Question

Imagine you're named an Economic Advisor to the president of a very poor and backward country (Sandokistan).   The President asks your advice on where they should use their very limited resources so that they can help escape the poverty trap. Should they invest in existing, traditional tools (think tractors, computers, known manufacturing techniques) or should they invest in cutting edge research where they might become a market leader? Please explain why you selected the option you did.   Conversely, why didn't you select the other option? How does the option picked fit with the theory learned this chapter?

Note: In a world of trade offs, you can pick only one. I won't accept an answer that says they are both important.

The theory names

The Solow Model and catching-up Growth

the investment rate and conditional convergence

New ideas and cutting-edge growth

the economics of ideas

the future of economic growth

Answer 1

In the modern world of trade offs a backward country can have the best solution for their growth is solow Model of steady state growth. Because the solow model says that if country want a growth then invest in the existing tools of the economy. Thats why in the above question it hints intimately about the Solow-Swan model of economic growth. The economic growth assumes that a continues production function linking output to the inputs of capital and labor which is leading to the equilibrium of the steady state of the economy.

                                Its assumptions are as follows.

1. One composite commodity is produced.
2. Output is regarded as net output after making allowance for the depreciation of capital.
3. There are diminishing returns to an individual input.
4. There are constant returns to scale.
5. Factors of production, labor and capital are paid according to their marginal productivity.
6. Prices and wages are flexibles.
7. There is full employment.
8. There is full employment of capital also.
9. Labor and capital is fully substitutable.
10. There is no technological progress.
11. Saving equal to investment.
12. Capital depreciates at constant rate.
13. Population growth is also constant.

The Model

From these assumptions, if technical progress changes then production function is

                        Y = F (K, L)                                                            ---------------- (1)

Here Y is income or output, K is capital and L stands for labor. By condition of constant returns to scale if we divide by L, the production function can be written as.

Y/L = F (K/L, 1) =L.(k)                            ------------------(2)

Where Y/L is output per worker, k=K/L is the labor capital ratio and the function f(k)=f(k,1) Thus, production function is determined as

                        Y=f(k)                                                   -------------------(3)

In this model saving is a constant function, s, of income. Then saving per worker is sy. Since income equals to output.

                                Sy=sf(k)                                                                -------------------(4)

The investment required to maintain capital per worker is k, depends upon population growth. And depreciation rate is d. since it is assumed that, population growth rate is constant n, the capital stock grows at the rate of n*k to provide capital to the growing population. Since depreciation is constant d, per cent of the capital stock, d.   k is the investment needed to replace worn out capital. This depreciation investment per worker is added to the nk, the investment per worker is to maintain capital labor ration for the growing population.

                                (nk+dk) = (n+d) k                                              -------------------(5)

this is the investment required to maintain the capital labor ratio.

                The net change in capital per worker i.e. capital labor ratio. k’ over time is the excess of saving per worker over the required investment to maintain the capital per worker,

                                K’=sf(k) – (n+d) k                                              ------------------(6)

This is the fundamental equation of this model where k’=0. The economy reaches to the steady state when

                                Sf(k)= (n+d) k                                                     ------------------(7)

This model can be explained with the diagram.

Output per worker is measured on Y Axis. And Capital per worker is measured on X Axis. K is measured with only X Axis. The y=f(k) curve is the production function it shows the output per worker increases at a diminishing rates, as k increases due to assumption of diminishing returns. The sf(k) curve represents the saving per worker. The (n+d)k is the investment required line from the origin with the a positive slope equal to (n+d). the steady state level of capital, k’ is determined where the sf(k)0 curve intersects the (n+d)k line at point E. the steady state income is y’ with the output per worker k’P, as measured by point p on the production function curve.

                In order to understand why capital k’ is steady state situation, Assume economy starts at point capital labor ratio k₁ . here saving per worker k₁ B exceeds the investment required to keep the capital labor ratio constant, k₁ A, (k₁ B > k₁ A ) thus k and y increased till k’ is reached, when the economy is is in steady state at point E. Or we can say oppositely, if the capital labor ratio is k₂ the saving per labor is k₂ C, will be less than the investment required to keep the ratios constant. Thus y will fall as k falls to the k’ and the economy reaches the steady state equilibrium E.

The other models are rejected with some reasons.

1. the investment rate and conditional convergence theory assumes that the investment rate and population growth rate beingheld constant.

2. Theory of the economics of ideas or we can say new ideas are more riskier to the developing or least developed country. It actually suggests that the incvestment in new ventures but it is risky.