EC210 LT Flashcards

Question

Pareto Optimum

Answer 1

A competitive equilibrium is Pareto optimal if there is no way to rearrange production or reallocate goods so that someone is made better off without making someone else worse off The first fundamental theorem of welfare economics states that, under certain conditions, a competitive equilibrium is Pareto optimal Allocation is Pareto efficient if it maximise the utility of households subject only to the physical constrains of an economy All households identical, no trade off of making some better off without making others worse off Pareto optimum requires MRS =MRT which is the marginal rate of substitution between consumption and leisure equated to the marginal rate of transformation which measures the technological possibility of converting one good into another For consumers, optimality requires that MRS in equal to the net wage, in the case of an income tax; MRS = (1-t)w For firms, optimality implies that MPn = w and therefore MRT = w Therefore due to a labour income tax, competitive equilibrium means MRS and MRT do not equal and so Pareto optimality is not met Consumers marginal product of labour would be higher than the after-tax wage the consumer receives Socially optimal to supply more labour, but the promotional tax scheme doesn’t motivate workers to do so

Answer 2

Takes into account that higher proportional tax rates provide less incentives for households to work (assuming the substitution effect dominates the income effect of a change in the real wage) Laffer Curve implies that there can be two different tax rates; low and high, both generate the same revenue As tax rate increases, there is a positive mechanical effect on total revenue but at the same time labour supply will decrease because of the higher income taxes If we are the wrong side of the Laffer curve, the incentive effect becomes the dominating factor: if the income tax rate falls, households will supply more labour such that the tax base increase outweighs the reduction in the tax rate and tax revenue will increase Individual labour supply: the substitution effect (leisure relatively cheaper, therefore work less) dominates the income effect (your total income goes down and you want to work more). If there is a higher tax, you get a lower real wage, and you will work less. This can also be aggregated for the whole labor market. For tax collection: There, the substitution effect is the effect described above: People substitute away from labor because their real wage is lower. The income effect is an income effect of tax collection: If you increase taxes, the units who still work will generate higher revenue. Substitution effect explains why curve is humped: as tax rate increases, workers substitute away from labour The tip of the curve shows where the income effect is offset by the substitution effect The laffer curve increasing is due to the dominant income effect Consumption = Output minus tax rate = Y - G (where G is gov spending which = T) Welfare is consumer’s utility, if wage increases, utility increases

Answer 3

Labour demand curve perfectly elastic at z where w=z and firms make zero profits regardless of how much labour is demanded (perfect competition expectancy) Assume that substitution effect on wage changes is larger than the income effect (WHAT DOES THIS IMPLY?) Equilibrium wage stays the same despite reduction in labour supply Real wage (w) = MPN in in equilibrium, coincides with TFP (z)

Answer 4

Opportunity cost of leisure increases -> l falls, c increases = N supply increases (Substitution effect) sub from leisure to consumption and go to work Substitution effect: change in consumption patterns due to a change in the relative prices of goods - Become more wealthy -> c increases, l can increase = N supply decreases (Income effect) - Income effect: change in consumption patterns due to a change in purchasing power - Conclusion: consumption must rise, but leisure may rise or fall - Assume sub effect is dominant - An increase in (pi-T) out of work earnings induces an inward shift in labour supply curve

Answer 5

An increase in total factor productivity z has two important effects First, because more output can be produced given capital and labour inputs when a increases, this shifts the production function up Second, the marginal product of labour increases when z increases This is reflected in the slope of production function (becomes steeper) An increase in z arises from anything that permits more output to be produced for given inputs

Answer 6

Taking the natural logarithm of the raw data is a common way to plot data Measuring growth Other important measures: life expectancy, infant mortality Countries that have experienced growth in per capita output also experienced a long period of stagnation in output per capita This stagnation is not because there was no growth in total output but because the increase in population offset the increase in output Countries started to enter modern growth at different points in time, divergence Will poor countries remain much poorer than rich countries or will they catch up, post WWII data seems to suggest convergence Countries with lower levels of output per capita have typically grown faster Conditional but not absolute convergence -> absolute = poor countries grow faster than rich/conditional = similar countries where the poorer countries grow faster than the richer 1) Before industrial revolution standards of living differed little across time and country -> population kept up with growth in aggregate income 2) Since the industrial revolution, per capita income has been sustained in the richest countries 3) There is a positive correlation between the rate of investment and out per worker across countries -> countries in which a relatively larger fraction of output is channelled into investment tend to have a relatively high standard of living 4) There is a negative correlation between the population growth rate and output per worker across countries -> Countries with high population growth rates tend to have low standards of living 5) Differences in per capita incomes increased dramatically among counties between 1800 and 1950 -> 6) There is essentially no correlation across countries between the level of output per capita in 1960 and the average rate of growth in output per capita for the years 1960-2007 7) Richer countries are much more alike in terms of rates of growth of real per capita income than are poor countries

Answer 7

Malthus argued that any advances in the technology for producing food would lead to further population growth Higher population would ultimate reduce the average person to the subsistence level of consumption they had before the advance in technology Malthusian theory predicts that technological growth will just increase population, with no long-run change in the standard of living, which is consistent with the data prior to the industrial revolution Improvements in the production technology or increase in the quantity of land have no effect on the long-run standard if living The factors of production are land and labour and there are constant returns to scale and diminishing marginal returns to each factor Land labour ratio L/N, if it increases, output per worker is higher Endogenous population growth, increasing function of consumption per worker, link between population growth and consumption per worker remains unchanged We assume that we have a concave function of N Concavity implies that there is a steady state in N towards which the economy converges Key assumption is that land is fixed Also: Population growth is an increasing function of consumption per worker: N’Ng(C/N) All output is consumed: Y = C (no saving rate) When population is low (below steady state), land per worker will be high leading to high output per worker High output per work means workers are well-off but then will have more children and increases future population leading output per worker to decline Lower output per worker leads to lower rate of population growth These mechanisms mean there will be no population growth where N’/N, g(C/N) = 1 High population and low land per worker implies starvation so population will decline Therefore there is a steady state standard of living which cannot increase in the LR External interventions such as birth control or improvements in medicine may lead to greater life expectancy and can produced a sustained change in the standards of living

Answer 8

If z increases, the shifts up the per-worker production function In the long run, the population increases to the point where per capita consumption returns to its initial level There is no long run change in living standards

Answer 9

The economy does not move to the new steady instantaneously, as is takes time for the population to adjust according to N’=Ng(c.) The transitional dynamics describe the changes in variable of the model (e.g. c and N) as the economy adjusts to the new steady state The transitional dynamics caused by a higher z are: y increases/c increases/increases N’>N

Answer 10

Reduces the population growth rate for each level of consumption In LR, per capita consumption increases and living standards rise

Answer 11

After population falls (disease), consumption per worker increases at once as there is more land availability per worker and serving workers are able to produce more output per capita Higher standards of living are present due to higher consumption per capita in SR and so population starts growing MP of labour will eventually return to it’s LR point where c* = 1

Answer 12

Model provides a good explanation for pre-1800 growth facts where production was mainly agricultural However after industrial revolution there is sustained growth in GDP per capita, the model did not predict technological advances on fertility?? And the role of human capital Also did not consider capital accumulation in growth

Answer 13

Technological advances will just increase population with no long-run standard of living In Malthus’ time, agriculture was the major production activity corresponding with the fact the model uses only labour and land as inputs of the production function Steady state consumption per worker is constant and is is determined solely by population growth function N’/N = g(C/N) = 1 -> independent of TFP growth (B) Growth in TFP(B) will only result in higher population, offsetting gains in productivity by decreasing land per worker with consumption per worker staying constant??? As all output is consumed, constant consumption per worker implies constant output per worker Most of today’s bottom 5% of countries have not experienced growth in output per worker until recently Therefore, differences in institutions or saving patters led some countries to switch from the Malthus technology into the Solow technology quicker than others As these countries started to experience growth in output per worker earlier, it generated divergences in income levels in the 19th and 20th century

Answer 14

Capital accumulation does not cause long term economic growth because it has diminishing returns and therefore output won’t increase continuously Capital accumulation equation shows that change in capital stock is investment minus depreciation where investment equals savings and savings are a constant proportion of output If saving rate (investment) > depreciation rate, incentive to accumulate more capital If saving rate < depreciation rate, incentive not to accumulate more capital Therefore, steady state where saving rate = depreciation Increasing capital (moving along savings curve), increases depreciation Increase capital per worker, increase output Sustained rise in capital investment increases the growth rate only temporarily because ratio of capital to labour goes up Marginal product of additional units of capital may decline and thus economy moves back to a long-term growth path, with real GDP growing at the same rate as the growth of the workforce plus a factor to reflect improving productivity Steady-state growth path is reached when output, capital and labour are all growing at the same rate, so output per worker and capital per worker are constant Assume population grows exogenously, growing population of consumers (workforce) Basis for modern theory of economic growth Steady state exists if two curves cross It is unique if the two curves cross only once Convergence if the saving curve is above the depreciation curve and if the saving curve is below the depreciation curve There is no growth in the long run If countries have the same n,s and d, then they have the same steady state so will converge, i.e. Solow Model predicts conditional convergence Along this convergence path, a poorer country grows faster Countries with different savings rates have different steady states and they will not converge (i.e. does not predict absolute convergence) When saving rates are different, growth is not always higher in a poorer country (country with lower initial capital stock)?? Solow model predicts both countries will converge to the same level of capital per work and output per worker and the poor country will catch up with the rich country with regard to living standards If rich and poor countries have the same labour force growth rate, their long-run growth rates in aggregate output will be identical Across countries, real per capita income and the investment rate are positively correlated g enters the steady state result: intuitively if investment only covers depreciation, capital per effective worker must be falling So investment must cover both depreciation and growth in B for capital per effective worker to remain constant)

Answer 15

Increase in saving rates increases growth rate temporarily but no effect on long run growth Higher k* and thus higher y* Converges to a new higher steady state in short run Trade-off as higher s reduces consumption share of income

Answer 16

Best steady state in the one with highest consumption per person: c = (1-s)zf(k*) Given quantity of capital per worker that maximises consumption per worker in the steady state This implies that an increase in the savings rate could cause a decrease in the steady state consumption per worker, even though an increase in the savings rate always increases output per worker When capital is accumulated at a rate that maximises consumption per worker in the steady state, the marginal product of capital equals the population growth rate plus the depreciation rate

Answer 17

Shifts up saving curve, increase steady state k* and y* Growth and output per worker increased temporarily No effect in long run growth rate of output per work, which is equal to zero Sustained increase in Z? Sustained increase in growth? Productivity improvements are an exogenous variable independent of amount of capital investment

Answer 18

One of the key reasons why our living standard is much higher than before is technological progress Higher z makes both capital and labour inputs more productive Capital per effective worker can only be constant if investment covers depreciation, population growth and technological progress Convergence in the Solow Model for countries that are identical in d,s,n and the same technology The rich country has higher initial physical capital than the poor one

Answer 19

Poorer countries can catch up initially by accumulating capital per capita Over time, returns to capital decreases, the economy attains a steady state Key condition: a < 1 - this means there is a diminishing marginal product to capital

Answer 20

- Higher labour force growth ultimately causes aggregate output to grow at a higher rate - Solow model predicts that capital per worker and output per worker will decrease in the steady state when the labour force growth rate increases, but aggregate output will grow at a higher ate, which is the new rate of labour for growth - Capital per worker falls and output per worker falls (lower steady state) - When the labour force growth rate increases, growth in all of these variable must also increase - Higher growth in aggregate income need not be associated, in the long run, with higher income per worker

Answer 21

1) Higher savings imply higher investment which translates into higher capital stock, output and consumption. However diminishing returns to capital sets in. 2) As we rise above the golden rule saving rate, the cost of increasing savings further outweighs the benefit of an additional unit of invested capital. Additional saving becomes inefefctciaint (in terms of consumption but not in terms of output)

Answer 22

If q = k, capital per worker does change so steady state stays the same hence output per worker and growth rate does not change in short or long run If q > k, capital per worker and output per worker increases in short run but starts decreasing until economy runners to steady state (i.e. depreciation rate has increased as there has been greater capital accumulation but no extra savings to fund it), SR negative growth and 0 LR growth If q < k, savings rate relative to depreciation will be greater as more people are in the economy and saving so there will be SR positive growth but 0 LR growth as we return to steady state

Answer 23

Growth accounting shows the important contribution of technological progress to growth within a country Development accounting shows differences in the levels of technology are needed to account for large cross-country income differences Why doesn’t capital flow from rich to poor: large differences in Y/N must imply large differences in K/N, which implies that returns to capital in the poor countries must be much higher than in the rich, so why doesn’t capital flow from rich to poor? There is missing capital in the model (e.g. human capital)? TFP is different across countries Growth rate will be higher in country one: The economist can come to this conclusion if the growth accounting exercise suggested that TFP growth was a larger component of output growth in in country 1 This is because the Neoclassical model assumes that factor accumulation can only have a temporary (SR) effect on growth in output per worker, but only TFP growth has a (LR) effect on growth per worker Even if both countries have same SR growth rate, they can end up at different LR growth rates if consumption of current SR growth is different

Answer 24

Poor countries do not need to carry out R&D, they can adopt the technology of the rich countries TFP is the effective level of technology but technology operates with different efficiencies in different countries One potential answer is: institutions. There is a gap between the marginal product of capital and private incentives to save/invest due to tax rates, corruption, risk of expropriation A lower y (output per worker) translates into higher MPK A poor country should attract large capital inflows because it’s marginal product of capital is high however this has not been observed in reality Introducing land into the production function breaks the one-To-one relationship between MPK and If rich countries had a higher level of land per worker, then this would raise their MPK relative to poor countries I.e. large countries can have more land and so higher levels of land per worker

Answer 25

A broad concept that captures a set of rules which govern the process of decision making Focus on the set of institutions that encourage productive activities such as investment in physical and human capital or technology adoption over diversion or rent-seeking

Answer 26

Measure how much of the growth in aggregate output is accounted for by: factor accumulation (capital, labour, human capital) and by increases in total factor productivity If the fast growth rate is due to a high rate of technological progress (rate g) then it implies higher steady state growth that will last in the long run If fast growth is due to high capital accumulation then growth in the short run exceeds steady state growth g but will eventually fall back to it due to the diminishing marginal products of capital Growth accounting implies growth in technology z is an important component for growth in output

Answer 27

Solow model predicts a country is poorer if it has a lower saving rate, a higher population growth rate or a higher depreciation rate Depreciation and population growth rates similar across countries (assume for simplicity) Therefore any differences in steady state output per worker must be due to differences in saving Left with saving/investment rate -> investment rate for poor countries is about five times lower than for the rich E.g. for a = 1/3, the ratio of y* rich to poor countries is equal to (5)^1/2 = 2ish which is much smaller than observed cross-country income differences. Difference in B is needed (TFP) Growth accounting implies growth in technology z is an important component for growth in output Development accounting shows differences in the level of technology are needed to account for large cross-country income differences Development accounting model shows differences in their savings rates are too small to account for their income differences and therefore we need to examine differences in the level of technology to explain large cross-country income differences (can’t just assume B is the same for each country)

Answer 28

Learning-by-doing: acquire knowledge as a by-product whilst working Human Capital: accumulated skills and talent of workers that puts ideas into production Research and development: produces new ideas and knowledge These are endogenous growth models in the sense that long-run growth is endogenously determined by the model

Answer 29

The endogenous growth model does not predict convergence in levels of per capita income across countries when countries are identical except for being initially rich and initially poor Predicts that differences in per capita income persist forever The growth mechanism that is endogenous to the Solow model is capital accumulation The presences of diminishing MPK implies that the incentive to accumulate capital declines as the capital stock increases Endogenous growth not possible in the Solow model If A is constant, then MPK falls as k rises, so the incentive to accumulate capital will eventually disappear -> this is why there is no growth in the steady state of the Solow model when A in constant If A is growing at a constant rate, then MPK might not be dismissing as k rises. More specifically, if the fall in k^a-1 is cancelled out by the rise in A, then MPK is constant -> this is why there is constant growth in the steady state of the Solow model at rate g The AK model: there is positive growth in the long run even if A is constant The savings curve becomes a straight line so there is no steady state for k, i.e. there is long run growth even if A is constant

Answer 30

Total factor productivity differs across countries Could take time for workers and manager to learn to use new technology, we should expect a learning period for the technologies that are used in rich countries to spread to poor countries Productivity differences can persist across countries because of barriers to the adoption of new technology, a protected industry will be less inclined to invest in research and development that makes it more competitive in world markets The level of aggregate technology can differ across countries because of the efficiency with which factors of production are allocated across firms in the economy With countries with different TFP, in the steady state, standards of living are permanently different but aggregate output grows at the same rate Skills or knowledge are accumulated during the production process So the skills or knowledge accumulation are free and is a by-product of production Investment by a firm generates a positive externality for the economy So there is no dismissing marginal product of capital at the aggregate level There is endogenous growth because the stock of knowledge is determined by the endogenous level of K through learning-by-doing New implications compared to the Solow model: saving rate affects not only the level of income but also the growth rate as x depends on s, the growth rate is constant in both the short and long run and there is no convergence There are scale effects: the growth rate depends on the size of the population Larger N implies stronger knowledge spill overs and therefor higher growth rate If we assume that the level of economy-wide knowledge is not exogenous then we can explain differences in income levels through differences in knowledge accumulation which, using an LBD model is due to differences in savings rates Idea of LBD model i) The production function holds for individual firms ii) For the economy as a whole, there are knowledge spillovers across firms which make B a positive function of average capital stock Despite diminishing marginal product of capital at the firm level, the presences of knowledge spillovers implies that the aggregate production function displays no diminishing MPK We get LR endogenous growth if the saving rate is high enough A difference in saving rates between high and low income countries would now mean that they grow at different rates and incomes will diverge over time, this can explain any level of income difference

Answer 31

The representative consumer allocates his or her time between supplying labour to produce output and accumulating human capital where human capital is the accumulated stock of skills and eduction taxation a worker has at a point in time Higher level of human capital means economy can grow at a faster rate as workers can produce more Skills are required to put ideas or knowledge into practice Unlike learning-by-doing, there are costs and returns to education Production of new human capital is proportional to existing human capital, i.e. AK for the production of human capital, there are no dismissing marginal product in the production of human capital Model predicts positives growth in the long run (without exogenous growth in technology) If b(1-u)>1, human capital increase forever - there is endogenous growth No diminishing returns as increasing human capital has no limit (non-rivalry?), physical capital has diminishing marginal returns and is rivalrous Growth rate of human capital increases if b increases or if u decreases B determines efficient of human capital accumulation technology, efficiency of the educational sector (countries with more efficient education systems should experience higher rates of growth in human capital) If u decreases this means more time is spent devoted to human capital accumulation and less to producing output in current period Growth rate of consumption Is identical to growth rate of human capital Human capital, consumption and output all grow at same rate in equilibrium Growth occurs due to endogenous forces (b and u) and not from population growth and not from technology growth as z remains fixed Convergence does not occur even if countries are identical (same b, z and u)?? Rich country has a higher initial human capital than the poor one

Answer 32

Poor countries will tend to catch up with or converge towards the income levels of rich countries if poor countries have similar savings rates for both physical and human capital

Answer 33

New ideas and knowledge are developed in the market through devoting resources to research and development Ideas are like capital -> cost to producing them, can be used in production, there is a price for them (value of a patent) Capital and ideas are very different -> ideas are rivalrous or nonrivalrous and have a degree of excludability??

Answer 34

No diminishing marginal returns in the production of ideas Production of new knowledge is proportional to the numbers of workers engaged in R&D Growth rate does not depend on existing stock of ideas (no diminishing returns) A growth in yA (fraction of workers engaged in R&D) leads to a permanent increase in the growth rate There are scale effects: the growth rate depends on the size of the population, larger L implies more workers engaged in R&D (for given yA) Implies countries with larger population have higher growth rates, levels of technology and are richer One interpretation of the model is that a country’s level of technology depends on R&D done around the world

Answer 35

Countries acquire new technologies either by invention or by imitation. The option of imitation is open only to the country that is the technology follower Cost of imitating a given technology is less than the cost of reinventing the technology In the steady state, the growth rates of A1, and A2 are equal An increase in yA2 shifts up the growth rate of A2, the new steady state is lower An increase in yA2 leads to a temporary increase in the growth rate for the follower

Answer 36

Technologies developed in the leader might not be appropriate for the follower e.g. rich country may have more physical or human capital Different types of technological change: Neutral/Capital-biased Neutral technological change: a proportional shift upward in the production function means a poor country would benefit as much as a rich country from technological change Capital-biased technological change: Only capital-rich countries benefit Enforcement of property rights (institutions) means R&D labs in developed countries don’t create technologies that developing countries could use

Answer 37

The derivation of equilibrium in the Solow model with technological progress is similar to before once we re-interpret the labour input in terms of “effective” units When N is constant, the dynamic equation for capital per worker (k=K/N) implies that steady state k is constant if investment covers depreciation When the number of workers N is growing, then if investment only covers depreciation, k must be falling So investment must cover both deprecation and population growth for capital per worker to remain constant Following the same intuition, capital per effective worker can only be constant if investment covers depreciation, population growth and technological progress Instead you state, both capital per effective worker and output per effective worker are constants, both are growing at the rate g (the growth rate of B) Convergence in the Solow model for countries that are identical (same d,s,n and the same technology)

EC210 LT Flashcards

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