Lecture 2.

Growth Facts, Production Function

and Growth Accounting
ECON30009 Macroeconomics
Shuyun May Li
Department of Economics
The University of Melbourne
Semester 2, 2014

Outline
1. Introduction
2. Modeling Production
3. Accounting for Growth
Required reading: Chap. 1 of AK
Further reading: On productivity: the influence of natural
resource inputs, Productivity Commission report (2013)

1. Introduction
Advanced economies produce a multitude of goods and
services. Despite the varied means to produce them, certain
features are common to all production processes.
All production processes use basic inputs to generate final
productsthe outputs, using a technology for combining
inputs to make outputs.
Macroeconomists are concerned with a countrys total
production of final goods and servicesits gross domestic
product, or GDP.
Economists refer to increases over time in real GDP as
economic growth.
Economic growth leads to improvement in a countrys living
standard which is measured by per capita GDP, or output
per person.
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US GDP per capita since 1960

Australian GDP and GDP per capita since 1901

Levels and growth rates of per capita GDP

Output per person in 6 rich countries

Convergence in per capita GDP

 Some central questions of growth theory:

How economic growth happens over time?
Why standards of living and growth rates vary substantially
across countries?
Can poor countries catch up with rich countries?
Intuitively, economic growth depends on various factors:
the availability and quality of inputs (capital accumulation,
population growth, human capital accumulation)
the efficiency with which inputs are combined to produce
output (learning-by-doing)
scientific and engineering advances that permits producing
more output from given inputs (technological progress)
the state of the economy (recessions or expansions).

 Correspondingly, there are many different channels through

which output grows.
Various growth models differ in what growth channels they
strive to explain.
In the Solow-Swan growth model, both labour and technology
are exogenous, while capital is endogenous, so the model
explains how growth happens through capital accumulation
(to a certain degree).
The life-cycle model well introduce represents another well
known growth modelthe overlapping generations growth
model, which further complete the story of growth through
capital accumulation.
Before we get into the model, we first briefly review some
concepts and measurement issues around the production
function.
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2.

Modeling Production

Economists conceptualise the production process of final goods

by a mathematical relationship known as the production
function:
Yt = F (At , Kt , Lt ).
Yt refers to the amount of output produced during a
particular time period.
Labour, Lt , refers to the total efforts supplied by workers,
managers and owners of business enterprises.
Capital, Kt , refers to the amount of nonhuman inputs
employed in the production (buildings, machinery, etc).
Productivity, At , refers to the efficiency with which capital
and labour are used.
F refers to a mathematical function that describes the
dependence of Yt on Kt , Lt and At .
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 A widely-used production function is the Cobb-Douglas (C-D)

production function:
Yt = At Kt L1
,
t
where At denotes multifactor productivity (MFP) or total
factor productivity (TFP), and (0, 1) is a parameter.
In a competitive economy operating with C-D production
function, the income share paid to capital and labour are
and 1 , respectively.
Constant returns to scale
Diminishing returns to each of the inputs
Historically, capitals share of US GDP has been remarkably
close to 1/3, so often takes the value of 1/3 or 0.3.
C-D production function is viewed as a good representation of
aggregate production for advanced economies.
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 Measuring capital
In any modern economy, a wide variety of capital goods are
used to help produce output: equipment, business
structures, inventories, residential structure, land, etc.
One approach to measure capital is to convert all types of
capital goods to constant dollar terms, then add them up.
Capital depreciates (wears out) over time, and capital
stock increases through investmentthe acquisition of new
capital goods.
The change in capital stock (productive capital available for
production) between two time periods:
Kt Kt+1 Kt = It Dt , i.e.

(1)

Kt+1 = Kt Dt + It .

(2)

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 Kt : the capital stock at the beginning of period t

It : new purchases of capital in period t, gross investment
Dt : depreciation of the capital stock that occurs in period t
It Dt : Net investment
Eq. (2) gives another approach to measure capital, known
as Perpetual Inventory Method.
The basic idea is to construct the series of capital stock
recursively using initial capital stock and data series on
depreciation and investment.
Dt is typically defined as a fraction of Kt ,
Dt = Kt ,
where varies for different types of capital goods, then (2)
becomes
Kt+1 = (1 )Kt + It .
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(3)

 Measuring labour: Economists typically measure labour input

by the number of hours worked.
(Total hours=working age population employment ratio
number of hours per employed.)
Labour productivity
Labour productivity is defined as the amount of output per
unit of labour input, Yt /Lt .
Rewriting the C-D production function in its intensive
form:
 
1
Yt
Kt
At Kt Lt

=
= At Kt Lt = At
,
Lt
Lt
Lt
or equivalently
yt = At kt ,

(4)

where yt and kt are labour productivity and capital-labour

ratio, respectively.
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 MFP
MFP plays a crucial role in increasing the economys
capacity to produce. Improvements in MFP make it
possible to produce more output without additional input.
A variety of factors can cause MFP to change:
improvements embodied in capital and labour inputs
that increase the quality of capital and labour
disembodied changes that boost productivity in a more
general way
Disembodied MFP changes refer to technological change,
but also reflect the presence of any productive factors not
measured as capital or labour inputs
So MFP or TFP is hard to measure directly.

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3.

Accounting for Growth

An important application of any production function is to use

it to conduct growth accounting.
It aims to answer the question: how much of output growth
between any two time periods is due to growth in inputs
(capital and labour) or improvements in productivity?
Growth accounting was pioneered by Abramovitz (1956) and
Solow (1957).
Using the C-D function, we can derive the growth accounting
formula (see Appendix) that decompose output growth
between any two time periods into 3 sources:
growth in TFP
growth in capital weighted by capitals factor share
growth in labour weighted by labours factor share.
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Yt
At
Kt
Lt
=
+
+ (1 )
,
Yt
At
Kt
Lt

(5)

Xt+1 Xt
t
where X

stands for the growth rate in X from

Xt
Xt
period t to t + 1.
Note that this formula also exhibit constant returns to scale
and diminishing returns to growth in each factor.

We have data on output, hours worked and capital, and 1

can be estimated by the income share of labour.
So the growth rate of A (TFP) is usually computed as a
residual, known as the Solow residual method.
At
Yt
Kt
Lt
=

(1 )
.
At
Yt
Kt
Lt
The Solow residual reflects the amount of output growth
that cannot be explained by (or thats left over after)
growth in the quantities of capital and labour.
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 The growth accounting formula can be rewritten as



Yt
Lt
At
Kt
Lt
,

=
+

Yt
Lt
At
Kt
Lt
Lt
t
where ( Y

Yt
Lt ) is the growth rate of
the growth rate of K
L.

Y
L,

t
and ( K
Kt

(6)
Lt
Lt )

is

This formula decomposes the growth in labour productivity

into 2 sources: MFP growth, and growth in capital-labour
ratio (capital-deepening).
It is more widely used in empirical growth accounting.
There have been many studies on growth accounting that build
on the basic framework or extends the basic framework (e.g.,
extract improvements in input quality from growth in MFP).

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Growth accounting for six rich countries

TFP growth accounts for most growth in the rich countries

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Asia Miracles? Growth rates: 1960-1990

Input growth accounts for most growth in many fast-growing

countries.
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Growth accounting for the US (BLS)

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Growth accounting for Australia

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Contribution of ICT capital

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Annual average labour productivity growth

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Review Questions
What is a common feature of all production processes?
What are the central questions of growth theory? Name a few
channels through which output grows.
What is a production function?
Write down the Cobb-Douglas production function. What does each
term refer to, and what properties the function exhibit?
Write down an equation that describes how the stock of capital
accumulates over time. Understand the concepts of gross
investment, depreciation and net investment.
Have a general understanding on how to measure capital and labour.
Understand the concepts of embodied and disembodied changes in
MFP.
What is labour productivity? How does it relates to MFP and
capital-labour ratio, under the Cobb-Douglas production function?
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 Write down the two growth accounting formulae. How do the

growth accounting formulae decompose output growth, and growth
in labour productivity?
How to measure the growth rate of MFP or TFP? Does the Solow
residual purely reflect technological progress?
Have a general idea on how to conduct growth accounting in
practice (The Productivity Commission report gives you a growth
accounting exercise).

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Appendix: Deriving the growth accounting formula

Taking the log of both sides of the C-D production function yields
ln Yt = ln At + ln Kt + (1 ) ln Lt .
For period t + 1, the equation above is written as
ln Yt+1 = ln At+1 + ln Kt+1 + (1 ) ln Lt+1 .
Taking the difference of the two equations above, we have
ln Yt+1 ln Yt = ln At+1 ln At + (ln Kt+1 ln Kt ) + (1 )(ln Lt+1 ln Lt ),
or equivalently,

At+1
Kt+1
Lt+1
Yt+1
ln
= ln
+ ln
+ (1 ) ln
.
Yt
At
Kt
Lt

(7)

Now we show that in the equation above, the ln terms are approximately the
corresponding growth rates. Recall that the growth rate of a variable Xt is defined
as
Xt
Xt+1 Xt
Xt+1

=
1,
Xt
Xt
Xt
so
Xt+1
Xt
=1+
.
Xt
Xt
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Then we have
ln

Xt+1
Xt

Xt
Xt
,
= ln 1 +

Xt
Xt

(8)

where the follows a mathematical approximation result:

ln(1 + x) x
for x that is close to zero. Eq. (8) implies that the growth rate of a variable can be
approximately calculated as the log difference of the variable:

Xt
Xt+1
ln
= ln(Xt+1 ) ln(Xt ).
Xt
Xt
This is exactly what statisticians do in practice. However, be aware that the
approximation is good only when the growth rate is small (the closer it is to zero,
the better is the approximation).
Applying this approximation result to Eq. (7), we obtain the growth accounting
formula:
Yt
At
Kt
Lt

+
+ (1 )
.
Yt
At
Kt
Lt
Note that the equality only approximately holds (youll see this in one of your
tutorial questions for week 3).

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