12 if factor prices differ between two sectors due to

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12 If factor prices differ between two sectors due to regulations or other reasons, then short-term equilibrium is achieved at point B , the intersection, not tangency, of the M M and NN curves. The output of N at point B equals that at point A , since both points are on the same isoquant NN . The output of M at point A is less than that at point B , because the M M curve is closer in distance to O M than the MM curve. This indicates that the intersectoral factor price differentials induce an inward shift in the production possibility frontier. Let us closely examine the shape of the production possibility frontier under the intersectoral factor price differentials. When either M or N is being solely produced, the output is the same regardless of whether factor prices differ or not between the sectors. Therefore, as Figure 3 shows, if factor price differentials exist, the production possibility frontier becomes less concave, compared with that of the H-O model, or, in a more extreme case, it becomes convex rather than concave to the origin. 13 11 In this paper, capital-intensive commodity and labor-intensive commodity are defined as follows. Let us denote capital and labor input necessary to produce one unit of commodity M as a KM and a LM respectively (the same is applicable to commodity N ). Accordingly, a KM / a LM > a KN / a LN means commodity M is capital-intensive and commodity N is labor-intensive. That is, when capital input necessary to produce one unit of one commodity exceeds that to produce the other, the commodity is capital-intensive. In addition, when labor input necessary to produce one unit of one commodity exceeds that to produce the other, the commodity is labor-intensive. 12 The contract curve is above the diagonal O M O N , since commodity M is capital-intensive and commodity N is labor-intensive. 13 Johnson (1966) simulates the effect of factor price differentials on the shape of the production possibility frontier. Jones (1971b) theoretically demonstrates these changes. He shows that in the
7 C. Implications for TFP Measurement The aforementioned argument that factor market distortions induce an inward shift in the production possibility frontier has an important implication for the measurement of TFP in growth accounting. The conventional framework of growth accounting assumes perfect factor markets, and regards differences between realized economic growth and the contribution of growth in productive factors as TFP. Thus, if factor market distortions actually exist, they are most likely to overestimate the contribution of productive factors. In such cases, estimated TFP is the sum of the true effect of technological progress and the negative effect of factor market distortions to economic growth. 14 For example, Hayashi and Prescott (2002) implicitly assume perfect factor markets and calibrate the Japanese economy using a Cobb-Douglas aggregate production function. Their estimation results show that a decline in working hours and TFP growth can account for Japan s long-lasting stagnation in the 1990s.

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