Topic 1: R&D and Growth

3 R&D and Growth with both Variety Expansion

and Quality Improvements: Howitt (1999) Model

3.1 Introduction

• Scale effect: Larger population ⇒ More supply of potential

R&D workers and larger market ⇒ Faster technological progress
⇒ Faster growth.
• Jones (1995)’s model: (i) Fact: absence of scale effect. (ii) Model:
semi-endogenous growth.
• Young (1998)’s model without scale effect: An increase in the
reward to innovation resulting from a larger population will be
dissipated in the long run by the product proliferation it induces:
the larger economy will have to allocate a larger number of work-
ers to the innovation process in order to maintain a constant rate
of productivity growth because those workers must improve a
larger number of products. However, government policies such
as R&D subsidies do not affect long-run growth because prod-
uct proliferation will dissipate the increased reward to innovation
from a subsidy in the same way as it dissipates the increased re-
ward to innovation from a larger population.

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3.2 The Model

There are two kinds of innovation: horizontal and vertical innovation.

• Preferences: Constant rate of time preference r > 0,

Z∞ −rt
U = E0 0
e Ct dt.

• A. Production Relations
Qt
AitxαitdiX 1−α
Z
Yt = Ct + Nvt + Nht = 0
(1)

where Yt is gross output, Ct is consumption, Nvt is vertical R&D

expenditure, Nht is horizontal R&D expenditure, Qt is the mea-
sure (number) of intermediate goods, xit is the quantity of inter-
mediate good i, Ait is a productivity parameter attached to the
latest version of intermediate good i and X = 1 is fixed factor.
Each intermediate good is produced using labor, according to
produced using skilled labor L.

xit = Lit, (2)

where Lit is the input of labor in sector i. The labor market-

clearing condition is
Qt
xitdi = Lt = egLt ,
Z

0
(3)

where gL is the exogenous population growth rate.

Vertical innovations are targeted at specific intermediate prod-
ucts. Each vertical innovation creates an improved version of
the existing product, which allows the innovator to replace an
incumbent monopolist until the next innovation in that sector.
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 Each horizontal innovation allows the innovator to monopolize a
newly created intermediate product until the first vertical inno-
vation arrives.
The final good producer’s demand for intermediate good i is
given by
pit = αAitxα−1
it

where pit is the price of intermediate good i in units of final out-

put. Intermediate good producer i’s profit maximization implies
that the producer supplies the quantity
1/(α−1)
w
 
t
xit =  2
 , (4)
Aitα
and earns the flow f profits
πit = Aitα(1 − α)xαit , (5)
where wt is the wage rate.

• B. Innovations

1. Vertical
The Poisson arrival rate of vertical innovations in any sector is
φt = λnt , λ > 0, (6)
λ > 0 is the productivity of vertical R&D, and
nt = Nvt/(Qt Amax
t ) is the productivity-adjusted expenditure
on vertical R&D, with Amax t = max{Ait, i ∈ [0, Qt]}. A
vertical innovator’s profit maximization gives the arbitrage
equation
1 − β = λνt, (7)
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where β is the subsidy rate and νt = Vt /Amax
t (Vt is the value
of a vertical innovation). The value of a vertical innovation is
given by
Z ∞  Z τ 
Vt = 0
exp − t
(rs + φs)ds π̃tτ dτ, (8)
where rs is the instantaneous rate of interest at date s and π̃tτ
is the profit flow at date τ to any sector whose technology is of
vintage t.
2. Horizontal
The rate of new product innovation is
Ψ(Nht , Yt)
Q̇t = , (9)
Amax
t
where Ψ is a concave, constant-returns production function
with positive marginal products. The average product Q̇t/Nht
is a decreasing function of the fraction ht = Nht /Yt of GDP
allocated to horizontal R&D (also the fraction of labor force
engaged in horizontal R&D).
Each horizontal innovation results in a new intermediate
product whose productivity parameter is drawn randomly from
the distribution of existing intermediate products. As a result,
the expected value of a horizontal innovation is
 1/(1−α) 
Ait
E  Vt .
  

Amax
  

t

The arbitrage equation for a horizontal innovator is

 1/(1−α) 
Ait
1 − β = ψ 0(h)E  νt , (10)
  

Amax
  

t

where ψ(h) = Ψ(h, 1), with ψ 0 > 0 and ψ 00 < 0.

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 C. Spillover
It is assumed that Amax
t grows at a rate (σ/Qt) proportional
to the aggregate rate of vertical innovations.
max
Ȧt
gt = max = σλnt. (11)
At
Because the distribution of productivity parameters among new
products at any date is identical to the distribution across
existing products at any time, the distribution of relative
productivity parameters ait = Ait/Amaxt converges
monotonically to the invariant distribution

Pr{ait ≤ a} ≡ F (a) = a1/σ , 0 < a ≤ 1. (12)

In the long run,

 1/(1−α) 
Ait
E  = Γ−1, (13)
  

Amax
  

t

where Γ ≡ 1 + [σ/(1 − α)].

3.3 Steady-State Analysis

• In a steady state: Lt /Qt = l, Nvt/(Qt Amax

t ) = n and Nht /Yt =
h are all constant. From (11), we have

g = σλn. (G)

From (9), we have

gL = ψ(h)y, (Y)
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 where y = Yt/(Qt Amax
t ) is the productivity-adjusted level of
GDP per intermediate product. We also have
y = Γα−1lα (14)

ω ≡ wt /Amax
t = α2Γα−1 lα−1 (15)
α/(α−1)
g(τ −t)

max  ωe
π̃tτ = At α(1 − α)  
. (16)
α2


From (7), along with φ = λn, (14) and (16), we have the first
equilibrium condition:
λα(1 − α + σ)y
1−β = . (N)
r + λn + [α/(1 − α)]g
and from (7), (10) and (13), we have the second equilibrium
condition:

ψ 0(h) = Γλ. (H)

3.4 Properties of the Model

• The steady-state values of (n, y, g and h) are determined by (N),

(Y), (G) and (H).
• Equation (N): (i) Population growth does not create continual
scale effect. (ii) [α/(1 − α)]g appears because a successful in-
novator’s profits are subject to gradual “crowding out” by the
continual rise in wages at the steady state.
• Equation (G): The potential supply-side scale effect of a rising
number of R&D workers is nullified by the rise in the number of
products which reduces the spillover coefficient σ/Qt.
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 • Equation (H) (along with with equation(Y)): The growth rate
depends positively on population growth.
The system of equations can be reduced to two equations (V)
and (H) in the two R&D intensities (n, h).

Proposition 1: The steady-state growth rate g depends posi-

tively on β, gL, λ and σ and negatively on r.

3.4 Postwar Facts on R&D Inputs

• The input to R&D, as proxied by the number of scientists and

engineers engaged in R&D, has risen dramatically over the past
half century, with no visible tendency for growth in output per
person or in productivity to increase.
• The model predicts that the fraction (Nvt + Nht )/Yt = (n/y)+ h
should remain constant in the steady state.

3.5 Conclusions

• The Schumpeterian approach to growth theory can reconciled

with Jones’s evidence of the absence of scale effect.
• Population growth has a positive effect on growth, but it is not
the only determinant.
• Government policies can have long-run growth effects.

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