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Beyond the Basic Model

Other types of models offer insights into New Zealand’s capital accumulation and productivity experience

So far this paper has relied on a basic model to frame discussion about capital accumulation and productivity. We need to consider what might be missing from the model and what more complicated models might be able to tell us.

The model developed by Grimes (2007) maintains much of the characteristics of the basic model: diminishing returns to capital, cross-country capital flows that act to equalize the marginal product of capital, and a focus on long-run considerations. However, the model allows for two domestic sectors (industries), each with its own production function. One produces internationally tradable goods and one produces goods solely for domestic consumption. This allows Grimes to directly consider the terms of trade as the ratio of the price of tradable goods to the (exogenous) price of imported capital goods.

The terms of trade appears to be particularly important for New Zealand

The results of the Grimes model are similar to the basic model, but offer additional insights, including the following three. First, as in the basic model, a currency premium (or any impediment) that raises the domestic economy’s cost of capital above the international level will lower capital intensity and labour productivity. Second, a fall in the terms of trade lowers capital intensity and labour productivity (similar to a fall in MFP in the basic model). New Zealand’s terms of trade experienced a large drop in the mid-seventies and is only recently re-approaching the average levels seen in the fifties and sixties (Borkin 2006). Grimes (2006) shows how the terms of trade explain a significant fraction of New Zealand’s growth experience since 1960. Third, a rise in MFP of the traded sector boosts capital intensity and labour productivity; non-traded sector MFP does not matter for capital intensity and has a lesser effect on labour productivity. Grimes notes this as a policy implication: in this model, achieving the same percentage increase in traded-sector MFP is better than the same percentage boost in non-traded MFP.

Capital accumulation may spill over to MFP growth – particularly FDI and ICT

Moving beyond the neoclassical framework of the basic model and the Grimes model, some types of endogenous growth models allow for investment to have significant spillover effects that boosts MFP. So far we have only allowed for MFP to affect capital intensity; it is also possible to model causation that runs in the other direction. For example, a firm may invest in capital that is effectively a carrier of technology invented in other countries. Other domestic firms could observe this process and implement some of the technology without incurring the same costs. If this sort of process is widespread, then there will be underinvestment from a social point of view, because individual firms are not rewarded for the full social benefits of their investments. Görg and Greenaway (2004) explain that there are many theoretical reasons to suspect that direct investment by foreign firms (FDI) may be a source of such spillovers, although their review of the literature concludes that 1) it is difficult to find strong empirical evidence of spillovers from FDI[20] and 2) policies that improve the general “economic environment” such as macroeconomic stability are preferable to policies that offer incentives for specific investments. Some analysts argue that New Zealand receives substantial FDI inflows but has yet to benefit from spillovers.[21]

There is a significant literature that looks at the spillover effects of investments in information and communication technology (ICT) on MFP. ICT helps firms use other labour and non-ICT capital more efficiently and also can contribute to better innovation on an economy-wide scale. Jorgensen et al (2005) trace the upturn in United States MFP growth to ICT. Pilat (2004) finds evidence for the link between ICT growth and MFP in a wider sample of OECD countries. For New Zealand, Engelbrecht and Xayavong (2006) find it difficult to confirm the spillover effects of ICT, but find that MFP growth in New Zealand has been stronger in ICT intensive industries relative to other industries.

New Zealand has some characteristics of a regional economy, competing for capital and labour with other parts of a broader Australia-New Zealand economy

The “new economic geography” features efforts to understand the costs of distance and the productivity effects of agglomeration (the concentration of economic activity in certain areas).[22] One class of models examines why a geographic region of an economy might develop and attract capital and labour at the expense of other regions. These models that try to understand regional differences within a country may be useful for understanding New Zealand’s capital intensity and productivity experience. We can think of most OECD countries as sharing in a global capital market, but not being very open to labour flows (either due to legal or linguistic barriers). However, to a larger extent, New Zealand shares a labour market with its neighbour. So, there may be some insights to be drawn by applying the economic geography literature and thinking about NZ as a "region" of a broader Australia-New Zealand economy. These kinds of models include increasing returns to scale: that is, there are agglomeration effects from locating in close proximity. As a result, firms have an incentive to put all their production in concentrated areas. Small historical differences between regions (or even random chance) may have decided the location where this high-productivity agglomeration gets started; but once it does, the productivity effects mean that there may be “lock-in”. That is the economic activity may stay concentrated in the same area, even if it would no longer be the ideal place to start from scratch.[23]

What are the implications of thinking about New Zealand’s regional characteristics within the Australia-New Zealand economy? Agglomeration patterns may be hard to change, but there may be scope to help spark the next wave of agglomeration and better compete with other regions for labour and capital. Krugman (2003) contemplates policy options for Scotland as a region of the UK, and suggests that education (human capital and higher education institutions), infrastructure and quality-of-life amenities (and to a lesser extent, tax policies) are important in attracting capital and labour, perhaps in addition to modest public efforts to back industrial “clusters”.

There is also an aspect of the new economic geography literature that looks at distance and agglomeration nationally (instead of regionally). As Venables (2005) points out, distance from foreign export markets and sources of savings can be effectively reduced by improving infrastructure (particularly ICT) and perhaps also by building greater cultural and social links.

Notes

  • [20]A more recent paper by Blitzer et al (2007) finds some evidence of FDI spillovers in OECD countries.
  • [21]See “Summary notes from Professor Peter Enderwick's Guest Lecture presented at the Treasury on 20 May 2003,” http://www.treasury.govt.nz/publications/media-speeches/guestlectures/enderwick-may03
  • [22]See Venables (2005) for an overview of the economic geography literature.
  • [23]Rice et al (2005) find empirical support for this kind of model in the UK context (that is, UK regions compete for capital and labour). They find that London pays higher wages because of agglomeration externalities, but offsetting congestion/housing costs prevent all labour from flooding to London.
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