Endogenous Growth theory: R&D

Tadele Ferede (PhD)

Department of Economics
Addis Ababa University
 1. Introduction
• The model without technological change predicts
that the economy will eventually converge to a
steady state with zero per capita income growth.
• No growth in the steady state
• The fundamental reason is the diminishing returns
to capital.
 Endogenous growth model
• Remember:
• Production function

• Where H refers to the stock of human capital

• CRS in K,H and L together

• Dynamics of K, H and L

• That sk and sh denote fraction of output devoted to physical and human capital, respectively.

• Assume a technological progress of the form:

 Beyond…

• Making use of the steady state conditions, we have:

sk k * h*   n  g  k *
sh k * h*    n  g  h*
• Star variables indicate steady state values.
• Solving for k and h and t taking logs, we have:
 Endogenous…

• Upon substitution into the production function:

• The determinant of income growth in the models we have

seen so far is the mystery variable effectiveness of labour
(A).
– This variable has been taken exogenous
• Note that these models do not address central question of
economic growth: sources of sustained economic growth.
• Here, we investigate sources of economic growth more
deeply.
 2. Research and Development models
• Technology as resulting from the research and
development (R&D) activities in an economy.
• Note that the driving force of growth is
accumulation of knowledge.
• Effectiveness of labour represents knowledge
accumulation or technology
• A natural extension of the exogenous growth
model is endogenize the effectiveness of labour (A)
• To do this, we introduce a special sector called R&D
sector.
 Research…
• Assumptions:
• A conventional production function in which labour,
capital and technology are combined to produce
improvements in technology.
• Devoting more resources to research yields more
discoveries, all else equal.
• The stock of knowledge (or technology) is denoted by A,
and A is non-rival and non-excludable.
• Both R&D and goods production are assumed to be
generalized Cobb-Douglas function
• The fraction of output saved, population growth rate, and
capital stock used in R&D as exogenous and constant.
 Research…
• The model
• The model involves four variables: L, K, A and Y.
• Two sectors:
– Goods-producing and R&D
• Note that a fraction aL of the labour force is used in
the R&D sector and 1-aL is used in the goods sector.
• Similarly, ak of capital stock is used in R&D sector
and the rest in the goods sector.
• Both sectors use the full stock of knowledge, A.
 Research…
• The production of new ideas depend on the quantities of labour
and capital engaged in research and on the level of technology:

• Under a generalized Cobb-Douglas production function, we

have:

• is a shift parameter.
• The production function of knowledge is not assumed to have
CR to labour and capital.
• CR is a replication one, i.e. if the inputs double, the new inputs
can do what the old inputs are doing , thereby doubling output.
 Research…
• In the case of knowledge, replicating what the
existing inputs were doing would cause the same
set of discoveries to be mad twice, thereby leaving
the growth of A unchanged.
• Thus it is possible that there can be diminishing
returns in R&D.
• But interaction among researchers, fixed set up
costs, etc may be important that doubling L and K
more than doubles output; increasing returns.
• No restriction on how the stock of knowledge affect
production of new knowledge.
 Research…
• If   1, A  is proportional to A.

• The effect is stronger if   1 and weaker other wise.

• As in the Solow model, saving rates are assumed to be
exogenous and constant.
• Ignoring depreciation, we have:

• Two stock variables K and A. We begin the model

without capital. To do so set     0
 The model without capital
• The dynamics of knowledge accumulation
• Without capital, the production function for output
becomes:

• Output per worker is proportional to A, implying

that the growth rate of output per worker equals
the growth rate of A.
• Similarly, the production function for knowledge
becomes:
 Research…
• The growth rate of A (gA)is given by:

• Since B and aL are constant, whether gA is rising, falling

or constant depends on
• The growth rate of gA is given by:

• This determines the subsequent behaviour of gA.

• Note that from the production function of knowledge,
gA is always positive.
 Research…
• Thus gA is:
• rising if is positive.
• falling if is negative, and
• constant if is zero.
• Hence, gA is constant when

• Regardless of the initial conditions, gA converges to g*A.

• On the balanced growth path, both A and Y/L grow at a
rate of g*A .
 Research…
• The long-run growth rate of output per worker is determined
endogenously-hence endogenous growth model.
• It is an increasing function of population growth rate. Does this
imply that countries with large population size grow faster?
• This seems to be at odds with the empirical regularity that the
growth rate of output per worker on average is not higher for
countries with faster population growth.
• Note that A denotes technology that can be used anywhere in
the world.
• Higher population is beneficial to the growth of worldwide
knowledge
• The larger the population is, the more people there are to
make new discoveries.
 Research…

• The fraction of labour force engaged in R&D doesn’t

affect the long-run growth rate.
• The increase in aL has only level effect but does not
have growth effect.
• Limited contribution of the additional knowledge to
the production of new knowledge.
 Research…
• This increase in the growth of knowledge is not
sustained.
 Research…

• This implies that is increasing in gA .

• The economy is experiencing ever increasing
growth rather than converging to a BGP.
•
 Research…
• Intuition:
• Knowledge is very useful in the production of new
knowledge,
• Each marginal increase in its level results in more new
knowledge that the growth rate of knew knowledge rises
faster.
• Once the accumulation of knowledge begins, the
economy embarks on ever increasing growth path.
• The impact of labour force engaged in R&D is now
dramatic.
• An increase aL causes an immediate increase in gA which
in turn increases
Research…
 Research…
• When n>0, gA is growing over time.
• When n=0 or if gamma is zero, gA is constant.
• In this case, knowledge is just enough in the production
new knowledge.
• The growth rates of knowledge and output per workers
are all equal to in this case.
• Hence, aL affects the long-run growth rate of the
economy.
• Note that since the output good is used for
consumption, thus 1-aL denotes resources devoted to
producing goods for current consumption.
 Research…
• Hence aL is a fraction of resources devoted to
producing knowledge that is useful for future
production.
• Hence aL is measure of society’s saving.
• Hence, the saving rate affects the long run growth
rate.
• Such models are known as linear growth models
 The AK Model

• The key property of this class of endogenous-

growth models is the absence of diminishing
returns to capital.
• The simplest version of a production function
without diminishing returns is the AK function:

• Where A is a positive constant that reflects the level

of the technology.
• Output per capita is:
 First…
• Recall the accumulation equation:

• Upon substitution, we have:

• Where we make use of the fact that

• Two constants: sA and (n+δ).
• The growth rate of k is the vertical distance
between these constants.
• Assume that sA>(n+δ)
– Perpetual growth of k occurs, even without technological
progress.
 First…
• Then we have:

• Since y=Ak, and , the model has no transitional

dynamics.
• All the per capita variables in the model always grow at the
same rate.
 First…
• Key predictions of the model
– Unlike the neoclassical model, a higher saving rate, s, leads to a
higher rate of long-run per capita growth.
– Changes in the rates of depreciation, δ, and population growth, n,
also have permanent effects on the per capita growth rate.
– Unlike the neoclassical model, the AK formulation does not predict
absolute or conditional convergence
• The speed of convergence is zero.
• The AK model delivers endogenous growth by avoiding
diminishing returns to capital in the long run.
• This particular production function also implies, that the
marginal and average products of capital are always constant
and, hence, that growth rates do not exhibit the convergence
property
 AK with physical and human capital
• Another major shortcoming of the baseline AK model is
that the share of capital accruing to national income is
equal to 1.
• One way of enriching the AK model is to include both
physical and human capital.
• Output is a Cobb-Douglas combination of capital
types

• There is a representative agent who wishes to

maximize the standard functional subject to the
adding up restriction:
 AK…
• Suppose that physical and human capital obey the
following laws of motion:

• where the shares of income going to gross

investment in each type of capital are denoted by sk
and sh, respectively.
• The Hamiltonian for this problem is:
 AK…
• FOCs:

• The shadow prices of each type of capital are

identical, and equal to the marginal utility of
consumption.
• The first order conditions with respect to physical
capital gives:
 AK…
• Upon substitution into the shadow prices to obtain:

• Similarly, the Euler equation for human capital:

• Returns on the two types of asset must be equal.

• Bringing the two equations, we have:

• One implication of this is that the expenditure

shares must be related by:
 AK…
• The Euler equation tells us the growth rate of
consumption is constant:

• Notice that this holds at all points on the optimal path

• The production technology can now be expressed as:

• The growth rate of output is thus:

• Implication: changes in the share of income going to

investment affect the growth rate.
• By continuously investing in human capital, growth can be
sustained.
 Beyond AK model: additional illustration
• Assumptions
• Production function

• Where H refers to the stock of human capital

• CRS in K,H and L together

• Dynamics of K, H and L

• that sk and sh denote fraction of output devoted to physical and human capital, respectively.

• Assume a technological progress of the form:

 Beyond…
• System dynamics
• Production function in per capita terms:

• Consider the evolution of k in the (h,k) space:

 Beyond…
• Notice that is zero when

• Solving for k, we have:

• Consider the relationship between k and h:

• The first derivative of k wrt h is positive (graph).
– increases in h
• But the second derivative of k wrt h is negative
since
 Beyond…
• Consider the evolution of k in the (h,k) space:
 Beyond…

• Similarly, consider h

• Note is zero when

• Or
• The first derivative of k wrt h is positive.
•
 Beyond…
• System dynamics
• Point E is globally stable (assume positive initial k and h).
• Whatever the economy’s initial position, it tends to E.
 Beyond…
• Implications:
• Once the economy reaches point E, it is on BGP.
• On BGP, k, h and y are all constant and growing at a
constant rate of g.
• Similar to the Solow-Swan model
• What about H, K and Y?
• What happens to the economy if sk increase?
• This change affects locus and it shifts up.
• On the old BGP, point E is on the locus which lies
below the new locus.
• Both k and h increase. How does h rise?
 Beyond…

• Effects of rising sk on the economy

 Beyond…

• Quantifying the impacts

• Making use of the steady state conditions, we have:

• Star variables indicate steady state values.

• Solving for k and h and t taking logs, we have:
 Beyond…

• Upon substitution into the production function:

• Overall: due to the assumption of diminishing marginal

return, rates of return are lower in rich than poor countries
• However, the model does not answer why capital does not
flow to poor countries.