UNIVERSITY OF PRETORIA

FACULTY OF ECONOMIC AND MANAGEMENT SCIENCES

DEPARTMENT OF ECONOMICS

ECONOMICS 214 SEMESTER TEST MARCH 2019

Examiner: Dr HR Bohlmann Time: 90 Minutes

ANSWER ALL QUESTIONS CLEARLY AND CONCISELY

1. Start with the basic Cobb-Douglas production function and allocate factor shares
of (α) to capital and (1-α) to labour. Using the first derivative, algebraically show
that the marginal product of capital in the Cobb-Douglas production function is
always positive (with 0<α<1). Briefly explain the economic interpretation of this
result. (5)

2. In our Cobb-Douglas production function, the second derivative of output with

respect to capital is negative. Briefly explain the economic interpretation of this
result, and draw a graph of the per capita production model to support your
answer. (10)

3. Write down the basic production model in per capita terms and briefly describe
the two key forces this model shows are the main drivers in income per capita
differences between countries. (5)

4. Human capital, technology, allocation of resources, management, and

institutions are typically identified in the literature as key sources of differences
in total factor productivity between countries. Define institutions and briefly
discuss any five institutions you believe are most important within the context of
total factor productivity and economic growth. (15)

5. Write down and briefly explain the capital accumulation equation in the Solow
growth model. (5)

6. Draw a well-labelled graph to indicate how the steady-state position is

determined in the Solow model, starting from a position of too little capital per
worker. (10)

[50]
SUGGESTED ANSWERS

1. Y = Af(K, L)
Y = KαL(1-α)

The standard Cobb-Douglas production function shows that total output is a

function of the amount of capital and labour (gross value added) employed in
an economy, and the level of total factor productivity.

The marginal product of capital can be found by taking the first derivative of Y
with respect to K from the production function in (1).

If 0 ≤ α ≤ 1 …

Y = Af(K, L)
Y = KαL(1-α)
∂Y/∂K = αK(α-1)L(1-α)
∂Y/∂K = αK(α-1)/L(α-1)
∂Y/∂K = α[K/L](α-1) > 0

This formally shows that output (Y) is always increasing in capital (K).

2. Following from (3), we can show that the Cobb-Douglas production function
exhibits a diminishing marginal product of capital by taking the second
derivative of Y with respect to K.

∂Y/∂K = αK(α-1)L(1-α)
∂2Y/∂K2 = α(α-1)Kα-1-1L1-α
If 0 ≤ α ≤ 1 then α(α-1) < 0 and
∂2Y/∂K2 = α(α-1)Kα-1-1L1-α < 0

Each additional unit of K increases Y by less and less.

3. y = f(k) with y=Y/L and k=K/L

The production model in per capita terms shows that differences in output or
income per capita (y) between countries must be driven by differences in
capital per worker (k) or total factor productivity (A). The literature shows that
differences in TFP or the A parameter explain the largest share of differences in
income per capita between countries.
4. Institutions are the rules of the game in society or, more formally, are the
humanly devised constraints that shape human interaction. It structures
political, economic and social interaction. Institutions consist of both informal
constraints (traditions, codes of conduct) and formal rules (constitutions, laws,
property rights). Throughout history, institutions have been devised by human
beings to create order and reduce uncertainty in exchange.

Key institutions include property rights, separation of powers, rule of law,

freedom of speech and the press, contract enforcement and an independent
electoral commission.

5. Capital accumulation equation: ∆K t+1 = s̅ Yt − d� K t

The change in capital stock is a function of net investment, that is, the value of
new investment (which is a function of savings) minus depreciation of existing
capital stock.

6. Transition dynamics will ensure that an economy starting at K0 will

automatically converge to its steady-state level of capital at K*