Physical Capital and Diminishing Returns

Do you recall our question about Germany and Japan from our previous video?

How did they achieve record economic growth following World War II?

Today's video will help answer that question. We'll be digging into the K variable of our simplified Solow model: physical capital.

To help with our discussion, we’ll be exploring two specific concepts. The first is the iron logic of diminishing returns which states that, for each new input of capital, there is less and less output produced. Your first input of capital will likely be the most productive, because you’ll allocate this first unit to the most important, value-adding tasks.

The second concept we’ll cover is the marginal product of capital. This concept describes the output created by each new unit of invested capital.

Can you already see how these two forces of capital help answer our question about Germany and Japan?

For these two war-torn countries, the first few units of invested capital had a lot of bang for their buck. The first roads between destroyed cities, the first new steel mills, the first new businesses—these helped boost their growth rate tremendously.

Even more so, remember that Germany and Japan were growing from a low economic base after the war. It's easy to grow a lot when the base is small. But all else being equal, you'd rather have a larger base, and grow slower.

Capital has some more nuances worth thinking about, which we'll show in the next video. So get to watching, and in our next macroeconomics video, we'll show you yet another problem surrounding physical capital.

Related video: Puzzle of Growth: http://bit.ly/1T5yq18

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