolden rulelevel of capital stock.
Let /
jc|o
cc
denote the golden rule level of capital stock. Recall consumption per worker is
calculated as
c = j c/
= )(/) c/
c is maximized when theslopeof theproduction function is equal to theslopeof c/:
Theslopeof )(/) = '11
Theslopeof c/ = c
Thus, when '11 =c is satised, c is maximized. Wecall "'11 =c" a golden rule.
Step 2 Find thecorresponding savings rate, :.
8
y.i
y=f(k)
MPK=
k
y
gold
ss
k
gold
ss
i=s
gold
f(k)
k
C
gold
ss
Css
i=sf(k)
MPK
kss
yss
a
b
c
0 k*
e
d
Figure4: Golden Ruleof Capital Stock
Note that /
jc|o
cc
is also steady state level. Thus it also satises the steady state condition,
:)(/) =c/ which wecan solvefor :.
Example 4 Suppose j =/
0.5
, and c =0.05. Find a savings rate that maximizes consumption in
steady state.
(Step 1) By the golden rule,
'11 = 0.5/ 0.5=0.05=c
! /
0.5
=0.1
! /
jc|o
=0.1
2
=100.
(Step 2) Plug/
jc|o
into the steady state condition and solve it for ::
: )(/
jc|o
cc
) = c/
jc|o
cc
:100
0.5
= 0.05100
: = 5,10=0.5.
Graphical representation
Dierent savings rates lead an economy to a unique steady state. In Figure 4, we have two
dierent savings rates. : leads the economy to /
cc
and c
cc
, and :
jc|o
leads the economy to /
jc|o
cc
9
and c
jc|o
cc
in thelong-term. In this example, /
jc|o
cc
satises thegolden rule'11 =c while/
cc
does
not. Therefore, weknowthat c
jc|o
is thegolden rulelevel of capital and is clearly larger than c
cc
.
Theinformation of '11 and c can beused toevaluatethecurrent statusof an economy in the
context of thegolden rule. If '11 =c is found, then theeconomy isne: peopleareenjoyingthe
maximal consumption level. If '11 < c isfound, it meansthat theeconomy hastoolittlecapital
stock. Toseethis, letslook at Figure4: with any capital stock levels less than thegolden rulelevel
of capital stock (/
jc|o
cc
), their marginal product of capital stock isgreater than thedepreciation rate
(c). So, politicians may want to increasethecapital stock so that theeconomy has thegolden rule
capital stock. In order to do so, they need to raisethesavings rate. If '11 c is found, on the
other hand, theeconomy hastoomuch capital stock. In thiscase, politiciansmay want todecrease
the savings rate to lead the economy to the golden rule capital stock level that is less than the
current level.
Situation Diagnoses Policy Implications
'11 c in ss ! too littlecapital stock ! increasethesavings rate
'11 =c in ss ! golden ruleof capital stock ! keep thesavings rate
'11 < c in ss ! too much capital stock ! decreasethesavings rate
A transition path of consumption when : is increased Supposethecurrent economy is
in steady stateof /
cc
as in Figure4. Thegolden ruleof capital stock implies, thecurrent economy
is not maximizing peoples consumption level and raising thesavings ratefrom: to :
jc|o
will lead
the economy to the golden rule level of capital stock; thus attaining optimal consumption in the
long-term. In theshort-term, however, the economy will experiencelower consumption levels due
to the increase in :. Too see this, we again look at Figure 4. In the original steady state, the
consumption level was given by a c (c
cc
). When weincreasethesavings ratefrom: to :
jc|o
, the
immediateconsumption level becomes/ c that isclearly lower than a c. Astimegoesby, capital
stock is accumulating, so that consumption starts increasing. Note that when the capital stock
level gets to /

, the economy brings d c units of consumption to each worker that is the same
as the original consumption level a c. So, until this point, the economy has lower consumption
levels, but thereafter the economy can enjoy higher consumption levels than the original one and
when it getstothesteady state, it can havetheoptimal consumption level. Theconsumption path
of consumption discussed hereis drawn in Figure5.
10
c
ss
c
gold
ss
time
c
Increase s capital stock = k* capital stock = k
gold
ss
Figure5: Consumption path when changing a savings ratefrom: to :
jc|o
5 Population Growth
Thusfar wehavexed thenumber of labor (=population) in themodel. TheSolowmodel assumes
that labor forceisgrowingover timeat a rateof :. Thismeans that population growth ratein the
model is exogenous. So, wecan demonstratea comparativestatic with respect to :. Beforegoing
intoit, weneed gureout howpopulation aectstheeconomy. Population growth spreadsthecap-
ital stock morethinly tolarger population, soit hasanegativeeect on capital stock accumulation.
In particular, theaccumulation rulefor theeconomy with population growth becomes:
/
t+1
= i
t
(c +:)/
t
+/
t
or 4 / = /
t+1
/
t
=i
t
(c +:)/
t
where (c +:)/
t
is called a break-even investment curve because it is the amount of investment
necessary to keep capital stock constant. SeeAppendix for thederivation of theequation.
Steady State Steady stateof theeconomy can beobtained in thesameway. In steady state,
capital stock per worker will beinvariant, so wehave
4 / =i (c +:)/ =0.
Givenaspecicfunctional formof aproductionfunctionandparameter values, wecanndasteady
stateof a particular economy (this will bea homework question).
Now, we are ready to demonstrate how population aects steady state of the economy. A
11
y, i
k
y=f(k)
i=sf(k)
(+n
H
)k
(+n
L
)k
k
Lss
k
Hss
y
Lss
y
Hss
0
Figure6: ComparativeStatic Analysis for Population Growth
graphical presentation is the best way to do it. The implications of Figure 6 is as follows. 1)
Population growth rate shifts the break-even curve. Given :
1
< :
1
, (c +:
1
)/ has a atter
slope than (c +:
1
)/. 2) Thus the corresponding steady state also shifts. When :
1
leads the
economy to thesteady state/
1cc
, whereas :
1
leads theeconomy to thesteady state/
1cc
. Clearly,
/
1cc
< /
1cc
. Figure7-7in Mankiw(p203) presents international evidence: high population growth
rates arenegatively associated with incomeper worker, which might support theprediction by the
Solowmodel. (Again why "might"?)
Golden Rule Given theaccumulation rule, thegolden ruleis:
'11 =: +c.
So, using this rule and the steady state condition, we can nd a savings rate that maximizes
consumption in steady state.
Summary 1
The steady state is a long-term equilibrium. The Solow model shows how an economy is
changing over timeuntil it gets to steady state.
Savings rates determine the level of per worker capital stock in steady state. Higher the
savings rate, thehigher thelevel of per worker capital stock.
Thegolden ruleof capital stock maximizes theconsumption level in thelong-term.
12
Population growth has a negative impact on capital stock accumulation. The higher the
population growth rate, thelower level of steady state.
However, neither factor can explain sustained economic growth as observed in developed
countries. In thecurrent model, capital stock per worker is invariant in steady state.
6 Technological Progress
Labor augmenting technology
To introduce a technology element into the model, we start with a new aggregate production
function:
1 =1(1, 1 1)
where 1 = output, 1 = capital stock, 1 = labor (workers), and 1 is eciency of worker. 1 1
in theproduction function is called eectiveworkers. In theeconomy, eciency of workers may be
determined by knowledge, experience, and skills of averageworkers. Becausetheeciency variable
is attached to labor input, it is called labor-augmenting technology: an increasein 1 can increase
output level as if morelabor input is used. In theSolowmodel, 1 is growing at a constant rateof
q (so, q is an exogenous variable).
We assume that the production function exhibits CRS. This means that we can divide both
sides by 1 1 to obtain:
j =)(/)
wherej =
Y
11
is output per eective worker, and / =
1
11
is capital stock per eective worker.
Likepopulation growth, technological progressaectscapital accumulation. Theruleof capital
accumulation (per eectiveworker) is now:
/
t+1
= i
t
(c +: +q)/
t
+/
t
or 4 / = /
t+1
/
t
=i
t
(c +: +q)/
t
where(c +: +q)/ is called a break-even investment curve becauseit is theamount of investment
necessary to keep capital stock constant. Appendix shows howthis equation is derived.
Steady state
Denition 3 Steady statein theeconomy with technological progress is an equilibriumstatewhere
/ (capital stock per eective worker) is invariant.
13
y, i
k
y=f(k)
i=sf(k)
(+n+g)k
k
ss
y
ss
0
Figure7: An Economy with Technological Progress and Population Growth
Thus thesteady statecondition is
4 / =i (c +: +q)/ =0
To obtain a steady state, weneed solvingthecondition for /. Figure7presents thesteady stateof
an economy with technological progress.
So, is thereany dierence? Theanswer is yes. Too seethis recall thedenition of each variable
is given by (seeTable2):
Table2: Steady StateGrowth Rates with Technological Progress
Vars Steady StateGrowth Rate
/ (capital stock per eectiveworker) 0
j (output per eectiveworker) 0
1 (labor/ population) :
1 (eciency of worker) q
1
1
=/ 1 (capital stock per worker) q
Y
1
=j 1 (output per worker) q
1 =/ 1 1 (capital stock) : +q
1 =j 1 1 (output) : +q
The implication of the information is as follows. In an economy with technological progress,
capital stock per eectiveworker is not growingin steady state. However, capital stock per worker
14
is growing at a rate of q (a rate of technological progress) even in steady state. Why? This is
because 1 is growing at q in all periods by assumption and because
1
1
is dened by / 1. So,
even if / is not growing in steady state,
1
1
is growing at q. Moreover, this means that
Y
1
, output
per worker (equivalent to individual income) is also growing at q even in steady state. Likewise,
capital stock and total output in theeconomy aregrowing at : +q. Thebottomlineof theSolow
model is: technological progress explains sustained economic growth in the context of individual
living standards.
The role of the government Researchers havefound what factors determinetheeciency
of workersin an economy. Thosefactorsinclude; education, health, infrastructure(road, highways,
airport, port, utilities, to name a few), law&order, and security (police, re ghting, military
services). Notethat many of the factors that aect eciency of an economy involve public goods
elements, andit iswell knownineconomicsthat marketsthemselvescannot provideenoughamounts
of publicgoods. Usually, governmentsaretheonlyagent that haveanabilitytoprovidethesucient
amount of public goods, which implies that theroleof thegovernment is important in (sustained)
economic growth.
Golden Rule With theaccumulation rule, thegolden ruleis given by:
'11 =: +c +q.
Usingthis ruleand thesteady statecondition, wecan nd asavingsratethat maximizesconsump-
tion in steady state.
Summary 2
TheSolow model shows how capital stock accumulates over time, determines the long-term
equilibrium, and shows how savings, population growth, and technology aects an economy
in thelong-term.
Savings and population growth determine the steady state level; however, neither variable
explains sustained economic growth.
Technological progress can explain economic growth in steady state. In steady state, output
per worker is growingat a rateof technological progress.
15
Governments can play a key rolein improving eciency of workers. Good education/ health
services, good infrastructure, strict law&order systems, and security improvetheeciency of
an economy and thus support sustained economic growth.
The rate of technological progress is exogenous in the Solow model. Thus the Solow model
itself does not determinesustained economic growth.
Appendix
1. Data Although it is very important to takea closelook at real data in studyingeconomic
growth, wehaveno timetodo so. However, alargenumber of useful datasources for international
economies arereadily available. If you areinterested, try thefollowing:
Summers-HestonPennWorldData(Universityof Pennsylvania): Veryuseful. Containsmany
key variables such as GDP, investment, labor forcefor most economies from1950. Data can
bedownloaded via http:/ / pwt.econ.upenn.edu/
WorldDevelopment Indicators(WorldBank): AvailableinWaitelibrary, or visit http:/ / www.worldbank.o
Human Development Report (United Nations): Estimates uniquevariables for human devel-
opment. Availablein Waitelibrary or visit http:/ / hdr.undp.org/ .
ThePenn World Data areused to construct thegureand tablebelow.
2. Examples
.
0
2000
4000
6000
8000
10000
12000
14000
16000
1
9
6
0
1
9
6
3
1
9
6
6
1
9
6
9
1
9
7
2
1
9
7
5
1
9
7
8
1
9
8
1
1
9
8
4
1
9
8
7
1
9
9
0
1
9
9
3
1
9
9
6
Year
G
D
P

p
e
r

c
a
p
i
t
a
Chad
South Korea
Why somecountries growfast whileothers do not? Chad and South Korea 1960-1998 (Note: 1996prices)
16
Why somecountries arerich whileothers arenot?
TheLiving Standards in 12 most populous countries 1998
Country GDP per Capita Population Country GDP per Capita Population
United States 31,049 275,675 Indonesia 3,521 203,678
J apan 23,345 126,410 China 3,203 1,238,599
Germany 21,724 82,047 India 2,464 978,672
Mexico 8,060 95,846 Pakistan 2,053 131,582
Russia 6,948 146,909 Bangladesh 1,655 125,629
Brazil 7,130 165,874 Nigeria 1,025 120,827
Note: GDP per Capita (in US dollars), Population (in thousand).
3. Mathematical Notes 3-1. Derive4 / =i (c +:)/.
Noting that
4 1 =
d1
dt
=1 c1
d1,dt
1
= :,
wehave
/
t+1
/
t
= 4 /
t

d/
dt
=
d(1,1)
dt
=
d1
dt

1
1

1
1
2

d1,dt
1
=
1 c1
1

1
1
d1,dt
1
= i c/ /:
! 4 / =i (c +:)/.
3-2. Derive4 / =i (c +: +q)/.
Noting that
d1,dt
1
= :
d1,dt
1
= q
d(11),dt
11
=
o1ot
1
1 +
o1ot
1
1
11
=: +q,
17
wehave
/
t+1
/
t
= 4 /
t

d/
dt
=
d(1,11)
dt
=
d1
dt

1
11

1
(11)
2
(
d1
dt
1 +
d1
dt
1)
=
1 c1
11

1
11
(
d1,dt
11
1 +
d1,dt
11
1)
= i c/ /(: +q)
! 4 / =i (c +: +q)/.
3-3 We show that shares of each input factor is equal to the elasticity of each input. Assume
theaggregateproduction function is given by:
1 = 1(1, 1)
Let r denote a rental rate of capital, and let n denote a wage rate. We want to show that
'11 =r
1
Y
and '11 1 =n
1
Y
. Theeconomy maximizes its prot:
max =1 n1 r1 =1(1, 1) n1 r1
Therst order conditions are:
d
d1
!
d1
d1
=n
d
d1
!
d1
d1
=r
Multiply both sides in therst equation by 1 and dividethemby 1 yields
d1
d1
1
1
= n
1
1
! '11
1
1
| {z }
elasticity of labor
= n
1
1
|{z}
labor share
18
For capital stock,
d1
d1
1
1
= r
1
1
! '11
1
1
| {z }
elasticity of capital stock
= r
1
1
|{z}
capital stock share
Cobb-Douglas Production function A Cobb-Douglas production function is the most
commonly used CRS production function:
1 =1
c
1
1 c
Theelasticities of each inputs for Cobb-Douglas aregiven by:
'11
1
1
= c
'11
1
1
= 1 c.
So, the factor shares for capital stock and labor are given by c and 1 c, respectively. This is
very convenient in practicebecause you need no calculation to nd capital shareonce you havea
production function.
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