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. 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

2. improvements in productivity can be linked to a faster pace of innovation and extra investment in human capital.

3. positive externalities and spill-over effects from development of a high valued-added knowledge economy

4. There are potential increasing returns from higher levels of capital investment5. Private investment in R&D is the central source of technical progress6. Protection of property rights and patents can provide the incentive to engage

in R&D7. 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.)

AC

MC

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Cost

• 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. 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.

2. Research Production Sector: New blueprints/ideas are created from labor inputs LA, building on the existing technology A. Labor force L=LY + LA.

3. 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=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+LYlabor is used either to produce new ideas or new goods

ALA .

– 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?

• The rate at which new ideas are derived depends on how the previous ideas help in promoting new ideas

A.

• Thus, the property of ᵹ depends on the value of 𝜙:– 𝜙=0:

• grows at constant rate; (1/month, 1/year, ….etc).ᵹ• 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,

• 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

ALAA

Steady State Growth

• Book