Week 1 Outline

Course Overview
Preliminaries
Neoclassical Basics

Introduction

Today, we will talk about the Neoclassical approach to technolo

and its role in the economy. The basic transmission mechanism
for technologys effects on well-being go through
firm costs and behaviour. The approach reasons that firms use
technology to affect the level or shape of their cost functions
and this, in turn, affects various decisions of firms as well as
their performance. In other words, well see that the shape of
costs affects the optimal scale of operation of a firm as
well as its diversification across products. The cost structure
also has implications for the market structure we expect to
observe in the economy. The level of costs and the market
structure affect firm profitability and pricing which, in turn,
affects consumer and social welfare. This conception of
technology has been used to build models of technological chang
effect on economic growth. As our emphasis here is on new
technology, we will focus on such innovations in the rest of the
course.
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Neoclassical Basics
Production transforms a set of inputs into a set of outputs
Technology determines the quantity of outputs that is feasible to
attain from a given set of inputs

What are inputs? Productive resources, such as labour and capita

equipment, that firms use to manufacture goods and services. Th
are also called factors of production

What are outputs? The amount of goods and services produced b

The firm is its output

Neoclassical Basics, Cd
The production function tells us the maximum possible output
that can be attained by the firm for any given quantity of input

A technically efficient firm is attaining the maximum possible out

from its inputs.
Are firms technically efficient?

Inputs

Outputs
Production
Technology

Black box

Neoclassical Basics, Cd

Example: Semiconductor Chips made by robot-intensive or huma

Intensive technology? (Robot Renaissance, Industry Week, Sept.
16, 1996)

Robot-intensive

Human-intensive
Q = 100
0

L
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Neoclassical Basics, Cd
An isoquant traces out all the combinations of inputs that allow
Firm to produce the same quantity of output

The shape of the isoquant indicates the degree of substitutability

the inputs

The marginal rate of technical substitution measures the am

of an input the firm would require in exchange for using a little le
of another input in order to just be able to produce the same outp
as before. It is reflected in the slope of the isoquant.
MRTSL,K = -K/L (holding constant output)

K
L

Q = 100

L
8

Q = 100
Q = 50
L
Different industries have differently shaped isoquants
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Neoclassical Basics, Cd

The marginal product of an input is the change in output that

results from a small change in an input holding the levels of all
other inputs constant
MPL = Q/L
It can be shown that the marginal rate of technical substitution
Be written as the ratio of marginal products:
MRTSL,K = MPL/MPK

Example: MRTS between high tech and low tech workers

(Lichtenberg, The Output Contributions of Computer Equipmen
Personnel: A Firm-Level Analysis, Economics of Innovation and
New Technology, 3, 1995.)
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K
L

Q = 100
Q = 95
0

L
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Neoclassical Basics, Cd

The average product of an input is equal to the total output d

By the quantity of the input used in production
APL = Q/L

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Neoclassical Basics, Cd
What is technological progress?

Technological progress shifts the production function by

allowing the firm to achieve more output from a given combinati
of inputs (or the same quantity of output with fewer inputs)
Neutral technological progress shifts the isoquant
Corresponding to a given level of output inwards, but leaves the
MRTSL,K unchanged along any ray from the origin.
Labour saving technological progress results in a fall in the
MRTSL,K along any ray from the origin

Capital saving technological progress results in a rise in the

MRTSL,K along any ray from the origin.
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Q = 100
Q = 100
0

L
14

Q = 100
Q = 100
0

L
15

Q = 100
Q = 100
0

L
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Neoclassical Basics, Cd
Example: Chemicals in the UK

Evidence for materials-saving and capital-using technological prog

In other words, evidence that MPM decreased relative to the MPO
and MPK increased relative to MPO
Further 30% of growth of input productivity attributable to
technological progress

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Neoclassical Basics, Cd
Returns to Scale: How much will output increase when ALL inputs
increase by a particular amount?
RTS = [%Q][%(all inputs)]
If a 1% increase in all inputs results in a greater than 1% increase in
output, then the production function exhibits increasing returns to
scale.

If a 1% increase in all inputs results in a exactly a 1% increase in out

output, then the production function exhibits constant returns to
scale

If a 1% increase in all inputs results in a less than 1% increase in

output, then the production function exhibits decreasing returns t
scale.

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Capital

2K1

K1

Q = 1000
Q = 100

L1

2L1

Labour
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Neoclassical Basics, Cd
When the production function exhibits increasing returns to
scale, the average cost curve decreases with output, all else
equal. The average cost curve exhibits economies of scale

When the production function exhibits decreasing returns to

scale, the average cost curve increases with output, all else
equal. The average cost curve exhibits diseconomies of scale.

When the production function exhibits constant returns to

scale, the average cost curve is constant, all else equal. The
average cost curve exhibits neither economies nor diseconomies
of scale.
Example: Technological Change in Electric Power Generation.
Example: Technological Change at Austin Rover
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Average Cost

efficient scale

Output
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Average Cost

Output
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Neoclassical Basics, Cd
Accounting for growth: Solows growth model
Assume constant returns to scale and perfect competition throughout:

If: Q = f(K,L) Q/L = f(K/L, L/L) q = f(k,1). If we add a shift paramet

a, so that q = af(k,1) we have
q/q = MPkk/k + a/a where is change over time

Hence, the percentage productivity growth, q/q, should be accounted

for by the percentage growth due to increase in capital intensity for the
same production function plus the percentage shifts in the production
function. In other words, as we look at the relation of q to k across time
we see changes that are a result of moves along the production functio
due to changes in k as well as shifts in the production function due to
technological progress. The problem is to tease this difference out of th
Well just give a graphical idea of the problem and Solows method for
detangling these effects
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We can draw our basic production story on a simple graph

with output per unit labour as a function of the capital/labo
ratio

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Inc.
Capital
intensity

Observation 2

Tech.
change

Observation 1

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Aggregate Production Function

Tangent line
flater
Observation 2

We need to know this

point

fearlier

Observation 1

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Aggregate Production Function 1909-1949 according to Solows Da

1949

1.275

Effect on q
of
technologic
al
1909
change

0.686

Effect on q of
capital accumulation

0.623

2.06

2.7

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Neoclassical Basics, Cd
Accounting for Growth, continued

Hence, Solow(1957) demonstrated that technological advancement a

increased human capital of the labour force accounted for between 8
and 90% of the annual productivity increase in the US economy betw
1909 and 1949, with increases in the capital/labour ratio accounting
for the remainder. Denison (1985) reached a similar conclusion for
1929-1982 with:
68%
34%
22%
13%

of productivity gains due to technological progress,

due to improved education of workers
due to scale economies,
due to increased capital intensity

But
-25% due to decreased work hours
-4% due to government regulation
(Restother factors)

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Neoclassical Basics, Cd
Example: Labour Productivity in Europe
Growth in Output per hour worked
Since the Second World War, productivity levels in Europe and the
have been converging. Indeed, average productivity of labour
1990-1995 grows at 1.1% in the US vs. 2.3% in EU-15 area.

Since mid-90s, labour productivity growth rates have been lower in

resulting in an increase in the productivity gap: in manufacturing, E
has fallen from 90% US level to 81%, 1994-2001.

While there is considerable variance across EU, we do not observe

consistent catching up (low productivity correlated with high g

In fact, an analysis of the sources of variation suggests that the in

is the largest single source of the variation in labour productivit
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Neoclassical Basics, Cd

Industries with high growth in quality with falling prices have the highe
measured productivity growth rates (ICT industries). US productivity
gains relatively better in ICT industries, while EU has performed bet
in registering gains in traditional manufacturing.

Hence, industry shares as well as differences in productivity growt

industries explains the differences.

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Neoclassical Basics, Cd
There are complementarities among inputs if the effect of an
increase in the quantity of one input on the marginal product of
another input is positive.

(In other words, if I raise capital, marginal product of labour rises

Example: Why has the shift to modern manufacturing been

clustered rather than incremental? Technologies that
characterise it are complementary. (Milgrom, P. and J. Roberts,
The Economics of Modern Manufacturing: Technology, Strategy,
And Organisation, American Economic Review, 80:3 (June, 1990
511-528. Also, same authors, Complementarities and Fit Jou
Of Accounting and Economics 19 (1995), 179-208.)
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Neoclassical Basics, Cd

Economies of Scope exist when the total cost of producing given

quantities of two (or more) goods in the same firm is less than the
total cost of producing those quantities in two (or more) single prod
firms.
TC(Q1, Q2) < TC(Q1, 0) + TC(0, Q2)
Economies of scope tell us that variety is more efficient than
specialisation
TC(Q1, Q2) TC(Q1,0) < TC(0, Q2) TC(0,0)
Or it is less costly for a firm to add a product given that it already
produces a product.
Example: mass specialisation
Nike
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Total Cost

Product 1 (quantity)

Product 2 (quantity)
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Summary
Read the course outline carefully.
If you dont have it already, get a copy of the handbook.

The Neoclassical model, while a bit of a black box, has useful

implications for how we analyse the sources of economic growt

It also introduces a set of concepts for thinking about how

technology affects firms and their costs. The linkage between
technology and costs can have public policy implications. We
will extend these later to similar notions of technologys effect
on quality.

Our next task will be to go inside the black box to see what we
mean by technology, and how this is created, protected, and
used in firm strategy.
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