Investment Specific Technology Change and Indivisible Labor

Economics Department, Universit Laval

2009 April 21

Delali Accolley
accolleyd@aim.com
http://www.scribd.com/accolleyd
Keywords
Investment specific shock, q shock,
indivisible labor
Acknowledgements
The author of this paper has benefited
from the extraordinary help of Dr.
Alain Gabler, Universit Laval, Quebec
in programming the simulations.

Abstract
The contribution of indivisible labor to an economy with investment specific
technology change has been assessed. Within an indivisible labor economy, an
investment specific technology shock positively and strongly impacts on hours
worked. Consequently, the impact of this shock on consumption and output is
stronger than within a divisible labor economy. Introducing indivisible labor has also
amplified the impact of the q shock on investment in structures. As far as investment
in equipment is concerned, indivisible labor has not added much to its response to q
shock.

1. Introduction
Jeremy Greenwood et al (1997, 2000), analyzing
the post-war US data, found a negative
correlation between the amount of new
equipment investment and its relative price.
The reported correlation coefficient between
both variables computed using detrended data
is -.46. They then attributed this phenomenon
to a technological change specific to the
equipment industry having rendered new
equipment less costly and more affordable.
They next amended the standard optimal
stochastic growth model by
distinguishing
between two types of physical capital:
equipment and structures,
and introducing
therein, alongside the usual sector-neutral
technology parameter affecting the aggregate
production technology, an investment-specific
technology shock hitting the relative price of
new equipment.
Simulating the designed
model reveals that investment specific
technology shocks explain 30% of the variability
observed in the US GNP whereas investment in
new equipment makes up only 7% of this
aggregate. The authors point out that this result
is likely to be underestimated. According to
them, including indivisible labor in the model

would amplify the responsiveness of the

economy to investment specific technological
shocks. Their model is sketched and simulated
herein in Section 2. It has then been amended
in Section 3 by introducing in indivisible labor.
The purpose of the investigations carried out in
Section 3 is to find out how and through which
mechanism the introduction of indivisible in the
model will increase the economys response to
the shocks under consideration. A priori, It is
known that an indivisible labor economy
exhibits more fluctuations in hours worked but
the implications of such a modification in the
model on the other variables is not obvious.
Section 4 concludes this project.

2. The Model
The economy consists of infinitely-lived
households, business firms, and government
whose economic behaviour is described below.

2.1 Firms
Firms produce aggregate output out of three
(3) inputs: equipment,
, structures,
, and
labor, . The production technology is CobbDouglas,

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Where , , and are respectively equipment
and structures depreciation rate, and real
interest rate.

[2.1]
Where
represent respectively the
total factor productivity and the equipment
utilization rate.
evolves over time according
to the law specify below:

Whereas the depreciation rate of structures is

constant over time that of equipment depends
on its utilization rate and takes the following
functional form:

[2.2]
[2.8]
where
is the average gross growth rate of
in [2.2] is a random variable following a
first-order Markov process with transition
density:

The laws of motion of equipment and structures

are:
[2.9]
[2.10]

Firms maximize their profit defined as:

Where
and
denote respectively the
investment in equipment and structures. The
stochastic variable
is the inverse of relative
price of new equipment and is indicative of
investment-specific
technological
change
affecting equipment only. It grows on average
at the rate and follows the process:

[2.3]
in [2.3] denote respectively real
rental price of equipment and structure, and
real wage. The first-order conditions (FOCs)
from this optimization programs are:

[2.11]
[2.4]
The random variable
in [2.11] follows the
first-order ergodic Markov process:

[2.5]
[2.6]

with

These conditions all state that the marginal

productivity of the inputs should equate their
real rental prices. From households point of
view, lending money or investing their savings
into acquiring equipment or structures being
substitutable ventures, in order to avoid
specialization, equilibrium in capital market
requires:

[2.12]

The economy faces the following resource

constraints:
[2.13]

[2.7]

meaning aggregate output less adjustment

costs
is affected to consumption and
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investments in both equipment and structures.
Adjustment costs
are made up of costs
specific to equipment
and structures

[2.14]

[2.15]

2.2 Government
Government proportionally levies taxes on both
capital and labor incomes at the flat rates
Greenwood, et al. (2000 & 1997)
posit the tax revenue raised each time period by
the government is rebated back entirely to
agents as lump-sum transfers.1
[2.16]
Where
, and denote respectively
equipment and structure real rental price, real
wage, the lump-sum transfer, and government
spendings on public goods.

2.3 Households
The representative households maximizes his
expected lifetime utility derived from
consumption and leisure
subject to his
resource constraints. His instantaneous utility
function is:

[2.17]
The Euler equations from the households
optimization problem are derived in Appendix 1
relations [A.1.13] through [A.1.17]. Relation
[A.1.13] regards the optimal choice of the
utilization rate of equipment. [A.1.15] governs
the intra-temporal substitution between
consumption and leisure. Conditions [A.1.16]
and [A.1.17] explain the representative
households
inter-temporal
pattern
of
consumption. Finally, [A.1.14] consists of the
various constraints the agent is facing.

2.4 General Equilibrium and

Balanced Growth Path, and
Calibration
The dynamics of the whole economy is
described by relations [A.1.18] through [A.1.22]
in Appendix 1.
As stated earlier in Subsection 2.1, total factor
productivity, , and the inverse of the relative
price of new equipment, , grow respectively at
the rate
and
- relations [2.2] and [2.11].
Labor and equipment utilization rate are
stationary. Adjustment costs,
and , grow
over time at the rate but are null along the
balanced growth path. The resource constraint
relation [2.13] and the law of motion of
structure investments relation [2.10]
suggest that
and
will grow at the
same rate along the balanced growth path. It
follows that equipment grows at a faster rate
- relation [2.9]. From the aggregate
production function relation [2.1], it
transpires that
, which means:

Here, one coud follow Greenwood, et al (1995),

among others, and introduce public spending in the
government finance in order not to exaggerate the
wealth effect occasioned by this redistribution
policy.

[2.18]

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computed using US time series over the period
1954-19990.2

[2.19]

Table 2.1: Calibrated Parameters

Since all variables are not stationary, there is a

need to normalize the model. Relations [A.1.23]
through [A.1.27] in Appendix 1 describe the
above mentioned dynamic equations as
function of the normalized variables.
As a
result, the deterministic balanced growth path
of the economy is summarized by:

Parameter Value
.18
.12
.97
1.032
2.32
2.4709
.53
.4

[2.20]

[2.21]

2.5 Simulation and Findings

The response of the economy to an exogenous
and stochastic shock to is sketched in Figure
2.1 below. 3

[2.22]
[2.23]

It appears in the fourth panel of Figure 2.1 that

investment specific shock has an immediate and
positive impact on the inverse of the relative
price of equipment. As a consequence, this
lowers the price of equipment, which occasions
a slight rise in households investment in
equipment and an important rise in the
utilization rate of existing equipment stock.
Investment in new equipment has not crowded
out consumption and investment in structures
which also has slightly increased for three
reasons. First, the existing equipment is not
fully used,
. Before acquiring new
equipment, firms must first increase the
utilization rate of the already existing
equipment stock.

[2.24]
[2.25]
[2.26]
For the adjustment costs to be null along the
balanced growth path, one needs to impose
some restrictions:

[2.27]
A similar reasoning shows that:

Parameter Value
.4
1.59
.2365
v
.056
.64
.35

The value of the parameter

is not from the
authors but has been computed assuming a
utilization rate of equipment of .9 and knowing that

The calibrated parameters used in simulating

the model are reported from Greenwood, et al.
(2000, p. 101) in Table 2.1 below. They were

The authors calibrated their model to a sample of

37 annual observations on US time series. In paper,
the model has been simulated over 150 periods.

Figure 2.1: Impulse Responses to a q Shock

This explains the important rise of 2.6% in
observed in the fourth panel of Figure 2.1.
Second, the q shock, by favoring new
investment in equipment, raises output as it
appears in the last panel of Figure 2.1 and
creates a wealth effect. Consumption rises due
to the increase in output. Thirdly, the rise in the
utilisation rate of equipment increases the
marginal product of equipment capital stock,
, which could have promote considerable
additional investment in equipment but this
expected substitution effect is cancelled out by
the rise in the depreciation rate of equipment
which is an increasing function of the
utilization rate.

3. Introducing
Indivisible
Labor in the Model
The indivisible labor model as popularized by
Gary Hansen (1985) is briefly presented. The
implications of introducing this model into
Greenwood, et al.,( 2000)s contribution is then
investigated.

3.1 Indivisible Labor

The indivisible labor real business cycle (RBC)
model, as put forth by Gary Hansen (1985), is
motivated by the fact that:

50% of the observed variability in total

hours worked is attributed to variations
in the number of people at work
whereas only 20% of this variability is
accounted for by the average hours
worked.
Most people either work full-time or
not at all.
Previous RBC equilibrium theories, by
hypothesizing that labor market is
always cleared, fail to account for
unemployment and fluctuations in the
rate of unemployment.

To take into account these realities, the one

sector stochastic growth model has been
revised so as to exclude part-time work
possibility from the model, i.e. indivisibility of
labor. Besides, working, in this model, does not
result from individuals will. It is the outcome of

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a lottery . Individuals are fully insured and get
paid whether they work or not.

The utility function in [3.3] is linear in hours

worked (and leisure) and is characterized by an
infinite elasticity of substitution of leisure.

In the indivisible labor economy, each

households instantaneous utility function is the
same as the one in [2.17]. But since labor is
indivisible people work either full-time,
hours, or not at all and working is the
outcome of a lottery
, the representative
households expected utility becomes:

3.2 Indivisible
Labor
and
Investment
Specific
Technological Change
A main feature of the indivisible labor RBC
model is that it increases the volatility of the
stochastic growth model for a given stochastic
process for technology shock. In this subsection,
the characteristic of this model With respect to
investment specific shock is checked.

[3.1]

The production side and the government

finance remain unchanged. Only the utility
function in [2.17] has been replaced by that in
[3.3]. The households optimization problem is
presented in Appendix 2. The FOC, except that
of hours worked, are the same as in the case
divisible labor. The value of
matching
Greenwood et al (2000)s data is .79.

Given that the proportion of households

working in the economy is , the per capita
hours worked is:
[3.2]
Substituting the relation

from [3.2] into

[3.1], one gets:

[3.3]
where

The response of the economy to a q shock when

labor is indivisible is sketched in Figure 3.1
below.

Figure 3.1 : Responses of the Divisible/Indivisible Labor Economy to a q Shock

It transpires from Panel 5 of Figure 3.1 that the
q shock has a stronger impact on hours worked
and consequently on output (Panel 6). By
raising output more than in the divisible labor
economy, the q shock has induced more wealth
effect, which has contributed to a significant
rise in consumption. The impact of the shock
on investment in structures is more important
than in the case divisible labor but its impact on
investment in equipment has not much changed
because the impact of the shock on the relative
price of equipment is the same in the two
economies.

4. Conclusion
This paper has investigated the transmission
mechanism through which a q shock propagates

within an economy. The two main determinants

of the strength of such a shock are: the
utilization rate of equipment and the intertemporal elasticity of substitution of leisure.
When a q shock lowers the price of equipment,
before making new acquisitions, the already
existing equipment is used more intensely. This
explains the positive impact of the shock on .
Within an indivisible labor economy, a q shock
has a positive a stronger impact on hours
worked. As a consequence, the impacts of this
shock on consumption, investment in
structures, and output are stronger than within
a divisible labor economy.

5. Appendices
Appendix 1: Divisible Labor
1. Households Optimization Problem

[A.1.1]
Bellmans equation

[A.1.2]

FOC and Euler equations

[A.1.3]
[A.1.4]
[A.1.5]
-

Envelope condition

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[A.1.6]

[A.1.7]

[A.1.8]

[A.1.9]
-

Envelope condition
[A.1.10]

[A.1.11]

[A.1.12]

[A.1.13]

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[A.1.14]

[A.1.15]

[A.1.16]

[A.1.17]

2. General Equilibrium
Replacing the rental prices of the inputs in the above Euler equations by the marginal products and
calling all the constraints and laws of motion agents face gives the equations making up the economys
dynamic stochastic general equilibrium.
[A.1.18]

[A.1.19]

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[A.1.20]

[A.1.21]

[A.1.22]

Normalizing the model

To normalize the model, new variables are defined by dividing all the non-stationary variables by their
rate of growth.
Define:

Defined also
[A.1.23]

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[A.1.24]

[A.1.25]

[A.1.26]

[A.1.27]

3. Steady State

[A.1.28]

[A.1.29]
[A.1.30]

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Some ratios expressed as a function of the baseline parameters
[A.1.31]

[A.1.32]

[A.1.33]

[A.1.34]

[A.1.35]

Appendix 2: Indivisible Labor

[A.2.1]

FOC
[A.1.3]
[A.2.2]
[A.1.3] and [A.2.2]
[A.2.3]

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Substituting [2.6] into [A.2.3] yields:
[A.2.4]

[A.2.5]

6. Works Cited
Greenwood Jeremy, Hercovitz Zvi and Krusell
Per
The
Role
of
Investment-Specific
Technological Change in the Business Cycle
[Journal] // European Economic Review. 2000. - Vol. 44. - pp. 91-115.

Greenwood Jeremy, Rogerson Richard and

Wright Randall Household Production in Real
Business Cycle Theory [Book Section] //
Frontiers of Business Cycle Research / book
auth. Cooley Thomas F. - Princeton : Princeton
University Press, 1995.

Greenwood Jeremy, Hercowitz Zvi and Krusell

Per Long-Run Implications of InvestmentSpecific Technological Change [Journal]. - [s.l.] :
The American Economic Review, June 1997. - 3 :
Vol. 87. - pp. 342-62.

Hansen Gary D Indivisible Labor and the

Business Cycle [Journal] // Journal of Monetary
Economics. - [s.l.] : Elsevier Science Publishers
B.V., 1985. - pp. 309-27. - 16.

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