Question #31
Reading: Reading 6 Economic Growth
PDF File: Reading 6 Economic Growth.pdf
Page: 14
Status: Unattempted
Question
Ruritania and Utopia are two emerging market economies for which Jon Gordon, CFA, calculated a potential GDP growth rate of 4.3% (for both). In calculating the identical growth rates, Gordon used the Cobb-Douglas production function and the following data: Labor Growth Rate Capital Growth Rate Growth in TFP* Ruritania 2.2% 3.1% 1.8% Utopia 1.7% 3.1% 1.8% *Total Factor Productivity Which of the following statements is most accurate regarding Gordon's assumptions in calculating growth rates?
Answer Choices:
A. Gordon has assumed that the elasticity of output with respect to labor is lower in Utopia than Ruritania
B. Gordon has assumed that the elasticity of output with respect to capital is higher in Ruritania than Utopia
C. Gordon has assumed that the elasticity of output with respect to TFP is higher in Utopia than Ruritania
Explanation
Using the Cobb-Douglas production function, the growth rate in potential GDP can be
calculated as:
Growth rate in Potential GDP = growth rate in TFP + α(growth rate capital) + (1-α)(growth
rate labor)
Where α = elasticity of output with respect to capital
And (1-α) = elasticity of output with respect to labor
The only data given that is different for the two countries is the assumed labor growth
rate. In order to calculate the same GDP growth rate, Gordon must assume a higher α and
hence a lower (1-α).
For Ruritania: 4.3% = 1.8% + 3.1%(α) + 2.2%(1-α)
Solving algebraically for α for Ruritania: α = 0.33 and (1-α) = 0.67
For Utopia: 4.3% = 1.8% + 3.1%(α) + 1.7%(1-α)
Solving algebraically for α for Utopia: α = 0.57 and (1-α) = 0.43
Thus Gordon has assumed that the elasticity of output with respect to labor (1-α) is lower
in Utopia (0.43) than Ruritania (0.67)