I NTERMEDIATE M ACROECONOMIC T HEORY

L ECTURE 3

Simon Fraser University

Instructor: Marieh Azizirad

Summer 2023
Our plan in this lecture

Understanding total factor productivity (TFP)

Cross-country income differences
Level accounting
Growth accounting

The economics of ideas and IRS

ECON 305 D100 Summer 2023, Lecture 3 2

Total factor productivity

TFP measures in general how efficient countries are using the capital and labor. It
is a "residual" that captures any other factors omitted from the production function.

Possible factors:
Technology
Human capital
Institution
Misallocation

ECON 305 D100 Summer 2023, Lecture 3 3

Total factor productivity

Technology
E.g. software, 5G, COVID-19 vaccine, military jets, etc.
Explains economic growth through research and innovation.
But technology cannot explain big income differences because:
Knowledge can travel very fast (check your phone);
Can hire advisers and engineers from anywhere.

ECON 305 D100 Summer 2023, Lecture 3 4

Total factor productivity

Human capital
A stock of skills that individuals acquired to make them more productive.
Can "invest" in human capital through education.
Returns to education:
→ In the U.S., one year of education on average increases one’s future wage by around
7%.

ECON 305 D100 Summer 2023, Lecture 3 5

Total factor productivity

Human capital
If we capture human capital in our Solow model, then the production function becomes:

Y = AK α H β L(1−α−β )
Assume human capital behaves similarly to physical capital:
Invest an sK proportion of income in K, and a sH proportion in H;
K depreciates at δK and H depreciates at δH .

ECON 305 D100 Summer 2023, Lecture 3 6

Total factor productivity

Human capital
The steady states income per capita is:
Y∗ 1 sK
1−α−β
α sH
1−α−β
β
= A 1−α−β
L δK δH

Exercise: solve the steady state K ∗ and H ∗ , and then check if you find the same equation for
the living standards.

ECON 305 D100 Summer 2023, Lecture 3 7

Total factor productivity

Human capital:
Around half of the TFP differences across countries can be accounted for by
incorporating human capital.
This means...
Access to education is very important.
The return to education may be higher in developing countries:
→ Educated workers are more scarce.
→ The return to primary and high school is higher than university.

ECON 305 D100 Summer 2023, Lecture 3 8

Total factor productivity

Institutions
refers to all social arrangements that determine how people usually interact.
→ E.g., legal system, governments, industrial structure, education system, religions,
etc.
Bad institutions are disruptive...
→ War, political chaos, corruption ...
Good institutions are constructive ...
→ Political stability, democracy;
→ Rule of Law: personal safety, low risk of expropriation, reliable contract enforcement,
reasonable and predictable regulations;
→ Reasonably free markets: openness to international trade, free movement of
workers and capital, ease of setting up a business;
→ A strong educational system.

ECON 305 D100 Summer 2023, Lecture 3 9

Total factor productivity

Misallocation
inputs and resources are not put to their best uses (inefficiency).
→ E.g. Engineers who drive taxis. Empty "ghost" cities.

Common reasons:
Corruption
Industrial policy (state control of companies/industries)
History ("we’ve always done it this way")

ECON 305 D100 Summer 2023, Lecture 3 10

Our plan in this lecture

Understanding total factor productivity (TFP)

Cross-country income differences
Level accounting
Growth accounting

The economics of ideas and IRS

ECON 305 D100 Summer 2023, Lecture 3 11

Cross-country income differences

What makes rich countries rich and poor countries poor?

Today, the per-person income in developed countries is about 50 times as high as in the
least developed countries.
70-80 times if you compare just the five richest and poorest!
How do we understand the income differences?
"Level accounting": attribute output differences to differences in the inputs.
"Growth accounting": attribute differences in output growth to differences in the growth
of inputs.

ECON 305 D100 Summer 2023, Lecture 3 12

Cross-country income differences

Level accounting:
In the context of Solow model, recall that output per person at S.S. is:
Y∗ 1 s
1−α
α
= A 1−α
L δ
Some facts:
The investment rates (s) in the richest countries: ∼ 25-30%, whereas that in the poorest
countries: ∼ 7%.
The depreciation rate (δ ) is the same worldwide.
Assume α = 1/3.

ECON 305 D100 Summer 2023, Lecture 3 13

Cross-country income differences

Level accounting; Lessons?

Rich countries are rich NOT because they have a lot of capital...
...but because they have a lot of TFP.

ECON 305 D100 Summer 2023, Lecture 3 14

Cross-country income differences

Growth accounting:
At S.S., output per person is:
Y∗ 1 s
1−α
α
= A 1−α
L δ
So the growth rate of output per person is:
α α 1
gy = gs − g + gA
1−α 1−α δ 1−α
→ s and δ are usually constant.
Lesson: long-run growth in output per capita is driven by the growth in A.

ECON 305 D100 Summer 2023, Lecture 3 15

Cross-country income differences

Growth accounting;
Out of the S.S., output per person is y = Akα . With α = 1/3,
1
gy = gA + gk
3

Lesson: TFP growth still accounts for most of the economic growth!

ECON 305 D100 Summer 2023, Lecture 3 16

Our plan in this lecture

Understanding total factor productivity (TFP)

Cross-country income differences
Level accounting
Growth accounting

The economics of ideas and IRS

ECON 305 D100 Summer 2023, Lecture 3 17

The economic of ideas

Ideas: "know-how"
Production of ideas improves productivity for everyone, not just for the innovator who
produced the idea.
This is different from human capital: human capital is skills that are embodied in a
person, whereas ideas can be shared and used by anyone. Ideas are non-rival.

ECON 305 D100 Summer 2023, Lecture 3 18

The economic of ideas

Ideas: Increasing returns to scale.

Recap: (IRS) For any parameter c > 0, F(c ∗ inputs) > c ∗ F(inputs).
An example of an IRS production technology compared to a CRS one:

ECON 305 D100 Summer 2023, Lecture 3 19

The economic of ideas

Ideas: Increasing returns to scale.

Implications: "Big-push" policy.
→ A firm’s decision whether to adopt IRS or not depends on its expectation of what
other firms will do; Nobody wants to be the first to invest.
→ In theory, the government could help firms embark on the path of IRS technology by
promoting a "big push" of investment in the industry.
→ E.g. Silicon Valley, Shenzhen Special Economic Zone, etc.

ECON 305 D100 Summer 2023, Lecture 3 20

The economic of ideas

Ideas: Increasing returns to scale.

Recap: (IRS) For any parameter c > 0, F(c ∗ inputs) > c ∗ F(inputs).
An IRS Cobb-Douglas production function:

Yt = F(Kt , Lt , At ) = At Ktα Lt1−α

At denotes the ’stock of ideas’ or ’knowledge’ variable.

Three input variables now: A, K, and L.
Prove the IRS property:

F(2Kt , 2Lt , 2At ) = 2At (2Kt )α (2Lt )1−α = 2 · 2α · 21−α At Ktα Lt1−α = 4F(Kt , Lt , At )

ECON 305 D100 Summer 2023, Lecture 3 21

The economic of ideas

The Romer model:

Features:
Incorporate the IRS and non-rivalry of ideas;
Output requires knowledge/ideas and labor;
Producing new ideas requires previous stock of ideas, the number of workers producing
ideas, and worker productivity.

ECON 305 D100 Summer 2023, Lecture 3 22

The economic of ideas

The Romer model, setup:

Assume IRS Cobb-Douglas production function with α = 0.

1−α
Yt = F(Kt , Lyt , At ) = At Ktα Lyt = At Lyt

→ where Lyt is the labor put into the production process.

ECON 305 D100 Summer 2023, Lecture 3 23

The economic of ideas

The Romer model, setup:

Assume that ideas are produced with:

∆At+1 ≡ At+1 − At = z̄At Lat

→ where Lat is the labor put into the ’idea’/’technology’ creation process. z̄
represents how effective ideas are produced. Also assume the economy starts out
at t = 0 with an existing stock of ideas A0 .

ECON 305 D100 Summer 2023, Lecture 3 24

The economic of ideas

The Romer model, setup:

Assume that:
Lyt + Lat = L̄

→ where Lat is a constant proportion of L̄: Lat = ℓ ∗ L̄

ECON 305 D100 Summer 2023, Lecture 3 25

The economic of ideas

The Romer model, setup:

Yt = At Lyt

∆At+1 ≡ At+1 − At = z̄At Lat

Lyt + Lat = L̄

Lat = ℓ ∗ L̄

→ Four equations, four endogenous variables, and four parameters.

ECON 305 D100 Summer 2023, Lecture 3 26

The economic of ideas

Solving the Romer model:

Yt = At Lyt

Output per person depends on the stock of ideas:

Yt
yt ≡ = At (1 − ℓ̄)
L̄
→ Whereas in the Solow model: Output per person depends on capital per person.
The growth rate of ideas is constant:
∆At+1
ḡ ≡ = z̄Lat = z̄ℓL̄
At

ECON 305 D100 Summer 2023, Lecture 3 27

The economic of ideas

Solving the Romer model:

The stock of knowledge depends on its initial value and its growth rate:

Combining with the output per person equation:

Yt
yt ≡ = At (1 − ℓ̄)
L̄
We have:
yt = A0 (1 − ℓ̄)(1 + ḡ)t

ECON 305 D100 Summer 2023, Lecture 3 28

The economic of ideas

Solving the Romer model:

yt = A0 (1 − ℓ̄)(1 + ḡ)t

ECON 305 D100 Summer 2023, Lecture 3 29

The economic of ideas

Lessons from the Romer model:

yt = A0 (1 − ℓ̄)(1 + ḡ)t

The Romer model produces long-run growth.

→ Does not have diminishing returns to ideas because they are non-rivalrous.
→ Labor and ideas have increasing returns together (Yt = At Lyt ).
→ In the Solow model, capital has diminishing returns, therefore eventually, capital and
income stop growing.

ECON 305 D100 Summer 2023, Lecture 3 30

Readings

Jones, Ch 4.4, Ch 6.1-6.3, Ch 6.5-6.6.

ECON 305 D100 Summer 2023, Lecture 3 31