Lecture 9
The New Growth Theory:
Endogenous Growth Models
• Content
– Basic ideas of new growth
– Problem of declining marginal returns
– The economics of ideas
– Outline of Romer/Jones model
Introduction
• The neoclassical growth model highlights
technological progress as the engine of economic
growth, but they assume that growth occurs
because of automatic and unmodeled
(exogenous) improvements in technology.
– these theories are unable to explain why growth rates
(and, in particular, the rate of technological progress)
might change from one time period to another.
– Solow’s growth model implies more rapid
convergence of incomes than seems actually to have
occurred, particularly between developed and
developing countries.
The problem of DMP
• The main reason why lon grun economic growth is to
cease or stagnant in the Solow Growth model is
because of the diminishing MP of inputs (capital and
labor), and exogenous technological growth.
• Empirical results on the neoclassical model raised
several questions about the diminishing marginal
returns to capital, the exogeneity of technical change
and hence researchers have focused on these
elements.
– The assumption of an exogenous growth rate is a
simplification to work with a simple model, but it is not
very realistic.
• The principal engine behind endogenous
growth is the elimination of the assumption of
decreasing returns to “capital.”
– how?
1. Through endogenizing technological growth
• If the rate of growth of A is not exogenous, what is
behind A?
– This is the aim of endogenous growth models: to explain the
engines of growth.
2. by direct assumption:
– The Endogenous Growth Models examine the
endogeneity of n, s and the rate of technological
change which are assumed to be exogenous in the
neoclassical model.
– The pioneer of “endogenous growth theory” is
Paul Romer. His 1986 paper in the Journal of
Political Economy is a seminal work in the modern
revitalization of growth theory.
Basic ideas of New Growth Theories
• The main points of the endogenous growth theory are as follows:
1.
2.
3.
4.
5.
6.
7.
The rate of technological progress should not be taken as a given in a
growth model – appropriate government policies can permanently
raise a country’s growth rate particularly if they lead to a higher level
of competition in markets and a higher rate of innovation
improvements in productivity can be linked to a faster pace of
innovation and extra investment in human capital.
positive externalities and spill-over effects from development of a
high valued-added knowledge economy
There are potential increasing returns from higher levels of capital
investment
Private investment in R&D is the central source of technical progress
Protection of property rights and patents can provide the incentive
to engage in R&D
Investment in human capital (education and training of the
workforce) is an essential ingredient of growth
The Economics of Ideas
• What is ideas/technology?
– …..is the way inputs to the production process are
transformed in to outputs.
• technologies are by no means limited to facts of
engineering, or an innovation of machine
– It is a thing that improves the efficiency of your job.
• It is any idea that improves the way inputs are used to
produce output.
– Thus, ideas are broadly defined to include:
• Designs for new products: the Pentium chip, the steam
engine,...
• New ways of organizing production: Walmart, the assembly
line.
Characteristics of Ideas
• Romer observed that ideas are very different
from most other economic goods.
– Most goods like CD player, lawyer services are
rivals.
– In contrast, ideas are non-rivalrous.
• An idea can be used by many at the same time.
– Once an idea has been created, any one with the knowledge
of the idea can take the advantage of it.
– Many people can use it without diminishing its value
» Ex:-just in time inventory method, BPR, Calculus, design
for some product
• In practice, it may not be possible to use the
same idea many times.
– Obstacles include: Patents, copy rights, Secrecy
• Thus, it may be possible to exclude others
from using an idea.
– Non-rivalry is a technological concept.
– Excludability is a social / legal arrangement.
• Note:
• Goods that are excludable allow their producers to capture
the benefit they produce
• Goods that are not excludable involves substatntial spillover
of benefits that are not captured by the producers.
• Goods with +ve spillover tend to be underproduced by mkt
• Goods with -ve spillover tend to be overproduced by mkt
• Goods that are rivalrous must be produced each time they
are sold; but non rivalrious goods need to be produced only
once.
• Production uses rival inputs (capital and labor)
and non-rival inputs (ideas).
– It seems safe to assume (at least) constant returns
to rival inputs
• Doubling K and L should (at least) double Y . - Why?
– That means: Doubling all inputs (including ideas)
more than doubling of output.
• Nonrivaly ⟹ Increasing returns to scale.
• We know from our intermediate microeconomics that
market economies tend towards “efficient” outcomes
only when markets are perfectly competitive.
– Under perfect competition prices reflect the marginal
"values" of goods.
– i.e., Perfect competition requires that goods are priced at
marginal cost.
• What happens if a firm tries that when production has
increasing returns to scale?
– With increasing returns: Marginal cost < average cost.
– Thus, the firms incurs a loss, if price = marginal cost.
• Note that non rivalrious goods have a fixed cost of production and
very low (and sometimes zero) marginal cost.
– Ex:
• It took Bill Gates millions of dollar, to develop microsoft but it is duplicated at
significantly lower cost.
• Many drugs should cost virtually nothing, but their prices must amortize
hundreds of millions of dollars in drug development costs. (It may costs $800m
to invent, but each dose costs $1 to produce.)
Cost
AC
MC
Q
• Thus, the economics of ideas is tied intimately
to the presence of Increasing RS and imperfect
competition.
• The innovator must be able to charge more
than marginal cost for some time.
– This is what the patent system achieves.
– While government incentives such as prizes or
public funding could substitute for these market
incentives in cetain cases, history suggests that it
is only when the market incentives were sufficient
that widespread innovation and growth took hold
– To promote market incentive, the government
often provides patent right to innovators.
• A patent is a legal document that describes an
invention and entitles the patent owner to a monopoly
over the invention for some period of time (like 17, 20,
50 years etc.)
Romer Growth model
• Basic element of the model:
– The model endogenizes technological progress by
introducing the search for new ideas by
researchers interested in profiting from their
inventions
• Note that in the advanced world technological progress
is driven by R&D
– Objective: to explain why and how the advanced
countries of the world exhibit sustained growth.
• How the world technological frontier is continually
pushed outward.
• Basic principle
– It combines neoclassical production with theory of
Research & Development
– Technological progress isn’t free—it is the result of costly
R&D efforts that must be rewarded in the market.
– Economy with three sectors:
1.
2.
3.
Final Production Sector: Final goods Y are produced from
intermediate products and labor LY at a given level of technology
A. Interpret “A” as number of existing blueprints/ideas.
Research Production Sector: New blueprints/ideas are created
from labor inputs LA, building on the existing technology A. Labor
force L=LY + LA.
Intermediate Products Sector: included as device to model cost
recovery for R&D, and to handle increasing returns to scale in K,
L, and A.
The Research Sector
• Assumption:
– Research is labor-intensive. For simplicity, omit capital inputs to research.
– Research output at the individual level is proportional to the labor input:
– technology is endogenized
• Romer defined the rate of technological growth as follows:

• Where:
A   . LA
– A=stock of existing knowledge (or number of ideas that has been invented up
to time t)
– Ả =the number of new ideas produced at any given point of time
– 𝜹=the rate at which new ideas are discovered
– LA= number of people attempting to discover new ideas
• Note: L=LA+LYlabor is used either to produce new ideas or new goods
– The above equation implies that how technology
grows depends on the rate at which technology is
discovered times the number of people engaged
in a creation of ideas (people engaged in research
and development).
– But what determines 𝜹?
   . A
• The rate at which new ideas are derived depends on
how the previous ideas help in promoting new ideas
• Thus, the property of ᵹ depends on the value of 𝜙:
– 𝜙=0:
• ᵹ grows at constant rate; (1/month, 1/year, ….etc).
• Productivity of research is independent of the stock of knowledge
– 𝜙<0: negative spillover from the existing research
• Fishing-out case
• The more technology is developed, the harder to get new technology
– 𝜙>0: positive knowledge spillover in reaserch
• A grows at an increasing returns
• Productivity of research increases with the stock of ideas that have
already been discovered.
• Hence,

A  A LA
• This implies that growth in A is proportional to LA. But
this is not always the case, for duplication of ideas.
– If more people do research competitively. Efforts
might be duplicated or wasted.
– Book page 382
Steady State Growth
• Book