EC2065 Macroeconomics | Chapter 1: The supply side of the economy

Chapter 1: The supply side of the economy

We start by studying the supply side of the economy. This means the economy’s capacity to
produce goods and services. We will defer consideration of demand-side issues until
Chapter 3. In this chapter, we will introduce a basic supply-side theory of gross domestic
product (GDP). GDP is a measure both of production and of income, so our model is a
starting point in understanding how much an economy is able to produce and how much
people within the economy are able to earn.

Using the supply-side model, we will look at what explains the level of GDP and how the
economy’s total income is distributed. This model serves as the foundation for our study of
economic growth in Chapter 2, where we will explore why there is growth in GDP per
person over time and why the level of GDP per person differs so much across countries.

Essential reading
• Williamson, Chapters 4, 5 and 7.

1.1 Production functions and factors of production

The supply-side model of an economy’s GDP has two ingredients: first, the quantities of
factors of production available and second, the production function.

1.1.1 Factors of production

Factors of production are basic inputs into the production process for goods and services.
Here, we consider three factors:
1. Labour
2. Land
3. Capital.
Capital refers to goods used to produce other goods in the future, for example, machinery,
tools, buildings, computers, vehicles. In our model, suppose that capital goods are
homogeneous and the capital stock, denoted 𝐾𝐾, is the quantity of units of capital available
to use for production. The quantity of capital can be increased by producing new capital
goods and this process of capital accumulation is described in Section 1.7. For now, the basic
supply-side model takes as given the available supplies of each of the factors of production,
including capital.
Land refers to physical space needed to produce goods and services, for example, farmland,
or a city-centre site for a shopping mall. An essential characteristic of land is that it is in fixed
supply. Even when we allow for the supplies of labour and capital to change over time in
later models, the quantity of land remains fixed. Treating units of land as homogeneous for

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simplicity, we denote the fixed quantity by 𝐿𝐿. Natural resources can also be included as part
of land, broadly interpreted.
Labour as a factor of production refers to work done by people to produce goods and
services. The supply of labour to the economy depends on how many workers there are and
the number of hours worked by each person. To begin with, we will treat labour as
homogeneous and denote the quantity by 𝑁𝑁 that, depending on the context, could be
measured as a number of people or a number of hours worked. More broadly, we could also
consider the skills, training and experience of the workforce as part of what determines the
supply of labour, although these are often counted as a separate factor of production
known as ‘human capital’, considered in Chapter 2.

1.1.2 The production function

The production function describes how the factors of production are combined to produce
the output of final goods and services. The production function is a high-level summary of
the production process, which may involve many stages and many intermediate inputs that
are not considered explicitly. The production function is the link between the basic inputs of
the factors of production and the output of final goods and services.
The economy’s real GDP 𝑌𝑌 measures output of final goods and services. In practice, this
comprises a large number of different products that are aggregated using their relative
prices. However, for much of the time we will simplify matters by assuming there is just a
single homogeneous good, or a stable basket of goods, produced in the economy.
The production function describes how output 𝑌𝑌 is produced:
𝑌𝑌 = 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝐿𝐿, 𝑁𝑁)
Assuming factors are fully employed, factor supplies 𝐾𝐾, 𝐿𝐿, and 𝑁𝑁 are inputs to production
function 𝐹𝐹 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁). In addition to the factor supplies, output also depends on the overall
productivity of the factors. This is the notion of total factor productivity (TFP), which is
represented in the production function by the coefficient 𝑧𝑧. The value of 𝑧𝑧 can represent the
level of technology, or how efficiently factors of production are allocated to their best uses.
The production function, together with the factor supplies and TFP, determine real GDP 𝑌𝑌.
We typically make some conventional assumptions about the function 𝐹𝐹(𝐾𝐾, 𝐿𝐿, 𝑁𝑁).
Constant returns to scale
The first assumption is that the production function has constant returns to scale. If the
economy were able to double its supplies of all factors of production then it should be able
to double its output. More generally, scaling all inputs of factors of production scales output
in same way. The usual justification for assuming constant returns to scale is the ‘replication
principle’. By using the same production techniques and technologies with the additional
factors organised in the same way as the original factors, it should be possible to make
double the original amount of output if all factors have been accounted for.

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Positive, but diminishing, marginal products

The second assumption is that increasing the supply of one factor of production without
changing the amounts of the other factors available raises output but less than
proportionately. The extra output produced by an extra unit of one factor is the marginal
product of that factor. Mathematically, a factor’s marginal product is the partial derivative
of the production function with respect to that factor. For example, the marginal product of
capital, denoted by 𝑀𝑀𝑃𝑃𝐾𝐾 , is:
𝜕𝜕𝜕𝜕
𝑀𝑀𝑃𝑃𝐾𝐾 = = 𝑧𝑧𝐹𝐹𝐾𝐾 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁)
𝜕𝜕𝜕𝜕
Stated in terms of marginal products, the second assumption is that each factor’s marginal
product is positive but diminishes as the supply of that factor increases. Mathematically,
𝑀𝑀𝑃𝑃𝐾𝐾 is positive but declines as 𝐾𝐾 increases. The same assumptions are made for the
marginal products of land 𝑀𝑀𝑃𝑃𝐿𝐿 = 𝜕𝜕𝜕𝜕⁄𝜕𝜕𝜕𝜕 and labour 𝑀𝑀𝑃𝑃𝑁𝑁 = 𝜕𝜕𝜕𝜕⁄𝜕𝜕𝜕𝜕.
Why are factors’ marginal products decreasing? Consider, for example, the use of capital in
an office job. Without a computer, it is very difficult to perform many tasks. Giving an office
worker a computer has a large effect on that worker’s output compared to no computer, so
marginal product of capital initially high. And while a more powerful computer may allow
the worker to produce more, given the nature of the task performed by the worker, extra
computing power is unlikely to raise the worker’s output proportionately. This means that
the marginal product of capital declines.
It is important to note that this argument holds fixed the number of workers, their skills and
state of technology. If the extra computing power were allocated to an additional worker, or
used by workers with higher skills to perform more advanced tasks then there is no
presumption that output will not rise proportionately.
Inada conditions
The third assumption on the production function is known as the ‘Inada conditions’. These
are essentially a stronger version of the assumption of diminishing marginal products.
Rather than just requiring the marginal product of a factor declines as the use of that factor
increases, the Inada conditions require that the marginal product declines all the way to
zero. Similarly, the Inada conditions require that the marginal product of a factor is initial
very high (mathematically, it is said to approach infinity) when the usage of the factor is
close to zero. One consequence of the Inada conditions is that some positive amount of
each factor of production is essential to produce any output.

1.1.3 Neoclassical production functions

In summary, the usual assumptions we make about production functions are:

• Constant returns to scale:

𝐹𝐹 (𝑠𝑠𝑠𝑠, 𝑠𝑠𝑠𝑠, 𝑠𝑠𝑠𝑠) = 𝑠𝑠𝑠𝑠(𝐾𝐾, 𝐿𝐿, 𝑁𝑁)
A scaling of inputs of all factors of production by 𝑠𝑠 (for example, 𝑠𝑠 = 2 is doubling
inputs) scales output by 𝑠𝑠.

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• Positive but diminishing marginal products of factors:

𝜕𝜕𝜕𝜕 𝜕𝜕 2 𝑌𝑌
𝐹𝐹𝐾𝐾 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) = >0 , 𝐹𝐹𝐾𝐾𝐾𝐾 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) = <0
𝜕𝜕𝜕𝜕 𝜕𝜕𝐾𝐾 2
These are for capital. The same assumptions hold for other factors. For land, 𝐹𝐹𝐿𝐿 > 0 and
𝐹𝐹𝐿𝐿𝐿𝐿 < 0, and for labour, 𝐹𝐹𝑁𝑁 > 0 and 𝐹𝐹𝑁𝑁𝑁𝑁 < 0.

• Inada conditions:
lim 𝐹𝐹𝐾𝐾 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) = ∞ , lim 𝐹𝐹𝐾𝐾 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) = 0
𝐾𝐾→0 𝐾𝐾→∞

These are for capital. The same assumptions hold in terms of 𝐹𝐹𝐿𝐿 and 𝐹𝐹𝑁𝑁 for land and
labour.

A production function that satisfies all three assumptions is called a ‘neoclassical production
function’. Figure 1.1 plots the relationship between output 𝑌𝑌 and capital 𝐾𝐾 for a neoclassical
production function 𝑌𝑌 = 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝐿𝐿, 𝑁𝑁). This is not a plot of the entire production function
because land and labour are held constant at 𝐿𝐿0 and 𝑁𝑁0 but similar diagrams can be used to
show the relationship between 𝑌𝑌 and 𝐿𝐿, and 𝑌𝑌 and 𝑁𝑁, holding the other two factors fixed.
However, the constant returns to scale assumption cannot be illustrated in the diagram
because that would require changing all the factor inputs at the same time.
Figure 1.1: A neoclassical production function

The production function is upward sloping because its gradient is the marginal product of
capital, which is positive. The gradient declines as 𝐾𝐾 increases because the marginal product
of capital is diminishing. The Inada conditions imply the production function is extremely
steep for 𝐾𝐾 close to zero and flattens out as 𝐾𝐾 becomes very large. The production function
must also pass through the origin because some capital is essential for production given the
neoclassical assumptions.

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1.1.4 The Cobb-Douglas production function

The most commonly used example of a neoclassical production function is the Cobb-
Douglas functional form:

𝑌𝑌 = 𝑧𝑧𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽 𝑁𝑁 1−𝛼𝛼−𝛽𝛽

The parameters 𝛼𝛼 and 𝛽𝛽 each lie between 0 and 1, and the sum 𝛼𝛼 + 𝛽𝛽 is less than 1. The
Cobb-Douglas production function satisfies the three neoclassical assumptions. First, it has
constant returns to scale because:

𝑧𝑧(𝑠𝑠𝑠𝑠 )𝛼𝛼 (𝑠𝑠𝐿𝐿)𝛽𝛽 (𝑠𝑠𝑁𝑁)1−𝛼𝛼−𝛽𝛽 = 𝑠𝑠𝑠𝑠𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽 𝑁𝑁 1−𝛼𝛼−𝛽𝛽

The marginal product of capital is:

𝑀𝑀𝑃𝑃𝐾𝐾 = 𝑧𝑧𝑧𝑧𝐾𝐾 𝛼𝛼−1 𝐿𝐿𝛽𝛽 𝑁𝑁 1−𝛼𝛼−𝛽𝛽

This is positive because 𝛼𝛼 > 0. It declines as 𝐾𝐾 increases because 𝛼𝛼 < 1, so the exponent of
capital in the expression for 𝑀𝑀𝑃𝑃𝐾𝐾 is negative. It follows that the marginal product of capital
is positive but diminishing. Using the partial derivatives with respect to land and labour, the
same is true of the marginal products of land and labour.
The expression for the marginal product of capital approaches infinity as 𝐾𝐾 → 0, and
approaches zero as 𝐾𝐾 → ∞. The same can be shown for the other factors. This confirms the
Inada conditions hold for the Cobb-Douglas production function.

1.1.5 The per worker production function

In many contexts, we are interested in how much output is produced per worker, rather
than total production. This is relevant if we want to calculate living standards in an
economy, which are connected to how much is produced per person.
Here, we focus on just two factors of production, capital 𝐾𝐾 and labour 𝑁𝑁. We assume a
neoclassical production function 𝑌𝑌 = 𝑧𝑧𝑧𝑧 (𝐾𝐾, 𝑁𝑁). Output per worker, denoted by 𝑦𝑦 = 𝑌𝑌/𝑁𝑁,
can be explained in terms of capital per worker 𝑘𝑘 = 𝐾𝐾/𝑁𝑁 and TFP 𝑧𝑧.
𝑌𝑌 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝑁𝑁) 𝐾𝐾 𝑁𝑁
𝑦𝑦 = = = 𝑧𝑧𝑧𝑧 � , � = 𝑧𝑧𝑧𝑧(𝑘𝑘, 1) = 𝑧𝑧𝑧𝑧(𝑘𝑘)
𝑁𝑁 𝑁𝑁 𝑁𝑁 𝑁𝑁
This equation is derived using the constant returns to scale property of a neoclassical
production function which implies a scaling of all factors of production (here by 1/𝑁𝑁) is
equivalent to scaling output in the same proportion. In the above, the function 𝑓𝑓(𝑘𝑘) is
simply used as a shorthand for 𝐹𝐹(𝑘𝑘, 1).

Taking the Cobb-Douglas production function 𝑌𝑌 = 𝑧𝑧𝐾𝐾 𝛼𝛼 𝑁𝑁 1−𝛼𝛼 for example:

𝑌𝑌 𝑧𝑧𝐾𝐾 𝛼𝛼 𝑁𝑁 1−𝛼𝛼 𝐾𝐾 𝛼𝛼
𝑦𝑦 = = = 𝑧𝑧𝐾𝐾 𝑁𝑁 = 𝑧𝑧 � � = 𝑧𝑧𝑘𝑘 𝛼𝛼
𝛼𝛼 −𝛼𝛼
𝑁𝑁 𝑁𝑁 𝑁𝑁
This confirms that 𝑦𝑦 = 𝑧𝑧𝑧𝑧(𝑘𝑘) with 𝑓𝑓(𝑘𝑘) = 𝑘𝑘 𝛼𝛼 in this case.
If the production function 𝑌𝑌 = 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝑁𝑁) is neoclassical, the per worker production function
has an increasing and concave shape. Observe that aggregate output is 𝑌𝑌 = 𝑧𝑧𝑧𝑧𝑧𝑧(𝐾𝐾⁄𝑁𝑁), so

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the marginal product of capital is 𝑀𝑀𝑃𝑃𝐾𝐾 = 𝜕𝜕𝜕𝜕⁄𝜕𝜕𝜕𝜕 = 𝑧𝑧𝑓𝑓 ′ (𝐾𝐾⁄𝑁𝑁) = 𝑧𝑧𝑧𝑧′(𝑘𝑘). The neoclassical
assumptions state that 𝑀𝑀𝑃𝑃𝐾𝐾 is positive but diminishing in capital 𝐾𝐾, which must also hold for
capital per worker 𝑘𝑘. This implies 𝑓𝑓′(𝑘𝑘) is an increasing and concave function of 𝑘𝑘.

1.2 Factor markets and the distribution of income

The previous section shows a simple model of how the real GDP of an economy is
determined by its production technologies and its supplies of factors of production. As well
as being a measure of production, GDP is a measure of total income in an economy, so the
model also explains aggregate income. The next step is to ask how that aggregate income is
distributed among the factors of production.
Up to this point, we have not considered markets in our model of the economy, although
markets were implicit in how the factors of production were organised and allocated among
different uses. Here, markets are introduced to explain the distribution of income. We use
an analysis with firms in perfectly competitive markets for factors of production. An
example of a factor market is a market for labour, a market where firms can hire the
services of workers for a time. There are also markets for renting land and capital.

For each of the factor markets, there is a factor price. In the labour market, this is a wage 𝑤𝑤
per hour of labour, or per person working for a given amount of time. For land, there is a
rent 𝑥𝑥 and for capital there is a rental price 𝑅𝑅. We do not consider markets for outright
purchases or sales of factors of production at this stage. In the factor markets, households
supply factors of production that they own, which are hired or rented by firms. Households
supply their own labour, together with land and capital goods. In this analysis, firms do not
own factors of production themselves. As in the earlier model of production, all supplies of
factors of production are taken as given, so the supply curves are price inelastic.
On the demand side, firms hire factors of production 𝐾𝐾, 𝐿𝐿 and 𝑁𝑁 to produce output 𝑌𝑌,
taking prices and factor prices as given. The production function is 𝑌𝑌 = 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝐿𝐿, 𝑁𝑁), which
has the same properties assumed earlier. Firms aim to maximise profits 𝜋𝜋:
𝜋𝜋 = 𝑌𝑌 − 𝑅𝑅𝑅𝑅 − 𝑥𝑥𝑥𝑥 − 𝑤𝑤𝑤𝑤
These profits are measured in real terms, making the price of a unit of output equal to 1.
The revenue of the firm is simply the quantity 𝑌𝑌 of output it produces and sells. Its costs are
its spending on hiring factors of production, which are given by the factor prices multiplied
by the quantities hired of each factor.
The first-order conditions for profit maximisation are 𝜕𝜕𝜕𝜕⁄𝜕𝜕𝜕𝜕 = 0, 𝜕𝜕𝜕𝜕⁄𝜕𝜕𝜕𝜕 = 0 and
𝜕𝜕𝜕𝜕⁄𝜕𝜕𝜕𝜕 = 0, which are equivalent to the following:
𝑧𝑧𝐹𝐹𝐾𝐾 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) = 𝑅𝑅 , 𝑧𝑧𝐹𝐹𝐿𝐿 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) = 𝑥𝑥 , 𝑧𝑧𝐹𝐹𝑁𝑁 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) = 𝑤𝑤

The terms 𝑧𝑧𝑧𝑧𝐾𝐾 , 𝑧𝑧𝑧𝑧𝐿𝐿 and 𝑧𝑧𝑧𝑧𝑁𝑁 denote the marginal products of capital, land and labour
respectively, where 𝐹𝐹𝐾𝐾 , 𝐹𝐹𝐿𝐿 , and 𝐹𝐹𝑁𝑁 are the partial derivatives of the function 𝐹𝐹(𝐾𝐾, 𝐿𝐿, 𝑁𝑁) with
respect to 𝐾𝐾, 𝐿𝐿, and 𝑁𝑁. These marginal products are diminishing in the quantity hired of
each factor, holding the quantities of the other factors constant. Hence, in each factor
market diagram with the factor price on the vertical axis and the quantity hired on the

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horizontal axis, the demand curves of firms are the downward-sloping marginal product
curves. The supply curves are vertical, representing given price-inelastic supplies of each
factor.
In competitive markets, the factor prices are determined by market clearing. The
equilibrium rental prices of capital and land 𝑅𝑅∗ and 𝑥𝑥 ∗ and the equilibrium wage 𝑤𝑤 ∗ are
found where the factor demand curves intersect the supply curves. This is illustrated in the
rental market for capital in Figure 1.2. The diagram shows how the amount of real capital
income 𝑅𝑅 ∗ per unit of capital owned is determined. The total amount of capital income is
then 𝑅𝑅 ∗ 𝐾𝐾, where 𝐾𝐾 is the supply of capital. Note that this is gross capital income – there is
no allowance made here for depreciation of capital, consistent with how GDP is a measure
of gross income. Similar diagrams can be used to see how rents of land and wages are
determined.
Figure 1.2: Factor market equilibrium

While firms are maximising profits when they choose their factor demands, perfect
competition and a constant-returns-to-scale production function imply that profits 𝜋𝜋 are
zero in equilibrium. It is a general mathematical property that if 𝑧𝑧𝑧𝑧 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) has constant
returns to scale then:
𝑧𝑧𝑧𝑧 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) = 𝑧𝑧𝑧𝑧𝐹𝐹𝐾𝐾 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) + 𝑧𝑧𝑧𝑧𝐹𝐹𝐿𝐿 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) + 𝑧𝑧𝑧𝑧𝐹𝐹𝑁𝑁 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁)
Intuitively, constant returns to scale implies that a 1% increase in each of the factors of
production 𝐾𝐾, 𝐿𝐿, and 𝑁𝑁 adds 1 per cent to existing output 𝑌𝑌, that is, this raises output by
0.01 × 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝐿𝐿, 𝑁𝑁). Adding 1 per cent to capital 𝐾𝐾 raises output by 0.01𝐾𝐾 × 𝑧𝑧𝑧𝑧𝐾𝐾 , where 𝑧𝑧𝑧𝑧𝐾𝐾
is the marginal product of capital. Adding 1% to labour 𝐿𝐿 would raise output by
0.01𝑁𝑁 × 𝑧𝑧𝑧𝑧𝑁𝑁 , and so on for all factors. Summing over all factors then confirms the equation
above.
Since profit-maximisation by firms in perfectly competitive markets equalises marginal
products and factor prices for each factor, it follows that
𝑌𝑌 = 𝑧𝑧𝑧𝑧 (𝐾𝐾, 𝐿𝐿, 𝑁𝑁) = 𝑅𝑅𝑅𝑅 + 𝑥𝑥𝑥𝑥 + 𝑤𝑤𝑤𝑤

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This means that payments to factors of production will use up all a firm’s revenues, so
profits 𝜋𝜋 are zero. Strictly speaking, this shows that economic profits are zero. Where firms
own factors of production themselves rather than renting them, which is often the case with
land and capital, some of the payments to factors described above effectively go the owner
of the firm. In that case, accounting profits would not be zero. However, these would not be
true economic profits but would instead represent the implicit rental of the factors of
production owned by the firm.

1.2.1 The Cobb-Douglas production function

As an example, consider the distribution of income when the production function has the
Cobb-Douglas functional form 𝑌𝑌 = 𝑧𝑧𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽 𝑁𝑁 1−𝛼𝛼−𝛽𝛽 . As seen earlier, the marginal products of
capital, land and labour are 𝑀𝑀𝑃𝑃𝐾𝐾 = 𝛼𝛼𝛼𝛼⁄𝐾𝐾, 𝑀𝑀𝑃𝑃𝐿𝐿 = 𝛽𝛽𝛽𝛽 ⁄𝐿𝐿, and 𝑀𝑀𝑃𝑃𝑁𝑁 = (1 − 𝛼𝛼 − 𝛽𝛽)𝑌𝑌 ⁄𝑁𝑁.
With these being equated to the factor prices 𝑅𝑅, 𝑥𝑥, and 𝑤𝑤, each factor of production
receives a constant share of GDP as income:
𝑅𝑅𝑅𝑅 𝑥𝑥𝑥𝑥 𝑤𝑤𝑤𝑤
= 𝛼𝛼 , = 𝛽𝛽 , = 1 − 𝛼𝛼 − 𝛽𝛽
𝑌𝑌 𝑌𝑌 𝑌𝑌
The income shares are given by the exponents of each factor of production in the Cobb-
Douglas formula. For example, the exponent of capital 𝐾𝐾 is 𝛼𝛼, a parameter between 0 and 1.
Total capital income 𝑅𝑅𝑅𝑅 as a fraction of GDP 𝑌𝑌 is equal to the parameter 𝛼𝛼.

Box 1.1: Understanding inequality in wages

The last few decades have seen rising income inequality within many countries. What
might explain why this has occurred? Here, we focus on inequality in wages rather than
income inequality more broadly (which would also consider capital income), or on
wealth inequality.

One important dimension of the rise in wage inequality is the increase in the relative
wages of highly skilled workers compared to those with more basic skills. While a
university or college education is not the only measure of having skills, the ‘college-
wage premium’ in the USA and elsewhere has received much attention. The size of the
wage premium from attending university is crucial to the debate on the returns to
higher education. A large premium means the returns might be high even if the cost of
education has risen.
In the USA, prior to 1980, an average college-educated worker earned less than 60 per
cent extra compared to an average worker without a college education. By the 2010s,
this college-wage premium had risen to close to 100 per cent. At first glance, this is
puzzling because there has also been a substantial increase in the fraction of college-
educated workers during that period, which rose from 20 per cent to 50 per cent. With
diminishing returns to individual factors of production, an increase in supply should
push down the factor payment, all else being equal. These observations suggest
something else must have changed after 1980.

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One hypothesis we will explore is a shift in the relative demand for workers with
different levels of skill. We separate the supply of labour into highly skilled workers 𝐻𝐻
and unskilled workers 𝑁𝑁. The supply of 𝐻𝐻 is related to the concept of ‘human capital’
studied in Section 2.8. We consider the following example of a production function 𝑌𝑌 =
𝑧𝑧𝑧𝑧(𝐾𝐾, 𝑁𝑁, 𝐻𝐻):
𝑌𝑌 = 𝑧𝑧(𝐾𝐾 𝛼𝛼 𝑁𝑁 1−𝛼𝛼 + 𝐵𝐵𝐾𝐾 𝛼𝛼 𝐻𝐻1−𝛼𝛼 )
As with a Cobb-Douglas production function, the parameter 𝛼𝛼, a number between 0 and
1, indicates the importance of physical capital in producing goods and services. The
variable 𝑧𝑧 is total factor productivity and a change in 𝑧𝑧 affects the marginal products of
all factors of production. What is new in the production function above is 𝐵𝐵, an
exogenous variable that represents what is known as ‘skill-biased technology’. A change
in 𝐵𝐵 affects the marginal product of skilled labour 𝐻𝐻 but not the marginal product of
unskilled labour 𝑁𝑁.
The production function above resembles two Cobb-Douglas production functions that
are added together. However, it is not possible to use a standard Cobb-Douglas
production function such as 𝑌𝑌 = 𝑧𝑧𝐾𝐾 𝛼𝛼 𝐻𝐻𝛽𝛽 𝑁𝑁 1−𝛼𝛼−𝛽𝛽 in this exercise. If 𝐻𝐻 were multiplied
by a coefficient 𝐵𝐵 then this would be algebraically equivalent to a change in total factor
productivity 𝑧𝑧. It is not possible to build in skill-biased technological change with a basic
Cobb-Douglas production function.
We now apply our analysis of the distribution of income. Competitive markets imply
wages 𝑤𝑤𝐻𝐻 and 𝑤𝑤𝑁𝑁 for skilled and unskilled labour that are equal to their marginal
products:
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
𝑤𝑤𝑁𝑁 = 𝑀𝑀𝑀𝑀𝑁𝑁 = = (1 − 𝛼𝛼 )𝑧𝑧𝐾𝐾 𝛼𝛼 𝑁𝑁 −𝛼𝛼 , 𝑤𝑤𝐻𝐻 = 𝑀𝑀𝑃𝑃𝐻𝐻 = = (1 − 𝛼𝛼 )𝑧𝑧𝑧𝑧𝐾𝐾 𝛼𝛼 𝐻𝐻 −𝛼𝛼
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
The implications for the relative wage 𝑤𝑤𝐻𝐻 /𝑤𝑤𝑁𝑁 can be deduced from these equations:
𝑤𝑤𝐻𝐻 (1 − 𝛼𝛼 )𝑧𝑧𝑧𝑧𝐾𝐾 𝛼𝛼 𝐻𝐻 −𝛼𝛼 𝐻𝐻 −𝛼𝛼
= = 𝐵𝐵 � �
𝑤𝑤𝑁𝑁 (1 − 𝛼𝛼 )𝑧𝑧𝐾𝐾 𝛼𝛼 𝑁𝑁 −𝛼𝛼 𝑁𝑁
The relative wage declines with the relative supply of high-skilled labour 𝐻𝐻/𝑁𝑁 but it
increases with skill-biased technological change, that is, higher 𝐵𝐵.
This logic suggests one explanation for the rising skill premium (the relative wage
𝑤𝑤𝐻𝐻 /𝑤𝑤𝑁𝑁 increasing) alongside an increase in the relative supply of skilled labour 𝐻𝐻/𝑁𝑁 is
skill-biased technological change. Skill-biased technological change is improvements in
technology that disproportionately boost the productivity of skilled workers compared
to unskilled workers. For example, advances in computing, telecommunications, data
science and e-commerce may increase demand for highly skilled workers but not
unskilled workers. These changes can be represented by an increase in 𝐵𝐵 rather than an
increase in total factor productivity 𝑧𝑧. Earlier technological progress that may have been
more uniform in its effects is represented by higher TFP 𝑧𝑧. As we have seen, higher 𝐵𝐵
can raise 𝑤𝑤𝐻𝐻 /𝑤𝑤𝑁𝑁 even though there is an increase in the relative supply 𝐻𝐻/𝑁𝑁 of skilled
workers. Changes in TFP do not affect relative wages 𝑤𝑤𝐻𝐻 /𝑤𝑤𝑁𝑁 .

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Skill-biased technological progress is not the only explanation for the rising skill
premium. Globalisation owing to lower barriers to international trade is another
explanation. Even if labour is not mobile internationally, free trade in goods tends to
equalise the skill premium across countries through equalising the relative prices of
goods that are produced more or less intensively using skilled labour. The skill premium
is then determined by the relative supply of skilled labour at world level, where there
are relatively fewer skilled workers than within advanced economies.

1.3 Population growth according to Malthus

We now extend the basic model of production and distribution so that the supplies of
factors of production can change over time. This allows us to consider the dynamics of
aggregate GDP and individual incomes. We begin by considering the supply of labour,
interpreted as the number of workers. One reason the supply of labour adjusts over time is
because the population rises or falls. Here, we study the theory of population growth put
forward by Malthus in the 18th century and its implications for economic growth.
A key prediction of the theory is that population growth holds down living standards when
production of goods depends on land that is in fixed supply. We will see that a Malthusian
model of the economy can explain the stagnation in per-capita incomes seen in most of the
world prior to the 19th century. Technological advances lead to population growth, but not
rising living standards.

1.3.1 Demographics
Malthus in his Essay on the principle of population argued that per capita income and
consumption affect population growth. Lower consumption per person leads to worse
nutrition and health, hence higher death rates and infant mortality, and lower or negative
population growth rate. Furthermore, lower income per person induces families to have
fewer children they would struggle to support, hence lower birth rates and a lower
population growth rate. Higher income and consumption have the opposite effects and
raise the population growth rate. These effects are larger when people are close to
subsistence.
In the model, assume that all individuals are workers. The current population and number of
workers is denoted by 𝑁𝑁. The future population is denoted 𝑁𝑁′, where the notation ′ refers
to a value of a variable in the next time period (the future). The population growth rate
between the current and future time periods is (𝑁𝑁 ′ − 𝑁𝑁)/𝑁𝑁. If 𝐶𝐶 is aggregate consumption,
𝑐𝑐 = 𝐶𝐶/𝑁𝑁 measures average consumption per person, which is a measure of average living
standards. A mathematical representation of the demographics assumed by Malthus is:
𝑁𝑁 ′
= 𝑔𝑔(𝑐𝑐 )
𝑁𝑁

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The demographic function 𝑔𝑔(𝑐𝑐) is increasing in 𝑐𝑐, an example of which is depicted in Figure
1.3. The population growth rate is 𝑔𝑔(𝑐𝑐 ) − 1, so for levels of 𝑐𝑐 where 𝑔𝑔(𝑐𝑐 ) > 1 the
population is rising , and for levels of 𝑐𝑐 where 𝑔𝑔(𝑐𝑐 ) < 1 the population is falling.
Figure 1.3: Demographics and living standards

1.3.2 An agricultural economy

Malthus’s demographic assumption is particularly relevant for the predominantly
agricultural economies of the past when land 𝐿𝐿 and labour 𝑁𝑁 were the key factors of
production. We assume a neoclassical production function 𝑌𝑌 = 𝑧𝑧𝑧𝑧(𝐿𝐿, 𝑁𝑁). The crucial
feature of land is that the supply 𝐿𝐿 remains constant over time. There is no capital, so no
investment and we ignore government and international trade in the model, hence average
consumption per person 𝑐𝑐 is equal to income per worker 𝑦𝑦 = 𝑌𝑌/𝑁𝑁.
For the same amount of land available, more workers can produce more output but there
are diminishing returns to labour. Think of additional workers needing to use lower quality
land relative to that already being farmed, or instead work more intensively on land already
in use. These do not increase output of crops as much as if additional workers had access to
unlimited land of the same quality as that used by existing workers.

The per-worker production function in the Malthusian model is:

𝑌𝑌 𝑧𝑧𝑧𝑧(𝐿𝐿, 𝑁𝑁) 𝐿𝐿 𝑁𝑁
𝑦𝑦 = = = 𝑧𝑧𝑧𝑧 � , � = 𝑧𝑧𝑧𝑧 (𝑙𝑙, 1) = 𝑧𝑧𝑧𝑧 (𝑙𝑙 )
𝑁𝑁 𝑁𝑁 𝑁𝑁 𝑁𝑁
Here, 𝑙𝑙 = 𝐿𝐿/𝑁𝑁 denotes the amount of land available per worker and 𝑓𝑓(𝑙𝑙 ) is simply a
shorthand for 𝐹𝐹(𝑙𝑙, 1). This per-worker production function is illustrated in Figure 1.4, where
output per worker is increasing in land per worker 𝑙𝑙. Hence, as the population 𝑁𝑁 rises,
available land per worker 𝑙𝑙 declines, which reduces average output produced per worker.
This is a reflection of diminishing returns to labour when land is in fixed supply.

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Figure 1.4: Per-worker production function

1.3.4 Dynamics of a Malthusian economy

How do the population and living standards change over time in a Malthusian economy?
Using 𝑁𝑁′⁄𝑁𝑁 = 𝑔𝑔(𝑐𝑐) and 𝑐𝑐 = 𝑦𝑦 = 𝑧𝑧𝑧𝑧 (𝑙𝑙 ) = 𝑧𝑧𝑧𝑧(𝐿𝐿⁄𝑁𝑁), the change in the population over time
is determined by the equation:
𝑁𝑁 ′ 𝐿𝐿
= 𝑔𝑔 �𝑧𝑧𝑧𝑧 � ��
𝑁𝑁 𝑁𝑁

For a low current population 𝑁𝑁, 𝑓𝑓(𝐿𝐿⁄𝑁𝑁) is high and g(z𝑓𝑓(𝐿𝐿⁄𝑁𝑁)) is greater than 1, so 𝑁𝑁 ′ >
𝑁𝑁, which means the population is increasing over time. For a high current population 𝑁𝑁,
𝑓𝑓(𝐿𝐿⁄𝑁𝑁) is low and g(z𝑓𝑓(𝐿𝐿⁄𝑁𝑁)) is less than 1, so 𝑁𝑁 ′ < 𝑁𝑁, which means the population is
falling over time. This tells us that for given parameters of this model, such as the level of
technology 𝑧𝑧, the population converges to a steady state 𝑁𝑁 ∗ .
A steady state is a value of a variable such that once the economy reaches that level of the
variable, there is no further change in that variable over time. The steady state of the
Malthusian model is depicted in Figure 1.5. Since the population converges to a steady
state, per capita income and consumption also reach a steady state 𝑐𝑐 ∗ . For this to result in
zero population growth, it must be the solution of equation 𝑔𝑔(𝑐𝑐 ∗ ) = 1. This solution is
shown using the demographic function in the left panel of the figure. Intuitively, if 𝑐𝑐 > 𝑐𝑐 ∗
then the population rises, pushing down 𝑙𝑙 and 𝑦𝑦 = 𝑐𝑐.

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Figure 1.5: Steady state of the Malthusian model

Given the steady state 𝑦𝑦 ∗ = 𝑐𝑐 ∗ for output and consumption per worker, the steady state for
land per worker 𝑙𝑙 ∗ is the solution of 𝑦𝑦 ∗ = 𝑧𝑧𝑧𝑧(𝑙𝑙 ∗ ). This is found using the per worker
production function in the right panel of the figure. Finally, given 𝑙𝑙 ∗ , the population in
steady state is simply 𝑁𝑁 ∗ = 𝐿𝐿⁄𝑙𝑙 ∗ .
As we will see in Section 2.1, the Malthusian model’s prediction of stagnation in living
standards 𝑐𝑐 ∗ is consistent with historical evidence prior to the 19th century.

1.3.5 What does (or does not) help?

The conclusion that living standards 𝑐𝑐 stagnate in the long run continues to hold even if
technology 𝑧𝑧 improves. This can be seen from Figure 1.5 observing that steady-state 𝑐𝑐 ∗ is
independent of 𝑧𝑧. Better technology 𝑧𝑧 ultimately leads only to a larger population 𝑁𝑁 ∗
because an upward shift of the per worker production function with the same 𝑐𝑐 ∗ = 𝑦𝑦 ∗
results in lower 𝑙𝑙 ∗ . There would be higher living standards during the period until population
converges to its new higher steady state but not in the long run.
The discovery of new land 𝐿𝐿 does not help either in the long run. This would simply cause
the population to rise (higher 𝑁𝑁 ∗ ) with no change in 𝑙𝑙 ∗ or 𝑐𝑐 ∗ in the long run, although there
would be temporarily higher living standards before the population reaches its new steady
state.
Weakening the link between the birth rate and living standards would help. This
demographic transition shifts down the 𝑔𝑔(𝑐𝑐 ) line and leads to a higher steady-state for
living standards 𝑐𝑐 ∗ .
Structural transformation of economy of the economy is another way the Malthusian trap
can be escaped. Industrialisation of the economy reduces the dependence of production on
land in fixed supply. Crucially, since capital can be accumulated, this helps to avoid the
problem of diminishing returns to labour.

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Box 1.2: A 14th-century pandemic

Around 1350, Europe, North Africa and Western Asia were struck by a bubonic plague
pandemic (known as the ‘Black Death’). This pandemic is believed to have killed more than
a third of the population of the affected areas. The main economic effect of the pandemic
came from the shortages of labour it created.
In the Malthusian model, a pandemic causes a temporary downward shift of the
demographic function 𝑔𝑔(𝑐𝑐). The population growth rate is 𝑔𝑔(𝑐𝑐 ) − 1, so more deaths can be
represented by a lower 𝑔𝑔(𝑐𝑐) for each value of 𝑐𝑐. Starting from a steady state, lower 𝑔𝑔(𝑐𝑐)
means a falling population. With a fixed supply of land 𝐿𝐿, land per worker 𝑙𝑙 = 𝐿𝐿/𝑁𝑁 rises, so
output and consumption per worker 𝑐𝑐 = 𝑦𝑦 = 𝑧𝑧𝑧𝑧(𝑙𝑙) are higher. This is illustrated in Figure
1.6.
For the survivors, the pandemic leads to higher output per worker because land was
previously more scarce. This is true even though total GDP 𝑌𝑌 declines when the population
falls. Once pandemic is over, 𝑔𝑔(𝑐𝑐) returns to normal and population and living standards
ultimately go back to their former steady state unless something else changes.
Figure 1.6: Population growth and output per worker in a pandemic

The pandemic also has significant distributional effects. Let us consider how total output 𝑌𝑌
is distributed among workers and owners of land in the Malthusian model. Workers do not
receive all of 𝑦𝑦 as income unless they own the land they use to produce. If competition
determines factor payments, wages 𝑤𝑤 and rents 𝑥𝑥 are equal to the marginal products of
labour 𝑀𝑀𝑃𝑃𝑁𝑁 and land 𝑀𝑀𝑃𝑃𝐿𝐿 .
With a neoclassical production function, the marginal product of labour 𝑀𝑀𝑃𝑃𝑁𝑁 is diminishing
in the population 𝑁𝑁. Given a fixed supply of land 𝐿𝐿, a lower population 𝑁𝑁 means the
marginal product of labour is higher, so wages 𝑤𝑤 = 𝑀𝑀𝑃𝑃𝑁𝑁 rise. What about rents 𝑥𝑥 = 𝑀𝑀𝑃𝑃𝐿𝐿 ?
The per worker production function implies 𝑌𝑌 = 𝑧𝑧𝑁𝑁𝑓𝑓 (𝐿𝐿⁄𝑁𝑁), which can be used to obtain
expressions for the marginal products of land and labour using the chain rule.

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𝜕𝜕𝜕𝜕 𝑁𝑁 𝐿𝐿
𝑀𝑀𝑃𝑃𝐿𝐿 = = 𝑧𝑧 𝑓𝑓 ′ � � = 𝑧𝑧𝑧𝑧′(𝑙𝑙)
𝜕𝜕𝜕𝜕 𝑁𝑁 𝑁𝑁
𝜕𝜕𝜕𝜕 𝐿𝐿 𝐿𝐿 𝐿𝐿
𝑀𝑀𝑃𝑃𝑁𝑁 = = 𝑧𝑧𝑧𝑧 � � − 𝑧𝑧𝑧𝑧 2 𝑓𝑓 ′ � � = 𝑧𝑧(𝑓𝑓(𝑙𝑙 ) − 𝑙𝑙𝑙𝑙′(𝑙𝑙))
𝜕𝜕𝜕𝜕 𝑁𝑁 𝑁𝑁 𝑁𝑁
These equations imply 𝑤𝑤 = 𝑦𝑦 − 𝑥𝑥𝑥𝑥, which says that wages are equal to output per worker
minus rent times land used per worker.
Both marginal products and hence wages and rents depend on the relative supply of land to
labour as measured by land-per-worker 𝑙𝑙 = 𝐿𝐿/𝑁𝑁. It can be seen that 𝑀𝑀𝑃𝑃𝐿𝐿 is diminishing in 𝑙𝑙
because 𝑓𝑓 (𝑙𝑙 ) = 𝐹𝐹(𝑙𝑙, 1), so 𝑓𝑓 ′′ (𝑙𝑙 ) < 0, whereas 𝑀𝑀𝑃𝑃𝑁𝑁 is increasing in 𝑙𝑙 because derivative of
𝑓𝑓(𝑙𝑙 ) − 𝑙𝑙𝑙𝑙′(𝑙𝑙) with respect to 𝑙𝑙 is 𝑓𝑓 ′ (𝑙𝑙 ) − 𝑓𝑓 ′ (𝑙𝑙 ) − 𝑙𝑙𝑓𝑓 ′′ (𝑙𝑙 ) = −𝑙𝑙𝑓𝑓 ′′ (𝑙𝑙 ) > 0. These relationships
are depicted in Figure 1.7. As the pandemic increases land per worker 𝑙𝑙, it causes a rise in
𝑀𝑀𝑃𝑃𝑁𝑁 and hence higher wages, but a fall in 𝑀𝑀𝑃𝑃𝐿𝐿 and hence lower rents.
Figure 1.7: Wages and rents with a lower population

1.4 Hours of work and the supply of labour

As well as changes in the population, the supply of labour also depends on how many hours
people work, which is related to decisions such as:

• Full-time versus part-time work?

• Participate or not in the labour market?
• Early retirement or continue working?
Here, we take as given the number of workers, also the skills, education and training of
workers, returning later to the issue of human-capital accumulation.
In our analysis of labour supply, the key trade-off is that more hours of work lead to more
income and hence a greater ability to purchase goods and services but also less time for
other things such as leisure.

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We use a simple static model (meaning there is no saving or borrowing) to study the choice
of labour supply by households. The supply of labour by a household (in units of time, e.g.
hours) is denoted by 𝑁𝑁. Time the household enjoys as leisure is denoted by 𝑙𝑙. ‘Leisure’ is a
catch-all term for anything other than time spent earning wages, so as well as leisure in the
usual sense, it also includes cooking, cleaning and childcare, activities known as ‘home
production’. While home production includes a component of work, the household benefits
from it in the sense that otherwise the household would have to pay for equivalent services
in the market, for example, eating out in restaurants, hiring a cleaner or a childminder.
A crucial constraint is that the household has a fixed amount of time ℎ available in a given
day, week, or year. Time used for work cannot also be used for leisure:
𝑁𝑁 + 𝑙𝑙 = ℎ
By working (not counting home production), the household is paid a wage 𝑤𝑤 per unit of
time, e.g. an hourly wage. This wage is specified in real terms, as with all other variables in
this chapter. If a household works for 𝑁𝑁 hours then total wage income is 𝑤𝑤𝑤𝑤. The ultimate
purpose of work is to use the income to buy goods and services. Consumption of goods and
services (not counting home production) is denoted by 𝐶𝐶.

Some households may also be able to use non-wage income such as dividend income from
owning shares to buy goods and services. The amount of non-wage income is denoted by 𝜋𝜋.
More broadly, considering the household as a family, 𝜋𝜋 could also be interpreted as the
income of an individual’s partner separate from the amount the individual earns direct.
Our analysis must also consider taxes, which influence how much households are able to
spend of their pre-tax incomes. For now, taxes are assumed to take a ‘lump sum’ form: an
amount of tax 𝑇𝑇 that must be paid irrespective of how much a household earns or
consumes, for example, a poll tax. While this simplifies matters, most taxes are not like this
and we will see what difference it makes by considering income taxes and consumption
taxes later. Note that we allow 𝑇𝑇 to be negative, indicating the household receives a
transfer payment from the government rather than being a taxpayer.
Given wage income 𝑤𝑤𝑤𝑤, non-wage income 𝜋𝜋, and taxes 𝑇𝑇, the maximum amount of
consumption affordable to a household is:
𝐶𝐶 = 𝑤𝑤𝑤𝑤 + 𝜋𝜋 − 𝑇𝑇
As this is a static model, there is no role for saving for the future in this budget constraint, so
households will consume their income. Instead, the purpose of the model is to analyse how
much labour households will supply, which affects their income and, hence, their
consumption.
Our analysis proceeds by combining the two constraints on time and spending power. Since
𝑁𝑁 = ℎ − 𝑙𝑙, we can write a combined constraint in terms of the consumption 𝐶𝐶 and leisure 𝑙𝑙
that the household ultimately values:
𝐶𝐶 + 𝑤𝑤𝑤𝑤 = 𝑤𝑤ℎ + 𝜋𝜋 − 𝑇𝑇

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This budget constraint is plotted in Figure 1.8 with leisure 𝑙𝑙 on the horizontal and
consumption 𝐶𝐶 on the vertical axis. Given the time physically available, it is not possible to
have more than ℎ hours of leisure. If a household chose the maximum amount of leisure 𝑙𝑙 =
ℎ this would mean supplying no labour and thus the ability to consume goods would depend
solely on non-wage income after tax 𝜋𝜋 − 𝑇𝑇. As leisure falls below ℎ, hours of labour supplied
increase and each extra hour of labour adds 𝑤𝑤 to wage income, increasing the ability to
consume by 𝑤𝑤. Therefore, the budget constraint is a downward-sloping straight line with
gradient −𝑤𝑤 that passes through the point (ℎ, 𝜋𝜋 − 𝑇𝑇).
Figure 1.8: Constraint on consumption and leisure

Households like both more consumption 𝐶𝐶 and more leisure 𝑙𝑙 but the constraints imply
there is a trade-off between them. To study the optimal choice of leisure and, hence, the
supply of labour, we need to say more about preferences.
We describe the household’s preferences over 𝐶𝐶 and 𝑙𝑙 using indifference curves added to
the diagram with the budget constraint. Indifference curves are downward sloping because
less of one thing the household likes requires more of the other to compensate. Indifference
curves are also assumed to be convex to the origin, as depicted in Figure 1.9. This shape
reflects a dislike of extremes where the household has very little consumption or leisure but
much more of the other.

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Figure 1.9: Indifference curves over consumption and leisure

The shape of the indifference curves can be described in terms of a diminishing marginal
rate of substitution 𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 between consumption 𝐶𝐶 and leisure 𝑙𝑙. The marginal rate of
substitution is how much extra of one good a household needs to be given to compensate
for the loss of one unit of another. The gradient of an indifference curve is −𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 , with
𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 representing how much extra consumption a household needs to receive to be no
worse off after giving up a unit of leisure by supplying more labour.
Consumption and leisure are also assumed to be normal goods. This means that when
households are better off and able to reach a higher indifference curve, they choose to have
more consumption and more leisure, holding constant the hourly wage 𝑤𝑤. In the diagram,
this means the line joining points on different indifference curves where the tangent lines
have the same gradient is upward sloping.
A household wants to reach the highest indifference curve subject to the constraints. As
shown in Figure 1.10, there are two general cases to consider. First, where it is optimal to
participate in the labour market (𝑙𝑙 < ℎ), in which case the optimal consumption-leisure
choice is where an indifference curve is tangent to the constraint, mathematically, 𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 =
𝑤𝑤. The second case is where the household does not find it optimal to participate in the
labour market (𝑙𝑙 = ℎ) and the optimal choice of 𝐶𝐶 and 𝑙𝑙 is at the corner of constraint.

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Figure 1.10: Labour-market participation decision

Participation in the labour market is optimal if the marginal rate of substitution 𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 at
zero labour supply (𝑙𝑙 = ℎ) is less than the hourly real wage 𝑤𝑤, i.e. the indifference curve
passing through the corner of the constraint is less steep than the budget constraint to the
left of this point.
This logic indicates participation in the labour market is more likely when wages 𝑤𝑤 are high,
which makes the budget constraint steeper. High taxes 𝑇𝑇 or low transfer payments (the
negative of 𝑇𝑇) increase the likelihood of participation, moving the corner (ℎ, 𝜋𝜋 − 𝑇𝑇)
downwards. Similarly, a low level of other income 𝜋𝜋 increases participation, with 𝜋𝜋 being
low because the household has little wealth or an individual’s partner does not have a high
income. Finally, preferences can also matter, with a strong preference for consumption over
leisure (a low marginal rate of substitution 𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 ) making participation more likely.

For those choosing to participate, we can also analyse how the number of hours worked
depends on these considerations.

1.5 The effects of wages on labour supply

This section studies how wages affect the supply of labour. We will use our analysis here to
derive a supply curve for labour. There are two aspects of the labour supply response to
wages. First, how do hours worked change for those participating in the labour market?
Second, how do wages affect the decision to participate or not in the labour market?

1.5.1 Effects on those already participating in the labour market

Let us first consider participants in the labour market. An increase in the real wage 𝑤𝑤 pivots
the budget constraint upwards, making a household better off all else being equal. A careful
study of how a household reacts to the wage change requires breaking down the response
into income and substitution effects.
Intuitively, the substitution effect captures the effect of wages on incentives. A higher wage
increases the price of leisure (more consumption is forgone by taking leisure), so a
household substitutes away from leisure towards consumption, which means choosing to
work more. The income effect captures the impact of wages on how well off households

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are. A higher wage makes a household better off and, since consumption and leisure are
both normal goods, there is desire to enjoy more leisure by choosing to work less.
Income and substitution effects are analysed in Figure 1.11. A higher wage makes the
budget constraint steeper, pivoting it around the corner. Formally, the substitution effect
(SE) is found by considering the effects of the steeper budget constraint gradient,
controlling for whether the household is made better off or worse off. Since the higher
wage makes the household better off, the substitution effect can be isolated by also making
a parallel shift downwards of the budget constraint so that it is tangent to the original
indifference curve. This results in a new tangency point north-west of the original tangency
because this is where the indifference curve is steeper. Leisure falls (labour supply
increases) and consumption rises.
Figure 1.11: Income and substitution effects on labour supply

The income effect (IE) is isolated by removing the hypothetical parallel shift of the budget
constraint used to derive the substitution effect. Hence, the income effect results from a
parallel upward shift of the budget constraint in this case, causing a movement on to a
higher indifference curve in a north-east direction. Leisure and consumption both rise, so
labour supply falls.
Overall, combining the substitution effect and income effect to obtain the combined effect,
consumption must rise but leisure may rise or fall. Thus, the effect of wages on labour
supply is ambiguous. In the diagram, income and substitution effects exactly cancel out for
leisure and labour supply but this is a special case. In general, either the substitution effect
or the income effect could dominate. If the substitution effect dominates, leisure falls and
labour supply rises, while if the income effect dominates, leisure rises and labour supply
falls.

1.5.2 Effect on the labour-market participation decision

What about those not already participating in the labour market? A higher wage 𝑤𝑤 makes
the budget constraint steeper, pivoting it around the point of non-participation. Since the

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indifference curve passing through that point needs to be steeper than the budget
constraint for non-participation to be optimal, a sufficiently high wage would cause an
individual to supply some labour. This is shown in Figure 1.12.
Figure 1.12: The effects of wages on labour-market participation

Taking 𝜋𝜋 as given, a higher wage 𝑤𝑤 has no offsetting income effect on the participation
decision because a higher wage does not make non-participants better off if they are not
earning any labour income. However, if 𝜋𝜋 is interpreted more broadly as including family
income from a partner who works, in this case higher wages have an income effect on the
household’s labour supply.

1.5.3 The labour supply curve

The labour supply curve shows the optimal choice of 𝑁𝑁 𝑠𝑠 = ℎ − 𝑙𝑙 for each level of real wages
𝑤𝑤. An example is shown in Figure 1.13 with the real wage 𝑤𝑤 on the vertical axis and the
quantity of labour on the horizontal axis.
Figure 1.13: The labour supply curve

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A labour supply curve can be drawn for an individual or for all households together. For
those participating in the labour market, hours worked increase with higher wages if the
substitution effect is larger than the income effect. For such households, the 𝑁𝑁 𝑠𝑠 curve is
upward sloping if the substitution effect dominates the income effect. For those not
participating initially, high wages make participation more likely and there is no offsetting
income effect until some labour is supplied by a household. An upward-sloping labour
supply curve drawn for all households can also represent more participation at higher wages
as well as those already working choosing to supply more hours.
If all households are participating in the labour market, we can think of the labour supply
curve as representing the optimality condition 𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 = 𝑤𝑤 with the marginal rate of
substitution between leisure and consumption rising as more labour is supplied because
leisure falls.

The labour supply curve shifts if there is a change in any variable that matters for optimal
labour supply other than the real wage. Lower non-wage income 𝜋𝜋, or higher taxes 𝑇𝑇, would
make a household worse off, reducing demand for leisure as a normal good and increasing
the supply of labour. This would cause 𝑁𝑁 𝑠𝑠 to shift to the right.
A very long-run perspective on labour supply is provided by the 160 years of data for the UK
shown in Figure 1.14. This graph shows time series of real wages, average hours worked per
week for those who have jobs and the fraction of the whole population who have jobs. Over
the 160 years, UK real wages rise by a factor of 20. Hours per worker, though, fall by around
half over this period. A broad measure of labour-market participation, the ratio of workers
to the total population (not adjusting for those of ‘working age’) does not display any clear
trend. One interpretation of this evidence points to the importance of income effects as UK
workers became significantly better off over this period and chose to work fewer hours.
Figure 1.14: UK wages and labour supply in the long run

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1.5.4 Do higher tax rates raise more revenue?

In the household budget constraint, taxes 𝑇𝑇 were assumed to have a ‘lump sum’ form
because the amount 𝑇𝑇 paid to the government does not depend on the household’s
choices. In practice, the amount of tax paid depends on individual behaviour. For example, a
proportional labour income tax has households pay a fixed percentage of labour income as
tax. If the household chooses to work more, more tax will be paid. Different from earlier,
this means that taxes also have effects on incentives.
Assume there is a proportional labour income tax rate of 𝜏𝜏, for example, 𝜏𝜏 = 0.2 if wages
are taxed at a 20 per cent rate. The pre-tax wage is denoted by 𝑤𝑤, and labour supply by 𝑁𝑁 𝑠𝑠 .
The amount of tax revenue collected by the government is 𝑇𝑇 = 𝜏𝜏𝜏𝜏𝑁𝑁 𝑠𝑠 in this case. The after-
tax real wage is (1 − 𝜏𝜏)𝑤𝑤, so the households now supply labour up to the point where:

𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 = (1 − 𝜏𝜏)𝑤𝑤
A higher tax rate 𝜏𝜏 reduces the after-tax wage (1 − 𝜏𝜏)𝑤𝑤, so the effects of tax are similar to
those of lower wages.
Since the tax rate 𝜏𝜏 affects tax revenue 𝑇𝑇 = 𝜏𝜏𝜏𝜏𝑁𝑁 𝑠𝑠 indirectly through its impact on
behaviour 𝑁𝑁 𝑠𝑠 as well as directly, the relationship between 𝜏𝜏 and 𝑇𝑇 is not always positive.
This leads to the ‘Laffer curve’ relationship between tax rates and revenue shown in Figure
1.15. To understand the Laffer curve, note that a 0 per cent tax rate obviously generates no
revenue. On the other hand, a 100 per cent tax rate implies no incentive to supply labour
because the after-tax wage is zero, so no tax revenue would be obtained in this case as
𝑁𝑁 𝑠𝑠 = 0. This basic logic indicates there is a tax rate somewhere between 0 per cent and 100
per cent where the Laffer curve peaks and tax revenue is maximised. After this point, higher
tax rates would reduce revenue.
Figure 1.15: A Laffer curve

Although the Laffer curve implies that ever higher tax rates eventually result in lower
revenue, it does not give specific guidance at which tax rate 𝜏𝜏 revenue will start to fall as 𝜏𝜏
rises. This is an empirical question.

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1.6 Equilibrium and efficiency

Having studied firms’ demand for labour in the context of the distribution of income in
Section 1.2 and now households’ supply of labour in Section 1.4, we can put the two
together to set up our first simple macroeconomic model. At this stage, the model is static
with only a single period, which misses out many important macroeconomic issues we will
address later.

1.6.1 A static macroeconomic model

This first macroeconomic model looks at the implications of optimising behaviour of
households and firms in the markets for labour and goods, where those markets will ‘clear’,
i.e. reach an equilibrium between demand and supply. The model will also have a
government that chooses a fiscal policy setting tax and public expenditure.
In the model, assume that all households share the same preferences (same indifference
curves over consumption and leisure) and all have equal claims on non-wage income (which
arises from ownership of capital or land). In this case, there is said to be a ‘representative
household’: the economy is comprised of many households, each of which is small relative
to the size of the economy but all will optimally choose to behave the same way because
they have the same preferences and face the same constraints.
As we have seen, optimisation by households implies a labour supply curve 𝑁𝑁 𝑠𝑠 . Since all
households are the same and will have to participate in the labour market in equilibrium, we
can represent the labour supply curve by the optimality condition 𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 = 𝑤𝑤, where
𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 is the marginal rate of substitution between leisure 𝑙𝑙 = ℎ − 𝑁𝑁 𝑠𝑠 and consumption 𝐶𝐶,
and 𝑤𝑤 is the real wage.
We have also seen that profit maximisation by firms implies a labour demand curve. Firms
hire labour up to the point where 𝑀𝑀𝑃𝑃𝑁𝑁 = 𝑤𝑤, where 𝑀𝑀𝑃𝑃𝑁𝑁 is the marginal product of labour
and 𝑁𝑁 is employment. Firms face a neoclassical production function where labour and
capital, and/or land are used to produce goods.
Other factors of production apart from labour, such as land or capital, are assumed to be in
fixed supply. This means we do not consider changes in the capital stock through investment
and there is no depreciation of existing capital. Factors of production are equally owned by
all households.
The government’s fiscal policy sets the level of public expenditure 𝐺𝐺, interpreted as
government purchases of privately produced goods and services. This expenditure is
financed by a lump-sum tax 𝑇𝑇 and every household faces the same tax 𝑇𝑇, so there is no
redistribution. Since the model is static, there is no scope here for government budget
deficits and debt, so the government’s budget constraint is 𝑇𝑇 = 𝐺𝐺.

1.6.2 Equilibrium in labour and goods markets

The labour market of the model is shown in Figure 1.16. Firms’ demand for labour 𝑁𝑁 𝑑𝑑 is
determined by 𝑀𝑀𝑃𝑃𝑁𝑁 = 𝑤𝑤, and households’ supply of labour is determined by 𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 = 𝑤𝑤.
The model is based on the real wage 𝑤𝑤 adjusting to clear the labour market, i.e. achieve

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𝑁𝑁 𝑑𝑑 = 𝑁𝑁 𝑠𝑠 , so the desired supply of labour is equal to the amount firms want to demand. This
occurs if the real wage 𝑤𝑤 adjusts to 𝑤𝑤 ∗ where the demand and supply curves cross.
Figure 1.16: Labour market equilibrium

Once equilibrium employment 𝑁𝑁 ∗ is known, the amount of goods and services 𝑌𝑌 produced
by firms is determined because all other factors (land, capital) are in fixed supply. This is the
amount firms supply to the goods market. On the demand side, households buy goods for
consumption 𝐶𝐶 and the government to provide public services 𝐺𝐺, so aggregate demand is
𝐶𝐶 + 𝐺𝐺. The government’s fiscal policy sets 𝐺𝐺 and households choose 𝐶𝐶 subject to their
budget constraint when making the consumption-leisure trade-off that underlies labour
supply. Equilibrium of the goods market requires 𝐶𝐶 + 𝐺𝐺 = 𝑌𝑌.
It turns out that another diagram for the goods market is not necessary given that labour-
market equilibrium has already been found. The amount of non-wage income received by
households is 𝜋𝜋 = 𝑌𝑌 − 𝑤𝑤𝑁𝑁 𝑑𝑑 . This is true irrespective of whether households or firms own
factors of production such as land and capital as households will ultimately receive these
factor payments as the owners of firms.
The household budget constraint is 𝐶𝐶 = 𝑤𝑤𝑁𝑁 𝑠𝑠 + 𝜋𝜋 − 𝑇𝑇, and substituting the government
budget constraint 𝐺𝐺 = 𝑇𝑇 and the equation for 𝜋𝜋, it follows that 𝐶𝐶 = 𝑌𝑌 + 𝑤𝑤(𝑁𝑁 𝑠𝑠 − 𝑁𝑁 𝑑𝑑 ) − 𝐺𝐺.
Writing this as 𝑌𝑌 − (𝐶𝐶 + 𝐺𝐺 ) = 𝑤𝑤(𝑁𝑁 𝑑𝑑 − 𝑁𝑁 𝑠𝑠 ), labour-market equilibrium 𝑁𝑁 𝑑𝑑 = 𝑁𝑁 𝑠𝑠 implies
𝐶𝐶 + 𝐺𝐺 = 𝑌𝑌, so the goods market must also be in equilibrium.

1.6.3 Economic efficiency

One important implication of equilibrium, at least for the simple model studied here, is that
the outcomes for employment, output and consumption are economically efficient,
conditional on the government’s choice of public expenditure 𝐺𝐺. This is because 𝑁𝑁 𝑑𝑑 = 𝑁𝑁 𝑠𝑠
means that 𝑀𝑀𝑃𝑃𝑁𝑁 = 𝑤𝑤 ∗ = 𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 , so the market-clearing real wage is equal to the marginal
product of labour and the marginal rate of substitution between leisure and consumption.
Intuitively, once the economy reaches equilibrium, the marginal value (measured in goods)
that households put on a unit of their time is equal to what amount of goods firms can

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produce with that unit of time. A basic function of an economy is to allow households to
turn their time as work into income that can be spent on goods and services. Here, the
market economy performs this task as well as possible and we say that the market
equilibrium is economically efficient, or Pareto efficient.
Note that we say nothing here about whether the government’s choice of public
expenditure 𝐺𝐺 is optimal and, hence, whether the allocation of resources between private
spending 𝐶𝐶 and public spending 𝐺𝐺 is optimal. The desirability of a particular amount of
public expenditure is taken as given here.

A more careful way to reach the efficiency result is to imagine a hypothetical world where a
government can control all economic decisions (consumption, employment, etc.) without
the need for markets. The government is said to be the ‘social planner’ in this case. Assume
the government acts benevolently with the aim of making the representative household as
well off as possible.
The economy’s ability to produce goods and services is still limited by the production
function 𝑌𝑌 = 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝑁𝑁), where 𝐾𝐾 is denotes a factor of production other than labour, for
example, capital. The supply of this factor is fixed here. Assume that a particular level of
public expenditure 𝐺𝐺 is desirable. The government faces a resource constraint 𝐶𝐶 + 𝐺𝐺 = 𝑌𝑌
and a constraint 𝑙𝑙 + 𝑁𝑁 = ℎ on households’ time. Combining these and the production
function leads to a single constraint 𝐶𝐶 = 𝑧𝑧𝑧𝑧 (𝐾𝐾, ℎ − 𝑙𝑙 ) − 𝐺𝐺 linking consumption 𝐶𝐶 and
leisure 𝑙𝑙, the two things households ultimately care about. The constraint and the
representative household’s indifference curves are illustrated in Figure 1.17.
The ability to raise consumption by reducing leisure and setting households to work longer
is found by differentiating the constraint with respect to leisure 𝑙𝑙:
𝜕𝜕𝜕𝜕
= −𝑧𝑧𝐹𝐹𝑁𝑁 (𝐾𝐾, ℎ − 𝑙𝑙 ) = −𝑀𝑀𝑃𝑃𝑁𝑁
𝜕𝜕𝜕𝜕
The gradient is the negative of the marginal product of labour, so the constraint is
downward sloping and becomes steeper as 𝑙𝑙 rises (because 𝑁𝑁 falls, increasing 𝑀𝑀𝑃𝑃𝑁𝑁 ). To
make representative-household utility as high as possible subject to the constraint, the
social planner would choose a combination (𝑙𝑙, 𝐶𝐶) such that 𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 = 𝑀𝑀𝑃𝑃𝑁𝑁 , where an
indifference curve is tangent to the constraint.

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Figure 1.17: The social planner allocation

Since the market equilibrium features 𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 = 𝑀𝑀𝑃𝑃𝑁𝑁 and satisfies the same constraints
faced by the government, the market equilibrium and the benevolent planner’s choice
coincide. It is not possible to make the representative household better off than in the
market equilibrium, so the equilibrium is efficient.
More generally, without a representative household, the market equilibrium is said to be
Pareto-efficient if no one can be made better off without making someone else worse off. It
is a general result (the first welfare theorem) that an equilibrium is Pareto efficient if:

• Markets are perfectly competitive

• There are no externalities or tax distortions
• There are no missing markets or restrictions on trade
We will see many examples later where an equilibrium is not efficient. In these cases, the
economy is failing in its basic function to allow households to convert their time into work
and enjoy the fruits of their labours.

Box 1.4: Should wages or rents be taxed to pay for public expenditure?
This application addresses the question of how a government should best pay for a given
amount of public services 𝐺𝐺 it needs to provide. Here we assume that lump-sum taxes are
not available. Instead, the government is restricted to taxing different types of income.
Assume firms produce output of goods and services using land 𝐿𝐿 and labour 𝑁𝑁. The
production function is 𝑌𝑌 = 𝑎𝑎𝑎𝑎 + 𝑏𝑏𝑏𝑏, which is linear in both 𝐿𝐿 and 𝑁𝑁. This is not a
neoclassical production function but it is useful for illustration and the arguments
developed here apply more generally. The marginal products of labour and land are
𝑀𝑀𝑃𝑃𝑁𝑁 = 𝑎𝑎 and 𝑀𝑀𝑃𝑃𝐿𝐿 = 𝑏𝑏, where 𝑎𝑎 and 𝑏𝑏 are positive constants. With firms hiring labour
and renting land in competitive factor markets, the pre-tax wage 𝑤𝑤 and rent 𝑥𝑥 must be
equal to these constant marginal products:
𝑤𝑤 = 𝑀𝑀𝑃𝑃𝑁𝑁 = 𝑎𝑎 , 𝑥𝑥 = 𝑀𝑀𝑃𝑃𝐿𝐿 = 𝑏𝑏

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The economy has a fixed supply of land 𝐿𝐿. The supply of labour 𝑁𝑁 is chosen by a
representative household that owns an equal share of the economy’s land. The
government can only levy proportional taxes on incomes, setting a tax rate 𝜏𝜏𝑤𝑤 on wage
income and a tax rate 𝜏𝜏𝑥𝑥 on rental income. The total amount of tax revenue raised is
𝜏𝜏𝑤𝑤 𝑤𝑤𝑤𝑤 + 𝜏𝜏𝑥𝑥 𝑥𝑥𝑥𝑥. With 𝑤𝑤 and 𝑥𝑥 equal to the constants 𝑎𝑎 and 𝑏𝑏, the budget constraint of
the government is:
𝑎𝑎𝜏𝜏𝑤𝑤 𝑁𝑁 + 𝑏𝑏𝜏𝜏𝑥𝑥 𝐿𝐿 = 𝐺𝐺
The total amount of income (wages and rents) the representative household receives
after tax is (1 − 𝜏𝜏𝑤𝑤 )𝑤𝑤𝑤𝑤 + (1 − 𝜏𝜏𝑥𝑥 )𝑥𝑥𝑥𝑥 and the budget constraint is 𝐶𝐶 = 𝑎𝑎(1 − 𝜏𝜏𝑤𝑤 )𝑁𝑁 +
𝑏𝑏(1 − 𝜏𝜏𝑥𝑥 )𝐿𝐿. With a given amount of time ℎ available, labour supply is equal to 𝑁𝑁 = ℎ −
𝑙𝑙, where 𝑙𝑙 is the choice of leisure. The combined constraint faced by the household is:
𝐶𝐶 + 𝑎𝑎(1 − 𝜏𝜏𝑤𝑤 )𝑙𝑙 = 𝑎𝑎(1 − 𝜏𝜏𝑤𝑤 )ℎ + 𝑏𝑏(1 − 𝜏𝜏𝑥𝑥 )𝐿𝐿
1.6.4 Taxing wages but not rents
Suppose initially that only wage income is taxed, so 𝜏𝜏𝑥𝑥 = 0. The government’s budget
constraint simplifies to 𝑎𝑎𝑎𝑎𝑤𝑤 𝑁𝑁 = 𝐺𝐺 and the household’s budget constraint is 𝐶𝐶 +
𝑎𝑎(1 − 𝜏𝜏𝑤𝑤 )𝑙𝑙 = 𝑎𝑎(1 − 𝜏𝜏𝑤𝑤 )ℎ + 𝑏𝑏𝑏𝑏. The household chooses 𝐶𝐶 and 𝑙𝑙 at the tangency of the
budget constraint and an indifference curve, i.e. where 𝑀𝑀𝑀𝑀𝑆𝑆𝑙𝑙,𝐶𝐶 = 𝑎𝑎 (1 − 𝜏𝜏𝑤𝑤 ). The
gradient of the budget constraint is the after-tax wage 𝑎𝑎(1 − 𝜏𝜏𝑤𝑤 ). Figure 1.18 depicts
this tangency point (𝑙𝑙1∗ , 𝐶𝐶1∗ ) as the economy’s initial equilibrium.
Figure 1.18: Taxes on rents instead of taxes on wages

1.6.5 Taxing rents but not wages

Now suppose the government switches completely to taxing rents instead of wages, so
𝜏𝜏𝑤𝑤 = 0. The government’s budget constraint is now 𝑏𝑏𝜏𝜏𝑥𝑥 𝐿𝐿 = 𝐺𝐺. For this alternative tax
system to be feasible it is necessary that 𝑏𝑏𝑏𝑏 > 𝐺𝐺, which says that there is enough rental
income to tax given the need for public expenditure (the government budget constraint
can hold for a tax rate less than 100 per cent). This is an important limitation on this
analysis that should be borne in mind.

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The household budget constraint in this case is 𝐶𝐶 + 𝑎𝑎𝑎𝑎 = 𝑎𝑎ℎ + 𝑏𝑏(1 − 𝜏𝜏𝑥𝑥 )𝐿𝐿. This has
gradient −𝑎𝑎 instead of −𝑎𝑎(1 − 𝜏𝜏𝑤𝑤 ), so the budget constraint becomes steeper as the after-
tax wage rises. The budget constraint also shifts down at 𝑙𝑙 = ℎ, reflecting the reduction in
non-wage income after tax.
A crucial observation is that the choice of 𝐶𝐶1∗ and 𝑙𝑙1∗ under the previous tax system remains
affordable under the new one. This is because 𝐶𝐶1∗ and 𝑙𝑙1∗ satisfy 𝑎𝑎𝜏𝜏𝑤𝑤 (ℎ − 𝑙𝑙1∗ ) = 𝑎𝑎𝜏𝜏𝑤𝑤 𝑁𝑁1∗ =
𝐺𝐺 = 𝑏𝑏𝜏𝜏𝑥𝑥 𝐿𝐿 and 𝐶𝐶1∗ + 𝑎𝑎(1 − 𝜏𝜏𝑤𝑤 )𝑙𝑙1∗ = 𝑎𝑎(1 − 𝜏𝜏𝑤𝑤 )ℎ + 𝑏𝑏𝑏𝑏, so they also consistent with the new
budget constraint 𝐶𝐶1∗ + 𝑎𝑎𝑙𝑙1∗ = 𝑎𝑎ℎ + 𝑏𝑏(1 − 𝜏𝜏𝑥𝑥 )𝐿𝐿. Therefore, the original choice of leisure
and consumption remains on the new budget constraint. Since the budget constraint is now
steeper, it must cut the indifference curve at this point because there is a tangency with a
less steep budget line there.
It is possible to reach a higher indifference curve under the new tax system by choosing less
leisure, a higher labour supply, and more consumption. The analysis indicates a switch from
taxing wages to taxing rents makes the representative household better off. This is because
households’ labour supply choice is distorted by a proportional income tax that
disincentivises work. On the other hand, the supply of land is inelastic and does not respond
to tax. The removal of this distortion to labour supply and production allows the
representative household to reach a higher indifference curve.
As noted, in practice, rental income may not be high enough to shift tax burden completely
away from wages (which would require total pre-tax rents exceed total public expenditure,
𝑏𝑏𝑏𝑏 > 𝐺𝐺). By having a representative household, the analysis also ignores the distributional
consequences of such shifts in the tax system.

1.7 Capital accumulation

Modern industrial or service-based economies produce output mainly using capital and
labour rather than land. Capital is defined as goods used for the production of other goods
and services in the future (in other words, capital is not an intermediate input that is
immediately used up in current production). Capital includes such things as machinery,
buildings, computers, and aeroplanes. An important question we will address is whether
economic growth can be explained through a process of accumulating capital. In Section
2.30, we will also look at whether different levels of capital accumulation across countries
can explain differences in countries’ income levels.

Capital 𝐾𝐾 used for production is a stock variable, not a flow. Adding new capital to the
capital stock is a flow variable known as investment 𝐼𝐼. While capital is not immediately used
up in producing other goods, it does not last forever, in other words, there is depreciation.
Depreciation is the loss of capital from wear and tear or obsolescence, or maintenance costs
incurred to avoid this loss. We assume depreciation of capital takes place at a constant rate
𝑑𝑑 over time. The following equation describes the process of capital accumulation:
𝐾𝐾 ′ = (1 − 𝑑𝑑 )𝐾𝐾 + 𝐼𝐼

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Next year’s capital stock 𝐾𝐾′ is equal to capital left over (1 − 𝑑𝑑 )𝐾𝐾 after depreciation from the
current time plus investment 𝐼𝐼.
Focusing on capital and labour as the relevant factors of production and ignoring land, the
production function is:
𝑌𝑌 = 𝑧𝑧𝑧𝑧 (𝐾𝐾, 𝑁𝑁)
GDP is 𝑌𝑌, the labour force is 𝑁𝑁 (the number of workers), the capital stock is 𝐾𝐾, and total
factor productivity (TFP) is 𝑧𝑧. The production function 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝑁𝑁) is assumed to be
neoclassical, and the most important of the neoclassical assumptions here is the diminishing
marginal product of capital. The Cobb-Douglas production function 𝑌𝑌 = 𝑧𝑧𝐾𝐾 𝛼𝛼 𝑁𝑁 1−𝛼𝛼 is one
such example of a neoclassical production function. The value of the parameter 𝛼𝛼 could be
estimated using the capital share of income.

How is the capital stock 𝐾𝐾 measured? There are two approaches. First, the perpetual
inventory method. The change in the capital stock from one year to the next can be
calculated using 𝐾𝐾 ′ − 𝐾𝐾 = 𝐼𝐼 − 𝑑𝑑𝑑𝑑. Hence, given an estimate of 𝐾𝐾, the capital stock 𝐾𝐾′ can
be estimated by adding investment 𝐼𝐼 from the national accounts and subtracting an
estimate of the depreciation rate 𝑑𝑑 multiplied by 𝐾𝐾. Starting from some conjectured initial
value, this method can be applied iteratively to construct a time series of capital-stock
estimates.
A second method is based on imputation from capital income. Suppose we have an estimate
of the gross percentage return on capital 𝑅𝑅. Then given a measure of GDP 𝑌𝑌 and the capital
share of GDP 𝛼𝛼, the implied capital stock is 𝐾𝐾 = 𝛼𝛼𝛼𝛼⁄𝑅𝑅 .
In studying capital accumulation, we will mainly be concerned with the output per worker
𝑦𝑦 = 𝑌𝑌/𝑁𝑁, not total output 𝑌𝑌. Since the production function 𝑌𝑌 = 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝑁𝑁) has constant
returns to scale, output per worker is given by:
𝑧𝑧𝑧𝑧(𝐾𝐾, 𝑁𝑁) 𝐾𝐾 𝑁𝑁
𝑦𝑦 = = 𝑧𝑧𝑧𝑧 � , � = 𝑧𝑧𝑧𝑧 (𝑘𝑘, 1) = 𝑧𝑧𝑧𝑧(𝑘𝑘)
𝑁𝑁 𝑁𝑁 𝑁𝑁
This shows that 𝑦𝑦 depends on capital per worker 𝑘𝑘 = 𝐾𝐾/𝑁𝑁 and TFP 𝑧𝑧. The equation 𝑦𝑦 =
𝑧𝑧𝑧𝑧(𝑘𝑘) is called the ‘per worker production function’, where the function 𝑓𝑓 (𝑘𝑘) is defined by
𝑓𝑓 (𝑘𝑘) = 𝐹𝐹(𝑘𝑘, 1). It is an increasing and concave function as shown in Figure 1.19 because
𝑧𝑧𝑓𝑓′(𝑘𝑘) is the marginal product of capital.

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Figure 1.19: Output per worker and capital per worker

1.8 The Solow model

The Solow model explains the level of capital accumulation in an economy with a
neoclassical production function 𝑌𝑌 = 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝑁𝑁) and its implications for the level and growth
rate of real GDP. To begin with, we will assume that TFP 𝑧𝑧 is constant over time. Later in 0,
we consider a version of the Solow model where 𝑧𝑧 is increasing over time owing to
technological progress.
The Solow model focuses on capital accumulation, so the supply of labour 𝑁𝑁, which is both
the labour force and the population, is taken to be exogenous. Assume that 𝑁𝑁 grows at rate
𝑛𝑛 over time. The Solow model assumes a closed economy with no government sector, which
implies investment 𝐼𝐼 is equal to household saving 𝑆𝑆 in equilibrium. This follows from the
definition 𝑆𝑆 = 𝑌𝑌 − 𝐶𝐶 with no taxes, and the goods-market equilibrium condition 𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼
with no public expenditure or international trade. Households’ saving behaviour is
exogenous – specifically, households save a given fraction 𝑠𝑠 of income 𝑌𝑌.
Mathematically, the assumptions of the Solow model are the following equations:

• The neoclassical production function: 𝑌𝑌 = 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝑁𝑁)

• The capital accumulation equation: 𝐾𝐾 ′ = (1 − 𝑑𝑑 )𝐾𝐾 + 𝐼𝐼
• Investment equals saving condition: 𝐼𝐼 = 𝑆𝑆
• Households’ saving behaviour: 𝑆𝑆 = 𝑠𝑠𝑠𝑠
• The labour force grows at a constant rate: 𝑁𝑁 ′ = (1 + 𝑛𝑛)𝑁𝑁
Putting together the production function, the requirement that investment equals saving
and the fixed saving rate, the implications for next year’s capital stock 𝐾𝐾′ are:
𝐾𝐾 ′ = (1 − 𝑑𝑑 )𝐾𝐾 + 𝑠𝑠𝑠𝑠𝑠𝑠(𝐾𝐾, 𝑁𝑁)
Together with the demographic assumption of constant population growth, we have
equations for 𝐾𝐾′ and 𝑁𝑁′ in terms of 𝐾𝐾 and 𝑁𝑁, so we can calculate how the supplies of factors
of production evolve over time in the economy.

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The per worker production function 𝑦𝑦 = 𝑧𝑧𝑧𝑧(𝑘𝑘) implies output per worker depends on the
ratio of 𝐾𝐾 to 𝑁𝑁. As 𝑦𝑦 is the ultimate variable of interest, we only need to keep track of the
ratio of capital per worker 𝑘𝑘 = 𝐾𝐾/𝑁𝑁 over time. By combining the equations for 𝐾𝐾 ′ and 𝑁𝑁 ′ :
𝐾𝐾 ′ (1 − 𝑑𝑑 )𝐾𝐾 + 𝑠𝑠𝑠𝑠 (1 − 𝑑𝑑 )𝑘𝑘 + 𝑠𝑠𝑠𝑠
𝑘𝑘 ′ = = =
𝑁𝑁′ (1 + 𝑛𝑛)𝑁𝑁 1 + 𝑛𝑛
Using 𝑦𝑦 = 𝑧𝑧𝑧𝑧(𝑘𝑘), the right-hand side of the equation depends on capital per worker 𝑘𝑘 only:
(1 − 𝑑𝑑 )𝑘𝑘 + 𝑠𝑠𝑠𝑠𝑠𝑠(𝑘𝑘)
𝑘𝑘 ′ =
1 + 𝑛𝑛
Subtracting 𝑘𝑘 from both sides leads to an equation for the change in 𝑘𝑘 over time:
𝑠𝑠𝑠𝑠𝑠𝑠 (𝑘𝑘) − (𝑑𝑑 + 𝑛𝑛)𝑘𝑘
𝑘𝑘 ′ − 𝑘𝑘 =
1 + 𝑛𝑛
We conclude from this equation that changes in the amount of capital accumulated per
worker are explained by the difference between two terms. First, 𝑠𝑠𝑠𝑠𝑠𝑠 (𝑘𝑘), the amount of
saving and hence of investment per worker, which is the saving rate 𝑠𝑠 multiplied by the per-
worker production function 𝑦𝑦 = 𝑧𝑧𝑧𝑧(𝑘𝑘). Second, (𝑑𝑑 + 𝑛𝑛)𝑘𝑘, the amount of investment per
worker needed to sustain the same level of capital per worker next year. This interpretation
comes from a fraction 𝑑𝑑 of all capital depreciating, so an amount of capital per worker 𝑑𝑑𝑑𝑑
must be replaced to keep capital per worker unchanged. Furthermore, the number of
workers increases by a percentage 𝑛𝑛 each year, so if existing workers use capital 𝑘𝑘 each,
there needs to be investment 𝑛𝑛𝑛𝑛 per existing worker to give future workers the same capital
𝑘𝑘 each as current workers.

1.8.1 The Solow diagram

We can use a diagram to study the evolution over time of capital per worker 𝑘𝑘 and its
implications for output per worker 𝑦𝑦. Figure 1.20 is this key diagram of the Solow model
that plots:

• The per worker production function 𝑦𝑦 = 𝑧𝑧𝑧𝑧(𝑘𝑘), which is an increasing and concave
function of 𝑘𝑘.
• The ‘saving line’ 𝑠𝑠𝑠𝑠𝑠𝑠(𝑘𝑘), a scaled-down version of 𝑧𝑧𝑧𝑧(𝑘𝑘) because of 0 < 𝑠𝑠 < 1 and,
hence, an increasing and concave function of 𝑘𝑘.
• The ‘effective depreciation line’ (𝑑𝑑 + 𝑛𝑛)𝑘𝑘, an upward-sloping straight line with
gradient given by the effective depreciation rate of capital per worker: the sum of
the depreciation rate plus the growth rate of the labour force.
Starting from a low level of capital per worker, the saving line is above the effective
depreciation line because the production function and saving line are initially very steep,
reflecting a high marginal product of capital. This means 𝑘𝑘 ′ − 𝑘𝑘 > 0, so capital per worker 𝑘𝑘
is increasing over time. This leads to higher output per worker 𝑦𝑦 since 𝑦𝑦 = 𝑧𝑧𝑧𝑧(𝑘𝑘), with the
economy moving along the per worker production function over time. Starting from this
position, by adding more capital per worker, workers’ productivity can be increased and the
economy experiences growth in output per worker coming from capital accumulation.

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Figure 1.20: The Solow model diagram

The steady state of the Solow model

It is an important implication of the Solow model that such growth in output per worker
cannot continue indefinitely. We can see this from the Solow model diagram because there
is a steady state where the saving line crosses the effective depreciation line. If the economy
reaches this level of capital per worker 𝑘𝑘, it will remain at that level of 𝑘𝑘 unless something
changes. Mathematically, if 𝑠𝑠𝑠𝑠𝑠𝑠 (𝑘𝑘) = (𝑑𝑑 + 𝑛𝑛)𝑘𝑘 then 𝑘𝑘 ′ = 𝑘𝑘.
With no further change in 𝑘𝑘, there is no further growth in output per worker 𝑦𝑦 unless
something else changes because 𝑦𝑦 = 𝑧𝑧𝑧𝑧(𝑘𝑘). Notice that both GDP 𝑌𝑌 and the total capital
stock 𝐾𝐾 are still growing in line with the labour force 𝑁𝑁 at rate 𝑛𝑛 but the more important
variable is how much is produced and earned per worker.

Does the basic Solow model always have such a steady state where growth in per worker
incomes grinds to a halt? If the production function is neoclassical, the gradient of 𝑓𝑓(𝑘𝑘) is
extremely large for 𝑘𝑘 close to zero but declines as 𝑘𝑘 increases and approaches zero as 𝑘𝑘
becomes large. The saving line 𝑠𝑠𝑠𝑠𝑠𝑠(𝑘𝑘), as a multiple of 𝑓𝑓(𝑘𝑘), shares the same properties.
On the other hand, the gradient of the effective depreciation line is constant. Consequently,
there exists a positive steady state 𝑘𝑘 ∗ (and only one) where the saving and effective
depreciation lines cross.
Moreover, the saving line is above the effective depreciation line for 𝑘𝑘 below 𝑘𝑘 ∗ , which
means that 𝑘𝑘 rises over time when it is below 𝑘𝑘 ∗ (and would fall over time if above 𝑘𝑘 ∗ ). The
economy thus converges to 𝑘𝑘 ∗ in the long run, so this point of stagnation is eventually
reached.
The Solow model also always has a steady state with zero capital per worker because some
capital is essential for production with a neoclassical production function. However, the
economy would diverge from this steady state no matter how close it gets, so this does not
need to be taken seriously and is ignored in what follows.

In summary, while the Solow model can explain how a country can become richer starting
from a low level of capital accumulation, it cannot explain long-run growth. Intuitively,
returns to capital are high when capital is initially scarce, so investment leads to large

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increases in income. After that, diminishing returns to capital means that further investment
has lower returns and, with less extra output generated per unit of capital while the
maintenance cost of capital increases proportionately, a point is reached where the capital
stock cannot rise any further.

Box 1.5: The ‘Asian tiger’ economies

The so-called ‘Asian tiger’ economies (Singapore, Taiwan, Hong Kong, South Korea)
experienced very fast economic growth in the period from 1960 to 1990 but their growth
rates subsequently declined. The process of development in these economies provides a
good example of the mechanisms at work in the Solow model.
Let us consider Singapore for illustration. Figure 1.21 shows that Singapore has had a very
high national saving rate, which was above 40 per cent since the 1980s and sometimes
even above 50 per cent. While not all of this saving was channelled into domestic
investment, the share of investment in GDP was also very high in Singapore. Consequently,
Singapore’s economy experienced rapid capital accumulation, although it started from a
low base in the 1960s. The time series of the average amount of capital per worker in
Singapore is plotted in Figure 1.22. The amount of capital per worker increases by
approximately 400 per cent (in real terms) over the 40-year period after 1970.
Figure 1.21: Singapore national saving rate

This process of rapid capital accumulation is what the Solow model predicts for an
economy with a high saving rate and a low initial level of capital per worker. The model
predicts this would lead to a significant increase in income per worker and income per
person as the economy moves along the per worker production function. Data on real
income per person are shown in Figure 1.23 and we see that there is a dramatic
improvement in prosperity.

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Figure 1.22: Singapore capital per worker

Another prediction of the Solow model is that the rate of progress, specifically, the growth
rate of income per person would gradually slow down over time, even if the economy
maintained very high rates of saving. It is not easy to read growth rates from a graph of
income plotted on an ordinary scale against time. By taking logarithms of the data, or
using a logarithmic scale, the gradient of the time series is informative about the growth
rate.
Figure 1.23: Singapore real GDP per person

Figure 1.24 plots the natural logarithm of real income per person against time. Here we
see that the gradient of the graph tends to decrease over time, indicating that economic
growth is slowing down in Singapore. This happens even though the saving rate does not
fall over this period but actually rises. Such a growth slowdown as capital per worker rises
is in line with the Solow model’s prediction, which is a consequence of diminishing returns
to capital.

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Figure 1.24: Singapore log real GDP per person

The growth slowdown can be seen more directly in Figure 1.25, which plots growth rates of
real income per person averaged over each decade.
Figure 1.25: Singapore average growth rates by decade

While these predictions are consistent with the basic Solow model, we do not necessarily see
evidence that growth rates of income per person are falling all the way to zero. Even in
developed economies that have been experiencing growth for more than a century, we still
typically see growth being positive. In contrast, the basic Solow model predicts that the long-
run growth rate of income per person is zero. The inability to explain long-run growth is one
of the major weaknesses of the Solow model and we will return to this issue in Chapter 2.

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Box 1.6: Interest rates in the long run

Capital accumulation in the Solow model is financed by households’ saving and,
moreover, in a closed economy with no government debt that investment is the only
outlet for those savings. What then are the Solow model’s implications for the return
received by savers?
The real interest rate 𝑟𝑟 is real return earned from owning capital. In an economy with
competitive markets, owners of capital are able to rent it to firms at price 𝑅𝑅 = 𝑀𝑀𝑃𝑃𝐾𝐾 , the
marginal product of capital. The real return 𝑟𝑟 on capital is equal to the rental price 𝑅𝑅
minus the cost of replacing capital lost through depreciation, which is 𝑑𝑑 per unit of
capital.
𝑟𝑟 = 𝑅𝑅 − 𝑑𝑑
Firms are producing output according to the production function 𝑌𝑌 = 𝑧𝑧𝑧𝑧(𝐾𝐾, 𝑁𝑁). In per
worker terms, this production function is 𝑦𝑦 = 𝑧𝑧𝑧𝑧(𝑘𝑘), where 𝑓𝑓 (𝑘𝑘) = 𝐹𝐹(𝑘𝑘, 1). Since
aggregate output can be written as 𝑌𝑌 = 𝑧𝑧𝑧𝑧𝑧𝑧(𝐾𝐾⁄𝑁𝑁), the marginal product of capital is
𝑀𝑀𝑃𝑃𝐾𝐾 = 𝜕𝜕𝜕𝜕⁄𝜕𝜕𝜕𝜕 = 𝑧𝑧𝑧𝑧′(𝐾𝐾⁄𝑁𝑁) = 𝑧𝑧𝑧𝑧′(𝑘𝑘). Therefore, the real return on capital is
𝑟𝑟 = 𝑧𝑧𝑓𝑓 ′ (𝑘𝑘) − 𝑑𝑑
The Solow model predicts that capital per worker 𝑘𝑘 converges to a steady state in the
long run. Starting from a low initial level, the stock of capital rises over time relative to
the number of workers as the economy converges to its steady state. With a diminishing
marginal product of capital, 𝑓𝑓′(𝑘𝑘) is decreasing in 𝑘𝑘, so this means 𝑟𝑟 declines as capital
per worker increases. The Solow model predicts the real return 𝑟𝑟 received by savers falls
over time, ultimately converging to a steady state. This argument is illustrated
graphically in Figure 1.26. As we will see, this steady state for 𝑟𝑟 could be positive or
negative.
Figure 1.26: Real interest rates over time in the Solow model

What can we say about real returns empirically over time? It is not easy to measure 𝑟𝑟 in
a consistent way over very long periods. Figure 1.27 plots a time series of real interest
rates on UK government bonds over a 300-year period. This real bond yield is taken as a
proxy for the real return earned by savers (even though government bonds are

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not included in the Solow model, if they were, savers would have a choice of holding
bonds or capital, so the returns on the two assets would be linked).
Real interest rates in the UK have fluctuated over a wide range during those three
centuries, sometimes being as high as 8 per cent and sometimes turning negative.
Looking at the picture as a whole, it appears there is a moderate downward trend in
real interest rates over time.
Figure 1.27: UK real interest rates in the long run

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