The Solow Model and Catch-Up

Growth

 In 2006 China: GDP per capita grew by

10%
U.S: GDP per capita grew by 2.3 %

United States has never grown as fast as

the Chinese economy is growing today.
Why is China growing more rapidly than
the U.S.?
Is there something wrong with the U.S.
economy?

Introduction
There are two types of growth
Catch-up growth
takes advantage of ideas, technologies,
or methods of management already in
existence
focuses on capital accumulation

Cutting-edge growth
developing new ideas
focuses on developing new technology
for resources.
3

The Solow Model and

Catch-Up Growth
Robert Solow (Nobel Laureate)
Total Output, Y, of an economy
depends on:
Physical capital: K
Human capital: education x Labor =

eL
Ideas: A

This can be expressed as the

following production function:

Y F(A, K, eL)

The Solow Model and

Catch-Up Growth

For now, ignore changes in ideas,

education, and labor so that A, e, and L are
constant. The production function
becomes:

Y F(K)

If L is constant, then increases in K mean

more capital per worker
MPK: marginal product of capital : The additional
output resulting from using an additional unit of
capital.
MPK diminishes the more capital is added.

The Solow Model and

Catch-Up
Growth
K
Assume a production functionYlike
Output, Y

Y K

5.0 4.7
MPK
0 .3
10 9

4
3
2
1

MPK

20
2
1 0

Conclusion: as
more
capital is added,
MPK declines.
Capital, K

0 1 2 3 4 5 6 7 8 9 10 11 12

13

Growth in China and United States

The iron logic of diminishing returns
largely explains why
The Chinese economy is able to
grow so rapidly.
It turned toward markets which
increased incentives.
The capital stock was low.
The MPK was high.
China will not be able to achieve
these high growth rates indefinitely.
7

The Solow Model and

Catch-Up Growth

Why Bombing a Country Can Raise

Its Growth Rate:

Much of the capital stock was

destroyed during WWII. Therefore the
MPK was high.
Following the war, both Germany and
Japan were able to achieve much
higher growth rates than the U.S. as
they caught-up.

The Solow Model and

Catch-Up Growth
Capital Growth Equals Investment
minus Depreciation
Capital is output that is saved and
invested.
Let be the fraction of output that
is invested in new capital.
The next figure shows how output is
divided between consumption and
investment when = 0.3. (30% of
additional output is saved and put into new
capital)

12.9

The Solow Model and

Catch-Up Growth
Output, Y
2
0

Capital Growth Equals Investment Minus

Depreciation

When K = 100, Output = 10

Y K

1
5

1
0

Consumption = (1- 0.3) x 10 = 7

Investment = 0.3Y

5
Investment = (0.3) x 10 = 3
3
2
0

0
400

100

200

300

Capital, K
10

The Solow Model and

Catch-Up Growth
Capital Growth Equals Investment
minus Depreciation (cont.).
Depreciation: amount of capital that
wears out each period
Let be the fraction of capital that
wears out each period. This is called the
depreciation rate so that:

depreciati on

K
12.11

The Solow Model and

Catch-Up Growth

Capital Depreciation Depends on the Amount of

Capital
Depreciation

Depreciation = 0.02K

8
6

42
Slope
200 100

100

200

300

Capital, K
400

12

The Solow Model and

Catch-Up Growth

Capital Alone Cannot be the Key to

Economic Growth
As capital increases,

depreciation increases at a constant

rate of
output increases at a diminishing rate.
Because investment is a constant
fraction of output, at some point
depreciation will equal investment.
The capital stock will stop growing.
Output will stop growing.

13

The Solow Model and

Catch-Up Growth

Capital Increases or Decreases Until Investment =

Depreciation
GDP, Y

Depreciation = 0.02K

8
At K = 400, Inv. < Dep. K

Investment =
0.3Y

4.
5
4

At K = 100,
Inv. > Dep.
K

3
2
0

100

200 225

300

Result:
equilibrium
at K = 225, Y =
4.5
investment =
depreciation =4.5
Capital,
400
K

14

Capital Adjusts Until

Investment = Depreciation

Check the Math

At K = 100, Y =100 = 10
Depreciation = 0.02100 = 2
Investment = 0.3x10 = 3
Investment > Depreciation
Result: K and Y grow.

At K = 225, Y =225
=15
Depreciation = 0.02x225
= 4.5
Investment = 0.3x15 =
4.5
Investment =
At K = 400, Y =400 = 20
Depreciation
Depreciation = 0.02x400 = 8
Investment = 0.3x20 = 6 Result:
Investment < Depreciation 1. Investment =
Depreciation
Result: K and Y decrease. 2. K and Y are constant.
15

The Solow Model and

Catch-Up Growth

The logic of diminishing returns means

that eventually capital and output will
cease growing.
Therefore, other factors must be
responsible for long run economic growth.
Consider:
Human capital: knowledge, skills,
experience
Technological knowledge: better ideas

16

Human Capital Investment

Pays Of

17

The Solow Model and

Catch-Up Growth

Better Ideas Drive Long Run Economic

Growth
Technological knowledge
A way of getting more output from
the same input (an increase in
productivity).
We can include technological
knowledge in our model by letting A
stand for ideas that increase
productivity. Now the production
function is:

YA K

18

The Solow Model and

Catch-Up Growth

Increasing technology (even while holding K constant)

creates a higher growth rate.

19

The Solow Model and

Catch-Up Growth
An Increase in A Increases Output
Holding K Constant
Conclusion:
Technological knowledge / better
ideas are the key to long run
economic growth.

Solow estimated that better

ideas are responsible for of our
increased standard of living.
20

The Solow Model

Details and Further Lessons

What we know so far:

If Investment > Depreciation K and Y

grow.
If Investment < Depreciation K and Y
fall.
If Investment = Depreciation K and Y are
constant.

Two important conclusions

Steady state equilibrium occurs when
investment equals depreciation.
When K is in steady state equilibrium, Y is
21
in steady state equilibrium.

The Solow Model

Details and Further Lessons
When K is in steady state equilibrium, Y is in steady state
equilibrium.

Output, Y

Depreciation = 0.02K

8
6
4.5
4

Investment = 0.3Y

3
The Steady State K is found
where Investment =

Depreciation

Capital, K
0

100

200 225

300

400

22

The Solow Model

Details and Further Lessons

When K is in steady state equilibrium, Y is in steady state

equilibrium.
Output, Y
20

Y K

Steady state output

15

Depreciation = 0.02K

10

Investment
0.3 K

Steady state capital stock

Capital, K

100

225 300
200

400

23

The Solow Model

Details and Further Lessons
The Solow Model and an Increase in
the Investment Rate
What happens when , (the fraction of
output that is saved and invested)
increases?

Y
Conclusion: an increase in the
investment rate increases a countrys
steady state level of GDP.
Countries with higher rates of investment
will be wealthier.

24

The Solow Model

Details and Further Lessons

GDP per Capita is Higher in Countries with Higher Investment

Rates

25

An Increase in the Investment

Rate Increases Steady State
Output, Y
Output
Y K

20

15
Depreciation = 0.02K
10

Inv. .4 K

Inv. 0.3 K

0
300

100

200 225

Capital, K
400
26

The Solow Model

Details and Further Lessons
Note:

An increase in the investment rate =

steady state level of output.

As the economy moves from the lower to
the higher steady state output =
growth rate of output.
This higher growth rate is temporary.

Conclusion: investment rate =

steady state level of output but not
its long-run growth rate.
27

The Solow Model

Details and Further Lessons

The Case of South Korea

In 1950, South Korea was poorer than

Nigeria.
1950s: the investment rate was < 10%.
1970s: Investment rate more than
doubled.
1990s: Investment rate increased to
over 35%.
South Koreas GDP increased rapidly.

As GDP reached Western levels,

the growth rate has slowed

28

The Solow Model

Details and Further Lessons

The Solow Model and Conditional

Convergence

Conditional Convergence: Among

countries with similar steady state levels
of output, poorer countries tend to grow
faster than richer countries, and so
converge in income.
The Solow model predicts that a country
will grow faster the farther its capital
stock is below its steady state value.
Conditional convergence is a prediction of the
Solow model
29

The Solow Model Details

and Further Lessons

Solow and the Economics of Ideas in

one diagram
Generation of ideas results in long run
economic growth.
Lets see how this works:

We begin at steady state equilibrium.

New ideas A Output at every level of K
Output Investment Investment >
Depreciation K Output (movement
along new production function).
As ideas continue to grow, output continues
to grow.
30

Solow and the Economics

of Ideas in One Diagram
Output, Y

Efect of A from 1 to 1.5

c

Y 1.5 K

33.7

Output

b
Better
Ideas

15

Y1 K

mulation
Capital Accu

Depreciation =

0.02K
Investment
0.3(1.5)K

Investment
0.3(1)K

225
Old steady
state capital

506
New steady
state capital

Capital, K
31

The Solow Model

Details and Further Lessons

The Big Question: What Determines

High Investment Rates?
Incentives which include
Low real interest rates
Low marginal tax rates

Institutions which include

Honest government
Secure property rights
Efective financial intermediaries
(banks)
32

Growing on the Cutting Edge: The Economics

of Ideas

The United States and other

developed regions such as Japan
and Western Europe are on the
cutting edge of economic growth.
In order to keep on growing these
countries must develop new ideas
to increase the productivity of
capital and labor.
Conclusion: The economics of
ideas becomes the key to growth
on the cutting edge.

12.33

Growing on the Cutting Edge: The Economics of

Ideas

The Economics of Ideas

1.Ideas for increasing output are
primarily researched, developed,
and implemented by profit-seeking
firms.
2.Spillovers mean that ideas are
underprovided.
3.Government has a role in improving
the production of ideas.
4.The larger the market, the greater
the incentive to research and
develop new ideas.

12.34

Growing on the Cutting Edge: The Economics of

Ideas

1.Research and Development Is

Investment for Profit.

keys to increasing technological

knowledge:
Incentives
Institutions that encourage investment
in physical and human capital and R&D.
70% of scientists and engineers in the
U.S. work for private firms.
Profits provide incentive to invest in R&D
Implication: Property rights, honest
government, political stability, a
dependable legal system, and
competitive open markets help drive the
generation of technological knowledge.

Growing on the Cutting Edge: The Economics of

Ideas

1. Research and Development Is

Investment for Profit (cont.).

Not just the number of scientists and

engineers that are important
All kinds of people come up with new ideas.
Business culture and institutions are also
important.

Institutions that are especially

important:
Commercial settings that help
innovators to connect with capitalists
Intellectual property rights
A high-quality education system
12.36

Growing on the Cutting Edge: The Economics of

Ideas

1.Research and Development is

Investment for Profit (cont.).

A commercial setting that helps

innovators connect with capitalists.
Ideas without financial backers are
sterile.
The U.S. is good at connecting
innovators with businessmen and
venture capitalists.
American culture supports
entrepreneurs:
People like Apple CEO Steve Jobs are lauded
in the popular media.

Growing on the Cutting Edge: The Economics

of Ideas
Institutions that are especially important
Intellectual property rights
New processes, products, and
methods can be copied by
competitors.
Patents
Grant temporary monopoly.
Can slow down spread of technology.
Trade-of between creating
incentives to research and develop
new products and avoiding too much
monopoly power = one of trickiest in
economic policy

12.38

Growing on the Cutting Edge: The Economics of

Ideas

Institutions that are especially

important (cont.)
A high-quality education
system
Important at all levels of
education.
Creates necessary talent.
Universities generate basic
and applied research.

12.39

Growing on the Cutting Edge: The Economics of

Ideas

2.Spillovers, and Why There Arent

Enough Good Ideas

Ideas are non-rivalrous.

Ideas can be used simultaneously.
Use of an idea by one individual does
not mean less of the idea available to
someone else.
The spillover or difusion of new ideas
generates widespread economic growth.
Implication: Spillovers mean that the
generator of the idea doesnt get all of
the benefits.
Result: Too few ideas are produced.

Growing on the Cutting Edge: The Economics of

Ideas

2. Spillovers, and Why There Arent

Enough Good Ideas (cont.)

Optimal social investment in R&D occurs

where: MSB = MSC

Optimal private investment occurs where:
MPB = MPC
With spillover benefits: MSB = MPB +
spillovers
and MSC = MSB
Conclusion:
Optimal Private
Optimal Social
< Investment in R&D
Investment in R&D

Implication: Spillovers result in too little

investment in research and development.

12.41

Growing on the Cutting Edge: The Economics of Ideas

Spillovers Mean Too Little Investment in Research and

Development

Spillover benefits
IP = optimal private investment in R&D
IS =optimal social investment in R&D

MPB = MPC

MSB = MSC

MPC = MSC

MSB

Assumes there
are no spillover
costs

MPB
IP

IS

Quantity of R&D

Growing on the Cutting Edge: The Economics of

Ideas

3.Governments Role in the Production

of New Ideas
Ideas in mathematics, physics, and
molecular biology have many
applications so spillovers can be
large.
Problem: Even if the social benefits are
large, the private benefits can be small.
Solution: Subsidize the production of new
ideas or give tax breaks for R&D
expenditures.
Both shift the MC of R&D curve down R&D
investment.

12.43

Growing on the Cutting Edge: The Economics of

Ideas

3.Governments Role in the Production

of New Ideas (cont.)
Large spillovers to basic science
suggest a role for government
subsidies to universities.

Especially those parts of the universities

that produce innovations and the basic
science behind those innovations.
Universities produce scientists
Most of the 1.3 million scientists were trained
in government subsidized universities.

12.44

Growing on the Cutting Edge: The Economics of

Ideas

4.Market Size and Research and

Development
Innovations like pharmaceuticals,

new computer chips, software, and

chemicals require large R&D
expenditures.
Companies will avoid investing in
innovations with small potential
markets.
Larger markets mean increased
rewards (thus incentives) for R&D.
As the world market grows companies
will increase their R&D investments.
12.45

The Future of Economic

Growth

Economic growth can be even faster.

How?
The following framework helps us think
about this.
A (ideas) = Population x Incentives x
Ideas/Hour
Population
population number of people with new
ideas

Much of the world is poor; thousands of

potentially great scientists are laboring
in menial jobs.
12.46

The Future of Economic

Economic growth can be even
Growth
faster. How? (cont.)

A (ideas) = Population x Incentives x

Ideas/Hour
Incentives
Appear to be increasing

Consumers are richer

Markets are expanding due to trade
World wide improvement in institutions
Property rights
Honest government
Political stability
Dependable legal system

12.47

The Future of Economic

Economic growth can be even
Growth
faster. How? (cont.)

A (ideas) = Population x Incentives x

Ideas/Hour
Ideas per Hour
New ideas do not experience diminishing
returns.
Two reasons why this is so.
1. Many ideas make creating new ideas easier.
2. The field of ideas that can be explored is so
large that diminishing returns may not set in
for a very long time.

12.48

The Future of Economic

Recap: Economic growth mightGrowth
be
even faster in the future than it has
been in the past.

There are more scientists and engineers

in the world than ever before, and their
numbers are also increasing as a
percentage of the population.
Incentives are increasing due to growing
markets resulting from
Increasing trade
Increasing wealth in developing countries

Better institutions and more secure

property rights are spreading throughout
the world.
12.49

Takeaway
As K accumulates, the MPK declines
until investment = depreciation, and
growth stops.
The Solow model tells us three things
about economic growth:
Countries that have higher
investment rates will be wealthier.
Growth will be faster the further
away a countrys capital stock is
from its steady state value.
Capital accumulation cannot explain
long-run economic growth.
12.50