Notes on the Solow Model (I)

Pablo Fajgelbaum
Last Updated: April 8, 2015

Intro
These notes correspond to the class of 04/08
These notes present the basic version of the Solow model.
Basic idea: differences in capital per worker drive differences in income
The model explains how differences in capital per worker are determined
These notes complement Chapter 3 from Weils textbook

Key Assumptions
Key assumptions
Closed economy
Single good used for both consumption and investment
Perfect competition and constant-returns-to-scale technologies
Representative firm
Representative consumer
Discrete time (t = 0, 1, 2, ..) and infinite horizon (the economy exists forever)

Technology and Firm Maximization

The production function relates output Y to the factors of production capital K and labor
L
Y = AF (K, L)
Technology is free (anyone can use it)
Neoclassical assumptions:
1

(1)

 Output increasing with inputs

F
F
FK > 0;
FL > 0
K
L
Decreasing returns in each individual input
2F
2F

F
<
0;
FLL < 0
KK
K 2
L2
Inada Conditions
lim FK = lim FL =

K0

L0

lim FK = lim FL = 0

Constant returns to scale in every input (CRS)

F (K, L) = F (K, L)
Thanks to CRS, we can define output per worker or per unit of labor as
y=

Y
= Af (k)
L

(2)

where k = K/L is capital per worker and where f (x) F (x, 1) is the intensive
form of the production function
Practice question:
show that
Y
= Af 0 (k)
K
Y
= Af (k) kAf 0 (k)
L

(3)
(4)

show that the assumptions on F imply f 0 (k) > 0 and f 00 (k) < 0
show that

f (k)
k

is decreasing with k

show that

Y
Y
K+
L=Y
K
L

(5)

This is called Euler Equation and is an implication of CRS

The representative firm solves
max Y rK wL
K,L

where r is the cost of capital, and w is the cost of labor

2

(6)

 Note that we normalize the price of the final good to 1, so that total output equals total
income in the economy.
The solution to the firm problem gives the first-order conditions (FOC):
Y
=r
K
Y
=w
L

(7)
(8)

These conditions say that the marginal product of labor (capital) equals the cost of using
labor (capital)
Using 7 and 8 gives the factor income shares:
wL
Y L
=
Y
L Y
rK
Y K
=
Y
K Y
where

wL
Y

is the income share of labor and

rK
Y

(9)
(10)

is the income share of capital

Note that, using 5, 9, and 10, we obtain:

rK + wL = Y,
i.e., the payments to capital and labor exhaust output (everything produced is distributed in form payments to capital or labor).
Practice questions
Show the first-order conditions (FOC) of the firm maximization problem (6) are equivalent to a situation where each individual worker hires capital per worker k, so that the
wage solves:
w = max Af (k) rk
k

Show that when the production function is Cobb-Douglas, so that F (K, L) = K L1 ,

then the capital share of income is
Show that when the production function has Constant Elasticity of Substitution


1
1
1

(CES) equal to , so that F (K, L) = K

+ (1 ) L
then the capital


K
share is increasing or decreasing with the capital-labor ratio L depending on whether
is greater or less than 1.