Endogenous Growth Models

Lorenza Rossi

Goethe University 2011-2012

Endogenous Growth Theory

Neoclassical Exogenous Growth Models

technological progress is the engine of growth
technological improvements are automatic and unmodeled (exogenous)

Endogenous Growth Models

Try to explain the engine of growth
It is important to understand the economic forces underlying
technological progress
Endogenous Growth and Learning

IDEA: Capital accumulation embeds technological improvements

(Arrow 1962 =)Romer 1982)
Firms production function

Y (i ) = AK (i )α L (i )1 α

where A is the Total Factor Productivity (TFP).

Technology A depends on Capital Stock. The higher the capital stock
the more the economy is able to use new technologies

A = BK 1 α

where K is the aggregate level of capital stock and B is the learning

factor (positive externality). Imposing symmetry across …rms and
substituting in the production function, we get the aggregate
production function
Y = BKL1 α
Endogenous Growth and Learning
Assuming that population L is constant and equal to 1. Then, the
aggregate production function becomes,
Y = BK
This production function is characterized by constant return to scale.
The marginal productivity of capital is constant and equal to the
average productivity of capital and is B.
The low of motion of capital is
K̇ = sY dK
hence the growth rate of capital is
K̇ Y
=s d = sB d
K K
given that YK = B =constant, K̇
K = Ẏ
Y . If sB > d =) the growth rate
is positive.
Endogenous Growth and Learning

NOTICE!!!! IMPORTANT!! The rate of growth of A is

Ȧ K̇
= (1 α) = (1 α) (sB d)
A K
Contrary to the Solow model, the rate of growth of technology
depends on the rate of growth of capital. At the same time
technology a¤ects capital. Growth is an endogenous process.
No transitional dynamics
An increase in savings means that the growth rate increases
permanently.
Endogenous Growth and Learning

How to introduce a transitional dynamics

Suppose that
A = B0 + B1 K 1 α

then
Y = B0 K α + B1 K
and the rate of growth of capital

K̇ 1
= sB0 K α + sB1 d
K
the rate of growth of K is decreasing in K and converges to sB1 d.
Endogenous Growth and Learning

Endogenous growth plus transitional dynamics

Endogenous Growth and Learning

Human capital and Endogenous Growth (Lucas 1988).

The production function

Y = K α (AL)1 α

where
A=H
human capital increases labor productivity, with L = 1

Y = K αH 1 α
Endogenous Growth and Learning

De…ne sK as the amount of GDP spend for capital accumulation. For

simplicity and without loss of generality, we now assume that the
capital depreciation rate is d = 0. Hence,

K̇ = sK Y = sK K α H 1 α

De…ne sH as the amount of GDP spent for human capital

accumulation.
Ḣ = sH Y = sH K α H 1 α
Endogenous Growth and Learning
De…ne γ = KH . substituting in the low of motion of capital and
dividing by K
K̇
= sK γ 1 α
K
Similarly
Ḣ
= sH γ α
H
Consider that
γ̇ Ḣ K̇
=
γ H K
Ḣ K̇ γ̇ K̇
If H > K =) γ > 0 and γ increases. If γ increases K increases,
Ḣ γ̇
while H reduces, so that γ decreases. On the contrary if
Ḣ K̇ γ̇ K̇
H < K =) γ < 0 and γ decreases. If γ decreases K decreases,
while Ḣ
H increases, so that γ̇
γ increases. The process stops only when
Ḣ K̇ γ̇
H = K and γ = 0.
Endogenous Growth and Learning

If γ̇γ = 0, then γ is equal to its steady state value, which is obtained

taking
Ḣ/H s γ α
= H 1 α =1
K̇ /K sK γ
solving for γ
sH
γ =
sK
Substituting this value in the low of motion of physical and human capital

K̇ Ḣ
= sKα sH1 α
=
K H
Endogenous Growth and Learning

The GDP growth rate is

Ẏ K̇ Ḣ
= α + (1 α)
Y K H
hence in the steady state of γ

Ẏ
= sKα sH1 α
Y
Barro’s model of Endogenous Growth with Government
Spending and Taxation

Barro (1990) suggests a simple endogenous growth model with

government.
In the Barro model public spending goes for public investment
(infrastructures, schools, sanitation etc.).
Public investments, which are …nanced through income taxes,
complement private investments.
Since public investments raise the productivity of private investments,
higher taxes can be associated with an increase or a decrease in
overall growth.
Barro’s model of Endogenous Growth with Government
Spending and Taxation

The model. Barro (1990) adds public spending to the Romer AK

model.
Y = BK 1 α G α
where
G = τY
substituting into the production function

Y = K1 α
(τY )α

solving for Y
1 α
Y = B1 α τ1 α K = B̄ (τ ) K
1 α
where B̄ (τ ) = B 1 α τ1 α
Barro’s model of Endogenous Growth with Government
Spending and Taxation
The low of motion of capital

K̇ = s (1 τ) Y dK

Then,
K̇ 1 α
= s (1 τ ) B̄ (τ ) d = s (1 τ) B 1 α τ1 α d
K
thus if s (1 τ ) B̄ (τ ) > d =) K̇
K >0
Which is the e¤ect of taxation on growth? The economy faces a
La¤er Curve
Which is the optimal tax rate, i.e. the tax rate maximizing
growth?
We consider two models. 1) a model with exogenous savings; 2) A
model with endogenous savings (Ramsey approach)
Barro’s model and the La¤er curve

Optimal taxation in a model with exogenous savings

K̇
It is su¢ cient to take the derivative of K wrt τ and set equal to zero.

∂ K̇
K 1 α α 1 1 +2α
=0: sB 1 α τ 1 α + s (1 τ) B 1 α τ 1 α =0
∂τ 1 α
solving for
τ =α
which is the optimal tax rate, i.e. the tax rate that maximizes growth.
Optimal taxation in a model with exogenous savings
The Barro model with endogenous savings

Optimal taxation in a model with endogenous savings

For simplicity, and without loss of generality, we assume that
population is constant and equal to L = 1, and that capital
depreciation rate is d = 0.
Given that L = 1 and constant, this means that per capita variables
are identical to variables in level, C = c, Y = y , K = k.
Then, the decentralized Ramsey problem is

C1 θ ρt
max e
fC ,K g 1 θ
s.t. K̇ = (1 τ ) Y C
Y = BK 1 α G α
The Barro model with endogenous savings

The present value Hamiltonian associated is

C1 θ
H= e ρt
µ (1 τ ) BK 1 α
Gα C
1 θ
FOCs wrt. consumption, capital and the costate variable are:

∂H θ ρt
1. = 0:C e µ=0
∂C
∂H α
2. = µ̇ : µ (1 τ ) (1 α) BK Gα µ̇ = 0
∂K
∂H
3. = K̇ : (1 τ ) BK 1 α
Gα C = K̇
∂µ
α α
notice that G α = B 1 α τ 1 α K α .
The Barro model with endogenous savings

Combining FOCs 1. and 2.

2 3
Ċ 14
= (1 τ ) (1 α) BK α
Gα ρ5
C θ | {z }
MPK
2 3
14 1
ρ5
α
= (1 τ ) (1 α) B 1 α τ 1 α
θ | {z }
MPK

where MPK states for Marginal Product of Capital.

The Barro model with endogenous savings

Notice that the MPK is

α
MPK = (1 τ ) (1 α) BK Gα
|{z}
| {z }
negative e¤ect of taxation positive e¤ect of public investment

Growth in consumption depends on: i) the gap between the MPK and
the rate of time preference ρ; ii) the intertemporal elasticity of
substitution θ.
Thus, Government a¤ects the MPK through two channels: i) increase
in G raises the MPK to a point; ii) taxes always reduces the private
return of capital.
The main objective of a good Government is to balance these two
e¤ects.
The Barro model with endogenous savings

Ċ
The tax rate maximizing consumption is obtained by di¤erentiating C
w.r.t. τ.

∂(Ċ /C ) 1 α 1 2α 1
1 1 α
∂τ = θ (1 τ) 1 α (1 α) B 1 α τ 1 α
θ (1 α) B 1 α τ 1 α =
0

simplifying and solving for τ

τ GR = α
∂ K̇
the same value we found for ∂τ
K
The Barro model with endogenous savings

Is the Decentralized solution also the …rst best solution?

It is important to compare the decentralized solution with the Social
Planner one.
Which is the Social Planner solution?
The Social Planner internalizes the e¤ect of G and thus the optimal
problem becomes

C 1 θ ρt
max e
fC ,K ,G g 1 θ
s.t. Resource Constraint
i.e. : Y = C +I +G
or : K̇ = Y C G = BK 1 α
Gα C G
The Barro model with endogenous savings

The present value Hamiltonian of the Social Planner is

C1 θ
H= e ρt
µ BK 1 α
Gα C G
1 θ
The Social Planner FOCs wrt. consumption, capital and the costate
variable are:
∂H θ ρt
1s. = 0:C e µ=0
∂C
∂H ∂Y
2s. = 0 : αBK 1 α
Gα 1
= 1 =) =1
∂G ∂G
∂H α
3s. = µ̇ : µ (1 α) K Gα µ̇ = 0
∂K
∂H
4s. = K̇ : BK 1 α
Gα C G = K̇
∂µ
The Barro model with endogenous savings

Combining FOCs 1s. and 2s.

Ċ 1h 1 α
i
= (1 α) B 1 α τ 1 α ρ
C θ
1 α 1 α
Notice that (1 α) B 1 α τ 1 α > (1 τ ) (1 α) B 1 α τ 1 α , hence the
MPK in the decentralized solution is (1 τ ) ∂Y ∂K , which is smaller
than what we get from the Social Planner solution, i.e. the social
marginal product ∂Y∂K , because of the tax rate. This gap between
social and private returns leads to a lower growth rate in the
decentralized solution.
Endogenous Growth and R&D Sector

The Romer model try to explain why and how advanced countries of
the world exhibit sustained growth.
Technological progress is driven by R&D sector in advanced
world.
Romer endogenizes technological progress by introducing an R&D
sector, i.e. search of new ideas by researcher interested in pro…ting
from their invention.
The aggregate production function in the Romer model is

Y = K α (ALY )1 α

Capital accumulation is

K̇ = sK Y dK
L̇
population growth is L = n.
Endogenous Growth and R&D Sector

The key equation of the Romer model is the one describing the R&D
sector.
According to Romer A is the number of ideas, or the stock of
knowledge accumulated up until time t.
The number of new ideas Ȧ is equal to the number of people devoting
their time in discovering new ideas LA , multiplied by the rate at which
they discover new ideas, i.e. δ̄. Thus,

Ȧ = δ̄LA

Labor is used either to produce good, LY , or to produce new ideas

LA . So the economy faces the following resource constraint:

L = LY + LA
Endogenous Growth and R&D Sector

The rate at which new ideas are discovered, δ̄, might be constant, or
an increasing function of A

δ̄ = δAφ

where δ and φ are constants.

Notice that with φ > 0 the productivity of research increases with the
stock of ideas that have already been discovered. On the contrary
with φ < 0, discovering new ideas becomes harder over time. With
φ = 0 the discovery rate is independent from the stock of knowledge.
Endogenous Growth and R&D Sector

It is possible that new ideas are more likely when there are more
persons engaged in research. Thus, the e¤ect of LA is not
proportional. Hence, it can be assumed that it is LAλ that enter in the
production function of new ideas, with 0 < λ < 1. The general
production function of new ideas is

Ȧ = δLAλ Aφ

Assuming that 0 < φ < 1. Dividing by A

Ȧ Lλ
= δ 1A φ
A A
which is the rate of growth along the BGP?
Endogenous Growth and R&D Sector

Along the BGP ȦA = gA = constant. Thus, the numerator and the
denominator should growth at the same rate, which means

L̇A Ȧ
λ (1 φ) =0
LA A
L̇ A
along the BGP LA = n and thus

Ȧ nλ
= gA =
A 1 φ

In this model, as in the Neoclassical model, even if growth is an

endogenous process, policy maker cannot do nothing to increase the
long-run growth rate. Indeed bot λ and φ are parameters independent
on policies, such as subsidies to R&D
Endogenous Growth and R&D Sector

Introducing Microfoundation. Romer (1990 JPE)

Romer (1990) explains how to construct an economy of
pro…ts-maximizing agents that endogenize technological progress.
The economy consists of three sectors:
1 A …nal good-producing sector
2 An intermediate good-producing sector: producing capital goods
3 A research sector
The research sector sells the exclusive right to produce a speci…c
capital good to an intermediate-good …rm. The intermediate-good
…rm, is monopolist, manufactures the capital good and sells it to the
…nal good sector which produces output.
Endogenous Growth and R&D Sector

The …nal-good sector is composed by a large number of perfectly

competitive …rms that combine labor and capital to produce the …nal
good, Y . There is more than one type of capital in the production
function, thus it is speci…ed as follows
N
Y = L1Y α
∑ xjα
j =1

where the capital goods xj , come from the intermediate

good-producing sector.
Inventions, or new ideas correspond to the creation of new capital
that can be used by the …nal-good sector to produce the …nal output.
Endogenous Growth and R&D Sector

The …nal-good sector

If A is the number of capital goods. Then N = A and the production
can be rewritten as
A
Y = L1Y α
∑ xjα
j =1

if the number of goods is continuos

Z A
Y = L1Y α
xjα dj
0

For simplicity we will use the second de…nition. Notice that, whether
we use a discrete number of goods or a continuos number, results
remain unchanged.
Endogenous Growth and R&D Sector

Final good price P is normalized to 1.

Firms in the …nal-good sector, choose labor and capital to maximize
pro…ts,
Z A Z A
max L1Y α
xjα dj wLY pj xj dj
f Y ,xJ g
L 0 0

where pj is the rental price for capital-goods and w the wage paid for
labor.
The FOCs imply:
Y
w = (1 α)
LY
pj = αL1Y α xjα 1
for each j

As usual prices of inputs equate their marginal product.

Endogenous Growth and R&D Sector
The intermediate good sector consists of monopolists who produce
the capital goods to sell to the …nal sector.
Firms gain their monopoly power by purchasing the design for a
speci…c capital good from the R&D sector. Because of patent
protection only one …rm manufactures each capital good.
Each …rm uses a very simple production function. One unit of raw
capital (purchased in the R&D sector) translates into one unit of
manufactured capital.
The pro…t maximization problem of the representative
intermediate-good …rm is

max pj (xj ) xj rxj

xj

where pj (xj ) is the demand function of the capital good,

corresponding to pj = αL1Y α xjα 1 and r is the interest rate, or the
rental rate of capital.
Endogenous Growth and R&D Sector

The FOC of the intermediate-good …rm is.

pj0 (xj ) xj + pj (xj ) r = 0

α2 L1Y α xjα 1 r = 0
| {z }
αp j

Imposing symmetry and solving for p

1 1
p= p 0 (x )x
r= r.
1+ α
p

which is the optimal price set in the intermediate-good sector.

Endogenous Growth and R&D Sector
Equilibrium and Aggregation
The total demand for capital from the intermediate good sector must
equal the total capital stock in the economy. Thus,
Z A
xj dj = K
0
Since the capital goods are each used in the same amount, x, the
previous equation can be used to determine x
K
x=
A
The …nal good production function can be rewritten as
Z A
Y = L1Y α
x α dj = L1Y α Ax α
0
K
substituting for x = A

Y = K α (ALY )1 α
Endogenous Growth and R&D Sector
In the Research Sector new design are discovered according to
Ȧ = δLAλ Aφ
When a design is discovered, the inventor receives a patent from the
Government for the exclusive right to produce the new capital good.
The patent last forever.
The inventor sells the patent to an intermediate good …rm and uses
the proceeds to consume and save.
What is the price of a new patent?
Anyone can bid for a patent. The potential bidder will be willing to
pay the discounted value of the pro…ts earned by an
intermediate-good …rm.
Let the discounted value of pro…ts earned by an intermediate-good
…rm be PA, where pro…ts are:
Y
π = α (1 α)
A
Endogenous Growth and R&D Sector
The research sector
How does PA change over time? Firms can put money (an amount
equivalent to the value of a patent, PA ), in a bank, earning the
interest rate r . Alternatively, they can purchase patent for one period,
manufacture capital, earn pro…ts and then sell the patent. In
equilibrium the return of these two alternatives must be the same.
Thus,
rPA = π + ṖA
Which gives
π Ṗ
r= + A
PA PA
Along the BGP r is constant and thus π and PA must grow at the
same rate, which is the population growth rate n (when λ = 1 and
φ = 0). Thus, along the BGP
π
PA =
r n
Endogenous Growth and R&D Sector

Share of population working in the R&D and good producing

sector
Once again we can use the arbitrage concept. It must be the case
that at the margin, individual are indi¤erent between working in the
…nal-good sector or the R&D sector.
We know that in the …nal-good sector
Y
wY = ( 1 α)
LY
in the R&D sector, real wages are equal to the marginal product of
labor δ̄, multiplied by the value of new ideas created, i.e. PA , thus

wR = δ̄PA
Endogenous Growth and R&D Sector
Because there is free entry in the two labor markets it must be that
wY = wR , then
Y δ̄π δ̄α (1 α) YA
(1 α) = δ̄PA = =
LY r n r n
then
1 δ̄α (1 α) Y (1 α) α δ̄
= =
LY r n A Y r nA
Ȧ δ̄L A
Rearranging and considering that Ȧ = δ̄LA =) A = A = gA along
the BGP, then
1 α gA
=
LY r n LA
LA αg A sR LA
LY = r n = 1 sR and sR = L is
1
sR = .
1 + rαgAn
Endogenous Growth and R&D Sector

OPTIMAL R&D. Is the share of population involved in R&D

sector optimal?
The answer is no. Why? The economy is characterized by three
distortions
1 The market does not endogenize the fact that new research may a¤ect
the productivity of future research. φ > 0, implies that productivity of
research increases with the stock of ideas. Researcher are not
compensated for their contribution toward improving the productivity
of future researcher. Thus, with φ > 0 the market provides too little
research and the fraction of population hired by R&S is too low. This
e¤ect is called spillover e¤ect or "standing on the shoulders e¤ect".
2 With λ < 1 research productivity is lower because of duplications.
Thus, too many people are hired by the research sector. This e¤ect is
called "stepping on toes e¤ect".
3 Consumer surplus e¤ect. The monopoly pro…ts are less than the
consumer surplus. This e¤ect tends to generate too little innovations.
Endogenous Growth and R&D Sector

OPTIMAL R&D
Classical economic theory: imperfect competition and monopoly are
bad for welfare and e¢ ciency because they generate a
deathweight-loss in the economy. This happens because prices are
higher than marginal costs. However, the literature on the economic
of ideas suggests that it is the possibility to make pro…ts, and thus to
set a markup over marginal costs, that incentives …rms, or the R&D
sector, to produce more ideas.
This means, that there is a trade-o¤ between short-run losses and
long-run gains.
Concluding. In deciding antitrust policies, the regulator has to
weight the deathweight losses against the incentive to innovate.