Economics 70-XA, Ateneo de Cagayan-Xavier University, AY 2011-2012

GROWTH ACCOUNTING1 Growth accounting pertains to the decisions regarding how much inputs should be utilized to attain a certain level of production. It answers questions such as: which inputs played a big role in growth? So, when does output grow? Every economics student must know the right answer to this basic macro question. Thus, this handout is an econ student-friendly guide to help you out.
a.) Define a Production Function (PF) without technology: Y = f (K, N) b.) Assume: only K, N are the inputs. Any increase in these inputs will lead to an increase in output. (Simply, MPK and MPL are positive).2

c.)Assume further: The economy is competitive (i.e., it has technological progress = A). In this case, technological progress means that there is no change in inputs but only better and efficient production. So, the PF becomes: Y = A [f (K, N)] Note: Technology in this case is called Total Factor Productivity (TFP) because it augments both capital and labor. But in most cases, technology can be: 1. Labor augmenting: Y = f[K, AN]; saves labor 2. Capital augmenting: Y = f[AK, N]; saves capital Now that you know the basics, we shall determine the growth model: d.) Fundamental model). Growth Equation (or Solow, neoclassical growth

This section will help you understand how much change in output (Y) is attained when capital, labor and technology changes (i.e., K, L, A).

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For inquiries, email me at michelle_b_abarca@yahoo.com.ph. Proof reading is taken for granted. You should already know by now the meaning of Marginal Productivities of Labor and Capital (MPL and MPK) from your Microeconomics class.

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Economics 70-XA, Ateneo de Cagayan-Xavier University, AY 2011-2012

S1.) Define the PF: Y = A [f (K, N)] S2.) Take the Y as: Y = (MPL)(N) + (MPK)(K) + [f(K,N)] (A)
Where: 1st term = additional labor productivity (i.e. additional output of the new labor) multiplied to the additional labor or population. 2nd term = same idea, only that its capital. 3rd term = output without technology multiplied to the introduction to new technology or an improved production method.

S3.) Divide everything by Y (Y/Y means growth rate of output.3). Y/Y = (MPL/Y)(N) + (MPK/Y)(K) + [f(K,N)/Y] (A) Simplifying, we can see that:4 Y/Y = (MPL/Y)(N) + (MPK/Y)(K) + (A)/A Another trick: Add N/N = 1 in the 1st term and K/K = 1 in the 2nd term.5 Y/Y = [(MPL)(N)/(Y)] (N/N) + [(MPK)(K)/(Y)] (K/K) (A)/A S4.) If I pay labor (N), then MPL= w=wage If I pay capital used (K), then MPK=c= capital payments We can see that: Y/Y = (wN/Y) (N/N) + (cK/Y) (K/K) + (A)A +

Recall that in order to get the growth rate of output, you need to do horizontal analysis: Present value- previous value and divide everything by the previous value (i.e. Y/Y ). 4 Note further: Y = A[f(K,N)] We can get: f(K,N) = Y/A and A = Y/ [f(K,N)]. 5 This doesnt affect the equation at all because it is the same as multiplying the terms by 1. Thus, it is needless to add the same expression on the Left-hand side (LHS) of the equation. A good question would be, why not add something to the 3rd term? We dont have to since it is a strong assumption in the Solow model that technological progress changes exogenously. This means that, we have no control of it and so we take it as given.

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Economics 70-XA, Ateneo de Cagayan-Xavier University, AY 2011-2012

Simplify with: wN/Y = labor share = 1 - cK/Y = capital share = We can see now a better equation: Y/Y = (1 ) (N/N) + (K/K) + (A)/A S5.) Mostly in economic growth models, we use Cobb-Douglas Production function (CD-PF).6 Applying this, we have: Y = A[f(K,N)] now becomes Y = A[K N(1-)]. Full stop. e.) What happens when the population grows? We now look at GDP per capita.7 S1.) Re-arrange from before. Expand the equation into: Y/Y = (1 ) (N/N) + (K/K) + (A)/A = (N/N) - (N/N) + (K/K) + (A)/A Is the GDP growth rate faster than population growth rate?8 Y/Y - (N/N) = S2.) Let: y = Y/N = GDP per capita k = K/N = Capital per capita And so we have: Y/Y = y/y - N/N.9 K/K = k/k - N/N.10
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(N/N) + (K/K) + (A)/A

The good thing with this PF is that it interprets inputs in percentage. For example, the economy uses 30% labor share and 70% capital share. 7 Per capita means per population. The common formula is GDP/population or simply GDP/N = Y/N. The same reasoning applies to capital per capita and labor per capita. 8 Simply transpose the term N/N or the population growth rate to the LHS. Always remember that this should always be positive. Otherwise, the economy falls into famine (more known as Malthusian Population trap). More to the point: The LHS is what we call surplus. 9 This is the GDP growth rate which is equal to the GDP per capita growth rate minus the population growth rate.

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Economics 70-XA, Ateneo de Cagayan-Xavier University, AY 2011-2012

S3.) Substituting these to the equation, we now have: Y/Y - (N/N) = (N/N) + (K/K) + A (A) (N/N) + (k/k - N/N) + (A)/A)

(y/y - N/N) - (N/N) =

Simplify and cancel the useless terms: y/y = (k/k) + (A)/A This means that the GDP per capita is composed of the capital share times the capital per capita plus the technological progress. Full stop Caution: N is interpreted either as labor or population. To reconcile the two, assume that the whole population participated in the work force (i.e. labor force= population) and we have no problem with the terminology. This is a disadvantage of the Solow model because, literally, even new-born babies are assumed to be workers, which is not true in reality. Moreover, we can also interpret k as capital to labor ratio in this sense. Another weakness is that didnt include human and natural resources which is essential to economic growth analysis. Lastly, the A/A is called TFP or famously Solow residual named after Robert Solow, the economist who dominated the economic growth analysis in the neoclassical period.

-Ciao! Buono studio, Mitch ^^

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The same explanation.

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