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Capital Shallowness: A Problem for New Zealand? - WP 05/05

6  Relative Prices of Labour and Capital

An important part of the New Zealand story is a decline in real labour costs over 1992-96, following the implementation of the ECA. In conjunction with welfare reform, this induced an employment expansion and held back growth in labour productivity.

(Parham and Roberts 2004)

6.1  Comparative Statics

We have observed that New Zealand is apparently “capital-shallow” in comparison with Australia; i.e., New Zealand has a lower capital-labour ratio. We have also shown that New Zealand appears to have a higher return to capital. However, the capital-labour ratio not only depends on the price of capital, but also on the price of labour. This can be illustrated as follows.

Suppose that New Zealand and Australia operate on a similar underlying production function which is depicted as the common unit isoquant in Figure 15. The two countries do not lie at the same position on the production function because they are subject to different relative prices. New Zealand, as drawn, has a lower price of labour relative to capital and thus lies further to the right along the production function, implying that the capital-labour ratio in New Zealand is lower than in Australia (where the capital-labour ratio is the slope of the ray from the origin to the point on the unit isoquant). In this case the lower capital intensity in New Zealand can be attributed to the fact that labour is cheaper in New Zealand relative to the price of capital. This is consistent with the finding that the real return on capital is higher in New Zealand.

If, instead, the two countries faced the same relative prices of labour and capital, as illustrated in Figure 16, New Zealand may have a lower capital-labour ratio than Australia because the two countries lie on different production functions. Of course in reality the differences in the capital intensities could refect both differences in relative factor prices and differences in the underlying production functions; i.e. some combination of the two extreme cases illustrated in Figures 15 and 16.

Figure 15: Differences in capital intensity arising from different relative factor prices
Differences in capital intensity arising from different relative factor prices
Figure 16: Differences in capital intensity arising from different production functions
Differences in capital intensity arising from different production functions

Margo (2004) reports on current work using the above framework to analyse the capital intensity of manufacturing in the south of the United States after the Civil War.

In ongoing work with my Vanderbilt colleague William Hutchinson, I examine changes in the wage-rental ratios in the South relative to the North after the War. Although wages fell in the South, interest rates rose, resulting in a sharp decline in the cost of labor compared to the cost of capital. Simple economic theory predicts that the capital intensity should have decreased in the South in response to this change in relative factor prices. Using establishment data from the 1850-80 censuses… our preliminary results suggest that manufacturing labor productivity fell in the South and… [this] can be accounted for fully by the reduction in relative capital intensity.

It should be noted that the models depicted in Figures 15 and 16 are comparative static models; i.e., they compare one equilibrium position with another after allowing for full adjustment to relative price changes. They are silent on the question of the time path of any adjustments. We address the question of short versus long-run adjustments in Section 6.4.

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