Advanced Economic Analysis

Lecture 9: The New Endogenous Growth Theory I

Contents

Background Basic Structure The AK models and optimal growth Two examples of AK models: Romer 1986 and Lucas 1988 Entrepreneurial efforts and innovation

Background

Main objectives of the NEGT:

Explain the Solow residual Make the economic growth rate dependent on the saving decision of individual agents

The basic structure of NEGT models

The Ramsey model: U = 0 U [C (t )] e nt e - t dt

(1) (2) (3) (5)

a = w + ra c na
u ' ' (c)c r = (c/ c) u ' (c)

(c/ c) = (1 / )( r )

The basic structure of NEGT models

The basic AK model: Y = AK dK(t)/dt = sY(t) dK(t)/dt = sAK (6)
(equation (2) Solow model)

(7)

long term growth rate depends on saving

(investment rate): scale effect

Comparison Harrod-Domar - Solow - AK

Harrod-Domar

gw = s/c
where c = incremental capital-output ratio

dK (t ) / dt c = K/Y K/ Y dY (t ) / dt

k/ y

Hence, also :

y/ k

= 1/c.

Comparison Harrod-Domar - Solow - AK

Solow model:

k = s (k) nk k /k = s (k)/k n
Since y = (k): k/k = s y/k n Assuming k = 0 s y/k = n, or gw = s/c = n gw = s/c = n +

(equation 4 Solow model)

where stands for exogenous technical progress

Comparison Harrod-Domar - Solow - AK

AK model,:
y = Ak, (6.1) (7.1)

where y = Y/L and k = K/L,

k = sAk k /k = sA
gw = s/c = s/(1/A) = sA

Comparison Harrod-Domar - Solow - AK

Harrod-Domar

Solow

AK models

gw =

s/c

n+

sA

Basic AK model

Growth rate of consumption (per capita):

A = r +d. Therefore: R=A-d

k /k = (c/ c) = (1 / )(( A d ) )

(8)

What is the meaning of constant returns to

capital?

Romer 1986

One-sector model Learning-by-investment Firm knowledge is a public good If Ai denotes all knowledge controlled by a firm, then changes in Ai correspond to learning-by-doing across economy and this is proportional to changes in capital stock

Romer 1986
Yi = F (Ki, K(Li)) Yi = A (Ki) (KLi) 1- Yi/Ki = AL1-
Therefore:

(9) (10)

k /k = (c/ c) = (1 / )( AL1 ) (11) y/k = AL1-. k /k PLANNER =

Therefore:

(1/ )( AL

(11a)

Romer 1986

Actual growth rate of decentralised economy is below optimal growth rate due to knowledge externalities Perfect competition prevails since producers remain unaware of positive externality (firm-external) Space for government policies

Lucas 1988

Two-sector model: capital accumulation and investment in education Constant rate of growth derived from interpretation of growth of labour efficiency as a combination of a given accumulation of knowledge with an explanation of its growth in terms of a society s preferences between present and future consumption

Lucas 1988

Y = a y K ( Ly H i )

1-

Ha

(12)

H = a H HL H

where ay is a positive constant (i.e. a parameter for technical progress) Ly is labour employed in the process of the production of real output, Hi corresponds to individual human capital, and Ha denotes the general state of education

(13)

where aH is a positive constant, H is the given stock of human capital, and LH is labour employed in the process of building human capital

Lucas 1988

Firms face constant returns to capital and labour Overall production function characterised by increasing returns to scale Formation/accumulation of human capital (13) characterised by exactly constant returns Existence of steady-state balanced growth attributed to human skills and knowledge (of human capital) acquired through intentional learning process Equation (13) effectively transforms labour from a scarce resource into an accumulable factor

Entrepreneurial efforts: R&D

Microeconomic explanation for endogenisation of technical progress Increasing returns to scale and imperfect competition Constant returns to some type of capital or accumulable factor of production remain central

Romer 1990

Product differentiation Knowledge is non-rivalrous and partially excludable IRS (research-intensive production) and imperfect competition 3-sector model: final goods, intermediate goods, research sector

Intermediate goods sector: monopolistic competition (high product variety and each individiual good is produced by a monopolist), free entry into the sector, returns to production of intermediate goods can be made firm-specific Research sector: perfect competition that determines the equilibrium number of intermediate inputs (A) and ensures zero profit for marginal entrant; researches make free use of knowledge stock A In the long run, general knowledge is both an input into and an output of the production of intermediate goods (blue-prints), i.e. positive knowledge externality in both intermediate and research sector

Romer 1990
Aggregate Production Function (14) where Ly is labour employed in the production process. The production of ideas and designs (A) is a function of the aggregate research effort (Li) and the rate of discovery of new ideas () in the following form:

Y = K (AL y ) 1

A = L I A

(15)

Romer 1990
The rate of technological progress (or the growth rate of A) is:

A = L I A

(16)

Productivity of research is exactly proportional to the existing stock of ideas, i.e. externality due to past innovations exhibits constant returns

Romer 1990
The steady-state growth rate for the decentralised economy is:

L gw = +

(17)

where = total labour supply, 1/ monopoly mark-up

Equilibrium growth rate of decentralised economy will be less than social optimum

Jones 1998
Adjusted R&D equation:

A = (A LI -1 )L I

(15a)

where 01 and 01. denotes an additional externality reflecting the likely duplication of research efforts.

Therefore, the rate of growth of the stock of ideas A now is:

LbI-1 A = 1- L I A A

(16a)

Jones 1998

Solving the model in the same way as Romer, the steady state growth rate of the stock of ideas or design becomes:

gw

n = 1

(17a)

where n denotes the population growth rate.

Jones 1998

A growing population rises the level of technology (conscious research efforts resulting in non-rivalrous ideas) Growth rate independent of the savings rate: Solowian dynamics

Schumpeterian innovation models

Vertical product innovation with obsolence ( creative destruction ) Imperfect (monopolistic) competition and IRS in research-intensive and innovation sectors Aghion and Howitt 1998:

Constant returns to research activities arise from the assumption that every innovation generates a proportionate increase in A and that the marginal productivity of research is independent of the number of researchers in the economy

Schumpeterian innovation models

Aghion and Howitt 1998 contd:

IRS generate externalities so that optimal and equilibrium growth paths differ (as in Romer 1990) In addition to positive intertemporal spillover effect from innovation, there is a negative business stealing effect and a positive appropriability effect. The relationship between the optimal and the equilibrium growth paths, and the design of government policies to promote innovation, depends on sizes of the two positive and the negative externalities.