Monthly Archives: January 2017

Keynes College

Appropriate technology and balanced growth

In macroeconomics, we typically model production by specifying a ‘production function,’ which tells us how much output is produced with given quantities of the ‘factors of production,’ often taken simply as capital and labour. Factor shares refer to the proportion of the income earned by production that goes to each factor, so the labour share is the proportion of this income that is earned by workers through supplying labour. There are various issues with how we measure factor shares, but a key aspect of what is known as ‘balanced growth’ is the idea that as income grows over long periods of time, the labour share remains approximately constant.

Some researchers dispute the idea of balanced growth, arguing for example that the labour share is currently declining. What there is no disagreement about is the fact that these factor shares are far more stable in the long run than they are in the short run. This creates a problem in the way we specify production functions. For example, the assumption of balanced growth has led Cobb- Douglas production functions to become standard in macroeconomic models because they imply constant factor shares with perfectly competitive markets. This, however, makes it more difficult to capture short- and medium-run fluctuations in factor shares. Market failures such as wage and price rigidities allow us to explain some of these fluctuations, but it is unlikely that they account for all of the fluctuations we see in factor shares, particularly in the medium run.

When the relative price of capital (to labour) rises, firms hire relatively less capital and more labour. The elasticity of substitution between capital and labour quantifies this effect; it tells us by how many percent the capital-labour ratio declines when the relative price of capital goes up by 1%. With Cobb-Douglas production functions, this elasticity is always one. However, much of the empirical evidence finds support for an elasticity below one. Indeed, production functions with an elasticity below 1 typically capture short-run fluctuations in factor shares significantly better than Cobb-Douglas. However, they have very important long-run consequences for income distribution. If the elasticity is different to one, productivity changes can cause the labour share to change. Since we have observed permanent changes in the productivity of investment goods in the last 30 years, an elasticity below one would lead to unbalanced growth with an increasing labour share, whereas typically researchers think that it is either constant or declining.

In this paper we propose a solution to this problem, using the idea of “appropriate technology.” This is the idea that firms not only choose the quantities of capital and labour to employ, but also make a technology choice – how labour- or capital-intensive they want production methods to be. This trade-off is expressed graphically by a technology frontier: technologies that are more efficient in using labour are less efficient in using capital and vice-versa. Given a change in factor prices, firms change their position on the frontier. We show how the shape of the frontier determines the long-run elasticity of substitution and long-run factor shares. Importantly, if firms face adjustment costs when changing their choice of technology, the short-run elasticity will be lower than the long-run elasticity. This provides a way of modelling production that is very easy to implement in macroeconomic models but that is flexible enough to be compatible with both short- and long-run data. The short-run elasticity can be calibrated to capture short-run fluctuations in factor shares in line with the evidence, while the shape of the frontier captures the properties of long-run growth. There is a specific shape of frontier that implies balanced growth. Here elasticity of substitution is below one in the short-run but adjusts towards one in the long run. We use this to provide a quantitative example for the US economy. The results support the use of this new production function because it improves the model’s ability to explain the business cycle and medium-run behaviour of the labour share.

This is the non-technical summary for a new discussion paper by Miguel A. León-Ledesma and Mathan Satchi, KDPE 1614, November 2016.

Dr Wei Jiang

Targeted fiscal policy to increase employment and wages of unskilled workers

by Konstantinos Angelopoulos, Wei Jiang and James Malley, discussion paper KDPE 1704, January 2017.

Non-technical summary

The evolution of inequality has been well documented in the data. Inequality in earnings has increased in recent decades and, in particular, wage inequality has increased dramatically since the beginning of the 20th century. As a result of this rise and its deleterious implications for the welfare of a large part of the population, societies and policymakers at large are paying increasing attention to better understanding causes and consequences of inequality.

This paper aims to contribute to the inequality literature by studying the difference in employment opportunities and labour productivities for workers with (skilled) and without (unskilled) college education which is a main contributor to wage and earnings inequality. The paper, in particular, focuses on the U.S. economy. The literature on the skill premium has demonstrated that there are significant differences in the wages between skilled and unskilled labour, and that the skill premium has increased in recent decades to its highest levels in a century. We investigate the so-called “college premium” or “skill premium” in the U.S. and its relationship with basic earnings inequality.

To this end, we model inequality in wages jointly with differences in employment opportunities between skilled and unskilled workers over the business cycle, with the aim of evaluating the effects of supply side fiscal interventions which intend to increase labour productivity and employment for the unskilled and to reduce inequality. We employ a standard approach to modeling unemployment using a setup with search and matching frictions that belongs to the Mortensen-Pissarides (MP) family, and extend this by allowing for ex ante heterogeneous workers who are employed in skilled or unskilled jobs and produce output under capital-skill complementarity. While their skill type is given, workers productivity benefits from lifelong learning associated with working experience and on-the-job learning (OJL), so that workers productivity is endogenous and a positive function of employment. As a result, differences in employment opportunities and inequality in wages are closely linked. This paper also allows for capital-skill complementarity in production. These extensions capture key characteristics of skilled and unskilled labour markets in the data.

We find that increases in public spending to enhance unskilled productivity via OJL are beneficial to employed unskilled workers and reduce earnings in-equality between employed skilled and unskilled labour. However, unskilled unemployment and labour income inequality within the group of unskilled labour rises. We next find that vacancy subsidies work to increase employment and returns to unskilled workers. However, unemployment for skilled workers rises and skilled wages and labour income fall in the short-run. We finally show that it is possible to increase skilled vacancy subsidies to nullify the negative effects on skilled employment following an increase in unskilled vacancy subsidies.

You can download the complete paper here.

Dr Adelina Gschwandtner

The willingness to pay for organic attributes in the UK

by Adelina Gschwandtner and Michael Burton, KDPE 1702, January 2017.

Non-technical summary

The main objective of the present project is to analyse and understand what drives purchases of organic food in the UK and how much UK consumers are willing to pay for organic food products so that new perspectives can be developed and proposed to policy makers. This is important since there has been almost no recent formal economic analysis of the willingness to pay for organic products in the UK. The existing organic markets in the UK allow us to understand real purchasing behaviour but this is limited to current market conditions. Stated preferences techniques allow to explore new, yet inexistent aspects of the market in a controlled, experimental way. However, by far the strongest criticism brought to stated preferences techniques is the hypothetical bias derived from the hypothetical nature of the experiment. The present study is intending to resolve this issue by collecting data on both real and hypothetical behaviour.

The analysis is important for the design of a strategic policy for the development of the UK organic food sector. The UK was one of the countries that recovered most slowly after the financial crisis with respect to organic sales. In 2013, while worldwide the sales of organic products were surging, the UK accounted a negative growth (Organic Market Report 2013). At present, the demand seems to have recovered and the organic food market seems to increase more than any other food market in the UK. However, the organically farmed area is still decreasing and UK organic farmers are converting back to conventional production (IFOAM 2012, DEFRA 2015, Organic market Report 2016). This implies that the organic food imports have increased which in return implies that the UK is missing important environmental and economic growth opportunities.

This is the non-technical summary for a new discussion paper by Adelina Gschwandtner and Michael Burton, KDPE 1702, January 2017.

Keynes College

Spatial differencing for sample selection models

by Alex Klein and Guy Tchuente, discussion paper KDPE 1701, December 2016.

Non-technical summary

This paper offers an identification strategy in the situation when researchers work with crosssectional data, face unobserved heterogeneity causing endogeneity problem, lack instrumental variables and, on top of it, face sample selection problem. To accomplish that, we take advantage of recent advances of spatial econometrics. What motives us to consider the case of cross-sectional data which data generating process involves sample selection and seemingly unsolvable problem of endogeneity and no instrumental variables?

Recent decades have witnessed a rise of panel data sets which was accompanied by the proliferation of estimation techniques attempting to take advantage of the time and cross section dimension to identify the causal effect of regressors on the variables of interest. Similarly, considerable advances were made in the areas of weak instrumental variable estimation techniques and imperfect instruments. All of this offers researchers various identification strategies which help them to identify vast variety of empirical models even in the situations when strong instrumental variables are not available or exclusion restrictions would not necessarily hold. But what if panel data sets or instrumental variables are not readily available to researchers?

There are three broad possibilities. One is to dispense of causality claim and consider the regression results as sophisticated correlations. Second solution is offered by the literature identifying causal effect with higher moments. Third solution is spatial differencing in which empirical model takes advantage of the spatial dimension of the data to control for unobserved heterogeneity that might render estimator biased and inconsistent. Our paper contributes to that literature. Spatial differencing has been used only in the context of linear regressions so far. We extend this approach to cross-section data with sample-selection. Specifically, we offer a solution to the problem of differencing out spatial unobserved effects when nonlinear element – in our case Mill’s ratio – is present, propose estimation procedure, and derive formula for estimating standard errors.