Problem Set 4 FE411 Spring 2008 Rahman Some Answers 1) An Alternative Produ tion Fun tion with !

uman "apital Heres a production function with a slight twist from the book - consider a Cobb-Douglas production function with three inputs. K is capital (the number of machines), L is labor (the number of workers), and H is human capital (the number of college degrees among the workers). The production function is

Y = K # " ! L# " ! H # " !

a# Deri$e an e%pression for the marginal product of labor. How does an increase in the amount of human capital affect the marginal product of labor& MPL = 1/3*K1/3H1/3 L-2/3. Increase in human capital raises MPL. b# Deri$e an e%pression for the marginal product of human capital. How does an increase in the amount of human capital affect the marginal product of human capital& MPH = 1/3*K1/3H-2/3 L1/3. Increase in human capital lowers MPH. # 'hat is the income share paid to labor& 'hat is the income share paid to human capital& (n the national income accounts of this econom), what share of total income do )ou think all workers would appear to recei$e& 1/3 1/3 an! 2/3 respecti"el#. d# *a) an unskilled worker earns the marginal product of labor, whereas a skilled worker earns the marginal product of labor plus the marginal product of human capital. +sing )our answers to (a) and (b), find the ratio of the skilled wage to the unskilled wage. How dies an increase in the amount of human capital affect this ratio& ,%plain. $s%ille!/$uns%ille! = &MPL ' MPH( / MPL = 1 ' &L/H(. $hen H increases this ratio )alls *ecause the !iminishin+ returns to human capital lower its return while at the same time increasin+ the mar+inal pro!uct o) uns%ille! wor%ers.

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Problem Set 4 FE411 Spring 2008 Rahman e# *ome people ad$ocate go$ernment funding of college scholarships as a wa) of creating a more egalitarian societ). /thers argue that scholarships help onl) those who are able to go to college. Do )our answers to the preceding 0uestions shed light on this debate& I) more colle+e scholarships increase H then it !oes lea! to a more e+alitarian societ#. ,he polic# lowers the returns to e!ucation !ecreasin+ the +ap *etween the wa+es o) more an! less e!ucate! wor%ers. More importantl# the polic# e"en raises the a*solute wa+e o) uns%ille! wor%ers *ecause their mar+inal pro!uct rises when the num*er o) s%ille! wor%ers rises. 2) $he Solow %rowth &odel with %rowing E''i ien ( o' )abor 1ssume that production is a function of capital and e))ecti"e labor, and that the rate of sa$ings, depreciation, population growth, and labor-augmenting technological progress are all constant, as described in Chapter 2s $ersion of the *olow 3odel. 4urther, assume that the production per effecti$e worker can be described b) the function

# = ) (% ) = %
where % is capital per effecti$e worker.

(# ) 5

a. +sing the functional form for #, write the functions for both consumption and in$estment in the *olow 3odel. i = s%-.. c = &1-s(%-.. b# 'rite the 6aw of 3otion of Capital (using the functional form for #). 'hat condition for the 6aw of 3otion of Capital must hold for the econom) to be in a stead) state& *how the stead) state condition on a graph with the in$estment function and the depreciation of capital per effecti$e worker. /% = s%-.. 0 &1'n'+(% 2or stea!# state this e3pression must e4ual 5ero. 67raph not shown see *oo% 8 notes9.

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Problem Set 4 FE411 Spring 2008 Rahman

# *ol$e for the stead)-state $alue of # as a function of s, n, +, and 1. s%*-.. = &1'n'+(%*. :ol"in+ )or %* +i"es us %* = &s/& 1'n'+((2. Plu++in+ this into our pro!uction )unction +i"es us; #* = s"&n'1'+(

d# 1 de$eloped countr) has a sa$ing rate of 527 and a population growth rate of #7 per )ear. 1 less-de$eloped countr) has a sa$ing rate of #87 and a population growth rate of 97 per )ear. (n both countries, + : 8.85 and 1 : 8.89. 4ind the stead)-state $alue of # for each countr). Plu+ into e4uation a*o"e. <e"elope! countr#; #* = = <e"elopin+ countr#; #* = 1 e# 'hat policies might the less-de$eloped countr) pursue to raise its le$el of income& In!uce sa"in+s; ta3 incenti"es *alancin+ *u!+et etc. In!uce re!uction in population +rowth; e3plicit laws ta3 incenti"es etc. '# ,%plain wh) the sa$ings rate in an econom) is so important for the stead) state. (f the less-de$eloped countr) increases its sa$ings rate, show on the graph from b what happens to the in$estment function and the stead) state le$el of capital. 'hat is the cost toda) of increasing the sa$ings rate& 'hat are the benefits of doing so& :a"in+s translates into permanent increases o) li"in+ stan!ar!s throu+h raisin+ capital stoc%s per person. >n the +raph 6not shown9 #ou woul! !raw a new in"estment line an! illustrate a hi+her %* an! #*. ,he cost o) raisin+ s is a lower consumption per person to!a#. ,he *ene)its come in the )orm o) hi+her output per person. $hether or not this also translates into hi+her lon+-run consumption per person is uncertain. g# 'rite the ;olden <ule for ma%imi=ing consumption. +se the ;olden <ule to sol$e for the ;olden le$el of stead) state %, #, c, and i.

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Problem Set 4 FE411 Spring 2008 Rahman ,he 7ol!en ?ule in this pro*lem is where MPK = n ' 1 ' +. @sin+ our )unctional )orm this means that MPK = -..%*--.. = n ' 1 ' +. :ol"in+ )or this capital per person le"el we )in! that; %*&+.r.( = &-../&n'1'+((2. ,his means that #*&+.r.( = &-../&n'1'+((. c*&+.r.( = &1-s(&-../&n'1'+((. i &+.r.( = s&-../&n'1'+((.
*

Aotice that the +ol!en rule income le"el is &-../&n'1'+(( while our 7BAB?CL pro!uction )unction in stea!# state is s"&n'1'+( &)rom part c(. :o how )ar is each countr# )rom the +ol!en rule le"el o) output pro!uctionD 2or the !e"elope! countr# with s = -.2E it is pro!ucin+ onl# -.2E/-.. = .FG as much as it shoul! *e i) it were attemptin+ to ma3imi5e lon+-run consumption. 2or the !e"elopin+ countr# with onl# s = -.1 it is e"en worseH it is pro!ucin+ -.1/-.. = 2-G as much as it shoul! *e i) it were attemptin+ to ma3imi5e lon+-run consumption. ,he *ottom line is it appears that each countr# is short-chan+in+ the )utureI 7ettin+ to the +ol!en rule le"el woul! clearl# re4uire sa"in+ .-G o) income an! thatJs a lot.

*) Predi tions o' the Real E onom( 'rom Solow -ro$e each of the following statements about the stead) state with population growth and technological progress. (>ote ?ou need to understand section 2-# fairl) thoroughl) for this one. >ote also that these are not $er) rigorous proofs @ )ou Aust need a bit of deducti$e logic). a# The capital-output ratio is constant. In stea!# state s# = &1'n'+(%. ,his means that %/# = s/&1'n'+( which is a constant. b# Capital and labor each earn a constant share of an econom)s income BHint <ecall the definition of 3-CD. KapitalJs share o) income is MPK*&K/Y(. 2rom part a we %now that K/Y is constant. 2urther +i"en that % is constant in stea!# state its mar+inal pro!ucti"it# must *e constant as well.

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Problem Set 4 FE411 Spring 2008 Rahman # The real rental price of capital is constant, and the real wage grows at the rate of technological progress +. BHint The real rental price of capital e0uals total capital income di$ided b) the capital stock, and the real wage e0uals total labor income di$ided b) the labor force.D ,he real rental price o) capital ? = ,otal Kapital Income/Kapital :toc% = &MPK*K(/K = MPK. ,his we %now is constant so the real rental price o) capital is constant. ,he real wa+e is w = ,otal La*or Income/La*or 2orce ,his means that w*L = ,otal La*or Income &,2I( Kon"ertin+ to rates o) chan+e; /w/w '/L/L = /,LI/,LI $e %now that the la*or )orce +rows at rate n an! that total la*or income +rows at rate n'+. ,hus real wa+es +row at rate +. Kool huhD $ell I thin% so an#wa#L

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