Economic growth and economic development 504

Introduction to Modern Economic Growth More interesting than the underinvestment result is the imbalance in the physical to human capital ratio of the economy, which did not feature in the previous two environments we discussed The following proposition summarizes this imbalance result in a sharp way: Proposition 10.5 Consider the positive activity equilibrium described in Proposition 10.3 Output is equal to if either λ = or λ = Moreover, there exists λ∗ ∈ (0, 1) that maximizes output Proof See Exercise 10.19 Ô Intuitively, dierent levels of λ create different types of “imbalances” between physical and human capital A high level of λ implies that workers have a strong bargaining position, and this encourages their human capital investments But symmetrically, it discourages the physical capital investments of firms, since they will only receive a small fraction of the output Therefore, high level of λ (as long as we have λ < 1) creates an imbalance with too high a level of human capital relative to physical capital This imbalance effect becomes more extreme as λ → In this limit, workers’ investment behavior is converging to the first-order condition of the ¯ i (k) for all k > 0) However, simultaneously, the ˆ i (k) → h social planner (i.e., h ˆ is converging to zero, and this implies physical capital investment of each firm, k, ˆ i (k) → 0, and production collapses The same happens, in reverse, when λ is that h too low Now there is too high a level of physical capital relative to human capital An intermediate value of λ∗ achieves a balance, though the equilibrium continues to be inefficient as shown in Proposition 10.5 Physical-human capital imbalances can also increase the role of human capital in cross-country income differences In the current model, the proportional impact of a change in human capital on aggregate output (or on labor productivity) is greater than the return to human capital, since the latter is determined not by the marginal product of human capital, but by the bargaining parameter λ The deviation from competitive factor prices, therefore, decouples the contribution of human capital to productivity from market prices At the root of the inefficiencies and of the imbalance effect in this model are pecuniary externalities Pecuniary externalities refer to external effects that work 490