Chapter 7

Endogenous Growth II: R&D and

Technological Change

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7.1

Expanding Product Variety: The Romer Model

There are three sectors: one for the nal good sector, one for intermediate goods, and one for R&D.
The nal good sector is perfectly competitive and thus makes zero prots. Its output is used either
for consumption or as input in each of the other two sector.
The intermediate good sector is monopolistic. There is product dierentiation. Each intermediate
producer is a quasi-monopolist with respect to his own product and thus enjoys positive prots. To
become an intermediate producer, however, you must rst acquire a blueprint from the R&D sector.
A blueprint is simply the technology or know-how for transforming nal goods to dierentiated
intermediate inputs.
The R&D sector is competitive. Researchers produce blueprints. Blueprints are protected by
perpetual patents. Innovators auction their blueprints to a large number of potential buyers, thus
absorbing all the prots of the intermediate good sector. But there is free entry in the R&D sector,
which drive net prots in that sector to zero as well.
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7.1.1

Technology

The technology for nal goods is given by a neoclassical production function of labor L and a
composite factor X :

Yt = F (Xt , Lt ) = A(Lt )1 (Xt ) .

The composite factor is given by a CES aggregator of intermediate inputs:

Xt =

1/

Nt

(Xt,j ) dj

where Nt denotes the number of dierent intermediate goods available in period t and Xt,j denotes
the quantity of intermediate input j employed in period t.

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In what follows, we will assume = , which implies

Nt

Yt = A(Lt )

(Xt,j ) dj.

Note that = means the marginal product of each intermediate input is independent of the
quantity of other intermediate inputs:
Yt
= A
Xt,j

Lt
Xt,j

1
.

More generally, intermediate inputs could be either complements or substitutes, in the sense that the
marginal product of input j could depend either positively or negatively on Xt .

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We will interpret intermediate inputs as capital goods and therefore let aggregate capital be given
by the aggregate quantity of intermediate inputs:

Nt

Kt =

Xt,j dj.
0

Finally, note that if Xt,j = X for all j and t, then

Yt = AL1
Nt X
t

and

Kt = Nt X,

implying
Yt = A(Nt Lt )1 (Kt )
or, in intensive form, yt = ANt1 kt . Therefore, to the extent that all intermediate inputs are used in
the same quantity, the technology is linear in knowledge N and capital K. Therefore, if both N and
K grow at a constant rate, as we will show to be the case in equilibrium, the economy will exhibit
long run growth, as in an AK model.
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7.1.2

Final Good Sector

The nal good sector is perfectly competitive. Firms are price takers.
Final good rms solve

Nt

max Yt wt Lt

(pt,j Xt,j )dj

where wt is the wage rate and pt,j is the price of intermediate good j.
Prots in the nal good sector are zero, due to CRS, and the demands for each input are given by
the FOCs
wt =

Yt
Yt
= (1 )
Lt
Lt

and

pt,j

Yt
=
= A
Xt,j

for all j [0, Nt ].

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Lt
Xt,j

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7.1.3

Intermediate Good Sector

The intermediate good sector is monopolistic. Firms understand that they face a downward sloping
demand for their output.
The producer of intermediate good j solves
max t,j = pt,j Xt,j (Xt,j )
subject to the demand curve

Xt,j = Lt

A
pt,j

1
1

where (X) represents the cost of producing X in terms of nal-good units.

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We will let the cost function be linear:

(X) = X.
The implicit assumption behind this linear specication is that technology of producing intermediate
goods is identical to the technology of producing nal goods. Equivalently, you can think of interme
diate good producers buying nal goods and transforming them to intermediate inputs. What gives
them the know-how for this transformation is precisely the blueprint they hold.

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The FOCs give

pt,j = p

1
>1

for the optimal price, and

Xt,j = xL
for the optimal supply, where
1

x A 1 1 .
The resulting maximal prots are
t,j = L
where
(p 1)x =

1
x

233

1
2
1 1
A 1 .

Economic Growth: Lecture Notes

Note that the price is higher than the marginal cost (p = 1/ > (X) = 1), the gap representing
the mark-up that intermediate-good rms charge to their customers (the nal good rms). Because
there are no distortions in the economy other than monopolistic competition in the intermediategood sector, the price that nal-good rms are willing to pay represents the social product of that
intermediate input and the cost that intermediate-good rms face represents the social cost of that
intermediate input. Therefore, the mark-up 1/ gives the gap between the social product and the
social cost of intermediate inputs.
Hint: The social planner would like to correct for this distortion. How?

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7.1.4

The Innovation Sector

The present value of prots of intermediate good j from period t and on is given by
Vt,j =

q
=t

qt

,j

or

Vt,j = t,j +

Vt+1,j
1 + Rt+1

We know that prots are stationary and identical across all intermediate goods: t,j = L for all t, j.
As long as the economy follows a balanced growth path, we expect the interest rate to be stationary
as well: Rt = R for all t. It follows that the present value of prots is stationary and identical across
all intermediate goods:
Vt,j = V =

L
L

.
R
R/(1 + R)

Equivalently, RV = L, which has a simple interpretation: The opportunity cost of holding an

asset which has value V and happens to be a blueprint, instead of investing in bonds, is RV ; the
dividend that this asset pays in each period is L; arbitrage then requires the dividend to equal the
opportunity cost of the asset, namely RV = L.
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New blueprints are produced using the same technology as nal goods: innovators buy nal goods
and transform them to blueprints at a rate 1/. It follows that producing an amount N of new
blueprints costs N, where > 0 measures the cost of R&D in units of output.
On the other hand, the value of these new blueprints is V N, where V = L/R.
It follows that net prots for a research rm are thus given by
prof itsR&D = (V ) N

Free entry in the sector of producing blueprints imposes prof itsR&D = 0, or equivalently
V = .

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7.1.5

Households

Households solve
max

t u(ct )

t=0

s.t. ct + at+1 wt + (1 + Rt )at

As usual, the Euler condition gives

u (ct )

= (1 + Rt+1 ).
u (ct+1 )

And assuming CEIS, this reduces to

ct+1
= [(1 + Rt+1 )] .
ct

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7.1.6

Resource Constraint

Final goods are used either for consumption by households (Ct ), or for production of intermediate

goods in the intermediate sector (Kt = j Xt,j ), or for production of new blueprints in the innovation
sector (Nt ). The resource constraint of the economy is therefore given by
Ct + Kt + Nt = Yt ,
where Ct = ct L, Nt = Nt+1 Nt , and Kt =

Nt
0

Xt,j dj.

As always, the sum of the budgets across agents together with the market clearing conditions reduce
to the resource constraint. Question: what are the market clearing conditions here? Related: what
are the assets traded by the agents?

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7.1.7

General Equilibrium

Combining the formula for the value of innovation with the free-entry condition, we infer L/R =
V = . It follows that the equilibrium interest rate is
R=

L
=

1
2
1 1
A 1 L/,

which veries our earlier claim that the interest rate is stationary.
The Euler condition combined with the equilibrium condition for the real interest rate implies that
consumption grows at a constant rate, which is given by

Ct+1
= 1 + = [1 + R] = 1 +
Ct

239

1
2
1 1
A 1 L/

Economic Growth: Lecture Notes

Next, note that the resource constraint reduces to

Nt+1
Ct
Yt
+
1 +X =
= AL1 X ,
Nt
Nt
Nt
where X = xL = Kt /Nt .
It follows that Ct /Nt is constant along the balanced growth path, and therefore Ct , Nt , Kt , and Yt all
grow at the same rate, , where, again,

1 + = 1 +

1
2
1 1
A 1 L/

The equilibrium growth rate of the economy decreases with , the cost of producing new knowl
edge.The growth rate is also increasing in L, or any other factor that increases the scale (size) of the
economy, and thereby raises the prots of intermediate inputs and the demand for innovation. This
is the (in)famous scale eect that is present in many models of endogenous technological change.

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7.1.8

Eciency and Policy Implications

Consider now the problem of the social planner. He chooses {Ct , (Xt,j )j[0,Nt ] , Nt+1 }
t=0 so as to
maximize lifetime utility subject to the resource constraint that the technologies.
Obviously, due to symmetry in production, the social planner will choose the same quantity of
intermediate goods for all varieties: Xt,j = Xt = xt L for all j. Using this, we can write the problem
of the social planner as follows:
max

t u(ct ),

t=0

subject to

Ct + Nt Xt + (Nt+1 Nt ) = Yt = AL1 Nt Xt ,

where Ct = ct L.

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The FOC with respect to Xt gives

Xt = x L,

where

x = A 1 1
represents the optimal level of production of intermediate inputs.
The Euler condition, on the other hand, gives the optimal growth rate as

1 + = [1 + R ] = 1 +

1
1
1 1
A 1 L/

where
R =

1
1
1 1
A 1 L/

represents that social return on savings.

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Note that
1

x = x 1 > x
That is, the optimal level of production of intermediate goods is higher in the Pareto optimum than
in the market equilibrium. This reects simply the fact that, due to the monopolistic distortion,
production of intermediate goods is ineciently low in the market equilibrium. Naturally, the gap
x /x is an increasing function of the mark-up 1/.
Similarly,
1

R = R 1 > R.
That is, the market return on savings (R) falls short of the social return on savings (R ), the gap
again arising because of the monopolistic distortion in the intermediate good sector. It follows that
1 + > 1 + ,
so that the equilibrium growth rate is too low as compared to the Pareto optimal growth rate.
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Policy exercise: Consider four dierent types of government intervention:

a subsidy on the production of nal goods
a subsidy on the demand for intermediate inputs
a subsidy on the production of intermediate inputs
a subsidy on R&D.
Which of these policies could achieve an increase in the market return and the equilibrium growth
rate? Which of these policies could achieve an increase in the output of the intermediate good sector?
Which one, or which combination of these policies, can implement the rst best allocation as a market
equilibrium?

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7.1.9

Building on the Shoulders of Giants

In the original Romer (1990) model, the innovation sector uses a dierent technology than the
one assumed here. In particular, the technology for producing a new blueprint is linear in the
eective labor employed by the research rm, where eective means amount of labor (number of
researchers) times the existing stock of knowledge. Hence, for research rm j,

Nj,t = Lj,t Nt
The aggregate rate of innovation is thus given by
Nt = LtR&D Nt
where LR&D
is the total amount of labor employed in the R&D sector. Market clearing in the labor
t
. The private cost of innovation is now proportional to wt , while the
+ LR&D
=L
market is now Lnal
t
t
value of innovation remains as before. The rest of the model is also as before.
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The key modication here in that the aggregate Nt enters the technology of producing new blueprints
new researchers build on the shoulders of previous researchers.
We have thus introduced a knowledge spillover that was absent in the previous model. When todays
research rms decide how much to spend on R&D, they do not internalize how this will improve the
know how of future innovators.
How does this aect the eciency/policy conclusions we derived in the previous model?
Imagine that the technology faced by research rm j was given by
Nj,t = (Lj,t )1 (Kj,t )2 (Nt )3

What are the restrictions for 1 , 2 and 3 that are necessary for perpetual growth? What are the
restrictions that are necessary for the individual rm to perceive constant returns to scale, and hence
for the R&D sector to be competitive?

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7.2

A Simple Variant of Aghion-Howitt

The economy is populated by a large number of entrepreneurs. Each entrepreneur lives (is present
in the market) for 1+T periods, where T is random. Conditional on being alive in the present period,
there is probability n that the entrepreneur will die (exit the market) by the end of that period. n is
constant over time and independent of age. In each period, a mass n of existing entrepreneurs dies,
and a mass n of new entrepreneurs is born, so that the population is constant.
In the rst period of life, the entrepreneur is endowed with the aggregate level of knowledge in the
economy. In the rst period of life, he also has a fresh mind and can engage in R&D activity. In
later periods of life, instead, he is too old for coming up with good new ideas and therefore engages
only in production, not innovation.
Young producers engage in R&D in order to increase the prots of their own productive activities
later in life. But individual innovation has spillover eects to the whole economy. When a mass of
producers generate new ideas, the aggregate level of knowledge in the economy increases proportion
ally with the production of new ideas.
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7.2.1

R&D Technology

j
Let Vt+1
denote the value of an innovation for individual j realized in period t and implemented in

period t + 1. Let z
tj denote the amount of skilled labor that a potential innovator j employes in R&D

and q(z
tj ) the probability that such R&D activity will be successful.
q : R
[0, 1] represents the
technology of producing innovations and satises q(0) = 0, q > 0 > q , q (0) = , q () = 0.
The potential researcher maximizes
j
q(z
tj )
Vt+1
wt ztj .

It follows that the optimal level of R&D is given by q (ztj )Vtj+1 = wt or

z
tj = g Vtj+1 /wt
where the function g(v) (q )1 (1/v) satises g(0) = 0, g > 0, g() = . Note that z will be
stationary only if both V and w grow at the same rate.
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7.2.2

The Value of Innovation

What determines the value of an innovation? For a start, let us assume a very simple structure. Let
A
jt represent the TFP of producer j in period t. The prots from his production are given by

jt = A
jt

where
represents normalized prots. We can endogenize , but we wont do it here for simplicity.
When a producer is born, he automatically learns what is the contemporaneous aggregate level of
technology. That is, A
jt = At for any producer born in period t. In the rst period of life, and only
in that period, a producer has the option to engage in R&D. If his R&D activity fails to produce an
innovation, them his TFP remains the same for the rest of his life. If instead his R&D activity is
successful, then his TFP increases permanently by a factor 1 + , for some > 0.

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That is, for any producer j born in period t, and for all periods t + 1 in which he is alive,

A
t
j
A =
(1 + )A

if his R&D fails

t

if his R&D succeeds

It follows that a successful innovation generates a stream of dividends equal to At

per period
for all > t that the producer is alive. Therefore,
Vt+1

1n
=
(At
) =
v At
1+R
=t+1

(7.1)

where where R is the interest rate per period and

1n
=1

1+R

.
R+n

Note that the above would be an exact equality if time was continuous. Note also that v is decreasing
in both R and n.
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Remark: We see that the probability of death reduces the value of innovation, simply because it
reduces the expected life of the innovation. Here we have taken n as exogenous for the economy. But
later we will endogenize n. We will recognize that the probability of death simply the probability
that the producer will be displaced by another competitor who manages to innovate and produce a
better substitute product. For the time being, however, we treat n as exogenous.

7.2.3

The Cost of Innovation

Suppose that skilled labor has an alternative employment, which a simple linear technology of pro
ducing nal goods at the current level of aggregate TFP. That is, if lt labor is used in production of
nal goods, output is given by At lt . Since the cost of labor is wt , in equilibrium it must be that
wt = At .

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7.2.4

Equilibrium

Combining (7.1) and (7.2), we infer that

Vt+1
=
v
wt
It follows that the level of R&D activity is the same across all new-born producers:

ztj = zt = g (v) .

The outcome of the R&D activity is stochastic for the individual. By the LLN, however, the aggregate
outcome is deterministic. The aggregate rate of innovation is simply
t = q(zt ) = (
v)
where (x) q (g (x)) .

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It follows that the aggregate level of technology grows at a rate

At+1
= 1 + t = 1 + (
v) .
At
An increase in
increases the incentives for R&D in the individual level and therefore results to
higher rates of innovation and growth in the aggregate level. An increase in has a double eect.
Not only it increases the incentive for R&D, but it also increase the spill over eect from individual
innovations to the aggregate level of technology.
What is aggregate output in the economy? Its the sum of the output of all entrepreneurs plus the
output of workers not employed in R&D. Check that aggregate output grows at the same rate as
aggregate knowledge.

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7.2.5

Business Stealing

Consider a particular market j, in which a producer j has monopoly power. Suppose now that there
is an outside competitor who has the option to engage in R&D in an attempt to create a better
product that is a close substitute for the product of producer j. Suppose further that, if successful,
the innovation will be so radical that, not only it will increase productivity and reduce production
costs, but it will also permit the outsider to totally displace the incumbent from the market.
Remark: Here we start seeing how both production and innovation may depend on the IO structure.
In more general versions of the model, the size of the innovation and the type of competition (e.g.,
Bertrand versus Cournot) determine what is the fraction of monopoly prots that the entrant can
grasp and hence the private incentives for innovation.

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What is the value of the innovation for this outsider? Being an outsider, he has no share in the
market of product j. If his R&D is successful, he expects to displace the incumbent and grasp the
whole market of product j. That is, an innovation delivers a dividend equal to total market prots,
, in each period of life. Assuming that the outsider also has a probability of death (or
(1 + )At
displacement) equal to n, the value of innovation for the outsider is given by
out
Vt+1

1n
=
[(1 + )At ]
= (1 + )
vAt
1
+
R
=t+1

Now suppose that the incumbent also has the option to innovate is later periods of life. If he does so,
he will learn the contemporaneous aggregate level of productivity and improve upon it by a factor
1 + . The value of innovation in later periods of life is thus the same as in the rst period of life:
in
Vt+1

1n
=
[At
] = vA
t.
1
+
R
=t+1

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Economic Growth: Lecture Notes

out
in
Obviously, Vt+1
> Vt+1
. This is because the incumbent values only the potential increase in produc

tivity and prots, while the outsider values in addition the prots of the incumbent. This business
stealing eect implies that, ceteris paribus, that innovation will originate mostly in outsiders.
Remark: In the standard Aghion-Howitt model, as opposed to the variant considered here, only
outsiders engage in innovation. Think why this is the case in that model, and why this might not
be the case here. Then, nd conditions on the technology q and the parameters of the economy
that would ensure in our model a corner solution for the insiders and an interior solution for the
outsiders. (Hint: you may need to relax the Inada condition for q.) We will henceforth assume that
only outsiders engage in innovation.
Remark: Things could be dierent if the incumbent has a strong cost advantage in R&D, which
could be the case if the incumbent has some private information about the either the technology of
the product or the demand of the market.

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out
Assuming that only outsiders engage in R&D, and using Vt+1
/wt = (1+)
v, we infer that the optimal

level of R&D for an outsider is

ztout = zt = g ((1 + )v) .
and therefore the aggregate rate of innovation is
t = q(zt ) = ((1 + )v)
We conclude that the growth rate of the economy is
yt+1
At+1
=
= 1 + ((1 + )
v) .
yt
At

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We can now reinterpret the probability of death as simply the probability of being displaced by a
successful outside innovator. Under this interpretation, we have
n = ((1 + )
v)
and v solves

v =

R + ((1 + )
v)

Note that an increase in

will now increase v by less than one-to-one, because the displacement rate
will also increase.

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7.2.6

Eciency and Policy Implications

Discuss the spillover eects of innovation... Both negative and positive...

Discuss optimal patent protection... Trade-o between incentives and externalities...

7.3

Ramsey Meets Schumpeter: The Aghion-Howitt Model

notes to be completed

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7.4

Romer Meets Acemoglu: Biased Technological Change

7.4.1

Denition

Consider a two-factor economy, with

Yt = F (Lt , Ht , At )
where L and H denote, respectively, unskilled labor and skilled labor (or any two other factors) and
A denotes technology.
We say that technology is Hbiased if and only if

F (L, H, A) /H
F (L, H, A) /L

>0

Note that this is dierent from saying that technology is Haugmenting.

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7.4.2

A simple model of biased technological change

We onsider a variant of the Romer model where we split the nal good sector in two sub-sectors, one
that is intensive in L and another that is intensive in H.
Aggregate output is given by

Yt = (YLt )

+ (1 ) (YHt )

where

NLt

YLt = L

(xLt )1 dj

YHt = H

NHt

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The dierentiated intermediate input rms use blueprints to transform 1 unit of the nal good to
one unit of the dierentiated intermediate good.
The R&D rms transform nal goods to blueprints. Blueprints
The resource constraint is given by
Ct + Kt + L NLt + H NHt Yt ,
where

NLt

Kt =

xLt dj +
0

xHt dj.
0

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NHt

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Given the technologies, the skill premium is given by

wH

= const
wL

NH
NL

where
( 1) (1 ) .

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L

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The relative value of innovations is given by

VH
VL

pH
pL

H
L

1 1
NH
H
= const
.
NL
L
=

and the equilibrium innovation rates satisfy

NH
NL

= const

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H
L

1
.

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Hence, once we take into account the endogeneity of technologies, the equilibrium skill premium is

given by

= const

265

H
L

2
.

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Finally, it is easy to show that the growth rate is given by

1
1
(1 ) (H H)1 + (L L)1 1 .

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