ANSWERS FOR FINAL EXAM

DEVELOPMENT ECONOMICS

1 [Link]
1.1 Growth
1.1.1 What is the role of diminishing returns of capital investment (k)?
Diminishing returns of capital investment indicates that the addition of a larger amount of
one factor of production ( in this case, the factor is capital investment) , while all other factors
(such as labor, technology progress) remain constant, ceteris paribus, inevitably yields decreased
per-unit incremental returns. Therefore, the illustration of production function of Solow model is
an upward curve (with concave shape) instead of a upward-sloping line as AK model of Harrod-
Domar. In other word, in Solow model, a sole increase in capital investment will not result in
growth rate in the long run because in a particular time, an increment of capital investment will
be offset exactly by depreciation rate and labor growth rate. This stable equilibrium is called
steady state.
1.1.2 What assumption about the production function gives us diminishing returns?
The assumption is constant returns to scale if all inputs (stock of capital and labor) are
increased by the same amount. γY=F(γK, γL). This is because in the Cobb-Douglas production
function, we have Y= F(K, L)=A.Kα.L1-α (α represents the elasticity of output with respect to
capital, is assumed to be less than 1). This formulation of neoclassical growth theory yields
diminishing returns both to capital and to labor.
1.1.3 What is the implication for growth in the short run? in the long run?
In short run, if we increase the rate of savings, s, there is likely a temporary increase in
the rate of output growth (economic growth) generated as we increase k (capital investment or
capital per worker).
In long run, though at a higher level of output per worker in each later year, we return to
the original steady-state growth rate (zero growth) which used to be attained before we raised the
rate of savings.
The key implication is that unlike in the Harrod-Domar (AK) analysis, in the Solow
model an increase in the rate of savings will not increase growth in the long run, it will only
increase the equilibrium k*. This is, after the economy has time to adjust, the capital-labor ratio
(k) increases, and so does the output-labor ratio (y), but not the rate of growth.
Sustained growth only happens with sustained increase in efficiency of technology, A.
1.1.4 What accounts for differences in income across countries?
The differential in the rate of savings can account for differences in income across
countries if we assume labor productivity, A, and labor growth, n, are same. At steady state,

(Or, see [Link] Mankiw, David Romer, and David [Link], “A contribution to the
empirics of economic growth,” Quarterly Journal of Economics 107 (1992): 407-437. This
article shows that when human capital is accounted for, as well as physical capital, the Solow
model does a rather good job of explaining incomes and growth across countries).
(Or A,s,n)
1.1.5 What are the two concepts of convergence: absolute and conditional?
The absolute convergence hypothesis, posits the following: consider a group of
countries, all of which have have access to the same technology (), the same population growth
rate (n) and the same savings propensity (s), and only differ in terms of their initial capital-labor
ratio (k). Then, we should expect all countries to converge to the same steady-state capital-labor
ratio (k*), output per capita (y*) and, of course, as long as they maintain the same population
growth rate (n). We can assume that k1 represents the capital-labor ratio of a poor country and
k2 the capital-labor ratio of a rich country. As their structural charateristics are identical, the
stability of the Solow model predicts that both the poor and rich countries will approach the same
k*. This means that the poor country will grow relatively fast (capital (k) and output (y) grow
faster than (n)), while the rich nation will grow quite slowly (capital and output grow slower than
n). Stated differently in adjustment terms, as k1 < k2, then   (k1) >   (k2), so the marginal
product of capital relative to labor is higher in the poor nations than in the rich ones, thus the
poor will accumulate more capital and grow at a faster rate than the rich. For a particular
example, in the end of World War II, when the capital stocks (but not the labor) of Japan and
Germany were destroyed by Allied bombing. So, relative to other industrialized countries with
similar parameters, post-war Germany and Japan had exceptionally low capital-labor ratios, k. In
accordance with the absolute convergence hypothesis, the Solow model would predict that these
two nations would subsequently grow faster than other industrialized countries in the immediate
post-war period. Indeed, they did.
The conditional convergence hypothesis states that if countries possess the same
technological possibilities (A) and population growth rates (n) but differ in savings propensities
(s) and initial capital-labor ratio (k), then there should still be convergence to the same growth
rate, but just not necessarily at the same capital-labor ratio. In short, the conditional convergence
hypothesis asserts that countries can differ in the their steady-state ratios (e.g. k1* vs. k2*) and
thus differ in output per capita, but as long as they have the same population growth rate, n,
then all their level variables -- capital, output, will eventually grow at that same rate.
1.1.6 What is the main source of growth (in gdp/capita) in the long run? Why?
Technological progress is the main source of growth which generates long-term
economic growth. Due to diminishing returns of capital investment, an increase in the rate of
savings can not generates economic growth in long term, an increment of capital investment will
be offset exactly by depreciation rate and labor growth rate at k*, called steady state.
Consequently, sustained growth only happens with sustained increase in efficiency of
technology, A.
1.1.7 Understand the idea of a steady state and the graphical representation of the steady
state and technology change.
The capital per worker k* represents the steady state. If k is higher or lower than k*, the
economy will return to it; thus k* is a stable equilibrium. This stability is seen in the diagram by
noting that to the left of k*, k<k*. Looking at the diagram, we see that in this case, (n+δ)k < sf(k).
But now looking at the Solow equation, we see that when (n+δ)k < sf(k), ∆k > 0. As a result, k in
the economy is growing toward the equilibrium point k*. By similar reasoning to the right of k*,
(n+δ)k > sf(k), and as a result, ∆k < 0, and capital per worker is actually shrinking toward the
equilibrium k*.

1.2 Growth Accounting

1.2.2 How do we calculate the ‘dual’ Solow residual? What data do we need for this exercise?
compare the primal and dual methods to calculate technology change.

1.2.3 Summarize the results of Alwyn Young and Chang Tai Hsieh on growth accounting in the
East Asian countries. How do these calculations compare to the Solow calculations for
the U.S. economy in the first half of the twentieth century?

1.2.4 The value of the factor shares is crucial in the calculation of technology change.
Understand why this is.