ECONOMIC GROWTH MODELS

_______________

A thesis

Presented to the

Faculty of

San Diego State University

_______________

In Partial Fulfillment

of the Requirements for the Degree

Master of Science

in

Applied Mathematics

_______________

by

Rosemary Nyambura Waithaka

Summer 2012
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Copyright © 2012
by
Rosemary Nyambura Waithaka
All Rights Reserved
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DEDICATION

This thesis is dedicated to my brother the late George Wachira Waithaka. Your love
and encouragement through my research process was priceless. You were always there to
support me and lift me up when I thought that I could not accomplish this. I hope that this
thesis makes you proud of me.
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ABSTRACT OF THE THESIS

Economic Growth Models

by
Rosemary Nyambura Waithaka
Master of Science in Applied Mathematics
San Diego State University, 2012

This thesis discusses the economic growth theory that Paul Romer introduced in his
classic paper Endogenous Technological Change. The main improvement that Romer makes
over the previous theory is to include an explicit model of the level of technology and how
this level changes due to the activities of a research sector. In addition the intensity of the
activity in the research sector is set endogenously in Romer’s model. This is achieved in a
simplified framework which makes everything in the economy analytically solvable in terms
of a few parameters describing the large scale economy. As background material, the thesis
also introduces and develops the neoclassical economic model. This then allows comparison
and contrast to pre-existing economic growth theories that set technological growth
exogenously to the model.
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TABLE OF CONTENTS

PAGE

ABSTRACT ...............................................................................................................................v
LIST OF TABLES .................................................................................................................. vii
LIST OF FIGURES ............................................................................................................... viii
ACKNOWLEDGEMENTS ..................................................................................................... ix
CHAPTER
1 INTRODUCTION .........................................................................................................1 
2 PRE-EXISTING ECONOMIC GROWTH MODELS ..................................................3 
2.1 The Solow Model...............................................................................................3 
2.2 The Neoclassical Model of Economic Growth ..................................................3 
2.2.1 The Life-Cycle Model of Saving and Consumption .................................6 
2.2.2 Consumer Utility Function .......................................................................7 
2.2.3 Properties of the Life-Cycle Model of Consumption .............................10 
3 ROMER’S THEORY ON ECONOMIC GROWTH ...................................................13 
4 COMPARISON BETWEEN NEOCLASSICAL AND ROMER’S MODEL.............20 
4.1 Differences Between the Two Models .............................................................20 
4.2 Similarities of the Models ................................................................................20 
5 CONCLUSION ............................................................................................................22 
REFERENCES ........................................................................................................................23
APPENDIX
A CODE USED FOR FIGURES AND EXAMPLES .....................................................24 
B TABLES OF SYMBOLS ............................................................................................29 
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LIST OF TABLES

PAGE

Table 2.1. This Table Shows the Total Net Wealth (Zi), the Consumption (Ci), the Net
Income (Yi), and the Savings (Si) Per Period of the Consumer Described in the
Example Above ............................................................................................................11 
Table B.1. This Table is a Legend of the Thesis .....................................................................30 
 viii

LIST OF FIGURES

PAGE

Figure 2.1. This is a graph of indifference curves for good 1 and 2 with the
consumers’ budget constraint. Only the combinations of good 1 and good 2
that fall below budget line EF are available to the consumer. .......................................7 
Figure 3.1. This is a flow chart showing the roles of each of the sectors in Romer’s
model. It illustrates the inputs that each sector utilizes. ..............................................14 
 ix

ACKNOWLEDGEMETS

I would like to thank Dr. Peter Salamon for helping me with this thesis project. I
would not have been able to complete it without his guidance and patience when things got
tough. Your quest for perfection always had me searching for new and better information to
improve my thesis.
I also greatly appreciate my mother, Dorcas Wanjiku, whose love and prayers have
kept me over the past year. My older brother, George was also a great source of strength and
encouragement before his passing.To my brother Paul ‘Shohi’ Waithaka, thank you for
giving me a place to stay as I completed my thesis and always being there to put a smile on
my face. I am also grateful to my sister Charity Njoki for always being in my corner cheering
me on. Finally to my boyfriend Robert Kimani, I will forever thank you for all the support
that you gave me during this process.
 1

CHAPTER 1

INTRODUCTION

Different economic models have been developed in order to explain how capital,
labor, consumption and investments grow with time within a given large scale economy.
These models try to understand the reasons behind a households’ or corporations’ choice to
either consume its income on the goods that they need or want now versus investing for
future use. The choices that these households and corporations make have a great effect on
the economy as described by the models found in Chapters 2 and 3. These models also show
how much a certain large scale economy will produce given the amount of capital and the
available work force.
How much an economy produces at the end of a time unit is referred to as the output
of the economy. Final output is given as a function of capital and labor force in both growth
models described here. The amount of capital available in the economy is dependent on how
willing the households are to invest, which depends on the amount of income that each
particular household receives and expect to earn in the future. A household’s decision to
invest depends also on the interest rate. All of the decisions made by the consumers in these
models have an effect on the whole economy since most inputs in an economy are
interdependent. Thus, economists have had to adjust their models to include or remove
certain inputs that would improve the existing model so as to be able to more accurately
forecast the behavior of the economy from one time step to the next.
Chapter 2 discusses the economic ideas that were in use before Romer’s theory on
technological change. This chapter deals with the Solow model which determines the effect
of each input on the growth of the economy. This thesis uses the neoclassical model in
conjunction with the life cycle model of consumption to model the decisions of a household
to either consume or save the income received.
Following the neoclassical model, Chapter 3 deals with the discussion of Romer’s
model described in his 1990 paper Endogenous Technological Change [3] which is viewed
as a major improvement on the neoclassical model. Although different, these two models
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share a lot of similarities. The main difference is in their discussion of the growth of
technology. Romer has technological growth endogenous to the model i.e. the growth of
technology is set within the model. On the other hand, the neoclassical model sets
technological change exogenously, that is the growth of technology is specified from outside
of the model. The neoclassical model views technology as a parameter that is useful in
making labor more efficient thereby increasing production.
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CHAPTER 2

PRE-EXISTING ECONOMIC GROWTH MODELS

Different economists have come up with theories that describe the behavior of a large
scale economy, for example a country, through time. They generate economic models using
various inputs such as the population present in the country, the labor force, the investment
rate, capital and consumption. This thesis will be looking at a brief summary of the Solow
model followed by an in depth study of the neoclassical growth model followed by a
discussion of Romers classic paper Endogenous Technological Change.

2.1 THE SOLOW MODEL

Robert Solow introduced a model of economic growth where he replaced the existing
production function with the Neo-classical production function. The major inputs of this
model include capital, population growth and technological change. His model allowed for
the substitution of the production factors rather than fixed ratios as initially required. The
production function that he introduced is characterized by diminishing returns to scale.
Technological change in this model is seen to increase productivity because an increase in
technology augments labor which increases output. Solow assumes that technological change
is exogenous to the model
In his model, Solow included a ‘sources of growth analysis’ [4] procedure meant to
determine how much of an effect each of his inputs had on the growth of the economy. This
model predicts that countries with high investment rates, low population growth rates and
low rates of depreciation are likely to have more output per worker. Moreover, all else being
equal, countries with a larger population are likely to have larger economies.

2.2 THE NEOCLASSICAL MODEL OF ECONOMIC

GROWTH
The neoclassical growth model involves the growth of labor L and capital K over
time. This model looks to find a combination of labor and capital in a productive process that
can be profitable to the owner of the capital. Some terms and definitions are necessary to
 4

understand the behavior of this model. The term National Product represents the value of the
aggregate output of the nation while the term National Income represents the total income
earned by the entire nation. The growth in the economy’s capital stock through the year is
referred to as the net investment while net savings refers to an increase in the net worth of the
households of the economy.
In addition to the terms above, the following assumptions are initially made about the
neoclassical growth model: first, technological improvements are nonexistent thus
technology is constant. Second, all consumer and capital goods that make up the national
product can be described by a single average production function. Third, all transactions of a
particular commodity take place at a given moment in time in a central location presided by a
specialist called an auctioneer. This auctioneer is given the task of doing all the necessary
research before setting either the rental rate for capital or the price for consumption goods.
The final assumption is that every worker is viewed as a business thus they face the
entrepreneur marginal productivity and production function.
The national product Y during year t is defined by the Cobb-Douglass production
function
Y BK L 2.1
where B is a scaling constant used to convert labor and capital into national product. This
equation displays constant returns to scale and diminishing returns to proportions as will be
evident in the output per capita equation. All the inputs must therefore be increased or
decreased proportionally in order to avoid this decreased returns to proportions; the
capital/labor ratio must be kept constant. Dividing the production function by N yields the
production per capita function y.This function implies that an increase in labor not followed
by an increase in capital stock will result in a decrease in output per capita which is defined
by the equation:
y BK L 2.2
The only way to increase output per worker consequently increasing the national
product is to increase the capital/labor ratio. This can be achieved by increasing the capital
stock, which grows through investments, at a faster rate than the human labor. The interest
rate of investment i , should therefore be higher than the rate at which the population grows
(n) from one time period to the next The particular level of investment needed to supply the
 5

new work-force with the same amount of capital stock as the pre-existing workers thus
maintaining the capital/labor ratio is referred to as capital widening and it is denoted i .
Capital deepening on the other hand refers to the level of investment that would result in an
increase in the capital/labor ratio.
Some of the properties of the neoclassical model are: capital stock per capita, output
per capita and consumption per capita all reach equilibrium even if the population continues
to grow. The increase in population causes a shift in the capital/labor ratio which can be
returned to its optimal ratio by supplying the new workforce with exactly the same amount of
capital stock as the people who are already working. Secondly, although all three of the
above reach equilibrium, aggregate national product, aggregate capital stock and aggregate
consumption grow at the same rate as the population. Third, the rate of growth of aggregate
national product may differ from population growth rate in the short run. Finally, a reduction
in consumption now will have no effect on the equilibrium growth rate of aggregate output.
In addition to these properties we follow the rules of demand for capital stock and output in
order to find the equilibrium values of the model.
The amount of capital available for employment at any given point in time is always
known but the rental rate is not. It is left to the auctioneer to adjust the rental rate for capital
stock until the quantity demanded is equal to the quantity supplied. The rental rate that
satisfies this requirement is referred to as the equilibrium price and all transactions will now
be made at this price. The equilibrium rental rate is very sensitive to both capital and
population growth. If there were an increase in the capital stock while the labor force stayed
constant, there would be a decrease in the rental rate for capital since capital is now more
readily available while a decrease in capital stock would result in an increase in the
equilibrium rental rate. If the capital stock were to remain the same while the labor force
grew, the equilibrium rental rate would increase making the labor force to use less capital
stock so that there would be enough to cater for the new work force.
In order to make the work force more efficient, technology is introduced into the
model exogenously. Technology grows at a rate of per year and serves to increase the
efficiency of labor just like population growth serves to increase the amount of labor. Now
all the variables of the model are interpreted as per effective labor units (L ) not just as units
of labor. The number of effective labor units grows at the rate 1 n 1 q 1 n
 6

q nq per year. This is referred to as the biological growth rate r and it is the equilibrium
growth rate. National product, investment and consumption are now all growing at the
equilibrium growth rate.

2.2.1 The Life-Cycle Model of Saving and

Consumption
The equilibrium growth rate depends on the rate of population growth and the rate of
technological change not on the saving rate. The savings rate directly affects the levels of
consumption and savings per capita. The savings rate is determined by consumption now
versus consumption later. Understanding the main influences on the saving behavior of the
individual households will help to understand the total flow of savings in the economy. One
of the methods that describe the savings decisions of the households is the life-cycle model
of individual saving which is based on the Fisherian model of saving. The life cycle model of
individual saving divides the life of the consumer into four periods depending on his income
(these time periods will be further explained later on in this section). His savings are treated
as a byproduct of his consumption while the Fisherian model of saving treats the savings
decision as a special case of the general problem of economic choice. The graph below
represents indifference curves showing different combinations of good one and two between
which the consumer is indifferent. The goal of the consumer is to achieve the highest
possible indifference curve within his budget. The slope of an indifference curve is the ratio
of the marginal utilities of the two goods. The absolute value of the slope of the indifference
curve is referred to as the marginal rate of substitution. It is the rate at which one good must
be increased while the complementary good is being reduced in consumption; it tells us how
much the consumer is willing to sacrifice one good in favor of another.
Figure 2.1, created by the use of Appendix A, illustrates indifference curves
u1, u2, u3, and u4 with EF representing the budget line. The consumer can choose a variety
of combinations of goods one and two as represented by the area boarded by the x-axis, y-
axis and the budget line. Suppose point A represents the combination of goods one and two
that the consumer had initially chosen. The budget line represents other combinations of
goods one and two that are available to the consumer; these combinations can fall on several
indifference curves. By trading along the line EF, the consumer gives up portions of good 1
in order to gain more of good 2. If he keeps doing this, he will arrive at point B where the
 7

Figure 2.1. This is a graph of indifference curves for good 1

and 2 with the consumers’ budget constraint. Only the
combinations of good 1 and good 2 that fall below budget
line EF are available to the consumer.

budget line acts as a tangent to the indifference curve u3, which is higher than the other two
indifference curves which the budget line intersects. Point B represents an equilibrium
combination of goods one and two for this consumer and lies on the highest indifference
curve that this particular consumer can achieve. This allows him to spend his money on
goods that he desires the most.

2.2.2 Consumer Utility Function

In the life cycle model, the consumers’ decision over what goods to spend his money
on can be represented by the utility function γ log c γ log c … γ log c , which
ranks every conceivable combinations of total consumption spending in each of the four time
periods mentioned before. Here c represents the total value of consumption in each period
and γ represents the weight the decision maker places on consumption in each time period.
If γ γ , then the consumer exhibits positive time preference. On the other hand,
consumers who have negative time preference, have a utility function where the coefficient
in period is smaller than the coefficient in period i t that is γ γ . If the consumer,
however, does not favor either one of the time preferences but chooses to consume uniformly
 8

throughout his life such that γ γ , then he exhibits zero time preference. It does not
matter which time preference that the consumer exhibits so for ease I shall use the zero time
preference and have γ γ 1.
Consider the consumption possibilities open to an individual at the start of the last
period of his life n . The individual has no more future earnings to borrow against and his
consumption has to be less than what he expects to earn in wages or non property income in
period n plus any financial assets from the past minus any debts accumulated over the other
time periods. He also does not leave anyone an inheritance so there is no need for him to
consume less than his total wealth. His consumption during the last period of his life will
therefore be represented by the equation:
c a w z 2.3
Where a is the consumers’ financial net worth at the start of period n , w is the non
property income that he will earn during period n and z is his total net wealth at the start
of period n . The financial net worth, a , at the start of n must be equal to the sum of the
financial net worth of the previous time period plus any additional savings acquired during
that time period times the interest rate:
a a s 1 r
a w c 1 r 2.4
By substituting the values of a we have:
c w a w c 1 r z
c w a w 1 r c 1 r
c c 1 r w a w 1 r / 1 r
c w
c a w z 2.5
1 r 1 r
z is the maximum amount that the individual can consume in period n 1 if there
were no consumption in the next period ( c 0) since it is his total wealth at the beginning
of this time period. Recall that he cannot spend more than the present value of his income
plus assets. This gives us the budget/wealth constraint faced by the consumer:
C C C W W W
c … z a w …
 9
I I
c w
2.6
1 r 1 r

The consumers’ main objective is to maximize the utility function subject to the budget
constraint above [1].

max ,
L log c log c … log c λ c … 2.7

The budget constraint in equation 2.7 [5] yields the following first order conditions:
1
λ 0
c
1 λ
0…
c 1 r
1 λ
0
c 1 r
This implies that
c c c
c … 2.8
1 r 1 r 1 r

We can now substitute all the terms in the budget constraint with c , that is:
C C C
c … z c c c … c
1 r 1 r 1 r
n i 1 c z
So now
1
c z 2.9
n i 1
The equation above implies that budgeted consumption for a particular time period is
proportional to the total wealth available at the beginning of that time period. The fraction

is the propensity to consume within a time period. The propensity to consume is

defined as the relationship between a given level of income and the expenditure on
consumption out of that same level of income.
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2.2.3 Properties of the Life-Cycle Model of

Consumption
Some of the properties of the life-cycle model of consumption can be illustrated by
using the example of the consumer who lives till the age of 80. His life-span can be divided
into four equal periods each representing a certain level of income. In his first period, he is
assumed to have no income and therefore he goes into debt in order to get an education and
provide for his basic needs. He then spends the next two periods of his life working but he
makes more money in the third period than he does in the second period of his life. He
spends the fourth period of his life living off the savings that he had accumulated during his
working years. This person’s consumption during the first period will be dependent on the
amount of money that he expects to earn during his working years. His consumption during
his working years will be dependent on the amount of money that he has to pay for the debts
incurred during the first period and the savings that he needs to maintain his standard of
living after retirement. Consumption is therefore taken as a function of wealth and age not
just income. Secondly, consumption is strictly proportional to total wealth. Thirdly, changes
in current income will have an effect not only on current consumption but future
consumption as well. Suppose the consumer had expected particular wages but experienced
lower levels of income during the course of his career (beginning of period 2). His
consumption for period two and three now has to be considerably lower than he had
anticipated because he spent too much in period one, which is money that he has to pay back
to the banks. Finally, a fall in the stock market accompanied by constant wages will cause a
drop in consumption resulting in an increase in the average propensity to save out of current
income.
Numerical Example [2]:
Suppose that a consumer expects to live all four periods of his life. In periods 2
and 3 he expects an income of $180,000 each with an interest rate of 50% per
period. Calculate his consumption in each period of his life:
c1 = 50,000, c2 = 75,000, c3 =112,500, c4 = 168,750
Table 2.1, generated by the code contained in Appendix B, shows the total net wealth
(Zi), the consumption (Ci), the net income (Yi) and the savings (Si) for the consumer in the
numerical example. As expected, his consumption increases one period after the next due to
an increase in expected net income in periods 2 and 3 of his life. In period 4, his consumption
 11

Table 2.1. This Table Shows the Total Net Wealth (Zi), the Consumption (Ci), the Net
Income (Yi), and the Savings (Si) Per Period of the Consumer Described in the Example
Above

PERIOD Zi Ci Yi Si
1 200,000 50,000 0 -50,000
2 225,000 75,000 155,000 80,000
3 225,000 112,500 195,000 82,500
4 168,750 168,750 56,250 -112,500

increases because he spends all his savings since he does not expect to leave an inheritance to
his children.
It now remains to merge the neoclassical economic growth model and the life cycle of
consumption and see how the economy approaches a steady state. The Cobb-Douglas
production function that we will use replaces labor with units of effective labor due to the
presence of technology. It is now
Y BK L 2.10
An economy is said to be in steady state if the wages and the labor force are each growing at
a constant rate of and n respectively. Moreover, the GNP, investment and consumption in
this model must also grow at a constant rate that is equal to the biological interest rate to
ensure that the economy is in a steady state. The investment/GNP ratio must also be constant
from one year to the next. In addition to the constant growth rate of the above parameters, to
ensure that the economy is at an equilibrium, all the capital investments must represent
capital widening not capital deepening. Suppose we have a country A that is currently at a
steady state, what would happen if there was a change in its capital/effective labor ratio?
If country A suffers through a war that causes it to lose10% of the population and
25% of the capital stock, the capital/effective labor ratio drops by about 15%. The auctioneer
also has to ensure that the demand for consumption and investment goods is equivalent to the
quantity supplied by the entrepreneurs. Since capital is now scarce relative to the labor force,
the auctioneer must drop the wages while increasing the rental rate for capital. The
auctioneer is able to manipulate the demand to the supply because he controls the rental rate
for capital stock for the next year. This rental rate determines the demand for capital stock for
 12

the next year thus it determines the demand for investments. For example if the auctioneer
keeps the rental rate constant form one year to the next then the only investment necessary
will be capital widening. If the rental rate is reduced, the demand for capital goods will
increase to allow capital deepening. Once the auctioneer has managed to reduce the wages
and increase the rental rate, country A will go through a period of savings allowing it to go
back to its original capital/effective labor unit ratio in a relatively short time. The rental rate
for capital stock also goes back to its equilibrium.
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CHAPTER 3

ROMER’S THEORY ON ECONOMIC GROWTH

In his paper, Romer based his model formulation on three propositions. The first
proposition is that technological change greatly influences economic growth because it leads
to increased output per hour worked. The second proposition is that technological changes
and advances are intentional. These advances are made in part due to market incentives. This
assumption makes the model endogenous rather than exogenous. The third proposition is that
instructions for working with raw materials are very different from other economic goods.
The costs of creating the instructions of a new design are only incurred once. These
instructions can then be used over and over again without incurring any new expenses.
The main inputs of this model include capital K which is measured in units of
consumption goods, labor services L in the form of skills provided by healthy individuals,
measured in counts of people, human capital H that is provided by people with a formal
education and measured in counts of people and finally the level of technology A measured
in number of designs. Human capital is divided into two: human capital devoted to
research HA and human capital devoted to final output HY and it is rented at the price
of per unit (this is the wage for human capital). Technology here is measured by a count
of the number of designs. This is because each new unit of knowledge leads to the design of
a new good.
The economic growth model presented in Romer’s paper comprises three sectors
which utilize one or more of the four inputs stated above. The research sector utilizes human
capital and existing knowledge to create new designs causing technological change. The
second sector uses the new found technology to produce the producer durables. The third
sector uses these producer durables, labor and human capital to produce the final outputs
which can either be consumed or saved as new capital. Figure 3.1 is a flowchart which
illustrates how each of these sectors uses the one or more of the inputs resulting in new
technology, producer durables and final output.
To make the model simple and easier to follow, Romer used the following
 14

Research Human capital + technology Technological

New designs
sector change

Second/Inter
Labor + technology Producer
mediate
sector Durables

Third/ Labor+ Human Capital

Production Final Output
Sector + Producer durables

Figure 3.1. This is a flow chart showing the roles of each of the sectors in Romer’s
model. It illustrates the inputs that each sector utilizes.
assumptions: The first assumption rules out varying population which leads to varying
amounts of labor available by making both the supply of labor and population constant. This
assumption also allows each person to participate as much as the next one all the while
providing the same amount of labor hour after hour. The second assumption is that the
amount of human capital present in the population is also fixed. The other assumptions that
he made do not deal with the main inputs of the model but with their outcomes. The first is
that capital goods are produced in a separate sector that has the same technology as the final
output sector. Another assumption is deals with the fungibility of capital; forgoing
consumption is the same as relocating the resources that have been achieved by the final
goods sector to the capital (research) sector.
Final output Y is expressed as a function of labor, human capital devoted to final
output and the capital which is measured in terms of distinct producer durables indexed by i.
If the total number of inputs used in the manufacture of producer durables is x x , there
is some value of knowledge A such that x 0 for all i A. The modified Cobb-Douglas
production function to represent the final output in this model is:

Y HY , L, x HY L x 3.1
 15

In this production function and the standardized Cobb-Douglass production function, total
capital K is proportional to the sum of all the different types of capital available. This implies
that all capital goods are perfect substitutes for each other. The production function above, on
the other hand, shows output as an additively separable function of all the different types of
capital goods available.
Equation (2.1) is homogenous of degree one which means that the production
function exhibits constant returns to scale. This implies that an increase in inputs is followed
by a proportional increase in output. Because of this, the final-goods sector described
previously can be viewed as a single price taking firm. The intermediate (second) sector,
however, cannot be defined as a single firm. It can be seen as distinct firms each of which
produces durable good for either sale or rental to a different firm. The only way that firm
can produce its producer durable is by first purchasing the design from the first sector. This
firm can then convert units of final output using into one unit of the durable good . If this
firm produces units of durable good , it can rent the th durable good out to the final-
goods sector at the rental rate which lies in the range ∞ . The durables that have
not been invented yet have an infinite price. Firm can also get a patent on the design for ,
making it an excludable good. Firm now faces a monopolistic demand-curve which will be
downward-sloping. The rental price for good will never drop; the only changes experienced
to its price will be due to its present value. The final goods sector will then set prices so that
it can maximize its profits.
For convenience, Romer makes a few assumptions on the production of the durable
good . The first is that only the firm that owns the patent for durable good gets to produce
it. In order to easily describe the equilibrium, he assumes that the research and development
department is treated as a separate firm that sells the design of good to a different firm
which manufactures the producer durable for rental purposes. The final assumption is that
the durable goods do not depreciate with time.
Since this model has more than one sector, total capital is defined as cumulative
forgone output. If C t denotes aggregate consumption at time , then capital with respect to
time will evolve according to the rule:
K t Y t C t 3.2
 16

Moreover, since it takes η units of forgone output to produce one unit of i, then total capital
can be defined as K η∑ x η ∑A x .
The growth of knowledge with time can be represented by the equation:
A δHA A 3.3

where δ is a growth parameter. This equation contains two functional and two substantive
assumptions. The latter assumptions include: dedicating more human capital to research leads
to the discovery of more designs and that the higher amount of knowledge there is in
existence, the higher the productivity of the individuals in the research sector will be. The
functional assumptions are that the output of designs is linear in each of HA and A when the
other is held constant. These assumptions make unbounded growth possible. This equation
encompassed with the idea that everyone can gain access to all the existing designs freely for
research purposes gives us a relationship between the rental price per unit of human capital
and the price of new designs PA: wH PA δA.
Once the research sector produces a new design, many different firms from the
intermediate sector bid for the rights to manufacture the producer durables. The aggregate
demand for these durables can be derived from a maximization problem conditional on them:

max HY L x i p i x i di

When this function is differentiated it results in the inverse demand function:

p i 1 α β HY L x i 3.4
This is the demand curve that each firm i will take in the manufacture of producer durable
good i. The firm will use this demand curve to set a profit maximizing price; given that
human capital, labor and interest rate r are constant. This firm will choose an optimal level of
output x that will maximize its revenue minus total costs:
π max p x x rηx

max 1 α β HY L x i rηx 3.5

From the equation it is clear that the rental income is p x x and the cost is the interest on
the ηx units of outputs needed to manufacture x producer durables.
This equation means that firm i will be a monopolistic firm with a constant marginal
cost and an elastic demand curve. This conclusion is consistent with the idea that the first
 17

sector sells the design for good i to only one company that offers the highest price. The rental
price set by the firm is therefore simply a markup over the marginal cost determined by the
elasticity of demand p rη⁄ 1 α β . The profit is π α β p x where x represents
the optimal level of output on demand curve (14) as implied by price p.
As stated previously, the first sector sells the design to the manufacturer with the
highest price. Since there exists a lot of competition among the manufacturers, the cost of the
design will be high enough such that it will be equal to the present value of the net revenue
that firm i will get from manufacturing at an optimal output . This implies that at every
date

e π τ dτ PA t 3.6

When this equation is differentiated with respect to time it results in

π t r t e π τ dτ 0

Substituting for PA gives us

π t r t PA
This equation tells us that the profit should only be just enough to cover the interest cost on
the initial investment in a design (intertemporal zero constraint).
Romer’s model on economic growth is very symmetrical. Due to this symmetry, all
durable goods are supplied at the same level x . If this were not the case, it would be possible
to increase profits in sector two by reducing the output of high output firms and reallocating
their capital to low output goods. Since A represents the number of durables that can be
manufactured and units of forgone consumption are required to manufacture one durable
good, we can solve for x from the equation K ηAx . Now output Y can be written as:

Y HY , L, x HY L x i di

HY L Ax
K
HY L A
ηA
HY A LA K η
HY L A K η 3.7
 18

As Romer drives towards a solution for balanced growth equilibrium, he does not
give consumption models much importance. He mentions the Ramsey consumer model that
implies a parallel relation between the growth rate of consumption and the marginal rate of
intertemporal substitution. This intertemporal condition implies that for a consumer faced
with fixed interest rate r, C⁄C r ρ /σ . These consumers are also faced with an
inelastic supply curve and fixed quantities of L and H. The Ramsey Consumer is represented
C
by: U C e dt, With the utility function U C for σ 0, ∞ .

Once Romer distinguishes all his inputs and the functions of all his sectors, he sets
out to find a balanced growth equilibrium for his model. This is done by showing that the
variables A, K and Y grow at the same exponential rates. If there exists a balanced growth
equilibrium then HA and HY remain constant as Y, K, C and A grow. Romer does not,
however, attempt to study what happens outside the balanced growth paths. He does not
explore how any of the parameters converge to the balanced growth ratio like Solow and
Uzawa do with their models [4].
The ratio of K to A should be constant making x constant as well. Due to the
accumulation of capital and number of designs, the wages paid to HY and productivity of
human capital will grow in proportion to A. Since the profit from any producer durable is
defined by the equation π α β p x then the present discounted value of this profit must
be equal to the price of the design such that:
1 α β α β
PA π px 1 α β HY L x i 3.8
r r r
When it comes to human capital, the wages paid to each sector must be the same. In
the final output sector, the wage for human capital is its marginal product. Human capital
receives all its income from the research sector therefore the wages are PA δA. To make the
wages equal in both sectors, choose HY H HA such that:
wH PA δA α HY L Ax 3.9
If we substitute PA from equation (18) into equation (19) and simplify, we find that:
1 α
HY r 3.10
δ 1 α β α β
For a fixed value of human capital allocated to research, HA H HY , the implied
exponential growth rate for A is δHA . From the properties of the model we know that x is
 19

constant if r is. We also know that output grows at the same rate as the number of designs if
labor, HY and x are constant. If x is fixed then K grows at the same rate as A since K ηAx.
Since K⁄Y is constant then C⁄Y must also be constant. The growth rate g of A, Y and K will
therefore be:
C Y K A
g δHA 3.11
C Y K A
If we use the constraint HY H HA instead of HA and substitute HY with equation (20) we
can define growth in terms of interest rate:
α
g δHA δH r 3.12
1 α β α β
This can simply be written as
g δHA δH Λr
Where:
α
Λ 3.13
1 α β α β
Since HA must be nonnegative and HY H then growth is also nonnegative.
To impose a relationship between growth and the interest rate, we combine equation
(21) and the growth of consumption i.e. g C ⁄C r ρ ⁄σ to find an expression for
growth in term of the fundamentals of the model,
δH Λρ
g 3.14
Λσ 1
This equation imposes certain restrictions: for the integral in the general consumer
preferences to be finite, the growth rate for the current utility 1 σ g . Therefore, for
σ 0 ,1 , 1 σ δH⁄ Λ 1 . If this inequality does not hold, the integral can be
infinite and the consumer model would have to include some overtaking criterion.
 20

CHAPTER 4

COMPARISON BETWEEN NEOCLASSICAL AND

ROMER’S MODEL

4.1 DIFFERENCES BETWEEN THE TWO MODELS

The main distinction between the two models is that Romer has technology
endogenous to the model while the neoclassical model introduces technology exogenously.
In Romer’s model, we have the source of technological change whereas the neoclassical
model does not provide one. The level of technology A in Romer’s paper is measured by
the number of designs that are created with the use of new and existing knowledge. This
technology is then applied to the production of producer durables. In the neoclassical model
however, technology is given a growth rate of q per year. Technology here serves to increase
the efficiency of labor therefore forcing the production function to use the units of effective
labor N rather than just units of labor N available in the economy. The new growth rate
of labor then changes from n to n q nq per year (the biological growth rate) all due to
the introduction of technology exogenously.
Population in the neoclassical model is expected to grow at 5% per year similar to the
growth rate that is experienced in reality. Romer however, assumes a constant population for
simplicity. The level of technology in Romer’s model is expected to grow exponentially and
at the same rate g as consumption and output whereas the neoclassical model gives
technology its own growth rate n since it is set independent of the model.

4.2 SIMILARITIES OF THE MODELS

Despite the differences mentioned above, these two models share some properties.
Both of their production functions display constant returns to scale and diminishing returns to
proportions. Diminishing returns to proportions means that all the inputs of production must
be increased or decreased proportionately to avoid a decrease in production. If one input is
increased while the others are held constant, then the average output per worker will
decrease. The equation that clearly explains this behavior for the neoclassical model is in
 21

section 2.1.2. It is easy to show that output per worker decreases in Romer’s production
function in the equations below:
Y HY L A K η
Y HY L A K η
HY HY
Y
Let y
HY

y HY L A K η
Since α 1
A K η
y 4.1
HY
Constant returns to scale implies that an increase in input is followed by a proportional
increase in output. It also means that both equations are homogenous of degree one.
The growth rate for the gross national product which is the output of the neoclassical
model and consumption growth rate are both equal to the biological interrest rate. This
property is also shared by Romer’s model; both consumption and output have the same
exponential growth rate g .
 22

CHAPTER 5

CONCLUSION

The neoclassical model for economic growth focuses on the capital/labor ratio so as
to explain what is going on in the economy. An increase in this ratio raises the output per
worker which raises the national output thus increasing the standard of living. One of the
ways to change this ratio in an economy that is not producing enough is through investment
into the economy such that the capital/labor ratio is increased; this is referred to as capital
deepening. Once the output has increased enough such that the optimal standard of living has
been reached, then the level of investment that is used to maintain the capital/labor ratio is
referred to as capital widening. Equilibrium in the neoclassical model involves a constant
capital/labor ratio and it is reached irrespective of a growing population. Technology in this
model is introduced exogenously. The effect of improved technology is to make labor more
effective and increase output.
Romer presents a growth model that is better than the ones that were previously in
existence simply because technology grows endogenously rather than exogenously. His
model is however primarily focused on the production aspect of the economy. He draws
attention to the importance of human capital to the growth of the economy by setting the
growth Equation (3.14) for the economy as being dependent on human capital. This implies
the same thing that Solow suggests: countries with larger populations are also likely to have
larger economies.
 23

REFERENCES

[1] W. H. BRANSON, Macroeconomic Theory and Policy, Harper and Row, New York City,
New York, 1972.
[2] M. H. MILLER AND C. W. UPTON, Macroeconomics: A Neoclassical Introduction,
University of Chicago Press, Chicago, Illinois, 1986.
[3] P. M. ROMER, Endogenous technological change, in The Problem of Development: A
Conference of the Institute for the Study of Free Enterprise Systems (Proc., 1990), vol.
98(5), pt. 2, of The Journal of Political Economy, Chicago, Illinois, 1990, pp. S71-S102.
[4] R. M. SOLOW, A Contribution to the theory of economic growth, Q. J. Econ., 70 (1), 1956,
pp. 65-94.
[5] P. VARAIYA, Lecture notes on optimization, Berkeley College of Engineering,
http://paleale.eecs.berkeley.edu/~varaiya/papers_ps.dir/NOO.pdf, accessed June 2012,
n.d.
 24

APPENDIX A

CODE USED FOR FIGURES AND EXAMPLES

 25

A.1 INDIFFERENCE CURVE CODE IN MAPLE

 26

A.2 NUMERIC EXAMPLE OF LIFE CYCLE MODEL OF

CONSUMPTION MATLAB CODE
close all;

clear all;

clc;

I2 = 180000

I3 = 180000

r = 1.5

consumption_model

n_3 = 4 % last period of his life

% i = 1

a_1 = 0 %financial net worth at the beginning of period 1

w_1 = 0 % non property income earned during this period

h_1 = (I2*((r)^-1))+(I3*((r)^-2)) %PV of all current and future non

property income

z_1 = h_1 %total net wealth at the beginning of period 1

c_1 = (1/((n_3)-1+1))* z_1 % consumption

y_1 = 0 % net income

s_1 = y_1 - c_1 %savings from period 1

% i = 2

a_2 = r*s_1 %financial net worth at the beginning of current period

in2 = a_2 - s_1 % interest accured on savings/debt from the previous

period

a_22= a_2 - in2

w_2 = I2 % non preperty income earned during this period

h_2 = (I2) + (I3*((r)^-1)) %PV of all current and future non property

income

z_2 = h_2 + a_2 %total net wealth at the beginning of this period
 27

c_2 = (1/((n_3)-2+1))* z_2 % consumption

y_2 = w_2 + in2 % net income= wages +income/loss from investments/debt

s_2 = y_2 - c_2 %savings from period

% i = 3

aa3 = s_2 - c_1 % use savings from period 2 to pay off all the debt

incurred in 1

a_3 = (r)*(aa3) %financial net worth at the beginning of current

period

in3 = a_3 - aa3 % interest accured on savings/debt from the previous

period

a_33=a_3 - in3

w_3 = I3 % non preperty income earned during this period

h_3 = (I3) %PV of all current and future non property income

z_3 = h_3 + a_3 %total net wealth at the beginning of this period

c_3 = (1/((n_3)-3+1))* z_3 % consumption

y_3 = w_3 + in3 % net income= wages +income/loss from investments/debt

s_3 = y_3 - c_3 %savings from period

% i = 4

aa4 = s_3 + aa3

a_4 = (r)*(aa4) %financial net worth at the beginning of current

period

in4 = a_4 - aa4 % interest accured on savings/debt from the previous

period

a_44= a_4 - in4

w_4 = 0 % non preperty income earned during this period

h_4 = 0 %PV of all current and future non property income

 28

z_4 = h_4 + a_4 %total net wealth at the beginning of this period

c_4 = (1/((n_3)-4+1))* z_4 % consumption

y_4 = w_4 + in4 % net income= wages +income/loss from investments/debt

s_4 = y_4 - c_4 %savings from period

C = c_1 + c_2 + c_3 + c_4

 29

APPENDIX B

TABLES OF SYMBOLS
 30

Table B.1. This Table is a Legend of the Thesis

SYMBOL REPRESENTATION

A Level of Technology

B Scaling constant in the neoclassical production function

H Human capital counted in number of educated people

HY Human capital devoted to output

HA Human capital devoted to research

K Capital

L Labor

η (ETA) Constant that converts forgone consumption into capital

WH Wages paid to human capital

Y Total output

y Output per capita

X(i) Inputs used in the manufacture of producer durables