Problem 1: Departing from Cobb-Douglas

Consider the production model where the aggregate production function is:

F(K;L) = �A KL

K +L with �A > 0; (1)

where K denotes capital and L denotes labor.

(i) (1 point) Does this production function exhibit constant returns to scale? (Give a proof).

(ii) (2 points) All markets are perfectly competitive. Derive the expressions for the wage (w) and the rental price of capital (r) as a function of K and L.

2

(iii) (2 points) Express the labor share of income as a function of K and L.

(iv) (2 points) Express per capita GDP, y � Y=L, as a function of k � K=L. Draw a graphical representation of this relationship (with k on the horizontal axis and y on the vertical axis).

3

(v) (1 point) Suppose that capital is accumulated as in the Solow growth model: a fraction �s of total income is invested into capital and the depreciation rate of the capital stock is �d. Write down the law of motion of the capital stock.

(vi) (2 points) Represent graphically the determination of the steady-state capital stock, K�.

4

(vii) (2 points) Give the closed-form expressions for the steady-state values for k and y (denoted k� and y�, respectively). Under which condition does a steady state with positive capital stock exist?

5

(viii) (2 points) Show analytically and graphically the effects of an increase of �s on k� and y�.

6

(ix) (BONUS: 2 points) Assume �d < �A. Find the closed-form solution for steady-state per capita consumption, c�, as a function of �s, �A, and �d. Plot c� as a function of �s. What is the golden-rule value for �s?

7

Problem 2: Public infrastructures and income differences

Consider an economy with the following aggregate production function, F(K;L) = AK1=3L2=3. We suppose that total factor productivity depends on the pro- vision of public goods as captured by per capita government purchases, g = G=L. We assume the following functional form: A = �Ag2=3. Hence,

F(K;L) = �Ag2=3K1=3L2=3:

(i) (2 points) Express per capita income, y � Y=L, as a function of �A, g, and k � K=L.

(ii) (2 points) Suppose that government purchases are �nanced with a proportional tax on income, g = ty where t is the tax rate. Express y as a function of �A, t and k.

8

(iii) (2 points) Suppose all countries have the same tax rate and factor productivity. We adopt the normalization �A3t2 = 1. Use the model to predict per capita income for the following countries:

country observed k predicted y observed y U.S. 1.000 1.000 1.000 U.K. 0.671 0.828 India 0.061 0.084 China 0.147 0.172

Textbook prediction 1 0.876 0.394 0.528

Does this model outperform the textbook model to predict per capita income?