Q = A f(X) X= x1, xn
Time suffixes are omitted for simplicity: however, we are interested in how Q increases over time when inputs change.
COBB-DOUGLAS PRODUCTION FUNCTION Q =AKL Cobb, C. and P. Douglas (1928) A Theory of Production, AER.
Charles Cobb was a mathematician. Paul Douglas (1892-1976) was an economist (University of Chicago) but also a politician. He served as a Democratic U.S. Senator from Illinois from 1949 to 1967.
LONG RUN ANALYSIS: THERE ARE NOT FIXED FACTORS OF PRODUCTION 1. CHOICE OF THE OPTIMAL COMBINATION (TECHNIQUE) OF K AND L: THAT MAZIMIZING THE FIRM PROFITS (maximum output for given costs or minimum costs for a given output) 2. ECONOMIES OF (OR RETURNS TO) SCALE 3. TECHNOLOGICAL CHANGE
THE MARGINAL PRODUCTIVITIES (OR RETURNS) OF CAPITAL AND LABOUR ARE POSITIVE BUT DECREASING.
dQ/dK is clearly positive (see above) To find whether it is increasing or decreasing in K, we must look at the second derivative
K Graphically, assuming for instance that L is given, the relationship between Q and K will be positive but less than proportional (i.e. decreasing).
Note: the presence of decreasing returns in K and L implies the convexity of ISOQUANTS which is essential for guaranteeing the choice of the optimal technique.
The assumption of decreasing returns has important implications when we move to the aggregate production function and analyse the growth of a countrys GDP over time (i.e. when moving to the growth theory).
RETURNS TO SCALE
Returns to scale are different from the returns of single inputs. In fact, they are associated with an equal positive variation of both inputs, which can be interpreted as an increase of the production scale. So, the question is: how Q changes when there is an identical change in K and L? According to the C-D production function the answer is given by the sum of the elasticities and . If the sum is equal to 1 there will be constant returns to scale. If lower than 1 decreasing, and if greater than 1 increasing returns to scale. To prove it, just assume that both K and L double and the new level of output is Q*
Q/L = A(K/L)
and shows that the average productivity of labour only depends upon the A factor and the capital/labour ratio (elevated to ).
If the C-B production function is taken as the base of a growth model (as it occurs with the neoclassical traditional model) an important implication is that labour productivity increases less than proportionally with the increase in the capital/labour ratio. This is due to the decreasing returns from the physical capital K ( <1).
Q/L
K/L
So, by using this narrow framework, the prediction is that, as far as K will become larger, the increases in labour productivity will be lower and, at the limit, will approach to zero. We will be back to this important issue in discussing (old and new) growth theories.
Note: if the returns to scale are not constant the level of labour productivity (Q/L) can be also affected positively (negatively) by the scale variable L+-1 if there are increasing (decreasing) returns to scale.
According to the traditional neoclassical approach (Solow, 1957), the growth rate of TFP is interpreted as the rate of change of output due to exogenous technological change (manna from heaven). Technological progress is then depicted as a (positive) shift of the production function and explains why labour productivity can continue to improve over time, even in presence of decreasing returns from capital.
Q/L
t2 t1
K/L
Above, you can find a graphical representation of the above phenomenon: from time 1 to time 2 the production function shifts upward: this implies that, for the same level of K/L, labour productivity reaches a level higher than that recorded at time 1.
GROWTH ACCOUNTING
Suppose of having data for Q (GDP), K and L of a given country for a given period of time. In order to find the growth rate of TFP by means of the equation
Similarly, it is easy to prove that =1- is equal to the share of income distributed to labour [that is (wL)/(pQ)]. Such a share, termed sL, is by definition, equal to 1- sK. In short, the share of labour income is precisely one minus the share of income that goes to capital. In general, it is easier to find data for sL and, then, obtain sK residually. As a consequence the growth rate of GDP (Q) can be decomposed in the following manner:
Q/L = A(K/L)
Assuming for notational simplicity q=Q/L and k=K/L, we have: q = Ak. By taking logs and computing annual log differences one gets lnq = lnA + lnk where the growth rate of labour productivity can be decomposed into two elements: the rate of change of A (or TFP) and that of the capital/labour ratio. Again, the change in A (or TFP) can be obtained as a residual
The table below shows the average annual rates of growth of labour productivity (lnq) and total factor productivity (lnA) concerned with four developed countries and different time periods from 1963 to 1998.
1963-73 lnq lnA Japan UK USA Italy 8.6 3.3 2.2 6.5 6.1 2.0 1.5 4.7
1973-79 lnq lnA 3.2 1.3 0.6 2.4 1.8 0.2 -0.1 0.5
1980-90 lnq lnA 2.7 2.3 1.1 2.0 1.6 n.a. 0.8 1.2
1990-98 lnq lnA 1.8 1.5 1.4 2.3 0.7 1.2 1.1 1.1
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Many stylized facts are well represented in the table. Over the first period, Japan and Italy were experiencing an intense process of catching-up. From 1973 to 1979 (i.e. after the international crisis due to the first oil shock and the end of the dollar standard) there was a productivity slowdown. The growth rates of the golden age were never achieved in the following years. Finally, while from 1963 to 1990 they were clearly losing ground, during the 1990s the United States have witnessed a recovery, especially in terms of TFP changes.
SOLOW RESIDUAL
Robert Solow (1957) was the first scholar employing a Cobb-Douglas aggregate production function to compute TFP as a residual. Moreover, he interpreted its growth over time as exogenous (and disembodied) technological progress. Taking the data for the US economy from 1909 to 1949 he first computed the annual log levels of TFP as residuals
labour input: it should be adjusted for the different composition in terms of skills and levels of education. Thus, one hour worked in 1949 is likely to be much more productive than one in 1909. The same applies to a capital unit. If labour and capital are not adjusted for quality changes, their increased productivity is captured by the residual. This contributes to explain its bigness.
Q= TFP f(K, L)
Then, it is assumed that TFP= g(A, T) where A= et (the shift factor A is an exponential function of time) and T is a measure of KNOWLEDGE OR TECHNOLOGICAL CAPITAL and can be computed as
Q= et T K L(1-)
Taking logs [the log of et is t, where t is time] one gets
The left-hand side of the above equation is precisely the rate of change of TFP. So we get
lnTFP = + lnT
which states that the growth rate of TFP is explained by a rate of exogenous technological change () and the change in knowledge capital T multiplied by the parameter . R&D expenditures include the costs for specific capital (scientific instruments), materials or intermediate goods used for laboratory experiments and proofs, and, above all, skilled and highly educated workers (researchers, scientists and engineers). If data are not corrected for the above double counting and there is a positive contribution to output of technological capital, this means that the specific inputs devoted to R&D activities are more productive than the traditional factor of production. In this sense, should be considered an "excess" elasticity. To be stressed is that the introduction of knowledge capital into the (augmented) C-B function solves the problem due to the assumption of decreasing returns for traditional physical capital (see below).
Qi= et Ki Li (1-) Ti Ta
where Ta = i Ti
Examples: the technological capital of an industry a is the sum of that of the firms i belonging to it. Alternatively, the technological capital of a country a is sum of that of its industries i. Thus, at the aggregate level, the elasticity of output with respect to technological capital will reflect both private and social returns to R&D and, as a consequence, it will be higher than at micro level.
This model, developed by Robert Solow and Trevor Swan in the 1950s, was the first attempt to model long-run growth analytically. It assumes that countries use their resources efficiently and that there are diminishing returns to capital and labour increases. From these two assumptions, the neoclassical model makes three important predictions. First, increasing capital relative to labour creates economic growth, since people working with more capital can be more productive. Second, poor countries with less capital per person will grow faster because each investment in capital will produce a higher return than that achievable by rich countries with greater capital. Third, because of diminishing returns to capital, economies will eventually reach a point at which no new increase in capital will create economic growth. This point is called "steady state". The model also stresses that countries can overcome this steady state and continue growing only thanks to technological change. However, the process by which countries may go on in their growth process (despite the diminishing returns to physical capital) is "exogenous" and represents the creation of new technology that allows to get the same output with fewer inputs. The empirical evidence does not support many of this model's predictions, in particular, that all countries grow at the same rate in the long-run or that poorer countries should grow faster until they reach their steady state.
convergence clubs) depending on the levels of knowledge and human capital that are available in a particular country. The above arguments have opened the door to policy interventions in support of knowledge and human capital investment with a view to sustaining economic growth. Thus, they have a lot to do with the growth-enhancing strategy launched by the EU in the 2000 Lisbon Council.
References
Abramovitz, Moses (1956) Resource and Output Trends in the United States since 1870, American Economic Review. Aghion, P. and P. Howitt (2009) The Economics of Growth, London: The MIT Press. Chapters: 1 (sections 1.1-1.2) and 5 (sections 5.1-5.5). Griliches, Zvi (1979) Issues in Assessing the Contribution of Research and Development to Productivity Growth, Bell Journal of Economics. Lucas, Robert (1988) On the Mechanics of Economic Development, Journal of Monetary Economics. Romer, Paul (1990) Endogenous Technological Change, Journal of Political Economy. Solow, Robert (1956) A Contribution to the Theory of Economy Growth, Quarterly Journal of Economics. Solow, Robert (1957) Technical Change and the Aggregate Production Function, Review of Economics and Statistics. Swan, Trevor (1956) Economic Growth and Capital Accumulation, Economic Record.
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