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6WeilEconomicGrowth,SecondEdition

Chapter3
PhysicalCapital
Note: Specialiconsinthemarginidentifyproblemsrequiringacomputerorcalculatorandthose
requiringcalculus.

n Solutions to Problems
1. Explainwhetherornotthefollowingisphysicalcapital.
a)adeliverytruck
b)milk
c)farmland
d)thePythagoreantheorem
ANSWERThefivekeycharacteristicsofphysicalcapitalarethatitisproductive,itisproduced,itsuseis
limited,itcanearnareturn,anditwearsout.
a. Adeliverytruckisphysicalcapitalbecauseitisproductive,i.e.,byallowingadeliverymanto
driveinsteadofwalkitincreaseshisoutput(deliveriesmade);ithasbeenproduceditself;itis
rivalinitsuse,i.e.,onlyonepersoncandriveittouseitatatime;itcanearnareturnifrented
out;anditsufferswearandtear(depreciation)fortheperiodofitsuse.
b. Milkisnotphysicalcapitalbecauseitisnotproductive.(Tobeslightlytechnical,milkisusedin
makingotherthingsforexample,cheese.Butinthiscasemilkisarawmaterialratherthana
factorofproduction.Ineconomicterms,cheeseproductionisthevalueaddedresultingfrom
usingcapitalandlabortoturnmilkintocheese.)
c. Farmlandisnotphysicalcapitalbecauseeventhoughitallowsaworkertoproducemoreoutput,
ithasnotbeenproduceditself.
d. ThePythagoreanTheoremisnotphysicalcapitalbecauseitisnonrivalinitsuse.Thatis,an
unlimitedamountofpeoplecanuseitatthesametime.

7WeilEconomicGrowth,SecondEdition

2.

UsetheSolowmodeltodescribeacountryasfollows:

Productionfunction:y=k1/2

k=400

Thefractionofoutputinvestedis50%.Thedepreciationrateis5%.
Isthecountryatitssteadystatelevelofincome?Ifnot,isitaboveorbelow?
ANSWER(NOCALCULATORNEEDED)Tofindthesteadystatevalueofoutputinthecountry,we
refertoEquation(3.3)onpage63
yss A

1
1

1
.

Plugginginvalues:A1, 0.5, 0.5,and0.05,weget:


1
1 0.5

yss 1

0.5

0.5 1 0.5
.
0.05

Simplifyingtheaboveequation,weget yss 10.


Tofindthecurrentoutputperworker,wesubstituteink400intotheproductionfunctiontoget:
1

y k 2 400 2 20.
Thatis,thelevelofcurrentoutputis20whereasthesteadystateoutputlevelis10.Therefore,we
concludethat y yss sothecountryisaboveitssteadystatelevelofoutputperworker.

Chapter3PhysicalCapital8

4.

Theinvestmentrateis5%incountry1and20%incountry2.Thetwocountrieshavethesamelevel
ofproductivityAandthesamedepreciationrate.Assumingthatthelevelof is1/3,calculatethe
steadystatevalueoftheratiobetweenoutputperworkerincountry1andoutputperworkerin
country2.Whatwoulditbetheratioifwere1/2?
ANSWERDenotingeachvariablebytheappropriatecountrysubscripti,wewriteEquation(3.3)from
page63inratioform.Thatis,

yi ,ss
y j ,ss

Ai

1
1

i 1

i

1
A j 1 j
j

Sinceproductivity,A,anddepreciation,,arethesame,wecancancelthemandrewritethepreviousratio
withtheappropriatevalues: 1 0.05, 2 0.2, andsetting 1/ 3.
y1,ss
y2,ss

(1/ 3) 1
3

1 0.05
1

0.2
2

(0.25) 2 0.5.

For 1/ 2, weget,
y1,ss
y2,ss

1 0.05
1

0.2
2

(1/ 2) 1
2

(0.25)1 0.25.

Therefore,when 1/ 3, theratiois0.5or1to2andwhen 1/ 2, theratiois0.25or1to4.Forbigger


valuesof,themarginalproductivityofcapitalinbothcountriesishigher.Thisdisproportionately
favorsthecountrywiththehigherpropensitytosaveandinvest.
5.

Herearethedataoninvestmentratesandoutputperworkerforthreepairsofcountries.
Investmentrate(19702005)

Outputperworkerin2005($)

Thailand

30.3%

14260

Bolivia

9.9%

6912

Nigeria

7.5%

3468

Turkey

14.6%

17491

Japan

31.3%

48389

NewZealand

20.7%

43360

9WeilEconomicGrowth,SecondEdition

Foreachcountrypair,computetheratioofGDPperworkerinsteadystatethatispredictedbytheSolow
model,assumingthatallcountrieshavethesameAand andthatthevalueof is1/3.
ThencalculatetheactualratioofGDPperworkerforeachpairofcountries.
ForwhichpairofcountriesdoestheSolowmodeldoagoodjobinpredictingrelativeincome?Forwhich
countriesdoesitdoapoorjob?
ANSWER(CALCULATORNEEDED)Sinceweknowproductivity,A,anddepreciation, ,arethesame,
weknowthattheywillcanceloutinoursteadystateratioanalysis.Therefore,with 1/3,our
equationofinterestboilsdownto
y1,ss
y2,ss

1
1
2

1 2

,
2

forallthreepairsofcountries.
UsingasubscriptTforThailandandasubscriptBforBolivia,werewritethepreviousequationfor
ThailandandBoliviaas
yT ,ss
yB,ss

2
T .
B

Substitutingin T 0.303 and B 0.099, wegetthesteadystateratiotobe:


yT ,ss
yB,ss

0.303 2

1.75.
0.099

Theactualratiois,
yT $14,260

2.06.
yB $6,912

Therefore,withapredictionerrorofabout15%,theSolowModeldoesagoodjobinpredictingrelative
incomeforThailandandBolivia.
Then,usingasubscriptNforNigeriaandasubscriptTforTurkey,werewritethepreviousequation,with
N 0.075 and T 0.146 toget,
yN ,ss
yT , ss
Theactualratiois,

2 0.075 2
N
0.72.
0.146
T

Chapter3PhysicalCapital10

yN $3,648

0.21.
yT $17,491

Therefore,withapredictionerrorof243%,theSolowModeldoesapoorjobinpredictingrelativeincome
forNigeriaandTurkey.
UsingasubscriptJforJapanandasubscriptNforNewZealand,werewritethepreviousequation,
with J 0.313 and N 0.207 toget,
yJ ,ss
yN ,ss

2 0.313 2
J
1.23.
0.207
N

Theactualratiois
yJ $48,389

1.12.
yN $43,360

Therefore,withapredictionerrorofsome9.8%,theSolowModeldoesagoodjobinpredicting
relativeincomeforJapanandNewZealand.
6.

CountryXandY:samelevelofoutputperworker,samedepreciationratesandsameproductivity.
YetoutputperworkerisgrowingincountryXandfallingincountryY.Whatcanyousayaboutthe
twocountriesinvestmentrates?

ANSWERIfoutputperworkerisrisinginCountryXandoutputperworkerisfallinginCountryY,we
canbeassuredthatbothcountriesarenotintheirrespectivesteadystates.Instead,theyare
convergingtotheirrespectivesteadystates.Inaddition,forCountryXandCountryY,wearegiven
informationthatdepreciation,productivity,andoutputperworkerareidentical.Bytheprocessof
elimination,theonlydifferencebetweenthecountriescanandmustbethelevelofcapitalstocks.
Capitalstocklevelsfollowtheprocess:
ki i f (ki ) i ki .

11WeilEconomicGrowth,SecondEdition

Assuch,wecanconcludethatdifferencesininvestmentratesareresponsibleforthedivergenceinoutput
perworker.Specifically,ariseinoutputperworkerforCountryXandafallinoutputperworkerfor
CountryYimplythattheratioofsteadystateoutputperworkeris,
yX ,ss
yY ,ss

1
1; therefore, X
1; implying, X Y .
Y

Consequently,wecandeterminethatCountryXhasahigherinvestmentratethanthatofCountryY,and
thesedifferencesaccountforthefallingandrisinglevelsofoutputperworker.
7.Inacountry,theproductionfunctionis:y=k1/2,thefractionofoutputinvestedis0.25andthe
depreciationrateis0.05.
(a)Computethesteadystatelevelsofkandy
(b)Inyear1,thelevelofkis16.InatablewithYear,capitalperworkerk,outputperworker
y=k1/2,investment y,depreciation k,changeincapitalstock( y k)ascolumns,
showhowcapitalandoutputchangeovertime.Continuethistableuntilyear8.
(c)Calculatethegrowthrateofoutputbetweenyear1and2
(d)Calculatethegrowthrateofoutputbetweenyear7and8
(e)Comparingyouranswersfromparts(c)and(d),whatcanyouconcludeaboutthespeedofoutput
growthasacountryapproachesitssteadystate?
ANSWER(CALCULATORNEEDED)
(a)Firstwefindthesteadystatelevelofcapitalperworker.Usingthevaluesforinvestment, 0.25,
depreciation, 0.05,productivity,A1,and 0.5,weget,
1

A 1
kss

(1)(0.25)

0.05

1
1 0.5

52 25.

Thatis,thesteadystatelevelofcapitalperworkeris25.Pluggingin k ss intotheproductionfunction
wegetthesteadystatelevelofoutputperworkertobe:
1

yss kss 2 (25) 2 5.


Thatis,thesteadystatelevelofoutputperworkeris5.
(b)Foryear2,using16.2asthevalueforcapitalperworker,calculateoutput,y,followedby
investment y,depreciation k,andthenchangeincapitalstock.Addthevalueforchangeincapital
stockto16.2,thevalueforcapitalperworkerinyear2,togetcapitalperworkerfor
year3.Useyear3capitaltoobtainallthevaluesforyear3andcontinueuptoyear8.Thefilledin
tableisbelow.
Year

Capital

Output

Investment

Depreciation

ChangeinCapital
Stock

1
2

16.00
16.20

4.00
4.02

1.00
1.01

0.80
0.81

0.20
0.20

Chapter3PhysicalCapital12

3
4
5
6
7
8

16.40
16.59
16.78
16.96
17.14
17.32

4.05
4.07
4.10
4.12
4.14
4.16

1.01
1.02
1.02
1.03
1.04
1.04

0.82
0.83
0.84
0.85
0.86
0.87

0.19
0.19
0.19
0.18
0.18
0.17

(c)Thegrowthrateofoutputbetweenyears1and2isgivenby:
y2
4.02
1
1 0.005.
4
y1

Thatis,outputperworkergrewatarateof0.5percentbetweenyears1and2.(Usingexactvalues,
thegrowthrateisapproximately0.62percentforyears1and2.)
(d)Thegrowthrateofoutputbetweenyears7and8isgivenby:
y8
4.16
1
1 0.0048.
4.14
y7

Thatis,outputperworkergrewatarateof0.48percentbetweenyears7and8.(Usingexactvalues,
thegrowthrateisapproximately0.52percentforyears7and8.)
(e)Thespeedofgrowthhaschangedfrom0.50percentto0.48percentimplyingthatgrowthhas
sloweddownatarateof4percent.Thus,asacountryreachestheirsteadystatevalue,therate
ofgrowthslows.
8.

(DIFFICULTPROBLEM)Supposethattherearenoinvestmentflowsamongcountries,sothatthe
fractionofoutputinvestedisthesameasthefractionofoutputsaved.Savingisdeterminedas
follows.Thereisasubsistencelevelofconsumptionperworkerc*.Ifincomeperworkerisequalto
c*,thenpeoplewillconsumealloftheirincome.Allincomeperworkerinexcessofc*willbesplit
betweenconsumptionandinvestment,withafraction goingtosavingandinvestment,andtherest
goingtoconsumption.UseadiagramlikeFigure3.4toanalyzethesteadystateofthiseconomy.

ANSWERBeforebeginningtheanalysis,wedefinetwonewvariables.
Thelevelofcapitalperworkernecessarytoachieveconsumptionlevelc*isdenotedk*.(Technically,k*is
givenby f 1 (c* ). ).Therefore,iftheinitiallevelofcapital,kiisabovek*,savingswillbepositive,and
ifkiisbelowk*,savingswillbe0.
ThesecondvariableIisdenoted k (refertosecondfigure).Itisthelevelofcapitalatwhichdepreciation
isequaltosavingsanddistinctfromthesteadystatelevelofcapital,ifitexists.Wearenowreadyto
beginouranalysis.Therearetwocases.
Case1.

DepreciationisalwaysgreaterthanSaving; k f (k ), k

Inthefigurebelow,atanyinitiallevelof ki , depreciationisalwaysgreaterthansavings.Thisis
becausetheeconomyisverypoorandincomeisnothighenoughtosatisfythebasicconsumption
needsofpeopleandthenleavesomeresourcesforsavingandinvestmentaswell.Thelevelofcapital
fallsovertime,asdoesthelevelofincomeperworker.Consequently,theeconomywillcontinueto
stagnateuntilthelevelofincomeandthecapitalstockarezero.Theeconomyimplodestozero.
Peoplewillbetakentostarvation(unlesssomeforeignaidsavesthem).

13WeilEconomicGrowth,SecondEdition

Case2.

DepreciationisnotalwaysgreaterthanSaving; k f (k ), forsomek

Thefigurebelowshowstwopossiblescenarios.Iftheinitiallevelofcapital, ki , isequaltoorbelow
k*,thensavingsintheeconomywillbezero.Thelevelofcapitalintheeconomyfallsdueto
depreciationandweachievethesameresultasinthefirstcase.Ontheotherhand,if ki k , then
thelevelofsavingsexceedsorwillexceedthelevelofdepreciationandthecapitalstockrisesover
time.Thecapitalstockwillreachastatestatevalueaswillincome.If k * ki k , thentheamount
ofsavingsdoesnotexceedtheamountofdepreciation.Thelevelofcapitalstockbeginstofalland
weareinthefirstcasewherebothincomeandcapitalgotozerolevels.Intheend,theultimate
determinantofwheretheeconomyrestsisdeterminedbytheinitiallevelofcapital,commensurate
withtheinitiallevelofincome.Thisisthemultiplesteadystateequilibrium,withtwopossiblesteady
states.Whichsteadystateiseventuallyreacheddependsontheinitiallevelofcapital.

9.Thegoldenruleofinvestment.Calculatetheinvestmentratethatmaximizesthesteadystatelevelof
consumptionperworkerinaneconomywheretheproductionisy=k .

Chapter3PhysicalCapital14

ANSWERFirst,inasteadystatelevelthatmaximizesconsumptionperworker,thechangeincapital
stockwillbezero.Thatis,
k 0 f ( k ) k.
Rearrangingthepreviousequation,weknowthatinvestmentmustequaldepreciation.

f (k ) k.
Second,giventhatanyoutputnotsavedisconsumed,wecanwriteanequationforconsumptionas,
C y f (k ) A(k ) k.
Inthelastpartofthepreviousequation,wereplacesavingswithdepreciationandwriteoutputin
functionalform.Inthisform,weareabletotakethederivativetofindthenecessaryconditionthat
willguaranteeconsumptionmaximization.Takingthederivativewithrespecttokandrearranging,
d
d
C
A(k ) k A(k ) 1 k.
dk
dk
aA( k ) 1 .
Thatis,themarginalproductofcapitalmustequaltherateofdepreciation.Combiningtheconsumption
maximizationcondition ( aA( k ) 1 .) withthesteadystatecondition ( f ( k ) k.), weget:
saving y f ( k ) k A(k ) 1 k A(k ) f (k ) y.
Therefore,itiseasytoseethe mustequal bytheabovestringofequalities.Inanysteadystatelevelof
consumptionperworker,theinvestment/savingratemustequalthevalue .