Physical Capital and Diminishing Returns

Physical Capital and Diminishing Returns


♪ [music] ♪ – [Alex] In our last video,
we introduced the variables in our Super Simple Solow Model. We have physical capital,
represented by “K,” human capital, represented by “e”
times “L,” and ideas, represented by “A.” In this video, we’re going to hold
human capital and ideas constant. That will let us focus in on K
so we can show what happens to output when the amount
of physical capital changes. Since capital is the only input,
output is a function just of the quantity of capital. Let’s write output
with the letter “Y.” Then we can say that Y is
a function of K. Output is a function
of the quantity of capital. What properties should
our production function have? First, it makes sense
that more K increases output. Recall from our earlier
video, our farmer. A farmer with a tractor can
produce a lot more output than a farmer with just a shovel. Similarly, a farmer with two
tractors can produce more output than a farmer with just one tractor. If we graph capital
on the horizontal axis and output on the vertical axis, we’re going to see
a positive relationship. As capital goes up,
output goes up. That seems pretty straightforward. The second property
our production function should have is
that while more capital produces more output,
it should do so at a diminishing rate.
What do I mean by that? Let’s go back to our farmer. The first tractor he gets is
the most productive. It helps him grow
a lot more wheat. The second tractor he might use if
the first tractor — it breaks down. So the second tractor is
less productive than the first. The third tractor is maybe just
a spare in case both break down. So the third tractor will boost
his output even less than did the second. Said another way, the farmer will
allocate his tractors so that the first tractor,
he’s going to allocate to the most important,
the most productive task. Meaning that subsequent tractors —
the farmer will allocate them to less and less productive tasks. We call this the Iron Logic
of Diminishing Returns. To represent both
of these properties, we can use a simple
production function, one which we’re already familiar
with: the square root function. Output equals the square root
of the capital inputs. So if we input 1 unit of capital,
output is 1. If we input 4 units of capital,
output is 2. If we input 9 units of capital,
output is… 3. The marginal product
of capital describes how much additional output is produced
with each additional unit of capital. Notice that the marginal product
of the first unit of capital is really high. But as the capital stock grows,
the marginal product of capital is less and less and less. Already, we can explain
one of our puzzles. Recall that growth was fast
in Germany and Japan after World War II. That makes sense,
because after the war, those countries — they
didn’t have a lot of capital. So that meant that the first units
of capital had a very high marginal product.
The first road between two cities or the first tractor on a farm,
or the first new steel factory — that gets you a lot
of additional output. Capital’s very productive
when you don’t have a lot of it. But don’t forget that Germany
and Japan were growing from a low base. You can grow fast
when you don’t have a lot, but all else being the same,
you’d rather have more and grow slower. So, capital can drive growth,
but because of the iron logic of diminishing returns,
the same additions to the capital stock may get
you less and less output. Unfortunately for K,
in the next video we’ll show that capital has another
problem to deal with. – [Announcer] If you want to test
yourself, click “Practice Questions.” Or, if you’re ready to move on, you
can click “Go to the Next Video.” ♪ [music] ♪ You can also visit MRUniversity.com
to see our entire library of videos and resources. ♪ [music] ♪

19 comments on “Physical Capital and Diminishing Returns

  1. Walter Clark Post author

    Krugman is attracted to the effect of war on the resetting of the "diminishing returns" curve. I'm pretty sure he is aware of the cost of war, but his claim is that if we pretend there is a war on, we can have our cake and eat it too.
    A refuting of that would be very interesting.

    Reply
  2. Marcio Lino de Almeida Post author

    hi! This video is currently the third in the growth model playlist, but it should be the second. 😉

    Reply
  3. Tomas Post author

    At 1:18 I think you said one farmer can produce more output with two tractors than one.. it is not possible as you only have one farmer.

    Reply
  4. Sarogo Gotye Post author

    Question, is the model required by empirical observation or reasoning to have the form Output = K^a * L^(1-a) (apart from the constant returns to scale requirement)? Because your tractor example looks like it would take the form of Output = (1-x^k)*L, where L is total labour, k is capital per labourer, and x is some number between 0 and 1?

    Reply
  5. Skillhood Post author

    Your lectures and hosting is simply phenomenal. Please continue to increase our marginal utility!

    Reply
  6. Feynstein 100 Post author

    I didn't know that the law of diminishing returns was accurately modeled by the square root function. I always assumed it'd be an exponential decay function.

    Reply
  7. aakash bagaria Post author

    great video but mentioning of catch up effect would have been easier in case of japan nd germany.

    Reply
  8. Soobin Park Post author

    I love the way they make videos that I want to know which programme they use when making such magnificent videossss!!

    Reply

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