Ecological Economics Week 6 Tiago Domingos Assistant Professor Environment and Energy Section Department of Mechanical Engineering Doctoral Program and Advanced Degree in Sustainable Energy Systems Doctoral Program in Mechanical Engineering

Assignments Cost minimization a) b)

Assignments Equilibrium a) b)

Assignments Equilibrium c) d) e e) Consumer surplus Producer surplus

Assignments Pollution economics Market equilibrium Social Optimum

Economic Growth and Dynamic Optimization Rui Mota – Tel Ext April 2009

Economic growth

Economic growth: Stylized facts (Check with IMF Data Mapper) Big differences in output per capita across countries. Growth rates vary substantially across countries. Convergence: In the long run, all countries will converge to the same growth rate and level of income per worker. –Income per worker converges to the same level across countries conditional on the countries being structurally alike. Conditional on structural differences across countries, a lower level of initial output tends to be associated with a higher rate of growth. Growth rates of GDP per capita have been relatively constant around percent in Western Europe and North America for at least 130 years.

Economic growth: Stylized facts (Check with IMF Data Mapper)

Economic growth: Kaldor (1961) Stylized facts Per capita output Y/L grows over time. Physical capital per worker K/L grows over time Rate of return to capital r nearly constant (profit on capital). Ratio of capital to output K/Y nearly constant Shares of labor wL/Y and physical capital rK/Y in national income nearly constant.

Solow Model Solow (1956) – Main theoretical tool for economic growth until the 1980’s Nobel prize in Economics for his contribution to the theory of economic growth. (1924- ) In spite of being very limited and largely inappropriate to account for the growth dynamics of modern economies, in particular the disparities of economic growth across time and space, the Solow model is the starting point for almost all analysis of economic growth. – Benchmark Model

Solow Model – Rationale Is it possible for an economy to enjoy positive growth rates forever by simply saving and investing in its capital stock? Starting point: Try to relate the growth rate with the willingness to save and invest. Simple model where the only source of growth is accumulation of physical capital (durable physical inputs – machinery, buildings, pencils...). General growth model: –Households own assets and inputs to production, and choose fractions of their income to consume and save. –Firms hire inputs (e.g., L, K) and use them with technology to produce goods that they sell to households or other firms –Markets exist for goods and inputs in production.

Solow Model – Assumptions Closed economy with no government; Single composite good is produced and transacted (this means that if we have more than one good the relative prices are constant); the good can be used for consumption and investment; the good is produced, using capital and labor; investment allows for capital accumulation, therefore physical capital is a reproducible input; population grows at an exogenous rate and all factors of production are fully employed. all markets, i.e., factors, product and financial markets are perfectly competitive;

Solow Model – Assumptions Can capital accumulation explain observed growth? How does the capital accumulation behaves along time and what are the explanatory variables? Consumers: – Receive income Y(t) from labour supply and ownership of firms –consume a constant proportion of income

Solow Model – Assumptions Labour augmenting production function: Constant returns to scale Positive and diminishing returns to inputs: Inada (1964) conditions: –Ensures the existence of equilibrium. Example of a neoclassical production function: –Cobb-Douglas: –Intensive form:

Solow Model – Dynamics Labour and knowledge (exogenous): Dynamics of man-made Capital Dynamics per unit of effective labor - actual investment per unit of effective labour - break-even investment.

Solow Model – Balanced Growth Path t How do the variables of the model behave in the steady state?

Solow Model – Dynamics On the Balanced Growth Path (BGP) – Each variable is growing at a constant rate. – Growth of output per worker is determined solely by the technological progress Stylized facts (Kaldor, 1961): – Growth rates of labor, capital and output are roughly constant; –Capital/output ratio roughly constant; – Output per worker and capital per worker are rising.

Solow Model – Central questions of growth theory Only changes in technological progress have growth effects on per capita variables. Convergence occurs because savings allow for net capital accumulation, but the presence of decreasing marginal returns imply that the this effect decreases with increases in the level of capital. Two possible sources of variation of Y/L: –Changes in K/L; –Changes in g. Variations in accumulation of capital do not explain a significant part of: –Worldwide economic growth differences; –Cross-country income differences. Identified source of growth is exogenous (assumed growth).

Growth accounting: Short-run sources of growth Breakdown observed growth in GDP, into components associated to changes in factors of production. Output growth only happens due to growth in productive inputs, including technology. Tehcnological progress is measured by indirectly, i.e., growth not attributed to changes in observable inputs. Solow refered to the residual as Total Factor Productivity (TFP)

Growth accounting: Short-run sources of growth Solow model explains more than ½ of output growth. An inportant part of growth is attributed to exogenous “inputs”. What is Technological progress? (residual) –Knowledge, institutions (property rights), education, culture,...

Ramsey Model: Endogenous saving Frank Ramsey ( ) - “A mathematical theory of saving”, 1928, Economic Journal. How much of its income should a nation save? Solow vs Ramsey –Solow : agents in the economy (or the dictator) follow a simplistic linear rule for consumption and investment –Ramsey : agents (or the dictator) choose consumption and investment optimally so as to maximize their individual utility (or social welfare). Establishes the benchmark model for modern dynamic macroeconomics and optimal intertemporal allocation of resources.

Ramsey Model: Rationale and households Does more savings today imply more consumption tomorrow? We must contrast the cost to postpone our consumption today with the benefit of enjoying it tomorrow. => Preferences for consumption at different dates Milton Friedman’s ( ) permanent income and life cycle hypothesis: Consumption/saving patterns determined not by current real disposable income but by their longer-term income expectations (i.e., individual's real wealth). Representative Household wealth: Most economic growth models assume infinite planning horizon. –Isomorphic to a model with finite-lives and random death. –Intergenerational altruism: individual not only derives utility from his consumption but also from the bequest he leaves to his offspring. Each individual internalizes the utility of all future members of the “dynasty”. => decision makers act as if they have an infinite planning horizon.

Ramsey Model: Representative Firm Representative Firm –With no externalities and competitive markets, our focus on the aggregate production possibilities set of the economy or on the representative firm is without loss of any generality. Ouput is produced using capital and labor (Assume a constant population normalized to 1). Capital does not depreciate. There is no technological progress. Firms’ decisions: how to allocate capital and labour inputs to production? How to expand activity? The output is either consumed or invested, i.e., added to the capital stock (as in Solow’s model) In a closed economy, savings equal investment.

Ramsey Model: Optimal saving Optimal growth with: –Closed economy –No population or technology growth –Single composite (investment/consumption) good –Competitive markets for inputs and outputs. The social planner (benevolent dictator) chooses how much the representative household should consume/invest (add to capital to provide consumption in future) Discount factor: €1 in T periods from now, is worth exp(−rT ) today. Same applies to utility. s.t.

Ramsey Model: Optimal saving Any solution must obey: Ramsey-Keynes rule: The higher the marginal product of capital, relative to rate of time preference, the more it pays to depress the current level of consumption in order to enjoy higher consumption later. Interpret ! As in Solow model capital and ouput converge to a steady state and growth will cease in the long run (without technological progress). Instantaneous elasticity of substitution between consumption in two dates

Ramsey Model: Phase Portrait

Ramsey Model: Conclusions There is no long term growth. Per capita variables converge to a stationary equilibrium. Ramsey models does not add any fundamental explanation of growth other than the Solow model. The central implications of the Solow model are not based on the assumption of constant savings. Solow + Ramsey: Significant differences in Y/L are explained by differences in K/L only if differences in K/L and in rates of return to capital are enormous. Not observed in the data. The identified source of growth is exogenous – Technological progress What is Technological progress? (residual) –Knowledge, institutions (property rights), education, culture,... Maybe capital is undervalued (using the private rate of return): –Human capital, natural capital, –Positive externalities of capital.

Dynamic Optimization: Infinite Horizon Optimal control: Pontryagin’s maximum principle Find a control vector for some class of piece-wise continuous r-vector such as to : Control variables are instruments whose value can be choosen by the decision-maker to steer the evolution of the state-variables. Most economic growth models consider a problem of the above form.

Pontryagin’s Maximum Principle – Usual Procedure Step 1 – Construct Hamiltonian Step 2 – Maximize the Hamiltonian in w.r.t the controls Step 3 – Write the Euler equations Step 4 – Transversality condition

Pontryagin’s Maximum Principle – With discount Step 1 – Construct the current value Hamiltonian Step 2 – Maximize the Hamiltonian in w.r.t the controls Step 3 – Write the Euler equations Step 4 – Transversality condition

Dynamic Optimization: Cake-Eating Economy What is the optimal path for an economy “eating” a cake? Optimal System: Transversality condition: subject to

Dynamic Optimization: Cake-Eating Economy

Explicit Solution: –From the dynamics of consumption –Resource stock constraint: The remaining stock of cake is the sum of all future consumption of cake, i.e., In the planning horizon, all the cake is to be consumed, i.e, The optimal strategy is to consume a fixed portion of the cake