ID# CU81

PUBLISHED ON
OCTOBER 21, 2013

The Solow Model Unleashed:

Understanding Economic Growth
BY NICOLAS VINCENT * AND PIERRE YARED

Background
DURABUILD: SEEKING NEW INSIGHTS
The peeling Durabuild Inc. sign, desperately in need of a touch up, caused Grant Stone to
cringe slightly as he entered the companys St. Louis headquarters. He had mixed feelings
about the meeting he had scheduled with the companys presidenthis father, Frank Stone
Jr. Grants agenda was a tough one: to try to get a better sense of what he viewed as his
fathers (and his grandfathers) less-than-perfect business acumen. In the weeks since Grant
had left his analyst position in New York to join the familys firm as vice president for
business development, he had become concerned about the companys future and had also
grown curious about details of its early growth.
Durabuild Inc. was a diversified, family-held business in the construction industry, with
significant interests in France as well as in the United States. The presidents spacious corner
office looked out over the faded glory of an industrial brick skyline. Grants father, finishing
up what appeared to be a customer call, silently motioned for his son to settle into the most
comfortable spot in the rooman overstuffed, butter-soft, leather armchair. A large-scale
aerial photo of Durabuilds operations in France circa 1962 hung on the wall.
As soon as his father hung up the phone, Grant cut right to the chase. Ive been studying
our books, Dad, trying to make sense of where Durabuild has been and where we are
headed. From what I can see, the companys best growth period was in the middle of the last
century, right after we opened operations in France. I want to work with you to understand
that growth in a larger context so we can try and recapture it. Maybe, as we discussed last
week, in China.

Author affiliation Copyright information

*
Assistant Professor, Institute of Applied Economics, HEC Montral 2013 by The Trustees of Columbia University in the City of New

Roderick H. Cushman Associate Professor of Business, Columbia York.

Business School
This case is for teaching purposes only and does not represent an
Acknowledgements endorsement or judgment of the material included.
Jennifer Freeman 91 provided writing support for this case.
This case cannot be used or reproduced without explicit permission
from Columbia CaseWorks. To obtain permission, please visit
www.gsb.columbia.edu/caseworks, or e-mail
ColumbiaCaseWorks@gsb.columbia.edu
DURABUILD: THE EARLY YEARS
Frank Jr. loved to tell stories, and especially liked to sprinkle them with facts about US
history, his passion. He poured himself a glass of chilled water from the carafe before he
began. Grant, I think you know how this story started. First, some history At the end of
World War II your grandfather saw a great opportunity in the G.I. Bill of Rights. Right after
the war, the G.I. Bill provided free college tuition to the millions of soldiers who came home
from the war. That bill gave veterans the opportunity to go to college, but it also gave
themhere he ticked the benefits off on his fingers housing subsidies, business loans,
and other help in getting their lives back on track.
When Grandpa Frank came back from France, he took out a business loan and established
Durabuild in 1947 with offices in the United States and France. The construction industry
was a good choice. After 15 years of the Depression and five years of war, housing in
America was in bad shape, or at least in need of renewal. Mortgage loan guarantees
provided by the G.I. Bill were helping the war veterans buy homes, which started a big
housing boom. Those were some of our best years.
But why expand into France? I never quite understood that choice.
Frank Jr. gazed out the window. As you know, during the war, your grandfather fought on
the front lines in Normandy. He saw firsthand the destruction of factories, the ashes of
villages, the wreckage of schools and bridges. As the US housing market shot up after the
war, he saw that once the recovery got underway in Europe, France would have an even
greater need to rebuild than we did here in America. And he was right. For nearly two
decades, Frances economy soared.
I remember once when I was about 10 years old, your grandfather told me about the
miracle of postwar Europe. Out of the ashes of destruction have risen the wings of
opportunity, he said. We, Durabuild, were helping to make that happen.
But Dad, did Grandpa Frank think the growth was going to continue forever?
Well, theres the catch. The housing market in France that had boomed so impressively in
the 1950s and 1960s leveled off in the 1970s, and my father didnt understand what was
happening. He fully expected the French market to get back on track any minute. He kept
thinking opportunity was just around the corner, because there was still so much room left
for France to grow. He shook his head.
Expecting the building industry to come roaring back, Grandpa invested Durabuilds
capital year after year in factories and warehouses from Calais to Cannes. While the US part
of the business held steady, Durabuilds French affiliates suffered. The demand for new
construction in France was drying up, but Grandpa Frank refused to see it. I was a young
apprentice at your grandfathers side at that time, and I admit I was taken in by his view of
the world. Or maybe blind to the same things.
Grant felt himself growing impatient. Whats frustrating to me is that you guys waited
around for more than 30 years, just hoping that Europe would return to the high growth
rates of the postwar times. Thirty years in the twentieth century and beyond! Didnt you

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even try to understand what was going on? It seems like the best tool in your whole
analytical toolkit was hope!
Hindsight is always 20/20, Grant. Why dont you bring your MBA toolkit in here and show
me how we should have done it.
LESSONS FROM THE PAST
A few days later, when Grant had calmed down, he opened his laptop in the company
conference room and dug into the kinds of source material he had not looked at since his
days at Columbia Business School, nearly a decade before. The growth of the construction
and building materials industry was closely tied to the overall economy, so he spent many
hours looking at macroeconomic trends in France and the United States since the end of
World War II. He also tried to recall the precise modeling tool that would help him to
understand how Grandpa Frank had so inaccurately forecast the longer-term potential of
Durabuilds operations in France. Drawing on his experience as an analyst, he prepared a
report for his father.
Grants report highlighted a number of important macroeconomic trends in the United States
and France. In the decades following World War II, he wrote, France grew at a much
faster rate than the United States. GDP per capita growth in France from 1950 to 1980
averaged 3.8%, compared to 2.2% in the United States. Between 1980 and 2000, however,
GDP per capita growth in France averaged 1.6%, compared to 2.3% in the United States. In
other words, economic activity expanded at a much more rapid pace in France during the
early years after the war, but the growth rate of the economy eventually tapered off. (See
Exhibit 1.)
Grants report continued, Part of the reason why France grew so quickly at first was that it
started at a much lower level relative to the United States. As a consequence of the
destruction of the war, in 1950 Frances GDP per capita was 54% that of the United States,
and its capital-to-labor ratio was less than 10% of the United States. France and the United
States had similar investment rates during this period, and because France started from such
a low capital base, its capital stock grew very rapidly, achieving the same capital-to-labor
ratio as the United States by 2000. Nonetheless, France never caught up. In 2000 its GDP per
capita was 75% that of the United States. (See Exhibit 2.)
Grants report then went on to try to analyze some of the problems with the French economy
and to describe some of the differences between the French and the American labor market,
which may have been behind the slowdown. In the decades following World War II,
unemployment in France was so low, around 3%, that US economists wondered how the
United States could replicate the labor miracle of France and the rest of Europe. By the end of
the century, however, Frances unemployment rate had risen to over 11%, more than twice
that of the United States. Moreover, total labor hours per capita in France were 72% that of
the United States. (See Exhibits 2 and 3.)
The French live very differently than Americans, the report went on. At the end of the
century, in France, the work week could not legally be longer than 35 hours, with a
mandatory five-week vacation. The average French worker put in 40 weeks per year, while

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the average US worker put in 46.2 weeks. The report then explained some of the possible
reasons behind these differences: The French unemployment insurance program, which
replaces 60% of prior pay for up to two years, may discourage individuals from seeking
work, while high marginal tax rates make working additional hours less interesting.
Furthermore, firms have little incentive to hire new workers, given the high minimum wage
regulation as well as the legal restrictions which make it difficult to fire workers.1
LESSONS FOR THE FUTURE
Grant was now walking along the Mississippi River, lost in his thoughts, envisioning
Durabuilds future plans. Did China present the best long-term potential, or would its
current high-growth phase peter out as it had in France? Chinas rate of investment was
extraordinarily high; it had never been replicated by either the United States or France and
was driving very rapid economic growth. Nonetheless, doing business in China was
difficult, given the difference between its regulatory environment and the United States or
Frances. How easy would it be to apply new technologies in China? How does Chinas one-
child policy affect its economic growth? When Grant had gotten about a mile down the river,
the tool he was searching for finally dawned on him: the Solow model.

The Solow Model Unleashed: Understanding Economic Growth | Page 4

Exhibits
Exhibit 1
Real GDP per Capita in France and the United States

Source: Original 19502000 GDP per capita data for France and US is from Penn World Tables 7.1.
Exhibit 1 compares the logarithm of the GDP per capita data.

Exhibit 2
Comparison of Factors in GDP per Capita (France/United States)
Year Y/POP A (K/N)^0.3 N/POP

1950 0.54 0.99 0.44 1.25

1980 0.86 1.05 0.88 0.93

2000 0.75 1.02 1.01 0.72

Source: Population (POP) and GDP per capita (Y/POP) are from Penn World Tables 7.1. Total hours
worked (N) is from the Conference Board. Capital (K) in 2000 is assumed to be 1/3 of total GDP at
2001, and capital at other dates is calculated using investment and a depreciation rate of 4.4%. (A)
refers to total factor productivity.

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Exhibit 3
Labor Force Participation in France and the United States

Source: 19502000 population data France and US is from Penn World Tables 7.1. Total hours
worked is from the Conference Board.

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Assignment
Your task is to try to better understand why France grew so quickly and why growth slowed
down and never fully caught up to that of the United States. You will also contemplate how
economic growth in China going forward depends on a different number of factors. To do
this, you will use the Solow model. The model is very simple and useful for understanding
the mechanics of economic growth.
To see how the model works, note that it uses the following relationship from class:

Yt = At Kt. 3 Nt. 7
where Yt is total production, At is total factor productivity (TFP), Kt is capital input, and Nt is
labor input, where these are in year t. The relationship implies that total output is increasing
in TFP, capital inputs, and labor inputs. It also implies that total output doubles if capital and
labor inputs each double. In addition, there are diminishing returns to capital and to labor
individually.
Note that by some algebra, the above condition implies that output per capita satisfies:


    . 3  

  

where  represents the total population at t. In growth rates, this can be written
(Approximately) as:

 
%    %   .3  %    %  
  

What this equation tells us is that total output per capita increases if TFP rises, if the capital-
to-labor ratio rises, and if the employment-to-population ratio rises. Capital
is accumulated over time according to the following relationship:
Kt+1 = Kt (1-d) +It
where d is some constant depreciation rate and It is the level of investment. This states that
capital at t + 1 equals the non-depreciated capital from t plus investment at t.

We have provided you with an Excel workbook that simulates economic growth in the
Solow model starting from some initial levels of TFP (Ao), population ( ), and capital
(Ko). The models assumptions imply that the following parameters are constant over time
and can be fed into the Excel workbook: population growth rate ( / ), employment to
population ratio (Nt /Popt ), investment rate (I t / Yt ), TFP growth rate (%At ) , and
depreciation rate (d). The w o r k b o o k u s e s t h e c a p i t a l a c c u m u l a t i o n equation
and t h e definition of production per capita in order to plot the level of production per
capita over time in two countries under different assumptions for inputs. Because the
model is very simple, we cannot explore for now its quantitative implications too seriously.
For this reason, we will primarily focus on how the level of production per capita evolves
over time qualitatively. Note that in the figure in the workbook, the y-axis, which plots
production per capita, is on a logarithmic scale, which means that a straight line
corresponds to a constant percent rate of growth in production per capita.

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Questions for Analysis
The purpose of these questions is to enhance your understanding of the Solow model and to
use this framework to better understand the different growth experiences of France and the
United States. For each question, you will only receive full credit if you provide an explanation of the
economic intuition behind the results.
1. Setting up the Solow model. The first step before analyzing the growth of the United
States and France is to set up the simulation. No explanation is required in this
section. Please note that you will not be able to answer any of the remaining
questions correctly if you do not answer this one carefully.
a. Complete the US column of the table in the Inputs and Figure sheet of the
Excel workbook provided with the case. Note that in some cases percentages
should be inputted in decimal form (i.e., 2% is written as 0.02). Here are the
inputs:
Population in 1950: 150 (in millions, but just write it as 150)
Stock of capital in 1950: 10,000
Total factor productivity in 1950: 10
Population growth rate: 2%
Employment-to-population ratio: 40%
Investment rate in 1950: 30%
Total factor productivity growth: 0% (We will change this later)
Depreciation rate: 5%
b. Now complete the rest of the table by inputting the parameters in the
France/US column of the spreadsheet. Note that changing this ratio will
automatically change the input in the France column, which will make your
life easier for future questions. In the case of France, let us assume for now
that all values are the same as for the United States except for the following:
Population in 1950: 45 (in millions), which is 30% that of the United
States
Stock of capital in 1950: 250, which is 2.5% that of the United States
Employment-to-population ratio: 50%, which is 125% that of the
United States
c. Your next task is to use the inputs to compute different quantities in 1950 in
the United States according to the Solow model. To do this, fill out the missing
cells in row 5 of US Projected Growth while referencing the parameters
from the Inputs and Figures spreadsheet whenever necessary. Notice that to
facilitate your job, the input cells have been labeled (e.g., in calculating
investment in cell H5 you can reference irateUS). In addition, note that in
order to calculate production you will need to use the production function
Yt= A t K t 0 . 3 N t 0 . 7 you can double-check your work by looking at row 5 of the
US Partial Answer worksheet. Now fill out the missing cells in row 5 of
France Projected Growth in an analogous fashion.

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 d. Use the model to fill out rows 6-65 in US Projected Growth. Note that to
calculate these values, you will need to reference previous cells as well as
parameters from the Inputs and Figures spreadsheet (e.g., cell b6 is
b5*(1+popgrowthus)). You will also need the dynamic equation relating this
years capital stock to the previous years capital stock K t+1  K t ( 1 d) +It in
column d (refer to the previous section for more details). You can double-
check your work by looking at rows 6, 25, 45, and 65 of US Partial Answer.
Now fill out the missing cells in rows 6-65 of France Projected Growth in an
analogous fashion.
2. Short run growth dynamics.
a. Exhibit 2 provides information on the relative situation of France vs. the
United States in 1950. For example, it shows that in 1950, output per capita in
France was 54% that of the US. Focusing on the information for Y/Pop and
(K/N)0.3 in 1950 in the US Projected Growth and France Projected Growth
spreadsheets, would you say that the numbers you obtain for these two
variables based on the initial inputs in Question 1 are consistent or not with
the information in Exhibit 2? Show how you reached that conclusion.
b. Referring to the economic performance of France following WWII, Grandpa
Frank used to say Out of the ashes of destruction have risen the wings of
opportunity. Based on your Solow model simulations and focusing on the
first 15 years, would you agree with this statement? Use the plot in the
Inputs and Figure sheet to support your answer. The pointers below are
there to guide you in answering the question.
i. If France had not suffered a large drop in its capital-labor ratio
during the war, how different would your answer be?
ii. Why is the capital-labor ratio growing in France between 1950 and
1965 according to the Solow model? (Hint: recall how the level of
investment and the rate of depreciation affect the level of capital
from one period to the next.)
iii. Is the growth rate of the capital-labor ratio in France accelerating or
slowing down between 1950 and 1965? What is the role of
diminishing returns in the production function? Can high growth
rates of output per capita be sustained forever in this example?
3. Long-term growth. Following the war, Grandpa Frank was very bullish on the
potential of the French market. He saw a country that would not only experience
short-term growth through its rebuilding effort, but also eventually catch up to the
standard of living of the United States. As Exhibit A clearly shows, this prediction
never materialized. This question will help you understand what actually happened.
a. Total Factor Productivity. The initial focus is on the role played by Total
Factor Productivity (TFP). We will start by assuming that TFP growth is zero

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 in both countries. In other words, there is no increase in the efficiency of the
economy in turning its inputs, labor and capital, into output.
i. In a scenario with no TFP growth, what theoretically would have
happened to the level and growth rate of output per capita in the
long run in the United States (i.e., does the level and the growth rate
approach some fixed number eventually)?
ii. Does your previous answer also apply to the level of output (instead
of output per capita)?
iii. Would France have eventually caught up, or even overtaken, the
United States in terms of output per capita?
iv. Now take into account that TFP growth was in fact positive in both
countries during this period and approximately equal to 2%. How
does your answer to question (i) change under this scenario? How
does the long run growth rate of production per capita in both
countries depend on the rate of TFP growth?
v. What does your answer in (iv) tell you about the importance of
productivity growth for long run improvements in standards of
living? Why cant we count on continuously increasing our capital-
labor ratio to grow in the long run?
b. Role of Labor Markets. Frances labor markets have evolved very differently
than those in the United States in the decades following WWII. While the
employment-to-population ratio was significantly higher in France in 1950, it
declined steadily afterward and now sits much lower than the United States
level (see Exhibit 2). In this question you will analyze how this development
matters. Start from the initial values described in Question 1, but this time use
a growth rate of TFP equal to 2% in both countries (Exhibit 2 shows that the
relative productivity levels did not change much over time).
i. If the employment-to-population ratio of France had stayed constant
at its 1950 level, how would Frances output per capita compare to
that of the United States right now? Is it in line with the evidence
presented in Exhibit 1? How about the growth rates of output per
capita?
ii. Now consider the realistic scenario where the employment-to-
population ratio in France fell to eventually reach a level 75% that of
the US, consistent with the information in Exhibit 2. To be precise,
suppose that the US employment-to-population ratio is constant, but
that the one in France is 125% that of the US from 1950 to 1955; 100%
that of the US from 1955 to 1975; and 75% that of the US from 1975
onward. How does this affect the level of output per capita in France
relative to the US in the long run? Is this more consistent with the

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 evidence presented in Exhibit 1? What is the impact of this
development on the growth rate of output per capita in the short run
(i.e., in the years following 1955) and long run?
c. Synthesis. Use what you have learned so far to analyze the performance of
Durabuild Inc. What was behind the strong growth of the business in the
1950s and 1960s? What is behind the slowdown afterwards? What did Grant
Stones grandfather miss in forecasting future growth?
4. Application to China. China is much more different than the United States today
than France ever was. Not only is its initial capital stock K0 much lower, but there are
many other important differences as will be discussed below. For this question, adapt
the spreadsheet (or make a copy) so that France is now labeled China.
a. Total Factory Productivity (TFP) differences between the US and France have
always been minimal. This is not true when comparing China and the United
States today. Explain the consequence for Chinas long run level and growth
rate of output per capita relative to the United States of a permanently lower
level of TFP. For this question, you can isolate the effect of the TFP difference
by letting the United States and China be similar with respect to other
parameters (HINT: let Chinas initial capital K0 and TFP A0but not its TFP
growth ratebe lower relative to the United States).
b. Chinas investment rate vastly exceeds that of the United States, and this very
high investment rate may be maintained for many years to come. Holding all
else fixed, how does this affect Chinas long run level and growth rate of
output per capita relative to the United States?
c. Chinas population growth rate is much lower than the United States as a
consequence of its one-child policy.
i. If this difference in population growth rate is not also reflected in
differences in participation rates, how does this affect Chinas long
run level and growth rate of output per capita relative to the United
States?
ii. Now take into account that a lower population growth rate can also
affect the employment-to-population ratio. How does a decreasing
population growth rate affect the demographic composition of China
in the medium and long run (i.e., how does it affect the number of
individuals retiring versus those working?). Does this increase or
decrease the employment-to-population ratio? What is the total
effect then of a lower population growth rate on Chinas level and
growth rate of output per capita relative to the United States, both in
the medium and long run?

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Endnote

1Robert Solow, Unemployment in the United States and in Europe: A Contrast and the Reasons,
Working Paper no. 231 (January 2000); Olivier J. Blanchard, Explaining European Unemployment,
NBER Reporter: Research Summary (Summer 2004); Richard Rogerson, Understanding Differences in
Hours Worked, Review of Economic Dynamics 9, no. 3 (July 2006).

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