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Tyler Cowen and Alex Tabarrok Chapter 7 Growth, Capital Accumulation, and the Economics of Ideas: Catching Up vs. the Cutting Edge
Copyright 2010 Worth Publishers Modern Principles: Macroeconomics Cowen/Tabarrok
Introduction In 2006:
China: GDP per capita grew by 10% United States: GDP per capita grew by 2.3%
the Chinese economy is growing today. Why is China growing more rapidly than the U.S.?
Is there something wrong with the U.S. economy? Do the Chinese have a magical potion for growth?
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Robert Solow Nobel Prize in Economics Total Output, Y, of an economy depends on:
Physical capital: K Human capital: education x Labor = eL Ideas: A
Y F(A,K, eL)
12.5
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The Solow Model and Catch-Up Growth For now, ignore changes in ideas, education, and
labor so that A, e, and L are constant. The production function becomes:
Y F(K)
Y K
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3.2 3
Y K
3.2 3.0 MPK 0.2 10 9
MPK 1 0 1 1 0
Capital, K 0 1 2 3 4 5 6 7 8 9 10 11 12 12.7
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Much of the capital stock was destroyed during WWII. Therefore the MPK was high. Following the war, both Germany and Japan were able to achieve much higher growth rates than the U.S. as they caught up.
12.9
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Conclusions: 1. Catch-up growth (Germany, Japan) is much greater than cutting-edge growth (U.S.) 2. Eventually the catch-up growth slows down.
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Y K
10
5 Consumption = (1- 0.3) x 10 = 7
Investment = 0.3Y
3 2
0 0 100
Investment = (0.3) x 10 = 3
Capital, K 200 300 400 12.12
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Depreciation: amount of capital that wears out each period Let d be the fraction of capital that wears out each period. This is called the depreciation rate so that:
depreciati on K
The next diagram shows that the amount of depreciation depends on the capital stock.
12.13
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4
2 0 0 100 200
6
Investment = 0.3Y
4.5 4 3 2
At K = 100, Inv. > Dep. K
Result: equilibrium at K = 225 Y = 4.5 inv. = dep. =4.5 400 Capital, K 12.16
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100
200 225
300
At K = 225, Y =225 =15 Depreciation = 0.02x225 = 4.5 Investment = 0.3x15 = 4.5 Investment = Depreciation
Result: 1. Investment = Depreciation 2. K and Y are constant.
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Better Ideas Drive Long-Run Economic Growth Human Capital Like capital, it is subject to diminishing returns and it depreciates. Logic of diminishing returns also applies to human capital. Conclusion: Human capital also cannot drive long-run economic growth. What about technological knowledge?
12.20
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YA K
12.21
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Conclusion: Technological knowledge or more generally better ideas are the key to long-run economic growth. Solow estimated that better ideas are responsible for of our increased standard of living.
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CHECK YOURSELF
What happens to the marginal product of capital as more capital is added? Why does capital depreciate? What happens to the total amount of capital depreciation as the capital stock increases?
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When in steady state equilibrium, Y Y is in steady state equilibrium. When K is K in is steady state equilibrium, is in steady state equilibrium.
Output, Y 8 6
Depreciation = 0.02K
Investment = 0.3Y
4.5 4 3 2
The Steady State K is found where investment = Depreciation
Y K
Depreciation = 0.02K
15
10
Investment 0.3 K
5
CHECK YOURSELF
What happens when the capital stock is 400? What is investment? What is depreciation? What happens to output?
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gKY
Conclusion: an increase in the investment rate increases a countrys steady state level of GDP. We show this result in the next diagram.
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Output, Y 20 15
Y K
Depreciation = 0.02K
10
Inv. 0.4 K
Inv. 0.3 K
Capital, K 0 100 200 225 300 400
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The Solow Model Details and Further Lessons An Increase in the Investment Rate Increases Steady State Output (cont.)
The results presented in the previous diagram predict that: An increase in investment rate, g, causes output to increase. Because labor is held constant, output per capita also increases. An important test of our model: Are its predictions consistent with real world data? The next figure suggests that they are.
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The Solow Model Details and Further Lessons An Increase in the Investment Rate Increases Steady State Output (cont.)
An Important Idea An increase in the investment rate = steady state level of output. As the economy moves from the lower to the higher steady state output = growth rate of output This higher growth rate is temporary. Conclusion: investment rate = steady state level of output but not its long-run growth rate. These points are illustrated in following case study of South Korea. 12.33
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The Solow Model Details and Further Lessons What Determines High Investment Rates?
Incentives which include Low real interest rates Low marginal tax rates Institutions which include Honest government Secure property rights One of the reasons that the investment rate increased in South Korea is that capitalists believed that their investments would be protected. Effective financial intermediaries
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The Solow Model Details and Further Lessons From Catching Up to Cutting Edge
Several predictions of Solow model are consistent with the evidence. Countries with higher investment rates have higher GDP per capita. Countries grow faster the farther their capital stock is from the steady state level.
Generation of ideas results in long-run economic growth. Lets see how this works: We begin at steady state equilibrium. New ideas A Output at every level of K Output Investment Investment > Depreciation K Output (movement along new production function). As ideas continue to grow, output continues to grow.
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c b
Better Ideas
Y (1.5) K
Output
Y (1) K
15
Depreciation = 0.02K
Investment 0.3(1.5) Investment 0.3(1) K K
225
506
Capital, K
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CHECK YOURSELF
What happens to investment and depreciation at the steady state level of capital? In Figure 7.9, how much is consumed in the old steady state? How much is consumed in the new steady state? Do countries grow faster if they are far below their steady state or if they are close? Do countries with higher investment rates have a lower or higher GDP per capita?
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The Economics of Ideas 1. Ideas for increasing output are primarily researched, developed, and implemented by profit-seeking firms. 2. Spillovers mean that ideas are underprovided. 3. Government has a role in improving the production of ideas. 4. The larger the market, the greater the incentive to research and develop new ideas.
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John Kay (1704-1780) invented the flying shuttle used in cotton weaving, the single most important invention launching the industrial revolution. Kay, however, was not rewarded for his efforts. His house was destroyed by machine breakers, who were afraid that his invention would put them out of a job. Kay was forced to flee to France where he died a poor man.
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<
MPC = MSC
MPB = MPC MSB = MSC
MPB IP
IS
Quantity of R&D
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3. Governments Role in the Production of New Ideas (cont.) Large spillovers to basic science suggest a role for government subsidies to universities. Especially those parts of the universities that produce innovations and the basic science behind those innovations. Universities produce scientists Most of the 1.3 million scientists were trained in government subsidized universities.
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4. Market Size and Research and Development Innovations like pharmaceuticals, new
computer chips, software, and chemicals require large R&D expenditures. Companies will avoid investing in innovations with small potential markets. Larger markets mean increased rewards (thus incentives) for R&D. As the world market grows companies will increase their R&D investments.
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CHECK YOURSELF
What would happen to the incentive to produce new ideas if all countries imposed high tax rates on imports? What are spillovers and how do they affect the production of ideas? Some economists have proposed that the government offer large cash prizes for the discovery of cures for diseases like malaria that affect people in developing countries. What economic reasons might there be to support a prize for malaria research rather than, say, cancer research?
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The Future of Economic Growth Over the last 10,000 years per capita world
GDP has been growing.
Dawn of civilization to about 1500: growth = 0% AD 1500 1760: growth = 0.08% Growth doubled in next 100 years. Increased even further during the 19th and 20th centuries. Today: world wide growth of per capita GDP = 2.2%
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The Future of Economic Growth Economic growth can be even faster. How?
The following framework helps us think about this.
A (ideas) = Population x Incentives x Ideas/Hour Population population number of people with new ideas Much of the world is poor; thousands of potentially great scientists are laboring in menial jobs. As the world gets richer production of ideas everyone benefits
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The Future of Economic Growth Economic growth can be even faster. How?
(cont.)
The Future of Economic Growth Economic growth can be even faster. How?
(cont.)
Takeaway
As K accumulates, the MPK declines until
investment = depreciation, and growth stops. The Solow model tells us three things about economic growth: Countries that have higher investment rates will be wealthier. Growth will be faster the further away a countrys capital stock is from its steady state value. Capital accumulation cannot explain long-run economic growth.
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Takeaway
Chapter 7 Appendix:
Excellent Growth
First, calculate the increasing capital stock using the formula in A3 and let the spreadsheet do the rest.
Note: Clicking on the lower right corner of a cell and dragging it down will duplicate the formula in the lower cells.
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Y K
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Third, graphs can be created using the data generated In the steps one through three. 12.68
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Lastly, you can experiment with different investment shares in E2 or the depreciation rates in F2. 12.69
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along the Transition Path Objective: To see how economic growth varies along the transition path to a new steady state equilibrium. We will do two things: Outline the mathematics. Use a spreadsheet to visualize our results.
12.70
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By plotting these two expressions separately on a graph, we can see how the steady state changes with the values of the investment rate and depreciation rate.
g
K
1 2 1 2
g
K
12.71
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Difference is the growth rate of the capital stock. The bigger the difference the faster K grows.
Result: The transition to steady state proceeds at a decreasing rate. As K approaches 400 growth slows down.
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