ECONOMICS 191 Chapter 4 Exercises

Dan: Stronger institutions to manage population growth and to attract better and higher yielding investments. d. Consider Table 4 1.

1. We now apply our knowledge of the two growth models to the particular context just provided. Consider Figure 41. a. Identify the two unstable equilibria: (i) The destitution steady state is : A (ii) The pretakeoff steady state is : C b. Identify the two stable equilibria: (i) The low-level-trap steady state is : B (ii) The takeoff steady state is : D c. Assuming a trap refers to a very low level of per capita income, this under-developed economy can escape the trap only if it can mobilize additional savings or if it experiences a cataclysmic drop in labor force growth. (i) At what point on the graph is the equilibrium position reached with the help of foreign transfers (aid)? c (ii) At what point on the graph is the equilibrium position reached with the help of depopulation or massive emigration? B/A (iii) What other possibilities might this economy use to escape the undesirable equilibrium? Carmel : better implementation of policies, technology to have better use of capital, population control Anne: They could implement better fiscal policies to create more employment resulting to higher incomes Queennie: Increase savings, technology to improve production allan: Increase sy- by borrowing to foreign countries, encouraging micro savings/finance, Decrease labor force growth- strict population control, encourage working abroad, Increase productivity- new (labor augmenting technologies that increases workers productivity. Mark: Invest in education to increase employment rate and also to improve technology

(i) Calculate nv using the data from the first two columns. Queennie: TAIWAN: 20.9, 11.22, 10.24, 3.78 SOUTH KOREA: 6.96, 5.2, 4.75, 3.24 HONG KONG: 4.2, 4.9, 3.78, 4.94 SINGAPORE: 5.44, 3.78, 2.73, 2.1 (ii) Determine the implied year of takeoff for each of the four countries: ALLan: Taiwan:1963, South Korea :1966, Hong Kong: 1965, Singapore: 1966 Anne: Taiwan:1963, SK: 1966, HK: 1965, SG: 1966 (iii) Why is the takeoff accompanied by rapid growth in capital intensity (k)? Answers: Carmel: Because with a higher saving thus having a higher investments and capital intensities, countries are able to propel their productivity upwards that could accommodate a growing population. Queennie: Higher savings lead to higher investments that could lead to more productive capital allan: according to the equation (change)k=sy-(n+d)k where d=0, k will increase if sy>nK which is the case for the take off years Mark: In take-off periods capital per labor ratio (k) must be pushed above its threshold. This implies that when the labor force is growing (which is true for most developing countries), capital must increase at a higher rate. (iv) What do the high growth rates coinciding with the takeoff year tell us about convergence in per capita income implied by the Solow model?

allan :Takeoff year leads to the steady-state where sy=(n+d)k, high growth rates means that sy>nk or capital deepening

which will eventually lead to sy=(n+d)k or capital widening at this point there will be convergence among countries. Mark: When the country has high economic growth and it has high capital per labor ratio, it will attract more investments. The convergence theory states that the income per caput of rich countries will converge with that of poor countries. For this to happen, the poor country must first go into its take off period. Dan: An increase in savings at the takeoff leads to greater investments resulting in even greater capital. (v) Look at the data in the last column. What might they tell us about closing financing gaps in natural-resource-poor developing economies? Queennie: foreign investments contributes greatly in financing domestic production allan: As the economy goes better, the percentage of foreign investment to total investment goes down which implies that the domestic economy is getting stronger and they dont depend on foreign investments anymore. 2. Harrod-Domar growth model. a. In Indonesia during the 1970s the incremental capitaloutput ratio (ICOR) averaged 2.50. (i) Using the Harrod-Domar growth equation, what saving rate would have been required for Indonesia to achieve an aggregate growth rate of 8 percent per annum? s =20 %. (ii) With the same ICOR, what growth target could be achieved with a saving rate of 27 percent? g = 10.8%. (iii) If there is a large increase in the saving rate, and therefore a large increase in the amount of new capital formation, is the ICOR likely to rise, fall, or remain the same? Explain. Answers: Carmel: It will remain the same if the increase in capital is efficiently used in order to be equal with the increase in output. But if the increase in capital is greater than the increase in total GDP, then ICOR will likely rise - meaning capital is inefficiently used.

Benot : Im not sure of the answer, im hesitating between this two : The ICOR will remain the same. Indeed, in the Harrod- Domar model, the ICOR is equal to the capital-output ratio which is constant. Or : In the Harrod-Domar model, the ICOR is equal to the capital-output ratio. This way : ICOR = v = s / g. If the saving rate increases, ICOR is likely to increase. Queennie: ICOR will remain the same since the increase in K will be utilized to be equal with the increase in output. But ICOR will increase as the increase in capital is not translated to an increases in production due to inefficiency. allan: It will increase if the new capital is more productive than the average productivity of capital It will fall if the new capital is less productive than the average productivity of capital it Will remain the same if the productivity of new capital is equal to the average productivity of capital Dan: ICOR will not increase or remain the same if there is inefficiency in using the increase in capital. If capital increases at the same rate as the growth in output, ICOR will remain the same. b. The government of a poor developing country fears that a political upheaval will occur unless the growth rate is at least 4 percent per annum. The ICOR and the saving rate are projected to be k = 5.0 and s = 14 percent, respectively. (i) Show that 4 percent growth cannot be achieved under these circumstances. Carmel: Because ICOR is usually fixed, the country's growth rate will only be at 2.8% and this will be constant unless the country finds a way to increase its productivity with the same amount of capital (lower ICOR) Benot : g = s / v with ICOR = v = 5,0 and s = 14. Therefore : g = 2,8 According to the Harrod-Domar model, the growth will be of at most 2,8%. Queennie: ICOR =v is constant. Given s= 14 and v= 5, g will remain to 2.8%

allan: ICOR=v not k assuming that it is only a typo v=5,s=14 then g=14/5-0=2.8%<4% Dan: projected g=.04 s=.14 v=k=5 g should be=.028

Carmel: Improved technology in order for capital to be efficiently used - with this, output will increase with the same amount of capital thus lowering the ICOR. Benot : v = s /g with g = -0,6 and s = 23. Thus v = -38.

(ii) With the saving rate as given, what ICOR would be required to achieve the 4 percent growth target? Carmel: ICOR should at least be at 0.29% (0.28571) Benot : ICOR = v = s / g with s = 14 and g = 4. Therefore : v = 3,5. The ICOR must be of 3,5. Queennie: g=s/v so 4=14/ICOR. Thus, ICOR=3.5 allan: 3.5 Dan: ICOR=3.5 (iii) No doubt, the government faces a serious threat due to poor economic performance. What types of changes in economic conditions would alter the ICOR as needed to achieve 4 percent growth? Give a few examples. Carmel: Improved technology in order for capital to be efficiently used - with this, output will increase with the same amount of capital thus lowering the ICOR. Benot : The country can focus on labor-intensive production rather than capital-intensive production. This way the ICOR would fall : more output would be produced with the same saving rate and capital input. Queennie: Improve labor-intensive production that starts with increasing the productivity of labor force through skills training that would lead to the same or greater level of output with less capital employed. allan:Increase the productivity of new capital, by using new technologies and methods that increases both productivity and efficiency Dan: Shift to labour-intensive production to cause the ICOR to fall. Promote efficiency through enhancing the skills and productivity of the labour force. c. More difficult. Over the period 1980 to 1992, the GNP in Peru grew by g = 0.6 percent per year, even though total savings (s) averaged 23 percent of GDP. How can you reconcile these figures with the Harrod-Domar growth model? What does the model suggest is the cause of Perus poor growth performance?

The ICOR is very high meaning that the capital, and capital is not productive at all. Given that investments comes from savings, the very high ICOR explains how a good saving rate can lead to negative growth. Queennie: V=ICOR = -38; ICOR is high. Both technology and increasing production of labor-intensive products would lead to a lower ICOR and positive growth

allan: -0.6=23/v-0 (assuming d=0) v=-38.3 which implies that the new capital are not very productive since v is negative. If d is not equal to zero the depreciation may be too large for the s/v to compensate (s/v<d) Dan: Peru had a high ICOR of 38.33 which means that a lot of capital is needed to produce an output. There must had been an inefficiency in using capital, and its labour force must have been poorly trained. 3. a. Figure 42 shows a set of fixed-coefficient isoquants for producing chicken soup. The label for each isoquant relates to a particular quantity (Q) of output. The farther the isoquant is from the origin, the higher the output level. (i) With 400 units of K and 60 units of L, Brrravia could produce barrels of chicken soup. The capital-output ratio would be K/Q= . 200, 2 (ii) With 600 units of K and 90 units of L, Brrravia could produce barrels of soup. Hence the 300, 2 (iii) If Brrravia had K = 600 and L = 120, then barrels of soup could be produced. The capital-output ratio would be K/Q = . 300,2 (iv) In the last case, is there a labor surplus in Brrravia? Explain. Carmel: Yes because even if you increase labor but capital remains the same, output would not increase. Therefore the additional labor of 30 units is a surplus.

Benot : The Harrod-Domar model is based on a fixedcoefficient production function, meaning that capital and labor must be used in a fixed proportion to each other : this proportion is capital-labor ratio, K/L = 200 / 30 = 20 / 3. In the last case, labor and capital are not used in the same proportion : more labor is used for an unchanged amount of capital. Consequently an unchanged amount of soup is produced : there is a labor surplus. Queennie: Yes due to fixed-coefficient production function, output will only be produced only when both capital and labor is increased at fixed proportion. In this case, only labor is increased so same level of output is produced while there is unutilized labor. allan: Yes since they can produce the same q given the same amount of capital using only 90 workers. Labor surplus is 30 Dan: The country produces in fixed amounts of inputs, so an increase in labour not accompanied by an increase in capital will not increase output. Therefore, there is a surplus.

(iv) In the last case, is there a labor surplus in Brrravia? Explain. Answers: Carmel: No, because in this case, the variables are not fixed. Therefore, increasing labor also increases output even with capital remaining the same. Benot : The neoclassical production function drops the fixed- coefficients production function for more flexbility : it allows substitution between the factors of production. Indeed, in the last case, the amount of capital is unchanged but more labor is employed. However, more barrels of soup are produced : there is no labor surplus. Queennie: There is no labor surplus since with neoclassical growth, varibles are not restricted to fixed proportions. Thus, an increase in one factor like labor in this case leads to an increase in output with capital remaing the same. allan: NO. because the isoquants suggest that different combinations of k and l can be used to produce the same amount of q. Dan: Since the production function now allows for more flexibility, production can now vary on combinations between labour and capital. There is no surplus labour since inputs are not restricted. (v) If Brrravia grew from K = 400 and L = 60 as in part (i) to K = 600 and L = 120 as in part (iii), the incremental capital-output ratio would be ICOR = . This ICOR differs from the one you calculated in part (ii). Why? Answers:

b. The isoquants in Figure 43 represent a neoclassical production function. (i) With 400 units of K and 60 units of L, Brrravia could produce barrels of chicken soup. The capital-output ratio would (again) be K/Q = . Answers: 200, 2 (ii) With 600 units of K and 90 units of L, Brrravia could produce barrels of soup. Hence, the incremental capitaloutput ratio for Brrravia is ICOR = . 300, 2 (iii) If Brrravia had K = 600 and L = 120, then approximately barrels of soup could be produced. The capital-output ratio would beK/Q = . Answers: Carmel: 350, 1.71429 Benot : 360 : 1.7 Queennie: 360, 1.67 allan: 350,1.714 Dan: 360, 1.7

Carmel: 1.33, Because labor increased therefore increasing the level of output and lowering the value of ICOR. Queennie: ICOR=change in K/ change in Y = 200/60 = 3.3 allan: ICOR= 200/50=4, Because capital output ratio is not assumed to be constant as the harrod domar model suggest, they can use different combinations of inputs. c. In Figure 4 4, the vertical axis shows the level of chickensoup production, while the horizontal axis shows the amount of labor input. Working from the information embodied in the isoquants shown in Figure 43, plot in Figure 4 4 the various combinations of L and Q consistent with a fixed capital stock of K = 600. Carmel: Cannot draw it here but what i drew was one curve sloping upward with the points from previous figure connected

Queennie: upwards sloping curve, diminishing marginal returns to scale allan: typical upward sloping curve that shows diminishing marginal returns How does this neoclassical production function reflect diminishing returns to labor? Carmel: With every increase in labor, the increase in output becomes smaller. Queennie: As labor increases, output produced decreases. allan: diminishing marginal returns on labor 4. Analysis of two-sector labor-surplus model. This exercise uses Figures 45 and 46. Be sure that you have read the Worked Example carefully. a. Lets see how the situation changes if the labor force in Machismo grows to 1,200 people. Start with all 1,200 workers placed in the agricultural sector. (i) From Figure 45 you can see that total farm output would be million kilograms of bananas per year. 1.8 (ii) Assuming that everyone eats an equal amount, this level of output permits each worker to consume kilograms of bananas per year. (Be careful with the units.) Answers: 1,800,000/1200=1500 (iii) Because of the extra mouths to feed, suppose that the price of bananas rises to 16 pesos per kilogram. The money value of each workers banana consumption is pesos per year. 16x1500=24000

(v) If this number of workers plus 100 more workers are withdrawn from agriculture, then the level of banana production would drop to million kilograms, which is enough for each worker in the economy to consume just kilograms of bananas per year. 1.62, 1,620,000/1200=1350 (vi) The decline in production causes the price of bananas to rise to 20 pesos per kilogram. At this price, the money value of each workers banana consumption costs pesos per year. 1350x20=27000 (27000 pesos for bananasr? LOL) b. Now look at these conditions from the perspective of the industrial sector. To attract workers from agriculture, industry has to pay an annual wage high enough to permit urban workers to eat as well as their kinfolk back on the farm. (i) Starting with all 1,200 workers in agriculture, industry has to pay a wage of pesos per year to attract labor from agriculture. 1,800,000/1200=1500x10=15000 (ii) As many as workers can be hired by industry without causing banana production to drop. As these workers move to industry, the production and consumption of bananas remain in balance. So there is no upward pressure on banana prices or on urban wages. 300 (iii) But if an additional 100 workers move to industry, then banana output drops to kilograms per worker (as you calculated above) and the price of bananas rises to 20 pesos per kilogram. Urban wages must rise to pesos per year to keep workers from moving back to the farm. 1.62, 1,620,000/1200=1350x20=27000

(iv) Study Figure 45 carefully. How many of the 1,200 workers could be withdrawn from agriculture before banana output begins to decline? workers. 1200-900=300