Chapter 4

A Model of Production
4.1 Introduction
In this chapter, we learn
• how to set up and solve a macroeconomic model.
• the purpose of a production function and its use for
understanding differences in GDP per capita across
countries.
• the role of capital per person and technology in
explaining differences in economic growth.
• the relevance of “returns to scale” and “diminishing
marginal products.”
• how to look at economic data through the lens of a
macroeconomic model.
Introduction
A model
• is a mathematical representation of a hypothetical
world that we use to study economic phenomena.
• consists of equations and unknowns with real-world
interpretations.
Macroeconomists
• document facts.
• build a model to understand the facts.
• examine the model to see how effective it is.
4.2 A Model of Production
Vast oversimplifications of the real world in a model
can still allow it to provide important insights.
Consider the following model:
• Single, closed economy
• One consumption good
Inputs in the production process:
• Labor
• Capital
Production function:
• Shows how much output (Y) can be produced given
any number of inputs
Setting Up the Model – Production Function
Model
Output growth corresponds to changes in .
There are three ways that can change:
• Capital stock (K) changes.
• Labor force (L) changes.
• Ability to produce goods with given resources (K, L)
changes.
• Technological advances occur (changes in A).
• TFP is assumed to be exogenous in the Solow
model.
Cobb-Douglas Production Function
The Cobb-Douglas production function is a particular
production function that takes the form of

where is assumed to be 1/3.

F(K,L) is increasing in both K and L.
• More inputs yield more output.
•
A production function exhibits constant returns to
scale if doubling each input exactly doubles output.
Constant Returns to Scale (CRS)
If and increase by x%,
• also increases by x%
Mathematically,
•
• Homogeneous function (of degree 1)
Standard replication argument
Output per Person (Intensive Form)
Divide output by the number of workers

• Per capita = per person = per worker

• Lowercase letters denote per capita.
We can rewrite output per person as

where and
Typical Production Function
Graph of
Note: If = 0 then = ( ) = 0.

10

6
y
4
k
2

0
0 200 400 600 800 1000
k
Returns to Scale Comparison
• Sum of exponents • Result
• Sum to 1 • Constant returns to scale
• Sum to > 1 • Increasing returns to scale
• Sum to < 1 • Decreasing returns to scale
Allocating Resources

• : profits
• r: rental rate of capital
• w: wage rate
The rental rate and wage rate are taken as given under
perfect competition.
• Hire capital until MPK = r.
• Hire labor until MPL = w.
For simplicity, the price of the output is normalized to
one.
Marginal Products
The marginal product of labor (MPL) is the additional
output that is produced when one unit of labor is
added, holding all other inputs constant:

The marginal product of capital (MPK) is the additional

output that is produced when one unit of capital is
added, holding all other inputs constant:
Diminishing Marginal Product of Capital in Production
Diminishing Returns
Formally:

Suppose we have one unit of K and one unit of L.

Assume this results in one unit of Y.
• Add a second unit of L.
• Previously, each unit of L had one unit of K to work
with.
• Now, each unit of L has ½ unit of K to work with.
• We are assuming that this will make each unit of L
less productive, and output will increase, but not
double.
One More Time: First Order Derivative
The first order derivative of the Cobb-Douglas production
function – which is positive – shows that output (Y) will always
increase for any given increase in inputs (capital or labour).
That is, F(K,L) is increasing in both K and L, or alternatively, the
marginal product of capital and labour is always positive.

For 0 1…
Y = Af(K, L), or more specifically, Y = K L(1- )

Y/ K = K( -1)L(1- )
Y/ K = K( -1)/L( -1)
Y/ K = [K/L]( -1) > 0
One More Time: Second Order Derivative
The second order derivative of the Cobb-Douglas production
function – which is negative – shows that output (Y) will
increase at a decreasing rate for any given continued increase
in capital or labour. That is, the function exhibits a diminishing
marginal product of capital and labour.

Following from the first order derivative…

Y/ K = K( -1)L(1- )
2Y/ K2 = ( -1)K -1-1L1-

If 0 1 then ( -1) < 0 and

2Y/ K2 = ( -1)K -1-1L1- < 0
Solving the Model: General Equilibrium—1
• Five endogenous variables • Five equations
• Output (Y) • The production function
• The amount of capital (K) • The rule for hiring capital
• The amount of labor (L) • The rule for hiring labor
• The wage (w) • Supply equals the demand
• The rental price of capital (r) for labor.
• Supply equals the demand
for capital.
Solving the Model: General Equilibrium—2
Solution—1
A solution to the model
• A new set of equations that express the five
unknowns in terms of the parameters and
exogenous variables
General equilibrium
• Solution to the model when more than a single
market clears
Supply and Demand in the Capital and Labor Markets
Solution—2
In This Model…
The solution implies that
• firms employ all the supplied capital and labor in
the economy.
• the production function is evaluated with the given
supply of inputs:

• = evaluated at the equilibrium values of Y, K,

and L.
• = evaluated at the equilibrium values of Y, K,
and L.
Interpreting the Solution
The equilibrium wage is proportional to output per
worker.
• Output per worker = (Y/L)
The equilibrium rental rate is proportional to output
per capital.
• Output per capital = (Y/K)
In the United States, empirical evidence shows:
• of production is paid to labor
• of production is paid to capital
• The factor shares of the payments are equal to the
exponents on the inputs in the Cobb-Douglas
function.
Labor’s Share of Income
Equilibrium
All income is paid to capital or labor.
• Results in zero profit in the economy
• Verifies the assumption of perfect competition
• Also verifies that production equals spending equals
income

• Income = production
4.3 Analyzing the Production Model
Development accounting:
• The use of a model to explain differences in incomes
across countries

• Setting the productivity parameter = 1

Comparing Models with Data
Our example uses only one good, but countries
produce far more than one good.
• How can our model help to understand per capita
GDP across widely different countries?
Models are simplified versions of reality. The best
models are those that tend to be very close to true,
despite the simplicity.
• If the gap between the model and the world is too
large, we will see this failure when we use data.
The Empirical Fit of the Production Function
If the productivity parameter is 1, the model
overpredicts GDP per capita.
Diminishing returns to capital implies that
• countries with low K will have a high MPK.
• countries with a lot of K will have a low MPK, and
cannot raise GDP per capita by much through more
capital accumulation.
The Model’s Prediction for Per Capita GDP (United States = 1)
Predicted Per Capita GDP in the Production Model
The Model’s Prediction for Per Capita GDP
Case Study: Why Doesn't Capital Flow from Rich to Poor Countries?

If MPK is higher in poor countries with low K, why doesn't capital

flow to those countries?
• Short Answer: A simple production model with no difference in
productivity across countries is misguided.
• We must also consider the productivity parameter.
• Various elements of risk that impact TFP may also be embedded
• Caselli subsequently questions why MPK is poor countries is not
much higher given that they have so little.
Productivity Differences: Improving the Fit of the Model
The productivity parameter measures how efficiently
countries are using their factor inputs.
• Total factor productivity (TFP)
• better model
Total Factor Productivity
Data on TFP is not collected.
• It can be calculated because we have data on output
and capital per person.
• See national growth accounting literature.
• TFP is referred to as the “residual.”
A lower level of TFP implies that workers produce less
output for any given level of capital per person.
Measuring TFP so the Model Fits Exactly—1
United States and Chinese Production Functions
Measuring TFP so the Model Fits Exactly—2
4.4 Understanding TFP Differences
Output differences between the richest and poorest
countries?
• Differences in capital per person explain about one-
third of the difference.
• TFP explains the remaining two-thirds.
Thus, rich countries are rich because
• they have more capital per person.
• more importantly, they use labor and capital more
efficiently.
Why are some countries more efficient at using capital
and labor?
Understanding TFP Differences
• Institutions, Institutions, Institutions
• Human capital
• Technology
• Misallocation
• Management
Institutions
Even if human capital and technologies are better in rich countries,
why do they have these advantages?
Institutions are in place to foster human capital and technological
growth.
• Private property rights
• The rule of law
• Contract enforcement
• Freedom of the press
• Government systems
Institutions
What are institutions exactly? Douglass North offers the following definition:
“Institutions are the rules of the game in a society or, more formally, are the
humanly devised constraints that shape human interaction. In consequence
they structure incentives in human exchange, whether political, social, or
economic”.
Of primary importance to economic outcomes are the economic institutions
in society such as the structure of property rights and the presence and
perfection of markets. Without property rights, individuals may not have the
incentive to invest in physical or human capital or adopt more efficient
technologies. Economic institutions also help to allocate resources to their
most efficient uses. When markets are missing or ignored, gains from trade
go unexploited and resources are misallocated. Societies with economic
institutions that facilitate and encourage factor accumulation, innovation
and the efficient allocation of resources will prosper.
Global Competitiveness Index
Human Capital
Human capital
• Stock of skills that individuals accumulate to make
them more productive
• Education and training
Returns to education
• Value of the increase in wages from additional
schooling
Accounting for human capital reduces the residual
from a factor of 11 to a factor of 6.
Technology
Richer countries may use more modern and efficient
technologies than poor countries.
• Increases productivity parameter
Misallocation
Misallocation
• Resources not being put to their best use
Examples
• Inefficiency of state-run resources
• Political interference
4.5 Evaluating the Production Model
Per capita GDP is higher if capital per person is higher
and if factors are used more efficiently.
Constant returns to scale imply that output per person
can be written as a function of capital per person.
Capital per person is subject to strong diminishing
returns because the exponent is much less than one.
Weaknesses of the Model
In the absence of TFP, the production model incorrectly
predicts differences in income.
The model does not provide an answer as to why
countries have different TFP levels.
Clicker Question 1

a. constant returns to scale

b. decreasing returns to scale
c. diminishing returns to scale
d. increasing returns to scale
Clicker Question 1 – Answer

a. constant returns to scale

b. decreasing returns to scale
c. diminishing returns to scale
d. increasing returns to scale
Clicker Question 2
A firm uses capital and labor to produce a good.
Which of the following is greatest?
a. accounting profit
b. economic profit
c. It depends on the situation.
d. All of these choices are equal.
Clicker Question 2 – Answer
A firm uses capital and labor to produce a good.
Which of the following is greatest?
a. accounting profit
b. economic profit
c. It depends on the situation.
d. All of these choices are equal.
Clicker Question 3
In the production model from the text, which of the
following is NOT an exogenous variable or a
parameter?
a. the supply of capital
b. the supply of labor
c. the amount of capital
d. the productivity of parameter
Clicker Question 3 – Answer
In the production model from the text, which of the
following is NOT an exogenous variable or a
parameter?
a. the supply of capital
b. the supply of labor
c. the amount of capital
d. the productivity of parameter
Clicker Question 4
Output per person is higher when
a. a country is more efficient in adopting a technology.
b. a country has a higher capital-to-population ratio.
c. a country has stronger property rights and contract
enforcement.
d. All of these choices are correct.
Clicker Question 4 – Answer
Output per person is higher when
a. a country is more efficient in adopting a technology.
b. a country has a higher capital-to-population ratio.
c. a country has stronger property rights and contract
enforcement.
d. All of these choices are correct.
Clicker Question 5
Output per capita and output per worker are
a. always equal.
b. equal in the production model, but output per
capita is smaller in general.
c. equal in general, but output per capita is smaller in
the production model.
d. not equal, because output per capita is always
greater.
Clicker Question 5 – Answer
Output per capita and output per worker are
a. always equal.
b. equal in the production model, but output per
capita is smaller in general.
c. equal in general, but output per capita is smaller in
the production model.
d. not equal, because output per capita is always
greater.
Clicker Question 6
Which of the following is included in TFP?
a. the amount of labor
b. the amount of capital
c. the quality of labor
d. All of these choices are correct.
Clicker Question 6 – Answer
Which of the following is included in TFP?
a. the amount of labor
b. the amount of capital
c. the quality of labor
d. All of these choices are correct.
Clicker Question 7
If the productivity parameter is assumed to equal 1,
the production model
a. correctly identifies that countries are richer if they
have more capital.
b. incorrectly predicts that poor countries are
substantially richer than they are.
c. incorrectly predicts that some countries are richer
than the United States.
d. All of these choices are correct.
Clicker Question 7 – Answer
If the productivity parameter is assumed to equal 1,
the production model
a. correctly identifies that countries are richer if they
have more capital.
b. incorrectly predicts that poor countries are
substantially richer than they are.
c. incorrectly predicts that some countries are richer
than the United States.
d. All of these choices are correct.
Clicker Question 8
Suppose India has a per capita GDP that is 0.074 times
the United States GDP. It has a capital-per-person ratio
that is 0.035 times that of the United States. Compared
to the United States, the implied value of total factor
productivity for India is approximately
a. 0.07.
b. 0.12.
c. 0.23.
d. 0.30.
Clicker Question 8 – Answer
Suppose India has a per capita GDP that is 0.074 times
the United States GDP. It has a capital-per-person ratio
that is 0.035 times that of the United States. Compared
to the United States, the implied value of total factor
productivity for India is approximately
a. 0.07.
b. 0.12.
c. 0.23.
d. 0.30.
Clicker Question 9

a. true
b. false
Clicker Question 9 – Answer

a. true
b. false
Clicker Question 10
Capital per person explains about one-half of the
difference in per capita income between the richest
and poorest countries.
a. true
b. false
Clicker Question 10 – Answer
Capital per person explains about one-half of the
difference in per capita income between the richest
and poorest countries.
a. true
b. false
Clicker Question 11
In a Cobb-Douglas production function, the factor
share of income going to each input is equal to the
exponent on the input in the production function.
a. true
b. false
Clicker Question 11 – Answer
In a Cobb-Douglas production function, the factor
share of income going to each input is equal to the
exponent on the input in the production function.
a. true
b. false
Clicker Question 12
The standard replication argument implies that Italy
can raise its per capita GDP by doubling the amount of
capital per person.
a. true
b. false
Clicker Question 12 – Answer
The standard replication argument implies that Italy
can raise its per capita GDP by doubling the amount of
capital per person.
a. true
b. false
Clicker Question 13
If the marginal product of capital is less than the rental
rate of capital, the firm should rent more capital.
a. true
b. false
Clicker Question 13 – Answer
If the marginal product of capital is less than the rental
rate of capital, the firm should rent more capital.
a. true
b. false
Clicker Question 14

a. 10
b. 24
c. 48
d. 1,600
Clicker Question 14 – Answer

a. 10
b. 24
c. 48
d. 1,600
Clicker Question 15
You plot the production function for the United States
on a graph with output per person on the vertical axis
and capital per person on the horizontal axis. If a shock
occurs causing the productivity parameter to increase,
the production function would shift upward.
a. true
b. false
Clicker Question 15 – Answer
You plot the production function for the United States
on a graph with output per person on the vertical axis
and capital per person on the horizontal axis. If a shock
occurs causing the productivity parameter to increase,
the production function would shift upward.
a. true
b. false
Clicker Question 16
What is the marginal product of capital (MPK) for the
production function =
a.

b.

c.

d.
Clicker Question 16 – Answer
What is the marginal product of capital (MPK) for the
production function =
a.

b.

c.

d.
Clicker Question 17

a. 5
b. 25
c. 125
d. 625
Clicker Question 17 – Answer

a. 5
b. 25
c. 125
d. 625
Clicker Question 18
According to Figure 4.5 (on the next slide), does the production
model accurately predict the level of per capita GDP for
Singapore?
a. Yes, because the predicted value of per capita GDP for
Singapore is close to the U.S. level (which is equal to 1).
b. Yes, because the predicted value of per capita GDP for
Singapore is close to the actual value of its per capita GDP.
c. No, because the predicted value of per capita GDP for
Singapore is different than the U.S. level (which is equal to
1).
d. No, because the predicted value of per capita GDP for
Singapore is different than the actual value of its per capita
GDP.
Clicker Question 18 (Figure 4.5)
Clicker Question 18 – Answer
According to Figure 4.5, does the production model accurately
predict the level of per capita GDP for Singapore?
a. Yes, because the predicted value of per capita GDP for
Singapore is close to the U.S. level (which is equal to 1).
b. Yes, because the predicted value of per capita GDP for
Singapore is close to the actual value of its per capita
GDP.
c. No, because the predicted value of per capita GDP for
Singapore is different than the U.S. level (which is equal to
1).
d. No, because the predicted value of per capita GDP for
Singapore is different than the actual value of its per capita
GDP.
Clicker Question 19

a. It cannot be determined because we don’t know

the wage rate and the rental rate of capital.
b. 152 tons of cream cheese
c. 40 tons of cream cheese
d. $40
Clicker Question 19 – Answer

a. It cannot be determined because we don’t know

the wage rate and the rental rate of capital.
b. 152 tons of cream cheese
c. 40 tons of cream cheese
d. $40
Clicker Question 20
If Country A has the Cobb-Douglas production
function: = ,
and Country B had the Cobb-Douglas production
function: = ,
which country pays a greater production share to
capital?
a. neither Country A nor B
b. Country A
c. both Country A and B
d. Country B
Clicker Question 20 – Answer
If Country A has the Cobb-Douglas production
function: = ,
and Country B had the Cobb-Douglas production
function: = ,
which country pays a greater production share to
capital?
a. neither Country A nor B
b. Country A
c. both Country A and B
d. Country B
Clicker Question 21
Country A and Country B are allies. Country A shares
its production function with Country B. The
production function for both countries is:
=
Both countries have = 100 and = 100, but Country
A has = 400 and Country B has = 300. Given the
information in this chapter, why is this happening?
a. differences in human capital
b. differences in technology
c. all of the above
d. none of the above
Clicker Question 21 – Answer
Country A and Country B are allies. Country A shares
its production function with Country B. The
production function for both countries is:
=
Both countries have = 100 and = 100, but
Country A has = 400 and Country B has = 300.
Given the information in this chapter, why is this
happening?
a. differences in human capital
b. differences in technology
c. all of the above
d. none of the above