You are on page 1of 9

American Economic Association

A Diagrammatic Exposition of Optimal Growth Author(s): Nissan Liviatan Reviewed work(s): Source: The American Economic Review, Vol. 60, No. 3 (Jun., 1970), pp. 302-309 Published by: American Economic Association Stable URL: . Accessed: 01/11/2011 15:07
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact

American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review.

It seems. it will be seen that the graphical presentation of the dynamic programming approach is closely related to the traditional Fisherine diagram of intertemporal analysis and to the standard Hicksian tools of demand analysis.Ct) and Lt and that Lt grows according to (4) Lt+1=nLt n > 1. by using optimal-control methods or by applying the technique of dynamic programming. for all t University of Jerusalem and visiting professor at University of California. for example. with current consurmLption one axis and on next year's capital on the other.1) is the net own rate of return on capital. Lt) It should be noted that F1=aF/a(Kt-Ct) is the marginal product of capital in period t in producing the capital stock of period t+ 1.A DiagrammaticExposition Optimal By of Growth NISSAN LIVIATAN* The theory of optimal growth can be analyzed. for example. 236-38) which is based on control theory. we shall deal with a * The author is professor of economics at the Hebrew one-sector model with no technological progress. there has been no attempt to formulate a graphical analysis which will bring out the essence of the dynamic programming approach2 to optimal growth. (We may assume that (1) incorporates an exponential depreciation factor. 302 . however. The purpose of this paper is to fill this methodological gap. A Restatement of Some Elementary Results In our analysis. We shall assume as usual that F is subject to constant returns to scale with respect to the inputs (Kt. we intend to show that the exposition of the optimal time path in a simple growth model does not require much more than a dynamic version of the well-known two-period Fisherine diagram. is as follows. the presentation in David Cass (pp. I See. as the capital stock available (for production or consumption) in the beginning of period t.) An alternative way of writing (1). Roy Radner. I. Thus it is customary to present the optimal growth path in terms of a trajectory in the phase-space. or the graphical exposition by Tjalling C. Define K. Moreover. Koopmans based on an equivalent calculus-of-variations formulation. as far as I know. as is well known. which we shall assume to be nonnegative. Indeed. This study was done during the tenure of a Ford Foundation Fellowship. Hence (F1. We then have (2) Kt = St + Ct Substituting (2) into (1) we obtain (3) Kt+1 = F(Kt - Ct. Berkeley.' However. 2 For an analytic exposition of optimal gowth based on dynamic programming see. that the graphical expositions for simple growth models have been developed only for the former approach. which is based on a discrete time model. Lt is labor input in period t. + Ct+1 = F(Sty LJ) where St denotes the stock of capital which enters as an input in the production function in period t. which is more useful for our purposes. and Ct+1 is consumption in period t+ 1. The production function of the economy is assumed to be of the following form: (1) St+.

Howk. we may write (6) as 1 (7) kt+l =-F(kt n -ct. implying a negative net marginal product of capital for a sufficienltlylarge capital input. possesses a . 1).. we may divide all variablesin (3) by Lt. Note that in assumptions (8')-(10') we made use of relation f'= Fl/n. consider X.x o and capital remains stationary. AA B I t Using lower case letters to denote per capita variables. since J'(oo) =1/n<1. kt+hat Denote the relationshipbetween ktand the valueof c which leavesit intact by c= s(k)p. Fi(oo. This will include as a special Of case the assumption f'> O and f'(oo =-O.Ct) is illustrated in Figure 1. it is clear that c. (It may be pointed out then ever.+1 f'(0) = o. 1) = 1 where Fn denotes a2F/a(Kt. 303 Dividing both sides of (5) by n and using (4).1) Lt Lt .ct in Figure 1. (10) F1(0. To see this. It follows from the foregoing f(O) = 0. FIGURE 1 As is usual in growth theory.and second-orderderivatives of f. O<kt < k. 1) = Fl. considered as a function of k. which yields Lt Lt Lt k. we may write (8') (9') (10') f'> - sumption (10') the curve correspondingto f must be above the 45? line for some range of (kt-Ct) and that it must intersect the latter at some kt-ct>O. it is convenient to define a new function 1 (11) f(kt - that our analysis will remain unaltered if we use the more genleral assumption <f(oo ) < 1. Applying assumptions (8)-(10) to f.LIVIATAN: OPTIMAL GROWTH where n is given exogenously. we have (6) K Lt+l -F n (---. n where f' and f" denote the first. It should be noted that by as- ct) _-F(kt - n Ct. Since n is a constant throughout our analysis. If ct= then k'. (8) 1): F(0. In view of Figure 1.Ct)2.ct = k and we have kt+i = > kt so that capital increases. ft(oo)= facts that for any value of kt. Using the property of constant returns to scale. 1) wheref incorporatesimplicitly the growth factor n. < O for all kt -ct > O oo. n f" <0.) The function f(kt. if ct equals the segment Ao]B. 1) = 0 (9) F. we make following assumptions about the F(kt-ct. > 1. there corresponds a positive value of ct which will leave capital intact.

. with Since this must be true for U'(ct)/au'(ct+i).e.1). it follows that the Fisher conditions are sufficient as well. for some t. Another implication of Figure 1 is derived from the fact that the average product of capital is less than unity for kt> k. This implies that Fi(k- at A* we have (12) f'(k-c) c. under our assumptions about the discount factor and about the concavity of the production and utility functions. This can be verified as follows. It is assumed that u has the following properties: (14) u' > u" < 0 for ct > 0 and in addition. The first-order conditions. Ordinarily these are only the necessary conditions for an interior maximum. the net own rate of . O<ct?kt. Consider an optimal program and denote the optimal values of kt by kt. t=O.1) must equal the net rate of population growth (n.e. i. we have established (17). at k-=k* and c=c*).Ct) with the marginal rate of substitution between ct+1 and ct. 1) = The problem of determining the optimal program can then be stated as follows: 00 Maximize (16) to co. . unique positive maximum3 at some k* O<k* <k. which yields u'(ct) -=f'(kt t = - Ct) (17) aut (Ct+1) 0 1. . This implies that for any feasible program(with 0 < Ct ? kt)kt and ct are boundedfrom above by max [k0. Let us turn now to the utility function which is supposed to represent the preferences of the economy as a whole. It follows therefore that s(k) has a unique absolute maximum. (Note that by (10') we have s'(0) = 1. all t. or the "Fisher . . to exclude cornersolutions 3This can also be verified as follows: In stationary solutions we have k =f(k-c). If. in the case where ct tends . namely 00 (13) U E atu(ct) t=o where a is a constant subjective discount factor satisfying 0 a < 1. =f(kt+i-ct+1). ] for all t. At an optimum of the miniature system we must therefore have an equality of f'(kt. It is seen immediately from Figure 1 that this maximum corresponds to the point A* where the tangent to f is parallel to the 450 line.. and u is a function of per capita consumption. with c* and k* being the golden rule4values of c and k.304 THE AMERICAN ECONOMIC REVIEW for ct (where ct =0). given initial return on capital (F1." for the optimal path require the equalization of the marginal rates of substitution in production to those in consumption for every t. U3 E tGo atu(ct) with respect to kt+l =f(kt - or F1= n. Differentiation with respect to k and c yields dc/dk=s'(k) = (f'. This is the so-called "golden rule" of capital accumulation.. By assumption (10') (f'.subject Ct).1)/f'. we take kt and kt+2as given. we shall assume (15) lim U'(Ct) = ?.. for example. . However. 4 See E. or kt+2=f f(kt. provided the program satisfies the condition atu'(ct)-*0 as t->oo (as. then in the optimal program atu(ct)+at+?u(ct+i) must be maximized with respect to ct and ct+i and kt+2 subject to kt+1=f(kt-ct) . We assume the standard type of utility function used in growth theory. when stationary consumption per caplta is maximized (i.) Differentiating once more we obtain s"(k)=f"/(f')3<0 which shows that s(k) is concave. In other words.e. capital ko. .Ct) -t+ The latter is a transformation curve between ct+i and ct with a slope of f'(kt-ct). i.1) changes sign. in fSe as E (1P2). At the maximum point we have s'(k) =0. 1. Phelps. which means that kt+i<kt if kt> k.. S.

we note that the utility sum of any feasible consumption sequence is bounded from above by u(M)/(1-a). Substituting the constant values of c and k into (17) we obtain (18) 1/a = f'(k - 305 by e and k. See. A related aspect of (16) is that the solution is independent of the calendar time.LIVIATAN: OPTIMAL GROWTH to a positive stationary limit). It has been shown. Note. The index t should be interpreted as indicating the "number of periods ahead" at any given calendar date. by Koopmans that this problem can be overcome by a proper adjustment of the origin of the function u. disregardinitial capital and examine whether our system is at all capable of a stationary optimal solution where t= c and kt= k for all t. This "dynamic consistency" property of the optimal program6 follows directly from the form of the utility function in (13). Consider the maximized value of U. It also follows from the fact that f' is monotonically decreasing that (k-c) is uniquelydeterminedby (18). We may then write (16) as (20) u(c0) + a max ct+1 E atu(ct+i) tso c). say U as a function of k0. Thus the process is a stationary one. or treat them as assumptions. the program satisfying the foregoing conditions is unique. It is also seen that as time preference decreases. The ReducedMaximization System We shall assume that for any kothere exists a unique solution of (16). We know that there must exist a positive solution to (18) if f'(0) > 1/a >f'(cc).e. As an indication that our assumption about the existence of a maximum is a reasonable one. and log log (kt-ct). that the problem of maximizing co=O atu(ct+?) for a given value of ki is formally identical with maxi7 The case where strictly a= 1 raises some mathematical problem concerning the convergence of the utility sum. We have formulated the maximization problem subject to a given arbitrary level of initial capital. so that "a" approaches unity.7 II.ignoringcompletely koand the relation k1=f(k0-c0). The proof of these statements' is of no direct concern to our discussion and we shall therefore take them as given. 96105). for a given value of k1. Since 1/a > 1 this is guaranteed by our foregoing assumption (10'). As a preliminary inquiry we may. ko]. where M =max [k. however. k<k* and <c*. the optimal stationary values approach those of the golden rule. Note that his equation (11) is our condition on atu(ct). for example. Radner (pp. constitute an optimal sta- tionary solution. Using the fact that 1/a =f'(k -e) >1. 6 On the possibility of dynamic inconsistency. Strotz. 8 In the logarithmic model where u(c) =log c. 0<-y<l.8 We c). In a stationary solution we must also have (19) k =-f(k - then assume that v(ko) is continuous and > twice differentiablefor all ko 0. however. however. 235) to our model. The optimal stationary consumption level is then AB <A*B*. Consider a two-stage maximization of (16). We may thereforedeterminefrom (18) and (19) a unique solution for c and k individually. An important feature of the solution of (16) is that it will remain optimal (as far as present and future consumption is concerned) when the economy reexamines it as it moves actually into the future. see the analysis by R. H. . Moreover.. i. to be denoted 5 These statements can be verified by adopting the method of proof used by Cass (p. we may infer that k and c are smaller than the correspondinggolden rule values. The foregoing values. This is illustrated in Figure 1 where the optimal stationary solution is represented by the point A1which corresponds to f'> 1. In the first stage we maximize the utility function treating coand ki as given parameters. one can verify f (kt-ct)=g+? that v (k0)= (1/1 --ya) log k0+constant (note that in this model f'(oo) =0). and denote this function by U = v(ko).

it presupposes that an appropriate infinite horizon problem has been solved in the first stage of maximization. from which we have obtained the reduced utility function (22).. does not cause any difficulty as long as we are not interested in the computational aspect of the problem. Bellman. Repeating the previous argument. In particular it contradicts our earlier conclusion that v'>O. Thus the value of ki determined by (23) becomes the next period's kowhich is used to determine by means of the same functions the value of the new ki and c0 and so on. It follows from (27) and (14) that v is concave if deo/dko>O. and given ko. Ct+1 t=O Substituting in (20). we may infer that '1 Note that we have used here the propertyof dynamicconsistency whichenablesus to relatethe planned path to the actual one. Then. an increase in initial capital) as in the original period. By using a somewhat more sophisticated argument.10 9 It should be noted that while (23) represents a twoperiod analysis.e. Note also that by the definition of v. 10See discussion concerning this type of equation in R. This determines the current period's optimal values of co and ki. This is only natural. we have (26) v(ko) = u(eo) + av[f(k. Consider the hypothesis that deo/dko<Ofor all ko. -c) Differentiating (26) with respect to koand using (25). Hence deo/dko>0 and v" <0 for all ko.e. one could also reject the hypothesis that de0/dko<O holds for some k. C+1 Denote the maximizing value of co by c where the latter can be considered as a function of ko.). the marginal utility of current capital equals the marginal utility of current consumption (and consequently v'> 0). we shall find that no ct will increase. The recursivenature of this system is clear. z. we face again the same kind of situation (i. Using the foregoing results and the functional equation.. When we are actually in the next period. implying that next period's "initial" capital increases. This. will not increase and hence ki will increase. we obtain v'(ko)= u'(o)deo/dko + av'Vf(k -co)] (27) *f'(ko u' (eo) This completes the first stage of maximization. The second-stageproblem9can then be written as max [u(c0) + av(ki)] Co t1 o)(1 - deo/dko) (23) subject to ki = f(ko . i. in spite of the fact that an increase in some ct's is feasible. .c0).)I CO which is the fundamental functional equation of dynamic programming. however. (21) max E atu(ct+i)= v(kl).'1 Clearly this cannot happen with optimal programs. compared with the originalpath. of course. that the reduced utility function depends not only on the original utility function but also on the production function.We may then use the foregoing v function to write 00 c)]f'(k0 .c. Substituting in (24).) In the second stage we treat c0 and k1as endogenous variables and maximize the reducedutility function (22) subject to the present period's production constraint k1=f(ko-c0). (23) satisfies (24) v(k0)=max {u(co) + avjf(ko -c.306 THE AMERICAN ECONOMIC REVIEW As a necessary condition for a maximum of the right-handside of (24). since one of the alternatives of using an increase in ko is consuming it in the currentperiod. we have (25) u'(c0)= af'(k0 - mizing E -o atu(ct) for a given value of ko. (It is understood. we have (22) max U = u(c0) + av(k1). if k'a increases.

R E V Cf(k. the slope of the production frontier at R is the same as at Eo.B. or ON in Figure 3... is determined by ki=f(1k-c') where k= k. i. The value of consumption corresponding to this point. We may then write (29) = ?ko ?o-ko--. The indifference curves II' in Figure 2 correspond to the A. just as is the case with the derivatives of u(c0). . 0 From our earlier results we know that v'>O and v" <0. to k'.e. it can be seen that the production frontier moves to the right parallel (horizontally) to itself.. Thus differentiating (25) with respect to ko and rearranging terms. i. the "Income Consumption Curve" EE' in Figure 2 must be upward sloping. To see this. The DiagrammaticAnalysis of OptimalGrowth The short-runequilibriumat some given date is illustrated in Figure 2 by means of a Fisherine diagram. It follows therefore that the indifferencecurves of our reduced utility function have the usual convex shape. say c'. k'). Consider now the intersection point QO the horiof zontal line correspondingto ki with A . So far we dealt with short-run comparative statics. The slope of this curve at any point is given by df/dco0= <0. What can be said about the new short-run equilibriumpoint El? We know from our foregoing analysis that both dco/dkoand dkl/dko are positive. we obtain dco (28) dko 1 307 family u(c0) + av(ki) = constant. 8) the formula for the income consumption curve is given by ki=Acy where A is a positive constant.Bl. If the initial capital is ko Figure 2.'3Hence El must be above Eo and to the right of it..B k0 00 k' co 0 FiGux. Then the production frontier moves uniformly"2to the right. -J' Similarly. Since ki is a monotonic function of ko-c0. for example.-c') 0 ~~~~I co 0 80.e. It also follows from these results that dkl/dko =f *(1-deo/dko) > 0. in Figure 2.The production possibility frontier for initial capital kois given by AB which representsthe function k1=f(k. which implies that f'(k0 -c0) is also the same. Suppose that the economy is initially at Eo in Figure 3.LIVIATAN: OPTIMAL GROWTH < deo/dko 1. is next period's initial capital. ~~~~1 _ __ _ a(vf" + f'2v") which is between zero and one. and is represented by (say) A . is then of the usual concave shape. Thus. this means that both Eo and R correspond to the same value of ko-co. III. ki) in the (co. 13In the logarithmic model (described in fn. The transformation curve relating ki and c. where on the horizontal axis we have co and on the vertical axis k1.i2 12 Moreover. Then in the next period the production frontier moves to (say) A lBl. in then the short-run equilibrium is determined at Eo so that the equilibriumvalues are given by (c?. Suppose now that initial capital increases to kl.. A. note that both E0 and R correspond to the same value of k1. We have to determine now how the system actually moves from one time period to the next.a2f/3c=-f" <0.

If in the next period the economy chooses E1 as its equilibrium point. so that y(c) is the inverse of s(k) for k < k*. Then from our foregoing analysis we know that e'>O. 16In the logarithmic model. f'(k-c) tends to infinity by (10'). we have c'=s(ki) 14 Let us now introduce in Figure 3 the (stationary state) function c=s(ki). k) on SS' below G the slope of the production frontier is f'(k-c) >1. Some additional features of Figure 3 should be noted. A similar analysis applies to the possibility where the equilibriumpoint is to the right of SS'. This is so since as we move up the SS' curve we increase steadily the value of ki and hence of ko-c0 (via ki =f(ko-c0)) so thatf'(k-c) A0~~~~~0 80 81~~~R ko N k. The production frontier of the next period will then pass through QO. i. we . i. Using our earlier notation. by (9') we always havef'> 1/n>O. for any point (c. the slope (in numerical value) of the production frontiers decreases steadily as we move upwardalong the SS' curve. It does. and consequently. y(c) tends to zero. and above G we havef'(k-c) <1. c' does not represent actually maintainable consumption. At this point the slope of the production frontier ABis unitary.. as we do in Figure 4. We can then see that if we start at Eo we may find a point (QO) the next period's proon duction frontier by the intersection of the horizontal line passing through Eo and the SS' curve. as in the case when the economy is 14 If k>k (see Figure 1). let the equation of OG. be denoted by k= y(c). We know from our earlier discussion that the point G correspondsto the golden rule levels of c and k. Then as c tends to zero.16 Then because of e' >0 15 In fact. decreases.e. Denote the equation corresponding to EE' by k= e(c).f'(k*-c*) = 1. as in the case with c'>O. Another point which should be noted is that at any point on SS' above G (such as H).15 it follows that Idk/dc| > J-f'| as stated. where e(c) =A cy. Finally.along SS'. The optimal path can now be easily determined if we introduce the incomeconsumption curve EE' into the picture. This can be seen by differentiating the equation k=f(k. Similarly. serve the purpose of determining graphically the next period's production frontier. then c'=s(ki) <0. It follows therefore from (30) that y'(0) = 1. however. in this case. have e'(O)= + oo . then in the following period the production frontier must pass through Ql. In fact. This yields -f' [ dk 11 (30) -== 1 dc 1-f' l s'(k)j Since above G we have 0 <1' <1 . than the slope of the A B curve which passes through that point. implying that we have to use the extended part of SS' in Figure 3 which continues to the left of the ki axis. Suppose that at the origin we have e'(0) >y'(0) (= 1).308 THE AMERICAN ECONOMIC REVIEW initially at R0. This is represented by the SS' curve whose properties are derived from Figure 1. the slope of SS' itself is always steeper.c) which determines the SS' curve. greater in numerical value..e. K) kCo FiGuE 3 from which it follows that c' is the stationary value of consumption which corresponds to ki. Clearly.

R. No. Strotz. St 309 A4- and that the intersection point must be below G17 as drawn in Figure 4. Thus suppose that EE' is below SS' except at M.C) = 1/a where k and j are determined by (18) and (19). Stud. 1956. and then. 3. it follows that at G the marginal rate of substitution of k1 for c0 on the consumption side is greater than on the production side.. R. co is more valuable (at the margin) in consumption than in production. E. Since this point is necessarily above EE'. Econ. It can then be seen that the system converges monotonically and asymptotically to the (stationary optimum) point M from must represent a stationary optimum. Athens 1963. Econ. Notes on the Theory of Economic Planning.LIVIATAN: OPTIMAL GROWTH we must have an intersection of EE' and SS' for some positive k and c. Bellman. It follows therefore that the intersection of EE' and SS' is unique k. had we started with ko> k. Stud. the EE' curve must intersect18SS' from below at some positive k. this implies an additional intersection. while for ko<k Ct will converge to zero. "Myopia and Inconsistency in Dynamic Utility Maximization. Rev. Then for initial ko>k the sequence ct will converge to e. July 1965. 18The possibility of tangency can be ruled out by simple considerations of continuity." Pontificia Academia Scientiarus.e. Sept. Consider the golden rule point G. Radner. Princeton 1957. pp. . the system would converge to M from above. Similarly. C. S.. Thus if the economy is given an initial capital 17 Since l/a=fJ'(k-e)>1. Dynamic Programming. Suppose now that the economy starts with some ko."Rev.. However. will reduce consumption and capital graduallyto the point M. since a (unique) positive stationary optimum is known to exist. Cass. This implies that v(ko) is discontinuous at k. H. in subsequent periods. Koopmans. D. "Optimum Growth in an Aggregative Model of Capital Accumulation. Rome 1965. 1961. 51. |B2 IB3 ~~k FIGuE 4 |B4 k' CO equal to k*. 276-79. "The Golden Rule of Accumulation: A Fable for Growthmen. Then the short-run equilibrium is determined in Figure 4 by the intersection of Ao0Bo EE' at the point and The next period's production frontier E. pp. Then. 233-40. koC' kO B. Since this point is both a stationary solution and a short-run equilibrium. contrary to out assumptions. i. where the two curves are tangent. T. is then A AB1 which passes through S0 and the new short-run equilibriumis at E1. 32. k E~~ E~~~~E E0 VS B. "On the Concept of Optimal Economic Growth.. 11-16. Econ. 23. Phelps. We have seen earlier that in a stationary optimum i'(k. which contradicts the uniqueness of the stationary optimum solution. Let M be an intersection point of the two curves. it will not stay at G but will rather increase consumption immediately to the point R. Suppose alternatively that at the origin e'(O)<1. REFERENCES R. 638-42." Amer. 165-80."Rev.