topic 4.3

topic 4.3

ANALYZING THE PRODUCTION MODEL

Back to the original question: why are some countries so much richer than others?

We need to convert to per capita terms

define

y = Y/L
k = K/L

then in equilibrium

y* = A.k1/3

so output per capita increases with

• a higher "productivity parameter"
• higher per capita capital

The Empirical Fit of the Model

Figure 4.5 shows that the model overpredicts the wealth of the poorest countries (setting A = 1)

How can we fix this poor fit? What about decreasing the capital exponent? The problem is that 1/3 is capital's share of output - it was not chosen arbitrarily.

An alternative is to allow A to vary.

We shall call A total factor productivity.

We allow TFP to vary for each country in such a way as to make the predicted and actual Y match.

TFP is a residual, a measure of our ignorance.

TFP "explains" two-thirds of GDP while capital per person explains one-third.

Ideally we would measure TFP compnents directly, then we could have a true test of the model.

TFP is a measure of using capital and labor efficiently. What explains differences in TFP?

1. Human Capital

Accumulated skills that make people more productive.

Education is easy to measure and does partly explain TFP.

2. Technology

We will get this later.

Institutions

Mancur Olson pointed out the natural experiments of Korea, Germany, China. (JEP 1996).

Institutions include rules, such as "rule of law". Property rights, contracts.

More research on institutions is needed.